Some Additional Reflections on the Economic Crisis and the Theory of the Cycle

by Jesus Huerta de Soto

The four years that have passed since the world financial crisis and subsequent economic recession hit have provided Austrian economists with a golden opportunity to popularize their theory of the economic cycle and their dynamic analysis of social conditions. In my own case, I could never have imagined at the beginning of 1998, when the first edition of my book Money, Bank Credit, and Economic Cycles appeared, that 12 years later, due undoubtedly to a financial crisis and economic recession unparalleled in the world since the Great Depression of 1929, a crisis and recession which no other economic paradigm managed to predict and adequately explain, my book would be translated into 14 languages and published (so far) in nine countries and several editions (two in the United States and four in Spain). Moreover, in recent years I have been invited to and have participated in many meetings, seminars, and lectures devoted to presenting my book and discussing its content and main assertions. On these occasions, some matters have come up repeatedly, and though most are duly covered in my book, perhaps a brief review of them is called for at this time. Among these matters, we will touch on the following:

1. The Relationship between Credit Expansion and Environmental Damage

"Free-market-environmentalism" theorists (Anderson and Leal 2001) have shown that the best way to preserve the environment is to extend entrepreneurial creativity and the principles of the free market to all natural resources, which requires their complete privatization and the efficient definition and defense of the property rights that pertain to them. In the absence of these rights, economic calculation becomes impossible, the appropriate allocation of resources to the most highly valued uses is prevented, and all sorts of irresponsible behaviors are encouraged, as is the unjustified consumption and destruction of many natural resources.

Nevertheless, free-market-environmentalism theorists have overlooked another major cause of the poor use of natural resources: the credit expansion that central banks orchestrate and cyclically inject into the economic process through the private banking system, which operates with the privilege of using a fractional reserve. In fact, the artificial expansion of fiduciary media triggers a speculative-bubble phase in which there is an "irrational exuberance." This phase ends up placing an unwarranted strain on the real economy by making many unprofitable projects appear profitable (Huerta de Soto 2009). The result is unnecessary pressure on the entire natural environment: trees that should not be cut down are cut down; the atmosphere is polluted; rivers are contaminated; mountains are drilled; cement is produced; and minerals, gas, oil, etc., are extracted in an attempt to complete overly ambitious projects that in reality consumers are not willing to demand, etc.

Eventually the market will impose the judgment of consumers, and many capital goods will remain idle, thus revealing that they have been produced in error (that is, distributed incorrectly in space and time), because entrepreneurs have allowed themselves to be deceived by the easy-credit terms and low interest rates decreed by monetary authorities. The result is that the natural environment is harmed needlessly, since consumers' standard of living has not increased at all. On the contrary, consumers become poorer with the malinvestment of society's scarce real savings in nonviable, excessively ambitious projects (for example, 1 million homes in Spain without buyers). Hence, credit expansion hinders sustainable economic development and needlessly damages the natural environment.

This brief analysis points to an obvious conclusion: nature lovers should defend a free monetary system, without a central bank, a system in which private bankers operate with a 100 percent reserve requirement on demand deposits and equivalents, a system that rests on a pure gold standard. This is the only way to eradicate the recurring stages of artificial boom, financial crisis, and economic recession, which do so much harm to the economic environment, mankind, and the process of social cooperation.

2. Then Is Credit Expansion Really Necessary to Boost Economic Growth?

A popular argument (employed and nourished by more than a few prestigious economists like Schumpeter) holds that credit expansion and low interest rates facilitate the introduction of technological and entrepreneurial innovations, which foster economic development. The argument is contemptible. In a market economy it is as important to provide financing for solvent, viable entrepreneurial projects as it is to deny it for nonviable, harebrained ones: many "entrepreneurs" are like runaway horses, and we must limit their chances of trampling on society's scarce resources.

"A popular argument holds that credit expansion and low interest rates facilitate the introduction of technological and entrepreneurial innovations, which foster economic development. The argument is contemptible."

The problem is that only the market is capable of distinguishing between these two types of projects, and it does so by a social process in which key elements are precisely the indicator of the real amount of saved resources and the social rate of time preference, which helps separate the projects that should be financed from those whose time has not yet come and which therefore must remain "in the pipeline." It is true that every artificial expansion of credit and of the fiduciary media that back it provoke a redistribution of income in favor of those who first receive the new available funds and that this does not permit us to theorize about the net effects the process will have on society's real saving. (That will depend on how the time preference of those who come out ahead compares with that of those who come out behind.) However, there are more than enough signs that inflation discourages real saving, if only because it generates an illusion of wealth, which stimulates spending on consumer goods and capital consumption.

Furthermore, in the end ("ex post") it is clear that only what has been previously saved can be invested. Even then, what has been previously saved can be invested wisely or foolishly. Credit expansion promotes the waste and malinvestment of scarce factors of production in unsustainable and unprofitable investment projects. This means that the model of economic development based on artificial credit expansion cyclically destroys a high volume of capital goods, which leaves society substantially poorer (compared with the standard of living that could be reached in the long term with sustainable growth unforced by credit expansion and more in keeping with the true wishes of consumers with respect to their valuations of time preference).

Moreover, let it not be said that fiduciary inflation at least serves to employ idle resources, since the same effect can be achieved without malinvestment and waste by making the corresponding labor and factor markets more flexible. In the long run, credit expansion generates unsustainable jobs, erroneous investments, and therefore, less economic growth.

3. Is It True that Banks Caused the Crisis by Incurring Risks Disproportionate to Their Capital?

To attribute the crisis to the bad conduct of bankers is to confuse the symptoms with the causes. After all, during the stage of speculative euphoria, bankers merely responded to the incentives (null or negative real interest rates and the artificial expansion of credit) created by central banks. Now, in a display of hypocrisy and manipulation of the citizenry, central bankers throw up their hands in horror, blame others for the consequences of their own unsound policies, and try to appear as saviors to whom we must be grateful for the fact that we are not in the grip of an even more severe depression. And we need not repeat that it is precisely during the boom stage that inflation in the prices of financial assets was so high that bankers were able to show considerable equity capital in their balance sheets, which, at least in appearance, gave them substantial leverage and permitted them to incur risks with little difficulty. This was all in an environment of null or even negative real interest rates and an extraordinary abundance of liquidity promoted deliberately by central banks. Under such conditions, no one should be surprised that increasingly, peripherally, financing was granted for investment projects that were more and more risky, and less and less profitable (and less certain of producing profit).

4. So the Problem with the Banking System Is that Bankers Did Not Manage to Properly Harmonize the Deadlines of Loans Granted with Those of Deposits Received?

No, the problem is that banks have operated with a fractional reserve; i.e., they have not maintained a 100 percent reserve with respect to demand deposits and their equivalents. The requirement of a 100 percent reserve on demand deposits avoids credit expansion and liquidity problems in the banking system, because it permits the investment of only what has been previously saved; and if investors make a mistake concerning the term of maturity and their projects are viable, they can request new loans (based on prior, real saving) to repay those that fall due. In contrast, credit expansion derived from fractional-reserve banking gives rise to a widespread malinvestment of resources that is confused by many with a failure to harmonize terms of maturity, when the problem is much deeper: investments that are unsustainable due to a lack of real saving. The fundamental economic problem does not stem from an error in the matching up of terms but from the absence of a 100 percent reserve requirement; in other words, it stems from fractional-reserve banking.

5. Can an Isolated Bank Escape Unscathed in the Case of Widespread Credit Expansion?

Those in charge of an individual bank may hope it will emerge unharmed from a process of credit expansion if (a) they believe they will be able to lend money peripherally for the most profitable and secure projects (those that will be least affected when the crisis hits); and (b) they believe that once they begin their credit expansion on these projects, the rest of the banks will follow the same expansionary policy at the same pace at least, and thus the bank will not end up alone nor will it lose reserves.

"Many 'entrepreneurs' are like runaway horses, and we must limit their chances of trampling on society's scarce resources."

In practice, b usually happens (generalized credit expansion orchestrated by the central bank itself); but a is highly unlikely to ever happen and amounts to a mere illusion: the new fiduciary media (created deposits) can only be lent at relatively reduced interest rates and can only be placed in the market as loans for projects that are increasingly lengthy (i.e., that mature in a more distant future) and risky (uncertain). These projects merely appear to be profitable at reduced rates, but as soon as rates increase, they immediately cease to be viable due to insufficient real saving.

Furthermore, any bank whose directors tenaciously decide to keep it out of the credit-expansion process will see its market share dwindle and will run the risk of becoming an exotic irrelevance. This should make it obvious that fractional-reserve banking exerts a corrupting effect on the entire banking system (an argument already put forward by Longfield in the 19th century). In addition, banking practice has continually offered confirmation of this phenomenon. (For instance, several presidents of Spanish banks have told me that during the boom stage they knew a large percentage of the real-estate loans they were granting were unlikely to be viable in the long term and were very risky, but they were "forced" to participate in many syndicated loans and questionable transactions under pressure from analysts, market agents, and their bank's need to grow or at least maintain its market share.)

6. Savings as a "Flow" Magnitude versus Cash Balances in the Form of Deposits as a "Stock" Magnitude

Money is not a consumer good (except for greedy Scrooge McDuck), nor is it a factor of production. It is a third type of good: a commonly accepted medium of exchange. Moreover, only as a present good does money fulfill its function as a medium of exchange. However, it can be lent, in which case it becomes a financial asset for the lender, for whom it ceases to provide services as a medium of exchange.

Therefore, it is absurd to claim that deposited money that forms part of an actor's cash balances has been "saved." The deposit is a cash balance and thus a stock magnitude. The flow of unconsumed income gives rise to the flow of savings that is invested in financial assets or directly in capital goods, unless someone decides to indefinitely increase his or her cash balances (a rise in the demand for money). Furthermore, cash balances can be increased not only by reducing the flow of consumption but also by reducing the flow of investment (or both).

The problem is that with a specific, stable flow of savings, if someone decides to channel his or her cash balances into demand deposits in a fractional-reserve bank, the flow of loans and investment swells without any increase in the flow of real savings, and this is precisely what sets the economic cycle in motion.

Only free banking with a 100 percent reserve requirement prevents the above anomaly by making it impossible for bankers to make the following accounting entry:

Loans to Deposits ----------x----------  

It is this kind of entry that reflects banks' main activity, but in a free banking system with a 100 percent reserve requirement, all deposits would be backed in cash by the corresponding balance, in keeping with general legal principles:

Cash to Deposits  ---------x---------  

7. Does Leland Yeager Offer a Sound Argument when He Asserts that It Is Impossible to Distinguish between Demand Deposits and Very Short-Term Loans?

When the principles and theory are well understood (that demand deposits and their equivalents must be backed at all times by a 100 percent reserve), the market invariably finds the most practical and operational solutions.

In an ideal banking system, with a 100 percent reserve requirement, short-term loans (from one to three months) would definitely be easy to distinguish from demand deposits, and the agents involved would undertake the usual operations necessary to match flows, operations that are so efficiently carried out in the free market, based on well-proven and deep-rooted principles of prudence.

"False" loans that disguise deposits would be easy to identify, especially if we take into account that on the edge of the very short term (from one week to one month), the demand for true loans is very weak (except under highly exceptional circumstances, and assuming the matching of flows is properly carried out).

In short, what is important is whether or not an actor subjectively considers that a "time" deposit or a (false) "loan" forms part of his or her immediately available cash balances. If so, we are dealing with true "demand" deposits, which require a 100 percent reserve.

8. What Are the Possible Scenarios in the Event of a Crisis like the Present One?

There are basically four:

1. The bubble is created again, with massive doses of new expansion. (This is practically the worst-case scenario, since the depression is only postponed at the cost of making it much more severe later: this is what happened in 2001–2002, when the expansionary stage was prolonged six additional years, but at the cost of a financial crisis and an economic recession unlike any in the world since 1929.)
2. The opposite extreme: the failure, as if by the domino effect, of all fractional-reserve banks and the disappearance of the financial system (a tragedy that has been avoided "in extremis" with the bailout of the banking system in the entire world).
3. The "Japanization" of the economy: government intervention (in the fiscal and credit spheres) is so intense that it blocks the spontaneous market processes that tend to rectify the investment errors committed in the bubble stage, and hence the economy remains in a recession indefinitely.

And 4, the most probable course of events: With great difficulty, the market, which is very dynamically efficient, ends up rectifying investment errors: companies and households put their balances on a sound footing by reducing costs (particularly labor costs) and repaying loans. The companies that remain have become "healthy" and the increase in saving permits the financing of new investment projects that are actually sustainable in the long term. Climbing unemployment reaches its peak when the reorganization has concluded, and at that point the top priority is to liberalize the labor market as much as possible (hiring, wages, dismissal, and collective bargaining) so that the unemployed can again enter the (now healthy) production chain to work on viable projects. Furthermore, maximum budget austerity is necessary in the public sector; it is important to avoid tax increases and to reduce bureaucracy and government intervention in the economy.

9. What Measures in the Right Direction Could Now Be Adopted to Bring Us Closer, Even If Timidly, to the Ideal Financial System of a True Free-Market Economy?

The following table offers an answer to this question:

Ideal Monetary Model	(Very) Timid Measures in the Right Direction
A pure gold standard (Growth in the world's stock of gold ≤ 2% per year)	Rigorous compliance with a limit of 2% per year to growth in the money supply, M. Fixed exchange rates. Euro.
A 100 percent reserve requirement (Bank crises are not possible.) The abolition of the central bank.	The central bank limits itself to providing liquidity to banks in trouble to avoid bank crises.
What is deposited is not lent, and there is a proper matching of the flows of savings and investment. The business of providing liquidity is separate from that of financial intermediation.	A radical separation between commercial banking and investment banking. (Glass-Steagall Act of 1933)

In many areas of the controlled market, which must be reformed (the privatization of streets, liberal immigration, etc.), it is a grave error to believe it necessary to eliminate all regulation until the ideal reform takes place. Quite the opposite is true. Until the reform occurs, a minimum of regulation is needed to simulate, as far as possible, the results of the ideal system: in the monetary sphere, a pure gold standard with a 100 percent reserve requirement and no central bank. Nevertheless, we must repeat again and again that, instead of trying awkwardly to replicate with doubtful half measures what the market would achieve, without a doubt the best and ultimately unavoidable line of action is to implement the definitive, radical reform demanded by the ideal monetary model.

Society is confused and bewildered by the crisis. The gulf between people and politicians is nearly unbridgeable. Moreover, the ignorance and confusion of the latter is also spectacular. However, the worst part of the situation is that most economic theorists themselves are drawing a blank in terms of theory, and they are not managing to grasp what is happening, why it has happened, and what could happen in the future.

10. Conclusion: Bewilderment among Theorists and Citizens

The loss of prestige suffered by neoclassical economics (the hypothesis of market efficiency, the theory of rational expectations, faith in "self-regulation," the principle of agent rationality, etc.) is complete and is mistakenly interpreted as a market failure that justifies more state intervention. (Keynesians attribute the crisis to the sudden financial "panic" and to a lack of aggregate demand for which the state must compensate.) Theorists of different camps fail in their understanding of the market, and thus in their analyses and prescriptions. Well into the 21st century, the theoretical void is enormous. Fortunately, the Austrian theory of the cycle, in general, and my book Money, Bank Credit, and Economic Cycles in particular, are there to fill this void and clear up the present confusion.