From: https://www.goldmoney.com/research/goldmoney-insights/lessons-on-inflation-from-the-past
Via: https://www.zerohedge.com/economics/lessons-inflation-past
Lessons on inflation from the past
By Alasdair Macleod
Goldmoney Insights September 24, 2020
This article examines two inflationary experiences in the past in an attempt to predict the likely outcome of today’s monetary policies. The German hyperinflation of 1923 demonstrated that it took surprisingly little monetary inflation to collapse the purchasing power of the paper mark. This is relevant to the fate of the “whatever it takes” inflationary policies of today’s governments and their central banks. The management of John Law’s Mississippi bubble, when he used paper money to rig the market is precisely what central bank policy is aimed at achieving today. By binding the fate of the currency to that of financial assets, as John Law proved, it is the currency that is destroyed.
Introduction
At the outset, I shall make a point about the relevance of the chart below, a screengrab from Constantino Bresciani-Turroni’s The Economics of Inflation[i], which has been frequently reproduced and will be familiar to many who have read about Germany’s post-First World War inflation.
Looking at the progress of the collapse of the paper mark from
its parity with the gold mark, we can take a
punt on where the dollar might be today on this scale. The dollar has lost 98.2%
of its purchasing power since the failure of the London gold pool in the late
1960s.
That puts the dollar at 56 on the chart,
which is approximately the equivalent of Germany’s paper mark valuation
relative to gold in the first half of 1922.
If it follows the same course as the paper mark, in five- or six-months’ time
it will be 100 and in ten- or twelve-months about 12,000. Instead of the paper
mark’s original pre-1914 parity to the gold mark, the dollar started at $35 to
the ounce, so the gold price in dollars would be $1960, $3,500 and $42,000
respectively. The final price at which the German inflation was stopped on 20
November 1923 when it was fixed to the rentenmark at a trillion to one would be
the equivalent today of $35 trillion to the ounce.[ii]
Playing around with figures like these is not a replacement for sound
reasoning, but it does impart an interesting perspective. A better
understanding of the possible demise of the unbacked dollar is not to think of
the numbers of dollars per ounce of gold rising or gold potentially hitting
$42,000 within a year, a seemingly ridiculous number, but to think of gold as
being broadly stable while the dollar loses its purchasing power. The
presentation of an impossibly steep and accelerating uptrend is less believable
than a collapsing one. Furthermore, the commonality of the paper mark and the
dollar is that they were and are unbacked state-issued currencies liable to the
same influences, a fact the consequences of which are becoming increasingly
apparent.
Germany’s 1920s hyperinflation
For the paper mark it all started in 1905, when a German
economist and leader of the Chartalist movement, Georg Knapp, published a book
whose title translated as the State
Theory of Money. Thus encouraged, under the direction of Bismarck the
Prussian administration financed the military build-up to the war to end all
wars by utilising the state’s seigniorage. And when Germany lost, any thoughts
of raiding the wealth of the vanquished came to nought. Instead, it was Germany
that faced reparations and a post-war crisis. Just as the Fed is responding to
the covid crisis today, the answer was to print money. Monetary inflation
became the principal source of government finance, just as it is now in America
and elsewhere.
There is hardly an economist today who does not condemn the Reichsbank for its
inflationary policies. Yet they are
supportive of similar monetary policies by the Fed, the European Central Bank,
the Bank of Japan and the Bank of England. We should compare the stewardship of
Rudolf Havenstein at the Reichsbank with that of Jay Powell, who after reducing
interest rates the previous week, on 23 March issued an FOMC statement
promising an inflationary policy of “whatever it takes”. And Rishi Sunak, the
British Chancellor, used the phrase multiple times in his emergency budget.
But there is a difference. Today, alternatives to inflationism are never
discussed amongst policy makers, who are like a blind cult believing entirely,
with only minor variations, that monetary inflation is the cure for all
economic ills. At least in Germany, the actions of the government were the
subject of wider debate both in Germany and without, even though the answers
were mostly ill-informed.
Part of the problem was the quantity theory of
money was dismissed in a confusion between cause and effect. As
Bresciani-Turroni put it, a great number of writers and German politicians
thought that government deficits and paper inflation were not the cause, but
the consequence of the external depreciation of the mark. A financier,
politician and one of the leading German economists at the time, Karl
Helfferich put it this way:
“The increase of the
circulation has not preceded the rise of prices and the depreciation of the
exchange, but it followed slowly and at great distance. The circulation
increased from May 1921 to the end of January 1923 by 23 times; it is not
possible that this increase had caused the rise in the prices of imported goods
and of the dollar, which in that period increased by 344 times.[iii]”
It is a valid and important point, but not in the way Helfferich thought. The
disparity between the increase in the money quantity and the increase in the
general level of prices should be noted by observers today. Crucially, it did not require hyperinflation of the
money supply to cause a hyperinflation of prices, a point we address
later.
As well as dealing with the post-war economy and the capital dislocation that
needed to be corrected, there was the burden of reparations. Many blamed the
collapse of the paper mark on the latter, which is an inadequate explanation,
when the Austrian crown, the Hungarian crown,
the Russian rouble and the Polish mark all collapsed at roughly the same time.
Having resorted to monetary inflation as the means of marginal finance it
rapidly became the principal source of government revenue. The German
authorities then observed a dislocation between the increase in the quantity of
money and the effect on its purchasing power, as described by Helfferich. It
was taken as evidence against the quantity theory, as expounded by David
Ricardo a century before, and upon which Peel’s Bank Charter Act of 1844 in
England was based. Clearly, the dismissal of
the quantity theory paved the way for more inflationary financing in 1920s
Germany in the manner of today’s monetary planning. It led to the
observation that the money supply was insufficient for an economy faced with
rapidly escalating prices for imported goods.
The disparity between increases in the money supply in Germany and the effect
on the paper mark’s purchasing power was so great that the accuracy of the
underlying numbers does not matter. But today, while we can presumably rely on
monetary statistics being reasonably accurate, the statistics that reflect the
effect on prices are not. Today’s suppression of increases in the general price level simply
disqualifies any statistical analysis, and in that sense, Helfferich’s observation is a more honest
appraisal than those of today’s monetary planners.
On the surface, his deduction appeared to have some merit. He goes on to say,
“The depreciation of the
German mark in terms of foreign currencies was caused by the excessive burdens
thrust on to Germany and by the policy of violence adopted by France; the
increase of the prices of all imported goods was caused by the depreciation of
the exchanges; then followed the general increase of internal prices and of
wages, the increased need for means of circulation on the part of the public
and of the State, greater demands on the Reichsbank by private business and the
State and the increase of the paper mark issues. Contrary to the widely held
conception, not inflation but the depredation of the mark was the
beginning of this chain of cause and effect; inflation is not the cause of the
increase of prices and of the depreciation of the mark; but the depreciation of
the mark is the cause of the increase of prices and of the paper mark issues.
The decomposition of the German monetary
system has been the primary and decisive cause of the financial collapse.”[iv]
The starting point in this logic is it is never the government’s fault
but always the fault of external factors and markets. And doubtless, as the
dollar declines in the foreign exchanges over the coming months and commodity
prices rise, we shall continue to see similar arguments embedded in future FOMC
statements.
The error common to both is to misunderstand the
underlying subjectivity of money. Money takes its value from the
marginal value placed upon it relative to owning goods. If money is widely regarded as sound, an economising man is
happy to hold a reserve of it, only exchanging it for goods and services when
they are needed. This is the most important quality of metallic money, to which
people have always returned when government money fails.
A further benefit, which state currencies lack, is that gold and silver as
money are accepted everywhere, having the same values in New York, London, and
Mumbai. With the exception of cross-border trade, investment, and perhaps
longer-term strategic considerations, government currencies are generally
restricted to national boundaries. Paper currencies are therefore vulnerable to
changes in demand in the foreign exchanges in a way gold and silver are not; if
the foreigners don’t like your currency,
they will reduce their exposure by selling it, irrespective of fundamental
considerations.
In a currency collapse, the foreign exchanges are often the first to be blamed,
as a press cutting from Germany towards the end of 1922 illustrates:
“Since the summer of 1921
the foreign exchange rate has lost all connection with the internal inflation.
The increase of the floating debt, which represents the creation by the State
of new purchasing-power, follows at some distance the depreciation of the mark.
Furthermore, the level of internal prices is not determined by the paper
inflation or credit inflation, but exclusively by the depreciation of the mark
in terms of foreign currencies. To tell the truth, the astonishing thing is not
the great quantity but the small quantity of money which circulates in Germany,
a quantity extraordinarily small from a relative point of view; even more
surprising is it that the floating debt has not increased much more rapidly.[v]”
Blaming a falling currency on foreign
influences is the oldest excuse in the fiat book, but generally,
foreigners who do not have much attachment to a national currency are only the
first to sell. Initially, domestic users notice that prices have generally
risen and that their income and savings buy less. It is a cause for complaint
instead of a reasoned assessment, and of the logic employed in the press
cutting above. And despite the evidence that it is the currency losing
purchasing power instead of prices rising, the purchasing power can fall
substantially before a currency’s users abandon it altogether.
[Fiat Money is normally Legal Tender, acceptable for taxes and
thus supported. So rate of increase of taxes is a consideration.]
Given upcoming events, we can see a similar trend for today’s paper money,
particularly when represented by the American dollar. The first covid wave was
assumed to be a one-off, hitting the American economy but to be followed by a
rapid return to normal — the V-shaped recovery. Everywhere the official story
was the same, that following lockdowns the economy, wherever it was, would
return to normality. But it drove the US budget deficit to over $3.3 trillion
in the fiscal year just ending, up from a previously forecast trillion or so.[vi] The Federal deficit is already one
hundred per cent of Federal tax revenues.
Now we face a second covid wave, which will require more money-printing. The US
Government budget deficit in the next fiscal year will again exceed revenues by
a substantial margin. From last March, it has been in the position the German
government faced in the early 1920s: monetary inflation has become the dominant
source of government funding over tax revenue.
The slide in global cross-border trade, which is the consequence of the
imposition of trade tariffs between America and China, comes at the end of a
decade-long period of bank credit expansion, replicating the fragile position
in America at the end of the roaring twenties. The stock market and economic
collapses that followed had limited inflationary effects at the price level
only due to a working gold standard; but even that could not withstand the
political consequences of the depression, leading to a dollar devaluation in
January 1934. This time, there is no check for the dollar, which is doubly
afflicted by coronavirus lockdowns.
In Germany, the collapse of the paper mark ended by being stabilised at the
rate of a trillion to one gold marks on 20
November 1923, the equivalent of 4.2 trillion to the US dollar. The
paper mark was then replaced by a new unit, the rentenmark which was simply
given the value of the gold mark. This arrangement only became legal on 11
October 1924. The success of the stabilisation, despite an inflation of the
rentenmark — the quantity increasing from 501 million on 30 November 1923 to
1,803 million by the following July — has confused economists ever since.
Students of the Austrian school, and particularly of the writings of Ludwig von
Mises should deduce that after the final flight out of money into goods, the
emergence of a new money requires its users to accumulate a reserve of it. All
that was required was a growing acceptance that the rentenmark would stick. The
increase in cash and savings balances in the economy absorbed the increased
inflation of the rentenmark with the result that consumer prices remained
broadly stable.
If the stabilisation arrangement had been introduced before foreigners,
businesses and the wider public had not discarded the paper mark entirely, the
stabilisation would have failed. Those who think a German-style inflationary
collapse today can be avoided by an early currency reset with a different form
of fiat should take note.
The comparison with John Law’s crisis in 1720
The collapse of the paper mark is not the sole representation of
how a government currency loses its facility. The advantage of its comparison
with today is that a substantial cache of books, records and statistics exist
on the subject, prompting economic historians to use it as a template for all
the other hyperinflations of fiat money recorded since.
The economic history of John Law’s experiment
in France in not so blessed in this regard. Exactly 300 years ago, his
Mississippi bubble deflated, taking his currency, the livre, down with it. But
to understand the relevance to the situation today, we must first delve into
the facts behind his scheme.
The death of Louis XIV in 1715 left France’s state finances (which were the
royal finances) insolvent. The royal debts were three billion livres, annual
income 145 million, and expenditure 142 million. That meant only three million
livres were available to pay the 220 million interest on the debt, and
consequently the debt traded at a discount of as much as 80% of face value.[vii]
Following Louis XIV’s death, the Duke of Orleans had been appointed Regent to
the seven-year old Louis XV, and so had to find a solution to the royal
finances. The earlier attempt in 1713 was the often tried and repeatedly failed
expedient of recoining the currency, depreciating it by one-fifth. The result
was as one might expect: the short-term gain in state revenue was at the
expense of the French economy by taxing it 20%. Furthermore, the Controller
General of Finances foolishly announced the intention of further debasements of
the coinage with a view to raising funds. This bizarre plan was announced in advance
as an attempt to somehow stimulate the economy, but the effect was to increase
hoarding of the existing coinage instead.
At about this time, John Law presented himself at court and offered his
considered solution to the Regent. He diagnosed France’s problem as there being
insufficient money in circulation, restricted by it being only gold and silver.
He recommended the addition of a paper currency, such as that in Britain and
Holland, and its use to extend credit.[viii]
Banknotes did not previously exist in France, all payments being made in
specie, and Law persuaded the Regent of the circulatory benefits of paper
money. He requested the Regent’s permission to establish a bank which would
manage the royal revenues and issue banknotes backed by them as well as notes
secured on property. These notes could be used as a loan from the bank to the
king at 3% interest instead of the 7½% currently being paid on billets d’etat.
On 5 May 1716 he gained permission to establish Banque Generale as a private
bank and to issue banknotes. Law succeeded in persuading the public to swap
specie for his banknotes. He was so successful that after only eleven months,
in April 1717 it was decreed that taxes and revenues of the state could be paid
in banknotes, of which Law was the only issuer.
Law could now capitalise his bank. Besides his own money, this was done mostly
with billets d’etat,
in the books at their face value but obtained at a discount of 70% or so. He
used public anticipation of future currency debasement to encourage the public
to swap metallic money for his notes, which he guaranteed were repayable in
coins that had the silver content at the time of the note issue. Law’s
banknotes became an escape route for the general public from further debasement
of silver coins.
The banknotes rose to a fifteen per cent nominal premium over coins within a
year. The bank was exempt from taxes, and by decree foreigners were guaranteed
their deposits in the case of war. The bank could open deposit accounts, loan
money, arrange for transfers between accounts, discount bills and write letters
of credit. Law’s banknotes could be used to settle taxes. There was no limitation
placed on the total number of banknotes issued.[ix]
Money that had been hoarded for fear of further debasement was liberated by the
premium on Law’s banknotes, and the improved circulation of money rapidly
benefited the economy. Other private banks and moneylenders used Law’s
banknotes as the basis of extending credit.[x] This success meant his credibility
with the Regent, the French establishment, and the commercial community was
secured.
The use of his banknotes to settle taxes gave the bank the status of a modern note-issuing
central bank. The expansion of circulating money stimulated trade, particularly
given the banknotes’ convenience compared with using coin. It is worth noting
that the earliest stages of monetary inflation
usually produce the most beneficial effects, and this combined with
Law’s apparent financial and economic expertise, particularly measured against
the ineptitude of the Controller-General of Finances, gave the economy a
much-needed boost.
It is worth noting that at this stage, there
was no material inflation of the currency, banknotes being issued only
against coins. However (and this appears to have generally escaped economic
historians) it was clear that a loan business was facilitated on the back of
Law’s paper money, which inflated the quantity of bank credit in the economy.
Law could now turn his attention to raising asset prices to pay down the royal
debts, to enhance the public’s riches, and thereby his own wealth and that of
his bank.
The Mississippi connection
The Regent was understandably impressed by Banque Générale’s
apparent success at issuing paper currency and rejuvenating the economy. The
bank was being run on prudent lines, with banknotes being exchanged only for
specie, and the quantity of what today would be called narrow money had not
expanded materially beyond the release of hoarded specie. But Law had a
problem: the note issue and the fact the bank had been capitalised on a mixture
of partial subscriptions and billets
d’etats at face value meant the bank had insufficient capital
and profits to achieve its ultimate objective, which was to reduce the royal
debts and the interest rates that applied to them.
Consequently, Law developed a plan to increase the bank’s assets as well as
those under its indirect control. In August 1717, Law had requested of the
Regent and was granted a trading and tax-raising monopoly over the French
territory of Louisiana and the other French dependencies accessed by the
Mississippi River, the existing trading lease having lapsed. A major attraction
was supposed to be precious metals as well as the tobacco trade.
The Mississippi venture’s corporate title was Compaigne de la Louisiane ou d’Occident,
but ever since has been commonly referred to as the Mississippi venture. For
nearly two years, Law kept the project on hold while he established his bank.
The shares languished at a discount to their nominal price of 500 livres, and
what was needed was a scheme of arrangement to beef up the both the bank and
the company.
As a first step, in the summer of 1719 he acquired three other companies to
merge with the Mississippi venture. These had exclusive trading rights to
China, the East Indies and Africa, which effectively gave Law’s Mississippi
company a monopoly on all France’s foreign
trade. To pay off these companies’ debts and to build the ships required
for transport, Law proposed a share issue of 50,000 shares at 500 livres per
share, 10% payable on application. By the time legal permissions were granted,
the shares stood at 650 livres, making the new shares worth three times their
subscription price in their partly paid form.
Law’s earlier success with his banknote issue, and the contribution made to
improving the French economy, coupled with his ability to enhance the share
price by issuing bank notes, were a guarantee that his scheme would be
spectacularly profitable for anyone lucky enough to have a subscription
accepted.
The bank was re-authorised as a public institution and renamed Banque Royale in
December 1718. At the same time, the Regent authorised the further issue of up
to a billion livres of notes, which was achieved by the end of 1719. While it
had been the Banque Generale, notes had only been issued in return for specie
to the extent of 60 million livres, but this new inflationary issue was
entirely different. While it is impossible at this distance to forensically
track the course of this money, we can be certain that it was used to manage
the share price of the Mississippi venture, and it fuelled much of the public’s
panic buying of shares that year.
But it was not only the printing of money to push the share price that fuelled
the bubble. Law’s skills as a promoter took its inflation to a new level, with
further issues of 50,000 shares approved in the summer of 1719 and executed as
rights issues that autumn. Existing shareholders were offered the opportunity
to subscribe for one share for every four old shares held, to be partly paid
with an initial payment of 50 livres, the next payment deferred for over a
month. These could be sold for an immediate profit, while providing a low-price
entry point for new investors.
The expansion of the banknote issue without an offsetting acquisition of specie
was used by Law to assemble and finance a total
monopoly of France’s foreign trade. As well as this monetary expansion,
we can be sure that private banks and moneylenders used it as a base to expand
credit. We know this to be the case from court documents in London when Richard
Cantillon in 1720 successfully sued English clients in the Court of Exchequer
for £50,000 owed to him (about £18 million today), despite having already sold
the Mississippi shares as soon as they were deposited as collateral.
It seems obvious to us that to give to one man both the monopoly of the note
issue and monopolies on trade, and then for him to use the notes to create
wealth out of thin air is extraordinarily dangerous. It seems equally obvious
that such an arrangement was certain to collapse when the excitement died down
and investors on balance sought to encash their profits.
It seems less obvious to us today that the principal elements of Law’s
monopolies exist in modern government finances, which use paper money to
inflate assets providing their electorates with the illusion of wealth.[xi] The difference is not in the methods
employed, but the gradualness of today’s asset inflation, and the claim by the
state that it is acting in the public interest, rather than one individual
making the same claim on the state’s behalf.
Meanwhile, the Mississippi venture share price had continued rising, and by the
end of 1719 it stood at 10,000 livres. Increasing pressure from share sales by
people who sought to take profits had to be discouraged. The announcement of a
200 livres dividend per share was undoubtedly with that in mind, to be paid, like in any Ponzi scheme, not out of earnings
but out of capital subscriptions. The price finally peaked at 11,000 livres on
8th January 1720.
By late-1719, Law had found it increasingly difficult to sustain the bubble.
The banknote issues continued. In late-February 1720, the Mississippi Company
and the Banque Royale merged. Afterwards, the shares began their precipitous fall,
and by May, Law lost his position as Controller-General and was demoted. By the
end of October that year, the shares had fallen to 3,200 livres, and a large
portion of them had faced further unpaid calls throughout that year.
The year 1719 saw monetary inflation take off, directly fuelling asset prices.
The decline of the Mississippi share price the following year was not as sharp
as might otherwise have been expected, but against that must be put the fall in
the paper livre’s purchasing power, particularly in the later months. The
exchange rate against English sterling fell from nine old pence to 2 ½ pence in
September 1720, most of that fall occurring after April as the price effect of
the previous year’s inflation worked its way through into the exchange rates.
In the last three months of 1720 there was no sterling price quoted for paper
livres, indicating they had become worthless.
The relevance to today
John Law’s ramping of
a single financial asset by monetary inflation correlates with the Fed’s
monetary policy today. The material differences are the suppression of interest
rates, and therefore the market costs of government funding, and the far wider
range of financial assets being inflated on the back of government bonds. The importance of maintaining financial asset prices
is not only Fed policy, but it is increasingly realised that it is a policy
that cannot be allowed to fail.
To the extent that other central banks are suppressing yields on their
government bonds, this policy extends beyond America. This time, the John Law strategy has gone truly global, with the
consequence that the future of fiat currencies is tied to the perpetuation of current
financial bubbles.
In this regard it is interesting to note that the most astute banker in John
Law’s time, Richard Cantillon, never played Law’s game on the bull tack. He
made his first fortune extending credit to others for the purchase of John
Law’s stock, which as collateral he promptly sold. Subsequently, he sued for
the return of the loans to those who refused to pay up, thereby getting two
bites of the cherry. His second fortune was shorting Law’s scheme in 1719, not
by selling shares in the scheme, but by selling the currency for foreign
exchange. In other words, he calculated that when the scheme failed, it would
be the currency that collapsed more than the shares. He was right.
Conclusion
The two empirical models by which we can judge the collapse of a fiat currency offer food for thought in our current situation. The policy of deliberately rigging financial markets replicates that of John Law’s scheme, suggesting the collapse of currencies will be tightly bound to the end of the government bond bubble. Today’s bubbles in financial assets are sustained by equally artificial means, even more transparent than Law’s market rigging —
· quantitative easing,
· suppressed and negative interest rates etc., to which we can add
· the manipulation of price inflation statistics.
The German experience in the early 1920s showed how it did not
take as much monetary inflation as monetarists might think to collapse a
currency. Karl Helfferich’s quote about the relationship between the 23 times
increase in the money quantity while the number of paper marks to the dollar
increased 344 times gives us an important perspective: it will not require a
hyperinflation of the money suppy to destroy paper currencies today.
A fundamental difference is that the greatest sinner, if not on scale
but likely effect, is the Fed in its puffery of the dollar, everyone
else’s reserve currency. And unlike Germany a century ago and unlike France
three centuries ago, there is no foreign currency against which to measure the
dollar’s decline, except perhaps in the short run, because all central banks
follow similar inflationary policies with their fiat currencies.
In the past a suitable foreign currency was fully exchangeable into silver or
gold, so the decline and collapse could only be measured accordingly. It also
means that it
will be impossible for businesses to bypass the currency collapse by
referencing prices to other currencies, being all similarly fiat. Many businesses in Germany survived
the paper mark collapse in this way, but their modern equivalents will not have
this option.
The final collapse of a currency is always a flight out of government fiat
currency into goods. That can be the
only outcome from the continuation of current macroeconomic policies. But above
all, it would be a mistake to think
· it cannot happen, nor that
· it will be a long process giving us all plenty of time to plan.
The final flight out of paper marks took approximately six months. Law’s scheme took slightly longer to destroy his livre. These should be our reference points.
[i] First published in Italian in 1931,
and in English in 1937.
[ii] For ease of reference, a milliard
was the term for today’s billion, a billion was the term for today’s trillion,
and a trillion was a million of today’s trillion.
[iii] Bresciani-Turroni, pp. 44,
translated from Helfferich’s Das
Geld (1923)
[iv] Ibid. pp. 45
[v] Ibid pp. 45
[vi] Latest Congressional Budget Office
estimate
[vii] Earl J Hamilton, The Political Economy of France at
the time of John Law (History of Political Economy – 1969)
[viii] Law appears to have failed to
emphasise sufficiently the sheet-anchor guaranteeing British banknotes through
conversion into silver on demand.
[ix] See Early Speculative Bubbles and Increases in the Supply
of Money, by Doug French (Mises Institute)
[x] The most famous of these private
bankers was Richard Cantillon, famous for his essay on economics and the
Cantillon effect.
[xi] Alan Greenspan made it clear that a
rising stockmarket was an essential objective of monetary policy to spread a
beneficial wealth effect, when he was Fed chairman.
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