[PDF]Money Bank Credit And Economic Cycles De Soto

Money,
Bank Credit,

and

Economic Cycles




Money,
Bank Credit,

and

Economic Cycles


Jesus Huerta de Soto
Translated by Melinda A. Stroup



Ludwig
von Mises
Institute


AUBURN, ALABAMA




First Spanish edition 1998, Dinero, Credito Bancario y Ciclos
Economicos, Union Editorial, Madrid
Copyright © 1998 Jesus Huerta de Soto

Second Spanish edition 2002, Union Editorial, Madrid

Copyright © 2006 Jesus Huerta de Soto
Translated from Spanish by Melinda A. Stroup
First English edition 2006, Money, Bank Credit, and Economic Cycles,
Ludwig von Mises Institute, 518 West Magnolia Avenue,
Auburn, Alabama 63832-4528

All rights reserved. Written permission must be secured from the
publisher to use or reproduce any part of this book, except for
brief quotations in critical reviews or articles.


ISBN: 0-945466-39-4
ISBN: 978-0-945466-39-0



Contents


Preface to the English-Language Edition xvii

Preface to the Second Spanish Edition xix

Introduction xxi

Chapter 1: The Legal Nature of the Monetary

Irregular-Deposit Contract 1

1 A Preliminary Clarification of Terms:

Loan Contracts (Mutuum and Commodatum)

and Deposit Contracts 1

The Commodatum Contract 2

The Mutuum Contract 2

The Deposit Contract 4

The Deposit of Fungible Goods or "Irregular"

Deposit Contract 4

2 The Economic and Social Function of Irregular

Deposits 6

The Fundamental Element in the Monetary
Irregular Deposit 7

Resulting Effects of the Failure to Comply
with the Essential Obligation in the
Irregular Deposit 9

Court Decisions Acknowledging the
Fundamental Legal Principles which Govern
the Monetary Irregular-Deposit Contract
(100-Percent Reserve Requirement) 11


v



Money, Bank Credit, and Economic Cycles


3 The Essential Differences Between the Irregular

Deposit Contract and the Monetary Loan Contract ... .13

The Extent to Which Property Rights are
Transferred in Each Contract 13

Fundamental Economic Differences Between
the Two Contracts 14

Fundamental Legal Differences Between the
Two Contracts 17

4 The Discovery by Roman Legal Experts of the

General Legal Principles Governing the Monetary

Irregular-Deposit Contract 20

The Emergence of Traditional Legal Principles
According to Menger, Hayek and Leoni 20

Roman Jurisprudence 24

The Irregular Deposit Contract Under Roman
Law 27

Chapter 2: Historical Violations of the Legal Principles
Legal Principles Governing the Monetary
Irregular-Deposit Contract 37

1 Introduction 37

2 Banking in Greece and Rome 41

Trapezitei, or Greek Bankers 41

Banking in the Hellenistic World 51

Banking in Rome 53

The Failure of the Christian Callistus's Bank 54

The Societates Argentariae 56

3 Bankers in the Late Middle Ages 59

The Revival of Deposit Banking in
Mediterranean Europe 61

The Canonical Ban on Usury and the
"Depositum Confessatum" 64


vi



Contents


Banking in Florence in the Fourteenth Century ... .70

The Medici Bank 72

Banking in Catalonia in the Fourteenth and
Fifteenth Centuries: The Taula de Canvi 75

4 Banking During the Reign of Charles V and the

Doctrine of the School of Salamanca 78

The Development of Banking in Seville 79

The School of Salamanca and the Banking
Business 83

5 A New Attempt at Legitimate Banking: The Bank of

Amsterdam. Banking in the Seventeenth and

Eighteenth Centuries 98

The Bank of Amsterdam 98

David Flume and the Bank of Amsterdam 102

Sir James Steuart, Adam Smith and the
Bank of Amsterdam 103

The Banks of Sweden and England 106

John Law and Eighteenth-Century Banking in
France 109

Richard Cantillon and the Fraudulent Violation
of the Irregular-Deposit Contract Ill


Chapter 3: Attempts to Legally Justify

Fractional-Reserve Banking 115

1 Introduction 115

2 Why it is Impossible to Equate the Irregular Deposit

with the Loan or Mutuum Contract 119

The Roots of the Confusion 119

The Mistaken Doctrine of Common Law 124


The Doctrine of Spanish Civil and Commercial
Codes


vii


127



Money, Bank Credit, and Economic Cycles


Criticism of the Attempt to Equate the Monetary


Irregular-Deposit Contract with the Loan or
Mutuum Contract 133

The Distinct Cause or Purpose of Each Contract . .134

The Notion of the Unspoken or Implicit
Agreement 139

3 An Inadequate Solution: The Redefinition of the

Concept of Availability 147

4 The Monetary Irregular Deposit, Transactions

with a Repurchase Agreement and Life Insurance
Contracts 155

Transactions with a Repurchase Agreement 157

The Case of Life Insurance Contracts 161


Chapter 4: The Credit Expansion Process 167

1 Introduction 167

2 The Bank's Role as a True Intermediary in the Loan

Contract 172

3 The Bank's Role in the Monetary Bank-Deposit

Contract 178

4 The Effects Produced by Bankers' Use of Demand

Deposits: The Case of an Individual Bank 182

The Continental Accounting System 184

Accounting Practices in the English-speaking
World 194

An Isolated Bank's Capacity for Credit
Expansion and Deposit Creation 200

The Case of a Very Small Bank 208

Credit Expansion and Ex Nihilo Deposit
Creation by a Sole, Monopolistic Bank 211


viii



Contents


5 Credit Expansion and New Deposit Creation by

the Entire Banking System 217

Creation of Loans in a System of Small
Banks 223

6 A Few Additional Difficulties 231

When Expansion is Initiated Simultaneously by
All Banks 231

Filtering Out the Money Supply From the
Banking System 239

The Maintenance of Reserves Exceeding the
Minimum Requirement 242

Different Reserve Requirements for Different
Types of Deposits 243

7 The Parallels Between the Creation of Deposits

and the Issuance of Unbacked Banknotes 244

8 The Credit Tightening Process 254


Chapter 5: Bank Credit Expansion and Its

Effects on the Economic System 265

1 The Foundations of Capital Theory 266

Human Action as a Series of Subjective
Stages 266

Capital and Capital Goods 272

The Interest Rate 284

The Structure of Production 291

Some Additional Considerations 297

Criticism of the Measures used in National
Income Accounting 305

2 The Effect on the Productive Structure of an Increase

in Credit Financed under a Prior Increase in
Voluntary Saving 313


IX



Money, Bank Credit, and Economic Cycles


The Three Different Manifestations of the
Process of Voluntary Saving 313

Account Records of Savings Channeled into
Loans 315

The Issue of Consumer Loans 316

The Effects of Voluntary Saving on the
Productive Structure 317

First: The Effect Produced by the New Disparity
in Profits Between the Different Productive
Stages 319

Second: The Effect of the Decrease in the Interest
Rate on the Market Price of Capital Goods 325

Third: The Ricardo Effect 329

Conclusion: The Emergence of a New, More
Capital-Intensive Productive Structure 333

The Theoretical Solution to the "Paradox of
Thrift" 342

The Case of an Economy in Regression 344

3 The Effects of Bank Credit Expansion Unbacked

by an Increase in Saving: The Austrian Theory or
Circulation Credit Theory of the Business Cycle 347

The Effects of Credit Expansion on the
Productive Structure 348

The Market's Spontaneous Reaction to Credit
Expansion 361

4 Banking, Fractional-Reserve Ratios and the Law of

Large Numbers 385

Chapter 6: Additional Considerations on the Theory

of the Business Cycle 397

1 Why no Crisis Erupts when New Investment is
Financed by Real Saving (And Not by Credit
Expansion) 397


x



Contents


2 The Possibility of Postponing the Eruption of the

Crisis: The Theoretical Explanation of the Process
of Stagflation 399

3 Consumer Credit and the Theory of the Cycle 406

4 The Self-Destructive Nature of the Artificial Booms

Caused by Credit Expansion: The Theory of

"Forced Saving" 409

5 The Squandering of Capital, Idle Capacity and

Malinvestment of Productive Resources 413

6 Credit Expansion as the Cause of Massive

Unemployment 417

7 National Income Accounting is Inadequate to Reflect

the Different Stages in the Business Cycle 418

8 Entrepreneurship and the Theory of the Cycle 421

9 The Policy of General-Price-Level Stabilization and

its Destabilizing Effects on the Economy 424

10 How to Avoid Business Cycles: Prevention of and

Recovery from the Economic Crisis 432

11 The Theory of the Cycle and Idle Resources:

Their Role in the Initial Stages of the Boom 440

12 The Necessary Tightening of Credit in the Recession

Stage: Criticism of the Theory of "Secondary
Depression" 444

13 The "Manic-Depressive" Economy: The Dampening

of the Entrepreneurial Spirit and Other Negative
Effects Recurring Business Cycles Exert on the
Market Economy 456

14 The Influence Exerted on the Stock Market by

Economic Fluctuations 459

15 Effects the Business Cycle Exerts on the Banking

Sector 467

16 Marx, Hayek and the View that Economic Crises

are Intrinsic to Market Economies 468

17 Two Additional Considerations 474


xi



Money, Bank Credit, and Economic Cycles


18 Empirical Evidence for the Theory of the Cycle 476

Business Cycles Prior to the Industrial
Revolution 479

Business Cycles From the Industrial
Revolution Onward 482

The Roaring Twenties and the Great
Depression of 1929 487

The Economic Recessions of the Late 1970s
and Early 1990s 494

Some Empirical Testing of the Austrian
Theory of the Business Cycle 500

Conclusion 503

Chapter 7: A Critique of Monetarist and

Keynesian Theories 509

1 Introduction 509

2 A Critique of Monetarism 512

The Mythical Concept of Capital 512

Austrian Criticism of Clark and Knight 518

A Critique of the Mechanistic Monetarist
Version of the Quantity Theory of Money 522

A Brief Note on the Theory of Rational
Expectations 535

3 Criticism of Keynesian Economics 542

Say's Law of Markets 544

Keynes's Three Arguments On Credit
Expansion 546

Keynesian Analysis as a Particular Theory 553

The So-Called Marginal Efficiency of Capital 555

Keynes's Criticism of Mises and Hayek 557

Criticism of the Keynesian Multiplier 558

Criticism of the "Accelerator" Principle 565

xii



Contents


4 The Marxist Tradition and the Austrian Theory of

Economic Cycles: The Neo-Ricardian Revolution

and the Reswitching Controversy 571

5 Conclusion 576

6 Appendix on Life Insurance Companies and Other

Non-Bank Financial Intermediaries 584

Life Insurance Companies as True Financial
Intermediaries 586

Surrender Values and the Money Supply 591

The Corruption of Traditional Life-Insurance
Principles 594

Other True Financial Intermediaries: Mutual
Funds and Holding and Investment
Companies 597

Specific Comments on Credit Insurance 598

Chapter 8: Central and Free Banking Theory 601

1 A Critical Analysis of the Banking School 602

The Banking and Currency Views and the
School of Salamanca 603

The Response of the English-Speaking World
to these Ideas on Bank Money 613

The Controversy Between the Currency School
and the Banking School 622

2 The Debate Between Defenders of the Central Bank

and Advocates of Free Banking 631

Parnell's Pro-Free-Banking Argument and the
Responses of McCulloch and Longfield 632

A False Start for the Controversy Between
Central Banking and Free Banking 633

The Case for a Central Bank 635

xiii



Money, Bank Credit, and Economic Cycles


The Position of the Currency-School Theorists
who Defended a Free-Banking System 639

3 The "Theorem of the Impossibility of Socialism"

and its Application to the Central Bank 647

The Theory of the Impossibility of
Coordinating Society Based on Institutional
Coercion or the Violation of Traditional
Legal Principles 650

The Application of the Theorem of the
Impossibility of Socialism to the Central
Bank and the Fractional-Reserve Banking
System 651

(a) A System Based on a Central Bank
Which Controls and Oversees a
Network of Private Banks that

Operate with a Fractional Reserve 654

(b) A Banking System which Operates with

a 100-Percent Reserve Ratio and is
Controlled by a Central Bank 661

(c) A Fractional-Reserve Free-Banking

System 664

Conclusion: The Failure of Banking
Legislation 671

4 A Critical Look at the Modern Fractional-Reserve

Free-Banking School 675

The Erroneous Basis of the Analysis: The
Demand for Fiduciary Media, Regarded as
an Exogenous Variable 679

The Possibility that a Fractional-Reserve
Free-Banking System May Unilaterally
Initiate Credit Expansion 685

The Theory of "Monetary Equilibrium" in
Free Banking Rests on an Exclusively
Macroeconomic Analysis 688


xiv



Contents


The Confusion Between the Concept of Saving
and that of the Demand for Money 694

The Problem with Historical Illustrations of
Free-Banking Systems 701

Ignorance of Legal Arguments 706

5 Conclusion: The False Debate between Supporters of
Central Banking and Defenders of Fractional-
Reserve Free Banking 713

Chapter 9: A Proposal for Banking Reform:

The Theory of a 100-Percent Reserve Requirement 715

1 A History of Modem Theories in Support of a

100-Percent Reserve Requirement 716

The Proposal of Ludwig von Mises 716

F.A. Hayek and the Proposal of a 100-Percent
Reserve Requirement 723

Murray N. Rothbard and the Proposal of a
Pure Gold Standard with a 100-Percent
Reserve Requirement 726

Maurice Allais and the European Defense of
a 100-Percent Reserve Requirement 728

The Old Chicago-School Tradition of Support
for a 100-Percent Reserve Requirement 731

2 Our Proposal for Banking Reform 736

Total Freedom of Choice in Currency 736

A System of Complete Banking Freedom 740

The Obligation of All Agents in a Free-Banking
System to Observe Traditional Legal Rules
and Principles, Particularly a 100-Percent
Reserve Requirement on Demand Deposits . . . .742


xv



Money, Bank Credit, and Economic Cycles


What Would the Financial and Banking System
of a Totally Free Society be Like? 743

3 An Analysis of the Advantages of the Proposed

System 745

4 Replies to Possible Objections to our Proposal for

Monetary Reform 760

5 An Economic Analysis of the Process of Reform

and Transition toward the Proposed Monetary

and Banking System 788

A Few Basic Strategic Principles 788

Stages in the Reform of the Financial and
Banking System 789

The Importance of the Third and Subsequent
Stages in the Reform: The Possibility They
Offer of Paying Off the National Debt or
Social Security Pension Liabilities 791

The Application of the Theory of Banking
and Financial Reform to the European
Monetary Union and the Building of the
Financial Sector in Economies of the
Former Eastern Bloc 803

6 Conclusion: The Banking System of a Free Society 806

Bibliography 813

Index of Subjects 859

Index of Names 871


XVI



Preface to the
English-Language

Edition


I t is a genuine pleasure for me to see this handsomely-
printed English edition of my book, Dinero, Credito Bancario
y Ciclos Economicos, which first appeared in Spain in 1998.
This translation incorporates the small number of corrections
included in the second Spanish edition of January 2002, and it
is the result of the great effort of Melinda A. Stroup, who
wrote the first English manuscript of the entire book.

This English version was thoroughly examined by Dr. Jorg
Guido Hiilsmann, whose comments on several important
points improved the manuscript significantly. I would also
like to acknowledge the work of my research assistant, Gabriel
Calzada, who searched for various English editions of rare
books unavailable in Spain and looked up certain quotations
and references. Last, I personally inspected the final version in
its entirety to ensure the accuracy of its content.

I am grateful to the Ludwig von Mises Institute, and espe-
cially to its president, Lewellyn H. Rockwell, Jr., for bringing
the project to its culmination with such high standards.


Jesus Huerta de Soto
Senorio de Santa


May 2005


Note: The author welcomes any comments on this English-language
edition and requests they be sent to huertadesoto@dimasoft.es.

xvii




Preface to
the Second
Spanish Edition


F ollowing the success of the first edition of Dinero, Credito
Bancario y Ciclos Economicos, which sold out rapidly, I am
pleased to present the second edition to Spanish-speak-
ing readers. To avoid confusion and facilitate the work of
scholars and researchers, the contents, structure, and page
numbering of the first edition have been maintained in the
second, though the book has been thoroughly examined and
all misprints detected have been eliminated.

In the wake of a decade marked by great credit expansion
and the development of a large financial bubble, the course of
economic events in the world from 1999 through 2001 was
characterized by the collapse of stock-market values and the
emergence of a recession which now simultaneously grips the
United States, Europe, and Japan. These circumstances have
left the analysis presented in this book even more clearly and
fully illustrated than when it was first published, at the end of
1998. While governments and central banks have reacted to
the terrorist attack on New York's World Trade Center by
manipulating interest rates, reducing them to historically low
levels (1 percent in the United States, 0.15 percent in Japan and
2 percent in Europe), the massive expansion of fiduciary
media injected into the system will not only prolong and hin-
der the necessary streamlining of the real productive struc-
ture, but may also lead to dangerous stagflation. In light of
these worrisome economic conditions, which have repeated
themselves since the emergence of the current banking sys-
tem, I fervently hope the analysis this book contains will help
the reader to understand and interpret the phenomena which
surround him and will exert a positive influence on public


xix



Money, Bank Credit, and Economic Cycles

opinion, my university colleagues and economic-policy
authorities in government and central banks.

Various reviews of this book's first edition have appeared,
and I am grateful to the eminent authors of them for their
many positive comments . 1 A common denominator among all
has been to urge the translation of this book into English, a
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