Current Market Conditions: 14 Oct. 2008

0:00This is Jeffrey Tucker with the Mises Org podcast. It's my great pleasure today to interview Jesus Huerta de Soto. He is the author of many books, most recently and in the Mises store, Money, Bank Credit and Economic Cycles. This book, many reviewers have regarded as being the most important book on money and banking since Mises' Theory of Money and Credit. It's been translated into many languages and it's about to go into a second printing because the book has been in enormous demand over the last several weeks as you could probably imagine.

0:47So I have Dr. De Soto on the phone from Madrid. What kind of responses have you been getting to recent events in light of your book? Well, a lot of colleagues and friends are telling me that I've been in a way vindicated with the last developments in the financial and economic environment. I don't think that these last events are a vindication. I answer then that it's better to say that this is an almost perfect illustration of all the analytical arguments that I develop in my book.

1:37Yes, it's not something that you expected to happen at this precise time. You wrote the book to be a book to apply to all times and all places. Sorry, can you repeat that please, because sometimes I cannot hear you. You wrote the book to apply to all times and all places, not just this one time, but I suppose you had an expectation that something like this was coming. Yes, of course. The book develops economic theory. Economic theory has an analytical value, no matter what the place and the historical time you are in.

2:22What happens is that with this analytical tool you are able to interpret the historical developments in a way that other economists cannot do because the analytical tools they are using are not correct from the theoretical point of view. So in my book, what I developed is a theory of in which way credit expansion affects the real capital structure of the economy, using generalized malinvestment, error of investment by entrepreneurs, and in which way this error at the end is covered by the markets and economic recession comes.

3:13So it is an explanation of precisely what happened in the last years of the so-called irrational exuberance or the bubble and the financial crisis we are experiencing right now. When do you date the beginning of the bubble? Well, this is an interesting question because I personally think that the last recession of 2001 was not allowed to develop. What I mean is that it was firstly closed. For several reasons, among them the attack to the World Trade Center, Alan Griespan very soon reacted, injecting huge doses of additional great expansion, so that the economy was not allowed to restructure itself as it needed.

4:19So on the old bubble, a new bubble was superimposed up to now. So we could say that in a way the trade expansion began from 1992 onwards mainly, with this A small recession of 2001, but soon you know the central bank and the Federal Reserve reacted. Central banks worldwide reacted, injecting new additional amounts of credit expansion. So furthering away the true recession with the cost of making it worse, and it seems So you expect that if the central bankers succeed in postponing a correction, a substantial correction, that we could see yet another round of a bubble and yet another crash in the future?

5:32Well, I don't think so. In fact, I see three different scenarios. The first one would be the one you just mentioned, that they now react so dramatically that they are able to create again a bubble. I don't think this scenario is something that is going to happen. I think that the reaction of the governments and central banks now at most, they will be able to avoid the fall of the financial system, but not to create any bubble. The second scenario is the scenario of Japan the last 10 years, is that government interventions and Central Bank Interventions just avoid the free market restructuring.

6:27So the economy is kept indefinitely in a recession. The third scenario is that even if we do not have the short-term financial crisis, the begins to try to discover where the errors of investment were committed and try to restructure the real economy. So I think this scenario is the most probable and I expect a worldwide economic recession at least for the next one year, one year and a half or two years. In Japan, it lasted something like 10 years.

7:13Yes, more or less, yeah. The Japanese economy is a very rigid one, for several reasons, cultural and others. It is not allowed, you know, people being fired and companies being restructured. So everybody kept, in theory, at least their artificial jobs, and the economy was not allowed to restructure. Part of the restructuring would be higher unemployment and lower productivity? Higher unemployment, of course, because what happened in the years of the bubble is that It was so cheap that many entrepreneurs began new investments that are maturing in the future, that is in the longer future, as if the real savings of the economy were increased when in fact this didn't happen.

8:23So those investment decisions were wrong and now they are discovered and it is necessary to reallocate the scarce resources and especially labor from the lines that were wrongly committed to new lines that should be profitable. So in the meantime this creates an important amount of unemployment and this is inevitable and it's also a healthy sign that the market is reacting. Yes, you have seen them. In fact, during this crisis, we have seen the market responding very well, haven't we? Yes, indeed. And it is funny because you sometimes hear and read that this proves that the market is not working well.

9:11Even I read a few days ago that this was like the fall of the Berlin Wall, but on the contrary, for the capitalist system. And I'm always answering the same thing, that probably the financial sector is the most intervened sector, the most hampered sector in the economy. So if the current financial crisis is showing something, it's the failure of interventionism, especially in the financial area. It's true a central planning system, let us recapitulate a little bit. First of all, money is not private, it's public, it was nationalized.

9:58Second, we have a central planning agency in the financial arena that is called the Central Bank or in the States the Federal Reserve. This central planning agency Theory, establishes the monetary supply and even it fixes a very important market price, the interest rate. Also there are a huge amount of regulations and finally private bankers do act with a The privilege of fractional reserve, a privilege that no other economic agents can follow in the rest of the market.

10:46So if this is a free market in the financial area, I would be very surprised that everybody in Paris shall think this is a free market. So this is a very intervened and hampered financial market and the financial crisis is just the proof that the central planning agency, mainly central banks, were not able to fine-tune the economy. One of the arguments of your book that makes it unique is that you have demonstrated that Fractional Reserve Banking is not viable in a market setting. Yeah, that's very important. And this is precisely the point that separates my analysis from the analysis of modern, even Austrian fractional reserve free bankers.

11:42The theory I developed in the book is that not only from a legal and ethical point of view, The theory that fractional reserve banking is not acceptable, but that also from an economic point of view, fractional reserve banking is prone to financial crisis, that whenever they appear, create an available incentive from all economic agents to ask for the creation of a lender of last resort, of a central bank, precisely to support the bankers with difficulties and also to try to guarantee the deposits of the people and now with this crisis, with many other crisis in the past, for instance with the so called Corralito in Argentina, we realize how strong is the force of everybody requesting the help of government, more government, the support of central banks and lenders of last resort in order to keep the deposits guaranteed and to maintain banks with difficulties.

12:53It is very strong. In fact, it's surprising the intolerance that people have towards not only declining stock prices, but also any bank, any financial institution that ever has any trouble. Most people feel like it should be saved. Yeah, so what happens is the following, that the deposit contract, the main cause of the contract to keep every time the availability of the money. Of course, if people can get interest, much better for them. And they are cheating themselves because what happens is that the bank loans the money received as a deposit. So from the moment the banks act in this way, they are not any more solvent. They cannot comply with the original contract of the deposit.

13:45So everybody is happy up to the moment they lose their confidence in banks. So all this trouble disappears if this kind of a contract, a deposit without 100% reserve ratio is not allowed. As a matter of fact, the general principle of private law does not allow not to maintain 100% reserve ratios in any deposits, side deposits, no matter if it is money, oil or wheat. So, it's only in banking that this privilege is permitted and mostly to benefit both the producer and the consumer, but only temporarily.

14:34You are entirely right, this is a privilege that was granted to private bankers but not to any other economic agent. And it was granted for several reasons, I discuss in my book, among other things, because with these privileged bankers are able to create money from nothing through the banking multiplier. And it is a way to find cheap finance to governments and everybody is happy, at least at the beginning, in the Bubbles, because it seems that you can have the availability of money and at the same time to receive interest, and there is availability of credits and very cheap interest rates, and it seems as if the economy could grow a lot without the need of making the sacrifice of saving, so everybody is happy with the credit expansion.

15:34What I explain in the book is that the market sooner or later reacts, discovering the errors, discovering the true value of malinvestments and when this begins the assets, the value of the assets of the banks goes down and everybody realizes that banks are insolvent and the financial crisis immediately comes and this is what we experienced the last few weeks. Is it possible to have something like a modern commercial society under 100% reserves? Is it really a viable plan for modernization? Yes, of course. The question should be the opposite. How is possible that we keep the current financial system at the beginning of the 21st century In this kind of volatility and financial crisis, it is almost unbelievable.

16:36Everybody comes from a historical accident, from Bill's Bank Act of 1844. In this act, it was required to keep 100% reserve ratio, but only for the printing of paper bills, that in those days British bankers were printing, as any other private bankers worldwide, but the law forgot to require the same 100% reserve ratio for demand deposits. The reason for that is that in those days the economists had not a clear idea yet that the demand deposits were part of the Monetary Supply as were the paper bills. So what happened is that from this law on, bankers kept making credit expansion but using as collateral the deposits, not the paper bills.

17:37So what happened is that after the law, the cycles were not avoided. The prestige of the Expansion Against Deposits, The Central Bank of England appeared as a lender of last resort, and printing as many paper pounds as needed in order to keep bankers afloat and this went up to now because all the financial systems in the western world were following the British system created from this law, Pills Bank Act of 1844. But imagine if this law were correct and required 100% reserve ratio for both, not only for paper bills but also for deposits.

18:53So the economic history of the world would have been entirely different. Because artificial Federal credit expansions would not be allowed by the financial system and bankers would be making loans only against money borrowed previously to them, so a much more perfect matching between real savings and credits would have been in the market. So no bubbles and no recession. The moment of economic growth would be much more stable and sustainable, and it is inevitable.

19:40I think that in the 21st century the main challenge we have is to, once we have experienced the fall of the Berlin Wall and the fall of the Socialism, the next step that we must fight for is the fall of Socialism in the financial arena. But it's getting worse, and it's been getting worse now for at least a century. Every time these crises come along, the banking system is further centralized. Yeah well, there is a kind of cycle of regulation also. Whenever we have a financial crisis, a huge mess of new regulations are created by central Bankers, but with no result because credit expansion begins again and a new bubble appears and a new burst.

20:36So the only radical reform with everything would be around three points, first of all to privatize money, second to eliminate central bankers and all their regulations, and third This is the most important, to submit bankers to the general legal principles, so that they are not able to keep demand deposits without 100% reserve ratio. This more or less is the same as separating the business of making money, extracting money from the mines, gold, and providing cash services and accounting services, Mises, separating this kind of business from a different, entirely different business of mutual funding investment or investment banking, taking loans from citizens or borrowing from individual private citizens and making loans to entrepreneurs as pure intermediaries.

21:48So, it is necessary to separate these two businesses, following the principles I announced you, and as a matter of fact, it seems as if the new regulations that are announced are in a way, in a very, you know, in perfect way toward this direction. Yes, I can see this. Part of the problem of permitting fractional reserves with demand deposits is precisely this issue that people benefit in the short run from fractional reserves and then it leads to crisis and that leads to a call to bail out the banks. So, would you favor statutory restrictions on fractional reserves or is it just simply a matter of enforcing contracts as they would be enforced in any other sector of commercial society?

22:44Well, I think it's a matter of enforcing contracts. So the general principle in private law is that in any deposit, 100 percent of what you When you say privatized money, do you imagine private production?

23:24Yes, of course. For me, money is commodity money, and especially the money that was selected as a result of the historical evolution, mainly gold. Of course, we don't know if gold would be kept in the future evolution, but what is needed is to go back up to the moment in in which the market inclusion of money was stopped violently when gold was expropriated and money nationalized by governments and central banks. Let me ask you about Spain today. What is the economic situation there in light of the financial crisis?

24:13Well, Spain was included in the monetary unit at the beginning of the century, so now we have the euro as money and this was in a way healthy for the country because the former In theory, the euro was increasing in its supply at an incredible rate, so the euro has been increasing in theory at a lower rate, interest rates went down, but what happened is the following, is that the increase in the monetary supply in Europe has not been distributed evenly among the different countries.

25:02The monetary supply increased at least three times quicker in Spain, Ireland and other periphery countries than in Germany and France. This happened through what Mises called passive inflationism, so people asking credits to Bankers, and credit bankers providing those credits at a very rapid pace. Well, this new money, this great expansion, especially effectiveness, I tell you, in these periphery countries, Ireland, Spain, and so on, was mainly invested in real estate.

25:48So we have now in Spain, well, for several years, we were building in Spain as many houses as in all the other countries of the European Union together. So we were building around 700,000 homes per year, which is comparable to adding up all the homes that were built in France, Italy, Germany, England together. And well, those houses were built, were bought by Spanish citizens, foreigners, immigrants and investors, but now we have a problem of malinvestment. We have around one million homes that cannot buy, cannot find a buyer.

26:37And this is creating huge problems to real estate companies and especially to bankers that make the loans to those developers. And the country entered in an economic recession. For instance, car sales went down 40%. People using private highways went down around 10%. The restaurants are empty now, so we are suffering, I think the first country is suffering a huge recession in the European Union and I expect the other countries will enter after us.

27:27Yes, that sounds remarkably like the United States actually. Well, there is just one difference, is that you in the States, instead of keeping the homes without selling them, you just sold the homes to the first one coming, to those called ninjas, no income, no job, etc., people. No, here in Spain we were a little bit more sensible and kept the homes without selling them. That's right. So we just added another layer of absurdity to this process. Well, the American system is better for real estate developers, but worse for bankers. Well, I suppose you expect the situation in Spain even to get worse rather than better in the near term.

28:17Well, if we begin earlier, we are somewhat fortunate because we lost the possibility of using an independent monetary policy. Because the monetary policy is established centrally by Frankfurt, by the European Central Bank. And the government is practically doing nothing, which is something quite good, This will force the market to find where the errors were committed and will force the unemployment and the restructuring of the economy. So if this goes in this way, I'm a little bit optimistic. Following Mises, I always explain that a recession is the healthy phase of the cycle in which the market begins the recovery.

29:03It's like the hangover after you drank the alcohol. The hangover is just the reaction of the body against the aggression of the alcohol. So in a way... If we begin earlier in Spain, eventually we will begin to recover earlier also. So it's a benefit to Spain that the central bank is gone? Yes, the central bank. I think it's something good. Imagine monetary nationalism, each tiny country in Spain with its own monetary supply, depreciating its own currency in a competitive way. This could be a huge mess.

29:49Well, you've given me the idea that perhaps we need to get the Federal Reserve to move to Montreal, or even better, something like the Pacific Ocean. The goal would be to hold the Federal Reserve and the European Central Bank, but it is even worse to have your own currency in Alabama, in Texas, and able to make an inflation. This is the goal of monetary nationalism that was praised so much by Keynes and also by Chicago I would like to run a little bit technical, but to stress is that the change in the accounting rules has been very, you know, affecting, worsening the situation.

30:46Accounting rules were following traditional principles of prudency since Luca Pacioli Luca Pacioli was the professor of mathematics of Leonardo da Vinci, but he also wrote the first textbook on accounting, on double entry accounting. So this gentleman sent out his book on the principle of prudency. The goal of accountancy is to help entrepreneurs to keep their capital intact. As a matter of fact, there is an interesting article by Hayek, in a debate he kept with Pigou, precisely entitled in this way, Keeping Capital Impact.

31:34So the goal of accountancy should be that. Well, what happened with the new accounting rules is that a new principle was included, What is called the fair value? This is a semantic trap because who is going to be against something fair? This means that the principle of currency is forgotten and it is substituted by the so-called mark-to-market value. This is a huge problem because in the bubble years the market value of the assets goes up and up and up and this is reflected with the new Accounting Rules in the books, and everybody thinks it's much richer than they are really, especially companies, bankers, and everybody's thinking they have much more net worth and takes much greater risks.

32:32What happens is that all of a sudden, when the burst comes, all this artificial wealth disappears, especially because the new principles increase volatility, they in a way push entrepreneurs to commit more wrongly investments. So the new accounting rules are making problems worse and one of the main important steps that we should take is to go back to the traditional accounting principles.

33:17Yes. Imagine these rules, as a matter of fact, were developed by a private committee in London mainly composed by investment bankers, people benefiting from the new hypothesis, auditors and so on. Accounting is too important to be left in the hands of the auditors. It's like the war, it's too important to be left in the hands of generals. You discuss some of the issues of accounting in your book, is that right? Yes, but as a matter of fact I'm trying now to write an article on this matter because it's funny, now a lot of financial institutions you have read probably that in this plan of Henry Paulson, it was included changes in the accounting rules toward the goal I mentioned, and also in Europe.

34:09What happened is that financial institutions realized about this problem, but only now where they are losing money, where the market discovered that the value of the assets is so low. But these institutions were very happy in the bubble years with the new rules. What I'm saying is that the new rules are very bad in both parts of the cycle, in the bubble years and now. And that the important role of the traditional principle of prudency should be kept all around the cycle, especially to avoid this false sensation of wealthiness in the bubble years. Accounting is the language of business.

34:54Well, I hope that the sales in your book are not merely an artificial bubble and that they will continue as we just go on because it is doing very well. We are going to move into a second printing. And if you would stay on the line, I'll say goodbye to you for the purpose of the podcast, Dr. De Soto, and I hope to have you back again.