Thursday, March 25, 2021

For Supply-Siders, Gold’s Market Value Is a Sensitive Indicator of Impending Changes in the Overall Price Level

Under the supply-siders’ preferred alternative, the Fed is obliged to target the price of a commodity, say gold, whose market value is believed to be a sensitive indicator of impending changes in the overall price level. For example, if the target price of gold is established at $400 per ounce and it starts to exhibit a tendency to decline below this level on the open market, it indicates to the Fed that there is a developing shortage of money and spending, which threatens to reduce prices throughout the economy. By purchasing gold or even Treasury securities from the public in exchange for newly-created dollars until the price of gold returns to its target level, the Fed automatically remedies the monetary shortage and thereby offsets the tendency of the price level to decline. On the other hand, a surfeit of cash balances in the economy [surfeit means an amount that is too large, or is more than is needed]   is indicated by upward pressure on the market price of gold. The Fed relieves this pressure by selling gold or securities to the public and, in the process, absorbs and extinguishes the excess dollars before the general price level can be driven up. 

—Joseph T. Salerno, “Two Traditions in Modern Monetary Theory: John Law and A. R. J. Turgot,” in Money: Sound and Unsound (Auburn, AL: Ludwig von Mises Institute, 2010), 27. 


The Supply-Side Gold Price Rule Is Akin to the Keynesian Formula; Monetarists Also Share a Kinship to Supply-Siders Since Both Seek Price Stability

The school of supply-siders who favor a gold standard is led by eminent writers and politicians, such as Robert Mundell, Arthur Laffer, Jude Wanniski, and Congressman Jack Kemp. They all want the Federal Reserve to follow a “price rule,” that is, to stabilize the value of the dollar by holding the price of gold at a certain point or within a certain range. 

The Federal Reserve is to engage in open-market operations or adjust the discount rate to maintain the price of gold at a certain point or within a certain range. With a price rule of $300 to $400 an ounce, if the price approached $400, the Fed would contract its total volume of credit to exert downward pressures on the price of gold; when the price fell to $300, the Fed would expand credit and send the price of gold back up again. By stabilizing the gold price through credit expansion or contraction, all other prices would be stabilized in the end. 

The supply-side scheme of price rules for gold is a derivation of Irving Fisher’s scheme for stabilizing the purchasing power of money by way of a “commodity standard.” However, while Professor Fisher (1867-1947) wished to retain redemption in gold, although no longer at a fixed weight of gold, most supply-siders have no such immediate intention. They would merely observe the price of gold, and then manage Federal Reserve credit in reaction to price changes. 

In a sense, the gold price rule is akin to the Keynesian formula of full employment and economic growth through contra-cyclical credit manipulation; however, Keynesian managers expand and contract always with an eye on several indexes, especially those of employment and economic growth. The task of supply-siders is much simpler; they merely need to watch the price of gold. 

The monetarists may notice a kinship to supply-siders despite their heated debates. Both build their structures on the foundation of a money monopoly and legal tender force; both would try to stabilize economic life through currency adjustments. Monetarists seek stability by means of a steady rate of currency issue; supply-siders prefer a price rule that calls for prompt adjustments in the stock of money. Both seek price stability. 

Supply-siders seem to be alone in their great naïveté about the Federal Reserve System’s ability to hold the price of gold at any level. In 1934, after just ten years of Federal Reserve manipulation, the dollar was devalued from 1/20.67 of an ounce of gold to 1/35, which raised the price of gold from $20.67 an ounce to $35.00. The dollar has suffered two formal devaluations and countless “floating” devaluations since then, raising the price of gold from $35 per ounce to more than $300 today. 

—Hans F. Sennholz, Money and Freedom (Cedar Falls, IA: Center for Futures Education, 1985), 43-44.


Tuesday, March 23, 2021

Regulatory Obfuscation and Accounting Gimmickry Have Been the Preferred Approaches of Central Banking with Respect to Capital Inadequacy in Banking

Today [June 1990], many large banks are operating with capital ratios below 5 percent. But even these ratios overstate capital adequacy in the banking system because banks do not adjust the value of their loan portfolios to reflect market values. The resort to accounting gimmickry to mask weakness in the banking system is not new, although it is accelerated when that weakness becomes widespread. One economist noted that “indeed, the use of book value accounting in banking was promoted by regulators in the 1930s to deliberately mask the banks’ poor financial condition . . . . It appears that opposition to market value accounting comes less from banks themselves than from the regulators.” The practical difficulties of marking loans to market value are starting to be overcome with the rise of a secondary market for bank loans. But this market is simultaneously providing evidence of how far bank loan values are overstated. For example, most banks have written down loans to Latin American countries by 25 percent, carrying them in effect at 75 cents on the dollar. Yet the secondary market for such debt shows its market value to be approximately 25 cents (as of late 1989) and declining rapidly, from 65 cents only 1 year earlier. Many money center banks would wipe out their equity cushion by recognizing the market value of these loans alone. The market for bank stocks has reflected this fact better than bank accountants and regulators (who should know better), as investors discount bank stock prices in relation to book values. Capital adequacy also has been overstated to the extent that banks have moved a significant amount of their liabilities off the balance sheet in the form of credit commitments, interest rate swaps, and standby letters of credit. The most important point is that regulatory obfuscation and accounting gimmickry, not genuine reform, have been the preferred approaches of central banking with respect to capital inadequacy in banking. 

—Richard M. Salsman, “Breaking the Banks: Central Banking Problems and Free Banking Solutions,” Economic Education Bulletin 30, no. 6 (June 1990): 65-66.


A Government-Guaranteed Deposit System Artificially Lowers the Cost of Debt Financing for Banks and Increases the Proportion of Debt in the Balance Sheet of the Banking System

Central banking’s provision of deposit insurance with artificial ceilings on interest rates paid on those deposits also diminishes capital adequacy in the banking system. Finance theory demonstrates that firms (banks included) will choose a proportion of debt and equity in their capital structure that minimizes the blended cost of capital. But a government-guaranteed deposit system that is backed by a central banking institution with a monopoly on fiat base money creation, lender-of-last-resort powers, and the right to limit deposit rates, artificially lowers the cost of debt financing for banks and increases the proportion of debt (and lowers the proportion of capital) in the balance sheet of the banking system. Banking is the only industry in which the government agrees to guarantee the short-term liabilities of every participant. It is an arrangement that naturally encourages the use of debt (deposits) instead of capital to finance asset growth. There is a substitution of “public capital” (government-insured deposits) for “private capital” (equity that would have been employed in the absence of government-guaranteed deposits). The imposition of corporate taxation and the tax-deductibility of interest expense (but not dividends) also reflects government intervention and further promotes leveraging and capital inadequacy in the banking industry. Although the banking industry shares with other industries this tax-driven motivation to employ more debt than capital, corporate taxation and tax-deductible interest nonetheless remain nonmarket factors bearing on the decision to leverage. They would not be operative in a free market.

—Richard M. Salsman, “Breaking the Banks: Central Banking Problems and Free Banking Solutions,” Economic Education Bulletin 30, no. 6 (June 1990): 30.


The Lender-of-Last-Resort Function Inherent in Central Banking Encourages Capital Inadequacy in the Banking System

The lender-of-last-resort function inherent in central banking also encourages capital inadequacy in the banking system. The central bank agrees to lend reserves to illiquid banks even if they also are insolvent. The lender of last resort is not concerned with the cause of the illiquidity, even if it arises due to depositors anticipating a bank’s insolvency. The illiquidity, not the insolvency, is seen as the problem requiring a solution. When illiquidity arising from the threat of bank insolvency is remedied by such nonmarket “lending” as the central bank provides, and when such lending is promised unconditionally as a matter of policy, capital adequacy is further undermined, or at least not rectified. 

The expectation that central bank lending is unconditional and unlimited derives from the fact that it is not actually lending at all. Last resort lending by a central bank does not have its source in some existing supply of capital or reserves. In the marketplace, “lending” consists of the transfer of existing purchasing power from one party to another, in which one foregoes its use over time in return for interest. But a central bank committed to rectifying banking system liquidity does not lend or transfer existing reserves. It “creates” reserves, not out of real resources or capital but solely by virtue of its monopoly power over fiat base money creation. This monopoly power sanctions risky banking and promotes banking system leverage through enhanced inflating capacity. Advocates of central banking believe that such a reserve base is beneficial because it is nearly costless. But the creation of fiat reserves costs the banking system its long-term strength.

—Richard M. Salsman, “Breaking the Banks: Central Banking Problems and Free Banking Solutions,” Economic Education Bulletin 30, no. 6 (June 1990): 29-30.


Monday, March 22, 2021

The Two Rules Regulating Socialism’s Capital Structure Can Be Viewed Profitably Alongside their Free-Market Counterparts

The controversy surrounding socialism does not so much concern the above; rather, it concerns production and how socialism can have accurate factor pricing without competition. Lange here introduces several rules that are intended to replace and improve upon capitalist production. The first rule is to have all producers equalize the ratios of marginal productivity to their prices, for all the factors of production (e.g.,  MPa ÷ Pa = MPb ÷ Pb = MPn ÷ Pn ).

The second rule, to be used in tandem with the above, is to price production equal to marginal cost, a principle first recommended by Fred Taylor and readily adopted by Lange. This marginal cost principle, the welfare ideal of neoclassical economics, is addressed not only to the singular firms but to the industries as well.

The above two rules regulating socialism’s capital structure can be viewed profitably alongside their free-market counterparts. Profit maximization under capitalism is replaced by producing at minimum average cost. Free entry/exit and the optimum size of plant in the market order are likewise duplicated by the same rule. The second rule, of setting price to marginal cost, conforms to the “pure and perfect competition” ideal under capitalism. Setting marginal benefits to marginal costs is seen as maximizing welfare (the Pareto optimality) for society. In all, the rules fully cover the economics of production, “determin[ing] the combination of factors of production and the scale of output” while also maximizing welfare. 

—Robert Bradley Jr., “Market Socialism: A Subjectivist Evaluation,” Journal of Libertarian Studies 5, no. 1 (Winter 1981): 24-25.


Sunday, March 21, 2021

Rampant Inflation Destroys the Capital Markets that Sustain Economic Production; Capitalists and Businessmen Learn to Hedge for Financial Survival

The Keynesian commitment to expansionary policies is a commitment to inflation that does not promote full employment. It does not achieve the “miracle . . . of turning a stone into bread,” but generates the business cycle with periods of high unemployment. Continued application of the Keynesian recipe must finally lead to the complete breakdown of the monetary system and to mass unemployment. 

Rampant inflation destroys the capital markets that sustain economic production. The lenders, who sustain staggering losses from currency depreciation, are unable to grant new loans to finance business. Even if some loan funds should survive the destruction, lenders shy away from monetary contracts for  any length of time. Business capital, especially long-term loan capital, becomes very scarce, which causes economic stagnation and decline. To salvage their shrinking wealth, capitalists learn to hedge for financial survival; they invest in durable goods that are expected to remain unaffected by the inflation and depreciation. They buy real estate, objects of art, gold, silver, jewelry, rare books, coins, stamps, and antique grandfather clocks. Surely, this redirection of capital promotes the industries that provide the desired hedge objects. But it also causes other industries to contract. It creates employment opportunities in the former and releases labor in the latter. As the hedge industries are very capital-intensive, working with relatively little labor, and the contracting industries are rather labor-intensive, with a great number of workers, the readjustment entails rising unemployment. Of course, the readjustment process is hampered by labor union rules, generous unemployment compensation, and ample food stamps. 

Similarly, double-digit inflation causes businessmen to hedge for financial survival. They tend to invest their working capital in those real goods they know best, in inventory and capital equipment. Funds that were serving production for the market become fixed investments in durable goods that may escape the monetary depreciation. Economic output, especially for consumers, tend to decline, which raises goods prices and swells the unemployment rolls.

—Hans F. Sennholz, “The Causes of Inflation,” in Age of Inflation (Belmont, MA: Western Islands, 1979), 37.