In 2008 we found ourselves in the midst of a global financial panic - allegedly caused by irresponsible lending by banks. Amongst the sound and fury generated by the crashing of banks, agencies and insurance companies, the world found itself on the brink of a financing crises that threatened stable companies with good balance sheets. They found that their production process was interrupted because their trading partners' banks would refuse to honor each others' Letter of Credit (LoCs).
To many this was a far scarier development than the market crash. It threatened to bring the production and distribution of goods to a grinding halt - all due to a failure of the Letter of Credit system for trade and production finance.
FINANCING THE INDUSTRIAL REVOLUTION
The curious reader may ask, what is the point of labeling a company "stable" if it is dependent of bank credit to finance production? The answer is that no matter how strong a company's balance sheet is, its purchases of raw materials for confirmed orders are almost always funded by banks.
In fact modern industrial economies have only become possible due to the efficiencies brought about through the financial innovation of LoC systems. I would go so far as to say that the industrial revolution would not have been possible without the financial innovation of LoCs.
To many this may sound as a fairly bold statement. What about the steam engine? Or the renaissance? Key scientific discoveries? Surely these were the real enablers of the industrial revolution, not some boring financial instrument! Yes, all of those were important. Yet, without the LoC the Industrial Revolution could not have taken place. The explanation is a bit involved but let us dive into it nonetheless.
Banks as a warehouse
Depository receipts gain currency
Gold and Silver were used as money for many millennia. People frequently deposited their money with Goldsmiths or in warehouses. In turn they would be issued warehouse receipts for their deposited gold. Gradually these receipts became accepted in lieu of physical coins for payments.
Medival prohibitions on usury in the Islamic and Christian worlds prevented a large increase in credit money throughout the dark ages.
As medieval prohibitions on usury were eased in pockets of Europe, banks started to loan out coins on deposit to generate a source of income for the warehouses. In order to attract deposits the warehouses offered interest on the deposits instead of charging depositors for safekeeping. Slowly they began to resemble today's banks rather than gold warehouses.
If a bank's loans went bad depositors run to the bank to be first in line to receive whatever gold remained the bank could produce from its vaults and by marketing or pledging its assets. Due to the constant threat of bank runs, the early banks were forced to lend money to only the safest and most liquid borrowers - as described in the next section.
Thus market forces made prudential lending a competitive advantage that helped a bank attract more deposits, not a regulatory annoyance imposed by the government. Adequate capitalisation too was a competitive advantage, not a regulatory burden - a well capitalised bank was more likely to weather losses and remain sound.
Most people hold money for short term needs in cash or demand deposits. Any savings were invested in bonds or equity. Longer term bank deposits too existed, and banks were careful to match the maturity profile of their liabilities and assets to avoid a liquidity crunch.
The aggregate term distribution of investments forecast the economy's intention of consumption over investment. Greater short term investments implied a lack of investable capital goods, and greater investment for the longer term implied productive capital surpluses available for longer term investing.
An eventual towel-buyer would hold a short-term balance £7 in a bank account in anticipation of buying a towel in the coming season (or his/her employer would in preparation to pay wages).
Knowing that the retailer regularly sells a number of towels every season, a bank can take an IOU worth £6 + interest from the retailer and an issue a £6 promissory note (payable in the 90 days) payable against the delivery of towels from the towel factory. The factory's banker will accept this note and further provide a £5 promissory note to the merchant's banker. His banker in turn writes a promissory note to the loom's banker, and so on.
When the customer pays the retailer, the retailer repays his loan. By this time, the retailer's bank's promissory note also comes due and is repaid with the customer's payment. The same process repeated down the supply chain. This type of credit is SELF LIQUIDATING. As goods in urgent demand are delivered, the payments liquidate the credit.
The promissory notes were very low risk forms of short-term credit. It is easy to see why. Retailers who regularly sell consumer goods in high demand such as food, clothing, toys, shoes, books, electronics, etc will continue to experience a very stable demand for their products. The credit is backed by their expected sales. People will continue to eat, be clothed and buy items of everyday use. Therefore it is safe to extend working credit to stock their inventories.
Consumer spending being the largest and least speculative portion of any economy, it is therefore no surprise that these promissory notes became very liquid and marketable instruments. As the industrial revolution swept the world, they began to circulate as money substitutes. Bank Notes from solid, dependable banks were widely accepted at par with coins, and warehouse receipts for bullion. Notes from lesser known banks would trade at a slight discount.
If a bank experienced excessive depositor demand for physical Gold, it could always sell (or borrow against) these safe assets with other banks in exchange for their bullion. This interbank lending market developed into the modern repo market.
Bank Notes and the Real Bill Markets
Self-liquidating credit - a sound portfolio for Banks
Every bank note in circulation is a liability of the bank, backed by a corresponding asset on its balance sheet - an IOU from a real business in the real economy drawn against confirmed orders, working to provide for urgently sought after items for be paid for on delivery with existing bank balances. Adam Smith used the term REAL BILLS to describe these IOUs.
Eventually secondary markets developed for these Real Bills. Banks and merchants regularly traded them. In fact a merchant could make more profit by investing in the higher yielding Real Bill of a competitor than to tie up capital in stocking his shelves with marginally profitable items.
We know that the yield levels in bond markets are driven by the PROPENSITY TO SAVE. If investors save more, more capital is available and yields go down.
However, the yields in the Real Bills market (more accurately the discount rate) were driven by the PROPENSITY TO CONSUME. If people expected to spend more money, the quantity of short term balances in banks grew, and this lowered their yield and send a clear demand signal throughout the production supply-chain. If consumers planned to cut back on spending, that drove up the discount rate in the Real Bill Markets and automatically put a brake on marginal production.
In this manner the Real Bill market acted as a wonderful signalling mechanism for the longer production chains, signalling consumer demand through the price of short-term, self-liquidating credit.
The supply of circulating notes smoothly grew with increasing economic activity and contracted without leading to deflationary depressions when demand slowed. There was no need for central banks to measure the money supply, set interest rates or gather data about economic indicators. All of this was effectively managed by the invisible hand of the market.
To many this was a far scarier development than the market crash. It threatened to bring the production and distribution of goods to a grinding halt - all due to a failure of the Letter of Credit system for trade and production finance.
FINANCING THE INDUSTRIAL REVOLUTION
The curious reader may ask, what is the point of labeling a company "stable" if it is dependent of bank credit to finance production? The answer is that no matter how strong a company's balance sheet is, its purchases of raw materials for confirmed orders are almost always funded by banks.
In fact modern industrial economies have only become possible due to the efficiencies brought about through the financial innovation of LoC systems. I would go so far as to say that the industrial revolution would not have been possible without the financial innovation of LoCs.
To many this may sound as a fairly bold statement. What about the steam engine? Or the renaissance? Key scientific discoveries? Surely these were the real enablers of the industrial revolution, not some boring financial instrument! Yes, all of those were important. Yet, without the LoC the Industrial Revolution could not have taken place. The explanation is a bit involved but let us dive into it nonetheless.
Banks as a warehouse
Depository receipts gain currency
Gold and Silver were used as money for many millennia. People frequently deposited their money with Goldsmiths or in warehouses. In turn they would be issued warehouse receipts for their deposited gold. Gradually these receipts became accepted in lieu of physical coins for payments.
Medival prohibitions on usury in the Islamic and Christian worlds prevented a large increase in credit money throughout the dark ages.
As medieval prohibitions on usury were eased in pockets of Europe, banks started to loan out coins on deposit to generate a source of income for the warehouses. In order to attract deposits the warehouses offered interest on the deposits instead of charging depositors for safekeeping. Slowly they began to resemble today's banks rather than gold warehouses.
If a bank's loans went bad depositors run to the bank to be first in line to receive whatever gold remained the bank could produce from its vaults and by marketing or pledging its assets. Due to the constant threat of bank runs, the early banks were forced to lend money to only the safest and most liquid borrowers - as described in the next section.
Thus market forces made prudential lending a competitive advantage that helped a bank attract more deposits, not a regulatory annoyance imposed by the government. Adequate capitalisation too was a competitive advantage, not a regulatory burden - a well capitalised bank was more likely to weather losses and remain sound.
Most people hold money for short term needs in cash or demand deposits. Any savings were invested in bonds or equity. Longer term bank deposits too existed, and banks were careful to match the maturity profile of their liabilities and assets to avoid a liquidity crunch.
The aggregate term distribution of investments forecast the economy's intention of consumption over investment. Greater short term investments implied a lack of investable capital goods, and greater investment for the longer term implied productive capital surpluses available for longer term investing.
Long Industrial Production Chains
Increased demand for Financing
The main characteristic of the industrial age was the dramatically increased division of labor, with an accompanied increase in specialization in each of the steps resulting in longer chains of production.
In the real world multiple inputs go into creating a finished product. A real production chain can be visualized as a river, with a number of tributaries flowing into the single river, each with their own sub-tributaries. However, to illustrate the effect of the division on labor on the demand for money it is sufficient to consider a linear production chain.
A longer production chain involves a larger number of financial transactions leading to the production of finished goods starting from raw material. Consumers only pay for an items at the point of sale. A retailer only pay for goods on delivery. Factories only pay for industrial inputs they become available, and so on all the way to the production of raw material.
Yet, the retailer cannot pay until the customer pays. The factory cannot pay until the retailer pays. The refiner cannot pay until the factory pays, etc. This has huge implications on the demand for capital.
Imagine a product, such as a factory made towel produced with Egyptian cotton. Let us say for sake for argument that the towel is produced in several steps from growing raw cotton in Egypt to selling it to a housewife in London. In each of the ten steps £1 of value is added to the product, and ultimately it sells for £7.
Without bank finance, to make this possible, the following must be happen for each towel sold:
- The retailer must pay the distributor £6
- before which the distributor pay the towel factory £5
- before which the towel factory must pay the cloth merchant £4
- before which the British cloth merchant must pay the Egyptian loom £3
- before which the Egyptian loom must pay the trader £2
- before which the Egyptian trader must pay the cotton grower £1
The total money at hand that the various parties required to finance this production chain is 6+5+4+3+2+1 = £21. That's a lot of capital to tie-up in the production of one towel worth £7 before the customer will pay for it. A huge £21 worth of consumption/investment is forsaken over the length of the production cycle to finance this production chain.
It is no wonder that sub-division of labor was never possible without some way of making this process more efficient and most manufacturing was a artisan type affair with not more than a couple of steps in the manufacturing process.
Let us now examine how bank loans made eased this demand for working capital and make longer production chains more capital-efficient.
Traditional Banking
Financing Industrial Production
Knowing that the retailer regularly sells a number of towels every season, a bank can take an IOU worth £6 + interest from the retailer and an issue a £6 promissory note (payable in the 90 days) payable against the delivery of towels from the towel factory. The factory's banker will accept this note and further provide a £5 promissory note to the merchant's banker. His banker in turn writes a promissory note to the loom's banker, and so on.
When the customer pays the retailer, the retailer repays his loan. By this time, the retailer's bank's promissory note also comes due and is repaid with the customer's payment. The same process repeated down the supply chain. This type of credit is SELF LIQUIDATING. As goods in urgent demand are delivered, the payments liquidate the credit.
The promissory notes were very low risk forms of short-term credit. It is easy to see why. Retailers who regularly sell consumer goods in high demand such as food, clothing, toys, shoes, books, electronics, etc will continue to experience a very stable demand for their products. The credit is backed by their expected sales. People will continue to eat, be clothed and buy items of everyday use. Therefore it is safe to extend working credit to stock their inventories.
Consumer spending being the largest and least speculative portion of any economy, it is therefore no surprise that these promissory notes became very liquid and marketable instruments. As the industrial revolution swept the world, they began to circulate as money substitutes. Bank Notes from solid, dependable banks were widely accepted at par with coins, and warehouse receipts for bullion. Notes from lesser known banks would trade at a slight discount.
If a bank experienced excessive depositor demand for physical Gold, it could always sell (or borrow against) these safe assets with other banks in exchange for their bullion. This interbank lending market developed into the modern repo market.
Bank Notes and the Real Bill Markets
Self-liquidating credit - a sound portfolio for Banks
Every bank note in circulation is a liability of the bank, backed by a corresponding asset on its balance sheet - an IOU from a real business in the real economy drawn against confirmed orders, working to provide for urgently sought after items for be paid for on delivery with existing bank balances. Adam Smith used the term REAL BILLS to describe these IOUs.
Eventually secondary markets developed for these Real Bills. Banks and merchants regularly traded them. In fact a merchant could make more profit by investing in the higher yielding Real Bill of a competitor than to tie up capital in stocking his shelves with marginally profitable items.
We know that the yield levels in bond markets are driven by the PROPENSITY TO SAVE. If investors save more, more capital is available and yields go down.
However, the yields in the Real Bills market (more accurately the discount rate) were driven by the PROPENSITY TO CONSUME. If people expected to spend more money, the quantity of short term balances in banks grew, and this lowered their yield and send a clear demand signal throughout the production supply-chain. If consumers planned to cut back on spending, that drove up the discount rate in the Real Bill Markets and automatically put a brake on marginal production.
In this manner the Real Bill market acted as a wonderful signalling mechanism for the longer production chains, signalling consumer demand through the price of short-term, self-liquidating credit.
The supply of circulating notes smoothly grew with increasing economic activity and contracted without leading to deflationary depressions when demand slowed. There was no need for central banks to measure the money supply, set interest rates or gather data about economic indicators. All of this was effectively managed by the invisible hand of the market.
Of course the whole production chain can break down if one of the links breaks down, akin to a series of interdependent house purchases falling through if one of sales in the chain does not succeed.
Central Banks
Lenders of last resort
Natural or man-made disruptions of this free-market financial system were common. Natural disasters, wars, etc would leave the banks "broken" if production was disrupted and borrowers could not repay in these circumstances.
The development of the insurance industry helped mitigate the risks of long distance trade. This made the financing chain more robust. However, excessive risks taken by banks were a constant threat to the smooth functioning of real bill markets. They often found themselves caught up in speculative manias such as the South Sea Bubble, the Tulip Mania, and many other less famous speculative periods.
Thus, regular economic activity unrelated to the speculation was often disrupted by the contagion. Bankers to cease accepting each others' promissory notes if the soundness of their holdings were called into question. This often fed through to the Real Bill market, causing economic dislocation.
Government set up Central Banks to mitigate this problem. These were lenders of last resort who could provide credit to the creditworthy when no one else would.
A BRAVE NEW WORLD
Credit Money
Crises, World Wars and the Great Depression
Through all this change and the innovation of financing production with liquid deposits one thing remained constant. All these forms of circulating money substitutes were always convertible into the coin of the realm (usually Gold coin or bullion) at the issuing bank.
Except if the governments suspended the convertibility by law.
In the lead up to the first world war many countries (notably France and Germany) suspended the convertibility of circulating notes into coin. This action allowed them to grow the supply of circulating bank notes, through bank loans to the governments.This novel technique allowed governments to invade the pool of capital goods and divert them towards war tear more effectively than would have ever been possible through borrowing, taxation or the debasement of coins. It has been argued that this is what caused the world wars to be longer and more bloody than the wars preceding them. Most wars between technologically equal adversaries end because one side is overwhelmed by the other.
The efforts of European powers to return to Gold convertibility after WW1 helped pushed the world into a Great Depression, towards Fascism and WW2. Too many bank notes were in circulation compared with the specie in bank vaults. Credit collapsed, and the wave of cascading bank defaults led to the Great Depression. One by one the countries were forced back off the Gold Standard in order to rehabilitate their economies.
By manadating government debt (or other currencies backed by government debt) as reserve assets, the entire monetary system is reduced to a pyramid scheme where savers are fleeced to finance unprecedented government deficits that are used to buy votes and influece by those in power. A large chunk of investible productive capital of the entire world has been dissipated on bread, circuses and wars in this manner.
Piling debt upon even more debt is making the overall system more and more unstable. When the sand pile finally collapses, it will take out the existing international power structures and many national regimes with it.
Central Banks
Lenders of last resort
Natural or man-made disruptions of this free-market financial system were common. Natural disasters, wars, etc would leave the banks "broken" if production was disrupted and borrowers could not repay in these circumstances.
The development of the insurance industry helped mitigate the risks of long distance trade. This made the financing chain more robust. However, excessive risks taken by banks were a constant threat to the smooth functioning of real bill markets. They often found themselves caught up in speculative manias such as the South Sea Bubble, the Tulip Mania, and many other less famous speculative periods.
Thus, regular economic activity unrelated to the speculation was often disrupted by the contagion. Bankers to cease accepting each others' promissory notes if the soundness of their holdings were called into question. This often fed through to the Real Bill market, causing economic dislocation.
Government set up Central Banks to mitigate this problem. These were lenders of last resort who could provide credit to the creditworthy when no one else would.
A BRAVE NEW WORLD
Credit Money
Crises, World Wars and the Great Depression
Through all this change and the innovation of financing production with liquid deposits one thing remained constant. All these forms of circulating money substitutes were always convertible into the coin of the realm (usually Gold coin or bullion) at the issuing bank.
Except if the governments suspended the convertibility by law.
In the lead up to the first world war many countries (notably France and Germany) suspended the convertibility of circulating notes into coin. This action allowed them to grow the supply of circulating bank notes, through bank loans to the governments.This novel technique allowed governments to invade the pool of capital goods and divert them towards war tear more effectively than would have ever been possible through borrowing, taxation or the debasement of coins. It has been argued that this is what caused the world wars to be longer and more bloody than the wars preceding them. Most wars between technologically equal adversaries end because one side is overwhelmed by the other.
The establishment of the Federal Reserve System also helped a great deal in the inflation of circulating money in the US. Note that the US did not suspend convertibility until after the full force of the debt deflation that caused the Great Depression had hit them.
The efforts of European powers to return to Gold convertibility after WW1 helped pushed the world into a Great Depression, towards Fascism and WW2. Too many bank notes were in circulation compared with the specie in bank vaults. Credit collapsed, and the wave of cascading bank defaults led to the Great Depression. One by one the countries were forced back off the Gold Standard in order to rehabilitate their economies.
After WW2 the industrial base of the warring European powers was decimated and their Gold reserves squandered on war. The US was the only country which maintained international Gold convertibility for Federal Reserve Notes. Domestic ownership was still illegal. The Breton-Woods system was set up to help finance the rebuilding of Europe. The US Dollar was convertible to Gold, and all other currencies were pegged to the US Dollar. In fact the articles of the IMF explicitly forbid member nations to make their currencies convertible to gold.
Post WW2 war spending in Vietnam, etc led to a dangerously large issuance of US currency in international hands, which if it were redeemed for Gold would certainly have drained US Gold reserves. An attempt by France to do convert large US Dollar holdings into Gold triggered the suspension of Dollar convertibility into Gold internationally by the Nixon administration.
As most other countries already held US Dollars as reserve assets and the US Dollar was the international trade currency it became the de-facto reserve currency in the new floating-currency system. At that time the US still had a huge industrial base and was a major creditor nation. For the rest of the world this is more an accident of history than by design.
The use of the dollar for international trade settlements is the key. It creates a demand for dollars. Nations like oil producers, Japan, Germany and China are forced to accumulate dollar reserves as a mathematical function of their trade surpluses, and not necessarily because they consider it a quality store of value, or believe in the “strong dollar policy” propaganda.
Today the US is still the largest manufacturing country in the world but continues to lose its industrial base due to free-trade with low-cost countries, and competitive currency devaluations. No country wants a strong currency as it makes exports uncompetitive. Governments in particular want inflation because it makes servicing of government debt issued to fund populist spending easier.
This is why Central Banks are never permitted tolerate any deflation – even that caused by productivity increases. Any country with a sound currency is forced to intervene to cap the exchange rates – as seen recently with Japan and Switzerland. This can be done either by a zero interest rate policy (ZIRP – e.g. Japan, Swiss), sterilizing trade surpluses (China/Japan/OPEC), or if all else fails by buying unlimited amounts of foreign currency to store as reserve (e.g. Swiss buying Euros).
I cannot see what will stop this race to the bottom in the era of big populist government spending and deficits, stimulus programs, international trade imbalances and exponentially increasing debt. If the powers that be coordinate a smooth international inflation savers and cash holder will continue to pay for the increase in nominal values of income producing assets like stocks. This will be accompanied by several alternating bubbles in various stock and commodity markets.
Sovereign and Financial debt worries and the sort of discord we see today in Europe will periodically create panics, but the printing presses will step in to try and and do everthing in their power to prevent a Great Depression style debt-deflation (as we saw in 2008/2009).
By manadating government debt (or other currencies backed by government debt) as reserve assets, the entire monetary system is reduced to a pyramid scheme where savers are fleeced to finance unprecedented government deficits that are used to buy votes and influece by those in power. A large chunk of investible productive capital of the entire world has been dissipated on bread, circuses and wars in this manner.
Piling debt upon even more debt is making the overall system more and more unstable. When the sand pile finally collapses, it will take out the existing international power structures and many national regimes with it.
Hopefully the survivors of this fallout will do better than the current breed running our world. And if they do let us hope that the new reserve asset of choice is the the best reserve currency created by nature that is no one’s liability – Gold.
