How Interest Rate Hikes Will Trigger The Next Financial Crisis – Jesse Colombo

About the author: Jesse Colombo is an economic analyst, registered investment advisor, and Forbes contributor who warns about bubbles and future financial crises.

 

On Wednesday, the U.S. Federal Reserve hiked its benchmark interest rate by a quarter-percentage point to 2% – 2.25%, which is the highest level since April 2008. As rates continue to climb off their post-Great Recession record lows, market participants and commentators are showing almost no signs of fear as the stock market is hitting records again and complacency abounds. Unfortunately, „soft landings“ after rate hike cycles are as rare as unicorns and virtually all modern rate hike cycles have resulted in a recession, financial, or banking crisis. There is no reason to believe that this time will be any different.

As I’ve explained in the past, periods of low interest rates help to create credit and asset booms in the following ways:

  • By encouraging more borrowing by consumers, businesses, and governments
  • By discouraging the holding of cash versus spending and speculating in riskier assets & endeavors
  • Investors can borrow cheaply to speculate in assets (ex: cheap mortgages for property speculation and low margin costs for trading stocks)
  • By making it cheaper to borrow to conduct share buybacks, dividend increases, and mergers & acquisitions
  • By encouraging higher rates of inflation, which helps to support assets like stocks and real estate

When central banks set interest rates and hold them at low levels in order to create an economic boom after a recession (as our Federal Reserve does), they interfere with the organic functioning of the economy and financial markets, which has serious consequences including the creation of distortions and imbalances. By holding interest rates at artificially low levels, the Fed creates „false signals“ that encourage the undertaking of businesses and other endeavors that would not be profitable or viable in a normal interest rate environment.

The businesses or other investments that are made due to artificial credit conditions are known as „malinvestments“ and typically fail once interest rates rise to normal levels again. Some examples of malinvestments are dot-com companies in the late-1990s tech bubble, failed housing developments during the mid-2000s U.S. housing bubble, and unfinished skyscrapers in Dubai and other emerging markets after the global financial crisis.

Though it can be difficult to tell precisely which investments or businesses are malinvestments in a central bank-distorted economy, a quote by Warren Buffett is extremely applicable: „only when the tide goes out do you learn who’s been swimming naked.“ For the purpose of this discussion, „the tide going out“ refers to rising interest rates. The mass failure of malinvestments in an economy as interest rates rise typically results in recessions or banking/financial crises.

The chart below shows how recessions or financial crises have occurred after historic interest rate hike cycles:

fed-funds-rate

Here is a list of historic recessions, banking, and financial crises that have occurred after interest rate hike cycles (this list corresponds with the chart above):

Late-1970s/early-1980s rate hike cycle:

  • 1980 recession: A 6-month recession that concentrated in housing, manufacturing, and the automotive industry.
  • 1981 – 1982 recession: A 16-month recession in which 2.9 million jobs were lost.
  • U.S. savings and loans crisis1,043 out of the 3,234 savings and loan associations failed as the interest rate at which they could borrow rose above the fixed interest rates on the loans that they had issued. In addition, savings and loan institutions were limited by interest rate ceilings, which caused them to lose deposits to higher-earning commercial bank accounts.
  • U.S. housing market bust: Mortgage rates surged as high as 18%, which caused housing affordability to sink. As a result, existing-home sales fell by 50% from 1978 to 1981, affecting the whole industry – including mortgage lenders, real estate agents, construction workers, etc.
  • Automotive industry crisis: Similar to the situation in housing, higher interest rates made automobile financing much more expensive. As a result, automobile sales plunged, causing 310,000 jobs (or one-third) in the industry to be cut.
  • Latin American debt crisisRising interest rates made it harder for heavily-indebted Latin American countries to pay back their debts.

Mid-1980s rate hike cycle:

  • Continental Illinois bank failure: In 1984, Continental Illinois became the largest bank failure in U.S. history (until Washington Mutual’s failure in 2008). Rising interest rates and bad loans to Texas and Oklahoma oil & gas producers strongly contributed to the bank’s demise.

Late-1980s rate hike cycle:

  • Early-1990s recessionAn 8-month recession in which 1.623 million jobs were lost.
  • U.S. savings and loans crisis: Higher interest rates and the U.S. real estate downturn caused a continuation of the savings and loans crisis that began in the early-1980s.
  • U.S. real estate downturn: Rising interest rates caused a downturn in both commercial and residential real estate.

Mid-1990s rate hike cycle:

  • Emerging markets crisis/Mexican peso crisis: Low U.S. interest rates in the early-1990s made higher-yielding emerging markets assets more attractive to investors. As U.S. interest rates rose, Mexico and other emerging economies experienced painful readjustments and currency devaluations.
  • Orange County, California bankruptcy: Bad bets on highly leveraged interest rate derivatives bankrupted the county as interest rates rose.

Early-2000s rate hike cycle:

  • Early-2000s recessionAn 8-month recession in which 1.59 million jobs were lost after the tech bubble burst.
  • Tech bubble bustHigher interest rates helped burst the late-1990s tech bubble that was centered around internet-related companies, dot-coms, the telecom industry, etc.

Mid-2000s rate hike cycle: 

  • Great Recession: An 18-month recession in which 8.8 million jobs were lost after the U.S. housing and credit bubble burst.
  • U.S. housing bubble bust/credit crunch: Low interest rates after the early-2000s tech bust led to the formation of a bubble in housing and credit. When interest rates rose again in the mid-2000s, housing prices and mortgage-backed securities plunged.

The Current Rate Hike Cycle Won’t End Any Differently

All of the modern interest rate hike cycles we have examined resulted in recessions or financial crisis, and the current one will be no different. This time around, it will be the „Everything Bubble“ that bursts. „Everything Bubble” is a term that I’ve coined to describe a dangerous bubble that has been inflating in a wide variety of countries, industries, and assets – please visit my website to learn more. After nearly a decade of ultra-low interest rates, the U.S. and global economy are saturated with bubbles and other distortions that will only be revealed by rising interest rates. Because of our record debt burden, interest rates do not have to rise nearly as high as in prior cycles to cause a recession or financial crisis this time around.

Here are some examples of interest rate-sensitive sectors that I believe are experiencing bubbles that will burst as interest rates rise:

  • Emerging markets: Ultra-low interest rates and quantitative easing in the U.S. and Europe after the Great Recession caused trillions of dollars worth of „hot money“ to flow into emerging economies, which led to the development of credit and asset bubbles in those countries. Emerging market debt nearly tripled to $60 trillion in the past decade. Turkey, South Africa, and many other emerging markets are being roiled as U.S. interest rates and the dollar rise.
  • U.S. corporate debt bubble: The low interest rate environment after the Great Recession has encouraged public corporations to borrow heavily in the bond market. Total outstanding non-financial corporate debt has increased by over $2.5 trillion or 40% since its 2008 high. U.S. corporate debt is now at an all-time high of over 45% of GDP (see chart below), which is even worse than the levels reached during the dot-com bubble and U.S. housing and credit bubble. Read my corporate debt bubble warning on Forbes to learn more.

us-corp-debt-share-of-gdp.jpg

  • U.S. shale energy boom/energy junk bonds: This boom/bubble is closely related to the corporate debt bubble discussed above. Extracting oil and gas from shale via fracking is extremely capital-intensive and would not be feasible in a normal interest rate environment. Thanks to the artificially low interest rate environment since the Great Recession, the shale energy industry’s net debt surged to $200 billion in 2015 – a 300% increase from 2005. Rising interest rates and the bursting of the corporate debt/junk bond bubble will cause a major bust in the shale energy industry.
  • U.S. auto loans: Low interest rates after the Great Recession made financing and leasing automobiles much cheaper, which has resulted in an automobile sales boom. Total outstanding auto loans increased 36% to $1.118 trillion in the past decade. Rising interest rates will cause monthly auto loan payments to be more expensive, which will result in lower sales and a bust in the automotive industry.
  • U.S. commercial real estate: Commercial real estate is a very interest rate-sensitive arena that has levitated due to low interest rates after the Great Recession. According to Green Street Advisors, U.S. commercial real estate prices have more than doubled since 2009.
  • U.S. residential real estate: As I’ve recently explained in Forbes, U.S. housing prices now exceed their housing bubble peak and are up 50% from their low point in 2012 thanks to ultra-low mortgage rates. Mortgage rates did not reach such low levels on their own, but due to intervention by the Fed in the form of quantitative easing. The Fed is now reversing its quantitative easing program by $40 billion per month and, unsurprisingly, mortgage rates just hit a seven-year high and the housing market is decelerating.

U.S. stock market investors are dangerously exposed to coming busts in interest rate-sensitive sectors, which will spill over into the highly-inflated stock market. Please read my U.S. stock market bubble report in Forbes for more information. The S&P 500 has risen over 300% since March 2009 due to the Federal Reserve’s market manipulation:

s&p500

Many valuation measures show that the U.S. stock market is more overvalued than it was at major generational market peaks, which means that another sharp bear market is inevitable. According to the U.S. stock market capitalization-to-GDP ratio (also known as Warren Buffett’s „favorite indicator“), the market is more overvalued than it was during even the dot-com bubble:

stock-market-cap-to-gdp

The current interest rate hike cycle won’t end any differently than the others discussed in this piece – if anything, it will likely end in an even worse manner because interest rates were held at record low levels for a record period of time. The coming recession, crisis, and bear market will be proportionate to the unprecedented imbalances and distortions that have built up in our economy.

Advertisements

The Social Function of Profit-and-Loss Accounting – Robert P. Murphy

This article is excerpted from Lessons for the Young Economist, part 2, advanced lesson 13, „Profit and Loss Accounting“ (2010).

Many naïve observers of the market economy dismiss concern with the „bottom line“ as a purely arbitrary social convention. To these critics, it seems senseless that a factory producing, say, medicine or shoes for toddlers stops at the point when the owner decides that profit has been maximized. It would certainly be physically possible to produce more bottles of aspirin or more shoes in size 3T, yet the boss doesn’t allow it, because to do so would „lose money.“ On the other hand, many apparently superfluous gadgets and unnecessary luxury items are produced every day in a market economy, because they are profitable. Observers who are outraged by this system may adopt the slogan: „Production for people, not profit!“

Such critics do not appreciate the indispensable service that the profit-and-loss test provides to members of a market economy. Whatever the social system in place, the regrettable fact is that the material world is one of scarcity — there are not enough resources to produce all the goods and services that people desire. Because of scarcity, every economic decision involves trade-offs. When scarce resources are devoted to producing more bottles of aspirin, for example, there are necessarily fewer resources available to produce everything else. It’s not enough to ask, „Would the world be a better place if there were more medicine?“ The relevant question is, „Would the world be a better place if there were more medicine and less of the other goods and services that would have to be sacrificed to produce more medicine?“

In standard introductory textbooks, they often define the economic problem as society’s decision on how to allocate scarce resources into the production of particular goods and services. In reality, „society“ doesn’t decide anything; individual members of society make decisions that interact to determine the ultimate fate of all the resources at humanity’s disposal. In the pure market economy, everyone in society obeys the rules of private property, which assign ownership claims to particular units of resources.

In this context, market prices are formed when individuals engage in voluntary exchanges with each other. The resulting prices in turn give entrepreneurs the ability to calculate (expected) profits and losses from various possible activities. It is the interaction of property owners in voluntary trades that „determines“ what goods and services get produced, but the signals provided by market prices — and the resulting calculations of profit and loss — help the property owners make informed decisions.

It might be useful to step back and look at the big picture. The entrepreneurs offer money to the owners of labor services, capital goods, and natural resources. The entrepreneurs then use these inputs to produce goods and services which they sell to consumers for money (see figure below).

When a particular entrepreneurial venture goes „out of business,“ what that ultimately means is that consumers were not willing to spend enough money on its finished output to cover the offers the entrepreneur needed to make in order to bid the scarce inputs away from other entrepreneurs who wanted the inputs for theirenterprises.

Workers

To see this principle more concretely, let’s work with a silly example. Suppose a successful builder dies and passes on his business to his foolish son. The son gets the bright idea to build new apartment buildings covered with pure gold. He correctly estimates that there would be high demand for apartments where the elevator, hallways, and kitchen shelves were coated with gold. In fact, the son can rent his units for much higher monthly fees than the owners of normal apartments in similar locations.

Of course, this isn’t the whole story. Even though his revenues are very high, the foolish son’s production costs are astronomical. In addition to the labor, wood, concrete, and other items, he must spend hundreds of millions of dollars buying large quantities of gold. His accountants inform him that despite the higher revenues, he is losing incredible amounts of money because of his decision to coat the apartments with gold. The son will have to either wisen up quickly, or he will squander all of his wealth. Either way, he won’t be building apartments coated with gold for very long.

Now if we were to interview the son and ask him what happened, he might say, „It’s too expensive to use gold in my business.“ But notice that this can’t be true for all entrepreneurs. After all, the reason gold is so expensive is that other buyers are paying such high prices for it. For example, jewelers still find it profitable to buy gold in order to make necklaces and earrings, and dentists still find it profitable to use gold for fillings. No jewelerwould say, „It’s too expensive to use gold in my business.“

Loosely speaking, the profit-and-loss system communicates the desires of consumers to the resource owners and entrepreneurs when they are deciding how many resources to send into each potential line of production. It’s ultimately not the owners of gold mines nor the captains of industry who determine how gold will be used in a market economy. Instead, these decisions are largely guided by the spending decisions of the consumers. It is the consumers’ demands for normal versus gold-coated apartments, in conjunction with their demands for silver- versus gold-coated necklaces, that leads to the outcome that gold-coated apartments are ridiculously unprofitable while gold-coated necklaces are perfectly sensible.

The profit-and-loss test provides structure to the free-enterprise system. People are free to start new businesses and to sell their resources (including the labor services of their bodies) to whomever they wish. In a market based on the institution of private property, profits occur when an entrepreneur takes resources of a certain market value and transforms them into finished goods (or services) of a higher market value. This is the important sense in which profitable entrepreneurs are providing a definite service to others in the economy. Without the feedback of profit-and-loss calculations, entrepreneurs would have no idea if they were making economical use of the resources used up by their business operations.

Malinvestment, Not Overinvestment, Causes Booms – Ludwig von Mises

[This article is excerpted from chapter 20 of Human Action: The Scholar’s Edition.]

„The boom is built on the sands of banknotes and deposits. It must collapse.“

The erroneous belief that the essential feature of the boom is overinvestment and not malinvestment is due to the habit of judging conditions merely according to what is perceptible and tangible. The observer notices only the malinvestments which are visible and fails to recognize that these establishments are malinvestments only because of the fact that other plants — those required for the production of the complementary factors of production and those required for the production of consumers’ goods more urgently demanded by the public — are lacking.

Technological conditions make it necessary to start an expansion of production by expanding first the size of the plants producing the goods of those orders which are farthest removed from the finished consumers’ goods. In order to expand the production of shoes, clothes, motorcars, furniture, and houses, one must begin with increasing the production of iron, steel, copper, and other such goods.…

The whole entrepreneurial class is, as it were, in the position of a master builder whose task it is to erect a building out of a limited supply of building materials. If this man overestimates the quantity of the available supply, he drafts a plan for the execution of which the means at his disposal are not sufficient. He oversizes the groundwork and the foundations and only discovers later in the progress of the construction that he lacks the material needed for the completion of the structure. It is obvious that our master builder’s fault was not overinvestment, but an inappropriate employment of the means at his disposal.

It is no less erroneous to believe that the events which resulted in the crisis amounted to an undue conversion of „circulating“ capital into „fixed“ capital. The individual entrepreneur, when faced with the credit stringency of the crisis, is right in regretting that he has expended too much for an expansion of his plant and for the purchase of durable equipment; he would have been in a better situation if the funds used for these purposes were still at his disposal for the current conduct of business.

However, raw materials, primary commodities, half-finished manufactures, and foodstuffs are not lacking at the turning point at which the upswing turns into the depression. On the contrary, the crisis is precisely characterized by the fact that these goods are offered in such quantities as to make their prices drop sharply.

The foregoing statements explain why an expansion in the production facilities and the production of the heavy industries, and in the production of durable producers’ goods, is the most conspicuous mark of the boom. The editors of the financial and commercial chronicles were right when — for more than a hundred years — they looked upon production figures of these industries as well as of the construction trades as an index of business fluctuations. They were only mistaken in referring to an alleged overinvestment.

Of course, the boom affects also the consumers’ goods industries. They too invest more and expand their production capacity. However, the new plants and the new annexes added to the already existing plants are not always those for the products of which the demand of the public is most intense.…

A sharp rise in commodity prices is not always an attending phenomenon of the boom. The increase of the quantity of fiduciary media certainly always has the potential effect of making prices rise. But it may happen that at the same time forces operating in the opposite direction are strong enough to keep the rise in prices within narrow limits or even to remove it entirely. The historical period in which the smooth working of the market economy was again and again interrupted through expansionist ventures was an epoch of continuous economic progress.

„The change in the banks’ conduct does not create the crisis. It merely makes visible the havoc spread by the faults which business has committed in the boom period.“

The steady advance in the accumulation of new capital made technological improvement possible. Output per unit of input was increased and business filled the markets with increasing quantities of cheap goods. If the synchronous increase in the supply of money (in the broader sense) had been less plentiful than it really was, a tendency toward a drop in the prices of all commodities would have taken effect.

As an actual historical event credit expansion was always embedded in an environment in which powerful factors were counteracting its tendency to raise prices. As a rule the resultant of the clash of opposite forces was a preponderance of those producing a rise in prices. But there were some exceptional instances too in which the upward movement of prices was only slight. The most remarkable example was provided by the American boom of 1926–29.

The essential features of a credit expansion are not affected by such a particular constellation of the market data. What induces an entrepreneur to embark upon definite projects is neither high prices nor low prices as such, but a discrepancy between the costs of production, inclusive of interest on the capital required, and the anticipated prices of the products.

A lowering of the gross market rate of interest as brought about by credit expansion always has the effect of making some projects appear profitable which did not appear so before.… It necessarily brings about a structure of investment and production activities which is at variance with the real supply of capital goods and must finally collapse. That sometimes the price changes involved are laid against a background of a general tendency toward a rise in purchasing power and do not convert this tendency into its manifest opposite but only into something which may by and large be called price stability, modifies merely some accessories of the process.

However conditions may be, it is certain that no manipulations of the banks can provide the economic system with capital goods. What is needed for a sound expansion of production is additional capital goods, not money or fiduciary media. The boom is built on the sands of banknotes and deposits. It must collapse.

The breakdown appears as soon as the banks become frightened by the accelerated pace of the boom and begin to abstain from further expansion of credit. The boom could continue only as long as the banks were ready to grant freely all those credits which business needed for the execution of its excessive projects, utterly disagreeing with the real state of the supply of factors of production and the valuations of the consumers.

These illusory plans, suggested by the falsification of business calculation as brought about by the cheap money policy, can be pushed forward only if new credits can be obtained at gross market rates which are artificially lowered below the height they would reach at an unhampered loan market. It is this margin that gives them the deceptive appearance of profitability. The change in the banks’ conduct does not create the crisis. It merely makes visible the havoc spread by the faults which business has committed in the boom period.

„The characteristic mark of economic history under capitalism is unceasing economic progress, a steady increase in the quantity of capital goods available, and a continuous trend toward an improvement in the general standard of living.“

Neither could the boom last endlessly if the banks were to cling stubbornly to their expansionist policies. Any attempt to substitute additional fiduciary media for nonexisting capital goods is doomed to failure. If the credit expansion is not stopped in time, the boom turns into the crack-up boom; the flight into real values begins, and the whole monetary system founders. However, as a rule, the banks in the past have not pushed things to extremes. They have become alarmed at a date when the final catastrophe was still far away.1

One should not fall prey to the illusion that these changes in the credit policies of the banks were caused by the bankers’ and the monetary authorities’ insight into the unavoidable consequences of a continued credit expansion. What induced the turn in the banks’ conduct was certain institutional conditions to be dealt with further below, on pp. 790–791. Among the champions of economics some private bankers were prominent; in particular, the elaboration of the early form of the theory of business fluctuations, the Currency Theory, was for the most part an achievement of British bankers. But the management of central banks and the conduct of the various governments’ monetary policies was as a rule entrusted to men who did not find any fault with boundless credit expansion and took offense at every criticism of their expansionist ventures.

As soon as the afflux of additional fiduciary media comes to an end, the airy castle of the boom collapses. The entrepreneurs must restrict their activities because they lack the funds for their continuation on the exaggerated scale. Prices drop suddenly because these distressed firms try to obtain cash by throwing inventories on the market dirt cheap. Factories are closed, the continuation of construction projects in progress is halted, workers are discharged. As on the one hand many firms badly need money in order to avoid bankruptcy, and on the other hand no firm any longer enjoys confidence, the entrepreneurial component in the gross market rate of interest jumps to an excessive height.

Accidental institutional and psychological circumstances generally turn the outbreak of the crisis into a panic. The description of these awful events can be left to the historians. It is not the task of catallactic theory to depict in detail the calamities of panicky days and weeks and to dwell upon their sometimes grotesque aspects.

Economics is not interested in what is accidental and conditioned by the individual historical circumstances of each instance. Its aim is, on the contrary, to distinguish what is essential and apodictically necessary from what is merely adventitious. It is not interested in the psychological aspects of the panic, but only in the fact that a credit-expansion boom must unavoidably lead to a process which everyday speech calls the depression. It must realize that the depression is in fact the process of readjustment, of putting production activities anew in agreement with the given state of the market data: the available supply of factors of production, the valuations of the consumers, and particularly also the state of originary interest as manifested in the public’s valuations.

These data, however, are no longer identical with those that prevailed on the eve of the expansionist process. A good many things have changed. Forced saving and, to an even greater extent, regular voluntary saving may have provided new capital goods which were not totally squandered through malinvestment and overconsumption as induced by the boom. Changes in the wealth and income of various individuals and groups of individuals have been brought about by the unevenness inherent in every inflationary movement.

Apart from any causal relation to the credit expansion, population may have changed with regard to figures and the characteristics of the individuals comprising them; technological knowledge may have advanced, demand for certain goods may have been altered. The final state to the establishment of which the market tends is no longer the same toward which it tended before the disturbances created by the credit expansion.

Some of the investments made in the boom period appear, when appraised with the sober judgment of the readjustment period, no longer dimmed by the illusions of the upswing, as absolutely hopeless failures. They must simply be abandoned because the current means required for their further exploitation cannot be recovered in selling their products; this „circulating“ capital is more urgently needed in other branches of want-satisfaction; the proof is that it can be employed in a more profitable way in other fields.

Other malinvestments offer somewhat more favorable chances. It is, of course, true that one would not have embarked upon putting capital goods into them if one had correctly calculated. The inconvertible investments made on their behalf are certainly wasted. But as they are inconvertible, a fait accompli, they present further action with a new problem. If the proceeds which the sale of their products promises are expected to exceed the costs of current operation, it is profitable to carry on. Although the prices which the buying public is prepared to allow for their products are not high enough to make the whole of the inconvertible investment profitable, they are sufficient to make a fraction, however small, of the investment profitable. The rest of the investment must be considered as expenditure without any offset, as capital squandered and lost.

If one looks at this outcome from the point of view of the consumers, the result is, of course, the same. The consumers would be better off if the illusions created by the easy-money policy had not enticed the entrepreneurs to waste scarce capital goods by investing them for the satisfaction of less urgent needs and withholding them from lines of production in which they would have satisfied more urgent needs. But as things are now, they cannot but put up with what is irrevocable. They must for the time being renounce certain amenities which they could have enjoyed if the boom had not engendered malinvestment.

But, on the other hand, they can find partial compensation in the fact that some enjoyments are now available to them which would have been beyond their reach if the smooth course of economic activities had not been disturbed by the orgies of the boom. It is slight compensation only, as their demand for those other things which they do not get because of inappropriate employment of capital goods is more intense than their demand for these „substitutes,“ as it were. But it is the only choice left to them as conditions and data are now.

The final outcome of the credit expansion is general impoverishment. Some people may have increased their wealth; they did not let their reasoning be obfuscated by the mass hysteria, and took advantage in time of the opportunities offered by the mobility of the individual investor. Other individuals and groups of individuals may have been favored, without any initiative of their own, by the mere time lag between the rise in the prices of the goods they sell and those they buy. But the immense majority must foot the bill for the malinvestments and the overconsumption of the boom episode.

One must guard oneself against a misinterpretation of this term, „impoverishment.“ It does not mean impoverishment when compared with the conditions that prevailed on the eve of the credit expansion. Whether or not an impoverishment in this sense takes place depends on the particular data of each case; it cannot be predicated apodictically by catallactics. What catallactics has in mind when asserting that impoverishment is an unavoidable outgrowth of credit expansion is impoverishment as compared with the state of affairs which would have developed in the absence of credit expansion and the boom.

The characteristic mark of economic history under capitalism is unceasing economic progress, a steady increase in the quantity of capital goods available, and a continuous trend toward an improvement in the general standard of living. The pace of this progress is so rapid that, in the course of a boom period, it may well outstrip the synchronous losses caused by malinvestment and overconsumption. Then the economic system as a whole is more prosperous at the end of the boom than it was at its very beginning; it appears impoverished only when compared with the potentialities which existed for a still-better state of satisfaction.

Inflation and the Fall of the Roman Empire – Joseph R. Peden

[This is a transcript of Professor Joseph Peden’s 50-minute lecture „Inflation and the Fall of the Roman Empire,“ given at the Seminar on Money and Government in Houston, Texas, on October 27, 1984. The original audio recording is available as a free MP3 download.]

Two centuries ago, in 1776, there were two books published in England, both of which are read avidly today. One of them was Adam Smith’s The Wealth of Nations and the other was Edward Gibbon’s Decline and Fall of the Roman Empire. Gibbon’s multivolume work is the tale of a state that survived for twelve centuries in the West and for another thousand years in the East, at Constantinople.

Gibbon, in looking at this phenomenon, commented that the wonder was not that the Roman Empire had fallen, but rather that it had lasted so long. And scholars since Gibbon have devoted a great deal of energy to examining that problem: How was it that the Roman Empire lasted so long? And did it decline, or was it simply transformed into something else (that something else being the European civilization of which we are the heirs)?

I’ve been asked to speak on the theme of Roman history, particularly the problem of inflation and its impact. My analysis is based on the premise that monetary policy cannot be studied, or understood, in isolation from the overall policies of the state.

Monetary, fiscal, military, political, and economic issues are all very much intertwined. And they are all so intertwined because any state normally seeks to monopolize the supply of money within its own territory.

Monetary policy therefore always serves, even if it serves badly, the perceived needs of the rulers of the state. If it also happens to enhance the prosperity and progress of the masses of the people, that is a secondary benefit; but its first aim is to serve the needs of the rulers, not the ruled. This point is central, I believe, to an understanding of the course of monetary policy in the late Roman Empire.

We may begin by looking at the mentality of the rulers of the Roman Empire, beginning at the end of the 2nd century AD and looking through to the end of the 3rd century AD. Roman historians refer to this period as the „Crisis of the 3rd Century.“ And the reason is that the problems of the Roman society in that period were so profound, so enormous, that Roman society emerged from the 3rd century very different in almost all ways from what it had been in the 1st and 2nd centuries.

To look at the mentality of the Roman emperors, we can look just at the advice that the Emperor Septimius Severus gave to his two sons, Caracalla and Geta. This is supposed to be his final words to his heirs. He said, „live in harmony; enrich the troops; ignore everyone else.“ Now, there is a monetary policy to be marveled at!

Caracalla did not adhere to the first part of that advice; in fact, one of his first acts was to murder his brother. But as for enriching the troops, he took that so seriously to heart that his mother remonstrated with him and urged him to be more moderate and to restrain his increasing military expenditures and burdensome new taxes. He responded by saying there was no longer any revenue, just or unjust, to be found. But not to worry, „for as long as we have this,“ he insisted, pointing to his sword, „we shall not run short of money.“

His sense of priorities was made more explicit when he remarked, „nobody should have any money but I, so that I may bestow it upon the soldiers.“ And he was as good as his word. He raised the pay of the soldiers by 50 percent, and to achieve this he doubled the inheritance taxes paid by Roman citizens. When this was not sufficient to meet his needs, he admitted almost every inhabitant of the empire to Roman citizenship. What had formerly been a privilege now became simply a means of expanding the tax base.

He then went further by proceeding to debase the coinage. The basic coinage of the Roman Empire to this time — we’re speaking now about 211 AD — was the silver denarius introduced by Augustus at about 95 percent silver at the end of the 1st century BC. The denarius continued for the better part of two centuries as the basic medium of exchange in the empire.

By the time of Trajan in 117 AD, the denarius was only about 85 percent silver, down from Augustus’s 95 percent. By the age of Marcus Aurelius, in 180, it was down to about 75 percent silver. In Septimius’s time it had dropped to 60 percent, and Caracalla evened it off at 50/50.

Caracalla was assassinated in 217. There then followed an age that historians refer to as the Age of the Barrack Emperors, because throughout the 3rd century all the emperors were soldiers and all of them came to their power by military coups of one sort or another.

There were about 26 legitimate emperors in this century and only one of them died a natural death. The rest either died in battle or were assassinated, which was totally unprecedented in Roman history — with two exceptions: Nero, a suicide, and Caligula, assassinated earlier.

Caracalla had also debased the gold coinage. Under Augustus this circulated at 45 coins to a pound of gold. Caracalla made it 50 to a pound of gold. Within 20 years after him it was circulating at 72 to a pound of gold, reduced to 60 at the end of the century by Diocletian, only to be raised again to 72 by Constantine. So even the gold coinage was in fact inflated — debased.

But the real crisis came after Caracalla, between 258 and 275, in a period of intense civil war and foreign invasions. The emperors simply abandoned, for all practical purposes, a silver coinage. By 268 there was only 0.5 percent silver in the denarius.

Prices in this period rose in most parts of the empire by nearly 1,000 percent. The only people who were getting paid in gold were the barbarian troops hired by the emperors. The barbarians were so barbarous that they would only accept gold in payment for their services.

The situation did not change until the accession of Diocletian in the year 284. Shortly after his accession he raised the weight of the gold coinage, the aureus, to 60 to the pound — this was from a low of 72.

But ten years later, he finally abandoned the silvered coinage, which by this time was simply a bronze coin dipped in silver rather quickly. He abandoned that completely and tried to issue a new silver coin, called the argenteus, struck at 96 coins to the pound of silver. The argenteus was fixed as equal to 50 of the denarii (the old coinage). It was designed to respond to the need for higher-tariffed coins in the marketplace, to reflect the inflation.

Diocletian also issued a new bronze coin tariffed at ten denarii, called the nummus. But less than a decade later, the nummus had gone from being tariffed at ten denarii to now equaling 20 denarii, and the argenteus had gone from 50 denarii to 100. In other words, despite Diocletian’s efforts, the Empire suffered 100 percent inflation.

The next emperor who interfered with the coinage in a meaningful way was Constantine, the first Christian emperor of Rome. In the year 312, which is also the year he issued the Edict of Toleration for Christianity, Constantine issued a new gold piece, which he called by a new name, the solidus — solid gold. This was struck at 72 to the pound, so it was in fact debased more than Diocletian’s.

These were very large issues of coin and historians have puzzled over where Constantine got all the gold; but I think the puzzle is not so difficult once you begin to look at his legislation.

First of all, Constantine issued two new taxes. One was on the estates of the senators. This was rather new because senators were usually free of most taxes on their land. He also issued a tax on the capital of merchants; not their earnings, but their capital. This was to be levied every five years and it was to be paid in gold. He also required that the rents from the imperial estates, which were rented out to tenants, were to be paid only in gold.

Constantine took on the bullion reserves of his former partner Licinius, who had extracted, by force, bullion from the treasuries of the cities of the Eastern Empire. In other words, any city that had any gold bullion or silver bullion left in its treasury was simply requisitioned by Licinius. This gold passed on now into the hands of Constantine who had gotten rid of Licinius in a civil war.

We’re also told that he stripped the pagan temples of their treasuries. This he did rather late in his reign. In the early days he was apparently still somewhat afraid of angering the gods of Rome. As his Christianity became more fixed, he felt greater ease at robbing the temples.

Now, in one sense, Constantine’s reform began the reversal of the process: the gold coinage was sufficiently large that it began to take hold and to circulate more freely. However, the silver coinage failed and, what was worse, at no time in this period did the central government try to control the token coinage. The result was that token coinage was being minted not only by the imperial mints, but also by the mints of cities. In other words, if a city couldn’t pay its costs or pay the salaries of its employees, it simply struck up some token coinage and issued that.

By the late 3rd century we also begin to have the massive appearance of what numismatists call counterfeits. I would say it would be called credit money today. People need small change, and they simply go and manufacture it. All of this of course meant that the amount of token coinage in circulation was uncontrolled and increasingly massive.

Now, one of the things that had happened in the course of this 3rd-century inflation was that the government found that when it paid its troops in token coinage, or even in debased silver coins, prices immediately rose. Every time the silver value of the denarius dropped, prices naturally rose.

The result was that the government, in order to try to protect its civil servants and its soldiers from the effects of inflation, began to demand payment of taxes in kind and in services rather than in coin. They wound up, in effect, repudiating their own issued coins, not accepting them for tax collection purposes.

With Constantine’s reform, this situation changed somewhat and, slowly but surely, the government began to move away from collecting taxes and paying salaries in kind, and began to substitute collecting taxes and paying salaries in gold. Over the long run, this meant that the gold standard was strengthened and gold remained the real money of the Roman Empire.

However, the inflation did not end for the masses of the people. In other words, gold was a hedge against inflation for those who had it, and these were principally the troops and the civil servants.

The taxpayers had to buy these gold coins in order to pay their taxes. If they were wealthy enough, they could afford to buy these gold coins, which were increasingly expensive in terms of token money. If they were poorer they simply couldn’t pay the taxes; they lost their lands in one form or another or became delinquents. We hear constant references to people abandoning their land, disappearing.

„If a city couldn’t pay its costs or pay the salaries of its employees, it simply struck up some token coinage and issued that.“

As a matter of fact in the 3rd century this was a constant problem in Rome: all sorts of people were trying to escape the increased taxes that the military needed. The army itself had grown from the time of Augustus, when they had about a 250,000 troops, to the time of Diocletian, when they had somewhat over 600,000. So the army itself had doubled in size in the course of this inflationary spiral, and obviously that contributed greatly to the inflation.

In addition, the administration of the state had grown enormously. Under Augustus, essentially, you had the imperial administration at Rome, the secondary level of administration in the governors of different provinces, and then the primary governmental units in the Roman Empire in this time were the cities.

By the time of Diocletian this pattern had broken apart. You had not one emperor, but four emperors, which meant four imperial courts, four Praetorian Guards, four palaces, four staffs, etc.

Under them were four Praetorian prefectures, regional administrative units with their staffs and their budgets. Under these four prefectures, there were then 12 dioceses, each diocese having its administrative staff and so on.

Under the diocesan rulers, the vicars of the dioceses, we have the provinces. In Augustus’s time there were approximately 20 provinces. Three hundred years later, with no substantial increase in territory, there were over a hundred provinces. The Romans had simply divided and subdivided provinces for the purposes of maintaining internal military control of the regions. In other words, the cost of policing and administrating the Roman state became increasingly enormous.

All these costs, then, are some of the reasons why the inflation took place; I’ll get to others in a moment. To give you some idea of the situation after Constantine’s reform of the gold, let me just briefly give you the figures for what it cost in terms of the denarius, the silver coinage, or token coinage now, to buy a pound of gold.

In Diocletian’s time, in the year 301, he fixed the price at 50,000 denarii for one pound of gold. Ten years later it had risen to 120,000. In 324, 23 years after it was 50,000, it was now 300,000. In 337, the year of Constantine’s death, a pound of gold brought 20,000,000 denarii.

And by the way, just as we are all familiar with the German currency of the 1920s with the bigger stamp on it, the Roman coinage also has stamps over stamps on the metal, indicating multiples of value.

At one point, one of the Roman emperors had a marvelous idea: instead of issuing coins he devised a method to handle the inflation. He took brass slugs, put them in a leather pouch, and called it a follis; and people began passing these pouches back and forth as value. I guess it was the Roman equivalent to those baskets of paper we see in the pictures of Germany in the 1920s.

Interestingly enough, within ten years or so after that began, the word follis — which had meant this bag of coins — had now drifted to mean just one of those brass slugs. One of those slugs was now the follis. They couldn’t even keep the bags stable, they too were inflated.

Now one interesting thing with all this inflation should be a great comfort to us: historians of prices in the Roman Empire have come to the conclusion that despite all of this inflation — or perhaps we should say, because of all of this inflation — the price of gold, in terms of its purchasing power, remained stable from the first through the fourth century. In other words, gold remained, in terms of its purchasing power, a stable value whereas all this other coinage just became increasingly worthless.

What were the causes of this inflation? First of all, war. The soldiers’ pay rose from 225 denarii during the time of Augustus to 300 denarii in the time of Domitian, about a hundred years later. A century after Domitian, in the time of Septimius, it had gone from 300 to 500 denarii; and in the time of Caracalla, about 10 years later, it had gone to 750 denarii. In other words, the cost of the army was also rising in terms of the coinage; so, as the coinage became more worthless, the cost of the army had to be increased.

The advance in the soldiers’ pay in the rest of the 3rd century and into the 4th century is not known; we don’t have figures. One reason is that the soldiers were increasingly paid in terms of requisitions of supplies and goods in kind. They were literally given food, clothing, shelter, and other commodities in lieu of pay. This applied also to the civil service.

When one Roman emperor refused to pay a donative on his accession — this was a bonus given to the soldiers on the accession of the emperor — he was simply murdered by his troops. The Romans had had this kind of problem even in the days of the Republic: if the soldiers don’t get paid they rather resent it.

What we find is that the donatives had been given on the accession of a new emperor from the time of Augustus on. In the 3rd century, they began to be given every five years. By the time of Diocletian, donatives were given every year, so that the soldiers’ donatives had in fact become part of their basic salary.

The size of the army, I indicated already, had also increased. It had doubled from the time of Augustus to that of Diocletian. And the size of the civil service also increased. Now, all these events strained the fiscal resources of the state beyond its ability to sustain itself; and the ship of state was kept going, frequently by debasing, then by taxing, and then often simply by accusing people of treason and confiscating their estates.

One of the Christian fathers, Saint Gregory Nazianzus, commented that war is the mother of taxes. I think that’s a wonderful thing to keep in mind: war is the mother of taxes. And it’s also, of course, the mother of inflation.

Now, what were the consequences of inflation? One of the odd things about inflation is, in the Roman Empire, that while the state survived — the Roman state was not destroyed by inflation — what was destroyed by inflation was the freedom of the Roman people. Particularly, the first victim was their economic freedom.

Rome had basically a laissez-faire concept of state/economy relations. Except in emergencies, which were usually related to war, the Roman government generally followed a policy of free trade and minimal restriction on the economic activities of its population. But now under the pressure of this need to pay the troops and under the pressure of inflation, the liberty of the people began to be seriously eroded — and very rapidly.

We could start with the class known as the decurions. This was your prosperous, small- and middle-landowning class who were the dominant elements of the cities of the Roman Empire. They were the class from whom the municipal counsels, magistrates, and officials were chosen.

Traditionally, they had viewed service in the governments of their towns as an honor and they had donated, not merely their time, but also their wealth to the betterment of the urban environment. Building stadiums and bathhouses, and repairing the streets and providing for pure water were considered benefactions. It was a kind of philanthropic act and their reward was, of course, public recognition and esteem.

This class, in the mid-3rd century, was assigned the task of collecting the taxes in the municipality. The central government could no longer collect its taxes effectively, so they made the decurion class collectively responsible for getting revenues and passing them on to the imperial government.

The decurions, of course, had as much difficulty as anyone else in doing this, and the returns were, again, frequently inadequate. So the government solved that problem by simply passing a law that any taxes that decurions could not collect from others, they would have to pay out of their own pockets. That’s known as the incentive method for the tax collector. [laughter]

As you can well imagine, as the crises became greater and the economy was disrupted by civil conflicts and invasions and the effects of inflation, the decurions, strangely enough, no longer wanted to be decurions. They began to abandon their lands, abandon their cities, and escape to wherever they could find refuge in other larger cities or other provinces. But they were not to be allowed to do that with impunity, and a law was then passed that any decurion discovered somewhere else was to be arrested, bound like a slave, and carted back to his hometown where he would be restored to his dignity as a decurion. [laughter]

The 3rd century is also the period of the persecution of the church. We find that at least some of the emperors must have had a sense of humor because they passed a regulation that if a Christian was arrested and found guilty of a capital crime, namely believing in Christ, he was not to be executed but offered the option of becoming a decurion. [laughter]

Now, the merchants and the artisans were traditionally organized into guilds and chambers of commerce and that sort of thing. They now, too, came under government pressure because the government could not obtain enough material for the war machine through regular channels — people didn’t want all that token coinage. So merchants and artisans were now compelled to make deliveries of goods.

So that if you had a factory for making garments, you now had to deliver so many garments to the government requisitions. If you had ships, you had to carry government goods in your ships. In other words, what we have here is a kind of nationalization of private enterprises, and this nationalization means that the people who use their money and their talent are now compelled to serve the state whether they like it or not.

When people tried to get out of this they were then, by law, compelled to remain in the occupation that they were in. In other words, you couldn’t change your job or your business.

This was not sufficient because, after all, death is a relief from taxes. So the occupations were now made hereditary. When you died, your son had to take up your profession. If your father was a shoemaker, you had to be a shoemaker. These laws started by being restricted to the defense-oriented industries but, of course, gradually it was realized that everything is defense-oriented.

The peasantry, known as the coloni, were leaseholders on both imperial and private estates. They too were formerly a free class. Now under the same kinds of pressures that all smallholders were in in this situation, they began to drift away, trying to find better opportunities, better leases, or better occupations. So under Diocletian the coloni were now bound to the soil.

Anyone who had a lease on a particular piece of land could not give that lease up. More than that, they had to stay on the land and work it. In effect, this is the beginning of what in the Middle Ages is called serfdom, but it actually has its origins here in late Roman society.

„War is the mother of taxes.“

We know for example from studies of Palestine, particularly in the Rabbinical writings, that in the course of the 3rd and early 4th century the structure of landholding in Palestine changed very dramatically. Palestine in the 2nd century was mostly composed of peasant landholders with very small acreage, perhaps an average of two and a half acres.

By the 4th century those smallholders had virtually disappeared and been replaced by vast estates controlled by a few large landowners. The peasants working the estates were the same people, but in the meantime they had lost their land to the larger landowners. In other words, landholding became a kind of massive agribusiness.

In the course of this, the population of Palestine, still principally Jewish, also changed in that the ownership of land passed from Jews to Gentiles. The reason for that undoubtedly was that the only people with large amounts of cash who could buy out these smallholders who were in distress were, of course, the government officials. And we hear of them being called potentates, powerful ones. In effect there is a shift in the distribution of wealth in Palestine; and obviously, from other evidence, similar things were happening in other places.

With regard to taxes, they naturally increased across the board, but Diocletian decided that it was a very inefficient system that he had inherited. Every province more or less had its own system of taxation going back to pre-Roman times. And so he, with his military mind, demanded standardization.

And what he did was to have all wealth, which was of course landed wealth, assessed by a standard unit of productivity, the iugum. In other words, every person who had land was either singly, if he was a large landowner, or collectively, for those who were smaller landowners, put into a iugum.

This meant that the emperor for the first time had the basis of a national budget, something the Romans never had before. Therefore, he knew at any given time how many taxable units of wealth there were in any province. He could simply levy an assessment and expect to get a fixed amount of money.

Unfortunately, this took no account of the fact that in agriculture productivity varies considerably from season to season, and that if an army has passed through your district it may take years to recover. The result is that we hear of massive petitions from whole regions asking the emperor to forgive them their taxes, to remit five years of past dues, or to reduce the number of units of productivity to reflect the loss of population or materials.

As a matter of fact, when people began to say „it used to be I had five people paying this unit of taxation, but two of them have fled and it’s only half the land in production,“ the response of the government was, „that doesn’t matter, you still have to pay for the land that is now out of production.“ So, I mean, there was no relationship between taxes and actual productivity.

How did people protect themselves from this? Well, first of all, long-term mortgages virtually ceased to be given. Long-term loans of any kind disappeared. No one would lend unless they were guaranteed payment in gold or silver bullion.

In fact the government itself, under Diocletian and Constantine, refused to accept gold coins in payment of taxes, but insisted instead on gold bullion. So that the coins that you bought in the marketplace had to then be melted down and presented in the form of bullion. The reason was that the government was never sure how adulterated its own gold coinage really was.

Pledges and securities for crops and for loans were always in gold, silver, or indeed in crops themselves. In Egypt we have a document in which it seems that the banks had been refusing to accept coins with the divine image of the emperor; in other words, state issues. The government’s reaction to that, of course, was to force the banks to accept the coinage. This led to wholesale corruption in Roman society, as people refused to exchange coinage at the officially fixed tariffs but instead used the black market to exchange coinage on a market principle.

There was, obviously, flight from the land, massive evasion of taxes, people left their jobs, they left their homes, they left their social status. Now, Diocletian’s final contribution to this continuing disaster was to issue his famous Edict on Maximum Prices, in 301 AD. This is a very famous instance of a massive effort by the government to limit inflation by price controls.

You have to realize that there was a little problem: the Roman Empire was a vast region running from Britain in the West to Iraq in the East; from the Rhine and the Danube to the Sahara.

It included areas of very sophisticated and very primitive economies, and thus the cost of living varied considerably from province to province: Egypt seems to have had the lowest cost of living; Palestine had a cost of living twice that of Egypt, and Roman Italy had a cost of living twice that of Palestine.

„The Roman people, the mass of the population, had but one wish after being captured by the barbarians: to never again fall under the rule of the Roman bureaucracy.“

Diocletian ignored that; he just issued a single standard price for the entire empire. The result was that in Egypt, the Edict probably had no effect, because the maximum price fixed in the Edict was very rarely reached in Egypt. It was the people in Rome, of course, who found the maximum price lower than the market price.

The result of that, of course, was riots in the street, and the disappearance of goods. The penalty for violating this law was death, a very common penalty in Rome for almost anything.

The mentality of Diocletian, and the cause of the maximum price edict, comes out in the preface to the law. I’ll just quote briefly some of it. When you hear these first words I’d like you to pay attention, because you may have a different interpretation of them than what Diocletian meant.

He says, „if the excesses perpetrated by persons of unlimited and frenzied avarice could be checked“ — he doesn’t mean himself [laughter] — „if the general welfare could endure without harm this riotous license, if these uncontrolled madmen, the unscrupulous, the immoderate, the avaricious, could be persuaded to desist from plundering the wealth of all, then all would be well.“ Now who are these people? They are the merchants; they are the avaricious greedy types who cause inflation as we all know.

Then he speaks about himself and his three partners. „[We, the protectors of the] human race“ — sounds familiar, doesn’t it? [laughter] „We are agreed that decisive legislation is necessary, so that the long-hoped-for solutions, which mankind itself could not provide“ — you know, it’s the same stuff [laughter]; we can’t do anything ourselves, we need the legislator.

„By the remedies provided by our foresight [laughter], these things may be remedied for the general betterment of all.“

In fact, as you read through the rest of the thing it becomes clear that the reason the Edict on Prices was issued was that the soldiers were the principal victims of the inflation. Diocletian was afraid he was losing control of his army. And so the people who are to be protected are the soldiers and the other servants of the state.

Now Diocletian’s monetary reforms were tentative steps in the right direction; except for the Edict on Prices, which, by the way, simply didn’t work and was gradually dropped. But his steps were not radical enough.

Because of his inability to create a sufficient supply of gold and silver coinage, combined with his continued reliance on payments in kind for taxes and salaries, and his continued issuance of fiat bronze coinage in endless amounts, he failed to make a significant dent in the problem.

Constantine’s reforms were also partial, but of sufficient vigor and radical character to make a difference. Through his willingness to extract by compulsion the gold reserves of the taxpayers, forcing them to disgorge their bullion, he placed an ever-increasing supply of gold in the hands of government officials.

This was increasingly used to pay military bonuses, salaries for bureaucrats, and even payments for certain public works. Increasingly, then, a two-tier monetary system emerged in which the government, the soldiers, and the bureaucrats enjoyed the benefits of a gold standard while the nongovernmental portion of the economy continued to struggle with a rapidly inflating fiat currency.

The new gold solidus — circulated widely by its possessors, the government-salaried employees — sold at various market rates to customers who desperately needed it to pay their taxes. Thus the state had found a way to protect itself and its servants from the unwholesome effects of its own earlier inflationary cycle, while slowly withdrawing from the cumbersome and wasteful system of accepting taxes and paying salaries in kind. Meanwhile, the masses suffered from a massive injection of fiat money, which they had to accept in payment for government requisitions of gold, silver, or other commodities.

Now, we may wish to find some lessons in this tale of the monetary policies of the late Roman Empire. The first lesson, I think, must be that if war is the health of the state, as Randolph Bourne said, it is poison to a stable and sound money. The Roman monetary crisis therefore was closely connected with the Roman military problem.

Another lesson is that problems become solvable when a ruler decides that something can be done and must be done. Diocletian and Constantine clearly were willing to act to protect their own ruling-class interests, the military and the civil service.

Monetary reforms were necessary to win the support of the troops and the bureaucrats, who composed the only real constituency of the Roman state, and the two-tier system was designed to this end. It brought about a stable monetary standard for the ruling group, who did not hesitate to secure it at the expense of the mass of the population.

The Roman state survived. The liberty of the Roman people did not. When freedom became possible in the West in the 5th century, with the barbarian invasions, people took advantage of the possibility of change. The peasantry had become totally alienated from the Roman state because they were no longer free. The business community likewise was no longer free. And the middle class of the cities was no longer free.

The economy of the West was perhaps more fatally weakened than that of the East. The early 5th century Christian priest Salvian of Marseille wrote an account of why the Roman state was collapsing in the West — he was writing from France (Gaul). Salvian says that the Roman state is collapsing because it deserves collapse; because it had denied the first premise of good government, which is justice to the people.

By justice he meant a just system of taxation. Salvian tells us, and I don’t think he’s exaggerating, that one of the reasons why the Roman state collapsed in the 5th century was that the Roman people, the mass of the population, had but one wish after being captured by the barbarians: to never again fall under the rule of the Roman bureaucracy.

In other words, the Roman state was the enemy; the barbarians were the liberators. And this undoubtedly was due to the inflation of the 3rd century. While the state had solved the monetary problem for its own constituents, it had failed to solve it for the masses. Rome continued to use an oppressive system of taxation in order to fill the coffers of the ruling bureaucrats and soldiers. Thank you. [applause]

This is a transcript of Professor Joseph Peden’s 50-minute lecture „Inflation and the Fall of the Roman Empire,“ given at the Seminar on Money and Government in Houston, Texas, on October 27, 1984. The original audio recording is available as a free MP3 download. This transcript ran first at LewRockwell.com

How the Early Capitalists Saved Europe From Starvation – Ludwig von Mises

Two hundred years ago, before the advent of capitalism, a man’s social status was fixed from the beginning to the end of his life; he inherited it from his ancestors, and it never changed. If he was born poor, he always remained poor, and if he was born rich-a lord or a duke-he kept his dukedom and the property that went with it for the rest of his life.

As for manufacturing, the primitive processing industries of those days existed almost exclusively for the benefit of the wealthy. Most of the people (ninety percent or more of the European population) worked the land and did not come in contact with the city-oriented processing industries. This rigid system of feudal society prevailed in the most developed areas of Europe for many hundreds of years.

However, as the rural population expanded, there developed a surplus of people on the land. For this surplus of population without inherited land or estates, there was not enough to do, nor was it possible for them to work in the processing industries; the kings of the cities denied them access. The numbers of these „outcasts“ continued to grow, and still no one knew what to do with them. They were, in the full sense of the word, „proletarians,“ outcasts whom the government could only put into the workhouse or the poorhouse. In some sections of Europe, especially in the Netherlands and in England, they became so numerous that, by the eighteenth century, they were a real menace to the preservation of the prevailing social system.

Today, in discussing similar conditions in places like India or other developing countries, we must not forget that, in eighteenth-century England, conditions were much worse. At that time, England had a population of six or seven million people, but of those six or seven million people, more than one million, probably two million, were simply poor outcasts for whom the existing social system made no provision. What to do with these outcasts was one of the great problems of eighteenth-century England.

Another great problem was the lack of raw materials. The British, very seriously, had to ask themselves this question: what are we going to do in the future, when our forests will no longer give us the wood we need for our industries and for heating our houses? For the ruling classes it was a desperate situation. The statesmen did not know what to do, and the ruling gentry were absolutely without any ideas on how to improve conditions.

Out of this serious social situation emerged the beginnings of modern capitalism. There were some persons among those outcasts, among those poor people, who tried to organize others to set up small shops which could produce something. This was an innovation. These innovators did not produce expensive goods suitable only for the upper classes; they produced cheaper products for everyone’s needs. And this was the origin of capitalism as it operates today. It was the beginning of mass production, the fundamental principle of capitalistic industry. Whereas the old processing industries serving the rich people in the cities had existed almost exclusively for the demands of the upper classes, the new capitalist industries began to produce things that could be purchased by the general population. It was mass production to satisfy the needs of the masses.

This is the fundamental principle of capitalism as it exists today in all of those countries in which there is a highly developed system of mass production: Big business, the target of the most fanatic attacks by the so-called leftists, produces almost exclusively to satisfy the wants of the masses. Enterprises producing luxury goods solely for the well-to-do can never attain the magnitude of big businesses. And today, it is the people who work in large factories who are the main consumers of the products made in those factories. This is the fundamental difference between the capitalistic principles of production and the feudalistic principles of the preceding ages.

The development of capitalism consists in everyone’s having the right to serve the customer better and/or more cheaply. And this method, this principle, has, within a comparatively short time, transformed the whole world. It has made possible an unprecedented increase in world population.

In eighteenth-century England, the land could support only six million people at a very low standard of living. Today more than fifty million people enjoy a much higher standard of living than even the rich enjoyed during the eighteenth-century. And today’s standard of living in England would probably be still higher, had not a great deal of the energy of the British been wasted in what were, from various points of view, avoidable political and military „adventures.“

These are the facts about capitalism. Thus, if an Englishman-or, for that matter, any other man in any country of the world-says today to his friends that he is opposed to capitalism, there is a wonderful way to answer him: „You know that the population of this planet is now ten times greater than it was in the ages preceding capitalism; you know that all men today enjoy a higher standard of living than your ancestors did before the age of capitalism. But how do you know that you are the one out of ten who would have lived in the absence of capitalism? The mere fact that you are living today is proof that capitalism has succeeded, whether or not you consider your own life very valuable.“

In spite of all its benefits, capitalism has been furiously attacked and criticized. It is necessary that we understand the origin of this antipathy. It is a fact that the hatred of capitalism originated not with the masses, not among the workers themselves, but among the landed aristocracy-the gentry, the nobility, of England and the European continent. They blamed capitalism for something that was not very pleasant for them: at the beginning of the nineteenth century, the higher wages paid by industry to its workers forced the landed gentry to pay equally higher wages to their agricultural workers. The aristocracy attacked the industries by criticising the standard of living of the masses of the workers.

Of course-from our viewpoint, the workers’ standard of living was extremely low; conditions under early capitalism were absolutely shocking, but not because the newly developed capitalistic industries had harmed the workers. The people hired to work in factories had already been existing at a virtually subhuman level.

The famous old story, repeated hundreds of times, that the factories employed women and children and that these women and children, before they were working in factories, had lived under satisfactory conditions, is one of the greatest falsehoods of history. The mothers who worked in the factories had nothing to cook with; they did not leave their homes and their kitchens to go into the factories, they went into factories because they had no kitchens, and if they had a kitchen they had no food to cook in those kitchens. And the children did not come from comfortable nurseries. They were starving and dying. And all the talk about the so-called unspeakable horror of early capitalism can be refuted by a single statistic: precisely in these years in which British capitalism developed, precisely in the age called the Industrial Revolution in England, in the years from 1760 to 1830, precisely in those years the population of England doubled, which means that hundreds or thousands of children-who would have died in preceding times-survived and grew to become men and women.

There is no doubt that the conditions of the preceding times were very unsatisfactory. It was capitalist business that improved them. It was precisely those early factories that provided for the needs of their workers, either directly or indirectly by exporting products and importing food and raw materials from other countries. Again and again, the early historians of capitalism have-one can hardly use a milder word-falsified history.

The Fear of Robots – Pedro Schwartz

One morning a week I take part in a discussion programme on a Spanish radio station that specializes in economic and business matters. Just before we come on air we hear the day’s expected events and statistics read by a new journalist in the firm: Sarah Bot, a very young robot with a strange voice. For the time being she has not displaced me and taken over my job.

I know I use robots continuously. I start with the iPhone that wakes me up in the morning, then read the mail I receive on my laptop, chase down on the internet the information I need to write my stuff (after all, Wikipedia is half run by machines!), send my ‘copy’ through the ether, so to speak, and read the newspaper where my article will be ‘printed’ also from far away. I well remember when I used to dictate my articles over the phone to patient tachygraphers at a cost perhaps higher than what I was paid for the piece. Still, like many others, I feel a vague disquiet at the as yet benign invasion of the robots.

Say’s Law

To allay my fears I remind myself, first, of Say’s Law and second, of the fate of horses. Let me start with Jean Baptiste Say (1767-1832). He was the French economist who introduced Adam Smith to French public opinion and to the learned classes of the European continent, most of whom read French rather than English. Say was born in a Protestant family that had taken refuge in the Swiss city of Geneva, fleeing persecution in France. The family returned to the textile city of Lyon, where Jean Baptiste was born. As a young man, he was sent by his father to England to see for himself how England was industrialising. It was not his only visit to the land of economic progress. Later in life he met and befriended the great economists of the time—David Ricardo, Thomas Malthus, James Mill, and John Ramsay McCulloch—and corrected and bettered some of the classical theories of English political economy. He published his successful Treatise of Political Economy in 1803. Napoleon invited him to dinner to try to make him correct some anti-protectionist and anti-statist passages in the book. Say, a moderate republican and a defender of individual liberty, did not comply. At different moments in his life, Say tried his hand at business—banking, insurance, cotton spinning, and sugar—variously succeeding and failing as an entrepreneur. In 1828-29 he published an ambitious Course of Political Economy in no less than six volumes. Say made signal contributions to economics. In price theory, he introduced utility into the demand side of price formation. He corrected Adam Smith by including services in the definition of wealth. Notably, he introduced the figure of the entrepreneur in the explanation of economic progress. Finally and in parallel with James Mill, he codified what is known as ‘Say’s Law’, to which I now turn in search of hope and consolation in a world beset with robots.[1]

One of the fears caused by robots is that total production in the economy will so increase that demand will not be sufficient to take it up, especially if people have become unemployed due to competition from non-humans. Could this bring about a general glut of the whole system? Would there then a crisis of overproduction, which might cause more unemployment? What Say’s law sets down is that the very fact of bringing goods to the market amounts to demanding goods in exchange. In the case of overproduction, the economy will tend to return to equilibrium if supply prices are flexible and are allowed to fall. This may take time, since the alarm caused by falling prices may lead to a period of money hoarding. In the long run, however and as Ricardo said, „there is no limit to demand,“ surprising or even shocking though this may sound to people who hate our consumptionist civilisation. This whole idea was summed up by Say in the following phrase: „Supply creates its own demand“.[2]

Disproportionate production

Say and his classical companions of course accepted that there could temporarily be excess production in one industry and shortages in another whose products were more demanded. This would be the case with path-breaking technological advances, such as steam threshing machines or mechanical knitting frames in the early 19th century (or robots today). Though not leading to general under-consumption, those advances would for a time bring technological unemployment in their wake, as workers were displaced by the new, more productive methods or by free trade. What is called ‘sunk capital’ can also be affected, so there may also be resistance put up by the owners of capital or land endangered by shifts in supply through new productive methods or through trade.

The revolts of workers who saw their wages fall because of competition from new machines are now a part of the social history of capitalism. In the years around 1810, summers were very wet in England, badly affecting crops. Also, the general blockade of trade with Britain decreed by Napoleon in Berlin and Milan in 1806 and 1807 throttled the import of grain and made bread unwontedly expensive. The wages got by threshing wheat from November to February in England gave employment in the lean winter months. Hostility to the new-fangled steam threshing machines erupted in an epidemic of machine breaking by crowds allegedly led by a legendary ‘Captain Ludd’—hence the name ‘Luddites’ applied to workers who wanted the competition of new machinery stopped. A repeat movement happened in the summer of 1830, dubbed the ‘Swing Letters’. Again, times were harsh in the hungry thirties. It was a time of political turmoil, what with the campaign for Parliamentary reform in England and the Revolution in France. Landlords who were known to use threshing machines in the Southern English counties received letters signed by a certain Captain Swing, threatening to break the threshers up and demanding higher wages.

This was not the only example of harsh technological competition suffered by manual workers. By 1830 the livelihood of some 400,000 handloom weavers was being threatened by the power-looms and knitting machines in the cotton mills. Those weavers were whole families who worked at home for merchants who ‘put out’ work at growingly extortionate rates, given the higher productivity of large factories. Petitions rained on Parliament. By 1840 the number of handloom weavers had fallen to 100,000, mainly specialised in silk fabrics and the more expensive cloths. The recourse to the 1834 Poor Law was felt to be a paltry remedy, since Poor Houses were organised on the principle that their standards should be less attractive than the least paid employment. A Royal Commission was formed to examine the plight of these workers, chaired by the economist Nassau William Senior. Famed for his understanding of the rapidly increasing productivity of the factory system when other classical economists saw England „within a hands breadth of the stationary state,“ Senior saw there was not much that could be done. Attrition had a human cost, but in the end an open door to radical technological change was the only answer. It is thus that the hungry 1830s and 40s turned into the more prosperous second half of the 19th century—helped by Robert Peel’s decision in 1844 to repeal the Corn Laws. The social safety net of today is much more comfortable than Dickensian poor houses. The opportunities of gainful employment, much greater.

What happened to horse-power?

When I say that the plight of working horses brings me some consolation as I think of the possible effect of robots on employment, I do not mean to belittle their centuries’ long contribution to the productive or destructive efforts of humanity. They were used in peaceful transport. Also, in all wars up to the middle of the 20th century, pack animals were used and sacrificed on the battlefields by their cruel and warring masters. I myself did my peacetime military service in a mounted regiment, where I learnt to ride the friendly beasts. In Hyde Park in the centre of London there stands a most affecting monument to the horses, mules, and donkeys misused by all armies in history. Anybody visiting London should take time to stop before it.

What I mean by linking the case of humans menaced by robots with that of horses displaced by the internal combustion engine is that there you have an example of job destruction by technological advance. The point I want to make is that horses could not and did not learn to drive motorcars and lorries. We men and women can learn new trades, albeit with some difficulty when we get older. Luddites are a danger to the very people they want to help because in the end progress will prevail.

The benefits of growth for the individual

Here is the crux of the matter. Technical advance makes for growth. The increasing use of robots is but a continuation of the story of triumphant capitalism. The countries of what we call the West have experienced a singular and unexpected two centuries of growth that is pulling the entire population out of poverty and into prosperity as never before in history. Now the rest of the world is joining in the ride, which we hope will last. There have been periods of growth in history that did not extend to the entire population of the world and ended in ruination. The examples that come to mind are those of Mesopotamia, Egypt, Rome, China, and the Aztec and Inca empires in America. In all of them the flame of growth died or was snuffed out by military disaster. Something quite different, however, happened in Britain around the beginning of the 19th century and then spread to continental Europe and North America. Productivity increased by leaps and bounds and was not even stopped by two world wars.

The size of these developments in the capacity to produce more with less are difficult to measure precisely. William Nordhaus, whose first claim to fame with the general public was his joint authorship with Paul Samuelson in the later editions of Economics, the textbook which has been the initiation rite of so many into the queen of social sciences. More recently, he has become one of the high priests of the new religion of climate change. Whatever the disagreements one might have with that textbook and this alarm, he is an outstanding professional economist. I want to draw attention to the striking way in which he has presented the growth of real wages from 1800. To calculate real wages he has to take nominal wages and deflate them by a price index. He finds much to query about the price indices normally used to do this calculation. He shows that price increases over the years are much exaggerated by not properly accounting for improvements in the quality of goods due to technological progress. The case he uses is that of lighting. Prices per ‘lumen’ (the measure of light intensity) have fallen much more quickly than shown by ordinary price indices. If the same method he uses for the true price of light is applied to general consumption (so as to take account of the incredible improvement of goods and services over the last hundred years), then real economic growth will turn out to have been much greater in the United States and Western Europe than is generally thought. „In terms of living standards, the conventional growth of real wages has been a factor of 13 over the 1800-1992 period.“ If the downward bias is corrected as Nordhaus thinks it should be on the lines of the cost of lighting, „real wages have grown by a factor of 970.“ Some growth! [3]

Let me show a graph I have used in a previous column, since it comes from so respected a pen as that of Angus Maddison. It shows the sudden increase in per capita production in the United States and the United Kingdom around 1840. The inflation adjustment is of the conventional kind: the productivity surge would be much larger if we used the Nordhaus method.

Figure 1. GDP Per Capita

SchwartzGDPpercapita

Note: A graph compiled from Angus Maddison’s data comparing the GDP per capita of a few major economies since 1700 AD. Source: M Tracy Hunter: Own work, CC BY-SA 4.0, https://commons.wikimedia.org/w/index.php?curid=34088252

A tax on robots?

Recently, Nobel laureate Robert J. Shiller has taken up the idea, characteristically hatched in the European Parliament, that a moderate tax should be laid on robots so as to put a brake on robot use. This tax would „slow the adoption of disruptive technologies“. He seems to be worried about the effects of robots in increasing inequality and considers the tax would „accord with our natural sense of justice“. The produce of the tax could then be used to finance an insurance fund to help the displaced workers who need time to change their calling. Professor Shiller seems to be another of those Nobel laureates who speaks outside his field of speciality, which in this case financial economics, not economic growth.[4]

What Shiller does not do is underline the trade-off between technical progress and anti-market regulation. In his future pronouncements in favour of a tax on robots he should pay some attention to worries generally expressed about the trend of economic growth in the United States and the rest of the Western world, especially Europe. I recently watched a TED talk by Professor Robert J. Gordon of Northwestern University.[5] As he has been doing for a number of years, he worried about the fall in the long term growth rate of the American and the world economy due to the lack of great technical innovations. He showed us pictures of 19th and 20th century transformative innovations that, he says, are not happening any more—water closets, electrical appliances such as washing machines and refrigerators, the internal combustion engine, airplanes or telephones—but he pictured no robots. Professor Gordon may turn out to be right in discounting robots and artificial intelligence as engines of growth, if the likes of Professor Shiller have their way. Luddites all!

 

[1] See Thomas Sowell’s doctoral thesis: Say’s Law. An Historical Analysis. Princeton University Press, 1972.

[2] One could not think of a view more contrary to the Keynesian idea that the main macroeconomic problem in a downturn is a failure of aggregate demand. Crises caused by the failure of misapplied investment suddenly revealed by a technical shift are characterised by a general thirst for cash or money hoarding. Capitalist growth is inevitably cyclical. It can be made less volatile by trying to keep the money supply stable, as Milton Friedman proposed. But this question is for another day.

[3] William D. Nordhaus: „Do Real Output and Real Wages Measures Capture Reality? The History of Lighting Suggests Not.“ NBER. PDF file.

[4] Robert J. Shiller: „Why robots should be taxed if they take people’s jobs“The Guardian, March 27, 2017.

[5] Robert J. Gordon, „The death of innovation, the end of growth,“. TED 2013.

The Rise, Fall, and Renaissance of Classical Liberalism – Ralph Raico

Originally published over several months in 1992, Raico’s brief history of classical liberalism was written in memory of Roy A. Childs, Jr. You can read the original here in three installments.

Part 1

Classical liberalism — or simply liberalism, as it was called until around the turn of the century — is the signature political philosophy of Western civilization. Hints and suggestions of the liberal idea can be found in other great cultures. But it was the distinctive society produced in Europe — and in the outposts of Europe, above all, America — that served as the seedbed of liberalism. In turn, that society was decisively shaped by the liberal movement.

Decentralization and the division of power have been the hallmarks of the history of Europe. After the fall of Rome, no empire was ever able to dominate the continent. Instead, Europe, became a complex mosaic of competing nations, principalities, and city-states. The various rulers found themselves in competition with each other. If one of them indulged in predatory taxation or arbitrary confiscations of property, he might well lose his most productive citizens, who could “exit,” together with their capital. The kings also found powerful rivals in ambitious barons and in religious authorities who were backed by an international Church. Parliaments emerged that limited the taxing power of the king, and free cities arose with special charters that put the merchant elite in charge.

By the Middle Ages, many parts of Europe, especially in the west, had developed a culture friendly to property rights and trade. On the philosophical level, the doctrine of natural law — deriving from the Stoic philosophers of Greece and Rome — taught that the natural order was independent of human design and that rulers were subordinate to the eternal laws of justice. Natural-law doctrine was upheld by the Church and promulgated in the great universities, from Oxford and Salamanca to Prague and Krakow.

As the modern age began, rulers started to shake free of age-old customary constraints on their power. Royal absolutism became the main tendency of the time. The kings of Europe raised a novel claim: they declared that they were appointed by God to be the fountainhead of all life and activity in society. Accordingly, they sought to direct religion, culture, politics, and, especially, the economic life of the people. To support their burgeoning bureaucracies and constant wars, the rulers required ever-increasing quantities of taxes, which they tried to squeeze out of their subjects in ways that were contrary to precedent and custom.

The first people to revolt against this system were the Dutch. After a struggle that lasted for decades, they won their independence from Spain and proceeded to set up a unique polity. The United Provinces, as the radically decentralized state was called, had no king and little power at the federal level. Making money was the passion of these busy manufacturers and traders: they had no time for hunting heretics or suppressing new ideas. Thus, de facto religious toleration and a wide-ranging freedom of the press came to prevail. Devoted to industry and trade, the Dutch established a legal system based solidly on the rule of law and the sanctity of property and contract. Taxes were low, and everyone worked. The Dutch “economic miracle” was the wonder of the age. Thoughtful observers throughout Europe noted the Dutch success with great interest.

A society in many ways similar to Holland had developed across the North Sea. In the 17th century, England, too, was threatened by royal absolutism, in the form of the House of Stuart. The response was revolution, civil war, the beheading of one king and the booting out of another. In the course of this tumultuous century, the first movements and thinkers appeared who can be unequivocally identified as liberal.

With the king gone, a group of middle-class radicals emerged called the Levellers. They protested that not even Parliament had any authority to usurp the natural, God-given rights of the people. Religion, they declared, was a matter of individual conscience: it should have no connection with the state. State-granted monopolies were likewise an infringement of natural liberty. A generation later, John Locke, drawing on the tradition of natural law that had been kept alive and elaborated by the Scholastic theologians, set forth a powerful liberal model of man, society, and state. Every man, he held, is innately endowed with certain natural rights. These consist in his fundamental right to what is his property — that is, his life, liberty, and “estates” (or material goods). Government is formed simply the better to preserve the right to property. When, instead of protecting the natural rights of the people, a government makes war upon them, the people may alter or abolish it. The Lockean philosophy continued to exert influence in England for generations to come. In time, its greatest impact would be in the English-speaking colonies in North America.

The society that emerged in England after the victory over absolutism began to score astonishing successes in economic and cultural life. Thinkers from the continent, especially in France, grew interested. Some, like Voltaire and Montesquieu, came to see for themselves. Just as Holland had acted as a model before, now the example of England began to influence foreign philosophers and statesmen. The decentralization that has always marked Europe allowed the English “experiment” to take place and its success to act as a spur to other nations.

In the 18th century, thinkers were discovering a momentous fact about social life: given a situation where men enjoyed their natural rights, society more or less runs itself. In Scotland, a succession of brilliant writers that included David Hume and Adam Smith outlined the theory of the spontaneous evolution of social institutions. They demonstrated how immensely complex and vitally useful institutions — language. morality, the common law, above all, the market — originate and develop not as the product of the designing minds of social engineers, but as the result of the interactions of all the members of society pursuing their individual goals.

In France, economists were coming to similar conclusions. The greatest of them, Turgot, set forth the rationale for the free market:

“The policy to pursue, therefore, is to follow the course of nature, without pretending to direct it For, in order to direct trade and commerce it would be necessary to be able to have knowledge of all of the variations of needs, interests, and human industry in such detail as is physically impossible to obtain even by the most able, active, and circumstantial government. And even if a government did possess such a multitude of detailed knowledge, the result would be to let things go precisely as they do of themselves, by the sole action of the interests of men prompted by free competition.”

The French economists coined a term for the policy of freedom in economic life: they called it laissez-faire. Meanwhile, starting in the early 17th century, colonists coming mainly from England had established a new society on the eastern shores of North America. Under the influence of the ideas the colonists brought with them and the institutions they developed, a unique way of life came into being. There was no aristocracy and very little government of any kind. Instead of aspiring to political power, the colonists worked to carve out a decent existence for themselves and their families.

Fiercely independent, they were equally committed to the peaceful — and profitable — exchange of goods. A complex network of trade sprang up, and by the mid-18th century, the colonists were already more affluent than any other commoners in the world. Self-help was the guiding star in the realm of spiritual values as well. Churches, colleges, lending-libraries, newspapers, lecture-institutes, and cultural societies flourished through the voluntary cooperation of the citizens.

When events led to a war for independence, the prevailing view of society was that it basically ran itself. As Tom Paine declared:

“Formal government makes but a small part of civilized life. It is to the great and fundamental principles of society and civilization — to the unceasing circulation of interest, which passing through its million channels, invigorates the whole mass of civilized man — it is to these, infinitely more than to anything which even the best instituted government can perform that the safety and prosperity of the individual and the whole depend. In fine, society performs for itself almost everything which is ascribed to government. Government is no further necessary than to supply the few cases to which society and civilization are not conveniently competent.”

In time, the new society formed on the philosophy of natural rights would serve as an even more luminous exemplar of liberalism to the world than had Holland and England before it.

Part 2: Triumphs and Challenges

As the nineteenth century began, classical liberalism — or just liberalism as the philosophy of freedom was then known — was the specter haunting Europe — and the world. In every advanced country the liberal movement was active.

Drawn mainly from the middle classes, it included people from widely contrasting religious and philosophical backgrounds. Christians, Jews, deists, agnostics, utilitarians, believers in natural rights, freethinkers, and traditionalists all found it possible to work towards one fundamental goal: expanding the area of the free functioning of society and diminishing the area of coercion and the state.

Emphases varied with the circumstances of different countries. Sometimes, as in Central and Eastern Europe, the liberals demanded the rollback of the absolutist state and even the residues of feudalism. Accordingly, the struggle centered around full private property rights in land, religious liberty, and the abolition of serfdom. In Western Europe, the liberals often had to fight for free trade, full freedom of the press, and the rule of law as sovereign over state functionaries.

In America, the liberal country par excellence, the chief aim was to fend off incursions of government power pushed by Alexander Hamilton and his centralizing successors, and, eventually, somehow, to deal with the great stain on American freedom — Negro slavery.

From the standpoint of liberalism, the United States was remarkably lucky from the start. Its founding document, the Declaration of Independence, was composed by Thomas Jefferson, one of the leading liberal thinkers of his time. The Declaration radiated the vision of society as consisting of individuals enjoying their natural rights and pursuing their self-determined goals. In the Constitution and the Bill of Rights, the Founders created a system where power would be divided, limited, and hemmed in by multiple constraints, while individuals went about the quest for fulfillment through work, family, friends, self-cultivation, and the dense network of voluntary associations. In this new land, government — as European travelers noted with awe — could hardly be said to exist at all. This was the America that became a model to the world.

One perpetuator of the Jeffersonian tradition in the early 19th century was William Leggett, a New York journalist and antislavery Jacksonian Democrat. Leggett declared:

“All governments are instituted for the protection of person and property; and the people only delegate to their rulers such powers as are indispensable to these objects. The people want no government to regulate their private concerns, or to prescribe the course and mete out the profits of their industry. Protect their persons and property, and all the rest they can do for themselves.”

This laissez-faire philosophy became the bedrock creed of countless Americans of all classes. In the generations to come, it found an echo in the work of liberal writers like R L. Godkin, Albert Jay Nock, H. L. Mencken, Frank Chodorov, and Leonard Read. To the rest of the world, this was the distinctively, characteristically American outlook.

Meanwhile, the economic advance that had been slowly gaining momentum in the Western world burst out in a great leap forward. First in Britain, then in America and Western Europe, the Industrial Revolution transformed the life of man as nothing had since the neolithic age. Now it became possible for the vast majority of mankind to escape the immemorial misery they had grown to accept as their unalterable lot. Now tens of millions who would have perished in the inefficient economy of the old order were able to survive. As the populations of Europe and America swelled to unprecedented levels, the new masses gradually achieved living standards unimaginable for working people before.

The birth of the industrial order was accompanied by economic dislocations. How could it have been otherwise? The free-market economists preached the solution: security of property and hard money to encourage capital formation, free trade to maximize efficiency in production, and a clear field for entrepreneurs eager to innovate. But conservatives, threatened in their age-old status, initiated a literary assault on the new system, giving the Industrial Revolution a bad name from which it never fully recovered. Soon the attack was gleefully taken up by groups of socialist intellectuals that began to emerge.

Still, by mid-century the liberals went from one victory to another. Constitutions with guarantees of basic rights were adopted, legal systems firmly anchoring the rule of law and property rights were put in place, and free trade was spreading, giving birth to a world economy based on the gold standard.

There were advances on the intellectual front as well. After spearheading the campaign to abolish the English Corn Laws, Richard Cobden developed the theory of nonintervention in the affairs of other countries as a foundation for peace. Frederic Bastiat put the case for free trade, non intervention, and peace in a classic form. Liberal historians like Thomas Macaulay and Augustin Thierry uncovered the roots of freedom in the West. Later in the century, the economic theory of the free market was placed on a secure scientific footing with the rise of the Austrian School, inaugurated by Carl Menger.

The relation of liberalism and religion presented a special problem. In continental Europe and Latin America, freethinking liberals sometimes used the state power to curtail the influence of the Catholic Church, while some Catholic leaders clung to obsolete ideas of theocratic control. But liberal thinkers like Benjamin Constant, Alexis de Tocqueville, and Lord Acton saw beyond such futile disputes. They stressed the crucial role that religion, separated from government power, could play in stemming the growth of the centralized state. In this way, they prepared the ground for the reconciliation of liberty and religious faith.

Then, for reasons still unclear, the tide began to turn against the liberals. Part of the reason is surely the rise of the new class of intellectuals that proliferated everywhere. That they owed their very existence to the wealth generated by the capitalist system did not prevent most of them from incessantly gnawing away at capitalism, indicting it for every problem they could point to in modern society.

At the same time, voluntary solutions to these problems were preempted by state functionaries anxious to expand their domain. The rise of democracy may well have contributed to liberalism’s decline by aggravating an age-old feature of politics: the scramble for special privilege. Businesses, labor unions, farmers, bureaucrats, and other interest groups vied for state privileges — and found intellectual demagogues to rationalize their depredations. The area of state control grew, at the expense, as William Graham Sumner pointed out, of “the forgotten man” — the quiet, productive individual who asks no favor of government and, through his work, keeps the whole system going.

By the end of the century, liberalism was being battered on all sides. Nationalists and imperialists condemned it for promoting an insipid peace instead of a virile and bracing belligerency among the nations. Socialists attacked it for upholding the “anarchical” free-market system instead of “scientific” central planning. Even church leaders disparaged liberalism for its alleged egotism and materialism. In America and Britain, social reformers around the dawn of the century conceived a particularly clever gambit. Anywhere else the supporters of state intervention and coercive labor-unionism would have been called “socialists” or “social democrats.” But since the English-speaking peoples appeared for some reason to have an aversion to those labels, they hijacked the term “liberal.”

Though they fought on to the end, a mood of despondency settled on the last of the great authentic liberals. When Herbert Spencer began writing in the 1840s, he had looked forward to an age of universal progress in which the coercive state apparatus would practically disappear. By 1884, Spencer could pen an essay entitled, “The Coming Slavery.” In 1898, William Graham Sumner, American Spencerian, free-trader, and gold-standard advocate, looked with dismay as America started on the road to imperialism and global entanglement in the Spanish-American War: he titled his response to that war, grimly, “The Conquest of the United States by Spain.”

Everywhere in Europe there was a reversion to the policies of the absolutist state, as government bureaucracies expanded. At the same time, jealous rivalries among the Great Powers led to a frenzied arms race and sharpened the threat of war. In 1914, a Serb assassin threw a spark onto the heaped-up animosity and suspicion, and the result was the most destructive war in history to that point. In 1917, an American president keen to create a New World Order led his country into the murderous conflict “War is the health of the state,” warned the radical writer Randolph Bourne. And so it proved to be. By the time the butchery ended, many believed that liberalism in its classical sense was dead.

Part 3: The 20th Century

The First World War was the watershed of the twentieth century. Itself the product of antiliberal ideas and policies, such as militarism and protectionism, the Great War fostered statism in every form. In Europe and America, the trend towards state intervention accelerated, as governments conscripted, censored, inflated, ran up mountains of debts, co-opted business and labor, and seized control of the economy. Everywhere “progressive” intellectuals saw their dreams coming true. Thee old laissez-faire liberalism was dead, they gloated, and the future belonged to collectivism. The only question seemed to be: which kind of collectivism?

In Russia, the chaos of the war permitted a small group of Marxist revolutionaries to grab power and establish a field headquarters for world revolution. In the nineteenth century, Karl Marx had concocted a secular religion with a potent appeal. It held out the promise of the final liberation of man through replacing the complex, often baffling world of the market economy by conscious, “scientific” control. Put into practice by Lenin and Trotsky in Russia, the Marxist economic experiment resulted in catastrophe. For the next seventy years, Red rulers lurched from one patchwork expedient to another. But terror kept them firmly in charge, and the most colossal propaganda effort in history convinced intellectuals both in the West and in the emerging Third World that communism was, indeed, “the radiant future of all mankind.”

The peace treaties cobbled together by President Woodrow Wilson and the other Allied leaders left Europe a seething cauldron of resentment and hate. Seduced by nationalist demagogues and terrified of the Communist threat, millions of Europeans turned to the forms of state worship called Fascism and National Socialism, or Nazism. Though riddled with economic error, these doctrines promised prosperity and national power through integral state control of society, while fomenting more and greater wars.

In the democratic countries, milder forms of statism were the rule. Most insidious of all was the form that had been invented in the 1880s, in Germany. There Otto von Bismarck, the Iron Chancellor, devised a series of old-age, disability, accident, and sickness insurance schemes, run by the state. The German liberals of the time argued that such plans were simply a reversion to the paternalism of the absolutist monarchies. Bismarck won out, and his invention — the welfare state — was eventually copied everywhere in Europe, including the totalitarian countries. With the New Deal, the welfare state came to America.

Still, private property and free exchange continued as the basic organizing principles of Western economies. Competition, the profit motive, the steady accumulation of capital (including human capital), free trade, the perfecting of markets, increased specialization — all worked to promote efficiency and technical progress and with them higher living standards for the people. So powerful and resilient did this capitalist engine of productivity prove to be that widespread state intervention, coercive labor-unionism, even government-generated depressions and wars could not check economic growth in the long run.

The 1920s and ’30s represent the nadir of the classical-liberal movement in this century. Especially after government meddling with the monetary system led to the crash of 1929 and the Great Depression, dominant opinion held that history had closed the books on competitive capitalism, and with it the liberal philosophy.

If a date were to be put on the rebirth of classical liberalism, it would be 1922, the year of the publication of Socialism, by the Austrian economist Ludwig von Mises. One of the most remarkable thinkers of the century, Mises was also a man of unflinching courage. In Socialism, he threw down the gauntlet to the enemies of capitalism. In effect, he said: “You accuse the system of private property of causing all social evils, which only socialism can cure. Fine. But would you now kindly do something you have never deigned to do before: would you explain how a complex economic system will be able to operate in the absence of markets, and hence prices, for capital goods?” Mises demonstrated that economic calculation without private property was impossible, and exposed socialism for the passionate illusion it was.

Mises’s challenge to the prevailing orthodoxy opened the minds of thinkers in Europe and America. F.A. Hayek, Wilhelm Roepke, and Lionel Robbins were among those whom Mises converted to the free market. And, throughout his very long career, Mises elaborated and reformed his economic theory and social philosophy, becoming the acknowledged premier classical-liberal thinker of the twentieth century.

In Europe and particularly in the United States, scattered individuals and groups kept something of the old liberalism alive. At the London School of Economics and the University of Chicago, academics could be found, even in the 1930s and ’40s, who defended at least the basic validity of the free-enterprise idea. In America, an embattled brigade of brilliant writers, mainly journalists, survived. Now known as the “Old Right,” they included Albert Jay Nock, Frank Chodorov, H. L. Mencken, Felix Morley, and John T. Flynn. Spurred to action by the totalitarian implications of Franklin Roosevelt’s New Deal, these writers reiterated the traditional American creed of individual freedom and scornful distrust of government. They were equally opposed to Roosevelt’s policy of global meddling as subversive of the American Republic. Supported by a few courageous publishers and businessmen, the “Old Right” nursed the flame of Jeffersonian ideals through the darkest days of the New Deal and the Second World War.

With the end of that war, what can be called a movement came into being. Small at first, it was fed by multiplying streams. Hayek’s Road to Serfdom, published in 1944, alerted many thousands to the reality that, in pursuing socialist policies, the West was risking the loss of its traditional free civilization. In 1946, Leonard Read established The Foundation for Economic Education, in Irvington, New York, publishing the works of Henry Hazlitt and other champions of the free market. Mises and Hayek, now both in the United States, continued their work. Hayek led in founding the Mont Pelerin Society, a group of classical-liberal scholars, activists, and businessmen from all over the world. Mises, unsurpassed as a teacher, set up a seminar at New York University, attracting such students as Murray Rothbard and Israel Kirzner. Rothbard went on to wed the insights of Austrian economics to the teachings of natural law to produce a powerful synthesis that appealed to many of the young. At the University of Chicago, Milton Friedman, George Stigler, and Aaron Director led a group of classical-liberal economists whose specialty was exposing the defects of government action. The gifted novelist Ayn Rand incorporated emphatically libertarian themes in her well-crafted best-sellers, and even founded a school of philosophy.

The reaction to the renewal of authentic liberalism on the part of the left — “liberal” — more accurately, social-democrat-establishment was predictable, and ferocious. In 1954, for instance, Hayek edited a volume entitled Capitalism and the Historians, a collection of essays by distinguished scholars arguing against the prevailing socialist interpretation of the Industrial Revolution. A scholarly journal permitted Arthur Schlesinger, Jr., Harvard professor and New Deal hack, to savage the book in these terms: “Americans have enough trouble with home-grown McCarthys without importing Viennese professors to add academic luster to the process.” Other works the establishment tried to kill by silence. As late as 1962, not a single prominent magazine or newspaper chose to review Friedman’s Capitalism and Freedom. Still, the writers and activists who led the revival of classical liberalism found a growing resonance among the public. Millions of Americans in all walks of life had all along quietly cherished the values of the free market, and private property. The growing presence of a solid corps of intellectual leaders now gave many of these citizens the heart to stand up for the ideas they had held dear for so long.

In the 1970s and ’80s, with the evident failure of socialist planning and interventionist programs, classical liberalism became a world-wide movement. In Western countries, and then, incredibly, in the nations of the former Warsaw Pact, political leaders even declared themselves disciples of Hayek and Friedman. As the end of the century approached, the old, authentic liberalism was alive and well, stronger than it had been for a hundred years.

And yet, in Western countries, the state keeps on relentlessly expanding, colonizing one area of social life after the other. In America, the Republic is fast becoming a fading memory, as federal bureaucrats and global planners divert more and more power to the center. So the struggle continues, as it must. Two centuries ago, when liberalism was young, Jefferson had already informed us of the price of liberty.