Virtually the whole of economics today assumes that you can only forestall the otherwise inevitable cycle of economic boom or bust by following the prescription of whatever school of economics they happen to belong to. The fact that none of the prescriptions touted today has ever really worked doesn’t seem to matter. As is usual, if something isn’t working these days, it’s because of a hidden conspiracy, people aren’t trying hard enough, not enough (or too much) money is being spent, the dog ate it, or anything else that comes to hand.
As we saw in the previous posting on this subject, however, the problem with the modern science of economics is not that some people are nefariously sabotaging the economy or that people are too stupid to do what others want them to do, but that they have a bad understanding of money and credit, the social tool by means of which economic activity is carried out. As Charles Morrison pointed out in his book An Essay on the Relations Between Labour and Capital (1854), if people have “confidence” in money and credit (i.e., that people will make good on the promises they make via credit instruments), the economy runs smoothly. If not, then the economy goes into a tailspin.
We would add that the economy will work if everyone has access to money and credit, the financial system is sound (i.e., the money supply is uniform, elastic, stable, and asset-backed), and money and credit are correctly viewed not as a commodity, but as a social tool by means of which I exchange what I produce for what you produce. That — and only that — is the essence of money and credit.
|E.F. Schumacher, New Age guru
Unfortunately, as we have also seen, today’s mainstream schools of economics do not view money and credit correctly. The Keynesians attempt to use money as a political tool to socialize the economy (Keynes, General Theory, V.24.iii, if you don’t believe it; Keynes may have been a crypto-member of the Fabian Society. His protégé, E.F. Schumacher was a member of the Fabian “inner circle” and a New AGe guru — his book Small is Beautiful (1973) was originally peddled as "The New Age Guide to Economics"). The monetarists/Chicago believe the quantity of money should be matched to the level of economic activity but don’t say how (except that the government waves a magic wand and creates money in whatever amount the experts think will work). The Austrians are at least rational in their insistence that the currency must be asset-backed, but impractical in thinking that it should be gold, and that “stability” consists in having a fixed money supply that does not expand or contract with the needs of the economy.
All of these different views of money assume as a given that money and credit are a commodity, and that economic activity derives from the quantity of money in the economy. The exact opposite, however, is the case. Once we understand that money is a social tool by means of which we carry out transactions, it’s not a question of whether we have enough money to drive economic activity, but whether we have the economic activity essential to the creation of legitimate money!
How does this relate to the Panic of 1825? The Industrial Revolution brought about a situation in which a few owners of capital could produce far more than they could consume. Relative to the amount they consumed (and even more true today), the new capitalist class was effectively able to produce without consuming. At the same time, the French Revolution and the Napoleonic Wars created a situation that showed how governments could as a usual thing consume in massive quantities without taxation and — of course — without having produced anything. You therefore had production without consumption, and consumption without production, both on a cosmic scale.
These new conditions of hyper-production by non-consumers, and hyper-consumption by non-producers, set the stage for a financial panic. Mercantile banks as well as governments were creating money backed by things of no real value (government debt) or by things of questionable or “fictitious” value, that is, things with only speculative value (such as today’s Bitcoin, a purely speculative virtual commodity), or of nominal real value but a great deal of speculative value.
As a result, the financial markets became uneasy when the paper floated by Sir Gregor MacGregor to finance his fictitious government of the Republic of Poyais — the ultimate in what Henry Thornton, the “Father of Central Banking,” called “fictitious bills”! — were recognized as worthless. This called into question the value of the paper issued by actual Central and South American countries as well as other speculative paper in the financial market.
At the same time, some “country banks” (i.e., mercantile banks not located in the City of London, the financial district) had been monetizing extremely speculative financial paper in an effort to get in on the profits being generated by larger banks’ speculation in government debt and to be able to compete or face being slowly driven out of business by economies of scale. The situation led the Bank of England to engage alternately in “quantitative easing” and then restricting credit to put a damper on economic activity. This was a pattern that made no sense given the true role of a central bank, and could only lead to disaster — which it did.
In a more or less sudden “loss of confidence” following the overheated economic activity caused by the infusion of what amounts to counterfeit money into the economy, the London financial market went into a panic and some seventy banks failed. The ensuing “Panic of 1825” is considered the start of the modern cycle of “boom and bust,” and locked in an erroneous understanding of money and credit that probably drove bankers like Ebenezer Scrooge to distraction, as we will see in the next posting on this subject.