The Mystery of Capital in Context

Given the rancorous debate unleashed by the UK electorate’s decision to depart the European Union – in particular, regarding the damage to the UK economy that independence might bring – it seems wise to re-examine the foundations of economic prosperity and its relationship to political and legal factors. I do so by examining Hernando de Soto’s seminal book, The Mystery of Capital, which goes to the heart of the relationship between political framework, legal framework, and economic development.


The “mystery of capital” is the intriguing title of one of the most important books of the new millennium. Written by the Peruvian economist Hernando de Soto, it breaks with the tradition of dealing with capitalism as a system established of, by, and for the rich, by looking at it from the bottom up: from the lowest levels of society. De Soto finds capitalism even at that level, albeit in a stage of dormancy, as it were. His treatise is intended to help us understand that capitalism is nothing esoteric – despite its being a “mystery” – but rather something down to earth, active in the lowest levels of society, and only waiting for a proper legal and political framework to become an equitable system, in the service of all, not just the well-to-do.

De Soto first made a name for himself with his path-breaking work in Peru, which culminated in the best-selling book The Other Path. In order to show an alternative route to a better society, De Soto developed a unique investigative method. At the time – the 1980s – the better society was being promised by radical revolutionary groups. In Peru, such a group was El Sendero Luminoso, the “Shining Path” – the path to the enlightened society, the workers’ paradise. Officially, this was the Communist Party of Peru, and throughout the 1980s it engaged in violent revolution. De Soto proposed El Otro Sendero, the “other path,” which would render the revolution irrelevant by integrating the real-world economies of the poor within an all-embracing economic framework that left no one out.

What De Soto and his colleagues at the Institute for Liberty and Democracy had discovered was that, at the poorest and most basic levels of society, a vibrant economy was already in existence. It functioned in spite of, rather than because of, the formal institutional and legal structures provided by the state. For in Third-World countries such as Peru, there was not one economy but two: the formal economy, the economy of the wealthy and middle class, connected with the rest of the world; and the informal economy, the economy of the poor, the “off the books” economy, comprising the residual and peripheral denizens who happened to make up the vast majority of the nation. Essentially, the legal and political institutions functioned within and for the benefit of the formal economy, while the informal economy ran on its own, ignored and neglected by the powers that be, kept by the phalanx of rules and regulations from ever graduating from the shadows into the sunlight of the economy proper.

De Soto’s book highlighted this situation and the potential that it held, if it could be harnessed, both for the benefit of the poor and for the nation as a whole. Mainly, the regime of bloated regulation and official corruption needed to be exchanged for the rule of law, specifically the institutions of property and contract. If this would occur, the chains would come off of the poor and they could become full-fledged participants in a functional rather than dysfunctional social order.

De Soto’s second book, The Mystery of Capital, is the culmination of the work done in the wake of, and building on the foundations laid in, The Other Path. It is the product of the transfer of the method pioneered in Peru into many other Third World countries facing similar problems. De Soto took his show on the road, making the Institute for Liberty and Democracy into a globally active entity.

Unlike The Other Path, however, The Mystery of Capital is more than an exposition of the findings of investigative field work. In fact, it transcends the empirical method altogether: it sets forth a philosophical outworking that is both result and foundation of those empirical findings.

In making this leap from practice to theory, De Soto had penned a most important book on the subject. He was enabled to do this precisely because of the empirical basis: the book went beyond economic theory to the real world in which economic practice is embedded, a world that economic theory studiously ignores; it takes into account the real-world framework within which economies function.

The recognition of the two-tiered economy led De Soto to perceive the crucial importance of the legal system. For in his findings, it was the legal system that made the difference between the two economies. This led him to explore virtually virgin territory: the relationship between the legal system and the economy has been largely ignored, except for certain specialty (and rather idiosyncratic) disciplines such as institutional economics, “new” institutional economics, and law and economics. While these latter disciplines have not been entirely fruitless, they have not helped to rework economic theory the way that De Soto had done in his book.

De Soto’s reworking of economic theory starts from a rather crucial distinction that is well known to legal philosophers, the distinction between possession and property. This is a staple of the Western legal tradition (both civil and common). Essentially, the difference between possession and property is physical versus mental – possession is physical holding, while property is an entitlement that stays in force regardless of whether the owner is in physical possession or not. And this distinction depends on a functioning legal order that enforces its arrangements. With possession, enforcement is essentially left to the possessor; with property, it is maintained by a separate entity charged with law enforcement, and hence is not dependent upon the physical strength of the owner in order to enforce possession.

With property arrangements, then, the relations of people and things are elevated to a higher plane than arrangements of pure possession. And they provide for higher-order exploitation of resources than simple possession does. For one thing, property rights can be split up and farmed out any number of ways. For another, property allows for encumbrance in credit contracts, whereby the property item serves as collateral. Without changing its physical status, the encumbered asset engenders a new set of economic advantages. The owner can borrow money against it; and, as Steuart showed back in the 18th century and Schumpeter in the 20th, this is essentially the way in which, in the modern world, money comes into being. At least, in a banking- as opposed to a coinage- or scrip-based system. Credit and debt are the source of money issue. As any bank balance sheet will show you, all money issued has as its counterpart an encumbered economic asset.

In his book, De Soto never explicitly refers to the legal doctrine of possession vis-à-vis property, but despite that, it underlies his entire exposition. He argues that it is the legal system that enables possessions to become property, thus assets, and assets to become capital – resources capable of generating new productivity and income. “Like electrical energy, capital will not be generated if the single key facility that produces and fixes it is not in place. Just as a lake needs a hydroelectric plant to produce usable energy, assets need a formal property system to produce significant surplus value. Without formal property to extract their economic potential and convert it into a form that can be easily transported and controlled, the assets of developing and former communist countries are like water in a lake high in the Andes – an untapped stock of potential energy.”[1]

De Soto’s argument is crucially important – as far as it goes. But it runs into problems when he goes further and highlights a single aspect of the legal system, to which he attributes excessive importance. This in turn causes him to lose sight of other aspects, and indeed, the bigger picture.

De Soto emphasizes the role of record-keeping as the determining factor in creating a cognitive layer overlaying the physical layer of tangible things. Records, titles, data storage and retrieval, allow the things that otherwise exist in isolation to be integrated together into a collective mind map, by which they become a synergistic whole that is greater than the sum of the parts. For De Soto, this is the crucial element of a system of property rights, which enables it to generate productive economic assets – capital.

But this is to overplay his hand. It is not so much record-keeping within a framework of law, but the framework of law itself that is the important thing. The key is the establishment of common law: a law that is valid across the board across the entire territory, which holds for everyone and which establishes at its core, property rights and freedom of contract, uniformly and equally enforced. Historically, this kind of common law was established early on in England, where the king’s writ came to run everywhere. Which is why England became the common-law country par excellence.[2]

Such an establishment of common law, in turn, depends upon the consolidation of sovereignty.

Sovereignty is the power by which the rule of law is established. It is the prerequisite of a functioning legal order. Sovereignty is the power to establish and confirm shared, social value. It does this through legislation and adjudication, establishing laws as standards by which the social order is ruled – the rule of law. These, then, are values, which are universally valid and binding.[3]

But there is more to the establishment of value than this. Valuation has, of course, an economic dimension as well as a juridical one. But does the legal system generate economic value? Yes it does, through the utilization of property and contract. And here we have the intangible, mental, symbolic dimension of the economy that De Soto intuits, but does not quite elucidate, given his focus on record-keeping. Property and contract generate value by the process of credit and debt. When property is harnessed as collateral in a credit contract, it is valued; and this valuation is expressed in the issuance of a monetary equivalent. A deposit is established at the bank, in the equivalent of the loan. Borrowing a metaphor from the days of minting coinage, Steuart called this the “melting down” of property into “symbolical” money. Hence, the regime of property and contract participate in the process of valuation in a very critical way. And out of this valuation comes capitalization – capital.

Now then, the context of this valuation and process issuing forth ultimately in that mysterious entity, capital, is a common legal order, the product of a consolidated and viable locus of sovereignty. Sovereignty, then, enables this whole process of capitalization to take place. What is the locus of sovereignty? Following the German Calvinist statesman and political philosopher, Johannes Althusius, we can answer unambiguously, the nation.[4]

The Industrial Revolution, the “take-off,” as W.W. Rostow put it, did not come about in a vacuum. It came about in nations in which sovereignty had been consolidated; and those nations in which sovereignty had not been consolidated, did not experience it. Nationhood and sovereignty go together. Like a lens out of focus, sovereignty is weak where it does not shine through the prism of nationhood. And, where sovereignty is weak, there also a domestic economy does not materialize; as a result, conditions are rife for an exploitative, colonial or neo-colonial framework. Wallerstein’s center-periphery framework then looms large. None of that is necessary for economic growth: in fact, it only benefits particular interests, at the expense of broad-based, populace-elevating economic growth.

So then, it is sovereignty refracted through nation-states that has enabled the genesis of the capital which De Soto seeks to demystify. Summarizing this state of affairs, I wrote: “Through the institutions of property and contract, credit and debt, the asset base in man (human capital) and through man (tangible and intangible property) becomes capitalized, generating a money supply which, when properly maintained, is the faithful representation of that asset base, no more and no less. The nations of the world have no need of a Wizard of Oz to grant them prosperity. It is in their hands to do so, if they would only recognize it.”[5] That is the mystery of capital explained. In its fullness, only nations can bring it off. Neither inchoate peoples, nor empires, ever have, or ever will.


[1] Hernando De Soto, The Mystery of Capital: Why Capitalism Triumphs in the West and Fails Everywhere Else (New York: Basic Books, 2000), p. 48.

[2] For more on this point see my book Common Law & Natural Rights (Aalten: WordBridge, 2009), pp. 68ff.

[3] For more on this point see my book Common-Law Conservatism: An Exercise in Paradigm-Shifting (Aalten: WordBridge, 2007), ch. 1.

[4] For more on this point see this previous post.

[5] Follow the Money, p. 190.

Maggie’s Revenge

The British vote on June 23rd, 2016, to leave the European Union, is one of those events that will long be remembered. Yet there was another event involving Britain on the one hand and the European Union (then Community) on the other, that likewise came as a shock, and which likewise lives on in the memory, at least for those who, at the time, were political aware. I refer to Margaret Thatcher’s resignation of the prime ministry, exactly 25 years and seven months earlier, on November 23rd, 1990. Personally, I remember exactly where I was and what I was doing when I heard that bit of news over the radio.

Thatcher’s resignation resulted from her opposition to European union. She paid the price by being cashiered by her own party, not by the electorate. I wrote an article in 1991, discussing this event, its significance, and what I considered to be its historical relevance. In terms of the latter, the article was flawed in its diagnosis, but not in its recognition of that relevance. And today, I think that Margaret Thatcher is looking down with a sense of grim satisfaction.

To honor this event, I excerpt from that article, published in 1991.


It came so suddenly as to leave the world in a state of shock. Margaret Thatcher, the “Iron Lady,” the fighter who would rather die than quit, did just that: she voluntarily resigned her position as Prime Minister of the United Kingdom. She did so as she reflected on what “a funny old world” it should be that a party leader never defeated in a general election, still commanding a majority of her own party, who had led that party to three successive election victories, who had spearheaded a thoroughgoing reformation of public policy whose very name was synonymous with that reformation, should be forced by her own party to resign her post. Truly these were rather funny goings-on.

To top it all, it was not any strictly domestic issue but “European unity” that brought all this about. To many, she was the champion of a by-gone era of national sovereignty and “Little England,” “the prim and condescending leader of a has-been empire bent on turning back the tide of history, a latter day King Canute who actually believed the sea would heed her.”(1) So it was portrayed: Thatcher versus Europe, isolation versus community, proud independence versus peaceful cooperation. And it turned out to be an Achilles’ heel which her opposition lost no time in exploiting as soon as opportunity presented itself.

Her enemies’ strategy worked. But to characterize Margaret Thatcher’s position with respect to the European Community (E.C.) in these terms is, at the very least, open to question. She regarded herself the most pro-European of them all; nevertheless her approach to and her concept of unity differed – fundamentally – from theirs.

Perhaps the key element of difference lay in the goal of monetary union. Thatcher remained to the end staunchly opposed to the formation of a pan-E.C. single currency administered by an independent central bank. Most others see such an arrangement as the indispensable core of a truly common market. Across Europe as a whole, the goal of monetary union commands broad support. Certainly it was this issue more than any other which isolated her from her peer heads of state and made her vulnerable to attack at home.

Such issues have not heretofore been the stuff of dramatic controversy, at least if one follows standard historical accounts. Most historically-conscious folks have a vague recollection, for example, that the establishment of a central bank in the United States was a very hot issue from time to time and was finally brought to pass with the Federal Reserve in 1913 (which isn’t really a true central bank but rather a “federally organized” group of regional banks). But they remain supremely indifferent to the subject and would much rather look into the accounts of politics or war or class struggles, or perhaps “social” histories of “everyday life” in such and such a period. The history of banking and monetary policy is definitely a subject for the specialist. And thus supremely boring.

Yet as contemporary events should insinuate, a long look needs to be taken especially at the history of monetary union. Upon further inquiry that history proves to be decisively important to understanding our present and certainly what Margaret Thatcher would consider our predicament. One has consequently to go back to its roots and see how and why it has become so fundamental – as it truly has – to modern society….

Mrs. Thatcher … faced opposition on two major points – domestically, the poll tax issue, and in external affairs, her position concerning the European Community. The poll tax weakened her position with respect to the electorate, enabling her opposition in the Conservative Party to gain ground on her. But in the final analysis the poll tax is not what felled her.

The timing of events leading to her fall is conclusive here. At the annual party conference in early October [1990], the Conservatives showed themselves lackluster, despondent, without much enthusiasm for the upcoming elections which they feared they might lose. More than anything else, it was the Europe issue that divided them. Many in the party were leaning toward a strong pro-Europe stance; Sir Geoffrey Howe, for instance, argued for full acceptance of monetary union, and Michael Heseltine preached pro-union to a well-attended side meeting. On the other side were the anti-union forces worried that Mrs. Thatcher, who had been showing herself conspicuously indeterminate in the last months, would be “led gently to monetary union, like some doddery old lady, with Mr Major and Mr Douglas Hurd… at either elbow.”(2)

Thatcher herself was then “ambushed” at the E.C. summit in Rome at the end of October. Italy’s prime minister Giulio Andreotti presented a proposal with definite dates for achieving monetary union, something which caught Mrs. Thatcher by surprise. This seems to have woken her from her lethargy. Back home she gave a rousing speech in the House of Commons against monetary union and giving over national sovereignty to Brussels. Her old followers were delighted. Others wondered how long she would last.

It was this speech and her renewed hard line which led to the resignation of Sir Geoffrey Howe from her cabinet. And it was his resignation speech which solidified the opposition against Mrs. Thatcher, prompting Michael Heseltine to run against her in the party election. Howe vociferated against her “anti-Europe” position, arguing that it jeopardized the future of the nation and its role in a united Europe. And then of course Heseltine gained enough votes on the first ballot to force a second one, after which Thatcher resigned.

It was, then, undoubtedly the Europe issue which brought Thatcher’s downfall. That much is clear. In the final analysis, however, not even the politicians were ultimately the cause. The powers-that-be want monetary union, and if anyone stands in their way, they will simply remove him, or her, to get it. The politicians know this and act accordingly if they know what is good for them. The people do not know any better than to accept this goal because it is proffered to them by every available media source from which they derive their opinions.


1. Newsweek, Dec. 3, 1990, p. 22.
2. The Economist, Oct. 31, 1990, p. 43.

The Problem of Saving

When Schumpeter writes, “Now to the question: what is a savings account?”,[1] he is not being facetious. There is more to savings than meets the eye. Of course, the bare fact of saving is simple enough to understand. Rather than spend all of our earnings, we take some and put it to one side. What could be more straightforward?

Actually, the problem is not so much understanding what savings, or a savings account, is, but what kind of effect it has. And that is anything but straightforward.

Essentially, what is accomplished with the act of saving is the removal of circulating medium from the cycle which is what an economy is.

An economy is a cycle or a circular flow: this is one of the first lessons of basic economics, encapsulated in the principle originally put forward by Jean-Baptiste Say, “supply creates its own demand.” All this means is that, at the end of the day, the producers are the consumer and the consumers, the producers. It is the same people producing who do the consuming, and vice versa.

At least, this is the basic picture, before things get complicated with things like foreign trade and fiscal policy. And things like savings. For what savings does is remove some of the circulating medium by which this economic cycle does its cycling. There are two aspects to the cycle: the circulation of goods and service, and the accompanying circulating medium by which the goods and services are accounted. When a shortfall of the circulating medium crops up, the result is deflation. And so, saving on the face of it has a deflating effect on wages and prices. And a deflationary environment is noxious to economic growth.

As a result, we have what economists have dubbed the “paradox of thrift” whereby saving, normally thought of as an act of economic virtue, or at least efficiency, actually depresses economic activity. The details as to how this occurs differ depending on the analyst, but the upshot is that saving, far from being the benign, even constructive act that it may well be on the personal level, actually has, or can have, a negative effect on the economy at large.

So which is it? Do we really have a paradox here along the lines of moral man, immoral society? Is personal saving something good for the individual or the household or other economic entity, but bad for the economy at large?

To figure this out, we have to take a look at what actually happens in the act of saving. First, of course, there is the proverbial mattress, or, especially in the days of coinage, the chest. In such a case, we have the circulating medium definitively removed from the economy for however much time the saver desires. (Or for much longer than that, as witness contemporary discoveries of hoards of coins from e.g. Roman times.) We can call this form of saving “hoarding.” It is peripheral to the main discussion.

What happens in the modern world is something different. When we save, our first resort is not the mattress but the bank. And when we do this, our money earns interest. What is interest? Let’s just say that is another of those phenomena that economists have a hard time figuring out. Perhaps we can address that subject in a future article. For now, we mention it in passing with the caveat that in the contemporary zero-interest-rate environment, it is not the incentive for saving that it normally might be.

So we put our money in banks. What happens then? Does it just sit there, like in the mattress? Not in the modern system. Instead, it enters into a second market, which runs independently of the market for goods and services with which we are already acquainted. We speak of the financial market. Banks (and non-bank financial institutions) are the gatekeepers of this market. We include a graphic taken from the accompanying course to indicate the structure of this second market.

Figure 3:  Two Markets, Two Monetary Circulations
Figure 1:  Two Markets, Two Monetary Circulations

Savings, then, go into this market, where they are “put to use” to earn income for the bank or other financial entity. The differential between what these latter entities earn and the interest they pay out is their profit.

What happens on this market? There are several submarkets which determine this. The bond market is where corporate and government borrowers go to get ahold of some of these savings. The stock market is where corporate interests go to sell stock in their companies – the money that goes here is not savings in the strict sense, as is money lodged with banks, but it does fall under the same category of earnings set aside to earn a separate income and to be available for future use, so we include it in our discussion.

“For future use” – this already indicates that the so-called paradox of thrift need not be so paradoxical. The writers on the problem of saving often seem to talk as if the money put into saving will never come back. In fact, the whole point of saving is to put earnings aside for “a rainy day,” or for the later purchase of big-ticket items, or for retirement – at any rate, not to eliminate it but to return it to circulation at some future time. And in a developed economy, over time the money put aside as savings will be counterbalanced by money previously set aside as savings and now returning to circulation. In addition, this money may have been supplemented by earnings on the financial market, which means that more money will be returning to circulation than left it. So on the face of it, this shouldn’t be a problem.

But there is a problem, and it is this. In normal situations this flow of funds back and forth between the ordinary and the financial markets is not problematic. But in the contemporary situation, it is.

One reason is because the ordinary market is being hit from various directions, making it unproductive and therefore unattractive. Firstly there are what Jane Jacobs (see this post for more on her) called “transactions of decline,” in which government removes money from productive activities, precisely because they are productive, and redistributes it to non-productive activities, precisely because they are unproductive. This can have a Keynesian motivation, whereby Say’s Law is turned on its head: demand then creates its own supply, and all government has to do is distribute money around to consumers (breaking the link between production and consumption) to generate productivity. According to Keynesians, this should in and of itself bring about prosperity, but as Jacobs points out, it only undermines productive activity and the human capital that underlies that productive activity, and so becomes a self-generating downward spiral.

Other things government engages in that undermine productivity are excessive taxation and regulation. All of this makes the ordinary market an unproductive affair, in which risks exceed rewards. The upshot is that savers put their money, not in ordinary investment, but in the financial market, which essentially is a zero-sum game, but in which at least the prospect of a decent return beckons.

And so more funds flow into the financial market than flow out, creating a dearth of liquidity in the ordinary market, which manifests itself in low interest rates combined with difficulty in borrowing (despite those low interest rates).

The flip side of the dearth of liquidity in the ordinary market is a glut of liquidity in the financial market. As funds pile into the market, returns there diminish and the quest for “alpha” (market-beating returns) becomes a frenzy. This is what happened during the 2000s in the run-up to the credit crisis. With the excess liquidity in the financial market, funds were available for lending that never would have been lent in a normal risk/reward analysis, often under political duress. An example is the subprime lending that took place. Michael Lewis (see this post for more on him) wrote about this in two of his most important books, The Big Short and Boomerang (the latter in particular gives a dramatic picture of the workings of the liquidity glut).

This was exacerbated by the trillions of dollars kept in the financial market by exporting countries like Japan and China (see this post this post for more on this), in their attempts to hold down the values of their domestic currencies. That in itself added substantially to the glut. But the very fact that what these countries were doing– looked at globally – was further undermining productivity by destroying productive capacity in rich countries while misdirecting investment in their own countries, only meant that another nail was being driven in the coffin of the ordinary market. Such “global value chains,” when established and maintained through currency manipulation and other fiscal and monetary policies designed to create unfair advantage for exporters at everyone else’s expense, only make the ordinary market even less attractive, which is another reason for the flight to financial markets, and even to inert investments like gold and other luxury items such as works of art.

A lot of work has to be done to restore ordinary markets to decent functionality. One of these is a return to an emphasis on the national economy as opposed to the lopsided emphasis on global-value-chain globalism such as obtains today. And within the national economy, a return to emphasizing the production side of the economy. Consumption does not magically engender productive activity; in particular, deficit spending to fund consumption is as pernicious a fiscal policy as can be devised. Various forms of capital are needed for that, various forms of infrastructure, from legal to educational (virtue versus entitlement) to religious. All of this is fodder for new discussions, so we’ll leave it at that for now.

This topic and more are dealt with more fully in the accompanying course.


[1] Treatise on Money, p. 147.

Confessions of a Free Trade Advocate

Ever since I can remember I have been a proponent of free trade. It seemed the logical thing: why should the government restrict economic activity which in itself is legal and aboveboard? And when I began exploring economic theory, lo and behold, free trade was at the forefront of most every exposition. It was the natural, the logical position to hold, and arguments against it seemed forced and, in fact, unfair, as if a basic principle of justice was being violated.

My instincts received even more validation from historical, moral theology. Francisco Vitoria, the Spanish theologian who was the first to flesh out a recognizably modern theory of the international community and law of nations, made freedom of trade one of the pillars of such a world order. As I wrote in 1991, “Freedom of trade Vitoria also includes among these rights of natural communication. This is quite noteworthy: remember, these rights belong to the ‘primary’ law of nations and as such may never be denied! National governments may infringe the right of neither their own nor of foreign private citizens and subjects to freely engage in trade, so long as trade and business may be carried on without prejudicing the health and safety of the community.” Free trade seemed to be a categorical imperative.

I continued along these lines in a book I published in 1999 entitled A Common Law. There I articulated a twofold tradition in Western constitutional theory and practice, the common-law tradition and the civil-law tradition. Of these two, the common-law tradition espoused limited sovereignty and the primacy of private law over public law, while the civil-law tradition embraced absolute sovereignty and the subordination of private to public law. As an extension of this, I included freedom of trade versus restriction of trade as a dividing line between the two traditions. With regard to the unification of Germany’s disparate states in the 19th century, I wrote that “The roots of German unification lay firmly in the civil-law tradition. Customs union lay the basis for further political union: free trade was established within the customs union, tariff barriers between it and the rest of the world…. In the civil-law tradition, trade can only be securely established within an area controlled by the sovereign; the domestic economy is the only stable economy. In the common-law tradition, trade binds societies under law, a law which also binds sovereigns and commits them to enforce it. In the civil-law tradition, law is the servant of the sovereign; in the common-law tradition, the sovereign is the servant of law” (pp. 125-126). Here again, I made free trade a categorical imperative and one of the core elements of a “constitution of liberty.”

As a final example, I wrote this in 1992: “Today the world is faced with the choice between two kinds of democracy. One, liberal democracy, is the descendant of the theocratic jus gentium, upholding freedom of trade, open borders, restricted national sovereignty, and the primacy of the private sector, considering that human society at the level of private association basically furthers the harmony of interests of its members, and that coercive authority is necessary only to ensure that violations in this harmony are punished. The other, social democracy, is the descendant of divine right absolutism, championing economic nationalism, closed borders, absolute national sovereignty (unless that sovereignty can be transferred to a supranational body), and the primacy of the public sector to rectify the inherent conflict of interests which exists in human society.”

So my free trade bona fides are fairly impeccable. But what I didn’t realize through all these expositions was something I only later began to uncover. It is a principle that already was elucidated by Friedrich List, one of the first post-classical economists to critique the doctrine of freedom of trade. The principle is this: trade between individuals and private entities is not the same as trade between nations, because it is nations that establish the framework within which trade can even take place. In the words of Karl Polanyi, markets are embedded. And this is of crucial importance. Nations establish currencies, laws, markets; they embody cultures and mores that impinge directly on economic performance; they embrace religions that, as Max Weber among others has shown, likewise are of crucial importance to economic activity. The public interest and the common-wealth are real factors that transcend private economy. They condition all economic activity and they cannot be abstracted away as if irrelevant to economics. This is the besetting sin of the free-trade theories of classical and neo-classical economics.

“How!” questions List. “The wisdom of private economy is then the wisdom of public economy! Is it in the nature of an individual to be preoccupied with the business and the wants of the future, as it is in the nature of a nation and of a government?” Leaving everything to individual action could not possibly ensure that collective interests will be taken care of. “Consider only the building of an American city; each man left to himself would think only of his own wants, or, at the utmost, of those of his immediate descendants; the mass of individuals as united in society are not unmindful of the interests and advantages even of the remotest coming generations; the living generation, with that view, submits calmly to privations and sacrifices which no sensible man could expect from individuals in reference to the interests of the present, or from any other motives than those of patriotism or national considerations” (National System of Political Economy, trans. G.A. Matile, Philadelphia: J.B. Lippincott & Co., 1856, pp. 245-246).

The absence of an understanding of the role of nations, and the focus on individuals, led classical economics to consider the entire world as one great commonwealth, with no distinctions of nationality and sovereignty. This is what led it astray. Its basic principles are valid within the framework of the nation, in their own sphere; but they run aground when trade between nations is considered. “In representing free competition of producers as the surest means for developing the prosperity of mankind,” List writes on p. 261, “the School is perfectly right, considering the point of view from which it regards the subject. In the hypothesis of universal association, every restriction upon honest trade between different countries would seem unreasonable and injurious. But as long as some nations will persist in regarding their special interests as of greater value to them than the collective interests of humanity, it must be folly to speak of unrestricted competition between individuals of different nations.” List here speaks only of national interests, but elsewhere he discusses the whole range of relevant criteria by which nations are distinguished. And so, “The arguments of the School in favor of such competition are then applicable only to the relations between inhabitants of the same country. A great nation must consequently endeavor to form a complete whole, which may maintain relations with other similar unities within the limits which its particular interest as a society may prescribe.” The social, public interests which obtain between nations are divergent; they differ from private interests and cannot be treated equally with them. “Now these social interests are known to differ immensely from the private interests of all the individuals of a nation, if each individual be taken separately and not as a member of the national association, if, as with Smith and Say, individuals are regarded merely as producers and consumers, and not as citizens of a nation” (p. 261).

So what does List propose as an alternative? Protectionism. This is his great failing. Because of this, his book has been neglected by those who realize the shortcomings of that doctrine, among whom I include myself. As I knew and still know, protectionism has its own set of problems.

Recall that “the School,” as List refers to the classical school of Adam Smith and Jean-Baptiste Say, advocated a commodity-money regime, which in effect harnessed the nations to a single currency. Because of this, if a nation wished to effectuate some sort of insulation of the domestic economy, it could only resort to protectionism as a fall-back.

The United States pursued a protectionist policy throughout the 19th and into the 20th century. The problems to which this led were given powerful expression at the crackup of the commodity-money regime in 1931, by James Harvey Rogers. Rogers placed a good deal of the blame for the bleak situation on the regime of tariffs obstructing trade.

The prominent part played by our high protective tariff in the present disastrous situation is beyond serious question. Aside from the political corruption which it has engendered in our national politics throughout more than a hundred years of our history, and aside, too, from the glaring domestic injustices which, since its inception, it has created and maintained; on it can now be laid the blame for a very important part in the extraordinary maldistribution of the money metal, in the recent drastic and rapid decline of prices, and therefore in the world-wide depression (America Weighs Her Gold, New Haven: Yale University Press, 1931, p. 193).

Of course this would have to be the case. Tariff walls short-circuit the functioning of a commodity-money regime. The attempt to eliminate trade imbalances through what effectively is a single currency run up against the shoals of that irreducible datum, the national economy. Domestic interests, in particular labor interests, simply will not pay the inflation/deflation whipsaw price to be paid to keep that system running. And so came the inevitable resort to trade barriers, and the eventual collapse of the system.

It is unfortunate that List’s exposition is known only for its advocacy of protectionism. Underneath that veneer lies a trenchant critique of the “cosmopolitan” system which is what unrestricted free trade embodies, which is valid now, as it was then. A common-law understanding of economics, which is what underlies List’s work, recognizes that nationhood and national sovereignty entail a framework of laws and institutions that delimit all economic activity and set up “natural” trade barriers that schemes like free trade and commodity money cannot overcome. A truly “natural” economic framework understands that currency is a function of sovereignty, and that floating exchange rates will provide the balancing mechanism that nations need to conduct trade relations with each other.

So how do we save freedom of trade? Not by eliminating nations, national sovereignty, national boundaries, and the like, but by embracing them within a framework that recognizes rather than undermines national sovereignty. Free-floating currencies are one crucial aspect of such a regime; after all, this is nothing else than free trade in currencies. Another is the adoption of domestic fiscal and monetary policies that do not promote the advantage of one nation over another. This is what happens when, for example, countries like Germany and China inflict forced-savings regimes on their own citizenry, punishing consumption and promoting production. What then in fact happens is that other countries are forced to take on board their excess production, as Michael Pettis has demonstrated in his book The Great Rebalancing. It is here that international efforts need to be conducted, not in imposing transnational regimes that undermine and displace national sovereignty altogether, and make a farce of even the pretense of democratic rule.

National Economy?

At first glance the notion of a national economy would seem to be self-evident. After all, the lion’s share of economic data comes in the form of “national accounts,” which treat the nation as a self-contained economic entity, like a business. And the talk, when it comes to the economy, is always of how the nation is doing, or how other nations or countries are doing. Likewise, history revolves around the nations and their economic progress, as with the US and its “manifest destiny.”

But the idea of a national economy does not extend to the level of theoretical category. Economic theory does not take it into consideration. It comes into play because of political, not economic, considerations. The fact of the matter is, because politics is concentrated at the national level, so also is fiscal and monetary policy. And this factual state of affairs determines the subject matter. It is at the national level that both fiscal and monetary policy takes place; it is the level at which results from these policies are expected.

Economic theory, however, is not discussed in terms of the nation but in terms of abstractions: the “market,” “business,” “consumers,” etc. This is, or at least it used to be, referred to as “microeconomics.” Then we have “macroeconomics,” which is essentially the economic role of the state with its aforementioned fiscal and monetary policies; in this way we smuggle the nation in through the back door, as it were.

But the nation never functions as a subject of economic theory in its own right. Economic practice, of course, cannot avoid it – the sovereign democratic state is the way things are, it delimits the subject matter at the “macro” level.

The unexamined presupposition in all of this is, what is the locus of the economy? It is actually a question of the utmost importance, because only in this way can we come to grips with crucially important notions – and realities that, like it or not, we have to deal with – like the “global” economy.

One person who, thankfully, did not leave this presupposition unexamined is Jane Jacobs. In her book Cities and the Wealth of Nations,[1] she puts the notion of a national economy, which she takes to be the reigning doctrine, squarely in the cross-hairs. In her view, such an economy is an artificial imposition: the real economy is city-oriented. Cities, not nations, form the watersheds of an economy. Which is to say, cities are the focus of integrated, mixed economies, involving all major sectors from agriculture to industry to finance. Within the city and its supply regions, a stable and integral economy is maintained.[2]

Therefore exporting and importing takes place between cities, not nations. By extension, cities perform the vital economic function of import-replacing: the replacement of imported goods with goods of their own making. In Jacobs’ model, it is this import-replacing function that is the basic motor of economic growth.[3]

Jacobs adds to this import/export functionality the logical corollary: currencies. Currencies function as feedback mechanisms: they provide economies with information with respect to their productivity vis-a-vis other economies. A rise in an economy’s currency indicates that it is more productive than other economies the currencies of which are falling in relative terms, while a fall indicates the reverse condition.

So then Jacobs draws the obvious conclusion. Since cities are the basic units of import and export, currencies, in order to best perform their function, should be geared to the city economy itself; their rise and fall would thus trigger the appropriate response in the city economy, because this currency fluctuation acts as both tariff barrier and export subsidy (a falling currency acts as an export subsidy, a rising currency as a tariff barrier). Cities should maintain their own currencies.[4]

This also indicates a problem with this entity known as the national economy. A larger political unit such as a nation-state, when it imposes a common currency on a multiplicity of cities, short-circuits this feedback function of currencies. It favors the economies of some cities at the expense of others. Since cities not only import and export to foreign nations but also to sister cities in the same nation,[5] the automatic feedback information provided by the currency does nothing to allow cities within the range of the currency to adjust their economies to each other. They receive none of the feedback information that a city-based currency would provide them. Therefore, the cities whose economic position is favored by the national currency continue to grow, while the others stagnate.[6]

Clearly Jacobs is no friend of the nation-state. “Virtually all national governments, it seems fair to say, and most citizens would sooner decline and decay unified, true to the sacrifices by which their unity was won, than prosper and develop in division.”[7] And she takes classical economics, especially as exemplified in Adam Smith’s tellingly titled Inquiry into the Nature and Causes of the Wealth of Nations, to task for this. Smith “accepted without comment the mercantilist tautology that nations are the salient entities for understanding the structure of economic life. As far as one can tell from his writings, he gave that point no thought but took it so much for granted that he used it as his point of departure.”[8] Smith’s unthinking assumption of this assumption was subsequently passed from generation to generation without any further thought on the matter. “Ever since, that same notion has continued to be taken for granted. How strange; surely no other body of scholars or scientists in the modern world has remained as credulous as economists, for so long a time, about the merit of their subject matter’s most formative and venerable assumption.”[9]

So Jacobs agrees with us that the locus of the economy is an unexamined proposition. Nevertheless, her thesis that the nation was the focal point of classical economic theory is debatable. In fact, it is contradicted by an early proponent of “The National System of Political Economy,” Friedrich List.[10] List certainly does not figure as an unthinking follower of Adam Smith. His description of Smith’s school is telling: he calls it “the Cosmopolitical System.” By which he means that, pace Jacobs, it is the antithesis of a “national system” of economics.

In line with the influential vision of “Perpetual Peace” put forward in the late 18th century by the celebrated Abbé St. Pierre, this “cosmopolitical system” of economics presupposes harmony and peace between the nations. In such a situation, nations per se have no interests; the human race is joined together as one; and for this reason, “for the most part the measures of governments for the promotion of public prosperity are useless; and that to raise a State from the lowest degree of barbarism to the highest state of opulence, three things only are necessary, moderate taxation, a good administration of justice, and peace.[11] Free trade is then the norm, and indeed, can only truly be implemented under the auspices of such a universal peace. But, argues List, this is to confuse a hypothetical goal toward which the nations should work, with a standing condition already attained.

The [classical] School has admitted as realized[,] a state of things to come. It presupposes the existence of universal association and perpetual peace, and from it infers the great benefits of free trade. It confounds thus the effect and the cause. A perpetual peace exists among provinces and states already associated; it is from that association that their commercial union is derived : they owe to perpetual peace in the place they occupy, the benefits which it has procured them. History proves that political union always precedes commercial union. It does not furnish an instance where the latter has had the precedence. In the actual state of the world, free trade would bring forth, instead of a community of nations, the universal subjection of nations to the supremacy of the greater powers in manufactures, commerce, and navigation. [12]

While Smith and the other proponents of the classical school did recognize the existence of nations and national interests, List correctly assesses the basic orientation of the system. Much of this was inchoate; Lists’s strictures served to stir up debate, generate criticism, and give rise to critical schools of economic theory, such as the so-called Historical School.

This is evident not only in the advocacy of free trade generally as panacea for all economic ills, but also, importantly, in the advocacy of free trade in the area of currency. As we explored in this earlier post, leaving currency to the free market is a key element in a cosmopolitan system that deemphasizes nations as economic actors and subjugates sovereignty, in order to establish a “center-periphery” system of exploitation. And Adam Smith’s classical system established commodity money as a cornerstone of its economic order. As such, in its essentials List’s construct holds true.

List is correct to point out that mercantilism, the target of the classical school’s vituperation, took the nation to be the focus of economics. The system of commodity money, established to overcome mercantilism, is thus a product of the cosmopolitan system. Indeed, the latter found its justification in the fact that it overcame mercantilism, with its supposed framework of conflict of interests and the struggle between nations.

The system of commodity money came to be embodied in the gold standard. As I have argued elsewhere (Follow the Money, ch. 14: “The Great Transformation”), that system ended up in the shipwreck of two world wars and a great depression. As such, it is forever a thing of the past.

Since then, we have had national currencies; and since 1971, ostensibly free-floating national currencies. Jacobs’ polemic against the current system of national currencies has this to say for it, that it understands the role of currencies as feedback mechanisms. Furthermore, the understanding of economies as things that are city-oriented and city-generated. Where Jacobs goes astray is in her exclusive focus on currencies as the only way imbalances are rectified.

As I outline in the accompanying course, economic regions within national boundaries, which thus share the same currency, adapt to each other and resolve imbalances between each other by changes in wages and prices. These changes trigger flows between the economic regions, which are called factor flows: flows of mobile factors of production. Two such factors are labor and capital. They flow back and forth between economic regions, depending on such things as wage levels, price levels, and interest rates.

In the cosmopolitan system, these flows take place not only within countries but between countries. The world is then viewed as a unified, universal jurisdiction of provinces, with the free flow of mobile factors of production settling up regional imbalances.

The problem with this system is, of course, that it does not take nations into account as inescapable realities with inescapable, differentiated, often conflicting characteristics. Nations have different cultures, languages, religions, mores, values, levels of material development, and certainly different approaches to and attitudes towards getting and spending. This leads to evident differentials in things like rates of economic growth.

There is more. Nations have an unsettling penchant: inner drive to establish sovereignty. This was one of the great insights of the German Calvinist statesman and political philosopher Johannes Althusius (1563-1638). At the time, the doctrine of sovereignty was for the first time being fully developed in its modern form as the power that cannot be gainsaid, the power that stands above all other human institutions and authorities and “speaks the law” to them in a final manner. The Frenchman Jean Bodin (1530-1596), coincidentally one of the forerunners of the theory of commodity money, was also the developer of this new theory of sovereignty, which he located squarely in the ruler, whether king or national assembly of whatever sort.

Althusius accepted Bodin’s doctrine of sovereignty but turned it on its head, as it were. It was not the ruler, but the nation as a whole which was the bearer and locus of sovereignty. The ruler was simply the administrator thereof, who exercised its power in the name of and in trust to the true sovereign, the people or nation.

I have attributed the rights of sovereignty, as they are called, not to the supreme magistrate, but to the commonwealth or universal association. Many jurists and political scientists assign them as proper only to the prince and supreme magistrate to the extent that if these rights are granted and communicated to the people or commonwealth, they thereby perish and are no more. A few others and I hold to the contrary, namely, that they are proper to the symbiotic body of the universal association to such an extent that they give it spirit, soul, and heart. And this body, as I have said, perishes if they are taken away from it. I recognize the prince as the administrator, overseer, and governor of these rights of sovereignty. But the owner and usufructuary of sovereignty is none other than the total people associated in one symbiotic body from many smaller associations. These rights of sovereignty are so proper to this association, in my judgment, that even if it wishes to renounce them, to transfer them to another, and to alienate them, it would by no means be able to do so, any more than a man is able to give the life he enjoys to another. For these rights of sovereignty constitute and conserve the universal association.[13]

This key consideration is something that Jacobs and economists in general overlook. Sovereignty is a legal and political doctrine that fixes economic reality in a determinate and conclusive manner. It transcends economics while also acting as a basic datum that real-world economics must take into consideration. And it is nations that exercise sovereignty. As such, it is nations that establish and maintain a common law, the determiner of economic reality: hence, common-law economics. Currency, for one thing, is a function of this common law. No nations, no sovereignty; and no sovereignty, no common law. As this piece is already long enough, I will spare the reader any further elucidations. But this on-site article can serve to fill the gap.


[1] Jane Jacobs, Cities and the Wealth of Nations: Principles of Economic Life (New York: Random House, 1984).

[2] Ibid., ch. 2.

[3] “Whenever a city replaces imports with its own production, other settlements, mostly other cities, lose sales accordingly. However, these other settlements – either the same ones which have lost export sales or different ones – gain an equivalent value of new export work. This is because an import-replacing city does not, upon replacing former imports, import less than it otherwise would, but shifts to other purchases in lieu of what it no longer needs from outside. Economic life as a whole has expanded to the extent that the import-replacing city has everything it formerly had, plus its complement of new and different imports. Indeed, as far as I can see, city import-replacing is in this way at the root of all economic expansion.” Ibid., p. 42.

[4] Ibid., ch. 11.

[5] Ibid., p. 43.

[6] Ibid., ch. 11.

[7] ch. 13; the quotes are from pp. 212, 215-16.

[8] Ibid., p. 30.

[9] Ibid., p. 31.

[10] As elaborated in his book The National System of Political Economy,  first published in German in 1841. The English translation was first published in 1856.

[11] National System of Political Economy (1856 ed.), p. 191.

[12] Ibid., p. 200.

[13] Frederick S. Carney (trans. and ed.), The Politics of Johannes Althusius (London: Eyre & Spottiswoode, 1965), p. 10. Emphasis added.

Capitalism and the “Modern World System”

World system analysis was first developed in the early 1970s as an alternative to the traditional nation-state-oriented analysis of the global economy. In its initial form (which has since been expanded – even, significantly, to ancient Mesopotamia[1]) the focus was put on the modern world system, as evidenced by the title of the pioneering work of the genre, by Immanuel Wallerstein: The Modern World-System. According to this version of events, the world system developed in the transition from medieval to modern times, with the key period being the 16th century.

What characterizes a world system is what is called a center-periphery relation. The center determines the flows and the rationale, while the periphery provides the means and materials. The center is the “why,” the periphery is the “how.” The whole thing exists for the benefit of the center; the periphery may derive some advantages from the relationship, but these are adventitious.

Wallerstein argues that such a system was set up by the Western colonial powers. Prior to this, the structure for economically connecting various regions was empire – a political method, not an economic one. In the imperial model, there is likewise a center-periphery relation, but it functions differently. Such empires “guaranteed economic flows from the periphery to the center by force (tribute and taxation) and by monopolistic advantages in trade.”[2] That was the good news; the bad news was that these forced contributions required massive outlays in coercive apparatus in order to be sustained. “The bureaucracy made necessary by the political structure tended to absorb too much of the profit, especially as repression and exploitation bred revolt which increased military expenditures;” the upshot is that empire was only “a primitive means of economic domination.”[3]

As such, the new method of world system was a great improvement exploitation-wise. “It is the social achievement of the modern world, if you will, to have invented the technology that makes it possible to increase the flow of the surplus from the lower strata to the upper strata, from the periphery to the center, from the majority to the minority, by eliminating the ‘waste’ of too cumbersome a political superstructure.”[4]

It was capitalism that enabled this great leap forward. Capitalism does not require political hegemony to realize these economic flows between the center and the periphery; rather, it makes use of political power to attain favorable terms of trade. “The state becomes less the central economic enterprise than the means of assuring certain terms of trade in other economic transactions.” It stacks the deck in favor of the center, to ensure the center’s superiority. Trade is the medium for accomplishing this. Not free trade, to be sure, but managed trade. “The operation of the market (not the free operation but nonetheless its operation) creates incentives to increased productivity and all the consequent accompaniment of modern economic development.”[5]

“The world-economy is the arena within which these processes occur.”[6] And so globalism came into being.

There have been many critiques of this framework. For one thing, was this really the first time such a world system has come about? There is good reason to believe that such a world system was already established in ancient Mesopotamia (at least, a far-reaching center-periphery arrangement based in capitalism and trade rather than conquest).

For another, does capitalism necessarily form such a world system? It can be argued that there are different forms of capitalism. Was it not a form of capitalism that participated in Wallerstein’s empire? It would seem that capitalism of some form was alive and well in, e.g., the Roman Empire. And cannot capitalism function just as well within a domestic economy, under the thumb of sovereignty?

Indeed, if there is a term subject to equivocal use, it is capitalism. Schumpeter referred to capitalism as “that word which good economists always try to avoid,” precisely because of the range of meanings attributed to it. For his part, Schumpeter defined it as “that form of private property economy in which innovations are carried out by means of borrowed money, which in general, though not by logical necessity, implies credit creation.” Those familiar with Schumpeter’s theory of economic development will recognize the emphasis he puts on this function; those who aren’t, might profit from the course in economics available elsewhere on this website, which highlights this functionality. For his part, Schumpeter defends the importance he attaches to it. “It undoubtedly appears strange at a first reading, but a little reflection will satisfy the reader that most of the features which are commonly associated with the concept of capitalism would be absent from the economic and from the cultural process of a society without credit creation.”[7]

Be that as it may, world system analysis is important, not as just another critique of capitalism, but as a critique of the form capitalism can take and the way in which trade, banking, etc., can be used to establish hegemonic exploitative regimes on a transnational basis.

One of the important aspects of world system analysis is the perspective it opens to the way sovereignty can be manipulated, even hijacked. For the center of the system is less a political power center than an amorphous, protean nerve center. Fernand Braudel, not quite a world-system analyst but a kindred spirit nevertheless, depicted this kind of capitalism quite starkly. From early on, he wrote, the great capitalists have seated themselves astride the currents of domestic and international trade; they have been able to make things happen for themselves in a major way.  “This commanding position at the pinnacle of the trading community was probably the major feature of capitalism in view of the benefits it conferred: legal or actual monopoly and the possibility of price manipulation.”[8]

Thus, “active social hierarchies” were constructed atop the market economy, and those at the pinnacles could call the tune in the great national and international markets. The esoteric privileged area of large-scale and international trade represented a “shadowy zone” atop the market economy.  “Certain groups of privileged actors were engaged in circuits and calculations that ordinary people knew nothing of.  Foreign exchange for example, which was tied to distant trade movements and to the complicated arrangements for credit, was a sophisticated art, open only to a few initiates at most.” For Braudel, this transnational perch is the linchpin of the arrangement. “To me, this second shadowy zone, hovering above the sunlit world of the market economy and constituting its upper limit so to speak, represents the favoured domain of capitalism.”[9]

This understanding opens the door to a critique of this world-system analysis. The core-periphery framework with which it works, demands strong states at the core and weak states at the periphery. “The world-economy develops a pattern where state structures are relatively strong in the core areas and relatively weak in the periphery. Which areas play which roles is in many ways accidental. What is necessary is that in some areas the state machinery be far stronger than in others.”[10]

In the early-modern period, according to Wallerstein, it was absolute monarchy which provided the strong state, benefiting the two main power groups, the so-called capitalist bourgeoisie and the feudal aristocracy. “For the former, the strong state in the form of the ‘absolute monarchies’ was a prime customer, a guardian against local and international brigandage, a mode of social legitimation, a preemptive protection against the creation of strong state barriers elsewhere. For the latter, the strong state represented a brake on these same capitalist strata, an upholder of status conventions, a maintainer of order, a promoter of luxury.”[11]

But as I have written elsewhere,[12] it was not any of the absolute monarchies but the Great Exception, the Dutch Republic, that functioned as the core of the budding world system. This was not an absolute monarchy but a country in which the very concept of sovereignty and its location was unclear. It was a country the political power of which was divided between a stadhouder (a viceroy without a king) and a city-oriented gentry which might serve as the poster children of Wallerstein’s capitalist bourgeoisie.

As I explained in a previous post, the Dutch Republic was able to establish its trading network basically by poaching the silver circulation of its neighboring “absolute monarchies,” which is one reason France invaded the country in 1672. In other words, it worked to undermine the sovereign attributes of its neighbors to establish this network. It also e.g. circumvented trade restrictions established by its more powerful neighbors. In other words, the world system functioned by weakening, not strengthening, national sovereignty.

This characteristic is overlooked by Wallerstein’s analysis. It recurs on a regular basis. The entire commodity-money framework which the Dutch Republic and then England worked to establish on a world-wide basis, the monetary framework that fostered the world system such as it was, takes money entirely out of the hands of the state and puts in in the hands of a private capitalist elite.

Del Mar’s scathing denunciation serves to highlight just how opposite to the notion of a “strong core state” this new monetary regime actually was:

From the remotest time to the seventeenth century of our æra, the right to coin money and to regulate its value (by giving it denominations) and by limiting or increasing the quantity of it in circulation was the exclusive prerogative of the State. In 1604, in the celebrated case of the Mixed Moneys, this prerogative was affirmed under such extraordinary circumstances and with such an overwhelming array of judicial and forensic authority as to occasion alarm to the moneyed classes of England, who at once sought the means to overthrow it. These they found in the demands of the East India Company, the corruption of Parliament[,] the profligacy of Charles II., and the influence of Barbara Villiers. The result was the surreptitious mint legislation of 1666-7: and thus a prerogative, which, next to the right of peace or war, is the most powerful instrument by which a State can influence the happiness of its subjects, was surrendered or sold for a song to a class of usurers, in whose hands it has remained ever since.[13]

In a similar vein, the core of John Hobson’s critique of British colonialism (taken over by Lenin in his Imperialism: the Highest Stage of Capitalism) is that colonialism serves the interests neither of the mother country nor of the colonies, but only the interests of certain specific parties who profit from the arrangement. It follows that such a world system is not necessarily benefiting the core countries at all – it might even be a serious drain on them. Qui bono? The answer is not so simple as the world system analysis might lead us to believe.

Fast forward to the contemporary situation. The arrangement in which we find ourselves, which has been gestating since the end of World War II and has settled into a familiar pattern since the 1980s, cannot be described in terms of this center-periphery arrangement. In fact, the argument can be made (and forcefully) that it has been the periphery which has taken advantage of the core. This has been accomplished mainly by pegging exchange rates at levels advantageous to exports from the periphery (production) paid for by the core (consumption). In this arrangement, the United States is referred to as the “consumer of last resort,” the place where excess production can be most efficaciously offloaded.

This hollows out the production capacity of the consumption-oriented countries running the trade deficit. Obviously, this is not good for workers in those countries. Nor is it beneficial to the workers in the producing and exporting economies. As Michael Pettis makes clear in his extremely important book The Great Rebalancing, it is by a form of forced “savings” (i.e., expropriation) imposed on households and thus workers that this trade advantage is maintained. Qui bono? Not the workers, neither in the exporting nor in the consuming countries. Rather, it is our familiar friend, Braudel’s “shadowy zone” of behind-the-scenes capitalist power brokers, which benefits from its “commanding position at the pinnacle of the trading community” to steer the profits in its direction and the losses to both ends of the trading network. In this arrangement, there is no core and no periphery – there are only regions of exploitation. The difference is in the form the exploitation takes.

Having covered these arrangements more extensively in the accompanying course, I direct the reader there for further background. In the meantime, it is enough to confirm that the seismic rumblings now being felt among the various electorates in the West have a solid basis in reality. It is only to be hoped that the powers that be take heed of these rumblings and make the appropriate adjustments, before they turn into actual political earthquakes.


 

[1] For example: Barry Gills, Andre Gunder Frank (eds.), The World System: Five Hundred Years Or Five Thousand? (London and New York: Routledge, 2014).

[2] Immanuel Wallerstein, The Modern World-System I: Capitalist Agriculture and the Origins of the European World-Economy in the Sixteenth Century, with a New Prologue, vol. 1 (Berkeley, CA: University of California Press, 2011 [1974]), p. 15.

[3] Ibid.

[4] Ibid., pp. 15-16.

[5] Ibid., p. 16.

[6] Ibid.

[7] Joseph Schumpeter, Business Cycles: A Theoretical, Historical, and Statistical Analysis of the Capitalist Process (New York: McGraw-Hill Book Company, Inc., 1939), vol. 1, pp. 223-224.

[8] Civilization & Capitalism, 15th-18th Century: Vol. II, The Wheels of Commerce (New York: Harper & Row, 1984 [1979]), p. 374.

[9] Civilization & Capitalism, 15th-18th Century: Vol. I, The Structures of Everyday Life (New York: Harper & Row, 1981 [1979]), p. 24.

[10] Wallerstein, The Modern World-System, p. 355.

[11] Ibid.

[12] See my Follow the Money: The Money Trail Through History (Aalten: WordBridge, 2013), pp. 84ff.

[13] Alexander Del Mar, Barbara Villiers: or, a History of Monetary Crimes (New York: Cambridge Encyclopedia Co, 1899), p. 7.

Weighing the Gold Standard

Seeing as how the gold standard is a “money method”[1] by which all exchange value is made dependent upon the weight of a certain substance, viz., gold, it would seem appropriate to “weigh it up” to determine whether or not, “weighed in the balance,” it is “found wanting.”

Indeed, weight measurement was the standard of value during the period when the gold standard held sway, and that standard was gold by weight: the dollar was set at 23.22 grains of pure gold (a grain being 1/7000 of a pound), the pound sterling at 113 grains, the German mark at 6.146 grains, the French franc at 4.98 grains, etc. In this manner, all the currency systems of the countries that adhered to gold standard were bound together by gold. Gold served as the currencies of the world’s reserve currency. This is likewise the origin of the modern system of reserve currencies, but we reserve that discussion for another opportunity (I discuss reserve banking in more detail here).

The gold standard is considered to be, well, the gold standard of money methods. Its great attraction lies in the discipline it lays on governments to conduct a strict and balanced fiscal policy. It does this because it ostensibly takes monetary policy out of the hands of the state. I say “ostensibly,” because the reality is a bit more complicated than that, as we shall see. Nevertheless, the gold standard system came also to be known as the “automatic mechanism” precisely because it functioned without government interference, indeed without any interference at all, guided by a veritable invisible hand. Again, this was not entirely the reality, but not entirely a departure from reality, either.

So the gold standard took currency management away from the state. Prior to it, the state did manage the currency. And that state-run currency system had its roots far back in history.

To be precise: with the advent of coinage in ancient Lydia (western Anatolia) around 700 B.C., the state became the manager of the monetary system.[2] Prior to this there were systems of commodity money – the Old Testament, for instance, speaks of silver as currency (a shekel being a weight measure of silver), and both silver and barley were used as commodity money in ancient Mesopotamia. These were not state-run but purely market affairs. Coinage was introduced, not as a form of commodity money, but precisely to counteract commodity money, which at that time was intimately tied up with the institution of debt slavery. It was introduced to insulate the domestic economy from foreign hegemony. It thus likewise accompanied the rise of the Western concept of freedom in the Greek city-states: coinage was one of the means which enabled the Greeks to wrestle their freedom from the Eastern (Persian) hegemonic empires.

Rome carried on the Greek tradition of coinage and introduced it throughout its empire (“Shew me a penny. Whose image and superscription hath it? They answered and said, Caesar’s. And he said unto them, Render therefore unto Caesar the things which be Caesar’s, and unto God the things which be God’s” (Luke 20: 24-25).) In so doing, it established for posterity the tradition of state management of the money supply. All of the Western European kingdoms took over this Roman institution and applied it as they waxed into independent sovereign states. But this system had its drawbacks. It required precious metals, mainly silver but also, secondarily, gold, to function. And during the entire period of medieval and early modern times, these metals were in short supply. The money supplies of these countries were subject to the vagaries of that supply – mines exhausted here, mines discovered there, new techniques opening new areas up for mining, the demand for silver from the East, in particular India and China – all of these factors played a role in the relative abundance or scarcity of the raw material needed to make the circulation go.

Add to this the practice of competitive devaluations conducted between currency regions, and one can understand the preoccupation for the provision of a supply of metallic currency; a preoccupation which later ages looked upon disparagingly. They even had a name for it: “mercantilism.” But this was no idle preoccupation, for the entire economic circulation depended on the existence of a metallic coinage; nothing else enjoyed the common consent and confidence necessary for a circulating medium.

Coinage was thus a state-run affair, and when the gold standard came around to supplant it, it actually supplanted the regime of coinage entirely. Where the gold standard became established, there coinage dried up. Gold coins never enjoyed the circulation the great silver pieces did, such as the Spanish pieces of eight, which in fact formed the bulk of colonial America’s circulation. No, the system of the gold standard was based on an entirely different “money method”: that of credit and banking.

This may come as a shock to those advocating a return to the gold standard. The common image is that of a rock-solid metallic currency that cannot be manipulated. But the reality of the gold standard was that, under its regime, credit exploded. This was not a bad thing; in fact, it was the way the Industrial Revolution was financed, and without it, that revolution probably would not have materialized. Still, the gold standard engendered a massive increase in banking and credit-derived bank money.

In this system, gold did not circulate in the sense of changing hands. Rather, it was locked up in bank vaults and served as the basis for the structure of credit. It was thus the reserve that every bank needed in order to issue credit. Theoretically, for every dollar of credit the bank issued, it could back in gold. Practice was different: reserve ratios were maintained depending on the likelihood of “cash,” i.e., specie, withdrawals. A ratio of 1/3 was common, at least initially. But with the practice of reserve banking, by which banks deposited their gold holdings with other “reserve” banks, the basis shrank.

So it was under the regime of the gold standard that we obtained an ever more “elastic” money supply. This was reflected in the explosion of credit. Macleod used the following example (from England) to show how the money supply there had changed under the gold standard.[3] He used the finances of the Slater house as representative of commerce in general. For year 1856, this is how its income statement looked:

macleod1

As Macleod noted, “Gold did not enter into their operations to even so much as 2 per cent. And this may furnish a clue by which we may obtain a rough estimate of the amount of Credit.” If this is representative, then credit amounted to 50 times the amount of gold. “This Credit produces exactly the same effects, and affects Prices exactly as so much Gold: and it is through the excessive creation of this kind of Property that all Commercial Crises are brought about.” It is a warning similar to the one Walter Bagehot made in his classic work Lombard Street: the entire edifice of credit was being erected on an ever slimmer basis.

Macleod avers that this lay at the heart of the commercial crises that repeatedly afflicted the economies under the gold standard. But it was the working of the gold standard during the times when it functioned automatically, the way it was supposed to work, that engendered the misery and resentment that led to the rise of the labor movement, political agitation, and the ultimate demise of the system.

This came about because of how the system affected wages and prices, enterprise, and employment. The automatic mechanism functioned through gold flows, and gold flows determined the money supply. Where gold flowed into the economy, the money supply could expand; where it flowed out of the economy, the money supply was forced to contract.

These flows occurred not only within countries but between them, given the international character of the gold standard. When economies, including national economies, ran trade surpluses or deficits, gold flowed to the surplus country, expanding its money supply and fomenting economic activity. By the same token, gold flowed out of the deficit country, restricting the money supply and depressing economic activity. The result was deflation in wages and prices.

So the gold standard worked by allowing inflationary and deflationary swings to redress trade imbalances. This resolved the underlying imbalance, but at what price? Severe bouts of unemployment, and consumption- (and thus production-) killing deflation. Schumpeter, perhaps the most thoughtful and nuanced defender of the gold standard, argued that deflation was not necessarily a bad thing, when all prices and wages moved in sync. Theoretically this might be true, but in practice, deflation has always been traumatic.

In fact, the only benefactors under a regime of regular deflation are creditors. This dynamic gave rise to the so-called social question and the various labor movements, socialism, and communism which characterized the later 19th century’s political landscape. The political unrest behind these movements found increasing recognition in the expansion of the suffrage, which brought the labor movement into the midst of the political arena, and put the interest of the workers on a line with those of the creditors. As a result, a new political calculus came to hold sway – called “stabilization” – consisting in the pursuit of price and wage stability. From this point on, governments pursued policies that could provide this kind of stability.

What then of the gold standard’s automatic mechanism? After all, it was based on the inflation/deflation model of rebalancing, and this new political agenda worked at obvious cross purposes to such rebalancing. The answer is, it was paid lip service as an ideal but was increasingly undermined in practice, first at the edges, later at its heart.

The first concessions to the new agenda were social programs and labor legislation. While they may have alleviated the working class’s lot, they did nothing to solve the underlying problem – the trade imbalance – and in fact hindered its resolution by devoting resources to perpetuating the status quo. Old-school conservatives recognized in this the first signs of state encroachment on the private sector, and they were right.

Along with this came central bank intervention. At first this was small-scale; but after World War I, it became de rigueur. Central banks came to master the art of “open-market operations” to control interest rates and, hopefully, changes in the money supply. But what really broke things open was the policy known as sterilization. By this policy, the automatic mechanism was entirely short-circuited. Sterilization entailed the removal of gold from circulation in the real economy to keep it from affecting prices and wages. This was done in the name of stabilization, but it effectively kept the gold standard from performing its rebalancing function. The countries from which gold flowed remained in a constrained economic situation, while the countries to which gold flowed were kept from expanding. Instead, that money went into the financial market. This precipitated the great bull run on the stock market in the late 1920s which ended in the Great Crash. After this, the gold standard system fell apart: some countries continued to adhere to it, allowing it to constrain their money supplies, while other countries went off of it and saw their money supplies expand and some degree of prosperity return. In addition, this period saw the advent of massive social programs administered by government, which required some degree of government influence on monetary policy in order to gain adequate financing. This dependence by government upon monetary policy, and the popularity this enjoyed among the electorate, sealed the fate of the gold standard.

What are the lessons to be learned from this history?

  1. The gold standard in its historic form as “automatic mechanism” will never be introduced as long as the electorate is democratic, i.e., as long as universal suffrage is the rule;
  2. The gold standard is not a coinage-based but a bank- and credit-based system;
  3. If it is a hard-money, coinage-based system that people are after, then a silver rather than a gold standard would be more feasible. For centuries, silver formed the backbone of the currency system, and for good reason: it is available in sufficient quantities to form an everyday circulation. When the gold standard was introduced, it displaced coinage, which brought great hardship on common people, who suffered from the lack of a circulating medium fitted to their needs.

 


 

[1] The term is Joseph Schumpeter’s: see his Treatise on Money (here and here).

[2] For the historical background to the following discussion, see my book Follow the Money. For more on this entire discussion, one may also consult the accompanying introductory course in economics, which goes into more detail.

[3] The following is taken from Henry Dunning Macleod, The Elements of Economics (New York: D. Appleton and Co., 1881), vol. I, pp. 324-325.

Cloverfield Government

Well it’s about time I woke up from hibernation to begin posting again. Not much to say for awhile there, not to mention being preoccupied with finishing the next volume of the Stahl translation, about the state and constitutional law. I hope to have it published within a month (that’s quite optimistic though). At any rate, I did have a thought to communicate! And that is this. I finally got around to watching the movie “Cloverfield.” It’s not one of those movies my wife likes to see, so it sat around gathering dust until she went out of town for a few days, at which point I blew the dust off of the said DVD and watched it. What a grotesque movie, yet very well done, because it seemed real enough to actually have happened. But, here comes the thought I wanted to communicate: the monster in Cloverfield, while highly believable, was not quite up to the times. If he really wanted to come over as a modern-day monster, he would have gotten on the national news, have blamed all the carnage in Manhattan on the army, and stated that he really was there to fix things, to restore order, to rebuild, he being the only entity large enough to be able to do that. After all, isn’t that what our government has done? Destroyed the economy through years of either parasitic or blatantly destructive action (e.g., subprime mortgage sponsorship), and then blame the entire mess on the victims, to wit, business and the market. We have a Cloverfield government; but there are those who are filming with their camcorders for posterity’s sake. This hopefully will allow future generations to learn from our mistake, not to listen to big ugly green monsters, replete with giant teeth, in politicians’ clothing.

Anticapitalism as Default Mode

What explains the uphill battle Republicans have in convincing people that their agenda is better for the economy than that of the Democrats? What explains the ease with which Democrats can pretend that economic woes are attributable to Republicans, in the face of all evidence to the contrary?

One may blame the monolithic left-wing mainstream media for the one-sided coverage they provide on the issue, but that in fact begs the question a bit. For how is it that the media can come to be so one-sided?

The bottom line is, human beings have a basic anti-capitalist bias that is the default mode in the face of any crisis. Facts don’t matter, emotions take over, and no amount of explanation seems to penetrate. Democrats simply appeal to this emotion.

Like taking candy from a baby.

What’s Behind the Meltdown

The stock markets continue to plummet in unnerving fashion. The blame for it is centering on the “bailout” package — was it too little too late, was it too much, was the passage of it a dispiriting display of bad leadership. I think it goes deeper than that. The bailout was never meant to solve the problem, only to stave off something worse. But what it most of all did was spark the fear of ever-more government takeover of the private sector, which combined with polls indicating Democratic victory in both Congress and the Presidency in November, has spooked the investor class to get out while the getting’s good. Let’s face it: if the Democrats win in November, this bailout package is going to look like libertarianism compared to the stuff they’re going to pull to “solve the crisis.”