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Thursday, May 27, 2010

Out of the Depths, Part II: Monsieur Law and His System

Despite what we might read in bad romance novels and, sometimes, worse history about the quantities of gold Guineas and silver Shillings flung about with abandon from carriages and across gaming tables, the coinage of Great Britain was grossly inadequate even for England at the end of the 17th and the beginning of the 18th centuries. That being the case, the other members of the United Kingdom were pretty much left to fend for themselves. It was fortunate that Scotland had a well-established and soundly organized commercial banking system in place that could respond to part of the demand for money and credit in a limited fashion. Economic activity would otherwise have become as difficult as it was in Ireland or the American colonies.

The Scottish System

The Scottish banking system was both ingenious and sound, deserving a much more extensive treatment than we can give it here. To understand what John Law did in France, however, we have to understand the background against which his knowledge of money and credit developed.

The Bank of England was established in 1694, and the Bank of Scotland the year after. These banks, however, were first intended only to provide commercial interests with banking facilities and offer discount accommodation for bills of exchange — changing private obligations of individual mercantile firms into generally accepted obligations of the commercial bank. This was a tremendous boost to economic growth — up to a point.

The problem was, while commercial bank discounting supplied the mercantile houses with liquidity, it did next to nothing to supply common circulating media for the general public. This was a serious deficiency that was to plague England until the "New Coinage" of 1816 finally put the currency of the United Kingdom on a sound basis. (James Mackay, A History of Modern English Coinage: Henry VII to Elizabeth II. New York: Longman, Inc., 1984, 129-133.)

The case was different in Scotland. The crown chartered two banks in Scotland. These were the Bank of Scotland in 1695, and the Royal Bank of Scotland in 1727. Unlike the Bank of England, however, these were not granted a monopoly or any other exclusive privilege. Consequently, a large number of private banks were also established. This forced the chartered royal banks to compete in the free market on the same terms as any other commercial bank.

There was another unique aspect of the Scots banking system. In an effort to garner as much banking business as possible, the Scots banks invented a new kind of loan, what is today called a "line of credit." Today this type of loan is quite common, but in the late 17th and early 18th century it was revolutionary. As Richard Hildreth described the innovation,
The Scotch Bankers, instead of confining themselves to the discount of mercantile paper, open what they call cash accounts; that is, upon the credit of a bond for repayment, signed by three responsible persons, they agree to advance money, for a certain time and to a certain amount, to the individual with whom the account is opened; but he is not obliged to draw out the money except at such times and to such amounts as he may think proper; interest begins only from the payment of his drafts; and he is at liberty to pay money into the bank, according to his own convenience, which payments cancel so much of his debt to the bank, and stop the interest upon it. (Richard Hildreth, The History of Banks. Boston: Hilliard, Gray & Company, 1837, 15-16.)
The Scottish system represented the highest development of "free banking," something widely misunderstood today. The concept and principles of free banking have been seriously eroded with the rejection of the real bills doctrine, and the reinterpretation of free banking as a form of deposit banking instead of issue banking (vide Vera C. Smith, The Rationale of Central Banking and the Free Banking Alternative. Indianapolis, Indiana: Liberty Fund, Inc., 1990). As Conant observed,
The Scotch system of banks of issue comes nearer to the ideal of successful free banking than that of any other country. Absolute freedom in note issues reigned for over one hundred years in Scotland, and during eighty years of that period general distrust of the banking system never occurred, small notes became the favorite medium of exchange among the people, and the deposits in the banks absorbed almost the entire savings of rich and poor and brought within the circle of active producing capital the entire accumulations of the country. Such defects as were disclosed in the early years of Scotch banking were corrected with experience, and the few departures which have taken place from sound principles have been such as to suggest no change in the established practice of the majority of Scotch banks, but, at the most, some official regulation which should hold all to the rules voluntarily adopted by the oldest banks and the soundest bankers. (Conant, op. cit., 142.)
John Law's Background

Coming from this financial environment in which competition and innovation were encouraged, it comes as no surprise that John Law was able to formulate his own revolutionary ideas about money and credit. He developed principles that, however poorly understood and badly implemented in practice, are fundamentally sound. At the start of his career, however, John Law probably had no thought of attempting a general reform of the world banking and currency system. In 1688, on the death of his father, he took himself to London to sport with the ladies (he was known as "Beau Law" amongst his set in Scotland) and "see the world."

John Law, however, was a Scotsman, and one who considered himself a gentleman. Reading Boswell's Life of Johnson, one is struck by the casual contempt or outright hostility that the English of that period had for the Scots, at least those Scots attempting to hold themselves out as equals of the English or English gentlemen. Possibly inspired in part by some need to demonstrate that he was at least as much of a gentleman as any Englishman, John Law managed to get himself involved in the gentlemanly pastime of dueling.

Law "killed his man" in a "Love Duel" in Bloomsbury Square, was arrested, and convicted. He fled the country to avoid sentence being carried out. He ended up in Holland where, presumably, the Dutch expertise in banks, loans and other financial matters gave him inspiration for his theories. A while back the Dutch had, after all, established one of the earliest banks that presaged the development of the concept of central banking, the Bank of Amsterdam (modeled on the Bank of Venice), and thus could be considered in the forefront of financial innovation.

The Bank of Amsterdam was not, of course, a bank of issue. It was, instead, a bank of deposit, but with an innovation. It took deposits of coin, and issued receipts against the deposited specie. Naturally, these receipts, called "bank money," soon circulated as a type of currency. This bank money was declared sole legal tender for the payment of all bills of exchange in excess of 600 Guilders. (Hildreth, op. cit., 9.) As Hildreth described the operation of the Bank of Amsterdam,
It received coin and bullion upon deposit on the following terms. When the coin or bullion was deposited, a certain sum of bank money was transferred to the account of the depositor, equivalent to the current value of the coin or the mint price of the bullion, with a small deduction varying according to circumstances. At the same time a receipt was issued to the depositor, entitling him or any bearer, to withdraw the coin or bullion from the bank, at any time within six months from the date of the receipt, first transferring to the bank, the same sum of bank money which had been granted to the depositor, and paying a commission for the keeping, . . . The profits of the bank were made by these commissions, and by the premium it obtained on the sale of coin, bullion, and bank money. It made no loans; and therein differed essentially from our modern banks. (Hildreth, op. cit., 9-10.)
One source claimed that John Law visited the American colonies soon after his departure from England, and there observed the land banks in operation under the various colonial governments. He is said to have witnessed their success, but did not stay around long enough to see the disastrous end result. (Angell, op. cit., 244.) Considering the difficulty of travel during the period, the relatively short time involved, the fact that other sources make no mention of Law's presumed American sojourn, as well as recognizing that a convicted murderer would have been extradited, the story is probably apocryphal, particularly as the source only related the story of John Law in order to discredit all paper money.

It is believed that after spending some time on the continent, John Law returned to Edinburgh around 1700. It was there that he published a pamphlet entitled, Proposals and Reasons for Constituting a Council of Trade. It is not, however, absolutely certain that he personally supervised publication. A few years later Law published his Money and Trade Considered. As we will see, this short work attracted a great deal of attention in the Scottish Parliament. Law's proposal for Scotland was to ameliorate the perennial shortage of current money by extending the land bank system to the economy as a whole.

Apparently Law didn't realize at the time that basing the currency on a limited asset — land — is just as constraining as using specie exclusively. He was making what Henry Dunning MacLeod identified as a fundamental error: that money either is or directly represents an existing commodity. MacLeod very carefully explains the subtlety of Law's error, which is the same as those whom Joseph Schumpeter termed "the bullionist school," and which are best represented today by the Austrian School of economics.

As MacLeod explained, Law's proposal, as it stood at this time, "was a violation of that fundamental principle we have obtained, — 'Where there is no debt there can be no currency'." (Henry Dunning MacLeod, The Theory and Practice of Banking. London: Longmans, Green, and Co., 1906, 253.) In more modern terms, money is not the commodity or anything else that backs the money. Money is a derivative of wealth, not wealth itself. What backs money is the present value of existing and future marketable goods and services, not the marketable goods and services. That is, money is backed by property in (ownership of) the present value of existing and future marketable goods and services, not the actual marketable goods and services.

This distinction may be too subtle for many people. It relies on grasping the difference in the accounting equation between net assets and owners' equity. This is where John Maynard Keynes got hung up. It is also, possibly, why he insisted that new capital formation could not be financed except by cutting consumption, accumulating savings, then investing. Keynes appears unconsciously to have leaped from "savings equals investment" (i.e., assets equal liabilities plus owners' equity), to "savings are investment"; that ownership or property in a thing is the same as the thing itself. (Vide Harold G. Moulton, Capital Expansion, Employment, and Economic Stability. Washington, DC: The Brookings Institution, 1940, 26.)

Returning to the error in Law's proposal, basing economic development and commercial activity exclusively on any commodity that is fixed in quantity (that is, accumulated savings) has serious consequences when there is an inadequate amount available — or too much. This was the case throughout Europe, but especially in Scotland and England. Wales and Ireland were generally ignored when it came to economic development at this period. As Conant remarked,
Ireland has had almost as varied an experience in banking as in the political fortunes of her people and her banking history has been affected more or less unfavorably by the agitated condition of the country. The policy of England towards Ireland was distinctly selfish during the seventeenth and eighteenth centuries. (Conant, op. cit., 171.)
Scotland's Monetary and Financial System

For all their financial and historical significance, Scottish paper money from the late 17th and early 18th centuries are, frankly, extremely ordinary in appearance, and are inadequately cataloged. Due to the very success of the system, notes are extraordinarily hard to come by, and specimens for study are rare. Many issues before 1780 are offered for sale so infrequently that they do not even have prices listed in hobby catalogues. In appearance, they all have a basic "certificate" look, making for an extremely dull impression all out of proportion to their actual importance.

Scotland's metallic currency is more interesting, at least in appearance. In the late 17th, early 18th centuries, Scottish current coin consisted of a perfunctory mintage of gold Pistoles and Half-pistoles (Five Dollars and 2-1/2 Dollars, respectively), and a somewhat larger coinage of shilling-denominated silver pieces: Five, 10, 20, 40 and 60 Shillings. There was a modest coinage of copper Bawbees (Six Pence) and Bodles (Two Pence, also called "Turners"), but, as the huge number of privately issued tokens indicates, the official coinage was inadequate to the task of providing sufficient small change. Because of close commercial ties with Northern Ireland, many Scots tokens circulated there, and many tokens produced in Northern Ireland were in the Two Pence denomination, which passed as Turners. (Peter Seaby, Seaby's Standard Catalogue, Part 3: Coins and Tokens of Ireland. London, B. A. Seaby, Ltd., 1970, 140.)

At this time, the Scots 60 Shillings was the equivalent of the French Ecu of Six Livres, which was valued, according to James Simon's 1749 Essay on Irish Coins (which has several charts giving the value of foreign coin in Ireland in both English and Irish currency) at 54 Pence, or 4s 6d. This is a little less than the Five Shillings given as the equivalent in Seaby's Catalogue, Coins of Scotland, Ireland and the Islands. The Scots 40 Shillings was the equivalent of the French Four Livres, while the 10 and 20 Shillings matched the One and Two Livres, respectively. The Scots 60 Shillings was also the equivalent of the 60 Schilling of the German-Danish Duchy of Schleswig-Holstein and other middle European states, which was itself the equivalent of the old Reichsspeziesthaler ("Imperial Silver Dollar"). This had the advantage of fitting the Scottish system conveniently into the prevalent systems on the continent.

The paucity of gold and especially silver coinage, as well as the basic inadequacies of backing the paper currency exclusively with land put a severe crimp in economic development that was not assuaged with the establishment of the Bank of England. Although intended as a means of supplying commerce and industry with adequate supplies of money and credit, the Bank of England, in common with most central banks the world over, soon became a means of financing government deficits, letting the commercial world fend for itself or at the behest or sufferance of the State.

Deflation and Inflation

Due to the scarcity of money, economic development was still hampered in England even after the founding of the Bank of England, an institution designed specifically to solve the problem. This precluded any immediate extension of the system to Scotland, even after the 1707 Act of Union. The bank was hijacked to political purposes by becoming the chief financial agent of the government and issuing enormous loans to the State. It was never a case of financial interests or "international bankers" sabotaging the world's money supply and controlling the world by taking over the government's financial system, but of government taking over control of the financial system for its own purposes. (Vide Henry C. Adams, Public Debts: An Essay in the Science of Finance. New York: D. Appleton and Company, 1898, 22-23.)

Ironically, the severe deflation of the day followed the chronic inflation that resulted from the influx of gold and silver from the mines in the New World. John Law was prescient enough to see that artificially limiting money and credit was a recipe for economic stagnation and decline. He published his theories in Money And Trade Considered With A Proposal For Supplying The Nation With Money (Edinburgh: Andrew Anderson, 1705). This treatise represented a limited version of the concept he later applied in France, albeit with the flaw we noted previously associated with backing money with a marketable good or service, especially one in limited quantity, instead of the present value of existing and future marketable goods and services.

Law's argument took into account the well-known conservatism of financial interests, and made the case for basing the currency exclusively on land. It was, admittedly, far easier for people to understand land as a productive asset than manufactories and trade. Whatever its merit, however, the Scottish parliament did not adopt Law's proposal. As Mackay related,
In a short time afterwards he published a project for establishing what he called a Land-Bank (The wits of the day called it a sand-bank, which would wreck the vessel of the state), the notes issued by which were never to exceed the value of the entire lands of the state, upon ordinary interest, or were to be equal in value to the land, with the right to enter into possession at a certain time. The project excited a good deal of discussion in the Scottish Parliament, and a motion for the establishment of such a bank was brought forward by a neutral party, called the Squadrone, whom Law had interested in his favour. The Parliament ultimately passed a resolution to the effect, that, to establish any kind of paper credit, so as to force it to pass [i.e., have legal tender status], was an improper expedient for the nation. (Charles Mackay, op. cit., 4.)
While rejected by the parliament and frequently excoriated, if not ridiculed by later economists and historians, the basic plan could not have been more sound. In light of the demonstrated inadequacy of metallic currency, Law proposed to form a bank of issue, with the notes backed by the value of the State's landed property. This would have extended the existing system of land banks, which monetized private land holdings, to the nation as a whole.

Law's proposal is almost identical to the "Rentenmark" plan implemented by Dr. Hjalmar Schacht that saved Germany in the 1920s. Schacht's plan brought a halt to the hyperinflation. Similar to the way the French Regent was to seize control of Law's "system," Schacht's plan was itself endangered when certain interests in Germany tried to manipulate the system through speculation before Schacht, unlike Law, was able to reassert control. (Vide Hjalmar Horace Greeley Schacht, Confessions of "The Old Wizard." Boston: Moughton Mifflin Company, 1956, 162-164, 198; John Weitz, Hitler's Banker: Hjalmar Horace Greeley Schacht. New York: Little, Brown and Company, 1997, 66-68, 70-71, 84-85.)

Failing both in his land bank project and to obtain a pardon for the murder, Law either remained on the continent or quickly removed there. For about fifteen years he roamed about Europe, apparently supporting himself by gambling. His considerable dexterity in mathematics played no small part in his success as a gamester. He was expelled from various world capitals as a bad influence on youth. While there is no record that he was ever anything but straight in his play, his gambling success apparently gave the worst sort of example to idle highborn lads with money in their pockets.

In France in 1708, John Law was about to be thrown out of Paris when he made friends with the Duc d'Orléans, a powerful and influential nobleman. This prevented Law's immediate deportation, but, when his banking scheme was proposed to Louis XIV, that monarch asked if the projector was Catholic. Receiving an answer in the negative, the Sun King refused to have anything to do with a "Huguenot," a somewhat reactionary if ultimately wise decision, given the enormous influence of the Duc d'Orléans and the way he managed in the end to seize control of the project. Almost immediately d'Argenson, then chief of police, had Law expelled from France as a suspicious character, possibly more to curry favor with the king than because he truly believed Law to be shady.

A few years later Law found himself in Italy and proposed the scheme to the Duke of Savoy. He was again refused, but the Duke encouraged him to try France again. That country should be wide-open for such a plan, with the recent death of the old king, the nation groaning under a large burden of debt, and the new, seven-year-old king under the charge of a regent — the Duc d'Orléans.