My unpublished (100,000 word) book “The Financial Jigsaw”, is being serialised here weekly in 100 Issues by Peter J Underwood, author
We left last week, Issue 9: https://www.theburningplatform.com/2018/07/14/the-financial-jigsaw-issue-no-9/#comment-1644729 wondering what options the tenant farmer has in financing or funding his crops before they are ready to harvest and this may be a full 6 months in advance; we pick up the story from there.
MONEY
To those who use well what they are given, even more will be given, and they will have abundance. But from those who do nothing, even what little they have will be taken away.
Bible: New Living Translation – 2007- Matthew25:29
Financial markets and Gold as money
The tenant farmer has some options; he could go to the local corn exchange and ‘forward sell’ his crop to millers or flour merchants or he could agree to take a bank loan, a much more risky prospect, and pay interest on the loan at the going rate. There are several other ways today offering access to money which is needed to start and continue production in whatever form it takes because markets are now mostly electronic and interconnected worldwide.
Clearly the banks have every incentive to get involved in these markets by making their profits from interest and fees earned in facilitating the deals using the money (represented by gold) which merchants had deposited in their vaults. Until the 1930s gold was used as a standard reference for money issued as bank notes and credit by the banks; this was known as the ‘gold standard’.[1]
As the demand for credit to fund expanding trade increased it became clear that the growing economies were suffering from the limitations of the supply of gold which has a relatively fixed supply (some 2,500 tonnes are mined each year).
Although paper money in the form of bank notes was in common use, they ‘promise to pay the bearer’ a sum (which used to be in the form of gold), banks had to keep a ‘reserve’ of gold to support the amount of currency (bank notes) in circulation. This restricted the money supply (the amount of money in circulation at any one time) because the supply of gold was limited. Only the banks were permitted to issue new bank notes and this was tightly controlled by the government working in conjunction with the country’s central bank – the Bank of England – in the case of UK.
After World War 2 the major trading nations’ banks got together at Bretton Woods to agree on a flexible financial system which would accommodate the expanding economies around the world. America was and still is the major trading nation in the world, accounting for around 25% of the global economy and the US dollar (USD) became an accepted international standard to which every other currency in the world is referenced.
The USD had become the world’s reserve currency, supplanting the British pound, used in colonial days, because of the immense size of the US economy which no other nation could match. The USA agreed to back the USD with its vast gold reserves held in Fort Knox and to replace paper USD with gold at an agreed, fixed price when any nation asked for its trade to be settled in this way. This assumed that trading partners would have faith in the dollar and would not actually require settlement or exchange of their USD for gold. This became known as the “Bretton Woods” agreement of 1944.
The Bretton Woods agreement fails
Conflicts arose between countries during the 1960s as it became clear that a system referencing to the gold standard limited the expansion of trade between nations and culminated in 1971; the French particularly having asked the USA for their trade balances to be paid in gold.
There had been a steady drain of gold reserves from the USA over this period, so much so that President Nixon unilaterally repudiated the Bretton Woods agreement by refusing to pay in gold, and caused the USD to be valued by reference to all other currencies; this is known as fiat currency using floating exchange rates; the term derives from the Latin fiat: “let it be done”; “it shall be”) because it is backed with nothing more than the faith and credit of the United States of America and was declared legal currency by the government.
All currencies today are fiat currencies as nations around the world gradually adopted the American system driven by the USD as the world’s adopted reserve currency which is used in over 60% of all global financial transactions; especially in exchange for oil.
The use of the USD was compounded during the 1973 oil crisis when America agreed with Saudi Arabia that all their oil exports would be paid in USD in return for military and economic support. This required all nations to obtain and hold USD to pay for their oil and allowed America to act as the issuer of a common ‘world’ currency.
This has given America a significant advantage because they can issue bonds and bring into existence as many USD as they wish without risking devaluing their dollar against other currencies; up to a limit of course, that limit being the degree of confidence given the USD by all its users as long as not too many dollars are issued.
History of fiat currency
The concept of a fiat currency is not easy to describe. Perhaps it would help to review a short historical example and look briefly at the “History of Monetary and Credit Theory (From John Law to the Present Day),” written by the late French economist and Bank of France official Charles Rist (1938), here is an extract from what says:
“But let us tackle the essential argument, the argument in which [John] Law is a real forerunner, the crushing argument which, since his time, has been used by all the currency cranks and by all plundering states.”
“What is money but a simple exchange voucher conferring the right to a certain quantity of goods? And if that is its function, what is the point of using a costly metal? Here we reach the cardinal point of Law’s theory. Money is only a voucher for buying goods. It is a formula which has provided the starting point for all currency cranks, an apparently self-evident axiom on which have been based all systems which deny the citizen the right to a means of storing value.”
“Money is made only to purchase with. Money is not the durable and indestructible good, of stable value and unlimited acceptability, with the help of which man has been able to put by the product of his labour, the instrument for saving by means of which a bridge is built between the present and the future and without which all provisions for the future would become impossible. No!”
“But apart from that, [Law] misunderstood the real character of metallic money, and it is this that makes him so representative of all the currency cranks. He ignored the function of money as a means of storing value in a world where men are so anxious to preserve the product of their labour and their saving from price fluctuations and vicissitudes of all kinds.”
“It is that which ruined [Law’s] System. That metallic money is not an ideal instrument of circulation, and that it can be conveniently replaced in this respect by all sorts of circulating credits has been known from the earliest times. But nobody has yet shewn that circulating credits can replace the precious metals in their function as a store of value.”
“None of the monetary systems yet known to us, even the most advanced, has dispensed with the precious metals, that ultimate ratio of trade.”
….and the famous quote from John Law: “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.”
From Wikipedia: “John Law (1671 – 1729) was an economist who believed that money was only a means of exchange that did not constitute wealth in itself and that national wealth depended on trade. He was appointed Controller General of Finances of France under King Louis XV. In 1716 Law established the Banque Générale in France, a private bank, but three-quarters of the capital consisted of government bills and government-accepted notes, effectively making it the first central bank of the nation. He was responsible for the Mississippi Bubble and a chaotic economic collapse in France”.
John Law’s experiences with money
Law was a gambler and brilliant at mental arithmetic. He was known to win card games by calculating the odds in his head, not unlike high-powered bankers today and so well described in Michael Lewis’s book: Liar’s Poker.
Law originated economic ideas such as “The Scarcity Theory of Value” and the “Real bills doctrine“. Law’s views held that money creation will stimulate the economy, that paper money is preferable to metallic money (gold and silver) which should be banned, and that corporate shares are a superior form of money since they pay dividends.
Law exaggerated the wealth of Louisiana, USA with an effective marketing scheme, which led to wild speculation in the shares of the Mississippi Company he founded in 1719. The scheme was to have the success of the Mississippi Company combine investor fervor and the wealth of its Louisiana prospects into a sustainable joint-stock trading company.
The popularity of company shares were such that they sparked a need for more paper bank notes, and when shares generated profits the investors were paid out in paper bank notes. In 1720, the bank and the company were united and Law was appointed Controller General of Finances to attract more capital. Law’s pioneering note-issuing bank was successful until the French government was forced to admit that the number of paper notes being issued by the Banque Royale were not equal to the amount of metal coinage it held.
The “bubble” burst at the end of 1720, when opponents of the financier attempted en masse to convert their notes into gold and silver, forcing the bank to stop payment on its paper notes. By the end of 1720, Law was dismissed from his positions by Philippe d’Orléans, regent of France for Louis XV. Law then fled France for Venice.
I wonder if Bitcoin today is following a similar course of events.
To be continued next Saturday
[1] Wikipedia has a good overview of the gold standard: https://en.wikipedia.org/wiki/Gold_standard
