The Socialist Anti-Semitic Myth of the Creation of Money out of Thin Air

Iakovos Alhadeff

 One of the most widely spread socialist anti-Semitic rhetorics is the “creation of money out of thin air” story.  It is extensively used by socialists of both kinds i.e. socialists of communist and socialists of Nazi origin.  Those of communist origin talk about the “greedy” banker, and those of “Nazi” origin talk about the “greedy Jewish” banker. All the difference  is this one word, which can be added or subtracted according to personal tastes.

This anti-Semitic propaganda says that “greedy Jewish” or “greedy” bankers create electronic money out of nothing. They press their keyboard and they create money, and they use that money to indebt people and control the world. This is one of the most important and widely spread socialist anti-Semitic rhetorics, and it is very important that it is destroyed.

Before destorying it, I have to explain what socialists mean when they say create money “out of thin air”. They mean that a banker, agrees with a customer to give him a loan, and when the contract is agreed, the banker opens a deposit account in the name of the borrower. This new account is money, since the borrower can write a cheque on it. Therefore the heart of this propaganda theory is that a Jewish banker, sitting at his chair, issues a loan, hits his keyboard and opens a deposit account too,  and charges interest on the borrower.

Therefore socialists claim, that Jewish bankers create money out of nothing and indebted the people in order to control the world, since they create money and charge interest on it. I will come back with a much longer and detailed document combating socialist anti-Semitic banking rhetoric, but I want to offer a first shorter and more general explanation of why this is pure anti-Semitism. Do you know how easy it is for a government to stop this “out of thin air” money creation? All it would have to do, would be to ask private banks to back deposits by 100% of paper money i.e. euro notes. Imagine an economy, where there is 1.000 euros circulating in the economy.

If the government asks private banks to back deposits with 100% of paper money, the following will happen. Let’s assume that I am the greedy Jewish banker, and one of you holds the 1.000 euros circulating in the economy. And you come and deposit it to my bank. If the government requires that I back my deposits with 100% of paper money, I cannot create money. If I want to create money, I will have to do the following. Issue a loan to a customer, and open a deposit account to this borrower. Let’s say I issue a loan of 1.000 euros, and I open a deposit of 1.000 euros to the borrower. Now deposits in my bank are 2.000 euros, and covered only by 1.000 paper euros, which is illegal, and my bank goes down.

If on the other hand the government asks me to back my deposits with 50% of paper money, I can do the following. Issue a loan of 1.000 euros, open a deposit to the borrower of 1.000 euros, and my total deposits will be 2.000 euros, while my reserves in paper euros will be 1.000 euros, which means 1.000/2.000=50% exactly as required by the law. Therefore a banker’s ability to create what socialists call “money out of thin air”, derives from the much lower than the 100% reserve requirement imposed by governments. To stop this “out of thin air” thing, all a government would have to do, would be to require private banks to back deposits by 100% paper euro notes. But do you ever hear socialists either of Communist or of Nazi origin saying so? No, you never do. You always hear them crying that “greedy Jewish” bankers create money out of thin air.

But they are so silly, that they forget that for a person to borrow, and indebted himself, he must know what he can buy with the money he borrows. I borrow 500 euros, because I want to buy a tablet. And as soon as I get the money I buy it. And I pay an interest of 3-5% which is very low. It is not real. It is the European Central Bank that keeps interest rates artificially low. They should be at the level of 15-20%.  But that’s not the issue. Therefore if the Jewish banker creates money out of nothing, it is not the borrower who is his victim. His victim is the producer, whose products the borrowers buys with money produced from nothing, and on which they pay very low interest rates.

Therefore if the Communists and Nazis were honest, they would attack the Jewish banker because he harms the producer, whose products are bought with money produced out of thin air. But do you ever hear them saying so?  No you don’t. They always present the borrower as the victim. The reason is that all socialists care about is controlling the banking system. And producers are the depositors/savers. And deposits are a liability for the banks. Therefore socialists always see positively a haircut in deposits because it makes banks healthier. But loans i.e. mortgages etc, are the banks’ assets. And if you allow the houses of the borrowers who do not pay their mortgages to be sold, their prices will go down. And if their prices go down, the banks’ assets will worth less and will be easier for foreign investors to buy them.

The truth is that producers’ goods were bought with money produced out of thin air by governments and not by Jews. But someone must be blamed. Moreover socialists like fractional reserve banking, because they want private banks to expand money supply swiftly, because they use the money supply to finance government spending, and as a means of stimulating the economy, as I was explaining in my essay “The Socialist Myth of the Greedy Banker”, which can be downloaded for free in pdf, mobi, or epub format from Smashwords, at the following address

Reading my essay “The Socialist Myth of Economic Bubbles” will also help one debunk socialist anti-Semitic propaganda. This essay can be downloaded for free from Smashwords at the following address

Or you can download for free my essays from Apple’s ibook store at the following address

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If you enjoyed this essay you might want to have a look at some of the following essays too:

The Socialist Myth of the Greedy Banker

The Socialist Myth of Economic Monopoly

The Socialist Myth of Economic Bubbles



The Socialist Myth of Economic Bubbles

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Iakovos Alhadeff


In my essay “The Causes of the Economic Crisis for non Economists”, I explained why the American crisis was caused by government intervention and not by the free market. Since the housing bubble was one of the main elements of this crisis, I discussed on the issue of the American housing bubble too. In this essay I want to examine asset bubbles on their own, and not as part of the American crisis or any other crisis. I will use various examples, but the emphasis will be on asset bubbles themselves and not on a particular crisis.  More specifically the emphasis will be on the forces that lead to their formation and collapse. I will focus on housing bubbles, since they are very common, and also a kind of bubble we have all gathered a lot of experience about.

I want to begin with a bubble in a simple barter economy, which will actually say almost everything that can be said about bubbles, because I believe asset bubbles are a much simpler phenomenon than they seem to be. The aim of this essay is to explain why bubbles are always the result of government policies and not of the free market. I believe it is better to read my essay “The Socialist Myth of the Greedy Banker” before reading this one. Because most people think that it is private banks that create money and crises, and in the aforementioned essay I explain why this is not so, which is the first step to understand bubbles. But the two essays are independent documents.

A Bubble in a Simple Barter Economy

Assume an economy with two individuals and many goods. The good used as money in the economy is oranges. And I happen to produce oranges. Everyday I produce 10 oranges and I consume 5 of them. I put the 5 oranges that I save in a box called “bank”. This box keeps track of the number of oranges I place in it everyday, and issues a receipt. This box is a mechanism that finds someone to lend my oranges and who is willing to pay a higher interest rate than the one the “bank” has to pay me. I do not know how my savings/oranges will be used. I simply have a deposit account which keeps track of the oranges I put in the box/bank.

Let’s assume that this mechanism/box/bank agrees with the other individual in the economy to lend him my oranges. The other person somehow decides that the most profitable way to use my oranges is to convert them to houses i.e. eat them in order to sustain himself and build houses. I assume for simplicity that he is using whatever materials he finds around to build the houses i.e. he does not have to buy and sell construction materials.

At some point the houses are ready. So I have deposited let’s say 1.000 oranges in the box/bank, the builder has eaten the oranges, and has built the houses. But now he has to repay his loan i.e. the 1.000 oranges. But in order to do so he needs to sell some of the houses. If I am willing to buy a part of the houses for 1.000 oranges, I will transfer him the credits in my deposit account, and everything will be fine. There is an intermediary of course i.e. the box/bank, but it is the two of us who are the important players. If I agree to buy at the price he is selling, and which is the price that covers for my oranges, everything is fine. Therefore if I want a house and I am willing to pay approximately 1.000 oranges for it, I will write a check transferring him the credits I have in my deposit account, he will put these newly earned credits in the box/bank to clear his debt, he will also make  a profit, and everything will be fine. Case closed.

If however I find the price he is asking i.e. something around 1.000 oranges very expensive, I will not buy the house. But this is a big problem, because the only way this man can find money to pay his debt is by selling houses to people with the purchasing power to buy houses i.e. people with the bank accounts i.e. people with the savings i.e. people whose savings (past surpluses) he used to built the houses i.e. only me in this case. If I do not want to buy the house at this price, it means I prefer something else i.e. a car. But my savings were used to produce a house and therefore there is no car. I therefore go to the bank to take my oranges back.

But my oranges are not there since the house builder ate them in order to produce the house. I am very upset and I ask for my oranges. The bank says that it does not have the oranges, but it can confiscate the houses of the person to whom my money was lent. But I have already seen this house as a consumer, and I did not want this house for 1.000 oranges. I would buy it maybe for 500 oranges. Therefore the bank confiscates it and gives it to me. But I am not happy. I want my other 500 oranges. The bank does not have these oranges, and it goes bankrupt. If there was a government it would either let me lose my savings/deposits of 500 “oranges”, or as it usually happens, it would ask the tax payer to pay for my deposits/ “oranges”.

So what really happened in this little story? What happened is that somehow my savings were used for something that I did not value as much as my 1.000 oranges, and which I would therefore not exchange for my savings/ “oranges”. This asset (the house in my example) is a bubble, since it cannot be sold for an amount which will cover its costs (1.000 oranges) i.e. the savings that were used for it. If you think about millions or even billions of savers you are talking about a huge bubble. That’s exactly the housing bubble today. Some people’s savings were used for housing or for other purposes, but these other purposes and housing were not what these savers wanted. They would not be willing to exchange their savings with what has been produced with their savings. Therefore, a bubble is a situation where savings have been used in the wrong way but in a massive scale. You might hear many definitions for bubbles, which might sound smarter, prettier, more sophisticated etc, but I believe this one is more accurate even though it sounds somewhat simplistic. And you should not think that only houses are involved in bubbles. As I already said, there are many other ways that savings can be used in the wrong way i.e. to produce something that savers do not value as much as their savings.


Therefore the magic word in order to understand bubbles is savings. And the magic question that needs to be answered in order to understand bubbles is why savings were inappropriately invested in the bubble market?  If we were to ask people what a housing bubble is, most of them would probably give the simplistic answer “too many houses were built and their prices collapsed”. Even though this statement has an element of truth, it is very simplistic and it does not help one understand what asset bubbles are. What is of great importance to realize, is that if the prices of houses were to decrease significantly, there would be a price level at which they would all be sold. If we all sell our property for 1 euro for example, everybody will rush to buy. Therefore if we want to be more accurate, the problem is not that too many houses exist. The problem is that market prices are so low that they cannot cover for their costs i.e. the loans provided by the banks i.e. the “oranges” that were deposited at the banks.

For instance I owe the bank 300.000 euros, and I have stopped paying my loan, and the bank cannot sell the house to someone else for let’s say more than 150.000 euros. This is exactly the same situation with the situation in my simple barter economy. At a price of 150.000 euros the bank will make a loss of 150.000 euros. If this was a single case it would not matter at all. The problem is that when bubbles arise this is a very common phenomenon. Therefore the banks make huge losses, and if the banks make huge losses the first thing that happens is that shareholders lose their equity and the bank shares go to the state, the second thing that happens is that banks’ creditors lose their money, and finally either depositors will have to lose their savings/deposits/ “oranges”, or the tax payer will have to pay for their deposits/savings/ “oranges” not to be lost. Depositors whose savings the banks cannot pay back are the equivalent of the orange producer in my example. What is of great importance is the issue of miscalculation of profits and misallocation of savings/ “oranges”. And the very important question that needs to be answered is “why so many people were the victims of this miscalculation of profits i.e. why they expected they would make profits from the houses at very high selling prices, and why savings were massively directed to the development of the wrong products? 

This is therefore the question that must puzzle us i.e. why there was this misallocation of resources, why so much of peoples’ savings were inappropriately invested in the bubble asset and not in something else more valued by savers. Man has unlimited wants, and therefore it can’t be that there was some idle capital and somebody said “hey guys lets build some housing with this extra capital”. Some countries with housing bubbles cannot even satisfy their primary needs i.e. meat, grains etc, and once the bubbles burst they face severe political turmoil or even the danger of  hunger, or even of civil war, if not supported by other countries i.e. Greece. And yet they excessively invested in houses that now nobody wants at prices that would cover their costs i.e. the mortgages. Therefore resources and savings that were used in housing in such countries should have been used in something else or even somewhere else i.e. in other countries. It is therefore very important to realize that the savings that are used in bubbles are not abundant savings,but rather misallocated savings. Once we realize that, we need to proceed and examine what leads home owners and house constructors all together to be so wrong at the same time.

Because many people think that the problem is that homeowners can’t pay their mortgages. That is indeed a problem, but it is not the main problem, because the houses these people are living in were not built with their own money (savings). They were built with depositors’ money/ “oranges”. The problem is that the people that are living in the houses cannot pay their mortgages, and people with whose savings/deposits/ “oranges” these houses were built, do not want to exchange their deposits/savings with these houses. If the real owners of these houses i.e. the people whose savings were used in order for these houses to be built i.e. the people with the deposit accounts, wanted the houses for prices that would cover their costs (mortgages), everything would be fine. The houses would be confiscated from the people that do not pay their mortgages and given to the people who really own them i.e. depositors. But as I already said depositors do not want to buy these houses at current prices i.e. they do not want to exchange their deposits/ “oranges” with these houses. They value more other products i.e. cars, oranges, televisions, computers, holidays etc.

As I will explain, behind every bubble there are one or more governments that mess with the way savings are allocated. By doing so, governments do not allow the market to allocate scarce resources according to economic fundamentals, and there is a misallocation of resources, and at some point the misallocation is so great that readjustment is unavoidable. There are endless policies by which governments affect the way savings are allocated. Different policies are used for different purposes by different governments in different countries. I cannot describe all of them. I will provide some examples, and I hope it will be quite easy to imagine many other paths by which governments try to affect the way savings are allocated focusing on their policy objectives and ignoring economic fundamentals.

Taxation, Debt and Inflation as Means of Financing Government Deficits 

Before I proceed, I want to mention that there are three ways by which governments can finance their spending, namely taxation, borrowing, and money creation (inflation). The first and second ones are quite straight forward. A government can tax its citizens or it can borrow domestically or internationally. The third one is somewhat less obvious but it is a very simple idea. A government can create new paper money through its central bank, either in electronic or paper form, and use it “buy” domestic or foreign citizens’ wealth. This is obviously a form of taxation, since the country’s wealth did not increase because new money was created. With newly created money, there is more money running after the same amount of wealth (goods), thus causing inflation.

In my essays “Central Banks for non Economists Part I: Inflation and Taxation”, and “The Socialist Myth of the Greedy Banker”, I describe in great detail how governments use their monetary policy to tax their citizens. However I will say a few words here too in order for this document to be autonomous. From these three ways of financing government spending, the most dangerous one is the creation of money, and the safest one is taxation. Taxation is observed both by the beneficiary and the payee, and therefore it does not create any illusions since both the payee and the beneficiary are fully aware that they are receiving and paying money. However this is not the case with money printing. In this case the payee incurs an obligation which is not obvious. Money creation is an indirect tax in the form of inflation. For instance let’s assume that there are 10 oranges in the economy and 10 euros, and each orange costs 1 euro.

If the government prints another 10 euros, there will be 20 euros running after the same oranges, and their price should increase to 2 euros each (this is an oversimplification of course). The government can now buy 5 of the oranges with the 10 newly printed euros (10/2 = 5 oranges), which means its citizens paid a real tax of 5 oranges. However they were not aware that they were paying a tax. They thought that their money lost its purchasing power because of inflation, and they think inflation is an exogenous phenomenon. It is exactly this difficulty on the part of the tax payer to understand the relation between money creation and taxation that makes financing government spending through money creation (inflation) so popular with politicians. I can now continue in demonstrating various ways that government policies can create bubbles. As I already mentioned, my examples will not be exhaustive, and they are meant to present only some of the possible ways that government intervention creates asset bubbles.

A Primitive Example of Government Induced Bubbles

I now want to use a second example of government intervention and bubble creation. Imagine a closed economy with no foreign trade and no paper (fiat) money. Let’s assume there are only two kinds of professions, the orange producers and the house builders. Oranges do not perish. People eat oranges to survive and build houses to protect themselves from the cold and rain, and when they can afford it they improve these houses to make them more comfortable. Therefore oranges cover a more basic need, and housing a more luxurious one.

For simplification imagine that house building is a pure service. House builders do not buy or sell materials. They only use their skills to build houses with whatever materials they find around. In the real world each person has his own personal preferences towards consumption (eating oranges), savings (saving oranges) and housing (giving oranges to house builders) etc, but in order to build an example, I will assume that all people have identical preferences, and want to consume 50% of their income (eat 50% of the oranges they have), save 30% of them (save 30% of the oranges they have), and invest 20% in housing (giving oranges to someone to build them a house, or eating oranges themselves while building a house themselves).

Thus the economy’s appetite for consumption, savings and housing is 50-30-20, it is constant, and identical for everyone. To invest in housing for the orange producers means to give oranges to a house builder, in order for the latter to build a house for them. To invest in housing for the house builders means to eat oranges previously earned for building houses for themselves. And let’s also assume for simplicity that productivity is constant, which means that to build more houses you must produce less oranges, and to produce more oranges you must produce less houses. In other words I assume for simplicity that there are no positive productivity shocks.

Please note that savings are not equally spread in the population. I assumed for simplicity that all people have equal tastes regarding consumption, savings, and housing (50-30-20), but that does not mean that they are all equally good in production. I did not assume wealth is evenly distributed in the economy. There are rich and poor. The oranges that were saved are not evenly spread. Some people produced more than others, and therefore the 30% of their savings amounts to a larger number of oranges in absolute terms.

Let’s assume that we are at time 0, and the government sets up a central bank, where people deposit their oranges (savings).  In the first year the economy produced 100.000 oranges. Therefore at the end of the year the citizens have consumed 50.000 of them, have deposited at the central bank 30.000 oranges, and have invested in housing 20.000 oranges. Let’s assume that next year they produce another 100.000 oranges. However the government needs some oranges to finance some expenditure. Let’s assume it wants to help some of the poorest citizens. Or it wants to construct a road. But because it does not want to tax its citizens, it takes their savings of 30.000 oranges and distributes it to the poor or use it for the road. And it replaces the oranges in the vault with pieces of paper that say how many oranges each citizen had, in order to pay them back at later more affluent times. Therefore there are now 130.000 oranges circulating in the economy during this second year. The 100.000 oranges produced, plus the 30.000 that were saved last year and which were thrown back in the economy by the government.

But the citizens’ tastes have not changed. Therefore they consume 50% i.e. 65.000 of the 130.000 oranges, save 30% of them i.e. 39.000 (130K * 30%) of them, and invest in housing 20% of them i.e. 26.000 (130K*20%) of them. Notice that total savings are 39.000 (0 left from last year plus the 39.000 oranges of this year), but citizens think they have saved 69.000 oranges, because they have not realized that the government has used their savings. Moreover notice that this year citizens invested in housing 26.000 oranges, while their true wish would have been to invest 20.000 oranges (i.e. 20% of the real production). But they were fooled by the 30.000 oranges that were thrown at them by the government, and which they perceived as new wealth, while in reality it was their last year’s savings. That means that the economic agents’ behavior was altered not by real factors but because of the government’s policies, and this led to higher consumption, higher investment in housing, and lower savings, all these contrary to the citizens’ wishes and without their knowledge.

In reality, the artificial increase in housing activity could have only been generated by a movement of workers from orange production to housing construction. Remember I assumed for simplicity constant productivity. If the government continues to throw savings in the economy, the increased investment in housing and the increased consumption will continue, which means that more and more workers will move from orange production to housing construction. As this process continues, orange production will keep falling, savings will keep falling, and housing construction and spending (orange eating) will keep rising. But as this process continues the government will find it increasingly hard to provide the same quality of social services, since orange production which satisfies the more basic needs is falling.

This situation is not sustainable. To build houses you need orange production to sustain the workers in the housing industry. At some point everybody will realize that there is not enough orange production to fund the house construction industry i.e. the economy does not produce enough oranges to feed so many workers in the housing industry, which means that some house builders will have to move from house construction to orange production. Citizens will realize that the prospects of the economy are not good, and will be panicked. They might rush to take their savings from the central bank. But to their surprise there will be no savings or there will be only a part of it. Everybody will try to sell their houses in order to get more oranges.

But because they are all trying to sell their houses and buy oranges, the prices of houses collapse. Actually the price of houses relative to the price of oranges must fall, since it became apparent that the economy has too many houses and too few oranges. But the panic makes things even worse. And citizens find it very difficult to find someone to pay them a descent amount of oranges for their houses. The reason that this happened is that an imbalance was created in the economy. Due to government intervention, the economy produced more housing and less oranges than the citizens wanted and could afford. This can now be only corrected by a painful depression. A reverse process must begin for the economy to go back to equilibrium, where workers must move from the housing business to orange production.

Unfortunately this cannot be done immediately because orange production requires a different set of skills than housing construction. Moreover people find it very painful to change professions and industries since they must start from scratch i.e. in a field they have not at all expertise, which means a decrease in their standards of living. Most of the citizens however, believe it was the free market that led to the misallocation of resources. They do not realize that it was the government’s mistake. And they are not helped by the media to realize it, since in every country the political system is always very well represented in the media. There will be growing political tension.

House builders will be losing their jobs and will be asking for more government protection, and house builders and orange producers will be asking the government to give them back the oranges they deposited. There can be riots or even a civil war between orange producers and house builders. Politicians will not accept responsibility and will try to persuade the public that the damage was caused by someone else i.e. capitalism, private banks, the Jews etc.

Introducing Paper Money 

The above example might not seem very realistic, but unfortunately it is not far from reality. Actually in reality it is much easier for governments to steal peoples’ savings/ “oranges”, because the good which is used as money (and as a store of value) is not a real good (i.e. oranges, gold etc), but paper money instead. Paper money is not a real good and it derives its value by a government law which establishes it as the legal means of payment. Therefore in monetary economies people do not save in real goods but in paper made by governments. In the example with the oranges, there was always the possibility that citizens’ would lose their confidence and ask to see their oranges, but there would be no oranges since the government cannot create oranges. This is a constraint for governments since it imposes a limit on the money creation process. However with paper money, the government can create as much paper money as it wants and can therefore confiscates its citizens’ savings without them noticing.

And even if they notice it, the government can always produce more paper to pay them back. Therefore even though my previous example seemed a bit simplistic, in reality it is even easier for governments to steal their citizens’ savings. But citizens are not aware that this is happening, they feel wealthier when the government is throwing paper money at them, and they do not change their consumption/savings patterns to account for the reduction in their real savings, which is a reduction in their real wealth, and they might even feel wealthier due to the expansionary government policies and increase spending, housing purchases etc.

Interest Rates, Real Savings and Paper Savings 

In previous sections I explained how governments can distort the market mechanism by irresponsible fiscal and monetary policies. But I omitted the main distortion caused by such policies, namely the effect such policies have on interest rates. The interest rate is the price investors have to pay if they want to borrow savings. If for instance the interest rate is 100%, it means that to borrow 1 orange of savings today, an investor has to pay 2 oranges in a year’s time i.e. a whole extra orange is the price for borrowing one orange of savings today (that is with an interest rate of 100%). The level of interest rates i.e. whether you pay 2%, 10% or 20% when you borrow savings, depends on the quantity of savings in the economy. The higher the quantity of savings the lower their price (interest rate), and the lower the quantity of savings the higher their price (interest rate).

Imagine an economy with 1.000 people who produce 1 orange each (1.000 oranges in total). And assume that everyday they need 1 orange each to survive. With less than that they die. For the economy to grow, there must be some people that do not work in orange production, but they spent their time constructing machines that will enhance orange production i.e. tractors, or building houses to improve the standards of living etc. People that will undertake such projects need to borrow savings i.e. oranges, to sustain themselves during the investment period, and pay for the savings they borrow when their investments bear fruits, which by the way is not certain (investments can go sour too).

But it is impossible to borrow in such an economy since each individual produces 1 orange and needs 1 orange to survive. Therefore if I wanted to borrow some oranges everyday in order to invest in something, it would be impossible. What would the interest rate in this economy be i.e. what would the price (interest rate) an investor would have to pay in order to borrow oranges? It would tend to infinity, because if a person wanted to save his orange and lend it to an investor, that person would die from famine, since I assumed each person needed at least 1 orange per day to survive. If the 1.000 people of the example did not only produce 1.000 oranges every day, but a bit more, interest rates would not tend to infinity, but they would be extremely high, because in a poor agricultural economy savings are very valuable, and people are very reluctant in using their savings to fund more sophisticated or luxurious projects. They worry about satisfying their most basic needs.

Very high interest rates are a signal to investors that there are not enough savings in the economy i.e. oranges are very scarce and valuable to citizens. They are therefore very reluctant to invest in luxuries i.e. better houses. They feel the pressure to invest in something that will deliver oranges quite fast i.e. in the next period. Because even when you invest in something that ultimately delivers oranges and not something more luxurious (houses), you have to decide on the time horizon of the investment. If oranges are scarce and interest rates for borrowing them are very high, an investor would go for the development of a simple tool i.e. shovels which would increase orange production soon. If on the other hand there is an abundance of oranges (savings) and the price (interest rate) of borrowing savings is very low, investors would go for a more ambitious and of longer term projects i.e. to develop tractors.

We therefore see that the interest rate is the price of borrowing savings (oranges), and the price of borrowing savings is one of the most important factors that businessmen take into account in order to decide whether a project is profitable or not. The lower the interest rates the more projects are profitable. A project that is profitable with an interest rate of 2% might be unprofitable with an interest rate of 10%. What I am trying to say is that interest rates play a major role in what will be produced with an economy’s savings i.e. oranges or houses, but they also play a major role on the time horizon of investments i.e. whether shovels or tractors will be produced. Prices are extremely important in free market economies, but if one had to decide which price is of the greatest importance, it would probably have to be the price of borrowing savings i.e. the interest rate. If the price of bread is for some reason distorted by government policies i.e. because of subsidies or tariffs it is of minor importance compared to distortions in the level of interest rates which have a much wider effect on the economy, since they play a major role in the process of savings allocation.

Interest rate is the free market mechanism that ensures savings will be directed towards the uses most preferred by the owners of these savings i.e. the people who had surpluses in previous years i.e. people with deposit accounts. To distort the interest rate mechanism, is to distort the ability of the economy to transform savings into something that depositors would exchange for their savings. It is mainly this distortion in interest rates caused by irresponsible fiscal and monetary policies that causes the creation of economic bubbles.

With the system of fiat (paper) money, governments can not only confiscate the economy’s savings without the owners of the savings (depositors) noticing as I explained before, but they can also artificially decrease interest rates (the price of borrowing savings), in order to make borrowing cheaper, thus boosting economic activity as I will now explain. Politicians always like low interest rate because they boost economic activity, and increased economic activity makes politicians popular. Imagine an economy where the medium of payments and the store of value are golden coins. In this economy, if I save an orange, I exchange it for let’s say a golden coin, and I keep my savings in gold. Gold is a scarce and real good like all other goods. It takes a lot of effort to produce gold. Sometimes more gold will be produced sometimes less, and accordingly its price relative to the prices of all other goods will fluctuate, in the same way that the price of apples will fluctuate relative to the prices of all other goods according to supply and demand. If for example there is enough gold, and what the economy needs is oranges, the price of gold will start falling relative to the price of oranges, which means people will start moving from the production of gold to the production of oranges.

Therefore when savings are kept in the form of a real good i.e. gold etc, the government cannot affect the price (interest rate) one has to pay for borrowing these savings, since the government cannot influence (increase or decrease) the quantity of savings (gold). And if the government cannot affect the quantity of savings (gold, oranges etc), it cannot affect their price either (the interest rate one has to pay to borrow these savings). But with fiat money, savings are kept in paper (fiat money) or electronic form (deposits), and the government can create as much of it as it wants. Therefore through its central bank it can increase the supply of paper and electronic savings until the price of borrowing savings i.e. the interest rate of borrowing paper savings, increases or decreases to the level that satisfies the government’s objectives. And that’s exactly what governments do. They print paper savings to buy (confiscate) a part of the real savings, and they ask banks to expand electronic savings (credit), in order to decrease interest rates and boost economic activity too. 

These actions have the following simple implications. Let’s say I have savings of 10 oranges. A part of it, let’s say 5 oranges, is confiscated by the government i.e. the government prints paper money and buys these 5 oranges directly and does whatever it wants with it. I am under the impression that I sold the 5 oranges while in reality they were confiscated. Investors can borrow what is left from my savings i.e. the other 5 oranges in order to invest them in something useful and profitable. However most of the time they pay a much lower price (interest rate) to borrow my real savings than the one dictated by economic fundaments, because governments perform a credit expansion through their central banks (an increase in paper and electronic savings), in order to lower interest rates and boost economic activity.

Therefore an investor goes to the bank, he takes a loan in paper or electronic form, and comes and buys these oranges from me, and I in turn take this paper money and deposit it to the bank, and earn an interest rate on my paper savings. The interest rates that the investor pays and I earn, are much lower than the interest rates he would pay and I would earn if the government had not ordered a credit expansion i.e. an increase in paper and electronic savings.

Therefore not only I lose the 5 oranges that were confiscated by the government with the newly create money, something I did not realize and therefore I feel wealthier than I really am (and I therefore spend more and save less), not only my savings are lent at interest rates that are much lower than the ones dictated by market fundamentals, but also the entrepreneurs that borrow the other 5 oranges which were left, receive the wrong signals from the very low interest rates that they have to pay. They are fooled to believe that there is an abundance of savings in the economy. Many projects seem to be profitable only because of the low interest rates one has to pay to borrow paper savings. But this is an illusion because lower interest rates are the result of the increase in paper and electronic savings, and not the result of an increase in real savings (“oranges”). That’s the problem with credit expansions. Credit expansions do not create more real savings they only lower the interest rate one has to pay for borrowing real savings.

Moreover with government induced credit expansions, consumers can borrow at very cheap rates too, and they might thing that it is a good idea to borrow in order to buy a house, a car, a holiday, or to invest in the stock market etc. I might decide to borrow to buy a house with an interest rate of 5% but maybe I would have decided differently if the interest rate was 15%. The point is that increases in paper and electronic savings are fake expansions of savings, but they have very real effects on the behavior of economic agents, and this smells like a bubble. At the end of this process, savers end up in a situation like the one described in my first example, where the person who saved the 1.000 oranges only had the option to exchange his savings with a house he did not value as much as his savings. Unfortunately a part of his savings was confiscated by the government without him realizing, and the other part was lent at artificially low interest rates and as a result it was malinvested.

He is therefore very upset, and the government instead of explaining him what really happened, it tells him that it guarantees his paper savings. But what it does not tell him is that his real savings i.e. the “oranges” are gone. Some of them were confiscated by the government (the ones confiscated with money creation) and some were misallocated by the private sector due to the artificially low interest rates that followed the aggressive monetary policy and the credit expansion. He is therefore left with paper savings and inflation or hyperinflation. The government by assuming responsibility of the savings (guaranteeing the savings), is essentially asking the tax payer to pay for these savings, which is called a “bail out”. The other option is to let depositors to lose their money, which is called a “bail in”.

Is It Moral for a Government to Use the Economy’s Savings? 

Before I continue with government distortions, I would like to clarify something. The aim of this essay is not to discuss how moral it is or it is not for a government to use its citizens’ savings. This is a very different issue, namely whether socialism is better than capitalism and whether equality is better than freedom. The aim of this essay is not to defend capitalism and freedom over socialism and equality. The aim of the essay is to demonstrate that it is government intervention that creates asset bubbles.

All the above distortions could have been avoided, if only the government had used taxation instead of monetary policy to finance its spending. Taxation does not create the illusion of wealth. People that pay for the social network through taxation are fully aware that they are paying, and they are not under the illusion that they are saving as the citizens of my examples were. Taxation does of course increase interest rates, because when a government is using a part of the economy’s savings, the quantity of savings that is left for the private sector is reduced, and therefore its price (interest rate) rises. But if the supplies of real savings fall interest rates must rise, so that investors receive the right signals and react accordingly, in order not to misallocate them (do not built houses instead of tractors).

Therefore the question is not whether the socialist principle of redistribution is correct or not. The issue is that socialist and interventionist governments should mainly use taxation as a form of financing their expenditures, in order to keep economic agents informed about the real wealth they possess. The problem is that the more socialist and the more interventionist a government is, the more it needs monetary policy as a means of taxation, since heavy taxes are never popular. On the contrary, the less socialist and the less interventionist a government is, the less it needs monetary policy, since some reasonable taxes are welcomed by everyone, and these reasonable taxes suffice to finance the activities of a market friendly government. And this is the reason that free market proponents are always in favor of passing laws that require balanced government budgets (no deficits). With balanced budgets (government expenditures equal government revenues i.e. taxes), and a government can only finance its policies through taxation, and therefore socialists and statists cannot fool voters by using monetary policy as a source of redistribution.

Trade Deficits 

In the previous examples I discussed misallocation of savings due to irresponsible fiscal and monetary policies within the same country i.e. for countries with production surpluses. However this is the good scenario. At the end of this process, banks owe money (savings) to depositors (whose savings were used), and these savings are not available. The good thing is that people with savings/deposit accounts are domestic citizens. They do not want to exchange their savings with these houses, but at least they are local citizens. After all, the government can say to local depositors “gentlemen, unfortunately your savings are gone, and now whether you like it or not you will take the houses held as collateral by banks in exchange for your savings/deposits”. That’s basically the outcome whether the government chooses a bail out or a bail in solution i.e. whether depositors’ money is guaranteed by the government and the taxpayer, or whether depositors lose their money. But since depositors are also tax payers and tax payers are also depositors, these solutions are not as clear cut as they seem to be. I personally think that bail ins are a bit more fair than bail outs, but this is open to discussion.

However things are more complicated when it is foreigners’ savings that have been used to finance the bubble. For instance the American and the Greek housing bubbles were financed with Chinese, German and other exporting countries savings. It is even worse when the misallocation of savings is not of domestic but of international nature. How can the Greeks say to Germans, Chinese etc that they will have to take the Greek stock of houses held as collateral by the Greek banks, in exchange for the loans they made to Greece, which were the savings of the German and the Chinese people? This situation does not only create political turmoil domestically, but it also creates international tensions and potential conflicts in the international arena.

USA and China 

A classic example of a housing bubble that involved international misallocation of savings i.e. misallocation of foreign savings, was the American one. The American bubble was funded through a flood of imports flowing from China to U.S.A. (from elsewhere too, but the main trading partner of U.S.A. was China). On one side there was a country hungry for imports i.e. U.S.A., and on the other side there was a country hungry for exports i.e. China. Huge production surpluses were flowing from China to cover huge production deficits in U.S.A., and huge numbers of securities (i.e. government and corporate bonds/debts) were flowing from U.S.A. to China to cover for the deficits in trade. For instance China was sending to U.S. a 50$ television and the U.S.A. was sending an American bond (debt) of 50$ to China (in a massive scale though).

It was therefore very easy for American people to obtain “oranges” from China. It was so easy that nobody had to worry about “oranges” anymore. Everybody worried about improving their standards of living i.e. buying nice houses, nice cars etc. Until one day the Chinese realized that it was not such a clever idea to send their “oranges” to the USA for the Americans to build nice houses and military aircrafts, since these nice houses and military aircrafts would not produce “oranges” to pay them back. Moreover the Americans realized that their “orange” production had decreased dramatically, and they had become very dependent and indebted to the Chinese.

Moreover the Chinese did not want to exchange their savings/oranges (which were lent to the U.S.A.) with the houses, the cars etc that were made with these savings/ “oranges” in the U.S.A. Maybe they would be willing to exchange a part of it with the military aircrafts that were made with these “oranges”, but of course the Americans would not agree. At some point, the Americans who were living in these houses, and were driving the nice cars stopped paying their mortgages and loans, and since the people (Chinese) whose savings had been used to produce these houses and cars did not want to take them in return for their savings, the prices of houses and cars etc collapsed, and the banks who were the intermediaries went bust.

One might say that the above situation is a free market flaw, but it is not. As I explain in my essay “Free Trade or Protectionism? The Case for Free Trade”, under a regime of free international trade it is impossible for significant trade imbalances to arise. However things are very different when international trade is conducted under heavy government intervention, which was the case in the American-Chinese trade relations. In the same way that it takes two to tango, it takes two to generate a great trade imbalance. Let’s assume that only the American government was willing to borrow excessively while the Chinese government was not willing to lend excessively. The U.S.A. would start importing excessively Chinese goods, but if the Chinese government was not interested to systematically fund American deficits, it would not intervene in foreign markets, and there would therefore be less demand for dollars and greater demand for yuans.

The higher demand for yuans would make the yuan more expensive vis a vis the dollar, making American goods more attractive for the Chinese, and Chinese goods less attractive for the Americans. In addition, the flood of the Chinese imports in the American markets would cause an increase in unemployment in the U.S.A. This would put downward pressure on American wages, making American goods cheaper and more attractive to foreigners. All the above would reverse the flow of imports. In a nutshell, when I trade with my neighbor, even if he is better in everything, if he does not want anything I produce, there will not be a trade deficit, because he will not desire any of my products, and if he does not desire any of my products he will not be willing to offer me any of his products either. But things are very different when you have an American government hungry for imports, and a Chinese government hungry for exports.

The Chinese government did want to fund American deficits, and the American government did want to run these deficits. The Chinese would therefore print new yuans, and use them to buy American bonds (from both the public and private sector), essentially giving American people yuans to buy Chinese goods, and thus creating artificially a high demand for the dollar. The Americans would use these yuans to import Chinese goods. Therefore even though Americans were asking huge quantities of yuans to import Chinese goods, the price of the yuan would not rise relative to the price of the dollar, because the Chinese government was offsetting the downward pressure on the price of the dollar by asking for dollars i.e. by buying dollars i.e. by buying American securities i.e. mainly American government bonds i.e. by lending to Americans in order for the latter to keep running deficits and keep buying Chinese goods. Thus the yuan would remain artificially cheaper and the Chinese competitiveness would not decrease, as would have happened under a free trade regime.

Moreover you have to keep in mind that China is under a Communist dictatorship, and therefore wages are set by the communist government and not by the market. Therefore wages would not rise as a result of the increasing demand for Chinese products as would have happened under a free market regime, since the Chinese government would not allow this to happen, and therefore the competitiveness of the Chinese economy was again kept artificially high.

But as I already said it takes two to tango. At the same time the Americans allowed an unprecedented credit expansion to take place at home. The huge credit expansion led to very low interest rates. Therefore economic activity did not decrease because Americans could borrow at very low interest rates and buy Chinese savings/“oranges”, and they could do whatever they wanted with these “oranges” i.e. eat them, build houses, invest in tractors etc. Unfortunately this is a recipe for bubbles. The bubble did not have to manifest itself in housing. It could have appeared somewhere else. But both Democratic and Republican governments were very active in channeling funds to the housing industry. If they had channeled them somewhere else, the bubble could have appeared somewhere else. Actually housing was not the only American bubble but that’s not the issue here. The above hunger of the U.S. to increase their standards of living and finance their wars, and the hunger of China to keep its economy rising by boosting competitiveness and exports, led to the American bubbles. However this crisis would have not happened if the U.S. and the Chinese governments had not undermined the free market forces.

But they did undermine the free market, and they ended up in a situation where Chinese savings were used to fund the American housing bubble and other American expenditures, and the Chinese are not happy about it, since the Americans are now paying them back by printing “soft” fresh dollars, doing what is called “debt monetazation”. Monetazing your debt is good since you do not pay your debt, but it creates tensions with the creditor countries, and moreover it involves the risk of destroying your currency through excessive use of the printing press i.e. high inflations or even hyperinflations at the end of the process. Therefore the American bubbles involved the misallocation of mainly Chinese savings into American houses, cars, military aircrafts etc.

The Eurozone Crisis

 With the introduction of the euro, the socialist Southern European countries had access to very cheap credit, since people thought that the euro would be a copy of the Deutsche Mark, and moreover that the northern countries would guarantee the debts of the southern countries. I have to say that the socialist South believes much more than the European North in using monetary policy aggressively for redistribution purposes. You have to remember that in monetary economies people do not save in real goods i.e. oranges, gold etc. If I have a surplus of an apple, I sell it for let’s say 1 drachma (the Greek currency), and I store my surplus/savings of 1 apple in drachmas.

Therefore the socialists can print more drachmas and confiscate part or all of my savings without me realizing at least for a while, what happened to my savings. The Southern European countries i.e. France, Spain, Italy, Greece, are socialist in the more traditional sense i.e. the do not only believe in redistribution, but also in heavy interventionism, and monetary policy is always the best tool for interventionism. On the other hand, the Northern countries had a lot more respect for their citizens’ savings, and would not fool them by taxing them indirectly through money creation. They were doing it too of course, but to a much lesser extent compared to the South. And you should not think that the Southerners are more sensitive when it comes to social issues. If you look at the following Eurostat link, you will see that spending for education (green color), health (light green color) etc are not lower in the Northern countries compared to the socialist south. The only difference is that the politicians of the Northern countries are more honest than the ones of the South.,_2011_(1)_(%25_of_GDP).png&filetimestamp=20130429100920

Therefore the Northerners were much more restrained in their monetary policies compared to the Southern countries, with Bundesbank being the best example of an independent central bank, which was beyond the political system’s control, and could not be used during elections etc. As a result people all around the world preferred to put their savings in the currencies of the Northern countries, since they knew that if they put them in the currencies of the Southern European countries, the socialists would confiscate them by money creation. As a result, the Northern currencies, and especially the Deutsche mark, were always embarrassing the currencies and the governments of the South, who very often would have to devalue their currencies and offer higher interest rates to depositors as a result of their aggressive monetary policies. After the fall of the Berlin Wall in 1989, the Germans had to surrender their currency to the socialist South (especially France), in order for the winners of WWII to allow the reunification of Germany.

The political background of the euro is beyond the scope of this essay, but those interested on the politics of the euro should read “The Tragedy of the Euro” by Philip Bagus, which is a great account of the Eurozone adventure. You can read this book at for free, or you can buy the kindle edition at Amazon. However the main economic issue, which is the one that led to the Southern housing bubbles, is that the socialist politicians of the South were suddenly found with Northern European credit cards in their hands, since investors saw the Greek, the Italian, the Portuguese debt as guaranteed by the Germans and the other Northerners. And the socialists of the South decided to do what socialists very often do. They used these northern “credit cards” to go shopping. According to the agreement for the common currency, Eurozone members were supposed to avoid budget deficits or keep them at very low levels. Unfortunately there was no mechanism to enforce fiscal discipline to the socialist South. This was a road which guaranteed the creation of bubbles.

Therefore because of the euro the southern countries had access to rivers of borrowed funds. There was a situation with irresponsible governments that could borrow savings/ “oranges” at very low prices (interest rates) using the credibility of the European North. And that’s exactly what they did. Now there is a lot of tension because the Northerners are very upset for having to pay irresponsible southern policies. They ask the southerners to liberalize their economies and make them more competitive in order to be able to produce more. However the southern countries don’t want to change their socialist and interventionist economic models. They want the northerners to pay even more than they are already paying, which generates even more tension.

In a nutshell, the bubbles of the European South were funded by the savings of people who thought that the Greek euros were identical to German euros etc. Therefore the bubbles were not created by the free market, but by establishing a common currency without first establishing a mechanism that would impose fiscal discipline on irresponsible southern politicians.

The motives of the American and the southern European governments that led to the bubbles were quite different, but the outcomes were quite similar. A flood of imports/ “oranges”, a lot of cheap credit, and too many houses, cars, holidays etc. The U.S.A. is not a socialist country though. Even though the U.S.A. has moved a lot from the ideal of freedom towards the ideal of equality, it is still a much more free country than the European countries which take equality much more seriously than freedom. I believe that if they didn’t have to fight the wars they would have not used their monetary policies in such an irresponsible way. The story is quite different for the socialist Southern European countries where redistribution counts a lot more than freedom as a policy objective. The Southerners would use their monetary policies aggressively even if they did not have to finance a defense system, because monetary policy is the most efficient way for redistribution. But at the end of the day, if you ignore the different motives, the mechanics of the bubbles were quite similar.

The American Great Depression of 1929

What China was doing in the 21st century i.e. exporting and lending to everybody, the U.S.A. was doing in the 1920’s. The U.S.A. was one of the few industrial countries (together with Sweden) that did not have battles on its territories (with a few exceptions i.e. Pearl Harbor).

The U.S.A. not only had to help the allies during the wars, but they also had to help them after the war in order for the latter to rebuild their countries. Actually they were not only helping the allies, but even the axis powers i.e. Germany. Helping the destroyed European continent involved huge costs. It is not a coincidence that the U.S.A. did not establish a central bank until 1914 (actually December 1913). On December 1913, the Federal Reserve Bank (the American central bank) came into being. It can be no coincidence that the American central bank, the Fed, was established at the outbreak of the First World War (1914-1918). It is a very common practice for all countries to use their central banks during wars in order to finance their military expenditures. The U.S.A. was not an exception to this rule.

From 1914 until the crash of 1929, there was a dramatic increase in the money supply in the U.S.A. American governments not only wanted to help their allies, but they also wanted to protect American producers from foreign competition i.e. farmers etc. They therefore imposed tariffs as a means of protecting American producers with political influence. This made it even harder for the rest of the world to buy badly needed American products, since it was even harder for them to sell to the U.S.A. their own goods, obtain dollars, and use them to buy the huge American production surpluses. American governments should have abolished tariffs in order for foreigners to be able to sell to the U.S.A. and obtain dollars to buy American goods. But instead of doing that, they started to encourage foreign lending, in order to help their allies, and protect their producers at the same time. They were therefore printing dollars, handing them to foreigners, who in turn used them to buy American goods. This was taking place both through the public and the private sectors. American governments were even encouraging the private sector to lend abroad.

The ability of the foreigners to repay these loans was not taken into account though. The lending was mainly based on politics. These foreign bonds were toxic bonds, and they were the equivalent of the toxic sub-prime mortgages of 2008. Foreign bonds held by Americans were the bubble of the time. They were a bubble in the sense that they represented savings of the American people that were lent or given in the form of help or lending abroad, which were never going to be paid back. They were a bubble in the same way that the American bonds held by the Chinese government today are a bubble since the Americans cannot pay them back with real goods but only with freshly printed dollars. Therefore the savings of the American people were misallocated in the 1920’s i.e. they were handed to foreigners who did not have the ability to pay back. At the same time the very low interest rates that resulted from the expansionary monetary policy in the U.S.A. distorted production and even led to a housing boom.

I am not judging whether American governments were right or wrong to help foreigners. I am judging the way they did so i.e. by indirect taxation i.e. by money creation. After the 1929 crash, foreign bonds held by Americans were selling at about 10% of their face value i.e. they lost approximately 90% of their value, which was also what happened to the bonds for the sub-prime mortgages of 2008. What happened to American people during 20’s is what recently happened to the Chinese people.

Once the foreign bond bubble burst, the foreign demand collapsed and so did the demand for American exports. The American economy had to readjust to absorb this great decline of foreign demand. The American automobile production capacity was 2 million vehicles annually in 1920 and increased to 6 millions in 1929. Automobile sales were 5.3 million vehicles in 1929 and decreased to 1.4 million in 1932.

It is therefore ridiculous to blame the free market for the 1929 crash. It was a period of world wars. Even in the freest economies of the world i.e. U.S.A. , governments were deciding what and how to be produced. And you have socialists advocating that the 1929 crash was caused by the free market. What can you do? Socialists….. 

The Dutch Tulip mania of the 1634 

Before the appearance of central banks it was very difficult to tax people by money creation. There were ways of course to do so, none of which had the efficacy of a central bank and paper money. For instance very often a king would ask his people to hand in their golden coins, and would debase these coins. For example he would make 3 out of each golden coin, and would give only 1 of them to the person who had handed in the original one. This was in effect a means of taxation, and such actions were a primitive form of central banking.

In early 17th century (1600-1699), Holland was one of the most dominant forces in European commerce. Even New York was originally under the control of the Dutch and was originally called New Amsterdam before the English took control of it and renamed it. At the time each country had its own coins, but it was difficult to be sure of the quality of these coins, and this was a restraint to trade. The Dutch government allowed free coinage. Free coinage meant that anyone could hand in his gold, and they would be minted to golden Dutch guilders by simply paying a commission. Moreover the Bank of Amsterdam was established in 1608, which offered deposits covered 100% by gold. In other words I could hand in my gold, and would receive a deposit for that gold. These deposits were highly regarded, since they were a uniform means of payment and did not carry the risk of golden coins which could be fake etc, and moreover they were covered 100% by gold.

This was a period that the Spanish and the Portuguese were stealing the gold of the Indians in Latin America. They were literally stealing it (their jewelry), but they were also using them as slaves to extract gold from the gold rich Latin America. The Free coinage regime in Holland, the provision of a sound monetary system, and the commercial significance of Holland, made a lot of this gold to find its way to Amsterdam. Having the Latin Americans working as slaves in order to extract gold and stealing this gold, was in essence like having a central bank. Of course gold can never be like fiat money, because even with slaves there is a limit to its production, while there is no limit in the production of fiat money.

There was therefore a tremendous increase in the Dutch money supply which led to the tulip mania. People were buying tulip bulbs at very high prices. The stranger the tulip color, the higher their prices. This frenzy lasted for three years, from 1634 to 1637.  This was one of the first bubbles in history. In this case the savings of the Indians were misallocated, and were used in the Netherlands for tulip bulbs and other purposes. But it was a minor bubble compared to the ones created by central banks.


 What I said for the socialist European South is also true for Greece. However all the wrong doings of the South are exacerbated in Greece. In this section however I do not want to elaborate on the Greek socialist economic model, with the large and corrupted public sector, but rather to say a few things about the Greek banking crisis.

Greek banks were not very exposed to toxic products of the sub-prime mortgagecrisis, but they were very exposed to Greek government debt. With the Greek bankruptcy and the PSI (the haircut in Greek government bonds), Greek banks lost approximately 35 billion euros. To give you an idea of how significant this figure is for the Greek banking sector, I must say that the fortune of one of the richest Greek banker, Spyros Latsis, is according to forbes’ list 2 billion euros. We all now that if he tried to sell everything he would obtain much less but anyway let’s pretend it is indeed 2 billion euros.

Spyros Latsis was the biggest shareholder of EFG Eurobank, one of the major Greek banks. And the Greek bankruptcy imposed a cost of 35 billion euros to the Greek banking sector. It therefore wiped out all of the big bankers share capital and much more. However this is not explained to the Greek people. The reason is that the Greek banking system was heavily controlled by the corrupted Greek political system, and that’s the reason that all political parties are heavily indebted to Greek banks, and these loans will never be paid back, and the Greek people will have to pay instead. After the haircut of the Greek government bonds, Greek banks had to be recapitalized. For bank recapitalization see my essay “Introduction to Bank Recapitalization”. But the Greek oligarchs did not have or did not want to put additional capital in the Greek banks.

Therefore the Greek government borrowed from the relevant European mechanism and injected more capital in the Greek banks, and the ownership of the Greek banks passed to the Greek state, and at some point it will go back to the private sector. The problem is that the Greek political system is very upset, because the Greek banking system was one of its major sources of funding. Not only in the form of lending to Greek parties, but also in the form of lending to private companies owned by friends of Greek politicians. Therefore Greek politicians do not want to lose control of the banking system. They want to control it either directly by public ownership, or they want the Greek banks to be run by businessmen who are within their control.

For this reason they do not explain to the Greek people what has happened. They blame the Germans, and they say to the Greek people that it is very unfair for the people that borrowed to buy the houses to lose the houses they are living in, and which are held by the banks as collateral. Depositors and taxpayers on the other hand, do not realize that these houses are their ownership and therefore they have no problem with that. Therefore the Greek political system (especially the left) has transformed mortgage owners (borrowers) to hostages, and they have persuaded them that it is the greedy bankers and the mean Germans that want to confiscate their houses. Therefore they have a large part of the electorate that wants the Greek banks to be permanently publicly owned, because they believe the state will let them keep the houses for free.

A main technique used by the Greek political system in order to attack mortgage lenders, is to ask them to count the total amount of payments they made to the banks. For instance if the monthly payment is 600 euros, and if they have been paying for 10 years the amount is 72.000 euros. And they tell them the capital paid is much smaller i.e. 30.000 euros, and therefore the banks are stealing them by charging too much interest. And they do not explain to them that in the first phases of a loan, the debtor has to pay a small part of the capital and a large part of the interest in order for the monthly payment to be small (because the full amount of capital is owed). As time goes by, capital owed is reduced and interest payments start falling, and at the end of the loan most of the payment covers capital and a small part covers interest.

But throughout the whole period the interest rate is 3%-4% something like that, which is extremely low. If I go now (2014) to borrow money from the Greek banks, they will not give me credit. And if I try to borrow from outside the banking system, I might have to pay 15% or even 20% to borrow, and that’s IF I find someone to lend me money. And at the same time the interest rates for people that borrowed to buy houses are kept at artificially low levels i.e. still in the region of 3 to 4 per cent. The low interest rates are not real, and it is the European Central Bank that keeps interest rates artificially low. And at the same time you have the Greek politicians saying to the Greek borrowers (mortgage owners) that the banks are stealing them, only to have them ready to ask for banks to become permanently owned by the state, so that politicians do not lose their control.

They do not say all the things I have said in this essay i.e. that the Greek political system has stolen the savings of the Greek people either in the form of deposits or in the form of insurance and security payments. And that in reality the houses held as collateral by bankrupt banks is these people’s property and not the property of borrowers. It is with their savings/ “oranges” that these houses were built, and not with the savings of the borrowers. But all Greek politicians care about is not to lose control of the goose with the golden eggs, and they therefore need borrowers as hostages. Therefore people have no idea about how their savings have been misallocated, and how the houses held by banks are these misallocated savings, and so they are not angry. Borrowers at the same time think that the houses they are living in, and for which they have stopped paying are their property and that the greedy bankers want to steal them from them. Therefore foreign banks will not dare to buy Greek banks, since they know that the Greek political system can turn borrowers against them. Only with the blessings of the Greek political system a foreign bank will dare to invest in Greek banks.

Free-Market versus Government Induced Bubbles

 As Murray Rothbard says in his famous book “America’s Great Depression”, main economic crisis of the bubble type that we experience today, appeared approximately in the 18th century (1700-1799). Before the 18th century, there were major crisis, but their causes were obvious. There was for instance a drought which would destroy agricultural production and would cause famine. Or there would be a war which would destroy the production process. Or there was a king who would confiscate most of his citizens’ wealth for some purposes. The causes of major economic crisis were always very visible and very easily explained. It was from the 18th century (1700-1799) onwards, that major crisis would arise, and which could not be easily explained. In other words after the 18th century, the causes of major economic crises stopped being obvious.

So in what respect was the world different in the 18th century? There were two major changes. One of them was the industrial revolution (approximately 1760), and the other was the appearance of central banks, with the Bank of Sweden being the oldest central bank, and the Bank of England being the second oldest one (Bank of Sweden 1656 and Bank of England 1694). According to socialists, crises are the result of the industrial revolution and the free market, and according to the free-market economists (mainly economists of the Austrian School) the crises are caused by central banks. Since socialists blame it on the market they ask for more government regulation, and since free-market economists blame it on governments they ask for less government intervention.

Socialists and interventionists use various theories to explain crises and bubbles. Very famous explanations are the “over production” crisis theory, the “under consumption” theory, and the “speculative” or “behavioral” explanations of crises. 

Under Consumption Theory

 The under consumption theory is a Marxist explanation of crises. Marxism has long been discredited as a valid economic theory. In my essay “Why Marx Was Wrong”, I explain why the Marxist theory is  discredited as a valid economic theory. But let’s assume that the Marxist theory was a valid one, and let’s examine housing bubbles using the under consumption theory. According to this theory, capitalists (producers) exploit poor people (workers), and therefore the latter do not have the purchasing power to absorb what they produce i.e. houses (or some other goods in bubble markets).

However Marxists fail to answer the most important question. Why prices do not fall enough for surpluses in the bubble markets to be sold? There are two possible explanations why sellers do not lower their prices. The first one is that sellers wait to obtain better prices in the future, and the second is that the current market prices do not cover costs. Which one of the two we observe today? If sellers could afford to wait, they would not be under extreme pressure, and they would not face the threat of bankruptcy. Is that what we see with banks for example? No, it is not. What we see is the second case i.e. the market prices of the houses held by banks as collateral, cannot cover the loans that were provided for these houses, and the banks go bankrupt.

But then the problem is not that the market cannot absorb these houses. If prices fall enough the market can absorb them. The problem is that market prices do not cover costs and cause bankruptcies. Therefore the problem is that for some “unexplained” reason, all market participants believed that these houses could be sold at higher prices. But then it is not a problem of under consumption, but a problem of misallocation of savings and miscalculation of profits. Put it in another way at current prices i.e. prices that cover bank loans, depositors/savers do not want to buy the houses. But the purchasing power is there i.e. the deposits. These deposits could be used to buy these houses. Therefore we have to assume that the market has used depositors’ savings in the wrong way and it did so in a massive scale.

And Marxists have no explanation of why market participants were wrong in such a massive scale. Shouldn’t we assume that there was an exogenous factor that fooled both producers and consumers? Why didn’t capitalists realize that poor people could not purchase these houses in order to produce something else? Remember that all countries with trade deficits that experience housing bubbles cannot cover their primary needs after the bubbles burst i.e. meat, grain, oil etc. Why then so much was invested in housing and not in meat production for example? Why didn’t capitalists realize that poor people could not purchase these houses in order to produce meat instead?

All Marxists will tell you that the Greek workers were exploited by Greek capitalists and that’s the reason of the crisis, but no Marxist will explain to you, why if Greece had not received the European support there would be many poor Greeks in expensive houses without meat to eat. How could that be?

I believe that a lot of confusion is due to the fact that many people do not realize that the housing bubble is a problem for depositors/savers and not for mortgage owners. The problem is that depositors do not want these houses. These houses were built with the depositors’ savings and not with the savings of the people who do not pay their mortgages. But nobody says that, because they do not want depositors to realize what happened, because if they do realize what happened, they will also realize what their governments did to their savings.

Moreover you have to remember that when a bubble bursts, it is the relative and not the nominal price of the good in the bubble market that must be adjusted. It is the relative price adjustment that is important and not the nominal one. For example during the bubble the price of a house was 1.000.000 oranges when its cost was measured in oranges, and now it has to drop to 500.000 oranges, its cost was 10.000 cars and now its price has to drop to 6.000 cars etc. In other words not all real prices go down. Some prices go up. What is a dramatic decrease in the relative price of the asset in the bubble market i.e. houses, is a dramatic increase in the relative price of all other goods when measured in houses. The relative price of houses drops from 1.000.000 oranges to 500.000 oranges but the relative price of oranges increases from 1/1.000.000 of a house to 1/500.000 of a house. A dramatic decrease in the relative price of houses is matched by a dramatic increase in the relative price of oranges. This is a clear indication that for some reasons the market produced more houses than oranges, and the mistake was not corrected for a long time. It is a clear misallocation of savings.

In a free market relative price changes occur all the time of course, and it is a very healthy phenomenon. However what happens in bubbles is quite unique. The relative price of the asset in the bubble market not only falls dramatically, but it also falls for almost all other goods in relative terms. Changes in relative prices which are due to changing market conditions are much smoother and they move in opposite direction i.e. the price of oranges measured in apples falls, but the price of oranges measured in pears rises. When a good’s relative price falls dramatically and for almost all goods, it means that its price was for some reason irrationally high i.e. there was a bubble. This can be only explained when there is an exogenous and obvious shock. For instance the OPEC countries reduce the quantity of oil supplied and the relative price of oil rises for all goods. But in cases of asset bubbles there is no exogenous shock. At least there is not an obvious exogenous shock. In reality there is an exogenous shock, and that shock is the dramatic increase in the money supply.

Therefore the problem is not as Marxists say that consumers do not have the purchasing power to absorb the goods. There are many depositors who could use their money to buy these goods. The problem is that these depositors and the economy in general need something else. The wrong goods have been produced, and the whole production structure was disrupted i.e. the market produced houses when it should have produced oranges. And now not only borrowers are found with houses they cannot pay, not only lenders (depositors) do not want to exchange their deposits/savings with these houses, but there is also an economy that does not have the production structure to produce the right goods i.e. the economy is set up to produce houses when it should have been set up to produce oranges. And the adjustment is a very painful recession.

We all experienced the Great Depression of 2008. We can judge for ourselves now, we do not need Marx, Adam Smith and John Maynard Keynes to understand. It is very easy to understand that what happened is not that workers were overexploited. The problem is that somehow the economy was overproducing luxury goods i.e. houses, cars, holidays etc, and under producing more basic goods i.e. meat, oranges etc. And Marxists have no explanation for that.

Another thing that Marxists cannot explain is that it is the industries producing producer goods that suffer first, and not the industries producing consumer goods i.e. companies producing goods for other companies suffer first, and not companies producing goods for consumers. If the Marxist theory was correct, the companies producing goods for consumers should have been hit first during recessions. But that’s not what we observe in practice. This might not seem to be a very important argument, but some economists consider it as the greatest flaw of the Marxist theory. 

Over Production Crises

 This theory is closely related to the under consumption one. Proponents of this theory, argue that sometimes the capitalist machine outperforms itself and it produces so much, that consumers’ incomes do not keep pace with increases in production, and they cannot absorb the outcome of the capitalist machine. They mean that they do not have the necessary means to absorb production increases. It is indeed a very naïve theory because producers could simply lower prices enough for the “bubble” products to be sold. And then again we enter a path of reasoning similar to the under consumption one, i.e. that there are two possible explanations why sellers do not lower their prices. One is that they wait to obtain better prices and two that market prices cannot cover costs. The reasoning is exactly the same with the under consumption theory, and the conclusion is that there is no over production in general, but over production in some sectors and under production in some other sectors i.e. misallocation of savings and miscalculation of profits and so on.

Psychological-Speculative Crises 

Others say that bubbles are due to psychological factors. People see rising house prices, and they believe that they will keep rising for ever, and they start investing in houses, and they keep buying houses, and that kind of nonsense. These people confuse the symptom with the cause. Optimism is the symptom of the excellent economic climate that follows the overproduction of paper money. The cause of this optimism is what people perceive as an abundance of “oranges”, an abundance of savings. “Oranges” are not important anymore, people stop worrying about the basics, the question is how to improve the standards of living i.e. houses, cars, holidays, education etc, how to increase profits etc. Everybody takes “oranges” for granted. Nobody believes that one day will come that oranges will be scarce again.

In the same way, the panic that follows the boom is not due to psychological factors. It is due to objective facts i.e. that everybody realizes that “oranges” should not be taken for granted, and there is even a possibility of living in a great house without any “oranges” to eat. It is very natural for people to panic. They panic because they realize there is a shortage in “oranges”, a shortage in savings, and in the same way they were optimistic because they thought there was an abundance of savings they are now pessimistic because they realize there is a shortage of savings. Both their optimism and pessimism were based on what was going on around them. The increase in the production of paper and electronic savings generated by the government was very real. How could people know that what they perceived as and abundance of savings was not real and that a recession would follow?

It is therefore the increase in paper savings that causes the optimism and the bull market and not psychology or a thirst for speculation. As I already explained, the increase of paper savings does not increase the real savings i.e. “oranges” of the economy. It either allows domestic citizens to borrow very cheaply domestic real savings i.e. at interest rates that are much lower than the ones dictated by economic fundamentals (in the case of countries with production surpluses), or they allow domestic citizens to borrow very cheaply foreign real savings. When the bubble is created with cheap foreign savings, the foreign governments did something wrong too i.e. China in the 21 century and U.S.A. in the 1920’s.

The Socialist Myth of the Greedy Banker 

An explanation of the crisis very often put forward by socialists is the one of the greedy banker. In my essay “The Socialist Myth of the Greedy Banker”, I explain why private banks have nothing to do with the crisis. Private banks buy and sell paper savings. The more paper savings they buy (deposits) and sell (loans), the more profit they make. However private banks have nothing to do with the quantity of paper savings in the economy. The amount of paper and electronic savings in the economy is controlled by the government and its central bank.

It is of course true that private banks will never say no to more credit, since with more credit they will make more loans and more profit. But they cannot create money as I explain in the aforementioned essay. People are confused by the fractional reserve system, under which private banks can lend more than they take in deposits. But this is a tool used by governments to boost credit and economic activity. It is very easy for governments to ask for less credit expansion. Anyway, since I explain it in detail in the relevant essay I will not elaborate further.


Murray Rothbard “The Great American Depression”

Murray Rothbard “What Has Government Done to our Money”

Murray Rothbard “The Case Against the Fed”

David Stockman “How the Artificial Boom of 1914 Caused the Great Depression”

Douglas French “Early Speculative Bubbles and Increases in the Money Supply”

Philip Bagus “The Tragedy of the Euro”

Irwin Schiff & Vic Lockman “How an Economy Grows and Why it Doesn’t”

If you enjoyed this essay you might want to have a look what some of the following essays too:

Conspiracy Theories About Israel

The Energy War Between U.S.A. and Russia and the Threat for Israel’s Survival

The Socialist Myth of the Greedy Banker

The Socialist Myth of Economic Monopoly

The Socialist Anti-Semitic Myth of the Creation of Money Out of Thin Air

Introduction to Banking



Introduction to Bank Recapitalization

***You can obtain a free copy of this essay in pdf, kindle and epub format at Smashwords or you can download it for free at Apple’s ibook store or at Barnes and Noble for nook devises at or buy the kindle edition at Amazon   Iakovos Alhadeff Introduction  After the economic crisis of 2008, and the banking crisis that followed, we have all heard hundreds of times the expression “banking recapitalization”. Because most people do not know how banks work, populists have extensively used the banking industry in order to disorient the public, and achieve political benefits for themselves. The way they do so, is by telling the innocent and ignorant on the subject people, that the government gives lots of money to the bankers instead of giving it to the poor. In this essay, I want to explain in very simple words what we mean by bank recapitalization, and how this takes place, so that everybody understands what it really is. I will use an example that I used in my essay “The Housing Bubble and the Banking Crisis for non Economists”, and modify it, in order to place the emphasis on the issue of bank recapitalization. I might add some accounting comments i.e. about balance sheets etc, but people who are not at all familiar with accounting can skip these comments, and still be able to understand everything. A Banking Example with Recapitalization Let’s assume that I want to open a bank. I put down 120 million euros in share capital in order to do so. The amount of 120M euros is arbitrary, as will be all the figures I will use. So I put down 120M euros. The money goes in the newly opened bank’s vault, and I get paper (shares) for 120 million euros (in the bank’s balance sheet the 120M euros will appear as cash on the asset side and as share capital on the liabilities side). The shares that I will get will be traded in the stock market. Their price goes up when the bank makes profits, and people have faith in the bank and want to buy its shares, and goes down when the bank makes losses, and nobody wants to buy them, and everybody wants to sell them instead. And for the moment I am holding all the shares. Therefore for the moment the bank is only funded with capital from its owners (me and the share capital I contributed). Therefore the bank finances its activities, mainly loans, with its own capital. But as time goes by, the bank will receive capital from outsiders (not the shareholders). The obvious sources of external funding are deposits and borrowing. You can deposit 1 million euros, and the bank can use it to make loans. Or the bank can issue a 1 million bond, and you can buy the bond thus lending the bank 1 million. The bank can again use this 1 million to make loans. Banking regulations require that some of the capital with which a bank finances its activities comes from its owners (shareholders), and that this capital (own capital) does not fall below a given percentage of total capital. Let’s suppose that regulation requires that own capital does not fall below 20% (arbitrary figure) of total capital. Imagine a bank with 100 million of shareholder (owners’) capital, which has also taken deposits of 100 millions, and has issued bonds (borrowed) another 100 millions. This totals to 300 million euros of capital (100+100+100), and if banking regulation requires that own capital does not fall below 20% of total capital everything is fine, since own capital is 100/300=33% of total capital. It is very reasonable to expect banks to have a part of their capital in the form of share capital (own capital), in order to make sure they are prudent. If I have a bank that is only financed through deposits and borrowing, I can take excessive risks, since even if the bank goes down I will not lose anything. On the other hand if some part of the bank’s capital is my capital (shareholder capital), and the bank goes down, I will lose my capital. And therefore I am more cautious in my management. So, there are 3 main sources that banks can use to finance their operations i.e. shareholder capital, deposits and borrowing. And banking regulations require that own capital (shareholder capital), does not fall below a given percentage of total capital as I already said. It can be more than that percentage, but not less than that. If the shareholder capital as a percentage of total capital falls below that percentage, the bank goes bankrupt and it is liquidated. In my essay I will arbitrarily set that percentage to be 20% of total capital i.e. (share capital) / (share capital + deposits + borrowing) must be greater or equal to 20%. An arbitrary figure I repeat. I must also add that banks can mainly borrow from other banks (inter-bank market), from the central bank, or directly from the public by issuing bonds. Now let’s come back to my example. Remember I opened a bank with 120 M euros. Now I also take a deposit of 100M euros from a rich customer. Now the bank has in its vault 220M euros, which are financed 55% by share capital (120M), and 45% by deposits (100M). Now the bank also issues bonds, and borrows from the public another 100M euros. Now the bank has in its vaults 320M euros, which are financed 37.5% by share capital (120M), 31.25% by deposits (100M), and 31.25% by borrowing (100M). The bank has not yet issued any loans or performed any other actions (it has a balance sheet with 320M cash on the asset side, and 120M share capital, 100M deposits, 100M debt (bonds) in the liabilities side). Everything is according to the banking regulations. Share capital is 37.5% of total capital, which is 17.5% more than the minimum level of 20%.

Assets Millions Liabilities Millions
Cash 320 Share Capital 120
Bonds Issued 100
Deposits 100
Total 320 320

Now the bank wants to make a loan of 150 million euros to a businessman who wants to buy a big building worth 150M. We are in 2008 before the crisis. So the bank issues a loan of 150 millions and the businessman buys the building which also serves as collateral for the loan. Nothing has changed in the liabilities side of the bank. Capital still stands at 320M, with 120M share capital, 100M borrowing (bonds) and 100M deposits. But on the asset side, the bank has only 170M euros in cash, and 150M in loans. This is not a problem, since the loan has a value of 150M euros. The bank can confiscate the building if the businessman does not pay his monthly instalments, and receive its 150M in cash. If the businessman meets his obligations, it will be even better for the bank since it will receive its money plus interest.

Assets Millions Liabilities Millions
Cash 170 Share Capital 120
Loans 150 Bonds Issued 100
Deposits 100
Total 320 320

So far, so good. But at the end of 2008 there is a huge economic crisis. The businessman leaves the country and the bank is left with the building. Let’s assume for simplicity that the businessman has not paid anything to the bank yet. Because of the crisis, the building’s value has fallen to 50M euros. Losses are always incurred by the shareholders and not by depositors and lenders, since the former are the owners of the bank. That is as long as there is shareholders’ capital. But in our case there is sufficient shareholder capital against which the losses can be written off. In accounting terms, the loss of the 100M euros, will go to the profit and loss account, and will appear as a negative number at the liability side of the balance sheet, thus reducing shareholders’ capital by 100M euros. Therefore at year end, the bank has 170M euros cash in its vault, and a building worth 50M euros. That’s the asset side of the balance sheet. And at the liability side, the bank has 20M shareholders’ capital, 100M borrowing (bonds) and 100M deposits. Now the 100M loss from the reduction in the building’s value has been taken off, both from the building’s value (as an asset), and from the shareholders’ capital (at a part of the bank’s capital at the liability side). The situation is presented in the following table.

Assets Millions Liabilities Millions
Cash 170 Share Capital 20
Loans 50 Bonds Issued 100
Deposits 100
Total 220 220

Don’t get confused by the accounting. Simply see the above economic event as a loss for the owners. The owners made a loan of 150M euros, the borrower could not pay back, the bank confiscated his building, which however has a value of only 50 million euros, and therefore there was a loss of 100M euros. Therefore the owners’ wealth is reduced by 100M euros. Therefore only 20M (120M initial offering- 100M loss) of shareholder capital is left. You can look at it in this simple way if you are confused with the accounting. It makes no difference at all. The accounting simply records this loss in the bank’s books. But the loss has nothing to do with accounting. It is a real loss. A real loss generated from a real economic event, which cost to the bank’s shareholders 100M euros. So, let’s now look at the bank’s capital. The bank has 20M of shareholder capital, 100M of borrowing (bonds), and 100M of deposits. Own capital (shareholder capital), now stands at 20M / 220M = 9%.

Share Capital 20M
Bonds Issued 100M
Deposits 100M
Total Capital 220M
Share Capital/ Total Capital = 20M/ 220M = 9 %

If the loss was greater the shareholder capital could have been totally erased. If the loss was even greater, a part of the bondholders’ and depositors’ capital could have been erased too. Imagine for example, that the loss was 200 million. All the 120 M of shareholder capital would have been erased. But another 80M euros would have been erased from bondholders and depositors. Actually it is right to assume that the 80M loss would be incurred by bond holders, since depositors are always the last ones to incur losses. If they incur any losses at all, since very often the government prefers to pass their part of the losses to the taxpayers. How Recapitalization Takes Place Now let’s go back to my example. There is a problem. Shareholders’ capital stands at 9% of total capital, and regulators require it to be at least 20%. Therefore the bank must be recapitalized. It is not a liquidity problem. The bank still has 170M euros in its vaults, and if depositors are not panicked and they do not rush to take their money there is no problem. The bank does not have a liquidity problem. But it has a capitalization problem. Shareholders’ capital stands at only 9% instead of 20%. Therefore the bank has to issue new shares, and receive new shareholders’ capital (be recapitalized) in order to meet minimum capital requirements. Under normal circumstances there is no problem. There are many people willing to buy the banks shares. But under a severe economic crisis, it is very likely that no one will be willing to risk his money by buying the troubled bank’s new shares. If that happens, there are two options. Either the bank will close down and be liquidated, or the government will become a shareholder, by contributing the shareholder capital that is missing. In our example, the government would have to contribute 30M euros, thus bringing shareholder capital at 50 million euros, and therefore 50M / (50 + 100 + 100) =  20% of total capital, as required by regulation. Therefore the bank was recapitalized. It could have been recapitalized by the market instead. But in troubled countries it is very likely that the market will be afraid to buy such shares. In my example, after the bank was recapitalized, the government holds 60% of the bank’s share capital, and the market holds 40% of the bank’s capital.

Share Capital (20M Private and 30M Public) 50M
Bonds Issued 100M
Deposits 100M
Total Capital 250M
Share Capital/ Total Capital = 50M/ 250M = 20 %

If the losses had erased 100% of share capital, the government would hold 100% of share capital. I must now say that I made a simplification. I assumed that the bank’s share price in the stock market did not change during 2008. This is of course very unrealistic, but it is a simplification that greatly helped me to explain what recapitalization is. Bank recapitalization should not be confused with short term liquidity provided by central banks to the banking sector, when the latter faces the danger of liquidity crisis and bank runs. I now turn to liquidity crisis to make sure there is not confusion between the two. A Banking Example with Liquidity Crisis I hope that by now it is clear what bank recapitalization is and how it takes place. And why it is important of course. Liquidity crisis are something very different. To demonstrate what liquidity crisis are I will use an example again. There is a bank, with 100M euros share capital, and 200M euros in deposits. There is no debt this time. No operations have been undertaken yet. So there are 300M euros in the company’s vault, financed by 100M of share capital and 200M of deposits. Like before, the bank issues a loan of 150M euros to a businessman wishing to buy a big building, and the building is used as collateral. As before, there is now 150M in cash at the bank’s vault, 150M in collateralised debt, which are financed as described above. But this time the businessman is very credit worthy, and has calculated everything correctly. Therefore he is not affected by the crisis. But due to the severe economic crisis, depositors are panicked and run to take their deposits from the banks. But the bank does not have 200M euros in its vault. It only has 150M euros in its vault. The bank does not have money to pay the depositors, even though it is perfectly healthy. In this case the central bank will provide liquidity to the bank, and when the confidence returns and depositors take their money back to the bank, the bank will return the short term liquidity back to the central bank. The real world The government (central bank) support under liquidity crisis is very different from the government support under recapitalization. But in the economic crisis of the recent years, both kinds of support were required. Because huge amounts of housing values held as collateral by the banks were evaporated, and when the corresponding loans became red, heavy losses were incurred erasing shareholder value. Therefore there was a need for recapitalization. At the same time in many countries i.e. Southern European countries there was a loss in confidence, and depositors were taking their deposits either to put them under their matrices, or to send them to more secure northern banks. I must mention that decreases in the value of houses held as collateral are only one of the possible sources of losses for the banks. There are many others. For instance in Greece, when the country’s debt was restructured in 2012 (a form of default actually), the Greek banks lost 37.5 billion euros. Because they were holding approximately 70 billion euros in government debt, and there was a haircut of approximately 50%. If you liked this essay you might want to have a look at the following essays too: Conspiracy Theories About Israel The Energy War Between U.S.A. and Russia and the Threat for Israel’s Survival The Socialist Myth of the Greedy Banker The Socialist Myth of Economic Monopoly The Socialist Myth of Economic Bubbles The Socialist Anti-Semitic Myth of the Creation of Money Out of Thin Air

Israel and Conspiracy Theories

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or you can buy the kindle edition at Amazon


Iakovos Alhadeff


The aim of this document is to offer a quick and simple presentation of the circumstances under which Israel was created. The document does not have any historical value, since thousands of books have been written on the subject, and I am not a historian either.

I write this document because I am tired of listening about a Jewish conspiracy for world dominance, part of which was the creation of Israel. I hope this essay will help the well intentioned and confused reader realize, that Israel was created in the same way that the Arab states and all other states were created. I will not touch the Arab-Israeli conflict which is a more complicated issue.

For each document like this one, hundreds of others supporting conspiracy theories are written. Therefore I cannot afford to use sources that are very good, but which are not “brand names”. I will use only well known sources like Wikipedia and History Channel, which are known to everybody.

The Arabs and the Israelis Today

Before I start presenting how Israel was created, I want to present a picture of the Arab Israeli world as it exists today. At the following map,


Map 1

the Arab world is the green colored area, and the Israeli world is the red colored area.

According to the following Wikipedia link (second paragraph)

the Arab world comprises 22 states and 422 million people (the green countries)

And according to the following Wikipedia link,

there are approximatelly15 million Jews worldwide, 6 of which are located in Israel.

This is the picture of the Arab Israeli world today.

The following map shows the geographic region that is called Middle East.


Map 2

It can be seen that Middle East does not include all the Arab countries, and it contains countries that are not Arabic i.e. Turkey and Iran.


A few years before 1900, a Jewish movement for the creation of an independent Jewish state starts developing. It is the well known “Zionist” movement. For many people the world “Zionism” is synonymous to the word “conspiracy”. And it is very understandable that many people believe so, since there is so much propaganda on the subject, financed with petrodollars.

In reality Zionism, was simply a Jewish movement for the development of an independent Jewish state, which would offer a shelter for the Jews that were leaving in countries were anti-Semitism was on the rise. And Zionism was not a world conspiracy, but rather a very reasonable response to the rising European anti-Semitism of the late 19th century (around 1900).

It is the time of the Dreyfus Affair in France (1894), the time the publication of the “Protocols of the Elders of Zion” in Russia (1903), and in general a time of declining civil rights and rising persecutions for the European Jews. I provide one of many links on the subject (Wikipedia),

which says in section “Persecution of Jews in the late Russian Empire”, that between 1881 and 1920, 2 million Jews left Russia due to the anti-Semitic laws and the Russian pogroms. Eastern Europe was at the time the home of the majority of the Jews. Therefore the creation of Zionism was a response to the rising European anti-Semitism, and not a world conspiracy for world dominance as propagandists suggest.

Palestine and the Ottoman Empire

When Zionism started developing, the region that is Israel today was part of the Ottoman Empire. Palestine was under Ottoman occupations since 1570. And what helped the Jews and the Arabs create independent states, was that the Ottomans were on the side of the Germans in World War 1 (1914-1918 WW1), and not on the side of the Allies (Britain, France, Russia). At the start of WW1 the situation in the Middle East is represented in the following map.


Map 3

As it can be seen, what is today Israel, Syria, Irak (Mesopotamia), Jordan, Lebanon, and part of Saudi Arabia, was part of the Ottoman Empire. The other country that was strong in the region was Britain (colored pink on the map).

The following map shows the region today


Map 4

Great Britain in the Middle East

It can be seen that at the time, England was controlling Egypt and the Suez Canal. As it can be seen on the following map, the Suez Canal was of great importance for the British since it almost cut in half the distance between England and its colony India.


Map 5

Moreover, as it can be seen at the following map,


Map 6

the region behind Israel, is a region of great importance. It is the region of the famous Persian Gulf (the gulf between Iran and Saudi Arabia), with the richest countries in oil i.e. Saudi Arabia, Kuwait, Iran, Iraq and Qatar. Therefore the region was of vital importance for England. It was offering a passage to the Indian Ocean and India, and it offered oil as well. I must mention that USA was not yet the great power that we all know today.

The English and the Ottomans

In 1915, the Ottoman Empire enters WWI on the side of Germany. This is something that terrifies the British, since, as it can be seen on map 3, the Ottomans were next to the Suez Canal. And the Ottomans are now on the side of the Germans and therefore an enemy of England. Moreover, as it can be seen on map 3, the Ottomans are very close to the Caspian regions (south Russia), from where Russia, an ally of the English, was getting its oil. And the Ottomans were also very close to Iran, from where the English were getting their oil.

Therefore the English badly needed allies to fight the Ottomans. And they tried to reach agreements with all parties that could help their war against them. Jewish and Arab nationalism were two such forces. The English will promise the Arabs independence if they help them defeat the Ottomans. The English agent Lawrence (the famous Lawrence of Arabia) will lead the Arabs against the Ottomans.

Moreover they promise the Jews that they will help the creation of a Jewish state in Palestine. The British were hoping that American Jews would use their influence in order for the USA to enter the war, and that Russian Jews in the Communist Party would use their influence for Russia to remain in the war on the side of the Allies. I must mention that during WWI (1914-1918) the Russian communists came to power (1917). The Jews also provided soldiers to the British, but not as many as the Arabs who were a much larger population.

Moreover with the Sykes-Pikot agreement, the British promised the French, control over the region that today is Syria and Lebanon. For the Sykes-Picot agreement, see the following Wikipedia link,

The following map shows how the British and the French had agreed to split the Middle East.


Map 7

As it can be seen on the map, the British would take control of Iraq, Jordan and Israel, so that they would control the rich in oil Iraq, and have access to the Mediterranean Sea. We therefore see that the British had promised too many things to too many interest groups. And their promises to various groups were sometimes conflicting. But in the end they did manage to defeat the Ottomans.

At the following link,

there is a History Channel documentary, “Promises and Betrayals”, which illustrates the various and conflicting English promises during WWI. It is a very good documentary and it takes only 50 minutes to watch. On 20.15, it says that the English believed that whether the Americans would enter the war, greatly depended on the public opinion. And by promising to help the establishment of a Jewish state, they were hoping that the American Jews would use their influence on this direction.

That does not mean of course that the Jews control the USA as many idiots believe. But this is another story. But according to History Channel (20.15) the British greatly overestimated the Jewish influence in the USA. But they certainly had some influence. According to the documentary (from 26.00 to 33.00), with the creation of the Jewish state, the English were also hoping to motivate the Russian communists of Jewish origin, to use their influence to keep Russia in the war. The English promised they would help the creation of the Jewish state with the Balfour Declaration in 1917, and the communists took control of Russia in October 1917. This promise should be very interesting, since in November 1917 the English army was entering and taking control of Palestine. In other words the English were promising to help the establishment of a Jewish state, in a region they already possessed.

In 30.30 of the History Channel documentary, it is said that it was very silly on the part of the English to believe, that the Russian  communists of Jewish origin would be touched by such an offer, since the latter were internationalists and believed that Zionism was a capitalist movement. Moreover, when communists took control of Russia, they turned their back on the allies, and left the war. And we are used to listen that communism was a part of the Jewish conspiracy for world dominance. And we can realize how wrong this is, by considering the communist reaction to the English offer for a Jewish state with the Balfour Declaration. And the communists not only left the war, but they also made public many secret agreements between the English, the French and the Russian Tsar, thus greatly embarrassing the allies. The Sykes-Picot agreement was one such document made public by the Russian communists.

And all this carries the authority of History Channel. The following Wikipedia link,

in section “Jews in the Bolshevik Party”, explains that the Jewish presence in the party was significant but not at all decisive. But I guess it was very convenient for the Nazi propaganda to identify communists with the Jews. A great hatred was cultivated to the German people for the Jews during WWII, which could be very easily passed to the Russians, if they were perceived as led by the Jews.

Therefore what I described above is the context within which the English, the Jews and the Arabs were trying to pursue their interests during WWI. I now want to take a closer look on the English and Jewish interaction during this period.

The English and the Jews

The commitment of the English towards the Jews for the establishments of a Jewish state is the famous Balfour Declaration in 1917. For Balfour Declaration see the following Wikipedia link,

The Balfour Declaration is the letter sent by Arthur Balfour, English secretary of foreign affairs, to Baron Rothschild, who was the most prominent figure of the British Jewry. Arthur Balfour was asking Baron Rothschild to pass this letter to the Zionist Council. With this letter the British were promising the Jews that they would help them create a Jewish state in Palestine. Actually with the Balfour Declaration the British were committing to help the establishment of a Jewish state in the area which is today Israel and Jordan, and not just in what it is today Israel. In the following map,


Map 8

you can see the area of the Balfour Declaration. And the following map shows the same area today (Israel+Jordan).


Map 9

As I said, it was in this area (Israel+Jordan) that the English promised to help create a Jewish state. This region (Israel+Jordan) was very underdeveloped, with only 1 million inhabitants at the time. There was therefore plenty of space for the creation of a Jewish state. The majority of the people living there at the time were Arabs though. And this is the reason the Arabs claim the Jews are not entitled to their own state, because in reality the Arabs are not willing to accept a state of Israel under any circumstances. The Jews on the other hand claim that this was the land of their fathers who were driven away by the Romans many centuries ago, and there was always a significant Jewish presence in the region throughout the centuries.

This region was called the British Mandate for Palestine, and was assigned to the British by the predecessor of the United Nations, namely the League of Nations, in order for the British to see the establishment of a Jewish state. All this happened of course with the help of the English. However with British initiative this mandate was later modified in order to exclude what is today Jordan (the region east of Jordan river) from a future Jewish state, and Jewish people were forbidden to move to this region. The reason the British did so, was because they wanted to offer the region to one of their Arab allies, namely Emir Abdulah. Abdulah was from the region that today is Saudi Arabia.

That’s how states were established during the world wars. Not only in the Middle East. The winners of the war were cutting pieces of land that belonged to their defeated enemies, and were offering them to their allies. Therefore the British cut 77% of the British Mandate for Palestine, which was the area where the Jewish state was supposed to take place. After that only the other 23% was left (what is today Israel). With most of the land of the British Mandate having gone to the Arabs, there was much less room for bargaining for the Jews and the Arabs living on what is today Israel. Even though as I said, the problem for the Arabs is existential and not territorial. They cannot accept a Jewish state. And the most honest of them admit so. The others pretend that the problem is a territorial one in order for the journalists they buy with petrodollars to have a stronger case. It is easier to gain support for a change of borders than for support of Israeli extinction.

Moreover if there was more space a stronger Jewish state could have been created. And at this point one can see that the English were not acting in favor of a world conspiracy. Otherwise they would have not cut 77% of what was the British Mandate and give it to their Arab allies. Moreover, with the White Paper of 1939, the English forbid the movement of more Jews to Palestine. According to this policy paper, only another 75.000 Jews could go to Palestine over the next 5 year period. And after this 5 year period, more Jews could go there only if the Arabs approved so. If the English had not forbid the Jews to go to Palestine, many of Hitler’s victims could have gone there and a much stronger Israel would exist today. Even if only a million of the Nazis’ victims had moved there, it would have been a huge number for the time, and would have made a great difference to the balance of power. But the Arabs new that, and under their influence the British forbid the establishment of further Jews in Palestine.

And therefore the people that claim that the British were acting for some dark forces, they must explain why the cut 77% of the British Mandate and gave it to the Arabs, and they also forbid the Jews to go there in 1939. The reason they forbid them to go there at the break of WW2, is that under the Nazi persecution there would be millions of Jews that would be willing to go there. And there were rich Jews like the Rothschild family, that they could buy land and send them there. And to prevent so, the Arabs and the British issued the White Paper of 1939 which fenced the European Jews in the European countries, and they were finally slaughtered by the Nazis.

And there are people that seriously claim that Hitler was working for the Rothschilds, in order to scare the Jews, and force them to go to Palestine and create Israel. But they can’t explain why the Rothschilds did not persuade the English not to cut 77% of the British Mandate and offer it to the Arabs. And they can’t explain why the Rothschilds did not persuade the English not to issue the White Paper of 1939 which forbid the movement of the Jews to Palestine. For the White Paper 1939 see

And in essence the English are partly guilty of the murder of millions of Jews, because they could have allowed them to go to Palestine, since the Jews did not have anywhere else to run. Nobody wants immigrants at a time of rampant economic crisis. And they therefore were fenced in Europe. But on the other hand without the help of the British at the time, there would not be a Jewish state today.

And then they do not explain why with the United Nations of 1947 and the partition of Palestine, another half of the remaining 23% of the British Mandate was also offered to the Arabs. The following map shows the partition of the 1947 United Nations partition.


Map 10

The orange region was the region where the Jewish state would be created, and the yellow region is the region where an Arab state would be created. The Jews welcomed the partition with great enthusiasm, while the Arabs attacked the newly established state, because as I said the issue is existential and not territorial for the Arabs. And in the war the Israelis won and they took more land.

Today the situation is as shown in the following map, with the orange areas, Gaza Strip, West Bank, and the Golan Heights, being the one we mostly hear in the news.


Map 11

I hope that with all the above, it will be clear to the well intentioned reader, that Israel is not the result of a world conspiracy, but rather the creation of a state, which was created in the way all other states were created. There were so many Arab states that were created in the 20th century, i.e. Lebanon 1943, Syria and Jordan 1946, Libya 1951, Morocco and Tunisia 1956, Iraq 1958, Algeria 1962, United Arab Emirates 1971, Saudi Arabia 1932, Yemen 1918, and nobody says they are the result of a world conspiracy. But the Jewish state is the result of a world conspiracy for world dominance.

And it makes one wonder, why this is so. Why only for the Jewish state there is so much conspiracy theory? And the answer is the following map


There are 400 million Arabs in the green regions, and only 6 million Jews in the red region. And the Arab countries are extremely rich in oil. And while the propagandists try to persuade everyone that Israel is the strongest country in the world and controls everybody, the truth is that Israel still exists due to its close ties with the USA. Not in the sense that the American Jews control the USA. This is another anti Jewish propaganda. The reason is that Israel and USA have a lot in common, Israel is the only democracy in the Middle East, and Israel has always been the loyal and reliable dog of the USA in the region.

If you enjoyed this essay you might want to have a look at some of the following essays too:

The Energy War Between U.S.A. and Russia and the Threat for Israel’s Survival

The Socialist Myth of the Greedy Banker

The Socialist Myth of Economic Monopoly

The Socialist Myth of Economic Bubbles

The Socialist Anti-Semitic Myth of the Creation of Money Out of Thin Air

Introduction to Banking


Why the Marxist explanation of the European crisis is wrong

Iakovos Alhadeff

I am not a specialist on Marxism, and I have no intention of becoming one. Time is limited and one has to choose what to learn and what not to learn.  But Karl Marx is always fashionable. In my document “Why Marx was wrong”, I explain why Marxism is based on wrong foundations, as all rational economists recognize today. In this document I would like to examine Marxism in the context of the current financial crisis.

Most people that you hear today talking about Marxism have no idea about what Marxism really is. What they are basically saying is that capitalists exploit workers during the production process, and therefore workers do not receive their true contribution to production, but they only receive a very small part of this contribution. According to Marx most part of this contribution is stolen by capitalists. Marx called this stolen value the “surplus value of labor”. For more information on the concept of the surplus value of labor see wikipedia

The whole concept of the Marxist surplus value is wrong. The thing however is that today’s ignorant European Marxists, use this argument in a simplistic way to explain the crisis. What they say is that capitalists exploit workers more and more, and as a result workers receive a decreasing part of their contribution to production. As a result their purchasing power is falling and they cannot absorb the wealth produced. The wealth produced is accumulated by capitalists and there is an under consumption crisis.

To summarize, their basic argument put into a sentence, is that workers receive an unfair, small, and declining part of their contribution to production, and they therefore cannot absorb this production. And they have to borrow from the capitalists in order to neutralize the fall in their real incomes, and be able to sustain themselves.  And this is the reason they claim that people are so indebted today.

I must say that this kind of reasoning is not put forward by Marxist economists or theorists, but by ignorant people who think they know what they are talking about. But it is this kind of reasoning that you are likely to come across in the social media. And this kind of reasoning is problematic in many respects. But for us, the Europeans and the Americans, it is not only problematic. It is a joke. Most European countries and the U.S.A. were for many years running deficits in our trade relations with the rest of the world. Think of a world that produces only tomatoes. These countries were for instance exporting 100 tomatoes and were importing 150 tomatoes. And they were borrowing from the rest of the world in order to cover for these trade deficits.

But a country that is running a trade deficit it is not exporting “surplus value of labor”. It is importing surplus value of labor. I hope this is clear. If the U.S.A. for instance is importing 200 tomatoes and exporting only 100 tomatoes, its total labor contribution to production is staying within the borders of the country, and the country imports additional labor power from the rest of the world. I believe everybody understands that, and there should not be any disagreements.

One could argue though, that domestic capitalists have at the same time stolen the surplus value of domestic workers, and they have also stolen the surplus value of labor of foreign workers (through imports) and this is the reason the country is indebted. That of course raises the question why the foreign capitalists left domestic capitalists to steal the surplus value of their workers and did not steal it themselves. But let’s forget about that. Let’s make things simpler. It must be kept in mind that for someone to even talk about Marxian theory, he must believe that the real wealth he produced was greater than the real wealth he consumed. And I am not talking in monetary terms but in real terms. For someone to talk about Marxism, he must believe that he produced 10 tomatoes in the last 10 years and he consumed only 6. If he thinks he produced 6 tomatoes and consumed 10, there is no way that someone could have possibly stolen his “surplus value of labor”. Even if he consumed these 10 tomatoes by borrowing it still makes no difference. The fact remains that he consumed more than he produced. I hope this is very clear. If I produce 1 tomato and consume 1.5 tomatoes, I borrowed somebody else’s product of labor.

And therefore one has to be honest when answering whether he produced more goods than he consumed in his life. And in reality we are not talking about tomatoes. We are talking about schooling, medical services, automobiles, trips and holidays, restaurants, houses, clothes, computers, cell phones, studies etc. Did the average European and American produce more than he consumed in order to claim that someone stole his “surplus value of labor”? Or did he “steal-borrow” the “surplus value of labor” of poor people in exporting countries like China and India? Because if the loans that we, the Europeans and the Americans, owe to such exporting countries are not paid back, it is these people that should claim that we have stolen their surplus value of labor.

And therefore socialists should be the first ones to demand that American and European loans are paid back to the exporting countries. At least they should ask so, when it comes to countries like China and India, where the average citizen is much poorer than the average European or the average American. But what do we see? We see that such people are always the first to say that debts should not be paid back. These people are an embarrassment for Marxist theory. And they cannot even be sincere to themselves, and admit that they consumed so much more than they produced.

The Socialist Myth of Economic Monopoly

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Iakovos Alhadeff


Economic monopoly is a major issue in economic and political discussions and I want to make a small contribution on the subject. Even though I have postgraduate studies in economics I am not a specialist, and this document is a common sense rather than an academic approach on the subject, and it is written for the general reader with no economic knowledge. English is not my first language and you will have to excuse my syntax.

The essay is mainly a critique to both the traditional Marxist approach on monopolies, and to the more modern academic approach, the so called “neoclassical theory of competition and monopoly”. According to the traditional Marxist approach, capitalism leads to economic monopolies. Poor people become poorer, and capital is concentrated in fewer and fewer hands, and at the end of this process capital ends up in the hands of a small group of capitalists. The modern academic approach does not claim that. It examines whether government has to ensure that companies do not acquire excessive market power and use this power to charge consumers with “unfair” prices.

The two approaches are not irrelevant of course, but rather one is the continuation of the other. You cannot afford to ignore either of them, since they are both used to this very day. The Marxist approach is mainly used in the form of propaganda to convince the public that capitalism is bad and socialism is the solution, while the neoclassical approach examines whether government intervention is required in order to protect consumers from large companies.

My impression is that non economists tend to believe the Marxist propaganda which postulates that capitalism i.e. the free market, does indeed lead to monopoly. I think they believe so because they have been exposed to a lot of Marxist propaganda. The size of the huge corporate champions of the business world tends to enforce such beliefs. Socialists have convinced them that the large corporate size is equivalent to economic monopoly, which is actually something very wrong. Think of a small island where the government has issued only one taxi license. Is this taxi a monopoly? Of course it is, since it is the only provider of a particular service. Therefore the relationship between company size and monopoly is not as simple as it seems.

Since large corporations have been the victims of such intensive socialist propaganda, there is no point in examining the issue of monopoly, if we don’t first examine large corporations irrespective of ownership. That is without examining if they privately or publicly run. After all under both forms of ownership the aim is to produce as much wealth as possible. After I examine company size, I turn my attention to the issue of ownership and monopoly. So what is it that determines the size of corporations? Which is the right size? Is it better for a company to be small, medium or large? After all a bakery wants to produce as much bread as possible whether it is publicly or privately run. Therefore the most important issue is how more bread can be produced. Is it better for the consumer if one or many small companies exist? How many bakeries should exist in a market? What should the optimal market structure be? By market structure I mean the number and size of companies in a specific market.

Factors that lead to large corporate sizes

It is better to think about the factors that lead to large corporate sizes in a communist economy, in order not to confuse company size with capitalism.

Economies of scale 

Economies of scale refer to a decrease in the average production cost with increasing levels of production. For instance a production unit costs 100 euros when 1.000 units are produced, 98 euros when 2.000 units are produced, 40 euros when 20.000 units are produced and so forth. There are many reasons why increasing levels of production lead to a decrease in average cost. Specialization is a good example. Imagine a company in a communist country that is producing 1.000 units of a product. This production level might allow for only one administrative employee. This employee must be both and accountant and a secretary. A production level of 2.000 units though, could possibly allow the company to operate with two administrative employees, one secretary and one accountant. These specialized employees could be far more productive. There are many other reasons why increasing levels of production lead to lower costs. Economies of scale are a very common and a generally accepted concept in economics.

Many non economists though, tend to think that economies of scale are present during all levels of production i.e. the more a company is producing the lower the average cost is. But this is of course nonsense. At some level of production economies of scale turn to diseconomies of scale, and this is accepted by all economists.

Diseconomies of scale 

Diseconomies of scale refer to rising average costs for higher levels of production. This can occur for many reasons, for instance due to bureaucracy. The larger a company becomes the more people are required to monitor its operations, and the harder it is for decisions to be taken, since it is impossible to have managers who know everything about the company. There are many other reasons why diseconomies of scale appear at some production levels. Moreover it is very difficult for very big companies to adjust to changes in consumers’ tastes. Imagine a company in a communist country that produces 100 thousands units and another that produces 10 million units. It is much harder and costlier for the larger company to change its product.

If economies of scale persisted for all levels of production, Marx’s prediction about capitalism and monopoly would have been realized, at least for standardized products i.e. salt. But as we observe this is not the case. It would actually be very nice if average costs continued to fall for all levels of production. At the limit unlimited amounts could be produced with almost zero average cost. Unfortunately this is not what happens. But non economists tend to focus on the advantages of being large and forget the disadvantages of being large. Economists are of course fully aware of diseconomies of scale.

Transaction Costs Economics TCE 

“Transaction cost” economics is a totally different approach to explain the size of companies. Economies of scale refer to production costs. Transaction costs refer to a very different category of costs. It is easier to understand “transaction cost” theory, when production costs are assumed to be known and given for everybody i.e. anybody can manufacture an iphone given he has the required capital. This is very unrealistic but it enhances illustration of what transaction costs are.

Let me give an example of a transaction cost. I have a business and I need someone providing cleaning services for 8 hours a day. Let’s say that the market daily wage for such a service is 25 euros. This is not a transaction cost but a production cost (I use the term production costs to also refer to administrative, financial costs etc for greater simplicity). I will pay this production cost (25 euro) whether I hire this person as an employee or whether I use his services as a separate business entity. The price of 25 euros for this service is something determined by the market i.e. how many people are offering cleaning services and how many people are looking for such services.

The question is whether it is better for me to hire such a person or him in the form of an external cleaning service provider. In both cases there is a production cost of 25 euros. What is best for my company? To answer this question one needs to take into account transaction costs. If I use that person as an external associate, a contract must be written. And the contract must clearly specify what he will do and how he will do it, and many other details. And if the person providing the cleaning service does not honor the contract’s terms I would have to go to the court.  If I hire him on the other hand, we would only need to agree that he will clean for 8 hours a day in the way he will be instructed to, which is much simpler. On the other hand an external cleaner might be more motivated because he knows that I can try somebody else at any time, while an internal employee might not possess this kind of motivation and need supervision. But then again I can train my employee to do things in exactly the way I want things to be done. So what is better for my company? Well there is not a clear cut answer. It depends on transaction costs. There are both benefits and costs when a company integrates more operations.

And this is not only true in a capitalist economy. Transaction costs have nothing to do with capitalism. Imagine that I am the manager of a company producing ice cream in a communist economy. People in communist economies eat ice cream too you know. And companies in communist economies have managers too. I am therefore the manager. Let’s assume that there is no money. We count costs in terms of working hours. There are other public companies producing ice cream in the country. The communist leadership evaluates my efficiency in terms of how many working hours it takes for my ice cream to be produced and how good this ice cream is. I therefore need to be at least in the same position in terms of cost and quality i.e. 5th costlier and 5th in quality. If I am 5th costlier and 6th in quality I am inefficient and if I am 5th costlier and 4th in quality I am efficient.

I must therefore improve the company’s performance to impress the communist elite, otherwise they will demote me.  Let’s further assume for simplicity that I only use milk to produce ice cream, and I take this milk from any public milk company I want. Assume that milk costs 1 working hour per liter, and that the production of 1 kilo of ice cream only requires 1 liter of milk. Therefore if it takes me 1.5 working hours to convert 1 liter of milk to 1 kilo of ice cream, my ice cream costs 2.5 working hours per kilo. But I want to do better than that in order to impress the communist elite. Would it be better for me to run a milk company too? Remember I assumed that production costs are given and known, which means that I can also produce 1 liter of milk per working hour if the communist elite allows me to run a milk company. What would be better for my final product i.e. my ice cream? Well, it depends again on transaction costs.

If I have my own milk company I will always have my milk on time, and there will be no more delays. Moreover I will make sure that the milk is always very fresh, while the current manager might give me milk that is not very fresh to squeeze his costs and impress the communist elite. I will also save the time I spent on checking the quality of the milk. On the other hand if I run a milk company too, I have to run a bigger company and it will be harder to control everything and I will have to rely on other people which might affect the quality of my decisions etc.

I hope the above provides in a simple way the “transaction cost” economics approach in explaining company size.

Technological Progress 

Imagine two factories in the same town both producing nails, and assume that consumers need 2.000 nails per month. Both factories have equipment that produces 1.000 nails per month at full capacity. But due to technological progress a new machine comes out which can produce 2.000 nails per month. For the technological progress to lead to lower prices one of the two companies must go. If both companies buy the new machine, and continue to produce 1.000 nails each, prices cannot go down since costs will have increased (new equipment) while sales have stayed at the same level. Actually prices have to increase if both companies buy the new equipment.

But if only one company is left, prices can fall. There are various ways for one of the companies to go. There might be a consolidation, one of the companies might go bankrupt etc. But no matter how this comes about, it is obvious that there is only space for one company. The example could involve 100 companies and technological progress could have wiped out 60 of them. The question is do we want cheaper nails or not? If we are not sellers and we are consumers we should prefer cheaper to expensive nails. If we sell nails we might prefer expensive nails of course.

The Development of Capital Markets 

Large corporations involve investments that are far beyond the limits of even the biggest capitalists. The gradual development of capital markets made possible the pool of resources and allowed large projects to be realized. The more sophisticated the capital markets become the larger the companies can become.

Taxation and company size

It might sound strange, but the socialist way of taxation led to larger company sizes. One of the principles of socialist taxation was to tax companies in two levels. That is to first tax the company’s profits at a certain tax rate, and then impose an additional tax for the profits distributed to shareholders in the form of dividends. The purpose of this form of taxation is to offer incentives to companies to reinvest and not distribute profits.

Assume that a company makes 100 euros of profit. Let’s say the tax rate is 30%. The company pays 30 euros in taxes and there is another 70 euros left. If these 70 euros are not distributed to shareholders, socialists do not impose further taxes. If on the other hand they are distributed as dividends, there is an additional tax of 20% on the 70 euros that are distributed (random numbers). Thus the owners have an incentive not to take their profits, hoping that these profits will be reinvested and generate further profits, which will be reflected in a higher share price. And they can then sell their shares receiving their profits in the form of capital gains which are usually taxed with very low rates. At least they were taxed with very low rates in the past to enforce this socialist incentive scheme for reinvestement. Such policies are of course wrong. Company size should only reflect economic factors and not tax incentives.

Moreover profitable companies have an incentive to buy other companies that have accumulated large losses in the past, in order to use them for tax purposes. The highest the tax rates are, the higher the incentive to do so. 

The Ideal Company Size

All the above factors i.e. economies of scale, transaction costs, technological progress and taxation affect company size. They are by no means the only factors affecting size. They are only some obvious considerations. After examining the above factors one has to wonder what is the optimal company size. According to Murray Rothbard there is no optimal company size. Each entrepreneur has to decide what the optimal size of his company is. On a theoretical basis one can only makes some basic assumptions about the optimal company size. For example economies and diseconomies of scale dictate some boundaries within which optimal size should be.

If for instance market conditions (technology, prices of raw materials, human capital, consumer tastes) in the automobile industry, lead to decreasing average costs until the production of 200.000 units, then the minimum company size involves production of 200.000 units. In the same way the other factors I examined dictate boundaries for company size. But the actual size can only be determined by the specific entrepreneur. The optimal size for Apple is different if it can sell 100.000, 200.000 or 100 million iphones. But we could say that economies of scale and transaction costs play a more important role in determining company size in markets for homogeneous products (i.e. salt), and a bit less important role in markets for products with great differentiation where the role of entrepreneur is more significant.

We could say that the optimal company size is determined by consumer preferences (quantities and quality required), from the ability of the economy (technology, availability of resources, human capital etc) to satisfy these needs, and from the ability of the specific entrepreneurs to detect and satisfy consumer needs by using scarce resources (highest possible quality at the lowest possible cost). The entrepreneur is a bridge between consumer preferences and scarce economic resources. And of course a charismatic entrepreneur will better satisfy consumers, will attract more clients, and employ more resources, and will end up with a larger company than a less charismatic entrepreneur facing the same conditions. In the place of the capitalist entrepreneur could be a manager in a communist economy without changing my discussion until now. I am not yet talking about capitalism or socialism, but instead for production units stripped from ideologies.

Therefore there is no optimal company size, but only boundaries within which a company’s size must be. What is unambiguous is that if the minimum possible price of salt is 50 cents per kilogram, and each production unit needs to produce at least 100 thousands tons to achieve this price, then the smallest company should produce at least 100 thousand tons of salt, both in capitalism and socialism. A useful concept for the discussion is that of “minimum efficient scale” of production (MES). Minimum efficient scale refers to a level of production at which it is not possible to increase production and achieve further economies of scale. Whether constant economies or diseconomies of scale appear after economies of scale depends on whether we consider the average cost curves to be L or U shaped, but this is beyond the scope of my document which is not a microeconomics document but a common sense approach to the issue of monopolies.

Company Size and Socialism 

To show that the large company size has nothing to do with capitalism, I would like to use the example of the Soviet Union and Sweden. The first was a communist economy and the second is very often used by socialists as a proof of the superiority of socialism over capitalism. It is actually a myth that Sweden’s success has anything to do with socialism, as I explain in my document “The Swedish Economic Model: A socialist or a free market success”, but nonetheless socialists very often use Sweden as an example. In both these countries the market was dominated by a small number of large companies.

Sweden & the Soviet Union 

Sweden is considered as the country of multinationals. The following link

mentions 26 Swedish multinationals that are in Forbe’s list with the 2.000 biggest companies in the world. Total revenues of these 26 largest companies amount to 230 billion dollars. In other words the revenue of the 26 largest companies of “socialist” Sweden’s is almost equal to the GDP of Greece (they both have approximately 11 million inhabitants). Socialists use Sweden as a proof of socialism’s superiority, and at the same time socialists blame everything on “greedy multinationals”. And the funny thing is that the success of the “socialist” Sweden has always been based on her very successful multinational. This is a very inconsistent socialist rhetoric. In the following link

Sweden’s minister of commerce (2010) proudly explains how Sweden managed to become “the small country with the big companies”.

M. Henrekson and S. Davis of the universities of Stockholm and Chicago respectively, in their article “Explaining National Differences in the Size and Industry Distribution of Employment”, examined the reasons that led to large enterprise sizes in Sweden compared to the rest of the world. In page 6 of their article, they mention research conducted by the Swedish government in 1992, according to which Swedish companies with at least 500 employees employed 60% of the Swedish workforce, while the European average was 30.4%. On the other hand companies with less than 10 employees, employed less than 10% of the workforce in Sweden while the European average was more than double that figure. 

The Soviet Union was another example of a market dominated by few and very large companies. In page 3 of their article “The Myth of Monopoly: A New View of Industrial Structure in Russia”, three academics from the university of Pennsylvania, explain that it was generally accepted in the Soviet Union that very large production units would lead to decreasing costs, and they provide further evidence. But I do not actually think that anybody claims this was not the case in the Soviet Union.

Since both in capitalist and socialist economies there is a tendency for companies to grow larger, one must conclude that large company size is not an attribute of capitalism or socialism, but rather a result of economic factors. And since both capitalism and socialism want as much wealth as possible to be produced, they must use large production units if the latter lead to more wealth creation.

I hope the discussion up to this point has persuaded the reader that large company size is not necessarily something negative, and that it is not an attribute of capitalism. And it is finally time to turn to the issue of “monopoly”.

The two theories of monopoly 

There are as expected two theories of monopoly, the socialist one and the libertarian. The socialist theory believes in “economic monopolies”, and the libertarian theory believes in “political monopolies”. When I say socialist theory I mean both the traditional Marxist approach to monopolies, and the more modern theory of monopolistic competition. And I discuss them separately. According to the libertarian theory, monopolies are always created by governmental laws. They are therefore political monopolies. This can take the form of a public company which is by law the only company in the market, or it can take the form of very few private companies that enjoy government protection and support. They are private in the sense that they are not owned by the state, but they are still protected by the political system and in return they offer political and financial support to politicians either legally or in the forms of bribes.

According to the libertarian theory, as long as there is no barrier to entry in the form of regulation, there is no monopoly irrespective of the number and size of companies in a particular market i.e. the market structure. The only condition of this theory is that anybody having the capital and will to enter into a market must be allowed to do so. Therefore this view of monopoly does not relate the concept of monopoly to the size and number of companies, but rather to an absence of pressure for decreasing costs and improving quality. 

On the other hand, the socialist theory of monopoly, which is by far the more widely spread and accepted, claims that monopolies are created by the free market, and therefore they are economic monopolies. According to this theory the state has to intervene to protect its citizens from the free market. What is crucial for this school of thought is the number and size of companies in a market.

The libertarian theory claims that monopolies are the result of government laws, which is quite straight forward, and therefore I will not discuss this theory any further. I will focus instead on the issue of economic monopolies and I will examine both the Marxist and the neoclassical theory of monopoly. 

Marxism and Monopoly 

Marxists in a way believe in the capitalist equivalent of “Chuck Norris”. They believe that capitalism leads to a capitalist that will beat all other capitalists, and employ and exploit all of us. And they therefore argue that capitalism leads to monopoly, and the only difference with socialism is that in capitalism the monopoly is run by a private tyrant that exploits everyone, while in socialism monopoly is run by righteous state employees that use their monopoly power for the benefit of their people.

In essence Marxists cannot distinguish between Microsoft and a state company. They do not see much difference between Microsoft, which derives its power from its ability to satisfy consumers, and a state monopoly which derives its power from the parliament. Actually Microsoft is a very good example, because it keeps improving its products and prices, without facing significant competition all these years. And the reason is that if Microsoft does not improve its products and lower its prices, one can keep using Microsoft XP and not upgrade to Windows 7. And if that happens profits will fall and the people that run the company will be fired. In other words Microsoft faces so much pressure without significant competition, simply by the threat of falling profits or the appearance of a potential competitor. Imagine if all these years there were another 5-6 companies seriously competing with Microsoft.

And the funny thing is that Google appeared out of the blue, and introduced the android operating system. And if tablets end up dominating the electronics industry as many people predict, the android system might threatens Microsoft’s windows. And this is not Linux or Mac, but Android which until very recently did not even exist. But that’s how capitalism works. And the truth is that Android did not appear out of the blue, but they were brought forward by another giant, namely Google. And this is where most people get it wrong. Because they think that since the small computer shop in their neighborhood cannot compete with Microsoft, no one can. But they forget that there are other giants in other sectors of the economy, that if they see profit opportunities in a market they can easily enter. They have the capital. The issue is whether there is enough profit to cover their investment. People tend to think that it is difficult to find the capital to compete with Microsoft. But they are wrong the issue is whether there is enough profit the costs. All free market companies are at the mercy of competition and consumers. And all consumers are at the mercy of political monopolies, which are immune from competition.

Private companies can indeed acquire monopoly power at some point of their economic life. But what is this monopoly power? If Samsung creates a new smart phone which we all want to buy, she will sure obtain some monopoly power. But what is this monopoly power? Isn’t this monopoly power exactly the same with consumers’ preference? For a private company monopoly power is nothing else than consumers’ loyalty. And government regulation is the monopoly power of political monopolies. But consumer loyalty and government regulation are very different forms of monopoly power. Samsung, or any corporate giant, cannot permanently enjoy the same consumer loyalty, since it is impossible to be always the first to understand what consumers want, and always be the best in finding the most cost efficient way to provide them with what they want. It is impossible for a management team to constantly come up with the best solutions, in the same way that it is impossible for a football team to always win the championship. And we should not forget that management teams have an expiry date. People die or they go to work for other companies. They leave Samsung for Apple and vice versa.

But even if a private company is always first in satisfying consumers, why should there be any problem? It means that this company is constantly improving quality and prices. On the other hand, if the government provides only one taxi license in a small island, the taxi driver has no motive to improve services and prices, because he has monopoly power. His taxi is a monopoly but not in the sense of large profits, but in the sense of no pressure for increasing quality i.e. buying a new car or reducing prices. Only political monopolies have the privilege to ignore the pressure for better services and lower prices. And therefore in the libertarian way of thinking the taxi is a monopoly and Microsoft is not.

And Marxists should answer a crucial question. Why capitalism did not lead to economic monopolies? Marx predicted so when he published “Capital” in 1867. Marx predicted in 1867 that the poor would become poorer and the rich richer, and that capitalism would end up with a small group of capitalists owning all the means of production and would exploit everybody else (for a discussion on the socialist myth of the poor who are getting poorer, see my document “Are the rich getting richer and the poor getting poorer?  Another socialist myth”). The average worker is much richer today than the average worker of 1867, and there are still plenty of companies producing salt in each country. How many centuries does it take for the markets of homogeneous products like salt, to become monopolized? Why there are still so many companies producing salt, chocolate, alcohol etc?

Concentration of Capital and Markets 

“Market concentration” usually refers to the market share of the 4-5 biggest companies of a particular market. The question however is whether companies become larger in the Marxist sense i.e. that one capitalist eats the other and wealth is constantly concentrating in fewer and fewer hands, with the poor becoming poorer an the rich richer, or whether they became larger due to cost factors, in order for lower prices to be achieved thus making more and more products available for everybody, including the poor. Because it is not enough to say that there are fewer and bigger companies in a sector than they were some years ago, to prove that the Marxist analysis is correct. If socialists are right, the fewer and larger companies in a market must have caused the production of lower quality and more expensive goods. If on the other hand increasing concentration led to higher quality and lower prices for goods, the Marxist analysis must be wrong, and there must be other factors i.e. cost factors, that led to increasing concentration. So what do you think? What has happened to the quality and pricing of products since 1867 when Marx’s “Capital” was published? Do workers today have access to more and higher quality or less and lower quality products than they had almost two centuries ago?

Therefore if socialists want to prove that Marx was right about capitalism, they have to prove that increasing market concentration leads to products that are of lower quality and higher prices (actually Marx was very wrong and most economists today agree on that, and I provide a simple explanation of why this is so, in my document “Why Marx was wrong”). Steven Lustgarten, in his article “Productivity and Prices: The Consequences of Industrial Concentration” showed that for the period 1947-1972, price increases were lower in industries with the highest increase in concentration, and in industries with the highest decrease in concentration, as compared to price increases in industries with relatively stable levels of concentration over time. He claims that changes in industry concentration were due to technological development which caused changes in the market structure and increased productivity, thus putting downward pressure on prices. While he claims that in industries that did not experience significant technological progress, concentration and prices tended to remain stable over time.

There is a lot of research on whether higher industry concentration leads to higher or lower prices. You should know that for every academic article that claims that higher market concentration leads to price increases, there is another paper showing the opposite. You just need to google expressions like “benefits of industrial concentration, benefits of market concentration, cost reductions-industrial concentration, why market concentration is good, which is the optimal market structure, benefits of mergers and acquisitions, prices and industrial concentration, innovation and industrial concentration” and you will find plenty of evidence.

People also tend to forget that large corporations are the sums of a huge number of capitalists. Millions of small, medium and large capitalists hold the shares of large corporations. And this was actually the reason that the institution of the stock market was invented i.e. to make huge projects feasible. Assume that there are 1.000 businessmen producing a particular product. And they then form a new company in which they all hold shares. Is there an increase in concentration? Well there is but isn’t this a pool of resources in a common effort to exploit economies of scale? In reality of course, not all of the 1.000 businessmen will hold shares in the new company, but some will go bankrupt instead. But there is an inherent risk in the business world and bankruptcy is a possibility for both a small grocery shop and a large corporation.

And to have an idea of the dispersion of ownership in large corporations, I provide the following links from yahoo finance. The following link states the largest shareholders of Microsoft

And this link states the largest shareholders of Apple

The largest individual shareholder of Microsoft is Bill Gates with 357 million shares, which represent less than 5% of ownership. And this man is the founder of Microsoft. The next biggest individual shareholder is Kevin Brian Turner with 1.5 million shares, which represent a bit more than 0% of ownership. The largest institutional shareholder of Microsoft is Vanguard Group with 366 million shares worth 12 billion dollars, representing less than 5% of ownership. And then there are few other institutional investors with a bit more than 1% ownership.

For Apple the largest shareholder is Arthur Levinson, with 162 thousands shares, which represent ownership of a bit more than 0%. The largest institutional investor is  again the Vanguard Group with less than 5% of ownership. And it must be noted that Vanguard Group is a company investing for millions of smaller investors. Consequently the ownership of large corporations like Microsoft and Apple is widely spread. Note that the data are not recent and my aim is not to provide up to date data, but rather to demonstrate the dispersion of ownership in big corporations.

I also want to give an example to show that market concentration is not necessarily something negative. Imagine an island where only cars and nothing else is produced. And there are let’s say 10 companies producing cars. After 10 years there are only 4 companies manufacturing cars but there is also a computer industry. Cars account for 40% of the island’s economy and computers for 60%. Has market concentration in the automobile industry increased? Well it did, but is this something negative? It is not because new companies appeared in other sectors. Isn’t that what we want? To produce what we already produced with less resources, in order to have resources for the production of new stuff?

Imagine 10 fishermen living in an island. In the beginning they are all fishing. Isn’t it a good thing if after some years, due to technology improvements, only 2 people are catching the same or even a larger amount of fish than before, and the other 8 people are producing something else? Doesn’t that make the island as a whole richer? If in 1950 there were 100 automobile industries employing 100.000 employees, and now there are only 40 companies employing only 50.000 employees, but at the same time these 50.000 employees are producing a larger quantity of higher quality automobiles than in 1950, it means that 50.000 people are freed from the automobile industry and can spent their time producing computers. That is what wealth creation is about. 

The price mechanism 

Non economists have a tendency to confuse the workings of the price mechanism with monopoly. And before explaining what I mean, I want to say a few words about the price mechanism. One of the strongest arguments against the Marxist model is that it does not allow the price mechanism i.e. the law of demand and supply, to allocate scarce economic resources. Without the price mechanism, the state has to decide how resources must be allocated. For instance the bureaucrats will decide that 100 oranges and 100 lemons will be produced without considering consumer preferences. Therefore if consumers prefer 150 oranges and 50 lemons they will not be able to manifest their preferences through the price mechanism.

In a capitalist economy on the other hand, excess demand for oranges and excess supply of lemons, would push orange and lemon prices upwards and downwards respectively, increasing and squeezing at the same time profitability for oranges and lemons. This would create new jobs in the orange market and a loss of jobs in the lemon market. The result would be a transfer of labour and capital from the lemon to the orange market. This process would stop when the market would reach a production level which would be in accordance with consumer preferences i.e. 150 oranges and 50 lemons. It is therefore this mechanism that signals that a transfer of resources must take place.

If Nokia manufactures a very good smart phone that we all want to buy, she will indeed be able for a while to charge high prices, since consumers will not consider smart phones sold by other companies as close substitutes, and they will have a strong preference towards the Nokia smart phone. Some companies might even go bankrupt, but you cannot blame Nokia for coming up with a better product. It is the price mechanism that will drive these companies out of business. The price mechanism will signal that the market needs more Nokia style smart phones, and it will manifest that through increased profits for Nokia and reduced profits for her competitors. Because that is what the price mechanism does. It shows through profit fluctuation where and how scarce economic resources should be allocated. And what is the price mechanism or the law of demand and supply? It is the needs of consumers on one side (demand), and the ability of the economy to satisfy these needs on the other side (supply). There is therefore nothing wrong with increasing profits in some sectors and decreasing profits in some others.  That is of course if the market is left to operate freely. If on the other hand the government intervenes excessively, increasing and decreasing profits might also show the relative power of interest groups that put pressure on government in order to gain privileges.

Moreover the libertarian competition model is based on what is called “innovation and imitation”. Companies struggle for a market share, and some of them manage to introduce new products and make large profits. The other companies will try to imitate the innovative companies, until they manage themselves to come up with something new. How easy it is for other companies to imitate depends on how sophisticated the product is. If for instance a company made large profits because it understood consumers’ need for more tomatoes, very quickly the other companies will increase production of tomatoes. If profits are due to a highly sophisticated and technologically advanced product, it will take some time for other companies to imitate or come up with something better. It might also be possible that the new product is protected by a patent and therefore the other companies have to wait some time before they are allowed to produce the product themselves. Patents should not be confused with government intervention. Patents must be protected in the same way that our home is protected otherwise businesses will not have a motive to invest on research and development of new products.

There is also the issue of “excess profits”. What do we mean by “excess profits”? There is no such thing as “excess profits”. By penalizing profits we also penalize the price mechanism which is the foundation of capitalism. And we should not confuse the cost of entering into a market with the profit opportunities that the market offers. If indeed a market offers profit opportunities new companies will enter. For instance if Samsung needs 1 billion euros to enter the automobile industry, she can find the capital to do so. Capital is not the issue for Samsung. The issue is whether the automobile industry has enough profits for one more player, or whether Samsung can come up with something better or cheaper than the products already produced in this market.

The free market anti-monopoly self defense 

There are many mechanisms that protect the free market from monopoly policies. These mechanisms ensure that there will be a continuous improvement in quality and a continuous reduction in costs and prices.

a) Substitutes For almost all products there are substitutes i.e. motorbikes, bicycles, public transportation are all substitutes for cars.

b) Potential Competition Even if there is only one company in a market, there is always the chance that new competition will appear. This company has a motive to continually improve its products and prices to discourage potential competitors. Microsoft’s windows and Google’s android is a good example. Only by government regulations can a company become immune to competition.

c) Demand Elasticity Demand for goods is never perfectly inelastic. For instance a dramatic increase in the price of cigarettes might lead consumers to quit smoking (actually taxes account for most part of the price of cigarettes). Or consumers can reduce the quantity they purchase or stop buying the new products of the company. For instance if Microsoft charges very high prices, consumers might decide to stay with windows XP and not buy windows 7.

d) Competition from all goods in the market People tend to think that a product only competes with similar products, which is not true. For instance a Fujitsu laptop does not only compete with an HP laptop. In reality all products compete with all products, because consumers’ income is limited and given. Therefore Fujitsu has to persuade a consumer to buy a new Fujitsu laptop and not a new bicycle or a new dvd player or take a short holiday instead. All companies compete with all companies in a free market.

e) Free International Trade As Milton Friedman said, the best defense against monopoly practices is to open the country to international competition. That is guaranteed to bring the lowest possible prices for consumers. And free international trade cannot lead to unemployment as I explain in my document “Free Trade or Protectionism? A Case for Free Trade”.

f) Division of labor and specialization. One of the main reasons capitalism managed to create this tremendous wealth in only 3 centuries, is the division of labor and specialization. Before capitalism that is before the market economy, every small society was organized as a self sufficient economic unit. Even families were organized as small self sufficient economic units. Each family would produce almost everything it needed. The market economy introduced the division of labor and specialization. Great businessmen became great because they had a specific talent. Bill Gates managed to create Microsoft, but that does not mean that he could be a successful businessman in the automobile industry, or that he could have made Microsoft what it is, without the help of millions of others i.e. employees, shareholders, scientists etc. I mean that Bill Gates is nothing on his own. He was clever in something, he had luck, but he is too insignificant on his own to control the world as Marx predicted, even with the help of some other mean capitalist friends. 

The neoclassical theory of monopolistic competition 

The Marxist theory of monopoly has long been discredited and it is rarely mentioned in academia. It is mainly used as a means of propaganda, as a means of convincing people that they need more government. In academia the neoclassical theory of monopolistic competition is taught, and even though it is a wrong theory, it is much more serious than its Marxist counterpart. Even though it is not probably correct to say that one wrong theory is more serious than another wrong theory, but anyway. The neoclassical theory of monopolistic competition can be found in most microeconomic textbooks if not all, and is taught in the best universities of the western world.

This theory is very strongly related to the supposedly superiority of equality over freedom. In the same way that we are taught that all people must be equal, we are taught that all companies must be equal. People that have studied economics will recognize egalitarianism as the basis of the neoclassical theory of perfect competition and monopolistic competition. Contrary to the Marxist approach this theory is in favor of a market economy but it recognizes as the PERFECT (and therefore ideal) form of competition, an economic environment where: a) There is a very large number of small firms b) The products produced are almost identical c) All consumers and producers have complete knowledge of the market d) There are no barriers to enter and exit the market e) Companies cannot affect prices i.e. they are price takers.

It is clear from the above that the philosophical base of perfect competition is equality (egalitarianism). In the same way that all people must be equal, all companies must be equal. After all, companies are simply an extension of people. Therefore to accept the above form of competition as perfect, is to indirectly also accept that the opposite i.e. a market with a few large companies that sell differenciated products, which have some control over their prices, and which have established some forms of barriers of entry i.e. successful brand names, is an inferior and problematic form of competition.

But they forget something very important. From all 5 characteristics of perfect competition, the element of competition is absent. The large number of small companies ignores the struggle of companies to grow larger in order to exploit economies of scale and become more efficient than their competitors. The assumption of identical products forgets that companies have to differentiate their products in order to make them more attractive to consumers, than their competitors’ products. The absence of barriers of entry means that companies should not establish successful brand names, or obtain high capitalization to exploit economies of scale. The assumption of perfect information forgets that one factor that separates successful from unsuccesful businessmen is the ability to communicate with customers. Finally to consider companies as price takers, is to ignore that companies must always struggle to find more cost efficient ways of production to obtain an advantage over their competitors.

Therefore the whole idea of perfect competition is totally incompatible with the notion of competition and perfectly compatible with egalitarianism. The economic environment it refers to is a business environment of zero competition and of equal business opportunities. It is clearly a socialist idea. And it is the idea of perfect competition that leads to the arbitrary assumption that a market with few large companies is not competitive. But this is not true. Large companies are the result of severe competition and of consumers’ pressure for better products and prices and not the result of monopolistic or oligopolistic competition.

The basic argument of monopolistic competition 

I will now present the basic argument of monopolistic competition by giving an example. It might look silly to someone that never took a microeconomic course, and yet it is on this silly idea that monopolistic theory is based. And the idea that the government should intervene to protect consumers from monopolies, is based on the theory of monopolistic competition, and therefore this silly idea that I will present have very important repercussions. It is actually a silly which is taught at all western universities.

Assume that there is a manufacturer of tables. He buys wood and produces tables. The more tables that he produces the lower their selling price will be. The latter follows from the law of demand and supply which says that a higher supply leads to lower prices (ceteris paribus).  This is a theoretical model and therefore prices are supposed to be know for different level of production i.e. the producer knows what the price of a table will be if he produces 100, 1.000 or 100.000  tables. He knows prices before even producing a single table. This is not realistic but this is only a theoretical model and not real life.

Let’s assume that he can sell each table for 10 euros if he produces 1.000 tables and 9.95 euros if he produces 1.001 tables. We see that the increase in quantity supplied generates a small fall in price from 10 to 9.95 euros or 0.05 cents. The thing is that the price fall does not only involve the last piece but all production i.e. each one of the 1.001 tables will be now sold for 9.95 and not 10 euros. And this is what makes the difference. Assume that marginal cost i.e. the cost of producing one more table, from 1.000 to 1.001, is 4 euros (fixed costs do not change with production). What would the producer do? Well by producing the 1.001th unit, he would incur a variable cost of 4 euros, would receive and additional 9.95 euros, and lose 0.05 for all the previous 1.000 units i.e. 1.000 times 0.05 =50 euros. Therefore the effect on his profits from the production of the 1.001th unit would be -50-4+9.95= -55.55 euros, and therefore he would not produce the 1.001th unit.

If on the other hand the company was operating in an environment such as the one described by perfect competition, the producer would be a price taker, and therefore he would go ahead with the production of the 1.001th unit. Because he would be a price taker, and therefore his production would not affect costs or selling prices. Therefore the situation would be the following. He would pay an additional cost of 4 euros, he would receive 10 euros for the 1.001th unit, since his increased production would not affect prices, and he would therefore increase his profits by 10-4=6 euros. He will then continue to produce until his marginal cost equals price i.e. MC=P. For those that have taken a course in microeconomics, what I am saying is that a monopoly produces until marginal cost equals marginal revenue i.e. MC=MR, while a perfectly competitive company produces until marginal cost equals price i.e. MC=P.

Therefore the dominant model of the neoclassical competition theory claims that the government should intervene to prevent companies obtaining significant market power, because significant market power will lead to higher prices and lower number of units produced, and therefore lower employment. Therefore the basic argument of monopolistic competition, and therefore of government intervention is that the “non-perfectly” competitive producer will take into account the effect that his production will have on the prices of his product, while the “perfectly” competitive producer will not take this into account.

And it is this model that determines government policies and not the Marxist nonsense. The Marxist monopoly nonsense is simply used to develop a corporate phobia to the public. Because it is much easier to say to the public that the poor are getting poorer and the rich are getting richer and that capital is increasingly concentrated in a few hands and bla bla bla, and that capitalism leads to monopoly, than explaining the neoclassical theory of competition. The Marxist approach is much more convenient for propaganda purposes. But policy makers in the Western world do not consider the Marxist nonsense at all. Policies are rather based on the neoclassical theory of competition.

Criticism to the model of monopolistic competition 

My criticism to the Marxist view of monopoly applies to the model of monopolistic competition too, and therefore I will not repeat it here. I will simply add a few things. As I already said, the key argument of the monopolistic theory is that big companies have some control over their prices, while small companies are price takers. But this is not a realistic assumption, since in reality all companies have some control over their prices, even the small ones. Moreover to penalize increased market concentration, is to give wrong incentives. Imagine a market with 4 big companies, where one of them has come up with a more efficient way of production. And the company wants to pass the reduction in cost to prices i.e. sell at lower prices. But if the company does so, it might increase its market share and drive some companies out of the market, thus making the state’s competition commission to take action against it. And therefore the company might decide to keep prices at the current level.

The other problem is that the government has to decide which price is low, reasonable or high. But how can a government decide that? If one invents a new vehicle that can fly and can substitute cars, how much should he charge for it? What should determine its price until competition comes up with something similar or even better? Should the price be determined by its cost, by the inventor’s intelligence, by its utility to consumers, a combination of these factors or something else? Why not let consumers decide what they are willing to pay for it? Is there really a better way to determine the right price? For an excellent criticism to the theory of monopolistic competition see chapter 2 of Dominick Armentano “Antitrust and Monopoly: Anatomy of a policy failure”, Brian Simpson “Markets don’t fail”, and Brian Simpson’s super article “Two theories of monopoly and competition”, which you can find at the following link 

The rhetoric of economic monopoly 

Politicians very often attack large corporations and multinationals because there is a huge dispersion of ownership and nobody pays much attention. People that hold significant numbers of shares are very few and they represent a very small number of votes. And politicians care about votes. Only with large number of votes they can remain in their office. And voters do not perceive attacking multinationals as an attack on their own interests, even when they hold some shares. But they should care because these companies are very important to them. And they are important not because they might hold a few shares, but because of the great products that these companies manufacture. But there is so much propaganda about big companies that people tend to be very suspicious towards them.

The truth is that the rhetoric of monopoly is always put forward by small less competitive units, in order to protect themselves from competition from larger and much more efficient producers. Small production units i.e. farmers, always represent more votes than big companies, and they therefore can exert much more political pressure. But people tend to think the opposite. That is they believe that the 50-100 largest companies of the country, actually run the country. But this is very wrong. Sure the political system can have and almost always have linkages to these companies, and might receive financial support or even bribes in corrupted countries, but it is always the large number of voters that keep politicians in place. And politicians care much more about gaining the support of strong guilds than the support of multinationals. Multinationals cannot keep politicians in office, but strong guilds and syndicates can. It is always and everywhere true, that the rhetoric of monopoly is in reality used to protect less efficient production units from competition and leads to higher and not to lower prices for consumers as politicians claim all the time.

I mean that the rhetoric of monopolies is used to cause corporate phobia to the public, and thus justify the introduction of regulations which are supposed to protect consumers from higher prices, but which are in reality meant to protect small inefficient producers that represent significant voting power i.e. farmers, or to protect large domestic producers from more efficient foreign competitors. In either case the result is higher prices for consumers.


If after reading this document one agrees that large companies and high market concentration is not necessarily something negative, one has to also realize that it is not possible to have very large numbers of very big corporations. Germany cannot have hundreds of automobile companies, because such economic sizes require huge amounts of capital to operate. And the economy does not only need automobiles, but it also needs medicines, food, houses, computers etc, and therefore there must be some champions in all economic sectors. The more the German economy grows the more automobile companies she can have, if that is what German people want.

What I mean is that there are few large corporations in the automobile industries because large economic size is required to produce better and cheaper cars, and there are not hundreds of such companies because an economy cannot afford to have many such companies, and not because capitalism leads to monopoly. An economy can only afford to have a few giants producing something. Some countries cannot afford to have any such companies actually. Therefore if we want highly sophisticated products at good prices, we have to see large companies as something positive, and at the same time we should not expect to see hundreds of them. The question then is what do socialists want? Do they want many small automobile, computer, airplanes companies to be happy and stop saying that capitalism leads to monopoly? Do they want each city to produce its own cars and airplanes in the same way it produces its own bread?

The wise thing to do before calling a market monopolistic is to observe whether there is pressure on the company or companies in this market to improve quality and prices. In my opinion the problem with these big companies is that they are under so much pressure to satisfy their clients and generate profits that they might sometimes do things they should not do. But I do not worry at all that they take consumers as granted and charge unreasonable prices.

 If you liked this essay you might want to have a look at some of the following essays too:

Conspiracy Theories About Israel

The Energy War Between U.S.A. and Russia and the Threat for Israel’s Survival

The Socialist Myth of the Greedy Banker

The Socialist Myth of Economic Bubbles

The Socialist Anti-Semitic Myth of the Creation of Money Out of Thin Air

Introduction to Banking


The Socialist Myth of the Greedy Banker and the Creation of Money

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Why Private Banks Cannot Create Money

Iakovos Alhadeff

Most people are convinced that private banks are responsible, or at least mostly responsible, for the current economic crisis. The truth is that the crisis is the outcome of the policies followed by the political systems of the U.S.A., the E.U. and China. But I describe the major causes of the crisis in my essay “The causes of the economic crisis”, and therefore the purpose of this document is not to explore them, but rather to explain in very simple words, why private banks are not at all responsible for the crisis, since they cannot “create” money. Even though I have postgraduate studies in economics I am not a specialist, and this document is the knowledge I gathered in an attempt to answer my own questions. Moreover English is not my first language and you will have to excuse my syntax.

To show that private banks cannot “create” money, is very important since excessive money creation in the U.S.A., the E.U. and China, was one of the main causes of the current crisis. Equally important is to explain why excessive money creation is always and everywhere a government act. What happened in reality is that excessive money creation was simply used to accommodate the unsustainable fiscal policies followed for years by many countries. Unfortunately it is much easier to notice the private banks credit expansion with the abundance of cheap credit, and the resulting bubbles, and much harder to realize that it was state policies and laws that dictated such expansions and led to bubble creation.

Since the average person is well aware of the credit expansion and the inflationary money of the pre-crisis era, it is not unreasonable for him to assume that the cause of the crisis is the “uncontrollable” and “unstable” private banking sector. But if a person is mistakenly convinced that the private banking sector is responsible for the crisis, a very reasonable response would be to ask for more government regulation. Wouldn’t that be the most natural response? I therefore believe that it is of great importance for the general public to realize that private banks cannot create inflationary money. Only governments can do so by introducing relevant laws as I explain below.

In order to do so, I use various economic examples to show that private banks cannot “create” money. First I use an example where private banks issue their own bank notes and there is no central bank. In the second example private banks still issue their own bank notes, but there is also central bank that only keeps the private banks’ gold at its vault, and clears their transaction. In the final example which is very realistic, there is a central bank that issues bank notes, which keeps at its vault all the gold, and that clears the transactions between private banks. But the bank notes it creates are still backed by gold. I show that in all cases private banks cannot create money. Then I explain why it is only the government that can create money, and I show how and why it does so. At the final part of the document I explain why conspiracy theories about central banks are not true.

But first of all, what do we mean by “inflationary money”? What do we mean by “excessive money creation”? The best description in my opinion is the following: “Inflationary money refers to an increase in the supply of money that is not matched by an increase of equal value in production”. For example there is an economy with 2 tomatoes and 2 dollars, and each tomato costs 1 dollar. A third dollar is now created, that is not matched by the production of a third tomato. Therefore the price of each tomato increases to 1.5 dollars, which means that the new dollar was inflationary. This is actually a way for the issuer of the third dollar to tax the 2 existing tomatoes.

In my document “Central Banks for non-Economists Part 1: Inflation and Taxation”, I explain the relationship between money creation and taxation, and therefore in this document I will not elaborate on the relationship of inflation and taxation. I will only say what is necessary for the purpose of this essay. I will therefore show with this document that in a free market system, private bankers cannot create money and tax the current wealth. A free market banking system is exactly the opposite from the banking system we know. And I am not saying that when the state follows an aggressive monetary policy, private bankers do not make big profits. They do make big profits at such times. But this has nothing to do with the evil private banking sector. When there is lots of money around, they make big profits because their job is to buy and sell money. In the same way that someone who sells nails makes lots of money if huge amounts of nails are bought and sold. This does not change the fact, that paper money is the most important state monopoly. But before I explain why private banks can not create inflationary money in a free market economy, I would like to say a few words about why it is good for an economic system to have a form of “money” (a medium of exchange), and a banking sector. After all, this document is written for non economists.

In a barter economy without any generally accepted medium of exchange, that is without a good that everybody accepts as a means of payment, a person wishing to sell his tomatoes and buy oranges, would have to find someone who sells oranges and wants tomatoes. This can be a very difficult and time consuming task. On the other hand if everybody accepts a good as a means of payment, i.e. gold, olive oil, paper money etc, this problem ceases to exist. If I want to sell tomatoes I simply have to find someone looking for tomatoes, and with the medium of exchange that I will receive, I will buy the oranges I want. This is a much more efficient way to trade, and it leads to much higher levels of productivity and welfare.

Moreover, the orange producer needs a way to store the value of his production surpluses. If he needs 100 oranges per year but he produces 200 oranges, he must somehow store the value of his surplus i.e. the 100 oranges. He therefore needs a non perishable good, that everybody accepts as a medium of exchange, in order to store his surplus of 100 oranges. This can be a good that can last for a long time i.e. olive oil, but silver, golden and other metal coins, or paper money, are much more suited to serve as mediums of exchange. There are more reasons why an economy needs a medium of exchange, but the above will suffice for my purposes.

Now I want to say why an economy needs a banking system. The farmer of the previous example had a surplus of 100 oranges. There is another farmer that is willing to pay 110 oranges in a year’s time if he borrows these 100 oranges today. But the other farmer is reluctant. He does not know if the borrower is capable of repaying the 100 oranges, and he does not want to risk his surplus. But if there is a specialist who can evaluate the borrowers’ creditworthiness, this problem ceases to exist. This specialist is called a bank. It could be called a money merchant or anything else. But these experts are called banks. There is no difference between a real estate agent and a money agent. One is an intermediary in transactions involving property and the other is an intermediary in transactions involving money. The above explanations of the usefulness of a common medium of exchange and of a banking system are enough for this document. After all nobody disagrees.

My starting point will be an economy with no money and no banking system. There are only farmers producing oranges. Farmers producing more oranges than they consume, worry about their surpluses. They are afraid that someone might steal them when they are absent. There is therefore demand for places to deposit these surpluses for greater security. New companies are created then, with huge vaults, where farmers can store their oranges. Let’s call these companies banks. Farmers store their surpluses in their vaults, and can go whenever they want to take oranges for personal consumption or commercial purposes. I assume for a minute that oranges do not perish, and therefore they can serve as a store of value.

When farmers deposit oranges at the banks, they receive paper receipts. An orange and the number “1” are stamped on each receipt. All receipts are identical, except that each one carries the name of the issuing bank. Gradually farmers start to use these receipts as money. They find it more convenient to do so, instead of carrying oranges around. We now have a monetary economy with a banking system. People do not exchange oranges but paper representing oranges. However citizens want a medium of exchange that is more convenient than oranges. They therefore start using gold, which is much better suited to serve as a medium of exchange than oranges. Now gold is not only used for jewellery but as a means of payment too. In the same way that some people work to produce oranges, some others work to extract and process gold. One should not confuse gold with paper money. Gold is a good like all other goods. Someone has to work hard to extract and polish it, and it has real value. Paper money on the other hand has no intrinsic value. Its value derives from a governmental law establishing as the legal and only means of payment.

The price of gold is affected by the same factors that affect the prices of all other goods in the economy i.e. its availability, demand and supply for gold, improvements in mining techniques, changes in tastes etc. Gold is a good like all other goods (oranges, wood, wine etc). It is not like paper money that has no intrinsic value. Gold simply possesses some special characteristics that make its use as a medium of exchange ideal. Therefore economic agents trade their goods for gold, and deposit their gold at the bank, which in turn issues and gives them a paper ticket (bank note). Let’s call these bank notes “1 gram of gold” notes. All bank notes are “1 gram of gold” notes, and the issuing bank’s name is written on these notes. Banks are obliged to redeem these notes for 1 gram of gold, if the bearer wishes so.

These papers are exactly the same with 1 dollar notes, except that “1 gram of gold” is written on them instead of “1 dollar”. Actually the main difference is that you cannot redeem dollars or euros for gold, while you can do so for the bank notes of my example. The bank notes of my example have real value. They do not derive their value from a law, but from the gram of gold that backs them (or from the oranges that backed them before I introduced gold into my example). And for simplicity I assume that there are only “1 gram of gold” bank notes, and the economy is only producing oranges and gold, and that oranges exchange for 1 gram of gold, and the price is fixed. All very unrealistic assumptions but they enhance intuition which is my aim.

Why private banks cannot create inflationary money

Now I turn my attention to the private banker, to whom all socialists attribute the crisis. As expected, the private banker wants to sell as much of the medium of exchange as he can, whether the medium of exchange is olive oil, whether it is golden coins, or paper money or whatever, because this is his job. This is what he does. In the same way that someone selling nails wants to buy and sell as many nails as he can, the banker wants to buy and sell as much money as he can. The more he buys and sells the more profit he makes, exactly like the nails merchant. If the interest on deposits is 5% and interest on loans is 10%, and the private banker lends 100.000 dollars, he will make 5.000, if he lends 1.000.000 he will make 50.000 dollars, if he lends 10.000.000 dollars he will make 500.000. The same principle applies whether you buy and sell nails or money. The more you buy and sell the more profit you make, assuming of course that each sale carries a profit mark up. Therefore it is very normal and very healthy that the private banker wants to lend as much as he can, given of course his customers are creditworthy.

We now have to think whether a private bank can “create” inflationary money if it wishes to do so. And the answer is of course no.   Let’s imagine a private bank, in which farmers have deposited 1.000 grams of gold, and which has issued 1.000 “1 gram of gold” notes, with its name on them. Therefore the issued bank notes are 100% covered by gold, which means that each bank note issued corresponds to 1 gram of gold in the bank’s vault. This bank now wishes to issue another 9.000 bank notes in order to lend them and make more profit. But the bank does not have another 9.000 grams of gold. Therefore these new notes will be inflationary notes. They will be money creation from thin air. Can the bank do so? No, it cannot as I already said. If X Bank attempts to do so, it will go bankrupt very soon. And here is why.

Imagine that the bank issues another 9.000 bank notes, and lends them to some customers in order to charge interest. The customers that will receive the “fresh” notes will use them to finance their activities, thus giving them to other economic agents, who in turn will deposit them to their domestic or foreign banks. The domestic and foreign banks that will receive the new bank notes will send them to the issuing bank to redeem them for gold, as the issuing bank is obliged to do. And more specifically they will require 1 gram of gold for each bank note. But the issuing bank has only 1.000 grams of gold in its vault, and therefore will not be able to redeem the banknotes. Therefore the issuing bank will go bankrupt shortly after the credit expansion.

In the banking system I just described, banks have to send loads of gold to each other every day, in order to clear their customers’ transactions. This is very inconvenient, and I will therefore introduce a central bank in my example. The private banks will continue to issue their own bank notes, and the central bank will simply hold their gold and clear their transactions. For instance when X Bank receives a bank note from Y Bank, it will send it to the central bank. The central bank will take a gram of gold from Y Bank’s box, and put it in X Bank’s box. Once the transfer of gold has taken place, the central bank will return the bank note to Y Bank, since the debt was fully paid. In a banking system like the one I describe, bank notes resemble bank checks, since the bank’s names are written on them.

The inclusion of a central bank into my example does not change much though. The private banks cannot create money for the reasons I described before. If Y Bank has “created” inflationary money, which means it issued more bank notes than the grams of gold it has at the central bank’s vault, it will go bankrupt. Assume farmers deposited 1.000 grams of gold at Y Bank, and Y Bank issued 1.000 bank notes of 1 gram of gold each. Now the bank issues another 9.000 bank notes not covered by gold i.e. inflationary money, and lends it to a customer. The customer buys something and the new bank notes end at X Bank. X Bank sends these bank notes to the central bank, and the central bank finds in the box of Y Bank only 1.000 grams of gold instead of 9.000 grams. The central bank therefore does not clear the transaction. Therefore the introduction of the central bank did not change anything.

Now let’s examine what happens when the central bank not only holds the private banks gold and clears their transactions, but in addition is the issuer of the economy’s paper money. But each bank note issued by the central bank issues is still covered by 1 gram of gold, as was the case in the previous examples. Can private banks now create inflationary money? No they cannot. For the central bank to issue a new bank note, someone will have to deposit in its vault 1 gram of gold, that someone being the government or a private bank (on its behalf or on behalf of a customer). Each private bank receives a bank note from the central bank, for each gram of gold it sells to the central bank. In other words, for each gram of gold that goes in the state’s box of gold at the central bank. Not for each gram of gold that the private banks deposit in their own box at the central bank’s vault. Bank notes are only issued when a gram of gold goes to the state’s box of gold. Therefore the country’s bank notes are real bank notes. For each one of these notes there is one gram of gold (at least) in the state’s box of gold at the central bank’s vault. They are “golden” paper notes.

I will use a full transaction as an example. I sell 1 orange to a person that extracted 1 gram of gold. Remember that I assumed oranges sell for 1 gram of gold. I then deposit this gram of gold at X Bank. X Bank has two choices. One is to buy the gold for itself and send it to the central bank for the latter to deposit it in X bank’s box of gold. Alternatively X Bank can send the gram to the central bank for sale. The central bank will then issue a “fresh” bank note, and send it to X Bank. The central bank will then put the gold in the state’s box of gold (and not in X Bank’s box). I, the seller of the orange, will take a bank note of 1 gram of gold in both cases. In the first case an existing bank note and in the second case a “fresh” one. I can give this bank note back to X Bank and open a deposit account or take it and leave. I use this example to emphasize that for a “fresh” bank note to be created someone has to put a gram of gold into the state’s box of gold. This is very important. And it is a very reasonable, since each bank note created represents for the country a debt of 1 gram of gold, whether this bank note is held by a local or a foreign citizen. And in order for the country to be able to redeem all the bank notes issued for 1 gram of gold, there must be (at least) 1 gram of gold for each bank note issued, in the state’s box of gold. That is why I call the banknotes “golden” notes. If these bank notes are not backed by gold they are not “golden”, they are simply paper deriving their value from a relevant law. Issuing “golden” bank notes is very healthy, since they represent real production surpluses and savings and not inflationary paper.

So, can a private bank in this environment “create” money if it wishes to do so? The answer is again no. If X Bank issues new loans, and gives let’s say bank checks to some customers (remember that now it is the central bank that issues the paper money), the customers will give these checks to other economic agents, these other economic agents will deposited these checks in foreign and domestic private banks, and eventually they will end up at the local central bank to be cleared. The central bank will not find enough gold in X bank’s box, and it will not clear the transactions.

We therefore see that private banks cannot create inflationary money under any circumstances. I hope it is now clear why the document is titled “the myth of the greedy banker”. Only the state through governmental laws, and through its monopoly as an issuer of paper money, can create inflationary money. Inflationary money is as I already said, money not covered by production surpluses. It is money that does not represent citizens’ savings, but it is rather a new government claim on the citizens’ savings. I must also say that a country does not have to produce gold. It can produce other goods and exchange some of them for gold. Gold is simply a good like all other goods.

Creation of money by the government

I hope that it is clear by now that private banks cannot create inflationary money. The problem for a political system with a banking system as described is that the government cannot create money either. And governments have only 3 ways to finance their deficits. The first one is taxation, the second one is domestic and foreign borrowing, and the third one is by printing new inflationary money. As I explain extensively in my other document, printing money is taxation through inflation. Inflation is a way of taxation that most governments very often prefer to use. Taxation is very unpopular, borrowing requires confidence on behalf of the lender that you will honor your obligations and carries the cost of interest, while printing money does not require a third party’s confidence in the government’s policies, it does not carry interest, and it is not as unpopular as taxation. Of course increasing the money supply increases inflation, but most people do not realize that inflation is taxation. Therefore taxation is more unpopular than inflation. If a government goes too far with the printing press though, it can cause very high levels of inflation, or even hyperinflation, with catastrophic consequences for the economy. But in the short run political parties tend to overlook the long run consequences.

I now want to describe the difficulties that a government faces under the gold standard, in its effort to finance deficits by printing money. To make things simpler, let’s start from day 0. Citizens have no savings in gold or oranges yet. They now start producing oranges and gold. Some of them produce oranges and some produce gold, and it is gold that serves as a medium of exchange and a store of value. Producers of oranges, exchange their surpluses with gold, and deposit gold at the bank. Similarly, gold miners exchange their gold for oranges, and deposit whatever quantity of gold is left at the bank. Note that the deposited gold does not represent only the past surpluses-savings of gold in the economy. It represents the surpluses-savings of all goods and services in an economy. When I exchange my extra orange for 1 gram of gold, and I deposit that gold at the bank, that gold represents a surplus of 1 orange that was stored in gold. I mean that the deposited gold at the banks represents all surpluses, all savings in the economy. Surpluses in oranges, surpluses in haircuts, surpluses in gold, surpluses in cleaning services etc, that are all converted and stored in the common store of value, which in my example happens to be gold. In my example gold is the only way to store value, but in reality this is not the case.

The private banks now deposit the citizens’ gold at the central bank, and the central bank issues new “1 gram of gold” bank notes. These notes could be called something else. They could be called dollar notes, or euro notes or whatever. I prefer to use the name “1 gram of gold” notes to emphasize that these notes are “made” of gold, they are backed by gold. Let’s assume now that there is 1.000.000 grams of gold deposited at the state’s box of gold in the central bank, and 1.000.000 “1 gram of gold” notes circulating in the economy.

Even though it makes no difference for my analysis, in order to be a bit more accurate, I have to add that the price of orange and gold would not be fixed in reality. The banknotes are indeed backed and redeemable for 1 gram of gold, but that does not mean that they will always buy 1 orange. The relative price of gold and oranges will vary according to weather, demand and supply, changes in tastes etc. In other words bank notes will always be redeemed for 1 gram of gold, but that gold might buy 1 orange, or 2 oranges, or half orange, depending on the prices prevailing at the market. But this should not be confused with a general increase of the price level that arises as a result of inflationary money creation. Relative prices must change when market conditions change.

So, we have 1.000.000 grams of gold in the state’s box at the central bank, and 1.000.000 “1 gram of gold” notes circulating in the economy. Let’s suppose that the government wants to issue some more “1 gram of gold” notes, to finance its deficits and avoid taxing its citizens. Can the government do that? Well for a while it can. I assumed that the total gold of the economy is 1.000.000 grams, and let’s say that 100.000 of these grams belong to the state. But the government decides to host the Olympic Games that cost 200.000 grams of gold. The treasury issues a check of 200.000 grams of gold, and gives it to the contractor. The contractor deposits the check at X Bank, in order for the latter to clear it. X Bank in turn sends the check to the central bank for the latter to clear it. The thing is that in reality, the gold is not kept in separate boxes with a bank name written on each box. It is placed all together at the central bank’s vault, and the central bank holds electronic information about the owners of that gold.

Therefore when the central bank receives the check issued by the treasury, it sees that the state’s gold of 100.000 grams is not enough to cover the expenses. However, contrary to what it would do for a private bank, it credits X Bank’s account with 200.000 grams of gold and says that everything is ok. X Bank then credits the contractor’s account, and the contractor starts preparations for the Olympics. The country now owes 100.000 grams of gold. In accounting terms this appears as a debt of the government to the central bank, but in reality it is a debt of the government to its citizens. Except that the citizens do not know that the just lent their government 100.000 grams of gold. Alternatively, instead of a check by the treasury, the government could have ordered the central bank to create 100.000 new notes. The central bank would create these notes pass them to the treasury, and write in the central bank’s books a government debt of 100.000 “1 gram of gold” notes. The treasury would pay the contractor, who would deposit these notes at X bank. X bank would open a deposit in his name and send the bank notes to the central bank in order for the latter to transfer 100.000 grams of gold in its box. The central bank would credit X bank’s gold account which would match the debt created by the government. I think the case with the check is better for illustration purposes. So you better think of this transaction in terms of the treasury check. But both cases are exactly the same. In both cases what happened is that the central bank owes a private bank 100.000 grams of gold, and the government owes the central bank 100.000 grams of gold. In reality, it is of course the government owing to its citizens 100.000 grams of gold, since the central bank is only a governmental institution.

The government just created money. But it did not created new wealth. It simply used its citizens’ accumulated wealth to finance the Olympics. This will of course appear as a debt of 100.000 grams of gold when the government prepares its financial statements at year end, but who notices? Everybody is happy. Everybody got their money. And the government did not have to tax anybody, and did not have to borrow any money. Only inflation was affected. But who cares when inflation is low? The problem for the government under the gold standard is that this artificial money expansion increases demand, it increases the price level, the country becomes more expensive and starts losing its competitiveness, imports start rising and exports start declining. The economic agents abroad that receive the country’s bank notes as a payment for their sales send these bank notes through their central banks, to the domestic central bank, in order for the latter to redeem it for gold.

Therefore if the government is very active in creating inflationary money, the country’s gold reserves will start declining. People will start doubting that the government will be able to redeem its bank notes for gold, and there will be a confidence crisis. Even domestic citizens might start redeeming their bank notes for gold. But there is not enough gold to pay for all bank notes in circulation, since the government used much of it for its expenditures. At some point the government will have to either abandon the gold standard all together i.e. stop redeeming the bank notes for gold, or change the exchange rate between bank notes and gold i.e. say that it will exchange each bank note for half instead of 1 gram of gold. Thus the gold standard imposes much more discipline on a government’s fiscal policies. On the contrary if the government passes a law, as is the case in all countries, imposing its paper money as the legal means of payment without promising to redeem it in gold, there is no limitation on the creation of inflationary money.

Now the bank notes do not derive their value from gold but from the law, and the government can create as much money as it wants. Well, almost as much, because excessive use of inflationary money as a means of taxation can lead to catastrophic hyperinflation. The point is that the gold standard imposes much more discipline on a government, and it is no surprise that governments do not like such regimes. It is no surprise either, that socialists hate the gold standard and libertarians love it. Because it is socialists that like excessive taxation, and since direct taxation is unpopular, they prefer to use the indirect taxation of monetary expansion. Libertarians do not favor big public sector and excessive taxes and they therefore love the gold standard as a barrier to socialist policies.

To make things simpler, think about it in the following. If society’s savings are a pile of gold, and the government takes some of this gold without taxing, it will have to pay back with gold. But the government does not have gold. But if, as it happens in all countries, the government passes a law that imposes paper money as the legal and only means of payment it is in effect forcing its citizens to save their surpluses in paper money. Now if the government can take some of the savings without taxing the citizens. If the citizens ever ask for their money back, the government can always print new money and pay them. But this paper will buy much less than it used to. Of course it is possible to save in gold but it is not as convenient. And therefore most people will hold their savings in the form of paper money. The honest thing for a government would be to back paper money with gold.

The gold standard and budget surpluses

As I already said, the gold standard is a regime favored by libertarians and of proponents of small public sectors in general. This rule prevents politicians, or at least makes it much harder for them, to follow policies based on budget deficits. There is another way however to prevent governments from creating deficits, and this is by passing a law requiring governments to have on average budget surpluses.  Some political systems in developed countries do so, as a means of self discipline. In Sweden for instance, there is a law imposing budget surpluses of +1% on average. That means that deficits are allowed, but they will soon have to be reversed. But such laws are not welcome at all by socialists, since they are even stricter than the gold standard. Under the gold regime as I described above, at least temporarily, a government could finance a deficit by monetary expansion. The law of budget surpluses makes life for socialists even tougher since they can only use taxation to finance their projects. There is also a softer version of this rule that allows deficits but only if they relate to public investment i.e. road networks, harbors etc, with the hope that such investments will increase the country’s GDP.

Central banks and conspiracy theories

The main idea of this document is that there are no fat greedy bankers, but rather fat greedy governments and politicians. However there is one last issue which is the conspiracy theories about central banks. Such theories claim that central banks print money for themselves and this is the cause of the crises. In other words they claim that it is not that central banks are directly or indirectly at the mercy of their political systems but the other way round. The following link has a lot of information about conspiracy theories concerning the Federal Reserve Bank, which is the central bank of the U.S.A.

Such conspiracy theories are everywhere and always supported by populists, or by people that are not very educated or intelligent, and they have a tendency to believe populists.  Political systems in developed countries try to make their central banks as independent as possible, in order to protect their monetary policy from political cycles. They do so in order to put a barrier between politicians and the money machines. And they do so with laws that they pass in their own parliaments. For instance the board of the Fed, is appointed by the president of the United States of America and approved by the congress, but the president cannot terminate the chairman’s tenure once he is appointed. They do so because they do not want the chairman of the central bank to be at the mercy of the president and the congress. They want the chairman to have some degree of independence in order to be able to resist pressures on behalf of the congress, to follow more expansionary policies. Because the truth is that politicians tend to focus on short rather than long term consequences.

The problem is that political systems do not provide enough independence to their central banks. For instance by law the Fed’s goals are price stability and low unemployment. The same applied for the central banks of the socialist southern European countries. However this was not the case for Germany. Bundesbank’s goal was set by law to be only price stability, and this partly explains the superiority of the German economy, since the political system had to be much more disciplined. Because when you include low unemployment as a goal of the central bank, the central banker is at the mercy of politicians. Politicians know that if their irresponsible fiscal policies lead to high unemployment, the central bank will have to step in and give them a hand in the form of monetary expansion, since it is required by law to do so. But an increase in paper money can only have short run positive effects and will definitely has very strong long term negative effects. Therefore this commitment of the central bank to intervene in case of rising unemployment gives negative incentives to the political system. If on the other hand the goals of central banks were only price stability and the stability of the financial system, politicians would be much more cautious and disciplined.

But even when low unemployment is one of the central bank’s goals, the economists from the academia that that run them, are a significant obstacle to the political system since they do not have to worry about political cycles. And this is the reason that socialists and statists want central banks to be at the absolute control of the political system. And they circulate conspiracy theories about central banks, in order to convince ignorant people that central banks should be stripped from any form of independence. They want the money machine under their complete control. When politicians have the money machine under their control, they can do the following. Suppose there is a 3 people economy, the president and two citizens. The president wants to take a dollar from John and give it to Nick. He can print 3 dollars give 2 dollars to John, and 1 dollar to Nick. If you take into account inflation, the net effect was to give 1 dollar to Nick. But John is happy too. He got a dollar. He did not realize that 1 dollar was taken from him. He thinks 1 dollar was given to him. He only notices inflation. This is the reason that politicians do not want economists running central banks. In less developed countries the money machines are indeed at the mercy of the political system, in the way that statists and conspiracy theorists want them to be. Only in the developed word central banks enjoy some degree of independence.

The Fed has indeed shares which are held by all the private banks operating in the U.S.A. But banks are required by law to hold the Fed’s shares. And by the same law they have to keep a part of their funds with the Fed. But private banks do not have a saying on the conduct of monetary policy which is determined by a board appointed by the president and approved by the congress. Moreover all the interest earned by the Fed is returned to the treasury at the end of each year (for more details see the link I provided above).

I will therefore conclude by saying that contrary to what conspiracy theorists suggest, the problem with central banks is that they do not have enough independence and they have to accommodate irresponsible fiscal policies. The most famous case is of the northern and southern European countries. The northern European countries provided much more independence to their central banks and they always outperformed the southern countries in economic terms.

If you liked this essay you might want to have a look at some of the following essays too:

Conspiracy Theories About Israel

The Energy War Between U.S.A. and Russia and the Threat for Israel’s Survival

The Socialist Myth of Economic Monopoly

The Socialist Myth of Economic Bubbles

The Socialist Anti-Semitic Myth of the Creation of Money Out of Thin Air

Introduction to Banking