Sunday, February 22, 2009


Part II: Stimulus Packages

Previously: Part I: Capital, Saving, and Our Economic Crisis

The Nature of Stimulus Packages

As was shown in Part I of this article, economic recovery requires greater saving and the accumulation of fresh capital, to make up for the losses caused by credit expansion and the malinvestment and overconsumption that follow from it. Yet the imposition of “stimulus packages” results in the further loss of capital. The Keynesians not only do not know this, but would not care even if they did know it.

Because of their ignorance of the role of capital in the economic system and resulting inability to see even the clearest evidence that suggests it, the Keynesians can conceive of no cause of a recession or depression but an insufficiency of consumption and no remedy but an increase in consumption. This is the basis of their calls for “stimulus packages” of one kind or another.

They assume that the economic system always has enough capital, indeed, that it is in danger of having too much capital, and that the problem is simply to get it to use the capital that it has. The way that this is done, they believe, is to get people to consume. Additional consumption will be the “stimulus” to new and additional production. When people consume, the products of past production are taken off the shelves and disappear from the stores. These products, the Keynesians believe, now require replacement. Hence, the shops will order replacement supplies and the manufacturers will turn to producing them, and thus the economic system will be operating again and recovery will be achieved, provided the “stimulus” is large enough.

The essential meaning of a “stimulus package” is the government’s financing of consumption, indeed, practically any consumption, by anyone, for almost any purpose, in the conviction that this will cause an increase in employment and production as the means of replacing what is consumed. Despite talk of avoiding wasteful spending and being “careful with the taxpayers’ money,” the truth is that from the point of view of the advocates of economic stimulus, the bigger and more wasteful the project, the better.

This was made brilliantly clear many years ago by Henry Hazlitt, who chose the example of government spending for a bridge. It is one thing, Hazlitt showed, if the government builds a bridge because its construction is necessary to facilitate the flow of traffic. It is a very different matter, he pointed out, if the government builds the bridge for the purpose of promoting employment. In the first case, the government wants the best bridge for the lowest possible cost, which implies the employment of as few workers as possible, both in the construction of the bridge and in the production of any of the materials that go into it.

In the second case, that of stimulating employment, the government wants a bridge that requires as many workers as possible, for their employment is its actual purpose. The greater the number of workers employed, of course, the greater must be the cost of the bridge.

Indeed, no one could be more clear or explicit concerning the nature of government “fiscal policy” and its “stimuli” than Keynes himself, who declared (on p. 129 of his General Theory) that “Pyramid building, earthquakes, even wars may serve to increase wealth, if the education of our statesmen on the principles of the classical economics stands in the way of anything better.”

Acts of sheer destruction, such as wars and natural disasters, appear as beneficial to Keynes and his followers for the same reason that the “stimulus” of government-financed consumption appears beneficial. This is because they too create a need for replacement and thus allegedly result in an increase in employment and production. So widespread is this view that one can very often hear people openly express favorable opinions about the alleged economic benefits of such things as earthquakes, hurricanes, and even wars.

Stimulus Packages Mean More Loss of Capital

Despite the fact that what the economic system needs for recovery is saving and the accumulation of new capital, to replace as far as possible the capital that has been lost, the effect of stimulus packages is further to reduce the supply of capital, and thus to worsen the recession or depression.

The reason that stimulus packages cause a further loss of capital is that their starting point is the consumption of previously produced wealth. That wealth is part of the capital of the business firms that own it. The stimulus programs offer money in exchange for this wealth and capital. But the money they offer does not come from the production of any comparable wealth by the government or those to whom it gives money—wealth which has had to be produced and sold and thus put into the economic system prior to the withdrawal that now takes place. The starting point for the government and its dependents is an act of consumption, which means a using up, a loss of previously existing wealth in the form of capital.

The supporters of stimulus packages look to the fresh production that is required to replace the wealth that has been consumed. It will require the performance of additional labor. They are delighted to the extent that this fresh production and additional employment materialize. They believe that at that point their mission has been accomplished. They have succeeded in generating new and additional economic activity, new and additional employment. The only shortcoming of such a policy, they believe, is that it may not be applied on a sufficiently large scale.

Unfortunately, there is something they have overlooked. And that is the fact that any fresh production and employment that results is incapable by itself of replacing the capital that was consumed in starting the process. The reason for this is that all production, including any new and additional production called into being by stimulus packages, itself entails consumption. And this consumption tends at the very least to approximate the fresh production and, indeed, is capable of equaling or even exceeding it.

Thus, for example, we start with the purchase and consumption of a new television set by someone who has not previously produced and sold anything of equivalent monetary value that provided the funds for his now buying the television set. He has simply received the money from the government. In this case, what we have is one television set withdrawn from the capital of the economic system and placed in the hands of a non-producing consumer.

We can assume, for the sake of argument, that the retailer of the television set will order a replacement set from the wholesaler, and that the wholesaler in turn will order a replacement set from the manufacturer. We can assume further that the manufacturer will now produce a new television set to replace the one that he sells to the wholesaler from his inventory.

The production of the replacement television set entails a using up of materials and components and part of the useful life of the plant and equipment required. Aspects of such using up of capital goods also take place on the part of the retailer and wholesaler and in the transportation of the television set.

Very importantly, any new and additional workers who may be employed—precisely the goal of the whole operation—in producing a new television set or in moving a television set through the channels of distribution must be paid wages, which they in turn will consume. The goods these workers receive when they spend their wages represents a further depletion of inventories, on the part of all the retailers with whom they deal. In addition, the various business firms involved have additional profits, or at least diminished losses, as the result of the various additional purchases. This enables their owners to consume more and probably results in the payment of additional taxes, which the government consumes.

Even whatever depreciation allowances are earned along the way in the various stages of replacing the television set are likely to be consumed. This is because in the context of a recession or depression investors are afraid of losses if they invest in private businesses and thus prefer to invest in short-term treasury securities, such as treasury bills, which they consider to be far safer. But when depreciation allowances are used to purchase treasury securities, they end up financing consumption rather than capital replacement. This is because the Treasury uses the proceeds from the sale of its securities to finance nothing but consumption, either that of the government itself or that of the private individuals to whom the government gives money.

The point here is that any replacement of a good consumed by a non-producer itself entails very substantial additional consumption of inventories and the useful life of plant and equipment of business firms. The same is obviously true of the replacement of goods that have simply been destroyed, whether by war or by an act of nature.

No matter how long the process of spending and respending of the funds introduced into the economic system by a stimulus package might continue—no matter how many instances of replacement production there might be following the purchase and consumption of our hypothetical television set or of any other such good—the initial loss of capital need never be made up.

This is because each act of replacement production is accompanied by corresponding additional consumption. Thus the initial act of consumption—or destruction—of wealth and capital may be followed by 10 or 100 acts of subsequent production, each carried on in order to replace the goods used up before it. But if each of these subsequent acts of production is accompanied by fresh consumption that is equivalent to it, the net effect is still one act of consumption. As a result, the supply of capital is reduced. For what is always present is X instances of production respectively following X+1 instances of consumption.

Now countries have suffered enormous losses of capital and yet still managed to recover and go on to new heights of wealth and prosperity. Germany and Japan in the decades following World War II are perhaps the most outstanding examples of this.

What enabled them to recover was not further acts of consumption, not “stimulus packages” of any kind, but increases in production in excess—substantially in excess—of increases in consumption. That is to say, it was a process of saving and capital accumulation that made their recovery possible. On average, people in those countries, in those years, saved and reinvested a major portion of their income, often in excess of 25 percent.

It is possible, but highly unlikely, that the replacement production induced by an initial consumption/destruction of wealth might itself entail some such new saving. If round after round of replacement production were in fact accompanied by some such saving, then, eventually, the original loss of capital would be made good. But that would be the case only if such saving was not offset by fresh acts of “stimulus” or other policies that waste or destroy capital.

However, as I say, such an outcome is highly unlikely. If for no other reason, this is because, as I have already pointed out, the stimulus packages take place in an environment in which investors fear to invest in private firms. As a result, they use not only whatever new and additional savings they might make, for the purpose of buying “safe” treasury securities but also even funds they earn that are required for the replacement of capital goods. In this way, savings are diverted into consumption rather than capital accumulation.

(It is ironic that while, if it did manage to occur and was not diverted into consumption, such saving might mitigate the effects of a stimulus package, it is attacked as undermining the process of recovery. Thus, for example, Paul Krugman, the 2008 Nobel Prize winner in economics, writes: “Meanwhile, it’s clear that when it comes to economic stimulus, public spending provides much more bang for the buck than tax cuts…because a large fraction of any tax cut will simply be saved.” New York Times, January 26, 2009, p. A23.)

In addition to the diversion into consumption of such new savings as might occur subsequent to a “stimulus,” there is the fact that the source of any such saving, namely, the net product produced, is likely to be greatly diminished. The net product is the excess of the product produced over the capital goods used up in order to produce it. It is what is available for consumption or saving out of current wage, profit, and interest income.

The net product is diminished to the extent that production is made to take place in accordance with methods requiring the employment of unnecessary capital goods per unit of output. Environmental and consumer product safety legislation provide numerous instances of this kind.

For example, requiring gas stations, dry-cleaning establishments, and many other types of businesses to substantially increase their capital investments merely in order to placate the largely groundless fears of the environmental movement. Similarly, requiring safety features in automobiles, dishwashers, display cases, ice machines, stepladders, and countless other goods—features that the market does not judge to be worth their cost—adds to the cost of the materials and components that enter into the production of products without increasing the perceived value of the products. In both instances, the result is a larger consumption of capital goods but no increase in production, and thus a reduction in the size of the net product produced and thus in the ability to engage in saving out of current income.

As indicated in Part I of this article, the effect of capital decumulation, whether caused by stimulus packages or anything else, is a reduction in the ability of the economic system to produce, to employ labor, and to provide credit, for each of these things depends on capital. The reduced ability to produce and employ labor may not be apparent in the midst of mass unemployment. But it will become apparent if and when economic recovery begins. At that point, the economic system will be less capable than it otherwise would have been, because of the reduction in its supply of capital. Real wages and the general standard of living will be lower than they otherwise would have been. And all along, the ability to grant credit will be less than it otherwise would have been.

Stimulus Packages Are a Drain on the Rest of the Economic System

Even though stimulus packages may be able to generate additional economic activity, they cannot achieve any kind of meaningful economic recovery. Their actual effect is the creation of a system of public welfare in the guise of work. That is in the nature of employing people not for the sake of the products they produce but having them produce products for the sake of being able to employ them.

But stimulus packages are much more costly than simple welfare. On top of the welfare dole that allows unemployed workers to live, stimulus packages add the cost of the materials and equipment that the workers use in producing their pretended products.

The work created by stimulus packages is a make-believe work that is carried on at the expense of the rest of the economic system. It draws products and services produced in the rest of the economic system and returns to the rest of the economic system little or nothing in the way of goods or services that would constitute value for value or payment of any kind. In other words, stimulus packages and the needless work they create cause the great majority of other people to be poorer. I’ve already shown how they cause them to have less capital. Shortly, I will show how they also cause them to consume less. (For elaboration on this point, please see the forthcoming republication of my article “Who Pays for `Full Employment’?”)

Rising Prices in the Midst of Mass Unemployment

If economic recovery is to be achieved, the first thing that must be done is to stop “stimulus packages” and undo as far as possible any that are already in progress. This is because their effect is to worsen the problem of loss of capital that is the underlying cause of the economic crisis in the first place.

Unfortunately, they are not likely to be stopped. If they are implemented, especially on the scale already approved by Congress, the effect will be a decumulation of capital up to the point where scarcities of capital goods, including inventories of consumers’ goods in the possession of business firms, start to drive up prices.

Higher prices of consumers’ goods will result not only from scarcities of consumers’ goods (which, of course, are capital goods so long as they are in the hands of business firms), but also from scarcities of capital goods further back in the process of production. Thus a scarcity of steel sheet will not only raise the price of steel sheet, but will carry forward to the price of automobiles via the higher cost of producing automobiles that results from a rise in the price of steel sheet. Likewise, a scarcity of iron ore will carry forward to the price of steel sheet, which, again, will carry forward to the price of automobiles. And, of course, the pattern will be the same throughout the economic system, in such further cases as oil and oil products, cotton and cotton products, wheat and wheat products, and so on.

A rise in the prices of consumers’ goods is capable of stopping further capital decumulation stemming from the stimulus packages. When the point is reached that additional funds spent on consumers’ goods serve merely to raise their prices, then no additional quantities of them are sold. The same quantities are sold at higher prices. This ends the decumulation of inventories. From this point on, the buyers who obtain their funds from the government consume at the expense of people who have earned their incomes but now get less for them.

Once inventories become scarce in relation to the spending for goods, all of the funds that the government has been pouring into the economic system become capable of launching a major increase in prices. This rise in prices can take place even in the midst of mass unemployment. This is because the abundance of unemployed workers does nothing to mitigate the scarcity of capital goods that has occurred as the result of the attempts to stimulate employment.

Even though rising prices can deprive stimulus packages of the ability to cause further capital decumulation, the inflation of the money supply by the government results in continuing capital decumulation. In large part, this occurs as the result of the fact that the additional spending resulting from a larger money supply raises business sales revenues immediately while it raises business costs only with a time lag. So long as this goes on, profits are artificially increased.

Despite the fact that most or all of the additional profits may be required simply in order to replace assets at higher prices, the additional profits are taxed as though they were genuine gains. This impairs the ability of firms to replace their assets. The destructive consequences of this phenomenon can be seen in the transformation of what was once America’s industrial heartland into the “rustbelt.”

At the same time, throughout the economic system, starting long before today’s stimulus packages and continuing on alongside them, regular, almost year-in, year-out government budget deficits do their work of destruction. They cause a continuing diversion into consumption not only of a considerable part of whatever savings might be made out of income but also of the replacement allowances for the using up of plant and equipment and all other fixed assets. Generations of government budget deficits have sucked up trillions of dollars of what would have been capital funds and have gone a long way toward turning America into an industrial wasteland.

The blind rush into massive “stimulus packages” is the culmination of generations of economic ignorance transmitted from professor to student in the guise of advanced, revolutionary thinking—the “Keynesian revolution.” The accelerating destruction of our economic system that we are now experiencing is the product of a prior destruction of economic thought. Our entire intellectual establishment has been the victim—the willing victim—of a massive intellectual con job that goes under the name “Keynesianism.” And we are now paying the price.

I say, willing victims of an intellectual con job. What other description can there be of those who were ready to hail as a genius the man who wrote, “Pyramid building, earthquakes, even wars may serve to increase wealth….”

Only a brave few—most notably Ludwig von Mises and Henry Hazlitt— stood apart from this madness, and for doing so, they were made intellectual pariahs. But the time is coming when it will be clear to all who think that it is they who have had the last word.

*Copyright © 2009, by George Reisman. George Reisman, Ph.D. is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor Emeritus of Economics. He is also a Senior Fellow at the Goldwater Institute. His web site is and his blog is A pdf replica of his book can be downloaded to the reader’s hard drive simply by clicking on the book’s title Capitalism: A Treatise on Economics and then saving the file when it appears on the screen. The book provides an in-depth, comprehensive treatment of the material discussed in this and subsequent articles in this series and of practically all related aspects of economics.

Labels: , , , , , , , , , , , , , ,

Saturday, February 21, 2009


This two-part article is the second in a series of articles that seeks to provide the intelligent layman with sufficient knowledge of sound economic theory to enable him to understand what must be done to overcome the present financial crisis and return to the path of economic progress and prosperity. The first article in the series was “Falling Prices Are Not Deflation but the Antidote to Deflation.”

Part I: Capital, Saving, and Our Economic Crisis

Imagine an individual who is lethargic and lacks the energy to function at his normal level because of too little sleep. There are drugs that can make him feel fully refreshed, even after a night without any sleep whatever, and apparently capable of functioning the next day with full efficiency.

Nevertheless taking such drugs is definitely not a good idea. This is because the individual’s underlying problem of insufficient sleep is not only not addressed by his being stimulated but is actually worsened. For the stimulus further depletes his body’s already diminished energy reserves and takes him down the path of utter exhaustion.

This description applies to the current slowdown in our economic system and to the efforts to overcome it through the use of “fiscal policy” and its “stimulus packages.” The meaning of these terms is more government spending and lower taxes specifically designed to promote consumption. This includes giving income-tax refunds to people who paid no income tax and who, because of their low incomes, can presumably be most counted on to rush out and consume more as soon as additional funds are put in their hands.

The main difference between such economic “stimulants” and pharmaceutical stimulants is that the economic stimulants will not succeed even in temporarily restoring the economic system to anything approaching its normal level of activity.

An economic system entering into a major recession or depression is in a situation very similar to that of our imaginary, sleep-deprived individual. All that one need do is substitute for the loss of the sleep required for the body’s proper functioning the loss of something required for the proper functioning of the economic system.


In the case of the economic system, that something is capital. The economic system is not functioning properly because it has lost capital. Capital is the accumulated wealth that is owned by business enterprises or individuals and that is used for the purpose of earning profit or interest.

Capital embraces all of the farms, factories, mines, machinery and all other equipment, means of transportation and communication, warehouses, shops, office buildings, rental housing, and inventories of materials, components, supplies, semi-manufactures, and finished goods that are owned by business firms.

Capital also embraces the money that is owned by business firms, though money is in a special category. In addition, it embraces funds that have been lent to consumers at interest, for the purpose of buying consumers’ goods such as houses, automobiles, appliances, and anything else that is too expensive to be paid for out of the income earned in one pay period and for which the purchaser himself does not have sufficient savings.

The amount of capital in an economic system determines its ability to produce goods and services and to employ labor, and also to purchase consumers’ goods on credit. The greater the capital, the greater the ability to do all of these things; the less the capital, the less the ability to do any of these things.


Capital is accumulated on a foundation of saving. Saving is the act of abstaining from consuming funds that have been earned in the sale of goods or services.

Saving does not mean not spending. It does not mean hoarding. It means not spending for purposes of consumption. Abstaining from spending for consumption makes possible equivalent spending for production. Whoever saves is in a position to that extent to buy capital goods and pay wages to workers, to lend funds for the purchase of expensive consumers’ goods, or to lend funds to others who will use them for any of these purposes.

It is necessary to stress these facts because of the prevailing state of utter ignorance on the subject. Such ignorance is typified by a casual statement made in a recent New York Times news article. The statement was offered in the conviction that its truth was so well established as to be non-controversial. It claimed that “A dollar saved does not circulate through the economy and higher savings rates translate into fewer sales and lower revenue for struggling businesses.” (Jack Healy, “Consumers Are Saving More and Spending Less,” February 3, 2009, p. B3.)

The writer of the article apparently believes that houses and other expensive consumers’ goods are purchased out of the earnings of a single week or month, which is the normal range of time between paychecks. If that were the case, no savings would be necessary in order to purchase them. In fact, of course, the purchase of a house typically requires a sum equal to the purchaser’s entire income of three years or more; that of an automobile, the income of several months; and that of countless other goods, too large a fraction of the income of just one pay period to be affordable out of such limited funds.

In all such cases, a process of saving is essential for the purchase of consumers’ goods. The savings accumulated may be those of the purchaser himself, or they may be borrowed, or be partly the purchaser’s own and partly borrowed. But, in every case, savings are essential for the purchase of expensive consumers’ goods.

The Times reporter, and all of his colleagues, and the professors who supposedly educated him and his colleagues, all of whom spout such nonsense about saving, also do not know other, even more important facts abut saving. They do not know that saving is the precondition of retailers being able to buy goods from wholesalers, of wholesalers being able to buy goods from manufacturers, of manufacturers, and all other producers, being able to buy goods from their suppliers, and so on and on. It is also the precondition of sellers at any and all stages being able to pay wages.

Such expenditures must generally be made and paid for prior to the purchaser’s receipt of money from the sale of his own goods that will ultimately result. For example, automobile and steel companies cannot pay their workers and suppliers out of the receipts from the sale of the automobiles that will eventually come in as the result of using the labor and capital goods purchased. And even in the cases in which the payments to suppliers are made out of receipts from the sale of the resulting goods, the seller must abstain from consuming those funds, i.e., he must save them and use them to pay for the capital goods and labor he previously purchased.

In contrast, the Keynesian reporters and professors believe that sellers do nothing but consume or hoard cash. They are too dull to realize that if that were really the case, there would be no demand for anything but consumers’ goods. This becomes clear simply by following the pattern of the Keynesian textbooks in allegedly describing the process of spending.

Thus a consumer buys, say, $100 dollars worth of shirts in a department store; the owner of the department store, following his Keynesian “marginal propensity to consume” of .75, then buys $75 worth of food in a restaurant, and allegedly hoards the other $25 of his income; the owner of the restaurant then buys $56.25 (.75 x $75) worth of books, while allegedly hoarding the remaining $18.75 of his income; and so on and on. Now, unknown to the Keynesians, if such a sequence of spending actually took place, all that would exist is a sum of consumption expenditures and nothing else.

The fact is that most spending in the economic system rests on a foundation of saving. The seller of the shirts will likely save and productively expend $95 or more in buying replacement shirts and in paying his employees and making other purchases necessary for the conduct of his business, and perhaps only $5 on consumption. And so it will be for those who sell to him, or to the suppliers of his suppliers, or to the suppliers of those suppliers, and so on.

Any business income statement can provide a simple confirmation of such facts. The ratio of costs to sales revenues that can be derived from it, is an indicator of the ratio of the use of savings to make expenditures for labor and capital goods relative to sales revenues. For the costs it shows are a reflection of expenditures for labor and capital goods made in the past. The saving and productive expenditure out of current sales revenues will show up as costs in the future. The higher is the ratio of costs to sales, the higher is the degree of saving and productive expenditure relative to sales revenues. A firm with costs of $95 and sales revenues of $100 is a firm that can be understood as saving and productively expending $95 out of its $100 of sales revenues. This relationship applies throughout the economic system.

Hoarding Versus Saving

To the extent that “hoarding” or, more accurately, an increase in the demand for money for cash holding takes place, it is not because people have decided to save. What is actually going on is that business firms and investors have decided that they need to change the composition of their already accumulated savings in favor of holding more cash and less of other assets.

For example, an individual may decide that instead of being 90 percent invested in stocks and other securities and having only 10 percent of his savings in cash in his checking account, he needs to increase his cash holding to 20 or 25 percent of his savings.

Similarly, a corporation may decide that it needs to increase its cash holding relative to its other assets in order to be better able to meet its bills coming due. Indeed, this is happening right now as more and more firms find that they can no longer count on being able to borrow money for such purposes.

Furthermore, the increases in cash holdings that take place in such circumstances are not only not an addition to savings but occur in the midst of a sharp decline in the overall amount of accumulated savings. For example, the increases in cash holdings that are taking place today are in response to a major plunge in the real estate and stock markets, of numerous and sizable corporate bankruptcies, and of huge losses on the part of banks and other financial institutions.

All of this represents a reduction in asset values, i.e., in the value of accumulated savings. People are turning to cash in order to avoid further such losses of their accumulated savings. Of course, widespread attempts to convert assets other than cash into cash, entail further declines in the value of accumulated savings, since the unloading of those assets reduces their value.

Accumulated savings in the economic system have fallen by several trillion dollars, and nothing could be more incredible than that, in the midst of this, many people, including the great majority of professional economists, fear saving and think that it is necessary to stimulate consumption at the expense of saving. Such is the complete and utter lack of economic understanding that prevails.

One might expect that a group of people such as most of today’s economists, who pride themselves on their empiricism, would once and a while look at the actual facts of the world in which they live, and, in the midst of the loss of trillions of dollars of accumulated savings, begin to suspect that there might actually be a need to replace savings that have been lost rather than do everything possible to prevent their replacement.

Depressions and Credit Expansion

The loss of accumulated savings is at the core of the problem of economic depressions. Recessions and depressions and the losses that accompany them are the result of the attempt to create capital on a foundation of credit expansion rather than saving. Credit expansion is the lending out of new and additional money that is created out of thin air by the banking system, which acts with the encouragement and support of the government. The money so created and lent has the appearance of being new and additional capital, but it is not.

The fact of its appearing to be new and additional capital creates an exaggerated, false understanding of the amount of capital that is available to support economic activity. Like an individual who believes he has grown rich in the course of a financial bubble, and who is led to adopt a level of living that is beyond his actual means, business firms are led to undertake ventures that are beyond their actual means.

For an individual consumer, the purchase of an expensive home or automobile in the delusion that he is rich later on turns out to be a major loss in the light of the fact that he cannot actually afford these things and would have been better off had he not bought them. In the same way, business construction projects, stepped up store openings, acquisitions of other firms, and the like, carried out in the delusion of a sudden abundance of available capital, turn out to be sources of major losses when the delusion of additional capital evaporates.

Credit expansion also fosters an artificial reduction in the demand for money for cash holding, which sets the stage for a later rise in the demand for money for cash holding, such as was described a few paragraphs ago. The reduction in the demand for money for cash holding occurs because so long as credit expansion continues, it is possible for business firms to borrow easily and profitably and thus to come to believe that they can substitute their ability to borrow for the holding of actual cash. The rising sales revenues created by the expenditure of the new and additional money that is lent out also encourages the holding of additional inventories as a substitute for the holding of cash, in the conviction that the inventories can be liquidated easily and profitably.

Recessions and depressions are the result of the loss of capital in the malinvestments and overconsumption that credit expansion causes. The losses are then compounded by the rise in the demand for money for cash holding that subsequently follows. They can be further compounded by reductions in the quantity of money as well, such as would occur if the losses suffered by banks resulted in losses to the banks’ checking depositors. (Checking deposits are part of the money supply, indeed, the far greater part. In such cases, they would lose the status of money and assume that of a security in default, which would render them useless for making purchases or paying bills.)

The Housing Bubble

Our housing bubble is an excellent illustration of the malinvestment and overconsumption caused by credit expansion. Perhaps as much as $2 trillion or more of capital has been lost in the construction and financing of houses for people who, it turned out, could not afford to pay for them. The housing bubble was financed by the creation of $1.5 trillion of new and additional money in the form of checking deposits created for the benefit of home buyers.

The creation of these deposits rested on the readiness of the Federal Reserve System to create whatever new and additional supporting funds were required in the form of bank reserves. In the three years 2001-2004, the Federal Reserve created enough such funds to drive the interest rate paid on them, i.e., the Federal Funds Rate, below 2 percent. And from July of 2003 to June of 2004, it created enough such funds to hold this rate down to just 1 percent. The end result was a substantial reduction in mortgage interest rates and thus in monthly mortgage payments, which served greatly to increase the demand for houses.

Government also greatly contributed specifically to loans being made to homebuyers who were not credit worthy. It did this through its various loan-guarantee programs, carried out by Fannie Mae, Freddie Mac, and the Department of Housing and Urban Development; and by means even of outright extortion, though the Community Reinvestment Act, which required banks to make sufficient such loans as would satisfy local “community groups.”

In physical terms, the result of credit expansion was the passage of literally millions of houses that represented capital to the firms that built them, and to the banks and others that financed them, into the hands of consumers who not only had not contributed anything remotely comparable to the wealth and capital of the economic system but also had no realistic prospect of ever being able to do so. The further result has been that many of the builders of these houses are now ruined as are many of the banks and other investors that financed the construction and sale of those houses. And because so many lenders have lost so much, the business firms that depend on them for loans can no longer obtain those loans, and so they must close their doors and fire their workers.

The growing problem of unemployment that we are experiencing and the accompanying reduction in consumer spending on the part both of the unemployed and of those who fear becoming unemployed is the result of this loss of capital, not of any sudden, capricious refusal of consumers to spend or of banks to lend. Indeed, the kind of consumer spending that so many people want to revive and encourage, by means of “stimulus packages,” played a major role in the loss of capital that has taken place and now results in unemployment and impoverishment.

During the housing boom, millions of owners of existing houses thought that they were growing rich as the result of the rise in the prices of their homes and that they could actually live to a substantial degree off the accompanying increase in the equity in their homes. They borrowed against the increased equity and spent the proceeds. This consumption was at the expense of capital investment in the economic system, which was rendered correspondingly poorer by it. And when housing prices collapsed, and fell below the enlarged mortgage debts that had been taken on, the effect was to add to the losses suffered by lenders. This was the case to the extent such equity-consuming homeowners then walked away from their homes, leaving their creditors to lose by the decline in the price of their homes.

Keynesian Ignorance and Blindness

The immense majority of people, including, of course, most professional economists, are ignorant of the actual nature and cause of our financial crisis. This is because they are ignorant of the role of capital in the economic system. They are all Keynesians. (Even Milton Friedman, the alleged arch-defender of capitalism is reported to have said, “We are all Keynesians now.”)

But as von Mises so aptly put it, “The essence of Keynesianism is its complete failure to conceive the role that saving and capital accumulation play in the improvement of economic conditions.” (Planning for Freedom, 4th ed., p. 207. Italics in original.) In the eyes of Keynes and his countless followers, economic activity begins and ends with consumption.

So deeply do people hold the view that consumption is everything, that it blinds them to obvious facts. Thus, the present crisis has been well underway at least since the late spring of 2007, when the sudden collapse of two large Bear Stearns hedge funds occurred. This was followed by a continuing string of bankruptcies between June of 2007 and August of 2008 of significant-sized and fairly well-known firms, such as Aloha Airlines, Levitz Furniture, Wickes Furniture, Mervyns Department Stores, Linens N’ Things, IndyMac Bank, and Bear Stearns itself. The list includes an actual run on a major bank—Northern Rock in Great Britain—in September of 2007, probably the first such run since the 1930s.

Financial failures reached a crisis point in September of 2008, with the collapse of such major firms as American International Group (AIG), Lehman Brothers, and the Halifax Bank of Scotland. These were followed by the bankruptcy of Fannie Mae and Freddie Mac, the two giant government-sponsored mortgage lenders that had led the way in guaranteeing sub-prime mortgages to borrowers who could not repay them.

Yet as late as September of 2008, the unemployment rate in the United States was no more than 6.2 percent and at mid-month the Dow Jones Industrial Average was still well above 11,000.

All this confirms that the crisis did not originate in any sudden refusal of consumers to consume or in any surge in unemployment. To the extent that unemployment is growing and consumption is declining, they are both the consequence of the economy’s loss of capital. The loss of capital is what precipitated a reduction in the availability of credit and a widening wave of bankruptcies, which in turn has resulted in growing unemployment and a decline in the ability and willingness of people to consume. The collapse in home prices and the more recent collapse in the stock market have also contributed to the decline in consumption, and probably to an even greater extent, at least up to now. Both of these events are also an aspect of the loss of capital and accumulated savings.

What Economic Recovery Requires

What all of the preceding discussion implies is that economic recovery requires that the economic system rebuild its stock of capital and that to be able to do so, it needs to engage in greater saving relative to consumption. This is what will help to restore the supply of credit and thus help put an end to financial failures based on a lack of credit.

Recovery also requires the freedom of wage rates and prices to fall, so that the presently reduced supply of capital and credit becomes capable of supporting a larger volume of employment and production, as I explained in
“Falling Prices Are Not Deflation but the Antidote to Deflation,” which was my first article in this series. Recovery will be achieved by the combination of more saving, capital, and credit along with lower wage rates, costs, and prices.

In addition, recovery requires the rapid liquidation of unsound investments. If borrowers are unable to meet their contractual obligation to pay principal and interest, the assets involved need to be sold off and the proceeds turned over to the lenders as quickly as possible, in order to put an end to further losses and thus salvage as much capital from the debacle as possible.

In the present situation of widespread financial paralysis, firms and individuals can be driven into bankruptcy because they are unable to collect the sums due them from their debtors. Thus, for example, the failure of mortgage lenders would be alleviated, if not perhaps altogether avoided in some cases, if the mortgage borrowers who were in default on their properties lost their houses quickly, with the proceeds quickly being turned over to the lenders.

In that way, the lenders would at least have those funds available to meet their obligations and thus might avoid their own default; in either event, their creditors would be better off. In helping to restore the capital of lenders, or what will become the capital of the creditors of the lenders, quick foreclosures would serve to restore the ability to originate new loans.

Recovery requires the end of financial pretense. There are banks that do not want to see the liquidation of various types of assets that they own, notably, “collateralized debt obligations” (CDOs). These are securities issued against collections of other securities, which in turn were issued against collections of mortgages, an undetermined number of which are in default or likely to go into default. The presumably low prices that such securities would bring in the market would likely serve to reveal the presence of so little capital on the part of many banks that they would be plunged into immediate bankruptcy. To avoid that, the banks want to prevent the discovery of the actual value of those securities. At the same time, they want creditors to trust them. Yet before trust can be established, the actual, market value of the banks’ assets must be established, even if it serves to bankrupt many of them. The safety of their deposits can be secured without the banks’ present owners continuing in that role.

When these various requirements have been met and the process of financial contraction comes to an end, the profitability of business investment will be restored and recovery will be at hand.

Next: Part II: Stimulus Packages

*Copyright © 2009, by George Reisman. George Reisman, Ph.D. is the author of
Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor Emeritus of Economics. He is also a Senior Fellow at the Goldwater Institute. His web site is and his blog is A pdf replica of his book can be downloaded to the reader’s hard drive simply by clicking on the book’s title Capitalism: A Treatise on Economics and then saving the file when it appears on the screen. The book provides an in-depth, comprehensive treatment of the material discussed in this and subsequent articles in this series and of practically all related aspects of economics.

Labels: , , , , , , , , , , , , , ,

Sunday, January 27, 2008

A Creditor’s Protection Bill

Today, in the world of financial celebrity, anyone who is anyone is a billionaire. By the same token, millions upon millions of people are or soon will be mere, everyday millionaires in the United States. Millionaires are on the way to becoming a dime a dozen.

Similarly, new cars cost what new homes did only a few decades ago. Men’s neckties often sell nowadays for as much as men’s suits did not so very long ago. To have a pair of soles and heels put on a pair of shoes today costs as much as a new pair of shoes did not too many years ago.

All of this is the result of continuous inflation of the money supply by the Federal Reserve System. As a result of the “Fed’s” actions, tens and hundreds of billions of new and additional dollars have poured into the economic system, correspondingly increasing spending and driving up prices. There are more and more billionaires and millionaires and shockingly high-priced goods simply because of the flood of new and additional money coming from the Fed.

It’s not such things as “oil shocks” or diverting food crops to fuel production that’s responsible. Without the flood of new and additional money, increases in the price of oil and farm products would be accompanied by decreases in the price of practically everything else. This is because practically all of whatever additional money was spent in buying oil et al. would have to be taken away from spending elsewhere, since the overall total ability to spend in the economic system would be limited by a limited quantity of money. And the rise in the price of oil and farm products would also not be nearly as great as it has been.

To confirm the fact that the source of today’s high and rising prices lies in the rapid increase in the supply of paper currency and checkbook money, it’s helpful to calculate prices in terms of the currency sanctified by the U.S. Constitution, namely, the gold dollar. A gold dollar contains approximately one-twentieth of an ounce of gold. Today an ounce of gold sells for more than $800 (it’s actually more than $900 at the present moment). That means that one gold dollar has the value of more than $40 paper dollars, because one-twentieth of $800 is $40. The result is that the price of everything stated in gold dollars is currently one-fortieth, or less, of its price in paper dollars.

Thus, a $1million home is $25,000 in gold dollars. A $50,000 automobile is $1,250 in gold dollars, and so on. The rise in prices is the result of the fact that we express prices in paper money, whose supply can be increased virtually without limit and without cost. Prices can never rise to anywhere near the same extent when stated in gold. That’s because gold is rare in nature and costly to extract.

Today, we have a credit crisis emanating from the collapse of the real estate bubble that the Fed launched in order to cope with the effects of the collapse of the stock market bubble that it had launched only a few years earlier. Now, in order to cope with the effects of the collapse of the real estate bubble, the government and the Fed are looking for yet another program of monetary “stimulus.” This time it’s to be in the form of cutting taxes while financing an undiminished, indeed, an increased amount of government spending by means of the creation of still more new and additional money.

The Fed and the rest of the government seem to think that their job is always to be sure that the stock market averages and the price of homes is never to be allowed to fall too far below their most recent peaks, and to flood the economy with as much new and additional money as may be required to accomplish this. Keeping up housing prices is an especially remarkable goal, inasmuch as only a year or two ago, all of the complaining was about how far housing prices had climbed relative to the ability of people to afford them. One would think that a sharp reduction in home prices is the very thing needed to solve that problem and that the process needs to go a good deal further than it has, in order to do so.

For the present and the foreseeable future, there is probably nothing that will stop the Fed from continuing with its inflation. Leading pressure groups are ardently in favor of it: tens of millions of share owners want it; the great majority of businessmen large and small want it; bankers and brokers want it; homeowners want it; labor unions want it; the political establishment wants it. If there is another terrorist attack, let alone another war, inflation will be used to pay much of the cost. To the extent that the environmentalist agenda of declining energy production is imposed, inflation will be used to finance subsidies to the growing numbers of Americans who will be impoverished by it. Their expenditure of those subsidies will drive up prices for everyone else and cause further impoverishment and the need for more subsidization and for still more inflation to pay for it.

In the face of such prospects, people around the world who have been willing to hold dollars because dollars were superior to their own, more rapidly inflating currencies, will lose their desire to hold dollars. They’re already losing that desire. The world’s supply of dollars will sooner or later reside exclusively in the United States. Indeed, the reflux of dollars appears to have already begun.

The dollar has begun the kind of slide taken in the past by such currencies as the Italian lira. In the 1930s, one lira was worth 20 cents. Twenty cents in that era had a buying power equal to several of today’s dollars. Before the lira was replaced by the euro, its value was less one-twentieth of one U.S. cent. A few days food and lodging at an undistinguished hotel cost more than a million lira. The fall of the lira took place in essentially the same way that the dollar is falling today—through the reckless increase in its quantity in response to widely held beliefs in the necessity of such increase.

Is there anything that can be done to stop the potential destruction of the real value of all dollar-denominated savings and long-term contracts by a flood of inflation? Is there anything that can protect people from a possible tsunami of inflation in the United States?

There is something that could be done. There is a financial life raft, as it were, that could be made available to everyone, that would enable people to salvage at least some significant portion of the real value of their savings and contracts denominated in fixed sums of dollars. It is something much more urgently needed, aimed at a much more realistic danger, and much more feasible than efforts to control global warming, say.

What is it? It is the enactment of a creditors’ protection bill, whose essential provisions would be the insertion into all outstanding contracts of a limited, contingent gold clause, and the removal of all legal obstacles to the inclusion of such clauses in all future contracts.

Here’s an example of how it would work. Imagine someone who owns $1 million of corporate bonds that he bought several years earlier and that are scheduled to be redeemed in another 25 years. Perhaps 25 percent of this sum, i.e., $250,000, would be designated as representing the quantity of gold that the owner of the bonds could choose to receive when the bonds came due, instead of the $1 million he is presently entitled to receive at that time. The actual quantity of gold he would be entitled to receive would be the amount that $250,000 could buy at the price of gold prevailing on some specified date within 12 months prior to the enactment of the law.

If that price of gold were $1,000 per ounce, say, then the $1 million dollar contract would contain a contingent liability calling for the payment of 250 ounces of gold. This payment would be at the creditor’s option. The creditor would have the right to choose to be paid 250 ounces of gold rather than $1 million dollars.

Obviously, no creditor would exercise this option if the price of gold remained at $1,000 per ounce, let alone if it fell below $1,000 per ounce. He would not exercise it if the price of gold rose to $2,000 per ounce. Nor would he do so if it rose to $3,000 per ounce. But when and if the price of gold exceeded $4,000 per ounce, then it would be to the advantage of the creditor to choose to be paid 250 ounces of gold, or the sum of dollars then necessary to buy 250 ounces of gold, for at that point 250 ounces of gold would represent more than $1 million.

If when gold reached, say, $5,000 per ounce, the 250 ounces of gold that the creditor was entitled to would be worth $1,250,000, i.e., $250,000 more than the million he had lent. This would not represent any real gain to the creditor, however, if over the same period of time, prices in general had also increased by a factor of 5. In that case, the actual buying power of the 250 ounces of gold would be no greater than it had been when the price of gold was $1,000 per ounce and prices in general were where they were at that time.

But even in this case, the creditor would not be quite as badly off as he would have been without the protection afforded by the 25 percent gold clause. For in its absence, he would have been repaid merely his original $1 million, that now had a buying power only one-fifth as great as it was originally. With this gold clause and his consequent receipt of $1,250,000, the buying power he receives is one-fourth as great as the sum he lent.

The difference between a fourth and a fifth is, of course, not very great. It would amount to our creditor incurring a loss in buying power of 75 percent rather than 80 percent, which is not an outcome to be particularly happy about.

But the odds are great that the protection afforded by such a gold clause would be equal to more than 25 percent of the real value of the sum originally due the creditor. This is because if prices were to start rising rapidly, the price of gold would almost certainly rise even more rapidly. Thus, for example, if prices in general were to rise on the order of 5 times over the course of a decade or two, say, the price of gold might very well rise by 10 or even 20 times. In that case, the 250 ounces of gold that the creditor would have the option of choosing, would be worth $2.5 million or even $5 million. In the face of a fivefold rise in prices, these sums would have the buying power of 50 percent or even 100 percent of the real value of the sum originally due the creditor.

What would serve to make the price of gold rise faster than prices in general is that in periods of rapid inflation, and in the absence of any reliable alternative paper currency, such as the dollar once appeared to be, gold is the ideal inflation hedge for most people. Even though its ownership entails some costs of storage and safekeeping, those costs are very modest. At the same time incurring them represents a far lesser loss than does practically all the usual forms of investment in a period of rapid inflation, including ownership of common stocks and family businesses. In these cases, capital gains taxes and income taxes consume funds needed for replacement at higher prices. As a result, a growing demand for gold as an inflation hedge appears, which operates on the price of gold alongside of and in addition to the forces operating to raise prices in general. In addition, the price of gold could be increased by the desire for accumulations of gold on the part of those who had agreed to accept contingent liabilities in gold.

A potential consequence of a system of such partial gold clauses could well be the development of substantial opposition to rapid inflation on the part of debtors, however paradoxical that may sound. This is because once the number of dollars payable under gold clauses started to exceed the number of dollars originally owed, debtors would be in a position in which further inflation served to increase their burden of debt rather than decrease it. Gold prices rising more rapidly than prices in general would mean that debtors would be in a position in which the additional inflated money they took in could not keep pace with the additional money they owed. They would do better to take in less additional inflated money and not be confronted with debt obligations rising even more rapidly. (This seemingly paradoxical effect of inflation under a system of gold clauses is a matter I discuss more fully in Capitalism.)

Enactment of a creditors’ protection bill along the lines I have described should be an essential part of the near-term political agenda of all defenders of economic freedom. It would offer a potentially valuable two-fold protection against the ravages of inflation. First, it could provide substantial protection to the real value of the assets of individuals. Second, it also might also ultimately turn debtors, who typically have a vested interest in inflation, into opponents of inflation, once they came to be faced with debts payable in gold, which would become harder to repay as inflation reduced the ability of paper money to serve as the means of repayment.

The insertion of a gold clause into existing contracts should by no means be regarded as any kind of new and additional government interference with the freedom of contract. To the contrary, it would be a major step in undoing such interference. Prior to their abrogation by the New Deal in 1933, full, 100 percent gold clauses were the norm in the United States in long-term term debt contracts, and had been since the Civil War. They are something that comes about on the foundation of the rational self-interest of individuals when it is allowed to operate free of government interference.

Obviously, the degree of gold clause protection would not by any means necessarily have to be the 25 percentage points that I have chosen for purposes of illustration. If a mere 5 or 10 percent protection could be enacted into law, it would be a major first step, simply by introducing the concept of gold clauses to the present generation. And, of course, it would still afford some actual measure of protection against the possible ravages of inflation.

The parties entering into new contracts should be free to include whatever degree of gold clause protection that was mutually agreeable. What presently stops such contracts from being made are considerations both of their enforceability in the courts and their likely treatment for purposes of taxation. As just mentioned, such contracts were abrogated on a mass scale in 1933 and the Supreme Court did nothing to uphold them. To be accepted with any degree of confidence, the enforceability of new, partial gold-clause contracts would have to have the benefit at the very least of a joint resolution of Congress directing the courts to uphold them.

The gold-clause contracts would have to be exempt from any possible application of usury statutes. Such statutes might come into play when creditors ended up being repaid sums of depreciated paper dollars that were greatly in excess of the sums originally lent—e.g., being repaid $2.5 million paper dollars when one had originally lent $1 million paper dollars. The contracts would have to be interpreted in terms simply of being repaid a fixed amount of gold principal—e.g., the 250 ounces of gold in the example above—irrespective of any increase in the price of gold.

Treatment of the gold-clause contracts in this way, would preclude the payment of taxes on any paper money gains reflecting merely the repayment of larger sums of paper to maintain parity with the same physical amount of gold. Thus, for example, the $1.5 million paper gain in the repayment of $2.5 million on a $1 million loan would not be subject to any kind of income or capital-gains taxation. The applicable principle would be that the lender has merely received the same physical quantity of gold that he was always entitled to. He has no gain whatever in terms of gold. In effect, he has lent a sum of gold and has been repaid that sum, nothing more. Thus, he has no gold income or gold capital gain.

Gold-clause contracts would almost certainly become very widespread if the market could take for granted their enforceability and exemption from taxation based merely on the rise in the price of gold.

As a matter of principle, the parties entering into new contracts should be legally free to agree to whatever degree of gold-clause protection they wished, all the way to 100 percent. Nevertheless, little actual harm would likely be done, if for a short time legal limits were imposed on the percentage of the value of new contracts that could enjoy gold-clause protection. Such a limitation would probably make the enactment of gold-clause protection politically more acceptable in the beginning, since it would be an incremental change and thus not appear too radical. Even with such a restriction, the gain simply from enacting the principle of gold-clause protection would be profound, not to mention the substantive protection likely afforded to creditors.

However, even in the absence of any legal limitation, for some period of time it would almost certainly be highly advisable in most cases for the contacting parties to agree to fairly modest partial gold clauses rather than full, 100 percent gold clauses. This is because partial gold-clause protection is what will be necessary in order not only to give creditors an important measure of the protection they need, but also to avoid the development of widespread bankruptcies on the part of debtors.

The threat of debtors going bankrupt arises because continuing inflation is likely to drive the real value of gold far higher than it is today and at the same time greatly reduce the ability of earnings in paper money to pay debts stated in gold. As a result, entering into 100 or even 50 percent gold-clause contracts today, at today’s price and real buying power of gold, would be an extremely risky proposition for debtors, one likely to result in their owing amounts of gold they simply could not pay.

Avoiding near-term widespread bankruptcies in gold is essential to gaining public support for gold’s once again serving to protect the real value of contracts on a large scale. Hopefully, education about the risks of owing too much gold would serve to prevent bankruptcies in gold from being too frequent. Partial gold-clause protection is what would follow from such education and accomplish its objective.

The implication here is that the degree of gold-clause protection in contracts should increase only as the risk of further increases in the real value of gold in the economic system relative to that of paper money declines.

Gold-clauses, of course, would protect not only lenders, but also people dependent on pensions or annuities or who would be the beneficiaries of such retirement vehicles in the future. They would also protect the grantors of long-term leases of all kinds.

The widespread establishment of partial gold clauses is an essential step in the protection of the buying power of creditors. It would also be a major step on the path toward the establishment of sound money.

Of course, it is possible that the Fed will pull back from its increasingly inflationary course and reverse field as it did in the early 1980s. In that case, gold-clause contracts will simply have a status comparable to fire insurance for people whose homes do not suffer fire damage greater than their deductible. They will serve simply as a form of insurance policy. One that, unfortunately, looks like it is increasingly needed.

Labels: , , , , , ,

Friday, August 10, 2007

The Housing Bubble and the Credit Crunch

The turmoil in the credit markets now emanating from the collapse of the housing bubble can be understood in the light of the theory of the business cycle developed by Ludwig von Mises and F.A. Hayek. These authors showed that credit expansion distorts the pattern of spending and capital investment in the economic system. This in turn leads to the large scale loss of capital and thereby sets the stage for a subsequent credit contraction, which is precisely what is beginning to happen now. (For the benefit of readers unfamiliar with the expression, credit expansion is the creation of new and additional money by the banking system and its lending out at artificially low interest rates and/or to borrowers of low credit worthiness.)

The genesis of the present problem goes back to the bursting of the stock-market bubble in the early years of this decade. In an effort to avoid its deflationary consequences, the bursting of the stock market bubble was followed by successive Federal Reserve cuts in interest rates, all the way down to little more than 1 percent by the end of 2003.

These cuts in interest rates were accomplished by means of repeated injections of new and additional bank reserves. The essential interest rate in question was the so-called Federal Funds rate. This is the interest rate that the banks that are members of the Federal Reserve System charge or pay in the lending and borrowing of the monetary reserves that they are obliged to hold against their outstanding checking deposits.

The continuing inflow of new and additional reserves allowed the banking system to create new and additional checking deposits for the benefit of borrowers. The new and additional deposits were created to a multiple of ten or more times the new and additional reserves and made possible the granting of new and additional loans on a correspondingly large scale. The sharp decline in interest rates that took place encouraged the making of mortgage loans in particular. The reason for this was the steep decline in monthly mortgage payments that results from a substantial decline in interest rates. The new and additional checking deposits were money that was created out of thin air and which was lent against mortgages to borrowers of poorer and poorer credit.

So long as the new and additional money kept pouring into the housing market at an accelerating rate, home prices rose and most people seemed to prosper.

But starting in 2004, and continuing all through 2005 and the first half of 2006, in fear of the inflationary consequences of its policy, the Federal Reserve began gradually to raise interest rates. It did so in order to be able to reduce its creation of new and additional reserves for the banking system.

Once this policy succeeded to the point that the expansion of deposit credit entering the housing market finally stopped accelerating, the basis for a continuing rise in home prices was removed. For it meant a leveling off in the demand for housing. To the extent that the credit expansion actually fell, the demand for houses had to drop. This was because a major component of the demand for houses had come to be precisely the funds provided by credit expansion. A decline in that component constituted an equivalent decline in the overall demand for houses. The decline in the demand for houses, of course, was in turn followed by a decline in the price of houses Housing prices also had to fall simply because of the unloading of homes purchased in anticipation of continually rising prices, once it became clear that that anticipation was mistaken.

This drop in the demand for and price of houses has now revealed a mass of mortgage debt that is unpayable. It has also revealed a corresponding mass of malinvested, wasted, capital: the capital used to make the unpayable mortgage loans.

The loss of this vast amount of capital serves to undermine the rest of the economic system.

The banks and other lenders who have made these loans are now unable to continue their lending operations on the previous scale, and in some cases, on any scale whatever. To the extent that they are not repaid by their borrowers, they lack funds with which to make or renew loans themselves. To continue in operation, not only can they no longer lend to the same extent as before, but in many cases they themselves need to borrow, in order to meet financial commitments made previously and now coming due.

Thus, what is present is both a reduction in the supply of loanable funds and an increase in the demand for loanable funds, a situation that is aptly described by the expression “credit crunch.”

The phenomenon of the credit crunch is reinforced by the fact that credit expansion, just like any other increase in the quantity of money, serves to raise wage rates and the prices of raw materials. It thereby reduces the buying power of any given amount of capital funds. This too leads to the outcome of a credit crunch as soon as the spigot of new and additional credit expansion is turned off. This is because firms now need more funds than anticipated to complete their projects and thus must borrow more and/or lend less in order to secure those funds. (This, incidentally, is the present situation in the construction of power plants and other infrastructure, where costs have risen dramatically in the last few years, with the result that correspondingly larger sums of capital are now required to carry out the same projects.) In addition, the decline in the stock and bond markets that results after the prop of credit expansion is withdrawn signifies a reduction in the assets available to fund business activities and thus serves to intensify the credit crunch.

The situation today is essentially similar to all previous episodes of the boom-bust business cycle launched by credit expansion. The only difference is that in this case, the credit expansion fed an expanded demand for housing and, at the same time, most of the additional capital funds created by the credit expansion were invested in housing. Now that the demand for housing has fallen, as the result of the slowdown of the credit expansion, much of the additional capital funds invested in housing has turned out to be malinvestments. In most previous instances, credit expansion fed an additional demand for capital goods, notably plant and equipment, and most of the additional capital funds created by credit expansion were invested in the production of capital goods. When the credit expansion slowed, the demand for capital goods fell and much of the additional capital funds invested in their production turned out to be malinvestments.

In all instances of credit expansion what is present is the introduction into the economic system of a mass of capital funds that so long as it is present has the appearance of real wealth and capital and provides the basis for sharply increased buying and selling and a corresponding rise in asset prices. Unfortunately, once the credit expansion that creates these capital funds slows, the basis of the profitability of the funds previously created by the credit expansion is withdrawn. This is because those funds are invested in lines dependent for their profitability on a demand that only the continuation of the credit expansion can provide.

In the aftermath of credit expansion, today no less than in the past, the economic system is primed for a veritable implosion of credit, money, and spending. The mass of capital funds put into the economic system by credit expansion quickly begins evaporating (the hedge funds of Bear Stearns are an excellent recent example), with the potential to wipe out further vast amounts of capital funds.

As the consequence of a credit crunch, there are firms with liabilities coming due that are simply unable to meet them. They cannot renew the loans they have taken out nor replace them. These firms become insolvent and go bankrupt. Attempts to avoid the plight of such firms can easily precipitate a process of financial contraction and deflation.

This is because the specter of being unable to repay debt brings about a rise in the demand for money for holding. Firms need to raise cash in order to have the funds available to repay debts coming due. They can no longer count on easily and profitably obtaining these funds through borrowing, as they could under credit expansion, or, indeed, obtaining them at all through borrowing. Nor can they readily and profitably obtain funds by liquidating the securities or other assets that they hold. Thus, in addition to whatever funds they may still be able to raise in such ways, they must attempt to accumulate funds by reducing their expenditures out of their receipts. This reduction in expenditures, however, serves to reduce sales revenues and profits in the economic system and thus further reduces the ability to repay debt.

To the extent that anywhere along the line, the process of bankruptcies results in bank failures, the quantity of money in the economic system is actually reduced, for the checking deposits of failed banks lose the character of money and assume that of junk bonds, which no one will accept in payment for goods or services.

Declines in the quantity of money, and in the spending that depends on the part of the money supply that has been lost, results in more bankruptcies and bank failures, and still more declines in the quantity of money, as well as in further increases in the demand for money for holding. Such was the record of The Great Depression of 1929-1933.

Given the unlimited powers of money creation that the Federal Reserve has today, it is doubtful that any significant actual deflation of the money supply will take place. The same is true of financial contraction caused by an increase in the demand for money for holding. In confirmation of this,
The New York Times reports, in an online article dated August 11, 2007, that “The Federal Reserve, trying to calm turmoil on Wall Street, announced today that it will pump as much money as needed into the financial system to help overcome the ill effects of a spreading credit crunch.… The Fed pushed $38 billion in temporary reserves into the system this morning, on top of a similar move [$24 billion] the day before.” In addition, the print edition of The Times, dated a day earlier, reported in its lead front-page story that “the European Central Bank in Frankfurt lent more than $130 billion overnight at a rate of 4 percent to tamp down a surge in the rates banks charge each other for very short-term loans.”

Thus the likely outcome will be a future surge in spending and in prices of all kinds based on an expansion of the money supply of sufficient magnitude to overcome even the very powerful impetus to contraction and deflation that has come about as the result of the bursting of the housing bubble.

Another outcome will almost certainly be the enactment of still more laws and regulations concerning financial activity. Oblivious to the essential role of credit expansion and of the government’s role in the existence of credit expansion, the politicians and the media are already attempting to blame the present debacle on whatever aspects of economic and financial activity still remain free of the government’s control.

It probably is the case that at this point the only thing that can prevent the emergence of a full-blown major depression is the creation of yet still more money. But that new and additional money does not necessarily have to be in the form of paper and checkbook money. An alternative would be to declare gold and silver coin and bullion legal tender for the payment of debts denominated in paper dollars. There is no limit to the amount of debt-paying power in terms of paper dollars that gold and silver can have. It depends only on the number of dollars per ounce.

To be sure, this is an extremely radical suggestion, but something along these lines will someday be necessary if the world is ever to get off the paper-money merry-go-round of the unending ups and downs of boom and bust, accompanied since 1933 by the continuing loss of the buying power of money.

Copyright © 2007, by George Reisman. George Reisman is the author of
Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor Emeritus of Economics. His web site is

Labels: , , , , , , ,