Re: A Creditors' Protection Bill: The Legitimacy of Inserting a Gold Clause in Existing Contracts

My recent article "A Creditors' Protection Bill" has been criticized because of its call for the insertion of a partial gold clause into existing contracts, with or without the consent of debtors. The criticism is that this would be an interference with the freedom of contract.

This claim is made on the grounds that the parties may have contracted precisely on the basis of the government's having arbitrary power over the purchasing power of the monetary unit and one of them (the debtor) may want it to continue. In the words of one critic, "Lots of people contracted with the intention of taking advantage of inflation, and the counter parties are responsible for evaluating their own risk. Changing the rules of the game is cheating someone."

This criticism, which appears to be the assertion of some sort of divine right to the continuation of inflation, is based on a failure to understand what the actual rules of the game are today. Superficially, the rule is that contracts are payable in fixed sums of dollars, the purchasing power of which the government steadily depreciates through the use of its power to increase the money supply.

More fundamentally, however, the actual rule of the game today is that the purchasing power of what is paid and received in the fulfillment of contracts is determined by the government. This wider, more fundamental and abstract rule of the game remains unchanged when the government inserts a gold clause into existing contracts. And it was this rule which the parties implicitly accepted when they signed contracts in a world in which the government determines the purchasing power of money.

What the insertion of gold clauses into existing contracts signifies is the use of government power to determine the purchasing power of what is paid and received in the fulfillment of contracts in a way that diminishes the further such use of its power. Henceforth its power of money creation will not serve to enrich debtors at the expense of creditors, or at least not to the same extent. Creditors will have a measure of protection from the exercise of the government's power. The case is analogous to the government using its power to enact and maintain a Bill of Rights.

Furthermore, the fact is that no creditor has ever entered into a contract payable in a fixed sum of paper money in anticipation of the purchasing power of that money so radically declining that what he will receive is likely to be of substantially less purchasing power than what he lent. If that were the anticipation, credit markets would soon cease to exist in that money.

The existence of credit presupposes a monetary unit whose future purchasing power can be more or less be reliably estimated. When the government accelerates inflation even to the level seen in the United States in the 1970s, credit markets break down, as witness the virtual disappearance of long-term fixed rate mortgages in 1979, after a few rounds or prices rising more rapidly than could be compensated for by inflation premiums in interest rates. The market was beginning to form the idea that no inflation premium would be sufficient, because, however high, inflation could soon be even more rapid.

The implication of this is that once inflation becomes more than modest, it necessarily violates creditors' rational understanding of the terms of the contracts into which they entered. It thus represents a defrauding of creditors and therefore a violation of their freedom of contract. Stopping that process is not a violation of the freedom of contract but an attempt to uphold it.

I find it the very height of gall for anyone to believe that his freedom is any way violated because he is deprived of such opportunities as being able to pay the proceeds of a life insurance policy with less purchasing power than is required to pay for the postage stamp needed to mail said proceeds. (This is an example out of the German inflation of 1923.) If he borrowed money in this kind of expectation, then he deserves to be disappointed. His freedom is certainly not violated because he his prevented from fulfilling it. To the contrary, the freedom of those whose wealth an unrestrained policy of inflation would have brought him is given a measure of protection.

Postscript: It may be objected that the insertion of any kind of gold clause into existing contracts would serve to protect the rights of creditors only by means of shifting the violation of rights to debtors, who, in some cases at least, might be obliged to suffer unanticipated real and substantial additional burdens of debt. This objection falls if it is held in mind that the proposal I made was for the introduction only of a partial gold clause. The example I used, purely for the sake of illustration, was a 25 percent gold clause that at a price of gold of $1,000 per ounce would impose a contingent gold debt of 250 ounces on the borrower of $1,000,000. Such a gold clause would not increase the number of dollars actually owed unless and until the price of gold reached $4,000 per ounce. Twenty-five percent may be too high a percentage. Ten percent might be a better number. In that case, starting at $1,000 per ounce, the price of gold would have to reach $10,000 per ounce before the number of dollars owed by any debtor actually increased.

Such an arrangement would give debtors ample time to join with creditors in opposing increases in the quantity of paper money of such magnitude as to drive the price of gold beyond $10,000 within the life of existing contracts. It would serve simply to remove debtors from the category of a vulture-like pressure group seeking to feast on every last scrap of meat left on the financial bones of creditors. Hopefully, it would gradually serve to make debtors join with creditors in demanding an end to inflation, which would then be perceived as harmful to both groups instead of to just one.

This article is copyright © 2007, by George Reisman. George Reisman is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor Emeritus of Economics. His web site is http://www.capitalism.net/.

A Creditor’s Protection Bill

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Credit Expansion, Economic Inequality, and Stagnant Wages

Capital in the form of credit is normally and, certainly, properly, extended out of previously accumulated savings. In sharpest contrast, credit expansion is the creation of new and additional money out of thin air, which money is then lent to business firms and individuals as though it were a supply of new and additional saved up capital funds. Its existence serves to reduce interest rates and to enable loans to be made and debts to be incurred which otherwise would not have been made or incurred. Always and everywhere, to the extent that private banks participate in the process of credit expansion, they do so with the sanction and generally with the active encouragement of the government.

Economists, above all Ludwig von Mises, have shown how credit expansion is responsible for the boom-bust business cycle and how its existence depends on deliberate government policy. Nevertheless, public opinion believes that the business cycle is an inherent feature of capitalism and that the role of government is not that of causing the phenomenon but of combating it. Indeed, as Mises observed, “Nothing harmed the cause of liberalism [capitalism] more than the almost regular return of feverish booms and of the dramatic breakdown of bull markets followed by lingering slumps. Public opinion has become convinced that such happenings are inevitable in the unhampered market economy.”

The truth is that credit expansion is responsible not only for the boom-bust cycle but also for another major negative phenomenon for which public opinion mistakenly blames capitalism. Namely, sharply increased economic inequality, in which the wealthier strata of the population appear to increase their wealth dramatically relative to the rest of the population and for no good reason.

It is not accidental that the two leading periods of credit expansion in history—the 1920s and the period since the mid 1990s—have been characterized by a major increase in economic inequality. Both in the 1920s and in the more recent period, a major cause of the increased economic inequality is that the new and additional funds created in credit expansion show up very soon in the financial markets, where they drive up the prices of securities, above all, common stocks. The owners of common stock are preponderantly wealthy individuals, who now find themselves the beneficiaries of substantial capital gains. These gains are the greater the larger and more prolonged the credit expansion is and the higher it drives the prices of shares. In the process of new and additional money pouring into the financial markets, investment bankers and stock speculators are in a position to reap especially great gains.

Since it’s so important, the main point just made needs to be repeated: credit expansion creates an artificial economic inequality by showing up in the stock market and driving up stock prices. Since the stocks are owned mainly by wealthy people, they are the main beneficiaries of the process. The more substantial and the more prolonged the credit expansion is, the larger are the gains enjoyed by wealthy people more than anyone else.

The new and additional funds injected into the economic system also soon show up in an additional demand for capital goods, such as business inventories and plant and equipment, and in an additional demand for consumers’ durable goods, such as houses and automobiles. The purchase of these latter goods, like the capital goods purchased by business firms, depends largely on credit and is encouraged by lower interest rates. It is also fed by the capital gains being reaped by wealthy individuals, which results in an especially pronounced increase in the demand for luxury housing and for luxury goods in general.

The additional demand for capital goods and consumers’ durable goods serves to increase business sales revenues and thus business profits across a wide spectrum of the economic system. Credit expansion increases profits in the economic system because the expenditure of the new and additional money in buying capital goods and labor increases the sales revenues of business firms immediately, while it increases the costs they must deduct from those sales revenues only with a time lag. This is also true to an extent of inflation that enters the economic system by means of its creators simply spending the new and additional money rather than lending it out—“simple inflation,” as Mises calls it. What is present in both kinds of inflation—credit expansion and simple inflation—is the fact that sales revenues rise as soon as new and additional money is spent, but the costs deducted from the sales revenues of any given year largely reflect outlays of money made in previous years. In those previous years the quantity of money and volume of spending of virtually all types was smaller, including the spending that shows up in the present year as costs in business income statements.

Credit expansion boosts profits more than does simple inflation because the reduction in interest rates it brings about serves to increase the time lag between the making of expenditures for capital goods and labor and their subsequent appearance as costs in business income statements. The low interest rates encourage the purchase of such things as durable machinery and the undertaking of construction projects. The kind of increase that this must bring about in economy-wide profits can be seen in the following examples.

Thus in one case, imagine that a business firm uses newly created money that has come into its hands to increase its newspaper advertising, say. Its additional expenditure will be equivalent additional sales revenue to the newspaper. It will also most likely be an equivalent immediate additional cost to it—a cost that it must deduct from its sales revenues in its very next income statement. Thus, in the same accounting period that the newspaper records additional sales revenues equal to the firm’s additional expenditure, the firm itself must record an equal additional cost of production to deduct from its own sales revenues. Obviously, in this case there is no increase in the economy-wide aggregate amount of profit. This is because economy-wide, aggregate sales revenues and economy-wide aggregate costs have both increased to the same extent.

But now imagine that the firm spends the same amount of money in buying durable machinery that will be depreciated over a ten-year period. Once again, a seller, this time the seller of the machinery, will immediately have additional sales revenues equal to our firm’s additional expenditure. But in this case, our firm will certainly not have an equally large additional cost of production to report in its next income statement. If its expenditure for the machinery was $1 million, say, then while the seller has $1 million of additional sales revenues in his next annual income statement, our firm will probably have merely $100 thousand of additional costs to report in its next annual income statement. This is because the purchase price of the machine is not charged off all at once, but only gradually, over its depreciable life. The implication of this example is that in the current year there will be an addition of $900,000 to economy-wide, aggregate profits. If our firm’s $1 million were part of an investment in the construction of a building with a forty-year depreciable life, the implied addition to economy-wide, aggregate profits would be even greater.

Such boosts to profits go hand in glove with the rise in common-stock prices and greatly reinforce them. Of course, once credit expansion comes to an end, the stimulus it gave to profits and to the stock market both disappear and at that point profits plunge and capital gains turn into capital losses. And at that point, the enemies of capitalism turn to attacking capitalism for causing depressions.

Now as the new and additional money created in credit expansion works its way through the economic system, one would expect the demand for labor and thus wage rates also to rise. This certainly does tend to happen and in the 1920s wages increased substantially in terms both of money and real buying power. They simply did not increase to nearly the same extent as the incomes of the wealthier strata of the population, nor, of course, to the extent that business profits increased.

In addition to the special stimulus given to profits, a second reason for the failure of wages to keep pace with the rise in profits, is that the encouragement given by credit expansion to the purchase of durable capital goods, particularly plant and equipment, tends to take place at the expense of funds that otherwise would be devoted to the purchase of labor services. As a result, the rise in wages is retarded at the same time that profits sharply advance. For this reason too it does not keep pace with the rise in profits.

Despite any appearances to the contrary, the rise in real wages in the 1920s was not the result of credit expansion but of rising production. Credit expansion actually operated to retard the rise in production insofar as it caused the wasteful investment of capital, i.e., what Mises calls malinvestment.

The rise in production is what prevented the prices of goods and services from rising as rapidly as credit expansion raised wage rates in terms of money. The rise in production, in turn, was based on a high degree of availability of capital funds provided by actual savings, as opposed to credit expansion, together with rapid scientific and technological progress. It was this that increased real wages, i.e., the goods and services that wage earners could actually buy with their wages.

In contrast to the experience of the 1920s, in the two great recent credit expansions, i.e., the dot.com bubble of 1995-2001 and its successor the presently collapsing housing bubble that began not long thereafter, there has been very little, if any, rise in real wages. Most commentators appear to attribute this to nothing more than the unrestrained greed of businessmen and capitalists. They apparently go on the theory that if there is anything in the economic system that breathes or moves other than at the command of the government, or other than with the active supervision and control of the government, it is proof that we live in an era of “laissez-faire.” For example, in The New York Times of December 30, 2007, in an article titled “The Free Market: A False Idol After All?,” Times columnist Peter Goodman writes:

For more than a quarter-century, the dominant idea guiding economic policy in the United States and much of the globe has been that the market is unfailingly wise. So wise that the proper role for government is to steer clear and not mess with the gusher of wealth that will flow, trickling down to the [sic] every level of society, if only the market is left to do its magic.

That notion has carried the day as industries have been unshackled from regulation, and as taxes have been rolled back, along with the oversight powers of government.

This alleged laissez-faire environment, such writers pretend, has enabled businessmen and capitalists shamelessly to enrich themselves at the expense of increasingly impoverished wage earners, to whom nothing any longer even “trickles down.” Increased free trade and “globalization,” of course, are attacked as part of the process and as greatly contributing to the stagnation or outright decline in real wages.

In sharpest contrast to such blather, in the real world there are innumerable rules and regulations enacted by the Federal Government to control virtually every aspect of economic activity. They are contained in the more than 70,000 pages of The Federal Register. The overwhelming mass of government interference described therein, and in its counterparts at the state and local level, is a glaring refutation of claims about the existence of any kind of laissez faire in the present-day world. The very description of such interference, in tens of thousands of pages of official text, is a refutation of such size and literal weight as to render any claims about laissez faire or insufficient government controls or regulations utterly nonsensical.

This truly massive body of material also suggests that the actual explanation of the stagnation in real wages is precisely an ever growing burden of government intervention in the economic system. The intervention is in the form of policies that undermine genuine saving and in numerous other ways undermine capital accumulation and the rise in the productivity of labor. Personal and corporate income taxes, the inheritance tax, the capital gains tax, and government budget deficits—all entail the taking away of funds that if left in the hands of their owners would have been heavily spent, indeed, overwhelmingly spent, in the purchase of capital goods and labor services. Instead, those funds are diverted into financing the consumption of the government and those to whom the government gives money.

Inflation and credit expansion greatly exacerbate this diversion of funds, because their effect is artificially to increase the incomes subject to these taxes and to thus to deprive business firms of the funds required to replace assets at prices made higher by the same process that increases their taxable incomes. The progressive aspect of income and inheritance taxes also worsens their effects, because incomes tend to be saved and invested the more heavily the larger they are; at the same time, substantial inheritances are more likely to be retained in the form of accumulated savings and capital than are modest inheritances.

Because of the reduced demand for labor that results from the taxation of funds that would otherwise have been used in employing labor and in buying capital goods, wages are substantially less than they otherwise would have been. At the same time, the buying power of those reduced wages is also sharply reduced in comparison with what it would otherwise have been.

It is worth pointing out that totally apart from the effect of social security in undermining the incentive to save, the sheer rise in tax rates since 1965 to pay for the system has taken away fully eight additional percentage points of the income of every wage earner whose earnings are equal to or less than the amount subject to such taxation. In 1965 the combined social security tax on wage earners and their employers was 7.25 percent, which applied to a maximum annual income of $4800. Today, the combined rate is 15.3 percent, which includes 2.9 percent for Medicare. The 15.3 percent rate currently, i.e., in 2008, applies to all wages and salaries up to a maximum of $102,000 per year. The effect of these major increases both in social security tax rates and in the amount of income
subject to them has been to reduce the take-home wages of many workers by considerably more than 8 percent.

The social security contribution of employers is a loss to wage earners, because it is a cost of employment no different than the payment of take-home wages. Financially, it is a matter of indifference to employers whether they pay this sum to the government or to their employees. The cost to them is the same. It is money that the employees could and would have had, if the government had not taken it from the employers.

The same is true of all other costs borne by employers on behalf of their workers, whether it is health insurance, day care, family leave, or whatever. The costs in question are all costs of employment, which, in the absence of such government interference, the wage earners could and would have had in their own pockets. Compelling employers to pay the costs of such things is at the expense of the workers’ take-home wages. The more such costs are imposed, the lower are take-home wages in comparison with what they otherwise would have been. The increase in such costs over time has correspondingly held down any rise in take-home wages.

Government intervention, as I’ve said, not only holds down the demand for labor and thus wages, particularly take-home wages, but it also reduces the buying power of wages. This is because the supply of capital goods is less, thanks to the diversion of funds from their purchase. The absence of these capital goods prevents the productivity of labor from being increased as much as it otherwise would have been. This in turn holds down the production both of consumers’ goods and of further capital goods. The consequence of a lesser supply of consumers’ goods is prices of consumers’ goods that are higher than they otherwise would have been and thus a buying power of wages that is correspondingly lower than it otherwise would have been.

The consequent absence of further capital goods compounds the negative effect on production, in a process that can be repeated over and over again, with each passing year. What this means is that because fewer capital goods in the form of factories and machines are available this year, the ability to produce capital goods in the form of factories and machines for the following year is reduced, because capital goods in the form of factories and machines are the means of producing further capital goods in the form of factories and machines no less than they are of producing consumers’ goods.

The buying power of wages is also reduced by all of the other laws and regulations that hold down the production and supply of goods in general and thus keep up prices. And again, there is a compounding effect. Environmental legislation deserves an especially prominent place in any list of such laws and regulations. Already, because of the restrictions it has imposed on the production of oil, coal, natural gas, and atomic power, it has served to raise the price of energy to unprecedented levels and to deprive many wage earners of the ability to buy gasoline for their cars or trucks and heating oil for their homes. To the extent that wage earners are able to pay energy prices reflecting a $100- per-barrel price of oil, their ability to buy other goods is correspondingly reduced. If the environmental movement’s agenda of radical reductions (up to 90 percent) in carbon dioxide emissions is imposed, meeting it will require absolutely crippling cutbacks in the production and use of oil, coal, and natural gas which must result in corresponding reductions in production, increases in prices, and absolute devastation for real wages.

The negative effect on production here is again a cumulative one, inasmuch as lack of energy supplies hampers the ability to find and exploit further supplies of energy. The more abundant and cheaper energy is, the greater is man’s ability to move masses of earth and to process them, thereby developing further energy supplies. Thus, government intervention that reduces energy supplies reduces the ability to find and exploit further energy supplies.

Other examples of laws and regulations holding down production are minimum-wage, prounion, and licensing legislation. These cause higher costs, higher prices, the diversion of labor from more productive pursuits to less productive pursuits, and, finally, unemployment. Subsidies of all kinds, tariffs, and consumer-product safety legislation also serve to hold down the production and supply of things and to keep up or add to their costs and prices. Again, to whatever extent production in general is curtailed, so too is the production of capital goods, with a consequent cumulative negative effect on subsequent production.

It should be clear that the resumption of an era of high and progressively rising real wages requires a radical reduction of government intervention into the economic system and the reestablishment of economic freedom.

What we have seen is that credit expansion is responsible not only for the boom-bust business cycle, as Mises showed, but also that it is a major source of artificial economic inequality and sharply increases profits relative to wages. These are processes that come to an end and are actually thrown into reverse as soon as credit expansion stops and the recession/depression that is its ultimate consequence begins. In wasting capital through malinvestment, it undermines the rise in production and accompanying rise in real wages. Despite credit expansion, real wages could still rise through most of American history, because of the substantial economic freedom enjoyed in the United States and did so even in the midst of credit expansion, as in the 1920s. In the last two episodes of major credit expansion, however, and over the last several decades as a whole, real wages have largely stagnated. This stagnation is the result of massive government intervention into the economic system that undermines capital accumulation and both the demand for labor and the productivity of labor. It is not the result of economic inequality, the profit motive, or any other aspect of the capitalist system.

I have explained all of the essential matters discussed in this article in full detail, with all of their presuppositions and implications, in my book Capitalism: A Treatise on Economics.


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

IS THERE A PROBLEM? BLAME GLOBAL WARMING

The Op-Ed page of Sunday’s (December 23, 2007) New York Times is devoted to moaning and groaning about the evils of global warming. One piece complains about the loss of a glacier. A second bemoans an abnormal weather pattern in which unseasonably warm weather was followed by cold snaps, with devastating effects on the writer’s olive trees in Provence. A third complains of China’s growing prosperity enabling people to consume more and more imported food, thereby contributing to greenhouse gas emissions because of the need to transport the food over long distances.

But it is the fourth piece that wins the prize for absurdity (and dishonesty). After casually substituting the words “climate change” for “global warming,” it dares to complain about “uncharacteristic frosts” ruining 40 percent of an avocado grower’s crop. In fact, in the apparent belief that its readers are unconcerned with contradictions, The Times actually titled this piece “Chile’s Rising Waters and Frozen Avocados.” The rising waters will supposedly come about because of the melting of Antarctic ice caused by global warming. And yet that same global warming is portrayed as the cause of uncharacteristic frosts and frozen avocados. The writer and The Times apparently believe, and expect their readers to believe, that freezing, no less than warming, is a product of global warming.

The news pages of the same edition of The Times contain yet another propaganda piece about the evils of global warming, this time without any excuse of being merely an expression of opinion. Disguised as a news story, the piece appears on page 16 of the paper’s main section, with the title “As Earth Warms, Virus From Tropics Moves to Italy.”

The virus in question is “chikungunya,” which is described as “a relative of dengue fever normally found in the Indian Ocean region.” A careful reading of the article, together with some investigation of actual climate conditions, shows no connection whatever between the arrival of this virus in Italy and global warming. In reality, its arrival in Italy is nothing more than an unfortunate by-product of globalization and its attendant increase in international trade and travel.

The facts reported in the article are that “[t]iger mosquitoes [a potential carrier of the virus] first came to southern Italy with shipments of tires from Albania about a decade ago” and then proceeded to enlarge their habitat. The mosquitoes by themselves caused no problems beyond that of being a nuisance. What was responsible for their becoming an actual carrier of the chikungunya virus was the arrival in an Italian city of a resident’s relative who had contracted the virus on a trip to India. He was bitten and the mosquitoes then spread the virus from him to others, in widening circles.

The only connection the article offers to global warming is the assertion that the tiger mosquito’s habitat “has expanded steadily northward as temperatures have risen,” as though there had been some significant rise in temperatures over the last ten years and that this rise was a prerequisite to the enlargement of the mosquito’s habitat, at least in a northerly direction. Yet the facts are that global mean temperature has risen a scant .7◦C (1.26◦F) over the entire period since 1900 and, according to data supplied by The University of East Anglia and The Hadley Centre, global mean temperatures have actually been modestly declining since 1998! (For verification of this last point, see the website http://www.eurekalert.org/pub_releases/2007-12/uoea-awy121207.php). Moreover, since temperature lows in the region of Italy where the outbreak occurred are lower than those in most of France and England by 1 or 2 degrees Celsius, temperature conditions in those areas, which are considerably further north, have been ripe for the tiger mosquito at least for a century or more. (For comparative temperature lows, see the website of Euroweather at http://www.eurometeo.com/english/climate/home_min).

Thus, however unfortunate the outbreak of the virus may have been, there is no actual basis for blaming it on global warming. The accusation is nothing more than part of the attempt to create panic over global warming and thus to stampede frightened and ignorant people into sacrificing their freedom and prosperity for the sake of what looks more and more like a coming global dictatorship.

This article is only one of many that make The Times read like something produced at a ministry of propaganda rather than a newspaper produced in a free country. Its author, one Elizabeth Rosenthal, has previously demonstrated that she is an enthusiastic and utterly naive advocate of environmentalism. (See her “Cleaner consumption and the low-carbon life” in the February 23 issue of the International Herald Tribune, a newspaper owned by The Times.) The Times definitely does not read like a newspaper in which reporters apply critical thinking, exercise independent judgment and common sense, verify the facts they report by means of doing the necessary research, and strive for logical consistency. It is in fact something of a joke as a newspaper, or at least would be a joke if it were not as successful as it has been in helping to poison our culture and destroy our country.

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

IF ABORTION REALLY WERE MURDER

In last Wednesday night’s debate among the eight Republican candidates contending for their party’s Presidential nomination, a young woman, via a YouTube video, asked the candidates an important and telling question on the subject of abortion. If abortion were made illegal, she asked, what punishment would the candidates propose for a woman who broke the law and had an abortion?

To a man, the candidates who were opposed to abortion (apparently all of them, with the exception of former New York Mayor Rudolph Giuliani) declared that there would be no punishment whatever for the woman. Only the abortionist, i.e., the physician or whoever else performed the abortion, would be punished.

Now I am not an attorney. Still less have I had any experience working in a prosecutor’s office. However, I have watched innumerable episodes of the television program “Law and Order” and similar shows. “Law and Order,” of course, is the show in which one of the Republican candidates, former United States Senator Fred Thompson, has played the role of district attorney for the last several years.

What I have learned from such shows and from casual reading on the subject is that the law punishes premeditated murder more severely than murder that is not premeditated, and also that it generally punishes the instigator and planner of a murder more severely than the person who is employed to carry out the murder. Accordingly, let us imagine that instead of a woman who has had an abortion and has paid a physician to perform it, we have a woman who has arranged the murder of her husband by means of hiring someone to do it.

I can imagine Senator Thompson, in his role as DA, telling one of his assistants to offer the suspected “hit man” a “deal,” in the form of pleading guilty to a lesser crime than Murder in the First Degree, say “Murder Two” or even “Man One,” in the vernacular of the show. The purpose of the deal, of course, would be to get the hit man to “roll” on the worse offender, in this case, the person—the woman—who employed him.

I now ask, what is different in the case of abortion, if abortion really is murder? Abortions do not occur spontaneously, in an isolated moment of disordered thinking and uncontrollable emotion. They must be planned. A woman who wants an abortion, must generally make an appointment at a medical facility to have it done. Before the abortion takes place, she will probably have to undergo an examination and tests of various kinds to be sure that the procedure does not pose an undue risk to her life or health. Thus, some period of time must elapse before the abortion actually occurs.

Especially in an environment of secrecy and stealth, of kitchen tables and coat hangers, in which abortions would once again have to be performed if they were once again made illegal, there must generally be a more or less considerable lapse of time between a woman’s forming the intent to have an abortion and being able to have it actually performed. This is because in such conditions, an abortionist cannot be found simply by looking in the yellow pages or on the internet. One can be found only through a series of discreet and time-consuming inquiries.

The inescapable conclusion to be drawn from all this is that a woman who has an abortion must not only form an intent to have it but must also maintain that intent for a more or less considerable period of time. What is the name for this if not premeditation?

Accordingly if abortion really is murder, then it is premeditated murder. And by the usual standards of justice, the guilt of the woman, as the instigator and planner of the murder, is greater, not less, than that of the physician or other party employed to carry it out.

But there is more, and it is downright scary. Most or all of the Republican candidates who oppose abortion are in favor of the death penalty for crimes such as premeditated murder. Thus, the logic of their view of abortion implies that they should not only urge the severe punishment of a woman who has an abortion, but capital punishment. Their alleged love of the life of the unborn fetus that is taken in an abortion should, in logic, lead them to urge the death of the woman who orders the taking of that life.

I must say that I am confident that the common sense and personal good will of the anti-abortion candidates would continue to prevent them from advocating any actual punishment of women who would have illegal abortions, let alone capital punishment, despite the fact that that is where the logic of their beliefs would take them. However, the same is by no means necessarily true of all of their followers and of the anti-abortion movement as a whole. In today’s world there seems to be no idea that is too bizarre to find followers once it is identified as a logical implication of a deeply rooted belief.

Hopefully, there will be a larger number of more reasonable people, who will be led to question the premise that abortion is murder. To do that, they will need to question the premise that a fetus, especially, in the early stages of pregnancy, is an actual human being. In reality, when, for example, a fetus must still be measured in mere tenths of an inch, it is simply not a human being. At that point, it is nothing more than a growth in a woman’s womb that has the potential to become a human being. Removing it is not killing a human being but simply stopping—aborting—a process that if left unchecked would result in a human being weeks or months later. Weeks or months later, there would be a human being. But not at the time of the abortion.

Unfortunately, persuading people of this elementary fact of perception can be very difficult. There are far too many people for whom seeing is not believing, but rather, if anything, believing is seeing—that is, people whose mistaken ideas are held so strongly that they override the evidence of the senses. Epistemologically, the notion that a speck in a woman’s womb is a human being is not all that different than the notion, popular elsewhere in the world, that animals carry the souls of one’s ancestors. Both notions represent seeing what just isn’t there, based on a projection from inside one’s mind.

Seeing a human being where there is none and consequently murder where there is none, serves to destroy the lives of women, and of families, who cannot afford the burden of an unwanted extra child, which they are nonetheless forced to accept because the possibility of abortion is denied them. Because of this distorted conception of things, a woman has only to become pregnant, and ownership of her body is immediately claimed by the State. Whatever plans she may have had for her future, such as gaining an education, pursuing a career, or simply enjoying her youth, are forcibly thrown aside, as she is made to live with no more choice in her own destiny than a pregnant animal. She is compelled to defer whatever hopes, dreams, and ambitions she may have had until she has completed what is tantamount to serving a twenty-year sentence in going through an unwanted pregnancy and then raising an unwanted child.

And why? By what right is such devastation inflicted on her life? The answer is that here in the United States, just as in the Middle East, there are large numbers of people who believe that the cloak of religion and their claim to be inspired by the will of God entitles them to practice lunacy, in total disregard of the suffering and harm they cause to others. Their pretended “love” and “goodness” is a sham.


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

WOULD HILLARY’S ELECTION VIOLATE THE TWO-TERM LIMIT?

Hillary Clinton may win the Democratic Party’s nomination and go on from there to be elected President of the United States. If that happens, her husband, William Jefferson Clinton, who was President of the United States from 1993 to 2001 for two full terms, would once again be a principal occupant of the White House.

As Hillary’s spouse, not only exercising the normal substantial influence of one spouse over the other but also being in possession of eight years of actual experience in the Presidency, it would appear that Bill Clinton would thus once again effectively exercise Presidential Powers. Yet this would be in substantive violation of the Twenty-Second Amendment to the United States Constitution, which states that “No person shall be elected to the office of the President more than twice . . . .”

True enough, Bill would not have been elected more than twice, and thus his presence and activities in the White House would not technically be in violation of the Constitution. But the obvious purpose of the Twenty-Second Amendment was to limit the occupation of the Office of President, and the exercise of the powers of that Office, to two terms. Its authors did not contemplate marriage as a route to the powers of the Presidency alternative to election to that Office.

If and to the extent that Mrs. Clinton’s chances of election increase, the couple needs to find a way to guarantee that Mr. Clinton would not in fact be a three or four-term President.

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

IN SUPPORT OF THE CONCEPT OF INTELLECTUAL PROPERTY

November 7, 2007*

1. Is identity theft, about which so many people are concerned, some form of mirage or is it a real phenomenon?

2. If it is a real phenomenon and identities are actually being stolen—as many thousands of victims of identity theft are prepared to swear, and as the banks and credit card companies of these victims also swear—then does it not follow that identities are a form of property? For nothing can be stolen that is not first owned by someone.

3. If identities are a form of property, are they not intellectual property, since they consist entirely of words and symbols, not the physical persons of the people to whom the identities refer?

4.If individuals do have a property right in their own identities, do they not also have a property right in the words and symbols that uniquely identify their products and services? And, by extension, do not voluntary associations of individuals, such as business partnerships and private corporations have a property right in the words and symbols that uniquely identify them and their products and services? Thus, for example, does not General Motors have a property right in its name and logo and in the names and logos of its various individual products and services? In other words, are not brand names and trademarks legitimate forms of intellectual property?

5. Are trademarks and brand names not essential for the operation of free competition, in which better producers benefit from their record of past good work and poorer producers suffer from their record of past poor work?.
I believe that the answers to these questions are all clearly “yes.”

I want to say that I recognize that we live in an age of intellectual disintegration, in which philosophers, lawyers, and judges have proved themselves capable of corrupting practically any concept. As a result, it should not be surprising that there are corruptions of the concept of intellectual property and its application. One that comes readily to mind is Ralph Lauren’s ability, according to John Stossel, to appropriate the word “Polo,” to the point that even organizations of actual polo players cannot use the word without being held guilty of violating an alleged intellectual property right of Lauren’s. The truth, of course, if Stossel is right, is that Lauren’s appropriation of the word “Polo” is a violation of their intellectual property rights.

I’ve deliberately avoided any discussion of patents and copyrights here because my purpose has been simply to establish the legitimacy of the concept of intellectual property as such.

GEORGE REISMAN

*This article was originally a posting to the Ludwig von Mises Institute’s discussion list.

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

DEFLATION AND THE GOLD STANDARD

November 5, 2007*

Calling falling prices per se “deflation” is one of the most serious errors one can make in economics. It’s tantamount to confusing becoming richer with becoming poorer. It leads people to believe that increases in production, which are the foundation of enrichment, but which also operate to make prices fall, are at the same time the source of depression and impoverishment.

To get matters straight, we need to clarify some things.

Prices can fall either because of more supply (i.e., more goods and services being produced and sold) or because of less demand (i.e., less money in existence and/or less overall spending of money in the purchase of goods and services).

A depression is characterized not only by falling prices, but also by a plunge in business profits (which may even become negative in the aggregate) and by a sharply increased difficulty of repaying debt. It is also characterized by mass unemployment.

While a gold standard very definitely can and probably will be accompanied by falling prices, it is not accompanied by plunging profits, a greater difficulty of repaying debt, or mass unemployment. The conjunction of these latter with falling prices is the result of a decrease in the quantity of money and volume of spending. A decrease in the quantity of money and volume of spending is the result not of a gold standard but of the incompleteness of a gold standard. It is the result of a fractional-reserve gold standard, in which gold represents only a portion of the money supply while the rest is based on debt. In such circumstances, the failure of debtors is capable of causing bank failures, which serves to reduce the quantity of money and volume of spending.

Under a full, i.e., 100-percent reserve gold standard, new and additional gold continues to be mined, and at a rate faster than gold is physically lost, e.g., in such things as shipwrecks and the burial of people with gold dental fillings in their mouths. Thus the quantity of money and volume of spending under a full gold standard increases. However, it does so at a modest rate. Prices fall under a full gold standard to the extent that the increase in the production and supply of goods and services other than gold outstrips the increase in the quantity of gold and the spending of gold.

Despite the fall in prices, the increase in the quantity of gold money and spending under a full gold standard serves to increase the economy-wide average rate of profit and interest. It does so for the simple reason that in the nature of the case there tends to be more money and spending in the economy at the time when products are sold than there was at the earlier points in time when money was expended for the means of producing those products. Thus the margin by which sales revenues outstrip costs is correspondingly increased.

Furthermore, despite the accompanying fall in prices caused by the more rapid increase in the production and supply of goods and services other than gold, the increase in the quantity of gold and the volume of spending in terms of gold serves to make the repayment of debt somewhat easier. For example, suppose that sales revenues in the economic system are rising at a two percent rate because of increases in the supply and spending of gold, but that prices are falling at a three percent rate because the supply of goods and services other than gold is increasing five percent per year. The average seller in this case will have five percent more goods to sell at prices that are only three percent less. His sales revenues will rise by two percent. He will be able to earn progressively increasing sales revenues and income despite the fall in his selling prices, because the increase in the supply of goods and services he has available to sell outstrips the fall in his selling prices to the extent of the increase in the quantity of gold money and spending.

The modest elevation of the rate of profit resulting from the increase in the quantity of gold is the opposite of what happens in a depression. So too is the greater ease rather than greater difficulty of repaying debt.

Thus, the truth is that a full gold standard, with its falling prices, is as much the enemy of deflation as it is of inflation.

As for mass unemployment: If there is a deflation, in the correct sense of a decrease in the quantity of money and/or volume of spending, then falling prices, so far from being the cause of deflation/depression are the way out of it. In such circumstances, a fall in wage rates and prices is precisely what’s needed to allow a reduced quantity of money and volume of spending to buy all that a previously larger quantity of money and volume of spending bought. If, for example, as in 1929, there was originally roughly $50 billion in payrolls employing 50 million workers at an average annual wage of $1,000 per year and now, because of deflation, there are only $40 billion of payrolls employing 40 million workers, full employment could be restored if the average wage rate fell from $1,000 to $800 per year. In that case, $40 billion could employ as many workers as $50 billion had done.

Viewing the fall in wage rates and prices that is needed to recover from deflation as itself being deflation and thus preventing the fall in wage rates and prices, as occurred under Hoover and the New Deal, serves only to perpetuate the unemployment and depression.

Confused concepts result in catastrophic consequences.

GEORGE REISMAN

P.S. For elaboration of the points made in this discussion, see my article "The Goal of Monetary Reform," The Quarterly Journal of Austrian Economics, Fall 2000, vol. 3, no. 3, pp. 3–18, and my book Capitalism: A Treatise on Economics, pp. 544–46, 557–59, 573–80, 809–20. See also my Mises.org Daily Article "The Anatomy of Deflation," August 22, 2003

*This essay was originally a posting to the Ludwig von Mises Institute’s discussion list.

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

The Housing Bubble and the Credit Crunch

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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

Gore: Ignorant or Dishonest?

In his July 1, 2007, New York Times Op-Ed piece, “Moving Beyond Kyoto,” Al Gore states:

Consider this tale of two planets. Earth and Venus are almost exactly the same size, and have almost exactly the same amount of carbon. The difference is that most of the carbon on Earth is in the ground — having been deposited there by various forms of life over the last 600 million years — and most of the carbon on Venus is in the atmosphere.

As a result, while the average temperature on Earth is a pleasant 59 degrees, the average temperature on Venus is 867 degrees. True, Venus is closer to the Sun than we are, but the fault is not in our star; Venus is three times hotter on average than Mercury, which is right next to the Sun. It’s the carbon dioxide.

No, Mr. Gore, it’s not the carbon dioxide. If you take the trouble to do an internet search on Google for “carbon dioxide” + “Martian atmosphere,” you will learn that the Martian atmosphere is 95 percent carbon dioxide, yet the average surface temperature on Mars is -63° C (-81° F). (It's true that the atmosphere on Mars is only about .6 percent as dense as that on Earth, but it's also true that its relative concentration of carbon dioxide is about 2400 times as great as that of Earth, which appears to make up for the thinness of the Martian atmosphere about 14 times over.)

But even putting this decisive objection aside, there is simply no informed or honest way for you to suggest that the amount of atmospheric carbon dioxide on Earth is or ever will be comparable to the amount on Venus. According to The Encyclopedia Britannica, the atmosphere of Venus is 96 percent carbon dioxide. The atmosphere of the Earth, in contrast, is less than .04 percent carbon dioxide. That’s not .04, but .0004, i.e., four one-hundredths of one percent. To be precise, carbon dioxide is presently 383 parts per million of the Earth’s atmosphere. All of the brouhaha going on about the subject is over a projected increase to perhaps as much as 1000 parts per million by the year 2100, i.e., to .1 percent, which is 10 one-hundredths of one percent.

It is on the basis of such ignorance or dishonesty that you declare that

we should demand that the United States join an international treaty within the next two years that cuts global warming pollution by 90 percent in developed countries and by more than half worldwide in time for the next generation to inherit a healthy Earth. (Italics added.)

The “global warming pollution” you talk about is the production of the energy that lights, heats, and air conditions our homes, powers our automobiles, trucks, trains, airplanes, and ships, runs our refrigerators, television sets, computers, and all other electrical appliances, and powers the machinery and equipment that produces all of the goods we buy. You want to cut this by a staggering percentage!

You conclude by describing this suicidal program as one of a “privilege”:

The climate crisis offers us the chance to experience what few generations in history have had the privilege of experiencing: a generational mission; a compelling moral purpose; a shared cause; and the thrill of being forced by circumstances to put aside the pettiness and conflict of politics and to embrace a genuine moral and spiritual challenge.

Such mindless, rabid enthusiasm for a cause so self-destructive calls to mind the equal moral fervor and rising to “spiritual challenges” of the generations led by such madmen as Lenin and Hitler. It is also very much in the spirit in which suicide bombers depart on their missions.

You feel free to make your calls for unprecedented economic destruction from the comfort of a home that consumes more than 20 times the electricity of the average American home. You apparently have no awareness of the extent of your hypocrisy because you have purchased “carbon offsets,” in such forms as paying for the planting of a few trees here and there that will supposedly absorb carbon dioxide equivalent to that emitted in powering your home. (Mark Steyn, “Rev. Gore Doesn't Practice What He Preaches,” The Bulletin, March 8, 2007.) Yet your “spiritual challenge” does not include such offsets for the rest of the American people, so that they too might go on enjoying their lives.

If you understood in personal terms what you are talking about, you would know that your supposedly glorious “spiritual challenge” is a call for Mrs. Gore to scrub your laundry (if you would still have any) against a rock on the bank of a river, the way women do in Third World countries. That’s the actual meaning and measure of your “spiritual challenge.” You want to turn our glorious economic system into a poverty-stricken hell-hole.

You need to calm down, Mr. Gore, and give yourself and the world a rest. Along the way, you should try to understand the extent and depth of the horrors you want to unleash.

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

UNIVERSAL HEALTHCARE IS WHAT'S SICKO By Gen LaGreca

Michael Moore says he made the film, "Sicko," to "ignite a fire for free, universal healthcare." How absurd is it for someone seeking proper healthcare to take an odyssey to Communist Cuba? That Moore's camera-rolling entourage would receive the same healthcare as a Cuban citizen stretches even a child's imagination. His film should be renamed "Another Celebrity Falls for Dictator's Dog-and-Pony Show."

People like Moore believe capitalism is the disease and government takeover the cure for our healthcare ills. They think people have a "right" to free healthcare simply because they need it.

If so, why stop at medicine? Couldn't we claim the same "right" to other necessities? Take food, for instance. What if the government seized control of the food industry and fed us for free with a new entitlement, "Foodcare"?

Initially Foodcare will empty the horn of plenty into your lap. With your appetite and wallet parting company, the lobster you ate only on your birthday will become regular fare, as will your favorite Belgian chocolates and filet mignon.

Because the same idea occurs to 300 million others, costs skyrocket, and a Foodcare crisis develops. Big Brother can no longer foot the bill for your busy mouth, so he must limit your mastication. This requires new agencies, bureaucrats, and a 100,000-page rulebook.

You visit your favorite restaurant to find it changed. Gone are the tablecloths, flowers, and cheerful hostess to greet you, enhancements you had gladly paid for in the price of your meal. The Department of Restaurants eliminated them as frivolous indulgences of the people’s resources.

The menu is reduced to a few modest offerings. Missing are the savory specials of the talented chef, whose last creation took forty pounds—not of ingredients but of paperwork—to gain approval from the New Recipe Administration.

You want steak, but getting it requires that the chef call a central office to obtain pre-authorization. With the clock ticking and a long line waiting to slide into your barely warm seat, you order hamburger instead. You notice your neighbor eating steak—and sitting at the best table. You remember when he was laid off and you bought him dinner. Back then, he thanked you for your charity and quickly got another job. But now that he has a “right” to food, he's stopped working to eat courtesy of your tax dollars.

You barely recognize the frazzled chef buried in paperwork. The once happy figure doting over your every need now slaves for a new master, one that denies his fee for serving Cognac, second-guesses his decision to make cheesecake, requires a Certificate of Need to buy an oven. You know that under Foodcare he's merely biding time till retirement. When he goes, you doubt he’ll be replaced because enrollment in chef’s schools has dropped as the number of bureaucrats hounding them has risen.

As time passes, everyone forgets how it started, but the crisis worsens. Michael Moore makes a pilgrimage to North Korea in search of adequate food.

You realize that the amount you pay into Foodcare exceeds what you had paid when you bought your own food and didn't obtain it for “free.” Then you didn't pay for bureaucrats and inspectors to tell you what to eat, or for those milking the system like your neighbor. Besides emptying your wallet, Foodcare has drained all the pleasure you once derived from eating.

Politicians blame their scapegoat, the capitalists—grocers, chefs, food manufacturers—and pass laws to prevent any from owning a Mercedes while someone goes to bed hungry in America. They tell us profit is evil and free food for all is a moral ideal.

You wonder: Is there something wrong with this picture? The ideal isn't the private system, with happy chefs and grocers earning a good living in return for their talent and entrepreneurial skill, and satisfied customers enjoying a Shangri La of affordable food. The ideal isn't a spectacular abundance, with everyone's standard of eating—including the poor—raised dramatically, and this achieved without government force—without fleecing taxpayers and robbing consumers and suppliers of their freedom to make their own personal choices and to interact voluntarily. Instead, the ideal is to transform free, self-determining individuals into state-controlled puppets.

The Foodcare scenario is actually playing out in healthcare. Once the gold standard of the world, American medicine has fallen to its knees from decades of crippling regulation, with the final blow about to come from universal healthcare.

To stop this despotism we must repudiate the notion that healthcare is a right. No one has a right to demand for free the goods and services produced by others. We have the freedom to take action to further our own lives—to work, earn money, and pay for the things we need—while respecting the same rights of others. We don't have any right to enact laws to seize people's money, control their activities, and force them to provide services on terms dictated by Big Brother.

No good can result when the means used to achieve it are plunder and coercion. Universal healthcare merits the label "sicko"—or more accurately "tyranny."

Genevieve (Gen) LaGreca is the author of Noble Vision, an award-winning novel about a doctor's fight for freedom in a state-run health system.