"The use of banks has been the best method yet practiced for the increase of money." John Law (1671-1729)
"The paper credit which, with such encomiums to themselves they boast to have set up, what effects has it produced, but only to lull the nation asleep, while the ready money that should even carry on our common business, has been exported." "�Can this imaginary wealth stand the shock of a sudden calamity?" Charles Davenant (1656-1714)
"When a State has arrived at the highest point of wealth�it will inevitably fall into poverty by the ordinary course of things. The too great abundance of money, which so long as it last forms the power of States, throws them back imperceptibly but naturally into poverty." From Richard Cantillon�s Essai (written between 1730 and 1734)
It is our basic premise that the U.S. monetary system (as well as global) is both fundamentally and severely flawed, and that an extremely unstable system again finds itself acutely vulnerable. Particularly here in the U.S., the preponderance of monetary expansion has come to revolve around asset price inflation. This is unsustainable, dysfunctional, and should today be recognized as a big problem. It is furthermore our strong contention that the very foundation of current economic prosperity is overwhelmingly monetary in nature. The boom has not been the consequence of new technologies, New Economies, New Eras or New Paradigms, and, as well, it is certainly not due to some miraculous increase in productivity. Instead, this has been primarily a historic financial bubble fueled by extreme money and credit inflation � or stated another way: absolutely reckless lending and speculative excess.
The boom has created little in the way of true economic wealth, but instead only the seduction of a massive inflation in perceived financial wealth; just mountains of financial claims. In fact, the source of this fateful boom is conspicuous in the data. Since 1995, broad money supply has increased a staggering $2.6 trillion, or 60%. Total credit market instruments have surged an astounding $9.3 trillion, or 54%, to $26.5 trillion. And, most unfortunately, since 1998, extraordinary excess has regressed into an absolute monetary fiasco, with broad money supply having jumped $1.5 trillion (27%) and credit market instrument $5.3 trillion (25%). Today, it is our strongly held view that we are falling head first into what should be appreciated as a very complex monetary crisis, the inevitable consequence of nurturing years of runaway credit bubble excess. It is, moreover, quite disconcerting to recognize how ill prepared we are as a country � citizens, businessmen, politicians, investors, central bankers and, particularly, the financial sector.
We have before compared the present cycle to John Law�s great Mississippi Bubble in France around 1720. Law, of course, introduced paper money and a �managed currency� system that fostered manic financial speculation and a spectacular bubble. This unsound boom abruptly gave way to an inevitable devastating financial and economic bust, discrediting John Law, his monetary theories and banks generally. This week, I am again highlighting monetary theory, hoping to shed further light on the gravity both for what has transpired and for what lies ahead. For valuable insights into Law�s system and monetary theory in general, one of our favorite sources is Dr. Douglas Vickers� Studies in the Theory of Money 1690-1776, first published in 1959. We will use a few quotes and analysis that are particularly pertinent today: note that a key aspect of Law�s failed system was a monetary authority with responsibility for regulating money supply.
"The central theoretical argument behind (John) Laws� banking proposals was concerned with the regulation of the supply of bank money to the demand for it in such a way that the desired and physically potential volume of trade may be realized (�by this money the people may be employed�) and the value of the currency maintained." Douglas Vickers, The Theory of Money
"This paper money will not fall in value as silver money has fallen or may fall�But the commission giving out what sums are demanded, and taking back what sums are offered to be returned; this paper money will keep its value, and there will always be as much money as there is occasion or imployment for, and no more." John Law
"This principle of the issue of notes and their return to the issuing authority dependent on the needs of trade was to recur in the later history of banking theory. The fallacy now, as later, lay in the failure to recognize that the reflux of notes gave the issuing authority power to contract its outstanding issue, but did not in any way compel it to do so. The assumption upon which the contrary proposition is based is that businessmen�s demands for currency for trade purposes could be regarded as independent of the actions of the monetary authorities. It was on precisely the fact that interdependent relationships within the monetary system did exist, however, that the purely theoretical adequacy of Law�s proposal foundered." Douglas Vickers, The Theory of Money
This is a key paragraph from Dr. Vickers. Importantly, John Law�s Mississippi Bubble was destined to fail as it lacked appreciation for "interdependent relationships within the monetary system" - or monetary processes. Law admitted as much after the spectacular collapse in 1720: "There are good reasons to think that the nature of money is not yet rightly understood." For too long the Fed has acted to peg short-term interest-rates and ensure "adequate liquidity in the marketplace" - basically nurturing leveraged speculation - without regard for the monetary processes set in motion that have come to structurally impair the U.S. financial system and economy through a massive inflation in money and credit.
From the current feeble understanding (and lack of interest) in the nature of monetary processes, it is clear that there has been a most unfortunate disregard for history; that many harsh lessons have been forgotten over the past 280 years. We don�t know if the current monetary boom is, like Law�s scheme, a big monetary experiment gone terribly awry, or if it has simply been a case of a reckless and wildcat financial sector combined with ineptness and negligence from the Greenspan Federal Reserve. Either way, there are clear and quite disconcerting parallels between these two booms. I will try to highlight some of the key monetary aspects that I believe clearly illuminate the serious flaws and vulnerabilities in the current monetary system.
"In the first place, the essence of Law�s scheme was his proposal for the monetization of certain existing assets�in the second place, Law�s proposal to base the issue of notes on the security of the value of land begs the essential question of the stability of value of the land itself. Quite apart from changes in real asset values dependent upon growth or variation in their intrinsic income-producing potential, the money value of the assets could change as did the availability of the notes of issue themselves. The theoretical possibility existed of an unlimited expansion of the note issue, pari passu with an induced and cumulative upward movement in the money values of the assets eligible as security." Douglas Vickers, The Theory of Money ...Article Continued