The current financial crisis is not only the fault of risky banking.  While it would be far easier to accept the common notion that the present crisis is the result of some irrationality innate amongst bankers, who all of a sudden get too greedy and all in concert, I think the explanation is a bit bare.  There are institutional problems, even if you do not accept Austrian business cycle theory.  There is something which, I think, obviously distorts the banking sector’s risk assessment, because no matter how greedy bankers get, there is no interest in losing all your wealth to a cluster of a poor decision making.

Ultimately, a bank tax distorts a true assessment of the problems in the banking industry (which I believe is the existence of a central bank) and only hurts the banking industry and its clientele.

Reuters reports,

The European Council agrees that a levy on financial institutions should be introduced to ensure that they contribute to the cost of crises…

I would argue that banks should suffer the full costs of bailing them out, and if they can’t find the liquidity they need to sell assets.  In any case, I thought this was what central banks were for, extending liquidity.  It seems that central banks failed.

Dear Mr. Weisbrot,

While true that Venezuela is not in the same exact situation as Greece regarding their level of national debt, it remains untrue that Venezuela is in a position to pursue “robust economic expansion”. Instead of borrowing credit, the Hugo Chavez junta instead finances its increasing public expenditure through an inflationary fiscal policy. Yes, this is one “advantage” to having your own central bank.

Venezuela suffered a 22% increase in the price level in 2007, 30.9% in 2008 and 25.1% in 2009, while the bolivar’s money base continues to rise at an exponential rate. So, while Venezuela’s export industry “gains” in the sense of increasing volume of trade (but with decreasing profits), the Venezuelan people as a whole become poorer thanks to a loss in purchasing power. Rising GDP figures due to an increase in the amount of money in circulation is not prosperity.

What will occur to Venezuela is exactly what would occur to Greece had Greece maintained the drachma as the national currency – hyperinflation.

Sincerely,

Jonathan

Monetary data is provided by the Banco Central de Venezuela.  I’d also like to point the read towards my piece on government debt and inflation, “Garet Garrett’s Invaluable Lesson“.  One of the most important quotes,

Government cannot print its way out of a debt that adjusts itself to the rise in the supply of money.

With the mission of eliminating Al-Qaeda ending in failure, the United States changed its purpose in Afghanistan to that of nation building.  This has come into conflict with their second original objective: ending Taliban rule.  While on the surface the coalition’s military has fought an eight year battle against resurgent Taliban warlords in different areas of the country, including the most recent offensive on Marjah,[1] behind the scenes U.S. policy makers have actually been working closely with certain elements of the Taliban in an effort towards stabilization.[2]

It is becoming more and more obvious that the United States’ government is looking to patch up its credibility as a “nation-builder”, before public opinion absolutely forces it to withdraw personnel from Afghanistan.  Current American policy is not too different from Richard Nixon’s “peace with honor” “exit strategy” during the Vietnam War.  As such, nation-building is really a misnomer for an objective which really involves providing Afghanistan a strong government in Kabul to offer the illusion of peace and stability, no matter what the cost to the Afghan people and long-term prosperity of the country.

To be fair, not everyone who believes that central governments can provide peace is being genuinely dishonest.  There has always been a strong belief in the connection between big government, stability and the establishment of an environment conducive to economic and social growth.  There is no doubt that the people of a country with a single authority have a greater opportunity to prosper than a people shackled by conflicting governments.  Just the same, an Afghani not suffering from the uncertainty of what military force will destroy his crops next will have a much greater opportunity to accumulate capital.

This is probably the mindset in which Professor Sheri Berman operated in while writing her piece for Foreign Affairs, “From the Sun King to Karzai”.[3] In the article, she draws attention to the rise of French King Louis XIV, who managed to dislodge French noblemen from positions of power in an effort to become an absolute monarch.  She means this as an analogy, as to argue that the best course of action in Afghanistan is to create a strong national government in Kabul at the expense of local, rural leaders.  It is clear that Berman believes that a strong central government in Afghanistan is bound to lead to development, growth and long-term prosperity.  If centralization of power under Louis XIV led to the development of modern France, a similar course of action will do the same in Afghanistan.

For all its appeal, there is a lacuna in the argument for strong central government.  Historically, some central governments have not been “strong” because they have been big, but because a wealthy economic environment has allowed them to come into existence.  Stability can therefore be said to come from wealth.  People free to prosper are people with incentives to avoid creating regime uncertainty.  Central governments can therefore form without too much opposition from the people they intend to preside over.  With this in mind, it is no coincidence that most politically unstable countries are also very poor.  But, the relationship between wealth and government dictates that wealth must precede central government.   So even if successful, the establishment of an authoritarian and strong central government will therefore not necessarily lead to positive economic and social development in Afghanistan, as the necessary prerequisites have not been established.

In fact, historically speaking, strong central governments in poor nations have simply been oppressive dictatorships.  Iraq, prior to the U.S. invasion, was one such example.  Neither have these “strong central governments” provided stability for long.  Even during Louis XIV’s reign there were repeated rebellions between 1630 and 1670.[4] In fact, it was not until Louis XIV reversed his crippling tax network and replaced mercantilism in favor of laissez-faire that France began to develop.[5] Freedom, not big government, is the catalyst for prosperity.

Current U.S. policy in Afghanistan is ensuring the creation of a big bureaucracy, dedicated to the oppression of the Afghani populace.  Malalai Joya, an Afghani woman elected to—and then banned from—parliament, has been a vocal critic of U.S. politics in her war-torn country.  She has brought attention to the fact that a large portion of Hamid Karzai’s government in Kabul is composed of warlords and religious extremists, many of which committed crimes against humanity during the civil war of the 1990s.[6] In effect, the United States is returning Afghanistan to the way it was before the 2001 invasion.  But, instead of the Taliban, the new despots will be “warlords and drug traffickers”.[7]

Professor Berman’s strategy for Afghanistan only promotes disaster.  While many of Louis XIV’s mercantilist policies were eventually rescinded, this occurred only because the France of the 17^th Century enjoyed a fairly large body of wealthy merchantmen with interest in struggle for freedom.  The poor of Afghanistan, which make up the supermajority of the population, do not enjoy the advantage of having a similar social middle class willing to pressure the Afghani government into being more business-friendly.  As a result, Berman’s strategy is bound to lead to dictatorship, not long-term peace and development.

No Easy Solution

Make no mistake, finding a solution to the “Afghan problem” is no simple task.  No matter the route taken, the immediate future holds much pain, suffering and uncertainty.  It is clear that overbearing government, whether coming from Kabul or originating from any of the various regional warlords, will not be defeated bloodlessly.  But, foreign intervention has obviously done nothing to better the situation.  Instead, it made the poor worse off by damaging their businesses and livelihoods, while reinforcing the power of the local governments by providing them military support.  Instead, Afghanistan must improve from within.

Admittedly, “improvement from within” is easier said than done.  It took most modern, first-world nation-states centuries of instability, war and evolution to reach their current degree of political stability.  In Afghanistan, the United States is looking to force this transition within the time span of a few years.  Tragically, this objective may simply not be realistic.  Any central government built through force, in Afghanistan, comes with a high degree of compromise.  Compromise in Afghanistan is leading to the construction of an oppressive regime.  A government designed without considering the interests of the people is a government that is bound to act against these same interests.

Historically, countries escaping tyranny and entering periods of healthy accumulation of wealth do so while there is a simultaneous decrease in the size of government.  The example of 17^th Century France has already been shared: it was only after Louis XIV’s government began to end interventions in the market that the people of France began to prosper.  The case is the same in Afghanistan.  A real rise in wealth will only occur when governments, whether central or local, stop interfering with the individual’s right to his property.

Providing a plan to guide Afghanistan step-by-step through the process of “nation building” may as well be impossible.  Truthfully, no matter how well one knows the politics and history of Afghanistan, no single plan will be very helpful.  Emulating the experience of modern first-world nations, Afghanistan will have to undergo a period of painful political development in which the Afghani people, as individuals, demarcate the boundaries of government—invariably, this means a reduction of government.  But, this series of events must occur from within and must be conducted voluntarily by the Afghan people, and as a result is largely unpredictable.

Professor Kimberly Marten, writing for International Security, provides an interesting case study of the method by which “warlordism” was overcome in Medieval Europe:

The economic surge across Europe at the turn of the first millennium created new opportunities for long distance trade. Merchants thus had an incentive to take political action to lower the transaction costs associated with doing business. The overlapping taxes and incompatible monetary systems of the feudal system gave them reason to escape to territory where they could conduct their business without interference from feudal lords. Merchants who were able to form or settle in self-regulating towns, where impersonal legal codes protected their property rights and set predictable tax rates, prospered. In turn, this prosperity gave them the power and means either to form their own armies for self-defense against warlord predation, or to bargain with kings who promised them protection and universal fair trade rules that extended over larger territories.[8]

This historical example is very revealing.  In Europe, prosperity did not come about until merchants, incentivized by their quest for profit, circumvented the restrictions placed on them by local governments.  Unsurprisingly, faster development took place after the merchant class broke the state’s monopoly on force.  It was the creation of a code of law by the merchants themselves, through voluntary contracts, which provided the stability necessary to foster an environment conducive to investment and economic growth.  The European experience, in fact, suggests that governments play absolutely no role in stabilization.

What is clear is that the current situation in Afghanistan makes it very difficult for such an environment to be created.  The Afghan merchant class is almost non-existent,[9] and the opportunity for the development of such an interest-group has been severely severed by the presence of American and NATO personnel.  In effect, foreign powers have been strengthening regional governments by incorporating them into the new government in Kabul and by providing them military assistance.  This is the exact opposite of what should happen in Afghanistan.  To some degree or another, what is occurring in Afghanistan is similar to what would occur if the United States was to provide military assistance to the likes of Hugo Chavez in Venezuela or the Castro family in Cuba.[10]

Direct foreign assistance by means of military force has turned out to be disastrous.  Direct foreign aid in the form of government-provided capital may not be what the doctor prescribed either.  Given the likely recipients of such foreign aid, the capital is unlikely to be allotted towards productive means.[11] The only worthwhile foreign aid is that provided by foreign entrepreneurs looking to invest in Afghanistan, and for that to occur peace must be established through internal reform.  Despite over-simplicity, the only way this will occur is if foreign troops withdraw from Afghanistan and the Afghan people struggle to reduce the size of their government.

Luckily, the existence of globalization has made it far easier for merchants to trade for capital-goods, replacing decades of capital accumulation.[12] This fact should shorten the process of the creation of a relatively wealthy merchant class in Afghanistan, which will also shorten the time necessary for the necessary political changes to be made.  Nevertheless, the presence of armed military personnel exercising a monopoly on force against the merchant class, or those hoping to become the merchant class, provides a strong barrier against progress.  For this reason, these troops must withdraw.

Entrepreneurship versus Government

Afghanistan will not be improved by the forceful construction of a bulky central bureaucracy.  There has been an incorrect assumption of causality between strong government, stability and entrepreneurship.  The relationship is the exact opposite.  Entrepreneurs, working around restrictions placed by the state, accumulated the wealth necessary for stable central governments to come into existence.  These “strong” central governments have either always been small, or have necessarily decreased in size, in order to allow for economic growth.  Their strength and stability, furthermore, does not stem from their size or power, but the fact that the smaller their role in regulating the actions of an individual the less an individual is likely to question the legitimacy of the state.

Such political development does not happen overnight, and cannot be forced on a people.  By perpetuating the impoverishment of the Afghans, coalition forces have set themselves up for failure.  What is necessary is the creation of a relatively wealthy pool of individuals, which give them an incentive to struggle against the state and provide the Afghan people in general with a stable environment promoting growth.  That being said, the best course of action for foreign countries directly intervening in Afghanistan today is to withdraw.

All the while, intellectuals looking to guide foreign policy by drawing analogies between historical examples and modern-day Afghanistan must come to the realization that social and economic development can only come voluntarily and can only stem from the passion for entrepreneurship existent within the Afghan people.[13] Big government and social engineering are burdens which act against entrepreneurship; prosperous and stable nations invariably require as small a government as possible or ideally no government at all.

[2] Gall, Carlotta, “As U.S. Weighs Taliban Negotiations, Afghans Are Already Talking”.  New York Times, 11 March 2009.

[3] Berman, Sheri, “From the Sun King to Karzai”.  Foreign Affairs, Volume 89, Number 2, 1 March 2010; pp. 2–9.

[4] Rothbard, Murray N., An Austrian Perspective on the History of Economic Thought: Economic Thought Before Adam Smith, Ludwig von Mises Institute: 2006; p. 225.

[5] Ibid., pp. 257–274.

[6] Joya, Malalai, “The big lie of Afghanistan”.  Guardian.co.uk, 25 July 2009.

[7] Joya, Malalai, “A troop surge can only magnify the crime against Afghanistan”.  Guardian.co.uk, 30 November 2009.

[8] Marten, Kiberly, “Warlordism in Comparative Perspective”.  International Security, Vol. 31, No. 3: Winter 2006/2007; p. 60.

[9] Ibid. p. 69.

[10] That being said, make no mistake that the United States does actively support tyrannical and murderous regimes throughout the world.  This fact alone makes the United States’ intention of real nation-building in Afghanistan dubious at best.

[11] For a general argument against foreign aid, see: Moyo, Dambisa, Dead Aid: Why Aid is Not Working and How There is a Better Way for Africa, Farrar, Straus and Geroux: 2009.

[12] Reisman, George, Globalization: The Long-Run Big Picture: 17 November 2006.

[13] Finegold Catalán, Jonathan, “Passion Comes From Liberty”.  Mises Daily:  9 February 2010.

How do you think that this continued policy of easy credit will affect the European economy in the coming months or years?

China’s new asset bubble, seemingly forming in such commodities like barley, also seems to offer new evidence to disprove the mainstream theory that vibrant capital markets (or flow of money) can cause instability in growing economies.  The Economist writes:

On November 25th China tightened the rules on foreign-currency transfers by individuals in a bid to control flows of hot money into the country. But signs of frothiness are also cropping up in odd places: garlic has become an unlikely target for Chinese speculators.

Perhaps it is time to take a look at what really drives instability. To be sure it is relevant to money and the monetary base.  But, is foreign capital really the source of instability?  Can a European investor invest in euros, or must he convert to renminbi before making the investment?  The only currency which drives the capital market in China is the renminbi, and the only means by which a foreign investor can make purchases in China is by trading in renminbi.  Therefore, it is nonsensical to blame economic instability on foreign currencies.  We can conclude that the only factor which drives a country’s money market is the monetary base of its currency, and therefore the decisions taken by the country’s central bank in expanding or contracting said monetary base.  This has become obvious in China, recently.  The Economist continues with:

“This sort of thing happens in China whenever you have too much bank lending,” says Jerry Lou of Morgan Stanley. “The liquidity spills everywhere. Garlic is just the area of the moment. We are at an asset-bubble-foaming stage.”

Jerry Lou is half-right.  But, the problem is not too much lending.  It is too much lending on fractional reserves.  Fractional reserve banking invariably leads to monetary expansion, which in turn drives asset bubbles as investors use all this new money to invest into lines of production.  Monetary expansion leads to commodity inflation, distorting relative prices and causing widespread malinvestment.  This is the nature of an economic asset bubble.  Fractional reserve banking is provided a lifeline through the central bank, which can provide liquidity to a bank’s assets by simply adding more money to its reserves.  While this reinforces a bank’s soundness, it does not allow them to correct lending mistakes and eventually causes the recurring boom and bust process.

So one thing should be clear: the sources of financial insecurity are not international capital markets, rather unsound monetary expansion by federally cartelized institutions.  As long as countries slow international trade and instead “solve” economic crises through bubble re-inflations, there will be no end in sight to our current financial woes.  Indeed, we will see brief moments of illusionary financial growth, and then the inevitable bust, and long-term currency debasement and the poverty which comes with it.

In the article How the Fed Helped Pay for World War I, author John Paul Kroning extracts the following from Milton Friedman and Anna J. Schwartz’ book, A Monetary History of the United States, 1867–1960:

“…total federal government expenditures during that period were $32 billion and additions to Treasury cash balances $2 billion.  Of that total of $34 billion, approximately 25 per cent was financed by explicit taxes plus nontax receipts; 70 per cent by explicit borrowing; and 5 per cent by direct money creation, which may be regarded for that period as largely an implicit tax on money balanced levied through the rise in prices.” (Friedman and Schwartz, p. 221)

But these statistics remain misleading.  As stated by Friedman and Schwartz, 70 percent of the war was paid through borrowing (for example, through the sale of bonds).  This represented a separate avenue for inflation and was orchestrated thanks to the Federal Reserve.  Indeed, economist Benjamin Anderson, in Economics and the Public Welfare, goes as far as to claim that without the Federal Reserve the United States’ financial sector would have collapsed under the enormous strain imposed on it by the government:

“The Federal Reserve System performed great and distinguished services for the government and the country in World War I. It is difficult, indeed, to see how we could have handled the financial problems of the war without it. It made possible a smoothness and simplicity in handling huge financial transactions that would have been incredible under the old system. In the summer of 1918, for example, the federal government collected around $4 billion in taxes in a few weeks. In connection with the first liberty loan in 1917, $2 billion were paid into the federal Treasury in a short time. Financial transactions of this magnitude would have led, under the old system, to drains, falling primarily on the New York banks, which would have forced the banks almost instantly to suspend cash payments. Had the old subtreasury remained in full vigor, under which all payments to the federal government were placed in cash vaults of the government itself, the mechanism would have broken down with the first liberty loan. Under the Federal Reserve System, however, these huge financial transactions were largely accomplished by bookkeeping entries.” (Anderson, pp. 57–58)

It immediately becomes evident that the Federal Reserve played a larger role in financing the war than is originally assumed by Milton Friedman and Anna Schwartz.  The reserve system effectively guaranteed government debt by allowing the banks to hold money being lent to explicitly be able to hold it for other uses, by simply creating an account which annotated the money the government owed.  It was another name for fractional reserve banking, which in and of itself is a cause of monetary inflation.  So, if 70% of the war was financed through debt which was only possible with a central bank, and another 5% of the war costs were financed through straight-forward monetary expansion by said central bank, then it could be claimed that as much as ¾ of the war was paid for thanks to the Federal Reserve.

Whether or not the First World War was “just”, at least in regards to allowing the United States to put an end to war in Europe, is irrelevant in the larger picture.  The fact is that a government-imposed monetary monopoly allowed every single power which eventually sparked the First World War to do so (see: von Mises, Ludwig, Nation, State and Economy, pp. 125–136).  Arguments of fractional reserve banking, fraud and boom and bust cycles aside, privatizing the industry of money and decartelizing the private banking industry would effectively hamstring a State’s ability to wage war.  Do you think that the United States could have operated in Vietnam without a central bank to maintain its debt, or even Iraq and Afghanistan?  Take into consideration that had it not been for Russia’s State Bank of the Russian Empire it would have been incapable of declaring and waging war against the German Empire in 1914, and the Russian Revolution and ensuing Russian Civil War would have been impossible to finance.

Nationalizing of the money supply and banking sector, made possible through the foundation of a central bank, is the greatest tragedy yet in the history of the human race.  The consequences can be seen in the destruction of capital during the war and the deaths of millions of people in the 20^th century alone.  The resulting inflation of the ever expanding money supply enriches only some (the original recipients of the money), while impoverishing everybody else (as their savings are now worth less).  Central banking and war finance utterly destroyed Germany during the early 20^th Century and led to the rise of Adolf Hitler.  How much damage will be done before the people realize the dangers of this practice?

There seems to be a great deal of misconceptions in regards to what market liberalization is, to how Capitalism can foster economic growth in any given country and the case of globalism in the Third World.  These misconceptions have caused many prominent economists, such as Joseph Stiglitz, to find the correlation between intensifying globalization of capital and increasing poverty in the majority of non-Western countries.  Furthermore, the success of liberalization in more closed economies, such as China’s, has been hailed as sufficient evidence to “prove” that government regulation of foreign capital and local markets is justified, as it is the only way in which globalism does not conduct itself in a zero-sum manner.  That is, only through regulation can a country avoid the inherent instability of globalization.  This is the viewpoint, at least, provided in Joseph Stiglitz’ Making Globalization Work.  Stiglitz, however, fails at providing a strong case behind his opinions, and fails to show how there is causation between globalization and spiraling world poverty (as, correlation is not causation).  Furthermore, although he finds it inevitable to concede that most of these failed Capitalist economies did not have proper private property rights established, he does not fully reconcile this fact with his own poorly fabricated theories.

He is not entirely wrong, but Joseph Stiglitz generally fails to correctly apply theories to reality, and he is found incapable of providing the details which would otherwise show that perhaps his conclusions are not as correct as he assumes they are.  In other words, many of his premises are correct, but he sets up straw men in an effort to disprove these premises (mostly in regards to free markets and liberalization of markets).  He defines the free market capitalist argument for globalization as one which “focused on minimizing the role of government, emphasizing privatization (selling off government enterprises to the private sector), trade and capital market liberalization (eliminating trade barriers and impediments to the free flow of capital), and deregulation (eliminating regulations on the conduct of business) (p. 27).”  In essence, he is right.  But, he follows with the idea that the Third World did follow these steps and ultimately came out poorer than they went in.

According to Stiglitz, one of the main reasons why globalization has punished much of the Third World is because of the inherent instability of a liberalized capital market.  He writes, “The most hotly contested policy issue of the 1990s was capital market liberalization, opening up markets to the free flow of short-term, hot, speculative money (p.16).”  Not only is this definition wrong, but it seems as if Joseph Stiglitz has a poor grasp on the theory of capital (interestingly, Jesús Huerta de Soto suggests that the major weakness in Keynesian economic theory is their lack of capital theory).  Even if you decide to give Stiglitz the benefit of the doubt, he conducts a poor effort in explaining how liberalized capital markets catalyzed instability in Third World countries.

We should attempt to define what capital is.  Even the most educated economists and intellectuals tend to be devoid of a true understanding of the nature of capital.  Indeed, our intellectual leadership seems intent on calling money capital, when it is in fact not capital.  According to Hernando de Soto, the word “capital” seems to have denoted “head of cattle” or “livestock” in medieval Latin.  At the time, the ownership of livestock was probably one of the most wealth generating, given that livestock produced meat, milk, hides, wool and fuel.  One could, therefore, conclude that capital simply represents assets owned.  These assets serve two principle purposes: they represent current wealth, and also the ability to produce wealth (for example, livestock have offspring and multiply). (See: de Soto, The Mystery of Capital, pp. 40–41)  To a degree, capital remains mythical in the sense that a particular asset need not have value prescribed to it, while capital is necessarily valuable.  One could say that in order for something to become capital the owner must be able to apply it in a way in that it gains value, as value is not intrinsic in any object.  Value, in short, in subjective.  In The Pure Theory of Capital, Friedrich Hayek underscores the above stated point:

Two ideas in particular have had a very harmful effect on the whole theory of capital.  The first is that the idea that particular capital items represented a definite value independently of the use that could be made of them…(p. 10)

This considered, it can be further deduced that money is not capital.  If we are to define capital as assets owned, we can therefore define money as a common medium of exchange which represents the capital that is actually being traded.  Going back to Joseph Stiglitz’ comment on capital markets and money, we can therefore assume that the money which was flowing into the opening markets was not capital in and of itself, but represented capital.  That money must have originated from the sale of capital, which allowed those “speculators” to then exchange it for capital from whichever country they were investing in.  Given that we now understand the nature of capital markets (at least, to enough of an extent to understand the folly in Stiglitz’ thesis) it is easier to see that there is no obvious instability in capital markets which must be regulated by the government.  This is merely an assumption which Stiglitz makes, as he does not understand capital theory and he has therefore not had any motivation to study the true reasons behind poverty in much of the Third World, despite globalization.

An interesting quote from Stiglitz’ book gives quite an account on the author’s cloudy understanding of what should be basic economic concepts for an economist with a doctorates, “If private firms are not providing the basic inputs for production—like steel and plastic—government should step in if it can do so efficiently.  Korea and Twain showed that it could… Taiwan’s government helped establish the enormously successful Formosa Plastic Corporation. (p. 33)”

Had there been capital market liberalization—that is, had Taiwan’s government reduced trade barriers—that plastic could have come from overseas.  Stiglitz purports to claim that the reason why a local plastic manufacturing company was unable to come into existence before it was subsidized by the government was because “demand was not guaranteed”.  Even if this was true, and their was no investor willing to risk the money, had there really been capital market liberalization then the same plastic-requiring companies could have simply purchased the plastic for a cheaper price from overseas providers, reducing the costs of production.  This goes to show the author’s’ limitations in the understanding on the subject of trade, capital markets and the nature of capital itself.  Unfortunately, one of the major barriers to offering a full critique is that his words remain vague, and he fails at giving a full explanation of why he believes liberalized capital markets cause instability.

He offers a hint that it is relevant to money and speculation.  In this case, Stiglitz may be correct, but he accuses the wrong phenomenon of being the culprit.  Capital markets are not the cause of instability—the world’s instabilities have been caused by government control and monopolization of the money supply.  This Keynesian and Monetarist institution has been at the heart of the modern day’s financial instability, inflation and much of the Third World’s problems.  You can hardly accuse Zimbabwe of being too Classical Liberal.  No, it was the Reserve Bank of Zimbabwe, operating under the orders of the central government that had run the printing press leading to severe hyperinflation.  In this sense, it is not foreign capital (not money) which is the problem, but foreign economic theories which have been exported to the Third World and have caused massive instability (just as they have caused massive instability in the First World).  This is perhaps one of the down sides of globalization, but it has nothing to do with market liberalization.  Indeed, it is the exact opposite.

Stiglitz is correct in suggesting that, for many, globalization has been a zero-sum game.  But, that is not a product of the free market.  That is the product of bureaucracy and political corruption.  Indeed, the act of favoring a foreign company that is paying you off is not a sign of small government more than it is of big, corrupt government playing the game of mercantilism.  The inability of Stiglitz to distinguish between the two is ultimately the cause of his downfall and the seed of his misunderstanding.  He concedes that these countries do not have ample property rights, but he states that it is because governments have not had the time to establish the necessary legal frameworks which make private property possible.  The case is the exact opposite.  Government has only made it more difficult for individuals to gain private property, and government has been the source of property theft.  One only has to look at the list of barriers which governments around the world have erected to make it more difficult for an individual to buy property and use it to invest accumulated wealth.  One does not have to look further than his or her own country, even if that country is the United States.

It is a shame that many economists have continued to spout incorrect statements and theories on the world’s problems.  Ultimately, these economists influence more than they should, and as a result aggravate, instead of relieve, instability.  The worst part is that Joseph Stiglitz was awarded the Alfred Nobel Memorial Prize in Economics.

In the twentieth century, advocates of the Federal Reserve System subtly but significantly modified this interpretation to support the supposed need for a government central bank to regulate the money supply and banking system. They blamed the Panic of 1837 on Jackson’s policy of “destroying” the second B.U.S. by depriving it of its regulatory powers over the state banks and providing the latter with the public money as a speculating fund. To students and superficial observers the two interpretations appeared to be the same, or at least complementary; but the two were not the same, as we shall see below.

Peter Temin’s The Jacksonian Economy (1969) has become the standard and definitive work on the causes of the Panic of 1837 for both libertarian free bankers and many Austrian 100 percent reservists. Temin absolved both the state banks and President Jackson of all blame for causing, or even contributing, to the Panic of 1837 and subsequent recession. To be sure, he acknowledges that a rapid expansion in the money supply in the 1830s resulted in rising prices and a business boom. However, he does not believe that that the increase in money made a contraction inevitable; nor does he believe that the banks were responsible for the inflation.  Rather, he attributes the inflation to a sudden influx of silver coin from Mexico. The reason for this influx was a dramatic change in the China trade. Because the Chinese demand for opium suddenly increased, the British could pay their remittances with Indian opium rather than Mexican silver. Thus, as British demand slackened, more Mexican silver remained in the United States. Temin cited another factor tending to keep Mexican silver, as well as gold coin, in the United States. The British were willing to grant credit to American importers to sustain a chronic trade imbalance and to lend capital to help fund the American canal and railroad boom. As a result of the increasing stock of specie in the United States due to the factors above, the banks could expand their loans and discounts without decreasing their proportion of specie reserves.  Temin marshals statistics to prove both that the stock of specie increased in the 1830s and “the reserve ratio of the American banking system as whole did not fall below its 1831 level throughout the 1830s.” His conclusion: “The factor leading to an expansion of the monetary stock . . . was the rise in the stock of specie”; “the money supply increased because the amount of specie in the country increased, not because banks expanded on the basis of fixed reserves.”

Temin also denies that the land boom of the 1830s fueled in any way the monetary or credit inflation of the period. On the contrary, by absorbing much of the new money being issued by the banks, “the land boom acted to retard the inflation.” Temin argues that because the price of public land remained fixed, regardless of the demand, the increasing land sales were due to an enormous latent demand that was freed by the increasing availability of credit due to the rise in the specie stock.

What then caused the Panic of 1837? According to Temin, there were two factors. First, beginning in late 1836, the British stopped exporting capital to the United States and demanded payment in hard currency for new exports. Second, in early 1837, the British demand for American cotton suddenly fell; and, as the demand fell, so did the price. “As this important price fell, the credit structure built with cotton as security collapsed.” The banks suspended in the spring of 1837, credit suddenly dried up, money became dear, and prices collapsed. Thus, “a diminution in the capital flow from England to America was the force that led to the crisis.”

Libertarian free bankers and Austrians seem to have uncritically accepted Temin’s interpretation. Temin gathers an impressive array of data to bolster his argument, and he obviously understands the banking and credit system of the period. Most importantly, by absolving the incorporated fractional-reserve banks of the states from any responsibility for the crisis, he bolsters the free-banking position that fiduciary media and free banks are not inflationary. Second, by denying that Jackson’s “war” on the federal bank had anything to do with the subsequent inflation and panic, he reassures them that the B.U.S. could not have served to restrain inflation. The B.U.S. could either foster and protect, or restrain, the inflationary tendencies of the state banks. Although the B.U.S. as a quasi-government bank had its own powerful motives and tendencies to inflate, it could, and did, at times repress inflation. Its second president, Langdon Cheves of South Carolina, who directed the bank from 1819 through 1822, repressed inflation by the state banks. Even Nicholas Biddle for the first eight years of his presidency was only a moderate inflationist.

Evaluation

Temin’s interpretation is not consistent with Austrian theory, nor does it refute the American hard-money or currency-school interpretation of the 1830s. Temin blames both the monetary inflation of the 1830s and the Panic of 1837 completely on changing market conditions, or real-world factors. He blames the inflation on the influx of specie from Mexico, the change in the China trade, and British investment, not money creation by the B.U.S., the state banks, or the policies of President Jackson. He blames the panic on the sudden drying up of British credit, the fall in cotton prices, and the rising British demand for specie, not on mal- investment caused by below market interest rates, unsustainable levels of debt and balance of payment deficits, or the excessive creation of new money.

According to Austrian monetary theory, when government and fractional-reserve banks of issue inflate the money supply and lower the natural interest rate they create an artificial investment (all funded by new money). The monetary inflation of the 1830s was not caused by the influx and then the retention of Mexican silver, but by the fractional reserve banking system, which used the silver as a fund on which to pyramid new discounts and loans. For every new Mexican silver dollar deposited in a bank by an American merchant or manufacturer, the bank created at least five new paper dollars or paper credits. The payment of a debt, or a purchase, by specie is not by itself inflationary, but to use the specie to build five times its amount in new money most certainly is inflationary. The statistical tables tell the story. The banks increased their holdings of specie, and they created new money on top of it (five times the amount).

Temin is wrong to conclude that the proportion of specie reserves did not drop during the 1830s. He organizes the reserve ratios of the banks by region. While this breakdown is useful for informing us that reserve ratios varied considerably from region to region—New England banks consistently kept a lower proportion of reserves relative to all other regions—it does not tell us whether the level of reserves was rising, falling, or staying the same for the country as a whole. When all the banks of the union are considered together, reserve ratios did fall from 18% in 1830 to 15.2% in 1833 (the year Jackson withdrew the government deposits from the federal bank). From 1833 to 1837 (the eve of the panic), reserve ratios fell again from 15.2% to 13.7%. Even Temin’s own statistical tables reveals that reserve ratios were falling in certain regions. Temin uses two sets of statistics. According to one set, reserve ratios fell in the middle Atlantic and northwestern banks between 1834 and 1837; according to the other, they fell in the northwestern and Southern banks. Furthermore, there is evidence that the state-bank depositories did lend out at least part of the public deposits with which they were entrusted. Treasury Secretary Taney informed them that they were expected to increase their discounts after receiving the government funds; and when the government in 1837 called on the banks to pay out the remainder of the surplus fund s deposited with them in previous years, the banks replied that the money was gone. Thus, it seems clear that by depositing the government’s funds in the state banks, President Jackson did contribute to the inflation of the mid-1830s.

Temin completely ignores the expansion in banking after President Jackson hinted in his first annual message (December 1829) that he would oppose a renewal of the charter for the second Bank of the United States. From January 1830 to December 1833, the number of banks increased from 330 to 506, a 53% increase. Then, from 1833 to 1837, the number of banks increased from 506 to 788, a 56% increase. The chartering of so many new banks meant that the banking system as a whole could inflate the money supply significantly even while maintaining the same proportion of reserves. Contemporary political economists (Gallatin, Gouge, and Raguet) all cited Jackson’s campaign against the federal bank as spurring a bank mania in the states. Bank projectors and state legislators rushed to organize and charter new banks in the hope not only of getting a share of the public deposits but a share in the bank business being forfeited by the Bank of the United States’ loss of prestige, circulation, and deposits resulting from the loss of its privileged federal status.

Finally, Temin’s contention that the land boom of the 1830s had a deflationary effect upon the economy is simply insane. The government accepted state bank paper in payment for the purchase of public lands. When the Bank of the United States was the fiscal agent of the federal government (from 1817 through mid-1833), this money was deposited in the federal bank or one of its branches. As the B.U.S. was a specie-paying bank, and as merchants and the public felt less compunction about withdrawing specie from it compared to their local bank, the federal bank had to keep a large stock of specie. If state bank notes began to accumulate due to an increase in land sales, the managers would have to return at least some of them for payment. This acted to check or restrain the state banks from inflating. However, after mid-1833, the B.U.S. was no longer the fiscal agent of the federal government, so state-bank paper used to purchase public lands now ended up in a state bank. The state banks then lent it out again. The same money could now be used to purchase more land, or for other purposes. It could be lent out a third and fourth time. Federal land sales simply exploded after 1833. They went from $4.2 million in 1833 to $6.1 million in 1834, $16.2 million in 1835, and $24.9 million in 1836, and $6.9 million the first few months of 1837 before the panic. While the price of public land was fixed by law, its price could, and did, rise after it was sold to the first purchaser (often a land speculator who bought up large amounts only to sell it at a profit).

In summation, Temin was right to notice that the inflation of the 1830s began in 1830 not in 1833. However, he is wrong to absolve President Jackson and the state banks of all blame for the monetary and credit inflation of the decade. The incorporated, fractional-reserve banks of the states were the chief cause of the inflation previous to the panic, and Jackson’s state-bank depository system was a secondary cause. Temin is also wrong to blame the Panic of 1837 merely on changing market conditions abroad. Had the United States had a sound banking and monetary system founded on 100 percent specie reserves, the fall in cotton prices and the drying up of British credit would have been a mere temporary  inconvenience and certainly would not have led to a calamitous panic, followed by a brief recovery and then a second panic and a four year business contraction.

The current recession has brought about renewed discussion on the origins of the business cycle, and invariably economists have looked at the Great Depression to provide a historical example.  Furthermore, the fact that this recession is one of the deepest since the crash of 1929–32 has also catalyzed a number of comparisons between the two.  Without a doubt, having an accurate understanding of how the 1929 recession came into being will be pivotal if there is ever to be any agreement between economists.  On the other hand, the 2008 recession has already taken place, and so arguing the origins of the credit crunch has become largely superfluous.  There is no doubt that in the long-run the explanation of the business cycle will be extremely important, but in the short-term it may be more valuable to discuss in what fashion an economy can recover from a recession.  The Great Depression is also a classic case study for this topic, and disagreement amongst professionals continues in regards to explaining what brought about a recovery during the 1930s and why the recovery took so long.  In many ways, the course of action of the Bush and Obama administrations have been very similar to, if not a mirror image of, the course of action taken by Presidents Herbert Hoover and Franklin Roosevelt.  There are also key differences.

One of the major disputes revolves around the question of whether or not the Federal Reserve took action to provide liquidity to failing banks.  In Free to Chose, Milton Friedman suggests that the decline in money stock between 1929 and 1933 represents the Federal Reserve’s inaction in the face of deflation.[1] Other economic historians have taken a similar stance.  For example, in his book on Roosevelt’s New Deal, Burton Folsom writes, “In the early 1930s, the Fed dithered and let the runs on banks continue.”[2] Murray Rothbard suggests something radically different, in America’s Great Depression, offering statistics on the expansion of controlled reserves by part of the Federal Reserve.  In fact, as early as the last week of October 1929 the Federal Reserve bolstered bank reserved by nearly $300 million, he claims and lowered the rediscount rate by 1½ percent by November.  He goes a long way in explaining why there was a general decrease in the money supply: “…controlled reserves increased by $359 million (with government securities the overriding factor), while uncontrolled reserves fell by $381 million.[3] Regardless if the Federal Reserve did, in fact, attempt to inflate the credit supply as early as late 1929, the fact of the matter that there was a deflation in the money supply between 1929 and 1932 due to a decrease in uncontrolled reserves, which outstripped any attempts to increase the money supply through controlled reserves.  The difference is that in the case of today’s recession, under Ben Bernanke the money supply has been growing at an accelerating pace.

Economist Jesús Huerta de Soto makes the argument that a recession can be temporarily avoided if the Central Bank creates money at an accelerating, or exponential, rate.[4] The ultimate conclusion to such a policy is still the inevitable reallocation of resources by the market, but only after a continued illusion of wealth—ultimately, such a policy will also lead to hyperinflation.  Therefore, unless the Federal Reserve suddenly ends the expansion of credit, there is the chance that the illusion of a recovery will be created.

As already explained, there are key differences between the Federal Reserve’s responses to either financial crisis; there is a minor similarity between the Federal Reserve’s policy between 1933 and 1936 and Ben Bernanke’s current fiscal policy.  It is generally accepted that in 1933 the United States economy had bottomed out.  At that time, the Federal Reserve continued its inflationary policy by expanding the money supply.  However, since the economy had bottomed out uncontrolled reserves were not decreasing at greater rates than controlled reserves, leading to a visible increase in the monetary base.  Simultaneously, Roosevelt continued and accelerated Hoover’s public works projects, sparking what was known as the New Deal.  Amongst the two, the latter has been at the forefront for explaining either why a recovery occurred at all after 1933, or why the recovery took so long to complete.  To a large degree, the former has been all but ignored.  However, the latter becomes more relevant when considering that in 1937 the economy suffered another downwards spike, which lasted for two years, largely undoing whatever recovery had taken place between 1933 and 1936 (although, this downturn was not as dramatic as the downturn of 1929–32).

The 1937 downturn, since then called Roosevelt’s Recession, has not been a major topic in any historical overview of the Great Depression.  The majority of books which deal with Roosevelt focus on the New Deal between 1933 and 1936, with only a scant look at the events of 1937 and 1938.  As it turns out, Roosevelt’s Recession of 1937 may be more relevant to the current financial situation in the United States than the Crash of 1929.  This is because we may be headed in the same direction.

Although the 1937 recession is only a minor focal point, that is not to say that economists have not drawn their own conclusions in regards to the causes of this event.  Keynesian economists, such as Paul Krugman and Jeff Madrick cite Roosevelt’s objective to balance the budget,[5] while Keynesians and Monetarists alike blame the Federal Reserves sudden tightening of the money supply.[6] Admittedly, the latter has a lot of merit and is empirically correct.  Nevertheless, these opinions have drawn to inevitable conclusions: one, the government must (seemingly) perpetually provide public goods by spending more money than collected through tax receipts, and two, the Federal Reserve should not increase interest rates, or at least should better calculate when to finally allow an increase in interest rates.  Now, the relationship between the period marked between 1933 and 1936 and the current financial situation in the United States should be clear.  Currently, controlled reserves are rising at a rate at which despite any possible decreases in uncontrolled reserves the monetary base is growing exponentially.  Furthermore, there is the risk that Obama will actively support the largest deficit spending programs in the fiscal history of the United States government.  If the conclusions of the 1937 recession are that bringing these two policies to an end will only lead to another recession then the country runs a real risk of complete and utter collapse when the people lose faith in both their government and their currency.  Therefore, the recession of 1937 merits a closer look and the pervasive mistakes made by Keynesian and Monetarist economists should be corrected.

Admittedly, of the two schools of thought, the Monetarists are probably closer to the truth.  What they fail to realize is the impossibility of calculating when to end credit expansion.  In two occasions during the Great Depression a sudden end to credit expansion ended in recession: 1929 and 1937.  Furthermore, during other recessions, notably during that of 1921, increases in the reserve ratio requirement as set by the Federal Reserve did not end in a lengthened period of recovery.  Instead, the 1921 downturn was one of the worst in the economic history of the nation, but one of the quickest.[7] It becomes obvious that the issue is not related to the sudden increase in interest rates by the Central Bank.  And so, while the Monetarists remain half-right, an Austrian approach must be made to this era as to provide an accurate lesson to apply to the current recession, and most importantly to correct the dangerous and false lessons as extracted by the Keynesian and Monetarist schools of thought.

Austrian economists are fighting an uphill battle to end the monopoly on money commanded by the Federal Reserve and ever-growing government fiscal interventionism.  Their most powerful case study is, ironically, one which has been largely ignored.  In his book The Politically Incorrect Guide to the Great Depression and the New Deal, Robert Murphy inexplicably lacks any length of a discussion on the events of 1937 and 1938.  Neither does he provide an Austrian explanation in his online debate with Jeff Madrick.  The only Austrian explanations are largely as a result of the work of Benjamin Andersen, in Economics and the Public Welfare, and Vedder and Gallaway in Out of Work.  An Austrian explanation of 1937 is in order, as it would severely undermine any pro-centralization arguments provided by rival schools of thought.

As with any historical study of a recession, explaining the downturn of 1937 requires a close examination of the fiscal policies which preceded it.  In this case, in order to show what made the crash of 1937 possible and to disprove Keynesian and Monetarist theories, we must put the events of 1933 through 1936 under a microscope.

[2] Folsom Jr., Burton, New Deal or Raw Deal?  How FDR’s Economic Legacy Damaged America, Threshold Editions, New York: 2008; p. 33.

[3] Rothbard, Murray, America’s Great Depression, BN Publishing: 2008; p. 191–192.

[4] Huerta de Soto, Jesús, Money, Bank Credit, and Economic Cycles, Ludwig von Mises Institute: 2009: pp. 404–405.

[5] Murphy, Robert and Madrick, Jeff, Was the New Deal a Raw Deal?

[6] Roose, Kenneth D., Federal Reserve Policy and the Recession of 1937–1938, The Review of Economics and Statistics, Vol. 32, No. 2: May 1950; p. 178.

[7] Vedder, Richard K. and Gallaway, Lowell E., Out of Work: Unemployment and Government in Twentieth-Century America, New York University Press, New York: 1993; p. 61.