Musings on Fekete and Rothbard

Nelson Hultberg

September 27, 2005

We live in a watershed era of history today. The ideological tides that govern the acts of men are sweeping America toward titanic events that will, in the upcoming years, end our world as we know it. It is with this backdrop in mind that one needs to approach the Fekete / Rothbard debate on gold and real bills. To the average layman, such esoteric concerns as “bills of exchange,” “gold redemption,” and “fractional reserves” are drab and boring. The real beef of life is tied up in Wall Street trading, fighting corrupt solons of the Potomac, and defending our country.

This, however, is a mistake. Real bills and gold are not esoteric irrelevancies that we can safely ignore, and they are certainly not “barbarous relics” that went out of fashion with hoop skirts and Victorian manners (as Keynesians so obtusely believe). They are of paramount importance to a sound monetary system, without which freedom and civilization cannot exist. The arguments and counter-arguments during the past several months of the Gold / Real Bills Debate are akin to the ancient Socratic debates in Athens whereby the thinking men of the city would probe the great issues of their existence, such as freedom, justice, economy, war, etc. Gold and real bills are in that class of importance.

The Fundamental Misunderstanding

The passions of this debate have arisen because of a fundamental misunderstanding about real bills and their necessity for the sound operation of a monetary system. The Real Bills Doctrine is condemned emphatically by most pundits in the modern era because these pundits have failed to see that there were two totally different doctrines that evolved intellectually during the 18th and 19th centuries. I alluded to this in a recent article, The Money Fallacies of Rothbard.

The two distinct doctrines were Adam Smith’s RBD and the Inflationist RBD. Smith mandated gold convertibility and free-market banking, while the Inflationists embraced irredeemable paper notes and government managed banking. These two doctrines were as different as a winged eagle and a rooting hog. Smith’s version was capable of flying; the Inflationist version was from the start corrupted with irrationality and doomed to disaster.

To understand this crucial distinction (and other vital aspects of this debate) it is mandatory to read Real Bills: an Emergent Market Phenomenon, by Bill Koures. He explains very clearly that what today’s pundits are attacking as the “Real Bills Doctrine” is a government managed doctrine of irredeemable paper instruments masquerading as real bills. As long as this terrible confusion prevails, all well-meaning pundits will continue to miss the powerful efficacy of Smith’s original doctrine and why it is so important to the restoration of gold as money. Naturally Rothbardians remain impervious to this confusion because they need a strawman to flog in order to try and convey to their readers that they are on the right side of the debate?

Dr. Koures’ paper is destined to become a benchmark analysis of this great monetary issue, which all opponents must now confront and which all advocates must thoroughly study. It is a brilliant theoretical refutation of the Rothbard position — rigorously scientific in form, yet accessible to the educated layman.

Fractional-Reserve Banking

Another source of the vehemence in this debate lies in the policy of fractional-reserve banking. Rothbardians and 100% gold advocates justifiably abhor this policy. And we in the Fekete camp do likewise. Fractional-reserve banking has, throughout the past 300 years, been the vehicle for a myriad of economic booms and busts, egregious paper issuance, and horrific wars funded by venal governments and kings.

But it is a mistake to condemn the policy itself as fraudulent. There are many fraudulent aspects of fractional-reserve banking that need to be purged from our monetary system, but it is neither rational, nor legally proper to condemn the policy itself as fraudulent. In other words, it is not wise to throw the baby out with the bathwater. Because the Rothbardians make this mistake, they mislead all who are seeking to understand how banking should be constructed.

If we are to conclude then that certain forms of fractional-reserve banking are permissible, what are they, and why are they permissible? To start with, everyone accepts that a banker is justified in loaning out time deposits, i.e., CDs, as long as the bankers’ loans are kept within the maturity parameters of the CDs. In this way bankers do not succumb to the cardinal sin of “borrowing short to loan long.” Time deposit loans are thus permissible and not a form of fractional-reserve banking. The dilemma of free-market banking, however, is how to keep bankers from loaning out demand deposits irresponsibly and thus borrowing short to loan long.

Rothbardians say it cannot be done, and thus it should not be attempted. Period. In fact, they go so far as to declare that any such attempt is fraud. Thus their advocacy of 100% gold reserve banking. Bankers simply cannot be allowed to loan demand deposits for any reason on any kind of security. In contrast to such rigidity, Fekete’s position is that,

“Demand deposits can only be ‘loaned out’ on the security of real bills [i.e., utilized to discount such bills]. In this case the bank is not engaged in a lending but a clearing operation, so the matter of borrowing short and lending long does not arise. This is not sophistry; the reality of the case is that the bank is backed up by a bill market that would discount a maturing bill that the bank may have to sell in a hurry to meet unusual demand for gold coins against its deposit liabilities. Real bills are the BEST AND MOST LIQUID EARNING ASSET THAT A BANK CAN HAVE. They can be liquidated pretty well without a loss. There are always other banks around that scramble for liquid earning assets as they have an excess of gold on hand. Besides, on average one ninetieth of the bill portfolio of a bank should reach maturity every day, which should normally suffice to meet the demand for gold.” [Email to this writer September 20, 2005.]

It is thus the existence of this vast and liquid “bill market” (to which any banker can go to sell portions of the real bills in his portfolio for gold coins) that negates the danger of using demand deposits to discount real bills for merchants. In this way, if a banker runs short of gold reserves to meet certain depositors’ requests, he merely enters the bill market and liquidates a portion of his bill portfolio for gold coins. Since real bills mature into gold in 90 days and are backed by real goods in urgent demand, there are always buyers for such bills. A banker can quickly convert them to gold, for they are earning assets that are considered to be “as good as gold.”

Fekete goes on to say:

“Neither is the bank committing fraud by issuing bank notes on the security of real bills. A bank note is not the same as a gold certificate: it does not say that there is gold on deposit in the amount of face value which is payable to bearer on demand. It does say that it promises to pay the face value to bearer on demand, but that is not the same thing, so there is no fraud. The bank puts its reputation on the line that it will be able to meet its promise to pay, because its portfolio of assets are liquid and the bill market is backing up its promises.” [Ibid.]

The banker then is not representing to the public that he holds an equivalent amount of gold in his vault to match the notes he issues in discounting real bills from merchants. He is simply saying that he will pay the value of the note in gold because he knows that if he runs short in his vault, he can obtain what he needs from the bill market itself.

The Mistake of Pure Rationalism

The above two points — 1) failure to grasp that the “government managed bills doctrine” is most emphatically NOT the “real bills doctrine,” and 2) refusal to accept that the discounting of real bills with demand deposits is NOT fraudulent — are what doom the Rothbardians to the briar patch of irrationality in which they have tangled themselves.

What causes this incomprehension on their part? In my opinion, it stems from their embrace of pure rationalism as their intellectual methodology, which stifles their discovery of truth. This means that the Rothbardian system has been spun out of a chain of deductive logic that has not been matched up to the real world to see if it is workable.

Every pure rationalist from the ancient Greek world, to Descartes of the 17th century, to Rand and Rothbard of the modern day has ended up with a false view of things. Pure rationalism (i.e., the use of a priori reason alone to validate an idea or system of ideas as truth) can never capture the real reality. One needs to blend in the other two intellectual methodologies of “experience” and “intuition.” Those thinkers who can accomplish this synthesis of reason, experience, and intuition are always the great contributors to human intellectual progress. Such a synthesis stems from what philosophers call the illative sense. And those thinkers with the most highly developed illative senses are the one’s who, in the end, discover the truth. All pure rationalists, pure empiricists, and pure intuitionists at best end up with flawed systems of thought, and at worst, end up deluding their fellow men into chasing dangerous utopian nostrums. History is littered with examples of these types of channeled thinkers.

The true scientist always strives to measure his theories against actual events in reality to see how his theories hold up. He establishes working models to test his hypotheses. He measures the efficacy of his conclusions through the use of both replicable experience (empiricism) and non-replicable experience (history).

The problem with pure rationalism is that if its fundamental axiom upon which it starts is falsely drawn, then everything that comes afterwards is false also. But its process of deductive logic cannot demonstrate when one’s fundamental axiom has been falsely drawn because all fundamental axioms are “self-evident” or “intuited.” Therefore in order to really “know” the truth, we must be willing to step outside the chain of deductive logic which pure rationalism relies upon and match our theories against reality to see how they would fare in the real world. In other words, we must use replicable and non-replicable experience to test our theories. We must conduct empirical observation and historical study. We must try and fathom if our a priori web of conclusions can be practically applied to actual humans in real life.

Have the Rothbardians done this? No, they haven’t, which is why they missed the essential truth of “real bills.” They failed to grasp that real bills are a market phenomenon rather than a banker’s contrivance, that such bills helped to lead us from the Middle Ages through the Renaissance to modern economies, that credit is comprised of two different forms (clearing and conventional) rather than monolithic, that the two credit forms are governed by different propensities (to spend and to save), and that the discount rate is separate from the interest rate. All these truths were discovered by Antal Fekete because he astutely made use of the experience of history and doggedly did the investigative spade work to reinforce the theoretical deductions churning through his mind from the axioms he had intuitively formed.

The great free-market economist, Henry Hazlitt, wrote on this flaw in the Rothbardian approach several decades ago: “When Rothbard wanders out of the strictly economic realm…he is misled by his epistemological doctrine of ‘extreme apriorism’ into trying to substitute his own instant jurisprudence for the common law principles built up through generations of human experience.” [Review of Man, Economy, and State for National Review, 1962.]

In light of Rothbard’s irrational gold theories, it appears that even in the economic realm, he was capable of becoming misled by his “extreme apriorism.”

The philosopher, John Hospers (a former colleague of Ayn Rand), also wrote about this problem that afflicts numerous thinkers in the freedom movement: “Libertarians need to be reminded of John Stuart Mill’s famous statement that what is held to be true in theory but is not applicable in practice, is not acceptable even in theory.” [Freedom and Virtue, George W. Carey, ed., University Press, 1984, p. 69.]

The Open Forum vs. Hermetically Sealed Cults

Any theory put forth by any thinker, if it is to be a truly scientific endeavor, must be submitted in such a way that it can be proven to be untrue. This is what is called the falsification process. All theories must adhere to this process, or they are automatically discredited as unscientific. This was one of the major black marks against Marxist thought from the beginning. It was presented in such a way that it could not be falsified. When logic demonstrated the irrationality of Marx’s theories, his followers would reply that the opponents of Marxism were using “bourgeois logic,” which was inferior to “proletarian logic.” Thus Marxists always had an out that they could use to resist the rigor of logical analysis.

This is the nature of unscientific intellectuals. They tend to seek ways to avoid the falsification process. Another way they do this is to develop hermetically sealed cults and rigidly police the tenor of the ideas that are permitted for discussion. Radically dissenting thought that casts doubt upon the fundamental premises of the cult is prohibited up front, and if by chance it is able to sneak into the active interchange of the cult, it is quickly purged. Protection of the established canon is the goal of all cults; not the discovery of truth. Cults do not admit this, of course. Their members subconsciously suppress it. But it is the fundamental characteristic of all cults. They become hermetically sealed organizations that oppose the vital falsification process in regards to the body of thought they espouse.

In addition, cults always attack those who oppose them with ad hominem smears. Ridicule rather than reason is far too often their tool of disputation. This is the way the Randians policed their Objectivist cult back in the sixties? They declared all those who poked holes in Rand’s reasoning to be “whim worshipers” and “social metaphysicians.” They sneered churlishly at critics as some kind of contemptible anti-humans rather than calmly counter their arguments with reason in a responsible and rigorous manner.

The communists under Lenin did the same thing in building their movement. Those who sought clarity and exposed contradictions in the theoretical underpinnings of Marxism were smeared as “criminal deviationists” and viciously ostracized.

Unfortunately this type of vilification has become the methodology of many of the followers of Rothbard today. Such a rancorous and rigid “circle the wagons” form of thinking can never build a philosophical movement capable of sweeping the world and ushering in a restoration of freedom. If we are to find our way out of the prison of tyrannical ideologies that shaped the 20th century and which is now threatening to plunge us into a high-tech dark ages, then we will have to accept the fact that we as humans — even giant cerebral humans such as Mises — do not have a corner on the truth! We must never allow ourselves to ossify our proselytizations into a sacred canon with gatekeepers to exclude ideas dangerous to it. We must build an Open Forum in the tradition of Socrates 2400 years ago. It is only in this way that a free America can be saved.