Well good afternoon ladies and gentlemen. As you all know, we are in a severe economic downturn, an advance over recession.
The official unemployment rate now exceeds 10% 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.
The important retailers such as CompUSA, Circuit City, Mervins and Linnens and 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 the majority
There has already been 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 as recently
as July of 2008, bank reserves were on the order of just 45 billion, that's total bank
Reserves, and excess reserves were less than $2 billion. Those $45 billion of reserves,
back in 2008, 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, insofar as checks
This 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%. Today, of the 1.1
trillion plus total of reserves, all but approximately 62 billion of required reserves are excess
reserves. As of the week of November 4th, 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
were sufficient, not so long ago, to support six 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.
The title of my talk, of course, is A Profit 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 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
is 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 any longer accept it.
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
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
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 of checking deposits of one kind or another.
The customers can continue to spend these 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 money he owns by any more than if he had
exchanged $1,000 in $100 bills for $1,000 in $50 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 possesses $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 of thin air. This is the nature and meaning
of credit expansion. Now, nothing of substance has 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 reserves. 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
Banking, 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
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 home ownership, lower
mortgage interest rates greatly encourage buying houses. This artificially increased
demand for houses, made possible by credit expansion, soon began to raise the price of
houses. And as the new and additional money kept pouring into the housing market, home
Home prices continue 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. That is, only by a relatively few percent of families. In the middle of
In 2004, the Federal Reserve became alarmed about the situation and its implication for
rising prices in general, and over the next two years, progressively increased its federal
funds interest rate from 1% to 5.25%. This rise in the federal funds rate signified a
reduction in the flow of new and additional excess reserves into the banking system, and
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
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 and the lending, investment spending, employment and consumer spending
that depended 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
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
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,
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
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 from our economic downturn can be understood only in the light of knowledge
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
For 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
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 the process of undoing some of the major
The most important single step, I believe, on the road to economic recovery is the establishment
of a 100% reserve system against checking deposits. Ideally, the 100% reserve would
be in gold, and that's ultimately what we should aim at, for all of the reasons Rothbard
explained. But even a 100% reserve in paper would do the job of totally preventing all
future credit expansion, and equally important, all declines in the money supply. Because
Because the 100% 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% reserve system in terms of paper, the government
would simply print up enough additional paper currency so that when added to the paper currency
In the 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 kind of denomination
of Currency. To illustrate the process of achieving a 100% 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
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.
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 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% reserve principle were breached, which of course would
be a serious danger. Under a 100% reserve, checking depositors could simultaneously all
demand their full balances in cash and the banks would be able to pay them all. Depositors'
Bankers' 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
There would 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 addition, a significant byproduct of a 100% reserve system would be that the FDIC
Now, an essential prerequisite of the 100% reserve is knowing the size of checking deposits,
so that it will be known how much the 100% 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 to which the 100% reserve would apply can plausibly be
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 investment.
In the first case, their funds would be in a checking account, against which the bank would have to hold a 100% 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% reserve would be ultimately
to convert it to a 100% gold reserve system. At that time, following ideas of Rothbard,
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
and the banks in exchange for all the outstanding Federal Reserve money.
The Fed would then be abolished, but this is clearly a very distinct and much later step
in a pro-free market reform.
Now it should be realized that a major consequence of the establishment of a 100% reserve system
could be a corresponding enlargement of the capital of the banking system and thus an
ability to cover even the very greatest losses and thereby avoid such things as government
bank bailouts and takeovers.
Consider the balance sheet of an imaginary nano-bank, we can call it, because it'll
be so small.
It's got checking deposits of $100. That's its main liability. Initially, it has assets
of $105, which implies that on the liability 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 bank's assets, in the part of its assets consisting
Banking 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% equality with
with its checking deposits, the bank's total, 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 liability 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, 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 three trillion, the Fed would give the banks additional
reserves that when added to their existing reserves would bring them up to three trillion.
If this had been done in September of 2008, bringing reserves up to three trillion would
would have required adding 2.955 trillion of new and additional reserves to the 45 billion
or so of reserves that the banks already had.
This vast addition on the asset side of the bank's balance sheets would have implied an
equivalent addition to the bank's capital on the liability side.
No matter how bad the bank's assets were, I think it virtually certain that an additional
sum of this size would have been far more than sufficient to cover all of the losses
The Federal Reserve has already supplied a vast amount of reserves, about 1.1 trillion, to the banks, through various programs,
to the extent that 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,
to the banks through various programs such as purchasing bad assets, mainly mortgages.
If the 100% reserve principle were adopted now, many or most of those assets could be
taken back and the programs that created them cancelled.
What I've shown here is how transitioning to a 100% 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 sound footing.
Now 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
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 bank's depositors
as well as to the banks.
Of course, a 100% 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% paper reserve 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
In any event, it would be an essential prerequisite for someday achieving gold reserves sufficient
to make possible the establishment of a 100% 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. Along with stabilizing the financial system through the adoption
of a 100% 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,
Today, that there is 10% unemployment, with only nine workers working for every ten who
are able and willing to work. The same total expenditure of money that today employs only
nine workers would be able to employ ten workers if the average wage per worker were 10% less.
At nine-tenths the wage, the same total amount of wages is sufficient to employ ten-ninths
What's the number of workers? It's a question of simple arithmetic. One divided by nine-tenths
equals ten-ninths. Now, obviously, this is an overall average result. In reality, some
wage rates would need to fall by less than ten percent and others by more than ten 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
It would increase, total wage payments would increase. This is because prior to their fall,
prior to the fall in wage rates, 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
Business 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 illegal for them to fall and which
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 the free market in labor is the total refutation of the Exploitation Theory
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% paper
money reserve system applied to checking deposits accompanied by a demonstrable commitment to
ultimately achieving a 100% gold reserve.
The 100% reserve in paper would put an end to all further credit expansion and at the
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 reserves. This will
require a 100% reserve gold 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.