There are quite a few so-called “libertarian” groups touting so-called “anarcho-capitalism”. To my mind this term is nothing but an oxymoron that serves to confuse people who have otherwise correct instincts. This might be because one of the apparent proponents of the idea was none other than Murray Rothbard. It’s possible, then, that this is just a case of guru-worship. At any rate, these are my views on the subject.

Before getting into a debate about complex philosophical topics like this, it is always a good idea to carefully define terms, so here are my definitions. Keep in mind that, as I will be discussing an ideal, I am using terms in the normative sense, that is, for example, law as it should be not law as it currently legislated. In other words, we are discussing theory and not practice.

• Politics – the study of the proper structure of a collective such that each individual within that collective has the maximum freedom to act ethically[1]
• Law – the body of ideas which delimit the manner in which individuals may act within society such that the political goal is achieved
• Government – the organized enforcement of law. A proper government is, in essence, a collective form of self-defense (and self-defense is the only lawful use of force.[2])
• Anarchy – the absence of organized law enforcement
• Capitalism – the economic ideal under which anyone may aspire to ownership of the means of production. Capitalism is the natural development of a proper political system.

Now, it should be clear from the above definitions that anarchy and capitalism are incompatible. Capitalism is the result of a proper system of government – i.e., it develops from a political (collective) system under which the individual’s rights to property are respected and the recognition of those rights is enforced. Without such enforcement, there is no means of dealing with criminals other than for each individual to engage in war each time he encounters one.

Now the so-called “agency-theorist” will argue that through freedom of association individuals are “free” to band together to protect themselves. This is true, however, the moment they do, organized law enforcement is born, at least within the collective, and there is no longer a state of anarchy. Everything external to that collective, however, is still potentially in a state of war – only now it is war between tribes.

Now, the same anarchist may argue that these “small” governments are preferable to the large centralized one. Again, this depends upon the state of the “small” government. If it is a criminal government, the same problem exists – the potential for tribal warfare. If they are not criminal then of course there is a consistency of law and so which “tribe” you belong to is largely irrelevant. It is for precisely this reason that there will always be a natural tendency towards centralization. Any proper government which encounters a criminal one is justified in removing the criminal government if it is within its power to do so. In fact, if it were possible to ensure that criminals could never gain control of the machinery of government, a world government would be ideal. Yet of course, this is impossible – the very thing that makes a proper government necessary is the very thing that threatens it – the existence of criminals.

It is because of this fact that government can only ever approach the ideal, it can never reach it. This is not a defect specific to Man – it is a defect of life itself. All living things are subject to ignorance and uncertainty and it is ignorance and uncertainty which breed crime, on the parts of both the perpetrator and the victim. Only a state of perfect knowledge would allow for a perfect government – but of course in a state of perfect knowledge no government would be needed.

That life is subject to ignorance is a priori true and from this it follows that there is no such thing as Utopia. The “agency theorists” make the same error that the socialists and globalists make. They assume that a “fool proof” government is possible. But fools make excellent criminals and even better victims. For this reason, neither world government nor anarchy will ever prevent tyranny, injustice or war. As many wise men have pointed out, liberty requires constant vigilance. This is not idle talk. There is no short cut.

The belief that a short cut exists and talk of the means to achieve it serve only to facilitate the eventual decline of a proper government. The populace becomes complacent, believing they cannot be victimized, and greater and greater ignorance of political matters becomes the norm. It is this ignorance that eventually leads to the criminal takeover of the machinery of government and so governments, like the population, have a life cycle with a difference only in the relative length of time they persist.

Does this mean that Man should not strive for ideals? After all, they are only approachable, and never fully realizable. This is a little like saying that one should not attempt to prolong his life because he must inevitably die. As with the question of life and death, recognizing these truths can only help us to better approach the ideals.

Some means of preserving a proper government do exist and are generally attempted. Democracy, for example, minimizes the ignorance of any one man, federation, i.e., the maintenance of local governments, checks the power of the central government, separation of powers limits the effects of any one arm of government, representation sets up a system of local responsibility, etc. Even so, these ideas can only maintain a proper government when the people are vigilant. None of them is “fool-proof” and none of them ever can be.

It should now be clear that our personal values are inextricably linked with and dependent upon the knowledge and vigilance of our fellow man. It is of this fact that criminals are least aware. They imagine that slaves can approach the productivity of free men. They confuse relative wealth with absolute wealth and imagine that there will always be a supply of able men to plunder, even as they murder all the able men. All man can hope for is to stamp out such ignorance whenever he encounters it. No one wants to hear this. But burying one’s head in the sand is exactly what needs to be avoided. Anarchy, which is essentially the return to a primitive existence, is certainly not the answer.

Notes:

[1] a discussion of this is a bit outside the scope of my article, but I will try to make this a little clearer for those who are new to the subject. Because knowledge remains unalterably dispersed among individuals, no man or group of men will ever be in a position to determine what action is for another man the ethical action. This determination must always be made by the acting individual alone and therefore he must always be as free as possible to make that determination – even if he may ultimately err. It is to ensure this freedom that laws are instituted which prohibit to men those acts which interfere with his neighbor’s identical freedoms. This is the basis for the ideal known as Natural Law.

[2] Please note that government is NOT defined as a “monopoly on the use of force”. This idea contains within it the notion that government rightfully exercises some power that is forbidden to the people. Under a proper government the citizens retain the individual right to self-defense and the only purpose of government is the defense of the collective. A proper government might under certain conditions err and imprison an individual who has exercised this right because it is often difficult determine that an act was performed in defense. It is for this reason that citizen are generally expected to leave law enforcement to the government. Nevertheless, I think it’s important not to confuse this with a “monopoly” on force.

One of the virtues of being a generalist is the ease with which one can often detect a con. While the specialist examines the bark of a single tree, the generalist sees the forest for the trees. The generalist’s overall knowledge of surrounding area often gives him vital clues, even before any specialized investigation begins. For that very reason the con man often attempts to envelop his intended victim in a specialized and intimidating language where the victim will no longer be able to identify contradictions on his own. Once the victim’s reasoning is crippled, there will be no choice but to rely on the opinions of the “experts”.

Enter Mr. Karl Denninger, a financial writer who has written several articles that attempt to undermine the case for “hard” money. In Sound Banking A Capitalist Imperative Mr. Denninger invokes the specialized field of accounting hoping to convince the reader that fractional reserve banking is not fraudulent and creates no new money. To the generalist, who can already place “fractional reserve banking” in its proper historical geopolitical context sans accounting, Denninger’s assertion is preposterous on its face.

Nevertheless, there remains good reason to proceed with a full investigation of Denninger’s “accounting” claim. If the generalist is able to decode the specialist language, he will not only deepen his own understanding but he will also be able to more easily communicate his argument to others. Let us put aside Mr. Denninger’s complex and incorrect accounting example for the moment and start from the beginning, with a much simpler example, a pawn shop with one item pawned in exchange for a 20 dollar loan:

Liabilities and Assets balance because the ring is in possession of the pawn shop. The balance sheet indicates that there has been no fraud or theft because liabilities and assets balance to zero. Indeed this is the philosophy and very reason for the existence of the accounting field. “Accounting” for things is merely the objective operation of ensuring that nothing has been lost or stolen, assets and liabilities must balance out. Despite the taxman’s best efforts to corrupt the accounting field with a myriad of endless depreciation schedules, accounting will never be able to determine wealth or value. Measuring wealth will always depend upon an individual’s particular context and situation. Accounting can certainly be a useful tool for clarifying and presenting data but it will never be able to objectively decide a hierarchy of values — that always requires the individual. The science of accounting will never replace the art of business.

Now that we understand the purpose of accounting and why the numbers are supposed to balance out, let’s attempt the same accounting example with a bank:

Again the numbers seem to balance out. Could Denninger be right?! But what happens once we try to physically verify where the entries are? Everything is verified except of course the depositor’s cash which is nowhere to be found! It appears only as an electronic blip worth as much as the numbers in front of you now.

Classical accounting fraud – the reason for audits

In the pawn shop example, if you discovered that the ring was missing from the shop’s inventory you would realize the pawn shop accounting numbers that seemed to balance out as electronic blips were actually a fraud. The same accounting logic that applies to pawn shops must apply to banks as well. Classical accounting fraud involves having false entries that do not correspond to physical reality, the numbers still seem to balance out, however one of the entries is a lie.

The auditing process – verifying each accounting entry is similar to verifying each syllogism of a mathematical proof. Only if each link in the chain of reasoning is correct can one proceed to validate the bottom line. In our example, our auditor discovers that not only is the Depositor’s Cash line a fraud but the $20,000 of reserve labeled as a bank asset mysteriously has the same identification numbers as some of the missing cash originally deposited by the bank’s customer!

How it is even worse than that because of the reserve multiplier

If the depositor hired an investigator to trace where the rest of the cash went he would find it residing in other banks as their cash reserves. If this bank was the only one in town the balance sheet might eventually look like this:

Obviously this process could continue until all $200,000 of the original depositor’s cash is listed as Bank Reserves. The overall deposits for customers would total 2 million dollars. Each of the deposit entries has no physical cash and is manifested only as an electronic bank credit. Nevertheless, Denninger concludes that his definitions are correct:

Ok, having settled on definitions, we will now turn to the fundamental reality of fractional reserve banking. Many people claim that banks “create money” or “print money.” This is not true; a bank recycles money, that is, it increases the velocity of a given amount of money in circulation, but an ordinary bank (not a Central Bank) never creates new money.

The sheer absurdity of Denninger’s claim is now exposed – regular banks must create new money out of electronic blips or they must commit fraud. Only because the electronic blips presented by banks are considered to have unique and magical properties is criminal prosecution avoided – namely that the electronic blips of banks are the creation of entirely new money.

Cash (paper) and Bank Credit (electronic blips in banks only) is the modern analogy to the gold and paper receipts of the past. Banks create credit and by doing so expand the money supply, nothing less than a euphemism for legalized counterfeiting. The accounting example above also explains why every electronic blip of bank credit (money creation) leaves a legacy of debt on the other side of the ledger. Is it any wonder why so much debt exists in the World today?

In another article Mish “Hard Money” Goes Off The Rails Mr. Denninger takes a completely different tack in trying to undermine the excellent case for hard money made by Mike Shedlock. This time Mr. Denninger attempts to provide a metaphysical justification for expanding the money supply as both natural and inevitable:

I walk into the forest (grow) and cut down trees (mine) which I then process into lumber (manufacture.) I dig up some iron ore (mine) and turn it into steel nails (manufacture.) With these two items I now construct a house (manufacture.) That house (and all the products that I used to make it) are in fact money. They were the product of mining, growing, and/or manufacturing. Each of these acts is in fact the creation of money.

Yet who decides to create the money from the house?! If Mr. Denninger constructs his own $500,000 house can I print myself $500,000 dollars (or even easier just enter the amount electronically into my bank account)? Can I then proceed to buy the house with my newly minted money? Can Mr. Denninger who built it? Apparently neither of us, somebody else has that privilege. A naive person might say “society”, those who suspect something is wrong would probably say “government”, while those who are in the know will tell you “the private banking cartel” of course!

In any case, Denninger’s concrete example is ultimately founded upon his own flawed definition of money, a definition that has conveniently confused the terms “money” and “wealth”:

Money: The product of either growing something, mining something or manufacturing something. “Money” is actual wealth, and comes into being only through creation. Ultimately, all money is traced to the only “free lunch” that exists in this solar system, that is, the power of The Sun, although in many cases (e.g. mining) the activity is in fact discovery of previously-created wealth (by the actions of The Sun) levered through human endeavor.

“Wealth” depends not only upon the individual person’s own definition but upon their particular location in time! “Money”, on the other hand, has an objective definition that can be easily quantified and agreed upon. Everyone agrees on how much “money” is needed to make 100 dollars, not everyone agrees on how much “wealth” they would personally ascribe to it. Should your organs be considered a new addition to society’s money supply?

Indeed, there is no way for banks to objectively grow money based upon “wealth” creation. Nor is there any reason to do so. Despite this fact banks create new money everyday with the most common excuse given to the public being the need to “stabilize” prices. Promoting themselves as defender of “stability”, they will never warn you that the “stability” they offer is the stability of a feudal system. For only a feudal lord seeks to “stabilize” prices – workers seek either an increase of their own wages or a decrease of their cost of living. Under a stable, fixed money regime the quality and quantity of goods is allowed to increase relative to the fixed quantity of money. The counterfeiter who instead “stabilizes” prices by destabilizing the quantity of money hinders the market process from producing an ever increasing prosperity. The ideal that people intuitively seek has never been stable prices but stable money.

All prices transmit important information to market participants and only when the quantity of money remains absolutely fixed in quantity is the price information of supply and demand transmitted “noise free”. The phenomena of boom and bust would disappear. Only with all counterfeiters removed, can the market operate as efficiently as possible.

Historical quest for the perfect money and cons perpetrated to profit from it

The desire to establish a fixed quantity of money has historically led to commodities such as gold and silver serving as money because such metals are the only commodities that can approach the abstract ideal of a stable money — readily fixed in quantity (new mines add little to the overall pre-existing quantity), easily portable, and difficult to counterfeit. Not surpisingly, Mr. Denninger also rails against such a fixed money supply based upon metal:

Mish and others like him are wrong because they have their premise incorrect. This incorrect base premise leads to shrill calls for that which will not work (hard currency) and in fact has a thousand-year plus history of not working to stop depressions and other serious economic imbalances.

Yet despite over a thousand years of history none of these people ever examine their premise to discover why these so-called “fixes” never, ever work. They instead wave their arms and try to come up with all sorts of other “explanations” for things like the Panic of 1873 and the Depression beginning in 1929 instead of examining the foundation of their premise and recognizing it’s infirmity.

Mr. Denninger’s superficial and deceptive historical commentary is an immense disservice to his fellow man and only exposes his own ignorance of the banking conditions that preceded the panics of 1873 and 1929. He assumes the rather naive notion that rulers have ever allowed a “hard currency” to exist without manipulation. Even old roman gold coins were diluted by the emperors. The gold gave the coins their appeal to the general public, the diluting copper gave the emperor his pound of flesh. As the coins became more diluted, prices rose. Every economic bust was the result of financial manipulation because every economic bust was preceded by the introduction of a legalized counterfeit. The consequent result is as inevitable as the series of events that follow a man jumping off the ground.

Perhaps the most concise definition of money is the best one: Money is the unique commodity that all sellers in a particular market agree to accept. Thus, the terms “money” and “market” become inextricably linked; the “market” being a group of sellers all of whom accept a common currency called “money”. Honey might be the currency of the beehive, while money is the currency of the rush hour commute. Using this simple paradigm, it becomes clear that there exists markets of all kinds each using their own currency. The obvious fact that certain proprietors are not interested or willing to sell their assets for a particular “money” should immediately dispel the illusion that “money can represent all wealth”.

Money serves a particular function no different than a nut or a bolt and like any tool has an optimal use. Unfortunately that use has been perverted to serve someone other than the ignorant public. If a central bank creates 100 billion dollars in a year, private banks can create one trillion dollars a year – conservatively speaking because the fractional reserve ratio only applies to checking accounts. A trillion dollars a year can change cultures, corrupt academic institutions and scientists, brainwash the public, create new religions and buy politicians. Perhaps it explains why the little mafias the world over have never been able to successfully engage in counterfeiting, perhaps it also explains why some people persist in the magical belief that banks can and should be doing something that nobody else can – turn electronic blips into money. To support his own belief in money creation, Mr. Denninger confuses “money” with “wealth” and in the process elevates money to life itself. He claims that hard money advocates engage in idolatry, while he himself requires money to be everything under the Sun.

This post is again inspired by an article from The Freeman, the magazine for the Foundation for Economic Education. In thinking about it now, I imagine that today I would disagree on some level with a great many of the articles published in the Freeman over the years. Some ideas are more distressing than others, though. For example, in a recent letter to the editor, Stephen C. Apolito corrects Howard Baetjer on the definition of inflation. Baetjer responds saying he agrees “with Murray Rothbard’s aversion to government-issued fiat money, largely because I believe that governments and their central bankers cannot possibly know how large the money supply should be” and he thinks that “when people wish to hold more money, banks should create more money. When they wish to hold less, banks should extinguish some.”

Banks should be creating and extinguishing money? In the words of the Freeman itself “It Just Ain’t So!” Whether “free banking” or no, banks shouldn’t be messing with the supply at all. Here’s why.

Why the Ideal Money Supply is of a FIXED and Arbitrary Quantity

First, let’s think about what money actually is. Money is NOT the “most sought after good”, although it usually develops from that. Yes, money is a “medium of exchange”, but defining money so generally doesn’t tell you anything about what serves as the ideal. In addition to its function facilitating exchange (or as part of it) money serves also as a “data storage” device and it facilitates calculation by keeping track of who owes what in terms of goods. In that sense, it is essentially an IOU.

I think some confusion over this concept stems from the fact that money usually develops spontaneously from a commodity, usually the most “sought after good”. But, money does not have to be a commodity. It can be sticks with carved notches (the tally sticks of Medieval England for example), numbers in a ledger, or blips in a computer.*

Now in real life, it’s nearly impossible to separate any legitimate money from a commodity. (You’ll see why I use the term legitimate in a minute). The reason is that any attempt to do so leaves open the ability to rig the tally. For this reason, the commodity chosen to be money is usually something rare and difficult to obtain more of. A good money generally has to have other properties, too, like being easily divisible, and every divided piece must be identical to the others. (This property is known as fungibility.) This is the reason that elements like gold and silver make such terrific money. The quantity of gold or silver in circulation at any given time is pretty much fixed because it is so difficult to mine and because it is a commodity which is used up to some degree (although gold and silver, as elements can always be reclaimed from waste, it is often expensive to do so.) Now of course, gold and silver are actual commodities and so the amount in circulation at any given time can and should shrink and grow. But it is for this reason that the concept money gets confused with the concept commodity in people’s minds. Money as a concept (Aristotle might have said money qua money) ought to be fixed in quantity. The quantity itself is irrelevant because money as a concept can be infinitely divided. It doesn’t matter how many goods there are, the money can be divided to accommodate any price. (Aren’t numbers beautiful?)

Just to make this really clear, let’s take a look at how it would work. Let’s say there are only 5 “blips” to go around and there are, at the start of our make believe society, exactly 5 baskets of goods. (In real life you could never divide all the goods and services in the world this way. No matter. Your brain just needs to simplify it in order to understand it. We can apply it to the real world later.)

Now we can see that each basket is worth 1 blip. What happens if the amount of goods increases to 10 baskets?

Now each basket is worth 1/2 a blip.

But what happens if our society is really productive. Suppose we end up with 10,000 baskets of goods! (Now that IS productive.)

How much is each basket worth now? We just divide 5 by 10,000 (can you DO that? Yes!) and we get each basket is worth 0.0005 blips!

Obviously with real commodity money this could get difficult. But conceptually, it’s doable and money is a concept. Even with a physical commodity money, chances are we would never need to adjust the amount of money in circulation because the arbitrary figure would be large enough to start with.

Now, why don’t I take into account the number of people in the society? The number of people in a society is not relevant to the money supply because money represents goods, not people. As long as any particular person is productive and produces goods, he ought to end up with some money, but it’s his goods (or services) which are traded for it.

Why is the ideal money supply fixed in quantity? Because modern money, unlike commodity money, is essentially a tally system. Money represents the portion of the supply of goods and services in an economy that you have a claim to. There is never any guarantee that you will get any particular amount of goods and services; the money represents a percentage of the goods and services available. If there is a hurricane that wipes out a portion of the supply of goods and services, you will suffer just like everyone else. When the supply of money changes, however, your proportion of the supply of goods and services changes.

Again, the truth is more complicated, but let’s looks at it simplified.

Suppose you have 2 electronic blips. The supply of money is 10 electronic blips. The amount of goods and services in our little world is 10 baskets. You therefore have a claim to 2 of them. That gives you 20% of the supply.

But, what happens if the money supply increases? You still have 2 electronic blips, but now the supply of money is 20 electronic blips. The amount of goods and services in our little world is 10 baskets. You now have a claim to 1 of them or only 10% of the supply.

Where did your other 10% go? It went into the pockets of the holders of the new money. And what did they do to earn it? Nothing.

It gets worse, however. In the above example, the pie remained the same. In a healthy economy, though, the pie does not remain the same. It grows. This allows those who keep the tally to skim quite nicely. If you only look at the “price” you are getting, you will never realize what is happening to you. Let’s look at it.

As you can see, although the “price” you pay and the number of baskets you get has remained the same, you still lost out. This is the effect of a growing money supply. And it gets worse still, because a growing (or shrinking) money supply means that calculating a profit or loss from a business becomes impossible. As this continues or worsens, business activity falls and the pie shrinks!

Why “Fractional Reserve Banking” is Always and Forever Fraud.

Now before we go on, it is necessary to understand how banks work. This is a complicated subject and I am going to take some liberties again in order to simplify it for you. First, why do we need banks?

Banks, as a concept (again Aristotle, and some other writers you may encounter might say banks qua banks), facilitate the use of money for productive enterprise. They do this by borrowing one individual’s money and lending it to another individual. For the service, banks (qua banks) take a portion of the interest the borrower pays (and sometimes some other fees). Interest, despite what you might have heard elsewhere is the necessary cost of borrowing. When you lend someone else your money you don’t have it anymore. You cannot spend it until the other person pays you back. That time is worth something and you should be compensated for it. That’s what interest does. Also included in interest payments are other factors, like what the risk is that the other person won’t be able to pay you back and in situations where the money supply is not fixed, how much inflation you can expect before the person pays you back.

This service performed by banks might not seem like much, but it is really the cornerstone of a modern economy. Think of it this way. If you decided to simply save your money in a mattress, the entrepreneur down the block who is planning to introduce an entirely new technology that will enhance your life experience 10 fold may never get the chance to introduce that technology. By lending to others we ourselves are ultimately rewarded. For this reason, banks (qua banks) are essential.

Because money and lending are so essential to a proper economy, bankers, if they are not ethical, are in a position to attain extreme power over others. They do this by obfuscating and confusing people into believing that the supply of money needs to “expand” and “contract” according to demand. This would be the case if the money were commodity based, like gold and silver. In that case the supply would expand and contract naturally based on the cost of mining and bankers would have no hand in it. Today, there is no commodity money. Today we are using a tally system with the quantity of the blips, or pieces of paper, expanding and contracting according to the whim of the banker. (It is important to note that your neighborhood banker is likely completely unaware of this. He is simply doing a job. In the US the “banker” would be the Federal Reserve, but there is likely a world system with bankers who control the Federal Reserve, too. For this reason, I don’t recommend confronting your neighborhood banker with what you learn here unless of course your goal is to help him understand.)

So, how does an ideal banking system work?

In an ideal banking system, if you lend someone your money, you cannot spend it until they pay it back. If you did, that would be kind of like having your cake and eating it, too, wouldn’t it? The modern CD or Certificate of Deposit account is closest to the ideal banking system. When you open a CD you are agreeing to lend your money to the bank for a specified length of time. For the use of your money the bank pays you a fee – the interest rate. During that specified length of time you do not have the use of your money. The bank might let you take it anyway if you need it sooner, but only after a delay and a penalty. The reason they do this is because they have promised that money to someone else as a loan and now they will have to ask that person to pay back the loan sooner. If you were the borrower in this case, you wouldn’t like that very much. (The reality is of course more complex than this – the bank might not need to ask for the money back, but they might have to turn down another loan to someone else because of it.)

Today, savings accounts, checking accounts, and other types of deposits can be “loaned out” even though technically you haven’t loaned the bank any money and you can supposedly claim it at will.

Now, how does “fractional reserve” banking work?

In the old days of the gold standard, paper money represented gold stored in a vault. It was simply easier to carry around a paper claim check than it was to carry around gold, which is heavy and hard to secure. For this reason people usually traded the claim checks and only rarely presented them to the banker to get their gold back. Nevertheless, the amount of claim checks in circulation was directly related to the amount of gold in a banker’s vault, therefore the supply of claim tickets would shrink and grow as people deposited more or redeemed claims. This wasn’t a problem because the gold was still the money and the paper just a substitute. As time went on, however, the claim checks became more and more standard and the people’s trust in them grew. At some point a banker realized that he could make a profit by “loaning out” the gold in his vault. He didn’t really have to remove any of the gold from the vault though; he could just print more claim tickets. In this case, each ticket is supposed to represent the same weight in gold, but in fact, it does not.

This is fraud.**

This is also the beginning of “fractional reserve banking.” The phrase “fractional reserve” is a banker’s euphemism. There is no reserve. The “fraction” is simply the amount of gold that the banker doesn’t print double tickets for. For example suppose the banker wants to keep a 10% “fractional reserve.” This just means that 10% of his claim tickets can be redeemed for gold before he goes bust. It also means that 90% of his claim tickets are fakes.

Now in modern times there is no gold at all. The “reserve” today is simply a percentage of the wealth that is deposited with the banks. I say “wealth” because that is the only way I can describe money which represents a real portion of the supply of goods and services as compared to money which represents nothing. In fact it is not so easy to divide like this. Unlike the gold claim tickets where the lucky few who managed to redeem their claim tickets before the banker went bust actually got the amount printed on the ticket, today there is no “amount” of anything on the ticket and it is the luck of the draw whether or not a person manages to get the full claim – in fact this may not even be calculable.

Now of course the above represents a very simplified explanation of how our modern banking systems work and how they should work. But I think it serves as a good starting point for understanding why no one – not even the government – ought to be messing with the amount of money out there. This concept is going to become more and more important for people to understand as we come to rely less and less on an actual object in our daily exchanges. Cash even in the form of paper is probably on its way out. Even today, the bulk of exchange is handled by computerized blips that have no physical representation outside of cyberspace. While convenient, this modern tally system is (and has been) an extremely dangerous state of affairs – something I think a lot of average people are starting to notice these days. I hope this article (and my previous articles The Basics: Money, Inflation and Deflation and The Basics: Banking, Inflation and Deflation) will help demystify the process somewhat.

Notes:

*I’ve gotten some questions regarding my use of the term “commodity” in this article. If you are using the term “commodity” to include any item that a person might want, money would certainly be a commodity. But, I think it’s important when defining terms not only to be clear but to have the terms be useful. I do not think it is particularly useful to define “commodity” in a way that does not differentiate money from the things it is used to buy – therefore money to me is not a commodity.

**Also known as counterfeiting. I don’t like this term, however, because some people will mistake counterfeiting as printing money against the wishes of the government. The government has no business printing money, either.

The Dow/Gold Zoom has been updated. The current ratio is 7.63.

Also updated is the “How Low Dow” chart, as I’ve started calling it.

In the first part of this two-part series on inflation and deflation we discussed how money came to be used to facilitate trade. Metals were the best commodities for use as money because they were durable, relatively rare, and were easy to mold into identical pieces. As the wealth of people grew, however, they’re store of metals came to be heavy and difficult to secure. For this reason people came to rely on specialists to whom they would entrust their gold for a fee. In return they were given a paper receipt showing that they were entitled to retrieve a certain amount of gold from the vault. For the sake of clarity we’ll call this type of specialist a “deposit banker.” If you wanted to pay someone in gold, you would simply give them your receipts for the gold in your deposit banker’s vault. In this way, paper eventually traded as if it were the gold itself. Continued…

What exactly does it mean to be a “soft science”? Over the holidays I got into a discussion with a relative about just this topic. Economics, he told me, is a “soft” science, unlike physics which is a “hard” science. What exactly is the difference?

The word “science” itself is a somewhat fuzzy term. It can be defined as any form of rational inquiry, but it can also be used to describe a particular type of rational inquiry, that of inductive reasoning – i.e., the scientific method. For the purposes of my article, I would like to define science as any form of rational inquiry. Why will become clear a little later on.

So now, having defined that, we can ask the question, what is a “soft” science?

The idea of a “soft” science is, of course, even fuzzier. When people use the term they rarely know what they are trying to say. In the end, the term usually evokes a list of what the person believes are soft sciences and a definition has to be obtained by working backwards and figuring out what they all have in common. A “soft” science is almost always a science that is impacted in some way by human motives, aspirations, and emotions. The list usually looks something like this (depending on what the person includes in the term “science”):

Economics
Politics
Psychology
Ethics
Aesthetics

And of course, all the sciences that deal with human motives and emotions rarely predict anything and are subject to endless debate. It is assumed that the topics are either too complex – as is the case with economics – or that they are relative to whatever opinion you might hold – as is the case with all branches of philosophy. This is not a coincidence. People have powerful motives to obfuscate and confuse both themselves and others with regard to these topics and the reason for that is obvious. Continued…

It sounds strange to a lot of people that both deflation and inflation are being talked about right now as if they could possibly happen at the same time. If inflation is rising prices, and deflation is falling prices, how could they happen at the same time? In fact, there are two distict meanings for the terms “inflation” and “deflation” which are often confused and interchanged, one that is common to the average person, a general rise or fall in the level of prices, and one that is more often used by economists, a rise or fall in the amount of money in circulation. Generally the latter leads to the former, but this is not always the case. For this reason we are going to be strict with the usage of these terms in this article. We will always mean a rise or fall in the level of money in circulation.

The method of inflation in the modern world is a complicated process, but we can simplify it dramatically for the purposes of understanding it. To understand what inflation is, you must first understand what MONEY is. That might seem simple, money is the green stuff you buy your bread with, right? Yes, of course. But how it got that way is not so apparent and because of that many people take it for granted without ever understanding it conceptually. Continued…

Cryptogon is an excellent news site which I highly recommend to anyone who would like his news pre-filtered for importance. In a recent post Cryptogon expresses surprise that the Fed might start buying treasuries. In fact, most of us have been wondering why the Fed HASN’T been buying treasuries, since, in fact, this is what the Fed does (buy treasuries in the open market) to implement monetary policy (i.e., inflate). Of course, inflating right now is not actually a good idea. Nevertheless, Helicopter Ben has made it seem that this is exactly what he would do to prevent a stock market crash and depression and well… so far he hasn’t done it. Maybe he’s smarter than he lets on.  (Why inflating right now is not a good idea is actually a bit complicated, I’ll try to come back to that in a follow-up post.)

You can see what treasuries the Federal Reserve currently holds by looking at the SOMA. All of the Feds holdings are here. (It is interesting that it’s called soma, which is the also the name of the happy pill from Brave New World! How Keynesian!).

Many people are also wondering why the dollar has been getting stronger. The banking system is a fractional reserve system. This means that the banks can pyramid loans on only 10% held in reserve, i.e., they can loan out 10 times what they actually have in deposits from people like you and me. When the Fed buys treasuries in the open market, they are adding to the banks’ reserves. However, if people like you and me take our money out of the bank and hold it in cash instead, we are subtracting from the banks’ reserves.  Either way, banks can ”pull in” loans or stop lending. If they do this the money supply shrinks by the amount of the expansion. As the money supply falls, so do prices. Hence, the falling stock market (and gold!) and the rising dollar. 

The quest for “liquidity” is related to this. When highly leveraged players (i.e., players who have used big loans to buy stocks) are asked to repay their loans, they have to sell their stocks to do it. The more they sell the more prices drop tripping the next round of repayment requests and so on.  The banks do not renew these loans or else individuals who would take loans to buy stocks remain on the sidelines waiting for the prices to fall further… and the credit contraction continues.

This is a fairly simplistic explanation of what is going on, but I think it will help you understand it conceptually and maybe understand the news a little better. When you hear the Fed is considering buying treasuries, you will now know that they are thinking of increasing bank reserves. I am currently working on an explanation of inflation and deflation for my new series “The Basics” and I hope to have that up for you soon. That article will go into detail about what inflation and deflation actually are. Stay tuned and by all means post any questions you have and I will do my best to answer them.

At this point, it’s worth taking a look at what happened in 1929. If you’re not yet familiar with this chart, let’s just say that you probably will become familiar with it over the next few years. This chart is from Yahoo. Click the image to go to Yahoo’s Finance site and play with it for yourself. (You may need to adjust the chart yourself back to the date range shown here.) I’ve put the cursor over the week of November 11, which is right before a powerful rally. But it’s a fools rally. For the next two years the Dow continued to decline another 85%! In fact, here are the stats:

1. a 40% decline from a high of 380.33 starting August 26, 1929 and ending the week of November 11, 1929
2. a powerful 28.5% rally that lasted until April 1930
3. a fall of 86% over the following 2 years until a low of 41.63 was reached on July 5, 1932

A total fall in the value of the Dow of 90%. If this were to happen today the Dow would end up at 1409.30. No the decimal is NOT in the wrong place.

If you are watching gold and the dow/gold zoom, then you have probably already considered that this could happen. Let me make this clear… THIS COULD HAPPEN. That doesn’t mean it will. What it means is that it COULD. It’s very easy to become so used to certain situations, hey, sometimes they’re all we’ve known in our entire lives, and we come to believe that things will always be as they are. The best way to save yourself in this market environment is to realize what could happen and protect yourself accordingly. Don’t fool yourself into thinking it can’t happen. That goes for the political environment, too. If you’re new to the idea that gangs of criminals run the governments of the world, I suggest you read a little history and recognize that about all that’s changed is the sophistication of the criminal. 

Educate yourself while you can still do it.

Be careful out there.

The idea that the government can bail out everybody seems to have given the market a kick. Personally, I think this is a whole lot of frantic short covering related to the attempt by the government to fix the prices of certain securities. In my humble opinion this can only lead to more pain later. The ultimate crash will only be that much bigger for having been delayed. The fact that a ban on (all) short selling of certain industries has been imposed only seems all the more ominous to me that they are no good. If you are trading this market, or if you have investments in it, all I can tell you is – be careful out there.

Given the significance of the date, and the fact that the markets went absolutely haywire, I figured it’s time for an update. The yearly chart hasn’t changed at all. Click the link for the latest on the other scales. I’ve added a new 2 year chart as well.

08/08/08 – Dow/Gold Zoom Update 08/08/08 – Current ratio: 13.76

07/22/08 – Dow/Gold Zoom Update 07/22/08 – Current ratio: 11.94

07/08/08 – Dow/Gold Zoom Update 07/02/08 – Current ratio: 12.14

03/11/08 – Dow/Gold Zoom Update 03/11/08 – Current ratio: 12.53

02/27/08 – Dow/Gold Zoom Update 02/27/08 – Current ratio: 13.23

01/08/08 – Dow/Gold Zoom Update 01/08/08 – Current ratio: 14.41

I haven’t had a lot of time to do updates, and not much had been happening anyway. But now seems about time to put up an update to the Dow/Gold Zoom!

11/26/07 – Dow/Gold Zoom Update 11/26/07 – Current ratio: 15.35

Given the panic conditions and the sell off in the Dow, it’s interesting that the ratio is still in the 20’s. Gold has held up very well during this correction and remains in a tight trading range.

08/10/07 – Dow/Gold Zoom Update 08/10/07 – Current ratio: 20.03

Continued…

Note: if you are searching for the Austrian Business Cycle and landing here, you might be interested in The Dow/Gold Zoom, which is a chart that shows the Dow Jones Industrial Average priced in gold. This might help you to get an idea where we are in the “cycle”.

The relationship between short and long term yields and the stock market (and gold) is apparent in this chart. This chart is currently in pdf format. Click the chart itself or the link below.

The Business Cycle

There is often talk in the financial papers about the “savings rate.” You’ll often see pundits making moral judgments about how Americans spend too much and save too little implying that the average American is a spendthrift, wasting resources, and living on borrowed time. On the flip side, there are those who say the economy is doing well and blast the idea that the low savings numbers matter at all. Both are wrong.

The rate at which people save and spend is self-adjusting in an unhampered market. This is because the ratio between this saving and spending is reflected in an interest rate that is received by savers and paid for by borrowers. The interest rate, like prices, is a means of communication. It tells savers and borrowers how other savers and borrowers are evaluating things. An interest rate tells a businessman when it is a good time to borrow. A low interest rate is tells him that it is a good time to expand production; people are saving for the future and there will be a future market for his products. A high interest rate tells a businessman the opposite. It tells him that people are spending now and its better to wait to expand production. The interest rate also sends messages to the consumers. A high interest rate tells them that savings are needed and attracts them to save, while a low interest rate indicates there is already plenty of savings available to expand production. All that information is hidden in an interest rate? Yes!

But, you might have noticed that all this talk about there not being enough in savings is following a time when the interest rate was very low. Doesn’t that suggest that there is a lot in savings?

Yes, it does. But there isn’t. Why?

This is because the market is not unhampered. In fact, the Federal Reserve garbles the interest rate message by “printing” money and putting it into “savings.” Obviously, you can’t really save by printing money. Money is just an intermediary that stands for something else. It stands for wealth, which isn’t money, but real things like food, refrigerators, microwaves, houses, cars, computers, phones, iPods, etc. By garbling the message, the Federal Reserve creates the appearance of wealth and prosperity, and plenty of savings for the future.

Economists sometimes point out that businessmen and consumers could eventually learn to ignore the faulty interest rate and act as if the interest rate is what it should be. This is not possible, no matter how adroit one might be at reading the signs. This is because the new money, the “savings” the Fed creates, is going to be spent by somebody and whoever spends it first benefits at the expense of those who spend it last. You can follow this reasoning for yourself. Just imagine a group of counterfeiters printing money in their basements. Would you object to their spending their newly created money if you could be certain that the new money would continue to circulate? Why? You would object because you know that the counterfeiters will get real goods without having to pay for them. Somewhere down the line there will be a shortage of goods everyone else. This isn’t changed because the new money continues to circulate; it is just hidden until the shortage of goods is revealed by higher prices.

American businessmen and consumers do not deserve the moral lashing they are getting for “spending too much” and “not saving enough.” They are doing exactly what they perceive to be in their best interests based upon the messages they are receiving. When the supply of money is expanding, it’s a very good time to be a borrower and a very bad time to be a saver.

This being said, it is absurd to think that the savings rate means nothing and that Americans can go on spending as they have been. The garbled message must eventually be corrected. This is the only thing that will make it worthwhile for individuals to save again and real savings are necessary for the production of real goods for the future. The Federal Reserve chairman, Ben Bernanke, knows this. That is why he must periodically “raise interest rates.” All Dr. Bernanke needs to do is stop the printing press and wait for the garbled interest rate message to right itself. You will recognize whenever the Federal Reserve is doing this by what economists commonly refer to as the “inverted yield curve.” Once the interest rate message has been revealed, the Federal Reserve can begin to slowly garble it again.

Why does the Federal Reserve print all that extra money and garble the interest rate message in the first place? They do it for the same reason counterfeiters print money in their basements.

Here I’ve adjusted the prices of gold and silver to the M2 money supply figure. Note the spike in the price of silver relative to gold in 1979.

This chart is in pdf format.

Silver and Gold M2 Adjusted

In any study of economics, it’s important to remember — all prices are ratios. That means that they are always in flux as the values of one or the other or both commodities change, whether one of those commodities is used as money or not. This is, of course, a lesson we wish politicians could learn. Nevertheless, it’s easy to forget as we get used to talking about prices in terms of monetary units, in our case, dollars. In the early part of this chart you can see that the exchange ratios between silver and gold were fixed, but ever since the American Civil War, the price of silver in terms of gold has, on average, been falling. There is a lot of talk on the net these days about this changing. Decide for yourself. I’ve labeled some of the spikes which were fairly obvious. If you think I should add anything, feel free to contract me through the discussion board.

This chart is in pdf format.

Silver/Gold Ratio