Fraud, Fraud Cycle and Business Cycle. An Austro-Thomistic into the nature and effects of fraud

7/24/2019 Fraud, Fraud Cycle and Business Cycle. An Austro-Thomistic into the nature and effects of fraud.

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FRAUD,FRAUD CYCLE,AND BUSINESS CYCLE

ANAUSTRO-THOMISTIC INVESTIGATIONINTO THE NATURE AND EFFECTS OF FRAUD

TUUR DEMEESTER*

Abstract

In this article we present the thesis that Misesian value free praxeology isinadequate to give a comprehensive account of the essential nature of the business cycle,and that instead the business cycle should be analyzed from a broader judicialphilosophical framework. Carrying out this analysis leads us to explaining the busines

cycle as being essentially a fraud cycle, to rehabilitating Menger's concept of imaginarygoods, to reformulating deposit and loan contracts as essentially trusts, and to reassessingthe case for honest fractional reserve banking.

In order to show the validity of our main thesis, we answer to seven possibleobjections against it, and as a means to demonstrate its relevance, we suggest a solutionfor three paradoxes that arise within the orthodox Austrian approach to the businesscycle.

* DRAFTDO NOT CITE: Critical remarks and suggestions are welcome at [email protected].


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TABLE OF CONTENTSFraud, Fraud Cycle, and Business Cycle

1. Method ......................................................................................................... 6An epistemological challenge ....................................................................... 6

Solution: an Austro-Thomistical framework .......................................... 102. The Nature of Fraud ................................................................................ 12

A short history and etymology of fraud ................................................... 12On means, goodwill, and the convivial order ........................................ 16On Fraud and Imaginary Goods .............................................................. 17

3: The Effects of Fraud ............................................................................... 20Is Fraud a Cyclical Phenomenon? ............................................................. 21Initial state of affairs: Order ....................................................................... 22Phase I: Fraud ............................................................................................... 23

The Swindler and the Ungenuine Trust .................................................... 23Phase II: Recovery ....................................................................................... 25

Graphical Illustration of the Fraud Cycle ................................................. 274.Reply to Seven Objections ....................................................................... 28

First objection ................................................................................................29Second objection ...........................................................................................33

Third objection ..............................................................................................34Fourth objection ...........................................................................................36Fifth objection ...............................................................................................40Sixth objection ...............................................................................................42Seventh objection ........................................................................................45

5. Three Austrian Paradoxes ....................................................................... 554.Conclusion .................................................................................................. 57


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1.METHOD

An epistemological challenge

Since action is never its own end, but rather the means to an end,we call an action good or evil only in respect of the consequences ofthe action. It is judged according to its place in the system of cause

and effect. It is valued as a means. And for the value of the meansthe valuation of the end is decisive.1

Ludwig von Mises

moral acts take their species according to what is intended, andnot according to what is beside the intention, since this is accidental

Thomas Aquinas

ACCORDING TO THEAUSTRIANTHEORY OF THE BUSINESS CYCLE, developed in

1912 by Ludwig von Mises in his Theorie des Geldes und der Umlaufsmittel, fractional reservebanking, and more specifically the expansion of credit by the ex nihilocreation of fiduciarymedia, is the primary cause of the boom-bust cycle in the economy. 2 This cycle isinitiated by a period of artificial growth and eventually and unavoidably leads toeconomic crises, depressions and recessions. Mises always insisted on economics being

value free, but in his magnum opus Human Action, he nonetheless makes it clear whatpractice causes the harmful effects of the business cycle:

The notion of normal credit expansion is absurd. Issuance ofadditional fiduciary media, no matter what its quantity may be, always sets

1 On the Epicurean vein in Ludwig von Mises's writings, see Martin Masse's presentation TheEpicurean Roots of Some Classical Liberal and Misesian Concepts, delivered at the Austrian ScholarsConference, Ludwig von Mises Institute, March 18, 2005, in Auburn, Alabama.

2 Often an artificially low interest rate is cited as being the essential cause of the businesscycle. However, it should be clear that, in absence of a central bank (acting as a central planningbureau), the lower interest rate is an effect, rather than a cause, of the issuance of fiduciary media.

And even with a central bank present, it merely acts as an incentive mechanism that stimulateseconomic actors to demand more (cheap) credit, thus enabling the banks to issue more fiduciarymedia. It is however only this money printing, and not the interest rate per se, which boosts theinflationary boom that initiates the the business cycle. In America's Great Depression, MurrayRothbard reminds us that Mises points out (Human Action, p. 789n.) that if the banks simplylowered the interest charges on their loans without expanding their credit, they would be grantinggifts to debtors, and would not be generating a business cycle. (America's Great Depression, Auburn,

Ala.: Ludwig von Mises Institute: 2000, p. 33, footnote 37). For the sake of clarity, here is Mises's

Theory of Money and Credit:"The issuers of the fiduciary media are able to induce an extension of the

demand for them by reducing the interest demanded to rate below the naturalrate of interest, that is below the rate of interest that would be established bysupply and demand of the real capital were lent in natura without the mediationof money, whereas on the other hand the demand for fiduciary media would bebound to cease entirely as soon as the rate asked by the bank was raised above thenatural rate." Ludwig von Mises, Theory of Money and Credit (New Haven: YaleUniversity Press, 1953), p. 306-307.

and further:

The number and extent of purchases and sales on credit are by no meansindependent of the credit policy followed by the banks, the issuers of fiduciary

media. If the conditions under which credit is granted are made more difficult,their number must decrease; if the conditions are made easier, their numbersmust increase. Ibid., p. 309.


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in motion those changes in the price structure the description of which isthe task of the theory of the trade cycle. Of course, if the additionalamount issued is not large, neither are the inevitable effects of theexpansion.3

Walter Block summarises the position of Ludwig von Mises as follows:

[T]he Misesian view is that the banks don't have to search for the naturalrate in order to avoid generating the business cycle; all they have to do is

not expand credit beyond their cash holdings. This is surely a much easiertask. The banks' insistence on expanding credit generates the businesscycle, and makes them responsible and thus "guilty" as charged.4

Mises's student Murray Rothbard also stated it very clearly:

The basic point is that banks only generate a cycle by expanding (fractionalreserve) credit; the key is the act of credit expansion, not whether their interestcharge was correct.5

Other than his teacher, Rothbard saw no contradiction in integrating moraljudgments within a praxeological framework,6 and combined Misesian apriorismenthusiastically with the traditional judicial principles that have been developed since theGreek and especially Roman antiquity, and medieval scholasticism. Rothbard also applied

this judicial reasoning to the practice of fractional reserve banking, which lead him tomake the following statement:

[a]ll men are subject to the temptation to commit theft or fraud. . . . Short of thisthievery, the warehouseman is subject to a more subtle form of the sametemptation: to steal or borrow the valuables temporarily and to profit byspeculation or whatever, returning the valuables before they are redeemed so thatno one will be the wiser. This form of theft is known as embezzlement, which thedictionary defines as appropriating fraudulently to ones own use, as money orproperty entrusted to ones care.7

Rothbard's standpoint, that fractional reserve banking is essentially fraudulent, hassince been championed by some of the most prominent theorists of the Austrian School.8

3 Ludwig von Mises, Human Action(Fox & Wilkes: San Francisco, 1996), p. 442.

4 Walter Block and Kenneth M. Garschina, Hayek, Business Cycles and Fractional ReserveBanking: Continuing the De-Homogenization Process, The Review of Austrian Economics Vol. 9, No. 1(1996): 77.

5 Murray Rothbard, as quoted in John P. Cochran, Steven T. Call, and Fred R. GlaheAustrian Business Cycle Theory: Variations on a Theme, Paper prepared for Presentation at AustrianScholars Conference 8 (2002), Mises Institute, Auburn, Alabama, March 15-16.

6 On the problems with value free science, see Frank van Dun, Economics and the Limitsof Value Free Science (Reason Papers No. 11 (Spring 1986) 17-32.), in which the author quotes Ludwig

von Mises: The intellectual methods of science do not differ in kind from those applied by thecommon man in his daily mundane reasoning. The scientist . . . merely uses them more skillfully and

cautious (Ludwig von Mises, Human Action, (Fox & Wilkes: San Francisco, 1996), p. 58.), and goes onto say that [n]either science nor "our daily mundane reasoning" fare well if we do not see thecontinuity or do not recognize that both equally face the challenge of reasonableness. If the ethical andpolitical requirements of the dialogue are valid for science, then they are universally valid whereverjudgment and decision based on knowledge may be involved. Van Dun continues: If the ethics andpolitics of the dialogue are valid for speech, they are also valid for action. Respect for the rationalautonomy of an agent is just as much a requirement of reasonableness as respect for the rationalautonomy of a speaker. Frank van Dun, Economics and the Limits of Value Free Science (ReasonPapers No. 11 (Spring 1986) 17-32.) pp 26-27.

7 Rothbard, The Mystery ofBanking, p. 90, as quoted in Jess Huerta de Soto,Money, Bank Credit,and Economic Cycles, (Auburn, Ala.: Ludwig von Mises Institute, 2006), pp. 183-84.

8 It is perhaps relevant to note how another major Austrian economist, Friedrich von Hayek,explicitly refused to accuse bankers as being guilty for the damaging effects of the business cycle:

... we can also see how nonsensical it is to formulate the question of the causationof cyclical fluctuations in terms of "guilt," and to single out, e.g., the banks as those"guilty" of causing fluctuations in economic development. Nobody has ever asked


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Those who have contributed most in defense of this position are Jess Huerta de Soto,Hans-Hermann Hoppe, Jrg Guido Hlsmann, and Walter Block. Now, if these scholarsare correct, which we believe they are, fraud is in effect the act that sets in motion theentire business cycle; it is its essential cause. This poses us before a major epistemologicalchallenge: if fraud, a judicial phenomenon, is actually the most fundamental cause of thebusiness cycle, is it then possible to develop a comprehensivetheory (i.e., a theory offering acomplete explanation of the essential causes) of the business cycle using nothing more thanthe Misesian (allegedly value free) methodological instruments? The answer is, or so we

hold in this article, negative.

We can define fraud concisely as deliberate deception causing injustice.9Following this definition, fraudulent actions are rendered meaningless in a theoreticalcontext that does not allow for the normative distinction between just and unjust.

This is why, for example, reference to the value free term error often tends to confusematters, because it lumps together just and unjust sources of change in society, theformer being essentially coordinating, the latter essentially discoordinating.10This, as wepropose at the end of our article, leads to paradoxes that cannot be solved within autilitarian praxeological framework. Now, given that fraud is a judicial concept, it seemsonly natural to suggest that a comprehensive understanding of the business cycle shouldbe rooted, not primarily in a value free body of praxeological theory, but rather in a

broader normative judicial-philosophical framework. Doing so is an important aim of thispaper.11

Solution: an Austro-Thomistical framework

In response to the epistemological challenge of the Austrian Business CycleTheory, we will here attempt to adapt a broader perspective, one of philosophical realism.More specifically, we will here exert ourselves starting from a metaphysical frameworkbroadly in accordance with that developed by Saint Thomas Aquinas (1225?-1274 A.D.).

To the modern reader and student of the Austrian School of economics this may seem abit of a surprising choice, given that only few Austrian economists make explicitreference to St. Thomas in their writings. Given that an investigation of the historical and

philosophical parallells between Thomism and Austrianism is outside the scope of thisarticle, we limit ourselves to three quotes as a means of illustration, each from a majorfigure in the Austrian tradition, each made late in their lives. The first quote by Ludwig

von Mises, in one of his last works, The Historical Setting of the Austrian School of Economics,

them to pursue a policy other than that which, as we have seen, gives rise to cyclicalfluctuation, seeing that the latter originate not from their policy but from the verynature of the modern organization of credit. (Hayek 1933, p. 189as quoted inBlock and Garschina's previously mentioned article, pp. 81-82.)

One wonders why the banker, unlike like any entrepreneur in the economy, should onlyconduct his business in ways other people ask him to do, i.e., why he should not be held responsiblefor his own actions. Furthermore, de Soto, in his Money, Bank Credit, and Economic Cycles, hasconvincingly shown how, throughout history, there have been bankers who actually have resisted to thetemptation of fraud.

9 For a full definition, see the next section.

10 The original idea behind Law was order, from the Scandinavian lag, meaning order orbond. Hence the opposite of Law was disorder, in Germanic werra, meaning confusion ordisorder. Similarly, the antonym of lag was orlaeg, clearly related to the Dutch word for war, oorlog.

Thus, lawful principles were traditionally seen as leading to order, and transgressions of the Law werethought of as leading to chaos. All the above in Frank van Dun, Natural Law, Liberalism, andChristianity,Journal of Libertarian Studiesvol. 15, no. 3 (Summer 2001) , pp. 1-36, esp. p. 3.

11 The original subtitle of this article was an Austro-Thomistic investigation into the causesandeffects of fraud. In our investigation into the causes of fraud, we were lead to the questions of howmeans are generated, and what the different causes of injustice are. During all of this, we relied heavilyon the philosophical vocabulary of St. Thomas, much more so than in the article as it is presented here.

Eventually, however, we decided not to include this section, in part because it may lead us too far fromthe main point, but also because we felt the theory developed therein was even more immature than theone presented here.


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the second is by Murray Rothbard, in a 1987 review of a book on the philosophicalbackground of the Austrian School, and the third quote is by Franz Brentano, theinfluential German intellectual and colleague of Carl Menger, where he reflects back onhis formational years.

"What is known as the Austrian School of Economics started in 1871 when CarlMenger published a slender volume under the title Grundstze derVolkswirtschaftslehre [Principles of Economics].... Until the end of the Seventiesthere was no 'Austrian School.' There was only Carl Menger."12

Ludwig von Mises

Carl Menger, the founder of Austrian economics, was steeped in Aristotelianepistemology and method . . . This volume has convinced me that it was notsimply Aristotleper se, but the Aristotelian Franz Brentano, a Catholic priest, bornin southern Germany, who formed the dominating milieu of Austrian philosophyand provided Carl Menger with his basic philosophic framework.13

Murray Rothbard

First of all I had to apprentice myself to a master. But since I was born whenphilosophy had fallen into most lamentable decay, I could find none better thanold Aristotle. To understand him, which is no always easy, I enlisted the help of

Thomas Aquinas.14

Franz Brentano

In what follows, we work in agreement with Gabriel J. Zanotti, when he asserts thatMises's praxeology . . . could function as a theorem within a Thomistic philosophicalstructure,15 and try our hand at making a contribution to what has been called theRothbardian project, of integrating the Austrian with the Thomistic tradition.16

12 Mises, The Historical Setting of the Austrian School of Economics, (Auburn, Ala.: Ludwig von MisesInstitute, 1984).

13 Murray Rothbard, Review of Austrian Economics: Historical and Philosophical Background,Wolfgang Grassl and Barry Smith, eds., London: Croom Helm, pp. 250. From Journal of AppliedPhilosophy,Vol. 4, No. 2, 1987, 248-50.

14 Brentano (ANR, p. 291)., as quoted in Rolf George and Glen Koehn's article Brentano'srelation to Aristotle, published in The Cambridge companion to Brentano, Dale Jacquette ed. (Cambridge:Cambridge University Press, 2004)

15 Gabriel Zanotti, Misesian Praxeology and Christian Philosophy, The Journal of Markets &Morality 1, no. 1(Spring 1998), 60-66. The following articles point at similarities between Mengerian-Misesian thought and Aristotelian-Thomistic thought. On purposeful human action, free will valuation,error and a priori methodology, see the short article of Gabriel J. Zanotti, Misesian Praxeology andChristian Philosophy, The Journal of Markets & Morality 1, no. 1(Spring 1998), 60-66. Onfoundationalism (the belief that logically self-evident, noncontradictory statements form a genuinefoundation for knowledge about reality) versus impositionism (the Kantian notion that the categories ofthe mind impose the perceived relationships and essences onto that what is being perceived), seeSteven Yates, What Austrians Should Know About Logic (And Why), The Quarterly Journal of Austrian

Economics Vol. 8, No. 3 (Fall 2005): 39-57. Also on this subject, the paper of Franois Facchini'sApriorism, Introspection, and the Axiom of Action: A Realist Solution, Quarterly Journal of Austrian

Economics(2007) 10:234-249. On the Aristotelian roots of praxeology, see Geoffrey Allan Plauch, OnPraxeology and the Question of Aristotelian Apriorism (published online, March 9, 2006).

16 See Jude Chua Soo Meng, Hopp(e)ing Onto New Ground: A Rothbardian Proposal forThomistic Natural Law as the Basis for Hans-Hermann Hoppes Praxeological Defense of PrivateProperty (published online, 2007).


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2.THE NATURE OF FRAUD

Multis annis jam transactisnulla fides est in pactisMel in ore, verba lactis,

Fel in corde, fraus in factis.17

Anonymous

imaginary wealth is exchanged for real wealth; and the realwealth is consumed by those who have produced nothing in placeof it.

Garet Garrett

In the present paper, we define fraud in brief as being deliberate deception causinginjustice. In a more precise definition, we may call it a deceptive act, or series of acts, with

which someone knowingly brings into being a situation of injustice. In this section we will firstindicate how this definition is historically and etymologically consistent, followed by aninvestigation into the judicial context in which fraud arises. We close with a revisitation ofMenger's imaginary goods in relation to fraud.

A short history and etymology of fraud

To grasp fraud in its historical context, it is necessary to go back to the Romanconcept of the dolus. In Roman law dolus (from dolere, suffer, having sorrow),traditionally took on the meaning of deception.18Doluswas subdivided in on the onehand dolus bonus; benine deception that can reasonably be expected and that is quitecommonly accepted,19 and on the other hand dolus malus; deception with an explicit

negative connotation. Aquilius Gallus, as quoted by Cicero, described dolus malus as todo one thing and to pretend another.20The description by Gallus did not offer a clear

17 This rhyme was beautifully translated by nineteenth century scholar and wizard CharlesLeland:

For many year, my friend, the fact isThat honesty is out of practiceAnd honey'd words and fawning smileAre ever mixed with fraud and guile.

Charles G. Leland,Meister Karl's Sketch-Book (Parry & McMillan: Philadelphia, 1855), p. 335.

18 In his famous and very influential Etymologies, Isidore of Seville (560-646 A.D.) defines

dolusas follows:

Deception (dolus) is a cunning of the mind, so named from the fact that it deludes(deludere), for the deceiver does one thing and pretends to do another. Petronius thinksotherwise when he says What, judges, is deception (dolus)? Surely, it is whensomething is done that is painful (dolere) to read about. You have 'deception'; now hearabout evil.. The Etymologies of Isidore of Siville, (Cambridge University Press, 2007), p.122.

Modern etymologists seem to prefer Petronius's interpretation.19 In K. Zweigert, International Encyclopaedia of Comparative Law (Mohr Siebeck, Tbingen:

Martinus Nijhoff Publishers, 1981), p. 86, the following is asserted on the dolus bonus: ...dolus bonusexpresses the legal order's acknowledgement that in trade and commerce common eulogismes andexaggerations may be used so as to present a product to potential customers in as favorable a light as

possible. For an elaborate discussion of the doctrine of the dolus bonus,see pp. 86-9 of this work.20 Cicero, De officiis, 3, 14, 60: C. Aquilius, collega et familiaris meus, protulerat de dolo malo formulas;

in quibus ipsis, cum ex eo quaereretur, quid esset dolus malus, respondebat, cum esset aliud simulatum, aliud actum..


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contrast between deception causing injustice, and deception that may be disapproved bysome, but that is not strictly unjust (such as that of a salesman selling the perfecthouse). In fact, the pure notion of fraud, or dolus malus, was for a long time no part ofthe legal vocabulary on the basis for which one could accuse others in court. The reason

why has been indicated by the 19thcentury classicist J.B. Moyle:

It is well known that until the time of Cicero fraud was no defense whatever toan action or an agreement expressed in solemn form, such as a stipulation, butthat straightforward dealing was deemed essential to the perfect validity of thoseother contracts which were sued upon by actiones bonae fidei: thus it is said thata covenant dolum malum a venditore abfuturum was superfluous and unnecessary,and that the vendor (and no doubt the purchaser equally) was unable to contracthimself out of the consequences which his fraud could entail, because ' dolus semperabesse oportet in iudicio empti, quod bonae fidei sit'.21(Italics are our own.)

Good faith was thus presupposed in the lawful order, which was then obviouslybreached whenever deception took place.

This changed with the actio de dolo, an edict enforced by Aquilius Gallus himself in66 B.C., which clearly defined dolus malus as an act causing injustice, and thereforepunishable by law.22 As time went by, the use of the wordfraud in stead of doluscame tobe used as a more specific concept to refer to deception causing unjust damage or loss.

Fraud derives from Latin, fraus, which is related to Greek thrauein(to break) and titroskein(to wound, damage). These etymologies indeed give some indication of the breach oftrust and the consequent injury or injustice as being essential to the phenomenon offraud.

Both the deceptive and the unjust character of fraud have been emphasized bydifferent thinkers throughout history. We limit ourselves a brief account of theinterpretation of two theorists in the Aristotelian tradition: Thomas Aquinas andLeonardus Lessius.

Thomas Aquinas categorized fraud (fraus) under cunning (astutia).23He gave threegeneral cases in which fraud can occur: when one hands someone something that isdifferent in nature, something that is from a different quantity, or that is from a different

quality, than was originally promised. Clearly St.Thomas had an exchange in mind, inwhich the victim gives up a real thing in exchange for a thing that is only real in hisimagination. The victim thus inevitably and involuntary suffers a loss, which results in astate of injustice.

The description of Leonardus Lessius (1554-1623) also confirms the definingcharacteristics of deception and injustice as we proposed them. Lessius, a member of theSchool of Salamanca,24 in his early and most famous work De iustitia et iure ceterisquevirtutibus cardinalibus (1605)summarized the scholastic consensus on the phenomenon offraud. He devided it under the dolus, whereby fraus was meant for cases of dolusthat arerelated to an object or an assignment that needs to be executed. Lessius distinguished

21 J.B. Moyle, The Contract of Sale in the Civil Law, (Oxford: Clarendon Press, 1892), p. 58.

22 See J.E. Spruit, Cunabula Iuris: Elementen uit het Romeinse Privaatrecht, (Deventer: Kluwer, 2003),p. 421.

23 Thomas Aquinas, Summa Theologiae, II.II, 55, art. 5, specifically the second counterargument.

24 See Marjorie Grice Hutchinson, The School of Salamanca, (Oxford: Clarendom Press, 1952) pp.81-89. Hutchinson writes:

Leonardus Lessius (1554-1623), professor of theology at Louvain, was a FlemishJesuit who had studied under Suarez and was a friend of Molina and Vasquez. He wasthe author of a treatise de justitia et jure (1605) which ran through nearly fortyeditions published in Atwerp, Louvain, Lyons, Paris, and Venice. Lessius wasespecially celebrated for his expert knowledge of commercial practice, and he was

often consulted by the merchants of Antwerp on problems of business morality, justas their forefathers had appealed to Vitoria and the doctors of Paris some eighty yearsearlier.


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from fraudfallacia andperiurium, the former being deceit which only involves words, andthe latter deceitful words that are accompanied by an oath.

The main characteristics of fraud are also beautifully portrayed in an illustration bythe Italian renaissance aesthetician Cesare Ripa, published in his influential Iconologia25. Letus read the revealing description:

'Fraud'. A woman with twoFaces, one young, the other old;

Feet like Eagles talons; a Taillike a Scorpion, two Hearts inher right Hand, and a Mask inher left. The two Faces denoteFraud and Deceit, everpretending well: the twoHearts, the two Appearances; theMask, that Fraud makes thingsappear otherwise than they are;the Scorpion, and Eagle, thebale Designs and Discord theyfoment, like Birds of Prey, torob Men of their Goods or

Honour.We believe our historical case, that fraud is deliberate deceit causing injustice has

now been sufficiently substantiated. Let us conclude with two modern definitions offraud. Webster's Dictionary defines the lemma fraud as follows:

intentional perversion of truth to cause a person to give up property or somelawful right.26

This is a more precise definition, by J.B. Moyle:

Fraud in the narrower sense may be defined as a false statement made withknowledge of its falsehood for the purpose of inducing the other party, andactually inducing him, to make the contract to his detriment.27

On means, goodwill, and the convivial order

Fraud is thus deliberate deceit causing injustice. Injustice is the breach of justice,with the latter being, traditionally, the domain in which man acts responsibly, only claimswhat is his to claim, and where he lives peacefully within his means. Injustice, then,involves a transgression of this natural order: the lawbreaker refuses to live within hismeans and unjustifiably interferes with the means of others. We can define an unjustaction or violation (i.e., an action violating justice) as an action that is brought to bear ona person or his means by an external agent, contrary to the person's intention.28

25

The first, unillustrated edition of Iconologia was published in 1593. The famous illustrationsonly came with the third, 1611 edition. The description is from the 1709 English translation. Ripa'sdepiction of 'Fraud' appears on the cover of a book used for the purpose of this article: Toon vanHoudt, red., On the Edge of Truth and Honesty, (Leiden: Koninklijke Brill NV, 2002).

26 Fraud. (2009). In Merriam-Webster Online Dictionary. Retrieved September 17, 2009, fromhttp://www.merriam-webster.com/dictionary/fraud

27 J.B. Moyle, The Contract of Sale in the Civil Law, (Oxford: Clarendon Press, 1892), p. 58.

28 For an act to be violent it is not enough that its principle be extrinsic, butwe must add 'without the concurrence of him that suffers violence.' ThomasAquinas, Summa Theologica, II-I, 9, art. 4.

For what follows, it is important to note that, since willing implies knowing, ignorance causesinvoluntariness. As Thomas Aquinas writes,

. . . a man may be ignorant of some circumstance of his act, which he was notbound to know, the result being that he does that which he would not do, if he knewof that circumstance . . . Such ignorance causes involuntariness simply. Thomas


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Now, in order to study the appearance the fraud cycle, we have to consider thestate of affairs in which fraud is not present, after which we can study its appearance,effects, and disappearance. Given that the essential nature of fraud is injustice (becausefraud is aimed at injustice29) we depart from a situation where injustice is absent. Fraus et

jus numquam cohabitant, as the Latin dictum goes; where there is justice, there is no fraud,and vice versa. Our starting point is thus a orderly state of affairs, which we can call theconvivial order30 or natural order. It is a situation in which people live next to oneanother and respect each other as natural, i.e., reasonable, persons; where each lives

within his own means and where a basic level of trust is cultivated, bona fides,good faith, orgoodwill, which means that in their daily dealings, people choose not to trap, trick ordeceive one another, as a hunter would do to an animal, but rather try and resolvedisagreements through reason and argumentation. Structural lack of this basictruthfulness would render all social cooperation impossible, causing the fabric of theconvivial order to disintegrate.31

On Fraud and Imaginary Goods

We now have a broader understanding of the nature of fraud. Given that fraud is adistortion of sound judgment, it follows that the person subjected to fraud misconceivescertain resources as being suitable as goods that are in fact not suitable in the intended

sense, or that he misconceives certain resources as possessing a potency that they really

Aquinas, Summa Theologica, II-I, 6, art. 8 (Whether ignorance causesinvoluntariness?).

29 Human action is essentially purposeful. The essence of an act is the end or purpose towardswhich it is intended. Without a purpose, behavior is pointless or random; it looses its meaning andceases to be action. Now fraud is an act, which applies deception as a means, or intermediary end,towards injusice. It follows that the essential nature of fraud is injustice. See also Thomas Aquinas, IISent., d. 2 a. 2, a. 1.: the finis operis is the goal to which the deed is ordered by the doer, and this iscalled the nature of the deed. On human action and the role of the finis operis, see Gabriel Zanotti, "ElMetodo de la Economia Politica", Revista Libertas40 (May 2004), p. 37.

30 On the concept of the convivial order, see the work of Frank van Dun. In his Concepts ofOrder (2006, p. 23), he writes, for example: A convivial order is not a society. It is a catallaxy, anorder of friendly exchange among independent persons. We can find examples of convivial order . . .

wherever people meet and mingle and do business in their own name, whether or not they belong tothe same or any social organisation. . . . [T]he paradigm of conviviality is a relation between naturalpersons.

31 The law of the first society islet us act in good faith (bona fide agito) . . . Thus, in theRoman system of right, at times, the expression good faith is taken to signify natural right itself.(Giambattista Vico, Universal Right (Amsterdam: Rodopi, 2000), p. 42.) When people act in bad faith, aredouble-minded and deceitful, the convivial order ceases to exist: it would be impossible for men tolive together, unless they believed one another, as declaring the truth one to another (Thomas

Aquinas, Summa Theologiae, II-II, 109, art. 3). Toon van Houdt's comment, describing the views of thescholastic theorists, is also relevant in this respect. It is worth citing it in full:

On a practical level, fraud and deceit are criticized as being detrimental to social lifeand to the instruments of communication on which the social life is based. Indeed,both a liar and a dissembler make abuse of the signs which we have at our disposal toexpress our inner thoughts and emotions and, by doing so, to enter into a meaningfulcommunication with others. They corrupt the natural function of language and bodylanguage which consist of a number of signs which enable us to signify or indicatesomething. According to the moral theologians, these signs have not been given to usfor our own sake but rather for the sake of our fellow men. While truthfulness entailssimplicity or open-heartedness (simplicitas), lying and deceit create discord andduplicity (duplicitas). Indeed, both a liar and a dissembler bear one thing in their heartbut show something completely different. In short, they create a gap between signifier(words, gestures, facial expressions, etc.) and signified (thoughts and feelings,character and moral disposition), and pervert the natural function of speech and body

language. By doing so, they destroy mutual trust and sympathy which are deemedessential to any society. Toon van Houdt in On the Edge of Truth and Honesty, p. 9(italics in original).


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do not. This illusionary reality is constituted of what we may call imaginary goods. Let usin what follows investigate what is understood by this.

In the act of fraud, the deception of the swindler imprints in the minds of hisvictims an understanding of the world that is not conform to the way things really are: hemakes them believe in the existence of goods that do not actually exist, 32or he secretlychanges the state of affairs, thus instilling in them the mistaken belief that actuallyremoved goods are still available to them. In either case supposed goods are created that

appear to be fitted to satisfy human wants,33

but do not actually: imaginary goods. Wehere use this term in line with Carl Menger's definition: things that are incapable ofbeing placed in any kind of causal connection with the satisfaction of human needs [that]are nevertheless treated by men as goods.

Menger saw two possible ways in which imaginary goods can come into being:

(1) when attributes, and therefore capacities, are erroneously ascribed to thingsthat do not really possess them, or (2) when non-existent human needs aremistakenly assumed to exist. In both cases we have to deal with things that donot, in reality, stand in the relationship already described as determining thegoods-character of things, but do so only in the opinions of people.34

Menger errs, as has been pointed out by Mises35, when he claims in an elaboration

of (2) that imaginary goods can derive from imaginary value or imaginary wants. Thereason why Menger is mistaken is that imagination (phantasy, illusion) ultimately springsfrom the senses,36 but value and wants ultimately do not. Hence, wants nor value canpossibly be illusory. However this does not in the least refute the possibility of theexistence of imaginary goods, since the first cause of this phenomenon as suggested byMenger, the false ascription of capacities to things that do not really possess them, isperfectly valid. Capacities of substances are indeed detected by the senses, and cantherefore be perceived where they are not present, or overlooked where they are. Itfollows that the distinction between imaginary and true goods is a valid one.

It is interesting to note that while Menger's criteria of the good clearly excludeimaginary goods as actual goods (Menger stipulates an objectively possible causalconnection between the desired end and the potency of the resources), Mises's suggested

correction of Menger lumps together imaginary goods with actual goods. Writes Mises:

. . . the third prerequisite for a thing to become a good would have to read: theopinionof the economizing individuals that the thing is capable of satisfying their

wants37

Mises goes on to recognize that [t]his makes it possible to speak of a category ofimaginary goods, only to dismiss the distinction as pointless;38 reason being thatimaginary goods are also sold for real prices in the marketplace.

32 One could remark here that the word for deception in Germanic languages ('bedrog' in

Dutch, 'Betrug' in German), is related to the on. draugr('ghost'), the os.gidrog (''appearance', 'chimera'),wt. bitriaga ('administering damage in a cunning way' )and the oi. drogha ('damage'). Indeed, mala fidedeception, and thus also fraud, deliberately brings about a harmful illusion or 'mental high' to work tothe advantage of the deceiver/swindler, and to the detriment of the victim.

33 Mises, Human Action, p. 93.

34 Carl Menger, Principles of Economics, (Auburn, Ala.: Ludwig von Mises Institute, 2007), p. 53

35 See Mises' 1928 article, translated as Remarks on the fundamental Problem of the SubjectiveTheory of Value, in Austrian Economics: An Anthology, (Irvington-on-Hudson: Foundation forEconomic Education, 1996) ed. Bettina Bien Greaves, p.119-36.

36 . . . an imaginary vision originates from sense; for the imagination is moved by sense to act.

Thomas Aquinas, Summa Theologica, I, 12, art. 3.

37 Mises, Remarks on the fundamental Problem of the Subjective Theory of Value (publishedinAustrian Economics: An Anthology, Irvington-on-Hudson: Foundation for Economic Education, 1996;ed. Bettina Bien Greaves, pp. 119-36). Italics in original.


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We hold, however, that the distinction between true and imaginary goods is notpointless, but rather a vital one; and this not only for philosophy of law, but also foreconomic science. In philosophy of law, because the differentiation of true and imaginarygoods aligns exactly with the difference between fraudulent and bona fide transactions;only actions in the category of fraud are intrinsically aimed at the creation of imaginarygoods39. As for the economic sciences, we admit that in the context of a market setting,

where each actor makes entrepreneurial predictions in the face of uncertainty, where bothimaginary and true goods are traded alike, and where the imaginary or true character of a

good is only distinguishable after the facts, the distinction between both types seemshardly, if at all, relevant: both will be demanded and offered on the market, which willdetermine a market price for each of them in similar ways. However when consideredfrom the point of view of the Austrian business cycle theory, the situation changes.Namely, it is our suggestion that the fundamental explanation of why crises and recessions inevitablymust take place following any fraudulent expansion of the money supply, lies exactly in the fact thatcreditexpansion in the form of ex nihilo creation of fiduciary media essentially amounts to the generation ofimaginary goods. Recognition of this fact leads to the insight that the bust phase of the crisisis simply the pop of an illusionary bubble and a return to reality.

3:THE EFFECTS OF FRAUD

Oh! What a tangled web we weave, when first we practice todeceive!

Sir Walter Scott

Introduction

We have thus far analyzed the context in which fraud becomes possible (theconvivial order), as well as the essential characteristic of the good with which fraudinterferes (sound judgment), and the inevitable byproducts of fraud (imaginary goods).

These will suffice as preliminary observations. We can now enter into a description of theessential elements of the fraud cycle. Before we continue, it is suitable to recognize theauthor who first conceived of the fraud cycle, even coining the term. It was Jrg GuidoHlsmann, in his 1998 paper Towards a General Theory of the Error Cycle, where healso provided a short description of this phenomenon:

The victim of fraudulent behavior is not aware of his situation and thus behavesas if everything was still in order. He thinks that he still can realize all the projectshe had planned. He does not know that the quantity of his means has beendiminished. Therefore, he will not adjust the structure of his property to the newcircumstances. He is likely to leave for holidays in cases where he should ratherbegin to save and live from hand to mouth. If fraud occurs on a large scale,society's capital structure will be distorted in an exactly analogous way. People do

not apprehend that the capital stock has been diminished by the embezzler and

38 Later authors in the Austrian tradition also seem to have rejected or at least brushed aside thecategory of imaginary goods. Joseph T. Salerno, for example, inEpistemological Problems of Economic Science(p. 185), calls the distinction superfluous. Further, George Reisman, though he acknowledgesimaginary goods as a valid concept, states:

it is not necessary, however, for economics to devote any special consideration tosuch goods beyond acknowledging the fact of their existence. This is both becausethey constitute unimportant exceptions and because the economic principles thatapply to such goods, such as the laws of price determination, are the same as that

apply to genuine goods. George Reisman,Capitalism, (1996), p. 41.39 Imaginary goods are an inevitable by-product of fraud. The intimate intertwinement of both

phenomena is illustrated by the origins of the German word for fraud, which is Betrug; see footnote 32.


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needs to be refilled through savings. Sooner or later they wil discover this error.This is when the crisis sets in.40

As is to be expected from the title of his article, Hlsmann dismisses his owntheory and defends instead another one, that of the general error cycle or illusioncycle of government.

Now, for our present analysis of the fraud cycle. We begin this section by askingwhether fraud actually is a cyclical phenomenon and with an analysis of the general

context in which fraud occurs. Next, we examine the fraud-phase of the cycle, whichconsists of an ungenuine trust, and an inflationary boom. This is followed by a discussionof the recovery-phase, consisting of the crisis, the deflationary correction, and therectification. We conclude our analysis of the fraud cycle with a graphical illustration.

Is Fraud a Cyclical Phenomenon?

A cycle is a causal chain of events that is repeated or repeatable (the word derivesfrom kyklos, circle). It seems that there are two ways in which phenomena can be calledcyclical. A first is a logico-sequential cyclicality, a second is cyclicality through time. Thelogico-sequential cyclicality is a natural feature of all phenomena: they move from non-existence, over appearance, towards disappearance. In this sense, every individual

phenomenon is cyclical in nature. A second way in which a phenomenon may be calledcyclical is when the circular sequence of aspects of which the phenomenon is constitutedis not only sequential, but also temporal, i.e., stretched out in time. The phenomenon offraud can be marked as also being cyclical in this second sense. The time element isinherent in the nature of fraud, for the reason that, by definition, there exists a (short orlong) time lag between the moment someone becomes the victim of fraud, and themoment in which the fraud is uncovered. We here follow the same line of reasoningGuido Hlsmann applies in his theory of the error cycle:

The theory of error cycles starts from the fact that error is committed at themoment choice but only revealed in the future. There is always a time lag betweena wrong choice and the discovery that it was a wrong choice, and at the momentof choice, one is never aware of one's errors-otherwise one would not engage in

this action at all. The necessary time lag between an error and its discoveryimplies an error cycle, with all the familiar features of the business cycle theory.41

What we assert is thus that cyclicality is a quality that necessarily follows from theconstitutive features of the phenomenon fraud. In other words: fraud is notsometimes, but always and inevitablycyclical in nature.

Let us now proceed to a description of the fraud cycle. As we will see in whatfollows, it can be divided in two general phases: the first is the phase of fraud, and thesecond is the phase of recovery.42Before the first phase, fraud, we find ourselves in anenvironment where good faith allows for trade and friendly relations: the convivial order.

Initial state of affairs: Order

This is the state of affairs we have studied in the above section On means, goodfaith, and the convivial order. Frank van Dun calls this the natural, or convivial, order:

[T]he convivial order is ius-based. The word ius refers to the Latin verb iurare,which means to swear; to speak solemnly; to commit oneself toward others. Theius-relation implies no positions of authority or command, but direct personalcontacts resulting in agreements, covenants and contracts, in mutual

40 Guido Hlsmann, Toward a General Theory of Error Cycles, p. 12.


42 We use the same division as Hlsmann's: Fundamentally, two stages can be distinguished.

At the beginning of the first stage the error is committed. The crisis marks the point in time wherethe error is discovered. Then begins the second stage, a phase of reestablished sobriety. GuidoHlsmann, Toward a General Theory of Error Cycles, p. 8-9.


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commitments, obligations or iura. Strictly speaking, the ius-relation can exist onlybetween natural persons, as they are the only persons that are naturally capable ofindependent speech and action. 43

In the convivial order, people maintain friendly relationships and generally trusteach other. In this atmosphere of genuine trust,44people engage in mutually beneficialcooperation, which results in peaceful commerce, division of labour, and sustainableeconomic growth. The attitude of genuine trust that exists in the convivial society isexpressed in trusting relationships between individuals, or trusts. In a trust, a trustorassumes the truthfulness of another person and has good reasons to expect that the other

will perform one or more actions.45These good reasons may be implicit, embedded in thesocial and cultural context, or made explicit, for example by a specific promise of theother person. The person wherein the trust to perform an action is placed, is whom wecan call the trustee.

Phase I: Fraud

The Swindler and the Ungenuine Trust

The violation of the convivial order by means of fraud begins when a person (we

will further refer to him as the swindler) decides to act in bad faith, thereby causing inthe mind of another a distorted judgment of the potency of his means, in order to gain tohis detriment. The swindler abuses the other's goodwill by representing something astrue, knowing that it is not. He succeeds in getting the other person to enter in a trust

with him, whereby he as trustee (or fiduciary46) commits himself to an act (or series ofacts) that is regarded as beneficial in the eyes of the trustor, in return for one or morefavours from the part of the trustor. The supposed benefits, falsely promised to the

43 Frank van Dun, Concepts of Order, 2006.44 See Tuomela, M., 2003, A Collectives Rational Trust in a Collectives Action, Understandingthe Social II: Philosophy of Sociality, Protosociology 18-19: 87-126

45 Maj Tuomela has done interesting work on trust. He writes:

Trust could be conceived of as an attitude that the trustor has towards the trustee inwhich the trustor, due to their relationship of mutual respect, normatively expects ofthe trustee, on social or (quasi-) moral grounds, that he will intentionally gratify thetrustor within a wide scope of matters. Such a relationship of mutual respect is oftendescribed as one of goodwill and trust. Maj Tuomela, Rational Social Normative

Trust as Rational Genuine Trust, published in Philosophy and Ethics: New Research,Laura V. Siegal ed., (New York: Nova Science Publishers, 2006), p. 2.)

The grounds of trust as described by Tuomela however, social or (quasi-) moral grounds,are very vague. In another article he does use the less arbitrary concept of rights, when he asserts:

The trustor believes that the trustee will intentionally perform the desired actionwith goodwill towards the trustor, partly in response to the trustor's right to expectthis good-willed action of the trustee. This belief is grounded in the trustor's belief of

having a relationship of mutual respect with the trustee. (Ibid., p. 27).

However, these rights are nowhere defined. It seems to us that the ultimate moral groundsof trust (i.e., the answer of the question why a trustee shoulddo the act the trustor trusts him to do) restsin the criterion of reasonability. To illustrate: as a Belgian I cannot travel to Great Britain and trust thatthe cars there will drive on the right hand side of the road. This wouldn't qualify as genuine trust; if mycar then was hit by a British driver, it would be absurd to accuse him of breaking my trust. The reasonfor this is because it isn't reasonable for me to assume that British cars should drive on the right handside of the road. More generally, it is not reasonable to cast judgement over an act or actor withoutconsidering the specific context. Trust has to be based on sound reasons. In our mind, genuine trusthas to be grounded in the same rational foundation as the convivial order itself, namely on theirrefutable one ought to be reasonable. On the ought of reasonability, see Frank van Dun,Economics and the Limits of Value-Free Science, Reason Papers No. 11 (Spring 1986) 17-32.

46 This would be a broad interpretation of fiduciary as it was used in Roman law. The Roman

institution of thefiduciafound its origins in the use of thepater familias(head of the family) to hand overthe management of his family, domain, and possessions to a friend. See R.H. Maatman, Dutch PensionFunds(Nijmegen: Kluwer, 2004), p. 63.


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trustor, are what we can call imaginary goods.47The swindler is a trustee in bad faith: hedoes not intend (or he knows beforehand that he is not able to) to fulfill his fiduciaryduty and to meet the lawful claim of the trustor.

The swindler and his victim can now, as is common practice between trustor andtrustee, decide to make up a trust agreement. This agreement serves as a fiduciary token,explicitating the existence of the trustee's fiduciary duty, and with that the relationship oftrust between trustor and trustee. Such a fiduciary token can take many forms: it can be a

written contract, a property title, a receipt of payment, or even a verbal agreement. Itsessential characteristic is that it mediates between trustor and trustee. In the case of fraud,the fiduciary token confirms the swindler's promise and the claim of the victim; the titleto a good that, given the malafide intentions of the swindler, is doomed to remainimaginary.

The strategical tricks of his fraudulent business partner lead the victim-to-be to thebelief that there is a possibility to a a genuine trust; a just and mutually beneficialrelationship. However, he is mistaken. The trustee who acts in bad faith is now vested

with the goods and the trust of his victim, while the fiduciary tokens that are handed overto the latter are empty shells: their title covers less than what should be reasonablyexpected under the given circumstances.

In f la t i onary boom mal inve s tment and ov e r consumpt i on

The fraud has now been committed, and the first phase of the fraud cycle isinitiated. The supply of true goods (means) of the victim has been inflated by anadditional supply of imaginary goods. Inflation derives from the Latin verb inflare,from in-into +flareto blow. The creation of imaginary goods indeed makes the totalsupply of goods seemingly swell, in the same way as that, when seen from a distance, a

water balloon seems to contain ever more water, while in fact it is inflated with more air.Likewise, the hot air of the imaginary goods leads to a seeming but nonexistentexpansion of the supply of true goods. This is why we consider the word inflation aptin this context, and call this phase the inflationary boom.48

As long as the deceit lasts, the fraud victim finds himself in a euphorical state ofmind, in that he imagines to possess more means than really is the case. Consequently, hewill invest his means in different ways than otherwise would have been the case. Theseinvestment choices will later prove to be based on a mistaken estimation of availableresources, which is why some, or many, will eventually have to be liquidated becausethere simply is not enough capital available for them. In short, fraud leads tomalinvestments. A second implication of the misconceived supply of means is that, sincethe victim imagines to have command over means that have more potency that actually isthe case, he will also ultimately consume more (and save less) than would have been thecase in absence of the deceit. Another consequence of fraud is thus overconsumption.

47 This imaginary good can take the shape of an alleged future good, promised but neveractually given to the victim, or it can be actually received resources with properties different in qualityor quantity, than the good the victim believes to have received.

48 In his Human Action, Mises warned against the use of popular terms such as inflation inacademic (praxeological) discourse:

The notions of inflation and deflation are not praxeological concepts. They were notcreated by economists, but by the mundane speech of the public and of politicians. . .. inflation and deflation are terms lacking the categorial precision required forpraxeoIogica1, economic, and catallactic concepts. Their application is appropriate forhistory and politics. (HumanAction, p. 419-420)

Nonetheless we think the terms of inflation and deflation, if properly defined, can proveuseful in clarifying the the dynamics of both the catallactic business cycle as well as the more genericfraud cycle.


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Phase II: Recovery

Cri s i s and Crack-up Boom

The second phase of the fraud cycle, the crisis, is initiated at the point in time wherethe illusion has reached its maximum size (simply because it cannot get bigger after this):the moment where the fraud is revealed. Ludwig von Mises, in his description of thebusiness cycle, used the term Katastrophenhausseto indicate this moment, and it illustrates

the essence of this point in the cycle well: the sudden turn (catastrophe) following the rise(hausse). At some point in time the genie leaves the bottle, the high wears off and givesrise to the inevitable downturn. What provokes this downturn is the bursting of theillusion created by the swindler. The victim now realizes he has been fooled: the fiduciarytokens he received from the swindler no longer cover the flag or duty they embodied.Guido Hlsmann puts it this way:

The victim of fraudulent behavior is not aware of his situation and thus behavesas if everything was still in order. he does not know that the quantity of hismeans has been diminished. Therefore, he will not adjust the structure of hisproperty to the new circumstances. People do not apprehend that the capitalstock has been diminished by the embezzler and needs to be refilled throughsavings. Sooner or later they will discover this error. This is when the crisis sets

in.49

The confrontation with the deceit makes the untenability of the situation obvious:the sum of the victim's means now turns out to be smaller than he thought it was (at anyrate it can serve his intentions less well), and, consequently, this prohibits him fromcontinuing on the same investment path. The swindler as well notices the change ofclimate and will have to change his strategy. This is what we can call the crisis(Gri. krisis:conflict, but also decision): the deciding moment, the hour of truth, has come, andthe hidden conflict breaks loose. It is now clear that the trust that the victim had placedin the swindler was painfully misguided.

Correc t ion Depress ion Recovery

The inevitable loss in confidence seriously affects the value of the victim's fiduciarytokens; these have now appeared to consist largely, or completely, out of hot air. Thiscauses the illusory bubble to deflate, and the inflationary boom reverses in a deflationarycorrection.50 In the words of Hlsmann: [t]he crisis marks the point of time when theerror is discovered. Then begins the second stage, a phase of reestablished sobriety.51During this process, the fraud victim attempts to exchange the fiduciary tokens hepossesses into true goods (flight into real goods). However, since these are not coveredby true goods, he will inevitably loose all or a large part of his original investments withthe swindler.

The euphoria of the inflationary boom has thus been replaced by a process ofsobering up; the victim of the fraud now assesses the means that are to his disposal in a

more realistic way. This painful process, whereby misconceptions become manifest andthe victim is confronted with the truth of the matter, is what we can call the depression.

The restoration of his own sound judgment in the state of affairs is at the same time thebeginning of the recovery process. This is the process whereby the victim readjusts hisconsumption and investment pattern in alignment with the actual means that are underhis command, thus freeing himself from the disorder brought about by the lies of the


50 In the context of the fraud cycle, and understanding law as order, we agree withPhilipp Bagus when he states that deflation, in contrast to inflation, is not a breach of the law,but rather, it is the restoration of the law. Philippe Bagus, Deflation: When Austrians Become

Interventionists, The Quarterly Journal of Austrian Economicsvol. 6, no. 4 (Winter 2003), p. 25. Just asa restoration of order can only occur after a preceding phase of disorder, deflation, in the abovesense of the word, can only occur after a foregoing phase of deflation.51 Guido Hlsmann, Towards a General Theory of Error Cycles, p. 9.


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swindler. When this process is finished, order is restored and the fraud cycle is brought toa close.

Graphical Illustration of the Fraud Cycle

Given all the problems involved with the visual and/or quantitative representation oftheory in the field of axiological science, we suggest the graphical illustration belowmerely for educational purposes, in an attempt to give some oversight of how the

simultaneous and successive phenomena involved in the fraud cycle coexist.

Fraudulent deception causes the generation and degeneration of imaginary goodsover time. Hence the two axes of our graphical illustration of the fraud cycle: time (X)

versusgoods-character(Y). The X-axis is divided into three phases:

1. First comes the phase of order, during which people are truthful and deal

with each other in good faith. There is no deception, which means thateach actor lives within his means, not claiming command over means thatare not his. This absence of deception further implies that nobody isdeceived into imagining certain goods to be present and available that infact are not. During the phase of order, the actors in question still commitentrepreneurial errors, with the consequent appearance of imaginarygoods, and the malinvestment and overconsumption following this.However we don't consider these here, since we are dealing with theeffects of fraud and not those of error in general.

2.

Next is the first phase of the fraud cycle; the phase during which

the actualfraud (in one or multiple acts) takes place. In the illustration thereare three acts of fraud, marked by T1, T2, and T3. Every act of fraudcauses a decrease in the availability of proper means (the illustration doesnot consider accidental increases or decreases unrelated to the fraud), andan increase in the amount of deprived means. The actual losses sufferedbecause of the fraud are covered up by a simultaneous creation ofimaginary goods.52

52 The victim of the fraud considers these imaginary goods to be of higher value than the

means he forsakes or allows to be manipulated, which is why we have made the volume of the figurerepresenting the imaginary goods with a bigger volume than that of the figure representing thecorresponding deprived means. The exact volumes are of course merely arbitrary.


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3. The second and last phase of the cycle is that of the recovery. It startswhen the fraud comes to light (crisis), and, as a consequence, theimaginary goods shrink rapidly in volume during a deflationary correction.

This is also when the process of deprivation transforms into areadjustment or recovery process, consisting of a reallocation of themalinvested goods and an increase in savings (decrease in consumption).

The fraud cycle ends when the damage or deprivation caused by the fraudhas been undone.

4. REPLY TO SEVEN OBJECTIONS

There can be no facts in a world without values.

Frank van Dun

Introduction

Now that we have shown in general terms what the causes and effects of fraud are,let us turn to some objections to our thesis.

The obvious and general one is the question of whether the business cycle isessentially a fraud cycle. The analogies between the two phenomena are quite clear, but isthe overlap really of such a kind that there can be no meaningful essential distinctionbetween both? Can all essential characteristics of the business cycle be explained in termsof fraud? Can non-fraudulent activities perhaps also lead to fraud cycles? In order tocounter these important criticisms, let us therefore muster our thoughts to show thereader that the business cycle can be explained as essentially a fraud cycle (objections 1-6),and that honest fractional reserve banking can impossibly bring about business cycles(objection 7).

FIRST OBJECTION:THE ESSENTIAL CHARACTERISTICS OF THE BUSINESS CYCLECANNOT BE EXPLAINED IN TERMS OF ITS FRAUDULENT NATURE.

On the contrary, we hold that the business cycle is essentially fraudulent, and thatits fundamental characteristics can be explained as consequences of fraud. Let us, in orderto convince the reader, analyse the emergence of a business cycle from a judicialperspective.

Bankers, at least traditionally, are entrepreneurs who operate in the market and whooffer certain services to the people. More specifically, bankers are entrusted with moneyby their customers, and promise to handle this money in specific ways. There is thus a

relationship of trust between bankers and their customers, in the context of which theyenter into formal agreements with one another. When customers hand over money totheir banker in the form of a loan or a deposit, 53 the formal agreement involved isessentially a trust.54 In the case of a depositor-depositary relationship, the formal

53 For an elaborate discussion on the traditional legal nature of the loan contract and depositcontract, as well as for a detailed historical account of the separate use of these two contract in banking,see Jess Huerta de Soto,Money, Bank Credit, and Economic Cycles, chapters 1 and 2. See also Jrg GuidoHlsmann, Banks Cannot Create Money, The Independent Review, v.V, n.1, Summer 2000, pp. 101110

54 trust, n. 1. The right, enforceable solely in equity, to the beneficialenjoyment of property to which another person holds legal title; a property interestheld by one person (the trustee) at the request of another (the settlor) for the benefit of

a third party (the beneficiary). For a trust to be valid, it must involve specific property,reflect the settlors intent, and be created for a lawful purpose. (Blacks LawDictionary (7th ed. 1999), p. 1513).


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agreement in question is more specifically a resulting trust.55 In order to make the trustbetween them and their customers formal and binding, bankers have traditionallyformalized and made explicit their fiduciary duties by writing out money titles, which areessentially fiduciary tokens that confirm that a certain customer X is entitled to receive acertain amount of money from the banker, either at wish (deposit) or after an agreedupon period of time (loan).

Now if the banker writes out money titles in excess of the actual money he has in

his own possession (i.e., money lent to or owned by him), he commits the crime of fraud,since he gives away something that does not belong to him, thus depriving the originalowner, while pretending that is not the case.56These money titles that are not backed byactual money are what in the Austrian tradition is called fiduciary media. Thesefiduciary media make the people who receive and use them believe they own or controlcertain goods which they in fact do not: imaginary goods.57With the money supply thusinflated by fiduciary media, actors in the economy will proceed to consume more thanthey otherwise would have (overconsumption) and to invest in different places in thestructure of production than they otherwise would have (malinvestment). From thegeneral perspective of the fraud cycle, we can describe this phase, fueled by fraudulentlycreated imaginary goods, as the inflationary boom. Of course, the inflationary boomcannot last forever. Ludwig von Mises explains why:

it is not possible to make the boom last forever because the boom is builtupon paper, on banknotes and checkbook money. It is based on the assumptionthat there are more goods available than there really are.

The imaginary good cannot remain undiscovered as such: one day the truth willcome out.The inevitable crisis sets in when a certain threshold of people calls upon theirbank in order to have it meet its fiduciary duties. Often the initial reason for this is not asudden loss of confidence in the banks (though it may), but rather the fact that the stock

55 ". . . a resulting trust arises whenever legal or equitable title to property isin one party's name, but that party, because he is a fiduciary or gave no value for theproperty, is under an obligation to return it to the original title owner, or to the person

who didgive value for it".

Donovan Waters, "Law of Trusts in Canada", 2e ed. (Toronto: Carswell, 1984), p. 300., asquoted in Robert Chambers, Resulting Trusts (Oxford University Press: New York, 1984), p. 1.Chambers further quotes the essential characteristic of the resulting trust as being the person in whosefavour the trust arises is the person who provided the property or equitable interest vested in theperson bound by the trust; quoting ibid., p. 302. On the history of the legal institution of the resultingtrust, see chapter 14 Unjust Enrichment of David J. Ibbetson, A Historical Introduction to the Law ofObligations, (New York: Oxford University Press, 1999), pp. 264-284, esp. p. 267.

56 It is important to note that the institution of fractional reserve banking, whereby customersare falsely lead to believe they have immediate access to their demand deposits, is inherently injurious.It has been said that when fractional reserve banking is practiced in moderation, the detrimentaleffects will not be that great, nor will they become immediately apparent. However, this is no ground tojustify the practice; stealing a thousand monetary units from a millionaire will also not likely producegreat damage to the person, but that does not justify the institution of stealing. One could also hold thattoday's bankers know of no better. That is to some extent true, fractional reserve banking is commonpractice and has been institutionalized to a great extent. However, that does not detract from thedeceitful nature and harmful effects of this practice, as the current state of the economy tragicallyillustrates. A thief who knows no better is still a thief.

57 Note that hereby it does not matter essentially whether this happens in the form of writingout circulation credit (credit merely based on the trust in the bank, not directly covered by the bank'sassets) or in the form of mere embezzlement of deposits. One could imagine a bank (for example acentral bank) that writes out circulation credit without any actual assets at all to cover it. This practice

would set in motion a business cycle. On the other hand, one could also imagine a bank or financial

institution (the investment firm of Bernard Madoff comes to mind) whereby lent or deposited money issystematically embezzled on a large scale. Also this would lead to malinvestment, overconsumption andthe inevitable crisis and recession in the economy.


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of real savings in the market place has been depleted to such an extent that it startsbecoming apparent in rising prices of consumer goods.58

When it becomes clear how difficult it is for financial institutions to meet theirobligations, people start becoming suspicious. Garet Garrett puts it cogently, referring tothe crisis following a debasement of a gold standard currency:

Suddenly doubt, then coming awake and panic. The spirit of gold has beendebased by senseless inflation. The faith is lost. All with one impulse people rush

to seize the gold itself as the only reality leftnot only people as individuals ;banks, also, and the great banking systems and governments do it, in competition

with people. This is the financial crisis.59

During the crisis, consumers collectively call upon their banks to meet theirfinancial obligations or fiduciary duties (bank run), which results in bank failures. Theseconsumers will simultaneously also adjust their consumption patterns, which leads to apainful readjustment of the structure of production during which capital goods are re-allocated from the stages far removed from consumption, towards the stages closer toconsumption. The effect is widespread failures in the economy and temporaryunemployment. In addition, a deflationary correction will take place in the form of acontraction of the (fiduciary) money supply. Translated in terms of the more generalfraud cycle: an increasing amount of fraudulent practices are being uncovered, and as a

consequence, a deflationary correction takes place which diminishes the supply of malafide fiduciary tokens (fiduciary media) in circulation. This contraction of the moneysupply, in turn, is in fact how the deflationary correction of goods, a move from a supplyfraudulently inflated by imaginary goods towards a supply ridden from these imaginarygoods, becomes apparent in the economy. The recovery phase of the business cycle is setin motion when entrepreneurs, now empowered by a more realistic assessment of theirmeans, start providing goods and services to meet the readjusted, more realistic demandsof their fellow men.

The following table gives an overview of the most important features of the fraudcycle and their corresponding, more specific, features of the business cycle.

Table 1: Comparison Fraud Cycle - Business Cycle

Fraud Cycle Business Cycle

Essential cause Deceit Deceitful creation ofmoney titles (fractionalreserve banking)

Actors Trustor and trustee Depositor and depositary

Relationship Trust Resulting trust

Means Mala fide fiduciary tokens Fiduciary media

Effects Inflationary boom ofimaginary goods, possiblyaccompanied by a boom infiduciary tokens

Inflationary boom offiduciary goods,accompanied by a boom infiduciary media

Deflationary correction:imaginary goods are seenas such, mala fide fiduciarytokens become valueless

Deflationary correction:fiduciary media are seen assuch, contraction of themoney supply

58 For a detailed discussion of the different phases of the business cycle, see Huerta De Soto's

Money, Bank Credit, and Economic Cycles, pp. 347-395.59 Garet Garrett,A Bubble That Broke the World, (Boston: Little, Brown, and Company, 1932), p.

124.


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Restoration Readjustment ofconsumption and savingpattern by the victims

Readjustment of thestructure of production, bya shift in demand from thepart of the consumers

The victim's saving andinvestment patternsreturns to being more in

line with the supply of realgoods.

Restoration of thestructure of production, inline with the real goods

present in the marketplace

Order is restored(rectification): in so far aspossible, damages arerepaired and means returnto their rightful ownerspeople live within theirmeans again

Order is restored(rectification): the assets ofthe bankrupt banks arereturned to their rightfulowners; banks stop writingout fiduciary media, andbecome full reserve banks

We have now seen that the essential characteristics of the business cycle can indeed

be explained in terms of the fraud cycle. Let us consider some further possibleobjections.

SECOND OBJECTION:ERRORS CANNOT BE EXPLAINED BY SINGULAR CHANGES OFCONDITIONS.THE CLUSTERS OF ERROR THAT LEAD TO CRISES AND RECESSIONS IN

THE ECONOMY MUST THEREFORE BE EXPLAINED BY OTHER FACTORS.

Guido Hlsmann writes:

Does the occurrence of singular events necessarily lead to error? This is the

decisive question. Yet this is definitely not the case. Errors cannot be explainedby singular changes of conditions because even such changes can beanticipated.60

On the contrary, we hold that errors can be explained by singular changes ofconditions. As writes St. Thomas:

Hence in one way truth varies on the part of the intellect, from the fact that a changeof opinion occurs about a thing which in itself has not changed, and in another

way, when the thing is changed, but not the opinion; and in either way there can be achange from true to false.61(italics are our own)

Deception, and the errors that follow from acting upon it, can be caused by singlechanges of things. Now we agree with Guido Hlsmann when he states that the

existence of singular events could only serve as a basis for a consequentialist explanationof error, if they impliederror. Otherwise, a mere change of conditions, and even a singularone, could never be a sufficient explanation of error. Indeed fraud, as we have seenabove, leads to a breakdown of the mutual trust of the market place and a creation ofimaginary goods that cause illusion, or error, to be inherently anchored in the chain ofevents. Thus fraud, even a singular act of fraud, implies error.

We further agree with Hlsmann when he says that

a program for the essentialist explanation of recurrent clusters of errors has toidentify more or less permanent patters of action (institutions) in which the errorof many persons is inherent. Instances of crises are then explained as situations in


61 Thomas Aquinas, Summa Theologiae, I, 16, art. 8.


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which many acting persons become aware of their errors or of the consequencesof their errors.62

Indeed, in the institution of fraud, the occurrence of error is inevitable. A singleinstance of fraud thus inevitably leads to errors on the part of its victims. This is why wehave to disagree with the same author when he states that [e]rrors cannot be explainedby singular changes of conditions because even such changes can be anticipated.63 Onthe contrary, fraud, or deliberate deception causing injustice can by definition not beanticipated, because if it was, it would have never been fraud in the first place. Wemaintain that fraud, even singular events of it, causes and thus explains error.

THIRD OBJECTION:FRAUD CANNOT BE THE ULTIMATE EXPLANATION FOR THEBUSINESS CYCLE,SINCE IT DOES NOT EXPLAIN FOR THE RECURRENCE OF THE

BUSINESS CYCLE.

Writes Guido Hlsmann:

Any business cycle theory is essentially a theory of error. Its aim is to explain therecurrence of the phenomenon that we call crisis; that is, a situation in which thesimultaneous economic failure of many people becomes obvious. Thus businesscycle theory not only has to explain the occurrence of error but the recurrence of acluster of errors as well.64

On the contrary, we hold that the business cycle is not inherently recurrent. Or, putdifferently, we hold that recurrence is not an essential quality of the business cycle. Acycle, as we've explained above, is a recurrent or reproducible succession of events. Now,given that the human will is free, there can be no absolute regularities in the incidents ofhuman action. Man is free to act and to refrain from acting. It follows that he is also freeto set in motion cyclical phenomena, and likewise free not to do so. Therefore we mustconclude that any cycle brought into being by human action, must possess the characteristic, not of (self-

generating) recurrence, but rather that of (voluntary) reproducibility.

Along these lines, Murray Rothbard states that

[r]ecurrence [of the business cycle] stems from the fact that banks will always tryto inflate credit if they can, and government will almost always back them up andspur them on. When the storm has run its course and recovery has arrived, thebanks and the government are free to inflate again, and they proceed to do so.Hence the continual recurrence of business cycles.65

What Rothbard points out is in fact how the recurrence of the business cycle is theresult of a free choice. Neither fractional reserve banking nor inflation, and consequentlyneither the business cycle, are necessarily recurrent phenomena. Both Ludwig von Misesand Murray Rothbard attested to this fact. Writes Mises:

Papiergeldinflationen zeigen keine Regelmssigkeit der Wiederkehr. Sie

entspringen im allgemeinen einer bestimmten Lage der Politiek und nichtirgendwelchen Vorgngen innerhalb der Wirtschaft.66

62 Guido Hlsmann, Toward a General Theory of Error Cycles, p. 9. Hlsmann formulatedthis paragraph while making the case for inclusion of the institution of government into the generaltheory that would explain the business cycle. We disagree, and hold that the right institution to refer tois that of fraud. See also below, under the reply to the objection on government interference, footnote76.


64 Ibid, p. 1.

65

Murray N. Rothbard, America's Great Depression, (Auburn, Ala.: Ludwig von Mises Institute:2000), p. 33-34.

66 Ludwig von Mises, Geldwertstabilisierung und konjunkturpolitik, (Jena: G. Fischer, 1928), p. 56.


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And Rothbard:

To avoid the business cycle, then, it is not necessary for the banks to beomniscient; they need only refrain from credit expansion. If they do so, theirloans made out of their own capital will not expand the money supply but willsimply take their place with other savings as one of the determinants of the free-

market interest rate.67

Here is a final argument. Defendants of the idea that business cycles are necessarily

recurrent can be asked the following question: suppose that in the course of history, onlyone banking system had once existed wherein fractional reserve banking had emerged,and this banking system had only generated one single inflationary boom, followed byone crisis and one deflationary correction. Suppose further that after this economic crisis,the public called loudly to only allow for full reserve banking, and that it was granted its

wish: the old full-reserve system was installed once more, remaining in place until thepresent day. Let us even, for the sake of argument, assume that this banking systemoperated under a central bank supported by the force of government. What else would

we call that unique episode in history, but a business cycle? And if we didn't call it so,how would we meaningfully differentiate it from genuine business cycles?68

We conclude here, with the contention that recurrence is not an essential but ratheran accidental property of the business cycle.

FOURTH OBJECTION:THE ESSENTIAL THEORY OF ECONOMIC CYCLES ISINCOMPLETE WITHOUT AN ACCOUNT OF THE ROLE OF GOVERNMENT

The above objection is our (granted, perhaps somewhat unjustified) interpretationof the following paragraph of Hlsmann:

The fraud cycle is likely to recur as long and insofar as government meddlingwith money takes place. It is the very purpose of monetary interventions tocommit fraud on large numbers of market participants. Now, one could insist

that fraud is not a feature particular to government. Even on the free marketthere could be counterfeiters and fraudulent bankers holding only fractionalreserves for the money they issued. This is true. However, such instances couldnever be sufficient to establish a business cycle theory. Let us recall that such atheory has to explain why there is a cluster of errors and why this cluster of errorsis likely to recur again. Pointing to the possibility of fraud on the free market doesnot solve these problems. At best, one can in this manner explain clustersof errors,but one invariably fails to explain their recurrence.69

On the contrary, we hold that government involvement is an accidental (orposterior) cause of economic cycles, not a substantial (or prior) cause.70In our opinion, in

67 Murray N. Rothbard,America's Great Depression, p. 33.

68 In his article Toward a Theory of Error Cycles, Guido Hlsmann gives a similar account,except he leaves out the government and gives the example of a free banking cartel that produces asingular economic crisis, to show that this is no business cycle because there is no recurrence. With ourcounterexample, we hope to have shown that even with government taken into the equasion, thebusiness cycle is not necessarily recurrent. See Guido Hlsmann, Toward a General Theory of ErrorCycles, p. 15.

69 Ibid., p. 15. Italics in original.

70 On prior and posterior causes, see St. Thomas:

For a cause can be called prior or posterior; for example, when art and the physicianare given as causes of health, art is prior and physician a posterior cause It shouldbe observed that it is always the more universal cause that is called remote and themore specific proximate Thomas Aquinas, On The Principles of Nature, translated in

Thomas Aquinas Selected Writings(Penguin Group: London, 1998), p. 27.On the difference between substance and accident, one of the classical texts is Porphyry's

Isagoge:


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order to develop a theory that fully describes the essential causes of economic cycles, onedoes not need to integrate into it a factor called government interference. Ourcounterargument is made up of two parts. First, we defend that government action canonly exist in the metaphorical sense of the word, and second, we defend that the businesscycle does not need an explanation for its alleged necessary recurrence, because it doesnot have such a necessary recurrence.

Let us begin with the first part of our reply to the objection, on the nature of

government. The government is in essence a corporation, an artificial personality that canonly act or speak in a metaphorical way, by the acts and through the mouths ofcertain natural persons that act and speak on behalf of it. As writes Frank van Dun:

A corporation that is compatible with natural law is no more than an associationof natural persons, who agree to recognize the association as an artificial personin its own right. However, as far as other persons are concerned, the exist

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