The Capital Market Is Utmost Imperfect for Entrepreneurial Businesses Severely Impeding the Use of 3 Valuation Methods

The problems described above lead to severe problems when applying multiples, DCF methods and real option approaches to valuing entrepreneurial businesses. Multiple approaches such as the ‘similar public company approach’ or the ‘recent acquisition approach’ attempt to draw conclusions about the value of the firm by looking at prices that were paid in the past for ‘comparable’ companies either in M&A deals or at the stock exchange. Comparable companies can hardly be found for entrepreneurial firms because of the uniqueness of their business model and the specific managerial expertise and networks of the founder. Therefore, multiples fail when valuing small, innovative firms.

In addition, the several variations of the DCF approach are not convincing for the purpose of valuing small, innovative firms. DCF methods aim to calculate the market value for the firm which is valid in a perfect capital market in equilibrium. However, the premises of a perfect capital market are not met at all in the case of entrepreneurial businesses, as mentioned above. As a consequence, DCF approaches fail when valuing small firms. They are based upon the CAPM and therefore cannot be applied under the assumption of an imperfect capital market.

The real options method computes the value of the firm as the sum of a basic value (calculated by the DCF method) and an option value that is generated, inter alia, according to the models of Black and Scholes or Cox et al. Both basic and option value are therefore calculated assuming a perfect capital market which is not met in the reality of entrepreneurial businesses. Despite this severe weakness, there are surprisingly many proponents of the real options method who claim that the approach is particularly adequate for valuing small, innovative firms.

—Gerrit Brösel, Manfred J. Matschke, and Michael Olbrich, “Valuation of Entrepreneurial Businesses,” International Journal of Entrepreneurial Venturing 4, no. 3 (2012): 241-242.

CAPM’s Assumptions Supplant Heterogeneous Human Persons with an Army of Homogeneous Robots

The current mainstream in investment appraisal relies on input parameters within the income approach that are much different from what investment theory requires. It is based upon neoclassical finance theory and neglects the crucial personal perspective in favor of a questionable “objective” market perspective (Matschke, and Brösel, 2013, pp. 26–27). Though the prevalent mainstream discounted cash flow (DCF) methods are also based upon the income approach, they are inadequate as a decision tool (e.g., Rapp, 2014b, p. 1067). The main reason for this diagnosis is the application of finance-theory based models within current DCF methods (Hering, 2014, p. 263).

In these methods, the discount rate is usually, at least partly, assessed using the capital asset pricing model (CAPM) (Koller, Goedhart, and Wessels, 2010, p. 234). Instead of considering the essential personal endogenous marginal interest rate, the CAPM aims at the determination and application of an “objective” discount rate (Hering, 2015, p. 307). In order to measure an, at least hypothetically, objective discount rate, the CAPM must rely upon several restrictive assumptions (e.g., Perridon, Steiner, and Rathgeber, 2012, p. 546, Hering, 2015, p. 297). These include a perfect capital market (which includes the existence of a single market interest rate for both investments and lending; unlimited access to lending independent of debt ratio, credit-worthiness, credit amount and time pattern; symmetric distribution of information; and the absence of taxes as well as transaction costs) and economic agents with both homogeneous expectations and a standardized risk appetite (µ-σ-principle). Basically, CAPM’s assumptions supplant heterogeneous human persons with an army of homogeneous robots. Because the subjective values of homogeneous robots coincide, the model can generate a (hypothetical) single objective market value (Matschke, and Brösel, 2013, p. 27). The uniformity of economic agents in the CAPM leads finally to the market portfolio which includes every risky asset and which is held by every single investor. In other words, in the CAPM world, everybody owns everything (Hering, 2015, pp. 298–299). The sole ownership of any company is, by definition, impossible. Thus, the purchase or sale of an entire company is excluded as well. Nevertheless, the CAPM is applied for the investment appraisal of entire businesses in preparation of merger and acquisition decisions all over the world every single day.

—Jeffrey M. Herbener and David J. Rapp, “Toward a Subjective Approach to Investment Appraisal in Light of Austrian Value Theory,” Quarterly Journal of Austrian Economics 19, no. 1 (Spring 2016): 20-22.

Utilizing Neo-Classical Equilibrium Properties, CAPM Explains Pricing on Idealized Capital Markets

In general, an equilibrium theory only has the power to explain a rigid, irrevocable state and is useless to indicate rational resource allocation in a dynamic economy (Herbener 1996, 160; Mises [1949] 1998, 708–9; Morgenstern 1935, 353). As a result, finding an application in a dynamic reality is unlikely. CAPM [Capital Asset Pricing Model] is an equilibrium model that explains pricing in the capital market under idealized assumptions. The application of such restrictive constraints should be carefully considered, especially for the sensitive purpose of calculating a decision value. Caution is advised by neo-classical luminaries. While the CAPM builds on the assumptions of the efficient market hypothesis, which was introduced by Fama (1970, 1965), Fama and French (2004, 43–4) later refute CAPM’s practical applicability and warn of its “seductive simplicity.”

—Michael Olbrich, Tobias Quill, and David J. Rapp, “Business Valuation Inspired by the Austrian School,” Journal of Business Valuation and Economic Loss Analysis 10, no. 1 (2015): 12.

The Austrian “Subjective Business Valuation Theory” As a Rival to the Neoclassical Discounted Cash Flows Valuation Method

The significant failure rates observed in mergers and acquisitions (M&A) indicate structural deficiencies in business transactions. This paper identifies serious weaknesses in common valuation methods that play a key role in poor transaction practice. Common valuation methods are in particular discounted cash flow (DCF) methods. DCF methods are usually based on neoclassical theories that assume the existence of a perfect and complete capital market. As will be demonstrated, the underlying theoretical patchwork is contradictory and lacks utility. Therefore, utilizing DCF methods to value a business and deduce economic decisions from such a valuation is decision-making built on sand. Following a normative-deductive methodology, this paper seeks an alternative theoretical concept to build a business valuation theory on solid ground. Such an alternative is found in the Austrian School of thought. The resulting valuation concept, subjective business valuation theory, is based on the theory of marginal utility proposed by Gossen, which was rediscovered and refined by the scholars of the early Austrian School. Contrary to highly restrictive neo-classical valuation, subjective business valuation approaches reality and is therefore well-suited for practical implementation.

—Michael Olbrich, Tobias Quill, and David J. Rapp, “Business Valuation Inspired by the Austrian School,” abstract, Journal of Business Valuation and Economic Loss Analysis 10, no. 1 (2015): 1.

The 2nd Cantillon Effect from Artificially Low Interest Rates Is Seen in the Wave of Mergers and Acquisitions

The second Cantillon effect from lower rates of interest is the impact on the size of firms. A lower cost of capital encourages firms to grow in size and to take advantage of economies of scale, such as the example of the dairy industry in transition. Here, companies that expand based on artificially low interest rates benefit, at least temporarily, at the expense of companies that do not and exit the industry. As part of this larger-scale, more roundabout production process, firms develop central offices or headquarters for their accounting, management, marketing, human resources, and product-development departments. This increases the demand for office space in central business districts. This demand in turn raises rents and encourages the construction of taller office buildings within the central business district.

The phenomenon of firms growing in size and scope in response to artificially low interest rates can be seen in the history of merger-and-acquisition waves. Mergers between two firms occur when both firms believe they can profit from combining their operations. Acquisitions and takeovers occur when one firm believes it can manage the combined assets of the firms in a more profitable manner. Lower interest rates reduce the cost of the capital to buy out investors of the other firm. Mergers and acquisitions have occurred in clusters or waves during periods of low interest rates and easy credit conditions (the boom), and because they often start operating as a united company during the bust, their record of success has not been great.

Saravia shows that waves of mergers and acquisitions that have been experienced in the past are consistent with Austrian business cycle theory (ABCT). Not only do low interest rates help finance mergers and especially acquisitions, but the demand for such business deals is a reflection of the “resource crunch” of ABCT as shown in the previous example of the expansion of the advanced computer-chip industry. Ekelund, Ford, and Thornton show that when mergers are delayed by government “red tape,” the resulting acquisitions and mergers tend to be unprofitable because they are often completed during an economic downturn. Thornton has furthered the discussion of why so many mergers and acquisitions turn out to be miscalculations.

—Mark Thornton, The Skyscraper Curse: And How Austrian Economists Predicted Every Major Economic Crisis of the Last Century (Auburn, AL: Mises Institute, 2018), 70-71.

High Yield Bonds (a.k.a. “Leveraged Buy-Outs” or “Junk Bonds”) Benefit Everyone Except the Inefficient Old Guard Elites

Mr. Milken was worth it because he has been an extraordinarily creative financial innovator. During the 1960s, the existing corporate power elite, often running their corporations inefficiently—an elite virtually headed by David Rockefeller—saw their positions threatened by takeover bids, in which outside financial interests bid for stockholder support against their own inept managerial elites.

The exiting corporate elites turned—as usual—for aid and bailout to the federal government, which obligingly passed the Williams Act (named for the New Jersey Senator who was later sent to jail in the Abscam affair) in 1967. Before the Williams Act, takeover bids could occur quickly and silently, with little hassle. The 1967 Act, however, gravely crippled takeover bids by decreeing that if a financial group amassed more than 5 percent of the stock of a corporation, it would have to stop, publicly announce its intent to arrange a takeover bid, and then wait for a certain time period before it could proceed on its plans. What Milken did was to resurrect and make flourish the takeover bid concept through the issue of high-yield bonds (the “leveraged buy-out”).

The new takeover process enraged the Rockefeller-type corporate elite, and enriched both Mr. Milken and his employers, who had the sound business sense to hire Milken on commission, and to keep the commission going despite the wrath of the Establishment. In the process Drexel Burnham grew from a small, third-tier investment firm to one of the giants of Wall Street.

The Establishment was bitter for many reasons. The big banks who were tied in with the existing, inefficient corporate elites, found that the upstart takeover groups could make an end run around the banks by floating high-yield bonds on the open market. The competition also proved inconvenient for firms who issue and trade in blue-chip, but low-yield, bonds; these firms soon persuaded their allies in the Establishment media to sneeringly refer to their high-yield competition as “junk” bonds.

People like Michael Milken perform a vitally important economic function for the economy and for consumers, in addition to profiting themselves. One would think that economists and writers allegedly in favor of the free market would readily grasp this fact. In this case, such entrepreneurs aid the process of shifting the ownership and control of capital from inefficient to more efficient and productive hands—a process which is great for everyone, except, of course, for the inefficient Old Guard elites whose proclaimed devotion to the free markets does not stop them from using the coercion of the federal government to try to resist or crush their efficient competitors.

—Murray N. Rothbard, “Michael R. Milken vs. the Power Elite,” in Making Economic Sense, 2nd ed. (Auburn, AL: Ludwig von Mises Institute, 2006), 182-184.

Ludwig von Mises on the Role the Capital and Money Market Plays in the Direction of Corporate Business

The illusion that management is the totality of entrepreneurial activities and that management is a perfect substitute for entrepreneurship is the outgrowth of a misinterpretation of the conditions of the corporations, the typical form of present-day business. It is asserted that the corporation is operated by the salaried managers, while the shareholders are merely passive spectators. All the powers are concentrated in the hands of hired employees. The shareholders are idle and useless; they harvest what the managers have sown.

This doctrine disregards entirely the role that the capital and money market, the stock and bond exchange, which a pertinent idiom simply calls the “market,” plays in the direction of corporate business. The dealings of this market are branded by popular anticapitalistic bias as a hazardous game, as mere gambling. In fact, the changes in the prices of common and preferred stock and of corporate bonds are the means applied by the capitalists for the supreme control of the flow of capital. The price structure as determined by the speculations on the capital and money markets and on the big commodity exchanges not only decides how much capital is available for the conduct of each corporation’s business; it creates a state of affairs to which the managers must adjust their operations in detail.

—Ludwig von Mises, Human Action: A Treatise on Economics, ed. Bettina Bien Greaves (Indianapolis: Liberty Fund, 2007), 2:306-307.

Blind Reliance upon “Experts” and Uncritical Acceptance of Popular Catchwords Is Tantamount to the Abandonment of Self-Determination

There is no means by which anyone can evade his personal responsibility. Whoever neglects to examine to the best of his abilities all the problems involved voluntarily surrenders his birthright to a self-appointed elite of supermen. In such vital matters blind reliance upon “experts” and uncritical acceptance of popular catchwords and prejudices is tantamount to the abandonment of self-determination and to yielding to other people’s domination. As conditions are today, nothing can be more important to every intelligent man than economics. His own fate and that of his progeny is at stake.

Very few are capable of contributing any consequential idea to the body of economic thought. But all reasonable men are called upon to familiarize themselves with the teachings of economics. This is, in our age, the primary civic duty.

Whether we like it or not, it is a fact that economics cannot remain an esoteric branch of knowledge accessible only to small groups of scholars and specialists. Economics deals with society’s fundamental problems; it concerns everyone and belongs to all. It is the main and proper study of every citizen.

—Ludwig von Mises, Human Action: A Treatise on Economics, ed. Bettina Bien Greaves (Indianapolis: Liberty Fund, 2007), 3:878-879.

Williams, of Dividend Discount Model Fame, Wanted to Eliminate Market Volatility by Putting Experts in Charge of Setting Prices

The intellectual foundations of modern finance lie in John Burr Williams’s 1937 Harvard dissertation-turned-book, The Theory of Investment Value (Harvard University Press, 1938), and in this ambitious man’s attempt to use scientific thinking to end the wild volatility of markets that had wreaked havoc on the country during the Great Depression.

Williams began his doctoral program at Harvard in 1932 with the goal of discovering the true causes of the crash of 1929. Just as the financial crisis of 2008 formed the first imprint on the minds of those of us who began our careers in finance in the past decade, the stock market crash formed an indelible impression on Williams and the cadre of young scholars who would attempt to invent the theory of finance. He believed that the “wide changes in stock prices during the last eight years, when prices fell as much as 80 or 90 percent from their 1929 peaks only to recover much of their decline later, are a serious indictment of past practice in Investment Analysis.”

Like many in his day, Williams believed in the promise of technocratic governance, that the world’s problems could be solved by men of solid intellect meeting in wood-paneled rooms to weigh in on matters of urgency for society. The dividend discount model, and the application of The Theory of Investment Value, had a simple purpose: making the excess volatility of markets disappear by putting experts in charge of setting prices.

Experts, not traders, would set the prices of the securities in the marketplace. “The time seems to be ripe for the publication of elaborate monographs on the investment value of all the well-known stocks and bonds listed on the exchanges,” he wrote. “The last word on the true worth of any security will never be said by anyone, but men who have devoted their whole lives to a particular industry should be able to make a better appraisal of its securities than the outsider can.”

In addition to making investing a far less exciting practice, Williams believed this new expert-based approach would result in “fairer, steadier prices for the investing public.” These experts needed only his formulas.

Williams’s new science of investing featured the now-familiar dividend discount model. In short, this model quantifies the idea that the investment value of a security is equal to “the present worth of the expected future dividends.”

—Daniel Rasmussen, “The Bankruptcy of Modern Finance Theory,” American Affairs 1, no. 2 (Summer 2017), under “John Burr Williams and the Dividend Discount Model,” americanaffairsjournal.org/2017/05/bankruptcy-modern-finance-theory/ (accessed March 7, 2020).

The Ubiquitous Modigliani-Miller Model Works in Times of Very Cheap Money Like We Had from 1995 to 2008

As with most of Modem Financial Theory, the flaws in Modigliani-Miller were primarily in the assumptions. Notoriously, taxes exist. Individuals cannot borrow at the same rates as companies, and borrowing rates are not the same as lending rates. However, the greatest problems in Modigliani-Miller’s assumptions lie in ignoring transactions costs and agency issues. While brokerage costs may be low, and borrowing costs for debt relatively so, the cost of bankruptcy, both to the company itself, to the economy, and to the company's employees and customers, is gigantic — far in excess of the minor savings from over-leveraging. Hence, to the extent it works at all, Modigliani-Miller works only in times of very cheap money, when debt is particularly inexpensive and bankruptcy particularly unlikely. Of course, from 1995-2008, that is exactly what we had.³ But even then, Modigliani-Miller was completely at odds with the increasing agency disconnect between management and shareholders, which worsened considerably after 1970.
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³We are not suggesting that Modigliani-Miller is complete rubbish. Were the assumptions valid, then the results in the theorem would follow with mathematical certainty. The issue is what to make of it, and our main criticism is simply that it does not justify high leverage in the real world.

—Kevin Dowd and Martin Hutchinson, Alchemists of Loss: How Modern Finance and Government Intervention Crashed the Financial System (Chichester, UK: John Wiley and Sons, 2010), 67, 67n3.

The “Capital Asset Pricing Model” (CAPM) Dominates MBA Schools Because of Its Relation to the “Efficient Markets Hypothesis”

The CAPM was to dominate academic finance for a long time. The key to its success was its unreserved adoption by the financial economists of the Chicago school, in conjunction with the closely related notion of the Efficient Markets Hypothesis. They defended the CAPM with religious zeal, and most business schools were soon teaching it as established orthodoxy, cranking out tens of thousands of MBAs a year who didn’t really understand the CAPM but who knew nothing better. . . .

In 1977 Richard Roll published a devastating critique that undermined the CAPM by showing that the market portfolio could never be reliably identified. Roll soon had people asking if beta was dead, but still the CAPM orthodoxy dismissed him as a spoilsport and the CAPM party continued for a little while longer.

The end finally came with a study by Eugene Fama and Kenneth French published in 1993, which showed that the beta was not related to stock market returns. This refuted the most basic prediction of the CAPM, namely, that stock market returns should be positively related to their betas. The bloody beta was useless. People were now mischievously asking if beta was dead, again.

From a purely scientific point of view, the Fama and French study was merely the latest in a long series of studies that undermined the scientific respectability of the CAPM. Its significance however was not in its results — although it should have been — but in its authorship. Fama, the inventor of the Efficient Markets Hypothesis, of which more below, was a key figure in the development of the CAPM itself. Thus, one of the key pillars of Modern Financial Theory was renounced by one of its principal creators.

—Kevin Dowd and Martin Hutchinson, Alchemists of Loss: How Modern Finance and Government Intervention Crashed the Financial System (Chichester, UK: John Wiley and Sons, 2010), 71-72.

Corporations Engage in Two Types of “Primary Market” Transactions: Public Offerings and Private Placements

In a primary market transaction, the corporation is the seller, and the transaction raises money for the corporation. . . . Corporations engage in two types of primary market transactions: public offerings and private placements. A public offering, as the name suggests, involves selling securities to the general public, while a private placement is a negotiated sale involving a specific buyer. . . .

Most publicly offered debt and equity securities are underwritten. In Canada, underwriting is conducted by investment dealers specialized in marketing securities. Examples are RBC Dominion, Scotia Capital, Nesbitt Burns, and CIBC World Markets.

When a public offering is underwritten, an investment dealer or a group of investment dealers (called a syndicate) typically purchases the securities from the firm and markets them to the public. The underwriters hope to profit by reselling the securities to investors at a higher price than they pay the firm.

By law, public offerings of debt and equity must be registered with provincial authorities, of which the most important is the Ontario Securities Commission (OSC). Registration requires the firm to disclose a great deal of information before selling any securities. The accounting, legal, and underwriting costs of public offerings can be considerable.

Partly to avoid the various regulatory requirements and the expense of public offerings, debt and equity are often sold privately to large financial institutions such as life insurance companies or mutual funds. Such private placements do not have to be registered with the OSC and do not require the involvement of underwriters.

—Stephen A. Ross et al., Fundamentals of Corporate Finance, 4th Canadian ed. (Toronto: McGraw-Hill Ryerson, 2002), 17-18.

On the Two Kinds of “Secondary Markets”: Auction Markets and Dealer or Over-the-Counter (OTC) Markets

Financial markets function as both primary and secondary markets for debt and equity securities. The term primary markets refers to the original sale of securities by governments and corporations. The secondary markets are where these securities are bought and sold after the original sale. Equities are, of course, issued solely by corporations. Debt securities are issued by both governments and corporations. . . .

A secondary market transaction involves one owner or creditor selling to another. Therefore, the secondary markets provide the means for transferring ownership of corporate securities. There are two kinds of secondary markets: auction markets and dealer markets. 

Dealer markets in stocks and long-term debt are called over-the-counter (OTC) markets. Trading in debt securities takes place over the counter. The expression over the counter refers to days of old when securities were literally bought and sold at counters in offices around the country. Today, like the money market, a significant fraction of the market for stocks and all of the market for long-term debt have no central location; the many dealers are connected electronically. . . .

Auction markets differ from dealer markets in two ways: First, an auction market or exchange, unlike a dealer market, has a physical location (like Bay Street in Toronto or Wall Street). Second, in a dealer market, most of the buying and selling is done by the dealer. The primary purpose of an auction market, on the other hand, is to match those who wish to sell with those who wish to buy. Dealers play a limited role.

—Stephen A. Ross et al., Fundamentals of Corporate Finance, 4th Canadian ed. (Toronto: McGraw-Hill Ryerson, 2002), 17-19.

Financial Markets Can Be Classified As Either “Money Markets” (Short-Term Debt) Or “Capital Markets” (Long-Term Debt)

Financial markets can be classified as either money markets or capital markets. Short-term debt securities of many varieties are bought and sold in money markets. These short-term debt securities are often called money-market instruments and are essentially IOUs. For example, a bankers acceptance represents short-term borrowing by large corporations and is a money-market instrument. Treasury bills are an IOU of the government of Canada. Capital markets are the markets for long-term debt and shares of stock, so the Toronto Stock Exchange, for example, is a capital market.

The money market is a dealer market. Generally, dealers buy and sell something for themselves, at their own risk. A car dealer, for example, buys and sells automobiles. In contrast, brokers and agents match buyers and sellers, but they do not actually own the commodity. A real estate agent or broker, for example, does not normally buy and sell houses.

The largest money-market dealers are chartered banks and investment dealers. Their trading facilities, along with other market participants, are connected electronically via telephone and computer, so the money market has no actual physical location.

—Stephen A. Ross et al., Fundamentals of Corporate Finance, 4th Canadian ed. (Toronto: McGraw-Hill Ryerson, 2002), 17.

War Is the Father of All Things, Declared the Greek Philosopher Heraclitus; It Was Certainly the Father of the Bond Market

‘War’ declared the ancient Greek philosopher Heraclitus, ‘is the father of all things.’ It was certainly the father of the bond market. . . . The ability to finance war through a market for government debt was, like so much else in financial history, an invention of the Italian Renaissance.

For much of the fourteenth and fifteenth centuries, the medieval city-states of Tuscany — Florence, Pisa and Siena — were at war with each other or with other Italian towns. This was war waged as much by money as by men. Rather than require their own citizens to do the dirty work of fighting, each city hired military contractors (condottieri) who raised armies to annex land and loot treasure from its rivals. . . .

The cost of incessant war had plunged Italy’s city-states into crises. Expenditures even in years of peace were running at double tax revenues. To pay the likes of Hawkwood [the great mercenary], Florence was drowning in deficits. You can still see in the records of the Tuscan State Archives how the city’s debt burden increased a hundred-fold from 50,000 florins at the beginning of the fourteenth century to 5 million by 1427. It was literally a mountain of debt — hence its name: the monte commune or communal debt mountain. . . .

—Niall Ferguson, The Ascent of Money: A Financial History of the World (New York: Penguin Press, 2008), 69, 70-71.

The Mob Has Always Been Eagerly Open to Bribes So Rulers Purchase Consent with Material Benefits Like Bread and Circuses

Specious ideology, mystery, circuses; in addition to these purely propagandistic devices, another device is used by rulers to gain the consent of their subjects: purchase by material benefits, bread as well as circuses. The distribution of this largesse to the people is also a method, and a particularly cunning one, of duping them into believing that they benefit from tyrannical rule. They do not realize that they are in fact only receiving a small proportion of the wealth already filched from them by their rulers. Thus:

Roman tyrants ... provided the city wards with feasts to cajole the rabble.... Tyrants would distribute largesse, a bushel of wheat, a gallon of wine, and a sesterce¹: and then everybody would shamelessly cry, “Long live the King!” The fools did not realize that they were merely recovering a portion of their own property, and that their ruler could not have given them what they were receiving without having first taken it from them. A man might one day be presented with a sesterce¹ and gorge himself at the public feast, lauding Tiberius and Nero for handsome liberality, who on the morrow, would be forced to abandon his property to their avarice, his children to their lust, his very blood to the cruelty of these magnificent emperors, without offering any more resistance than a stone or a tree stump. The mob has always behaved in this way — eagerly open to bribes. . . .

Here La Boétie proceeds to supplement this analysis of the purchase of consent by the public with another truly original contribution, one which Professor Lewis considers to be the most novel and important feature of his theory. This is the establishment, as it were the permanent and continuing purchase, of a hierarchy of subordinate allies, a loyal band of retainers, praetorians and bureaucrats. La Boétie himself considers this factor “the mainspring and the secret of domination, the support and foundation of tyranny.” Here is a large sector of society which is not merely duped with occasional and negligible handouts from the State; here are individuals who make a handsome and permanent living out of the proceeds of despotism. Hence, their stake in despotism does not depend on illusion or habit or mystery; their stake is all too great and all too real.

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¹From dictionary.com: A sesterce is a silver coin of ancient Rome, the quarter of a denarius, equal to 2½ asses: introduced in the 3rd century b.c.

—Murray N. Rothbard, introduction to The Politics of Obedience: The Discourse of Voluntary Servitude, by Étienne de la Boétie, trans. Harry Kurz (Auburn, AL: Mises Institute, 2002), 26-28.

When Europe Revived out of the Dark Ages, Currencies with Names Denoting a Weight of Precious Metals Were Established

In the sixth century BCE, when Rome was still ruled by kings, the “as” coin was instituted and embedded with one pound of copper. Later during the Republican period, largely to finance the Punic Wars with Carthage as well as Rome’s conquests, the copper content was systematically cut down. By 250 BCE, the as was down to 1/12 of a pound, and by 130 BCE that fraction had dropped to 1/24 on its way to becoming a mere token. An analogous, though ultimately more destabilizing, depreciation took place later after Rome had become an empire. That political behemoth had to finance a growing bureaucracy, an extensive system of handouts and entertainments to mollify the populace, persistent trade deficits fueled by the import of luxuries from the East, and, most importantly, a considerable military force to defend its far-flung borders. To pay for all this, the Roman Empire continuously debased its denarii. At the time of Nero in the first century CE, these silver coins were made up of 99% pure silver. But in 64, Nero lowered it to 93.5%, beginning a series of debasements that over the next two centuries would see the silver content of Rome’s currency reduced to almost nothing (Fig. 2.1 ).

Inflation thus began to ravage Rome’s economy, which arguably played a crucial role in the empire’s decline and fall.  Subsequently, when a desolated Europe began to revive out of the Dark Ages, currencies with names denoting the weight of precious metals embedded in them were established, such as the English pound and French livre. Well before the widespread adoption of paper currency reduced the commercial relevance of the metal content in coins, these post-Roman monies were eventually stripped and adulterated to the point where we are now—that is, in which the names of those currencies serve merely as a historical reminder of the way money was once supposed to be worth its weight.

—George Bragues, Money, Markets, and Democracy: Politically Skewed Financial Markets and How to Fix Them (New York: Springer Nature, 2017), 32-33.

Keynes’s Criticisms of “the Free Market” Were Actually Criticisms of Unfree Central Banking Regimes

Keynes’s analysis of the possibility of underconsumption in capitalist economies is not a general theory of market economies, but rather is relevant, at best, to economies with central banking systems. Selgin helps demonstrate that by contrast, competition in money production can link saving and investment, thus avoiding Keynes's critique. In addition, Selgin's argument provides a framework to understand central banking’s inability to achieve its intended results. Many of the macroeconomic problems in historical capitalism can thus be traced to interference with financial markets, rather than to market failures.

The economist Henry Simons once observed that Keynes’s criticisms of “the free market” were actually criticisms of unfree central banking regimes. George Selgin’s recent book contributes to that perspective by showing how a completely unregulated banking system could avoid the macroeconomic problems that have plagued economies with central banking systems the world over.

If Selgin is right, Keynes’s theory of underconsumption is not a “general theory” of capitalism’s failures, but a special theory about how economies may fail when hampered by specific financial institutions. Aside from misspecifying the problem, the Keynesian theory also provides unsatisfying solutions. Hence, Selgin offers a modernized version of pre-Keynesian theory and a way of eliminating both the problems with which Keynes was concerned and those that the implementation of his theories eventually caused.

—Steven Horwitz, review of The Theory of Free Banking: Money Supply under Competitive Note Issue, by George Selgin, Critical Review: A Journal of Politics and Society 3, nos. 3-4 (Summer-Fall 1989): 411-412.

On Negative Interest Rates and the War Against Cash: Two Reasons Why Statists Do NOT Like Cash

A more radical alternative proposal of some negative interest rate proponents is to radically reduce the availability of cash in the economy, especially eliminating large-denomination banknotes. If cash is only available in small denominations, then the scope for avoiding negative rates on deposits by cash withdrawal could be reduced, as the storage costs and inconvenience costs of cash as a deposit alternative would be that much greater. Some of the negative interest rate advocates are also warriors against cash—a convenient coincidence—justifying their views by pointing to how cash can facilitate various illegal activities, whether people smuggling, narcotics smuggling, or tax evasion.

The view that the “abolition” or “reduction in use” of cash would serve two purposes—the reduction of illegal activities and giving new scope for negative rates to be used as a contra-cyclical tool—was a central theme of Rogoff’s advocacy (see Rogoff 2016). The author concedes there are some “liberty considerations” but largely dismisses these, concluding: “all in all, the case for going to a less-cash society if not quite yet a cashless society seems pretty compelling, with most of the various and sundry objections being easily handled. Facilitating negative interest rate policy is not the main reason for phasing out paper currency, especially large denomination notes. But it is an important collateral benefit”.

The facts do not bear out Rogoff’s advocacy. A good summary of these can be found in Mitchell 2016. The author points out that there are two reasons why statists don’t like cash: first, they prefer a system that would allow them to track and tax every possible penny of our income and purchases; second, Keynesian central bankers would like to force us to spend more money by imposing negative interest rates on our savings. As a practical matter, the author disputes the claim that removal of large-denomination banknotes would deter crime, citing evidence from anti-corruption experts. Moreover, mafia activities which result in victims paying protection in cash would continue, but the victims would be at even greater risk of harm due to being more intricately drawn into the mafia operations as part of the process of transferring revenues.

—Brendan Brown, The Case Against 2 Per Cent Inflation: From Negative Interest Rates to a 21st Century Gold Standard (Cham, CH: Springer International Publishing, 2018), 159.

The Federal Reserve Fits Naturally into the “Capture Theory” of Regulation as a Government-Enforced Cartel

Chicago School economists who researched the Progressive Era regulatory institutions referred to a “capture theory” of regulation whereby regulators were routinely “captured” politically by the industries they were supposedly regulating “in the public interest.” The “independent” Civil Aeronautics Board enforced a monopolistic, cartel-pricing scheme for the benefit of the airline industry for decades; the Interstate Commerce Commission did the same for the trucking and railroad industries; and so on. George Stigler (1975) was perhaps the most prominent Chicago School economist associated with the capture theory of regulation, which was mentioned by the Nobel Committee upon awarding him the Nobel Prize in Economic Science in 1982.

The Fed fits naturally into this capture theory mold as a government-enforced cartel for the benefit primarily of the banking industry, which has always been the Feds main source of political support. . . . 

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When Congressman Henry Gonzalez proposed legislation in the 1990s that would have opened up some of the Fed’s behavior to public scrutiny, the banking industry’s trade associations swung into action again and mounted a powerful and successful political campaign in opposition to the Gonzalez reforms. The same thing happened yet again when Congressman Ron Paul introduced legislation to audit the Fed in 2009.

At the time of the Gonzalez proposals Rothbard (2013) asked the trenchant rhetorical questions: “[W]hy should bankers be so ready to defend a federal agency which controls and regulates them, and virtually determines the operation of the banking system? Shouldn’t private banks want to have some sort of check, some curb, upon their lord and master? Why should a regulated and controlled industry be so much in love with the unchecked power of their own controller?”

The obvious answer to these rhetorical questions is that the banking industry is so supportive of the Fed as its “regulator” because the Fed regulates the money supply for the benefit of the banking industry and not “the public.” The more power (and the more secrecy) the Fed has the better as far as the banking industry is concerned.

—Thomas DiLorenzo, “A Fraudulent Legend: The Myth of the Independent Fed,” in The Fed at One Hundred: A Critical View on the Federal Reserve System, ed. David Howden and Joseph T. Salerno (Cham, CH: Springer International Publishing, 2014), 66-67.

Modern Macroeconomics Is Built around the “Level” of Demand, But Before Keynes the “Structure” of Demand Mattered Most

Recessions occur because goods and services are produced that cannot be sold for prices that cover their costs. There are countless possible reasons why and how such mistaken production decisions occur. But when all is said and done, the causes of recessions are structural. They are the consequence of structural imbalances that result from errors in production decisions, not the fall in output and demand that necessarily follows.

This cannot be emphasized enough. Modern macroeconomics is built around the notion of the level of demand, while before Keynes recessions were understood in terms of the structure of demand. The difference could not be more profound. To policy-makers today, the basic issue in analysing recessions is whether there is enough demand in total. To economists before Keynes, the central issue was to explain why markets had become unbalanced.

In modern economic theory, rising and falling levels of spending are for all practical purposes what matters. That is why increasing public spending and adding to deficits are seen as an intrinsic part of the solution, not as the additional problem such spending actually is.

Missing in modern economic debates is an understanding of the importance of structure: the parts of the economy must fit together. What’s missing is an understanding that if the entire economic apparatus goes out of sync, recession is the result and recession will persist until all the parts once again begin to mesh.

—Steven Kates, “The Crisis in Economic Theory: The Dead End of Keynesian Economics,” in Macroeconomic Theory and its Failings: Alternative Perspectives on the Global Financial Crisis, ed. Steven Kates (Cheltenham, UK: Edward Elgar Publishing, 2010), 119-120.

Central Banks and the Monetary Games They Play: On the Inflationist Doctrine of “Lowering Interest Rates”

Countries around the world became involved in monetary games like the “stop-go” policies of Britain, in which an attempt to “lower interest rates” (the “go” period) would result in a small inflationary boom and a sagging value of the pound. At that point, to maintain the Bretton Woods system’s fixed exchange rates, the central bank would then have to engineer a monetary contraction (the “stop” period) to support the currency. It was the same thing that the Bank of England had done in 1825. But while the Bank of England had recognized its accidental mistake in 1825, the young inflationists did the same thing on purpose. The stop period would of course tend to be recessionary, which only created an impetus for another go period of excessive monetary expansion and fueled the inflationists’ dreams of what would be possible if they weren’t bound by the “golden fetters” of the Bretton Woods system. . . . 

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The inflationists at times gained the upper hand over the discipline of the Bretton Woods peg. In the late 1940s in Britain, the authorities argued that “lowering interest rates” would make it cheaper to service the national debt, and they embarked on a program of keeping short-term rates at a tiny 0.5 percent. This is almost exactly the game the Federal Reserve had been pressured into playing in 1919. The Fed called a halt to the charade—it was involved in similar foolishness in the late 1940s as well, before pulling back again—but the Brits carried it through to its logical conclusion. The pound was devalued from $4.03 to $2.80 on September 18, 1949. The existing national debt did indeed become cheaper to service, since the government essentially defaulted on much of it through the mechanism of devaluation. 

The end result of all this “lowering interest rates” throughout the world was in fact a persistent rise in interest rates after World War II, as lenders demanded an extra premium to protect themselves against the risk of devaluation and inflationary default (which is exactly what happened).

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The result of the continuing dominance of the gold standard through the Bretton Woods system was that the inflationist doctrine of “lowering interest rates” was never fully debunked, and instead completely saturated the academic economics establishment. The principles of economics upon which the gold standard was founded were scrubbed clean from textbooks after World War II. Frustrated by the inability to carry out their policies to their conclusion, the descendants of Keynes instead strengthened their position by indoctrinating two generations of economists to their way of thinking.

—Nathan Lewis, Gold: The Once and Future Money (Hoboken, NJ: John Wiley and Sons, 2007), 202-204.

Edwin W. Kemmerer, the “Money Doctor” of the 1920s, Imposed Central Banks and Gold-Exchange Standards on 3rd World Countries

The War Department was beside itself: How could it drive Mexican silver coinage out of the Philippines? In desperation, it turned to the indefatigable Conant, but Conant couldn’t join the colonial government in the Philippines because he had just been appointed to a more far-flung presidential commission on international exchange for pressuring Mexico and China to go on a similar gold-exchange standard. Hollander, fresh from his Puerto Rican triumph, was ill. Who else? Conant, Hollander, and several leading bankers told the War Department they could recommend no one for the job, so new then was the profession of technical expertise in monetary imperialism. But there was one more hope, the other pro-cartelist and financial imperialist, Cornell’s Jeremiah W. Jenks, a fellow member with Conant of President Roosevelt’s new Commission on International Exchange (CIE). Jenks had already paved the way for Conant by visiting English and Dutch colonies in the Far East in 1901 to gain information about running the Philippines. Jenks finally came up with a name, his former graduate student at Cornell, Edwin W. Kemmerer.

Young Kemmerer went to the Philippines from 1903 to 1906 to implement the Conant plan. Based on the theories of Jenks and Conant, and on his own experience in the Philippines, Kemmerer went on to teach at Cornell and then at Princeton, and gained fame throughout the 1920s as the “money doctor,” busily imposing the gold-exchange standard on country after country abroad.

Relying on Conant’s behind-the-scenes advice, Kemmerer and his associates finally came out with a successful scheme to drive out the Mexican silver coins. It was a plan that relied heavily on government coercion.

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But the true successor of Conant was Edwin W. Kemmerer, the “money doctor.” After his Philippine experience, Kemmerer joined his old Professor Jenks at Cornell, and then moved to Princeton in 1912, publishing his book Modern Currency Reforms in 1916. As the leading foreign financial adviser of the 1920s, Kemmerer not only imposed central banks and a gold-exchange standard on Third World countries, but he also got them to levy higher taxes. Kemmerer, too, combined his public employment with service to leading international bankers. During the 1920s, Kemmerer worked as banking expert for the U.S. government’s Dawes Commission, headed special financial advisory missions to more than a dozen countries, and was kept on a handsome retainer by the distinguished investment banking firm of Dillon, Read from 1922 to 1929. In that era, Kemmerer and his mentor Jenks were the only foreign currency reform experts available for advising. In the late 1920s, Kemmerer helped establish a chair of international economics at Princeton, which he occupied, and from which he could train students like Arthur N. Young and William W. Cumberland. In the mid 1920s, the money doctor served as president of the American Economic Association.

—Murray N. Rothbard, A History of Money and Banking in the United States: The Colonial Era to World War II, ed. Joseph T. Salerno (Auburn, AL: Ludwig von Mises Institute, 2002), 223-224, 233-234.

Ralph Hawtrey Was One of the Evil Geniuses of the 1920s; He Was One of the First to Call for Gold-Exchange Standard Adoption

Ralph Hawtrey proved to be one of the evil geniuses of the 1920s. An influential economist in a land where economists have shaped policy far more influentially than in the United States, Hawtrey, Director of Financial Studies at the British Treasury, advocated international credit control by Central Banks to achieve a stable price level as early as 1913. In 1919, Hawtrey was one of the first to call for the adoption of a gold-exchange standard by European countries, tying it in with international Central Bank cooperation. Hawtrey was one of the prime European trumpeters of the prowess of Governor Benjamin Strong. Writing in 1932, at a time when Robertson had come to realize the evils of stabilization, Hawtrey declared: “The American experiment in stabilization from 1922 to 1928 showed that an early treatment could check a tendency either to inflation or to depression. . . . The American experiment was a great advance upon the practice of the nineteenth century,” when the trade cycle was accepted passively. When Governor Strong died, Hawtrey called the event “a disaster for the world.” Finally, Hawtrey was the main inspiration for the stabilization resolutions of the Genoa Conference of 1922.

—Murray N. Rothbard, America's Great Depression, 5th ed. (Auburn, AL: Ludwig von Mises Institute, 2000), 176-177.

Rothbard Tells of American Attempts to Replicate British Monetary Imperialism in the Foreign Territories They Controlled

The essential elements of the currency board system were created between 1890 and 1912, a period in which the London money market went from one crisis to another. These reserves crises had a central bearing on colonial currency policies, both in terms of the gold reserves they were required to hold in London, as well as their holdings of undesirable British Government securities. For imperial authorities, the colonial currency systems provided an extremely valuable mechanism to immediately counter reserves crises by mechanisms totally within the control of the Secretary of State for Colonies, not available through their normal London Money market control mechanisms. . . .

While my original DPhil did not examine the colonial currency policies of other imperial powers such as France and Holland, Rothbard (2002, pp 210–32) has a fascinating account of American attempts to replicate British monetary imperialism in foreign territories they controlled, but based on the US dollar reserves in New York, comparable to sterling reserves in London, for British colonies. Rothbard describes how the leading lights of the American Economic Association, in co-operation with American bankers, foreign investors, and corporate interests in gold and silver, set out to foster similar imperialist monetary systems in Puerto Rico, Philippines, Mexico, Cuba and China. The systems were supposed to be gold exchange standards, but based on dollars deposited in New York. The currencies in circulation would be new silver tokens with the seigniorage also deposited in New York, while the Mexican dollars would be eliminated by several artificial means. In Rothbard’s accounts, the American attempts succeeded in Philippines and Mexico, but failed in Cuba because of the American sugar interests there. They also failed in China, which recognized all the disadvantages in the American proposals.

—Wadan Narsey, British Imperialism and the Making of Colonial Currency Systems, Palgrave Studies in the History of Finance (Houndmills, UK: Palgrave Macmillan, 2016), 158-159.