Building a monetary and financial system for a free society

By Sanjeev Sabhlok, published in Freedom First, Mumbai, January 2009.

For a wealth-destroying event of the magnitude of the global financial crisis (GFC) to have taken place despite celebrated economists running Western economies tells us that ‘standard’ economics has failed at a most fundamental level, like theories which said the earth is flat. Instead, the ideas of thinkers like Ludwig von Mises and Friedrich Hayek (the economics Nobel prize winner of 1974) of the Austrian school of economics, who repeatedly warned about the dangers of state-induced distortions in money markets, have been fully vindicated.

Unfortunately, the economics taught today continues to ignore these great economists’ insights. Current economics is more inclined to side with Marx who dreamt of state-controlled credit in the hands of a national bank. It is time the world asks these ‘standard’ economists the blunt question: why must free societies have Marxian central banking?

Unfree financial markets
People exchange goods and services in the free market at a mutually agreed price. The unit and medium of exchange, money, is also created by these markets. For instance, notes issued by private banks in medieval Europe, being commitments to pay specified amounts of gold to the bearer of these notes, were readily accepted as money. This system of money creation and banking, based on the ‘gold standard’, arose spontaneously from freedom.

However, in 1694, the British government, in financial distress, found a convenient way to produce money from thin air by giving sole rights to produce money to the newly established (private) Bank of England, and receiving an advance of £1.2 million in return. This anti-competitive distortion of previously free money markets became very popular among later governments. Some enlightened governments did allow free banking for a while: for instance, in Sweden between 1830 and 1902. Indeed, this (Swedish) free banking episode eliminated booms and busts and dramatically reduced bank failures. But Sweden soon abandoned free banking because it demands great discipline from governments which would rather follow Robert Mugabe’s inflationary footsteps, instead.

The free market also ordinarily determines the price of money, which is the interest rate that this money commands in a competitive marketplace. This market-based interest rate perfectly matches the society’s time preference of consumption. But central banks are established exclusively to interfere with this free determination of interest rates by distorting money supply and fixing the price of money. Naturally consumers and entrepreneurs are confused in these economies.

We can see why Americans save so little and borrow so much. By deliberately preventing the time preference of society from being disclosed through the market, and by (often) forcing interest rates to fall below their market rate, people are motivated to consume more and save less. Sensible persons won’t save when their savings don’t earn much interest or even earn a negative interest after inflation and taxes. They would rather borrow at low interest rates and consume in excess. Americans are quite rational; it is their politicians and central bankers whose heads need a check up.

Betrayal of freedom
Like other socialist planners, central banks are prone to imagine that the solutions to the world’s problems lie inside their presumably super-intelligent but in reality deeply flawed and ill-informed brains (we are all similarly endowed: that is the basic truth about human frailty). Fatal conceit afflicts them as they try to ‘fine tune’ the economy by randomly tinkering with money supply and its price. Alan Greenspan (whom the great philosopher of freedom, Ayn Rand, erroneously considered as her disciple) wrote in the 1960s that the US Federal Reserve (Fed) had ‘nearly destroyed the economies of the world’ in the 1920s, and that ‘a free banking system stands as the protector of an economy’s stability and balanced growth’. This was, no doubt, good thinking.

But strange things happened between 1987 and 2006. As Chairman of the Fed, Greenspan changed colours. Not only did he not liberate the money markets, he kept interest rates artificially low, particularly between January 2001 and June 2004. Had he recalled the Austrian trade cycle theory (which Ayn Rand endorsed) he would have realized the great dangers of administering the price of money. His artificially low interest rates persuaded entrepreneurs worldwide to build things like houses and car factories in great excess, leading to the same over-investment that led to the roaring 20’s and thence to the Great Depression. Greenspan thus did exactly what he had earlier decried. Freedom was betrayed by the man once considered its great votary. It is now time to stop this stupidity of having a controlled product (money) in otherwise frees societies. Central banking, the illegitimate child of mercantilist monarchs and communist utopians, must be abolished. We must get free banking, instead: based on the gold standard.

US government’s socialist interventions
These massive failures of the Fed were greatly exacerbated by American welfare socialism. Nationalised Fannie Mae was created in 1938 to funnel federal funds into home loans, artificially boosting the demand for housing. It was (notionally) privatised in 1968 but remained guaranteed by the US government. Freddie Mac was later created in 1970 to allegedly provide Fannie Mae with competition. American welfare socialism worsened with Jimmy Carter’s 1977 Community Reinvestment Act which required all banks to give loans to people without income or on low income, over-riding good lending practices. Fannie May and Freddie Mac (FMFM) were thereafter ‘leaned upon’ by successive US governments to buy the sub-prime mortgages issued by banks. Then started what can only be (in polite terms) termed as government-supported fraud. FMFM started guaranteeing sub-prime loans issued by Bear Stearns and also directly sold such debt to foreigners.

Catching and punishing those who make false or misleading claims about a product is a primary function of the government, but the US Office of Federal Housing Enterprise Oversight (charged with supervising FMFM) did nothing to block these falsehoods. Activities of a similar nature were also unfolding in the private marketplace in relation to financially engineered products. For instance, Credit Suisse Group Sellers misled markets about the risks of its securities by touting the AAA ratings it got (bought?) from Standard & Poor’s. Self-regulation dramatically failed in the financial sector.

In addition, urban planning laws in many parts of the USA prevented urban boundaries from expanding even though thousands of new housing loans had been issued. This caused house prices to skyrocket. All these bad policies, together with low interest rates, fuelled a major housing bubble which has now burst. The main lesson we can draw from the GFC is that economic booms and busts are always created by government interference, mismanagement, and incompetence; not when markets are free and held to account.

I fear that worse things may be in store for the USA, including the possible collapse of the US dollar by about 2018 given its massive unfunded social security and medicare obligations (the only way to save USA would be for other countries to follow even worse policies!). After destroying and socialising its financial system, the USA government has now started throwing its taxpayers’ money at failing companies. In a free society each business or company must take responsibility for its own decisions; if it becomes insolvent it must declare bankruptcy as part of its accountability. If any value is still left over, private investors will buy it out. Using taxpayer funds to bail out companies that no one wants to touch, amounts to theft of taxpayers’ hard-earned money. Also, by rewarding incompetents, it creates disincentives for prudential management.

Lessons for India
Despite being founded under the banner of liberty, America has never been completely free. But its badly regulated money and financial markets, coupled with its socialist response to the GFC, shows that it is no longer fit to talk about freedom. This makes it even more important for India to show the way.

India’s Reserve Bank should get out of the business of creating money and fixing the price of money. It should become an independent regulator of a private money and banking system. Its current functions should be unbundled: coins and notes should be issued only by private banks; the lender of last resort function should be performed by private insurance companies. Reforms on these lines will disclose the market’s true interest rate, and price risks transparently, thus enabling uninterrupted economic growth. Good fiscal policy would have to accompany such reforms, including policies to minimise inflation, but I’ll touch upon these related policies in a separate article.

The Freedom Team of India
India needs leaders urgently to take it to freedom. I’d like to request you to consider joining the Freedom Team ( to lead India. The task is clearly becoming more urgent than ever before.


Addendum 13 June 2009. A sensible article by Paul Kelly in The Australian today. Fix it, Don’t Break it.

Addendum:Recession is ‘cleansing’, Corbett says‘, 15 May 2009 by Nine MSN.

Addendum: Eight centuries of financial folly and counting, 23 April 2010. Public Sector Development Blog

Addendum: Copy of the entire article by Paul Kerin (“There should be less government intervention, not more”, published in The Australian, 14 Sept. 2009):

MANY claim that the global financial crisis has slain the most important economic theory of the last half-century — the efficient markets hypothesis (EMH) — and, therefore, that much more government intervention in financial markets is necessary.

In fact, the GFC didn’t even give the EMH a flesh wound. At least in Australia, there should be less intervention — not more.

Kevin Rudd blames the EMH for engendering the “belief in the superiority of unregulated financial markets” that he holds responsible for the GFC. Even my excellent MBS colleague Ian Harper — member of the 1997 Wallis Inquiry into Australia’s financial system — says the GFC had “blown efficient markets theory out the water”. Other doubters include ASIC chairman Tony D’Aloisio and Warren Buffett, justifiably the world’s most admired investor.

EMH critics either don’t understand what it is or (in Harper’s case) refer to one particular corollary, on which doubts are most defensible. In 1965, Eugene Fama — who fathered the EMH — defined an “efficient market” as one in which individual security prices “fully reflect all available information”.

Critics often cite economist Robert Shiller, author of the best-seller Irrational Exuberance, which was published just before the dotcom crash. Shiller agrees with the famous “Samuelson dictum” — that financial markets are micro-efficient, but may not be macro-efficient. That is, markets price individual securities well, but overall market levels may not reflect reality. Nobel Prize winner Paul Samuelson propounded his dictum in the midst of the dotcom boom and soon after the Asian financial crisis.

The entire rationale for light regulation rests on financial market’s micro-efficiency, not macro-efficiency.

In 2005, Shiller concluded: “Substantial evidence vividly illustrates the truth in Samuelson’s dictum for the US stockmarket since 1926.” His key reason is that substantially more information is available on the drivers of individual firms’ cashflows (hence their intrinsic values) than on the overall market’s drivers (such as future macro-economic growth).

Even the world’s best-known EMH advocates recognise that macro-inefficiency may exist. Six months before the 2007 market peak, Burton Malkiel (author of A Random Walk Down Wall Street) questioned in The Wall Street Journal whether the market was exhibiting “irrational complacency”, given that macro-economic indicators were already slowing.

Critics also mock assumptions that they claim the EMH makes. Even the otherwise sensible Lindsay Tanner wrote: “The efficient markets theory and the assumption that people act rationally are under intellectual siege.” But Fama explained in 1965 that this and other assumptions — if true — were sufficient for the EMH to hold, but not necessary. Those assumptions probably don’t hold in the banana market either, but it works pretty well.

If critics cite any micro-inefficiency examples, they’re the usual suspects: the Dutch tulip and South Sea “bubbles”. The tulip case actually reflected a government-supported change in trading rules and a ban on short-selling. As tulip bulbs cannot be uprooted between October and May, the large price rises between November 1636 and February 1637 were on futures contracts, which obligated buyers to pay the contracted price for next season’s bulbs. But from November 1636, the Florists Guild had been moving to give buyers the right to avert this obligation by paying a small fee — and for this change to apply retrospectively to all contracts made from that time.

That is, the market knew that “futures” contracts may become “options” contracts from November. The likelihood of this happening kept rising until it was mandated in February 1637. As that likelihood rose, buyers willingly agreed to higher prices because they were less likely to have to pay them. The “crash” in February 1637 simply reflected the fact that, in any market, options trade at a small fraction of futures prices. “Tulipmania” claimants are comparing the prices of apples and bananas. Indeed, UCLA’s Earl Thompson concluded that “Tulipmania” was actually a “remarkable illustration of market efficiency”.

The South Sea fiasco didn’t reflect market inefficiency. Market prices can only reflect available information. Instead, it highlights the dangers in governments granting monopolies to private companies. After the crash, fraud by South Sea directors and corruption in the British Cabinet was exposed. The chancellor of the exchequer was jailed.

While macro-inefficiency may be possible, stockmarket crashes do not “prove” it. We often und
erestimate the impact that new information can have on estimated intrinsic values. The intrinsic value of a share paying $1 a year dividend with expected annual growth of 5 per cent and a 10 per cent cost of equity is $21. Suppose a “shock” (subprime crisis, say) raises investors’ risk premium by 1 per cent and makes them expect a 30 per cent dividend cut to 70c a share for the next three years, before 5 per cent annual dividend growth is restored. Rational investors would cut their estimated intrinsic value fall by 49 per cent — about how much our market dropped by.

While most EMH tests are of micro-efficiency, there is even some evidence supporting macro-efficiency. A 2008 study by Australian researchers Jae Kim and Abul Shamsuddin of sharemarket indices (like the Nikkei) before and after the Asian financial crisis found they were efficient in relatively developed markets, such as Hong Kong and Japan. Market efficiency was strongest in nations with business cultures and regulatory arrangements conducive to transparent corporate governance (such as good disclosure rules).

In questioning the EMH, D’Aloisio cited the collapse of various unlisted managed investment schemes and debenture issues. But no EMH advocate has ever claimed it applies to these over-the-counter products, for good reason. Investor prices (on both buy entry and exit) are set by issuers, not by a free, competitive, transparent market. In the latter, sophisticated investors and arbitrageurs work to keep security prices sensible; they cannot do so with the products D’Aloisio cites.

And D’Aloisio was wrong in claiming that the Wallis Inquiry said “there shouldn’t be capital requirements” on issuers of these products due to “the efficiency of the market”. The Wallis committee didn’t recommend capital requirements because they were unnecessary to protect financial system stability — those products, in total, represent too tiny a share of total financial assets to pose any significant systematic risk. Wallis instead emphasised the need for good disclosure requirements, which ASIC is now moving to strengthen.

The very best protection for retail investors is free, competitive, transparent securities markets, because prices are then most likely to reflect intrinsic values. Governments should certainly ensure transparency by mandating good disclosure and punishing rumour-mongering and insider trading. But interventions like short-selling bans actually inhibit market efficiency — putting retail investors at more risk, not less.

It is also important to distinguish between macro-inefficiency in financial markets versus the real economy. Samuelson once said that the real economy’s business cycle “like herpes, has always been with us”. A Keynesian, he supports activist macro-economic policies to keep that disease in check — but not activism in financial markets. The Federal Reserve’s 1929 intervention to prick what it saw as a stockmarket bubble — and the Great Depression that followed — demonstrates the danger.

My big worry is that our Prime Minister will overreact. Rudd had advocated “constraining excessive expansion of derivatives markets” and a “fundamental regime change” to “social capitalism” — “a system of open markets, unambiguously regulated by an activist state”. Activism can be taken far too far.

Politicians may think markets overreact, but never look in the mirror. At least markets soon correct themselves. Politicians rarely do.

Paul Kerin is Professorial Fellow, Melbourne Business School

Here’s an excellent article: “Milton Friedman and the Case against Currency Monopoly” by Selgin, George; Cato Journal, Spring-Summer 2008, v. 28, iss. 2, pp. 287-301 (EconLit with Full Text) – Crisis puts nails back in Keynesian coffin, by Michael Stutchbury, Economics editor From: The Australian June 15, 2010 (Fiscal time bomb yet to explode, Tim Colebatch The Age, 15/6/2010)  It is never going to be easy to kill such panics. Considered infrastructure funding is hard, mindless throwing away of taxpayer funds is easy. This is an article with much useful information to add to fiscal policy debates.

See this blog post at Marginal Revolution: Research shows that “The Fed’s full history (1914 to present) has been characterized by more rather than fewer symptoms of monetary and macroeconomic instability than the decades leading to the Fed’s establishment”

A debate at:

Housing: Too Good to be True: June 04, 2004 by Mark Thornton

The myth of deregulation being a cause of the GFC.

How much did Fannie and Freddie cause the financial crisis? [A nice piece on one of the causes of the US housing debacle]


MURRAY AND BIER: Avoiding a lost decade: Obama on course to repeat Japan’s errors of the 1990s {one of the best articles on the subject}

Gary Becker says:

The widespread demand after the financial crisis for radical modifications to capitalism typically paid little attention to whether in fact proposed government substitutes would do better, rather than worse, than markets.

Government regulations and laws are obviously essential to any well-functioning economy. Still, when the performance of markets is compared systematically to government alternatives, markets usually come out looking pretty darn good.

Also see this blog post for a clear rebuttal of false claims by Steve Horwitz:

Here’s a nice summary of what went wrong:

(The turning point was the spring and summer of 2004. Fannie and Freddie had kept their exposures low to loans made with little or no documentation (no-doc and low-doc loans), owing to their internal risk-management guidelines that limited such lending. In early 2004, however, senior management realized that the only way to meet the political mandates was to massively cut underwriting standards.)

ADDENDUM 18 June 2014

The Virginian 2 hours ago

I would fully endorse the Justice Department criminally pursuing the people who did the bad deeds.  But, they instead have chosen to treat the banks as piñatas and a ready source of cash to fund U.S.  government operations.

These large fines don’t do anything to the people who did the deeds – they just reinforce the belief that it’s a cost of doing business.

Instead, they wreak tremendous damage on stockholders, which are primarily American citizens, their pension funds and insurers.

Let’s not forget that most of the ‘bad deeds’ began by the exhortations of:
1) Barney Frank (a famous US Congressman who was the Chairman of the House Financial Services Committee), who pushed U.S. banks to loan money to poor people who couldn’t qualify for mortgages as part of his belief in social justice … and who famously  said “I want to roll the dice a little bit more in this situation toward subsidized housing.”
2) the Federal Reserve, which pressured the banks to buy the companies that often did the bad deeds in order to save the U.S. financial system and, by extent, the world economy as the economic crisis deepened.  (The most famous example is Bank Of America’s purchase of Countrywide, which actually made the bad loans BAC is being punished for.)

There is plenty of blame to go around … but, much of it is directly attributable to the U.S. Government Congress, both political parties, and our vaunted regulatory agencies which aggressively enforced the political clamor to make mortgage loans to poor people so they could own homes, regardless of their ability to repay).

Hypocrisy is an elemental part of the political process and we see it every day in our government.  I just want it to finally be moderated here so that us stockholders can regain our savings and fund our retirements … and so that our banks are again willing to make the loans necessary to grow our economy.

Right now, the U.S. government is actively sabotaging all three of these necessary requirements through their extended bleeding of Bank America, Citigroup, JP Morgan, and other banks.



An alterantive view (which I don’t find persuasive): The housing bubble: Perceptions and reality – Scott Sumner. My comment:

This article is off the mark.

That the steep decline in the Fed funds rate in 2002-2004 set off a housing bubble is clearly vindicated by looking at this chart of house prices:

This bubble was purely created by loose monetary policy. That doesn’t mean everyone has to start defaulting in their payments immediately. It would be a mistake to default if your house price is increasing in value.

However, in the US, most mortgagees can walk out of their mortgage once the property goes below its purchase price. So AFTER the bubble burst (due to many factors – all bubbles burst sooner or later), the default rate THEN shot up. The buyers who had bought high, walked out, setting off a chain reaction, making it attractive even for those who could pay, to default.

The problem with Erdmann’s spurious argument is his assumption (2):

“2) As rates rose, low income households with unsustainable ARM mortgages couldn’t afford their mortgage payments. Delinquencies started to pile up.”

No one in his right mind said that. See my January 2009 article in which I refer to the HOUSING BUBBLE (not delinquencies) and a range of socialist policies as the driver of the GFC.

Even a Harvard professor understands that government caused the Global Financial Crisis: