Financial Crisis and Economic Recession. Banking Reform and the Future of Capitalism

[20.10.2009, Jesús Huerta de Soto, CONSERVATIVE LETTERS]

Conservative Letters

I will concentrate on the financial crisis and the current economic recession as one of the most challenging problems we must now cope with. Having witnessed the defeat of socialism, in my opinion one of the main challenges that still remains for the future of Capitalism is the need to privatize money by dismantling the Organ of Central monetary planning: the Central Bank.

The whole financial system is based on the legal privilege given by the state to private bankers to act with a fractional reserve ratio in relation with the demand deposits they receive from their clients. As a result of it, private bankers are not true financial intermediaries, but are mainly creators of deposits materializing in credit expansions. These credit expansions are artificial and do not correspond to any previous increases in the voluntary savings of the citizens. In this way the current fractional reserve banking system, tends to worsen and amplify the systemic intertemporal distortions and investment misallocations that the macroeconomic planners working for central banks induce in the production structure of the whole real economy. These distortions manifest themselves in the stages of financial bubbles, economic boom, overall malinvestment and afterwards in the stages of financial crisis, deep economic recession and unemployment.

Similarly, the expansionary cycle which has now come to a close was unbacked by a parallel increase in voluntary household saving. For many years, the money supply in the form of banknotes and deposits has grown at an average rate of over 10 % per year. The media of exchange originating from this severe fiduciary inflation have been placed on the market by the banking system as newly-created loans granted at extremely low interest rates. The above fueled a speculative bubble in the shape of a substantial rise in the prices of capital goods, real estate assets, and the securities which represent them and are exchanged on the stock market, where indexes soared.

Today there is no doubt about the recessionary quality the monetary shock always has in the long run: newly-created loans (of money citizens have not first saved) immediately provide entrepreneurs with purchasing power they use in overly ambitious investment projects. Entrepreneurs act as if citizens had increased their saving, when they have not actually done so. Widespread discoordination in the economic system results: the financial bubble exerts a harmful effect on the real economy, and the process reverses in the form of an economic recession, which marks the beginning of the painful and necessary readjustment. This readjustment invariably requires the reconversion of the entire real productive structure, which inflation has distorted.

The most rigorous economic analysis of recent economic and financial events lead inexorably to the conclusion that central banks cannot possibly succeed in finding the most advantageous monetary policy at every moment. Moreover, nothing is more dangerous than to indulge in the “fatal conceit” – to use Hayek’s useful expression – of believing oneself omniscient or at least wise and powerful enough to be able to keep the most suitable monetary policy fine tuned at all times. Hence, rather than soften the most violent ups and downs of the economic cycle, the Fed and, to a lesser extent, the ECB, have most likely been their main architects and the culprits in their worsening. Central banks can either allow the recessionary process to follow its path, and with it the healthy and painful readjustment, or they can escape forward toward a “renewed inflationist” cure. With the latter, the chances of even more severe recession (even inflationary recession) in the not-too-distant future increase exponentially.

The most appropriate policy would be to liberalize the economy at all levels to permit the rapid reallocation of productive factors (particularly labor) to profitable sectors. Likewise, it is essential to reduce public spending and taxes, in order to increase the available income of heavily-indebted economic agents who need to repay their loans as soon as possible. Economic agents can only rehabilitate their finances by cutting costs (especially labor costs) and paying off loans. Essential to this aim are a very flexible labor market and a much more austere public sector.

Systemic changes of accounting rules are needed too. We must not forget that a central feature of the recent period of artificial expansion was a gradual corruption, on the American continent as well as in Europe, of the traditional principles of accounting as practiced globally for centuries. To be specific, acceptance of the international accounting standards (IAS/IFRS) and their incorporation into law in most countries have meant the abandonment of the traditional principle of prudence and its replacement by the principle of fair value in the assessment of the value of balance sheet assets, particularly financial assets.

We see that new accounting rules act in a pro-cyclic manner by heightening volatility and erroneously biasing business management: in times of prosperity, they create a false “wealth effect” which prompts people to take disproportionate risks; when, from one day to the next, the errors committed come to light, the loss in the value of assets immediately decapitalizes companies, which are obliged to sell assets and attempt to recapitalize at the worst moment, when assets are worth the least and financial markets dry up.

Accounting principles which have proven so disturbing must be abandoned as soon as possible, and all of the accounting reforms recently enacted, must be reversed. I must emphasize that the purpose of accounting is not to reflect supposed “real” values under the pretext of attaining a “accounting transparency”, but to permit the prudent management of each company and to prevent capital consumption . This requires the application of strict standards of accounting conservatism (based on the prudence principle and the recording of either historical cost or market value, whichever is less).

If we want to get rid of real socialism in the monetary and credit sector, I mean get rid of central banks, and if we want to create a truly free and stable financial and monetary system in this new 21st century, it will be necessary to take three steps: 1) the reestablishment of a 100-percent reserve requirement on all bank demand deposits and equivalents; 2) the elimination of central banks as lenders of last resort (which will be unnecessary if the preceding principle is applied, and harmful if they continue to act as financial central-planning agencies); and 3) the privatization of the current, monopolistic, and fiduciary state-issued money and its replacement with a classic gold standard.

Jesús Huerta de Soto is Professor of Political Economy at the King Juan Carlos University of Madrid.

Article is an abstract of the lecture presented at the Conservative Economic Quarterly Lecture Series (CEQLS) held by the Conservative Institute of M. R. ©tefánik in Bratislava on September 28, 2009.

The lecture is available also as a video here.

Article was published in Slovak language in Conservative Letters 09/2009, a newsletter of the Conservative Institute.