Montreal, October 15, 2008 • No 260



Martin Masse
is publisher of QL.




by Martin Masse


          In his Communist Manifesto published in 1848, Karl Marx proposed 10 measures to be implemented after the proletariat takes over power, with the aim of centralizing all instruments of production in the hands of the state. Proposal #5 was to bring about the "centralization of credit in the banks of the state, by means of a national bank with state capital and an exclusive monopoly."


          If he were to rise from the dead today, Marx might be delighted to discover that most economists and financial commentators, including many who claim to favour the free market, agree with him.

          Indeed, analysts at several organisations known to oppose government intervention, and commentators in the Wall Street Journal and in this very page, have made declarations in favour of the massive "injection of liquidities" engineered by central banks in recent months, the government takeover of giant financial institutions, as well as the still stalled $700-billion bailout package. Some of the same voices were calling for similar interventions following the burst of the dotcom bubble in 2001.

          "Whatever happened to the modern followers of my free-market opponents?" Marx would likely wonder.

          At first glance, anyone who understands economics can see that there is something wrong with this picture. The taxes that will need to be levied to finance this package may keep some firms alive, but they will siphon off capital, kill jobs and make businesses less productive elsewhere. Increasing the money supply is no different. It is an invisible tax that redistributes resources to debtors and those who made unwise investments.

          So why throw this sound free-market analysis overboard as soon as there is some downturn in the markets?

          The rationale for intervening always seems to centre on the fear of reliving the Great Depression. If we let too many institutions fail because of insolvency, we are being told, there is a risk of a general collapse of financial markets, with the subsequent drying out of credit and the catastrophic effects this would have on all sectors of production. This opinion, shared by Ben Bernanke, Henry Paulson and most of the right-wing political and financial establishments, is based on Milton Friedman's thesis that the Fed aggravated the Depression by not pumping enough money into the financial system following the market crash of 1929.

          It sounds libertarian enough. The misguided policies of the Fed, a government creature, and bad government regulation are held responsible for the crisis. The need to respond to this emergency and keep markets running overrides concerns about taxing and inflating the money supply. This is supposed to contrast with the left-wing Keynesian approach, whose solutions are strangely very similar despite a different view of the causes.

          But there is another approach that doesn't compromise with free-market principles and coherently explains why we constantly get into these bubble situations followed by a crash. It is centered on Marx's Proposal # 5: government control of capital.

          For decades, Austrian School economists have warned against the dire consequences of having a central banking system based on fiat money, money that is not grounded on any commodity like gold and can easily be manipulated. In addition to its obvious disadvantages (price inflation, debasement of the currency, etc.), easy credit and artificially low interest rates send wrong signals to investors and exacerbate business cycles.

"For decades, Austrian School economists have warned against the dire consequences of having a central banking system based on fiat money, money that is not grounded on any commodity like gold and can easily be manipulated."

          Not only is the central bank constantly creating money out of thin air, but the fractional reserve system allows financial institutions to increase credit many times over. When money creation is sustained, a financial bubble begins to feed on itself, higher prices allowing the owners of inflated titles to spend and borrow more, leading to more credit creation and to even higher prices.

          As prices get distorted, malinvestments, or investments that should not have been made under normal market conditions, accumulate. Despite this, financial institutions have an incentive to join this frenzy of irresponsible lending, or else they will lose market shares to competitors. With "liquidities" in overabundance, more and more risky decisions are made to increase yields and leveraging reaches dangerous levels.

          During that mania phase, everybody seems to believe that the boom will go on. Only the Austrians warn that it cannot last forever, as Friedrich Hayek and Ludwig von Mises did before the 1929 crash, and as their followers have done for the past several years.

          Now, what should be done when that pyramidal scheme starts crashing to the floor, because of a series of cascading failures or concern from the central bank that inflation is getting out of control? It's obvious that credit will shrink, because everyone will want to get out of risky businesses, to call back loans and to put their money in safe places. Malinvestments have to be liquidated; prices have to come down to realistic levels; and resources stuck in unproductive uses have to be freed and moved to sectors that have real demand. Only then will capital again become available for productive investments.

          Friedmanites, who have no conception of malinvestments and never raise any issue with the boom, also cannot understand why it inevitably leads to a crash. They only see the drying up of credit and blame the Fed for not injecting massive enough amounts of liquidities to prevent it.

          But central banks and governments cannot transform unprofitable investments into profitable ones. They cannot force institutions to increase lending when they are so exposed. This is why calls for throwing more money at the problem are so totally misguided. Injections of liquidities started more than a year ago and have had no effect in preventing the situation from getting worse. Such measures can only delay the market correction and turn what should be a quick recession into a prolonged one.

          Friedman – who, contrary to popular perception, was not a foe of monetary inflation, but simply wanted to keep it under better control in normal circumstances – was wrong about the Fed not intervening during the Depression. It tried repeatedly to inflate but credit still went down for various reasons. This is a key difference in interpretation between the Austrian and Chicago schools.

          As Friedrich Hayek wrote in 1932, "Instead of furthering the inevitable liquidation of the maladjustments brought about by the boom during the last three years, all conceivable means have been used to prevent that readjustment from taking place; and one of these means, which has been repeatedly tried though without success, from the earliest to the most recent stages of depression, has been this deliberate policy of credit expansion. ... To combat the depression by a forced credit expansion is to attempt to cure the evil by the very means which brought it about..."

          The confusion of Chicago school economics on monetary issues is so profound as to lead its adherents today to support the largest government grab of private capital in world history. By adding their voices to those on the left, these confused free-marketeers are not helping to "save capitalism," but contributing to its destruction.


* Article first publiched in the Financial Post on September 30, 2008 (version franηaise disponible ici).