INTRODUCTION

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The economic analysis of juridical institutions has come

to the fore in recent years and promises to become one

of the most fruitful spheres of economics. Much of the

work completed thus far has been strongly influenced by tra-

ditional neoclassical assumptions, namely by the concept of

strict maximization in contexts of equilibrium. Still, economic

analyses of law reveal the shortcomings of the traditional

approach and do so perhaps better than any other branch of

economics. In fact, juridical institutions are so intimately

involved in daily life that it is notoriously difficult to apply the

traditional assumptions of economic analysis to them. I have

already attempted elsewhere to expose the dangers the neo-

classical perspective brings to the analysis of juridical institu-

tions.1Economic analyses of law are certainly necessary, but

they call for a less restrictive methodology than has generally

been used to date, one more suited to this particular field of

research. The subjectivist view is a more fitting approach.

Developed by the Austrian School, it is based on their concept

of creative human action or entrepreneurial activity and

implies a dynamic analysis of the general processes of social

interaction. This perspective promises to make great contribu-

tions to the future development of the economic analysis of

juridical institutions.

In addition, most studies of juridical institutions carried

out so far have had exclusively microeconomic implications

because, among other reasons, theorists have simply borrowed

the traditional analytical tools of neoclassical microeconomics

1See Jesús Huerta de Soto, “The Ongoing Methodenstreit of the Aus-

trian School,” Journal des Économistes et des Études Humaines 8, no. 1

(March 1998): 75–113.

xli

and applied them to the analysis of law. This has been the

case, for example, with respect to the economic analysis of con-

tracts and civil liability, bankruptcy law, the family, and even

criminal law and justice. Very few economic analyses of law

have had mainly macroeconomic implications, and this reflects

the harmful decades-long separation between these two sides

of economics. However, this need not be the case. It is neces-

sary to recognize economics as a unified whole, where macro-

economic elements are firmly rooted in their microeconomic

foundations. In addition, I will attempt to demonstrate that

the economic analysis of some juridical institutions yields crit-

ical implications and conclusions that are essentially macro-

economic. Or, in other words, even when the basic analysis is

microeconomic, the conclusions drawn and primary out-

comes resulting from it are macroeconomic. By closing the

profound artificial gap between micro and macroeconomics,

we arrive at a unified theoretical treatment of legal issues in

the economic analysis of law.

This is my primary goal as I undertake an economic analy-

sis of the monetary irregular-deposit contract, in its different

facets. Furthermore, I intend my examination to cast light on

one of the most obscure and complex spheres of economics:

the theory of money, bank credit, and economic cycles. Now

that the issue of socialism has been resolved,2at least from a

theoretical standpoint, and it has been empirically illustrated

to be impracticable, the main theoretical challenge facing

economists at the dawn of the twenty-first century lies most

likely in the field of money, credit, and financial institutions.

The highly abstract nature of social relationships involving

money in its various forms makes these relationships remark-

ably difficult to understand and the corresponding theoretical

treatment of them particularly complex. In addition, in the

financial and monetary spheres of western countries, a series of

institutions has been developed and imposed; namely central

banks, bank legislation, a monopoly on the issue of currency,

xlii

Money, Bank Credit, and Economic Cycles

2Jesús Huerta de Soto, Socialismo, cálculo económico y función empresarial

(Madrid: Unión Editorial, 1992; 2nd ed., 2001).

and foreign exchange controls. These institutions thoroughly

regulate every country’s financial sector, rendering it much

more similar to the socialist system of central planning than is

appropriate to a true market economy. Hence, as I will attempt

to demonstrate, the arguments which establish the impracti-

cability of socialist economic calculation are fully applicable to

the financial sphere. Supporters of the Austrian School of eco-

nomics originally developed these arguments when they

showed it was impossible to organize society in a coordinated

fashion via dictatorial commands. If my thesis is correct, the

impracticability of socialism will also be established in the

financial sector. Furthermore, the inevitable discoordination

to which all state intervention gives rise will be vividly

revealed in the cyclical phases of boom and recession which

traditionally affect the mixed economies of the developed

world.

Any theoretical study today which attempts to identify the

causes, stages, remedies for, and chances of preventing eco-

nomic cycles is guaranteed to be front-page material. As a

matter of fact, as I write these lines (November 1997), a serious

financial and banking crisis grips Asian markets and threatens

to spread to Latin America and the rest of the western world.

This crisis comes in the wake of the period of apparent eco-

nomic prosperity which in turn followed the severe financial

crises and economic recessions that shook the world at the

beginning of the nineties and particularly the end of the sev-

enties. Furthermore, in the eyes of ordinary people, politi-

cians, and the majority of economic theorists themselves, an

understanding has not yet been reached as to the true causes

of these phenomena, the successive and recurrent appear-

ances of which are constantly used by politicians, philoso-

phers, and interventionist theorists alike as a pretext for reject-

ing a market economy and justifying an increasing level of

dictatorial state intervention in the economy and society.

For this reason, from the point of view of classical liberal

doctrine, it is of great theoretical interest to scientifically ana-

lyze the origin of economic cycles, and in particular, to deter-

mine the ideal model for the financial system of a truly free

society. Libertarian theorists themselves still disagree in this

Introduction                                                                                                 xliii

area, and there are great differences of opinion as to whether

it is necessary to maintain the central bank or whether it

would be better to exchange it for a system of free banking,

and in the latter case, as to what concrete rules economic

agents participating in a completely free financial system

should have to follow. The central bank originally appeared as

the result of a series of dictatorial government interventions,

though these were mainly urged by various agents of the

financial sector (specifically by private banks themselves),

who on many occasions have considered it necessary to

demand state support to guarantee the stability of their busi-

ness activities during stages of economic crisis. Does this

mean the central bank is an inevitable evolutionary outcome

of a free-market economy? Or rather, that the way private

bankers have characteristically done business, which at a cer-

tain point became corrupt from a legal point of view, has

brought about financial practices unsustainable without back-

ing from a lender of last resort? These and other issues are of

utmost theoretical interest and should be the object of the

most careful analysis. In short, my main objective is to

develop a research plan to determine which financial and

banking system is appropriate for a free society.

I intend this research to be multidisciplinary. It will have to

rest not only on the study of juridical science and the history of

law, but also on economic theory and specifically on the theory

of money, capital, and economic cycles. Furthermore, my analy-

sis will shed new light on some historical economic events

related to the financial realm, and will better illustrate the evo-

lution of certain trends in the history of economic thought itself,

as well as the development of various accounting and banking

techniques. A proper understanding of finance requires the

integration of various disciplines and branches of knowledge,

and we will consider these from the three perspectives I deem

necessary to correctly comprehend any social phenomenon:

historical-evolutionary, theoretical, and ethical.3

xliv

Money, Bank Credit, and Economic Cycles

3I have presented the theory of the three-tiered approach to studying

social issues in Jesús Huerta de Soto, “Conjectural History and Beyond,”

Humane Studies Review 6, no. 2 (Winter, 1988–1989): 10.

This book comprises nine chapters. In the first I describe

the legal essence of the monetary irregular-deposit contract,

paying special attention to the main characteristics distin-

guishing it from a loan contract, or mutuum. In addition,

Chapter 1 deals with the different legal logic inherent in these

two institutions, their mutual incompatibility at a fundamen-

tal level, and how the unique ways each is regulated embody

traditional, universal legal principles identified and devel-

oped from the time of Roman classical law.

Chapter 2 is a historical study of economic events. There I

examine ways in which the traditional legal principle govern-

ing the irregular-deposit contract has been corrupted over

time, mainly due to the temptation felt by the first bankers to

use their depositors’ money to their own benefit. The interven-

tion of the political establishment has also played an important

role in this process. Always eager to secure new financial

resources, political authorities have turned to bankers

entrusted with others’ deposits and have attempted to exploit

these funds, granting the bankers all sorts of privileges, chiefly

authorization to use their depositors’ money for their own ben-

efit (of course on condition that a significant part of such funds

be loaned to the politicians themselves). This chapter offers

three different examples (classical Greece and Rome, the resur-

gence of banking in medieval Italian cities, and the revival of

banking in modern times) to illustrate the process by which the

traditional legal principles governing the monetary irregular-

deposit bank contract have become corrupted and to outline

the resulting economic effects.

In chapter 3 I adopt a legal viewpoint to consider different

theoretical attempts to come up with a new contractual frame-

work in which to classify the monetary bank-deposit contract.

Such attempts are aimed at justifying banks’ lending of

demand-deposit funds to third parties. I intend to show that

these attempts at justification are riddled with an insoluble

logical contradiction and therefore doomed to failure. I will

also explain how the effects of privileged banking practices (see

chapter 2) expose profound contradictions and weaknesses in

the formulation of a new legal, theoretical basis for the mone-

tary irregular-deposit contract. The attempt to establish such a

Introduction                                                                                                 xlv

foundation dates back to the Middle Ages and has continued

until practically the present day. We will take a detailed look

at different efforts to formulate an unorthodox legal principle

capable of governing present-day monetary bank deposits in

a logical, coherent manner. I conclude that such attempts

could not possibly have been successful, because current

banking practices are based precisely on the violation of tra-

ditional principles inherent in property rights, which cannot

be violated without serious harmful effects on the processes of

social interaction.

Chapters 4, 5, 6, and 7 comprise the heart of my economic

analysis of the bank-deposit contract as it has developed over

time; that is, using a fractional-reserve ratio in violation of tra-

ditional legal principles. I will explain why Hayek’s insightful

rule rings true in the banking field as well. This rule states that

whenever a traditional legal principle is violated, sooner or

later there are serious harmful effects on society. From a theo-

retical viewpoint, I will analyze the effects the current banking

practice of disregarding traditional legal principles in the

monetary-deposit contract has on the creation of money, intra-

and intertemporal market coordination, entrepreneurship,

and economic cycles. My conclusion is that the successive

stages of boom, crisis, and economic recession recurring in the

market result from the violation of the traditional legal princi-

ple on which the monetary bank-deposit contract should be

based. They stem from the privilege bankers have come to

enjoy and have been granted in the past by governments for

reasons of mutual interest. We will study the theory of eco-

nomic cycles in depth and critically analyze the alternative

explanations offered by the monetarist and Keynesian schools

for this type of phenomena.

Chapter 8 focuses on the central bank as a lender of last

resort. The creation of this institution resulted inevitably from

certain events. When the principles which should govern the

irregular-deposit contract are violated, such acute and

inescapable effects appear that private bankers soon realized

they needed to turn to the government for an institution to act

on their behalf as lender of last resort and provide support

during stages of crisis, which experience demonstrated to be a

xlvi

Money, Bank Credit, and Economic Cycles

recurrent phenomenon. I will endeavor to show that the cen-

tral bank did not emerge spontaneously as the result of mar-

ket institutions, but was forcibly imposed by the government

and responds to the demands of powerful pressure groups. I

will also examine the current financial system, which is based

on a central bank, and apply to it the analytical economic the-

ory of the impracticability of socialism. Indeed, the current

financial system rests on a monopoly one government agency

holds on the chief decisions regarding the type and quantity

of money and credit to be created and injected into the eco-

nomic system. Thus it constitutes a financial market system of

“central planning” and therefore involves a high level of inter-

vention and is to a great extent “socialist.” Sooner or later the

system will inevitably run up against the impossibility of

socialist economic calculation, the theorem of which main-

tains it is impossible to coordinate any sphere of society, espe-

cially the financial sphere, via dictatorial mandates, given that

the governing body (in this case the central bank) is incapable

of obtaining the necessary and relevant information required

to do so. The chapter concludes with a review of the recent

central-banking/free-banking controversy. We will see that

most current free-banking theorists have failed to realize that

their plan loses much of its potential and theoretical weight if

not accompanied by a call to return to traditional legal princi-

ples; that is, to banking with a 100-percent reserve require-

ment. Freedom must go hand-in-hand with responsibility and

strict observance of traditional legal principles.

The ninth and last chapter presents an ideal, coherent

model for a financial system which respects traditional legal

principles and is thus based on the adoption of a 100-percent

reserve requirement in banking. Also considered are the dif-

ferent arguments made against my proposal. I criticize them

and explain how the transition from the current system to the

proposed ideal system could be carried out with a minimum

of tension. A summary of main conclusions wraps up the

book, along with some additional considerations on the

advantages of the proposed financial system. The principles

studied here are also applied to certain urgent practical issues,

such as the construction of a new European monetary system

Introduction                                                                                                xlvii

and of a modern financial system in the former socialist

economies.

A summarized version of this book’s essential thesis was

first presented in a paper before the Mont Pèlerin Society in

Rio de Janeiro in September 1993 and received the support of

James M. Buchanan, to whom I am very grateful. A written,

Spanish version has been partially published in the “Intro-

ducción Crítica” of the first Spanish edition of Vera C. Smith’s

book, The Rationale of Central Banking and the Free Banking

Alternative.4It was later published in French as an article enti-

tled “Banque centrale ou banque libre: le débat théorique sur

les réserves fractionnaires.”5

I express my gratitude to my colleague at the law school of

Madrid’s Universidad Complutense, Professor Mercedes

López Amor, for her help in the search for sources and a bibli-

ography regarding the treatment under Roman law of the

irregular deposit of money. Also, my former professor, Pablo

Martín Aceña, from the University of Alcalá de Henares

(Madrid), offered direction in my study of the evolution of

banking throughout the Middle Ages. Luis Reig, Rafael Man-

zanares, José Antonio de Aguirre, José Luis Feito, Richard

Adamiak of Chicago, the late Professor Murray N. Rothbard,

xlviii

Money, Bank Credit, and Economic Cycles

4Vera C. Smith, Fundamentos de la banca central y de la libertad bancaria

(Madrid: Unión Editorial/Ediciones Aosta, 1993), pp. 27–42. (The Ratio-

nale of Central Banking and the Free Banking Alternative [Indianapolis: Lib-

erty Press, 1990].)

5Jesús Huerta de Soto, “Banque centrale ou banque libre: le débat

théorique sur les réserves fractionnaires,” in the Journal des Économistes

et des Études Humaines 5, no. 2/3 (June-September 1994): 379–91. This

paper later appeared in Spanish with the title “La teoría del banco cen-

tral y de la banca libre” in my book, Estudios de economía política, chap.

11, pp. 129–43. Two other versions of this article were also later pub-

lished: one in English, entitled “ACritical Analysis of Central Banks and

Fractional Reserve Free Banking from the Austrian School Perspective,”

in The Review of Austrian Economics 8, no. 2 (1995): 117–30; the other in

Romanian, thanks to Octavian Vasilescu, “Banci centrale si sistemul de

free-banking cu rezerve fractionare: o analizá criticá din perspectiva

Scolii Austriece,” Polis: Revista de stiinte politice 4, no. 1 (Bucharest, 1997):

145–57.

and Professors Hans-Hermann Hoppe from Las Vegas Uni-

versity in Nevada, Manuel Gurdiel from the Universidad

Complutense in Madrid, Pablo Vázquez from the University

of Cantabria (Spain), Enrique Menéndez Ureña from the Uni-

versidad Comillas (Madrid), James Sadowsky from Fordham

University, Pedro Tenorio from the U.N.E.D. (Spain), Rafael

Termes from the I.E.S.E. (Madrid), Raimondo Cubeddu from

the University of Pisa, Rafael Rubio de Urquía from the Uni-

versidad Autónoma in Madrid, José Antonio García Durán

from the Universidad Central de Barcelona (Spain), and the

learned José Antonio Linage Conde from the University of San

Pablo-C.E.U. in Madrid have been a great help with their sug-

gestions and provision of books, articles, and rare biblio-

graphic references on banking and monetary issues. My stu-

dents in doctorate courses at the law school of Madrid’s

Universidad Complutense, especially Elena Sousmatzian,

Xavier Sampedro, Luis Alfonso López García, Rubén Manso,

Ángel Luis Rodríguez, César Martínez Meseguer, Juan Igna-

cio Funes, Alberto Recarte and Esteban Gándara, along with

Assistant Professors Óscar Vara, Javier Aranzadi, and Ángel

Rodríguez, have provided innumerable suggestions and

worked hard to correct typing errors in several previous ver-

sions of the manuscript. I express my gratitude to all of them

and free them, as is logical, of all responsibility for the book’s

final contents.

Finally, I would like to thank Sandra Moyano, Ann Lewis,

and Yolanda Moyano for their great help and patience in typ-

ing and correcting the different versions of the manuscript.

Above all, I am grateful, as always, to my wife, Sonsoles, for

her help, understanding, and continual encouragement and

support throughout this entire project. This book is dedicated

to her.

Jesús Huerta de Soto

Formentor

August 15, 1997