The Bear’s Lair: What Liverpool could teach today’s Fed

Robert Banks Jenkinson, Lord Liverpool, said it best, in a House of Lords speech of May 26, 1818: “The tendency of an inconvertible paper money is to create fictitious wealth, bubbles, which by their bursting, produce inconvenience.” His phrase “fictitious wealth”, or better “fictitious capital” has a similar (but not, as I shall explain, identical) meaning to the Austrian economists’ “malinvestment” a century later, yet it is in eloquent English, not the made-up word of droning German-speaking professors. We should recognize Liverpool’s priority, and follow his economic thinking.

Liverpool elaborated somewhat on the “fictitious capital” idea in the debates on returning to the Gold Standard the following year: “the consequence of (the paper money system on which Britain had operated since 1797) is too often an encouragement to speculation, to unsound dealings, to the accumulation of fictitious capital; from all of which, in the course of a given number of years, a greater quantity of evil would probably accrue than of real advantage.”

According to Google’s admirable “Ngram Viewer” search system, the use of the term “fictitious capital” peaked in those years of 1818-21, very probably as a result of Liverpool’s use of the term – he was, after all prime minister and First Lord of the Treasury at the time, responsible for the organization of Britain’s financial system. There was then a second peak in the early 1840s, perhaps resulting from the railway speculations in those years, after which the term was quiescent until the inflation of World War I, finally resuscitating to a steady level of usage (but lower than in 1820 and the 1840s) after World War II.

Interestingly, Liverpool as a young man may have been the effective originator of the “fictitious capital” term. The earliest reference in the Google database is in the Monthly Review of December 1793, a publication for which we know Liverpool’s father, the first Earl, wrote in the 1750s. The passage describes the speculative trade from the 1793 inflation due to the war as being “likely to engross our whole commercial capital, and exchange it gradually for currency of imaginary value” – it then describes this “fictitious capital” as being the cause of the country bank bankruptcies of that year.

Liverpool and Ludwig von Mises, a century later, agreed about the effect of excessive issues of paper money. However, their terms used to define the problem are subtly different. “Malinvestment,” the Austrian-economics term, suggests that foolish actors in the economy are through delusion making bad investments, which then need to be liquidated. “Fictitious capital” in Liverpool’s sense of the term, suggests that in a funny-money economy, much of the capital may not be real at all. It is not the result of foolish decisions made by economic participants who in a better-run economic system would be more sensible; it is a figment of the imagination.

Both Liverpool and von Mises would be in total agreement that the monetary policy of the last 24 years has been extremely foolish, and consequently could be expected to have led to gigantic amounts of malinvestment or fictitious capital. Interestingly, while both would expect an unpleasant experience at the end of the process, that experience would differ between the two analyses. Von Mises’ malinvestment would require to be liquidated, requiring a lengthy legal and bureaucratic process and physical destruction of unwanted assets. Liverpool’s fictitious capital, on the other hand, being fictitious, would simply disappear. One day the bubble would burst, and the economy would immediately be without the fictitious capital, with no physical or legal destruction process needing to take place.

Under von Mises’ analysis, a lengthy period of destruction and rehabilitation would occur, taking perhaps as much as a decade in an extreme case – the 1930s being the best-known example. Under Liverpool’s analysis, the fictitious capital would disappear immediately, and provided there was enough real capital left, the economy would right itself in a few months – as it did in 1826, after the banking crisis of 1825, or in 1721, after the bursting of the South Sea Bubble.

Look around today’s economy, and you will see many examples of assets that are not just malinvestment, but fictitious capital. For example:

  • New York, San Francisco and London apartments and townhouses. The assets are real enough – indeed, some of the London ones have been around since Liverpool’s day – but the valuations are fictitious. If apartments in those three cities typically go for $5 million, and in a Gold Standard economy with today’s overall price level would go for $500,000, then the extra $4.5 million is fictitious capital. It’s not malinvestment; many of the residences were built long before current monetary policies, and most of their current inhabitants bought the apartment to live in rather than as a speculative investment. However, when the crash comes the $4.5 million will disappear. Needless to say, any mortgage debt won’t disappear in the crash; such of that as defaults was genuine malinvestment by the lender.
  • Many Fortune 500 Corporations like Boeing (NYSE:BA) have bought back all their equity, and are now operating entirely on fictitious capital, with no book net worth and only the buoyancy of the stock market preventing insolvency. Their disappearance in a downturn may be very sudden.
  • In the tech sector, companies such as Uber Technologies Inc. (NYSE:UBER) that have achieved larger market capitalizations ($75 billion currently for Uber) or private market valuations with no profits and no likelihood of making profits in the short term are clearly fictitious capital in Liverpool’s sense of the term, and will disappear altogether in a crash. There is no non-bubble reason for their existence.
  • “Intellectual property,” most of which is carried in companies’ books as if it represented real value, but which in reality is worth only what lawyers can extract from competitors, will collapse in value in a downturn. In the case of the Walt Disney Company’s (NYSE:DIS) properties, the assets will be fictitious in every possible sense, since they represent the value of fictions.
  • Global warming assets, such as wind power and solar arrays that rely on subsidies to participate in the electric power grid, are fictitious assets, being based on the fiction of planet-threatening global warming. Once the crash comes, these plants will be switched off; the world will no longer be able to afford the subsidies and will no longer believe the fictions of the global warming extremists.
  • Crypto-currencies – the world economy has now demonstrated the power of fictitious assets by inventing $300 billion of assets that don’t even pretend to have any reality.

In 1929’s highly manufacturing-oriented U.S. economy, the majority of bubble assets were represented by malinvestment; if an unprofitable automobile company was created, it was a conscious investment decision and its bankruptcy left large physical assets in plant and equipment. In today’s intellectual-property-oriented economy, with much manufacturing outsourced and few hard physical assets, the majority of bubble assets represent fictitious capital. When the bubble bursts they disappear altogether.

Liverpool’s 1825 British economy, which beyond the agricultural sector was heavily oriented towards trading and services was more like the modern U.S. economy than the manufacturing behemoth-ridden U.S. economy of 1929. There were as yet few substantial factories and few machines, and bankruptcies tended to occur in the financial and services sector. Indeed, agriculture itself was a substantial source of fictitious assets; if as in 1810-14 farmers over-planted, cultivating land that was uneconomic at post-bubble corn prices, that land simply was allowed to go fallow and had essentially no residual value or use.

When the current “funny money” bubble bursts, the fictitious assets in the economy will disappear, leaving no residue of redundant factories. If governments avoid attempting Keynesian fiscal or monetary stimulus, the downturn will be blessedly short, as in 1826 after the 1825 crash. Unfortunately, the experience of 2008 shows that such nineteenth century self-restraint on the part of governments is very unlikely indeed. Any prolonged depression will then be the result of governments’ wrong-headed to attempts to cure it, and not of the collapsed fictitious investment, which will leave simply voids, into which other non-fictitious competitors can move.

Liverpool, as part of his claim to be Britain’s Greatest Prime Minister, was by far the most sophisticated thinker among senior politicians of the nineteenth century. Since British economic policy in the 20th and 21st Centuries has been distinctly less successful than in the 19th, it makes sense that we can still learn from him today. The concept of “fictitious capital” and the implications of that concept in today’s world are his lesson.

(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.)