Inflation? “It leads to the redistribution of wealth – some get significantly wealthy, they are billionaires and millionaires, and most others lose without knowing it, explains Professor of Economics JESÚS HUERTA DE SOTO.
You come from Spain? Why has that country been so hit by the crisis?
In recent years, loans in Spain grew two or three times faster than in the rest of Europe. Loans went primarily into the building of real estate – and a bubble was created. Now, in the country there are about a million new houses that no one wants. The entire economy must painfully adapt, redirect its investment flows from the real estate sector elsewhere, which will take several months or years.
How much are real estate prices going down?
That depends a lot on the locale. On the Mediterranean, a drop by fifty percent is no exception, whereas in certain parts of Madrid, the prices only went down by five or ten percent. It may therefore be a good time to buy.
It depends when the bottom will come. What do you think?
As an economist, I cannot predict; as an entrepreneur, I would dare to bet – but I won’t give you my tip.
Had you expected such a massive crisis two or three years ago?
I was surprised at how quickly and how far the prices went down.
You have said that the Spanish crisis is due to excessive credit engagement. That is, evidently, behind the financial crisis in general.
In the last five to seven years, the supply of money in the economy grew very rapidly. We must realise that money in the form of coins and banknotes accounts for only ten percent (the so-called monetary base, note by L.K.), the remaining ninety percent is virtual money. Essentially, only records in the accounting ledgers of banks. The banking system created deposits literally “from nothing”). The pledge against these liabilities is a loan provided to an entrepreneur or a company. The entrepreneur who newly acquires the money does not know whether it comes from savings; i.e., whether it constitutes the postponed consumption of bank clients, or not. In certain years, the level of savings, for example in the United States, was negative, consumption was high, but in spite of that, entrepreneurs were investing a lot, as if savings were growing. Therefore, in the last approximately seven years, a slight discrepancy between savings and investments occurred, which could simply not last forever. The basic cause of the crisis therefore rests in the artificial credit expansion, which was caused by the central banks, primarily by the US Federal Reserve System.
Is this related to the policy of cheap money, i.e., low interest rates, that central banks followed?
Yes. An interest rate is the basic price in any market economy and it should be determined spontaneously, in a market environment. That is not the case: interest rates are set by a decree of the central bank. But interest rates are an important signal for entrepreneurs and companies. When they are going down, albeit artificially, business revives and launches into new projects (again: as if the level of savings by the population were going up and as if there really were money for the increased investments). Low interest rates (even negative when expressed in real terms) ignited the crisis.
Tell us at least your tip as to how long the crisis will last.
When you drink too much alcohol, a hangover is inevitable. And when we have committed an excessive artificial credit expansion, and hence committed mistakes in investment calculations, an economic recession is inevitable. But the beginning of a recession is also the beginning of a revival: the market discovers what was done wrong in the previous period and starts looking for the right prices, which is why those drops and fluctuations are so frequent these days. Adaptation will require time – in the real and in the financial sphere. It can happen fast, let’s hope over the course of one or two years, or it can be interrupted.
By drastic government interventions. All those stimuli can be ultimately counterproductive. When governments provide “easy loans” to companies, for example, companies will not be compelled to deal with the difficult situation. That happened in Japan: in response to a crisis, the government made loans easily accessible, which, however, stopped the process of market adaptation. The country found itself in a recession that lasted for over ten years. Let us hope that such mistakes will not be repeated on a global scale. Obama’s recovery subsidies to selected sectors are, however, very dangerous.
What about the European packages?
The situation in Europe is not as bad, because there are many governments here. Agreeing on some kind of far-reaching, grandiose recovery plans is much more difficult. On the other hand, politicians are responding to the demand from the public to be active, to “do something”. Political mastery now consists of a politician trying to “do something” without the measure having any impact (chuckles).
Jesús Huerta de Soto Ballester (52)
A Spanish professor of political economy who lectures at the University of King Juan Carlos in Madrid. He and his wife, who studied psychology and works at the same institution, have six children. De Soto lives in Madrid and owns other properties in Mallorca and Navarre. He inherited a company from his father, so he is also a businessman. He likes to play golf in the mornings and owns a Bentley. He came to Prague on the occasion of the publishing of the Czech version of his book Money, Bank Credit, and Economic Cycles.
But politicians are active; they have, for example, pushed through new accounting rules?
The evolution of accounting has been interrupted in recent years – it is called the International Financial Reporting Standards. Accounting is the language of business. Like Czech or Spanish. Any language that is used does not arise out of nothing, nor is it invented by a “council of sages” – that is well illustrated by the collapse of Esperanto, an artificial language. Accounting, too, did not develop overnight: we know of records of financial transactions from the twelfth century, and they were used in ancient Greece and in Ptolemy’s Egypt. Accounting evolved gradually – it was developed by generations of merchants and industrialists, and it was based on several principles. The key one was the principle of prudence, based on the term ‘historical price’ – the price paid during a transaction (see History or Justice). Only if the market price was lower than the historical price was the accounting value reduced. If it was higher, they adhered to the historical price.
And now it is different.
The prudence principle was replaced by the “fair value” principle. That is a bit of a trick: who would be against fair valuation? This “fair” principle leads to valuation not on the basis of the price at the time of the transaction, but on the basis of the current market price. But market fluctuation is so considerable that accounting balances are of no use. During boom times, they are unduly inflated, which leads entrepreneurs and companies to make further investments, to consume, and to take to further risks – simply put, to a state of euphoria. And accounting, for generations an attending phenomenon of prudent trading, changes into a stimulus that leads away from prudence. The market fluctuates, and that is why one day we are millionaires in accounting terms, while the next day, we are facing bankruptcy and calling for capital injections. The new accounting multiplies the effects of ups and downs. The idea that a balance should reflect market prices is very foolish. If the new accounting is lethal for bankers, it is also lethal for that corner shop. It can destroy capitalism.
What can be done about it?
We must quickly do away with all those reforms of accounting rules that have been made in recent years – both in Spain and in the Czech Republic. It was a foolish decision of the European Commission.
But you see the root of the crisis going as far back as 1844.
Yes, it all started with the enactment of the UK Bank Charter Act in 1844. It became the prototype for all other acts concerning banking in the developed world. It laid down the obligation to cover 100% of banknotes with gold. But its authors forgot to create the same obligation for deposits. Yet deposits and banknotes have essentially the same function; however, the economists of the time did not see that far. After the Act came into force, commercial bankers were engaging in an artificial credit expansion “covered” by deposits, not by the issuing of new banknotes. That is why we keep having recessions and bubbles.
What can be done about it?
The first reform step would be to remove the bad things that the Bank Charter Act caused. It would suffice for banks to keep 100% reserves against deposits upon demand and their equivalents. Then there would be no discrepancy between savings and investments. Banks would only be able to lend against what they have themselves first borrowed: term deposits are not deposits, they are loans to banks. Money would not be created “out of nothing”.
What to do with central banks?
The Bank Charter Act was not able to prevent what it was supposed to prevent – the occurrence of financial bubbles. After every crisis, the Bank of England suspended its application to be able to rescue commercial banks – by printing new money. Commercial bankers discovered that they need a lender of last resort, who will intervene whenever a crisis comes. A central bank is simply required in a banking system based on partial reserves. And vice versa: with 100% coverage, no lender of last resort is required. The elimination of central banks, the second step of my reform, would be a good thing, as it would not determine interest rates. That would be the function of the market. A central bank, that is central planning, Gosplan (the economic planning committee in the former Soviet Union, note by L.K.), socialism: a group of bureaucrats determines what supply of money is optimal.
Who will determine the monetary base, if not the central bank?
Money should again be private – as it was for centuries. We must return to the point when gold was nationalised by governments. Gold has several advantages. Its supply increases at a relatively stable rate, of one to two percent per year.
Those who object to returning to the gold standard, however, claim that there is not a sufficient amount of the precious metal in the world to cover the money newly created in connection with the economic growth of the global economy.
That is a popular argument. All the gold in the world would fit into three Olympic-size swimming pools. A monetary supply covered by gold cannot be reduced (with the exception of historical examples, such as from the sixteenth century, when a Spanish galleon sunk with the entire load of the metal it was carrying). Gold is a suitable candidate for covering money and we should not worry too much about whether there is enough of it in the world, or not. That is irrelevant. Even a single gram of gold can have great purchasing power. Any amount of money is optimal; the problem with money arises when its supply grows or drops. A return to the gold standard would be the final step of a financial system reform.
Does deflation indeed pose as great a threat as many politicians – but also economists – claim today?
Inflation is always popular and deflation is always unpopular. Several years ago, we had an anti-deflation hysteria that led to low interest rates and an increased the supply of money. During a monetary expansion, some people make huge money to the detriment of most of those who do not even find out that they are losing something. Why not divide it fairly among everyone, when the growth of the money supply is so beneficial? No, some people want to be the first to get the new money.
Then you can shop with new money at old prices.
Yes, new money will only have a subsequent inflationary effect. Furthermore, the inflationary effect will be distributed among millions of unsuspecting people. Hence, there is a redistribution of wealth – some people get very rich, becoming multimillionaires and billionaires, while most others lose without knowing it. And the key excuse for it is the scarecrow of deflation. That is why some people call out: there is a threat of deflation, we need more money, but please, deliver the new money to us, first! The others only see prices go up, without their incomes growing.
Who are the people who usually get to new money first?
Well, all those investment bankers, stock speculators, and managers with option plans. But also analysts and auditors – that whole world is living off of a monetary expansion.
History or Justice
The debate over accounting methods pits relevance and reliability against each other. The proponents of accounting on the basis of a fair price warn that financial reports based on historical prices are not relevant, as they do not provide information about current prices. The opponents, on the other hand, hold that reports resting on the principle of a fair price are not reliable, as they are not based on actually effected transactions. Whereas the concept of a historical price builds on the price paid on an authentic transaction in the past, the fair-price concept considers the price prevailing on the liquid market at the given moment as decisive, if such a market exists for the asset at hand (if it does not, then various estimates must be used). The concept is therefore also called “mark-to-market” valuation.
The financial crisis is showing that accounting based on the fair price principle has more negative aspects than had been anticipated and, above all, that those negative aspects have a destructive impact. Robert Rubin, former US Secretary of the Treasury and former Co-chairman of the Board of Directors of the investment bank Goldman Sachs expressed it very well, as quoted by Bloomberg at the end of January 2009: “During my entire career at Goldman Sachs, I had believed in the principles of accounting on the basis of a fair price, but if we look at the developments of the last two years, I think that that accounting has led to awfully vicious circles in the prices of assets.” Accounting rules that force companies to value their assets at lower and lower values each quarter – as prices drop on panicking markets – have caused immense damage, according to him.
An abbreviated version of this interview, obtained in Prague, was published in Týden No. 9 on 2 March 2009.