The Cash Nexus: Money and Politics in Modern History, 1700-2000

by Niall Ferguson

  For reasons to be analysed in Chapter 7, raising taxation across the board to pay off bondholders is seldom politically popular. It is also economically problematic, since the income and consumption taxes conventionally used to finance such repayments are, as economists say, distortionary.10 An alternative policy which is not distortionary is to levy a one-off capital levy on the bondholders themselves: in effect to pay them off with their own money. However, the occasions when this has been politically possible have been relatively few; and the occasions when it has been successful even fewer.11 The attempt of the German Finance Minister Matthias Erzberger in 1919 to reduce the Weimar Republic’s deficit with a one-off, steeply progressive ‘Reich Emergency Sacrifice’ (Reichsnotopfer) on all property-owners failed miserably, for the simple reason that the tax could be paid in instalments over periods ranging from 25 to 47 years, with interest charged at only 5 per cent after December 1920. So long as inflation remained above 5 per cent, delayed payment could be relied upon to erode the real value of the liability.12

  The simplest solution to a problem of excessive debt is, of course, not to pay at all. Outright default was the habitual response of medieval and early modern monarchs when the costs of debt service were consuming too much of their income. Edward III ruined the Bardi and Peruzzi families this way in the 1340s.13 Jacques Côeur, the fifteenth-century French financier fell victim to a similar default by Charles VII.14 In the early modern period defaults by the great powers became so frequent that they were more or less institutionalized; it may indeed be more accurate to think of them as moratoria, reschedulings or forced conversions of debt, rather than state bankruptcies.15 Thus Spain defaulted on all or part of her debt fourteen times between 1557 and 1696.16 What happened was that existing debts were effectively rescheduled – usually by converting short-term asientos into long-term juros – and new borrowing resumed shortly afterwards. However, even habitual defaulting had a cost. After 1627 Genoese financiers limited their exposure to asientos, foreseeing yet another bankruptcy which would leave them holding lower-yielding juros. The decline in the outstanding amount of asientos from its peak in 1625 (12.4 million ducats) to little more than 1 million in 1654 reflected Spain’s narrowing fiscal room for manœuvre. This had direct political implications at a time when France and the United Provinces were able to borrow more at home and abroad.17 Moreover, Spanish finances remained prone to default throughout the nineteenth century: there was another major episode in the mid-1870s.

  France too was a regular defaulter in the early modern period. Sir George Carew had said of Henry IV that he ‘wringeth them [financiers] like sponges and ransometh every three or four years’.18 It was a practice his successors were obliged to imitate. The royal government defaulted wholly or partially in 1559, 1598, 1634, 1648, 1661 and 1698, and again in 1714, 1721, 1759, 1770 and 1788. As in the Spanish case, default became part of a more or less predictable pattern: ‘Borrow to fight the war, struggle in vain to raise taxes sufficiently to pay the debt, borrow even more to service the debt and … ultimately default on part of the debt to restore balance.’19 It is possible to distinguish between three kinds of default: temporary suspension of reimbursement payments; ‘reform’, which meant restoring the interest on debts to 5 per cent; and outright repudiation, when the interest rate was reduced below 5 per cent.20 Since the reign of Francis I, the government had used periodic chambres de justices – special commissions to inquire into financial fraud – not only to purge the fiscal system, but to default on various obligations. There were eleven such episodes between 1597 and 1665.21 It was Louis XVI’s refusal to default in the usual manner, it has been suggested, that forced him to summon the Estates General, and thereby unleash the revolutionary crisis. Yet this merely postponed – and at the same time worsened – the fiscal crisis. The default of 1797 affected fully two-thirds of the entire national debt, overshadowing even the Visa that followed the collapse of Law’s schemes.

  David Hume cynically observed that if Britain had defaulted as France had in the eighteenth century, the effects would have been minimal: ‘So great dupes are the generality of mankind, that, notwithstanding such a violent shock to public credit, as a voluntary bankruptcy in ENGLAND would occasion, it would probably not be long ere credit would again revive in as flourishing a condition as before.’22 Hume was right in one respect: defaults may raise the price of borrowing for a country, but they seldom scare lenders away for long. England had indeed experienced a kind of default in 1672, when Charles II decreed a moratorium on all ‘orders of payment’ not repayable from an earmarked source of future revenue. This ‘Stop of the Exchequer’ had disastrous consequences for the London goldsmiths who had been giving the government short-term credits in this form since 1665. In the 1680s interest payments on the Exchequer debts were suspended, and were not resumed again until 1705.23 Nevertheless, the costs of default are usually quantifiable in terms of the higher interest rates (and therefore higher debt charges) paid by defaulting governments on new post-default borrowing. As we shall see, the best explanation of the differential between British and French financial strength in the eighteenth century lies here.

  Although the American federal government never defaulted on its debt, the same cannot be said of the American states themselves. In the recession of 1837–43, there were defaults on around half of the outstanding state debts; 10 per cent of the total amount owed by the states was repudiated altogether. There were further rashes of default in 1857 and again in the 1870s.24 Latin American states were the perennial defaulters of the nineteenth and twentieth centuries. There were waves of default in the 1820s, the late 1880s (Argentina and Colombia), the pre-1914 period (Brazil and Mexico), the 1930s and again in the 1980s. The Middle Eastern states were not much better. There was a calamitous Turkish default after 1875, which also hit holders of Egyptian bonds. The collapse of the Ottoman Empire after the First World War led to another major default; though not on the scale of the Russian default of 1917, perhaps the biggest in financial history. However, these cases were all complicated by the fact that a substantial proportion of bondholders were foreigners, raising quite different economic and political questions from a purely domestic default. We will return to this point in Chapter 10.

  Conversion – the exchange of one kind of bond for another paying a lower coupon – is distinct from default, providing investors consent to the exchange. In 1672, as we have seen, the English Crown suspended payments on its ‘orders of payment’, but ultimately converted the debt into perpetual annuities;25 and in 1715 the Dutch Generality suspended and then reduced interest payments, an operation repeated in 1753.26 There were more or less successful conversions of parts of the British national debt in 1707–8, 1716–17, 1727, 1749–50, 1756, 1822, 1824, 1830, 1834 and 1844; but in 1853 Gladstone’s bid to convert 490,000 of ‘consolidated’ and ‘reduced’ annuities into a new 2½ per cent stock foundered; and it was thirty-five years before another such operation was attempted by Goschen, who succeeded in reducing the interest on a substantial portion of the debt to 2¾ per cent.27 A crucial conversion was that of 1932, which belatedly cut the coupon on £2.1 billion of the First World War debt still outstanding from the by then excessive level of 5 per cent to 3½ per cent. The success of this immense operation – involving a quarter of the entire national debt, equivalent to around half a year’s national income – brought the government an annual saving of £30 million.28

  Unlike defaults, such operations were managed in a transparent and predictable way, in response to perceptible declines in market interest rates. More importantly, conversions are based – or should be – on consent. A conversion like that of 1932 effectively invited investors to switch to a longer and lower-yielding asset: when the Midland Bank refused to accept the Bank of England’s terms, it was not forced to. On the other hand, smaller investors were cajoled into accepting the conversion not only by patriotic propaganda, but also by carrots and sticks. Bonds that were not converted ceased to be eligible for r
ediscount at the Bank, for example.29

  The British tradition of negotiated conversions has in many ways been exceptional, however. When the French premier Villèle tried a British-style conversion in 1824 he encountered stiff opposition in the aristocratic Upper Chamber, and the scheme ultimately foundered. The vicomte de Chateaubriand claimed it was an Anglo-Austrian ruse to defraud the French rentier, while the fact that some of the proceeds would have financed compensation to aristocratic victims of the Revolution added to the political difficulty.30 When negotiated conversions have proved impossible, authoritarian governments have sometimes used compulsion. This was the key to Mussolini’s stabilization of the Italian debt in the 1920s. There were two mandatory conversions (conversione forzosa) in 1926, when short-term bonds were converted into 5 per cent long-term bonds (titoli del Littorio), and again in 1934, when these new bonds were converted into 25-year 3½ per cents.31

  As these examples make clear, there is in truth no clear-cut distinction between default and conversion; what matters is the way creditors are induced to reduce their claims on the state, and the extent to which those claims are reduced.

  THE INFLATION TAX

  Capital levies, defaults and conversions are all overt ways of reducing a debt burden. However, it has long been recognized that there is a covert way too; namely, to debase the unit of account in which a debt is denominated. The issuing of money to cause an unanticipated rise in the price level operates as a fiscal tool in a number of ways. First, it permits a government to swap intrinsically worthless pieces of paper (or their electronic equivalents) for actual goods and services. This real transfer to governments, or ‘seigniorage’, is paid for by the private sector through a decline in the real value of their money balances generated by the policy’s attendant inflation. Secondly, raising prices by ‘printing’ money reduces the real value of non-price-indexed government wage payments, transfer payments, and official debt repayment. Inflation simply reduces the real value of the government’s debt, provided it is denominated in local currency. Thirdly, inflation permits the government to push the public into higher tax brackets.

  Historically, this is how most states have coped with severe fiscal imbalances. The ‘inflation tax’ on holders of money and financial assets was no invention of the twentieth century, though that century saw its most extensive and ruthless use.

  Though precious metals have been the foundation of the monetary system since the third millennium BC, coinage did not come into existence until around the seventh century BC.32 From Roman times at the latest it appears to have been understood that reducing the gold and silver content of coins was a source of revenue. There was sustained debasement of the Roman denarius after the reign of Marcus Aurelius, reducing its silver content by nearly 99 per cent by the time of Diocletian.33 In medieval and early modern France revenue from seigniorage was high – as much as eleven times more than other sources of royal income in 1421. Between 1318 and 1429 the French coinage was debased four times.34 There were debasements in Florence in the fourteenth century, Castile and Burgundy in the fifteenth, England in the sixteenth and much of Germany in the early seventeenth century. In the 1540s Henry VIII issued debased coins with a face value of £4.4 million, twice the price of the metal they contained. He made a profit of 46 per cent on every coin, or some £2 million.35 The metallic content of gold coins was reduced by around 25 per cent and of silver coins by 80 per cent.36 In the same way, the silver content of the French livre tournois fell by around half between 1513 and 1636.37 The legitimacy of such operations had been asserted in the fourteenth century by the writer Nicolas Oresme, whose De moneta argued that, in a just cause, debasement was a legitimate form of tax.38 But this was not a popular view, and the practice was supposed to be secret. Henry VIII’s Secretary Thomas Wriothesley called the Mint ‘our holy anchor’, but urged that its operations be kept secret, ‘for if it should come out that men’s things coming thither be thus employed, it would make them withdraw and so bring a lack’.39 Germans remembered the time of the Thirty Years War as the Kipper- und Wipperzeit: the age of the coin-clippers.

  The correlation between debasement and price inflation was seldom exact: early modern prices were influenced as much by international specie flows, to say nothing of agricultural and demographic fluctuations, and there were in any case physical limits on how much the money supply could be expanded by debasement. Nevertheless, the apparent link between debasements and sixteenth-century price rises provoked a theoretical and practical reaction. To Jean Bodin, writing in 1568, it was ‘a fraud and a pure trumpery of courtesans to claim that the king and the people gain [from debasement]’; the king might well, but the people patently did not.40 By the seventeenth century successive debasements had led to something verging on monetary chaos in Europe. In 1610 there were around a thousand different gold and silver coins in circulation in Amsterdam, pushing up the transaction costs of commerce.41 At the same time, the returns of seigniorage tended to diminish with each successive debasement.

  In response, two countries endeavoured to adopt systems of fixed exchange rates. In 1638 the Dutch guilder was set at slightly less than 10 grams of silver, though the unit of account at the Amsterdamse Wisselbank remained the 1544 guilder. This facilitated the creation of a unified system of payments, but with flexibility in the exchange rate between the coinage in circulation, mainly used for domestic transactions, and the bank guilder, reserved for foreign trade. In England the practice of clipping silver coins was halted after a burst of wartime depreciation with the great recoinage of 1696.42 Since the aim was to establish a bimetallic system, the price of the gold guinea was fixed in terms of silver; however, the rate chosen undervalued silver relative to France and Holland, causing silver coins to be removed from circulation. The drift to gold continued in 1717 when the Master of the Mint, the great physicist and mage Sir Isaac Newton, set the mint price of gold at £317s. 10½d. per ounce; once again gold was overvalued relative to silver, and silver coins effectively vanished from circulation. For larger transactions the place of silver was gradually taken by paper money backed by gold. In 1774 silver ceased to be legal tender for sums in excess of £25.43 For similar reasons, the coinage of the United States, formally bimetallic under the 1792 Coinage Act, was first predominantly silver (because of undervaluation of gold at the mint), then after 1834 predominantly gold (because of undervaluation of silver).44

  However, the development of paper money – which can be traced as far back as eleventh-century China, but did not begin in the West until 1690 – created new opportunities for levying the inflation tax.45 Between 1704 and 1707 the French caisse d’emprunts issued up to 180 million livres in interest-bearing notes, though the market soon knocked these down to around two-thirds of their face value.46 As we have seen, one of the key elements of John Law’s disastrous experiment with French finances was a massive expansion of the supply of paper money to some 2,235 million livres in 1720, compared with 344 million livres in 1708.47 There was another, less blatant, expansion of the paper money circulation in the second half of 1789 as a result of government borrowing from the Caisse d’Escompte.48 After 1768 Russia too relied heavily on printing paper money (as well as debasing the coinage) to finance her deficits.49 So did Spain, though the vales reales issued by Charles III from 1780 were interest-bearing.50 In the same way, a substantial part of the Austrian debt between 1790 and 1820 was financed by issuing paper Zettel.51 Often the paper notes in question were technically short-term debt instruments rather than cash proper; but the inflationary effect was much the same.

  The most spectacular of all eighteenth-century inflations was that of the assignats issued by the French National Assembly in anticipation of sales of confiscated royal and church property. Although originally intended to reimburse and indeed replace the so-called dette exigible52 of the old regime, the assignats swiftly became a device to finance the revolutionary regime’s large wartime deficits. The original 400 million livres issued in December 1789 were
interest-bearing, but from October 1790 the assignats ceased to pay interest and the volume in circulation rose swiftly from 1.2 billion that September to 2.4 billion in October 1792. By February 1796, when the printing machines were publicly smashed, 40 billion had been issued – about eight times the nominal amount of the ancien régime’s debt.53 The assignats’ purchasing power in terms of gold fell from 91 per cent in January 1791 to 0.5 per cent in 1796.54 This wiping out of the debts of the eighteenth century meant that, by 1818, the per capita burden of debt was fifteen times higher in Britain than in France.55 On the other hand, the experience of the assignats left a lasting scar on the French psyche, in the form of a reluctance to rely on paper money which persisted for the better part of a century. In 1850 more than 90 per cent of all transactions in France were settled in specie, compared with just over a third in England and only a tenth in Scotland.56

  The French experience was not unique. Between 1786 and 1815 the circulation of paper roubles increased by a factor of 18. The equivalent figure for Austria between 1790 and 1811 was 37.57 Napoleon was right that paper money was one of the foundations of Austrian war finance: in September 1809 he even ordered the printing of 100 million gulden of fake Austrian banknotes in order ‘to depreciate this paper issue, and to force Austria back onto a metal currency’, which would ‘compel her to reduce her army’.58 Moreover, while France achieved a successful and enduring currency stabilization under Napoleon with the creation of the franc germinal in 1803, the East European states were much slower to wean themselves off paper money.