by David Orrell
The problem, it seemed, was that while under the gold standard a coin or banknote might have a well-defined value corresponding to a physical quantity of gold, the same could not be said of a share in a company or a futures contract to buy a tulip bulb at the end of the growing season, because these represented bets on future prospects, which are inherently uncertain. One of the victims of the South Sea Bubble was Isaac Newton, who lost a large part of his fortune and concluded: “I can calculate the motions of heavenly bodies, but not the madness of people.” As discussed in chapter 5, his losses paled in comparison with those of the Paris-based Scotsman John Law—who in the space of a few years may have made (in the literal sense of created) and lost more money than anyone in history.
Lender of Last Resort
The Bank of England’s founding as a public–private merger may have been a shotgun marriage; but it worked, and endured, in large part because of the way in which it separated out responsibility for the dual heads–tails aspects of money. The state (heads) supplied the official government stamp that specified value. The private sector (tails) put up the store of precious metal that backed the currency. The balance between the need for stable money and sufficient supply was skillfully managed by the Bank. It recovered from the damage of the South Sea Bubble and gradually expanded its role by establishing a near monopoly (and in 1844 a full monopoly) in the issuance of notes and becoming a clearinghouse for settling transactions between other banks such as London & Westminster, Lloyds, and Barclays. By 1776, Adam Smith could write that paper money outnumbered the total coin in circulation and “the stability of the Bank of England is equal to that of the British government.”36 As the hub of the “fractional reserve” system (box 4.2), it also became what the financial journalist Walter Bagehot called the “lender of last resort,” responsible for bailing out smaller banks that became the victim of bank runs or South Sea–like crises.
Box 4.2
The Multiplier
One of the most mysterious arts of finance is how money is created in the first place. The basic idea, as traditionally described in most economics textbooks, is similar to the way in which the Bank of England was founded: a central bank buys a government bond (initially with gold, later by fiat). The government then pays this amount into the accounts of its creditors, and the new money enters the larger economy.
Under fractional reserve banking, however, these payments are just the first stage in a process. Suppose, for example, that one such payment from the government is for £1,000. The bank that receives the deposit has a new asset worth that amount. If the bank’s reserve requirement is 10 percent, that means it can lend out up to 90 percent of the deposit, so £900. Say that the £900 is lent to a customer, who in turn deposits the £900 into the account of a merchant. That bank can now lend out 90 percent of that amount, or £810, which again ends up in another account. The original deposit of £1,000 therefore creates a cascade of further deposits, and the total amount of money thus created is £1,000, plus £810, plus £729, and so on, which sums (in the limit) to £10,000. Of course, only the first £1,000 can be traced back to the central bank, so the other £9,000 has been created out of thin air (though loans are backed by things like property titles). The original deposit has therefore been “multiplied up” by a factor of 10.
The central bank can also destroy money by selling its government securities for cash and/or raising the interest it charges for loans. Either of these reduce the amount of cash held by private banks, and therefore the amount they in turn can loan out.
This, at least, is the conventional picture.* As discussed further in chapter 7, the system doesn’t work that way in practice—in fact, it is the other way around. In most countries reserve requirements have been diluted or eliminated—in Canada, for example, they were phased out in the 1990s—and private banks are effectively free to lend as much money as they want, with only indirect restrictions, such as the interbank lending rate that is controlled by the central bank.† Therefore the bulk of the money supply is really set not by the central bank but by private banks in response to demand for loans. “Fractional reserve” no longer seems quite the right name, since there are no set fractions or reserves. Alternative currencies, of course, need not rely on central banks at all.
However you name it, the system has obvious risks (such as the possibility of a bank run), but it also has advantages. For example, it makes deposits more valuable to banks, which means savings accounts can earn interest, and it allows money supply to scale easily to the demand for loans.
*According to Michael McLeay, Amar Radia, and Ryland Thomas, “The reality of how money is created today differs from the description found in some economics textbooks” (“Money Creation in the Modern Economy,” Quarterly Bulletin [Bank of England], no. 1, March 14, 2014, 1).
†The U.S. Federal Reserve does set some reserve requirements, one example being for checking accounts at depository institutions, but they can be funded using loans with nonreservable liabilities and play only a small role in the money creation process. See Ed Dolan, “Whatever Became of the Money Multiplier?,” September 23, 2013, EconBlog, www.economonitor.com/dolanecon/2013/09/23/whatever-became-of-the-money-multiplier.
Under the fractional reserve system, banks maintained only small reserves with the central bank. In theory, rational customers would assess this risk, and banks that did not maintain adequate reserves would go out of business. As Bagehot noted, however, trade was “largely carried on with borrowed money” and was backed by only a sense of trust and confidence that eluded rational analysis and that financial crises had repeatedly shown to be fragile: “No abstract argument, and no mathematical computation will teach it to us.”37 Bank runs were an inevitable feature of the system, and the only way to treat them was for the central bank to pump credit and liquidity into the system when it threatened to run dry by lending at high rates against collateral. (Another approach, used in 2014 by banks in China’s city of Yancheng following rumors they had run out of cash, was to display piles of notes in the window.)
This role of the central bank was not, as Bagehot pointed out, explicitly acknowledged either by the bank or by Parliament. And perhaps this was part of the reason it worked, for to officially accept the responsibility would have encouraged smaller banks to take risks (so-called moral hazard). Money is based on the fragile and uncertain relationship between number and value, which seems more comfortable in the shadows and doesn’t always respond well to attempts at transparency. Nonetheless, an implication of its position at the pinnacle of the monetary system was that the central bank, even if it was nominally a privately owned, independent institution, was no longer a normal company, but one that required considerable political oversight.
The power of the bank expanded with the world economy as the Industrial Revolution took hold. Money and industry grew in concert: the new steam engines of Andrew Boulton and James Watt powered trains and industrial plants, but also the screw presses at the Royal Mint, which cranked out shiny new copper pennies. By the end of the nineteenth century, the Bank of England was firmly ensconced as the go-to financier and backstop for the British Empire, as well as the unofficial guardian of the international gold standard, which had gradually won out over bimetallism to create a unified global currency.38 The model of a dominant central bank, acting as the central hub for an ecosystem of private and commercial banks, was also adopted in other wealthy countries. Each country maintained large gold reserves, which were thought to act as a kind of automatic stabilizer on the world economy. In theory at least, if one country had a trade deficit, gold would flow out of the country to pay for it; the money supply would decrease; prices would fall; there would be a curative spell of austerity and belt-tightening, making the country more competitive; and exports would improve, bringing the deficit back into balance. In practice, it was found that correlations between things like prices and exports were not so neat—but as always in economics, the story counted as much as the reality.
During this time of unprecedented rapid economic change, the gold standard provided a number of advantages, including predictable exchange rates, a degree of stability, and a brake on the tendency of governments to print money to pay off debt. Above all, it gave money a reassuring sense of credibility, by rooting it in gold, and endowed nations with pride in their currency. The economist Joseph Schumpeter described it as a “badge of honor and decency.”41 The system particularly benefited England, which as ruler of the largest empire in history could control much of the international money supply. As the nineteenth-century economist David Ricardo noted, “Neither a State nor a bank has had the unrestricted power of issuing paper money, without abusing that power; in all States, therefore, the issue of proper money ought to be under some check and control; and none seems so proper as that of subjecting the issuers of paper money to the obligation of paying their notes, either in gold coin or in bullion.”42 According to Baron Overstone, “Precious metals alone are money. Paper notes are money because they are representations of metallic money.”43 Of course, the Chinese were several centuries ahead of the English in discussing this issue, as when the medieval historian Ma Twan-lin argued that “paper should never be money (but) only employed as a representative sign of value existing in metals or produce. … When the government … wished to make a real money of paper, the original contrivance was perverted.”44
The sense of stability granted by the gold standard was captured by the Austrian writer Stefan Zweig in his autobiography The World of Yesterday (1942, translated into English in 1943), in which he wrote about how “the Austrian crown circulated in bright gold pieces, an assurance of its immutability. Everything had its norm, its definite measure and weight.”45 Despite these advantages, the maintenance of the gold standard was vulnerable to the trade disruptions that occurred at times of war. In Austria, the hyperinflation that occurred after World War I—and which Zweig said “struck the word ‘security’ from our vocabulary”—appears also to have marked the worldview of many Austrian economists, including Ludwig von Mises, who urged a return to the gold standard.46 The desire for an inflexible standard also lives on in the form of German ordoliberalism, a rule-based approach to economics emphasizing things like monetary stability, low inflation, and balanced budgets, which has influenced the European Union and the European Central Bank (as Greece discovered during the Grexit crisis).
While the gold standard helped protect the currency from the vagaries of politicians, linking the quantity of money to a finite commodity also meant that the money supply did not adjust appropriately to the size of the economy and left it vulnerable to changes in gold supply. After a large find or improvement in mining technology, the money supply might become too large, causing inflation. Alternatively, it might not keep up with the pace of economic growth, with the result that gold became too expensive, causing deflation and recession. As discussed in the chapter 5, those conditions, as experienced in France and America, led to the next financial revolution, whose implications are still unfolding today.
5
A Wonderful Machine
Real talers have the same existence that the imagined gods have. Has a real taler any existence except in the imagination, if only in the general or rather common imagination of man? Bring paper money into a country where this use of paper is unknown, and everyone will laugh at your subjective imagination.
KARL MARX, “THE DIFFERENCE BETWEEN THE DEMOCRITEAN AND EPICUREAN PHILOSOPHY OF NATURE”
The study of money, above all other fields in economics, is one in which complexity is used to disguise truth or to evade truth, not to reveal it. The process by which banks create money is so simple the mind is repelled. With something so important, a deeper mystery seems only decent.
JOHN KENNETH GALBRAITH, MONEY: WHENCE IT CAME, WHERE IT WENT
There never seems to be enough money to go round. This is especially a problem when the money is either made of precious metal, or is backed by it, as under the gold standard. One idea—which was proposed in eighteenth-century France by John Law, but later found more fertile soil in the United States—was to create a new currency whose value was maintained only by the support of the government. This chapter discusses the history and properties of fiat currencies and shows that money might not grow on trees, but it grows faster if it is printed on paper—and faster still if it is produced electronically.
When King Louis XIV of France (the Sun King) died in 1715, he left his country in an appalling financial condition. The country had enormous debts, both from funding his wars and from underwriting the costs of his extravagant lifestyle, including the construction of the palace of Versailles. The next in line for the throne, Louis XV, was only five. Control of the country therefore passed to the regent, the duc d’Orléans. Somewhat overwhelmed by too many financial problems on his already-full plate, he did what someone in a similar position would do today: he hired a consultant.
John Law came highly recommended by the regent’s brother-in-law, Duke Victor Amadeus of Savoy, to whom Law had pitched his ideas for financial reform. In a letter to the regent, Law outlined a similar proposal that would cure France’s financial problems in a single stroke: “I will devise a scheme that will astonish Europe by the alterations it will make in France’s favor, alterations more radical than those procured by the discovery of the Indies or the introduction of credit.”
Law’s personal history was complicated. He came from a well-off Scottish family—his father was a goldsmith—and was a trained mathematician with a great aptitude for mental calculation. In 1694, at the age of twenty-three, he killed another man in a duel in London. He was arrested and sentenced to death but somehow escaped to Holland. He took up with a married woman, had two children with her, and traveled around Europe supporting his family by gambling.
He then returned to Scotland and tried to convince the government to adopt a new monetary system inspired by what he had seen in the Bank of Amsterdam and the Bank of England, but with an improvement. Instead of issuing banknotes backed by loans of gold from private bankers, the government could issue notes backed by land—which Law argued was the ultimate source of all wealth. A banknote would therefore be like a mortgage against a piece of Scotland.
Law’s idea was turned down. Instead, Scotland united with England, and its financial system was folded into the purvey of the Bank of England. Worse for Law, this legal union meant he would be wanted for murder in his home country, and he again had to flee to Europe, which is how he ended up in France. (One imagines that very little of this was on his CV when he first approached the regent.)
In direct opposition to Locke and Newton, Law believed that money had little meaning other than as a kind of casino chip: “Money is not the value for which goods are exchanged but the value by which they are exchanged; the use of money is to buy goods, and silver, while money, is of no other use.” It made no sense for a country to use silver or gold as a currency, especially if it were not blessed with the mines to supply those metals. France’s problem, he told the regent, was that it did not have enough money. The solution, therefore, was to print some.
Like the Scottish government, the regent balked at the idea of reinventing the entire monetary system. However, he did allow Law to set up a small bank, so long as he funded it himself. The Banque générale, which
issued banknotes against coin deposits, was so successful that the notes actually traded at a small premium, since they were easier to handle than coins and could not be clipped or otherwise degraded. In 1718, the bank was nationalized, becoming the Banque royale. With the currency now backed by the power of throne, Law did a sleight of hand that outdid even the Bank of England: he delinked the banknotes from reserves of precious metals, turning the money into a fiat currency. No one seemed to mind, because the easing of the monetary drought meant that the French economy was suddenly coming alive.
At the same time, Law established the Mississippi Company. This was run along the same lines as its competitor the South Sea Company (which had not yet gone bust) but had exclusive trading rights over the enormous area of the Mississippi River basin, including its tobacco plantations and its rumored huge deposits of gold. Law’s “system,” as he called it, was truly coming together. The company’s share price soared as people used the freshly created banknotes to buy stock in the venture. The money supply doubled within a year, with much ending up in real estate; the resulting price increase meant that land that had earned 4 to 5 percent per year, according to the eighteenth-century French economist Nicolas Dutot, now yielded only 1.2 percent.1 Law, who by this point was the richest man in the world, invested in a number of grand chateaux and a couple of blocks of Paris. The duc d’Orléans had a city named after him (New Orleans).
Clearly on a roll, Law arranged for the company to buy the national debt and take over the collection of taxes. This expansion required more shares, and more banknotes to pay for them. Unfortunately, the massive increase in money supply was feeding into inflation, with food bills soaring. At the same time, Law’s opponents in the business community spread rumors that the Mississippi might be a gold-free zone. The system unraveled as quickly as it had come together, with the share price of the Mississippi Company dropping peak to trough by almost a factor of 20. In the panic to offload shares, fifteen people were crushed to death in the crowd outside the exchange, and a run on the bank meant that Law’s banknotes became effectively unusable. As Voltaire is supposed to have remarked: “Paper money has now been restored to its intrinsic value.”