Anti-Obamanomics: Why Everyone Should Be in Favor of Tax Cuts for the “Rich”

Portions of this article are adapted from pp. 308-310 and 830-831 of the author’s Capitalism:A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996).

I

Are the American people being primed to elect as President of the United States a home-grown version of Hugo Chavez, in the person of Barack Obama? This is a question one can come away with after reading “Obamanomics,” the featured article in this last Sunday’s (August 24, 2008) New York Times Magazine. Written by Times’ columnist David Leonhardt, the article provides insight into Obama’s thinking on economics and the economic policies he would be likely to pursue if he were elected President.

The subject of this, present article of mine is essentially limited to an analysis and critique of a major aspect of the views on taxation attributed to Obama. That aspect, in the words of The Times’ article is that “Obama’s agenda starts not with raising taxes to reduce the deficit, as Clinton’s ended up doing, but with changing the tax code so that families making more than $250,000 a year pay more taxes and nearly everyone else pays less. That would begin to address inequality.” He will “use the tax code to spread the bounty from the market-based American economy to a far wider group of families.”

Obama’s agenda, we are told in more detail, includes “a $500 cut in the payroll tax for most workers” and major middle- and lower-income tax credits, to the point of simply handing out government money to those for whom the tax credits more than eliminate the taxes they would otherwise have to pay. “These tax cuts,” Leonhardt writes, “are really the essence of his market-oriented redistributionist philosophy (though he made it clear that he doesn’t like the word `redistributionist’). They are an attempt to address the middle-class squeeze by giving people a chunk of money to spend as they see fit.” (Of course, no mention is made of depriving anyone who is to be compelled to pay for this largesse, of the ability to spend the money he has earned as he sees fit. Obama’s concept of “market-oriented” works out to be that money is taken from some people at the point of a gun and then spent according to the free choice of those who are given the loot.)

The sums that are to be forcibly taken to make possible Obama’s largesse are described by Leonhardt as “raising taxes on the affluent to a point where they would eventually be slightly higher than they were under Clinton” and as raising taxes “for the top 0.1 percent of earners—those making an average of $9.1 million…by an average of $800,000 a year.”

Now these proposals, at least on their face, are not on the scale of the philosophically similar proposals imposed by Hugo Chavez as president of Venezuela and by other current Latin American leaders. But they are based on the same philosophy of law and economics, namely, that it is a legitimate function of government to take from the rich and give to the poor and that such policies are of economic benefit to the poor.

That philosophy is reinforced by the corollary conviction, clearly present in Obama’s case, that prosperity can be achieved by consuming the means of production, i.e., by “eating the seed corn,” so to speak. This belief is not only present implicitly in his and all other redistributionists’ views on taxation, but it is also present in open, public view on his website, in his proposal to “Enact a Windfall Profits Tax [on the oil companies] to Provide a $1,000 Emergency Energy Rebate to American Families.” (See http://my.barackobama.com/page/content/newenergy.) This is a proposal to take away funds that can be used in the discovery and development of new oil fields and the production and transportation of oil and oil products and give those funds to people to scramble for the limited supplies of oil and oil products presently available.

When Obama’s proposals are viewed not as isolated pronouncements but as instances of the application of the fundamental principles just described, it would be very foolish to expect that his application of those principles will by any means necessarily be confined within any sort of modest limits. Indeed, Obama has shown that he is not frightened by the prospect of making enormous changes. He’s called for a compulsory 80 percent reduction in carbon dioxide emissions in the US by 2050, in order to fight global warming. There’s no reason why he could not later on call for a vastly higher degree of redistribution than indicated in The Times’ article.

The kind of proposals made by Obama and all other redistributors need to be answered in terms of fundamental economic analysis, one clear and powerful enough to show, as the title of this article states, “Why Everyone Should Be in Favor of Tax Cuts for the `Rich.’” Understanding this conclusion should serve as a full and sufficient answer to proposals for increasing taxes for purposes of redistribution.

II

The progressive personal income tax, the corporate income tax, the inheritance tax, and the capital gains tax are all paid with funds that otherwise would have been saved and invested. All of them reduce the demand for labor by business firms in comparison with what it would otherwise have been, and thus either the wage rates or the volume of employment that business firms can offer. For they deprive business firms of the funds with which to pay wages.

By the same token, they deprive business firms of the funds with which to buy capital goods. This, together with the greater spending for consumers' goods emanating from the government, as it spends the tax proceeds, causes the production of capital goods to drop relative to the production of consumers' goods. This implies a reduction in the degree of capital intensiveness in the economic system and thus its ability to implement technological advances. The individual and corporate income taxes, and the capital gains tax, of course, also powerfully reduce the incentive to introduce new products and improve methods of production. In all these ways, these taxes undermine capital accumulation and the rise in the productivity of labor and real wages, and thus the standard of living of everyone, not just of those on whom the taxes are levied.

Two major impediments make it difficult for people to recognize the fact that everyone would benefit from reductions, or, better still, the total abolition of all of these taxes on the so‑called rich—made possible, of course, by equivalent reductions in government spending. The first is simply massive ignorance of economics, especially of the general benefit from private ownership of the means of production. People have not grasped the profound insight of Mises that, in a market economy, in order benefit from privately owned means of production, one does not have to be an owner of the means of production. This is because one benefits from other people’s means of production—every time one buys the products of those means of production.

One benefits from other people’s means of production not only in one’s capacity as a buyer of products but also as a seller of labor. Other people’s means of production, other people’s capital, are the source both of the supply of the goods one buys and of the demand for the labor one sells. The greater is other people’s accumulation of capital, the more abundant and less expensive are the products available for one to buy in the market and the greater is the demand for the labor one sells in the market and thus the higher the wages at which one can sell it. Abundant and growing capital in the hands of one’s suppliers and potential employers is the foundation of low and falling prices and of high and rising wages.

In contrast, the view of redistributionists, such as Obama, founded in the most complete and utter ignorance, is that the only wealth from which an individual can benefit is his own. This is a view that was not unreasonable in the ages before the rise of capitalism and its market economy. Until then, the only people who could in fact benefit from a given piece of land or a given barn or plow, or whatever, was the family that owned them and used them to produce for its own consumption. This is the view that the redistributionists continue to hold, centuries after it has lost its applicability. They have not yet awakened to the modern world. And it is on this basis that they support the redistribution of wealth. The redistribution of wealth is allegedly necessary to enable an individual who does not own the wealth presently owned by others to benefit from that wealth. Only as and when their property passes to him can he benefit from it, the redistributors believe. This is the kind of “largesse” Obama intends to practice. It is taking funds from those most prodigious at accumulating capital, capital that would benefit all, and then giving the funds to others to consume. Meeting the needs of the poor with the consumption of capital is Obama’s formula for prosperity.

The second impediment that stands in the way of people recognizing that everyone benefits from tax cuts for the rich is something closely related to redistributionism. This is collectivistic habits of thought inspired by Marxism and its doctrine of class interest. What I mean by this is that when it comes to matters of economics, most people tend to think of themselves essentially as members of the class of wage earners rather than as separate individual wage earners, and to think of their interests as indistinguishable from the interests of other wage earners.

Thus, an individual wage or salary earner knows that he would certainly be better off if his own taxes were reduced by some given amount than if the taxes of a millionaire or some large corporation were reduced by that same amount. As far as it relates just to himself, that conviction is absolutely correct. I, for example, would be much better off if my taxes were reduced by, say, a thousand dollars a year than if the taxes of some contemporary John D. Rockefeller or the taxes of General Motors were reduced by a thousand dollars a year. Where most wage earners go wrong is in generalizing from what is true of a reduction in their own, individual taxes, in comparison with an equal reduction in the taxes of businessmen and capitalists—the “rich”—to conclusions about the effects on them of reducing the taxes of other wage earners, in comparison with the same amount of reduction in taxes on businessmen and capitalists.

In considering, for example, whether the taxes of businessmen and capitalists as a class should be reduced by some large sum, such as $100 billion, or whether the taxes of wage earners as a class should be reduced by that sum, almost everyone mistakenly assumes that the interest of the individual wage earner lies with the tax reduction going to the wage earners, as though all wage earners shared a common class interest against all capitalists. This, however, is a fallacy, which becomes apparent as soon as one objectively analyses the situation from the perspective of the individual wage earner. Then it becomes clear that much more is involved than the matter of a reduction in the taxes of the rich or an equal reduction in the individual wage earner's own taxes. For example, while it is certainly true that I gain more from my own taxes being cut by $1,000 rather than the taxes of a Henry Ford or a Bill Gates, it is absolutely false to believe that I gain more from the taxes of my random fellow wage earners—call them Henry Smiths and Bill Joneses—being cut by $1,000 each rather than the taxes of Ford and Gates being cut by $1,000 each.

What is actually involved in the question of a reduction in taxes on businessmen and capitalists as a class in the amount of $100 billion, versus an equal reduction in the taxes of wage earners as a class, is two separate, further questions, that represent distinct elements of this question. There is first the question of the benefit to an individual wage earner of his own taxes being cut by $1,000, versus the taxes of any businessman or capitalist being cut by $1,000. We know the answer to this question: it is more to the individual wage earner's interest that his own taxes be cut. But then there is a second question. Namely, which is more to an individual wage earner's self‑interest: a reduction in the taxes of businessmen and capitalists in the remaining amount of $99,999,999,000, or a reduction in the taxes of wage earners other than himself in the same remaining amount, that is, of 99,999,999 other individuals very much like himself perhaps, but not himself, each getting a reduction of $1,000?

In other words, put aside the question of a cut in the individual wage earner's own taxes of $1,000 versus a $1,000 cut in the taxes of businessmen or capitalists. Consider only the effect on his self‑interest of a cut in the taxes of all other wage earners besides himself—all of the Henry Smiths and Bill Jonses of the country—in the combined amount of $99,999,999,000, versus an equivalent cut in the taxes of businessmen and capitalists—all of the Henry Fords and Bill Gateses of the country. A $99‑billion‑plus cut in the taxes of all those other wage earners will make each of them better off, but what will it do for him, for the particular, individual wage earner we are focusing on? To what extent will his fellow wage earners save and invest their tax cut and so raise the demand for his labor? To what extent will his fellow wage earners increase the demand for capital goods and the rate of business innovation and thus bring about improvements in the quantity and quality of the products he buys and thereby increase the buying power of the wages he earns?

It is obvious that the individual wage earner benefits far more from tax reductions on businessmen and capitalists, the so‑called rich, than from equivalent tax reductions on his fellow wage earners, and that this is true of each and every individual wage earner, for any wage earner could take the place of the particular individual we have focused on. A tax reduction on businessmen and capitalists will promote capital accumulation, far, far more than a tax reduction on the mass of the individual wage earner's fellow wage earners. The average businessman and capitalist will save and invest the taxes he no longer has to pay, in far greater proportion than would the average wage earner. He will be induced to introduce more improvements in products and methods of production, which are also a major cause of capital accumulation, and is a process in which wage earners qua wage earners play little or no role. (This is not to say that wage earners are never responsible for innovations. They often are. But as soon as they are, they typically become businessmen. Fundamentally, it is always the prospect of higher profits that stimulates innovations, not the earning of higher wages. It is the prospect of higher profits that leads employers to offer incentives to wage earners to make innovations.) And the greater saving of the businessmen and capitalists will promote innovation by virtue of making the economic system more capital intensive. Thus the individual wage earner has far more to gain from the taxes of businessmen and capitalists being reduced than from the taxes of his fellow wage earners being reduced.

The gains from this aspect of the matter are so substantial that they almost certainly outweigh the fact that having them precludes the ability to have the benefit of one's own taxes being reduced by a sum such as a thousand dollars a year. This is merely to say that the gains to an individual wage earner of his own taxes being cut by a sum such as $1,000 a year are far less than the gains to him of the taxes of businessmen and capitalists being cut by an immensely larger sum such as a $100 billion a year—that is, by an amount that equals the potential $1,000 tax cuts of all the millions of other wage earners in the economic system, which, in the hands of those fellow wage earners, would have been of little or no value to him.

As I have shown, the individual wage earner gains from cutting the taxes of businessmen and capitalists in part because the effect of their sharply increased saving is significantly to raise the demand for labor and thus, quite possibly, significantly to raise his own wage income. (Even if the effect is not to raise wage rates, but, in raising the demand for labor, to reduce or eliminate unemployment, that too operates to increase the funds available to the average wage earner—by virtue of reducing what he must pay to support the unemployed.) But far more importantly, the effect of cutting the taxes of businessmen and capitalists rather than of wage earners will be a substantial rise in the demand for capital goods relative to the demand for consumers' goods and a substantial rise in the rate of innovation, including under the latter head the ability of upstart new firms to grow rapidly and thus to challenge old, established firms.

The effect of this combination is continuing capital accumulation and thus a continually rising productivity of labor. The effect of this, in turn, is a continually growing supply of consumers' goods relative to the supply of labor, and thus prices of consumers' goods that are progressively lower relative to the wages of labor, which means progressively rising real wage rates, so that in not too many years the average wage earner is far ahead of where he would have been on the strength of a cut in his own taxes.

Starting with tax cuts for the so‑called rich—based on equivalent reductions in government spending—is the only hope for the resumption of significant economic progress, indeed, for the avoidance of economic retrogression and growing impoverishment. Because of this, it is actually the quickest and surest road to any major reduction in the tax burden of the average wage earner. It holds out the prospect of the average wage earner being able to double his standard of living in a generation or less. The average standard of living would double in a single generation if economic progress at a rate of just 3 percent a year could be achieved. Such economic progress would also mean a halving of the average wage earner's tax burden in the same period of time—if government spending per capita in real terms were held fixed, for then he would have double the real income out of which to pay his present level of taxes. And then, of course, once all the taxes that most stood in the way of capital accumulation and economic progress were eliminated, further reductions in government spending and taxation could and should take place that would be of corresponding direct benefit to wage earners, that is, show up in the reduction of the taxes paid by them.

Ironically, an aspect of this approach exists in, of all places, Sweden! What has enabled Sweden to have one of the world's highest burdens of taxation and, at the same time, to remain a modern country, more or less advancing, is the fact that the tax burden in Sweden falls far more heavily on the average Swedish wage earner than it does on Swedish business, whose tax burden is actually less than that of business in many other Western countries. (For example, when allowance is made for the fact that Swedish companies can automatically deduct 50 percent of their profits as a tax‑free reserve for future investment, the effective corporate income tax rate in Sweden turns out to be below that in the United States: 26 percent versus 35 percent.) If Swedish business had had to bear the burden of taxation borne by Swedish wage earners, the Swedish economy would long since have been in ruins.

This is certainly not to argue for taxation of American workers at a level comparable to the taxation of Swedish workers, or for any increase in the taxes paid by American workers whatever. It is to argue for reductions in government spending sufficient both to eliminate the budget deficit and to make possible substantial tax cuts on businessmen and capitalists, the so‑called rich. It is to argue that as soon as the resulting economic progress begins to increase the real revenues of the government, further tax cuts of the same kind occur, in order further to accelerate economic progress. It is to argue for the achievement first of the total elimination of the inheritance tax, the capital gains tax, the corporate income tax, and the progressive portion of the personal income tax, all taken together, and then, once that has been achieved, for the continuing reduction in the remaining personal income tax, until the personal income tax is totally eliminated. The essential mechanism for achieving these results is a combination of economic progress and continuing reductions in government spending. This is how radically to reduce the taxes of everyone. It is the only way.

III

Several times, I’ve referred to tax reductions on the rich being accompanied by equivalent reductions in government spending. It should be clear that reducing taxes without reducing government spending cannot promote saving and capital formation, but must undermine them further, even if the funds no longer claimed by taxes are overwhelmingly saved. For in this case, the government must substitute a dollar of borrowing for a dollar of tax revenues. Each dollar borrowed by the government is a dollar less of savings available for the rest of the economic system. Thus even if a dollar less of taxes results in as much as ninety cents of additional saving, there is a significant net reduction in the supply of savings available for the rest of the economic system. In this instance, while ninety cents of additional saving takes place as the result of tax reductions, a full dollar less of savings is available to business and private consumers as the result of the government's borrowing, and thus there is a net reduction of ten cents of savings available for every dollar of such tax cuts based on increases in the government's deficit.

Tax cuts to promote saving and capital formation which are financed by deficit increases are thus simply contrary to purpose. The fact that they are contrary to purpose remains if, instead of being financed by borrowing, the resulting deficits are financed by the more rapid creation of money. In this case, all of the destructive effects inflation has on capital formation come into play.

By the same token, balancing the budget by means of raising taxes is destructive of saving and capital formation to the degree that the additional taxes fall on saving and the productive expenditure of business firms for labor and capital goods. Ironically, it is precisely taxes that fall heavily on saving and productive expenditure that today's advocates of balancing the budget through tax increases favor. This is because the taxes they wish to increase are precisely those which land on corporations and the so‑called rich.

The only way that these advocates of balanced budgets through tax increases could proceed consistently with the goal of capital formation would be by increasing the taxes of the very people they claim to be concerned about, namely, the poor and the mass of wage and salary earners, who save relatively little. Indeed, the only way that greater saving and capital formation is possible in the absence of decreases in government spending, is by means not only of increasing such taxes to the point of balancing the budget, but also increasing them still further, to compensate for decreases in the kind of taxes that land more heavily on saving and productive expenditure. In essence, if one advocates greater saving and capital formation and yet refuses to support reductions in government spending, one is logically obliged to advocate increasing the taxes of wage and salary earners and of the “poor” in order both to balance the budget and to compensate for reductions in taxes on profits and interest and on the “rich.”

But there is absolutely no reason to advocate such a downright fascistic policy. (As I’ve shown, just such a policy has been pursued in Sweden, the model country of today's “liberals.”) Instead of sacrificing anyone to anyone, the simple, obvious solution is sharply to reduce the sacrificing that is already going on—namely, sharply to reduce and ultimately altogether eliminate pressure‑group plundering and the government spending that finances it at the sacrifice of everyone. (The ultimate, truly progressive long-range goal would be the elimination of virtually all government spending other than for defense against common criminals and foreign, aggressor governments. The first is the police function of state and local governments; the second is the national defense function of the Federal government.)

This analysis makes clear that an essential flaw of so‑called supply‑side economics—the policy both of the Reagan administration and of the present Bush administration—was the failure to face up to the need to reduce government spending. While the policy of reducing taxes by both administrations was perfectly correct, most of the potential benefit of the tax cuts was lost through the corresponding enlargement of federal budget deficits. Regrettably, both administrations and their supporters lacked the courage required to abolish government spending programs to make those tax cuts possible without deficits.

Their failure to have done so explains why the great mass of the American people have not benefitted from the tax cuts as they should have. The explanation is that, absent equivalent reductions in government spending, the tax cuts did not translate into increases in capital formation, but the opposite. Instead of there being more demand by business for labor and capital goods there was less; instead of more rapid economic progress and rising real wages, there has been economic stagnation or outright decline, along with stagnant or falling real wages.

Ever-growing government intervention, especially in the form of environmental legislation, has also worked against capital accumulation by requiring the use of more and more capital to achieve the same results, such as requiring gas stations, dry-cleaning establishments, and numerous other types of businesses to engage in costly capital investment for the sake of protecting the environment rather than for the production of goods and services.

In addition, capital accumulation has been enormously undermined by the Federal Reserve System’s policies of credit expansion and inflation, extending back to its inception. In the last decade, these policies were responsible first for the stock-market bubble and then for the housing bubble. In both cases, vast sums of capital were wasted through malinvestment and eaten away though overconsumption based on delusions of prosperity. Thus, for example, in the housing bubble, not only were the housing-construction and building supply industries greatly overexpanded and an enormous number of homes built that should not have been built, but millions of homeowners were led to greatly increase their consumption on the strength of no foundation other than the rise in house prices induced by inflation and credit expansion. Earlier in the decade, the same kind of overconsumption took place on the foundation of inflated stock prices and similar malinvestment took place in other industries, such as telecommunications.

Finally, it must be mentioned that the Fed’s inflation and credit expansion have also been responsible for a vast, artificial increase in economic inequality since the mid 1990s, just as they were during the 1920s. This economic inequality was built not on inequality of economic contribution, as is normally the case, but merely on new and additional money. This new and additional money created by the Fed and its client banking system, poured into the stock market and then the housing market. In the process, it created vast paper capital gains in terms of stock and housing prices—the same paper gains that brought about overconsumption. In the case of the stock market, the paper gains went overwhelmingly to the wealthy; they had the largest investments in stock and were more likely to be in a position know how to take advantage of the rising market. At the same time, the artificially low interest rates caused by the infusions of new and additional money encouraged an artificial lengthening of what “Austrian” economists call the structure of production. Such artificial lengthenings create a corresponding artificial increase in the magnitude of profits in the economic system.

This last point can be understood by recognizing that when taken in the aggregate, the funds business firms expend in paying wages and in buying capital goods (e.g., materials, components, supplies, advertising, lighting and heating, as well as machinery and plant) generate or, indeed, directly constitute the great bulk of business sales revenues in the economic system. In every year, the expenditure for capital goods constitutes equivalent sales revenues to the sellers of capital goods. In every year, the payment of wages enables wage earners to expend an approximately equivalent amount in buying consumers’ goods from business. Thus the total of business firms’ productive expenditures in any given year directly or indirectly show up as business sales revenues in the economic system, for all practical purposes within the same year. (The extent to which the wage earners of any given year might wish to defer the expenditure of some the wages paid to them in December into January, say, is counterbalanced by the same kind of choices made the year before.)

Now sooner or later, those same productive expenditures that underlie most of the sales revenues of business also show up as costs of production of business needing to be deducted from sales revenues in the computation of profits.

A key question is when do they show up as such costs of production? The same dollar amount of productive expenditure is capable of showing up as an equivalent amount of cost to be deducted from sales revenues within days or weeks or only over a period of months or years. For example, $1 million expended by grocery stores in buying produce at wholesale will show up as $1 million of such cost within days. However, $1 million expended in the construction of a new building with a depreciable life of forty years will show up as a cost of production to be deducted from sales revenues only after the building is fully completed, and then at the rate of just $25,000 per year, as per its forty-year depreciable life. Before $1 million of expenditure for the construction of such buildings could result in $1 million of depreciation cost being incurred each year, the process would have to be repeated for forty years, by which time forty such buildings would be in existence, each being depreciated at $25,000 per year.

The implication of this discussion is that shifts in the pattern of productive expenditure with respect to the time when the expenditures will show up as costs ready to be deducted from sales revenues, are capable of having a profound effect on business profits for a more or less considerable period of time. This is because while the sales revenues that result in any given year from any given amount of productive expenditure in the economic system remain the same, the costs to be deducted from those sales revenues that correspond to that given amount of productive expenditure are capable in varying degrees of being deferred to future years. Thus, for example, shifting $1 million of productive expenditure from the purchase of groceries at wholesale to the construction of a new building implies a reduction in the costs deducted from sales revenues in the economic system in the amount of $1 million in the current year. (The reduction is a full $1 million, because while the building is under construction it does not yet give rise even to the $25,000 per year depreciation cost that it will occasion when completed and brought on stream.) Thus, to the extent that the structure of production is lengthened and more and greater deferrals of cost accordingly take place in the face of sales revenues of any given amount, profits in the economic system are correspondingly increased. These are the profits of the boom period.

The Federal Reserve’s easy money, low-interest rate policy both puts new and additional money into the market that raises productive expenditures and sales revenues and simultaneously encourages the shifting of productive expenditures to points more remote from the time when they will show up as costs of production. Productive expenditures aimed at results further in the future are an inevitable accompaniment of lower interest rates. In this way, the policy of credit expansion brings about a systematic deferral of business costs in the face of any given volume of business sales revenues and a corresponding enlargement of business profits for which there is no sound underlying economic basis and which would not exist in the absence of credit expansion.

Thus, to the extent that it is not the result economic ignorance and/or sheer malicious envy, the left’s resentment of economic inequality turns out to be a resentment that logically should be directed against its own beloved policy of credit expansion.

IV

All of the left’s dissatisfaction and resentment should be directed against its own policies and against itself for its volitional, chosen economic ignorance. It knows nothing about the role of capital in production or what real wages and the standard of living actually depend on, or practically any other aspect of economics. It is intent on driving the machinery of government in a mental state comparable to the driver of a car or truck under the influence of alcohol or other, stronger drugs.

Its response to the growing destruction it causes as it proceeds along in its mental fog is to call again and again for “change.” It brings about one change after another, each time for the worse. It can neither tolerate the conditions its policies create nor find the courage to admit how profoundly wrong it has been in urging its policies, which might then permit its members to begin to learn the economics and political philosophy they need to know to urge rational policies. Instead, it is so fundamentally and profoundly wrong that it goes on upholding its ignorance as truth even in the face of the worldwide collapse of what for generations its members had expected to become a utopia, namely, socialism.

Instead of taking the failure of socialism as evidence of its own ignorance, it chooses to take it as a failure of human reason. And in consequence it has now turned on reason, science, and technology. Perhaps in implicit recognition of its own capacity for destruction and carnage, it has turned from a movement that only a few decades ago eagerly looked forward to the results of paralyzing the actions of individuals by means of “social engineering” to now seeking to paralyze the actions of individuals by means of more and more prohibiting engineering of any kind. What the left should want to stop are its own actions. Because they are truly dangerous, and on some level it knows this.

Of course, in a further display of their ignorance and blindness, members of the left will undoubtedly characterize the line of argument I’ve presented in this article as the “trickle‑down theory.” There is nothing trickle‑down about it. There is only the fact that capital accumulation and economic progress depend on saving and innovation and that these in turn depend on the freedom to make high profits and accumulate great wealth. The only alternative to improvement for all, through economic progress, achieved in this way, is the futile attempt of some men to gain at the expense of others by means of looting and plundering. This, the loot‑and‑plunder theory, is the alternative advocated by the redistributionist critics of the misnamed trickle‑down theory. The loot‑and‑plunder theory is the theory of Obama, of the Democratic Party, and of much of the Republican Party. It is time to supplant it with the sound economic theory developed by generations of intellectual giants ranging from Smith and Ricardo to Böhm-Bawerk and Mises.


Copyright © 2008, by George Reisman. George Reisman, Ph.D. is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor Emeritus of Economics. His web site is http://www.capitalism.net/ and his blog is www.georgereisman.com/blog/. A pdf replica of his complete book can be downloaded to the reader’s hard drive simply by clicking on the book’s title Capitalism: A Treatise on Economics and then saving the file when it appears on the screen.

In the U.S. Senate the Guilty Repeat Their Interrogation of the Innocent

On March 15, 2006, I posted the following article on this blog. Not a single word needs to be changed today, more than two years later, because it describes the identical travesty of ignorant and dishonest United States Senators heaping blame on others for the consequences of their own reckless and destructive policies.

In an article titled “A Senate Panel Interrogates Wary Oil Executives” today’s New York Times reports that “The nation's top oil executives were called before Congress again yesterday to defend their industry's...record profits, in the face of public outrage over high oil and gasoline prices.”
.... I titled this article “In the U.S. Senate the Guilty Interrogate the Innocent.” A more complete title would be "In the U.S. Senate, Senators Serving the OPEC Cartel Interrogate American Energy Producers Whom They Prevent from Breaking that Cartel.” How do U.S. Senators, and the whole US government, do this? They do it by preventing the expansion in domestic oil production that could take place in Alaska, offshore on the continental shelf, and in the vast territories that have arbitrarily been set aside as wildlife preserves and wilderness areas and closed to oil drilling. They also do it by preventing the construction of new atomic power plants and by impeding the mining of coal and the development of additional supplies of natural gas.
Larger supplies of domestically produced oil would increase the world supply of oil and drive down its price. And they could do so very dramatically, because just as a few percent decrease in the supply of oil is capable of increasing its price by a multiple of several times that few percent, so a few percent increase in the supply of oil would work just as powerfully in the opposite direction.
At the same time, the availability of larger supplies of atomic power, coal, and natural gas, would reduce the demand for oil, since the additional supplies of these fuels would replace oil to an important extent. The oil no longer needed by an electric utility, for example, because that utility would now use atomic power or burn coal, that oil would have to find some alternative use, and to open up that use its price would have to be substantially lower.
Our government’s policy of preventing the increase in the supply of oil, atomic power, coal, and natural gas, is what is responsible for the high prices of oil and gasoline that we must now pay. Let it just get out of the way, and the supply of all these forms of energy will dramatically increase and the price of oil and gasoline will fall, even more dramatically.
Every senator who votes to place obstacles in the way of U.S. energy production, who helps to harass U.S. energy producers, is voting to hamper OPEC’s most important competitors and to allow OPEC to go on obtaining high prices. Such senators are the ones who bear responsibility for the high price of oil and gasoline. They are senators serving OPEC not the American people.
They are the ones who deserve to be interrogated, in order to learn how they could be so blind, so stupid, and so destructive.


This article is copyright © 2008, 2006, by George Reisman. George Reisman, Ph.D. is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor Emeritus of Economics. Copyright © 2008, by George Reisman.

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

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

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

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

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

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

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

The Role of Leverage

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

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

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

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

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

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

Leverage and Bank Capital

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

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

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

Credit Contraction and Deflation

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

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

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

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

Bank Failures and Bank Runs

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

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

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

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

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

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

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

The Potential for Deflation Today

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

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

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

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

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

In addition to these checking deposits, our present money supply consists of approximately $800 billion in currency outside the banking system. Our total money supply is thus currently $3.3 trillion. Of these $3.3 trillion, the quantity of standard money is approximately $840 billion: the currency outside the banks plus $40 billion of currency reserves of the banking system.[4]

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

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

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

Why Massive Deflation Must Be Prevented

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

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

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

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

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

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

True and False Remedies

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

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

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

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

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

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

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

How to Increase the Capital and Reserves of the Banking System

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

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

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

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

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

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

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

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

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

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

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

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

Gold as the Source of New Bank Capital and Reserves

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

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

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

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

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

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

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

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

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

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

This 100-percent-reserve gold standard as thus far described would obviously be a long way from the full-bodied 100-percent-reserve gold standard that Rothbard envisioned, and which I myself have elaborated upon and advocated. It would be a standard that for some time was largely just nominal, in that the actual gold of the of monetary system would still be in the possession of the Federal Reserve System. Nor would there yet be any obligation of the Fed to buy or sell gold at the price of $12,700 per ounce or at any other price. The purpose of the system I have described would simply be the twofold one of providing reserves sufficient to prevent any possible reduction in the supply of checkbook money and also of providing capital to banks sufficient to substantially more than offset the losses otherwise resulting from a decline in the value of banks’ assets.[5]

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

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

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

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

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

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

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


Notes

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

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

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

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

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

[6] See above, the preceding note.

Copyright © 2008, by George Reisman. George Reisman, Ph.D. is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor Emeritus of Economics. His web site is www.capitalism.net and his blog is www.georgereisman.com/blog/.

The Nature of Environmentalism

In my previous post, “A Word to Environmentalists,” I wrote "the first step you need to take is to stop using the same word `environmentalist’ to describe both them [advocates of mass destruction and death] and you. So long as you do use the same word, people cannot help but think of you all in the same terms.”

In reply, a respected colleague of mine at the Mises Summer University, wrote the following:

I'm not sure I buy that argument. It seems to assume something like the following premise: “If many of the most prominent people who embrace the label `X-ist’ have advocated bad stuff, then one shouldn't call oneself an `X-ist.'” But that premise seems to have some odd con-sequences, as follows:

Many of the most prominent people who embrace the label "atheist” (e.g. Stalin, Pol Pot) have perpetrated great evil, so Ayn Rand shouldn't have called herself an atheist.

Many of the most prominent people who embrace the label “liberal” (e.g. Woodrow Wilson, FDR) have perpetrated great evil, so Ludwig von Mises shouldn't have called himself a liberal.

Many of the most prominent people who embrace the label “capitalist” or '”free-marketer” (e.g. the GOP) have perpetrated great evil, so George Reisman shouldn't call himself a capitalist or a free-marketer.

Many of the most prominent people who embrace the label "egoist” (e.g. Max Stirner, Nikolai Chernyshevsky), while not exactly perpetrators of evil, have at any rate advocated some pretty dubious stuff, so Ayn Rand shouldn't have called herself an egoist.

And so on.

I mean, why let the bad guys set the meanings of all these terms?

I have quoted my colleague not so much in order to answer him in particular, but because his response provides a good starting point for providing a further explanation of the profound and inherent evil of environmentalism and why a reasonable person should no more call himself an environmentalist than he would call himself a Communist or Nazi.

It should be realized first of all that “environmentalism” is in a very different category than the examples of the advocacy of atheism, liberalism, et al. by authors who also propound clearly destructive ideas. This is because atheism, liberalism et al. in themselves do not represent a philosophy or program that is evil on its face or that necessarily implies evil. (In this connection, it should be recalled that Stalin and Pol Pot committed their atrocities not in the name of atheism, but in the name of Communism.) In addition, in all of the examples cited there are also prominent supporters of the doctrines who go out of their way to present theories and programs that demonstrably promote human life and well being. Thus both Ayn Rand and Mises were atheists, liberals, pro-capitalist and pro-free market, and were egoists. Their writings serve as far more than a counterweight to the wrong or dubious ideas of other supporters of these doctrines and, indeed, make a compelling case for why these doctrines themselves in fact serve to promote human life and well being.

However, there are no counterparts to Rand and Mises in the advocacy of environmentalism. (Nor could there be.) No one in environmentalism rises to challenge the evils that its leaders and spokesmen advocate or to show that environmentalism is the opposite of what they claim.

By way of contrast, consider the following case. Imagine that someone known as a prominent supporter of Austrian economics wrote an article or gave a speech in which he advocated the enactment of wage and price controls or the nationalization of industry. I think that everyone affiliated with the Mises Institute, certainly myself included, would be all over this person and make it as clear to the world as possible that his views not only did not represent those of Austrian economics but were in complete and total opposition to everything Austrian economics stands for.

Now imagine that a prominent environmentalist writes an article or gives a speech in which he expresses the wish for a virus to come along and wipe out a billion people. What will be the reaction of the environmental movement? Will that individual be denounced for misrepresenting the movement? Will the rest of the movement’s leaders rush to assure the world that that individual was so far from representing environmentalism that he actually represented the diametric opposite of its principles?

Not at all. There will be no negative reaction of any kind from within the movement, not even a raising of eyebrows. I can say this with the utmost confidence, because such statements have already been made, and made repeatedly. And there has been no outrage, no negative response of any kind from within the environmental movement.

Here’s David M. Graber, in his prominently featured Los Angeles Times book review of Bill McKibben’s The End of Nature: “McKibben is a biocentrist, and so am I. We are not interested in the utility of a particular species or free-flowing river, or ecosystem, to mankind. They have intrinsic value, more value—to me—than another human body, or a billion of them.… It is cosmically unlikely that the developed world will choose to end its orgy of fossil-energy consumption, and the Third World its suicidal consumption of landscape. Until such time as Homo sapiens should decide to rejoin nature, some of us can only hope for the right virus to come along.”

And here’s Prince Philip of England (who for sixteen years was president of the World Wildlife Fund): “In the event that I am reincarnated, I would like to return as a deadly virus, in order to contribute something to solve overpopulation.” (A lengthy compilation of such statements, and worse, by prominent environmentalists can be found at Frightening Quotes from Environmentalists.)

There is no negative reaction from the environmental movement because what such statements express is nothing other than the actual philosophy of the movement. This is what the movement believes in. It’s what it agrees with. It’s what it desires. Environmentalists are no more prepared to attack the advocacy of mass destruction and death than Austrian economists are prepared to attack the advocacy of laissez-faire capitalism and economic progress. Mass destruction and death is the goal of environmentalists, just as laissez-faire capitalism and economic progress is the goal of Austrian economists.

And this is why I call environmentalism evil. It’s evil to the core. In the environmental movement, contemplating the mass death of people in general is no more shocking than it was in the Communist and Nazi movements to contemplate the mass death of capitalists or Jews in particular. All three are philosophies of death. The only difference is that environmentalism aims at death on a much larger scale.

Despite still being far from possessing full power in any country, the environmentalists are already responsible for approximately 96 million deaths from malaria across the world. These deaths are the result of the environmentalist-led ban on the use of DDT, which could easily have prevented them and, before its ban, was on the verge of wiping out malaria. The environmentalists brought about the ban because they deemed the survival of a species of vultures, to whom DDT was apparently poisonous, more important than the lives of millions of human beings.

The deaths that have already been caused by environmentalism approximate the combined number of deaths caused by the Nazis and Communists.

If and when the environmentalists take full power, and begin imposing and then progressively increasing the severity of such things as carbon taxes and carbon caps, in order to reach their goal of reducing carbon dioxide emissions by 90 percent, the number of deaths that will result will rise into the billions, which is in accord with the movement’s openly professed agenda of large-scale depopulation. (The policy will have little or no effect on global mean temperatures, the reduction of which is the rationalization for its adoption, but it will have a great effect on the size of human population.)

It is not at all accidental that environmentalism is evil and that its leading spokesmen hold or sanction ideas that are indistinguishable from those of sociopaths. Its evil springs from a fundamental philosophical doctrine that lies at the very core and deepest foundations of the movement, a doctrine that directly implies the movement’s destructiveness and hatred of the human race. This is the doctrine of the alleged intrinsic value of nature, i.e., that nature is valuable in and of itself, apart from all connection to human life and well being. This doctrine is accepted by the movement without any internal challenge, and, indeed, is the very basis of environmentalism’s existence.

As I wrote in Capitalism, “The idea of nature’s intrinsic value inexorably implies a desire to destroy man and his works because it implies a perception of man as the systematic destroyer of the good, and thus as the systematic doer of evil. Just as man perceives coyotes, wolves, and rattlesnakes as evil because they regularly destroy the cattle and sheep he values as sources of food and clothing, so on the premise of nature’s intrinsic value, the environmentalists view man as evil, because, in the pursuit of his well-being, man systematically destroys the wildlife, jungles, and rock formations that the environmentalists hold to be intrinsically valuable. Indeed, from the perspective of such alleged intrinsic values of nature, the degree of man’s alleged destructiveness and evil is directly in proportion to his loyalty to his essential nature. Man is the rational being. It is his application of his reason in the form of science, technology, and an industrial civilization that enables him to act on nature on the enormous scale on which he now does. Thus, it is his possession and use of reason—manifested in his technology and industry—for which he is hated.”

Thus these are the reasons that I think it is necessary for people never to describe themselves as environmentalists, that to do is comparable to describing oneself as a Communist or Nazi. Doing so marks one as a hater and enemy of the human race.

Whoever believes that it is possible to be a “free-market environmentalist” is guilty of a contradiction in terms. The free market rests on a foundation of human life and well-being as the standard of value. Environmentalism rests on a foundation of the non-human as the standard of value. The two cannot be reconciled. It’s either-or.

I know that these conclusions are upsetting to many people. It’s got to be upsetting to realize that one is advocating destruction and death. But fortunately, there’s a simple and ultimately happy solution: just stop doing it. Stop being an environmentalist!

Copyright © 2008, by George Reisman. George Reisman, Ph.D. is the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor Emeritus of Economics. His web site is www.capitalism.net.