The Great Historical Mistake

There once was a time when the science of economics – based on sound reasoning - concluded that economic liberalism was the best way to achieve lasting and growing prosperity. Classical economists may have been stumped by the theory of value, a problem satisfactorily solved by Carl Menger in the 1870's, but on the whole, their teachings were conducive to the adoption of free market capitalism. This ushered in an age of unprecedented capital accumulation and prosperity.

One other area in which 19th century economists were unfortunately deficient was monetary theory. In the battle between the banking and currency schools that culminated in the adoption of the Peel Act in the UK in 1844, the otherwise sound theorists of the currency school made a few crucial mistakes: they failed to recognize that deposit money plays exactly the same role as banknotes and specie, i.e., that it is in fact money, and they erroneously held that it was a good idea to grant a monopoly of money issuance to a central bank. As J.H. de Soto mentions, a third error, or rather omission, was that they failed to connect their monetary theory to trade or business cycle theory, i.e. they did not realize what the effects of monetary expansion on the economy's production structure are.

The Peel Act failed to fulfill its promise precisely because the deposit money problem was not properly considered. While the issuance of unbacked banknotes was curtailed by the act, the issuance of deposit money was not and so the boom-bust cycles which the adherents of the currency school wanted to stop continued to bedevil the economy.

Ludwig von Mises finally did in 1912 what his predecessors failed to do, in that he corrected the errors of the currency school, while building on its sound basic ideas and creating a coherent whole with the publication of the Theory of Money and Credit. Mises' conclusion, namely that the expansion of fiduciary media (deposit money not backed by money proper) was responsible for creating the business cycle made an ironclad case that sound money was the only basis for the realization of smooth economic progress.

Ironically, the Federal Reserve Act was passed just one year later, representing the first crucial step toward the abandonment of sound money in the US. Only eight years after the creation of the Fed, the biggest boom-bust cycle in the nation's entire history up to that point began.

It is highly unfortunate that the language barrier stood in the way of a wider reception of the work of the Austrian school in Anglo-Saxon nations at the time, otherwise a lot of mischief might have been prevented.

When Keynes published his anti-free market screed in the mid 1930's, governments finally got from economics what they always wanted. Instead of economists telling them that they could not achieve their goals with interventionism, here was finally a scientific fig leaf justifying intervention in the economy on a grand scale. Instead of the free market being hailed as the most efficient method of allocating scarce resources and as a system that should be left to work in as unhampered a fashion as possible, here was an economist claiming that government must stand ready to rectify the alleged 'mistakes' of the free market economy.

Intellectuals in turn were eager to be enrolled in support of statism, as this promised them pay and influence way above what they could have expected to achieve in a free market economy.

This is the program that has been adopted and been in force ever since. Not surprisingly, the nations that adopted it would never again replicate the strong economic growth seen in the late 19th century, have ever since been plagued by high institutionalized unemployment and have gone through secular boom-bust cycles of ever increasing amplitude. Along the way, there have been occasional attempts to roll back some of the more pernicious outgrowths of interventionism and mercantilism, while other errors were concurrently intensified (to name some examples, on the positive side of the ledger, trade was made more free, but on the negative side, all vestiges of sound money were dismantled step by step).

In the modern regulatory democracies of the West, we have today a state-capitalistic system drowning in an absurd thicket of regulations and burdened by onerous taxes, which are laid down in what are by now entire libraries of statutes and codes of impenetrable complexity. The economy rests on the quicksand of a central bank-led fractionally reserved banking cartel and the irredeemable fiat money it issues, which has created a gargantuan edifice of unproductive debt that leaves us continually dancing on the edge of an abyss. The vast growth in debt that has commenced with the abandonment of the last link the monetary system had to gold in the early 1970's has coincided with economic growth that was markedly lower than the growth experienced prior to this enormous credit expansion.

This relative weakening in growth happened in spite of enormous technological progress and the vast improvements in economic productivity it made possible. In short, the credit boom and money supply inflation have deprived us of enjoying the fruits of the advance in productivity to its full extent.

Finally, after four decades of unbridled credit expansion, we have arrived at the point where evidently so much capital has been consumed by malinvestment that economic crisis has seemingly become a permanent condition.

However, instead of reflecting on the errors that have led us to this juncture and proposing a different approach, both the academic economic orthodoxy and policymakers are simply repeating the same mistakes all over again, only on an even greater scale.

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