Money Bank Credit and Economic Cycles De Soto Book

Money Bank Credit and Economic Cycles De Soto Book
  • Page 1

    MONEY, BANK CREDIT,ANDECONOMIC CYCLES

  • Page 2

  • Page 3

    MONEY, BANK CREDIT, ANDECONOMIC CYCLESJESÚS HUERTA DESOTOTRANSLATED BYMELINDA A. STROUPLudwigvon MisesInstituteAUBURN, ALABAMA

  • Page 4

    First Spanish edition 1998, Dinero, Crédito Bancario y Ciclos Económicos, Unión Editorial, MadridCopyright © 1998 Jesús Huerta de SotoSecond Spanish edition 2002, Unión Editorial, MadridCopyright © 2006 Jesús Huerta de SotoTranslated from Spanish by Melinda A. StroupFirst English edition ...

  • Page 5

    vCONTENTSPREFACE TO THEENGLISH-LANGUAGE EDITION . . . . . . . . . . . . . . .xviiPREFACE TO THESECOND SPANISH EDITION . . . . . . . . . . . . . . . . . . .xixINTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .xxiCHAPTER 1: THE LEGAL NATURE OF THEMONETA...

  • Page 6

    vi3 The Essential Differences Between the Irregular Deposit Contract and the Monetary Loan Contract . . . .13The Extent to Which Property Rights are Transferred in Each Contract . . . . . . . . . . . . . . . . . .13Fundamental Economic Differences Between the Two Contracts . . . . . . . . . . . ....

  • Page 7

    Banking in Florence in the Fourteenth Century . . . .70The Medici Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .72Banking in Catalonia in the Fourteenth and Fifteenth Centuries: The Taula de Canvi . . . . . . . . .754 Banking During the Reign of Charles V and the Doctrine of the...

  • Page 8

    Criticism of the Attempt to Equate the Monetary Irregular-Deposit Contract with the Loan or Mutuum Contract . . . . . . . . . . . . . . . . . . . . . . . . . . .133The Distinct Cause or Purpose of Each Contract . .134The Notion of the Unspoken or Implicit Agreement . . . . . . . . . . . . . . . ....

  • Page 9

    5 Credit Expansion and New Deposit Creation by the Entire Banking System . . . . . . . . . . . . . . . . . . . . . . . .217Creation of Loans in a System of Small Banks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2236 A Few Additional Difficulties . . . . . . . . . . ....

  • Page 10

    The Three Different Manifestations of the Process of Voluntary Saving . . . . . . . . . . . . . . . . . .313Account Records of Savings Channeled into Loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .315The Issue of Consumer Loans . . . . . . . . . . . . . . . . . .31...

  • Page 11

    2 The Possibility of Postponing the Eruption of the Crisis: The Theoretical Explanation of the Process of Stagflation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3993 Consumer Credit and the Theory of the Cycle . . . . . . . . .4064 The Self-Destructive Nature of the Ar...

  • Page 12

    18 Empirical Evidence for the Theory of the Cycle . . . . . . . .476Business Cycles Prior to the Industrial Revolution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .479Business Cycles From the Industrial Revolution Onward . . . . . . . . . . . . . . . . . . . . . . . . .482The ...

  • Page 13

    4 The Marxist Tradition and the Austrian Theory of Economic Cycles: The Neo-Ricardian Revolution and the Reswitching Controversy . . . . . . . . . . . . . . . . . .5715 Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .5766 Appendix on Life Insurance Companie...

  • Page 14

    The Position of the Currency-School Theorists who Defended a Free-Banking System . . . . . . . . .6393 The “Theorem of the Impossibility of Socialism” and its Application to the Central Bank . . . . . . . . . . . . .647The Theory of the Impossibility of Coordinating Society Based on Instituti...

  • Page 15

    The Confusion Between the Concept of Saving and that of the Demand for Money . . . . . . . . . . . .694The Problem with Historical Illustrations of Free-Banking Systems . . . . . . . . . . . . . . . . . . . . . . .701Ignorance of Legal Arguments . . . . . . . . . . . . . . . . .7065 Conclusion: T...

  • Page 16

    What Would the Financial and Banking System of a Totally Free Society be Like? . . . . . . . . . . . . . .7433 An Analysis of the Advantages of the Proposed System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7454 Replies to Possible Objections to our Proposal ...

  • Page 17

    PREFACE TO THEENGLISH-LANGUAGEEDITIONIt is a genuine pleasure for me to see this handsomely-printed English edition of my book, Dinero, Crédito Bancarioy Ciclos Económicos, which first appeared in Spain in 1998.This translation incorporates the small number of correctionsincluded in the second ...

  • Page 18

  • Page 19

    PREFACE TOTHESECONDSPANISH EDITIONFollowing the success of the first edition of Dinero, CréditoBancario y Ciclos Económicos, which sold out rapidly, I ampleased to present the second edition to Spanish-speak-ing readers. To avoid confusion and facilitate the work ofscholars and researchers, the...

  • Page 20

    opinion, my university colleagues and economic-policyauthorities in government and central banks.Various reviews of this book’s first edition have appeared,and I am grateful to the eminent authors of them for theirmany positive comments.1 A common denominator among allhas been to urge the trans...

  • Page 21

    INTRODUCTIONThe economic analysis of juridical institutions has cometo the fore in recent years and promises to become oneof the most fruitful spheres of economics. Much of thework completed thus far has been strongly influenced by tra-ditional neoclassical assumptions, namely by the concept ofst...

  • Page 22

    and applied them to the analysis of law. This has been thecase, for example, with respect to the economic analysis of con-tracts and civil liability, bankruptcy law, the family, and evencriminal law and justice. Very few economic analyses of lawhave had mainly macroeconomic implications, and this...

  • Page 23

    and foreign exchange controls. These institutions thoroughlyregulate every country’s financial sector, rendering it muchmore similar to the socialist system of central planning than isappropriate to a true market economy. Hence, as I will attemptto demonstrate, the arguments which establish the...

  • Page 24

    there are great differences of opinion as to whether it is neces-sary to maintain the central bank or whether it would be bet-ter to exchange it for a system of free banking, and in the lat-ter case, as to what concrete rules economic agentsparticipating in a completely free financial system shou...

  • Page 25

    This book comprises nine chapters. In the first I describethe legal essence of the monetary irregular-deposit contract,paying special attention to the main characteristics distin-guishing it from a loan contract, or mutuum. In addition,Chapter 1 deals with the different legal logic inherent in th...

  • Page 26

    foundation dates back to the Middle Ages and has continueduntil practically the present day. We will take a detailed lookat different efforts to formulate an unorthodox legal principlecapable of governing present-day monetary bank deposits ina logical, coherent manner. I conclude that such attemp...

  • Page 27

    recurrent phenomenon. I will endeavor to show that the cen-tral bank did not emerge spontaneously as the result of mar-ket institutions, but was forcibly imposed by the governmentand responds to the demands of powerful pressure groups. Iwill also examine the current financial system, which is bas...

  • Page 28

    and of a modern financial system in the former socialisteconomies.A summarized version of this book’s essential thesis wasfirst presented in a paper before the Mont Pèlerin Society inRio de Janeiro in September 1993 and received the support ofJames M. Buchanan, to whom I am very grateful. A wr...

  • Page 29

    and Professors Hans-Hermann Hoppe from Las Vegas Uni-versity in Nevada, Manuel Gurdiel from the UniversidadComplutense in Madrid, Pablo Vázquez from the Universityof Cantabria (Spain), Enrique Menéndez Ureña from the Uni-versidad Comillas (Madrid), James Sadowsky from FordhamUniversity, Pedro ...

  • Page 30

  • Page 31

    1THE LEGAL NATUREOF THEMONETARYIRREGULAR-DEPOSITCONTRACT1APRELIMINARY CLARIFICATION OFTERMS:LOAN CONTRACTS (MUTUUM ANDCOMMODATUM)ANDDEPOSIT CONTRACTSAccording to the Shorter Oxford English Dictionary, a loan is“a thing lent; esp. a sum of money lent for a time, to bereturned in money or money...

  • Page 32

    THE COMMODATUM CONTRACTCommodatum (from Latin) refers to a real contract made ingood faith, by which one person—the lender—entrusts toanother—the borrower or commodatary—a specific item to beused for free for a certain period of time, at the end of whichthe item must be restored to its ow...

  • Page 33

    fungible good. By this contract, a certain quantity of monetaryunits are handed over today from one person to another andthe ownership and availability of the money are transferredfrom the one granting the loan to the one receiving it. The per-son who receives the loan is authorized to use the mo...

  • Page 34

    or implicit establishment of a fixed term, the mutuum contract orloan cannot exist.THE DEPOSIT CONTRACTWhereas loan contracts (commodatum and mutuum)entail the transfer of the availability of the good, which shiftsfrom the lender to the borrower for the duration of the term,another type of contra...

  • Page 35

    main element is the complete availability of the depositedgoods in favor of the depositor, as well as the obligation on thepart of the depositary to conscientiously guard and protect thegoods. The only difference between the deposit of fungiblegoods and the regular deposit, or deposit of specific...

  • Page 36

    ownership is not transferred, but rather the depositor contin-ues to own the good, while in the case of the deposit of fungi-ble goods, one might suppose that ownership is transferred tothe depositary). Nevertheless, we must emphasize that theessence of the deposit remains unchanged and that the ...

  • Page 37

    the regular deposit, or deposit of specific goods, the depositaryis not responsible for the loss of a good due to an inevitableaccident or act of God, while in the irregular deposit, thedepositary is responsible even in the case of an act of God.Therefore, in addition to the traditional advantage...

  • Page 38

    another depositor, as long as he maintains available to the origi-nal depositor oil or grain of the same quantity and quality as thosedeposited. In the deposit of money the same rule applies. If afriend gives you a twenty-dollar bill in deposit, we may con-sider that he transfers to you the owner...

  • Page 39

    To sum up, the logic behind the institution of irregulardeposit is based on universal legal principles and suggests thatthe essential element of custody or safekeeping necessitates thecontinuous availability to the depositor of a tantundem equal tothe original deposit. In the specific case of mon...

  • Page 40

    expert Antonio Ferrer Sama has explained that if the depositconsists of an amount of money and the obligation to returnthe same amount (irregular deposit), and the depositary takesthe money and uses it for his own profit, we will have to determine which of the following situations is the correcto...

  • Page 41

    COURT DECISIONS ACKNOWLEDGING THEFUNDAMENTAL LEGALPRINCIPLES WHICHGOVERN THEMONETARY IRREGULAR-DEPOSITCONTRACT (100-PERCENT RESERVE REQUIREMENT)As late as twentieth century, court decisions in Europehave upheld the demand for a 100-percent reserve require-ment, the embodiment of the essential ele...

  • Page 42

    Spain, Barcelona’s northern court of original jurisdiction, inresponse to protests of checking-account holders demandingrecognition as depositors, pronounced a judgment acknowledg-ing them as such and identifying their consequent preferentialstatus as creditors of a bankruptcy claiming title to...

  • Page 43

    3THE ESSENTIAL DIFFERENCES BETWEEN THEIRREGULAR DEPOSIT CONTRACT AND THEMONETARY LOAN CONTRACTIt is now important to review and stress the fundamentaldifferences between the irregular deposit contract and theloan contract, both with respect to money. As we will see laterin different contexts, muc...

  • Page 44

    rights are transferred in the irregular deposit, unlike the loancontract, where complete availability of the loaned good istransferred for the duration of the contract’s term. Therefore,even given the one feasible “similarity” between the irregulardeposit and the monetary loan (the supposed...

  • Page 45

    Therefore, in the monetary irregular deposit there is norelinquishment of present goods in favor of a larger quantityof future goods at the end of a time period, but rather simplya change in the manner of possessing present goods. Thischange occurs because under many circumstances the depos-itor ...

  • Page 46

    irregular-deposit contract, interest agreements are contra natu-ram and absurd. Coppa-Zuccari, with his customary insight,explains that the absolute impossibility of including an inter-est agreement in the irregular deposit contract is, from a legalviewpoint, a direct result of the right granted ...

  • Page 47

    of the irregular deposit contract, which contrasts sharply withthe legal essence of the loan contract.17FUNDAMENTAL LEGAL DIFFERENCES BETWEENTHETWO CONTRACTSThe essential legal element in the irregular deposit con-tract is the custody or safekeeping of the money deposited. Tothe parties deciding ...

  • Page 48

    imagine a monetary loan contract without a fixed term (duringwhich not only is ownership transferred, but availability is lostto the lender as well), at the end of which it is necessary toreturn the tantundem of money originally loaned plus interest,in the irregular deposit contract there is no t...

  • Page 49

    TABLE 1-1ESSENTIAL DIFFERENCES BETWEEN TWORADICALLY DIFFERENT DISTINCT CONTRACTSMonetary Irregular DepositMonetary LoanEconomic DifferencesThe Legal Nature of the MonetaryIrregular-Deposit Contract191. Present goods are notexchanged for futuregoods.2. There is complete, contin-uous availability i...

  • Page 50

    irregular deposit contract (which could be considered arequirement of the fungible nature of the deposited goods)does not imply a simultaneous transfer of availability of thetantundem, in the loan contract there is a complete transfer ofownership and availability of the tantundem from lender tobo...

  • Page 51

    through a repetitive, evolutionary process. Perhaps one ofCarl Menger’s most important contributions was the develop-ment of a complete economic theory of social institutions.According to his theory, social institutions arose as the resultof an evolutionary process in which innumerable humanbei...

  • Page 52

    interaction which Menger believes should be the main subjectof research in economics.22Menger’s ideas were later developed by F.A. Hayek invarious works on the fundamentals of law and juridical insti-tutions,23 and especially by the Italian professor of politicalscience, Bruno Leoni, who was th...

  • Page 53

    Cicero’s rendering of Cato’s words, specifically points out thatRoman jurists knew Roman law was not the personal inven-tion of one man, but rather the creation of many over genera-tions and centuries, given that there never was in the world a man so clever as to foreseeeverything and that ev...

  • Page 54

    individual takes into account his own circumstances and thebehavior of others and the law is perfected through a selectiveevolutionary process.26ROMAN JURISPRUDENCEThe greatness of classical Roman jurisprudence stems pre-cisely from the realization of this important truth on the partof legal expe...

  • Page 55

    application of these unchanging universal principles to newsituations and problems arising continually from this evolu-tionary process.29 In addition, Roman jurists worked inde-pendently and were not civil servants. Despite multipleattempts by official legal experts in Roman times, they werenever...

  • Page 56

    Roman classical jurists deserve the credit for first discov-ering, interpreting, and perfecting the most important juridi-cal institutions that make life in society possible, and as wewill see, they had already recognized the irregular depositcontract, understood the essential principles governin...

  • Page 57

    Gaius’s Institutiones. The Digest or Pandecta is a compilation ofclassical legal texts which includes over nine thousandexcerpts from the works of different prestigious jurists. Pas-sages taken from the works of Ulpian, which comprise a thirdof the Digest, together with excerpts from Paul, Papi...

  • Page 58

    de intensifies the meaning, which reflects that all obligationscorresponding to the custody of the good belong to that per-son.33A deposit can be either regular, in the case of a specificgood; or irregular, in the case of a fungible good.34 In fact, innumber 31, title 2, book 19 of the Digest, Pa...

  • Page 59

    In other words, Paul clearly indicates that in the monetaryirregular deposit the depositary’s only obligation is to returnthe tantundem: the equivalent in quantity and quality of theoriginal deposit. Moreover, whenever anyone made an irreg-ular deposit of money, he received a written certificat...

  • Page 60

    The essential obligation of depositaries is to maintain thetantundem constantly available to depositors. If for some reasonthe depositary goes bankrupt, the depositors have absoluteprivilege over any other claimants, as Ulpian skillfully explains(paragraph 2, number 7, title 3, book 16 of the Dig...

  • Page 61

    is today called the crime of misappropriation was includedunder the definition of theft in Roman law. Ulpian, in referenceto Julianus, also concluded: if someone receives money from me to pay a creditor ofmine, and, himself owing the same amount to the creditor,pays him in his own name, he commit...

  • Page 62

    he and his successors are most certainly obliged to carry outthe task accepted and to fulfill the trust placed in them.41It is recognized, in short, that those who receive money ondeposit are often tempted to use it for themselves. This isexplicitly acknowledged elsewhere in the Corpus Juris Civi...

  • Page 63

    as irregular deposits and then deliberately delaying repay-ment, thus authorizing the charging of interest. If these con-tracts had from the beginning been openly regarded as loan ormutuum contracts they would not have been permitted bycanon law.Finally, we find evidence in the following extracts...

  • Page 64

    Money, Bank Credit, and Economic Cycles34It is therefore clear from Ulpian’s writings in this sectionthat bankers carried out two different types of operations. Onone hand, they accepted deposits, which involved no right tointerest and obliged the depositary to maintain the full, con-tinuous av...

  • Page 65

    3515, book 3) the distinction is made between the deposit “ofsome counted money or raw silver or gold,” received from“another, by weight,” in which case “the goods may be usedand goods of the same quantity and quality as those receivedmay be returned;” and the deposit “which is seal...

  • Page 66

    Money, Bank Credit, and Economic Cycles36which, against traditional legal principles, gradually gainedacceptance. Then in chapter 4 we will begin to consider theeconomic consequences of these events.

  • Page 67

    2HISTORICAL VIOLATIONSOF THELEGAL PRINCIPLESGOVERNING THEMONETARYIRREGULAR-DEPOSITCONTRACTIn this chapter we will present various examples to showhow bankers have throughout history violated traditionallegal principles in the irregular deposit, and we will con-sider the reasons behind the failure...

  • Page 68

    those who from the beginning received money from their fel-low citizens for safekeeping knew the obligations they weretaking on, specifically, to guard the tantundem like a good par-ent, to keep it constantly available to the depositor. This is pre-cisely the meaning of safekeeping in a deposit c...

  • Page 69

    already been in operation so long and had acquired suchpower that it was practically impossible to effectively curbcorruption. Moreover, the gradual discovery authorities madeof banks’ immense power to create money explains why, inmost instances, governments ended up becoming accomplicesto bank...

  • Page 70

    the bankers privileges so they could carry out their activitieswith impunity in exchange for specific favors, but they haveeven created government banks in order to directly takeadvantage of the corresponding profits.Although banking activities developed long ago and prac-tically coincided with t...

  • Page 71

    the irregular deposit by bankers and authorities in three dif-ferent historical instances: the Greco-Roman world; the Mediter-ranean trading cities of the late Middle Ages and the begin-ning of the Renaissance; and finally, the emergence of the firstimportant government banks beginning in the sev...

  • Page 72

    B.C.5 It is a forensic speech in which Isocrates defends theinterests of the son of a favorite of Satyrus, king of Bosphorus.The son accuses Passio, an Athenian banker, of misappropri-ating a deposit of money entrusted to him. Passio was an ex-slave of other bankers (Antisthenes and Archetratos),...

  • Page 73

    deposits entrusted to his bank by taking advantage of hisdepositor’s difficulties, for which he did not hesitate todeceive, forge, and steal contracts, bribe, etc. In any case, thisspeech is so important to our topic that it is worth our effort toconsider some of its passages in detail.Isocrate...

  • Page 74

    Isocrates explains that his client, who was planning a trip,deposited a very large amount of money in Passio’s bank.After a series of adventures, when Isocrates’s client went towithdraw his money, the banker claimed he “was withoutfunds at the moment and could not return it.” However, the...

  • Page 75

    their fraudulent activity is very significant. Also, we maydeduce from Isocrates’s speech that for Passio this was not anisolated case of fraud, an attempt to appropriate the money ofa client under favorable circumstances, but that he had diffi-culty returning the money because he had not maint...

  • Page 76

    Furthermore, Isocrates claims that the point most likely toconvince the judges of the deposit’s existence and of the factthat Passio tried to appropriate it was that Passio alwaysrefused to turn over the slave who knew of the deposit, for interroga-tion under torture. What stronger evidence exi...

  • Page 77

    Aristolochus, who owned a field “he bought while owingmoney to many people,” as well as of Sosynomus, Timode-mus, and others who went bankrupt, and “when it was nec-essary to pay those to whom they owed money, they all sus-pended payments and surrendered their assets to creditors.”11Demos...

  • Page 78

    This speech, delivered in 362 B.C., is the first to documentthat bankers made book entries of their clients’ deposits andwithdrawals of money.14 Demosthenes also explains howchecking accounts worked. In this type of account, banksmade payments to third parties, following depositors’ instruc-t...

  • Page 79

    On various occasions research has suggested Greekbankers usually knew they should maintain a 100-percentreserve ratio on demand deposits. This would explain the lackof evidence of interest payments on these deposits, as well asthe proven fact that in Athens banks were usually not consid-ered sour...

  • Page 80

    bankers operating, against general legal principles, with a frac-tional-reserve ratio bring about credit expansion19 unbackedby real savings, leading to artificial, inflationary economicbooms, which finally revert in the shape of crises and economicrecessions, in which banks inexorably tend to fa...

  • Page 81

    amounted to sixty talents; given a constant value for gold, thiswould add up to nearly forty-four million dollars.22BANKING IN THEHELLENISTIC WORLDThe Hellenistic period, especially Ptolemaic Egypt, was aturning point in the history of banking because it marked thecreation of the first government...

  • Page 82

    who, whether farmers or not, did business through banks andmade payments out of their deposits and bank accounts. Rel-atively wealthy people were few, and most of the bank’s cus-tomers were retailers and indigenous craftspeople, linen mer-chants, textile workers, tailors, silversmiths and a tin...

  • Page 83

    making deposits as well as payments. In addition, due to theirhighly-developed accounting system, paying debts throughbanks became extremely convenient, as there was an officialrecord of transactions—an important piece of evidence in caseof litigation.The Hellenistic banking system outlived the...

  • Page 84

    delightful dialogues describing financial operations, clearings,account balances, the use of checks and so on.26 In any case, itappears the work done by professional jurists better regulatedRoman banking and provided at least a clearer idea of whatwas and was not legitimate. However, this is no g...

  • Page 85

    Refutatio omnium haeresium, a work attributed to Hippoly-tus and found in a convent on Mount Athos in 1844, reportsCallistus’s bankruptcy in detail.29 Like the recurring criseswhich plagued Greece, the bankruptcy of Callistus occurredafter a pronounced inflationary boom followed by a seriouscon...

  • Page 86

    THE SOCIETATES ARGENTARIAEBanker associations or societates argentariae were a peculi-arity of banking in the Roman world. Financial contributionsfrom members supplied the capital to form them, and thiscapital was relied upon to pay debts. However, as banks wereof particular public interest, Roma...

  • Page 87

    The argentarii conducted their business in a special placecalled a taverna. Their books reflected the debits and creditsmade to their clients’ checking accounts. Roman bankers’books qualified as evidence in court and had to be kept as setdown in the editio rationum, which stipulated the wayac...

  • Page 88

    called mensarii, after the mensa or counter where they origi-nally carried out their money-changing activities. Much liketoday’s banking licenses, the mensa could be transferred. InRome, however, as the state owned the premises where bank-ing took place, it was the right to operate (granted by ...

  • Page 89

    3BANKERS IN THELATE MIDDLE AGESThe fall of the Roman Empire meant the disappearance ofmost of its trade and the feudalization of economic and socialrelationships. The enormous reduction in trade and in thedivision of labor dealt a definitive blow to financial activities,especially banking. The ef...

  • Page 90

    The end of the eleventh century and beginning of thetwelfth brought a moderate resurgence of business and trade,mainly among the Italian cities on the Adriatic (especiallyVenice), Pisa, and later, Florence. These cities specialized intrade with Constantinople and the Orient. Significant financial...

  • Page 91

    Barcelona’s Bank of Deposit, or Taula de Canvi, and others wewill consider later).39THE REVIVAL OFDEPOSIT BANKING INMEDITERRANEAN EUROPEAbbott Payson Usher, in his monumental work, The EarlyHistory of Deposit Banking in Mediterranean Europe,40 studies thegradual emergence of fractional-reserve ...

  • Page 92

    than by the former. Usher states that: “the history of banks ofissue has, until lately, obscured the importance of due depositbanking in all its forms, whether primitive or modern.” In anironic reference to the undue importance given by economiststo the problems of banks of issue versus the o...

  • Page 93

    Usher also highlights the failure of public officials at dif-ferent levels to enforce sound banking practices, particularly a100-percent reserve requirement on demand deposits. More-over, the authorities ended up granting banks a governmentlicense (a privilege—ius privilegium) to operate with a...

  • Page 94

    THE CANONICAL BAN ONUSURY AND THE“DEPOSITUM CONFESSATUM”The ban on usury by the three major monotheistic reli-gions (Judaism, Islam and Christianity) did much to compli-cate and obscure medieval financial practices. Marjorie Grice-Hutchinson has carefully studied the medieval prohibition ofin...

  • Page 95

    act as mere financial intermediaries. The evolution of Churchdoctrine on interest in no way implies a sanction of fractional-reserve banking, i.e., bankers’ self-interested use (which usu-ally means granting loans) of demand deposits.47To a great extent, the conceptual confusion we are dealingw...

  • Page 96

    in order to circumvent the canonical ban on interest, manybankers and depositors expressly declared that they had takenpart in a monetary irregular-deposit contract, when they hadactually formalized a true loan or mutuum contract. Themethod of concealment to which this declaration belongedwas apt...

  • Page 97

    As a result of both doctrinal stances, scholars came tobelieve that the “irregularity” in the monetary irregulardeposit referred not to the deposit of a certain quantity of afungible good (the units of which were indistinguishable fromothers of the same type and the tantundem of which was to ...

  • Page 98

    the canonical ban on interest had the unexpected effect ofobscuring Roman jurists’ clear, legal definition of the mone-tary irregular-deposit contract. Many capitalized on the ensu-ing confusion in an attempt to legally justify fraudulent bank-ing and the misappropriation of demand deposits. Ex...

  • Page 99

    deposits, often, in fact, to rulers. This gave rise to fractional-reserve banking and artificial credit expansion, which in thefirst stage appeared to spur strong economic growth. Thewhole process ended in a general economic crisis and the fail-ure of banks that could not return deposits on deman...

  • Page 100

    BANKING INFLORENCE IN THEFOURTEENTH CENTURYAround the end of the twelfth and beginning of the thir-teenth centuries, Florence was the site of an incipient bankingindustry which gained great importance in the fourteenth cen-tury. The following families owned many of the most impor-tant banks: The ...

  • Page 101

    price of Florentine government bonds. In Florence, publicdebt had been financed by speculative new loans created outof nowhere by Florentine banks. A general crisis of confidenceoccurred, causing all of the above banks to fail between 1341and 1346. As could be expected, these bank failures werede...

  • Page 102

    THE MEDICI BANKThe history of the Medici Bank has come to light throughthe research and determination of Raymond de Roover, whosework was in turn advanced by the 1950 discovery of theMedici Bank’s confidential ledgers (libri segreti) in Florence’sArchivio di Stato.57 The secrecy of these ledg...

  • Page 103

    bank paid clients who loaned it money in the form of time“deposits.”In his book, Raymond de Roover performs a thorough,detailed study of the development and vicissitudes of theMedici Bank through the century of its existence. For ourpurposes, it is only necessary to emphasize that at some poi...

  • Page 104

    unbacked by growth in real savings, the reversal of theprocess was inevitable, as chapters 4 and following willexplain in detail. This is exactly what happened in Italy’s largebusiness centers in the second half of the fifteenth century. Interms of economic analysis, Raymond de Roover’s grasp...

  • Page 105

    of its assets fell into the hands of its creditors. The bank’s com-petitors failed for the same reasons: the unavoidable effects ofthe artificial expansion and subsequent economic recessioninvariably generated by the violation of the traditional legalprinciples governing the monetary irregular ...

  • Page 106

    Nevertheless, there are indications to show that, in spite ofeverything, private bankers soon began to deceive theirclients, and on August 14, 1321 the regulations pertaining tobank failures were modified. It was established that thosebankers who did not immediately fulfill their commitmentswould...

  • Page 107

    sorts of excuses, told them to “come back later” and wouldpay them (in the end, if the clients were lucky) only in smallcoins of little value and never in the gold which had originallybeen deposited.66The bank crisis of the fourteenth century did not lead toincreased monitoring and protection...

  • Page 108

    4BANKING DURING THEREIGN OFCHARLES V AND THEDOCTRINE OF THESCHOOL OFSALAMANCA69Banking during the reign of Charles V is a good exampleof the scenario we have been describing. First, the massiveinflux of precious metals from the Americas shifted the eco-nomic focus, at least temporarily, from the ...

  • Page 109

    THE DEVELOPMENT OFBANKING INSEVILLERamon Carande deserves credit for uncovering in somedetail the development of private banking in Seville duringthe reign of Charles V.70 According to Carande, his researchwas aided by the discovery of a list of bankers compiled priorto the confiscation of precio...

  • Page 110

    Morga, along with the less prominent Cristóbal Francisquín,Diego Martínez, Juan Íñiguez, and Octavio de Negrón. All ofthem inexorably went bankrupt, for the most part due to alack of liquidity with which to satisfy depositors’ withdrawalsof demand deposits. This demonstrates they were ope...

  • Page 111

    as soon as his withdrawal was completed.72 It is unfortunatethat Ramón Carande uses such inadequate analytical toolsand that his interpretation of these bank failures derivesmainly from anecdotal information, such as the greed for met-als, which constantly threatened banks’ solvency; bankers...

  • Page 112

    reverse in the second half of the sixteenth century, whendepositors nervously started to experience economic difficul-ties and the most important Florentine banks began to fail.According to Cipolla, this phase of expansion was set inmotion in Italy by the directors of the Ricci Bank, who used ave...

  • Page 113

    Of international relevance were the long-standing rela-tions between Charles V and members of the prominent Fug-ger banking family (known in Spain as the Fúcares). The Fug-gers of Augsburg started out as wool and silver merchants andalso traded spices between their city and Venice. Later theycon...

  • Page 114

    Chronologically speaking, the first work to consider,and perhaps the most relevant to our thesis, is Instrucción demercaderes (Instruction to merchants), written by Doctor LuisMoney, Bank Credit, and Economic Cycles84política (Madrid: Unión Editorial, 1996), pp. 234–54; Marjorie Grice-Hutchi...

  • Page 115

    Saravia de la Calle and published in Medina del Campo in1544. Saravia de la Calle criticizes bankers harshly, callingthem “voracious gluttons who swallow everything, destroyeverything, confuse everything, steal and soil everything, likethe harpies of Phineus.”77 He says bankers “go out into...

  • Page 116

    bankers carry out: demand deposits and time “deposits.” Inthe first case, customers entrust their money interest-free tobankersso the money will be safer, and more accessible for makingpayments, and to avoid the hassle and trouble of countingand guarding it, and also because, in gratitude for...

  • Page 117

    He believes the banker will probably guard the money hedeposits and not do business with it, when this cannot beexpected of any of these profiteers. On the contrary, thebanker will soon invest the deposit for profit and try to earnmoney with it. How could bankers who pay 7 and 10 per-cent interes...

  • Page 118

    theoretical analysis which demonstrates that the expansionaryphase brought on by the artificial expansion of credit grantedby these “profiteers” is inevitably followed by a period ofrecession, during which the non-payment of debts produces achain of bank failures. He adds that the merchant do...

  • Page 119

    As we see, Saravia de la Calle’s analysis, along with hiscleverness and humor, is impeccable and free from contradic-tions. However, in his criticism of bankers, he perhaps placestoo much emphasis on the fact that they charged and paidinterest in violation of the canonical prohibition of usury,...

  • Page 120

    As we see, Martín de Azpilcueta regards the monetaryirregular-deposit contract as a completely legitimate contractby which people entrust the custody of their money to a pro-fessional (the banker), who must safeguard it like a good par-ent and keep it constantly available to the depositors, prov...

  • Page 121

    In his book, Suma de tratos y contratos (Compilation of dealsand contracts) (Seville 1571), Tomás de Mercado performs ananalysis of the banking business very much in the same line asthe studies by the preceding authors. He begins by correctlystating that depositors should pay bankers for the wor...

  • Page 122

    transfer of availability of the tantundem and therefore, for allpractical purposes, there is no full transfer of property. Heexpresses himself quite well: “they [bankers] must under-stand that the money is not theirs, but belongs to others; andit is not fair that by using it, they cease to serv...

  • Page 123

    Also, at the end of chapter 4 of Suma de tratos y contratos,Tomás de Mercado states that the bankers of Seville holddeposits of money and precious metals belonging to merchantswho traded with the New World, and that with such consid-erable deposits they “make great investments,” obtaininghef...

  • Page 124

    by the medieval tradition of the glossators, which we coveredin section 2 of this chapter, and especially by the doctrinal con-fusion resulting from the depositum confessatum. De Soto andespecially Molina view the irregular deposit as a loan in whichboth the ownership and full availability of the...

  • Page 125

    Tratado sobre los cambios (Treatise on exchanges) (1597), heupholds the medieval doctrine that the irregular deposit is aloan or mutuum contract in favor of the banker, a contract inwhich not only ownership is transferred, but full availability ofthe tantundem as well, which means the banker can ...

  • Page 126

    terms of legal nature and essence, with the loan or mutuumcontract. Therefore, his doctrinal attempt to identify the twocontracts with each other is a clear step backward, not only inrelation to the much more coherent views of Saravia de laCalle and Martin de Azpilcueta, but also with respect to ...

  • Page 127

    overseas that, should the ship sink or be captured by pirates,they would not be able to repay deposits even after selling allof their assets. And they are not guilty of mortal sin only whenthe deal turns out poorly, but also when it turns out well. This isdue to the chance they take of hurting de...

  • Page 128

    5ANEW ATTEMPT ATLEGITIMATE BANKING:THE BANK OFAMSTERDAM. BANKING IN THESEVENTEENTH ANDEIGHTEENTH CENTURIESTHE BANK OFAMSTERDAMThe last serious attempt to establish a bank based on thegeneral legal principles governing the monetary irregulardeposit and to set up an efficient system of government c...

  • Page 129

    For a very long time, over one hundred fifty years, theBank of Amsterdam scrupulously fulfilled the commitmentupon which it was founded. Evidence reflects that during thefirst years of its existence, between 1610 and 1616, both thebank’s deposits and its cash reserves came very close to onemill...

  • Page 130

    over both halves of the globe, and her wealth is so great thatduring the war she supplied as much as fifty millions a yearif not more.104In 1802, when, as we will now see, the Bank of Amsterdamstarted to become corrupt and violate the principles on whichit was founded, the bank still enjoyed enor...

  • Page 131

    Therefore, we see that the Bank of Amsterdam did not tryto attain disproportionate profits through the fraudulent useof deposits. Instead, in keeping with the dictates of Saravia dela Calle and others we have mentioned, it contented itself withthe modest benefits derived from fees for safeguardin...

  • Page 132

    DAVID HUME AND THEBANK OFAMSTERDAMA sign of the enormous prestige of the Bank of Amsterdamamong scholars and intellectuals, as well as merchants, is theexpress mention David Hume makes of it in his essay OfMoney. This essay first appeared, with others, in a book calledPolitical Discourses, publis...

  • Page 133

    the creation of a public bank with these characteristics, he hadin mind the success of the Bank of Amsterdam and the exam-ple it had already set for over one hundred years. Furthermorethe third edition of his Essays and Treatises on Several Subjects,published in four volumes in London and Edinbur...

  • Page 134

    diminutions, according to the greater or less demand for bankmoney.109At any rate, Steuart indicates that the bank’s activities “areconducted with the greatest secrecy,” in keeping with the tra-ditional lack of openness in banking and especially significantin the case of the Bank of Amsterd...

  • Page 135

    and that it was under the direction of four burgomasterswho changed each year. Each burgomaster visited thevaults, compared their content in cash with deposit entriesin the books and with great solemnity declared under oaththat the two coincided. Adam Smith remarks, tongue-in-cheek, that “in th...

  • Page 136

    In addition, Adam Smith refers to other sources of incomewe have already mentioned, such as the exchange of moneyand the sale of gold and silver bars.Unfortunately, in the 1780s the Bank of Amsterdam beganto systematically violate the legal principles on which it hadbeen founded, and evidence sho...

  • Page 137

    separately from one another, in practice they were separateonly on paper, and the Bank of Stockholm soon abandoned thestandards set by the Dutch bank.114 The Swedish authoritiesnationalized it in 1668, making it the first government bank ofthe modern world.115 Not only did it violate the traditio...

  • Page 138

    never achieved. In short, the Bank of England eventuallyfailed, despite its privileged role as the government’s banker,its monopoly on limited liability in England and its exclusiveauthorization to issue banknotes. As a result of its systematicneglect of the safekeeping obligation and its pract...

  • Page 139

    the bank, and an attempt was made to limit advances andloans to the government.118 This was the dawn of the modernbanking system, based on a fractional-reserve ratio and a cen-tral bank as lender of last resort. In chapter 8 we will analyzein detail the reasons central banks were created, their r...

  • Page 140

    interventionism in general, arose from three different, thoughinterconnected factors. First, disregard for traditional legaland moral principles, particularly the requirement for contin-ual safekeeping of 100 percent of deposited money. Second, areasoning error that appears to justify violating l...

  • Page 141

    few decades later, as evidenced by the serious monetary chaosduring the revolutionary period and the uncontrolledissuance of assignats at that time. All these phenomena made apermanent impression on the collective psyche of the French,who are still aware today of the grave dangers of papermoney i...

  • Page 142

    Thornton. Their banks all failed.121 Cantillon alone escapedrelatively unscathed, not only because he stopped his riskyspeculation in time, but also (and most importantly) becauseof the large profits he fraudulently obtained by violating theobligation to safeguard his customers’ assets.Indeed, ...

  • Page 143

    Cantillon tried to defend himself by claiming that the stocksdeposited with him as unnumbered fungible goods had notactually constituted a true deposit, but a loan implying thefull transference of ownership and availability to the banker.Thus, Cantillon considered his operations perfectly “legi...

  • Page 144

    Bank of Barcelona and of other Catalonian banks that system-atically accepted the irregular deposit of securities withoutkeeping full custody of them.123 Instead, to attain a profit, theyused them in all sorts of speculative operations to the detri-ment of their true owners, just as Cantillon had...

  • Page 145

    3ATTEMPTS TOLEGALLY JUSTIFYFRACTIONAL-RESERVEBANKINGThis chapter contains a critical examination of the differ-ent theoretical attempts to legally justify fractional-reserve banking. We will consider the proposed argu-ments intended to legally support a monetary irregular depositcontract in which...

  • Page 146

    authorities and confusion arising from the depositum confessa-tum, a product of the canonical ban on interest). As is logical,the lack of a legal basis for such a widespread practice soonprompted bankers and theorists alike to search for a fittinglegal justification. Moreover, this urge was reinf...

  • Page 147

    amount than is actually deposited, it is clear that these actsshare the same characteristic present in all other criminal actsof misappropriation which have always been the object of doc-trinal analysis by criminal law experts. The similarity betweenthe two sets of actions is therefore so obvious...

  • Page 148

    set fall into the same errors and legal contradictions we willsee in those of the first. In addition, in the next chapter we willexplain why the doctrinal essence of the new interpretation ofavailability (based on the “law of large numbers”) is inadmis-sible from the standpoint of economic th...

  • Page 149

    without backing. We will also discuss the corrupting influenceexerted on the insurance business by the recent trend (mostapparent in government legislation) toward clouding andobscuring the traditional legal and technical boundariesbetween the two types of institutions.2WHY IT ISIMPOSSIBLE TOEQUA...

  • Page 150

    purpose of safekeeping or custody predominate. Accordingly,although we might in theory consider that ownership istransferred, in practice such a transference is negligible, sincethe safekeeping or custody of the fungible good requires theconstant availability of the tantundem to the depositor. Th...

  • Page 151

    to disguise a loan as a deposit in order to make the paymentof interest legal, legitimate and socially acceptable. For thisreason, bankers started to systematically engage in operationsin which the parties openly declared they were entering into adeposit contract and not a loan contract. However,...

  • Page 152

    several members of the School of Salamanca, such as Luis deMolina, who believed the monetary irregular-deposit contractto be a “precarious loan” in which ownership of the money istransferred to the banker (which we have seen is admissible inthe case of a deposit of fungible money), as well as...

  • Page 153

    mutatis mutandis, to all other deposits of fungible goods; andin particular, to deposits of securities as goods indistinguish-able from one another. Hence we must emphasize that anypossible doctrinal analysis against the legality of a completetransfer of ownership and availability in an irregular...

  • Page 154

    legality of the other (the deposit of money).7 In conclusion,the legal arguments used by Cantillon in his defense werederived from theories regarding the monetary irregular-deposit contract, and if we consider them valid, then they alsojustify Cantillon’s obvious swindling of his customers and ...

  • Page 155

    customs, and even the government, and it was ruled that themonetary irregular-deposit contract was no different from theloan contract, and therefore that bankers making self-inter-ested use of their depositors’ money did not commit misap-propriation.9 Of all of these court rulings, it is worthw...

  • Page 156

    Considering this type of ruling, it is not surprising thatRichard Cantillon fled from France to England, where finan-cial practices were much more lax, and as we have seen, courtrulings ended up defending the same line of argument heused in his defense. In continental Europe, in contrast, theRoma...

  • Page 157

    precedents, while the continental system, based on Romanlaw, rests on precedents, sound doctrine, and juridical theory.THE DOCTRINE OFSPANISH CIVIL ANDCOMMERCIAL CODESA group of Spanish theorists has also tried to equate themonetary irregular-deposit contract and the loan contract. Cit-ing severa...

  • Page 158

    intended to distinguish whether or not the tantundem is keptcontinuously available to the depositor, it would be perfectlypossible under Spanish positive law to recognize the existenceof an irregular deposit contract that is radically distinct fromthe loan contract. In fact Article 1770 of the ve...

  • Page 159

    whenever the depositary, with the consent of the depositor,uses the goods deposited, either for himself or his businessactivities, or in operations ordered by the depositor, therights and obligations of depositor and depositary shallcease, in favor of the rules and provisions applicable to thecom...

  • Page 160

    company’s statutes, then by the prescriptions of this codeand last by common law rules applicable to all deposits. The nature of the “odious” privilege enjoyed by banks andother similar associations is obvious. Even from the stand-point of Spanish positive law, it could be argued that, acco...

  • Page 161

    positive law requires bankers to maintain continuously avail-able to depositors the entire amount of their deposits (tantun-dem); that is, to maintain a 100-percent reserve ratio. Thesejudgments (such as the Spanish Supreme Court decision ofJune 21, 1928 and others cited in chapter 1) have been b...

  • Page 162

    the bank may open and manage checking accounts of cashor securities for individuals or legal entities and duly repre-sented corporations or organizations whose application isconfidentially reviewed by the institution and accepted. Thefollowing may be deposited in ordinary cash accounts: legalbank...

  • Page 163

    of the violation of traditional principles of property rightswith respect to the monetary irregular deposit. In the follow-ing chapters we will examine these effects (the distortion ofthe productive structure; the generation of successive, recur-rent stages of economic boom and recession; the pro...

  • Page 164

    1, it would have been very interesting to know what Garriguescould and should have said about the arguments againstequating the two contracts, a matter we will now consider ingreater depth.14THE DISTINCT CAUSE ORPURPOSE OFEACH CONTRACTThe most significant and definitive argument in favor of adist...

  • Page 165

    legal motive (related to the so-called cause15 of contracts)which is closely connected with the parties’ distinct subjectivereason16 for deciding to enter into one contract or another.Therefore a perfect symbiosis exists between the subjectivist concep-tion on which modern economic theory is ba...

  • Page 166

    deposit, the objective or cause of the contract is radically dif-ferent. In this case there is no exchange of present goods forfuture goods, nor does the depositor have the faintest desire tolose the immediate availability of the good deposited. Hencethe essential element in the irregular deposit...

  • Page 167

    over their money with the desire to retain full availability ofthe good turned over (monetary deposit “on demand”),19while banks accept deposits not with the aim of keeping 100percent of the tantundem in their possession at all times, butrather with the intention of using most of what they re...

  • Page 168

    this dual availability is precisely the reason it is difficult toformulate a legal description of the contract, because avail-ability in favor of the depositor, a key feature of deposits,harmonizes poorly with availability in favor of the bank.21Rather than to say it is difficult to formulate a l...

  • Page 169

    way the irregular deposit contract with the loan contract.Upon reading Garrigues’s treatment of monetary bank-deposit contracts, one inevitably gets the impression that Gar-rigues himself suffers from a rather “guilty conscience” forcarrying out such a forced legal analysis to try to justif...

  • Page 170

    mutuum or loan contract. As we know, the legal cause or pur-pose of this contract is radically different (it entails not onlythe transfer of ownership and power to use the goods, but alsothe transfer of the availability of the goods, which is simulta-neously lost to the lender). Therefore, and ac...

  • Page 171

    idea invests it. Hence, this is a clear case of error in negotio,which is an error concerning the nature of the transaction andrenders it completely void.25 To many this conclusion mayappear extreme or disproportionate, but it is difficult to arriveat any other if we base our analysis on the lega...

  • Page 172

    worthless or of limited value and therefore incapable of bal-ancing the corresponding deposit accounts on bank balancesheets. Consequently, bank insolvency tends to recur, banksbeing repeatedly unable to meet their obligations (without theexternal support of the central bank).In addition, if for ...

  • Page 173

    A natural incompatibility exists between the legitimateirregular deposit contract, the purpose of which is the custodyor safekeeping of the deposited goods, and the authorizationfor depositaries to use for their own profit the money theyreceive. These depositaries (bankers) take in funds they agr...

  • Page 174

    valores de Barcelona, pp. 370–71. It is true that Felipe Clemente de Diegomakes this comment in response to the argument of bankers whowished to defend the validity of the contract of irregular deposit of secu-rities, with a fractional-reserve ratio, in which the depositary would bepermitted to...

  • Page 175

    the value and efficacy of surrendering a good depend on theprocedure or document accompanying the action, then it isclearly important that the procedure or contract be well-defined and appropriately named, that its conditions bewell-regulated and that both parties be aware of the legalconsequence...

  • Page 176

    cause or purpose is the exchange of present goods for futuregoods plus interest, a true time “deposit” takes place. From alegal standpoint, this is unquestionably a mutuum or loanwhich can later be changed to or substituted for by a monetaryirregular deposit through an express agreement betwe...

  • Page 177

    established a monopoly on the issue of paper money anddeclared it legal tender, it has the function of ensuring the cre-ation of all the liquid assets necessary to satisfy any immediateneed private banks may have for funds. In chapter 8 we willstudy the resulting emergence of a centralized moneta...

  • Page 178

    of demand deposits, could ultimately guarantee the bank’sability to return deposits whenever requested by a depositor.Thus, to Garrigues the obligation to maintain depositsavailable to depositors “becomes a duty to work diligently, tomake prudent and sensible use of deposits, so the bank isal...

  • Page 179

    Quite significantly, Garrigues himself acknowledges thatall of this doctrine involves “the unavoidable replacement ofthe traditional concept of custody by an ad hoc concept, theplausibility of which is highly doubtful.”35 Garrigues is rightin considering this reinterpretation by theorists of ...

  • Page 180

    period of time until the bank has, in a more or less orderlyfashion, converted its assets into cash and can pay.Though the concepts of solvency and the prudent use ofresources are not sufficient to modify the essential meaning ofavailability in the irregular deposit contract, one might at leastth...

  • Page 181

    banking system based on the irregular deposit with a frac-tional reserve, the institution Clemente de Diego called an“aberration” or “legal monster,” invariably and ultimately(and this is one of the main contributions made by economicanalysis to this field of law) leads bankers to become ...

  • Page 182

    a fractional reserve is used the bank will always be able tohonor all repayment requests, but it also infallibly starts aprocess which, at least every certain number of years, resultsin the inevitable loss of confidence in banks and the massiveunforeseen withdrawal of deposits. Conclusive proof o...

  • Page 183

    Hayek means that today’s banking structure may appearsustainable despite its juridical inconsistency, due to the sup-port it currently receives from the state and to an official cen-tral-banking institution which generates the liquidity neces-sary to bail out banks in trouble (in exchange for t...

  • Page 184

    take the form of a continuous 100-percent reserve require-ment. Consequently, any use of this money, particularly tomake loans, entails a violation of this principle and an act ofmisappropriation. Throughout history, bankers have beenquick to violate this traditional rule of conduct, making self-...

  • Page 185

    to cause inevitable spontaneous adjustments. At first theseadjustments manifest themselves as expansions in the moneysupply (via the creation of loans which do not correspond toan actual increase in voluntary saving), inflation, a general-ized poor allocation of society’s scarce productive reso...

  • Page 186

    TABLE 1SEVEN POSSIBLE LEGAL CLASSIFICATIONS OF THEBANK-DEPOSIT CONTRACT WITH AFRACTIONAL RESERVE1. There is deception or fraud: the crime of misappro-priation is committed and the contract is null andvoid (the historically corrupt origin of fractional-reserve banking).2. There is no deception, bu...

  • Page 187

    TRANSACTIONS WITH AREPURCHASE AGREEMENTWhenever we observe, as in the monetary deposit, that theimmediate availability of the good is offered to customers inorder to attract their funds39 and then invest their money oremploy it in private transactions, etc., we should be on ourguard, irrespective...

  • Page 188

    whose liquidity on the market is implicitly “guaranteed” at alltimes by a trustworthy institution.40 Therefore, it is not sur-prising that many bank crises have arisen more from the mas-sive sale of bank stocks than from a widespread withdrawal ofdeposits. These stocks were supposed to consti...

  • Page 189

    employ their analytical judgment in the study of this eco-nomic-financial transaction and to decide exactly what type ofoperation it is, its true nature and its consequences, in light ofthe legal principles examined in these first three chapters andthe economic implications we will now consider.4...

  • Page 190

    by a few clear, simple rules included in the Civil, Commercialand Penal Codes. The main purpose of these rules would be toguarantee adherence to the strict safekeeping principle (100-percent reserve requirement) regarding not only monetarydemand-deposit contracts, but also any other economic-fina...

  • Page 191

    new ways to break the law and defraud others does not in theleast detract from the fundamental importance of a set of clearprinciples to guide citizens and direct authorities in their dutyto define and defend property rights.THE CASE OFLIFE INSURANCE CONTRACTSLife insurance is a typical time-hono...

  • Page 192

    event, such as the death or survival of the policyholder). Thelife insurance contract is therefore equivalent to a savingstransaction (in which the ownership and availability of pres-ent goods are relinquished in exchange for the ownershipand availability of future goods), but it is a form of per...

  • Page 193

    An added complexity emerges because some types of lifeinsurance include the right of surrender. This means policy-holders can cancel their contract and obtain in cash the math-ematical liquidation value of their policy. Some theorists havedefended the position that insurance policies which includ...

  • Page 194

    True monetary-deposit operations have begun to appearon the market disguised as life insurance policies. The mainselling point presented to customers is that with these trans-actions they need not commit to a long-term savings opera-tion involving regular payments, since the funds handed overto t...

  • Page 195

    (operations completely unrelated to life insurance) have beenincluded in the official statistics of life insurance premiums,and in the midst of the great confusion in the market, tradi-tional life insurance policies have become discredited andtheir definition blurred.48Fortunately, normality is b...

  • Page 196

  • Page 197

    4THE CREDITEXPANSION PROCESSThis chapter and the following five comprise an analysisof the economic consequences of violating the generallegal principles inherent in the irregular deposit con-tract. We examined the legal and historical consequences ofsuch violations in chapters 1, 2, and 3 and wi...

  • Page 198

    thought. This body of economic knowledge has followed therelevant events (the development of fractional-reserve bank-ing and the recurring cycles of boom and recession) and cor-responding legal formulations with great delay. As we haveseen, the study of legal principles, the analysis of their loo...

  • Page 199

    differential between the rate they receive on loans they grantand the one they agree to pay to customers who initially giveloans to them. None of these operations constitutes a mone-tary bank-deposit, a transaction we will examine in the fol-lowing sections. As we will see, this contract undoubte...

  • Page 200

    carry through the necessary reforms, the theoretical analysisof institutional coercion and the granting of privileges in thelabor field is clearly less complex. As a result, the awareness itarouses has spread faster and penetrated deeper at all levels ofsociety. Related theories have been signifi...

  • Page 201

    recently managed to recover from it.2 And once again, morerecently (in the summer of 1997), an acute financial crisis dev-astated the chief Asian markets, threatening to spread to therest of the world. A few years later (since 2001) the three maineconomic areas of the world (the United States, Eu...

  • Page 202

    on substantiating this assertion and some of its implications andin subsequent chapters will undertake the study of the eco-nomic effects of credit expansion (the analysis of economiccrises and recessions).To continue the pattern set in the first chapters, we willfirst consider the effects from a...

  • Page 203

    Economically speaking, this contract clearly involves asimple exchange of present goods (the availability of which istransferred from the lender to the bank) for future goods(which Bank A agrees to turn over to the lender at the end ofone year). Therefore, from a monetary standpoint there is noch...

  • Page 204

    In this case Bank A clearly acts as a true financial intermedi-ary. Its managers recognize and take advantage of a businessopportunity.4 Indeed, they see a chance to make a profit, sinceat one place in the market there is a lender willing to loanthem money at 10 percent interest, and at another B...

  • Page 205

    Soon afterward, Bank A must in turn honor the contract itentered into with the original lender, returning to him the1,000,000 m.u. its managers had committed to pay at the endof one year, along with 10 percent interest. The entries are asfollows:(4) Bank ADebi...

  • Page 206

    This income statement reflects an entrepreneurial profitfor the year of 50,000 m.u., a net income derived from the dif-ference between the year’s revenue (150,000 m.u. in interestreceived) and the year’s expenses (100,000 m.u. in interestpaid).At the end of the year, Bank A’s balance sheet ...

  • Page 207

    intermediary—Bank A—; seven, in the course of its activities,Business Z brought in a profit enabling it to make the interestpayment of 150,000 m.u. (these 150,000 m.u. do not representany money creation, but are simply obtained by Business Z asthe result of its sales and purchases); eight, at...

  • Page 208

    3THE BANK’S ROLEIN THEMONETARYBANK-DEPOSIT CONTRACTThe economic events and accounting procedures involvedin the monetary bank-deposit contract are substantially differ-ent from those examined in the preceding section, on the loanor mutuum. (We covered the loan contract first in order to bet-ter...

  • Page 209

    transfer of ownership may be established, availability is nottransferred to the depositary, because in the irregular depositcontract he is obliged to continuously safeguard the tantundemof the deposit and therefore must always maintain available tothe depositor units of an equal quantity and qual...

  • Page 210

    We see that, although Bank A is justified in making thisbook entry, since it becomes owner of the monetary units andstores them in its safe without distinguishing them from oth-ers, the reference entries should only affect information ormemorandum accounts. This is due to the fact that, thoughthe...

  • Page 211

    Bank A(8)DebitCredit30,000 Cash Income fromClient X in paymentfor services 30,00020,000 Operating expensesCash 20,000paid by the bank in order to offer its servicesAt the end of the year, Bank A’s income statement and balancesheet would be a...

  • Page 212

    As we see, up to now there has been nothing unusual orsurprising about the economic events or accounting processesresulting from the monetary irregular-deposit contract. Thebank has made a small legitimate profit, derived from its roleas a renderer of services valued by its customer at 30,000 m.u...

  • Page 213

    them to maintain the tantundem of monetary irregulardeposits continuously available to depositors, and they endedup using at least a portion of demand deposits for their ownbenefit. In chapter 3 we covered the comments of Saravia de laCalle with respect to this human temptation. Now we muststress...

  • Page 214

    bankers record the appropriation of demand deposits in theiraccount books. Our study will begin with the case of an indi-vidual bank and will later extend to the banking system as awhole.THE CONTINENTAL ACCOUNTING SYSTEMTwo accounting systems, the continental and the Anglo-Saxon, have traditional...

  • Page 215

    European accounting system, this economic event would berepresented in the following way:8When Mr. X makes the demand deposit, a book entryidentical to number (7) is made, though this time it is not con-sidered a memorandum entry.Bank A(10) DebitCredit1,000,000 Cash D...

  • Page 216

    in cash as if the money were physically “in his possession,”since according to his contract it remains fully available to him.From an economic standpoint, there is no doubt the 1,000,000m.u. Mr. X deposited in Bank A continue to contribute to hiscash balances. However, when the bank appropria...

  • Page 217

    Nevertheless the form of the money varies: Borrower Z pos-sesses it in a different form from Mr. X, who made the deposit.Indeed, Z has available to him 900,000 physical monetary units(which we could call commodity money or, nowadays, papermoney or fiat money), while Depositor X has a checking acc...

  • Page 218

    bank’s reserves (fiduciary media) is also called a secondarydeposit or derivative deposit.11Once banks had violated the legal principle that no one mayappropriate a deposit made with them for safekeeping, and hadceased to guard 100 percent of the tantundem, it was natural forthem to try to just...

  • Page 219

    indicates we are faced with a radically different economicevent, one that involves the creation ex nihilo of 900,000 m.u. offiduciary media or derivative deposits when the bank loans 90percent of the money it has in its vault.In addition it is important to understand clearly that if thebank uses ...

  • Page 220

    Clearly, the banker will tend to deceive himself, thinkinghe has received his depositors’ money as a loan. Furthermore,it will never occur to him that by granting the loan to BusinessZ he has created 900,000 m.u. ex nihilo, nor much less that hehas granted a loan without the prior backing of an...

  • Page 221

    regularly promises more than it could actually pay should theworse come to the worst”?14 In any case, these are simply indi-cations which any practical person could understandably inter-pret in a wide variety of ways. Legal principles exist for pre-cisely this reason. They act as an “automati...

  • Page 222

    Though private bankers may often be unaware that theirability to create new money ex nihilo (by using customers’deposits to grant loans) constitutes a source of huge profits, andalthough they may naively believe they are merely loaning apart of what they receive, the majority of their profits s...

  • Page 223

    If we suppose the bank performs the cashier and book-keeping services described earlier, which are typical of check-ing accounts and generate an operating cost of 20,000 m.u. inour example, then by covering these costs with interestincome it is even able to provide these services free of charge.T...

  • Page 224

    After carrying out all of the operations, the bank’s balancesheet would appear as follows:(16) Bank ABalance Sheet(End of the year)AssetsLiabilitiesCash 215,000Owner’s Equity(Profit for the year) 115,000Loans granted 900,000...

  • Page 225

    The difference between the Anglo-Saxon and the conti-nental system lies in the entry the English-speaking bankermakes upon deciding to grant a loan to Z, and hence to makeself-interested use of 900,000 m.u. the banker holds in hisvault in excess of his security reserve. In Anglo-Saxon bankingprac...

  • Page 226

    900,000 m.u., it simultaneously generates deposits ex nihilo forthe sum of 900,000 m.u. In other words, the bank places at thedisposal of the borrower up to 900,000 m.u., which raises thebalance of demand deposits to 1,900,000 m.u. Of this amount,1,000,000 m.u. correspond to physical monetary uni...

  • Page 227

    of wealth to bankers persists as long as the banking businesssuffers no disruptions and assets keep increasing bankers’ bal-ances in the form of loans and investments backed by the cor-responding deposits created from nothing. The full recogni-tion of this never-ending source of financing and o...

  • Page 228

    Bank A (t2)(21) DebitCredit400,000 Demand deposits Cash 400,000(the remainder of the loan)After the borrower withdraws the entire loan, the bank’sbalance sheet looks like this:(22) Bank ABalance SheetAssetsLiabilitiesCash ...

  • Page 229

    The main advantage of the Anglo-Saxon accounting sys-tem is that it demonstrates, as Herbert J. Davenport pointedout in 1913, that banks “do not lend their deposits, but rather,by their own extensions of credit, create the deposits.”19 Inother words, banks do not act as financial intermediari...

  • Page 230

    Instead banks simply grant loans against deposits they createfrom nothing (fiduciary media) and which therefore have notfirst been entrusted to them by any third party as deposits ofphysical monetary units. Not even under the continentalaccounting system are banks financial intermediaries, sincet...

  • Page 231

    d1: the money or reserves which leave the bank as a resultof loans it grants;x:the bank’s maximum possible credit expansion start-ing from d;c: the cash or reserves ratio maintained by the bank, in keeping with the banker’s experience and his care-ful judgment on how much money he needs to ho...

  • Page 232

    (1 – k)x + ckx = d – cdx(1 – k + ck)= d(1 – c)Therefore the maximum credit expansion, x, an isolatedbank could bring about ex nihilo would be:20x =d (1 – c)1– k(1– c)Money, Bank Credit, and Economic Cycles20220Significantly, however, Ludwig von Mises, in his important theoreticaltre...

  • Page 233

    Or to put it another way:[3]x =d (1 – c)1 + k(c– 1)As formula [3] makes clear, the reserve ratio, c, and theaverage percentage of loans which remain unused, k, haveopposite effects on an isolated bank’s capacity to create loansand deposits. That is, the lower c is and the higher k is, thehi...

  • Page 234

    larger their subsequent market share, the greater the possibil-ity that the citizens who receive the banks’ fiduciary mediawill be their own customers. Therefore both k and the corre-sponding capacity to create loans and deposits from nothingwill be increased and the resulting profit much great...

  • Page 235

    20 percent; and that the sum of the original deposits, d, madein the bank is equal to 1,000,000 m.u.; then, by substitutingthese values into formula [3] we obtain:[4]x = 1,000,000 (1 – 0.1) = 1,097,560 m.u.1 + 0.2 (0.1 – 1)Therefore we see that a bank which accepts 1,000,000 m.u.in demand de...

  • Page 236

    Bank A(23) DebitCredit1,000,000 CashDemand deposits 1,000,000(checking accounts)1,097,560 Loans granted Demand deposits 1,097,560(newly-created deposits)These entries correspond to an original deposit of1,000,000 m.u. and an isolated bank’s ex nihilo creation of loansa...

  • Page 237

    Bank A(24) DebitCredit878,048 Demand deposits Cash 878,048(80% of 1,097,560)The bank’s balance sheet would appear as follows:The Credit Expansion Process207If we suppose that 20 percent of the 900,000 m.u. which leave the bank’svault will again be deposite...

  • Page 238

    (25)Bank ABalance Sheetc=0.1 and k=0.2AssetsLiabilitiesCash121,952Demand deposits 1,219,512Loans1,097,560Total Assets 1,219,512 Total Liabilities1,219,512THE CASE OF AVERY SMALL BANKLet us now consider a particular type of isolated bank: avery small or “Lilliputian” bank; that is, one ...

  • Page 239

    This means borrowers immediately withdraw the entireamount of their loans, and those to whom they make paymentsare not customers of the same bank as the borrowers. If k=0,then by substituting this value into formula [3] we obtain for-mula [5]:[5]x = d(1 – c)And since in our example d = 1,000,00...

  • Page 240

    Banks expand credit and deposits on their own and also par-ticipate in processes which bring about even greater creditand deposit expansion in the banking system as a whole.Moreover, in this process banks strive to play an increasinglyimportant role with respect to other banks, and as a result th...

  • Page 241

    2 percent2.04 percent5 percent5.26 percent7 percent7.52 percent13 percent14.94 percent15 percent17.64 percent17 percent20.48 percent20 percent25.00 percentCREDIT EXPANSION ANDEX NIHILO DEPOSITCREATION BY ASOLE, MONOPOLISTIC BANKLet us now suppose that k=1. We are dealing either with asole, monopo...

  • Page 242

    Following the example of Bresciani-Turroni,26 and assum-ing all payment transactions are carried out between cus-tomers of the same bank (given that it is monopolistic, orbecause certain circumstances exist which produce this situa-tion), we will now use accounting records to show the processlead...

  • Page 243

    t3 900,000 CashDemand depositsmade by A900,000t4 810,000 Loans to VCash 810,000We will assume that Borrower V withdraws his moneyand pays Creditor B, who is also a customer of the bank anddeposits his money back into it. This repetitive process con-tinues, producin...

  • Page 244

    The above expression represents the sum of the terms in ageometrical progression. The terms increase and have a com-mon ratio of 0.9.27In our example, r=0.9 and a=1,000,000 m.u., and hence thesum of the terms would be equal to:[13] a= 1,000,000 = 1,000,000 = 10,000,000 m.u.1 – r1 – 0.9 ...

  • Page 245

    If we keep in mind that d represents the 1,000,000 m.u.originally deposited, and that r=1-c; that is, r=1-0.1=0.9, thenclearly the sum of all the bank’s deposits (original and sec-ondary) would be:[14] d d1 – (1 – c) cThus, the total volume of deposits in a monopolistic bank(o...

  • Page 246

    words, the deposits or fiduciary media generated from noth-ing to make the credit expansion possible):[15] x = d – d = d–dcc c c Now we factor out common factors:[16] x = d(1 – c)cThe above formula coincides with [6].In fact, when d=1,000,000 m.u. and c=0.1, in the c...

  • Page 247

    With only 1,000,000 m.u. in original deposits safeguardedin its vault, Bank A, a monopolist, has expanded credit bygranting loans for the sum of 9,000,000 m.u. and creating fromnothing 9,000,000 m.u. in new deposits or fiduciary media toback these loans.295CREDIT EXPANSION ANDNEW DEPOSIT CREATION...

  • Page 248

    deposits and brings about much greater credit expansion.Indeed, in this respect the fractional-reserve system produceseffects resembling those of a monopolistic bank. We will baseour demonstration on the most general case, a banking systemcomprised of a group of normal banks, each of which main-t...

  • Page 249

    Bank A(34) DebitCredit878,048 Demand depositsCash 878,048The balance sheet of Bank A following these entries wouldlook like this:(35) Bank ABalance Sheetc=0.1 and k=0.2AssetsLiabilitiesCash121,952Demand deposits1,219,512Loans1,0...

  • Page 250

    After these operations, Bank B’s balance sheet wouldappear as follows:(37) Bank BBalance Sheetc=0.1 and k=0.2AssetsLiabilitiesCash 107,079Demand deposits 1,070,789Loans 963,710Total Assets1,070,789Total Liabilities1,070,789If we imagine that ...

  • Page 251

    (39)Bank CBalance Sheetc=0.1 and k=0.2AssetsLiabilitiesCash 94,021Demand deposits940,206Loans 846,185Total Assets940,206Total Liabilities940,206And if Creditor T, upon receiving the money he was owed,deposits it in his own bank, Bank D, these entries wouldresult:...

  • Page 252

    (41) Bank DBalance Sheetc=0.1 and k=0.2AssetsLiabilitiesCash82,555Demand deposits825,547Loans742,992Total Assets825,547Total Liabilities825,547The process continues in this way, and the chain ofdeposits and loans extends to all banks in the system. Oncethe eff...

  • Page 253

    r = 0.72 = 0.87804878 0.82And since |r| <1, we apply formulas [11] and [12].[23] arn= a= 1,219,512 = 10,000,000 m.u.1 – r 0.1219512Thus the sum of the deposits in the banking system, D,would be equal to:[24] D = ds1= 10,000,000 m.u.1 –(1 – k)(1 – c)1 + k(c –...

  • Page 254

    TABLE IV-1SYSTEM OF“NORMAL”-SIZED BANKS(k=0.2 and c=0.1)Money remainingCredit expansionin each bank’s vault(Loans createdex nihilo)DepositsBank A122,0001,098,0001,220,000Bank B107,100964,0001,071,000Bank C94,000846,000940,000Bank D82,600643,000826,000Bank E72,500652,000725,000Bank F63,70057...

  • Page 255

    The Credit Expansion Process225

  • Page 256

    When Z withdraws 900,000 m.u. to pay Y, Bank A’s bal-ance sheet would appear as follows:(43) Bank ABalance Sheetc=0.1 and k=0AssetsLiabilitiesCash 100,000Demand deposits1,000,000Loans to Z900,000Total Assets1,000,000Total Liabilities1,000,000If Y, in turn, de...

  • Page 257

    The Credit Expansion Process227Now, if V withdraws the loan from his bank to pay U, andU deposits the money in his bank, Bank C, also a small bankwith a k equal to zero and a c equal to 0.1, these would be BankC’s entries:Bank C(46) DebitCredit810,000 CashDemand deposits 810,00...

  • Page 258

    Money, Bank Credit, and Economic Cycles228Bank D(48) DebitCredit729,000 CashDemand deposits729,000656,100 LoansDemand deposits656,100656,100 Demand depositsCash656,100In turn, Bank D’s balance sheet would appear as follows:(49) Bank DBalance Sheet...

  • Page 259

    The Credit Expansion Process229a =a =a= 1,000,000 = 10,000,0001 – r1 – (1 – c) c0.1As a=d=1,000,000 m.u. originally deposited, the totaldeposits would be indicated by the formula:[27] d =d1 – (1 – c) cThis formula is identical to the deposit multiplier in thec...

  • Page 260

    Money, Bank Credit, and Economic Cycles230TABLE IV-2SYSTEM OFSMALL BANKS(k=0 and c=0.1)Money remainingCredit expansionin each bank’s vault(Loans createdex nihilo)DepositsBank A100,000900,0001,000,000Bank B90,000810,000900,000Bank C81,000729,000810,000Bank D72,900656,000729,000Bank E65,600590,00...

  • Page 261

    The Credit Expansion Process231Depending upon the text, the author refers either to a systemof tiny banks or to a single, monopolistic bank (or one whosecustomers are the final recipients of the loans it grants).316AFEW ADDITIONAL DIFFICULTIESWHEN EXPANSION ISINITIATED SIMULTANEOUSLY BYALL BANKSI...

  • Page 262

    Money, Bank Credit, and Economic Cycles232expand credit without having to decrease their cash reserves,because although they grant loans which could lead to a with-drawal of cash (as we have supposed up until now in theaccounting entries), they simultaneously receive the depositof a portion of th...

  • Page 263

    The Credit Expansion Process233approach of Rothbard and others is totally correct lies in thefact that for our purposes it makes no difference whether westudy the case examined up to this point (an original deposit,extended throughout the banking system, of 1,000,000 m.u. inBank A), or we conside...

  • Page 264

    Money, Bank Credit, and Economic Cycles234(50)Bank ADebitCredit1,000,000 CashDemand deposits 1,000,000900,000 LoansDemand deposits900,000900,000 Demand depositsCash 900,000This decrease in cash would be counteracted by a demanddeposit from a final recipient of a loan granted, for ...

  • Page 265

    The Credit Expansion Process235(52) Bank ADebitCredit810,000 CashDemand depositsfrom loans grantedby Bank C810,000729,000 LoansDemand deposits729,000729,000 Demand depositsCash 729,000As this process continues, Bank A would receive depositsfrom...

  • Page 266

    Money, Bank Credit, and Economic Cycles236Therefore, the balance sheet of each bank would coincidewith the one we discovered when we assumed k was equal toone (a monopolistic bank or one whose clients are the ultimaterecipients of the loans it grants). This is due to the fact thatalthough in this...

  • Page 267

    The Credit Expansion Process237banks and banking systems, is the most realistic. In the currentmonetary system, increases in the money supply filterthroughout the system and reach practically all banks, per-mitting them to expand their credit simultaneously accordingto the processes we have studi...

  • Page 268

    Money, Bank Credit, and Economic Cycles238account books that deposits back the wealth bankers appro-priate upon expanding their credit. From an accounting (butnot a legal) standpoint, the formal ownership of these loanscorresponds to the deposit-holders, since under normal cir-cumstances they con...

  • Page 269

    FILTERING OUT THEMONEY SUPPLYFROM THEBANKING SYSTEMAnother complexity derives from the fact that in reality, eachtime loans are granted and deposits are created and withdrawn,a certain percentage of the money supply “filters” out of thesystem and is kept by individuals who do not wish to depo...

  • Page 270

    Money, Bank Credit, and Economic Cycles240If we substitute into this equation the value of DN in for-mula [29] and the value of F in [30], we obtain:[32]d = (DG – F) . c + fDGIf we replace F in the equation with fDG, we obtain:[33]d = (DG – fDG)c + fDGThen we factor out DG:[34]d = DG (c – c...

  • Page 271

    The Credit Expansion Process241now to determine the total volume of deposits and the totalcredit expansion:[38] DN =d =1,000,000 = 10,000,000c0.1and[39] x = d d =d(1 – c) =1,000,000(0.9)= 9,000,000c c 0.1Let us see to what value credit expansion is reduced ...

  • Page 272

    Money, Bank Credit, and Economic Cycles242THE MAINTENANCE OFRESERVES EXCEEDING THEMINIMUMREQUIREMENTAnother complication which produces effects similar tothose covered in the preceding section takes place when bankshold cash reserves exceeding the minimum requirement. Thistends to occur at certai...

  • Page 273

    The Credit Expansion Process243DIFFERENT RESERVE REQUIREMENTS FORDIFFERENTTYPES OFDEPOSITSFinally, another complication we could consider derivesfrom the fact that in many countries the reserve requirementfor demand deposits differs from the requirement for timedeposits, even though as we know, i...

  • Page 274

    Money, Bank Credit, and Economic Cycles2447THE PARALLELS BETWEEN THECREATION OFDEPOSITSAND THEISSUANCE OFUNBACKED BANKNOTESThe economic analysis of the issuance of unbacked bank-notes, an operation which emerged long after the discovery offractional-reserve banking, is not one of the main purpose...

  • Page 275

    The Credit Expansion Process245If the bank fulfills its commitments for a lengthy period oftime and people completely trust it, it is certain that the pub-lic will gradually begin to use the banknotes (or the depositslips or receipts the bank issues in exchange for monetaryunits deposited) as if ...

  • Page 276

    Money, Bank Credit, and Economic Cycles246We have assumed the bank uses the counterfeit bills togrant loans, but it could use them for any purpose, for exam-ple to purchase any other asset (like lavish buildings) or sim-ply to pay day-to-day expenses. If the bank uses the bills togrant loans, its...

  • Page 277

    The Credit Expansion Process247These accounting entries reflect the fact that the banker issure he will never have to return the sum of the bills, since hisbills circulate as money. The bank’s balance sheet will look likethis:(58) Bank ABalance SheetAssetsLia...

  • Page 278

    Money, Bank Credit, and Economic Cycles248deposits. In fact the nature of banknotes is identical to that ofsecondary deposits and both produce the same economiceffects. They actually represent the same operation and resultin identical accounting records.Both activities generate considerable asset...

  • Page 279

    The Credit Expansion Process249The wealth banks have gradually accumulated can and mustbe returned to the citizens. Through a process of privatization,it should become available for different uses of great impor-tance to society (for example, to help pay off the national debt,or make a transition...

  • Page 280

    Money, Bank Credit, and Economic Cycles250If we suppose that the borrowers pay this money to otherpeople, who eventually take it to another bank, for instanceBank B, which also issues banknotes without backing, Bank Bwould make the following journal entries:Bank B(61) DebitCredit900,000 Cas...

  • Page 281

    The Credit Expansion Process251monetary units in the form of bills unbacked by originalmoney (gold or any other type of commodity money).We would have obtained the same result in the case of amonopolistic bank, one that enjoys the trust and business ofeveryone, with a reserve ratio, c, of 0.1 and...

  • Page 282

    Money, Bank Credit, and Economic Cycles252That is, the bank will have the capacity to create 1,097,560m.u. in the form of unbacked bills. One by one we couldduplicate for banknotes all of the results we obtained for bankdeposits, which shows that there is no economic differencebetween the issuanc...

  • Page 283

    The Credit Expansion Process253as unbacked banknotes. As a result, the Act did not outlawfractional-reserve banking and allowed the age-old practice of“issuing” unbacked (secondary) deposits to continue. In real-ity secondary deposits predated the fiduciary issue of ban-knotes, but because th...

  • Page 284

    Money, Bank Credit, and Economic Cycles254The Economist, 1847), p. 282; see also Vera C. Smith’s comments in herbook, The Rationale of Central Banking and the Free Banking Alternative, p.89. Smith makes a most perceptive observation when referring to Wil-son and to the grave error of the Curren...

  • Page 285

    The Credit Expansion Process255events serve to establish that such a process has been set inmotion: (a) a decrease in original deposits; (b) an increase inthe desire of the public to hold monetary units outside thebanking system (i.e., an increase in f); (c) a rise in banks’ “pru-dence,” le...

  • Page 286

    Money, Bank Credit, and Economic Cycles256Bank A(64) DebitCredit1,000,000 CashDemand deposits 1,000,000900,000 Loans Demand deposits900,000900,000 Demand deposits Cash 900,000(65)Bank ABalance Sheetc=0.1, k=0 and f=0AssetsLiabilitiesCash100,000 ...

  • Page 287

    The Credit Expansion Process257(67)Bank ABalance Sheetc=0.1, k=0 and f=0AssetsLiabilitiesCash1,000,000 Demand deposits1,000,000Total Assets1,000,000Total Liabilities1,000,000Economically speaking, this means that from the point ofview of an individual bank, there has been a 900,000 m.u.decrease i...

  • Page 288

    Money, Bank Credit, and Economic Cycles258If all the bank’s borrowers return their loans paying withchecks, the bank’s balance sheet will look like this:(69)Bank ABalance Sheetc=0.1, k=0 and f=0AssetsLiabilitiesCash1,000,000Demand deposits1,000,000Total Assets1,000,000Total Liabilities1,000,0...

  • Page 289

    The Credit Expansion Process259(71)Bank ABalance Sheetc=0.1, k=0 and f=0AssetsLiabilitiesCash1,000,000Deposits10,000,000Losses for the 9,000,000yearTotal Assets10,000,000Total Liabilities10,000,000If we compare this balance sheet with (69), we see the bankholds the same amount in cash reserves in...

  • Page 290

    Money, Bank Credit, and Economic Cycles260be one step away from losing the confidence of their deposi-tors, who may force them to suspend payments and/ordeclare bankruptcy, and in this case even the 1,000,000 m.u.originally deposited in cash would be withdrawn, threateningthe existence of the ent...

  • Page 291

    The Credit Expansion Process261(adversely affecting the banks’ solvency). Just as the moneysupply was expanded according to the bank multiplier, artifi-cial economic expansion fostered by the ex nihilo creation ofloans eventually triggers an endogenous recession, which inthe form of a widesprea...

  • Page 292

    Money, Bank Credit, and Economic Cycles262cautious about granting more. Hence the natural reluctance ofthe demoralized public to request loans is reinforced bybanks’ greater prudence and rigor when it comes to givingthem. In addition, as bankers see their profitability fall alongwith the value ...

  • Page 293

    The Credit Expansion Process26344In the last chapter we will examine the comparative advantages of theclassic gold standard based on a banking system subject to legal princi-ples; that is, with a 100-percent reserve requirement.convulsions that are very difficult, if not impossible, to miti-gate ...

  • Page 294

  • Page 295

    5BANK CREDIT EXPANSIONANDITS EFFECTS ON THEECONOMIC SYSTEMIn the previous chapter we explained how the monetarybank-deposit contract with a fractional reserve leads to thecreation of new money (deposits) and its infusion into theeconomic system in the form of new loans unbacked by a nat-ural incr...

  • Page 296

    the processes spontaneously set in motion in an economic systemwhen new loans originate from a voluntary increase in society’sreal saving; then in contrast and by comparison it will be easierto understand what happens when banks create loans ex nihilothrough a process of credit expansion.1THE F...

  • Page 297

    believes it will help him to achieve. Means must be scarce bydefinition: if the actor did not regard them as such in light ofhis objectives, he would not even take them into accountbefore acting. Ends and means are not “given” (i.e., data) butinstead result from the fundamental entrepreneuria...

  • Page 298

    Money, Bank Credit, and Economic Cycles268All human action is directed toward the attainment of anend, or consumer good, which can be defined as a good thatdirectly and subjectively satisfies the needs of the humanactor. The term first-order economic goods has traditionallyreferred to those consu...

  • Page 299

    Bank Credit Expansion and ItsEffects on the Economic System269up his personal action process. Furthermore the future is opento man’s every creative possibility, and at any point the actormay modify his objectives or vary, rearrange and revise thestages of the action processes in which he is inv...

  • Page 300

    Money, Bank Credit, and Economic Cycles270that human action processes tend to achieve aims of greatervalue the longer the processes last. Indeed if this were not thecase, i.e., if the actor did not attach greater value to the resultsof longer actions, he would never undertake them and wouldopt fo...

  • Page 301

    Bank Credit Expansion and ItsEffects on the Economic System271physiological concept, but necessarily follows from the logicalstructure of action present in the mind of all human beings. Inshort, human action is directed toward certain ends and theactor chooses the means to accomplish them. The go...

  • Page 302

    Money, Bank Credit, and Economic Cycles272just before they were reached, and therefore no end wouldever be achieved and human action would be senseless.9CAPITAL ANDCAPITAL GOODSWe may use the term capital goods to designate the inter-mediate stages of each action process, subjectively regarded as...

  • Page 303

    Bank Credit Expansion and ItsEffects on the Economic System273Hence capital goods are “higher-order economic goods,”or factors of production which subjectively materialize at eachintermediate stage in a particular action process. Moreovercapital goods arise from the union of three essential e...

  • Page 304

    Money, Bank Credit, and Economic Cycles274reach successive and increasingly time-consuming intermedi-ate stages if he has first sacrificed the chance to undertakeactions which would produce a more immediate result. Inother words, he must give up the achievement of immediateends which would satisf...

  • Page 305

    Bank Credit Expansion and ItsEffects on the Economic System275his effort in relation to the goal he longs to achieve. So hedecides to reduce his consumption (in other words, to save)for several weeks while storing his leftover berries in a basketuntil he has accumulated an amount he believes will...

  • Page 306

    Money, Bank Credit, and Economic Cycles276needs to survive, and he can spend the rest of his time restingor pursuing subsequent goals that are much more importantto him (like building a hut or hunting animals to vary his dietand make clothes).Robinson Crusoe’s production process, like any other...

  • Page 307

    Bank Credit Expansion and ItsEffects on the Economic System277example, might take him a month minimum), a plan hewould not be able to carry out without first having saved alarge quantity of berries. Therefore he would either starve todeath or the project, out of all proportion to his potential sa...

  • Page 308

    Money, Bank Credit, and Economic Cycles278For instance the process of producing a car consists ofhundreds or even thousands of productive stages requiring avery prolonged period of time (even several years) from themoment the car company begins to design the vehicle (thestage furthest from final ...

  • Page 309

    Bank Credit Expansion and ItsEffects on the Economic System279Therefore it is clear that, just as the difference between the“rich” Robinson Crusoe with the stick and the “poor” Robin-son Crusoe without it lay in the capital good the former hadobtained through prior saving, the essential d...

  • Page 310

    Money, Bank Credit, and Economic Cycles280capital equipment is not only physical, but technological andeconomic as well (obsolescence). Hence capital goods must bepreserved and maintained (in Robinson Crusoe’s case, hemust take care of his stick and protect it from wear). Thismeans entrepreneur...

  • Page 311

    Bank Credit Expansion and ItsEffects on the Economic System281become utterly useless or they may be useful only after acostly conversion. The actor could also find a way to use thegoods, yet still feel that had he known in advance they wouldeventually be needed in a different production process, ...

  • Page 312

    Money, Bank Credit, and Economic Cycles28216A demoralized entrepreneur who wishes to abandon his business andsettle elsewhere can find sure, constant mobility in the market: legalcontracts permit him to put his business up for sale, liquidate it and usehis new liquidity to acquire another company...

  • Page 313

    Bank Credit Expansion and ItsEffects on the Economic System283the cost involved in the production processes, neither wouldit be possible to direct in a coordinated way the efforts of peo-ple who contribute to the different action processes.18We have attempted elsewhere to demonstrate that all sys...

  • Page 314

    Money, Bank Credit, and Economic Cycles284a dynamic and very complex productive structure whichalways tends to expand horizontally and vertically.20 Withoutfree entrepreneurship, nor free markets for capital goods andmoney, it is impossible to make the necessary economic calcu-lation regarding th...

  • Page 315

    Bank Credit Expansion and ItsEffects on the Economic System285scale of value, means that in a market comprising many eco-nomic agents, each of which has his own distinct and variabletime preference, multiple opportunities arise for mutuallybeneficial exchanges.Hence people with a low time prefere...

  • Page 316

    Money, Bank Credit, and Economic Cycles286precisely the savers; that is, all those relatively more willing torelinquish immediate consumption in exchange for goods ofgreater value in the future. The buyers of present goods are allthose who consume immediate goods and services (be theyworkers, own...

  • Page 317

    Bank Credit Expansion and ItsEffects on the Economic System287From a legal standpoint, exchanges of present goods forfuture goods can take many forms. For instance, in a coopera-tive the workers themselves simultaneously act as capitalists,waiting until the end of the entire production process to...

  • Page 318

    Money, Bank Credit, and Economic Cycles288a society in which no loan market exists, and all economicagents invest their savings in production directly (via internalfinancing and retained earnings through partnerships, corpo-rations, and cooperatives). Although in this case no interestrate would b...

  • Page 319

    Bank Credit Expansion and ItsEffects on the Economic System289In the outside world, the only directly-observable fig-ures are what we could call the gross interest rate or marketrate of interest (which coincides with the interest rate in thecredit market) and the gross accounting profits generate...

  • Page 320

    Money, Bank Credit, and Economic Cycles290who own the company. This implicit component, togetherwith the risk factor and entrepreneurial profits or losses whichresult from the purely entrepreneurial activity of the business,give rise to accounting profits. From this perspective it is pos-sible fo...

  • Page 321

    Bank Credit Expansion and ItsEffects on the Economic System291and harmonious development of society.25 In short the inter-est rate conveys to entrepreneurs which new productivestages or investment projects they can and should embark onand which they should not, in order to keep coordinated, asmuc...

  • Page 322

    Money, Bank Credit, and Economic Cycles292Moreover although this chart is not strictly necessary forexplaining the essential theoretical arguments, and in fact,authors of the stature of Ludwig von Mises never used it intheir presentation of the theory of capital and of businesscycles,26 tradition...

  • Page 323

    Bank Credit Expansion and ItsEffects on the Economic System293

  • Page 324

    Money, Bank Credit, and Economic Cycles294The stages of the productive structure reflected in Chart V-1 do not represent the production of capital goods and con-sumer goods in physical terms, but rather their value in m.u.To the left of the chart we assume that the productive structureis composed...

  • Page 325

    Bank Credit Expansion and ItsEffects on the Economic System295census. These pyramids represent cross-sections of the realpopulation, which is classified by ages. In them we can alsosee the change in the number of people of each age whoremain alive (mortality table); this second interpretationmean...

  • Page 326

    Money, Bank Credit, and Economic Cycles296consumer goods for 100 units, they obtain an accountingprofit or interest derived from having advanced 90 m.u. fromsavings a year earlier. This difference between the totalamount they advanced, 90 m.u. (which they could have con-sumed, yet they saved and ...

  • Page 327

    Bank Credit Expansion and ItsEffects on the Economic System297of net income, which coincides exactly with the amount spenton final consumer goods during the period.SOME ADDITIONAL CONSIDERATIONSWe must now discuss some important additional consid-erations regarding our outline of the stages in th...

  • Page 328

    origin and cannot be traced back indefinitely in time; insteadeach stops at the very moment a certain entrepreneur took upthe pursuit of an aim which constituted the imagined finalstage in his process.30 Thus the first stage of production beginsprecisely at the moment the entrepreneur conceives o...

  • Page 329

    3. Fixed and circulating capital goods. A third pertinent observation about our portrayal of pro-ductive stages is that it includes not only fixed capital goods,but also circulating capital goods and durable consumergoods. From a human actor’s prospective point of view, thedistinction between f...

  • Page 330

    periods. In this way, inventories make it possible for clients atall levels (not only at the level of consumption, but also at thelevel of intermediate goods) to have at their disposal a grow-ing variety of products to choose from and acquire immedi-ately. Hence one manifestation of the lengtheni...

  • Page 331

    processes and of the increase in their number of stages con-sists precisely of the production of a larger number of durableconsumer goods of increasing quality and durability.335. The trend toward the equalization of the rate of accountingprofit or interest at each stage.The fifth fundamental poi...

  • Page 332

    were otherwise; that is, if in one of the stages the rate ofaccounting profit or interest were higher, then disinvestmentwould take place, and productive resources would be with-drawn from the stages with a lower rate of profit and directedto those with a higher rate of accounting profit. This re...

  • Page 333

    Bank Credit Expansion and ItsEffects on the Economic System303TABLEV-1 THESUPPLYOFANDDEMANDFORPRESENTGOODSSuppliers of Present GoodsDemanders of Present Goods(Savers, or demanders of future goods)(Suppliers o...

  • Page 334

    Money, Bank Credit, and Economic Cycles3047. Gross and net income for the year.Seventh, we could view Chart V-1, our outline of the dif-ferent stages in the production process, as an illustration of theflow of both capital goods and money. Indeed capital goods“flow downward,” i.e., from the s...

  • Page 335

    unshaded area corresponding to the final stage, that of con-sumer goods, versus the shaded areas pertaining to the otherstages (including the net monetary income of the factors ofproduction, shown at the top). Hence it is an unquestionablefact that the amount of money spent on intermediate goods ...

  • Page 336

    TABLE V-2GROSS OUTPUT ANDNET INCOME FOR THEYEARGross Output for the Year100 m.u. of final consumption +270 m.u. of total supply of present goods (Gross Saving and Investment as shown in detail in Table V-1)Total Gross Output: 370 m.u.Net Income for the Yeara) Net Income ReceivedCapitalists 1st st...

  • Page 337

    certain structure of productive stages remains the same orchanges, becoming narrower or broader, depends solely uponwhether the entrepreneurs of each stage subjectively decide itis worthwhile to reinvest the same percentage of the monetaryincome they have received, or instead, they believe it is ...

  • Page 338

    even the amount spent on consumer goods and services dur-ing each productive period. Therefore the key is to study grosssaving and investment, i.e., the aggregated value, in monetaryterms, of the stages of intermediate goods prior to final con-sumption, an amount which remains hidden if we focus ...

  • Page 339

    a small percentage of the total of capital goods. Indeed GNPincorporates the value of the sales of fixed or durable capitalgoods, such as real estate, industrial vehicles, machinery,tools, computers, etc., which are finished and sold to theirfinal users during the year, and thus are considered fi...

  • Page 340

    In short the Gross National Product is an aggregate figurerepresenting added values, and it excludes intermediategoods. The only reason national accounting theorists offer forusing this figure is that with this criterion they avoid the prob-lem of “double counting.” Yet from the standpoint of...

  • Page 341

    intermediate stages is not guaranteed, but results from a con-stant, uncertain series of concrete entrepreneurial decisionswhich depend on expected accounting profits and on thesocial rate of time preference or interest rate. The use of GNPin national income accounting almost inevitably implies t...

  • Page 342

    products, and it would be possible to follow the proportion ofthe amount spent each year on consumer goods and servicesto the amount spent at all intermediate stages. This ratio isultimately determined by the social rate of time preference,which establishes the proportion of gross saving and inve...

  • Page 343

    2THE EFFECT ON THEPRODUCTIVE STRUCTUREOF ANINCREASE INCREDIT FINANCED UNDERAPRIOR INCREASE INVOLUNTARY SAVINGTHE THREE DIFFERENT MANIFESTATIONS OF THEPROCESS OFVOLUNTARY SAVINGIn this section we will examine what happens within thestructure of production when, for whatever reason, economicagents ...

  • Page 344

    are exchanged for future goods encompasses society’s entirestructure of productive stages, such increases in saving andtheir manifestation in new investments are often the mostimportant in society.Second, owners of the original means of production (work-ers and owners of natural resources) may ...

  • Page 345

    which present goods are exchanged for future goods throughself-financing or capitalists’ direct reinvestment of presentgoods in their productive stages (the first and second proce-dures of saving-investment mentioned above). Though thissystem of saving is important, it is usually secondary to t...

  • Page 346

    (73) DebitCredit1,000,000 CashLoan received 1,000,000The entrepreneur who receives these present goods usesthem to acquire: (1) capital goods from prior productivestages; (2) labor services; (3) natural resources. Through thisthird procedure, savers who do not wis...

  • Page 347

    goods of any stage in the productive structure. Therefore onlya hypothetical consumer loan allocated for financing a house-hold’s current expenditure on non-durable consumer goodswould have the effect of immediately and directly increasingfinal current consumption. Nonetheless despite the fact ...

  • Page 348

    For analytical purposes we will begin by considering anextreme situation which nevertheless will be of great assis-tance in graphically illustrating and better understanding theprocesses involved. We will suppose that economic agentssuddenly decide to save 25 percent of their net income. Ourstart...

  • Page 349

    FIRST: THE EFFECT PRODUCED BY THENEW DISPARITY INPROFITSBETWEEN THEDIFFERENT PRODUCTIVE STAGESIf there is an increase in social saving of one-fourth of netincome, clearly the total monetary demand for consumergoods will decrease by the same proportion. Chart V-2 illus-trates the effect this has o...

  • Page 350

    Money, Bank Credit, and Economic Cycles320

  • Page 351

    Bank Credit Expansion and ItsEffects on the Economic System321Chart V-2 shows that before the increase in saving, 100m.u. of net income were spent on final consumer goods pro-duced by companies which first incurred expenses totaling 90m.u. Of this amount, 80 m.u. corresponded to the purchase ofca...

  • Page 352

    national output, which encompasses all stages of the produc-tion process. Therefore the fact that accounting losses occur inthe final stage does not immediately affect the stages prior toconsumption, in which a positive difference continues to existbetween income and expenditures, a difference si...

  • Page 353

    from the fifth stage increase their investment in original factorsand productive resources from 18 m.u. to 31.71 m.u., a figurenearly double their initial outlay. (Of this amount 21.5 m.u. arespent on the productive services of capital goods and 10.21 m.u.are spent on labor services and natural r...

  • Page 354

    Moreover the increase one might expect to observe in theprices of the factors of production (capital goods, labor andnatural resources) as a result of the greater demand for themin the fifth stage does not necessarily occur (with the possibleexception of very specific means of production). In fac...

  • Page 355

    backed by real voluntary saving and lead to an increase in themonetary demand for original means of production and capi-tal goods used in such stages. As we saw at the beginning ofthis chapter, production processes tend to be more productivethe more stages distant from consumption they contain, a...

  • Page 356

    brought about by an increase in saving, causes the presentvalue of a capital good with a very long life to more than dou-ble (the present value of a perpetual unitary rent at 11 percentinterest is equal to 1/0.11 = 9.09; and the present value of aperpetual rent at 5 percent interest is equal to 1...

  • Page 357

    market value of projects for lengthening the productive struc-ture through new, more modern stages further from con-sumption begins to rise and may even come to exceed the costof production, rendering these projects worthwhile. Hence thesecond effect of a decrease in the interest rate caused by a...

  • Page 358

    goods. Only securities which represent the property of thecompanies closest to consumption will undergo a temporary,relative decline in price, as a result of the immediate, negativeimpact of the decrease in the demand for consumer goods thatis generated by the upsurge in saving. Therefore it is c...

  • Page 359

    THIRD: THE RICARDO EFFECTAll increases in voluntary saving exert a particularlyimportant, immediate effect on the level of real wages. ChartV-2 shows how the monetary demand for consumer goodsfalls by one-fourth (from 100 m.u. to 75 m.u.), due to the risein saving. Hence it is easy to understand ...

  • Page 360

    The first to explicitly refer to this third effect was DavidRicardo. He did so in his book, On the Principles of PoliticalEconomy and Taxation, the first edition of which was publishedin 1817. Here Ricardo concludes that [e]very rise of wages, therefore, or, which is the same thing,every fall of ...

  • Page 361

    Hence the “Ricardo Effect” is a third microeconomicexplanation for the behavior of entrepreneurs, who react to anupsurge in voluntary saving by boosting their demand forBank Credit Expansion and ItsEffects on the Economic System331in voluntary saving exerts on the productive structure, though...

  • Page 362

    capital goods and by investing in new stages further fromfinal consumption.It is important to remember that all increases in voluntarysaving and investment initially bring about a decline in theproduction of new consumer goods and services with respect tothe short-term maximum which could be achi...

  • Page 363

    CONCLUSION: THE EMERGENCE OF ANEW, MORECAPITAL-INTENSIVE PRODUCTIVE STRUCTUREThe three effects we have just examined are provoked bythe entrepreneurial process of seeking profit, and the combi-nation of the three tends to result in a new, narrower and moreelongated structure of capital goods stag...

  • Page 364

    Money, Bank Credit, and Economic Cycles334

  • Page 365

    Bank Credit Expansion and ItsEffects on the Economic System335approximately 1.70 percent annually) approaches this figure.The net income received by the owners of the original means ofproduction (workers and owners of natural resources) and bythe capitalists of each stage, according to the net in...

  • Page 366

    Chart V-4 is simply the result of superimposing Chart V-1(line) on Chart V-3 (bar), and it shows the impact on the pro-ductive structure of the 25 m.u. growth in voluntary net sav-ing. Hence we see that the voluntary increase in saving pro-vokes the following effects:• First: a deepening of the...

  • Page 367

    Bank Credit Expansion and ItsEffects on the Economic System337TABLEV-3THESUPPLYOFANDDEMANDFORPRESENTGOODS(FOLLOWING25M.U.OFVOLUNTARYNETSAVING)Suppliers of Present GoodsDemanders of Present Goods(Savers or demanders of future goods)(Suppliers of future goods)Capitalists 1st stage=64.25 + 9.50 = 7...

  • Page 368

    Money, Bank Credit, and Economic Cycles338TABLE V-4GROSS INCOME ANDNET INCOME FOR THEYEAR(following 25 m.u. of voluntary net saving)Gross Income for the Year75 m.u. of final consumption + 295 m.u. of total supply of present goods(Gross Saving and Investment as shown in detail in Table V-3)(Note: ...

  • Page 369

    Bank Credit Expansion and ItsEffects on the Economic System339In short, in our example there has been no drop in themoney supply (and therefore no external deflation, strictly-speaking), nor has the demand for money risen. So if weassume both of these factors remain constant, then the generalfall...

  • Page 370

    Money, Bank Credit, and Economic Cycles340

  • Page 371

    remains the same or even diminishes somewhat, permit theearner to acquire an increasing quantity of consumer goodsand services of higher and higher quality: the decline in theprice of these goods is proportionally much sharper than thepossible decline in wages. In brief this is the healthiest, mo...

  • Page 372

    THE THEORETICAL SOLUTION TO THE“PARADOX OFTHRIFT”57Our analysis also allows us to solve the problems posed bythe supposed dilemma of the paradox of thrift or saving.This “paradox” rests on the concept that, though saving byMoney, Bank Credit, and Economic Cycles34257The essential argument...

  • Page 373

    individuals is positive in the sense that it allows them to aug-ment their income, socially speaking, when the aggregatedemand for consumer goods diminishes, the decrease eventu-ally exerts a negative effect on investment and production.58In contrast we have presented the theoretical argumentsBan...

  • Page 374

    which demonstrate that this interpretation, based on the oldmyth of underconsumption, is faulty. Indeed, even assumingthat gross national output in monetary terms remains con-stant, we have shown how society grows and developsthrough an increase in real wages, even when the monetarydemand for con...

  • Page 375

    decrease in society’s voluntary saving. Let us begin by suppos-ing that the productive structure closely resembles thatreflected in Chart V-3. If society as a whole decides to saveless, the result will be an increase, of for instance 25 m.u., inthe monetary demand for consumer goods and service...

  • Page 376

    never reaches the level of growth undergone by monetaryprices of consumer goods and services.According to John Hicks, Giovanni Boccaccio, in an inter-esting passage in the Introduction to Decameron, writtenaround the year 1360, was the first to describe, in rather pre-cise terms, a process very s...

  • Page 377

    3THE EFFECTS OFBANK CREDIT EXPANSIONUNBACKED BY ANINCREASE INSAVING:THE AUSTRIAN THEORY ORCIRCULATIONCREDIT THEORY OF THEBUSINESS CYCLEIn this section we will examine the effects banks exert onthe productive structure when they create loans unbacked bya prior increase in voluntary saving. These c...

  • Page 378

    63“So far as deposits are created by the banks, money means are created,and the command of capital is supplied, without cost or sacrifice on thepart of the saver.” F.W. Taussig, Principles of Economics, 3rd ed. (NewYork: Macmillan, 1939), vol. 1, p. 357.from nothing new m.u. in the form of de...

  • Page 379

    The “lengthening” of the productive structure derivesfrom the fact that the only way banks can introduce into theeconomy the new money they create from nothing and grantas loans is by temporarily and artificially reducing the inter-est rate in the credit market and by easing the rest of the e...

  • Page 380

    of profitability to investment projects which until that pointwere not profitable, giving rise to new stages further fromconsumption, i.e., stages which are more capital-intensive.The process through which these stages come into existenceclosely resembles the one involved when society’s volunta...

  • Page 381

    the productive structure; that is, they act as if society’s savinghad increased, when in fact such an event has not occurred. Inthe case of an upsurge in voluntary saving, which we exam-ined in the last section, the individual behavior of the differ-ent economic agents tended to become compatib...

  • Page 382

    unrealizable. Entrepreneurs embark upon the execution ofsuch projects. Business activities are stimulated. A boombegins.68At first the discoordination expresses itself in the emer-gence of a period of exaggerated and disproportionate opti-mism, which stems from the fact that economic agents feela...

  • Page 383

    consumers continue to consume at a steady (or evenincreased) pace and do not worry about stepping up their sav-ing.69To illustrate the initial effect credit expansion exerts on thereal productive structure, we will follow the system used inthe last section to present several graphs and tables whi...

  • Page 384

    Chart V-5 provides a simplified illustration of the effectexerted on the structure of productive stages by creditexpansion brought about by the banking system without thenecessary increase in social saving. When we compare it withChart V-1 of this chapter, we see that final consumptionremains unc...

  • Page 385

    Bank Credit Expansion and ItsEffects on the Economic System355expansion without the backing of any saving. Thus credit expan-sion has the effect of artificially raising the supply of presentgoods, which are demanded at lower interest rates by ownersof the original means of production and by capit...

  • Page 386

    Money, Bank Credit, and Economic Cycles356

  • Page 387

    Bank Credit Expansion and ItsEffects on the Economic System357indicators (such as the price of present goods in terms offuture goods, or the market rate of interest), or the granting ofprivileges against traditional legal principles, spontaneouslytriggers certain processes of social interaction w...

  • Page 388

    TABLEV-5THESUPPLYOFANDDEMANDFORPRESENTGOODS(WITHCREDITEXPANSION)Suppliers of Present GoodsDemanders of Present Goods(270 m.u. come from savers and 113.75 m.u. (Suppliers of future goods)have been created ex nihilo via bank credit)Capitalists 1st stage = 85.75+10.25 = 96.00 Z85.75 to Capitalists ...

  • Page 389

    Bank Credit Expansion and ItsEffects on the Economic System359As we will have the opportunity to study later, prior toMises various scholars of the School of Salamanca (Saravia dela Calle for instance) and others of the nineteenth century,mainly intellectuals of the Currency School (Henry Thornto...

  • Page 390

    Money, Bank Credit, and Economic Cycles360

  • Page 391

    THE MARKET’S SPONTANEOUS REACTION TOCREDIT EXPANSIONWe will now consider the microeconomic factors which willhalt the process of exaggerated optimism and unsustainableBank Credit Expansion and ItsEffects on the Economic System361Essays, Roy McCloughry, ed. (Chicago: University of Chicago Press,...

  • Page 392

    “pioneering work in the theory of money and economic fluctuations.”See William J. Zahka, The Nobel Prize Economics Lectures (Aldershot,U.K.: Avebury, 1992), pp. 19 and 25–28. Writings in Spanish on the Aus-trian theory of the business cycle are few but can be traced back to thearticle by Mi...

  • Page 393

    phenomena (economic crises, depression, and unemploy-ment) back to their fundamental microeconomic roots. We willnow study, one by one, the six microeconomic causes of thereversal of the boom that credit expansion invariably triggers:1. The rise in the price of the original means of production.Th...

  • Page 394

    launched investment projects above the amount originallybudgeted. Nevertheless this effect alone is still not sufficient toend the wave of optimism, and entrepreneurs, who continueto feel safe and supported by the banks, usually go ahead withtheir investment projects without a second thought.742....

  • Page 395

    goods and services. Furthermore as the capital theoryoutlined at the beginning of the chapter explains, thegeneralized lengthening of production processes andthe incorporation into them of a greater number ofstages further from consumption invariably leads to ashort-term decrease in the rate at w...

  • Page 396

    been produced, which further increases the pressureof the monetary demand for final consumer goods.75It is important to underline the effect of the more-than-proportional rise in the price of consumer goods with respectto the rise in the price of original factors of production. Theo-retically thi...

  • Page 397

    unsold and which sustained the owners of the original factorsof production while new processes of production could becompleted). When there is no prior growth in saving, andtherefore consumer goods and services are not freed to sup-port society during the lengthening of the productive stagesand t...

  • Page 398

    bring in less profit, an accounting result of a rise in costs morerapid than the corresponding increase in income. These twofactors produce the following combined effect: it graduallybecomes evident throughout the productive structure that theaccounting profits generated in the stages closest to ...

  • Page 399

    in wages provokes the “Ricardo Effect,” which we have cov-ered in detail, but which now exerts an impact contrary to theone it exerted in our last example, where real growth tookplace in voluntary saving. In the case of voluntary saving, thetemporary decrease in the demand for consumer goodsb...

  • Page 400

    about a short-term decrease in the demand for consumergoods and in their price, and thus a boost in real wages whichencouraged the substitution of machinery for workers,growth in the demand for capital goods and a lengthening ofproductive stages. Now we see that the relative rise in theprice of c...

  • Page 401

    5. The increase in the loan rate of interest. Rates even exceed pre-credit-expansion levels.The last temporary effect consists of an escalation in inter-est rates in the credit market. This rise occurs sooner or later,when the pace of credit expansion unbacked by real savingstops accelerating. Wh...

  • Page 402

    interest rates in real terms, they will have to add (tothe interest rate which prevails prior to the beginningof the credit expansion process) a component for“inflation,” or in other words, for the expected drop inthe purchasing power of the monetary unit.81(b) There is another powerful reaso...

  • Page 403

    detail in 1937.82 Hayek demonstrated that the processof investment in capital goods generates anautonomous demand for subsequent capital goods,precisely ones which are complementary to thosealready produced. Furthermore this phenomenon willlast as long as the belief that the production processesc...

  • Page 404

    they have begun and which they begin to see threat-ened, turn to banks and demand additional loans,offering a higher and higher interest rate for them.Thus they start a “fight to the death” to obtain addi-tional financing.84Money, Bank Credit, and Economic Cycles374The entrepreneurs cannot pr...

  • Page 405

    6. The appearance of accounting losses in companies operatingin the stages relatively more distant from consumption: theinevitable advent of the crisis. The above five factors provoke the following combinedeffect: sooner or later companies which operate in the stagesrelatively more distant from c...

  • Page 406

    85In the words of F.A. Hayek himself: The crux of the whole capital problem is that while it isalmost always possible to postpone the use of things nowready or almost ready for consumption, it is in many casesimpossible to anticipate returns which were intended tobecome available at a later date....

  • Page 407

    microeconomic processes examined above invariably andspontaneously bring to light the error committed. This errorderives from the fact that for a prolonged period of time eco-nomic agents believed available savings to be much more con-siderable than they actually were. This situation is very simi...

  • Page 408

    obvious that saving is inadequate to permit the completion ofthe more capital-intensive investments made by mistake. Thesituation would resemble that of the imaginary inhabitants ofan island who, having undertaken the construction of an enor-mous machine capable of completely satisfying their nee...

  • Page 409

    Chart V-7 reflects the state of the productive structureonce the crisis and economic recession provoked by creditexpansion (i.e., unbacked by a prior increase in voluntary sav-ing) have become evident and the necessary readjustmentshave been made. As the chart makes clear, the new productivestruc...

  • Page 410

    increase in the price of consumer goods places the owners ofthese factors at a considerable disadvantage in real terms.Moreover the interest rate, or rate of accounting profitapproached at each stage, has risen above 13.5 percent, i.e., toa level which even exceeds that of the interest in the cre...

  • Page 411

    Bank Credit Expansion and ItsEffects on the Economic System381In summary, we have described the microeconomic basisfor the spontaneous market reaction which consistently tendsto follow credit expansion. This reaction gives rise to the con-secutive cycles of boom and recession which have regularly...

  • Page 412

    Money, Bank Credit, and Economic Cycles382increase in loans, if not backed by a corresponding prior rise in vol-untary saving, will permit society to reduce the necessary sacri-fices all processes of economic growth require, and foster and accel-erate sustainable growth in the absence of a volunt...

  • Page 413

    Bank Credit Expansion and ItsEffects on the Economic System383

  • Page 414

    Money, Bank Credit, and Economic Cycles384TABLEV-6THESUPPLYOFANDDEMANDFORPRESENTGOODS(Following the Economic Crisis Caused by Credit Expansion Unbacked by Saving)Suppliers of Present GoodsDemanders of Present Goods(Savers)(Suppliers of Future Goods)Capitalists 1st Stage =106.50+10.20=116.70Z106.5...

  • Page 415

    4BANKING, FRACTIONAL-RESERVE RATIOS,AND THELAW OFLARGE NUMBERSOur analysis up to this point permits us to comment onwhether it is possible, as certain scholars maintain, to insurethrough the application of the law of large numbers the prac-tice of fractional-reserve banking. Essentially we will r...

  • Page 416

    92On this topic see Huerta de Soto, Socialismo, cálculo económico y funciónempresarial, pp. 46–47.93“The Bayesian approach rules out the possibility of surprise.” J.D.Hey, Economics in Disequilibrium (New York: New York UniversityPress, 1981), p. 99. Along the same lines, Emiel F.M Wubbe...

  • Page 417

    insurable. The technical-economic reason it is impossible toinsure uncertainty stems basically from the fact that humanaction itself brings about or creates the events which an attempt ismade to insure. In other words, withdrawals of deposits areinvariably influenced by the very existence of the ...

  • Page 418

    Money, Bank Credit, and Economic Cycles388TABLE V-7The Field of Natural Science The Field of Human Action1. Class probability: Thebehavior of the class isknown or knowable,while the behavior of itsindividual elements arenot.2. A situation of insurablerisk exists for the wholeclass.3. Pr...

  • Page 419

    unbacked by a prior increase in saving (credit expansion) andinitially provokes artificial widening and lengthening of theproductive structure (illustrated by the shaded areas inChart V-6). Nevertheless sooner or later the microeconomicfactors explained in detail in the previous section set inmot...

  • Page 420

    system. In fact those entrepreneurs who fortunately manageto save their companies from a suspension of payments andbankruptcy restructure the investment processes they initi-ated. They paralyze them, liquidate them and accumulate theliquidity necessary to return the loans they obtained from theba...

  • Page 421

    minor and merely a matter of degree, making a significantfinancial and credit squeeze inevitable. Events of this sort (suchas the economic crisis Florentine banks provoked in the four-teenth century) have repeatedly occurred since the dawn offractional-reserve banking. At any rate it has been dem...

  • Page 422

    about credit expansion, and therefore banks are unable toeliminate their liabilities at the same rate the value of theirassets drops. An accounting maladjustment ensues, leading tosuspensions of payments and to the bankruptcy of marginallyless solvent banks. If pessimism and the lack of confidenc...

  • Page 423

    focused on its most visible, short-term results (waves of opti-mism, economic booms). However what can be said of thebankers themselves, who throughout history have experi-enced numerous bank runs and crises that have repetitivelyand seriously endangered their business or even ended it?Given that...

  • Page 424

    the ex nihilo creation of money, an ability all credit expansioninvolves, generates such large profits that bankers eventuallysuccumb to the temptation to revert to a fractional reserve. Inaddition no particular banker can be absolutely certain his bankwill be one of those that eventually suspend...

  • Page 425

    survival during panic stages.99 From this point of view, thehistorical emergence of the central bank as an institution wasan inevitable result of the very privilege which allows banksto loan most of the money they receive on deposit, through themaintenance of a fractional-reserve ratio. Furthermo...

  • Page 426

  • Page 427

    6ADDITIONALCONSIDERATIONSON THETHEORY OFTHEBUSINESS CYCLEThis chapter presents some additional considerations toclarify various aspects of the circulation credit theory ofthe business cycle. These reflections are intended tofurther our analysis as much as possible and to shed light ondifferent pe...

  • Page 428

    expansion and which reverse the artificial boom that creditexpansion initially creates. In fact in such a case there is noincrease in the price of the original means of production. Onthe contrary, if the loans originate from an upsurge in real sav-ing, the relative decrease in immediate consumpti...

  • Page 429

    negative. This is because, as we have seen, the tendency istoward a fall in the price of consumer goods (in the short- andlong-term), which tends to drive up the purchasing power ofmoney, an event which will exert even further downwardpressure on nominal interest rates. In addition economicgrowth...

  • Page 430

    the six phenomena we explained in chapter 5, which alwaystend to spontaneously reverse the initial consequences of allcredit expansion in the market. However, while this proce-dure may postpone the depression, and may even do so forrelatively long periods of time,2 this strategy is condemned toin...

  • Page 431

    The success of this strategy of postponing the crisisthrough additional loans hinges on a continuously-growingrate of credit expansion. Hayek already revealed this principlein 1934 when he stated: “[I]n order to bring about constantadditions to capital, [credit] would have to . . . increase at ...

  • Page 432

    (a) The rate at which credit expansion accelerates eitherslows down or stops, due to the fear, experienced bybankers and economic authorities, that a crisis willerupt and that the subsequent depression may beeven more acute if inflation continues to mount. Themoment credit expansion ceases to inc...

  • Page 433

    Hayek revealed that the increasing speed at whichthe rise in the monetary income of the factors of pro-duction pushes up the demand for consumer goodsand services ultimately limits the chances that theinevitable eruption of the crisis can be deferred via thesubsequent acceleration of credit expan...

  • Page 434

    (c) Finally let us suppose that the banking system at notime reduces the rate at which it accelerates creditexpansion, and instead does just the opposite: it con-stantly and progressively intensifies it, with the pur-pose of quashing any symptom of an emergingdepression. In this case, the moment ...

  • Page 435

    will ensue when the hyperinflation process destroysthe purchasing power of the monetary unit and eco-nomic agents spontaneously start to use anothertype of money. At that point the six microeconomicreversion effects we are familiar with will appear inall of their intensity, as will an acute econo...

  • Page 436

    3CONSUMER CREDIT AND THETHEORY OF THECYCLEWe are now able to identify the modifications, if any, to bemade to our analysis when, as in modern economies, a signif-icant portion of the credit expansion banks bring about with-out the support of voluntary saving takes the form of con-sumer credit. Th...

  • Page 437

    loans in favor of the stages furthest from consumption, thusinstigating the typical processes of expansion and recession weare familiar with; or the loans exert their impact on currentconsumption while no additional capacity is freed for grantingloans to industries from the stages furthest from c...

  • Page 438

    At any rate credit expansion always gives rise to the samewidespread malinvestment in the productive structure,whether by artificially lengthening the existing structure(when expansion directly affects the most capital-intensivestages, financing durable consumer goods) or shortening it(when credi...

  • Page 439

    4THE SELF-DESTRUCTIVE NATURE OF THEARTIFICIALBOOMS CAUSED BYCREDIT EXPANSION:THE THEORY OF“FORCED SAVING”In the broad sense of the term, “forced saving” arises when-ever there is an increase in the quantity of money in circula-tion or an expansion of bank credit (unbacked by voluntarysavi...

  • Page 440

    obliged to reduce their consumption, other things beingequal.10Whether this phenomenon of forced saving, which is pro-voked by an injection of new money at certain points in themarket, leads to a net increase or decrease in society’s overall,voluntary saving will depend on the circumstances spe...

  • Page 441

    each historical case. In fact if those whose income rises (thosewho first receive the new money created) consume a propor-tion of it greater than that previously consumed by thosewhose real income falls, then overall saving will drop. It isalso conceivable that those who benefit may have a strong...

  • Page 442

    stages in the productive structure, changes which stem fromcredit expansion the banking system launches without thesupport of voluntary saving. As we know, this process initiallygenerates an increase in the monetary income of the originalmeans of production, and later, a more-than-proportional ri...

  • Page 443

    correctly indicates).12 Instead, regardless of the final amountof saving and investment in society (always identical ex post),all that is achieved by an attempt to force a level of investmentwhich exceeds that of saving is the general malinvestment ofthe country’s saved resources and an economi...

  • Page 444

    factors of production have been transformed into capitalgoods, these goods become non-convertible to a certain extent.In other words, many capital goods will lose all of their valueonce it becomes clear there is no demand for them, they weremanufactured in error and they should never have been pr...

  • Page 445

    may also be left half-completed, as their promoters abandonthem upon realizing they cannot continue to obtain the newfinancial resources necessary to complete them, or thoughthey may be able to continue to secure loans, they recognizethat the investment processes lack economic viability. In short...

  • Page 446

    existence of “idle capacity” in many production processes(but especially in those furthest from consumption, such ashigh technology, construction, and capital goods industries ingeneral) in no way constitutes proof of oversaving and insuf-ficient consumption. Quite the opposite is true: it is...

  • Page 447

    6CREDIT EXPANSION AS THECAUSEOFMASSIVE UNEMPLOYMENTThe direct cause of massive unemployment is labor marketinflexibility. In fact state intervention in the labor market andunion coercion, made possible by the privileges the legal sys-tem confers on unions, result in a series of regulations (mini-...

  • Page 448

    serious, large-scale entrepreneurial error. When the crisis hitsand the errors come to light, new massive transfers of originalfactors of production and labor from the stages furthest fromconsumption to those closest to it will be necessary and willrequire an especially flexible labor market, one...

  • Page 449

    be explained in the following manner: contrary to the veryimplications of the term gross, which is added to the expres-sion “National Product,” GNP is actually a net figure thatexcludes the value of all intermediate capital goods which at theend of the measurement period become available as i...

  • Page 450

    income, relegate to third place, after government expenditure,the production of final capital goods completed throughoutthe period (the only capital goods reflected in the GNP bydefinition) and absurdly exclude approximately half of all ofsociety’s entrepreneurial, labor and productive effort, ...

  • Page 451

    8ENTREPRENEURSHIP AND THETHEORY OF THECYCLEThe conception of entrepreneurship developed by Lud-wig von Mises, Friedrich A. Hayek, and Israel M. Kirzner liesat the very root of a theory of entrepreneurship which wehave presented elsewhere.22 An entrepreneur is any humanactor who performs each of h...

  • Page 452

    and irresponsible behaviors. From this point of view our the-ory of the cycle could be considered an application of the moregeneral theory of entrepreneurship to the specific case of theintertemporal discoordination (i.e., between different time periods)which follows from banking activity not sub...

  • Page 453

    they are aware of the theory concerning it. Logically no onecan predict precisely when and where the crisis will erupt,and a large number of entrepreneurs will undoubtedly be“surprised” by the event and will encounter serious difficul-ties. Nonetheless, in advance, from a theoretical standpoi...

  • Page 454

    itself to those entrepreneurs shrewd enough to arrive at thisrecession stage in the cycle with liquidity and to very selec-tively acquire those capital goods which have lost nearly all oftheir commercial value but which will again be consideredvery valuable once the economy recovers. Hence entrep...

  • Page 455

    artificially expanded and the quantity of money in circulationremains more or less constant, growth in voluntary savinggives rise to a widening (lateral) and lengthening (longitudi-nal) of the capital goods stages in the productive structure.These stages can be completed with no problem, and once...

  • Page 456

    At this point it should be evident that a policy of creditexpansion unbacked by real saving must inevitably set inmotion all of the processes leading to the eruption of the eco-nomic crisis and recession, even when expansion coincideswith an increase in the system’s productivity and nominalpric...

  • Page 457

    consumption soared throughout the final years of the expan-sion, as a result of the substantial increase in their productiv-ity. Their goods were sold at constant nominal prices in anenvironment of great inflationary expansion. Therefore thefactors which typically trigger the recession (relative ...

  • Page 458

    of stabilizing the purchasing power of the monetary unit isincompatible with the necessary function of money withrespect to coordinating the decisions and behaviors of eco-nomic agents at different points in time. Hayek explains thatif the quantity of money in circulation remains constant, thenin...

  • Page 459

    Hence it is not surprising that F.A. Hayek and the othertheorists of his school during the latter half of the 1920s, uponexamining the expansionary monetary policy of the UnitedStates (which, nonetheless, given the increase in productivity,did not manifest itself as a rise in prices), were the on...

  • Page 460

    [t]he creation of new circulating media so as to keep con-stant a price level which would otherwise have fallen inresponse to technical progress, may have the same unstabi-lizing effect on the supply of money capital that has beendescribed before, and thus be liable to lead to a crisis. Inspite o...

  • Page 461

    hit if all credit expansion is not prevented. Thus in the nearfuture these considerations may very well regain their veryimportant practical significance. At any rate, they are of greatuse in understanding many economic cycles of the past (themost consequential of which was the Great Depression o...

  • Page 462

    10HOW TOAVOID BUSINESS CYCLES: PREVENTION OFANDRECOVERY FROM THEECONOMIC CRISISAt this point we can easily deduce that once banks haveinitiated a policy of credit expansion, or the money supply hasincreased in the form of new loans granted without the sup-port of new voluntary saving, processes w...

  • Page 463

    Assuming credit expansion has taken place in the past, weknow the economic crisis will inevitably hit, regardless of anyattempts to postpone its arrival through the injection of newdoses of credit expansion at a progressively increasing rate. Inany case the eruption of the crisis and recession ul...

  • Page 464

    the beginning of the readjustment are naturally followed by adrop in the interest rate. This drop arises from the reductionand even the disappearance of the premium based on theexpectation of a decrease in the purchasing power of money,and also from the increased relative saving the recession pro...

  • Page 465

    true desire with regard to saving, to liquidate the investmentprojects undertaken in error and to massively transfer factorsof production toward the stages and companies closest to con-sumption, where consumers demand they be employed.Therefore the only possible and advisable policy in the case o...

  • Page 466

    which always acquire great popularity and political supportduring crises, in view of the socially painful nature of suchphenomena. The following are among the main steps whichare normally proposed and should be averted:(a) The granting of new loans to companies from the morecapital-intensive stag...

  • Page 467

    reorganize. The granting of new loans simply post-pones the eruption of the crisis, while making the nec-essary subsequent readjustment much more severeand difficult. Furthermore, the systematic concessionof new loans to repay the old ones delays the painfulinvestment liquidations, postponing, ev...

  • Page 468

    their pockets, in a way that makes it impossible forthose very jobs to be profitable. Hence the only laborpolicy possible is to facilitate the dismissal and rehir-ing of workers by making labor markets highly flexi-ble.(c) Likewise, any policy aimed at restoring the status quowith respect to macr...

  • Page 469

    manipulated. Indeed in the recovery phase the inter-est rate in the credit market will spontaneously tendto decline, given the drop in the price of consumergoods and the increase in saving brought about by thereorganization the recession entails. Nevertheless anymanipulation of the market rate of...

  • Page 470

    employed through this procedure dedicate most oftheir income to consumption, the price of consumergoods tends to rise in relative terms, causing the deli-cate situation of companies from the stages furthestfrom consumption to deteriorate even further. In anycase, in their contracyclical policies ...

  • Page 471

    idle.39 In fact Mises demonstrated from the beginning that theunemployment of resources was not only compatible with thetheory he had developed, but was actually one of its essentialelements. In market processes in which entrepreneurs under-take plans that involve the production of heterogeneous ...

  • Page 472

    The theory of the business cycle teaches precisely thatcredit expansion unbacked by an increase in real saving willencourage the malinvestment of productive resources evenwhen there is a significant volume of idle resources, specifically,unemployed labor. In other words, contrary to opinionsexpre...

  • Page 473

    consumer goods and services. The relative prices of thesegoods and services rise more rapidly than the prices of prod-ucts from the stages furthest from consumption, thus dimin-ishing real relative wages and setting off the “Ricardo Effect”and the other effects which lead to crisis and recess...

  • Page 474

    12THE NECESSARY TIGHTENING OFCREDIT INTHERECESSION STAGE: CRITICISM OF THETHEORY OF“SECONDARY DEPRESSION”We will now consider three different types of deflation,defined as any decrease in the quantity of money “in circula-tion.”42 Deflation consists of a drop in the money supply or arise ...

  • Page 475

    production, because although the income of workers and ofthe other owners of original factors may remain constant, innominal terms, the prices of the consumer goods and servicesworkers acquire drop considerably. In this case the decline inthe general price level is not monetary in origin, but rea...

  • Page 476

    (a) The first type consists of policies adopted by publicauthorities to deliberately reduce the quantity ofmoney in circulation. Such policies have been imple-mented on various historical occasions45 and trigger aprocess by which the purchasing power of the mone-tary unit tends to increase. Moreo...

  • Page 477

    This whole process of deliberate deflation contributesnothing and merely subjects the economic system tounnecessary pressure. Regrettably, politicians’ lack oftheoretical knowledge has led them on various histor-ical occasions to deliberately initiate such a process.46Additional Considerations ...

  • Page 478

    (b) The second type of deflation, which should be clearlydistinguished from the first, occurs when economicagents decide to save; that is, to refrain from consum-ing a significant portion of their income and to devoteall or part of the monetary total saved to increasingtheir cash balances (i.e., ...

  • Page 479

    resources have been freed in the stages closest to con-sumption. The only difference between this situationand that of an increase in voluntary saving which isimmediately and directly invested in the productivestructure or capital markets is as follows: when savingmanifests itself as a rise in ca...

  • Page 480

    (c) The third type of deflation we will consider resultsfrom the tightening of credit which normally occurs inthe crisis and recession stage that follows all creditexpansion. This process was mentioned in chapters 4and 5, where we analyzed the following: just as creditexpansion increases the quan...

  • Page 481

    experienced an increase in monetary income. Now, inthe stage of credit tightening, this forced redistribu-tion of income reverses in favor of those who in theexpansionary stage were the first harmed, and thuspeople on a fixed income (widows, orphans, and pen-sioners) will gain an advantage over t...

  • Page 482

    than the reduction in the price of consumer goods andservices, if such a reduction takes place. Consequently,in relative terms, the wages and income of the originalmeans of production will decline, leading to anincreased hiring of workers over machines and a mas-sive transfer of workers toward th...

  • Page 483

    recovery of economic activity. If wages are inflexible, hiringconditions very rigid, union power great and governmentssuccumb to the temptation of protectionism, then extremelyhigh unemployment can actually be maintained indefinitely,without any adjustment to new economic conditions on thepart of...

  • Page 484

    economic policy, and its answer must depend on a correctevaluation of the severity of each particular set of circum-stances. Although theory suggests that any policy which con-sists of an artificial increase in consumption, in public spend-ing and in credit expansion is counterproductive, no oned...

  • Page 485

    Now let us suppose politicians ignore the economist’s rec-ommendations and circumstances do not permit the liberal-ization of the economy, and therefore unemployment becomeswidespread, the readjustment is never completed and theeconomy enters a phase of cumulative contraction. Further-more let ...

  • Page 486

    unemployed) would be the least debilitating under theextreme conditions described above.5313THE “MANIC-DEPRESSIVE” ECONOMY:THE DAMPENING OF THEENTREPRENEURIAL SPIRITANDOTHER NEGATIVE EFFECTS RECURRING BUSINESSCYCLES EXERT ON THEMARKET ECONOMYThe economic crises credit expansion repeatedly pro...

  • Page 487

    necessary to highlight the way in which the current monetarysystem, based on credit expansion, has made it customary forbooms and crises to disturb economic development. In otherwords, it appears as if “manic-depressive” behavior wererequired of a market economy.Indeed businessmen, journalist...

  • Page 488

    to finance all sorts of speculative operations, takeover bidsand financial and trade wars in which the culture of short-sighted speculation prevails. In other words the misconceivedidea that it is possible and desirable to accumulate astronom-ical profits with astonishing ease and swiftness sprea...

  • Page 489

    evils of the credit policy. This creates an environment of mon-etary irresponsibility which tends to aggravate problems andmakes it highly unlikely they will be resolved through a sensi-ble readjustment and liquidation which lay the foundations fora sustained recovery that does not depend on cred...

  • Page 490

    embodiment of investments which savers, or capitalists, makein the following type of transaction: Capitalists concede pres-ent goods to demanders of present goods, who are willing tohand over a larger quantity of future goods to savers, orlenders, in the future in exchange for the ability to use ...

  • Page 491

    In an economy which shows healthy, sustained growth,voluntary savings flow into the productive structure by tworoutes: either through the self-financing of companies, orthrough the stock market. Nevertheless the arrival of savingsvia the stock market is slow and gradual and does not involvestock ...

  • Page 492

    an end as long as credit expansion lasts. As Fritz Machlupexplains:If it were not for the elasticity of bank credit, which has oftenbeen regarded as such a good thing, the boom in securityvalues could not last for any length of time. In the absenceof inflationary credit the funds available for le...

  • Page 493

    what specific circumstances the artificial nature of the expan-sion will become evident in the stock market, ultimately settingoff a crisis. However the stock market will definitely offer thefirst sign that the expansion is artificial and has “feet of clay,”and then quite possibly, the slight...

  • Page 494

    Indeed neither the public nor the majority of specialists wishto accept that the stock market decline is the initial warning ofthe inevitable recession and that stock market indexes cannotremain unchanged in the absence of new doses of credit.66Such credit would only postpone the crisis and make ...

  • Page 495

    long as the readjustment, and could last indefinitely if thereadjustment never concludes because new loans prolongmalinvestment, and labor and all other markets are highlycontrolled and rigid.68When the readjustment has ended the recovery can begin,assuming economic agents regain confidence and a...

  • Page 496

    Although many additional considerations regarding theevolution of the stock market during the business cycle couldbe presented, the most important idea is this: in general, nosignificant, continuous rise in the price of securities can beaccounted for by an improvement in production conditionsnor ...

  • Page 497

    15EFFECTS THEBUSINESS CYCLE EXERTSON THEBANKING SECTORAt this point in our analysis it should be easy to identifythe effects and relationships which link the business cycle andthe banking sector. To begin with, we must recognize that thebusiness cycle stems from credit expansion the banking secto...

  • Page 498

    Hence we can conclude that an inherent trend in the priv-ileged exercise of fractional-reserve banking leads to bank con-solidation and encourages bankers to develop and maintain closerelations with the central bank as the only institution capable ofguaranteeing banks’ survival in moments of cr...

  • Page 499

    requested less than before, given that new companies areless numerous. However the producers of the means of pro-duction cannot withdraw their capital from their compa-nies, and in addition, the importance of the capital involvedin the form of buildings, machines, etc., obliges producers tocontin...

  • Page 500

    monetary and credit system, the expansion of which, at alltimes, would “guarantee” economic development. Specifi-cally, Hayek asserted that economic crises arose from the very nature of the modern organization of credit. Solong as we make use of bank credit as a means of furtheringeconomic de...

  • Page 501

    This early thesis of Hayek’s, which partially coincideswith that of Marx, would only be valid if the very Austriantheory of business cycles had not revealed that economiccrises cause great damage to the productive structure andwidespread consumption of accumulated capital. Theseeffects seriousl...

  • Page 502

    necessary to strictly regulate and control labor markets to“protect” workers from entrepreneurs and their capacity forexploitation, it has precisely been Marxist ideology. HenceMarxism has played a key and perhaps unintentional75 role injustifying and fostering the rigidity of labor markets, ...

  • Page 503

    from above and does not coincide with the desires of citizensand it is theoretically impossible for the system to correct itsmaladjustments and discoordination.76 Therefore to contendthat an economy of real socialism offers the advantage of elim-inating economic crises is tantamount to affirming ...

  • Page 504

    malinvestment of productive resources, a phenomenon whichhas even been accompanied by cyclical adverse changes andwhich has been studied in certain detail by various theoristsfrom the former Eastern economies.78The appalling economic difficulties presently confrontingthe economies of the former E...

  • Page 505

    which gives rise to an artificial boom and to the business cycle,from the mere creation of new money and the placing of it inthe hands of the state, a procedure which exerts the effectstypical of an inflationary tax.79Another final consideration relates to the internationalnature of business cycl...

  • Page 506

    In any case the definitive elimination of economic criseswill require a worldwide reform of the monetary system. Sucha reform is outlined in the ninth and final chapter of this book.18EMPIRICAL EVIDENCE FOR THETHEORY OF THECYCLEIn this section we will study how the theory of the busi-ness cycle p...

  • Page 507

    social realm is always “historical,” i.e., it consists of extremelycomplex events in which innumerable “variables” areinvolved. It is not possible to observe these variables directly;we can only interpret them in light of a prior theory. Further-more both events (with their infinite compl...

  • Page 508

    valid theories which permit the adequate interpretation ofreality. Hence no irrefutable historical evidence exists, muchless evidence capable of confirming that a theory is valid orinvalid. Therefore we should be very cautious and humble inour hopes of empirically corroborating a theory. At most ...

  • Page 509

    explanation, which is rejected because there is no sufficientquantitative evidence for it.81While taking the above warnings and considerations intoaccount, in this section we will see that the available historicaldata concerning past cycles of boom and recession fits inexcellently with our theory...

  • Page 510

    following R.C. Mueller’s studies,83 documented thesubstantial credit expansion Florentine banks broughtabout starting at the beginning of the fourteenth cen-tury.84 The result was a significant economic boomthat made Florence the center of financial and tradeactivity in the Mediterranean. Nonet...

  • Page 511

    In chapter 2 we critically analyzed Cipolla’s use of themonetarist theory which underlies his interpretationof Florentine monetary processes.(b) The second economic crisis Cipolla has studied indepth can also be fully accounted for in terms of theAustrian theory of the business cycle. It involv...

  • Page 512

    87Ibid., p. 111.88See Hayek’s article, “First Paper Money in Eighteenth CenturyFrance,” printed as chapter 10 of the book, The Collected Works of F.A.Hayek, vol. 3: The Trend of Economic Thinking, pp. 155–76. See alsoKindleberger, A Financial History of Western Europe, pp. 98ff.out cash),...

  • Page 513

    a now classic book on the subject. The panic was preceded byan expansion of credit and of the money supply, both in theform of bank bills and of loans, neither of which were backedby real saving. The newly-created Bank of the United Statesplayed a leading role in this process. This produced great...

  • Page 514

    began to shoot up. The crisis came to a halt when banks decidedto stop increasing their loans in light of the fact that they werelosing more and more gold reserves, which were leaving thecountry, headed mainly for the United States. Starting in 1836prices plunged and banks failed or suspended pay...

  • Page 515

    impacted the iron, steel and coal industries and the crisis hit.It spread quickly, triggering a worldwide depression. August22, 1857 was a day of true panic in New York and many bankssuspended their operations.6. The Crisis of 1866. The expansionary stage began in 1861.The evolution of banking in...

  • Page 516

    and steel industries underwent intensive development.Expansion spread to the rest of the world and in Europe therewas tremendous stock market speculation in which industrialsector securities soared. Crisis hit first on the Continent inMay of 1873 and following the summer in the United States,when...

  • Page 517

    Following the crisis of 1907 a new boom began, and in1913 it culminated in a new crisis similar to previous ones.This new crisis was interrupted by the outbreak of World WarI, which altered the productive structure of nearly all coun-tries in the world.91THE ROARING TWENTIES AND THEGREAT DEPRESSI...

  • Page 518

    expanded bank credit by more than twice as much, and inthe years which followed we paid a terrible price for this.92Murray N. Rothbard calculates that the money supply inthe United States grew from $37 billion in 1921 to over $55 bil-lion in January 1929.93 These figures closely approximate thees...

  • Page 519

    F.A. Hayek himself was a qualified first-hand witness ofthe expansionary credit policy the Federal Reserve followed inthe 1920s. Indeed between 1923 and 1924 he spent fifteenmonths studying in situ the monetary policy of the U.S. Fed-eral Reserve. One outcome of that stay was his article onAmeric...

  • Page 520

    a poor allocation of resources in the productive structure andsubsequently, a deep depression. This is what actually hap-pened.Indeed the goal of stability in the general price level ofconsumer goods was very nearly achieved throughout the1920s, at the cost of great credit expansion. This generat...

  • Page 521

    terms of justifying credit expansion with the supposedly ben-eficial goal of keeping the general price level constant. Accord-ing to Hawtrey, The American experiment in stabilization from 1922 to 1928showed that early treatment could shake a tendency eitherto inflation or to depression in a few m...

  • Page 522

    expansionary growth in loans exerted a highly unequal effecton the productive structure and relative prices. Professor Irv-ing Fisher was perhaps the most famous American economistat the time, and his comments were among those which moststood out. Fisher obstinately defended the theory that thest...

  • Page 523

    Furthermore a drastic credit squeeze took place, and gross pri-vate investment shrank from over $15 billion in 1929 to barely$1 billion in 1932. In addition unemployment reached its peakin 1933 at around 27 percent of the active population.The duration and particular severity of the Great Depres-...

  • Page 524

    THE ECONOMIC RECESSIONS OF THELATE 1970S ANDEARLY 1990SThe most characteristic feature of the business cycleswhich have followed World War II is that they have originatedin deliberately inflationary policies directed and coordinatedby central banks. During the post-war decades and well intothe la...

  • Page 525

    was an unprecedented phenomenon: an acute depressionaccompanied by high rates of inflation and unemployment.103The crisis of the late seventies belongs to recent economichistory and we will not discuss it at length. Suffice it to saythat the necessary worldwide adjustment was quite costly.Perhaps...

  • Page 526

    and spread throughout Japan, England, and the rest of theworld. Despite the stock market’s “warnings,” particularly thecollapse of the New York Stock Exchange on October 19, 1987,“Black Monday,” (when the New York Stock Exchange Indextumbled 22.6 percent), monetary authorities reacted b...

  • Page 527

    these facts. Furthermore Hughes examines the impact ofcredit expansion and recession on different sectors belongingto various stages of the productive structure (some closer toand some further from consumption). His empirical time-series study confirms the most important conclusions of ourtheory ...

  • Page 528

    economy has played in it. Particularly in the four-year periodbetween 1987 and 1991, the Japanese economy underwentenormous monetary and credit expansion which, as theory sug-gests, affected mainly the industries furthest from consumption.In fact although the prices of consumer goods rose only by...

  • Page 529

    consequence of Spain’s entrance into the European Eco-nomic Community. Moreover the recession hit within a con-text of an overvalued peseta, which had to be devalued onthree consecutive occasions over a period of twelve months.The stock market was seriously affected, and well-knownfinancial and...

  • Page 530

    SOME EMPIRICAL TESTING OF THEAUSTRIAN THEORYOF THEBUSINESS CYCLESeveral fascinating studies have lent strong empirical sup-port to the Austrian theory of the business cycle. This hasoccurred despite the difficulties in testing a theory based onthe impact of credit expansion on the productive stru...

  • Page 531

    first proposition. Wainhouse’s second proposition is that mod-ifications in the supply of credit give rise to changes in theinterest rate, and that the two are inversely related. Abundantempirical evidence also exists to support this second proposi-tion. Wainhouse’s third proposition states t...

  • Page 532

    Another empirical study pertinent to the Austrian theoryof the cycle is one conducted by Vladimir Ramey, of the Uni-versity of California at San Diego.115 Ramey has developed anintertemporal model which breaks down into different stagesthe inventories which correspond to: consumer goods, whole-sa...

  • Page 533

    Hopefully the future will bring more frequent and abun-dant historical-empirical research on the Austrian theory ofthe business cycle. With luck this research will rest on datafrom input-output tables and permit the use of the Austriantheory to reform the methodology of the national accounts,thus...

  • Page 534

    their own analysis (be it Keynesian, monetarist, or of anyother tendency) relies on the implicit assumption that themonetary factors related to credit play a leading role. Thesefactors are fundamental to understanding the expansion andinitial boom, that excessive, continuous increase which invari...

  • Page 535

    cleared away all notions of an alleged neutrality of money.It has proved irrefutably that there are in the market econ-omy factors operating about which a doctrine ignorant ofthe driving force of money has nothing to say. . . . It has beenmentioned already that every nonmonetary explanation ofthe...

  • Page 536

    Money, Bank Credit, and Economic Cycles506CrisisBoomExpansionS1 Consumption does not decline.S1 Banks grant new loans on amassive scale and the interestrate drops.S2 Capital goods rise in price.S2 Prices climb on the stockmarket.S2 The productive structure isartificially lengthened.S2 Large accou...

  • Page 537

    Additional Considerations on theTheory of the Business Cycle507S4 Real wages fall. The RicardoEffect : capital equipment isreplaced by workers.S5 The capital-goods sector sus-tains heavy accounting losses.(Demand decreases theRicardo Effect and costsrise. The interest rate andwages increase.)S5 W...

  • Page 538

    Money, Bank Credit, and Economic Cycles508NOTES ONTABLE VI-11.All references to “increases” and “decreases” in pricesrefer to relative prices, not nominal prices or absolutemagnitudes. Thus, for example, an “increase in theprices” of consumer goods indicates that such pricesrise, in r...

  • Page 539

    7ACRITIQUE OFMONETARIST ANDKEYNESIAN THEORIESIn this chapter we will criticize alternative theoreticaldevelopments aimed at explaining economic cycles. Morespecifically, we will consider the theories of the two mostdeeply-rooted schools of macroeconomics: the MonetaristSchool and the Keynesian Sc...

  • Page 540

    revolution Carl Menger started in 1871 has been fullyabsorbed by modern economic theory, to a large extent thisclaim is mere rhetoric. The old “objectivism” of the ClassicalSchool which dominated economics until the eruption of themarginalist revolution continues to wield a powerful influ-enc...

  • Page 541

    contribution to economics was his theory of economic goodsof different order (consumer goods, or “first-order” economicgoods, and “higher-order” economic goods). According to thistheory, higher-order economic goods are embodied in a num-ber of successive stages, each of which is further f...

  • Page 542

    in the grip of a crisis, shares many of the theoretical errors ofmonetarist macroeconomics.32ACRITIQUE OFMONETARISMTHE MYTHICAL CONCEPT OFCAPITALIn general the Neoclassical School has followed a tradi-tion which predated the subjectivist revolution and whichdeals with a productive system in which...

  • Page 543

    of production give rise, in a homogenous and horizontal man-ner, to consumer goods and services, without at all allowingfor the immersion of these factors in time and space through-out a temporal structure of productive stages. This was moreor less the basic framework for the research of classica...

  • Page 544

    the work of John Bates Clark (1847–1938). Clark was Professor ofEconomics at Columbia University in New York, and hisstrong anti-subjectivist reaction in the area of capital and inter-est theory continues even today to serve as the foundation forthe entire neoclassical-monetarist edifice.5 Inde...

  • Page 545

    processes is painfully absent.6 It is surprising that a theorysuch as the one Clark defends has nevertheless become themost widely accepted in economics up to the present day andappears in most introductory textbooks. Indeed nearly all ofthese books begin with an explanation of the “circular fl...

  • Page 546

    groundless supposition which not only avoids solving impor-tant, real economic issues, but also constitutes an almostinsurmountable obstacle to the discovery and analysis of themby economics students. This idea has also led Clark and hisfollowers to believe interest is determined by the “margin...

  • Page 547

    After John Bates Clark, another American economist,Irving Fisher, the most visible exponent of the mechanisticversion of the quantity theory of money, also defended thethesis that capital is a “fund,” in the same way income is a“flow.” He did so in his book, The Nature of Capital and Inco...

  • Page 548

    AUSTRIAN CRITICISM OFCLARK ANDKNIGHTAustrian economists reacted energetically to Clark andKnight’s erroneous, objectivist conception of the productionprocess. Böhm-Bawerk, for instance, describes Clark’s conceptof capital as mystical and mythological, pointing out that pro-duction processes ...

  • Page 549

    Years after Böhm-Bawerk, fellow Austrian Fritz Machlupvoiced his strong criticism of the Clark-Knight theory of capi-tal, concluding that [t]here was and is always the choice between maintaining,increasing, or consuming capital. And past and “present”experience tells us that the decision in ...

  • Page 550

    of capital is far from being impossible or improbable. Capi-tal is not necessarily perpetual.12Realizing the debate between the two sides is not pointless,as it involves the clash of two radically incompatible concep-tions of economics (namely subjectivism versus objectivismbased on general equil...

  • Page 551

    the two is composed precisely of the temporal plans of cre-ative entrepreneurs who, by definition, are excluded from theWalrasian model of the economic system, the model Clark andKnight incorporate into their theory of capital.14Ludwig von Mises later joined the debate, showing hisdisapproval of ...

  • Page 552

    production process. Individuals’ different plans regarding thespecific capital goods they may decide to create and employ intheir production processes are not even considered. In shortClark and Knight assume that the course of events flows “byitself” and that the future is an objective give...

  • Page 553

    Supposing the “velocity of circulation” of money remainsrelatively constant over time, and the gross national productapproximates that of “full employment,” monetarists believemoney is neutral in the long run, and that therefore an expan-sion of the money supply (M) tends to proportionall...

  • Page 554

    The English economist R.G. Hawtrey, a main exponent ofthe Monetarist School in the early twentieth century, is onewhose position illustrates the theoretical difficulties of mone-tarism. In his review of Hayek’s book, Prices and Production,which appeared in 1931, Hawtrey expressed his inability ...

  • Page 555

    More recently other monetarists have also revealed theirlack of an adequate capital theory and have thus expressed thesame bewilderment as Hawtrey with respect to studies on theeffects of monetary expansion on the productive structure. Mil-ton Friedman and Anna J. Schwartz, in reference to the po...

  • Page 556

    empirical features which largely coincide with those observedin all cycles from the time they began.Friedrich A. Hayek stated that his chief objection against [monetarist] theory is that, as what iscalled a “macrotheory,” it pays attention only to the effectsof changes in the quantity of mone...

  • Page 557

    price level, fluctuations in credit constitute a “revolution”which affects all relative prices and eventually provokes a cri-sis of malinvestment and an economic recession. The inabilityto perceive this fact led the American economist Benjamin M.Anderson to assert that the fundamental flaw in...

  • Page 558

    Furthermore not only are monetarists incapable ofexplaining economic recessions except by resorting to theeffects of the monetary contraction;27 they have also beenunable to present any valid theoretical argument against theAustrian theory of economic cycles: they have simply ignoredit or, as Fri...

  • Page 559

    in Laidler’s argument was clearly exposed by Hayek in 1941,when he explained that the only possible way for productionprocesses financed by credit expansion to be maintained with-out a recession would be for economic agents to voluntarilysave all new monetary income created by banks and used to...

  • Page 560

    It is interesting to note that one of today’s most prominentmonetarists, David Laidler, is forced to resort to Keynesianarguments in a fruitless attempt to criticize the Austrian theoryof economic cycles. Nevertheless the author himself correctlyrecognizes that from the standpoint of the Austri...

  • Page 561

    “equation of exchange” is simply an ideogram which ratherawkwardly represents the relationship between growth in themoney supply and a decline in the purchasing power ofmoney. The origin of this “formula” is a simple tautology whichexpresses that the total amount of money spent on transac...

  • Page 562

    quantities of goods and services exchanged over a period oftime. The lack of homogeneity makes this an impossible sum.32Mises also points out the absurdity of the concept of “velocityof money,” which is defined simply as the variable which,dependent on the others, is necessary to maintain the...

  • Page 563

    (i.e., the price of the monetary unit in terms of every good andservice). Nevertheless its use as a supposed aid to explainingeconomic processes has proven highly detrimental to theprogress of economic thought, since it prevents analysis ofunderlying microeconomic factors, forces a mechanistic in...

  • Page 564

    What policy do monetarists advocate to prevent andcounter crises and economic recessions? They generally con-fine themselves to recommending policies that merely treatthe symptoms, not the ultimate causes, of crises. In otherwords they suggest increasing the quantity of money in circu-lation, and...

  • Page 565

    the purchasing power of money, this action would trigger andintensify all of the processes which inexorably lead to invest-ment errors and crisis, and which monetarists are incapable ofunderstanding, due to the obvious deficiencies in the macro-economic analytical tools they use.38ABRIEF NOTE ON ...

  • Page 566

    to recognize it as an acceptable explanation.40 Furthermore forexactly the same reasons the economic theory of socialism hasproven it is impossible for a hypothetical benevolent dictator-scientist to obtain all practical information concerning his sub-jects, it is equally impossible for each econ...

  • Page 567

    profit motive will inevitably lead them to take advantage ofthe newly-created money. In fact even if they understand thedangers of lengthening the productive structure without thebacking of real savings, they can easily derive large profitsby accepting the newly-created loans and investing thefun...

  • Page 568

    from knowledge of specific conditions with respect to time andplace, and entrepreneurs may well discover significant oppor-tunities for profit in each historical process of credit expan-sion, despite their theoretical knowledge of the processeswhich inexorably lead to a depression, a stage they m...

  • Page 569

    In addition rational expectations theorists still do not com-prehend the Austrian theory of the cycle, and, like mone-tarists, they lack an adequate capital theory. In particular theyfail to see how credit expansion affects the productive struc-ture and why a recession inevitably results, even wh...

  • Page 570

    and the appearance of expectations regarding its conse-quences. In any case the formation of realistic expectationsmerely speeds up the processes that trigger the crisis andmakes it necessary for new loans to be granted at a progres-sively increasing speed, if the policy of loan creation is to co...

  • Page 571

    precisely predict the course of events.46 Defenders of thishypothesis fail to realize that, as Mises correctly explained, theconcept of neutral money is a contradiction in terms: The notion of a neutral money is no less contradictory thanthat of a money of a stable purchasing power. Money with-ou...

  • Page 572

    why such shocks recur regularly and consistently exhibit thesame typical features.493CRITICISM OFKEYNESIAN ECONOMICSAfter our examination of monetarism, it seems appropri-ate to embark on a critical analysis of Keynesian theory. Wehave chosen this approach for two reasons. First, the “Keyne-sia...

  • Page 573

    certain significant peculiarities of Keynesian thought warrantdiscussion.Before we begin, however, let us remember that Keynespossessed only a very limited knowledge of economics in gen-eral, and of the market processes of entrepreneurial coordina-tion in particular. According to F.A. Hayek, Keyn...

  • Page 574

    Keynes was not a highly trained or a very sophisticatedeconomic theorist. He started from a rather elementaryMarshallian economics and what had been achieved byWalras and Pareto, the Austrians and the Swedes was verymuch a closed book to him. I have reason to doubt whetherhe ever fully mastered t...

  • Page 575

    upon which the classical analysis rests. Nonetheless Keynesoverlooked the fact that the analysis carried out by AustrianSchool theorists (Mises and Hayek) had already revealed thatprocesses of credit and monetary expansion ultimately distortthe productive structure and create a situation in which...

  • Page 576

    capital goods. Therefore it is not surprising that the absence ofan elaborate capital theory in Marshallian economics andKeynes’s ignorance of Austrian contributions led Keynes tocriticize all classical economists for assuming that “supplymust always automatically create its own demand.” In...

  • Page 577

    and investment. Indeed by the time Keynes published TheGeneral Theory, he had already debated enough with Hayek toidentify Hayek’s main argument: that credit expansion givesrise to a temporal, unsustainable separation between entrepre-neurial investment and society’s real, voluntary saving. I...

  • Page 578

    Second, Keynes, realizing the great weakness of his“accounting argument,” puts forward an even more prepos-terous one. He maintains that new loan funds the bank createsand grants its customers are not used to finance new investmentabove the level of voluntary saving, since the newly-createdmo...

  • Page 579

    any increase in the money supply via credit expansionwould be tantamount to an “increase in saving,” which issheer nonsense.61 Even if we concede for the sake of argumentthat all investment financed by new credit has been immedi-ately and simultaneously “saved,” a problem still faces us.O...

  • Page 580

    of voluntary saving (more voluntary saving without invest-ment), but also on that of investment (more investment with-out prior saving). In the first case there is an increase in thedemand for money. As we saw in the last chapter, such anincrease provokes several overlapping effects: both thosech...

  • Page 581

    which would lead to a rise in income and therefore eventu-ally also boost saving. Thus Keynes believes entrepreneurscannot possibly invest loaned funds at a rate faster than that atwhich the public decides to increase savings. In Keynes’s ownwords: The notion that the creation of credit by the ...

  • Page 582

    investment is to be upheld by a subsequent rise in voluntarysaving, economic agents will ultimately have to save absolutely allmonetary income derived from the new investment. In other wordswhen the portion of gross income shaded in Chart V-6 reachesthe pockets of consumers, they will have to sav...

  • Page 583

    KEYNESIAN ANALYSIS AS APARTICULAR THEORYAs Austrian economists in general and Mises in particulardemonstrated as early as 1928, in the specific event that idleresources and unemployment are widespread, entrepreneurs,relying on new loans, may continue to lengthen the produc-tive structure without ...

  • Page 584

    when the price of consumer goods and services begins to risefaster than wages.68Money, Bank Credit, and Economic Cycles55468It is interesting to remember how Keynes defines “involuntary”unemployment:Men are involuntarily unemployed if, in the event of a smallrise in the price of wage-goods re...

  • Page 585

    THE SO-CALLED MARGINAL EFFICIENCY OFCAPITALWe find another indication that Keynes’s is a specific the-ory, rather than a general one, in his definition of the “mar-ginal efficiency of capital,” which he expresses as that rate of discount which would make the present value ofthe series of an...

  • Page 586

    Marshall, at least regarding the supply side of price determi-nation.70Hayek has conclusively demonstrated that the entire Key-nesian doctrine of the “marginal efficiency of capital” as thedetermining factor in investment is acceptable only if weassume that there is absolutely no shortage of ...

  • Page 587

    productive structure, a theory we covered in chapter 5. In factwe know that the interest rate is the price of present goods interms of future goods, and that it tends to manifest itselfthroughout the productive structure in the accounting profitdifferential which arises between the different stag...

  • Page 588

    CRITICISM OF THEKEYNESIAN MULTIPLIERKeynes commits such errors because he lacks a capital the-ory to help him grasp how saving converts into investmentthrough a series of microeconomic processes he overlooksentirely. Therefore it is not surprising that Keynes is simplyincapable of understanding t...

  • Page 589

    no sense at all of these schools of thought.”73 Keynes’s lack ofan adequate theory of capital also explains his development ofa mechanistic conception of the investment multiplier, whichhe defines as the reciprocal of one minus the marginal propen-sity to consume. Thus according to Keynes, th...

  • Page 590

    the relationships between the propensity to consume andthe multiplier, which is destined to give shape and strengthto those observations, turns out to be not an empirical state-ment which tells us something interesting about the realworld, but a barren algebraic relation which no appeal tofacts c...

  • Page 591

    goods or in capital goods, but whether to invest in productionprocesses which will yield consumer goods in the near future or inthose which will yield them in a more distant future. Thus Keynes’snotion of a productive structure comprised of only two stages(one of consumer goods and another of c...

  • Page 592

    further complicates the process by which the productive struc-ture readjusts, and it worsens the outlook for the stages fur-thest from consumption. As a result of Keynesian “remedies,”entrepreneurs will surely encounter even greater difficulty inconsistently financing these stages using volun...

  • Page 593

    Hence we must concur with Hayek’s statement that thedoctrines of John Maynard Keynes take us back to the pre-scientific stage of economics, when the wholeworking of the price mechanism was not yet understood, andonly the problems of the impact of a varying money streamon a supply of goods and s...

  • Page 594

    In fact Keynesian remedies which consist of increasingeffective demand and credit expansion do not begin to relieveunemployment. Instead they inevitably worsen it, as theyresult in a poor allocation of jobs and factors of productionthroughout a series of productive stages which consumers donot wi...

  • Page 595

    CRITICISM OF THE“ACCELERATOR” PRINCIPLEOur theory on the impact of credit expansion on the struc-ture of production rests on a capital theory we examined indetail in chapter 5. According to this theory, a healthy, perma-nent “lengthening” of the productive structure is contingenton a prio...

  • Page 596

    yearly sales of cloth. Thus, when its sales have remained at$30 million per year for some time, its balance sheet will show$60 million of capital equipment, consisting of perhaps 20machines of different ages, with 1 wearing out each year andbeing replaced. Because replacement just balances deprec...

  • Page 597

    thrift”). Therefore it is particularly important that we thor-oughly expose the errors and fallacies which form the basis ofthe principle.81The theory based on the accelerator not only omits themost elementary principles of capital theory; it was alsodeveloped based on a mechanistic, automatic ...

  • Page 598

    goods and services. The accelerator principle fails to take intoaccount that the same result in terms of consumer goods and serv-ices can be achieved using many different combinations of fixed cap-ital, variable capital and especially, labor. The specific combina-tion an entrepreneur may choose i...

  • Page 599

    in the demand for consumer goods can only be financed ifsubstantial credit expansion is initiated and sustained. Inother words, the accelerator principle ultimately presupposesthat the increase in credit expansion necessary to stimulate anenormously exaggerated investment in capital goods takespl...

  • Page 600

    heterogeneous magnitudes is absurd and makes entrepre-neurial economic calculation utterly impossible. Obviously, ifthe price of capital goods begins to increase, entrepreneurialdecisions will not mechanically manifest themselves in “fixedproportions” of inputs. Instead entrepreneurs will car...

  • Page 601

    effects of the price system, the possibility of substituting cer-tain inputs for others, the most essential aspects of capital the-ory and of the analysis of the productive structure, and finally,the microeconomic principles which govern the relationshipbetween saving and the lengthening of the p...

  • Page 602

    The Marxist theorist Mijail Ivanovich Tugan-Baranovskylater expanded on and reworked Engels’s comments with theaim of developing a theory of economic cycles based on thephenomenon of “overproduction” in the stages of investment.As we have already indicated, this theory is very closelyrelate...

  • Page 603

    the heterogeneous, complementary nature of different capitalgoods (in the purest Austrian tradition), versus the neoclassi-cal conception of capital as a homogeneous fund. FurthermoreAustrians, and Hayek in particular, showed from the begin-ning that the lengthening of the productive structure co...

  • Page 604

    project, this occurrence is merely a concrete sign, in the con-text of a particular production process, that this process hasbecome longer as a result of the rise in saving and the fall inthe interest rate.90Therefore we must not be deceived by the “comparativestatic equilibrium analysis” car...

  • Page 605

    plans (due to a rise in saving), all initial factors (land, labor,and existing capital goods) are subjectively deemed to be “orig-inal means of production” which merely determine the start-ing point of the production process. It is therefore irrelevantwhether or not the new investment process...

  • Page 606

    5CONCLUSIONFrom the standpoint of our analysis, it is clear that thereare far greater similarities than possible differences betweenmonetarists and Keynesians. Indeed Milton Friedman himselfhas acknowledged: “We all use the Keynesian language andapparatus. None of us any longer accept the initi...

  • Page 607

    A Critique of Monetarist and Keynesian Theories577His economics is pure macroeconomics, with the nationalgovernment as the one unit, the one dynamic force, control-ling the economy through the money supply. Friedman’seconomics are completely demand-focused. Money andcredit are the pervasive, an...

  • Page 608

    Chicago School were already prescribing the typical Keyne-sian remedies for depression and fighting for large budgetdeficits.96Table VII-1 recapitulates the differences between the Aus-trian perspective and the major macroeconomic schools. Thetable contains twelve comparisons that reveal the radi...

  • Page 609

    A Critique of Monetarist and Keynesian Theories579Table VII-1 groups monetarists and Keynesians togetherbecause their similarities far outweigh their differences. Nev-ertheless we must acknowledge that certain important differ-ences do separate these schools. Indeed, though both lack acapital the...

  • Page 610

    see a direct, immediate and effective connection betweenmoney and real events. In contrast Keynesians base theiranalysis on the short term and are very skeptical about a pos-sible connection between money and real events, a link capa-ble of somehow guaranteeing equilibrium will be reached andsust...

  • Page 611

    A Critique of Monetarist and Keynesian Theories581(Roger W. Garrison, “Time and Money: The Universals ofMacroeconomic Theorizing,” Journal of Macroeconomics 6, no.2 [Spring, 1984]: 203)According to Garrison, the Austrians adopt a healthy middle ground inthe area of expectations as well: Assum...

  • Page 612

    Money, Bank Credit, and Economic Cycles582Macroeconomists(Monetarists and Keynesians)1. The influence of time is ignored2. Capital is viewed as a homogeneousfund which reproduces on its own3. There is a notion of a one-dimensional,horizontal productive structure in equi-librium (circular flow of ...

  • Page 613

    any case, as we have already argued, the indirect,underlying cause of economic maladjustments lies incredit expansion, which provokes a generalized mal-investment of resources, which in turn creates unem-ployment. The more rigid the markets, the higher theunemployment.3. When economic agents ente...

  • Page 614

    Money, Bank Credit, and Economic Cycles5846APPENDIX ONLIFE INSURANCE COMPANIESANDOTHER NON-BANK FINANCIAL INTERMEDIARIESThe analysis of the last four chapters has put us in a posi-tion to understand the important role true financial interme-diaries play in the economy. Logically, we use the term ...

  • Page 615

    A Critique of Monetarist and Keynesian Theories585on a major role in modern economies because they act asfinancial intermediaries, but because they typically createloans, and thus deposits, ex nihilo, thereby increasing themoney supply. Hence it is not surprising that banks are capa-ble of distor...

  • Page 616

    Money, Bank Credit, and Economic Cycles586are those entrepreneurs who specialize in convincing eco-nomic agents of the importance and necessity of short-,medium- and long-term saving, as well as in efficiently con-necting lenders and borrowers, spreading risk and takingadvantage of the correspond...

  • Page 617

    A Critique of Monetarist and Keynesian Theories587The fact that life insurance companies do not expand creditnor create money is obvious, especially if one compares thecontracts they market with banks’ demand deposit opera-tions. The accounting entries typical of a life insurance com-pany are a...

  • Page 618

    Money, Bank Credit, and Economic Cycles588(77) Debit CreditOperational costs Cash(Claims, administrative expenses, etc.)We should point out that operational costs absorb only aportion of the total amount paid in premiums to life insu...

  • Page 619

    A Critique of Monetarist and Keynesian Theories589(80) Life Insurance Company EBalance Sheet(End of the year)Assets LiabilitiesLong-term investmentsMathematical reservesObviously no money is created, and mathematicalreserves, which represent the book value of future obligat...

  • Page 620

    Money, Bank Credit, and Economic Cycles590It is clear that insurers’ accounting profit arises from thedifference between revenues (premiums and financialincome) and expenses (operational costs and those resultingfrom increases in mathematical reserves). Insurance compa-nies usually make a very ...

  • Page 621

    A Critique of Monetarist and Keynesian Theories591expectations. Thus life insurance companies tend to underes-timate their assets, overestimate their liabilities, and reach ahigh level of static and dynamic solvency which makes themimmune to the deepest stages of the recessions that recur witheco...

  • Page 622

    Money, Bank Credit, and Economic Cycles592106[T]he cash surrender values of life insurance policies are notfunds that depositors and policy holders can obtain andspend without reducing the cash of others. These funds are inlarge part invested and thus not held in a monetary form.That part which i...

  • Page 623

    A Critique of Monetarist and Keynesian Theories593clearly handed over and the full availability of them lost, inexchange for the guarantee of a substantial income or capitalunder certain future circumstances (those in which a family’sneed may be greatest, such as the death of a provider or sur-...

  • Page 624

    Money, Bank Credit, and Economic Cycles594THE CORRUPTION OFTRADITIONAL LIFE-INSURANCE PRINCIPLESDespite the above considerations, we must acknowledgethat in recent times, under the pretext of a supposedly beneficial“deregulation of financial markets,” the distinct boundariesbetween the instit...

  • Page 625

    A Critique of Monetarist and Keynesian Theories595which we touched on in chapter 3, has exerted a very negativeinfluence on the insurance sector as a whole and has made itpossible for some life insurance companies to market depositsin violation of traditional legal principles and thus to act, ind...

  • Page 626

    Money, Bank Credit, and Economic Cycles596and causes economic cycles and recessions. Furthermore thesecompanies have done serious harm to the insurance industryitself, which has been the object of increasing state and cen-tral-bank intervention and has lost many of the fiscal advan-tages it had a...

  • Page 627

    A Critique of Monetarist and Keynesian Theories597fostering long-term saving and investment and hence, the sus-tainable economic development of society.OTHER TRUE FINANCIAL INTERMEDIARIES: MUTUAL FUNDSANDHOLDING ANDINVESTMENT COMPANIESOther true financial intermediaries which would becomeeven mor...

  • Page 628

    Money, Bank Credit, and Economic Cycles598have spread, the contracts and institutions in question havebegun to produce the same harmful effects as fractional-reserve banking. Therefore as we will see in the followingchapters, any proposal to reform the banking system mustinclude a plan to quickly...

  • Page 629

    A Critique of Monetarist and Keynesian Theories599workers and owners of the original means of production, aswell as to their customers, whom they grant a period of sev-eral days or months to pay their debts. Logically, this creditcustomers receive always requires a prior sacrifice on the partof c...

  • Page 630

    Money, Bank Credit, and Economic Cycles600meanwhile, to make the necessary collections and maintain thenecessary financial stability.111Successive cycles of boom and depression invariably posea formidable challenge to credit insurance companies, whichapart from their traditional services (collect...

  • Page 631

    8CENTRAL ANDFREEBANKING THEORYThis chapter contains a theoretical analysis of the argu-ments raised for and against both central and freebanking throughout the history of economic thought.To begin we will review the theoretical debate between thosein favor of a privileged banking system, i.e., on...

  • Page 632

    also provide us with a chance to study the controversybetween supporters of the central bank and defenders of afree banking system. We will see that at first members of theCurrency School by and large defended the central bank, andBanking School theorists favored a free banking system, yetin the ...

  • Page 633

    THE BANKING ANDCURRENCY VIEWS AND THESCHOOL OFSALAMANCAThe theorists of the School of Salamanca made importantcontributions in the monetary field which have been studiedin detail.2The first Spanish scholastic to produce a treatise on moneywas Diego de Covarrubias y Leyva, who published Veterumcol...

  • Page 634

    In the lands where there is a serious shortage of money, allother saleable items and even the labor of men are given forless money than where money is abundant; for example,experience shows that in France, where there is less moneythan in Spain, bread, wine, cloth and labor cost much less;and eve...

  • Page 635

    a catalog of the requirements for a fair and lawful monetarybank deposit. These early authors could be viewed as mem-bers of an incipient “Currency School,” which had long beendeveloping at the very heart of the School of Salamanca. Thesescholars typically adopt a consistent, firm stance on t...

  • Page 636

    to discover that demand deposits in banks form part of themoney supply in their entirety, and thus affect the economy inthe same way as bank bills. Luis de Molina had already clearlyillustrated this fact over two centuries earlier in Disputation409 of his work, Tratado sobre los cambios [“Treat...

  • Page 637

    Most of the transactions made in advance [are concluded]using signed documents, since there is not enough money topermit the huge number of goods for sale at the market to be paidfor in cash, if they must be paid for in cash, or to make so manybusiness deals possible.8Finally, Molina distinguishe...

  • Page 638

    that their standard of prudence is not an objective criterion ade-quate to direct the actions of bankers. It certainly does notcoincide with bankers’ ability to return all deposits in theirkeeping at any time, and Molina and Lugo themselves arecareful to point out that bankers commit “mortal ...

  • Page 639

    Lugo’s principles of prudence were an objective no bank ful-filled in practice. It seems as if Tomás de Mercado was awarethat such principles do not constitute a practical guide toguaranteeing the solvency of banks. Moreover if these princi-ples are ineffectual in consistently achieving the go...

  • Page 640

    a thorough description of the practices of money changersand bankers. Here we do find explicit approval of creditcreation, though not with the formal appearance of createdcredit. Banks do business with the deposits of their clients,who at the same time do not give up the use of their ownmoney. Ba...

  • Page 641

    Father Dempsey’s theoretical knowledge of money, capitaland cycles serves as the foundation of his study and repre-sents a much sounder basis than the one Father Belda buildsupon.17Strangely, Dempsey does not develop his thesis with ananalysis of the views of those members most against banking(...

  • Page 642

    Dempsey, this ex nihilo generation of buying power, whichimplies no previous loss of purchasing power to other people,violates the essential legal principles Molina and Lugo them-selves lay down and in this sense is reprehensible. Specifically,Dempsey asserts: We may conclude from this that a Sch...

  • Page 643

    THE RESPONSE OF THEENGLISH-SPEAKING WORLDTO THESEIDEAS ONBANK MONEYAlthough a comprehensive analysis of the evolution ofmonetary thought from the scholastics to the English ClassicalSchool would exceed the scope of this book,20 it is fitting thatwe should comment briefly on the evolution of ideas...

  • Page 644

    others, it was not until John Law, Richard Cantillon, andDavid Hume had made their contributions that we findexpress reference to the problems posed by fractional-reservebanking with respect to both monetary issues and the real eco-nomic framework.We have already referred to John Law (1671–1729...

  • Page 645

    later discredited by Hume and Austrian School monetary the-orists, has in one form or another survived up to the present,not only through the work of nineteenth-century Banking-School theorists, but also through many modern-day mone-tarists and Keynesians. In short, Law attributes Scotland’spoo...

  • Page 646

    level. Cantillon, a banker first and foremost, justified frac-tional-reserve banking and his self-interested use of anymoney or securities his customers entrusted to him as anirregular deposit of fungible goods indistinguishable fromone another. In fact chapter 6 (“Des Banques, et de leurcredit...

  • Page 647

    After Cantillon, and aside from some interesting monetaryanalysis by Turgot, Montesquieu, and Galiani,29 no importantreferences to banking appear until Hume makes his essentialcontributions.David Hume’s (1711–1776) treatment of monetary mattersis contained in three brief but comprehensive and...

  • Page 648

    unqualified acknowledgment that the volume of money isinconsequential does not prevent him from correctly recogniz-ing that rises and falls in the amount of money in circulation dohave a profound effect on real economic activity, since thesechanges always influence primarily the structure of rela...

  • Page 649

    under disadvantages, by encreasing money beyond its natu-ral proportion to labour and commodities, and therebyheightening their price to the merchant and manufacturer.And in this view, it must be allowed, that no bank could bemore advantageous, than such a one as locked up all themoney it receive...

  • Page 650

    by the encrease of prices: But not being now collected intoany large masses or stocks, the disproportion between theborrowers and lenders is the same as formerly, and conse-quently the high interest returns.36Hume’s two brief essays constitute as concise and correctan economic analysis as can b...

  • Page 651

    deposits “prudently,” for if they abandon caution, they losethe confidence of their customers and fail. As was the casewith those Salamancan scholastics (Molina and Lugo) whoseviews were closest to those of the Banking School, nowheredoes Smith define his criterion of “prudence,” nor does...

  • Page 652

    only Wicksell’s theory on the natural rate of interest, but alsomuch of the Austrian theory of the economic cycle.41After Thornton’s, the most notable work was produced byDavid Ricardo, whose distrust of banks parallels Hume’s.Ricardo may be regarded as the official father of the EnglishCur...

  • Page 653

    became more widespread and systematic in England duringthe first half of the nineteenth century, owing to the efforts ofthe so-called Banking School.44 During that period a sizeablegroup of theorists (Parnell, Wilson, MacLeod, Tooke, Fullar-ton, etc.) formed, bringing together and systematizing t...

  • Page 654

    issuance of paper bills unbacked by commodity-money, per-mits increases in the money supply to meet the “needs oftrade” without producing inflationary effects or distortions inthe productive structure.John Fullarton (c. 1780–1849) was undoubtedly the mostprominent of Banking School represen...

  • Page 655

    theory might make the inflationist fallacies of this schoolappear somewhat credible. The main error in Fullarton’s lawof reflux lies in its failure to account for the nature of fiduciaryloans. We know that when a bank discounts a bill or grants aloan, it exchanges a present good for a future go...

  • Page 656

    doctrine (i.e., that bank deposits are part of the monetary sup-ply) had already been espoused by the Salamancan groupmost favorable to banking (Luis de Molina, Juan de Lugo,etc.), in nineteenth-century England it had been practicallyforgotten when Banking School theorists rediscovered it. Per-ha...

  • Page 657

    The credits in current accounts or deposits of our banks arealso in their origin and effect perfectly assimilated to bank-notes, and we cannot therefore but consider the aggregateamount of credits payable on demand standing on thebooks of the several banks as being part of the currency ofthe Unit...

  • Page 658

    Currency School theorists provided a valid explanation of therecurring phases of boom and recession which plagued theBritish economy in the 1830s and 1840s: the booms had theirroots in credit expansion which the Bank of England initiatedand the other British banks continued. Gold systematicallyfl...

  • Page 659

    neutral, an idea today’s monetarists have supported. There-fore it was not until 1912, when Ludwig von Mises reformu-lated Currency School teachings, that monetary theory wasfinally fully integrated with capital theory, within a generaltheory of the economic cycle. The third fatal error of the ...

  • Page 660

    encourage policies of monetary recklessness and financialexcesses much worse than those it was originally designed toprevent.54Consequently, even though in terms of theory the BankingSchool was utterly defeated, in practice it ultimately triumphed.Indeed Peel’s Bank Charter Act failed because i...

  • Page 661

    2THE DEBATE BETWEEN DEFENDERS OF THECENTRAL BANK ANDADVOCATES OFFREE BANKINGAn analysis of the nineteenth-century debate betweendefenders of the central bank and advocates of free bankingmust begin with an acknowledgment of the indisputable,close connection which initially existed between the Ban...

  • Page 662

    regulation in the form of a central bank intended to avoid theabuses the Banking School attempted to justify.PARNELL’S PRO-FREE-BANKING ARGUMENT AND THERESPONSES OFMCCULLOCH ANDLONGFIELDWe will not embark here on a comprehensive account ofthe controversy between the Free-Banking and Central-Ban...

  • Page 663

    analysis has considerable merit and lies at the heart of thearguments invoked to date in favor of free banking. His analy-sis was used and developed even by certain authors of theCurrency School (like Ludwig von Mises) who were nonethe-less highly skeptical of the central-bank system.57AFALSE STA...

  • Page 664

    takes time, and there is always a (perhaps irresistible) tempta-tion to overissue on the assumption that all other banks willsooner or later do the same. In this way the first bank tolaunch an expansionary policy derives the most profit andeventually establishes a position of advantage over its c...

  • Page 665

    THE CASE FOR ACENTRAL BANKThus began a prolonged controversy between free-bank-ing champions and central-bank promoters. The latter offeredthe following arguments to support their case against theposition of the Banking and Free-Banking School:First, a free-banking system, by its very nature, eve...

  • Page 666

    start in the free-banking/central-banking debate, in the sensethat the argument would be meaningless if traditional legalprinciples were respected and a 100-percent reserve require-ment were reestablished for banking. Under these conditions,no harm would be done to holders of banknotes and deposi...

  • Page 667

    jeopardize those banks which expand their credit base fasterthan the rest. Even if most banks expand their deposits andbills simultaneously, the spontaneous processes identified bythe theory of economic cycles soon gather momentum andtend to reverse the initial expansionary effects and bankruptma...

  • Page 668

    their approach to the debate between central-banking andfree-banking supporters. Although interbank clearing mecha-nisms and continuous public supervision would tend to limitcredit expansion in a fractional-reserve free-banking system,they would be unable to prevent it completely, and bank crises...

  • Page 669

    supposed “need” for a “rational” monetary policy imposedfrom above through the central bank. The second argument isrelated to the first and centers around the need to establish anadequate policy of monetary cooperation among differentcountries. Supposedly this goal also requires the exist...

  • Page 670

    banknotes and deposits.61 By this indirect route, they plannedan effective move toward the objective of a 100-percentreserve requirement (for both bills and deposits), an aim to bepursued by all legal means available in each historical context.This idea was first defended in France by Victor Mod-...

  • Page 671

    Cernuschi’s doctrine had only two flaws: it referredmerely to banknotes and ignored bank deposits. And further-more, it was not so radical as Modeste’s who considered frac-tional-reserve free banking a fraudulent business that shouldnot be allowed at all.While the French Currency School was e...

  • Page 672

    the only way to eradicate them.65 Tellkampf, who had visitedthe U.S. as a young man, witnessed the abuses and highlydamaging effects of fractional-reserve banking there and wasimbued with the rigorous monetary doctrine being developedin America at the time. When he returned to Germany andwas appo...

  • Page 673

    views of Tellkampf and the American school. Hübnerobserved that the less regulated banks were, the less frequenttheir solvency problems tended to be. He felt the choice wasbetween a system of privileged banks protected by a centralbank and apt to encourage irresponsible practices, and a free-ban...

  • Page 674

    free-banking system as a means to curb abuses and movetoward the ideal of a 100-percent reserve requirement.69The tradition of Modeste, Cernuschi, Hübner, andMichaelis was continued by Ludwig von Mises, who in 1912conclusively upheld the tenets of the Currency School. He notonly asserted that bo...

  • Page 675

    intentions with which it was drafted, failed to ban the expan-sionary creation of fiduciary deposits as it did with banknotes.Mises also condemns the use of the law to constitute and rein-force a central-bank system which, as we know, was eventu-ally used to justify and promote policies of moneta...

  • Page 676

    later, in 1920, that he expounded his famous theorem of theimpossibility of socialist economic calculation, initiating theimportant debate that would surround this topic in the follow-ing decades. No explicit evidence suggests Mises was awarethat the fundamental arguments he raised in 1920 on the...

  • Page 677

    3THE “THEOREM OF THEIMPOSSIBILITY OFSOCIALISM”AND ITSAPPLICATION TO THECENTRAL BANKIn chapter 2 we saw that throughout history central bankshave emerged not as a result of the spontaneous, evolutionaryfree-market process, but as a consequence of deliberate gov-ernment intervention in the bank...

  • Page 678

    as lender of last resort, would guarantee their survival intimes of trouble. In this way the interests of private bankerscame to coincide with those of the state and its central bank,and a symbiosis formed between the two. The state obtainseasy financing in the form of loans and inflation, the co...

  • Page 679

    The above explains the historical appearance of the centralbank, which is founded on the complicity and community ofinterests which have traditionally united governments andbankers and which fully account for the intimate “under-standing” and “cooperation” between these two types of insti...

  • Page 680

    THE THEORY OF THEIMPOSSIBILITY OFCOORDINATINGSOCIETY BASED ONINSTITUTIONAL COERCION OR THEVIOLATION OFTRADITIONAL LEGAL PRINCIPLESElsewhere we have defended the thesis that socialismshould be redefined as any system of institutional aggressionon the free exercise of entrepreneurship.74 This aggre...

  • Page 681

    and inefficiency which stem from the interventionist welfarestate characteristic of western economies.Likewise, the granting of privileges which conflict withtraditional legal principles prevents coordinated cooperationamong the different agents in society. Indeed traditional legalprinciples are ...

  • Page 682

    Indeed the modern financial and banking system of mar-ket economies is entirely based on systematic coercion againstthe free exercise of entrepreneurship in the financial sectorand on the concession to private banks of privileges whichconflict with traditional legal principles and allow banks too...

  • Page 683

    and credit matters, our situation matches that which prevailedin the socialist countries of the former Eastern bloc, whichattempted to coordinate their economic decisions andprocesses through a system of central planning. In otherwords “central planning” has become commonplace in thebanking a...

  • Page 684

    (a) A system based on a central bank which controls and oversees anetwork of private banks that operate with a fractional reserveThe system made up of a central bank and private bank-ing with a fractional reserve is the most disruptive example of“central planning” in the financial sphere.80 I...

  • Page 685

    cannot prevent it. In a fractional-reserve free-banking system(with no central bank), the reversion tends to occur much ear-lier, due to spontaneous interbank clearing processes (thoughthe productive structure is still somewhat distorted). The cre-ation of a central bank to act as lender of last ...

  • Page 686

    The above accounts for the great difficulty central bankersface in eliminating economic crises, despite their effort anddedication. It also explains the tight control the central bankmaintains over private banking, through administrative legis-lation and direct coercion.83Moreoever, like Gosplan,...

  • Page 687

    and particularly difficult to obtain in the financial sector.Hence it is painfully obvious that the central bank cannot pos-sibly acquire all the information it would need to act in a coor-dinated manner, and its inability to do so is one more illustra-tion of the theorem of the impossibility of ...

  • Page 688

    statistical, and material resources, to realize this objective.Nevertheless the failure of such efforts could not be moreobvious.84It is impossible for the central bank, as a financial central-planning agency, to somehow carry out the exact functionprivate money would fulfill in a free market sub...

  • Page 689

    which have been studied by the Public Choice School.Indeed central-bank officials are human and are affected bythe same incentives and restrictions as all other public offi-cials. Therefore they may be somewhat swayed in their deci-sion-making by groups with a vested interest in influencingthe ce...

  • Page 690

    them has led to the consensus that central banks should be as“independent” as possible of the political decisions of themoment and that this independence should even be incorpo-rated into legislation.86 This constitutes a small step forwardin the reformation of the financial system. However, ...

  • Page 691

    propositions regarding the central bank are bound to fail. Theywill be unsuccessful because from the start they ignore theessential fact that the officials responsible for governmentagencies, whether state-owned companies or central banks,cannot in their daily lives escape from the bureaucratic e...

  • Page 692

    economic agents’ true desires with regard to saving, and thedistortion caused by credit expansion (i.e., unbacked by aprior increase in real, voluntary saving) would be checked.Nevertheless we cannot conclude that all discoordination gen-erated by the central bank would disappear, since the mer...

  • Page 693

    Furthermore, although we cannot refer to any trueinstance in which a central bank has overseen a system of pri-vate banks which have operated with a 100 percent reserve,such a system would also be subject to the political influencesand lobby pressures studied by the Public Choice School. Itwould ...

  • Page 694

    reserve, theorists who defend the conservation of the centralbank under these circumstances are naive in that they con-sider that the government and different social groups woulddesire and be able to develop a stable, and (as far as possible)“neutral,” monetary policy. Even if banks kept a 10...

  • Page 695

    of a central bank, and therefore abuses and distortions cannotbecome as severe as they often do when a lender of last resortexists and orchestrates the entire expansionary process.Thus it is conceivable that in a free-banking system, iso-lated attempts to expand bank credit would be curbed rela-t...

  • Page 696

    effects on the real economy by provoking bank crises and eco-nomic recessions.93Not only is fractional-reserve free-banking incapable ofavoiding credit expansion and the appearance of cycles, but itactually tempts bankers in general to expand their loans, andthe result is a policy in which all ba...

  • Page 697

    the cost of his irresponsible act is shared by all other economicagents. It is for this reason that bankers face the almost irre-sistible temptation to be the first to initiate a policy of expan-sion, particularly if they expect all other banks to follow suitto one degree or another, which often ...

  • Page 698

    This table reflects the existence of two banks, Bank A andBank B, both of which have two options: either to refrain fromexpanding credit or to adopt a policy of credit expansion. Ifboth banks simultaneously initiate credit expansion (assum-ing there are no other banks in the industry), the abilit...

  • Page 699

    Central and Free Banking Theory669The above analysis extends to a large group of bankswhich operate in a free-banking system and maintain a frac-tional reserve. The analysis shows that under such circum-stances, even if interbank clearing mechanisms limit isolatedexpansionary schemes, these spont...

  • Page 700

    designed to orchestrate and organize it. In this way, the “unco-operative” behavior of a significant number of relatively moreprudent bankers is prevented from endangering the solvencyof the rest (those who are more “cheerful” in granting loans).Therefore our analysis enables us to conclu...

  • Page 701

    Fractional-reserve banking distorts the productive structureand provokes widespread, intertemporal discoordination inthe economy, a situation bound to spontaneously reverse inthe form of an economic crisis and recession. Although in afractional-reserve free-banking system independent reversionpro...

  • Page 702

    commands which dictate exactly how the supervised eco-nomic agent should behave. Thus to the extent that privilegesand institutional coercion spread and develop, traditionallaws cease to act as standards of behavior for individuals, andthe role of these laws is taken over by the coercive orders a...

  • Page 703

    Each time a new crisis hits, a complete set of new laws oramendments to prior ones is swiftly enacted under thenaive assumption that the former laws were insufficient andthat the new, more detailed and all-encompassing ones willbetter avoid future crises. This is how the government andthe central...

  • Page 704

    keeping with Mises’s view, the above proposal entails the sub-stitution of several clear, simple articles, to appear in the com-mercial and penal codes, for the current web of administrativebanking legislation, which has not achieved the objectives setfor it.101It is interesting to note that mo...

  • Page 705

    not be to permit the exploitation of the lucrative possibilitieswhich always arise from credit expansion. Instead free bankingshould be seen as an indirect route to the ideal free-banking sys-tem, one subject to legal principles, i.e., a 100-percent reserverequirement. All legal means available i...

  • Page 706

    whom we could mention certain members of the AustrianSchool who, in our opinion, have missed some of Mises’s andHayek’s teachings on monetary matters and the theory of cap-ital and economic cycles, members like White,104 Selgin105 and,more recently, Horwitz;106 members of the English Subjecti...

  • Page 707

    Milton Friedman,111 though he cannot be considered a memberof this new school, has been gradually leaning toward it, espe-cially following his failure to convince central bankers thatthey should put his famous monetary rule into practice.Modern fractional-reserve free-banking theorists havedevelo...

  • Page 708

    In a nutshell, this argument centers around the hypotheti-cal results of an increase in economic agents’ demand for fidu-ciary media, assuming reserves of specie in the banking sys-tem remain constant. In that event, theorists reason, the paceat which fiduciary media are exchanged for bank rese...

  • Page 709

    the idea goes to one of White’s most noted students, George A.Selgin. Let us now critically examine Selgin’s theory of “mon-etary equilibrium,” or in other words, his revised version ofsome of the Old Banking School doctrines.THE ERRONEOUS BASIS OF THEANALYSIS: THE DEMANDFORFIDUCIARY MEDI...

  • Page 710

    that, on the side of the money supply, the Austrians havedemonstrated that credit expansion seriously distorts theeconomy, a fact which in any case seems to warrant a rigidmonetary system117 capable of preventing the monetaryexpansions and contractions typical of any fractional-reservebanking sys...

  • Page 711

    wish to justify a fractional-reserve free-banking system inwhich there may be substantial increases and decreases in themoney supply in the form of fiduciary media, they must inde-pendently look to the side of demand in the hope of being ableto demonstrate that such modifications in the supply of...

  • Page 712

    completely free banking system credit expansion would becurbed sooner than in the current system, and it is quite anotherto claim that credit expansion brought about in a fractional-reserve free-banking system would never distort the produc-tive structure, since a state of supposed “monetary eq...

  • Page 713

    largely creates its own demand. In other words, modern free-banking theory contains the Old Banking School’s funda-mental error, which, as Mises adeptly revealed, lies in a fail-ure to reflect that public demand for credit depends preciselyon banks’ inclination to lend. Thus those bankers who...

  • Page 714

    This first stage of the inflationary process may last for manyyears. While it lasts, the prices of many goods and servicesare not yet adjusted to the altered money relation. There arestill people in the country who have not yet become awareof the fact that they are confronted with a price revolut...

  • Page 715

    THE POSSIBILITY THAT AFRACTIONAL-RESERVE FREE-BANKINGSYSTEM MAY UNILATERALLY INITIATE CREDIT EXPANSIONVarious circumstances make it possible for a fractional-reserve free-banking system to initiate credit expansion in theabsence of a corresponding, prior increase in the demand forfiduciary media....

  • Page 716

    Granted, the process itself will tend to reveal and eliminatethe errors committed, but only following a period of varyinglength, and damage to the real productive structure will notbe avoided. If we add that, as we saw in the last section, thesupply of fiduciary media tends to create its own dema...

  • Page 717

    despite the doubts of many authors regarding the effective-ness of Selgin’s mechanism,127 even if we allow for the sake ofargument that Selgin is correct, it can still be argued that theadjustment will never be perfect nor immediate, and thereforein-concert expansion and mergers may provoke sig...

  • Page 718

    THE THEORY OF“MONETARY EQUILIBRIUM” INFREE BANKINGRESTS ON ANEXCLUSIVELY MACROECONOMIC ANALYSISWe must point out that the analysis of modern free-bank-ing theorists ignores the microeconomic effects which arise fromincreases and decreases in the supply of and demand for fidu-ciary media insti...

  • Page 719

    this theory does not fit in with their analysis of the issuance offiduciary media in a fractional-reserve free-banking system.These theorists thus take refuge in an exclusively macroeco-nomic analysis (monetarist or Keynesian, depending on thecase) and, at most, use instruments which, like the eq...

  • Page 720

    relative prices of the various kinds of input and on the meth-ods of production that will appear profitable.132Hayek clarifies his position even further: All that is required to make our analysis applicable is that,when incomes are increased by investment, the share of theadditional income spent ...

  • Page 721

    Chart VIII-1 the increase in the demand for fiduciary mediashifts the hypotenuse of the triangle toward the left. Thismovement reflects a drop in the monetary demand for con-sumer and investment goods, since the proportion of one tothe other (or time preference) has not varied. In this chart, sur...

  • Page 722

    Money, Bank Credit, and Economic Cycles692to “B”) reflects the portion of the new fiduciary media whichthe final holders spend on the goods closest to consumption.The productive structure regains the proportions shown inChart VIII-1, but only following the inevitable, painful read-justments w...

  • Page 723

    explains and which a free-banking system, as we have justseen, would be incapable of preventing. Therefore we mustconclude, in contrast to what Selgin and White suggest,136 thateven if the expansion of fiduciary media fully matches a priorincrease in the demand for them, it will provoke the typic...

  • Page 724

    THE CONFUSION BETWEEN THECONCEPT OFSAVINGAND THAT OF THEDEMAND FORMONEYThe attempt to recover at least the essence of the old“needs of trade” doctrine and to show that a fractional-reservefree-banking system would not trigger economic cycles hasled George A. Selgin to defend a thesis similar ...

  • Page 725

    Under these conditions, banks are simply intermediaries ofloanable funds.138Nonetheless it is entirely possible that the public maysimultaneously increase their balances of fiduciary media andtheir demand for consumer goods and services, if they decideto cut back on their investments. For economi...

  • Page 726

    consumption and investment remains unchanged, that thenew fiduciary media the bank creates may be used to step upspending on consumer goods, thus pushing up the relativeprices of this type of good.Fractional-reserve free-banking theorists generally con-sider any note or deposit a bank issues to b...

  • Page 727

    money balances are perfectly compatible with different com-binations of simultaneous increases and decreases in the pro-portions in which he consumes or invests. In fact his balancesof fiduciary media may rise simultaneously with his spendingon consumer goods and services, if he only disinvests s...

  • Page 728

    this position when he criticizes Machlup’s view143 that theexpansionary granting of loans creates purchasing powerwhich no one has first withdrawn from consumption (i.e.,Money, Bank Credit, and Economic Cycles698143Selgin’s unjustified criticism of Machlup appears in footnote 20 onp. 184 of h...

  • Page 729

    saved). For credit to leave the productive structure undis-torted, it logically must originate from prior saving, whichprovides present goods an investor has truly saved. If such aCentral and Free Banking Theory699money” (ibid., p. 60). In contrast, for Machlup (and for us), at least sur-face ...

  • Page 730

    sacrifice in consumption has not taken place, and investmentis financed by created credit, then the productive structure isinvariably distorted, even if the newly-created fiduciarymedia correspond to a previous rise in the demand for them.Hence Selgin is obliged to redefine the concepts of saving...

  • Page 731

    THE PROBLEM WITHHISTORICAL ILLUSTRATIONS OFFREE-BANKING SYSTEMSNeo-banking authors devote strong efforts to historicalstudies which they intend to support the thesis that a free-banking system would protect economies from cycles of boomand depression, owing to the “monetary equilibrium” mecha...

  • Page 732

    In fact, in a recent study, George A. Selgin looks at theoccurrence of bank runs in different historical free-bankingsystems versus certain systems controlled by a central bankand reaches the conclusion that bank crises were more numer-ous and acute in the second case.146 Moreover the main thesis...

  • Page 733

    their bankers, who accused them of “disloyalty” and threat-ened to make it difficult for them to obtain loans in the future.Furthermore, as Professor Sidney G. Checkland has shown,149the Scottish fractional-reserve free-banking system still wentthrough frequent, successive stages of credit ex...

  • Page 734

    Courcelle-Seneuil’s influence in Chile during the ten years hetaught there was so great that in 1860 a law permitting theestablishment of fractional-reserve free banking (with no cen-tral bank) was enacted. At this point the traditional financialstability of the Chilean system gave way to stage...

  • Page 735

    Moreover the fact that various historical studies appear toindicate that fewer bank runs and crises arose in free-bankingsystems than in central-banking systems does not mean theformer were completely free of such episodes. Selgin himselfmentions at least three instances in which acute bank crise...

  • Page 736

    benign effects, since strictly theoretical procedures must beused to refute this theory.155IGNORANCE OFLEGAL ARGUMENTSTheorists of fractional-reserve banking tend to excludelegal considerations from their analysis. They fail to see thatthe study of banking issues must be chiefly multidisciplinary...

  • Page 737

    Such an act clearly constitutes misappropriation and fraud,offenses committed during at least the early stages in thedevelopment of the modern banking system, as we saw inchapter 2.Once bankers obtained from governments the privilege ofoperating with a fractional reserve, from the standpoint ofpo...

  • Page 738

    public order and harms third parties. In fact, because frac-tional-reserve banking expands loans without the support ofreal saving, it distorts the productive structure and thereforeleads loan recipients, entrepreneurs deceived by the increasedflexibility of credit terms, to make ultimately unpro...

  • Page 739

    repayment of their deposits at any time, no one can guaranteethey will be repaid in monetary units of undiminished pur-chasing power. Third, all other borrowers and economicagents are harmed, since the creation of fiduciary credit andits injection into the economic system jeopardizes the entirecr...

  • Page 740

    disruption of the public order.160 Economically speaking, thequalitative effects of credit expansion are identical to those ofthe criminal act of counterfeiting banknotes and coins, anoffense covered, for instance, by articles 386–389 of the newSpanish Penal Code.161 Both acts entail the creati...

  • Page 741

    eliminating from the corresponding instruments an importantcharacteristic of money: perfect, i.e., immediate, complete, andnever conditional, liquidity. Thus not only would depositorsbecome forced lenders at the will of the banker, but a depositwould become a type of aleatory contract or lottery,...

  • Page 742

    were fully aware of it, to the extent that these individuals andall other economic agents subjectively considered demanddeposits and notes to be perfect money substitutes, the clausereferred to would only be capable of preventing the immedi-ate suspension of payments or failure of banks in the ev...

  • Page 743

    as counterfeiters and embezzlers who should be crackeddown on by the full majesty of the law. Forced repayment toall the victims plus substantial jail terms should serve as adeterrent as well as to meet punishment for this criminalactivity. (Murray N. Rothbard, “The Present State of AustrianEco...

  • Page 744

    fractional-reserve banking and from which a central bank(lender of last resort) will inevitably emerge and control theentire financial system.These are the only two theoretically and practically viablealternatives. Up to this point we have examined the economiceffects of fractional-reserve bankin...

  • Page 745

    9APROPOSAL FOR BANKINGREFORM: THE THEORY OFA100-PERCENT RESERVEREQUIREMENTIn this last chapter, following a brief review of twentieth-century proposals for the establishment of a 100-percentreserve requirement in banking, we will present our rec-ommendation for reforming the banking system, a pro...

  • Page 746

    1AHISTORY OFMODERN THEORIES INSUPPORT OFA100-PERCENT RESERVE REQUIREMENTWe know that distrust of fractional-reserve banking datesback at least as far as the Salamancan theorists of the sixteenthand seventeenth centuries, David Hume in the eighteenth cen-tury, theorists of the school of Jefferson ...

  • Page 747

    The possibility of causing temporary fluctuations in theexchange ratios between goods of higher and of lowerorders by the issue of fiduciary media, and the perniciousconsequences connected with a divergence between the nat-ural and money rates of interest, are circumstances leadingto the same con...

  • Page 748

    The most important prerequisite of any cyclical policy, nomatter how modest its goal may be, is to renounce everyattempt to reduce the interest rate, by means of banking pol-icy, below the rate which develops on the market. Thatmeans a return to the theory of the Currency School, whichsought to s...

  • Page 749

    International Currency and Banking Policy.” There, before themonetary and banking experts of his day, Mises expressed hisideas as follows:It is characteristic of the gold standard that the banks are notallowed to increase the amount of notes and bank balanceswithout a gold backing, beyond the t...

  • Page 750

    Ten years after delivering this memo before the League ofNations, Mises once more defended a 100-percent reserverequirement, this time in the first German edition of his all-embracing economic treatise, published as Nationalökonomie:Theorie des Handelns und Wirtschaftens (Economics: Theory ofAct...

  • Page 751

    a 100-percent reserve requirement with his objection not onlyto the central bank, but also to a fractional-reserve free-bank-ing system: although such a system would greatly limit theissuance of fiduciary media, it would be inadequate to com-pletely eliminate credit expansion nor the recurrent bo...

  • Page 752

    the conservation of the central bank and the adoption of anindexed monetary unit. In fact, according to Mises, the sug-gestion to reestablish a 100-percent reserve requirement, yetpreserve the central bank, is insufficient: [I]t would not entirely remove the drawbacks inherent inevery kind of gov...

  • Page 753

    Though further on we will again deal with the process oftransition to the ideal banking system, we observe here thatMises, in keeping with his 1928 writings, proposes the samesystem of transition as the one applied to banknotes withPeel’s Act (which required that only newly-created bills beback...

  • Page 754

    10Hayek, “The Monetary Policy of the United States after the Recov-ery from the 1920 Crisis,” chapter 1 of Money, Capital and Fluctuations:Early Essays, p. 29; italics added. This article is the English translationof the theoretical portion of the original, which was published in Ger-man with...

  • Page 755

    The undeniable attractiveness of this proposal lies exactly inthe feature which makes it appear somewhat impracticable,in the fact that in effect it amounts . . . to an abolition of depositbanking as we know it.11Nearly forty years later, F.A. Hayek again took up the sub-ject of money and banking...

  • Page 756

    MURRAY N. ROTHBARD AND THEPROPOSAL OF APURE GOLDSTANDARD WITH A100-PERCENT RESERVE REQUIREMENTIn 1962 Professor Murray N. Rothbard’s now classic arti-cle, “The Case for a 100-Percent Gold Dollar,” appeared in thebook, In Search of a Monetary Constitution13 (which was editedby Leland B. Yeag...

  • Page 757

    Nevertheless we deem Rothbard’s main contribution to bethe strong legal foundation on which he builds his proposal.In fact he accompanies his economic analysis with an essen-tially legal, though multidisciplinary, study aimed entirely atshowing that banking with a 100 percent reserve is simply ...

  • Page 758

    MAURICE ALLAIS AND THEEUROPEAN DEFENSEOF A100-PERCENT RESERVE REQUIREMENTIn Europe, the Frenchman Maurice Allais, who receivedthe Nobel Prize for Economics in 1988, has championed theproposal of a banking system subject to a 100-percent reserverequirement. As Allais recently stated: The credit me...

  • Page 759

    Though Maurice Allais often quotes Ludwig von Misesand Murray N. Rothbard, and though Allais’s economicanalysis of the effects of fractional-reserve banking and its rolein provoking economic crises is impeccable and heavily influ-enced by the Austrian theory of the economic cycle, in the endAll...

  • Page 760

    bankers, should take advantage of the expropriation whichcomes with the possibility of creating money. Thus his proposalof a 100-percent reserve requirement is not the logical result ofapplying traditional legal principles to banking, as in the case ofMurray N. Rothbard. Instead, it represents an...

  • Page 761

    THE OLD CHICAGO-SCHOOL TRADITION OFSUPPORTFOR A100-PERCENT RESERVE REQUIREMENTThe Chicago School prescription of a 100-percent reserverequirement dates back to March 16, 1933, when Henry C.Simons, Lloyd W. Mints, Aaron Director, Frank H. Knight,Henry Schultz, Paul H. Douglas, Albert G. Hart and o...

  • Page 762

    A democratic, free-enterprise system implies, and requiresfor its effective functioning and survival, a stable frameworkof definite rules, laid down in legislation and subject tochange only gradually and with careful regard for thevested interests of participants in the economic game.22Neverthele...

  • Page 763

    Simons’s contributions24 were followed by those FritzLehmann made in his article, “100 Percent Money”25 and bythe article Frank D. Graham published in September of 1936with the title, “Partial Reserve Money and the 100 Percent Pro-posal.”26Irving Fisher compiled these proposals in book ...

  • Page 764

    and in an interesting footnote he mentions the complete free-banking system, defended by Gary Becker, as one way toapproach this objective.31Henry C. Simons comes closest to recognizing the juridi-cal-institutional demands for a 100-percent reserve require-ment.32 However, in general, Chicago the...

  • Page 765

    a 100 percent-reserve banking system for exclusively practicalreasons, believing this requirement would make governmentmonetary policy easier and more predictable. Therefore thetheorists of the Chicago School have been guilty of naiveté inascribing to governments the desire and ability to admini...

  • Page 766

    2OUR PROPOSAL FORBANKING REFORMLogical deduction based on this book’s analysis points to aparticular program of banking reform: on the one hand, theinstitutions related to the financial market should be madecontingent on traditional legal principles; and on the other, thegovernment agencies whi...

  • Page 767

    elimination of legal tender regulations which oblige all citizens,even against their will, to accept the state-issued monetary unitas a liberatory means of payment in all cases. The revocationof legal tender laws is therefore an essential part of anyprocess of deregulation of the financial market...

  • Page 768

    particularly suspicious of proposals to create an artificialcurrency, no matter how many advantages such a plan may atfirst appear to have.36Money, Bank Credit, and Economic Cycles738when, for the first time in history, people began to demand a certaingood as a medium of exchange. Therefore this ...

  • Page 769

    Therefore our proposal of free choice in currency is clear.In the transition process which we will examine further on,money in its current form is to be privatized via its replace-ment by that form of money which, in an evolutionary man-ner, generation after generation, has prevailed throughout h...

  • Page 770

    ASYSTEM OFCOMPLETE BANKING FREEDOMThis second element of our proposal refers to the necessityof revoking banking legislation and eliminating central banksand in general any government agency devoted to controllingand intervening in the financial or banking market. It shouldbe possible to set up a...

  • Page 771

    process of social cooperation. Thus free banking should haveno other limit than that established by the framework of gen-eral legal principles. This brings us to the third essential ele-ment in our proposal; let us now consider it.40A Proposal For Banking Reform:The Theory of a 100-Percent Reserv...

  • Page 772

    THE OBLIGATION OFALL AGENTS IN AFREE-BANKING SYSTEMTOOBSERVE TRADITIONAL LEGAL RULES ANDPRINCIPLES,PARTICULARLY A100-PERCENT RESERVE REQUIREMENT ONDEMAND DEPOSITSThere remains little for us to add here on the recommen-dation of a 100-percent reserve requirement for banking. Wehave devoted this bo...

  • Page 773

    market economy, institutions which would facilitate economicdevelopment and the accumulation of wisely invested capital,while preventing the maladjustments and crises which thecurrent, rigorously controlled and centralized system causes.WHAT WOULD THEFINANCIAL ANDBANKING SYSTEMOF ATOTALLY FREE SO...

  • Page 774

    a portion of current “deposits.” These mutual funds would behighly liquid, due to the existence of widespread secondaryfinancial markets. However, as is logical, they would notguarantee their participants the recovery at any time of thenominal value of their investments. As with the value of ...

  • Page 775

    complete freedom, the predominant form of money willalways be a metallic one with at least those essential charac-teristics that until now gold alone has offered: immutability,great homogeneity, and above all, scarcity. For the scarcermoney is, and the more unlikely significant increases ordecrea...

  • Page 776

    legal principles in the irregular deposit, anyone who receivesmoney on deposit is required to keep on hand at all times atantundem equal to 100 percent of the money received, it isobvious that depositors will be able to withdraw the amountdeposited at any time without placing any financial strain...

  • Page 777

    societies against recurrent economic crises. In fact, under thesecircumstances, the volume of loans could not increase withouta prior, parallel increase in society’s real, voluntary saving.Under such conditions, it would be impossible to imagine thatthe productive structure could be distorted a...

  • Page 778

    Money, Bank Credit, and Economic Cycles748reserve requirement (Simons, Mints, Fisher, Hart, and Fried-man) primarily sought to facilitate monetary policy and pre-vent bank crises (point one above), but their macroeconomic-monetarist analytical tools kept them from seeing that evenmore harmful tha...

  • Page 779

    749for demand-deposit bank contracts would stamp out the legalcorruption which has plagued the institution of banking fromits very beginning. As we saw in our historical study of theevolution of banking, governments first overlooked the fraud-ulent nature of fractional-reserve banking. Then, when...

  • Page 780

    replaced by another much more stable and sustained one. Infact, not only would artificial expansion be prevented, alongwith the stress it involves at all levels (economic, environmen-tal, social, and personal), but the recessions which inevitablyfollow each period of expansion would be prevented ...

  • Page 781

    Not only is this drop perfectly compatible with sustainableeconomic development from a theoretical and practical stand-point, but it would also guarantee that the benefits of suchgrowth would profit all citizens through a constant increase inthe purchasing power of their monetary units.50This mod...

  • Page 782

    making certain reductions in nominal wages necessary (in anycase, these would generally be smaller than the drop in thegeneral price level).51Finally, we should point out that the chief virtue in therigidity of the proposed monetary system is that it would com-pletely prevent sudden contractions ...

  • Page 783

    most salient features of gold, and possibly the most influentialin gold’s evolutionary predominance as money par excel-lence, is its homogeneity and immutability throughout thecenturies. Thus the main advantage of the proposed model isthat it would preclude the sudden reductions in the volume o...

  • Page 784

    wild stock-market speculation would also be thwarted, andtake-over bids, which are harmless in themselves, would onlybe made in the presence of true, objective, economic reasonsfor them. They would not be a mere result of great ease inobtaining external financing due to ex nihilo credit expansion...

  • Page 785

    monetary-planning agency, on the control and management ofthe banking and financial system of any country. Even certaindistinguished politicians, such as the nineteenth-century Amer-ican President Andrew Jackson, understood this idea perfectlyand, motivated by it, fiercely opposed the establishme...

  • Page 786

    here, permits the discontinuation of state intervention in thefield of money and finance. Mises sums up this argumentquite well: The reason for using a commodity money is precisely to preventpolitical influence from affecting directly the value of the monetaryunit. Gold is the standard money . . ...

  • Page 787

    operates with a fractional reserve, permits the ex nihilo cre-ation of purchasing power which benefits the state and cer-tain individuals and companies, to the detriment of the rest ofsociety. This possibility is exploited mainly by the govern-ment, which uses it as a mechanism for financing its ...

  • Page 788

    a large portion of this “inflationary tax.” Maurice Allais hasgiven an abundantly clear assessment of this point. He states: Given that any creation of money exerts the same effects aswould a true tax imposed on all whose income is dimin-ished by the rise in prices which inevitably follows th...

  • Page 789

    had not been for states’ mounting influence in monetary mat-ters and, ultimately, their acquired control over credit expan-sion and the creation of money. Indeed, governments haveconcealed the true cost of military conflicts from their citizensby largely financing these costs using inflationary...

  • Page 790

    thus no risk that such a bank would manipulate the worldwidesupply of money and credit. In this way, we would enjoy allthe advantages of a single, international monetary standard,yet suffer none of the disadvantages of intergovernmentalagencies related to money. Furthermore this system would notp...

  • Page 791

    with it the money supply, and thereby trigger recurrent cyclesof boom and recession.A significant number of totally legitimate activities wouldremain to sustain the banking business, and bankers couldcontinue to pursue these activities, thus fulfilling the needs ofconsumers. One such activity wou...

  • Page 792

    2. “The proposed system would largely decrease the amount ofavailable credit, thereby pushing up the interest rate and hinderingeconomic development.” This is the popular criticism most oftenexpressed, and it mainly comes from those economic agents(businessmen, politicians, journalists, etc.)...

  • Page 793

    to disproportionate investment projects which they will neverbe able to successfully complete.Therefore this second objection is unfounded: with a 100-percent reserve requirement, banks would continue to loanwhat is saved, yet entrepreneurs would tend to invest savedfunds in a much more prudent, ...

  • Page 794

    Therefore a system composed of a pure gold standard anda 100-percent reserve requirement would not weaken eco-nomic development. In fact, such a system would give rise toa model of stable, continuous development, free from themanic-depressive reactions which we have, with difficulty,become used t...

  • Page 795

    themselves actually bear the full cost (explicitly or implicitly)of these benefits.As to the explicit interest often available on deposits, suchpayments are usually compensated for by the continualdecline in the purchasing power of depositors’ monetary units.In the proposed system, which includ...

  • Page 796

    importance of preventing governments from using inflationand credit expansion to finance their expenditures in a con-cealed manner. Moreover we need not reiterate the details ofthe obscure legal basis and harmful effects of private banks’power to issue loans and deposits.4. “A 100-percent res...

  • Page 797

    this legitimacy in keeping with traditional legal principles. Infact if third parties suffer harm as a result of such a contract,the contract is illegitimate, null, and void, because it disruptsthe public order.67 According to the analysis we present in thisbook, it is precisely this lack of legi...

  • Page 798

    to voluntarily establish a banking system based on a 100-per-cent reserve requirement and that their unwillingness is evi-denced by the fact that nowadays they could freely agree to asimilar arrangement (but do not) by using the safe depositboxes banks rent out in the market. In contrast to this ...

  • Page 799

    5. “Financial ‘innovations’ will inevitably trigger the resur-gence of fractional-reserve banking.” According to this argument,any legal precautions taken to prohibit fractional-reservebanking and, thus, to establish a 100-percent reserve require-ment on demand deposits will be insufficie...

  • Page 800

    To begin with, even if this objection were justified, itwould not constitute even a hint of an argument against theattempt to reach the ideal goal: a proper definition anddefense of traditional private-property-law principles in con-nection with demand deposits. In fact in many other contexts,for...

  • Page 801

    have touched on operations with an agreement of repurchaseat their nominal value; different transactions with “American”put options; so-called time “deposits,” which in practice act astrue demand deposits; and demand deposits carried outthrough the completely unrelated institution of life...

  • Page 802

    Finally, we must make a few important clarificationsregarding the concept of “innovation” in the financial marketand the essential difference between so-called “financial inno-vations” and the technological and entrepreneurial innova-tions introduced in the sectors of industry and commerc...

  • Page 803

    fundamental structure of these types cannot be modifiedwithout distorting and violating the most basic legal princi-ples. Therefore the only conceivable way to introduce “new”financial products is to make different combinations of legiti-mate, existing legal contracts, though innovation possi...

  • Page 804

    which are often confused in theoretical discussion and analy-sis. Deflation refers to either an absolute decrease or contrac-tion in the money supply or to the result such a contractiongenerally (but not always) tends to produce, i.e., a rise in thepurchasing power of the monetary unit, or in oth...

  • Page 805

    expected future evolution of the purchasing power of money.However in this respect it is only important that in practiceeconomic agents be able to easily predict the evolution of thepurchasing power of money and to take it into account whenmaking decisions. This would be sufficient to avert the s...

  • Page 806

    market rate of interest tend to drive up the present value ofcapital goods and investment projects: a decrease from 1 to 0.5percent will double the present value of durable capital goods,and this value will double again if rates fall from 0.5 to 0.25percent. Therefore it is inconceivable that nom...

  • Page 807

    Even various members of the Neo-Banking School offractional-reserve free banking have exaggerated the sup-posed dangers of “deflation.” For example, Stephen Horwitzquestions the gradual, continuous decline in prices in ourmodel and states that just as sudden changes affect growthin prices tod...

  • Page 808

    in the past on various occasions. For example, we havealready mentioned the case of the United States during theperiod from 1867, following the Civil War, until 1879. EvenMilton Friedman and Anna J. Schwartz have had to admit thatthis period was a vigorous stage in the continued economic expansio...

  • Page 809

    it would be equal to about 1 percent of the gross domesticproduct of each nation.83 It is obviously much “cheaper” toissue paper money than to mine the earth for gold at a cost ofaround 1 percent of the gross domestic product of all countriesthroughout the world.Nevertheless to reject this mo...

  • Page 810

    difficult to believe that a gold standard costs less than apaper standard.85In addition, we would add the high cost of maintaining theentire worldwide network of central banks and their well-paidemployees, and the substantial economic resources used ingathering statistics and financing “researc...

  • Page 811

    has spontaneously evolved over a very prolonged period oftime, as a result of the contributions multiple generations ofpeople have made to social processes through their partici-pation in them. Thus such institutions, like the pure goldstandard, private-property law, and the family, carry withthe...

  • Page 812

    extracted each year (South Africa with 34 percent and the for-mer Soviet Union with 18 percent of the annual productionof new gold),88 the relative importance of the volumes theyproduce, in comparison with the existing stock of gold in theworld (which has accumulated throughout the history of civ...

  • Page 813

    9. “The supposed failure of a 100-percent reserve requirement inArgentina during the regime of General Perón.” The twentiethcentury provides one historic attempt, at least in a rhetoricalsense, to establish a 100-percent reserve requirement for bank-ing. However in this case, the reform was ...

  • Page 814

    administrative expenses, and now that recipient banks canno longer use deposits in the absence of an agreement withthe central bank, those deposits have ceased to “weigh on”banks, so to speak, and they have stopped impelling banksto expand loans beyond useful limits. This is the road tohealth...

  • Page 815

    by the central bank in the form of a discount to the differentbanks, with no limit on volume or expansionary capacity.Hence this enormous power would be used to favor thoseinstitutions most sympathetic to the current political regime.Consequently, and despite its initial rhetoric, Perón’s refo...

  • Page 816

    expansion for the government, and hence to prevent privatebanks from profiting from a substantial portion of this expan-sion, as had been the norm until then. In any case, the inten-tion was never to privatize the monetary system and do awaywith the central bank. The Peronist reform confirms a fa...

  • Page 817

    agreement.” Although the most advantageous course of actionwould be to establish a pure gold standard and 100-percentreserve requirement on an international level, and though anagreement to do so would tremendously facilitate a transitionto the new system, there is no reason the different state...

  • Page 818

    5AN ECONOMIC ANALYSIS OF THEPROCESS OFREFORM ANDTRANSITION TOWARD THEPROPOSED MONETARY ANDBANKING SYSTEMTo begin this section, we will briefly consider the majorissues involved in any political strategy for bringing abouteconomic reform in any area, including that of finance, credit,and money.AFE...

  • Page 819

    A Proposal For Banking Reform:The Theory of a 100-Percent Reserve Requirement789be coherent with them. This strategy alone will make politicallypossible in the medium- and long-term what today may seemparticularly difficult to accomplish.95Let us now return to our topic: banking reform in markete...

  • Page 820

    to the present time. The central bank holds a monopoly on theissuance of currency and at any given time determines thetotal amount of the monetary base and the rediscount rateswhich apply to private banks. Private banks operate with afractional reserve and expand credit without the backing ofreal...

  • Page 821

    stock-market crises and economic recessions continue to hit,though they are less serious than in the first stage.96In the third stage, the central bank would remain inde-pendent, and a radical step would be taken in the reform: a100-percent reserve requirement would be established for pri-vate ba...

  • Page 822

    them).97 Each depositor to select this option would receive anumber of shares strictly proportional to the sum of hisdeposits with respect to the total deposits at each bank. Eachbank would transfer its assets to a mutual fund which wouldencompass all of the bank’s wealth and claims (except for...

  • Page 823

    A Proposal For Banking Reform:The Theory of a 100-Percent Reserve Requirement793

  • Page 824

    bank’s issuance of these legal bills would not be inflationaryin any way, since the sole purpose of this action would be toback the total amount of demand deposits (and equivalents),and each and every bank would receive banknotes for a sumidentical to its corresponding deposits. In this way a 1...

  • Page 825

    Hart’s proposal that the basis of the reform consist of sim-ply giving banks the sum of the bills they need to reach a 100-percent reserve ratio is a bitter pill to swallow. This methodwould make the total of private banks’ current assets unnec-essary in the account books as backing for depos...

  • Page 826

    which does not seem equitable. For if any group of economicagents has historically taken advantage of the privilege ofgranting expansionary loans unbacked by real saving, it hasprecisely been the stockholders of banks (to the extent that thegovernment has not at the same time partially expropriat...

  • Page 827

    move would eliminate a large number (or even all) of thebonds issued by the government, which would benefit all cit-izens, since from that point on they would no longer have topay taxes to finance the interest payments on the debt. Fur-thermore the current holders of treasury bonds would not bead...

  • Page 828

    Money, Bank Credit, and Economic Cycles798had been backed by a 100 percent reserve and mutual fundshad been created with the system’s assets. From that point on,banks’ activities would simply consist of managing the mutualfunds created with their assets, and bankers could obtain newloans (in ...

  • Page 829

    bank, which would occur in the fourth stage. Indeed, once pri-vate banking is made subordinate to legal principles, com-plete banking freedom should be demanded, and remainingcentral-bank legislation could be eliminated, as could the cen-tral bank itself. This would require the replacement of tod...

  • Page 830

    Murray N. Rothbard has devoted considerable thought tothe process of exchanging for gold all bills already issued bythe Federal Reserve, a step which would follow the establish-ment of a 100-percent reserve requirement on all bankdeposits. Based on data from 1981, Rothbard reaches the con-clusion...

  • Page 831

    A Proposal For Banking Reform:The Theory of a 100-Percent Reserve Requirement801

  • Page 832

    The fifth and last stage in the privatization of the financialand banking system would begin when the conditions of goldproduction and distribution had stabilized. This last stagewould be characterized by absolute freedom in banking(though the system would be subject to legal principles, andhence...

  • Page 833

    Thus would be the end of the final stage in the privatiza-tion of the banking and financial sector, and economic agentswould reinitiate the spontaneous market process of experi-mentation in the field of money and finance, a process whichwas historically interrupted by the nationalization of money...

  • Page 834

    and medium term would consist of the introduction through-out Europe of complete freedom of choice in currencies, bothpublic and private and from both inside and outside theUnion. The national currencies still in use due to traditionwould be placed in a system of fixed exchange rates108 whichwoul...

  • Page 835

    would preclude monetary interference and manipulation onthe part of each member country and oblige those countrieswith more rigid economic structures (Germany and France,for example) to introduce the flexibility they need to competein an environment in which resorting to inflationary nationalmone...

  • Page 836

    6CONCLUSION: THE BANKING SYSTEM OF AFREE SOCIETYThe theory of money, bank credit, and financial marketsrepresents the greatest theoretical challenge confronting econo-mists as we enter the twenty-first century. In fact it is no stretchto claim that once the theoretical gap embodied by the analysi...

  • Page 837

    A Proposal For Banking Reform:The Theory of a 100-Percent Reserve Requirement807the Currency School, on the other. Many free-banking advo-cates did base their position on the fallacious, unsound infla-tionary arguments of the Banking School, and most CurrencySchool theorists did plan to reach the...

  • Page 838

    Money, Bank Credit, and Economic Cycles808monetary principles was through a free-banking system sub-ject without privileges to private law (i.e., with a 100-percentreserve requirement).The failure of most Currency School theorists was fatal.These theorists were responsible for the fact that Peel...

  • Page 839

    A Proposal For Banking Reform:The Theory of a 100-Percent Reserve Requirement809whenever a traditional rule of conduct is broken, eitherthrough institutional government coercion or the granting ofspecial privileges by the state to certain people or organiza-tions, sooner or later grave, undesirab...

  • Page 840

    Money, Bank Credit, and Economic Cycles810credit expansion and for imposing on all citizens the legal ten-der regulations of its own monopolistic currency.Nevertheless the unfortunate social consequences of thisprivilege granted to bankers (yet to no other institution orindividual) were not entir...

  • Page 841

    811In short, the essential goal of monetary policy should beto subject banks to the traditional principles of civil and com-mercial law, according to which each individual and com-pany must fulfill certain obligations (100-percent reserverequirement) in strict keeping with the terms agreed to in ...

  • Page 842

    Money, Bank Credit, and Economic Cycles812system be subject to and comply with traditional legal rulesand principles, especially the principle that no one, not even abanker, can enjoy the privilege of loaning something entrustedto him on demand deposit (i.e., a free-banking system with a100-perce...

  • Page 843

    BIBLIOGRAPHYAbrams, M.A., Money in a Changing Civilisation (London: John Lain,1934).Aguirre, J.A. de, El poder de emitir dinero: De J. Law a J.M. Keynes (Madrid:Unión Editorial, 1985).Aguirre, J.A. de, La moneda única europea (Madrid: Unión Editorial,1990).——, Appendix to the Spanish editi...

  • Page 844

    Anderson, B.M., Economics and the Public Welfare: A Financial and Eco-nomic History of the United States, 1914–1946 (Indianapolis, Ind.: Lib-erty Press, 1979).Andreu García, J.M., “El coeficiente de caja óptimo y su posible vincu-lación con el déficit público,” Boletín económico de I...

  • Page 845

    Barrallat, L., La banca española en el año 2000: un sector en transición(Madrid: Ediciones de las Ciencias Sociales, 1992).Becker, G.S., “A Proposal for Free Banking,” Chapter 2 in Free Banking,Modern Theory and Policy, L.H. White, ed., vol. 3, pp. 20–25.Belda, F., “Ética de la creaci...

  • Page 846

    Boettke, P., “Where Did Economics Go Wrong? Modern Economics as aFlight from Reality,” Critical Review 1 (Winter, 1997): 11–64.Boettke, P., and Prychitko, D.L., eds. The Market Process: Essays in Con-temporary Austrian Economics, 2 vols. (Aldershot, England: EdwardElgar, 1998).Bogaert, R., ...

  • Page 847

    Butos, W.N., “The Recession and Austrian Business Cycle Theory: AnEmpirical Perspective,” Critical Review 7, nos. 2–3 (Spring and Sum-mer, 1993).Cabrillo, F., ed., Lecturas de economía política (Madrid: Minerva Ediciones,1991).——, Quiebra y liquidación de empresas: un análisis econ...

  • Page 848

    ——, Money in Sixteenth-Century Florence (Berkeley.: University of Cali-fornia Press, 1989).Clark, J.B., “Concerning the Nature of Capital: A Reply,” Quarterly Jour-nal of Economics (May 1907).——, The Distribution of Wealth (New York: Macmillan, 1899; New York:Augustus M. Kelley, 1965)...

  • Page 849

    Courcelle-Seneuil, J.G., La banque libre: exposé des fonctions du commerce debanque et de son application à l’agriculture suivi de divers écrits de contro-verse sur la liberté des banques (Paris: Guillaumin, 1867).Covarrubias y Leyva, D., Veterum collatio numismatum, in Omnia opera(Salamanc...

  • Page 850

    ——, Discursos privados II (Madrid: Editorial Gredos, Biblioteca ClásicaGredos, 1983).Dempsey, B.W., Interest and Usury, Introduction by Joseph A. Schum-peter (Washington, D.C.: American Council of Public Affairs, 1943).Díez-Picazo, L., and A. Gullón, Sistema de derecho civil, 6th ed. (Madr...

  • Page 851

    Escarra, J., E. Escarra, and J. Rault, Principes de droit commercial (Paris:Recueil Sirey, 1947).Estey, J.A., Business Cycles: Their Nature, Cause, and Control, 3rd ed.(Englewood Cliffs, N.J.: Prentice Hall, 1956); Spanish edition Tratadosobre los ciclos económicos (Mexico: Fondo de Cultura Econ...

  • Page 852

    Fraser, H.F., Great Britain and the Gold Standard (London: Macmillan,1933).Friedman, M., “Comment on the Critics,” in Milton Friedman, MonetaryFramework, Robert J. Gordon, ed. (Chicago, Ill.: Chicago UniversityPress, 1974).——, Dollars and Deficits (Englewood Cliffs, N.J.: Prentice Hall, 1...

  • Page 853

    Gallatin, A., Considerations on the Currency and Banking System of theUnited States (Philadelphia, Penn.: Carey and Lea, 1831).García del Corral, I.L., ed., Cuerpo de derecho civil romano: a doble texto, tra-ducido al castellano del latino, translated into Spanish by Ildefonso L.García del Corr...

  • Page 854

    ——, “What about Expectations?: A Challenge to the Austrian Theory,”presented at the 2nd Austrian Scholars Conference, Auburn Univer-sity, April 4–5, 1997.Gellert, W., H. Kustner, M. Hellwich, and H. Kastner, eds., The ConciseEncyclopedia of Mathematics (New York: Van Nostrand, 1975).Gey...

  • Page 855

    ——, “What is New-Keynesian Economics?” Journal of Economic Litera-ture 28 (September 1990).Gottfried, D., ed., Corpus iuris civilis (Geneva, 1583).Graham, F.D., “Partial Reserve Money and the 100 Percent Proposal,”American Economic Review 26 (1936): 428–40.Granger, C.W.J., “Invest...

  • Page 856

    Guzmán Hermida, J.M., “Introducción General” to Discursos (Madrid:Biblioteca Clásica Gredos, 1979), vol. 1.Haberler, G., Der Sinn der Indexzahlen: Eine Untersuchung über den Begriffdes Preisniveaus und die Methoden seiner Messung (Tübingen: Verlagvon J.C.B. Mohr [Paul Siebeck], 1927).—...

  • Page 857

    Hart, A.G., “The ‘Chicago Plan’ of Banking Reform,” Review of EconomicStudies 2 (1935): 104–16.Hawtrey, R.G., Capital and Employment (London: Longmans Green,1937).——, “Review of Hayek’s Prices and Production,” Economica 12 (1932):119–25.——, The Art of Central Banking (Lo...

  • Page 858

    Intertemporal Price Equilibrium and Movements in the ‘Value ofMoney,’” in Classics in Austrian Economics: A Sampling in the Historyof a Tradition, vol. 3, The Age of Mises and Hayek, Israel M. Kirzner, ed.(London: William Pickering, 1994), pp. 161–98.——, Hayek on Hayek: An Autobiograp...

  • Page 859

    ——, “The Keynes Centenary: The Austrian Critic,” Economist 7293(June 11, 1983).——, “Three Elucidations of the Ricardo Effect,” Journal of Political Econ-omy 77, no. 2 (1979); reprinted as Chapter 11 in New Studies in Philos-ophy, Politics, Economics and the History of Ideas (Londo...

  • Page 860

    ——, “The Ricardo Effect,” Economica 34, no. 9 (May 1942): 127–52;reprinted as Chapter 11 in Individualism and Economic Order(Chicago, Ill.: University of Chicago Press, 1948), pp. 220–54.——, Individualism and Economic Order (Chicago, Ill.: University ofChicago Press, 1948).——,...

  • Page 861

    Hicks, J.R., “Is Interest the Price of a Factor of Production?” in Time,Uncertainty, and Disequilibrium: Exploration of Austrian Themes, M.J.Rizzo, ed. (Norwell, Mass.: Lexington Books, 1979).——, Capital and Time: A Neo-Austrian Theory (Oxford: Clarendon Press,1973).——, The Theory of ...

  • Page 862

    Huerta de Soto, J., “Conjectural History and Beyond,” Humane StudiesReview 6, no. 2 (Winter, 1998–1989): 10.——, “The Ongoing Methodenstreit of the Austrian School,” Journal desÉconomistes et des Études Humaines 8, no. 1 (March 1998): 75–113.——, “Banque centrale ou banque l...

  • Page 863

    ——, “Génesis, esencia y evolución de la Escuela Austriaca deEconomía,” Chapter 1 in J. Huerta de Soto, Estudios de economíapolítica (Madrid: Unión Editorial, 1994), pp. 17–55.——, “Historia, ciencia económica y ética social,” Chapter 7 in JesúsHuerta de Soto, Estudios de...

  • Page 864

    ——, Politically Impossible...? (London: Institute of Economic Affairs,1971).Ibn Abí Zayd (Al-Qayrawání), Compendio de derecho islámico (Risála, Fí-l-Fiqh), J. Riosalido, ed. (Madrid: Editorial Trotta, 1993).Ihering, R.v., El espíritu del derecho romano, F. Vela, ed. (Madrid: MarcialPon...

  • Page 865

    Juurikkala, O., “The False Money Debate in the Journal des Économistes:Déjà Vu for Austrians?,” Quarterly Journal of Austrian Economics 5, no.4 (Winter, 2002): 43–55.Kaldor, N., “Capital Intensity and the Trade Cycle,” Economica (Febru-ary 1939): 40–66.——, “Professor Hayek an...

  • Page 866

    ——, ed., Essays on John Maynard Keynes (Cambridge: Cambridge Uni-versity Press, 1975).Kindleberger, C.A., A Financial History of Western Europe, 2nd ed. (NewYork: Oxford University Press, 1993).Kirzner, I.M., Essays on Capital and Interest: An Austrian Perspective (Chel-tenham, England: Edwar...

  • Page 867

    Lachmann, L.M., “Austrian Economics under Fire: The Hayek-SraffaDuel in Retrospect,” in Austrian Economics: History and PhilosophicalBackground, W. Grassl and B. Smith, eds. (London and Sydney:Croom Helm, 1986), pp. 225–42.——, “John Maynard Keynes: A View from an Austrian Window,” S...

  • Page 868

    Layard, R., and A. Richter, “Who Gains and Who Loses from RussianCredit Expansion?” Communist Economies and Economic Transforma-tion 6, no. 4 (1994): 459–72.Lee, G.A., “The Oldest European Account Book: A Florentine BankLedger of 1211,” in Accounting History: Some British Contributions,...

  • Page 869

    ——, The Works of John Locke, 12th ed. (London: C. and J. Rivington,1824), vol. 4.Longfield, S.M., “Banking and Currency,” 4 articles, Dublin UniversityMagazine 15: 3–15, 218–33; 16: 371–89, 611–20, 1840.López, G., Las siete Partidas de Alfonso X “El Sabio,” annotated by G.Ló...

  • Page 870

    Mariana, J. de, Tratado y discurso sobre la moneda de vellón que al presentese labra en Castilla y de algunos desórdenes y abusos; original ed., Demonetae mutatione, 1609; reprint with a preliminary study by LucasBeltrán (Madrid: Instituto de Estudios Fiscales, Ministerio deEconomía y Haciend...

  • Page 871

    ——, A Treatise on Metallic and Paper Money and Banks (Edinburgh: A. andC. Black, 1858).Meltzer, A., “Comments on Centi and O’Driscoll,” presented at the gen-eral meeting of the Mont Pèlerin Society, Cannes, France, September25–30, 1994.Menger, C., Grundsätze der Volkswirthschaftsleh...

  • Page 872

    economía; 7th ed., with a preliminary study by J. Huerta de Soto(Madrid: Unión Editorial, 2004).——, “The Position of Money Among Economic Goods,” originally pub-lished in Die Wirtschaftstheorie der Gegenwart, H. Mayer, ed. (Vienna:Julius Springer, 1932), vol. 2; English translation by A...

  • Page 873

    ——, “Pensions, the Purchasing Power of the Dollar and the New Eco-nomics,” in Planning for Freedom and Twelve Other Addresses (SouthHolland, Ill.: Libertarian Press, 1974), pp. 86–93.——, Omnipotent Government: The Rise of the Total State and Total War(New York: Arlington House, 1969...

  • Page 874

    Newman, P., M. Milgate, and J. Eatwell, The New Palgrave Dictionary ofMoney and Finance, 3 vols. (London: Macmillan, 1992).Nichols, D.M., Modern Money Mechanics: A Workbook on Deposits, Cur-rency and Bank Reserves (Chicago, Ill.: Federal Reserve Bank ofChicago, 1970).Niveau, M., Historia de los h...

  • Page 875

    Parker, R.H., and B.S. Yamey, Accounting History: Some British Contribu-tions (Oxford: Clarendon Press, 1994).Pastor, L.M., Libertad de Bancos y Colas del de España (Madrid: B. Car-ranza, 1865).Patinkin, D., “Real Balances,” in The New Palgrave: A Dictionary of Eco-nomics, vol. 4, pp. 98–1...

  • Page 876

    Pollock, A.H., “Collateralized Money: An Idea Whose Time Has ComeAgain?” Durrell Journal of Money and Banking 5, no. 1 (March 1993):34–38.Powell, E.T., Evolution of Money Markets (London: Cass, 1966).Principe, A., La responsabilità della banca nei contratti di custodia (Milan:Editorial Giu...

  • Page 877

    Roca Juan, J., “El depósito del dinero,” Comentarios al Código Civil y com-pilaciones forales, Manuel Albaladejo, ed. (Madrid: Editorial Revistadel Derecho Privado EDERSA, 1982), tome 22, vol. 1, pp. 246–55.Rockwell, Jr., L.H. ed., The Gold Standard: An Austrian Perspective, intro-duction...

  • Page 878

    ——, Man, Economy, and State: A Treatise on Economic Principles, 3rd ed.(Auburn, Ala.: Ludwig von Mises Institute, 1993). The Scholar’s Edi-tion, Man, Economy, and State with Power and Market (Auburn, Ala.:Ludwig von Mises Institute, 2004).——, “Aurophobia: or Free Banking on What Stand...

  • Page 879

    Rubio Sacristán, J.A., “La fundación del Banco de Amsterdam (1609) yla banca de Sevilla,” Moneda y crédito (March 1948).Rueff, J., “The Fallacies of Lord Keynes’ General Theory,” in The Criticsof Keynesian Economics, H. Hazlitt, ed. (New York: Arlington House,1977), pp. 239–63.Ruiz...

  • Page 880

    Sardá, J., La política monetaria y las fluctuaciones de la economía española enel siglo XIX (Barcelona: Ediciones Ariel, 1970; Madrid: Consejo Supe-rior de Investigaciones Científicas, Instituto de Economía “Sanchode Moncada,” 1948).Scaramozzino, P., Omaggio a Bruno Leoni (Milan: A. Gui...

  • Page 881

    ——, “Are Banking Crises a Free-Market Phenomenon?” presented atthe regional meeting of the Mont Pèlerin Society, Rio de Janeiro, Sep-tember 5–8, 1993.——, “Short-Changed in Chile: The Truth about the Free-BankingEpisode,” Austrian Economics Newsletter (Spring–Winter, 1990).—...

  • Page 882

    Skidelsky, R., John Maynard Keynes: The Economist as Saviour, 1920–1937(London: Macmillan, 1992).Skousen, M., The Economics of a Pure Gold Standard (Auburn, Ala.: Prax-eology Press, [1977] 1988; New York: Foundation for Economic Edu-cation, 1996).——, “I Like Hayek: How I Use His Model as ...

  • Page 883

    Sprague, O.B.W., History of Crises and the National Banking System (1910;Fairfield, N.J.: Augustus M. Kelley, 1977).Sraffa, P., “Doctor Hayek on Money and Capital,” Economic Journal 42(1932): 42–53.——, Production of Commodities by Means of Commodities: Prelude to a Cri-tique of Economic...

  • Page 884

    ——, “La banca privada española durante la Restauración, 1874–1914,”in La banca española en la Restauración (Madrid: Servicio de Estudiosdel Banco de España, 1974), vol. 1.Tellkampf, J.L., Die Prinzipien des Geld- und Bankwesens (Berlin: Put-tkammer and Mühlbrecht, 1867).——, Es...

  • Page 885

    Todd, S.C., The Shape of Athenian Law (Oxford: Clarendon Press, 1993).Tooke, T., A History of Prices and of the State of the Circulation from1793–1837, with an appendix by J. Pennington (London: Longman,1838), vol. 2.——. An Inquiry into the Currency Principle (London 1844). Toribio Dávila,...

  • Page 886

    Usher, A.P., The Early History of Deposit Banking in Mediterranean Europe(Cambridge, Mass.: Harvard University Press, 1943).Valpuesta Gastaminza, E.M., “Depósitos bancarios de dinero: libretas deahorro,” in Contratos bancarios, E. de la Torre Saavedra, R. GarcíaVillaverde, and R. Bonardell ...

  • Page 887

    Wicker, E., The Banking Panics of the Great Depression (Cambridge: Cam-bridge University Press, 1996 and 2000).Wicksell, K., Geldzins und Güterpreise: Eine Studie über die den Tauschwertdes Geldes bestimmenden Ursachen (Jena: Verlag von Gustav Fischer,1898); English translation by R.F. Kahn, In...

  • Page 888

  • Page 889

    Accelerator principle, criticismof the, 565–70AccountingContinental accountingmethods used for the irreg-ular deposit, 184–94in the English-speakingworld, 194–200in stages closest to final con-sumption, 367–68losses in stages distant fromconsumption, 375–82profits from production, 289Se...

  • Page 890

    endowment of a Nobel Prizein Economics, 107nBank crises, and the superiorityof the proposed system incounteracting them, 745–46Bank failuresBangkok Bank of Commerce(Thailand), 498nBank Korea First (Korea),498nCrédit Mobiliaire (France),485Hokkaido Takushoku(Japan), 498nJay Cook and Co. (United...

  • Page 891

    strategy for reforming, essen-tial principles, 788–89to prevent economic cycles,746–48See also National debtBanking School, 254ndebate with CurrencySchool, 622–30definition, 601n, 623in the School of Salamanca,601Banking systemand the capacity for creditexpansion, 200–23compared with stoc...

  • Page 892

    Commercial and Penal Codes,proposed reform of their arti-cles, 741nCommercial Code and the mone-tary deposit, 127Commixtion (art. 381 of theSpanish Civil Code), 5nCommodatum, definition, 2Common law, doctrine of irregu-lar deposit, 124–26ContractsAleatory, 142, 150deposit, 4loan, 1–2monetary ...

  • Page 893

    contract of, concept andessence, 4derivative, 188economic difference from aloan, 14–16, 19, 35guarantee systems, 656nlegal difference from loan,13, 17–20, 67nprimary deposits, 187secondary, 188“time,” 20Ulpian’s definition, 27–28Ulpian, difference in loans, 33Depositi a discrezione, 7...

  • Page 894

    Fiduciarycommodity money, 198demand for, regarded as anexogenous variable, 679–84media, 187, 191nmoney, definition, 187Filtration of the money supplyout of the economic system,239–41Financial asset, 696“Financial innovations,” criti-cism of, because they flout thereserve requirement, 772...

  • Page 895

    market rate of interest, pre-mium for expected inflationor deflation, 289saving, 302Gross Domestic Output (GDO),420Gross National Output (GNO),definition, 310nGross National Product (GNP),308, 418–20Hoarding, or deflation provokedby an increase in the savingsdevoted to cash balances,448–49Hol...

  • Page 896

    social function of, 6–7See also Common lawIslamic law, regarding irregulardeposits, 61nJapan, speculative crisis of the90s, 498Jerusalem temple, 56nJews. See BankersJurisprudence, 24–26Keynes, John Maynardcriticism of his theory, 542–71limited knowledge of eco-nomics, 543–44ignorance of G...

  • Page 897

    Loose joint, between real andmonetary sides of economics,according to Hayek, 580Macroeconomicaggregates, 438policy, according to the Aus-trian School, 581–83Macroeconomics, Hayek’s criti-cism of, 564nMalinvestment, 375usefulness after the boom,416nresources in the boom priorto the economic cr...

  • Page 898

    Multiplier, criticism of, 558–64Mutual fund banking. See Bank-ingMutuum, definition, 2–4National debt, conversion inreform of the banking system,791–802National income accountingcriticism of its measures,305–12, 338–39ninadequate to reflect differ-ent phases in the economiccycle, 418–...

  • Page 899

    temporary effect on, producedby disparity of profits, 319–25Productivity theory of capital.See CapitalProfit, rate of, 288Ptolemies. See BankingPublic-choice School, 659, 663 Public works, 439–40Purchasing power of money. SeeMoneyPut, sale option, 159n, 771Quantity theory of moneycritique of ...

  • Page 900

    Scotland. See BankingScholastics, “Currency” and“Banking” Schools, 603–12Secondarydeposits, 188depression, 453–56Securities, prices, relative to theinterest rate, 327–28Security mutual fundcharacteristics and futurerole of, 791–803true financial intermediary,597–98Sevillebanking...

  • Page 901

    Aguirre, José A., 471n, 791, 804Albácar López, José L., 128Albaladejo, Manuel, 18nAllais, Maurice, 664, 728–30,753n–54n, 758, 765n, 787, 798,804Al-Qayrawání, 61nAnderson, Benjamin M., 487,527, 547, 548n, 694nAndreu García, José M., 244nAnes, Rafael, 646nAngell, James W., 731Apollonius...

  • Page 902

    Clark, John Bates, 307n, 311n,514–22Clough, Shepard B., 116Cohen, Edward E., 47n, 50n, 51nColmeiro, M., 80nComo, 47Copernicus, Nicholas, 604nCoppa-Zuccari, Pasquale, 7n,16n, 28n, 68n, 144n Cottenham, Lord, 125Courcelle-Seneuil, Jean-Gustav,703, 704Covarrubias y Leyva, Diego de,42n, 603Cowen, Ty...

  • Page 903

    Gregory, Sir Theodore E., 361nGresham, Thomas, 80, 81nGrice-Hutchinson, Marjorie, 64,94nGroenveld, K., 730nGullón, Antonio, 5n, 135nGuyot, Yves, 361Haberler, Gottfried, 361n, 362n,431n, 544n, 559, 560nHadrianus, 54Hagemann, H., 266n, 529n, 541nHahn, L. Albert, 431nHall, Robert E., 497n, 576nHank...

  • Page 904

    Kaldor, Nicolas, 353nKeynes, John Maynard, 164n,317n, 542–51, 553–54n, 555,556n, 557–61, 562n, 563, 564n,594n, 620n, 694, 778Kindleberger, Charles P., 107nKirzner, Israel M., 273n, 521, 522,574n, 743Knight, Frank H., 311n, 511,513n, 517–22, 792Kornai, János, 661Lachmann, Ludwig M., 269n,...

  • Page 905

    Nelson, R.B., 491Newton, Sir Isaac, 446nNordhaus, William D., 515nNorman, George W., 627O'Driscoll, Gerald P., 538Ozcáriz Marco, Florencio, 17nPapinian, 25, 27, 29, 32, 33n, 56nParnell, Henry, 632, 634, 681Passio, 42, 44, 45, 46, 50Paul, 25, 28–30Pauly, Mark V., 387nPeel, Sir Robert, 717Pennin...

  • Page 906

    Simons, Henry C., 731–32, 733n,734Skidelsky, Robert, 578nSkousen, Mark, 278n, 279n, 310n,379n, 402n, 418n, 419n, 420n,434n, 502n, 545n, 578n, 680n,681n, 728n, 750nSmith, Adam, 104–06, 305,620–21, 711Smith, Vera C., 253n, 254n, 633n,643n, 644n, 645n, 648, 649nSocrates, 42nSoto, Domingo de, 9...