Speech given to the Committee for Monetary Research and Education

Alasdair Macleod – At the Fall Meeting, 20th October 2011.

Before addressing the consequences of today’s macro-economic policies I want to tell you my philosophy. I support sound money for two very good reasons:

  • Firstly, it is a basic human right to choose to save, without our savings being debased by the tax of monetary inflation. Those that are worst affected by this inflation tax are not the rich, they benefit; but the poor and the barely well-off, which is why monetary inflation undermines society and why the right to sound money should be respected. If government gives itself a monopoly over money, it has a duty to protect the property rights vested in it.
  • Secondly, it is a basic right for us to own our own money rather than have it owned by the banks. For them to take our money and expand credit on the back of it debases it. It is an abuse of an individual’s property rights and a banking licence is a government licence to do so. If anyone else was to do this, they would be guilty of fraud. Banks should be custodians of our money, and it should not appear in their balance sheets as their property.

If we had stuck to these sound money principals, several benefits automatically follow, some of which I will briefly summarise for you, and I will have a little more to say about them in a moment:

  1. With sound money, governments cannot print money to fund their activities, so the true cost of government becomes apparent to the electorate. The result is that in a democracy the electorate votes for small government because profligate politicians simply do not get elected. Indeed, we need sound money for democracy to work.
  2. With sound money, governments are unable to go to war without taxpayers being conscious of the true cost. This is a great incentive for peace and an electorate that accepts the benefits of free markets, and therefore peaceful trade, is less belligerent.
  3. With sound money, savings are protected. Prices tend to fall gradually over time, reflecting improved efficiencies in production and of economic progress generally. So the purchasing power of savings increases over the years. For a pensioner, the purchasing power of his savings grows. He can then afford the healthcare he increasingly requires as he ages, and he can afford to leave something for his family when he dies. His savings work with his needs, which is the opposite of the situation in our inflation-ridden economies. In a sound money economy, our pensioners look after themselves and need not be a burden on the state.
  4. With sound money, business cycles do not occur. The business cycles we are familiar with are in fact credit-driven cycles, the result of central banks expanding money and overseeing bank credit. They are the result of the misconception that monetary expansion leads to growth. It doesn’t: it merely distorts the economy by favouring a select few at the expense of the many.

These are just some of the benefits of sound money; benefits we can only dream about today. So long as we have unsound money we will have difficulties that will always end in a crisis. Today, we have sunk to the point where the answer to everything is found in more money and bank credit instead of the genuine production of goods and services.

The long-term consequence of monetary inflation is that voters now believe that a government always has the money to provide everything they need. So they naturally vote for more government. They do not question the source of government’s money. They have also been encouraged to believe that the freedom for everyone to do what they want with their own money, only enriches the few, when the opposite is the case. People have become genuinely frightened by the thought of free markets. For this reason, governments regulate most of the private sector. Between government spending and government regulation, the private sector is now dominated by government interference. A minimal amount of capitalism is tolerated in economies that are otherwise socialistic; yet our ills are blamed on the only part of the economy that actually works.

The most effective curb on political ambition is sound money. But we don’t have sound money. So government abuses its monopoly power over the currency to pay for its ambitions. Fiat money gives a free rein to the ambitious politician. The First World War was made possible by German economists, led by George Knapp, the Keynes of his day. He showed the Kaiser the way to finance a war without increasing taxes. In the four years from 1913 the Reichsbank increased paper money in circulation to pay for 85% of Germany’s war expenditure for those years. Of course, after that the script did not go to plan, and as we all know it ended with the total collapse of the currency in 1923.

Collapse the currency, and you collapse savings. Savings today are continually devalued by the expansion of money and credit. Only a fool lends his money for an interest return, and savers are therefore forced to speculate to protect themselves. The result is that there is now a separate destabilising pool of foot-loose capital. It is used by the financial engineers of Wall Street and the City of London to offer higher speculative returns. It has become the feedstock for spendthrift borrowers, particularly governments, who have no intention of ever repaying it.

The damage of unsound money to business has been acute. Business cycles are actually credit cycles, the result of the central banks’ monetary policies. It is easy to understand why the expansion of money and credit drives us into cycles of boom and bust – the exact opposite of what it is meant to achieve.

Take the example of businesses operating with sound money. A business developing a new product or improving an existing one has to invest its own funds, or find a lender with savings. In either case, this takes money away from consumption, money that is reallocated into savings and from there into the proposed investment. And because this money is not spent on consumption, the labour and raw materials required for any new project become available. There is a shift of resources from consumption into savings, from savings into investment, and from there into capital goods. A balance is maintained within the economy and there is no boom and bust. It is a non-cyclical process, driven only by peoples’ economic needs. Business activity is inherently stable.

Now look at the situation when business investment is financed by newly created money and bank credit instead of savings. The process starts with the central bank lowering interest rates. Cheap credit makes investment appear attractive, so the businessman borrows to invest in his business. But many other businessmen are encouraged by the same cheap credit to do the same thing at the same time.

Businesses start investing simultaneously. The randomness has gone. But it gets worse: cheap money also supports consumption, because saving money is less attractive due to lower interest rates.

So our businessman has to bid up for labour, because it hasn’t been released by lower consumption, and he is in competition with the other businesses also taking advantage of cheap credit. He has to pay up for raw materials, for the same reasons. The combination of industry and consumers responding to cheap finance, in the short-term will drive the economy better. But with no extra resources available, prices rise due to bunched demand. And since the quantity of money in the economy has increased, its purchasing-power also falls; exacerbating price inflation even more.

And with prices now rising strongly, interest rates also now rise from artificially low levels. Our businessman’s plans are totally screwed. He got the cost of labour and raw materials completely wrong, and because interest rates have shot up, his Return-On-Investment calculations turn out to be far too optimistic. And to make matters worse, the deteriorating economic conditions that follow, as surely as night follows day, forces him to accept that his sales projections were also too optimistic.

His fellow entrepreneurs are in the same boat. Businesses start cutting back. They act as a crowd on the way up and on the way down.

The essential point is fake money has created a business cycle which didn’t exist before. It is never just a question of central banks getting their timing wrong, as many suppose.

The central bank then compounds the problems it has created by again lowering interest rates with the downturn. More than anything else it is scared of a fall in GDP, so it cannot allow the distortions and false investments of the earlier round of monetary stimulation to unwind properly.

But next time round, the businessman is not so easily tricked. He builds greater margins into his investment calculations. So the economy becomes slower to respond to a new, deeper round of interest rate cuts. The central bank has to act more aggressively to create yet more fake money, to get a result.

These credit expansions work like a ratchet, becoming more destabilising over each credit cycle.

The businessman eventually wises up, overcomes his patriotic instincts and moves his manufacturing to somewhere where at least some of the factors of production are available. He needs to plan for ten, fifteen, twenty years. He cannot afford to ride destructive credit-driven cycles of three or four years. It is cheaper for him to build a factory in the jungle and train up hard-working natives. It is unsound money that has driven him abroad more than any other factor. Over a number of these credit cycles, the economy in countries with falling savings, like the US and UK, becomes more and more dependent on consumption, and less and less on manufacturing.

And eventually, to encourage GDP growth, consumers are encouraged to actually borrow to spend and abandon saving altogether. So on every credit cycle, savings diminish and debt increases, finally accelerating to unsustainable levels of debt. And that is where we arrived in 2008. That marked the end of the road for the post-war Keynesian experiment.

So understanding our economic condition from a sound money perspective gives us a unique viewpoint. It makes it easier to see through the fog of weak money. It also allows us to see through the problems posed by reconciling contrary statistics. And it is here that the establishment deludes itself as well as the rest of us.

The abuse of the GDP statistic is the most important delusion of all, because all economic policy is directed at ensuring it grows. But we must stop and think what it actually represents. GDP is not economic output, it is its money-value, which is a very different thing. It gives us no information about the relative values of the goods and services that constitute the economy.

It is crucial to appreciate this distinction, so by way of explanation let us again assume sound money. This is like an economy operating with gold as money and without credit expansion. To keep it simple, assume that trade is in balance, and there are no net capital flows to or from other countries. Therefore, at the end of the year, there is exactly the same amount of money, or gold, as there was at the start of the year.

What does this mean for GDP? It is exactly the same of course, irrespective of actual economic activity. It doesn’t matter how much people save, because those savings are reapplied into the production of capital goods. The rest goes on consumption. It really doesn’t matter what proportion is private sector and how much is government. But if you start with a million ounces of gold, after a year you still have a million ounces of gold. The only difference is what a million ounces buys. The reconciliation between the start and the end of the year is obviously a combination of prices and how efficiently the available gold is deployed.

In practice, human nature constantly strives for improvement, so over a period of time in a free market the purchasing power of sound money increases. This was borne out by the experience of Britain, which went on the gold standard in 1821 and only went off it before the First World War. During that time, Britain freed up her economy by dropping tariffs and other restrictions on free trade, and we became the most powerful nation on earth. The purchasing power of the gold sovereign increased substantially over those ninety-odd years.

So if we look at how an economy operates in a sound-money environment, we see that the benefits of free-markets flow to consumers, savers and businesses. We can see that any attempt to measure these benefits by changes in GDP are simply absurd. It therefore follows that any change in GDP represents a change in the quantity of money in an economy and not of the level of production.

Now, for some of us this is quite a discovery. We are so used to thinking that GDP is the economy that government policies are now entirely focused on boosting it, mistaking it for the economy itself. It justifies mainstream macro-economic theory, because within that money identity, there is no differentiation between good and bad deployment of economic resources. This, in the minds of most economists, is why badly targeted government spending is no different from the productive private sector’s use of economic resources. It persuades Keynesians and Monetarists that injecting government spending into an economy or expanding the quantity of money in the economy is a valid route to recovery.

Understand this error and you understand why unemployment in the United States is already at depression levels, but according to the GDP statistic you have only just arrived at the brink of a possible economic downturn. Understand this error, and you understand the frantic attempts to get more money and credit into the economy rather than address the real issues. Understand the error of confusing the condition of an economy with its accounting identity and understand the policy mistakes yet to be made.

So we can see that governments are doing just about everything wrong. They have completely failed to understand the productive difference between free markets and government intervention. They have no knowledge of the real cost of diminishing the productive private sector, to pay for the unproductive public sector. The activities of central banks have encouraged boom-bust cycles that have led to the accumulation of debt in both private and public sectors to the point where it has finally become unsustainable. In the process, they have destroyed savings, which are the necessary pre-requisite, the bed-rock for any sustainable recovery.

This is the background to today’s crisis. Governments everywhere are now trying to borrow the largest amounts of money in history, all at the same time. And to those who say that global savings are high, I say those savings are in the hands of the Chinese and Indian workers, who wisely are more likely to buy gold and silver than our government debt.

Governments are now waking up to the fact that real economic growth is disappearing far into the future and taking their hoped-for tax revenues with it. The debt-trap has snapped firmly shut. Some countries, such as the Eurozone members, who cannot print money to finance themselves, are simply the first victims of the imbalance between the financing requirements of governments and the available capital. Others, such as the UK and US, who can print money, do so to defer funding problems and keep their borrowing costs low; but it is only a matter of time before they are found out.

Price inflation will put an end to these artificially low bond yields, if markets don’t first: it has always been this way in the past and now is no different. We already see prices measured in paper currencies rising everywhere. Commodity prices are reflecting the increased quantities of paper money and credit. Prices of essentials, such as food and energy, have been rising sharply. But there are still people who think that the risk is deflation not inflation. Presumably the Fed thinks so, since it has stated that it expects interest rates to stay at close to zero until mid-2013. They will be in for a shock, and here’s why.

They are about to learn the difference between sound money and their fiat money. Real money cannot be issued by central banks. Fiat money is an undated interest-free claim on a government whose central bank merely tells us that it is money. The difference is important, because in a depression, the purchasing power of real money, measured in goods, increases. In the same depression the purchasing power of fake money falls with the financial condition of the issuing government and with its accelerating supply. This is the dynamic behind the rise in the price of gold over the last decade.

The rising inflation I’ve talked about is measured in fiat money. The rise will accelerate because when you are in a debt trap the only way bills get paid is to issue increasing quantities of fiat money and to borrow. And remember, in a depression tax revenues collapse, while social security costs escalate. To defer the “Grecian moment” we have become unhappily familiar with, both the US and the UK will require more fiat money and bank credit than we can imagine.

So what those who worry about a depression haven’t noticed, is that we have been in one for some time. That comes of confusing GDP with real goods and services. Produce enough fake money and GDP looks good. What doesn’t is the level of unemployment. Doubtless George Knapp – remember him? The German predecessor to Keynes? – Knapp would have felt good that German GDP from 1920 to1923 looked fantastic. But then there was the small matter of a collapse in the fiat money of the day, and GDP hadn’t yet been invented anyway.

Today people are stumbling towards an awareness of some of these problems. Most visible to everyone so far is the parlous state of the banks. While it would be foolish to completely discount systemic risk, we should bear in mind two things. Firstly, the central banks are now very aware of this risk, which is different from the time of the Bear Sterns and Lehman collapses. So you can reasonably bet that every scenario that frightens us has been anticipated. The banks themselves are now acutely aware of counterparty risk. Secondly, the evolution of banking over the years has given central banks enormous control over their banking systems. It is wrong to think that you can compare the situation today to that of the banking crisis triggered by the collapse of Kredit Anstalt in 1931. The ECB in Europe only has to stand by with unlimited funds when necessary. Indeed, there has been a run on the Greek banks for at least the last eighteen months without systemic failure. All that is required is for the ECB to make its fiat money available in sufficient quantities.

In a few months we will enter 2012. The immediate stresses of today will probably diminish when enough fiat money has been thrown at them. So to my mind the two biggest headaches for next year will be increasing price inflation, the result of too much paper money chasing too few goods if you like, and rising interest rates. I do not expect the Fed to keep its promise of zero rates into 2013. I do expect them to blame unexpected stagflation.

And finally, we must understand that when it comes to resolving our current difficulties, the order of events is bound to be crisis first, solution second. I wish it could be the other way round, but that is the political reality. What we must do meanwhile is get the message home why the establishment has got its macroeconomics so wrong, and why the only solution is to progress towards sound money.

Today I have only focused on two aspects of the problem: the destabilising effects of credit-driven business cycles, and the misapplication of a statistic, GDP, which should have no importance whatsoever. There is much, much more in this sorry tale. I have touched on the role of savings, without going into how their destruction through monetary inflation is now bankrupting governments. I have not gone into the fallacies surrounding trade imbalances, which are always the result of unsound money. I have not asked how we are to feed our elderly and poor, who have become reliant on government pensions and hand-outs, which governments can increasingly ill-afford.

Please just accept, even if you don’t follow my analysis, that sound money guarantees a stable yet progressive economy where people are truly equal. It allows people to save properly for their retirement so that they will not become a burden on the state. It leads to democracy voting for small governments. It encourages peaceful trade and discourages war. It is the only path, after this mess, that leads us to long-lasting and peaceful prosperity. We really need everyone to understand this for the sake of our future.

Thank you.

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Alasdair started his career as a stockbroker in 1970 on the London Stock Exchange. In those days, trainees learned everything: from making the tea, to corporate finance, to evaluating and dealing in equities and bonds. They learned rapidly through experience about things as diverse as mining shares and general economics. It was excellent training, and within nine years Alasdair had risen to become senior partner of his firm. Subsequently, Alasdair held positions at director level in investment management, and worked as a mutual fund manager. He also worked at a bank in Guernsey as an executive director. For most of his 40 years in the finance industry, Alasdair has been de-mystifying macro-economic events for his investing clients. The accumulation of this experience has convinced him that unsound monetary policies are the most destructive weapon governments use against the common man. Accordingly, his mission is to educate and inform the public in layman’s terms what governments do with money and how to protect themselves from the consequences.

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