Posts
Recently I was fortunate enough to have an entire day to myself in London, probably my favorite city in the world. Well, an entire day AFTER filling my family’s tea order at Fortnum and Mason plus buying cups, saucers, and plates approved by William and Kate as an “official” remembrance of their upcoming royal wedding. So, what would any American economist do to fill up the rest of his day except take a tour of the Bank of England, AKA “The Old Lady of Threadneedle Street”.
Unfortunately there is no regular tour of the bank itself, but I was directed to the bank’s official museum just around the corner. After spending a delightful and informative two hours there, I believe a tour of the building itself would have been much less interesting. After all, it is just a jumble of bricks and mortar, whereas the museum is an intellectual explanation of the bank’s history and its role in English and world history. And quite a history it is!
First of all, the good news—entrance to the museum is free; there is not even a charge for the handheld recorder that one really must use for a full understanding of the bank’s fascinating history and especially of how the bank sees itself. The museum is arranged approximately half interesting displays of physical objects, such as building plans, old bank notes, old registers of founding members, etc. and half history of the bank’s operation and its role in English life. Sometimes these two halves overlap. For example, behind a glass case was a mock up of a basket of groceries from 1958. The basket included two large, round loaves of unsliced bread, a pound of bacon, a dozen eggs, a pound of butter, and a quart of milk. This basket of groceries cost slightly over twelve shillings--approximately six tenths of a pound--in 1958. Today a pound costs approximately $1.61, so this rather large basket of wholesome English fare cost around a dollar in 1958!
I could see that we now were about to get down to brass tacks, so to speak, so I examined the bank’s mission. A pamphlet titled “Your money: what the bank does” states that the bank’s three main goals are “trust in banknotes, stable financial system, and low inflation”. Needless to say, the bank has failed miserably at all three, as it admits in so many words when recounting its own history. The bank was forced to suspend specie redemption several times throughout its long history due to its fraudulent (my word, not the bank’s!) issue of paper certificates in excess of its gold holdings. Each of these suspensions was discussed very matter-of-factly, as if a meteorite had struck the bank, destroying its ability to redeem banknotes for gold.
The Bank of England Funds the Crown’s Wars
Most of these suspensions of specie redemption came during or immediately after war, illustrating the bloodthirsty link between the crown and the bank. This is a symbiotic relationship. The crown grants the bank the monopoly of money production, meaning that its stockholders and officers have the ability to charge excess signori age charges, and immunizes the bank from commercial law by allowing it to suspend specie redemption without turning its assets over to its creditors. In return the bank monetizes the crown’s debts, allowing it to confiscate more resources than its citizens would allow were the crown forced to tax them directly or borrow honestly in the credit markets. Then the citizens might question the wisdom of the crown’s military adventures, requiring it to seek more pacific and, of course, less costly solutions to its international adventures.
Inflation Just Happens
Its explanation of inflation—i.e., higher prices— was very amusing. A recorded min-lecture and video display purported to explain this mysterious phenomenon (mysterious to The Old Lady of Threadneedle Street, anyway). I was very excited! I knew that either I was going to hear a self-critical explanation or, more likely, some hogwash. Hogwash won, hands down! Showing videos of life a hundred or so years ago and contrasting it with videos of modern, bustling London, the audio lecture claimed that demand for modern conveniences and the rising cost of imported goods were the two main “causes” of inflation. The explicitly stated message is that if we want all the conveniences of modern life, then everything is going to cost more. There simply is nothing that The Old Lady can do about it, don’t you see?
This entirely non-Austrian, yet typical explanation ignores the fact that all prices in general cannot rise unless either spending increases, due to an increase in the quantity of money, or the supply of goods decreases. The videos made it clear that modern day Britons live in wonderfully more prosperous times than their ancestors who ruled two-fifths of the surface area of the world a hundred years ago. So the paucity of goods explanation of inflation does not hold water. What about the higher cost of some imported goods? After all, Britain is a trading nation, dependent upon imports for its daily bread (the reason that Churchill claimed that the Battle of the Atlantic was the most crucial for Britain’s survival in World War II). But this is a circular argument; it begs the question of why imports cost more and there is no economic difference whether the staple of modern life is imported or not. Political borders have no bearing on economic law.
In a sound money economy—that is, one in which the money supply is held stable--an increase in the price of any good or service must cause a corresponding decrease in the price of some other good(s) or service(s). A nation’s finances are no different from that of the individual household. Let’s say that the price of some essential good such as gasoline (ahem!) goes up in price. Most of us would find it difficult, at least in the short term, to curtail our purchase of gasoline sufficiently to spend no more total dollars on this good than before the price rise. Over the longer term we may adjust by driving less, which means that the automobile is not as convenient as it was before the price rise, or we may take more drastic action, such as carpooling, walking to a bus stop, buying a more fuel efficient car, etc. But in the short term we must curtail the purchase of something else. That “something else” is the good or service which falls at the lowest end of our personal utility scale. For most of us that means that we may save less, until we adjust our lifestyle to higher priced gasoline. Then we may extend the date upon which we would purchase some large, expensive good, or we may forego its purchase entirely. This is Frederic Bastiat’s “unseen” cost to society. We can see more people riding the bus or walking to work, but we cannot see the vacation they did not take or the new dining room set they can no longer afford.
But the Bank of England hasn’t a clue. Higher prices are just part of modern life…if we want more “stuff”, especially foreign-made “stuff”, we just have to accept a higher price level. Don’t blame the Old Lady. What can it do? Certainly you don’t expect an institution that can manufacture money out of thin air to behave any differently, do you?
Monday, March 28, 2011
Thursday, March 24, 2011
"Fear the Boom, not the Bust": My Speech at the Mount Sterling Investment Seminar, York, England, 17March2011
“Fear the Boom, not the Bust”
Speech Delivered at:
The Mount Sterling Wealth Seminar
Thursday, March 17, 2011
York, U.K.
By Patrick Barron
All of the industrial world’s central banks and public treasuries currently are engaged in an impossible exercise—trying to re-inflate an artificially created boom through zero interest rates and deficit spending. The reality is that the current financial crisis was caused by central bank money expansion, so it cannot be cured by further money expansion. It is as if the so-called-doctor is continuing to bleed the patient who is already bleeding to death. The monetary induced boom destroys capital, but its destruction is masked by a monetary illusion. This illusion cannot be discovered by normal financial due diligence; it can only be understood by an understanding of proper economic theory, which is called the Austrian School economic theory, also known as “reality economics”.
In order to avoid unprofitable investments, you need to understand how a central bank monetary induced boom proceeds from the euphoria of “new era/new paradigm” illusions to the despair that “all is lost”. You must understand that the boom is the problem and that the bust is the solution. So, “fear the boom and not the bust”.
Like others before it in the modern era, this recent boom/ bust cycle was caused by expansion of credit, which expanded the money supply out of thin air due to fractional reserve banking.
Overall prices rise and wealth is re-distributed from those who produce it to those who consume it. Central bank money expansion initiates this boom/bust cycle, whereby capital is malinvested in longer term production processes for which there is insufficient real capital for profitable completion. Later higher prices and higher real interest rates bring the artificially initiated boom to an end, but not before real capital, real vendible goods, have been invested in enterprises which will never turn a profit. Money expansion ultimately destroys capital and leads to lower production in the future. Since the entire process was a monetary illusion of wealth creation when in reality it was capital destruction through malinvestment, the coming of the bust should be celebrated, for it is the beginning of the process of re-establishing the structure of production to reflect the true preferences of the consumer. The sooner the boom ends, the better. The boom destroys capital; the bust replenishes capital through savings. The economy needs savings, which the the foundation of production. The current fad, promoted by all central banks worldwide, is exactly the opposite. Central Banks want everyone to believe that it is Spending that drives the economy not savings. This is called ‘Shop Until You Drop Economics’ and is inherently flawed and unsustainable as I will further demonstrate.
Why Governments Destroy Sound Money
Governments destroy sound money, because sound money forces every economic actor, including government itself, to practice fiscal discipline. But central bank created fiat money allows government’ to avoid the hard choices that are part and parcel of an economy ruled by scarcity and uncertainty and opens the floodgates for unlimited – for a time – deficit spending by politicians. It can buy the votes of special interest groups through its control of money production and avoid the unpopular necessity of taxing the people or borrow honestly in credit markets, which crowds out private investors. So expansion of fiat money is in government’s self interest but not the peoples’ self interest, although this fact is hidden and propagandized away--for example, by blaming the credit crisis on “greedy bankers”.
Furthermore, we all receive or expect to receive expropriated property in some form, buying us off with retirement benefits and free healthcare services, for example. Under sound money the people are the masters and government is its servant. But under fiat money government is the master and the people are the servants. This is why Ludwig von Mises said that sound money is as important to human liberty as bills of rights and constitutions.
Inflating a New Bubble
Because monetary expansion masks the true nature of the economy and the systemic risks, it is advisable to rely upon an understanding of Austrian economic theory to guide our investment decisions. AE theory tells us that new money will go somewhere, creating bubbles that cannot be sustained. Examples are the dot com bubble of the late 90s and the housing bubble of the first decade of the new millennium. Today’s zero interest rates probably are inducing a stock market and bond market bubble right now.
Bubbles will appear also in commodities. The prices of corn, wheat, soybeans, iron ore, and oil have risen tremendously in the last year at the same time that production has risen also. This phenomenon is possible only due to an increase in money.
There is the great probability of another bubble in farm land prices in America, so it is probably the same in Europe. High commodity prices and low interest rates drive up the capital value of farm land. But this is a mirage. When the bubble bursts and interest rates rise, the capital value of farm land will fall. This has happened several times in my banking career. The last one in the 1980s was vicious—bankers in Iowa were murdered, because they were forced to repossess family farms that were used as collateral for farm land purchases. Other bankers were driven from their professions after death threats. I witnessed this phenomenon first hand. A banker from Wisconsin, a prime American agricultural state, recently told me that a land bubble probably already exists…but it is hard to tell. Exactly. It is hard to tell, because the standard risk analysis methods make farm loans appear to be sound…for now…because crop prices are high and interest rates are low. This is the perfect storm for a bubble in farm land prices.
But what about the higher bank capital requirements of Basel III? Won’t more capital protect us from bad loans? It is true that higher capital requirements will slow bank lending. If banks cannot raise capital, their only option is to reduce assets in order to meet the new, higher capital-to-assets ratios. But keep two things in mind: one, more capital will not prevent malinvestment via the boom and bust business cycle and, two, governments want the money supply to expand and they will continue to make it happen. A South Dakota banker recently told me, “We don’t know what to do with our excess liquidity.” But bankers WILL find something to do with their excess liquidity. They will make loans in the latest hot market, whether it is housing, farm land, directly to cities and municipalities (which is a new trend in the USA) or something else that is not on our radar screen right now. At his latest testimony before the Senate Banking Committee, Fed Chairman Ben Bernanke was questioned by a Democratic senator about why bankers weren’t utilizing their excess reserves to support new lending. The Fed chairman reassured the senator that in time they would! Where? We don’t know, but beware of the latest “can’t miss” loan bubble. Remember, five years ago housing was seen as a very safe investment. It was assumed that the price of homes never went down, or if they did, it wasn’t for very long. But AE tells us that it is foolish to rely upon past experience to predict the future. Just because housing has always been a safe investment does not guarantee that it will be in the future.
Austrian Investment Guidelines
Remember that the purpose of monetary expansion is to make it possible for government to steal resources from the legitimate owners and to take a greater share of new wealth generation (the silent tax of inflation). So, it is very difficult to invest safely in such an environment, because government WILL expropriate resources. Your challenge is to avoid investments that appear to be sound under normal financial analysis methods, but are more likely to suffer losses due to the distorted economic environment in which you must operate. So, here are some guidelines.
Number one; avoid those industries that are most capital intensive, because in an inflationary environment government taxes phony profits. Much capital investment was expended years ago at lower replacement prices, but the tax man does not recognize replacement cost, only historical cost. So capital intensive industries report higher profits due to low, historical depreciation expense. In effect, they are being taxed on their capital and cannot retain enough earnings to replace their worn-out plant and equipment. America’s so-called “rust belt” of the 70’s and 80’s can be attributed to the inflation that was begun in the 60’s. Now it is coming back.
Number two, be very careful investing in the expansion of industries which are most removed temporally, meaning further away in time, from generating revenue. Two examples are mining and wineries. Unless new mines or wineries can be opened or expanded and new equipment can be employed in a very short period of time, which is unlikely, the boom will be over. This is the classic example of malinvestment in higher order goods—further away temporally from final, consumer goods—that cannot be sustained due to lack of real capital from real savings…not paper capital from the monetary printing press.
Number three, avoid industries that depend upon increased money creation or some form of government coercion for their existence. This includes governments, who are spending beyond their ability to pay with revenues from taxes. Taxes can be raised only so high before they begin to destroy the very basis of government’s existence; i.e., the private wealth creators. So, governments will attempt to pay off their debt with debased money. This has pernicious effects for the investor. Government bonds will fall in price, as interest rates rise, and some governmental bodies may default—for example, the state governments of California and Illinois. Governments are not productive enterprises; they depend entirely upon taxing away the wealth of others. They will eventually run out of ‘other people’s money. I would recommend that you avoid them.
Number four, avoid investments that catch the eye of government and environmentalists, such as natural resource exploration companies. Also avoid investments that governments might tax, regulate, or confiscate. Third world countries are notorious for allowing investment into their country only to confiscate them later, such as Venezuela’s oil industry or Cuba’s sugar industry.
Number five, do not base investment decisions on tax credits, subsidies, etc.—for example, sugar, milk, wind power, solar power, etc. America’s most grievous program along these lines is ethanol production, which is supported by all three types of government interventions. It is subsidized; there are trade barriers to the importation of competing ethanol products, such as sugar cane based ethanol; and its use is mandated. (The reduced demand for gasoline in recession America has created an ethanol glut. By law the refineries must mix a certain total amount of ethanol with gasoline per year. Currently the maximum ethanol blend is 10% ethanol/90% gasoline. But at the 10% blend American refineries will not use the mandated amount of ethanol. Congress recently stopped a bill that would require that refineries change the ratio to 15% ethanol/85% gasoline.) So, America is facing an ethanol glut. America has had these gluts before, and they usually end in price collapse. For example dairy industry subsidies created a cheese mountain in the 1980s. The government bought milk at subsidized support prices and stored it in government warehouses in the form of cheese. Eventually, the warehouses were full and the government gave away cheese “wheels” to city governments to distribute to the poor. This program became the subject of ridicule in America.
Number six, do not rely upon government oversight agencies or private rating agencies to protect you from what later becomes “obvious” malinvestment. New agencies armed with new regulations and enforced by new bureaucrats are fruitless attempts to prevent the evils caused by monetary expansion. But malinvestment is inevitable and impossible to identify even by an army of regulators. The regulators will be blinded by money expansion, too. A lower interest rate appears to regulators and entrepreneurs alike to be a fact of the market when it is not…it is artificial. Furthermore, early entrants into a market may make money if they get out early. This leads to the illusion that the market is in equilibrium when it is not. And, don’t forget that government WANTS more credit expansion, so even honest, professional regulators will be under pressure to issue rosy reports of the markets they regulate.
Investing in Gold
Let’s now talk about gold. I know that gold does not pay dividends. It is not an earning asset. Nevertheless, I cannot see that the price of gold can go anywhere but up. I say this due to fundamentals. The price of gold is really the gold price of money—dollars, Euros, Pounds. Instead of looking at the rising price of gold in money terms, we should be looking at the falling value of various types of money in terms of gold. The determination of the gold/money price is their relative demands and their relative supplies. The supply of gold cannot be increased very rapidly, and it can be increased only at great expense; whereas, the supply of fiat money can be increased to infinite amounts at zero cost. The demand for gold has been rising, as investors and average citizens like me seek a safe haven for whatever wealth they have accumulated. The demand of money has been shrinking—China and other savvy investors have been shedding the dollar, for example—and the selloff may become a rout.
One way to get a feel for the dollar/gold exchange ratio--also known as the “price of gold”, but really it is the gold price of money--is to calculate how many dollars an ounce of gold would “cover”, if the Fed were to anchor the dollar in its gold holdings. (By the way, this is what the Fed promised to do as a result of the Bretton Woods agreement; i.e., that it would anchor the dollar to its gold holdings at $35 per ounce. But the Fed did not keep its promise.) Notice that in 1980, when gold traded at $613 per ounce in the open market, the Fed could have covered its entire monetary base—that is, reserves plus cash held by the public—by revaluing its gold holdings at only $505 per ounce. Or, it could have anchored M1—checking accounts and cash held by the public—by revaluing its gold at $1,476 per ounce. Keep in mind that gold was trading at roughly 40% of this amount. Or it could have anchored all of M2—which adds short term savings and certificates of deposit to M1—at $5, 671 per ounce.
The Fed’s gold holdings have not changed--it still holds 261.5 million ounces of gold—but the monetary base, M1, and M2 have expanded tremendously. (At present the monetary base actually is larger than M1, an indication of the Fed’s frantic efforts to expand the money supply). Anchoring the monetary base in gold today would mean a dollar price of gold of almost $8,000 per ounce. Anchoring M1 would mean over $7,000 per ounce, and anchoring M2 would mean almost $34,000 per ounce. Noted Austrian School economist Thorsten Polleit has recommended anchoring ALL bank liabilities, not just M2, in gold at whatever the price may be. His rationale is that this is the only way to protect the people’s wealth. Otherwise, the continued expansion of fiat money will mean the total collapse of the dollar and destruction of the American middle class, as happened in Weimar Germany in 1923.
Ludwig von Mises’ explained how a fiat currency collapses in his “three phases of money destruction”. In the first phase, the peoples’ deflationary expectations—that prices will fall-- leads to higher money demand—sometimes called hoarding--and deflation, or price stability, becomes self-fulfilling…for awhile. Eventually price increases lead to a fall in the demand for money; people start spending before prices rise even further. This causes prices to rise even faster. Now we enter the “danger zone”, the final phase of money destruction in which the public expects prices to continue to rise forever, so demand for money collapses and the crackup boom occurs.
It is very likely that the U.S. is past phase one and well into phase two at the present time. Although Austrian economics is not a predictive science, be aware that currencies can collapse very quickly--in a Whoosh!, so to speak. Examples are Germany in 1923 and modern Zimbabwe.
In conclusion, do not be misled by all the illusions caused by increased monetary expansion, no matter how fashionable. The immutable laws of economics will prevail. They cannot be rescinded, no matter how much enticement, coercion, and even terror a government attempts. Do not be swayed by government propaganda that zero interest rates and deficit spending have cured the economy and that it is safe and even patriotic to “invest in the future”. This is a time for capital and wealth preservation, so that society has something upon which to build when economic intervention has run its course and the people are desperate enough to, once again, give freedom and liberty a chance.
Speech Delivered at:
The Mount Sterling Wealth Seminar
Thursday, March 17, 2011
York, U.K.
By Patrick Barron
All of the industrial world’s central banks and public treasuries currently are engaged in an impossible exercise—trying to re-inflate an artificially created boom through zero interest rates and deficit spending. The reality is that the current financial crisis was caused by central bank money expansion, so it cannot be cured by further money expansion. It is as if the so-called-doctor is continuing to bleed the patient who is already bleeding to death. The monetary induced boom destroys capital, but its destruction is masked by a monetary illusion. This illusion cannot be discovered by normal financial due diligence; it can only be understood by an understanding of proper economic theory, which is called the Austrian School economic theory, also known as “reality economics”.
In order to avoid unprofitable investments, you need to understand how a central bank monetary induced boom proceeds from the euphoria of “new era/new paradigm” illusions to the despair that “all is lost”. You must understand that the boom is the problem and that the bust is the solution. So, “fear the boom and not the bust”.
Like others before it in the modern era, this recent boom/ bust cycle was caused by expansion of credit, which expanded the money supply out of thin air due to fractional reserve banking.
Overall prices rise and wealth is re-distributed from those who produce it to those who consume it. Central bank money expansion initiates this boom/bust cycle, whereby capital is malinvested in longer term production processes for which there is insufficient real capital for profitable completion. Later higher prices and higher real interest rates bring the artificially initiated boom to an end, but not before real capital, real vendible goods, have been invested in enterprises which will never turn a profit. Money expansion ultimately destroys capital and leads to lower production in the future. Since the entire process was a monetary illusion of wealth creation when in reality it was capital destruction through malinvestment, the coming of the bust should be celebrated, for it is the beginning of the process of re-establishing the structure of production to reflect the true preferences of the consumer. The sooner the boom ends, the better. The boom destroys capital; the bust replenishes capital through savings. The economy needs savings, which the the foundation of production. The current fad, promoted by all central banks worldwide, is exactly the opposite. Central Banks want everyone to believe that it is Spending that drives the economy not savings. This is called ‘Shop Until You Drop Economics’ and is inherently flawed and unsustainable as I will further demonstrate.
Why Governments Destroy Sound Money
Governments destroy sound money, because sound money forces every economic actor, including government itself, to practice fiscal discipline. But central bank created fiat money allows government’ to avoid the hard choices that are part and parcel of an economy ruled by scarcity and uncertainty and opens the floodgates for unlimited – for a time – deficit spending by politicians. It can buy the votes of special interest groups through its control of money production and avoid the unpopular necessity of taxing the people or borrow honestly in credit markets, which crowds out private investors. So expansion of fiat money is in government’s self interest but not the peoples’ self interest, although this fact is hidden and propagandized away--for example, by blaming the credit crisis on “greedy bankers”.
Furthermore, we all receive or expect to receive expropriated property in some form, buying us off with retirement benefits and free healthcare services, for example. Under sound money the people are the masters and government is its servant. But under fiat money government is the master and the people are the servants. This is why Ludwig von Mises said that sound money is as important to human liberty as bills of rights and constitutions.
Inflating a New Bubble
Because monetary expansion masks the true nature of the economy and the systemic risks, it is advisable to rely upon an understanding of Austrian economic theory to guide our investment decisions. AE theory tells us that new money will go somewhere, creating bubbles that cannot be sustained. Examples are the dot com bubble of the late 90s and the housing bubble of the first decade of the new millennium. Today’s zero interest rates probably are inducing a stock market and bond market bubble right now.
Bubbles will appear also in commodities. The prices of corn, wheat, soybeans, iron ore, and oil have risen tremendously in the last year at the same time that production has risen also. This phenomenon is possible only due to an increase in money.
There is the great probability of another bubble in farm land prices in America, so it is probably the same in Europe. High commodity prices and low interest rates drive up the capital value of farm land. But this is a mirage. When the bubble bursts and interest rates rise, the capital value of farm land will fall. This has happened several times in my banking career. The last one in the 1980s was vicious—bankers in Iowa were murdered, because they were forced to repossess family farms that were used as collateral for farm land purchases. Other bankers were driven from their professions after death threats. I witnessed this phenomenon first hand. A banker from Wisconsin, a prime American agricultural state, recently told me that a land bubble probably already exists…but it is hard to tell. Exactly. It is hard to tell, because the standard risk analysis methods make farm loans appear to be sound…for now…because crop prices are high and interest rates are low. This is the perfect storm for a bubble in farm land prices.
But what about the higher bank capital requirements of Basel III? Won’t more capital protect us from bad loans? It is true that higher capital requirements will slow bank lending. If banks cannot raise capital, their only option is to reduce assets in order to meet the new, higher capital-to-assets ratios. But keep two things in mind: one, more capital will not prevent malinvestment via the boom and bust business cycle and, two, governments want the money supply to expand and they will continue to make it happen. A South Dakota banker recently told me, “We don’t know what to do with our excess liquidity.” But bankers WILL find something to do with their excess liquidity. They will make loans in the latest hot market, whether it is housing, farm land, directly to cities and municipalities (which is a new trend in the USA) or something else that is not on our radar screen right now. At his latest testimony before the Senate Banking Committee, Fed Chairman Ben Bernanke was questioned by a Democratic senator about why bankers weren’t utilizing their excess reserves to support new lending. The Fed chairman reassured the senator that in time they would! Where? We don’t know, but beware of the latest “can’t miss” loan bubble. Remember, five years ago housing was seen as a very safe investment. It was assumed that the price of homes never went down, or if they did, it wasn’t for very long. But AE tells us that it is foolish to rely upon past experience to predict the future. Just because housing has always been a safe investment does not guarantee that it will be in the future.
Austrian Investment Guidelines
Remember that the purpose of monetary expansion is to make it possible for government to steal resources from the legitimate owners and to take a greater share of new wealth generation (the silent tax of inflation). So, it is very difficult to invest safely in such an environment, because government WILL expropriate resources. Your challenge is to avoid investments that appear to be sound under normal financial analysis methods, but are more likely to suffer losses due to the distorted economic environment in which you must operate. So, here are some guidelines.
Number one; avoid those industries that are most capital intensive, because in an inflationary environment government taxes phony profits. Much capital investment was expended years ago at lower replacement prices, but the tax man does not recognize replacement cost, only historical cost. So capital intensive industries report higher profits due to low, historical depreciation expense. In effect, they are being taxed on their capital and cannot retain enough earnings to replace their worn-out plant and equipment. America’s so-called “rust belt” of the 70’s and 80’s can be attributed to the inflation that was begun in the 60’s. Now it is coming back.
Number two, be very careful investing in the expansion of industries which are most removed temporally, meaning further away in time, from generating revenue. Two examples are mining and wineries. Unless new mines or wineries can be opened or expanded and new equipment can be employed in a very short period of time, which is unlikely, the boom will be over. This is the classic example of malinvestment in higher order goods—further away temporally from final, consumer goods—that cannot be sustained due to lack of real capital from real savings…not paper capital from the monetary printing press.
Number three, avoid industries that depend upon increased money creation or some form of government coercion for their existence. This includes governments, who are spending beyond their ability to pay with revenues from taxes. Taxes can be raised only so high before they begin to destroy the very basis of government’s existence; i.e., the private wealth creators. So, governments will attempt to pay off their debt with debased money. This has pernicious effects for the investor. Government bonds will fall in price, as interest rates rise, and some governmental bodies may default—for example, the state governments of California and Illinois. Governments are not productive enterprises; they depend entirely upon taxing away the wealth of others. They will eventually run out of ‘other people’s money. I would recommend that you avoid them.
Number four, avoid investments that catch the eye of government and environmentalists, such as natural resource exploration companies. Also avoid investments that governments might tax, regulate, or confiscate. Third world countries are notorious for allowing investment into their country only to confiscate them later, such as Venezuela’s oil industry or Cuba’s sugar industry.
Number five, do not base investment decisions on tax credits, subsidies, etc.—for example, sugar, milk, wind power, solar power, etc. America’s most grievous program along these lines is ethanol production, which is supported by all three types of government interventions. It is subsidized; there are trade barriers to the importation of competing ethanol products, such as sugar cane based ethanol; and its use is mandated. (The reduced demand for gasoline in recession America has created an ethanol glut. By law the refineries must mix a certain total amount of ethanol with gasoline per year. Currently the maximum ethanol blend is 10% ethanol/90% gasoline. But at the 10% blend American refineries will not use the mandated amount of ethanol. Congress recently stopped a bill that would require that refineries change the ratio to 15% ethanol/85% gasoline.) So, America is facing an ethanol glut. America has had these gluts before, and they usually end in price collapse. For example dairy industry subsidies created a cheese mountain in the 1980s. The government bought milk at subsidized support prices and stored it in government warehouses in the form of cheese. Eventually, the warehouses were full and the government gave away cheese “wheels” to city governments to distribute to the poor. This program became the subject of ridicule in America.
Number six, do not rely upon government oversight agencies or private rating agencies to protect you from what later becomes “obvious” malinvestment. New agencies armed with new regulations and enforced by new bureaucrats are fruitless attempts to prevent the evils caused by monetary expansion. But malinvestment is inevitable and impossible to identify even by an army of regulators. The regulators will be blinded by money expansion, too. A lower interest rate appears to regulators and entrepreneurs alike to be a fact of the market when it is not…it is artificial. Furthermore, early entrants into a market may make money if they get out early. This leads to the illusion that the market is in equilibrium when it is not. And, don’t forget that government WANTS more credit expansion, so even honest, professional regulators will be under pressure to issue rosy reports of the markets they regulate.
Investing in Gold
Let’s now talk about gold. I know that gold does not pay dividends. It is not an earning asset. Nevertheless, I cannot see that the price of gold can go anywhere but up. I say this due to fundamentals. The price of gold is really the gold price of money—dollars, Euros, Pounds. Instead of looking at the rising price of gold in money terms, we should be looking at the falling value of various types of money in terms of gold. The determination of the gold/money price is their relative demands and their relative supplies. The supply of gold cannot be increased very rapidly, and it can be increased only at great expense; whereas, the supply of fiat money can be increased to infinite amounts at zero cost. The demand for gold has been rising, as investors and average citizens like me seek a safe haven for whatever wealth they have accumulated. The demand of money has been shrinking—China and other savvy investors have been shedding the dollar, for example—and the selloff may become a rout.
One way to get a feel for the dollar/gold exchange ratio--also known as the “price of gold”, but really it is the gold price of money--is to calculate how many dollars an ounce of gold would “cover”, if the Fed were to anchor the dollar in its gold holdings. (By the way, this is what the Fed promised to do as a result of the Bretton Woods agreement; i.e., that it would anchor the dollar to its gold holdings at $35 per ounce. But the Fed did not keep its promise.) Notice that in 1980, when gold traded at $613 per ounce in the open market, the Fed could have covered its entire monetary base—that is, reserves plus cash held by the public—by revaluing its gold holdings at only $505 per ounce. Or, it could have anchored M1—checking accounts and cash held by the public—by revaluing its gold at $1,476 per ounce. Keep in mind that gold was trading at roughly 40% of this amount. Or it could have anchored all of M2—which adds short term savings and certificates of deposit to M1—at $5, 671 per ounce.
The Fed’s gold holdings have not changed--it still holds 261.5 million ounces of gold—but the monetary base, M1, and M2 have expanded tremendously. (At present the monetary base actually is larger than M1, an indication of the Fed’s frantic efforts to expand the money supply). Anchoring the monetary base in gold today would mean a dollar price of gold of almost $8,000 per ounce. Anchoring M1 would mean over $7,000 per ounce, and anchoring M2 would mean almost $34,000 per ounce. Noted Austrian School economist Thorsten Polleit has recommended anchoring ALL bank liabilities, not just M2, in gold at whatever the price may be. His rationale is that this is the only way to protect the people’s wealth. Otherwise, the continued expansion of fiat money will mean the total collapse of the dollar and destruction of the American middle class, as happened in Weimar Germany in 1923.
Ludwig von Mises’ explained how a fiat currency collapses in his “three phases of money destruction”. In the first phase, the peoples’ deflationary expectations—that prices will fall-- leads to higher money demand—sometimes called hoarding--and deflation, or price stability, becomes self-fulfilling…for awhile. Eventually price increases lead to a fall in the demand for money; people start spending before prices rise even further. This causes prices to rise even faster. Now we enter the “danger zone”, the final phase of money destruction in which the public expects prices to continue to rise forever, so demand for money collapses and the crackup boom occurs.
It is very likely that the U.S. is past phase one and well into phase two at the present time. Although Austrian economics is not a predictive science, be aware that currencies can collapse very quickly--in a Whoosh!, so to speak. Examples are Germany in 1923 and modern Zimbabwe.
In conclusion, do not be misled by all the illusions caused by increased monetary expansion, no matter how fashionable. The immutable laws of economics will prevail. They cannot be rescinded, no matter how much enticement, coercion, and even terror a government attempts. Do not be swayed by government propaganda that zero interest rates and deficit spending have cured the economy and that it is safe and even patriotic to “invest in the future”. This is a time for capital and wealth preservation, so that society has something upon which to build when economic intervention has run its course and the people are desperate enough to, once again, give freedom and liberty a chance.
Wednesday, March 23, 2011
My Speech at the Eurpean Parliament--March 16, 2011
Why Monetary Expansion Must Stop
Address Delivered at the European Parliament, Brussels on March 16, 2011
By Patrick Barron
Introduction: The Illusion of Unlimited Resources
The current problems faced by all the world’s economies stem, primarily, from one source: the demise of sound money, whose quantity could not be increased without significant cost, and its replacement with fiat money that can be inflated to infinite amounts at almost no cost to the producer.
Expansion of fiat money makes it appear to ALL market participants, including financial regulators, that there are more resources available than really exist. Thusly, all participants, including governments, embark on programs which cannot be completed…there just are not enough resources in the economy. Not only does fiat money create the illusion of greater wealth, it makes embarking on new projects irresistible. After all, does it not always appear that lack of money is all that stands between man and the fulfillment of all his dreams? Now, with unlimited quantities of fiat money, the day seems to have arrived when anything is possible. But this is an illusion.
Throughout my talk I will refer to economic laws that act as impenetrable barriers to achieving the goals sought by monetary expansion. These are laws of human nature—to ignore them brings serious adverse consequences. Economics is a social and not a natural science, because man is a social being. His actions are not governed by physical stimuli but by preferences derived from subjective valuations, all of which are unknowable, undergo constant change, and, thusly, cannot be predicted. Nevertheless, we do know that man is rational; that he acts to attain goals which he believes will improve his satisfaction; that he employs scarce means to do so and that means imply costs; but, since he expects to improve his satisfaction, he expects the costs to be less than the satisfaction to be attained; so man expects to profit from his actions. From this brief explanation of man as a rational being, we can derive irrefutable economic laws.
Two Evils of Monetary Expansion:
There are two main evils of monetary expansion: (1) recurring financial crises and (2) expansion of the wealth destroying welfare/warfare state.
I’ll start with why we continue to have recurring and ever more damaging financial crises. If there is enough time, I will speak very briefly on expansion of the wealth destroying welfare/warfare state.
No Societal Benefit from Monetary Expansion
Expansion of fiat money denies the irrefutable economic law that money is subject to the Law of Diminishing Marginal Utility. This insight was explained by Ludwig von Mises in his 1913 classic The Theory of Money and Credit. Mises explained that money is not “neutral”, that money is a good and is subject to all the laws of economics as are all other goods. Since each new marginal unit conveys less utility than all previous units and, since money is fungible—meaning that each new unit is indistinguishable from monetary units already existing—then the purchasing power of all money is reduced. The first users of the new money benefit most from the newly created money. This is a tight circle nearest the event of the new money being created. Those furthest away from this event, who are in a wider circle of the general economy, all lose since this new money dilutes the value of each unit of money they are already holding. Think of it as pouring water into milk. Therefore, expansion of the money supply conveys no overall societal benefit.
Money Expansion Is Not Stimulative:
Immediately we see that an increase in money cannot be stimulative overall. Although it can stimulate some parts of the economy (those who get the new money first), it can do so only at the expense of all other parts, violating another immutable law of economics, Say’s Law, which essentially tells us that we can’t get something for nothing. With the creation of new fiat money wealth has been redistributed from the current holders of money—the rightful owners--to illegitimate new allocators who steal, without getting noticed, other people’s money. The first or early receivers of the new money benefit at the expense of those who receive it later, through the market process, or do not receive it at all; for example, retirees living on privately accumulated wealth. The early receivers buy at existing lower prices; later receivers pay higher prices.
As this newly created money dilutes the existing money’s purchasing power we see this as high prices—later and not immediately. Higher overall prices are the logical consequence of any expansion of money. The price level can be thought of as the result of total monetary spending divided by the total supply of goods and services offered on the market. If the numerator—total spending-- goes up or the denominator—total market supply of goods—goes down, the price level increases. Some may object to this explanation, saying that “sometimes the price level remains relatively flat despite an increase in the quantity of money, because the total supply of goods increases enough to offset increases in total spending.” My answer is that this is a justification for slow, planned inflation which ignores damaging structural changes that still occur in the economy. I will discuss these in a few minutes.
The Prosperity Illusion Caused by a Rising Gross National Product
Unfortunately, increased spending creates the illusion of increased prosperity, because we measure prosperity by the growth in Gross National Product (GNP), a measure only of total spending, the numerator in the Quantity Theory of Money equation. Under sound money, GNP remains the same, because the quantity of money…and thusly, the quantity of total spending…remains unchanged. But under fiat money inflationary spending, caused by planned inflation of the money supply, this is described as economic “growth”. The more government inflates the quantity of money, the greater economic growth appears to be as measured by GNP. But, this is an illusion. It is not growth at all. It is just a consequence of measuring higher prices.
So far we have seen that fiat money does not stimulate the economy overall; it merely rewards some at the expense of others and creates higher overall prices. But the main structural damage, to which I earlier referred, occurs in the structure of production as manifested by recurring boom/bust cycles. Here is where fiat money and credit expansion cause pure capital consumption, robbing the future productive capability of the economy.
Malinvestment and the Austrian Business Cycle
In the mistaken belief that the economy can be stimulated into a higher level of production by more money, central bankers lower interest rates below the natural, market rate. The ultimate result of such intervention is destruction of capital through what Austrian economists call malinvestment. Capital is devoted to lines of production, primarily into longer term investments, that will never be profitably completed.
We must address this most pressing question: Why do so many businesses fail at the same time? Can it be that a mass incompetence spreads through the economy so that we experience a wide scale bust from time to time? Governments and central bankers focus on this bust and try to postpone it, thinking that this bust is the problem. But, ladies and gentlemen, I am here to tell you that the bust is not the problem. The problem is the boom and why it was created in the first place. Fortunately this business cycle phenomenon has been very well explained by Austrian Economics. For those of you who have the time, I will be happy to explain the details of this after my talk. Suffice it to say that it is the intervention of the central bank that puts into motion the culprit of “artificial interest rates”. These are false signals to businesses that there are new, real resources for investing in longer-term capital expansion projects. But this is a false signal. There are no new, real resources for the successful and profitable completion of all new boom-time projects.
Coercion Is No Solution
Rather than cease its monetary intervention, government counters these consequences with coercion in the form of increasing bureaucratic oversight of banks, mandatory increases in bank capital requirements, and the creation of bailout funds.
Increasing bureaucratic oversight rests on two false ideas—that bureaucrats CAN discern potential problems to which bankers are blinded and that, unlike bankers, bureaucrats are not greedy by nature, so they will not take on increased risk. But government bureaucrats can no more detect errors, culpable or otherwise, than can the financial community they are supposed to regulate. The normal economic cues are hidden by expansion of money and manipulation of the interest rate. Regulators and systemic risk analysts are no more able to detect these errors than anyone else. All the oversight boards will accomplish is adding cost to the banking system and possibly creating what Wilhelm Ropke called repressed inflation and what we today call stagflation, whereby production declines and employment falls while prices rise.
Bailout funds are the culprits behind any increased risk taking by greedy bankers. These funds create moral hazard, whereby market participants know that some or all of the cost of increased risk will be borne by others but that benefits will not be shared. In addition, due to the law of diminishing marginal utility of money, the funds themselves continue rather than cure the problem initially caused by money expansion, for the funds are formed by even more money expansion.
All of this intervention leads back to the evils of redistribution of wealth, higher prices, and more malinvestment, a vicious and destructive cycle.
The Cognitive Dissonance of Money Expansion Followed by Increased Coercion
This entire process is a psychological phenomenon called cognitive dissonance; that is, holding two conflicting thoughts in the mind at the same time. Expansion of the money supply and lowering of interest rates in order to stimulate the economy is not compatible with increased bank capital requirements and oversight boards to detect systemic risk. The government expects that a lower rate of interest will promote more economic activity through increased lending. Yet the law of diminishing marginal utility applies to lending also. The only way to make more loans is to lend to less creditworthy customers. Yet this is the situation that more oversight attempts to prevent. Therefore, even if the governments’ oversight boards could detect less creditworthy borrowers, the very purpose of lower interest rates is one in which such lending is required. This makes no sense from an economic or financial point of view, but it does make sense from a political, command and control point of view. So lower interest rates and increased government oversight becomes nothing more than full employment for bureaucrats who enjoy the perks of power and who bear none of the responsibility for their actions.
The choice is clear—either more of the same—that is, more fiat money pumping and more regulation, with increasing worse outcomes--or an abandonment of monetary expansion and bank oversight by government and its replacement by sound money and the normal checks and balances of the free market.
Expansion of the welfare/warfare state:
Since we have time, I’ll now discuss the second main evil of fiat money growth--expansion of the wealth destroying welfare/warfare state.
Because the wealth generating sector of society has nothing to gain and everything to lose by expansion of the welfare/warfare state, under a sound money environment these wealth destroying activities would be vigorously opposed. But under a fiat money system, many of those who benefit from the unhampered market economy are blinded by the money illusion and believe that government spending does not come out of their own pockets. Therefore, it is no coincidence that the Progressive Movement in the late nineteenth and early twentieth centuries coincided with both increased government spending AND an increase in the money supply to be provided by central banks. Like all unsustainable enterprises, the welfare/warfare state depends upon ever increasing injections of fiat money; otherwise its programs collapse rather quickly. Ever larger increases in fiat money merely delay the day of reckoning, because the ordinary cues of higher taxes and higher interest rates are avoided for a time. So fiat money leads government to make promises that it ultimately cannot deliver.
When government finally becomes aware that it IS limited in what it can accomplish, it is faced with a stark choice. If it scraps programs, it risks civil unrest from the program constituents. The alternative is to continue the programs in name only, resorting to price controls and rationing. National healthcare systems are the best examples of this phenomenon. Not only is demand for healthcare services greatly increased—a true tragedy of the commons, whereby commonly held resources are plundered to extinction—but the quantity and quality of services actually decline. The Medicare system in America tries to solve this problem by underpaying for services and then forcing providers, via threats to pull their business licenses, to absorb Medicare losses in the hopes of making up the difference with private pay patients. To avoid losses and remain in business, medical practices counter with lower service quality and delays. Our neighbor to the north rations care to those who can live and suffer long enough to advance to the front of long waiting lists. In a recent suit brought by a Canadian patient, a Canadian judge stated that “access to a waiting list is not access to healthcare”.
The Long Term Solution: Liberate Money and the Economy from Government Control
A free market economy, which includes money freely chosen by the market, does not suffer disequilibria, periodic booms and busts, or high unemployment. The constant search of market participants to better themselves will result in cooperation rather than confrontation with all peoples everywhere. The liberal order, as envisioned by scholars such as Ludwig von Mises, can expand to encompass the entire world, resulting in peace and ever expanding prosperity for all cooperating men everywhere.
Sound money is essential; therefore, the first order of business for Europe is to stabilize the Euro. Stop inflating its supply. Stop purchasing sovereign debt. Anchor the Euro in gold and/or silver. Try to gain international cooperation when doing so, in order to prevent large swings in gold and silver imports and exports when other nations see that they must emulate Europe. Nevertheless, if this is not possible, anchor the Euro in gold or silver anyway.
Then begin the process to privatize money by eliminating legal tender laws. Let the market use whatever money it chooses, even multiple monies. Some Austrian economists believe that eliminating legal tender laws is all that is required of government…that the free market will choose the money that it finds best suits its purposes. That may be the case; it certainly is worth the effort. A practical step would be to relax legal tender laws in one or both of two ways, the non-enforcement of legal tender laws or the de-criminalization of private money production. Non-prosecution would open the door to private, competing monies.
End all regulation of banking, including deposit guarantees, which only cause moral hazard. But, enforce 100% reserves against money certificates and demand deposits. Reform the commercial code to provide legal protections for bank depositors just as is the case with any warehouse bailment. But allow complete freedom of loan banking, whereby the banker takes legal ownership of funds for some set period of time, with a promise to return the funds, plus interest, at the end of the contract. This form of loan banking can be risk free, as when customer loans to the bank are less than the bank’s capital account. It is also non-inflationary, because the bank lends only funds that have been transferred to it and it alone—the depositor gives up his claim to the funds for the length of the contract. Undoubtedly, under such legal protections and known risks, the public would be better served than by the current, fractional reserve system of constant expansion and contraction of the money supply via bank lending.
Rules for the Statesman
Those in positions of power, such as all of you here, must be guided by reason and not emotion. Adopt as your motto Immanuel Kant’s categorical imperative. Pass only laws that are universally applicable--that benefit all men at all times and in all places. Treat men as ends in themselves rather than as means to other ends, such as national or regional pride. Not many laws will meet these high standards. Certainly printing money, which reduces the purchasing power of money already in circulation and benefits some at the expense of others, fails this test, as does buying sovereign debt at subsidized interest rates. Both of these practices lead not to freedom and security but to suffering and conflict. I ask you to lead as statesmen always do: based on principles that work, are true, and are real.
Address Delivered at the European Parliament, Brussels on March 16, 2011
By Patrick Barron
Introduction: The Illusion of Unlimited Resources
The current problems faced by all the world’s economies stem, primarily, from one source: the demise of sound money, whose quantity could not be increased without significant cost, and its replacement with fiat money that can be inflated to infinite amounts at almost no cost to the producer.
Expansion of fiat money makes it appear to ALL market participants, including financial regulators, that there are more resources available than really exist. Thusly, all participants, including governments, embark on programs which cannot be completed…there just are not enough resources in the economy. Not only does fiat money create the illusion of greater wealth, it makes embarking on new projects irresistible. After all, does it not always appear that lack of money is all that stands between man and the fulfillment of all his dreams? Now, with unlimited quantities of fiat money, the day seems to have arrived when anything is possible. But this is an illusion.
Throughout my talk I will refer to economic laws that act as impenetrable barriers to achieving the goals sought by monetary expansion. These are laws of human nature—to ignore them brings serious adverse consequences. Economics is a social and not a natural science, because man is a social being. His actions are not governed by physical stimuli but by preferences derived from subjective valuations, all of which are unknowable, undergo constant change, and, thusly, cannot be predicted. Nevertheless, we do know that man is rational; that he acts to attain goals which he believes will improve his satisfaction; that he employs scarce means to do so and that means imply costs; but, since he expects to improve his satisfaction, he expects the costs to be less than the satisfaction to be attained; so man expects to profit from his actions. From this brief explanation of man as a rational being, we can derive irrefutable economic laws.
Two Evils of Monetary Expansion:
There are two main evils of monetary expansion: (1) recurring financial crises and (2) expansion of the wealth destroying welfare/warfare state.
I’ll start with why we continue to have recurring and ever more damaging financial crises. If there is enough time, I will speak very briefly on expansion of the wealth destroying welfare/warfare state.
No Societal Benefit from Monetary Expansion
Expansion of fiat money denies the irrefutable economic law that money is subject to the Law of Diminishing Marginal Utility. This insight was explained by Ludwig von Mises in his 1913 classic The Theory of Money and Credit. Mises explained that money is not “neutral”, that money is a good and is subject to all the laws of economics as are all other goods. Since each new marginal unit conveys less utility than all previous units and, since money is fungible—meaning that each new unit is indistinguishable from monetary units already existing—then the purchasing power of all money is reduced. The first users of the new money benefit most from the newly created money. This is a tight circle nearest the event of the new money being created. Those furthest away from this event, who are in a wider circle of the general economy, all lose since this new money dilutes the value of each unit of money they are already holding. Think of it as pouring water into milk. Therefore, expansion of the money supply conveys no overall societal benefit.
Money Expansion Is Not Stimulative:
Immediately we see that an increase in money cannot be stimulative overall. Although it can stimulate some parts of the economy (those who get the new money first), it can do so only at the expense of all other parts, violating another immutable law of economics, Say’s Law, which essentially tells us that we can’t get something for nothing. With the creation of new fiat money wealth has been redistributed from the current holders of money—the rightful owners--to illegitimate new allocators who steal, without getting noticed, other people’s money. The first or early receivers of the new money benefit at the expense of those who receive it later, through the market process, or do not receive it at all; for example, retirees living on privately accumulated wealth. The early receivers buy at existing lower prices; later receivers pay higher prices.
As this newly created money dilutes the existing money’s purchasing power we see this as high prices—later and not immediately. Higher overall prices are the logical consequence of any expansion of money. The price level can be thought of as the result of total monetary spending divided by the total supply of goods and services offered on the market. If the numerator—total spending-- goes up or the denominator—total market supply of goods—goes down, the price level increases. Some may object to this explanation, saying that “sometimes the price level remains relatively flat despite an increase in the quantity of money, because the total supply of goods increases enough to offset increases in total spending.” My answer is that this is a justification for slow, planned inflation which ignores damaging structural changes that still occur in the economy. I will discuss these in a few minutes.
The Prosperity Illusion Caused by a Rising Gross National Product
Unfortunately, increased spending creates the illusion of increased prosperity, because we measure prosperity by the growth in Gross National Product (GNP), a measure only of total spending, the numerator in the Quantity Theory of Money equation. Under sound money, GNP remains the same, because the quantity of money…and thusly, the quantity of total spending…remains unchanged. But under fiat money inflationary spending, caused by planned inflation of the money supply, this is described as economic “growth”. The more government inflates the quantity of money, the greater economic growth appears to be as measured by GNP. But, this is an illusion. It is not growth at all. It is just a consequence of measuring higher prices.
So far we have seen that fiat money does not stimulate the economy overall; it merely rewards some at the expense of others and creates higher overall prices. But the main structural damage, to which I earlier referred, occurs in the structure of production as manifested by recurring boom/bust cycles. Here is where fiat money and credit expansion cause pure capital consumption, robbing the future productive capability of the economy.
Malinvestment and the Austrian Business Cycle
In the mistaken belief that the economy can be stimulated into a higher level of production by more money, central bankers lower interest rates below the natural, market rate. The ultimate result of such intervention is destruction of capital through what Austrian economists call malinvestment. Capital is devoted to lines of production, primarily into longer term investments, that will never be profitably completed.
We must address this most pressing question: Why do so many businesses fail at the same time? Can it be that a mass incompetence spreads through the economy so that we experience a wide scale bust from time to time? Governments and central bankers focus on this bust and try to postpone it, thinking that this bust is the problem. But, ladies and gentlemen, I am here to tell you that the bust is not the problem. The problem is the boom and why it was created in the first place. Fortunately this business cycle phenomenon has been very well explained by Austrian Economics. For those of you who have the time, I will be happy to explain the details of this after my talk. Suffice it to say that it is the intervention of the central bank that puts into motion the culprit of “artificial interest rates”. These are false signals to businesses that there are new, real resources for investing in longer-term capital expansion projects. But this is a false signal. There are no new, real resources for the successful and profitable completion of all new boom-time projects.
Coercion Is No Solution
Rather than cease its monetary intervention, government counters these consequences with coercion in the form of increasing bureaucratic oversight of banks, mandatory increases in bank capital requirements, and the creation of bailout funds.
Increasing bureaucratic oversight rests on two false ideas—that bureaucrats CAN discern potential problems to which bankers are blinded and that, unlike bankers, bureaucrats are not greedy by nature, so they will not take on increased risk. But government bureaucrats can no more detect errors, culpable or otherwise, than can the financial community they are supposed to regulate. The normal economic cues are hidden by expansion of money and manipulation of the interest rate. Regulators and systemic risk analysts are no more able to detect these errors than anyone else. All the oversight boards will accomplish is adding cost to the banking system and possibly creating what Wilhelm Ropke called repressed inflation and what we today call stagflation, whereby production declines and employment falls while prices rise.
Bailout funds are the culprits behind any increased risk taking by greedy bankers. These funds create moral hazard, whereby market participants know that some or all of the cost of increased risk will be borne by others but that benefits will not be shared. In addition, due to the law of diminishing marginal utility of money, the funds themselves continue rather than cure the problem initially caused by money expansion, for the funds are formed by even more money expansion.
All of this intervention leads back to the evils of redistribution of wealth, higher prices, and more malinvestment, a vicious and destructive cycle.
The Cognitive Dissonance of Money Expansion Followed by Increased Coercion
This entire process is a psychological phenomenon called cognitive dissonance; that is, holding two conflicting thoughts in the mind at the same time. Expansion of the money supply and lowering of interest rates in order to stimulate the economy is not compatible with increased bank capital requirements and oversight boards to detect systemic risk. The government expects that a lower rate of interest will promote more economic activity through increased lending. Yet the law of diminishing marginal utility applies to lending also. The only way to make more loans is to lend to less creditworthy customers. Yet this is the situation that more oversight attempts to prevent. Therefore, even if the governments’ oversight boards could detect less creditworthy borrowers, the very purpose of lower interest rates is one in which such lending is required. This makes no sense from an economic or financial point of view, but it does make sense from a political, command and control point of view. So lower interest rates and increased government oversight becomes nothing more than full employment for bureaucrats who enjoy the perks of power and who bear none of the responsibility for their actions.
The choice is clear—either more of the same—that is, more fiat money pumping and more regulation, with increasing worse outcomes--or an abandonment of monetary expansion and bank oversight by government and its replacement by sound money and the normal checks and balances of the free market.
Expansion of the welfare/warfare state:
Since we have time, I’ll now discuss the second main evil of fiat money growth--expansion of the wealth destroying welfare/warfare state.
Because the wealth generating sector of society has nothing to gain and everything to lose by expansion of the welfare/warfare state, under a sound money environment these wealth destroying activities would be vigorously opposed. But under a fiat money system, many of those who benefit from the unhampered market economy are blinded by the money illusion and believe that government spending does not come out of their own pockets. Therefore, it is no coincidence that the Progressive Movement in the late nineteenth and early twentieth centuries coincided with both increased government spending AND an increase in the money supply to be provided by central banks. Like all unsustainable enterprises, the welfare/warfare state depends upon ever increasing injections of fiat money; otherwise its programs collapse rather quickly. Ever larger increases in fiat money merely delay the day of reckoning, because the ordinary cues of higher taxes and higher interest rates are avoided for a time. So fiat money leads government to make promises that it ultimately cannot deliver.
When government finally becomes aware that it IS limited in what it can accomplish, it is faced with a stark choice. If it scraps programs, it risks civil unrest from the program constituents. The alternative is to continue the programs in name only, resorting to price controls and rationing. National healthcare systems are the best examples of this phenomenon. Not only is demand for healthcare services greatly increased—a true tragedy of the commons, whereby commonly held resources are plundered to extinction—but the quantity and quality of services actually decline. The Medicare system in America tries to solve this problem by underpaying for services and then forcing providers, via threats to pull their business licenses, to absorb Medicare losses in the hopes of making up the difference with private pay patients. To avoid losses and remain in business, medical practices counter with lower service quality and delays. Our neighbor to the north rations care to those who can live and suffer long enough to advance to the front of long waiting lists. In a recent suit brought by a Canadian patient, a Canadian judge stated that “access to a waiting list is not access to healthcare”.
The Long Term Solution: Liberate Money and the Economy from Government Control
A free market economy, which includes money freely chosen by the market, does not suffer disequilibria, periodic booms and busts, or high unemployment. The constant search of market participants to better themselves will result in cooperation rather than confrontation with all peoples everywhere. The liberal order, as envisioned by scholars such as Ludwig von Mises, can expand to encompass the entire world, resulting in peace and ever expanding prosperity for all cooperating men everywhere.
Sound money is essential; therefore, the first order of business for Europe is to stabilize the Euro. Stop inflating its supply. Stop purchasing sovereign debt. Anchor the Euro in gold and/or silver. Try to gain international cooperation when doing so, in order to prevent large swings in gold and silver imports and exports when other nations see that they must emulate Europe. Nevertheless, if this is not possible, anchor the Euro in gold or silver anyway.
Then begin the process to privatize money by eliminating legal tender laws. Let the market use whatever money it chooses, even multiple monies. Some Austrian economists believe that eliminating legal tender laws is all that is required of government…that the free market will choose the money that it finds best suits its purposes. That may be the case; it certainly is worth the effort. A practical step would be to relax legal tender laws in one or both of two ways, the non-enforcement of legal tender laws or the de-criminalization of private money production. Non-prosecution would open the door to private, competing monies.
End all regulation of banking, including deposit guarantees, which only cause moral hazard. But, enforce 100% reserves against money certificates and demand deposits. Reform the commercial code to provide legal protections for bank depositors just as is the case with any warehouse bailment. But allow complete freedom of loan banking, whereby the banker takes legal ownership of funds for some set period of time, with a promise to return the funds, plus interest, at the end of the contract. This form of loan banking can be risk free, as when customer loans to the bank are less than the bank’s capital account. It is also non-inflationary, because the bank lends only funds that have been transferred to it and it alone—the depositor gives up his claim to the funds for the length of the contract. Undoubtedly, under such legal protections and known risks, the public would be better served than by the current, fractional reserve system of constant expansion and contraction of the money supply via bank lending.
Rules for the Statesman
Those in positions of power, such as all of you here, must be guided by reason and not emotion. Adopt as your motto Immanuel Kant’s categorical imperative. Pass only laws that are universally applicable--that benefit all men at all times and in all places. Treat men as ends in themselves rather than as means to other ends, such as national or regional pride. Not many laws will meet these high standards. Certainly printing money, which reduces the purchasing power of money already in circulation and benefits some at the expense of others, fails this test, as does buying sovereign debt at subsidized interest rates. Both of these practices lead not to freedom and security but to suffering and conflict. I ask you to lead as statesmen always do: based on principles that work, are true, and are real.
Monday, March 14, 2011
My letter to the Telegraph re: Economic Fallacy
From: patrickbarron@msn.com
To: atletters@telegraph.co.uk; stletters@telegraph.co.uk
CC: tomrstevenson@fil.com
Subject: Economic Fallacy
Date: Mon, 14 Mar 2011 05:52:48 -0400
re: Japan could emerge stronger from the catastrophic quake, by Tom Stevenson
Dear Sirs:
Mr. Tom Stevenson is the latest financial "expert" to be blinded by the illusions of monetary expansion. In his column on Sunday, March 13 he stated the following:
"In the short term, the impact on the Japanese economy will be negative...Further out, the rebuilding effort will probably stimulate the economy via construction and other capital spending. The net impact on GDP might be positive, not the least because the Bank of Japan quickly made it clear it will provide whatever liquidity is required."
This is the nonsensical conclusion that one draws from blind adherence to Keynesian economics, which equates demand-side monetary expansion with an increase in the well-being of an economy. By this logic one should rejoice at the destruction of war and natural disasters that destroy capital and lives. Perhaps we all should burn down our homes, factories, and shops, so that our central banks can shower us with pieces of paper, making us feel oh-so-rich! Japan needs savings, not spending, to obtain the capital it will need to rebuild. Monetary expansion does not create new capital. It is nothing more than an accounting fiction, made possible by the ability of central banks to create fiat money out of thin air.
Patrick Barron
To: atletters@telegraph.co.uk; stletters@telegraph.co.uk
CC: tomrstevenson@fil.com
Subject: Economic Fallacy
Date: Mon, 14 Mar 2011 05:52:48 -0400
re: Japan could emerge stronger from the catastrophic quake, by Tom Stevenson
Dear Sirs:
Mr. Tom Stevenson is the latest financial "expert" to be blinded by the illusions of monetary expansion. In his column on Sunday, March 13 he stated the following:
"In the short term, the impact on the Japanese economy will be negative...Further out, the rebuilding effort will probably stimulate the economy via construction and other capital spending. The net impact on GDP might be positive, not the least because the Bank of Japan quickly made it clear it will provide whatever liquidity is required."
This is the nonsensical conclusion that one draws from blind adherence to Keynesian economics, which equates demand-side monetary expansion with an increase in the well-being of an economy. By this logic one should rejoice at the destruction of war and natural disasters that destroy capital and lives. Perhaps we all should burn down our homes, factories, and shops, so that our central banks can shower us with pieces of paper, making us feel oh-so-rich! Japan needs savings, not spending, to obtain the capital it will need to rebuild. Monetary expansion does not create new capital. It is nothing more than an accounting fiction, made possible by the ability of central banks to create fiat money out of thin air.
Patrick Barron
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