From John Law to John Maynard Keynes
by Steve H. Hanke
The economic-financial crisis of 2008 has produced, if nothing else, grist for the financial press. Bernard Madoff's alleged $50 billion scam and the assertion that we need a mega-Keynesian stimulus package— the bigger, the better—represent two of today's favorite topics. In an attempt to make their reportage and opinions more interesting, the authors often attempt to link historical episodes to their Madoff and stimulus stories.
John Law and his Mississippi Company, which was established in 1717 and collapsed in 1720, are standard references that accompany Madoff's alleged Ponzi scheme. In fact, the only obvious connection between Law's Mississippi Company and Madoff's operations is that their values went up and then down. This fact fails to merit mention, however.
What merits attention is that Law was an economist of note and a precursor to John Maynard Keynes and Keynesian economics. Indeed, Law's Essay on a Land Bank (1704) and Money and Trade (1705) brought high praise from no less than Joseph Schumpeter, who wrote in A History of Economic Analysis: "John Law (1671-1729) I have always felt in a class by himself. He worked out the economics of his projects with a brilliance and, yes, profundity, which places him in the front ranks of monetary theorists of all time."
John Law's link to today's economic and financial turmoil is a Law-Keynes linkage. Like Keynes, Law thought the economy could be stimulated and that growth rates could be permanently elevated through active monetary, fiscal and exchange-rate policies. In short, both economists supported the idea of an active, interventionist government. That said, Keynes curiously avoids mentioning Law, when noting the antecedents to the ideas contained in The General Theory of Employment, Interest and Money (1936). Perhaps Keynes didn't want to be associated with Law's Mississippi System—a grand project which ended in failure.
The opportunity for Law to implement his ideas arose after Law learned that his good friend, the Duc d' Orleans, had become the Regent of France. In 1710, the Scotsman emigrated from London to Paris. France was in financial trouble. Among other things, it was in partial default on its bonds. In consequence, the Regent was susceptible to Law's proposals.
In June 1716, Law launched his first big project. It was then that the Banque Générale was established. It issued paper money which was not fully backed by specie (gold or silver). Instead, government bonds were used to back 50% of the paper money issued by the Banque Générale. This fractional reserve setup was approved by the Crown and the Banque's paper money was granted legal tender status.
This represented a breakthrough for Law because one of his ideas was to replace specie-based banking systems with credit based systems. Instead of counterbalancing banks' liabilities (paper money and deposits) with gold or silver assets, the liabilities in a credit-based system would be counterbalanced with loans. The accompanying table highlights the differences between these two systems.
Interestingly, the international monetary system today looks a great deal like the credit-based system envisioned by Law. Indeed, in 1971—300 years after John Law's birth—the international monetary system abandoned the last vestiges of the gold standard. John Law's next venture was the establishment of the Mississippi Company. It was granted monopoly rights for trade and development in France's Louisiana and Canadian territories. And through a series of takeovers and mergers, it became a giant holding company which controlled a vast empire of French trading companies. In addition, the Mississippi Company took over most of the financial functions of the Crown. These included the sole right to coin money, to collect all direct and indirect taxes and to manage the Crown's debt.
When it came to debt management, Law displayed his flair for innovation. The Mississippi Company was created, in part, to facilitate a debt-for-equity swap in which the Company's shares were issued in exchange for the Crown's debt. In consequence, the Crown was able to unload its entire stock of high-yielding debt. The British, not to be outdone by the French, followed Law's lead and allowed the South Sea Company to assume the bulk of the British government's debt.
With the prospect of spectacular returns, Paris became swollen with investors from all parts of Europe. And as the accompanying chart indicates, the price of the Mississippi Company's shares soared. So did Law's fortunes. Among other things, in December 1719, he was appointed Controller-General of Finances—a position that made him the virtual Prime Minister of France.
Richard Cantillon (1680/90?-1734)—a great economic theorist, financier and advocate of specie-backed money—succeeded in making two fortunes from Law's Mississippi System. The first was made on the rising market for Mississippi Company shares. Cantillon's second fortune was made on exchange-rate speculation. Cantillon spotted a fatal flaw in Law's strategy: the increase in the issue of banknotes unbacked by specie that were required to put a floor under the Mississippi shares at 9,000 livres per share. Accordingly, Cantillon concluded that the monetization of Mississippi shares would result in a surge in the money supply and a sharp fall in the value of the livre against the pound sterling. In consequence, Cantillon took a large speculative position against the French currency—an action that made him a fortune and caused Law to expel him from France.
This brings us back to the present and the Law-Keynes linkage. As ever-larger stimulus packages and intervention strategies are contemplated, it might be worth reflecting on the fate of John Law's Mississippi System.
(For a full treatment of the topics discussed, see: Antoin E. Murphy, Richard Cantillon: Entrepreneur and Economist. Oxford: Oxford University Press, 1986 and Antoin E. Murphy, John Law: Economic Theorist and Policy-Maker. Oxford: Oxford University Press, 1997.)
We Can't Spend Our Way out of This Quagmire
by Lawrence H. White and David C. Rose
The cause of the economic crisis was not the collapse of the secondary mortgage market, policies aimed at increasing home ownership or the rise of exotic financial instruments. These factors affected the nature of the crisis, but the ultimate cause was the bursting of a real estate bubble made possible by excessive money growth.
Abundant money and lower interest rates spur buying, pushing up prices. Since the supply of housing is relatively inflexible, housing prices rise quickly. Beginning in 2001, rising house prices and a rallying stock market increased homeowners' perceived net worth. People believed they didn't have to save as much for retirement or for their children's college education. And they could borrow more against their increased home equity, allowing them to buy more goods, services, stocks and real estate. Credit-fueled spending reinforced the rising prices of everything, but especially real estate and stocks.
But the increase in real estate prices and the increased spending it supported were a fantasy. The economy's ability to produce real goods and services is determined by the amount of plant and equipment, the number of workers, the supply of raw materials, and so on. We inevitably moved into a period of general inflation, so the Fed eventually had to reign in its easy money policy. Borrowing became more expensive, so people scaled back their spending or began selling assets to sustain it. Either response puts downward pressure on the prices of real estate and stocks, so prices that everyone counted on to rise forever began falling. The bear stampede was on.
In 2001, the Federal Reserve began expanding the money supply. Year-over-year growth rose briefly above 10 percent and remained above 8 percent into the second half of 2003. The effect on interest rates was immediate; the Fed funds rate that began 2001 at 6.25 percent ended that same year at 1.75 percent. It fell further in 2002 and 2003, reaching a record low of 1 percent in mid-2003. But if the Fed hadn't increased the money supply from 2002 to 2006, increased demand for credit resulting from deficit spending and the increased demand for real estate would have pushed up interest rates. This would have discouraged borrowing. Rising interest rates would have thwarted the process by which an increase in borrowing by the government and by the public artificially inflates asset prices, begetting even more borrowing.
Most economists, government officials and politicians continue to believe the standard Keynesian explanation for recessions: Recessions are caused by consumers and firms becoming "spooked" for no meaningful reason, so consumption and investment spending falls below normal levels. This reduces demand for goods and services, which reduces employment, which reduces spending even further, and so on. Since the level of spending before the "spooking" was presumed to be sustainable, the solution to the problem is simple: Increase spending to where it had been during the boom.
You can't solve an excessive spending problem by spending more. We are making the crisis worse.
In reality, excessive money growth drove asset prices up and drove interest rates down, making people feel richer than they really were and lowering the cost of borrowing money to facilitate more spending. Since the level of spending before the period of excessive money growth was just sustainable, the resulting level of consumption and business investment spending was unsustainable. The solution is to allow asset prices to fall to levels that accurately reflect what our economy can produce. This will make it clear to people that they are not as rich as they thought two years ago and thereby return spending to sustainable levels.
Still, virtually everyone agrees that we need to further stimulate the economy even though current attempts to solve our crisis by increasing spending is exactly the wrong thing to do. No one wants to bear the political cost for appearing to be uncaring by favoring a policy of "doing nothing." Out of political cowardice, the federal government is attempting to produce a solution that is penny-wise and pound foolish. You can't solve an excessive spending problem by spending more. We are making the crisis worse.
We have been down this road before. Most recessions start with the bursting of bubbles that grew large because of excessive money growth. But again and again, we presume a Keynesian cause and a Keynesian cure.
Our recent stock market and housing market crashes can prove to be the start of a sound and rapid recovery — if we will have the courage to let it be so.
Wednesday's Daily News
Andrew Roth
THE DAILY NEWS
Let's Stimulate Private Risk Taking - A. Alesina & L. Zingales, WSJ
Mr. President, Suspend Mark-to-Market - B. Wesbury & B. Stein, Forbes
Questions for Mr. Geithner - New York Times Symposium
Geithner and Our Incomprehensible Tax System - Steven Malanga, RCM
How to Save $40 Billion - Wall Street Journal Editorial
Online Watchdogs Dissect the Stimulus Bill - DC Examiner Editorial
The Economy Is Bad, but 1982 Was Worse - Mark Perry, Carpe Diem
Vouchers: The Smart Fiscal Choice - Marcus Winters, National Review
Sacrifices: Who Will Make Them for Us? - Union Leader Editorial
Twenty-Six File for Emanuel Seat - Reid Wilson, The Hill
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| 2009-2010 will rank with 1913-14, 1933-36, 1964-65 and 1981-82 as years that will permanently change our government, politics and lives. Just as the stars were aligned for Wilson, Roosevelt, Johnson and Reagan, they are aligned for Obama. Simply put, we enter his administration as free-enterprise, market-dominated, laissez-faire America. We will shortly become like Germany, France, the United Kingdom, or Sweden — a socialist democracy in which the government dominates the economy, determines private-sector priorities and offers a vastly expanded range of services to many more people at much higher taxes. Obama will accomplish his agenda of “reform” under the rubric of “recovery.” Using the electoral mandate bestowed on a Democratic Congress by restless voters and the economic power given his administration by terrified Americans, he will change our country fundamentally in the name of lifting the depression. His stimulus packages won’t do much to shorten the downturn — although they will make it less painful — but they will do a great deal to change our nation. In implementing his agenda, Barack Obama will emulate the example of Franklin D. Roosevelt. (Not the liberal mythology of the New Deal, but the actuality of what it accomplished.) When FDR took office, he was enormously successful in averting a total collapse of the banking system and the economy. But his New Deal measures only succeeded in lowering the unemployment rate from 23 percent in 1933, when he took office, to 13 percent in the summer of 1937. It never went lower. And his policies of over-regulation generated such business uncertainty that they triggered a second-term recession. Unemployment in 1938 rose to 17 percent and, in 1940, on the verge of the war-driven recovery, stood at 15 percent. (These data and the real story of Hoover’s and Roosevelt’s missteps, uncolored by ideology, are available in The Forgotten Man by Amity Shlaes, copyright 2007.) But in the name of a largely unsuccessful effort to end the Depression, Roosevelt passed crucial and permanent reforms that have dominated our lives ever since, including Social Security, the creation of the Securities and Exchange Commission, unionization under the Wagner Act, the federal minimum wage and a host of other fundamental changes. Obama’s record will be similar, although less wise and more destructive. He will begin by passing every program for which liberals have lusted for decades, from alternative-energy sources to school renovations, infrastructure repairs and technology enhancements. These are all good programs, but they normally would be stretched out for years. But freed of any constraint on the deficit — indeed, empowered by a mandate to raise it as high as possible — Obama will do them all rather quickly. But it is not his spending that will transform our political system, it is his tax and welfare policies. In the name of short-term stimulus, he will give every American family (who makes less than $200,000) a welfare check of $1,000 euphemistically called a refundable tax credit. And he will so sharply cut taxes on the middle class and the poor that the number of Americans who pay no federal income tax will rise from the current one-third of all households to more than half. In the process, he will create a permanent electoral majority that does not pay taxes, but counts on ever-expanding welfare checks from the government. The dependency on the dole, formerly limited in pre-Clinton days to 14 million women and children on Aid to Families with Dependent Children, will now grow to a clear majority of the American population. Will he raise taxes? Why should he? With a congressional mandate to run the deficit up as high as need be, there is no reason to raise taxes now and risk aggravating the depression. Instead, Obama will follow the opposite of the Reagan strategy. Reagan cut taxes and increased the deficit so that liberals could not increase spending. Obama will raise spending and increase the deficit so that conservatives cannot cut taxes. And, when the economy is restored, he will raise taxes with impunity, since the only people who will have to pay them would be rich Republicans. In the name of stabilizing the banking system, Obama will nationalize it. Using Troubled Asset Relief Program funds to write generous checks to needy financial institutions, his administration will demand preferred stock in exchange. Preferred stock gets dividends before common stockholders do. With the massive debt these companies will owe to the government, they will only be able to afford dividends for preferred stockholders — the government, not private investors. So who will buy common stock? And the government will demand that its bills be paid before any profits that might materialize are reinvested in the financial institution, so how will the value of the stocks ever grow? Devoid of private investors, these institutions will fall ever more under government control. Obama will begin the process by limiting executive compensation. Then he will urge restructuring and lowering of home mortgages in danger of default (as the feds have already done with Citibank). Then will come guidance on the loans to make and government instructions on the types of enterprises to favor. God grant that some Blagojevich type is not in charge of the program, using his power to line his pockets. The United States will find itself with an economic system comparable to that of Japan, where the all-powerful bureaucracy at MITI (Ministry of International Trade and Industry) manages the economy, often making mistakes like giving mainframe computers priority over the development of laptops. But it is the healthcare system that will experience the most dramatic and traumatic of changes. The current debate between erecting a Medicare-like governmental single payer or channeling coverage through private insurance misses the essential point. Without a lot more doctors, nurses, clinics, equipment and hospital beds, health resources will be strained to the breaking point. The people and equipment that now serve 250 million Americans and largely neglect all but the emergency needs of the other 50 million will now have to serve everyone. And, as government imposes ever more Draconian price controls and income limits on doctors, the supply of practitioners and equipment will decline as the demand escalates. Price increases will be out of the question, so the government will impose healthcare rationing, denying the older and sicker among us the care they need and even barring them from paying for it themselves. (Rationing based on income and price will be seen as immoral.) And Obama will move to change permanently the partisan balance in America. He will move quickly to legalize all those who have been in America for five years, albeit illegally, and to smooth their paths to citizenship and voting. He will weaken border controls in an attempt to hike the Latino vote as high as he can in order to make red states like Texas into blue states like California. By the time he is finished, Latinos and African-Americans will cast a combined 30 percent of the vote. If they go by top-heavy margins for the Democrats, as they did in 2008, it will assure Democratic domination (until they move up the economic ladder and become good Republicans). And he will enact the check-off card system for determining labor union representation, repealing the secret ballot in union elections. The result will be to raise the proportion of the labor force in unions up to the high teens from the current level of about 12 percent. Finally, he will use the expansive powers of the Federal Communications Commission to impose “local” control and ownership of radio stations and to impose the “fairness doctrine” on talk radio. The effect will be to drive talk radio to the Internet, fundamentally change its economics, and retard its growth for years hence. But none of these changes will cure the depression. It will end when the private sector works through the high debt levels that triggered the collapse in the first place. And, then, the large stimulus package deficits will likely lead to rapid inflation, probably necessitating a second recession to cure it. So Obama’s name will be mud by 2012 and probably by 2010 as well. And the Republican Party will make big gains and regain much of its lost power. But it will be too late to reverse the socialism of much of the economy, the demographic change in the electorate, the rationing of healthcare by the government, the surge of unionization and the crippling of talk radio. |
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