Economic Recessions, Banking Reform and the Future of Capitalism

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given at the London School of Economics and Political Science, Hayek
Memorial Lecture, October 28, 2010

It is a great
honor for me to have been invited by the London School of Economics
to deliver this Hayek Memorial Lecture. To begin, I would like to
thank the school and especially Professor Timothy Besley for inviting
me, Professor Philip Booth and the Institute of Economic Affairs
for allowing me to also use this as an opportunity to introduce
my most recent book entitled Socialism,
Economic Calculation and Entrepreneurship
, and finally Toby
Baxendale for making this whole event possible.

Today I will
concentrate on the recent financial crisis and the current worldwide
economic recession, which I consider to be the most challenging
problem we as economists must now face.

fatal error of Peel's Bank Act.

I would like
to start off by stressing the following important idea: all the
financial and economic problems we are struggling with today are
the result, in one way or another, of something that happened precisely
in this country on July 19, 1844… What happened on that fateful
day that has conditioned up to the present time the financial and
economic evolution of the whole world? On that date, Peel's Bank
Act was enacted after years of debate between Banking and Currency
School Theorists on the true causes of the artificial economic booms
and the subsequent financial crises that had been affecting England
especially since the beginning of the Industrial Revolution.

The Bank Charter
Act of 1844 successfully incorporated the sound monetary theoretical
insights of the Currency School. This school was able to correctly
discern that the origin of the boom and bust cycles lay in the artificial
credit expansions orchestrated by private banks and financed not
by the prior or genuine savings of citizens, but through the issue
of huge doses of fiduciary media (in those days mainly paper banknotes,
or certificates of demand deposits issued by banks for a much greater
amount than the gold originally deposited in their vaults). So,
the requirement by Peel's Bank Act of a 100 percent reserve on the
banknotes issued was not only in full accordance with the most elementary
general principles of Roman Law regarding the need to prevent the
forgery or the over-issue of deposit certificates, but also was
a first and positive step in the right direction to avoid endlessly
recurring cycles of booms and depressions.

However Peel's
bank Act, not withstanding the good intentions behind it, and its
sound theoretical foundations, was a huge failure. Why? Because
it stopped short of extending the 100 percent reserve requirement
to demand deposits also (Mises 1980, 446–448). Unfortunately, by
Peel's day, some ideas originally hit upon by the Scholastics of
the Spanish Golden Century had been entirely forgotten. The Scholastics
had discovered at least three hundred years earlier that demand
deposits (which they called in Latin u201Cchirographis pecuniarium,u201D
or money created only by the entries in banks' accounting books)
were part of the money supply (Huerta de Soto 2009, 606). They had
also realized that from a legal standpoint, neglecting to maintain
a 100 percent reserve on demand deposits is a mortal sin and a crime
not of forgery, as is the case with the over-issue of banknotes,
but of misappropriation.

This error
of Peel's Bank Act, or rather, of most economists of that period,
who were ignorant of something already discovered much earlier by
the Spanish Scholastics, proved to be a fatal error: after 1844
bankers did continue to keep fractional reserves, not on banknotes
of course, because it was forbidden by the Bank Charter Act, but
on demand deposits. In other words, banks redirected their activity
from the business of over-issuing banknotes to that of issuing demand
deposits not backed by a 100 percent reserve, which from an economic
point of view is exactly the same business. So, artificial credit
expansions and economic booms did continue, financial crises and
economic recessions were not avoided, and despite all the hopes
and good intentions originally put into Peel's Bank Act, this piece
of legislation soon lost all of its credibility and popular support.
Not only that, but the failure of the Bank Act conditioned the evolution
of financial matters up to the present time and fully explains the
faulty institutional design that afflicts the financial and monetary
system of the so-called free market economies, and the dreadful
economic consequences we are currently suffering.

When we consider
the failure of Peel's Bank Act, the evolution of events up to now
makes perfect sense: bubbles did continue to form, financial crises
and economic recessions were not avoided, bank bailouts were regularly
demanded, the lender of last resort or central bank was created
precisely to bail out banks and to permit the creation of the necessary
liquidity in moments of crisis, gold was abandoned and legal tender
laws and a purely fiduciary system were introduced all over the
world. So as we can see, the outcome of this historical process
sheds light on the faulty institutional design and financial mess
that incredibly is still affecting the world at the beginning of
the second decade of the 21st century!

healthy process of capital accumulation based on true savings.

Now it is important
that we quickly review the specifics of the economic processes through
which artificial credit expansions created by a fractional-reserve
banking system under the direction of a Central Bank entirely distort
the real productive structure, and thus generate bubbles, induce
unwise investments and finally trigger a financial crisis and a
deep economic recession. But before that, and in honor of Hayek,
we must remember the fundamental rudiments of capital theory which
up to the present time and at least since the Keynesian revolution,
have been almost entirely absent from the syllabus of most university
courses on economic theory. In other words, we are first going to
explain the specific entrepreneurial, spontaneous and microeconomic
processes that in an unhampered free market tend to correctly invest
all funds previously saved by economic agents. This is important,
because only this knowledge will permit us to understand the huge
differences with respect to what happens if investment is financed
not by true savings, but by the mere creation out of thin air of
new demand deposits which only materialize in the entries of banks'
accounting books. What we are going to explain now is nothing more
and nothing less than why the so-called u201Cparadox of savingu201D is entirely
wrong from the standpoint of economic theory (Hayek 1975, 199–263).
Unfortunately this is something very few students of economic theory
know even when they finish their studies and leave the university.
Nevertheless this knowledge applies without any doubt to one of
the most important spontaneous market processes that every economist
should be highly familiar with.

In order to
understand what will follow, we must visualize the real productive
structure of the market as a temporal process composed of many very
complex temporal stages in which most labor, capital goods and productive
resources are not devoted to producing consumer goods maturing this
year, but consumer goods and services that will mature, and eventually
be demanded by consumers, two, three, four, or even many more years
from now… For instance, a period of several years elapses between
the time engineers begin to imagine and design a new car, and the
time the iron ore has already been mined and converted into steel,
the different parts of the car have been produced, everything has
been assembled in the auto factory, and the new cars are distributed,
marketed and sold. This period comprises a very complex set of successive
temporal productive stages. So, what happens if the subjective time
preference of economic agents suddenly decreases and as a result
the current consumption of this year decreases, for example, by
ten percent? If this happens, three key spontaneous microeconomic
processes are triggered and tend to guarantee the correct investment
of the newly saved consumer goods.

The first
effect is the new disparity in profits between the different
productive stages: immediate sales in current consumer goods industries
will fall and profits will decrease and stagnate compared with the
profits in other sectors further away in time from current consumption.
I am referring to industries which produce consumer goods maturing
two, three, five or more years from now, their profitability not
being affected by the negative evolution of short-term current consumption.
Entrepreneurial profits are the key signal that moves entrepreneurs
in their investment decisions, and the relatively superior profit
behavior of capital goods industries which help to produce consumer
goods that will mature in the long term tells entrepreneurs all
around the productive structure that they must redirect their efforts
and investments from the less profitable industries closer to consumption
to the more profitable capital goods industries situated further
away in time from consumption.

The second
effect of the new increase in savings is the decrease in the
interest rate and the way it influences the market price of capital
goods situated further away in time from consumption: as the interest
rate is used to discount the present value of the expected future
returns of each capital good, a decrease in the interest rate increases
the market price of capital goods, and this increase in price is
greater the longer the capital good takes to reach maturity as a
consumer good. This significant increase in the market prices of
capital goods compared with the relatively lower prices of the less
demanded consumer goods (due to the increase in savings) is a second
very powerful microeconomic effect that signals all around the market
that entrepreneurs must redirect their efforts and invest less in
consumer goods industries and more in capital goods industries further
from consumption.

Finally, and
third, we should mention what Hayek called The Ricardo
Effect (Hayek 1948, 220–254; 1978, 165–178), which refers to
the impact on real wages of any increase in savings: whenever savings
increase, sales and market prices of immediate consumer goods relatively
stagnate or even decrease. If factor incomes remain the same, this
means higher real wages, and the corresponding reaction of entrepreneurs,
who will try in the margin to substitute the now relatively cheaper
capital goods for labor. What the Ricardo Effect explains is that
it is perfectly possible to earn profits even when sales (of consumer
goods) go down, if costs decrease even more via the replacement
of labor, which has become more expensive, with machines and computers,
for instance. Who produces these machines, computers, and capital
goods that are newly demanded? Precisely the workers who have been
dismissed by the stagnating consumer goods industries and who have
relocated to the more distant capital goods industries, where there
is new demand for them to produce the newly demanded capital goods.
This third effect, the Ricardo Effect, along with the other two
mentioned above, promotes a longer productive process with more
stages, which are further away from current consumption. And this
new, more capital-intensive productive structure is fully sustainable,
since it is fully backed by prior, genuine real savings. Furthermore,
it can also significantly increase, in the future, the final production
of consumer goods and the real income of all economic agents. These
three combined effects all work in the same direction; they are
the most elementary teachings of capital theory; and they explain
the secular tendency of the unhampered free market to correctly
invest new savings and constantly promote capital accumulation and
the corresponding sustainable increase in economic welfare and development.

unsustainable nature of the Bubbles induced by artificial credit
expansions created by the fractional-reserve banking industry.

We are now
in a position to fully understand, by contrast with the above process
of healthy capital accumulation, what happens if investments are
financed not by prior genuine savings but by a process of artificial
credit expansion, orchestrated by fractional-reserve banks and directed
by the lender of last resort or Central Bank.

credit expansion means that new loans are provided by banks and
recorded on the asset side of their balance sheets, against new
demand deposits that are created out of thin air as collateral for
the new loans, and are automatically recorded on the liability side
of banks' balance sheets. So new money, or I should say new u201Cvirtual
moneyu201D because it only u201Cmaterializesu201D in bank accounting book entries,
is constantly created through this process of artificial credit
expansion. And in fact roughly only around ten percent of the money
supply of most important economies is in the form of cash (paper
bills and coins), while the remaining 90 percent of the money supply
is this kind of virtual money that only exists as written entries
in banks' accounting books. (This is precisely what the Spanish
Scholastics termed, over 400 years ago, u201Cchirographis pecuniarumu201D
or virtual money that only exists in writing in an accounting book.)

It is easy
to understand why credit expansions are so tempting and popular
and the way in which they entirely corrupt the behavior of economic
agents and deeply demoralize society at all levels. To begin with,
entrepreneurs are usually very happy with expansions of credit,
because they make it seem as if any investment project, no matter
how crazy it would appear in other situations, could easily get
financing at very low interest rates. The money created through
credit expansions is used by entrepreneurs to demand factors of
production, which they employ mainly in capital goods industries
more distant from consumption. As the process has not been triggered
by an increase in savings, no productive resources are liberated
from consumer industries, and the prices of commodities, factors
of production, capital goods and the securities that represent them
in stock markets tend to grow substantially and create a market
bubble. Everyone is happy, especially because it appears it would
be possible to increase one's wealth very easily without any sacrifice
in the form of prior saving and honest hard individual work. The
so-called u201Cvirtuous circle of the new economyu201D in which recessions
seemed to have been avoided forever, cheats all economic agents:
investors are very happy looking at stock market quotes that grow
day after day; consumer goods industries are able to sell everything
they carry to the market at ever-increasing prices; restaurants
are always full with long waiting lists just to get a table; workers
and their unions see how desperately entrepreneurs demand their
services in an environment of full employment, wage increases and
immigration; political leaders benefit from what appears to be an
exceptionally good economic and social climate that they invariably
sell to the electorate as the direct result of their leadership
and good economic policies; state budget bureaucrats are astonished
to find that every year public income increases at double-digit
figures, particularly the proceeds from Value Added tax, which,
though in the end is paid by the final consumer, is advanced by
the entrepreneurs of the early stages newly created and artificially
financed by credit expansion.

But we may
now ask ourselves: how long can this party last? How long can there
continue to be a huge discoordination between the behavior of consumers
(who do not wish to increase their savings) and that of investors
(who continually increase their investments financed by banks' artificial
creation of virtual money and not by citizens' prior genuine savings)?
How long can this illusion that everybody can get whatever he wants
without any sacrifice last?

The unhampered
market is a very dynamically efficient process (Huerta de Soto 2010a,
1–30). Sooner or later it inevitably discovers (and tries to correct)
the huge errors committed. Six spontaneous microeconomic reactions
always occur to halt and revert the negative effects of the bubble
years financed by artificial bank credit expansion.

spontaneous reaction of the market against the effects of credit
expansions: first the financial crisis and second the deep economic

In my book
on Money,
Bank Credit and Economic Cycles
(Huerta de Soto 2009, 361–384)
I study in detail the six spontaneous and inevitable microeconomic
causes of the reversal of the artificial boom that the aggression
of bank credit expansion invariably triggers in the market. Let
us summarize these six factors briefly:

The rise in the price of the original means of production (mainly
labor, natural resources, and commodities). This factor appears
when these resources have not been liberated from consumer goods
industries (because savings have not increased) and the entrepreneurs
of the different stages in the production process compete with each
other in demanding the original means of production with the newly
created loans they have received from the banking system.

The subsequent rise in the price of consumer goods at an even quicker
pace than that of the rise in the price of the factors of production.
This happens when time preference remains stable and the new money
created by banks reaches the pockets of the consumers in an environment
in which entrepreneurs are frantically trying to produce more for
distant consumption and less for immediate consumption of all kinds
of goods. This also explains the 3rd factor which is

The substantial relative increase in the accounting profits of companies
closest to final consumption, especially compared with the
profits of capital goods industries which begin to stagnate when
their costs rise more rapidly than their turnover.

u201CThe Ricardo Effectu201D which exerts an impact which is exactly
opposite to the one it exerted when there was an increase in voluntary
saving. Now the relative rise in the prices of consumer goods (or
of consumer industries' turnover in an environment of increased
productivity) with respect to the increase in original-factor income
begins to drive down real wages, motivating entrepreneurs to substitute
cheaper labor for machinery, which lessens the demand for capital
goods and further reduces the profits of companies operating in
the stages furthest from consumption.

The increase in the loan rate of interest even exceeding pre-credit
expansion levels. This happens when the pace of credit expansion
stops accelerating, something that sooner or later always occurs.
Interest rates significantly increase due to the higher purchasing
power and risk premiums demanded by the lenders. Furthermore, entrepreneurs
involved in malinvestments start a u201Cfight to the deathu201D to obtain
additional financing to try to complete their investment projects
(Hayek 1937).

These five
factors provoke the following sixth combined effect:

Companies which operate in the stages relatively more distant from
consumption begin to discover they are incurring heavy accounting
losses. These accounting losses, when compared with the relative
profits generated in the stages closest to consumption, finally
reveal beyond a doubt that serious entrepreneurial errors have been
committed and that there is an urgent need to correct them by paralyzing
and liquidating the investment projects mistakenly launched during
the boom years.

The financial
crisis begins the moment the market, which as I have said is
very dynamically efficient (Huerta de Soto 2010a, 1–30), discovers
that the true market value of the loans granted by banks during
the boom is only a fraction of what was originally thought. In other
words, the market discovers that the value of bank assets is much
lower than previously thought and, as bank liabilities (which are
the deposits created during the boom) remain constant, the market
discovers the banks are in fact bankrupt, and were it not for the
desperate action of the lender of last resort in bailing out the
banks, the whole financial and monetary system would collapse. In
any case, it is important to understand that the financial and banking
crisis is not the cause of the economic recession but one
of its most important first symptoms.

Economic recessions
begin when the market discovers that many investment projects launched
during the boom years are not profitable. And then consumers demand
liquidation of these malinvestments (which, it is now discovered,
were planned to mature in a too-distant future considering the true
wishes of consumers). The recession marks the beginning of the painful
readjustment of the productive structure, which consists of withdrawing
productive resources from the stages furthest from consumption and
transferring them back to those closest to it.

Both the financial
crisis and the economic recession are always unavoidable once credit
expansion has begun, because the market sooner or later discovers
that investment projects financed by banks during the boom period
were too ambitious due to a lack of the real saved resources that
would be needed to complete them. In other words, bank credit expansion
during the boom period encourages entrepreneurs to act as if savings
had increased when in fact this is not the case. A generalized error
of economic calculation has been committed and sooner or later it
will be discovered and corrected spontaneously by the market. In
fact all the Hayekian theory of economic cycles is a particular
case of the theorem of the impossibility of economic calculation
under socialism discovered by Ludwig von Mises, which is also fully
applicable to the current wrongly designed and heavily regulated
banking system.

specific features of the 2008 Financial Crisis and the current economic

The expansionary
cycle which has now come to a close was set in motion when the American
economy emerged from its last recession in 2001 and the Federal
Reserve embarked again on a major artificial expansion of credit
and investment, an expansion unbacked by a parallel increase in
voluntary household saving. In fact, for several years the money
supply in the form of banknotes and deposits has been growing at
an average rate of over ten percent per year (which means that every
seven years the total volume of money circulating in the world has
doubled). The media of exchange originating from this severe fiduciary
inflation have been placed on the market by the banking system as
newly-created loans granted at extremely low (and even negative
in real terms) interest rates. This fueled a speculative bubble
in the shape of a substantial rise in the prices of capital goods,
real estate assets, and the securities which represent them and
are exchanged on the stock market, where indexes soared.

Curiously enough,
like in the u201Croaringu201D years prior to the Great Depression of 1929,
the shock of monetary growth has not significantly influenced the
unit prices of the subset of consumer goods and services (which
are only approximately one third of the total number of goods that
are exchanged in the market). The last decade, like the 1920s, has
seen a remarkable increase in productivity as a result of the introduction,
on a massive scale, of new technologies and significant entrepreneurial
innovations which, were it not for the u201Cmoney and credit injection,u201D
would have given rise to a healthy and sustained reduction in the
unit price of the goods and services all citizens consume. Moreover,
the full incorporation of the economies of China and India into
the globalized market has gradually raised the real productivity
of consumer goods and services even further. The absence of a healthy
u201Cdeflationu201D in the prices of consumer goods in a stage of such considerable
growth in productivity as that of recent years provides the main
evidence that the monetary shock has seriously disturbed the whole
economic process. And let us remember the u201CAntideflationist Hysteria”
of those who, even during the years of the bubble, used the slightest
symptoms of this healthy deflation, to justify even greater doses
of credit expansion.

As we have
already seen, artificial credit expansion and the (fiduciary) inflation
of media of exchange offer no shortcut to stable and sustained economic
development, no way of avoiding the necessary sacrifice and discipline
behind all high rates of voluntary saving. (In fact, before the
crisis and particularly in the United States, voluntary saving not
only failed to increase, but even fell to a negative rate for several

The specific
factors that trigger the end of the euphoric monetary u201Cbingeu201D and
the beginning of the recessionary u201Changoveru201D are many, and they
can vary from one cycle to another. In this crisis, the most obvious
triggers were first, the rise in the price of commodities and raw
materials, particularly oil; second, the subprime mortgage crisis
in the United States; and finally, the failure of important banking
institutions when it became clear in the market that the value of
their debts exceeded that of their assets (mainly mortgage loans
erroneously granted).

If we consider
the level of past credit expansion and the quality and volume of
malinvestment produced by it, we could say that very probably in
this cycle the economies of the European Monetary Union are in comparison
in a somewhat less poor state (if we do not consider the relatively
greater Continental European rigidities, particularly in the labor
market, which tend to make recessions in Europe longer and more
painful). The expansionary policy of the European Central Bank,
though not free of grave errors, has been somewhat less irresponsible
than that of the Federal Reserve. Furthermore, fulfillment of the
convergence criteria for the monetary union involved at the time
a healthy and significant rehabilitation of the chief European economies.
Only some countries on the periphery, like Ireland and Spain, were
immersed in considerable credit expansion from the time they initiated
their processes of convergence.

The case of
Spain is paradigmatic. The Spanish economy underwent an economic
boom which, in part, was due to real causes (like the liberalizing
structural reforms which originated with Jos Mara Aznar's administration).
Nevertheless, the boom was also largely fueled by an artificial
expansion of money and credit, which grew at a rate nearly three
times the corresponding rates in France and Germany.

Spanish economic
agents essentially interpreted the decrease in interest rates which
resulted from the convergence process in the easy-money terms traditional
in Spain: a greater availability of easy money and mass requests
for loans from Spanish banks (mainly to finance real estate speculation),
loans which Spanish banks granted by creating the money ex nihilo
while European central bankers looked on unperturbed. Once the crisis
hit Spain the readjustment was quick and efficient: In less than
a year more than 150,000 companies – mainly related with the
building sector – have disappeared, almost five million workers
who were employed in the wrong sectors have been dismissed, and
nowadays we can conclude that although still very weak, the economic
body of Spain has been already healed. We will later come back to
the subject of what economic policy is most appropriate to the current
circumstances. But before that, let us make some comments on the
influence of the new accounting rules on the current economic and
financial crisis.

negative influence of the new accounting rules.

We must not
forget that a central feature of the long past period of artificial
expansion was a gradual corruption, on the American continent as
well as in Europe, of the traditional principles of accounting as
practiced globally for centuries.

To be specific,
acceptance of the international accounting standards (IAS) and their
incorporation into law in most countries have meant the abandonment
of the traditional principle of prudence and its replacement by
the principle of u201Cfair valueu201D in the assessment of the value of
balance sheet assets, particularly financial assets.

In fact, during
the years of the u201Cspeculative bubble,u201D this process was characterized
by a feedback loop: rising stock-market values were immediately
entered into the books, and then such accounting entries were sought
as justification for further artificial increases in the prices
of financial assets listed on the stock market.

It is easy
to realize that the new accounting rules act in a pro-cyclic manner
by heightening volatility and erroneously biasing business management:
in times of prosperity, they create a false u201Cwealth effectu201D which
prompts people to take disproportionate u201Crisksu201D; when, from one
day to the next, the errors committed come to light, the loss in
the value of assets immediately decapitalizes companies, which are
obliged to sell assets and attempt to recapitalize at the worst
moment, when assets are worth the least and financial markets dry
up. Clearly, accounting principles which have proven so disturbing
must be abandoned as soon as possible, and the recent accounting
reforms recently enacted, must be reversed. This is so not only
because these reforms mean a dead end in a period of financial crisis
and recession, but especially because it is vital that in periods
of prosperity we stick to the principle of prudence in valuation,
a principle which has shaped all accounting systems from the time
of Luca Pacioli at the beginning of the fifteenth century till the
adoption of the false idol of the International Accounting Rules.

It must be
emphasized that the purpose of accounting is not to reflect supposed
u201Crealu201D values (which in any case are subjective and which are determined
and vary daily in the corresponding markets) under the pretext of
attaining a (poorly understood) u201Caccounting transparency.u201D Instead,
the purpose of accounting is to permit the prudent management of
each company and to prevent capital consumption, as Hayek already
established as early as 1934 in his article u201CThe Maintenance of
Capitalu201D (Hayek 1934). This requires the application of strict standards
of accounting conservatism (based on the prudence principle and
the recording of either historical cost or market value, whichever
is lower), standards which ensure at all times that distributable
profits come from a safe surplus which can be distributed without
in any way endangering the future viability and capitalization of
each company.

is responsible for the current situation?

Of course the
spontaneous order of the unhampered market is not responsible
for the current situation. And one of the most typical consequences
of every past crisis and of course of this current one, is how many
people are blaming the market and firmly believing that the recession
is a u201Cmarket failureu201D that requires more government intervention.
The market is a process that spontaneously reacts in the way we
have seen against the monetary aggression of the bubble years, which
consisted of a huge credit expansion that was not only allowed but
even orchestrated and directed by central Banks, which are the
institutions truly responsible for all the economic sufferings from
the crisis and recession that are affecting the world. And
paradoxically central banks have been able to present themselves
to the general public not only as indignant victims of the list
of ad hoc scapegoats they have been able to put together (stupid
private bankers, greedy managers receiving exorbitant bonuses, etc.),
but also as the only institutions which, by bailing out the banking
system as a last resort, have avoided a much greater tragedy.

In any case,
it is crystal clear that the world monetary and banking system has
chronically suffered from wrong institutional design at least since
Peel's Bank Act of 1844. There is no free market in the monetary
and banking system but just the opposite: private money has been
nationalized, legal tender rules introduced, a huge mess of administrative
regulations enacted, the interest rate manipulated and most importantly,
everything is directed by a monetary central-planning agency: The
Central Bank.

In other words,
real socialism, represented by state money, Central banks and financial
administrative regulations, is still in force in the monetary and
credit sectors of the so-called free market economies.

As a result
of this fact we experience regularly in the area of money and credit
all the negative consequences established by the Theorem of the
Impossibility of Socialism discovered by those distinguished members
of the Austrian School of Economics: Ludwig von Mises and Friedrich

the central planners of state money are unable to know, to follow
and to control the changes in both the demand for and supply of
money. Furthermore, as we have seen, the whole financial system
is based on the legal privilege given by the state to private bankers,
who can use a fractional-reserve ratio with respect to the demand
deposits they receive from their customers. As a result of this
privilege, private bankers are not true financial intermediaries,
but are mainly creators of deposits materializing in credit expansions
that inevitably end in crisis and recession.

The most rigorous
economic analysis and the coolest, most balanced interpretation
of past and recent economic and financial events lead inexorably
to the conclusion that central banks (which, again, are true financial
central-planning agencies) cannot possibly succeed in finding the
most convenient monetary policy at every moment. This is exactly
the kind of problem that became evident in the case of the failed
attempts to plan the former Soviet economy from above.

To put it another
way, the theorem of the economic impossibility of socialism, which
the Austrian economists Ludwig von Mises and Friedrich A. Hayek
discovered, is fully applicable to central banks in general, and
to the Federal Reserve and (at one time) Alan Greenspan and (currently)
Ben Bernanke in particular. According to this theorem, it is impossible
to organize any area of the economy and especially the financial
sector, via coercive commands issued by a planning agency, since
such a body can never obtain the information it needs to infuse
its commands with a coordinating nature. This is precisely what
I analyze in Chapter 3 of my book on Socialism, Economic Calculation
and Entrepreneurship, which has been published by Edward Elgar
in association with the Institute of Economic Affairs, and which
we present today (Huerta de Soto, 2010b).

Indeed, nothing
is more dangerous than to indulge in the u201Cfatal conceitu201D — to use
Hayek's useful expression (Hayek, 1990) — of believing oneself omniscient
or at least wise and powerful enough to be able to keep the most
suitable monetary policy fine-tuned at all times. Hence, rather
than softening the most violent ups and downs of the economic cycle,
the Federal Reserve and, to a lesser extent, the European Central
Bank, have been their main architects and the culprits in their

the dilemma facing Ben Bernanke and his Federal Reserve Board, as
well as the other central banks (beginning with the European Central
Bank), is not at all comfortable. For years they have shirked their
monetary responsibility, and now they find themselves up a blind
alley. They can either allow the recessionary process to follow
its course, and with it the healthy and painful readjustment, or
they can escape forward toward a u201Crenewed inflationistu201D cure. With
the latter, the chances of an even more severe recession (even stagflation)
in the not-too-distant future increase dramatically. (This was precisely
the error committed following the stock market crash of 1987, an
error which led to the inflation at the end of the 1980s and concluded
with the sharp recession of 1990–1992.)

the reintroduction of the artificially cheap-credit policy at this
stage could only hinder the necessary liquidation of unprofitable
investments and company reconversion. It could even wind up prolonging
the recession indefinitely, as happened in the case of the Japanese
economy, which, though all possible interventions have been tried,
has ceased to respond to any stimulus involving either monetarist
credit expansions or Keynesian methods.

It is in this
context of u201Cfinancial schizophreniau201D that we must interpret the
u201Cshots in the darku201D fired in the last two years by the monetary
authorities (who have two totally contradictory responsibilities:
both to control inflation and to inject all the liquidity necessary
into the financial system to prevent its collapse). Thus, one day
the Fed rescues Bear Stearns, AIG, Fannie Mae, Freddie Mac or City
Group, and the next it allows Lehman Brothers to fail, under the
amply justified pretext of u201Cteaching a lessonu201D and refusing to fuel
moral hazard. Finally, in light of the way events were unfolding,
the US and European governments launched multi-billion-dollar plans
to purchase illiquid (that is, worthless) assets from the banking
system, or to monetize the public debt, or even to buy bank shares,
totally or partially nationalizing the private banking system. And
considering all that we have seen, which are now the possible future

future scenarios and the most appropriate economic policy.

under the wrongly designed current financial system, once the crisis
has hit we can think of four possible scenarios:

The first
scenario is the catastrophic one in which the whole banking
system based on a fractional reserve collapses. This scenario seems
to have been avoided by central banks which, acting as lenders of
last resort, are bailing out private banks whenever it is necessary.

The second
scenario is just the opposite of the first one but equally
tragic: it consist of an u201Cinflationist cureu201D so intense, that a
new bubble is created. This forward escape would only temporarily
postpone the solution of the problems at the cost of making them
far more serious later (this is precisely what happened in the crisis
of 2001).

The third
scenario is what I have called the u201Cjapanizationu201D of the economy:
it happens when the reintroduction of the cheap-credit policy together
with all conceivable government interventions entirely blocks the
spontaneous market process of liquidation of unprofitable investments
and company reconversion. As a result, the recession is prolonged
indefinitely and the economy does not recover and ceases to respond
to any stimulus involving monetarist credit expansions or Keynesian

The fourth
and final scenario is currently the most probable one: It happens
when the spontaneous order of the market, against all odds and despite
all government interventions, is finally able to complete the microeconomic
readjustment of the whole economy, and the necessary reallocation
of labor and the other factors of production toward profitable lines
based on sustainable new investment projects.

In any case,
after a financial crisis and an economic recession have hit it is
necessary to avoid any additional credit expansion (apart from the
minimum monetary injection strictly necessary to avoid the collapse
of the whole fractional-reserve banking system). And the most appropriate
policy would be to liberalize the economy at all levels (especially
in the labor market) to permit the rapid reallocation of productive
factors (particularly labor) to profitable sectors. Likewise, it
is essential to reduce public spending and taxes, in order to increase
the available income of heavily-indebted economic agents who need
to repay their loans as soon as possible. Economic agents in general
and companies in particular can only rehabilitate their finances
by cutting costs (especially labor costs) and paying off loans.
Essential to this aim are a very flexible labor market and a much
more austere public sector. These measures are fundamental if the
market is to reveal as quickly as possible the real value of the
investment goods produced in error and thus lay the foundation for
a healthy, sustainable economic recovery.

However, once
the economy recovers (and in a sense the recovery begins with the
crisis and the recession themselves which mark the discovery by
the market of the errors committed and the beginning of the necessary
microeconomic readjustment), I am afraid that, as has happened in
the past again and again, no matter how careful central banks may
be in the future (can we expect them to have learned their lesson?
For how long will they remember what happened?), nor how many new
regulations are enacted (as in the past all of them and especially
Basel II and III have attacked only the symptoms but not the true
causes), sooner or later new cycles of credit expansion, artificial
economic boom, financial crisis and economic recession will inevitably
continue affecting us until the world financial and banking systems
are entirely redesigned according to the general principles of private
property law that are the essential foundation of the capitalist
system and that require a 100 percent reserve for any demand deposit


I began this
lecture with Peel's Bank Act, and I will also finish with it. On
June 13 and 24, 1844 Robert Peel pointed out in the House of Commons
that in each one of the previous monetary crises u201Cthere was an increase
in the issues of country bank paperu201D and that u201Ccurrency without
a basis (…) only creates fictitious value, and when the bubble bursts,
it spreads ruin over the country and deranges all commercial transactions.”

Today, 166
years later, we are still suffering from the problems that were
already correctly diagnosed by Robert Peel. And in order to solve
them and finally reach the only truly free and stable financial
and monetary system that is compatible with a free market economy
in this 21st century, it will be necessary to take the
following three steps:

to develop and culminate the basic concept of Peel's Bank Act by
also extending the prescription of a 100 percent reserve requirement
to demand deposits and equivalents. Hayek states that this radical
solution would prevent all future crises (Hayek 1984, 29) as no
credit expansions would be possible without a prior increase in
real genuine saving, making investments sustainable and fully matched
with prior voluntary savings. And I would add to Hayek's statement
the most important fact that 100 percent banking is the only system
compatible with the general principles of the law of property rights
that are indispensable for the capitalist system to work: there
is no reason to treat deposits of money differently from any other
deposit of a fungible good, such as wheat or oil in which nobody
doubts the need to keep the 100 percent reserve requirement.

In relation
to this first step of the proposed reform it is most encouraging
to see how two Tory MPs, Douglas Carswell and Steve Baker, were
able to introduce in the British Parliament on September the 15th
and under the 10-minute rule the first reading of a Bill to reform
the banking system extending the prescriptions of Peel's Bank Act
to demand deposits. This u201Ccustomer Choice Disclosure and Protection
Billu201D will be discussed in its second reading, three weeks from
now, on November the 19th, and has two goals: first to
fully and effectively defend citizens' right of ownership over money
they have deposited in checking accounts at banks; and second, to
once and for all put an end to the recurrent cycles of artificial
boom, financial crisis and economic recession. Of course this first
draft of the bill still needs to be completed with some important
details, for instance the time period (let us say a month) under
which all deposits should be considered demand deposits for storage
and not for investment, and any contract that guarantees full availability
of its nominal value at any moment should be considered at all effects
a demand deposit for storage. But the mere discussion of these matters
in the British Parliament and by the public at large is, in itself,
of huge importance. In any case it is exciting that a handful of
MPs have taken this step against the tangle of vested interests
related to the current privileged fractional-reserve banking system.
If they are successful in their fight against what we could call
the current u201Cfinancial slaveryu201D that grips the world they will go
down in history like William Wilberforce — with the abolition of
the slave trade – and other outstanding British figures to
which the whole world owes so much.

if we wish to culminate the fall of the Berlin wall and get rid
of the real socialism that still remains in the monetary and credit
sector, a priority would be the elimination of Central Banks, which
would be rendered unnecessary as lenders of last resort if the above
100 percent reserve reform is introduced, and harmful if they insist
on continuing to act as financial central-planning agencies.

And third,
who will issue the monetary base? Maurice Allais, the French Nobel
Prize winner who passed away two weeks ago, proposed that a Public
Agency print the public paper money at a rate of increase of 2 percent
per year. I personally do not trust this solution as any emergency
situation in the state budget would be used, as in the past, as
a pretext for issuing additional doses of fiduciary media. For this
reason, and this is probably my most controversial proposal, in
order to put an end to any future manipulation of our money by the
authorities, what is required is the full privatization of the current,
monopolistic, and fiduciary state-issued paper base money, and its
replacement with a classic pure gold standard.

There is an
old Spanish saying: u201CA grandes males, grandes remedios.” In English,
u201Cgreat problems require radical solutions.” And though of course
any step toward these three measures would significantly improve
our current economic system, it must be understood that the reforms
proposed and taken by governments up to now (including Basel II
and III) are only nervously attacking the symptoms but not the real
roots of the problem, and precisely for that reason they will again
miserably fail in the future.

it is encouraging to see how a growing number of scholars and private
institutions like the u201CCobden Centreu201D under the leadership of Toby
Baxendale, are studying again not only the radical reforms required
by a truly honest private money, but also very interesting proposals
for a suitable transition to a new banking system, like the one
I develop in chapter 9 of my book on Money, Bank Credit and
Economic Cycles. By the way, in this chapter I also explain
a most interesting by-product of the proposed reform, namely the
possibility it offers of paying off, without any cost nor inflationary
effects, most of the existing public debt which in the current circumstances
is a very worrying and increasingly heavy burden in most countries.

Briefly outlined,
what I propose and the Cobden Centre has developed in more detail
for the specific case of the United Kingdom, is to print the paper
banknotes necessary to consolidate the volume of demand deposits
that the public decides to keep in the banks. In any case, the printing
of this new money would not be inflationary, as it would be handed
to banks and kept entirely sterilized, so to speak, as 100 percent
asset collateral of bank liabilities in the form of demand deposits.
In this way, the basket of bank assets (loans, investments, etc.)
that are currently backing the demand deposits would be u201Cfreed,”
and what I propose is to include these u201Cfreedu201D assets in mutual
funds, swapping their units at their market value for outstanding
treasury bonds. In any case, an important warning must be given:
naturally, and one must never tire of repeating it, the solution
proposed is only valid in the context of an irrevocable decision
to re-establish a free-banking system subject to a 100 percent reserve
requirement on demand deposits. However, no matter how important
this possibility is considered under the current circumstances,
we must not forget it is only a by-product (of u201Csecondaryu201D importance)
compared to the major reform of the banking system we have outlined.

And now to
conclude, should in this 21st century a new Robert Peel
be able to successfully push for all these proposed reforms, this
great country of the United Kingdom would again render an invaluable
service not only to itself but also to the rest of the world.

Thank you very


HAYEK, Friedrich
A. (1937), u201CInvestment that Raises the Demand for Capital,u201D Review
of Economics and Statistics, 19, no. 4. Reprinted in Profits,
Interest and Investment
, pp. 73–82.

HAYEK, Friedrich
A. (1948), u201CThe Ricardo Effectu201D in Individualism
and Economic Order
, Chicago: University of Chicago Press,
pp. 250–54.

HAYEK, Friedrich
A. (1975), u201CThe u2018Paradox' of Savingu201D in Profits,
Interest and Investment and other Essays on the Theory of Industrial
, Clifton, N.J.: Augustus M. Kelly.

HAYEK, Friedrich
A. (1978), u201CThree Elucidations of the Ricardo Effectu201D in New
Studies in Philosophy, Politics and the History of Ideas
London: Routledge and Kegan Paul, pp. 165–78.

HAYEK, Friedrich
A. (1984), u201CThe Monetary Policy of the United States after the Recovery
from the 1920 Crisis,” Chapter 1 in Money,
Capital and Fluctuations: Early Essays
, R.M. McCloughry,
ed., Chicago: University of Chicago Press.

HAYEK, Friedrich
A. (1990), The
Fatal Conceit: The Errors of Socialism
, W.W. Bartley, III
(ed.), London: Routledge and Chicago, Il.: The University of Chicago

Jess (2009), Money,
Bank Credit and Economic Cycles
, Auburn, Al.: Mises Institute
(2nd English edition). First Spanish edition 1998.

Jess (2010a), The
Theory of Dynamic Efficiency
, London and New York: Routledge.

Jess (2010b), Socialism,
Economic Calculation and Entrepreneurship
, Cheltenham,
UK and Northampton, Massachusetts, USA: Edward Elgar.

MISES, Ludwig
von (1980), The
Theory of Money and Credit
, Indianapolis, Ind.: Liberty
Classics. First German edition 1912, 2nd German edition

with permission from The Cobden

4, 2010

Huerta de Soto, professor of economics at Rey Juan Carlos University
in Madrid, is Spain’s leading Austrian economist. As an author,
translator, publisher, and teacher, he also ranks among the world’s
most active ambassadors for classical liberalism. He is the author
of Money,
Bank Credit, and Economic Cycles

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