Introduction
Jesús Huerta de Soto holds a PhD in economic science and a PhD in law from the Complutense University of Madrid. He is also a mathematical actuary and holds a MBA from Stanford University. He is a member of the Mont Pelerin Society, the Royal Economic Society (London), the American Economic Association, and the Spanish, Portuguese, and Swiss Associations of Actuaries. He has been awarded the King Juan Carlos International Prize for Economics (Madrid, 1983), the Adam Smith Award (Brussels, 2005), the Franz Cuhel Memorial Prize for Excellence in Economic Education (Prague, 2006), and the Gary G. Schlarbaum Prize for Liberty (Salamanca, 2009), as well as honorary doctorates by Francisco Marroquín University (Guatemala, 2009) and Alexandru Ioan Cuzá (Romania, 2010). Since 2000 he has been professor of political economy at the King Juan Carlos University of Madrid. Huerta de Soto is currently considered to be one of the most representative exponents of the Austrian School of Economics and has published numerous research works and articles on subjects related to his specialty.
In your 2010 Hayek Memorial Lecture to the London School of Economics and Political Science, you suggested that the laws governing banking had gone wrong way back in 1844—that the West missed an opportunity then to put itself on a sound economic path. Can you take us through this?
I began by saying that without doubt the recent financial crisis and the subsequent worldwide recession constitute the most challenging problem that we, as economists, now face, and I suggested that the problems we are struggling with today are the result, in one way or another, of something that happened in England on July 19, 1844. On that date Sir Robert Peel’s Bank Act, also known as the Bank Charter Act, was approved. This approval followed years of debate between two schools of thought, the Banking School theorists and the Currency School theorists, on the true causes of the artificial economic booms and the subsequent financial crises that had been affecting England, especially since the beginning of the Industrial Revolution.
On the plus side, the Act successfully incorporated the sound monetary theoretical insights of the Currency School. This school argued, in my view completely correctly, that the origin of the country’s boom and bust cycles lay in the artificial credit expansions orchestrated by private banks and financed not by the prior or genuine savings of citizens, but through the issue of huge doses of fiduciary media—in those days mainly paper banknotes, or certificates of demand deposits issued by banks for a much greater amount than the gold originally deposited in their vaults.
Accordingly, Peel’s Bank Act brought in a requirement for banks to hold 100% gold reserves on all banknotes issued. This goes back to the most elementary general principles of Roman law concerning the need to prevent forgery; issuing more banknotes than you hold gold for is nothing short of a sleight-of-hand or confidence trick played on your customers. It was a first and positive step in the right direction in order to avoid endlessly recurring cycles of boom and depression.
Unfortunately, while bolting one door, the Act left another door wide open, and this rendered it a disastrous failure, notwithstanding the good intentions behind the Act, and in spite of its sound theoretical foundations. It failed to extend the 100% reserve requirement to demand deposits. The originators of the Act failed to see that demand deposits were also part of the money supply. This had been clear to the scholars of the Spanish Golden Century, the Siglo de Oro, three hundred years earlier, but the knowledge had been entirely forgotten. As a result the Act opened the way, after 1844, for bankers to continue the practice of keeping fractional reserves—creating new credit by fiat, by issuing demand deposits that are not 100% backed by reserves.
Thanks to the Act, they could no longer issue profligate amounts of banknotes, but there was nothing to stop them from switching their attention to demand deposits, which they rapidly did. From an economic point of view, this gave the banks the power to create vast amounts of new credit at will, exactly as issuing banknotes unsupported by reserves would have done. So, of course, artificial credit expansions and economic booms continued, and these led in turn to financial crises and economic recessions. Despite all the hopes and good intentions originally put into Peel’s Bank Act, this piece of legislation soon lost all of its credibility and popular support.
Worse, the failure of the Bank Act conditioned the evolution of financial matters up to the present time and fully explains the incorrect institutional design that afflicts the financial and monetary system of the so-called free market economies. In that sense it underpins the dreadful economic consequences that we are currently suffering.
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