Thursday, September 22, 2011

Back to Our Story

Any of you who managed to work through the posting on the theory of pure credit yesterday deserve to be commended. And rewarded. So here is your reward: the reason for droning on and on (and on) about banks of issue, banks of deposit, past savings, future savings, forced savings, and everything else.

Following the suspension of convertibility of Bank of England banknotes into gold in 1797, the economists shifted into high gear. Based on the work of Adam Smith in The Wealth of Nations a quarter century before, bankers like Henry Thornton (no relation to William Thornton, as far as we know) and economists like Jean-Baptiste Say worked out the basic theory we just presented above. This was summarized in "Say's Law of Markets" and the "real bills doctrine."

Very briefly, Say's Law (he didn't develop it, just gave what is probably the clearest explanation of it . . . before we got to work, that is) is that we don't really purchase what others produce with this thing we call "money." No, money is just a symbol of what we produce with our labor and capital. Money is the "medium of exchange." By means of money, we can trade our surplus goods and services for the surplus goods and services others produce.

The real bills doctrine (again, briefly) is that, as long as the money we create by issuing bills of exchange and having them accepted does not exceed the present value of existing and future marketable goods and services in the economy, there will be no inflation. Together, Say's Law and the real bills doctrine sum up the essence of the "Banking Principle."

The trouble was that you also had the "Currency Principle." In contrast to the Banking Principle, the Currency Principle is simplicity itself. The idea is that "money" consists exclusively of coin and State-issued or authorized banknotes backed by gold or government debt. The only way to have money, and thus finance new capital ventures such as land acquisition by peasants, is to cut consumption and accumulate savings in the form of money.

Obviously, this means that the only people who can own future capital are, in general, those who already own present capital. Nobody else — especially people who were going through one of the most horrific famines in history and who couldn't possibly cut consumption — has the ability to save enough to purchase capital, particularly as technology advances and capital becomes increasingly expensive.

The common sense of the Banking Principle shows up the flaws in the Currency Principle immediately. That didn't matter, however, in early 19th century England and Ireland. The people who backed the Banking Principle had sound theory and practice on their side. The people who backed the Currency Principle had the self-interest of the already wealthy and the desire of politicians to spend money without raising taxes on theirs. It's obvious who won — and why. Here's the story in brief.

David Ricardo (1772-1823) set out to correct the theories of Adam Smith. The theory that we're interested in, of course, is the Banking Principle found in Book II of The Wealth of Nations. Smith adhered to the real bills doctrine, although he didn't call it that. The term wasn't current until Henry Thornton, a banker, wrote a book in 1802 with the ponderous title, An Enquiry into the Nature and Effects of the Paper Credit of Great Britain. Thornton, too, set out, in part, to correct a few mistakes he believed Smith had made.

Thornton, however, thought that Smith had a good grasp of the basic theory. As a practicing banker, though, Thornton realized that Smith had gotten some technical details wrong. Consequently, Thornton's corrections of Smith took up, at most, a couple of paragraphs in The Paper Credit of Great Britain.

Ricardo, on the other hand, decided that Smith didn't know what he was talking about in several critical areas. This was not just a matter of correcting a few technical details. Ricardo believed that Smith was 'way off base on basic theory.

On a number of theories, actually — the labor theory of value, the theory of rent, and so on. The theory that concerns us, however, was Ricardo's understanding of money and credit. Ricardo believed that it is impossible to finance new capital formation until and unless consumption is reduced and money savings accumulated. Further, "money" is not anything that can be used to settle a debt, as Smith believed, but coin and banknotes. (The fight within the Currency School over whether demand deposits are money would wait another century.)

The bottom line to this is that, where Smith maintained that the purpose of production is consumption, Ricardo had to include "and reinvestment to finance new capital" as an increasingly important purpose of production. This created a paradox that in the 1930s Dr. Harold G. Moulton of the Brookings Institution would call "the economic dilemma." That is, if new capital can only be financed by cutting consumption, no sane businessman will ever finance new capital because the demand will no longer exist to make the new capital financially feasible.

Resolving this paradox requires that we realize that we shouldn't rely on past savings for financing, but on pure credit future savings. Ricardo, however, couldn't make that leap because he was locked into a flawed definition of money.

Ricardo passed this flawed understanding of money on to John Ramsay Muculloch (1789-1864), a Scottish economist, author and editor whom William Thornton referenced approximately a dozen times in his Plea — and not in a very complimentary way, either.

This makes sense. Thornton was all in favor of widespread ownership of landed capital. Macculloch, as the inheritor of Ricardo's mantle (Macculloch was considered the head of the "Ricardian" school of classical economics), believed that concentrated ownership of capital, whether land or machinery, was essential. This was so the rich could afford to save and buy more capital in order to create jobs for the rest of us.

A proposal such as Thornton made would have sounded like rank socialism to Macculloch. Macculloch necessarily believed that the rich are a special breed to be nurtured and protected with privileges and benefits to ensure that they will be ready, willing and able to finance new capital to create jobs. Never mind the fact that Macculloch's theories also justified backing banknotes with debt-backed State-issued bills of credit and rejected private sector asset-backed bills of exchange as the backing for the currency.

Macculloch was thus able to tell the wealthy and political elite of early-19th century Great Britain exactly what they wanted to hear. Being rich and powerful was not only God's Will, but the way a sound economy and financial system had to run if the sun was never to set on the British Empire, predestined for all time to rule the world. The fact that, as Walter Bagehot maintained in mid-century in The English Constitution (1867), the real rulers of the Empire were members of the wealthy commercial class, not the Widow of Windsor or her unemployed son, simply corroborated this belief.

Consequently, Macculloch's views had enormous influence on the financial and political elite of the British Empire. This was of critical importance when the charter of the Bank of England came up for renewal in 1844. Lord Overstone, a banker in real life, was a fervent believer in Ricardo's — and thus Macculloch's — theories. It didn't help any that he inherited Macculloch's library.

Further, as the owner of an investment bank and not a commercial or mercantile establishment, Lord Overstone did not appreciate the difference between the kind of bank he ran, and the special function of commercial banks and the Bank of England, generally considered the first true central bank. Lord Overstone understood deposit banking, not issue banking, and was thus the worst person to frame the legislation for the British Bank Charter Act of 1844. Naturally he got the job. With the assistance of Sir Robert Peel, Lord Overstone got the Act passed, and locked the British Empire into unsound principles of money, credit, banking and finance that have persisted — and continued to spread — down to the present day.

Thus, it is no wonder that, even if the British government had been in any way inclined to adopt Thornton's proposal to build ownership of Ireland at least partly into the people of Ireland, it would have deemed the idea impossible. Trapped by bad ideas and assumptions, they would have tossed it aside without further consideration.

#30#

No comments: