Tuesday, March 14, 2017

Good as Gold, V: Debt Money Replaces Asset Money

Last Thursday we closed the previous posting in this series by noting how Henry VIII Tudor’s debasement of the English and Irish coinage did not affect as many people in the same way it would have had the two countries been more dependent on a cash economy.  It was bad, of course, but the fact that most trade and even daily transactions were carried out by means of direct barter and contracts well into the nineteenth century limited the evil.
Issuing a charter to the Bank of England.
Toward the end of the eighteenth century, however, governments discovered they could manipulate the value of a currency by issuing debt-money (government contracts representing a vague promise to pay out of future taxes, or “debt backed by debt”) in place of asset-money (private sector contracts representing a obligation to deliver a specific amount or value of goods and services, or “debt backed by assets”).  It was then that economic growth and financial wellbeing of ordinary people became subject to the whims of the powerful, whether in the private sector (capitalism) or the public sector (socialism).  Added to the growing concentration of capital ownership in fewer and fewer hands as a result of the shift to the cash economy and concentrated control over the means of acquiring and possessing capital, manipulation of the monetary and tax systems was a disaster for ordinary people.
It all began innocently enough, or so it seemed.  When the “merchant adventurers” who organized and founded the Bank of England requested a charter for this new type of bank, they did not intend for the institution to become a money machine for the State or really have anything to do with government at all, other than to operate within the law . . . which meant it required a charter.
The idea was that they would establish a bank for banks, spreading out risk and ensuring that member banks would always be able to get adequate “accommodation,” meaning they would always be able to obtain adequate credit and access to reserves to meet sudden obligations.  To do that they put £1.2 million in gold and silver to pool the reserves of the individual member banks and capitalize the venture.
And that was their first mistake.
William III, Short of Cash
The government (as always) was short of cash.  The merchant adventurers were short of a charter.  It seemed the most natural thing in the world for the government to demand what amounted to a bribe in the form of a “loan” of £1.2 million, to be replaced with “government stock” (i.e., debt), secured by the government’s ability to collect taxes in the future and repay the loan (which it never actually got around to doing).
At one stroke the Bank of England changed from being an institution designed and intended purely for private enterprise, and became the single largest creditor of the British government.  It was, however, a creditor with a difference: it was only allowed to be owed money because the government — the debtor — recognized the debt . . . which it could repudiate at any time.
Fortunately, the British government kept the reins on spending, not getting too far beyond what it could collect in taxes.  Additional debt consisted primarily of government bonds sold for cash, i.e., existing pools of savings.  With the Bank of England being the chief financial agent for the government, and still attempting to fulfill its primary role of stabilizing the money and credit system and providing adequate liquidity for the private sector, the government could not simply issue more debt for the Bank to buy when it needed cash.  The bulk of the Bank’s business remained acting as a clearinghouse, discounting and rediscounting private sector financial paper, and issuing notes backed by private sector paper when more circulating media were required for business and commerce.
Total War requires a great deal of cash.
Then came the French Revolution and the Napoleonic Wars.  This was not the limited type of warfare to which Europe had become accustomed, with relatively small private armies using military action as an extension of politics (or its failure, depending on how you look at it).  This was something new, the concept of total war, the complete mobilization of a nation’s resources to carry out conquest or defend against it.  A great deal of Napoleon’s success in battle was due to the fact that he was one of the first world leaders to understand the concept while his first opponents did not, and thereby created momentum and a myth of invincibility.
The Man of Destiny also created something else: the need for government to spend vastly beyond its means to prosecute a war.  Historically, it has rarely been possible for a government to tax people more than 20% of GDP, although it has been possible to go up to as much as 25% in emergencies.  Total war, however, requires a much greater proportion of GDP, although how much more can be wrested from the economy without the economy imploding is a matter for a much more in-depth analysis than is possible on a blog — even this one!
The Man of Destiny — Napoleon Bonaparte
The question for a government involved in the total spending that accompanies total war is, How do you increase taxes beyond the level that is ordinarily — or extraordinarily — collectible?
The answer?  By backing the currency with government debt instead of private sector assets . . . a technique that can only be done if a government has access to the central bank as a buyer of its debt instruments.  The “hidden tax” of inflation can vastly increase the ability of a government to tax and shift wealth from the private sector to the State — and it’s a tax (loan, really) that the government can levy without the consent of the governed and doesn’t have to repay, because it’s in the form of value lost to the issuer of the debauched currency: the government.
A government can, in this way, tax more than GDP, because the inflated currency bids up the prices of everything in the economy, not just current production.  To correct Proudhon’s glib aphorism, property isn’t theft, inflation is theft — and the government is the thief.
And yet “Modern Monetary Theory” (MMT), based on the theories of Georg Friedrich Knapp and John Maynard Keynes, assume as a given that backing the entire money supply with government debt — a 100% tax on everything in the economy — is the only right way to regulate a currency.
And that creates a few problems as well. . . .

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