Free Trade and the US

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One of the characteristics of the anti-globalisation movement personified by US President Donald Trump is its apparent opposition to free trade. Free trade is not only associated with the globalisation agenda of the liberal elite but is also held responsible for the shipping of jobs and production overseas where cheaper labour and cheaper raw materials can be exploited, leaving at home nothing but crumbling factories and swathes of unemployed workers. Hence a considerable part of Trump’s “America First” programme appears to be devoted to distinctly anti-free trade measures, such as increased protectionism and tax penalties for firms relocating jobs overseas.

What should be the reaction of Austro-libertarians to this phenomenon? Do we not believe that free trade is almost the very essence of freedom and the fountain of prosperity? Should we not oppose any attempt to restrain trade by either tariffs or regulations? On the other hand, what are we to do when such policies are seemingly associated with nothing but destitution and misery for a significant proportion of the population?

For libertarians to simply repeat like a broken tape that trade should be left “free” runs the risk of considering only surface phenomena while failing to examine deeper, underlying problems. In the first place, of course, the association of the globalising movement with free trade is patently false. Those behind this movement are not in favour of genuine free trade; rather, they promote a heavily managed trade environment – one governed by trade agreements, trade deals, and a complex myriad of rules and regulations which favour only large corporations and the politically well connected. Indeed, trade agreements and trade deals are the antithesis of free trade, the latter of which demands a complete absence of the state from any involvement in trade. The terms “free trade agreements” and “free trade deals” are therefore nothing more than meaningless doublethink. A grave mistake that the anti-globalisation movement is likely to make is to confuse political globalisation – the consolidation of and intensified co-operation between states and state institutions, which is a relatively new phenomenon – with economic globalisation, which is private institutions trading peacefully and voluntarily on terms agreed by themselves, a situation which has existed for centuries. Political globalisation should be opposed bitterly while economic globalisation and the expansion of the international division of labour should be promoted. The bigger problem, however, is the fact that free trade today, if it is genuinely free, is carried out in a context where there is a gross, underlying violation of private property rights – in other words where the players who are demanding freedom are benefitting from the curtailment of other people’s freedom. For instance, banks are restrained from being “free” by heavy regulation and oversight because their lending activities have the tendency to blow up bubbles which lead to crippling busts. However, the reason for this tendency is that banks are, simultaneously, legally privileged (by the ability to hold only fractional reserves) and economically privileged (by being the first parties to receive new money that is freshly printed central bank – money which is itself, of course, subject to legal tender laws and of which the central bank is legally privileged as the sole issuer). It would be a travesty for Austro-libertarians to respond to any call for increased bank regulation by pointing out that such regulations are a violation of freedom. While this is true in and of itself, the real problem is clearly the state’s monopoly money and its dissemination through fractional reserve banking. To take another example, entities that are endowed by the state with a monopolistic or quasi-monopolistic privilege are normally able to charge higher prices to their customers and to pay lower prices to their suppliers. If, in response to the resulting “obscene” profits and high prices, the state proposes to regulate the prices of the entity’s products or tax away a significant portion of its profits, Austro-libertarians pointing out the pitfalls of price control and the injustice of taxation would be speaking the truth as far is goes. However, they would be ignoring the bigger, underlying problem which is the entity’s monopoly privilege, and that what is really needed is to rescind this privilege in order to open up the market to genuine competition. Only in this context is the freedom of firms to set prices both legitimate and economically beneficial.

When it comes to free trade, part of the underlying problem that is easy to ignore is that, of course, US workers are burdened by minimum wage laws and employment regulations which, to any employer, makes them relatively more expensive than workers overseas who may not be burdened by such interventions. However, the bigger “macro” problem is the fact that trade today takes place with the exchange of state-issued, paper currency which can be expanded at will, rather than with “sound” money such as gold or silver. The added complication in the case of the United States is that it is, currently, the issuer of the world’s reserve currency. What we will see is that, even without minimum wage laws and employment regulations, this would cause jobs to vanish overseas.

When the entire world is trading with “sound” money such as gold the prices of labour in the US and overseas depend upon the relative supply and demand for gold and for labour in each location. In which circumstances could labour be cheaper overseas? (By “cheaper” we mean that wages are lower per unit of production and not per hour. Wages in developed countries are higher per hour because labourers there can produce more in each hour on account of the relatively high amount of capital goods per worker – more tools, machines, factories and so on. Wages in poorer countries may be lower per hour because each worker can produce less per hour, but in equilibrium they would not be lower per unit of production). If labour is cheaper overseas then it means there is a relatively higher supply of money and a relatively lower supply of labour in the US while there is a relatively lower supply of money and a relatively higher supply of labour overseas. Employers therefore divert more of their funds to employing workers overseas in order to take advantage of the lower wages. This, however, is simply the correction of a disequilibrium which will reach its own natural limit. As money leaves the US then money there will become relatively scarcer while the amount of labour will remain the same and so US wages will fall; the new money flowing into countries overseas, on the other hand, will cause wages there to rise. At some point wages both at home and overseas will equalise. Of course, if the reverse happens – that wages are higher overseas than in the US – then the opposite process will occur, with money being drawn out of overseas countries and coming home to the US to bid up wage rates there. All of this is part of the natural process of economising behaviour which seeks to employ resources across the world by directing them to their most highly valued use. Absent any further state interference such as minimum wage laws and onerous employment regulations, all workers, both overseas and at home, will end up employed at the same wage rate (per unit of production).

What happens, however, when we are trading not with “sound” money, such as gold or silver, but, rather, with a paper money which can be issued by the state at will? If the domestic state chooses to expand the supply of money then this will cause an effect similar to that we just outlined. The supply of money at home will increase causing local prices – including wages – to rise. Prices overseas, however, will not yet have risen on account of the fact that the new money has not yet reached there. This process takes places through the complicating factor of the exchange rates between currencies, which is itself, of course, a price and is subject to the same influences. If the US prints more money but the overseas country does not then the first firms to spend the newly printed money on foreign currency will benefit from the old exchange rate and will be able to obtain more foreign currency than they otherwise would have which they can then use for purchasing goods and labour from abroad. Firms will therefore divert more of their spending to importing resources and seeking foreign labour than they would domestic labour. For the majority of countries such printing of currency can have only a very limited effect. If the inflation is a one shot affair then, eventually, increased bidding for foreign currency with the newly printed money will cause the exchange rate to adjust, strengthening foreign currencies and weakening the domestic currency. Fewer units of foreign currency can be bought with the additional supply of domestic currency and so the attractiveness of foreign goods and services diminishes, vanishing entirely when the currencies reach purchasing power parity. Currencies reach a state of purchasing power parity when the exchange rate between currencies and between goods is harmonious. For example, if an apple costs two South African Rands or one US Dollar, then in a state of purchasing power parity one US Dollar would equal two South African Rands. At this point there is no additional benefit from buying goods and services from abroad than there is from buying them at home. If, on the other hand, the inflation is continuous then such continuation comes to be expected. This expectation of inflation will in and of itself cause a much quicker adjustment to the exchange rate than previously, thus nullifying, or at least blunting, the benefits to the recipients of the newly printed money, robbing them of the power to ship jobs and the supply of resources overseas. The only thing that is experienced is domestic price rises. Of course, if the continuous inflation becomes abusive then it sows the seeds of hyperinflation as bigger and bigger doses of inflation are required in order to “cheat” inflationary expectations until the inflation reaches such a degree that such cheating is no longer possible and price rises even begin to exceed the rate of inflation. By this point, needless to say, a country has a lot more to worry about that jobs being shipped overseas. Thus what we can see is that with both “sound” money and independently issued, national paper monies mechanisms exist which prevent a permanent loss of jobs and the sourcing of supplies from overseas.

The situation is different, however, where the issuer of the paper currency happens to be the issuer of the world’s reserve currency. This is the dubiously privileged position in which the US and the US Dollar finds itself today. For when a country is the issuer of the world’s reserve currency the price adjustment mechanisms that we outlined above, which prevent the permanent loss of jobs overseas, are disrupted.

The US Dollar became the world’s reserve currency partly as a legacy of the Bretton Woods gold exchange standard, where the US pyramided the issue of US dollars on gold and the rest of the world pyramided its currencies on the US dollar. Today, however, the US dollar owes it reserve status largely to the petrodollar system – the agreement of oil exporting countries, led by their lynchpin, Saudi Arabia, to price and sell oil in US dollars – and the resulting domination of US based financial networks. The upshot of all of this is that in order the buy oil (which everybody needs) and in order to engage in international commerce pretty much everybody everywhere must buy and hold a significant quantity of US dollar reserves. And as the demand for oil has increased over the past forty years so too has the demand for the US dollar. Thus there has existed a continuously buoyant demand for the holding of US dollars which is sufficient to outstrip the increase in any supply of those US dollars. This buoyancy of demand is also maintained and strengthened by the fact that several countries, most notably China, unit recently pegged their currency to the dollar in order to fuel export driven growth. In other words, they deliberately weakened their own currency by printing more of it to buy dollars, thus pushing up dollar demand and increasing Renminbi supply. Even though China has used most of those dollars to purchase US treasury bonds, thus nullifying the increase in demand for US dollars, it would still be the case that their own currency would emerge weaker (which if, of course, the entire point of the peg). This leads us onto the next problem and one that is most relevant to the recent past – that the reserve currency becomes a “safe haven” asset. The US dollar index, which tracks the value of the dollar against a basket of other currencies, has risen since 2011, particularly as a result of crises in the Eurozone which has served to weaken the world’s second most dominant currency, the Euro. Indeed, against the US dollar, every single major currency is lower than it was five years ago. This is something that US dollar doomsayers are yet to understand. Yes, the dollar is being printed into oblivion, but so too is every other currency; the dollar just happens to be the least rotten apple in the cart.

The effects of all this are that when the Federal Reserve prints fresh, US dollars domestic prices will rise. However, because the dollar is able to maintain its strength on the world stage vis-à-vis other currencies, holders of US dollars find themselves in the continued position of being able to source goods and services cheaper from abroad than they can at home. Indeed, for several decades now the US dollar has effectively been able to buy more than it is really worth. People happily hand over goods and services in exchange for the medium with which they can trade oil and engage in international commerce. Because the US can simply buy what it needs by printing a currency which everyone wants, the result has been to turn it into a giant consumer economy rather than a producer economy – an economy which has no need for jobs. After all, why not just put all of those jobless people on welfare that can be paid for with printed dollars which will buy them Chinese goods? Indeed, in spite of the resilience of the American entrepreneurial spirit, the US is, today, a very difficult place in which to be a producer. According to a ranking by the World Bank, the US was as low as the 51st best place in which to start a business, a paltry 39th best place in which to deal with building permits, ranked only 36th for the ease of obtaining electricity, registering property and for taxes, and 35th for trading across borders. Yet, in full congruence with what we have explained here, the US was, apparently, the second best place in the world in which to obtain credit! Other rankings tell much the same story, with Forbes placing the US at 23rd overall on their list of best places to do business at the end of 2016 – not too bad, you might say, until you realise that is was ranked first just ten years ago.

Needless to say, much of the global monetary situation may now be changing, particularly with moves by China – itself a big consumer of oil – to compete with the petrodollar system and to establish alternative clearing institutions for international commerce that are not reliant upon the US dollar. What we can see from all this, however, is that, on the one hand, to blame free trade for the flight of US jobs overseas is clearly incorrect; yet it is foolish and naïve for Austro-libertarians to defend free trade on the surface when the underlying property rights are far from free. The lesson to be learnt, therefore, is that when confronting issues that threaten our freedom, Austro-libertarians should remember to examine them on the deepest possible level and not simply react to what they see in plain sight.


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The Nature and Origin of Rights, Part One

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There is nothing that highlights more the uphill struggle faced by libertarians than an old joke which is directed at the economics profession in general:

How many economists does it take to change a lightbulb? None – the market will take care of it.

Unlike our statist counterparts, as proponents of the free market we have no precise design for the solutions of particular issues and problems. We do not have an energy plan, a transport plan, a housing plan or a healthcare plan. Rather, we believe that freely acting individuals, endowed with private property rights, will find the solutions that utilise the scarce resources that we have in the most efficient way possible. Indeed, when asked the (almost tiresome) question “who will build the roads?” we don’t, strictly, know that a free market will produce any roads whatsoever. There may, in fact, be some better transport solution that compulsory government road funding prevents us from discovering. This is, in fact, the entire point of the free market – that there is no grand, overarching plan with particular solutions that are imposed upon everyone else from on high. Moreover, any kind of centralised plan or desire for the government control of goods and services has always presupposed the existence of industries and products, such as roads, that were invented by freely acting individuals.

This key aspect of the free market – a complete lack of centralised design of products, services and entire industries – is not limited to the substantive configuration of resources. Rather, as we shall attempt to argue at length in this two-part series of essays, it extends also to the very concepts and institutions that uphold a free market order – in particular, laws, rights, property, non-aggression. Part of the question we wish to explore here, then, is if we, today, had to the opportunity to sweep aside the entire mantra of statist oppression, would the institutions that we put in its place be subject to some kind of design by libertarians or would they also be subject to some kind of decentralised action by freely acting individuals? In other words, would we come along and say “this individual has rights”; “this object is property”; “this act is aggression”? More potently, however, we need to explore whether the nature and origin of concepts such as rights, property, aggression, and conflicts lend themselves to some kind of conscious design or whether they depend upon the behaviour of freely acting individuals in order for their true meaning to be realised. Once we have determined this we will be able to conclude whether it is only by recognising the dependence of these concepts upon freely acting individuals that a genuine libertarian society be built.

Some readers will recognise that we are following here a line of epistemological thinking propounded by F A Hayek, mostly in Law, Legislation and Liberty, as to the appropriate use of rationalism in understanding and framing societal institutions – i.e., is our rationality, our ability to reason and to act purposefully, better suited to constructing and designing social institutions, or rather, are these institutions instead the product of some kind of “spontaneous order”? If the answer is the latter then the focus of our rational endeavours should be to gain comprehension, insight and understanding into elements of human interaction that have already been built and not to recreate these elements anew.

Let us begin with some simple examples in order to illustrate what we mean by this. The first example we shall use is language. Any language that we speak is a complicated thing, with lots of different words and lots of different rules for using those words. However, language itself and the very vast majority of specific languages were not invented explicitly by anyone. Rather, they grew up through millennia as a result of individual people striving to communicate ideas to each other. The meanings of words but also the concepts of sentences and grammar also developed without any centralised plan and before anyone acknowledged consciously the precise forms and structures they were using. For example, if, years ago, one of the first humans said “I will throw this ball”, neither he nor his partners in dialogue would have known explicitly that he was using a subject, a verb and an object to create what we now call a sentence. If he elaborated and said “I will throw this red ball” he would not have known that he just inserted what we now call an adjective. Yet anyone he spoke to would have understood the ideas that he was trying to communicate in the sentence. Moreover, if he tried to say something like “ball thrown I red” those listening to him would probably recognise that he was talking utter nonsense – but they would not necessarily be able to say precisely why this sentence is wrong. Indeed, even the idea behind concepts such and nouns and verbs probably never even entered these people’s minds – in the same way that they do not explicitly enter the minds of the vast majority of people who communicate through language today. It was only after many centuries of languages being used and developed that linguists came along in order to study the phenomenon of language systematically and to develop the rules and concepts of grammar, writing and speech. Yet, crucially, the role of the linguist or grammarian was not to invent or design these rules, or to reconfigure language as a whole. Rather, his role was to gain insight and understanding into a process that already existed – to gain rational comprehension of a phenomenon that was of no single human’s construction. For example, an adjective is a particular concept that concerns the use of words in order to describe nouns. For example, a red ball; a tall boy; an old lady. By calling these words adjectives the linguist did not invent the concept of an adjective. Rather, the concept itself already existed as a phenomenon of human interaction for which the linguist only provided a label for us to identify it and distinguish it from other phenomena. Thus the label “adjective” aids the endeavour of gaining rational insight and understanding into the phenomenon of language and does not amount to the construction of anything that was not already there. If, on the other hand, linguists tried to reinvent these concepts or to attempt to apply them to other phenomena then we can see easily that we would run into all sorts of trouble. Let us imagine that a budding, pioneering linguist comes along with the aim to reinvent the rules of language, to undergo a reconstruction in order make it more coherent and, no doubt, more “rational”. After all, he is a scientist of the human race, a race that has managed to build everything from enormous craft that fly into space all the way down to tiny computers that fit into your hand. Surely he can master the design of something as simple as how we speak to one another? Let us say that he decrees that an adjective should describe not the noun in a sentence but, rather, the verb. So in the sentence “I will throw this red ball” this linguist would claim that the word “red” should actually describe the verb “throw” – so that the quality of throwing is, in some way, red. Or in the sentence “I will drink this hot coffee” the word “hot” describes the act of drinking rather than the condition of the coffee. Clearly such a reinvention would lead to utter nonsense and a complete breakdown of the purpose of language, which is the successful communication of an idea, i.e. making yourself understood by another party. The concepts that the linguist identifies, such as adjectives, are not open to his reconstruction – to him they are phenomena that already exist as a given, much like the fact that the sun rises and water flows down. The only difference is that the phenomena associated with language arose out of the interaction of many millions of human beings across centuries rather than straight out of the natural world. These concepts the linguist identifies describe a strand of reality that are already there for him to identify and to understand; any attempt by him to impose an alternative meaning or definition of these concepts results in something completely different from their original nature.

Whether or not alternative languages can, in fact, be designed, is beside the point. Languages have been designed explicitly, with Esperanto being the most notable, although any designed language has failed to gain any significant use. Our point here, however, is that existing languages are not the product of design or reinvention and that the concepts we use to identify and understand them are also not invented phenomena. Our attempt to engage in such a reinvention must necessarily result in something completely different from that which already exists.

In order to explore this further let us take another example of a social phenomenon such as prices. Indeed, prices are a classic example of a social institution that, unlike language, has been subject to a kind of constructivist reinvention. The phenomenon of prices appeared as a result of millions of private, bilateral transactions millennia before anyone actually stopped to determine what prices actually were and how individual prices are set at the levels they are. Just as the linguist used his capacity for rational analysis to determine the elements of language, so do did the economist approach the concept of prices with the desire to comprehend and gains insights into this reality, not to construct anything new (an endeavour which was only accomplished sufficiently after the realisation of the law of marginal utility). What was learnt was that a price is the exchange ratio between two goods that results from the competing valuations of those who supply a good versus those who demand it with another good (usually money). The specific price is set between the valuations of the marginal buyer and the marginal seller. The effect of a price at this level was that the willing supply and willing demand for a good were equalised.

What happens, however, when we deflect our rational thinking away from gaining comprehension of this phenomenon and embrace, instead, the desire to gain control of and “create” or (as economists usually say) “fix” prices? This false, constructivist approach looked only at surface level phenomena of prices that were manifest in the fact that the act of pricing was largely carried out by entities that were sellers of commodities and buyers of labour – in other words, businesses. This, aided by other confusions such as the paradox of value – the conundrum as to why a diamond costs more than water when the latter is infinitely more useful to mankind – led to the conclusion that prices were simply declared (as opposed to estimated) by sellers and/or were merely the arbitrary and capricious results of unrestrained greed. It would follow from these falsehoods that the price of a good could be manipulated at will or established by decree. Yet it is clear that this conception of prices has entirely different ramifications from the previous one that we outlined. With these new, constructed prices their ultimate influence is not the individual interactions of all of the millions of people attempting to fulfil their purposes but rather the preoccupations of those who decree them (i.e. the state), which are mainly political. Most of the famous cases of price fixing were designed to counteract the effects of rampant inflationism, such as the Emperor Diocletian’s fourth century Edict on Maximum Prices and President Nixon’s price and wage controls in the 1970s. The results of these prices too are markedly – even catastrophically – different. If the decreed price is too high relative to the price that would be set by supply and demand then an unsold surplus of the good would accumulate; if the price was too low then a chronic shortage would ensue. In both cases the quantity demanded and the quantity supplied are shifted out of balance, resulting in economic turmoil – as it was in the 1970s when Nixon’s price controls exacerbated the effects of the OAPEC oil embargo, leading to an acute shortage of gasoline (which, of course, promoted further government intervention in the form of selective government rationing, the 55mph speed limit and the moral degradation that occurs as a result of the destruction of the supplier/customer relationship).

Under both conceptions of prices – the un-designed and the designed – all of the surface phenomena of prices are constant. Price tags are still on the goods (if there are any goods) and money still changes hands. Yet it is clear that the difference between the two concepts is to encapsulate two entirely different strands of reality that each have vastly different origins and motivations, and vastly different consequences. In moving from the first conception to the latter, the concept of price has been changed from meaning the exchange ratio that results from the interaction of supply and demand to basically meaning the exchange ratio that is ordered by the state.

It is clear from this, therefore, that a concept, such and nouns, verbs, prices, which developed as a result of human interaction, cannot simply be changed at will or by agreement without entirely undermining its essence. Indeed with prices not even an explicit agreement amongst all of the consenting citizenry as to what a particular price should be would circumvent this fact because the resulting exchange ratio would still not accord with the reality that the concept of price tries to capture, which is the exchange ratio that results from supply and demand. What we can also begin to see is that any attempt to redesign or reconstruct these phenomena destroys their service for free, individual people and instead places them at the service of the state and is therefore antithetical to liberty. We can see this more clearly in a third example of this type of concept which is money itself. The phenomenon of money – the generally accepted medium exchange – appeared through millions of bilateral exchanges before anyone stopped to think about precisely what they were doing when they handed over, say, lumps of metal like gold or silver in exchange for stuff they could eat or use as shelter. Money was something created as a result of human interaction but nobody designed or invented money. The product of this was a medium of exchange that served reliably as a store of value, as a unit of account and as a major bulwark of sustainable economic progress. All of the monetary issues we experience today – the business cycle, inflation, and a grossly unstable financial system – stem from the attempt to recreate the concept of money as something that is created and enforced by the state, an endeavour that has not only resulted in the catastrophic effects we just outlined but also a tremendous loss of liberty as governments have been able to fund their bloated operations without resort to regular taxation.

Bearing all of this in mind, then, what is the nature of other sociological concepts which form the core of libertarian theory? These are concepts such as property, rights, obligations, laws, conflicts, and aggression. Are these phenomena which appeared gradually over many hundreds of years through social interaction? Or were they the explicitly designed product of, say, a wise and benevolent ruler who sought to create order out of chaos? We shall argue here that concepts such as rights and obligations are indeed of the same ilk as prices – they appeared over millennia as a result of millions of humans attempting to fulfil their individual purposes. The concepts were not the product of explicit, human construction; rather, they were a reality that already existed before anyone consciously thought of the matter. The purpose of our rationality is to reflect upon this reality, understand and comprehend what was occurring, and from this understanding fashion these concepts in order to explain and describe this reality. Any attempt to reconstruct them anew will, as we shall see, destroy their real value to the freely acting individual and instead place them in the service of the state.

Let us recall that the question of rights and property only arise because of conflicts that result from scarcity – the fact that two or more individuals cannot satisfy their ends owing to shortage of means. Rights and obligations over physical matter that is designated as “property” are the solution to these conflicts. In other words, rights and obligations only arose because individual, rationally acting beings, incurred a reciprocal recognition in a particular situation that physical means available were not sufficient to satisfy the ends of each, hence one had to yield and refrain from action and the other could act. The source of a conflict was the fact that one of the parties would have to suffer a loss of *value* – and end worse than the one he sought – if he had to yield to the other party, who, in turn, would have his value realised. These conflicts and their prescribed resolutions are endemic to the situation of humans as social animals. It is highly unlikely that two humans ever interacted without running into some kind of conflict over scarce means, particularly as primitive man suffered from the scarcity of the most basic of needs far more than we do today. Hence social rules are likely to be as old as humans themselves. These conflicts and their resolution through a system of rules began long before anyone actually explicitly enunciated that which was occurring. Indeed the words “rights”, “ownership” and what they were may not even have been known to anyone who sought them, in much as the same way as no one knew what a verb or a noun are until long after people actually began to communicate through language. Nobody at any point woke up one morning and said ‘Gosh, I believe it would be awfully nice if everyone had the right to private property!” as if it was an entirely new creation, nor did anyone ever explicitly “agree” the same thing. The earliest rules were probably acknowledged and understood tacitly with communication through body language. Later, as the earliest civilisations were born, customary legal systems developed through appeals by the conflicting parties for adjudication by a plurality. They made this appeal because, in the long run (and according to their own valuations), ad hoc conciliation is uncertain while resolution by violence is both uncertain and costly and dangerous. Indeed, we might say that although this process requires a degree of reflective ability of the plurality’s members, the legal rules and principles that crystallised depended upon a) their ability to address the situation that identified by the rational actors to which they need to be applied, b) the willingness of the parties to yield to them and thus avoid violence, and c) their ability to serve as a guide to behaviour in order to avoid similar incursions in the future. Crucially, there was no centralised force that had the authority to either decree or enforce the law, such authority, where it existed, resulting from usurpation. Rather, adjudicators had to earn and maintain their reputation in the knowledge that parties could seek justice elsewhere and that they – the adjudicators – might too, one day, be involved a conflict and stand to be judged. To this extent, therefore, the dispensation of impartial and principled justice resulted from self-interest. Indeed, we might say that the whole edifice of consistently and impartially applied legal rules existed solely because, in the long run, these things were the cheapest option for people to fulfil their ends. In other words, that agreeing to resolve conflicts peacefully through a system of rules was, in the long run, the best way for people to maximise their wellbeing. The result of this was, of course, the development of society – the peaceful co-operation between individuals seeking to fulfil their needs and better their lives.

Indeed, it is important to stress that a well ordered and functioning society was the product of customary social rules and was not their precursor – the peaceful resolution and avoidance of conflicts is what permits social co-operation, either primitively or under the division of labour, to flourish, and it only did so because people desired it. “Society” did not come first in order to fashion and enforce the law or to determine what conflicts were and where they existed and how everybody should behave. We are tempted to address this chicken and egg problem differently today because “society” precedes us and so we also think that it precedes our rights and obligations; we were born into an existing social order that seems to grant and impose these things on us from on high. It certainly true that latecomers to a social order, who, like us, were born in succeeding generations or were formerly outsiders, were likely to find themselves bound by previously enunciated rules. However, the origin of those rules was the perception of conflicts by individual, rationally acting people. So when, today, for example, we extrapolate from these past cases and say that a particular right applies to me and to everyone else in the world it is true that these rules and concepts predated anyone who is alive today so that it appears as though somebody else is either granting us these rights or enforcing these obligations upon us. But even today we can see that rights, obligations and conflicts must originate from the minds of the parties to the dispute that the legal rule seeks to solve. Strictly speaking when we say that “I have the right to private property” what I am really saying is that this right would be enjoyed by me in a hypothetical case where I enter a conflict over a particular good. But just as in the pre-historic cases that crystallised the concept of a right, this conflict would have to be perceived by me in order to be a breach of my rights. Someone taking my property is not theft unless I do not want them to take it; if I am perfectly fine with it then my right is not infringed (indeed, in a world where everyone helped themselves to each other’s stuff as they pleased and everyone had no problem with it no one would even know what a right to private property was). Rape is only rape because a woman (or a man, even) does not want to be penetrated; if he/she doe then it is sexual intercourse. One person injuring another is only assault because the latter does not wish the former to injure him; if the injury is the result of a consensual contact sport or an unusual sexual fetish then it isn’t. A person’s free speech is only infringed because he wants to speak. If, on the other hand, he is an uncontrollable blabbermouth who talks before he thinks then he may welcome the occasional physical restraint from speaking. In all of these cases where the physical act is consensual there is a harmony of interests – the scarce, physical matter available is directed an end that is sought by both parties and thus there is no conflict. The question of rights only arises, however, when the two parties are trying to direct physical matter towards different ends (and also, we might add, when the cost of resolving the matter in this manner is less than the cost to the plaintiff of fulfilling his ends with other means; if you steal from me a paperclip it is probably cheaper for me to buy a new one than it is to sue you for it; the history of fencing laws is illustrative of the changing economic dimension of rights and obligations). In short, because it is my right it is my choice to waive it when someone else’s goals with the same, physical matter are identical to mine.

Let us re-emphasise, therefore, that the nature of these concepts – rights, obligations, conflicts and so on – were revealed to us through rational reflection upon social interaction, and the distillation of common elements and their justification according to common principles uncovered – not created – the formulae that we libertarians cherish today, such as the individual’s right to private property.

Let us turn now to a different, constructivist conception of what rights and obligations may be – that is that these concepts were deliberately created or invoked by specific persons such as monarchs, leaders or intellectuals. It is clear that if the origin of a proposed right is not the resolution of a conflict arising from the competing valuations that exist in the minds of the parties, it must, rather, be something else. There are only two possibilities. First, a third party constructs a right according to what he hypothesises is a conflict between the parties over the property in question when there is in fact no such conflict. In other words, rather than being a party to a conflict himself, this third person looks upon the condition of other people and declares that they are in a conflict with each other that needs to be corrected with a system of rights. The second possibility, which is joined at the hip with the first, is that the conflict over property results from the valuations of a third party or of a group (such as intellectuals) who call for the construction of rights and obligations according to their own direction. In other words, these people want to distribute property rights according to what they want rather than what everybody else wants when everyone else may, in fact, be living in perfect accord with one another. In both cases the concept of a right has been changed from the resolution of a conflict over scarce, physical goods as perceived by the parties into being the resolution of a conflict over the same goods perceived by somebody else. Your rights and obligations are no longer determined by what you, as a freely acting individual want and value; rather they are defined by some other person. This is something that is markedly different, something that changes not only the definition of a right itself but also the definition of specific rights.

An exaggerated example of the first type of “right” – one that is simply imposed – is a right of each person to air. Intuitively, a right to air sounds more than plausible – after all, a person will live for barely minutes if he is not able to breathe. Surely, as some pioneering progressive might say, it is a travesty of justice that we do not all have a right to something as basic as air?! Under the state’s self-appointed mantle that it needs to ensure that we all have enough air to breathe, perhaps we can imagine exclusion zones round each other’s bodies which no one else may breach in case they breathe “your” air in the zone. Or, needless to say, we could imagine countless other ridiculous “solutions” to this non-problem. Rights to air do not exist, of course, because nobody (yet) conflicts over particles of air. The supply is more than sufficient to meet each person’s need without anyone ever coveting the air breathed by someone else. Hence rights and obligations in this scenario are superfluous and any invocation of them is an unwarranted affront to people’s perfectly peaceful behaviour. (The contrary case – that of taking away rights when they are, in fact, demanded, such as with rights to own animals that are members of an “endangered” species – is of the same ilk, but we need not deal with that here).

With the second type of constructed rights, let us take the right to private property which protects one against, say, theft. If, in order to “protect” my property, this right is no longer defined according to my valuation as to how I best want my property directed – i.e. my willingness to “exercise” my right – it must be defined by reference to something else. This can only be what the imposing party, or his intellectual advisers, regard as their valuation as to how the property is best directed. The resulting prohibited action is no way a vindication of my right to private property at all – if I am perfectly happy for my property to be taken in a particular incident and this is clearly evident then there is no discord between me and the alleged thief, nothing that the imposition of a right needs to solve. What has in fact been accomplished is the voiding of a transaction that the imposing party disapproves of according to his valuations at the expense of the valuations of me and the person who took my property. The critical element required for a generation of rights and obligations – a competing valuation over scarce, physical goods – is held by the imposing party, not by the constructed “rights” holder (i.e. me). Hence, the de facto right – i.e. the ability to have property directed to ends according to which one desires – is also held by the imposing party, not by the constructed rights holder, for it is really the imposing party’s valuation regarding this particular piece of property that is vindicated. Theft has now been constructively redefined from meaning a conflict between a property owner and a person who takes it, into a conflict between those two parties and the state. This is clearly anti-libertarian as it subsumes the desires of all of individual people and permits the imposing party to direct everyone else’s property to its desired end. The result is practically the same as the government simply outlawing certain types of voluntary trade, such as drugs or prostitution.

What we will proceed to explore in part two of this series of essays is precisely how this state of affairs – the movement from rights as a product of human interaction to being a product of explicit construction – came about and how devastating it can be to individual liberty.


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Fractional Reserve Banking – The Ethics and Economics

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

What is Fractional Reserve Banking?

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

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

Fractional Reserve Banking – Fraudulent or Legitimate?

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

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

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

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

Fractional Reserve Banking and Economic Instability

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

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

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

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

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

Conclusion

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

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

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

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

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

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

Economic Myths #5 – Banking is Capitalist

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By both mainstream economists and the general public alike the cycle of “boom and bust” is believed to be a tendency inherent in any capitalist economy. The fact that the latest such cycle, resulting in the seemingly endless stagnation that we are enduring now, originated in the banking sector and that large banks and bankers ratcheted up huge earnings and bonuses only to cause disaster has implicated banking to represent the very worst aspects of capitalism, motivated by uncontrollable greed that ends in destruction.

Unfortunately this popular view of the mainstream could not be further from truth. In fact with its intimate ties to government and its special, legal privileges it is hard to imagine a less capitalistic industry than banking. Part of the deception – wilfully inflamed by politicians and their lackeys – is one that engulfs other industries subject to government meddling such as energy; that simply because the participants in the industry are private individuals or entities and are not officially part of the government means that the enterprise must be classified as part of the free market and saddled with all of the supposed flaws of that system. Very often however private companies and brands are simply the public facing part of what is essentially a government operation or a government controlled cartel. Britain’s railways, for example, are owned by Network Rail, a statutory corporation with no shareholders; the train operations are parcelled out into geographic monopoly franchises that are awarded to private bodies by the government. The network is, therefore, under the de facto control of the government. And yet when you are stranded for two hours on a crowded platform because of delays whose logo is it you see everywhere at the station? Whose name is embossed proudly along the side of the train that you’ve been waiting for and who – and, by extension, which economic system – gets all of the blame for the problems? This is just as true in the banking sector as it is in the railways. Banking is nothing more than a government run cartel operated in front of the public by private bodies.

The supporting pillar of this government cartel is the central bank. Although this body is not always government owned it possesses a key legal privilege which is to be the sole producer of the nation’s money supply. Since 1971 (but in practice much earlier) all of this money in the world has been paper money, irredeemable and unbacked by any precious metal or market-chosen commodity. This is a very hefty privilege indeed for who wouldn’t want to have the legal ability to just print the very thing that can be exchanged for valuable goods and services? The central bank can manipulate interest rates (the most important prices in the economy) and control the volume of money either by changing the reserve requirements of the commercial banks or by making open market purchases (usually of government bonds but since 2008 pretty much any asset) with freshly printed cash. At the very bedrock of the banking system, therefore, is an institution that is blessed not by the voluntary purchases and exchanges of individuals but rather by the aegis of government. This institution would not exist in a genuine, capitalist economy as its powers rely not upon free exchange but upon government enforcement. Money would not be a centralised, government issued ticket on worthless paper nor would anyone have monopoly control over its production. Rather, money would be a commodity such as gold or silver. No one would be able to simply wave a wand and make gold appear in the way that central banks can make paper money appear, nor could anyone simply do the equivalent of no productive work in order to purchase valuable assets. Rather they, like anyone else, would have to earn their money through productivity that serves consumers. The volume of money in the economy would be regulated not by the central bank’s fiat but by the demand for freshly mined gold from the ground. Interest rates would be set by the demand for and supply of loanable funds and not by the arbitrary decree of monetary policy.

The reason why private banks appear to be the epitome of greed is that they are the channel through which the central bank’s deeds flow. They are the recipients of new money from open-market operations and of new loan-issuing powers when reserve requirements are altered. Credit expansion under the business cycle therefore affects the banking industry first and it is this industry that demonstrates the largest paper gains – all of those huge profits and hefty bonuses – and, consequently, the most catastrophic losses when the inflation stops. And yet the only method of making the fraudulent and destabilising fractional reserve system work, at least for a time, is the monopoly issuance of paper money by a central authority, robbing people of the ability to redeem notes that are over-issued and allowing the banks to inflate continually in concert. Furthermore, under this system banks are endowed with a special legal privilege in that they do not have to time their assets in line with their liabilities. When the disaster of “borrowing short” to “invest long” finally unravels who is that steps in to save the day? Why, the cartel-managing central bank of course, in its role as a lender of “last resort”, permitting the private banks to privatise their gains and socialise their losses. Once this fact – recognised in the US as the infamous Greenspan put – is understood by the private banks it will serve only to inflame risky and reckless business ventures. After all, why bother with prudence when you know that someone else will mop up the mess? None of this would be possible in a genuine, capitalist economy where each bank would have to suffer its losses and take full responsibility for its risky ventures.

This short description indicates that banking is woefully far from being a capitalist industry. Rather it is an industry that is well and truly in bed with government, relying on government for its profits, for the sustainability of its operations and for the absorption of its losses. “Private” banks they may be but a part of the free market? Absolutely not!

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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.

 

Capital – The Lifeblood of the Economy

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It is the gravest deficiency of mainstream economics that it fails to understand the necessity, role and structure of capital in the economy, a failure that permeates through to lay debates concerning production, income, wealth and redistribution. This essay will explain why this deficiency will lead to economic ruin unless its errors are comprehended and corrected.

Production

It is self-evident that everything desired by humans that is not the free gift of nature at the immediate point of consumption must, in some way, be worked for. By “worked for” we mean that the human consciously strives to devote means to bringing about an end that would not otherwise exist. The benefits of air, for example, must be “worked for” in the sense that the body has to contract the diaphragm to inhale. But to the extent that this is not a conscious process, that the human does not knowingly have to divert resources to meet this end means that air is, to all intents and purposes, a free good. Very few, if any, other goods meet this criteria and the environment of the first human that walked on the Earth was one of unrelenting scarcity, a complete and utter dearth of anything necessary, enjoyable or desirable for that human being’s existence.

An isolated human, therefore, has to work to produce his goods. The extent of his success determines his productivity or, to put it more starkly, his income. If, at the start of the day, he has nothing and he labours to produce three loaves of bread then by sunset we may say that his productivity, or his income, is three loaves of bread per day. Productivity does not rise proportionally with effort. It may be possible to achieve a high level of productivity with relatively little effort or, conversely, to waste ones efforts on boondoggles that turn out to be a complete failure. While it is generally true, therefore, that harder work will begat a greater level of productivity it is not necessarily true – humans must direct their efforts in the most appropriate way to enable the greatest productivity, not necessarily in the hardest way.

Let us take, then, the first human on Earth who has nothing except air to breathe and nature’s gift of his body which empowers him with the ability to labour. Let us say that, at this point, his wealth, his accumulated stock of produced goods, is zero. It will be the task of his existence to increase this level of wealth. How does and how should he go about this?1 Let us say that his first desire is to find firewood to burn and keep warm. So on the morning of day one of his existence he has no logs to burn and his wealth is zero. Off he goes on a brief expedition and, using only the body that nature has given him, he returns in the evening with three logs. His productivity, or his income for the day, is therefore three logs. We may also say that his wealth has increased from zero to three logs. However, he then makes the decision to burn all of the three logs to keep him warm for the night. His act of burning the logs is his consumption. He has used the three logs as consumer goods to directly yield him a satisfaction in his mind. However, with the arrival of morning, he is in exactly the same position that he was in on the previous morning – his stock of wealth is once again zero. So off he goes on another expedition and returns again, with three logs. Once again his income is three logs and his wealth has expanded by three logs. But again he burns them overnight, meaning that yet again his stock of wealth on day three is back to zero.

It is therefore the case that one’s stock of wealth is directly related to the amount of it that is consumed. The more of one’s produced product (income) that is consumed, the less overall wealth one has.

Let us say that, within a week, our human grows weary of collecting three logs every single day only to see them vanish again overnight. He wants to increase his wealth. What can he do? It should be self evident that the only thing he can do is to reduce his consumption; if, he wants to be wealthier at the start of tomorrow than he was at the start of today he needs to reduce his level of consumption by abstaining from burning one or more logs. Let us say that he decides to burn only two logs and sets aside one. The following morning, therefore, his wealth is now one log, whereas the previous morning it was zero logs. He is now wealthier today than he was twenty four hours ago, this increase of wealth being owed to the fact that our human he has engaged in an act of saving2. With his saved wealth he can do one of two things. The first possibility is that he can hoard it. If he hoards it then all this means is that, while his wealth will increase as his act of hoarding continues, the human’s consumption of the wealth that he is accumulating daily is merely delayed. This method of saving does not, in and of itself, permit wealth to grow and from this perspective serves little purpose. If all else is equal, he might as well burn the third log today and enjoy the extra warmth rather than leave it lying around for a future date3. However, the second thing that he can do is to take his saved logs and invest them. To invest means rather than consuming his wealth directly the human takes it and uses it as a tool of production of further goods. This must be the result of a transformation of the goods into such a tool. Let us say that the human saves enough logs to invest in the production of a wheelbarrow and that, for one week, he labours to construct the wheelbarrow. The finished wheelbarrow is now a capital good – a good used in the production of further goods. The aim, in this case, is for the wheelbarrow to be used to transport logs that will then, in turn, be burnt as firewood. Let us say that with the aid of the completed wheelbarrow he is now able to bring home six logs per day rather than the initial three. By aid of the capital good he is therefore able to increase his production of other goods. His wealth therefore increases by more than it would have done so without the aid of the capital good.

What, therefore, are the inherent qualities of this act of saving and investment? What, in particular, will induce the human to engage in it? There are several aspects to note:

  • It requires abstinence from direct consumption of the good that will be transformed into a capital good;
  • The abstinence is for a period of time, that is the time taken to transform the goods into capital goods that yield further goods for consumption;
  • In order to justify the period of abstinence, the yield of goods from the capital goods must be higher than it would have been without the capital good.

This final point is of crucial importance. For what will determine the human’s propensity to save/invest on the one hand and his propensity to consume now on the other? The answer will be his willingness to trade the period of waiting in which the capital good will be constructed against the increased quantity of goods that will result. He will start to save at a point when the increased quantity of goods yielded is more valuable to him than the utility gained from direct consumption now of the capital good. He will stop saving when consuming now will yield him more utility than waiting for an increased quantity of goods in the future. This propensity to wait is called his time preference. If time is relatively more valuable to him than an increased quantity of goods then he has a high time preference. If the increased quantity of goods is relatively more valuable than the waiting time then he has a low time preference.

Increasing Capital – the Structure of Production

The consequences of the increased yield of consumer goods – in this, case, from three logs per day to six logs per day – and the resulting increase in wealth means that our human yet again has to face the same choice as he did with his original stock of wealth – to consume or save (hoard/invest). Only now, however, he has to make this choice with an increased quantity of goods. What will be the possibilities?

  • He could choose to consume and save at the same rate as he did previously, that is one saved log per two consumed. Out of a total of six logs he will, therefore save two logs per day and consume four;
  • He could choose to consume at an increased rate and save at a reduced rate. One day of doing this would be to save the same quantity of logs as he was before (one) and consume the remainder (five); however, he could also increase the quantity he saves while decreasing the rate, for example by saving one and a half logs and consuming four and a half.
  • He could choose to save at an increased rate and consume at a reduced rate, for example by consuming the same quantity of logs as he did before (two) and saving the remainder (four); however, he could also increase the quantity he consumes while decreasing the rate, for example by consuming three logs and saving three.

The precise consequences of each choice are unimportant, merely that each will occur at a different rate depending on what is chosen. It should be self-evident that more saving will begat more capital goods and more consumption but only after the period of waiting; more consumption will mean more goods can be enjoyed today at the expense of relatively fewer in the future. But in practice, we might add, it tends to be the case that the wealthier a person becomes the more he tends to follow the third scenario, specifically by increasing the quantity he consumes while decreasing the rate. The rich, for example, consume a much greater quantity of goods than poorer people do but as a proportion of their wealth they consume less. This will have important consequences as we shall see when we consider the effects of taxation and redistribution below.

However, let us assume that, whatever choice the human makes, there will be a rate of saving that permits investment to continue. What will happen now?

As the level of production is now dependent upon a capital good, the rate of saving must, at the very least be able to maintain this capital good. Capital goods are not consumed directly but they are consumed in the process of production through wearing down. While no new wheelbarrow will need to be produced, of course, a level of saving that permits its parts to be repaired or replaced will be necessary. If the human is not able to maintain his capital goods what happens? It means that he is using it for the purposes of production the results of which are consumed to the detriment of repairing and replacing the capital stock; in short he is engaging in capital consumption. It should be self evident that if the capital is lost, production must decline and so too will the standard of living. The dangers of capital consumption will become clearer when we discuss it below4.

However, let us assume that our lone human is able to maintain the existing capital stock and also has enough further saving that does not need to be used for this purpose. What will happen? He will, of course, invest in further capital goods to increase his production of consumer goods. Let us say that, satisfied with the utility gained from and his ability to maintain his wheelbarrow, he decides instead to invest his logs in the production of tools. Let us say that he fashions from a log directly an axe handle. But the axe head cannot be made out of wood. He must acquire and fashion metal in order to complete the axe. Aren’t the saved logs useless for this purpose? Not at all; for while the saved logs cannot be used directly in the production of the axe head, they can be used indirectly in order to sustain our human during the production of the axe head. In short, let’s say he goes on an expedition far from home in order to acquire the material to fashion the axe head. He takes the saved logs with him and burns them at night to keep him warm. To the extent that the venture is successful and he returns from the expedition with the material to fashion the axe head, then the consumption of the logs has been compensated by the acquisition of the axe head. The axe head can then be used to fell entire branches or even trees which can then be transported in the wheelbarrow for our human to consume. Let us say that, once again, his output doubles as a result of the introduction of the axe, meaning that he now takes home twelve logs each day.

What does this addition of another capital good – the axe – demonstrate? In the first place, it once again demonstrates the requirement of waiting during the production of the additional capital good, waiting that must be sufficiently offset (in the valuations of the human) by the resulting increased level of production. But there are two more crucial aspects:

  • That, in terms of providing for the human’s needs, it is relatively less important to stress the amount of capital he possesses as compared to its precise structure. The new capital structure is intricately woven and the stages are dependent upon each other. For example, if he had two axes and no wheelbarrow, he could fell a lot of trees but would lack the means to transport them. If he had two wheelbarrows and no trees then he could transport a lot of logs but he wouldn’t be able to fell enough trees to fill and use two wheelbarrows. As we can see therefore, capital growth manifests itself as increasing the stages of an intricate production structure through the passage of time. Any interference with the precise structure of capital would be as detrimental as capital consumption; in the complex economy a corollary would be all of the world’s factories, tools and machines, consisting only of tractors. It would not be hard to see that, in spite of the overall level of capital being very high, the specific glut of tractors and corresponding shortage of absolutely anything else would lead to a very severe degree of impoverishment;
  • That the logs used in discovery and fashioning of the axe head, by not being used directly as a capital goods, were used as a fund to produce a capital good. The majority of capital investment is, in fact, the use of a fund of saved products that are consumed in the production of other products and these latter products are the capital goods. In the complex economy we can see how wages, for instance, which are consumed by workers are paid out of saved funds in return for their production of goods which are either sold or used as capital goods (or both if the buyer uses them as capital goods), just in the same way that the logs were consumed in production of the axe head.

This method of saving and investment in capital goods is frequently termed in “Austrian” literature as “roundabout” methods of production; that an increase in capital leads to a longer production structure with multiple stages (in our case hacking of logs off the trees with tools, collection of logs in the wheel barrow, followed by consumption). However a more appropriate description would be that increased saving and investment in capital goods results in a process of production that takes more time for a greater quantity of produced products.

Further Increases in the Structure of Production – The Source of Wealth

This outline of a simple economy consisting of our lone human and two stages of production should illustrate how that human can further increase his wealth. Assuming he continues to save at a rate above that which permits him to maintain the existing capital goods (the wheelbarrow and the axe) he can continue to expand the stages of production of logs or begin to invest in the lower stages of production of other goods. He might, for example, use one log to build a fishing net to catch fish, thus increasing his quantity of fish to add to his wealth. He then might be able to use quantity of saved fish and saved logs to sustain him in building a boat which permit him to catch and even greater quantity of fish. It is this process of capital accumulation, its maintenance and its regulation into a particular structure that is the cause of the increase of wealth. Relatively speaking, the more capital that our human has, the more tools, equipment, machines, etc. that he fashions by abstaining from the consumption of the goods that make them (and by waiting for them to be completed), the wealthier he is.

It should not be difficult to abstract from this simple illustration the workings of a complex economy. The only substantial differences are the existence of the division of labour and the resulting necessity of trade which serve as the most complicating factor in trying to visualise the complex, growing economy. For in such an economy people, on the whole, do not produce goods for their own consumption but rather they concentrate on the production of a specific good (or service) which they then trade in return for other goods. The other goods, of course, are never traded directly but with the aid of a medium of exchange, money, so that you sell the goods that you produce for money and then take money to buy the goods and services that you want to consume5. Each and every single day, then, any person who goes to work engages in production of a produced product. If you are a baker you produce bread, if you are a butcher you produce meat, if you are a fishmonger you produce fish. But no one butcher, baker or fishmonger directly consumes his own product, rather he trades it for money which he then uses to buy the goods he wants. So the baker, for example, may sell bread to the fishmonger who will pay for it with money. The baker may then use the money he receives to buy meat from the butcher. From the point of view of the economy as a whole, the situation is no different from that of the economy with the lone individual. We will remember that, in the latter situation, if our loner produced three logs per day and burnt (consumed) three logs per day then on the morning of the following day he is in exactly in the same position regarding his personal wealth as he was the previous morning. If, in our complex economy, the butcher, baker and fishmonger produce, respectively, on one day three cuts of meat, three loaves of bread and three fish, then if after trade these are all consumed by somebody at the end of the day, then tomorrow the economy as whole will be in exactly the same position as it was at the start of the previous day. If, however, some of these products are saved then tomorrow the economy as a whole will be wealthier than it was at the start of the previous day6.

Saving and investment in the complex economy will not, of course, take place in the form of hoarding the physical products like it did in the simple economy. Rather, let’s say that that the baker sells three loaves of bread to the butcher and receives in exchange for them money. His saving takes place in the form of saving money rather than goods directly. His investment will come in the form of spending this money on goods that are used for investment – i.e. are transformed into capital goods – rather than for consumption. For example, let’s say that he takes his saved money (we shall call it £100) and buys fish from the fishmonger. In exactly the same way as the logs sustained the lone human in constructing the axe head, the fish provide sustenance for the baker while he increases his capital at his bakery – let’s say he invests in a new oven. The fish, therefore, provided a fund which was used to construct a new capital good, the oven which will produce more consumer goods. In his own mind, however, the baker will not reckon in terms of fish, ovens, or the extra amount of bread that is produced as a result of the oven’s construction. Rather, he will say that he has an investment of £100, an investment whose return will be measured not by the physical quantity of extra bread produced but by the increased money he will receive from being able to sell the extra bread. It is this extra money that, in his own mind, compensates him for the waiting time in constructing the capital good. If we say, for example, that he invested his £100 at the start of the year and by the end of the year his sales had increased by £10 then we may that the return is 10% per year. This return is known as interest, the compensation for the waiting time between the point of saving and the point that the increased quantity of consumer goods is available for consumption (and in this case, when the baker has the money from the increased sales).

Another possibility is that rather than expanding his existing business the baker creates a new one; or he could lend the saved funds to somebody else to invest in their business. Let’s say that he lends the money to a new entrepreneur, the candlestick maker. The candlestick maker has himself also saved £100. for his new business and so, together with his own saving and the money lent to him by the baker, he has a total investment in his firm of £2007. The candlestick maker will then take that money and spend it on the fish (or other goods) that will sustain him in producing the capital goods needed for his new candlestick business. Let us say that this business is successful and, at the end of the year, the resulting sales means that the value of the business has increased from the initial £200 to £220 – the original £200 capital and £20 return on that capital as a result of increased sales. This £20 will be divided between the baker and the candlestick maker depending on the terms of their investment, but overall the firm has received interest of 10% per annum.

We have, of course, left out of this simplistic calculation the fact of depreciation – the wearing down of the capital goods during their use in production. Suffice it to say here that at the end of the year the original amount of saving reckoned in money terms will be less than £200 owing to the depreciation of the capital goods in the venture. More on this can be read here].

Another aspect we have deliberately ignored is entrepreneurial profit and loss. The rate of return that any one person needs to receive to induce him to save and invest is the interest return – the compensation for waiting. We have assumed in all of the illustrations above that any saving and investment will for sure result in the return that is expected. But this is never the case in real life – the actual return may be greater than, less than, or equal to what was expected. In all cases, then, the actual return will consist of:

Interest + Profit/Loss8

Going back to our original lone human, he may find that his wheelbarrow actually is only enough to bring him an extra two logs per day whereas he originally wanted three. His return will therefore consist of an interest return of three logs and a profit/loss of negative one log. Or, he may be delightfully surprised to find that his wheelbarrow is enough to bring in four logs per day in which case he will earn interest of three logs and profit/loss of one log. Or, the most disastrous of all outcomes would be that he finds the wheelbarrow is a complete hindrance and, in fact, means that he is able to harvest fewer logs than he was with his bare hands! Let’s say he can only bring home two. In that what is earned is interest of three logs and profit and loss of negative four logs. The real loss that he experiences is much higher than the nominal loss of logs – four and one respectively – as, at the time he decided to save and invest, he needed a return of three logs to justify the waiting time. Although he only appears to lose one log by erroneous construction of the wheelbarrow his actual loss is much greater because of the waiting time he endured. In our complex economy, profit and loss takes the form of having to anticipate that other people will want to purchase the additional produce that is enabled by the capital good. If the actual selling price of the final goods is more than what was needed to induce an entrepreneur to save and invest then this represents an entrepreneurial profit. If it is less than he suffers an entrepreneurial loss9.

It is not necessary for the reader to dwell too much on the intricacies of profit and loss in order to understand the role of capital in increasing wealth. An elaboration is offered here merely for the sake of a degree of completion. Interest, however, is vital in understanding the role of capital. It must be emphasised again that people will begin to save and invest in capital goods when the resulting outlay of consumer goods is higher than what could be produced without the capital goods, and this outlay must be sufficient to compensate for the waiting time in which the capital goods are constructed. In short, people must make a choice between having fewer goods to consume today or more goods to consume at a future date. The number of additional goods that a person wants to appear at the future date to induce saving is his interest return. Whether this return actually appears or not and to what degree determines his profit and loss. But it is this desire to consume more in the future, to abstain from consumption today for a lot more of it tomorrow, that enables the economy to grow and for wealth to expand. There is no other way than by saving and investment in capital goods.

In the complex economy, of course, everyone can be savers and investors and we do so in a multitude of different ways and through different channels. Anyone who earns a wage and then spends a portion of it on his monthly outgoings (i.e. consumption) and uses the remainder to, say, deposit in a savings account, or to buy bonds or shares is investing in capital goods and increasing the capital stock of the economy. If it is saved in a savings account, the bank will lend that money to companies who will use it to invest in the capital goods, the return on which will enable the bank to pay interest to the depositor. If stocks or bonds are bought then money is advanced to a company directly. The crucial aspect is that by saving money, you are not consuming. By investing it you are turning those goods that could have been consumed today into capital goods that will produce more goods to be consumed in the future.

Having therefore examined in some detail the role of capital in wealth accumulation and raising the standard of living, let us proceed to analyse some aspects of Government interference that will affect the rate of saving and investment.

Taxation

Taxation is the deliberate confiscation by the Government of that which has been produced. It must be emphasised that all taxation, whatever name it is given, however one may attempt to justify it, must be a taxation of produce. There must be something that has been produced that the Government can come along and take. In our example of the lone human, the Government would have come along and taken some of his logs, i.e. confiscated his produce directly. In the complex economy the Government tends not to confiscate produce directly but rather money which it then spends on produce, i.e. the produce that the taxed individual could have bought is diverted, by way of money, to the Government.

From our analysis of saving and investment above we also know that there are only two types of produce that can be taxed – that which is produced today (income) and that which was saved and invested (capital, or wealth). There is nothing else that can be taxed and all taxes are either taxes on income or on wealth. What are the implications and results of each? Let us deal with the material effects first of all. If the Government taxes income, that is, the presently produced product, we know from our analysis above that it can do so up to a point which still permits enough saving to maintain the existing capital stock. If it does this, the present level of production can continue as the capital goods will keep functioning. However, for the remainder of the produce that is confiscated, there will be less saved in the hands of private individuals and entrepreneurs to invest and increase the capital stock. Capital growth, therefore, will be retarded. And even if the private individuals would not have saved this income but would have consumed it, it is still the case that they have suffered a loss from the fact that the produce is directed towards Government ends rather than their own. The important point is, however, that taxation retards the ability of private individuals to grow capital and increase production and, hence, the standard of living must either stagnate or improve less quickly.

It is no answer to this charge to assert that Government might take this money and spend it on allegedly “important” capital projects such as roads, schools, hospitals, and other spending on what they like to call “infrastructure”. As we noted above it is not the capital stock that is so important but rather the capital structure. For the invested capital must take a form in which it meshes cleanly with the rest of the existing capital and its produce supports the production of goods further down the chain of production. It would, for example, be useless to bring a fishing net to a cattle ranch. The only way to determine whether capital contributes to the capital structure is through the pricing, profit and loss system – that capital that is successfully producing generally needed products to create further products will turn a profit for the enterprise. But how does Government, devoid of the need for profit and loss, know that, say, a factory or a road must be built? What if it diverts its taxed resources to building a grand factory but there are no machines to put in this factory? How does it know how large the factory should be, what it should produce, etc.? No Government has any method of gauging these criteria. Our lone human, we noted, needed in his capital structure an axe to fell trees and a wheelbarrow to transport the logs. Having instead two axes or two wheelbarrows would have been of no use to him. Precisely the same is encountered when Government produces roads when there are no cars, hospitals but no operating equipment, tractors but no plough, railway locomotives but no wagons. Such was frequently the case in the former Soviet Union where buildings and machinery frequently were lying incomplete because a crucial part had received underinvestment and hence was simply missing. It is true, of course, that the capital structure that remains in private hands will adapt to the capital that Government has forced upon it. If a Government produces a road, for example, it becomes more economical to increase the production of cars in order to fill it. But all this means is that private investment has been forced to adapt to what the Government has produced whereas these Government projects are frequently sold to the public as being necessary to “boost the economy” etc. Instead the capital structure has been twisted and distorted from the form that it would have taken had it been left alone and the structure that is in fact produced is serving ends that are relatively less valuable than those that would have been served in the absence of the Government interference. As Bastiat would put it, the Government may be able to point to its wonderful roads that are full of cars (that which is seen), but what is not seen is all that was not produced as a result of this diversion of funds10. It is for this reason that, economically, all Government spending must be regarded as waste spending.

However, what if the Government initiates an even higher level of income taxation, a level that does not permit enough saving to main the existing capital stock? Then, disaster will strike. For now the existing capital stock will start to wear down and cannot be replaced. As the capital structure collapses, production will decline and so too will the standard of living. Production processes will become shorter and less roundabout as the produce that could have maintained them is siphoned off into Government consumption. The situation is exactly the same as if the lone human consumed the logs that should have been diverted to maintaining his wheelbarrow. He enjoys, for the moment, the additional consumption of the log but at the expense of a severely reduced level of consumption in the future. But when the Government taxes income at such a level the private citizens do not even get to enjoy this temporary upswing of consumption, merely the bureaucrats and politicians whose lifestyles it is supporting.

Within this category of taxation of income we may place all of the everyday taxes from which people suffer – income taxes, sales taxes, excise taxes, corporation taxes, capital gains taxes, dividend taxes, VAT, etc. Anything that is a tax on productivity or newly produced good is a tax on income.

Finally, we consider the horror of horrors – when Government doesn’t tax the presently produced product but instead directly taxes the existing stock of capital. Within this category fall inheritance taxes, property taxes and wealth taxes. The results of such action should be obvious as it deliberately sets about consuming the capital stock. It dismantles the factories, machines and tools and diverts them towards Government consumption and even if the Government diverts them to “investment” then this will simply be of the same kind of Government “investment” that we just outlined with regard to income taxes. Wealth taxes are the most ruinous and destructive, attacking the very means of production and leading to a rapid decline in output and the standard of living. The situation is precisely analogous to our lone human chopping up his wheelbarrow and using it as firewood – there is a temporary increase in enjoyment today that must be offset by a very rapid decrease tomorrow.

It is at this point that we should consider all “soak the rich” taxation rhetoric and practice. For it is usually the point of view of politicians and the non-rich that the wealthy provide an inexhaustible slush fund that can be plundered and pillaged to serve whatever “needs” might be desired. Earlier we noted that there is a tendency (although not strictly a necessity) that as income increases the proportion of that income that a person devotes to consumption decreases and the proportion that is devoted to saving and investment increases. Therefore, while the rich consume more in terms of quantity than a poorer person, as a percentage of their overall income they consume far less. A person earning an income of £1 000 per month might consume £800 worth and save £200, a consumption rate of 80% and a saving rate of 20%. However a person earning £10 000 per month might consume £3 000 and save £7 000 – a consumption rate of 30% and a saving rate of 70%. So while the rich person is visibly consuming more in terms of quantity he is saving and investing a very great deal more. This saving and investment is obviously channelled into capital goods, goods which are used in the production of consumer goods that other people can buy. By increasing the supply of consumer goods the prices of these items drop and so they become more affordable to everyone else and the general standard of living increases. To the extent that the “rich become richer” through this process it is only because they invest in those capital goods that produce the wares that are most eagerly sought for by the masses. Indeed the only way to really become rich under conditions of free exchange is to abstain from consumption and divert your savings to that which people most want to buy11.

If the Government therefore sets about taxing the rich to what extent can it do so? It should be clear from our analysis that it can tax the proportion of the rich person’s assets that comprise his consumption spending. If this is done then what the rich man would have spent on fine dining, chauffeurs, exotic holidays etc. is simply diverted to Government spending. The capital structure remains untouched. But the amount of consumption spending by the rich is extremely limited; indeed if all of it was to be confiscated and distributed to the world’s poor there would barely be enough to give everyone a handful of pennies. Therefore, if taxes on the rich are to be increased then they must start attacking the saved wealth of the rich, that is the capital structure. In short, factories, machines, and tools – the very things that were churning out affordable products that the masses wanted to buy – are liquidated and diverted to Government uses, either to Government consumption or to a form of investment that, as we noted above, must necessarily be less valuable than that which existed before. The very worst thing that can be done is to tax the capital stock and distribute it in welfare for then the saved wealth of society is quite literally transferred from those who saved and invested it to those who consume and destroy it. With fewer machines and tools there will be less production, with less production there will be fewer goods, with fewer goods there are higher prices and with higher prices there is less that everyone is able to buy.

We might conclude this section, therefore, by saying that from the point of view of the standard of living, all taxation will retard its level or growth. However, that form of taxation which decays the existing capital stock is the most destructive. Wealth taxes, inheritance taxes, property taxes and their ilk should be firmly resisted.

It is not sufficient, however, to merely consider the material effects of a policy of taxation, wherever it may fall. We also need to consider the psychic effects. It is self-evident that all taxation is a confiscation from one set of persons and a distribution to another set of persons. Those who have had their goods confiscated must be producers; those who receive in distribution must be (relative) non-producers. Indeed, usually some kind of non-productive status is what qualifies a person as a recipient of welfare spending – poverty, illness, disability, etc. It is an axiom of human action that all humans devote their energies to that which has the most benefit for the smallest cost. We endure the toil of labour because the loss experienced in doing so we deem to be worthwhile for the value that is gained as a result. The same is true of consumption and investment. Each has its own benefits and costs. The benefit of consumption is the enjoyment that it provides to the mental faculties; its cost is the labour expended in production of the article to be consumed and that, once it is consumed, it is gone forever and cannot be devoted to an alternative or additional use and further needs must be met by increased production. The benefit of investment is an increased yield of consumer goods in the future; its cost is the pain of having to deny oneself the consumption today of the goods that will be added to the capital stock.

If there is any change in the relative proportions of these benefits and costs it follows that certain activities will become more attractive (i.e. more valuable) and others will become less attractive. Yet this is precisely what the effects of taxation are, effects that fall heavily upon the impetus to produce, consume, or invest. We noted earlier that a person will start to invest at the point that the increased quantity of goods that results from the investment is sufficient to compensate him for the waiting time necessary to produce the capital good. Yet if the fruits of this productivity are taxed it means that the yield is reduced. To the individual saver and investor, the benefit of saving and investment has declined, but the costs remain the same – he must still expend the same amount of labour and must endure the same amount of waiting time but only now for a smaller yield. The value, therefore, of investing will, to him, decline and consumption will become relatively more attractive. There will therefore be less investment and more consumption, lower output and the standard of living will decline. It gets worse, however, when we look to the recipients of taxed income or wealth. For in a world where there is no tax, the enjoyment of consumption must be outweighed by the costs of production and the incentive to invest. Only if the value of consumption is higher than the toil of production and the yield from investment will consumption be carried on. But if one now receives an income free of the necessity to produce, both of these costs are removed. For now, why should one labour to produce when he can simply receive the benefit – the enjoyment – for free? And why should he invest when he can simply demand another article from the Government once he has consumed the first? And even if he did invest his income from other people’s taxes, this will simply be taxed away anyway. Why bother?

In short, therefore, taxation reduces the relative value of production and investment. It increases the relative value of consumption. There will therefore be less production and investment and more consumption, the stock of capital will decline, output will decline and the standard of living will lower also.

Regulation

Regulation is, in common social democratic discourse, deemed to be a necessary tempering (or tampering, one might say) of the otherwise capitalist economy, the wise overlords stepping in and ensuring that people do not compromise “safety”, “quality” or whatever in their supposedly lustful pursuit of profits. We will leave to one side any discussion of the fact that regulation is itself a service that consumes scarce resources and that the benefits of a regulation must be offset by its cost – hence it is a market activity just the same as any other. Rather, we shall focus exclusively on the effects of Government (i.e. forced) regulation upon saving and investment in the capital stock.

The effect of a regulation is to ban a certain activity from being carried on by otherwise free individuals; an example would be a restriction on to whom a certain product can be sold, perhaps by age or income. Or, it can take the effect of a requirement to do so something, usually before something else can be done. For example, it may be required to provide a list of ingredients or a nutritional breakdown on an item of food before it can be sold. However sensible they may seem the effect of regulations is to limit the ends to which capital may be devoted.

Let us first of all consider regulations that take the form of bans. As we noted above the incentive to save is dependent upon the fruits of production that are the result of the investment. In a free market a person can invest in whatever he thinks people will want to buy. By advancing goods and services to meet people’s ends he earns a return. The public could, for example, in the saver’s estimation be demanding more of goods X, Y and Z. He will invest in the line of production that he believes will yield the highest return. But what happens if the Government then intercedes with a regulation? It is effectively saying to the investor “you may invest in goods X or Y, but not in good Z”. In other words, an entire avenue of investment opportunity is closed off even though both the public and the investor may wish to trade the good Z. What then happens if Z was the most profitable investment? Then, by having to invest in the relatively less profitable X or Y, the value of saving and investing to the investor will reduce. Therefore, there will be less saving and less investment. Indeed he might even decide that the profit opportunities afforded by X or Y to be insufficient to reward him for the waiting time between the act of saving and the receipt of returns. He may just decide to consume entirely that which he would have invested. The amount of capital investment therefore decreases and so too does the standard of living. But even if he does invest in X or Y this is not what the buying public are demanding – they want Z and no extra amount of X or Y will compensate for this loss.

However, the more common type of regulation is of the second kind – that a product may be invested in but there are regulatory requirements that must be met before one can do so. Let us take the typical type of regulation on which the Government feels itself qualified to pronounce judgment and that is health and safety. If the public demands food, for example, it may be perfectly happy to buy food that comes without any detail of ingredients or nutritional breakdown. The Government then decides that people aren’t giving enough thought to their health (probably as a result of them being able to get free healthcare, which has been dealt with in detail here). So the Government then steps in and says to the investor “OK, you can invest in food but to do so you must provide a list of ingredients, a nutritional breakdown and, with every sale, you must provide a free fact sheet of how to live healthily.” The effects of such an edict should be clear – for every article that is now sold, the investor must spend additional money on analysing every article of food for its ingredients and nutritional content and must spend even more money further on producing the factsheet. Yet the public are not demanding these things so they will not be willing to pay any more for the articles that are purchased. The effect of this regulation, then, is to increase the amount of capital that is needed to produce the same return. Or, to put it another way, the same amount of capital produces a lower return. So once again, then, the value of investing to the investor is lowered and there will be less of it. By heaping on to production artificial, deadweight costs that serve no one capital is simply consumed purposelessly. It is conceivable that regulation may cripple an industry so much that it deters all investment and investors will simply stop producing the regulated products altogether. In practice what tends to happen is that regulation forces out the smaller investors, the upstart companies, while the big players are able to absorb the added costs. The economy is then left with a few key providers in each sector who are able to raise prices and lower quality as a result of this insulation from competition.

Regulation is therefore one of the most powerful ways in which capital investment can be restricted, possibly even more so than taxation.

Uncertainty

The final aspect of Government intervention into saving and investment we will consider is that of uncertainty. Whereas before we were analysing the effects of known Government policies on taxation or regulation, here we will look at what happens when someone simply doesn’t know, or cannot be sure of, precisely what the Government will do.

Rothbard describes succinctly the role of uncertainty in human action:

[A] fundamental implication derived from the existence of human action is the uncertainty of the future. This must be true because the contrary would completely negate the possibility of action. If man knew future events completely, he would never act, since no act of his could change the situation. Thus, the fact of action signifies that the future is uncertain to the actors. This uncertainty about future events stems from two basic sources: the unpredictability of human acts of choice, and insufficient knowledge about natural phenomena. Man does not know enough about natural phenomena to predict all their future developments, and he cannot know the content of future human choices. All human choices are continually changing as a result of changing valuations and changing ideas about the most appropriate means of arriving at ends. This does not mean, of course, that people do not try their best to estimate future developments. Indeed, any actor, when employing means, estimates that he will thus arrive at his desired goal. But he never has certain knowledge of the future. All his actions are of necessity speculations based on his judgment of the course of future events. The omnipresence of uncertainty introduces the ever-present possibility of error in human action. The actor may find, after he has completed his action, that the means have been inappropriate to the attainment of his end.12

It follows from this excerpt that an increased degree of uncertainty leads to an increased possibility of error – that there is an increased likelihood that the scarce goods used in attainment of the end will, in fact, not attain the end and will be wasted. And, as Rothbard highlights, part of the composition of this uncertainty stems from future human choice, in our case the choices of the Government actors.

We noted above that the effect of Government taxation and regulation is to render less valuable the act of saving and investment to the individual. If he knows that he will be taxed and regulated to nth degree then he can, at least, factor this in to his calculations and act accordingly. If, however, the Government creates an aura of uncertainty – that an individual investor may find his fruits taxed or regulated not necessarily to the nth degree but may be to the n + 1st degree, or the n – 1st degree, or to a whole other range of possible degrees, then this weighs heavily on his mind in deciding whether to save and invest. Indeed heaping on uncertainty effectively increases the psychic costs of an action. The greater the degree of uncertainty and the more likely it is that his decision to invest will result in error (the error in this case being that he will suffer a more crippling degree of taxation or regulation than he would prefer) the more costly it becomes. Hence, the relative attractiveness of consumption increases. Indeed, consumption renders neutral this uncertainty – if something is consumed then the Government, for sure, can’t come along later and attempt to tax it away. There will, therefore, be more consumption and less saving and investment. The capital stock will not grow as fast and neither also will the standard of living.

Uncertainty, often labelled “regime uncertainty”, has been an important factor following the 2008 financial crisis and the subsequent malaise. Precisely because nobody knows precisely what the Government will try next, whether it be stimulus, taxes, regulations, capital controls, inflation or whatever, nobody is willing to take the risk to save and invest. Indeed, in the US, the huge increase of excess bank reserves – i.e. banks simply holding onto cash – following the expansion of the monetary base is at least partly explained by the phenomenon of increased uncertainty.

Conclusion

What we have realised through our analysis, therefore, is that capital accumulation is the source of increased wealth and an increased standard of living. Where there are strong private property rights to this capital and its fruits then capital accumulation will, all else being equal, be encouraged. Where these rights are compromised by taxation and regulation, they will be discouraged. Further, as our discussion of uncertainty entails, it is not sufficient that these rights are left uncompromised today but there must also be an expectation that they will not be compromised in the future.

We have not said much about Government-induced credit expansion that leads to business cycles. The effect of credit expansion is to divert goods away from consumption and to invest them in more roundabout production processes. This looks, on the face of it, as if the Government is doing a benevolent thing – it is causing us to increase the capital stock! But as we noted above, the return on capital must be sufficient to justify the waiting time. If people are not willing to endure this waiting time then investment cannot occur. Indeed credit expansion is forced saving and investment in an increased capital stock. When the credit expansion halts it is not possible to continue this diversion of goods into building and maintaining this capital structure; rather the latter now becomes fully dependent upon the consumption/saving preferences of consumers. But these preferences are not sufficient to carry out the level of investment required. The capital structure is revealed as malinvestment and must be unwound. Tragically, the Government, in ignorance of what we have learnt here about waiting times and the necessity for a precise capital structure that meets the needs of consumers, responds to this series of events by trying to boost consumption, even though it is not consumption that needs a shot in the arm. If anything, there needs to be more saving and investing so that at least some of the projects that were embarked upon during the credit expansion can be justified.

All in all the effects of Government upon capital accumulation and the creation of wealth are a disaster. All that is needed for these things to occur is private property and free exchange and Government, if we are to endure at all, should concentrate on guaranteeing these institutions.

1Strictly it is a necessity of human action that it seeks improvement to the current condition. Therefore, simply moving an object out of one’s way or to where one would prefer it to be is an act of “production” and an increase in “wealth” from the acting human’s point of view. But for the sake of simplicity we will discuss production, income and wealth as alluding to driving towards an increase in the number of material, tangible goods that the human can enjoy.

2Here we may briefly consider what the purpose of increasing wealth is. Excluding the possibility that someone gains utility simply from owning a lot of stuff, it can only be to consume in the future. The ultimate aim of all production is consumption, if not by yourself then by your heirs. Production that does not eventually result in consumption gains nothing. This is important for understanding what the human does with his saved wealth.

3We must add emphatically that hoarding is not unproductive and typically takes place in times of uncertainty – when one does not know whether he might suddenly need to call upon extra resources – or to cater for a known period of un-productivity, such as storing food for the Winter.

4Technically speaking if the level of “saving” is insufficient to maintain capital then there is a net dis-saving. As Mises puts it: “The immediate end of acquisitive action is to increase or, at least, to preserve the capital. That amount which can be consumed within a definite period without lowering the capital is called income. If consumption exceeds the income available, the difference is called capital consumption. If the income available is greater than the amount consumed, the difference is called saving. Among the main tasks of economic calculation are those of establishing the magnitudes of income, saving, and capital consumption.” Ludwig von Mises, Human Action, Scholar’s Edition, p. 261. However for the purposes of this essay we shall define income as the produced product and saving as the portion of the income that is not consumed, regardless of whether the rate of saving is sufficient to maintain the capital stock.

5Money as well as being the medium of exchange is also is the facilitator of economic calculation without which a complex economy could not exist. Money is also a good in its own right but there is not space here to dwell on the fascinating reasons how and why it comes into existence. Interested readers should consult Ludwig von Mises, The Theory of Money and Credit.

6A word of extreme caution in necessary when discussing the economy in the aggregate. Simply because we say that x amount of produce is consumed or y amount of produce is invested does not mean that it does not matter precisely who is consuming and who is investing. For it matters very much to the particular individuals concerned. If, for example, the baker purchases three cuts of steak from the butcher with the intent to consume all of them but the fishmonger steals them and consumes two but saves one, even though the fishmonger has “saved” one steak that would have been consumed by the baker we can in no way say that the economy is “better off”. The loss of utility of steak consumption to the baker cannot be compared or measured against the gain of utility to the fishmonger who consumes two steaks and saves one. Similarly if a slave is forced to labour to produce bread in the bakery and he gets nothing in return we cannot say that the economy is better as a result for there has been a very real loss to the slave in spite of the bread produced. We can only assume that there are gains in utility when there is voluntary exchange and any analysis of the economy as a whole which results in conclusions of one state of affairs being “better” or “wealthier” than the other must be made under the assumption of voluntary production and exchange.

7Whether someone is a stockholder or a lender to a firm or enterprise is a legal difference, not an economic one. They are both advancing saved funds to further the firm’s ventures but on different terms.

8There is also the possibility of additional compositions of return that we will ignore here. See Murray N Rothbard, Man, Economy, and State, Scholar’s Edition, pp 601-5, although it remains doubtful whether some of these can be distinguished conceptually from existing categories of return.

9Calculated profit and loss in the complex economy is measured against the societal rate of interest which is determined by the societal time preference rate. The societal interest rate is the price at which all willing borrowers can borrow money and all willing lenders can lend it and the success of failure of an enterprise will, by and large, be judged against this rate.

10Claude Frédéric Bastiat, That Which Is Seen and That Which Is Not Seen.

11Capitalism, in contrast to socialist and Marxist myths, has always been a system of production for the masses, of increasing the outlay of basic, everyday items that are sold inexpensively to everyone. Very little of capitalist production is devoted to luxury production for the rich.

12Rothbard, p.7, (italics in original).

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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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