Common Law Economics

Isaac Newton and the Alchemy of Finance

Western Christendom experienced a sea change in the late 17^th century. On one side of that divide was theological dogmatics, scholastic philosophy, the divine right of kings and priests, and, seemingly in their train, wars of religion; on the other side, there was theological indifference, mechanical philosophy, government by consent of the governed, latitudinarian and sectarian church polity, and the political balance of power. Not that these things came all at once; but the tendencies were clear. The mood and temper of the peoples had swung; religion lost its position of overriding importance, to be replaced by economic and political considerations, reason of state, and the wealth of nations.

A pantheon of figures has been elevated to apostolic status as trailblazers in the transition from the Darkness of the one side of this great divide to the Enlightenment of the other. Hugo Grotius, Rene Descartes, Baruch Spinoza, John Locke, Pierre Bayle, Montesquieu, Voltaire, all figure in enumerations of enlightened progenitors of the new era. Paired with these names was a new theoretical orientation which determined the mindset, the Zeitgeist, the Weltanschauung of this new dawn: a new science putting the categories “nature” and “natural law” on a new footing, providing the essential authoritative basis for the new order.

Thus “nature” was the determining factor. The “imperative of nature” came to dominate all areas of inquiry and practical philosophy. The “state of nature” became the orientating condition; rights in a state of nature came to be the touchstone of all just legal and political order; natural religion, religion in accordance with the dictates of nature, came to be touchstone to judge revelation, or at least to form a stand-alone, autonomous body of knowledge alongside revelation; and a new school of thought, economics, arose from out of the disarray of “mercantilist” controversy, basing itself upon – you guessed it – nature, with the initial iteration provided by Richard Cantillon and François Quesnay, and which issued forth as “physiocracy”: the rule of nature.

Perhaps one figure above all others represented and personified this trend. That would be Isaac Newton, the progenitor of the paradigm that anchored all these areas of thought in terms of a unified theoretical construct. Newton put science on a new plane, providing an integrated theoretical explanation for phenomena that had stumped scientists for generations; and it was upon this foundation that the orders of religion, law, politics, and economics were shunted. Alexander Pope’s well-known “Epitaph on Sir Isaac Newton” was, if anything, an understatement of the sentiment of the age:

Nature and Nature’s Laws lay hid in Night:

God said, “Let Newton be!” and all was light.

Christian theology became wedded to Newtonian physics, which in particular served as a tool of apologetics.[1] The philosophy of law and politics, already argued in terms of the individual and consent, received a powerful support from the notion of an atomistic universe. And this very same Newtonian construct likewise served to buttress the budding school of classical economics with all of its “natural laws” of wealth and poverty centering on the individual and self-interest.

In all of these areas, Newton’s philosophy, the “settled science” of the day, supplied a powerful sanction. But this is not everything there is to know about Newton. Some areas of his labor, to which he devoted at least as much time as his scientific investigations, have come to light of late, after having languished in the obscurity they were left in by hagiographic biographers determined to highlight the rational character of one of the chief developers of the scientific method, while ignoring what they deemed to be irrational. And Newton exhibited this “irrationalism” in spades.

One of these areas was biblical study. Newton devoted a great deal of time and effort to biblical chronology and to deciphering the Temple of Solomon. The latter in particular he held to be an expression of hidden truth to be unraveled by the initiate. This interest in the Bible and in theology, along with Newton’s clear belief in the biblical version of events regarding, e.g., six-day creation and the Flood, were enough to put a serious dent in Newton’s reputation as the objective enlightened scientist. But the most egregious offense in this regard was provided by the realization that Newton dabbled in alchemy. More than that: he spent a major portion of his investigative life, not in scientific experimentation, but in alchemic explorations, pursuing the transmutation of elements.

It was John Maynard Keynes who first lifted the lid on this aspect of Newton’s legacy. “Newton was not the first of the age of reason,” Keynes wrote in his posthumously published and delivered lecture, “Newton the Man.” Rather, “He was the last of the magicians, the last of the Babylonians and Sumerians, the last great mind which looked out on the visible and intellectual world with the same eyes as those who began to build our intellectual inheritance rather less than 10,000 years ago.”

Keynes discovered the “real” Newton while perusing a box of forgotten documents he obtained at an auction in 1936. This led to a radical reevaluation on his part. “In the eighteenth century and since, Newton came to be thought of as the first and greatest of the modern age of scientists, a rationalist, one who taught us to think on the lines of cold and untinctured reason. I do not see him in this light. I do not think that any one who has pored over the contents of that box which he packed up when he finally left Cambridge in 1696 and which, though partly dispersed, have come down to us, can see him like that.”

That box revealed Newton the alchemist. Alchemy is the pursuit of transmutation, and Newton avidly pursued it. What the alchemists were after was gold. What one needed for that was the philosopher’s stone; with that in one’s possession, one might convert base metal into the precious yellow metal.

It goes without saying that Newton never came into the possession of such a stone, nor did he ever successfully transform base metal into gold. But it cannot be said that he was altogether unsuccessful in his manipulations in favor of the yellow metal. And here comes the part of the story that is never told, because insufficiently understood. It is the story of how Newton participated in one of the great transformations of world history: the shift of England’s currency from silver to gold, which precipitated the change from a coinage- to a banking-based monetary system. He did so as Master of the Mint, a position he occupied from 1699 until his death in 1727.

A little background is in order at this point. The 16^th century witnessed the development of a new order of trade, or, in Immanuel Wallerstein’s terminology,[2] a world-system integrating far-flung areas of the world into a trading network. At the center of this trade network was the fledgling Dutch Republic. In the face of the mercantilist imperative – policies to maximize the retention of precious metals in order to maintain a viable domestic circulation – the Dutch Republic instituted a novel arrangement with regard to currency, dictated by this trading network.

This arrangement facilitated trade with the East. This was because the West ran a chronic trade deficit with the East. There was nothing new about this; from the early medieval period on, the West basically had nothing to offer the more advanced East than such things as furs and slaves, the latter until the slave supply from the Western countries dried up. But there was great demand in the West for what the East had to offer: for instance, silks and spices. How to finance the importation of these luxury goods? Silver.

The one thing the West had that the East wanted, especially since Spain’s discoveries in the New World, was silver. Silver in the East carried a premium vis-à-vis the West, making it profitable to export: this was what made it effective as a means to settle up the trade deficit.

Thanks to new mining techniques and Christopher Columbus, silver became abundant in the 16^th century, precipitating the so-called Price Revolution of that century. But in the 17^th century the supply began drying up, one of the factors behind the so-called General Crisis of the 17^th century and one of the spurs to the spate of policy proposals and implementations summed up in the term “mercantilism.” For one thing, the mines of New Spain were not producing as much as they once did. For another, the flow of silver to the East, primarily China – that bottomless pit, “the World’s Silver Sink”[3] – was beginning to have its effect.

The Dutch Republic served as the funneling mechanism for this flow. Its counter-mercantilist policy allowing the free import and export of specie, and the demand for silver for export exerted a magnetic attraction from all over Europe, with the resulting abundance of coin even precipitating the Tulip Mania of the 1630s.[4] Much of it simply went to offset the burgeoning import business.

English merchants watched all of this with proverbial Argus eyes. They looked on as the Dutch East India Company established its trading network, helped by its special advantage of readily available specie. They sought ways to get around the royal prohibition on the export of currency, and chafed under the restriction.

The breakthrough came in 1663, with the passage of legislation establishing a regime of free coinage. Del Mar finds the impetus for this legislation in the intrigues of Barbara Palmer, Duchess of Cleveland, Charles II’s mistress.[5] With this opening, the East India Company worked diligently to build its own trading network. The needed silver it obtained, among other places, from the domestic circulation, precipitating a dearth of coin. Together with the wars against Louis XIV conducted by “King Billy,” the Dutch stadhouder become King of England, this precipitated an economic and budgetary crisis.

This decimated the coinage, which suffered from debasement at minting as well as the techniques of clipping and sweating. As a remedy, the wise men of the age recommended a restoration of the coinage to the condition it enjoyed under Queen Elizabeth a century earlier. According to Whig historiography, the great men who recommended this measure, occupants of the Enlightened Pantheon, men like John Locke, here once again displayed their sagacity. Post-Whig reassessment has been less kind.[6]

The attempt to restore the coinage to the silver content of days when silver was abundant had, as its detractors predicted it would, a strongly deflationary effect. And it had the opposite result than hoped, for it simply provided a prime source of silver for export. Full-weight silver coins were simply too juicy to let pass. On these terms, it was quite simply more profitable to export silver than allow it to continue in circulation.

So the result of the so-called Great Recoinage was virtually to establish gold as the currency standard for England.[7] Here is where Newton comes in. As Master of the Mint, Newton ensured the continuation of this trend, maintaining a ratio of silver to gold (15 ½ to 1) that upheld the continued priority of gold over silver. By pricing gold favorably against silver, this ratio ensured that the export of silver in favor of gold would continue to be profitable. Both Newton and Locke indicated the direction that the natural philosophy was going to take with regard to economics: the commodification of money, with all the consequences that this would entail.

But the establishment of gold at the heart of the English currency system had another consequence of a different order: it established fractional-reserve banking in place of coinage as the “money method.” This system of banking had a magical working. It turned paper into gold, or gold into paper, for it multiplied a bank’s specie holdings and circulated a currency “as good as gold” albeit many times the actual amount of gold. This alchemical process actually worked, contrary to Newton’s experiments with the philosopher’s stone. And so Newton stood at the cradle of a new alchemy with far-reaching consequences.

It is one of those curious coincidences of history that Keynes, considered by many to be the modern progenitor of the alchemy of finance, was the first to discover and publicize Newton’s own alchemical wizardries. Keynes’ alchemy consisted in the magical transformation of fiat currency into productivity, growth, and wealth, simply by wielding “effective demand.” Newton’s consisted in the more mundane magic of the multiplication of gold reserves. “Their works follow after them,” for their alchemy lives on. In our day and age, the paradigm of alchemical transmutation has crossed over even into biology and gender. As such, it is the pulsating heartbeat of the age in which we live, all pretensions of scientific rationality notwithstanding.

[1] See in particular Margaret C. Jacob, The Newtonians and the English Revolution 1689-1720 (Ithaca, NY: Cornell University Press, 1976).

[2] Immanuel Wallerstein, The Modern World-System I: Capitalist Agriculture and the Origins of the European World-Economy in the Sixteenth Century, with a New Prologue, vol. 1 (Berkeley, CA: University of California Press, 2011 [1974]).

[3] Dennis O. Flynn and Arturo Giráldez, “Born with a ‘Silver Spoon’: The Origin of World Trade in 1571,” Journal of World History, Vol. 6, No. 2 (Fall, 1995), p. 206.

[4] Doug French, “The Dutch Monetary Environment During Tulipmania,” in The Quarterly Journal of Austrian Economics (Vol. 9, No. 1, Spring 2006), pp. 3-14.

[5] Alexander Del Mar, Barbara Villiers: or, a History of Monetary Crimes (New York: Cambridge Encyclopedia Co, 1899).

[6] For instance: Peter Laslett, “John Locke, the Great Recoinage, and the Origins of the Board of Trade: 1695-1698,” in The William and Mary Quarterly, Vol. 14, No. 3 (July 1957), pp. 370-402.

[7] A recent article making this case is Charles James Larkin, “The Great Recoinage of 1696: Charles Davenant’s Developments in Monetary Theory” (2006), available at https://goo.gl/JtcWCH.

Honest Money?

“Honest money” is a phrase bandied about as a self-evident truth. As the accompanying graph indicates, its incidence coincides with the heyday of the gold standard. As such, it is the pithy summary of a strongly-held view on the nature of money, which at the time of the gold standard had a highly political charge. The only honest money was gold.

As an example, Stanley Waterloo’s Honest Money: “Coin’s” Fallacies Exposed, published in 1895. Here, silver currency is made out to be a dishonest con game: “The Silverite Argument: 1/2=1.”

Modern defenders of “honest money” are not as fastidious. In this, they have forgotten, or at least laid to one side, the controversy of the 19^th century as to gold versus silver. Nowadays, according to a leading proponent of this doctrine,[1] honest money is metallic money, preferably gold, but also silver; the only honest money is either a coinage of pure gold or silver composition, or a paper issue 100% backed by such money metal; banks that do not adhere to this are a fraud; the state has no role to play here except enforcement of contracts.

The role of the state is reduced, because honest money is commodity money. In the jargon of the economic historians, money is the “most marketable commodity.” It has developed from the give-and-take of trade as the commodity, or form of merchandise, that proved to be most liquid, i.e., most current, most acceptable to any market participant, not as something directly desired, but as something that could be held and used at a later time in a later exchange.

Hence, the market takes care of money as a sort of automatic by-product. And, according to this version of events, silver and gold constituted the most marketable commodities.

The standard is weights and measures, as befits a commodity. This explains the biblical insistence on honest scales. The shekel, mentioned in the Bible as a unit of currency, was a unit of weight.

Coinage came in later on, as a means of simplifying matters. Instead of weighing out the money commodity for each transaction, coinage was developed in terms of standardized units, in various denominations, unvarying in each denomination, presumably with the weight stamped on each exemplar by way of convenience.

Presumably – because in actual fact, there is no historical example of a coinage stamped with its weight, the way a modern ingot is. What’s more, this version of events is without basis in historical fact.

Not that money did not start out as commodity money. It did, only it did not function in the way the “honest money” proponents would have us believe. The earliest records show a functioning commodity system, but one entirely different from this. In ancient Mesopotamia, a commodity money system developed, but it was, primarily, barley that was the “most marketable commodity.” The barley standard seems to have developed out of the need to store and dispense barley by the cities of the Fertile Crescent, which were more or less autonomous and had to provide for their own citizens. This storage took place in the temples, and was centrally organized. Silver was the other mainstay in monetary transactions. It was used for more high-end and inter-local transactions, while barley was used for local, lower-end transactions.[2]

The important thing to note here is that these commodities were used as units of account. “The temples in Babylonia from the Ur III period through the Achaemenid period use barley like money, especially as a unit of account.”[3] A unit of account serves to facilitate transactions on paper, not actual hand-to-hand transactions. In other words, the commodity was stored away to serve as a basis for monetary transactions, while not actually changing hands. Here we see beginning to take shape before us the basis for the banking system that is the bane of the “honest money” proponents: fractional-reserve banking.

“These institutions were in a position to store grain. They needed it to feed their dependents, and it is clear that they could turn it rather easily into all sorts of other things they might need, ranging from labor-services to commodities.”[4] As Powell notes, the majority of the population was relatively poor and dependent upon these temples for work and sustenance. If payments were made in barley, these could be made on paper (actually, clay tablets) rather than in kind; and as such, they could be expanded far beyond the actual holdings. This in turn would feed indebtedness, which is what a fractional-reserve banking system generates.

The indebtedness is attested by the innumerable cuneiform tablets on which these transactions were recorded. And indebtedness led ineluctably to all manner of social oppression, up to and including debt slavery. This, in turn, led to “clean slate” legislation in which debts were cancelled, debtors were freed from slavery, confiscated lands were returned to the original owners. In fact, the first instance of the word “liberty” – the Sumerian amargi, used by Liberty Press as its logo – does not refer to liberty in the abstract, or to economic freedom, but to the very specific act of debt cancellation. “The term should not be translated vaguely as ‘liberty’ or ‘freedom’ in the abstract, but as an economic ‘Clean Slate.’”[5]

The point here is the one I made in my book Follow the Money: “This practice [of fractional-reserve banking] … follows in commodity-based banking’s wake” (p. 15). Commodities used as money do not circulate freely, at least not nearly as much as other commodities, and the more valuable they are, the less freely they circulate. In fact, they have a habit of disappearing from circulation. They wind up in temples or in chests or in vaults, and they circulate only among the very wealthy. Abraham may have had 400 shekels of silver – “Abraham weighed to Ephron the silver, which he had named in the audience of the sons of Heth, four hundred shekels of silver, current money with the merchant” – but Abraham was a rich man, for a single shekel of silver was the equivalent of a laborer’s month’s wages.[6]

The biblical prohibition on interest needs to be understood in this context. North argues that the Old Testament does not outlaw the taking of interest. He does so by distinguishing between “usury” and “interest” as two different things. “The Hebrew word ‘usury’ was a term of criticism. Usury referred only to interest taken from a poor fellow believer, in other words, interest secured from a charitable loan. Such usury is prohibited by Biblical law. But interest as such isn’t prohibited.”[7] This suggests there are two words for the phenomenon of interest in the Old Testament, or that the word is used in two senses. This is not the case. There is only one word, and it used in only one sense: interest on loans, not just charitable loans but all loans. By the Law of Moses, any interest at all was illegal, at least to fellow Israelites.

How to understand this? The biblical prohibition on interest was part of a larger complex of institutions, such as the Jubilee, aimed at mitigating the effects of indebtedness. Abraham had been called from “Ur of the Chaldees,” one of the leading cities of “the Mesopotamian Way”; God called him to found a new nation, one that would be able to stand against these nefarious institutions and ward off their debilitating effects. The prohibition on interest was there to keep these institutions from gaining a foothold in Israel. Later on, the Phoenicians, through Jezebel, would introduce their land law into Israel and corrupt it from that end. But the prohibition on interest was intended to prevent Israel from falling under the sway of these foreign influences.

So the Old Testament, while not prohibiting commodity money, mitigated the effects of its use, for it is precisely this that the prohibition on interest provided. Honest money, indeed.

But one might object that this was an aberration. Commodity money as the basis of a fractional-reserve system is not at all what is intended (even though that is what the modern gold standard entailed); commodity money which circulates and/or which forms part of a warehouse-deposit banking system is.

This is problematic. For one thing, it flies in the face of recorded history. Coins valued at weight have hardly ever been able to sustain a circulation. They get removed from circulation precisely because there is no difference between the coin and the commodity. In order to keep coinage in circulation, the value of the coin has to be set at a level higher than its market (intrinsic) value, otherwise it will disappear. This is Gresham’s Law looked at from the other side: it is not that bad money drives out good, but that only “bad” money circulates at all. Which is why nearly all systems of coinage have been fiduciary. Contrary to popular belief, coinage was never a system established to make it easier for commodity money to function, with a coin’s weight stamped on it to simplify matters. Rather, it was established precisely to escape the system of commodity money with its accompanying inconveniences and injustices.[8]

There have been attempts to maintain an “intrinsic” value coinage. But what is clear from them is that their purpose was not to provide for a wide domestic circulation, but only for the upper levels of the economy, for high finance and international trade. During the Dutch Golden Age, for example, the Dutch produced what they called negotiepenningen, “trade pennies,” which were pure silver coins of a certain weight to facilitate trade. These were minted exclusively for international trade and were not meant for domestic circulation – hence the name. Similar examples are the Venetian ducat and the Florentine florin.

The greatest example of such a currency was the Byzantine solidus or bezant, a gold coin maintained for hundreds of years in Byzantium, minted at the rate originally set by Constantine: 72 coins per pound weight of gold. But this coin was part of an intricate system of coinage formed of three metals, copper, silver, and gold. The day-to-day economy ran on silver and copper; the upper reaches of the economy made use of gold. And the empire sacrificed prodigiously to maintain that gold coinage. The state strictly controlled trade to ensure that gold was not exported. It spent massive amounts of resources on gaining and maintaining gold mining regions. Tax rates were high to pay for all of these state activities, to control trade and maintain far-flung armies, all for the sake of maintaining the coinage. And economic development stagnated while economies in neighboring Islamic countries bounded forward: The Muslims, for their part, maintained a silver standard and reaped the benefits of it.

Now let’s suppose that we followed the hard money advocates’ advice and introduced a strictly commodity money based on the precious metals. And further, let’s suppose that we followed their advice and maintained this currency on a basis of strict 100% backing, i.e., without engaging in any fractional-reserve banking or making use of any sort of credit instruments that did not have a strict monetary backing. For one thing, this would call for a heavy dosage of state oversight to ensure that all transactions were conducted on the “up-and-up.” Credit would be eliminated, because credit intrinsically expands the money supply. No lending with the promise of money repayment could take place even on a personal basis, that did not have strict 100% monetary backing. For every such “credit transaction” would in essence expand the money supply. Even the corner grocer’s provision of groceries with a promise of repayment when the paycheck comes in, would be illegal and punishable.

So the state would be heavily involved in the administration of such a standard. But beyond that, it would mean an enduring and drastic deflation, with all the traumatic consequences of such a deflation. This is because the money supply, being limited to the amounts of precious metal that are available to be put into circulation, is by the nature of the case kept at a more or less constant level, while the broader economy, with its innovation, its new technologies, its expanding workforce, its expanding output and consumption, continually outstrips that circulation. With expanding goods and services and a constant money supply, the only direction for prices to go is down. And a deflationary environment is one in which spending collapses, consumption collapses, and everyone holds onto the money they have, to spend it only on things of pressing importance. That is the nature of a deflationary economy. The holders of precious metal would see their holdings appreciate in value daily, while those without such holdings would be left to the mercies of a contracting economy and the opportunities, or lack thereof, it affords.

The attraction of “honest,” i.e., market-based commodity money, is that it seems to be immune to the manipulations of dishonest actors, whether they be bankers, or merchants, or minters, or the state. But this is a mirage. Such an institution never has existed and probably never will. Money needs to be adaptable to the needs of the economy. The money supply needs to be capable of expansion. How that is to be achieved is another question, one which I answer in my oft-mentioned book Follow the Money, to which I refer the reader for further investigation.

[1] Gary North, Honest Money: The Biblical Blueprint for Money and Banking (Auburn, AL: The Ludwig von Mises Institute, 2011 [1986]).

[2] A helpful summary of Mesopotamian money can be found in Marvin A. Powell, “Money in Mesopotamia,” Journal of the Economic and Social History of the Orient, Vol. 39, No. 3 (1996), pp. 224-242.

[3] Powell, “Money in Mesopotamia,” p. 229.

[4] Powell, “Money in Mesopotamia,” p. 229.

[5] Michael Hudson, The Lost Tradition of Biblical Debt-Cancellation (New York: 1993), p. 16. Download here.

[6] Powell, “Money in Mesopotamia,” p. 229.

[7] North, Honest Money, pp. 81-82.

[8] My book Follow the Money contains much more on this topic.

Weighing the Gold Standard

Seeing as how the gold standard is a “money method”[1] by which all exchange value is made dependent upon the weight of a certain substance, viz., gold, it would seem appropriate to “weigh it up” to determine whether or not, “weighed in the balance,” it is “found wanting.”

Indeed, weight measurement was the standard of value during the period when the gold standard held sway, and that standard was gold by weight: the dollar was set at 23.22 grains of pure gold (a grain being 1/7000 of a pound), the pound sterling at 113 grains, the German mark at 6.146 grains, the French franc at 4.98 grains, etc. In this manner, all the currency systems of the countries that adhered to gold standard were bound together by gold. Gold served as the currencies of the world’s reserve currency. This is likewise the origin of the modern system of reserve currencies, but we reserve that discussion for another opportunity (I discuss reserve banking in more detail here).

The gold standard is considered to be, well, the gold standard of money methods. Its great attraction lies in the discipline it lays on governments to conduct a strict and balanced fiscal policy. It does this because it ostensibly takes monetary policy out of the hands of the state. I say “ostensibly,” because the reality is a bit more complicated than that, as we shall see. Nevertheless, the gold standard system came also to be known as the “automatic mechanism” precisely because it functioned without government interference, indeed without any interference at all, guided by a veritable invisible hand. Again, this was not entirely the reality, but not entirely a departure from reality, either.

So the gold standard took currency management away from the state. Prior to it, the state did manage the currency. And that state-run currency system had its roots far back in history.

To be precise: with the advent of coinage in ancient Lydia (western Anatolia) around 700 B.C., the state became the manager of the monetary system.[2] Prior to this there were systems of commodity money – the Old Testament, for instance, speaks of silver as currency (a shekel being a weight measure of silver), and both silver and barley were used as commodity money in ancient Mesopotamia. These were not state-run but purely market affairs. Coinage was introduced, not as a form of commodity money, but precisely to counteract commodity money, which at that time was intimately tied up with the institution of debt slavery. It was introduced to insulate the domestic economy from foreign hegemony. It thus likewise accompanied the rise of the Western concept of freedom in the Greek city-states: coinage was one of the means which enabled the Greeks to wrestle their freedom from the Eastern (Persian) hegemonic empires.

Rome carried on the Greek tradition of coinage and introduced it throughout its empire (“Shew me a penny. Whose image and superscription hath it? They answered and said, Caesar’s. And he said unto them, Render therefore unto Caesar the things which be Caesar’s, and unto God the things which be God’s” (Luke 20: 24-25).) In so doing, it established for posterity the tradition of state management of the money supply. All of the Western European kingdoms took over this Roman institution and applied it as they waxed into independent sovereign states. But this system had its drawbacks. It required precious metals, mainly silver but also, secondarily, gold, to function. And during the entire period of medieval and early modern times, these metals were in short supply. The money supplies of these countries were subject to the vagaries of that supply – mines exhausted here, mines discovered there, new techniques opening new areas up for mining, the demand for silver from the East, in particular India and China – all of these factors played a role in the relative abundance or scarcity of the raw material needed to make the circulation go.

Add to this the practice of competitive devaluations conducted between currency regions, and one can understand the preoccupation for the provision of a supply of metallic currency; a preoccupation which later ages looked upon disparagingly. They even had a name for it: “mercantilism.” But this was no idle preoccupation, for the entire economic circulation depended on the existence of a metallic coinage; nothing else enjoyed the common consent and confidence necessary for a circulating medium.

Coinage was thus a state-run affair, and when the gold standard came around to supplant it, it actually supplanted the regime of coinage entirely. Where the gold standard became established, there coinage dried up. Gold coins never enjoyed the circulation the great silver pieces did, such as the Spanish pieces of eight, which in fact formed the bulk of colonial America’s circulation. No, the system of the gold standard was based on an entirely different “money method”: that of credit and banking.

This may come as a shock to those advocating a return to the gold standard. The common image is that of a rock-solid metallic currency that cannot be manipulated. But the reality of the gold standard was that, under its regime, credit exploded. This was not a bad thing; in fact, it was the way the Industrial Revolution was financed, and without it, that revolution probably would not have materialized. Still, the gold standard engendered a massive increase in banking and credit-derived bank money.

In this system, gold did not circulate in the sense of changing hands. Rather, it was locked up in bank vaults and served as the basis for the structure of credit. It was thus the reserve that every bank needed in order to issue credit. Theoretically, for every dollar of credit the bank issued, it could back in gold. Practice was different: reserve ratios were maintained depending on the likelihood of “cash,” i.e., specie, withdrawals. A ratio of 1/3 was common, at least initially. But with the practice of reserve banking, by which banks deposited their gold holdings with other “reserve” banks, the basis shrank.

So it was under the regime of the gold standard that we obtained an ever more “elastic” money supply. This was reflected in the explosion of credit. Macleod used the following example (from England) to show how the money supply there had changed under the gold standard.[3] He used the finances of the Slater house as representative of commerce in general. For year 1856, this is how its income statement looked:

As Macleod noted, “Gold did not enter into their operations to even so much as 2 per cent. And this may furnish a clue by which we may obtain a rough estimate of the amount of Credit.” If this is representative, then credit amounted to 50 times the amount of gold. “This Credit produces exactly the same effects, and affects Prices exactly as so much Gold: and it is through the excessive creation of this kind of Property that all Commercial Crises are brought about.” It is a warning similar to the one Walter Bagehot made in his classic work Lombard Street: the entire edifice of credit was being erected on an ever slimmer basis.

Macleod avers that this lay at the heart of the commercial crises that repeatedly afflicted the economies under the gold standard. But it was the working of the gold standard during the times when it functioned automatically, the way it was supposed to work, that engendered the misery and resentment that led to the rise of the labor movement, political agitation, and the ultimate demise of the system.

This came about because of how the system affected wages and prices, enterprise, and employment. The automatic mechanism functioned through gold flows, and gold flows determined the money supply. Where gold flowed into the economy, the money supply could expand; where it flowed out of the economy, the money supply was forced to contract.

These flows occurred not only within countries but between them, given the international character of the gold standard. When economies, including national economies, ran trade surpluses or deficits, gold flowed to the surplus country, expanding its money supply and fomenting economic activity. By the same token, gold flowed out of the deficit country, restricting the money supply and depressing economic activity. The result was deflation in wages and prices.

So the gold standard worked by allowing inflationary and deflationary swings to redress trade imbalances. This resolved the underlying imbalance, but at what price? Severe bouts of unemployment, and consumption- (and thus production-) killing deflation. Schumpeter, perhaps the most thoughtful and nuanced defender of the gold standard, argued that deflation was not necessarily a bad thing, when all prices and wages moved in sync. Theoretically this might be true, but in practice, deflation has always been traumatic.

In fact, the only benefactors under a regime of regular deflation are creditors. This dynamic gave rise to the so-called social question and the various labor movements, socialism, and communism which characterized the later 19^th century’s political landscape. The political unrest behind these movements found increasing recognition in the expansion of the suffrage, which brought the labor movement into the midst of the political arena, and put the interest of the workers on a line with those of the creditors. As a result, a new political calculus came to hold sway – called “stabilization” – consisting in the pursuit of price and wage stability. From this point on, governments pursued policies that could provide this kind of stability.

What then of the gold standard’s automatic mechanism? After all, it was based on the inflation/deflation model of rebalancing, and this new political agenda worked at obvious cross purposes to such rebalancing. The answer is, it was paid lip service as an ideal but was increasingly undermined in practice, first at the edges, later at its heart.

The first concessions to the new agenda were social programs and labor legislation. While they may have alleviated the working class’s lot, they did nothing to solve the underlying problem – the trade imbalance – and in fact hindered its resolution by devoting resources to perpetuating the status quo. Old-school conservatives recognized in this the first signs of state encroachment on the private sector, and they were right.

Along with this came central bank intervention. At first this was small-scale; but after World War I, it became de rigueur. Central banks came to master the art of “open-market operations” to control interest rates and, hopefully, changes in the money supply. But what really broke things open was the policy known as sterilization. By this policy, the automatic mechanism was entirely short-circuited. Sterilization entailed the removal of gold from circulation in the real economy to keep it from affecting prices and wages. This was done in the name of stabilization, but it effectively kept the gold standard from performing its rebalancing function. The countries from which gold flowed remained in a constrained economic situation, while the countries to which gold flowed were kept from expanding. Instead, that money went into the financial market. This precipitated the great bull run on the stock market in the late 1920s which ended in the Great Crash. After this, the gold standard system fell apart: some countries continued to adhere to it, allowing it to constrain their money supplies, while other countries went off of it and saw their money supplies expand and some degree of prosperity return. In addition, this period saw the advent of massive social programs administered by government, which required some degree of government influence on monetary policy in order to gain adequate financing. This dependence by government upon monetary policy, and the popularity this enjoyed among the electorate, sealed the fate of the gold standard.

What are the lessons to be learned from this history?

The gold standard in its historic form as “automatic mechanism” will never be introduced as long as the electorate is democratic, i.e., as long as universal suffrage is the rule;
The gold standard is not a coinage-based but a bank- and credit-based system;
If it is a hard-money, coinage-based system that people are after, then a silver rather than a gold standard would be more feasible. For centuries, silver formed the backbone of the currency system, and for good reason: it is available in sufficient quantities to form an everyday circulation. When the gold standard was introduced, it displaced coinage, which brought great hardship on common people, who suffered from the lack of a circulating medium fitted to their needs.

[1] The term is Joseph Schumpeter’s: see his Treatise on Money (here and here).

[2] For the historical background to the following discussion, see my book Follow the Money. For more on this entire discussion, one may also consult the accompanying introductory course in economics, which goes into more detail.

[3] The following is taken from Henry Dunning Macleod, The Elements of Economics (New York: D. Appleton and Co., 1881), vol. I, pp. 324-325.

Another Look at Quantitative Easing

In a previous post (“Quantitative Easing and Substitutionary Atonement”), I discussed some of the underlying philosophy of quantitative easing, the latest of the Fed’s attempts to “stimulate” the economy.

Quantitative easing, to recap, is the term for central bank purchases of assets on the open market.

The difference with traditional “open-market operations” is twofold.

Firstly, the purpose: open-market operations normally have interest-rate manipulation as their goal. The Fed maintains what is called the federal funds rate, which is the interest rate (yield) the Fed targets in buying and selling short-term treasury paper, the most liquid asset on the money market. This sets a floor for interest rates generally. Quantitative easing, on the other hand, is not conducted to manipulate interest rates. Rather, it is conducted to amplify the money supply in the financial market, and in this manner to affect asset prices.

Quantitative easing comes into play when interest-rate manipulation has run its course — such as when interest rates have already been lowered to zero or near-zero, in which case those efforts come to resemble pushing on a string.

Secondly, and in line with the purpose, the quantity involved: as can be seen on the accompanying graph, quantitative easing involves a massive increase in asset purchases as compared with standard open-market operations. The latter were in operation prior to the credit crisis of 2008, and the asset level was stable at around $900 billion, reflecting the fact that buying and selling were conducted interchangeably. The former was initiated soon thereafter, as can be seen from the explosion in asset holdings. In the meantime, it has stabilized at $4.5 trillion (!).

fed balance sheet 2007-2016 — Fed balance sheet, 2007-2016. Data obtained from the Federal Reserve Board.

What has been the effect of this? Well, as my previous post explained, it has simply increased the money circulating within the financial market. By contrast, it has done nothing to stimulate the ordinary market. This disconnect between the two markets is explained further in our course in economics, which outlines the relationship between these markets.

Now let’s juxtapose the Fed’s balance sheet with the Dow Jones Industrial Average, this time updated to March 2016:

Correlation of the Fed's balance sheet with the Dow Jones Industrial Average, 2007-2016 — Correlation of the Fed’s balance sheet with the Dow Jones Industrial Average, 2007-2016. Data obtained from the Federal Reserve Board and S&P Dow Jones Indices LLC.

The correlation still seems to hold true. The Fed has not added to its holdings since late 2014, and the DJIA has been unable to break through the ceiling that inaction has formed. Whether or not the correlation is a direct one, or whether there is any real relationship between the two, is more a matter of theoretical plausibility than practical proof, but it would certainly seem that there is some causal relationship.

Assuming that there is such a relation, this would also indicate where the stock market is headed once the assets start being reduced, either by being sold or by being retired. This will take money out of the financial market, causing prices to drop. This in turn might lead investors to take out their own money, precipitating what could become a rout.

Thoughts on the Piketty Thesis

As is the case with the vast majority of commentators on this topic, I have not read Thomas Piketty’s book (Capital in the Twenty-First Century). The following is therefore gleaned from other sources, mainly this interview, from which, unless otherwise indicated, the following quotations are taken.

The first thing to say is that, on the face of it, Piketty’s exposition is capitalism-friendly. In fact, his approach would seem to be a capitalist prerequisite, for it requires wealth to be put to work, which is a capitalist imperative. In his own words “my point is not at all to destroy wealth. My point is to increase wealth mobility and to increase access to wealth.” Which sounds like a good thing.

But, for one thing, it would entail the capitalization of resources that otherwise would be kept out of the sphere of what is unkindly referred to as capitalist exploitation. For instance, forestry. Having been an undergraduate forestry student, I recall the discussion in forest economics class with regard to the exigency placed on forests by a property tax. All of a sudden, a landowner must generate a revenue from that forest simply in order to pay the tax, on a piece of land that otherwise might be left undeveloped, hence ecologically undisturbed. This could lead to the application of sustainable multi-use forestry practices, or it could lead to elimination of the forest, depending upon the ecosystem involved. The same thing applies to traditional, less-than-profitable land uses. Followers of the television series Downton Abbey will recall the difficulties put upon the estate by the imposition of a wealth tax, causing Lord Grantham to anguish over having to remove inefficient tenants in order to turn the land to more productive uses.

Furthermore, a wealth tax would penalize saving in favor of consumption. Piketty can argue that consumption is difficult to distinguish from investment: “What’s the consumption or income of Warren Buffett or Bill Gates when they are using their corporate jet? Are they consuming? Are they investing? Nobody knows.” But the fact of the matter is, the imposition of a wealth tax would establish a prima facie incentive to spend income rather than save it, especially given the bias against inheritance Piketty displays (“In order to get a zero capital tax result, you need basically two very strong assumptions. One is that wealth is entirely a life-cycle wealth; you have no inheritance at all. Once you have inheritance, you want to tax it”). The moral will be, “eat, drink, and be merry, for what is not taxed today will be taxed tomorrow, if you try to hold onto it.” In Holland, there already is a wealth tax, on top of the 52% income tax (highest bracket, which begins rather early), the 21% VAT, the gasoline tax that jacks the price of a gallon up over $10, etc. So the money that escapes the fevered clutches of the Belastingdienst the first time around gets hit at the rate of 2.5% a year in perpetuum. The moral: spend it before it gets eaten away. Or at least, invest it for a return in excess of 2.5%, which in this day and age is no mean feat.

Another point is that Piketty’s wealth tax would be tax on “net” wealth, in other words, assets minus liabilities, property owned net of debt. It thus incentivizes indebtedness. “If you own a house worth $500,000, but you have a mortgage of $490,000, then your net wealth is $10,000 so in my system you would owe no tax. Under the current system, you pay as much property tax as someone who inherited his $500,000 home or who paid off his debt a long time ago.” The anti-saving bias is evident here. What is also evident is the built-in incentive to take on debt so as to offset taxable property holdings.

Regarding Piketty’s discussion of inequality: the message is that inequality has been increasing over the past 20-plus years, precisely the period of time in which globalization and international trade have surged forward. While Piketty himself does not argue this point, his findings do prompt the conclusion that globalization and free markets lead to inequality, while protectionism and government intervention are needed to foster income equality. And Piketty’s wealth tax is precisely one form of government intervention.

Piketty argues that income and wealth inequality have been increasing (although his findings are disputed), and blames it on the “huge cut in marginal tax rates.” From the interview: “Matthew Yglesias: How do we know that high executive compensation comes out of the pockets of other wage earners? Thomas Piketty: Well, because the labor share including CEO compensation did not increase. It actually declined. Maybe it would have declined even more without the rise in CEO compensation, but that’s hard to believe. I think the rise of very large CEO compensation came at the expense of the workers.”

This does seem to be the case, but as a matter of fact, I would have been shocked if the effect of the globalization of the post-Bretton Woods period had not led to greater inequality. But that doesn’t entail a critique of globalization per se, nor excessively low marginal tax rates, but the way in which the international trading system has been manipulated. Let me explain.

Ever since Bretton Woods, we have had a system of ostensibly floating exchange rates. Ostensibly — because exporting countries have been resorting to various hooks and crooks to maintain their exchange rates at artificially low levels, thus to manipulate and subvert that float. The dollar being the reserve currency of choice, and the US being the export market of choice (referred to tongue-in-cheek as “the consumer of last resort”), the manipulation is conducted against the dollar, keeping the exporting country’s exchange rate low vis-à-vis the dollar, allowing the exporting country to sell its production to America at ongoing low-wage-maintaining levels. The result is that production capacity shifts towards the low-wage countries, because the exchange rate is not allowed to adjust upward like it should. So the low-wage countries remain low-wage. Meanwhile, production capacity shifts away from the US, leaving only service-economy jobs there, which likewise generally command lower wages than manufacturing jobs. So in both the exporting countries and the consuming countries, the tendency is to depress working-class wages. On the other hand, the profits from the exchange continue to flow, into the hands of exporting country elites and multinational corporation managements, along with (of course) investors in those enterprises. This works to expand the income gap and thus income inequality. No surprise, really.

So the solution to this problem is not to abolish globalization per se, nor to increase marginal tax rates. Rather, it is to get the countries involved to stop manipulating the global system in favor of various special interests and elites, be they domestic or foreign. After all, the working class in the exporting countries suffers just as much from this situation as does the working class in the importing countries. Both are having their wages depressed.

Again, from the interview: “Matthew Yglesias: I thought one of the most interesting graphics in the book is the one where you show the price-to-book ratio in Germany is quite a bit lower than in the other countries. Is there an important lesson the rest of the world can learn there? Thomas Piketty: Yeah. Actually, to me this was quite striking. Previously I didn’t take seriously this idea that there were different ways of organizing capitalism and the property of capitalistic firms. I think the lesson from this graph is that the market value of a corporation and its social value can be two different things. Of course you don’t want the market value to be zero, but the example of the German corporation shows that even though their market value is not huge, in the end they produce some of the best cars in the world. They export a lot, and they are very successful. I think getting workers involved on the board of German corporations maybe reduces the market value for shareholders, but in the end, it forces workers and unions to be a lot more responsible for the future of the company.” I don’t want to speculate as to the reasons why German companies have relatively low valuations, but I will point out that Germany is at the exporters’ end of the export-import imbalance, only this time the import partners are southern Europe. How did the southern European countries run up so much debt? Mainly by paying for imports from, in the main, Germany. Germany’s model parallels Japan’s and China’s, only it functions mainly within the European sphere, with the help of the euro. In essence, Germany’s currency is structurally undervalued, while Spain’s, Italy’s, Greece’s, is overvalued. That’s how Germany can display such favorable economic data. But as Michael Pettis has shown, Germany’s workers are structurally underpaid because of it. The surplus goes to Euro elites.

There is much more to this story than merely the level of marginal tax rates. As long as the causes of inequality are misconstrued, the solutions on offer will always have be more akin to political footballs than actual fixes. Piketty claims that his “point is not to increase taxation of wealth. It’s actually to reduce taxation of wealth for most people, but to increase it for those who already have a lot of wealth.” Which of course appeals to most of us, because most of us don’t have “a lot of wealth.” But this “fix,” like many others past, present, and future, will get nowhere unless based upon a proper evaluation of the causes of the problem it purports to address.

Quantitative Easing and Substitutionary Atonement

In attempting to explain to my wife why investing in the stock market right now is not such a good idea, I came up with a little graph, which at one glance reveals the matter succinctly. Here it is:

It shows that the stock market growth of recent years has less to do with fundamental economic growth, which has been anemic, than with the action of the Federal Reserve. The Dow Jones Industrial Average has been rising in close correlation with the growth of the Fed’s balance sheet. The Fed’s program of “quantitative easing” has been nothing less than a boon for the stock market.

What we have here is the Fed’s version of “blessing.” It is blessing the stock market by assuming the “curse” – debts – of big banks, and exchanging them for deposits, which those banks can then turn around and lend. That money appears to be going into speculation, not productive activity. And voila! We have a stock market boom. Such a blessing cannot endure, despite what prognosticators may say.

The fresh funds provided by the Fed in exchange for this debt are no “godsend.” They only add to already existing funds on the money market seeking for returns in a return-starved economy. And so they only serve to feed asset bubbles. Which is why they are being funneled into speculation on the stock market, yielding the direct correlation to be seen in the graph between the Dow on the one hand and the Fed’s balance sheet on the other. This gives an appearance of prosperity, but in fact is only turning the stock market into a casino.

That’s not all. This “blessing” of stock market growth is balanced by the Fed’s assuming the curse of debt burden. Hence the Fed is functioning as mediator, the absolver of debt. But this Christ-like function is only an appearance. For the Fed cannot wipe the slate clean, cannot atone for these debts, cannot defray them. It can only assume them. They continue their existence, and will eventually have to be sold back onto the market, draining it of liquidity and precipitating a downturn (or even a crash), or be held until maturity or default.

In the end, the bonds, consisting mainly of treasury paper and mortgage-backed securities, will have to be either repaid or defaulted on. For the time being at least, treasury paper can be counted on, but the mortgage-backed securities are another story. If they are defaulted on, they blow a hole in the holder’s balance sheet: all of a sudden, liabilities are left without corresponding assets.

If this were to happen to the Fed, the shortfall would still have to be made up, for contrary to popular opinion, the Fed cannot “print” money directly, but only issue it against market-valued assets. There are always assets on its balance sheet to offset the liability of note issue. And so, a reduction on the asset side of its balance sheet would have to be compensated by a reduction on the liability side, either by reducing member bank deposits or eliminating notes issued. How that exactly would work, I have no idea, but the effect would be highly deflationary, as it would collapse the money supply to the money market.

Quite obviously, the Fed’s program of quantitative easing cannot go on forever. Adding $1 trillion-plus a year to its balance sheet will eventually lead to its collapse. So it is trying to backtrack. But every hint of “tapering” leads to market disruption — which is not the desired outcome.

Summing up, we can conclude that the Fed’s little adventure in substitutionary atonement only points up the artificiality of man’s efforts to bequeath himself blessings. In the economy, as in life, atonement is not attained by shifting debts and passing on burdens. It is attained by paying up. For redemption to function, one needs someone with the requisite amount of legal tender ready and willing to make a final settlement of “all debts public and private.” In the temporal as in the spiritual economy, there are no free lunches.

Is There a PIIG in Germany’s Parlor?

“It is a truth universally acknowledged that a single country in possession of a current account surplus must be in need of an export market.” With apologies to Jane Austen, of course: the sentiment thus expressed actually is anything but universally acknowledged. In fact, it flies in the face of received wisdom. We are accustomed to thinking of countries running current account surpluses as generating these surpluses by dint of superior industry, frugality, in short, superior economic character.

Take Germany. It has been running current account surpluses ranging from 2% to 7½% of GDP since 2001. The popular view is that such surpluses result from thrift or productivity. Let’s assume that’s the case. Given floating exchange rates, the current account surplus should result in an appreciating exchange rate, so that the surplus would result in more expensive exports and cheaper imports. This would then bring the current account back into equilibrium with trading partners; trade “imbalances” would automatically adjust.

But that hasn’t happened with Germany. The current account surpluses have been persistent, and persistently high. That absence of an equilibrating effect is due to the fact that the German currency does not float. Rather, it is linked to the other currencies of the European Monetary System who share a common currency, the euro.

Once upon a time there was a mechanism to bring about equilibrium, even between countries that shared a common currency. This was the “automatic mechanism,” the gold standard of the late 19th century. That mechanism (as I explain in my book Follow the Money) brought about an equilibrium through gold flows. In the country experiencing a current account surplus, gold would flow inward; and in the country experiencing a deficit, gold would flow outward. Thanks to the banking system, this in turn led to expansion in the surplus country, contraction in the deficit country. The boom country, experiencing a rise in prices, would thus import more and export less, while the depressed country, where prices were falling, would begin exporting over importing. And so the two economies would come back into some sort of equilibrium.

Nowadays, of course, there is no gold-standard automatic mechanism: there are no gold flows to do the equilibrating. So Germany’s current account remains in surplus, and its trading partners, chiefly the countries of southern Europe which likewise share the euro, remain in deficit. These countries are collectively known as the PIIGS, an acronym for Portugal, Ireland, Italy, Greece, and Spain. (Of course, Ireland is not in Southern Europe, but functionally it belongs in this group.)

The deficits being run by the PIIGS form the reverse image to Germany’s surpluses, as the following graphs indicate. Each graph shows Germany’s current account balance (surplus or deficit as percentage of GDP) together with each of the PIIGS (source: tradingeconomics.com):

Take another look at those graphs: prior to 2001 and the introduction of the euro, it was Germany that was running current account deficits! The PIIGS, for their part, ran surpluses or modest deficits. The change came about with the introduction of the euro. The euro was set at exchange rates that favored Germany’s economy and disfavored those of the PIIGS. Essentially, Germany was set too low while the PIIGS were set too high.

So then, thrift or economic virtue might explain Germany’s initial current account surplus, but it is the euro that has kept the system from coming into equilibrium, thus perpetuating those surpluses. The euro also has essentially bankrupted the PIIGS, who paid for their deficits by going into massive debt.

Persistent current account surpluses are not a sign of thrift but of dysfunctional exchange rates, not allowed to perform their equilibrating function. That, of course, is nothing new. But it needs to be recognized.

Fact and Fiction on Reserve Requirements

In the system we have now, we do use both a reserve restriction and an asset restriction. But, the modern reserve restriction has changed fundamentally, and has nothing to do with the monetarist understanding of reserve restrictions, except in a purely formal sense.

In the day of specie convertibility, reserve restriction had a definite functionality. It served to limit the amount of money subsitutes put into circulation, because by law and custom all such money substitutes had to be convertible into specie on demand. Therefore, the reserve restriction had to do with specie – at the end of the day, banks had to have a certain percentage of specie holdings – reserves – or they would either be shut down or fail. So there were two kinds of money, and reserve restriction had to do with maintaining some ratio between them.

Central banks arose only in response to this specie convertibility arrangement. Bagehot’s Lombard Street describes the process. Banks began depositing their reserves with other banks, big banks, on Wall Street or, in England, at the Bank of England. The latter bank only hesitatingly and with trepidation accepted the responsibility this entailed. For this developing practice led to a gigantic inverted pyramid of money substitutes. Those banks continued to issue money subsitutes against their reserves; but the Bank of England turned around and used these reserves to engage in similar monetary expansion, so that at the end of the day the total amount of specie left to cover all those money substitutes became rather minuscule. This was the problem Bagehot blew the whistle on.

This arrangement of centralized specie reserves only served to facilitate control of the money supply by private bankers. On the face of it, it served the economy by providing the means to generate an elastic money supply far beyond the actual amount of specie available. In practice, it led to dizzying booms and horrendous busts, depending on how specie holdings were manipulated. It also led to the social question, socialism, communism, and the modern labor movement. But that’s another story.

Within that context, one can easily see the rationale of reserve restrictions. They helped keep the generation of money substitutes within some reasonable distance of the original specie of which they were supposed to be the direct representation.

Nowadays, we have no specie convertibility requirement, so reserve restrictions have nothing to do with there being real money on the one hand, and money substitutes on the other. All attempts by monetarists to establish Federal Reserve generated money as in some sense “real” money, in terms of which regular banks issue money “substitutes” like in the old days, are only attempts to maintain the fiction of continuity between this system and that one, and to maintain a centralized control of the money supply like in the days of specie of convertibility. But events have shown that the money supply in the modern banking and monetary system cannot be manipulated like it was in the days of specie convertibility. For this we should be very thankful. In formal terms, the money multiplier is still in effect, but in practice it only serves to set some ultimate limit to lending, a limit that is never reached.

We still have reserve requirements today, and they are useful, but for an entirely different reason than in the days of specie convertibility. In fact, using the same word for today’s reserves and for the reserve banking model of yore, of which our Federal Reserve system is an obsolete example, is an exercise in equivocity. Reserves today have a totally different function than reserves then.

This is because there is no money substitute that has to be kept within some sort of relation to “real” money. The money generated by the banking system is all the same, from the central bank to the bank across the street. Rather, what reserve requirements do is keep banks from running into liquidity problems in making the regular payments to customers and other banks that they need to do to stay in business. A reserve serves as a buffer to absorb losses in the case of loan defaults. With bad loans, a bank is left without payments budgeted to come in, income that was budgeted to cover payments, payments that still have to be made. So reserves help to cover such shortfalls. But the center of gravity in the new system is precisely asset valuation, in order to minimize the negative effects of such defaults. If the collateral base accurately approaches the value of the loan, then a default is not a disaster, for the underlying security is still valuable, and can still be used to cover costs. In the case of the credit crisis, a whole mass of similar assets (foreclosed homes) came on the market at the same time, precipitating a collapse in market value of those assets and thus the book value of securities (mark to market).

In this world, a central bank no longer has any function as a reserve bank. The banking system as a whole can serve as a reserve bank, the one for the other. There is absolutely no need for traditional reserve banking with its money multiplier; the system runs on an entirely different principle. The Federal Reserve could go back to being the government’s banker, which is what public banks usually were before the notion of central banking ever got off the ground. The history of the Bank of England provides the foremost example. Both the first and second Banks of the United States were called into being simply to facilitate the fiscal needs of the federal government. The nascent central banking functionality exercised by Biddle had nothing to do with any “lender of last resort” and any money multiplier function. It was only an attempt to keep banks from overstepping specie reserve requirements – to keep them honest. And they didn’t like it, and got Andrew Jackson to do their dirty work for them. Andrew Jackson was not the champion of the people against the banks, but of the banking interest against Nathan Biddle! But that,too, is another story.

Private Issue of Money — the Root of Our Monetary Problem?

In a comment posted under an article by my friend Jerry Bowyer (Where’s the Hyperinflation?), “ps61penn62prin64” writes that “private currency monetary systems… are doomed to fail the interest of American citizens.”

Bowyer’s article discusses the sizeable increase in the money supply generated by the Fed, and how this has — or has not — affected the inflation rate. Bowyer concludes that although inflation has not manifested itself because of Fed action, it will. This is because the Fed has “an almost unlimited capacity to produce syrup [i.e., base money] and pump it at high pressure into the system. And they want to do so. They want more money in circulation, because their Keynesian models tell them that easy money is the answer to our economic stagnation.”

This view of our monetary system is based on the notion that we have a fractional-reserve system. Which we do, but only in the most formalistic sense. For all practical purposes, our system is not tied to some base money, manipulated by the Fed, allowing it to stretch and shrink the money supply at will. The Fed does not have this unlimited power — if it did, we’d have been toast (Weimar Germany, anyone?) long ago. If this were true, how do we explain our current struggle, which is a low-interest-rate, low-inflation environment?

But let’s now address the issue raised by ps61penn62prin64, as to whether the private issue of currency is the problem.

Right up front, I will state that the state-sanctioned private issue of money, such as is provided for by the Federal Reserve system, by no means need be a problem. Indeed, it is simply a function of “the common law right to borrow” (as Hammond pointed out in his Pulitzer Prize-winning book, Banks and Politics in America, published in 1957). In such a system, banks take a position front and center, as “experts in futurity” to use John R. Commons’ pregnant phrase, converting property into liquidity. This is not banks loaning depositors’ state-issued money; this is banks loaning money of their own creation. It is not the Jimmy Stewart, but the James Steuart form of banking.

This being so, the banks are creating representations, symbols, of property holdings, and it is these symbols that form the money supply. These symbols, these representations, only reflect a deeper reality — the reality of the issuing agents’ (i.e., banks’) balance sheets.The problems we face are thus not problems of liquidity, but of solvency. Our problems are not that there is not enough liquidity, as in the days of the gold standard, nor that there is too much liquidity. Our problems revolve around solvency: that the assets on the books of banks (and this holds for the “shadow banking system” as well) do not match up with the liabilities.

When this happens, we have a freeze-up of credit, as banks only become concerned with restoring balance sheets rather than engaging in fresh lending. This is why we are dealing not with an inflation problem but rather with a disinflation problem.

Originally the Constitution authorized only Congress to create and manage money, in the form of coinage. Coinage is the preeminent form of state-created money. Coinage had always been the prerogative of the state. But with the shift toward a commodity-based money system during the 18th century, power over coinage and over money had been passing out of the hands of the state and into the hands of the bankers. The regime of coinage was already on its last legs at the time of the Constitution’s ratification. My forthcoming book will discuss this transformation in detail.

Hence, the Constitution was outdated already at the time of ratification. It did not address the issue of banks. Hammonds’ book details the debate surrounding this issue as it developed during the early Republic, as the pros and cons of banks’ private money were discussed. The principle was finally accepted in terms of fractional-reserve — banks were only creating money substitutes, and were under the obligation to provide real money — specie — whenever asked.

We labored under this system for a long time. But when we threw off the gold standard, we threw off fractional reserve banking. Our banking system is now asset-based, not reserve-based. It is a system of state-sanctioned, yet market-driven, money. There is nothing wrong with that, in principle. In practice, it can be problematic. The problems mainly come about because we don’t understand it, and act in terms of faulty understanding. Especially when governments get in on the action. Then the liquidity bias, fomented by our faulty understanding, gives government room for its misplaced Keynesianism. And we discover once again that the problem had nothing to do with liquidity, but rather with solvency.

And so we need to look at other things than the Fed’s production of “syrup” if we want to understand what is going on with inflation rates, interest rates, and thus the economic fundamentals that determine how are economic lives are to be lived.

We need to go from Jimmy Stewart to James Steuart.

Why We Do NOT Have a Fractional-Reserve System

This blog entry is for anyone who believes, as John Tamny here puts it, that “Fractional reserve banking quite simple IS.”

Among the many good points Tamny makes in his article, there is the underlying assumption that our system is, in some important sense, a fractional-reserve system. But is this a valid contention?

My contention is that it is misleading to view our system as a fractional-reserve system, that a truly fractional-reserve system functions in a very different way than ours does, and that the focus on reserves obfuscates the true nature of money. If our system is fractional-reserve, then why don’t we have any panics and deflationary contractions the way we did in the 19th century, the heyday of fractional-reserve banking?

The way it worked then was that there was a specie convertibility requirement. Specie – gold or silver – had to be held by banks for them to issue money substitutes, either notes or deposits. The reserve ratio – required by law – was set at 1:3 or 1:5, although in practice banks would often exceed this ratio. What would happen is that there would be drains of specie, for various reasons, out of the banks, to the big banks in New York, or oftentimes out of the country as well. In the case of the Panic of 1837, it was the government that unwittingly set off the panic. The government began requiring specie payments for land purchases in the western territories, leading to demand for specie that outstripped supply, thus drains of specie, runs on banks by depositors afraid that their particular bank would not be able to maintain specie levels, resultant bank failures, business failures, unemployment, etc.

This is quite definitely a problem of liquidity shortage. The banks’ books balanced, assets matched liabilities; the only problem was the specie requirement, a setup that, in James Steuart’s words, was only demanded by custom, as only specie was considered to be real money – Keynes’ “barbarous relic.” It was finally dispensed with, for all practical purposes, during the 1930s.

Fast forward to today. When does anyone talk of reserve requirements the way they did in the 19th century? When does anyone worry that banks don’t have enough reserves, therefore they ought to pull their savings or cash deposits out of the bank, precipitating a bank run? We don’t have “runs on the bank” any more. Why? Why is the Fed’s discount window — the ultimate source of liquidity in need — hardly ever resorted to?

The problem we have today regarding bank reserves is of an entirely different order. When we worry about a bank’s reserves, we worry about whether it can deal with a balance-sheet problem: assets that have lost their value, as for instance collateral being marked to market. We have solvency problems today, not liquidity problems. There is plenty of liquidity. The problem is, where the assets aren’t available to exchange for liquidity, the provision of liquidity becomes problematic. The solvency problem then becomes a liquidity problem. Interbank lending rates go through the roof. And commercial/business lending, the heart and soul of economic growth, grinds to a halt.

The protagonist of Fed fiat money as base money would say that this base money forms the reserve, is established by law as reserve against which reserve requirements must be met. So that, if the Fed wished, it could precipitate similar deflationary contractions simply by selling off part or all of its holdings, thereby reducing deposits and/or bank notes in circulation, precipitating a reduction in the money supply by the amount dictated by the money multiplier. This doesn’t happen, our protagonist would say, because of political pressure. But it could, theoretically. Let’s suppose that it did. Does anyone think that the banking system really would participate in reducing the money supply to that degree? Not only would it miss out on the profits involved in lending, such a measure would precipitate a depression. It is my view that as soon as banks realized what the Fed was doing, they would stand up to this obvious insanity and refuse to comply with the legal reserve requirement. What would then happen? I don’t think the government could force compliance across the board, perhaps at one bank or a few banks, but not all the banks. Because the reserve requirement is an entirely artificial arrangement and has nothing to do with actual practice, the way it did in the day of specie convertibility. In those days, it was customers, not the government, that enforced compliance. In our day, the banks would simply refuse compliance, not to customers, but to the government.

For this reason, it is permissible to speak of the modern banking system as a fractional-reserve system only in the most formalistic way. Actual practice makes fractional reserve a non-issue. Reserve requirements do not have the importance that they had in the days of specie convertibility. We have made the transformation that James Steuart foreshadowed, when he pointed out that bank money was not money because an extension of specie – a fortiori of “base money” – but because a representation of the assets put up for security. This “Copernican Revolution” has yet to be adequately acknowledged. Theorists like Hyman Minsky work within its framework. They don’t talk of fractional-reserve requirements, they talk about asset bubbles as problematic because leading to balance-sheet mismatches.

Why do we maintain the fiction of the centrality of fractional-reserve? Because the system we now have grew out of a true fractional-reserve system. We removed the base money component, and the Fed has endeavored to maintain the illusion that its money somehow is as important as specie used to be. But Fed action does not produce automatic changes in the money supply the way gold inflows and outflows did in days of yore. Fed action can only indirectly induce changes in the money supply by influencing interest rates, and thus making lending more or less attractive. In our system, the liquidity problem has receded; it is solvency (balance-sheet) problems that we have to worry about.

To make my point crystal clear: our system may be labelled fractional-reserve in the same way that England may be labelled a monarchy. In terms of law, England is a monarchy. But if the queen ever attempted to exercise the power of a monarch, the monarchy would be peremptorily abolished. In the same way, in terms of law we have a fractional-reserve system. But if the Fed ever attempted to exercise the power inherent in such a system, such as absolute reductions of the money supply by virtue of the money multiplier mechanism, it would be peremptorily abolished as well.

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