In the early 1980’s, an employee of the Federal Reserve Bank of Kansas City was required to tell bank presidents that their over-leveraged banks would be put into bankruptcy. Living in the community of those now defunct banks, he saw the pain caused to families and entrepreneurs.
My bank and I were also affected by those Fed decisions, and I can remember discussing with my bank manager the pain I was facing. What was particularly egregious was that the bank had exacerbated my pain to reduce theirs. They had become overextended with loans on a large condominium complex and when Mr. Volker struck, rather than lose their investment, they took ownership of the project, finished construction, and offered free rent and television sets to prospective renters. This drained every other apartment complex in the community putting several into bankruptcy. I chuckle as I write this, but our conversation consisted of me leaning over his desk and expressing my pique in a very loud voice. I made quite a caricature of the angry borrower.
Tom Hoenig was the Kansas City Reserve Bank employee and he later became the President of the Federal Reserve Bank of Kansas City. According to Christopher Leonard, Mr. Hoenig voted against Quantitative Easing at every opportunity. He was viewed as a pariah at the Federal Reserve. I see him as a hero.
Modern Monetary Theory
A significant part of our economic problem is due to decisions based on Modern Monetary Theory (MMT). What is MMT? Simply put, the theory posits that the economic policies of sovereign countries which issue fiat currencies (unsecured paper) do not require balanced budgets. They can spend with little regard to deficits or accumulating debt. In short, the theory says that there really is a money tree in the back yard. Accordingly, debt is not a precursor to economic collapse and deficits increase personal savings accounts. “Just look at Japan!” the proponents of MMT gleefully shout. “They are not bankrupt! QED!” For them, inflation is only an issue when there are shortages of goods or people. MMT was most recently proposed by economist Warren Mosler who, to his credit, bet on his own theory. He loaded up on Italian bonds when it was feared that Italy would default on its debt and when there was no default, he made a lot of money. Therefore, his theory was right… right?
Right or wrong the theory is not so new and perhaps we can learn from John Law who, three hundred years ago, proposed and got rich acting on his version of MMT. As we wait to see whether Mosler was right or just lucky we can learn how things turned out for his predecessor.
John Law and his Modern Monetary Theory
John Law was born into a wealthy Scottish banking family in 1671. Unlike our modern caricature of the dour Scottish banker, Mr. Law was what we might call a “player”. He fought over women, lost fortunes in gambling and was imprisoned for murder. His death penalty was commuted to incarceration for life, and he immediately escaped from Newgate Prison to live in Amsterdam. The story of how Law then charmed his way into the most powerful salons of Europe is fascinating reading and ably told by Charles MacKay in Extraordinary Popular Delusions and the Madness of Crowds. Every introductory course in economics should start with Mr. MacKay’s book.
As he gambled his way in and out of debt, Law developed a theory of money that resembles modern monetary theory. “Governments own the money supply and therefore can never be bankrupted by their own debts”, said Mr. Law. When King Louis XIV of France died in 1715, he left behind a Treasury that was empty, a debt registry that was full and a government that was exhausted. Attempts by the French to keep a Bourbon on the throne of Spain during the War of Spanish Succession created the financial conditions that allowed Law to test his ideas about government financing. Louis XV needed help and, for him, it was “any port in a storm”. Mr. Law was that port.
By invitation, in May 1716 Law established the Banque Générale Privée and printed paper currency for the bank that was backed by gold coins rather than the livre – the common currency. His theory was working and the more money he printed the richer both he and the state became. By 1720 Law was the Comptroller General of Finances and he oversaw the consolidation of French businesses into government monopoly corporations. They were financed by his paper currency which was inflated with each new company formed and each new project initiated. It was to become one of the most successful public-private partnerships ever conceived. Until suddenly it failed. Spectacularly.
The most famous of his ventures, the Mississippi Company, had been chartered in 1684 by the famed French explorer, Renee-Robert Cavelier de la Salle, to establish a French colony at the mouth of the Mississippi River. That project failed and in 1719 Law merged the Mississippi Company with the Company of the East Indies, the Company of China and other trading companies with a charter to manage commerce external to France under the supervision of Law’s new Banque Royal. The company was re-capitalized with 50,000 shares priced at 500 livres per share payable in eighteen installments.
Due to his promotion of the project, the distribution was sold out and the share price rose to 1,000 livres before the second instalment was due. Heady with success, Law printed 300,000 Mississippi Company shares at a notional value of five thousand livres per share and lent them to the French government at an interest rate of three percent cancelling the national debt of 1.5 billion livres. By the end of 1719 the value of the company shares was ten thousand livres per share. An extraordinary popular delusion driven by the madness of crowds. It was like the mining company BreX on steroids except that BreX was a fraud and Law was just following what was, to him, modern monetary theory. It makes one think that if you blow things up enough your fraud becomes an economic theory.
By the end of 1720, the bubble popped, the share price of the Mississippi Company was zero, and John Law was dismissed from all positions with the French Government. Meanwhile, the price of food in France rose by sixty percent and the seeds of the coming revolution were sown. John Law lost his considerable fortune and moved to Brussels from where he gambled throughout Europe to recover his wealth. Renewed prosperity eluded him and he died in poverty in Venice in 1729. Antoin Murphy, in his book “John Law: Economic Theorist and Policy-maker” summarizes the theories of John Law by saying that he "captured many key conceptual points which are very much a part of modern monetary theorizing." Over to you Mr. Mosler.
The reserve currency
It can be argued that the theories of Mr. Law and Mr. Mosler differ because the French livre of 1720 is not the US dollar of 2022. Since the end of World War II, the US dollar has been the reserve currency for every country in the world. A reserve currency is that foreign currency held by countries to reduce the effects of swings in the value of their own currency. It is a stable store of value that reduces exchange rate risk in international business. Until recently, virtually all commodity exchanges (purchase and sale of gold, oil, and gas for example) were denominated in US dollars irrespective of the countries engaged in the exchange. Therefore, the quantity of US dollars in the world is orders of magnitude greater than any other currency. It is a vast, expandable reservoir and destroying its value is tantamount to destroying the world economy.
But what happens if US dollar reserves owned by foreign countries are suddenly embargoed? What happens to the US dollar if other countries, concerned about their reserves being embargoed, sell their US dollar reserves and conclude significant amounts of world trade in currencies other than the US dollar? For example, if the Europeans want to buy Russian oil or natural gas, they no longer pay the Russians in US dollars but in Russian roubles which is why the Russian rouble has strengthened despite stiff sanctions. If the world moves away from the US dollar as a reserve currency, then the value of the dollar will collapse and the United States will go into bankruptcy. The United States will be followed into bankruptcy by those countries that hold US debt. Think China in the context of the saying, “Owe the bank $100 and you have a problem. Owe the bank $1 million and the bank has a problem.” But what does it mean when a country goes bankrupt?
What is going to happen next?
If I had an answer to this question I would be sunbathing by the pool of a fabulous villa on my island in the Caribbean. That I am hunkering down for another cold winter suggests correctly that I don’t have an answer. But here are some things to think about to inform your own thoughts on the matter.
The United States spent trillions of dollars fighting wars in the Middle East that arguably have done nothing except destabilize those governments and put millions of people into early graves. That is a lot of money spent to accomplish nothing of value. Now the same brain trust, who personally made a lot of money from the Fed printing machine during that time, is pounding the drums of war to destabilize Russia. With over $31 trillion of debt and the erosion of its position as the world’s reserve currency one might ask how this destabilization is going to be financed?
The US Secretary of State recently suggested that whoever blew up the natural gas pipelines from Russia into Europe did a wonderful thing that will provide great opportunities. What world does this man live in? Now the United States will feed, shelter, and warm Europe in some modern Marshall Plan? With over $31 trillion in debt and a desire to fight wars to destabilize Russia, how is this Marshall Plan to be financed?
Many nations in the developing world made the rational decision to load up on low interest rate debt nominated in US dollars. Soon they will have to renew their debt with US dollars that are significantly more expensive relative to their own currencies and at interest rates that are substantially higher. Many will be faced with bankruptcy. Who is going to bail them out? The World Bank and the IMF? And where do the World Bank and the IMF get their money?
The good citizens of upper-class Martha’s Vineyard declared their community to be a sanctuary for “your tired, your poor, your huddled masses yearning to breathe free, the wretched refuse of your teeming shore.”1 Except they didn’t really mean it and immediately kicked those yearning to be free off their island. It was a revealing moment to the large and increasingly disenfranchised American middle class that is tired of being left out of the deal. Remember how the Fed policies enriched the already rich at the expense of the middle classes and their great-great-grandchildren? The people of the American middle class are starting to remember as well.
Recently, the OPEC+ countries flipped the bird to the Biden administration by announcing production cutbacks of two million barrels of oil per day driving up gasoline prices almost immediately. But cartels are illegal, and these countries should be disciplined should they not? But isn’t the US government, due to the reserve currency status of the US dollar a cartel of one? I wonder if the Fed considered the results of its policies on the people of Peru. Of course, they did, but Peru comes in a distant second to Peoria. Just like Washington comes a distant second to Moscow and Riyadh.
There is an electoral trend developing around the world that also bears watching. Elections with surprising results have taken place in Canada, Sweden, Italy, and Brazil. Centre-right nationalists won or moved to a run-off, and this was not supposed to happen. What will happen on November 8 in the US mid-term elections?
These are some of the significant headwinds to my retirement planning. “How do you want the future to unfold to maximize your peace of mind?” you ask. I will tell you. I hope that Mr. Powell sticks to his guns, raises interest rates, and finally destroys the hedge fund managers who need to pay for their bad behaviour (both in 2008 and in 2020). This desire is vindictive and counter intuitive to improving my financial situation, but I am going to get hurt however things turn out and I have more recovery runway today than I will in a year or two.
I hope enough fiscal hawks are elected to the US Congress to dramatically reduce budgets that do not finance silly wars. It would be useful if the US government got out of the way of energy and transportation infrastructure development as well.
I hope that world leaders put on their big boy pants and negotiate an end to the war in Ukraine. Such negotiation should maintain the integrity of what remains of the country, permanently keep NATO and the EU out of Ukraine and, finance the repair of that country’s infrastructure. Those poor people have suffered enough.
I hope that the coming boom in commodities (minerals, oil and gas, foodstuffs etc.) will cause Canada to prosper in an environment of smaller, more agile, and capable governance. I hope we pay down some debt and don’t blow the benefits of a boom as we usually do.
None of this, of course, will happen and so I hope we will all help those who are going to be hurt by the tough times ahead. Economic pain is not terminal. Unemployment is not the end of the world and flying near the foam spraying off the surface of bankruptcy can be refreshing in the long run. These are the things that I have learned in my own financial misadventures. Always bear in mind that Adam Smith’s unseen hand (the aggregate decisions of billions of people in the world economy) is remarkably self-correcting so we will get through the consequences of our dalliance with modern monetary theory. We have learned that the aggregate actions of individual actors are, in fact, rational and that economies are driven by psychology and not printing presses.
Here is someone’s representation (seekingalpha.com) of the psychology of economies and extraordinary popular delusions. I think we are entering the “Despair” region. The good news is that things always return to the long term mean but the last twenty minutes are always the worst.
Central authorities, like the Wizard of Oz, can not control the economy with their buttons and levers. Toto has finally pulled back the curtain and now we see that, once again, we must pay for the hubris of our “betters”.
Next week, my third and final post on this topic will examine the history and worldviews that support the strange global machinations of the past 40 or 50 years. We will start in 1853 and the Crimean War, drive past the Franco-Prussian War and blow through the charnel house that was the 20th Century. I think we are witnessing the existential battles between three dominant worldviews as undertaken by four or five major players. Battles that started long ago. Buckle in.
Inscribed on the Statue of Liberty