UNDERSTANDING ECONOMICS IN ONE HOUR

1 – Overview

Looking about us, what we see is the passing show. Despite every appearance of reality, it is ephemeral, ever-changing. It is Prospero’s “insubstantial pageant”. What we see is a “result” of something else, always a manifestation rather than a “cause”.

It is difficult to discern the real that lies behind and beyond the passing show – which therefore seems hardly the place in which to discover the permanent and immutable laws that govern the economic workings of society. The operation of these laws is subtle. They may be discerned, but they are never obvious.

This duality – the seen and the unseen – underlies all major disciplines, and the science of economics is no exception. As the economist Henry Hazlitt put it: “Many things that seems to be true when we concentrate on a single economic group are seen to be illusions when the interests of everyone, as consumer no less than producer, are considered. To see the problem as a whole, and not in fragments: that is the goal of economic science.”

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The prosperity of any community rests on observance of four guiding economic principles: free people; free trade; sound money; and small government.

To understand them in a practical sense we need to drop down a level and begin by considering the operation of production and consumption.

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2 – Production & Consumption

Now, before we get going, I must warn you not to get sidetracked by this thing called “demand”. What is demand, anyway? It is an inexhaustible feature of the human condition: there is always something we require, want, need, desire. Demand is therefore a transitory abstraction – more of a feeling than a commanding “economic actor”. It can be satisfied only by consumption – and that’s what matters. Demand has economic meaning only when linked to a product (or service) that will satisfy it.

 

 

 

 

 

 

 

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But without production there can be nothing to consume. Demand can never be satisfied by anything that has not been produced: production must precede consumption.

The 18th Century French classical economist, Jean-Baptiste Say, who was heavily influenced by the writings of Adam Smith, is chiefly remembered for formulating this law. It has become known as “Say’s Law”, or “Law of Markets”.

This may be expressed very simply: People produce things so that they can buy other things: production must therefore precede consumption.

[Now don’t bring money into it at this stage. People don’t produce and sell things “for money”. Money merely facilitates the exchange of goods and services that have value. Money is no more than the conduit. We’ll consider money a little later.]

If all this is blindingly obvious to you, bear in mind that it has been the subject of intense disputation between mainstream economists ever since John Maynard Keynes postulated his theories of “demand management”. These tried to prove that production is brought into action by stimulating demand, and not the other way round

Take a topical example. Which comes first – production of a driverless car, or demand for one? Until such a thing actually comes into being, it can’t possibly be demanded. In fact no one knows that it amounts to anything more than a figment of a designer’s dreams – let alone that it exists, and is available.

But once it’s in production, seen to function and is available at an affordable price, there is a measurable demand for it. Only now does demand have economic significance: the ability to satisfy it exists!

[There may have been earlier musings such as “wouldn’t it be a great idea if….”. There may even have been some market research – but the history of technology is littered with brilliant ideas that went nowhere.]

Yet Keynes seriously urged politicians to kick-start a sluggish economy – not by tackling the underlying causes of economic sluggishness, but by stimulating demand – even to the point of paying workers to dig holes in the ground, then paying them again to fill up those holes. He even devised mathematical equations to prove he was right!

Not surprisingly, this graphic piece of advice has found its place in economic folklore. To this day it underpins much popular thinking on jobs and welfare. Keynes’s theory is that putting money in the hands of the “hole-diggers/fillers” will give them purchasing power to buy goods and services, and this new demand will “get production going”, and lead to the employment of other workers too. If it sounds too good to be true, that’s because it is too good to be true!

 

 

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Keynes’s clever theory ignores the fact that the digging and filling of holes is nothing but a gratuitous distraction from what is really happening, as follows:

Purchasing power is being gratuitously dispensed despite the fact that (i) neither its recipients, nor anyone else, has earned it; (ii) the grant of purchasing power was based on neither current production nor past savings, having been conjured up out of thin air; (iii) it has, in the process, inflated the money supply, causing prices to rise; (iv) it has in effect inflicted a tax on every member of the population whose purchasing power has been diminished by this insidious illusion; and (v) it has devalued the currency by creating debt that the debtor can never repay.

[Now check this point: Do you find this reference to “debt” puzzling? How does paying people to dig, then fill, holes create “debt”?

Well, let’s assume that, in return for your digging and filling, the government pays you £20. Look at the £20 banknote you have just been given and read what it says: “I promise to pay the bearer on demand the sum of twenty pounds.” It is signed by the “Chief Cashier for the Governor and Company of the Bank of England”.

You are holding in your hand a sworn declaration, from no less eminent a source than the Governor of the Bank of England on behalf of the Treasury, that he owes you £20. So the “debt” is his, not yours!

What a bargain! In return for the worthless act of digging, then filling, holes, he, as agent of the Treasury, has magically made you “£20 richer”. But note this: the £20 was not the Governor’s to give in the first place. It didn’t belong to him before he gave it to you. That’s because it didn’t exist – until he had it specially printed for you! That’s called counterfeit. You have been suckered!

I also said in (v) above that this is a debt “the debtor can never repay”. Can this be right? After all, the government’s sole justification for putting Keynes’s theory of “demand stimulus” into effect was to kick-start production. So surely future production can be used to repay the debt?

The answer, however, is an emphatic “NO”. Future production must pay for its own costs. Past debts can be repaid only from past production – which is impossible, because there wasn’t any! That’s the whole point.

Check this too: Note also, from point (iv) above, that this theft of purchasing power is the equivalent of a tax on every member of the population. So, although the debt is owed by the signatory to the promise, the Governor of the Bank of England, not by you, it is you, and everyone else, who finish up paying it in the end!

This is one of the oldest “con tricks” in the world. Every act of government that devalues the currency is, by definition, a theft of purchasing power and therefore has exactly the same effect as a tax – levied by sleight of hand, not statute. I repeat: that reward you received for hole-digging/filling is counterfeit!]

 

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Question: Do you suppose that Keynes’s crude “digging & filling” proposal is any different, in principle or effect, from the following government practice: (i) instructing the Treasury to print IOUs (called “government bonds”); (ii) arranging for its banking arm, the Bank of England, to buy those bonds out of its unlimited overdraft facility with the Treasury; and (iii) instructing the Bank to flood the financial institutions with the ill-gotten proceeds of this grotesque monetary distortion?

Answer: Yes. There is one small difference: instead of describing this action as the counterfeit it surely is, the Treasury has given it the grandiose title of “quantitative easing”, which suggests that, even if not rocket science, it is something really clever that will save us from dips in the “economic cycle” that threaten to engulf us.

But what they themselves don’t recognise is that these mad practices, all carried out in the name of “stimulating the economy into growth mode”, are a repeat of the very actions that brought on the last credit crisis. You have heard this phrase: “This time it’s different”. Bear in mind that a lunatic is someone who does the same thing, but expects a different result!

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The above is a classic description of short-termism that backfires. Yet there is hardly a central bank anywhere that has not made a devil’s pact with its own treasury to create debt out of thin air, then “monetise” it into circulation and swamp the financial markets with it.

Although the USA and the UK are no longer actively pursuing it, the European Central Bank (ECB), charged by the European Commission to bail out any member of the EU that reneges on its debt repayments, is even now printing away at the rate of 50 billion euros per month! The ECB is awash with euros just waiting to be funnelled into the rescue of some profligate south European state. Just last week the EC announced plans for a multi-billion facility to grant interest-free loans to member states in crisis due to “external shocks”. The inflationary consequences hardly bear thinking about.

As Henry Ford put it: “It is as well that the people of the nation do not understand our banking and monetary system for, if they did, I believe there would be a revolution before tomorrow morning!”

[“Fractional reserve banking” is another grand euphemism for counterfeit, yet it draws far less attention than the more blatant forms of monetary expansion like “quantitative easing”. This is probably because it has been going on for so long that it has become an unquestioned banking norm. It relies on the fact that depositors are unlikely to act in concert when it comes to taking their money out of their bank, and so the bank can safely keep only a small proportion of your money to allow for withdrawals, and lend out the rest.

 

 

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Control over the entire monetary system is entrusted to the perpetrators of this scam. Under fractional reserve banking only a small percentage of deposits is held in reserves. The rest is lent out at double the rate of interest. But note: those loans will, in turn, be deposited somewhere and the process repeated, creating yet another tranche of money that represents nothing but the thin air from which it was conjured.]

3 – The Factors of Production

In the light of the law formulated by Jean-Baptiste Say, the true focus of economics is production, or wealth creation, the subject of Adam Smith’s immortal tome “An Inquiry into the Nature and Causes of the Wealth of Nations”.

The establishment of every productive enterprise is preceded by judiciously assembling and combining the fundamental factors necessary for fulfilling its particular purpose. Those factors are land, labour and capital.

Land is provided by nature; labour is provided by people; and capital is provided by savings out of profits of past production – either your production or borrowed from others. Each of these factors commands a “return” for its use – rent, in the case of land; wages in the case of labour; and interest in the case of capital.

(i) Land

Although land is a gift of nature, in the modern era all productive land is “enclosed”, in private or public ownership. The “return” for the use of land in production is rent, payable to its owner – and is not to be confused with the rent of buildings, equipment, vehicles and so on – which is simply payment for the use of someone else’s assets.

But the source of this factor is, of course, land. When you are next in the City of London raise your eyes to the inscription above the Royal Exchange, in the very heart of the world of finance, trade and commerce, and you will read: “The Earth is the Lord’s and the fullness thereof “, taken from Psalms and Corinthians. It serves as an eloquent, and salutary, reminder of who the ultimate landlord is!

(ii) Labour

Labour applied to land can, on its own, be productive, but only in the very limited sense that the act of plucking an apple from a tree will provide you with some sustenance. For all practical purposes we are not, by nature, self-reliant, and hence the most productive outcome will always derive from (i) division of labour into specialisms arising from aptitude, talent and opportunity; and (ii) trade, which enables us to take advantage of other people’s work.

 

 

 

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Some of you will remember, from childhood, AA Milne’s delightful poem “The Old Sailor” about a solitary sailor shipwrecked on a desert island. He is so overwhelmed by the things he needs to do to satisfy his multiple needs – hat to avoid sunstroke, water to drink, fish-hooks, and much more – that he can never decide where to begin. The final verse is a gem:

 

          “And so in the end he did nothing at all,

           But basked on the shingle wrapped up in a shawl.

           And I think it was dreadful the way he behaved –

           He did nothing but bask until he was saved!”

 

Division of labour is tricky when there’s only one of you!

 

The long journey that began with hand-to-mouth subsistence has been marked with many milestones: division of labour, specialisation, exchange through trade, mechanisation, automation, robotics – it will never end. The nature of the work changes at every stage, but there is always more, much more, to be done.

The flavour of this progression may be glimpsed if we take another look at your highly instructive £20 banknote. It shows a profile of Adam Smith, accompanied by the following statement: “The division of labour in pin manufacturing; and the great increase in the quantity of work that results”.

The lesson this conveys is that of the “Invisible Hand”, the self-organization principle of the market – namely that, in the case of pins, the metal-cutter, pin-drawer, roller, finisher, pin-head maker, all worked together to increase their combined productivity, and thereby increase the wealth of society as a whole.

Clearly, advances in technology will always entail job losses and associated pain – but this is the price suffered by the few of progress that benefits society as a whole. The entire historical catalogue of industrial strife, the machine-smashing Luddite movement, job-protection law, large-scale redundancies, protectionism, workers’ rights, union-backed job reservation rules – all exist as testimony to the ultimate futility of efforts to derail the inexorable march of progress towards higher living standards.

Politicians are quick to seize on the notion that robots will make millions jobless. Some have even hit on the idea of imposing a “robot tax” to redistribute the proceeds of technology to the new masses of unemployed.

Actual evidence of job-stealing androids is sparse. More people are in work than ever before. Among 16 to 64-year olds in the UK, 74.5% are working. Lower employment rates in Southern Europe are a hangover from the financial crisis, not technology. At no previous time, nor now, have technological advances resulted in millions of long-term unemployed.

 

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This is yet another lesson in the danger of focussing on what is seen, while failing to discern the unseen. Narrow-sighted reaction against these advances did not foresee the rise of the service economy. Or the jobs actually created by the rise of computers. Witness the articulated robot arms used to illustrate every news story about the motor industry.

Indeed, latest studies have found that automation in fact created far more jobs than it destroyed in 18 advanced economies between 1970 and 2007. Automation raises productivity and consumer incomes, boosting real demand and employment across the whole economy. It also lowers the cost of inputs for downstream industries, again boosting employment.


Automation can certainly lead to significant changes in the way that jobs are performed, rather than to outright elimination. This means working with the robots rather than competing against them.

[As I write, the French people yet again have to endure the crippling affliction of countrywide rail strikes against President Macron’s recourse to “executive power” to reform labour laws that bestow privilege on a single group while disregarding the wider community.

Ironically, Macron is kept in office by the very unions that he is now battling. His current efforts mirror those of his predecessor – and several before him – efforts that failed totally to redress the blatant abuses that favour employees of SNCF, the nationalised rail company, while disregarding the consequences for the poor users.

Jobs-for-life; 25-hour working week; automatic annual pay rises; retirement at 50 for TGV drivers; end-of-year bonuses; journey bonuses; TGV bonuses; coal bonuses; holiday gratuities; annual bonuses; generous overtime; away-from-base premiums (non-taxable); free healthcare; free travel for drivers and their families; and, for SNCF office-workers, a “lack-of-bonus” bonus. The result is an annual salary, net of tax, of more than £60,000 for a 40-year-old TGV driver.

It should come as no surprise that SNCF’s annual expenditure budget of €15 billion is exactly double its total revenues!

The unionised set-up at Air France, the national carrier, is no better. Every attempt to introduce reform is met by rigid intransigence, even bringing the entire country to a standstill – autoroutes blocked, post undelivered, train and air crews on strike, rubbish uncollected.]

 

 

 

 

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(iii) Capital

Capital is not a primary factor of production. Its existence is obviously attributable to earlier production. Capital is the seed-corn that has been set aside in the form of savings, rather than consumed, out of profits achieved by past production. It is the “wherewithal” made available to facilitate new production. Its owner, the “capitalist”, has invested it with a view to profit. The investor of capital may or may not be the “entrepreneur” who originated the entire enterprise.

The entrepreneur is the visionary who combines the factors of production and brings the enterprise into being – work that is often classified as a fourth factor of production, because without it the venture would lack direction, organisation or effective management. It would flounder and fail.

Interest Rate

Let’s look more closely at the natural role of interest rates. Money is one of many forms in which wealth may be held, but money and wealth are not synonymous. Wealth is the accumulation of savings. Savings, in a business, are what is left after meeting all its direct and indirect costs, depreciation, distributions to the factors of production (rent, wages, interest on loans and dividends to shareholders) and taxation.

The entrepreneur must choose what to do with those savings. He may choose to “plough them back” in the business, such as incurring the cost of creating new product lines, or acquiring another business – the possibilities are endless. Or he may simply choose to lend his savings in return for interest.

But at what rate of interest? Determination of interest rates is a behavioural phenomenon, depending on the borrower’s and lender’s respective time preferences for money.

Interest rates therefore arise out of our very nature as human beings. People will generally prefer to have desires met sooner rather than later. I might offer to let you have a loan of £10,000 in 10 years’ time, but if you want it now you may have to accept a discount and settle for £8,000, with £10,000 repayable in 10 years’ time. Interest of £2,000 is therefore “implied in the logic of human action.”

 

The “time preference” of the borrower manifests itself in the interest rate. The greater the time preference (the more urgently the borrower needs the money) the higher the rate applicable. It is therefore the natural law of human interaction, via the market, that determines the interest charge – not a central bank!

 

Central banks’ attempts to annihilate interest are therefore a huge economic error. Credit markets have the crucial function of channeling resources from savers to investors, establishing equilibrium between them and enabling both to contribute to wealth creation in the community.

 

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Interest is natural! Its rate would be determined quite naturally if left to the market. But the Keynesian god is demand, and if people and businesses can buy things on credit and pay little or no interest, that surely will stimulate demand! So the state steps in and manages it instead.

 

Since the last financial bust in 2008 governments all over the world, via their central banks, have forced interest rates lower and lower. The idea of freedom from the bondage of having to pay interest is, of course, sheer nonsense – a fool’s paradise. Indeed, it is amazing how long central bankers can drag out the agony: an official “bank rate” of, say, 2%, may be dropped to 1.5%, then 0.5% (where it got stuck for years in the UK) only to be followed by 0.25%!

But why stop there? The Bank of Japan even ventured into negative territory, charging depositors for the service of “looking after your money”. If you have £1,000 you can deposit it with a Japanese bank and it will promise to give you £950 in a year’s time, a practice that turns the rules of borrowing and lending upside down. No wonder the sale of domestic safes is now a booming business in Japan!

 

Yet none of this Keynesian demand-stoking has ever been effective beyond the expediency of short-term crisis management. Feeding demand achieves nothing on its own.

There can never be a shortage of demand if there are people. While that is a statement of the obvious, production is not obvious. It requires human endeavour; it must be created

After all, if stimulating demand could magically generate the production needed to satisfy it, Venezuela, Zimbabwe and the Democratic Republic of the Congo would be among the most prosperous countries on earth!

[Let’s be clear: the contrived suppression of interest rates is unsustainable and cannot last indefinitely. Investors, savers and pension fund managers have been giving vent to their frustration with the central bank’s idiotic interest rate suppression, and they no longer swallow the Chancellor’s putative rationale. He has been compelled by public pressure to ease rates at last, in an upward direction.

 

When interest rates are suppressed businesses like Carillion are tempted to initiate long-term investment projects “on the cheap”. These projects cannot be subjected to normal economic criteria to test their viability, and they will never turn a profit, eventually having to be abandoned. This is the very essence of malinvestment causing destruction of capital that can never be recovered. Meanwhile real satisfactions go unmet. But people don’t know about it for the very reason that an unmet satisfaction is not seen!]

 

 

 

 

 

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5 – Sound Money

 

Having seen the nature and causes of unsound money, what can we say about sound money?

 

It is money that can be trusted, by anyone and everyone who uses it. Trusted to do what? Trusted to retain its purchasing power.

 

After all, what matters is what money can buy, not the money itself. Sellers of goods and services expect payment for their products in a medium that can be used for making purchases. (Our old friend Say’s Law over again.)

 

At 3 per cent, the current rate of inflation, the purchasing power of your money will be halved in 23 years. It was not always so. The pound took 164 years, from 1750 to 1914, to halve in value. One dollar today is worth one cent of a century ago!

 

It could be worse: think of the poor Zimbabwean farmer who wants to export his crop of delicious oranges. Unlike a German exporter, happy to accept payment in his own currency, our farmer will accept payment in just about any currency except Zimbabwean dollars, because they fail the crucial purchasing power test.

In Zimbabwe, the 100-trillion-Z$ note bestows purchasing power equivalent to 40 US cents. With which you may be able to buy a cup of coffee! [I am not making these numbers up – you can check for yourself!]

This, of course, is what we call “hyperinflation”, with a vengeance. Even barter would make more sense!

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The unrestricted credit creation called “quantitative easing” raises an obvious question: What happens to all the new money?

It is a mathematical certainty that if the quantity of money increases in relation to a given level of available assets, prices must rise. Not necessarily all prices, and not necessarily immediately. To see what its “first receivers” in financial institutions do with the money, you should simply identify the assets that have become dramatically more expensive after a few bouts of quantitative easing, coupled with cheap credit.

 

 

 

 

 

 

 

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The initial impact is evident in the adverts for luxury cruises; extravagant town-houses with underground swimming pools and gyms in the most prestigious locations; £50,000 timepieces; gleaming sports cars; hand-crafted yachts; branded clothes and bejeweled baubles exclusive to Bond Street arcades; Chateau-bottled wines (or the chateaux themselves) – all at asset prices pushed sky-high by the new zillions! Much of it finds its way into speculation on stocks and shares; private clinics and health spas; and, inevitably, obscene levels of executive pay, disgracing the integrity of boardrooms everywhere.

 

The next phase is a “filtering-down”, which dictates that the impact of new money on the price of foodstuffs, household goods and the basic ingredients in most people’s budgets takes longer to arrive, by which time their prices have been pushed up by the earlier inflationary impact – and the same happens to ordinary domestic housing everywhere, making home ownership for the younger generation prohibitive. Uncomprehending politicians will scream about the need for “more affordable housing” – but causes elude them altogether!

 

This process bites especially harshly in locations where shoppers, whose budgets are already stretched, are forced to seek out the lowest prices for essentials. The reduced “footfall” on the High Street causes many shops, already beleaguered by the competition of online shopping, to close. The insidious impact is transformative – just look at the changing composition of the typical High Street, where there used to be hardware stores, outfitters, hairdressers, decent restaurants, jewelers, fishmongers, professional offices, clinics, travel agencies, furniture stores, art and antique shops, bathroom showrooms. And now?

 

Apart from all the “to let” spaces where there used to be shops, there are charity shops, newspaper shops also selling cheap deli food and booze, cheaply appointed coffee-and-cake counters, kebab, burger and pizza bars, a couple of bank branches, estate agents advertising low-rent lettings, mini-cab call centres, mobile phone stores, clothing outlets with racks of cut-price clobber, traders in any rapid turnover enterprise.

 

[The impact of inflation can be more reliably observed over a period when measured against an essential commodity, such as oil.

 

Fifty-two years ago the price of a barrel of oil was $3.1. Today it hovers around $65. Although it appears as though the price of oil has gone up, hugely, that apparent rise is rather a measure of the loss in the dollar’s purchasing power over that period – some 95 per cent.

 

But what happens if you measure the price of that same barrel of oil against a stable commodity, such as gold, instead of the volatile dollar? Fifty-two years ago that barrel equated to 2.75 grams of gold. Now it equates to 1 gram of gold. Therefore the purchasing power of gold, measured in barrels of oil, has all but trebled.]

 

 

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Money and gold

 

When money, as both a convenient medium of exchange and a reliable store of value, gradually superseded barter, the commodity used as a medium for settling domestic and international debts was gold because it possesses the key attributes that serve so well as currency: relative rarity; durability; limited alternative utility; recognition and acceptance.

 

Most important of all, it is immune from the ravages of the government’s printing presses and under the gold standard there can be no “inflation” as we know it today.

 

The only serious debasements to afflict gold are the practices (at which Henry VIII was expert) of “coin-clipping”, and the mingling of inferior alloys, often to pay for foreign wars.

 

Gold Standard

Under a gold standard a country’s unit of currency is defined by a specified quantity of gold held by its central bank, and into which its convertibility is guaranteed without restriction. Its unrestricted export and import makes it ideal for settling international obligations.

A country on the gold standard cannot increase the amount of money in circulation without also increasing its gold reserves. Because the global gold supply grows only slowly, being on the gold standard holds government spending and inflation in check.

In 1944 representatives of the allied nations and their central bankers met at Bretton Woods in New Hampshire, where it was agreed that the US dollar would be accepted as the settlement currency for international trade; and that the US dollar would be redeemable in gold on presentation at the fixed rate of $35 to the ounce.

Redeeming those dollars

But throughout the 1950s and early 1960s the USA just kept on printing dollars regardless of whether they could redeem them in gold at $35 to the ounce. They were effectively paying for their imports with fake currency.

 

 

 

 

 

 

 

 

 

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In 1958 General de Gaulle became President of France and over the next few years he noted with increasing alarm that the French Central Bank was stuffed full of US dollars, and French exports to the USA (wine, cheese, machinery, cars, clothes, etc) were being paid for, not in francs, but in still more dollars. In 1969 De Gaulle started to redeem the dollars France was holding against gold at the official rate of $35 to the ounce.

 

Other central bankers duly noted this redemption and soon began to follow suit. By 1971 America’s gold reserves had become seriously depleted, and President Nixon took the coward’s way out of the problem by simply declaring that debts denominated in dollars were no longer redeemable in gold – effectively taking America off the gold standard.

 

[Nixon could, of course, have faced up to the damage inflicted by the Federal Reserve’s systematic dollar destruction over decades. He could have devalued the dollar by restating its revised value in terms of gold, and then desisting from further debasement. It is reliably estimated that the true relationship between dollars and gold in 1971 was around $400 to the ounce.

 

If correct, this means the dollar lost almost 90 per cent of its purchasing power over the 27 years from 1944 to 1971. Reinstating the gold standard could have arrested this slide, albeit fixed at a revised conversion rate.]

 

Economists who favour state control over the economy claim that the chief drawback of a gold standard is that it restricts government’s ability to control the money supply when, in their view, state intervention is warranted.

However, economists who consider that markets are preferred arbiters of what, if anything, is needed, regard this restriction on monetary meddling as the gold standard’s greatest strength!

“Fiat” Money

In 1971 the gold standard was replaced by a system of “fiat” money under which the currency is not linked to the value of any commodity, but is instead allowed to fluctuate dynamically against other currencies on the foreign-exchange markets.

The term “fiat” is derived from the Latin “fieri” – meaning arbitrary act or decree. In keeping with this etymology, fiat currencies are accepted only because they are defined as legal tender by way of government decree, not because they retain purchasing power, which they do not!

 

 

 

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Finally, you will hear politicians opining on the effect of individual currencies: “If only the Italians ditched the euro and returned to the lira their exports would be more competitive…..” And the same sentiment over the Greek drachma, Spanish peseta, etc. This is all nonsense. It is not currencies that that need to be made more “competitive”, but production. German cars are not world beaters because they are cheap, but because their production methods guarantee value for money – any money!

6 – Free trade

In essence, the huge Brexit ideological battle is being waged between upholders of free trade and believers in protectionism.

The waters are muddied by misunderstandings on the part of politicians on both sides. For example, many proclaiming themselves to be free trade supporters emerge on closer questioning to favour free trade between members of a “group”, a “customs union” or “association” of countries. Yet, restricting your “free trade” agreements to those within your trading circle remains grossly protectionist, and is not at all what any true free trader means by free trade.

Free trade means “unilateral” (“one-sided”) free trade. Nations like New Zealand, Singapore and Hong Kong regularly enter into free trade agreements with any nation who wishes to do so. It does not take two to tango and any other view is protectionist and perverse. Unilateral free trade is unconditional and unrestricted.

Protectionists’ instruments of torture are tariffs, if they are protecting domestic trade from cheaper imports; and subsidies, if they are helping their own exporters to compete with cheaper products in the target country.

Here’s what happens:

1 – Protectionist lobbies urge the government to compel its own citizens to pay higher prices so that domestic producers are able to maintain their current revenues.

2 – Protectionists claim that the foreign producers are subsidized by their own governments, and are therefore not competing “on an even playing field”. This can only mean that the domestic population is receiving the gift of lower-priced goods from foreign producers. It is not the role of government to make consumers poorer by preventing them from accepting this gift.

 

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3 – Protectionist lobbies are quick to warn government that an entire industry’s viability is at stake if it doesn’t act to retaliate against the artificially low-priced goods from abroad. With free trade and a sound currency importers (on behalf of consumers) will always seek the best products at the lowest prices, regardless of where they are sourced.

4 – Advocates of protectionist policies view trade economics through an upside-down prism. It is the function of consumers to consume, – not to serve producers. The function of producers is to serve consumers. If consumers, in exercising their free choice, are spending their money in ways that do not please domestic producers, it is not government’s role to intervene to end such “perverse” spending preferences.

5 – There is a tariff wall around the EU designed to protect its agriculture and manufacturing. The tariffs cause EU citizens to pay prices higher than in world markets. Because of the tariff barrier, Caribbean sugar producers, African agricultural exporters and Asian cloth-makers (and many other overseas producers) cannot sell their cheaper products into EU markets. Businesses that are protected by the EU tariffs benefit – but the losers are the overseas exporters and every EU consumer!

 

6 – Forget concepts like “multilateral” or “bilateral” trade agreements that imply government has a role in negotiating on behalf of individuals and businesses perfectly capable of reaching their own agreements. Only “unilateral” free trade is optimal. It needs to be “declared” – not “negotiated”!

 

7 – It is all based on mythology anyway! The myth is that governments and countries trade. They don’t trade, ever! In any case, they wouldn’t have a clue. Only people – representing real businesses – trade! Trade comes into action when there is a product, a willing buyer and a willing seller. All they want from government is to get out of the way so that they can get on with it!

 

8 – Protectionism never works. The only people it punishes are the citizens of the country that imposes it!

 

 

 

 

 

 

 

 

 

 

 

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7 – Small Government [and its counterpart, low taxation]

 

When Keynes was asked, “Why pay them to dig and fill holes? Why not pay them to build roads and schools?” he replied: “Fine, pay them to build schools. The point is it doesn’t matter what they do – as long as the government is creating jobs.”

 

That, however, is not the role of government.


In essence, the proper role of government is to protect the lives, property and civil freedoms of its subjects, and few would resent paying taxes to cover those essentials. Moreover, sound money and free trade automatically reduce the role of government to those natural limits.

 

Note these basic truths:

 

(i) Whatever government spends has to be paid for in taxes raised from the private sector. The public sector cannot be taxed, as it is paid out of taxes.

 

(ii) In a sound-money economy government cannot print fiat money. For every pound it wishes to spend it must either tax or borrow honestly – bearing in mind that there is a natural limit to public tolerance for taxes; and increased borrowing drives up the interest rate, increasing the burden on the productive economy.

 

(iii) An economy running on unsound money creates an appearance of unlimited resources. This, of course, is the progenitor of the “entitlement culture”. To pay for its unfunded promises and good works, all it has to do is print more money.

 

(iv) Political animals with power to set priorities, and make spending decisions, forget all too easily that their own remuneration comes out of taxes and that they are public servants, not masters.

 

(v) Government expenditure is simply not susceptible to the kind of economic analysis that citizens apply when spending their own money. There is no incentive to raise productivity in the public sector. Only half of NHS employees are doctors or nurses; only one-third of the state education sector’s employees are teachers.

 

(vi) Politicians with unbridled power to spend their citizens’ money are the worst culprits. The more grandiose the project, the greater the potential for unchecked extravagance – whether it relates to new power generators, runways, high-tech university labs, bridges or tunnels.

 

 

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The reason that no consideration is given to the questions that arise when private capital is involved (such as whether the project’s returns are likely to exceed its origination and operating costs) is that such questions are meaningless when the mindset is “bounty unlimited”.

 

This key question is rarely asked: “How will the nation suffer if this project is abandoned right now?”

 

Wherever tax-funded infrastructure spending is let loose on the basis of little more than political whim, the result is a pure gamble with taxpayers’ money:

 

  • How else is it possible to close a hospital operating theatre in Barcelona, yet keep open an airport with 40 employees, at which no plane has landed?

 

  • Or Portuguese electronic toll-roads that drivers avoid like the plague? [They have no tollbooths, and require drivers to buy transponders and variable-priced pre-paid cards!]

 

  • Or the World Bank aid project that diverted fresh water from Lesotha Highlands into South Africa at a cost of $3.5 billion to produce electricity that proved (a) too expensive for consumers; and (b) created environmental havoc downstream?

 

  • Or the Norwegian government’s $22 million development aid-funding of a fish processing plant on Lake Turkana to “create jobs” in Kenya? Did no one tell them that the Turkana people are nomads with no history of ever catching or eating fish? And the cost of operating freezers was prohibitive anyway! The empty plant stands as a monument in the “museum of well-meaning cock-ups”.

 

Nor is there an end to the government’s “social engineering” meddling, as if it has an electoral mandate to apply our taxes according to its political agenda – whether its imposing a sugar tax, printing health warnings on every surface in sight or building more lethal cycle lanes.

 

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What we come down to is this. Provided that the principles of free trade and sound money are properly understood, and applied, government would be left with little to do beyond its primary raison d’etre of protecting the lives, property, liberty and civil rights of its citizens.

 

Limiting the role of government is difficult to visualize. But if we allow the subtle world of what is unseen to enter our consciousness, we’ll find it far more powerful than the chimera now frustrating our search for economic justice.

 

Understanding economics leaves us with a profound sense of awe: these simple but irreducible principles hold the key to the ordering of human affairs as they might exist – a vision that is also a lifeline.

 

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Footnote – but would it work in practice?           

 

I am often asked to provide an illustration or example of these fine principles being successfully applied in the real world. There are many examples, but this one should amply suffice. I am grateful to my colleague Alasdair Macleod for providing the narrative.

 

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Have you never pondered the astonishing economic turnaround that transformed Germany from deep and desperate economic ruin in 1945 to become, in seeming record time, one of the world’s most dynamic industrial powerhouses? If ever there was a case of an economic miracle, this is it.

 

How was such a thing possible? It was neither luck nor magic, though you could be forgiven for thinking so!

 

No, it happened only because one man, Ludwig Erhard, in the right place at the right time, understood and applied the principles that I have outlined above.

 

Here’s the story:

 

 

By the mid-1940s both the Nazi war machine and allied bombing had destroyed Germany’s post-war economy. The country was in ruins and people were starving. The British and American military solution was to extend and intensify rationing and throw more aid at the problem.

 

 

 

 

Page 19

 

Then Ludwig Erhard was appointed director of economics and in effect became finance minister. He decided, despite British and American misgivings, as well as opposition from the Social Democrats, to do away with price controls and rationing, which he did in 1948. These moves followed his currency reform that June, which contracted the money supply by about 90%, ending the reichsmark hyperinflation and instituting deutschmarks instead. He also slashed income tax from 85% to 18% on annual incomes over Dm2,500 (US$595 equivalent).

Erhard’s reforms went totally against the prevailing bureaucratic grain, and the military governor of the US Zone, General Lucius Clay, to whom he reported, duly upbraided him.

“Herr Erhard, my advisers tell me what you have done is a terrible mistake. What do you say to that?”

Erhard replied, “Herr General, pay no attention to them! My advisers tell me the same thing.”

Then a US Colonel confronted Erhard: “How dare you relax our rationing system when there is a widespread food shortage?”

Erhard replied, “I have not relaxed rationing, I have abolished it. Henceforth the only rationing ticket the people will need will be deutschmarks. And they will work hard to get those deutschmarks, just wait and see.”

The US Colonel did not have to wait long. According to contemporary accounts, within days of Erhard’s currency reform, shops filled with goods as people recognized that the money they sold them for would retain its purchasing power. People no longer needed to forage for the basics in life, so absenteeism from work halved, and industrial output rose more than 50% in the second half of 1948 alone.

Erhard had spent the war years studying free-market economics, planning how to structure Germany’s economy for the post-war years. His free-market approach made him a long-standing and widely recognised opponent of Nazi socialism, a fact that enhanced his credibility with the military authorities tasked with repairing the German economy.

[He became an early member of the Mont Pelarin Society, a grouping of free-market economists inclined towards the Austrian School, founded in 1947, and whose first President was Friedrich von Hayek, mentor to both Reagan and Thatcher.]

Erhard simply understood that ending all price regulation, introducing sound money and slashing the burden of taxation, were the basics required to revive the economy, and that the state must resist the temptation to intervene.

He remained a highly successful finance minister for fourteen years, before succeeding Konrad Adenauer as Chancellor in 1963.

 

Page 20

Erhard not only allowed unfettered free markets to rapidly turn Germany around from economic devastation, but being publicly credited with this success he presided over the economy long enough to ensure that bureaucratic meddling was kept at bay. His legacy served Germany well, despite the generally destructive actions of his successors.

The contrast with Britain’s economic performance was stark, where rationing was not finally lifted until 1954, and her post-war socialist, anti-market government was nationalising key industries. The contrast between Germany’s revival and Britain’s decline could not have been more marked.

The point to note well is that free markets are demonstrably more successful than regulated markets as a means of ensuring economic progress.

The same phenomenon was observed in Hong Kong, where John Cowperthwaite succeeded in stopping his own local officials and London’s Colonial Office from imposing regulations on the island’s economy in the post-war years. Cowperthwaite was roughly contemporary with Erhard, retiring as Hong Kong’s Financial Secretary in 1971. Yet despite this indisputable evidence that free unregulated markets actually work best, both the central and local political classes can never resist the compulsion to regulate, and their efforts invariably have an effect diametrically opposed to what’s needed.

 

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[May 2018]