Sunday, November 22, 2009

A Pro-Free-Market Program for Economic Recovery

The following is a speech delivered by George Reisman at the Ludwig von Mises Institute's Mises Circle in Newport Beach, California on November 14, 2009.

Good Afternoon, Ladies and Gentlemen:

As you all know, we are in a severe economic downturn. The official unemployment rate now exceeds 10 percent and according to many observers is actually substantially higher. Within the last year or so, our financial system has been rocked to its foundations. The collapse of the housing bubble and the numerous defaults and bankruptcies connected with it brought down major financial institutions, such as Bear-Stearns, Lehman Brothers, and Merrill Lynch. It also brought down numerous small and medium-sized banks and threatened to bring down even such banking giants as Citigroup and Bank of America. The Dow Jones stock average fell from a high of 14,000 to about 6,500. Important retailers such as CompUSA, Circuit City, Mervyns, and Linens ‘N Things went under, as did countless small businesses throughout the country. Practically every shopping mall gives testimony to the severity of the downturn in the form of vacant stores.

The collapse of the housing bubble and the massive losses and mounting unemployment that have resulted from it have unleashed a veritable firestorm of hostility against capitalism, in the conviction that it is capitalism and its economic freedom that are responsible. It is now generally taken for granted that any solution for the downturn requires massive new government intervention, to curb, control, or abolish this or that aspect of capitalism and its alleged evil.

Reflecting this view, in an effort to avoid financial collapse, the government’s response was the enactment of an $800 billion “stimulus package” designed to boost spending throughout the economic system, and the pouring of more than $1.1 trillion of new and additional reserves into the banking system, along with the direct investment of capital in the country’s most important banks and in major automobile firms, in order to prevent them from failing.

As a result of its so-called “investments,” the government now owns a majority interest in the common stock of General Motors, once the flagship company of capitalism. There have been important extensions of government control over the economic system in other areas as well. For example, the stimulus package contains substantial funding for new bureaucracies to control health care and energy production.

The new and additional bank reserves, moreover, are not only massive, but almost all of them are excess reserves. Excess reserves are the reserves available to the banks for the making of new and additional loans, i.e., for new and additional credit expansion. They are the difference between the reserves the banks actually hold and the reserves they are required to hold by law or government regulation.

To gauge the significance of today’s excess reserves, one should consider that total bank reserves as recently as July of 2008 were on the order of just $45 billion, and excess reserves were less than $2 billion. Those $45 billion of reserves supported a total of checking deposits in one form or another on the order of $6 trillion (a sum that included traditional checking deposits, so-called “sweep accounts,” money-market mutual-fund accounts, and money-market deposit accounts inasmuch as checks could be written against them). That was a ratio of checking deposits to reserves in excess of 100 to 1, or equivalently, a fractional reserve of less than 1 percent.

Today, of the $1.1 trillion-plus of total reserves, all but approximately $62 billion of required reserves are excess reserves. As of the week of November 4, excess reserves were $1.06 trillion.

Fortunately, for the time being at least, the banks are afraid to lend very much of this sum, but the potential is clearly there for a massive new credit expansion and corresponding increase in the quantity of money. Recognition of this potential is reflected in the current surge in the price of precious metals. Indeed, since $1.06 trillion of new and additional excess reserves are more than 22 times as large as the $45 billion of reserves that were sufficient not so long ago to support $6 trillion of checking deposits, they might potentially support checking deposits in excess of $132 trillion. In effect, what has happened is that our recent brush with massive deflation has turned out to be an occasion for a massive inflationary fueling period in the effort to avoid that deflation.

Inflation and Deflation: Credit Expansion and Malinvestment

The title of my talk, of course, is “A Pro-Free-Market Program for Economic Recovery.” What this entails changes as the government adds new and additional measures that create new and additional problems. If I were giving this talk a year ago, my discussion would have been weighted somewhat more heavily toward deflation and somewhat less heavily toward inflation than is the case today.

A fundamental fact is that our present monetary system is characterized both by irredeemable paper money, i.e., fiat money, and by credit expansion. There is no limit to the quantity of fiat money that can be created. This is the foundation for potentially limitless inflation and the ultimate destruction of the paper money, when the point is reached that it loses value so fast that no one will accept it any longer.

The fact that our monetary system is also characterized by credit expansion is what creates the potential for massive deflation—for deflation to the point of wiping out the far greater part of the money supply, which in the conditions of the last centuries has been brought into existence through the mechanism of credit expansion.

Credit expansion is what underlay the housing bubble, and before that, the stock market bubble, and before that a long series of other booms and busts, running through the Great Depression of 1929 that followed the stock market boom of the 1920s, through the 19th and 18th Centuries all the way back to the Mississippi Bubble of 1719, and perhaps even further back.

Credit expansion is the lending out of money created virtually out of thin air. It is money manufactured by the banking system, always with at least the implicit sanction of the government, which chooses not to outlaw the practice. Since 1913, credit expansion in this country has proceeded not only with the sanction but also with the approval and active encouragement of the Federal Reserve System, which, as I’ve shown, is now desperately trying to reignite the process as the means of recovering from the current downturn.

The new and additional money is created by the banking system through the lending out of funds placed on deposit with it by its customers and still held by those customers in the form checking accounts of one kind or another. The customers can continue to spend those checking deposits themselves, simply by writing checks or using other, similar methods of transferring their balances to others.

But now, at the same time, those to whom the banks have lent in this way also have money. To illustrate the process, imagine that Mr. X deposits $1,000 of currency in his checking account. He retains the ability to spend his $1,000 by means of writing checks. From his point of view, he has not reduced the amount of money in his possession any more than if he had exchanged $1,000 in hundred-dollar bills for $1,000 in fifty-dollar bills, or vice versa. He has merely changed the form in which he continues to hold the exact same quantity of money.

But now imagine that Mr. X’s bank takes, say, $900 of the currency that he has deposited and lends it to Mr. Y. Mr. Y now possess $900 of spendable money in addition to the $1,000 that Mr. X continues to possess. In other words, the quantity of money in the economic system has been increased by $900. Mr. Y’s loan has been financed by the creation of new and additional money virtually out thin air. This is the nature and meaning of credit expansion.

Now nothing of substance is changed, if instead of lending currency to Mr. Y, Mr. X’s bank creates a new and additional checking deposit for Mr. Y in the amount of $900. (This, in fact, is the way credit expansion usually occurs in present-day conditions.) There will once again be $900 of new and additional money. There will be altogether $1,900 of money resting on a foundation merely of the $1,000 of currency deposited by Mr. X.

The $1,000 of currency that Mr. X’s bank holds is its reserve. If Mr. Y deposits his currency or check in another bank, it is the banking system that now has $1,000 of reserves and $1,900 of checking deposits. On the foundation of these reserves, it can create still more money and use it in the further expansion of credit. Indeed, as we have seen, the process of credit expansion is capable of creating checking deposits more than 100 times as large as the reserves that support them.

Credit expansion makes it possible to understand what caused the housing bubble and its collapse. From January of 2001 to December of 2007, credit expansion took place in excess of $2 trillion. This new and additional money made available in the loan market drove down interest rates, including, very prominently, interest rates on home mortgages. Since the interest rate on a mortgage is a major factor determining the cost of homeownership, lower mortgage interest rates greatly encouraged buying houses.

This artificially increased demand for houses, made possible by credit expansion, soon began to raise the prices of houses, and as the new and additional money kept pouring into the housing market, home prices continued to rise. This went on long enough to convince many people that the mere buying and selling of houses was a way to make a good living. On this basis, the demand for houses increased yet further, and finally a point was reached where the median-priced home was no longer affordable by anyone whose income was not far in excess of the median income, i.e., only by a relatively few percent of families.

In the middle of 2004, the Federal Reserve became alarmed about the situation and its implications for rising prices in general, and over the next two years progressively increased its Federal Funds interest rate from 1 percent to 5.25 percent. This rise in the Federal Funds rate signified a reduction in the flow of new and additional excess reserves into the banking system and thus its ability to make new and additional loans. This served to prick the housing bubble.

But before its end, perhaps as much as a trillion and a half dollars or more of credit expansion and its newly created money had been channeled into the housing market. Once the basis of high and rising home prices had been removed, home prices began to fall, leaving large numbers of borrowers with homes worth less than they had paid for them and with mortgages they could not meet.

The investments in housing represented a classic case of what Mises calls “malinvestment,” i.e., the wasteful investment of capital in inherently uneconomic ventures. The malinvestment in housing was on a scale comparable to the credit expansion that had created it, i.e., about $2 trillion or more. That’s about how much was lost in the housing market. When the money capital created by credit expansion was wiped out, the lending, investment spending, employment, and consumer spending that had come to depend on that capital were also wiped out.

And, particularly important, as vast numbers of home buyers defaulted on their mortgages, the mounting losses on mortgage loans increasingly wiped out the capital of banks and other financial institutions, setting the stage for their failure.

The current plight of the economic system is the result of credit expansion and the malinvestment it engenders. Capital in physical terms is the physical assets of business firms. It is their plant and equipment and inventories and work in progress. As Mises never tired of pointing out, capital goods cannot be created by credit expansion. All that credit expansion can do is change their employment and shift them into lines where their employment results in losses. The empty stores and idle factories around the country are very much the result of the loss of the capital squandered in malinvestment in housing.

Other Consequences of Credit Expansion

The plight of the economic system is also the result of other consequences of credit expansion, namely, the encouragement it gives to high debt and dangerous leverage. This is the result of the fact that while credit expansion drives down market interest rates, the spending of the new and additional funds it represents serves to drive up business sales revenues and what the old classical economists called the rate of profit. This combination makes borrowing appear highly profitable and greatly encourages it. Individuals and business firms take on more and more debt relative to their equity. They expect borrowing to multiply their gains.

In addition, credit expansion is responsible for many business firms operating with lower cash holdings relative to the scale of their economic activity, in many cases, dangerously low cash holdings. Many businessmen develop the attitude, why hold cash when credit expansion makes it possible to borrow easily and profitably? Instead, invest the money.

Thus, when credit expansion finally gives way to the recognition of vast malinvestments and the accompanying loss of huge sums of capital, the economic system is also mired in debt and deficient in cash. Thus, it is poised to fall like a house of cards, in a vast cascade of failures and bankruptcies, first and foremost, bank failures.

The Road to Recovery

The road to recovery from our economic downturn can be understood only in the light of knowledge of credit expansion and its consequences. The nature of credit expansion and its consequences imply the nature of the cure.

The prevailing—Keynesian—view on how to recover from our downturn totally ignores credit expansion and its effects. It believes that all that counts is “spending,” practically any kind of spending. Just get the spending going and economic activity will follow, the Keynesians believe.

This conception of things, which underlies the support for “stimulus packages” and anything else that will increase consumer spending is mistaken. It rests on a fundamental misconception. It ignores the fact that the fundamental problem is not insufficient spending, but insufficient capital due to the losses caused by malinvestment. It ignores the further facts that credit expansion has brought about excessive debt and, however counterintuitive this may seem, insufficient cash. Too little capital, too much debt, and not enough cash are the problems that countless business firms are facing today as a result of the credit expansion that generated the housing bubble.

Just as a reminder: the way that credit expansion brings about a situation of too little cash while itself constituting a flood of cash is that it makes it appear profitable to invest every last dollar of cash in the expectation of being able easily and profitably to borrow whatever cash may be needed.

What this discussion implies is that an essential requirement of economic recovery is that the widespread problems in the balance sheets of business firms must be fixed. Business firms need more capital, less debt, and more cash. When they achieve that, business confidence will be restored.

Ironically what could achieve at least less debt and more cash in the hands of business, and thus actually do some significant good is if when people received government “stimulus” money, they did not spend very much of it, or, better still, any of it at all. To the extent that all people did with money coming from the government was pay down debt and hold more cash, they would be engaged in a process of undoing some of the major damage done by credit expansion. They would be reducing their burden of debt and increasing their liquidity, thereby increasing their security against the threat of insolvency. Such behavior, of course, would be regarded by Keynesians as constituting a failure of their policies, because in their eyes, all that counts is consumer spending.

The 100-Percent Reserve

The most important single step on the road to economic recovery is the establishment of a 100-percent reserve system against checking deposits. Ideally, the 100-percent reserve would be in gold. And that’s ultimately what we should aim at, for all of the reasons Rothbard explained.
[1] But even a 100-percent reserve in paper would do the job of totally preventing all future credit expansion and, equally important, all declines in the money supply.

(Because the 100-percent gold reserve standard is the long-run ideal of advocates of sound money, I cannot help but feel a sense of great satisfaction in the fact that a major step toward its achievement is what turns out to be urgently needed as a matter of sound current economic policy.)
In the simplest terms, to establish a 100-percent-reserve system in terms of paper, the government would simply print up enough additional paper currency so that when added to the paper currency the banks already have, every last dollar of their checking deposits would be covered by such currency. (Strictly speaking, a significant part, and for some months now the far greater part, of the reserves of the banks are not in actual currency but in checking deposits with the Federal Reserve. For the sake of simplicity, however, we can think of the checking deposits held by the banks with the Federal Reserve as a denomination of currency, since, for the banks, they are fully as interchangeable with currency as $50 bills are with $100 bills and vice versa.)

To illustrate the process of achieving a 100-percent reserve, imagine that total checking deposits are $3 trillion. In that case, the Fed would give the banks new and additional reserves that when added to their existing reserves would bring them up to $3 trillion. Through various programs, such as purchasing bad assets, the Fed has in fact already brought the total reserves of the banks up to over a trillion dollars, but almost all of those reserves, as we’ve seen, are excess reserves, a ready foundation for a massive new credit expansion, since excess reserves can be lent out.

What my example implies is adding to the $1.1 trillion of reserves the banking system now has, a further $1.9 trillion and making all $3 trillion of reserves required reserves. This would mean that the banks could not engage in any lending of these reserves and thus would be unable to finance credit expansion or any increase in the supply of checking deposits on the strength of them. The money supply in the hands of the public and spendable in the economic system would thus not be increased. That would happen only if and to the extent that the 100-percent reserve principle were breached.

Under a 100-percent reserve, checking depositors could simultaneously all demand their full balances in cash and the banks would be able to pay them all. Depositors’ demand for cash would not create a problem and no amount of losses by the banks on their loans and investments would prevent them from honoring their checking deposits immediately and in full. Thus the checking deposit component of the money supply could not fall and nor, of course could its other component which is the paper money in the hands of the public, usually described as the currency component. Thus, there could simply be no deflation of the money supply. And, as I’ve said, because all reserves would be required reserves, there would simply be no reserves whatever available for lending out, and thus no credit expansion whatever. The expression “killing two birds with one stone” could not have a better application.

In a addition, a significant by-product of a 100-percent reserve system would be that the FDIC would no longer serve any purpose and thus could be abolished.

Now an essential prerequisite of the 100-percent reserve is knowing the size of checking deposits, so that it will be known how much the 100-percent reserve needs to cover. At present, when one allows for such things as “sweep accounts,” money-market mutual funds, and money-market deposit accounts, the magnitude of checking deposits to which the 100-percent reserve would apply can plausibly be argued to range from about $1.5 trillion to $6 trillion. It is very solidly $1.5 trillion, but does in fact range up to $6 trillion in that checks can be written on the additional sums involved, at least from time to time and for some large minimum amount.

To clearly establish the magnitude of checking deposits, bank depositors should be asked if their intention is to hold money in the bank, ready for their immediate use and transfer to others, or to lend money to the bank. In the first case, their funds would be in a checking account, against which the bank would have to hold a 100-percent reserve. In the second case, their funds would be in a savings account, against which the bank could hold whatever lesser reserve it considered necessary. In this case, the bank’s customers could not spend the funds they had deposited until they withdrew them from the bank.

As I’ve said, the long-run goal in connection with the 100-percent reserve would be ultimately to convert it to a 100-percent gold reserve system. At that time, following ideas of Rothbard further, the gold reserve of the Fed would be priced high enough to equal the currency and checking deposits of the country and be physically turned over to the individual citizens and the banks in exchange for all outstanding Federal Reserve money. The Fed would then be abolished. But this is a distinct and much later step in pro-free-market reform.

The 100-Percent Reserve and New Bank Capital

It should be realized that a major consequence of the establishment of a 100-percent-reserve system could be a corresponding enlargement of the capital of the banking system and thus an ability to cover even very great losses and thereby avoid such things as government bank bailouts and takeovers.

Consider the balance sheet of an imaginary bank. It’s got checking-deposit liabilities of $100. Initially, it has assets of $105, which implies that on the liabilities side of its balance sheet it has capital of $5 in addition to its checking-deposit liabilities of $100.

Now unfortunately, malinvestment has resulted in a loss of $20 in the banks’ assets, in the part of its assets consisting of loans and investments. As a result, its total assets are reduced from $105 to $85 and its capital is completely wiped out and becomes negative in the amount of $15.

However, on its asset side the bank still has some cash reserve, say, $10. If $90 of new and additional reserves were added to these $10, to bring the bank’s reserves up to 100-percent equality with its checking deposits, the bank’s asset total would also be increased by $90. This $90 increase on the bank’s asset side would have to be matched by a $90 increase on its liabilities side, specifically by a $90 increase in its capital. Its capital would go from minus $15 to plus $75.

Applying this to the banking system as a whole in transitioning to a 100-percent reserve, we can see that the creation of such a vast amount of new bank capital would be entailed as easily to overcome whatever losses the banks might have suffered in their loans and investments.

As explained, if checking deposits were $3 trillion, the Fed would give the banks new and additional reserves that when added to their existing reserves would bring them up to $3 trillion. If this had been done in September of 2008, bringing reserves up to $3 trillion would have required adding $2.955 trillion of new and additional reserves to the $45 billion or so of reserves the banks already had. This vast addition on the asset side of the banks’ balance sheets would have implied an equivalent addition to the banks’ capital on the liabilities side. No matter how bad the banks’ assets were, I think it’s virtually certain that an additional sum of this size would have been far more than sufficient to cover all the losses that the banks had incurred in their bad loans and investments. Their capital would have ended up being increased to the extent the additional reserves exceeded the losses in assets under the head of loans and investments.
The government’s bailout program of stock purchases in the banks would have been avoided, along with all of its subsequent interference in matters of bank management.

Now, as we’ve seen, in fact the Fed has already supplied a vast amount of reserves, about $1.1 trillion, to the banks through various programs such as purchasing bad assets. If the 100-percent reserve principle were adopted now, many or most of those assets could be taken back and the programs that created them cancelled.

Thus, what I’ve shown here is how transitioning to a 100-percent reserve would guarantee the prevention both of new credit expansion and of deflation of the money supply. It could also provide additional capital to the banking system on a scale almost certainly far more than sufficient to place it on a financially sound footing. To avoid what would otherwise likely be an excessive windfall to the banks, it would be possible to match a more or less considerable part of the increase in their assets provided by the creation of additional reserves, with the creation of a liability of the banks to their depositors, perhaps in the form of some kind of mutual-fund accounts. Thus, the newly created reserves might provide a financial benefit to the banks’ depositors as well as to the banks.

Toward Gold

Of course, a 100-percent reserve system in which the reserves are fiat money does not address the problem of preventing inflation of the fiat money. It would still be possible for the government to inflate the fiat money without restraint. That is why it is necessary to have gold in the monetary system, serving as a restraint on the amount of currency and reserves.

Thus, an important ancillary measure in connection with the transition to a 100-percent paper-reserve system would be for the government to demonstrate a serious intent to move to a gold standard. Obliging the Federal Reserve to carry out a program of regular and substantial gold bullion purchases might accomplish this. In any event, it would be an essential prerequisite for someday achieving gold reserves sufficient to make possible the establishment of a 100-percent-reserve gold system. Along the way, this measure should lead to the day when purchases of gold bullion were the only source of increases in the supply of currency and reserves.

Establishing the Freedom of Wage Rates to Fall

Along with stabilizing the financial system through the adoption of a 100-pecent reserve, it’s absolutely essential to establish the freedom of wage rates and prices to fall. This is what is required to eliminate mass unemployment. Whatever the level of spending in the economic system may be, it is sufficient to buy as much additional labor and products as is required for everyone to be employed and producing as much as he can.

Nothing could be more obvious if one thinks about it. Assume, as is the case today, that there is 10 percent unemployment, with only 9 workers working for every 10 who are able and willing to work. The same total expenditure of money that today employs only 9 workers would be able to employ 10 workers, if the average wage per worker were 10 percent less. At nine-tenths the wage, the same total amount of wages is sufficient to employ ten-ninths the number of workers. It’s a question of simple arithmetic: 1 divided by 9/10 equals 10/9.

(Obviously, this is an overall, average result. In reality, some wage rates would need to fall by less than 10 percent and others by more than 10 percent.)

Of course, total wage payments are not fixed in stone. They can change. And in response to a fall in wage rates to their equilibrium level, to eliminate mass unemployment, they would increase. This is because prior to their fall, investment expenditures have been postponed, awaiting their fall. Once that fall occurs, those investment expenditures take place.

Finally, with debt levels sufficiently reduced and cash holdings sufficiently high, and thus business confidence restored, there is no reason to believe that a fall in wage rates could abort the process of recovery as the result of already employed workers earning less and thus spending less before new and additional workers were hired. The cash reserves and financial strength of business firms would enable them easily to ride out any such situation. And thus mass unemployment would simply be eliminated.

What stops wage rates from falling, what makes it actually illegalfor them to fall, and which thus perpetuates mass unemployment, is the underlying pervasive influence of the Marxian exploitation theory. That doctrine is responsible for the existence of such things as minimum-wage laws and coercive labor unions and their above-market wage scales.

The most important fundamental requirement for achieving a free market in labor is the total refutation of the exploitation theory and its complete discrediting in public opinion. Such a refutation will show that it is not government and labor unions that raise real wages but businessmen and capitalists, and that essentially, all that unions do is cause unemployment and a lower productivity of labor and thus prices that are higher relative to wage rates. This knowledge is what is required to make possible the repeal of minimum-wage and pro-union legislation and thus achieve the fall in wage rates that will eliminate mass unemployment.


In summation, my pro-free-market program for economic recovery is a provisional 100-percent-paper-money-reserve system applied to checking deposits, accompanied by a demonstrable commitment to ultimately achieving a 100-percent-gold-reserve system. The 100-percent reserve in paper would put an end to all further credit expansion and at the same time make the money supply incapable of being deflated. Its establishment would also greatly increase the capital of the banking system. It would do so by more than enough to cover all the losses on loans and investments incurred in the aftermath of the collapse of the housing bubble and thus make possible the elimination of government ownership of common stock in banks and its interference in bank management. What it would not do is control the increase in paper currency and paper-currency reserves. That will require a 100-percent gold reserve system.

Finally, the freedom of wage rates and prices to fall must be established through the repeal of pro-union and minimum-wage legislation, and more fundamentally, the education of the public concerning the errors of the Marxian exploitation theory and their replacement with actual knowledge of what determines wages and the general standard of living. To say the least, this will certainly not be an easy agenda to follow, inasmuch as it must begin in the midst of a Marxist occupation of our nation’s capital.

Thank you.

[1] Rothbard deserves credit for his ideas on money, especially for his views on the subject of the 100-percent-gold-reserve system. This acknowledgement, however, should not be construed in any way as an endorsement of Rothbard’s belief in a system of “competing governments” or his belief that the United States was the aggressor against Soviet Russia in the cold war.

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, above, and then saving the file when it appears on the screen.

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Friday, January 09, 2009


This is the first 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.

A disastrous economic confusion, one that is shared almost universally, both by laymen and by professional economists alike, is the belief that falling prices constitute deflation and thus must be feared and, if possible, prevented.

The front-page, lead article of The New York Times of last November 1 provides a typical example of this confusion. It declares:

As dozens of countries slip deeper into financial distress, a new threat may be gathering force within the American economy—the prospect that goods will pile up waiting for buyers and prices will fall, suffocating fresh investment and worsening joblessness for months or even years.

The word for this is deflation, or declining prices, a term that gives economists chills.

Deflation accompanied the Depression of the 1930s. Persistently falling prices also were at the heart of Japan’s so-called lost decade after the catastrophic collapse of its real estate bubble at the end of the 1980s—a period in which some experts now find parallels to the American predicament.
Contrary to The Times and so many others, deflation is not falling prices but a decrease in the quantity of money and/or volume of spending in the economic system. To say the same thing in different words, deflation is a general fall in demand. Falling prices are a consequence of deflation, not the phenomenon itself.

Totally apart from deflation, falling prices are also a consequence of increases in the production and supply of goods, which are an essential feature of economic progress and a rising standard of living. In such circumstances, falling prices are not accompanied by any plunge in business sales revenues or profits, by any increase in the difficulty of repaying debt, or by any surge in bankruptcies. All of these phenomena are the result purely and simply of deflation, not falling prices.

Indeed, under a full-bodied, 100-percent-reserve gold standard, falling prices, caused by increased production, are likely to be accompanied by a modest elevation of the rate of profit and a somewhat greater ease of repaying debt, both owing to the increase in the production and supply of gold and thus in the spending of gold. Under such a gold standard, prices fall to the extent that the increase in the production and supply of ordinary goods and services outstrips the increase in the production and supply of gold and the consequent increase in spending in terms of gold.

While this must certainly come as a surprise to The Times, and to everyone else who does not understand the nature of deflation, falling prices are in fact so far removed from being deflation that they are the antidote to deflation. They are what enables an economic system that has experienced deflation to recover from it and thereafter to enjoy the fruits of economic progress.

This conclusion can be demonstrated Socratically, by means of a simple question that could be used on an economics exam for sixth graders.

Thus, imagine that prior to the present financial downturn, Bill used to go shopping once a week in his local supermarket. When he went there, he could afford to spend $10 for bottled water. At the prevailing price of $1 per bottle, he was able to buy 10 bottles. Now, in the midst of the downturn, when Bill visits the supermarket, he can afford to spend only $5 for bottled water.

Here’s the question: At what price per bottle of water would Bill be able to buy for $5 the 10 bottles of water he used to buy for $10? Answer: 50¢.

As this question and its answer make clear, a fall in prices enables reduced funds available for expenditure to buy as much as previously larger funds could buy.

This point applies even when lower prices do not result in greater purchases of the particular item whose price has fallen. Thus, suppose that the price of a gallon of milk is $8 and now falls to $4. Yet Bill and his family do not need more than one gallon in any given week, and so won’t buy any larger quantity of milk at its now lower price. The fall in its price still helps economic recovery. It does so by freeing up $4 of Bill’s funds to make possible the purchase of other things, that he wants but otherwise couldn’t afford because of the lack of available funds.

Another, similar example is that of a fall in the price of gasoline or heating oil, which helps to increase the ability of people to spend in buying products throughout the economic system.

As indicated, in sharpest contrast to falling prices, deflation is a process of financial contraction. In our present crisis, it is a contraction of credit and of the spending that depends on credit. A fall in prices and, of course, in wage rates too, is the essential means of adapting to this deflation and overcoming it.

Nevertheless, the prevailing bizarre confusion of falling prices with deflation, stands in the way of economic recovery. In regarding falling prices, which are the effect of deflation and at the same time the remedy for deflation, as somehow themselves being deflation, people are led to confuse the solution for the problem with the problem that needs to be solved.

On the basis of this confusion, they advocate government intervention to prevent prices from falling. The prices they want to prevent from falling are, variously, house prices, farm and other commodity prices, and, above all, wage rates. To the extent that such efforts are successful, and prices are prevented from falling, the effect is to prevent economic recovery. It prevents economic recovery by preventing the reduced level of spending that deflation represents, from buying the larger quantity of goods and services that it would be able to buy at lower prices and wage rates.

Just as falling prices are so far from being deflation that they are the remedy for deflation, so too preventing prices from falling is so far from preventing deflation that it actually worsens the deflation. This is because it leads people to postpone buying even in instances in which they have the ability to buy. They put off buying in the expectation of being able to buy on better terms later on, when prices and wage rates have fallen to the extent necessary to permit economic recovery.

By the same token, when prices and wage rates finally do fall sufficiently to permit economic recovery, an increase in spending in the economic system will almost certainly occur. This is because the funds that people had been withholding from spending, awaiting the fall in prices and wages rates, will now, in the face of the necessary fall, be spent. Thus the necessary fall in prices and wage rates achieves economic recovery by means of creating greater buying power for a reduced amount of spending. It also brings about a partial restoration of spending and thereby definitively ends the deflation.

Just how far it is necessary for prices and wage rates to fall in order to achieve economic recovery depends on the change that has taken place in what Mises calls “the money relation.” This is the relationship between the supply of money and the demand for money for holding.

During the boom, inflation and credit expansion increase the supply of money and at the same time reduce the demand for money for holding. Then, in the subsequent bust phase of the business cycle, the demand for money for holding rises and the supply of money can actually fall. Both of these factors make for a decline in total spending in the economic system and thus the need for a correspondingly lower level of wage rates and prices to achieve economic recovery.

How far these processes might go in our present circumstances and what might be done, consistent with the principle of economic freedom, to mitigate them, is too large a subject to explain in this one article.[1] However, I must state here that a decrease in the quantity of money can be altogether prevented and that this would dramatically limit the extent of the decline in overall spending in the economic system.

Whatever the reduced levels of spending that the changed money relation will support, the freedom of wage rates and prices to fall can achieve not only economic recovery but more than economic recovery. It can achieve the employment of everyone able and willing to work, i.e., full employment. And it could do so with no decline in the real wages of the average worker in the economic system, indeed, with a significant rise in his real wages. Unfortunately, this too is a subject too large to discuss further in the present article.[2]


Before closing, I must say a few words about the present efforts of the government to overcome the crisis by means of “bailouts” and their associated financing by budget deficits. Ultimately, these efforts are an attempt to overcome the effects of a rise in the demand for money for holding by means of a sufficiently large increase in the supply of money. In its campaign, the government appears to care for nothing but overcoming the crisis of the moment, without regard to the fuel it is providing for the next crisis.

The government today has unlimited powers of money creation. And so it is highly likely, given its evident willingness to use those powers, and the overwhelming public support that exists for using them, that the increase in the supply of money it brings about will ultimately outweigh the present increase in the public’s demand for money for holding. When and to the extent that that happens, and business sales revenues and profits begin to rise and employment and wage rates begin to rise, the public’s demand for money for holding will once again begin to fall.

At that point the massive increase in the quantity of money the government is currently bringing about will fuel sharply rising prices and give birth to a new crisis. This time, a crisis of inflation. Then, the government will either have to be content with a US economy that resembles the economic system of a Latin American country or it will have to rein in its inflation. If it chooses the latter quickly, we’ll be back to the situation that prevailed in the early 1980s and have to undergo a fresh economic contraction, though probably one of much greater size than then, because of the unfinished business left over from the present crisis.

If the government delays too long in reining in its inflation, then when it finally does decide to do so, it may be confronted not only with prices rising as rapidly as they did in Latin America decades ago, but also with the massive unemployment rates that accompanied the efforts to rein in such major inflation. At that time, prices rising at a rate of 20, 30, or 50 percent or more were accompanied by comparably high unemployment rates. (To understand how such a thing can happen, imagine total spending and prices both rising at the rate of, say, 50 percent per year. Now the government, in an effort rein in inflation, succeeds in reducing the increase in spending to 15 percent. If the rise in wage rates and prices has any kind of significant inertia, such as continuing at 40 percent, the effect will be a drop in production and employment to a level equal to 1.15/1.4, which represents a drop of about 18 percent. In the nearer-term future, unemployment will be promoted by any additional powers the government may give to labor unions, who will use them to raise wage rates even in the midst of mass unemployment, as they did from 1932 on in the Great Depression.)

Of course, given the prevailing readiness massively to expand the powers of government in order to deal with short-term crises, it is also possible that the government will enact wage and price controls in its efforts to fight the consequences of its inflation. If and when the controls are subsequently removed, there will again be a crisis of rising prices that, if not accompanied by still more inflation, will be followed by a major financial contraction. If the price controls are not removed, the economic system will be paralyzed and ultimately destroyed.

The upshot is that there is no good way out of the present crisis other than by meeting it through the free-market’s means of a fall in wage rates and prices, mitigated to the maximum extent possible in ways consistent with the principle of economic freedom. What is required is a way out that once and for all ends the boom-bust cycle of inflation and credit expansion followed by deflation and contraction. The free market, a freer market than we have had up to now, is the only such solution.

Economic freedom and economic recovery both require that prices and wage rates be free to fall and that all legal obstacles in the way of their falling be immediately removed. In order for that to happen, as many people as possible must understand that falling prices are not deflation but the antidote to deflation.


Postscript: Two points need to be briefly addressed that I could not deal with in the body of my article. One concerns the effect of the prospect of falling prices on the postponement of expenditures. This postponement applies only to the case in which the fall in prices is in response to a fall in demand, not an increase in production and supply. In this case, if prices do not fall, demand falls further, as I showed.

However, the prospect of falling prices resulting from increased production and supply does not imply a postponement of purchases. This is because in this case the prospective fall in prices is not the result of any decrease either in spending or in any other major monetary aggregate. On the contrary, here the prospective fall in prices means an increase in the prospective buying power of all accumulated savings as well as of the income that will be earned in the future. In this way, the process of economic progress portends being financially better off in the future than in the present. The effect of this in turn is to enable people to afford to consume more in the present. This counterbalances the benefit to be derived by waiting to take advantage of lower prices in the future. In other words, falling prices due to increased production and supply are essentially neutral in their overall effect on the relationship between spending for present consumption versus saving for future consumption.

The second point that needs to be addressed concerns housing prices. It is often asserted that falling house prices are responsible for bank failures and that the continuation of falling prices for housing must result in more such failures and therefore must be stopped.

Falling home prices are not in fact responsible for bank failures, any more than falling prices of aging automobiles are responsible for bank failures. The fact that homeowners may owe more on their homes than their homes are worth has no more fundamental connection with defaults on mortgage loans than the fact that many or most automobiles purchased with installment loans are worth less than the outstanding loan balances owed on them. Indeed, the mere act of driving a new car off the dealer’s lot is often sufficient to put its resale value below the value of the outstanding loan balance on the car.

What leads to defaults, whether on home loans or on automobile loans, is the inability or unwillingness of borrowers to honor their financial obligations, not the market value of the homes or cars.

Only decades of inflation and credit expansion could make it possible for people to think of the houses they occupy as an investment. In reality, a house is a consumers’ good, just like an automobile or a refrigerator. The only difference is that it depreciates more slowly than they do. Only a long string of years in which inflation took place more rapidly than houses depreciated enabled their prices to rise every year and people to come to regard them as a source of financial gain. If not for inflation and the rise in prices that it produces, it would be very clear that housing is a wasting asset, a slowly wasting asset to be sure, but a wasting asset nonetheless.

If not for inflation, the price of new houses would not rise. They would probably even fall from year to year. In addition, the price of a house that was 5, 10, or 20 years old would be significantly less than the price of a new house. Thus even constant prices of new houses, let alone falling prices of new houses, implies that the price of a house declines as it ages. That is the normal situation. That is the situation in the absence of inflation.

The accelerated credit expansion of recent years and the rapid rise in house prices that it caused made it appear for a while that it was profitable to buy houses for no other reason than quickly to resell them. It also made it appear that people could live off the rise in equity in their homes, by borrowing against it. The frenzy of the housing bubble was such that at its peak the price of the median house could be afforded only by people earning the top 15 percent of incomes.

There is no reason to attempt to maintain artificially high house prices and to rescue the borrowers and lenders who were responsible for them. Furthermore, the attempt to do so must perpetuate the suspicion that the lenders are still basically unsound and cannot be counted on to be able to meet their own financial obligations. Such bad loans must be owned up to and cleared off the books of the banks and the other financial institutions that made them, before confidence can be restored in the financial system.

The fall in housing prices that is taking place needs to go further. The median home price is still considerably higher than the median income level. Calls for stabilizing house prices are a demand for government intervention on behalf of reckless borrowers and lenders, paid for by taxpayers.

The lower home prices that will result from the freedom of the housing market from government interference will reduce the size of the mortgages that are necessary to buy homes. If a house sells for half a million dollars instead of a million dollars or for one-hundred thousand dollars instead of two-hundred thousand dollars, then the amount of mortgage financing required to buy it is correspondingly reduced and the housing market comes into alignment with the reduced overall supply of credit that is available.

[1] For a discussion of the subject, see the author’s Capitalism: A Treatise on Economics, pp. 959-962.

[2] I have discussed it at length in Capitalism; see pp. 580-587.

*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.

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Saturday, March 22, 2008

Our Financial House of Cards and How to Start Replacing It With Solid Gold

A credit crisis has been spreading through the economic system.[1] It began with the collapse of the housing bubble, which was the result of years of Federal-Reserve-sponsored credit expansion. This credit expansion poured hundreds of billions of dollars into the purchase of homes largely by sub-prime borrowers who never had a realistic capability of repaying their mortgage debts in the first place. And, not surprisingly, large numbers of them in fact stopped making the payments required by their mortgages.

At first apparently confined to the market for sub-prime mortgages, the credit crisis has spread to other portions of the mortgage market, to the usually staid municipal bond market, and within the last week or so has led to a run against a major investment bank (Bear Stearns). Along the way, triple-A rated securities have overnight turned into junk bonds, multi-billion dollar hedge funds have collapsed, and major commercial banks have lost tens of billions of dollars of capital. All this, despite massive infusions of funds into the market by the Federal Reserve System and other central banks and a reduction in the Federal Funds rate from 5.25 percent in September of 2007 to 2.25 percent currently.

In the process, the triple-A rated securities that turned out to be junk served to confirm the old truth that lead cannot be turned into gold: the alleged triple-A securities were backed by collections of mortgages that in the last analysis consisted largely or even entirely of sub-primes. An important new truth also appears to have emerged: namely, that Ph.Ds. in finance, the likely authors of the schemes for creating such securities, can turn out to be far more costly than anyone had ever dreamed possible.

Currently, untold billions more of banks’ capital now hinge on the survival of bond insurers striving to insure more than two trillion dollars of outstanding bonds on the basis of capital of their own of roughly ten billion dollars. Collapse of the bond insurers would mean that credit-rating firms, such as Moody’s and Standard and Poor’s, would reduce the ratings of all the bond issues that would consequently be deprived of insurance coverage. This in turn would serve to reduce the prices of those bonds, because lower credit ratings would make them ineligible for purchase by numerous investors, such as many pension funds. To the extent that the bonds were owned by banks, the value of the banks’ assets would be correspondingly reduced and with it the magnitude of the banks’ capital.

The decline in the assets and capital of banks that has already taken place has served to reduce the ability of banks to lend money to borrowers to whom they would otherwise normally lend. To the extent, for example, that sub-prime mortgage borrowers have stopped paying interest and principal on their loans, the banks do not have those funds available to make loans to other borrowers.

The effects of such credit contraction can already be seen in business bankruptcies precipitated by an inability of firms to obtain refinancing of debts coming due. It can also be seen in the growing difficulty even of sound firms to obtain financing required for expansion.

The Role of Leverage

Our present circumstances follow decades, indeed, generations of almost continuous inflation and credit expansion, in which almost everyone has become accustomed to assume that asset values will always rise or at least will quickly resume their rise after any pause or decline. This assumption not only played an important role in the eagerness with which people lent and borrowed in the mortgage market, but also in bringing about the very high degree of financial leverage that has come to characterize practically all areas of our financial system. (Leverage is the use of borrowed funds to increase the returns that can be earned with a given sized capital. It equivalently increases the losses that can be incurred on that capital.)

Unduly high leverage explains the failure of major lenders in the prime portion of the real estate market. As the result of losses sustained in sub-prime mortgages, banks and other lenders could no longer provide funds as readily for the purchase of prime mortgages. The resulting few percent drop in the value of prime mortgages has served to wipe out the entire capital of prime mortgage lenders whose capital was so highly leveraged that it constituted an even smaller percentage of the value of their assets than the few percent drop in the price of those assets. For example, if a mortgage lender initially had assets worth $103 and debts of his own of $100 incurred in order to finance the purchase of those assets, a mere 4 percent decline in the value of his assets would wipe out his entire capital and then some. Multiply these numbers by many billions, and the example corresponds exactly to the real-world cases of Thornburg Mortgage and Carlyle Capital reported on the front page of The New York Times of March 8, and to that of Bear Stearns reported on the front page of The New York Times just one week later.

The liquidation of the assets of such lenders, which consisted mainly of prime mortgages, has meant a further fall in the price of prime mortgages, to the point where the credit even of the government-sponsored mortgage lenders Fannie Mae and Freddie Mac has come into question. These two lenders have outstanding mortgage-backed obligations of more than $4 trillion, which sum until recently was assumed also to be an obligation of the US government. Now it has become uncertain whether the actual obligation of the US government extends beyond the less than $5 billion in lines of credit these lenders have with the US Treasury.

The Federal Reserve’s rescue of Bear Stearns can be understood in part in the light of its desire to avoid further declines in the assets and capital of Fannie Mae and Freddie Mac, which would have resulted if Bear had had to sell off its holdings of mortgages. The likelihood that the failure of Bear would have triggered the failure other major Wall Street firms and thereby have resulted in even more massive sell offs of mortgages, along with other assets, was a related important consideration.

Remarkably, at the very same time that the Federal Reserve has been striving to cope with the consequences of excessive leverage and possibly thereby help to prevent the collapse of Fannie Mae and Freddie Mac, the government regulator of these institutions—the Office of Federal Housing Enterprise Oversight—is not content with the fact that they are already skating on dangerously thin ice. Thus, The New York Times of March 20 reports that the regulator has just decided to reduce their capital requirements, for the purpose of enabling them to take on still more leverage. The effect of this will be that an even more modest decline in home prices and mortgage values will be sufficient to drive Fannie Mae and Freddie Mac into bankruptcy than is now the case.

As these examples illustrate, the failure of debtors can serve to wipe out the capital of highly leveraged creditors, who then become unable to pay their debts, perhaps causing the failure of their creditors, and so on. In other words, one failure can set off a domino effect of a chain of failures. What serves to end the process is when someone in the chain finally accumulates enough salvageable assets from those earlier in the chain to be able to satisfy his creditors.

Leverage and Bank Capital

Operating alongside the process of chains of failures is another, even more important aspect of the leverage present in today’s financial system. This is the fact that reductions in the capital of banks can result in multiple contractions of credit. As a rough average, banks are normally required to possess capital equal to five percent of their outstanding loans and investments. (Investments are purchases of securities.) The implication of this is that reductions in banks’ capital below the five percent level have the potential to result in contractions of credit twenty times as large, in efforts to reestablish the five percent ratio.

For example, a bank with an initial capital of $5 billion, could support $100 billion in outstanding loans and investments, based on the requirement that its capital be at least 5 percent of the credit it has granted. But if its capital falls to $4 billion, it must reduce its outstanding loans and investments to $80 billion to be in compliance with that requirement. In other words, a $1 billion reduction in bank capital can cause a $20 billion reduction in outstanding bank credit.

Such announcements as that recently made by Citibank, that it would reduce its holdings of home loans by 20 percent, are entirely consistent with this phenomenon, as are the recent failures of banks and brokers to make bids in markets for so-called auction-rate notes. (These are credit instruments whose interest rates are set periodically on the basis of auctions and that until recently were billed as the equivalent of cash. Bidding for them would have placed banks at risk of acquiring additional assets and indebtedness when they urgently needed to reduce their assets and indebtedness.)

Credit Contraction and Deflation

Of the greatest importance is the further fact that credit contraction by banks has the effect of reducing the outstanding volume of checking deposits in the economic system and to that extent the quantity of money in the economic system. This result follows from the fact that when debtors repay their loans, they do so by means of writing checks, the proceeds of which are subtracted not only from their accounts but also from the balance sheets of the banks on which the checks are drawn. If those banks do not then make equivalent new loans, accompanied by the creation of equivalent fresh checking deposits for new borrowers, the amount of the checking deposits used to repay the loans simply disappears. (The same result occurs when banks sell portions of their securities holdings to members of the public. The buyers of the securities pay for them by means of writing checks, and the proceeds of those checks then disappear not only from the checking accounts of the purchasers but also from the balance sheets of the banks on which the checks are drawn.)

Such contraction of credit and money operates to reduce the amount of spending in the economic system. The money that is no longer present in the economic system, because the credit that would have provided it has disappeared, is money that can no longer be spent. Money no longer spent is business sales revenues no longer earned. A drop in business sales revenues, in turn, causes a drop in spending by the firms that would have earned those sales revenues.

This further drop in spending reduces both the sales revenues of other firms, namely, those that would have supplied the firms in question, and wage payments to workers, as employees are laid off in the face of declining sales. And, of course, as wage payments fall, so too does the spending of wage earners for consumers’ goods. The decline in spending, sales revenues, and wage payments is repeated again and again throughout the economic system, as many times in a year as the vanished sum of money would have been spent and respent in that year.

Of no less importance is the fact that a decline in the quantity of money and volume of spending can itself cause further declines in the assets and capital of banks. This is because as the sales revenues of business firms decline, so too do their profits and their ability to repay debts, including debts to banks. The resulting further declines in the value of bank assets further reduce the capitals of banks, causing more credit contraction, further reductions in the quantity of money and volume of spending, and still more reductions in the asset values and capitals of banks, on and on in a self-reinforcing vicious circle.

Bank Failures and Bank Runs

Historically, processes such as those just described have not taken place smoothly and gradually, in a manner akin to the air slowly leaking from some kind of giant inflated balloon. To the contrary, they have been characterized by sudden massive ruptures in the fabric of the system, namely, by bank failures, often precipitated by bank runs.

Sooner or later, the erosion of its capital makes a bank actually fail. What is meant in saying that bank failures were often precipitated by bank runs is merely that at some point depositors woke up to the fact that a bank’s assets were no longer sufficient to guarantee the repayment of its deposits, and so raced to withdraw their funds while it was still possible to do so.

Bank failures, and even bank runs, are by no means a phenomenon confined to history. Intermittent bank failures continued to occur through the entire 20th century. And the present Chairman of the Federal Reserve System has said that some bank failures are to be expected in our present crisis. Only late last summer there was not only a failure but also an actual run on a major British bank, Northern Rock. If our own credit crisis continues and deepens further, it should not be surprising to start seeing bank runs here in the United States as well. Indeed, what happened to Bear Stearns—which is an investment bank—on March 13 and made it seek the help of the Federal Reserve System was precisely a run, as large numbers of its clients sought to withdraw their funds all at once. It is very possible that what has just happened at Bear Stearns will also happen at one or more major commercial banks, whose customers hold checking or savings accounts. (In this connection, it should be kept in mind that federal deposit insurance is limited to a maximum of $100,000 per account. The run would be on the part of those whose accounts are larger than $100,000.)

When a bank fails, unless it is immediately taken over by another, still solvent bank, its outstanding checking deposits lose the character of money and assume that of a security in default. That is, instead of being able to be spent, as the virtual equivalent of currency, they are reduced to the status of a claim to an uncertain sum of money to be paid at an unspecified time in the future, i.e., after the assets of the bank have been liquidated and the proceeds distributed to the various parties judged to have legitimate claims to them. Thus, what had been spendable as the equivalent of currency suddenly becomes no more spendable than any other security in default.

This change in the status of a bank’s checking deposits constitutes a fully equivalent reduction in the quantity of money in the economic system. Thus, for example, if a bank were to fail with outstanding checking deposits of $100 billion, say, and not be taken over immediately by another, still-solvent bank, the quantity of money in the economic system would also immediately fall by $100 billion.

As a result of this fact, bank failures have the potential greatly to accelerate and deepen the descent into deflation and economic depression. For they represent much larger, more sudden reductions in the quantity of money and volume of spending in the economic system. And, just like lesser reductions, their effect, unless somehow checked or counteracted, is to launch a vicious circle of contraction and deflation. The period 1929-1933 provides the leading historical example.

In 1929, the quantity of money in the United States was approximately $26 billion and the gross national product (GNP/GDP) of the country, which provides an approximate measure of consumer spending, was $103 billion. By 1933, following wave after wave of bank failures, the quantity of money had fallen to approximately $19 billion and the GNP to less than $56 billion. The failure of wage rates and prices to fall to anywhere near the same extent resulted in mass unemployment.

The Potential for Deflation Today

In order to understand the potential for deflation today, in 1929, or at any other time, it is necessary to understand the concepts “standard money” and “fiduciary media.” Standard money is money that is not a claim to anything beyond itself. It is money the receipt of which constitutes final payment. Under a gold standard, standard money is gold coin or bullion. Paper currency under a gold standard is not standard money. It is merely a claim to standard money, i.e., gold.

Since 1933, paper currency in the United States has been irredeemable. It has ceased to be a claim to anything beyond itself. Its receipt constitutes final payment. Thus, since 1933, the standard money of the United States has been irredeemable paper currency.

Most of the money supply of the United States, today as in 1929, is not standard money of any kind, but rather fiduciary media. Fiduciary media are transferable claims to standard money, payable on demand by their issuers, accepted in commerce as the equivalent of standard money, but for which no standard money actually exists.

What precisely fits the description of fiduciary media are checking deposits insofar as they exceed the reserves of standard money held by the banks that issue them. Checking deposits are, first of all, transferable claims to standard money, payable on demand by the banks that issue them, and accepted in commerce as the equivalent of standard money. To the extent that they exceed the currency reserves owned by the banks that issue them, they are fiduciary media.

At the present time, there are approximately $2.5 trillion of checking deposits in one form or another. These checking deposits are those reported as part of the M1 money supply ($625 billion), plus those reported as so-called sweep accounts by the Federal Reserve Bank of St. Louis ($765 billion),
[2] and those reported as retail money fund accounts ($1078 billion).[3]

In addition to these checking deposits, our present money supply consists of approximately $800 billion in currency outside the banking system. Our total money supply is thus currently $3.3 trillion. Of these $3.3 trillion, the quantity of standard money is approximately $840 billion: the currency outside the banks plus $40 billion of currency reserves of the banking system.

There are no reserve requirements on either sweep accounts or retail money fund accounts. Supposedly there is a basic 10 percent reserve requirement against the checking deposits counted under M1. Nevertheless, the actual reserves held against these checking deposits are not $62 or $63 billion, but merely on the order of $40 billion, which implies an overall effective reserve requirement of less than 7 percent against these checking deposits. When compared to the total checking deposits of the economic system, the roughly $40 billion of reserves constitute a reserve on the order of less than 2 percent. This is the measure of the leverage of today’s banking system with respect to reserves.

In an ongoing process of a vicious circle of bank failures, a falling quantity of money and volume of spending, and thus falling business sales revenues, mounting business losses and business failures, resulting in still more bank failures, the volume of checking deposits might ultimately be reduced all the way down to the system’s $40 billion of standard money reserves. This last is the actual currency either in the possession of the banks or belonging to them while held by the Federal Reserve System. This currency is the only asset of the banks whose value cannot be reduced by the failure of debtors.

The potential deflation of checking deposits, if nothing were done to stop it, is the difference between their present amount of $2.5 trillion and the $40 billion of reserves that stand behind them. The potential deflation of the money supply as a whole, if nothing were done to stop it, is the difference between $3.3 trillion and $840 billion, i.e., approximately 75 percent.

Why Massive Deflation Must Be Prevented

Massive deflation is always something that should be avoided if it is humanly possible to do so. The surest and best way to avoid it is to avoid the prolonged credit expansions that set the stage for it.

The only way that the economic system can adjust to deflation once it has occurred is by means of corresponding reductions in wage rates and prices. These serve to increase the buying power of the reduced quantity of money and the reduced volume of spending that it supports. If they were sufficient, they would enable the reduced quantity of money and volume of spending to buy all that the previously larger quantity of money and volume of spending had bought.

Yet there are powerful obstacles in the way of wage rates and prices falling. Not the least of these is the prevailing belief that rather than it being the reduction in the quantity of money and volume of spending that is deflation, it is the fall in wages rates and prices that is deflation. This incredible confusion leads to misguided attempts to combat deflation by means of preventing the only thing that would make possible a recovery from deflation, namely, a fall in wage rates and prices.

This confusion is joined by the even more influential errors of the Marxian exploitation theory, which claims that employers would arbitrarily set wage rates at the level of minimum subsistence if not prevented from doing so by government intervention. The result of this stew of ignorance is the existence of laws such as pro-union and minimum-wage legislation, which make it extraordinarily difficult or plain impossible for wage rates to fall. These laws are tantamount to simply making it illegal for the process of recovery to proceed.

To these laws must be added the virtual paralysis of our present-day judicial system. Not only do convicted murderers often sit on death row for years or even decades before their sentences are carried out or finally set aside, but ordinary law suits now normally take years to wind their way through our court system. A leading consequence of a massive deflation would be millions upon millions of business and personal bankruptcies, which our court system is simply not equipped to handle. The functioning of an economic system depends on clear knowledge of who owns what and who has the legal right to do what with what property. It cannot wait years for judges to make clear and final decisions about such matters, which is the likely period of time it would take them if the present typical performance of our judicial system is any guide.

Given these legal obstacles, the effect of massive deflation would be long-term mass unemployment and economic paralysis. Literally tens of millions would be unemployed, with no way to find new employment. Such conditions, in combination with the massive economic illiteracy that prevails in our culture, would likely result in the adoption of many new and additional acts of destructive government interference. It would not by any means be out of the question that the likes of a native-born Hugo Chavez could be elected president of the United States.

True and False Remedies

It should be obvious from much of what has been said in this article that what is driving our impending deflation is the lack of capital on the part of the banks, resulting from the losses they have thus far sustained on their assets. This is what has been impelling them to contract credit, and which, if unchecked will serve to reduce their assets and capital further and further, until much or all of the banking system and the checking deposit money it has created collapses under its own weight for a sheer lack of monetary reserves.

In the light of this knowledge, such solutions as the recently enacted “stimulus package” designed to promote consumer spending should be dismissed as laughably naive. The economic system is not going to be rescued by consumers, let alone by consumers so incapable of producing that they require government handouts in order to consume. No one benefits by giving people the money with which to buy his products. Yet this is the position such programs force taxpayers to assume.

Likewise, when one keeps in mind that the problem is a lack of capital, such alleged solutions as the Federal Reserve’s current policy of reducing interest rates must appear as clearly counterproductive. Reductions in interest rates in the United States relative to those in Europe and elsewhere serve to keep badly needed capital out of our country by making investment there more profitable than investment here. In keeping down the overall supply of capital in the United States, they contribute to the lack of credit and to making it more difficult for banks to obtain the additional capital they need. The Federal Reserve has carried this policy a large step further, with its most recent reduction in the Federal Funds rate from 3 percent to 2.25 percent.

Similarly, the rescue measure proposed for homeowners faced with foreclosure, namely, forcibly reducing interest rates on sub prime mortgages in violation of the contractual terms of the mortgages and against the will of the mortgage holders, would serve further to reduce the earnings, assets, and capital of the banks. Decisions of judges to place obstacles in the way of the foreclosure process, such as insisting on the presentation of the original mortgage documents, even though it is undisputed that the borrower is in default, also serve to weaken the financial position of banks. It can do so not only directly but also indirectly, by contributing to the bankruptcy of non-bank mortgage lenders with debts to banks.

The sympathy expressed for the families threatened with foreclosure is very largely misplaced. It is forgotten how many of them purchased their homes without making any down payment of any kind, and often without being obliged to make any payments of principal on their mortgages. Many of the homes now being foreclosed were purchased by such buyers not for the purpose of having a place to live, but for the purpose of profiting from a speculative investment.

Of course, there are also some homeowners who did make substantial down payments in purchasing their homes, even during the housing bubble. But there are many more who purchased their homes before the bubble began but who in recent years foolishly chose to consume their equity, by incurring additional debt to finance consumption in excess of their incomes. At the time, these people were lauded as pillars of the economy’s strength, on the basis of the same ridiculous beliefs that underlie the proposals to rescue the economy now by still more consumption on the part of people who can’t afford it.

The effect of the years of Federal-Reserve-sponsored credit expansion and the resulting spending binge on housing that people could not afford was to make housing unaffordable by millions of other people. It was to raise median house prices in many places to the point where only the top 15 or 20 percent of income earners in the area could afford the median priced home. To make housing affordable once again by the mass of people who normally could afford to buy a home, housing prices need to fall to whatever extent their rise in recent years has exceeded the rise in median family incomes. The foreclosure process is an essential step in bringing that about. It should not be prevented in any way from taking place.

How to Increase the Capital and Reserves of the Banking System

Since the problem behind our impending deflation is the lack of capital on the part of the banks, and beyond that the lack of monetary reserves to maintain the supply of checkbook money when banks fail, it should be obvious that what is needed to avoid the threat of deflation is an increase in the capital and reserves of the banks.

When the problem is stated this way, a thought that is likely to occur to many people is that the banks should simply go out and raise additional capital. They should sell stocks and bonds, for example. And, in fact, that has actually happened in some cases, for example, that of Citibank, which raised $14.5 billion in new capital from foreign investors this last February.

One problem with such a procedure is how much of the bank’s ownership has to be given to the new investors to make their investment worthwhile for them. And, as indicated, raising the necessary capital is made more difficult by Fed’s policy of low interest rates, which keeps down the supply of capital by discouraging foreign investment in the United States. Another, deeper problem for many banks is that in the minds of potential investors the bank’s actual capital may be negative, requiring investors to put up not only new and additional capital but also capital required to overcome the bank’s negative capital. (Negative capital can easily result when on the left-hand side of a bank’s balance sheet there are tens or hundreds of billions of dollars of assets whose value can decline, while on the right-hand side there are tens or hundreds of billions of dollars of deposits whose value is fixed. As we saw earlier, when capital is only a very few percent of assets to begin with, even a modest decline in the value of assets can turn it negative.)

The existence of negative capital entails requiring first an investment sufficient to reach the point of zero capital. And only then the investment of the capital that will enable the bank to maintain and increase its operations. Moreover, the extent of the capital deficiency may not even actually be knowable. Such considerations make the raising of additional capital by conventional means extremely difficult or altogether impossible. It’s a case simply of having to invest too much in order to receive too little.

In these circumstances the only party willing to provide the needed capital funds is the government, i.e., the Federal Reserve System, which has the power simply to print them if necessary.

At present, the Federal Reserve is already supplying the banking system (and the major investment banks as well) with capital. But it is doing so only to the extent of overcoming negative capital, and perhaps doing that less than fully. This is the essential meaning of the Fed’s acceptance of billions of dollars of assets of dubious value in exchange for its own assets of relatively secure value, i.e., US government bonds and Treasury bills. (The Fed now even accepts assets for which there is no market because finding a market would require a radical reduction in the price of the assets compared to what was originally paid for them, and correspondingly wipe out capital on the books of the banks.)

The Fed has committed almost half of its own principal assets to this project: $400 billion out of its most recently reported total holdings of government securities of $828 billion. It will not be able to commit much more of those securities. Indeed, however ironic it may be, the Federal Reserve—the “lender of last resort,” the alleged bailer-outer of the banking system and of the whole economy—is or may fairly soon be itself technically bankrupt as the result of this operation. (This would be clear if the assets it receives had to be valued at their actual market value. The result would be that the assets of the Fed would be less than the face value of its outstanding US currency and other liabilities.)

Unless the Fed’s actions up to now prove sufficient to end the financial crisis, its next step will be the printing of money to prop up the banking system. Indeed, even if the crisis were to end as of now, there would still be the problem that the Fed’s infusion of capital has thus far been only on a temporary basis. The banks are supposed to take back their low-grade and non-performing assets within a month or so and return the Fed’s securities. Clearly, a solution to the problem of a lack of bank capital needs to be long-term, not something that must be renewed month by month.

Moreover, a proper solution to our present crisis should do more than merely overcome the difficulties of the moment. It should, in addition, provide a guarantee against the recurrence of such crises in the future. Above all, a proper solution to this or any other economic or political crisis should also meet the criterion of serving to advance the cause of economic freedom and should be designed with that objective in mind.

There is a means of accomplishing all three of these objectives.

That means is the use of gold as a major asset of the banking system.

Despite the certainty that a proposal of this kind will be almost completely ignored and has virtually no chance of being enacted in the foreseeable future, it still must be made. This is because the most fundamental and important consideration is not what people are willing to accept or reject at the moment but what would in fact accomplish the objectives that need to be accomplished. Using gold as a major asset of the banking system, in the way set forth below, would in fact safeguard the banking system from possible deflationary collapse, prevent the recurrence of any such threat, and do so in a way that substantially advanced the cause of economic freedom. Making the proposal is necessary in order to uphold the philosophy of economic freedom, by providing a demonstration that that philosophy offers the solution to the growing monetary problems we face and is not their cause.

Gold as the Source of New Bank Capital and Reserves

The Federal Reserve System holds approximately 260 million ounces of gold. The market price of gold recently reached $1,000 per ounce. This means that the Fed’s gold can easily be thought of as an asset with a market value of roughly $260 billion.

As an initial approach to understanding the solution to our problem, let us assume that the Federal Reserve declared its gold holding as being held in trust for the benefit of the American banking system, and proceeded to allow every bank to enter on the asset side of its balance sheet a portion of this gold corresponding to its share of the total of the $2.5 trillion of checking accounts presently in the economic system. The banks would not physically possess the gold but only book entries corresponding to it.

The gold entered on banks’ balance sheets could also count as equivalent new and additional bank reserves. Thus the measure would simultaneously add $260 billion of new and additional bank reserves in the form of gold as well as $260 billion of new and additional bank capital. The reserves and the capital would both be essentially permanent.

In order to prevent the monetization of the gold reserves, the Fed could mandate a permanent required gold reserve against all checking deposits—those counted in M1, those counted as “sweeps,” and those counted as retail money funds—in the ratio of $260 billion to $2.5 trillion, i.e., a little over 10 percent.

A major shortcoming of this very simple solution is that the addition of $260 billion in gold to bank assets would probably be insufficient. It almost certainly would be if the Fed decided, as it should, to take back its government securities from the investment banks and give them back their securities of far less value. That would probably bankrupt most or all of the investment banks. Furthermore, because the commercial banks are their main creditors, the assets of the investment banks would move into the possession of the commercial banks and do so, of course, at a far lower value than the loans that had been made to the investment banks. Thus, the present capital of the commercial banks and much more would be wiped out.

Accordingly, the book value placed on the Fed’s gold holding needs to be substantially higher than $1,000 per ounce, if it is to result in the creation of sufficient bank capital and reserves. The question is, how much higher?

The most logical answer to this question was supplied as far back as the 1950s by the late Murray Rothbard, who argued for the establishment of a 100-percent-reserve gold standard by means of pricing the Fed’s gold stock at whatever price was necessary to make it equal the outstanding supply of money.

Taking the outstanding supply of money today as being $3.3 trillion, Rothbard’s proposal implies a gold price of approximately $12,700 per ounce. At such a price, the Fed’s gold stock would be sufficient to provide a 100 percent reserve against both all US checking deposits and all US currency.

The provision of a 100 percent reserve would be an immediate guarantee against any reduction in the supply of checkbook money. This would obviously be the case if the banks simply paid out gold in response to customers’ demands for the redemption of their checking deposits. At $12,700 per ounce, the banks and the Fed would have enough gold to redeem every single dollar of checking deposits and currency in the economic system. (That’s the meaning of a 100 percent reserve.)

Of course, in the circumstances envisioned here, the banks would not pay out physical gold. But they would have the ability to pay out paper currency to the full extent of outstanding checking deposits, and that currency would have an undiminished gold backing at the price of gold of $12,700 per ounce. Thus whatever the recession that might develop in the months ahead, it would be contained, insofar as the money supply of the country would not be reduced. That would guarantee a major reduction in the possible severity of what might otherwise develop.

This 100-percent-reserve gold standard as thus far described would obviously be a long way from the full-bodied 100-percent-reserve gold standard that Rothbard envisioned, and which I myself have elaborated upon and advocated. It would be a standard that for some time was largely just nominal, in that the actual gold of the of monetary system would still be in the possession of the Federal Reserve System. Nor would there yet be any obligation of the Fed to buy or sell gold at the price of $12,700 per ounce or at any other price. The purpose of the system I have described would simply be the twofold one of providing reserves sufficient to prevent any possible reduction in the supply of checkbook money and also of providing capital to banks sufficient to substantially more than offset the losses otherwise resulting from a decline in the value of banks’ assets.

Indeed, given that what would be present is an addition to the assets of the banking system in an amount equal to the full magnitude of outstanding fiduciary media, i.e., of $2.5 trillion of checking deposits minus $40 billion of presently existing standard money reserves, the overwhelming likelihood is that the banks would be handed far too much capital. Even with losses of $1 trillion on their existing assets, they would still stand to gain practically $1.5 trillion in new and additional capital. Such a bonanza would not be justifiable. The solution would be to pass most of it on to the banks’ depositors in the form of bank stock or bonds paid as a dividend on their accounts.

It is not possible in the space of one article to explore, beyond the very limited extent to which I’ve done so,
[6] the problems and the solutions entailed in moving on to the full-bodied 100-percent-reserve gold standard that is the ultimate objective of my proposal. Under such a gold standard, paper currency and checking deposits will, of course, be fully convertible into gold, physical gold coin will enjoy wide circulation, and the supply of gold in the country will be free to increase or decrease simply in response to market forces.

All I have tried to show here is how the twin problems of a lack of bank capital and of bank reserves, which are the core of the threat of deflation, could be solved by means of establishing the framework of a 100-percent-reserve gold monetary system.

Needless to say, such a system would not only end the threat of deflation, but, equally important, it could end the threat of inflation as well. For if it were actually followed, the increase in the quantity of money would be limited to the increase in the supply of gold, which is extremely modest compared with increases in the supply of irredeemable paper money. This is because gold is rare in nature and costly to extract. Irredeemable paper money in contrast is virtually costless to produce and is potentially as abundant as the supply of currency-sized sheets of paper, indeed, as abundant as the size of the largest number that can be printed on all such sheets of paper.

Above all, the solution I have proposed would constitute a major step toward the establishment of a full-bodied precious metal monetary system and thus toward ultimately eliminating the government’s physical control over the money supply and all of the violations of individual freedom that that control represents and makes possible.

And what is more, it could be accomplished at a cost to the Federal Reserve not of hundreds of billions of dollars—the sums the Fed is risking in exchanging its government securities for bank assets of vastly lower value—not for the $30 billion it has risked to bail out just Bear Stearns, but for a little more than $11 billion! Just $11 billion is the value at which the Fed carries its gold stock on its balance sheet, at a price of gold of approximately $42 per ounce.

Thus, to say it all in one sentence, the threat of massive deflation can be eliminated, the threat of inflation ended, and the actual and potential domain of economic freedom greatly expanded, for $11 billion—an $11 billion that would not even be an out-of-pocket expense to anyone but merely a balance-sheet charge on the books of the Federal Reserve System when it deducted its gold holding from its balance sheet and added it to the balance sheets of the banks.


[1] I am indebted to Prof. William Barnett, II, of Loyola University, New Orleans. His recent internet postings on the mises@yahoogroups list made me aware of the fact that the capital requirements of banks under the Basel II Capital Accord, rather than official reserve requirements imposed by the Federal Reserve System, is all that has served to constrain the increase in the quantity of money in the United States in recent years. His comments also served to provide important insight into understanding the role of banks’ capital requirements in explaining essential aspects of their recent behavior as well as their likely behavior in the weeks and months ahead.

[2] Sweep accounts are checking deposits that banks transfer into savings deposit accounts overnight, on weekends, and on holidays, in order to reduce their required reserves and thus be able to use any given amount of reserves to support a larger volume of checking deposits.

[3] Inasmuch as the accounts subsumed under this last head generally allow the writing only of a limited number of checks per month, and sometimes impose limits on the minimum dollar amount of the checks that may be written, they probably should not be counted as part of the money supply to their full extent. To precisely what extent they should be counted is an open question. Nevertheless, it may be that counting them to their full extent represents a lesser error than attempting to adjust them downward. This is because doing so makes allowance for the extent to which roughly $2.1 trillion of institutional money funds may also actually serve as money.

[4] The $800 billion of currency outside the banks is counted as part of the M1 money supply along with the checking deposit component of $625 billion previously referred to. Thus, at present, M1 is approximately $1.4 trillion.

[5] It should be realized that in the absence of any commitment of the Fed to buy gold at $12,700 per ounce, the market price of gold would almost certainly be radically lower. To the extent that additional gold could be purchased at lower prices, the possibility would exist of increasing gold reserves relative to outstanding checking deposits and currency and thus of ultimately having a 100-percent reserve at a price of gold less than $12,700 per ounce. Furthermore, it should be kept in mind that the Fed would need to proceed with great caution in purchasing additional gold. The danger to be avoided is that of initially drawing a disproportionate share of the world’s gold to the United States, when it alone was in process of remonetizing gold. If the US economy became accustomed to such a large gold supply, and then, later on, if and when the rest of the world remonetized gold and drew much of that gold back out, the US would be in the position of experiencing first a virtual inflation in terms of gold and then a virtual deflation in terms of gold, the very kind of sequence of phenomena that a properly established 100-percent-reserve gold standard would permanently prevent.

[6] See above, the preceding note.

Copyright © 2008, 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. His web site is and his blog is

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