Gold Research Videos
In this interview, Jesús Huerta de Soto, Professor of Political Economy at Rey Juan Carlos University, Madrid, outlines how central banks caused the financial crisis. He explains why fractional reserve banking causes economic problems, and why artificially-low interest rates are a bad idea. Fractional reserve banking creates “too big to fail” banks. An 100 per cent reserve system would give smaller banks a chance to compete.
Huerta de Soto also discusses the paradox of blaming the free market for the financial crisis, how the monetary system has been nationalised, and how central banking amounts to “pure socialism”. De Soto argues that efforts by central banks to maintain an “optimum” money supply and fix interest rates at the “correct” level are doomed to failure.
Furthermore, he explains the three measures he would take to fix the financial system. These are 100 per cent bank reserve requirements, the abolition of central banks and the implementation of a pure gold standard. He outlines why under a free banking system, fractional reserve banking would die out.
Although gold would likely play a role in a free-market monetary system, the professor states that a gold standard system can only work in an 100 per cent bank reserve system. Huerta De Soto argues that the popularity of banking theories is irrelevant in assessing their validity.
At the end, he discusses how his book, Money, Bank Credit and Economic Cycles, has been favourably received and translated into many languages, and how it can help central bankers anticipate economic cycles. He also shares how encouraging it is that students around the world are becoming critics of fractional reserve banking and supporters of sound money.
Professor Jesús Huerta de Soto: Well, this financial crisis, the crisis we have experienced in the last at least 200 years, has been caused by a previous process of huge credit expansion that was orchestrated by central banks, and that consists of a process of creation of new money that materialises in demand deposits that are created out of thin air by the banks and given as loans to entrepreneurs so that entrepreneurs will receive the signal that they should invest as if real savings in the society have increased, when in fact this didn't happen. The whole process was financed, as I said, through artificial credit expansion. As a result of that, huge malinvestments were committed and the market, which is a very dynamically efficient process of creativity and discovery, sooner or later discovers these malinvestments, and when the discovery is done, the financial crisis comes.
The process is the result of an accident of the history. In Peel's Bank Act that was enacted on July 19th, 1844, Robert Peel diagnosed, correctly, that the cycles of financial exuberance, crisis, and economic recessions that were affecting England in those days were the result of a banking system that was operating with a fractional reserve.
In those days, the main business of bankers consists of issuing paper bank notes that were certificates of deposits of real money – in those days, gold. I mean, they were issuing certificates of deposits in an amount greater than the gold really deposited in the banks. This created an inflation of fiduciary media, and the new paper money, the new paper bank notes, were lent to entrepreneurs. So, the malinvestment was created, and the financial crises, inevitably, at the end, came, once after the other.
So, in order to avoid that, in this legislation, Peel required a 100 percent reserve requirement as a collateral for the bank notes issued by bankers. But, unfortunately, in the legislation, it was forgotten that demand deposits do have exactly the same role as money, as paper bank notes. So, what happened in the legislation is that private bankers redirected their business, from the business of issuing paper bank notes or reissuing bank notes – that was forbidden since the Peel's Bank Act – to the business of issuing demand deposits, which, as a matter of fact, from the point of view of economic theory, is exactly the same business.
So, the bubbles were not avoided. They did continue. Bank trends did continue. And it was needed to create a lender of last resort, a central bank, in order to bail out private bankers when the crisis came.
So, the central bank took the role of the director of the credit expansion. In this sense, the true responsible of the current crisis are central banks, who either actively promoted the artificial credit expansions in the past years or passively accepted this expansion created by private bankers. So, there is no doubt, from the point of view of economic science, that central bankers are the true responsible of the current financial crisis.
And secondly, also is responsible this wrongly designed financial and monetary system that is affecting the world at least since Peel's Bank Act, which is based on the fractional reserve of deposits. If Robert Peel had demanded also a 100 percent ratio, not only for paper bank notes but also for demand deposits, all bubbles and financial crises could have been avoided.
The audience should, first of all, understand how the process of artificial credit expansion works. This means that when a bank acts with a fractional reserve, the bank only keeps a fraction of the real money deposited in it. At the end, in considering the private banking system in an aggregate way, what they do is to create money, materialising in deposits, which are book entries in the accounting books of the banks, and use it as a collateral in order to provide loans for entrepreneurs.
So, it's very easy. I lend you one million euros, and this is recorded in the asset side of my balance sheet as a loan, against one million euros of demand deposits, created anew, out of thin air, and materializing only as an entry written in the liability side of the balance sheet of the banks. This is done. This is the way in which money is created nowadays, it is what I call 'virtual money,' in the sense that it does not materialise, neither in paper bank notes nor in coins, only in accounting entries in the liability side of the banks.
So, this is the process. The expansion is created. And the expansion is very dangerous for our society, because it is like a drug. When the new money is injected in this way in the system, the system reacts in a very expansionary way. Everybody is happy in the party. Entrepreneurs do receive very cheap financing for almost every project, no matter how crazy it would appear in other circumstances. At the same time, unions and workers do see that there is strong demand for their services. Consumer goods are demanded strongly. Public income keeps increasing year after year. So there is a bubble. This bubble is specifically created through this process, and the institution responsible of allowing the process to go on is the central bank. For that reason, I was blaming the central bank as the true culprit, as the institution that everybody should blame for the current situation. At the same time, the central bank was created, was an avoidable institution, once the fractional reserve banking system kept alive after Peel's Bank Act.
What is true is that whenever there is a fractional reserve private banking system, there is a very strong incentive among private banks to merge with each other, because in this way they decrease the probability of losing reserves. If you merge with another bank, and at the end you get 25 per cent of market share, for instance, as a banker in Spain now has, the probability that everyone using the bank system being your client is 25 per cent. So, your position is very comfortable, much more comfortable than if you were a tiny bank, trying to increase your fiduciary media, your demand deposits, always with a danger of, through the chamber of liquidation, being requested to give you back in reserves the demand deposits you have created.
So, there is a tendency to have a merger. In fact, if, in theory, all private bankers were merging in just one private banker worldwide, no problem whatsoever of solvency would appear. [laughs] So, for the theoretical point of view, this is the tendency we should see whenever the fractional reserve banking system is kept.
On the contrary, if we could reform the current financial system, reintroducing the 100 per cent reserve requirement as was required by Peel's Bank Act, not only for paper bank notes but also for demand deposits, then the number of private bankers would be irrelevant. We could see thousands of banks, tiny, medium, or large ones, competing with each other freely in the market. But, no economics of scale on the allocation of reserves would be needed, as they are now needed.
One of the most paradoxical consequences of the current crisis is that, by and large, citizens, people, tend to blame the free market for it. Whenever there is a crisis, the politicians, the social leaders, even many of my colleagues do argue that the crisis shows that the market experience a failure and that more regulation is needed. In fact, the reality is just the opposite. The financial system is very far from a free market, and we could just recapitulate a little bit how it has been built.
First of all, money has been nationalised and expropriated to individuals and substituted by purely fiduciary paper public money. Secondly, a central planning agency called central bank has been created in order to give support to bail out private bankers whenever they experience a crisis. And thirdly, a huge mess of administrative regulations are enacted by central banks. The legal tender laws have been enacted in order to force all individuals to accept the public fiduciary paper money as legal payment.
And even worse, the central bank tries to fine tune the economy, injecting what they think is the optimal monetary supply needed in every moment. And even worse again, they fix the interest rate, which is a very important prize that should be the most free prize in a market, because it's the most important: the prize of pricing goods in terms of future goods.
So, there is not a free market in the financial area. There is pure socialism, directed by a central planning agency. And all the tenets of the theorem of the impossibility of socialism that was discovered by the Austrian economists Friedrich Hayek and Mises are fully applicable to the central bank. It is theoretically impossible that they are successful in their attempts to fine tune the economy, precisely by one fundamental reason: it is impossible that they are able to get the specific information they need to give a coordinating nature to the commands, to the regulations.
This is the heart of the argument of the theorem of the impossibility of socialism, discovered by Mises and Hayek. And precisely for the same reasons that real socialism fall after the fall of the Berlin Wall, we are having suddenly the same problems now in the fully regulated and nationalized financial system orchestrated by the central planning agency that we call the central bank. It's still affecting the world.
So, there is no way that in the future these financial crises and economic recessions are avoided whenever we keep our the current fractional reserve banking system orchestrated by the instructions of the central bank. So, these two institutions should disappear.
The three measures that should be taken in order to avoid these cycles of bubbles and financial crises and economic recession should be recapitulating the following. First, to reintroduce the 100 per cent reserve requirement for demand deposits. If you want to complete Peel's Bank Act precisely, it was not completed in 1844.
Secondly, this would allow to abolish central banks, because they wouldn't be necessary any more in order to give support to private bankers.
And third, it would be needed to substitute the current purely fiduciary paper money issued by the states by a pure gold standard. Gold has a very important advantage. It's that it cannot be manipulated by public officials.
The amount of gold worldwide, the store of gold, is increasing around 1 2 per cent per year, and it is a very rigid stock. It can neither be increased or decreased. So it would avoid the cycles of expansion, a deficit expansion and contraction we're currently suffering.
If you are referring to free banking, of course, banks could be entirely freely be created in every way the deem fit, provided these three principles are allowed. So when we are talking about free banking, we could not understand, we are talking about fractional reserve free banking. And I totally disagree with my colleagues that the problem is the existence is the problem of the central bank. I think fractional reserve banking inevitably creates all the incentives to the foundation of a central bank.
As a matter of fact, this is in an interesting discussion. It is quite irrelevant, the debate between fractional reserve free bankers and 100 per cent free bankers. Because I'm quite sure that in a purely free market economy, for instance in a co capitalist system, all private bankers would be acting with 100 per cent reserve requirement. I think the main deposits or equivalents.
Because even the slightest lack of confidence in a bank would make it empty, would empty at the speed of the light, using all Internet and all the technological means we have today.
So, all of them would be acting in this way. And we could imagine a system in which some institutions would be providing the monetary supply, extracting gold from the mines and providing accounting services and so on.
And other intuitions would be acting as financial intermediaries so that the intermediation of investment and the function of supplying money would be entirely separated and not mixed as they are now.
And also I would say to my colleagues that defend the fractional reserve free banking system that they do not have suitable transition to their ideal system. If they only defend the abolition of the central bank, what we could expect is the highest bank run that we could imagine in the history. Whenever people realise that the money is not guaranteed by a central bank, everybody would go to all banks and the whole system would collapse.
So, even if they want to defend the abolition of the central bank, they should accept the first step is the 100 per cent requirement, because it's the only way to allow for that abolition without the destruction of the whole monetary system.
So, I think they are forced at least to accept the three steps I'm defending.
Be careful with that, because the gold standard was a goal working with the fractional reserve banking system, which means that bankers were able to create perfect money substitutes as if they were gold.
The only way a gold system, monetary system, can work is with a 100 per cent reserve requirement, both for certificates of deposits, paper certificates or deposit or virtual certificates of deposits, or the main deposits.
There is no way for a gold system to be alive if the fractional reserve banking system is working. And this is another way in which I disagree with my fellow members of the Austrian school that are more prone to defend fractional reserve banking, free banking system.
We are talking about gold because, looking at the history, it's the money that has been mainly chosen by the civilisation, by generation after generation of human beings. But, of course we cannot be sure how this evolution would evolve in the future if it is established free.
I personally think gold would be kept as the monetary system in a purely free market system, but this is something that cannot be guaranteed because we do not know how the evolution of institutions would evolve considering the future information that entrepreneurs could create in the future.
Information that is – it has not been created yet. We do not know yet. But theoretically, we can understand why gold was chosen.
Even considering that my book is purely a theoretical book, I think it can be very helpful even for them. Because imagine that you are in a boat of the central bank. No matter if is the Federal Reserve banking system or the central bank of Europe.
You know then that a great expansion is going to provoke malinvestment, and sooner of later a financial crisis. So, if you know what it is written in my book, you could try to at least stop earlier the great expansion.
It's like having a compass in the dark of the night in the sea. You see where the north is. Even for those gentleman, it can be very helpful.
What I'm really very happy to have seen the Dutch translation, very handsomely printed by Arco Publishers. This is the seventh country in which my book has been published. In some of them we have published already five different editions in Spanish and now the third edition in English is being prepared.
The book has been publishes also in Russia, in Poland, in Romania, in Czechoslovakia. And now it's being printed by Lucius in Germany. By Lock Martine in France, and by Rubertino in Italy. The book is being published in July in China, and I do expect that it will have a lot of impact in China. Already a lot of people, a lot of scholars in China are commenting on the manuscript of my book and are sending me questions. They are very interested in these financial matters.
And Portuguese edition will appear in Brazil. The book has also been translated into Arabic, although we are still looking for a suitable publisher. And finally in Japanese. It's very interesting also what would be the reaction of the Japanese public to the book.
I wrote the book in 1997. It's the result of 20 years, making research and studying and thinking about it, although I wrote it in six months. It was easy to dictate the book once I had the whole picture together.
In fact, it's not a very original book. What I have done is to put together the theories that were scattered in different books, mostly of Austrian school economists. Of course with some original aspects that you will see.
For instance, I think it's an important byproduct of the transition I propose, is that it would allow to give back all public debt without any cost to governments, more inflationary effects. This is an important byproduct, because if you consolidate with a 100 per cent current demand deposits with new money printed by governments, assets that currently are collateral of those current deposits will refit.
And what I propose is to create mutual funds with those assets and to switch the units of these mutual funds against the leading public debt.
So, according to the calculations I include in the book, this would allow to give back all public debt in the future. This would mean to give back to the citizens what has been, century after century, expropriating to them through the private banking system acting with the fractional reserve ratio.
I was the first one to be surprised with the success of the book. And I think the success has been the result of mainly the financial crisis and economic recession, because it is something unbelievable. But, most of the people, including most of my colleagues, could not understand what happened.
For instance, last October, I delivered a speech, the Hayek Memorial Lecture at the London School of Economics. There were 600 people hearing me. And those were normal students and teachers and professors, that they only wanted to understand why the financial crisis came and the economic recession.
And this is something that in my book is very logically explained step after step. The protagonists of the future is the young people, and our most important responsibility is to provide the intellectual tools to the youngest generation so that they accomplish, for instance, the design, the badly needed redesign of the financial system, in order in the future to avoid the repetition of these cycles.
And I'm very optimistic, because the best reaction I'm seeing all around the world is from the youngest students. For instance, I just was invited by the Financial University and the government of the Russian Federation – this is the official of the university what was created in Moscow in 1929 – in order to lecture to the brightest 400 students of the Russian Federation that were chosen by the government, precisely on the financial crisis and the economic recession.
And I was really moved when the people organising this meeting, the young students, told me, 'We had been literally raised with your books,' which means they had been studying the different editions, each one after the other one, that have printed of my four books in Russia.
So, they are very eager to hear directly from the author the theory. And I'm very proud and honored that the university also decided to confer upon me the honorary doctorate degree on economic science precisely for that reason.
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