Thursday, February 25, 2016

The Crisis That Need Not Be, I: A System Designed to Fail

Maybe it was the tagline that caught our attention: “Suddenly banks everywhere are in deep, deep trouble.”  (“The Return of Crisis,” Peak Prosperity Blog, February 8, 2016.)  After we finished laughing, we decided that the reason for our merriment might make a good blog posting.  It still does, even though it was from something we saw on the internet a couple of weeks ago.

Sealing the Bank of England Charter, 1694
It was the “suddenly” that got us.  There has been nothing “sudden” about the trouble banks are in.  It’s been building up since the establishment of the Bank of England as the world’s first true central bank in 1694.
The Bank of England was established to ensure that England’s mercantile banks (their term for “commercial banks”) always had “accommodation,” that is, could always get credit and always had sufficient reserves.  A central bank was only ever intended to be a “bank for banks.”
So how did central banks get into financing government?  In order to ensure that the Bank of England always had enough gold and silver reserves to lend to its member mercantile banks, all the member banks deposited £1.2 million in gold and silver, then applied for a charter so the Bank could legally operate as a corporation.
William III: "Yew may hev yo chawtaw for £1.2 million."
King William, however, needed cash.  Revolutions, no matter how Glorious, are expensive, and that £1.2 million in specie (gold and silver) was very tempting.  So the king and parliament cut a deal with the Bank of England: “loan” the government £1.2 million worth of gold and silver, and the government will pledge £1.2 million in “government stock” (interest bearing debt) as security for the loan.  In return, the Bank would get a 48-year charter.
In this way the Bank became the government’s banker instead of the banker for banks.  Government debt paper became as good as gold (and silver) because it had the government’s word behind it.  The whole faith and credit of the British government stood behind the debt paper that now served as reserves instead of gold and silver.
Of course, if something happened to the government, or the private sector couldn’t produce enough to support the tax base that supported government debt, then government debt paper was not quite as good as gold.  Thus, every time there was a political upheaval, or the possibility of a political upheaval, or people thought there might be the possibility of something happening, the public rushed to convert their banknotes backed with government debt into gold.
This, of course, caused gold reserves to plummet, convertibility would be suspended, and the paper money would depreciate in terms of gold, and the price level would rise.  The answer the economists came up with was to end convertibility into gold permanently, and back the entire money supply with government debt.
Knapp: The State Theory of Money
This is called “chartalism,” and was developed by Georg Friedrich Knapp in the 1880s as a way of shifting from capitalism to socialism without an armed revolt.  John Maynard Keynes adopted chartalism as the basis of his monetary theories, with the result that today economists and politicians have a hard time imagining that anything other than government debt can back a currency.
So what’s wrong with backing the money supply (or even just the currency) with government debt?  Doesn’t the government have the sole right as a sovereign entity to create money, and nobody else has it?
Well . . . no.  The government doesn’t actually have the right to create money, not even the United States government.  If we read Article I, § 8 of the Constitution carefully, we see that a certain key phrase is omitted from the enumerated powers: “emit bills of credit.”  A “bill of credit” is the special constitutional term meaning “create money.”
Now, that doesn’t mean that a government cannot restrict the manufacture of coin or other forms of currency to itself, or create a standard for the currency.  That’s different from creating money, and is a proper job for government.
In fact, government creation of money backed only by its own debt is (as most authorities agree) what started the modern business cycle of “boom and bust.”  This was the cause of the “Panic of 1825.”
"Vive l'ME!
Following the Napoleonic Wars and the breakup of the Spanish Empire, the governments of the new republics of Central and South America were a trifle short of cash.  Consequently they financed operations by floating massive quantities of debt, much of it of rather dubious quality.  Some was so dubious that the country issuing it didn’t even exist . . . .
By 1825, government debt had become the single largest type of security traded on the world’s exchanges.  When the governments of Central and South America started defaulting on their debt, a financial panic ensued.  This dried up credit for private sector productive use, and the global economy went from boom to bust.
When the private sector managed to get back into shape, governments (as usual) began spending more than they collected in taxes, creating more money backed by their own debt, and throwing a monkey wrench into the economy by increasing demand beyond current productive capacity.  This spurred a “boom” which collapsed when the government couldn’t make good on its promises or private sector producers couldn’t increase production fast enough to keep up with government spending, and the cycle started all over again.
J.M. Keynes: "Don't worry.  Just print and spend money."
Keynesian economics and its “counter-cyclical” approach didn’t solve this problem.  All it did was cover it up with a lot of spackle in the form of flooding the channels of commerce with more government debt.  Had productive capacity not managed to keep pace, largely by means of tremendous technological advances, the crash would have come decades ago.
It’s coming closer and closer now because, for all the productive potential of the world’s economies, fewer and fewer people are able to be productive.  If people can’t be productive, they can’t purchase what others produce: production equals income, per Say’s Law of Markets.  The fewer people who are producing and are thus able to sustain demand naturally without inflation or redistribution, the worse the ultimate crisis is going to be.
“The Return of Crisis”?  It never left.  The problem is what to do about it — something we’ll address on Monday.

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