Restoring Say's Law
In an economy in which human labor is the predominant means of production, ownership of land or capital vests the possessor with a great deal of power — but not as much as might otherwise be presumed. In a labor-centric economy, land or capital is essentially worthless without the addition of labor, as Adam Smith pointed out in his "invisible hand" argument. Nevertheless, access to capital — technology — is necessary as well, or even the greatest labor expended on land will have little effect.
This is because the effect of technology (capital) is to replace labor, not supplement or enhance it; technology is a substitute for labor, not an addition to labor. As technology advances, labor becomes relatively less valuable as a factor of production. It becomes essential, then, that people who formerly relied on labor alone to generate an adequate and secure income must replace the income capacity of labor with capital and land.
Land, however, is (as we have seen) limited. That leaves only capital as a replacement for the income generating capacity of labor — and democratic access to a financial system that can turn the present value of existing and future marketable goods and services into "money" so that exchanges can be made.
Therein lay the real failure — or, at least, partial success — of the Homestead Act. The Emancipation Proclamation of 1863 and the 13th Amendment made all labor nominally free, while the Homestead Act made some land available without having to accumulate savings. Obtaining the technology necessary to make the land and labor effective, however, still required most people to cut consumption, save, then invest before purchasing capital. There was also no effective means whereby the Homesteaders could tie into the marketing and distribution of their crops, or gain an ownership stake in the industrial and commercial frontier to complement their ownership of land and labor. Under this arrangement of the economy and the financial system, Say's Law could only be partially restored — and then only as long as there was "free" land.
An Economy Divided
The rising "capitalist" class, of course, generally had no problem persuading a bank to discount its notes to finance the new factories and, especially, the railroads. The farmer and the small artisan, however, generally could only obtain credit by mortgaging what he or she already owned — hence the "first principle" of finance being the ability to distinguish between a bill of exchange based on the present value of existing and future marketable goods and services to be produced, and a mortgage based on the present value of an owned asset. (Benjamin M. Anderson, Economics and the Public Welfare: A Financial and Economic History of the United States, 1914-1946. Indianapolis, Indiana: Liberty Fund, Inc., 1980, 233.)
Lack of democratic access to land and capital as well as labor exaggerated a conflict that had always existed, but which gained force as society was now beginning to be sharply divided into three classes. These were, one, the growing number of propertyless workers: the proletariat. These were dependent wholly on selling their labor to gain an income. As a general rule, the only credit available to members of this class was and remains consumer credit. Consumer credit, along with government expenditures is usurious, "usury" being the taking of a profit when no profit has been generated. The nature of consumer and government credit is that the proceeds of a loan are not expended on something that pays for itself.
Two, there was the class of small owners, consisting of farmers, small ranchers, artisans, and shopkeepers. This class depended on profits from ownership, frequently supplemented with temporary or part-time wage system employment, to gain an income. Before the Industrial Revolution, these small owners had, in large measure, been the backbone of the economy. As technology advanced, however, and non-landed capital became increasingly and, finally, prohibitively expensive, the small owner was faced with three choices: 1) Not take advantage of the new technology and become non-competitive. 2) Gain access to technology only on extremely unfavorable terms, e.g., access to rail freight that cost the small owner much more per mile than the large owner. 3) Surrender ownership and become a member of the proletariat. In general, the only credit available to members of this class was consumer credit or mortgage-backed debt.
Three, there was the rising capitalist class, consisting of large ranchers, industrialists, and commercial interests, which last included freighting and shipping. While there might be some token wages or salaries paid to members of this class — American industrial folklore abounds in stories of extremely wealthy capitalists who were paid a "salary" of $1.00 per year — the vast bulk of the income received by this class consisted of profits of ownership: "interest" in classical economics. (In the classical analytical framework, "wages" go to labor, "rent" goes to the landowner, and "interest" goes to the owner of capital, thereby matching outputs to the three classic inputs of labor, land, and capital.)
As long as the credit of a member of the capitalist class was "good," he or she usually had the capacity to draw bills of exchange on the present value of existing and future marketable goods and services. He or she could then either use the bill as money directly, discounting and rediscounting with other businesses, or discount the paper at a commercial bank in exchange for banknotes or demand deposits. It was in this manner that the great industrial and commercial expansion of the latter half of the 19th century was financed. Members of this class rarely used consumer credit as anything more than a convenience (often a necessity for the proletariat), while a mortgage loan (usually the only type of credit available to the small owner) was frequently viewed as an admission that someone's credit was either deteriorating or already gone.
The Birth of a Nation
It was thus becoming critical that the financial system be restructured, both to open up democratic access to capital credit that did not rely on existing accumulations of savings, and to ensure that the money supply be both sound and adequate for the needs of agriculture, industry, and commerce. Neither was done.
Instead, the United States and Great Britain — arguably the two greatest industrial and commercial powers of the latter half of the 19th century — took a wrong path. Based on an incorrect understanding of money, credit, banking, and finance, concentrated ownership of the means of production became perceived as the only way in which society could advance economically.
Basing the whole of the money supply on existing savings meant that "money" itself had to be redefined. Bills of exchange could not be recognized as money because many of them were based on the present value of future marketable goods and services. That is, because the marketable goods and services did not yet exist, the bill was based on the general "creditworthiness" of the drawer of the bill, not the drawer's existing accumulation of money savings.
Due in large measure to the British Bank Charter Act of 1844 and the United States National Bank Act of 1863, however, government monetary and fiscal policy, as well as large sectors of the financial system were implemented or employed in a way that ignored the bulk of the money supply. Officially (and incorrectly), "money" was limited to meaning accumulated savings in currency form — even though, as Harold Moulton demonstrated in The Formation of Capital, money savings played a relatively small role in the economy, and almost no role in the financing of new capital formation.
Nevertheless, the redefinition of money (and thus credit) embedded the false notion that the "supply of loanable funds" (existing accumulations of savings) and the "production possibilities curve" (capital that could be financed out of existing savings without cutting consumption too much) imposed limits on economic growth — and who was permitted to participate in that growth. Basing economic growth on cutting consumption, accumulating money savings, and investing necessarily meant that there had to be a relatively small class of persons (and the smaller, the better) able to save without deprivation. As capital became increasingly expensive, so the rationale goes, so the rich presumably had to become ever-richer in order to finance the new capital.
All of this, of course, was based on the wrong definition of money that came out of the Currency School. By redefining money, Say's Law and the real bills doctrine had to be discarded, for they rely on "money" being anything that can be used in settlement of a debt, and limit the role of the State with respect to money to setting the standard of the currency and regulating it to ensure that it remains sound.
Not only were there serious economic and financial consequences to the redefinition of money, however, the political system changed for the worse — although, confusingly, retaining the outward forms. This was, in fact, the theme of Walter Bagehot's The English Constitution (1867) and Lombard Street (1873), who divided the system in England into the "efficient" and the "dignified" forms, depending on whether he considered them practicable or just for show.
In the history of finance, Lombard Street qualifies as a brilliant examination of a system of banking and finance that assumes concentrated ownership of the means of production, oppression, exclusion, and the degradation of individual human dignity and personal sovereignty as a given. It is a classic of economic injustice, and the antithesis of the Homestead Act and Abraham Lincoln's vision of democracy as being a government "of the people, by the people, and for the people." Paradoxically, Lombard Street is lauded as a pillar of laissez faire capitalism, considered by its proponents to be the system that best embodies "freedom."
Lombard Street describes the operation of a financial system based on exclusionary barriers to participation, State control of the money supply, mercantilism, a permanent outstanding State "floating debt," and economic subjugation of colonies to the mother country, among a great number of other systemic violations of essential human dignity and personal sovereignty. Bagehot's book is, in short, a literary pillar and financial justification of the British Empire under the absolute rule of the House of Commons.
Not surprisingly, Lombard Street is an application of Bagehot's theories of sovereignty described in The English Constitution. In this, we can draw an analogy: The English Constitution is to Lombard Street, as Adam Smith's The Theory of Moral Sentiments (1759) is to The Wealth of Nations (1776). Both men applied their philosophical orientation more or less consistently in books that attempt to describe the way economic society works.
What Smith might consider an unfortunate but inevitable working of economic laws (actually a distortion of economic laws), however, Bagehot, and Keynes after him, regarded as the proper ordering of society. Like Keynes, Bagehot rejected the idea of democracy, while calling his system democratic. As Bagehot explained in The English Constitution — in which there is a single reference to Magna Carta, and that dismissive of basic human rights (Walter Bagehot, The English Constitution. Portland, Oregon: Sussex Academic Press, 1997, 154),
It is often said that men are ruled by their imaginations; but it would be truer to say they are governed by the weakness of their imaginations. The nature of a constitution, the action of an assembly, the play of parties, the unseen formation of a guiding opinion, are complex facts, difficult to know and easy to mistake. But the action of a single will, the fiat of a single mind, are easy ideas: anybody can make them out, and no one can ever forget them. When you put before the mass of mankind the question, "Will you be governed by a king, or will you be governed by a constitution? the inquiry comes out thus — "Will you be governed in a way you understand, or will you be governed in a way you do not understand?" (Ibid., 21)
In other words, most people are simply too stupid and incompetent to be able to govern themselves. They need a political and financial elite, endowed as such by a Creator, to make decisions and run things for them. There is enough anti-American sentiment expressed in The English Constitution to justify the impression that Bagehot loathed the United States and everything for which it stood.
It is hardly a matter for comment that, in light of his orientation, Bagehot made approving noises regarding the political theories of Thomas Hobbes, (ibid., 120) the totalitarian political philosopher. Bagehot ignored completely both John Locke and Algernon Sidney, two thinkers somewhat more in tune with human nature, and thus having a great deal more respect for human dignity. Locke and Sidney, along with Charles-Louis de Secondat, baron de La Brède et de Montesquieu, were significant influences on the American Founding Fathers and framers of the U.S. constitution.
Montesquieu (1689-1755) was a French social and political commentator who wrote The Spirit of Laws, which was used by the American Founding Fathers as a virtual textbook on government. Montesquieu was a strong advocate of separation of powers, a concept explicitly rejected by Bagehot, who ridiculed the idea of checks and balances: "Hobbes told us long ago, and everybody now understands, that there must be a supreme authority, a conclusive power, in every State on every point somewhere." (Ibid.)
Bagehot then went on to attack the U.S. Constitution, indeed, the entire American political system, at one point calling one of its important institutions a "farce." (Ibid., 15) This makes it all the more surprising that many of today's political scientists and economists view Bagehot in a very favorable light, (Bruce Ackerman, "Obama, Warren and The Imperial Presidency," The Wall Street Journal, 09/22/10, A21) even though Bagehot rejected sovereignty of the people against an absolute monarch or totalitarian State, and thought the divided sovereignties between the states and the federal government, and checks and balances to secure oversight and accountability, ludicrous concepts.
The Political Theory of Capitalism
A reading of The English Constitution — a virtual necessity if one is to understand Lombard Street — gives a very clear exposition of Bagehot's position. A relatively small elite — the "Upper Ten Thousand" as they were called — were in control of the country, and (according to Bagehot) properly so. Bagehot carefully distinguished leadership in "society" (meaning parties, balls, race meets, and so on) from leadership in government and the economy. The Queen (a "retired widow") and the Prince of Wales ("an unemployed youth") are the leaders of society and play an important role in providing the lower classes with the easily understood fallacy that the monarch rules the country. Bagehot called this the "dignified" aspect of the English Constitution, a social convention to pacify the unintelligent masses.
The real power resided in the House of Commons, the House of Lords being another "dignified" aspect of the Constitution of the country. The House of Commons is "efficient" as opposed to "dignified," and, so far as the traditional structures of government allowed, ran the country essentially as a business corporation. The propertied classes were (in a sense) the shareholders of the national corporation. Common unpropertied people, as well as aristocrats whose wealth and power were in decline as agriculture diminished in relative importance, were to some extent supernumeraries, redundant employees and pensioners of the national corporate State.
The House of Commons, elected by a relatively small number of voters, was, essentially, the board of directors of the country, "a class . . . trained to thought, full of money, and yet trained to business." (The English Constitution, op. cit., 66.) In other words, the governing body of the Empire was a carbon copy of the owners and upper management of the East India Company, a private enterprise that governed India for the Crown until 1858, eight years before Bagehot wrote The English Constitution.
Do not assume, due to his assertion that ultimate power resided in the House of Commons, that Bagehot supported popular sovereignty. It must clearly be understood that the electorate at the time he wrote, 1867, was extremely small, and composed exclusively of men of property, a financial elite which thereby secured a self-perpetuating political power — the "pocket (or "rotten") borough" system. This was only right, for Bagehot believed that the masses are too stupid to be able to vote or do anything other than take orders:
• "We have in a great community like England crowds of people scarcely more civilized than the majority of two thousand years ago; we have others, even more numerous, such as the best people were a thousand years since. The lower orders, the middle orders, are still, when tried by what is the standard of the educated 'ten thousand', narrow-minded, unintelligent, incurious." (Ibid., 6)As Bagehot declared, "The principle of popular government is that the supreme power, the determining efficacy in matters political, resides in the people — not necessarily or commonly in the whole people, in the numerical majority, but in a chosen people, a picked and selected people." (Ibid., 17) [Emphasis in original.] Not surprisingly, one of the "defects" Bagehot listed in the American system is the impossibility of a dictatorship in times of national emergency. (Ibid., 20) Another problem is that Americans do not accept the opinions of their betters without question: "They have not a public opinion finished and chastened as that of the English has been finished and chastened." (Ibid., 13.)
• "We have whole classes unable to comprehend the idea of a constitution." (Ibid., 23)
• "A free nation rarely can be — and the English nation is not — quick of apprehension." (Ibid., 74)
Natural rights, the judiciary, — such things are ignored. They are unimportant because they are not "efficient," that is, they do not increase the effectiveness of government, the purpose of which is to protect the interests of the propertied classes who run the country. Weaknesses appear in government to the extent that the State administration departs from the principles of business, e.g., lack of efficient structure, redundancy, etc. The fact that these structures were at least initially intended to provide accountability to the citizens is irrelevant. The capitalist of Bagehot's day was not accountable to his workforce or his customers, so the government should not be accountable to the citizens it governed.
Bagehot simply didn't understand that the State is not a business corporation owned by a small capitalist elite. While principles of sound business (as opposed to the diseased structures that have grown up to support and protect capitalism and socialism) can be applied in government to great advantage, ultimately there comes a parting of the ways. A business corporation exists to make a profit and benefit the individual workers, shareholders, and customers, while a government exists to keep order and care for the common good; it is not an enterprise to be run for individual benefit or profit.
The Economic Theory of Capitalism
Bagehot's theories of sovereignty may have been derived from his economics and finance, detailed in Lombard Street: A Description of the Money Market. Bagehot asserted that he would have nothing much, if anything, to say about the Bank Charter Act of 1844 that congealed the tenets of the Currency School into British (and American) fiscal and monetary policy. The book assumed reliance on existing accumulations of savings as a given, indeed, the only possible arrangement of the financial system.
Banks of deposit are the only recognized financial institutions in Bagehot's framework. Consequently, economic power is as necessarily concentrated as political power. Although Bagehot is lauded as a champion of laissez faire economics, the system he described requires increasing levels of State interference to ensure the stability of that portion of the currency that is backed by government debt.
Further, Bagehot seemed unaware that allowing the State to "create" money to any degree or in any way, shape, or form was to ensure the intrusion of the State into virtually every area of life in order to try and force the system to work against its natural tendencies, and ultimately destroys the personal liberty of everyone, not just the unpropertied masses.
In the end, Bagehot's work did not break new ground. Instead, it provided a diagnosis of a system that was rapidly approaching non-sustainability. Bagehot's mistake was to assume that the system he described was not only acceptable, but somehow ideal.