Jan Spörer's Reviews > Money, Bank Credit, and Economic Cycles

Money, Bank Credit, and Economic Cycles by Jesús Huerta de Soto
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it was amazing

Huerta de Soto's book is comprehensive and represents an extraordinary way of thinking about economics. My economics lectures in college (major in international business administration) did not cover monetary policy in such depth and the Austrian School tends to be not very present in economics classes. Therefore, I took away many new insights and I am glad to have read this lengthy book.

Some aspects, however, were repeated too often, making the lack of conciseness the main downside. Still, one should consider that Huerta de Soto used a lot of footnotes that are not a must-read. (I did not read the footnotes at all and was still able to follow.) Therefore, the book is not as long as one may initially think. The rather wordy style makes the ideas in the book relatively easy to comprehend.

All in all, the book is a great read for anyone who wants to understand our monetary system better but the book does demand some time and effort.

These are the notes that I took when reading the book:

-State intervention in the financial sector leads to similar distortions as socialism (p. xxiii)
-“I will endeavor to show that the central bank did not emerge spontaneously as the result of market institutions, but was forcibly imposed by the government and responds to the demands of powerful pressure groups.” (p. xxvii)
-Chapter 1: The author explains different forms of deposit contracts and contrasts them to loan contracts. He classifies money that is deposited at a bank as a monetary “irregular deposit contract”, a contract for depositing fungible goods. Huerta de Soto argues that The fungible nature of the deposit does not allow the depository to use the good (the money) in any way because the ownership of the good is not transferred. As a result of this rule, a 100% reserve requirement is necessary to guarantee 100% availability of the deposits. (pp. 1-36)
-Chapter 2: The author states that fractional-reserve banking has been used illegally throughout large parts of history.
--On the one hand, governments sanctioned risky behavior and bankruptcies of banks, on the other hand, governments funded state banks and benefitted from the financial power of fractional-reserve banking.
--Huerta de Soto describes when and why government banks introduced fractional-reserve banking.
--Governments commonly introduced fractional-reserve banking in times of financial difficulty (especially wars), with the bank of Amsterdam being the last bank to make that decision in the fourth Anglo-Dutch war: “The Bank of Amsterdam was the last bank in history to maintain a 100-percent reserve ratio, and its disappearance marked the end of the last attempts to found banks upon general legal principles.” (p. 106)
--Three of the most noted monetary theorists of the eighteenth and early nineteenth centuries were bankers: John Law, Richard Cantillon, and Henry Thornton. (pp. 111-112)
-Chapter 3: The author refutes arguments for legally justifying fractional-reserve banking.
--One argument made by defenders of fractional-reserve banking is that depositors know that it is not a real deposit. Huerta de Soto argues that even then, the contract is impossible because irregular deposits cannot have the characteristics of a loan.
--Fractional-reserve banking is a legal paradox.
--Government deposit guarantees do not guarantee purchasing power.
--Sophisticated risk assessment will never be able to solve the economically adverse consequences of fractional-reserve banking (e.g., misallocation of funds).
--“The legal doctrines aimed at justifying fractional-reserve banking have been formulated ex post facto.” (p. 115)
--Huerta de Soto contrasts life insurance with irregular deposit contracts. He states that “... life insurance contracts, the calculation of probabilities based on mortality and survival tables, and the principle of mutualism or dividing loss among all policyholders sustaining an institution make is possible from the first moment to receive, should the anticipated event occur, a significant sum of money which, using other methods, could only be accumulated after a period of many years.” (p 162)
-Chapter 4: Explanation of the credit expansion process
--Natural means of production = labor and natural resources
--Fractional-reserve banking in an economy with one bank has the same effect as fractional-reserve banking in an economy with more than one bank.
--“This is precisely why we should be especially critical of traditional national accounting measures. For example, the traditional definition of “gross national product” (GNP) contains the word “gross,” yet in no way reflects the true gross income spent during the year on the entire productive structure. On the one hand, GNP figures hide the existence of different stages in the production process. On the other hand, what is even more serious and consequential is that the gross national product, despite the “gross” in its name, does not reflect the total gross monetary spending which takes place in all productive stages and sectors of the economy. This is because it is based solely on the production of goods and services delivered to final users. In fact, it rests on a narrow accounting criterion of added value which is foreign to the fundamental truths of the economy; it only adds the value of consumer goods and services and of the final capital goods completed during the year. It does not incorporate the other intermediate products which make up the stages in the production process and which pass from one stage to another during the financial year. Hence gross national product figures only include a small percentage of the total of capital goods. Indeed GNP incorporates the value of the sales of fixed or durable capital goods, such as real estate, industrial vehicles, machinery, tools, computers, etc., which are finished and sold to their final users during the year, and thus are considered final goods. However it in no way includes the value of circulating capital goods, intermediate non-durable products, nor of capital goods which are not yet finished or if so, pass from one stage to another during the process of production. In contrast, our gross output figure from Table V-2 incorporates the gross production of all capital goods, whether completed or not, fixed, durable or circulating, as well as all consumer goods and services produced during the financial year.
--In short the Gross National Product is an aggregate figure representing added values, and it excludes intermediate goods. The only reason national accounting theorists offer for using this figure is that with this criterion they avoid the problem of “double counting.” Yet from the standpoint of macroeconomic theory, this argument rests on a narrow accounting concept applicable to individual companies and is very dangerous, as it excludes from the computation the enormous volume of entrepreneurial effort which each year is dedicated to the production of intermediate capital goods, the bulk of economic activity but not all worth evaluating, according to GNP figures. To get an idea of the amounts involved, it suffices to consider that the gross output (calculated according to our criterion) of an advanced country like the United States is equal to more than twice the country’s official GNP.” (The author later states that the use of GNP almost inevitably implies that production is instantaneous and requires no time, i.e., that there are no intermediate stages in the production process and that time preference is irrelevant with respect to determining the interest rate.) (pp. 308-310)
--Gross national product exaggerates the importance of consumption. Gross domestic output (GDO) would be a better measure. (pp. 419-420)
--There are different ways how savings can be transferred into investments. The credit market is “of secondary importance and plays a subsidiary role in relation to the more general market in which present goods are exchanged for future goods through self-financing or capitalists’ direct reinvestment of present goods in their productive stages (the first and second procedures of saving-investment mentioned above).” The first and second procedures of saving-investment are direct saving-investments by capitalists, and saving-investments by workers and owners of natural resources and are, as mentioned, significantly more important than saving-investments through the credit market. (p. 314)
--Expansions of the production structure in an economy without fractional-reserve banking
---Savings lead to a lengthened/deepened production structure. Suppose there is only one stage of production in the economy. This stage of production incurs costs of 90 and has a gross income of 100. When demand for final goods (gross income) drops from 100 to 75 (savings increase by 25), the final stage of production would make a loss (costs of 90; gross income of 75). Therefore, the resources freed through saving are transferred to stages further from consumption (stages before the final stage; stage 2, 3 etc.). “... all increases in saving cause considerable relative losses to or decreases in the accounting profits of the companies which operate closest to final consumption.” (p. 321)
---The stages closest to consumption suffer the highest losses when savings increase. Therefore, capitalists seek to invest into stages further from consumption after savings increase. This leads to a uniform interest rate throughout the productive structure. (pp. 322-323)
---The production structure becomes wider (existing stages of production far away from consumption expand). Also, new capital goods that were not profitable before are introduced. Stages close to consumption become more narrow.
---The increase in prices of the capital goods also increases stock prices (except those stocks that represent equity close to consumption)
---The Ricardo effect is explained: Savings increase -> Consumption decreases -> Prices of consumer good decrease -> Real wages increase -> Labor is replaced by capital -> Lengthening and widening of productive structure
---Naturally, savings decrease the output of consumer goods in the short run. This slowdown lasts until the capital-intensive processes are completed. The temporary drop in the supply of new consumer goods would trigger a substantial rise in the relative price of consumer goods if there were no excess supplies (as a result of the drop in consumption).
--Expansions of the production structure in an economy with fractional-reserve banking
---Entrepreneurs that receive financing act as if there were enough savings to finance their investment projects. They invest into capital goods even though the necessary savings to produce those capital goods are not existent, causing a bad resource allocation in the economy. The projects that the entrepreneurs invested in may not be profitable if the interest rate had not been artificially reduced. Huerta de Soto explains that this intertemporal discoordination between investments and savings/consumption leads to initial optimism. The prices for original means of production increase dramatically because entrepreneurs compete for the small amount of existing means of production (small because there were no savings to back up the provision of those means). This inflationary process gets stronger over time so that long-lasting projects far exceed their budgets.
---The initial interest rate decline under unbacked investments is less severe than the interest rate decline under real saving-investments (because consumption does not decline when investments are unbacked by savings).
---Increases in the price of consumer goods:
----Original means of production are taken away from the stages closest to consumption, causing consumer prices to rise due to lower output of final goods.
----Workers and landowners (owners of original means of production) increase their income as a result of increased prices for their services. This increases their purchasing power and the demand for consumer goods.
----Entrepreneurs overestimate their future profit (illusion of entrepreneurial prosperity), causing them to overconsume.
----All in all, the inflationary effects on consumer good prices exceed the positive income effects that owners of original means of production enjoy.
---The increases in the prices of consumer goods cause the stages closest to consumption to become relatively more profitable again. The prices for original means of production rise less quickly. Entrepreneurs thus rethink their initial investment strategy and shift investments to stages closer to consumption.
---Ricardo effect: The over-proportional increase of consumer good prices decreases the real prices of original means of production (esp. wages). This causes a drop in demand for capital goods, decreasing the accounting profits of the stages furthest from consumption. (pp. 368-370)
---Interest rates return to their pre-credit-expansion level and even exceed it as soon as credit expansion stops again.
----Lenders add an inflation premium on their interest rates.
----Entrepreneurs are willing to pay high interest rates to finish their projects (they want to pay capital goods that are complementary to the goods they purchased before)
---The factors above cause losses for the stages furthest from consumption. Capital is shifted from the stages furthest from consumption to the stages closest to consumption. This adjustment is accompanied by high costs. Capital becomes non-convertible to a certain extent (see also pp. 413-414). Some projects cannot be completed, leaving society with capital that is now worth less than the initial purchase value.
-Other chapters
--It is not possible to predict whether savings will increase as a result of credit expansion. (pp. 410-411)
--The best way to deal with economic crises is to make markets as flexible as possible, especially labor markets. (pp. 434-435)
--The public perception of state intervention is often wrong. Crises seemingly prove that state interventions are necessary, but those interventions only pave the way for the next crisis (p. 459)
--Uninterrupted stock market growth never indicates favorable economic conditions. Such growth is a sign of credit expansion unbacked by real saving. (p. 462)
--Stock markets can be used as an indicator for a crisis because companies in the stages furthest from consumption are hit hardest. (p. 464)
--Socialist economies take a very long time to adjust to a market economy because they are in a permanent state of crisis (which is defined as a time in which means of production are badly allocated). The shift from socialism to a market economy can be compared to the adjustments that are necessary after an economic crisis.
--The summary of the stages of economies with and without credit expansion is a good read: pp. 506-507.
--Huerta de Soto, in line with the Austrian school, advocates a focus on individuals and refrains from overly confident macroeconomic analyses. (pp. 519-512) Capital is not just a single, homogenous productive fund but consists of different stages. (p. 522)
--Macroeconomic theory disregards relative prices. (p. 526)
--“The above reflections on monetarism (its lack of capital theory and the adoption of a macroeconomic outlook which masks the issues of true importance) would not be complete without a criticism of the equation of exchange, MV=PT, on which monetarists have relied since Irving Fisher proposed it in his book, The Purchasing Power of Money. Clearly this “equation of exchange” is simply an ideogram which rather awkwardly represents the relationship between growth in the money supply and a decline in the purchasing power of money. The origin of this “formula” is a simple tautology which expresses that the total amount of money spent on transactions conducted in the economic system during a certain time period must be identical to the quantity of money received on the same transactions during the same period (MV = sum pt). However monetarists then take a leap in the dark when they assume the other side of the equation can be represented as PT, where T is an absurd “aggregate” which calls for adding up heterogenous quantities of goods and services exchanged over a period of time. The lack of homogeneity makes this an impossible sum. Mises also points out the absurdity of the concept of “velocity of money,” which is defined simply as the variable which, dependent on the others, is necessary to maintain the balance of the equation of exchange The concept makes no economic sense because individual economic agents cannot possibly act as the formula indicates.” (pp. 530-532)
--Money is not neutral. It modifies the structure of relative prices of goods and services because it is injected into the economy in a sequential manner and at various specific points (via public expenditure, credit expansion, or the discovery of new gold reserves in particular places). “To the extent this occurs, only certain people will be the first to receive the new monetary units and have the chance to purchase new goods and services at prices not yet affected by monetary growth. Thus begins a process of income redistributions in which the first to receive the monetary units benefit from the situation at the expense of all other economic agents, who find themselves purchasing goods and services at rising prices before any of the newly-created monetary units reach their pockets.” (p. 533)
--As classical economics assumes money neutrality, crises cannot be explained using those theories.
--Table that contrasts the Austrian School and “macroeconomics”: p. 582.
--Proposed banking reform (p. 736)
---Freedom of currency
---Free banking, no central bank
---100-percent reserve requirement (gold as a transition currency; just see which currency will be adapted afterwards)
--Advantages of the proposed banking system (pp. 745-760)
---Prevention of bank crises.
---Prevention of cyclical economic crises.
---Respect for private property (no misuse of deposits).
-Reduction of market transaction costs (esp. labor negotiations) as a result of stable economic growth.
---Reduction of excessive financial speculation.
---Minimization of public interventions (esp. the central bank).
---System has a better compatibility with democracy (less influence of powerful people on a key aspect of the economy, the monetary policy).
---Reduced potential for war because states find it harder to conceal the true costs of war.
--Replies to possible objections to the proposed banking system: pp. 760-787.
--Overview about the extent of government control on the monetary system and the stages in the process of banking reform: p. 793.
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