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Austrian Economics,
Money and Finance

The financial crisis has exposed severe shortcomings in mainstream monetary eco-
nomics and modern finance. It is surprising that these shortcomings have not led
to a wider debate about the need to overhaul these theories. Instead, mainstream
economists have closed ranks to defend existing theories and public authorities
have expanded their interference in markets.
This book investigates the problems associated with mainstream monetary eco-
nomics and finance, and proposes alternatives based on the Austrian school of eco-
nomics. This school emanated from the work of the nineteenth-century Austrian
economist Carl Menger and was developed further by Eugen von Böhm-Bawerk,
Ludwig von Mises, and Friedrich August von Hayek. In monetary economics,
the Austrian school regards the creation of money by banks through credit exten-
sion as a key source of economic instability. From this follows the need for a
comprehensive reform of our present monetary system. In a new monetary order,
money could be issued by both public and private institutions, and there would be
no need for fractional reserve banking. Instead of creating money, banks would
intermediate it.
In finance, the Austrian school rejects the notion of rational expectations and
measurable risk. Individuals use their subjective knowledge to gather and evalu-
ate information, and they act in a world of radical uncertainty. Hence, markets
are not “efficient” nor can portfolios be built on the basis of known probability
distributions of asset prices as described in the modern finance literature.
This book explores the need for a new theoretical foundation for asset pricing
and investment management that will give practitioners more useful orientation.

Thomas Mayer is Founding Director of the Flossbach von Storch Research Insti-
tute, Cologne, Germany. He is former Chief Economist of Deutsche Bank Group
and has held positions at Goldman Sachs, Salomon Brothers, the International
Monetary Fund and the Kiel Institute.
Banking, Money and International Finance
For a full list of titles in this series, please visit www.routledge.com/series/BMIF

1 Alternative Banking and Financial Crisis

Edited by Olivier Butzbach and Kurt von Mettenheim

2 Financial Innovation, Regulation and Crises in History

Edited by Piet Clement, Harold James and Herman van der Wee

3 Asian Imperial Banking History

Edited by Hubert Bonin, Nuno Valério and Kazuhiko Yago

4 Colonial and Imperial Banking History

Edited by Hubert Bonin and Nuno Valério

5 Financing California Real Estate

Spanish Missions to Subprime Mortgages
Lynne P. Doti

6 History of Financial Institutions

Essays on the History of European Finance, 1800–1950
Edited by Carmen Hofmann and Martin L. Müller

7 Growth Without Inequality

Reinventing Capitalism
Henry K. H. Woo

8 Austrian Economics, Money and Finance

Thomas Mayer
Austrian Economics,
Money and Finance

Thomas Mayer
First published 2018
by Routledge
2 Park Square, Milton Park, Abingdon, Oxon OX14 4RN
and by Routledge
711 Third Avenue, New York, NY 10017
Routledge is an imprint of the Taylor & Francis Group, an informa business
© 2018 Thomas Mayer
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asserted by him in accordance with sections 77 and 78 of the Copyright,
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All rights reserved. No part of this book may be reprinted or reproduced or
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registered trademarks, and are used only for identification and explanation
without intent to infringe.
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For Marie
“Only fools believe that they know all, but there are many.”
F. A. von Hayek
Contents

List of figures xi
List of tables xiii

1 Introduction 1

PART I
Money 7
2 The functions of money and money creation 9

3 The nature of inflation 31

4 The concept of interest 43

5 The order of money and its consequences 61

6 Blueprints for monetary reform 79

PART II
Finance 93
7 Debt and ownership 95

8 The building blocks of Modern Finance 107

9 The failures of Modern Finance 127

10 How Modern Finance has contributed to financial crises 141

11 Building blocks of a theory of Austrian Finance 161

12 From theory to practice – applications of Austrian Finance 179

13 Epilogue 197

Index 199
Figures

3.1 Stock prices and inflation in the US 37

3.2 Investment ratio and consumer price inflation in
advanced economies 38
3.3 Consumer and wealth prices in Germany 39
3.4 Consumer price inflation in the UK 40
4.1 Current account balance of emerging market economies
and yield on US government bonds 44
4.2 Savings rate and working age population (15–74 years)
in Japan 45
4.3 The Hayek Triangle with five stages of production 48
4.4 The Hayek Triangle with seven stages of production
after a reduction of the interest rate from a to b 49
4.5 The Hayek Triangle with three stages of production
after an increase of the interest rate from a to c 50
4.6 US Fed Funds Rate and Taylor Rate 52
4.7 Duration of a bond with a 5-year term and a 2-percent
coupon rate as a function of the market rate 56
4.8 Price of a bond with a 5-year term and a 2-percent
coupon rate as a function of the market rate 56
5.1 Credit Boom-Bust Cycle according to Wicksell,
von Mises, and von Hayek 69
5.2 Changes in real private demand and credit flows
(credit impulse) in the US, 1928–2016 70
8.1 Return and volatility in a portfolio 109
8.2 Portfolio efficiency frontier and indifference curve
between risk and return 110
8.3 Return and volatility in a portfolio with a “risk free” asset 111
8.4 Security Market Line in the Capital Asset Pricing Model 114
8.5 Binomial model of the option price for two periods 121
8.6 Binomial model of American option prices for two periods 122
9.1 S&P 500 equity price index (percent change between ends
of months) 132
9.2 DAX und REXP – correlation coefficients of weekly
returns in the respective quarter 133
xii Figures
9.3 Density function of the Pareto Distribution 134
9.4 Frequency distribution of the VIX index of US stock
market volatility and the Power Law 136
10.1 Interventions of the Federal Reserve in support of the
equity market (Dow Jones Industrial Index) 143
10.2 Volatility shock in the US stock market (VIX Index) 146
10.3 Outplacement of bank credits through securitization 148
10.4 Decline in implied equity price volatility (S&P 500) in
the era of the “Great Moderation” 152
10.5 Short and long-term interest rates in the US 153
10.6 Shift of the Capital Market Line and of the Efficiency
Portfolio due to QE 155
10.7 Target2 balances in Germany and Italy 157
10.8 Balance sheet of central banks and investment ratio 158
11.1 Key characteristics of human action in Austrian
Finance Theory 164
11.2 Return and Certainty in portfolio construction 169
12.1 Global development of ETFs, 2000–17 180
12.2 Objectives and utility value of a portfolio 193
Tables

2.1 Money systems and orders 15

2.2 Development of deposits and loans in a fractional
reserve system 17
2.3 Balance sheet of the bank at the beginning 19
2.4 Balance sheet of the central bank at the beginning 19
2.5 Balance sheet of the bank at credit extension 19
2.6 Balance sheet of the bank with credit extension completed 19
2.7 Balance sheet of the central bank with credit extension
completed 20
2.8 Balance sheet of the bank before cash withdrawal 21
2.9 Balance sheet of the central bank 21
2.10 Balance sheet of the bank after cash withdrawal 22
2.11 Company Bank extends credit and loses deposit 23
2.12 Employee Bank gains deposit 23
2.13 Company Bank receives loan from Employee Bank 23
2.14 Company Bank pays for a loss of deposits with reserve money 24
2.15 The relationship between short and long-term interest rates 25
5.1 Mean and coefficient of variation of year-on-year growth
rates of US real GDP (in %) 71
6.1 The Credit Money System 81
6.2 The 100 Percent Money System 82
6.3 The “Vollgeld” System 83
6.4 The Neo-Austrian Money System 86
6.5 The Active Money System with a conventional payment
technology 87
6.6 The Active Money System with a peer-to-peer payment
technology 88
8.1 Price of a call option in the binomial model with one period 119
11.1 Austrian Finance in comparison 171
12.1 Portfolio returns of selected Focus Investors and
corresponding market returns 185
12.2 Income and wealth of John Doe 191
12.3 Income and wealth of John Doe with higher interest rate 192
1 Introduction

As I write these lines I have an eye on the Dome of Cologne. The foundation
block of this monumental cathedral was laid in 1248. The choir was inaugurated
in 1322 and building work continued until 1590, when it was stopped, probably
for financial reasons. In 1842 construction was resumed and the cathedral was fin-
ished in 1880. In 1943, the Dome withstood bombs of British war planes and was
repaired after the war. Since 1996 it has been a UNESCO World Heritage Site.
Most of the time, those building the Dome were not construction engineers but
master builders. Master builders used common sense and their experience, gained
through trial and error, to create astonishing works, which have not only been
beautiful, but have also stood the test of time. With the rise of the science of phys-
ics, the master builders were replaced by architects and construction engineers.
The latter applied the law of physics to construction. Some of the beauty created
by the master builders may have been lost, but the construction engineers were
able to build bigger and taller buildings. Thanks to construction engineering, we
can today build skyscrapers 830 meters high (the Burj Khalifa in Dubai), which
are even resilient to earthquakes (the 300 meter high Abeno Harukas in Osaka).
No one in his right mind would advocate abandoning construction engineering
and going back to construction in the way the master builders did it.
As long as people have built buildings they have also saved and invested (which
in fact are requirements for being able to build). Most of the time, savers and
investors have relied on common sense and experience, gained through trial and
error, like the master builders. With the rise of economics as a science, however,
the investing of savings has also turned into an engineering science. This science,
known as Modern Finance, emerged in the 1950s and rapidly gained influence on
decision makers in the financial area. Like the construction engineer in the build-
ing trade, the financial engineer became the dominant figure in the financial sec-
tor. And like the construction engineers in the real world, the financial engineers
built skyscrapers in the financial world, because they were convinced that they
had equally reliable formulas at hand.
However, during the Great Financial Crisis of 2007–08, the financial skyscrap-
ers fell down. The general public blamed the greed and irresponsibility of bankers
for the catastrophe. Politicians and academics in economics and finance joined in
on the banker bashing as it distracted attention from their own contribution to the
mess. I do not want to whitewash the bankers. But in this book I shall make the
2 Introduction
case that mainstream macroeconomics and Modern Finance deserve a fair share
of the blame. They produced theories which may have been internally consistent,
but not applicable to the real world. Nothing would have happened, had they
remained a pastime for the residents of the ivory towers. But they broke out and
guided decision making in economic policy and financial activities.
What is to be done now? In this book, I argue that practitioners in economic
policy and the financial sector need to go back to practical knowledge, based
on common sense and experience gained from trial and error. Physical science
can be successfully applied in construction, but mainstream macroeconomics and
modern finance do not work in the fields of economic policy and finance. What is
then left for economics and finance as sciences? Economics and finance are social
sciences and follow rules that are different from those of natural sciences. They
are unable to derive reliable quantitative impulse response functions for individu-
als, groups or societies as a whole in the way natural sciences do for objects.
But they can analyze and describe the patterns of behavior of individuals, groups
and societies. Based on the recognition of such patterns, they can make qualita-
tive predictions. In this book, I shall argue that the Austrian school of economics
provides a highly useful base for rethinking macroeconomics and finance from a
sociological perspective.
The remainder of this book is organized as follows. Part I is about money. In
Chapter 2 we discuss the functions and the creation of money. Money is an insuf-
ficiently understood social instrument, created by human societies more complex
than families or tribes, to facilitate economic transactions. In the course of history,
money has acquired several functions. It has been used as a means of exchange,
store of value, and unit of account on the one hand, and as a measure of debt on
the other. Where money is used as a means of exchange, store of value and unit of
account, it can exist without a state. Even when anarchy rules and people do not
trust each other, money will emerge spontaneously (i.e., without being planned) to
allow people to transact. Since money in this function was generally derived from
a suitable commodity, it has been called commodity money. Reflecting its nature
of an asset, I call it “active money”.
Things are different when economic transactions are based on credit and debt.
In this case, every more complex society needs an authority to enforce creditor-
debtor relationships when needed. Hence, the function of money as a measure of
debt tends to emerge in societies that organize themselves as states. States tend to
take advantage of their role as enforcers of creditor-debtor relationships expressed
in monetary terms by monopolizing the issuance of money. This allows them
to issue new money to appropriate goods, services and assets of their citizens
to themselves. Money becomes “legal tender”, which is another word for state
money. Reflecting its nature of a liability I call it “passive money”.
Chapter 3 reviews different perspectives on the nature of inflation. Mainstream
economists all agree that inflation refers to an increase in the general level of con-
sumer prices, whereby changes in relative prices do not play a major role. Seen
over the long-term, inflation is the result of an excess supply of money. According
to the Keynesian view, money may influence the real economy in the short-term
but is neutral in the long-term there as well. The mainstream theories are fairly
vague about how new money reaches people. This is exactly the point where the
 Introduction 3
Austrian school of economics comes in. It explains the creation of money as a
result of the extension of credit by the banks. This has consequences considerably
different from the mainstream view. Money creation leads to a change in relative
prices and influences the real economy in a decisive way over both the long and
short term. Inflation can manifest itself in a rise in consumer prices, asset prices
or both. Credit extension and money creation have a significant influence on the
distribution of income and wealth.
Chapter 4 discusses the concept of interest. There are an astonishingly large
number of ideas in the economic literature about the nature of interest and how it
arises. It is even more astonishing that there is no consensus among economists,
which one of the various ideas and explanations is the most appropriate one. In
accordance with the Austrian school of economics, I end up with the definition of
interest as time preference. Since time is a scarce resource for humans, waiting
must be compensated by interest.
Should we be content with our existing monetary order or does it pose prob-
lems? If so, are there better alternatives? These are the questions pursued in
Chapter 5. Answers to these questions are closely associated with the question of
whether the state should play a constructivist role in the economy or better show
more restraint, because it throws spanners in the works of the economy. In my
view, history has answered this question clearly: Less state influence confined to
the upholding of a market liberal economic order is better than more meddling.
Consequently, this chapter ends with a plea for the move from our existing money
order, which leads to more and more government interference, to another one
more distant from the state, in which money is legally defined as an asset.
In our existing system, credit money is produced in a public-private partnership
(PPP). Banks create book money through credit extension, while the public sector
guides the money creation process and acts as a backstop in the case of problems.
Chapter 6 discusses the alternatives to this system, which follow from the disso-
lution of the PPP of money production: the nationalization or the privatization of
money production. The chapter concludes with the support of private issuance of
active money in a competitive setting. Government plays a minor role in an active
money order as this order is based on social convention instead of government
design. The role of government is to enforce general and abstract legal principles
in the financial sector, and not to organize it according to its own design.
Part II of the book is about finance. To set the stage, the role of ownership and
debt in investing is discussed in Chapter 7. Ownership is central to economic
growth and development. By investing in shares, one can participate in the return
of productive capital. Yet, when investing in shares, one must always evaluate
how the company is positioned and whether the interests of shareholders are
appropriately considered. Investing in bonds requires less intimate knowledge of
the issuer’s economic circumstances and provides the bondholder more protection
against losses than a shareholder gets. This is why the return for bonds is lower
than that for equities. Government bonds are particularly popular among inves-
tors. However, it is precisely with this type of borrower that the risks are high, as
a government may choose to repay its debt with money that is worthless.
Chapter 8 presents the building blocks of Modern Finance Theory (MFT),
which extends from the “Mean Variance Optimization” (MVO) introduced by
4 Introduction
Harry Markowitz in 1952 to the option pricing theory (OPT) of Fisher Black
and Myron Scholes published in 1973. Between these two building blocks are
important others, such as the “Efficient Markets Hypothesis” (EMH) established
by Eugene Fama in the 1960s, and the “Capital Asset Pricing Model” (CAPM)
developed by William Sharpe, John Lintner and Jan Mossin and extended by Rob-
ert C. Merton in 1973. The sketch given here should not be seen as a short-cut to a
more intensive study of MFT and its elaborations, although it intends to give more
than just a superficial introduction. Its purpose is to enable the reader to appreciate
the achievements of MFT, and to better understand the criticism of it presented in
the following chapter.
In Chapter 9 we look at assumptions needed for the theory of Modern Finance
to work. We examine in particular the assumptions of the rationality of investors,
and of the Normal Distribution of financial prices. For both cases, we arrive at the
conclusion that the assumptions do not hold in real life. The consequence is that
markets are not “efficient” in the sense of Modern Finance, and risk cannot be
measured as described there.
This alone would be sufficient to reject the application of Modern Finance as a
guide for practical action in the financial area. But other important assumptions,
such as permanently liquid markets or unrestricted access to loans at a risk free
rate, are also not fulfilled. Nevertheless, many actors in financial markets and
economic policy have relied on the wisdom of Modern Finance. The consequence
of this is the subject of the following chapter.
Chapter 10 uses three historical events to show how Modern Finance contrib-
uted to financial crises, and how it arrived at the end of its wisdom in the zero-rate
era after the Great Financial Crisis of 2007–08. First, in the stock market crash
of 1987 “portfolio insurance”, which had promised to limit drawdowns in port-
folio values by computer-driven quick sales of equity holdings in difficult mar-
ket conditions, was demystified. Second, towards the end of the 1990s the hedge
fund Long-term Capital Management (LTCM), staffed with Nobel Prize winning
economists, failed because of the incomputability of risks. Third, in the course of
the 2000s the engineering science of Modern Finance seduced market participants
to the construction of products and management of risks, with which any level of
indebtedness allegedly could be carried without any problems. After the Great
Financial Crisis, the recipes of Modern Finance have been used to repair the dam-
age created by their use. It is high time to heed Albert Einstein’s warning that we
cannot solve our problems with the same thinking we used when we created them.
Chapter 11 presents the main building blocks to an alternative theory to Mod-
ern Finance, which I call Austrian Finance. As explained above, economics and
finance are social sciences. They need to analyze and describe the patterns of
behavior of individuals, groups and societies, in order to make qualitative pre-
dictions. The key insights of this analysis are: (1) people base their action on
subjective knowledge; (2) they minimize the time it takes to reach their objectives
and hence have positive time preferences and positive “natural” interest rates; (3)
markets are in a continuous dynamic disequilibrium; (4) uncertainty is radical
and cannot be measured; (5) the diversification of portfolios serves the purpose of
 Introduction 5
reducing the consequences of errors and follows the rule of diminishing benefits
from diversification.
Chapter 12 gives a few examples of the application of the insights of Aus-
trian Finance. First, we discuss the rationale for “passive investment” in index- or
exchange-traded funds, and “active investment” in discretionary funds. Next, we
have a look at hedge fund strategies and so-called “factor investment”. Finally, we
discuss the problem of an investor who intends to distribute his consumption over
his lifetime more equally through saving and dissaving.
Chapter 13 concludes with a few thoughts on the relationship between the order
of our society and of our monetary and financial order. Our existing monetary
order reflects the mixture of private and public elements in the order of our soci-
ety. Since the Great Financial Crisis, the public elements have increased. In the
monetary domain, this has been reflected in the rising influence of central banks
and the growth of government regulation. The next step would be the nation-
alization of money or, as the advocates put it, the change-over from our mixed
order to a sovereign money order. This seems more likely than the opposite, the
reestablishment of money as a social technique developed in a spontaneously
ordered society. The demise of liberal principles in the order of our society seems
inevitable. It is also regrettable as it undermines the progress mankind has made
applying these principles.
Part I

Money
2 The functions of money
and money creation

Whether we like it or not: Money plays a crucial role in our lives. Soon after we as
children learn how to do simple math, we start using this skill with money. Then
there are those who spend their last days of clarity mulling over who will inherit
the money they have earned over a lifetime. Due to its importance to our lives,
many of the social sciences deal with the question of money.
Monetary theory and policy also figure prominently in the economic sciences.
One would therefore assume that we know full well what money constitutes. But
as surprising as it may sound, that is not the case. Money is a complex and insuffi-
ciently understood social instrument. As we will see later in this chapter, there are
two very different views of what money represents. For some money is a special
commodity which, as a result of social consensus, has developed into a means for
the exchange of goods. For others it is only a measure of debt that we owe others
who provide us with an economic good.

Give and take versus trade

In literature, there are two schools of thought on the nature of money: an anthro-
pological one and an economic one. The best-known representative of the eco-
nomic one is the Scottish philosopher Adam Smith who, in the eighteenth century,
laid the foundation for the doctrines behind what constitutes economics today.
But, one of Smith’s challengers from our current time is the anthropologist and
activist David Graeber, who is a professor at the London School of Economics
and Political Science. In this unfair competition, we have on the one side a social
philosopher from the eighteenth century and an anthropologist, financial system
critic and self-declared anarchist on the other. Let us look at both more closely.
According to Smith, production can be increased by the division of labor. From
this follows the need to trade.

This division of labour, from which so many advantages are derived, is not
originally the effect of any human wisdom, which foresees and intends that
general opulence to which it gives occasion. It is the necessary, though very
slow and gradual, consequence of a certain propensity in human nature which
has in view no such extensive utility; the propensity to truck, barter, and
exchange one thing for another.1
10 Money
The individual, Smith goes on to write, “is led by an invisible hand to promote
an end which was no part of his intention”.2
Graeber and other adherents to an anthropological view of economic history
emphasize that loans were at the center of economic relations in ancient times.
Trade came into play only when members of a certain community began an eco-
nomic relationship with members from other communities. Therefore, money did
not emerge as a means of exchange, as classic economists contend, but rather as
a measure for loans or debt, particularly that owed to government. In his book,
Graeber cites fellow anthropologist Caroline Humphrey to back up his claims:
“No example of a barter economy, pure and simple, has ever been described, let
alone the emergence from it of money; all available ethnography suggests that
there never has been such a thing”.3
Graeber cites numerous studies of primitive societies where the economic rela-
tionship is described as a form of “giving and taking,” or “loan and debt,” but
never as barter. He writes that barter takes place only when two parties do not trust
each other, like in cases where they are from different tribes.

Now, all this hardly means that barter does not exist – or even that it’s never
practiced by the sort of people that Smith would refer to as ‘savages’. It just
means that it’s almost never employed, as Smith imagined, between fellow
villagers. Ordinarily, it takes place between strangers, even enemies.4

Graeber explains that “giving and taking” was the dominant form of exchange
in pre-Christian societies like Mesopotamia and Babylonia. “Money” in the sense
of a universal means of exchange or measurement did not exist. In his “Unauthor-
ised Biography of Money,” Felix Martin also writes that transactions in Mesopo-
tamia were simply accounted for and settled.5
The pacific island of Yap became famous for its credit-based monetary sys-
tem, after the American adventurer William Henry Furness wrote about his travels
there in a book published in 1910.6 The inhabitants of Yap, Furness discovered,
paid in millstone coins that were huge. The result was that the coins almost never
changed hands during transactions but instead were simply stored. Indeed, the
stones were so heavy that when one was brought on a ship to change location, the
ship sank and the stone with it. Although the stone coin was at the bottom of the
ocean, this did not adversely affect the standing of its owner, as the stones were
not a means of payment but a guarantee of the creditworthiness of their owners.
When transactions were not completely balanced and somebody became a net
creditor or debtor, a piece of stone virtually changed owners to clear things. The
stone’s physical location, however, remained the same.
As an accounting unit, money can take many forms, including cattle, crops, nails
or precious metals. In medieval and early modern-age England, that is, between
the twelfth and late eighteenth centuries, willow sticks along the banks of the
Thames river were used by the government as a means for settling transactions.
The transactions were written on willow sticks and then they were cut length-
wise, with a half each going to lender and borrower to certify the transaction.
Yet, despite the use of these sticks for more than 600 years, few have endured. In
 The functions of money and money creation 11
1782 the British parliament banned the use of the sticks in transactions, though
the practice continued unofficially until 1834, when the sticks were replaced with
paper notes. As a result of the transition to paper currency, a decision was made
to burn the remaining tally sticks in an oven at the upper house of the British
parliament. However, care was not taken, and suddenly the wooden walls of the
chamber caught fire. The fire then spread to the parliament’s lower house, result-
ing in the entire complex being destroyed. Both houses of parliament were rebuilt
in 1852 in the shape with which we are now familiar.
According to Graeber, money changes its role as a measure of credit and debt
and becomes a means of exchange only when confidence in society evaporates
and is replaced by power politics. Graeber says that currency emerged mostly for
military reasons. Rulers paid their soldiers in coins and had farmers pay taxes in
the same way. Conveniently, soldiers could also be used to ensure that farmers
paid their taxes, if needed. Thus, the money supply created in this way was jux-
taposed to artificially created money demand. Farmers had to surrender goods for
the coins they received from soldiers to both pay their taxes and be left alone by
the soldiers. Such provisioning of the army was more orderly and less damaging
to the economy compared with the alternative, namely soldiers simply plundering
farmers for what they needed. If money is to be seen largely as a measurement of
debt to the state on part of the subject, and later citizen, it follows that the state
must distribute the money with which that debt must be repaid. This is reflected
in the example with the ruler and his coins. The subject or citizen needs to acquire
state-issued money to pay his debt to the state. In the above example, the ruler
accepts that the farmers’ taxes are settled with the return of coins to him.
A citizen can exchange money for a good or service with a third person and this
person can then use that money to repay his own debt to the state or pass it on to
another person. In this way, money circulates in the economy until the state takes
it back. The less involved the state is in the economy, the more money circulates
among economic players themselves instead of between those players and the
state. According to Felix Martin, money is not a physical means of transaction but
instead a social technology based on three key elements. The first element is an
abstract measurement of value. The second is a system of accounts to affirm who
owes what whenever a transaction takes place. The third is the possibility that the
original payer can transfer the debt owed to him to a third person wanting to pay
off her own debt.7
Unlike the anthropologists, most economists in the tradition of Adam Smith
stress the role of money as means of exchange. According to their interpretation,
economic relations began with the exchange of goods. Smith writes:

In a tribe of hunters or shepherds a particular person makes bows and arrows,

for example, with more readiness and dexterity than any other. He frequently
exchanges them for cattle or for venison with his companions; and he finds
at last that he can in this manner get more cattle and venison, than if he
himself went to the field to catch them. From a regard to his own interest,
therefore, the making of bows and arrows grows to be his chief business, and
he becomes a sort of armourer.8
12 Money
So that the armorer can exchange his bow and arrow for cattle and deer, he
needs a partner that is interested in an exchange. If he fails to find one, a deal can-
not be transacted. One way of resolving this would be to exchange the bow and
arrow for another good, and then exchanging that good for the desired cattle and
deer. Hence, the other good is nothing more than a means of exchange.
In order to fulfill its purpose, the means of exchange has to be of a general
standard of quality and unable to be created at will by those who wish to use it
to acquire another good. If its quality varies, it loses its character as a universally
accepted good and becomes something that is not easily exchanged for another
good. And if the means of exchange is made by those who want to use it for the
purpose, then the seller of a good could begin to doubt whether it truly represents
the value he needs to acquire yet another good. It therefore follows that some
goods are better suited for a means of exchange than others. Precious metals that
are durable and scarce are particularly suitable, for example. And in order to best
identify the amount and quality of a precious metal, and as a result its worth as a
means of exchange, a well-known and respected goldsmith or state authority can
give it a seal of approval. To make transactions even easier, the precious metal can
be stored in a safe place like a bank and then paper notes based on it distributed.
This is where the state comes in, when it regulates the circulation of paper notes
and, for instance, charges private business people a fee for having a monopoly on
the distribution of such notes.9
As we have seen, the anthropologists believe that this explanation of money is
not based in historical fact. They point to studies that Adam Smith was not famil-
iar with and which indicate that the barter economy followed the earlier economy
based on credit and debt. The anthropologists may be right, in which case the
origin of money as a means of exchange would have to be corrected in economic
textbooks. However, contrary to what Graeber concludes, it does not follow from
this that the barter economy and money as a means of exchange would simply
be footnotes in history and that debt money issued by the state would emerge as
the natural form of money in the dialectical evolution of history. From Karl Pop-
per we have learned that history does not follow any laws we could derive from
historic developments.

Monetary systems according to Walter Eucken

It would seem a good time to introduce Walter Eucken into the debate, one of the
founders of the so-called ordo-liberal Freiburg School.10 Eucken identified three
types of the monetary system:11

• In the first system money is created when a good becomes money. This cor-
responds to the aforementioned view of money as a means of exchange. The
array of materials that can be used as money ranges from precious metals to
grains and clams. A single ruler can have a monopoly over the production of
money or several issuers, such as cities or private persons, can compete for
such a production. One example is the moneyers active during the Kingdom
of the Franks in the sixth century A.D.
 The functions of money and money creation 13
• In the second system money is created as debt when a good is delivered or
a service provided. A prime example of this is the issuance of government
debentures to pay for delivered goods in Babylonia during the second and
third century B.C. This debt category includes the aforementioned system of
payment of soldiers by the state.
• In the third system a lender creates money which is then destroyed when the
loan is repaid. This type of “credit money” is created by central banks when
they, for example, buy government bonds on the open market or by private
banks when they provide a loan to a borrower (and credit his account with the
loaned funds).

The concept of credit money brings us back to the anthropological view that money
is a measure for credit relationships. According to the anthropological literature,
such relationships are regulated by family, tribe, village or even a paternalistic state.
They can be settled in currency, but this is not obligatory. In the credit money sys-
tem, the credit relationships are governed by law, which represents the institutional-
ized form of the archaic relations. In such a system, loans are naturally accounted
for in monetary units and not extended purely in good faith and trust.
Loans were traditionally granted on the basis of personal relationships. Nothing
was more important to an old school banker than knowing a borrower’s character
and circumstances. For him, a loan was a question of trust. Recently, however,
the relationship between the banker and the borrower that was based on trust has
been replaced by financial technology. As a result, the relationships have become
impersonal and the natural barrier in the production of loans has been lowered.
According to modern financial theory, it should, through aggregation, be possible
to upgrade loans that old school bankers would have never approved. The trick is
to aggregate single credit risks that ostensibly do not correlate with one another,
or are even negatively correlated, into a tradable credit security of allegedly lower
risk (more on this in the following chapters).
Graeber and others point out that debt forgiveness was a part of ancient mon-
etary systems. Michael Hudson, for example, says that in Babylonia debts were
forgiven every 16 years in the period between 1880 and 1636 B.C.12 From this
Graeber and Hudson conclude that debt forgiveness should be a key element of
today’s credit money system. Indeed, debt forgiveness does take place at the level
of companies and households, as part of bankruptcy proceedings. For sovereign
states, there are however no official bankruptcy proceedings, and in the banking
sector insolvency proceedings are usually rare. This may be due to the fact that
there is no firm legal base for the credit money system. Jesus Huerta de Soto
argues that a contract which governs a bank deposit is of a different legal nature
than that for a loan.13 According to him, a loan involves the transfer of the agreed
sum from the lender to the borrower for the life of that loan. By contrast, there is
no transfer of ownership associated with a bank deposit as the client is afforded
complete access to his or her money. According to Huerta de Soto, a bank that
keeps only a small part of the deposit and lends out the rest is defrauding its cli-
ents. This is why fractional reserve banking was a punishable offense in Ancient
Rome. However, after the fall of the Roman Empire, the legal understanding of
14 Money
fractional reserve banking dissolved in the Middle Ages and it became standard
operating procedure for banks.
Eucken finds that current monetary orders are all combinations of the different
types of monetary systems, though these have different weights in the various
orders. For example, commodity money as well as state debt money can be com-
bined with credit money, if banks are able to create book money through credit
extension beyond the stock of commodity and state debt money. The credit money
system, where money is created through the extension of credit (Eucken’s third
system), has become increasingly important while the other two systems have lost
importance in the course of time.
Yet, Eucken also believed that the credit money system is inherently unstable.
Hence, already in the 1940s he was quite skeptical about the future development
of a monetary order based on this system. Eucken wrote:

Perhaps the exceptional instability of the money that constitutes the curren-
cies of the middle of the century will induce currency reforms, so that the
third system no longer dominates the provision of money, but the provision of
money will be linked to the production of important commodities.14

Eucken was a supporter of the concept of a commodity reserve currency pro-

posed by Benjamin Graham in 1937.15 In this, the money supply would be man-
aged on the basis of the development in prices of crucial commodities. The central
bank would keep a vault for the commodities. If their price would rise, it would
sell some of these holdings. As a result, the supply of the commodities would rise
while the money supply would decline. And when prices of the commodities fell,
the central bank would acquire them, reducing supply and driving up their prices
as well as the money supply.
Eucken’s systematization of money helps to resolve the contrast of money
either as a means of exchange or as a measure of debt discussed earlier. Depend-
ing on the historic circumstances, money can take the one form or the other. The
characteristics of money, in other words, are subject to change. In order to better
understand them, we can simplify Eucken’s classification of monetary systems
by differentiating between money as an asset and as a liability. If money has the
characteristics of a good, it is marked down in the balance sheet of the money-
creating institution as an asset. A gold mine registers extracted gold as an asset on
its balance sheet while registering the funds needed for the gold extraction as a
liability. But debt or credit money – and the equity-like money of central banks –
appear on the liability side of the balance sheet of the money-creating institutions.
They are considered financial instruments. This is true for bank notes, covered by
claims on the state or on other borrowers or not covered at all, as well as for book
money created by banks through the extension of credit.
Hence, in the remainder of this book, we will distinguish active money, active
money systems, and active money orders from passive money, passive money
systems, and passive money orders (see Table 2.1 for an overview). Active money
is created through social convention as part of the spontaneous order and can do
without state power. Active money is endowed with the trust of those who use it
that it will be accepted by other users as a means of exchange.16
Another random document with
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 “Yes,” she returned; “I have a swelled face.”
“How sorry I am!” said the soldier sympathetically, “for I came this
afternoon in the hope of hearing you sing.”
“And so you shall,” returned the girl kindly. “You shall not go away
disappointed.” And, taking the bandage from her face, she sang
song after song to the fascinated General.
The progress of the courtship was swift, and the marriage was
celebrated with great magnificence in the palatial abode of Queen
Maria Cristina in Paris, with the attendance of representatives of the
most distinguished families of France and Spain.
When General Narvaez returned to Madrid he became Prime
Minister of Spain.
Unfortunately, the marriage did not prove a happy one, and,
indeed, it would have been difficult for anyone to live peacefully with
the irascible Spaniard. This irascibility was seen at the funeral of
General Manso de Zuñiga, who had died in the expedition against
Prim, in the mountains of Toledo. General Narvaez was chief
mourner on the occasion, as the deceased officer had been husband
of Doña Valentina Bouligni, a lady of great importance at this epoch,
with whom he was connected; and the Bishop of Pharsalia was
master of the ceremonies.
At a certain point in the function the order was given to kneel.
But, probably absorbed in some knotty State question, the Duke of
Valencia still stood. Upon this the Bishop quickly approached the
grandee, and said:
“Kneel down, kneel down!”
“But I don’t want to kneel,” returned the General petulantly, and
so he remained standing for the rest of the service.
 G E N E R A L N A RVA E Z

When she came to Madrid as the wife of the great General, the
Duchess of Valencia was appointed Lady-in-Waiting to Queen
Isabella, and she never failed in her loyalty to the dynasty which was
in power when she came to the country of her adoption by marriage.
Many years later she was in an hotel in Switzerland, where she
purposed making a long stay, when Don Carlos happened to come
to the same hotel, accompanied by his secretary. As the Duchess of
Valencia was unacquainted with the Pretender to the throne of
Spain, she wondered who the imperious-looking new arrival could
be, who was greeted so respectfully by everybody. Her curiosity was
soon satisfied, for the gentleman’s secretary presented himself
before her to say that the Duke of Madrid begged the honour to pay
his respects to her.
 The message filled the Duchess with dismay, for, although she
held the Princes of the blood in great respect, she had no intention of
receiving one who disputed the throne with the reigning Queen.
So, summoning all her dignity to her aid, she said, in a tone of icy
politeness:
“Tell the Duke of Madrid that I am very sorry not to have the
honour of receiving his visit, but to-morrow I leave for Paris.”
And in effect the lady left the hotel on the morrow, and thus the
meeting of one of the oldest and most valued Ladies-in-Waiting with
Don Carlos was avoided.
Isabella certainly never expected that she would be dethroned,
for a few weeks before the revolution of September, 1868, the
celebrated General Tacon, Duke of the Union of Cuba, announced
the forthcoming marriage of his daughter Carolina with the Marquis
Villadarías, of the première noblesse, and a perfect type of a
Spanish grandee, and she said: “I congratulate her sincerely on her
engagement; but,” she added sadly, “for myself I am sorry, as I shall
see her no more at Court.” The Queen here referred to the well-
known Carlist opinions of the Marquis Villadarías, which would have
made it impossible to receive the Marchioness at the palace if she
had remained there.
So Isabella II. was dethroned in 1868, and she can truly be said
to have been the victim of circumstances. From the moment King
Ferdinand died his daughter had been the object of intrigue and
ambition. Whilst our Queen Victoria was carefully educated and
drilled in high principles, Isabella was the prey of those who wished
to rise to power by her favour. Ministers made love to the Sovereign
instead of discussing the welfare of the nation; flowery speeches on
patriotism meant merely the gratification of the orator’s vanity to be
remarked by Her Majesty. Personal advancement was the end and
aim of those in the Government, and thus poor Isabella’s
susceptibilities were worked upon to an awful extent.
It is well known that General Serrano, who might have been
thought to have the welfare of his country at heart, gained an undue
influence over the Queen by means of her affections, and fomented
to a great extent the matrimonial differences between her and her
husband. Generous to a degree, Isabella paid the debts of this
courtier twice, and yet it was this same General who was the first to
have her hurled from the royal palace.
When the great Canning visited Madrid, Bulwer Lytton showed
him at a Court ball the many women who were the favourites of the
Ministers, and there was, indeed, hardly a statesman who would not
sacrifice principles to the pleas of his mistress. It was at this Court,
steeped in immorality, that Isabella was brought up with little or no
knowledge of right and wrong, and even in her marriage she was a
victim to the intrigues and ambitions of other Courts of Europe as
well as those of her own. She was, in fact, a scapegoat of the nation.
Harassed and in desperation at being pressed on to a miserable
marriage destitute of all that could justify it, Isabella, after one of
those long and fruitless discussions with her mother, once addressed
a letter to our Queen Victoria; but in a pure Court like that of England
little idea could be formed of the stagnant atmosphere of the Spanish
palace from which the poor young Queen sent forth her plaint.
Beyond the Court raged the stormy discontent of the country, which
had been thwarted for more than thirty years of the fulfilment of its
constitutional rights promised by Ferdinand VII. as the condition of
his return to the throne of Spain.
Whilst Queen Victoria was daily increasing in the knowledge of
constitutional rights which are the base of a Sovereign’s power, poor
Isabella’s Prime Ministers resigned at any moment in pique or
jealousy of some other politician, and the people grew daily more
discontented at finding the Parliament was a farce, and it meant
neither the progress of the land nor the protection of the people.
Bulwer Lytton was constantly sending despatches to England
about the shortcomings of Isabella II. as a woman, but he seemed to
lay no stress on the cause of her failure as a Queen. Under proper
conditions Isabella doubtless would have been a good woman and a
great Queen, but choked with the weeds of intrigue she was lost.
Undisciplined and uneducated, the poor Queen fell a victim to what,
if properly directed, would have been virtues instead of vices.
The marriage to which Isabella was forced by intrigue was, of
course, the greatest evil which could have befallen such an
impulsive, warm-hearted girl, who knew no more how to turn a deaf
ear to a claimant for her favour than to keep her purse shut to the
plea of an unfortunate beggar.
The Right Hon. Henry Lytton Bulwer wrote a little later from the
British Embassy at Madrid to the Court of St. James’s, saying that he
“looked at the Queen’s conduct as the moral result of the alliance
she had been more or less compelled to contract, and he regarded
her rather with interest and pity than blame or reproach.”
Isabel’s natural intuition of our Queen Victoria’s good heart
prompted her letters to her. They were sent by a private hand, and
who knows what evils might have been prevented in the Court of
Spain if the long journey, so formidable in those days, had not placed
the sister-Queens so far apart?
Espartero’s plea for Isabel to marry Don Enrique de Assisi, the
man of her heart, met no support in a Court torn with intrigue, and
the sad, bad story of Isabel doubtless had its source in the tragedy of
an unhappy marriage. At the plea of a persistent wooer, who knew
that the Queen had the right of dissolving a Ministry, a Government
would fall; and as the station of her favourites became lower and
lower, as time went on the ill-regulated Sovereign had a Government
as undependable as her friends.
Treachery was the keynote of the Court of Spain, and some of
the leaders of the revolution were those who had used the
Sovereign’s ignorance and foolhardiness to their own ends. In such
an atmosphere of untruth and treachery such men as Espartero,
Prim, etc., could play no enduring part. Hardly had Espartero swept
the Court clean of the Regency of Queen Maria Cristina than his fall
was encompassed by O’Donnell, his rival. The flagrant falsification of
the Parliamentary election returns—which is still the cankerworm of
the country—was the check to all progress. Count San Luis made a
primitive effort for the reform of the elections; he suggested that the
names of the candidates as deputies should be put in a bag, and
drawn out by a child blindfolded, for the law of chance seemed to
him better than the custom of deception.
Isabella’s acts of generosity are still quoted with admiration at the
royal palace of Madrid by those who served her as Queen.
Four hundred girls owed their marriage dots to Isabella, and it
was the fathers of these four hundred royally endowed brides who
treacherously worked for her expulsion.
One day, hearing the story of the penury of a clever man of
letters, Isabella commanded 20,000 francs to be sent to him. The
administrator of her finances, thinking the Queen could hardly know
how much money this sum represented, had twenty notes of 1,000
francs each changed into small money, and put out on a table by
which she had to pass.
“What is all this money for?” asked Isabella, when she saw it
spread out to view.
“It is the money for the man of letters, and this shows Your
Majesty how large is the sum of 20,000 francs.”
 “So much the better,” was the prompt reply; and the courtier saw
it was not by proving the amount of the boon that he could check his
Sovereign in her generous actions.
A Court official at Madrid, who has been sixty years in office at
the palace, told me he often saw Isabella take off her bracelets, and
give them to the beggars who pressed upon her as she crossed the
courtyard of the royal domain.
“And who could help loving her?” said the old courtier, with tears
in his eyes; “I know I could not.”
Caught in the darkness of ignorance and intrigue, Isabella was
naturally enraged at the revolution. When her son Alfonso was
nearly made captive by the Carlists at Lucar, she said: “I would
rather my Alfonso be a prisoner of the Carlists than a captive of the
revolutionists.”
Isabella had a faithful friend in the Marquis of Grizalba, and he
said to Croze:[18]
“It is the loss of faith which causes our woes; the charm of death
has been destroyed with the hope of a hereafter. But Spain will die
like a gentleman.”
[18] The author of “La Vie intime d’Alfonse XIII.”

From September 19, 1868, to 1870 there is no history of the

Court of Spain, as there was no King, and it was not known if there
ever would be one again. Isabella lived, as we know, in Paris, and
her son pursued his education in Vienna, in the Theresan College,
and later at Sandhurst. The young ex-Prince was devoted to society
and to gaiety, and, seeing how his mother was fêted in Paris, he was
often heard to say:
“I should rather like to be a dethroned King and live in Paris with
plenty of money.”
 In Spain, meanwhile, Serrano, Duke de la Torre, was enjoying his
long-sought-for ambition of being supreme in the country, whilst
General Prim was President of the Council of Ministers. The
Duchess of la Torre made an ineffectual attempt to gather a Court
around her at La Granja; but a palace made after the essentially
royal abode of Versailles, with its countless well-kept alleys and its
many panoramas of fountains adorned with allegorical scenes and
figures, did not lend itself to anything but the stately entourage of a
royal Court.
Whilst the Republican party grew in power in the Parliament, the
Generals who had made the revolution sighed after a monarchy.
The Duke of Montpensier, the brother-in-law of the ex-Queen,
might have had a good chance as candidate to the throne, and he
was supported by Topete and the three Liberal Generals; but Spain
could not forget his treachery and ingratitude to Isabella by joining
with her enemies against her, and he found he could gain no real
support from the country. And this coldness became more marked
after the tragedy in which he was the chief actor made a dreadful
stain on Court history.
It will be remembered that Prince Henry of Bourbon, the brother
of the ex-King, whom Isabella had personally preferred to the
husband she was finally obliged to accept, and who married, in
1849, Helena, daughter of the Count of Castellvi, had been removed
from his position of a General of the army, to which he had been
appointed by his cousin, and expatriated for a writing which was very
insulting to the Queen.
Having thus associated himself with republicanism, Prince Henry
became the source of many disloyal publications against the Queen
and her Ministers, and when the blow was struck for the
dethronement of Isabella, he openly welcomed the revolution.
 The final opinions which caused the tragic ending to his life were
expressed in an article entitled “The Montpensiers,” and this so
enraged the candidate to the throne that he called out the author of
the pamphlet in a duel, and a wave of horror swept over the Court of
Spain when the ex-King’s brother thus met his death at the hand of
the Duke of Montpensier.
The funeral of the Prince was solemnized with all the insignia of
his rank as Lieutenant-Colonel and the owner of the Collar of
Charles III., and with the rites due to a Freemason of high office. He
was buried in the Escorial, and it is said that his remains will be
finally removed from the simple niche where they now lie to the
imposing tomb of “the Infants.”
Another tragedy befell the family of the ex-Queen of Spain in
December, 1871. On May 13, 1868, the Infanta Isabella, the eldest
daughter of Queen Isabella II., married Count Frederick Girgenti,
who created a most favourable impression in the country by the
valiant way he fought in the Battle of Alcolea under the Marquis of
Novaliches.
But the brave young Prince was subject to epileptic fits, and one
day in December, 1871, to the horror of his wife, he shot himself in
Lucerne. The poor man lived for some hours, tended by his
sorrowing wife. But neither love nor science could avail in such a
case, and the Infanta Isabella found herself a widow at the age of
twenty. However, the Infanta never allowed sorrow to kill her
sympathy for her compatriots, and to go to Spain is to find that no
philanthropic scheme or project is considered complete without the
patronage of the Infanta Isabella.
 CHAPTER XIII
THE COURT OF SPAIN UNDER ITALIAN SWAY

In February, 1869, Serrano was chosen head of the Executive

Government, and in June of the same year Serrano, Duke de la
Torre, was appointed Regent until a King should be elected.
To General Prim, whose ideal had always been that of Liberty, it
was not surprising that, in seeking a Sovereign who, it was hoped,
would steer the country through the shoals of self-interest and
stagnation, set up by an autocrat monarchy, his eyes should turn to
Prince Amadeus of Savoy, whose father had led such a splendid
struggle for the freedom of the country from the despotism of
clericalism. A deputation, formed by deputies who subsequently
became Ministers of Alfonso XII., presided over by Ruiz Zorilla, who
was later a pronounced republican, were thus sent to Italy to submit
the offer of the throne of Spain to the Prince of Savoy. Their mission
to the Prince over, they proceeded to the bedroom of his young wife,
who had recently been confined, and there conveyed to her in due
form the invitation to become Queen of Spain.
The claim of the Italian Prince to the throne rested on the royal
decree of Philip V. of Spain, which formed the integral part of the
Treaty of Utrecht, November 5, 1712. This decree set forth the claim
to the throne of Spain through failure of legitimate line by the Duke of
Savoy, and through failure of the male line by Prince Amadeus of
Carignano and his sons, as descendants of the Infanta Catharine,
daughter of Philip II. When the question of the claims to the throne of
Spain was put to the vote, it was found that Amadeus registered 199,
Espartero 8, Alfonso 2, and for a Republic 63.
Castelar used all his eloquence against the Italian candidate.
“Who are these wretched Dukes of Savoy,” he said, “that run like
hungry dogs in the wake of the coach of our Kings?”

EMILIO CASTELAR

Courage was a great characteristic of young Prince Amadeus.

When only twenty-one, in 1866, he saved a wounded soldier’s life by
carrying him out of danger on his own mule, in one of the skirmishes
during the struggle for Italy’s liberty.
The young man’s calmness in the hour of danger was shown in
1867, when the boiler burst on the ship on which he was returning to
Italy, after attending the function of the opening of the Suez Canal.
The Count of Castiglione was killed, and the panic on board
threatened more disaster. But Amadeus was cool and collected. He
calmed the people and insisted on the sailors’ return to their several
duties, and the ship was successfully brought back.
Fortunately, the young Prince was allowed to marry the lady of
his choice, who proved a devoted friend and companion in all the
vicissitudes of their lives.
When Signor Francisco Cassini, the President of the Chamber of
Deputies, told King Victor Emmanuel whom his son wished to marry,
the royal father said: “Do the young people love each other?”
“They idolize each other,” returned the statesman.
“Then very well; they shall be married,” was the reply. “It is not for
me to stand in opposition to the sentiment of my son.”
So the royal couple were married, and thus fate led to Princess
Maria del Pozzo becoming Queen of Spain.
Naturally, Amadeus was not attracted by all he heard of the
country over which he was called to reign. However, when his father
said, “Of course, it is very hot in Spain at this time, and by going
there you would also run the risk of a disagreeable adventure, and
perhaps even get a bit of lead in your ribs,” the natural courage of
the Prince was stimulated, and he declared he would accept the
invitation to the throne, come what may.
As the new King of Spain’s wife had not recovered sufficiently
from her recent confinement to travel, her husband went alone to
Spain. Before starting for his new country, Amadeus said to his
friends:
“I go to fulfil an impossible mission. Spain, now divided into
various parties, will unite against a foreign King, and I shall soon be
obliged to return the crown they offered me.”
 A M A D E U S O F S AV O Y, D U K E O F A O S TA , A F T E RWA R D S K I N G O F
S PA I N

However, the Italian Prince knew he had a valiant supporter in

General Prim, who used all his oratory and influence to get the
sympathy of his countrymen on the side of the new-comer. But, as
we know, it was not the fate of the pioneer of Liberty to see the
realization of the scheme which he had hoped would be for the
welfare of the country, and on December 30, 1870, the day on which
Amadeus landed on Spanish soil, Prim was foully murdered by
Spaniards.
Long inquiry and investigation never revealed convincingly the
hand that shot the General in the street. It was supposed by some to
have been a partisan of an unsuccessful candidate to the throne;
others think it was a gipsy, who did it as a deed of outlawry. Be that
as it may, strong suspicion fell upon Señor Paul y Angulo, who
expressed his indignation strongly in the prologue to his paper on
“Revolutionary Truths”:
“The sacrifices that I have made for my country have been no
light matters, and all I have in return is to find myself obliged to leave
my poor country, to be the victim of vile calumniators, and to have to
fly from persecution as if I were some horrible criminal.”
Prim’s death was accompanied with much suffering, for some of
his fingers were so seriously injured by the shot, it was thought that
their amputation would save his life. But the operation was in vain,
and the General died in two days, just as Amadeus landed at
Carthagena.
When the sad news reached the new King, that his ardent
supporter had fallen a martyr to his cause, he said:
“Gentlemen, my duty is clear: I must go on to Madrid.”
Arrived at the Spanish capital on January 2, 1871, where a fall of
snow added gloom to the occasion, Amadeus at once repaired to the
Church of Atocha, to pay his respects to the remains of the man to
whom he mainly owed the throne of Spain.
As the young King gazed at the corpse of the great leader, who
had inspired trust and confidence in all with whom he came in
contact, he prayed for strength to be able to fulfil the hopes which
the Spaniard had directed to himself. With Prim, the pioneer of
Liberty in Spain, young Amadeus, who had fought for the same
cause in his own country, had always felt in sympathy.
Those who had suffered for their religious opinions had looked to
the great soldier as the herald of a new era. Juan Cabrera, the
leader of the Protestant movement, who had fled to Gibraltar for fear
of imprisonment, and there led a life of exile and hardship, hastened
to meet Prim after the coup which put Spain practically in his hands.
“May I return to my country?” asked Cabrera, when he saw him
at Gibraltar.
“Yes, yes, my man,” replied the General, whilst fixing his keen
eyes on the Protestant’s face, worn with study and anxiety, “you can
go back to Spain now with your Bible under your arm.”
And this the preacher of the reformed faith found to be true, for
Spain had no longer to fear the active persecution of those who
resisted the introduction of the Bible into their land.
As Amadeus gazed at the features of the General, set in death,
he sighed deeply in sorrow at his loss, and when he arrived at the
royal palace, the magnificent setting of so many scenes of struggle
for supremacy in the country, he sat down wearily, and said:
“I feel sure that my loyalty will not be able to save Spain from the
fury of contending factions.”
When the new King took up his abode in the fine domain, with
Prim dead, he felt as if he were starting for a voyage on a ship of
which the rudder was lost, for he knew not whom to trust or to whom
to turn for counsel.
But Amadeus was not a man to let himself be enervated by fears
and doubts for the future, although the first few weeks of his
residence in the palace were additionally anxious from the fact of his
wife being ill at Alassio. For the new young Queen of Spain had not
been able to accompany her husband to Spain, as she was not
sufficiently recovered from her confinement; and when, in her desire
to join Amadeus in the new sphere of influence, the journey was
made too soon for her health, she was for some time ill at Alassio.
At last the new Queen was able to undertake the ten days’
journey by sea to Alicante, where she was received with great
delight by the young King.
The bright spring day which saw the arrival at Alicante of Queen
Maria Victoria seemed to augur well for the success of the young
couple. A thrill of pride passed through the young wife when she saw
her husband come out to meet her in a white-and-gold launch, his
face bright with hope, and looking every inch a King. As the bright
barque cut through the sunlit waters, with Amadeus accompanied by
his Ministers, who had come to welcome her in state, she stepped to
the prow with pretty words of greeting on her lips, and when she was
finally taken off from the Italian ship to set foot on Spanish soil, a
storm of cheers burst from the throats of the Italian sailors, to be
echoed by those from the Spanish crews and sight-seers anxious to
welcome the new Sovereign. The bright and intelligent young wife
did indeed seem to bring sunshine to Spain, and in the opening of
the Senate there was a sincerity in the royal speech which found an
echo in the hearts of those who really wished for the welfare of the
country.
“When my feet touched Spanish soil,” said Amadeus, in a voice
which penetrated to every part of the house, “I determined to merge
my ideas, my sentiments, and my interests, in those of the nation
who elected me as its head, and whose independent character
would never submit to foreign and illegitimate intrigues. My sons will
have the good fortune to receive their first impressions of life here;
their first language will be Spanish; their education will be in
accordance with the customs of the nation; they will learn to think
and feel as you think and feel; and we shall unite with imperishable
bonds our own fate with your fate.”
 But no patriotic sentiments could entirely extinguish the sparks of
smouldering resentment that a foreigner should be set over Spain.
The pride of the Castilians was wounded, and no salve of
sympathy could prevent the canker caused by such a hurt.
Everything the Italian King and Queen did was purposely
misinterpreted. He was dubbed “King Macaroni,” and this mocking
appellation expressed the resentment of the Court and country.
The very democratic simplicity of the young couple was an
offence to a land which revels in old-world ceremony and stately
Court etiquette, and the clerical party never let the people forget that
it was Victor Emmanuel, the father of their new King, who had
ousted the Pope from his position of political supremacy.
Of course Isabella was very indignant when she heard who had
been elected as ruler at the Court of Spain, and she expressed her
feelings in a torrent of speech.
“The revolution continues,” she said, whilst her eyes blazed with
indignation, “and it has just disavowed the rights of my son, who is
to-day your legitimate King according to all the Spanish constitutions,
by calling to the throne of St. Ferdinand a foreigner, whose merits,
however great, cannot entitle him to be your Sovereign, in the face of
the rights of a whole dynasty, which is the only one that has in its
favour the legitimacy which has been consecrated by the lapse of
ages and by constitutions which it has been a signal folly to
disavow.”
Of course the Bourbon party echoed these sentiments of its ex-
Queen, and Amadeus felt the want of unity which has ever been the
main defect of the country.
People who came into contact with Amadeus at the Court of
Spain admired the sense of his opinions, although the form of their
utterance was not in accordance with that adopted by former rulers
at the palace; for the King had many habits of a nervous man. One
of these was to take hold of a chair when he was talking, and twist
first one of his long legs, and then the other, in and out of the
woodwork as he turned it about before him.
As simplicity was a very marked trait in the young royal couple’s
tastes, they rejected the idea of establishing themselves in the
magnificent apartments used by the ex-Sovereigns, and chose a
simple suite of somewhat small rooms commanding a beautiful view
of the Casa de Campo, and there the King passed the happiest
hours of the day with his wife and children. The young Queen’s fine
intelligence rendered her an able confidante for her consort’s State
difficulties, and she was generally present at the discussions with the
Ministers.
Sunday generally saw an intellectual gathering round the royal
dinner-table, but the admiration of the select few who began to
appreciate the gifts and aims of the young couple did not,
unfortunately, represent the feeling of the country, and it required all
the charity and philosophy of King Amadeus and Queen Maria
Victoria to ignore the half-concealed sneers of those at Court who
mocked at the foreigners and their simple, superior tastes.
Indeed, the Alfonsists never lost an opportunity of testifying their
allegiance to the Bourbon dynasty, and, as they studiously avoided
the royal palace from whence it had been expelled, the Court society
of Madrid presented a strange medley of people who were so little
conversant with the customs of such centres that Amadeus began to
doubt if Madrid had any really good society.
A certain Señor B., who was subsequently a Minister during the
Regency, was invited to a function at the palace. So he went to a
first-rate shirt-maker and ordered a shirt for the occasion. The shirt
came with the fine embroidered cambric frill set out over blue tissue-
paper. So, thinking the blue paper was meant to be worn with the
shirt, Señor B. strutted into the royal presence quite proud of his
attire—paper and all.
So naturally Don Amadeus was constantly saying: “But there is
no society in Madrid.” This remark was repeated in one of the salons
of the aristocracy on the eve of the funeral of Blanca Osma, the
Marchioness of Povar, mother of the present Duke of Arion, who had
been renowned for her beauty and elegance, and, stung at this slight
to their circles, somebody said: “Well, to-morrow Amadeus shall see
whether there be any good society in Madrid, for we will all parade in
front of the windows of the palace after the funeral.” And so they did,
and thus the demonstration of sympathy for the family of Osma and
Malpica became one of political importance.
February 10, 1872, was celebrated at the palace of the Dukes of
Bailen by a magnificent ball. The minuet was danced by ladies in
most beautiful Pompadour dresses, trimmed with handsome lace,
and their hair powdered in the style of the last régime, and the
gentlemen showed their high degree in dress and dignity. This
minuet was repeated in the Palace of the Plaza del Angel by request
of the mother of the Empress Eugénie, and society kept alive the
feeling for the ex-régime by the same sort of fêtes until the day
dawned for the restoration, which doubtless these gatherings aided,
for the little rooms adjoining the salons were the scene of many
councils in the cause of the Bourbons.
One day this feeling of antagonism was expressed in a more
patent and painful form.
It was a hot evening, which the King and Queen had spent
listening to the music in the gardens of the Buen Retiro. The royal
couple was returning to the palace by the Arenal, when suddenly a
vehicle opposed the passage of the carriage by crossing just in front
of it. The coachman checked the horses and cleverly prevented a
collision, and just then a shot was directed towards the royal party.
 Upon this the King sprang boldly to his feet, exclaiming:
“Here is the King! Fire at him, not at the others!”
But no further attempts were made at assassination, and the
retinue reached the palace in safety, where the young Queen sought
to still her tremors of anxiety by the sight of her brave young
husband standing sound and well before her.
To the King the late hours of the Court were particularly
disagreeable. At work from six o’clock in the morning, he rang at
eight o’clock for breakfast; astonishment was on the lackey’s face
when answering the summons; he heard that it had never been
customary for their ex-Majesties to be served before eleven o’clock.
So Amadeus, wishing to avoid any friction by insisting on earlier
hours, adopted the habit of going to a café for his early meal after
long application to State matters had made him conscious of the
necessity of breaking his fast.
Thus the maids, who sally forth in Madrid with baskets on their
arms to be filled with necessaries for the household, would often
return and regale the ears of their mistresses with how they had
brushed against His Majesty as they did their business in the market-
place. In one of these peregrinations Amadeus noticed that Castelar,
the leader of the Republican party, raised his hat to him. Surprised at
this sign of respect from the enemy, the young man stopped, and
said he wondered that anybody of Castelar’s opinions should salute
royalty, to which the great orator replied, with all the grace and
charm of an accomplished Castilian:
“My salute was not to royalty, sire, but to the bravest man in
Christendom.”
And it was this bravery which aroused the admiration of Spain.
However, no quality could overcome the country’s rooted prejudice
against “the foreigner,” and when Amadeus had taken his seat on
the throne in the magnificent crimson-and-gold setting of the state
salon of the palace, it was not to take real possession of his subjects’
hearts. There was no antagonism against the Italian King, but utter
indifference for him, which was much more difficult to deal with. He
was unknown to the Spaniards, a mere guest, and the necessity of
forming a Court for his wife was attended with the difficulty of the
ladies of high degree being Alfonsists or Carlists, and thus many of
them considered themselves superior to the lady on the throne.
The ladies of the last régime openly showed the Italian royal
couple that their loyalty was still directed to the Spanish ex-
Sovereigns, by constantly presenting themselves in the Buen Retiro,
and other resorts where they drove or walked, in the white lace
mantillas and other characteristics of costume especially Spanish.
As a counterfoil to these signs of disrespect to those in power,
the ladies who were followers of King Amadeus and his wife
arranged a cortège formed of women of the town, who were all
dressed like the Spanish doñas of high degree, and they were
accompanied by a noisy, bullying sort of fellow who obviously
represented the King’s Chamberlain, the Duke of Sexto.
Thus the feeling of the Court of Spain at this epoch was
manifested in a series of spiteful acts unworthy of people of high
position.
The Court ladies showed little sympathy with the philanthropic
aims of Queen Maria Victoria. The existing Home for the Children of
Laundresses is still a standing proof that the sight of the thousands
of women on their knees by the side of the River Manzanares,
washing linen, had evoked a feeling of pity in the heart of the young
royal mother.
The King found it impossible to take any action for good in his
adopted country. The want of sympathy, and suspicion, which met
every suggestion of the young King, allied with the confusion
reigning in every department of the Government, made progress
unattainable, and the King, having nothing to do with his time in a
serious way, was soon found to be an easy prey to the seductions of
designing Spanish women, and it was not known till some time
afterwards that the Government had to interfere in ridding the Court
of an adventuress who managed to get into the Court circle.
As Queen Maria Victoria wrote to a valued friend in Italy, she
seemed wanting in the essential to make her a good Queen of
Spain, and that was the desire to remain in the country.
Sensitive as the young Sovereign was, she was ever conscious
of the half-concealed looks of scorn of those about her, who
wondered that she preferred the simple customs of a happy
domestic life to the pomp and etiquette of an old Court régime. The
Countess della Alinma and the Marquis of Ulugares sympathized
with Their Majesties’ tastes, but these two friends could not stop the
whispers of discontent and disapprobation reaching them from the
large circles of the great palace.
Much of the rigidity of Court etiquette was abandoned during the
short reign of Amadeus and Maria Victoria. The custom of courtiers
prostrating themselves on their knees before Their Majesties was
abandoned, and, thanks to the good sense of Alfonso XII., it was
never more resumed.
Queen Maria Victoria created an Order which was called by her
name, but it lapsed after her departure from the palace.
We read in “Cosas del Año 1873” (Things of the Year 1873), by
Carlos Frontaura, that many open insults had been levelled at the
Italian Sovereigns during the last few weeks of their reign. At the
Court reception which is always customary on New Year’s Day in
Spain, the Conservative deputies were conspicuous by their
absence, and Generals Serrano, Concha, Infante, Rivero, Allende,
Zabala and Hoyos, Topete, Malcampo, Martinez Espinosa, and the
ex-Ministers Rios, Rosas, etc., all excused themselves from
attending the banquet which took place in the evening.
The Countess of Heredia-Spinola gave a magnificent ball in her
house in Calle Fernando el Santo, and all the guests wore the fleur-
de-lis as a sign of their devotion to the Bourbon family.
Society at the Court of Spain was very different in the year 1872
from what it had been during the late dynasty.
As Napoleon I. said, “You may confer titles and dignities, but you
cannot give that particular cachet which goes with real Court
society.”
The Countess of Campo Alange always said, “Did So-and-so
learn the minuet when he was young?” For if the answer to this
question were in the negative, it showed that the courtier only
belonged to the new dynasty.
The Marquis of San Rafael was then Prime Minister, but when
the Marchioness wished to enter the Queen’s presence she was not
allowed to pass, whereas an arrogant lady of the old aristocracy
quickly forced her way in. The Prime Minister was advised to report
this slight to Amadeus himself. When the King heard of the matter,
he only shrugged his shoulders, and said, “Let them fight it out.”
The King and Queen felt that their days in Spain were numbered,
and it only wanted some incident to put the match to the train of
discontent.
The ostensible cause of the break of the King with the
Government was the appointment to the command of the artillery of
Hidalgo, who five years before had been in command of the
company which had made the insurrection in the barracks of San Gil
in 1866. The King himself did not favour this appointment, but when
Ruiz Zorilla showed him a vote of confidence in the course carried by
the Congress, Amadeus thought it time to resign the crown which
meant nothing but mortification to himself and his wife. So on that
evening (February 11, 1873) the republic was proclaimed, and six
o’clock the following morning saw the sad exit from Spanish Court
life of the Italians who had been so fruitlessly summoned to its circle.
Queen Maria Victoria had also been wounded in her
susceptibilities as a mother. When her second child was born to her
about a fortnight before the proclamation of the republic, the young
Sovereigns naturally expected that the Ministry, Diplomatic Corps,
military dignitaries, and clerical leaders, would be ready to greet the
baby Prince according to the Court etiquette of the country. But the
representatives of the country did not feel sufficient interest in the
birth of “the little foreigner” to hasten to pay him their respects; and
although the red and yellow flags waved triumphantly above the
royal palace, it was several hours before there gathered in the
audience chamber an assembly sufficiently large and august to
receive the presentation of the son of Amadeus and Maria Victoria.
It was hardly a fortnight later when the die was cast, and the
Italians decided to abandon the throne of Spain.
The personal attendants of the Queen wept as they saw her
carried to the entrance of the palace still weak and ill from her recent
confinement. The dethroned young King took the frail form of his wife
in his arms when she was taken from the litter at the foot of the
grand staircase, and, after placing her in the carriage waiting in the
archway, proudly saluted the Guard and stepped in by her side.
In a departure arranged so hurriedly, all the necessary comforts
were forgotten, and the royal invalid was faint for want of
nourishment, which was only attainable after hours of travelling.
Amadeus was grateful indeed for the soup he was at last able to
procure at a little railway-station on the line, and he boldly met the
remarks and curious looks of the people who crowded to see the
royal fugitive as he bore the cup from the restaurant to his wife.
 Once in Portugal, Amadeus had nothing more to fear for the
personal safety of the family, and it was from thence they soon sailed
quietly for Italy.
 CHAPTER XIV
SOME TRUTHS ABOUT THE REPUBLIC

1873–1874

We have an interregnum in the history of the Court of Spain during

the republic which held rule from February 11, 1873, until the
restoration of the monarchy on December 30, 1874; but those
readers, who like to have some idea of what was passing in Spain
whilst the palace was empty, may be interested in the following
particulars, drawn from a book entitled “Contemporaneous Truths,”
by His Excellency Vicente Lafuente. These truths were republished
by Colonel Figuerola Ferretti[19] in 1898, with an able prologue from
the officer’s pen, to show those malcontents who wished to return to
this form of government how baneful it was for the welfare of the
land.
[19] This Spaniard is connected on his mother’s side with Pope
Pius IX. (Mastai-Ferretti), whilst his father was Figuerola, the patriot
of Cuba.
 L I E U T E N A N T- C O L O N E L L U I S D E F I G U E R O L A F E R R E T T I

From a Painting by Miss A. J. Challice, exhibited at the Royal Academy, London

Queen Maria Cristina graciously accepted the book from the

Colonel, who was then a Chamberlain at her Court, and it doubtless
served to disperse the false ideas as to the nature of a Spanish
republic which had arisen in the minds of those who were absent
from the country whilst it held sway.
 Twenty-five years had elapsed since Spain adopted the republic,
but, as Figuerola Ferretti reminds his readers, that time had not
obliterated the horrors of that period from those who belonged to that
time.
Those who were inclined to regard a republic as an ideal form of
government were reminded that the fatal night of February 11, 1873,
saw the opening of the Pandora box, whence issued all sorts of
moral and political calamities, which spread like a black cloud over
the Spanish nation in both worlds. With the enthronement of moral
and material disorder, licence and anarchy came from all sides, to
the increase of impiety and corruption of customs, the ruin of
families, the debasement of the public credit, the demoralization of
the forces on sea and land, the loss of honour and national dignity,
and the peril of the independence and integrity of the country both in
the Peninsula and in America.
Such is the picture of the republic from the night of February 11,
1873, until the morning of January 3, 1874, when it was dissolved by
the coup of General Pavia. This opinion is no mere expression of
party rancour, for, as it is founded on the facts and events recorded
in the Gazette and the Journal of the Sessions of the Cortes, which
were noted day by day, they became, under the pen of the historian
Lafuente, the true history which, according to Cicero, is “the light of
truth and the master of life.”
A few quotations from this diary of facts, which Ferretti
republished as an antidote to the anti-dynastic feelings which were
aroused by the loss of Cuba, give some idea of the effect of the
republic on Spain:
“February 16, 1873.—Assassinations in Montilla under shocking
circumstances. Eight houses sacked and burnt; Señor Robobo
assassinated and quartered. Abolition of the oath of loyalty in the
army.
 “February 20 and 21.—During these days the theatre of
Barcelona was the scene of dreadful military orgies and acts of
immorality and barbarism. The column of Cabrinati rebelled in Santa
Coloma de Farnés, at the instigation of the republicans, and the cry
of ‘Down with the officers!’ was heard all over Catalonia.
“February 24.—There was a general Carlist rising in Navarre, and
a call to arms of all men between twenty and forty years of age.
“February 28.—The neighbourhood of Madrid, in view of the
prevailing want of discipline and the ease with which dwellings could
be invaded, began organizing armed bands.
“March 15.—The battalion of ‘the Cazadores of Madrid’
committed unspeakable horrors in Falset, and several companies of
Catalonia began a course of pillage and immorality.
“March 17.—General Hidalgo harangued the savage soldiers of
Falset, but he was so hissed that he was obliged to retire, like almost
all the other officers.
“March 18.—A great meeting was held at San Isidro, where the
public commemorated what they called ‘the glories of the Commune
of Paris,’ which they were evidently seeking to imitate.”
The record of March closes with the mention of the occupation of
the churches of Barcelona as barracks and theatres.
April 3 we read: “The republicans of Manresa invade and profane
a church, take possession of the library and rooms of the seminary,
and the town-hall of Tarragona.
“May 13.—An electoral meeting in Barcelona; the popular Mayor
Buxó is wounded by a stone. The voluntary troops of Madrid knock
down and wound the chaplain of the hospital, insult the officials who
seek to release him, and commit various robberies and
assassinations, so that the troops have to be called out against
them.
 “June 3.—In Madrid and other places the procession of the
Corpus Christi could not take place on account of the uproars in the
streets. Orgies in the churches of Belen and San José at Barcelona,
and indecent balls, in which the mysteries of our redemption were
mocked at.
“June 16.—Horrible assassinations at Bande (Orense). Sixty
unhappy beings of all ages and both sexes fell victims to this
savagery.”
After three days’ fighting the international incendiaries and
assassins were expelled from Seville, leaving the city stained with
blood and injured by fire.
“September 23.—General Don Manuel Pavia was appointed
Governor of Madrid.”
Carlism was rapidly gaining ground during these months. There
were 8,000 Carlists in Aragon and Valencia, and as many more in
Catalonia, 12,000 in Navarre, and more than that number in the
Basque provinces, thus making more than 40,000 Carlists in all
Spain.
“November 7.—Señor Castelar, the President of the Republic,
was daily losing power in the Congress, where neither eloquence nor
good sense seemed to have any sway over the turbulent spirits.”
When the Corporation of the city became disaffected from the
Government, it seemed to the Governor of Madrid that it was time for
him to assert the power of military rule.
So on December 2, when the chamber of the Congress was
nothing but a scene of riot and disorder, each deputy striving by his
loud voice and violent actions to overpower his fellow, the cultured
Castelar, the head of the republic, whose orations would have
reflected honour on the Areopagus of old, was met by a vote of want
of confidence.