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«Besley for inviting me, Professor Philip Booth and the Institute of Economic Affairs for allowing me to also use this as an opportunity to introduce ...»

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investors are very happy looking at stock market quotes that grow day after day; consumer goods industries are able to sell everything they carry to the market at ever increasing prices;

restaurants are always full with long waiting lists just to get a table; workers and their unions see how desperately entrepreneurs demand their services in an environment of full employment, wage increases and immigration; political leaders benefit from what appears to be an exceptionally good economic and social climate that they invariably sell to the electorate as the direct result of their leadership and good economic policies; state budget bureaucrats are astonished to find that every year public income increases at double digit figures, particularly the proceeds from Value Added tax, which, though in the end is paid by the final consumer, is advanced by the entrepreneurs of the early stages newly created and artificially financed by credit expansion.

But we may now ask ourselves: how long can this party last?

How long can there continue to be a huge discoordination between the behavior of consumers (who do not wish to increase their savings) and that of investors (who continually increase their investments financed by banks’ artificial creation of virtual money and not by citizens’ prior genuine savings)? How long can this illusion that everybody can get whatever he wants without any sacrifice last?

The unhampered market is a very dynamically efficient process (Huerta de Soto 2010a, 1-30). Sooner or later it inevitably discovers

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(and tries to correct) the huge errors committed. Six spontaneous microeconomic reactions always occur to halt and revert the negative effects of the bubble years financed by artificial bank credit expansion.

The spontaneous reaction of the market against the effects of credit expansions: first the financial crisis and second the deep economic recession In my book on Money, Bank Credit, and Economic Cycles (Huerta de Soto 2009, 361-384) I study in detail the six spontaneous and inevitable microeconomic causes of the reversal of the artificial boom that the aggression of bank credit expansion invariably

triggers in the market. Let us summarize these six factors briefly:

1st The rise in the price of the original means of production (mainly labor, natural resources, and commodities). This rise appears when these resources have not been liberated from consumer goods industries (because savings have not increased) and the entrepreneurs of the different stages in the production process compete with each other in demanding the original means of production with the newly created loans they have received from the banking system.

2nd The subsequent rise in the price of consumer goods at an even quicker pace than that of the rise in the price of the factors of production.

This happens when time preference remains stable and the new money created by banks reaches the pockets of the consumers in an environment in which entrepreneurs are frantically trying to produce more for distant consumption and less for immediate consumption of all kinds of goods. This also explains the 3rd factor which is 3rd The substantial relative increase in the accounting profits of companies closest to final consumption, especially compared with the profits of capital goods industries which begin to stagnate when their costs rise more rapidly than their turn over.

4th «The Ricardo Effect» which exerts an impact which is exactly opposite to the one it exerted when there was an increase in voluntary saving. Now the relative rise in the prices of consumer 324 NOTICIAS goods (or of consumer industries’ turnover in an environment of increased productivity) with respect to the increase in originalfactor income begins to drive down real wages, motivating entrepreneurs to substitute cheaper labor for machinery, which lessens the demand for capital goods and further reduces the profits of companies operating in the stages furthest from consumption.

5th The increase in the loan rate of interest even exceeding pre-credit expansion levels. This happens when the pace of credit expansion stops accelerating, something that sooner or later always occurs.

Interest rates significantly increase due to the higher purchasing power and risk premiums demanded by the lenders. Furthermore, entrepreneurs involved in malinvestments start a «fight to the death» to obtain additional financing to try to complete their investment projects (Hayek 1937).

These five factors provoke the following sixth combined effect:

6th Companies which operate in the stages relatively more distant from consumption begin to discover they are incurring heavy accounting losses. These accounting losses, when compared with the relative profits generated in the stages closest to consumption, finally reveal beyond a doubt that serious entrepreneurial errors have been committed and that there is an urgent need to correct them by paralyzing and liquidating the investment projects mistakenly launched during the boom years.

The financial crisis begins the moment the market, which as I have said is very dynamically efficient (Huerta de Soto 2010a, 1-30), discovers that the true market value of the loans granted by banks during the boom is only a fraction of what was originally thought. In other words, the market discovers that the value of bank assets is much lower than previously thought and, as bank liabilities (which are the deposits created during the boom) remain constant, the market discovers the banks are in fact bankrupt, and were it not for the desperate action of the lender of last resort in bailing out the banks, the whole financial and monetary system would collapse. In any case, it is important to understand that the financial and banking crisis is not the cause of the economic recession but one of its most important first symptoms.





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Economic recessions begin when the market discovers that many investment projects launched during the boom years are not profitable. And then consumers demand liquidation of these malinvestments (which, it is now discovered, were planned to mature in a too-distant future considering the true wishes of consumers). The recession marks the beginning of the painful readjustment of the productive structure, which consists of withdrawing productive resources from the stages furthest from consumption and transferring them back to those closest to it.

Both the financial crisis and the economic recession are always unavoidable once credit expansion has begun, because the market sooner or later discovers that investment projects financed by banks during the boom period were too ambitious due to a lack of the real saved resources that would be needed to complete them. In other words, bank credit expansion during the boom period encourages entrepreneurs to act as if savings had increased when in fact this is not the case. A generalized error of economic calculation has been committed and sooner or later it will be discovered and corrected spontaneously by the market. In fact all the Hayekian theory of economic cycles is a particular case of the theorem of the impossibility of economic calculation under socialism discovered by Ludwig von Mises, which is also fully applicable to the current wrongly designed and heavily regulated banking system.

The specific features of the 2008 Financial Crisis and the current economic recession The expansionary cycle which has now come to a close was set in motion when the American economy emerged from its last recession in 2001 and the Federal Reserve embarked again on a major artificial expansion of credit and investment, an expansion unbacked by a parallel increase in voluntary household saving.

In fact, for several years the money supply in the form of banknotes and deposits has been growing at an average rate of over ten percent per year (which means that every seven years the total volume of money circulating in the world could have 326 NOTICIAS been doubled). The media of exchange originating from this severe fiduciary inflation have been placed on the market by the banking system as newly-created loans granted at extremely low (and even negative in real terms) interest rates. This fueled a speculative bubble in the shape of a substantial rise in the prices of capital goods, real estate assets, and the securities which represent them and are exchanged on the stock market, where indexes soared.

Curiously enough, like in the «roaring» years prior to the Great Depression of 1929, the shock of monetary growth has not significantly influenced the unit prices of the subset of consumer goods and services (which are only approximately one third of the total number of goods that are exchanged in the market). The last decade, like the 1920s, has seen a remarkable increase in productivity as a result of the introduction, on a massive scale, of new technologies and significant entrepreneurial innovations which, were it not for the «money and credit injection,» would have given rise to a healthy and sustained reduction in the unit price of the goods and services all citizens consume. Moreover, the full incorporation of the economies of China and India into the globalized market has gradually raised the real productivity of consumer goods and services even further. The absence of a healthy «deflation» in the prices of consumer goods in a stage of such considerable growth in productivity as that of recent years provides the main evidence that the monetary shock has seriously disturbed the whole economic process. And let us remember the «Antideflationist Hysteria» of those who, even during the years of the bubble, used the slightest symptoms of this healthy deflation, to justify even greater doses of credit expansion.

As we have already seen, artificial credit expansion and the (fiduciary) inflation of media of exchange offer no shortcut to stable and sustained economic development, no way of avoiding the necessary sacrifice and discipline behind all high rates of voluntary saving. (In fact, before the crisis and particularly in the United States, voluntary saving not only failed to increase, but even fell to a negative rate for several years.) The specific factors that trigger the end of the euphoric monetary «binge» and the beginning of the recessionary «hangover» are

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many, and they can vary from one cycle to another. In this crisis, the most obvious triggers were first, the rise in the price of commodities and raw materials, particularly oil, second, the subprime mortgage crisis in the United States, and finally, the failure of important banking institutions when it became clear in the market that the value of their debts exceeded that of their assets (mainly mortgage loans erroneously granted).

If we consider the level of past credit expansion and the quality and volume of malinvestment produced by it, we could say that very probably in this cycle the economies of the European Monetary Union are in comparison in a somewhat less poor state (if we do not consider the relatively greater Continental European rigidities, particularly in the labor market, which tend to make recessions in Europe longer and more painful). The expansionary policy of the European Central Bank, though not free of grave errors, has been somewhat less irresponsible than that of the Federal Reserve. Furthermore, fulfillment of the convergence criteria for the monetary union involved at the time a healthy and significant rehabilitation of the chief European economies. Only some countries on the periphery, like Ireland and Spain, were immersed in considerable credit expansion from the time they initiated their processes of convergence.

The case of Spain is paradigmatic. The Spanish economy underwent an economic boom which, in part, was due to real causes (like the liberalizing structural reforms which originated with José María Aznar’s administration). Nevertheless, the boom was also largely fueled by an artificial expansion of money and credit, which grew at a rate nearly three times the corresponding rates in France and Germany.

Spanish economic agents essentially interpreted the decrease in interest rates which resulted from the convergence process in the easy-money terms traditional in Spain: a greater availability of easy money and mass requests for loans from Spanish banks (mainly to finance real estate speculation), loans which Spanish banks granted by creating the money ex nihilo while European central bankers looked on unperturbed. Once the crisis hit Spain the readjustment was quick and efficient: In less than a year more than 150,000 companies —mainly related with the building 328 NOTICIAS sector— have disappeared, almost five million workers who were employed in the wrong sectors have been dismissed, and nowadays we can conclude that although still very weak, the economic body of Spain has been already healed. We will later come back to the subject of what economic policy is most appropriate to the current circumstances. But before that, let us make some comments on the influence of the new accounting rules on the current economic and financial crisis.

The negative influence of the new accounting rules

We must not forget that a central feature of the long past period of artificial expansion was a gradual corruption, on the American continent as well as in Europe, of the traditional principles of accounting as practiced globally for centuries.

To be specific, acceptance of the international accounting standards (IAS) and their incorporation into law in most countries have meant the abandonment of the traditional principle of prudence and its replacement by the principle of «fair value» in the assessment of the value of balance sheet assets, particularly financial assets.

In fact, during the years of the «speculative bubble,» this process was characterized by a feedback loop: rising stock-market values were immediately entered into the books, and then such accounting entries were sought as justification for further artificial increases in the prices of financial assets listed on the stock market.



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