Sir Edward Burne-Jones"The Golden Stairs"The government-controlled monetary regime — the most destructive force set into motion by state interventionism — has finally been blown to pieces. This is the message conveyed by the monetary fiasco in global capital markets, typically referred to as the international credit crisis.
However, politicians and central bankers the world over are taking great efforts to hide this truth and its full consequences from the public's attention by taking recourse to even more far-reaching market interventionism.
Central banks provide commercial banks with any amount of base money needed to prevent them from defaulting on their payment obligations. The Federal Reserve, for instance, keeps expanding the monetary base at the highest rate seen since 1919 (see graph below).[1]
The Federal Reserve has started monetizing various types of paper assets. As a result, the Fed's balance sheet volume rose from US$909 billion to US$2,189 billion from the end of August 2007 to the middle of November 2008, much of it reflected by a considerable rise in deposits held by depository institutions, the US Treasury, and others with the Fed (see graph below).
What is more, not only the Federal Reserve but virtually all other major central banks have cut interest rates sharply to cheapen funding costs for commercial banks and borrowers in general (see graph below). By pushing official interest rates down, central banks hope to unfreeze credit markets, support asset prices, and keep the economies on an expansion path.
However, the lowering of short-term central-bank interest rates has (so far) not succeeded in bringing down credit costs, which have risen considerably following the turmoil in credit markets. In fact, corporate bond yields have continued to edge up. This holds true for risky as well as for less risky corporate bond yields in the United States, for instance (see graph below).
The yield differential between central-bank short-term interest rates and corporate bond yields — that is, the yield spread, which can be interpreted as a measure of (default) risk — has been rising strongly in recent months. US yield spreads have reached the highest level since the Great Depression period (see graph below).
Despite growing concern about rising defaults in credit markets, depositors and investors in commercial-bank debentures seem to have remained reasonably confident that emergency measures taken by governments will be successful in preventing bank failures on a grand scale.
People seem to believe that governments will, should commercial banks run the real risk of defaulting, expropriate taxpayers (particularly the future generation via raising government debt) on their behalf to make good any potential losses.
Such a belief might have been instilled in particular by government bank-rescue packages — including capital injections for ailing banks, guaranteeing banks' liabilities, and taking over (part of) their bad assets.
Meanwhile, however, the gigantic financial burden heaped upon (future) taxpayers has led to growing concern about government defaults, as evidenced by the edging up of the so-called credit-default-swap (CDS) spreads (see graph below); the latter can be interpreted as the market price for insurance against losses from investing in government bonds.
Politicians, central bankers, and the public at large may hope that by announcing banking-sector-support measures confidence can be restored, so that financial-market participants will lose their risk aversion and return to business as usual — that is, to lend and borrow as they did before the turmoil started in autumn 2007.
Destroying What Is Left of the Free-Market Order
However, any such optimism is naïve, especially as much more is now at stake. Ludwig von Mises, one of the leading scholars of the Austrian School of economics, was aware of the dangers to freedom when the government-sponsored credit-and-money system runs into trouble. Mises wrote that
all isolated measures of government interference with market phenomena must fail to attain the ends sought. If the interventionist government wants to remedy the shortcomings of its first interferences by going further and further, it finally converts its country's economic system into socialism of the German pattern. Then it abolishes the domestic market altogether, and with it money and all monetary problems, even though it may retain some of the terms and labels of the market economy.[2]
Mises clearly saw that a monetary fiasco would not be ascribed to state interventionism in monetary affairs, but that it would compromise capitalism: people would ascribe the ensuing evils — such as job losses, falling income, etc. — to the machinations of the free market. What is more, they would call for more government intervention, convinced that such action would lead the way out of calamities. Mises noted,
The boom produces impoverishment. But still more disastrous are its moral ravages. It makes people despondent and dispirited. The more optimistic they were under the illusory prosperity of the boom, the greater is their despair and their feeling of frustration. The individual is always ready to ascribe his good luck to his own efficiency and to take it as a well-deserved reward for his talent, application, and probity. But reverses of fortune he always charges to other people, and most of all to the absurdity of social and political institutions. He does not blame the authorities for having fostered the boom. He reviles them for the inevitable collapse. In the opinion of the public, more inflation and more credit expansion are the only remedy against the evils which inflation and credit expansion have brought about.[3]
Circulating Credit Brings Disaster
The causes of the current monetary fiasco can indeed be traced back to the government-controlled fiat-money system. Under such a regime, commercial banks, with the support of the central bank, increase the money supply whenever they extend loans to nonbanks (private households, firms, and public-sector entities) or buy assets from them.
Such an arrangement, which allows commercial banks to create money out of thin air, spells trouble, as banks decouple the money supply from the economy's real savings. Bank credit supply (and the corresponding additional money supply in the form of fiduciary media) in excess of the economy's real savings is what Mises called circulation credit.
Savings are the part of people's current income that are not consumed but invested. As such, savings represent present goods that are exchanged (in the time market) for future goods; the latter are simply goods that are expected to become — after emerging from the production process — present goods in the future.
In the United States, for instance, people's savings have declined strongly relative to their income in the last decades. The personal saving rate has fallen from a range of around 8–10%, which prevailed from the 1950s to the middle of the 1980s, to just 1.1% in the third quarter 2008 (see graph below).
The finding of a declining savings rate has been accompanied by bank-credit expansion increasingly outstripping income since around the middle of the 1980s (following the scrapping of the last remnants of the gold standard at the start of the 1970s), a process that has even gained momentum since the middle of the 1990s.
That said, a chronically declining savings rate accompanied by bank credit supply increasingly outstripping income points towards great doses of circulation credit, a process that puts the economy on an unsustainable path, according to the Austrian monetary theory of the trade cycle.
Initially, the rise in money supply via circulation credit leads to more investment, employment, and overall output. However, any such upswing is ill-fated from the start, as the economy lives beyond its means. Sooner or later it becomes obvious that the monetary demand outstrips the economy's real resources.
Production, stimulated by an artificially lowered interest rate, becomes increasingly roundabout, causing disequilibria in peoples' desired consumption-saving relation. As people scale back their purchases of investment goods, the boom turns to bust, and jobs created during the boom are destroyed.
When the economy slows down (due to a cluster of errors), people call for government support — particularly in the form of lower central-bank interest rates. A lowering of interest rates may do the trick (at least for a limited number of cases), reversing the bust into boom. However, such a policy causes rising disequilibria over time.
This is because a monetary policy of manipulating interest rates downwards keeps alive unsustainable consumption patterns and unproductive investments. Borrowers of economically wasteful spending projects do not need to liquidate and repay their debt. On top of that, artificially lowered interest rates encourage new investments.
That said, a monetary policy of repeatedly fending off cyclical downturns by cutting interest rates via expanding the credit-and-money supply risks resulting in ever-higher levels of debt for consumers, firms, and governments relative to their incomes.
When Inflation Changes to Deflation
At some point, private owners of commercial banks might no longer wish to put their money at risk, especially when they fear that borrowers could default on their debt loads. Commercial banks will reduce their credit-risk exposure, and the process of deleveraging, or derisking, starts.
When commercial banks stop making new loans and demand their borrowers to pay down their debt, the economy's credit-and-money supply contracts. At this point inflation — the increase in the money stock through circulation credit — turns into deflation.
Deflation corrects misallocations (malinvestments) that were caused by inflation. The ensuing decline in output, employment, and prices may be painful for those who have benefited from inflation (borrowers), but it will reallocate resources to those who have economically suffered from previous inflation (lenders).
A free-market economy could certainly deal with the correcting effects of deflation. However, the coercive apparatus of government cannot: its very existence rests in great part on ever-higher amounts of credit and money, in particular to finance cascading amounts of public debt at low interest rates.
This might explain why governments do everything they can think of to keep the current system churning out credit and money: by increasing the base money supply, cutting interest rates, spending (future) taxpayers' money on an unprecedented scale, or nationalizing the banking sector.
However, these measures will not solve the problem brought about by circulation credit. As Mises noted,
The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. The boom comes to an end as soon as additional quantities of fiduciary media are no longer thrown upon the loan market. But it could not last forever even if inflation and credit expansion were to go on endlessly. It would then encounter the barriers which prevent the boundless expansion of circulation credit. It would lead to the crack-up boom and the breakdown of the whole monetary system.[4]
Returning to Free-Market Money
Ever-higher doses of government intervention will not solve the trouble brought about by government intervention in monetary affairs. Any attempt to do so would increasingly erode what little is left of the free societal order — already greatly damaged by the consequences of a government-sponsored monetary regime.
One strategy to prevent complete disaster — the destruction of the currency — would be returning money to the free market, as put forward by Mises and developed further by Murray N. Rothbard, one of Mises's most brilliant students. According to Rothbard's blueprint, the outstanding money stock should, in a first step, be linked to the gold stock in the hands of central banks. [5]
Money holders would, by law, receive a property right to redeem commercial bank money on demand in gold, with the money defined as a unit of weight of gold.[6] Such a change would leave commercial banks solvent. Commercial banks could, at any one time, redeem their obligations in gold (100%-reserve system).
While such a scheme would (arbitrarily) freeze the status quo brought about by inflation (bygones are bygones), it nevertheless has a great deal of political charm. First, bankruptcies among banks would no longer reduce the money stock, thereby preventing the widely feared economic and political consequences of deflation. Second, it would prevent losses for borrowers and lenders on a grand scale, thereby reducing the political incentive for starting the printing press.
In a second step, the banking sector could be privatized, and the government's grip on the money stock would be abolished. It would then be up to the free market to decide what medium will serve as the universally accepted means of exchange; maybe gold, silver or both (bimetallism) would emerge as the money standard. The central bank would be closed down. The interest rate would become a free-market phenomenon, free of government manipulation.
However, it would be misleading to hope that governments and their central bankers would induce any such change. The golden way out of the monetary fiasco can only come with a change in public opinion. People must relearn that free-market money, or sound money, as Mises put it, is the indispensable element for preserving the free societal order. As Mises wrote,
It is impossible to grasp the meaning of the idea of sound money if one does not realize that it was devised as an instrument for the protection of civil liberties against despotic inroads on the part of governments. Ideologically it belongs in the same class with political constitutions and bills of rights.[7]
Thorsten Polleit is Honorary Professor at the Frankfurt School of Finance & Management. Send him mail. Comment on the blog.
Notes
[1] The increase in the stock of base money was largely due to higher bank reserves holdings, most of it in the form of excess reserves (rather than an increase in peoples' holdings of coins and notes). Banks' required reserves with the Fed stood at US$39.7 billion in August 2007 and US$50.5 billion in November 2008.
[2] Mises, L.v. (1996), Human Action, 4th ed., Fox & Wilkes, San Francisco, p. 474.
[3] Ibid., pp. 576.
[4] Ibid., p. 555.
[5] See, for instance, Rothbard, M.N. (1983), The Mystery of Banking, 1st ed., Richardson & Snyder, pp. 263. In this context it might be of interest to note that according to statistics provided by the Austrian National Bank, all euro-area central banks held a total of 350.63 million fine ounces of gold at the end of September 2008, the US 261.5 million and Japan 24.6 million.
[6] Of course, one could discuss the inclusion of the stock of coins and notes outstanding in the money stock redeemable in gold. What is more, one should also discuss the option of linking the commercial banking sectors' total liabilities (possibly excluding equity capital) to the central bank's gold reserves.
[7] Mises, L.v. (1912), The Theory of Money and Credit, p. 454.
