The Bear’s Lair: Back to Stuart finance!

Since this column appears on the 413th anniversary of Guy Fawkes’ attempt to blow up the Houses of Parliament, I thought it worth reflecting on why he got so close. The principal reason was the parlous state of early Stuart finances, which was due to two factors: the lack of a central bank and the lack of a reliable government bond market. Modern governments don’t have this problem; indeed, they feel able to finance deficits as large as they like for as long as they want, using a poodle central bank to print money when necessary. Given current policies, that will eventually end, and the era of Stuart finance will return.

The value of a fiat currency such as today’s dollar depends on two things: public confidence in the currency itself and an issuing authority such as the Fed or the Bank of England that keeps the amount of currency issued under control, ideally growing at a modest rate that matches the economy’s growth.

In the early days of fiat currencies, their potential instability was well understood. As Lord Liverpool, then prime minister, explained to the House of Lords in 1813, when Britain was off the Gold Standard, using a wartime system (1797-1819) of paper money issued by the Bank of England: “The noble earl, however, has urged the extraordinary proposition, that a paper currency should be issued by government. Upon this point, all experience is against the noble earl, as in every country where that has been tried, it has uniformly produced the most ruinous effects. … The great security of our paper currency, and that which constitutes the important difference between it and the paper currency of other countries is, that it is issued by an individual banking company, or by individuals for the sake of their own interest. The Bank of England would no doubt be willing to accommodate the public service, but they could refuse to issue their notes, and whenever they acted on any ground other than their own interest, it would be the first step to their ruin.”

Liverpool drew a very important distinction, between a privately-owned and profit-oriented Bank of England, then very independent of the government, issuing bank notes and the state itself doing so. In Liverpool’s view the state that issued bank notes would naturally issue too many notes, as the American colonists had done with the Continentals and the French Revolutionaries with the assignats. Only in the 20th Century, with Keynesian economics and a public much more inclined to believe in the competence and power of its government, did states come to issue notes, either directly or through a state-controlled central bank, which comes to the same thing. The Bank of England had already become the government’s poodle by the start of the 20th Century; by its nationalization in 1946 it officially became the government’s stuffed poodle.

For 25 years after World War II, the Bretton Woods system allowed everybody to pretend that currencies were linked to gold. This allowed governments to inflate their currency, to a truly disgraceful degree in Britain’s case, but it built up confidence in paper money among the public. Then in 1971-73, the world went to a system of floating exchange rates, with no longer any nominal anchor to which its currencies were tied. For its first decade, this new system had the effect you would expect, with inflation gradually increasing year by year in an apparently uncontrollable manner.

Then in 1979 the great Paul Volcker took over at the Fed and proved that if you had Paul Volcker controlling the central bank, and a President who allowed him to get on with it, a central bank could indeed bring down inflation and restrict it to a modest level. Once Volcker left the Fed, after a few years of good behavior, Fed chairmen started to inflate the money supply again as though they had learned nothing from the 1970s, let along from the earlier Continentals and Assignats fiascos.

That policy of over-issuance of money has been repeated worldwide, as has another policy that would have been anathema to Liverpool or any of his 19th Century successors: losing control of public spending so that deficits grow ever larger and the debt to GDP ratio spirals to infinity. President Trump has been little help on this front in the United States; the omnibus budget bill signed last February added $296 billion to spending in just one year. Trump’s tax cuts have increased the deficit in the short term, but may pay for themselves over the medium term, since it is now clear that they have sparked a period of faster economic growth, while productivity growth has been reawakened by the rise in interest rates. In Britain, the “austerity” of the last eight years, which has brought deficits down only achingly slowly, has now been abandoned, with more hard-earned taxpayer money being poured into the bottomless pit of the National Health Service.

It is very clear that the U.S. economy is now running close to full capacity. What’s more, there is a huge overhang of dead investment, 24 years of Schumpeter as I described it last week, which must be cleared out of the system – and that dead overhang exists throughout the rich world, because all countries have followed the same dead-end monetary policies. Hence at some stage there will be a recession, and when that occurs public sector deficits, already bloated, will spiral off towards infinity. The point at which public debt becomes impossible to refinance will vary from country to country – in Japan and China that point could come as early as next year. However, by 2030 at the latest we will be faced with a mass worldwide default on public sector debt, probably accompanied by an uncontrolled surge in inflation and certainly by a worldwide loss of confidence in fiat currencies.

We will then have to revert to Stuart finance. With government bond markets worldwide having defaulted, the world’s governments will no longer be able to finance persistent deficits, any more than the Stuarts could. The reason for the Parliamentary sitting which Guy Fawkes attempted to blow up was that James I was being forced to go to Parliament and beg for money, since his traditional revenues were inadequate for his needs (they were mostly set at nominal amounts, and inflation had reduced the value of money by three quarters in the previous century.) It wasn’t the military-industrial complex that forced him to do this; James I, the most timorous of monarchs (not unreasonably; apart from Guy Fawkes’ plot the Gowrie Conspiracy of 1600 had attempted to assassinate the entire Royal family) was an ardent pacifist. There was no standing army, and the navy that had defeated the Armada in 1588 was rotting to pieces on seaport beaches.

Eventually, the Stuarts solved their revenue problem (not without Parliament starting a Civil War and executing the inoffensive and artistic Charles I.) They established colonies in North America and the West Indies and grew addictive products there – tobacco and sugar – which could be sold for huge markups in European markets and taxed heavily on their way through Britain. By the 1680s, Royal finances were in good shape in time of peace, even with a modernized, non-rotting Navy. The Bank of England and the National Debt were invented by William III and the Whigs in the 1690s simply so they could involve the country in endless unnecessary wars.

Once the world’s currencies have lost people’s confidence and the world’s government debts have defaulted, our impoverished successors will be faced with the problem of the Stuarts. They will doubtless be threatened with random plots to blow up Congress, which they will have great difficulty thwarting, since the armed forces, the FBI and the CIA will all have been de-funded and replaced by a dozen chaps with feathered hats and match-lock muskets from the Smithsonian.

There is however, a 21st Century equivalent of sugar and tobacco which will be available as a source of revenue – Internet advertising. Millennials are as addicted to Facebook and Google as their ancestors were to sugared candies and pipes of Virginia tobacco. Hence a tax on Internet advertising will raise revenue that is at least sufficient for a peacetime 17th Century-style government, complete with a palace or two and modest patronage of the arts and sciences but no defense budget and no entitlements or healthcare spending. (Free leeches will NOT be available on Medicare.)

Containing as it did Shakespeare, Newton and Francis Bacon, the British 17th Century was the most creative period in the history of mankind. It will be good for us to return to that simpler, small-government time, though the process of doing so will doubtless be painful. Given current policies worldwide, such a return is however inevitable.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)