"If, on the breaking out of any future war, we shall not have very considerably reduced our debt, one of two things must happen, either the whole expense of that war must be defrayed by taxes raised from year to year, or we must, at the end of that war, if not before, submit to a national bankruptcy; not that we shall be unable to bear any large additions to the debt; it would be difficult to set limits to the powers of a great nation; but assuredly there are limits to the price, which in the form of perpetual taxation, individuals will submit to pay for the privilege merely of living in their nation country." (Ricardo, Principles, Ed. Straffa, p.249).

Gordon Brown has no intention of embarking on a new war, though he has defence commitments in Afghanistan, but he has failed to foresee that a large deficit makes it more difficult to support future deficits. They will be harder to meet by borrowing and they will result in levels of taxation which will discourage enterprise and possibly lead to migration.

On page 356 there is the statement on which the nineteenth century gold standard was based:
"Experience, however, shows that neither a State nor a Bank ever have had the unrestricted power of issuing paper money, without abusing that power; in all States, therefore, the issue of paper money ought to be under some check and control; and none seems so proper for that purpose as that of subjecting the issues of paper money to the obligation of paying their notes, either in gold or bullion."

Under the gold standard, national governments had to regulate the issue of money by the discipline of convertibility into gold. William Stanley Jevons published his book on Money in 1873 - 58 years after Ricardo. He quotes Daniel Webster's observation about the U.S.: "We have suffered more from paper money than from every other cause or calamity. It has killed and caused more injustice than even the arms and artifices of our enemy." Jevons also observes, in his own right: The principle objections to "inconvertible paper currency are two in number,. 1. The great temptations which it offers to over issue and consequent depreciation. 2. The impossibility of varying its importance in accordance with the requirements of trade."

The essential qualification of an exchange system in classical Ricardian economic theory is therefore one of convertibility. The value of a currency is determined by its relative scarcity, and its relative scarcity is determined by its convertibility at a fixed rate into a fixed commodity; the Victorian economists regarded gold as the most convenient commodity, and the one which had the nearest to a stable rate of production.

There is a growing feeling that the present economic crisis requires a stabilisation of national currencies against some sort of world currency. The Chinese Government is interested in a world currency system such as Maynard Keynes advocated at Bretton Woods in 1944. The Russians have called for a partial restoration of a gold based system. In The Daily Telegraph of March 30th, Ambrose Evans-Pritchard reports that Arkady Dvorkevich, the Kremlin's Chief Economic Adviser, has stated that Russia "favours the inclusion of gold bullion in the basket-weighting of a new gold currency based on 'Special Drawing Rights' issued by the International Monetary Fund."

Historically, the world has moved in the course of a century from the pre-1914 gold standard, which was a system of classical discipline based on convertibility into gold, through a succession of floating rates, with the ultimate American convertibility into gold broken in 1971. As Jevons observed, an inconvertible floating paper money is in practice extremely liable to over-issue, leading to inflation. In the absence of convertibility at a fixed rate, a currency degenerates into mere paper. The Russians are the second largest gold producer, and are also major oil and gas producers. Naturally, they would like gold to play a part in any bundle of assets on which a new world currency might be based. We are in an early stage of a new exchange debate. What is interesting is that the debate has started with big power participation from China and Russia.

William Rees-Mogg
for The Daily Reckoning Australia

• Is Gold Money?
• There Are Two Ways of Studying Economic Theory
• Financial Crises in History
• A New Bretton Woods Vs. The Old Bretton Woods
• Will Synchronized Rate Cuts Solve International Financial System Problems?

The events of 2007 and 2008 have shown the limitations of the mathematical method. The credit crunch was not foreseen by anyone that I read, but it came as a shock to the number-crunchers – it took them completely by surprise. It did not come as a shock to the economic historians, who happily settled down to discuss the resemblances between this credit crisis and earlier ones, going back to the South Sea Scheme in 1720 or the Wall Street panic of 1907. The economic historians know that similar events had happened before, and had also learned, often by painful experience, that such events are quite common.

Neither group foresaw the actual events of August 2007, but the historians were quite able to put the credit crisis in a context of other crises. Even though both groups were taken by surprise, it was the mathematicians whose previous forecasts were stood on their heads. By and large, historical economists, who follow the example of major English economists such as Maynard Keynes or W.S. Jevons, do not regard timing as any more predictable for economic shocks than for earthquakes. One can say that there is a build up of stress in the system which will eventually have to be released. One cannot say that the release of pressure will occur next Tuesday or next August or even next century. Some say the big earthquake will happen along the San Andreas Fault in California. It may come tomorrow; it may come before 2050; it may not happen for 500 years. We can usefully predict what and where, but we can very seldom predict when. This makes expectation difficult to quantify, though all markets are based on expectations.

What we do know from economic history is that there is a cycle of debt which has to be relieved. In twentieth century history the war debts of the first war played their malign part in the European depression of the 1920s and eventually in the Great Depression of the 1930s. The Austrian School of Economics, and particularly Friedrich von Hayek, developed the Debt-Deflation theory of the business cycles. Hayek indeed foresaw the risk of a deflationary crisis as early as 1927.

Keynesian economics, as expounded in his General Theory, 1936, were criticised at the time for an inadequate appreciation of the negative aspects of excessive debt. Bankers of the Gold Standard era attached great importance to the balance sheet rather than the profit and loss account. I get the impression nowadays that people read the current account much more carefully than they do the capital account – partly because they think that off balance sheet financing has reduced the transparency of the balance sheet itself.

As a result, government balance sheets, bank balance sheets, corporate balance sheets and personal balance sheets have all deteriorated. Finance ultimately depends on the security of capital, and weak balance sheets, at any level, are exposed to risk and to problems of opportunity cost.

An old-fashioned banker would now be calling for strengthening of balance sheets at every level. But the liquidation of debt takes years to accomplish and diverts fund from current consumption. The 2007 credit crunch calls for liquidation of debt, but that is bound to have a deflationary effect.

William Rees-Mogg
for The Daily Reckoning Australia

• Economic Crisis Discussions in the House of Lords
• Emerging Markets in the New World Disorder
• Level 3 Assets Growing in All Five U.S. Investment Banks
• Economic Cycle Theory
• The Growing Pile of Cash On Corporate Balance Sheets

What brought about economic growth, inflation, or the business cycle in China 300 BC are the same institutions that drive phenomena in the United States in AD 2008. The circumstances of time and place change, but the underlying economic reality is identical.

That claim has made other economists - to say nothing of sociologists, historians, and politicians - scatter like pigeons. The Historical School poured scorn on this idea, and Carl Menger, the founder of the Austrian School, fought them tooth and nail. The Chicago School of positivists found the claim preposterous, and Mises and Hayek and Rothbard battled them. The Keynesians have long been outraged, and the postwar Austrian generation reasserted the truth. The socialists, who posit that rearranging property titles will transform all of reality, say that the claim is absurd, capitalistic nonsense.

But there it stands. No matter where or when, the essential prerequisite for economic growth is capital accumulation in a framework of freedom and sound money. The consequence of price control is shortage and surplus. The effect of money expansion is inflation and the business cycle. The effect of every form of intervention is to make society less prosperous than it would otherwise be.

The list of universals is endless, which is why every age needs good economists to explain and articulate the truth.

Well, I would like to add that there are universal fallacies too.

Frédéric Bastiat pointed to one: the belief that the destruction of wealth fuels its creation. He explains this by means of an allegory that has come to be known as the story of the broken window. Most famously it was retold as the opening of Henry Hazlitt's Economics in One Lesson, which is probably the bestselling economics book of all time.

A kid throws a rock at a window and breaks it, and everyone standing around regrets the unfortunate state of affairs. But then up walks a man who purports to be wise and all-knowing. He points out that this is not a bad thing after all. The man fixing the window will get money for doing so. This will then be spent on a new suit, and the tailor too will get money. The tailor will spend money on other items and the circle of rising prosperity will expand without end.

What's wrong with this scenario? As Bastiat put it, "It is not seen that as our shopkeeper has spent six francs upon one thing, he cannot spend them upon another. It is not seen that if he had not had a window to replace, he would, perhaps, have replaced his old shoes, or added another book to his library. In short, he would have employed his six francs in some way which this accident has prevented."

You can see the absurdity of the position of the wise commentator when you take it to absurd extremes. If the broken window really produces wealth, why not break all windows up and down the whole city block? Indeed, why not break doors and walls? Why not tear down all houses so that they can be rebuilt? Why not bomb whole cities so construction firms can get busy rebuilding?

It is not a good thing to destroy wealth. Bastiat puts it this way. "Society loses the value of things which are uselessly destroyed."

It sounds like an unexceptional claim. But herein rests the core case against everything the government does. Perhaps, then, we can see why the allegory is not better known. If we took it seriously, we would dismantle the whole apparatus of American economic intervention.

If you are with me to this point, perhaps you have a hard time believing that anyone really believes that wealth destruction is actually a good thing. Let me try to show that the fallacy is as pervasive as ever.

After every natural disaster, we at the Mises Institute start what we call the Broken Window Watch.

After Hurricane Katrina, the Labor Secretary said: "What will happen - and I have seen this in previous catastrophes and hurricanes - there is a bright spot in that new jobs do get created."

And The Economist said, "While big hurricanes like Katrina destroy wealth, they often have a net positive effect on GDP growth, as the temporary downturn immediately after the storm is more than made up for by the burst of economic activity that takes place when the rebuilding begins."

And the New York Times said: "Economists point out that although Katrina has destroyed a lot of accumulated wealth, it ultimately will probably have a positive effect on growth data over the next few months as resources are channeled into rebuilding."

After last year's California fires, we heard this. "In the odd nature of economic accounting, this will probably be a stimulus," said Alan Gin, a University of San Diego economist. "There will be a huge amount of rebuilding in the next couple of years, financed by insurance payments."

And CBS MarketWatch said: "Economists have noted the perverse reality that in the wake of disasters, re-construction spending helps the economy, even as people are still struggling to recover from their personal losses."

Note that personal loss here is deemed rather irrelevant compared with the beneficial macroeconomic results. Here we have a theme we find often in economics, the attempt to drive a wedge between what makes sense for individuals and what is good for society. We see this on display in this recessionary environment, when people are told to spend spend spend, even though most people understand that recessions are times for saving.

Continuing on, we find the Broken Window fallacy popping up even after 9-11.

Timothy Noah of Slate wrote: "We live in a very wealthy nation that responds to horrible disasters by spending large sums of money... It will also provide a meaningful Keynesian stimulus to a national economy that, let's face it, was tottering on the brink of recession well before Sept. 11. The recession may still come, but the countercyclical spending should help shorten it."

Another economist declared: "Initially, this could provide a significant boost to an economy that had been slumping. The construction industry could benefit from the rebuilding process. There may also be a boon for slumping tech sales, in replacing lost equipment."

Thus can we see the continuing relevance not only of Bastiat's allegory but also of the characters in the story. The posturing wiseguy who says that breaking windows is good for the economy keeps reappearing again and again. So entrenched is this mistake that we might call it official economic doctrine for the whole country.

Regards,

Lew Rockwell

• None Found