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example, in the 1930s, the Federal Reserve Board reduced the money supply by one-third while Congress simultaneously passed legislation to maintain prices at 1920s levels. Farmers were paid to bum potatoes and plow under cotton crops to create high prices. (Many farmers in the 1930s used mules for plowing, and mules have a reputation for being dumb. But to plow under a crop, the mule had to walk directly on the plants, and it was said that the mules refused to do it. One editorialist suggested that the mules knew more about economics than the govemment.) Merchants were rewarded with a "Blue Eagle" insignia in their windows if they adhered to artificially high govemment price guidelines, and Roosevelt in his "fireside chats" encouraged consumers to shop only at Blue Eagle stores and to snitch on merchants who violated the guidelines. Labor legislation empowered and encouraged unions to increase their wage demands and stopped industries from instituting wage reductions. The result was that real wages increased during a period of declining output and widespread unemployment. For some reason, it never dawned on govemment officials that a de crease in the money supply would necessarily result in lower prices! The result, of course, was the most prolonged recession in U.S. economic history.

Our govemments spending and monetary policy altemates between inflation ary booms driven by easy credit policies, followed by busts resulting from the tightening of money and credit to control inflation. It is our govemments policies of deficit spending and control of the money supply through the Federal Reserve

system that make it virtually impossible for modem Americans to imagine prosperity during a period of price declines. But wouldnt it be incredible to be able to put money in the bank and actually have its purchasing power increase without worrying about price inflation? Can you imagine how fast the prices of high-tech items would drop when you combined the effects of technological improvements, competition, and deflating prices because of the increasing purchasing power of the dollar? The major point is that business declines are not caused by, and do not necessarily have anything to do with, declining prices.

The miser, at worst, by removing money from circulation can have only a limited effect on prices and the markets. Assuming that the money supply is static, prices will eventually adjus t to a higher level as the result of his actions. If the money supply is continually increasing relative to other goods and services, as is presently tme, then his money will lose purchasing power. If a miser stuffed a million dollars into his mattress in 1940, it would today be worth only $120,000 in terms of relative purchasing power. So the miser really only hurts himself with his hoarding.

There are many alleged justifications for govemment regulation of money and credit, but among the most influential is Keynes argument that saving is unproductive-that business declines are caused by "underconsumption," which means hoarding. For years, saving has been equated with hoarding, but I have just shown that the most foolish of misers really does no damage except to himself by stuffing money into his mattress.

The average saver is not a miser, but rather puts money into the bank or into other institutions and instmments which make savings available for use in the credit market. This kind of saver entmsts another person or institution to keep his money in retum for the benefits to be derived from their management of his savings. It is this kind of savings that provides the fuel for an expanding economy. In addition, the higher the level of savings, the lower the cost of credit-its a simple matter of supply and demand.

The principle is no different than Cmsoe saving food so he would have time to build shelter. It just happens on a more abstract level and at a more accelerated pace through the process of credit transactions.

A credit transaction is an agreement to loan either goods or claims on unconsumed goods (money) to another person or group in retum for repayment, usually plus interest, after the passage of some time period. The exchange is based on the lenders confidence in the borrowers ability to pay out of future production. If the borrower makes good on his loan, he exercises his borrowed claims (he spends the money) but also produces enough new wealth to replace them with claims of greater value (the principal amount plus interest). The positive difference between the value borrowed and the value retumed is the lenders retum for not consuming now.

If the borrower defaults, what actually happens is that the claims for the goods are exercised, the

goods are at least partially consumed, and not enough new wealth is produced to replace them. The creditor is left with the burden of redeeming what

value remains of the debtors holdings. The difference in market value between what is loaned and what is redeemed is a loss-wealth is consumed-the goods no longer exist in their formerly marketable form.

A credit exchange is neither a gift nor a grant; it is a trade just like any other on the market. The borrower, whether an individual or a group, earns and builds credit by consistently producing and meeting obligations undertaken in exchange agreements (contracts). The money may be borrowed for investment or consumption, but either way the exchange is money or goods for a promise to pay. The lender chooses to loan the money rather than consuming it himself or investing it in his own pursuits, and in so doing puts confidence in the borrowers ability to repay.

The transaction is one based on a difference in time-preference between the creditor and the debtor.l7 The creditor, more precisely the depositor of savings, chooses to delay investment or consumption on his own account until some later date, and the debtor chooses to consume or invest beyond his current means and pay out of future production.

In a complex market economy, the majority of economic transactions involve credit of one form or another. Merchants receive their products from wholesalers with 30 days or longer to make payment. Auto dealers borrow money to buy inventory based on their ability to sell it profitably. Corporations borrow money through bond issues to finance business expansion. Stock speculators buy on margin. But no matter what form credit takes, it represents a claim on unconsumed goods traded by one party in retum for a promise to pay by another. The lender chooses to forgo consumption until some future date, and the borrower chooses to consume now and pay for his consumption in the future.

I have already touched on the fact that when a bank makes a loan it doesnt actually lend away savings, it creates new money. Nevertheless, it does put actual savings (in the form of capital) at risk. On the upside, borrowers create enough new wealth to pay back the loan and still profit or at least break even. But on the downside, if they default, then existing goods (savings) are either consumed or rendered useless. When a business borrows money to invest in new equipment or machinery, two things happen: The business commits a portion of future profits to savings, and the lending institution puts actual savings at risk. In this way, no matter what the govemments fiscal and monetary policy is, credit is tied directly to savings.

If I seem to be overemphasizing the fact that when you borrow money, what you are borrowing is someone elses claim on unconsumed goods, then it is only because I have been faced countless times by people who dont understand the relationship of savings, credit, investment, and wealth. Savings provide the basis for the extension of credit. Credit provides the fuel which accelerates investment in capital goods. And the accumulation of capital goods accelerates the rate of growth of wealth. But anjiime a loan is "written off," someone somehow, now or later, pays the full price out of savings; that is, goods are consumed but not replaced.

There is a widespread and very dangerous misconception that because the govemment and the banking system can create money from what seems like nothing,

they can also clean the slate of bad loans with an eraser without paying the price in real goods and services. The treasury in particular is viewed as an unlimited resource, bound only by public confidence. And like the "unsinkable Titanic, the sick irony is that the govemment is floundering from the continuing demands of special interest groups for handouts when, by normal standards of pmdence, the treasury should be considered bankmpt.

There is nothing magic about govemment borrowing and govemment "guaranteed" notes and loans. When the govemment sells a bond or T-bill, the purchaser refrains from consuming and lets the govemment consume in retum for a promise to pay in the future. But unlike commercial borrowing, the govemments ability to repay is backed not by its ability to produce in the future, but by its ability to tax in the future; which means that govemment borrowing is incurred at the expense of your and your childrens future real income-their productive ability.

Govemment income, whether generated from taxes, borrowing, or inflation of the money supply is

by its nature a burden on the productive capability of the nation. It is a forced redistribution of wealth that shifts the balance of normal market factors. Most govemment activity is inherently consumption oriented, and does not produce anything. 18

The fact that govemment lending and borrowing are "guaranteed" changes nothing. The guarantee is based solely on the ability to tax and/or print money. And if debt is paid by printing money, the result is a debasement of the dollars value through inflation, which is simply another (and much more perverse) form of taxation. You cant get something from nothing, but you can get nothing from something. Sooner or later, the debt incurred by deficit financing of govemment expenditures has to be paid in full, and so does the cost of a business expansion built and dependent upon easy credit. Whether the price takes the form of higher taxes, inflation, a general business decline (recession or depression), or some combination of the three, the price is always the same -wealth is consumed.


America never ceases to amaze me. I have a fax machine in my office that cost about $1600, and about once a week I marvel at what it can do. Somehow images on paper are turned to el ectric impulses that can be transferred over miles of phone cable to another machine where they are turned back into the same images.

Im totally ignorant about chips, digitizers, transducers, and so forth, but for a mere $16001 can reap the benefits of the creative minds and the countless hours and dollars that went into research, development, and marketing of that product. And Im sure that if I had waited, I could have gotten a better product even cheaper.

On a simpler level, I can eat two eggs with toast and juice, and if I cook it myself, it costs me less than a dollar. Just think what it would cost if I tried to produce the same breakfast by growing wheat, grinding the flour, cultivating

the yeast, raising the orange trees, raising the chickens, and so forth. It is simply fantastic-the closest thing there is to a free breakfast.

Its fantastic, but it is not an accident or a miracle; it is the result of productive people trading property by free association in the marketplace. Without govemment intervention, our economy would experience natural minor cyclical adjustments as the markets changed to accommodate new technologies, changes in consumer preferences, and shifts in credit; but production and prosperity would maintain an ever-increasing upward trend. But we have, and always have had, govemment intervention. As a result, we have a business cycle subject to major swings, both up and down. Everybody loves the upside, but very few know how to protect themselves from the downside.

As a businessman, the only way I know to protect myself from financial disaster in crashes, recessions, or depressions is through the ability to anticipate long-term market turning points and position myself accordingly. This means being leveraged and long at market bottoms and liquid and short at market tops. To do this requires an understanding of the basic economic principles I have described and the principles discussed in previous chapters.

In this chapter, I have presented the basic economic concepts required to un derstand the effects of govemment intervention on the markets. In the next two chapters, Ill show how the govemment, through deficit spending and the Federal Reserve System, intervenes with monetary and fiscal policy; and I will demonstrate how this intervention is the key determinant of the long-term trend of the economy. The objective is to demonstrate how to apply the fundamental principles of economics to stop the interventionists from consuming your capital, while making money in the process.

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