Free Banking Theory and History of the Monetary Sphere

Monetary Piece by Josh L. Ascough

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Throughout the history of economic development, banking, and the monetary sphere as a whole, has been the subject of widespread unease to people and a seductive opportunity for Governments. Indeed, there is likely no other institution that has seen such a wide array of Government controls in some form or another; whether that be the formation of central banks, regulations, interventions or monopolisations; all for the purposes, we are told, of maintaining stability and ensuring any economic crises is averted or lessened.

This however is not the case. In fact governments’ seizing control over any aspect of money and banking, has seldom been for the purposes of stability or fiscal reasoning.

The purpose of this piece is to demonstrate the theory of what has been coined, Free Banking. Free Banking looks at the theoretical, historical and empirical examples of a money and banking system, free from government control; with private banks setting their own reserve rates, and issuing their own competitive notes.

The piece will go over several key subjects, in order to provide a greater, in depth analysis of the Free Banking theory; with corresponding historical and empirical evidence.

The topics of discussion are:

The Free Banking Theory

Unstable Restrictions and Bad Regulations

History and Instability of The Bank of England

Bygone Gold Standard – The Possible Future of Free Banking

– The Free Banking Theory –

The first and naturally the most important question to answer at this time is, how does free banking operate?

Banks are allowed to issue any liabilities they wish; subject only to the constraint that they persuade their customers to accept them of their own free will. The competition between the banks forces them to make their notes convertible. The banks are compelled to make their notes convertible by persuading a noteholder that it will retain its value; this trust in the stability in the notes value, is achieved by making a legally binding guarantee of the future value of the note. A bank that makes its notes convertible holds a competitive advantage over rival banks that do not have convertibility. Because entry into the competitive market is free (freedom of entry), the banks are unable to form a lasting cartel of inconvertibility; if such an act was tried, it would merely encourage new competitors to enter the market, who would gain an advantage by offering convertible notes, and the cartel banks would lack legal means of privilege and protection to keep the competitor out. Member banks of the cartel would be incentivised to undermine the competition by offering tacit convertibility to noteholders in order to gain an advantage.

In order for a bank to increase the demand of its notes, it would have to expand its attractiveness and trust among customers; advertising more, branching out, increasing its reputation etc. but it could not do so simply by putting more notes out into circulation, when the demand to hold these notes is not there.

This freedom to issue notes competitively, is not without constraint, which is attained via what can been referred to as being similar to a chain gang, and is regulated by market forces.

Kevin Dowd gives details into the restraints banks face and as to why unlimited, undesired expansions of issued notes would not work in the banks favour; stating that:

“Given the fact that banks will choose to commit themselves to convertibility, then it is the need to maintain convertibility which forces banks to limit their note issue. This is so because the circulation of convertible notes is limited by the public demand to hold them. […] Any notes issued beyond the demand to hold them […] would simply be returned for redemption, since the notes would not remain in circulation for long enough to justify the expense of putting them out and taking them back again.” (Dowd 1989, pp. 8-9)

Banks not just in a free banking system, but in all systems have to guard themselves from two kinds of financial risks: an insolvency risk, and an illiquidity risk. Insolvency is the risk of a bank’s net worth becoming negative, and this kind of risk is one which banks share with all private businesses. Illiquidity is the risk that a bank may default on its legal obligation to redeem its notes or deposits. To protect and attempt to prevent the former, a bank will look to diversify its portfolio, so that fluctuations in asset value are likely to cancel each other out, or be of minimal harm. However, if the bank’s net value is found to be negative, its creditors would run on the bank and shut it down, since said bank is shown to be badly managed with loans not performing, and a risk to its creditor’s capital. When it comes to the latter (illiquidity), the banks could, in principle, operate as “warehouses” in which there is no risk of illiquidity due to operating on a 100% reserve rate. The problem with this though, is the banks would be unable to lend and could only make profits from charging deposit fees. Additionally historical evidence indicates depositors prefer fractional reserve banking due to receiving interest on their deposits; rather than the fees 100% reserve “warehouses” would have to charge its depositors, in order to cover expenses.

Before continuing, an important distinction of the different degrees of money needs to be made:

MOE = Medium of Exchange: Refers to the debt instrument which is transferred in the exchange process (notes). MOA = Medium of Account: Refers to the commodity in terms of units which are quoted as prices (gold) (so many units of good x for one unit of good y). UA = Unit of Account: Refers to those units (MOA). The distinction is important because different considerations apply to MOE and MOA. MOE tends to require the use of an instrument that cannot be used for some other purpose at the same time. A MOA however is free of this limitation an can be used by any number of people simultaneously.

How is the value and quantity of bank-issued money determined under free competition; more specifically, if the banks are subject to no ceiling on currency issue, nor a floor on their reserve ratios, what market forces are in place to compel the banks to limit their issues and hold positive reserves? Assuming gold to be the basic money that acts as the MOA and the MOR (Medium of Redemption), then the purchasing power of money (or MOE) is the purchasing power of gold (PPG); the demand and supply of money determines the PPG; or, the rate of issue relative to the velocity of money or demand to hold determines the purchasing power, which tends to be reflected in prices: MV=PY (money velocity = price of output). The monetary stock demand for gold is the sum of the banks’ demand for reserves, and the demand for bank reserves derives from each bank solving a reserve-holding optimisation problem. In the event of a money shock to supply or demand, the stock quantities supplied and demanded for gold, are represented as:

These are brought back into long-run equilibrium by international flows of gold. This is what the classical Economist David Hume classed as the ‘specie-flow mechanism’.

To obtain a greater understanding of long-run equilibrium, we can observe it in diagram format:

The vertical axis represents the banks supply of reserves, with the horizontal representing the banks demand for reserves. The rate of money velocity determines the rate at which the banks hold a demand for reserves; as well as the market rate of interest: for example; if no one spends anything and people are signalling a demand to hold liabilities (notes and deposits) then the bank wouldn’t need reserves and could issue more loans, and transfer larger quantities of credit; the reverse effect takes place if MV is high. If people’s demand for bank liabilities is low and their time preference is for goods sooner, then the banks notes will be returned to them sooner for redemption in gold; meaning the banks will need to hold a higher reserve ratio.

In long-run equilibrium, with PPG being the same worldwide, then the individual country’s share of the world stock of gold; represented as (G i / G w), corresponds to that country’s share of demand for gold-holding on the world scale:

What happens if an individual bank over-issues? Before delving into this important question, we need to take a look at a bank’s balance sheet. This very basic bank balance sheet displays variables for the bank, which seeks to maximise and optimise the total size of each side of the sheet. If we simplify things a bit more and assume K is fixed, then the balance sheet imposes the following constraint:              

(R + L = N + D + K).

The banks have an incentive to hold an adequate reserve ratio; not only to enhance profits but to reduce its liquidity cost Q, which is the estimated value of costs incurred in the event the bank runs out of reserves, or reaches negative reserves. The cost of negative reserves may be in the form of legal penalties, the clearinghouse issuing a penalty, or the bank seeking to liquidate its assets in order to cover short notice calls for redemption. The bank’s choice of its level for R and its circulation of  N and D, depend on how its choice influences Q. Having a greater volume of  N and D circulating raises the number of claims against the bank that can be brought for redemption, and therefore clearings large enough to bring about negative reserves.

There is an equilibrium size of a bank’s currency circulation that satisfies equi-marginal conditions. This is measured by the value of the public’s desire to hold currency issued by the bank i. This value is measured as N i* p, where ‘p’ indicates the public who hold it as an asset, ‘i’ is the issuing bank, and * is the desired value. If the bank’s circulation exceeds the desired level

what would happen? If we assume the excess currency is introduced via loans, the borrower spends the currency; leading to the recipient to have balances of bank i in excess of their desired holdings. The recipient; for which notes issued are greater than notes desired, can respond to this excess in several ways.

(1) Direct Redemption

(2) Deposit Into Another Bank

(3) Spending the Excess.

As a consequence of reserve losses from over-issue, the bank i finds its reserves below its desired ratio, formulated as:

The net benefits of holding reserves now exceed the net revenue from making loans via continued over-issue.

So what of the risks of bank runs? What happens if the banks expansionary endeavours lead to a run? The first thing to note is isolated bank runs are tolerable, because what bad banks lose, better ones gain. Secondly, we need to make a distinction.

There are two kinds of bank runs:

(1) – Deposit Runs: Deposit runs occur when the public runs to convert deposits into notes.

(2) – Note Runs: Note runs occur when note holders run on the bank in order to redeem in specie (gold/silver).

Before we continue we need to define our terms. A deposit is a liability of a bank, which is redeemed with one of the banks liabilities, called a note. A note, is a bank liability that has to be redeemed with an asset, known as specie (commonly gold/silver). A deposit run therefore, is when the public run upon the bank to convert one liability with another; deposits for notes. Note runs then, are runs where the public demands to convert bank liabilities into assets which is an outside medium; or, to put it another way, a medium of redemption that is not a product of the bank such as gold and silver. In the situation of a deposit run, there is a sudden but short demand to convert deposits into notes. This sudden shortage of liquid assets will be reflected in the liquidity market, and will (temporarily) drive up the interest rate. So long as the deposit run does not turn into a note run, the bank could temporarily create extra liquidity simply by issuing more notes. In short, if a deposit run were to occur, the banks would have the incentive to create the necessary liquidity in order to correct it. Note runs on the other hand occur when the public run on the banks to redeem bank notes for specie. Under a fractional reserve system, the banks would be unable to redeem all their notes at once without prior notice; nor is it within the banks abilities to create more specie at will, unlike notes to deal with deposit runs. A single bank may be able to purchase additional specie to cover the redemption, but if the note run is on the banking system as a whole, then all banks will be short of reserves. The banks can avoid the possibility of defaulting on redemptions, by relaxing the convertibility contracts; instead of being bound to redemption on demand without notice, they would use an option clause, giving the banks the option to defer redemption for a pre-specified period of time, so long as they pay a pre-specified rate of interest on the notes which had deferred redemption. It would not be worth suspension if the overnight interest rate is less than the compensation rate the bank would have to pay from deferring. The question then arises: why would the public be willing to have redemption deferred? The noteholders would be compensated if a bank suspended redemption, and the presence of an option clause would reassure risk-averse holders that they would lose little or nothing if they were not first in line during a note run.

“If the public withdraws currency from deposit accounts, then reserves will be drained from the banks, which forces them to contract their balance sheets; unless the central bank expands the monetary base. A centralised, monopoly of currency is then seen to create incentive and epistemic problems seldom present with a decentralised, competitive system”

An advantage of letting banks issue their own notes, without state-enforced reserve requirements, would be that the banks would be better suited to accommodate changes in the public’s desired currency-deposit ratio, simply by changing the mix of note and deposit liabilities. To give a simple example, let us assume a case, where banknotes alone are used as currency and the desired reserve ratios for notes-deposits are the same; no expansion or contraction would be required of overall money or credit. The stock of base money, ‘B’ is equal to the stock of reserves, ‘R’, while the money stock ‘M’, is equal to that of bank deposits, ‘D’ plus outstanding banknotes, ‘N’.

B = R and M = D + N

Equilibrium here requires that actual bank reserves are equal to the desired bank reserves:

R = r(D + N); where ‘r’ = R/M is the desired bank reserve ratio. By adding ‘B = R’ – ‘R = r(D + N) to subtract D and N gives us: M/B = 1/r. Which indicates the independence of the money multiplier, M/B, from the publics’ desired currency-deposit ratio. Under a central banking system however, all currency takes the form of base money. This means instead of the above mentioned (B = R and M = D + N) we have:

‘B = R + C’ and ‘M = D + C’

Where ‘C’ is the publics’ holding of base money. As commercial bank liabilities don’t include banknotes, the condition for reserve equilibrium is:

R = r(D)

Having c = C/D denotes the publics’ desired currency-deposit ratio, and substituting to subtract D and C gives:

M/B = (1 + c)/(r + c)

The expression in brackets is the standard money multiplier. Unlike a free banking multiplier, the standard under central banking implies that, holding ‘B’ constant, a change in the publics’ desired currency-deposit ratio alters the equilibrium quantity of money. If the public withdraws currency from deposit accounts, then reserves will be drained from the banks, which forces them to contract their balance sheets; unless the central bank expands the monetary base. A centralised, monopoly of currency is then seen to create incentive and epistemic problems seldom present with a decentralised, competitive system.

Under a free banking system, directors of competitive banks have no specific difficulty meeting demands for currency. If a depositor wishes to convert some or all of their balance, the bank need only to supply the depositor with additional notes. If many or all of the banks depositors come forward for the same reason, the bank simply issues further additional notes. The form of liabilities demanded is not a matter of concern for the bank in question, what matter is their total value. When depositors convert deposits into notes or vice versa, there is simply a reduction of one balance sheet item in exchange for an increase in another; this would be similar to changing a £5 note for five £1 coins. As a final point this relates back to what was discussed about deposit runs; a deposit run is a simple action for a bank to deal with, so long as there are no restrictions of note issue in place.

Another way of looking at the calculation problems under central banking can be shown further in two diagrams. We’ll assume two different scenarios; one where central banks operate on a fractional reserve basis, and the other where central banks operate under 100% reserves:

If the central bank holds a monopoly of currency; thereby all the gold stock goes to the central bank and commercial banks treat its IOU’s as their reserves, and it doesn’t back its notes 100% then that spells serious trouble, as when the central bank operates on a fraction it can shift Rs out. As the central bank’s reserve ratio effectively determines the reserve ratios of other banks, this would lead to PY seeing an increase. Where P is the price and Y is output.

In the second scenario where the central bank operates on a 100% reserve requirement, we can see the effects below:

Under 100% the central bank is forced to issue nominal quantities of notes equal to the quantity of gold in its vaults; the central bank is forced to hold on to its gold reserves. This may seem a better scenario, however, we need to remember that the central banks notes; because it has monopoly of currency, are treated as reserves to the commercial banks. The effects of this are shown in the diagram: If people withdraw more notes, then reserves decline; if they redeposit them, reserves go up; meaning we would obtain instability in the currency ratio, making it still inferior to free banking and the natural, market mechanisms which regulate the banks.

Opponents of Free Banking; or fractional reserve banking in general, base their criticism on two key areas:

The first being the argument that fractional reserve banking is fraud. This argument is focussed on looking at the credit banks issue; viewing it as “created credit”, and that two people cannot hold a claim of ownership to the same coin.

There are two important factors which make the bankers ability to operate on a fractional reserve basis possible. The first is the fungibility of money, which allows depositors to be repaid in coin, bullion or whatever the commodity may be, other than that which was originally handed to the banker. Second is the law of large numbers; which as George Selgin notes, is that which

“ensures a continuing (though perhaps volatile) supply of loanable funds even though single accounts may be withdrawn without advance notice.” (Selgin 1988, p. 20)

The operation of banks classifying deposits of gold in any shape other than an ornament, and acting as savings-investment intermediaries goes back to the days of the goldsmiths. Historically in England, as early as the time of King Charles II (1660-85), the role of the bailee and the debtor of the depositor, developed side by side.This lead to money warehouse receipts becoming IOU notes, or debt instruments. This has been named as the bagging rule. Under this rule coins placed in a sealed bag or container saw the goldsmith treated as a bailee; storing them safely, with a fee charged for storage. On the other hand loose coins brought to the goldsmiths, were acknowledged as loans to the banker; the goldsmith was seen as a debtor, with the depositor holding the right to call upon their loan for repayment. By 1672 the practise of free loans (demand deposits) to the bankers had become widespread.

Since its early development, a fractional reserve bank free from regulation, performs an intermediary role. The bank recognises credit granted to it by depositors/holders of the banks notes, and makes the funds available for loans and investments. As confidence in the demand liabilities of the bank rises, the entire demand for MOE can be performed successfully by them, so all commodity money is withdrawn from circulation and left at the disposal of the bank. Stock equilibrium is reached at the point when the demand for the money commodity for non-monetary purposes (such as bank reserves; industrial/consumption purposes) is sufficient to absorb the surplus created by the use of bank notes. The size of the bank money stock, is determined by the demand to hold bank money at the new equilibrium rate. From this stage onwards, additional expansion of bank money will only appear viable as the aggregate demand for money balances expands. Under a free banking system, historically the banks have continued to demand commodity money for their reserves. This is to maintain a margin of error with regards to the redemption of an individual bank’s notes. Furthermore, banks will regularly send rival bank notes back to the issuer for redemption through the clearinghouse. By returning its rivals notes for redemption, the bank only gives up assets which earn no interest and in return, receive either its own notes (which protects it from unexpected redemption) or it’ll receive commodity money in the form of gold, which is more liquid and a risk-free asset.

On the subject of “created credit” it is agreeable that lending not backed by voluntary savings contributes to instability and financial crises. However, the distinction between transfer credit and created credit helps to illuminate the difference between warranted and unwarranted expansions of the inside money stock. Transfer credit is granted by banks in relation to people’s desire to abstain from current consumption by holding. Created credit on the other hand is generated regardless of any voluntary abstinence of spending. If the nominal supply of inside money is not reduced in tune with a fall in demand for holding money, then the credit is created, rather than transferred. Created credit can only exist in the short run; credit created leads to an adjustment of prices which (eventually) restores monetary equilibrium, causing all outstanding credit to adjust back to the aggregate demand. Since nobody holds inside money in excess of the balance he desires to hold, all credit under monetary equilibrium is transfer credit; meaning any referral to created credit, is the temporary expansion of the money supply due to excess bank lending or investment. Unlike operations  of credit transfer, created credit leads to disproportional activities in the production process. This artificial diversion of resources due to the “forced savings” of created credit is halted once prices adjust to eliminate the excess money supply. This expansion and credit creation, is the classic example of the boom-bust cycle; unwarranted expansion, followed by a contraction back to equilibrium. To give a further examination of the difference, credit creation arises when credit granted gives rise to bank liabilities being in excess of the demand for inside money balances. Transfer credit on the other hand, consists of credit granted which gives rise to liabilities in tune and consistent with the demand to hold inside money. It is on this topic that sadly many Austrian Economists fall flat on their theories; including unfortunately Rothbard and Mises. They viewed any credit not backed by 100% as unwarranted, but this would not be a form of credit; any “bank” holding 100% reserves on all its liabilities is not an institution that grants credit, it is merely a warehouse.

Another common argument against Fractional Reserve Banking; besides the “fraud” argument previously discussed with reference to the bagging rule, goes as the following: A warehouse storage on money is legitimate, a time deposit account is legitimate; a demand deposit account is neither a warehouse nor a time deposit. Therefore a demand deposit is illegitimate. This argument however, is based on what is known as fallacy of denying the antecedent, or fallacy of the inverse. It would be on similar lines to saying: a car has wheels and is transport, a bus has wheels and is transport; a train has no wheels, therefore a train is not transport. The difference is not that of kind, but is instead a difference in degree.

In a debate with Economist George Selgin, Robert Murphy makes the claim that it is Fractional Reserve Banking that makes bank runs possible, and that, under a 100% reserve system, bank runs can’t happen. This claim is extremely flawed however, because it looks at the matter backwards; bank runs are seldom unprovoked. This claim holds that banks fail because they are run upon; rather than the banks being run upon because they’re failing. Additionally, this concept insinuates that under a 100% Reserve system, it is not possible for banks to be run upon due to bad loan’s being invested in, poor management by banks of their policyholder’s money, or because of any other criteria which may lead to distrust of the banks. This almost seems like a use of Neo-Classical ‘General Equilibrium Theory’; that under such a banking policy, we must presume the banks to have perfect information and know the costs, desired outcomes, and time preferences of consumers; under such a theory we must presume already achieved states of equilibrium, and for bankers to be omniscient. Such presumptions and already known possibilities, removes the possibility of disequilibrium in the monetary sphere. This seems dishonest, due to the Austrians rejecting the general equilibrium theory of Neo-Classical Economics.

So if it is not fractional reserves which cause instability, cycles or bank panics*, what are the causes?

*A bank panic occurs when a run on the bank liabilities threatens the solvency of the banking system. They’re not only a cause for concern due to threatening the liquidity of the banks; leading to the public questioning the soundness of their medium of exchange, but additionally because they disrupt the information gathering functions of the financial sector. This type of panic raises the cost of credit, though an important distinction to be made is this increase in cost for credit is not accompanied by any increase in incentives to save or to expand credit. The resulting pressure on credit caused by the panic runs a real risk of causing a recession.

There are three schools of thought on banking instability:

(1) – The Bubble Explanation: Instability is caused by bank runs as random phenomena.

(2) – The Incomplete Information: Banking instability is due to bank runs, as rational responses by depositors who are imperfectly informed.

(3) – State Intervention: Suppressing the automatic stabilising mechanisms that evolve in the market; these suppressions can take the form of restrictions of note issue, restrictions of banks as intermediaries, state-mandated liability insurance, using the monetary system to raise revenue, and the lender of last resort.

The bubble explanation sees bank runs as speculative bubbles; underlying a mob psychology. The main characteristic of this, is prophecies are self-fulfilling – any factor that makes people anticipate a panic, will lead to a panic, however irrelevant the factor may be. This theory has the following explanation: (1) banks operate on fractional reserve banking and are unable to redeem all liabilities at once. (2) Banks are obliged to redeem on demand, and do so via a “first come, first serve” basis. (3) The public knows the banks cannot redeem all liabilities, and is concerned to avoid capital losses. As a result, depositors have an incentive to beat runs.

The incomplete information explanation states that bank panics are caused by the depositors’ lack of knowledge of the net worth of banks. This theory suggest that bank runs occur when depositors get noisy signals that suggest the banks are insolvent. The difference between this and the Bubble is that the indicators that cause the panic are relevant economically; they convey information – imperfect as it may be about the state of the banks. In the case of the bubble argument any variable can cause a bank run if it leads to depositors to anticipate a panic. The run of the Incomplete Information theory is “rational”, if relying on it ex-ante. This does not mean the speculation is correct; if it is correct that a bank is insolvent, then the bank run will have served a socially useful purpose by shutting down an insolvent bank. If the speculation is incorrect then it will lead to depositors shutting down a solvent bank.

“Free bankers do not deny that a bank may be run upon without state interference, but the theory differs from the other two by denying the banks fail because there are runs; free banking instead recognises the banks are run upon because they’re failing”

The regulatory explanation* explains that bank runs are caused by bad regulations of the banking system. The market would protect itself from bank runs if it were unrestricted, and allowed genuine market forces to operate and coordinate, but is prevented and stalled by outside, state-based interference. Free bankers do not deny that a bank may be run upon without state interference, but the theory differs from the other two by denying the banks fail because there are runs; free banking instead recognises the banks are run upon because they’re failing. There is imperfection in information, but free bankers state that these discoordination of signals; as well as most bank runs throughout history, are the cause of interference in the monetary system from the government, as well as the monopoly position and exemption from market restraints of central banks.

*The effects of regulations and central banking on stability and crises will be discussed in detail in the Bad Regulations and Central Banking sections.

On the subject of the history Free Banking holds, many countries throughout history operated on a free banking basis; Canada is the closest contrast to the American system of regulations and national banks prior to the Federal Reserve system; to keep close to Europe, Scotland was arguably the most successful system close to free banking.

The Scottish Free Banking era begins roughly around 1695 by an act of the Scottish Parliament; one year after the creation of the Bank of England. The Act gave the Bank of Scotland a legal monopoly over the issuing of notes and banking activities. While an act of legal monopoly may not seem like Free Banking, the Bank of Scotland thought its position safe; assuming Scotland could not accommodate more than one bank, and took no effort to renew its monopoly position when it expired in 1716.

Though the Bank of Scotland had an official sounding title, it was not treated nor recognised as a state institution. Larry White explains the details of this, stating that:

“The government neither did business with the bank nor regulated it. […] the act creating the bank prohibited its lending to the government, under heavy penalty.” (White 1995, p. 22)

White continues explaining the circumstances which lead to such arrangements:

“The crown of Scotland had been joined to that of England since 1603, and union of the parliaments was soon to in 1707. Shortly after the bank’s founding there would no longer be a Scottish government with which to become entangled. In London the Bank of Scotland was commonly suspected of disloyal Jacobite leanings throughout the early 18th century. The British Parliament therefore turned a deaf ear to the bank’s petitions against the chartering of its first rival, the pointedly named Royal Bank of Scotland, in 1727.” (White 1995, p. 23)

“The Royal Bank tended to dispatch agents to trade its notes for the notes of The Bank of Scotland, and would present large quantities of them for redemption; with hopes of embarrassing their rival. The Bank of Scotland retaliated in the same manner, but lost the game. It was forced to suspend payment in 1728, due to the continued conflict draining it of its reserves”

A rivalry between the two banks in Scotland began from day one of the Royal Bank opening for business. The Royal Bank tended to dispatch agents to trade its notes for the notes of The Bank of Scotland, and would present large quantities of them for redemption; with hopes of embarrassing their rival. The Bank of Scotland retaliated in the same manner, but lost the game. It was forced to suspend payment in 1728, due to the continued conflict draining it of its reserves. The bank made calls for its loans to be paid, a 10% call to its shareholders, and resorted to closing its doors for several weeks. This was not a single occurrence however, The Bank of Scotland had already faced suspensions; a run in 1704, which was sparked by rumours of revaluations of coin, forcing it to suspend for four months. While the bank was not insolvent, its assets were illiquid. It was at the time of this run that the bank set an important procedure, by announcing that all notes would be granted a 5% annual interest, which would be in effect during the period of a delay of payment to the bearer. This clause was called again for the eight month suspension in 1715, following a run during the civil unrest, and once more in 1728. During the suspension of 1728, a merger was proposed by the Royal Bank’s directors. However, the two sides were unable to reach an agreement in terms of how to value the Bank of Scotland’s stocks; providing historical evidence of the difficulty of securing a cartel of an industry. The competition between the two banks offered innovation in the banking industry. In 1728, the Royal Bank introduced the cash credit account, which was a form of overdraft. An individual applying for a cash credit account was required to provide evidence of sound character, and at least two co-signatories. Once the account was opened, the holder of the account could draw upon the whole amount or a fraction for personal or business transactions. There was interest charged on the account, but only in the event of an outstanding balance. The CCA lowered the cost of maintaining note circulation for the bank, by introducing more of the public to the use of notes. The account allowed an individual to borrow against his capital at lower costs; allowing him to take on productive endeavours that otherwise would have been unprofitable. The Bank of Scotland followed suit, by introducing their own CCA in 1729. The rivalry between the Royal Bank and Bank of Scotland began to come to an end in the 1740s. In order to counter the popularity of the Royal Bank among merchants in Glasgow, the Bank of Scotland granted a sizable cash advance to a partnership in Glasgow in 1749, for the purpose of forming the Glasgow Ship Bank. The partners promised to promote the circulation of the Bank’s notes. In an attempt to counter the promotion, the Royal Bank sponsored the founding of the Glasgow Arms Bank in 1750. In what was seen as a surprising move to the two banks in Edinburgh, the Ship Bank and Arms Bank began issuing their own notes; leading to the two Edinburgh banks to cease their feud. The Edinburgh banks chose to withdraw their credit from the banks in Glasgow, and stopped credit to any bank in Edinburgh or Glasgow which was circulating Glasgow notes. By 1756 the Glasgow banks proposed a geographical division of the Scottish market between the banks. However, to add more evidence to the difficulty of cartelisation, no agreement could be reached; allowing competition to be maintain in the industry. An important entrant into the banking sector was the British Linen Company. The corporation was chartered in 1746 to promote the linen trade. In 1747, the company’s directors began issuing interest bearing promissory notes, which would be used to pay its agents weavers, manufacturers and other customers. In 1750 it began shifting into the banking sector by issuing non-interest bearing notes payable to the bearer on demand. The Linen Company began to devote its time entirely to banking and withdrew from the linen industry; renaming itself to the British Linen Bank. The bank held a truly innovative role, by being the world’s first success with branch banking. By 1793 the bank had 12 branches in operation, leading to the British Linen Bank having the industries greatest note circulation in 1845. The entrepreneurial efforts of the British Linen Bank; from linen company to bank, showcases the innovative competition achievable under freedom of entry.

An important innovation in banking development, was that of bank-issued notes transferable by endorsement. Assignable notes gave way to fully negotiable banknotes assigned to no one in particular, but instead payable to the bearer on demand. A further development was the non-negotiable check, allowing the depositor to transfer balances to a specific party. Thus, at this time the modern form of inside money; redeemable bearer notes and checkable deposits are established. In England bearer notes were first recognised during the period of Charles II’s reign, it was around this time that warehouse banking was giving way to fractional reserve banking. Initially the courts reluctantly gave approval to the growing practice. Then after some controversy, fully negotiable notes were recognised by an act of Parliament.

While it may be argued no bank would accept a competing bank’s notes at par value, the reality is that banks hold more to gain from accepting foreign notes at par, as both a defensive mechanism to maintain their reserves, but also to attract more customers depositing and conducting business with them. Established banks that refused to take the notes of newly entering banks, or of established rivals soon had to change their policies, since the new banks would accept the established bank’s notes, and would drain their established rivals reserves; providing many an embarrassment for the banks who refused acceptance or par value, while the mentioned established banks were not offsetting their losses, due to not accepting at par. The rivalrous behaviour of banks accepting at par, causes inside money to become more attractive to use over commodity money. This is due to the fact that, since notes from one town are accepted at par value at a bank in another town, there is little reason and is seen as more convenient to carry notes, rather than lugging huge sacks of gold across towns and dealing with the large costs which would come from transporting gold. As George Selgin states:

“As par note acceptance developed during the 19th century in Scotland, Canada, and New England — places where note issue was least restricted — gold virtually disappeared from circulation. In England and in the rest of the United States where banking (and note issue in particular) were less free, considerable amounts of gold remained in circulation.” (Selgin 1988, p. 25)

The notes of Scottish banks, unlike that of Bank of England notes, could be issued into small denominations; though no notes smaller than £1 could be issued under the Act of 1765.

Contrary to the notion, Scottish banks were less at risk to counterfeiting, whereas counterfeiting of Bank of England notes was commonplace, especially in periods of suspension. The reason behind this is that the likelihood of counterfeiting going undetected coincided directly with the length of time a note circulated before being returned for redemption at the issuing bank. Scottish notes on average held a brief time of circulation, as rival banks would not hold the notes of competitors in their tills, but would return them through the clearinghouse for redemption. This was not the case for Bank of England notes, due to restrictions of note issue on banks in London, and the Bank of England’s notes acting as reserves for commercial banks. The six-partner rule as part of the Act of 1708, prevented England from experiencing strong join-stock banks similar to those based in Scotland.

The alarm in February of 1797 that an invasion from France was imminent, accelerated a draining outflow of gold which had already encouraged the Bank of England to restrict its discounts in 1795. This alarm led the Bank of England to suspend payments in specie on its notes. The suspension was approved by Parliament and was not lifted until 1821. While banks in Scotland were mostly exempt from ther drain, when managers received the news that London banks had suspended payment, the managers of the leading banks; the Bank of Scotland, Forbes, Hunter & Co, the Royal Bank and the British Linen Bank, met and came to the conclusion to follow the actions of the Bank of England and suspended payments. The reason for this, was that the Scottish banks feared, if they had made payment in specie available while the Bank of England maintained suspension, the English demand would have drained them of their reserves. It is theorized that the banks continued to quietly redeem their notes in Scotland for specie, handed to them by favoured customers.

The Free Banking era of Scotland came to an end with the passage of the Peel’s Bank Acts of 1844 and 1845. The Act further imposed the privileged monopoly position of the Bank of England, and suppressed freedom of note issue in the countryside, Ireland, and Scotland.

– Unstable Restrictions and Bad Regulations –

We have now shown in detail the history and theory of free banking, but what of an unfree system of money and banking? what are the effects of regulations on the banks?

While it may be argued that the biggest cause of instability are central banks, financial instability is not restricted to central banking. Bad regulations and restrictions can, and do, affect an economies stability.

While England gives a clear example of the instability of central banking, America (which until the Federal Reserve Act has been wrongly classed as free banking) provided clear examples of bad regulations.

While there were various “free banking” laws passed in the US between 1837 and 1861, the classification of these as “free banking” is facetious at best. State laws for “free banking” may have allowed for freer entry into banking, but they required banks to collateralise their notes by lodging them to state government bonds, which in turn tended to fall in value and not be very stable, and so bank portfolios would be stuffed with state bonds not worth their salt. This is in combination to the fact that many state governments restricted branch banking and outlawed notes that gave the issuing bank an option to delay redemption; or an options claws. In short the American “free banking” experience could be summarised as a free entry ticket into quick sand: you can enter for free, but it’s highly volatile with very little benefit.

“Interstate and Intrastate banking laws (Unit Banking) – restrict banks to operate only within the state or county they are chartered; limiting the banks’ economies-of-scale and their ability to branch out; the benefit of not restricting these would be the diversification of capital portfolios to limit the risk of failures, and withstand a crises”

The United State held two consistent regulations which had a huge effect on its financial instability; one being eluded to above, namely a restriction on branch banking.

Interstate and Intrastate banking laws (Unit Banking) – restrict banks to operate only within the state or county they are chartered; limiting the banks’ economies-of-scale and their ability to branch out; the benefit of not restricting these would be the diversification of capital portfolios to limit the risk of failures, and withstand a crises. American Glass-Steagall Act – The Glass-Steagall Act separated commercial banks from investment banks; prohibiting deposit-based institutions from engaging in investment securities, and investment-based institutions from issuing deposits. It was introduced with the belief that the combination of these institutions was a contributor to the banking collapse of the 1930s, but the restriction actually increases the risk of bank failure, because the banks are restricted in their ability to diversify their portfolios.

Another is that of a restriction on the issuing of bank notes. Restrictions on the note issue are potentially destabilising because they interfere with the mechanisms by which the free market can correct a deposit run; we remember, a deposit run is simply a run for bank notes, not a note run, in which the public is running to redeem their notes for the MOR. A monopoly lender of last resort can be destabilising, because it removes the automatic check on over-issue; the note-clearing system, which would have arisen spontaneously had the note issue not been monopolised and restricted.

Economist Kevin Dowd comments on the increased risk of deposit runs after the American civil war; stating that:

“After the Civil War the note issue was effectively cartelised under the National Banking System and banks of issue were subject to various limits on their note issues. Deposit runs were very frequent but the banks’ ability to deal with them was limited. These runs usually lead to suspensions.” (Dowd 1989, p. 33)

It’s not just regulations which can have negative effects on the monetary system. State interventions, combined with bad regulations, tend to have the effect of inducing instability and bad incentives for maintaining said instability.

State Sponsored Liability Insurance is a perfect example of this. While they protect banks against runs in the short run, in the long run they have the side effect of encouraging policies and bad incentives which are more likely to produce failure, due to the fact that big risk taking banks pay the same premiums as those that pursue safer policies.

The two primary arguments in favour of interventionism in the money and banking sphere are:

(1) Confidence.

(2) Information.

The Confidence Externalities Argument for State Intervention: This argument for state intervention in the monetary sphere takes the basic stance of: Government intervention is necessary to increase insufficient confidence levels that would be provided under a free market in banking. This argument can refer to either a single bank or the banking system as a whole. It runs against the fact the banks, as private establishments have every incentive to promote confidence. Each bank will recognise that, if it does not maintain confidence, it will face greater risk of a run; at beast, forcing it to borrow liquidity, or use its option clause to give it time to liquidate assets to gather the proper funds to meet demands to cash out; at worst, it will be driven out of business. Given this, there is no a priori argument for why a bank will take insufficient measures to promote confidence. Either way if this argument is true it proves too much. If it justifies the suppression of competition within the banking system, then it may justify suppression of competition among other industries which rely on competition; such as insurance, healthcare, broadband, commercial airlines etc.

The Information Externalities Argument for State Intervention: This argument for state intervention states that a competitive banking system would impose large information requirements. It argues that the uniformity of money is a public good, which reduces the information burden; with the conclusion that the government must suppress the varieties of money that would arise under competition. This argument, like the former asks too much, and could apply to any good or service. It can be equally argued against a variety of products or brands. It is simply the argument that too much choice makes life difficult, and should be suppressed by government decree, with the government choosing for its ‘subjects’.

There are many issues for when Governments intervene in the monetary sphere, the two primary issue however are:

(1) The establishment of a central bank to act as a lender of last resort (LLR),

(2) The establishment of state-sponsored deposit insurance.

The LLR role of the central bank – according to proponents – is to provide liquidity to banks who otherwise cannot obtain it. Since the LLR role is meaningless to a good bank; as they can almost always obtain loans to maintain liquidity, LLR protects bad banks from the consequences of their own high-risk investments, over-expansions and lack of confidence from its clients. This leads to central banks encouraging the very instability they claim to be set up to keep under control. It also affects the market in a less obvious manner. Since the LLR role of the monopoly bank tries to keep weaker, less stable banks open, the very existence of LLR reduces the incentives for good banks to build up their customer base, diversifying their portfolio, and generating higher confidence in anticipation of winning the bad banks market share. That competitive aspect of banking relies on weaker, less sound banks facing ruin, and this aspect cannot yield much pay-off if the over aggressive banks are to be bailed out under a LLR. The LLR leads to circumstances where even good banks may act more aggressively in their lending and take more, high-risk investments that weaken the confidence of its client base. As stated above, the irony of the lender of last resort role is it can produce the very instability its proponents claim would otherwise occur without a central bank. The sad reality is, the central banks LLR role could be falsely seen as the cure to financial instability; unfortunately, it often is. Deposit insurance has similar, negative incentive effects. DI leads to depositors being less scrutinising of the banks activities and its management; managers see this and no longer need to worry about maintaining confidence. A rational response from a bank would be to reduce its capital, since one of the main roles of maintaining capital of high strength; to maintain confidence of its depositors, no longer applies. Even if a good bank wished to maintain the high strength of its capital, it would be beaten by bad banks acting on bad incentives who cut their capital ratios to reduce their costs; the fight for shares of the market, would force ex-ante good banks to imitate the bad. State-mandated deposit insurance therefore turns strong capital positions and client confidence, into competitive liabilities and waste.

A final note to make, is on the topic of contagions. Proponents of State involvement look to the nation-wide panic in America during the 1930s. However, these panics were not occurring due to a lack of regulation; on the contrary, they occurred because of regulation and State involvement. The runs which occurred throughout the 30s were due to fears that FDR would devolve the dollar, alongside speculation; prompted by the Governor of Nevada, that the other States would issue bank holidays; if people in one State see another’s governor issuing a bank holiday in which redemption is void, they will begin to speculate and fear similar actions by their own States.

As Economist George Selgin notes:

“Contagion effects also appear to have played a more limited role than is usually supposed during the “Great Contraction” of 1930 to 1933. Prior to 1932, bank runs were confined mainly to banks that were either pre-run insolvent themselves or affiliates of other insolvent firms […] Serious regional contagions erupted in late 1932, but these were aggravated if not triggered by state governments’ policy of declaring bank “holidays” in response to mounting bank failures […] The truly nationwide panic that gripped the nation in the early months of 1933 appears to have been more a run on the dollar than a run on the banking system, triggered by rumors that Roosevelt intended to reduce the dollar’s gold content […].” (Selgin 2015, p. 25)

The combination of reserve requirements, anti-branching laws and restrictions on note issue fostered the panics of America’s National Banking era, as these prevented banks from issuing additional notes to meet growing demand to hold, or effectively mobilising reserves to meet demands; instead these regulations promoted interbank scrambling for base money. Looking at Canada as a contrast to the US; as Scotland was to England, gives us further indication that regulatory restrictions were fundamental in fostering panics, since Canada had a large absence of panics and lacked the restrictions found in the US.

– History and Instability of The Bank of England –

The most malevolent means for a Government to hold control over the monetary sphere, outside of regulations, is through that of a Central Bank. If the United States gives us examples of the instability of regulations and interventions, England gives us an old history of monopolisation and financial instability under central banking. Indeed, the two things which perpetuate State power the most, are financial crises and wars; a Central Bank helps the State in financing the latter and (to give benefit of the doubt; unintentionally) enacting the former.

History shows many examples of governments seeking to use the banking system to raise more revenue. An example of this is in Britain from the period of 1793-1797, in which the government needed funds in order to wage a war with France, so it pressed the Bank of England for loans. These ended up depleting the Bank of its reserves, and when rumours in 1797 of French invasion surfaced, it caused a run on the Bank that it did not have the resources to withstand. This lead the government to stepping in, in order to save the Bank from failure, by relieving it of its obligation to redeem its notes for gold. The early history of the Bank of England can be summed up as a series of purchases of privileges by the Bank from the Government. Originally, the Bank made a loan to the Government of £1,200,000 for William III’s war with France, in return for the right to issue notes to the same amount. This fixed amount was extended in 1697, when it was argued that the Bank should enjoy a monopoly of chartered Banking in England, and the privilege of limited liability for its shareholders.

This privilege is expanded on by Economist Kevin Dowd. Dowd comments on the privilege over monopoly of note issue; stating that:

“[An] example of destabilising restrictions on the monopoly note issue is provided in the 1844 Bank Charter Act in the UK. This act gave the Bank of England an effective monopoly of the note issue, but it also divided the Bank into an Issue Department (responsible for the note issue) and a Banking Department (responsible for the rest of the Bank’s business), and these two departments were to be entirely separate from each other. […] The effect was to leave the Bank wide open to deposit runs since the Banking Department had no access to additional notes (or specie, for that matter) if it were faced with a run on its deposits. This created the absurd possibility that the Bank of England might default on its obligations to redeem its liabilities despite the fact that the vaults of the Issue Department were full of gold. Three times subsequently – 1847, 1857 and 1866 – the Bank was faced with such runs […].” (Dowd 1989, pp. 32-33)

In order to obtain proper context of the Bank of England, we require going back ex-ante its establishment, as well as ex-post its monopoly roots reaching into the core of money and banking.

The origin of modern banking can be traced back to around the middle of the 17th century, when merchants took up depositing their MOE with goldsmiths. In order to expand their operations, the goldsmiths began offering interest on deposits; the receipts they issued out for deposits would begin to circulate as a good alternative to lugging around heavy bags of bullion; this is what would lead to the paper receipts becoming IOU’s, or debt-instruments. Banking development took a change towards more centralised and monopolised methods around 1694, by events of purely political nature. King Charles II had run himself into considerable debt via relying on loans from the London Bankers, and 1672 Charles II suspended payments, and the repayments of bankers advances. This caused the King’s credit to be thereby ruined for several decades. This lead to William III and his Government to follow the scheme of a financier, named Patterson for the founding of an institution known as the Governor and Company of the Bank of England; later to be known as it is today as simply the Bank of England. The early period of the Bank of England’s origin was summarised by a series of exchanges of favours between a needy government and a corporation more than happy to accommodate. The BoE was founded with a capital accumulation amounting to £1,200,000, which was immediately lent to the government; in return, the BoE was authorised to issue notes of the same amount. In 1697 the government renewed the BoE’s charter, along with extended privileges; allowing it to increase its capital stock, and thereby its note issue, in addition to providing it the monopoly possession of government balances, via the order that all sums due to the government (taxes), must be paid through the BoE. Furthermore, a clause in the Tunnage Act provided limited liability to the members; this favour was to be denied to all other banking associations for over a century, giving the monopoly bank not only a great degree of privilege, but a “head-start”. Further grounding in the BoE’s monopoly and privilege was established in 1709 when the Bank’s charter was renewed once more. In addition to allowing it to raise its capital in return for a loan to the government, the Act decreed that no firms of more than six partners may issue notes payable on demand less than six months; this decree excluded joint stock banks from issuing their own notes. There were further renewals of the BoE’s charter which reaffirmed its privileges, accompanied loans and increase in capital and note issue in 1713, 1742, 1751, 1764, 1781 and 1800. To put it briefly, the Treasury had benefitted from the BoE’s monopoly position no less than seven times. Soon after the French war broke out, Pitt requested advances from the BoE. However, the 1694 Act had prohibited advances to the government without direct authorisation from Parliament; though for many years small amounts had been advanced on Treasury Bills made payable at the Bank. In 1793 the BoE applied to the government to indemnify it against liability of loans made in the past, and give it legal authority to carry out transactions in the future. Pitt agreed to bring the Bill to Parliament, but conveniently left out a limiting clause, leading to the Bank becoming compelled to complying with government requirements of any amount. By the period of 1795, these borrowings had reached such an excess that it affected the foreign exchanges, and endangered the BoE’s reserves; leading to the Bank’s directors to plead with the government to keep its demands down. Finally, in 1844, an Act was passed which ensured the Bank of England held monopoly of the issuing of notes in the country.

Many proponents of central banking would point to the British journalist and essayist Walter Bagehot and his famous book Lombard Street as argument for the existence of the Bank of England; stating that Bagehot called the Bank’s primary responsibility to be a lender of last resort, in order to ensure financial stability.

The problem with such an argument is that Bagehot’s call for the Bank to operate as a LOLR, was not out of belief that a central bank is necessary, but because he saw it as the only viable option to ensure the Bank of England performed as little damage as possible; that if a nation finds itself stuck with a monopoly bank of currency, it is to act in this way but that nations should not aim to establish such a bank in the first place.

We can see proof of this, anti-central bank position by simply reading straight from the source:

“In consequence all our credit system depends on the Bank of England for its security. On the wisdom of the directors of that one Joint Stock Company, it depends whether England shall be solvent or insolvent. This may seem too strong, but it is not. All banks depend on the Bank of England, and all merchants depend on some banker.” (Bagehot 2009, pp. 19-20)

Bagehot continues by stating that:

“The result is that we have placed the exclusive custody of our entire banking reserve in the hands of a single board of directors not particularly trained for the duty – who might be called ‘amateurs’, who have no particular interest above other people in keeping it undiminished – who acknowledge no obligation to keep it undiminished who have never been told by any great statesman or public authority that they are so to keep it or that they have anything to do with it who are named by and are agents for a proprietary which would have a greater income if it was diminished, who do not fear, and who need not fear, ruin even if it were all gone and wasted.” (Bagehot 2009, pp. 22-23)

“We are so accustomed to a system of banking, dependent for its cardinal function on a single bank, that we can hardly conceive of any other. But the natural system – that which would have sprung up if Government had let banking alone – is that of many banks of equal or not altogether unequal size.” (Bagehot 2009, p. 33)

Here Bagehot makes the remark on not returning to a system of competing banks of issue; not due to the superiority of the Bank of England, but due to the belief that no one would listen to him if such a call was made, as well as how the Bank should behave as a second best to it not existing at all:

“On this account, I do not suggest that we should return to a natural or many-reserve system of banking. I should only incur useless ridicule if I did suggest it.” (Bagehot 2009, p. 34)

“I can only propose […]. There should be a clear understanding between the Bank and the public that, since the Bank hold out ultimate banking reserve, they will recognise and act on the obligations which this implies; that they will replenish it in times of foreign demand as fully, and lend it in times of internal panic as freely and readily, as plain principles of banking require.” (Bagehot 2009, p. 35)

Walter Bagehot makes his final remarks here on how impossible it seemed to do away with the Bank of England; equating it to being easier to imagine the abolition of the Monarchy:

“I have tediously insisted that the natural system of banking is that of many banks keeping their own cash reserve, with the penalty of failure before them if they neglect it. I have shown that our system is that of a single bank keeping the whole reserve under no effectual penalty of failure. And yet I propose to retain that system […] I can only reply that I propose to retain this system because I am quite sure that it is of no manner of use proposing to alter it […] You might as well, or better, try to alter the English monarchy and substitute a republic, as to alter the present constitution of the English money market, founded on the Bank of England, and substitute for it a system in which each bank shall keep its own reserve.” (Bagehot 2009, p. 144)

If one were to look at the shaky ground the English Monarchy has found itself in recent years with questions about its future, it can only be hoped that the British public will soon begin to question the validity of the Bank of England.

History shows not only the financial crises and major restrictions of regulations mentioned previously, but also those of central banking.

Below we see a historical record of financial crises and major restriction from the period of 1793 – 1933; the record shows America and England with their free banking counterparts, Scotland and Canada. An x indicates a crises for that period, and a black square indicates major restrictions enacted.

Source: George Selgin 2015, pp. 196-197 [condensed]. In reference to Bordo “Financial Crises”, Schuler “World History”, Schwartz “Financial Stability”.

Here we can see that the systems of high regulations, restrictions and monopoly of currency far out-performed for the grand prize of most crises riddled system than their free banking counterparts; not a good achievement to say the least, but an achievement none the less.

Under a central monopoly bank of issue system, as opposed to a free banking system of competitive note issue, things are radically different, due to the monopoly bank’s notes acting as reserves for the commercial banks, with the commercial banks issuing central bank notes, and are prohibited from issuing their own. In order to pay out notes to customers, a bank must acquire the notes in the interbank market, or from the bank of issue. If no additional notes are made available, then reserves become deficient and the banks must perform a contraction of their liabilities to avoid a default. In this scenario the supply of loanable funds is constrained, and lending rates rise above equilibrium, which then leads to a scarcity of credit, despite individuals’ demand to hold having seen no change. If the monopoly bank provides the desired reserves then a credit shortage is prevented. However, there is no certainty that the central bank will cooperate. Even if said central bank were to do so, there is no certainty that the notes issued for emergency purposes will be retired once the public no longer demands them. Unless such a precaution is taken, the surplus notes could return to the deposit banks, leading to them serving as the basis for inflationary expansion of bank credit.

Negative effects of central banking continue into the realm of deflation. In economics there is a distinction between good deflation and bad deflation.

Good deflation occurs due to an increase of productivity and reduced cost of production; leading to supply shifting to the right, and prices falling. This kind of deflation has a tendency to be relative; meaning certain industries such as computers, cars, crops or (in a parallel universe for Britain) housing.

However most central bankers don’t (or can’t) make the distinction between good and bad deflation.

A shortage in the money supply below that demanded, will lead to deflation; with reduced sales leading to production cutbacks in certain sectors, followed by reduced demand for the products of other sectors and finally to general unemployment. This is the bad kind of deflation which is not caused by productivity; either in a particular sector or the economy as a whole. Unfortunately, central bankers persist in regarding all deflation as the bad kind.

To add further setback to the general understanding of deflation, many Austrian Economists* persist in insisting that there is no such thing as bad deflation, and that all deflation is good. This perspective very much comes across as merely contrarianism; simply looking at the central bank’s view of deflation and frantically insisting on the opposite as a fact, when in reality the fact is based on a difference of degree.

In addition to what can be classed as “Young Austrians” and “Rothbard Fans” rather than readers.

What is the method to the madness? Why and how does the government benefit from a central monopoly bank of currency? For an answer we need to look at Siegniorage.

Siegniorage is the concept that governments reap the profits from producing new money at an expense less than the value of the money produced. The government is then able to finance additional expenditure by spending the new money into circulation. If the new money is interchangeable with the old, then an expansion of the stock of money taxes money holders by reducing the value of already established money balances (i.e. inflation). Under a specie standard of gold or silver, siegniorage was the differing value of minted coins and the actual content of gold/silver in them. This minting process, algebraically was subject to the following accounting identity:

M = PQ + C + S.

Where ‘M’ is the nominal value assigned to a batch of coins (e.g 100 pounds) ‘P’ is the nominal price paid by the mint per ounce, ‘Q’ is the number of ounces of precious metals embodied in the coins, ‘C’ is the remaining average cost of operating the mint, ‘S’ is the nominal siegniorage.

Modern banking and monetary systems do not operate under a specie system though, so how does siegniorage operate under a fiat system? Since the bullion content is 0 and production costs are close to 0, we need to set Q as Q=0; to further simplify we’ll set C as C=0. This follows that M=S. Nominal siegniorage equals one pound for each pound produced. Therefore a government’s siegniorage per year is equal to the change in the money stock. This can be written as:

S = ^H

Where ^ (delta in Greek) indicates the change in H, which is the stock of base money. Real siegniorage is marked as:

s = ^H/P

Where the lower case represents deflated variables, and P is the price index.

The budget constraint for a government that issues fiat money is:

G = T + ^D + ^H

Where G is government spending and T is tax revenue. ^D is the change in interest-bearing debt held by the public and not government. ^H is the change in non-interest-bearing debt (base money) held by the public.

The financing benefits to government via siegniorage is obvious when it comes to the mere printing of money. Via the method of open market operations, the method is a bit more indirect. By purchasing ^H worth of bills in the open market, the central bank retires that much debt; with the interest going to the central bank, and makes it possible for the treasury to finance a host of new streams of spending, whose current value is equal to ^H. In order to conduct the new spending in the current period, the treasury sells new debt to the public, replacing the debt which the central bank bought. The central bank’s open market purchase expands H and contracts D. The treasury’s issue of new debt sees D rise back up, followed by a rise in G. The overall impact is an increase in G financed by ^H; just as if the central bank had simply printed new currency and given it to the government to spend.

Vera Smith sums up the potential of central banks for governments in a statement from her book The Rationale of Central Banking:

“[…] it must be admitted that it is almost certain that by far the most powerful reason leading to the maintenance of Government intervention in the banking sphere, at a time when it was on the decline in other industries, was that power over the issue of paper money, whether such power is direct or indirect, is an exceedingly welcome weapon in the armoury of State finance.” (Smith 1990, p. 9)

– Bygone Gold Standard – The Possible Future of Free Banking –

As the final section I wish to present to the reader the following hypothesis:

Many supporters of free banking have suggested we would require returning to a gold standard, or keep a small remnant of the central bank if we retain a irredeemable fiat system.

The argument mentioned above goes along these lines:

If we were to return to a free banking system of competitive banks issuing their own notes, we would have to return to a gold standard in order to have the currency anchored to something. Irredeemable IOU’s would provide too much risk for financial instability. If we cannot return to a gold standard, then in order to have something like a free banking system, we would have to keep some degree of central banking, but get rid of the discretionary power to manage the monetary standard.

I propose that thanks to the technological developments of the past 10 years, a return to the bygone gold standard is not necessary; nor is maintaining a remnant of a central bank of monopoly issue.

“the fiat system should be converted to a crypto format of pound sterling, with scarcity artificially built and coded into the outside money and MOR. The new crypto-based outside money and MOR, would be obtained alongside the banks issuing their own debt instrument”

The proposal goes as follows:

Maintaining the MOA and UA as pound sterling, the fiat system should be converted to a crypto format of pound sterling, with scarcity artificially built and coded into the outside money and MOR. The new crypto-based outside money and MOR, would be obtained alongside the banks issuing their own debt instrument; IOU’s on a fractional reserve, with no floor restriction on how small denominations may be, with redeemability of the crypto MOR being transferred to a customer’s private wallet should they call upon the bank to pay the bearer on demand; an option clause would remain in place with interest to be pay of 5% should the bank require time to redeem.

It may be argued that such a proposal is not needed, because we have Bitcoin.

While I am a fan of Bitcoin I don’t think it is up to the task, due to its high volatility, and because I don’t think Bitcoin maximalists actually know what they want it to be when they say “Bitcoin can be the new money”.

The typical counter from Bitcoin maximalists on the subject of volatility is “if you think Bitcoin is volatile you should see the fiat money. What about that? Why not criticise government money?”

My response would be simply I have criticised State centralised, monopolised, irredeemable money throughout this piece, and this argument is simply Whataboutism; a variant of the tu quoque fallacy. The response to criticism of volatility being “look what the other guy’s doing” is not an argument nor a solution.

On the point of Maximalists not knowing what they want, I refer to the case that, the demographic in question tend to not make a distinction and other times will blend terms together.

“We need a Bitcoin standard” Well this a loaded statement. What is meant by it? Are we looking at Bitcoin as a future medium of exchange, medium of account, unit of account, medium of redemption, or a blend? If we are looking at Bitcoin being a MOE, then it would simply act as a base money with the UA remaining as pounds, dollars etc. If we are looking at it being a MOA, then we are going to have some extortionately high costs. It’s not cheap or of no cost to change the account medium or the unit; excessively large amounts of time would be the price for accounting how much x quantity of a good is worth of y unit; it would not be a simple difference of “2+2=4” and changing it to “2×2=4”, it would be as if creating an entirely new number; the time and costs of figuring out what is less, what is more, and what it equals when correlated with other numbers.

This does not mean Bitcoin or any other cryptocurrency cannot or should not play a role in the proposal. It is entirely possible that an individual bank could issue Bitcoin as an alternative medium of redemption, should it find itself unable to redeem in crypto pounds.

To get back to the matter, what of the banks’ individual debt instruments? Crypto is entirely digital so how would banks issue IOU’s?

in the crypto sphere there is what is known as paper wallets. These are essentially slips of paper with QR codes which keeps track of the currency a person holds, which can be redeemed into their private wallets via scanning the QR code.

Bank IOU’s would function in a similar manner to that of paper wallets, and the debt instruments issued by various banks during the Scottish free banking area.

Above we see some basic designs to provide an idea for how these bank IOU, “paper wallets” could be presented.

The banks would issue debt instruments with their logos printed on to the slips to better advertise their services in the hopes of raising demand for their notes; just as banks in a free banking system would do. These notes would be issued to customers after making a deposit of crypto pound sterling (from this point we’ll refer to it as CPS); unless the account created is a time deposit, the deposit will be treated as a loan to the bank, with the bearer having the right to call upon the bank for redemption and for the bank to make payment upon its debts. This method of redemption would function on the same grounds as it does with paper wallets in the crypto sphere. When the debt instrument is brought for redemption, the QR code will be scanned and the CPS electronically transferred to a customer’s private wallet.

When it comes to the velocity of the bank notes, the transferring of notes would work the same way it does today and during the Scottish free banking era. Notes used for financial exchanges, after the settlement is made, can be deposited at the recipient’s bank, spent further, or redeemed at the bank of issue for CPS.

If an individual bank were to over expand beyond the demand to hold its notes, the same equation mentioned previously would occur:

Leading to the same outcome when over issued notes are brought for redemption by the public, or at the clearinghouse:

What about coins? There are many instances where small change is needed for transactions, would small denominations of coins remain or would the smallest be notes of £1?

To answer simply, yes denominations smaller than £1 would remain; in either the form of coin or, if an individual bank’s customers held a demand for smaller denominations but held a preference for notes, the bank could issue notes of 50 pence, 20 pence, 10 pence etc.

We’ll assume a similar case to that of our current one with the exception of £1 notes existing.

Denominations smaller than £1 would be conducted as minted coins, tow which either the banks would mint their own with the ability of redemption in small denominations of CPS (or small “p” for crypto pence; Cp), or independent minters would provide said coins for circulation; similar to what occurred with the Birmingham Button Mints.

These coins would not necessarily have to be minted from silver but could be simple plastic tokens as, the material they’re made from would not be of great importance.

These coins, like the notes displayed above, would hold a QR code raised on the coins similar to that of braille. When used in a machine for payment such as parking, the raised QR code would be scanned to assess what denominations are being entered; alongside ensuring the braille-like QR code is unique to the denomination in question and is not a counterfeit.

Depositing the small coins and redemption would work the same way as the notes. The code would be scanned and the MOR would be transferred to the customer’s private wallet; in the case of depositing into the bank, it would be managed in the same manner with the balance being issued and credited to the customer’s account.

Who would “mine” the CPS?

Banks themselves would not mine for the CPS, this venture would be handled by private coders being commissioned to produce the CPS; receiving a percentage as payment based on hash rate and proof of work, as is similar to how miners are compensated in the crypto sphere. It is unlikely banks would find an attraction to mining themselves, due to the difficulty of obtaining results the closer a cryptocurrency reaches its scarce limit, as well as the costs of maintaining their own resources for mining and coding, due to requiring high powered technology for efficient hash rates. It is therefore more plausible that the banks and minters would find it more efficient to shop around; find high quality miners who have good track records and contract them for their work and offer a percentage of the coins mined as compensation.

– Final Thoughts –

While this proposal is a short one and more work is certainly needed to expand further details, it should be clear that cryptocurrency technology offers a viable method of abolition central banking without reinstituting a bygone gold standard. We have the technology, we know it’s possible to encrypt scarcity into cryptocurrencies, and it does not require the high costs and delays of changing the MOA or UA. Under such a system it is more likely and probable of getting government out of money and banking; learning from the more free systems of the past, and developing a more private, competitive and free monetary system.

– Sources –

  • Dowd, K 1989, The State and the Monetary System, St. Martin’s Press, New York (pp. 8-9)
  • White, L 1999, The Theory of Monetary Institutions, Blackwell Publishers, Oxford (pp. 54 – 61)
  • Selgin, G 2015, Bank Deregulation and Monetary Order, Routledge, New York (pp. 19-21)
  • Selgin, G 1988, The Theory of Free Banking, Rowman & Littlefield, New Jersey (p. 20)
  • Selgin, G 2015, Bank Deregulation and Monetary Order, Routledge, New York (p. 99)
  • Selgin, G 2015, Bank Deregulation and Monetary Order, Routledge, New York (p. 61)
  • Selgin, G 1988, The Theory of Free Banking, Rowman & Littlefield, New Jersey (pp. 60-62)
  • https://www.cato.org/blog/bagging-rule-or-why-we-shouldnt-arrest-all-bankers
  • Does Fractional Reserve Banking Endanger the Economy? A Debate, (2018), YouTube video, added by ReasonTV [online]
  • White, L 1995, Free Banking in Britain, Institute of Economic Affairs, London (pp. 22-23)
  • White, L 1995, Free Banking in Britain, Institute of Economic Affairs, London (p.24-26)
  • Selgin, G 1988, The Theory of Free Banking, Rowman & Littlefield, New Jersey (p. 25)
  • Selgin, G 2015, Bank Deregulation and Monetary Order, Routledge, New York (p. 62)
  • White, L 1995, Free Banking in Britain, Institute of Economic Affairs, London (pp. 41-42)
  • White, L 1995, Free Banking in Britain, Institute of Economic Affairs, London (p. 85)
  • Selgin, G 2015, Bank Deregulation and Monetary Order, Routledge, New York (pp. 30-31)
  • Dowd, K 1989, The State and the Monetary System, St. Martin’s Press, New York (p. 33)
  • Dowd, K 2014, Money and the Market, Routledge, New York (p. 21)
  • Selgin, G 2015, Bank Deregulation and Monetary Order, Routledge, New York (p. 25)
  • Dowd, K 1989, The State and the Monetary System St. Martin’s Press, New York (pp. 32-33)
  • Smith, V 1990, The Rationale of Central Banking, Liberty Fund, Indiana (pp. 9-21)
  • https://www.bankofengland.co.uk/markets/bank-of-england-market-operations-guide/our-objectives
  • Bagehot, W 2009, Lombard Street, Seven Treasures Publications, United States (pp. 19-20)
  • Bagehot, W 2009, Lombard Street, Seven Treasures Publications, United States (pp. 22-23)
  • Bagehot, W 2009, Lombard Street, Seven Treasures Publications, United States (p. 33)
  • Bagehot, W 2009, Lombard Street, Seven Treasures Publications, United States (p. 34)
  • Bagehot, W 2009, Lombard Street, Seven Treasures Publications, United States (p. 35)
  • Bagehot, W 2009, Lombard Street, Seven Treasures Publications, United States (p. 144)
  • https://www.bankofengland.co.uk/knowledgebank/what-is-deflation
  • Selgin, G 2015, Bank Deregulation and Monetary Order, Routledge, New York (p. 112)
  • Selgin, G 2015, Bank Deregulation and Monetary Order, Routledge, New York (p. 145)
  • White, L 1999, The Theory of Monetary Institutions, Blackwell Publishers, Oxford (p. 39)
  • Smith, V 1990, The Rationale of Central Banking, Liberty Fund, Indiana (p. 9)

Image: https://unsplash.com/photos/WgUHuGSWPVM

The Anti-Free Trade Position Returns

Protectionism, Mercantilism, and the Denial of Consumer Sovereignty

Image: https://pixabay.com/photos/container-goods-ship-porto-4675851/

Opinion Piece by Josh L. Ascough

On the 21st June, 2021, Labour MP Emily Thornberry appeared on BBC radio 4, insisting that the government must cease the lifting of protections in place for British Steel; stating that:

We have to stop this government lifting the protections that steel has at the moment, because if we don’t, then we could end up with cheap steel being dumped in this country and it being the end of the steel industry.”

Throughout the Free Trade talks with Australia as well, farmers unions have been demanding for greater protections to be in place, with suggestions of restrictions on the number of meat produce that can be imported into the country, while allowing the free export of British meat.

One has to ask whether we’re seeing a return to Protectionism and Mercantilism.

In a sense the UK has never truly abandoned fallacious positions of trade. The British Steel industry has a history of bail outs and subsidies; in 2019 the government issued British Steel a £300 million bailout. In the same year, it received £43 million in subsidies.

But what is Protectionism, and what is Mercantilism?

Protectionism is idea that government must implement policies that restrict international trade, with the guise of helping domestic industries, and protecting consumers from making “harmful” choices.

Mercantilism is an economic policy designed to maximise the exports of the nation and minimise the imports to said nation, via regulations, tariffs, and to a degree outright bans of imports for certain goods.

On the surface there is very little difference between the two positions, as in the end both stifle competition and offer privileges to protected industries.

The conclusion from many Protectionists and Mercantilists is to issue tariffs on foreign imports, and offer subsidies to national industries in order to avoid a trade deficit, and have fair competition.

“domestic consumers face the costs of these tariffs, as they find the goods and services they wish to buy cost more; thereby reducing the consumers standard of living”

Tariffs however, hurt a nations consumers. While the country’s government in question may issue tariffs for the purposes of protecting domestic industries and consumers from apparent “dumping”, the domestic consumers face the costs of these tariffs, as they find the goods and services they wish to buy cost more; thereby reducing the consumers standard of living.

The issue of subsidies has a similar effect on consumers. A subsidy at the end of the day is a tax, and by extorting from consumers in order to prop-up a domestic industry, you’re reducing their expendable income.

The area Protectionists wish to avoid however, that of a trade deficit, is fallacious at best. The trade deficit myth looks at purely the flow of financial capital from one nation to another, yet it fails to look at why money is flowing and what those who transferred capital received in return; that being, the goods; whether that be goods of higher order for the purposes of more efficient production processes, or lower order goods (final goods: consumer goods). The problem with the concept of a trade deficit is, it answers too much: If more money via trade flowing from one country to another, while disregarding the goods received is a serious issue, then we must also look at the trade deficit between England and Scotland; or London and Oxford.

“the trade deficit doctrines logic, I have a trade deficit with the hobby business, Games Workshop. Over the course of 10 years, I’ve probably given £50,000 to the company. We have to ignore the products I received in exchange”

By the trade deficit doctrines logic, I have a trade deficit with the hobby business, Games Workshop. Over the course of 10 years, I’ve probably given £50,000 to the company. We have to ignore the products I received in exchange, and all the subjective value I attained from these goods, and time spent utilising them; we should only look at the movement of money. I need to issue quotas against Games Workshop of how many goods they’re allowed to sell me, in order for the payments between me and them to equalise.

The ends which Protectionists wish to reach, is that which they loosely label “fair competition”. The problem is, their concept of fair competition is not only far from any meaning of fair; as it requires the protection of some industries and barriers in place of others, but, also that the fair competition doctrine is very similar to the idea of perfect competition.

The theory of Perfect Competition is the state of affairs, where there are a certain number of buyers and sellers, selling (buying) the same quantities for the same price. The question that arises is; where is the competition?

The market is not a state of affairs; it is a process of discovery. To get right to the core of the problem with this doctrine, via the perfect competition doctrine, you rule out the possibility of the entrepreneur discovering an absence of information that is held by consumers and his competitors. Under the perfect (“fair”) competition doctrine, it is attempted to maintain what could be called a static form of the market; the subjective values, marginal utilities and choices of consumers, and the multi-period production processes of competitors put a wedge in your plans. Consumers have made the “wrong” choices; competitive entrepreneurial producers have discovered how to sell the same product cheaper – it’s not “fair”.

The Market is a process of discovery. At any moment, market participants can face utter ignorance; not just that of optimal ignorance – where participants know what they don’t know, but the costs outweigh the gains, but that of an absence of information; we do not know what we don’t know.

It is the role of the entrepreneur to be alert to the ignorance of market participants, and predict what the future price and value of goods will be. It is the role of the entrepreneur to see incoordination in the market –  where there are two prices for the same good; indicating to the entrepreneur that sellers(buyers) are offering(charging) too high(low) a price; if he is alert and sees one selling for 20 and one for 10, he will buy at 10 and sell for 15. It is through this entrepreneurial process of discovery, that we move away from disequilibrium and closer to equilibrium.

There is not just the pure entrepreneur who sees sellers, one at 10 and one at 20 and chooses to sell at 15. The entrepreneurial producer discovers he can produce the same product for a lower price, and the entrepreneurial seller may request his employees to smile more to appear friendlier in order to sell more goods.

The only way to allow the market process to operate, and to have entrepreneurial discovery is to have actual “fair” competition, which is freedom of entry; i.e. no privileges.

That which is often; intentionally or not, overlooked, ignored, and disregarded by the Protectionists; Consumer Sovereignty, must be stressed here.

“Consumer sovereignty is often something that Interventionists of all stripes; no matter the term we use, wish to stamp out. …Consumers vote with their feet and wallets”

Consumer sovereignty is often something that Interventionists of all stripes; no matter the term we use, wish to stamp out. Consumers ultimately have the final say of which goods are produced; how successful a production processes product will be, and who provides greater value via the epistemic nature and signal of profits. Consumers vote with their feet and wallets.

There is an entrepreneurial aspect to the consumers as well as those mentioned previously. An entrepreneurial consumer, who discovers he can satisfy his wants/needs for a cheaper price, will seek to obtain these means to satisfy his wants, and utilise them for the value they achieve, and profits from their service to him.

The practices of the Protectionist and the Mercantilist require denying the consumer of his sovereignty, and to classify the praxeological aspect of the consumers’ choice as wrong; the interventionist ideals of these two require not only the denial of consumer sovereignty, but the denial of subjective value.

Is Our Core Argument Based On Efficiency?

The answer to this question, to which we’ll finish with, is in the negative. The core of the argument for free trade is the same as that for the market process as a whole: coordination.

The purpose behind why the free market in all areas is the superior system; including that of trade, is because it better achieves coordination of the subjective values of individuals. The free market, through the entrepreneurial process of discovery, and the freedom of entry into the competitive market, allows for greater ability to coordinate market signals, and Protectionism stifles with this coordination; placing static over the signals and providing false or faulty signals – in total reducing the quality and leaving values unsatisfied.

It is for coordination that we should reject Interventionism in all its forms; whether it be Protectionism, Mercantilism, or Nationalism.

Undead Capitalism – The Effects on Time Preference and Interest Rates If Humans Were Immortal

Image: https://pixabay.com/vectors/zombie-spooky-scary-creepy-monster-521243/

Josh L. Ascough

– This Piece Is Satire and Should Not Be Taken Seriously –

– If You Do Take This Piece Seriously, Please Thoroughly Research The Term ‘Satire’ –

– Dedicated To Jessi Bennett. You Made Me Do This –

Human life, as all life, faces a time constraint; it is in large part due to this constraint that humans rely on their subjective time preference with regards to the choice for current consumption or future consumption.

To add to this, the time preference over current/future consumption is what makes interest rates possible. The time preference aspect of interest is based on the notion that humans’ prefer to consume in the present, rather than at a designated later, future time period; it is this time preference which helps to explain monthly payments of, for example, a TV.

(Due to time preference, people tend to accept small payments over a set time period for full ownership in the future, i.e. £500 for a TV to buy it in the present, or a £50 deposit followed by monthly payments plus interest, unless ceteris paribus, their ordinal ranking of the good is high, as well as the demand to satisfy their wants/needs for current consumption, i.e. they’re not willing to postpone; people would not be willing to pay the final settlement price for a good they want to satisfy their wants now, if they have to wait for the future to receive the good)

What would happen though, if some genius entrepreneur discovered a way to make humans immortal?

“Governments would hate it because they wouldn’t be able to issue a Death Tax or Inheritance Tax, so they would probably try to ban it”

Firstly Governments would hate it because they wouldn’t be able to issue a Death Tax or Inheritance Tax, so they would probably try to ban it, it would then enter the black market and cartels would tamper with it and turn everyone into zombies.

But assuming Governments don’t interfere (I know, it’s a big assumption more unlikely and unrealistic than this piece), the other question to ask is, how immortal would it make people? Would it be a simple case of humans wouldn’t die of old age, but could die from starvation and disease, or, would it be a case of complete immortality; no disease, mortal wound, aging, or level of hunger could kill a human?

We’ll assume it to be the more simple case, since it’s easier to grasp and if we assumed complete immortality, then the Hyperventilating Overpopulation Ensemble (HOE) would have a heart attack.

“we would likely see a large shift in the market from current consumption to future consumption, with the time preference for goods and services extending for future periods of ownership and consumption”

If humans had the basic degree of immortality (cannot die of old-age, but can from mortal wounds, starvation and disease), then since the time constraint of life would be unaffected by old age, while the time preference and marginal utility of food and medicine would remain the same, we would likely see a large shift in the market from current consumption to future consumption, with the time preference for goods and services extending for future periods of ownership and consumption.

Under this assumption, since peoples’ time preference as a whole has seen a shift to the future, if people still prefer small payments over a prolonged time period, then we would likely see, ceteris paribus interest rates plummet, since people would be saving far more than they are spending; meaning an exponentially larger pool of funds, would be available for long-run multi-period projects of production, expansions in capital goods for larger scale productions of consumer goods in the future, a larger housing supply etc.

In conclusion: I the writer clearly need to get out more.

The Cure for Healthcare

Reforming Healthcare against NHS Propaganda

Economic Piece by Josh L. Ascough

No subject could be more controversial to discuss in the UK more than reforming; or abolishing the NHS. The NHS has existed for over 70 years, and over that time the British people have insisted in telling themselves that, they have ‘the best healthcare system’, and that the NHS is ‘the envy of the world’.

The only problem is…none of this is even close to being true.

The idea that the organised working classes were demanding a government takeover of healthcare is a post-hoc rationalisation, which projects the fondness for the NHS, which the public subsequently developed, back into the period of its creation”

We continue to tell ourselves that the NHS was the great achievement of the working classes; rising up and demanding national healthcare, in which free access would give power to the people. But, as Kristian Niemietz of the Institute of Economic Affairs points out:

“The creation of the NHS had little to do with pressure from below; it was not a change that ordinary people had fought for. Far from being People Power in action, the NHS was a brainchild of social elites, to which the general public just passively acquiesced. The idea that the organised working classes were demanding a government takeover of healthcare is a post-hoc rationalisation, which projects the fondness for the NHS, which the public subsequently developed, back into the period of its creation.” (Kristian Niemietz. Universal Healthcare Without the NHS. p. 19)

Nick Hayes has reiterated this ex-post rationalisation; explaining that huge support for a nationalised health system was merely a pipe dream piece of propaganda:

“The evidence before us seems to indicate a fairly large amount of resistance to State interference in the field of medicine […] roughly half the population was opposed to any major change on the health front, a quarter disinterested and a quarter in favour of State intervention.” (Nick Hayes. English Historical Review. p. 659)

Evidence in our modern times, gives an interesting expansion on this. The British Social Attitudes Survey (2015) reveals when members of the public, are asked if they would hold a preference for being treated by an NHS-based provider of healthcare, a private profit driven, or a private non-profit provider, 43% state no general preference. A further 18% provide an explicit preference for independent, non-state-based providers of healthcare.

The phony info from NHS propagandists’ continues. The system prior to the creation of the NHS was not a bleak world where people died in the streets; desperately searching for a doctor only to find none exist. Before 1948, the health system operating in the UK was well developed. The system was rooted in the mutualism of the 19th century. The creation of the NHS was not the development of a new system; it was simply a government takeover.

Let’s get back to the common phrase mentioned earlier: the NHS is the envy of the world. The argument is that the NHS is the envy of the world, due to instituting a system, which does not base its service on an individual’s ability to pay for said service. This is treated as an outstanding achievement, yet the vast majority of the developed world has universal access to healthcare (the US is the exception, but we will come to that later). Are we not begging the question of how the NHS is the envy of the world, when the reality of the developed world’s health systems indicates otherwise? Your neighbour can hardly envy you for what you have, if he already has it.

“if the NHS is the envy of the world, then why is it, after over 70 years no developed nation has copied the structure the UK has; why does it refuse to copy the system it apparently envies so much?”

Furthermore, if the NHS is the envy of the world, then why is it, after over 70 years no developed nation has copied the structure the UK has; why does it refuse to copy the system it apparently envies so much? The answer comes in two:

(1) Other developed nations understand there is a difference between universal access as a standard, and the nationalisation of healthcare.

(2) The NHS is not the envy of the world; nor has it ever been.

The NHS is not just far from the envy of the world when looking at the universal healthcare status of other developed nations, but according to the OECD, the UK has one of the worst healthcare systems within the developed world. When the report was first published, The Independent stated:

“The quality of care in the UK is “poor to mediocre” across several key health areas […] and the NHS struggles to get even the “basics” right […] Britain was placed on a par with Chile and Poland.”

The Financial Times in addition reported on the findings; stating the following:

“Britons are less likely to survive a heart attack, stroke and leading cancers than people in many other developed nations, according to an assessment of international health systems”

Many apologists for the NHS, would be quick to point to the Commonwealth Fund Study; proclaiming that the CFS “proved” that the NHS is the best system in the world, because it was ranked 1st.

This completely ignores that the CFS looked at inputs, not outcomes. When it came to the one category which looked at outcomes, the UK came out second to last, only slightly above the US. In addition the Commonwealth Fund Study was designed to systematically favour healthcare systems which are tax-funded. The CFS asked patients if their insurer ever declined payment for treatment, and whether they have ever incurred out of pocket payments in excess of over £1,000. These declining of payments and out of pocket payments, would not only be almost impossible under the NHS, but under the systems of Sweden and Norway also. Looking to the CFS for neutrality is like looking to the Central Bank of England for financial stability; you have to lie and make assumptions that fit the outcome you want. The CFS held a category for cost issues titled ‘Cost-Related Access Problems’; this however is based on price limitations with regards to consumers, and mentions nothing on the matter of non-cost based restrictions, such as state rationing.

Many proponents of the current system, when presented with this information, would be quick to state: “okay sure, the NHS has some problems, but that’s just because of underfunding and the spending being cut.”

“In 2018, spending on the NHS was £214 billion; an increase in spending of 296% over a 20 year period. If there has been a cut in spending on the NHS, I’m failing to see where it is”

Well, reality paints a different picture.

According to data from Statista, from the period of 1997 to 2018, spending on the NHS has been on a continuous increase, as shown below:

As shown in the data, in 1997, spending on the NHS was at roughly £54.9 billion, and has been on a consistent rise. In 2018, spending on the NHS was £214 billion; an increase in spending of 296% over a 20 year period. If there has been a cut in spending on the NHS, I’m failing to see where it is.

Before we touch on the US healthcare system, and the myth of it being a free market system, I think the reader would agree it is important to “put my money where my mouth is”, and provide examples of how the NHS fares compared to other developed nations.

The next few sections will look at the following:

  • NHS Outcomes Compared to Other Developed Nations.
  • The Universal Systems of Other Developed Nations

After we’ve discussed the US healthcare system, we will go over potential reforms and alternative means of providing healthcare, while keeping the essence of universality.

NHS Outcomes Compared to Other Developed Nations

Let’s take a look at performance rates of the NHS and other systems.

The above table showcases how countries’ healthcare systems compare when it comes to waiting times for GP appointments and A&E.

Nations marked as green indicate an average waiting time of less than 1 hour, yellow in between 1 – 3 hours, and red over 3 hours.

As we can see, the top performers are Belgium, Denmark, Portugal, Switzerland, the Czech Republic, and Hungary. The worst performers include Lithuania, Sweden, and England. Under the NHS, obtaining a same day appointment to see a GP is close to impossible, and waiting times in A&E on average are over 3 hours.

In the second table we look at the waiting times for surgeries and cancer therapies. The top performers here are: Belgium, Denmark, Finland, France, Germany and others. The worst performers include Ireland, Poland, and Slovakia. The NHS rates yellow, meaning roughly 50% can be conducted within 3 months.

The third table looks at the waiting time for diagnostics, and how easy it is to receive specialist care; if a patient can access such care directly, or if there is gate-keeping in place such as going through a GP.

The top systems in this regard are Austria, Belgium and Switzerland. The longest waiting times for diagnostics and restrictions in place for accessing specialist care occur in Ireland, Malta, Spain, Sweden and England.

Throughout all of these areas, many systems dip between green and yellow, some more than others consistently keeping in the green. The NHS on the other hand, the majority of the time remains in the red, with only one example of being in the middle (yellow).

We’ve taken a look at waiting times, what about survival rates? Let’s take a look at cancers first.

In the UK the most common form of cancer is breast cancer. The diagram above shows the 5 year survival rate for breast cancer patients. The UK’s survival rate is 81.1%; roughly 5% behind South Korea, and roughly 2% behind Austria; if NHS patients had been treated under the South Korean system, we can speculate roughly 2,500 lives could have been saved, and extended every year.

The second diagram shows the five year survival rate for prostate cancer. Under the NHS system, the survival rate is 83%, which is lower than most of the developed world. For patients in Sweden which ranks 12th in the diagram, the survival rate is roughly 6% higher. We can estimate that if NHS patients were treated there, a further 2,800 could have survived.

Lung cancer is next on the list. The UK has a survival rate of less than 10%, making it the worst performing compared to all high income, developed nations. Roughly 2,400 additional lives could have been saved under the Australian system, which is 5% higher than the UK.

Let us take a look at stroke mortality rates:

Ischaemic strokes are one of the most common types of stroke in the UK, with roughly 150,000 cases per year (Stroke Association 2016). The UK has a survival rate of 9%. Again, if NHS patients were treated in Sweden, around 3,000 extra lives could have survived an Ischaemic stroke.

Finally, we look at the mortality rate for Haemorrhagic strokes. The UK, once again, is a poor performer for survival. The UK has a mortality rate of 26.5%, which is over 4% higher than the US; translating to roughly 1,000 excess deaths.

“The systems of Switzerland, the Netherlands, Germany and Belgium, can be described under a broad term of operating under Social Health Insurance systems. In the rankings previously shown, these countries have consistently outperformed the NHS”

The Universal Systems of Other Developed Nations

We’ve looked at survival rates and mortality under the NHS system, and so we shall now go over what the universal character of other developed nations looks like.

The systems of Switzerland, the Netherlands, Germany and Belgium, can be described under a broad term of operating under Social Health Insurance systems. In the rankings previously shown, these countries have consistently outperformed the NHS.

How Does Social Health Insurance Work?

Social Health Insurance works a similar way to standard insurance. There are however a few unique qualities which are:

  • Community Rating: Under a SHI system, insurance companies cannot raise premiums based on an individual’s health risks.
  • Obligation to Accept: SHI systems prohibit insurers from rejecting coverage based on an individual’s medical history.
  • No Exclusion: Pre-existing conditions cannot be denied for coverage under a system of SHI.
  • Individual Mandate: Under a SHI system, it is compulsory for all individuals to purchase SHI, and is mandated by the state. If an individual does not purchase SHI, then they are put on one automatically; even against their will.
  • Premium Subsidies: Due to the point of mandates, the government subsidises the SHI of people on low incomes. For some nations this is a means-tested based subsidy, in others it is income dependent.

Under the Swiss system of SHI, it could be argued there is a higher degree of freedom of choice for patients than in other SHI systems, including a cost-sharing measure worth looking into. Out-of-pocket payments under the Swiss SHI, account for roughly a quarter of total healthcare spending (according to W.H.O 2015: 132-133). This system has two distinct components: deductible and proportional co-payments. Deductible works similar to most insurance systems with excess; there is a minimum cost threshold which, once costs exceed this, the insurance covers the excess costs. People can freely have a higher minimum threshold set, in return for premium rebates.

Co-Payments are capped at a certain amount per year. Once a patient’s collective medical bills reach said amount, then they face no further expenses.

“In order to prevent the cost of healthcare rising exponentially during old age, German PKV insurers are required to smooth premiums over people’s lifetime. This “pre-funding” mechanism works in a similar way to a pension”

The German health system has two types of healthcare coverage. These are the standard type of Social Health Insurance; known as GKV, with the community rated premiums and other qualities mentioned above, and a conventional, private health insurance; known as PKV, with varying premiums, and no risk compensation.

Additionally, the German system has a quality that many nations could learn from: an accumulation of old-age reserves. We understand that healthcare costs are flat for the majority of life (not including exceptions), and then rise with age. In order to prevent the cost of healthcare rising exponentially during old age, German PKV insurers are required to smooth premiums over people’s lifetime. This “pre-funding” mechanism works in a similar way to a pension; insurance companies build up an old-age fund on behalf of their clients during their working life, and later draw on this fund for care during old age.

Before we go into the US, I want to briefly talk about the South Korean system.

South Korea has a universal health insurance system, similar to that of SHI; the difference being though, is that the state is unable to set market prices. Many Koreans seek additional private coverage due to the state-based insurance being insufficient to cover all the costs; around 8 out of 10 Koreans take out private coverage, with an average cost of 120,000 Won (£75) a month.

Care in South Korea is provided by hospitals which are 94% private, a fee-for-service model and no direct subsidies. This private system is not purely for-profit, the Korean system has a mix between for-profit, non-profit and charity foundations. The presence of private hospitals expanded in the early 2000s; from 2002 to 2012, private hospitals rose from 1,185 to 3,048. Further information on the South Korean system with a comparison to Italy, and a look at how it handled the outbreak of Covid-19, can be found here:

The USA: Free Market Healthcare?

Most of the time NHS propagandists will point to the US and decree: “See! That’s free market healthcare for you! If we didn’t have the NHS (praise be upon it) then we’d have a US system!”

There are two problems. firstly, NHS propagandists intentionally ignore the vast majority of other SHI systems which outperform the UK; relying on the publics ignorance of other systems outside the UK and US. Secondly, the US has not had anything close to a free market in healthcare for at least 100 years. It has become an interventionist, heavily regulated system with positions on competition similar to that (which I’ve discussed a fair number of times) of Neo-Classical General Equilibrium Theory and Perfect Competition. I won’t go into the subject in order to save the reader time, but if you’re interested in understanding what I’m referring to, you can check out my article where I discuss it in detail here – http://croydonconstitutionalists.uk/marshallian-curve/

As was mentioned above, the United States has not held a free market in healthcare since 100 years ago. Jacob Hornberger, the founder and president of the Future of Freedom Foundation, gives a mention to this in his book, The Dangers of Socialized Medicine:

“For over one hundred years, the American people said no to governmental intervention into health care. Americans did not permit their respective states to licence physicians and other health-care providers. They did not permit government to provide health care to the poor and needy. No one was required to purchase health insurance.” (Jacob Hornberger. The Dangers of Socialized Medicine. p. 15)

The government has always attempted to interfere in healthcare, including various lobby groups and unions wishing to curtail care with the use of government power, however it could be argued the defining moment American healthcare changed for the worst forever was the successful lobbying done by the American Medical Association. To further quote Mr Hornberger, he goes into great detail on the impact the AMA had on healthcare in the US:

“The American Medical Association is perhaps the strongest trade union in the United States. The essence of the power of a trade union is its power to restrict the number who may engage in a particular occupation. This restriction may be exercised indirectly by being able to enforce a wage rate higher than would otherwise prevail. If such a wage rate can be enforced, it will reduce the number of people who can get jobs and thus indirectly the number of people pursuing the occupation. This technique of restriction has disadvantages. There is always a dissatisfied fringe of people who are trying to get into the occupation. A trade union is much better off if it can limit directly the number of people who enter the occupation-who ever try to get jobs in it. The disgruntled and dissatisfied are excluded at the outset, and the union does not have to worry about them” (Jacob Hornberger. The Dangers of Socialized Medicine. p. 65)

“the number of medical schools in the US, from the period of 1910 to 1920 dropped from 131 to 85. This cut in medical schools not only had; and continues to have, a supply-side effect by causing prices to artificially be forced up”

The AMA’s successful lobbying campaign, was to restrict the number of doctors who could enter the medical profession by drastically reducing the number of medical schools in the country, and enforcing mandatory licencing into the nation. After the successful lobbying for accreditation was granted, the number of medical schools in the US, from the period of 1910 to 1920 dropped from 131 to 85. This cut in medical schools not only had; and continues to have, a supply-side effect by causing prices to artificially be forced up, it had a huge impact on women and African Americans entering the medical profession. By the time of 1944, the total number of medical schools which admitted black people was cut from 7 to 2.

Many may argue that licencing is good particularly for healthcare. But a licence does nothing to prove a doctor is competent. A doctor could have been in the medical profession for 30 years and be completely incompetent. Two types of objections can be made against licencing:

Economic Objections | Licencing puts a gap between patients and healthcare providers. By restricting the trade of healthcare through additional costs for licencing, it reduces the supply; by reducing the supply this, as stated previously, artificially forces the price up. This added cost is passed on to the consumers of healthcare services. This barrier to entry goes completely against the freedom of entry required for a competitive market to function, under entrepreneurial discovery.

Social Objections | Licencing gives a false sense of security to patients that lead to unfulfilled expectations of doctors being medical automatons; incapable of making human errors and bringing nothing but unnatural perfection to the table. This can harm the relationship between the doctor and patient; causing high dependency and resentment. Furthermore licencing as indicated above, discriminates against not only African Americans and women, but poor people too. While it has been used to keep women and minorities out of the medical profession in the past, the continued effect it has on the poor, is to force them out of the market through disincentives; via expensive education and other requirements for licencing.

Licencing, to some up, is designed to keep doctors free from competition, and increase their wages, through the means of the government giving out privileges and putting up barriers to entry. It is a throwback to the old, European Guild system, and has made the healthcare market aristocratic.

To quote Hornberger once more:

“Licencing is a special-interest legislation for the benefit of physicians and other medical personnel. Its primary purpose and effect are to limit entry into the medical profession in order to protect medical people from competition. Does licencing ensure competent doctors and nurses? If it does, then why do we continue to have so many malpractice judgments against doctors and other medical personnel? And one problem with licencing is that it seduces the public into believing that because a person has been licenced by the state, he must be competent. What would happen if licencing were repealed? Well, no one would run out into the street looking for a quack to perform heart surgery on him. […] What if someone needed a new doctor? The likelihood is the person would rely on the recommendation of his current physician. Moreover, well-established and well-known physicians in the community would band together to publish a list of recommended doctors in the area; private certifying agencies (i.e., Consumer Reports or Good Housekeeping) would do the same.” (Jacob Hornberger. The Dangers of Socialized Medicine. p. 22)

“the government pays for roughly half of all healthcare purchased in the US. Since Medicare and Medicaid patients pay little or nothing, it creates an incentive to consume more than one would value if they incurred the costs”

Medicare and Medicaid

What are the interventionist effects of Medicare and Medicaid? Aside from the extortion of resources, the two forms of medical welfare have negative effects on the demand-side of the equation.

The way it is affected is, the government pays for roughly half of all healthcare purchased in the US. Since Medicare and Medicaid patients pay little or nothing, it creates an incentive to consume more than one would value if they incurred the costs, which if the costs were internalised, it would create incentives to shop around for care. Up until the 1980s, Medicare and Medicaid reimbursed providers, meaning neither patient nor doctor had any incentive to keep either costs down. This lead to a sharp upward movement in prices for insurance and healthcare in general. As a result, many people and small businesses were and are, priced out of the insurance market.

The FDA, patents and insurance regulations also play a huge role in the high expense American’s pay for healthcare.

Insurance

Employer-Provided Health Insurance (1943) – While not mandatory in all states, Employer-Provided Health Insurance requires an employer to pay for the coverage of their employees. Since the individual patient is not facing the costs of said coverage, this leads to people not being as fiscally responsible as they would be; leading to higher risks and higher costs. This also plays a role in why low-pay workers find it hard to leave their job; if they did they would be at risk of not being covered should they face medical needs, leading to employees in states where it is mandatory being dependent on their employer.

Mandated Coverage – The state of California since 2011 has made it mandatory for insurance providers to cover maternity leave (legislation SB 299, AB 592, SB 222 and AB210) This means that even if a woman does not want children, or cannot have children for medical reasons; or because of age, she still has to pay for the coverage of something she will either never want, or never be able to have. This waste not only affects the insurer, but the policy holder, by forcing them to pay a higher price.

Mandatory Insurance – The Obamacare Individual Mandate, made it mandatory on the federal level for all American’s to purchase health insurance. This has the obvious effect of artificially forcing up the quantities being purchased and the demand, leading to higher prices for insurance and medical care. As of 2019 the mandate was no longer required on the federal level, however at least 5 states and the District of Columbia have maintained the mandate for purchasing health insurance.

FDA

Slow-Testing and Approval Process – The FDA’s process of approval times and testing has gone through a very regressive motion. Before 1962 the FDA was required to approve a drug within 180 days unless the new drug was proved to not be safe; meaning there was a time constraint on the FDA, and new drugs could get into the medical market faster. After 1962, said time constraint was removed, and since then the drug approval process has lengthened exponentially. To give a bit of context, prior to 1962 the time between filing and approval was an average of 7 months, after 1967 that time rose to 30 months, and by the late 1980s the time between filing and approval shot up to 8 – 10 years. This excessively lengthened process has seen the cost of testing new drugs rise to around $800 million per drug, and due to the lack of viable substitutes for patients has caused the price of drugs already on the market to rise.

Anti-Advertisement – Advertisement of approved drugs for newly discovered uses, which may be more beneficial than it’s conventional use, is prohibited under FDA rules. This leads to many companies not finding it worthwhile to re-evaluate an approved drug for alternative uses. This restriction has created a barrier to entry in the drug market; not only blocking entrepreneurial innovators from advertising their discoveries, in the attempt to alert consumers of what they may hold an absence of information over, but is designed to protect already existing drug companies from competition.

Patents

IP the Restrictor of Competition

IP is designed to protect the producer of a drug from competitors who wish to reverse engineer their drug, in order to sell similar drugs on the market. IP is not simply the protection of a brand, it restricts who can produce and sell what. It is IP which has led to the rising costs of epipens and insulin. An example of drugs without IP and drugs with, are painkillers and Epipens. In 2020 the average cost of a two-pack of Epipens was $699.82. Pain Relievers with no IP can be purchased at a low price of $3.88 for a 24 pack. If IP was removed from all drugs and reverse engineering by competitors was allowed, dominant drug companies would have to find new ways to innovate their drugs, lower their prices to withhold and stall competition, or be priced out of the drug market.

“Mandates and freedom are opposites. If a person is free, then that means he is not mandated to buy anything. If a person is mandated to buy something, then he is not free. Mandates are not a free-market alternative, because mandates violate free-market principles.” (Jacob Hornberger. The Dangers of Socialized Medicine. p. 14)

“Private doesn’t simply mean “for-profit”, private means there is no government intervention, micro-management, protections, controls or ownerships”

An Alternative to the NHS

Keeping in mind everything we’ve gone over, is it possible to have universal access to healthcare within a free market in healthcare? Yes; if you allow for variety in the means of acquiring medical care, and the ways to provide it.

What do I mean by this? Private doesn’t simply mean “for-profit”, private means there is no government intervention, micro-management, protections, controls or ownerships.

Assuming the reader understands how a for-profit provider would operate (like any other service provider), in order to save time we’ll simply look at what alternatives could exist alongside for-profit providers.

Limited Local Government Display

The British people are a very charitable people, and Britain has had a culture that values empathy and charity for centuries. The difficulty that comes with seeking help, is an absence of information, with regards to the existence of charities that can help people. Local councils can play a very limited role, in advertising all health-based charities that operate within their borough, or that operate nationwide, but which have easy access facilities within the borough. These advertisements could be in the form of notice boards in the council buildings, as well as mailing lists to communities the councils’ understand to have poor demographics.

This would not only expose large numbers of charities to potential donors who did not know these charities existed, but also to the poor who may not know where or who they can turn to.

To put my thoughts into actions, I recommend donating to BenendenHealth. They are a non-profit, affordable care provider that was established in 1905, with the purpose of joining people together to help with medical care when they need it. You can make a donation at https://www.benenden.co.uk/about-benenden/charitable-trust/donations/

Subscription Institutions

This one may seem a bit strange to the reader, so I’ll need to take some time to explain what I mean. The Subscription Institution proposal I’m making, is based on the structure and methods of provision of the Mises Institute. The Mises Institute is a non-profit organisation dedicated to spreading the economic theories of the Austrian School.

The Mises Institute, generates its funds via donations, but also raises funds through a subscription basis; where subscribers pay a monthly fee, and receive benefits such as discounts, newsletters, magazines, and updates on events for members. An additional means of raising funds is by selling products both to members and non-members. As of late, due to charitable donations the institute has begun its own Master Degree in Economics for a lower price than other universities; the average cost for a Masters course ranges from $20,000 – $60,000, whereas the Mises Institute charges around $4,000.

A similar format could be imagined for private, subscription-based healthcare institutions. We can refer to these as Healthcare-Subscription-Institutions (HSI).

Above we see a basic outline of how such an institution could function. They would receive donations from members of the public on a voluntary basis, as well as universities and other institutions who would mutually benefit from research being conducted.

Secondly, the option of a monthly subscription, would allow members of the public to receive certain benefits; such as free care services, newsletters on developments and research being conducted with/without collaboration with other institutions, and discounts on products such as books, human anatomy models, and health conferences.

Thirdly, the Healthcare-Subscription-Institution (HSI) would generate additional financial capital by selling books by academics, doctors and recently graduated students. This would benefit the producers of these books by expanding the access to their work, as well as assisting to build up a resume for recently graduated students.

Finally, Future-Reserve-Accounts would allow individuals to set up what could be likened to a savings account for their children or grandchildren. They would pay a monthly deposit, to which the HSI would use a fraction for further investments, branching out, diversifying their capital stock and creating additional research and services. At the payee’s end of life, the collected funds would be transferred to the declared recipient; either child or grandchild, with added interest.

This would result in a care service which would be free for members; due to continued commitment to their subscription payments, and a limited fee for non-members.

Healthcare in the UK is in desperate need of reform. We continue to not help our national situation by being in a state of denial and nostalgia for days and standards to which never even existed. One type of private healthcare would be as effective as a nationalised system; it cannot meet the demands of all. If universality is the principle which British people refuse to budge on, then a private system with a diverse way of providing care has a greater chance; allowing a wide variety of methods for providing care, would ensure a greater degree of people have access to care; we have a variety of methods for providing other products, so why not healthcare? Rather than an ultimatum between ‘for-profit or nothing’, or ‘nationalised or nothing’, let’s try a decentralised, denationalised variety of choice.

For-Profit, Non-Profit, Charities, One-to-One Personal Family Doctors, Healthcare-Subscription-Institutions; whichever you subjectively prefer, choice is the best cure for healthcare.

Sources:

https://pixabay.com/photos/ecg-electrocardiogram-stethoscope-1953179/

A Defence of Advertisement

Methods of Information Under the Market Process

Economic Piece by Josh L. Ascough

Advertisement has often been the aspect of the market most attacked; both by supposed supporters of the market and detractors of the market economy.

Decrees of false information, wasteful spending and other wide sweeping accusations are made against advertisers and their methods of marketing a product, but these are claims that can only hold artificial weight to them if our economic models are that of general equilibrium and perfect competition; in addition most arguments against advertising are based on ex-post the consumers choice to consume the product.

I’ve gone into criticisms of the general equilibrium theory and perfect competition before, so I won’t make this piece another critique; you can find the full piece here – http://croydonconstitutionalists.uk/marshallian-curve/ – but to summarise, the general equilibrium model relies on assuming a state of affairs where all economic actors are fully aware at all times of various economic activities: i.e. a degree of omniscience; perfect information. Under this model it acknowledges ignorance to which is optimal (we know what we are ignorant of, but the cost of information is higher than the benefit), but assumes away the possibility; or the high likelihood of an absence of information (we don’t know what we are ignorant of). The perfect competition model proposes that competition is a state of affairs where there is a certain number of buyers and sellers all buying (selling) the same quantities and qualities at the same price; no one sells higher because it would be economic suicide, and no one sells lower because he could sell the same quantity at the set market rate.

These two states of affairs not only assume no possibility of any absence of information, but deny the possibility of any entrepreneurial activity.

Let’s get back to the matter.

Advertisements are often criticised for pressuring consumers to buy particular products, providing over the top, loud commercials that could’ve been made for less, if they just got to the point with what they’re selling, and for providing no “relevant” information.

These criticisms are seldom legitimate when we analyse the market; including advertisement as a process, and when we acknowledge the role of discovery brought about by entrepreneurs.

I spoke earlier about arguments against advertisement to be based ex-post the consumer’s choice to purchase the product. The question to ask is: how did our consumer come to be aware of the product? What led to the decision to buy rather than to abstain? For the answer we need to look ex-ante the consumer’s activity and decision; furthermore we require acknowledging that at any time, the market can be filled with utter ignorance from economic actors, and to remember that we are in a process of disequilibrium where (successful) entrepreneurial activity tends to bring us closer to positions of equilibrium.

“Advertisers don’t just have to tell consumers that there is a product to buy; they need to make their adverts eye-catching in order for the consumer to discover the possibility of owning the product”

Advertisers don’t just have to tell consumers that there is a product to buy; they need to make their adverts eye-catching in order for the consumer to discover the possibility of owning the product. If we suppose a seller of petrol for cars, displaying a sign outside his establishment which says: “Petrol for sale. Lower than other sellers. £1 per litre”. An omniscience external observer would say he has made a clear concise advert for his product; if consumers don’t buy it is because the cost of finding this sign is too high. But humans are not omniscient, nor are they always on a deliberate search; our petrol seller requires making his advertising venture eye-catching not just to those already searching for petrol but to those who (a) don’t know that they need petrol, and (b) do not know that they don’t know they can buy petrol for a low price. Though the physical qualities of the product exist, and the seller is aware of what he can sell, to those who are not alert to its possibilities the product may as well not exist.

Where a seller decides to advertise also plays an important role in how many consumers will discover the product. If we suppose in a community none of the residence drive, because all sellers they are aware of have too high a price; leading to everyone either walking or cycling, no one is going to be searching for petrol and so an entrepreneurial producer, who can sell petrol for a fraction of the price of other sellers, cannot simply put a sign outside his business. In order for consumers to enter a process of discovery, our seller has to stand out.

Many times people will point to how simple advertisement was many years ago. They will point to old black and white adverts on television sets showing the product, its price and the brand. But this again is an ex-post argument, from the point after the advertisement has occurred.

I’d like to explain the ex-ante present advertisement argument with a little hypothesis:

Imagine if you will a school hallway where the walls are blank. Each day students walk to and from classrooms completely ignoring the blank walls. A student; let us call him George, finds there are no after-school clubs available, and so creates a chess club. George is unable to inform all the students of the school by talking to them, because he too has classes to attend. Supposing he is an alert individual, he comes to the discovery that he can place a poster on the blank wall informing students of the new after-school club; it will be the only poster on the blank wall, and so is likely to be discovered by his fellow students. This will not just be noticed by students who also know they wanted an after-school club, but possibly by those who hold an absence of information over the enjoy-ability of an after-school club, and by those who may not have known what chess even is; since there’s been no after-school clubs where they could see students playing chess.

Sooner or later, more students start advertising on the blank walls for a variety of things; some for clubs, events, and some for student-to-student tutoring. Because everyone is advertising with plain white paper and black text, many go unnoticed until one student makes the entrepreneurial discovery that he can use plain red paper with black text, and it is discovered by students etc.

As the process goes on, students find new ways to make their advertisements more noticeable.

This ex-ante look at the process informs us that when advertisement is absent, not a lot needs to be shown in order for the product to be noticed, but as more and more people advertise what they wish to inform others of, they require finding new ways of standing out and being eye-catching.

There are two final areas I wish to go into before we conclude; these will be with respect to the subjectivity of value and diminishing marginal utility on the part of consumers, and how these can affect our perspective of advertisement.

Due to value being subjective, the attractiveness of an advertisement can be affected by the value judgements of an individual; either by pre-existing tastes towards a general subject while holding an absence of information to the specific heterogeneous product, or by a known judgement towards a specific product.

To give an example for a better explanation, I hold no value for anything to do with football; I find the game dull, and so anytime an advertisement for football comes on; whether it’s a live match, a videogame or memorabilia, I find it irritating and a waste of time. If it is a new product to do with football, then I have discovered a new product I have zero interest in.

I am however a fan of snooker and pool, and so an advertisement for a live game will either (a) lead me to the discovery of the new possibility of satisfying a want for engaging in the game, or (b) if I had been on a deliberate search for a live match, will have allowed me to become informed of the whereabouts of a product I had known my ignorance of.

Diminishing marginal utility can also play a role with how attractive advertisement may be for specific products.

To give an illustration we take a look at figure 1.1:

In the diagram the vertical axis shows Marginal Utility, with the horizontal axis showing the Quantity of units consumed. As more quantities of the good are consumed, it reaches a peak where satisfaction is highest at MU8/Q6. After this point the marginal utility of the good begins to drop, and further consumption of the good will be unsatisfactory; as shown by Q8. An example of this could be the consumption of alcohol. At the start of a drinking session the consumption of unit 1 may not satisfy the want/need fully, as more and more units are consumed there will be a peak when total satisfaction has been reached. After this point; let us say unit 6, the marginal utility for further alcohol drops, and the want/need to satisfy the thirst for alcohol diminishes.

If an advertisement was to be seen ex-post the consumption of a satisfactory level of alcohol, it is likely the drinker will find little utility and value in further consumption.

This can also be translated into a change in tastes, as shown in figure 1.2:

A man who has achieved satisfaction of a want/need to consume alcohol, may find himself impelled to act in order to satisfy the want/need for food. A change in tastes simply refers to a reordering of the positions of items on the consumer’s scale of value; or ordinal ranking of goods.

This will lead to the altering of our individual consumer’s marginal utility of the unit(s) of some good to lower positions, while the marginal utility of some other good (in our case of the drinker, food) will be higher. Now our drinker is seeking to move expenditure from the lower ranked good (alcohol), to the higher ranked good (food).

In our diagram, the drinker had satisfied his want/need for alcohol at point P2. This indicates that a move from P2 to P3 along the opportunity line AB. Since our drinker’s tastes have changed, and shifted away from DP2 of Y, towards that of X, he has shifted to a position of DP3 of X, and so our consumer acts to achieve the situation of P3; i.e. the consumption of food.

To translate this back to advertisement, if our drinker is now seeking to satisfy P3, then advertisements for food will lead to a discovery of how/where to satisfy a want/need.

To conclude our look into advertisement, it is axiomatic that not all advertisements will appeal to every individual; it is not the purpose of this piece to make such an argument. It is to try and show that advertisement; like many areas of economics, is epistemic, and, to a degree, hold an entrepreneurial element of discovery to them. The world is full of scattered pieces of information in a realm of disequilibrium; advertisements, just like prices, play an important role in attempting to coordinate the expectations, actions, and value judgements of subjective individuals.

Picture: https://pixabay.com/photos/outdoor-street-road-city-view-3973811/

A Look at Universal Basic Income – The Pros and Cons

Image: https://pixabay.com/photos/calculator-calculation-insurance-1680905/

Economics Piece by Josh L. Ascough

Universal Basic Income has become a hot topic in recent years; propping up in the news and mentioned by politicians from time to time.

The standard definition of UBI is a government program where every adult citizen receives a set amount of money on a regular basis; either weekly or monthly. The goal; as stated by supporters of the measure is to alleviate poverty, and to ensure every adult; even if unemployed, has some form of income to support them.

It is quite standard for the majority of supporters of UBI to be of a, Social Democrat position. There are however some Conservative-esque arguments in favour of UBI. These Conservative-esque arguments tend to be more based in deterministic elements of automation, and tend to believe UBI a possible ex-post rather than ex-ante; with the basis of: “if automation is inevitable, there should be a UBI on the table when that time comes.”

There are standard arguments against UBI to do with the ethics of redistribution, but I’m only interested in briefly talking about the economic pros and cons.

This pro/con dynamic really can be broken down to ideal and practical.

The pro of UBI, would be if we got rid of everything and replaced it with UBI. When I say get rid of everything; I mean abolish the NHS, Disability Benefits, Child Tax Credits, Government/Public Schools, and every other form of the welfare state, and replaced it with a UBI program, which gives people the finances and allows them to decide how they’re going to use it, based on their own ordinal ranking and marginal utility.

We would still have the ethical problems of redistribution, however, if it were an automatic program of transferring income to person A, the program would be less costly than all the current programs we have. Most of our welfare programs take up a lot of time and therefore resources, due to lots of bureaucracies and civil servants involved; so instead of welfare 1 going to person A, form 1 for welfare 1 goes to civil servant 1, to be forwarded to bureaucrat 5, so form for welfare 1.5 can be signed by civil servant 7 etc.

This means the idealistic pro of UBI, is that we would in principle have less civil servants and bureaucrats; thereby reducing the overall cost of welfare.

The con of UBI is very much a practical problem. There are other cons to UBI such as the effects of price increases, particularly if the program sees MV (money velocity) rise, but since our pro is an idealistic one, it comes logically that our primary con is a practical one.

The practical problem of UBI is that it is very unlikely that these other programs would be abolished and replaced with a single, simple UBI system, because it would be political suicide. Even if a politician explained to people very clearly and said: “We’re getting rid of the welfare state, including the NHS and replacing it with a UBI. This way money goes directly to people so they can choose for themselves where they want it to go, in terms of what they need to support themselves. All the money is going to go directly to the citizens.” It would still be political suicide, because then bureaucrat’s and civil servant’s jobs would be at risk. Under a UBI, there would be little argument in favour of having so many bureaucrats and civil servants, since money goes directly to people rather than to programs.

The likelihood is, if UBI was instituted, it would be on top of all our current programs; adding to the overall cost rather than seeing a reduction and a simplification in the idealistic.

Libertarians aren’t against welfare per se, it all depends where said welfare is coming from; for example a government program is coerced on to people, and forced extraction; or, extortion breeds resentment among people and violates property rights; whereas charity is voluntary and breeds compassion.

The UK is a very charitable country. The most recent, everyday example being the late Captain Tom Moore, Captain Moore raised roughly £32.8 million on a JustGiving page for the NHS, simply by walking back and forth in his garden. This was a sum of money raised in a nation with a progressive tax system, and under circumstances where large numbers of the population had become unemployed due to lockdown; imagine how much more could’ve been raised with a low flat tax system, and where large numbers of people weren’t forced into unemployment. It’s more than likely at least £100 million could’ve been raised.

As stated above, the UK is a very charitable nation, but one problem facing people receiving help is the absence of information; people don’t know there are charities out there that can help them. It’s anecdotal, but I recently came to the discovery of a private healthcare charity in the UK called The Benenden Charitable Trust; because humans aren’t omniscient, it is more than likely there are charities out there that could help people, but those people don’t know they exist.

This is where local government could play a role.

Local governments could advertise charities that operate within their borough, to help people become aware of charities that could help them. This wouldn’t do anything about the apparent stigma attached to asking for help however; nor is this something the government should get involved in because this would result in government’s watching what people spend and knowing every tiny private detail, and forcing them into accepting help. The stigma is something that could theoretically be lessened if people see what help is out there.

This short piece should not be seen as any form of argument for or against UBI, it should be seen purely for what it is; looking at the costs and benefits of a UBI program.

A Critique of the Marshallian Curve and Perfect Competition

A State of Affairs vs A Process of Discovery

Image source: AmosWEB is Economics: Encyclonomic WEB*pedia

Economics Piece by Josh L. Ascough

The standard theory of the market as it is expressed in the classic supply and demand curve, also known as the Marshallian curve or cross, notes that the price gravitates towards the quantity supplied by the quantity demanded, and that this ensure a state of equilibrium.

Figure 1

This is undeniably a very useful tool for giving a 30 minute talk on economics for a short and sweet answer; but it’s all wrong.

The claim that the Marshallian Cross is wrong does not invalidate the value in the basic demonstration it provides; nor the utility gotten out of a short answer to a question of market activity, but it is very much like taking a photo of a couple at point A, then a few minutes later at point B. We are skipping the market process and assuming perfect states of equilibrium. In fact, further analysis of the cross allows us to realise, that we violate the possibility of disequilibrium, and in so doing, the entrepreneur.

Let us examine this in more detail in the next few diagrams:

Figure 2

In our diagram we suppose, firstly, that the price is above equilibrium, where there is excess supply (Ex S) over the quantity demanded (QD). What does this do to the price?  – It forces it down.

In our second point, we suppose that there is an excess demand (Ex D) over the quantity supplied (QS) this has the same effect but in reverse by forcing the price up.

Notice how under the curve, we assume two things:

  • That we are consistently in equilibrium.
  • That there is always a single price.

Under the Neo-Classical view, everything that is to be known is already known; man is omniscient. He has access to perfect knowledge and he need merely to analyse the data he already knows; there is no room for discovery of unknowns, nor room for the entrepreneur. The entrepreneur to our curve is an analytical pest.

I mentioned above the assumption of there always being a single price, below we can see a quite comical examination of what is meant by this:

Figure 3

Under the equilibrium model and the Marshallian Cross, we are hypothetically assuming that with each supply curve, there is an equal demand curve running parallel to it. In fact every demand curve assumes an equal supply curve running parallel to it also; thereby consistently assuming the hypothetical to reality, that being only a single price is constant, and there is no possibility of two or more prices existing for the same product.

“It is a fundamental law of Economics that there is a single price for a product. However, this is a tendency. The reason to say it is a tendency is due to the fact that at any time, the market can be filled with ignorance”

It is a fundamental law of Economics that there is a single price for a product. However, this is a tendency. The reason to say it is a tendency is due to the fact that at any time, the market can be filled with ignorance; either optimal ignorance, whereby you know you lack information but the cost outweighs the benefit of acquiring said information, or further, the ignorance may be based in the absence of information (not knowing what you don’t know).

If there is no optimal ignorance, nor absence of information for a particular consumer good, input or resource, then the tendency for pricing signal’s to converge to a single price occurs.

To give an example, I am optimally ignorant of how to speak Korean. I would like to know how to speak and understand it, but I have analysed the cost in terms of resources and time are too great, and would be better spent on ventures I value more highly.

I would give an example of where I personally have an absence of information…but I don’t know what it is.

Further examination of this gap to which is ignored and incompatible with the equilibrium state of affairs is detailed below:

Figure 4

In the diagram shown above, under the Neo-Classical equilibrium context, we assume a quantity of QR. The question is what is the highest price that is low enough, to get consumers to buy this quantity? The answer is the top left noted as HP. Following this, what is the lowest price which is high enough to get suppliers to offer this quantity? The answer is the bottom left LP. This indicates; under an Austrian perspective rather than a Neo-Classical perspective, as shown in the greyed out section, that there is a gap.

A wider examination of this gap can be explained before moving on further:

We suppose two examples: Sellers selling a good; let’s say shoes, for £10 at the LP quadrant. Buyers who are late to the market, or hold a high marginal utility for shoes find they cannot acquire shoes, but would be more than willing to pay £17 for shoes. The second example, being that sellers selling shoes in the HP quadrant, are selling shoes for £20. Buyers with lower expendable income, or whose marginal utility is lower, cannot afford the shoes at £20, but would be willing and able to buy at £16. There is an absence of information for both buyers of the HP and LP, and sellers of the LP and HP. Sellers (buyers) of the LP are unaware they can sell (buy) at a higher price, and buyers (sellers) are unaware they can buy (sell) at a lower price.

We have a situation where two prices for the same good prevails because of ignorance.

“This is where the entrepreneur comes in. A sharp individual sees there is an unexploited opportunity by seeing the price difference. If they are sharp; as we have assumed, they will see there is opportunity for pure entrepreneurial profit”

This is where the entrepreneur comes in. A sharp individual sees there is an unexploited opportunity by seeing the price difference. If they are sharp; as we have assumed, they will see there is opportunity for pure entrepreneurial profit. The entrepreneur will buy shoes from LP for £10, and sell to buyers from both HP and LP for £15. Buyers from LP who were willing to pay £17 will gladly pay the £15, and buyers from HP who could not afford £20, but were willing to pay £16, will be able to satisfy their needs/wants by purchasing the shoes for £15. Additionally, sellers from LP will see they made a critical error as they could have sold for a higher price, and sellers from HP will see they could have sold more for a lower price; ergo, the market through entrepreneurial alertness has moved from disequilibrium to a position closer to equilibrium.

The market is in positions closer to disequilibrium positions, and the entrepreneur through the incentive for profit, discovers these gaps and brings prices closer to that of the tendency of a single price.

The market process is one of discovery; rather than an equilibrium state of affairs.

Competition Under The Market Process

Taking into consideration our examination of Neo-Classical Equilibrium, and the market as a process of discovery, what does the equilibrium state of affairs and the market process of discovery have to say about competition?

The Neo-Classical has a stark difference in terms with regards to competition as compared to the layman, and that of the process of discovery.

Under the equilibrium theory of the market as a state of affairs, the definition is classed as Perfect Competition. Perfect competition is a state of affairs, where we have an unlimited number of buyers and sellers; all sellers are selling at the exact same price, and all buyers are buying at the exact same quantities. All decisions, quantities, and production methods are known, and so everyone is constrained into this state of affairs, due to nothing else to discover.

Under perfect competition, no seller attempts to sell for a higher price, because a single market price is established and it would be suicide, and no seller equally attempts to sell for a lower price, because he knows for the set single price he can sell the exact same quantity. Furthermore, buyers do not attempt to bid a higher price because they know they can purchase the same quantity for the single price, and buyers do not attempt to acquire a lower price, because they will not acquire the products they desire.

Under the equilibrium theory of the market as a state of affairs, all quantities demanded and quantities sold are perfectly inelastic; they are static.

This theory of competition, ironically, has no semblance of any form of competition; under the layman sense or that of the market as a process of discovery.

Under the equilibrium state of affairs, everything is already known, and nobody can buy or seller at higher or lower prices, and so there is no competition.

Additionally, this state leaves no room for the entrepreneur.

I have mentioned the market as a process of discovery several times; what is it that is meant by this with regards to competition?

Competition under the market as a process, is simply freedom of entry.

“Under freedom of entry, there are no privileges in the form of institutional blockage into the market. A man can be a very successful entrepreneurial producer, but is constantly looking over his shoulder because at any point, another could enter the market”

Under freedom of entry, there are no privileges in the form of institutional blockage into the market. A man can be a very successful entrepreneurial producer, but is constantly looking over his shoulder because at any point, another could enter the market and undermine his product by selling at a price, quantity, or quality that is more appealing to consumers.

If we look back at our example of the entrepreneur buying shoes for £10 and selling for £15, because other sellers held an absence of information, and had not seen an opportunity for profit, we can understand the role competition plays in the market as a process of discovery. The market is flooded with ignorance from various economic actors, who overlook opportunities due to an absence of information and a lack of omniscience. These unseen opportunities; if our entrepreneur is sharp, are discovered, either through active search for opportunities or through a sharp eye where no search was active, and merely saw what was unseen by others.

What is required for the market to operate as a process, is decentralised discovery. What is required for competition within the market process, is freedom of entry.

Sources:

  • Israel Kirzner: Competition and Entrepreneurship (pp. 10-11, 13, 20, 26, 28, 37-40.)
  • Israel Kirzner: Discovery, Capitalism and Distributive Justice (pp. 8, 23-31.)
  • Israel Kirzner: Competition, Economic Planning and the Knowledge Problem (pp. 9-10.)
  • Entrepreneurship and the Market Process with Israel Kirzner (2011) YouTube video, added by Foundation for Economic Education [Online]

The Micro Lens Perspective of Equilibrium and Disequilibrium – Kirzner’s Entrepreneurship vs Schumpeter’s Entrepreneurship

Image: https://www.beloit.edu/live/profiles/543-israel-kirzner . http://www.khappucino.com/2011/12/joseph-schumpeter-dynamic.html

Economic Piece by Josh L. Ascough

There is a fierce differentiation between Professor Israel Kirzner’s entrepreneur and his role, and that of the late Joseph Schumpeter’s entrepreneur and the role he plays in the market.

For those who are unaware, the entrepreneur, as according to Professor Kirzner, is an equilibrating force who, through discovery, perceives unseen opportunities for pure profit due to imperfect knowledge of market participants; under the market process and the state of disequilibrium, he moves the market closer to a state of equilibrium. The late Schumpeter had, as would appear on the surface, the complete opposite view of the entrepreneur. To Schumpeter, the state of equilibrium is a set routine; an even state of circular flow, and the entrepreneur, for Schumpeter, breaks away from convention; he is a disruptive force, who breaks away from the set and known; to destroy existing structures, creating a new state of disequilibrium by dislodging it from the state of equilibrium.

At a first glance these two concepts can easily be seen as separate theories of entrepreneurship; and they are. However, both theories can also be looked at as being the same, but under a different lens of perspective; one expanding to see a wider view, another contracting to focus on a singular area of interest.

This is what I hope to share with the reader; an idea that Kirzner’s and Schumpeter’s entrepreneurial actor and process can be seen as merely being witnessed from differing angles of the same lens and can, in theory, be woven together.

It should be noted I will be referencing Professor Kirzner’s work; Competition and Entrepreneurship, solely for this. Due to Schumpeter’s passing before Kirzner’s work on entrepreneurship began, we cannot know of his views of Kirzner’s work, or what his perception of Professor Kirzner’s entrepreneur would have been. In such case, I shall refer to Kirzner’s work to give insight into the perceived theoretical difference between the two concepts of the entrepreneur.

If we look into Professor Kirzner’s writings on the monopolist, he speaks of how, if a perceived monopolist holds his position due to a claim of ownership over a particular resource required for production, from a short-run view he would appear to be a monopolist. However, if our view is not focussed on a particular period, and is instead expanded to before he acquired the resource and it is that of a long-run view, if his acquiring was due to other profit seekers not knowing of the profit opportunities of this resource, due to a state of disequilibrium, then he is an entrepreneur who; through discovery, saw an absence of information and a missed opportunity for pure profit.

Taking this understanding into mind, if we return to the two arguments from Krizner and Schumpeter on the topic of the entrepreneur, we can theorize that the two are true, but merely being viewed through the same lens at a short-run, contracted view, and a long-run, expanded view of the entrepreneurial process and market state of equilibrium and disequilibrium.

What is meant by this? Let us go into a bit of investigation.

According to Schumpeter’s view of the entrepreneur, when the market is in states of equilibrium; producers produce the same quantities of goods and services as that of previous periods, the entrepreneur detracts from this convention and breaks away into a new route of market activity; distorting existing structures and moving the system into uneven states of disequilibrium. This, according to Schumpeter, is the creative destruction of the market economy, and the market process.

If we contract our lens to view the perception of the market actors prior to the entrepreneur’s activities, then we can see how, to the understanding of what is known to said actors, they were in a state of equilibrium and the “pest” known as the entrepreneur, had unravelled what they perceived to know as being all information available. We are now looking at the economic process prior to the entrepreneur’s arrival, within a short-run period.

As explained earlier, according to Professor Kirzner’s view of the entrepreneur, at any given time, the market is paved with ignorance of the individual economic actors, with missed, unknown opportunities, and that the market is in these states of disequilibrium, due to no actor having perfect knowledge; no economic actors are omniscient. The entrepreneur, as an outside observer, sees these missed unperceived pieces of information of resources to which could have more profitable uses, consumer desires not being met, and want/needs unknown to consumers to which they had no prior understanding for their satisfaction; he prepares forward looking, multi-period plans in order to achieve pure entrepreneurial profit. It is this outcome, if successfully perceived, which brings market activity via a process, closer to a state of equilibrium.

If we now expand our lens to ex-post the entrepreneurial actor’s seeking of the opportunity for pure profit, we see; through our expanded lens, that there were unnoticed, unknown opportunities for profitable market activity, to which the producers prior faced an absence of information (they don’t know what they don’t know), or, they faced optimal ignorance (they know what it is they don’t know, but it is more costly than beneficial, and so efficient to be ignorant).

While Kirzner and Schumpeter did have different theories around the subject of the entrepreneur; there is no doubt to be had, if we take Professor Kirzner’s short-run and long-run argument of examining the monopolist; with regards to looking at the matter from a shorter or longer period, it becomes possible to see why a state of equilibrium was perceived by the economic actors with regards to their known information ex-ante the entrepreneurs arrival.

This short piece should not be seen as a criticism of either Professor Kirzner’s or Schumpeter’s work; on the contrary, it is an attempt to explain that the two theories can be examined to be perspectives of differing periods of time, from the perspective of the economic actors of said differing times; the ex-ante and ex-post of the entrepreneur.

This is purely designed to be a short piece on the matter; if further examination is desired, you may find it in the following books:

  • Competition and Entrepreneurship – Israel Kirzner
  • Discovery, Capitalism, and Distributive Justice – Israel Kirzner
  • Essays on Capital and Interest – Israel Kirzner
  • Theory of Economic Development – Joseph Schumpeter
  • Capitalism, Socialism and Democracy – Joseph Schumpeter

Slowing Recovery to Recover Faster-Why the Chancellor’s Tax Plan Is a Fallacy

Image: https://pixabay.com/photos/wallet-credit-card-cash-investment-2292428/

Economic Opinion Piece by Josh L. Ascough

At the beginning of March, Rishi Sunak; Chancellor of the Exchequer, announced the first budget since the pandemic was declared.

As part of the budget and this “recovery” plan, two specific changes to taxes were announced: Corporation Tax is set to rise on large companies from 19% to 25%, and a freeze on Income Tax thresholds; bringing roughly 1 million more people into paying Income Tax, and a million more into paying at the higher rate.

The Institute for Fiscal Studies reported it is set to raise an extra £29 billion by 2025-26.

But this is fallacious at best and bad economics at worst.

One thing to note of before continuing; which will help in explaining the problems with these hikes, is that Governments’ don’t control taxes, they control tax rates. Taxes are what happen when you combine tax rates with economic behaviour. In addition corporations don’t “pay” taxes, they collect taxes; taxes to a corporation are simply an additional cost, and an increase to costs will create differing economic behaviour.

With these in mind it should become obvious at merely a glace that the tax hikes are not going to have the perceived effects the Chancellor thinks they will.

Let us address these in separate sections; from the simplest to most complex, starting with the new Income Tax thresholds.

“Most jobs paying these rates are part-time or sales assistant retail work, therefore it will have a negative financial effect on these demographics; such as single parents looking to work part time and students. Further, this will cause a hit to high-street businesses struggling to find employees”

Freezing the Income Tax thresholds will force those earning £12,500 and below to start paying Income Tax. This will inevitably lead to low income individuals to see their living standards drop further, due to the forced decrease in expendable income, many will find it more difficult to satisfy their wants/needs and see their marginal utility of goods drop. As a result a few things will happen:

  • More people with no work experience or qualifications will remain and enter the benefit trap, since the credits and additional welfare assistances will be not necessarily more appealing, but more manageable for meeting expenses than the large cost to incomes, due to welfare acting as a substitute to income, rather than a supplement, which means the government will not be getting as many additional receipts as they imagine.
  • Due to those earning £12,500 or lower paying Income Tax, spending by those demographics will see a decrease, which means there will be less revenue generated via the Sales Tax, and this decrease in consumption could further hurt small businesses already on the margin.
  • There will be a further disincentive to work in these positions. Most jobs paying these rates are part-time or sales assistant retail work, therefore it will have a negative financial effect on these demographics; such as single parents looking to work part time and students. Further, this will cause a hit to high-street businesses struggling to find employees, and as mentioned above, will mean the government will not get as many additional receipts as they imagine.
  • There will be mounted pressure to raise the minimum wage in an attempt to counteract the introduced taxes. If this occurred those unable to produce at the new rates, would find themselves laid off and unemployed; essentially making it impossible for them to find employment; increasing the unemployment rate, and, once again, decreasing the degree of receipts the government is expecting to gain.

But that is just the lower income thresholds, as mentioned above millions are expected to be pushed into the higher Income Tax rate of 40%. What can we expect the results of this will be?

Similar as mentioned above, the push up to a higher tax threshold will mean those previously paying 20% will find due to the decrease in expendable income that their living standards will decline do being able to satisfy less needs/wants, and will find their marginal utility of goods and services decrease.

I’ve gone over this a few times in previous pieces but to reiterate, let’s illustrate what is meant.

If we look at the Mangerian representation of marginal utility we get a much clearer picture of this:

Suppose ‘A’ has an annual income of £30,000; after a progressive income tax of 20%, ‘A’ is left with £24,000. Additionally suppose ‘A’ has 9 needs/wants in order of importance for satisfaction. These are:

  • Food.
  • Bills.
  • Clothing.
  • Travel.
  • Owning a Pet.
  • Pet Food.
  • Leisure.
  • Saving.
  • Holidays.

Suppose ‘A’ is only able to satisfy six of these needs/wants. Because marginal utility is based on the level of satisfaction = utility, and the lowest want = marginal, ‘A’ would do without the 9th, 8th, and 7th. Under the pushed up threshold of 40%, ‘A’ would be left with £18,000, and would have to do without the 6th, 5th, and 4th.

Now these needs/wants illustrated are not determined and can be interchanged with each other or different goods and services based the subjective values of the individual, but it still stands that the new threshold will force median earners to restrict themselves further.

This in turn has a negative feedback to the industries which provide those goods and services done without. Those industries, to which consumers pushed into higher tax thresholds have done without, will in due course see a drop in sales; not just meaning they are making fewer or no profits, but are not covering their costs, which will in turn cause further unemployment, closing of shops in locations hit hardest, and possibly lead to bad deflation; the kind of deflation which occurs due to economic downturns in production and productivity.

There are also the effects on savings and investment.

If people are leaving consumption needs/wants unsatisfied in order to satisfy those needs/wants that hold a higher marginal value, then we can expect those median earners to reduce the amount they are saving; since current consumption is more intense than ability and/or desire to save for future consumption, once pushed into an Income Tax threshold of 40%

In such an instance MV (money velocity) would be at a high, indicating people’s time preference for current consumption. This would mean the banks would not be able to lend as much, and the interest rate would have to rise; signalling to businesses and entrepreneurs that now is a bad time to expand their capital goods or bring new markets to consumers.

This would mean fewer businesses will be able to diversify themselves through expansion, leading to a slower growth in production and job creation.

“Does it sound like a bad budget? …The Corporate Tax is scheduled to rise from 19% to 25%, making it the highest rate of Corporate Tax since 1982 when the rate was roughly 30%”

Does it sound like a bad budget? Well we haven’t even gotten into the Corporate Tax and things are about to get a lot worse with even more negative feedbacks.

The Corporate Tax is scheduled to rise from 19% to 25%, making it the highest rate of Corporate Tax since 1982 when the rate was roughly 30%.

This will have a variety of negative effects, depending on how businesses respond to the rise in corporate tax; a combination of behaviours could be expected, considering the harm to which the economy has been subject to due to the lockdown and other government policies.

While the budget states that it is only large corporations that will see their tax rate increase, it is still to have a negative effect on small businesses; but we’ll get to that as we go along.

As stated earlier, not only are taxes what happen when combining tax rates with economic behaviour, but corporations don’t “pay” taxes, they collect them. What should be heard when “we’re raising taxes on corporations” is uttered, is:

“We’re going to use corporations as a funnel for higher rates of collection”.

With this in mind what behaviours are to be expected from the funnelling of taxes via corporations?

Let’s talk about consumer prices first, because this links closest to what was mentioned with regards to Income Tax.

One way economic behaviour can respond to an additional cost is to see an increase in consumer prices. This would mean alongside the new Income Tax thresholds, many consumers will find their cost of living rising sharply, and have to readjust their optimal ranking of goods and services they hold a utility for, to which would mean there would be additional needs/wants left unsatisfied.

This, similar to what was stated earlier, would mean businesses would not see as high profits as the government is counting on, and government receipts via the Corporate Tax would see a decrease, because people are seldom able or willing to spend as much.

This large reduction in spending, alongside a possible withholding from investment into expansion, is what could lead to the bad kind of deflation. A basic outline can be seen below.

In the illustration shown above we see a basic example of a fall in spending. Aggregate Demand (A.D1) shifts downwards to the curve of A.D2. This causes output to fall also, as displayed by Aggregate Supply (A.S1) shifting downwards to A.S2. This leads to the price of goods in turn falling from P1 to P2.

It must be stressed that to class this fall as a good thing would be in the negative. Remember, these falls in prices and demand aren’t because an optimal quantity of goods have satisfied consumer wants/needs for the complete period in which they wish to utilise them; it is because overall spending has fallen, and because output has shrunk. Which means there are expansions of capital goods that have been abandoned, and in order to offset the cost, wages have to be cut, workers laid off and prices have to fall.

It is a somewhat similar story with regards to other behaviours that can be an outcome of the tax hikes.

A rise in tax rates on profits would mean in order to offset the additional cost, wages could see a decline. This brings us back to what was mentioned earlier about lower expendable income in a cycle:

Income Tax Rate Rises Less Expendable Income People Spend Less Corporate Tax Rate Rises Wages Fall/Prices Rise Cost of Living Rises People Spend Less Cost to Businesses Rise/Revenue Falls Outputs/Wages Fall.

Leading to, as mentioned before, the government finding its receipts are not as plentiful as they anticipated; fewer receipts via the Sales Tax, Corporate Tax, and, if workers are laid off, Income Tax.

Another Area to talk about is the process of production and entrepreneurship.

Capital and production are forward-looking, multi-period processes. The process of production is not a simple, pre-determined static motion; entrepreneurial producers set plans in motion during set periods and can have these changed, moved forward as they originally anticipated, or at worst abandoned at the difference stages of completion.

To go into more detail, let us suppose the following:

Suppose I hold a claim to wheat seeds. I wish to plant the seeds and grow wheat in order to make bread, so I search to purchase land that is suitable for my purposes. I find a landowner and agree to pay him with a portion of the funds I receive from selling the wheat, plus interest.

After time has passed and the wheat is fully grown, the first period of my plan is complete. I discover there is a high demand for vodka, and so must make the choice whether to continue with the production of bread, produce vodka, or sell my wheat to those who produce vodka. I finally decide on the selling of the raw wheat itself.

After selling my wheat to bread makers and vodka producers, I pay the land owner and must make the following decision:

Do I continue to pay him for the use of this land; or, with my revenue, do I buy the land outright, and rent it to producers looking to produce wheat for bread and vodka, knowing that this is an industry in high demand. Or, alternatively, do I buy the land outright, and continue to produce wheat for high demand industries without needing to pay rent?

Ultimately I decide to buy the land outright; initially to produce wheat for bread and vodka. However, I see consumers are favouring a competitor for bread, and demand for vodka is not being met due to most wheat producers selling to this bread maker for possible higher returns. Finally I decide to dedicate my wheat production to the manufacturing of vodka alone; specialising in one particular area of the market.

The point of this long winded story, is to illustrate that at any time, initially perceived long-run plans for the market can change. That the market process is not an indefinite, unchanging plan, but that the plans producers make are multiple; in varying periods of production and can change from initial desired outcomes.

Because the process of production is a long-run, multi-period one, added externally imposed costs do not merely effect the outputs by seeing a smaller scale of outputs, they can and will effect different periods of production; which can in turn, effect the employment of those in the production of goods of higher order. The market is interdependent, and so negative shocks to one period of the process can and will send negative feedback to earlier stages of production.

I gave mention earlier to how the rise in Corporate Tax rates would have an effect on small businesses and not just larger businesses; this, like most of what we’ve talked about here, would be a knock on effect.

How so?

Small businesses unlike larger, more international businesses don’t have the ability to branch out; nor large stocks of capital to diversify themselves and rely on other companies to provide products for them to line the shelves with. Small businesses don’t have the means to produce output, nor do they have large quantities of capital goods to utilise input materials should a supply run short. If the higher rate of Corporate Tax causes a reduction in outputs, or, at the least, a slower expansion of production, then small businesses; particularly small, family owned retail shops, will find the already produced, output stock they can store for sale will be heavily reduced or have a higher cost.

A higher Corporate Tax rate may not hurt small businesses directly, but it hurts them indirectly by reducing the amount of outsourced goods they can afford; requiring them to lower their stock or increase their prices, making them more at risk of shutting down.

“The Laffer Curve theorises that there are two peak points of a tax rate, at which the government would receive 0 revenue. At the top is a 100% tax rate, at which the government would receive zero revenue due to driving out any and all investments, wages, savings and other means of generating wealth”

Before concluding I want to briefly talk about the Laffer Curve.

The Laffer Curve theorises that there are two peak points of a tax rate, at which the government would receive 0 revenue. At the top is a 100% tax rate, at which the government would receive zero revenue due to driving out any and all investments, wages, savings and other means of generating wealth. At the bottom is 0% tax rate, at this point the government receives zero revenue because it places no rate of tax on its citizens and their activities.

While it shows at both these points the government receives 0 revenue, each peak point has different effects on citizens. At the top point the citizens’ economic activity would be non-existent and be put into positions of poverty, while at the bottom point the citizens economic activity, productivity and accumulation of wealth would be at its maximum optimal level; higher tax rates slow economic activity, lower tax rates accelerate economic activity.

So why, even if we believe what has been discussed here to be the worst of a worst case scenario, hasn’t the government seen these issues?

Well the shortest answer I can give without taking too much more of the readers time, is that it is a theoretical error with Mainstream Economics, viewing the economy as a static period; merely a mathematical formula not affected by human choice, values, ambitions and action. It is viewing economic activity as if it is not affected by externally imposed costs; that the economic actors will bring about a certain level of activity regardless of how high a tax rate is increased. It is seeing you have 12 eggs to make a large cake, taking 8 and believing you can make the exact same sized cake with 4 as you could with 12.

There is little excuse for a fallacious budget. Even if taking the assumption that such a bad budget was desperately brought in, in order to expand the governments revenue there are two problems with this:

  • Taking a larger amount from a small pie is not the same as taking a smaller amount from a large pie. Or, in money terms: There’s a difference between taking, say, 5% of £300 million, and 20% of £3 million.
  • The government already has a large revenue stream. Revenue isn’t the government’s problem, and I’m going to show this briefly before concluding:

Let us compare Government debt with Government receipts; the amount of money the Government collects in a year from all sources.

If we give the Government some leeway on its debt for the year 2020 and take a look at this ratio from the year 2019, we see the following. First it is important to look at the revenue streams from the financial years of 2009 to 2019.

As is shown, the Government receipts in the financial year of 2019 were at 634.64 billion GBP; an increase of 52.95% since the year 2009.

Next we look at the Government receipts compared to Government spending for the year 2019.

Government spending compared to receipts, was 851.3 billion GBP; which equates to roughly 34.13% higher than all sources of revenue collected by the Government.

Finally let’s look at the Government receipts for the year 2019 as compared to the debt as it stood in 2019.

“The Government doesn’t have a revenue shortage problem; the Government has a spending spree problem.

If the government was looking to have economic recovery, slowing down that recovery is certainly a strange way of doing it”

In quite startling results the government debt in 2019, stood at 1821.9 billion GBP; or 1.8 trillion. The government debt is 187.07% higher than the Government receipts collected from all sources.

The Government doesn’t have a revenue shortage problem; the Government has a spending spree problem.

If the government was looking to have economic recovery, slowing down that recovery is certainly a strange way of doing it; to say the least in the most polite way possible. if the Chancellor was serious about recovery, and giving the private sector a strong push off the ground, he would’ve done well to have drastic reforms to the tax system; particularly Income Tax and Corporate Tax, into low, flat rate taxes of 5% and 10%.

Politicians like to talk a lot about the private sector giving back to the public, but for a year, the private sector has made huge sacrifices; sometimes willingly, sometimes forced on to it, in order to keep the public sector afloat; perhaps then, it’s time the public sector and the government, gave back to the private… something other than more debt, preferable.

The Epistemology of Entrepreneurship, Prices, and Profits – The Knowledge in Commerce

Image: https://pixabay.com/illustrations/balloon-thought-bubble-head-man-912806/

Economic Piece by Josh L. Ascough

Most mainstream presentations of the market economy place a focus on the incentive effects of profit and loss; known as the profit incentive. While it is undeniable, that profits incentivise market activity towards making good decisions about the allocation of resources, it is far too narrow a lane for looking at profits and the price mechanism.

Profits and prices are not a key function of the market economy for the incentives alone; these factors of the market economy have an epistemological nature to them; not just for the short term, current consumption and production, but in future consumption and interest too.

“To assume such a state would be to assume it possible for human beings to be omniscient; to hold perfect information for any given time period, and a state of perfect equilibrium”

Information and knowledge are not centrally organised and distributed goods. To assume such a state would be to assume it possible for human beings to be omniscient; to hold perfect information for any given time period, and a state of perfect equilibrium. If we look at the Austrian understanding of the market process and the entrepreneur, this gives us a clear insight into the Subjectivist theory; this includes the standard of value being subjective, but also the step prior to the arrival of value, that being information. The profit and loss network works in a similar way, as described by Professor Steve Horwitz:

 “Profit and loss are like the pleasure and pain signals sent by our nerve endings. If we didn’t feel the pain of our hand on a hot stove, we wouldn’t know that we were burning ourselves.” (Horwitz, Austrian Economics, pp. 49-50).

Without the price mechanism, we would hold no means of understanding the relative scarcity of goods and services, and have no methodology of passing on information in terms of where supply is needed; whether it is needed, and neither for passing information about where demand is; if it exists, for the particular final consumption good, or the capital goods of higher order.

To get back to the entrepreneur, The Austrian school of Economics places a high emphasis on the role of the entrepreneur, as well as the entrepreneurial process in the confines of the subjectivist theory.

The Misesian approach to the entrepreneurial process and how it relates to the theory of subjectivism, is that at any time market forces can face an absence of information (not knowing what we don’t know), and that this creates a disequilibrium. This mutual ignorance between buyers and sellers creates opportunities for the entrepreneur to acquire pure profit. If ‘A’ is selling oranges for $6 a bag, yet I value the oranges at no higher than $4 and I am subject to an absence of information because I do not know of ‘B’, who is selling oranges for $2 a bag, the entrepreneur has an opportunity for pure profit and to eliminate this absence of information. If he himself as an external observer is aware of the opportunity, he will buy oranges from ‘B’ for $2 a bag and sell to me in the middle for $3 a bag.

There is also the possibility that my ignorance is not an absence of information, but a matter of rational ignorance, or optimal ignorance. Suppose I am aware that I can acquire oranges from ‘B’, but the cost of transportation I deem as too great, or the time to get to seller ‘B’ does not fit within my time preference of having the oranges for current consumption. I have made a rational decision to remain ignorant.

If the entrepreneur has accurately perceived the information that I was ignorant of, then, ceteris paribus, that knowledge will be transferred to the market; informing consumers of an alternative choice they were absent of knowing, and competitors of the missed opportunity for profit. As explained by Jesus Huerta de Soto:

“The entrepreneurial creation of information implies its transmission in the market. Indeed to transmit something to someone is to cause that person to generate in their own mind part of the information which other people have created or discovered beforehand.” (de Soto, The Austrian School, p. 22).

These unnoticed opportunities play a key role in the economic world, because as stated, knowledge and information are not, and cannot be a centralised body, because at no time can one person or everybody know everything; such an approach would render knowledge and information; as translated into prices and profits, as static.

On the subject of interest, the time preference of consumers provides signals of information to the entrepreneur in terms of whether people hold a need-want for current consumption, or future consumption. The lower interest rates (due to real savings, not the artificial decrease by central banks), gives a means of knowledge to the entrepreneur that it is more profitable to create a future alternative to what is currently provided on the market, or to develop a new area of the market which had unexplored opportunities for pure profit, due to a previous absence of information, or optimal ignorance on the part of buyers and sellers. As Professor Israel Kirzner notes:

“Ever since Bohm-Bawerk, Austrian capital-and-interest theory has revolved around the concept of “roundaboutness.” This insight-that production takes time-focusses attention on intertemporal allocation of resources, on intertemporal rates of exchange, and on the structure over time of the stock of capital in the economy. Because the passage of time permits us to witness the successive initiation of time-consuming processes of production (and their subsequent successive completion), a cross-section of production activities at a given date will reveal a wide array of processes of production arrested at different stages towards completion, embodying stocks of resources invested already for a wide array of lengths of past time.” (Kirzner, Austrian Subjectivism and the Emergence of Entrepreneurship Theory, p. 112).

What happens when there are political forces which alter these signals? If an intervention of price controls or a “cap” on profits is brought into effect, then not only does this effect the incentives, but it skews the information being sent to market participants by giving false signals as to the quantity available to consumers, and to the profit seeker, as to how accurate he is interpreting knowledge and information. As Mises noted in his book Liberalism:

“But once the supplies already on hand at the moment of the government’s intervention are exhausted, an incomparably more difficult problem arises. Since production is no longer profitable if the goods are to be sold at the price fixed by the government, it will be reduced or entirely suspended. If the government wishes to have production continue, it must compel the manufacturers to produce, and, to this end, it must also fix the prices of raw materials and half-finished goods and the wages of labor.” (Mises, Liberalism, p. 52).

“These interventions stifle knowledge, and holt the movements of information; creating an institutional blockage of information”

As further controls are put in place, additional inaccurate signals of information are sent out to market participants, to which we are then left in a situation where we not only have an absence of information, but the information we are aware of is false, and so we are operating under an absence of efficiently perceived information; a blindness of externally imposed ignorance. These interventions stifle knowledge, and holt the movements of information; creating an institutional blockage of information.

This makes the existence of a government bailout much more onerous than simply creating bad incentives for a failed business or bank; it is a punishment of consumers, for the business’s or bank’s failure to accurately interpret market activity.

The entrepreneurial process, prices, and profits are seldom irrational. They are epistemic; a means of acquiring knowledge about the value judgements and time preferences of our fellow man. They provide signals of information; if a man makes a profit he has been informed that he perceived the information accordingly, if he makes a loss he recognizes he misread said signals and miscalculated, or misinterpreted the information (or lack thereof) he had available. Any and all regulations, controls and artificial changes of these areas by government, merely obstruct our ability to utilise market signals efficiently; usually at great peril.

References:

  • Steve Horwitz: Austrian Economics: Capital and Calculation (pp. 49-50).
  • Israel Kirzner: Austrian Subjectivism and the Emergence of Entrepreneurship Theory: The Modern Austrian Subjectivism (p55).
  • Steve Horwitz: Austrian Economics: Market Process and Spontaneous Order (p. 23-24).
  • Jesus Huerta de Soto: The Austrian School: Knowledge and Entrepreneurship (p. 22).
  • Israel Kirzner: Austrian Subjectivism and the Emergence of Entrepreneurship Theory: Capital and Interest Theory (p. 112).
  • Ludwig Von Mises: Liberalism: Liberal Economic Policy (p. 52).