Money, Banking, and the Business Cycle: Volume II: Remedies and Alternative Theories 1137340770, 9781137340771

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Money, Banking, and the Business Cycle

Also by Brian P. Simpson Money, Banking, and the Business Cycle, Volume 1: Integrating Theory and Practice Markets Don’t Fail!

Mon e y, Ba n k i ng, a n d t h e Busi n ess C yc l e Remedies and Alternative Theories

Volume Two

B r ian P. S impso n

MONEY, BANKING, AND THE BUSINESS CYCLE

Copyright © Brian P. Simpson, 2014. All rights reserved. First published in 2014 by PALGRAVE MACMILLAN® in the United States— a division of St. Martin’s Press LLC, 175 Fifth Avenue, New York, NY 10010. Where this book is distributed in the UK, Europe and the rest of the world, this is by Palgrave Macmillan, a division of Macmillan Publishers Limited, registered in England, company number 785998, of Houndmills, Basingstoke, Hampshire RG21 6XS. Palgrave Macmillan is the global academic imprint of the above companies and has companies and representatives throughout the world. Palgrave® and Macmillan® are registered trademarks in the United States, the United Kingdom, Europe and other countries. ISBN: 978–1–137–34077–1 Library of Congress Cataloging-in-Publication Data Simpson, Brian P., 1966– Money, banking, and the business cycle : integrating theory and practice / Brian P. Simpson. volumes ; cm Includes bibliographical references and index. ISBN 978–1–137–33531–9 (hardback) 1. Business cycles. 2. Monetary policy. 3. Banks and banking. I. Title. HB3714.S56 2014 338.5⬘42—dc23 A catalogue record of the book is available from the British Library. Design by Newgen Knowledge Works (P) Ltd., Chennai, India. First edition: July 2014 10 9 8 7 6 5 4 3 2 1

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To Annaliese Cassarino, my wife, and Charles and JoAnn Simpson, my parents

C on t e n t s

Preface

ix

Acknowledgments

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Introduction

1

Part I Refutation of Alternative Explanations of the Business Cycle 1 2 3

Underconsumption and Overproduction Theories of the Business Cycle Keynesian Business Cycle Theory, Part Deux: Inflexible Prices and Wages

45

Real Business Cycle Theory

79

Part II 4

9

To Cure the Business Cycle

Government Interference, Fiat Money, and Fractional-Reserve Banking

113

The Characteristics and Effects of a Free Market in Money and Banking

151

The Significance of Some of the Historically Freer Banking Periods

187

7

Gold and 100-Percent Reserves

219

8

How to Transition to a Free Market in Money and Banking

243

5 6

Epilogue

261

Notes

265

Selected Bibliography

291

Index

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P r e fac e

It took nine years to complete this book and get it published. It took me

about six years to write a very rough first draft, about seven months to write the second draft, and about four months to complete the third draft. Securing a publisher, going through several more rounds of editing, and getting the book finalized for publication occupied the rest of the time. I did not realize how large a task it would be when I started it. It required far more research into more areas than I thought would be necessary. The project grew so much that it eventually became two volumes. I wrote this book in part because people have a poor understanding of the business cycle. This lack of knowledge has been highlighted since the 2008–9 recession. Wrong explanations have been provided and bad policy prescriptions have been recommended and implemented. The world desperately needs to learn what is required to achieve financial stability in an economic system. The two volumes I have written on the business cycle will enable people to acquire the knowledge they need on this crucial subject. The first volume shows theoretically and empirically what causes the business cycle, and the second volume refutes alternative theories of the business cycle and provides government policy prescriptions, based on the theory in volume one, to solve the problem of monetary-induced recessions, depressions, and financial crises. Portions of the two volumes of this work, such as the discussions on money, inflation, the causes of the business cycle, particular episodes of the cycle, the invalidity of Keynesian depression and business cycle theory, the invalidity of real business cycle theory, the nature of a free market in money and banking, the benefits of a gold standard, and other topics are appropriate for use as supplemental reading material in courses on “macroeconomics” and money and banking. The two volumes could also be used as the main textbooks either by themselves or with other, supplemental readings in courses on the business cycle. It would be well worth it to include the two volumes. They will help readers gain an integrated and comprehensive understanding of the business cycle and business cycle theory. BRIAN P. SIMPSON La Jolla, CA January, 2014

Ac k now l e dgm e n t s

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here are a number of people and organizations whose help in bringing this project to completion I want to acknowledge. I thank the Social Philosophy and Policy Center—which before it merged with the Center for the Philosophy of Freedom at the University of Arizona was located at Bowling Green State University in Bowling Green, OH—for providing me with a visiting scholar position in the fall of 2008. I thank, in particular, Fred Miller, the executive director of the center. Before my position at the center I was not hopeful about completing the book because of the extensive amount of research I still needed to perform. I was able to complete much of the remaining research at the center. I also thank National University for providing me with a sabbatical in the spring of 2012. While on sabbatical I was a visiting scholar at the Clemson Institute for the Study of Capitalism at Clemson University in Clemson, SC. I thank the Clemson Institute and its executive director, Brad Thompson, as well. I was able to complete far more work on the project than I thought I ever would while on sabbatical. It was not until I was finished with the sabbatical that I knew I would complete the book. I also acknowledge my intellectual indebtedness to George Reisman and make a general reference to all of his works pertaining to the topics in this book. I have referenced his works extensively but since I owe so much of my knowledge of economics to this man, I underscore the importance of his influence on my thinking in economics and express my gratitude to him here. In addition, I thank my beloved wife, Annaliese Cassarino, for all her support. In particular, I thank her for putting up with the long hours I worked to complete this project, especially in the final phases. Despite the support of other people and organizations in completing this project, I alone am responsible for the views expressed in this book.

I n t roduc t ion

This is the second of two volumes I have written on the business cycle. In

a sense, the two volumes are a continuation of a previous book I have written titled Markets Don’t Fail! It is thought by many that business cycles— especially recessions and depressions—are inherent features of a free-market economy. It is claimed that a free-market economy is inherently unstable and leads to protracted periods of high unemployment and decreased economic activity. In other words, recessions, depressions, and financial crises are examples of alleged market failure. Government interference through so-called fiscal and monetary policies (among other means) is said to be needed in order to stabilize the market economy. Essentially, this means that the government must manipulate the amount of spending and impose various types of regulations on the economy to stabilize it. The two volumes that make up this work on the business cycle show that this is not true. They demonstrate that financial crises, recessions, depressions, and the business cycle more generally are products of government interference in the market. Specifically, they are the result of government interference in the monetary and banking system. It is the government’s manipulation of the supply of money and credit through the fiat-money monetary system and fractional-reserve checking system that is responsible for the cycle today. The government is directly responsible for the manipulation of the supply of bank reserves through the fiat-money system and indirectly responsible, through banking regulations, for the ability of banks to manipulate the supply of money and credit through the fractional-reserve checking system. The two volumes I have written show that Austrian business cycle theory (ABCT) is the only theory that provides a comprehensive and logically consistent explanation of the cycle. ABCT shows how the government’s manipulations cause changes in spending, revenue, profits, interest rates, output, and more. The solution to the problem of financial crises, recessions, depressions, and the business cycle is to abolish the offending government interference. This means a free market in money and banking must be established to eliminate the business cycle. In other words, financial crises, recessions, and depressions are not a case of market failure but of government failure. They are a case of the government failing to protect individual rights consistently. Violations of individual rights lead to periodic economic crises. If the government consistently protected individual rights, cyclical recessions and depressions would virtually disappear.

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In the first volume, I provide the theoretical foundations of ABCT. As a part of that task, I discuss the nature of money, banking, and inflation, with insights on these topics that will be new to many. I also show in volume one how the government’s manipulation of the supply of money and credit creates the cycle. Here is a brief summary of that discussion. When the government increases the money supply at an accelerating rate, it temporarily reduces interest rates and increases spending, revenues, and profits in the economy. When the latter increase unexpectedly, businesses expand their activities and produce more in an attempt to take advantage of the unexpectedly profitable times. This is the essence of the expansion phase of the business cycle. The contraction ensues when the government decreases the money supply or does not increase it sufficiently. At this point, spending, revenues, and profits fall or fail to rise sufficiently (especially relative to expectations). Interest rates also rise due to the decrease or insufficient increase in the money supply. In volume one, I also explain the role the fractional-reserve checking system plays in causing the business cycle. Because of this system, most of the new money enters the economic system as additional supplies of credit. This increased credit is what keeps interest rates low, especially relative to the rate of profit, during the expansion phase of the cycle. Likewise, the correspondingly reduced supply of credit brought about by the fractional-reserve checking system during the contraction causes interest rates to rise relative to the rate of profit during that phase. The movements in interest rates and the rate of profit provide two incentives for businesses to expand and contract during those respective phases of the cycle. During the expansion phase, since the rate of profit is high, businesses have an incentive to invest more. At the same time, low interest rates give them the incentive and ability to borrow more to expand. The low interest rates also provide an incentive to take on longer-term investment projects due to the effects of compounding. During the contraction, the low rate of profit gives businesses the incentive to contract. Likewise, high interest rates make it more expensive to maintain their existing activities and provide a motivation to take on investment projects of shorter duration. After presenting my positive exposition of ABCT, the next task I undertake in volume one is to defend the theory from criticisms. I show that ABCT is consistent with “rational expectations” (as contemporary economists use that term), that the theory is not overly complex, that it does not exaggerate the role interest rates play in the cycle, and that the creation of mal-investment during the cycle does not depend on the existence of fully employed resources at the beginning of the expansion phase of the cycle. I defend ABCT from many other criticisms as well. In addition, I extensively apply ABCT in volume one by performing a historical analysis of the business cycle in America from the beginning of the twentieth century up through 2012. I also go back to eighteenth-century France and the Mississippi Bubble to demonstrate the explanatory power of the theory. In my analysis, I show how fluctuations in the rate of change of

I n t r oduc t ion

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the money supply drive changes in the velocity of circulation of money, the rate of profit, interest rates, output, and other variables. I do this by presenting and analyzing extensive amounts of data for the period pertaining to America. For the period in France, I use what data are available, as well as historical accounts of the period, to show how ABCT explains that episode. Where data are available, my analysis in volume one employs a more comprehensive measure of output, as compared to gross domestic product (GDP), to provide a more complete picture of what events are taking place during the cycle. The more comprehensive measure is known as gross national revenue. GDP is deficient as a measure of spending and output because it mainly only measures spending on consumers’ goods. It fails to include most spending by businesses. In addition, my analysis in volume one utilizes a better understanding of inflation to explain the cycle. It focuses on inflation as an undue increase in the money supply or, equivalently, an increase in the money supply by the government, instead of mere increases in prices. This focus allows for a deeper understanding of the causes of the cycle. Many more insights based on this better understanding of inflation will also be made in the current volume. My analysis in volume one reveals that variables fluctuate as predicted by ABCT. The data also show changes in the structure of production during the cycle that ABCT predicts. That is, output in industries that are more sensitive to interest rates fluctuates more than output in industries that are less sensitive to interest rates. Through an integration of theory and practice, volume one clearly and convincingly demonstrates the validity of ABCT. In addition, as a part of my analysis in volume one, I discuss other factors that contributed to specific episodes of the cycle. These include the government controls imposed by Presidents Hoover and Roosevelt during the Great Depression. Such controls took the economy down to unprecedented depths and made the recovery from that devastating episode much more difficult. For example, Hoover’s White House Conferences, where he used the presidency as a bully pulpit to (among other things) get businesses to keep wages high, sent unemployment to levels far above any that have been seen before or since. The other factors also include, in connection with the 2008–9 recession, the Community Reinvestment Act of 1977 (CR A) that, in essence, forced banks to provide mortgage loans to poor people—people who could not afford to borrow such large sums of money. They include the creation and continued existence of the mortgage-loan giants Fannie Mae and Freddie Mac—huge players in the home mortgage markets that stimulated substantial amounts of irresponsible home buying and mortgage lending. They did so by using their government backing to raise far more capital than they otherwise could have and used these funds to purchase mortgages originated by home mortgage lenders. The CR A, Fannie, and Freddie—as well as other forms of government interference—were partners in crime in generating a massive housing boom in the years leading up to the recession of 2008–9 and made the recession far worse than it otherwise would have been.

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My analysis shows that far from being incompatible with ABCT, these other factors are complementary to ABCT in explaining specific episodes of the cycle. However, my analysis also shows that ABCT identifies the primary drivers of the cycle: the drivers that exist in each cycle. The other factors are merely adjuncts to ABCT that appear occasionally in different forms for some cycles. In volume one, I also address other attempts to explain specific episodes of the cycle. I show that these other attempts do not provide valid explanations. For instance, I show that the Arab oil embargo of the 1970s did not cause the recession that occurred in the mid-1970s. Reductions in the supply of a commodity do not cause changes in the amount of spending that occur in the economy during the cycle and they do not cause the right pattern of fluctuations in industries. For example, ceteris paribus, an oil embargo would create a boom for oil companies not involved in the embargo, as prices rose, and a contraction in industries that use oil as an input. This is not the pattern of fluctuations we see during the cycle. As another example, I show that the Smoot-Hawley Tariff did not cause the Great Depression. For one thing, the tariff was enacted into law after the depression had already begun. For another, tariffs create expansions in domestic industries protected by the tariff and contractions in import (and eventually export) industries. This is not the pattern of fluctuations we see during the cycle. Further, tariffs do not create the changes in spending seen during the cycle. Such factors as embargos and tariffs can make recessions or depressions worse, but they are not the cause of the business cycle. The task of this volume is to complete the case for ABCT. To do this, I show that other, prominent theories of the business cycle, such as real business cycle theory and the Keynesian “sticky price theory” of the cycle, do not provide valid explanations of the cycle. This task is undertaken in part one of this volume. In part two, I show how government interference in the economy is responsible for the existence of fiat money and fractional-reserve banking. I also show what a free market in money and banking will look like and what it will lead to. The basic result will be a much more stable monetary and banking system. In addition, I provide an investigation into the types of monetary and banking systems that have existed in a number of countries around the world during the last 300 years or so. While not an exhaustive study—whole books have been written on this subject—by analyzing some of what are considered to be the freer episodes in money and banking, I show that a free market in money and banking has not existed. In fact, governments interfered early on in the history of money and banking (even much farther back than the periods I investigate). They did so mainly to finance their own spending. In the next-to-last chapter, I discuss the benefits of a gold standard and 100-percent reserve banking. I also show that criticisms of gold and 100-percent reserves are not valid. Gold and 100-percent reserves have the ability to essentially eliminate the business cycle and help lead to much higher

I n t r oduc t ion

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rates of economic progress. They lead to greater progress because of the stable financial environment they create. Finally, in the last chapter, I show how to transition to a free market in money and banking. The transition can be completed smoothly, without a depression or even a minor financial contraction. As a part of this last topic, I analyze a number of alternative plans to transition to a gold standard. Let us now begin investigating these subjects with an analysis of the overproduction and underconsumption theories of the business cycle.

Pa r t I

R e f u tat ion of A lt e r nat i v e E x pl a nat ions of t h e Busi n ess C yc l e

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Un de rc onsu m p t ion a n d O v e r produc t ion Th eor i es of t h e Busi n ess C yc l e

Introduction There are many theories of the business cycle. Some are better than others but all of them are deficient in some way except Austrian business cycle theory (ABCT). None of the alternative theories provide, as does ABCT, a comprehensive and logically consistent explanation of the business cycle based on the facts of reality. Some correctly identify some aspects of the cycle and may offer valid explanations of some aspects of the cycle, but none of them fully explain the causes of the cycle or the monetary and real changes occurring in the economy as a result of the cycle. I address the main attempts to explain the cycle in this and the following two chapters. I show logically and factually why they do not provide a valid explanation of the cycle. Once this has been done, and if one reads volume one of this work on the business cycle, one will have a complete understanding of the cycle. One will know logically what causes the cycle, will see and understand the causal factors at work in the facts of history, and will understand where alternative theories go wrong. In the next few chapters, I discuss overproduction and underconsumption theories of the cycle, John Maynard Keynes’s theory of depressions and fluctuations (which is also underconsumptionist), so-called sticky price theory (which is also Keynesian), real business cycle theory, among a few other theories.

Overproduction The overproduction theory of the business cycle originated with socialist thinkers or those who leaned in that direction and was advocated by such individuals as Thomas Malthus, the nineteenth-century Swiss socialist J. C. L. de Sismondi, and Karl Marx.1 This theory says recessions and depressions occur because capitalism is characterized by periods of too much production. During these periods of excess production, businesses begin to accumulate

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inventory, cannot sell the inventory at profitable prices, and must cut back on production. The cutback in production leads to workers being laid off, factories being shut down, and causes a general decline in business activity. Hence, recessions and depressions result from overproduction in the free market. Employment and production increase only after the inventories of businesses have been depleted sufficiently to make production profitable once again. So the economy goes back and forth between these periods of overproduction and production, in an endless cycle. The specific reasons why it is said capitalists periodically produce too much vary, but it is generally based on the belief that the need and desire for goods is limited and the rapidly expanding production in a capitalist society inherently leads to the supply of goods outstripping the limited need and desire. If the need and desire for goods is less than the supply, then of course the demand will also be insufficient to purchase all the goods produced. Hence, production is periodically reduced back down to the demand for goods in recurring recessions and depressions. The first and most obvious point to make with regard to this theory of depressions is that there is an inherent contradiction in it. The claim is that recessions and depressions occur because too much has been produced. This implies they are periods of abundance or greater prosperity. If more has been produced than people have a need or desire for, then, in essence, people have grown so rich that they can cut back on production and enjoy the fruits of their labor. Obviously, this is false. Recessions and depressions are periods of greater poverty and hardship, not prosperity. This alone is enough to discredit this theory as a valid theory of the business cycle. However, there is another problem with the theory. The other problem is with the idea that humans have a limited need and desire for wealth. This idea is false. Humans, in fact, have a limitless need and desire for wealth. This desire is based on the fact that human beings are rational beings—beings that possess the faculty of reason. Reason is the faculty that makes it possible for humans to think at the conceptual level (in terms of principles and ideas). The possession of reason makes it possible for humans to continuously expand the knowledge they possess. It makes it possible for them to progress forward through the continuous acquisition and application of knowledge. This progression is a part of how man improves his ability to survive and flourish; it is a part of man using reason—his basic tool of survival—to continuously improve his ability to further his life and happiness. As a result of the possession of reason and the progression it makes possible, man has a potentially limitless range of knowledge and awareness and thus the potential for a limitless range of actions and experiences based on this knowledge. One can begin to see the limitless need and desire for wealth in the advance of knowledge and production since the beginning of the Industrial Revolution. One need merely think of the myriad products available today that were not even dreamed of in the mid-eighteenth century: from cellular

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phones, automobiles, and space travel to air conditioning, life-saving drugs, electronic computers, all sorts of other electronic devices, and many more. The production of and desire for these products represent an enormous increase in the need and desire for wealth. There is no limit to progress as long as man is able to use reason to acquire knowledge and apply it to production. Even satisfying one of man’s basic needs, such as his need for shelter, implies a limitless need and desire for wealth. Man does not satisfy this need by living in a cave that he happens to stumble upon, like the lower animals might do. Man must grow trees for lumber, build lumber mills, build hardware stores, and produce all the products that these stores sell. He must mine ores and build steel mills to produce steel. He must produce transportation systems to carry building materials to where they are needed. He must produce aluminum siding and stucco, windows, heating and air conditioning systems, appliances, and plumbing systems (including pipes, pumping stations, water purification systems, etc.). The list could go on and on, and this is just with regard to producing shelter to meet his needs and desires. Even as we grow richer, our need and desire for wealth remains limitless. As beings that possess reason, we have a continuous desire to progress forward economically. For example, if a man owns a car, then perhaps he would like to own a better car. If he has one of the best cars, perhaps he would like several vehicles to fulfill his transportation needs and desires (an exotic sports car, a family car, an off-road vehicle, a truck for hauling items, etc.). If he owns a home, then perhaps he would like a better home. If he has the house of his dreams, perhaps he would like a second home in a beautiful vacation spot. Perhaps he would also like to be able to afford more and better vacations, to be able to spend more time with his family and engage in more and better leisure activities, retire at an earlier age than he can presently afford, provide a better education for his children, and so on. To afford all of these things, a greater productive capability and higher standard of living are required; that is, more wealth is needed. Satisfying our needs and desires requires an ever expanding ability to produce wealth. Man’s possession of reason vastly increases the scope of his needs and desires. In addition, by enabling him to increase his capacity to produce wealth, it makes it possible for him to constantly improve his ability to satisfy his needs and desires. This is something that is impossible for beings that do not possess reason to do, such as dogs, cats, cows, zebras, chimpanzees, and all the other lower animals. They go through their lives, generation after generation and century after century, performing the exact same tasks in the exact same manner as each previous generation. All they do is eat, sleep, eliminate, and mate over and over again until they die. There is no forward movement with the lower animals. There is no progression of knowledge. Later generations do not build upon the knowledge gained by previous ones. There is no ability or desire to constantly improve upon the satisfaction of their needs.2

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The above implies that, in a general sense, there can never be too much production. There is always some use to which man can put greater sums of wealth, if not to improve upon the satisfaction of an already existing need or desire, then to satisfy a different need or desire that has arisen due to the discovery of new knowledge. The only sense in which there can be an overproduction of goods is in a partial or relative sense: there can be an overproduction of some goods in the economy; however, this implies a corresponding underproduction of other goods. Such a situation implies that the areas of the economy that are experiencing the overproduction will be depressed: prices and profits will be low, workers will be laid off, factories will shut down, and businesses will go bankrupt. However, this implies at the same time that the areas of the economy that are experiencing the underproduction will be booming: prices and profits will be high, workers will be hired, new factories will be built, existing businesses will expand, and new businesses will open. This is not a general, economy-wide business cycle. It is not the boom and bust that is the focus of business cycle theory. It is a boom and bust only within certain industries and will not lead to an overall rise and fall of production in the economy but to a shifting of production from some areas of the economy to others. To illustrate that there can be no economy-wide overproduction, imagine that production magically doubles overnight in the economy. Imagine that there are twice as many automobiles, computers, cellular phones, homes, clothes, toothpicks, swimming pools, thimbles, and so on produced overnight. Surely it appears that there is an economy-wide overproduction. However, even here there is not. Although it might be true that people do not want twice as many of all products, there are some products of which people want more than twice as many. For instance, most people do not want twice as much table salt, twice as many toothpicks, or twice as much low quality food (such as low quality types of meat). But most people do want twice as many cars, homes, vacations, restaurant meals, et cetera, and if they do not want twice as many of these things, most people certainly want the equivalent of twice as much in improved quality. That is, they might not want two Toyota Corollas but they would like to own a Lexus instead of a Corolla. Further, some of the increase in production could be devoted to the invention and development of new products, unheard of and impossible to produce with the previously lower productive capability. In general, people do not want twice as many staple and low quality goods, but they do want more than twice as many luxury and high quality goods, the equivalent of more than twice as much in improved quality, and the equivalent of more than twice as much in the form of the invention and development of new products. What this means is, if a uniform doubling in the productive capability occurs throughout the economy, productive resources must be transferred from some areas of the economy to others. Capital and labor must be transferred

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from the areas in which too much is produced to those in which too little is produced. As stated by the economist George Reisman, “The problem in such a case is not any actually excessive ability to produce, but merely the misapplication of an increased ability to produce in an undue concentration on the production of a particular good. The solution is thus simply a better balance in the production of additional goods.”3 So the overproduction theory is not a valid theory of the business cycle. It implies prosperity in the midst of poverty. Further, humans have an unlimited need and desire for wealth and therefore economy-wide overproduction is impossible. The overproduction theory is based on the fallacy of composition. Since one industry can be unprofitable due to its overproduction, people think that when virtually all industries are unprofitable it must be from all of them overproducing. What people forget is that when one industry is experiencing lower profits or losses due to its overproduction, other industries are correspondingly more profitable due to their underproduction. This is because the industries are competing with each other. However, at the level of the economy as a whole, there is no competition. Competition only takes place within an economy. Changes in profitability at the level of the economy as a whole, as well as recessions and depressions, occur due to changes in the supply of money and spending.4

Underconsumption Closely related to the overproduction theory of the business cycle is the underconsumption theory of the cycle. This theory has been put forward by Sismondi, Keynes, and others.5 Although the details may vary among supporters of this theory, the main claim is that when there is not enough consumptive spending in the economy, goods go unsold, workers are laid off, and businesses shut their doors. In other words, a depression occurs. One reason given why there is not enough consumptive spending is that capitalists might shift their spending from hiring workers to purchasing capital goods (i.e., substitute capital for labor). This means workers will be paid less and thus will allegedly not have enough money with which to consume all the goods produced. Whatever the reason given for the lack of consumption, the result is the same according to supporters of underconsumption theory: economic crisis and depression. The situation is made worse, according to advocates of underconsumption theory, to the extent that greater savings accompany the lack of consumption because this leads to a greater supply of capital goods and thus a greater supply of goods produced. What this means, according to proponents of this theory, is that the supply of goods increases at the same time that spending for goods decreases and thus the underconsumption depression is exacerbated. As an example of underconsumption theory that focuses on too much saving, here is a quotation from the economist J. A. Hobson and his coauthor A. F. Mummery in John Maynard Keynes’s

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The General Theory of Employment, Interest, and Money, whom Keynes quotes favorably: The object of production is to provide “utilities and conveniences” for consumers, and the process is a continuous one from the first handling of the raw material to the moment when it is finally consumed as a utility or a convenience. The only use of Capital being to aid the production of these utilities and conveniences, the total used will necessarily vary with the total of utilities and conveniences daily or weekly consumed. Now saving, while it increases the existing aggregate of Capital, simultaneously reduces the quantity of utilities and conveniences consumed; any undue exercise of this habit must, therefore, cause an accumulation of Capital in excess of that which is required for use.6

Because it is generally claimed that reduced spending and a depression result from too much saving, this theory can also be referred to as the over-saving doctrine. To ensure there is no doubt what too much saving (or too little consumption) leads to, a further quotation from Hobson and Mummery in Keynes’s The General Theory identifies the results very clearly: “such undue exercise impoverishes the Community, throws labourers out of work, drives down wages, and spreads that gloom and prostration through the commercial world which is known as Depression in Trade.”7 There are a number of errors with the underconsumption argument. Let us now look at them. The underconsumption argument makes the false assumption that the demand for goods comes only or mainly from workers and that, essentially, the only demand for goods is that for consumers’ goods. However, the demand for goods by businesses is every bit as much a demand for goods as is the demand for consumers’ goods (whether the demand for consumers’ goods comes from workers or capitalists). Every dollar of spending by businesses for capital goods generates a dollar of revenue for a business, just as a dollar of spending by workers for consumers’ goods generates a dollar of revenue. So, when capitalists spend more on capital goods, whether due to greater savings or a shift in spending from labor to capital, just as much spending is taking place that would have taken place otherwise. For example, if total spending for all goods in the economy (viz., total sales revenue) is $1,000 and is comprised of $200 of spending on consumers’ goods and $800 of spending for capital goods and there is a shift in spending of $50 from consumers’ goods to capital goods, the same total spending exists. Now there is simply $850 of spending on capital goods and $150 on consumers’ goods. This is true whether the additional money spent on capital goods comes from a shift in spending for labor by capitalists or a shift from consumption to savings and investment by capitalists. For instance, assume further that total wage payments to workers by businesses are $100 in the economic system and that consumption by capitalists is $100. Whether capitalists reduce their own consumption to $50 or their demand for labor to $50, the reduced spending for consumers’ goods is exactly made up for by the increased spending for capital goods. For the sake of simplicity, I am

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assuming here that wage earners consume with all of their wages and do not save and invest themselves (i.e., are not capitalists themselves). I must emphasize that in my example I use a realistic ratio of spending for capital goods to spending for consumers’ goods. As I have shown elsewhere, spending by businesses far exceeds spending for consumers’ goods.8 So there is a much larger sector of the economy in which spending could easily increase to offset the reduced consumptive spending, since any reduction in consumptive spending would require a much smaller percentage increase in spending by businesses to make up the difference. The claim regarding spending for capital goods being greater than spending for consumers’ goods is true despite what one might believe based on aggregate economic accounting in the form of gross domestic product (GDP). GDP is a grossly inaccurate measure of gross spending in the economy because it fails to account for most spending by businesses for inventory. It measures only net spending by businesses for inventory and therefore fails to account for a large portion of spending for capital goods.9 If spending is shifted from consumers’ goods and/or labor to capital goods, the economy becomes more capital intensive. The ratio of spending on capital goods to consumers’ goods rises from 800:200 to 850:150 or from 4:1 up to 5.67:1. This means more capital goods are produced in the economy relative to consumers’ goods: there is a shift from the production of consumers’ goods to the production of capital goods, since the latter is relatively more profitable. This also means workers have that much more capital to work with and are much more productive. Eventually, due to the greater productive capability made possible by the greater supply of capital goods, there would be both a greater supply of capital goods and consumers’ goods produced. The demand for consumers’ goods, by itself, does not need to cover the outlays by businesses for factors of production. In each scenario above, the outlays by businesses for factors of production are covered by both the demand for consumers’ goods and the demand for capital goods. That is, in the original scenario, the demand for factors of production is $900 ($800 for capital goods and $100 for labor). The demand for factors of production in the scenario in which $50 of spending by businesses shifts from labor to capital goods is no different: it is $900. The only difference is that now it is comprised of $850 of spending for capital goods and $50 of spending for labor. In the scenario in which capitalists decrease their consumption by $50, the demand for factors of production is now $950 ($850 of spending for capital goods and $100 for labor). In every case, however, costs in the economy, which are determined by the spending by businesses for capital and labor, are covered by the $1,000 of economy-wide demand for goods (i.e., economy-wide sales revenue).10 Notice also that in the case in which spending by businesses is shifted from labor to capital goods, economy-wide profits do not change relative to the original example: they are $100 ($1,000 in sales revenue minus $900 in costs). This is because economy-wide costs have not changed. Only the mix

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of costs has changed (i.e., more spending for capital goods and thus greater costs on account of capital goods and less spending for labor and thus lower costs on account of labor). In the scenario in which the consumption of capitalists has declined, profits are now only $50 ($1,000 in revenue minus $950 in costs). While this decline might seem like it would induce a recession, one need not be alarmed. Such a large shift from consumptive to productive expenditures would only take place if time preference in the economy decreased dramatically, that is, if people made more provision for the future and thus began to save more. Such a change in time preference dictates that rates of return (including interest rates and the rate of profit on capital invested) would have to decline. The causal factor is the change in mentality that reduces capitalists’ time preference. This causes them to save more and reduces the rate of return they require to get them to save and invest. It is not somehow that the rate of return mysteriously falls and capitalists are forced to accept it. The same thing that causes a reduction in rates of return makes capitalists willing to accept a lower rate of return: a lower time preference. Further, one does not need to be worried about profits falling to zero under the conditions assumed here. This is because profits in an economy with an invariable supply of money are determined by the consumption of capitalists. This value, by its very nature, cannot go to zero. This is because capitalists, like everyone else, must consume something in order to survive. This number, therefore, must have some positive value.11 The large relative change in the consumption of capitalists assumed above, or the large shift in spending by businesses from labor to capital, is extremely unlikely. I use them here only to illustrate my point. That point is that increased saving by capitalists or a shift in spending by businesses from labor to capital does not reduce the ability of the spending for goods in the economy to cover the outlays by businesses to produce those goods. This is because, as stated previously, spending by businesses for capital goods is every bit as much a demand for goods as is spending for consumers’ goods. The point underconsumptionists fail to understand is that changes from consumptive to productive spending in the economy do not represent a decrease in spending; they represent merely a shift in spending. Therefore, no economy-wide contraction comes about in these scenarios. Consumers’ goods industries contract while capital goods industries expand. In fact, not even all consumers’ goods industries contract since some consumers’ goods can be used as capital goods. For instance, the same number of trucks might be produced and sold but now more are sold to businesses instead of consumers. The key point is that there is no net change in spending and no recession or depression. Indeed, overall production and the standard of living rise because of the greater capital intensity and productive capability in the economy. In addition, because the shifts in spending relative to the size of the economy tend to be much smaller than I have assumed, any industry-wide contractions and expansions that take place will tend to be much smaller as well.

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One dollar of spending shifted from labor to capital goods or consumption by capitalists to capital goods in my example is more realistic. Finally, in the case of shifts in spending from labor to capital goods, while it will reduce overall money wages in the economy (assuming that the same number of workers are employed), such a decline would not constitute a decline in real wages in the long run. This is because capitalists will only be induced to spend more on capital goods and less on labor if it increases productivity and thus reduces costs. There is no reason to shift spending if there is no change in productivity, and there is certainly no reason to shift spending if productivity falls. The rise in productivity increases the rate of economic progress and eventually increases the supply of goods, including consumers’ goods, to the point where, eventually, real wages are higher than they otherwise would have been. So everyone will be better off.12 The cause of a recession or depression is not a shift in spending but a decline, less rapid increase, or a less rapid acceleration in spending.13 The key is that a decline in total spending (or a decline in the rate of increase or acceleration of total spending) is required, not merely a decline in consumption (i.e., not merely a shift in spending from consumers’ goods to capital goods). Advocates of the underconsumption theory of the business cycle commit the same error that Keynesians commit in the use of their “multiplier.” That is, they equate saving with hoarding. This is the only way for spending to decrease in response to greater saving. In fact, virtually no saving takes place in the form of hoarding. Most savings are spent in one way or another: whether they are spent by businesses to purchase factors of production, by those who borrow the savings, by those who receive the proceeds from the purchase of shares of stock, and so forth.14 The only time people generally save in the form of hoarding is when a recession or depression (or a “credit crunch”) has already begun. Such hoarding occurs because people become unduly illiquid during inflationary expansions and must scramble to build up money balances when other sources of money begin to dry up (such as selling inventory into a growing revenue stream). This is not a cause of the business cycle (although it can make a business cycle worse). It is one of the effects of the business cycle. Moreover, such hoarding is beneficial to the economy in the long run since it corrects the previous errors individuals made of becoming unduly illiquid in response to the easy credit terms created by a government inflationary expansion. Once individuals become more liquid, it puts them on a more sound financial footing and helps to prevent future financial contractions, recessions, and depressions.15

The Keynesian Underconsumption Theory of the Business Cycle There are a couple of Keynesian theories of the business cycle. In this section I focus on the underconsumption variant of Keynesian business cycle

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theory.16 In the next chapter I refute the variant that focuses on allegedly inflexible prices (although the inflexible price theorists still tend to embrace underconsumptionism). I put the Keynesian version of underconsumptionism in a separate section because it requires significant exposition to explain and refute due to the sophistries employed by Keynes. The refutation of inflexible price theory requires a separate chapter because there are many issues to address in connection with it that are separate from the underconsumption and overproduction theories. Keynes’s basic idea regarding the business cycle is that it is caused by fluctuations in investment. When investment is “high,” a boom occurs and when investment is “low,” a bust occurs. Before describing the nature of the cycle, according to Keynes, I discuss the state of chronic depression that Keynes claims would exist in a free-market economy, which is the context within which the cyclical fluctuations take place. I mainly focus on Keynes’s ideas here instead of the ideas of his followers because his ideas are still extremely popular and used as the basis for government policies, such as so-called fiscal policy and the “stimulus packages” used during the 2008–9 recession. Further, although in many cases his exact description for why recessions, depressions, and the business cycle occur has largely been abandoned, his ideas still serve as the basis for business cycle theory put forth by many economists today. In fact, most economists today are either Keynesian economists or embrace significant aspects of Keynes’s ideas (whether knowingly or not). While his writings have been criticized by many authors, I present a critique of his theory of depressions and business cycles here because not all the errors of Keynes’s analysis have been exposed (since there are so many).17 As long as his ideas are popular, new criticisms of them must be published (and old ones republished) to keep showing people their invalid nature. To best understand his ideas, I primarily turn to what Keynes himself says about depressions, the business cycle, and related issues. I present his ideas as expounded in his works, focusing mainly on The General Theory but referring to his other works as necessary. This will give the reader the best statement of what his views are on these subjects. After a presentation of his ideas, I then provide my analysis of them, which shows that his theories of the business cycle and depressions are invalid. Keynes’s First Claim: The Free Market’s Chronic State of Depression To Keynes, a state of high unemployment is a part of the normal conditions of a free market. He claims, “the evidence indicates that full, or even approximately full, employment is of rare and short-lived occurrence.” He also says, “it [the economic system] seems capable of remaining in a chronic condition of sub-normal activity for a considerable period.”18 To understand what Keynes means by a “condition of sub-normal activity,” one must keep in mind that he wrote The General Theory when economies were still recovering

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from the Great Depression and he was referring to an economy that was in a state of depression. This chronic state of “sub-normal activity,” according to Keynes, is caused by too much saving and not enough consumption and/or investment. In Keynes’s words, “If the propensity to consume and the rate of new investment result in a deficient effective demand, the actual level of employment will fall short of the supply of labour potentially available.”19 If there is any doubt about what Keynes means by all this, I refer the reader back to the second quotation of Hobson and Mummery provided in the section on underconsumptionism in this chapter. Keynes quotes these two authors with approval and this quotation definitively states that too much saving leads to depression. The problem of too much saving and the chronic state of depression is especially true for a wealthy society, according to Keynes. He states: The richer the community, the wider will tend to be the gap between its actual and its potential production. . . . [A] poor community will be prone to consume by far the greater part of its output, so that a very modest measure of investment will be sufficient to provide full employment.

A “rich” community, on the other hand, “will have to discover much ampler opportunities for investment if the saving propensities of its wealthier members are to be compatible with the employment of its poorer members.” “This analysis,” according to Keynes, “supplies us with an explanation of the paradox of poverty in the midst of plenty.”20 This claim by Keynes typically goes by the name of the “Paradox of Thrift.” It says that saving can lead to less spending for goods, lower employment, less production, lower income, and, paradoxically, a lower standard of living. Keynes makes it clear what he thinks the result of greater saving will be when he says: It follows that of two equal communities, having the same technique but different stocks of capital, the community with the smaller stock of capital may be able for the time being to enjoy a higher standard of life than the community with the larger stock; though when the poorer community has caught up [with] the rich—as, presumably, it eventually will—then both alike will suffer the fate of Midas.21

To sum this point up in my own words, if income outstrips consumption by too much (i.e., too much saving takes place), then investment will not be sufficient to absorb all the saving taking place. This will result in a reduction in demand, a rise in unemployment, and thus a fall in incomes. Keynes also believes that the inducement to invest is weak, so it is unlikely to bridge the gap between the amount of income and consumption. Here is his statement on the subject: “there has been a chronic tendency throughout human history for the propensity to save to be stronger than the inducement to invest. The weakness of the inducement to invest has been at all times the key to the economic problem.” The reason for the weak inducement to invest

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is capital accumulation. He states, “To-day the explanation of the weakness of this inducement may chiefly lie in the extent of existing accumulations [of wealth and capital].”22 Capital accumulation also leads to what Keynes calls a low marginal efficiency of capital (MEC). The MEC is the rate of profit on additional capital investment (i.e., net investment). Keynes means that the rate of profit on additional capital investment is too low to induce the additional investment. This is because the MEC is inversely related to the amount of net investment, according to Keynes. He states, “If there is an increased investment in any given type of capital during any period of time, the marginal efficiency of that type of capital will diminish as the investment in it is increased.”23 The MEC allegedly declines with increases in net investment, according to Keynes, “partly because the prospective yield will fall as the supply of that type of capital is increased, and partly because, as a rule, pressure on the facilities for producing that type of capital will cause its supply price to increase.”24 What this means is that firms face simultaneously lower selling prices and rising costs. More net investment leads to lower selling prices for the greater supply of goods produced with the larger supply of capital. Costs rise because of the increased demand for capital and diminishing returns experienced in the facilities in which this capital is produced.25 These factors lead to higher purchasing prices for capital. Other alleged reasons for the low inducement to invest include the disappearance of the frontier, a reduction in the population growth rate, and reductions in the rate of technological progress. Plenty of uncharted territory, a rapidly growing population, and increasing rates of technological progress allegedly make possible more investment without pushing the MEC “too low.”26 While the inducement to invest in modern times is allegedly weak because of the accumulated wealth that exists (and for a variety of other reasons), it has always been weak, according to Keynes, albeit not always for the same reasons. Keynes states: Formerly, risks and hazards of all kinds may have played a larger part [relative to the effects of accumulated capital]. But the result is the same. The desire of the individual to augment his personal wealth by abstaining from consumption [i.e., saving] has usually been stronger than the inducement to the entrepreneur to augment the national wealth by employing labour.27

To what does all this lead? One can see the answer in a question Keynes asks: “What would this [keeping capital scarce enough] involve for a society which finds itself so well equipped with capital that its marginal efficiency is zero and would be negative with any additional investment?” His response: “for a society such as we have supposed, the position of equilibrium, under conditions of laissez-faire, will be one in which employment is low enough and the standard of life sufficiently miserable to bring savings to zero.”28 According to Keynes, people are poor because they are rich; they are

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unproductive because they have so many productive assets. All because the high incomes under capitalism allegedly lead to too much savings and thus the need for sufficient unemployment to insure incomes are low enough to keep savings, and the creation of capital to which they lead, scarce enough so that there is an adequate inducement for businessmen and entrepreneurs to invest. This is not merely a hypothetical scenario to Keynes. He believes that it would be fairly easy for a “modern” society to accumulate enough capital to drive the MEC to zero and eliminate the inducement to invest. In fact, according to Keynes, the MEC would not even have to be driven this low to eliminate the inducement to invest.29 How can an economy be lifted out of the chronic slump, according to Keynes? Greater investment spending does not do it (at least not permanently) because it leads to a low MEC and thus requires a reduction in employment to raise the MEC sufficiently to maintain the inducement to invest at an adequate level. Lower wages will not achieve full employment either because, according to Keynes, they lead to too much saving, less demand (in particular, not enough consumption), and thus, ultimately, no increase in employment. In connection with entrepreneurs being able to employ more workers at lower wages, he states that they will only be able to do so if: The community’s marginal propensity to consume is equal to unity, so that there is no gap between the increment of income and the increment of consumption; or if there is an increase in investment, corresponding to the gap between the increment of income and the increment of consumption, which will only occur if the schedule of marginal efficiencies of capital has increased relatively to the rate of interest.

The problem, ultimately, is too much saving, for he goes on to say: If entrepreneurs offer employment on a scale which, if they could sell their output at the expected price, would provide the public with incomes out of which they would save more than the amount of current investment, entrepreneurs are bound to make a loss equal to the difference; and this will be the case absolutely irrespective of the level of money-wages.30

However, even if lower wages could somehow temporarily increase employment, there is also the fact that the lower wages would lead to more investment with the greater goods that would be produced by the additional employment and thus a lower MEC, an insufficient inducement to invest, and thus eventually less employment. Keynes also makes the argument that wage rates cannot fall quickly enough in a free-market economy to achieve full employment. He claims that wages can only fall quickly if they are determined by “administrative decree” and that rapid drops in wage rates cannot occur in a “system of free wage-bargaining.” The need for rapid drops in wages exists because, according to Keynes, if wages fall too slowly it “serves to diminish confidence

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in the prospective maintenance of wages,” which leads to further unemployment. However, even if wage rates do fall rapidly it will not increase employment because although the rapid fall will promote more employment it will also “shatter confidence,” which will, according to Keynes, offset its advantageous effects. Whatever the reason, falling wages cannot achieve full employment. After a long discussion on the effects of lower wages on the marginal propensity to consume, the MEC, and interest rates and how lower wages will not bring about the effects necessary to increase employment, Keynes concludes that “[t]here is, therefore, no ground for the belief that a flexible wage policy is capable of maintaining a state of continuous full employment.”31 To get the economy out of the slump, according to Keynes, more consumption is needed. This will absorb the “excess” savings and not reduce the MEC. Here is Keynes’s view on the benefits of consumption, quoting Hobson and Mummery favorably, “in the normal state of modern industrial Communities, consumption limits production and not production consumption.” Keynes himself on the subject states, “capital is brought into existence not by the propensity to save but in response to the demand resulting from actual and prospective consumption.”32 And what is the best way to promote consumption? Individuals cannot be relied upon to consume with extra income because they might save for their future. Increased consumption is best achieved, according to Keynes, through greater government spending. He says the state must provide a guiding influence on the propensity to consume in a number of ways and that we need more so-called investment by the state to achieve full employment, including spending through so-called fiscal policy.33 Keynes states that even “ ‘wasteful’ loan expenditure may . . . enrich the community on balance.” Even pyramid building and wars “may serve to increase wealth.”34 In essence, we will be saved only if the government is sufficiently profligate. To sum up Keynes’s argument thus far, full employment is a rare and shortlived occurrence in a market economy. The chronic state of depression that exists is caused by too much saving and too little consumption and investment. “Rich” communities are more susceptible to depression than “poor” economies because more consumption takes place in “poor” economies relative to total income. In addition, the inducement to invest is weak, so investment is unlikely to overcome the gap between income and consumption. In any case, more investment is not a long-term solution because it leads to more capital accumulation, a lower MEC, and thus a weaker inducement to invest. Furthermore, employment must be low enough to create an adequate inducement to invest. Lower employment means less income, less saving and investment, and a higher MEC. The only permanent solution to the chronic state of depression and high unemployment is more consumption. More consumption leads to a higher MEC, a higher inducement to invest, and greater employment. The best way to increase consumption is through greater government spending. One can see here why Keynesian theory is an underconsumptionist theory.

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Keynes’s Second Claim: Fluctuations Caused by Wild Swings in Investment Spending According to Keynes, it is normal for a laissez-faire capitalist society to be in a chronic state of depression. However, such an economy will not always remain in this depressed state. There will be fluctuations around this depressed state.35 The business cycle, according Keynes, occurs due to fluctuations in investment. In Essays in Persuasion, Keynes writes, “When investment runs ahead of savings, we have a boom. . . . When investment lags behind, we have a slump.”36 Elsewhere Keynes states that investment is volatile and savings are stable.37 The volume of investment is dependent on the MEC and the MEC is dependent on expectations, which are volatile. Keynes states, “It is important to understand the dependence of the marginal efficiency of a given stock of capital on changes in expectation, because it is chiefly this dependence which renders the marginal efficiency of capital subject to the somewhat violent fluctuations which are the explanation of the trade cycle.”38 These fluctuations in investment will lead to changes in employment if they are not offset by changes in consumption. In the words of Keynes, “Any fluctuation in investment not offset by a corresponding change in the propensity to consume will, of course, result in a fluctuation in employment.”39 (Emphasis is in the original.) So investment fluctuates due to fluctuations in the MEC and the MEC fluctuates due to changes in expectations. This all leads to changes in employment and output. In other words, it leads to the business cycle. What, at root, causes expectations to change? Investment fluctuates wildly, according to Keynes, because man, by his nature, tends to make irrational investment decisions. This is the result of his expectations and investment decisions being based on “whim” and “animal spirits.” Man focuses too much on the short term, trying to make a quick buck, and not enough on long-term investment, according to Keynes. He changes his mind, about how much to invest, for any random reason and therefore for no particular reason at all.40 Because man tends to make irrational investment decisions, investment cannot be left, at least entirely, to free, private individuals according to Keynes. He states: In conditions of laissez-faire the avoidance of wide fluctuations in employment may, therefore, prove impossible without a far-reaching change in the psychology of investment markets such as there is no reason to expect. I conclude that the duty of ordering the current volume of investment cannot safely be left in private hands.41 (Emphasis is in the original.)

The solution to this alleged problem, according to Keynes, which is implied in the last quotation from him, is government coercion. Keynes proposes such “remedies” as making it more costly to switch investments through a tax on investment transactions or forcibly preventing investors from making short-term investments.42 He makes these specific statements in connection

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with investment in the stock market but given his belief that wild swings in investment, in general, explain the business cycle, there is no reason to believe that he would not hesitate to employ these “solutions” to force all types of investments to be more amenable to his wishes and desires. Finally, while Keynes offers us reasons why both economic fluctuations occur and a laissez-faire capitalist economy will be in a chronic state of depression (in essence, chronically in the depression phase of the cycle), the fundamental point is the latter. The fluctuations just make the depression more or less severe. Hence, Keynes’s depression theory is the more important to refute. I will now proceed to refute his depression theory and will then refute his theory of fluctuations. The Refutation of Keynes’s Theories Before refuting his theories, a further word needs to be said about why his theories need to be refuted. Keynesianism eventually gave way to neoKeynesianism. In response to relatively minor criticisms by the British economist A. C. Pigou, Keynesian economists conceded that it may be possible for full employment to be reached in a laissez-faire capitalist society by a fall in wages and prices. However, they also believed that wages and prices would have to fall significantly, and thus spending would have to fall considerably, for unemployment to be eliminated. This would be “hopelessly disruptive” to the economy. The implication is that full employment would be impossible to obtain or could only be obtained temporarily. So the neoKeynesians still accept the Keynesian premise that a laissez-faire capitalist society is inconsistent with full employment.43 Neo-Keynesianism has also moved from the claim that protracted periods of high unemployment can occur because it is impossible for lower wages to eliminate unemployment, to the claim that prices and wages are inflexible (especially in the downward direction) and thus an unacceptably long period of time must pass before the unemployment is eliminated. More recently, the “new Keynesian” economists have spent much effort attempting to provide reasons why prices and wages are inflexible. All Keynesian theories have in common the claim that high unemployment—whether chronic or periodic— is a natural part of a laissez-faire capitalist society.44 In addition, it is obvious that industrialized nations have not suffered from a chronic state of depression or stagnation since the time that Keynes wrote The General Theory.45 Moreover, the Keynesian argument is not fundamentally different than underconsumptionist arguments for recessions and depressions that were put forward prior to Keynes and discussed above in this chapter. After all, it is just another underconsumptionist argument—and a particularly intellectually dishonest form of this argument at that. Anyone who studied economics as much as Keynes and who claims that useless or destructive activities and events, such as earthquakes and pyramid building, are beneficial to an economy or that wasteful activities, such as burying jars of government banknotes in the ground for businesses to dig up, are good

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ways to restore employment, and a way to increase real income, must be intellectually dishonest.46 No one could be that ignorant of a subject he had studied so much. Given all this, one might question even more the need to criticize Keynes’s arguments on recessions, depressions, and the business cycle. First, let me reiterate that one must bother to do so because Keynes is still a popular and respected economist. In addition, devoted Keynesian economists might claim that modern economies have not suffered from a chronic state of depression or stagnation because of the existence of the types of government policies that Keynes advocated (such as budget deficits) and which allegedly prevent economies from suffering such a fate. So his arguments must be thoroughly refuted and the sophistries in his arguments must be exposed. To help eliminate his influence in economics, everything possible must be done to show that, no matter in what manner it manifests itself, underconsumptionism is false. Or, as stated by George Reisman, “My purpose in what follows is to provide intellectuals who do take ideas seriously with the means of quashing any possible future resurrection of Keynesianism.”47 I consider the following my contribution to this effort. Why Keynes’s Claim about the Free Market’s Chronic State of Depression Is Wrong The first thing that is necessary in refuting Keynes’s arguments is to recall the discussion on the human need and desire for wealth in the section on overproduction in this chapter. There I demonstrated that humans have a limitless need and desire for wealth. Keynes, on the other hand, believes humans have only a limited need and desire for wealth.48 This is a part of the root cause, from an economic standpoint, of many of Keynes’s false ideas. If one believes that there is only a limited need and desire for wealth, it logically follows that “too much” savings can exist and that the amount of saving will chronically outstrip the amount of investment. Further, it also follows that the inducement to invest will be weak because of the great abundance of capital goods in capitalist societies. The false nature of the idea that there is only a limited need and desire for wealth completely undercuts Keynes’s claims at their economic roots. The limitless need and desire for wealth implies that a potentially limitless number of investment opportunities exist in producing more and better goods for individuals to purchase in virtually every line of production. For example, opportunities exist to produce more of the higher quality goods in every line of production, including the best automobiles with all the latest features, the best and most luxurious homes, the most technologically advanced computers and cellular phones, the fanciest restaurant meals, and so on. Upgrading already existing products to the best and most advanced level does not even consider the investment opportunities in creating products in every line of production that are better than the best currently existing. Further, it does not consider the investment opportunities in developing

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and producing completely new products. Because of man’s limitless need and desire for wealth, slow population growth (even population decline), a lack of “new frontiers,” a slow rate of technological progress, and the massive amounts of capital goods that exist in industrialized societies do not reduce the number of investment opportunities. If they did, we should have even fewer investment opportunities today than when Keynes complained about it. Obviously this is not the case. Based on the nature of man and economic activity, there is no inherent limit to the number of investment opportunities. But the production of more and better consumers’ goods is just the tip of the investment opportunity iceberg. Consumptive spending is small in comparison to productive spending. Businesses by far outspend consumers in the economy, including both individual consumers and the government.49 Virtually limitless opportunities exist for businesses to upgrade their facilities to the latest technology and methods of production. Any where there is an old factory or machine, there is an investment opportunity to replace it with a new one. If saving rates increase, it will not be a problem to find additional investment opportunities for the savings. If people are willing to save more, this implies that they must be acting in a more long-range fashion; that is, their time preference has fallen. A lower time preference means, ceteris paribus, individuals are placing increasing importance on consumption in the future relative to consumption in the present. This is why they are saving more and consuming less in the present. The greater savings and focus on the future will lead to a more capital intensive economic system. It will lead to more and better capital goods being employed in production, more and better products being produced, and more skilled labor being employed. The average period of production in the economy will increase. The average period of production is the average amount of time it takes for a good to go through its various stages of production: from raw materials to work-in-progress to finished product. In addition, as the rate of profit falls due to the lower time preference, land has the potential to absorb a potentially infinite amount of savings. The value of any indestructible asset that is expected to earn an income into the indefinite future will approach infinity as the expected rate of return declines.50 For instance, the value of an asset that is expected to earn $1,000 in annual income indefinitely will be $10,000 if the expected rate of return on that asset is 10 percent. If the expected rate of return is 5 percent, then the value is $20,000. If the expected rate of return is 1 percent, the value is $100,000. Although the rate of profit and interest rates will fall as a result of the lower time preference, the demand for goods will not fall one iota. The greater savings will be the source of the greater capital intensity; it will finance the investment in more and better capital goods. A shift in spending from consumers’ goods to capital goods will occur, as discussed above in the section on underconsumptionism.

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The decreased rate of profit will arise with the lower time preference because the greater demand for capital goods will mean higher costs (eventually) in the economy. Productive spending underlies the phenomenon of costs and greater amounts of productive spending lead to greater costs (i.e., spending by businesses for capital goods and labor generally shows up as costs on their profit and loss statements sooner or later). In the face of a constant supply of money and volume of spending (and thus constant business sales revenues), this means lower overall profits. In addition, when the rate of profit falls, interest rates fall as well because the two represent competing rates of return.51 The existence of time preference guarantees that the potential uses for savings and the number of potential investment opportunities will always be far greater than the actual amount of savings and investment funds available. This is true because time preference guarantees that individuals will always focus at least a portion of their wealth on the satisfaction of their needs and desires in the present. It guarantees that individuals will not pursue every single profitable, economically productive activity available to enlarge their future income because they will want to consume some of their wealth in the present. Indeed, they will need to consume some of their wealth in the present to survive.52 I now turn to Keynes’s claim that a fall in wage rates will not reduce unemployment. This is a major error. Normally, one would think that a fall in wage rates would reduce unemployment. The falling wage rates make labor more affordable and more attractive to businesses to employ relative to capital goods and thus, in accordance with the law of demand, they hire more workers. Keynes gives many reasons why this allegedly will not occur. One reason is that reduced wages mean workers will allegedly not be able to afford to engage in as much consumption as they otherwise would have. One error Keynes commits here is that he confuses wages rates, total wage payments, and consumption with total spending in the economy.53 Keynes’s error here is similar to that committed by the underconsumptionists in their argument I refuted above regarding a shift from spending on labor to capital goods. Let me address a few points on this issue as they pertain specifically to falling wages. Just because wage rates decline, this does not mean total spending, consumption, or total wage payments decline. The latter depends on the elasticity of demand for labor. If labor demand is elastic, total wage payments increase with a decrease in wage rates. If labor demand is inelastic, total wage payments decline. However, even if labor demand is inelastic, total spending in the economy does not necessarily decline. First, lower total wage payments mean business owners can increase their own consumption by the reduction in wage payments. Second, firms have more funds available to purchase capital goods. In fact, the latter is more likely to occur. I say this because if wage rates decline, this implies a decrease in costs of production and higher rates of profit, and this makes many investments look more attractive to businesses.

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This tends to promote less consumptive spending and more productive spending in the economy. So the economy becomes more production oriented and less consumption oriented. Furthermore, if wage rates are falling during a depression or recession, which is the situation on which Keynes focuses, this eventually draws funds out from businesses and causes them to spend more. In other words, the fall in wage rates helps lead to a recovery from the depression. Often, the reason why businesses refuse to spend during a recession or depression is because they are waiting for costs to fall relative to the potential revenues that could be generated from an investment. So when wage rates fall, this provides the needed impetus to induce businesses to spend. In fact, lower wage rates help lead to recovery during a depression from both sides: they reduce costs and lead to increased spending by businesses. Also, as a consequence of the increased spending by businesses to which lower wage rates during a depression lead, they lead to greater total wage payments as well.54 Another error committed by Keynes in his confusion between wage rates, total wage payments, consumption, and total spending in the economy is the belief that a demand for consumers’ goods is a demand for capital goods and labor.55 However, the demand for consumers’ goods and capital goods are competing demands, as are the demand for consumers’ goods and the demand for labor by businesses. To the extent that consumption takes place, it necessarily does so at the expense of investment, which means at the expense of capital goods and the purchase of labor by businesses. So when consumption increases, the demand for capital goods and labor by businesses cannot increase at the same time, ceteris paribus. Demand by businesses would, in fact, decrease. Consumption does not foster more production; it undermines production. Productive expenditure fosters production, and productive and consumptive expenditure are two competing alternatives. For instance, a business owner can use the revenues received by his firm to purchase capital goods and labor or he can purchase consumers’ goods for his own use. He cannot purchase both at the same time with the same funds.56 What about the idea that lower wages could lead to more investment, a lower MEC, and, eventually, less investment and employment? Recall that more investment leads to a lower MEC because selling prices for businesses are lower due to the greater supply of goods and costs are higher due to the greater demand for capital goods and the law of diminishing returns. One must keep in mind here the context Keynes is discussing. The context is: can a fall in wage rates achieve full employment? Keynes confuses this context, which would lead to an increase in the quantity of capital goods demanded, with an increase in demand for capital goods. As I have stated, lower wages mean costs for businesses will be lower and this implies lower prices for the goods businesses produce, including capital goods. Businesses can afford to invest in more capital goods because prices are lower. This is a movement down along the demand curve for capital goods, not a shift of the curve. Greater demand for capital goods would lead to higher prices, but what is

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happening here is that lower wages are leading to lower prices for capital goods and thus a greater quantity demanded. Further, businesses can afford to receive lower selling prices for the greater supply of goods produced with the additional capital goods because of the lower costs (i.e., lower wages and capital goods prices). In fact, the lower prices are brought about by the lower costs. So the rate of profit does not fall. This scenario is a case of an increase in the overall supply of goods due to lower wages (i.e., a shift to the right of the supply curve), not a shift of the demand curve for goods (whether capital goods or goods in general). Keynes commits the error of context dropping when he claims that the prices of capital goods will rise.57 Ayn Rand was the first to identify context dropping as a major logical fallacy.58 Keynes drops the context that is being analyzed. In this case, a fall in wages and prices is being analyzed, including a fall in the prices of capital goods, to determine whether such a fall can lead to full employment from a state of high unemployment. Instead, he drops this context and switches to a different scenario: an increase in the demand for capital goods. This might be an interesting scenario but is not the one under investigation. Moreover, diminishing returns on the variable factors added to the factories producing the capital goods (i.e., Keynes’s “pressure on the facilities for producing . . . capital” argument) is not relevant to the case. The case under consideration by Keynes, again, is one of mass unemployment and thus of unused productive capacity. Diminishing returns might only become significant once full employment is restored and factories are possibly pushed to the limits of their productive capacities. If that occurs, it becomes profitable to invest in greater factory capacity and better technology, which the recovery makes possible and which will overcome the diminishing returns. However, such a scenario is irrelevant to a recovery from mass unemployment, when capacity utilization rates of factories are low. Keynes’s additional claim that rapidly falling wage rates will not reduce unemployment because it will “shatter confidence” is an arbitrary assertion. He provides no evidence for this claim. However, there is evidence that rapidly falling wage rates will reduce unemployment and spur recovery from a depression. The depression of the early 1920s provides a good example. Here wage rates decreased by 19 percent—in one year!59 As a result, the recovery from this depression was fairly quick. This rapid change in wages did not “shatter confidence.” It led to lower costs, greater investment, improved profitability, and greater production. If the alternative is “high” wages, mass unemployment, and misery and poverty versus “low” wages, a job to work at every day, and a much higher standard of living, nothing could restore confidence more than a dramatic drop in wage rates. It will enable people to get on with the task of furthering their lives and happiness. What about the claim that wage rates cannot fall rapidly enough in a free-market economy to achieve greater employment? The depression of the early 1920s should dispel that myth. This was the last depression during which the US government followed a relatively noninterventionist policy.60

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The alternative policy, what Keynes refers to as wages being set by “administrative decree” (i.e., central planning), will not lead to the appropriate level of wages. Government officials do not have the incentive of the profit motive to lead them to set the appropriate level of wages. In fact, it is government interference (such as minimum wage laws, pro-labor union legislation, and welfare for the unemployed) that prevents wages from falling appropriately and leads to higher unemployment. These will be discussed in chapter 2. In the end, Keynes’s claims, of whatever variety they come in, that lower wage rates cannot achieve full employment are an implicit denial of the law of demand. This is a fundamental and well-proven law of economics and is based on the nature of goods and the nature of man. Its existence is not to be questioned, but any claims to the contrary are. What about the claim Keynes makes about the relationship between the MEC and net investment? The claim is that there is an inverse relationship between these two variables. However, the actual relationship is direct, especially during depressions, which is the situation that Keynes focuses on.61 Net investment occurs when spending by businesses exceeds the costs incurred by businesses in a given period. More net investment means more spending on capital goods and labor, which either directly or indirectly leads to more revenues and profits.62 For instance, if a business purchases a capital good, this directly generates revenues and helps to contribute to the bottom line of the business that sold the capital good. If a business invests by purchasing labor, the income earned by workers will eventually be spent on goods and services the individuals need or want. These purchases will generate revenues and contribute to the profits earned by the businesses that sell the products and services the workers purchase. So either way, revenue is generated through investment spending by businesses. More significantly, during a depression or recession, net investment is typically low or negative. As I have stated, businesses are typically waiting for costs to fall to justify investment spending. When net investment begins to recover, profits recover along with it as a result of the increase in spending the net investment creates. Net investment recovers as wages and prices, and therefore costs, fall. So more investment does not weaken the inducement to invest, it enhances the inducement to invest. This is because the investment spending itself generates revenue and helps to produce profits for businesses, and businesses respond to these profit opportunities by investing accordingly. This means the relationship between the MEC and net investment is the opposite of what Keynes claims: there is a direct relationship, not an inverse relationship, between these two variables. Implied in Keynes’s argument about the rate of profit being driven too low to achieve full employment is the belief that net saving and net investment are at very high levels during a depression and that they must be driven to even higher levels during the recovery from the depression. This is what allegedly drives the rate of profit down to a level that takes away the incentive

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to invest and perpetuates high unemployment. As we have seen, this is not true. In fact, dissaving occurs during depressions because many people are out of work and must live off of their savings. Further, the low profits or losses experienced by businesses prevent them from saving much, if anything at all, and may cause them to decrease any accumulated savings. Spending by businesses also declines dramatically while costs remain high (which means low or negative net investment). Costs remain high because they reflect spending in the past, prior to the depression. This is especially true of depreciation costs but is also true for costs of goods sold to the extent the depression does not last too long.63 At this point I must address a less important argument in connection with the alleged declining MEC. This less important argument is the claim by Keynes that the real impediment to the achievement of full employment is that the interest rate will not fall (or fall enough or fast enough). This argument is not fundamental because it is dependent on the alleged declining MEC doctrine, which I have shown to be false. I address it because many economists believe that it is the most important argument Keynes makes as to why full employment cannot be achieved. Keynes believes that the interest rate must fall to justify greater investment because the interest rate is a cost of doing business and, as the MEC falls due to greater production, the interest rate must fall with it in order for businesses to be able to cover all of their costs of production (including interest costs).64 Here is Keynes’s statement on the subject: Now those assets of which the normal supply-price [viz., cost of production] is less than the demand-price [viz., selling price] will be newly produced; and these will be those assets of which the marginal efficiency would be greater . . . than the rate of interest. . . . As the stock of the assets, which begin by having a marginal efficiency at least equal to the rate of interest, is increased, their marginal efficiency . . . tends to fall. Thus a point will come at which it no longer pays to produce them, unless the rate of interest falls pari passu.65 (Emphasis is in the original.)

Without falling interest rates, investment, production, and employment will have to be curtailed to raise the MEC sufficiently, according to Keynes. Keynes claims that there are, in essence, two reasons why interest rates will not fall or fall sufficiently along with the MEC. First, money is not produced like other goods and thus its “rate of return” (i.e., the interest rate) does not fall like the MEC of other goods, whose supply can be increased merely by increasing the supply of labor involved in producing them. The only exception to this Keynes cites is in the case of a country whose major industry is the production of commodity money when such a monetary standard is used. But this, he says, is a minor exception.66 Second, he claims that the demand for money can increase indefinitely and thus prevent the interest rate from falling below some minimum (he uses 2 percent). This occurs because presumably it is not worth it to lend money at low interest rates, so people hold on to their money instead. The reasons

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it is allegedly not worth it to lend at low interest rates, according to Keynes, are twofold: (1) the cost of bringing borrowers and lenders together is too high to justify lending at low interest rates and (2) the possibility of interest rates rising when interest rates are low discourages lending. In addition, the indefinite increase in the demand for money reduces the demand for goods and thus can presumably further reduce the MEC relative to the rate of interest.67 There are a few reasons why this argument is invalid. The major reason is that it assumes the MEC is declining with new investment. This is clearly seen in the quotation above from Keynes on the subject. That is why the alleged necessity for the interest rate to fall is not a fundamental argument against full employment, the beliefs of a large number of contemporary economists to the contrary notwithstanding. If the MEC does not decline with new investment, but rises (especially in the context of recovery from a depression and mass unemployment), the need for the interest rate to fall disappears. In fact, just as the rate of profit on new investment (i.e., the MEC) rises during a recovery, so too does the interest rate (barring any action by the central bank to keep it low). It rises to the extent that the demand for loans used for investment purposes by businesses increases (due to the better investment opportunities) and to the extent that a rising rate of profit provides an alternative place for potential lenders to earn a higher rate of return on their money.68 While the above is enough to show that the claimed need for a falling rate of interest is invalid, the reasons Keynes gives for why the interest rate will allegedly not fall are also invalid. First, claiming that money is not produced like goods and thus its MEC does not fall in the same manner as the MEC for goods accepts the premise that the declining MEC doctrine is valid. As I have shown, however, this doctrine is a completely wrong approach to understanding how the rate of profit changes with net investment. Hence, it should not be used as the basis for any discussion on what does or does not affect the rate of profit (or interest), whether in connection with money or anything else. To make sure there is no confusion, I must mention that more money might lead to low interest rates in the short run due to the process of credit expansion on the part of banks. However, this has nothing to do with the declining MEC doctrine Keynes puts forward. This is apparent in the fact that in the long run more money leads to higher, not lower, interest rates.69 Second, Keynes’s claim that the demand for money can increase indefinitely is invalid as well. The increase in the demand for money is self-limiting: once the demand for money has increased sufficiently, it actually raises the prospective rate of return on new investment and thus creates a strong incentive to invest. I have addressed this elsewhere.70 At this point, I address in detail only Keynes’s claims about why it allegedly does not pay to lend money at low interest rates. One point he makes is that people will allegedly refuse to lend at low interest rates for fear of interest rates rising. However, if people

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expect interest rates to rise, either their expectations are correct, interest rates rise, and they lend at the higher interest rates or their expectations are wrong, they have nothing to fear, and can lend at the lower interest rates. Either way, the problem disappears. The claim that it is not possible to cover the cost of bringing lenders and borrowers together at low interest rates, and thus lenders will not lend at the low rates, is not valid either. Covering the cost of bringing borrowers and lenders together at low interest rates merely requires that the loan amount be sufficiently large or that the loan must be made for a sufficiently long period of time. Hence, a lower interest rate might increase the average maturity of loans and the average sum it pays to lend, but it most certainly will not prevent lending from existing.71 So Keynes’s arguments with regard to the alleged need for interest rates to fall to achieve full employment are not valid and neither are his claims in connection with why interest rates will not fall, fall enough, or fall fast enough. But as I have said, these are secondary issues to the major arguments—and errors—Keynes makes. I now return to addressing these arguments. One major problem with Keynes’s analysis of income, savings, and investment is that he focuses on these variables at the net level and does not consider their significance at the gross level. In fact, based on some of his statements, one can conclude that he did not have a proper understanding of gross income, savings, and investment because he equates gross with net values in some cases. Keynes’s focus on net values for these variables is readily apparent in his presentation of the definitions of income, savings, and investment.72 He focuses solely on income after the deduction of various costs. For instance, his largest income variable is determined by subtracting what he calls the “user cost” (which includes depreciation costs and costs for materials) from revenue. He then proceeds to derive values for savings and investment using this income variable (and a smaller income variable). He does not consider savings and investment out of revenue. Revenue only comes into play in calculating his (highly netted) income variables. This means he ignores or fails to realize the significance of income, savings, and investment at the gross level. Income, savings, and investment at this level dwarf income, savings, and investment after Keynes’s user cost is deducted. Business revenues are far greater than profits (even the profits that Keynes is calculating by subtracting his user cost, which does not include all costs). So Keynes focuses on savings and investment out of a type of profit. However, this type of savings and investment is a highly netted form of savings and investment. It is savings and investment that focuses largely on merely adding to the existing stock of capital goods. Most of the savings and investment out of business revenues occurs to replace the stock of capital goods. This is far greater than the portion of savings and investment that adds to the stock of capital goods. Keynes, on more than one occasion, even refers to the investment variable he derives (which is derived from his income that is net of user costs) as a form of “gross” investment.73 This shows he does not have a proper

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understanding of the nature of gross investment. Using a form of net income to derive “gross” investment leads to a highly netted “gross” investment. Gross investment should not subtract out the costs incurred by businesses (i.e., it should not be derived using the profits of business). It should be derived using the revenues of businesses generated by the spending of other businesses. In addition, Keynes claims that investment is “measured by the net addition to wealth whether in the form of fixed capital, working capital, or liquid capital.”74 (Emphasis added.) This also shows that he is ignoring the great bulk of investment spending, which is not merely to add to the assets already in existence but to replace the assets that already exist. That is, he ignores investment spending to maintain the current stock of economically productive assets. Focusing solely on a form of net income, savings, and investment and equating gross with net values (whether for investment or otherwise) is a problem because it leads one to ignore or fail to see the bulk of income, savings, and investment. If one focuses on income, savings, and investment after subtracting costs (or, at least, a large portion of costs or any costs for that matter), one will fail to see the portion of income, savings, and investment hidden by the costs deducted. I grant that it is important to gain a proper understanding of these variables at the net level; however, it is also important to properly understand them at the gross level. If one analyzes these variables as Keynes has done, one will have a poor understanding of these variables at the gross level and will radically understate the amount of income, savings, and investment at that level. This is not the only place that Keynes misses a large portion of some variable in the economy. He does this when he confuses wage rates, total wage payments, and consumption with total spending in the economy. He commits this error throughout his analysis. It leads to major errors with regard to the composition of spending and how an economy recovers from recessions and depressions. In addition to the above errors, Keynes commits the error of equating saving with hoarding.75 He does this by severing the link between saving and spending, especially investment spending.76 He states: It is natural to suppose that the act of an individual, by which he enriches himself without apparently taking anything from anyone else, must also enrich the community . . . so that . . . an act of individual saving inevitably leads to a parallel act of investment. . . . Those who think in this way are deceived. . . . They are fallaciously supposing that there is a nexus which unites decisions to abstain from present consumption with decisions to provide for future consumption.77

I have addressed the claim that saving equals hoarding elsewhere.78 Here I want to address a few other points on the nature of saving. The significance of saving is at the gross level, that is, saving out of revenues earned by businesses, not out of income earned by wage earners or net

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income earned by business owners. Revenues far exceed the income of wage earners and the profits of businesses. For example, in 2010, total wage payments were about 14 percent of business revenues.79 Further, gross saving can continue even when net saving disappears.80 Keynes’s equation of gross values with net values prevents him from seeing the significance of saving at the gross level. Moreover, he sees savings as only pertaining to money (i.e., only money can be saved).81 In doing so, he ignores the vast amount of savings that exist in the form of plant, equipment, and other capital goods, as well as homes, automobiles, and other expensive consumers’ goods. The portion of the useful life of all goods that have yet to be consumed represents savings. Focusing the concept of savings solely on money ignores all of these forms of savings. In addition, Keynes believes that saving can only be engaged in by individual consumers.82 Again, this ignores the far larger amount of saving engaged in by businesses. As one can see, Keynes commits many errors. This makes his analysis completely invalid. My criticisms here by no means expose all of his errors. However, what I have provided here is more than enough to demolish Keynes’s ideas. I have shown that he embraces the false view that man has only a limited need and desire for wealth and that this is the fundamental source of his belief in a limited amount of investment opportunities. I have shown that the so-called MEC does not decline with greater net investment but in fact increases. Keynes also commits the logical error of context dropping in connection with the declining MEC. Furthermore, I have shown that Keynes believes that savings and net investment are at their highest points during a depression, when, in fact, savings and net investment are at their lowest points. Keynes also equivocates between changes in wage rates and total wage payments, consumption, and total spending in the economy. He commits the further error of equating the demand for consumers’ goods with the demand for capital goods. His arguments why interest rates will not fall when necessary are invalid. In addition, he equates gross values with net values. This prevents him from seeing the actual significance of the role of saving in spending. Finally, he commits the error of equating saving with hoarding. Given all these errors, it is not surprising that his conclusions regarding savings, investment, and the effects of these things on employment are so thoroughly wrong. Why Keynes’s Claims about Fluctuations and Investment Are Wrong While the fundamental claim of Keynes is that capitalism leads to perpetually high unemployment and thus a chronic state of depression, he also claims that there will be fluctuations about this depressed state, that is, that capitalism will experience a business cycle. His reason why these fluctuations occur is, as I state above, because investment fluctuates wildly (due to wildly fluctuating expectations) and savings remain fairly stable. Even though he claims the fluctuations occur around a depressed state of the economy and economies have not, in fact, remained in depressed states (as well as the fact that I have shown his depression theory to be false anyway), we can

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still consider Keynes’s theory of fluctuations because it can be considered separately. Presumably, the fluctuations could occur around any level of economic activity. I will now show why even his claims with regard to the cause of the business cycle are false. While it may be true that investment fluctuates more than savings, this does not mean the business cycle is caused by such fluctuations. I have shown elsewhere what causes the business cycle.83 Keynes offers no valid evidence as to how fluctuations of investment relative to savings cause the cycle. He offers only the argument that saving equals hoarding and that if investment spending does not offset the hoarding, spending in the economy will be reduced and a “slump” in business will occur. However, the claim that saving equals hoarding is completely false.84 Further, as I said at the end of the section on underconsumptionism, saving in the form of hoarding during a recession or depression—that is, people holding on to higher money balances relative to their spending—is good. It makes people and businesses more liquid after they have become inordinately illiquid due to the government’s inflationary policy. The problem here is not the building up of money balances, but the government’s unsound policies. Individuals and businesses would not have to build up money balances if the government did not create the incentives for individuals to become illiquid in the first place.85 Investment in the economy fluctuates during the cycle for the same reason that fluctuations in liquidity occur: due to the instabilities created by the government’s manipulation of the supply of money and credit. It can also fluctuate for other reasons in connection with the business cycle, such as during the Great Depression when Presidents Hoover’s and Roosevelt’s policies created a dramatic shift from the government following a policy of more or less laissez-faire during depressions to one of creating massive numbers of new regulations and government welfare programs. This dramatically increased the uncertainty and risks businesses faced concerning the potential profitability of their investments. With the prospect of their investments becoming unprofitable due to the government’s violations of individual rights, investors and businesses radically reduced their investment activities.86 Nonetheless, the main drivers of fluctuations of investment during the business cycle are ultimately the government’s manipulation of the supply of bank reserves and its policies that give banks the ability to manipulate the supply of money and credit through the f ractional-reserve checking system. How government policies make it possible for banks to manipulate the supply of money and credit will be discussed starting in chapter 4. Even without government interference in the economy investment might fluctuate more than savings, as well as more than consumption. A certain amount of consumption must take place for people to keep themselves alive, so it makes sense that investment fluctuates more. Moreover, because savings are broader than investment, since they encompass the purchase of consumers’ goods used up over long periods of time (such as homes), it may

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be the case that investment fluctuates more than savings. However, none of this points to these fluctuations causing the business cycle. Fluctuations in investment, savings, and consumption are effects of the business cycle, not causes. Expectations fluctuate for the same reason that investment fluctuates during the cycle: the government’s inflationary policy and then the abandonment of this policy lead to businessmen changing their expectations about the prospects for future profitability. Expectations change because the economic data change as the government manipulates the supply of money and credit. The change in expectations is a case of businessmen reacting to the perverted incentives created by fiat money, fractional-reserve banking, and the corrupt government policies and practices that make such institutions possible and use such institutions to manipulate the supply of money and credit. If the money supply was not manipulated by the government, spending, revenues, profits, and the supply of credit would be more stable, as would expectations regarding changes in these variables. Keynes believes expectations are unstable due to man’s alleged tendency to make irrational investment decisions. Man, according to Keynes, acts on “animal spirits”—an inexplicable “urge to action.” This “urge to action” is precarious and is often not adequate enough to get men to act. It is based on “nerves and hysteria and even the digestions and reactions to the weather.” Only when man is briefly able to overcome his fear of failure is he able to take action in the face of the uncertainty of the future. Keynes states that he does not believe “that everything depends on waves of irrational psychology.” Long-term expectations are “often steady.” However, the essence of his view of investment decisions is that they tend to be irrational. He states that we are “often falling back for our motive on whim or sentiment or chance.”87 Keynes generally believes that investment for the short term is irrational and that investment for the long term is rational. He despises the stock market because he believes it is dominated by “the mass psychology of a large number of ignorant individuals” and that valuations of investments are “liable to change violently as the result of a sudden fluctuation of opinion due to factors which do not really make much difference to the prospective [long-term] yield.”88 His statements are akin to a metaphysical whine about the nature of reality. He whines that people do not focus on making long-term investments, as he wishes. According to him, they focus only on making short-term investments. As Keynes states: For most of these persons [professional investors] are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public. They are concerned, not with what an investment is really worth to a man who buys it “for keeps,” but with what the market will value it at, under the influence of mass psychology, three months or a year hence.89

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Investing for long-term gains, according to Keynes, is virtually impossible in modern investment markets. He states: Investment based on genuine long-term expectation is so difficult to-day as to be scarcely practicable. He who attempts it must surely . . . run greater risks than he who tries to guess better than the crowd how the crowd will behave; and, given equal intelligence, he may make more disastrous mistakes. There is no clear evidence from experience that the investment policy which is socially advantageous [long-term investment] coincides with that which is most profitable.

He states further that “life is not long enough—human nature desires quick results . . . and remoter gains are discounted by the average man at a very high rate.” 90 Unfortunately, Keynes did not live long enough to become familiar with an investor named Warren Buffet, who become a billionaire (and the richest man in the world at one point) using a long-term, buy-and-hold investment strategy in which he identified undervalued companies that had great potential. And there are other, lesser-known investors who have made fortunes following a similar strategy. Keynes also did not live long enough to see the many failed investments of the great majority of professional workers (such as doctors and lawyers) who quit their jobs to engage in day trading over the Internet during the boom of the latter 1990s. Perhaps if he lived long enough he would have seen the millions of workers who invest in mutual funds and stocks for the long term, and build up substantial sums of financial assets, through their employer 401(k) and 403(b) retirement plans. Perhaps he would have seen the rise in popularity of the indexed mutual fund as a way for investors to enjoy the long-term gains of various market segments. Perhaps he would have seen the significant returns one could make by investing in the stock market for the long term. For example, the Dow Jones Industrial Average has increased at about a 5 percent annual rate since the late nineteenth century. Most investors today know that it is easier to make money in the stock market by investing for the long term than trying to predict the peaks and valleys of every short-term fluctuation. Perhaps Keynes would have changed his view had he lived long enough to see the evidence of today, but I doubt it. Significant evidence existed even in his day. Keynes does not base his claims on the evidence. His claims are more often than not arbitrary assertions based on his invalid premise that man is innately irrational and that man cannot be left free to act to further his own life. If man is left free, it allegedly leads to high unemployment and depressions. Keynes’s claims are based on his desire to use government force to make people act as he wishes. Where is Keynes’s evidence that man bases his actions on nerves, hysteria, bowel movements, and the weather? Where is his evidence that man bases his actions on whim, sentiment, and chance? Where is his evidence of these “animal spirits”? Where is his evidence that most investors are concerned

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only with the short term? Where is his evidence that long-term investment is unprofitable? Or his evidence that humans, by nature, desire quick results? He offers no evidence for these claims. Further, why is it that only investment for the long term is rational and that short-term investment is irrational? There are many short-term changes that occur that can, potentially, undermine the long-term viability of investments. This is particularly true in the context of today’s fiat-money, fractional-reserve monetary systems, where statist politicians and government bureaucrats exert a major influence through such irrational and destructive institutions as the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC). These institutions are the source of the short-term fluctuations that exist today that are known as the business cycle. I have discussed the effects of the former institution in detail elsewhere.91 The latter institution creates instability by being partially responsible, through its deposit insurance scheme, for the existence of the fractional-reserve monetary system. The FDIC will be discussed starting in chapter 4. The point to understand here is that these institutions make it necessary for investors and businessmen to focus more on the short term. Also, because of the government’s inflationary policies, discount rates used in placing a value on profits to be earned in the future are generally higher than they otherwise would be. This means more weight is placed on short-term profits and less on long-term profits. To the extent that investors’ and businessmen’s focus is short term, it is largely the irrational policies of statist politicians and government bureaucrats (and the intellectuals who support them ideologically) that are causing it. It would be irrational for investors and businessmen to ignore the destructive influence of these individuals. Nonetheless, even in a fully free market, without the Federal Reserve and FDIC (among other institutions that violate individual rights), short-term investment would not necessarily be irrational and long-term investment would not necessarily be rational. For instance, if the costs of a business temporarily increase due to, say, a temporary disruption in supply of one of its primary inputs (perhaps because of bad weather, such as a hurricane), this could affect the short-term profitability of the business. Such information needs to be incorporated into the value of the company. Of course, Keynes would dismiss this as not having much effect on the long-term yield. Here it would be Keynes that is acting irrational. He would, apparently, ignore an important new fact that makes the value of the company, in the present, less. However, one cannot ignore any new fact when valuing a company. Whenever information changes that affects the value of a company, investors must take this information into account and respond to it accordingly. They cannot pretend it does not affect the value of the company. This would be ignoring the facts. This is irrational. Going by reason (i.e., man’s rational faculty) means always basing one’s actions on the facts, whether they have long- or short-term consequences. This includes even sometimes making decisions based on the weather.

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The ability to engage in short-term investment is important because so many factors affect the value of stocks that cause it to fluctuate in the short term. This is especially true with the existence of so many mixed economies throughout the Western world and outright dictatorships throughout the rest of the world. The interference foisted upon businesses by governments in these types of countries breeds volatility in stock markets and every other market; they are a breeding ground for all kinds of financial and economic disasters. Protecting the rights of investors to engage in short-term investment is extremely important to making investment markets, in general, possible. Without the ability to pull one’s capital out of a market on short notice, vast sums of capital simply would not be invested and a significant amount of the investment funds that are currently available would not be available to companies. The elimination of the ability to engage in short-term investments would mean more savings would take the form of hoarding cash or consumers’ goods (such as precious gems or gold). The productive capability and standard of living throughout the world would suffer dramatically as a result.92 One should bear this in mind when considering the “solution” Keynes proposes to the alleged ills created by short-term investment: government force to prevent or discourage such investment. Keynes also thinks that the basis for one’s actions is a choice between making precise mathematical calculations of the prospective profits and losses of an investment and acting on whim. He states, “Most, probably, of our decisions to do something positive, the full consequences of which will be drawn out over many days to come, can only be taken as a result of animal spirits . . . and not as the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.” 93 This is a false alternative. Decisions in the face of uncertainty can be rational. As long as one is going by facts and logic, even if one does not have all the facts, one’s actions are based on reason.94 Of course, one has to determine whether one has enough information on which to act and one may have to act with very little information or less information than one would like. The desire to always want a precise mathematical outlook of the future is irrational. It is a sign that one is either compulsive and thus suffers from a psychological disorder or one wants to use mathematics in an overzealous fashion (or both). Mathematics is obviously very useful in the assessment of prospective yields but it is neither always necessary nor possible to make a precise mathematical calculation. Keynes’s claims with regard to why investors and businessmen act are completely wrong. If men want to succeed in business, they cannot act on whim or mysticism (i.e., animal spirits). Actions on the basis of such irrational considerations will lead to losses. If one looks at successful businessmen, such as Thomas Edison, Sam Walton, or Bill Gates, one can see they acted based on rational considerations. They did not always make the right decisions (being rational does not mean being omniscient and never making mistakes) but, as proof that they went by the facts, they were willing to change their strategy if they saw that they made a wrong decision.

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Bill Gates and Microsoft provide an excellent example. Microsoft relentlessly improved its products under Gates and still does today. If it finds a flaw in one of its software products, it acts aggressively to correct the problem. Thomas Edison was the same way. He would search endlessly in his laboratory for methods to create innovative products. He performed thousands of experiments just to develop a filament for the light bulb. He understood that failed attempts at developing a product were useful facts and still knowledge gained. He acknowledged and went by the facts by using such attempts to help him find a way to successfully develop products.95 There are many other successful, well-known businessmen who have amassed fortunes and there are countless businessmen who are not well known and who have not amassed fortunes but who have built successful businesses and accumulated significant sums of wealth through rational action. This also provides evidence against Keynes’s claim that the inducement to invest has been weak in the past because of various risks and is weak today because of the accumulation of wealth. This claim is another arbitrary assertion, since he provides no evidence, and thus it can properly be dismissed without consideration, as is the appropriate way to deal with all arbitrary assertions.96 Business owners invest enormous sums of money every day. This includes rich and poor business owners, new and long-established owners, those with innovative ideas that are untested, and those investing in industries and businesses that have been around for a long time. There is certainly no shortage of risk taking in business. One thing that can reduce investment, as I have mentioned previously, is government regulation that creates uncertainty and decreases both the probability of success and the potential returns. Perhaps Keynes confused the drop in investment that occurred for this reason during the period in which he wrote The General Theory with a lack of investment in general. Furthermore, Keynes’s first reason for a lack of investment contradicts his second. He says the inducement to invest has been weak in the past due to “risks and hazards of all kinds” and now it is weak due to “existing accumulations” of capital.97 How, if the inducement to invest has always been weak, have we reached the point where people have invested so much that we allegedly have too much capital invested to provide an adequate rate of return? Further, his claim that investments are engaged in based on “animal spirits,” whim, bowel movements, hysteria, and so forth contradict his claim that the inducement to invest is weak. Why would people who invest based on their bowel movements or hysteria be risk averse or care if rates of return are low or even negative? If this is why they invest, they would not care whether returns are high or low or whether there is great risk or no risk at all involved. They would invest for any arbitrary reason. Moreover, if man by his nature makes irrational decisions, then how will greater government controls on investing—which is Keynes’s proposed solution—lead to more rational investments? If man is irrational, so are government officials. This means the laws that will be passed are irrational and will not improve matters. Likewise, if man by nature is irrational, so

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is Keynes. This implies that either his ideas are irrational or he commits the fallacy of self-exclusion (i.e., Keynes’s ideas apply to everyone but him) and therefore his ideas are not universal truths. Either way, they must be rejected. In the end, Keynes does not even believe the rate of profit is too low. He states: There are valuable human activities which require the motive of moneymaking. . . . But it is not necessary for the stimulation of these activities and the satisfaction of these proclivities that the game should be played for such high stakes as at present. Much lower stakes will serve the purpose equally well, as soon as the players are accustomed to them.98

Keynes is not trying to explain why people do or do not invest. He is really attempting to rationalize greater government control of the economy. The last chapter of The General Theory makes this clear. In this chapter he says he wants enough “communal saving through the agency of the State to . . . allow the growth of capital up to the point where it ceases to be scarce.” He wants to eliminate the scarcity of capital to achieve the “euthanasia of the rentier, and, consequently, the euthanasia of the cumulative oppressive power of the capitalist to exploit the scarcity-value of capital.” He goes on to say “that a somewhat comprehensive socialisation of investment will prove the only means of securing an approximation to full employment.” He states further that “[t]he central controls necessary to ensure full employment will, of course, involve a large extension of the traditional functions of government.” 99 Keynes does not want complete government control of the economy. He just wants more controls than presently exist (at least during the time he wrote, but I am willing to bet he would want more even today). He states that “no obvious case is made out for a system of State Socialism which would embrace most of the economic life of the community.” He says that “there will still remain a wide field for the exercise of private initiative and responsibility.” He does not want outright socialism; he just wants to move closer to socialism. Moving closer to socialism will, of course, ultimately help achieve the goals of the socialists.100 Finally, Keynes’s claims with regard to why people invest in the stock market are all invalid as well. Successful investing is not about predicting “mass psychology.” There is not a day that goes by that investors in the stock market, and other investment markets, are not reacting to good or bad profit reports, the Fed pushing interest rates higher or lower, the dollar being weak or strong, the price of gold rising or falling, prices in general rising or falling, political instability in oil producing nations, changes in dividends, and so on. Successful investing requires correctly forecasting and successfully acting on a whole host of facts that can influence the value of companies and other assets. It most certainly is not a game of predicting what the average investor will do or, as Keynes also states, predicting what the average prediction will

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be of what the average investor will do.101 Using such a method of investing would lead to losses. Man is not by his nature irrational. Man is the rational animal. This means man possesses reason and has the ability to act based on a logical analysis of the facts. If man was not rational, he would not have been able to advance out of the cave, let alone build skyscrapers and develop an industrialized society. It may be that some people invest for irrational reasons. Being the rational animal does not guarantee that all people will choose to be rational or choose to be rational all the time. Man has free will and this involves choosing whether one will be rational or not. However, to the extent that individuals invest irrationally, they will reduce their influence in the marketplace through the losses they incur. The rational will prevail if the freedom to pursue profitable investments is protected.

Conclusion Neither the overproduction nor the underconsumption view of the business cycle (in any of their variations) validly explains why business cycles, recessions, and depressions occur. They, at best, identify one aspect of the cycle (such as the fact that spending for consumers’ goods can decrease during the contraction) and attribute causal significance to that phenomenon. Capitalism does not lead to underconsumption, overproduction, high unemployment, recessions and depressions, monetary induced business cycles, and so on. The price system and profit motive provide the coordinating functions to quickly eliminate any excess supplies or demands should they occur (for labor or anything else). In fact, in the great majority of cases they prevent excess supplies or demands from occurring in the first place. For example, in a capitalist society if workers are laid off and have no savings to live off of, they have the strongest possible motivation to obtain another job and offer to work for lower wages to outcompete other workers. They do not have minimum wage laws or legislation favoring labor unions preventing them from competing for jobs or welfare for the unemployed providing them with less motivation to get a job. Because the freedom to produce and live one’s life is protected under capitalism, the system leads to low unemployment, low costs, a rising productivity of labor, and a rising standard of living for everyone who participates in such a system. While this book does not focus primarily on these topics, we will see in the next chapter some of the coordinating features of capitalism. For further reading on the coordinating features of capitalism and the rapidly rising standard of living to which it leads, see my book Markets Don’t Fail! and Capitalism: A Treatise on Economics by George Reisman. Keynes’s theory of depressions and fluctuations is filled with contradictions, arbitrary assertions, and major logical errors. His view of man is wrong; his theory of the business cycle, recessions and depressions is wrong; and his economic theory in general is wrong. The policy recommendations based on Keynesian ideas will neither reduce unemployment nor eliminate

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the business cycle. They will lead to a lower rate of economic progress, a lower standard of living, and greater instability in the economy. Keynes is responsible for much confusion that exists today in economics. He is responsible for much economic hardship based on the destructive economic policies governments have implemented and which he advocated or which his followers have advocated based on his ideas. The best thing that could happen for the economic future of the world is that his ideas be rejected as quickly as possible.

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K e y n esi a n Busi n ess C yc l e Th eory, Pa r t De u x : I n f l e x i bl e P r ic es a n d Wages

Introduction In chapter 1, I discussed two variations on Keynes’s ideas that his followers advocate. First, I discussed the followers who, in response to mild criticisms of Keynes’s ideas, claimed that falling wages could eliminate unemployment but that wages would have to fall too far to eliminate it and that this would be “hopelessly disruptive” because of the dramatic decrease in spending this would allegedly cause. I refuted this claim in chapter 1. However, there are also the followers who say falling wages and prices might be able to reduce unemployment but that wages and prices are “sticky” (especially in the downward direction with regard to wages) and therefore will not eliminate unemployment very quickly. Furthermore, I mentioned that in more recent years so-called new Keynesians have spent much effort trying to provide reasons why prices and wages are allegedly inflexible. Finally, I stated that the acceptance of these ideas by Keynes’s followers represents a significant abandonment of the substance of the Keynesian position. Followers of Keynes realized the untenable nature of the claim that a reduction in wages could not reduce unemployment, but still wanted to justify government interference in the economy due to their underlying moral disdain for capitalism. In an attempt to keep the Keynesian denunciations of the free market alive—as well as the justification for government violations of individual rights—followers of Keynes have latched on to a few statements by Keynes that claim wages are “sticky.”1 The retreat to the “stickiness” of prices and wages represents an attempt to put Keynesian ideas on life support; it is a last attempt to save Keynesian economics. Such an attempt is futile because Keynesian economics is intellectually bankrupt. Nonetheless, this is a popular theory of the business cycle today and a widespread rationalization for government violations of individual rights through so-called monetary and fiscal policies (among other means). It is also a popular reason given for why the recovery from a recession or depression takes so long. It is a part of the standard Keynesian treatment of aggregate supply and demand analysis (specifically, why the aggregate supply curve is flat or upward sloping).

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I now proceed to show why inflexible price and wage theory is invalid. I first discuss what Keynesian inflexible price and wage theory is and then show the theoretical problems with the theory. Next, I discuss empirical evidence concerning the nature of how prices and wages change in the economy. Finally, I show why the speed at which prices change, when they are free to do so, does not cause the business cycle and does not lead to extended periods of stagnation.

Inflexible Price and Wage Theory The inflexible price and wage theory of the business cycle says that capitalists and businessmen are reluctant to change prices and therefore, in the face of continuously rising spending, business owners step up production since there will be more demand for goods with a greater volume of spending if prices have not risen to offset the spending. This constitutes the essence of the expansion phase of the business cycle. Eventually, businessmen give in and raise prices because, as advocates of this theory state, firms run out of excess capacity with which to increase production. Hence, prices rise to catch up with the increased spending, production is reduced, and the contraction phase of the business cycle sets in.2 The above description is one way Keynesians use “sticky price and wage theory” to explain the business cycle. Another version of the theory says that spending increases during the expansion but decreases during the contraction. The expansion phase in this version looks like the expansion phase discussed in the first version of the theory. As spending increases during the expansion, prices and wages do not rise quickly enough and thus employment and output expand in response. If prices and wages increased sufficiently in the face of the increased spending, according to Keynesians, no increased output or employment would result. The contraction phase is a little different than in the first version of the theory. Here, as spending contracts during the recession or depression, prices and wages do not fall quickly enough to offset the decreased spending. If they did fall quickly enough, the same goods and labor could be purchased with the decreased money and spending. Therefore, output and employment would not decline and the contraction could be averted. In this scenario, inflexible price and wage theory is supposed to explain why output fluctuates more during the cycle than prices. It is also supposed to explain why recessions and depressions can be so deep and last so long. Up through the 1970s, Keynesians did not try very hard to understand why prices and wages are allegedly inflexible. They just assumed that prices and wages are inflexible in a free market.3 Furthermore, they did not provide a proper standard to use as a basis of comparison to determine whether prices and wages are inflexible. Starting in the 1980s, more effort was placed on attempting to provide reasons why prices and wages are inflexible. Since then there has been no shortage of reasons, provided by Keynesians, concerning why prices and

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wages are allegedly inflexible. However, no attempt has been made to provide a proper standard against which to judge whether inflexibility exists. Let us consider some of the explanations, given by Keynesians, of price and wage “stickiness.” First, focusing on prices, there is the “menu cost” theory of price inflexibility. The typical example is the cost to a restaurant of changing the prices on its menu (hence the name “menu cost”). This involves the cost of printing new menus. Some firms might have to print new catalogs and would have to incur a cost to do that, although with the rise of the Internet the cost incurred is more often than not just updating one’s website. These costs give businesses an incentive to change prices less frequently than they would if they did not have to incur such costs.4 Related to this is the idea that prices are inflexible due to what is called “administered pricing.” The claim here is that prices are set for an extended period of time for certain types of products and are changed only periodically. For instance, an automobile manufacturer might set the prices on its various models of cars and trucks and not change them for a year. The alternative to “administered prices” is prices that are established in an auction market, where they would be determined, presumably, minute by minute for all products, even for automobiles.5 The idea of “administered prices” is not fundamentally different than the idea of price inflexibility due to “menu costs”: a firm might “administer” its prices due to the costs of having to frequently change its prices. “Administering” prices and prices being determined in an auction market are distinguishing characteristics of “imperfectly competitive” and “perfectly competitive” markets. Prices are said to be determined in an “administered” fashion in the former markets while pricing in an auction format is said to capture the essence of how prices are determined in the latter markets. Furthermore, one might have contracts with one’s customers that stipulate the prices to be paid and thus prevent one from changing prices for a significant period of time (or changing them enough), until the contracts expire. This might occur, for example, in the cases of rental contracts with building tenants and purchase contracts with business customers. A variation on this argument is that a firm might have implicit, rather than explicit, agreements with its customers not to change prices. It might be implied that a firm will not raise prices (or not be able to raise them enough or will have to delay raising them) as demand increases. Likewise, it might also be implied that a firm will not be required to lower prices (or will not be required to lower them as much as dictated by market conditions or will be allowed to delay lowering them) as demand decreases.6 Moreover, firms might be afraid to raise their prices because other firms might not follow suit. If you are the only firm that raises your price, you could lose a substantial number of customers. Hence, firms might be hesitant to raise their prices. This sometimes goes by the name “coordination failure” in the Keynesian literature because it allegedly represents an inability of firms to coordinate their price increases. In addition, if a firm lowers its price other firms might lower their prices so they do not lose substantial

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business to the one that initially lowered its price. Hence, the price reduction might not lead to a very big increase in unit sales since one’s price relative to other firms’ prices is the same as prior to the price reduction. This provides a disincentive to lower one’s price. The combined effect of firms being hesitant to raise or lower their prices falls under what mainstream economists call “kinked demand curve theory.”7 There are many more reasons Keynesians give regarding why prices are allegedly inflexible. I have only given a few of the main reasons here to provide the reader with a basic understanding of the kinds of reasons Keynesians give.8 One can see that the specific reasons why businessmen are supposed to be reluctant to change prices vary, but they mainly involve some cost or disadvantage associated with changing prices or an inability to change prices. Whatever the reasons, price changes are said to be performed infrequently. Changes in production are said to be less costly or easier to engage in and thus occur more frequently than changes in prices. “Sticky price theory” also says that wages, which are the price of labor, are inflexible and help to cause the fluctuations in unemployment that occur during the business cycle. For instance, as spending for labor rises at a constant rate (with a general increase in money and spending) but wages fail to follow, unemployment decreases. Likewise, as wages rise to catch up with the rise in spending, more unemployment is created. These fluctuations coincide with the expansion and contraction phases of the business cycle, respectively. As with so-called price inflexibility, wages are also considered to be inflexible because of the existence of contracts and “administered wages.” With regard to contracts, it is claimed that because wage contracts are negotiated infrequently—perhaps only once every three years—wages will not change much (or enough) during the period of time that elapses between new wage contracts. Further, because wage contracts are uniform across many workers, relative wages—the differences in wages for various types of jobs—are said not to change very quickly. Hence, it is claimed by proponents of this theory that wages (including relative wages) remain inflexible (or, at least, insufficiently flexible) for significant periods of time, followed by changes in wages during a new contract year.9 With regard to so-called administered wages, the claim is that wages are set for an extended period of time for certain categories of workers and are changed only periodically. The wages are not fixed contractually in the case of “administered wages.” Firms in markets in which wages are “administered” presumably can get away with setting them only infrequently (or have incentives to set them only infrequently) and therefore do so. As an example, a bank might set wages for secretaries, tellers, loan consultants, et cetera and not change the wages for a year or two. The alternative to “administered wages” is, as with the alternative to “administered prices,” an auction market for labor where, again, presumably, wages for all workers would be set minute by minute.10 The problem with the labor market, according to one Keynesian economist, is the long-term nature of the relationship between the employer and

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the employee: workers’ jobs tend to last for a significant period of time and wages for any particular worker do not fluctuate radically to reflect changes in supply and demand in the labor market over that period. If only all employers and workers could get together and agree on the level of employment for each type of job, wages would not be inflexible and therefore unemployment would not be unnecessarily high during certain periods. The alleged ideal would be for all employers and workers (or, at least, all employers and workers within each field) around the country (or globe for that matter) to get together to determine wages in a spot market for labor. Then wages would not be “sticky.”11 As a part of the inflexibility of wages, it is claimed by advocates of this theory that wages are particularly inflexible in the downward direction. This is used to explain how contractions are made worse than they otherwise would be had wages been “sufficiently” flexible. This means, allegedly, that unemployment is higher, declines in output are larger, and recoveries are longer during contractions. While by far the most focus of Keynesian economists is on the inflexibility of wages in the downward direction, and it is generally believed that wages have much more downward inflexibility than prices more broadly considered, prices in general are not immune to downward inflexibility according to Keynesians (as discussed above). Firms might not be able to lower their prices when economic conditions necessitate it. This, too, allegedly exacerbates recessions and depressions. For example, the downward inflexibility of wages and prices is used by Keynesians to explain the high unemployment and low output during the Great Depression. Many reasons are given why wages are quicker to rise than to fall and for unemployment to remain persistently high. For example, it is said that workers gladly accept higher money wages, since this is associated with a higher standard of living, and are resistant to accept lower money wages, since this is associated with a lower standard of living. As Paul Samuelson and William Nordhaus put it in the context of potentially lower wages, “a machine cares not a bit about its price, but workers care a great deal about their wages. So when you tried to reduce wage rates, existing workers would probably resent you, call you a ‘union-busting scab,’ and pelt you with eggs.”12 This also serves as an argument, by Keynesians, for why wages are more inflexible than prices more generally. Another reason given is “efficiency wage theory.” This theory says employers pay wages above the market-clearing wage because it leads to greater worker loyalty and enables employers to attract and retain higher quality workers. This leads to greater productivity and efficiency for the firm. However, as a consequence, this is supposed to lead to persistently high unemployment because the wages are allegedly above the wage that would clear the labor market, and presumably employers are reluctant to lower wages because this would lead to lower productivity and efficiency.13 So-called insider-outsider theory is allegedly another reason for wages not falling very quickly to reduce unemployment. The claim here is that workers

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already working at the firm (the insiders) influence the hiring process so that it is harder for the firm to hire additional workers (the outsiders). As stated by two Keynesian economists, “After an adverse shock that reduced employment, workers who are still employed have no desire to cut the nominal wages so as to increase employment.”14 How exactly “insiders” influence the hiring process is not always clearly stated. However, presumably workers will be able to strike (in the case of unionized workers) or reduce their work effort (in the case of unionized and nonunionized workers) if they do not get the wages they want.15 Yet another unemployment theory put forward by Keynesians is the “hysteresis” theory. Based on this theory it is claimed that the longer someone remains unemployed the harder it is for that person to gain employment. Hence, the long-term unemployed allegedly exert less influence in the labor market and thus put little or no downward pressure on wages so that unemployment can be reduced. Reasons for why the long-term unemployed might exert little influence on the labor market, according to Keynesians, include their skills atrophying and the workers therefore not being able to compete in the labor market. They might also become discouraged in their search for a job and their search intensity might decrease.16 There are other reasons Keynesians give for why wages have downward inflexibility, but this gives one an idea of the arguments provided.

A Refutation of Inflexible Price and Wage Theory There are many problems with “sticky price and wage theory,” both theoretically and empirically. I first discuss the theoretical problems and then the empirical ones. Finally, I discuss the implications of so-called sticky price and wage theory. I discuss the features that would accompany a “business cycle” created by inflexible prices and wages, if they did create one. I show that such cycles would not include all of the features of actual business cycles. By the end of the chapter, one will see that “sticky price and wage theory” does not explain many of the main characteristics of the business cycle, it does not agree with many other economic facts, it is based on a false theory of competition and pricing, and it contains many logical inconsistencies. At that point, one will be able to completely reject “sticky price and wage theory,” both as a theory of the business cycle and as an explanation of how prices and wages change. Theoretical Problems with Inflexible Price and Wage Theory Problems with Various Reasons Keynesians Use to Claim Prices and Wages Are Inflexible While Keynesians might actually have identified some reasons why firms delay changing prices, their analysis is not comprehensive or logically rigorous and therefore is of poor quality. Let us take a look at why this is the case.

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First, consider contractually fixed wages. Keynesians claim that wages are inflexible because they are often contractually fixed and new contracts are negotiated only infrequently. However, contracts usually include clauses to allow sufficient flexibility. During times of rapid (or even moderate) inflation, most wage contracts have automatic, preset increases in wages during the length of the contract that account for expectations about the rise in the general price level. If inflation and the increases in prices it creates are erratic, a contract might adjust wages based on a cost-of-living index. Finally, if during the length of the contract inflation occurs at a much different rate than expected and no means to appropriately adjust wages exists within the contract, the contract can be renegotiated earlier than planned.17 Many precautions can be taken and methods used to ensure wages are as flexible as they need to be. Similar means of adjusting prices can be used in contracts firms have with their business customers regarding the purchase of goods. So such mechanisms can be used to create sufficient flexibility in the prices of goods as well. In addition, contracts that stipulate fixed prices and wages (or that stipulate prices and wages that, in general, do not correctly anticipate changes taking place in the economy) must have an effect on the prices of future purchases and the wages of workers hired in the future to induce changes in the amount of goods purchased or workers hired as spending changes. To the extent the contracts apply only to past transactions, they will not influence future purchases or hiring. For example, if spending is rising but wages are contractually fixed for current employees only, firms will still have to pay current market wages to hire new workers. This means the fixed wages will not induce additional hiring since firms will have to pay higher wages for newly hired workers. As another example, if businesses rent property to others and have longterm leases with fixed rental rates, it does not prevent them from raising rents in future rental agreements if spending in the economy is rising. The contracts only apply to property rented in the past, not future rentals. Rents in future contracts can still take into account any changes in market conditions not captured by existing rental agreements. So no additional transactions are induced by the contractually fixed rents. Note that the lack of ability, identified here, of contractually fixed prices and wages to explain fluctuations in economic activity is not insignificant. The rental example itself has great significance because the construction industry plays a large role in the business cycle. This industry is usually one of the largest and earliest movers during the business cycle and the rental real estate business accounts for a significant portion of the fluctuations in this industry. One would think, based on inflexible price theory, that contractually fixed rents would explain these fluctuations (or, at least, a large portion of them), but they do not. However, the theory of the business cycle put forward in this book does explain these fluctuations. Specifically, changes in interest rates and the rate of profit caused by the manipulation of the supply

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of money and credit by the government explain such fluctuations.18 Notice also that it is changes in prices that are a part of this explanation, not constant or inflexible prices. Moreover, one must not forget how government interference forcibly prevents prices from changing appropriately. For example, natural gas, electric, cable, and other utilities are often forced to sell at prices fixed by public utility commissions (PUCs). This inflexibility is not a feature of the free market and the nature of contracts; it is due to government coercion. To change their prices (or the rate of change of their prices), utilities must petition the PUC to obtain permission to make the change, which can be a lengthy, drawn-out process. In the meantime, if, for example, the money supply and spending are increasing more rapidly than expected and prices are unable to be raised appropriately due to the regulations, buyers of these goods and services can purchase greater quantities. The effect of government interference must be kept separate from the costs of changing prices in a free market because it has nothing to do with a free market. It is a fundamentally different cause of how prices change than, say, the cost of changing prices on a menu. Without this type of regulation, prices would be much freer to fluctuate. There are rational reasons why firms and their customers or employees might want to engage in long-term contractual relationships to fix prices and wages (or the rate of change of prices and wages). For example, it helps create stability in the prices and wages one receives or pays and thus helps one plan one’s life or business activities in a much easier fashion. Imagine the uncertainty workers would face if wages were actually determined in an auction market and workers thus had to be concerned about their wages changing from one minute to the next. One minute a worker might be paid $30 per hour and the next minute $10 per hour. I am certain that Keynesians and other statists would scream for government controls to stabilize wages—and rationalize it with theories that justify “sticky” wages—if wages were actually determined in this manner.19 Contracts, more generally considered, also make the terms of trade explicit and help prevent confusion about who is obligated to do what. However, contracts can be written, and even renegotiated, to ensure that prices and wages can change when necessary. So there is no problem in ensuring that the proper amount of flexibility in prices and wages exists, that is, the amount that prevents economic inefficiency. The key is to ensure that all parties to a contract have the ability and motivation to negotiate appropriate terms for the contract. This means that sellers of both goods and labor must have the ability and incentive to establish an appropriate price and negotiate a new price if necessary. Government interference can prevent appropriate contracts from being negotiated. For example, providing subsidies to businesses can take away the incentive to charge a higher price or renegotiate a contract for a higher price if necessary. In addition, imposing maximum price controls on businesses can legally prevent them from charging a higher price. Furthermore, legislation that favors

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labor unions can take away the incentive of workers to accept lower wages or renegotiate their labor contracts should business turn down. This legislation can provide such an incentive because it often forces employers to hire union workers and thus stifles competition from nonunion workers and gives unions artificial powers to impose higher wages on employers (i.e., wages higher than their members could earn in a free market). To give all parties the ability and incentive to negotiate appropriate contracts, one must protect individual rights and freedom so no perverse incentives are created by government interference and each party can engage in contractual relationships that are in its self-interest. Another critique of the Keynesian “sticky price” argument pertains to the case of firms not being able to coordinate their price increases, which leads to delays in price increases. This problem could easily be solved by firms communicating with each other to explicitly coordinate their price changes. Unfortunately, such coordination is made illegal by the antitrust laws. So it is government violations of individual rights that prevent prices from being more flexible in this case. Moreover, one must consider the cost of not raising prices, which is not emphasized by the Keynesians. If other firms in an industry refuse to raise their prices in the face of the need to do so, it might pay a firm to raise its price even if it is the only one to do so. If a business refuses to raise its price when necessary, it will likely incur costs in the form of input prices that have risen relative to its selling prices. This will reduce profitability. This cost could be larger than the cost of a firm raising its price while others leave their prices the same. So it is not clear that the latter cost will prevent a business from raising its price. At some point it would pay a firm to raise its price even if other firms do not. Furthermore, as a firm expands production because of its refusal to raise its price, it will incur additional costs. For example, it may have to put existing workers on overtime or hire new workers. Putting workers on overtime raises costs because workers must be paid a premium to work overtime. Hiring new workers requires businesses to incur the cost of recruiting and training them. These can be substantial. Again, it is not clear that the cost of raising prices would always be greater. What about the alleged inflexibility of prices in the downward direction? Here Keynesians are a little better; however, they still miss a number of facts. To understand what happens in this situation, one must recognize that prices tend to gravitate toward costs of production plus a going or average rate of profit in the economy.20 Further, one must recognize that industries often have a price leader: one firm that is more efficient than the rest and that has lower costs of production. In this case, the price leader can afford to lower its prices because of its lower costs. It does not matter to the price leader if other firms lower their prices because it can maintain profitability (and even increase it) due to its lower costs. If the other firms do not match its efficiency, they will lose money and have to eventually raise their prices. The price leader has no reason to be hesitant about lowering its prices.

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One must also understand that while in some cases firms might not change their prices because other firms are not willing to change theirs or due to explicit or implicit agreements not to change them, the speed of adjustment of prices is not the fundamental factor with regard to the business cycle. Even if firms fully and immediately raise their prices in response to an increase in spending, the expansion phase of the business cycle will still occur. As spending increases, the prospect of selling at rising prices merely signals greater profitability and spurs greater economic activity, as it did during the housing boom prior to the 2008–9 recession. Moreover, even if prices rise, credit will still be easier to obtain since interest rates will be low (at least relative to the rate of profit) due to the process of credit expansion. The lower interest rates will also induce greater investment and shift investment from short-term to long-term projects due to the effect lower discount rates have on the present value of future income streams. In addition, rising spending and revenues make debt taken on in the past easier to pay off. Profitability is what drives businesses to change their production quantities, and the fundamental economic factor that affects economy-wide profitability as a part of the business cycle is changes in the amount of money and spending. Greater spending in the economy raises profitability, and the thing a business must do to make a profit is produce, not raise prices. Likewise, if spending has declined and profits have turned into losses, businesses must reduce production to avoid further losses. A business owner will only succeed in driving himself out of business if, in the face of dramatic losses, he declares, “We must lower prices and keep producing!” As with rising prices in conjunction with increased spending, falling prices do not eliminate the effects of decreased money and spending. Falling prices with decreased spending merely confirm to businesses that the economic outlook is not good and that they should cut back on production. Credit will also be harder to obtain because interest rates will be high (again, at least relative to the rate of profit) due to the process of credit contraction. Investment will also decline and shift from long-term to short-term projects due to higher discount rates. Furthermore, any debts taken on by businesses in the past will still need to be paid off. Even if prices fall, these payments will be harder to make as spending and revenues decline. If a business has a 15-year loan with fixed payments on a factory it owns, falling spending and revenues will make it harder or impossible to make those payments. The key to being able to begin the recovery is not that prices must fall but that the financial contraction must be allowed to run its course so that it can come to an end as quickly as possible. Another factor that allegedly creates “stickiness” is so-called efficiency wages, that is, employers paying wages higher than the market-clearing wage. Keynesians claim that this prevents wages from adjusting downward quickly. High unemployment is supposed to persist as a result. The problem here is that Keynesians fail to keep the entire context of this theory in mind. Remember, the higher wage is paid to improve efficiency and/ or productivity (hence the name efficiency wage). What this means is overall

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costs are either reduced or remain the same when the efficiency wage is paid. They are reduced if the cost reductions, due to the efficiencies gained, more than offset the higher wage paid. They are the same if the cost reductions, due to the efficiencies gained, exactly offset the higher wage paid. If the reduced costs due to the efficiencies gained do not at least offset the cost of the higher wages, employers will not pay the higher wages. Because of this, the reduced costs justify the higher wage; they make it possible for employers to afford the higher wage. Therefore, the “efficiency wage” is the market clearing wage; no additional unemployment results from employers paying such a wage. The only results are a greater production of wealth and a higher standard of living in the economy with the same amount of employment. What about the claim that wages are inflexible relative to other prices because workers resist wage decreases, so it is difficult for wages to fall? To quote Samuelson and Nordhaus again, “a machine cares not a bit about its price, but workers care a great deal about their wages.”21 Prices can allegedly fall more easily for nonhuman factors of production than for human ones. Again, Keynesians ignore a crucial fact with such a statement: machines might not be human but their owners are and their owners do care about the price that can be obtained for their machines or the output from their machines. If I own a business, the output I sell represents my livelihood and you better believe I am going to be very concerned about the selling price of my product falling because, ceteris paribus, it will mean less income for me. Even worse, it could mean losses, which wage earners most certainly do not have to be concerned with since their wages are never negative. So this reason for why the prices of human factors will not fall as easily as the prices of nonhuman factors is not valid. The different type of relationship between business owners or managers and their workers versus that between businesses and their suppliers of other factors of production might have an effect on how wages move in comparison with the prices of other factors of production. The relationship between employers and their workers tends to be closer and more long term. An employer might see his employees every workday. This provides an opportunity to build closer relationships with them than with suppliers, who one might never meet in person. The relationship with employees probably does tend to render wages less flexible than other prices. This is probably one of the reasons why unemployment is one of the slowest variables to change during the business cycle. Unemployment tends to remain low well into recessions and high during recoveries. This factor applies in particular to the slow rise of unemployment during recessions. Keynesians might rejoice at this point since it appears that their analysis is validated (at least based on this factor). However, their analysis is not valid because such inflexibility does not create any type of economic inefficiency. There are rational reasons why wages change more slowly. First, because of the relationship they build with their employees, employers will tend to have respect for their (good) workers and thus have positive feelings toward them.

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No one wants to kick hard-working, ambitious, and talented individuals into the ranks of the unemployed if he can help it. As a result, employers will wait as long as possible, hoping for business to pick up, before doing this. There are not only rational personal reasons not to lay off workers or reduce their pay as soon as business declines, there are rational economic reasons as well. Businesses delay layoffs and reductions in worker pay to reduce hiring costs, maintain worker morale, and improve their reputation as an employer in the labor market, the latter of which helps businesses attract good workers. This also explains why unemployment remains higher during the recovery than it otherwise would. When hiring workers, employers must be careful to make sure they really need the workers. It is not good for a business to hire and lay off workers in a haphazard manner. It is very costly to hire and then lay off workers that one ended up not really needing or laying off workers that it turned out one did need (and thus having to go through the process of rehiring those workers or hiring new ones to replace them). This can even reduce the morale of workers that are retained in their positions when they see their coworkers constantly coming and going due to layoffs and rehiring. It will be more difficult for an employer to attract good workers if it gets a reputation for being too quick to hire and lay off workers (or too quick to raise and lower their pay) with each fluctuation in business during the cycle. So Keynesians have nothing to rejoice about. Their analysis on the alleged inflexibility of wages (especially in the downward direction) is far from complete. It does not identify any actual economic inefficiency that exists in the labor market and it fails to identify a number of economic efficiencies that result from the nature of the labor market. Another criticism of so-called sticky price and wage theory pertains to the claim that the inflexibility of prices and wages during a recession or depression makes these events worse by deepening and prolonging them. First, it must be emphasized that this claim is not actually a theory of what causes recessions and depressions. It assumes that the downturn is already present. The inflexibility under this scenario, even if it is true, does not explain the origin or cause of recessions and depressions but only, at best, the deepening and prolonging of recessions and depressions. Prices and wages often do fail to adjust appropriately during recessions and depressions and at other times. However, it is not because of some inherent rigidity of prices and wages. What “sticky” price and wage advocates typically fail to recognize is that, when prices and wages do not move quickly enough and economically harmful results are created, government violations of individual rights in the economy are generally the cause. Governments forcibly prevent prices and wages from changing in a number of ways. For example, government coercion in the form of minimum wage laws keeps wages of unskilled workers artificially high and as a result prevents wages from adjusting downward. In addition, price controls more generally—of both the maximum and minimum variety—often prevent prices from adjusting appropriately, such as in the case of rent controls

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in various cities throughout the United States or in the case of maximum price controls on oil, gasoline, and natural gas in the 1970s or on all products in the United States during World War II. Further, legislation that favors labor unions—including the National Labor Relations Act and the Norris-La Guardia Act—is often used to force employers to hire union workers (instead of protecting the right of employers to hire whomever they want). This makes it possible for unions to force wages up to artificially high levels, prevents employers from hiring nonunion replacement workers in many cases, and thus prevents wages from falling when necessary. As a final example of government violations of rights creating rigidity in prices and wages, there is the case of Herbert Hoover using the presidency as a bully pulpit to keep wages high during the Great Depression. This prevented wages from adjusting appropriately and caused (at least in part) the economy to sink into a deep depression. It is only when prices and wages are prevented from moving due to government violations of individual rights that economic inefficiencies result, such as unemployment from minimum wage laws. So-called price and wage stickiness from voluntary trade in the marketplace—whether due to so-called menu costs, explicit or implicit contracts, or anything else—does not lead to economic inefficiency. Voluntary trade in a free market leads to economically rational delays in price and wage changes (when they occur). It does not lead to high unemployment or “too much” or “too little” production. Freedom provides the means for people to find employment when they need it and determine the appropriate amount of goods to produce. The incentive of the profit motive and coordinating features of the price system (including wages in the labor market) ensure this. Keynesians typically advocate government interference in the marketplace in response to price and wage “stickiness.” However, this is a case of advocating government controls to solve the problems of previous rounds of controls. Of course, the additional controls will not solve the problems created by the previous controls but will merely add to the problems. The only proper solution is to get rid of the government controls preventing prices and wages from adjusting appropriately. Here is an example. Minimum wage laws cause unemployment by making it more expensive for employers to hire workers and thus decreasing the number of workers that employers can afford to hire. In response, because more people are unemployed, politicians and advocates of the welfare state want to provide them with welfare—so-called unemployment insurance. Welfare for the unemployed—rather than unemployment insurance—is a better description of what the unemployed receive because it is a transfer from employers to the unemployed, since employers are forced to pay a tax to finance the payments to the unemployed. Furthermore, the welfare is often extended. For example, during the 2008–9 recession welfare for the unemployed was extended from six months to, in some cases, almost two years. I do not know of any case in which holders of an insurance policy can receive almost quadruple the benefits with no increase in premium.

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What does the unemployment welfare do? It further increases the unemployment rate! Now those who are unemployed have a greater incentive and ability to remain unemployed since they are being paid to not work. So it ends up making the problem worse. The solution to the problems caused by minimum wage laws is the same as the solution to the rest of our economic ills: the protection of individual rights and freedom. In this example, the solution is not to make it easier for people to remain unemployed, but to abolish minimum wage laws. Government violations of individual rights also explain why so-called insiders are able to have much more influence over the hiring process than they would otherwise be able to. It also explains so-called hysteresis in unemployment. Why is it that current workers are able to exert so much influence over the wages employers offer? The answer: because of legislation that gives unions power to force employers to do business with the unions. Sometimes Keynesians even admit this, although they typically place very little emphasis on it.22 Unions can influence the hiring process by, for instance, threatening to strike if their terms are not met. In a free market, workers would simply be fired for walking off the job. However, this cannot be done in a mixed economy in which legislation exists that violates the rights of employers, in this case by preventing employers from firing striking union workers and hiring permanent, nonunion replacements if that is in their self-interest. If a buyer is forced to do business with one particular seller, this gives great power to the seller to dictate the terms of the sale in ways that he would not be able to had the buyer not been forced to do business with him. Think of the power to raise prices that grocery store owners would possess if consumers were forced to purchase their groceries at one particular store. The results are no different in the labor market when employers are forced to purchase their labor from one seller of labor: the union. Sure employers can negotiate with the union over worker pay and other terms of employment, just as consumers who are forced to purchase their groceries at one grocery store could negotiate with the grocery store over prices. However, the fact remains that unions have enormous power over employers because employers are forced to deal with the unions. So-called insiders would have a greatly diminished ability to influence the wages of so-called outsiders if the rights of employers to hire whomever they wanted were protected. What about so-called hysteresis? Why is it that once individuals are unemployed they can afford to remain unemployed for an extended period of time? The answer: in the absence of any savings or charity to live off of, they can afford to because they receive welfare for the unemployed. Again, sometimes Keynesians admit this but they place very little emphasis on it. They focus on many other reasons why hysteresis allegedly occurs.23 But those reasons are not valid. They are effects of giving welfare to the unemployed. For example, it is claimed that unemployment might persist because workers’ skills might atrophy and the workers might therefore find it harder to obtain employment the longer they remain unemployed. The first question to ask here is: how can a worker afford to remain unemployed long enough

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for his skills to atrophy? He can, barring access to savings or charity, due to welfare for the unemployed. What if he has a hard time quickly finding a position that best uses his skills? In this case, he might have to lower the wage for which he is asking, look for a position in a wider geographic region, or temporarily accept a job that is not in his preferred field while he continues to look for something in his preferred line of work. What if he has savings and chooses to live off of it long enough for his skills to atrophy? In this case, as his savings dwindle he will have to accept a job for which his atrophied skills are adequate. He will not be able to afford to remain unemployed. Another reason claimed for the existence of hysteresis is that the intensity of the search of an unemployed person might decline if he remains unemployed for a prolonged period of time. This is said to occur because he might become discouraged about his prospects of finding a job that satisfies him. However, without welfare for the unemployed an unemployed person will have to find a job to support himself (assuming, again, he has no savings and cannot rely on charity). This should provide an adequate incentive to keep the intensity of his search high enough to find a job. And there are other Keynesian arguments that fall victim to a similar fate. Regardless of the scenario, the protection of individual rights prevents “hysteresis” from occurring. So, there are a number of problems with the claims Keynesians make regarding why prices and wages are inflexible. We have seen that sufficient flexibility can be incorporated into contracts and inflexibility does not necessarily lead to economically harmful results (in fact, any inflexibility in a free market will tend to be beneficial). Keynesians also fail to take into account the limitations in the ability of contractually fixed prices and wages to affect economic activity. They do not consider the costs associated with failing to raise prices and why some firms may be willing to lower prices even if other firms do. They fail to recognize that the important factor with regard to the business cycle is not changes in prices (or a lack thereof) but changes in spending, interest rates, and profitability. With their “efficiency wage theory,” they fail to properly identify the equilibrium wage. They also fail to recognize the important role the profit motive plays in assuring adequate flexibility in prices and wages. Most importantly, they fail to recognize the major role government interference plays in creating inflexibility in prices and wages and the important role protecting individual rights and freedom plays in creating adequate flexibility in prices and wages. The Inappropriate Standard Keynesians Use to Judge Whether Prices and Wages Are Inflexible The most fundamental critique of “sticky price and wage theory” pertains to the standard Keynesians use to judge whether prices and wages are “sticky.” Keynesians and mainstream economists in general often think that, in order for markets to be efficient, prices and wages should change instantaneously in response to even the smallest changes that occur in the supply and demand for goods and labor. Prices and wages should be determined in an auction market so they adjust appropriately, according to this view. Otherwise, prices

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and wages are “administered.” As I stated above, “administered” prices and wages allegedly exist in what are known as “imperfectly competitive” markets, whereas price determination by auction occurs in what are known as “perfectly competitive” markets. Perfect competition is an ideal form of competition according to mainstream economists. Prices being determined in an “administered” fashion allegedly leads to inefficiencies, such as high unemployment due to a slow adjustment of wages. In fact, according to Samuelson and Nordhaus, this is the fundamental reason that labor markets are inefficient.24 Perfect competition is an invalid theory of competition. This is the case because the theory excludes many characteristics of competition. For example, can firms compete by becoming more efficient through economies of scale? Not according to perfect competition. There must be a large number of small firms in an industry according to this theory of competition, and no one firm can be larger than any other. Likewise, can firms differentiate their products to gain a competitive edge over their rivals? Again, the answer is no. Firms must all produce identical or homogeneous products according to this theory. Becoming large and efficient through economies of scale and differentiating one’s products create elements of monopoly power according to the theory of perfect competition. They lead to “imperfect competition.” Nevertheless, differentiating one’s products and gaining economies of scale are key ways in which firms compete. To reject them as aspects of competition is to have a thoroughly flawed concept of competition. These are not the only characteristics of competition that “perfect competition” excludes. Firms also need to possess “perfect” or complete information about their markets according to this theory. This basically means omniscience with regard to production. Firms must know all the best prices for inputs and where they are sold, all the best production techniques, the location of all the customers for the good, and so forth. The problem with this characteristic—besides the minor fact that humans are not omniscient— is that a part of competition is competition concerning knowledge and information. For example, gaining knowledge about how to produce a better product through research and development, gaining knowledge about one’s potential customers through marketing research (such as focus group studies), and disseminating information about one’s product through advertising are all a part of competition regarding knowledge and information. Firms are not supposed to compete in connection with knowledge and information according to perfect competition. They are supposed to already possess all relevant knowledge. If they do not, competition is lacking according to this theory. An element of monopoly power exists (for the firms possessing more knowledge and information) if all firms do not have the same knowledge and information, according to this theory. The last characteristic of perfect competition I will discuss here is that all producers in a so-called perfectly competitive market are “price takers.” That is, they have no ability to influence the price in the market, so they

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take whatever price is offered in the market. Firms are “price takers” because if a market is comprised of a large number of small firms selling identical products and possessing perfect information, only one price will prevail in the market and no firm will be able to charge a different price. A firm cannot raise its price above the market price because it will lose all its business to others. Furthermore, why would it lower its price below the market price since it can sell as much as it wants at that price? The fact is, though, most firms set their price; they are not “price takers” but “price setters.” They set their price based on the costs of production they can achieve or that they think their competitors can achieve. So, perfect competition has nothing to do with competition and actually means the absence of competition because it says that activities such as differentiating one’s product, gaining economies of scale, gaining knowledge about customers, and so on are not a part of competition when, in fact, they are the competition.25 The “ideal” of prices and wages changing instantaneously follows from the characteristics of “perfect competition.” If there are a large number of small firms that produce identical products, possess perfect information, and are “price takers,” prices should change instantaneously. However, this is a Platonic ideal and is invalid. It is completely divorced from reality. The idea of prices changing instantaneously in all types of markets is absurd. It is impossible for prices in markets other than those of actual auction markets to change in such a manner, and it would be extremely inefficient if all prices were to do so. Further, imagine if all workers and employers had to get together periodically to determine wages. The costs would be enormous, even with advances in computer technology. The same is true if prices and wages changed instantaneously in response to every little change in supply and demand. The consideration of such an idea as valid represents a complete rejection of reality. One has to take into account the nature of reality—in this case the nature of the goods and services being bought and sold, among other things—to properly explain how it is that prices and wages can be determined in an economically efficient and effective manner. Products and services being bought and sold in the labor market and the markets for most goods cannot change hands instantaneously, as shares of stock being bought and sold electronically do. The fact that most prices and probably all wages do not change instantaneously is not a valid critique of the market. Perfect competition, and the instantaneous price changes it implies, does not provide a valid standard upon which to judge whether changes in prices and wages—and markets in general—are efficient. The economists who believe this critique is valid embrace a completely untenable theory of competition and do not base their thinking on the facts of reality. Competition has nothing to do with small producers being omniscient, producing identical products, and not being able to influence prices. Competition, properly understood, involves firms vying to produce and trade goods and services in a voluntary manner in a free market. It encompasses

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firms differentiating their products, advertising, driving their costs down through economies of scale, setting prices, gaining knowledge about one’s customers and about the products one produces, and driving their rivals out of business. Keynesians use the false theory of perfect competition and how prices should change based on that false theory to rationalize government controls in the economy. Their fundamental premise, that the government should violate individual rights, is wrong. Instead of acting on this false premise they need to reject it and embrace sound ideas. They need to embrace the protection of individual rights. This is a fundamental requirement of human life. They need to understand that it is government violations of individual rights that cause the business cycle. They need to understand that it is government violations of rights that create significant rigidity in prices and wages and any inefficiencies that arise due to that rigidity. They need to understand that it is government violations of individual rights that are the primary obstacle to individuals raising their standard of living. “Perfect competition,” prices changing instantaneously, and the desire for government violations of rights cause Keynesians to place their focus on the wrong phenomenon: how prices change. Instead, they should be placing their focus on what causes changes in the money supply and spending. In other words, Keynesians should not be focusing on “sticky price and wage theory.” They should be focusing on “erratic money supply and spending theory.” This is what drives the cycle and the need for prices to change more than they otherwise would have to. As I have stated, changes in the money supply and spending cause the business cycle regardless of whether prices appropriately adjust. The Intellectual Dishonesty of Keynesians There is another problem with Keynesian analysis. There is more than a little evidence to support the claim that Keynesians are intellectually dishonest. In the section of chapter 1 on Keynes, I identified examples of the intellectual dishonesty of Keynes himself. There is also evidence of intellectual dishonesty in connection with Keynesian “sticky price theory.” For example, Keynesians sometimes admit that they do not know what causes prices and wages to be inflexible. Quoting Samuelson and Nordhaus on wage inflexibility: But why do wages not move up or down to clear markets? Would not the economy function better if labor markets were more like auction markets? The answers to these questions are among the deepest unresolved mysteries of modern economics. . . . [N]o one completely understands the reasons for the sluggish behavior of wages and salaries.26

Two other Keynesian economists say “the reasons why prices and wages do not adjust quickly to changes in aggregate demand remain mysterious.”27 Yet Keynesian economists are never at a loss to offer reasons why prices and wages are allegedly inflexible. They offer a litany of reasons why this is the

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case, even though, as they sometimes admit, this phenomenon remains a mystery to them. If the reasons they offer for why prices are allegedly “sticky” do not explain the stickiness that is claimed to occur, perhaps Keynesians should check their premises and abandon the “price stickiness” mantra. What is particularly relevant to understanding the lack of intellectual honesty of Keynesian economists is the fact that they merely assumed prices and wages to be “sticky” in order to “explain” why recessions, depressions, and high unemployment allegedly occur in a free market. Three Keynesian economists discussing the subject state this to be the case: “the crucial nominal rigidities were assumed rather than explained.”28 Only after it had been “established” that recessions and depressions occur in a free market due to “price stickiness” did they attempt to explain why prices might be “sticky.” This means Keynesians used “sticky price theory” to explain recessions and depressions before they knew whether prices were actually sticky. In other words, Keynesians witnessed the occurrence of recessions, depressions, and high unemployment and wanted to attribute this to the free market so they assumed that prices and wages are inflexible to allegedly show that recessions, depressions, and high unemployment are, indeed, an inherent part of the free market. Seen in this light, it is obvious that the program of the so-called new Keynesians to explain why prices are allegedly inflexible is merely a rationalization for the assumption that recessions and depressions are an inherent feature of a free market and that such events are allegedly explained by so-called sticky prices and wages. Keynesians had already formed their conclusions before observing the facts. Once some economists identified that this was what they were doing, instead of correcting their thinking and basing their conclusions on the facts, they proceeded to try and come up with reasons why they could still cling to their conclusions. It is clear here that the conclusion that the free market is somehow deficient is the one thing that is not to be abandoned. The dishonesty of Keynesians is particularly visible in a chapter on unemployment in a popular book written by a Keynesian economist on “advanced” (read: mathematical) so-called macroeconomics for graduate students. The chapter on unemployment presents five main theories of unemployment. They are the “efficiency wage theory,” the existence of contracts, “insider-outsider theory,” “hysteresis,” and “searching and matching theory.” The obvious reason for unemployment—government interference—is not included.29 Even more alarming is the fact that this book, as stated by its author in the introduction, provides “an overview of the field” of macroeconomics by presenting “the major theories concerning the central questions of macroeconomics.”30 That government violations of individual rights are not included as major theories of unemployment is a testament to the intellectual bankruptcy and economic ignorance of not only Keynesian economists but, unfortunately, much of the economics profession. It illustrates the depths to which the field has sunk in the decades since Keynes, especially in graduate education. One cannot dismiss this as a presumptuous statement by the

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author either. The book has gone through multiple editions over many years and is a popular textbook on the subject. Further evidence of the dishonesty of Keynesian economists is seen in another book whose lead author is a prominent Keynesian economist. The book provides a summary of theories of why prices are allegedly inflexible. It mentions 20 theories concerning why prices are allegedly sticky. Not one includes government interference in the market.31 It is intellectually dishonest to ignore government violations of individual rights that have the explicit goal of restricting movements in prices or wages (such as minimum wage laws, maximum and minimum price controls more generally, and the Hoover White House Conferences to prevent wages from falling [in connection with the Great Depression]). It is dishonest to ignore government interference that has the obvious effect of creating unemployment (such as welfare for the unemployed) and keeping wages artificially high (such as legislation that favors labor unions). One cannot dismiss ignoring these as an innocent error. Not when it is done by a large number of economists—an entire school of economic thought—over decades and in the face of countless arguments and irrefutable evidence put forward by their intellectual adversaries showing the causal role of government interference in these matters. Given their premise that capitalism creates undesirable and harmful results, K eynesians refuse to see that minimum wage laws, pro-labor union legislation, welfare for the unemployed, the manipulation of the supply of money and credit, and other forms of government violations of individual rights are the reasons why recessions and depressions, and the high unemployment that comes along with them, occur. These causal factors make it harder or impossible for prices and wages to adjust or, in the case of the manipulation of the supply of money and credit, create greater volatility in the economy, make it necessary for prices and wages to adjust more than they otherwise would have to, and thus make it so prices and wages are more likely to be out of line with their long-run values. In fact, the dishonesty of Keynesians goes much farther. Not only do they ignore government violations of individual rights as a cause of unemployment, they actively deny the causal role that violations of individual rights play in increasing unemployment. This is seen in a book titled Myth and Measurement: The New Economics of the Minimum Wage by two Keynesian economists.32 This entire book is devoted to denying the causal role of minimum wage laws in increasing unemployment. It is an attempt to rationalize government violations of individual rights and represents the lowest level of intellectual dishonesty to which Keynesian economists have sunk thus far. One of the main claims made by the authors is that they have found statistical evidence based on the performance of “natural experiments” that shows employment increasing when the minimum wage is increased. The authors also reevaluate some past statistical analyses that show the expected negative effects of a rise in the minimum wage on employment. The authors claim that there are a number of problems with these analyses and that because of

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this the results do not support the inverse relation between the minimum wage and employment that many people think exists. There are many problems with Myth and Measurement. Here are just a few of the more significant ones. Criticisms made of Myth and Measurement include that the “natural experiment” used in the book is not very good for determining the effect of the minimum wage.33 The idea behind the “natural experiment” in economics is that different areas of the economy are used in the same way that control groups and treatment groups are used in a drug study. In a drug study, the control group is given a placebo while the treatment group is given a new drug and the results are determined by comparing the differences in the symptoms between the treatment and control groups. In Myth and Measurement, different states (and cities) are used as the “control” and “treatment” groups. In one case, eastern Pennsylvania is used as the “control” group because the minimum wage did not change in that state, while New Jersey is used as the “treatment” group because the minimum wage did change in that state. Imposing a higher minimum wage in New Jersey at a specific point in time is like administering a new drug in a drug experiment. The effects of the study show that employment in the fast-food industry in New Jersey increased relative to employment in the same industry in eastern Pennsylvania after the rise in the minimum wage in New Jersey. One problem with this study (and similar studies in the book) is that the two groups are not similar enough for such a study to be valid. States and cities often have different regulations, income levels, mixes of industries within their borders, et cetera and they often have different changes in income, employment, prices, output, and so forth occurring in the short term due to the business cycle. They also often enter the expansion and contraction phases of the cycle at different times. This is hardly an environment conducive to performing this type of “natural experiment.” Differences in changes in employment between two regional economies in a short period of time could be due to a whole host of factors. Moreover, employment fluctuates a large amount over short periods of time for workers affected by the minimum wage (such as teenagers). This occurs even when there is no change in the minimum wage. So the effects of small changes in the minimum wage are more than likely hard to detect within these large fluctuations.34 In addition, one reviewer of Myth and Measurement discusses how a large number of statistical analyses have been performed on the minimum wage since the early part of the twentieth century and none of them (including those in Myth and Measurement) have provided conclusive evidence for their findings.35 This is more an indictment of statistical analysis qua statistical analysis than of the inverse relation between the minimum wage and employment.36 This latter is based on the law of demand. One would have to deny the existence of this law in order to believe the results from a statistical analysis that allegedly show that a rise in the minimum wage increases employment. We should not be questioning the validity of the law of demand. However, we should be questioning the intellectual honesty of any economists who deny this law, even if only implicitly.

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There are a number of other examples of dishonesty in the book as well. For instance, one reviewer of the book states that “sometimes misleading references” are provided regarding the history of economists’ attempts to measure the effect of the minimum wage.37 Myth and Measurement leaves a number of important references out when discussing the history of “natural experiments” used to assess the effects of the minimum wage. The reviewer questions whether this is done because these references are not completely consistent with the arguments made in the book. In another example, the same reviewer states, “The findings [in Myth and Measurement] are tilted toward the view that the minimum wage does not reduce employment: results that are favorable to this view are accepted at face value, but unfavorable results are exposed to ‘close scrutiny’ and found wanting.”38 Another reviewer questions the conclusions in Myth and Measurement made in connection with the authors’ reevaluation of past statistical analyses that show a negative effect of the minimum wage on employment. The reviewer states, “Their general conclusion is that this evidence [from the reevaluation] ‘is consistent with . . . a small, positive effect on employment.’ ” The reviewer goes on to say, “This is an astounding conclusion . . . especially for the U.S. time series. Every estimate that they cite or generate is negative, though not all are significantly so. No unbiased reader [of Myth and Measurement] could conclude . . . anything other than that the effect is small and negative and thus inconsistent with results from CK’s NEs [Card and Krueger’s natural experiments].”39 (Emphasis is in the original.) Final Remarks on the Theoretical Problems with “Sticky Price and Wage Theory” Keynesians do not perform a thorough and honest analysis on the issue of how and why prices and wages change (or fail to do so). There are numerous deficiencies in their arguments. Most notably, they ignore or evade the role government interference plays in causing price and wage rigidity. Further, their analysis is corrupted by the false premise of “perfect competition” and the desire to violate individual rights through government regulation of the economy. It is amazing that prices and wages are as flexible as they are today given the massive government interference that exists that creates rigidity in these variables. Wages and prices would be much more flexible if this interference was abolished. In fact, they would be as flexible as they possibly could be if individual rights were consistently protected, including private property rights. This means a laissez-faire capitalist society must be established. In such a society, the right of employers to change prices and wages as they deem necessary will be protected. This will give businesses the ability—and the strongest motivation—to establish appropriate compensation policies and prices. It will give both businesses and workers the ability and incentive to negotiate (and renegotiate if necessary) appropriate labor contracts. As a result, economically inefficient outcomes due to the inflexibility of prices and wages will generally not occur.

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Empirical Evidence on How Prices and Wages Change There is much empirical evidence on the nature of how prices and wages change that contradicts Keynesian claims concerning price and wage “stickiness.” I now proceed to present some of the more significant pieces of this evidence. It provides further confirmation that “sticky price and wage theory” does not give an accurate picture of how prices and wages change. There is evidence from American history to show how fast prices and wages are capable of changing. During the decade of the 1970s, prices and wages increased at a rapid pace. Prices as measured by the consumer price index (CPI) increased by 87 percent during the period from 1970 to 1979. The maximum increase in any single year during this period was over 11 percent in both 1974 and 1979, followed by 9 percent in 1975, and almost 8 percent in 1978. Prices as measured by the producer price index (PPI) increased by 113 percent during the same period. The maximum annual increase was almost 19 percent in 1974. Nominal wages went up about the same amount as prices as measured by the CPI during the same period, with single-year increases of over 8 percent in 1978, just under 8 percent in 1979, and 7 percent or more in 1972, 1974, 1976, and 1977.40 As one can see, businesses were not hesitant to raise prices and wages. In fact, prices were rising so fast that there were complaints of grocery stores raising prices “too much.”41 The money supply and spending had been increasing at an accelerating rate since the latter 1950s.42 Once businesses had come to expect continued acceleration, they were not hesitant to raise prices and wages appropriately. It shows that businesses are not afraid to raise prices and wages rapidly if they think it is necessary and they have the legal ability to do so. Having the legal ability to raise prices and wages is an important point to mention in connection with the 1970s, since universal price and wage controls were imposed for a short period of time in the early 1970s during the Nixon administration and price controls existed on oil products, natural gas, agricultural commodities, and other products during significant periods of the 1970s. Imagine how much easier it would have been to raise prices and wages and how much faster they would have risen had these and other government violations of individual rights not existed. A comparison of the 1970s to the 1960s is illustrative of how businesses raise prices and wages more when spending increases and causes businessmen to anticipate even more rapid increases. Spending increased, as measured by nominal gross national revenue (GNR), by 83 percent from 1960 to 1969. From 1970 to 1979 spending increased by 191 percent. At the same time, prices as measured by the CPI and PPI increased 24 and 12 percent, respectively, from 1960 to 1969.43 These are much less than the 87 and 113 percent increases, respectively, from 1970 to 1979. Wages also increased less during the 1960s than in the 1970s: only 46 percent from 1960 to 1969 as compared to 86 percent from 1970 to 1979.44 As businessmen adjusted their expectations, they were not afraid to make the appropriate adjustments in prices and wages.

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The housing boom from 2003 to 2006 is another great example of how quickly prices can change in response to dramatic increases in spending. During this period, demand for housing was rising rapidly due to the inflationary policies of the Federal Reserve from 2001 to 2003. These policies made credit easily available, and much of the new and additional credit was used to purchase homes. As a result, housing prices rose at about a 15 percent annual rate in the United States from 2003 to 2006. Prices also fell dramatically from 2006 to 2009, at around a 12 percent annual rate.45 The rapid fall in prices and the quick change from rapidly rising to falling prices also contradict the Keynesian premise that prices are not able to move quickly. What about the Great Depression? Keynesians use this as an example of the inflexibility of wages. They claim that this inflexibility is responsible for unemployment being so high during the depression.46 However, it was government violations of individual rights that prevented wages from falling. As one will recall, it was Hoover using the presidency as a bully pulpit through his White House Conferences that kept wages high. Minimum wage laws and legislation that favored labor unions played a role as well. It most certainly was not any natural tendency for wages to remain high that prevented them from falling.47 Evidence that wages and prices can adjust downward rapidly can be seen in the depression that occurred at the beginning of the 1920s, just eight years before the Great Depression. In that depression, as I stated in the previous chapter, wages fell by 19 percent in one year (1921). Prices also fell by 11 percent in that year, as measured by the CPI, and by 37 percent, as measured by the PPI. This dramatic drop in wages and prices helped to lead to a quick recovery from that depression. What makes this even more dramatic is that in the prior year prices rose by 16 and 11 percent for the CPI and PPI, respectively.48 This shows that businessmen are not reluctant to reverse course and lower prices when necessary, even after having raised prices dramatically in the previous year. It also contradicts the claim, which Keynesians are much more adamant about making, that wages are especially inflexible in the downward direction. If the rights of businessmen are protected, they have no problem lowering wages when business conditions necessitate it. It is no accident that wages were able to change so rapidly during the depression of the early 1920s because it was, as the economist Benjamin M. Anderson stated, “our last natural recovery to full employment,” that is, our last recovery without substantial government violations of individual rights.49 Further evidence that contradicts the claim that wages are inflexible in the downward direction due to workers resisting wage decreases comes from workers themselves. A survey in 2008 showed that almost two-thirds of workers preferred a 5-percent wage cut to layoffs.50 This makes sense: better to have a lower paying job than no job at all. The survey probably understates the willingness of workers to endure pay cuts. This is because the survey asked respondents if they would be willing to take a 5-percent pay cut to save jobs at their workplace. It did not ask them about taking a pay cut to save

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their own jobs. Workers would most likely be much more willing to take a pay cut to save their own jobs than jobs at their workplace in general. Even more illustrative of how prices are capable of changing at different rates, depending on the need to change, is a comparison of countries that have low to moderate inflation (say between 3 and 10 percent) with countries that have extremely rapid inflation (say 50 to 1,000 percent). In these countries, prices change at much different rates, generally corresponding to the different rates of inflation of the money supply. The United States versus Latin American and Caribbean nations from decades during the latter part of the twentieth century provide good examples to compare. The economist Heinz Kohler provides valuable information on the Latin American and Caribbean nations from the 1970s to the 1990s. In his textbook, Economic Systems and Human Welfare, he says that “governments assured themselves of popular support by promising almost everything to everyone.” For example, governments took over near-bankrupt firms to “save jobs,” established “wildly unrealistic” pension plans to provide old-age security, and initiated massive public works projects to satisfy special constituencies. To finance these schemes, Kohler states, “governments ran huge and persistent fiscal deficits, which were covered by printing money or borrowing massive sums from foreign banks.”51 As a result of the money printing portion of these schemes, between 1970 and 1980, prices in Latin America and the Caribbean rose by 47 percent annually. From 1980 to 1993 they rose by 245 percent annually. These large averages are dwarfed by some of the annual rates of price increases in individual countries at certain points during the 1980s, such as 2,750 percent in Brazil, 7,650 percent in Peru, and 14,300 percent in Nicaragua.52 However, the averages for Latin America and the Caribbean dwarf the average annual increases in the CPI in the United States of 8 percent from 1970 to 1980 and 4 percent from 1980 to 1993.53 The United States was not engaging in the massive money printing operation that Latin American and Caribbean nations were engaging in, so the money supply increased at a much faster rate in the latter countries. For example, during the 1980s the highest annual rate of inflation of the money supply for Brazil was 1,337 percent, for Peru 1,649 percent, and for Nicaragua 11,673 percent, while for the United States it was only 17 percent.54 As a result of the higher rate of inflation in Latin America and the Caribbean, businesses were not afraid to raise prices at much more rapid rates. As if prices increasing at the rate of several thousand percentage points per year is not high enough, even more dramatic are the price increases in countries that experience massive hyperinflations, in which the money supply, spending, and prices might increase by the equivalent of one million—or even one trillion—percent annually for a period of time.55 Businesses are certainly not afraid to raise prices in these situations. The key is that businesses have the freedom to make the appropriate changes. The following evidence on the nature of how prices change, which contradicts the Keynesian notion that prices are “sticky” and that this “stickiness”

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creates changes in output, actually comes, ironically enough, from a Keynesian economist. Alan Blinder performed a survey of businesses in the northeastern United States to determine how often they change prices and what factors are important in explaining the magnitude and frequency of price changes. One of the more important factors was “non-price competition,” which includes changes in delivery lags, product quality, selling effort, and the level of auxiliary services. How does this factor affect price changes? Instead of changing the price of a product, businesses change the selling effort for that product or make other changes with respect to that product. For example, snack food or candy manufacturers may reduce the size of a potato chip bag or candy bar instead of raising the price. In addition, companies may reduce delivery lags or increase the selling effort for a product instead of lowering the price. These changes represent ways in which businesses can counteract changes in demand with changes in variables other than the price of a product. Of all the firms surveyed, 57 percent said that this factor was at least moderately important in their pricing strategy.56 These are changes that businesses can make instead of merely responding by producing more or less of a good in response to changes in the quantity of money and volume of spending in the economy. When firms respond to increases in spending for their goods by, for instance, reducing the size of the product or when they respond to decreases in spending by, for instance, speeding up delivery of the product, it is not the case that they are merely increasing or decreasing the production of their goods while leaving the prices unchanged. In the case of increased spending, for example, the same result can be achieved by reducing the size of the product or increasing the price. Whether the price of a candy bar is doubled or the size is cut in half, it is the same to the customer: a candy bar that is twice as expensive (measured in terms of the price per unit of weight). Likewise, if a firm speeds up the delivery of a product, in place of lowering the price, it can offset at least to some extent for a period of time the lesser amount of spending and demand for the product. Firms’ attempts to take offsetting actions will tend to lessen (or completely compensate for) any reductions in production and the use of resources in the economy due to the decreased spending. This will help to eliminate economy-wide fluctuations between price changes (i.e., it will help to eliminate the business cycle). It must be noted that, based on the survey, non-price competition is more applicable to situations in which firms need to lower the price than when they need to raise it. Still, 29 percent of firms that responded believe it is at least equally applicable to situations when firms consider raising prices.57 Here one must also take into account the fact that it is much easier to admit to improving service, product quality, and delivery time instead of reducing prices than it is to admit to offering worse service, reducing product quality, and delivering the product in a slower manner rather than raising prices. Since firms may be reluctant to admit the latter, non-price competition may be more applicable to situations in which prices need to be raised than is

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indicated by the survey. Because of the likelihood of firms not wanting to admit that they take various economizing actions instead of raising prices, the authors state that with regard to this particular survey question “the responses . . . should be heavily discounted.”58 The most compelling evidence provided by the Blinder survey regarding the nature of price changes is the fact that 90 percent of all businesses surveyed changed their prices at least once a year. Further, the median number of times per year that firms in Blinder’s survey changed their prices was 1.4. This means the median firm changed its prices about once every three quarters.59 It must be recognized here that Blinder’s survey was performed in the early 1990s, a period during which moderate inflation existed. During the early 1990s, the money supply increased at about a 5 to 10 percent annual rate. If the survey had been performed in a period of more rapid inflation, the frequency of price changes would have been greater. If it had been performed in a period of slower inflation, the frequency would have been lower. What the survey says, along with the results previously discussed, is that the great majority of businesses are adjusting their prices regularly based on their expectations for inflation. In addition, over half use other methods to adjust the effective price of the product, change the selling effort, and so forth to delay downward price adjustments, and almost 30 percent (but possibly more) use these methods to delay upward price adjustments. The survey clearly shows that businesses are doing what is necessary to make appropriate changes to prices or make other adjustments instead of just producing more or less of the good in response to increases or decreases in spending. There are a couple of other points worth noting about the Blinder survey. First, “fully regulated firms” were not included in the survey but “partially regulated firms were included.” This biases the survey results away from showing the significance of government interference in creating price rigidity. Nonetheless, about 23 percent of the firms in the survey “reported some sort of regulatory limitation on their ability to raise or lower prices.”60 This provides an indication that government interference plays a significant role in making prices more rigid. Second, the survey showed “essentially no evidence for the common belief that prices adjust more rapidly upward than downward.” Approximately the same amount of time passes between a significant increase or decrease in demand or cost and a price adjustment. In addition, the time for the adjustment is not long (only about three months in all cases).61 This time for adjustment must be considered, again, in light of the fact that the survey was performed during a period of only moderate inflation. The fact that the survey does not show greater inflexibility in prices in the downward direction is a blow to Keynesian inflexible price theory because the claim that prices (and wages) are “stickier” in the downward direction is a major component of this theory. The book by Blinder and his coauthors is worth reading if one is interested in this topic because it offers further evidence, beyond what I have presented here, for the arguments I am making in this chapter. However, not all of the results from the Blinder survey support the view that prices are not “sticky.”

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Some of the results do show that some businessmen are reluctant at times to change prices. For example, one factor firms considered important in determining whether to change their prices was whether others had changed their prices. In fact, this was found to be the most important factor of all those considered in the survey. Of all the firms surveyed, 62 percent considered coordination failure either moderately or very important in slowing their price adjustments.62 Another factor was implicit agreements firms had with their customers not to change prices. It is estimated that implicit agreements exist at 64 percent of all US companies based on the survey.63 Nonetheless, given that 90 percent of firms surveyed change their prices at least once a year (and, again, in only a moderately inflationary environment), it is safe to conclude that prices are being changed quite frequently and that, apart from various forms of government interference that restrict price changes, there is no price inflexibility creating economically inefficient outcomes. The results of the survey certainly do not warrant the conclusion in the book that “the evidence in this study emphatically supports the mainstream view that sticky prices are the rule, not the exception, in American industry.”64 My question to Professor Blinder and his coauthors is: Sticky compared to what? The standard of perfect competition and instantaneously changing prices is an invalid standard, as I have shown. Blinder comes as close as he can, given his philosophical context, to admitting the bankruptcy of this standard. Unfortunately, for him, the problem is only that the standard established by perfect competition (what he calls “the Walrasian norm”) is unmeasurable. He still thinks it is an appropriate standard.65 The false premise he accepts—that perfect competition is a valid standard— leads him to the problematic position of claiming that he knows for sure that prices are sticky even though, as he admits, Keynesian economists have completely failed to show, despite decades of trying, why this is the case. The false premise can be seen in the question Blinder asks and attempts to answer with his survey. That question is: Why are prices sticky? He says the entire book was motivated by the failure of conventional economics to answer this question.66 He and the rest of the “sticky price” economists need to check their premises. Specifically, they need to check their premises that perfect competition is valid and that government interference in the economy is both morally and economically good. The latter is what leads them, at least in part, to use the standard of perfect competition. If they use a standard that is completely divorced from reality and thus impossible to meet, they will always be able to claim the market is deficient and rationalize government interference. If they reject these premises and embrace a theory of competition based on rivalry among producers in voluntary trade, along with a moral theory that recognizes the fundamental importance to human life of protecting individual rights and freedom, they will be logically led to perform a more comprehensive analysis on what prevents prices from changing. Specifically, their main focus will shift from alleged deficiencies in the market to government interference that prevents prices from changing. That, ultimately, is the only thing that can prevent prices from changing in an economically

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efficient manner. Rejecting their false premises will also lead them to ask a philosophically sound question: Are prices “sticky”? This question does not assume that they are. The answer to the philosophically sound question is that, as long as government interference does not prevent them from changing, prices (and wages) most certainly are not “sticky” in either the upward or downward direction. The empirical evidence shows that businesses are willing to change prices and wages by large amounts when necessary. They are willing to make radical changes in these variables from one year to the next (both in magnitude and direction). The key, as I have stated before, is ensuring they have the freedom to make the changes necessitated by economic conditions. This requires protecting the right of business owners to offer and accept prices and wages that are in their self-interest. It also requires the protection of the rights of workers to compete for jobs and offer to work for wages that are in their self-interest. What Would a “Sticky Price” Business Cycle Look Like? The strongest evidence to refute the claim that “sticky prices” cause the business cycle is provided, again, by the Blinder survey. Let us focus on an economy with an expanding quantity of money and volume of spending. To understand the evidence in this context, one must remember that the business cycle is an economy-wide, general phenomenon; it is not specific to only one or a few businesses or industries. Next, one must ask the question: Why would all businesses in all industries (or, at least, the great majority of businesses in the great majority of industries) raise their prices at the same time (or roughly the same time)? Even if businesses were reluctant to raise their prices, there is no reason to believe that millions of businesses in, perhaps, hundreds of industries would raise them at the same time, and no evidence has ever been presented by Keynesians to show that all businesses raise their prices at the same time. But this is what would be required if “sticky price theory” was true. This is what would be required to obtain an economy-wide business cycle if this, indeed, was the cause. Based on the fact that all firms do not change their prices at the same time, if reluctance by firms to raise prices actually did cause the business cycle, different businesses would experience expansions and contractions at different times based on when their latest price change occurred. For instance, if spending is rising at a constant rate, those who just went through their periodic increase in prices would experience “recessions.” Those who had not raised their prices recently would experience “expansions.” This contradicts the economy-wide aspect of the business cycle. A Keynesian might reply at this point, “Ah ha! Businesses wait for each other to raise their prices, so it might be the case that they raise their prices at the same time.” First, Blinder’s survey showed that this is not completely true. The survey showed that 38 percent of businesses consider coordination in changing prices to be either of minor importance or totally unimportant.67 But even if one assumes that every business waits for its competitors to raise

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prices before it raises its price, an economy-wide business cycle would still not result. In this case, different industries (or groups of competitors) would experience expansions and contractions at different times. However it works itself out, at the aggregate level, the various expansions and contractions being experienced would, more than likely, cancel each other out. Therefore, no economy-wide, general business cycle would occur.68 Even though the business cycle is economy-wide, some industries do tend to move before others. However, the timing of the changes based on “sticky price theory” does not explain the pattern of changes we actually observe during the course of a cycle. For example, the construction industry tends to move before other industries and is often used as a predictor of where the economy is headed. It moves earlier because it is more sensitive to interest rates and thus subject to larger fluctuations. As a result, firms in this industry tend to be more observant of changes in interest rates and where the economy in general is headed and quicker to react to these changes. The timing of the changes is not based on when firms change their prices. If it was, some industries would not consistently lead the rest of the economy in terms of when they move from expansion to contraction or vice versa (like the construction industry). When firms move would be based on when they change their prices. Furthermore, if “sticky price theory” was valid, the magnitude of the changes in output would be dependent on the magnitude of the changes in prices businesses make or dependent solely on the magnitude of the change in money and spending in the cases in which businesses have yet to change their prices. For instance, businesses that raise their prices by a larger percentage would tend to experience deeper “recessions.” Those that raise their prices by a smaller percentage would tend to experience more mild “recessions” (or, perhaps, less rapid expansions if they do not raise their prices at a more rapid rate than the rate of increase in the money supply and spending). Those who have yet to raise their prices would tend to experience expansions. However, this does not explain the patterns in the magnitudes of the expansions and contractions we see in the economy. Industries farther removed from final consumption and more sensitive to interest rates tend to move more. Again, the construction industry is a good example of this. The patterns in the magnitudes of the expansions and contractions businesses experience certainly are not explained by changes in prices or a lack thereof. The Blinder survey also provides evidence to support the claim that if mere price changes (or a lack thereof) caused businesses to experience expansions and contractions, they would experience the fluctuations at different frequencies. The results show that 15 percent of all businesses surveyed change their prices more than 12 times a year. This means these businesses should experience a cycle with a period of less than one month. Also, 8 percent of the businesses surveyed said they change prices between 4 and 12 times a year. These businesses should experience cycles with a period between one and three months. Further, 90 percent of businesses change their prices one

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or more times a year. Therefore, according to inflexible price theory, most of the economy should experience a cycle at least once a year.69 We do not see these patterns in the economy. The business cycle is a phenomenon that occurs with a period of, perhaps, five or ten years and is the same for all businesses. In the analysis of the last few paragraphs I assumed inflation occurs at a constant rate. I did this because it highlights a crucial difference between the theory of the business cycle that is supported in this book and Keynesian inflexible price theory. An important implication of inflexible price theory is that business cycles arise by the mere fact that businesses are reluctant to raise prices. If this is true, one should be able to show that business fluctuations occur regardless of the type of inflation (whether accelerating or constant). However, with constant inflation no business cycle occurs because businessmen come to expect the inflation and adjust prices and other variables accordingly, with no change in production.70 But even if we ignore this and assume that “sticky price theory” does explain the business cycle and therefore constant rates of inflation could cause the cycle, many characteristics of the cycle would be different than the actual characteristics we observe. Because businessmen would expect the inflation and changes in prices with a constant rate of inflation, the expansions and contractions that would occur would also be anticipated. This means one would not see the mal-investment that occurs during the business cycle. Businesses would not gear up for increases in demand that suddenly do not come about. They would know that the increase in demand they are experiencing is temporary, due solely to their lagging price changes, and would not make long-term changes that have to be reversed once prices are raised and the quantity demanded decreases. Further, such cycles would not produce any changes in the rate of profit or interest rates, since the inflation is constant, and there would be no change in interest rates relative to the rate of profit. The constant rate of inflation would merely add a constant, positive component to the nominal rate of profit and interest rates. This is not what is observed. Short-term interest rates generally rise relative to the rate of profit prior to or during the contraction and fall prior to or during the expansion. Because there would be no rise in the rate of profit and fall in interest rates during the expansion, there is no incentive for businesses to take on excessive amounts of debt to expand their activities and no change in the structure of production. In addition, as the contraction begins, because it is fully expected, one would not see businesses scrambling to build up money balances to pay down debt and prepare for the tough times ahead. Of course, one would also not see the bankruptcies and insolvencies associated with the scramble to become more liquid. In short, this theory does not predict the phenomena that are seen on the side of money during business cycles. Such cycles would look similar to the seasonal cycles experienced every year in economies where Christmas is celebrated. During these cycles, production and consumption are at a maximum during the last quarter of the

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calendar year. During the first quarter of the year, a contraction is experienced. The economy expands slightly during the second quarter and contracts slightly during the third quarter, as people take vacations during the summer months.71 The fluctuations are much more pronounced in some industries than in others, especially in connection with the Christmas holiday. Seasonal cycles do not produce many of the events that occur during the business cycle. Seasonal cycles are well anticipated and easy to explain. There is no tendency for businesses to engage in mal-investment, acquire a disproportionate amount of debt, scramble for cash during the contraction phase of the cycle, and experience an inordinate number of bankruptcies and insolvencies during the contraction. The “sticky price theory” of the business cycle might identify a few superficial characteristics of the business cycle. It may take businessmen a certain amount of time to adjust their expectations during the cycle and change prices and wages appropriately to reflect economic conditions. Wages and prices might also be contractually prevented from changing for a period of time. This may even lead to a greater or lesser amount of products sold (or labor hired) by particular businesses, during the cycle, relative to what they would have sold (or hired) otherwise. However, this is not a causal factor of the cycle. It is one of the many effects of the cycle. As a reminder, the causal factor is the manipulation of the supply of money and credit, which is ultimately caused by the government. It is the money supply and volume of spending increasing rapidly (viz., at a rate greater than people expect) that causes revenues and profits to rise and businesses to expand. It is the decrease of these variables, especially relative to expectations, that brings on the recession or depression. Any lags in changes in prices or wages are caused by changes in the supply of money and spending that are different than what people expect. So the key fact to remember is that the business cycle is caused by accelerating changes in the supply of money and spending. This is what leads to changes that are different than what people expect. In contrast, “sticky price theory” says that a business cycle would occur repeatedly with constant changes in the money supply and spending. While this does not actually occur, a recession or depression could be produced in conjunction with a constant increase in the supply of money and volume of spending. However, this would only occur if the constant increase was followed by a sudden decrease in these variables (relative to expectations). So even this is not consistent with “sticky price theory,” since the theory does not require sudden changes in the rate of change of spending to induce a recession or depression. Remember, “sticky price theory” merely requires a reluctance on the part of businessmen to change prices and then the eventual changing of prices, with the money supply and spending increasing at a constant rate during the entire process. Based on “sticky price theory,” the fundamental causal factor is not accelerating changes in the money supply but an inability of wages and prices to change in synchronization with changes in the supply of money and spending. Based on “sticky price theory,” accelerating changes in the money

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supply and volume of spending may have an influence on how a particular cycle looks but the fact remains that, according to this theory, inflexible prices are the fundamental causal factor of the cycle, not accelerating changes in the money supply. To sum up this subsection, the inflexible price theorists have only captured one minor, nonessential aspect of the business cycle: lagging price changes. However, they do not understand or are not concerned about the fact that the lagging price changes occur due to monetary demand being different than expectations (i.e., due to accelerating changes in the money supply). Further, many of the characteristics that would be a part of a “sticky price” business cycle are inconsistent with the observed features of the cycle. For example, some businesses would experience expansions at the same time that others experience contractions if the cycle was caused by businesses being reluctant to change prices. In addition, the frequencies of these cycles would be much higher than those seen for actual business cycles. Moreover, the magnitude of the changes in output would be dependent on the price changes businesses make. Inflexible price theorists also have not captured many aspects of the cycle. They do not explain economy-wide fluctuations in business. They do not explain the mal-investment engaged in by businesses during the cycle. They do not achieve the right movement in interest rates. They do not explain why businesses take on too much debt. They do not explain the scramble for liquidity, insolvencies, and bankruptcies during the contraction. Because of this, the inflexible price theory of the business cycle is, in fact, no explanation of the cycle at all.

Conclusion I have shown that so-called sticky price theory has many logical inconsistencies and does not agree with the economic facts. I have shown, for example, that the “efficiency wage” is the market clearing wage. I have shown that contracts can have the appropriate mechanisms in them to render prices and wages sufficiently flexible. Furthermore, businessmen and capitalists eagerly change prices and wages when necessary, as long as they are legally able to. I have shown this in the context of the depression of the early 1920s, the inflation of the 1970s, and the hyperinflations of Latin American nations during the last few decades. I have also shown that if a cycle did result from prices and wages being “sticky,” it would not look like the type of cycle that is known as the business cycle. In addition, I have shown that so-called sticky price theory is based on an improper standard of judgment: perfect competition and instantaneous changes in prices. I have shown that Keynesians display great intellectual dishonesty in their advocacy of “sticky price theory” in that they ignore or evade the role that violations of individual rights by the government play in preventing prices and wages from changing, such as price controls and legislation favoring labor unions.

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Keynesians refuse to abandon their false premise that a free market is morally wrong. This false moral premise leads them to engage in invalid economic analysis to rationalize government interference in the economy. Ultimately, to abandon their false economic theories and invalid analysis, they must reject the invalid moral ideas on which their beliefs and rationalizations are based. Specifically, Keynesians must abandon the idea that it is a virtue for individuals to sacrifice themselves to others and a vice to pursue what is in their rational self-interest. This is what leads them to believe that the selfish pursuit of profit in a free market is immoral. It is what leads them to desire government interference in the economy to counteract the individualist nature of capitalism. The contradiction between sound economic analysis and the Keynesians’ false moral theory makes it difficult for them to see or admit the errors in their economic analysis. If they embrace the moral idea that it is a virtue to act in one’s rational self-interest, their moral ideas will not act like a ball-and-chain that prevents them from moving forward. Their moral ideas will actually help them move forward and come to a better understanding of economics. Then, both their moral and economic ideas will be consistent with the requirements of human life.72 It will also help prevent them from putting forward false theories of the business cycle: theories that claim it is a natural part of the free market and that government violations of individual rights are necessary to eliminate or reduce its effects.

3

R e a l Busi n ess C yc l e Th eory

Introduction Real business cycle (RBC) theories are nonmonetary explanations of the business cycle. Supporters of RBC theory claim that business cycles arise due to changes in real factors, instead of monetary factors, in the economy. The focus is on alleged causes of the business cycle that emanate from places other than changes in the supply of money and spending. Further, such cycle theory assumes markets are always in equilibrium (i.e., they always clear, even during recessions and depressions).1 Probably the most popular version of RBC theory claims that changes in the level of technology affect the economy such that it causes fluctuations in output and employment (i.e., a business cycle). The claim is that a new invention will increase productivity and bring on an expansion in the economy as the use of this invention becomes widespread. Likewise, technological regression will cause a decrease in overall production in the economy, thus creating a contraction.2 Another RBC theory is the fad theory of the cycle. If a product suddenly comes into fashion, there will be an increase in demand for the product and a boom will be created in the production of that product. This might extend to other areas of the economy to the extent that some products are complementary to the good in question. Further, since the good in question requires the use of factors of production to be produced, the boom might extend to the factors of production as well. If the expansion is widespread enough, it might create the expansion phase of a general business cycle, according to supporters of this theory. When the fad ends, demand and production decline and create a slump. Government interference can cause the business cycle according to some versions of RBC theory. This encompasses government interference that does not affect the amount of money in the economy. It is not discussed as widely as the other forms of RBC theory I am discussing in this chapter but is nonetheless consistent with RBC theory.3 Such interference includes, but is not limited to, changes in taxes, tariffs and quotas, and government spending, as well as the regulation of various areas of the economy (such as financial markets, food production, and prescription drug production). These are real

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factors because they represent obstacles or encouragement to produce goods and services that do not emanate from changes in the money supply. Even changes in government spending represent real changes to the extent they are not occurring as a part of the creation or destruction of money. Increases in interference are used to explain recessions and depressions and reductions in interference are used to explain expansions. Some RBC theorists claim that the business cycle consists of random fluctuations in production with no specific cause. According to this theory, the business cycle represents natural oscillations in production. According to some advocates of this theory, these oscillations might result from a periodic coalescing of many small perturbations such that they create the economywide movements known as the business cycle.4 Some advocates of RBC theory even say that business cycles and seasonal cycles are related. The claim is that the two display some of the same characteristics and have some mechanisms in common that create them. This means that some of the same types of factors that cause economy-wide fluctuations in economic activity due to Christmas or the weather are at work creating the business cycle.5 Based on RBC theory, the business cycle can be a natural by-product of economic activity—something that emerges naturally from the free market. RBC theory gives no causal role (or, at most, only a subordinate role) to money. In fact, the claim by some RBC theorists is that changes in the money supply occur only as an effect. They result from changes taking place in the economy due to the business cycle.

Refutation of Real Business Cycle Theory In this section I show that RBC theory, in all of its variations, is not a valid theory of the business cycle. Hence, it does not provide a valid explanation of recessions and depressions. This is the case primarily because it does not explain the type of economy-wide fluctuations we see and the events that occur on the side of money during the business cycle. These observations, in essence, were made long ago by the great Austrian economist Ludwig von Mises in his comments on nonmonetary explanations of the business cycle. He showed that they are all invalid.6 My analysis goes much farther than Mises’s analysis because I go into much more detail to show why RBC theory is invalid. I also cover a far broader range of topics than Mises. However, his analysis does serve as a guide for my analysis. In considering my critique of RBC theory, one should keep in mind that there are many RBC theories. The critiques I provide below can be used to refute all of them. This is the case because all the different RBC theories are fundamentally the same; they are all based on some nonmonetary explanation of the business cycle. Hence, in order to refute RBC theory, one does not have to refute every specific RBC theory. One can generalize from the specific versions of RBC theory addressed below to refute other versions not mentioned here. Here I focus on the more prominent RBC theories.

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The most important task in showing that RBC theory is invalid is to refute the fundamental causal factors that RBC theory claims to be at work. Once the fundamental claims are shown to be invalid, no version of it will be tenable. As an analogy, think of it this way: once the foundation of a skyscraper is shown to be weak, one does not have to show that the structure of a particular floor of the building is weak to be sure that the floor is in danger of collapsing. That floor, and every other floor, will collapse because of the weak foundation. The same is true of different RBC theories. An Invalid Method of Analysis Let me start with a criticism pertaining not to the content of RBC theory but to the methodology of RBC theorists. RBC theorists often simply attempt to mimic the movement of variables during business cycles, such as unemployment and output, using mathematical equations.7 They believe that this somehow makes their “theory” valid. However, simply being able to mimic a phenomenon does not provide an explanation for why that phenomenon occurs. To explain a phenomenon one must be able to show logically what factors are causing that phenomenon to occur. One may be able to mimic changes in output, unemployment, interest rates, the money supply, and so on and one may even be able to obtain the correct relative changes in these variables; however, unless one can show why these variables are changing or why a change in one variable causes a change in another, one does not have an explanation for the movements. In fact, one does not have a theory at all for why the phenomenon occurs. One merely has an intellectually empty imitation of variables. This is equivalent to creating a mechanical device that mimics the motion of the planets around the sun. One could create such a device to maintain the appropriate, scaled distances of each planet relative to the sun and each other. However, this does not explain what causes the motion of the planets. Without showing what factors affect the motion of each body, one does not have an explanation of why the bodies follow the paths that are mimicked in one’s model. Such a model might be a good tool to illustrate the motions of the planets, but beyond that, as with mimicking economic data, the model is devoid of intellectual substance. In addition, curve fitting data, or what contemporary, mainstream economists might call “calibrating” a “model,” does not provide an explanation of why the variables in the “model” change. It does not identify the causal factors involved. One needs a logical explanation grounded in the nature of the phenomenon and entities being studied to understand why variables move as they do. I will make one last point on methodology before I start addressing specific RBC theories. RBC theorists, like Keynesians, use perfect competition in their analysis. The difference is that while Keynesians claim that the characteristics of perfect competition are not met (i.e., markets are “imperfect”), RBC theorists claim that they are and that fluctuations are a part of

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competitive equilibrium and market clearing economic activity. RBC theorists accept the same false premise as Keynesian economists, they simply claim that the premise holds. RBC theorists, like Keynesians, need to reject the false premise and (among other things) embrace the sound theory of competition I discuss in chapter 2. In a sense, RBC theory is worse than Keynesian “sticky price theory.” The Keynesians are right to claim that the characteristics of perfect competition do not hold in reality because these characteristics have nothing to do with the nature of competition. The RBC theorists are not deterred by this and claim that the business cycle consists of natural fluctuations within a perfectly competitive equilibrium. While it may seem plausible that expansions are consistent with market clearing economic activity, it is more difficult to believe this for contractions. This is the case in particular for severe contractions. Are we to believe that the recession of the early 1980s, the recession of 2008–9, and even the Great Depression were fluctuations in which markets cleared? Changes in Technology While the above is an important attack on RBC theory, it is not a direct attack. I have not shown why RBC theory is false. I have shown only that the method of analysis used by RBC theorists does not help one understand the causal factors involved in the business cycle. In essence, this attack is just an aerial bombardment designed to weaken the fortifications of the RBC theorists and prepare them for the full, frontal assault. I now proceed to show that RBC theory not only embraces bad methodology, but the conclusions drawn based on the theory do not make sense logically or agree with the facts pertaining to the business cycle. As a result, this critique will be an even more powerful criticism of RBC theory than the critique of the methodology. It shows that even if RBC theorists abandon their bad methodology, their arguments are still invalid. First, consider the fact that RBC theory does not properly explain economy-wide or general economic fluctuations. Consider the case of technological advancement. If a new machine is invented that vastly improves the productive capability, the firm that invented the machine will expand rapidly and profit tremendously. However, at the same time firms that compete with the new technology (firms that produce old technologies that stand to be replaced by the new invention) will contract and lose money or, at least, see their profits decline dramatically. In addition, suppliers to the firm that produces the new machine and producers of goods complementary to the new machine will also expand, but perhaps not by as much as the firm that invented the machine. Also, firms that are early adopters of the new invention in their productive processes will expand as well, although, again, probably not as much as the firm that invented the machine. The early adopters of the new invention will expand based on the lower costs (and thus lower prices) the invention will help them achieve. Late adopters of the invention might

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still expand and earn higher profits, but not as much as the early adopters. If the late adopters wait too long to adopt the invention, they might experience substantial losses for a significant period of time due to their higher costs. The firms that completely fail to adopt the invention might be driven into bankruptcy or might be bought out by their more innovative rivals who are looking to expand their productive capacity through acquisitions. During the expansion phase of the business cycle, industries whose goods are farther removed from final consumption (such as capital goods industries and industries in which long-lasting assets are produced) tend to expand more than industries closer to final consumption. So, for example, manufacturing businesses tend to expand more than retail industries during the cycle. Industries on the forefront of technology might also expand more than other industries, since rates of profit tend to be higher in these industries. Industries do not generally go against the trend, except perhaps the pawn broker industry (and possibly a few other industries). In the pawn broker industry, during the expansion, for example, fewer people need to pawn items to raise cash due to the easy credit that is available during the inflationary boom and, in fact, is causing the boom. So this industry may contract. However, this is perfectly consistent with the business cycle theory I defend in this volume and elsewhere (as are the possible movements in the opposite direction in a few other industries, such as industries that produce what economists call inferior goods).8 The above pattern is not what we see when the economy expands due to technological advancement. The pattern seen with technological advancement is rapid expansion in the industry in which the technology is being produced, expansion in industries that are able to incorporate the technology into their productive processes, expansion in industries that supply inputs to help produce the new invention, expansion of industries that produce complementary goods, and contraction in industries competing with the new technology. The mass production of the automobile in the early twentieth century can be used to illustrate the changes that take place in the economy due to the increased use of a new invention—at least the automobile was still a relatively new invention at that time. In this case, the original Henry Ford’s company experienced a rapid expansion. Producers of steel (suppliers to the automobile industry) also expanded fairly rapidly. Those businesses that began adopting the use of the automobile and trucks in their businesses early on probably saw dramatic improvements in efficiencies in their productive processes and expanded rapidly as well. However, buggy makers, horse breeders, and blacksmiths—those competing with Ford—experienced a decline in their business. I have conceded too much to the RBC theorists. From the above it might appear that technological advancement typically has widespread effects in the economy (even if the effects are different for different industries and companies). However, this is not the case. Many, if not most, inventions and innovations will not have the economy-wide impact that major inventions

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and innovations have, such as the mass production of the automobile. The automobile has widespread effects because every industry can benefit from a better means of transportation. However, the invention of a device with more narrow applications, such as a sewing machine, will not have such widespread effects. It will dramatically affect the clothes manufacturing industry, retail clothing shops, and even all consumers. But it will have little impact on a broad range of industries, such as the oil industry, utility industries, food manufacturing industries, and the construction industry. The invention of a more reliable rocket engine would have the same type of effect. It would affect rocket engine producers, launch vehicle companies, spacecraft manufacturers, satellite communications companies, and so forth, but have little or no effect outside those industries, which includes most of the economy. These types of technological advancements will not even have an economy-wide effect and thus it is not even plausible to attempt to explain economy-wide expansions based on their creation. Notice also in the above description the primary and secondary effects experienced throughout the economy due to the new invention. Some businesses, such as the creator of the invention and its immediate competitors, are affected dramatically. Other businesses, such as the earliest adopters of the invention, are affected less dramatically. Some businesses and individuals, those who use goods produced by the invention, are affected even less dramatically. Many businesses and individuals, such as those who have no use for the invention or products built with it, will not be affected at all by the invention. This is not the type of expansion that occurs during the business cycle. Some businesses are affected more than others but the effects of the expansion do not radiate out from the creator of a new invention, diminishing in intensity as one becomes farther removed. In addition, all companies tend to be affected in the same way. That is, the inflation and credit expansion tends to raise profits throughout the economy. This is how the general expansion is brought about. Further, no industry contracts during the expansion phase of the business cycle (again, with the possible minor exceptions of the pawn broker industry and a few other industries). Such is not the case with technological advancement. Another criticism of RBC theory pertains to the empirical question of identifying the specific advances in technology that fueled specific expansions. One might argue that advances in computer technology brought about the expansion of the latter 1990s. This is wrong but, at least on the surface, plausible. The actual nature of the case is that the inflationary policies of the Federal Reserve caused the general expansion, of which mal-investment in computer technology was one aspect (i.e., the dotcom bubble).9 However, what about the expansion during the Mississippi Bubble in eighteenthcentury France?10 This was an extremely short and dramatic expansion (followed by an equally dramatic crash). What advance in technology caused this expansion? The idea that technological advancement caused this expansion is not even superficially plausible.

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Explaining the contraction phase of the business cycle based on changes in technology is even more difficult than explaining the expansion. Are we having technological regression every five or ten years, for a year or so, that is creating the periodic recessions and depressions we experience? Did we have technological regression in 2001, 2008–9, and in the early 1990s? No one has ever identified the existence of such changes. It is particularly useful to think of the Great Depression in connection with this point. One might be able to argue that recent downturns have been only mild to moderate in severity and therefore identifying the technological regression that brought them about is difficult because, RBC theorists might claim, it was probably not that large. After all, it is more difficult to measure changes in technology than changes in output. But the Great Depression is a different case. Output declined by almost 40 percent in three years. The technological regression necessary to cause such a precipitous decline in output would be massive. Such regression would be easily observable. But no such technological regression occurred. Technological regression is possible. However, to the extent that it takes place, it would be a phenomenon that would cause a slow, long-run decrease in the productive capability (barring a violent socialist revolution or some catastrophe [such as a nuclear war or a large meteorite hitting the earth] that initiates the regression, but then the problem would not be the technological regression). Technological regression would take place as the knowledge of how to produce certain products and use certain methods of production is lost. Knowledge must be passed on from generation to generation along with the necessary capital to continue to employ current technologies. This is not guaranteed. For example, technological regression occurred during the fall of the Roman Empire. Significant technological regression would not take place in the short run, and it is short-run changes that we must explain if we are to explain the business cycle. Another aspect of changes in technology that is inconsistent with the business cycle is the fact that prices move in the wrong direction. As technology advances rapidly, which is supposed to be equivalent to the expansion phase of the business cycle, prices decline (ceteris paribus). During technological regression, which is supposed to be equivalent to the contraction phase of the business cycle, prices rise. This is due to the fact that the supply of goods increases with technological advancement and decreases with technological regression. However, prices tend to rise during the expansion phase of the business cycle and fall or rise more slowly during the contraction. This is due to the rapid expansion of the money supply and spending that causes the expansion phase and the slowing of inflation or outright deflation that causes and accompanies the contraction. A good example of these price movements occurred in connection with the recession of 2008–9. Prices during the expansion phase prior to that recession, based on the producer price index, rose by 45 percent. During the recession, they declined by 9 percent.11 So once again changes in technology do not explain the facts of the business cycle.

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Of course, changes in prices are not fundamental to the theory of the business cycle I am defending.12 The fundamentals are changes in the money supply and volume of spending. These lead to changes in the rate of profit and interest rates. Nothing dictates that prices have to change in the ways mentioned, although they tend to do so because of the economic forces involved. Fads and Changes in Fashion Another version of RBC theory says that fads and changes in fashion (i.e., shifts in taste) cause the business cycle.13 The idea is that expansions occur when a new fad or craze emerges, such as the fad for Pet Rocks or Beanie Babies. When many people purchase the latest fashion item, it might lead to the expansion phase of the business cycle as well, according to this version of RBC theory. When the fads or fashions die out, the contraction occurs. The essential aspect is that increases and then decreases in demand for certain products create the cycle. It should be obvious by now why this does not generate a business cycle. Fads and changes in fashion do not produce economy-wide effects. If people are spending more money on Beanie Babies, they are spending correspondingly less on competing items, ceteris paribus. If women are buying more miniskirts and fewer long skirts, ceteris paribus, then the demand for the former has increased while the demand for the latter has decreased. These are not economy-wide increases in demand. They are shifts in demand. So there is no general expansion. There is an expansion of the Beanie Baby market but a corresponding contraction in other markets that compete with Beanie Babies. Likewise, there is an increase in the sale of miniskirts and a corresponding decrease in the sale of long skirts. Further, when fads and fashions change, there will not be any economywide contraction. Beanie Baby sales slump while the sales of substitutes increase. Likewise, sales of miniskirts contract but sales of long skirts expand. Again, these are shifts in demand not overall changes in demand. Hence, there is no cycle of the kind that is the subject of this book. The only way for fads and changes in fashion to be accompanied by economy-wide changes in demand is through changes in the money supply and spending that occur in addition to the fads and changes in fashion. Here it would be possible for total, economy-wide demand to increase as people purchase the item that has become a fad or that is now in fashion. But the increased economy-wide demand would not occur due to the fad or change in fashion. It would occur due to the change in money and spending. The only way individuals can spend more on the new fad or fashion without having to decrease their purchases of other goods is if more money is available to purchase other goods in addition to the new fad or fashion. The same is true, mutatis mutandis, for economy-wide decreases in demand. These could occur as fads die out or goods go out of fashion, but only if there is a decrease in the money supply (or insufficient increase) and thus a decrease in the volume of spending. Again, the causal factor is not the fad or change in fashion but the change in money and spending.

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Matches between Tastes and Technology The RBC theory I address in this section is matches and mismatches between what is produced and the tastes or preferences individuals have for goods. This theory says that the business cycle is caused by shifts in tastes and technology (i.e., shifts of demand and supply curves) and the associated uncertainty with these shifts. Due to the uncertainty, it is claimed that some sectors of the economy might produce goods that no one wants to buy and others might produce goods that are aligned with demand. When the number of sectors producing the right goods is high, many businesses are profitable and an expansion occurs. When the number of sectors producing the right goods is low, many businesses are unprofitable and a contraction occurs.14 As an example, the onset of a recession might occur due to an unanticipated shift in tastes. Here the economy would move from a position where production in many sectors is in line with tastes to a position where there are few sectors producing what buyers want. The theory is said to be concerned with matches between tastes and technology because producing the right goods means the resources (i.e., “technologies”) being employed are in concert with people’s tastes. This first thing to point out about this theory is its focus on shifts within the economy. As I have stated, shifts within the economy do not explain economy-wide increases or decreases in economic activity. Based on the logic of the theory, some areas of the economy will be more profitable and others less profitable, depending on whether the shifts are in their favor or against them. Of course, some areas of the economy will not be affected at all by the shifts to the extent the shifts are neutral to those areas. Moreover, the solution to any lack of matching between tastes and what is produced in many sectors, as stated by the adherents of this theory, is that a shift in resources must take place from those sectors that have mismatches to those that have matches.15 This implies an expansion of some sectors and a contraction of others. This is not a general movement in the amount of production taking place but a relative movement in production. While it may be possible for shifts in tastes to create cycles for an individual firm, an entire industry, or even a specific geographic region of an economy, typically such shifts do not cause economy-wide cycles. The one case in which shifts in demand can cause economy-wide expansions or contractions is the case of small nations that produce or provide primarily one good or service, such as tropical island nations that provide tourist services to the rest of the world. For example, if a tropical island nation suddenly becomes a popular vacation destination, this shift in demand can create an economy-wide expansion. However, we do not need business cycle theory to explain these changes. Government Interference Other Than That Which Affects the Money Supply According to RBC theory, changes in government interference can cause the business cycle. The forms of interference I am referring to here are forms

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that do not affect the money supply. They include all manner of interference, including (but not limited to) changes in regulations, taxes, and even government spending (apart from changes in the money supply). Changes in government spending constitute real changes no less than shifts in demand in the economy due to changes in tastes and preferences, such as people deciding to consume less beef and more chicken due to concern about getting heart disease. These are factors businesses must deal with that emanate from a source other than changes in the money supply and thus are not mere nominal changes in the economy. Let us take a look at a few examples of government interference, apart from its effect on the supply of money, to see why it is not the cause of the business cycle. If the government changes regulations in the economy, it generally does not affect the entire economy. It affects only or mainly the area of the economy in which the regulations are changed. For example, if the government imposes stricter safety and efficacy testing requirements on prescription drug producers, this will affect the pharmaceutical industry. Costs and prices will rise while the production of new drugs decreases. There will be effects on industries that use prescription drugs (such as the medical industry), which will face higher costs, and some industries might expand a small amount as capital is withdrawn from the pharmaceutical industry due to the higher costs and lower profits, but these will be small relative to the main effect on the pharmaceutical industry. In addition, while overall production in the economy will decrease (as in a recession or depression), the decrease will be concentrated almost entirely in one industry (which is unlike a recession or depression). So the effects from the regulation will not be economy wide. Furthermore, one will also not see industries farther removed from final consumption contract more than industries closer to final consumption. Some regulations can have effects across the entire economy but they still do not cause the business cycle. For example, stricter environmental regulation on the production of oil will have negative effects across virtually the entire economy, since practically every industry uses an oil product (viz., gasoline) as an input (for transportation). One might think it would produce the contraction phase of the business cycle, but there are many crucial differences between the contraction that such a regulation would cause and the contraction phase of the business cycle. First, some industries will expand in this situation, namely, industries seeking to develop sources of energy other than oil. Second, one will not see industries farther removed from final consumption contracting more than industries closer to final consumption. One will see the oil industry contracting the greatest amount and other industries contracting based on the portion of their total costs that are due to the cost of oil. One form of government regulation that is sometimes thought to cause the business cycle is restrictions on international trade. I have discussed elsewhere the effects of restrictions on international trade in connection with the Smoot-Hawley Tariff during the Great Depression.16 In that discussion, I stated that restrictions on international trade do not produce the

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business cycle. Nonetheless, they can affect production and the standard of living in ways similar to the business cycle. For instance, higher tariffs and/or lower quotas reduce trade and the average standard of living in the economy by raising the cost of obtaining foreign-produced goods and services. The reduction in the standard of living looks like the contraction phase of the cycle, but there are crucial differences. Let’s look at the ways in which they are different. The discussion referred to above on this topic that I provided elsewhere and the forthcoming discussion provide a comprehensive refutation of the claim that restrictions on international trade cause the business cycle. First, one will not see the economy-wide effects one sees during the business cycle. With more restrictive tariffs and quotas, economic activity in the importing industries declines and, as a result, trade in the exporting industries tends to decline as well. Imports and exports tend to move together (as long as the government does not attempt to “stimulate” exports separately from its policy to curtail imports, such as by devaluing the currency). The two move together because exports are ultimately used to pay for imports. Thus, the negative effects will tend to be concentrated in the importing and exporting industries. In addition, the customers of the importers will tend to be negatively affected as well, since they will face higher prices due to the reduced supply of the imported goods. At the same time, however, business will pick up in industries that compete with imports, since now the goods produced in these industries are rendered relatively less expensive. The new domestic customers of those companies that used to export more abroad will also benefit, since they will tend to pay lower prices due to the greater supply of goods available domestically. Overall, production and the standard of living will decline because the country will not be taking advantage of the law of comparative advantage to the extent it used to, but the pattern of decline is different than in a recession.17 In a recession, everyone tends to be harmed, not just importers, exporters, and those who do business with them. Further, when greater restrictions on international trade are imposed, one does not see the other changes that occur during the business cycle, such as changes in the structure of production. What about changes in government spending and/or taxes? Here one does not see the same effects that are seen during the business cycle either. Changes in these variables fall under so-called fiscal policy.18 An increase in taxes, for instance, tends to decrease production, since funds that could be used for production by businesses are now taken by the government for consumption. Moreover, this tends to have an economy-wide effect (as long as the taxes are the type that affect the general economy); however, overall spending in the economy will not change as long as the government does not act to increase its money balances or change the money supply in conjunction with the rise in taxes. If the government increases spending by an amount equivalent to that of the taxes, taxpayers spend less and the government spends more. If it pays off debt it owes to the public, the former

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government bond holders spend more and taxpayers spend less. Either way, overall spending in the economy does not change. But changes in spending are a prominent feature of the business cycle. If the type of interference that I have been discussing in this subsection did cause the business cycle, one would expect to see it occurring at the right time and moving the economy in the correct direction (i.e., toward expansion or contraction). Where is this interference? For example, if changes in restrictions on international trade cause the cycle, why don’t we see the appropriate changes in trade restrictions at the appropriate times? One might think the Smoot-Hawley Tariff is an example of this. However, this tariff was not the cause of the depression that started in the late 1920s that eventually became the Great Depression because it was implemented after the start of that depression.19 Moreover, most expansions and contractions have no change in trade restrictions associated with them. In general, throughout the history of the United States and other countries for which substantial business cycle data exist, one does not see the appropriate changes occurring. And even if the proper changes did occur, as I have been discussing, it would not produce all of the effects of a monetary induced cycle—the type of cycle that has actually been occurring on a periodic basis around the globe for centuries and is the subject of this book. The types of government interference being considered in this subsection might make a cycle (or a phase of the cycle) more severe, but they are not the cause of the cycle and they are not the primary cause of any movement in the economy during a particular phase of the cycle. The Business Cycle as Random The RBC theory I discuss next is the claim that the business cycle is a random event.20 This theory says that the cycle is created by random variations in production in the economy. These variations might be due to, for example, uncertainty in demand and supply conditions in markets (and thus variations in production occur because of the uncertainty regarding the amount businesses should produce) or they might be due to individuals independently substituting leisure activities for work or vice versa (the aggregate effect of which is fluctuations in economic activity).21 If one is going to claim that a phenomenon is random, one must present evidence to back up one’s claim. One must show that there is no regular, predictable cause of the phenomenon. This means one must show that the causal explanations of the business cycle put forward by others are false, including the explanation I defend. I am doing the work of refuting the main alternative theories. Those who claim the cycle is random still need to refute the theory I defend. To do so, they must show that the business cycle does not arise when the causal factors that I describe are present. They must show where my argument is factually and logically wrong. The entire book I have written titled Money, Banking, and the Business Cycle, Volume 1: Integrating Theory and Practice denies the claim that the business cycle is a random

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event. I present ample evidence to defend the theory that I say explains the cycle, so they cannot dismiss my denial that the cycle is random as a mere arbitrary assertion—an assertion without evidence. Let us consider the evidence pertaining to a random business cycle by looking at the implications of such a cycle. This and the evidence I have presented for the explanation of the cycle that I defend will lay to rest once and for all the idea that the business cycle is random. In this endeavor one must keep in mind that the business cycle is an event in which the economy shows fluctuations about a secular expansion trend. This means, as the rate of economic progress fluctuates about the trend, the economic activities of most individuals and businesses are expanding at rates above or below the trend. One must also keep in mind that complete cycles have occurred about every six years, on average, in the United States since World War II. If fluctuations in the rates of change of the economic activities of people and businesses about the trend are determined in a purely random fashion, given an economy with a large number of people and businesses, one would not expect the activities of most people and businesses to change in the same direction at the same time so frequently relative to the trend. One would also not expect to see so much deviation from the trend. One would expect to see equal numbers of people and businesses above and below the trend, and the overall rate of economic progress remain very close to the trend, if the fluctuations of the rates of expansion (and contraction) of their activities about the trend are random. This would occur due to the law of large numbers. Moreover, the idea of people independently choosing to substitute “leisure” activities for work in such a way that it leads to unemployment and poverty during recessions and depressions is absurd. For example, why did so many people during the Great Depression decide to substitute “leisure” activities for work such that it led to about 25 percent of the labor force being unemployed and many people being so poor that they had to stand in bread lines to obtain food? If one thinks this is explained by the fact that enough businesses independently chose to reduce their activities such that it led to that amount of layoffs, then why did enough businesses choose to reduce their activities (and even shut their doors) to cause so many layoffs? It is ridiculous to think people are choosing to engage in activities that lead to impoverishment during recessions and depressions. Some might claim in response to these arguments that economic variables often behave in a random manner. For example, some claim that movements in stock prices are a random walk (the so-called random walk hypothesis). Why can’t the rest of the economy behave in this manner to generate the business cycle? The random walk hypothesis is not fundamentally different than the claim that the business cycle occurs due to random variations in economic activity about a secular expansion trend. The random walk hypothesis says that all known information is immediately incorporated into the price of a company’s stock and any new information that must be incorporated into

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the price of the stock will be unpredictable (in terms of the implications for whether the new information will affect the stock price negatively or positively). Hence, stock prices will move in a random walk around some trend. To the extent that one might apply the random walk hypothesis to economic activity in general and claim that the rate of change of the economic activity of each individual and business moves in a random walk about some secular expansion trend, a criticism similar to that discussed above in connection with random variations in the rate of change of economic activity about a positive trend applies. Specifically, if the variation around the trend is due to a random walk, why is it that the rates of change of the activities of most or all people and businesses are above or below the trend so frequently? Due to the law of large numbers, with a large number of people and businesses, even with a random walk one would expect to see the same number of people and businesses above and below the trend. To the extent that the rates of change of the economic activities of a large majority of people and businesses are being driven above or below the trend, some force that is not random must be driving them in that direction. That force, as I have shown in Money, Banking, and the Business Cycle, Volume 1, is the government’s manipulation of the supply of money and credit. There is a more fundamental criticism of the random theory of the business cycle. To the extent the explanation of a random business cycle rests on the idea that businesses and individuals change the intensity of their activities randomly (even if this only applies to variations about the trend), it implies they act in a random manner. This is an absurd idea. Imagine, for instance, if businesses decide to hire more or fewer workers, build or sell facilities, move into or out of various geographic markets, and so on based on the toss of a coin or the roll of the dice. They would not last very long. Likewise, workers who randomly decide to vary the amount of work or leisure activity in which they engage would meet a similar fate. The view that humans act randomly contradicts the fundamental nature of human beings. Humans are the rational animal. That is, they possess reason and thus are capable of acting based on facts and logic. Humans act with a purpose; they do not act randomly. If humans acted randomly it would mean making no distinction between eating food or poison, stepping off a curb or off the edge of a cliff, investing in profitable industries or unprofitable industries, and so on. If chance dictated that one should eat poison, so be it. That is what one should do if the actions of people are random. Of course, this is not how we observe humans acting. They do not act for no particular reason at all because if they did they would not survive very long. Sometimes it is claimed that one does not need everyone to choose to act a certain way to get many people to engage in a certain type of behavior. The claim is that maybe a relatively small number of people initiate a particular type of action and the great majority of people follow the leaders. This can, allegedly, be used to explain how large numbers of people change their economic activities at the same time and in the same direction; that is, it

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can allegedly be used to explain how the business cycle could be a random event.22 It may be true in some cases that there are a relatively small number of leaders and many followers in many markets. This might be true in a division of labor society because relatively few people might be experts in a specific field and others might act based on the advice of these experts. So it might be the case that, for example, there is a relatively large number of investors (the followers) that act on the advice of a relatively small number of brokers and financial advisors (the experts). Likewise, in the economy more broadly considered, industry leaders and innovators might expand first and be followed by those that are not as innovative or who are not leaders in the field. Nonetheless, to the extent that a nation has a significant number of “leaders,” the same type of criticism given above in response to the idea that the cycle represents random variations about a trend applies to the follow-the-leader argument. That is, at a minimum, one would not expect the rates of change of the economic activities of all or most of the “leaders” to be above or below the trend at the same time so frequently. One would expect equal numbers of leaders to have rates of change in their economic activities above and below the trend. An important question to ask regarding this issue is: When the leaders move together, what makes them do so? The answer lies in the causes of the business cycle that I defend: the manipulation of the supply of money and credit by the government. Moreover, why is it that such a large number of businesses have the ability to expand their activities just because a particular business expands its activities (even if it is a “leader”)? Just because one business has the ability to expand does not mean others can. And if every business suddenly has the ability to expand (or, at least, many do), why does this occur? What is causing every business (or many) to possess the ability to expand? Again, the answer lies in the causes of the business cycle that I defend. In whatever way the cycle unfolds, whether people follow leaders or not or whether people’s choices are rational or not, people are responding to the government’s manipulation of the supply of money and credit. People have both the incentive and ability to act in ways they would not otherwise act because of these manipulations by the government. A more fundamental criticism of the follow-the-leader argument is that it implies humans are deterministic. This is not true. Human beings do not react like robots to those around them. They have free will. If one individual chooses to spend more, it does not mean that other individuals must spend more. In fact, it might mean that others have to decrease their spending to the extent the individual who is spending more is borrowing more or lending less to do so. But even this action is not deterministic. Likewise, if an individual cuts back on his spending, it does not mean that others must do so. And, again, it might mean that others can spend more to the extent the individual in question is borrowing less or lending more. The idea that humans are deterministic is inconsistent with the facts we observe. Human beings make choices based on their judgment of their particular circumstances, and

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while the actions and beliefs of some people can influence the choices others make, it does not imply that humans deterministically respond to those around them. This critique can also be applied to the idea that humans act randomly. If one claims that humans act randomly, one is also claiming that humans are deterministic. Here I am referring to determinism in the epistemological sense, not the mathematical sense. From an epistemological standpoint, there is no fundamental difference between one’s thoughts and actions being determined by, for example, one’s race, gender, or income level and one’s thoughts and actions being determined by the roll of the dice or the flip of a coin. In all these cases one’s thoughts and actions are determined by forces out of one’s control. For those reading these words who are familiar with probability theory, what this means is that even stochastic processes are deterministic from an epistemological standpoint. Lastly, if one is going to argue against my position by claiming that people do not have free will, such an argument is invalid because one has to accept free will (at least implicitly) in any attempt to deny it. If humans do not have free will, then the argument that humans do not have free will is merely the product of whatever forces are determining the thoughts and actions of the person making the argument. Hence, his utterances are not knowledge. If one is to claim that he has discovered a universal truth, he must be able to consider all the evidence and come to an independent conclusion. He must not be led down a specific path to a particular conclusion by forces out of his control (regardless of what the evidence says). Because one must accept free will in any attempt to deny it, the advocate of determinism ends up committing the fallacy of self-exclusion. That is, at least implicitly he must argue that determinism applies to everyone but him, which means he has not discovered a universal truth. Either way, the determinist’s claims are invalid. The claim that the business cycle is random fails on a number of counts: (1) those who make the claim have not shown that the theory I defend is false, (2) it does not agree with what we observe people doing, (3) it goes against what one would expect to occur based on the nature of random events, and (4) it contradicts the fundamental nature of human beings. It is not a valid theory of the business cycle. Seasonal Cycles and the Business Cycle Some economists attempt to draw conclusions about the business cycle by making connections between it and seasonal cycles (such as the cycle due to Christmas).23 For instance, they claim that the business cycle and seasonal cycles might have the same explanation because they have many of the same characteristics (such as the same variables moving up and down).24 The attempt to explain the business cycle by making a connection between it and seasonal cycles must be addressed. Seasonal cycles and the business cycle might have some similarities but they are fundamentally different and do not have the same causes. The cause

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of seasonal cycles is obvious: the weather, Christmas, or other major seasonal celebrations. For example, ski resorts experience a boom in the winter and a bust in the summer. Beach resorts experience a bust in the winter and a boom in the summer. Likewise, the general increase in production and retail trade in the fourth quarter of the calendar year is due to Christmas. The decline in production in the first quarter occurs because Christmas is over and no more production is necessary to produce goods to be exchanged as gifts. The slight rise in the second quarter probably takes place as spring approaches and some types of production that cannot take place in cold climates in the winter (such as construction and agriculture) begin to increase in activity. The decline during the third quarter probably occurs due to people taking their summer vacations (Who wants to work when it’s warm and sunny out?). Whatever the reasons for seasonal cycles, such cycles are easily anticipated and thus easy to plan for. They occur regularly at the same time each year and one can anticipate them well in advance. There is no mal-investment and overconsumption as seen during the business cycle (except for maybe an overconsumption of Christmas cookies, turkey, eggnog, and the like at Christmastime, but this does not have monetary manipulations as its source). Businesses know that the boom is temporary, when it will end, and can plan for it accordingly. They do not build new factories and buy new equipment anticipating that the expansion will last indefinitely, as they might do during the business cycle. Economic activity decreases after Christmas and other peak seasons, which causes many businesses to stop doing business (until next season), but one does not see the flood of bankruptcies and financial distress seen during the contraction phase of the business cycle. With regard to the cycle that occurs due to Christmas (and perhaps other seasonal celebrations around the world), it is possible (at least in some cases) for businesses to smooth out this cycle by producing more during the slower times of the year to be prepared for the greater economic activity that occurs during the Christmas season. There are risks involved with attempting to smooth the cycle: it might be difficult to determine the demand for products well in advance of the Christmas season (such as which toys or electronic devices will experience high demand). However, it might be possible for manufacturers of staple Christmas products (such as Christmas cards) to spread the production of their products (at least some of it) over the entire year (or some portion of it). There is absolutely no chance of this occurring with the business cycle. No one knows when the peak is coming or how great the amplitude will be. The period has varied anywhere from a few to about ten years. If the right political system is established—a laissez-faire capitalist society— “smoothing” could take place in the sense that monetary induced cycles would be virtually eliminated. I discuss what is necessary to eliminate the cycle in chapters 4, 5, and 7. But given the existence of the wrong political system—a mixed economy with government interference in the monetary and banking system—the cycle cannot be smoothed. It will exist as long as

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we have fiat money and fractional-reserve banking, although its severity can be reduced if the government responds appropriately once a recession begins. Skepticism is a hallmark of modern intellectuals and economists have fully embraced the modern intellectual trends. Contemporary intellectuals, including contemporary economists, love to contemplate that which they would like to believe is inexplicable. They love to make that which is simple appear complicated. This is true of seasonal cycles, whose causes are extremely easy to understand.25 Next, economists may study why there is an economic boom during the day and a bust at night. They may ponder why most people work on Monday through Friday and take the weekend off, or they may write papers on the bathroom cycle: that strange occurrence in which productivity declines when a worker takes a bathroom break and increases between breaks.26 As I state in Chapter 3 of Money, Banking, and the Business Cycle, Volume 1, the analysis of seasonal cycles is an analysis of the obvious. It is not very exciting economics and there is nothing of great significance to be gained in understanding the business cycle by studying the seasonal cycle. Economists must realize that the business cycle and seasonal cycles have fundamentally different causes. One would still exist without the other. “Supply Shocks” So-called supply shocks do not cause the business cycle, whether positive “shocks” creating the expansion or negative “shocks” creating the contraction. First, one does not consistently observe “shocks” at the right points in time. Second, they do not create economy-wide events. When they do occur, they typically pertain to one or only a few goods, such as a bumper crop in agriculture or the Arab oil embargo against the West in the 1970s. Third, they do not create the appropriate effects on the side of money, such as the changes in the supply of money, volume of spending, rate of profit, and interest rates. I will not address any of these topics in this chapter. I have already done so in Chapter 5 of Money, Banking, and the Business Cycle, Volume 1. Everything stated in that chapter in connection with the Arab oil embargo of 1973–74 applies to so-called supply shocks in general. Changes on the Side of Money So far I have shown that the factors identified by RBC theory that affect the economy typically do not produce economy-wide effects and usually create opposite effects in different industries (some industries contract in response to the expansion of other industries). In this and other ways that I have identified, they do not produce the patterns we see during the business cycle. One issue I have not addressed (except only in brief statements) is changes on the side of money. I said toward the beginning of this chapter that RBC theory does not explain these changes. No RBC theory can explain the

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changes that occur with regard to the money supply, spending, profits, and interest rates. Because of this, no RBC theory can explain the widespread bankruptcies that are possible during the contraction phase of the cycle. I now proceed to show why this is the case. RBC theorists have realized they need a way to explain the events that take place on the side of money during the business cycle. Therefore, they have put forward an idea called “reverse causation,” which allegedly explains the monetary aspects of the cycle.27 This says that during the expansion phase of the cycle, when the supply of goods and services is expanding at a greater-than-normal pace, a higher volume of “transaction services” (i.e., money and credit) is demanded. This demand is met by banks decreasing their reserve ratios and making more loans. Furthermore, based on this theory, real rates of return (i.e., interest rates and the rate of profit on capital) move in a countercyclical manner due to diminishing returns. During the expansion, for example, since business activities have increased and more of the profitable opportunities have been taken, fewer profitable opportunities will be available and thus the returns that can be earned will be lower. The opposite occurs during the contraction phase. It should be obvious that the claim about the rate of profit is not valid. I have shown both empirically and theoretically elsewhere that the rate of profit moves with output; it is driving businesses to produce more or less.28 However, even if RBC theorists claimed that the rate of profit moved cyclically, their “reverse causation” argument is still invalid. It is apropos that RBC theorists describe their theory of how output affects money as one of “reverse causation,” because it is exactly that. The theory is a reversal of cause and effect. The actual relationship between money and output is one in which changes in the supply of money have the ability to affect the level of output. To see the real relationship between money and output under the scenarios RBC theorists claim create the business cycle, let us look at some examples already considered above in which output changes (or, at least, the mix of output changes) and see what changes, if any, on the side of money occur. I will then look at some additional claims RBC theorists make regarding how monetary variables allegedly change in connection with the business cycle. Technology Imagine an economy in which all economic variables are initially constant. The supply of goods and services produced, the quantity of money, volume of spending, and prices all remain constant. For my initial analysis, I also assume the use of fiat paper money. Now imagine that the supply of goods produced each year in the economy begins to significantly increase, perhaps due to an advance in technology that occurs throughout the economy. Let us say that technology advances so rapidly that within a year the supply of goods produced in the economy increases at a rate of 0.5 percent per year, in two years it is increasing at 1.5 percent per year, in three years 3 percent, and in four years 6 percent. This rapid increase in the productive capability

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is assumed to simulate the actual characteristics of the expansion phase of the business cycle. For the purpose of this analysis, I ignore the fact that advances in technology do not typically happen this quickly and thus do not increase the productive capability of the economy so significantly over such a short period of time. I also ignore the fact that in the short run they tend to be concentrated in small areas of the economy and only over the long run do they spread throughout the economy. This type of mental experiment, where only one factor changes initially, is performed for the same reason only one variable would be changed in a laboratory experiment: to isolate the causal factor and see its effect. Now let us look at what happens in this “experimental” economy as output increases. Since businessmen are producing more, to sell the greater supply of goods they would lower prices. Their ability to charge lower prices would be based on the fact that it is costing them less to produce the goods, thanks to the improved technology. This, of course, would occur economy wide based on the assumption I have made that the technological advancement is occurring economy wide. Advanced technology reduces costs by making it possible to produce more with the same resources, that is, the same supply of capital and labor. The decreased costs make it possible for businesses to lower their prices and maintain the same level of nominal profits. This last statement is important to understand. The nominal level of profits has not changed. The quantity of money and volume of spending have remained constant. This implies business revenues and profits have remained constant. In this case, the economy expands through lower prices. It is important to remember that these lower prices are not deflationary. Deflation would occur only if the quantity of money, volume of spending, and thus revenues and profits decreased. See chapter 7 for more on this topic. Even though nominal profits have not changed, real profits have. They have increased. This occurs because the same amount of money and spending, from one year to the next, buys a larger supply of goods since prices are falling. However, falling prices have the same effect on real interest rates as they have on real profits. The falling prices increase real interest rates. Notice also that the same relationship between interest rates and the rate of profit is preserved (for both real and nominal values). There is no change between the rate of profit and interest rates. Interest rates do not decrease relative to the rate of profit as they do during the expansion phase of the business cycle. This latter observation is important. If there is no change in the relationship between the rate of profit and interest rates, there is no extra incentive for businesses to take on debt to expand. Businesses do not take on added debt for no reason at all; they do so only if it will make them more profitable. If no change has occurred to make the acquisition of debt more profitable, businesses will not increase their demand for debt. One might think that simply because businesses are more profitable in real terms, this will provide them with the incentive to take on additional debt. However, this is not so. The important factor to consider is not the rate of profit alone, but the rate of profit in relation to interest rates. If the rate of

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profit does not increase relative to interest rates, there is no greater incentive to borrow more. If businesses want to expand, they already have the means to do so without borrowing more. Thanks to the falling prices, business can expand with the funds they generate internally, even though the funds have not increased in nominal terms. The falling prices make possible the purchase of a greater quantity of goods and services with the same amount of money. The additional real funds generated by the additional real profits businesses earn can be plowed back into each enterprise to further expand the volume of business activity. However, no increase in the volume of credit transactions is necessary for this to occur, although the value of the same volume of credit will increase in real terms due to the falling prices. So the monetary side of the expansion is left unexplained by RBC theory. One can provide a similar description of the events that would transpire for a contraction in the supply of goods and services that is alleged, by RBC theorists, to cause the contraction phase of the business cycle. Here perhaps a loss of technology occurs. While this is unlikely to occur today, it is a possibility if technological knowledge is not passed on from generation to generation. In this case, too, the relationship between interest rates and the rate of profit is maintained, so there is no lesser incentive for businesses to take on debt. Here the economy contracts through higher prices, but all monetary relationships (viz., the money supply, volume of spending, revenues, and nominal profits and interest rates) remain as they were prior to the contraction. Hence, the monetary side of the cycle is left unexplained during the contraction as well. Because RBC theory cannot explain the events that occur on the side of money during the business cycle, it cannot explain the expansion and contraction (or slowing) of spending, the building up of debt, the scramble to build up money balances at the start of the contraction, bankruptcies, bank insolvencies, and bank runs. In short, this theory cannot explain the financial crises that result as a part of the cycle. Fads and Fashions A change in fads or fashions has the same effect on total revenue and spending in the economy as a change in technology: it has no change in the context of a fiat paper money. When a new fad or a change in fashion occurs, it is a case of demand shifting from one area of the economy to another. Those who produce the goods going out of fashion experience a decrease in demand, while those who produce the goods that come into fashion experience an increase in demand. There is no net change in economy-wide demand. This means economy-wide profits do not change. Some businesses’ profits rise (those producing the now fashionable items) while others’ profits fall (those producing the goods now out of fashion) but on net profits are the same. There is no change in interest rates either, since no new reserves for banks to loan out have been created by the Federal Reserve and nothing has happened to cause a change in time preference in the economy.

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Matches between Tastes and Technology The same is generally true with matches or mismatches between tastes and technology. If there is a shift in tastes, ceteris paribus, the quantity of money and volume of spending in the economy do not change. Hence, the rate of profit and interest rates do not change (or, at least, do not change in the right direction with regard to the rate of profit). If individuals’ tastes or preferences change, they either consume other goods or save the funds. Either way, the money is spent in the economy. This is obvious in the case of individuals shifting their purchases from one set of goods to another. However, it is also true in the case of individuals saving more (i.e., a decrease in time preference). In this latter case, the greater savings generate lower interest rates and inspire businesses to borrow and spend more to expand their operations or invest in new lines of business. Less saving (i.e., an increase in time preference) has an opposite effect: less business activity and more consumption. Nonetheless, the amount of spending in the economy still does not change. It is important to note here that a change in tastes does not cause people to hoard money (or stop hoarding it). People hoard money (or stop hoarding it), in connection with the business cycle, due to the government’s manipulation of the supply of money and credit. But this is not a part of RBC theory. It is a part of the positive theory expounded in this book and in Money, Banking, and the Business Cycle, Volume 1. The scenario above that focuses on a lower time preference may sound similar to the expansion phase of the business cycle and by implication the case of a higher time preference may sound similar to the contraction phase. But they only contain some similarities. There are also many differences. First, economy-wide changes in time preference (if not induced by war or the occurrence of some other calamitous event) occur over long periods of time. Economy-wide shifts in time preference tend to be in response to changes in the ideas that are accepted throughout a culture and which cause people to act in a more long- or short-range manner. An example of such a change would be ideas that are accepted that make property rights either more or less secure. In such cases, people would tend to have lower or higher time preference, respectively, given that they would be more or less likely to benefit from the rewards of their savings. Since business cycles occur over short periods of time, changes in time preference do not explain these fluctuations. In addition, as mentioned, changes in time preference do not generate changes in spending in the economy, since the quantity of money remains constant. Finally, the rate of profit moves in the wrong direction. For example, as time preference decreases, the rate of profit falls due to greater productive spending and less consumptive spending. However, this is the opposite of what happens during the expansion phase.29 As one can see, the shift-in-tastes-and-technology explanation of the business cycle fails to explain the events that occur on the side of money. Because of this, it also cannot explain the widespread financial crises that can accompany business contractions.

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Government Interference Changes in government interference other than that in the monetary and banking system generally do not affect the money supply and amount of spending in the economy either. It may cause a shift in spending, but this has the same effect as a new fad or change in fashion. For example, restrictions on international trade shift spending from goods produced abroad to goods produced domestically. Importing firms experience decreased revenues and profits while their domestic rivals experience an increase in revenues and profits. I discuss the effect on the money supply and spending of restrictions on international trade at length in connection with the statist policies of President Hoover during the Great Depression in Chapter 8 of Money, Banking, and the Business Cycle, Volume 1. As another example, restrictions on oil and gasoline production due to environmental regulations cause more money to be spent to purchase a lesser quantity of oil and gasoline (due to the inelasticity of oil and gasoline). Again, this shifts spending from other goods that would have been purchased with the money to oil and gasoline. These types of regulations do not generally affect interest rates either because there is no causal factor involved influencing interest rates. Hence, regulations like these do not explain the monetary features of the business cycle. Seasonal Cycles The money supply and spending may fluctuate seasonally due to fluctuations in spending in connection with Christmas and changes in the weather (more spending at planting and harvest time, for example); however, this has nothing to do with the business cycle and does not produce the same effects as the business cycle. It does not produce mal-investment during the “boom” and it does not produce the wave of bankruptcies and dislocations during the “contraction.” In most economies today, any seasonal changes in the money supply with changes in output are probably due to manipulations of the money supply by central banks. Many central banks smooth interest rates during the seasonal cycle. In so doing they cause the money supply to fluctuate with output and spending. This is not a part of the nature of money as such. It is an effect of fiat money and fractional-reserve banking, that is, government interference in the economy. Fiat money gives central banks the ability to manipulate the supply of standard money (or monetary base), and when banks increase their lending they typically do so by lending out reserves that back checking deposits. Hence, the money supply increases through the process of credit expansion under fractional-reserve banking. I discuss how fiat money and fractional-reserve banking arise from government interference in the economy in chapter 4. In an economy that has a free monetary and banking system, which I discuss in chapters 5 and 7, the money supply may also fluctuate with the seasons or Christmas. Interest rates may fluctuate as well. However, these are not fundamental characteristics of the system. Such a system would have commodity money at its base (gold and/or silver) and would tend to lead to 100-percent reserves on checking deposits. Fluctuations in the money supply

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may occur to the extent that additional spending is financed by reducing reserve ratios. The reserves used to finance the spending will probably come largely from reserves that back savings deposits. Banks will need to keep a very small portion of reserves backing these accounts to meet daily net withdrawals and may vary reserve ratios on these accounts to meet demands for loans. Fluctuations in these reserves will not affect the money supply.30 But depending on the size of the fluctuations, some of the additional spending may be financed with reserves backing checking accounts (which will affect the money supply), although as I said, these latter reserves will tend to head toward 100 percent of checking deposits. Credit Expansion and Contraction Due to Changes in the Supply of Goods RBC theorists claim that the money supply changes in response to changes in output during the cycle because the need for money to purchase the output changes directly with the amount of output produced. Hence, during the expansion phase the money supply rises because, allegedly, individuals need more money to purchase the greater supply of goods produced. Likewise, during the contraction phase the money supply shrinks because, allegedly, individuals do not need as much money to purchase the diminished output.31 One claim as to how the money supply increases during the expansion is that banks provide more loans to individuals who have a greater “demand for money” due to the greater supply of goods to purchase. People want or need more money so they can purchase the greater supply of goods in existence and banks respond accordingly.32 Here the money supply increases through a process of credit expansion in response to real economic activity. Before addressing the claims that are the main substance of this theory, one must first recognize that needing or wanting more money to purchase goods is not a demand for money. A demand for money is a desire and ability to hold on to money; it is not a need or desire to spend money. The demand for money manifests itself in changes in the velocity of circulation of money. Increases in the demand for money lead to decreases in velocity; decreases in the demand for money lead to increases in velocity.33 Increases in the demand for money lead to decreases in spending, not increases. When people have a greater demand for money, they want to hold on to it for longer periods of time. This means the money does not circulate as fast throughout the economy and does not generate as much spending in the economy during any given period of time compared to a lower demand for money and consequently higher velocity. The additional spending generated by a larger quantity of money, ceteris paribus, is neutral with regard to the demand for money. Thinking that purchasing more goods with a larger quantity of money represents an increased demand for money confuses an increase in the demand for goods with an increase in the demand for money. The two are very different and do not lead to the same effects. Despite this error with regard to the nature of the demand for money, it is still believed that the supply of credit provided by banks changes with output

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due to the alleged change in the need for money to purchase the greater or lesser amount of goods during the expansion and contraction, respectively. The banks are said to provide “transaction services” and since, for example, during the expansion there are a greater number of goods and services to buy, and therefore presumably a larger number of transactions to engage in to purchase the goods and services, banks must provide the additional funds to engage in the additional transactions. It is not inconsistent with RBC theory that a central bank initiates or joins in the process of helping to provide the funds individuals allegedly need (or do not need) by changing the supply of reserves banks have access to and thus making it easier or harder for banks to loan funds according to what phase of the cycle the economy is in. It is also not inconsistent with RBC theory that the buyers of goods initiate the change in borrowing or, at a minimum, act at the same time the banks and the central bank act to change the funds available in the economy. Whatever happens, in some way, the banking system allegedly provides greater or fewer funds based on variations in output during the cycle. Focusing on the expansion, the question the above scenarios raise is: How do banks, the central bank, and buyers of goods know there are more goods available to purchase? If they are to provide either more funds to borrow, more reserves for banks to lend, or actively seek to borrow more funds in response to a greater supply of goods, they must first know that there are more goods available to purchase. If they do not know whether more goods are being produced, they could just as easily provide or borrow fewer funds when they should be increasing their lending or borrowing. The fact is that banks, the central bank, and buyers of goods do not automatically know that more goods are available. They do not magically change the amount they lend or borrow just because producers have more goods to sell. Individuals first need to be made aware of the fact that producers have more goods to sell. And the ones who initially have information regarding the quantity of goods available to sell are the producers themselves. They are the ones producing the goods, so it makes sense that they know before anyone else what quantity of goods are available to purchase. Producers then communicate to buyers that they have more goods available for purchase. How do they do this? They do so by lowering prices. One might claim that maybe banks and buyers will not lend and borrow more because they do not know there is a greater supply of goods available (during the expansion), but producers might borrow more in conjunction with their increased production. The question here is: Why are producers borrowing and producing more? As I have discussed, they do not do so randomly. This brings one back to the theory of the business cycle I defend. Businesses are borrowing and producing more due to the extraordinary profitability created by the government’s manipulation of the supply of money and credit. Here the manipulation of the supply of money and credit creates changes on the real side of the economy, which is not what RBC theorists say occurs.

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The RBC theorists’ scenario would not lead to more money and spending in the economy at all (at least not with a fiat-money monetary system). What they are describing, for the expansion, is a situation in which the productive capability in the economy has increased. An increased productive capability means, ceteris paribus, lower costs to producers and thus the ability to maintain profitability even as they lower prices. If producers do not lower prices initially, then it leads to higher profits per unit. If this occurs, competition for the higher profits eventually gives producers the incentive to lower prices. It also means, since producers have more to sell, that they will not be able to sell all the units available if they do not lower prices. Hence, prices need to be lowered to get people to purchase more goods, in accordance with the law of demand. These facts give producers the incentive and ability to eventually lower prices if they do not do so immediately. However you look at it, prices fall. With lower prices, buyers do not need more money to purchase the greater supply of goods. They are able to purchase the greater supply of goods with the same amount of borrowing and money. Production affects the number of purchases through prices, not the quantity of money and the amount of loans made. The economy expands through lower prices and these lower prices are based on the lower costs that have been achieved. RBC theorists are confusing an increase in aggregate supply with an increase in aggregate demand. More production, by itself, leads to a greater aggregate supply and lower prices, not more money, spending, and greater aggregate demand. Their description of events, at least with regard to the increase in the production of goods, is applicable to the case of economic progress, not the business cycle. Economic progress leads to more output and lower prices. Economic progress and the business cycle are two entirely different phenomena and have different causes, although progress is undermined by the factors that cause the business cycle, as I discuss in chapter 7. The RBC theorists’ description of how an increase in the supply of goods affects the monetary side of the economy (i.e., prices, the money supply, etc.) is not accurate. Of course, the same is true of the claim that the money supply decreases when there is a decrease in the supply of goods during the contraction. If productivity declines, banks, the central bank, and buyers of goods do not know this until businesses raise prices. Just as with an increase in productivity, when there is a decrease in productivity businesses are the ones that have the information regarding what has happened to the supply of goods and they communicate this knowledge by raising prices. They have a strong incentive to raise prices because their costs have risen. If they do not raise prices immediately, eventually they will go out of business. Therefore, ultimately, there is no way for businesses to avoid raising prices. Under this scenario, the money supply does not shrink in response to fewer goods. The same amount of money purchases fewer goods due to rising prices. Again, the equilibrium is achieved through changes in prices, not changes in the money supply.

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This analysis highlights the importance of keeping track of how changes in some variables (such as output) affect other variables (such as prices and money). There is no inherent reason under a fiat-money monetary system why changes in output must influence the supply of money and credit. However, there is a causal link between output and prices. That link is businessmen. They are the ones that have the knowledge about how the supply of goods has changed and have the ability and motivation to make changes that serve their interests. Serving those interests involves changing one of the variables over which they have control: prices. I have emphasized in the above discussion that there is no reason under a fiat-money monetary system that changes in the supply of goods should affect changes in the supply of money and credit. However, under a commodity standard, such as gold, there is a causal link between output and money. Under a gold standard, the money supply increases when there is an increase in the supply of goods, but it does not expand due to some alleged need for more money to buy more goods. It expands because gold itself is a good and to the extent that the productive capability increases, the ability to produce gold improves as well. Furthermore, if the productive capability is expanding and the supply of goods other than gold is expanding, this decreases prices stated in terms of gold. This makes it more profitable to produce gold because the same quantity of gold now buys more goods. One can think of this as a decrease in the cost of producing gold. The capital goods that gold mining companies must use to produce gold are now less expensive, but they still obtain the same amount of gold, which is their revenue. With diminished costs and the same revenue, one has higher profits. However, long before profits rise much or at all, the supply of gold will increase. This tends to keep prices stable. But remember, the increase does not come about due to banks, central banks, or buyers of goods lending or needing more money to purchase goods. It comes about due to the general increase in the productive capability and the increased profitability of producing gold that this brings about when the supply of goods other than gold increases relative to the supply of gold. More will be said about the connection between the demand for money and the supply of goods in chapter 4 when I discuss a similar theory that relates these two variables. However, one can see that in connection with the business cycle and RBC theory, changes in the supply of goods do not cause changes in the supply of money. The only link between the two is between changes in the productive capability and the supply of commodity money, but this has nothing to do with the business cycle or RBC theory.

Conclusion to This Chapter RBC theory does not provide a valid explanation of the business cycle primarily because it does not explain economy-wide movements in output and it does not explain movements we see on the side of money during the cycle. RBC theory applies only to cycles created by real factors, such as seasonal

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cycles. It also applies to downturns in business (i.e., events that are like recessions or depressions) that occur due to, say, a hurricane passing through a small tropical island nation. As the hurricane approaches and tourists leave, business activity for those who cater to tourists decreases. If the hurricane is powerful enough, business activity will also decline for those businesses that are damaged. However, business will be brisk for hardware stores, grocery stores, and so forth. It is easy to understand the causal factors involved in such changes in business activity. But as I have shown throughout this chapter, this is not the type of phenomenon business cycle theory attempts to explain. One must explain economy-wide changes in output, profitability, interest rates, the money supply, and other variables. This is what the business cycle theory expounded in Chapter 3 of Money, Banking, and the Business Cycle, Volume 1 does. RBC theory does not because it does not recognize the fundamental causal role of changes in the money supply. Not all RBC theorists believe that money has absolutely no effect on the economy. They might claim that money has some effect but perhaps it is just a small one. Some might even believe money has a significant effect but that it is not a primary causal factor in the business cycle. Some business cycle theorists might think that it shares equally in causing the business cycle with real factors. These latter theorists I do not categorize as RBC theorists because they do not embrace the essence of RBC theory. They are not committed to either a monetary theory of the business cycle or RBC theory. They think both or some combination provides a valid explanation. It is to the credit of these people that they recognize the causal role of money. However, this does not detract from the forcefulness of my criticisms of RBC theory. I am analyzing the essence of the theory—that real factors are the only or primary cause of the business cycle. They are not.

Concluding Remarks on the Refutation of Alternative Theories There are many alternative theories of the business cycle that I do not address. There are too many alternative theories to refute them all. Besides, some are not full-fledged theories of the cycle, some are subsumed under theories I address in this book, and some have been refuted by others. Let me say a few brief words about some of the more significant alternative theories I do not address in this book (at least in detail). I do not address monetarist theories or purely monetary theories of the business cycle. They have some similarities with Austrian business cycle theory (ABCT) in that they generally claim that it is manipulations of the money supply that generate the cycle. However, there are significant differences as well. For example, monetarists have a homogeneous view of capital as opposed to the heterogeneous view that Austrians have. As a result, monetarist theories do not identify the changes in the structure of production that take place due to changes in interest rates. They generally do not believe that the boom leads to the bust, that is, that the two come as a set. They do not generally

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focus on how new money can be spent in some areas of the economy before it is spent in other areas and how more of the new money can be spent in some areas of the economy relative to other areas. Likewise, they do not generally focus on how the prices of all goods do not rise at the same time or to the same extent. Monetarists also often believe the business cycle is a natural part of the free market and their solutions generally involve some aspect of government interference, such as a constant increase in the supply of fiat money by a central bank. Monetarist theories have been addressed extensively by Austrian economists and I have nothing new to add to their criticisms.34 I do not address political business cycle theory. This is the idea that, to improve their chances of remaining in office, politicians create expansions just prior to elections and allow contractions to occur just after elections. This is not a separate theory of the business cycle but would have to be implemented based on valid business cycle theory to be accomplished. Politicians may or may not engage in such activities but I am not concerned with politicians and government bureaucrats using business cycle theory to their short-term advantage. I am concerned with the fundamental economic causes and cures of the business cycle. I do not address many theories of individual economists, even some economists who have written extensively on the business cycle. These generally fall under one or more of the theories that are addressed in this book. For example, Joseph Schumpeter’s creative destruction theory, which is both a theory of the business cycle and a theory of economic and technological progress, is an RBC theory (falling under the version of RBC theory that says changes in technology cause the cycle).35 Wesley Clair Mitchell’s theory provides another example. His theory has a few similarities with ABCT in terms of how the cycle unfolds. However, he believed business cycles are an inherent feature of capitalism. Depression eventually gives way to prosperity as economic activity is revived. This eventually leads to a crisis and another depression. He does not explain how or why depression eventually gives way to subsequent prosperity and crisis. It just, somehow, happens in the capitalist system due to the quest for profits.36 Based on ABCT, we know that it is the manipulation of the supply of money and credit by the government that causes the cycle. It is not a feature of capitalism but of violations of capitalism.37 Irving Fisher’s theory provides yet another example. It is an eclectic theory of the business cycle. The start of the expansion can be due to investment opportunities, such as new discoveries or inventions. This falls under RBC theory. However, he also provides a place for monetary factors (i.e., money and credit) in causing the business cycle, either in a primary or secondary role. He believes that depressions are preventable through so-called monetary policy and other forms of government interference.38 I have shown in Money, Banking, and the Business Cycle, Volume 1 that government interference causes the cycle and the only cure is to eliminate the offending interference. I will provide much more detailed arguments on this topic below in chapters 4, 5, and 7.

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A final example is provided by Michal Kalecki. His theory of fluctuations is consistent with John Maynard Keynes’s theory. Kalecki believed fluctuations in investment drive the cycle. He also thought that the business cycle is an inherent feature of capitalism.39 At the least, my refutation of Keynes’s theory in chapter 1 applies to it. Of course, the only theory connected to a particular economist that I address in this book is Keynes’s theory. I address this because his ideas represent an entire school of economic thought. I will also not address the “acceleration principle” (at least not in detail). This has been addressed adequately by other economists.40 This principle attempts to explain the volatility of investment relative to consumption by claiming that increases in output or consumption lead to greater increases in investment and the production of capital goods. Here is an example of the principle from two of its main expositors: Imagine a typical textile firm whose stock of capital equipment is always kept equal to 2 times the annual production (or constant-dollar value of 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 perhaps of 20 machines of different ages, with 1 wearing out each year and being replaced. Now let us suppose . . . sales rise by 50 percent—from $30 to $45 million. To keep the ratio of capital to output at 2, the number of machines must also rise by 50 percent. . . . [I]nstead of 1 machine, 11 machines must be bought—10 new ones in addition to the replacement of the worn-out one. Sales rose by 50 percent. How much has investment in machines gone up? From 1 machine to 11; or by 1000 percent! This accelerated response of investment to a change in output gives the accelerator principle its name. If sales go on rising . . . by the same $15 million [annually], we’ll continue to need 11 new machines (10 + 1) every year. So far, the accelerator principle has given us . . . a tremendous burst in investment spending as a result of a moderate increase in sales. . . . According to the accelerator principle, sales must continue to keep increasing at the same speed in order for investment to stand still. If sales should stop growing at so rapid a rate—if they should level off . . . then net investment will fall away to zero, and gross investment will for many years fall back to only 1 machine. . . . [The $15 million annual increase in sales occurs for only three years in the example.] The accelerator principle can work in both directions. Should sales drop . . . gross investment would drop away to nothing for a long time; in fact, the firm might want to disinvest by selling off some of its used machinery. . . . Hence, investment can drop sharply, perhaps causing a recession, just because output has stopped growing.41 (Emphasis is in the original.)

There are a number of errors in this principle that have been identified by others. One error is the claim that greater consumption spending in the economy means more investment will take place.42 However, if only

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consumption spending is increasing in the economy, additional investment cannot take place. Consumption spending is a competing alternative to investment spending and to the extent that it increases, ceteris paribus, investment spending must decrease. This was discussed in detail in the critique of Keynes’s theory of depressions in chapter 1. Even if the increase in spending does not come from an increase in consumption, there are further problems with the acceleration principle. The main criticism can be understood by asking: Where does the increase in sales revenue in the above example come from? As I have stated, increases in spending do not come about arbitrarily. They require increases in the money supply. If there is no increase in the money supply, sales will decrease elsewhere in the economy to the same extent and thus there is no overall increased sales and investment. ABCT explains how increases in total sales revenue occur in the economy. Further, ABCT explains why investment fluctuates more than consumption. It is because the production of goods farther from final consumption is more sensitive to changes in interest rates due to the compounding effect, and we know based on ABCT how manipulations of the supply of money and credit affect interest rates. The acceleration principle does not explain the sensitivity. It assumes investment mechanically responds to consumption and sales revenue, and it completely ignores the role of interest rates and the structure of production. Finally, I will not address so-called mania theories of financial crises and depressions either. According to mania theories, investors become obsessed with some particular commodity or investment—such as stocks, real estate, or tulip bulbs (these latter in the Netherlands in the seventeenth century)— and bid up prices in a frenzied manner until something bursts the bubble and prices come tumbling down. Investments in the particular item may start slowly enough but end with prices being bid to unsustainable and often irrational levels. This theory has been applied to the real estate market during the rise and fall of real estate prices that preceded the 2008–9 recession. The question to ask regarding mania theory, as with the acceleration principle, is: What generates the mania? How do people afford to massively bid up the prices of certain goods without the prices of other goods falling dramatically? Without the inflation of the supply of money and credit, there can be no mania in one market without depression in another. In other words, no general, economy-wide boom can occur. Further, manias do not arise for no reason at all. As I have stated, man is not innately irrational. He is a being of free will and thus can choose to be rational or irrational. It is the inflation of the supply of money and credit that typically produces so-called manias. When credit is easily forthcoming, it can lead investors to put little forethought into the investments they make.43 Why should they when piles of easy money are available? Easy credit policies are breeding grounds for irrationality and a short-range investment mentality. It can lead people, who in more normal times would make rational decisions, to make irrational investments.

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As I discussed elsewhere in connection with “rational expectations,” while easy credit policies lead to far more people engaging in irrational investment activities, the main irrationality in such instances does not come from those making investments with no forethought. It comes from the government’s easy credit policies. It comes from the fiat-money, fractional-reserve monetary and banking system that makes easy credit policies possible. It comes from the politicians and government bureaucrats who make such a system possible. Most fundamentally, it comes from the intellectuals who develop and put forward ideas that justify such a system.44 So mania theory does not provide an explanation of booms and busts. ABCT provides the explanation. At best, it is complementary to ABCT (at least in some cases). Now that I have refuted the main alternative theories of the business cycle, let us see how to radically increase the financial and monetary stability in an economy and virtually eliminate the scourges of recessions, depressions, and financial crises (i.e., the business cycle). That is the purpose of part two.

Pa r t I I

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G ov e r n m e n t I n t e r f e r e nc e , Fi at Mon e y, a n d Fr ac t iona l-R ese rv e Ba n k i ng

Introduction Fiat money and fractional-reserve banking play primary roles today in causing the business cycle. Fiat money has not always played a role, since it has not always existed. However, fractional reserves existed early in banking history and have virtually always played a role in causing the business cycle. Debasing and clipping commodity money have contributed to episodes of the cycle in the past as well (and perhaps have even been the sole cause in some cases). However, their causal role has been minor when considering the overall history of money and banking. The main causes have been fiat money and fractional-reserve banking, especially the latter. Government violations of individual rights are responsible for the existence of fiat money and fractional-reserve banking. In this chapter, I explain why this claim is true. In the next chapter, I discuss how a completely free market in money and banking leads to a gold-based monetary system and a 100-percent reserve (on checking deposits and banknotes) banking system. In chapter 6, I analyze a number of the more free-market-oriented periods in money and banking that have existed throughout history to see what can be learned from them. In chapter 7, I show the benefits of and refute the common objections to gold and 100-percent reserves. Finally, in chapter 8, I show how to create a smooth transition to a 100-percent reserve gold standard. That will complete my discussion of the business cycle. As a part of this discussion, one will see how a free market in money and banking will all but eliminate the business cycle.

The Government’s Role in Creating Fiat Money and Fractional-Reserve Banking Banks create money by lending out funds used to back checking deposits.1 This is known as a fractional-reserve banking system. One might think banks are responsible for the creation of money in this manner. While banks are the

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proximate cause of the creation of money through this process, they are not the ultimate cause. The government is the ultimate cause. The government encourages and makes it possible for banks to get away with many unsound practices, including fractional-reserve banking. The banking system, insofar as it has anything to do with the creation of the fractional-reserve system and the business cycle, must be given a secondary role to the government. Government interference is responsible for the dramatic increase in the supply of standard money (i.e., the monetary base) that the banks multiply into greater amounts of money through the fractional-reserve checking process, and government regulation is also responsible for the legal environment that gives banks the ability to get away with loaning out reserves on checking deposits. How is this so? Fiat Money Fiat-money monetary systems have been forcibly imposed on individuals by governments around the world. They have not been embraced by individuals voluntarily and they have not arisen naturally through the free market. Fiat money includes all paper money that has been declared by arbitrary fiat of the government to be money. In the United States, legal tender laws require that the government’s money be used for the payment of all debts and taxes. Furthermore, the possession and use of alternative monies, such as gold, have been declared illegal at various times (such as in the 1930s in the United States under FDR’s presidency). This is how the government forces its money on individuals. Fiat money makes the dramatic and erratic inflation of the money supply possible. While it is true that governments were able to cause changes in the money supplies of their respective countries before the existence of fiat money (and I discuss below how they did this), the existence of fiat money makes it much easier for them to manipulate their money supplies. The manipulation of the money supply is required to generate the business cycle.2 In the United States, the Federal Reserve manipulates the supply of standard money, mainly by buying government securities in the “open market.”3 These funds can then be loaned out by banks. In this way, checking account balances can be increased at an extremely rapid rate if the Fed so desires. Fiat money gives the government great power to increase the money supply. Why do we have fiat paper money if it is one of the causes of the business cycle, including recessions and depressions? Ironically, people claim a government controlled fiat money is necessary in order for the government to “manage” the business cycle. This was one of the primary reasons behind the creation of the Federal Reserve in 1913. The belief is that financial crises and depressions are inherent to a free-banking system and that the money supply must be sufficiently “elastic” so that the government can “manage” it and thus prevent or lessen the effects of the business cycle. My writings on the business cycle show otherwise.4

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This leads me to the actual reason for government-controlled fiat paper money: to increase government spending without having to directly tax citizens of a nation. This is seen clearly in times of war when governments often use massive amounts of fiat money to pay for the wars, such as during the Civil War when the US government issued its first fiat money and in conjunction with the Napoleonic Wars and related wars when England went off the gold standard from 1797 to 1821. Fiat paper money arises in a statist environment in which there is a desire to have greater government “involvement” in the economy, whether through the provision of welfare, the imposition of regulations, or through other means. In fact, government control of the money supply is merely another means by which the government controls people’s lives. Interference in general is far easier to finance by inflating the money supply than by directly expropriating funds from citizens through taxes. It is much easier for the government to increase spending if it can just print money, and increases in government spending are exactly what have taken place in the United States with the rise of fiat money and greater government interference in the banking system during the last century. Printing money enables the government to increase its spending through two means. The first is the obvious fact that if the government can print money, it can have more money to spend. However, the government does not even need to create more money to be able to spend more when it has control of fiat paper money. Just because it has the ability to create money it can borrow money in an easier fashion (i.e., at lower interest rates). If one can create money ex nihilo, one can always, at least in nominal terms, pay off one’s debts. This lowers the risk of lending money to the government and therefore lowers the interest rates it will have to pay. Of course, there are limits to how much the government can inflate the money supply. There may be protests by citizens to stop increasing the money supply by large amounts because it is causing prices to rise rapidly. However, making the connection between rapidly rising prices and large increases in the money supply requires a proper understanding of the nature of inflation. Since this understanding is often lacking, greedy businessmen are often blamed for the price increases, not the government’s creation of money. Nonetheless, if a money-printing scheme is extreme enough, people may be more likely to see that the government is to blame. Another force preventing rapid inflation is the realization on the part of politicians and economists that they are harming the economy by inflating the money supply at a rapid rate. This has occurred to some extent and has prevented the moderate inflation that the United States experiences from becoming more severe. However, statist politicians and economists have an insatiable desire to create money at a more rapid rate to increase government spending. They do so as a means to finance the welfare state, maintain an easy credit policy, bail out financially troubled firms in an attempt to cover up the harmful effects of their previous inflationary policies, and in general interfere in the economy more.

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If government officials cannot adequately restrain themselves, the ultimate end to inflation is the breakdown of the monetary system, where people no longer use the worthless money to purchase goods and services. This last implies grave economic consequences for individuals in the economy. We place ourselves in a dangerous position when we depend on the self-restraint of statist politicians, whose goal is to continuously expand their power over people’s lives. It is clear that they are readily willing to use this tool to expand those powers. This can be seen, for example, in the United States in the rise in government spending relative to total spending in the economy as the government has gained greater control over the money supply. It can also be seen in the fact that real, per capita government spending has increased dramatically during this time as well. Fractional-Reserve Banking It is often believed that without regulations requiring them to hold a certain amount of reserves to back their checking deposits, banks will lend out most of their reserves so they can increase the interest income they earn and remain more competitive with other banks by offering the highest possible returns to their depositors. The claim is that holding on to reserves to back all checking deposits is a waste of resources. It is believed that most of the reserves would just be collecting dust in banks’ vaults when, in fact, they could be earning income for the bank and providing higher interest rates to bank depositors. These arguments are false. The fallacies behind them and the reasons why, in fact, free banking tends to lead to 100-percent reserves being held by banks to back their checking deposits will be discussed eventually. Of more immediate concern is how government interference via regulations leads banks to hold on to reserves that represent only a fraction of their checking deposits. However, before discussing this topic, a discussion of why a fractional-reserve system is so unsound compared to a 100-percent reserve banking system is needed. Why a Fractional-Reserve System Is Unsound Fractional reserves are inferior to 100-percent reserves because they make the banking and monetary system very unstable, which includes generating the business cycle and all its attendant ills. Fractional reserves turn the monetary and banking system into a house of cards that can literally collapse at the slightest sign of trouble. It is an inherently dishonest system because it is an attempt to violate the law of identity with regard to money by attempting to make it possible for people to spend their money and lend it out at the same time. Such a system inevitably leads to instability and periodic financial disasters because it is impossible for money to be in two places at the sametime.5 To see why it leads to disaster, think of how fractional reserves come into existence. Imagine that $1,000 of reserves is used to create $10,000 of money in checking accounts through the fractional-reserve banking system.

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The $9,000 of checking deposit liabilities unbacked by reserves are backed by the $9,000 in loans made by banks, which is how the banking system creates $10,000 out of $1,000.6 The important point to note here is that a fractional-reserve banking system is capable of dramatically increasing the money supply over and above the level of reserves it possesses. Where is the instability in this illustration? The instability exists first in the fact that the money supply can be increased dramatically. This can put upward pressure on prices and profits and downward pressure on interest rates (at least initially) because the money comes into existence in the form of an additional supply of loans. The movements in these variables represent the expansion phase of the business cycle. Further, once the money supply has been increased through the creditexpansion process, it is easy to see how the monetary and banking system is very unstable. It is unstable because the far greater portion of checking account funds is not backed by standard money; however, funds in checking accounts are claims to standard money. In the above example, claims to standard money total $10,000 but only $1,000 of standard money actually exists. This can create a catastrophic problem if enough people decide to withdraw funds from their accounts at any one point so that the total withdrawals that people want to make are greater than $1,000. This is exactly what happens when runs occur on banks, as occurred during the Great Depression. Everyone demands standard money but there is not enough standard money to go around. Therefore, everyone either receives only a portion of the funds in their checking accounts (in the above example, 10 percent) or those who are too late receive nothing while those who get there early enough receive the entire amount. What happens in the case of a run is that the money supply and the amount of spending shrink dramatically. In other words, deflation occurs. In the above example, the potential exists for the money supply to shrink from the $10,000 of checking account deposits all the way down to the $1,000 of standard money. This can cause a recession or depression or make such an event worse. The latter is exactly what happened during the Great Depression. As the depression started and borrowers failed to pay off loans, banks became insolvent and people made runs on banks to get their funds before the banks went bankrupt. However, since the supply of standard money was far less than the supply of checking deposits, all depositors could not be paid off and therefore the money supply began to shrink until it fell, by 1933, to a level that was about 25 percent below its high in 1928.7 This is the position in which fractional-reserve checking places a monetary and banking system. By making it possible for people to have a claim to their checking account money and at the same time lend out these funds, it makes possible a rapid inflation and expansion. However, because all of the standard money that people have a claim to does not exist, it makes the system vulnerable to a dramatic deflation and depression should anything happen to cause people to attempt to exercise their claims. In fact, the fractional-reserve system breeds financial panic and disaster because banks do not possess enough

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reserves to back all their checking deposits. This means potentially large decreases in the money supply are possible, along with the attendant financial ruin that occurs when individuals and businesses have a harder time raising funds, paying for goods and services they need, and paying off debt. Without such a system, the swings of the business cycle would, at a minimum, be greatly reduced. How the Government Creates Fractional Reserves Now that I have shown why a fractional-reserve system is unsound, just how does the government bring it into existence? There are several means by which government interference does this, including governments and central banks acting as “lenders of last resort,” creating deposit insurance, restricting branch banking, suspending the payment of standard money, among other means.8 Probably the most obvious way in the past that governments created fractional reserves was by forcing banks to loan the government reserves that were used to back checking deposits or by allowing banks to violate their contractual obligations to hold 100-percent reserves so that they could lend the government money. This was a blatant rejection of 100-percent reserves for the purpose of the government gaining access to more funds. Government interference also perpetuates the fractional-reserve banking system by bailing out financially troubled banks. This has been done throughout history. In the United States, the First and Second Banks of the United States— government banks that existed in the late eighteenth and early nineteenth centuries—often provided loans to financially troubled commercial banks. More recently, the Federal Reserve and US Treasury have bailed out financially troubled banks. One reason that many banks get into financial trouble is due to not having enough reserves to pay off depositors who demand standard money. By bailing out unsound banks, the government enables them to remain in existence and perpetuate their unsound business practices. If unsound banks were not bailed out, they would have been driven out of business (along with their unsound business practices). As banks come to expect the government to bail them out when they get into financial trouble, they are provided with an incentive to take on greater financial risk, including lowering the fraction of reserves they keep on hand to back their checking deposits and being less careful in the loans they make (among other things). Whenever a third party (in this case taxpayers) pays the bill for bad decisions made by two other parties (in this case banks and depositors), irresponsibility and recklessness are encouraged. As I tell students in my classes, if they were to cover the losses my broker incurs in investing my money, both my broker and I would not care at all about the risk we take on. We would only consider the upside potential of investments regardless of the downside risks. In general, if one bails out businesses that are in financial trouble, one encourages sloppy business practices. If the government did not interfere and bail out banks, the banks would not come to expect such bailouts. They would have to be much more careful with

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the loans they make and carry far higher reserves to stay in business for the long term. The government and government banks are often considered “lenders of last resort” that private banks must turn to when no one else will lend funds. One reason governments and their banks can play the role of “lender of last resort” is because of their ability to create money. If the government can print money, it is impossible for it to go bankrupt (at least in nominal terms). It always has additional funds that it can use to lend when no one else can or will. If the government could not print money, it would not have an endless supply of funds to sustain the fractional-reserve system. It is the existence of fiat money that enables governments to get away with playing the role of “lender of last resort.” To get rid of fractional-reserve banking and all the problems it creates, one must also get rid of government issued fiat money. While it is true that governments and government banks sometimes acted as “lenders of last resort” even before the existence of fiat money, they did not do so to the extent they have done it since the existence of fiat money. Prior to the existence of fiat money, they had to make sure they did not allow their supply of gold reserves to become too low for fear of jeopardizing their own solvency, although in many cases governments just temporarily abolished the use of commodity money and forcibly imposed the use of fiat money on citizens to avoid this limitation. With fiat money, the government appears as a veritable Santa Claus because it can bear gifts—financial gifts—that appear to come from nowhere and cost nothing. However, the costs are great. The financial hardship and ruin of countless people and businesses have been caused by the recessions and depressions brought about by the cycles of boom and bust that are created by the existence of fiat money and fractional-reserve banking. If one abolishes government created money, the need for a so-called lender of last resort would be significantly reduced. In addition, if the government did not play the role of “lender of last resort,” banks would have to carry far more reserves in order to survive and this would put them in a much better financial position. These changes would also put the economy in a much more financially sound position and make economy-wide financial collapses much less likely. Another result of the government acting as a so-called lender of last resort is the fact that taxpayers are forced to pay the bill for propping up unsound and poorly run businesses. Even if some taxpayer funds are eventually paid back to the government and a rate of return is earned on such funds, funds are not always paid back (and this is typically the case) and it forces taxpayers to take risks with their money that they would not take otherwise. If people were willing to take such risks voluntarily, businesses could raise the funds they need through private means and would not have to turn to the government for a bailout. Propping up companies through inflation also forces taxpayers to pay the bill. Inflation is a hidden tax because it erodes the value of people’s income without many of them knowing how this occurs. It is therefore one of the

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most pernicious taxes. Further, the undermining of the productive capability of the economic system—and thus the rate of economic progress and standard of living—occurs due to the inflation of the money supply (which I discuss in detail in chapter 7) that fiat money makes possible. In fact, being able to inflate the money supply is the reason why fiat money is imposed on economies in the first place. As another mechanism for perpetuating the fractional-reserve system, governments have often allowed banks to suspend payments of specie or standard money when they have gotten into financial trouble. This has occurred throughout the history of the Western world. The banking “holiday” imposed by FDR during the Great Depression is just one example from US history. Such violations of individual rights by the government enabled banks to get away with carrying fewer reserves than they would have otherwise needed. Had their contracts to pay been enforced, banks that did not carry enough reserves would have been forced out of business. But allowing the contracts to be violated prevented banks with too few reserves from being driven out of business through lawsuits by their creditors (i.e., depositors) and allowed such banks to return to continue their poor banking practices. In fact, if banks had understood that they could not have gotten away with violating their contractual obligation to pay—that is, had there been no government interference casting aside the sanctity of contract—they would have been led to carry higher reserves relative to their checking deposits so that they would not have put themselves in a position in which they were unable to pay. Not only have governments allowed banks to suspend payments, banks have used schemes to avoid having to pay specie (even when they were not in financial trouble) to reduce the amount of specie they had to hold and increase the circulation of their banknotes. These methods included refusing to lend to depositors who insisted on withdrawing specie and leveling charges of “disloyalty” against them.9 Banks attempting to avoid paying specie, by itself, is not inconsistent with a free society. While it is a poor business practice because it is not customer friendly and therefore would tend to be eliminated in a free market, there is no violation of individual rights inherent in such action. Moreover, although such actions do tend to arise in an atmosphere in which rights are not respected, they are not necessarily the product of government interference. However, if such actions represent violations of contractual obligations and the government does not properly enforce the contracts in response to civil suits by depositors, then the government is complicit in these violations of individual rights. Any lack of protecting rights on the part of the government would encourage banks to hold lower gold reserves in these situations. As a part of enforcing contracts, the government should not only enforce contracts to pay depositors on demand if the contract is broken and depositors bring suit against the bank, it should also enforce contracts that require banks to keep 100-percent reserves on hand if the banks do not hold such reserves and depositors bring suit. A major step into the realm of fractional-reserve

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banking involved court rulings in cases in England over the span of three centuries (the seventeenth through nineteenth centuries) in which customers brought suits against bankers over fractional reserves and the legal status of customers’ deposits. The courts ruled in favor of the bankers in almost every case.10 The basis of the rulings was that money is fungible and that one coin of a certain kind cannot be distinguished from another of the same kind. Hence, the courts claimed that the banks were in the position of a debtor and not a bailee to customers and thus were not obligated to keep 100-percent reserves. Originally, goldsmiths, who were the predecessors of banks, had been in the position of bailees to their customers. Customers brought suit because they viewed banks as still in the same position as the goldsmiths. These rulings were inappropriate. While the claim regarding fungibility is true, this only justifies banks not having to return the exact same coins that were submitted in bailment to the banks. However, this does not justify the banks holding less than 100-percent reserves. If the deposit contract stipulates that 100-percent reserves must be held, this is what the banks should do and when customers bring suits against the banks to enforce the contracts, this is what the courts should require the banks to do. By not enforcing the contracts, the British courts set a major precedent for the acceptability of fractional-reserve banking at the expense of the violation of the property rights of depositors. Had the opposite precedent been set, perhaps the history of banking and the business cycle during the last few centuries would have been much different. Restrictions on branch banking (in the form of preventing banks from opening new branches in any location they chose) also encouraged irresponsible banking practices, including fractional reserves. Banks were often limited to doing business only in one particular state, and sometimes states even limited branch banking within their borders. Such restrictions made possible more irresponsible banking practices by limiting competition from better run, more conservative banks (including banks that had higher reserves) and thus preventing them from expanding at the expense of their poorly run rivals.11 Businesses successfully expand over the long term by building a good reputation and using that reputation to move into new territories. For banks in a free market, without the ability to be bailed out by the government, this means first and foremost ensuring that their customers’ deposits are safe. To do this, among other things, they must engage in sound lending practices and ensure they have sufficient reserves to meet customers’ liquidity needs and protect themselves against larger than usual withdrawals. Earning high rates of return on customers’ deposits is not the goal of banks. Banks are places in which individuals put their money for safekeeping (i.e., in checking deposits) or through which individuals make some of the safest investments (through savings and time deposits). Hence, preservation of principal is the first priority for banks. If individuals want high rates of return, they turn to the stock market or other risky markets. (Of course, in a free market banks could invest clients’ money in risky investments, but

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I believe the funds available through checking, savings, and time deposits would not be used to make such investments.) The intense competition that would develop among banks in an environment in which the freedom of competition is protected—and thus banks had to earn their customers’ business and survive on their own—would serve to discipline banks to carry higher reserves. Banks must be adequately liquid to succeed and there is no better way to achieve adequate liquidity than to carry cash, which in a free market means carrying gold or notes backed by gold. Minimum capital requirements and extended liability for bank shareholders (the latter constituting an obligation imposed on shareholders by government regulators to provide funds, should a bank become financially troubled, beyond those used to purchase shares of stock in a company), as well as government bank examinations, assurances, inspections, and endorsements—any form of attempting to artificially build confidence in the banking system—also serve to promote unsound banking practices, including fractional reserves. All of these regulations attempt to make it seem that banks are sound when, in fact, due to their fractional-reserve nature, they are unsound. Such mechanisms merely create the facade that banks are in good shape. In essence, they ignore the nature of fractional reserves. They lull depositors into a sense of complacency and make them think that, because the government has put its stamp of approval on a bank or because the government has forced owners to contribute (or potentially contribute) additional capital, their funds are safe. These mechanisms do not address the root cause of the instability in the banking system. They merely attempt to cover up the problems. They encourage banks to engage in unsound banking practices by making it possible for banks to get away with such practices. Without such regulations, customers would have to be much more careful about where they put their money. The free market could make such a decision-making process easy by providing mechanisms to determine the soundness of banks through such means as private bank rating agencies (that do not require government approval to do business). Such mechanisms have even existed in the past. Only the best methods of determining bank soundness would tend to survive in a free market. Such an industry would be exposed to full and open competition, as every other industry is in a free market. As a result, people would seek out the best methods and reject any others in order to best insure the safety of their money. In a free market, methods for assessing the soundness of banks would not merely perpetuate the fractional-reserve system. Banks would have to earn good ratings not only by demonstrating their financial soundness to rating agencies, but also in open competition with each other. Government deposit “insurance” also makes the banking system unsound. Such schemes were created by state governments in the United States during the nineteenth century. Since 1934, federal deposit insurance has existed in the United States. These schemes make the banking system unsound because they take a large portion of the responsibility of providing sound banking and financial services off the shoulders of bankers. Deposit “insurance”

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provides bankers with a greater incentive to take on more risk because depositors will not lose money if banks lose money.12 In fact, the distorted incentives are often not even limited by the limit of the “insurance.” In the past, federal deposit insurance has been extended beyond the stated limits (previously $100,000 and now $250,000 per account) to include all amounts on deposit.13 The “insurance” creates greater risk by encouraging bankers to use less equity and more debt (i.e., deposit) financing.14 It also makes it easier for banks to lend out reserves since taxpayers will bear the burden of paying off depositors if banks fail to do so. It is similar to the students in my class covering the losses I incur due to the bad investments my broker makes. But, one might ask, don’t banks pay for the “insurance” through premiums that give them the right to have the “insurance” coverage? Banks do pay but government deposit “insurance” schemes are notorious for being actuarially unsound; that is, premiums are generally not high enough to cover the potential losses that could be incurred.15 So such schemes routinely run out of money and taxpayers end up paying a large portion of the cost. This has occurred as recently as the late 1980s when the Federal Savings and Loan Insurance Corporation went bankrupt and taxpayers had to pay approximately $124 billion to bail out depositors at savings and loan institutions.16 In a free market, private deposit insurance may exist (although probably not, see the next chapter on this topic). However, if it did exist, such insurance would look very different than government deposit “insurance.” Premiums would vary based on the riskiness of the deposits being insured; that is, premiums would vary directly with the probability of a claim being made against the insurer and the expected size of the claim. Until 1991, premiums were flat under the US government “insurance” scheme. This encouraged risk taking and forced low-risk banks to subsidize high-risk banks. Even though the government is now varying premiums based on risk and the balance of insured funds, premiums would still be much higher in a free market (relative to the risk being insured against) because sellers of such insurance would expect to earn a profit in the business, so the business would have to be actuarially sound. Furthermore, private insurers could not count on the “full faith and credit” of the US government, which the federal deposit insurance scheme counts on today if the fund runs out of money. The embracement in the 1980s of the policy that some financial institutions are “too big to fail” also implies that taxpayers will bear the cost of covering deposits that the “insurance” fund will not be able to cover (and even the cost of the financial trouble that firms outside the banking industry get into should they be deemed “too big to fail”). While legislation in 2010 allegedly ended “too big to fail” (the Dodd-Frank Act), this is doubtful. Banking legislation passed in 1991 was supposed to do the same thing (the FDIC Improvement Act, which is the same act that introduced risked-based premiums to federal deposit insurance) but firms deemed “too big to fail” were still bailed out after the passage of this legislation. The fact that DoddFrank also gives the power to the government to designate some companies

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as “systemically important” to the stability of the financial system indicates that companies will still be bailed out if the government deems it necessary to do so. If government deposit “insurance” did not exist, banks would have to increase the equity financing they use, increase their cash on hand and the liquidity of their investments in general, make sure they do a better job of matching the maturity of investments and deposits, and carry a greater fraction of reserves relative to their checking deposits. These things would reduce the risk exposure of banks and provide greater certainty that depositors would be paid off, especially in the event of a run. In fact, in order to prevent runs from occurring in the first place, banks would have to engage in these practices to convince depositors they are in a financially sound position. Arranging for the takeover of failing banks by financially more sound banks (sometimes coerced by twisting the arm of the acquiring bank) is another way governments have perpetuated poor business practices in banking, including fractional reserves. These troubled banks can then return to continue their fractional-reserve banking practices under new ownership. Without these government initiated takeovers, at least some of these banks would be liquidated. Liquidations would serve both as a means and incentive to maintain a larger fraction of reserves on hand. They would tend to eliminate banks engaging in poor business practices and provide an incentive for banks in general to engage in better business practices. The liquidations would also serve as a reminder to depositors that they cannot depend on government initiated takeovers of unsound banks to protect their money. If a bank gets into financial trouble, depositors may have to work things out with the bank on their own to prevent liquidation (to the extent that other banks do not agree voluntarily to take over the bank). Depositors will have to demand as a condition of depositing their funds that, among other things, higher reserves be kept on hand by banks to prevent the banks from going bankrupt. Otherwise, depositors should take their business elsewhere. Governments have also promoted fractional-reserve banking in the past by accepting banknotes from banks—such as in payment for taxes—that do not have 100-percent reserves backing their checking deposits and banknotes and then using these notes to conduct their daily business. Governments should not have done this. The reasons why are discussed in chapter 5. Here let me say that when the government accepts notes issued by a particular bank and uses those notes in its daily business, it creates a greater demand for those notes and makes it easier for that bank to issue more notes. The government should accept payment only in the notes or checks of banks that back their notes and checking deposits 100 percent or it should accept payments only in gold or silver (or whatever standard money has been established in the marketplace).17 If the government receives payment in a form that is not backed 100 percent, it should immediately redeem

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that payment for standard money. This would provide an incentive for banks to hold greater reserves. In essence, governments, including the US government, have done everything they can to instill unsound, risky business practices in the banking industry. They have created an environment in which the normal mode of operation is for the government and taxpayers to pay the bill for the mistakes made in the banking industry. Further, they have also taken away much of the incentive for depositors to carefully scrutinize with whom they are entrusting their money. In a fully free market in banking, bankers would never be able to get away with the unsound banking practices in which they engage today and depositors would be much more careful about where they put their money. If America had a completely free market in its banking and monetary system, that is, if it had a banking and monetary system with no government deposit insurance; no government “lender of last resort”; no government examinations, assurances or inspections; no government imposed capital requirements, restrictions on competition or extended liability for bank shareholders; and no government provided fiat money and Federal Reserve, its banking system would be as sound and as stable as possible. The system would be based on a 100-percent reserve gold standard. This is the monetary and banking system of a free market. Such a system would create a rock-solid foundation on top of which economic progress could take place. Such a system would virtually eliminate the vicious cycle of boom and bust that has come to be known as the business cycle. In succeeding chapters I show just how a 100-percent reserve monetary and banking system would be achieved within the context of a free market in money and banking and how this system would create such a stable financial environment. At this point, I turn to why a free market would not lead to fractional reserves.

Why a Free Market Would Not Lead to Fractional Reserves As I stated at the start of the previous section, it is often believed that if banks were free to lend reserves on checking deposits, they would hold very little reserves backing such deposits. In fact, many who do not understand the nature of banking, and business in general, believe that banks would hold no reserves if they were legally allowed to do so. Regardless of the level of reserves it is claimed banks would hold, most people believe that banks would certainly hold significantly less than 100-percent reserves. As I have stated, it is my contention that this is not true. My claim is that a free market in money and banking tends to lead banks to hold 100-percent reserves on their checking deposits (and banknotes issued). I discuss in the next chapter just how it will lead to 100-percent reserves. In this section I focus on two points: why banks have the right to issue fiduciary media and why if this right is protected it will not lead to banks holding fractional reserves.

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Why Banks Have the Right to Issue Fiduciary Media The issuance of fiduciary media, by itself, does not violate individual rights.18 It can be performed in a way that is consistent with the protection and respect for rights. Some economists, such as Hans-Hermann Hoppe, Jörg Guido Hü lsmann, and Walter Block, believe that the issuance of fiduciary media is in every case an act of fraud and thus a violation of individual rights. They state, “any contractual agreement that involves presenting two different individuals as simultaneous owners of the same thing (or alternatively, the same thing as simultaneously owned by more than one person) is objectively false and thus fraudulent.”19 To see why this is not the case, one must understand what fraud is. Fraud involves the use of trickery or deceit. As the tenth edition of the MerriamWebster’s Collegiate Dictionary puts it, “fraud” is the intentional perversion of the truth in order to induce another to part with something of value or to surrender a legal right. A bank lending out reserves on checking deposits does not necessarily involve an act of deceit. The same is true if it issues notes not backed by reserves. The bank could make it known to depositors that it might lend out reserves backing checking deposits and that it might delay payment if necessary or that the depositor might not receive some portion or any of his funds, due to the fractional-reserve nature of the bank, if a run occurs. This could be stated in the deposit contract. That the bank is a fractional-reserve bank could also be printed on all checks it provides to its depositors so that anyone who accepts checks drawn on its depositors’ accounts will have knowledge of its fractional-reserve nature. This could be printed on its notes as well. Such measures would make it possible to prevent any “perversion of the truth” from taking place on the part of banks. It might be appropriate for the government to require banks to take such measures to prevent people from inadvertently accepting checks or notes from fractional-reserve banks. However, before this is done, there must be evidence that such action by the government is necessary, that is, that the rights of unsuspecting recipients of the checks or notes are violated. If it becomes a widespread problem that individuals are unknowingly accepting such financial instruments and being harmed financially (i.e., are not able to get the money they have a right to), then it would be appropriate for the government to create laws requiring notification of when checks or notes are being issued by fractional-reserve banks. However, if banks engage in fractional-reserve banking and few people are financially harmed by banks engaging in this type of banking or it is generally known who the fractionalreserve banks are, then no laws requiring notification would be necessary. Isolated cases in which it is alleged that banks did not provide appropriate notification of their fractional-reserve nature could be dealt with via individual lawsuits. Furthermore, whether the government requires notification by fractional-reserve banks or not, it would be easy to prevent fraud from arising if the government engages in appropriate criminal prosecutions. So fractional-reserve banking, by itself, does not involve an act of fraud or violate

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individual rights. Banks have the right to engage in this type of banking so long as they do not attempt to hide this information from individuals. Another economist, Jesús Huerta de Soto, makes the same argument as the economists above regarding the allegedly fraudulent nature of fractionalreserve banking and its alleged violation of property rights.20 However, he also provides other legal arguments as to why this type of banking should be outlawed. He says that bank deposit contracts with fractional reserves are “null and void” because the existence of fractional reserves implies there is an error concerning the nature of the transaction between bankers and depositors. He also says deposit contracts are incompatible with loan contracts, the transaction is impossible to carry out, and it does serious harm to third parties (because it causes financial crises, recessions, and depressions).21 Let us analyze each of these. With regard to the idea that an error must have occurred in the creation of a deposit contract when fractional reserves exist, it is claimed that if the depositor intends money to be kept on hand for safekeeping (100-percent reserves) and the bank enters the contract to receive money loaned to it and will not keep it on hand but will loan it out to others, then the contract is null and void. This might be true if each party misunderstands the reasons the other is entering into the contract; however, it is possible for the two parties to enter the contract knowing exactly what each intends to do. A depositor might enter a contract intending to use the funds deposited for writing checks and know that the banker will not keep all of the funds on hand at any one time. A depositor who intends to write checks on the funds deposited does not have to enter a contract in which he intends all the funds to be kept by the banker at all times for safekeeping. Hence, no error occurs in this case and the contract is valid. Huerta de Soto claims that even if the two parties fully understand the nature of the (checking) deposit contract they are agreeing to, in the case of fractional reserves, the contract is still null and void because deposit contracts are incompatible with loan contracts. He explains that such a contract would be “legally null and void as any contract in which one of the parties authorizes the other to deceive him or accepts in writing self-deception to his own detriment.”22 This is a non sequitur. How is the depositor being deceived? When he enters such a contract, he knows the full nature of the contract in which he engages. He knows (or, at least, can know) that not all his money will be kept on hand for safekeeping and that the banker might lend it out or use it for other purposes. Explicit use of the option clause (i.e., the option to pay interest or higher rates of interest while funds are not available) or delays in payment incorporated into the contract could be used to further protect the banker from having to pay any funds to the depositor on demand. No agreement to be deceived is involved. Based on Huerta de Soto’s historical research on the subject of deposit contracts and loan contracts, 23 he thinks because individuals started out either handing money over to banks for safekeeping, expecting the funds to always be there, or giving money to banks to loan the money out and earn

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interest for the banks and their customers, we are forced to continue with only these two options in banking. This is an intrinsicist argument and is therefore false. Just because contracts started out in history being written in only certain ways does not mean we have to require that all contracts now be written that way. If new types of banking contracts can be written—with no force or fraud involved—that allow depositors to write checks on accounts while at the same time the bank only keeps a portion of the funds on hand, then such contracts are completely valid from a legal and moral standpoint. This most certainly is the case with fractional-reserve checking accounts (and banknotes) as long as the depositors are properly informed. Huerta de Soto’s argument that deposit contracts within the context of fractional-reserve banking are null and void because they are impossible to carry out is also invalid. While it may be true that if all depositors at a fractional-reserve bank attempt to withdraw their funds (or, at least, enough do to deplete the reserves) that not everyone would be able to obtain their funds or people would only get a portion of their funds, it is not true in every case and it is not the typical circumstances of a banking system with fractional reserves that depositors cannot obtain all of their funds. In the majority of cases, where only a small percentage of depositors withdraw their funds or many depositors withdraw only small amounts of their funds, while at the same time other depositors are depositing funds, depositors will be able to obtain all the funds they have in their accounts or all the funds they need. This is no different, in essence, than the case of many people loaning significant sums of money to a company and the company not being able to pay off all its creditors should they all decide to call the loans at the same time (assuming all the loans are callable at any time). Engaging in such loan contracts might not be a sound business practice but that does not mean such contracts should be illegal. The same is true of fractional-reserve deposit contracts. What about the claim that fractional-reserve banking harms third parties because it is one of the causes of financial crises, recessions, and depressions? While it may be true that fractional-reserve banking is one of the causes of economic crises, this does not, in and of itself, constitute a violation of individual rights and thus grounds for the government to ban the activity. First, individuals who want nothing to do with fractional-reserve banking can protect themselves from the destructive effects of such banking. They can choose not to do business with fractional-reserve banks or individuals who have their money in such banks. For example, they can choose not to put their own money in fractional-reserve banks, accept checks from individuals whose money is deposited at fractional-reserve banks, accept notes from fractional-reserve banks, and so forth. Of course, people might go to the greatest extremes to protect themselves from fractional-reserve banking and still be financially harmed from the economic crises caused by such banking. Nonetheless, financial harm is not, in and of itself, a violation of rights. When Wal-Mart opens a store in a city, surrounding retailers may be driven out of business and their former owners

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might be financially worse off as a result. Further, you may build a home that blocks my view of the ocean from my home and, as a result, the value of my home might decrease. However, neither of these cases are violations of individual rights. Wal-Mart has the right to enter and compete in voluntary trade and you have the right to engage in voluntary trade to purchase land and build a home, even if it blocks my view. In the latter case, I should have thought ahead and purchased the land that leads all the way down to the ocean to ensure the existence of my view. In both of these cases, individuals are financially harmed but rights are not violated. Rights can only be violated through the initiation of physical force or fraud.24 In both of these cases, no force or fraud is used. To the extent that people are financially harmed by fractional-reserve banking even though they would rather not deal with such banks (or such banks’ customers) and even though they might take every precaution to not do business with such banks or these banks’ customers, they must deal with the fact that the voluntary actions of others (i.e., actions fully consistent with the protection and respect for rights) might affect them negatively from a financial standpoint. Such is just a possibility in a division of labor, capitalist society. If one does not want to be affected by the actions of others, one should go live as a hermit in Alaska. Throughout his book Money, Bank Credit, and Economic Cycles, Huerta de Soto ignores facts to rationalize his argument that fractional reserves must be outlawed. For instance, he claims that “without the explicit or implicit establishment of a fixed term, the . . . loan contract cannot exist.”25 This simply is not true. For example, there is the case of consols issued by the United Kingdom in the mid-eighteenth century. These have no stated maturity date and it still makes payments on them today. Perpetual bonds, issued by banks today, have no stated maturity date as well. While perpetual bonds and consols are not used extensively, they are used and they are examples of a true perpetuity. Traditional savings accounts have no stated maturity date as well. The funds could remain in the account for as long or as short as the depositor wants. In this sense, checking deposits, which have no stated maturity date, are similar to savings accounts. Huerta de Soto attempts to use the above, as well as other arguments, to claim there is a clear legal distinction between loans and checking deposits (what he calls irregular deposits) and thus to claim that it is impossible to equate a checking deposit with a loan contract. Based on this, he then claims that fractional-reserve checking deposits should be illegal because the fractional-reserve aspect of these deposits makes them loans and therefore not consistent with “traditional legal principles.” By ignoring the existence of consols and the nature of savings accounts, he is simply ignoring facts that do not fit his conclusion. Huerta de Soto confuses the legal and economic aspects of fractional reserves and completely ignores the philosophical nature of fractional reserves. Fractional reserves are economically unsound because they lead to periodic economic crises, but this does not mean they should be illegal. Economic and financial stupidity, by itself, does not violate rights and therefore should

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not be illegal. The real problem with fractional reserves, which makes them economically unsound, is the fact that they are philosophically unsound. They attempt to violate the law of the excluded middle.26 This law states that a thing is either A or non-A. In the case of money, at any one point in time either I am in possession of the money and can spend it or someone else is in possession of the money and can spend it; however, two people cannot be in possession of the money and spend it at the same time (this latter is the law of noncontradiction). This is why fractional reserves lead to periodic economic disasters. They are an attempt to violate immutable laws of reality: the fundamental laws of logic. One can attempt to do so, just as one can attempt to violate the law of gravity by jumping off a skyscraper, but the attempt will lead to disaster. Huerta de Soto not only confuses economically unsound acts with acts that should be illegal but, at the same time, confuses the philosophically unsound with the illegal.27 This confusion manifests itself as a case of confusing the metaphysical with the man-made.28 He thinks it is legally impossible to recognize fractional reserves as if there is something from a metaphysical standpoint preventing us from doing so. However, both fractional reserves and government-created laws are man-made phenomena. Hence, there is nothing stopping man from creating laws that recognize fractional reserves. What man cannot do, however, is violate the laws of logic without suffering the consequences. These are metaphysical facts that cannot be changed. So banks have the ability and right to engage in fractional-reserve banking and therefore such banking should not be made illegal. However, as I show below, banks will tend not to practice this type of banking because of the risk taking involved with it and the disasters to which it leads. Why Fractional Reserves Will Not Exist in a Free Market If banks are free to engage in fractional-reserve banking, why won’t this type of banking exist? This is the question the current section answers. There have been many arguments made for why fractional reserves would come into existence if they were legal in a free market. I will address these here. One claim is that if fractional reserves are legal in a free market, bankers face an irresistible incentive to expand their lending based on the tragedy of the commons.29 The classic example of the tragedy of the commons is the case of the public ownership of grazing land. Public ownership of grazing land leads to overgrazing because no one has an incentive to use the land carefully and preserve it into the long-term future, since he will not gain the benefit from preserving it. If an individual chooses to preserve the land for his long-term use, others will quickly use what he does not. Therefore, the incentive is to use the grazing land as much as possible and gain the shortrun benefits before anyone else does. No single individual owns the land and has control of it and therefore no single individual has the incentive or ability to preserve the land for long-term use. Hence, the source of food on the land is depleted very quickly.

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The claim with regard to fractional-reserve banking is that bankers face a strong incentive to use reserves that back checking deposits because the short-term profits from doing so are allegedly so enormous that, no matter how prudent a banker is, he eventually succumbs to the temptation. In fact, allegedly there is an incentive to act sooner rather than later to operate with fractional reserves so banks can “expand their credit before other banks and hence to take full advantage of the profits of the expansion while leaving the rest of the banks, and the entire economic system in general, to jointly bear the extremely harmful consequences which ultimately follow.”30 The harmful consequences that will follow are the recessions, depressions, and financial crises that inevitably result from fractional-reserve banking. The fact that a bank faces a greater risk of failing by engaging in fractional-reserve banking is not relevant, according to proponents of this argument, because “no particular banker can be absolutely certain his bank will be one of those that eventually suspend payments or fail.”31 (Emphasis is in the original.) The major problem with this argument is that the tragedy-of-thecommons argument is not applicable to fractional-reserve banking. As illustrated in the classic tragedy-of-the-commons example, no rancher gains any long-term benefits from using the public grazing land in a long-term fashion. Any benefits from one rancher refraining from overusing the grazing land are bestowed on other ranchers, who now have more grass available for their cattle to consume. However, this is not the case with fractional-reserve banking. If an individual banker maintains 100-percent reserves, he sees a long-run benefit: he is better able to survive an economic crisis. He puts his bank in a more sound financial position and can use this to his competitive advantage to gain business. He can demonstrate to his customers and potential customers that their funds are safe with his bank. So this argument does not imply that fractional reserves will come into existence if they are legal. The argument fails because there is no “public property” in the case of fractional-reserve banking being legal in the context of a free market. All banks are privately owned and one succeeds or fails based on the soundness of the business decisions one makes. The fact that third parties might benefit or suffer from your decisions, depending on whether you choose 100-percent or fractional reserves, or that your knowledge of the future success of your business is uncertain does not deny the fact that if you make bad decisions they will affect you negatively and if you make sound decisions they will affect you positively. There will be no government regulations or agencies to bail you out, prop you up, or otherwise save you from your bad decisions in a free market. You sink or swim on your own. Those who make the tragedy-of-the-commons argument even recognize the very consequences of fractional-reserve banking that will provide a strong incentive to never even attempt to engage in such banking and tend to eliminate it if people do attempt to engage in it. Ironically, they do this in the middle of making their argument that protecting the right of bankers to engage in this type of banking will allegedly lead to the existence

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of fractional-reserve banking. For example, Huerta de Soto claims that “a banker who expands his loans brings in a handsome, and larger, profit (if his bank does not fail ), while the cost of his irresponsible act is shared by all other economic agents.”32 (Emphasis added.) He ignores a key aspect of fractional-reserve banking in this statement. At best he considers it a minor side issue, since he places it in parentheses. However, the fact is that, ceteris paribus, fractional-reserve banks will be more likely to fail than 100-percent reserve banks and the lower the reserve ratio they operate with, the more likely they will fail. This will lead to these banks earning lower profits, not higher. This will tend to eliminate fractional-reserve banks. They will suffer the consequences of their own poor decisions. Yes, they may affect others negatively through the crises they generate or help to make worse. But they will suffer the most and the 100-percent reserve banks will tend to survive the crises and benefit in general from their sound decisions. The only way one can say such a business will earn higher profits is in the sense of a fly-by-night, crooked business trying to make as much money as it can before the public catches on to it. However, this is certainly not how one makes large profits; it is certainly not how industrialists have amassed fortunes throughout the history of capitalism. They have done so by building huge enterprises that are viable in the long term. There is no reason to think that the banking industry is any different (and history tells us that it is not). Throughout his book, Huerta de Soto discusses how fractional-reserve banks tend to fail and those with 100-percent reserves tend to last. For example, he discusses the Bank of Amsterdam and how it maintained 100-percent reserves for almost 170 years and was very stable as a result. He also discusses how its downfall was brought about by its eventual lending of reserves on demand deposits.33 He also says that “bankers can initiate credit expansion in a free-banking system if for some reason they disregard their own solvency.”34 (Emphasis added.) Further, he states that “the central bank tends to counteract the mechanisms which work in a free market to spontaneously reverse the expansionary effects of banking. (Such mechanisms consist precisely of the rapid failure of the most expansionary and least solvent banks.)”35 (Emphasis added.) However, he ignores or fails to see the implications in these statements when he says that, even though fractional-reserve banks will tend to fail, “there is no doubt that the process only works a posteriori and cannot prevent the issuance of new fiduciary media.”36 (Emphasis is in the original.) He thinks that although errors will tend to be eliminated (including the error of issuing fiduciary media), they will only be eliminated after a significant period of time.37 Further, he claims, “the supply of fiduciary media largely creates its own demand,” so banks will easily and routinely be able to issue it.38 (Emphasis is in the original.) Perhaps his most definitive statement on the issue is a quotation from Ludwig von Mises, with which Huerta de Soto agrees: What calls for special explanation is why attempts are made again and again to improve general economic conditions by the expansion of circulation

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credit in spite of the spectacular failure of such efforts in the past. The answer must run as follows: According to the prevailing ideology of businessman and economist-politician [sic], the reduction of the interest rate is considered an essential goal of economic policy. Moreover, the expansion of circulation credit is assumed to be the appropriate means to achieve this goal.39

In contrast, here is an excerpt from Mises’s writings from a period later in his life where he quotes with approval the French banker and economist Henri Cernuschi: “I want to give everybody the right to issue banknotes so that nobody should take any banknotes any longer.”40 One must keep in mind that in this quotation banknotes are used by Mises to represent fiduciary media. He makes this clear on the page after the quotation. This quotation provides an indication of what will happen in a free market in which the right to issue fiduciary media is protected. Huerta de Soto seems to think that bankers will just not learn. They will always want to engage in fractional-reserve banking because they can allegedly make large profits or because they have an ideological predisposition for low interest rates through credit expansion. The correct answer to Mises’s question, which Mises identifies in the later quotation of Cernuschi, is that bankers can and will learn to engage in sound banking practices. They are not doomed to repeat the same mistakes decade after decade and century after century. Men possess reason and can use it to understand complex phenomena and act in a long-range fashion. This includes being able to understand the nature of fractional-reserve versus 100-percent reserve banking and that the former will lead them to bankruptcy and the latter to financial success. This may occur over a longer or shorter period of time and a number of economic crises may occur as a result, but this will only serve to strengthen the understanding of the destructive nature of fractional-reserve banking and the soundness of 100-percent reserve banking. It will also reinforce the fact that the supply of fiduciary media does not create its own demand but leads to the bankruptcy of those who issue it. This will discipline banks and lead them to 100-percent reserves (or, at least, something close to it). Of course, the above will only occur once the principles underlying a free market are fully and consistently embraced throughout a nation and thus absolutely no government interference exists to promote fractional-reserve banking. Bankers, and individuals in general, are not hardwired to embrace any particular ideas, including the belief that lowering interest rates through credit expansion is sound economic policy. Humans have free will and can choose to apply their individual reason to understand an issue, even one as complex as fractional-reserve versus 100-percent reserve banking. That we are hardwired to accept certain ideas is certainly an implication of the quotation above from Mises with which Huerta de Soto agrees. The difference between Mises and Huerta de Soto is that Mises must have abandoned this belief because he eventually realized that a free market in banking (including the right to issue fiduciary media) would lead to 100-percent reserves.

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However, Huerta de Soto appears to still embrace this belief despite the fact that he writes about how fractional-reserve banks tend to fail and 100-percent reserve banks tend to survive. Another argument for allegedly why a free market in banking in which the right to issue fiduciary media is protected will lead to fractional reserves states that bank customers will want fractional reserves instead of 100-percent reserves backing their checking deposits because they will want to earn interest on their checking deposits instead of having to pay a fee for the storage of the reserves in the vault. The claim is that banks will be able to pay higher interest rates on checking deposits or provide other banking services at a lower cost or no cost at all.41 There are a number of problems with this argument. Let’s take a look at them. Bank customers might be able to earn higher rates of interest with the issuance of fiduciary media but it is only nominal interest they receive. They do not earn higher rates in real terms. This is because if banks are lending reserves on checking deposits, this increases the supply of money at a faster rate and tends to raise prices at a faster rate as well. Furthermore, in a free market if banks lend reserves backing checking deposits, they will not tend to earn higher returns than banks that refuse to lend such reserves. This is the case because the issuance of fiduciary media creates the expansionary phase of the business cycle and once the process of credit expansion comes to an end or slows sufficiently, the recession or depression ensues. This causes bank customers, especially those at banks that are engaging in riskier activities (including those at fractional-reserve banks who are earning the extra interest), to incur losses that either eliminate any extra returns from the issuance of fiduciary media or actually turn overall returns negative. In addition, the issuance of fiduciary media, since it is a part of the more general process of inflation, leads to all the negative effects of inflation, which are discussed in chapter 7 below. These effects include mal-investment, overconsumption, the withdrawal of wealth, the reversal of safety of fixed income investments, higher tax rates, and the erosion of savings and income, all of which lead to capital decumulation, a lower productive capability, and a lower standard of living. So the extra income due to higher interest rates is illusory. The effect is no different than what occurs today (2013) in connection with checking deposits. Some checking deposits pay interest to depositors today but the interest is only, perhaps, 0.5 percent annually at best. However, prices rise on average, perhaps, 2 to 3 percent per year. This means in real terms checking deposits are earning negative 1.5 to 2.5 percent interest; that is, depositors are losing money. So depositors are still paying a fee, many of them just do not know it because it is hidden by the inflation of the money supply. While interest rates are extraordinarily low today due to the Federal Reserve’s easy credit policy, interest rates on checking deposits have generally tended to be lower than the annual rate of increase in prices under the current monetary and banking system. Of course, today what causes much of this phenomenon is the existence of fiat money. If commodity money existed and banks loaned reserves on

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checking deposits, as the fraction of reserves decreased, the extra interest earned and higher prices would be due solely to fractional reserves. Prices would not rise as rapidly under such a system as under a fiat-money system, but interest rates would tend to be lower as well. So even though the source would be different, prices would not rise quite as fast, and interest rates would not be quite as high, the essential effect would be the same: fees on checking accounts that are hidden by inflation. Other arguments that are made, which are related to the extra-interest argument for why fractional reserves will allegedly come into existence when the right to issue fiduciary media is protected, are the claims that fractional reserves increase the supply of savings, reduce the cost of providing money, and increase the supply of capital in the economy. As a result of these benefits, it is claimed that individuals have historically chosen fractional reserves when they have had the freedom to do so.42 Fractional reserves are said to increase the supply of savings because “[w]henever a bank expands its liabilities in the process of making new loans and investments, it is the holders of the liabilities who are the ultimate lenders of credit, and what they lend are the real resources they could acquire if, instead of holding money, they spent it.”43 The increase in bank liabilities refers to the issuance of fiduciary media. If the supply of fiduciary media increases in response to people’s desire to hold more money, then the claim is the supply of savings has increased by the supply of goods not purchased. Hence, the issuance of fiduciary media allegedly leads to more savings. First, one must understand that while an increased money demand does reduce the demand for goods, the situation would be essentially the same whether the amount of money was increased in response to the increased money demand or not. The main difference between the money supply increasing to offset increases in money demand and the money supply not increasing to offset increases in money demand is that spending and prices would fall under the latter scenario. When money demand increases and the money supply remains constant, spending for goods decreases as individuals attempt to increase their money holdings. However, since there is no more money available, the total amount of money held remains unchanged. One is left merely with a reduction in the velocity of circulation of money, less spending, and lower prices. If the money supply is increased to offset the increased money demand, whether through increases in the supply of fiduciary media or otherwise, individuals still attempt to increase their money holdings. However, here they can actually increase the amount of money they hold since there is more money available. This leaves the amount of spending and prices for goods unchanged but still reduces the velocity of circulation of money. Nothing is fundamentally different from the previous scenario, including the fact that the amount of savings has not increased in real terms. Why don’t savings increase in real terms? One must understand what one is attempting to do when one increases his money demand. One is attempting to hold more money, but how can one do this? The only way is by decreasing

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his holdings of other assets (at least relative to the amount of money one holds). Hence, when one increases his money demand, he is attempting to change the composition of his savings. He is attempting to increase the portion of his savings comprised of money and decrease his savings comprised of other assets (his homes, business assets, etc.).44 Individuals generally do this when they have become unduly illiquid and are attempting to restore their liquidity. Changing the mix of assets one holds as one’s savings does not increase savings in real terms because it does not increase the supply of physical assets in the economy that are productively employed or the amount of physical assets that last many time periods and that can be used in future periods (such as homes). In the case in which no new money comes into existence and there is no increase in actual money holdings, the composition of savings in the economy is changed by a decrease in the prices of assets saved (such as homes, shares of stock, business inventories, etc.) and thus a decrease in the nominal value of total savings. Here, decreases in the value of other assets saved and no decrease in money holdings increases the proportion of monetary holdings in one’s savings relative to the total monetary value of one’s savings. In the case in which the money supply increases to offset the increased money demand, the value of assets saved other than money remains the same but the amount of money held increases, so the proportion of money held in one’s savings still increases relative to the total value of one’s savings. I must note here that it does not matter how one attempts to increase the proportion of money in one’s savings. One may refrain from purchasing goods or investment vehicles (such as shares of stock) or one may actually sell off assets previously saved. Most likely a combination of these will occur. Nonetheless, the end result will be the same: increased money holdings relative to the total monetary value of one’s savings. One must also understand that reducing one’s purchases of goods by increasing one’s money demand will not lead to additional savings. Some economists claim that it will increase savings because individuals allegedly tend to reduce their consumption purchases.45 However, changing preferences between the consumption/savings mix is a different phenomenon than changing the composition of one’s savings. Changing one’s consumption/ savings mix is determined by how present or future oriented one is and occurs due to changes in time preference. No change in time preference is implied by a change in money demand. Changes in money demand focus on the composition of one’s savings (the changes occur within one’s savings), they do not cause changes between one’s savings and consumption. While no change in time preference is implied with a change in money demand, a change in the rate of change in the money supply may cause changes in both money demand and time preference. For example, if the rate of change of the money supply is decreased enough, money demand will increase. If a severe enough recession or depression is induced, this will also increase the time preference of individuals. Individuals may actually deplete their savings to pay their bills because they may no longer have the income

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to pay them. The time preference of individuals increases because they must be concerned with surviving the financially tough times. It is like one’s time preference increasing in an emergency situation, such as surviving while lost in the desert. For a brief time period one is concerned only with survival in the present and the future becomes unimportant. Observe, though, that during the financially tough times savings still do not increase. In fact, they decrease. So savings and money demand move in opposite directions, which is the opposite of what is claimed to occur. Lastly on the subject of money demand (at least for now), one must understand that one’s money holdings are a part of one’s savings. Some economists believe otherwise.46 Savings constitute one’s provision for the future; they constitute the portion of the revenue or income one earns that one does not use for current consumption. Money holdings obviously fall into this category. We hold money for all sorts of reasons, all of which constitute savings (even if it is only held for a short period of time). For instance, I hold on to money in my checking account so I can pay my upcoming bills. While I could hold the funds in my savings account until the last second, I would have to waste a lot of time making sure that enough funds are transferred to my checking account in time to pay my bills, so it is easier to just keep the funds in my checking account. Also, I keep money in my checking account as a cushion so that checks do not bounce. Again, I could keep the funds that constitute the cushion in my savings account, but this would lead to added costs in over withdrawal fees and added anxiety worrying about whether I have enough money in my checking account to pay my bills. I also keep some cash on me just in case I need some. Again, I could put these funds in my savings account but then I would be stuck without cash on the increasingly rare occasions when I need it to make a purchase. All of these are cases of making provision for the future, even if the future is not that far off. What the economists who believe that our money holdings are not a part of our savings might be confusing is the fact that only individuals can increase their savings by increasing their money holdings. Saving at the level of the economy as a whole cannot take place by people increasing their money holdings. This is the case because, ceteris paribus, for every extra dollar one person holds another person must give up a dollar.47 What about the argument that fractional-reserve banking reduces the cost of providing money? The issuance of fiduciary media is believed to do this because to the extent that money is provided by the increase in fiduciary media, it reduces the amount of resources that are employed in the mining of gold and other commodities used for money. If this is the case, then the capital available for producing other goods is greater and thus the supply of capital goods in the economy has been effectively increased. Given two economies that are initially identical, including the possession of two monetary systems with the same supply of monetary gold, the same “price” of gold, and both with 100-percent reserves, it is true that issuing fiduciary media under one of the systems will reduce the resources used in

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mining operations under that system.48 As the reserve ratio is lowered, the money supply increases in the fractional-reserve system at a rate more rapid than the long-term average increase in the money supply (which is determined by the increase in the supply of gold) and thus the value of money declines. This reduces the incentive to mine gold for monetary purposes. This implies that the supply of gold in the 100-percent reserve system increases at a greater rate than in the fractional-reserve system because there will be more resources producing gold under that system. It also implies that the supply of goods in the fractional-reserve system will increase at a greater rate than in the 100-percent reserve system because more resources will be devoted to goods production. However, it is safe to say that the addition to the rate of increase in the supply of money under the fractional-reserve system will be much greater than the addition to the rate of increase in the supply of goods because it is very easy to increase the money supply through the issuance of fiduciary media but not so easy to increase the supply of goods. This latter requires productive effort. Based on this, one can say when the reserve ratio reaches bottom in the fractional-reserve system, the general price level will be greater in that economy. Hence, the ratio of the “price” of gold to the general price level will be lower in the fractional-reserve economy since the “price” of gold is the same in the two economies. This last implies that the supply of gold will continue to increase at a slower rate under the fractional-reserve system once the reserve ratio reaches bottom in that economy. This slower rate of increase occurs because a given quantity of gold will buy fewer goods in the fractionalreserve system (i.e., the real “price” of gold is lower). Assuming that it takes the same amount of resources to produce a given quantity of gold under both systems, more resources will need to be expended to produce the gold necessary to purchase a given quantity of goods under the fractional-reserve system and less gold will be produced as a result. To concretize this, imagine that the money supply in each economy is initially 90 ounces of gold, the general price level in each economy is one dollar, and the dollar is defined as one-fiftieth of an ounce of gold (i.e., the “price” of gold is fifty dollars per ounce). After the reserve ratio reaches bottom in the fractional-reserve economy, if the general price level in that economy rises to $1.25 due to the creation of fiduciary media but remains at one dollar in the 100-percent reserve economy, then the ratio of the “price” of gold to the general price level will be 40:1 in the former economy and remain at 50:1 in the latter economy. This means the same quantity of gold buys 80 percent of the goods in the fractional-reserve economy. For instance, one-fiftieth of an ounce of gold buys one dollar of goods in both economies, but one dollar in the fractional-reserve economy buys 80 percent of the goods because prices are 25 percent higher in that economy. Since it takes the same resources to produce a given quantity of gold, 25 percent more resources will be required in the fractional-reserve economy to produce the gold needed to purchase the same quantity of goods. So it is 25 percent more costly in real terms to produce gold in the fractional-reserve economy when the reserve ratio reaches bottom.

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Because it is less profitable in real terms to produce gold under the fractional-reserve system, less will be produced. As the money supply rises at a slower rate under that system, the ratio of the “price” of gold to the general price level will rise toward equality with that in the 100-percent reserve system. Once the two ratios are equal, the relative incentive to produce gold will be the same in both systems and so the gold supplies and money supplies will increase at the same rate. Once the money supplies are increasing at the same rate, the 100-percent reserve economy will employ more resources in the production of gold, since it will have a greater supply of gold to increase. For example, assuming the 100-percent reserve economy has 110 ounces of gold money and the fractional-reserve economy has 100 ounces of gold at the base of its monetary system, if both money supplies increase at a 3 percent annual rate, then 3.3 ounces of gold will be produced in the former economy and 3 ounces in the latter. Given that the resources needed to produce a given quantity of gold are the same in both economies, 10 percent more resources will be devoted to the production of gold in the 100-percent reserve economy each year. If this was the end of the process, one could say that the fractional-reserve economy provides the money at a lower cost. However, one must remember that issuing fiduciary media is inflation. It leads to a temporarily high rate of profit and low interest rates. This does not occur in the 100-percent reserve economy since there is no credit expansion. This means that the fractionalreserve system creates an inflationary expansion and this will turn to a contraction once the inflation stops or merely slows sufficiently. This will either occur once the reserve ratio reaches bottom or, most likely, far sooner. This scenario will repeat itself every time banks decide to start decreasing reserve ratios.49 The question to ask here is: Will the mal-investment, overconsumption, and other periodic losses due to the inflationary expansions and contractions in the fractional-reserve economy be less than, equal to, or greater than the added cost of providing money under the 100-percent reserve system? This is a question that can only be definitively answered by establishing a free market in money and banking and seeing which type of system emerges. Since the occurrence of that is a very long way off, my assessment is that the 100-percent reserve system will be less costly and be the one to emerge. Why I say this will become clearer in the chapters to follow, especially chapters 5 and 7. Here I will only say that I do not believe a system will emerge that will lead to periodic booms and busts. Since the fractional-reserve system is the one that creates these episodes, I do not think it will emerge. Some might claim that my argument above favors the 100-percent reserve system because I assume that both systems initially possess 100-percent reserves and then show what unfolds as credit expansion takes place in one system. One might ask here, what about the alternative scenario where the fractional-reserve system is established from the very beginning with a reserve ratio that is equal to the long-run reserve ratio that will prevail under such a system? This would not create a need for credit expansion to take place.

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There are a few problems with this argument. First, what is the long-run reserve ratio? If something less than 100-percent reserves does emerge, it is impossible to know what that ratio will be. Therefore, it is very unlikely that the long-run reserve ratio can be established at the start. The ratio established will most likely be either too high or too low. If it is too high, as the ratio falls, what I describe above will take place. If it is too low, banks will act to raise the reserve ratio. This will lead to a monetary contraction, recession or depression, and all the associated ill effects. Hence, this leads to essentially the same results as I describe above, except without the delay during which the money supply increases due to credit expansion. What if those who establish the new monetary system get lucky and pick the long-run reserve ratio? The problem with this (and this entire exercise) is that it assumes there is a long-run reserve ratio less than one that can be maintained. Whatever the reserve ratio that might be chosen (that is significantly below one), any large enough instability that arises in the system will generate a scramble for liquidity. How the instability arises is not important. It could arise, for example, due to some banks attempting to take their reserve ratios too low, a large firm or bank getting into financial trouble, or an outflow of gold due to a sudden shift in the terms of trade with other countries. Once the process is started, the scramble for liquidity can spread quickly and the supply of money and spending can fall rapidly. This latter accelerates the spread of the panic. A 100-percent reserve monetary and banking system is very different. It limits any instability so that it does not spread throughout the rest of the economic system due to a contraction of the supply of money and spending. An issue related to the cost of providing money is that, as one economist claims, banknotes will only be issued under a fractional-reserve system; they will allegedly not be issued under a 100-percent reserve system.50 This is supposed to be the case because under a fractional-reserve system the cost of storing gold placed on deposit in exchange for notes can be covered by lending out a portion of the gold to earn interest. Here the interest covers the storage costs (and perhaps more). However, under a 100-percent reserve system, since the gold deposited to obtain notes will not be loaned out, the storage costs cannot be covered. Therefore, banks will have little motivation to issue notes and the cost of providing the notes will discourage depositors from using them. This is another reason why a fractional-reserve system will allegedly emerge in a free market. However, as with the discussion on the cost of providing money in general, one cannot consider only the direct cost of providing the banknotes. Issuing banknotes on a fractional-reserve basis is a part of the process of inflation and credit expansion. It contributes to inflationary expansions and contractions. Hence, one must also consider the costs of the expansions and contractions. If one considers these costs, as with the provision of money in general, I think the cost of providing notes on a fractional-reserve basis will be greater and the 100-percent reserve system will prevail. Again, my discussions in

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chapters 5 and 7 make it clearer why this will happen. As to the question of how the costs of providing banknotes under a system of 100-percent reserves can be covered, there are a number of options. For example, based on present value analysis a fee equivalent to the expected storage costs of the gold while the notes are circulating could be charged to the depositor who wishes to receive notes. Alternatively, the costs could be incorporated into other fees the bank charges or in the interest rates the bank charges for loans. Here the notes would be provided to depositors as a courtesy service. Another possibility is that the bank could use the notes as a marketing tool by prominently displaying its logo on the notes or charging others to advertise on the banknotes.51 Probably a combination of these and other methods would be used. One last issue related to storage costs must be addressed. This is the fact that storage costs of all monetary gold under a 100-percent reserve system will be greater than storage costs of all monetary gold under a fractionalreserve system. This is true even if one ignores the interest that can be earned from lending out reserves under fractional reserves. This occurs because storage costs vary directly with the quantity and value of the item being stored (this latter pertains to storage-related insurance costs, which are different than deposit insurance). Since providing a given quantity of money under a fractional-reserve system can be accomplished with either a lesser quantity of gold at the same “price” as under a 100-percent reserve system or the same quantity of gold as under a 100-percent reserve system at a lower “price” (or even a lesser quantity of gold at a lower “price”), the storage costs will be lower for the fractional reserve system. This might be seen as another reason why fractional reserves will prevail over 100-percent reserves. However, again, one cannot consider only the direct costs of providing the money. One must consider the cost of the inflationary expansions and contractions that the fractional-reserve system will create. These will more than offset the lower direct costs of such a monetary system. The economists George Selgin and Lawrence White claim that history shows that fractional-reserve banking is more popular with bank customers than 100-percent reserve banking. That is allegedly why it has been more prevalent throughout Western history than 100-percent reserve banking. They claim that the relatively unhampered banking systems, in which government deposit insurance or any type of government guarantees on deposits did not exist (such as that of nineteenth-century Canada and the “freebanking” era in eighteenth- and nineteenth-century Scotland), show that banking customers freely choose fractional-reserve banks over 100-percent reserve banks.52 However, free banking systems did not exist in the countries and periods they use to make this claim. In fact, from early on in the history of banking governments interfered mainly to expropriate funds from banks for their own use. The interference goes far beyond the deposit insurance and deposit guarantees mentioned by Selgin and White. It includes requiring banks to make loans to the government, taking over failed banks, allowing banks to

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suspend payment of specie, and more. The interference goes back as far as ancient Greece and existed soon after the banking revival at the end of the Middle Ages, such as in fourteenth-century Italy.53 This is what has led to the rise and continued existence of factional-reserve banking. So it is not the case that individuals have been voluntarily choosing in a free market to frequent fractional-reserve banks over 100-percent reserve banks. The government interference that has existed throughout the history of banking has prevented a free market in banking from existing. This is true even in the so-called free-banking eras in eighteenth- and nineteenthcentury Scotland and nineteenth-century Canada. Significant amounts of government interference existed in all so-called free banking eras and the interference has had significant effects. At best, the eras of so-called free banking were periods with less government interference than in other eras. I discuss the history of government interference in banking during some of the freer historical episodes in chapter 6 below. Another claim is that through the use of the option clause, banks will be able to retain something less than 100-percent reserves on checking deposits and banknotes in a free market. The option clause gives banks the option to defer the payment of specie to those who demand it in place of banknotes and checking deposits. In return, banks pay a stipulated interest rate during the deferment period, which might last six months, as compensation for not providing the specie demanded. Banks can use the option clause to stop a run during a liquidity crisis and allegedly prevent the collapse of a fractionalreserve banking system, since depositors and note holders will be prevented from depleting the issuing banks of their reserves (at least temporarily).54 This gives them the ability to operate with a lower fraction of reserves. There are a number of deficiencies with this argument. First, the option clause does not change the fact that the issuance of fiduciary media will create the business cycle, recessions, depressions, financial crises, and all their attendant ills. Hence, while the clause may be able to delay the complete collapse of some banks and perhaps even give the occasional bank enough time to regroup and survive a liquidity crisis, many banks will still collapse once the option period is over and people still demand the payment of specie. Such episodes would tend to rid the banking industry of the financially weak banks, which of course would tend to include those with lower fractions of reserves, and push the overall reserves in the banking industry toward 100 percent. Second, and more significantly, the historical record of the option clause provides us with evidence that such clauses would tend not to be used by banks, even though proponents of the clause think it provides evidence for the opposite. The best historical evidence on the option clause comes from eighteenth-century Scotland from 1730 to 1765 during the so-called Scottish free-banking period where the clause was in use on some banknotes. Initially, notes with the option clause were accepted at par with notes without the clause. There was no flight from notes with the clause to notes without it. Proponents of the option clause claim this is proof that

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the public believes that notes with an option clause are just as good as notes without a clause.55 However, this does not tell the whole story. For one thing, if the option clause offers greater protection to bank customers, as modern-day advocates of the clause claim, one would have expected a flight from the notes without the clause to notes with the clause. This was not witnessed.56 In addition, notes of banks that tended to exercise the option clause traded at a discount to other notes and gold. A part of the problem with the option clause was that banks often recklessly used the option clause to protect their specie, threatening to invoke it against even routine redemption demands (not just during a liquidity crisis or run). The banks that did this were generally disreputable and it is no accident that these were the types of banks making use of the clause.57 The clause provides a means for disreputable banks to protect themselves and continue to engage in reckless policies, and even though the option clause was generally only invoked by disreputable banks, the use of “evasive maneuvers” was widespread among all banks to protect their reserves, including the “sound” and unsound banks, often in violation of their contractual obligation to provide specie on demand. These “evasive maneuvers” included not only the practices mentioned previously in this chapter of suspending convertibility even when no option clause was in place and questioning the loyalty of those seeking to obtain specie, but also questioning the patriotism of those seeking to redeem their notes, giving tellers long and frequent breaks when counting the notes of those seeking to redeem them, and in general using beguiling and even coercive means to prevent individuals from obtaining the specie that was rightfully theirs.58 The option clause is just one of many methods some banks have used to perpetuate unsound banking practices. It ultimately does not provide protection against financial crises and bank runs; it is merely a cosmetic attempt to cover up the instability created by fractional reserves. The only sure way to eliminate such instability is to not engage in this type of banking. If the government had enforced banks’ obligations to pay specie on demand in Scotland, and had not interfered in various ways, banks would have held 100-percent reserves and the option clause never would have been seen as necessary. The strongest historical evidence against the belief that the option clause would be used on a wide scale (or perhaps at all) in a free market is something that all free-banking theorists overlook. That is, the public does not want the option clause. This was seen clearly in eighteenth-century Scotland. As the option clause was invoked more routinely, the public clamored for it to be outlawed. As a result, after only a brief existence, it was made illegal in 1765.59 Of course, in a free market, unless it is being used routinely as an instrument to dupe people out of their money, the option clause cannot be made illegal. This is because only those laws that protect individual rights (i.e., ban the initiation of physical force and fraud) can be passed. In a free market, if people do not like the product or service a company provides, they go elsewhere and the company goes out of business or changes its product

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or service to cater to the demands of the marketplace in a better fashion so it can remain in business. This is how, even if the option clause was used in a non-fraudulent manner and therefore not outlawed, it would eventually disappear in a free market. Another argument that attempts to show that banks will tend to hold reserves that represent only a fraction of their checking deposits and notes issued is the claim that in a free market banks will change the money supply by automatically varying their reserve ratios inversely in response to changes in the demand for money. It is also claimed that this will help stabilize the economy by reducing or eliminating fluctuations in spending and reducing the need for changes in prices. These changes in money demand might occur, for instance, for random and unexplained reasons or due to the business cycle and financial crises.60 A slightly different but related argument is the claim that banks would vary their reserve ratios, and thus change the money supply, in response to the need for money for trading. The claim is that when, for instance, economic progress occurs and thus more goods are available, individuals need more money to purchase the greater supply of goods and banks will provide them with the additional money they need by lowering reserve ratios. Also, if there are fluctuations in trade throughout the year, such as seasonal fluctuations due to the weather or Christmas, banks will vary their reserve ratios and increase or decrease the money supply directly in response to the amount of trade in which people are engaging.61 Whatever the source for changes in the “demand for money,” the claim is that banks will hold something less than 100-percent reserves to back checking deposits and notes issued and vary their reserve ratios so that the amount of money counterbalances changes in its “demand.” One thing to note before addressing these claims is the similarity between the argument mentioned above concerning how economic progress (i.e., a greater supply of goods) creates a greater demand for money and the argument criticized in chapter 3 regarding how the money supply changes in response to fluctuations in the supply of goods during the business cycle. Because of the similarity, many of the same criticisms apply to this argument. For example, spending more money to purchase a larger supply of goods, ceteris paribus, is not a greater demand for money. It is a greater demand for goods. Before discussing in detail why the above arguments are not valid, let us focus on a few other erroneous claims regarding the demand for money made by at least one advocate of the argument that says that banks will automatically vary reserve ratios to counterbalance changes in the demand for money. This will help avoid possible confusion related to this important concept. One such erroneous claim is that a change in money balances means the demand for money has changed.62 For example, if money balances increase then it is claimed that the demand for money has increased. I show in Chapter 2 of Money, Banking, and the Business Cycle, Volume 1: Integrating Theory and Practice that a change in the demand for money, by

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itself, does not cause changes in the average money balance held in the economy. Likewise, changes in the average money balance in the economy do not imply that a change in the demand for money has occurred. For example, if the number of people holding money remains constant, whenever the money supply decreases the average money balance decreases. However, this does not mean the demand for money has decreased. One has to look at the average amount of spending people are engaging in relative to the average money balance to determine if the demand for money has changed. The demand for money could increase at the same time the average money balance decreases, which is what happens during depressions. It all depends on what the velocity of money is doing. In addition, a change in the number of people holding money does not mean the demand for money has changed. The claim here is that the demand for money changes directly with the number of money balances being held.63 However, more people in the economy holding a proportionately greater total amount of money (so the average money balance stays the same) does not mean the demand for money has increased. Again, it depends on how long each dollar is being held on average and thus on what the velocity of money is doing. Furthermore, if the average value of each transaction in the economy changes and the number of transactions changes inversely in a proportional manner, this does not imply a change in money demand either. The claim here is that, for example, as the average value of each purchase increases in the economy, the average money balance will increase as well and so the demand for money will increase.64 The average money balance must increase because people must build up higher balances to be able to afford the more expensive purchases. However, if people go from writing 100,000 checks per week with an average value of ten dollars per check to writing 50,000 checks per week with an average value of twenty dollars per check, this does not necessarily mean the demand for money has increased. In this example, since the total spending in both cases is the same, as long as the money supply and thus velocity of money remain constant, there is no change in the demand for money. This argument confuses the average payment size with the average money balance held. While it is true that the average payment increases in the above scenario, it is an instance of the fallacy of composition to believe the average money balance increases. As long as the money supply remains the same, if one person holds on to more money, others must hold on to correspondingly less. No change in the average money balance occurs without a change in the money supply (assuming a constant number of people over which to average the total money balances). Now that I have dispelled the last of the errors to be addressed in this book regarding what the demand for money is, let me address the claim that the money supply will be varied by banks through changes in the reserve ratio to counteract changes in money demand. If banks varied the reserve ratio in response to changes in money demand, there is no reason why this

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would not happen today, despite the fact that we do not have a free market in banking. However, advocates of the fluctuating-reserve-ratio argument have never provided any evidence of this because none exists. Banks today do not behave as advocates of this theory claim.65 Advocates of this argument might claim that banks do not vary their reserve ratios because required reserve ratios imposed by the Federal Reserve create obstacles that prevent the ratios from fluctuating. However, required reserve ratios are so low today (on the order of 10 percent) it is hard to believe they create obstacles that would completely prevent fluctuations in reserve ratios. They would probably tend to only limit the downward movement in reserve ratios but allow some upward movement to exist. Advocates might also claim that the other types of government interference we have in the banking and monetary system prevent banks or take away the incentive of banks to adjust their reserves in the way claimed. But none of the regulations that exist today prevent banks from adjusting their reserves (as long as they hold on to their legally required reserves). While the interference that exists certainly distorts incentives and thus changes how banks react to what is happening in the economy, it would probably create reactions by banks in addition to the reactions advocates of this theory claim would exist in a free market, or perhaps at most it would only partially offset the reactions advocates of this theory claim banks would have in a free market to changes in the demand for money. In fact, with the government interference we have today, one would probably be more likely to observe the reactions of banks that advocates of this theory say the banks should have. This is the case because the interference we have today is responsible for large swings in velocity (much larger than would exist in a free market), which creates an even better environment to test a theory that says bank reserve ratios should vary to counteract changes in money demand. Again, though, no evidence has been provided by advocates of this theory because banks today do not engage in such behavior. Although no evidence has been provided that banks adjust their reserve ratios inversely to the demand for money, there is evidence that shows banks react in the exact opposite way that advocates of this theory claim. That is, evidence shows that banks tend to vary reserve ratios not to counteract changes in the demand for money but to exacerbate them. The conclusion based on this evidence is stated definitively by William M. Gouge, a nineteenth-century author on the US banking system. Gouge quotes another writer who says that “the value of Bank medium consists in its elasticity— in its power of alternate expansion and contraction to suit the wants of the community. . . . [T]he merit of a Bank is nearly in proportion to the flexibility of its medium.” In response to this writer, Gouge then perceptively identifies that “most unfortunately for this argument, when the demand for money is greatest, the Banks are compelled to contract their issues. When the natural demand is least, they are able to expand most.”66 This is what typically happens. For example, during recessions, depressions, and financial crises banks generally do not increase their lending and lower

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their reserve ratios, precisely when the demand for money rises. They contract it. This is the situation when money is most needed by individuals and businesses. So the forces compelling banks to counteract the rise in money demand should be greatest and thus if banks were to act in this manner, we would be most likely to see it here. However, the banks’ demand for money increases during these crises for the same reason that everyone else’s demand for money increases: individuals and businesses are financially strapped.67 They are attempting to build cash reserves (i.e., increase their money demand) to deal with the crises. This is exactly what happened during the 2008–9 financial crisis and recession. Reserve ratios increased dramatically, going from around 7 percent of checkable deposits in 2008 to a high of around 170 percent in 2011.68 While the increase in the reserve ratio during this crisis was exaggerated by a number of factors, including the Federal Reserve’s loose monetary policy, its new policy of paying interest on reserves banks hold at the Fed, and its (and the US Treasury’s) purchase of financial assets that declined dramatically in value, more conservative policies on the part of banks are generally the case during financial crises. Except for the cases of some clearinghouse associations that have loaned more during crises, banks tend to lend less.69 According to advocates of the counterbalancing-reserve-ratio theory, banks should normally expand their lending during economic crises. However, if banks did this they would jeopardize their own existence because this is precisely when people can least afford to take on more debt. Crises, in part, occur because individuals and businesses (including banks) take on too much debt. The last thing that is needed is that banks reduce their reserve ratios (i.e., lend more) and perpetuate the debt crisis. Likewise, during inflationary expansions, precisely when the demand for money is low, banks expand their lending. They do this because people and businesses can better afford to borrow and pay off debt and thus the banks can make more money by extending more loans. Banks act in the same manner as individuals and businesses in general during expansions and contractions. So, far from counteracting the demand for money with inverse changes in the reserve ratio, banks tend to change their money demand in the same direction as everyone else and for the same reasons. This has been seen both with and without the existence of central banks. In fact, William Gouge lived, observed, and wrote about times in the United States when there was no Federal Reserve and the banking system was much more free-market oriented than today. Gouge demonstrated his knowledge of the importance of restricting the issue of fiduciary media (referred to as “bank medium” in the first quotation from Gouge’s book above) when he stated, “one of the principal inducements for preferring the precious metals as the material for money, is their want of this very ‘elasticity’ or ‘flexibility.’”70 (Emphasis is in the original.) There is also the question of what the source of these mysterious changes in money demand is. Advocates of this theory do not always indicate where they come from. They sometimes claim that changes in money demand can be autonomous, which means they are left unexplained.71 A sound theory of changes in the demand for money sees them as primarily due to changes in

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the supply of fiat money, which are caused by government interference.72 In a free market, changes in the demand for money would be relatively minor. In fact, because the money supply would be based on gold, the money supply would be fairly stable and thus the demand for money would be stable. So even if in a free market variations in the reserve ratio by banks did offset changes in money demand, there would not be that much change in the demand for money (if any) to offset. While this does not address the issue of whether changes in the demand for money are offset by inverse changes in the reserve ratio by banks (although I have addressed it above and will continue to do so below), it does provide greater evidence of a lack of understanding of the nature of the monetary system on the part of those who advocate this theory and thus does undermine their argument. What about the argument mentioned above that changes in money demand come from changes in the supply of goods? That is, as the supply of goods increases due to economic progress, the claim is that there is a need for more money to purchase the additional goods and thus the demand for money increases. This is known as the “needs of trade” argument for why banks change their reserve ratios to change the money supply. It is a longlived argument and dates back to the nineteenth-century British Banking School and the real-bills doctrine.73 There are a number of problems with this argument. First, recall the arguments provided in chapter 3 that show that the “reverse causation” argument of how the money supply changes during the business cycle, according to real business cycle theory, is invalid. Remember, banks and buyers do not magically know there are more goods available to purchase and so do not automatically lend and borrow more. Producers do know and they lower prices to signal the availability of a greater supply of goods. Producers can afford to lower prices because of the lower costs they incur to produce the goods (which is a part of economic progress). Buyers can then purchase the greater supply of goods with the same amount of money. So the money supply does not need to increase with the “needs of trade.” Supporters of this argument are confusing an increase in aggregate supply with an increase in aggregate demand. Also recall from chapter 3 that advocates of this argument might claim that banks and buyers of goods do not initially know about the greater supply of goods available but producers do and might borrow to produce more. Hence, banks respond to the increased demand for credit by lending more through lower reserve ratios as a part of the economic progress taking place. There is an additional criticism to consider here, in the case of economic progress, which was not applicable to the case of the business cycle in chapter 3. This additional criticism is that such a claim implies continuously declining reserve ratios and businesses becoming more and more leveraged. Over the long term, as economic progress continuously occurs, reserve ratios should approach zero and debt-to-asset ratios should approach 100 percent. This does not occur. Again, economic progress takes place through lower prices. Producers are able to expand production due to lower costs, so they can

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purchase more inputs without the need for additional quantities of money (or debt). At this point the following question might be raised: What if producers pay off the loans with the extra profits they earn from the greater production? In this case, leverage ratios would not increase toward 100 percent. Businesses are temporarily borrowing to produce more (so the reserve ratio falls and the money supply expands) and then eventually paying off the loans (so the reserve ratio rises and the money supply contracts). The problem here is that production and trade continue to rise with economic progress even after the loans are paid off. So if this argument is made, then the reserve ratio does not continuously fall with the “needs of trade” and the claim that it does is still invalid. I now ask the reader to recall that the “needs of trade” claim regarding the demand for money does not actually identify a demand for money (since purchasing goods is a demand for goods, not money) because I want to shift the focus from the “needs of trade” to the actual demand for money. A change in the supply of goods does not generally change the demand for money. This is the case because the supply of goods does not generally change at a rapid enough pace to have a large enough effect on the value of money. Remember, the main factor causing changes in money demand is the change in the supply of fiat money. The supply of fiat money can change rapidly enough to affect the value of the currency significantly enough to cause people to change their demand for it. This is illustrated best in hyperinflations (such as in Weimar Germany) but is also illustrated in the three or four decades after World War II in the United States.74 The supply of goods, relatively speaking, changes at a much slower and smoother pace and therefore does not have the necessary effect on the value of money. The only way the supply of money changes in response to the supply of goods, as discussed in chapter 3, is in connection with gold or commodity money. However, here the supply of money does not respond to the “needs of trade” and the demand for gold money. More gold is produced because, for among other reasons, more of all goods are produced as economic progress occurs. Finally, there might be something to the idea that the demand for money changes seasonally due to the weather (which creates changes in agricultural activities) or due to Christmas. Such changes might induce changes in reserve ratios, although based on a proper understanding of the demand for money they would not be inverse changes in reserve ratios but changes in reserve ratios in the same direction. This was discussed in chapter 3 in connection with possible seasonal fluctuations in the money supply. Beyond possible seasonal changes in the money supply one must remember that changes in money demand do not cause changes in the supply of money. They cause changes in the amount of spending. Further, the seasonal changes in money demand would not produce any instability in the economy because the changes would be well known and understood and people could very easily adjust to the changes in spending that result.

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Conclusion I have shown in this chapter how government interference in the monetary and banking system leads to fiat money and fractional-reserve banking. I have also shown why these institutions do not arise in a free market. They are the result of the government’s desire to finance its own spending on such things as wars and the welfare state. They also come about due to the perverse incentives created by regulations the government imposes on the monetary and banking system. A free market in money and banking would lead to gold or another form of commodity money and 100-percent reserves (of the commodity money) on checking deposits and banknotes. Just how this would occur is the topic of the next chapter.

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Th e Ch a r ac t e r ist ic s a n d E f f ec t s of a Fr e e M a r k et i n Mon e y a n d Ba n k i ng

Introduction This chapter shows that a free monetary and banking system means absolutely no government interference in money and banking. It discusses what is meant by “no government interference.” Such a system is unprecedented in history, except for possibly the very first banks in ancient Greece or fourteenth-century Italy. From the very beginning, or very shortly thereafter, governments interfered in monetary and banking systems to gain advantage for themselves and those they wanted to favor. This interference existed in the form of minting coins, debasing the currency, allowing banks to suspend payment when payment was contractually required on demand, raiding bank vaults, and so on. A free market in money and banking will lead to a level of stability in the economy that will make the economic system seem boring compared to today, since it will virtually eliminate monetary induced financial crises, recessions, and depressions. Developments in the economy will still be exciting; however, the excitement will be confined to rapid rates of economic progress; innovations in products and methods of production; the development of new technologies; the exploration of space and the colonization of moons, planets and other solar systems by private individuals; and a rapidly rising standard of living. The first task of this chapter is to discuss what constitutes a free market in money and banking. Then, I discuss what a free market in money and banking will lead to. Lastly, I address the many fallacies people embrace concerning what a free market will lead to.

What Constitutes a Free Market in Money and Banking? Describing what constitutes a free market in money and banking is more about describing what it is not than what it is. This is because describing what it is essentially involves identifying that it is an economic system in which the

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government does not interfere in any way whatsoever in the monetary and banking system. It means implementing a laissez-faire capitalist society with regard to money and banking, in which the only function of the government is to protect people from the initiation of physical force and fraud. The question that arises at this point concerns the details of a laissez-faire capitalist society in regard to money and banking. Here is where I must explain what actions the government cannot engage in in a laissez-faire capitalist society because such actions would either violate individual rights or favor some individuals over others and thus go beyond the government’s appropriate function. The only proper function of a government is to protect individual rights. What does this imply about what the government can and cannot do in a society with a free market in money and banking? A number of economists have provided answers to this question.1 Some have done a good job in describing what a free market in money and banking looks like. Most have done a poor job because they do not know what a free market is. My response draws out the logical implications of a free market in money and banking. Here is my response. First, no government central bank would exist in a free market. The government would neither control the money supply nor regulate the banking system. It would not establish reserve requirements (whether 100 percent or less), it would not manipulate interest rates, it would not “manage” the economy through so-called monetary policy, it would not manipulate foreign exchange rates, it would not charter and examine banks, it would not hold gold or other commodity money for banks, it would not provide a clearinghouse for banks, it would not provide automatic debit and credit functions for banks and their customers, it would not provide check processing services, and so on. This is a part of achieving what the novelist and philosopher Ayn Rand called a complete separation of the state from the economy, and it needs to be achieved for the same reason and purpose that we need a complete separation of church and state: because force and mind are opposites. This means that to be able to use his basic tool of survival— his reasoning mind—man needs freedom.2 Man needs the freedom to think and act to further his life and happiness, which means the freedom to ask questions, make logical connections, draw conclusions, disagree with others, produce wealth, consume the wealth he produces, et cetera. The government protects freedom by protecting individual rights. What constitutes money and how much exists would also be determined by individuals acting in the free market. They would choose what they want to use as money just as they choose which goods to buy and sell. Based on the voluntary choices of individuals, commodity money would emerge in such a society (i.e., gold and/or silver). Banknotes would exist in such a society as well; however, they would be issued only by private banks. The government would be prevented by law from issuing banknotes. Subsidiary coin, for small purchases and making change, would be issued by private banks as well. The government would not be involved here either. The government would in no way mint coins, certify the weight and fineness of coins (unless

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it needs to verify the weight and fineness of coins it receives or determine the weight and fineness of coins to enforce a contract in a civil dispute), or favor any privately created money (at least not beyond accepting only bank money backed 100 percent by commodity money). The government would not pass legal tender laws either, which force people to accept certain money in trade and for debts. These activities have nothing to do with protecting individual rights. The only way the government would limit the minting of coins by private individuals, limit the issuance of private money, or get involved with the monetary system at all is when it has objective evidence of force being used or fraud being committed in connection with the use of money. When force is used or fraud is committed, it is proper for the government to stop them and appropriately punish the offender. Otherwise, it would have nothing to do with the provision of money. Of course, the government would have to use money to buy goods and services and receive money in taxes and from borrowing. However, in a free market the government would be restricted to accepting only gold, silver, or some other form of standard money in payment for tax revenues and the provision of loans to the government. The government could also receive only private banknotes that are backed 100 percent by standard money or checks drawn on banks that have 100-percent reserves backing their checking deposits. This is essentially equivalent to the Specie Circular issued by President Andrew Jackson in 1836 that required buyers of government land to pay in specie. Likewise, the government would only pay in standard money or banknotes or checks backed 100 percent by standard money. These are the only forms of money the government should receive and pay with because the government should not lend to anyone. It should not lend to students, small businesses, farmers, financially troubled businesses, foreign governments, or anyone else. It should also not guarantee loans made by others, such as Fannie Mae, Freddie Mac, and Sallie Mae. Government lending goes beyond the appropriate bounds of protecting individual rights. Government lending or guaranteeing of loans forces taxpayers to lend money they might not want to lend or guarantee loans they might not want to guarantee. As a result, loans are made to borrowers that are not credit worthy and at interest rates that are not high enough for the risk involved. If the borrowers were credit worthy and the interest rates appropriate, the borrowers would not have to depend on the government for such loans because the money could be borrowed in the private loan markets. Government lending leads to an inefficient and ineffective use of such funds and thus lowers the productive capability, standard of living, and level of satisfaction and wellbeing in the economy. While I will argue below that a free market in money and banking tends to lead to banks holding 100-percent reserves (and possibly more) backing their notes and all checkable deposits, as I have stated previously in chapter 4, banks would have the right in a free market to keep less than 100-percent reserves backing their notes and checkable deposits as long as it does not involve a violation of their contractual obligations or an act of fraud. If

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the government receives notes or checks from banks that do not possess 100-percent reserves, the government would put itself (at least implicitly) in the position not of a receiver of money for payment but of a grantor of credit to the institution whose notes or checks it receives.3 Based on this, one of the legitimate activities of the government would involve verifying that the bank money it receives is fully backed by standard money. Why would the government implicitly be a lender if it accepted notes or checks not backed 100 percent by commodity money? First focusing on deposits, depositors can give money to a bank for one of two reasons: they can give it to the bank for the bank to hold for safekeeping or they can loan money to the bank for the bank to, in turn, lend the money to others and earn interest for both the bank and the depositor. In the first case, the depositor is not a lender. He merely gives the money to the bank to hold because it is a safer and more convenient place to hold his money. In the second case, the depositor is a lender. In the first case, the depositor has a claim to the money the bank is holding for him. In the second, the depositor does not have a claim to money but a claim to a loan that the bank has made on his behalf and which is earning interest for him (and the bank).4 Depending on the nature of the deposit contract with the bank, it could take a long time for the depositor to get his money or it could take a short time. Either way, the depositor is still a creditor to the bank until he gets his money back. When a bank lends some portion of the reserves backing a checking deposit, the depositor is in the situation of both individuals discussed above; that is, he is both a depositor of funds for safekeeping and a lender to the bank. To the extent the bank has reserves backing the deposit, the depositor is someone whose money is being held for safekeeping. However, to the extent the bank has loaned the money out, the depositor is now a financier of the lending activities in which the bank is engaging; that is, the depositor is now a creditor to the bank. The same can be seen by using some simple accounting tools. If a depositor deposits $100 in a checking account and the bank holds all the money on reserve, the deposit liability the bank has perfectly matches the reserves on the asset side of the balance sheet and thus one can see that the bank is merely holding the money for safekeeping. However, if the bank loans out, say, $10 of the $100 deposit, now the $100 deposit liability is backed not by $100 of reserves but by only $90 of reserves and $10 of loans on the asset side of the balance sheet. So the bank is only holding $90 of the money for safekeeping. The rest of the money received from the depositor is being used to finance the bank’s lending activities. So the depositor is part lender to the bank and part depositor of funds for safekeeping. Now imagine that someone receives a check as payment from someone else who has a checking account at a bank that does not back its checking deposits 100 percent with reserves of standard money. Since the amount on the check is only partially backed by reserves, until he receives the funds, the recipient of the check (in our case, the government) is now essentially in the same position as the depositor: he is a lender to the bank to the extent the bank is

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not backing its checking deposits 100 percent with reserves. It may only be a short period of time before the recipient of the check is able to take possession of the funds in the amount stated on the check; however, this does not deny the fact that until he receives the funds he is a lender to the bank because the checking deposit is not fully backed by reserves. Even if the amount stated on the check is smaller than the total reserves the bank possesses, the recipient of the check is still a lender to the bank. One has to look at the total reserves relative to the total checking deposits at the bank to determine to what extent each depositor is a lender versus a depositor of funds for safekeeping (and, likewise, to determine the position of anyone who receives a check from one of these depositors). It is not the case that some of the depositors with checking accounts (or those who receive checks from them) have claims to money held for safekeeping and some are lending money to the bank. Each depositor with a checking account will be in the same position (part lender, part depositor of funds for safekeeping) based on the extent to which checking deposits are backed by reserves. The situation is essentially the same when a bank issues banknotes, which are a claim to standard money deposited in the bank. The holder of the banknotes has funds deposited for safekeeping in the bank to the extent that the bank backs the notes and checking deposits with reserves of standard money. The holder of notes is a lender to the extent the bank backs the notes and checking deposits with loans the bank makes. So the total reserves must be compared to both the total checking deposit and banknote liabilities the bank has outstanding to determine the extent to which depositors and note holders are providing credit to the bank or having their money held for safekeeping. How will the government determine whether banks are holding 100-percent reserves backing their checking deposits and notes? It must audit banks. This would be a voluntary arrangement. Banks do not have to allow the government to audit their books; however, their notes would be redeemed for standard money as quickly as possible. The government could use as money only the notes of banks that retain 100-percent reserves backing their notes and checks. What if people do not want to make payments or loans to the government with standard money or notes or checks backed 100 percent by standard money? In these cases the government should not consider itself in receipt of money until it has redeemed the notes or checks for the standard money. It should be required by law to redeem notes and checks not backed fully by standard money for the standard money within a short period of time. What if people want to use as money government checks they receive in payment? To prevent this, the checks should be nontransferrable so that only the payee can receive the funds. Expiration dates should also be placed on the checks to limit the extent to which they might circulate as money. Now that issues related to the government’s payment and receipt of money have been cleared up, I continue with the discussion of what the government can and, mainly, cannot do in an economy with a free market in money and banking.

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Although a government central bank would not exist in a free market, a government bank would have to be established for the purpose of the government having a place to hold its money and remitting payments. In contrast to private banks, this bank would be required by law to keep 100-percent reserves backing its deposits. It would also hold only money received by the government through taxes and borrowing. In addition, it would not lend to any one (including the government) and it would issue no banknotes. Moreover, the accounts at this bank would consist only of government checking accounts (i.e., it would not have any savings accounts nor would it have accounts for any other banks, businesses, or individuals). Whether there is one of these banks to accept deposits from all levels of government (at the local, state, and federal level) or two or three or more of these banks to accept deposits from different levels of government is irrelevant. The point is that, in a free market, any government bank would be subject to the restrictions I have outlined above in order to achieve and maintain the separation of the state from the economy. One reason why the government bank or banks would be subject to such restrictions is because, again, the government should not be lending to anyone. This implies the government’s bank must hold 100-percent reserves. Further, the government should not be in the business of creating money, so it should not be issuing banknotes, whether backed by 100-percent reserves or not. This activity has nothing to do with protecting individual rights. This restriction is necessary to ensure the government is kept separate from the economy. Moreover, because the government cannot lend to anyone the government bank has no reason to accept savings deposits, since the purpose of receiving such funds is to lend them out to earn interest. At this point one might ask, why can’t the government deposit its funds at one or more private banks instead of establishing a government bank? The reason for this is to make sure the government is separated from the economy and stays separated. While in a free market the government would be much smaller than it is today (relative to the size of the entire economy), it would still be a large entity and require large bank accounts and monetary transactions. For example, the federal government presently (2013) has an annual budget of almost four trillion dollars. State and local governments have a combined annual budget of over two trillion dollars. Governments in a free society will probably be 10 to 20 percent of the size of governments in our very left-leaning mixed economy. To see why this is the case, one need only identify the portion of federal, state, and local government budgets that represent appropriate government activities (i.e., activities that protect individual rights). If one does this, one will see that the vast majority of government spending is for inappropriate activities and would be eliminated in a free society. However, even if one assumes governments will be only 10 percent of their size today, that still means the federal government will have an annual budget of about four hundred billion dollars (in 2013 dollars). State and local governments combined will have an annual budget of around two hundred billion dollars (in 2013 dollars). If this much smaller federal government was

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a company, it would be one of the world’s largest based on annual expenditures. The state and local governments would be large economic entities as well. This large size would allow them, potentially, to wield substantial influence over the banking system, and thus the economy, if they deposited their funds into private banks. Every measure should be taken to ensure that the government does not exert such influence, especially at the time of the transition to a free market (and for a long time afterwards). How, one might ask, would the government then interact with private banks? The government would do so through privately established clearinghouses. The government would be forbidden from establishing clearinghouses itself. The establishment of clearinghouses has nothing to do with protecting individual rights. Of course, the government might still be able to influence the economy through the clearinghouses. To prevent this, accounts the government keeps at the clearinghouses should only contain either standard money or notes or deposits backed 100 percent by standard money. In addition, the contracts the government engages in with clearinghouses must stipulate that the clearinghouse cannot lend any government funds held at the clearinghouse. Likewise, any lending to the government by the clearinghouse must be in the form of commodity money or notes or checks backed 100 percent by commodity money. One might still question the restriction of preventing the government from depositing money in private banks. Since the government might still influence the economy through the clearinghouses, why not just allow it to deposit its money in the banks? What’s the difference between letting the government influence the economy through private banks versus through clearinghouses? Also, since the government in a free market will be buying goods from other private businesses, such as defense contractors and even office supply stores, why not let the government purchase banking services from private banks? One thing that must be recognized here is that the government has not used other industries, such as the defense industry, to manipulate the entire economy. It does use the banking system for this purpose. Not allowing the government to deposit its funds in private banks will signal that a clean break is being made from the statist past. The government is no longer allowed to even attempt to manipulate economic outcomes through the banking system. Restricting the government’s interactions with the banking system to those at the clearinghouses will aid in this endeavor. Government funds on hand at the clearinghouses will be much less than at the government banks. It will only need enough funds on hand at the clearinghouses to settle net debits. This will limit the government’s ability to attempt to manipulate the economy. Placing the restrictions discussed above on the government accounts at the clearinghouses will also help prevent it from manipulating the economy. Although I do not think it is necessary or appropriate, if one still wants to allow the government to hold its money at private banks, it should not be

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allowed to do so during the transition to a free market and for a very long time afterwards. Moreover, private banks that choose to hold government funds must be required by law to hold 100-percent reserves on all their checking deposits and banknotes. Further, the government funds should only be held in the form of checking deposits and banknotes. This will ensure that the government is engaging in no lending. Moving on to other issues, the government would also not act as a so-called lender of last resort or bail out any financially troubled institution, business, or individual. As I said, it would not lend money to anyone. The government would also not allow banks to suspend payments if banks are contractually required to pay. The enforcement of banking contracts could occur through the appropriate legal proceedings if necessary. However, if option clauses are used or other contractual provisions allow for the suspension of payments, banks could engage in this activity. The government would ensure the enforcement of the provisions of all legitimate banking contracts. No government deposit insurance would exist. If individuals want to obtain insurance on their funds at banks, they would have to purchase it from private insurers. However, private insurance of this type will tend not to exist because, as I discussed in chapter 4, it is actuarially unsound. I will discuss this topic in detail below in this chapter. No government chartering, certifying, or licensing of banks would exist. No government examinations, endorsements, and assurances of banks would exist either (except to verify 100-percent reserves on a bank’s notes and checks to determine if the notes can be used as money by the government). Private certification companies might arise for banks as they would exist for other industries, but government assurances of quality and the setting of any other standards (except insofar as it involves the prosecution of fraud) have nothing to do with protecting individual rights. No provisions to require banks to buy government bonds (whether federal, state, or local) as a condition for issuing notes or otherwise doing business would exist. The government would not restrict banks from competing in any way. No regulations separating commercial and investment banking would exist. Banks would be free to make any investments they thought were best for themselves and their customers. No government requirement for bank shareholders to have extended liabilities would exist either. However, banks might choose privately to do this. The only time the government might prevent a bank from opening up is if it has knowledge that it is part of some fraudulent activity or activity that initiates force in some other way. Otherwise, the government will leave the banking industry untouched. As I have mentioned above in passing, the government might have occasion to borrow money. This is consistent with the government’s proper function of protecting individual rights. The government might need to borrow money to build an aircraft carrier, a military airbase, a new courthouse, a police station, and so forth. The key is that any borrowed funds (and all funds) be used by the government to protect individual rights.

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Strict rules about when and from whom the government can borrow must be established. The government should not use its borrowing as a tool to favor some banks and harm others. The purpose should be to protect individual rights, and lenders should be able to loan to the government as long as they meet objectively determined, preestablished criteria developed for the purpose of ensuring that the borrowing is done to protect rights in the most cost-effective manner. The government should not be able to arbitrarily decide from whom to borrow or base its decisions on anything other than how best to finance the protection of individual rights. Ideally, the underlying restrictions on what the government can and cannot do should be established in a constitution. Any details of how the government is to be restricted can be left to the passage of laws consistent with the constitution. However, if it is not politically feasible to establish a constitution with the appropriate fundamental restrictions or amend an existing constitution with such restrictions, passing laws to establish the fundamental restrictions on what the government can and cannot do will work. The key is to eliminate the government’s interference in the monetary and banking system. This will lead to the greatest possible stability in the monetary and banking system and provide a rock-solid foundation upon which rapid rates of economic progress can be achieved. I now turn to a detailed presentation of the effects of such a system.

What Will a Free Market in Money and Banking Lead To? Why will a complete free market in money and banking, as described in the previous section, lead to the greatest stability that is possible with regard to a monetary and banking system? What will be the other important effects of a complete free market in the monetary and banking system? These are the questions I answer in this section.5 Most economists—and people in general—do not believe an unregulated monetary and banking system will lead to stability. They believe it will lead instead to financial crises, recessions, depressions, fraud, and, in a word, instability. But this is not true. People are generally led to these beliefs today based on a lack of understanding of sound economics and, more fundamentally, the acceptance of bad philosophy. I am not going to discuss these issues here. See my book Markets Don’t Fail! for a discussion of these issues, as well as any of the works by the economist George Reisman and the novelist and philosopher Ayn Rand. Here I am only going to discuss just how the stability in a completely free monetary and banking system will be brought about. First, a free market in money and banking would lead to a gold standard (or a standard based on some other precious metal). Gold emerged as worldwide money when people were free to choose what they wanted to use as money. People choose gold because it has objective value: value based on an assessment of the facts through the use of the individual mind. Gold has value as ornament and for industrial purposes. Gold has the best

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characteristics for serving as money (it is rare, durable, portable, storable, etc.). More virtues of gold will be discussed in chapter 7. Its objective value and its possession of the appropriate characteristics are what have led to it being accepted worldwide as money and what would lead to it fulfilling this role again in a free market. Countries have not voluntarily moved away from gold. Governments have forced people off gold. This was done in the United States mainly by the Federal Reserve confiscating gold from banks shortly after the Fed’s creation. Then in the 1930s, the government confiscated monetary gold from all citizens, devalued the gold dollar, and eventually took the United States off gold completely in the late 1960s and early 1970s by ending its support of the $35 per ounce gold price on the London gold market and ending the redemption of dollars for gold by foreign countries. Silver and other commodities might (and probably will) be used as money alongside gold in a free market. Voluntary agreement among individuals on what to use as money will lead to the most efficient and financially sound forms of money. As was discussed in the previous section, the government should not dictate what can or cannot be used as money. It should also not dictate the exchange ratios between the various forms of money accepted in a country or the exchange ratios relative to foreign currencies. These should all be determined through voluntary interaction in the marketplace. The supply of gold (and silver) tends to increase at a slow and steady pace, especially when compared to fiat paper monies, which have been increased in some cases at over one trillion percent on an annualized basis. This happened in Germany in the 1920s, Hungary after World War II, and Yugoslavia in the 1990s. Gold cannot be increased at the whims of politicians or banks. Further, once gold comes into existence, it tends not to go out of existence. Factors decreasing the supply of gold, such as the very small amount of loss due to wear and tear, tend not to decrease the existing supply but merely reduce the rate of increase. Even gold lost in sunken ships tends not to decrease the money supply but merely slows its rate of increase. Gold provides a very stable base for the monetary system. Only allowing private individuals to coin money will also help achieve stability.6 Governments throughout history have routinely debased coins and currency to finance their spending on wars, palaces, and the welfare state. Taking the minting of money out of the government’s hands will prevent it from doing this. Exposing the coinage of money to competition between private minters will discipline the minters by forcing them to provide only the highest quality money. If they want to build and maintain a good reputation and remain profitable into the indefinite future, they will have to provide a good product, as any company must do to remain competitive. Those who do a poor job will be driven out of business by people refusing to accept their money. Those who commit fraud will be punished by the government, as they should be. Second, and perhaps most controversial, a free market in money and banking will lead to 100-percent reserves (and perhaps more) on checking deposits

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and banknotes. I say this is the most controversial point because even most advocates of free banking do not believe this. However, most advocates of free banking, unfortunately, do not have a proper understanding of what a free banking system looks like and do not have a good understanding of the relationship between fractional reserves and the business cycle. In a very general sense, 100-percent reserves will be achieved because the burden of ensuring a particular bank’s long-term profitability and existence will be on the bank itself, instead of taxpayers, so banks will have to follow conservative policies, especially with their most liquid accounts. There will be no propping up of banks by the government and no regulations to create perverse incentives for taking on undue risk. Banks and their depositors will sink or swim on their own, and this will create a very strong incentive to hold 100-percent reserves, as well as follow other conservative policies. Let’s take a look at some of the specific characteristics that will lead banks to hold 100-percent reserves. Since there is no government provided deposit insurance, there will be no incentive to take on undue risk. Depositors and bankers will be responsible for their own funds and this will lead them to want more conservative policies in connection with bank accounts. This is true for savings and time deposits, but it is especially true for checking deposits. Savings, time, and checking deposits are the accounts that people generally want to take the least risk with, and since checking accounts are the most liquid—the accounts whose funds people use for day-to-day living—depositors generally want to take even less risk with these funds than funds in savings and time deposits. If people want to take on risk to earn higher returns, they buy stocks, junk bonds, commodities, foreign currencies, and so on. They do not put their money in the bank. As discussed in chapter 4, government deposit insurance encourages risk taking by using flat premiums and premiums that are too low. In addition, it uses taxpayers as the ultimate source to pay off depositors for lost deposits. The latter provides the primary incentive for risk taking. It lifts the burden of risk off depositors and bankers and places it on taxpayers. One way banks take on greater risk is by reducing reserve ratios. Of course, banks also take on more risk by making riskier loans, not performing adequate due diligence when considering someone for a loan, operating with more debt and less equity on their balance sheets, not matching the maturities of their loans and deposits, among other things. Eliminating government deposit insurance will help improve all of these. Government deposit insurance would not be appropriate even if the government charged higher premiums and varied premiums based on risk. The only proper function of a government is to protect individual rights and providing deposit insurance is not consistent with this. In a free market, banks and depositors will have to obtain deposit insurance from private insurance companies and, as I have stated, I do not think such insurance will exist in a free market. Evidence for this can be seen in the fact that, throughout history, deposit insurance has generally only been provided by governments; private insurers have rarely provided it.

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There is good reason for this. A loss of deposits, especially in a fiat-money, fractional-reserve monetary and banking system, is not an actuarially appropriate risk to insure.7 This is the case because losses of deposits are not completely independent of each other. Insurers want to insure against risks that do not generate additional events that lead to further claims for which the insurer must pay, and they want to be able to diversify themselves as much as possible (geographically and otherwise) to reduce the overall risk to which they are exposed. Deposit insurance does not provide insurers the ability to do either of these. Why is this true? When insurers insure against, say, damage from a hurricane, the hurricane does not generate additional hurricanes that spread throughout the economy and cause further damage. This is generally true of the types of risks insurers insure against (i.e., floods, fires, earthquakes, etc.). The damage is restricted to a limited geographic region. However, in an economy in which all banks have a low fraction of reserves backing their checking deposits and banknotes, the failure of one bank can cause the failure of more banks. This can occur because the failure of one bank reduces the money supply and spending and makes it harder for other individuals to pay off debts. If enough debtors of other banks fail to pay off their loans as a result, it can cause those banks to fail. The process can feed on itself until all the fiduciary media are wiped out of existence. That is, the money supply has the potential to shrink to the level of standard money. In this case, one event that requires insurers to make a payment on a claim has the potential to create other events that require payments by insurers. The exposure of insurance companies can even go beyond just the amount of fiduciary media since any savings and time deposits that are insured might lose value. One must keep in mind that both fiat money and fractional-reserve banking add to the risk to which insurers are exposed. They make the economy much more volatile (such as by creating and perpetuating the boom-bust business cycle and attendant financial crises) and thus generate the kinds of events that lead to more claims against insurers. In an economy based on gold and 100-percent reserve checking and banknotes, private insurers might provide deposit insurance since the major source of financial contagion will be eliminated. However, this means that in such an environment the overall risk of failure will be greatly reduced. This also means the need for deposit insurance will be greatly reduced, if not completely eliminated, and that such insurance will tend not to be that prevalent. Also leading to greater reserves is the fact that the government will not bail out financially troubled banks (i.e., it will not act as a so-called lender of last resort). In fact, it will not bail out any companies at all. This will create a large incentive for banks (and companies more generally) to take on less risk. Government bailouts add substantially to the financial irresponsibility that exists in our economic system. One of the strongest forces leading to greater reserves in a free market will be that the government will not allow banks to suspend payment to depositors when payment is contractually required on demand. Depositors will be able

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to enforce contracts through appropriate legal actions. If banks are unable to pay, they could be liquidated. This is something that will be unprecedented in the history of banking. Throughout the history of banking, banks have been routinely allowed to suspend payments after getting into financial trouble. This has enabled banks to engage in financially unsound banking practices (including keeping far too little reserves on hand). It has enabled banks to stay in business and continue to engage in fraudulent activity. While holding fractional reserves, as such, does not involve an act of fraud, stating in a contract that one will pay specie on demand and then refusing to do so because one did not hold enough reserves does involve an act of fraud. This will end with a free market in money and banking. The sanctity of contract will be upheld in the banking industry. This will help drive many unsound banks out of business. In fact, it will cause most banks to engage in financially sound policies so they can avoid legal actions in the first place. Of course, banks may have provisions in their deposit contracts that allow them to delay payment. This is the way banks can legitimately suspend payment. However, as I argued in chapter 4 in connection with the option clause, I do not think depositors want such provisions in deposit contracts. We saw this in connection with banknotes in eighteenth-century Scotland. One has to remember that funds in one’s checking account are the funds to which one needs immediate access to pay bills and, in general, live one’s life. The option clause makes it harder for one to gain access to one’s money. It does not help banks provide better service to customers but helps banks get away with providing worse service to customers. It protects banks at the expense of customers. The way to protect banks and provide sound monetary services to customers is for banks to hold 100-percent reserves on checking deposits and banknotes. Creating an even stronger incentive for banks to hold greater reserves is the fact that the government will be required to accept in payment only standard money or checks and notes backed 100 percent by standard money. As I mentioned above, even though the size of the government will be significantly reduced in a free market, the government will still be a large entity in the economy (especially when one considers federal, state, and local governments combined), and banks will need to hold 100-percent reserves if they want their notes to be used as money by the government and not immediately redeemed for standard money. This alone may bring about 100-percent reserves. However, this and enforcing payment by banks when payment is contractually required will provide a dual force that will probably be powerful enough—by themselves—to lead to 100-percent reserves. Banks will also have to engage in better maturity matching between their assets and liabilities. Since they cannot count on the government to bail them out or deposit insurance to save depositors, they will have to do a better job making sure the loans they make have the same time to maturity as the deposits they receive. For instance, five-year loans will have to be matched with time deposits of five years. Proper maturity matching will prevent banks from being insufficiently liquid when funds are due to depositors. Due to

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the perverse incentives created by government interference today (such as government deposit insurance), banks tend to use short-term borrowing to finance long-term lending.8 This is a recipe for disaster. If a bank uses funds obtained from one-year time deposits to make ten-year loans to companies for the purchase of machines to be used in their factories, how will the bank pay depositors when the funds are due back to them? The greater the amount of “borrowing short” and “lending long” a bank engages in, the more likely it is to face a deficiency of reserves. Let me emphasize that banks have a right to engage in maturity mismatching. Such mismatching is not inherently fraudulent as some economists believe.9 As long as depositors and borrowers are properly informed of the lending practices of the bank, maturity mismatching can be engaged in without any intentional deception of either party. The problem is that it is an unsound banking practice. Related to the issue of matching maturities is the fact that, in a free market, banks will have to operate with far more equity capital than they do presently. Using more equity is a way to increase the time to maturity of the funds one uses to finance one’s business, since equity investment has, in essence, an infinite time to maturity. Long-term loans (such as mortgage loans) will generally be made out of equity capital. Using more equity financing is a way of reducing the risk a bank takes on in its methods of financing its business activities. Whether or not a bank has adequate equity capital is an indicator of its solvency.10 In the United States before the financial crisis of 2008, commercial banks operated with equity-to-asset ratios of 10 percent or less. In Scotland in the eighteenth and nineteenth centuries, where there was less government interference, banks operated with equity-to-asset ratios around 25 to 30 percent and in some cases even well over 50 percent.11 Equity-to-asset ratios have been lowered by the massive government interference we have today. This has increased the risk to which banks are exposed. It is less risky to lend one’s own money than to lend money one has borrowed from someone else. If a bank loses its own money, it is much less likely to go bankrupt, since the bank’s owners cannot force it into bankruptcy. However, this is not true if a bank loses money by making bad loans with money it has borrowed. Deposit insurance and government bailouts encourage banks to borrow more of their capital (i.e., replace equity with deposits) by encouraging undue risk taking. Abolishing this government interference will raise equity levels and thus reduce the risk of bank failures. Banks will also tend to be far more diversified geographically and in terms of the investments they hold. No regulations requiring the separation of commercial banking and investment banking will exist. This will enable banks to invest their money or their customers’ money in a wider variety of investment vehicles. No investments will be off limits to banks. This will enable banks to lower their overall investment risk. Competition will be more intense among banks because of their ability to compete in wider geographic areas and make a wider variety of investments.

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Competition among banks will also include competition in the issue of banknotes. Because of this, the soundest banknotes will tend to prevail under free note issue. If banks want their notes to be accepted as widely as possible, they will have to follow conservative policies with regard to note management. Who is going to accept notes that decrease in value dramatically and with respect to which payment of specie is unlikely? Mechanisms emerged in the freer banking eras to distinguish good banknotes from bad banknotes.12 For a bank to maintain a competitive advantage and long-term profitability, it will have to make sure it does not overissue and that it has sufficient reserves backing its notes (which will tend toward 100-percent reserves). Private clearinghouses will also emerge in a free market. Historically, these were often established without any government involvement (such as the Suffolk Bank System).13 They provide a very important cost reducing function to the banking system by reducing the number of monetary transfers between banks. Clearinghouses also help to achieve greater reserves. To the extent the ratio of a bank’s checking accounts and outstanding notes relative to its reserves are greater than the corresponding ratios of other banks, it will be met with net debits or “adverse clearings” on its accounts at the clearinghouses that must be settled through transfers of gold. To the extent its gold supply is decreased, a bank will have to contract its lending and note issue to build reserves.14 For example, if the clearinghouse consists of two banks (A and B) each with $1,000 in reserves but bank A issues $2,000 in notes while bank B issues $10,000 in notes, ceteris paribus, bank A will tend to end up with five times as many of bank B’s notes as B ends up with A’s notes. So, due to the transactions taking place in the economy during a given period of time, bank A might end up with $1,000 of bank B’s notes while bank B ends up with only $200 of bank A’s notes. To settle their accounts, $800 of reserves will have to be transferred from bank B to bank A. At some point B will be forced to contract its note issue or lose all its reserves. Even if bank B has more reserves than A, if B issues more notes relative to its reserves it will tend to lose reserves to A. For example, if A has $1,000 in reserves and B has $2,000 in reserves but A still issues $2,000 in notes while B issues $20,000 in notes, A will tend to end up with $10 of B’s notes for every $1 B receives of A’s notes (ceteris paribus). So B might receive $100 of A’s notes but in the same time period A will receive $1,000 of B’s notes. Again, net transfers of reserves to A will take place and B will be forced to contract its note issue or eventually lose all its reserves. One might think based on the above that note dueling will occur. However, it will not take place to any significant extent in a free market. Note dueling occurs when banks accumulate other banks’ notes and present them to the issuing banks all at one time hoping to force the issuing banks to run out of reserves. This did take place in the past and does have the beneficial function of disciplining banks, but it gave way to the clearinghouse in the end.15 In a free market, large banks or clearinghouses may bail smaller banks out in some situations; however, their resources will be limited (unlike a

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government that can print money in an economy based on fiat money) and the lenders will take on the risk of bailing out financially unsound peers, which will expose the lenders to the risk of failure themselves (again, unlike a government that can print money). This will severely limit the number of bailouts that take place, limiting them only to the ones that private individuals think make financial sense (i.e., the ones in which it is believed the financially troubled banks can recover and lenders can get their money back with an adequate return). Consistent with this conclusion is the fact that during the freer banking periods clearinghouses sometimes acted as so-called lenders of last resort in specific situations.16 Nonetheless, extensive studies of the freer banking periods also show that there was no general tendency for such lenders to develop or be needed.17 On this subject, one must consider why sound banks would want to bail out their weaker rivals. Why not let them fail and let the business come to you (the sound bank)? Perhaps, one might claim, that the sound banks might think if any banks get into financial trouble, it might tarnish the reputation of the entire industry and thus harm the sound banks by association. Sound banks might think this for a while and bail out their weaker rivals a few times, but eventually they will learn their lesson, if not by incurring losses then by the incessant pleas from weak banks to “bail me out.” There is no reason to believe the sound banks will not eventually learn (or even understand from the very beginning and never bail out their weaker rivals) that it pays to put their own business in a good financial position, maintain their own good reputation, and let the weak banks fail. If a bank has a record of financial stability, its reputation will not be tarnished by the failure of weak banks; in fact, it can use the failure of the weak banks to further enhance its reputation and gain more business. If a fully free banking and monetary system is established, clearinghouses may perform other functions that regulators engage in today, such as providing bank examinations, assurances, and endorsements. However, one must remember that private provision of such services is fundamentally different than government provision of such services, since in the former case it is based on voluntary trade and in the latter it is forcibly imposed on the market. Because their actions are based on voluntary trade, private organizations will only tend to provide functions that lead to greater stability in the economy and that are of benefit to individuals in the economy. For instance, private clearinghouses can require banks to submit to their inspections in order for the banks to be eligible to join the clearinghouses, but a particular clearinghouse cannot prevent a bank or banks from doing business outside the clearinghouse or from establishing another clearinghouse. Any standards established with regard to bank examinations and the like will have to benefit all involved, including the banks and their customers. Such examinations will be of benefit to banks so that they can gain a competitive advantage by, in essence, gaining the stamp of approval of a reputable certification organization and, ultimately, putting the banks in a sound financial position so they can provide good service to their customers. The standards

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that prevail will be subject to competition themselves, not forced on people by the government, so the ones that prevail will tend to be the ones that take all the relevant factors into account (i.e., stability, cost, etc.).18 One also has to consider the context within which examinations and the like have occurred. So far, such activities have taken place in a context of government interference in which it is believed that banks holding low reserves and engaging in other unnecessarily risky behavior is the norm and perfectly legitimate. Once the government interference is eliminated and it is clearly seen what is necessary for banks to put themselves on a sound financial footing (and it is seen that the government interference itself actually causes the instability and undue risk taking in banking and is not beneficial, but harmful, to the economy), the irrational standards of the past and today used by bank examiners will disappear. Just as banks will not be able to get away with irrational practices in a free market, so (private) rating agencies in the banking industry will not be able to do so either (if such rating agencies exist at all). The nature of competition in a free market is that it leads to—and has led to wherever it has existed throughout history—better products being produced and the more financially sound companies surviving. Why, if this is the way competition has worked in so many areas of the economy, would it be any different in banking? Why would the less sound banks who provide a less stable service survive? Why would poor standards for evaluating banks prevail? This contradicts everything we know about the nature of competition in a free market.19 Regarding the issuance of fiduciary media, some economists claim that clearinghouses can only put a check on some banks overexpanding relative to others. These economists claim that if all banks expand in unison (i.e., they increase their ratios of checking deposits and notes issued to reserves at the same rate), clearinghouses do not provide a mechanism to put a check on the expansion.20 This claim is made because the check that clearinghouses provide requires that some banks have net debits at the clearinghouses. This is true, but this does not mean banks can overexpand. First, one must understand that as all banks overexpand together, even though they will not have net debits at the clearinghouse, they will face the risk of their depositors engaging in larger-than-usual withdrawals that could deplete their reserves. This puts a limit on how far they can reduce their reserves relative to checking deposits and outstanding banknotes. Further, even though banks on average might not have net debits at the clearinghouse if they expand in unison, the smaller their reserves relative to checking deposits and outstanding notes, the larger the potential net debit that any one bank might face at any point in time that it must settle its accounts at the clearinghouse. This will also put a check on how much banks can expand even if they do so in unison.21 One also has to consider the fact that the clearinghouse is just one mechanism that disciplines banks. There are many other mechanisms that discipline banks in a free market (many of which I have been discussing, such as not allowing banks to suspend payments if contractually obligated to do so).

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The overall incentive provided by clearinghouses and the fact that banks will be financially responsible for their own decisions (as opposed to taxpayers bailing them out) will be for banks to reduce the risks they take on (if they want to ensure their long-run viability), and this will include maintaining a far higher amount of reserves than they otherwise would. There is no substitute for liquidity for a bank, since a major part of a bank’s business is providing monetary services to customers. Adequate liquidity requires cash and history shows that high reserve banks beat out low reserve banks.22 There is also the fact that if banks expand in unison, they will create the expansion phase of the business cycle. As we know, bust by necessity follows boom. Here the contraction will set in when the banks stop reducing their reserve ratios or merely slow the rate of reduction sufficiently. As banks reduce their reserve ratios, they will increase the money supply, spending, revenues, and profits and reduce interest rates. However, when they have reduced their reserve ratios to levels that are too risky and must stop reducing them, the money supply, spending, revenues, and profits will stop growing (or just fail to rise sufficiently) and interest rates will rise. Since businesses and individuals will have taken on plans during the expansion phase of the cycle based on the continued rise in spending and profits, and low interest rates, once the trend is reversed many plans will have to be scrapped because they will be unsustainable in the now tighter monetary environment. This latter is the contraction phase of the business cycle. This will drive the least sound banks out of business (along with many businesses outside the banking industry) and restore reserve ratios to more appropriate levels. The financially sound banks will do well in such an environment, since customers will flee the collapsing banks for the security of the conservative banks. In this way, with no government interference to save the weak banks, the economic system itself will put a check on how much banks can expand, punish the irrational banks, and reward the rational banks. It is sometimes claimed that in a financial crisis the panic spreads even to the sound banks. However, one must consider the context within which this statement is made. It is made with respect to economic systems that have significant government interference in banking (even during the so-called free banking eras throughout history this is the case). This means banks have taken on greater amounts of risk than they otherwise would, including by reducing their reserves to low levels. All banks in such a system are in an unsound position. Government interference fosters irresponsibility and excessive risk taking. Indeed, it requires excessive risk taking for banks to be competitive in such an environment. One must engage in a massive paradigm shift to see, not a world in which perverse incentives exist that essentially beg banks to take on undue risk, but a world in which economic incentives ruthlessly punish banks that do not follow the most conservative policies. It is difficult for many to see the alternative because it is so radical from what they have experienced and, in fact, what has been experienced for centuries—and even millennia—in the banking world.

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I do not think the economic system will face an endless cycle of booms and busts into the indefinite future in a free market. Some banks will expand more than others and some will not overissue at all. The ones that get into the most financial trouble will be the ones that take on the most risk and overexpand the most. The ones that have the easiest time surviving the contraction and resulting financial crisis (and actually gain business from their poorly managed rivals) will be the ones that follow the most conservative policies, which will include those that do not overissue at all. Over time, it will become clear what is the cause of the problem and what a depositor should do if he wants to make sure his funds are secure: he must keep them in the most conservatively managed banks. These banks will tend to prevail over time as the poorly managed banks go under. Competition will weed out the poorly managed, risky banks. What will be left are the most expertly managed banks that will provide the most solid monetary foundation possible. From a monetary standpoint, this will provide the greatest ability for the economic system to progress forward. Beyond facilitating trade and extending the division of labor to credit markets, stability is the most important thing needed from a monetary and banking system to foster economic progress. Stability will be created because gold and 100-percent reserves will virtually eliminate inflation and monetary induced business cycles. The supply of gold increases at a slow and steady pace, especially relative to fiat money. One-hundred-percent reserves (or higher) on checking deposits and notes will keep the money supply from rising rapidly due to banks lowering reserve ratios. This will provide a slow and stable increase in the money supply. This is how gold and 100-percent reserves prevent the business cycle and the recessions, depressions, and financial crises that are a part of it. I am not saying monetary induced instability will completely disappear. There may be instances where even the supply of gold changes rapidly in a country or region. This might occur due to gold inflows or outflows from changes in international trade and investment, or from discoveries of gold and an influx of gold money into a local economy as a result. The point is that these fluctuations will be far less frequent, their swings will have far lower amplitudes, and their effects will be far less severe and more localized. The supply of gold cannot fluctuate—and has not fluctuated throughout history—as much as fiat money. The government’s power to print (or electronically create) money under a fiat-money system far surpasses the ability to mine gold. Further, banks and individuals will be protected to a far greater extent from fluctuations because they will practice far more conservative policies with regard to their money, thanks to the incentives provided by the free market. For instance, since the money supply will not rise rapidly, velocity will not rise as much. This means individuals, businesses, and banks will be far more liquid. This will eliminate the need to scramble for liquidity should monetary induced fluctuations occur. Likewise, influxes of money to a local economy will be felt most dramatically by only that particular local economy. The effects will dissipate and be less severe (both for other

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localities and the locality to which the gold originally flowed) as the money spreads throughout the national and world economies. What I am saying will emerge in a free market in money and banking through the incentives that such an environment provides (not by law) is 100-percent reserves on checking accounts and on banknotes. Other accounts (savings and time deposits) will not and should not have 100-percent reserves backing them. Checking accounts and banknotes are the most liquid banking instruments that exist (except for standard money). These are the liabilities banks must generally provide specie for on demand. Therefore, it is most important that banks back these fully. Savings and time deposits are not money and while it is important for banks to keep some reserves to back them, since there will be occasional net withdrawals from these types of accounts, depositors have temporarily given up access to these funds to earn a rate of return and will have to understand that because of this they might not have immediate access to these funds. To earn a rate of return, the bank must loan out these funds, so they will not be in the possession of the bank. Banks not keeping reserves backing savings and time deposits (at least for the far greater majority of them) does not pose a problem to the economy because this will not lead to changes in the money supply and spending and thus it will not cause the business cycle. Depositors cannot spend these funds until they get them back—which might require a long wait, especially if the funds are in a long-term certificate of deposit—and transfer them to a checking account or withdraw them in gold or notes. Hence, lending these funds does not change the money supply. It merely transfers the money from one person to another—from the lender to the borrower. Moreover, if loans made with funds in a savings deposit are not paid back, it does not affect the money supply (in contrast to loans made from funds backing a checking deposit or loans made with the issue of unbacked banknotes that are not paid back, which can affect the money supply). Since the savings deposit is not money, if the loan is not paid back, it is the case that a highly liquid asset has lost value but the money still exists. The bank and the depositor just do not have it anymore. The money is in the hands of the person to whom the loan recipient gave it (or the person that person gave it to, etc.). So the money supply remains the same.23 When loans made out of funds backing checking deposits are not paid back and a bank gets into financial trouble as a result, the checking deposits lose their character as money. This manifests itself in the fact that checks from such a bank are no longer accepted in transactions. So the money supply shrinks and, as I have discussed, it has the potential to shrink down to the level of standard money. I have mentioned that reserves backing checking deposits at banks may be more than 100 percent in a free market. This is due to the existence of savings and time deposits and the need for some very small amount of reserves to back these accounts. These additional reserves might, in effect, create more than 100-percent reserves backing checking deposits. In actuality

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these additional reserves are backing the savings and time deposits but they do provide an added cushion to the overall activities of the bank. One might think the distinction between savings and checking accounts is not as sharp as I have made it out to be. One might think the distinction between these accounts is often blurred by such things as the capability of automatically transferring funds from a savings to a checking account. Here depositors can keep much of their funds in their savings account and write checks on their checking account to take advantage of the automatic transfer. If savings and checking accounts are becoming essentially oneand-the-same type of account, then my argument that 100-percent reserves will emerge in a free market to back checking accounts and only a very small amount of reserves will back savings accounts is not valid. Why would close-to-zero reserves be used to back savings accounts and 100-percent reserves back checking accounts if the two types of accounts are essentially the same? While it is true that improvements in technology have made it easier to transfer funds between accounts and gain access to them for payment purposes, this does not change the fundamental distinction between savings and checking accounts (i.e., that the latter are money and the former are not). Banks can provide such services as automatic transfers from savings accounts by ensuring they have enough reserves backing savings accounts to handle the net debits from such transfers (and probably charge a fee for these services). The ability to make quick transfers with new technology does not deny the validity of my argument regarding the radically different amounts of reserves that will be used to back each type of account because the blurring between checking and savings accounts does not come from improved technology. It is the result of government interference in the banking system. The government interference about which I have been writing leads to banks holding much lower reserves backing checking deposits and thus makes checking deposits look more like savings deposits. Without such interference, a much sharper distinction between savings and checking accounts will exist because banks will have to keep far more reserves in general and will have to keep the most reserves backing the most liquid accounts—the accounts available to depositors on demand. Banks will also make sure they distinguish in the deposit contracts between the different types of accounts. They might explicitly state that funds in savings accounts could be temporarily unavailable until the bank obtains the funds and that funds in checking deposits will be available on demand (that’s why the name originally used for checking deposits was demand deposits). Based on the clearer distinction between checking and savings deposits, the amount of savings deposits will most likely rise relative to the amount of checking deposits after the move to a free market. People will realize to earn interest on funds at banks they will have to keep such funds in a savings account. As discussed in chapter 4, there will be no nominal interest rates earned on checking accounts to mask the fees charged on such accounts. This will make it easier to achieve 100-percent reserves on checking deposits.

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This could be a significant factor in achieving 100-percent reserves since the movement of funds from checking to savings accounts could be quite large. What about the issue of some banks (typically smaller banks) holding the notes of other banks (typically larger banks) as reserves or some banks keeping their reserves in the form of checking accounts at other banks or at the clearinghouse? There may even be multiple banks involved in a chain of notes or checking deposits until one ultimately arrives at the bank that has the specie. For example, bank A holds the notes of bank B as reserves and bank B holds the notes of bank C as reserves, which possesses the specie. This is not a problem and will not detract from the incentives leading to 100-percent reserves. Banks probably will not hold all their reserves in this manner. However, banks may want to hold at least some of their reserves somewhere else if they believe it is safer and/or more cost effective to do so. Banks that do this will still have their contracts enforced to pay specie on demand (when their contracts require this). Of course, banks that hold their reserves in this way will have to ensure that the ultimate holder of specie backs its notes and checking deposits 100 percent with specie if the bank using other banks to hold its reserves wants the government to accept its notes in payment. This is necessary to ensure that the government is receiving a claim to money and not a claim to debt through these payments. Money market mutual fund (MMMF) style checking accounts might exist in a free market, but probably not. The check writing feature of these accounts (and their counterparts at banks, money market deposit accounts or MMDAs) most likely arose due to regulations limiting the interest rates that could be paid on checking accounts.24 It is likely that MMMF style accounts will exist in a free market, just without the check writing capabilities. MMMF accounts give equity claims to depositors in the assets funds own; they do not create liabilities for the companies issuing shares in the funds. Such accounts do not fundamentally change the incentives and requirements faced by the financial institutions that offer them. They will still be required to pay specie on demand if contractually obligated to do so and to hold 100-percent reserves backing their notes and checking deposits if they want their notes to be used in transactions by the government. While it is impossible for an MMMF to be forced into bankruptcy by depositors, since the deposits represent shares of ownership of the fund instead of debts the fund owes to depositors, such funds are not immune to financial troubles. If enough shares in the fund are sold, the share price can fall. This rarely happens but an MMMF has failed in the past.25 In addition, MMMFs got into much financial trouble during the financial crisis of 2008. The problems were so great the US Treasury Department actually intervened to insure qualifying MMMFs in a manner similar to how federal deposit insurance covers bank deposits.26 Of course, this type of government interference would not exist in a free market. If the reserves of MMMFs are not adequate and share owners cannot withdraw money as a result or their checks are no longer accepted in payment as a result, then

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the owners will probably quickly sell their shares and the fund will cease to exist. Alternatively, if recipients of checks drawn on the fund cannot obtain the funds to which they are entitled, the fund could be forced into bankruptcy by the unpaid check recipients. This might occur through a class action lawsuit by check recipients who have not been paid against owners of the fund (i.e., depositors) that owe them money. However it works itself out, MMMFs, as with all financial institutions, will have to sink or swim on their own and thus be naturally led to hold 100-percent reserves to back any accounts on which checks can be written. MMDAs are different from MMMFs because the depositors do not have an equity claim on the assets purchased with the funds from the accounts. MMDAs are essentially checking accounts that have restrictions on the accounts designed to reduce their liquidity (such as minimum balance requirements and limits on the number of checks that can be written per month). MMDAs were created to compete against MMMFs. The essence of what I have discussed in this book in regard to checking accounts applies to MMDAs. What about sweep accounts? These accounts allow funds to be swept from checking deposits to other accounts (such as MMDAs) when the banks are closed. Will these accounts exist in a free market? Probably not, since they exist to get around reserve requirements and regulations that limit interest rates on checking deposits. Nonetheless, even if they did exist, they would not fundamentally change things. They would still be subject to all the incentives and requirements that any other checking account would be subject to. Thus, if they did exist, these accounts would be naturally led toward 100-percent reserves. As I have been making clear throughout this book and this section, there should be no legal enforcement of 100-percent reserves on checking deposits. As I have also been making clear, the market will still be led to 100-percent reserves or something close to it on checking deposits. However, if banks engage in deception to conceal the fact that they are engaging in fractional-reserve banking, it should be prevented because it is fraud. The individual banks who engage in deceptive practices should either be shut down, required to explicitly state they are fractional-reserve banks, subjected to periodic inspections if they are going to continue to claim to retain 100-percent reserves, or punished in some other appropriate manner. Government action should be taken only to protect individual rights. Under no circumstances should the government initiate physical force. In order to use force, it must have evidence of violations of rights. Of course, when the government uses force to prevent fraud it is retaliating with force, not initiating force. Retaliatory force is the only type of force a government is allowed to use in a free market. What about the case in which large numbers of banks routinely but honestly hold fractional reserves and such policies lead to periodic financial crises, recessions, and depressions? People will be financially harmed in this case but if people knowingly want to engage in practices that harm themselves,

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that is their choice. I do not believe that if individual rights are protected large numbers of people will be so irrational. Indeed, the achievement of a society that consistently protects individual rights presupposes a significant degree of rationality within it. This is why I believe that ultimately such a society will be led to engage in policies that create stability and progress, not financial crises, recessions, and depressions. Of course, people can choose to hold their money in 100-percent reserve banks to protect themselves from such economic disasters. These people might be financially harmed by the economic disasters but the harm should be minimal. Even in the environment that exists today in the United States, in which we have massive regulations in banking and the instability to which such regulations lead, individuals and banks are able to protect themselves. They do so, for instance, by not taking on too much debt or not getting caught up in the euphoria of the boom and engaging in the irrational speculation that accompanies the booms and rapidly drives up the prices of some assets (such as houses and stocks). Many individuals and businesses survive crises today with little or no financial harm being visited upon them. In a free market, which will be far more stable, it will not be very difficult for individuals and businesses to protect themselves because monetary induced crises will be far less frequent and severe and limited to much smaller portions of the economy. In fact, as I argue throughout this book, such crises will tend to be nonexistent. Finally, as I discussed in the previous chapter, financial harm to third parties does not by itself represent a violation of individual rights. Hence, it is not a justification for government action. I will not consider the debate closed about whether fractional reserves or 100-percent reserves on checking deposits will be achieved in a free market in money and banking until a free market is actually achieved. My trump card in the debate, and what is unprecedented in history, is that in a free market the government will be required to accept only standard money or checks and notes drawn on 100-percent reserve banks as payment (or only consider itself paid when it takes possession of the reserves to which the notes and checks are a claim in the case of receiving notes and checks from fractionalreserve banks). The government will also only be able to use as money in daily transactions either standard money or the notes from banks that maintain 100-percent reserves on their notes and checking deposits. This, by itself, will probably lead to 100-percent reserves. However, the fact that banks will be rigorously required to pay specie on demand if they are contractually obligated to and the fact that if a large number of banks pare down their reserves enough it will lead to the business cycle, at the end of which the weaker banks will be weeded out, will add even greater force toward achieving 100-percent reserves. Throughout the history of banking—even in the so-called free banking eras, such as during portions of the eighteenth and nineteenth centuries in Scotland—banks routinely suspended payment of specie when they got into financial trouble even though they were contractually obligated to pay. Indeed, banks refused to pay specie on demand, when obligated to do so, even when they were not in financial trouble. Banks

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used intimidation tactics and other inappropriate means to prevent customers from withdrawing specie to which the customers had a right.27 This will not be the case in a free market. Banks have also been routinely bailed out or provided liquidity by government central banks, quasi-central banks, or the government itself when they got into financial trouble during the recessions, depressions, and financial crises created by fractional-reserve banking. This will not occur in a free market either. Finally, the shift of funds from checking to savings deposits after the move to a free market will be a significant factor as well in achieving 100-percent reserves. All of these forces will help put an end to fractional-reserve banking.

Fallacies of a Free Market in Money and Banking Above I discuss the nature of a free market in money and banking: what it is and what it will lead to. However, many claims are made by economists about such a market that are not valid. These include claims that a free market in money and banking will lead to massive inflation, rampant counterfeiting and fraud, a monopoly in banking, the disappearance of commodity money, among many others. I refute these fallacies in this section. The first fallacy I address is the claim that a free market in money and banking will lead to rampant fraud and counterfeiting with regard to banknote issue and the level of reserves banks hold. It is claimed that government control of the monetary and banking system is needed to prevent these. However, in the freer periods in money and banking throughout history, fraud and counterfeiting have never been a major problem.28 Any fraud and counterfeiting that occurs should not be used to rationalize government interference. If the government performs its appropriate function of protecting individual rights, those who commit acts of fraud or who engage in counterfeiting will be swiftly punished. Fraud and counterfeiting will be minimal under a free market in money and banking, as they were in the freer banking periods. Banks, as with all businesses, have a strong incentive not to engage in fraud both because of the legal ramifications and the damage it would do to their reputations and ability to earn profits and remain economically viable. Banks also have a strong incentive to prevent counterfeiting of their currency for the same reason. In fact, banks who compete against each other in the issuance of banknotes have a stronger incentive to prevent counterfeiting than a government who has a legal monopoly in the issue of notes because the government does not face the possibility of losing business to rivals in the issuance of notes. So if the government does its job, there will be no problems with regard to these matters. It is also claimed that a massive inflation of the money supply will occur in a free market because there are allegedly no restraints on issuing money, since anyone is free to issue their own notes or create fiduciary media.29 I have extensively discussed in this chapter why banks will not issue fiduciary

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media in a free market and the historical record shows banks held more reserves in the freer periods than the less free periods. This will be discussed more in chapter 6. As I have discussed above in the current chapter as well, competition among banks to get people to accept their notes requires that banks judiciously issue notes, not issue them in an uncontrollable fashion so that their value decreases to zero. The latter is what governments have routinely done when they control the money supply. One reason governments do this is that a government with a legal monopoly on the issue of money does not lose business if it overissues. In addition, as I have shown above, even if banks create fiduciary media or issue notes in unison, it will not last. The tendency will be for banks to be financially conservative because this is what will be required for their own profitability and survival. Another reason government controlled money leads to massive inflation and a free market in money and banking does not is that government fiat money can be arbitrarily and massively increased. In contrast, the increase in the supply of gold money in a free market is strictly limited to the supply of gold that can be dug out of the ground in any one time period. No such limits exist for fiat money. The history of the freer banking periods has been one of small increases in the money supply and stable prices. This will be discussed more in chapter 7. Governments have been the ones to devalue currencies and have always been the source of massive inflations. No honest historian or contemporary observer can deny this. Whether it is Weimar Germany in the 1920s, Hungary after World War II, or the many other massive inflations, nothing that has occurred under a gold standard during the freer banking periods has come even remotely close to these. Governments have been responsible for prices rising over one trillion percent annually based on their massive creation of money. In addition, throughout the latter twentieth century, countries such as Israel, Turkey, Mexico, many South American nations, and many more have routinely had 100 and even 1,000 percent annual increases in prices based on their creation of money. Governments create money at such massive rates to finance the welfare state, the government officials’ own lavish lifestyles, and to maintain control of the economy. Government control of the money supply is a form of statism and arises for the same reason that other forms of government control of the economy arise: because it is believed the individual does not have a right to his own life and that the state has the right to dispose of the individual in any way those who control the state think he should be disposed of. This, from a moral perspective, is why governments take control of money and why it leads to massive inflation. Another alleged problem with a free market in money and banking is that a single, large bank might emerge as the only bank in the economy. Some claim that banking is a so-called natural monopoly, in which one bank can most efficiently and effectively provide banking services in the economy. It may be true that one bank would dominate the banking industry; however, if it did it would not reduce the quality of services provided by the banking

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industry, but improve them. Such a bank would not have a legal monopoly in the provision of banking services; that is, it would not be protected by the government from competition from other banks or potential banks. Hence, if one bank did become dominant, it would have to acquire the business of customers and drive other banks out of business through voluntary trade. It would have to do this by providing some combination of better services and/or lower prices. Further, as it must achieve its dominant position through voluntary trade, so it must maintain it. If it becomes complacent and starts to become inefficient and not provide the types of services that customers want, other (much smaller) banks that are already in the industry can easily erode its market share or other individuals can enter the industry to take away market share. It is very difficult for dominant firms in a free market to remain dominant because they cannot rest on their laurels. They must continuously innovate and remain efficient to maintain their dominance. Many firms that were dominant at one time have lost their dominance or even gone out of existence or bankrupt due to poor business practices, including Ford under the original Henry Ford, Sears and Roebuck, and Montgomery Ward. Firms that were small by comparison relative to the once dominant firms sometimes rise to become the dominant firms. Wal-Mart is a good example. It is only firms that have a legal monopoly—in which competition is forcibly prevented by the government—that can achieve and maintain a dominant position even though they provide bad service and have high costs. The US Post Office and utility companies are good examples of these.30 Even though a single firm emerging as the only bank in a free market in banking would be a positive result economically, I do not believe one firm will come to dominate the banking industry. The banking industry will probably be dominated by a few or several large firms with many branches. There will most likely be many small regional and local banks in the industry as well. It will probably be no different than many retail industries (such as groceries or department stores), in which a few large firms exist but many small firms exist as well. The banking industry tended to look like this during the periods when it was freer, such as in eighteenth- and nineteenthcentury Scotland and nineteenth-century Canada and Australia.31 Some also claim that if one bank did become the only bank in the industry, it would be able to overissue banknotes and create fiduciary media more generally. Despite these claims, even if one bank did become the only bank in the economy, it would not be able to get away with overissuing banknotes or creating fiduciary media in other ways and survive. Such a bank would be in the same position as many banks who attempted to overissue in unison. The possibility of larger withdrawals would put a limit on how much the bank could issue. In addition, such a bank would still face all the other incentives that would exist in an environment of free banking: it would still be responsible for its own success or failure and it would not be bailed out by the government or provided inexpensive government deposit insurance. If a bank was to achieve a sole-supplier position in the industry, it would have

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to earn everyone’s business. It would not be given, by the government, the privilege to be the sole bank. It would be extremely difficult to achieve this sole-supplier position in banking (in fact, I think it would be impossible in a free market). To do so, it would have to follow sound financial principles, pay specie on demand when contractually obligated to do so, and make sure its notes and checking deposits are backed 100 percent if it wants its notes and checks to be accepted by the government as payment. Even harder, to maintain its sole-supplier position, the bank would have to continuously provide the services customers demanded and continuously adapt and innovate to satisfy customers. The freedom of competition would prevail in banking—as it would prevail throughout a free economy—so this bank would always face the potential threat of competition and invite new entrants into the industry if it did not satisfy customers. Moreover, if such a bank created fiduciary media, it would generate the boom-bust business cycle and face the potential threat of bankrupting itself. In fact, what might happen with such a monolithic bank is that branches in some areas of the country might follow more sound financial principles than others and thus survive a crisis in a better fashion than the weaker branches. In this way, reserves within the one huge bank would tend to rise and the poor financial practices would be eliminated. In essence, competition among different branches of the bank would emerge and help the bank achieve a more financially sound position. The elimination of weaker branches would also open the door for new competitors in the areas that the weaker branches once served. So on this count too there is nothing to worry about with regard to a single provider of banking services emerging in a free market. Another claim is that in a free market no bank would act as a so-called lender of last resort.32 This is not necessarily a fallacy because it is probably true, but it would be a positive outcome if no one did act as such a lender. One does not want a bank or clearinghouse propping up unsound banks. Banks need to follow sound financial principles to survive on their own. This will best ensure the survival of the individual banks and the stability of the banking system. If a so-called lender of last resort does emerge in a free market, as I have discussed above in this chapter, it will not have a bottomless pit of credit to extend (unlike government central banks that have a monopoly issue on money). It will be exposing itself to the threat of failure to the extent it routinely bails out banks, so it will need to be very careful about which banks it provides credit to. Another claim is that central banking is a natural development in banking,33 as if it would emerge from a free market in banking. This could not be farther from the truth. Central banking has always and everywhere been created by the government initiating physical force.34 This is even admitted by an economist who believes the development of central banking has been “natural.”35 This, of course, is true of all the central banks that exist today, even going back to one of the oldest central banks, the Bank of England (established in 1694), which started out being given monopoly privileges by the English

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government to finance government spending and was granted additional powers as time went on. It also includes the Federal Reserve System, which was created by the US government to regulate America’s banking and monetary system. So central banking most certainly does not emerge naturally from the free market. It has always been forcibly imposed on the market by the government and is thus always a violation of individual rights. As I discussed above in this chapter in connection with clearinghouses, large banks and/or clearinghouses might perform some of the functions that central banks perform but they would not have a monopoly privilege on note issue, they would not regulate the banking system, and they could not provide endless supplies of credit to the banking system and the economy in general. In short, they would not be central banks but large banks or financial institutions that exert great influence on the system to, presumably, promote stability in the system. Such functions would not be necessary but that does not mean some large institutions might not attempt to perform such functions. I will end this section with some of the more nonsensical and philosophically corrupt views on what would emerge in a free market in money and banking. Some economists think that under a free monetary and banking system, gold would disappear as money. One variation on this claim is that there would be no commodity at all that serves as standard money. The unit of account that money provides would be “abstract” (i.e., not actually based on any good that is traded).36 The idea is that values in accounts would be transferred among account holders but the accounts would not be a claim to any commodity or asset (even fiat money). No physical medium would be exchanged for goods (except in the case of small payments, then a fiat paper money would be used). Another variation on this is that the medium of exchange would be a basket of commodities. Wheat, sugar, beef, ammonium nitrate, copper, and plywood have been suggested (not necessarily together).37 The claim is that tying our monetary system to a single commodity (i.e., gold), which has very few practical uses (at least compared to staple commodities), creates instability in our monetary system. Using gold as money also subjects us to the alleged vagaries of the supply of and demand for gold.38 Using no commodity or a basket of basic, less expensive commodities would allegedly save us resources as well.39 Also among the claims I will address here is that the unit of account and the medium of exchange would be divorced if a free market in money and banking existed.40 That is, what is used for a unit of account would not be used as a medium of exchange. This would allegedly prevent the medium of exchange from exerting any (or much) influence over economic activity and would be more efficient.41 In addition, bank accounts as we know them would allegedly disappear. It is claimed by some that checking accounts would consist only of ownership in mutual fund portfolios, such as MMMFs.42 Whether accounts exist as traditional bank liabilities or MMMF type accounts, to these monetary theorists this would essentially be the only form of money (if money exists at all), since commodity money would disappear.

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I am not going to refute the claims above in detail. That has already been done in the excellent article by Lawrence H. White that I cited previously.43 I will limit my economic criticisms to just the more important arguments. I will also show the philosophic corruption upon which these ideas are based and which White either does not address or, in fact, embraces.44 Fortunately, White’s acceptance of bad philosophy does not detract from the forcefulness or validity of his economic arguments against the claims he refutes. The above claims display ignorance of the objective need for money and the need for objectivity in general. They are based on a view that “alternative worlds” can be posited which have nothing to do with the facts of reality, including the requirements of production and trade and thus of human life. They are, fundamentally, based on a view that the metaphysical nature of reality can be changed and therefore that we can arbitrarily assert how we want reality to be. This is what the novelist and philosopher Ayn Rand described as the fallacy of attempting to rewrite reality.45 We cannot rewrite the metaphysical nature of reality. We can only accept it and act within it. The nature of reality is that money is used to help individuals further their lives and well-being by facilitating trade. Its use develops because it greatly reduces the cost of trade, relative to barter, and thereby makes possible a radical expansion of the division of labor, a radical increase in the ability to produce wealth, and a tremendous rise in the standard of living.46 Gold outcompeted other commodities and objects to serve as worldwide money because it has the characteristics that make it best able to provide for the needs that money meets. For example, gold is rare and so large quantities of it do not need to be carried around, which makes it easier to use as money. This prevents cheap, staple commodities, such as those mentioned in connection with a basket of basic commodities (like copper or plywood), from displacing gold as money. Gold is also durable: one can hold it for a long time and not worry about it spoiling (such as with wheat or beef) and thus losing all its value. There are many other characteristics of gold that make it a good form of money and that explain why it emerged as worldwide money, but these are well known and should have been clear to the advocates of the ideas I am criticizing here. The problem with the type of mentality that accepts corrupt ideas at a fundamental philosophical level is that well-known facts and powerful logical arguments are no deterrent to advocating nonsensical ideas. According to this mentality, we can just arbitrarily assert what we want in spite of the facts and logic. We can just simply rewrite reality. Once people begin to accept a commodity in exchange, its acceptability is reinforced until it emerges as money. A basket of commodities could not emerge as money through this process because the basket would not be as readily acceptable as its most readily acceptable component.47 Further, it pays sellers to quote prices in this commodity (i.e., to use it as a unit of account). It pays sellers to do this because they are willing to receive the commodity in payment and others are willing to make payments with it. In other words, sellers quote prices in this commodity because of its acceptability. Its acceptability makes the commodity less costly to use as a unit of account relative to

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any other. So the use of a commodity as a unit of account arises because of its use as a medium of exchange and is inextricably linked to its use as a medium of exchange. One cannot just arbitrarily assume this link away.48 The paragraph above can be used to highlight the fact that to claim the unit of account can be divorced from the medium of exchange is to engage in context dropping and commit the fallacy of the stolen concept. Both of these fallacies were first identified as major logical errors by Ayn Rand.49 Context dropping was discussed in chapter 1 in connection with Keynes’s theory of depressions. The fallacy of the stolen concept involves using higher-level— more abstract—concepts while denying the existence or validity of the lowerlevel concepts on which they depend. For example, if one was to say that there are no entities, only motion exists, the concept “motion” would be a stolen concept. Motion implies motion of an entity. If no entities exist, then no motion can exist. One has no epistemological right to speak of motion while denying the existence of entities. Motion depends on entity. Hence, the original statement is invalid.50 With regard to money, the role of money as a unit of account cannot exist without money first serving as a medium of exchange. We can separate the two roles conceptually and analyze them separately, but what is it that is being used as a unit of account if it is not some item that can be exchanged for any good? Accounting for the value of goods implies that some numeraire is being used to assess their value. This means something must be used as the basis of comparison to determine the value of all goods relative to each other. Only a medium of exchange can do this. Hence, to speak of a “unit of account” without reference to a “medium of exchange” means “unit of account” is a stolen concept. One has no epistemological right to use the characteristic “unit of account” if one rejects the characteristics on which its existence depends. The confusion that seems to arise here is that some economists think because we can conceptually separate money’s role as a medium of exchange from its role as a unit of account and analyze them separately, we can also separate the two roles in the economic system (i.e., in real-life economic activity). They drop the context of how the role of the unit of account depends on and is derived from the role of money as a medium of exchange in the economic system. Note that even if one attempts to eliminate the medium of exchange and use only the unit of account in an economic system, then the unit of account becomes the new medium of exchange based on the past relationship between the unit of account and the original medium of exchange. So the medium of exchange does not disappear.51 It is impossible to separate them in the economic system. One “monetary theorist” has gone even farther than claiming a basket of basic commodities would emerge as money and actually proposed that shares of a portfolio of common stocks would emerge as a “means of payment.”52 However, there is no valid basis to make this claim. First of all, in a primitive barter economy in which very little division of labor has

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developed, the standard of living would be too low to have the resources to devote to supporting a stock market (not to mention that there are no businesses to buy and sell). Such a development occurs only once an extensive division of labor exists, and this occurs only after the use of money has been established and has helped to make possible the extensive division of labor. Therefore, by necessity, the monetary object must be something readily acceptable by everyone in a primitive economy. This means it must be some commodity that everyone has or can obtain and that meets at least some of the basic characteristics of good money. What about the emergence of common stock as a new medium of exchange through the voluntary choices of individuals in an advanced economy in which money has already been established? In this case, there is too much variability in the value of stock and it is too costly to determine what the future value would be (i.e., research costs and the cost of gaining the knowledge about how best to value companies).53 Assets emerge as money in a free market not only because they are readily acceptable but because of the stable value they possess and because it is relatively easy to determine their value (one does not need a degree in finance to assess the value of a gold dollar). Such obvious facts would occur to a good monetary theorist but not one caught up in the corrupt philosophical view of subjectivism, where anything goes. Even worse, some “monetary theorists” have stated that the transfer of all kinds of property will occur in place of the use of commodity money and, in fact, in place of the use of any type of money at all.54 This, of course, is barter. Those who make this claim admit that it is barter but attempt to rationalize their view by saying it is not “crude barter” but “sophisticated barter.” They do not mention what the difference is. They do not because there is no difference. It is all simply barter. Many of the monetary theorists who subscribe to the ideas I am criticizing here would agree with me that commodity money will emerge from a barter economy and even last for a long time as the money that has ultimate debt paying power. However, they might ask, why wouldn’t commodity money eventually be replaced with only deposit money (either at banks or in MMMF type of accounts)? If commodity money is mainly used as reserves and people get accustomed to using only bank money and not using commodity money, wouldn’t it eventually disappear? Why would banks need to keep it in their vaults? According to some economists, if we do not use commodity money we can save resources and protect ourselves from the vagaries of the supply of commodity money. The use of commodity money in daily transactions has, when it was used, declined over time and would, under a free market, continue to do so. However, there are reasons for commodity money to remain in use to some extent even in daily transactions. First, it is generally easier to use standard money in small transactions than to pay by check. Second, debit or credit cards are not always accepted for small transactions or at all. Third, in many cases checks are not accepted due to the uncertainty of whether the payer has sufficient funds in his account. Fourth, when it is desired to have no record

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of payment available to hide the transaction, cash is preferred.55 So it would not completely disappear from daily transactions. Even if we ignore the above and assume that all commodity money is used only as reserves and its use completely disappears in daily transactions, the objective tie to the commodity as a unit of account still exists and the supply of money (or monetary base) can only increase with the increase in the supply of the commodity. This is what maintains the stable value of the monetary unit. If the tie to the commodity is completely severed, the money supply can increase arbitrarily, just by whoever controls the money arbitrarily declaring that he has more of it. This should sound familiar to anyone who has lived under a government fiat money. This is exactly what government fiat money has done. Such money has no tie to any commodity, so the massive increases in this type of money are no accident. More fundamentally, such money does not have an objectively valid basis for existing; it does not emerge from a free market based on the value people see in it through their own observations and rational assessments. It has been forced upon the market through government coercion (to increase the government’s ability to spend money). This is why government fiat money has harmful economic effects (as this book shows). In a free market, no one would have a monopoly over the issue of money and thus no one could arbitrarily increase the supply of money. In an economic system in which the freedom of competition prevails in money, if an individual was able to establish a fiat money and began increasing it dramatically, people would quickly switch to other forms of money. However, it is doubtful that individuals could establish fiat monies in a free market. One could only do so based on the sound reputation one has achieved and which takes time and a proven track record to build. During the time one builds such a reputation, one would have to use the long-established commodity money. This context would make it extremely difficult for a financial institution to introduce a fiat money. There would have to be a rational basis for doing so to get people to accept it. If one is going to claim that we can save resources by ridding ourselves of the commodity, I submit that the use of gold and other valuable commodities as money does save resources and make possible the most rapid rates of economic progress. I discuss this in chapter 7. If one is going to claim that we can eliminate our dependence on the vagaries of the supply of the commodity, as I have discussed above in this chapter and discuss more in chapter 7, the supply of gold and other valuable commodities are far more stable than fiat money, even a fiat money (or bank deposit money) subject to competition. Once individuals begin to “manage” the currency (assuming they can get a significant number of people to accept it), its supply eventually becomes subject to all the potential abuses and mismanagement that such control implies. It may take a long time for individuals to abuse their power over the control of the money supply, or just mismanage the money supply, and thus the harmful effects of such actions may take some time to appear.

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Furthermore, it might be that not everyone is affected, or affected significantly, to the extent that competing currencies exist, but such problems will inevitably arise. While the results of a fiat money subject to competition would be better than a fiat money under monopoly control of the government, it would be a worse alternative to a commodity that people agree to use as money. It would be worse because the supply of the commodity money is not subject to the kinds of abuses and mismanagement that fiat money is subject to, since no one manages the supply of commodity money. To paraphrase William Gouge, the nineteenth-century American writer on the US banking system, the precious metals are preferred precisely because of their want of this management.56 The lack of “management” would help create greater stability in the monetary system. The last point to address on this topic and in this section is the idea that MMMF type of accounts would completely replace checking deposit liabilities at banks. To do this, they would have to offer some advantages over checking deposit liabilities, either being less costly and/or having more benefits. As I said above in this chapter on the brief discussion of whether MMMFs would exist in a free society, these accounts (as a form of money) are probably the product of regulations limiting interest rates on checking deposits. Furthermore, it appears from the fact that MMMFs put a minimum limit on the size of checks that can be written ($500) that these accounts are more costly, since checking deposit liability accounts require no such limit. In fact, in many cases MMMF accounts do not allow check writing at all.57 The cost is not just higher for the financial institutions offering them but for the funds’ owners who face higher costs to assess the performance of a much more complicated asset portfolio. Debt contracts are traditionally easier to monitor and enforce than equity contracts.58 Finally, the fact that MMMFs generally have a checking account at banks to make payments shows that MMMFs are dependent on bank liability accounts and not vice versa.59 So we see that commodity money would not disappear in a free market. This only happens under government compulsion and coercion. We also see that the medium of exchange and unit of account are tied together in a fundamental way and that checking deposit liability accounts will not disappear. I exposed a number of other fallacies in this section. For instance, I exposed the fallacies that fraud and counterfeiting will be rampant in a free market in money and banking, that the free market will lead to massive inflation, that central banking naturally arises out of the free market, among others. This should help one not fall victim to accepting the many fallacies put forward about a free market in money and banking.

Conclusion I covered a number of topics in this chapter. I described the characteristics of a free market in money and banking and the effects to which a free market will lead. One feature of a free market in money and banking is the fact that

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the government will only be able to receive payments in standard money or money substitutes backed 100 percent by standard money. Further, the government will only be able to use as money banknotes that are 100 percent backed by standard money. Any other notes received in payment will be redeemed for standard money as quickly as possible. Another important feature is that the government will rigorously enforce the payment of specie when banks are legally required to pay and depositors take the appropriate legal action to obtain specie in the face of banks attempting to not pay specie. These features (among others) will tend to lead to perhaps the most controversial effect: banks holding 100-percent reserves backing all banknotes and checkable deposits. Let me emphasize again that 100-percent reserves will not be enforced by law and that not holding 100-percent reserves is not, by itself, fraudulent. Banks will be led to this position through the economic forces involved. To the extent that banks do not hold 100-percent reserves, it will lead to the boom-bust business cycle and tend to eliminate the weaker banks, which will also help lead to 100-percent reserves. The next chapter will show what to make of some of the relatively more free-market periods in money and banking that have existed throughout history. It will discuss whether they provide evidence for the claim that 100-percent reserves or fractional reserves will exist in a free market, among other things.

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Th e Sign i f ic a nc e of S om e of t h e H istor ic a l ly Fr e e r Ba n k i ng P e r iods

Introduction The history of banking is one of the most researched subjects in economics. Many so-called free banking periods have been identified. One source reports that about 60 free banking periods have existed.1 However, none of them have been completely free banking periods.2 Significant government interference has existed in all the “free banking” episodes, most notably restrictions on note issue and entry into the industry, government banks and central banks that influenced the banking industry and were typically used to finance government spending, the government not collecting taxes in specie or bank money backed 100 percent by specie, and a lack of legal recognition of the right of depositors to require bankers to pay specie on demand when bankers were contractually obligated to do so. The question is: Can the freer banking periods be used to understand what might happen under actual free banking? The answer is yes, with some qualifications. One can determine in many cases how much government interference existed and how severe it was. Further, because there has been enough contrast between the more and less free banking periods, one can say the more free banking periods in history do show that free banking is more stable than periods with greater government interference. However, because significant government interference has existed in all “free banking” periods, one has to be careful in drawing conclusions from individual historical episodes about what will occur under free banking. One has to do some extrapolating from what has existed and use our theoretical knowledge to make conclusions about what will occur under free banking. Given the greater stability we see under the freer banking periods relative to those periods with more government interference, it is possible to say that a system of complete free banking will be even more stable and promote greater prosperity than the freer banking periods that have existed. This conclusion is confirmed by our theoretical understanding.

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In this chapter, I look at some of the freer banking periods and show why they were not periods of complete free banking. I also compare and contrast the freer banking periods with some of the less free banking periods. This will give one an idea of why a free market in money and banking is unprecedented in history and provide some historical evidence for the theoretical arguments I have made about what to expect from free banking. I briefly cover banking in Scotland, England, the United States, and Canada. Chilean and Australian episodes are also discussed.

Scottish (and English) Banking from the Late Seventeenth to the Mid-Nineteenth Century Scotland is said to have had a fairly free banking industry from the creation of the Bank of Scotland (BOS) in 1695 until the passage of a number of restrictive bank acts on the British Isles in 1844–45.3 While there is much disagreement among economic historians about how free Scottish banking was during this period, there is complete agreement on the fact that Scottish banking was not free banking. Let us take a look at some of the more significant forms of government interference in banking during this period to get an idea of the nature of banking in Scotland during this time. Unfortunately, banking in Scotland during this period did not get off to a good start from the standpoint of the government protecting individual rights and freedom. The BOS was created by an act of the Scottish Parliament in 1695, thus beginning a 21-year public (but not private) banking monopoly (in terms of being the only chartered bank in Scotland).4 It did not seek to renew its monopoly when it expired in 1716. In 1727, the Royal Bank of Scotland (RBS) was chartered by the Parliament of Great Britain. The Parliament of Great Britain was created in 1707 by combining the Parliaments of England and Scotland. A third company was chartered to do banking in 1746.5 While there are debates about how much privilege the charters granted these three banks, it must have been significant. This conclusion is based on the fact that even those who downplay the significance agree that the charters must have been valuable, since resources were expended both to fight for and against corporate charters during this time.6 Obviously, the charters would not have been valuable if they did not bestow some monopoly privilege and ability to earn higher profits on the recipients. Of course, no chartering of banks by the government would take place in a free market. The BOS did not take long to start violating the rights of its customers. It suspended the payment of specie for the first time in 1704, only nine years after its creation, despite its obligation to pay on demand.7 It suspended a second time in 1715 and a third time in 1728, the latter resulting from a duel with the newly formed RBS.8 The RBS was in a much stronger position than the BOS at its founding, in part due to the deposits of government agencies.9 The BOS had suspended payment three times already in the first 33 years of its history.

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Of course, in a free market private banks should not take deposits from the government. As discussed in chapter 5, all government funds should be deposited in a government bank or banks. In addition, banks will not be allowed by the government to suspend payment if customers choose to enforce banks’ contractual obligations to pay on demand. The BOS eventually got around the need to pay on demand in 1730 by the use of the option clause.10 In 1765, an act was passed that banned the option clause and made notes under one pound illegal in Scotland. In England, notes under one pound were declared illegal in 1775 and notes under five pounds were declared illegal in 1777.11 These acts are violations of free banking principles. The next major suspension occurred in 1797 and was initiated by the Bank of England (BOE). Banks in Scotland quickly followed suit, despite the fact that suspending payments was illegal. This suspension was the mother of all suspensions during the so-called free banking period in Scotland because it lasted 24 years, until 1821.12 This suspension had significant consequences. Reserve ratios in Scotland declined dramatically from the second half of the eighteenth century to the first half of the nineteenth century.13 Note issue also increased dramatically as a result of the suspension, given that banks were no longer required to convert notes into specie.14 The BOE had a significant influence on banking in Scotland. It did so primarily through its influence on the supply of money and credit, both in England and Scotland. While the BOS could not obtain credit directly from the BOE until 1791, the RBS did so from 1728, only a year after its creation.15 Despite the fact that the BOS could not get credit directly from the BOE until almost a century after the former’s creation, it was able to indirectly benefit from the BOE’s ability to create money and credit. The BOE’s ability to create money and credit was due to the monopoly powers granted to it by the English government. The BOS indirectly benefitted from the BOE because it was able to obtain credit from London banks starting on the day that it opened its doors for business, and the London banks were able to obtain credit from the BOE. This indirect benefit also existed for the RBS and Scottish banks in general. The first line of defense for Scottish banks was specie, the second was London balances.16 Scottish banks were especially dependent on their liquid investments in London in times of crisis.17 Eventually, the entire Scottish banking system became explicitly dependent on the BOE.18 The direct and indirect tie to the BOE is another important aspect of government interference in Scottish banking because the BOE was a government created bank that was granted special powers and eventually became the central bank of England, with all the powers that a contemporary central bank has today. Despite the above dependency, the BOS and BOE were different entities, as was banking in England and Scotland in general.19 The BOE was chartered by the English government in 1694 to raise money for the government and “manage” the government debt. However, the BOS was forbidden to lend to the government; it played no role in the “management”

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of government debt.20 In addition, by an act in 1697, the BOE was the only chartered bank in England. The BOE also benefitted from an act in 1708 that stipulated that no group of men greater than six in number could do business as a bank in England. This privilege was reserved exclusively for the BOE. This gave the BOE a significant monopoly privilege given that no six men could match its capital. This was eventually relaxed but not until 1826 (118 years later!). At that time, an act removed the restriction on the number of partners for a note-issuing bank but only for banks more than 65 miles from London. Banks could do business in London only if they did not issue notes.21 Monopolies like those in England were not granted in Scotland. 22 This was true even after the unification of England and Scotland in 1707 because the monopoly legislation did not apply to Scotland. The economist Lawrence White attempts to show in one of his works that Scottish banks were not dependent on the BOE or, at least, that Scottish banks could not consistently count on the BOE.23 However, in his very attempt to show that Scottish banks were not dependent on the BOE, he shows that they were. For example, he states explicitly that “the Bank of England could disturb the quantity of money in England significantly enough to cause cyclical effects . . . with spill-over effects on the Scottish economy.”24 This clearly shows that he thought the BOE influenced the Scottish economy and banks. His complaint regarding the influence of the BOE on the Scottish economy, in this context, was that this does not imply, as some economists claim, that BOE policies controlled the Scottish banking system or that the English and Scottish economies were all a part of one system controlled by the BOE. These latter points may have been true but do not deny that Scottish banks were influenced by the BOE. White also admits that the Scottish banks directly depended on the BOE for specie. He says, “It is true that the Bank of England was the principal source of specie in London. . . . To draw gold from London, the Scotish [sic] banks acquired and redeemed Bank of England liabilities. . . . [T]he Bank of England may have distorted the market for specie somewhat.”25 After saying this, he then attempts to rationalize the significance of this statement away by saying, “But it probably did not loosen constraints on the acquisition of specie, compared with those the Scottish banks would have faced had there been a plurality of issuing banks serving as specie sources in London.”26 What this means, in essence, is that if multiple issuing banks serving as sources of specie had existed in London, instead of mainly the BOE, it would have been just as easy for the Scottish banks to obtain specie. While this claim is debatable, the significant point to understand is that if a free market in money and banking had existed in England—which requires much more than just multiple banks serving as sources of specie—it is highly unlikely that the same results in both English and Scottish banking (and their economies more generally) would have been brought about. As I have been showing throughout this book, a free market achieves radically different results than an economy with government interference. But all of this is moot because it

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does not deny that the BOE did exist and that Scottish banks did depend on it for specie, as White explicitly states. White’s analysis of the dependency of Scotland on London and the BOE is deficient in a number of other ways as well. For example, he misses the significant point when he uses a statement by Sydney Checkland, an economic historian who wrote extensively on Scottish banking during this period, as alleged proof of the Scottish banks’ lack of dependency on either the BOE or London banks. In this statement, Checkland says that Scottish banks held government obligations, BOE stock, and East India Company stock as a secondary reserve (behind gold) that they could sell in London as a source of liquidity, instead of deposits at the BOE or London banks.27 White uses this statement to prove wrong those who say the Scottish banks held significant deposits at the BOE as reserves. He is right that Checkland’s statement lends credence to the claim that those who said this are wrong. Nonetheless, the important point that White misses is that Checkland’s statement actually strengthens the claim that Scottish banks were dependent on the BOE and London banks. At one point, White explicitly states that Scottish banks occasionally depended on the London financial market for liquidity needs.28 However, he then goes on to say he does not believe that this means they were reliant on the “good graces of the Bank of England” or that they borrowed (explicitly or implicitly) from the BOE.29 Another objection of his against those who claim Scottish banks were dependent on the BOE is that the BOE did not act as a lender of last resort or in a manner consistent with what we would consider a central bank today because it did not regularly or consistently provide liquidity to Scottish banks.30 A further objection is that Scottish banks depended on London only in a “short-run sense” but not in a “long-run sense.”31 None of these objections provide evidence to deny that the Scottish banks were dependent on the BOE, as White himself admits and as Checkland, whom White considers the authoritative writer on the facts of Scottish banking during this period, clearly states.32 The only issue White raises with his arguments is the degree of the dependency. Given White’s own statements and the statements of the historian who is the authoritative source on this topic, the dependency appears to have been fairly significant. Based on the evidence presented here, it is safe to conclude that Scottish banks did depend on the BOE directly and, to the extent they depended on London for liquidity and the BOE had a significant influence in London, they depended on it indirectly as well. Of course, such dependency creates distorted effects, such as lowering reserve ratios and creating the boom-bust business cycle, which were evident in Scotland. While anyone could start a private bank in Scotland during this time33 — one of the free-market aspects of banking in Scotland—there were other violations of free banking principles. Usury laws were imposed in 1714 that typically kept interest rates at 5 percent.34 This would lead to greater borrowing and note issuing and more dramatic swings of the business cycle. In

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addition, customs officials only accepted banknotes from chartered banks, thus giving the chartered banks a monopoly privilege over private banks in this area and providing an advantage for the chartered banks to expand their business over the private banks.35 White explicitly states that this privilege “clearly had some value.”36 This was one of the advantages of the chartered banks in Scotland and provided one reason why the charters were considered valuable. Of course, in a free market, payments to the government could be made in the notes of any bank that backs its deposits and notes 100 percent with standard money. Another reason the charters were valuable was due to the fact that the chartered banks were the only banks allowed to have limited liability. Shareholders of private banks were forced by the government to have unlimited liability. There is some controversy about how much benefit limited liability conferred on the chartered banks.37 One would think it was significant. However, Lawrence White claims that restrictions against limited liability did not limit the ability of private (non-chartered) banks to compete (in White’s words, the restrictions on limited liability were not “binding” on the private banks) because non-chartered banks waited 20 years after an 1862 act legally allowed them to use limited liability before they adopted it.38 Tyler Cowen and Randall Kroszner retort that banks waited because the 1862 act to which White refers permitted most types of companies to incorporate with limited liability but it was not effectively available to banks until an 1879 act.39 White’s rejoinder is that while the 1862 act maintained unlimited liability for note issue, it provided for limited liability for other bank obligations. He claims that if unlimited liability prevented banks from competing (i.e., was “binding”), why wouldn’t the banks at least take advantage of the limited liability that was made available to them in 1862?40 According to White’s view, private banks thought they could compete adequately against the chartered banks without limited liability, so they did not adopt the limited liability open to them in 1862. Implied in this is that limited liability must not have conferred much of an advantage on the chartered banks (at least not enough that the private banks thought it was worth it to adopt the limited liability made available to them in 1862). My contribution to this debate is that White misses the fundamental point in connection with this issue. It is not a significant fact that banks failed to take advantage of limited liability in its limited form of 1862. What is significant is that when limited liability was extended further in the 1879 act, banks eventually did take advantage of it. They did so because there is a significant advantage to this type of business structure. If the limited-liability option had been open to all banks from the creation of the BOS in 1695, I am sure many more, if not all, banks would have chosen this option. For White’s point to be valid, even after the 1879 act we should have seen banks choosing not to take advantage of limited liability; they never should have chosen limited liability at all if unlimited liability was not “binding.” The fact that they did eventually choose limited liability shows that they thought it provided a significant advantage, even though they might not have seen it as

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an advantage in its 1862 form (or, at least, enough of an advantage to make it worth it for them to bear the cost to change their business structure). I do not want readers to think there was no competition among banks in Scotland and that the chartered, limited-liability banks faced little or no competition. As I have been saying, Scotland’s banking industry was much freer than banking in England. If one looks at the multitude of significant sized banks that existed in Scotland, in addition to the three chartered banks, one understands that unlimited liability and not being able to gain a charter did not completely prevent banks from succeeding and becoming large. In 1845, in addition to the three chartered banks granted limited liability, there were sixteen other banks. Some of the other banks were, by some measures, even larger than the chartered banks.41 The point to remember here is that chartering and granting limitedliability status to some banks and not to others does convey some advantages relative to those banks that do not have these options open to them. Even White admits the chartered, limited-liability banks may have had an advantaged position, at least prior to 1810.42 This was 115 years after the creation of the BOS! Such favoring by the government is a violation of individual rights. It creates distorted effects and inefficient outcomes since the protected firms do not face the threat of competition (or, at least, as great a threat). In a free market, the government would not be able to arbitrarily choose who is granted limited-liability status. Objective laws already exist (laws pertaining to incorporation) that would allow any business to use the limited-liability form of ownership as long as it meets the requirements of the law. One final issue that needs to be discussed regarding banking in Scotland during this period is the lack of respect for property rights and the sanctity of contract Scottish bankers displayed in refusing to pay bank customers specie on demand when the banks were contractually obligated to do so. This occurred throughout the period, both prior to the use of the option clause in 1730 and after the option clause was banned in 1765. The abuse to which the use of the option clause led in just 35 years of its existence is indicative of the lack of respect for property rights as well. Such abuse was, in fact, what led people to clamor for its abolition. The belief on the part of Scottish bankers that they should not have to pay specie when contractually obligated to do so was widespread and ingrained over a long period of time. This is seen in statements from economic historians. For example, Frank W. Fetter writes, “to a large degree there was a tradition, almost with the force of law, that banks should not be required to redeem their notes in coin. Redemption in London drafts was the usual form of paying note holders.” To emphasize how strong this mentality was, Fetter goes on to say that there was “a core of truth in the remark of an anonymous pamphleteer: ‘Any southern fool [i.e., someone from England] who had the temerity to ask for a hundred sovereigns, might, if his nerves supported him through the cross examination at the bank counter, think himself in luck to be hunted only to the border.’ ”43

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Checkland says essentially the same thing: The Scottish system was one of continuous partial suspension of cash payments. No one really expected to be able to enter a Scots bank, perhaps especially a public bank, with a large holding of notes and receive the equivalent immediately in gold or silver. They expected, rather, an argument, or even a rebuff. At best, they would get a little specie and perhaps bills on London. If they made serious trouble, the matter would be noted and they would find the obtaining of credit more difficult in future [sic].44

Checkland also states that “requests for specie met with disapproval and almost with charges of disloyalty.”45 There are other examples of this kind.46 This mentality had a significant influence on banking in Scotland because, as Checkland observes elsewhere, “A run for gold was unknown in Scotland, for people did not think in gold terms.”47 This is probably why during the 24-year suspension, from 1797 to 1821, that even though it was illegal for banks to suspend at the time, no one in Scotland sued to force the banks to end the suspension, although there was much “public excitement” over the action taken by Scottish banks to suspend.48 What might have also contributed to this mentality was the series of lawsuits brought forward in England by depositors over three centuries (the seventeenth through nineteenth) that I discussed in chapter 4. Here bank customers sued to force banks to hold 100-percent reserves (which the customers believed the banks were contractually obligated to hold), but the courts ruled in favor of the banks in almost every case and thus the banks were legally allowed to carry only fractional reserves.49 These suits may have had some effect on banking in Scotland, if not legally then at least in terms of the mentality they created throughout Great Britain. The mentality of bankers in Scotland certainly is not the mentality that will prevail in a free market. While it may be the case that a few bankers may act in this manner in a free market, it will not be the norm, as appears to be the case in Scotland during this time. In an environment in which property rights are respected, banks will provide the specie required when requested to do so. If banks do not pay voluntarily, it is much more likely that in such an environment individuals will take legal action to obtain what is rightfully theirs and have the contractual obligation of banks to pay on demand upheld. In such an environment, suspensions will have a much greater impact. Banks that suspend may be forced out of existence or be subjected to other legal punishment. In such an environment, banks will find it necessary to keep far higher specie reserves on hand to stay in business and gain a competitive advantage. It is no accident that specie reserves in Scotland tended to be fairly low. Understanding the anti-free market mentality that prevailed helps to explain why this was the case. The Scottish banking industry certainly had significant free-market elements and may have been the most free-market oriented banking industry that has existed to date. However, there were also some violations of

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individual rights. The Scottish economy did benefit from the significant free-market elements and did tend to be more stable than economies whose banking industries were less free-market oriented, such as that of England. Checkland makes a number of references to the greater stability in Scotland versus England due to the different banking systems.50 However, because of the government interference, Scotland does not provide us with a good template for what will happen in a free market. Governments deposited money into privately owned banks, some banks were given special privileges over others, the BOE propped up banks both directly and indirectly, and banks whose notes or checks were used to remit payments to the government were not required to back their notes and checks 100 percent with standard money. These are just some of the examples of how the Scottish banking industry during this period was not a free market. We should use these violations of free-market principles in Scotland as an example to make sure we do not commit the same errors when establishing a free market in the banking industry in the future.

A Brief History of the US Banking and Monetary System It will be instructive to consider banking in the United States and the American colonies. One period in American history is seen as a “free banking” period: the period starting with the expiration of the federal charter of the Second Bank of the United States in 1836 and ending with the passage of the National Bank Act in 1863. However, as with the case of Scotland in the eighteenth and nineteenth centuries, this so-called free banking period should not be seen as a completely free banking period. It can only, properly, be seen as a period of freer banking than other periods in US history. As with Scotland, let us take a look at some of the government interference that existed in the United States and the American colonies to see just how free the banking and monetary system was.51 Unfortunately, even in the American colonies government interference existed in the monetary and banking system. The colonial governments often debased money by changing the standard weights to which the monetary units referred. They also arbitrarily redefined the value of one monetary unit in terms of another. Many of the colonial governments quickly learned that it was much easier to debase the currency by printing paper money than by manipulating standards of metallic money, and the colonies soon engaged in this type of debasement. If their notes began to depreciate against specie, they might declare the discounts illegal to prevent the appearance of debasement and, in essence, force the use of their debased currency through Gresham’s law. One small example in the colonies of the benefits of sound money and the harmful nature of unsound money occurred after King George’s War in the mid-eighteenth century. Those colonies that returned to a hard money, specie standard after the war prospered while trade in those colonies that remained on paper money stagnated.52

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During the American Revolutionary War, the Continental Congress issued and dramatically debased the Continental currency to pay for the war. Even after the war was over and the US Constitution had been established, America’s monetary and banking system was not on solid ground. The First and Second Banks of the United States, created by acts of Congress, interfered with the monetary and banking system and violated individual rights. While these banks were not outright central banks, they were quasi-central banks. The First Bank (existing from 1791 to 1811) evolved into a banker’s bank and gained the power to police the smaller commercial banks. The Second Bank (existing from 1816 to 1836) acted much more like a central bank than the First Bank. It performed certain control measures, such as lending money to financially troubled commercial banks, in order to preserve the liquidity of the banking system as a whole. Both banks, by virtue of their large size and national branch banking capability (thanks, in part, to having the federal government as their largest depositor), were able to exert measurable influence on America’s banking system.53 Of course, in a free market government banks would have no power to police the commercial banks or lend money. These functions are not consistent with the proper functions of a government; that is, they are not consistent with protecting individual rights and freedom. In fact, in some cases these functions are violations of rights. During the period after the demise of the Second Bank until the passage of the National Bank Act in 1863, the US banking and monetary environment was fairly free. During this period, the main feature making it relatively free was the absence of federal government regulation or involvement. Government interference existed, but only at the state level. While not all states had the same types of laws pertaining to banking and some preserved greater elements of freedom than others, there were some controls on banking that were more widespread than others.54 The primary ways by which state governments interfered were through the requirement that banks hold state bonds as security for issuing banknotes and the state chartering system that limited the ability of banks to open branches outside the state in which they were chartered (and sometimes within the state). Some state governments also imposed deposit insurance schemes on banks within their borders and some allowed banks to suspend payments even though they were contractually obligated to pay on demand.55 The conventional view of this period with greater freedom in banking is that it was filled with instability, failures, and fraud. Nonetheless, careful research has shown the exact opposite to be true.56 One major fallacy of the so-called free banking period in US history is the notion that “wildcat” banking was widespread and that it was the result of more freedom in banking. Wildcat banking focuses on the idea that without regulation anyone can open a bank, issue banknotes in massive amounts in exchange for real assets (such as gold), and then abscond with the booty from the note issue. However, such activities were not that prevalent, did not have that much of an influence on banking during the “free banking” period, and to the extent

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that they did exist historical research shows they were largely the result of government interference in the banking industry.57 Wildcat banking was encouraged in financially troubled states that allowed state bonds, which banks were forced to use as security backing the issue of notes, to be valued at par for the purpose of determining how much note issue could occur even though the bonds traded at a discount to par. Many “banks” were able to purchase the bonds at a discount and after depositing them with the state government, they could issue notes equivalent to the par value of the bonds to purchase real assets or make loans to friends. Once these “bankers” fled after the issue of the notes, note holders were not able to get the full value of their notes back from the government, since the bonds deposited with the government were only worth a fraction of the face value of the notes.58 Many of the other episodes of wildcat banking stem from interference by the Michigan state government. Three months after passing a free banking law in that state, which allowed free entry into the banking industry (as long as banks deposited state bonds with the state government), Michigan proceeded to pass a law suspending specie payment during the panic of 1837. This made it so banks could issue notes that they were not legally required to convert into specie. A significant number of corrupt banks took advantage of this arrangement by quickly opening up, issuing notes, and absconding with the proceeds.59 Tales of wildcat banks being the product of freedom in banking do not agree with the historical facts and do not make sense logically based on what businesses, including banks, must do to grow their business into a sound and profitable entity. They are the kinds of stories statists tell to rationalize greater government control over people’s lives. The issuance of greenbacks during the Civil War was another form of government interference in the US monetary and banking system. It substantially increased the supply of money in circulation. It represented a significant step toward a complete fiat-money monetary system, with no commodity at its base. The greenback was the first fiat money issued by the government. Its initial irredeemability and the passage of the Resumption Act, which allowed greenbacks to be redeemed for gold starting in 1879, helped to further break the link between gold and money. The greenbacks were believed to be “as good as gold” and their eventual redeemability made it appear that they were. They got people familiar with using government issued paper instead of gold. This represented a significant step further away from free-market money and toward a more unstable monetary system that is susceptible to greater and more erratic inflation. The National Bank Act of 1863 was another major violation of individual rights by the government in money and banking. It is considered the end of the “free banking” period in America. It inaugurated direct federal regulation of the banking and monetary system. This act imposed a uniform banknote on banks. The act also required national banks to have minimum capital requirements and reserve ratios. It created a pyramiding of reserves in which “country banks” included their checking deposits at “reserve city

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banks” as reserves. Furthermore, the act limited the kinds of business that national banks could conduct. Finally, it limited competition among banks by imposing taxes on state banknotes.60 Throughout the nineteenth century, and also during the twentieth century, the federal and state governments violated free banking principles in other ways. These included imposing extended liabilities on bank stockholders and engaging in examinations, inspections, assurances, and endorsements of banks. In fact, the violations of individual rights did not stop there. The final major act of government interference, before the Great Depression, was the Federal Reserve Act of 1913 (and its amendment in 1917). This act created an institution whose explicit purpose was to control the money supply and interest rates, act as a so-called lender of last resort for financially troubled banks, and impose other regulations on the banking system.61 In addition, gold was confiscated from the banking system through the amendment to the Federal Reserve Act in 1917. The confiscated gold was used as the ultimate reserve at the Federal Reserve and reserves and the money supply were increased on top of that at the commercial banks through the pyramiding of reserves. This was done to finance spending during World War I, was a significant step to force the country off of the gold standard, and led to greater inflation of the money supply. During the Great Depression, the federal government interfered in the monetary and banking system in several ways. Under Hoover, loans were made to banks through the Reconstruction Finance Corporation. Interference on the part of the government also included the various banking “holidays” by state governments and the week-long national banking “holiday” initiated by FDR soon after he took office. Finally, also under FDR, there was the confiscation of private gold holdings, the repudiation of gold clauses in public and private contracts, and the devaluation of the dollar from $20.67 per ounce of gold to $35 per ounce in the 1930s. All of these acts were gross violations of individual rights. When the seizure and devaluation of gold occurred, for all practical purposes the United States was no longer on the gold standard. Then, in 1968, the US government stopped supporting the $35 per ounce gold price on the London gold market and in 1971 it abandoned its obligation to redeem dollars held by foreign governments and central banks. At that point the United States was officially and fully off the gold standard and was free to inflate the money supply at even greater rates. As monetary statistics—and the price of gold—attest, that is exactly what the US government has done.62 There have been a large number of other regulations not discussed here both earlier in US history and later in its history. Nonetheless, one gets the idea from the regulations discussed that the United States was never a free market in money and banking and has grown more statist over time. One would like to compare the United States during its freest period, between the demise of the Second Bank and the Civil War, with Scotland during its freest period, pre-1765; however, that is not an easy task. There were fewer restrictions on entry into banking in Scotland than in the United

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States. The state restrictions on entry and requirements regarding securitization, in the United States, were the cause there. However, the influence of the BOE on Scotland during its “free banking” period was unmatched in the United States during its “free banking” period. It is not important to determine which example was more or less free. The important thing to understand is that neither was a free market in money and banking. Nonetheless, some conclusions can be made about the nature of more free versus less free banking periods. This is easier to do in one country over time as banking laws change and between countries that have close relations in some way (such as politically and geographically). I will make some conclusions regarding the nature of more free versus less free banking periods at the end of this chapter. In the next section, I discuss nineteenthcentury Canada.

Money and Banking in Canada in the Nineteenth Century The history of money and banking in Canada has some good features relative to the United States. The first and most important point to make, as with all the historical episodes of so-called free markets in money and banking, is that even at its freest point banking in Canada during the nineteenth century was not a complete free market. However, there were far fewer restrictions on branch banking in Canada relative to the United States, especially toward the end of the nineteenth century.63 This led to fewer bank failures, since the banks tended to be larger and more diversified geographically. Let us take a brief look at some of the more prominent features of the banking and monetary system in Canada in the nineteenth century, since it was during this century that the freest period existed. Banking in early nineteenth-century Canada was a mix of monopoly through restrictions from government chartering in some provinces and competition in other provinces. However, by the mid-1830s an unwritten rule emerged that any individuals who could raise a minimum amount of capital would be granted a charter.64 Initially, there were some interprovincial restrictions on branch banking as well. During the panic of 1837, this led to the only system-wide, peacetime banking crisis in Canada.65 There were also significant restrictions on note issues by Canadian banks starting in the second-third of the nineteenth century. Up through the mid1830s in Ontario, small, private banks could be started quite easily and no acts prohibiting the issue of banknotes were yet in force. However, the freedom of note issue changed by the late-1830s.66 Restrictions on note issues existed at that time with respect to private banks. Chartered banks could issue notes more freely than private banks but restrictions existed with respect to the notes chartered banks could issue as well. The note issue restrictions, whether on private or chartered banks, did not apply to all banks and in all periods. Restrictions on note issues generally existed to preserve the government’s ability to issue notes.67 At first, the restrictions preserved the ability

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of provincial governments to issue notes. Later on, it preserved the federal government’s ability to issue notes. Canadian banks were also required to operate with unlimited liability and double liability on shareholders in some cases.68 While in a free market bank owners could choose to organize their bank in this manner, probably few (if any) would. In a free market, banks could incorporate with limited liability just as any other business could. In addition, Canadian banks were sometimes allowed to suspend payments even when they were contractually obligated to pay.69 If they are obligated to pay, banks should only be allowed to get away with suspending if no depositors or note holders bring suit against the bank or if the bank has an option clause in place. It is doubtful that suits would not be brought against banks in many of the cases in which banks suspend payment. In cases in which runs occur, it is obvious that bank customers want to enforce the contract to pay. In some cases, customers have engaged in violent protests in response to a bank’s suspension of payments. Here too the customers would have preferred the enforcement of the contract. Sometimes it is believed that the liquidation of assets can be undertaken in a more “orderly” fashion if banks are allowed to suspend payments. This is claimed to be true in Canada during the panic of 1837. It is claimed that the public preferred the suspensions in this case.70 However, it is hard to believe the public preferred the suspensions given the fact that it was a time of general financial panic. If banks knew they would have been legally held to their contractual obligation to pay, the panic of 1837 probably never would have taken place (or would have been much less severe), since banks would have been in a much more financially sound position given that they would have held on to much higher ratios of specie to notes and deposits. It is hard to believe that the public would prefer to have, and that it is much more orderly to have, financial panic and suspensions rather than the enforcement to pay when contractually obligated to do so, the greater liquidity this gives rise to, and the financial stability to which these lead. One cannot ignore the fact that suspensions and financial panic come as a set. That is, if banks know they will be able to suspend, they operate with far less reserves and this leads to periodic crises and financial panics. If the government performs its appropriate function of protecting individual rights, including enforcing contracts, instead of violating individual rights and being a party to the violations of contractual obligations, the public will have a very different experience that I think it will much prefer and that will be much more orderly. After the union of Upper and Lower Canada in 1841, steps were taken to make the regulations of the banking system uniform. Upper Canada corresponds today to the southern portion of the province of Ontario while Lower Canada corresponds to the southern portion of the province of Quebec. One regulation passed in 1850, which was put forward as an act to establish freedom in banking, included provisions intended to mimic banking in New York State, as that state was much more prosperous than the two

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Canadian provinces and it was believed that its banking system had something to do with that. This act had as a goal the creation of small banks without branches and with note issue backed by provincial securities. This act was considered to be a failure as early as 1854, since banks did not expand as much as desired.71 Additional interference after the union of the two provinces included imposing a 1-percent tax on banknote circulation in 1844 as a revenue raising device.72 In 1870 and 1871, after the Canadian Confederation in 1867 (which created a constitutionally unified Canada made up initially of only four provinces), another bank act was passed. This act had even more restrictive features. Some of the main features included that double liability was imposed on bank stockholders, every bank had to be chartered by the federal government, banks could not engage in mortgage lending or nonbanking business activities, banks had to hold at least half of their total reserves in government legal-tender notes (to create a demand for the notes), and banks needed at least $100,000 of paid-in capital. Many of these provisions were continued, albeit in a sometimes modified form, in the Bank Act of 1890.73 As one can see, banking in Canada certainly did not take place in a free market. There were many forms of government interference in the banking industry in Canada. While it is not always clear from the historical accounts what specific effects these regulations had, they probably had effects similar to the same types of regulations in other countries.

Money and Banking in Chile in the Nineteenth Century Chile had a fairly free-market oriented banking and monetary system in the nineteenth century. It had no central bank during the century, although a national bank was established during the second half of the century. For the first half of the nineteenth century, it had no paper money or fractionalreserve banking. Unfortunately, this was not achieved through a free market but through government force: the Chilean finance minister was opposed to fractional reserves and paper money. In 1839, the Chilean government even passed a law banning the issue of paper money without permission from the government.74 While the Chilean government appears to have opposed these things for the right reasons (i.e., to achieve financial stability), the ends do not justify the means. Initiating physical force is not justified just because people have “good intentions.” One cannot evaluate the ends to be achieved while ignoring the means used to achieve them. Achieving anything through the violation of individual rights is not appropriate because it stands in opposition to the fundamental requirements of human life. Paper money and fractional-reserve banking are legitimate from a legal standpoint if they are created on a voluntary basis and no fraud is used to establish them. Paper money also has economic legitimacy as long as it is backed 100 percent by commodity money. The paper money can be used to

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reduce the cost of providing monetary services, since it is easier to pass the paper money from hand to hand than to pass the commodity. In 1860, a law was passed that established greater freedom in the Chilean monetary and banking system. The law allowed anyone to set up a bank and issue banknotes. Additionally, the law imposed no reserve requirements, no minimum capital requirements, and no inspections by government agencies (among protecting other freedoms). However, the law did impose a maximum note issue of 150 percent of a bank’s capital and banned the issue of very small notes (under 20 pesos).75 The law of 1860 did a better job of protecting individual rights than what existed previously but did also violate rights to some extent. The government has no business restricting note issues (even for very small notes) and limiting the issue of notes based on the capital bank owners have invested. As long as banks engage in these activities without the use of force or fraud, they have every right to engage in such activities. The government preventing banks from engaging in voluntary trade in connection with these activities violates the rights of the banks and those who would voluntarily do business with them. The economist Murray Rothbard has stated that the “free banking” law of 1860 in Chile quickly led to accelerating inflation (within five years) and banking crises because of the lack of restrictions on the banking system.76 His view is that having no legally imposed reserve requirements will lead to large creations of money. Banks must be forcibly required to hold 100-percent reserves to prevent them from inflating the money supply, according to Rothbard. However, the economist George Selgin brings a number of facts to bear to gain a better understanding of the Chilean episode. He states that the problems experienced by the Chilean banking system were caused not by the banking law of 1860 but by the government’s bimetallic legislation of 1851. He states that they were also caused by the government’s sanctioning of inconvertible currency in 1865 (during a war with Spain) and again in 1878.77 Both of these are violations of free-market principles. Sanctioning inconvertible currency and the problems to which this leads require no further explanation. Many nations have engaged in such a policy, including the United States during the Civil War, and I have discussed this topic elsewhere in this book (such as in chapter 4). However, the problem with a bimetallic standard requires elaboration. Governments establish bimetallic standards by mandating a legally fixed “price” between gold and silver (such as, perhaps, 15 ounces of silver for 1 ounce of gold).78 The problem is that since the value of gold and silver fluctuate relative to each other in the marketplace, the ratio of the value of gold relative to the value of silver in the market will typically be different than the fixed ratio. When the ratio in the market is different than the fixed ratio, one metal generally ceases to circulate as money. Based on Gresham’s law, the overvalued metal is the one people prefer to use as money, since it is more valuable as money than it is in the marketplace. The undervalued metal will

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not be used as money (at least domestically) since it can be used to buy more goods abroad (assuming foreign countries either do not have a bimetallic standard or have a standard that does not undervalue the same metal). Fluctuations of the ratio of the values of the two metals in the marketplace can cause alternating rounds of each metal circulating as money, depending on which is overvalued. For example, if the fixed ratio of silver to gold set by the government is 15:1 (i.e., 15 ounces of silver to 1 ounce of gold) and the ratio in the market is 16:1, the fixed ratio overvalues silver and only it will circulate as money. When the ratio in the market is 14:1, the fixed ratio overvalues gold and only it will circulate as money. This can cause dramatic changes in the amount of money and spending in the economy and have a destabilizing effect to the extent the monetary supplies of gold and silver that circulate within the country have significantly different values. This is what happened in Chile under its bimetallic standard.79 In addition, it must be noted that because of the problems to which a bimetallic standard leads, such a standard would most likely not be established in a free market even though banks would be free to attempt to establish such a standard. It was the violations of free-market principles that led to monetary instability in Chile. In addition to its bimetallic standard, the desire of the Chilean government to finance its spending for the war with Spain must be noted. According to one commentator, banknotes did not enter into circulation “to any extent until 1865, the year of the breaking out of the war with Spain.”80 Furthermore, the desire to finance the government’s spending was the reason for the subsequent suspension of specie payments in 1878, after convertibility had been resumed in 1866. This suspension was, according to Selgin, “aimed entirely at bailing out several politically-favored banks” and lasted for 50 years (with a 3-year interruption from 1895 to 1898).81 Rothbard discusses a number of other violations of free-market principles in banking that contributed to the problems in Chile during this time. He mentions that the Chilean government saved insolvent banks at the start of the war and directly created an inconvertible paper money through the newly created National Bank of Chile. The government also, as Rothbard describes it, “bestowed a host of special privileges” on banks that loaned money to the government, which included the government making all banknotes inconvertible. He states that since the “signal had been given to the banks that the government would bail them out in times of real financial trouble,” an inflationary boom soon followed through bank credit expansion.82 As one can see, the Chilean episode was most certainly not a free market in money and banking.

Banking in Australia in the Nineteenth Century Banking in Australia in the nineteenth century was fairly free. However, there were a number of interferences, as in the other so-called free banking periods, that made Australia during this period (again, like the others) more accurately described as a hampered market economy with regard to

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banking. The most important issue to address in Australia during the nineteenth century is not its allegedly free banking system but the financial crisis that occurred at the end of the century. This is the only case, according to the economist Kevin Dowd, in which free banking is associated with a major banking collapse.83 I show, in fact, this crisis was caused by the same type of government interference that causes financial crises and depressions in general (and which is the subject of this book). The interesting fact in this case is that the relevant government interference was not mainly in Australia. This crisis had its origins in Great Britain and, even more surprising, Argentina. According to George Selgin, banking in Australia was largely unregulated during the nineteenth century.84 Entry into the industry was fairly unrestricted, banks were free to issue notes, and no statutory reserve requirements were enforced. One major part of the relative freedom of the Australian banking industry in the nineteenth century was its lack of a central bank. Nonetheless, despite the fact that Australia itself did not have a central bank, we will see that Australian banking was affected by the actions of central banks, especially those of the BOE. Finance scholars Charles Hickson and John Turner state that the Australian banking system also had no government deposit guarantees, no branching restrictions, and no credible restrictions on assets, liabilities and bank capital.85 Selgin goes on to say that the system prospered and showed great stability for a significant period of time (especially relative to more restricted banking systems). The stability of the system has also been commented on by David Merrett.86 However, Selgin also states that in the mid-1880s real estate prices collapsed, banks suffered large losses, and eventually the banking system collapsed in 1893, with many banks suspending payments and depositors being forced to suffer large losses as well.87 I now turn to a discussion of the government interference that prevented Australia’s banking system during this time from being a completely free market. Prior to 1840, Australian banks were required to have unlimited liability and were restricted to six partners.88 In 1840, the United Kingdom’s Colonial Bank Regulations established broad guidelines for colonial governors to follow when chartering banks. The first form of government interference to be noted in connection with the 1840 regulations is the fact the British government and its colonies thought it was their proper duty to charter banks. In a free market, of course, the government would not perform such a function. Banks (and businesses in general) could be established by anyone at any time, without approval by the government, so long as they do not involve the initiation of physical force, fraud, or pose an objective threat to violating individual rights in any way. The Colonial Bank Regulations also established government interference in the banking system in the form of requiring bank shareholders to be subject to personal liability twice the value of their subscribed capital. While this was a reduction compared to what existed prior to the 1840 regulations, starting in 1863 liability gradually became unlimited again for banks in Australia (at least for note issues). These are requirements that would not

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exist in a free market. In a free market, bank owners, and business owners in general, could choose to extend their liability beyond their paid-in capital by establishing the business without the limited liability of a corporation. However, the government would not impose any type of liability on bank shareholders through regulations. In addition, based on the 1840 regulations, banks were not allowed to lend on land, deal in real estate or merchandise (except under limited circumstances), and issue banknotes less than one pound. There were also restrictions on total bank indebtedness as a part of these regulations. In 1846, a revision to the regulations stipulated that note issues should be restricted to the amount of paid-in capital. Eventually, note issues were taxed as well.89 Some of these regulations did not place significant restrictions on banks. For instance, even though there were restrictions, taxes, and eventually unlimited liability on note issues, banknotes were a fairly minor portion of the business banks engaged in and the ratio of notes to total assets declined starting in 1862. In addition, the double liability imposed on shareholders for liabilities other than note issues, it is claimed, was not effective because, in the event of bankruptcy, shares were often transferred quickly to individuals who had insufficient assets to meet the obligations. Further, restrictions on lending on land were legally circumvented by the 1850s and by 1888 the colonial government of Victoria completely removed the restrictions because they were believed to be ineffectual. The fact that many banks incurred large losses in real estate in the 1880s confirms the claim that the restrictions with regard to lending on real estate must have been circumvented to a great extent.90 While it might have been true that some of the regulations had limited effects or were circumvented, it does not deny that the regulations were violations of individual rights and placed at least some restrictions on what banks could do and provided them with an incentive to do some things they might not have done otherwise. For example, the fact that lending on land had to be engaged in by circumventing the laws shows that the laws influenced what bankers did. In addition, while the regulations with regard to note issues may have had only a small effect, since note issues were not a large part of the business that banks engaged in, to the extent that they did issue notes the regulations would have affected them. Furthermore, the unlimited liability and taxes on notes, as well as the restriction on note issues below one pound (which was not circumvented), may have reduced the note issues of banks. Note issues might have represented a larger part of the business banks engaged in and might not have declined (or declined as much) starting in 1862 had these restrictions not existed. Moreover, the restrictions on chartering by the government remained in effect (and were not circumvented), as well as did the restrictions on total bank indebtedness. It is important to note here the perverse incentives created by forcing extended liability on bank shareholders. One might expect it to reduce risktaking by banks, since bank owners have more capital exposed to risk in this situation. However, empirical evidence shows that banks might actually

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operate in a riskier manner due to extended liability. In the United States, prior to the existence of federal deposit insurance, ratios of equity capital to assets of banks that were subject to double liability were lower than those of banks not subject to double liability.91 This additional risk taking might have occurred because forcing extended liability on bank shareholders is, like deposit insurance, an attempt by the government to artificially boost confidence in the banking system. Therefore, much like deposit insurance, extended liability might provide an incentive for depositors to ignore risk. It is not clear which will dominate: the incentive for shareholders to be more risk averse or the incentive for depositors to take on greater risk. The capitalto-asset ratios provide an indication that the latter might be the case. While some claim that greater caution in bank management due to extended liability manifests itself in the form of banks being more willing to close their doors through voluntary liquidation, before becoming insolvent and being forced by creditors to liquidate, it is not clear that this represents a case of greater caution on the part of bank management. In support of their claim, those who make this argument note that, in the United States prior to the existence of federal deposit insurance, of the banks that were liquidated and had double liability imposed on them, far more liquidated voluntarily rather than involuntarily.92 The claim is that banks in financial trouble closed before their liabilities exceeded their assets to prevent shareholders from being assessed the extra liability. By doing so, the contention is that the banks allowed creditors (including depositors) to avoid potential losses. This might be true; however, one has to wonder why these banks were in financial trouble in the first place and thus faced the prospect of having to close their doors. Could extended liability have had something to do with that? It is not clear from the existing empirical studies that I have seen. However, the low capital-to-asset ratios indicate that banks with extended liability might be more likely to get into financial trouble. A comparison of the proportion of banks with double liability imposed on them that failed or were liquidated during this period with the proportion of banks without double liability imposed on them that failed or were liquidated would be helpful in answering this question. It is also important to note here that any problems created by extended liability are made worse when shareholders sell their shares to avoid having to make good on the additional liability. To the extent it is believed that shareholders will make good on the extra liability but do not, depositors will be encouraged to take on added risk but will not have any added protection. This will make the banking system more unstable. There were also various interferences that arose in Australia during the banking crisis in the late nineteenth century that I will discuss shortly. However, as I mentioned at the beginning of this section, for an economy like the Australian economy in the late nineteenth century, which was heavily dependent on another, much larger economy (Great Britain), the government interference does not necessarily come from within. Much of the government interference that caused the crisis in Australia came from the

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BOE. To the extent that a freer economy is dependent on an economy with greater government interference, the freer economy cannot completely render itself immune to the interference. I will now discuss the government interference influencing Australia in the late nineteenth century that came from outside the Australian economy. Some writers have attributed the banking crisis in Australia in the 1890s to that country’s relatively free banking system.93 However, as I have stated, free banking did not cause the crisis; government interference in the economy did. The interference that created the crisis was a credit expansion instigated by loose so-called monetary and fiscal policies in Great Britain and Argentina. The role of Great Britain and Argentina in the Barings crisis of 1890 and the effect this crisis had on the flow of funds around the world is widely acknowledged.94 The Australian economy was not immune to these effects. For example, the flow of funds from Britain drove real estate prices up in Australia prior to the crisis.95 I do not mean to rule out financial irresponsibility in Australia having some role generating the crisis. There is some evidence of that.96 I would need to do more research on the fiscal activities of the Australian colonial governments to verify to what extent they contributed to the crisis. Nonetheless, any conclusion that would be reached in that matter would not change the validity of my argument here. The Australian colonial governments acting in a financially irresponsible manner is perfectly consistent with my claims here. It may just shift the blame somewhat from Great Britain and Argentina to the Australian colonial governments themselves. The BOE engaged in a low interest rate, inflationary policy during the 1880s that spawned a global credit boom. The low interest rates provided British investors the incentive to look abroad for higher returns, and the creation of reserves to keep rates low ensured that they had ample funds to invest abroad. The inflationary expansion came to a halt in 1889 when the BOE raised interest rates.97 Argentina and Australia were two of the destinations for British investment during this period. Argentina engaged in inflationary policies during this period as well.98 The push for inflationary policies was particularly intense in the late 1880s after a change of government in 1886 from a president who tended to favor hard currency to one who favored easy credit.99 There was a large amount of borrowing from national to local levels of government in Argentina. For example, the city government of Buenos Aires wanted to turn itself into the “Paris of South America” and borrowed heavily for infrastructure improvement in order to attempt to do this. The Argentine national government also guaranteed interest rates to foreign investors in Argentine railways to attract foreign investment. In addition, state banks (some in name only) were set up to finance the spending of a financially strapped Argentine government through foreign loans and the emission of banknotes.100 Eventually, the collapse in Argentina came. It came not only from the excessive borrowing and spending by Argentine governments but from the

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reversal of the inflationary policies of the BOE.101 Since British investors had investments throughout the world, the effects of the tightening were felt throughout the world. The problems in Argentina were also transmitted throughout the rest of the world. The London-based Barings Bank was heavily invested in Argentina and got into serious financial trouble due to its investments there. The BOE provided funds and brokered a deal with the Russian government, the Bank of France, and the major financial houses in London to bail out Barings in 1890. The result of the Barings crisis was that British investors were much more cautious and reluctant to lend abroad, including in Australia. This reluctance led British investors to pull large amounts of funds from abroad, again, including from Australia.102 The crisis in Australia occurred after the Argentine crisis and was less intense.103 However, Australian colonial governments did engage in various acts of government interference that generally make these types of crises more severe, prop up financially troubled banks, and move economies in the direction of a more unstable financial base (and make possible further financial crises). The main form of interference made it more difficult for depositors to liquidate banks that suspended. This interference allowed the banks that suspended to reconstruct themselves financially on more favorable terms and then return to business. The favorable reconstruction included, among other things, being able to convert some short-term deposits to long-term deposits.104 The favorable terms actually encouraged banks to suspend so that they could financially reconstruct themselves. Hence, it is misleading to talk of banking “failures” during this crisis (as some commentators do), especially given that virtually all of these banks eventually reopened successfully.105 Hickson and Turner claim that allowing banks to suspend and reconstruct was better than allowing them to be liquidated because the banks’ assets were unsalable and may have had near zero value anyway. They focus on the fact that the banking system survived and many depositors thought reconstruction was the best outcome that could be achieved. They claim that this is proof that the best option was the government “encouraging” reconstruction. However, mere survival of the banking system should not be the standard of success. One should strive for a flourishing banking system (and economy in general). The fact that the Australian banking system was experiencing a crisis was not a sign of a flourishing system. Moreover, if reconstruction was the best option for depositors and creditors more generally, then it would not have required government “encouragement” for this to happen. Once the banks were facing bankruptcy, depositors would have chosen voluntarily to allow reconstruction if this made the most sense. The “encouragement” by the government not only created the impetus to suspend (and thus probably led to far more suspensions than otherwise would have occurred),106 it effectively (and forcibly) limited the options available to creditors by violating the rights of creditors. In addition, such interference by the government encourages further irresponsible behavior on the part of banks, since banks know (or, at least, assume that it is likely) that they will be protected when they get into financial trouble in the future.

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If creditors allowed reconstruction once the banks were facing bankruptcy, it would have been done on terms most favorable to the creditors. This may have included removing current management. Nevertheless, whether they chose liquidation or reconstruction, under a system of dealing with bankrupt businesses that respects property rights and the sanctity of contract, greater financial discipline would have been instilled in the banks. This would have placed the Australian banking system on a much more sound financial footing. Also, the colonial government of Victoria declared a five-day bank “holiday.”107 This holiday is reported to have caused greater concern among depositors of the soundness of banks. Depositors should be concerned about such holidays because they generally protect financially unsound banks. The sound banks do not need “holidays” (where all activities of the bank are suspended). It just gives the unsound banks time to raise funds or work out more favorable arrangements for themselves and ultimately continue their irresponsible ways. To ensure the greatest financial soundness in the banking industry, the most strict bankruptcy laws should be ruthlessly and rigidly enforced. Only if creditors choose to allow a debtor to reorganize should this be an option. It should not be imposed on creditors by the government. There was additional government interference in the middle of the crisis as well. This included, in the colony of New South Wales, granting the governor the ability to declare banknotes legal tender (which allowed banks to cover their deposit outflows), giving the government the ability to inspect banks, empowering the government to advance treasury notes (that had legal-tender status) to some depositors to cover a portion of their deposits, and declaring that no bank with its head office in New South Wales would be permitted to fail.108 All of these acts violate individual rights in one form or another and all of them create an incentive for banks to operate in a less sound manner. In the context of an economy in which banknotes are not legal tender and in which many banks are in financial trouble, giving the government the ability to declare which notes are legal tender—even though it should not have this ability—in order to make it easier for troubled banks to meet their payments has the effect of propping up the banks that have been irresponsibly managed and thus perpetuates poor management practices. In addition, government inspections have the effect of establishing which banks are sound based on government standards—regardless of whether those standards are rational or irrational—instead of banks having to prove themselves worthy of customers’ business in the marketplace. The government’s standards might include (and actually have included in some cases) whether banks own sufficient government bonds to secure their note issue or back up their deposits. Of course, it is no accident that the requirement for banks to own government bonds makes it easier for governments to borrow money. Finally, using treasury notes to pay off depositors and not permitting banks to fail obviously have the perverse incentives of keeping unsound banks in business and not allowing both bankers and depositors to suffer the consequences of their poor financial choices.

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Hickson and Turner claim that the above interference had the effect of rendering the crisis less severe.109 As proof of their claim, they cite the fact that the banking crisis was less severe in New South Wales than in Victoria. According to Hickson and Turner, there was greater government interference in the former than in the latter colony. While it may be true that, once the crisis had already begun, government interference made it less severe in New South Wales than in Victoria (although I do not consider this fact proven definitively at this point based on my knowledge of the subject), this does not prove that government interference leads to less severe crises in general (or fewer crises for that matter). First, one cannot ignore the evidence I have provided that shows that government interference in the economy, particularly in the monetary and banking system, causes business cycles, financial crises, recessions, and depressions.110 The Great Depression is particularly important to consider here. Government interference in the United States turned what would have been an ordinary depression of the time (itself caused by government interference) into a massive depression: the Great Depression. Furthermore, one must not ignore the fact that the Australian crisis of the 1890s and the broader crisis that occurred around the world were caused by government interference in the form of the BOE in Great Britain and in various forms in Argentina. In addition, one cannot ignore the interference in Australia prior to the crisis in the form of the government chartering banks and imposing extended liability on bank shareholders. These not only limit competition and the discipline brought about by it, they artificially boost confidence in the banking system and thus encourage excessive risk taking. One can also not ignore the government interference in Australia prior to the crisis in the form of large government budget deficits incurred for the purpose of financing public-works projects, which also contributed to the crisis.111 Government interference in the midst of a crisis reduces the severity of a crisis in the same way that going off the wagon reduces the withdrawal effects of a drug addict or alcoholic. The withdrawal effects do not feel good to the abuser and resuming the use of the drugs or alcohol temporarily alleviates the symptoms. However, it also prevents the abuser from reaching a long-term state of better health. The same is true of an economy. The drugs are forced on the economy by the government interference that exists in the form of government budget deficits used to finance inappropriate and excessive forms of government spending, a credit expansion based on inflationary policies of central banks, perverse incentives for banks created by government regulation of the banking system, and so on. The result is a “high” in the form of an inflationary expansion and credit boom, accompanied by stock market booms (typically, but not always) and mal-investment (often in real estate and advanced technology goods of the time, but not limited to these areas). The withdrawal symptoms include the crisis, recession, or depression, during which time the economy corrects the effects of the harmful “stimulants.” By going back on the drugs (in this case, engaging in more government interference to cover

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up or temporarily alleviate the withdrawal symptoms), one merely leads the economy to a state of worse health in which it becomes more dependent on the drugs (i.e., credit expansion and regulation) and leads to more disasters in the future, much as will occur with the drug addict who refuses to rid himself of his addiction. The ultimate end for the drug addict is death due to an overdose if he does not stop using drugs. While an economy cannot die, it can stagnate and become poorer as its productive capability and standard of living decrease due to the government interference. The government interference also leads to a more unstable financial base on top of which economic progress can occur. It generally causes an economy to take a longer time to recover from a financial crisis or recession as well. While we have not seen industrialized economies becoming poorer relative to the late nineteenth century, financial crises, recessions, and depressions are still experienced due to government interference in the monetary and banking systems in countries around the globe. Further, greater government interference has led to lower rates of economic progress, more volatile business cycles, and higher unemployment.112 In recent history, in connection with the financial crisis and recession of 2008–9, some economies have been on the brink of collapse due to government interference not only in their monetary and banking systems but in the form of massive welfare states. So, one should not see the temporary masking of the harmful effects of government interference with more government interference, as appears to have occurred during the Australian banking crisis in the 1890s, as a beneficial phenomenon. It merely sets the economy up for further problems in the future. One last point that must be addressed in connection with Australian banking in the late nineteenth century is the nature of competition and its effect on the Australian banking system (and banking in general). Some claim that, during this period, competition and a lack of regulation led to lower standards and greater risk taking in Australian banking that allegedly contributed to, and even caused, the banking crisis in 1893. For example, Merrett states that “the result of free entry into an effectively unregulated industry was that . . . banks took higher risks.” He also says that “prudential standards were undermined by free entry into the industry.”113 In addition, Hickson and Turner state that “the decline in prudential standards and the identified structural weaknesses of the banking system were a consequence of an unregulated banking system.”114 Such views display a profound ignorance of the nature of competition. Free competition generally reduces risk and improves stability in the banking industry. Many writers have observed this.115 It does so in one way by increasing the geographic diversity of banks. If free entry into banking exists, that means banks can enter the industry in multiple geographic regions. This reduces the probability of failure because it is less likely that all geographic areas will experience a financial crisis or recession at once. Hence, a bank can survive by using its branches in the areas not exposed to financial problems to compensate those in the financially troubled regions. In another way,

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competition makes it possible for banks to diversify their investments. For instance, if banks are forced by government regulations to make only mortgage loans, this could lead to financial problems should the housing market collapse. However, if banks can make multiple types of loans (home loans, car loans, business loans, etc.), invest in stocks, provide investment banking services, and so forth, the likelihood of all these investment vehicles and services experiencing trouble is lower. Therefore, to the extent that banks experience trouble in any one area of their business, if they have multiple areas in which they do business, the areas in which financial performance is good can support the areas in which financial performance is poor. Furthermore, to the extent that banks have to prove themselves in the marketplace, as opposed to being given a position of dominance through government protection from competition, they will have to provide a good service to earn a good reputation. This means making sure they do a good job managing the money of depositors and making sure the money is there when depositors need it. In all of these ways, and many more, competition fosters higher standards and less risk taking on the part of banks. We have seen throughout this book how government regulation and restrictions of competition lead to greater risk taking (such as through government deposit insurance schemes and bailouts of financially troubled banks) and lower quality services (due to chartering and examinations of banks by the government). In contrast, in a free market, if banks do a poor job or take on excessive risk, they are punished by a loss of funds through the clearinghouse, depositors taking their business elsewhere, and ultimately bankruptcy if they do not learn a better way. Australian banking in the late nineteenth century had many forms of government interference that contributed to the instability and riskiness of the system. The writers who claim that competition and a lack of regulation were the problem attempt to reduce the significance of the regulation that existed. They also confuse the effects of a government sponsored credit expansion with the effects of competition.116 Competition does not lead to credit expansion. It leads to greater safety and more conservative banking. The credit expansion that occurred in the latter nineteenth century in Australia prior to the crisis of the 1890s had its root, at least in part, in government interference in Great Britain through the BOE’s inflationary policies. When credit is made easy to obtain due to government interference, banks become sloppy in their lending practices. This leads to greater risk taking and instability. The discipline of the marketplace is muted or disappears altogether. In conclusion, banking in Australia in the late nineteenth century was fairly free but, as with other episodes of so-called free banking around the world, there was substantial government interference that wreaked havoc upon the Australian economy. The big difference with Australia during this period is that much of the government interference that influenced the Australian economy came from Great Britain (and indirectly Argentina). It was this interference that caused the inflationary expansion during the 1880s and the banking crisis and contraction during the 1890s. Once again,

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free banking is not to blame for the problems that it is alleged to cause by some economists. And also once again, the free market takes the blame for the problems caused by government interference.

Conclusions to Be Drawn from Banking History What can be concluded from the discussion in this chapter? Unfortunately, the periods of freer banking do not provide enough information to make definitive conclusions about the details of what will happen in a free market in money and banking because even the freest banking periods were not close to periods of free banking. As I have said, they are more accurately referred to as periods in which the monetary and banking systems of various countries and time periods were freer than the monetary and banking systems of other countries and time periods. The discussion above on the freest monetary and banking systems that existed shows that there was significant government interference even in those systems. The world will have to wait until a completely free monetary and banking system exists to see in practice the specifics of what it will bring. Until then, we have to use our theoretical knowledge in conjunction with comparisons between more free and less free banking periods to determine what will happen. Although based on historical evidence no conclusions can be made regarding the details of a completely free monetary and banking system, the fact that some episodes were freer than others allows one to make some conclusions about the effects of more freedom versus less freedom in money and banking. One conclusion is that greater freedom tends to lead to greater stability in the monetary and banking system. This was highlighted in the comparison between the Scottish and English banking systems and is highlighted in the literature on the history of money and banking in general. In addition, the free banking periods led to more sound banking and financial systems. This is seen above, for example, in the fact that governments often used interference in the monetary and banking system to finance their own spending. Greater freedom in banking also tends to be associated with greater rates of economic progress. There are a number of writers that illustrate all of these points.117 One issue that I was hoping the historical episodes would provide evidence to draw a conclusion about is how the amount of reserves that banks hold relative to checking deposits and banknotes varies from the more free to the less free episodes. If you have read the previous chapters of this book, you know by now that I believe 100-percent reserves (perhaps even more) will be established in a free market in money and banking relative to checking deposits and banknotes. This is what will help to eliminate the business cycle in a free market. While there is some evidence from the literature on the historical episodes that shows that reserve ratios do tend to increase with less government interference and decrease with more government interference,118 the little evidence that exists certainly does not indicate whether 100-percent reserves will be established in a free market. Moreover, some of the historical

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data do not confirm—and even appear to be inconsistent with—the expected link between government interference and the reserve ratio.119 Furthermore, during what is believed by some to have been one of the freest and longestrunning episodes of “free banking”—the Scottish “free banking” period— reserve ratios appear to have been quite low,120 which contradicts what I am claiming will occur. The fact that reserve ratios were low in the Scottish “free banking” period does not concern me. Given the influence of the BOE and the lack of respect for property rights by Scottish bankers, it is not surprising that reserve ratios were low. The political and, more importantly, the philosophic environment that a free market requires will create far greater respect for property rights and the sanctity of contract in a free market than existed in Scotland. This will help lead to far greater reserves. In addition, there are a number of problems with much of the data from Scotland and other historical periods. Because of these problems, I do not think the historical data can be used to definitively confirm or deny whether 100-percent reserves will be achieved in a free banking system. First, complete sets of data for banks do not exist in any of the data sets I have seen and the data become spottier as one goes back in time. Much interpolation and/or extrapolation is engaged in by authors to present what looks like a full set of data. Data often do not exist during many years and for the years for which data can be obtained, they are sometimes only for a small fraction of the banks in existence. Also, there is often no distinction made between time and demand deposits for banks prior to the twentieth century (and in some cases even well into the twentieth century). To obtain a true picture of the reserve ratios, such a distinction must be made. This is especially true because time deposits are generally greater relative to demand deposits the farther back in time one goes. This makes it look like banks are carrying fewer reserves relative to demand deposits than they really are to the extent the reserve ratios are calculated relative to both types of deposits. Moreover, reserves often include more than just commodity money. They often include government issued paper money even before the paper money was standard money. Only standard money, as well as notes and demand deposits backed fully by standard money, should be included in calculating reserve ratios. Including notes not fully backed makes reserve ratios look higher than they really are. Finally, data are often not consistent from one author to another or from one period that is written about to the next. All of these issues make it difficult to establish the historical trend of reserves. Despite the difficulties with most of the historical banking data, the twentieth and twenty-first centuries in America do afford one the ability to get an indication of what happens to reserve ratios with greater government interference. Data are widely available and there is a clear record of greater government interference in the monetary and banking system during the last century. The major forms of government interference include the creation of the Federal Reserve System in 1913 and amendments to the Federal Reserve Act that, among other things, allowed for the confiscation of gold reserves

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from banks. They also include the Banking Act of 1933 (often referred to as the Glass-Steagall Act) that, among other things, created the Federal Deposit Insurance Corporation and separated investment and commercial banking. In addition, they include the devaluation of the gold dollar and the confiscation of gold from individuals in the 1930s, the complete abandonment of gold as money in the late 1960s and early 1970s, the creation of Fannie Mae and Freddie Mac and the incentives provided to banks by these two government entities to engage in irresponsible mortgage lending, the embracement of the principle of “too big to fail” in the 1980s and the bailouts of financial firms that have resulted from this, and the Basel Accords that among other things established international capital standards for banks and have lowered those standards from what they otherwise would have been. There have been some modifications to banking and financial regulations since the 1980s, including the elimination, addition, extension, and more vigorous enforcement of some regulations. Sometimes it is believed that since the 1980s the banking and financial system has been deregulated. However, this is not true. The overall trend has been one of greater regulation, even since the 1980s.121 Since 1914, the start of operations for the Fed, the ratio of demand deposits to reserves has generally increased. It has fluctuated throughout the period during recessions, depressions, and expansions, but has generally moved higher. One estimate puts the ratio at 6.1 in 1914. The estimate for 2003 is 15.3 (the high watermark). The value remained as high as 13.5 until late 2008. Then, during the financial crisis and recession of 2008–9, the ratio dramatically decreased to a value below 1. This was due to the massive injection of reserves by the Federal Reserve and the fact that the Fed started paying interest on bank reserves held at the Fed during the financial crisis. The decline of the ratio is not unusual during recessions or depressions, although the decline during the 2008–9 episode was much larger than typical. For comparison purposes, during the Great Depression the ratio went from a high of 7.1 in 1929 to a low of 2.2 in 1940. The data I used to calculate these ratios are not without their problems. Through 1960, I used demand deposits and reserves from Milton Friedman’s and Anna J. Schwartz’s A Monetary History of the United States, 1867–1960. After 1960, I used data on total checkable deposits and total reserves from the St. Louis Fed’s FRED database.122 The two data sets are not identical and do not generate the same ratios during periods when they overlap (although the values are close). Moreover, the latter data do not include the portion of money market mutual funds (MMMFs) used as money and the reserves backing them. Including these data would most likely further increase the ratios during the decades MMMFs have been used as money since MMMFs generally have checking accounts at banks to make payments. This means the reserves backing MMMFs are probably largely included in the above data while the amount of MMMFs used as money is not. Nonetheless, the data do provide a good indication of the smaller fraction of reserves to which the regulation of the banking system leads. By implication, it also provides

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evidence of the larger fraction of reserves to which a freer banking system will lead. While the data presented above show the variation in reserve ratios one would expect and the historical episodes show the stability of freer monetary and banking systems compared to less free systems, to understand what a complete free market in money and banking will lead to one must do a massive paradigm shift from today’s world and the monetary and banking systems that have existed throughout human history. Government interference in banking is almost as old as the industry itself, going back all the way to ancient Greece.123 This is no accident because banking is the easiest and most tempting industry to regulate. It is also one of the easiest industries in which to engage in fraud because it is easy for bankers to secretly lend reserves that they are contractually obligated to keep on hand.124 If governments had protected individual rights (and in many cases not been an accomplice in the fraud), this practice would have been stopped and the establishment of 100-percent reserves would have been encouraged. One cannot look at banking today or even in the freest periods and think that a free monetary and banking system will look anything at all like what exists or has existed. Those who think a free monetary and banking system will be anywhere close to what we have known so far do not understand what constitutes freedom in money and banking. They mistakenly think many forms of government interference are a part of a free monetary and banking system. Making the claim that a free market in money and banking will lead to 100-percent reserves on checking deposits and banknotes is analogous to making the claim that the government of a laissez-faire capitalist society should be financed through a system of voluntary taxation. People look at me as if I am crazy when I make these claims. In fact, more people think I am crazy when I discuss voluntary taxation. They think there is no way people will ever pay voluntarily for the government.125 They cannot imagine a world without confiscatory taxation because that is the only type of tax system that has ever existed (besides some minor exceptions, such as modernday lotteries that fund some government spending). People are, at best, stuck in the paradigm of the mixed economy. The same is true of those who do not understand how free banking will lead to 100-percent reserves. Government interference, for the most part, is the only thing that has ever existed and therefore is essentially all people have ever known or read about. I will grant that the analogy between establishing voluntary taxation and 100-percent reserves is not perfect. The former would be established by law in a free market and thus there is no question that it would be achieved. The latter would be achieved not by law but by the economic motivations provided by the laws that establish a free market in money and banking. I make the analogy here merely to emphasize the radical nature of the changes that must take place to achieve a free market in money and banking. The implication is that such radical changes will bring about radically different results than what we are used to.

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If one understands that a free market in money and banking means people choosing what they want to use as money (i.e., gold, silver, and banknotes backed by them), that it means no central bank, no government deposit insurance, no government manipulation of interest rates, no government bailouts of banks, no suspensions of payment when banks are contractually obligated to pay (unless depositors choose not to enforce the contract), no government examinations, assurances and endorsements, no government issued fiat money, no extended liability forced on banks by the government, no government chartering of banks, no government limit on branch banking (this and the previous mean that the government does not limit competition in the banking system), no deposits of government money in private banks, and no lending by the government, then one will understand the radical changes that must take place to achieve a free market in money and banking. If the government only protects individual rights in the monetary and banking system (as it will be doing everywhere else in a laissez-faire capitalist society), the perverse effects that have existed throughout the history of banking will disappear, including fractional-reserve banking.

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Introduction By getting rid of fiat money and fractional-reserve banking and establishing a completely free market in money and banking, one can vastly improve an economic system. One can essentially eliminate the business cycle. I will discuss the few, minor exceptions below. One can virtually eliminate both inflation and deflation. One can make it harder for the government to interfere in the economy. One can also increase the ability of individuals in the economy to save, accumulate capital, and raise the productivity of labor and standard of living. In this chapter, I focus on these benefits of gold and 100-percent reserves, as well as many others. I also discuss criticisms of gold and 100-percent reserves and show why the criticisms are not valid. For example, I show that falling prices under a gold standard, if they were to occur, do not constitute deflation and are not a problem. I also show that the costs of a gold standard are far lower than the costs of a fiat-money system with fractional reserves. In addition, I show that a gold standard leads to more capital funds being available in the economy (at least in real terms).1

The Benefits of Gold and 100-Percent Reserves The basic virtue of a 100-percent reserve gold standard with respect to the business cycle is that it is both deflation and inflation proof. Gold is inflation proof because its quantity cannot be increased at rapid rates. In order to increase the quantity of gold, one must put forth great effort and resources to mine gold. Therefore, its quantity is incapable of increasing at rapid rates. In fact, if gold was money the quantity of money might increase at about 3 percent per year on average. This is equal to the annual increase in the worldwide supply of gold during much of the nineteenth century and up until the creation of the Federal Reserve.2 It is important to note the role that the 100-percent reserve aspect of a 100-percent reserve gold standard plays in preventing inflation. If a nation is on a fractional-reserve gold standard, the money supply is capable of increasing at a greater rate than the supply of gold from year to year. This is because if the fraction of gold at the base of the monetary system decreases

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from year to year, for example from 100 to 80 percent, the money supply is capable of increasing at a rapid rate, at least for some period of time. Assuming all money exists in the form of checking deposits and the initial supply of monetary gold is $1 million, as more fiduciary media are created, the money supply increases to $1.25 million as the reserve ratio decreases from 100 to 80 percent, even with no change in the amount of monetary gold. This can cause prices to rise and generate the expansionary phase of the business cycle.3 Gold is deflation proof because once it comes into existence, it cannot go out of existence. Exceptions to this, such as losing a quantity of gold in a ship that has sunk, do not reduce the supply of gold but merely prevent it from increasing at a higher rate over any significant period of time. Furthermore, in such cases, there is the chance that the gold can be recovered. Loss of gold due to wear and tear has the same effect. It reduces the rate of increase but does not cause the rate of change in the supply to be negative. Unlike a fractional-reserve monetary system, each unit of the currency is fully backed by a physical quantity of gold (or silver) and therefore the money supply is incapable of being dramatically and rapidly reduced. With a fractional-reserve monetary system, since each unit of the currency is only partially backed by a physical quantity of some commodity (and the rest is backed by debt), the money supply is capable of being reduced by the amount of fiduciary media in existence. If a reduction in the supply of money occurs, this can reduce the amount of spending in the economy, have dramatic effects on the ability of debtors to pay off debts, and result in a large number of bankruptcies in the economic system. This is why a fractional-reserve checking system is inherently unstable and serves as a breeding ground for financial crises, recessions, and depressions. Because gold is both inflation and deflation proof, it provides great stability in the level of prices. Prices, over long periods of time, tend to remain constant (or perhaps fall at a very slow and steady pace). Studies across centuries show this to be true.4 This occurs because gold, since it must be produced like any other good, tends to increase in supply at a slow and steady pace. Based on several historical studies, the world’s supply of gold has never increased by more than 5 percent in any one year and on average has increased by 1–2 percent per year.5 Hence, an increasing aggregate supply of goods would be faced with an aggregate demand that would tend to increase at the same rate or perhaps a bit more slowly. While gold discoveries can have more dramatic effects on the increase in the supply of money and prices in the countries in which the gold is discovered, even these larger increases in the money supply under gold are not close to the massive increases under fiat money and fractional-reserve banking.6 Some economists ignore or evade this point.7 Fiat money and fractional reserves have led to fantastic—even incomprehensible—annual percentage increases in the supply of money and prices, far exceeding values in the trillions,8 and they have routinely led to annual percentage increases in the supply of money and prices in the thousands (such as in Turkey, Israel, some Latin American

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countries, and other countries in recent history). See the discussion in chapter 2 on how quickly prices are capable of changing for evidence from Latin American and Caribbean countries. The fact that the supply of money and prices might increase 15 or 20 percent per year over short periods of time during a new gold (or silver) discovery and a cycle might be created by the discovery as a result is nothing compared to the massive increases in money and prices and the devastating and widespread cycles caused by fiat money and fractional reserves. On a gold standard, the effects have not even generally occurred across an entire country but have been limited to small regions of a country, closest to where the gold discoveries are made (such as in San Francisco and other towns and cities near the discoveries). Gold is extremely stable because it must be extracted out of the ground at great cost and effort and thus cannot be arbitrarily and massively increased like the supply of fiat money and fiduciary media. With fiat money, all monetary authorities need to do is purchase government bonds or other assets and make entries on a computer keyboard to increase the supply. If they want to increase the money supply $1 million, all they need to do, in essence, is enter a one with six zeros in the appropriate accounts. If they decide they want to increase it by $1 billion instead, they simply add three zeros. It’s that simple. In addition, banks can increase the money supply at a rapid rate by creating fiduciary media. Of course, the fact that the fiduciary media can disappear adds to the instability. Because gold is very stable and creates nearly constant prices over extremely long periods of time, it makes business forecasting easier to engage in, which helps to improve forecasts and reduce the cost of forecasting. This is important if businesses are to properly plan their productive activities, purchase the right amount of materials for their manufacturing processes, stock the appropriate levels of inventories, and so on. It is easier to forecast under gold because a fluctuating variable in the economy has been largely eliminated: changes in prices due to changes in the money supply. This reduces the level of uncertainty in the economy. The constant (or fairly constant) price level means that changes in prices that do take place in the economy tend to be real changes in prices and relative changes in prices. That is, the changes in prices that take place tend to be due to changes in real factors, such as changes in supply or preferences. This makes the price system more transparent since prices are not being distorted by the artificial stimulus of inflation (or deflation). Commodity money provides a stable and easily understandable measure of value, since one will not have to be concerned with the value of money changing over long periods of time (at least not that much). If the overall price level remains constant, one will not have to convert nominal values into real values to make comparisons of variables across time because the nominal values will be the same as the real values. In other words, no price indices will be needed. This means the price system can communicate changes in relative prices in a much easier fashion and make it much easier to anticipate and observe changes occurring in the economy. It is conducive to lower costs

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and thus higher rates of economic progress, since fewer resources will need to be employed to generate forecasts and fewer bad decisions (based on data distorted by inflation and deflation) will tend to be made. Note here that when I discuss inflation and deflation, I am not referring to mere changes in prices. Proper knowledge of inflation means understanding that the fundamental characteristic of inflation is the increase in the money supply at a rate more rapid than the increase in the supply of gold or other money chosen in the free market. In a similar manner, a proper understanding of deflation is based on changes in the money supply. However, the essential characteristics of deflation are expanded to include decreases in spending as well. Deflation is a decrease in the supply of money and/ or spending. A decrease in the volume of spending can occur without a decrease in the money supply. This can occur if the money supply merely fails to expand or expand sufficiently relative to expectations and causes people to hold on to money in order to build up money balances to prepare for financially tough times ahead. This means an increase in the demand for money has occurred (or a decrease in the velocity of circulation of money) and thus potentially a drop in spending. Despite the expansion of the essential characteristics to include a decrease in spending, deflation still has its root cause in a decrease in the money supply. It is just that in this case the root cause might not be an actual decrease in the supply of money but a decrease in the rate of increase in the money supply (particularly relative to expectations for increases in the money supply), which leads to increases in the demand for money.9 I have argued elsewhere that rising prices are not inflation but merely a symptom of inflation.10 The same is true of falling prices. Deflation leads to more than just falling prices. It also leads to a widespread decline in the rate of profit (even general unprofitability) and a dramatically reduced ability to pay off debt. These are phenomena associated with depressions, which are another effect of deflation. One can get falling prices without deflation. Falling prices due to increased production under a gold standard do not lead to general unprofitability. Because the amount of money and spending continue to increase, the revenues and profits of businesses increase. The key to increasing profitability is that the amount of spending increases. This is what happens under a gold standard. The same is true with regard to the ability to pay off debt. As long as the amount of spending, sales revenue, and income are maintained or increased, businesses and individuals have no lesser ability to pay off debt. A lack of ability to pay off debt occurs when revenues and incomes decline. Under that scenario, debts taken on in the past when revenues and incomes were higher become harder to pay off. The slow and steady rise in the supply of money and spending under gold keeps revenues and incomes rising, even if prices fall. Another way to look at it is that falling prices do not reduce the ability of businesses to pay off debt under a gold standard because the falling prices

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are based on increased production. This means that while businesses might receive less revenue per unit of the goods they sell (i.e., prices are lower), they have more units to sell and are able to generate the same total revenue. If output doubles and the overall price level is cut in half, businesses have the same ability to generate revenue in any given period and pay their bills. Indeed, under a gold standard they have an even greater ability due to the increased supply of money and spending, which result from the increased supply of gold.11 Some economists think that falling prices due to increased production under a gold standard might lead to the disappearance of lending. The claim is that if the anticipation of rising prices leads to higher nominal interest rates, then the anticipation of falling prices will lead to lower nominal interest rates. If prices fall by a large enough percentage, interest rates could hit zero. If they hit zero, no lending will take place. This conclusion, by some economists, is made based on the mistaken belief that the anticipation of changing prices leads to changes in nominal interest rates. However, changes in nominal interest rates occur due to changes in the amount of money and spending, not due to the anticipation of changing prices. Changes in prices, whether due to changes in the money supply and spending or changes in production, lead to changes in real interest rates. For example, if the money supply and spending increase, they add a positive component to the economy-wide rate of profit due to the additional revenues they create for businesses and the historical nature of costs. This leads to higher interest rates, since interest rates and the rate of profit are competing rates of return.12 However, to the extent that prices rise due to the increased money and spending, real interest rates (and the real rate of profit) are reduced. For instance, a 3-percent rise in prices leads to a 3-percent reduction in the real interest rate and rate of profit. As an approximation, real rates are adjusted by subtracting the rate of change in prices. Even if prices do not rise due to the increased money and spending but instead remain constant, perhaps because production increases an equivalent amount to offset the increase in money and spending, interest rates still rise because of the positive component the additional money and spending add to the rate of profit and interest rates. This will still be true even if prices fall due to production increasing by a greater percentage than the supply of money and spending. The only difference in these two scenarios is that real interest rates and the real rate of profit will not be adjusted at all in the former scenario and will be adjusted up in the latter. Likewise, if the money supply and spending fall from year to year, this reduces the economy-wide rate of profit and pushes interest rates down. However, to the extent that prices fall due to the decreased money and spending, real interest rates (and the real rate of profit) are increased (because subtracting a negative rate of change in prices from the nominal rates leads to a positive adjustment to real rates). Interest rates still fall even if prices remain constant or rise. The key is to make sure the money supply and spending do not fall, which is what a 100-percent reserve gold standard does.13

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It is a lack of understanding of inflation and deflation on the part of economists that leads them to believe falling prices under a gold standard create a problem. In fact, not only is there no problem, a gold standard helps achieve the highest rate of economic progress, the greatest prosperity, and the greatest stability that are possible.14 Evidence for this claim is seen by comparing the period of the last couple of decades of the nineteenth century up to World War I with subsequent periods in the United States. The former was a period when the United States more consistently adhered to the gold standard. As a result, prices generally remained constant or declined slowly and the rate of economic progress was much higher than in subsequent periods (when prices rose much more rapidly). The subsequent periods were periods in which the United States was either off gold completely or taking significant steps in that direction.15 Another way in which a 100-percent reserve gold standard prevents inflation and deflation is by virtue of maintaining a low and stable velocity of circulation of money. The major influence on the velocity of money is rapid changes in the supply of money.16 If a 100-percent reserve gold standard exists and the money supply does not increase rapidly, but increases at a steady rate from year to year, this helps maintain a low but stable velocity of circulation and thus prevents changes in the amount of spending in the economy due to changes in velocity. The low velocity of circulation implies a significant level of financial liquidity for the average person and business. This high level of financial liquidity places the economic system in an extremely sound financial position. This is the case because if people have more money on hand relative to their spending, it is much less likely that they will not be able to make any payments that come due, including payments on debt. This is another way in which a 100-percent reserve gold standard prevents depressions from occurring. Further, with a 100-percent reserve gold standard, there are no artificial inducements for people to lower their demand for money and become unduly illiquid. There is no ability of the government to increase the supply of money and credit at dramatic rates and then cut back on the increase.17 The erratic manipulation of the supply of money and credit has the effect of artificially decreasing people’s demand for money as the inflationary expansion takes place and then suddenly increasing it when the inflation is stopped or slowed sufficiently. It is the low demand for money that puts businesses and people in general in an unsound financial position, where their spending and debt levels increase relative to their money balances. This creates a recipe for financial disaster, especially when the inflation stops or slows sufficiently and reduces revenues and incomes relative to debt levels. This brings on the scramble to build money balances, as well as the financial crisis and recession or depression. If businesses and individuals maintain a higher level of money balances relative to the spending they engage in and the debt they take on, they will be better able to deal with any temporary financial hardships they face, whether due to individual circumstances or due to broader instabilities in the economy. Businesses and individuals will be much less likely to

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get into financial trouble if they have larger money balances relative to their spending. Let me make it clear that I am not saying that under such a system no one will get into financial trouble. There will always be those who make bad decisions and take on too much debt or make bad loans. However, a 100-percent reserve gold standard prevents the default of one debtor (or even many debtors) from causing a monetary contraction and thus causing other debtors to go bankrupt. Further, such a system prevents governments from making such a financial contraction possible by preventing them from dramatically inflating the supply of money and credit. In essence, a major source of volatility is eliminated by moving to a 100-percent reserve gold standard. Business cycles caused by monetary phenomena will be rendered virtually impossible. For the most part, people will only have to deal with cyclical fluctuations created by real economic forces (such as the weather, natural disasters, dramatic shifts in demand, etc.), and these will be much more contained than any type of monetary induced financial crisis. If one is thinking that the higher money balances will be a waste of resources because it is money that could be spent and put to use purchasing and employing real resources (such as factories and machines), stop right there. A higher demand for money does not waste resources. In fact, the lower demand for money brought on by the inflation of the supply of money and credit wastes resources. A lower demand for money does not enable more real resources to be employed. It merely raises the prices of existing resources through the greater spending it generates. With lower money demand one merely creates higher prices and puts the economic system in a financially precarious position, one in which financial collapse will occur once the inflation of the supply of money and credit stops or slows sufficiently. To the extent that the rising velocity (i.e., falling demand for money) contributes to the boom, the financial contraction and recession or depression will be that much worse. The boom and bust brought on by the inflation of the supply of money and credit do not simply cancel each other out so that the economy is, on net, no better or worse off relative to where it would have been had there been no cycle.18 There are several harmful effects of inflation that lead to a lower overall productive capability, rate of economic progress, and standard of living as a part of the business cycle. This is the result of the waste of resources I refer to above. By eliminating inflation, a 100-percent reserve gold standard eliminates these harmful effects, improves the efficiency and effectiveness in the use of real resources, and thus raises the rate of economic progress. This is a part of the greater stability and higher standard of living that gold and 100-percent reserves help to achieve. What are these harmful effects that gold and 100-percent reserves eliminate? They include mal-investment, overconsumption, the negative effect of taxes, the withdrawal-of-wealth and reversal-of-safety effects, tax-bracket creep, the need to employ assets as an inflation hedge (a form of mal-investment), the erosion of people’s savings and income, and the culmination of all these

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effects: decreases in the rate of capital accumulation and, if inflation is severe enough, outright capital decumulation. Let us see in detail what these harmful effects of inflation are so we can understand just what gold and 100-percent reserves are able to protect us from. The first effect of inflation I will discuss is mal-investment. I discussed mal-investment in some detail in Chapter 3 of Money, Banking, and the Business Cycle, Volume 1: Integrating Theory and Practice. Let me reiterate that mal-investment is investment whose profitability is based solely on the existence and continuation of inflation. For example, mal-investment occurs when a business purchases additional inventory to take advantage of rising revenues and prices due to inflation. Inflation creates incentives to invest in areas of the economy where demand is higher because of the inflation. It leads to assets being poorly invested, since many assets would be invested differently had the inflation not existed. A recession or depression is the process of wiping out mal-investments. Assets and workers that have been put to work in areas that only looked profitable due to inflation must be redeployed once the inflation stops or slows sufficiently (or does not accelerate sufficiently) and it is seen that these investments are not sustainable. In addition to the discussion referred to above, let me emphasize that even if investments made because of inflation make money, they are still mal-investments. The investments are bad because they are made based on the existence of an artificial stimulus and would not have been made had inflation not existed. Some investors might be able to make money off of these investments. For instance, an investor might make money by buying and selling gold as an inflation hedge. However, the fact is he would not have made this investment and would have invested his money in other areas of the economy had inflation not existed. Likewise, during the housing boom some investors might have made money “flipping” houses (i.e., buying and selling houses quickly as prices rose). But again, they would have employed their resources in other areas had the inflation not existed. Let me also emphasize that I am not saying these investments should not necessarily be made. It may be prudent to purchase gold (or something else) as an inflation hedge so one can protect oneself from inflation. It might also be rational for businesses to purchase additional inventory in an attempt to sell it into a rising revenue stream (created by inflation). The investments might be the best options available given the existence of inflation. The point is that inflation is artificial—something imposed on the economy through the initiation of physical force by the government—and the investments made based on its existence would not be made had inflation not existed. One effect of mal-investment is that the level of satisfaction and wellbeing in the economy are lower, since businesses are led by inflation to produce goods for which people have less preference and not produce goods for which people have a greater preference. It also leads to less wealth being produced to the extent that resources are employed in hedging against inflation, instead of producing wealth for which people have a real demand (i.e., demand not created by inflation). In addition, it leads to less wealth being

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produced since some of the capital invested during the inflationary expansion is specific to the purpose for which it was employed and is thus not transferrable to other industries and must be scrapped once the inflation ends and the unprofitable nature of the mal-investments is revealed. To the extent that resources can be transferred to other industries, some of those resources must be consumed in the switch over once the inflation slows (including retraining workers and converting the transferrable assets over to uses in other industries). With productive resources wasted, the productive capability and standard of living suffer.19 The second effect of inflation I will discuss is overconsumption. This occurs because of the illusion of prosperity that is created by an inflationary boom. It takes place early in the inflationary expansion when incomes and prices of investments or assets that represent a large portion of people’s savings increase before prices in general. A rapidly rising stock market, rising home prices, and inflated business profits are just three of the forms in which this illusion can occur. This deludes people into thinking they are better off than they really are and induces them to consume a larger amount than if inflation had not existed. For instance, due to the increase in the value of their stock portfolios (because of inflation) people might purchase a larger home than they otherwise would have or they might take a more expensive vacation than they otherwise would have. Hence, less wealth is available for capital accumulation and the production of wealth, which results in a lower productive capability and standard of living. Some might ask the question: Why are people so stupid that they are fooled by the artificially high incomes into consuming more than they otherwise would have? I refer the reader back to Chapter 4 of Money, Banking, and the Business Cycle, Volume 1 for my discussion on rationality and so-called rational expectations theory for a complete answer. Here I merely state that inflation creates real distortions in the economy that have very real incentives. Incomes and asset prices might be artificially inflated for many years due to inflation, leading people to eventually believe that these are permanent parts of their income and savings. Furthermore, when cheap money and credit are made available through inflation and people do not have to put forth great thought and effort to obtain it, they tend to become more careless in the investments they make and more irresponsible in their spending habits.20 Inflation fosters the worst elements in people from the standpoint of financial responsibility, which includes encouraging people to live beyond their means by borrowing and consuming too much. Inflation can also undermine capital accumulation and economic progress by creating a reversal-of-safety effect on the safest, fixed income financial assets, such as high-grade corporate bonds and certificates of deposit (CDs). Inflation can make these investments riskier because it decreases the return that individuals can earn on such investments. For example, if an individual purchases a one-year CD whose interest rate is fixed at 5 percent for the year while the general level of prices due to the change in the money supply remains constant, the real return will be 5 percent. However, if

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inflation causes prices to rise by 5 percent during the year, the individual’s real return will be zero percent. If inflation causes price increases of greater than 5 percent, the individual’s real return will be negative. To the extent that inflation rises in an accelerated and more unpredictable manner and erodes the value of the return from these investments in an accelerated and unpredictable manner, it will make these normally very safe investments more risky. Many of the people who typically invest in these safe investments will not do so when rapid inflation exists, but will consume their savings instead, since the real return on their preferred investment has been pushed to zero or negative and they have no alternative investment to turn to that is equivalent in safety. To the extent that the safest investments are more popular than other investment vehicles (which is generally the case because of their safety), this implies that a significant amount of savings may be consumed, instead of invested, when inflation is high. This is how the reversal-of-safety effect undermines the ability of an economy to save and accumulate capital and therefore reduces the rate of economic progress. Another way in which inflation causes capital decumulation and decreases the rate of economic progress is through the effect of taxes on the profits of businesses. Inflation artificially increases the profits businesses earn. To see this, one must understand that the costs firms incur are historical in nature relative to revenues.21 That is, a firm purchases assets and, over some period of time, uses them to produce some output which it can sell to generate revenue. This period of time may be rather short, perhaps weeks or months, for assets such as inventory, or may be rather long, such as years or decades, for assets such as plant and equipment. This causes costs to increase at a slower pace than revenues when inflation occurs. Because costs eventually rise, inflation increases only the nominal profits a firm earns and not the real profits. The detrimental effect of taxes on the increased nominal profits can be illustrated in an example. Suppose a firm normally purchases goods for inventory to be sold exactly one year later. If the goods purchased by the firm cost $100 and the average rate of return that can be earned on capital invested in the economy is 10 percent, assuming this firm is an average firm and has no other costs, it will be able to sell the goods at the end of one year for $110 and earn a profit of $10. Now suppose that, during the year that intervenes between when the firm purchases its inventory and sells the inventory, the quantity of money increases such that it increases the volume of spending and prices by 10 percent. Because of this increase in spending, the same inventory that originally sold for $110 at the end of one year will now sell for $121 (= 1.1 x $110). In other words, since the volume of spending has increased by 10 percent, business revenues will also increase by 10 percent. This greater revenue will cause the profits the firm can earn to rise from $10 to $21. To see whether the firm is better or worse off with inflation, one must consider the higher nominal profits against the higher replacement costs the firm will incur due to inflation. Based on this consideration, the firm is no

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better or worse off with inflation. Originally, the firm had $10 of profits which could be used by the owners to consume or add to their supply of capital. With the inflation, the firm has $21 in profits; however, fully $10 of this $21 in profits is needed to purchase inventory at the higher replacement cost of $110. This occurs because replacement costs for the inventory will increase, along with revenue and spending in general, at the 10-percent rate used in the example. Therefore, the same inventory that at the beginning of the year cost only $100 now costs $110. Hence, the firm must spend $10 extra out of its profits in order to maintain its capital and business activity at a constant level. After subtracting the $10 necessary to maintain the level of capital from the $21 of nominal profits, the firm is left with $11 in profits. However, since the volume of spending has increased by 10 percent and prices have increased by the same amount, $11 with inflation buys no more than the original $10 in profits. Therefore, inflation has left the firm with the same funds in real terms, which can be used by the owners to consume or add to their supply of capital. The above example has left out one step so far: the effect of taxes. Including the effect of taxes shows how the firm is actually worse off with inflation. If the tax rate on profits is 50 percent, the after-tax profits with and without inflation are $10.50 and $5, respectively. Initially, the firm’s owners had $5 after taxes to use for consumption or add to the firm’s supply of capital. With inflation, the firm still requires an extra $10 out of its after-tax profits just to be able to replace its inventory at the higher cost of $110. Subtracting this $10 from the after-tax profits with inflation leaves only 50 cents for the firm’s owners to consume or add to their supply of capital. Furthermore, since prices have increased by 10 percent, 50 cents with inflation buys only about the same as 45 cents without it. Therefore, with inflation the firm’s owners have less than one-tenth of what they had, in the initial case, to consume or add to the firm’s supply of capital. In the above example, the firm is worse off, after taxes, with inflation because the additional nominal profits are taxed as though they are additional real profits. In other words, a portion of the profits needed simply to replace the firm’s capital at the higher replacement cost is taxed away, leaving the firm with a lesser ability to accumulate capital. I will grant that prices in the real world might not rise as rapidly as in my example. The example is used only to illustrate the principle that inflation undermines capital accumulation when nominal profits are taxed as if they are real. In the real world, additional profits due to inflation may appear to be real for a while because prices may rise with a lag (as individuals adjust their expectations). However, to the extent that prices rise along with inflation, profits needed to replace capital will be taxed and firms will be worse off as a result. This is especially true for longer-lasting assets. The negative effect of inflation described above is separate from the effect of tax-bracket creep. The above does not require a so-called progressive tax system. Even if tax rates are constant with income levels, the above effect

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exists. Tax-bracket creep is a separate and distinct harmful effect of inflation and also leads to capital decumulation and undermines the productive capability. To the extent that the government does not raise the levels of the tax brackets, incomes will rise into higher brackets and be taxed at higher rates. In this case, too, nominal increases in income are taxed as if they are real. An additional way that inflation undermines capital accumulation and economic progress is through the withdrawal-of-wealth effect. This occurs insofar as the new and additional money that enters the economy is first spent for purposes of consumption. Goods purchased and consumed with the new money have been effectively removed from the economic system and are no longer available to be invested and added to the supply of capital. Those who spend the new money exchange nothing, in real terms, in return for the wealth they are able to consume. Obviously the person who consumes using the new money exchanges the money newly created. However, he does not produce anything to earn the possession of the new money. The normal procedure, for those who do not have access to the printing press or computer to create money, is that people must earn the money by first providing a good or service in exchange for the receipt of money. They can then decide to consume with the money they have earned. If one has access to the monetary printing press or computer, he does not need to produce anything to obtain money. So when wealth is consumed with the new money, it is withdrawn from the economy because no wealth was first added to the economy to earn the money that is spent on consumption. It may be the government who consumes with the new and additional money or it may be individuals who receive, for example, welfare from the government who use the funds to consume. It does not matter who consumes with the new money, wealth is still withdrawn from the economy. Even those who receive loans from banks through credit expansion receive unearned money with which to consume. They do so because such loans have been obtained as a result of the government interference—compulsion and coercion—in the economy that fractional-reserve banking requires and thus the subsidy that credit expansion represents. Additionally, much lending to the government represents an unearned receipt of funds with which the government can consume, and the goods purchased by the funds leant represent a withdrawal of wealth, because the government would not be able to borrow and spend as much without its ability to create money and appear as a less risky borrower. Of course, some of the new money will not be used to consume but will be invested. To the extent that investors who obtain funds by virtue of the creation of new and additional money could not have obtained such funds otherwise, the money obtained is unearned and the investment is malinvestment. Inflation erodes people’s savings and income as well. This is particularly true with regard to incomes that are contractually fixed for a period of time, such as fixed interest income, pension income, or rental income. The worse

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the inflation, the harder it will be for incomes that are fixed, even for shorter periods of time, to escape this harmful effect. Fixed incomes are vulnerable because to the extent that inflation drives up prices, real returns are reduced. They can even be turned into losses if the inflation is rapid enough. This means that the value of people’s savings can decline in real terms. It is true that some of the harmful effects of inflation can be combated by indexing tax schedules, wage contracts, and so on, but the best way to combat a problem is to attack it at its causal root. One does not fix a problem by attempting to cover it up, which is what indexing attempts to do. Indexing does not actually get rid of the problem of inflation and, at best, can only help individuals catch up, especially with accelerating inflation. Indexing only allows people to play catch up with inflation because if inflation is continuously engaged in, then people are continuously losing money. The points in time at which index values are used to make adjustments do not make up for the losses people have been incurring since the last adjustment (again, especially with accelerating inflation). In a statist culture, where it is believed the individual’s life (or some part thereof) belongs to the state and the state should be allowed to sacrifice the individual (or some part of his life) for whatever purpose it deems appropriate, inflation tends to accelerate. It accelerates because inflation itself is a thoroughly statist phenomenon: it is used to expand a statist government’s power and spending (such as for the welfare state). It is much easier for the government to expand its spending and power over the economy and people’s lives through inflation than through direct taxation. The acceleration of inflation has been witnessed since the early twentieth century in the form of more rapidly rising prices as countries have moved farther away from gold and then completely off gold. If one wants to solve the problem of inflation one must eliminate the source of the inflation. The causal root of inflation is, of course, fiat money and fractional-reserve checking. Gold and 100-percent reserves will eliminate inflation and all its harmful effects. By doing this, they will improve the ability of a nation to save, accumulate capital, and increase the productive capability and standard of living. Further virtues of a 100-percent reserve gold standard include the fact that it compels governments to maintain balanced budgets. Governments will not be able to finance spending through the creation of money. Also, and possibly more importantly, governments will not be able to borrow the amount of money they currently do, in relation to their tax revenues, by appearing to be a less risky investment because of their ability to print money. When one has the power to print money, there is no amount of debt one cannot repay (at least in nominal terms). However, in the context of a 100-percent reserve gold standard, any debt taken on by the government will have to be paid off through taxes. Here people will directly see the negative effect of an increase in government debt and will be more likely to put pressure on the government to take on a greatly reduced amount of debt. Decreased government spending, deficits, and debt reduce interest rates and increase the productive capability and standard of living in an economy.

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It frees up funds and goods for businesses to use to produce wealth. Governments do not produce wealth; they consume it.22 Governments also do not act on the profit motive as businesses do. To earn profits, businesses must produce goods that individuals want to purchase. Businesses also have an incentive to produce as efficiently as possible as a way to earn more profits. As a result of the greater relative spending by businesses and the greater business activity, more wealth will be produced and a greater level of satisfaction and well-being will be achieved. In conjunction with compelling governments to operate with balanced budgets is the fact that a 100-percent reserve gold standard requires the government to be more representative of the people. It will not, in essence, be able to finance projects behind their backs through the printing press. It will have to directly tax people to finance projects (or raise taxes to pay off loans it took on to finance projects). It gives citizens greater control over government spending. By eliminating inflation, decreasing government budget deficits and spending, and improving a nation’s ability to save and accumulate capital, the productive capability will be improved, a major source of volatility will be removed, greater financial liquidity will be achieved (which will help protect individuals from insolvency and bankruptcy), and businesses will be better able to fulfill the demands of customers. All of these characteristics of a 100-percent reserve gold standard will enable people to benefit more from the benevolent effects of the profit motive and price system, which ultimately means a higher standard of living. Additional virtues of gold and 100-percent reserves include their moral virtues. Such a monetary system is fully consistent with financial honesty and does not attempt to cheat reality. Fiat money requires the initiation of physical force to impose the use of a certain type of money on the citizens of a country. A nation’s monetary system should be a free market for the same reason that every other area of an economy should be a free market: because protecting freedom and individual rights is a fundamental requirement of human life. A free market enables individuals to do the necessary thinking and take the necessary actions to further their lives and happiness. As discussed in chapter 4, fractional-reserve banking is an attempt to cheat reality because it is a situation in which people attempt to have their money and lend it too. They attempt to become, simultaneously, holders of money and lenders of the very same money. It is no accident that such a system inevitably leads to financial and economic catastrophes. Gold also has objective value, that is, value based on a rational assessment by individuals of the ability of gold to further their lives and happiness. The uses of gold include its industrial uses and uses for ornament. Gold does not have arbitrary or subjective value like fiat money, which is dependent on the arbitrary designation by the government of what a paper dollar is worth with no connection to the value of the materials necessary to produce it. What a piece of fiat paper money is worth is dependent solely on how many zeros government officials want to place on the bill. More significantly, the value

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of fiat money is also subject to the arbitrary whims of government officials to create more of it, which typically leads to its rapid decline in value. In contrast, gold has inherent limits on how low its value can fall due to the high cost of mining it. This generally leads to its value remaining stable or even rising. Finally, as I allude to above in this section, there is an important monetary role for silver. Given the very high value of gold that would exist, silver coins would be used for smaller purchases. Of course, banknotes and checks backed by gold could be used as well but there is a cost to managing these, such as protecting banknotes from counterfeiting. Coins made of the monetary metals would be a good substitute in many cases. However, even silver might prove too valuable for the smallest of purchases. Token coins would be used for these purposes. As with banknotes, token coins would be backed by precious metals. As one can see, the benefits of gold are tremendous. However, not everyone believes a 100-percent reserve gold standard is an appropriate monetary system. Many criticisms have been made against it. I turn now to address the more substantial criticisms.

Criticisms and Responses to Criticisms of Gold and 100-Percent Reserves One common claim against a 100-percent reserve gold standard is that it produces falling prices, deflation, and recessions or depressions. This is claimed to be true because the supply of money under a 100-percent reserve gold standard will not necessarily increase at a sufficient rate to keep prices rising. I have shown in the previous section that the claims of deflation, recessions, and depressions are not true. Because gold money increases at a slow and steady pace, it keeps the amount of spending increasing at a slow and steady pace and does not induce the undue illiquidity which spawns financial crises, recessions, and depressions. Some might think that because gold does not allow prices to rise (and in fact sometimes they have fallen for significant periods on the gold standard), it will lead to slower rates of economic progress and more volatile business cycles. Some point to the late nineteenth century as alleged evidence of this. However, the gold standard leads to the opposite. Periodic decreases in the rate of economic progress in the late nineteenth century in the United States that were mistaken for depressions is one reason why the gold standard is believed to lead to more volatility and slower rates of economic progress.23 Even as prices declined in the late nineteenth century, economic progress continued at rapid rates.24 Moreover, the belief that the business cycle was more severe in the late nineteenth century than in the late twentieth century has been shown to be due to the different methodologies used to collect data on the cycle during the different periods.25 For the reasons discussed throughout this book, the business cycle under a complete free market in money and banking will be virtually nonexistent.

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Some might worry that as the stock of gold is increased and the quantities in the ground are depleted, the rate of increase in the money supply will approach zero. In addition, some might worry that if prices continuously fall, they, too, might approach zero. These are not phenomena we need to be concerned with. Why is that the case? If the money supply actually did stop rising and remained constant, total spending, revenues, and income in the economy would remain constant. This would insure a continued ability to pay off debts. Even if revenues for individual firms and incomes for individuals fell due to an increasing number of firms and increasing population, this would not be a problem. The rate of decrease would occur at a slow and steady pace and would be matched by decreases in the amount of borrowing that individual firms and individuals in general would engage in. This is the case because if the money supply remains constant, ceteris paribus, the amount of loanable funds available would remain constant. However, if the number of firms and the population increase, the amount of borrowing and lending per individual would tend to decrease as the loanable funds available per person and firm decrease. Nonetheless, it is unlikely the increase in the money supply would fall to zero. The earth has huge quantities of raw materials and back-of-the-envelope calculations show that it could allow for the mining of raw materials for perhaps millions of years.26 The development of new mining techniques and methods of finding deposits would enable a continued ability to increase the supply of monetary metals. More importantly, in a free market in money if the growth of the supply of monetary metals decreased and it ever became a problem, individuals could simply embrace new metals as money. For instance, platinum could be used as money. If people had a demand for greater quantities of money, there would be profits to make for those who provide the money. If individuals are left free, they can easily solve any problems that might arise due to a lack of increase in the monetary metals. So, in the end, there would be no problem. What about the issue of prices falling to zero? As long as there is some significant amount of monetary metals one does not have to be concerned about prices falling to zero. A zero price level can only be reached if there is no money supply. The real issue is: Can the money supply be divided into small enough units to facilitate the smallest of transactions? If this was not the case, in a free market there would be a strong incentive to create new monetary units that are sufficiently small. Just as innovative entrepreneurs invent all kinds of wonderful products and come up with new ways to satisfy the demands of their customers, the same would be true for banks, mining companies, and minters in a free market in money. However, it would likely never become a problem. One of the more naïve claims against 100-percent reserves is that it is more costly to depositors than fractional reserves. This issue was discussed in chapter 4 in connection with why fractional reserves would not exist in a free market. The claim is that depositors do not pay a fee or service charge for

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checking deposits with fractional-reserve banking but earn interest instead, since banks lend out a portion of the funds that under 100-percent reserves the banks would hold on to.27 Those who subscribe to this viewpoint fail to see all the effects of lending out reserves on checking deposits. In chapter 4, I stated that while it might be true that depositors earn interest on their checking deposits under fractional reserves, it is also true that the increase in the money supply and spending in the economy, due to the lending of these reserves, raises prices. The money supply increases through the money multiplier. Under 100-percent reserves, the money multiplier is one. Under fractional reserves, as banks lend more reserves backing checking deposits, the money multiplier and money supply increase. As a result, the interest earned is merely nominal interest. Another na ïve claim against 100-percent reserves, and related to the claim above, is that fewer funds will be available for investment under 100-percent reserves relative to fractional reserves because, again, reserves backing checking deposits will be loaned out under fractional reserves but not under 100-percent reserves.28 This falls victim to the same critique as the “lower service fee” argument. Again, while there are greater funds available in nominal terms for investment, there is also an increase in the money supply to the same extent. This will merely increase spending and prices so that no greater investment funds are available in real terms. It is utterly naïve to believe that increasing the number of little scraps of paper in the economy or the amount available on bank ledgers can increase the supply of capital goods available to invest. More factories, machines, lumber, iron ore, computers, and so on do not magically come into existence just because more money is available. What Austrian business cycle theory teaches us, and what I have discussed throughout this book, is that in the short-term lending reserves on checking deposits causes mal-investment. For example, investment shifts from less interest sensitive areas to more interest sensitive areas (such as from consumers’ goods to capital goods) due to the lower interest rates that are created in the short term from the process of credit expansion. In the long term, real investment is reduced due to the mal-investment, overconsumption, negative tax effects, and other harmful influences on capital accumulation that the inflation of the money supply has on the economy, which comes from lending reserves on checking deposits. Additional costs include the financial crises, recessions, and depressions to which the process of credit expansion leads. Another claim is that 100-percent reserves will increase interest rates due to the reduction in the loanable funds available. This is essentially the same as the “reduced investment funds” argument. The loanable funds available under fractional reserves may increase in nominal terms but not in real terms. Interest rates can only be lowered temporarily by moving from a 100-percent reserve monetary system to a fractional-reserve system. The reduction in rates occurs while the fraction of reserves is being decreased and thus while the supply of loanable funds is increased. This is the process of

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inflation. Once this process stops or merely slows sufficiently, interest rates will rise and the financial crisis, recession, or depression will occur. This and the other harmful effects of inflation will undermine the productive capability, rate of economic progress, and standard of living. A special concern in connection with this issue that sometimes arises is the belief that the loans that back fiduciary media will disappear and thus reduce the supply of loanable funds available during the transition from a fiat-money, fractional-reserve system to a gold-based, 100-percent reserve system. This is not true because, as a part of the transition from our fiat-money, fractionalreserve banking system to a 100-percent reserve, gold-based system, gold will be turned back over to the banks to cover all fiduciary media. This will be discussed in detail in the next chapter on the transition to a 100-percent reserve gold standard. The important point to understand here is that, after the transition is complete, the loans backing fiduciary media will be loans made out of the equity capital of banks, not from the reserves backing checking deposits. In addition, of course, banks will also be able to loan funds deposited in savings accounts and CDs. Lending will still take place through bond markets and commercial paper markets as well. Hence, there will be no reduction in loanable funds and corresponding increase in interest rates due to the disappearance of fiduciary media or for any other reason. Likewise, there will be no reduction in the productive capability and standard of living either. In fact, interest rates will tend to be lower due to the slowly rising quantity of money and volume of spending, and the rate of economic progress and standard of living will be greater due to the elimination of inflation and all its harmful effects. An important point to note on the issue of funds available for lending and investment is that the supply of savings available for private individuals to borrow and invest will be much greater under a 100-percent reserve gold standard than under a fiat-money, fractional-reserve monetary system. This is the case because the government will not be able to borrow as much. This will free up a large portion of the supply of savings and make it possible for businesses to engage in economically productive activity with it, instead of the funds being used by the government to engage in consumption. Industrialized nations around the world have extremely large amounts of government debt that could be used to increase the degree of capital intensity in their economies. One way to do this is to decrease the ability of the government to borrow and force it to pay down a substantial portion of its existing debt. This will dramatically improve the productive capability and standard of living in countries that have massive amounts of debt, such as the United States. Another claim regarding gold money is that countries without gold mines will be dependent on countries with gold mines. What those who make this claim forget is that the production of new gold represents only a small fraction of the supply of existing gold (generally less than 5 percent).29 Because it is indestructible, the supply of existing gold includes gold that has been produced throughout the history of mankind.

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The supply of gold money in countries relative to the world’s supply of gold will tend to be proportional to the size of each country’s economy relative to the world economy (or the portion of the world economy using gold as money). That is, if a country’s economy is 10 percent of the world economy, it will tend to have 10 percent of the world’s supply of gold money circulating within its borders. This is the case because to the extent that the ratio of the supply of gold in a country to the world’s supply of gold money is less than the ratio of the size of the country’s economy relative to the world economy, the average price level will be lower in that country than in the rest of the world. This will create an incentive for individuals to purchase goods in that country. This means the exportation of goods from that country and the importation of money into that country will both increase. The opposite will occur if the country has a disproportionately large amount of the world’s supply of gold. So if a country’s money supply ever became inordinately low, economic forces would cause it to increase. In the extreme case, which would probably never exist, that somehow a country was prevented from obtaining the commodity money used by the rest of the world, individuals could choose the next best alternative commodity to use for money that is available in their own country. As I have said before, but it bears repeating given the apparent ignorance on the subject, when individuals are left free it is relatively easy for them to come up with solutions to problems they face when trying to further their lives and happiness. A minor claim against gold is the belief that people will be burdened by having to carry gold around with them to make purchases on a gold standard. This is not true. People can carry gold with them if they choose to. This, of course, would represent a benefit of gold. However, it will not be necessary to carry it around if people do not want to. Banknotes that are fully backed by gold can serve as an alternative to using gold for purchases. The claim that banknotes would be an inefficient means of payment because there would be a large number of them is not a valid critique of a gold standard either. Many banknotes from local banks would probably be accepted in local areas, while notes from the largest banks would probably be accepted in much wider areas (perhaps around the world). Of course, checks, debit cards, and credit cards would be accepted as they are today. So no problems would exist in terms of individuals having access to multiple means of payment and having to carry around gold or precious metals if they do not want to. Another claim that is made against gold is the belief that there is no longer enough gold to be used as money. The solution to this alleged problem is to make sure the “price” of a unit of gold (in terms of currently existing fiat money) is high enough to ensure that the quantity of gold in existence can support all the spending currently engaged in with the fiat money. This just means that the definition of the monetary unit, in terms of an amount of gold, must be low enough to allow the total quantity of monetary gold in a country to back all the fiat money that exists in that country. This will be discussed in detail in the next chapter.

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Another complaint against the gold standard is that greater resources will be taken up in the production of gold and that it will reduce the rate of economic progress. Here it is claimed we can decrease the amount of resources devoted to the production of money if we move to a fractional-reserve gold standard and could reduce those resources even more if we move completely off of gold to a fiat-money monetary system.30 This issue was addressed with regard to a fractional-reserve gold standard in chapter 4 in the discussion of the cost of a 100-percent reserve gold standard versus a fractional reserve gold standard. There are a few additional arguments to add to what was said in chapter 4. Debasing gold money and going completely off of gold have led to wellknown examples of financial irresponsibility and even financial ruin. The massive inflation of the Continental paper currency by the Continental Congress during the American Revolution to the point it was worthless is one example. The inflation of greenbacks during the Civil War is another. Countries have routinely gone partially or fully off gold during times of war and massively inflated paper currencies to pay for the wars. Today (2013) Greece is essentially bankrupt due to the massive size of its welfare state. The size of this welfare state was made possible (at least in part) by Greece’s ability to print money. Since moving to the Euro, Greece is no longer able to finance its spending through the inflation of its own currency and thus has had to borrow massively in a currency it has no ability to inflate. As a result, it must now depend on bailouts from other members of the European Union. Then there was the massive inflation of Weimar Germany in the 1920s and the massive inflations of a number of other countries around the globe, based on the use of fiat money, throughout the twentieth century. John Law’s financial scam in early eighteenth-century France is another example of the bankruptcy to which fiat money leads.31 The financial disasters that result from these episodes are just one cost of fiat money. The less dramatic but still large inflations and the normal, everyday inflation of the money supply under fiat money (and fractional reserves) probably create much larger costs in total because even though any single episode of the less dramatic and everyday inflations is less costly, these episodes are far more prevalent. The mal-investment, overconsumption, withdrawal of wealth, negative effect of taxes, and the periodic financial crises, recessions and depressions to which inflation leads create great costs that lower the productive capability and standard of living. Many of these costs are present all of the time that inflation is present. These costs are essentially nonexistent under a 100-percent reserve gold standard. The ultimate cost of the abandonment of gold is best illustrated by the fall of the Roman Empire. The fall of the Roman Empire was caused, at least in part, by the Roman rulers’ debasement of the currency and massive consumption by the government that occurred based on this.32 It was not caused by the rulers’ sound financial policies. It was caused by the massive consumption undermining the productive capability and the division of labor that had been achieved throughout the empire. It led to the beginning

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of a feudal existence in Europe and a much lower standard of living relative to what had been achieved in the Roman Empire. So, far from creating economic progress, abandoning gold undermines it while adhering to the gold standard promotes it. As I emphasized in chapter 4, when determining the cost of a monetary system one cannot consider only the direct costs associated with providing a particular type of money. One cannot consider only the cost of producing gold versus printing scraps of paper to determine the relative costs of gold versus fiat money. One must also consider the effects of each system. These effects are recognized in the comprehensive analysis of the costs of a gold standard in a chapter of a book by the economist Roger Garrison. He includes the above costs and identifies a number of other factors that render a gold standard less costly than fiat money.33 He states that people claim if we moved to a gold standard the production of gold will increase dramatically and thus require a large amount of resources to produce the extra gold. However, he notes that the supply of gold is very inelastic and thus the additional amount produced—and resources required—will not be that great.34 He also notes that significant amounts of gold are produced even though no country has been on a gold standard since, in essence, the 1930s. So the costs of producing gold will exist whether we are on a gold standard or not.35 Further, the cost of enforcing a fiat-money, fractional-reserve monetary system, including the costs of the Federal Reserve, the Federal Deposit Insurance Corporation, and other regulatory bodies, would disappear if the state just protected the rights of citizens to choose in a free market what they want to use as money.36 In addition, costs of a fiat-money system include the costs of different political factions expending resources to ascend to power in government to gain control of the spending by the government. I have shown that a significant amount of this spending is directly or indirectly based on the government’s ability to print money. The costs also include the use of resources by those who lobby the government to get the government to spend money to benefit them.37 There are other factors the enemies of gold ignore as well.38 Garrison uses an analogy he attributes to Alan Greenspan to emphasize the less costly nature of gold relative to government fiat paper money: “Allowing the state to create paper money is like putting a penny in the fuse box. The resource costs of the penny may be lower than the resource costs of the fuse, but the total costs, which take into account the likelihood of a destructive fire, are undoubtedly higher.”39 Related to the claim that gold is more costly than fiat money and fractional reserves is the claim that using a basket of basic, less expensive commodities as money (such as a basket containing certain quantities of iron ore, aluminum, coal, etc.) would be less costly than gold. I have addressed this argument in chapter 5 in the section on the fallacies of a free market in money and banking. Let me simply reiterate here that, if this is the case, and a basket of basic commodities is superior to gold, then it would emerge in a free market as the preferred type of money. Given that gold won the battle

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for being used as money on a worldwide basis whenever and wherever people have been free to choose, the evidence we have points to gold. One might claim that when gold won the battle, prior to the Industrial Revolution, there were few commodities to compete against gold. In fact, this is not true. The use of iron was so prevalent it even has its own period in human history named after it, as does bronze. In addition, many commodities and other items have served as money in limited areas, including tobacco leaves, shells, livestock, beads, copper, rice, salt, massive stone disks (in the Yap Islands of the Pacific Ocean), and many more. There have been large numbers of basic commodities that could have emerged as money in competition with gold if they were better than gold, either individually or in combination with other commodities. Gold emerged because it is a superior form of money. Some have used the massive inflation in (the former) Yugoslavia in the 1990s as alleged evidence that people prefer fiat money over gold. The inflation was so massive that prices at one point in the early 1990s rose by five quadrillion percent in just over a year. That’s a five with 15 zeros after it! Instead of choosing gold as an alternative, the German Deutsche Mark became the effective currency of Yugoslavia. Why didn’t people choose gold if it is better than fiat money? First, people do not automatically know that gold is better. If they have been taught (erroneously) that fiat money is better and are used to fiat money, then they might believe what they have been told and use the fiat money. People must learn through practice and sound monetary theory that gold is better. Second, during a time of massive inflation people will use the alternative currency that has the greatest stability and is most readily available. In a world of government fiat monies, that will be another government fiat money. There were probably few or no gold coins even available in Yugoslavia in the 1990s. A free market did not exist in Yugoslavia in the 1990s (or Germany or anywhere else for that matter) and so such an example does not detract from what I am saying here about the superiority of gold as money. If fiat money is the best type of monetary system, it will emerge from a free market. If a basket of basic commodities is the best, it will emerge. However, neither of these types of money has ever defeated gold in a free market for the worldwide supremacy as money. This provides more evidence for why gold would use fewer resources than fiat money or another system. The most economically efficient methods of production and exchange emerge from a free market. When people are completely free to trade for what they want and with the medium of exchange they prefer, greater economic efficiency results. So whichever form of money emerges, it will be the most efficient. If gold is so inefficient and ineffective at helping people produce wealth and further their lives and happiness, why do people freely choose to use it? Lastly, some claim that the supply of gold cannot expand fast enough and, as a result, unemployment will rise or the supply of money will not change to counteract changes in the demand for money.40 This is a particularly

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interesting argument given the fact that some economists have argued that the supply of gold money changes too much. One is left to wonder which is true. Does the supply of gold change too much or not enough? I have shown in the previous section that the supply of gold does not change too rapidly. There are also a number of problems with the claim that the supply of gold cannot expand fast enough. First, recall the discussion from chapter 4 regarding the claim that bank reserve ratios will allegedly change to counterbalance mysterious changes in the demand for money. As a part of that discussion, I showed that under a gold standard the demand for money is very stable because the supply of gold is stable. Also, recall that changes in the demand for money come largely from changes in the supply of money under a fiat-money, fractional-reserve monetary regime. It is the rapid and erratic changes in the supply of money under such a system that lead to dramatic changes in the demand for money.41 Based on the above, one need not worry about whether the supply of gold money will respond rapidly enough to changes in the demand for money. Because the demand for money will be very stable there will be nothing for the supply of money to respond to. In fact, not only will the demand for money be stable, but with the slow increase in the money supply under gold and the fact that the monetary unit will retain its value (or even increase in value slowly and steadily), the demand for money will be quite high (i.e., velocity will be fairly low). This means that people will already be fairly liquid and thus have no reason to further increase their liquidity. So on the rare occasion that there might be a significant outflow of gold (say due to a significantly sized country [from an economic standpoint] not previously on the gold standard moving to such a standard), individuals should be able to deal with it fairly easily thanks to the high level of liquidity gold money leads to. What about the issue of gold not being produced in great enough quantities and thus leading to insufficient demand in the economy and chronic unemployment (an argument made by Keynes)? I have addressed this in another context in chapter 2 and the portion of chapter 1 on Keynes. Let me briefly recap. Everyone who wants to be employed can be employed as long as wage rates are free to adjust. This requires complete freedom in the labor markets. Laws such as minimum wage laws and pro-labor union legislation prevent wage rates from adjusting appropriately. Welfare for the unemployed also reduces the incentive for the unemployed to accept work, since they can receive some money for not working at all. Inflation under fiat money and fractional reserves also leads to unemployment when the inflation stops or slows and the financial crisis and recession or depression occur. In a recession or depression, wage rates not falling to adjust to the higher demand for money and lower volume of spending in the economy also tends to retard investment by businesses. It therefore leads to less employment and delays recovery as businesses wait for costs (i.e., wages) to fall so that potential investments become more profitable. The lack of ability of wages to adjust during recessions and depressions is, of course, due to government

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interference as well. So the cause of unemployment is not gold but the exact opposite. It is government interference in the form of fiat money, fractional reserves, and various forms of regulation in the labor markets that increase unemployment.

Conclusion As one can see, the criticisms put forth against gold and 100-percent reserves are not valid. As shown in the section on the benefits of gold and 100-percent reserves, they will actually lead to great improvements in the economy. They will lead to greater liquidity, more stability in the short term and long term, fewer financial crises, fewer recessions and depressions, and a higher productive capability, rate of economic progress and standard of living. Now that we have seen the benefits of gold and 100-percent reserves and why the criticisms against them are not valid, let us take a look in the next chapter at how to transition from fiat money and fractional reserves to a 100-percent reserve gold standard.

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How t o Tr a nsi t ion t o a F r e e M a r k e t i n Mon e y a n d Ba n k i ng

Introduction In this chapter, I discuss how to transition from the current monetary and banking system to one with gold and 100-percent reserves backing all checking deposits and banknotes. I discuss why the gold dollar must be defined with a sufficiently small quantity of gold (or, alternatively, the “price” of gold must be sufficiently high) as a part of the transition. I discuss how the government can make the transition quicker and easier by facilitating transactions in gold, such as by not taxing capital gains from the appreciation of gold. I also discuss how the government must hand over all minting responsibilities to private minters and hand over all gold it possesses (except that which will back the money the government possesses at the time of the change). Additionally, I discuss how the transition can take place without a financial contraction. I also discuss many other issues that must be grappled with in the transition to gold. Finally, I critique a number of alternative plans to transition to a gold standard or monetary systems that incorporate gold in some way.

The Transition to a Free Market in Money and Banking The transition to a free market in money and banking should occur as quickly as possible. It should involve the complete abolition of government involvement in money and banking, including the abolition of the Federal Reserve, the Federal Deposit Insurance Corporation, and all regulations pertaining to money and banking. The first task that should be performed once the nation is ready to make the change is the backing of all money with gold (including Federal Reserve Notes, coins, and checking deposits) and the transfer of US government gold to individuals and private banks. After the money supply has been fully backed by gold, the Federal Reserve and other regulatory bodies can be easily abolished. Securities owned by the Fed should be transferred over to private banks on a pro-rata basis. This will be the easiest way to make the transition. It will be much easier and less costly

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than selling these assets to the general public. It will start the new banking and monetary system off on the most sound footing possible and make the transition for the general public as smooth as possible. In this section, I provide a brief outline of what needs to be done. For more details of some of the elements of the transition, see the following works: George Reisman, Capitalism: A Treatise on Economics ; Richard M. Salsman, Breaking the Banks: Central Banking Problems and Free Banking Solutions ; and Murray N. Rothbard, The Mystery of Banking.1 My plan is essentially the same as those of George Reisman and Murray Rothbard, since their plans are virtually identical. However, Richard Salsman provides a few details that are important to incorporate. Most of the time during the transition should be spent planning for the actual movement from the current to the new system. This will take a significant amount of time. Once the specifics of the change are established, it should occur very quickly, with the transfer of assets and the abolition of regulations and the government bodies that enforce them taking place in a short period of time. The change can take place in this manner because once the money supply is backed fully by gold, it will be on an extremely sound footing and will not require propping up by the various regulatory schemes that the current system requires (such as deposit insurance and bailouts by the Fed). In addition, because the regulations create perverse incentives for—and, indeed, require—banks to engage in unsound banking practices, it will not be beneficial to allow the regulations and the agencies that enforce them to remain in existence after the monetary system has moved to gold. Banks and individuals in general should be left to sink or swim on their own so they have the strongest motivation possible to act in a financially sound manner. Besides determining the details of the change and preparing to make the change, one reason for taking significant time to get to the point at which the change will take place is to provide enough time for the price of gold to rise sufficiently. The price of gold must rise substantially to cover all the dollars in existence because the US government has inflated the money supply massively since we have been off gold. How high the price of gold needs to rise will be discussed below. However, there are a number of steps the government can take prior to the change to get people accustomed to using gold and enable its price to rise. For example, the government should not tax the purchase or sale of gold. No sales or excise taxes should be charged and no capital gains taxes should be imposed on the money people make from the rise in the value of gold. In addition, there should be no restrictions on the importation of gold. This will help bring in greater quantities of gold and reduce the price of gold necessary to back all dollars in existence (to the extent the government comes to possess it). The government should also start collecting a portion of taxes in gold and slowly increase the percentage of taxes collected in gold. After the transition has been made, the government should

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only accept payments made in standard money or money substitutes backed 100 percent by standard money. As part of a broader movement for government reform, and what would help in the transition to gold, the government could begin selling off assets for gold that have nothing to do with its proper function of protecting individual rights (and which the government should therefore not own). These assets include but are not limited to national parks and other government land holdings in the West and Alaska. They also include the Post Office and Amtrak. All of these actions would help get people used to using gold and increase its value before the change to the new monetary system takes place. Further, any additional gold obtained by the government from the sale of assets during the transition period could be used to back the money supply existing at the time of the change to the new system. Very importantly, during the transition the government should also protect the right of individuals to use gold in transactions. So if individuals want to engage in contracts that are partially or fully payable in gold, such contracts should be enforced in the courts. Further, any gains from these contracts due to a rise in the price of gold should not be taxed. Sellers should also have the right protected to discriminate between gold and the government’s paper money before the change to the new system takes place. Gold must be able to compete freely with the government’s paper money, so laws such as legal tender laws must be abolished well before the change to the new system takes place. After the change to the new system takes place, all creation of money, including the minting of coins and issuance of notes, should be performed by private entities (private minters and banks). To help the transition to private money go more smoothly, banks and minters should be allowed to use the seal of the United States on their coins and notes for a limited amount of time until people become familiar with the private coins and notes. In addition, holders of Federal Reserve Notes should have only a limited amount of time to redeem their notes for gold from the US government. After that time period, it should not be possible to obtain gold or any other form of standard money in exchange for the notes. After this period, Federal Reserve Notes may still be accepted as money—although I highly doubt it—but it will be up to individuals to decide whether they want to accept them, as it will be up to individuals to decide about all forms of money to accept in trade. No government regulations will force any kind of money on people in trade. The only requirement with regard to what money will be accepted in transactions that the government could impose is in connection with the money it receives. The government should only accept in payment either standard money or notes and checks fully backed by standard money (whether for taxes, any other government fees, or the proceeds of a loan). If people pay the government with a form of money that is not fully backed, the government should be required by law to redeem it for standard money within a very short period of time. The government should not hold for significant

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periods of time or use in its daily transactions any form of money that is not standard money or fully backed by standard money. It is important that all government gold used to back the money supply existing at the time of the change to the new system be handed over to banks and individuals. The government should hold no standard money used to back the money supply. Of course, the government will need to retain gold for its own monetary needs. However, as I said in chapter 5, it should create no money on its own. Once the change to the new system has taken place, the Federal Reserve System, Federal Deposit Insurance Corporation, and other regulatory bodies (and the regulations they enforce) can easily be abolished. The Fed should engage in no open-market operations once the change has taken place and its activities should be reduced throughout the transition. Any financial assets on the Fed’s balance sheet (including government securities) should be transferred to private banks on a pro-rata basis, along with any capital on the Fed’s balance sheet. Any liabilities should either be paid off (such as in the case of deposits held for banks) or transferred to private banks on a prorata basis. Nonfinancial assets on the Fed’s balance sheet, such as buildings and land, can be sold by the government for gold. The sale of assets could also be completed during the transition phase to help increase the value of gold and get people accustomed to using it. However, at the latest the assets should be sold as soon as possible after the change. The Treasury securities on the Fed’s balance sheet should not be written off. As I state, they should be transferred to private banks. While neither of these choices is fundamental to the transition, the best option is to transfer government debt to private banks so the government must repay it. This will help instill a measure of financial austerity and discipline in the government during the change to the new system. If the government debt is merely written off, it may make it too easy for the government to begin borrowing anew once the change has taken place. While it is appropriate for the government to borrow in some cases (even in a free market), one does not want to make it too easy for it to do so, especially at the creation of the new monetary and banking system. It is best to require the government to pay off debt it had previously owed to the Federal Reserve System, except of course the debt will now be repaid to private banks. Once under the new system, the right of banks to engage in any kind of business activity they wish should be protected. This includes but is not limited to commercial and investment banking, insurance, mining gold, and opening branches anywhere they see as necessary. Banks should pursue whatever business opportunities are in their self-interest. The banks, their shareholders, depositors, and creditors will bear the consequences, whether good or bad. The government will need a bank to hold its money and process transactions (both the receipt and payment of funds) after the change to the new system takes place. As I state in chapter 5, no government (whether federal, state, or local) should put its money in any private bank. This is necessary

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to separate the government as much as possible from the private sector. Governments should keep their funds only at government banks. The government banks can interact with the private banking sector through private clearinghouses that have been established through the free market. Of course, the government may attempt to reward some private clearinghouses and punish others. To avoid this, strict and well-established rules as to how the government should do business with the clearinghouses should be followed. The government should not arbitrarily favor or punish any clearinghouse (or any business at all for that matter). It should use whichever private clearinghouses are necessary to transact its daily business of protecting individual rights. The name “Federal Reserve” should not be used to make it clear that the new government banks are in no way connected to the old system. These banks will have no ability to manipulate the supply of money and credit or regulate the banking system. If some assets of the Federal Reserve System (such as buildings or land) can be appropriately used by the new banks, it would obviously make sense for the government to retain those assets. However, these new banks would not hold any government debt. As I also state in chapter 5, these banks should engage in no lending of any kind (whether to any government or anyone else). They merely take in and dispense funds for the government. Movement from a fiat-money, fractional-reserve monetary system to gold can end inflation without a massive financial contraction and recession or depression during the transition. The key is to define the dollar so that the “price” of gold is high enough to allow the stock of monetary gold in the country to cover all the money in existence, both in the form of checking deposits and currency held by the public. For instance, if the stock of gold in the United States at the time of conversion to the gold standard is 260 million ounces and the money supply is $4.2 trillion (the approximate values in 2012), then the dollar must be defined so that the “price” of gold is over $16,000 per ounce (= $4.2 trillion / 260 million ounces).2 In this case, every dollar in existence will be fully covered—100 percent—by gold. This implies that the dollar is defined as approximately one-sixteen thousandth (1 / 16,000) of an ounce of gold. In the above paragraph, as in other chapters, I put the word “price” in quotation marks because, in fact, there is no price of gold under a gold standard. The monetary unit is defined in terms of a quantity of gold. This definition establishes the value of gold in terms of the monetary unit. A significant amount of dollars circulate outside the United States, including as the official currency for some countries (such as Panama). These dollars should be included in the calculation to determine the “price” of gold; however, only monetary gold within the United States at the time of the transition should be included. Holders of dollars outside the United States should have the same amount of time to redeem their dollars for gold from the US government as those inside the United States. If they do not redeem their dollars, the gold should belong to the US government and the government

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should be allowed to spend the gold as a part of its normal operations. This may lead to an increase in the amount of spending in the United States. However, a one-time increase in spending should not be feared. Why this should not be feared will be discussed below. Some might think that such a high price of gold will create great dislocation in the economy because the price will have to rise dramatically and make it difficult for those who need to purchase gold to obtain it. It is true that some problems may be created, but the alternative is worse: more inflation and periodic financial crises, recessions, and depressions. Most people will not have any problem obtaining the gold they need because, as I have stated, as a part of the transition the government will hand its gold over to those who hold dollars. Once the transfer of gold is made, checking deposits at banks will be fully backed by gold instead of largely backed by loans as they are now. The transfer of gold necessary to do this will represent a dramatic increase in the capital and assets possessed by banks. The transfer of capital, liabilities, and other assets from the Fed’s balance sheet will also expand the balance sheets of banks by a large amount. However, these transfers are necessary to move to a monetary system that protects rights, creates stability, and fosters economic progress. The increase in assets and capital of banks, due to the transfer of gold, will be equal to the amount of fiduciary media that are implied on their balance sheets. For example, assume a bank has $100 in checking deposits backed by $10 of reserves and $90 of other loans. Assume also that these are the only assets and liabilities the bank has and that it has no equity capital. In this case, $100 of gold must be transferred to the bank to back the checking deposits. This will replace the $10 of fiat-money reserves. These will be written off. The remaining $90 of gold will increase the equity capital of the bank. Therefore, after the transition the bank will have checking deposit liabilities of $100 and assets of $100 in reserves and $90 of other loans. To achieve equality on the balance sheet the bank will also have $90 of equity capital. At least one economist claims that gold should not be transferred to the banks during the transition because the banks have allegedly expropriated wealth for themselves through the lending of reserves that back checking deposits.3 This conclusion is not valid for a couple of reasons. First, while the banks obviously chose to make the loans, they are not the ones ultimately responsible for the existence of fractional reserves. Government interference is to blame. It is government interference that makes it possible for banks to engage in fractional-reserve banking, as I show in chapter 4. Fundamentally, the banks cannot be blamed for the political system that exists, even if some or all of them have lobbied for regulations that led to the ability of banks to engage in fractional-reserve banking. The political system we have is a function of the fundamental philosophical ideas prevalent in our culture, primarily the moral and epistemological ideas.4 The fact that any individual or business (not just banks) can lobby for government favors and

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regulations is the fault of statist ideas that dominate our culture and create our mixed economy. This implies that leftist intellectuals who originate and advocate such ideas are primarily to blame. Secondarily, leftist politicians (including both Democrats and Republicans) who enact statist laws are to blame. Those who lobby for regulations and favors are culpable only at a tertiary level. They would not be able to engage in these activities if not for the existence of the first two. In addition, even if banks engage in some fractional-reserve banking without the existence of government interference that promotes such banking, it would not be an expropriation of wealth. I have shown that fractionalreserve banking as such is not fraudulent. As long as banks do not attempt to hide what they are doing, the lending of reserves backing checking deposits is a perfectly legitimate, voluntary transaction in which to engage. Let me emphasize that I mean legitimate from a legal standpoint. As I have shown, it is economically unsound and philosophically corrupt. The above paragraph also applies to the context of a mixed economy with government interference promoting fractional-reserve banking. Banks in recent history have not attempted to hide the fact they are engaging in fractional-reserve banking. Anyone can verify what the banks are doing by looking at their balance sheets. Putting the blame on banks takes the focus off the two parties that make such a system possible: statist intellectuals and their politician counterparts. Shifting the focus back to the rise in the “price” of gold, not everyone will face greater costs as a result of the increase in this “price.” Those who currently possess large amounts of gold will be better off, such as gold mining companies. Only those who need to purchase gold for industrial or other nonmonetary uses will face more difficulty (such as jewelers). This is the nature of a price increase: some benefit (sellers) and some do not (buyers). While it is true that some will be harmed in the short run due to the move to a 100-percent reserve gold standard, everyone is being harmed now and will continue to be harmed over the long run by inflation. Therefore, the key is to move to a gold standard as soon as possible and make the transition as quickly as possible to eliminate the harmful effects of inflation as soon as possible. It is not the transition that is ultimately to blame for any harmful short-term consequences caused by the transition. It is the violations of individual rights that currently exist and that make the transition necessary that are to blame. This includes the violations of rights that have led to the need for such a high “price” of gold. The alternative to making the transition would not only be morally wrong because it would allow the violations of rights to continue, it would also be economically destructive. The “price” of gold might not have to be as high as stated above. The unilateral movement to a gold standard by the United States will probably attract some inflows of gold from other countries. This will increase the potential monetary supply of gold in the United States and thus reduce the defined price of gold necessary to cover all the government fiat money in existence (to the extent the government gains possession of this gold prior

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to the change to gold). Nonetheless, the inflows of gold will probably not be that large. Most of the impact of the transition, if the United States was to move unilaterally to gold, will probably be experienced through a rising worldwide price of gold. It is not that important to define the dollar such that the supply of gold exactly covers the amount of government money. The key is to make sure, at a minimum, the government’s fiat money is covered. In fact, it would be best to define the dollar so that the initial supply of gold money exceeds the supply of fiat money in existence at the time of the movement to gold. This can be thought of as a last, one-time bout of inflation. This would be beneficial to ensure that spending in the economy does not decline. This last, one-time bout of inflation will not create an inflationary expansion because it will only be one time and it will be well-known why it is occurring. Hence, people will know it is a purely monetary phenomenon and not react to it with changes to their real economic activities. Prices of goods (except, of course, gold) will tend to remain constant in terms of dollars or only slightly increase to the extent the spending stays the same or only slightly increases during the transition. The velocity of money will most likely decline initially in the move from fiat money to gold. Setting the “price” of gold at a high enough level is extremely important to offset the decline in spending the decreasing velocity will cause. Spending, revenues, and incomes must at least remain constant to prevent mass defaults and bankruptcies. In essence, one wants to prevent a financial crisis and depression from occurring due to the transition. Of course, one should take care to ensure that spending and prices do not rise too much because this will harm lenders. Part of the problem of what “price” to establish will be solved once it is announced that movement to a complete free market and corresponding gold standard will be made in the near future. This will cause the price of gold to rise significantly before the movement to a gold standard and will provide a better idea of what the “price” at the transition needs to be. In addition, once it is known the movement to gold will take place in the near future, gold should start to flow into the country. This will provide a better idea of the stock of monetary gold that will ultimately end up in the country. The defined price of gold necessary to exactly match the amount of spending in fiat money at the time of the transition will be dependent on the total quantity of fiat money and total spending in fiat money at the time, as well as the estimated amount of gold money that will exist in the United States at the time of the transition and the velocity of the gold money. One will have to estimate how much gold will flow in from abroad to estimate the stock of monetary gold that will exist. This will be higher if the United States moves to gold unilaterally and lower the larger the number of economically significant countries that move to gold simultaneously. One can get a minimum estimate of the total amount of gold that will exist in the United States by calculating the world supply of potential monetary gold and using the percentage of US output relative to world output

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to determine the portion of the world’s supply of gold that will end up in the United States. The figure will be significantly higher should the United States move to gold unilaterally. It would be best if the entire world moves to gold at the same time; however, if no other countries move to gold, the United States should do so unilaterally. It will benefit far more with all countries on gold but will certainly benefit enormously if it alone moves to gold. Some people might attempt to rationalize sticking with fiat money because no one else moves to gold. This would be like a person handicapping himself in a sporting event (such as a runner shooting himself in the foot) just because everyone else does. If we move to gold by ourselves, we will gain all the possible benefits from being on gold and other countries will continue to experience the ill effects of the inflation of their own money supplies. Unfortunately, we too will experience some ill effects due to the inflation by other countries of their money supplies to the extent we have dealings with them, but the unilateral move to gold will at least eliminate the ill effects due to the inflation of the US money supply. If the United States moves to gold unilaterally, there is the possibility that it will come to possess a disproportionately large amount of the world’s supply of gold. This could lead to an outflow of gold when the rest of the world moves to gold. This does not necessarily present a problem for individuals in the United States. As long as they maintain sufficient liquidity, they will stand to benefit from the inflow and later outflow of gold. They will benefit because they will import the gold at a relatively low price (before any other country moves to gold and thus has a greater demand for it) and will export it at a higher price (after more countries move to gold and thus have a greater demand for it). In fact, much of the gold may flow in before the United States officially moves to gold. It might flow in during the time when the move to gold is still being discussed and planned. This will make the price at which people in the United States obtain the gold and the price at which they sell it even more profitable. A worldwide gold standard will create a completely unified worldwide monetary system and make international trade much easier. There will be no need to be concerned with fluctuations between different currencies if they are all fixed to gold. In fact, gold currencies are the only currencies compatible with fixed exchange rates. Fiat currencies are incompatible with fixed exchange rates because governments forcibly impose fiat currencies on the market to manipulate and inflate them. That is why the fixed rates often break down and why such currencies are generally so unstable relative to other currencies. Fixed exchange rates under gold mean there will also be no reason to use resources to hedge against the depreciation of currencies (to the extent countries are fully committed to gold). As a result of the worldwide use of gold money, international trade will be much more transparent and less costly. In connection with the dislocation caused by the high “price” of gold, at least one writer believes it will lead to higher prices in general for goods,

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massive importations of gold if the United States moves to gold unilaterally, the destruction of all dollar savings, and a reduction in international trade because trade depends heavily on the dollar.5 These claims are mistaken because they assume the value of the dollar will decline with respect to all goods. This is not true. The value of the dollar will decline only with respect to gold. This reflects the greater importance and demand for gold since it will be used as money. However, as I state above, the key is to make sure the amount of dollar spending in the economy remains the same or only slightly increases during the transition. Hence, the dollar demand for other goods will be approximately the same and thus the prices of other goods will tend not to change. What will change are the prices of other goods in terms of gold after the transition relative to the implied prices of other goods in terms of gold before the transition. These prices will fall dramatically. However, this is not a problem since gold is not used as money before the transition. All the lower prices of goods in terms of gold do is make it so the monetary stock of gold can purchase all other goods; that is, they make the spending in terms of gold after the transition the same as the spending in terms of dollars prior to the transition. This is what helps to make the transition a smooth one. If the United States moves to gold unilaterally, massive amounts of gold will not be imported due to the high “price.” As I state above, some additional amounts might be imported but worldwide gold markets move largely in synchronization. The new definition of the dollar in terms of gold will quickly cause the worldwide price of gold to rise dramatically. Most of the impact of the change will be in the form of higher worldwide gold prices instead of inflows of gold. As a part of this, and as a general part of the transition, the value of currencies might change relative to the dollar. There may be more demand for foreign currencies to purchase gold in foreign gold markets, which will cause the value of the dollar to decline in foreign exchange markets. However, at the same time, there might be more demand for the dollar with the move to gold because it will mean the dollar will tend to appreciate over time relative to other currencies, as other countries inflate their fiat monies. The change in the value of the dollar relative to foreign currencies will cause losses for some and gains for others but it should not cause significant problems. For example, as the dollar appreciates, foreign exchange traders who hold dollars and those with most of their business in importing to the United States (or exporting from other countries) will benefit, while foreign exchange traders who hold foreign currencies and those with most of their business in exporting from the United States (or importing to other countries) will lose. As long as those with losses do not have too much of their business tied up in the losing ventures, they should be able to survive. They might even be acquired by those who have gained from the change to gold. In addition, the change will not destroy the dollar value of savings. It will only decrease the gold value of savings; that is, total savings after the transition will be equivalent to a smaller quantity of gold relative to its gold

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equivalent before the transition. This, again, is not a problem since gold is not used as money before the transition. Finally, foreign trade will not be reduced dramatically either because of the reduction in the value of the dollar in terms of gold. The volume of trade will probably be the same or perhaps even rise (at least in connection with the United States and its trading partners and other foreign trade denominated in dollars) because a significant source of instability and uncertainty in foreign trade will be removed: the government’s manipulation of the supply of dollars.

Alternative Plans That Incorporate Gold into the Monetary System A number of other plans have been proposed to move to a gold standard or a system that incorporates gold into the monetary system in some way. Most of them are fundamentally different than the plan outlined above because they do not propose to move toward an actual gold standard but only to a monetary system that is linked to gold or includes some role for gold. They also differ in that they generally do not attempt to establish a free market in money and banking. Let us take a look at some of these plans. Most of the alternative plans I discuss here are addressed in the excellent article by the economist Joseph Salerno titled “The Gold Standard: An Analysis of Some Recent Proposals.”6 He analyzes a number of proposals that incorporate gold. The main virtue of this article is that the proposals he analyzes cover a wide variety of alternative systems that are not particular to any one individual but are similar to monetary systems that many individuals have proposed or that have actually existed in practice. The proposals analyzed in his article are, for the most part, fundamentally different than a gold standard. His critique of each system is very thorough. I briefly summarize it here. The first plan is the gold certificate plan. Here the Federal Reserve would be legally required to maintain a reserve of gold certificates whose value would be legally fixed in proportion to the Federal Reserve Notes outstanding. The value of gold would be fixed by law but periodically increased at a stipulated monthly rate to allow for some growth in the money supply. This plan is similar to the Bretton Woods System prior to 1968, when the value of gold was fixed at $35 per ounce. The difference with the Bretton Woods System is that the value of gold did not change under that system. As Salerno points out, this is not a gold standard at all but is closer to a monetarist system in which the money supply is increased at a fixed rate. Such a system does not establish a free market in money and banking. For instance, there is a prominent role for the Federal Reserve. Such a system falls victim to all the critiques I have made of government interference in money and banking throughout this book. As Salerno also points out, the system could easily be amended or abandoned to manipulate the money supply to an even greater extent than is incorporated in the basic system should an “emergency” arise.

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Another plan is the gold “price rule.” This plan involves fixing the price of gold based on the price that prevails in the gold market on a preestablished day in the future. Once the price is set, from then on the Federal Reserve will stand ready to redeem gold for dollars and vice versa at that price. The Fed will also attempt to keep in its possession, at some point after the price is fixed, a level of gold reserves that represents a specific portion of its outstanding liabilities, although some variation in this will be allowed. The Fed will still engage in monetary policy (such as open-market operations) but will be constrained somewhat by the “fixed” price of gold. I say constrained somewhat and put “fixed” in quotation marks because there are provisions to abandon the established price of gold should the need arise. As Salerno points out, this is also not a gold standard. This system is similar to the Bretton Woods System. There is significant government interference and it is certain that some “need” would arise to rationalize the abandonment of the fixed price. This system, too, falls victim to all the criticisms of government interference in money and banking in this book. Another proposal is to define the dollar in terms of a fixed amount of gold and have Federal Reserve Notes and dollar-denominated checking deposits become warehouse receipts for gold. This is similar to the “classical” gold standard that existed prior to World War I. This is closer to a free market in money than the previous two proposals but still allows for a significant amount of government interference in the form of a central bank (i.e., the Federal Reserve). The Fed is a statist institution and, as I have stated, its creation represented a significant step off the gold standard. While the Fed would be constrained if a gold standard of this type was established, its ability to regulate the market represents a significant violation of individual rights and could easily be used to rationalize greater violations. Even if one abolished the Fed and went back to the “classical” gold standard that existed prior to World War I, while it would be much better than the system we have today it would not be a free market in money and banking. As I have stated, there was significant government interference in the US monetary and banking system prior to World War I, including state deposit insurance schemes, the imposition of national banknotes imposed by the federal government, capital requirements, and more. Such a system led to financial instability and periodic financial crises, recessions, and depressions to the extent that government interference existed. Such episodes were often used to rationalize greater government interference for the alleged purpose of preventing future financial and economic disasters and would certainly be used to rationalize greater government interference again in the future if this type of system was established. A proposal for a parallel, private gold standard has also been put forward. This would be a gold standard that exists alongside a government fiat-money system. This plan would also involve the privatization of the Fed. The regional Federal Reserve Banks would be turned over to the private banks that could then use them as clearinghouses (or, presumably, shut them down if so desired). Gold would then be used alongside of the fixed amount of Federal

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Reserve Notes in existence. A variation on this plan that has been put forward does not call for the immediate abolition of the Fed but would establish a parallel gold standard that would compete with the government provided money. Under this latter version, the government would still manipulate its fiat money but could not prevent private notes from being used, contracts from being stated in terms of gold, private firms from minting coins, and foreign currency from being used in daily transactions. The belief is that, under either system, a gold standard would eventually be established. The first thing to note is that neither of these scenarios represents a free market in money and banking. The first scenario comes closest with the abolition of the Fed. However, the system still retains the fixed quantity of government money that had been created before the existence of the parallel system. Eventually such a system would probably give way to a gold standard, but why not abandon the government interference completely, right from the start. Gold has prevailed as the worldwide money people have chosen when they have had the freedom to do so. Establish that as the free market baseline and if people want to use a fiat money in their transactions, such a system would emerge from the marketplace. In the establishment of a free market, no aspect of government interference or remnants of government interference should be countenanced. Under the second scenario, it certainly would be the case if the government did not sabotage the competition between its money and gold that gold would prevail as the government inflated the supply of its money to finance its spending. Of course, the government would have a much stronger incentive not to inflate its money supply given the competing alternatives available. However, given the precedent of allowing government interference in the system, in the form of a government provided fiat money, it is virtually certain that more government interference would follow to prevent competition from taking place with the government’s fiat money. The key to getting rid of government interference is to completely abolish it from the beginning. While some of the above proposals are better than others, none represent a free market in money and banking and thus all have at least some flaws. The system I propose will establish a free market in money and banking. It is fundamentally different from the alternatives that have been discussed in this section. However, there are two systems of transition to a gold standard that I have yet to discuss. I now turn to an exposition and analysis of these methods of transition. The economist Jesús Huerta de Soto proposes a plan to transition to a 100-percent reserve gold standard.7 He believes the only way to maintain 100-percent reserves is to legally require them. I show in chapter 4 that this is not necessary and provide refutations of a number of his arguments and the arguments of other economists who believe the same. Here I show that Huerta de Soto’s plan for transitioning to a 100-percent reserve gold standard is not a good plan. It has too many steps and is needlessly complex. There are many details of the Huerta de Soto plan that I purposely do not

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discuss. My goal here is to focus mainly on the deficiencies to demonstrate why it is not a good plan. See his book for the full details of the plan. Some features of his transition are the same as what I propose. For example, he wants to eliminate the central bank and all government regulations in money and banking. He also wants to define the dollar at a sufficiently high “price” of gold so that all outstanding checking deposits and bank notes are fully backed. The main problem is that Huerta de Soto does not want to hand gold reserves over to banks to back their checking deposits 100 percent because he thinks that this would be an undeserved gift for bankers. He considers them culpable in the creation of fiduciary media and believes they have obtained undeserved gains from its creation.8 I have discussed this above and shown that the bankers are not, ultimately, responsible for the existence of fiduciary media. They are merely acting within the legal context that has been created by the government and should not be blamed since a bank could not survive in such an environment if it attempted to engage in sound banking practices (the type of practices it would have to follow in a free market). In fact, banks have been victims of government interference in money and banking because gold was confiscated from them and handed over to the Federal Reserve shortly after the creation of the Fed. Instead of defining the dollar in terms of a small enough quantity of gold and handing the gold over to bankers and Federal Reserve Note holders, which would be the easiest way to transition to a 100-percent reserve gold standard, he wants to turn banks into, in essence, mutual-fund companies and bankers into mutual-fund managers. His plan is designed to prevent bank shareholders from receiving substantial capital by handing back gold possessed by the government to the banks. His first step in turning banks into mutual-fund companies is to give depositors the option to replace their demand deposits with shares in a mutual fund managed by the bank that would consist of assets of the bank equivalent in value to the demand deposits replaced. These mutual-fund accounts would have no check writing features.9 This leaves one to wonder why depositors of money (i.e., demand depositors) would want to receive shares in assets, at the time of the transition, that are not money. If these depositors wanted mutual-fund shares in highly liquid assets, they would have purchased money market mutual funds (MMMFs)—or their competitors at banks: money market deposit accounts (MMDAs)—prior to the transition. MMMFs and MMDAs are more liquid than the mutual-fund accounts Huerta de Soto proposes, since one can write checks on the former accounts but not on the latter. Therefore, it is hard to believe depositors will take the mutual-fund shares offered by Huerta de Soto. Nevertheless, the choice to trade one’s demand deposits for mutualfund shares is at the option of the depositor, so bank accounts will probably remain as they were prior to the transition. The transition could be made much easier if this option was eliminated altogether. He then states that the central bank should print “legal bills”—a new kind of government paper money—to back all remaining demand deposits.10 This step could also be eliminated. What is the purpose of backing demand

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deposits with another fiat money in the process of transitioning to a gold standard? That is not a step in the direction of gold. It would be easier to establish the right “price” of gold so that it can back all demand deposits and outstanding government banknotes 100 percent. One could then simply hand the gold over to banks (and note holders) without the step requiring that checking deposits be backed 100 percent by another fiat money. After creating “legal bills” to back all demand deposits (and other checking deposits), Huerta de Soto then wants to transfer more bank assets to mutual funds and hand the shares of ownership in these mutual funds over to holders of Treasury bonds for the cancellation of the debt the bonds represent. Where possible, other government liabilities should be replaced with these mutual-fund shares (such as Social Security obligations).11 For example, Social Security recipients might receive the present-value equivalent, paid in these mutual-fund shares, of the future Social Security payments owed to them. Huerta de Soto is not clear exactly what portion of bank assets he wants to convert into mutual funds. The portion he mentions ranges from bank assets equivalent to the amount of checking deposits to the amount of bank assets reduced by the net worth and Treasury bonds on bank balance sheets. The Treasury bonds on bank balance sheets would be cancelled. Assets equivalent to the net worth would be retained by bank shareholders.12 The lack of clarity regarding the amount of bank assets to convert makes it uncertain how much government debt would be cancelled under Huerta de Soto’s plan. Adding to the uncertainty is the fact that the respective market values of the outstanding government debt and the mutual-fund shares at the time of the conversion are not precisely known. Nevertheless, no attempt should be made to cancel any of the debt. As I have said, the government should be required to pay off its debt to instill some financial discipline in the government. Additionally, it is important to recognize in connection with this issue that Huerta de Soto is not willing to give the banks a gift but has no problem giving a gift to the government in the form of potentially absolving it of all its debt. The gift to the government is certainly the worst of the two options. Given the uncertainty of how much government debt will be cancelled under Huerta de Soto’s plan and the fact that the government will have to pay off all its debt under my plan, what should be done if the government cannot pay off its outstanding debt after the transition to a gold standard? If this occurs, which is unlikely, the government’s bankruptcy should be explicitly recognized. This will help instill greater financial responsibility throughout the economy. It will be on display for everyone to see that this is what happens if you act in a financially irresponsible manner. It will let people know that there is a very real risk to lending to the government. Hence, it will make people less likely to lend to the government and lend only at higher interest rates (rates commensurate with the risk). I say it is unlikely that the government will be unable to pay off its debt because as a part of any move to a 100-percent reserve gold standard there must first be financial reforms in government spending. Spending must be

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drastically reduced so that massive surpluses are achieved. This will require drastic reductions in welfare spending (and its eventual abolition). Decreases in spending are needed because the government will not be able to finance its spending by printing money and it will not be able to borrow from private lenders at artificially low interest rates due to the perceived lower risk of the government because of its ability to print money. In other words, movement to a gold standard must be just one part of an overall movement to laissezfaire capitalism. If government spending is reduced drastically, then the surpluses that are achieved could be used to pay down debt. Once the debt is paid off, taxes could be reduced.13 Finally, the Ludwig von Mises scholar Bettina Bien Greaves presents a plan to transition to a gold standard in a paper in The Freeman: Ideas on Liberty titled “How to Return to the Gold Standard.” I referenced this paper above in the section on the transition. I will not elaborate on all the details of her plan. As with Huerta de Soto’s plan, I focus mainly on the deficiencies of the plan. Also as with Huerta de Soto’s plan, there are a number of similarities between my plan and Greaves’s plan. For example, she wants gold coins to circulate and she wants to transfer gold from the government to banks and individuals. There is one major deficiency in her plan. It stems from her erroneous belief that the high “price” of gold necessary to back all outstanding notes and checking deposits under a gold standard would cause prices in general to rise, erode the value of people’s savings, and cause other disruptions in the economy. I have revealed the errors in these claims in the previous section. However, because of these erroneous beliefs, she, in essence, wants to use the market price of gold on the day of the changeover to gold to establish the legal definition of the dollar. At the same time, she wants to avoid deflation and back all outstanding money 100 percent. But if these latter are to be accomplished, the “price” of gold must be set at the appropriate level, one that ensures that all dollars are backed with gold and that spending does not decrease, regardless of what the price of gold is in the market just before the change occurs. As I have said previously in this chapter, what the “price” must be depends on the projected velocity of money under a gold standard, as well as the spending in dollars and the amount of gold that exists in the country at the time of the change. Once it is determined what the definition of the dollar must be, the price in the market will tend to move toward that level, but the required definition of the dollar must drive the price prior to the change, not vice versa. One can look to the market for gold prior to the changeover for indications of what the “price” should be but the “price” ultimately has to be determined by the variables mentioned here. If Greaves’s plan is followed and the market does not establish a high enough price, it will not prevent the deflation she wants to avoid. Likewise, if the market price is too high, it will needlessly increase the amount of spending in the economy. So the “price” of gold should not be determined in the market.

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Conclusion We can transition to a 100-percent reserve gold standard with minimal disruption. After a lengthy education and investigation phase, during which the necessary values of variables that will be used to make the transition to a gold standard can be established (such as the “price” of gold) and people can be informed of what a 100-percent reserve gold standard means, the actual move to gold and 100-percent reserves should occur as quickly as possible. Gold should be handed over from the government to individuals and private banks and all regulations and the regulatory bodies that enforce them should be abolished. Throughout history, returns to sound money have brought economic booms.14 These booms have not been permanent because governments have not been consistently committed to protecting individual rights and freedom. There is no reason why we cannot have a permanent economic “boom” if governments once-and-for-all stick to performing this task—their only legitimate function.

E pi l ogu e

T

here are grave consequences in allowing the current monetary and banking system, with its significant government interference, to exist. In fact, there are grave consequences in allowing all government interference to exist. It has led to slower rates of economic progress in the United States. As the interference grows, the slower rates will turn to economic stagnation and, eventually, regression. The ultimate end is the collapse of the United States in a growing tide of statism. No one can say when or if the collapse will occur. It could be in 50, 100, or 200 years. It is impossible to make a prediction of the exact timing of a collapse or whether a nation will continue down the destructive path it is headed. However, one prediction that can be definitively made is that if the current trends continue, the collapse will occur at some point. As I discussed in chapter 7, we have the precedent of the fall of the Roman Empire as evidence. If you think you do not have to worry about these issues because you will not be alive when the collapse occurs, think again. It might be true that you will not be around for the final collapse; however, things will get progressively worse as time goes by and you, your children, and grandchildren will experience these tougher times. So attempting to implement a free market in money and banking (and the rest of the economic system) is in your self-interest. We may not get to a complete free market in your lifetime, but the steps forward will be improvements from which we can all benefit. Furthermore, even if enough changes do not take place to improve the state of the economy, the changes that do occur could be enough to slow the rate of collapse. This is still a benefit. Even if one only gets to experience it in the form of a reduction in the harm that occurs. If government interference in the monetary and banking system (and elsewhere) is so bad, why do we have so much and why does it continue to grow? Those are good questions, and the answers are not the subject of this book. I have answered these questions in my book Markets Don’t Fail! Ayn Rand has provided the answers in her works, which is where I get them from. Briefly, government interference exists and grows because people consider it morally good. They consider it morally good because of the wide acceptance of the morality of self-sacrifice. Government interference is used to force some people to sacrifice themselves to others. For example, it is claimed that interference is needed to redistribute income, to “protect” the natural environment, to force bankers

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to lend to poor individuals, to bail out large companies and banks, to prevent profit-seeking bankers from allegedly taking advantage of customers, to keep interest rates low, to provide deposit insurance, and more. Government control of the monetary and banking system is a part of implementing the barbaric code of sacrifice. For instance, the Community Reinvestment Act of 1977 sacrifices banks to poor individuals by forcing banks to lend to poor individuals for the purpose of such individuals purchasing homes that, in reality, they cannot afford. In addition, the use of fiat money makes it easier for the government to finance its spending and thus allows it to expand its control over the economy. This makes it easier to engage in such activities as redistributing income, regulating the monetary and banking system, and imposing regulations that sacrifice people to “the environment.” These activities raise costs in the economy, undermine the productive capability, and lower the standard of living. Despite the harmful results to which the morality of sacrifice leads, as long as people consider it an ideal, they will rationalize away any harmful results by blaming them on other factors (such as bad people abusing allegedly good ideas, which is what the failure of socialism is often blamed on). One might ask here why people accept a bad code of morality if it leads to harmful results. The answer I will limit myself to here is that people are not omniscient and are not guaranteed to discover the right answers. The code of sacrifice has been accepted more or less throughout human history. It is only recently that Ayn Rand has developed and fully validated an alternative—the morality of rational self-interest—that promotes human life instead of undermining it. Hence, there is still a long way to go to spread the right ideas. The morality of rational self-interest is completely inconsistent with statism. It is only consistent with freedom and the protection of individual rights. Therefore, if one wants to see the rise of freedom and capitalism— and a flourishing of human life—one must embrace the morality of rational self-interest (and the epistemology of reason on which it is based). See Ayn Rand’s works for the details. Let me say a word about the practicality of a free market, including a free market in money and banking. They are both extremely practical because they have the ability to achieve success in practice. That is, they will help increase the productive capability and raise the standard of living if they are put into practice. Unfortunately, some people oppose the establishment of a free market because they think it is not practical. However, their thinking is flawed. If a higher standard of living for oneself and others is one’s goal, one must support the free market. The alternatives are not practical. Socialist economies are antithetical to economic progress and human life itself. They lead to misery, poverty, and mass murder. Mixed economies reduce the rate of economic progress and standard of living compared to the free market. If no fundamental philosophical shift away from the morality of self-sacrifice and toward the morality of rational self-interest occurs, eventually mixed economies lead to stagnation and regression as they move toward socialism

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or something similar. See my book Markets Don’t Fail! for more on the free market versus socialism and the mixed economy. When people say the free market is impractical, they might be confusing impracticality with a lack of political support to implement a free-market economy. However, whether enough people support an idea or policy to implement it politically does not determine the practicality of the idea or policy. Enough people may support a policy to establish it as law but that does not mean once the policy becomes law it will be successful in creating a higher standard of living. These two must be kept separate and distinct in one’s mind. That is, there is a difference between whether legislation will become law—Do you have the votes?—and whether the legislation will succeed once it becomes the law. This contrast can be seen in the battle between legislation that creates government interference in the monetary and banking system and legislation that achieves a free market in money and banking. The former legislation will not help lead to stability and prosperity just because there are many historical examples in which such legislation has been passed by legislative bodies. Likewise, legislation to achieve a free market in money and banking has the ability to help achieve stability and prosperity even though such legislation could not be passed in the United States at this time (2013). The solution to not having the votes to pass practical legislation is to show those members of the opposition who still have a respect for reason and logic the invalidity and impracticality of their ideas and policies. As for those who do not have a respect for reason and logic, they should be denounced for such an irrational and destructive position. So, one should advocate a free market in money and banking with the righteousness of knowing that it is both moral and practical. In fact, it leads to success in practice because it is moral (based on a rational moral standard). This means it leads to economic success because it is consistent with the requirements of human life. It will help lead to far greater stability in the economic system and a high and rapidly rising standard of living.

No t es

1

Underconsumption and Overproduction Theories of the Business Cycle

1. For a sample of Malthus’s view on overproduction, see William J. Barber, A History of Economic Thought (Harmondsworth, UK: Penguin Books Ltd., 1967), pp. 70–72. For a sample of Marx’s view, see Karl Marx and Friedrich Engels, The Communist Manifesto (London: Penguin Books Ltd., 1967 [1848]), pp. 86 and 109 and Karl Marx, Capital, vol. 1 (Chicago, IL: Encyclopedia Britannica, Inc., 1952 [1867]), pp. 222–223. On Sismondi’s view, see Mark A. Lutz, Economics for the Common Good (London: Routledge, 1999), pp. 28–31. 2. My discussion on the limitless need and desire for wealth is based on George Reisman, Capitalism: A Treatise on Economics (Ottawa, IL: Jameson Books, 1996), pp. 43–45. 3. Ibid., p. 54. My discussion of the impossibility of absolute overproduction is based on ibid., pp. 544–546 and 561–569. 4. Ibid., p. 573. Also see Chapter 3 of Brian P. Simpson, Money, Banking, and the Business Cycle, Volume 1: Integrating Theory and Practice (New York: Palgrave Macmillan, 2014). 5. On Sismondi’s view of underconsumption, see Lutz, Economics for the Common Good, pp. 31–33. 6. See John Maynard Keynes, The General Theory of Employment, Interest, and Money (Basingstoke, UK: Palgrave Macmillan, 2007 [1936]), p. 367. 7. Ibid. 8. See Chapter 5 of Simpson, Money, Banking, and the Business Cycle, Volume 1. 9. Ibid. 10. For the sake of simplicity, I assume all spending by businesses shows up as a cost in the year in which the expenditure is made. Therefore, I am assuming there are no depreciation costs or costs expensed over multiple accounting periods. Incorporating such costs does not fundamentally change the conclusions drawn, although it can increase profits when a shift in spending from labor to capital goods occurs. For why this latter point is true, see Reisman, Capitalism, pp. 754–756. 11. On the consumption of capitalists as a source of profits, see ibid., pp. 725–728. 12. The basis for my discussion on shifts in spending is ibid., pp. 838–859. 13. See Chapter 3 of Simpson, Money, Banking, and the Business Cycle, Volume 1. 14. On the “Keynesian multiplier” and saving versus hoarding, see Chapter 2 of ibid. 15. See Chapters 2 and 3 of ibid. for more on this topic.

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16. The presentation in this section of the chronic state of depression in which Keynes claims a market economy would be in and the refutation of this claim are based on Brian P. Simpson, “Needed in the Context of the Renewed Popularity in Keynes’s Ideas: An Analysis of His Errors,” The Journal of Social, Political and Economic Studies vol. 37, no. 1 (Spring 2012), pp. 67–93. 17. For some examples of criticisms, see Henry Hazlitt, The Failure of the “New Economics”: An Analysis of the Keynesian Fallacies (Princeton, NJ: D. Van Nostrand Co., Inc., 1959); Roger Garrison, “Intertemporal Coordination and the Invisible Hand: An Austrian Perspective on the Keynesian Vision,” History of Political Economy vol. 17, no. 2 (1985), pp. 309–319; Mark Skousen, ed., Dissent on Keynes: A Critical Appraisal of Keynesian Economics (New York: Praeger, 1992); Reisman, Capitalism, pp. 863–892; and James C. W. Ahiakpor, “On the Mythology of the Keynesian Multiplier: Unmasking the Myth and the Inadequacies of Some Earlier Criticisms,” American Journal of Economics and Sociology vol. 60, no. 4 (2001), pp. 745–773. 18. Keynes, The General Theory, p. 249. 19. Ibid., p. 30. 20. Ibid., pp. 30–31 for the quotations in this paragraph. 21. Ibid., p. 219. 22. Ibid., pp. 347–348. 23. Ibid., p. 136. 24. Ibid. 25. On the effects of diminishing returns, see ibid., p. 328. Also see the following work by a neo-Keynesian economist: Joseph P. McKenna, Aggregate Economic Analysis, 5th ed. (Hinsdale, IL: The Dryden Press, 1977), p. 139. This work contains expositions of many of Keynes’s ideas. 26. McKenna, Aggregate Economic Analysis, p. 137. 27. Keynes, The General Theory, p. 348. 28. Ibid., pp. 217–218. 29. Ibid., pp. 30–31 and 218–221. 30. Ibid., pp. 261–262 for the quotations in this paragraph. 31. Ibid., p. 267. For further discussion on falling wages and employment by Keynes, see ibid., pp. 260–269. 32. Ibid., p. 368 for the quotations in this paragraph. 33. Ibid., pp. 94–95 and 377–380. 34. Ibid., pp. 128–129. 35. Ibid., pp. 249–250. 36. John Maynard Keynes, Essays in Persuasion (New York: Harcourt, Brace, and Co., 1932), p. 124. 37. John Maynard Keynes, A Treatise on Money, vol. 1 (London: The Macmillan Press Ltd., 1971 [1930]), pp. 250–252. 38. Keynes, The General Theory, pp. 143–144. 39. Ibid., p. 314. 40. Ibid., pp. 158–161. 41. Ibid., p. 320. 42. Ibid., pp. 159–160 and 164. 43. McKenna, Aggregate Economic Analysis, pp. 220–223. 44. See Reisman, Capitalism, pp. 865–867 for more on the change from Keynesian to neo-Keynesian economics. For a discussion of inflexible wages, see Paul A. Samuelson and William D. Nordhaus, Economics, 13th ed. (New

No t e s

45. 46. 47. 48. 49. 50. 51.

52. 53.

54. 55. 56. 57. 58. 59.

60. 61. 62. 63. 64. 65. 66. 67. 68. 69. 70. 71. 72. 73.

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York: McGraw-Hill Book Co., 1989), pp. 706–707. They are neo-Keynesian economists. On Keynes’s statements regarding inflexible wages, see Keynes, The General Theory, pp. 232, 268, and 303. See Paul Krugman, “Introduction to New Edition” in Keynes, The General Theory, pp. xxxv–xxxvi on this topic. Keynes, The General Theory, p. 129. Reisman, Capitalism, p. 867. Keynes, The General Theory, p. 106. See Chapter 5 of Simpson, Money, Banking, and the Business Cycle, Volume 1 for a discussion of the size of productive and consumptive spending. Reisman, Capitalism, pp. 856–857. See Chapter 2 of Simpson, Money, Banking, and the Business Cycle, Volume 1 on productive spending and costs, as well as on the relationship between the rate of profit and interest rates. For more on time preference and the scarcity of savings it implies, see Reisman, Capitalism, pp. 56–58 and 856–859. See Keynes, The General Theory, pp. 258–262 and A Treatise on Money, vol. 1, pp. 159–160. Also see McKenna, Aggregate Economic Analysis, pp. 216–217. Hazlitt, The Failure of the “New Economics,” pp. 267–269 recognizes the same error, although it is not stated as precisely as it will be here. Reisman, Capitalism, pp. 883–884. Keynes, The General Theory, pp. 29, 106, and 368–369 Reisman, Capitalism, pp. 685–689. Ibid., pp. 879–881. Harry Binswanger, ed., The Ayn Rand Lexicon: Objectivism from A to Z (New York: Penguin Books, 1986), pp. 104–105. For the data used to calculate the change in wage rates, see Wages in the United States, 1914–1930 (New York: National Industrial Conference Board, Inc., 1931), p. 44. The fourth quarter values for 1920 and 1921 were used. See Chapter 9 of Simpson, Money, Banking, and the Business Cycle, Volume 1 on this topic. Reisman, Capitalism, pp. 881–883. For a discussion of how net investment adds to aggregate profits, see ibid., pp. 744–750. Ibid., pp. 881–882. Keynes, The General Theory, pp. 216 and 222. Ibid., p. 228. Ibid., pp. 230–231 and 235. Ibid., pp. 201–202, 218–219, and 231–236. Again, for more on the relation between the rate of profit and interest rates, see Chapter 2 of Simpson, Money, Banking, and the Business Cycle, Volume 1. Ibid. See ibid. See in particular the discussion on the Keynesian notion of the so-called liquidity trap. My analysis of the alleged fear of lending and covering the cost of bringing borrowers and lenders together is based on Reisman, Capitalism, p. 886. Keynes, The General Theory, pp. 52–65. Ibid., p. 102 and John Maynard Keynes, “Fluctuations in Net Investment in the United States,” The Economic Journal vol. 46, no. 183 (1936), pp. 540–547. See p. 542 in the latter reference.

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74. Keynes, A Treatise on Money, vol. 1, p. 155. 75. This has been recognized by many economists. See, for example, Ahiakpor, “On the Mythology of the Keynesian Multiplier,” pp. 750 and 757; Reisman, Capitalism, p. 691; and Jeffrey Herbener, “The Myths of the Multiplier and the Accelerator” in Skousen, Dissent on Keynes, pp. 73–88. In the latter reference, see in particular pp. 74–75. Also see Hazlitt, The Failure of the “New Economics,” pp. 121, 146, and 219–220 and A. C. Pigou, “Mr. J. M. Keynes’ General Theory of Employment, Interest and Money,” Economica vol. 3, no. 10 (1936), pp. 115–132. See in particular pp. 125–127 of this latter reference. 76. Keynes, A Treatise on Money, vol. 1, pp. 156–157 and 159 and The General Theory, pp. xxii–xxiii, 19–21, and 210–211. 77. Keynes, The General Theory, pp. 20–21. 78. See Chapter 2 of Simpson, Money, Banking, and the Business Cycle, Volume 1 on the topics of the “Keynesian multiplier” and the belief that savings “leak” from the economy. 79. See exhibit 5.2 in Chapter 5 of Simpson, Money, Banking, and the Business Cycle, Volume 1 for the source of the wage data. For the revenue data, see the sources for gross receipts in connection with the discussion on total spending in the economy in Chapter 2 of ibid. 80. Reisman, Capitalism, pp. 835–836. 81. Keynes, A Treatise on Money, vol. 1, p. 155. 82. Ibid. 83. See Chapters 3 and 5–9 of Simpson, Money, Banking, and the Business Cycle, Volume 1. 84. See Chapter 2 of ibid. 85. See Chapters 2 and 3 of ibid. for a discussion of why illiquidity results from inflationary policies of the government. 86. See Chapter 8 of ibid. 87. Keynes, The General Theory, pp. 161–163. 88. Ibid., pp. 149–161. The quotations in this paragraph are on p. 154. 89. Ibid., pp. 154–155. 90. Ibid., p. 157 for the quotations in this paragraph. 91. See Chapters 2 and 5–9 of Simpson, Money, Banking, and the Business Cycle, Volume 1. 92. Reisman, Capitalism, p. 465. 93. Keynes, The General Theory, p. 161. 94. See the section on “rational expectations” in Chapter 4 of Simpson, Money, Banking, and the Business Cycle, Volume 1 for discussion of this topic. 95. On Microsoft and Bill Gates, see Robert A. Guth, “Free to Choose,” The Wall Street Journal (May 19, 2003), p. R6 and Edwin A. Locke, The Prime Movers: Traits of the Great Wealth Creators (New York: AMACOM, 2000), pp. 54, 56–57, and 127. On Thomas Edison, see Locke, The Prime Movers, pp. 24, 46–48, and 95. On Sam Walton, see Locke, The Prime Movers, pp. 45–46, 52, 55, 132, and 171. There are many other stories of the rational actions of successful businessmen in The Prime Movers. 96. On arbitrary assertions, see Leonard Peikoff, Objectivism: The Philosophy of Ayn Rand (New York: Meridian, 1991), p. 164. 97. Keynes, The General Theory, pp. 347–348. 98. Ibid., p. 374.

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99. For the quotations in this paragraph, see ibid., pp. 376, 378, and 379, respectively. See Reisman, Capitalism, pp. 891–892 for a statement on Keynes similar to what I have made in the last two paragraphs. 100. For the quotations in this paragraph, see Keynes, The General Theory, pp. 378 and 380, respectively. 101. Ibid., pp. 155–156.

2

Keynesian Business Cycle Theory, Part Deux: Inflexible Prices and Wages

1. John Maynard Keynes, The General Theory of Employment, Interest, and Money (Basingstoke, UK: Palgrave Macmillan, 2007 [1936]), pp. 232, 268, 276, and 303. 2. Paul A. Samuelson and William D. Nordhaus, Economics, 13th ed. (New York: McGraw-Hill Book Co., 1989), pp. 155–157 and 160–161. 3. On this point, see ibid., p. 291 and Laurence Ball and David Romer, “Sticky Prices as Coordination Failure,” The American Economic Review vol. 81, no. 3 (June 1991), pp. 539–552. See in particular p. 539 in the latter reference. Also see Laurence Ball, N. Gregory Mankiw, and David Romer, “The New Keynesian Economics and the Output-Inflation Trade-Off,” Brookings Papers on Economic Activity no. 1 (1988), pp. 1–65. See in particular pp. 1–2. 4. For a typical statement of this theory, see Alan Blinder, Elie R. D. Canetti, David E. Lebow, and Jeremy B. Rudd, Asking About Prices: A New Approach to Understanding Price Stickiness (New York: Russell Sage Foundation, 1998), p. 21. 5. Samuelson and Nordhaus, Economics, p. 605. 6. For typical examples, see ibid., pp. 156–157 and Blinder et al., Asking About Prices, pp. 27–28. 7. For a typical exposition, see Roger A. Arnold, Economics, 5th ed. (Cincinnati, OH: South-Western College Publishing, 2001), pp. 563–565. 8. See Blinder et al., Asking About Prices, pp. 16–46 for more. 9. Samuelson and Nordhaus, Economics, p. 156. 10. Ibid., pp. 291–292. 11. See Robert E. Hall, “Employment Fluctuations and Wage Rigidity,” Brookings Papers on Economic Activity no. 1 (1980), pp. 91–123. See in particular pp. 92–93. 12. Samuelson and Nordhaus, Economics, p. 707. 13. David Romer, Advanced Macroeconomics (New York: The McGraw-Hill Companies, Inc., 1996), pp. 440–442. 14. Olivier J. Blanchard and Lawrence H. Summers, “Hysteresis in Unemployment” in David Romer and N. Gregory Mankiw, eds., New Keynesian Economics, vol. 2, Coordination Failures and Rigidities (Cambridge: The MIT Press, 1991), pp. 235–243. See in particular p. 238. 15. See ibid., p. 237 for the latter. 16. Ibid., p. 240. 17. Note that here, as in volume one of this work on the business cycle, by inflation I mean an undue increase in the money supply or, equivalently, an increase in the money supply by the government. See Chapter 1 of Brian P. Simpson, Money, Banking, and the Business Cycle, Volume 1: Integrating Theory and

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18. 19. 20. 21. 22. 23.

24. 25. 26. 27.

28. 29. 30. 31. 32. 33.

34. 35. 36.

37. 38.

No t e s Practice (New York: Palgrave Macmillan, 2014) for more on my use of the concept “inflation.” See Chapter 3 of ibid. for a detailed discussion of this business cycle theory. Robert P. Murphy, “Are ‘Sticky Wages’ a Market Failure?” Mises Daily, January 31, 2011. Brian P. Simpson Markets Don’t Fail! (Lanham, MD: Lexington Books, 2005), pp. 54–55. Samuelson and Nordhaus, Economics, p. 707. See Keynes, The General Theory, p. 303 for essentially the same claim. See Blanchard and Summers, “Hysteresis in Unemployment,” pp. 237–238 and Romer, Advanced Macroeconomics, p. 466. See Blanchard and Summers, “Hysteresis in Unemployment,” p. 240 for an example of when Keynesians admit that welfare for the unemployed is the reason why unemployed workers can afford to remain unemployed. Throughout this work, they also provide other reasons why “hysteresis” allegedly occurs. Samuelson and Nordhaus, Economics, p. 292. See Simpson, Markets Don’t Fail!, pp. 37–41 for a thorough refutation of the theory of perfect competition. Samuelson and Nordhaus, Economics, p. 291. George A. Akerlof and Janet L. Yellen, “A Near-Rational Model of the Business Cycle” in David Romer and N. Gregory Mankiw, eds., New Keynesian Economics, vol. 1, Imperfect Competition and Sticky Prices (Cambridge: The MIT Press, 1991), pp. 43–58. The quotation is on p. 44. Ball, Mankiw, and Romer, “The New Keynesian Economics,” pp. 1–2. Romer, Advanced Macroeconomics, pp. 439–486. Ibid., p. 1. Blinder et al., Asking About Prices, pp. 18–39. David Card and Alan B. Krueger, Myth and Measurement: The New Economics of the Minimum Wage (Princeton, NJ: Princeton University Press, 1995). See John Kennan, “The Elusive Effects of Minimum Wages,” Journal of Economic Literature vol. 33, no. 4 (December 1995), pp. 1950–1965. See in particular p. 1958. Also see Daniel S. Hamermesh, “Review Symposium— Myth and Measurement: The New Economics of the Minimum Wage,” Industrial and Labor Relations Review vol. 48, no. 4 (July 1995), pp. 835–838. See in particular pp. 835–837. See Kennan, “The Elusive Effects,” pp. 1955 and 1958 and Hamermesh, “Review Symposium—Myth and Measurement,” p. 837. Kennan, “The Elusive Effects,” pp. 1952 and 1964. I say this because statistical analyses are not appropriate tools to use to attempt to gain knowledge in economics, excluding descriptive statistics and maybe the most basic regression analyses. If anything, statistical analyses have made economists more ignorant because such analyses take the focus off the fundamental causal factors that have been identified in economics and place it on statistical analyses that often end up showing inconclusive results or, even worse, results that contradict the nature of the phenomenon being investigated (such as in the case of Myth and Measurement). I merely assert here that the use of statistical analysis in economics is invalid. A detailed assessment of statistical analysis as a method of analysis will have to wait until my next book. Kennan, “The Elusive Effects,” p. 1951. Ibid., p. 1964.

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39. Hamermesh, “Review Symposium—Myth and Measurement,” p. 837. 40. Price data used in these calculations were obtained from the Federal Reserve Bank of St. Louis, FRED database, series IDs CPIAUCNS and PPIACO. Wage data were obtained from the Bureau of Labor Statistics, historical hours and earnings data, Table B-2 at http://bls.gov/ces/tables.htm#ee. Price data obtained February 18, 2013. Wage data obtained January 24, 2012. 41. George Reisman, Capitalism: A Treatise on Economics (Ottawa, IL: Jameson Books, 1996), p. 231. 42. See Chapter 5 of Simpson, Money, Banking, and the Business Cycle, Volume 1 for a discussion of this topic. 43. For the source of the data to make the price-change calculations, see the Federal Reserve Bank of St. Louis reference above. For the source of the GNR data, see exhibit 5.2 in Chapter 5 of Simpson, Money, Banking, and the Business Cycle, Volume 1. Chapter 5 also contains a discussion on the nature of GNR and its relationship to gross domestic product (GDP). GNR is a much more comprehensive measure of spending than GDP. GDP only includes spending on final goods and services produced, while GNR includes spending on all goods and services produced, including both final and intermediate goods and services. 44. For the source of the wage data from the 1960s, except 1960, see the Bureau of Labor Statistics (BLS) reference above. A wage rate for 1960 could not be obtained from the BLS. A value for 1960 that is consistent with BLS data was calculated using hourly earnings data from the US Census Bureau, Statistical Abstract of the United States, various editions, Washington, DC. Hourly earnings data from both the BLS and the Statistical Abstract for 1967–76 were used to calculate an average ratio between these two variables and then the hourly wage according to the Statistical Abstract for 1960 was scaled by this ratio to obtain an hourly wage consistent with BLS data. I preferred to use BLS wage data over Statistical Abstract wage data because the former were generally more readily available. 45. Changes in housing prices are according to the S&P/Case-Shiller Home Price Index (20-City Composite). See “2012 Home Prices Off to a Rocky Start According to the S&P/Case-Shiller Home Price Indices,” Press Release, S&P Indices, March 27, 2012. 46. See Samuelson and Nordhaus, Economics, p. 160 for an example. 47. See Chapter 8 of Simpson, Money, Banking, and the Business Cycle, Volume 1 for a discussion of these topics. 48. For the source of the data used to calculate the changes in prices, see the Federal Reserve Bank of St. Louis reference above. Unfortunately, I was unable to obtain wage data for 1919, so I do not know how wages changed from 1919 to 1920. 49. Benjamin M. Anderson as quoted in Murray N. Rothbard, America’s Great Depression, 5th ed. (Auburn, AL: Mises Institute, 2000), p. 186. 50. Peter Hart and Bill McInturff, “Study #6091,” NBC News/Wall Street Journal Survey (December 2008). 51. For the information and quotations on Latin America and the Caribbean, see Heinz Kohler, Economic Systems and Human Welfare: A Global Survey (Cincinnati, OH: South-Western College Publishing, 1997), p. 650. 52. For these price data, see ibid. 53. For the source of the data used to calculate the changes in prices in the United States, see the Federal Reserve Bank of St. Louis reference above.

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54. For a comparison of money supply data for the United States and Latin American and Caribbean nations, see International Financial Statistics Yearbook (Washington, DC: International Monetary Fund, 2000), pp. 90–93. 55. See Phillip Cagan, “The Monetary Dynamics of Hyperinflation” in Milton Friedman, ed., Studies in the Quantity Theory of Money (Chicago: University of Chicago Press, 1956), pp. 23–91 for some examples. 56. Blinder et al., Asking About Prices, p. 285. 57. Ibid., p. 288. 58. Ibid., p. 78. 59. Ibid., p. 84. 60. Ibid., p. 95. 61. Ibid., pp. 86–87. 62. Ibid., pp. 110 and 262. 63. Ibid., pp. 95, 153, and 164. 64. Ibid., p. 298. 65. Ibid., pp. 4, 6, and 15. 66. Ibid., pp. 3–4, 15, 295–296, and 302. 67. Ibid., p. 262. 68. I originally thought of this idea after reading Andrew S. Caplin and Daniel F. Spulber, “Menu Costs and the Neutrality of Money,” The Quarterly Journal of Economics vol. 102, issue 4 (November 1987), pp. 703–725. They make a similar argument to claim that money has no effect on the economy in the short run. See in particular pp. 711 and 713. I have shown in Simpson, Money, Banking, and the Business Cycle, Volume 1 that this is not true. What it would have been accurate for Caplin and Spulber to say is that the short-run effects of money do not arise due to the inflexibility of prices. 69. Blinder et al., Asking About Prices, p. 84. 70. See Chapter 3 of Simpson, Money, Banking, and the Business Cycle, Volume 1 for the analysis that shows that no business cycle results from constant inflation. 71. These fluctuations might not show absolute increases and decreases to the extent there is a significant secular trend in the data. However, they still occur in a relative sense (relative to the trend). 72. For a discussion of the link between morality and economics, see Chapters 1, 6, and 7 of Simpson, Markets Don’t Fail!

3

Real Business Cycle Theory

1. See John B. Long, Jr. and Charles I. Plosser, “Real Business Cycles,” Journal of Political Economy vol. 91, no. 1 (February 1983), pp. 39–69 and George Stadler, “Real Business Cycles,” Journal of Economic Literature vol. 32, no. 4 (December 1994), pp. 1750–1783 for detailed articles describing RBC theory. For a basic description of RBC theory, see Roger A. Arnold, Economics, 5th ed. (Cincinnati, OH: South-Western College Publishing, 2001), pp. 379–380. 2. For a description of this version of RBC theory, see Andrei Shleifer, “Implementation Cycles,” Journal of Political Economy vol. 94, no. 6 (December 1986), pp. 1163–1190. 3. Hear Richard Salsman, “The Myth of Market Bubbles,” audio recording (Gaylordsville, CT: Second Renaissance Books, 2000) for examples of this kind of RBC theory.

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4. For an example, see José A. Scheinkman and Michael Woodford, “SelfOrganized Criticality and Economic Fluctuations,” The American Economic Review vol. 84, no. 2 (May 1994), pp. 417–421. 5. On this idea, see Robert B. Barsky and Jeffrey A. Miron, “The Seasonal Cycle and the Business Cycle,” Journal of Political Economy vol. 97, no. 3 (June 1989), pp. 503–534. 6. See Ludwig von Mises, Human Action, 3rd rev. ed. (Chicago: Contemporary Books, Inc., 1966), pp. 554–555 and 580–586. 7. See Federal Reserve Bank of Minneapolis, “In This Issue,” Quarterly Review (Fall 1986), pp. 1–2. In particular, see p. 1. Also see Robert G. King and Charles I. Plosser, “Money, Credit, and Prices in a Real Business Cycle,” The American Economic Review vol. 74, no. 3 (June 1984), pp. 363–380. See in particular p. 363. 8. See Brian P. Simpson, Money, Banking, and the Business Cycle, Volume 1: Integrating Theory and Practice (New York: Palgrave Macmillan, 2014). 9. See Chapter 6 of ibid. on this topic. 10. See Chapter 7 of ibid. on this topic. 11. Price data used here were obtained from the Federal Reserve Bank of St. Louis, FRED database, series ID PPIACO. Data obtained on February 18, 2013. 12. On this topic, see Chapters 3 and 4 of Simpson, Money, Banking, and the Business Cycle, Volume 1. 13. See Sushil Bikhchandani, David Hirshleifer, and Ivo Welch, “A Theory of Fads, Fashion, Custom, and Cultural Change as Informational Cascades,” Journal of Political Economy vol. 100, no. 5 (October 1992), pp. 992–1026 and Fischer Black, “Noise,” The Journal of Finance vol. 41, no. 3 (July 1986), pp. 529–543 for examples of these theories. The former article does not explicitly focus on the business cycle but can be used as a basis for business cycle theory. The latter does explicitly focus on changes in taste causing the business cycle. 14. See Fischer Black, Business Cycles and Equilibrium (New York: Basil Blackwell Inc., 1987), pp. 117–118 and 123–124 for an example of this theory. 15. Ibid. 16. See Chapter 8 of Simpson, Money, Banking, and the Business Cycle, Volume 1. 17. For those who do not know how the standard of living is raised through the law of comparative advantage, see George Reisman, Capitalism: A Treatise on Economics (Ottawa, IL: Jameson Books, 1996), pp. 350–354. 18. See Chapter 2 of Simpson, Money, Banking, and the Business Cycle, Volume 1 for a discussion of “fiscal policy.” 19. See Chapter 8 of ibid. 20. For examples, see Black, “Noise” and Scheinkman and Woodford, “SelfOrganized Criticality.” 21. See Black, “Noise,” pp. 529–530 and Edward C. Prescott, “Theory Ahead of Business Cycle Measurement,” Quarterly Review, Federal Reserve of Minneapolis (Fall 1986), pp. 9–21. See in particular pp. 9, 10, and 21 in the latter reference. 22. See Bikhchandani, Hirshleifer, and Welch, “A Theory of Fads.” 23. See J. Joseph Beaulieu, Jeffrey K. MacKie-Mason, and Jeffrey Miron, “Why Do Countries and Industries with Large Seasonal Cycles also Have Large Business Cycles?” The Quarterly Journal of Economics vol. 107, no. 2 (May 1992), pp. 621–656 and Barsky and Miron, “The Seasonal Cycle.” 24. Barsky and Miron, “The Seasonal Cycle,” p. 529.

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25. See Jeffrey Miron, “The Economics of Seasonal Cycles,” NBER Working Paper no. 3522 (November 1990) for an example of an economist who attempts to make seasonal cycles appear complicated. See especially pp. 4 and 11–14. 26. Unfortunately, one of these topics has already been studied. See ibid., pp. 25–27. 27. See King and Plosser, “Money, Credit, and Prices,” pp. 367–368 and Stadler, “Real Business Cycles,” pp. 1762–1764. 28. See Chapters 3 and 5–9 of Simpson, Money, Banking, and the Business Cycle, Volume 1. 29. See Chapter 4 of ibid. for more points on time preference that are relevant to this discussion. See Chapter 2 of ibid. and chapter 1 above on the relationship between productive spending, consumptive spending, and the rate of profit. 30. This is the case because savings deposits are not money to depositors. This money has been given to banks to loan out. However, to the extent banks hold some of the money to accommodate net withdrawals from these accounts, these reserves should be counted as money to the banks, since they are choosing to employ the money in a manner different than loaning it out. In contrast, reserves backing checking deposits should not be included in the money supply because these deposits are money to depositors and the money to which checking deposits are a claim is merely being held for safekeeping by the banks. 31. See King and Plosser, “Money, Credit, and Prices,” pp. 368, 370, 372, and 374–376 and Richard M. Salsman, Gold and Liberty (Great Barrington, MA: American Institute for Economic Research, 1995), pp. 33 and 35 for examples. 32. King and Plosser, “Money, Credit, and Prices,” pp. 367–368. 33. See Chapter 1 of Simpson, Money, Banking, and the Business Cycle, Volume 1 for a discussion of the nature of the demand for money. See Chapter 2 of ibid. for a discussion of the relationship between the velocity of circulation of money and the demand for money. 34. For an example of a critique, see Jesús Huerta de Soto, Money, Bank Credit, and Economic Cycles, translated by Melinda A. Stroup (Auburn, AL: Ludwig von Mises Institute, 2006), pp. 512–542 and 582. While not all Huerta de Soto’s criticisms of monetarist theory are valid, overall he provides a good analysis of the theory. 35. Joseph A. Schumpeter, Business Cycles: A Theoretical, Historical, and Statistical Analysis of the Capitalist Process, vol. 1 (Chevy Chase, MD: Bartleby’s Books, 2005 [1939]), pp. 138 and 143. 36. Wesley Clair Mitchell, Business Cycles and Their Causes (Berkeley, CA: University of California Press, 1941), pp. ix and 149–162. 37. See Simpson, Money, Banking, and the Business Cycle, Volume 1. Also see chapters 4, 5, and 7 below on this subject. 38. Irving Fisher, Booms and Depressions: Some First Principles (New York: Adelphi Company, 1932), pp. viii, 41–49, and 141–142. 39. Michal Kalecki, Essays in the Theory of Economic Fluctuations (New York: Farrar & Rinehart, Inc., 1939), pp. 144–149. 40. See Reisman, Capitalism, p. 716, note 19; Murray N. Rothbard, America’s Great Depression, 5th ed. (Auburn, AL: Mises Institute, 2000), pp. 60–68; and Jeffrey Herbener, “The Myths of the Multiplier and the Accelerator” in Mark Skousen, ed., Dissent on Keynes: A Critical Appraisal of Keynesian Economics (New York: Praeger, 1992), pp. 73–88. See in particular pp. 79–87 of the latter

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41. 42. 43.

44.

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work. While not all the criticisms in the latter two works are valid, they do provide a number of valid criticisms worthy of citation. Paul A. Samuelson and William D. Nordhaus, Economics, 13th ed. (New York: McGraw-Hill Book Co., 1989), pp. 215–216. A.D. Knox, “The Acceleration Principle and the Theory of Investment: A Survey,” Economica vol. 19, no. 75 (August 1952), pp. 269–297. See p. 275. George Reisman, “The Stock Market, Profits, and Credit Expansion,” http://capitalism.net/articles/Stock%20Market,%20Profits,%20Credit%20 Expansion.htm (2002). See section 6 titled “Why the Credit-Expansion Boom Cannot be Sustained.” Article accessed December 10, 2011. See Chapter 4 of Simpson, Money, Banking, and the Business Cycle, Volume 1.

4

Government Interference, Fiat Money, and Fractional-Reserve Banking

1. See Chapter 1 of Brian P. Simpson, Money, Banking, and the Business Cycle, Volume 1: Integrating Theory and Practice (New York: Palgrave Macmillan, 2014) to see how this is done. 2. See Chapter 3 of ibid. on how the manipulation of the money supply causes the business cycle. 3. See Chapter 2 of ibid. 4. In addition to this book, see Simpson, Money, Banking, and the Business Cycle, Volume 1 as proof of the validity of this statement. 5. George Reisman, Capitalism: A Treatise on Economics (Ottawa, IL: Jameson Books, 1996), pp. 513 and 957. 6. See Chapter 1 of Simpson, Money, Banking, and the Business Cycle, Volume 1 for a detailed explanation of the creation of money through the fractional-reserve checking system and the example from which these values are taken. 7. See Chapter 8 of ibid. on the Great Depression for more details on this episode. 8. Much of my discussion on how the government has made the creation of fiduciary media possible is based on Reisman, Capitalism, pp. 515–516. 9. See Larry J. Sechrest, Free Banking: Theory, History, and a Laissez-Faire Model (Auburn, AL: The Ludwig von Mises Institute, 2008), pp. 87–88; Sydney G. Checkland, Scottish Banking: A History, 1695–1973 (Glasgow, Scotland: Collins, 1975), pp. 184–186 and 222; Jesús Huerta de Soto, Money, Bank Credit, and Economic Cycles, translated by Melinda A. Stroup (Auburn, AL: Ludwig von Mises Institute, 2006), pp. 43–44; and Frank Whitson Fetter, Development of British Monetary Orthodoxy, 1797–1875 (Cambridge, MA: Harvard University Press, 1965), p. 122. 10. Mark Skousen, Economics of a Pure Gold Standard, 3rd ed. (Irvingtonon-Hudson, NY: The Foundation for Economic Education, Inc., 1996), pp. 22–24. 11. Richard M. Salsman, Breaking the Banks: Central Banking Problems and Free Banking Solutions (Great Barrington, MA: American Institute for Economic Research, 1990), p. 80. 12. Richard M. Salsman, The Collapse of Deposit Insurance—and the Case for Abolition (Great Barrington, MA: American Institute for Economic Research, 1993), p. 13. 13. Ibid., p. 18.

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14. George J. Benston, Perspectives on Safe & Sound Banking: Past, Present, and Future (Cambridge: The MIT Press, 1986), p. 231 and Salsman, Breaking the Banks, p. 66. 15. Salsman, The Collapse of Deposit Insurance, p. 10. 16. Maureen Burton and Ray Lombra, The Financial System and the Economy, 3rd ed. (Mason, OH: South-Western, 2003), pp. 312–314. 17. For a similar view, see William M. Gouge, A Short History of Paper Money and Banking in the United States, to Which Is Prefixed: An Inquiry into the Nature of the System, part 1 (New York: Augustus M. Kelley, 1968 [1833]), pp. 113 and 119. 18. For those unfamiliar with fiduciary media, see Chapter 1 of Simpson, Money, Banking, and the Business Cycle, Volume 1. 19. Hans-Hermann Hoppe, Jörg Guido Hü lsmann, and Walter Block, “Against Fiduciary Media,” The Quarterly Journal of Austrian Economics vol. 1, no. 1 (1998), pp. 19–50. The quotation is taken from pp. 21–22. 20. Huerta de Soto, Money, pp. 666, 674, 706, and 810. 21. Ibid., pp. 139–147, 156, and 708–710. 22. Ibid., p. 143. 23. Ibid., pp. 20–36. 24. Ayn Rand, The Virtue of Selfishness (New York: Signet, 1964), pp. 126 and 130. 25. Huerta de Soto, Money, pp. 3–4. See also pp. 17–18. 26. Reisman, Capitalism, p. 957. 27. Huerta de Soto, Money, pp. 141 and 706. 28. For a thorough discussion of the distinction between the metaphysical and the man-made, see Ayn Rand, Philosophy: Who Needs It (New York: Signet, 1982), pp. 23–34. 29. Huerta de Soto, Money, pp. 392–395 and 666–670. For similar arguments, see Stanley Jevons, Mountifort Longfield, and Charles A. Conant as presented in Skousen, Economics of a Pure Gold Standard, p. 98. 30. Huerta de Soto, Money, p. 394. 31. Ibid. 32. Ibid., pp. 666–667. 33. Ibid., pp. 98–106. 34. Ibid., p. 683. 35. Ibid., p. 654. See also pp. 49 and 72–77 for more examples. 36. Ibid., p. 665. 37. Ibid., p. 686. 38. Ibid., pp. 682–683. 39. Ibid., p. 688, note 130. 40. Ludwig von Mises, Human Action, 3rd rev. ed. (Chicago: Contemporary Books, Inc., 1966), p. 446. 41. See George Selgin and Lawrence H. White, “In Defense of Fiduciary Media—or, We Are Not Devo(lutionists), We Are Misesians!” The Review of Austrian Economics vol. 9, no. 2 (1996), pp. 83–107. See in particular pp. 93–94 and 98. Also see Richard M. Salsman, Gold and Liberty (Great Barrington, MA: American Institute for Economic Research, 1995), p. 53 and Skousen, Economics of a Pure Gold Standard, p. 98. 42. See Selgin and White, “In Defense of Fiduciary Media,” pp. 94 and 97–98 and George A. Selgin, The Theory of Free Banking (Totowa, NJ: Rowman & Littlefield, 1988), pp. 54–55. 43. Selgin, The Theory of Free Banking, p. 55.

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44. See Reisman, Capitalism, p. 693. Also see Chapter 2 of Simpson, Money, Banking, and the Business Cycle, Volume 1 for related discussion. 45. See Selgin, The Theory of Free Banking, pp. 54–55 for the view being critiqued here. 46. See Huerta de Soto, Money, pp. 694–700 for the view that one’s demand for money is not a part of one’s savings. 47. This was discussed in Chapter 2 of Simpson, Money, Banking, and the Business Cycle, Volume 1 in connection with the Keynesian equivocation between saving and hoarding. 48. I put the word “price” in quotation marks in the main text because under a gold standard there is no price of gold in the traditional sense. The monetary unit is defined as a certain quantity of gold under a gold standard. This establishes the monetary value of gold. 49. See Chapters 2 and 3 of Simpson, Money, Banking, and the Business Cycle, Volume 1 and chapter 7 below for more on these topics. 50. Lawrence H. White, “Accounting for Fractional-Reserve Banknotes and Deposits—or, What’s Twenty Quid to the Bloody Midland Bank?” Independent Review vol. 7, no. 3 (Winter 2003), pp. 423–441. See in particular pp. 425–427. 51. On this idea, see Olivier Ledoit and Sébastien Lotz, “The Coexistence of Commodity Money and Fiat Money,” University of Zurich, Department of Economics Working Paper Series, working paper no. 24 (August 2011). See p. 5 of this paper. 52. Selgin and White, “In Defense of Fiduciary Media,” pp. 95–99. 53. See Huerta de Soto, Money, pp. 39, 50–51, 71, 76–77, and 392 for more statements on this subject. 54. See George Selgin, Bank Deregulation and Monetary Order (London: Routledge, 1996), p. 135 and Kevin Dowd, “Option Clauses and the Stability of a Laisser Faire Monetary System,” Journal of Financial Services Research vol. 1, no. 4 (December 1988), pp. 319–333 for this argument. See p. 327 in the latter reference. 55. Dowd, “Option Clauses,” p. 328. 56. Parth J. Shah, “The Option Clause in Free-Banking Theory and History: A Reappraisal,” The Review of Austrian Economics vol. 10, no. 2 (1997), pp. 1–25. See p. 16. 57. Ibid., pp. 13 and 16–17 and Dowd, “Option Clauses,” pp. 330–331. 58. Shah, “The Option Clause,” p. 13; Checkland, Scottish Banking, pp. 184–186; and Adam Smith, An Inquiry into the Nature and Causes of the Wealth of Nations, vol. 1 (Indianapolis, IN: Liberty Fund, 1979 [1776]), p. 325. 59. Dowd, “Option Clauses,” p. 329 and Shah, “The Option Clause,” p. 16. 60. For some examples, see Selgin, The Theory of Free Banking, pp. 54–56 and 66–67 and Roger W. Garrison, “Central Banking, Free Banking, and Financial Crises,” The Review of Austrian Economics vol. 9, no. 2 (1996), pp. 109–127. See in particular pp. 111, 113, 117, 118, and 125 of the latter reference. 61. See Salsman, Gold and Liberty, pp. 33 and 35 and Robert G. King and Charles I. Plosser, “Money, Credit, and Prices in a Real Business Cycle,” The American Economic Review vol. 74, no. 3 (June 1984), pp. 363–380 for examples. For the latter reference, see in particular pp. 368, 370, 372, and 374–376. 62. See Selgin, The Theory of Free Banking, pp. 64 and 66. 63. Ibid.

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64. Ibid., p. 77. 65. Brian P. Simpson, Trade Cycle Theory: A Market Process Perspective (Ann Arbor, MI: Bell & Howell Information and Learning Company, 2000), pp. 94–95. 66. Gouge, A Short History of Paper Money, p. 62. 67. See Checkland, Scottish Banking, p. 214 on this point. 68. Based on “Total Checkable Deposits” data (series ID TCDNS) and “Board of Governors Total Reserves, Not Adjusted for Changes in Reserve Requirements” data (series ID TOTRESNS) obtained from the St. Louis Federal Reserve’s online FRED database. Data obtained June 6, 2012. 69. See Jeremy Atack and Peter Passell, A New Economic View of American History, 2nd ed. (New York: W. W. Norton & Company, 1994), p. 502 and Richard H. Timberlake, Jr., “The Central Banking Role of Clearinghouse Associations,” Journal of Money, Credit, and Banking vol. 16, no. 1 (February 1984), pp. 1–15 for discussions of lending by clearinghouses during financial crises. See pp. 13 and 14 of the latter source. 70. Gouge, A Short History of Paper Money, p. 63. 71. See Selgin, The Theory of Free Banking, pp. 54, 64–70, and 79 and Selgin and White, “In Defense of Fiduciary Media,” pp. 101–104 for economists who leave the changes in money demand unexplained. See Hoppe, Hü lsmann, and Block, “Against Fiduciary Media,” p. 46 and Simpson, Trade Cycle Theory, pp. 95–96 for instances in which it has been identified that these theorists have left the changes in money demand unexplained. 72. See Chapter 1 of Simpson, Money, Banking, and the Business Cycle, Volume 1 for an explanation of this theory. 73. Lawrence H. White, The Clash of Economic Ideas (Cambridge: Cambridge University Press, 2012), pp. 89–90 and 95–97. 74. See Chapters 1 and 5 of Simpson, Money, Banking, and the Business Cycle, Volume 1 for more on these examples.

5 The Characteristics and Effects of a Free Market in Money and Banking 1. For some examples of answers (or partial answers) to this question from other economists, see George A. Selgin and Lawrence H. White, “How Would the Invisible Hand Handle Money?” Journal of Economic Literature vol. 32, no. 4 (December 1994), pp. 1718–1749; Larry J. Sechrest, “White’s Free-Banking Thesis: A Case of Mistaken Identity,” The Review of Austrian Economics vol. 2, no. 1 (1988), pp. 247–257; and Vera C. Smith, The Rationale of Central Banking and the Free Banking Alternative (Indianapolis, IN: Liberty Fund, 1990 [1936]), pp. 169–170. In the article by Selgin and White, see pp. 1718–1719. In the article by Sechrest, see p. 248. 2. Ayn Rand, The Virtue of Selfishness (New York: Signet, 1964), p. 37. 3. George Reisman, Capitalism: A Treatise on Economics (Ottawa, IL: Jameson Books, 1996), pp. 517 and 954. 4. See Lawrence White, “Competitive Payments Systems and the Unit of Account” The American Economic Review vol. 74, no. 4 (September 1984), pp. 699–712 for a similar view in a different context. See in particular p. 708. 5. For the answers to these questions from other economists, see Selgin and White, “How Would the Invisible Hand Handle Money?” and Lawrence H. White,

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6. 7.

8.

9.

10. 11.

12.

13.

14. 15.

16. 17. 18.

19. 20. 21. 22. 23.

279

“What Kinds of Monetary Institutions Would a Free Market Deliver?” Cato Journal vol. 9, no. 2 (Fall 1989), pp. 367–403. Elgin Groseclose, Money and Man: A Survey of Monetary Experience (New York: Frederick Ungar Publishing Co., 1961), p. 172. See Krishna G. Mantripragada and H. Banerjee Rau, “Private Deposit Insurance: An Assessment,” Journal of Insurance Regulation vol. 14, no. 1 (Fall 1995), pp. 90–114 for the characteristics of privately insurable risks. Richard M. Salsman, Breaking the Banks: Central Banking Problems and Free Banking Solutions (Great Barrington, MA: American Institute for Economic Research, 1990), pp. 33 and 60. William Barnett II and Walter E. Block, “Time Deposits, Dimensions, and Fraud,” Journal of Business Ethics vol. 88, no. 4 (September 2009), pp. 711–716. See p. 713. Salsman, Breaking the Banks, pp. 9–10. See Sydney G. Checkland, Scottish Banking: A History, 1695–1973 (Glasgow, Scotland: Collins, 1975), pp. 722–723 and 734 for the equity capital to total asset ratios in Scotland during the eighteenth and nineteenth centuries. For a similar ratio during recent US history, see James D. Gwartney, Richard L. Stroup, Russell S. Sobel, and David A. Macpherson, Economics, 12th ed. (Mason, OH: South-Western Cengage Learning, 2009), p. 268. See William H. Dillistin, Bank Note Reporters and Counterfeit Detectors: 1826–1866 (New York: The American Numismatic Society, 1949), pp. 25–27 and 41 for some examples in US history. See Jeremy Atack and Peter Passell, A New Economic View of American History, 2nd ed. (New York: W. W. Norton & Company, 1994), pp. 501–502 and Richard H. Timberlake, Jr., “The Central Banking Role of Clearinghouse Associations,” Journal of Money, Credit, and Banking vol. 16, no. 1 (February 1984), pp. 1–15. See in particular pp. 2–5 in the latter reference. See George A. Selgin, The Theory of Free Banking (Totowa, NJ: Rowman & Littlefield, 1988), pp. 40–42 on the principle of adverse clearings. See Kevin Dowd, “Introduction” in Kevin Dowd, ed., The Experience of Free Banking (London: Routledge, 1992), pp. 1–6. See in particular p. 5. Also see Kurt Schuler, “The World History of Free Banking: An Overview” in Dowd, The Experience of Free Banking, pp. 7–47. See in particular p. 17 of the latter reference. Timberlake, “The Central Banking Role,” pp. 2–3 and 5–6. Schuler, “The World History of Free Banking,” p. 39. For more on the nature of private certification organizations in a free market, see Brian P. Simpson Markets Don’t Fail! (Lanham, MD: Lexington Books, 2005), pp. 106–107. Brian P. Simpson, Trade Cycle Theory: A Market Process Perspective (Ann Arbor, MI: Bell & Howell Information and Learning Company, 2000), p. 105. Selgin, The Theory of Free Banking, pp. 80–82 provides several examples of such a view. See ibid., pp. 73–78 for more on this topic. Salsman, Breaking the Banks, pp. 11 and 80. See Chapter 1 of Brian P. Simpson, Money, Banking, and the Business Cycle, Volume 1: Integrating Theory and Practice (New York: Palgrave Macmillan, 2014) for more on the nature of savings deposits.

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24. On this topic, see White, “Competitive Payments Systems,” p. 708 and Timothy Q. Cook and Jeremy G. Duffield, “Money Market Mutual Funds: A Reaction to Government Regulations or a Lasting Financial Innovation?” Economic Review (July/August 1979), pp. 15–31. See in particular pp. 16 and 29 of this latter reference. 25. Jeff Haymond, “Are MMMFs Money?” The Quarterly Journal of Austrian Economics vol. 3, no. 4 (Winter 2000), pp. 53–68. See p. 55. 26. George Selgin, William D. Lastrapes, and Lawrence H. White, “Has the Fed Been a Failure?” Journal of Macroeconomics vol. 34, issue 3 (September 2012), pp. 569–596. See in particular p. 587. 27. Frank Whitson Fetter, Development of British Monetary Orthodoxy, 1797–1875 (Cambridge, MA: Harvard University Press, 1965), p. 122. 28. Salsman, Breaking the Banks, pp. 116–117 and Hugh Rockoff, “Lessons from the American Experience with Free Banking” in Forrest Capie and Geoffrey E. Wood, eds., Unregulated Banking: Chaos or Order? (New York: St. Martin’s Press, 1991), pp. 73–109. In the latter, see in particular pp. 93 and 97–98. 29. For such a claim with regard to the issue of notes, see John Ramsay McCulloch, Historical Sketch of the Bank of England (London: Longman, Rees, Orme, Brown, and Green, 1831), pp. 51–52. 30. On the nature of monopoly and competition, see Simpson, Markets Don’t Fail!, pp. 31–37 and 53–57. 31. See Dowd, “Introduction,” p. 4 and Kevin Dowd, “Free Banking in Australia” in Dowd, The Experience of Free Banking, pp. 48–78. See in particular p. 56 in the latter reference. Also see George Selgin, Bank Deregulation and Monetary Order (London: Routledge, 1996), pp. 21–22. 32. See McCulloch, Historical Sketch, p. 52 for such a view. 33. For one advocate of this view, see Charles Goodhart, The Evolution of Central Banks (Cambridge: The MIT Press, 1988), pp. vii–viii. 34. See Richard M. Salsman, Gold and Liberty (Great Barrington, MA: American Institute for Economic Research, 1995), pp. 83–87; Salsman, Breaking the Banks, p. 122; and Schuler, “The World History of Free Banking,” p. 39. 35. Goodhart, The Evolution of Central Banks, pp. 19–20. 36. For an example of someone who advocates this, see Fischer Black, “Banking and Interest Rates in a World Without Money,” Journal of Bank Research (Autumn 1970), pp. 8–20. Also see White, “Competitive Payments Systems,” pp. 699–700 for a summary of Black’s views. 37. For an example of an economist who advocates this, see Robert E. Hall, “Explorations in the Gold Standard and Related Policies for Stabilizing the Dollar” in Robert E. Hall, ed., Inflation: Causes and Effects (Chicago, IL: The University of Chicago Press, 1982), pp. 111–122. See in particular pp. 111–112. Also see F. A. Hayek, Individualism and Economic Order (Chicago, IL: The University of Chicago Press, 1948), p. 213. 38. See Tyler Cowen and Randall Kroszner, “The Development of the New Monetary Economics,” The Journal of Political Economy vol. 95, no. 3 (June 1987), pp. 567–590. See p. 570 for the authors’ view on what some earlier writers on the subject thought. 39. Ibid., p. 585 for their statement of the British economist Henry Meulen’s view on this issue. 40. For an example of this view, see Eugene F. Fama, “Banking in the Theory of Finance,” Journal of Monetary Economics vol. 6, issue 1 (1980), pp. 39–57. See in particular pp. 42–44.

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41. See Robert L Greenfield and Leland B. Yeager, “A Laissez-Faire Approach to Monetary Stability,” Journal of Money, Credit, and Banking vol. 15, no. 3 (August 1983), pp. 302–315. See in particular pp. 302–305 and 308–313. 42. Fama, “Banking,” pp. 41–42. 43. See White, “Competitive Payments Systems,” pp. 706–711. 44. Ibid., pp. 711–712 for the philosophically corrupt idea that White accepts. 45. Ayn Rand, Philosophy: Who Needs It? (New York: Signet, 1982), p. 30. 46. See White, “Competitive Payments Systems,” pp. 703–706 for a brief summary of the rise in the use of money. See Carl Menger, “On the Origin of Money,” Economic Journal vol. 2, no. 6 (June 1892), pp. 239–255 for a more detailed account—and the original account—of the rise in the use of money. 47. White, “Competitive Payments Systems,” p. 711. 48. Ibid. 49. On context dropping, see Harry Binswanger, ed., The Ayn Rand Lexicon: Objectivism from A to Z (New York: Penguin Books, 1986), pp. 104–105. On the fallacy of the stolen concept, see Ayn Rand, Introduction to Objectivist Epistemology, expanded 2nd ed., Harry Binswanger and Leonard Peikoff, eds. (New York: Meridian, 1990), pp. 59–61. 50. See Ayn Rand, For the New Intellectual (New York: Signet, 1961), p. 154 for this example and more. 51. White, “Competitive Payments Systems,” p. 706 explains the transition to fiat money from commodity money in a similar fashion. 52. Black, “Banking and Interest Rates,” p. 14. 53. White, “Competitive Payments Systems,” pp. 710–711 does a good job addressing this. 54. Greenfield and Yeager, “A Laissez-Faire Approach,” pp. 307, 310, and 314. 55. White, “Competitive Payments Systems,” p. 710. 56. For the paraphrased statement, see William M. Gouge, A Short History of Paper Money and Banking in the United States, to Which Is Prefixed: An Inquiry into the Nature of the System, part 1 (New York: Augustus M. Kelley, 1968 [1833]), p. 63. 57. Steven J. Pilloff, “Money Market Mutual Funds: Are They a Close Substitute for Accounts at Insured Depository Institutions?” The Antitrust Bulletin vol. 44, no. 2 (Summer 1999), pp. 365–385. See Table 4 on p. 373. 58. Selgin, Bank Deregulation, p. 70. 59. White, “Competitive Payments Systems,” pp. 707–708.

6 The Significance of Some of the Historically Freer Banking Periods 1. Kurt Schuler, “The World History of Free Banking: An Overview” in Kevin Dowd, ed., The Experience of Free Banking (London: Routledge, 1992), pp. 7–47. See in particular pp. 9 and 40–45. 2. Richard M. Salsman, Gold and Liberty (Great Barrington, MA: American Institute for Economic Research, 1995), p. 23. 3. See Sydney G. Checkland, Scottish Banking: A History, 1695–1973 (Glasgow, Scotland: Collins, 1975), pp. 454–456, 458, and 715 for a description of these acts. 4. Ibid., p. 25. 5. Lawrence H. White, “Free Banking in Scotland before 1844” in Dowd, The Experience of Free Banking, pp. 157–186. See pp. 158–159 and 185.

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6. See Lawrence H. White, “Banking without a Central Bank: Scotland before 1844 as a ‘Free Banking’ System” in Forrest Capie and Geoffrey E. Wood, eds., Unregulated Banking: Chaos or Order? (New York: St. Martin’s Press, 1991), pp. 37–62. See especially pp. 44–45. 7. Checkland, Scottish Banking, p. 46. 8. On the third suspension, see ibid., p. 60. 9. White, “Free Banking in Scotland,” p. 160. 10. Checkland, Scottish Banking, p. 67. 11. Ibid., p. 121. 12. White, “Free Banking in Scotland,” pp. 180–181. 13. Ibid., p. 186. 14. Murray N. Rothbard, “The Myth of Free Banking in Scotland,” The Review of Austrian Economics vol. 2, no. 1 (1988), pp. 229–245. See p. 231. 15. Checkland, Scottish Banking, p. 76. 16. Ibid., p. 193. 17. Ibid., pp. 74–75, 193–194, 432, and 437–438. Also see, Larry J. Sechrest, “White’s Free-Banking Thesis: A Case of Mistaken Identity,” The Review of Austrian Economics vol. 2, no. 1 (1988), pp. 247–257. See pp. 252–253. 18. Checkland, Scottish Banking, pp. 214–215, 219–220, 276, 404, 410, 411, 432, and 444. 19. Ibid., pp. 46, 121, 248, and 275–276 and White, “Free Banking in Scotland,” p. 173. 20. Checkland, Scottish Banking, p. 24. 21. White, “Free Banking in Scotland,” pp. 173 and 175–176. 22. Checkland, Scottish Banking, p. 46. Also see this reference for the statement regarding the limited capital six partners could raise compared to the BOE. 23. White, “Banking without a Central Bank,” pp. 49–59. 24. Ibid., p. 53. 25. Ibid., pp. 57–58. 26. Ibid., p. 58. 27. Ibid., p. 52. 28. Ibid., pp. 56–57. 29. Ibid., pp. 58 and 59. 30. Ibid., pp. 54 and 58. 31. Ibid., p. 57. 32. For White’s view on Checkland, see Lawrence H. White, Free Banking in Britain: Theory, Experience, and Debate, 1800–1845 (Cambridge: Cambridge University Press, 1984), p. 33. Also see Sechrest, “White’s Free-Banking Thesis,” p. 248. 33. Checkland, Scottish Banking, pp. 255, 275–276, and 711. 34. Larry J. Sechrest, Free Banking: Theory, History, and a Laissez-Faire Model (Auburn, AL: The Ludwig von Mises Institute, 2008), pp. 89–90 and Checkland, Scottish Banking, p. 184. 35. Checkland, Scottish Banking, p. 186. 36. White, “Banking without a Central Bank,” p. 45. 37. Ibid., pp. 42–43. 38. White, “Free Banking in Scotland,” p. 176. 39. Tyler Cowen and Randall Kroszner, “Scottish Banking before 1845: A Model for Laissez-Faire?” Journal of Money, Credit, and Banking vol. 21, no. 2 (May 1989), pp. 221–231. See p. 226.

No t e s 40. 41. 42. 43. 44. 45. 46. 47. 48. 49.

50. 51.

52.

53.

54. 55.

56. 57.

58. 59. 60. 61. 62.

63.

64. 65.

283

White, “Banking without a Central Bank,” p. 43. White, “Free Banking in Scotland,” p. 170. White, “Banking without a Central Bank,” p. 45. Frank Whitson Fetter, Development of British Monetary Orthodoxy, 1797–1875 (Cambridge, MA: Harvard University Press, 1965), p. 122. Checkland, Scottish Banking, p. 185. Ibid., p. 184. Ibid., pp. 186 and 253. Also see Sechrest, “White’s Free-Banking Thesis,” p. 249. Checkland, Scottish Banking, p. 437. Andrew William Kerr, History of Banking in Scotland, 4th ed. (London: A. & C. Black, Ltd., 1926), pp. 126–127. Mark Skousen, Economics of a Pure Gold Standard, 3rd ed. (Irvingtonon-Hudson, NY: The Foundation for Economic Education, Inc., 1996), pp. 22–24. See Checkland, Scottish Banking, pp. 407, 414, and 438 for some examples. This section is based to some extent on Brian P. Simpson, Trade Cycle Theory: A Market Process Perspective (Ann Arbor, MI: Bell & Howell Information and Learning Company, 2000), pp. 106–110. Murray N. Rothbard, “Salutary Neglect”: The American Colonies in the First Half of the Eighteenth Century, vol. 2 of Conceived in Liberty (Auburn, AL: The Ludwig von Mises Institute, 1999), pp. 127–129, 131, 133, and 137. See Jeremy Atack and Peter Passell, A New Economic View of American History, 2nd ed. (New York: W. W. Norton & Company, 1994), pp. 90–94 and Peter Temin, The Jacksonian Economy (New York: W. W. Norton & Company, Inc., 1969), pp. 53–55. See Sechrest, Free Banking, pp. 96–97 for a discussion of some of the differences from state to state. Richard M. Salsman, Breaking the Banks: Central Banking Problems and Free Banking Solutions (Great Barrington, MA: American Institute for Economic Research, 1990), pp. 91–95. Sechrest, Free Banking, pp. 95–108. On the insignificance of wildcat banking, see Kevin Dowd, “U.S. Banking in the ‘Free Banking’ Period” in Dowd, The Experience of Free Banking, pp. 206–240. See in particular pp. 217–219. Salsman, Breaking the Banks, pp. 98–99. Ibid., pp. 99–100 and Dowd, “U.S. Banking,” pp. 211–212. Atack and Passell, A New Economic View, pp. 502–505 and Salsman, Breaking the Banks, pp. 104–105. Atack and Passell, A New Economic View, p. 93. See Chapters 5, 6, 8, and 9 of Brian P. Simpson, Money, Banking, and the Business Cycle, Volume 1: Integrating Theory and Practice (New York: Palgrave Macmillan, 2014) for some of these monetary statistics. See Kurt Schuler, “Free Banking in Canada” in Dowd, The Experience of Free Banking, pp. 79–92. See in particular pp. 80, 82, and 87. See B. E. Walker, A History of Banking in Canada (Toronto, Canada: [n. p.], 1909), pp. 41–42 for a brief comparison of banking in Canada versus New York State in the midnineteenth century. Schuler, “Free Banking in Canada,” p. 80. Ibid., p. 83 and Walker, A History of Banking in Canada, pp. 35–36.

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66. Walker, A History of Banking in Canada, pp. 31–32. 67. Ibid., pp. 21, 25, 27, 28, 31–32, and 43 and Schuler, “Free Banking in Canada,” pp. 86 and 88. 68. Walker, A History of Banking in Canada, pp. 21, 27, 30, and 41. 69. Ibid., pp. 36–37 and 48. 70. Schuler, “Free Banking in Canada,” p. 83. 71. Walker, A History of Banking in Canada, pp. 42–43. 72. Ibid., p. 38 and Schuler, “Free Banking in Canada,” p. 84. 73. See Schuler, “Free Banking in Canada,” p. 86 for the main provisions of the 1870 and 1871 Bank Act. See Walker, A History of Banking in Canada, pp. 53–59 for a summary of the provisions in the 1890 act. 74. Frank Whitson Fetter, Monetary Inflation in Chile (Princeton: Princeton University Press, 1931), pp. 6–7. 75. Ibid., pp. 7–8 and Murray N. Rothbard, “The Other Side of the Coin: Free Banking in Chile,” Austrian Economics Newsletter vol. 10, no. 2 (1989), pp. 1–4. See in particular p. 2. 76. Rothbard, “The Other Side of the Coin,” p. 2. 77. George Selgin, “Short-Changed in Chile: The Truth about the Free-Banking Episode,” Austrian Economics Newsletter vol. 11, no. 1 (1990), pp. 5–7. See p. 5. 78. I put the word “price” in quotation marks in the main text because this is not a price in the traditional sense. It is a ratio of the monetary values of the metals as determined by the separate definitions of the monetary unit in terms of each metal. 79. Selgin, “Short-Changed in Chile,” p. 6. 80. Edward H. Strobel, “Cheap Money in Chile,” Sound Currency vol. 3, no. 16 (July 15, 1896), pp. 547–570. See p. 550 for the quotation. 81. Selgin, “Short-Changed in Chile,” p. 7. 82. Rothbard, “The Other Side of the Coin,” p. 2. 83. Kevin Dowd, “Free Banking in Australia” in Dowd, The Experience of Free Banking, pp. 48–78. See p. 49. 84. George Selgin, Bank Deregulation and Monetary Order (London: Routledge, 1996), pp. 271–272. 85. Charles R. Hickson and John D. Turner, “Free Banking Gone Awry: The Australian Banking Crisis of 1893,” Financial History Review vol. 9 (2002), pp. 147–167. See p. 147. 86. D. T. Merrett, “Australian Banking Practice and the Crisis of 1893,” Australian Economic History Review vol. 29, no. 1 (March 1989), pp. 60–85. See pp. 64 and 84. 87. Selgin, Bank Deregulation, p. 272. 88. Hickson and Turner, “Free Banking Gone Awry,” p. 152. 89. Dowd, “Free Banking in Australia,” pp. 52–53. 90. Hickson and Turner, “Free Banking Gone Awry,” pp. 153–154. 91. See Jonathan R. Macey and Geoffrey P. Miller, “Double Liability of Bank Shareholders: History and Implications,” Wake Forest Law Review vol. 27 (1992), pp. 31–62. See in particular pp. 59–60. 92. Ibid., pp. 34 and 57–58. 93. For an example, see Hickson and Turner, “Free Banking Gone Awry,” pp. 153–154. 94. For example, see Chay Fisher and Christopher Kent, “Two Depressions, One Banking Collapse,” Reserve Bank of Australia, Research Discussion Paper,

No t e s

95. 96. 97. 98.

99. 100. 101. 102. 103.

104. 105. 106. 107. 108. 109. 110. 111. 112. 113. 114. 115.

116.

117.

118.

285

Research Discussion Paper 1999–06 (June 1999), pp. 1–54. See pp. 27 and 35. Also see Kris James Mitchener and Marc D. Weidenmier, “The Baring Crisis and the Great Latin American Meltdown of the 1890s,” The Journal of Economic History vol. 68, no. 2 (June 2008), pp. 462–500. See pp. 465–467. In addition, see Barry Eichengreen, “The Baring Crisis in a Mexican Mirror,” International Political Science Review vol. 20, no. 3 (July 1999), pp. 249–270. See pp. 250 and 253–254. Finally, see Hickson and Turner, “Free Banking Gone Awry,” p. 150. Merrett, “Australian Banking Practice,” pp. 60–62. See Hickson and Turner, “Free Banking Gone Awry,” p. 150. Eichengreen, “The Baring Crisis,” pp. 253–254 and 266. Ibid., pp. 250 and 262 and J. Bradford Delong, Richard N. Cooper, and Benjamin M. Friedman, “Financial Crises in the 1890s and the 1990s: Must History Repeat?” Brookings Papers on Economic Activity vol. 1999, no. 2 (1999), pp. 253–294. See p. 263. H. S. Ferns, “The Barings Crisis Revisited,” Journal of Latin American Studies vol. 24, no. 2 (May 1992), pp. 241–273. See pp. 250 and 257. On the last few points, see Eichengreen, “The Baring Crisis,” pp. 252, 255–256, and 262. On the excessive borrowing and spending in Argentina, see ibid., pp. 263–265. Merrett, “Australian Banking Practice,” pp. 60–61. Albert C. Stevens, “Analysis of the Phenomena of the Panic in the United States in 1893,” The Quarterly Journal of Economics vol. 8, no. 2 (January 1894), pp. 117–148. See p. 121. Hickson and Turner, “Free Banking Gone Awry,” p. 162 and Dowd, “Free Banking in Australia,” p. 49. Dowd, “Free Banking in Australia,” p. 49. Ibid. p. 70. Hickson and Turner, “Free Banking Gone Awry,” p. 163. Ibid., pp. 163–164. Ibid., pp. 162–165. See chapters 1, 3, and 4 above, as well as Chapters 2–9 of Simpson, Money, Banking, and the Business Cycle, Volume 1. Hickson and Turner, “Free Banking Gone Awry,” p. 150. Salsman, Gold and Liberty, pp. 47–48 and 82. Merrett, “Australian Banking Practice,” pp. 63–64. Hickson and Turner, “Free Banking Gone Awry,” p 151. For some examples, see Kevin Dowd, “Introduction” in Dowd, The Experience of Free Banking, pp. 1–6. See pp. 3–6 where he summarizes the discussion on this topic in the rest of his book by a number of other authors. For evidence of the credit expansion from the very writers who claim competition is to blame, see Hickson and Turner, “Free Banking Gone Awry,” pp. 148 and 160 and Merrett, “Australian Banking Practice,” pp. 60–61, 63, and 65. Also see the discussion above in this section on the credit expansion that was the source of this crisis. See Salsman, Breaking the Banks, pp. 39–78 and 89–111 and Gold and Liberty, pp. 47–48 and 82; Schuler, “The World History of Free Banking,” pp. 19–24, 26–27, and 39; and Selgin, Bank Deregulation, pp. 195–201, 204, and 208–214 to name just a few. For some examples, see Elgin Groseclose, Money and Man: A Survey of Monetary Experience (New York: Frederick Ungar Publishing Co., 1961), pp. 216–218

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119. 120. 121.

122.

123.

124. 125.

and J. Van Fenstermaker, John E. Filer, and Robert Stanley Herren, “Money Statistics of New England, 1785–1837,” The Journal of Economic History vol. 44, no. 2 (June 1984), pp. 441–453. See in particular pp. 452–453 of the latter reference. In addition, see Salsman, Breaking the Banks, p. 46. For an example, see Davis Rich Dewey, Financial History of the United States, 10th ed. (New York: Longmans, Green and Co., 1928), p. 260. See Checkland, Scottish Banking, pp. 84, 237, and 424 for evidence of this. On this last point, see Yaron Brook and Don Watkins, Free Market Revolution: How Ayn Rand’s Ideas Can End Big Government (New York: Palgrave Macmillan, 2012), pp. 52–56. Also see Steven Horwitz and Peter Boettke, “The House That Uncle Sam Built: The Untold Story of the Great Recession of 2008” (October 8, 2010), http://c457332.r32.cf2.rackcdn.com/wp-content /uploads/2009/12/HouseUncleSamBuiltBooklet.pdf, pp. 11–14, 17, and 18, accessed February 22, 2013. Here are the citations: Milton Friedman and Anna Jacobson Schwartz, A Monetary History of the United States, 1867–1960 (Princeton: Princeton University Press, 1963). I used demand deposits of commercial banks from Table A-1 and bank reserves from Table A-2, both in Appendix A. For checking deposits after 1960, see the Federal Reserve Bank of St. Louis, FRED database, series ID TCDNS (“Total Checkable Deposits, Not Seasonally Adjusted” from the H6 “Money Stock Measures” release). For reserves after 1960, see the Federal Reserve Bank of St. Louis, FRED database, series ID TOTRESNS (“Board of Governors Total Reserves, Not Adjusted for Changes in Reserve Requirements, Not Seasonally Adjusted” from the H3 “Aggregate Reserves of Depository Institutions and the Monetary Base” release). Online data obtained June 6, 2012. See Jesús Huerta de Soto, Money, Bank Credit, and Economic Cycles, translated by Melinda A. Stroup (Auburn, AL: Ludwig von Mises Institute, 2006), p. 50 for a suspension granted by Grecian authorities. He says it is the first historically documented privilege for banks. For one example, see ibid., p. 100. For how such a system would work, see Ayn Rand, The Virtue of Selfishness (New York: Signet, 1964), pp. 135–140 and Brian P. Simpson, Markets Don’t Fail! (Lanham, MD: Lexington Books, 2005), p. 208.

7

Gold and 100-Percent Reserves

1. It should come as no surprise that I rely heavily on George Reisman, Capitalism: A Treatise on Economics (Ottawa, IL: Jameson Books, 1996) for my discussion of the benefits of gold and responses to criticisms of gold. See pp. 928–950 and 954–959. I also rely on Brian P. Simpson, Trade Cycle Theory: A Market Process Perspective (Ann Arbor, MI: Bell & Howell Information and Learning Company, 2000), pp. 114–125 for the benefits and responses to criticisms of gold and 100-percent reserves. I make one general reference here to these sources on these topics instead of multiple specific references throughout the chapter. However, I do reference these sources where necessary on related topics. 2. See Michael David Bordo, “The Gold Standard: Myths and Realities” in Barry N. Siegel, ed., Money in Crisis: The Federal Reserve, the Economy, and Monetary Reform (Cambridge, MA: Ballinger Publishing Company, 1984), pp. 197–237. See p. 215.

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3. See Chapters 1 and 3 of Brian P. Simpson, Money, Banking, and the Business Cycle, Volume 1: Integrating Theory and Practice (New York: Palgrave Macmillan, 2014) for a detailed discussion of how fractional-reserve banking causes the business cycle. 4. See Roy W. Jastram, The Golden Constant (New York: John Wiley & Sons, 1977), pp. 34–37 and 147–148 and Bordo, “The Gold Standard,” pp. 211–214. Also see Mark Skousen, Economics of a Pure Gold Standard, 3rd ed. (Irvingtonon-Hudson, NY: The Foundation for Economic Education, Inc., 1996), pp. 108–109 and Alan Reynolds, “Why Gold?,” Cato Journal vol. 3, no. 1 (Spring 1983), pp. 211–238. See p. 221 in the latter reference. 5. Skousen, Economics of a Pure Gold Standard, pp. 83–86. This average and the average reported above are different because they come from different time periods and different references. 6. Ibid., pp. 83–89. 7. For a few economists who do this, including John Maynard Keynes, see ibid., pp. 105–107. For a few other economists, see Reynolds, “Why Gold?,” p. 217. For the “new monetary economist forerunners” who do this, see Tyler Cowen and Randall Kroszner, “The Development of the New Monetary Economics,” The Journal of Political Economy vol. 95, no. 3 (June 1987), pp. 567–590. See p. 570. Paul Samuelson and William Nordhaus do this as well. See Paul A. Samuelson and William D. Nordhaus, Economics, 13th ed. (New York: McGraw-Hill Book Co., 1989), p. 949. For one last example, see David I. Meiselman, “Is Gold the Question?” Cato Journal vol. 3, no. 1 (Spring 1983), pp. 269–275. See especially pp. 273–274. 8. For some examples of massive inflations under fiat money, see Phillip Cagan, “The Monetary Dynamics of Hyperinflation” in Milton Friedman, Studies in the Quantity Theory of Money (Chicago: University of Chicago Press, 1956), pp. 23–91. See p. 26. 9. For more on inflation, the demand for money, and velocity, see Chapters 1 and 2 of Simpson, Money, Banking, and the Business Cycle, Volume 1. 10. See Chapter 1 of ibid. 11. See Reisman, Capitalism, pp. 973–974 for more on why falling prices under a gold standard do not represent deflation. 12. See Chapters 2 and 3 of Simpson, Money, Banking, and the Business Cycle, Volume 1 for why the propositions in the two preceding sentences are true. 13. On the subject of the effect that changes in prices and changes in the money supply and spending have on rates of return, see Reisman, Capitalism, pp. 825–826. 14. Alan Reynolds, “Gold and Economic Boom: Five Case Studies, 1792–1926” in Siegel, Money in Crisis, pp. 249–268 and Reynolds, “Why Gold?,” pp. 216, 218–220, and 229–230. 15. See Edwin A. Locke, The Prime Movers: Traits of the Great Wealth Creators (New York: AMACOM, 2000), p. 2 for evidence of the fact that the rate of economic progress during the former period was higher than in the latter periods. 16. See the discussions on the demand for money and velocity in Chapters 1 and 2 of Simpson, Money, Banking, and the Business Cycle, Volume 1. 17. See ibid. and chapter 4 above on how the government manipulates the supply of money and credit. 18. See Chapter 3 of Simpson, Money, Banking, and the Business Cycle, Volume 1 for greater discussion of this topic.

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19. See Jesús Huerta de Soto, Money, Bank Credit, and Economic Cycles, translated by Melinda A. Stroup (Auburn, AL: Ludwig von Mises Institute, 2006), pp. 380–381 and 413–416 on mal-investment as well. 20. George Reisman, “The Stock Market, Profits, and Credit Expansion,” http://capitalism.net/articles/Stock%20Market,%20Profits,%20Credit%20 Expansion.htm (2002). See Section 6 titled “Why the Credit-Expansion Boom Cannot be Sustained.” Article accessed December 10, 2011. 21. See Chapters 2 and 3 of Simpson, Money, Banking, and the Business Cycle, Volume 1 for a detailed discussion of this topic. 22. See Chapter 2 of ibid. on this topic. 23. Richard M. Salsman, Gold and Liberty (Great Barrington, MA: American Institute for Economic Research, 1995), pp. 47–48. 24. Huerta de Soto, Money, p. 341. 25. See Christina D. Romer, “Remeasuring Business Cycles,” The Journal of Economic History vol. 54, no. 3 (September 1994), pp. 573–609. See in particular pp. 574–576 and 606. 26. George Reisman, “Mining for the Next Million Years,” http://georgere ismansblog.blogspot.com/2006/08/mining-for-next-million-years.html (August 14, 2006). Article accessed June 21, 2012. 27. George Selgin, Bank Deregulation and Monetary Order (London: Routledge, 1996), pp. 98 and 194. 28. Ibid., p. 194. 29. Skousen, Economics of a Pure Gold Standard, pp. 84–85. 30. See Cowen and Kroszner, “The Development of the New Monetary Economics,” p. 585 for the acceptance of this idea by both Henry Meulen and Adam Smith. For Paul Samuelson’s acceptance of this idea, see a quotation from him in Huerta de Soto, Money, p. 778. See also George A. Selgin, The Theory of Free Banking (Totowa, NJ: Rowman & Littlefield, 1988), p. 22 for J. Carl Poindexter’s acceptance of this idea. 31. See Chapter 7 of Simpson, Money, Banking, and the Business Cycle, Volume 1 on Law’s scam. 32. Ludwig von Mises, Human Action, 3rd rev. ed. (Chicago: Contemporary Books, Inc., 1966), pp. 767–769. 33. Roger W. Garrison, “The Costs of a Gold Standard” in Llewellyn H. Rockwell, Jr., ed., The Gold Standard: Perspectives in the Austrian School (Auburn, AL: Ludwig von Mises Institute, 1992), pp. 61–79. See in particular pp. 67–68. 34. Ibid., pp. 66–67. See also Samuelson and Nordhaus, Economics, p. 949 for recognition of the inelasticity of the supply of gold. 35. Garrison, “The Costs of a Gold Standard,” p. 70. 36. Ibid., pp. 70–71 and Huerta de Soto, Money, p. 780. 37. Garrison, “The Costs of a Gold Standard,” p. 68. 38. Ibid., pp. 67, 69, 71, and 73. 39. Ibid., p. 68. 40. See John Maynard Keynes, The General Theory of Employment, Interest, and Money (Basingstoke, UK: Palgrave Macmillan, 2007 [1936]), pp. 235–236 and F. A. Hayek, Individualism and Economic Order (Chicago: The University of Chicago Press, 1948), p. 211. 41. See Chapter 1 of Simpson, Money, Banking, and the Business Cycle, Volume 1 for more on how changes in the supply of money cause changes in the demand for money.

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289

How to Transition to a Free Market in Money and Banking

1. Here are the full citations: George Reisman, Capitalism: A Treatise on Economics (Ottawa, IL: Jameson Books, 1996), pp. 951–954; Richard M. Salsman, Breaking the Banks: Central Banking Problems and Free Banking Solutions (Great Barrington, MA: American Institute for Economic Research, 1990), pp. 130–140; and Murray N. Rothbard, The Mystery of Banking, 2nd ed. (Auburn, AL: Ludwig von Mises Institute, 2008), pp. 261–268. 2. For the sources of the money supply, see Chapter 6 of Brian P. Simpson, Money, Banking, and the Business Cycle, Volume 1: Integrating Theory and Practice (New York: Palgrave Macmillan, 2014). The money supply value used here is the one in Chapter 6 that is close to M1.5. For the source of the gold supply, see Department of the Treasury, Agency Financial Report, Fiscal Year 2012 (November 15, 2012), p. 86. 3. Jesús Huerta de Soto, Money, Bank Credit, and Economic Cycles, translated by Melinda A. Stroup (Auburn, AL: Ludwig von Mises Institute, 2006), pp. 794–795. 4. On this point, see Brian P. Simpson, Markets Don’t Fail! (Lanham, MD: Lexington Books, 2005), pp. 12–24 and 27 and the references provided there. 5. Bettina Bien Greaves, “How to Return to the Gold Standard,” The Freeman: Ideas on Liberty vol. 45, issue 11 (November 1995). 6. Joseph T. Salerno, “The Gold Standard: An Analysis of Some Recent Proposals,” Policy Analysis, no. 16 (September 9, 1982). 7. Huerta de Soto, Money, pp. 788–805. 8. Ibid., pp. 794–796. 9. Ibid., pp. 743 and 791. 10. Ibid., pp. 792 and 794. 11. Ibid., pp. 796–801. 12. Ibid., pp. 796–797 and 801. 13. For more on achieving a laissez-faire capitalist society, see Simpson, Markets Don’t Fail!, pp. 206–209. For a more detailed discussion of this topic, see Reisman, Capitalism, pp. 969–989. 14. Alan Reynolds, “Gold and Economic Boom: Five Case Studies, 1792–1926” in Barry N. Siegel, ed., Money in Crisis: The Federal Reserve, the Economy, and Monetary Reform (Cambridge, MA: Ballinger Publishing Company, 1984), pp. 249–268.

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I n de x

acceleration principle, 108–9 “administered” prices and wages, 47, 48, 60 altruism. See morality of self-sacrifice American banking. See banking American Revolution, 196, 238 Anderson, Benjamin M., 68 antitrust laws, 53 Arab oil embargo, 4, 96 arbitrary assertion, 29, 38, 41, 43, 91, 180–1 Argentina, 204, 207–8, 210, 212 auction-market pricing, 47, 48, 52, 59–60, 61, 62 Australian banking. See banking Austrian business cycle theory (ABCT), 1–4, 9, 106–7, 109–10, 235 average period of production, 26 Bank Act of 1890 (Canada), 201 bank examinations, assurances, inspections, and endorsements, 122, 125, 158, 166–7, 198, 212, 217 Bank of England (BOE), 178–9, 189–91, 195, 199, 214 and the financial crisis in Australia at the end of the nineteenth century, 204, 206–8, 210, 212 Bank of Scotland (BOS), 188–90, 192–3 banking, 2 American, 195–9 in ancient Greece, 142, 151, 216 Australian, 177, 203–13 branch, 121, 177, 196, 199, 204, 211, 217, 246 Canadian, 141–2, 177, 199–201 Chilean, 201–3 English, 120–1, 188–91, 193–5

“holidays,” 120, 198, 209 Italian, 142, 151 during the Middle Ages, 142 Scottish, 141–3, 163, 164, 174, 177, 188–95, 198–9, 213–14 wildcat, 196–7 see also fractional-reserve banking, one-hundred-percent reserve banking Barings crisis, 207–8 Basel Accords, 215 bimetallic standard, 202–3 Blinder, Alan, 69–74 Block, Walter, 126 Breaking the Banks: Central Banking Problems and Free Banking Solutions, 244 Bretton Woods System, 253–4 British Banking School, 148 Buffet, Warren, 38 Canadian banking. See banking Canadian Confederation, 201 capitalism, 9–10, 21, 35, 43, 132, 258, 262 belief that the business cycle is an inherent feature of, 1, 107, 108 Keynesian economists’ moral disdain for, 45, 78 see also free market, free market in money and banking Capitalism: A Treatise on Economics, 43, 244 Caribbean, 69, 221 Cernuschi, Henri, 133 Checkland, Sydney, 191, 194, 195 Chilean banking. See banking Civil War (United States), 115, 197, 198, 202, 238

300

I n de x

clearinghouse associations, 147, 165–8, 172, 178–9, 212, 254 and the government, 152, 157, 247 Colonial Bank Regulations, 204 commodity money, 105, 119, 134, 137, 149, 154, 157, 160 alleged disappearance in a free market, 175, 179–84 and the business cycle, 113 costs of, 239–40 and stability, 221 and the use of banknotes, 201–2 see also free market Community Reinvestment Act, 3, 262 consols, 129 context dropping, 29, 35, 181 Continental currency, 196, 238 contracts. See “new Keynesian” economics Cowen, Tyler, 192 credit expansion, 32, 132–4, 139–40, 207, 210–11, 212, 230, 235 see also real business cycle (RBC) theory deflation, 85, 98, 117, 219–24, 233, 258 demand for money, 31–2, 102, 144–9, 222, 224–5, 240–1 see also fiat money, inflation, inflationary policy/expansion, real business cycle (RBC) theory, velocity of circulation of money Democrats, 249 deposit insurance, 122–3, 141, 161–2, 163–4, 172, 206, 239, 262 and the creation of instability in the economy, 39 and a free market, 123, 125, 158, 217, 244, 246 and risk taking, 123, 161, 164, 212 at the state government level, 196, 254 and the transition to a free market in money and banking, 243 see also fiat money, fractional-reserve banking depression of the early 1920s, 29, 68, 77 determinism, 93–4 Deutsche Mark, 240 Dodd-Frank Wall Street Reform and Consumer Protection Act, 123

double liability. See extended liability Dowd, Kevin, 204 econometrics. See statistical analysis Edison, Thomas, 40–1 efficiency wage theory. See “new Keynesian” economics egoism. See morality of rational self-interest English banking. See banking erratic money supply and spending theory, 62 European Union, 238 exports, 4, 89, 237, 251, 252 extended liability, 122, 125, 158, 198, 205–6, 217 in Australia, 204–5, 210 in Canada, 200, 201 in Scotland, 192–3 fallacy of self-exclusion, 42, 94 fallacy of the stolen concept, 181 Fannie Mae (Federal National Mortgage Association), 3, 153, 215 FDIC Improvement Act, 123 Federal Deposit Insurance Corporation (FDIC), 39, 215, 239, 243, 246 Federal Reserve, 39, 114, 146, 179, 198, 214, 215, 219 and the confiscation of gold from banks, 160, 198, 256 as a cost of fiat money and fractional reserves, 239 and a free market, 39, 125, 147 inflationary policy of, 68, 84 and interest rates, 42, 99, 134 and “monetary policy,” 147, 215, 254 and monetary systems that incorporate gold in some way, 253–5 recent policy of, 68, 84, 118, 134, 147, 215 and the transition to a free market in money and banking, 243–4, 246, 247, 248 Federal Reserve Act, 198, 214 Federal Reserve Notes, 243, 245, 253, 254–5, 256 Federal Savings and Loan Insurance Corporation, 123

I n de x fiat money, 119, 134–5, 257, 262 its creation through government interference, 4, 37, 101, 107, 110, 114–16, 242 and the demand for money, 148, 149, 241 and deposit insurance, 162 and a free market, 125, 183–4, 217, 219 versus the gold standard (or commodity money), 160, 169, 176, 183, 220–1, 232–3, 236, 237–41 and greenbacks, 197 and inflation, 120, 231, 241, 247 and monetary systems that incorporate gold in some way, 254–5 and real business cycle theory, 97, 99, 101, 104, 105 its role in creating the business cycle, 1, 95–6, 113 and the transition to a free market in money and banking, 237, 249–52 see also individual rights, inflation fiduciary media, 126–30, 132–5, 137–9, 142, 147, 162, 256 and a free market, 167, 175–6, 220, 221 and the transition to a free market in money and banking, 236, 248 see also fractional-reserve banking First Bank of the United States, 118, 196 “fiscal policy,” 1, 18, 22, 45, 89, 207 Fisher, Irving, 107 forecasting, 42, 221–2 fractional-reserve banking, 37, 39, 101, 110, 116–18 and the business cycle, 1–2, 95–6, 113, 161, 175 in Chile, 201 court rulings in favor of, 120–1, 194 its creation through government interference, 4, 114, 118–25, 215–16, 230, 242, 248 and deposit insurance, 162 and fraud, 126–7, 163, 173, 249 and a free market, 125–49, 174, 215–17 and inflation, 241 versus one-hundred-percent reserve banking, 219–21, 231, 232, 234–6, 238–9

301

and the transition to a free market in money and banking, 247 see also fiduciary media, inflation France, 2–3, 84, 238 fraud, 126–7, 129, 159, 163, 164, 173, 216 and a free market, 143, 152, 153, 158, 160, 175, 196 see also fractional-reserve banking Freddie Mac (Federal Home Loan Mortgage Corporation), 3, 153, 215 free market, 114, 120, 125–49, 196, 213–14, 232, 240 allegedly leads to the business cycle, 1, 10, 78, 80, 107 analysis of Keynes’s views regarding, 25–35 and Australian banking, 204–5, 212–13 and Canadian banking, 199, 200, 201 and Chilean banking, 201, 202, 203 and commodity money, 101, 150, 152–3 and competition, 61 the cure for the business cycle, 1, 233 and English banking, 190 and inflation, 222 and Keynesian “sticky price theory,” 45, 46, 52–3, 57, 58, 59, 63, 78 Keynes’s views regarding, 18–24 and Scottish banking, 191–2, 193, 194–5 see also capitalism, deposit insurance, Federal Reserve, fiat money, fiduciary media, fractional-reserve banking, fraud, free market in money and banking, gold standard, inflation free market in money and banking, 4–5, 121–3, 188–9, 213, 216–17, 234, 239, 261 alternative plans to transition to, 255–8 characteristics of, 151–9 the effects of, 159–75 fallacies regarding, 175–84 how to transition to, 243–53 practicality of, 262–3 see also deposit insurance, Federal Reserve, fiat money, fiduciary media, fractional-reserve banking, inflation

302

I n de x

free will, 43, 93–4, 109 freedom, 43, 152, 196, 213, 232, 241, 255, 259 in Australia, 204 of competition, 122, 178, 183 and Keynesian “sticky price theory,” 53, 57–8, 59, 69–70, 72–3 and the morality of rational self-interest, 262 in Scotland, 188 and wildcat banking, 197 The Freeman: Ideas on Liberty, 258 Friedman, Milton, 215 Garrison, Roger, 239 Gates, Bill, 40–1 Glass-Steagall Act of 1933, 215 gold certificate plan, 253 gold “price rule,” 254 gold standard, 198, 247, 249–53 alternative plans to transition to, 255–8 benefits of, 219–26, 231–3 “classical,” 254 criticisms and responses to criticisms of, 233–4, 236–42 and a free market, 125, 159 how to transition to, 243–53 and inflation, 176 parallel, 254–5 and real business cycle theory, 105 see also fiat money “The Gold Standard: An Analysis of Some Recent Proposals” (article), 253 goldsmith, 121 Gouge, William M., 146, 147, 184 Great Britain, 188, 194, 204, 206–7, 210, 212 Great Depression, 3, 4, 36, 117, 120, 198, 210, 215 and Keynesian “sticky price theory,” 57, 64, 68 and real business cycle theory, 82, 85, 88, 90, 91, 101 Greaves, Bettina Bien, 258 Greece, 238 greenback, 197, 238 Greenspan, Alan, 239 Gresham’s law, 195, 202

gross domestic product (GDP), 3, 15 gross national revenue (GNR), 3, 67 Hickson, Charles, 204, 208, 210, 211 hoarding, 17, 34, 35, 36, 100 Hobson, J. A. 13–14, 19, 22 Hoover, Herbert, 3, 36, 57, 64, 68, 101, 198 Hoppe, Hans-Hermann, 126 “How to Return to the Gold Standard” (article), 258 Huerta de Soto, Jesús, 127–30, 132–4, 255–8 Hülsmann, Jörg Guido, 126 Hungary, 160, 176 hyperinflation, 69, 77, 149 hysteresis. See “new Keynesian” economics imperfect competition, 47, 60, 81 imports, 4, 89, 101, 237, 244, 251–2 individual rights, 36, 39–40, 143, 176, 179, 196–8, 249, 254 in Australia, 204–5, 208–9 and the business cycle, 1 in Chile, 201–2 and fiat money and/or fractionalreserves, 113, 120, 126–7, 128–30, 174, 216, 217 and a free market in money and banking, 152–3, 156–9 and Keynesian “sticky price theory,” 45, 53, 56–9, 62, 63–4, 66, 67–8, 72–3 and the morality of rational self-interest, 262 and the proper function of government, 161, 173, 175, 200, 245, 247, 259 as requirements of human life, 232 in Scotland, 188, 193–5 inflation, 51, 69, 71, 85, 109, 115–16, 219–21 capital decumulation, 225–31 and the demand for money, 225 and economic progress, 120, 225 erosion of people’s savings and income, 119–20, 230–1 and fiat money and/or fractional reserves, 114, 134–5, 139, 140, 238, 241

I n de x and a free market, 175, 197 and gold and one-hundred-percent reserves, 169, 198, 219, 247, 248, 249, 251 and government control of money, 176, 198 indexing, 231 mal-investment, 2, 75–7, 84, 139, 210, 226–7, 235, 238 negative effect due to taxes, 228–9, 238 overconsumption, 95, 134, 139, 227, 235, 238 proper understanding of, 3, 115, 222, 224 reversal-of-safety effect, 134, 227–8 tax-bracket creep, 229–30 and the transition to a free market in money and banking, 250 withdrawal-of-wealth effect, 134, 230, 238 see also money supply inflation hedge, 225, 226 inflationary policy/expansion, 37, 39, 83, 115, 210, 227 and the demand for money, 17, 36, 147, 224 and fractional reserves, 139, 140, 141 insider-outsider theory. See “new Keynesian” economics Israel, 176, 220 John Law’s financial scam (Mississippi Bubble), 2, 84, 238 Kalecki, Michal, 108 Keynes, John Maynard the ability of a fall in wages to decrease unemployment, 21–2, 27–30 confusion of gross and net values, 33–4 desire for government control of the economy, 42 equates saving with hoarding, 34–5 implicit denial of the law of demand, 27, 30 inducement to invest, 19–21, 22, 25, 30, 41 interest rates, 31–3 marginal efficiency of capital (MEC), 20–3, 28–9, 30–2

303

and the need for more consumption, 19, 21, 22, 27–8 theory of depressions, 18–22, 25–35 theory of economic fluctuations, 23–4, 35–43 view of expectations, 23, 35, 37–8 view that humans have a limited need and desire for wealth, 25 view that man by nature is irrational, 23, 37, 41–3 “Keynesian multiplier,” 17 Keynesian “sticky price theory,” 45–50 empirical problems with, 67–77 theoretical problems with, 50–62 see also free market, freedom, Great Depression, “new Keynesian” economics, real business cycle (RBC) theory kinked demand curve theory. See “new Keynesian” economics Kohler, Heinz, 69 Kroszner, Randall, 192 laissez-faire capitalism. See capitalism Latin America, 69, 220–1 law of comparative advantage, 89 law of demand, 27, 30, 65, 104 law of diminishing returns, 20, 28–9, 97 law of identity, 116 law of large numbers, 91, 92 law of noncontradiction, 130 law of the excluded middle, 130 “legal bills,” 256 “lender of last resort,” 119, 125, 158, 162, 165–6, 178, 191, 198 limited liability, 192–3, 200, 205 see also extended liability limitless need and desire for wealth, 10–11, 25–6 London, 160, 189–91, 193–4, 198, 208 Lower Canada, 200 mal-investment. See inflation Malthus, Thomas, 9 mania theory, 109–10 Markets Don’t Fail!, 1, 43, 159, 261, 263 Marx, Karl, 9 maturity matching, 124, 161, 163–4

304

I n de x

medium of exchange, 179, 181–2, 184, 240 menu costs. See “new Keynesian” economics Merrett, David, 204, 211 Mexico, 176 Michigan, 197 minimum capital requirements, 122, 197 minimum wage laws. See price controls minting coins, 151, 152–3, 160, 234, 243, 245, 255 Mises, Ludwig von, 80, 132–3 Mississippi Bubble. See John Law’s financial scam Mitchell, Wesley Clair, 107 mixed economy, 40, 58, 95, 156, 216, 248–9, 262–3 monetarists, 106–7, 253 A Monetary History of the United States, 1867–1960, 215 “monetary policy,” 1, 152 see also Federal Reserve Money, Bank Credit, and Economic Cycles, 129 Money, Banking, and the Business Cycle, Volume 1: Integrating Theory and Practice, 144, 226, 227 and real business cycle theory, 90, 92, 96, 100, 101, 106, 107 money market deposit accounts (MMDAs), 172, 173, 256 money market mutual funds (MMMFs), 172–3, 179, 184, 215, 256 money supply, 247 accelerating changes in, 2, 67, 76–7, 117, 202, 228, 231 constant, 27, 97–8, 100, 135, 145, 234 constant rate of increase in, 73–6 monopoly, 60, 175, 176–7, 178–9, 183–4, 199 and English banking, 189, 190 and Scottish banking, 188, 190, 192 morality of rational self-interest, 78, 262 see also freedom morality of self-sacrifice, 78, 231, 261–2 Mummery, A. F., 13–14, 19, 22 The Mystery of Banking, 244 Myth and Measurement: The New Economics of the Minimum Wage, 64–6

National Bank Act of 1863 (United States), 195, 196, 197 National Bank of Chile, 203 National Labor Relations Act, 57 “natural experiment,” 64–6 “natural monopoly,” 176–7 “needs of trade,” 148–9 neo-Keynesianism, 24 “new Keynesian” economics, 24, 45, 63 contracts, 47, 48, 51–3, 57, 63, 66 efficiency wage theory, 49, 54–5, 59, 63, 77 hysteresis, 50, 58–9, 63 insider-outsider theory, 49–50, 58, 63 kinked demand curve theory, 48 menu costs, 47, 52, 57 New South Wales (Australian province), 209–10 New York State, 200–1 Nixon administration, 67 Nordhaus, William, 48, 55, 60, 62 note dueling, 165 one-hundred-percent reserve banking, 153–8, 160–3, 165, 169–75, 187, 194, 201, 213–16 alternative plans to transition to, 255–8 benefits of, 219–20, 223–6, 231–3 criticisms and responses to criticisms of, 233–6, 238 versus fractional reserves, 116, 118, 120–1, 124–5, 131–4, 137–44 how to transition to, 243–53 and real business cycle theory, 101–2 see also inflation Ontario (Canadian province), 199, 200 option clause, 127, 142–4, 158, 163, 189, 193, 200 overproduction, 9–13, 18, 25, 43 perfect competition, 59–62, 66, 72, 77, 81–2 perpetual bonds, 129 Pigou, A. C., 24 political business cycle theory, 107 price controls, 56, 64, 67, 77 maximum, 52, 56–7 minimum wage laws, 30, 43, 56–8, 64–6, 68, 241

I n de x pro-labor union legislation, 30, 43, 52–3, 57, 64, 68, 77, 241 Quebec, 200 Rand, Ayn, 29, 152, 159, 180, 181, 261, 262 rationality, 10, 39, 40–1, 43, 92, 93, 109, 227 real business cycle (RBC) theory, 4, 79–81 business cycle as random, 80, 90–4 changes in technology, 79, 82–6, 97–9 changes on the side of money, 96–105 credit expansion, 84, 101, 102–5 demand for money, 102 fads and changes in fashion, 79, 86, 99 “fiscal policy,” 89–90 government interference, 79–80, 87–90, 101 Keynesian “sticky price theory,” 82 matches between tastes and technology, 87, 100 methodology, 81–2 perfect competition, 81–2 random walk hypothesis, 91–2 regulation, 88–9 restrictions on international trade, 88–9 taxes, 89–90 time preference, 99, 100 velocity of circulation of money, 102 see also fiat money, one-hundredpercent reserve banking, seasonal cycles real-bills doctrine, 148 recession of 2008–9, 18, 54, 109, 147, 164, 172, 211, 215 and real business cycle theory, 82, 85 secondary contributory factors, 3, 57 Reconstruction Finance Corporation, 198 Reisman, George, 13, 25, 43, 159, 244 Republicans, 249 Resumption Act, 197 Roman Empire, 85, 238–9, 261 Roosevelt, Franklin Delano (FDR), 3, 36, 114, 120, 198 Rothbard, Murray, 202, 203, 244 Royal Bank of Scotland (RBS), 188–9

305

Salerno, Joseph, 253–5 Salsman, Richard, 244 Samuelson, Paul, 49, 55, 60, 62 saving, 40, 58–9, 100, 236, 251, 252 and fractional reserves, 135–7 and Keynes’s theory of depressions, 19, 20–2, 25–7, 30–1 and Keynes’s theory of fluctuations, 23, 36–7 net versus gross savings, 33–5 and underconsumptionism, 13–16 see also inflation, Keynes, John Maynard Schumpeter, Joseph, 107 Schwartz, Anna J., 215 Scottish banking. See banking seasonal cycles, 75–6, 80, 94–6, 101–2, 105–6, 144, 149 Second Bank of the United States, 118, 195, 196, 198 selfishness. See morality of rational self-interest self-sacrifice. See morality of self-sacrifice Selgin, George, 141, 202, 203, 204 silver, 101, 124, 152–3, 160, 202–3, 217, 220, 233 Sismondi, J. C. L. de, 9, 13 skepticism, 96 Smoot-Hawley Tariff, 4, 88, 90 socialism, 42, 262–3 South America, 176, 207 spending accelerating changes in, 2, 17, 67, 76–7 constant, 27, 97, 98, 100, 135, 234, 250 constant rate of increase in, 73–6 economically consumptive, 13, 15, 16, 26, 28, 100, 108–9 economically productive, 16, 26, 27, 28, 100, 236 standard money, 101, 114, 179, 182, 195, 214, 245 and the government’s use of money in a free market, 124–5, 153–5, 157, 163, 174, 192, 244–5, 245–6 and monetary stability, 117, 118, 120, 162, 170

306

I n de x

statistical analysis, 64, 65 “sticky price theory.” See Keynesian “sticky price theory” structure of production, 3, 75, 89, 106, 109 sweep accounts, 173 tariff, 4, 79, 88–9, 90 time preference, 16, 26–7, 99, 100, 136–7 see also real business cycle (RBC) theory “too big to fail,” 123, 215 tragedy of the commons, 130–4 Treasury securities, 246, 257 Turkey, 176, 220 Turner, John, 204, 208, 210, 211 underconsumption, 13–17, 18, 22, 24–5 unemployment “insurance.” See welfare for the unemployed unit of account, 179, 180–1, 183, 184 United Kingdom, 129, 204 United States, 115–16, 147, 149, 164, 206, 233, 236, 261 brief history of money and banking in, 195–9 business cycle in, 90, 91 changes in prices in, 57, 68, 69–72

monetary and banking regulations in, 114, 118, 122, 160, 174, 202, 210, 224 transition to a free market in money and banking in, 245–8, 249–53 unlimited liability. See extended liability Upper Canada, 200 US Treasury, 118, 147, 172 velocity of circulation of money, 3, 102, 135, 145–6, 169, 222, 224–5, 241 and the transition to a free market in money and banking, 250, 258 see also demand for money, real business cycle (RBC) theory Victoria (Australian province), 205, 209, 210 Walton, Sam, 40 Weimar Germany, 149, 176, 238 welfare for the unemployed, 30, 43, 57–9, 64, 241 White House Conferences, 3, 64, 68 White, Lawrence, 141, 180, 190–3 wildcat banking. See banking World War I, 198, 224, 254 World War II, 57, 91, 149, 160, 176 Yugoslavia, 160, 240