Archive for the ‘austrian school’ Category

From page 154-155, “Alchemists of Loss: How Modern Finance and Government Intervention Crashed the Financial System” by Kevin Dowd and Martin Hutchinson. Referring to the causes of the 2008 financial crisis:

“It is here that one can most ferociously blame Fed Chairmen Alan Greenspan and Ben Bernanke, and their decade and more of irresponsibly cheap money. By distorting price signals throughout the economy and producing burst bubble after burst bubble without any significant improvement in living standards except at the very top, they have not only gravely damaged the economy, but enabled the Left to claim that free markets “don’t work” so we must bring in government and the unfortunate taxpayer to solve our economic problems. Of course, this crisis is not a failure of free markets and not even a failure of capitalism – unless you accuse modern mangerialist crony capitalism, in which case you would be right.”

This quote jumped off the page at me. It surmises the cause the cause of the boom that lead to the bust – low interest rates and loose monetary policy (as the authors point out on page 154, from 1995 the Fed expanded the money supply 5% faster than output for 13 years). It hints at the damage this has caused to the reputation of both free markets and capitalism, even though it had very little to do with either. It also correctly acknowledges that much of the growth and rise in living standards enjoyed during the boom was illusory.

It is a fascinating world we live in. There are few people who suggest that the government should control the price of milk or manipulate the supply of shoes.  Luckily, most people recognise that government is hilariously incompetent at the functions it already performs and would resent it encroaching into areas where the free market already provides a valuable service.

Yet when it comes to money, the masses are blissfully ignorant. Money is a commodity like most other goods, albeit a special one with value added as a widely accepted medium of exchange. So why are we happy that governments (through their central banks) are allowed to manipulate the price (interest rates) of money?

We accept that the government would do a lousy job of supplying milk but simultaneously believe that it’s all knowing bureaucrats can somehow get the supply of money just right. We would rightly shudder at the thought of the government setting the price for a pair of shoes but are perfectly happy to allow  it’s all knowing functionaries the discretion of setting interest rates.

Money is not the creation of the state. Just as the state did not invent money, nor is the state required to manage money. Money came from people, emerging through “spontaneous order”. People, interacting with each other through voluntary exchange gradually realised that certain commodities are uniquely desirable to use as money (due to properties such as divisibility and function as a store of value etc).

So what materials did individuals (free from government coercion) decide to use as their preferred money? The historical record is clear – they chose gold and they chose silver. I know of no example when people, free to choose, have settled upon paper. This is because paper money is intrinsically worthless. It can only function as money via government “fiat”, coercively imposed upon society via legal tender laws.

It shouldn’t take a great deal of imagination to understand why the state likes it this way. The printing press gives the state an unrivalled power – the ability to create money out of thin air. Except it is nothing like as harmless as that. The price is paid for by those who save, those with pensions and those on lower incomes. Inflation is a stealth tax on the poor and the thrifty, simultaneously eroding the value of saved capital and redistributing wealth from the poorest to the richest in society.

The financial sector is largely complicit in this redistribution, benefiting as the first recipients of the freshly printed money. They enjoy the benefits of the new money before inflation has eroded its purchasing power. By the time the new money reaches the poorest in society, any benefit to be derived from it has been wiped out by the increase in prices. Thus are the poor forced to pay more for everyday items and sacrifice a portion of their savings through loss in purchasing power.

Further damage is caused by the “misallocation” of capital as a result of low interest rates. In English, this means that when money is cheap people invest it in products, processes and ventures which are not sustainable. Sub-prime housing bubble anyone?

Interest rates should convey information about the time preferences of society. When people value present consumption more they will save less, driving interest rates up. When people defer consumption they save more, which drives interest rates down. However, in our current, centrally planned monetary system the interest rate is just an arbitrary number decided upon by a central bank committee (sound soviet enough for you?). The entrepreneur looking to invest capital receives a false signal – artificially low interest rates will falsely signal that society is prepared to defer consumption and has saved more capital to be in invested in longer, more marginal production processes. Except that society has done no such thing. Businesses inevitably make foolish investments and begin production of products which later turn out to be unprofitable. The end result? Boom followed by bust.

The neatest trick of all is that somehow all of this is blamed on free market capitalism. It should be clear that there is nothing free market about fiat money and centrally planned interest rates. The blame lies squarely with the state.

Truly free markets are just that – free, and do not suffer the interventions of the state. The state has always looked on jealously at the innovation and wealth creation made possible by markets, like a burglar peeking through someone’s front window.  The tendency of the state is always to grow larger, a self replicating monolithic bureaucracy that breeds its own army of foot soldiers on a staple diet of dependency and empty promises. This ever expanding monster needs money to sustain its growth. The private sector is easy prey for a state with a big appetite as the state can always rely upon its monopoly on the legal use of force to extract revenue from private individuals and businesses.

The more the state encroaches on the private sector, the more life it sucks out of the economy. Eventually it becomes trapped in a circle of ever diminishing returns. Every malinvested penny spent by the state  is penny that could have been used by the private sector. Sure, not all money spent by the state is wasted. Likewise, not all money spent by the private sector is invested wisely. But the private sector has a key advantage – prices.

Prices are amazing. They convey information between participants in a market. This allows the private sector to efficiently allocate resources based upon people’s real demands. Of course, markets are never perfect and mistakes are often made. But free markets have the ability to assess this misallocation of resources and adjust accordingly because prices will guide the market to correction. For instance, if a rubber duck costs more to make than people are willing to pay for it  then companies producing rubber ducks will lose money. This signals to entrepreneurs that resources are not being used efficiently and should be redirected towards other activities, such as producing yo-yos. The entrepreneurs could also work out more efficient and productive techniques to produce  the ducks. By doing this they may be able to lower the cost of production to a level which allows  the duck to be sold a price acceptable to the consumer and  also create a profit.  This profit tells the entrepreneur to keep doing what he is doing. It rewards the producer for enriching the lives of his customers. It encourages him to do it more. If profits are big it encourages others into the market, thereby increasing supply to satisfy demand and thus normalize profits. This increased level of competition also makes producers work harder to maintain their market share and profit margins (or in other words, their signal that they are using resources efficiently) by coming up with more efficient and productive processes. This competition drives down the cost of the product and society benefits from cheaper goods.

The public sector has no equivalent to prices. For instance, if a entrepreneur in a company hires a new worker to increase productivity and generate more profits he will be able to use the price system as a way of assessing the success of his investment. If he makes more money as a result then the worker keeps his job, maybe even more people get hired. If he loses money then the price system will tell him that he is not utilizing resources efficiently, the likely result being in the worker losing his job.  The same process can not occur in the public sector. The government can not assess demand like the free market can. Society can not accurately inform the government how much it is prepared to pay for bridges, local council art, flower beds or whatever else the state aims to provide. The government tells you how much you pay for it. Think about that. In every private business individuals co-operate to increase their own wealth by trading for things which they value more than the thing they trade the other way. It’s a two way gain. The shop keeper values your 50pence more than he values his one newspaper. You value the newspaper more than the 50pence or else why would you give the 50 pence up for it? A trade is completed and both parties benefit. Both parties will likely thank each other, which neatly symbolizes the mutual benefit of this arrangement. Now try and remember the last time you thanked the government for taking your taxes. Sure, you get things in return. But you don’t necessarily value them more than the money the state took from you by force.  The cost to you in taxes may be clear, but the cost to your liberty is more subtle.

Is that a price worth paying?

Last weekend I had the pleasure of meeting Kevin Dowd at Liberty League Freedom Forum 2012.  


Kevin’s message is chillingly clear. The shit has yet to hit the fan. All the economic stimulus, money printing and bailouts haven’t solved any of the underlying problems in the economy – they have simply made the problem worse and deferred  it to a later date. 


I found Kevin’s explanation about why we have not experienced higher levels of inflation yet particularly interesting (and frightening). Using the government’s own figures he showed how the monetary base of the economy has been expanded several times over since the crisis in 2008 and how this extra money has been ‘trapped’ in the banking sector. The Bank of England bought the government’s debt with the freshly printed (or ‘clicked’, if you prefer) money. This depressed the interest rate that the government borrows at but also swamped the commercial banks with huge amounts of the new money. In a business environment severely lacking  confidence the banks are holding on to this money  rather than lend it out. After all, why would they go to the bother of lending this to small and medium businesses when they run the risk of going bust in the prevailing business conditions. The problem is that this money can’t stay there forever. Kevin used the example of a huge lake hemmed in by a glacier. Just like when the Ice Age ended, the glaciers melted and released a torrent of water across the land, leading to widespread destruction. The same thing will happen once this money is released into the wider economy. And once the inflation takes hold (and it will) it will be impossible to stop. According to Kevin, even Mervin King acknowledges that there is no exit strategy for this huge experiment in monetary policy. 


Other things to feel optimistic about include: 


  • Record low interest rates can NOT stay at these levels forever and the banks are in no fit shape to survive the consequences of higher interest rates. Another banking crisis, even bigger than the last time, is just around the corner. 

  • Inter-governmental interference in the world economy has exacerbated the problems (see Basel 1 &2 which created the regulatory framework which left banks hopelessly exposed to first the subprime and then sovereign debt crises)   

  • The next crisis will be bigger. The same  policy prescriptions, having been shown to fail at every previous attempt, will be implemented again. The potential for rioting and societal breakdown is huge and Kevin is surprised it hasn’t happened already. 


Gloomy stuff. Apologies if I’ve got any of it wrong on here, I wasn’t taking notes during his talk so this is all just from memory. Kevin seemed like a genuinely nice guy and we should all hope and pray he is wrong with all his predictions. Unfortunately I happen to think he’s bang on the money (so to speak) and would recommend people to look at his book “Alchemists of Loss”.