If the average interest rate were merely 2 percent, then a 300 percent debt-to-GDP ratio means that the economy needs to grow at a nominal rate of 6 percent to cover interest. With nominal GDP growth lagging, we’re experiencing about a half trillion dollar annual shortfall in growth compared to what would be required to cover interest on outstanding debt. Far from growing out of the debt burden, the economy is sinking under it. The World Bank estimates that the ratio of nonperforming loans to total outstanding reached 4.3 in 2015. Compare that to 4.2 percent on the eve of the last financial crisis.4
A little-noted feature of the hypertrophy of debt in the fiat money system, where almost all our money is borrowed into existence as debt, is that the more money is borrowed, the stronger the deflationary trap is poised to snap shut. For one thing, debt drives production. Capitalists whose investments are financed by debt have incentives to continue expanding production, even at lower prices, to meet fixed debt payment obligations. When central banks encourage credit demand by slashing interest rates to invisibility, they stimulate a “cross-border carry trade” in which borrowers operating in countries with higher interest rates are tempted to borrow dollars at low interest rates. As of Q1 of 2015, according to the Bank for International Settlements, “nonfinancial” companies outside the United States had collectively borrowed $9 trillion. This is tantamount to a multi-trillion-dollar short position against the dollar. As the borrowers are obliged to buy dollars to repay their debt, the effect is equivalent to a short squeeze in currency markets.
When the Obama administration, with an eye on US elections in November 2014, amplified propaganda about a “vigorous recovery” in the late spring of 2014, an expectation of a coming interest rate rise in the United States helped compound a self-reinforcing rally in the dollar. The effect was to shrink demand for key commodities priced in dollars. Prices collapsed for a whole range of dollar-denominated commodities, undermining both cash flow and collateral, thus jeopardizing the ability of debtors to repay.
Also note that the ability of the real economy to support rapidly compounding financial claims (most of the financial assets are debt instruments) is exaggerated by looking at compound growth since 1980. Remember, from 1992 through 2000, reported US GDP growth only fell below 3 percent twice—in 1993 when it was 2.7 percent and in 1995 when it was 2.5 percent. But those days are past. More recent figures show that even by official accounts of growth it has dwindled to a standstill.
As David Stockman pointed out in his May 2015 article, “Wake-Up Call for B-Dud and the New York Fed Staff—This Isn’t ‘Transitory’,” April 2015’s number for manufacturing production represented a 0.33 percent annual growth rate since December 2007.5
Debt and Money Destined to Be “Destroyed on a Truly Enormous Scale”
In other words, financial claims have been multiplying more than thirty times faster than industrial production since the onset of the last recession. This underscores Tim Morgan’s thesis in his 2013 book, Life after Growth. Morgan states that “the total of financial claims has become vastly larger than anything that the real economy can deliver. . . . This divergence between real potential output and the scale of monetary claims helps explain why the world is mired in debts that cannot be repaid, and it also explains why the process of the destruction of the value of money is inevitable and is starting to gather pace.” Morgan concludes, “What it means is the that financial and real economies can be reconciled only if financial claims (meaning both debt and money) are destroyed on a truly enormous scale.” Unless you think like Obama in pretending that real economic growth is poised to surge, spiraling financial claims on a stagnant real economy imply an enormous wipeout of financial claims—hence my expectation of a coming “terminal crisis” of US hegemony.
The US government has become the world’s greatest purveyor of economic lies since the Soviet Union. The government remorselessly overstates economic growth and exaggerates strength of the employment market. As pointed out by Zero Hedge in the May 2015 article “The Big Lie: Serial Downward Revisions Hide Ugly Truth,” the level of US retail sales has been chronically exaggerated. Between 2010 and 2015, over 20 percent of the initial gains in retail sales were removed by serial downward revisions in later months. According to the article, “For over 65 percent of the time, a ‘good’ number prints, stocks rally, the everything-is-awesome meme is confirmed, and then a month later (or more) retail sales data is downwardly revised.” (Along the same lines, the unemployment rate for April 2015, officially reported at 5.4 percent, is really 23 percent, as reported by Shadow Government Statistics, computed as Statistics Canada computes the unemployment rate in Canada.)
Then there is the dramatic 25 percent dollar rally that began around May 2014, which was triggered, in part, by the response of traders to statistical factoids that exaggerated the strength of the US economy. A stronger dollar, in turn, contributed to the systemic price reversal that cratered the price of oil and other economically sensitive commodities. These were second-order effects of China’s monumental credit bubble.
There has been no lack of alarm about the fact that we are dependent on paper money that could quickly lose value—or perhaps suck your livelihood and fortune into a deflationary vortex. The current monetary system is unsustainable, and it’s bound to collapse. To get a better perspective on this, let’s take a step back. The US dollar and the world monetary system need to be understood in the broader context of fading US hegemony.
Rules from America’s Days at the Summit of the World
The United States wrote the rules of the world economy when we were far and away the world’s richest and most powerful economy. Today, our luster has faded. One of the puzzles we must decipher as investors is how, and under what conditions, the US dollar’s role as a reserve currency is likely to end. Also, the current system should be understood as the culmination of a centuries-long process in the evolution of money and credit, as shaped by successive hegemonies. As Hayek pointed out in New Studies in Philosophy, Politics, Economics and the History of Ideas, the institutions of the moment are the latest attempt to cope with the demand for more, and cheaper, money—“a tradition of our civilization for centuries.”6
A review of the past stages of hegemony shows several points to bear in mind now:
1. Banking has never been a truly free market activity. During each of the successive stages of hegemony over the past five centuries, the predominant power has sponsored an official or quasi-official bank that has determined the role of money and credit during that stage of the world’s economic development.
2. As the scale of government has grown, there has been a loosening of restrictions that commodity-based money imposed on credit expansion, creating a general tendency for credit to become easier.
3. Debt crises have a way of coming to the fore during the twilight of hegemony. No matter the institutional framework of banking, the phase of financialization that follows the signal crisis of hegemony culminates in a terminal crisis of debt distress, often aggravated by the ruinous expenses of war.
4. Money and banking have evolved over the past half millennium to permit more promiscuous extension of credit. The US system of pure fiat money reflects the unprecedented scale of the US government as the largest the world has ever seen and the declining marginal returns (accelerating inefficiency) of a system that cannot pay its way. In this light, easy credit at an unprecedented scale is the monetary reflection of scale diseconomies. The government needs to create trillions of dollars out of “thin air” to pay its otherwise unaffordable operating expenses. The terminal crisis of US hegemony may well prove to be the end of fiat money and fractional reserve banking, as the unstable fiat system collapses and money and banking devolve to a smaller and more efficient scale.
As Hall of Fame baseball genius, the late Yogi Berra is famous for pointing out, “You can observe a lot just by watching.” What you can see if you look is that a distinctive feature of US hegemony in its twilight is the imposition of pure, fiat mon
ey throughout the globe. Although you can see some foreshadowing of the US monetary system in the period of British hegemony, no previous dominant regime had strayed far from commodity-based money. For perspective, let’s take a quick historical tour of previous hegemonies over the past five centuries. You can see how money and banking have evolved through half a millennium to permit banks to create money “out of thin air,” with the changes driven in large measure as expedients for financing ever-larger governments ever-more desperate for funds.
1. Genoan/Iberian Hegemony
La Casa delle compere e dei banchi di San Giorgio
Medieval Banking in Sixteenth-Century Dress
The financial hub of the first modern hegemony was Genoa, which specialized in finance capitalism, mainly extending credit to princes at a time when bankers did not create money, but only lent sums that already existed. How did that work?
You could learn a lot about banking in sixteenth-century Genoa by parsing the original name of Genoa’s leading banking institution—“La Casa delle compere e dei banchi di San Giorgio.” This is usually translated as “The Bank of Saint George.” But a literal rendition of the Italian is “The House of public debts & ‘banks’ (plural) of Saint George.” As Professor Giovanni Felloni elucidates, casa more or less approximates “corporation” as “it denotes a body with its own legal identity” that “survives the succession of those managing it.”7
The affinity for Saint George probably also needs explaining. “It was the norm in medieval life to invoke the protection of a saint.”8 The creditors who funded Genoa’s bank chose the warrior Saint George, whose cross not incidentally formed the design of the Genoan flag—essentially identical to that of England, as both incorporated the red Saint George’s cross on a white field.
And delle compere refers to a type of public debt, the compera, that enabled Genoa’s bankers to “finance the ambitions of foreign and local princes including the King of Spain.” Part of the magic of the compera in its time was that it entitled buyers of sovereign debt to receive dedicated streams of income from the proceeds of specific taxes, thus circumventing prohibitions of the medieval church against “usury.” Think of the contortions among Islamic banks today.
Note also that dei banchi, which literally means “the benches,” is a medieval designation of “banks” (plural), so named because in the Middle Ages, Genoan bankers did not do business not from workshops, as did the craftsmen, but from behind a table, a flat surface a (bancus) set up in the market square. Note that bancus is not only the root of “banks” but also of “bankruptcy.” The word bancus means “table or bench,” and ruptus means “broken.” When a merchant or banker could no longer honor his debts, his bancus or table in the market was broken to warn others not to conclude business with him.
Banchi is the plural form of banco. In late medieval and early modern Genoa, “dei banchi di San Giorgio” “signified ‘bank counters,’ since each banco had its own cash desk and set of accounts; the word in the plural form ‘banchi’ indicated the existence of several bank counters at the same time and, in fact, there were 3 from 1408 to 1445, rising to 8 between 1531 and 1805.” Among them were a gold bank, one that worked in silver and another in Spanish “real de a ocho” coins.9
The “real de a ocho,” or the piece of eight (Spanish peso de ocho), was a silver coin, worth eight reales, that was minted in the Spanish Empire after 1598. It was conceived to correspond in value to the German thaler. The Spanish dollar was widely used by many countries as international currency because of its uniformity in standard and milling characteristics.
As you know, the Spanish dollar was the coin upon which the original US dollar was based, and it remained legal tender in the United States until the Coinage Act of 1857. It was also the origin of the “peso” currencies in use in many countries, as well as the Chinese yuan. Because it was widely used in Europe, the Americas, and the Far East, it became the first world currency.
In short, the first modern hegemony, the Genoan/Iberian regime, involved a continuation of medieval money and banking in the service of the new Iberian empires. It was all about the importation of gold and silver from the New World. Spanish and Portuguese banking was primitive, but as described above their coin was good. This formed the basis of a symbiotic relationship with the Most Serene Republic of Genoa, the small city-state that became the financial partner with the Iberian powers, in their period of hegemony in the sixteenth century.
“Up for Anything”
Most of the money that circulated in Genoa was minted by other states. But as discussed, Genoa did have a prominent and hyperactive financial institution, of medieval vintage, the Bank of Saint George, one of the oldest banks in the world. Run by Genoan oligarchs—who, like beer drinkers in the Bud Light commercial, were “up for anything”—the banks were major players in the slave trade and even administered their own colonies in Corsica, Gazaria in Crimea, and the Taman Peninsula on the Black Sea in present-day Russia.
Ferdinand and Isabella, as well as Christopher Columbus, maintained accounts at the Bank of St. George. The bank specialized in financing the Hapsburg sovereigns in anticipation of erratic shipment of silver from Peru. They lent especially vast sums to Spanish king Charles V, upon which Spain repeatedly defaulted—in 1557, 1560, 1575, and again in 1596—making it the first modern nation to default and signifying the signal crisis of Genoan/Iberian hegemony.
2. Hegemony of the United Provinces
Amsterdamsche Wisselbank (Bank of Amsterdam)
Pawn Shop for Debased Coin
The period of Dutch predominance began with an innovation during the rebellion against Spanish rule—the creation of the Bank of Amsterdam. Acting through the bank, the Dutch “provincial government minted and supported two good coinages, the guider (golden) and stuiver (silver)” worth one-twentieth of a guilder.
The Bank of Amsterdam served as a clearinghouse for currencies, acting much like a pawnshop for debased coins. It accepted deposits of any currency, or bullion, and then assessed the gold and silver content of such assets and gave the depositors an equivalent value in guilder and stuivers. This was important, because as Francis Turner put it, seventeenth-century “Europe was filled with coins of varying values, issued by governments of varying degrees of trustworthiness. To make it worse, each system had different ratios of the numbers of coins of one denomination that made up the next.”10 The Bank of Amsterdam became a financial clearinghouse. “The guilder and stuiver became the preferred currency for international exchange.” Other currencies then in use were deposited in accounts of the Bank of Amsterdam and translated into the preferred “guilder and stuiver.” In effect, the bank provided liquidity to debased currencies, crediting their holders with their precious metals content.
In short, the Bank of Amsterdam provided liquidity to any holder of gold and silver, even in the dilute form afforded in coinage of jurisdictions that seriously debased their currencies with base metal alloys. In so doing, the Bank of Amsterdam facilitated trade and encouraged in the inflow of funds to Bourse of Amsterdam.
Note that the Bank of Amsterdam practiced “warehouse” banking. Depositors paid the bank for the service of safekeeping their money rather than earning interest on deposits. This reflected the fact the Bank of Amsterdam was not engaged in fractional reserve banking—lending out some fraction of deposits, as goldsmiths had traditionally done and the banks we are familiar with do.
3. Hegemony of the United Kingdom
The Bank of England: Central Banking for Profit
The prime monetary innovation of British hegemony was the advent of central banking and legal sanction for the creation of money ex nihilo “out of thin air.” The Bank of England received its Royal charter on July 27, 1694 (while Dutch hegemony was still in place), with the explicit purpose of creating money to fund the rebuilding of the English fleet.
England’s Dutch King, William III, who was also Prince William of Orange, the hereditary “Stadtholder” of Holla
nd, Zeeland, Utrecht, Gelderland, and Overijssel in the Dutch Republic, found the English Treasury bare when he invaded England and seized the throne from James II. Subsequently, the English Navy, along with the Dutch fleet had been decisively defeated by the French at the Battle of Beachy Head, an ill-advised encounter prompted by direct orders from Queen Mary, wife of King William who was away in Ireland at the time.
Without ready funds to rebuild the navy, you will not be shocked to know that some members of Parliament thought immediately of clipping coins—to raise funds by reducing the value of money. King William and his advisers preferred to raise funds by chartering a for-profit bank, two schemes for which were entertained. One that failed was for a “Land Bank,” proposed mainly by the king’s opponents, in which King William himself was to be the lead investor with a subscription of £5,000. But this plan was scrapped when only £7,500 was committed, whereas the Bank of England was chartered as a for-profit corporation, with an initial capital of £1,200,000, a sum that was raised in twelve days. Part of the reason for the king’s enthusiasm for the new arrangement was that the Bank of England offered a mechanism for transferring the personal royal debt into a public debt controlled by the Parliament.
In return for creating a limited liability corporation, which would act as a bank for the government and have the right to issue banknotes, the shareholders of the Bank of England loaned the bank £1,200,000 at 8 percent interest. Of this sum, lent in turn to the government, half went immediately to fund a shipbuilding project for the Royal Navy. The Bank of England was also given a special dispensation to suspend conversion of its bank notes into gold.
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