The following is a speech delivered by
George Reisman at the Ludwig von Mises Institute's Mises Circle in Newport
Beach, California on November 14, 2009.
Good Afternoon, Ladies and Gentlemen:
As you all know, we are in a severe economic
downturn. The official unemployment rate now exceeds 10 percent and according to
many observers is actually substantially higher. Within the last year or so, our
financial system has been rocked to its foundations. The collapse of the housing
bubble and the numerous defaults and bankruptcies connected with it brought down
major financial institutions, such as Bear-Stearns, Lehman Brothers, and Merrill
Lynch. It also brought down numerous small and medium-sized banks and
threatened to bring down even such banking giants as Citigroup and Bank of
America. The Dow Jones stock average fell from a high of 14,000 to about 6,500.
Important retailers such as CompUSA, Circuit City, Mervyns, and Linens ‘N Things
went under, as did countless small businesses throughout the country.
Practically every shopping mall gives testimony to the severity of the downturn
in the form of vacant stores.
The collapse of the housing bubble and the
massive losses and mounting unemployment that have resulted from it have
unleashed a veritable firestorm of hostility against capitalism, in the
conviction that it is capitalism and its economic freedom that are responsible.
It is now generally taken for granted that any solution for the downturn
requires massive new government intervention, to curb, control, or abolish this
or that aspect of capitalism and its alleged evil.
Reflecting this view, in an effort to avoid
financial collapse, the government’s response was the enactment of an $800
billion “stimulus package” designed to boost spending throughout the economic
system, and the pouring of more than $1.1 trillion of new and additional
reserves into the banking system, along with the direct investment of capital in
the country’s most important banks and in major automobile firms, in order to
prevent them from failing.
As a result of its so-called “investments,”
the government now owns a majority interest in the common stock of General
Motors, once the flagship company of capitalism. There have been important
extensions of government control over the economic system in other areas as
well. For example, the stimulus package contains substantial funding for new
bureaucracies to control health care and energy production.
The new and additional bank reserves,
moreover, are not only massive, but almost all of them are excess
reserves. Excess reserves are the reserves available to the banks for the making
of new and additional loans, i.e., for new and additional credit expansion. They
are the difference between the reserves the banks actually hold and the reserves
they are required to hold by law or government regulation.
To gauge the significance of today’s excess
reserves, one should consider that total bank reserves as recently as July of
2008 were on the order of just $45 billion, and excess reserves were less than
$2 billion. Those $45 billion of reserves supported a total of checking deposits
in one form or another on the order of $6 trillion (a sum that included
traditional checking deposits, so-called “sweep accounts,” money-market
mutual-fund accounts, and money-market deposit accounts inasmuch as checks could
be written against them). That was a ratio of checking deposits to reserves in
excess of 100 to 1, or equivalently, a fractional reserve of less than 1
Today, of the $1.1 trillion-plus of total
reserves, all but approximately $62 billion of required reserves are excess
reserves. As of the week of November 4, excess reserves were $1.06 trillion.
Fortunately, for the time being at least, the
banks are afraid to lend very much of this sum, but the potential is clearly
there for a massive new credit expansion and corresponding increase in the
quantity of money. Recognition of this potential is reflected in the current
surge in the price of precious metals. Indeed, since $1.06 trillion of new and
additional excess reserves are more than 22 times as large as the $45 billion of
reserves that were sufficient not so long ago to support $6 trillion of checking
deposits, they might potentially support checking deposits in excess of $132
trillion. In effect, what has happened is that our recent brush with massive
deflation has turned out to be an occasion for a massive inflationary fueling
period in the effort to avoid that deflation.
Deflation: Credit Expansion and Malinvestment
The title of my talk, of course, is “A
Pro-Free-Market Program for Economic Recovery.” What this entails changes as the
government adds new and additional measures that create new and additional
problems. If I were giving this talk a year ago, my discussion would have been
weighted somewhat more heavily toward deflation and somewhat less heavily toward
inflation than is the case today.
A fundamental fact is that our present
monetary system is characterized both by irredeemable paper money, i.e., fiat
money, and by credit expansion. There is no limit to the quantity of fiat money
that can be created. This is the foundation for potentially limitless inflation
and the ultimate destruction of the paper money, when the point is reached that
it loses value so fast that no one will accept it any longer.
The fact that our monetary system is also
characterized by credit expansion is what creates the potential for massive
deflation—for deflation to the point of wiping out the far greater part of
the money supply, which in the conditions of the last centuries has been brought
into existence through the mechanism of credit expansion.
Credit expansion is what underlay the housing
bubble, and before that, the stock market bubble, and before that a long series
of other booms and busts, running through the Great Depression of 1929 that
followed the stock market boom of the 1920s, through the 19th and 18th
Centuries all the way back to the Mississippi Bubble of 1719, and perhaps even
Credit expansion is the lending out of money
created virtually out of thin air. It is money manufactured by the banking
system, always with at least the implicit sanction of the government, which
chooses not to outlaw the practice. Since 1913, credit expansion in this country
has proceeded not only with the sanction but also with the approval and active
encouragement of the Federal Reserve System, which, as I’ve shown, is now
desperately trying to reignite the process as the means of recovering from the
The new and additional money is created by the
banking system through the lending out of funds placed on deposit with it by its
customers and still held by those customers in the form checking accounts of one
kind or another. The customers can continue to spend those checking deposits
themselves, simply by writing checks or using other, similar methods of
transferring their balances to others.
But now, at the same time, those to whom the
banks have lent in this way also have money. To illustrate the process, imagine
that Mr. X deposits $1,000 of currency in his checking account. He retains the
ability to spend his $1,000 by means of writing checks. From his point of view,
he has not reduced the amount of money in his possession any more than if he had
exchanged $1,000 in hundred-dollar bills for $1,000 in fifty-dollar bills, or
vice versa. He has merely changed the form in which he continues to hold
the exact same quantity of money.
But now imagine that Mr. X’s bank takes, say,
$900 of the currency that he has deposited and lends it to Mr. Y. Mr. Y now
possess $900 of spendable money in addition to the $1,000 that Mr. X
continues to possess. In other words, the quantity of money in the economic
system has been increased by $900. Mr. Y’s loan has been financed by the
creation of new and additional money virtually out thin air. This is the nature
and meaning of credit expansion.
Now nothing of substance is changed, if
instead of lending currency to Mr. Y, Mr. X’s bank creates a new and additional
checking deposit for Mr. Y in the amount of $900. (This, in fact, is the way
credit expansion usually occurs in present-day conditions.) There will once
again be $900 of new and additional money. There will be altogether $1,900 of
money resting on a foundation merely of the $1,000 of currency deposited by Mr.
The $1,000 of currency that Mr. X’s bank holds
is its reserve. If Mr. Y deposits his currency or check in another bank, it is
the banking system that now has $1,000 of reserves and $1,900 of checking
deposits. On the foundation of these reserves, it can create still more money
and use it in the further expansion of credit. Indeed, as we have seen, the
process of credit expansion is capable of creating checking deposits more than
100 times as large as the reserves that support them.
Credit expansion makes it possible to
understand what caused the housing bubble and its collapse. From January of 2001
to December of 2007, credit expansion took place in excess of $2 trillion. This
new and additional money made available in the loan market drove down interest
rates, including, very prominently, interest rates on home mortgages. Since the
interest rate on a mortgage is a major factor determining the cost of
homeownership, lower mortgage interest rates greatly encouraged buying houses.
This artificially increased demand for houses,
made possible by credit expansion, soon began to raise the prices of houses, and
as the new and additional money kept pouring into the housing market, home
prices continued to rise. This went on long enough to convince many people that
the mere buying and selling of houses was a way to make a good living. On this
basis, the demand for houses increased yet further, and finally a point was
reached where the median-priced home was no longer affordable by anyone whose
income was not far in excess of the median income, i.e., only by a relatively
few percent of families.
In the middle of 2004, the Federal Reserve
became alarmed about the situation and its implications for rising prices in
general, and over the next two years progressively increased its Federal Funds
interest rate from 1 percent to 5.25 percent. This rise in the Federal Funds
rate signified a reduction in the flow of new and additional excess reserves
into the banking system and thus its ability to make new and additional loans.
This served to prick the housing bubble.
But before its end, perhaps as much as a
trillion and a half dollars or more of credit expansion and its newly created
money had been channeled into the housing market. Once the basis of high and
rising home prices had been removed, home prices began to fall, leaving large
numbers of borrowers with homes worth less than they had paid for them and with
mortgages they could not meet.
The investments in housing represented a
classic case of what Mises calls “malinvestment,” i.e., the wasteful investment
of capital in inherently uneconomic ventures. The malinvestment in housing was
on a scale comparable to the credit expansion that had created it, i.e., about
$2 trillion or more. That’s about how much was lost in the housing market. When
the money capital created by credit expansion was wiped out, the lending,
investment spending, employment, and consumer spending that had come to depend
on that capital were also wiped out.
And, particularly important, as vast numbers
of home buyers defaulted on their mortgages, the mounting losses on mortgage
loans increasingly wiped out the capital of banks and other financial
institutions, setting the stage for their failure.
The current plight of the economic system is
the result of credit expansion and the malinvestment it engenders. Capital in
physical terms is the physical assets of business firms. It is their plant and
equipment and inventories and work in progress. As Mises never tired of pointing
out, capital goods cannot be created by credit expansion. All that credit
expansion can do is change their employment and shift them into lines where
their employment results in losses. The empty stores and idle factories around
the country are very much the result of the loss of the capital squandered in
malinvestment in housing.
Other Consequences of
The plight of the economic system is also the
result of other consequences of credit expansion, namely, the encouragement it
gives to high debt and dangerous leverage. This is the result of the fact
that while credit expansion drives down market interest rates, the spending of
the new and additional funds it represents serves to drive up business sales
revenues and what the old classical economists called the rate of profit. This
combination makes borrowing appear highly profitable and greatly encourages it.
Individuals and business firms take on more and more debt relative to their
equity. They expect borrowing to multiply their gains.
In addition, credit expansion is responsible
for many business firms operating with lower cash holdings relative to the
scale of their economic activity, in many cases, dangerously low cash
holdings. Many businessmen develop the attitude, why hold cash when credit
expansion makes it possible to borrow easily and profitably? Instead, invest the
Thus, when credit expansion finally gives way
to the recognition of vast malinvestments and the accompanying loss of huge sums
of capital, the economic system is also mired in debt and deficient in cash.
Thus, it is poised to fall like a house of cards, in a vast cascade of failures
and bankruptcies, first and foremost, bank failures.
The Road to Recovery
The road to recovery from our economic
downturn can be understood only in the light of knowledge of credit expansion
and its consequences. The nature of credit expansion and its consequences imply
the nature of the cure.
The prevailing—Keynesian—view on how to
recover from our downturn totally ignores credit expansion and its effects. It
believes that all that counts is “spending,” practically any kind of spending.
Just get the spending going and economic activity will follow, the Keynesians
This conception of things, which underlies the
support for “stimulus packages” and anything else that will increase consumer
spending is mistaken. It rests on a fundamental misconception. It ignores the
fact that the fundamental problem is not insufficient spending, but insufficient
capital due to the losses caused by malinvestment. It ignores the further
facts that credit expansion has brought about excessive debt and, however
counterintuitive this may seem, insufficient cash. Too little capital,
too much debt, and not enough cash are the problems that countless business
firms are facing today as a result of the credit expansion that generated the
Just as a reminder: the way that credit
expansion brings about a situation of too little cash while itself constituting
a flood of cash is that it makes it appear profitable to invest every last
dollar of cash in the expectation of being able easily and profitably to borrow
whatever cash may be needed.
What this discussion implies is that an
essential requirement of economic recovery is that the widespread problems in
the balance sheets of business firms must be fixed. Business firms need more
capital, less debt, and more cash. When they achieve that, business confidence
will be restored.
Ironically what could achieve at least less
debt and more cash in the hands of business, and thus actually do some
significant good is if when people received government “stimulus” money, they
did not spend very much of it, or, better still, any of it at all. To the extent
that all people did with money coming from the government was pay down debt and
hold more cash, they would be engaged in a process of undoing some of the major
damage done by credit expansion. They would be reducing their burden of debt and
increasing their liquidity, thereby increasing their security against the threat
of insolvency. Such behavior, of course, would be regarded by Keynesians as
constituting a failure of their policies, because in their eyes, all that counts
is consumer spending.
The most important single step on the road to
economic recovery is the establishment of a 100-percent reserve system against
checking deposits. Ideally, the
100-percent reserve would be in gold. And that’s ultimately what we
should aim at, for all of the reasons Rothbard explained.
But even a 100-percent reserve in paper would do the job of totally
preventing all future credit expansion and, equally important, all declines in
the money supply.
(Because the 100-percent gold reserve standard
is the long-run ideal of advocates of sound money, I cannot help but feel a
sense of great satisfaction in the fact that a major step toward its achievement
is what turns out to be urgently needed as a matter of sound current economic
In the simplest terms, to establish a
100-percent-reserve system in terms of paper, the government would simply print
up enough additional paper currency so that when added to the paper currency the
banks already have, every last dollar of their checking deposits would be
covered by such currency. (Strictly speaking, a significant part, and for some
months now the far greater part, of the reserves of the banks are not in actual
currency but in checking deposits with the Federal Reserve. For the sake of
simplicity, however, we can think of the checking deposits held by the banks
with the Federal Reserve as a denomination of currency, since, for the banks,
they are fully as interchangeable with currency as $50 bills are with $100 bills
and vice versa.)
To illustrate the process of achieving a 100-percent reserve, imagine that
total checking deposits are $3 trillion. In that case, the Fed would give the
banks new and additional reserves that when added to their existing reserves
would bring them up to $3 trillion. Through various programs, such as purchasing
bad assets, the Fed has in fact already brought the total reserves of the banks
up to over a trillion dollars, but almost all of those reserves, as we’ve seen,
are excess reserves, a ready foundation for a massive new credit
expansion, since excess reserves can be lent out.
What my example implies is adding to the $1.1
trillion of reserves the banking system now has, a further $1.9 trillion and
making all $3 trillion of reserves required reserves. This would mean
that the banks could not engage in any lending of these reserves and thus would
be unable to finance credit expansion or any increase in the supply of checking
deposits on the strength of them. The money supply in the hands of the public
and spendable in the economic system would thus not be increased. That would
happen only if and to the extent that the 100-percent reserve principle were
Under a 100-percent reserve, checking
depositors could simultaneously all demand their full balances in cash and the
banks would be able to pay them all. Depositors’ demand for cash would not
create a problem and no amount of losses by the banks on their loans and
investments would prevent them from honoring their checking deposits immediately
and in full. Thus the checking deposit component of the money supply could not
fall and nor, of course could its other component which is the paper money in
the hands of the public, usually described as the currency component. Thus,
there could simply be no deflation of the money supply. And, as I’ve said,
because all reserves would be required reserves, there would simply be no
reserves whatever available for lending out, and thus no credit expansion
whatever. The expression “killing two birds with one stone” could not have a
In a addition, a significant by-product of a
100-percent reserve system would be that the FDIC would no longer serve any
purpose and thus could be abolished.
Now an essential prerequisite of the
100-percent reserve is knowing the size of checking deposits, so that it
will be known how much the 100-percent reserve needs to cover. At present, when
one allows for such things as “sweep accounts,” money-market mutual funds, and
money-market deposit accounts, the magnitude of checking deposits to which the
100-percent reserve would apply can plausibly be argued to range from about $1.5
trillion to $6 trillion. It is very solidly $1.5 trillion, but does in fact
range up to $6 trillion in that checks can be written on the additional sums
involved, at least from time to time and for some large minimum amount.
To clearly establish the magnitude of checking
deposits, bank depositors should be asked if their intention is to hold
money in the bank, ready for their immediate use and transfer to others, or to
lend money to the bank. In the first case, their funds would be in a
checking account, against which the bank would have to hold a 100-percent
reserve. In the second case, their funds would be in a savings account, against
which the bank could hold whatever lesser reserve it considered necessary. In
this case, the bank’s customers could not spend the funds they had deposited
until they withdrew them from the bank.
As I’ve said, the long-run goal in connection
with the 100-percent reserve would be ultimately to convert it to a 100-percent
gold reserve system. At that time, following ideas of Rothbard further,
the gold reserve of the Fed would be priced high enough to equal the currency
and checking deposits of the country and be physically turned over to the
individual citizens and the banks in exchange for all outstanding Federal
Reserve money. The Fed would then be abolished. But this is a distinct and much
later step in pro-free-market reform.
Reserve and New Bank Capital
It should be realized that a major consequence
of the establishment of a 100-percent-reserve system could be a corresponding
enlargement of the capital of the banking system and thus an ability to
cover even very great losses and thereby avoid such things as government bank
bailouts and takeovers.
Consider the balance sheet of an imaginary
bank. It’s got checking-deposit liabilities of $100. Initially, it has assets of
$105, which implies that on the liabilities side of its balance sheet it has
capital of $5 in addition to its checking-deposit liabilities of $100.
Now unfortunately, malinvestment has resulted
in a loss of $20 in the banks’ assets, in the part of its assets consisting of
loans and investments. As a result, its total assets are reduced from $105 to
$85 and its capital is completely wiped out and becomes negative in the amount
However, on its asset side the bank still has
some cash reserve, say, $10. If $90 of new and additional reserves were added
to these $10, to bring the bank’s reserves up to 100-percent equality with its
checking deposits, the bank’s asset total would also be increased by $90. This
$90 increase on the bank’s asset side would have to be matched by a $90 increase
on its liabilities side, specifically by a $90 increase in its capital. Its
capital would go from minus $15 to plus $75.
Applying this to the banking system as a whole
in transitioning to a 100-percent reserve, we can see that the creation of such
a vast amount of new bank capital would be entailed as easily to overcome
whatever losses the banks might have suffered in their loans and investments.
As explained, if checking deposits were $3
trillion, the Fed would give the banks new and additional reserves that when
added to their existing reserves would bring them up to $3 trillion. If this had
been done in September of 2008, bringing reserves up to $3 trillion would have
required adding $2.955 trillion of new and additional reserves to the $45
billion or so of reserves the banks already had. This vast addition on the asset
side of the banks’ balance sheets would have implied an equivalent addition to
the banks’ capital on the liabilities side. No matter how bad the banks’ assets
were, I think it’s virtually certain that an additional sum of this size would
have been far more than sufficient to cover all the losses that the banks had
incurred in their bad loans and investments. Their capital would have ended up
being increased to the extent the additional reserves exceeded the losses in
assets under the head of loans and investments.
The government’s bailout program of stock
purchases in the banks would have been avoided, along with all of its subsequent
interference in matters of bank management.
Now, as we’ve seen, in fact the Fed has
already supplied a vast amount of reserves, about $1.1 trillion, to the banks
through various programs such as purchasing bad assets. If the 100-percent
reserve principle were adopted now, many or most of those assets could be taken
back and the programs that created them cancelled.
Thus, what I’ve shown here is how
transitioning to a 100-percent reserve would guarantee the prevention both of
new credit expansion and of deflation of the money supply. It could also provide
additional capital to the banking system on a scale almost certainly far more
than sufficient to place it on a financially sound footing. To avoid what would
otherwise likely be an excessive windfall to the banks, it would be possible to
match a more or less considerable part of the increase in their assets provided
by the creation of additional reserves, with the creation of a liability of the
banks to their depositors, perhaps in the form of some kind of mutual-fund
accounts. Thus, the newly created reserves might provide a financial benefit to
the banks’ depositors as well as to the banks.
Of course, a 100-percent reserve system in
which the reserves are fiat money does not address the problem of preventing
inflation of the fiat money. It would still be possible for the government to
inflate the fiat money without restraint. That is why it is necessary to have
gold in the monetary system, serving as a restraint on the amount of currency
Thus, an important ancillary measure in
connection with the transition to a 100-percent paper-reserve system would be
for the government to demonstrate a serious intent to move to a gold standard.
Obliging the Federal Reserve to carry out a program of regular and substantial
gold bullion purchases might accomplish this. In any event, it would be an
essential prerequisite for someday achieving gold reserves sufficient to make
possible the establishment of a 100-percent-reserve gold system. Along
the way, this measure should lead to the day when purchases of gold bullion were
the only source of increases in the supply of currency and reserves.
Freedom of Wage Rates to Fall
Along with stabilizing the financial system
through the adoption of a 100-pecent reserve, it’s absolutely essential to
establish the freedom of wage rates and prices to fall. This is what is
required to eliminate mass unemployment. Whatever the level of spending in
the economic system may be, it is sufficient to buy as much additional labor and
products as is required for everyone to be employed and producing as much as he
Nothing could be more obvious if one thinks
about it. Assume, as is the case today, that there is 10 percent unemployment,
with only 9 workers working for every 10 who are able and willing to work. The
same total expenditure of money that today employs only 9 workers would be able
to employ 10 workers, if the average wage per worker were 10 percent less. At
nine-tenths the wage, the same total amount of wages is sufficient to employ
ten-ninths the number of workers. It’s a question of simple arithmetic: 1
divided by 9/10 equals 10/9.
(Obviously, this is an overall, average
result. In reality, some wage rates would need to fall by less than 10 percent
and others by more than 10 percent.)
Of course, total wage payments are not fixed
in stone. They can change. And in response to a fall in wage rates to their
equilibrium level, to eliminate mass unemployment, they would increase.
This is because prior to their fall, investment expenditures have been
postponed, awaiting their fall. Once that fall occurs, those investment
expenditures take place.
Finally, with debt levels sufficiently reduced
and cash holdings sufficiently high, and thus business confidence restored,
there is no reason to believe that a fall in wage rates could abort the process
of recovery as the result of already employed workers earning less and thus
spending less before new and additional workers were hired. The cash reserves
and financial strength of business firms would enable them easily to ride out
any such situation. And thus mass unemployment would simply be eliminated.
What stops wage rates from falling, what makes
it actually illegal for them to fall, and which thus perpetuates mass
unemployment, is the underlying pervasive influence of the Marxian exploitation
theory. That doctrine is responsible for the existence of such things as
minimum-wage laws and coercive labor unions and their above-market wage scales.
The most important fundamental requirement for
achieving a free market in labor is the total refutation of the exploitation
theory and its complete discrediting in public opinion. Such a refutation will
show that it is not government and labor unions that raise real wages but
businessmen and capitalists, and that essentially, all that unions do is cause
unemployment and a lower productivity of labor and thus prices that are higher
relative to wage rates. This knowledge is what is required to make possible the
repeal of minimum-wage and pro-union legislation and thus achieve the fall in
wage rates that will eliminate mass unemployment.
In summation, my pro-free-market program for
economic recovery is a provisional 100-percent-paper-money-reserve system
applied to checking deposits, accompanied by a demonstrable commitment to
ultimately achieving a 100-percent-gold reserve system. The 100-percent
reserve in paper would put an end to all further credit expansion and at the
same time make the money supply incapable of being deflated. Its establishment
would also greatly increase the capital of the banking system. It would do so by
more than enough to cover all the losses on loans and investments incurred in
the aftermath of the collapse of the housing bubble and thus make possible the
elimination of government ownership of common stock in banks and its
interference in bank management. What it would not do is control the increase in
paper currency and paper-currency reserves. That will require a 100-percent-gold-reserve
Finally, the freedom of wage rates and prices
to fall must be established through the repeal of pro-union and minimum-wage
legislation, and more fundamentally, the education of the public concerning the
errors of the Marxian exploitation theory and their replacement with actual
knowledge of what determines wages and the general standard of living. To say
the least, this will certainly not be an easy agenda to follow, inasmuch as it
must begin in the midst of a Marxist occupation of our nation’s capital.
Copyright © 2009 by George Reisman. George Reisman, Ph.D. is the author of
Capitalism: A Treatise on Economics
(Ottawa, Illinois: Jameson Books, 1996) and is Pepperdine University Professor
Emeritus of Economics. He is also a Senior Fellow at the Goldwater Institute.
His web site is
and his blog is
A pdf replica of his book can be downloaded to the reader’s hard drive simply by
clicking on the book’s title, above, and then saving the file when it appears on