"
"
am happy to present the second English edition of Money,
Bank Credit, and Economic Cycles. Its appearance is particu-
larly timely, given that the severe financial crisis and result-
ing worldwide economic recession I have been forecasting,
since the first edition of this book came out ten years ago, are
now unleashing their fury.
The policy of artificial credit expansion central banks have
permitted and orchestrated over the last fifteen years could not
have ended in any other way. The expansionary cycle which
has now come to a close began gathering momentum when the
American economy emerged from its last recession (fleeting
and repressed though it was) in 2001 and the Federal Reserve
reembarked on the major artificial expansion of credit and
investment initiated in 1992. This credit expansion was not
backed by a parallel increase in voluntary household saving.
For many years, the money supply in the form of bank notes
and deposits has grown at an average rate of over 10 percent
per year (which means that every seven years the total volume
of money circulating in the world has 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 very low (and even negative in real
terms) interest rates. The above 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, like in the “roaring” years prior to the Great
Depression of 1929, the shock of monetary growth has not sig-
nificantly influenced the prices of the subset of consumer
goods and services (approximately only one third of all
goods). 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 entrepre-
neurial innovations which, were it not for the injection of
money and credit, would have given rise to a healthy and sus-
tained reduction in the unit price of consumer goods and serv-
ices. Moreover, the full incorporation of the economies of
China and India into the globalized market has boosted the
real productivity of consumer goods and services even fur-
ther. The absence of a healthy “deflation” in the prices of con-
sumer goods in a stage of such considerable growth in pro-
ductivity as that of recent years provides the main evidence
that the monetary shock has seriously disturbed the economic
process. I analyze this phenomenon in detail in chapter 6, sec-
tion 9.
As I explain in the book, artificial credit expansion and the
(fiduciary) inflation of media of exchange offer no short cut to
stable and sustained economic development, no way of avoid-
ing the necessary sacrifice and discipline behind all high rates
of voluntary saving. (In fact, particularly in the United States,
voluntary saving has not only failed to increase in recent
years, but at times has even fallen to a negative rate.) Indeed,
the artificial expansion of credit and money is never more
than a short-term solution, and that at best. In fact, today there
is no doubt about the recessionary quality the monetary shock
always has in the long run: newly-created loans (of money cit-
izens have not first saved) immediately provide entrepreneurs
with purchasing power they use in overly ambitious invest-
ment projects (in recent years, especially in the building sector
and real estate development). In other words, entrepreneurs
act as if citizens had increased their saving, when they have not
actually done so. Widespread discoordination in the economic
xviii
system results: the financial bubble (“irrational exuberance”)
exerts a harmful effect on the real economy, and sooner or
later the process reverses in the form of an economic recession,
which marks the beginning of the painful and necessary read-
justment. This readjustment invariably requires the reconver-
sion of every real productive structure inflation has distorted.
The specific triggers of the end of the euphoric monetary
“binge” and the beginning of the recessionary “hangover” are
many, and they can vary from one cycle to another. In the cur-
rent circumstances, the most obvious triggers have been the
rise in the price of raw materials, particularly oil, 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 liabilities exceeded that of their
assets (mortgage loans granted).
At present, numerous self-interested voices are demand-
ing further reductions in interest rates and new injections of
money which permit those who desire it to complete their
investment projects without suffering losses. Nevertheless,
this escape forward would only temporarily postpone prob-
lems at the cost of making them far more serious later. The cri-
sis has hit because the profits of capital-goods companies
(especially in the building sector and in real-estate develop-
ment) have disappeared due to the entrepreneurial errors pro-
voked by cheap credit, and because the prices of consumer
goods have begun to perform relatively less poorly than those
of capital goods. At this point, a painful, inevitable readjust-
ment begins, and in addition to a decrease in production and
an increase in unemployment, we are now still seeing a harm-
ful rise in the prices of consumer goods (stagflation).
The most rigorous economic analysis and the coolest, most
balanced interpretation of recent economic and financial
events support the conclusion that central banks (which are
true financial central-planning agencies) cannot possibly suc-
ceed in finding the most advantageous monetary policy at
every moment. This is exactly what became clear in the case of
the failed attempts to plan the former Soviet economy from
above. To put it another way, the theorem of the economic
impossibility of socialism, which the Austrian economists
Preface to the Second English Edition
Ludwig von Mises and Friedrich A. Hayek discovered, is fully
applicable to central banks in general, and to the Federal
Reserve—(at one time) Alan Greenspan and (currently) Ben
Bernanke—in particular. According to this theorem, it is
impossible to organize society, in terms of economics, based
on coercive commands issued by a planning agency, since
such a body can never obtain the information it needs to
infuse its commands with a coordinating nature. Indeed,
nothing is more dangerous than to indulge in the “fatal con-
ceit”—to use Hayek’s useful expression—of believing oneself
omniscient or at least wise and powerful enough to be able to
keep the most suitable monetary policy fine tuned at all times.
Hence, rather than soften the most violent ups and downs of
the economic cycle, the Federal Reserve and, to some lesser
extent, the European Central Bank, have most likely been their
main architects and the culprits in their worsening. Therefore,
the dilemma facing Ben Bernanke and his Federal Reserve
Board, as well as the other central banks (beginning with the
European Central Bank), is not at all comfortable. For years
they have shirked their monetary responsibility, and now they
find themselves in a blind alley. They can either allow the
recessionary process to begin now, and with it the healthy and
painful readjustment, or they can escape forward toward a
“hair of the dog” cure. With the latter, the chances of even
more severe stagflation in the not-too-distant future increase
exponentially. (This was precisely the error committed follow-
ing the stock market crash of 1987, an error which led to the
inflation at the end of the 1980s and concluded with the sharp
recession of 1990–1992.) Furthermore, the reintroduction of a
cheap-credit policy at this stage could only hinder the neces-
sary liquidation of unprofitable investments and company
reconversion. It could even wind up prolonging the recession
indefinitely, as has occurred in Japan in recent years: though
all possible interventions have been tried, the Japanese econ-
omy has ceased to respond to any monietarist stimulus involv-
ing credit expansion or Keynesian methods. It is in this context
of “financial schizophrenia” that we must interpret the latest
“shots in the dark” fired by the monetary authorities (who
have two totally contradictory responsibilities: both to control
xx
inflation and to inject all the liquidity necessary into the finan-
cial system to prevent its collapse). Thus, one day the Federal
Reserve rescues Bear Stearns, AIG, Fannie Mae, and Freddie
Mac or Citigroup, and the next it allows Lehman Brothers to
fail, under the amply justified pretext of “teaching a lesson”
and refusing to fuel moral hazard. Then, in light of the way
events were unfolding, a 700-billion-dollar plan to purchase
the euphemistically named “toxic” or “illiquid” (i.e., worth-
less) assets from the banking system was approved. If the plan
is financed by taxes (and not more inflation), it will mean a
heavy tax burden on households, precisely when they are
least able to bear it. Finally, in view of doubts about whether
such a plan could have any effect, the choice was made to
inject public money directly into banks, and even to “guaran-
tee” the total amount of their deposits, decreasing interest
rates to almost zero percent.
In comparison, the economies of the European Union are in
a somewhat less poor state (if we do not consider the expansion-
ary effect of the policy of deliberately depreciating the dollar, and
the relatively greater 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, ful-
fillment of the convergence criteria involved at the time a healthy
and significant rehabilitation of the chief European economies.
Only the countries on the periphery, like Ireland and particularly
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 eco-
nomic boom which, in part, was due to real causes (liberalizing
structural reforms which originated with José María Aznar’s
administration in 1996). Nevertheless, the boom was also largely
fueled by an artificial expansion of money and credit, which
grew at a rate nearly three times that of the corresponding
rates in France and Germany. Spanish economic agents essen-
tially interpreted the decrease in interest rates which resulted
from the convergence process in the easy-money terms tradi-
tional in Spain: a greater availability of easy money and mass
requests for loans from Spanish banks (mainly to finance real-
estate speculation), loans which these banks have granted by
creating the money ex nihilo while European central bankers
looked on unperturbed. When faced with the rise in prices,
the European Central Bank has remained faithful to its man-
date and has tried to maintain interest rates as long as possi-
ble, despite the difficulties of those members of the Monetary
Union which, like Spain, are now discovering that much of
their investment in real estate was in error and are heading for
a lengthy and painful reorganization of their real economy.
Under these circumstances, the most appropriate policy
would be to liberalize the economy at all levels (especially in
the labor market) to permit the rapid reallocation of produc-
tive factors (particularly labor) to profitable sectors. Likewise,
it is essential to reduce public spending and taxes, in order to
increase the available income of heavily-indebted economic
agents who need to repay their loans as soon as possible. Eco-
nomic agents in general and companies in particular can only
rehabilitate their finances by cutting costs (especially labor
costs) and paying off loans. Essential to this aim are a very
flexible labor market and a much more austere public sector.
These factors are fundamental if the market is to reveal as
quickly as possible the real value of the investment goods pro-
duced in error and thus lay the foundation for a healthy, sus-
tained economic recovery in a future which, for the good of
all, I hope is not long in coming.
We must not forget that a central feature of the recent
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 Stan-
dards (IAS) and their incorporation into law in different
countries (in Spain via the new General Accounting Plan, in
effect as of January 1, 2008) 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 bal-
ance sheet assets, particularly financial assets. In this aban-
donment of the traditional principle of prudence, a highly
influential role has been played by brokerages, investment
banks (which are now on their way to extinction), and in gen-
eral, all parties interested in “inflating” book values in order
to bring them closer to supposedly more “objective” stock-
market values, which in the past rose continually in an eco-
nomic process of financial euphoria. 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.
In this wild race to abandon traditional accounting prin-
ciples and replace them with others more “in line with the
times,” it became common to evaluate companies based on
unorthodox suppositions and purely subjective criteria
which in the new standards replace the only truly objective
criterion (that of historical cost). Now, the collapse of finan-
cial markets and economic agents’ widespread loss of faith in
banks and their accounting practices have revealed the seri-
ous error involved in yielding to the IAS and their abandon-
ment of traditional accounting principles based on prudence,
the error of indulging in the vices of creative, fair-value
accounting.
It is in this context that we must view the recent measures
taken in the United States and the European Union to “soften”
(i.e., to partially reverse) the impact of fair-value accounting
for financial institutions. This is a step in the right direction,
but it falls short and is taken for the wrong reasons. Indeed,
those in charge at financial institutions are attempting to “shut
the barn door when the horse is bolting”; that is, when the
dramatic fall in the value of “toxic” or “illiquid” assets has
endangered the solvency of their institutions. However, these
people were delighted with the new IAS during the preceding
years of “irrational exuberance,” in which increasing and
excessive values in the stock and financial markets graced
their balance sheets with staggering figures corresponding to
their own profits and net worth, figures which in turn encour-
aged them to run risks (or better, uncertainties) with practi-
cally no thought of danger. Hence, we see that the IAS act in a
pro-cyclic manner by heightening volatility and erroneously
biasing business management: in times of prosperity, they cre-
ate a false “wealth effect” which prompts people to take dis-
proportionate risks; when, from one day to the next, the errors
committed come to light, the loss in the value of assets imme-
diately decapitalizes companies, which are obliged to sell
assets and attempt to recapitalize at the worst moment, i.e.,
when assets are worth the least and financial markets dry up.
Clearly, accounting principles which, like those of the IAS,
have proven so disturbing must be abandoned as soon as pos-
sible, and all of the accounting reforms recently enacted,
specifically the Spanish one, which came into effect January 1,
2008, must be reversed. This is so not only because these
reforms mean a dead end in a period of financial crisis and
recession, but especially because it is vital that in periods of
prosperity we stick to the principle of prudence in valuation,
a principle which has shaped all accounting systems from the
time of Luca Pacioli at the beginning of the fifteenth century
to the adoption of the false idol of the IAS.
In short, the greatest error of the accounting reform
recently introduced worldwide is that it scraps centuries of
accounting experience and business management when it
replaces the prudence principle, as the highest ranking among
all traditional accounting principles, with the “fair value”
principle, which is simply the introduction of the volatile mar-
ket value for an entire set of assets, particularly financial
assets. This Copernican turn is extremely harmful and threat-
ens the very foundations of the market economy for several
reasons. First, to violate the traditional principle of prudence
and require that accounting entries reflect market values is to
provoke, depending upon the conditions of the economic
cycle, an inflation of book values with surpluses which have
not materialized and which, in many cases, may never mate-
rialize. The artificial “wealth effect” this can produce, espe-
cially during the boom phase of each economic cycle, leads to
the allocation of paper (or merely temporary) profits, the
acceptance of disproportionate risks, and in short, the com-
mission of systematic entrepreneurial errors and the consump-
tion of the nation’s capital, to the detriment of its healthy pro-
ductive structure and its capacity for long-term growth.
Second, I must emphasize that the purpose of accounting is
not to reflect supposed “real” values (which in any case are
subjective and which are determined and vary daily in the
corresponding markets) under the pretext of attaining a
(poorly understood) “accounting transparency.” Instead, the
purpose of accounting is to permit the prudent management
of each company and to prevent capital consumption,1by
applying strict standards of accounting conservatism (based
on the prudence principle and the recording of either histori-
cal cost or market value, whichever is less), standards which
ensure at all times that distributable profits come from a safe
surplus which can be distributed without in any way endan-
gering the future viability and capitalization of the company.
Third, we must bear in mind that in the market there are no
equilibrium prices a third party can objectively determine.
Quite the opposite is true; market values arise from subjective
assessments and fluctuate sharply, and hence their use in
accounting eliminates much of the clarity, certainty, and infor-
mation balance sheets contained in the past. Today, balance
sheets have become largely unintelligible and useless to eco-
nomic agents. Furthermore, the volatility inherent in market
values, particularly over the economic cycle, robs accounting
based on the “new principles” of much of its potential as a
guide for action for company managers and leads them to sys-
tematically commit major errors in management, errors which
have been on the verge of provoking the severest financial cri-
sis to ravage the world since 1929.
1See especially F. A. Hayek, “The Maintenance of Capital,” Economica 2
(August 1934), reprinted in Profits, Interest and Investment and Other Essays on
the Theory of Industrial Fluctuations (Clifton, N.J.: Augustus M. Kelley, 1979;
first edition London: George Routledge & Sons, 1939). See especially section
9, “Capital Accounting and Monetary Policy,” pp. 130–32
In chapter 9 of this book (pages 789–803), I design a
process of transition toward the only world financial order
which, being fully compatible with the free-enterprise system,
can eliminate the financial crises and economic recessions
which cyclically affect the world’s economies. The proposal
the book contains for international financial reform has
acquired extreme relevance at the present time (November
2008), in which the disconcerted governments of Europe and
America have organized a world conference to reform the
international monetary system in order to avoid in the future
such severe financial and banking crises as the one that cur-
rently grips the entire western world. As is explained in detail
over the nine chapters of this book, any future reform will fail
as miserably as past reforms unless it strikes at the very root
of the present problems and rests on the following principles:
(1) the reestablishment of a 100-percent reserve requirement
on all bank demand deposits and equivalents; (2) the elimina-
tion of central banks as lenders of last resort (which will be
unnecessary if the preceding principle is applied, and harmful
if they continue to act as financial central-planning agencies);
and (3) the privatization of the current, monopolistic, and
fiduciary state-issued money and its replacement with a clas-
sic pure gold standard. This radical, definitive reform would
essentially mark the culmination of the 1989 fall of the Berlin
Wall and real socialism, since the reform would mean the
application of the same principles of liberalization and private
property to the only sphere, that of finance and banking,
which has until now remained mired in central planning (by
“central” banks), extreme interventionism (the fixing of inter-
est rates, the tangled web of government regulations), and
state monopoly (legal tender laws which require the accept-
ance of the current, state-issued fiduciary money), circum-
stances with very negative and dramatic consequences, as we
have seen.
I should point out that the transition process designed in
the last chapter of this book could also permit from the outset
the bailing out of the current banking system, thus preventing
its rapid collapse, and with it the sudden monetary squeeze
which would be inevitable if, in an environment of wide-
spread broken trust among depositors, a significant volume of
bank deposits were to disappear. This short-term goal, which
at present, western governments are desperately striving for
with the most varied plans (the massive purchases of “toxic”
bank assets, the ad hominem guarantee of all deposits, or sim-
ply the partial or total nationalization of the private banking
system), could be reached much faster and more effectively,
and in a manner much less harmful to the market economy, if
the first step in the proposed reform (pages 791–98) were
immediately taken: to back the total amount of current bank
deposits (demand deposits and equivalents) with cash, bills to
be turned over to banks, which from then on would maintain
a 100-percent reserve with respect to deposits. As illustrated in
chart IX-2 of chapter 9, which shows the consolidated balance
sheet for the banking system following this step, the issuance
of these banknotes would in no way be inflationary (since the
new money would be “sterilized,” so to speak, by its purpose
as backing to satisfy any sudden deposit withdrawals). Fur-
thermore, this step would free up all banking assets (“toxic”
or not) which currently appear as backing for demand
deposits (and equivalents) on the balance sheets of private
banks. On the assumption that the transition to the new finan-
cial system would take place under “normal” circumstances,
and not in the midst of a financial crisis as acute as the current
one, I proposed in chapter 9 that the “freed” assets be trans-
ferred to a set of mutual funds created ad hoc and managed by
the banking system, and that the shares in these funds be
exchanged for outstanding treasury bonds and for the implicit
liabilities connected with the public social-security system
(pp. 796–97). Nevertheless, in the current climate of severe
financial and economic crisis, we have another alternative:
apart from canceling “toxic” assets with these funds, we could
devote a portion of the rest, if desired, to enabling savers (not
depositors, since their deposits would already be backed 100
percent) to recover a large part of the value lost in their invest-
ments (particularly in loans to commercial banks, investment
banks, and holding companies). These measures would
immediately restore confidence and would leave a significant
remainder to be exchanged, once and for all and at no cost, for
a sizeable portion of the national debt, our initial aim. In any
case, an important warning must be given: naturally, and I
must never tire of repeating it, the solution proposed is only
valid in the context of an irrevocable decision to reestablish a
free-banking system subject to a 100-percent reserve require-
ment on demand deposits. Any of the reforms noted above, if
adopted in the absence of a prior, firm conviction and decision
to change the international financial and banking system as
indicated, would be simply disastrous: a private banking sys-
tem which continued to operate with a fractional reserve
(orchestrated by the corresponding central banks), would gen-
erate, in a cascading effect, and based on the cash created to
back deposits, an inflationary expansion like none other in
history, one which would eventually finish off our entire eco-
nomic system.
The above considerations are crucially important and
reveal how very relevant this treatise has now become in light
of the critical state of the international financial system (though
I would definitely have preferred to write the preface to this
new edition under very different economic circumstances).
Nevertheless, while it is tragic that we have arrived at the cur-
rent situation, it is even more tragic, if possible, that there exists
a widespread lack of understanding regarding the causes of
the phenomena that plague us, and especially an atmosphere
of confusion and uncertainty prevalent among experts, ana-
lysts, and most economic theorists. In this area at least, I can
hope the successive editions of this book which are being pub-
lished all over the world2may contribute to the theoretical
2Since the appearance of the first English-language edition, the third and
fourth Spanish editions have been published in 2006 and 2009. Moreover,
Tatjana Danilova and Grigory Sapov have completed a Russian translation,
training of readers, to the intellectual rearmament of new gen-
erations, and eventually, to the sorely needed institutional
redesign of the entire monetary and financial system of cur-
rent market economies. If this hope is fulfilled, I will not only
view the effort made as worthwhile, but will also deem it a
great honor to have contributed, even in a very small way, to
movement in the right direction.
Jesús Huerta de Soto
Madrid
November 13, 2008
which has been published as Dengi, Bankovskiy Kredit i Ekonomicheskie Tsikly
(Moscow: Sotsium Publishing House, 2008). Three thousand copies have
been printed initially, and I had the satisfaction of presenting the book Octo-
ber 30, 2008 at the Higher School of Economics at Moscow State University.
In addition, Professor Rosine Létinier has produced the French translation,
which is now pending publication. Grzegorz Luczkiewicz has completed
the Polish translation, and translation into the following languages is at an
advanced stage: German, Czech, Italian, Romanian, Dutch, Chinese, Japan-
ese, and Arabic. God willing, may they soon be published.
by
http://topbusinessessay.blogspot.com/
Bank Credit, and Economic Cycles. Its appearance is particu-
larly timely, given that the severe financial crisis and result-
ing worldwide economic recession I have been forecasting,
since the first edition of this book came out ten years ago, are
now unleashing their fury.
The policy of artificial credit expansion central banks have
permitted and orchestrated over the last fifteen years could not
have ended in any other way. The expansionary cycle which
has now come to a close began gathering momentum when the
American economy emerged from its last recession (fleeting
and repressed though it was) in 2001 and the Federal Reserve
reembarked on the major artificial expansion of credit and
investment initiated in 1992. This credit expansion was not
backed by a parallel increase in voluntary household saving.
For many years, the money supply in the form of bank notes
and deposits has grown at an average rate of over 10 percent
per year (which means that every seven years the total volume
of money circulating in the world has 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 very low (and even negative in real
terms) interest rates. The above 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, like in the “roaring” years prior to the Great
Depression of 1929, the shock of monetary growth has not sig-
nificantly influenced the prices of the subset of consumer
goods and services (approximately only one third of all
goods). 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 entrepre-
neurial innovations which, were it not for the injection of
money and credit, would have given rise to a healthy and sus-
tained reduction in the unit price of consumer goods and serv-
ices. Moreover, the full incorporation of the economies of
China and India into the globalized market has boosted the
real productivity of consumer goods and services even fur-
ther. The absence of a healthy “deflation” in the prices of con-
sumer goods in a stage of such considerable growth in pro-
ductivity as that of recent years provides the main evidence
that the monetary shock has seriously disturbed the economic
process. I analyze this phenomenon in detail in chapter 6, sec-
tion 9.
As I explain in the book, artificial credit expansion and the
(fiduciary) inflation of media of exchange offer no short cut to
stable and sustained economic development, no way of avoid-
ing the necessary sacrifice and discipline behind all high rates
of voluntary saving. (In fact, particularly in the United States,
voluntary saving has not only failed to increase in recent
years, but at times has even fallen to a negative rate.) Indeed,
the artificial expansion of credit and money is never more
than a short-term solution, and that at best. In fact, today there
is no doubt about the recessionary quality the monetary shock
always has in the long run: newly-created loans (of money cit-
izens have not first saved) immediately provide entrepreneurs
with purchasing power they use in overly ambitious invest-
ment projects (in recent years, especially in the building sector
and real estate development). In other words, entrepreneurs
act as if citizens had increased their saving, when they have not
actually done so. Widespread discoordination in the economic
xviii
system results: the financial bubble (“irrational exuberance”)
exerts a harmful effect on the real economy, and sooner or
later the process reverses in the form of an economic recession,
which marks the beginning of the painful and necessary read-
justment. This readjustment invariably requires the reconver-
sion of every real productive structure inflation has distorted.
The specific triggers of the end of the euphoric monetary
“binge” and the beginning of the recessionary “hangover” are
many, and they can vary from one cycle to another. In the cur-
rent circumstances, the most obvious triggers have been the
rise in the price of raw materials, particularly oil, 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 liabilities exceeded that of their
assets (mortgage loans granted).
At present, numerous self-interested voices are demand-
ing further reductions in interest rates and new injections of
money which permit those who desire it to complete their
investment projects without suffering losses. Nevertheless,
this escape forward would only temporarily postpone prob-
lems at the cost of making them far more serious later. The cri-
sis has hit because the profits of capital-goods companies
(especially in the building sector and in real-estate develop-
ment) have disappeared due to the entrepreneurial errors pro-
voked by cheap credit, and because the prices of consumer
goods have begun to perform relatively less poorly than those
of capital goods. At this point, a painful, inevitable readjust-
ment begins, and in addition to a decrease in production and
an increase in unemployment, we are now still seeing a harm-
ful rise in the prices of consumer goods (stagflation).
The most rigorous economic analysis and the coolest, most
balanced interpretation of recent economic and financial
events support the conclusion that central banks (which are
true financial central-planning agencies) cannot possibly suc-
ceed in finding the most advantageous monetary policy at
every moment. This is exactly what became clear in the case of
the failed attempts to plan the former Soviet economy from
above. To put it another way, the theorem of the economic
impossibility of socialism, which the Austrian economists
Preface to the Second English Edition
Ludwig von Mises and Friedrich A. Hayek discovered, is fully
applicable to central banks in general, and to the Federal
Reserve—(at one time) Alan Greenspan and (currently) Ben
Bernanke—in particular. According to this theorem, it is
impossible to organize society, in terms of economics, based
on coercive commands issued by a planning agency, since
such a body can never obtain the information it needs to
infuse its commands with a coordinating nature. Indeed,
nothing is more dangerous than to indulge in the “fatal con-
ceit”—to use Hayek’s useful expression—of believing oneself
omniscient or at least wise and powerful enough to be able to
keep the most suitable monetary policy fine tuned at all times.
Hence, rather than soften the most violent ups and downs of
the economic cycle, the Federal Reserve and, to some lesser
extent, the European Central Bank, have most likely been their
main architects and the culprits in their worsening. Therefore,
the dilemma facing Ben Bernanke and his Federal Reserve
Board, as well as the other central banks (beginning with the
European Central Bank), is not at all comfortable. For years
they have shirked their monetary responsibility, and now they
find themselves in a blind alley. They can either allow the
recessionary process to begin now, and with it the healthy and
painful readjustment, or they can escape forward toward a
“hair of the dog” cure. With the latter, the chances of even
more severe stagflation in the not-too-distant future increase
exponentially. (This was precisely the error committed follow-
ing the stock market crash of 1987, an error which led to the
inflation at the end of the 1980s and concluded with the sharp
recession of 1990–1992.) Furthermore, the reintroduction of a
cheap-credit policy at this stage could only hinder the neces-
sary liquidation of unprofitable investments and company
reconversion. It could even wind up prolonging the recession
indefinitely, as has occurred in Japan in recent years: though
all possible interventions have been tried, the Japanese econ-
omy has ceased to respond to any monietarist stimulus involv-
ing credit expansion or Keynesian methods. It is in this context
of “financial schizophrenia” that we must interpret the latest
“shots in the dark” fired by the monetary authorities (who
have two totally contradictory responsibilities: both to control
xx
inflation and to inject all the liquidity necessary into the finan-
cial system to prevent its collapse). Thus, one day the Federal
Reserve rescues Bear Stearns, AIG, Fannie Mae, and Freddie
Mac or Citigroup, and the next it allows Lehman Brothers to
fail, under the amply justified pretext of “teaching a lesson”
and refusing to fuel moral hazard. Then, in light of the way
events were unfolding, a 700-billion-dollar plan to purchase
the euphemistically named “toxic” or “illiquid” (i.e., worth-
less) assets from the banking system was approved. If the plan
is financed by taxes (and not more inflation), it will mean a
heavy tax burden on households, precisely when they are
least able to bear it. Finally, in view of doubts about whether
such a plan could have any effect, the choice was made to
inject public money directly into banks, and even to “guaran-
tee” the total amount of their deposits, decreasing interest
rates to almost zero percent.
In comparison, the economies of the European Union are in
a somewhat less poor state (if we do not consider the expansion-
ary effect of the policy of deliberately depreciating the dollar, and
the relatively greater 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, ful-
fillment of the convergence criteria involved at the time a healthy
and significant rehabilitation of the chief European economies.
Only the countries on the periphery, like Ireland and particularly
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 eco-
nomic boom which, in part, was due to real causes (liberalizing
structural reforms which originated with José María Aznar’s
administration in 1996). Nevertheless, the boom was also largely
fueled by an artificial expansion of money and credit, which
grew at a rate nearly three times that of the corresponding
rates in France and Germany. Spanish economic agents essen-
tially interpreted the decrease in interest rates which resulted
from the convergence process in the easy-money terms tradi-
tional in Spain: a greater availability of easy money and mass
requests for loans from Spanish banks (mainly to finance real-
estate speculation), loans which these banks have granted by
creating the money ex nihilo while European central bankers
looked on unperturbed. When faced with the rise in prices,
the European Central Bank has remained faithful to its man-
date and has tried to maintain interest rates as long as possi-
ble, despite the difficulties of those members of the Monetary
Union which, like Spain, are now discovering that much of
their investment in real estate was in error and are heading for
a lengthy and painful reorganization of their real economy.
Under these circumstances, the most appropriate policy
would be to liberalize the economy at all levels (especially in
the labor market) to permit the rapid reallocation of produc-
tive factors (particularly labor) to profitable sectors. Likewise,
it is essential to reduce public spending and taxes, in order to
increase the available income of heavily-indebted economic
agents who need to repay their loans as soon as possible. Eco-
nomic agents in general and companies in particular can only
rehabilitate their finances by cutting costs (especially labor
costs) and paying off loans. Essential to this aim are a very
flexible labor market and a much more austere public sector.
These factors are fundamental if the market is to reveal as
quickly as possible the real value of the investment goods pro-
duced in error and thus lay the foundation for a healthy, sus-
tained economic recovery in a future which, for the good of
all, I hope is not long in coming.
We must not forget that a central feature of the recent
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 Stan-
dards (IAS) and their incorporation into law in different
countries (in Spain via the new General Accounting Plan, in
effect as of January 1, 2008) 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 bal-
ance sheet assets, particularly financial assets. In this aban-
donment of the traditional principle of prudence, a highly
influential role has been played by brokerages, investment
banks (which are now on their way to extinction), and in gen-
eral, all parties interested in “inflating” book values in order
to bring them closer to supposedly more “objective” stock-
market values, which in the past rose continually in an eco-
nomic process of financial euphoria. 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.
In this wild race to abandon traditional accounting prin-
ciples and replace them with others more “in line with the
times,” it became common to evaluate companies based on
unorthodox suppositions and purely subjective criteria
which in the new standards replace the only truly objective
criterion (that of historical cost). Now, the collapse of finan-
cial markets and economic agents’ widespread loss of faith in
banks and their accounting practices have revealed the seri-
ous error involved in yielding to the IAS and their abandon-
ment of traditional accounting principles based on prudence,
the error of indulging in the vices of creative, fair-value
accounting.
It is in this context that we must view the recent measures
taken in the United States and the European Union to “soften”
(i.e., to partially reverse) the impact of fair-value accounting
for financial institutions. This is a step in the right direction,
but it falls short and is taken for the wrong reasons. Indeed,
those in charge at financial institutions are attempting to “shut
the barn door when the horse is bolting”; that is, when the
dramatic fall in the value of “toxic” or “illiquid” assets has
endangered the solvency of their institutions. However, these
people were delighted with the new IAS during the preceding
years of “irrational exuberance,” in which increasing and
excessive values in the stock and financial markets graced
their balance sheets with staggering figures corresponding to
their own profits and net worth, figures which in turn encour-
aged them to run risks (or better, uncertainties) with practi-
cally no thought of danger. Hence, we see that the IAS act in a
pro-cyclic manner by heightening volatility and erroneously
biasing business management: in times of prosperity, they cre-
ate a false “wealth effect” which prompts people to take dis-
proportionate risks; when, from one day to the next, the errors
committed come to light, the loss in the value of assets imme-
diately decapitalizes companies, which are obliged to sell
assets and attempt to recapitalize at the worst moment, i.e.,
when assets are worth the least and financial markets dry up.
Clearly, accounting principles which, like those of the IAS,
have proven so disturbing must be abandoned as soon as pos-
sible, and all of the accounting reforms recently enacted,
specifically the Spanish one, which came into effect January 1,
2008, must be reversed. This is so not only because these
reforms mean a dead end in a period of financial crisis and
recession, but especially because it is vital that in periods of
prosperity we stick to the principle of prudence in valuation,
a principle which has shaped all accounting systems from the
time of Luca Pacioli at the beginning of the fifteenth century
to the adoption of the false idol of the IAS.
In short, the greatest error of the accounting reform
recently introduced worldwide is that it scraps centuries of
accounting experience and business management when it
replaces the prudence principle, as the highest ranking among
all traditional accounting principles, with the “fair value”
principle, which is simply the introduction of the volatile mar-
ket value for an entire set of assets, particularly financial
assets. This Copernican turn is extremely harmful and threat-
ens the very foundations of the market economy for several
reasons. First, to violate the traditional principle of prudence
and require that accounting entries reflect market values is to
provoke, depending upon the conditions of the economic
cycle, an inflation of book values with surpluses which have
not materialized and which, in many cases, may never mate-
rialize. The artificial “wealth effect” this can produce, espe-
cially during the boom phase of each economic cycle, leads to
the allocation of paper (or merely temporary) profits, the
acceptance of disproportionate risks, and in short, the com-
mission of systematic entrepreneurial errors and the consump-
tion of the nation’s capital, to the detriment of its healthy pro-
ductive structure and its capacity for long-term growth.
Second, I must emphasize that the purpose of accounting is
not to reflect supposed “real” values (which in any case are
subjective and which are determined and vary daily in the
corresponding markets) under the pretext of attaining a
(poorly understood) “accounting transparency.” Instead, the
purpose of accounting is to permit the prudent management
of each company and to prevent capital consumption,1by
applying strict standards of accounting conservatism (based
on the prudence principle and the recording of either histori-
cal cost or market value, whichever is less), standards which
ensure at all times that distributable profits come from a safe
surplus which can be distributed without in any way endan-
gering the future viability and capitalization of the company.
Third, we must bear in mind that in the market there are no
equilibrium prices a third party can objectively determine.
Quite the opposite is true; market values arise from subjective
assessments and fluctuate sharply, and hence their use in
accounting eliminates much of the clarity, certainty, and infor-
mation balance sheets contained in the past. Today, balance
sheets have become largely unintelligible and useless to eco-
nomic agents. Furthermore, the volatility inherent in market
values, particularly over the economic cycle, robs accounting
based on the “new principles” of much of its potential as a
guide for action for company managers and leads them to sys-
tematically commit major errors in management, errors which
have been on the verge of provoking the severest financial cri-
sis to ravage the world since 1929.
1See especially F. A. Hayek, “The Maintenance of Capital,” Economica 2
(August 1934), reprinted in Profits, Interest and Investment and Other Essays on
the Theory of Industrial Fluctuations (Clifton, N.J.: Augustus M. Kelley, 1979;
first edition London: George Routledge & Sons, 1939). See especially section
9, “Capital Accounting and Monetary Policy,” pp. 130–32
In chapter 9 of this book (pages 789–803), I design a
process of transition toward the only world financial order
which, being fully compatible with the free-enterprise system,
can eliminate the financial crises and economic recessions
which cyclically affect the world’s economies. The proposal
the book contains for international financial reform has
acquired extreme relevance at the present time (November
2008), in which the disconcerted governments of Europe and
America have organized a world conference to reform the
international monetary system in order to avoid in the future
such severe financial and banking crises as the one that cur-
rently grips the entire western world. As is explained in detail
over the nine chapters of this book, any future reform will fail
as miserably as past reforms unless it strikes at the very root
of the present problems and rests on the following principles:
(1) the reestablishment of a 100-percent reserve requirement
on all bank demand deposits and equivalents; (2) the elimina-
tion of central banks as lenders of last resort (which will be
unnecessary if the preceding principle is applied, and harmful
if they continue to act as financial central-planning agencies);
and (3) the privatization of the current, monopolistic, and
fiduciary state-issued money and its replacement with a clas-
sic pure gold standard. This radical, definitive reform would
essentially mark the culmination of the 1989 fall of the Berlin
Wall and real socialism, since the reform would mean the
application of the same principles of liberalization and private
property to the only sphere, that of finance and banking,
which has until now remained mired in central planning (by
“central” banks), extreme interventionism (the fixing of inter-
est rates, the tangled web of government regulations), and
state monopoly (legal tender laws which require the accept-
ance of the current, state-issued fiduciary money), circum-
stances with very negative and dramatic consequences, as we
have seen.
I should point out that the transition process designed in
the last chapter of this book could also permit from the outset
the bailing out of the current banking system, thus preventing
its rapid collapse, and with it the sudden monetary squeeze
which would be inevitable if, in an environment of wide-
spread broken trust among depositors, a significant volume of
bank deposits were to disappear. This short-term goal, which
at present, western governments are desperately striving for
with the most varied plans (the massive purchases of “toxic”
bank assets, the ad hominem guarantee of all deposits, or sim-
ply the partial or total nationalization of the private banking
system), could be reached much faster and more effectively,
and in a manner much less harmful to the market economy, if
the first step in the proposed reform (pages 791–98) were
immediately taken: to back the total amount of current bank
deposits (demand deposits and equivalents) with cash, bills to
be turned over to banks, which from then on would maintain
a 100-percent reserve with respect to deposits. As illustrated in
chart IX-2 of chapter 9, which shows the consolidated balance
sheet for the banking system following this step, the issuance
of these banknotes would in no way be inflationary (since the
new money would be “sterilized,” so to speak, by its purpose
as backing to satisfy any sudden deposit withdrawals). Fur-
thermore, this step would free up all banking assets (“toxic”
or not) which currently appear as backing for demand
deposits (and equivalents) on the balance sheets of private
banks. On the assumption that the transition to the new finan-
cial system would take place under “normal” circumstances,
and not in the midst of a financial crisis as acute as the current
one, I proposed in chapter 9 that the “freed” assets be trans-
ferred to a set of mutual funds created ad hoc and managed by
the banking system, and that the shares in these funds be
exchanged for outstanding treasury bonds and for the implicit
liabilities connected with the public social-security system
(pp. 796–97). Nevertheless, in the current climate of severe
financial and economic crisis, we have another alternative:
apart from canceling “toxic” assets with these funds, we could
devote a portion of the rest, if desired, to enabling savers (not
depositors, since their deposits would already be backed 100
percent) to recover a large part of the value lost in their invest-
ments (particularly in loans to commercial banks, investment
banks, and holding companies). These measures would
immediately restore confidence and would leave a significant
remainder to be exchanged, once and for all and at no cost, for
a sizeable portion of the national debt, our initial aim. In any
case, an important warning must be given: naturally, and I
must never tire of repeating it, the solution proposed is only
valid in the context of an irrevocable decision to reestablish a
free-banking system subject to a 100-percent reserve require-
ment on demand deposits. Any of the reforms noted above, if
adopted in the absence of a prior, firm conviction and decision
to change the international financial and banking system as
indicated, would be simply disastrous: a private banking sys-
tem which continued to operate with a fractional reserve
(orchestrated by the corresponding central banks), would gen-
erate, in a cascading effect, and based on the cash created to
back deposits, an inflationary expansion like none other in
history, one which would eventually finish off our entire eco-
nomic system.
The above considerations are crucially important and
reveal how very relevant this treatise has now become in light
of the critical state of the international financial system (though
I would definitely have preferred to write the preface to this
new edition under very different economic circumstances).
Nevertheless, while it is tragic that we have arrived at the cur-
rent situation, it is even more tragic, if possible, that there exists
a widespread lack of understanding regarding the causes of
the phenomena that plague us, and especially an atmosphere
of confusion and uncertainty prevalent among experts, ana-
lysts, and most economic theorists. In this area at least, I can
hope the successive editions of this book which are being pub-
lished all over the world2may contribute to the theoretical
2Since the appearance of the first English-language edition, the third and
fourth Spanish editions have been published in 2006 and 2009. Moreover,
Tatjana Danilova and Grigory Sapov have completed a Russian translation,
training of readers, to the intellectual rearmament of new gen-
erations, and eventually, to the sorely needed institutional
redesign of the entire monetary and financial system of cur-
rent market economies. If this hope is fulfilled, I will not only
view the effort made as worthwhile, but will also deem it a
great honor to have contributed, even in a very small way, to
movement in the right direction.
Jesús Huerta de Soto
Madrid
November 13, 2008
which has been published as Dengi, Bankovskiy Kredit i Ekonomicheskie Tsikly
(Moscow: Sotsium Publishing House, 2008). Three thousand copies have
been printed initially, and I had the satisfaction of presenting the book Octo-
ber 30, 2008 at the Higher School of Economics at Moscow State University.
In addition, Professor Rosine Létinier has produced the French translation,
which is now pending publication. Grzegorz Luczkiewicz has completed
the Polish translation, and translation into the following languages is at an
advanced stage: German, Czech, Italian, Romanian, Dutch, Chinese, Japan-
ese, and Arabic. God willing, may they soon be published.
by
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