Thinking about Evolution & Economics and Some Notes on the Natural Selection of Ideas
Part 13 - The strange tale of instinctive Moral Sentiments, rent seeking Parasites & Predators, Comparative Advantage, Total Factor Productivity & the invisible hands of Creative Destruction ... or risks, rewards & money flows?
Banking, Business Cycles & Balance Sheets.
Now God said, and I agree with him - 'a fool thinks he needs no advice, but a wise man listens to others ...'
So where did all this wealth creation & economic growth come from? And why growth? Why was there no steady state where all things bright & beautiful just existed? ... or did the 2nd Law of Thermodynamics have anything to do with it?
Hmmmm ... well, stuff always seemed to be happening ... and there always seemed to be patterns & even a direction to the happenings ... they were never random, there were always those wretched patterns, shapes & trends ... even if trends were just towards growing complexity?
Soooo ... if all the happenings evolved, then they were inherited & connected, but always inherited with random variations ... the 2nd law saw to that ... and then some of the variations differentially survived creating new possibilities for interconnections ... and you can't have inheritance with new interconnections without growing complexity in the population of happenings ... can you? ... think about it? ...
But folk never understood this complex complexity business ... no wonder ... the 2nd law of thermodynamics made two things indisputable & certain -
the future was inherited from the past but it was different because entropy had increased and
it was impossible to know in advance which new differences would survive because they were new differences ... if you get the drift ...?
... this was a double whammy ... change & ignorance ... but all was not lost because there were always those wretched patterns as entropy increased ... were these the patterns of 'micro states' which Boltzmann discovered in 1872?
So the show was on the road ... it seemed as entropy increased, novel structures emerged & some survived & interacted ... and some of these structures were in the brains of folk and they led to strange behavioural traits & strange beliefs ... and, perhaps, economic behaviour emerged because uneconomic behaviour died out ... nobody could afford to pay the bills. It was like the giraffes long neck, it was not the whim of Kings, but the slow death of short necked giraffes.
So perhaps economic systems evolved by natural selection and vaguely emerged from the mists of deep history ... as folk recognised & remembered patterns & learned, that's how folk survived ... folk learned by generating ideas & testing out new behaviours and remembering what seemed to work. They discovered & accumulated a bit of 'know how' ... that's what folk with brains did ... so this 'know how' must have been something to do with what was going on in folk's heads ... was this the dissipation of energy through neural pathways as entropy spontaneously increased? ... or something else just as bewilderingly complex? Was all this change driven by the 2nd law? ... after all this was the only known law of nature that had direction? ... there was no alternative explanation? ... what else could the change in 'know how' be? ... what else could Darwin's 'tree of life' be? ... what else could anything be?
... unless ... a supernatural omnipotent God did it all by himself!
But nobody knew ... folk were mainly ignorant ... ignorant of what it was they didn't know ... it was always very difficult to admit that nobody knew what was going on ... wasn't it?!
Unsurprisingly, mere mortal understanding of this immense complex complexity was an arrogant conceit, understanding always hurt the brain for very good reasons -
the behaviour of folk themselves was an integral coevolving part of a damned complex whole shebang & caboodle which emerged
complexity, change, conflict & scarcity were always associated with the emergence of any useful behaviour
innovative behaviour was always unexpected by definition, an unintentional bifurcation & discontinuity
bottom up natural selection was not designed, the process only worked because failures didn't survive and folk always found it difficult cope with failure, especially the Bishops, Princes, Generals & Bureaucrats who always thought they knew better
the universal human emotion of intention & purpose always felt 'as if' it were an imperative top down design ... ask Rene Descartes ...
and invariably the pre Darwin interpretation of history described a top down intelligent design ... there was no known alternative ... was there?
No wonder folk assumed things were designed by someone clever ... an omnipotent ... no wonder there was a God behind every tree?
Then in 1859 Darwin suggested that history was different. History was a bottom up emergence of increasing complexity ... inheritance with modification & differential survival ... Darwin focused on death not design!
In this way, perhaps, the universal assumption of human 'intention' was itself a remarkable survival aid ... an adaptation ... an attempt to make sense of the world, to understand, to explain, to rationalise human behaviour 'as if' a top down design? A strange paradox became apparent ... a strange inversion of reason ... maybe survival chances were increased if omnipotent design conspiracies were believed?
Imagine if somebody really was controlling economic activity? ... maybe in the basement of The Bank of England? ... if folk could 'control' economic activity they could make things better? ... would such a belief make folk -
arrogantly seek power (hubris)? ... or
apathetically blame the 'powers that be' (nemesis)? ... or
inspire them to work hard & experiment to discover for themselves what works (catharsis)? ...
... take your pick ... or maybe all three are involved ... depending ... hubris, nemesis. catharsis.
So some folk learned to go with the flow as dissipating energy flowed into new structures, riding the pathways 'as if' trying hard to survive ... trialing & erroring ... and, maybe, energy dissipation pathways in the brain were just like energy dissipation pathways in steam engines? There was nothing supernatural about steam engines ... so why should there be anything supernatural about brains?
And so, back to economics, the connection was clear because steam engines powered the economics of the Industrial Revolution!? ... yes?
And for sure the Industrial Revolution was all about folk who used their brains and discovered new physical structures - Henry Cort's reverberatory furnaces, Abraham Darby's cast iron pots, Richard Arkwright's cotton gins, Thomas Telford's bridges and Josiah Wedgwood's delicate pottery ... then burgeoning cites, and more & more folk ... an explosion of new physical structures, an explosion of complexity ...
The Industrial Revolution was a spectacular example of wealth creation and it became the focus of attention for the classical economists ... ask Adam Smith, David Ricardo, Thomas Malthus and Karl Marx about wealth creation? ... they all grappled with the stupendous puzzle of economic growth. What on earth was going on? ... they didn't know ... how could they? If this was evolution driven by the 2nd law then neither of these ideas were even half baked until much much later ... natural selection 'just happened' without anybody knowing about it ... as it had done for eons & eons before before ...
So it came to pass that after 1859 one or two economists started to change their assumptions, suppose happenings did evolve ... suppose -
economies were complex adaptive systems, 'designed' by a process of Darwinian natural selection - a process of inheritance with random modification & differential survival where what survived into the future emerged & was unknowable and us folks were just one part of the complex coevolving whole shebang & caboodle.
Once this penny dropped, the understanding of history and economics changed fundamentally and a stream of exciting new insights emerged ... so here we go ... let's accept the mind boggling complex complexity and just assume for the moment that Darwin was on to something ...
Adam Smith's astonishing anticipation of Charles Darwin - Moral Sentiments & Wealth Creation
Gluts & Queues, Supply & Demand
In 1776 a giant arrived on the scene, Adam the Smith explained all about the industrial revolution and the wealth of nations, there was no omnipotent, no supernatural conspiracy. Self sustaining economic growth was just a hard reality, another product of evolution.
The industrial revolution fed on survival 'know how' from synergies associated with social interactions as folk cashed in on specialisation & scale ... everyone beavered about doing deals as they learned more & more specialised skills and lived in larger & larger groups ... after all there was no point in specialising if you didn't exchange your skills with your mates ... and everyone knew about the more the merrier and economies of scale.
Adam the Smith told stories of synergy, specialisation & scale - increasing returns in pin factories where 'division of labour was limited by the extent of the market', a positive sum game of 2 + 2 = 5 ... but most folk thought Adam was an academic joke when he talked about supply & demand where market prices cleared the goods and gluts & queues disappeared ... 'as if by an invisible hand which was not part of intention' ...
But how were these miraculous clearing prices fixed? ... who was in charge? ...
In 1859, 83 years after Adam wrote his stories, Charles Darwin explained the process of natural selection ... perhaps this was the answer ... measured by trusted quids, bobs, tanners & pennies, millions of folk all over the place did deals which were part of an endogenous economic system which was orderly and seemed to work? It was uncanny ... a system which seemed to work without orchestration by Bishops, Princes, Generals & Bureaucrats ... no one was in control!
Funny word - 'endogenous' ... economists used it all the time, one dictionary defined it as -
'originating, internally from within, without external cause' ... folk had to learn what endogenous meant otherwise 'evolutionary economics' was a mystery ...
Of course lots of folk had lots of ideas about what was going on and who should do what, where, when & with whom, and lots of folk had lots of ideas about prices especially the Bishops, Princes, Generals & Bureaucrats who always wanted them higher or lower depending on the state of their own coffers ... but they would say that wouldn't they? But always when anyone tried to fix prices the gluts & queues appeared and always when market prices emerged the gluts & queues disappeared 'as if' ... by an invisible hand?
In 1874 Leon Walras added to the general confusion by developing sophisticated mathematical models which showed not only how potato markets cleared but also how all markets were interconnected and how all markets cleared ... if the prices were right. But Walras, like everyone else, had no idea how the prices were fixed. Some thought the excruciating puzzlement must have affected his brain when he suggested a mythical auctioneer was in charge of the process, he even added a new word for students to learn - 'tatonnement', prices were fixed by 'groping'? ... what madness was that?
In this way Adam's invisible hand was an astonishing anticipation of the Darwinian nature of economics. Much later it became clear to some folk that market prices weren't fixed by anyone and folk like Richard Dawkins even wrote that genes themselves did cost / benefit analysis ... otherwise they wouldn't have survived! ... just as the giraffe's long neck resulted from the death of the short necked variety ... prices that weren't right died out ... nobody could afford to be lumbered with the costs of useless gluts & queues, so they didn't! Could it be that some genes evaluated marginal utility & opportunity cost better than their competitors? Cost/benefit analysis by genetic chemistry? ... more madness?
In the face of all this mind boggling complexity folk did the only thing they could, they beavered away and trialled & errored, hoping for better deals at better prices, chasing profits and cutting losses ... more deals, more synergy, more specialisation, more scale, more wealth creation & economic growth ... but inevitably more complexity, more change, more conflict, more scarcity ...
But trial & error always seemed to involve almost as many errors as trials. So what happened when the Gods were angry and the ship sank? Why did it all go wrong so often? Who was to blame for all the ruin if no one was in charge? Why weren't synergies involved in all deals? ... were bad deals legal?... and what was a deal anyway? ... was a handshake a deal? ... was a word a bond? ... and what was a tort? ...
But Adam the Smith had already fired his second barrel. 'The Theory of Moral Sentiments' put in place the second piece of the jigsaw puzzle. Folk were social animals and the search for survival synergies was driven by instincts, by ancient unconscious emotions, survival networks & circuits deep down in the skull were mediating decisions about deals ... deals that involved trust & cooperation. Adam's insight was dramatic ... even at the right price no deals would be done without trust. There was always a counter party risk to every decision ... even when choosing a wife ... or a boyfriend!
So all this economic growth was an interactive social affair, there were two sides to every bargain and the instinctive moral sentiments associated with rights & obligations were a vital part of every deal. And when trust was reinforced by a generally accepted system of Tort Law, folk seemed to have an insatiable tendency 'to truck barter & exchange' ...
Doing deals was a cooperative affair where clearing prices and moral sentiments got rid of those dreadfully expensive gluts & queues ... he knew a thing or two did Adam!
Adam wrote about his double barreled explanation of economic growth -
'Theory of Moral Sentiments' in 1759 - no trust, no cooperation = no deals !
'Wealth of Nations' in 1776 - no deals = no synergy, no wealth creation !
... it seemed both barrels were necessary ... Adam was on the ball -
no trust no exchange
no exchange no synergies
no synergies no survival
Adam was describing the industrial revolution and a new general theory of evolutionary economics ... but evolution was unheard of and Adam Smith was a moral philosopher not an economist ... in 1996 Paul Krugman suggested the ideas of trade & evolution were very difficult to grasp ... economics was NOT associated with -
laissez faire where selfish greed was thought to be the behavioural norm ... evolutionary economics stressed freedom within the law, no one, not one, not no one was free to harm others ... hard work, honesty & thrift were involved ... the folk markets were accountable human beings facing the consequences of their deals ... regulated by moral sentiments ...
mercantilism where wealth was thought to be accumulated gold (or stolen! or taxed!) ... evolutionary economics stressed technological 'know how' where wealth was production and value determined by folk in free exchange markets ...
In this way folk's salvation lay in doing deals with their mates as everybody depended on everybody else and everybody tried to imagine & secure mutual benefits - real productivity growth in the real world, real wealth creation, real economic growth as billions of deals all over the world were sealed in the hope of discovering synergies ...
But, of course, nobody said it was easy, there was complexity, change, conflict & scarcity and more -
always hopeless trust busting failures ... as nobody knew in advance which deals would be profitable ...
always expensive gluts & queues ... as folk persistently tried to fix prices ...
always heinous predators & parasites ... as moral sentiments were never straight forward, there were plenty of folk around who tried to secure wealth by theft ...
always arrogant Bishops, Princes, Generals & Bureaucrats who thought they knew better ... as tax (the premium) was paid for protection (the insurance) ... moral hazard escalated as failure were bailed out ...
Funny words - 'moral hazard'? ... another of those strange phrases economists used? ... one dictionary defined it as -
the lack of any incentive to guard against risk when a deal exists to protect against it ...
And keeping track of all the myriad exchange deals and synergies was a nightmare ... who owed how much of what when to whom and where how? ... and who benefitted? ... where was the synergy? ... how was it measured? ... who trusted who? ...
Things were getting real complicated ... but, of course, that's what evolution did, it always made everything more complicated ... and such complexity beggared belief ... the crunch was that nobody knew the 'right' price that cleared the markets ... clearing prices had to be discovered by trial & error, they emerged ... so how did folk decide which deals were a good investment? ... did a company Balance Sheet help? ...
Free Trade, Opportunity Costs
Synergies of Specialisation & Scale and the mystery of 'Comparative Advantage'
By 1815 David Ricardo had learned all about the synergy benefits of specialisation & scale and the money flows which tracked them but he was sorely troubled by the English Corn Laws. It seemed folk preferred the diminishing returns from the Corn Laws to the increasing returns from the pin factories? Opportunities were being missed ... and that was a cost economists called an 'opportunity cost' ...
Ricardo felt the most odious of the parasites & predators were the rent seekers who didn't bother to search for synergies but resorted to theft to fill their coffers ... they 'cut themselves a bigger slice of the cake rather than making the cake bigger'. Protectionist import tariffs were all the rage and reflected this mercantilist worldview which encouraged greedy Bishops, Princes, Generals & Bureaucrats (and many irate folk as well) to succumb to an irresistible urge to accumulate riches without synergies, a zero sum game of 2 - 2 = 0 ... why bother with risky innovation & work if you could preserve your cosy earners and monopolies of yesteryear and blame somebody else for any losses & misfortunes? ... given half a chance the rent seekers always blamed the entrepreneurs with their risky wealth creating innovations and tried every ruse possible to confiscate their surpluses ... especially if the entrepreneurs were distant strangers overseas ... (or hated Jewish bankers?) ...
Were the rent seekers lost in a mire of envy & greed? ... or did the protection of the Corn Laws really help the economy?
The Corn Laws were a demand for the impossible - the protection of privileged farmers from risk & competition, protection from change & economic growth ... there was much head burying and renting of cloth but eventually in 1846 the Corn Laws were repealed ... but Ricardo knew most folk still didn't get it ... the farmers benefitted from the output of the factories, that's why they bought Darby's pot & pans and Wedgwood's cups & plates ... the workers benefited from the higher wages in the factories, that's why they flocked to the cities for jobs ... and the strangers overseas benefited because if they didn't export their corn they couldn't import the mass produced factory output of cheap, high quality goodies ...
Perhaps 'comparative advantage' was a confusing description ... especially when arrogant folk thought some of the strangers overseas were quite backward and inefficient ... how could they possibly produce anything better than us? ... especially with all those transport costs? ... folk understood absolute advantage and how the fastest runners won the race, but the idea that downtrodden folk folk could benefit in the economic rat race was a bit of a stretch ... but that was the way evolution worked ... genes cooperated to survive ... mitochondria cooperated in eukaryotic cells and all the giraffes ended up with long necks ... but back came the protectionists ... how could everybody benefit? ... somebody must be screwing somebody? ... there's no such thing as a free lunch? ... and why couldn't prices be fixed to protect folk from unfair competition? ... surely all they had to do was pass a law? ... but weren't there already laws against stealing and weren't parasites & predators already outlawed? ... and what exactly was it that was unlawful? ... what was 'protectionism'? ... and how was who manipulating whom? ... it just didn't make sense ... 'comparative advantage' remained an unfathomable mystery ... it really was a puzzle ...
He tried to make it simpler ... it was profitable for different folk, in different places, at different times with different opportunity costs to trade their wares and cash in, so that's what they did ... not winners and losers but mutual benefit because anybody, in any place, at any time could generate the next good idea and trade it, opportunities were not restricted to a chosen elite... trade was a double hit -
everybody benefited 'cos synergies involved wealth creation
everybody was included in 'cos everyone had different opportunity costs ...
Ricardo was reduced to tears and endless repetition of ... hard work, honesty & thrift ... synergy ... 2 + 2 = 5 ... 2 + 2 = 5 ... 2 + 2 = 5 ... 2 + 2 = 5 ... but the concept of 'comparative advantage' remained elusive ... most folk just didn't get it ...
Ricardo had seen it all before ... a strange failure to learn from history ... he mused that some folk would never understand the benefits of free trade from the economic synergies of specialisation & scale ... just as folk never understood the moral & mutual financial benefits of credit & interest which flowed from overturning the Act of Usury way back in 1625 ... ?
Years later economist Paul Samuelson was still trying to teach perplexed students about Ricardo's principle and mused that -
'thousands of important and intelligent men have never been able to grasp the principle of comparative advantage or believe it even after it was explained to them'.
The sages at The Open University had another go in 2000 -
'the principles of comparative advantage and gains from trade are the most important results in the whole of economics. They apply at national, and also individual level. If each specialises in the activity in which they have comparative advantage and engage in trade they are both better off than if each tries to be self sufficient'.
Evolution by natural selection was a natural process of innovation & growth ... an unstoppable process of discovery & accumulation ... so folk went with the flow ... driven by emotions deep down in the skull and the rights & obligations of ancient customs ... hard work, honesty & thrift ... underpinned by moral sentiments, controlled by invisible hands ... everybody participated simply 'cos everybody could benefit ... but were the benefits measured by the audited Balance Sheets of companies? ...
Marginal Utility, Technological 'know how'
The missing Factor of Production and the enigma of 'Total Factor Productivity'.
In 1967 Robert Solow was awarded a Nobel Prize for his effort to explain the extent of our economic ignorance and he gave it a new name - 'total factor productivity' ... were economic analysts really ignorant? ... they would never admit it ... would they? ...
Robert looked at the figures ... it seemed wealth was being created on average at around 3% pa, most of the audited Balance Sheets agreed on that ... but what were the Balance Sheets measuring? ... the classical economists never agreed amongst themselves ... what was wealth? -
David Ricardo's scarce land?
Robert Malthus' multiplying labour?
Karl Marx's class capital?
... the figures looked very odd ... wealth didn't seem to be about any of the traditional factors of production ... there seemed to be another significant factor involved which dwarfed all the rest?
The neo-classical economists had always considered technological 'know how' & social 'know how' to be an exogenous black box. But Bob Solow now suggested technological 'know how' was driving economic growth ... wow! ... this insight reverberated round the economic scholars ... no wonder he got a Nobel Prize ... all that effort to commandeer resources and legislate wealth and the answer to wealth creation and economic growth was 'know how'? ... and what mattered was new 'know how', innovation, which, by definition, couldn't be purchased off the shelf ... infuriatingly, there were no specifications, no blue prints and no instruction manuals for innovation ...
There was a real problem now ... for eternity Bishops, Princes, Generals & Bureaucrats had claimed credit for their policies which created wealth ... Roman Emperors had dictated prices & shot messengers, Prime Ministers had 'saved the world' & eliminated 'boom & bust' and American Presidents had 'New Deals' & 'Great Societies' ... all were futile attempts to 'fix prices', 'pick winners' and 'beggar-thy-neighbour' as a blizzard of dirigisme was unleashed ... but all the time it was technological & social innovation which moved us out of the pits ... it seemed neither instructions nor entreaty were very helpful ... after all innovation was ... errr ... new!
Don't get me wrong Bishops, Princes, Generals & Bureaucrats could have good ideas ... but not as often as the millions of folk they tended to tyrannise & oppress ... it was a matter of statistics not 'sound judgement' ... more folks thinking more chance of a good idea ...
But this new fangled idea didn't sink in ... it was not 'resources' nor 'money' that aided the survival of folk but technological & social 'know how' ... how counterintuitive was that! ... but Darwin himself said adaptation 'was an awful stretcher' ... perhaps economists themselves added to the confusion when they talked about missing factors of production and measures of ignorance ... 'Total Factor Productivity' was another stupendous puzzle for most folk ...
The whammies mounted ... not only was it real difficult to teach folk that market prices removed gluts & queues and that comparative advantage generated trade & mutual benefit but also that unpredictable innovation was driving growth ...
The new insights were cataclysmic! How was innovation encouraged and how was interference with prices, valuations & exchange rates stopped? ... surely there was a way of helping folk? ... and the problem was getting worse as the Chinese were now in on the act with those darned surpluses ... who were they helping? ...
But if 'know how' could not be produced by soothsayers in their closets, could the benefits of ephemeral 'know how' be measured by company Balance Sheets? ...
The disturbing notion of 'Creative Destruction' & Counterintuitive Evolution.
How to find a way out of this quagmire? ... how to tie it all together? ... it seemed honest introspection was required ... maybe folk had to go with the flow of the 2nd law, moral sentiments, comparative advantage & total factor productivity ... but these concepts were all very difficult to get your head around ... invisible hands ... jeez ... and if it was all about natural selection, why bother to do anything at all?
Of course intractable global problems had always existed - complexity, change, conflict, scarcity ... and there had always been ignorance about the solutions ... omnipotent design was plausible but omnipotent power always seemed to lead to corruption and the associated tax burden had become a nonsense ... bribing one interest group with other people's money ... this was rent seeking with no synergies in sight ... 'fixing prices', 'beggar-thy-neighbour' and 'picking winners' didn't work they just encouraged folk to forget hard work, honesty & thrift ... some economists called it 'moral hazard'? ... it's that phrase again? ...
But help was at hand ... as long ago as 1942 Joseph Schumpeter had sussed out economic growth and the associated cycles of booms & busts, Kondratieff Waves and Business Cycles, he called it 'creative destruction' ... but perhaps the ancient Greeks had cottoned on to the process yea
rs ago as the phoenix rose from the ashes? ...
So it came to pass, as they struggled to solve the puzzle of wealth creation & economic growth, some economists changed their focus from the static equilibriums of neo-classical theory to progressive change and creative destruction ... they opened up the road to Paul Romer's 'Endogenous Growth Theory' of the 1980s ... perhaps endogenous was just another name for natural selection? ... perhaps neo-classical analysis using exogenous variables was a misleading simplification which introduced new distortions as theory effected policy? ... for sure economists themselves & their theories were part of natural selection as everything interacted with everything else ... so nothing could be exogenous ... could it? ... think about it ...
Nevertheless most economists remained locked into unrealistic assumptions and bum predictions ... so Joe Schumpeter started shouting -
'the essential thing to grasp is that economic growth is an evolutionary process'!
... weeding out failures? ... but, of course, the louder he shouted the fewer folk listened ... in any case the maths in the classical economics textbooks couldn't cope with the dynamic iterative changes of evolution ... it was the introduction of personal computers which performed extensive iterative calculations that sorted out the maths and demonstrated Darwin's power of time & natural selection ...
But the perennial gales of creative destruction were everywhere ... unleashed by technological & social innovation - new markets, products, equipment, sources of labour and raw materials - new methods of organization, management, inventory systems, transportation systems, communication systems, methods of advertising & marketing, financial instruments, legal strategies and even new ways to lobby politicos ...
Schumpeter's heroes were the entrepreneurs ... hitherto unconnected connections ... the creators of new technology and the destroyers of obsolete technology ...
But deep sorrowful emotions welled up every time a short necked giraffe died, folk got frightened when they killed off failures, bankruptcy was a no no ... everyone wanted everything to survive ... but that of course was impossible ... it was always the kids that survived not the old men ... funny that? ... and more kids seemed to survive when they got excited about technological innovation ... the trouble was no one liked destruction and 'creative' destruction just didn't make sense, so talking about creation and destruction in the same breath was heresy, Joe became a pariah, he was hated ... but more and more help was at hand
Thomas Kuhn wrote his epic ‘The Structure of Scientific Revolutions' in 1962 where he suggested the progress of science followed the same process of creative destruction as obsolete paradigms were replaced by new, as paradigms shifted ... phlogiston was scrapped for oxygen and Newton's gravity was supersede by Einstein's version. 'Know how' itself evolved the same way ... by natural selection as failures were killed off! And Karl Popper proposed all 'proper' science was falsifiable.
Interestingly most folk missed the essential mechanism of Darwin's natural selection over time - changes in population frequency as failures were weeded out ... without the destruction of failures there was no space nor time for the better alternatives to grow ... economic boom required the clear out of economic bust ... but it was difficult and 'creative destruction' remained a paradox and yet another stupendous puzzle ...
60 years after Joe's impassioned plea the scientists had learned a lot more about the process of evolution and more & more of them accepted that Darwin's idea was powerful enough to explain everything, including economics -
creativity was destruction
innovation was 'know how'
Evolutionary scientists & economists began to suspect that Schumpeter's cycle of creative destruction involved real energy flows which generated real emotions which mediated real decisions which created real innovations which were accompanied by real money flows ... the whole shebang & caboodle from genes, to brains, to theories, to policy, to actions was an evolving interconnected whole ... emotional cycles, activity cycles, business cycles, credit cycles ... nothing new ... just one damned innovation after another ...
The deep point about the evolutionary process of creative destruction, was that the cycle of boom & bust was the result of a cycle of emotions ... a cycle of chemistry in the brain ... a heady mix of testosterone & dopamine, in diverse proportions, a chemical cocktail which triggered the firing of neural networks ... choices of behaviour to try out ... deep deep down in the skull there were competitive emotions of excitement & fear as neural networks & circuits drove emotional flip flops which generated a diversity of ideas, which resulted in innovation actions some of which were successful as old 'know how' was replaced by new 'know how' ... endogenous emotions created diversity ... this was not about exogenous plans & instructions, but better described as Keynes' 'animal spirits', Greenspan's 'irrational exuberance' and FDR's 'nothing to fear but fear itself' ...
Here then was the essence of the evolutionary reality of economics, cycles of emotions inspired cycles of innovation -
Optimism - Excitement - Thrill - Euphoria - Suspicion - Anxiety - Denial - Fear - Desperation - Panic - Capitulation - Despondency - Depression - Hope - Relief - Optimism ...
Crucially the emotional cycles were way beyond the control of Bishops, Princes, Generals & Bureaucrats ... all these soothsayers were, of course, an integral part of the evolving whole shebang & caboodle, influencing activities and creating waves but all the time they were ignorant of outcomes ... the powers that be just trialled & errored like everyone else ... not easy to accept, is it? ... after all some folk had sound judgement? ... sound judgement about the future? ...
In this way folk were driven to experiment, 'to truck, barter & exchange', whenever & wherever they saw an opportunity to discover & accumulate synergies ... whenever & wherever there was an opportunity for specialisation & scale ... whenever & wherever they found market clearing prices which avoided expensive gluts or queues ... whenever & wherever there were different opportunity costs for comparative advantage ... whenever & wherever they discovered better total factor productivity ... and whenever & wherever they discovered a new mouse trap which folk found exciting ... whenever & wherever company failures released resources for better alternatives ... whenever & wherever there was creative destruction ...
The crunch was that adaptations depended on differential survival of behavioural traits as everyone rushed around trying to survive ... there was no slothful indifference ... and perhaps the evidence was in the history of the industrial revolution? ... did self sustaining economic growth result from synergistic deals, underpinned by the rights & obligations of Tort Law, controlled by invisible hands, where everybody traded their technological innovations and where failure & cycles were manifestations of Darwin's natural selection? ... a far cry from 'fixing prices', 'beggar-thy-neighbour', 'picking winners' and 'moral hazard' ... and was it the history of the industrial revolution which suggested self sustaining economic growth was measured by the audited Balance Sheets of competitive companies? ... measured by money balances?
Strange History of Money, Banking & Credit.
Once upon a time as the exchange deals of social folk burgeoned; more synergies, more specialisation, more scale, there was also an associated explosion in the money measurement system ... synergy required exchange and exchange required some problem solving ... it was easy to see how useful money was because exchange of gifts was so risky and barter exchange was so clumsy ... money solved problems associated with -
double coincidence of wants
indivisibility of goods & services
common measure of value
pre & deferred payments
storage of wealth over time
Over the years all manner of bits & things had been used as money to measure & facilitate exchange deals - useful commodities like grain & salt, even cows, then cowry shells, specie & gold ... even cigarettes ... maybe symbols etched on wood or stone ... and the most outrageous of all ... 'paper' money with a signature ... and then unbelievably 'electronic' money with no signature!? ... why on earth were folk willing to exchange value with a piece of paper? ... 'I promise to pay the bearer' whoever he may be? ... or 'electronic' money that folk couldn't even see! ...
It seemed as the energy flowed, folk went with the flow and the measurement system followed, chasing the profits and cutting the losses, a money measurement system evolved which facilitated exchange - money which conveniently accounted for both sides of the deals.
The system evolved over centuries, it was a slow & risky process, there was always confusion; exciting opportunities and fearsome failures but understanding the rules of money production were unfolding from the start -
Survival Value - the value of the synergies from specialised production and economies of scale was determined by output of exchangeable goods & services ... folk were doing deals in widgets & tings ...
Trust & Confidence - rights & obligations had to be generally accepted rules of behaviour within 'the club' ... an exchange of promises involved a hand shake ... broken promises involved a remedy ...
private property - had to be identified & protected
debt recovery - had to be reliable & routine
lawful remedies; compensations & sanctions - had to be easily & quickly available
Money x Velocity of Circulation = Price x Output - money measured the value of production
No free lunch - money could not be created out of nothing
Savings = Investment - forgoing consumption today levered production tomorrow through investment in profitable projects
Wealth Creation & Economic Growth Cycled - the discovery & accumulation of wealth involved cycles of human emotions from excitement to fear
Money facilitated & measured cash deals, but there were also credit deals which provided money now for repayment later ... then there were deals in money to make more money ... continuous innovations ... one money substitute after another ... cash, credit, bonds, stocks, shares, insurance, options, puts, hedges, derivatives, credit default swaps ... all at a cost, there was no free lunch ... but money was a superb product, everyone wanted it ... what excitement!
But money was always painful to produce because money was all about trust & confidence and trust & confidence had to be earned ... discovering value was hard work ... accumulating value was hard work ... everyone enjoyed instant gratification (ask the boys?) ... saving & investment was risky (ask the girls?) ... no wonder some folk went for short cuts and tried to steal ... as soon as their were stocks there were thieves ... as soon as there was cooperation there were predators & parasites ... as soon as there were coins there were coin clippers ... immunity from this treachery was impossibly difficult, it was a never ending arms race, eternal vigilance was always required ... a strong dose of 'caveat emptor' & 'due diligence' ... what fear!
Then there were other money puzzles -
why were there were lots of things money just couldn't buy? ...
why were the important things like health & happiness & education not available in the shops? ...
how was trust & confidence in money exchange generated? ...
why did money constantly change, morph and cycle? ...
why couldn't it just stay as cowry shells? ...
why did the kings always seem to monopolise the supply of money and then debase it? ...
could trust & confidence in money be a legal requirement? ...
could wealth be created by edict? ...
could the kings force the folk to trust them? ...
why were the money lenders almost universally reviled? ...
why was credit readily given to the rich but only reluctantly to the poor? ...
why did the churches and the bankers become rich as the kings became poor? ...
why did the kings always seem to overspend? ...
why did the cycles almost invariably result in inflation? ...
why did economic growth require credit? ...
why was there a difference between a Bill of Exchange and a Mortgage? ...
why did taxing money seem to slow down wealth creation? ...
was saving & investment different from taxing & spending? ...
what exactly did the strange word 'seigniorage' mean? ...
why bother about the hard work, honesty & thrift of production & exchange of useful goods & services if folk could steal stocks? ...
what happened if the king himself stole the stocks? ...
Puzzle after puzzle ... throughout history ... money was 'anything' generally trusted & accepted in exchange as payment for goods & services & repayment of debts.
Money as Specie & Gold
'The Gold Standard'
The money problems - the double coincidence of wants, the indivisibility of goods & services, the common measure of value, the pre & deferred payments and the storage of wealth over time - were often best solved with specie.
Specie money; gold & silver coins, were easy to understand as they secured the benefits of convenience for exchange because their value was based on their weight as bullion; precious metals with intrinsic value were much safer and more easily trusted than cowry shells ... especially after Archimedes and his Eureka moment solved the quality problem ... and the stamp of king's head was the mark of quality ... everybody trusted the king ... didn't they?
The first banks were probably in the temples where folk deposited their stocks of goodies for safe keeping ... no use eating or spending it all at once if seven lean years were to follow ... everybody wanted a safe rainy day fund ... and if you couldn't trust the Gods to keep things safe, who could you trust?
So the holy men acted as intermediaries and built The Artimision which became one of the seven wonders of the world and they put the Goddess Artemis in charge ... that was cool and safer.
Money and banking institutions developed in the first civilisations in Mesopotamia, Greece and Rome as an emerging moral empathy led folk to enjoy trust & confidence with their family & friends and join social clubs of their choice where there were real rewards to be had from the synergies of cooperation.
But as soon as there was success and some rainy day funds accumulated there were inevitable parasites & predators. Not only the petty thieves, conmen and fraudsters who missed out on morality but also 'the powers that be' who often succumbed to temptation ...
Enter the coin clippers. The king was short of money ... the bankers had all the money ... taxing & borrowing didn't cut the mustard, financing wars and elections was a bit difficult and then in the end became impossible.
A familiar historical pattern established itself - tax, borrow, print - time & time again the focus of attention was on the money measurement system and not on the wealth creation process of hard work, honesty & thrift which delivered the goodies!
It was always thought to be so much easier to clip coins than work hard.
Mesopotamia - for more than 4500 years, when people spoke of 'money', they meant one thing; precious metals coins; but precious metals lost their shine long before Richard Nixon in 1971. The coin clippers were around from the start!
Greece - flourished under a monetary system and became a great civilization, but why did Athens fall? There was no one cause, lots went wrong but things were not helped by debasing the currency, to finance long and costly wars. Athens came up with a very clever way to fund the war. The powers that be took in 1,000 gold coins in taxes and mixed them with an equal amount of copper and then they had 2,000 coins to double their spend? The ruse failed; you can fool some of the people all the time and all the people some of the time but not all the people all the time. Archimedes understood what was going on, no one was guarding the guardians, the miracle of seigniorage was a sham!
Rome - eventually succumbed in the same way and in 301AD the inflation thing got so bad that Diocletian issued his 'Edict of Prices'; the death penalty for anyone selling goods for more than the government mandated price ... selling at less than the cost was not on, so nobody bothered to make anything to sell!
When the king was short of money, royalty themselves clipped coins and even golden specie was vulnerable. Charles De Gaulle and many others got it right -
'He who bets on the king's money bets against 6,000 years of recorded human history'.
Money as Paper Promises & Fiat Currency.
'I promise to pay the bearer on demand the sum of one pound'.
There followed an enterprising development, not orchestrated by 'the powers that be' but an innovation that 'just happened' like evolution itself ... the IOU receipts issued by the bankers to acknowledge the deposits of goodies, also began to be used for exchange ... much more convenient than using the goodies themselves and less costly ... and then once these tokens, backed by the trust & confidence of the bankers, were used for exchange there was an opportunity for credit to become a commissioned service ... IOUs risked default so there was a cost associated with their use which had to be recovered ... there was no free lunch.
An IOU became a legally defined instruction a 'Promissory Note', 'Bill of Exchange', 'bank note' or 'cheque'. A negotiable instrument was a contract promising unconditional payment of a specific amount of money, either on demand, or at a future time with the payer named. A written order issued by one person to his bank to pay another person a specific sum on a specific date.
A Mortgage was not an unconditional promise to pay, it was very different; an interest in real property held by a lender as a security for a debt. It was not the debt but security for the debt. A transfer of interest from the owner to the lender, on the condition that this interest will be returned to the owner when the terms of the mortgage have been satisfied or performed. A Bill of Lading was a document issued by a carrier to an owner, it was a receipt for the goods shipped; evidence of the contract of carriage; and a document of title. A deed was a document confirming an interest in property. A letter of credit was a document promising payment to a seller of goods or services provided certain documents have been presented to the bank.
Bewildering examples of trust & confidence.
As the variety of money issues increased there was pressure for common law, money exchanges and more uniformity & standardisation. Royal authentication of monopoly legal tender had great merit as everybody trusted the king's money ... didn't they? The value of legal tender was maintained because it was always accepted for tax payments. However often the winners of the wars imposed legal tender on the banks and exchangers thus opening up the opportunities for debasement and Gresham's Law as bad money drove out good money. How could reputation matter if there was an imposed monopoly? ... and canny folk always paid their taxes with bad money ... it seemed there was always an arms race between good & bad money ... it was never easy to determine the value of money anymore ... no wonder taxes were always rising?
Money as more Money & Credit.
'My word is my bond'.
Later as trust & confidence increased, another innovation; IOUs were issued without 100% backing of goodies. More risk and more enterprise because now more benefits could be secured as more synergistic trades could be financed ... at a cost ... in this way a series of money developments lubricated trades as transaction costs were reduced ... but it all depended on the reputation of the banker who signed the IOU ... and that reputation depended entirely on the selection of profitable projects. No profit, no repayment, bankruptcy and no reputation.
The first money traders had problems with the incentives to save & invest because there was little protection from theft and little enthusiasm for the recovery of bad debts ... Ebenezer Scheister and Shylock produced a product everybody wanted - credit ... but it seemed common decency and the law were against them as property rights and debt recovery were not readily enforced in the courts ... the money lenders provided a service and charged commission but the hated Jews in Christendom had a problem because the Bishops (and most folk!) believed they were exploiting the poor ... usury was immoral ... the pain was almost intolerable but the Jews had learned because they were excluded out from all the other games ... they had learned about synergy & mutual benefits of trade and they had learned about credit ... in any case who else but desperate minorities would take on such risky activities ... remember how Shylock mused 'Antonio is a good man'? ... who to do deals with? ... who to trust? ... fate had dispersed the Jews but not broken their kinship and beliefs ... this turned into a strength ... in every city there was someone to trust ... another Jew!
But what happened when the cookie crumbled the other way? ... why didn't more folk just take the money and run? ... after all Shylock couldn't get his pound of flesh, the court in Venice protected the thieves? ... so what to do about those thieves?
could trust & confidence be stolen? ... could a reputation be purchased?
Money for Synergies & Trade
'Buy now pay later'
'Half a pound of tupenny rice, half a pound of treacle, that's the way the money goes; pop goes the weasel'. The readies were needed for trade in the markets and at the fairs. From ancient China 3,000 years ago and now now everybody was into pawn. Usury was sin but taking collateral was OK.
The Lombards of Northern Italy were three balls men. They followed the action and provided competition for the Jewish money lenders with their new fangled pawn shops ... the medieval trade fairs presented opportunities for financing exchange deals with strangers over distances in different monies ... collateral in exchange for the different monies reduced the costs & risks ... the pawn shops thrived ... Lombard financial skills involved enterprise, literacy & numeracy and accounting in weights & measures, they followed the trail of international trade from the land routes of the Champagne Fairs to the sea routes of the Hanseatic League, to the international trade centres in Amsterdam, London and New York ... the Lombards were busy reducing the transaction costs of international trade ... what a service, pawn was an act of kindness, St Nicholas the patron saint of pawn, would have been pleased ... it was St Nicholas who provided the legendary three purses of gold to help a desperate man save his daughters!
With the readies, the trades and the fairs flourished ... but as distances escalated and strangers got stranger the risks were rising ... especially when foreign lands were full of thieves and had no Contract Law and no remedies for Torts!
why did different countries have different money? ... how was trust & confidence established between different countries? ... when trust & confidence broke down could international courts protect private property and recover debts? ...
Money for War & Defence
'Protection of stocks from predators & parasites'
In the 12th Century not all the Knights Templar were warriors, some provided supporting financial services ... the Knights accounted for their clients property and savings in money terms as deals were done to finance the Crusades ... carrying gold to far away places was a risky business ... and cost ... safekeeping and safe stewardship of money became a valued service ... deals had to be done with strangers across borders ... so how to settle debts? ... the Knights set up a network of trusted members, a secret society with onerous membership criteria in an attempt to keep out charlatans ... once you were 'in' your reputation was established and then written instructions to other members were all that were needed ... what a service! ... 'bills of exchange', 'letters of credit' & 'cheques' were honoured and the bullion remained safe in the vaults ...
The Jews trusted their clan associates and the Knights trusted their religious associates ... but what about those stranger strangers who had snake oil to sell and what about counter party risk? ... and there were rumours that some innovative snake oils actually worked and needed to be tested!
did family membership or secret societies restrict economies of scale? ... how could more folk be included in? ... were there other ways of establishing trust & confidence? ... were there always two sides to every deal? ... did every right involve an obligation? ...
Money for Egos & Indulgences
'Delusions of grandeur'.
From the 14th Century several families built banking systems in Florence and good reputations became associated with the city ... no banker from Florence could afford to let the side down, they would have been hounded out of town, reputations which took years to build up could be destroyed in a second ... bankers lived on trust ... 'I promise to pay the bearer' ... it was a good wheeze until the powers that be tried to steal it and offer 'a government guarantee on deposits' ... but the looting machines always ended in tears, trust was not easy to steal ... think about it?
Money making ideas were continuously hatched and many the city states of Northern Italy competed for the lending spoils ... but the business of lending money and assessing the associated counterparty risk was not easy ... the terms the bankers offered reflected their assessment of the risk that they were undertaking ... after all it was their money ... the King of England was considered a good bet and the Florentine Banks waded in.
The king was short of money and he wanted to do great things ... for his people? He knew way back that the Romans had a great scheme, they taxed their enemies and recruited them as slaves and forced them to do the honours. But Edward soon found it was now impossible to tax his enemies, they were resentful and they also had spears ... so he taxed his own people instead, wherever and whenever he could find riches. But it seemed his own people were also resentful, they hated the kings great schemes and grandiose ego trips, they never seemed to help and there was plague and pestilence everywhere. So the English peasants spent their hard earned wherewithal on their own family survival efforts and satisfactions. Any left over was for a rainy day, and they hid it in mattresses or in Cyprus or where ever they hoped it was safe. In this way it seemed the kings always had to borrow because any tax revenues they managed to pilfer were spent 'just like that' ... but to borrow the kings had to meet their due debts on the due day ... but the kings didn't work hard at a 'trade' so the only way they repaid debts was through their capacity to tax ... where else could they get the lucre? And if debts weren't repaid folk didn't like it and there always seemed to be crowd trouble.
So King Edward of England soon learned that he had little control over his capacity to tax, he had to rely on the hard work of his subjects ... Edward always hoped that tax revenues would flow from the plunder of winning wars but meanwhile he sort to divert the profits of Yorkshire wool exports into his coffers ... the merchants of Pudsey had worked hard at their trades and were doing very well thank you, English wool was the envy of the world. Some said it was luck, but the merchants knew the harder they tried the luckier they got! English wool was something else.
Unfortunately Edward failed miserably to cash in on the war against the French as it went on and on at exorbitant expense for 100 years ... and there was more ... furthermore tax revenues from wool were ravaged by the trials & tribulations of the Black Death. The merchants knew all about feast & famine that's why they had rainy day funds ... but their rainy day funds had already been confiscated by Edward's looting machine.
By 1345 Edward III had big problems ... he even tried to pawn the crown jewels to the Lombards, this was hard core pawn ... but debts was debts. He couldn't repay and reneged, and with him went the Bardi & Peruzzi families who dominated the banks in Florence ... tant pis? ... but their own underwriting standards were at fault they shouldn't have trusted Edward ... the banks went bust and immediately demanded 'control' over Edward's depleted income streams and charged 120% with penalties of 60% if agreed payments were delayed ... debts was debts.
These contractual costs were called 'conditionalities' not 'interest' ... remember usury was immoral? It was immoral right up until the 1624 Usury Act when the Bishops decided to change morality to help them out of a hole ... suddenly interest rates were not immoral after all. But who was immoral in 1345, Edward or the Bankers? ... it certainly wasn't those folks beavering away with wool in Pudsey and selling their luxurious wool to the Flemish weavers.
In a vain attempt to legislate wealth Edward devised another scheme ... his best yet. 'The Statute of Labourers of 1351' was a brainwave. The statute decreed on pain of death that wages would be fixed at the low pre-plague levels. This would immediately enhance the profits of the wool merchants and thus raise the associated tax revenues? Brilliant! Wot a great scheme?
Of course the ruse failed in ignominy; something they called 'supply & demand' could not be controlled by kings. The landowners competed for scarce labour driving up wages and their surplus wealth for investment went down ... the wool trade was in crisis and with it down went Edward's tax revenues!
All folk could do was mutter about unintended consequences ... remember Adam the Smith had not yet written his tomes.
There was more, it was also rumoured that the Pope was rubbing salt in Edward's wound by taxing the English churches and using the revenues to support the French armies! ... so big trouble escalated ...
In any case, since 1215 things had changed at Runnymede and in England and from 1265 parliament had to approve all the kings taxes and Simon de Montford & the Forty Shilling Freeholders were none too keen on paying for all the king's pork and his wars that couldn't be won ... and paying for the Pope's follies was just not on either ... so Edward defaulted, the banks blew up, credit vanished and inevitably the wool trade was decimated ... the goose that laid the golden egg was lame ... or worse it was in the pot.
Edward learned the hard way ... there were limits to taxing & borrowing (they were both the same thing really, just pay now or pay more later) and at the end of the day taxes always seemed to ignite crowd trouble (ask Wat Tyler?) ... and perversely tax revenues seemed to depend on economic growth (funny thing but it seemed wealth had to be created before it could be taxed?) ... and more perversity ... more tax always seemed to result in less investment and less economic growth ... or were they the same thing? ... economists called this conundrum a dead weight burden and no one sussed that out until much later ... but it became very clear to Edward that as the banks failed, the credit financing the English wool trade also disappeared and with it his tax ... a downward spiral of complex catastrophes which knackered comprehension and hurt the brain.
Was Edward the hapless zombie, yet another example of the king who ran out of money as he walked into the trap of tax, borrow & coin clip as he grappled with reality and tried to fulfill his dreams of power?
Much was known & clear with hindsight ... but unfortunately hindsight was not available to folk with foresight at that time ...
Then there was the final twist that neutered poor Edward, he failed to realise that it was Philippa who took all the decisions, as the girls always did. And of course it was not Edward but the Black Prince who did all the heavy lifting.
... and then as Mildred Bailey sang in 1936 -
'out of the darkness she suddenly appeared, she smiled and he was taken by surprise, he should have seen right through her but the moon got in his eyes'
... Alice Perrers (1348-1400) ran off with all the loot!
In 2012 Anne O'Brien detailed this wonderful yarn about Alice in her book The King's Concubine ... much preferred to Alice in Wonderland ... hindsight together with Darwin's insight suggested history was never how it was wrote!
After all of Edward's macho posturing with his conscripts and spears the laws of supply & demand were unimpeacheable, there was just to much demand for tax and too little supply so the price rose ... a simple enough but many folk just don't get it ... Alice, of course, got it ... she understood about rampant demand and the value of denied access! Much later it was Darwin who explained the reality of Edward's folly?.
The truth never dawned on the powers that be as the alternative to taxes was incomprehensively difficult to fathom. Kings were insignificant beggars always short of tax revenues, and it was the bankers who bank rolled the profitable projects which were the only route to economic growth ... but the system only worked if the banks could discover profitable projects to finance ... gravy trains like Pudsey wool were few and far between and nobody knew the where, when, who, what or the how of the next happening!
Xenophanes - ‘The Gods did not reveal, from the beginning, all things to us, but in the course of time through seeking we may learn & know things better. But as for certain truth no man knows it, nor shall he know it, neither of the Gods nor yet of all things that I speak. For even if by chance he were to utter The Final Truth, he would himself not know it: for all is but a woven web of guesses'.
In this way Edward's tax prospects were dependent on the profitable projects that the bankers discovered and bankrolled ... and as long as debt financed the banks, the international global bond markets mattered ... were the international bond markets more powerful than the kings? And what about Alice Perrers? As history rhymes and the next crisis of tax, spend & print is upon us, to all who say 'this time is different', we say remember Alice Perrers!
In the grand scheme of things and happenings Edward was as helpless as Canute, his mate from way back, but Canute was smarter, he had the nous to realise his powerlessness!
were the banks too greedy? ... or was Edward too ambitious? ... why were the bankers richer than the kings? ... can anyone legislate wealth? ... can money be created out of nothing?
And there was more; not only the King of England but even the Pope couldn't be trusted to do great things ... as the Medicis found out
Money for Family & Trusted Friends
'Rainy Day funds'.
By the time of the Renaissance the Medici family had learned that if trust & confidence were established, those with the money but no ideas could finance those with the ideas but no money ... but it was a risky business and risk was managed by lending carefully to selected reliable people. Only lend to those with the good ideas? Wot a great strategy, why had no one thought of it before? It was almost as good as buying at the bottom and selling at the top!
Giovanni Medici founded a banking dynasty. He started with nothing but Giovanni was a smart cookie, he bet on the Pope!
The family slowly built an extended social banking network, they lent to the family first and then to those committed to the family through marriage, then ... the master stroke ... they enrolled the Papacy complete with God's collateral ... and finally they extended the deals into the globally respected Renaissance movement ... this resulted in scale & diversity across the boundaries of competitive city states and beyond ... the Medicis hoped scale & diversity would reduce the risks of bad debts still further ... networks were decentralised so that lenders were close to borrowers and they could see the whites of their eyes ... they also built in checks & balances as interest rates followed risk ... but if interest rates were too high, folk defaulted and if interest rates were too low, there was no reward for risk ... it seemed interest rates were quite important?
The family kept a meticulous recording system as ledgers with double entry book keeping kept track of every deal.
It was rumoured that they had discovered the 3-6-3 system - 3% interest paid on depositor's accounts, 6% interest received from loans of depositor's money and then by 3pm they were on the golf course!
The Medicis started their lending business with the lucrative dependable flourishing trade in wool but they ended up at the top with governments and the Pope. The hard nosed traders in wool were focused on the truth & reality of every deal which made an income stream; but once politics, faith & money enter the fray things became much more fickle ...
Maybe it was the betrayal of Galileo that started the decline & fall of the Medicis. If Galileo could be jailed on a Papal whim what chance had a legitimate claim for the recovery of debts? ... and interminable politics compounded the risk as there was no apology for this act of treachery until 25th October 2007!
So it seemed the most trusted of customers, the Bishops, couldn't be trusted ... was no one immune from bad debts?... the Medicis should have remembered that way back it was the Bishops in collusion with the King of France who stitched up the Knights Templar!
if all successful banks went for scale & diversify to reduce risks why did they continually get involved in state politics? ... were the banks pressurised by the powers that be to lend to the powers that be and their henchmen? ... and who fixed the interest rates? ...
As the Florentine Bankers and then the Medicis dropped the baton the Fuggers in Germany picked it up.
Money for Success & Picking Winners
In 1525 Anton Fugger inherited his uncle's business and established an international banking dynasty which profited hugely from propitious lending to rich winners ... he was respectfully called the 'Prince of Merchants' and set the course for the future of the Fugger family. He prepared the next generation of the family through the old trick of arranged marriages ... his sons and daughters were paired with the nobility.
The original strategy of 'chasing profits'.
It was a Fugger loan which supported the election campaign of the Hapsburg Charles V against the French pretender ... it seemed there was a big upside in lending to the winners of wars? ... history, of course, doesn't record what would have happened to the Fuggers if Charles had lost!
This was gambling, as those with foresight had only hindsight to go on ... but there was an infuriating path dependency which biased minds ... until a 'black swan' arrived. In 1648 The Thirty Years' War ended with the Peace of Westphalia which changed the old order of Empire and downed the Fuggers. In 1740 in the Habsburg male line went extinct with the death of Holy Roman Emperor Charles VI. The Fuggers had had a good run but could do nothing about death & taxes.
Clearly the strategy of 'chasing profits' had to be inextricably linked with 'cutting losses'. Were The Fuggers the first to try to buy at the bottom and sell at the top?
How were bad debts avoided? ... is a bad credit the same as a bad debt? ... how were the good projects sifted from the bad projects? ... why did the banks lend to rich folk but not to poor folk? ... did the bankers see a good credit risk in the whites of the eyes? ... or in the size of the arsenals? ...
Money for Everyone & Usury
By now the holy men had another enduring problem; the Jews and other money lenders were making a lot of money ... usury ... they invariably believed selling money for interest was immoral ... banking was moribund for centuries ... money was strange ... but was credit even stranger?
was money simply trust & confidence? ... was credit different? ... was debt money? ... why was usury immoral?
In 1624, the burgeoning global trade synergies exploited by the Dutch, put unbelievable pressure on the Bishops in England ... after 50 years of agonised debate the Bishops reversed their earlier 1571 Act of Usury and decreed that the offer of credit for interest was moral & legal after all ... it seemed morality was not etched in the stones? ...
But there was a deal, an exchange of promises, sure debts had to be repaid with interest ... but 'I promise to pay on demand' was an opposite and equal obligation ... and coin clipping was as evil as a bad debt ...
This was a fundamental change in perception about banking behaviour. In 1571 God's Law was an unquestionable revealed truth, usury was immoral ... by 1624 morality was a matter for the individual conscience. Money lending and credit facilities had become an economic necessity because by 1624 competing with the Dutch in international trade was a matter of survival ... could the voyages of discovery have been financed without credit?
At a stroke the English banking system was rejuvenated as the legal ban on money lending for interest was lifted ... those with the money started again to share profits with those with the ideas ... a whole range of new synergies became available ... folk could diversify investments on an unprecedented scale ... and now bad debts could be recovered in the courts ... far more cost efficient than in the alternative of street fights and vendettas!
As credit exploded, at the front of the queue, as expected, were the kings who always had expensive habits which were usually associated with delusions of grandeur and expensive wars ... don't get me wrong, of course, some grandiose schemes were useful and some wars were just ... but 'just wars' didn't crowd out profitable projects ... 'just wars' were profitable projects!
did commercial law evolve? ... did morality itself evolve? ...
Money for Government & Taxes
'Political Bribery & Corruption'. The Looting Machine. Thieves of State.
In 1694 The Bank of England was formed privately to lend £1.2 million pounds @ 8% pa to the English government ... but it was a stitch up, a monopoly in fat fees from the tax payer in return for funds for war? ... the current generation had been taxed and squeezed until the pips squeaked, but now there was an innovative borrowing device which fiddled the tax burden onto future generations ... it seemed the new morality didn't extend to tax? ...
In 1700 after the decentralisation of the Holy Roman Empire. The South Sea
Company proposed to parliament that holders of the government’s IOUs should
pass them to the company in exchange for shares.
The former debt holders received dividends instead of interest.
The directors received the debt ... quaintly described as 'Gilt Edged', Government debt was 'safe as houses' because it was backed by a taxation monopoly ... question mark for the wary?
The dividends were buttressed with profits from slave trading and other risky ventures ... question mark for the wary?
Parliament were relieved of the burden of raising revenue from taxation for payment of interest from outraged tax payers who saw their hard earned lucre confiscated to waste on endless & fruitless wars.
The result was that British government debt became tradeable for the first time, ensuring a long-lasting competitive advantage in war finance over France. This was a rerun of 1345 when Edward III arrogantly & vainly decreed a wage cap ... to increase profits ... to increase tax revenues on companies! Wot a scheme? The timimg was a disaster, just as the Black death had decimated the population and shortages of labour were drivinng up real wages ... just as the iron Law of Supply & Demand dictated.
However the power of mathematics and the method of Empirical Science
(observation, theory, hypotheses, validation, peer revue) associated with
the scientific revolution created new ways to think about money, risk and
uncertainty, which came to full fruition in the financial engineering that
characterised the bubble year of 1720 ... and share trading in the coffee
shops of Exchange Alley in the City ... with fascinating shows such as
Newton’s extraordinarily modern management techniques of reason and logic
when running the Royal Mint.
Also reason & logic were not exclusive in the human psych emotion & creativity were also involved.
Bubble prices were set by a wide range of different investors with different information, at different times in different places each with different world views and investment philosophies and different personalities
and flip flopping emotions of excitment & fear.
A triangle that describes the necessary conditions for a bubble - marketability of the assets, expansionary money and credit and intense speculation about an unknowable future.
The early bank followed history and was preoccupied making money out of their monopoly in Government debt ... no wonder their market was called The Stock Exchange ... equity shares were for the future ...
Some Bank of England notes, promises to pay, escaped into circulation but the lowest denomination was £10 and of no use for general circulation. Convertibility acted as a check against over issue. Gold and silver was also purchased by the bank for use by the Mint.
The English banks had had a couple of lucky breaks ... although many insisted it was not luck but the natural selection of profitable cultural traits? ... the excesses of the grandiose spending of the Kings and the associated bad debs had been curtailed by the checks & balances of 1215 & 1265 and the success of parliamentary scrutiny ... but the plumb for the banks was the industrial revolution itself which produced profitable projects in an abundance never seen before ... and initially capital requirements were relatively modest ... what investment opportunities!
why did the marginal productivity of capital depend on credit for profitable projects? ... was the industrial revolution itself dependent on the new morality of bank credit? ... or was it just a lucky break? ... were the strategies of scrutiny, diversity & scale; just luck? ... were the strategies of hard work, honesty & thrift; just luck? ...
There were also private banks; servicing the great trading companies, with loans and discounting bills of exchange. Mainly lending to the wealthy and not yet involved in trade.
Mayer Rothschild (1744–1812), a German Jew was born in Frankfurt, he founded of the Rothschild international banking group that became one of the most successful family businesses in history. The Rothschild's had established a modern banking system which coped with bad debts by careful and diversified lending which was decentralised across risks and across currencies ... unprecedented scrutiny, diversity & scale ... family members in different countries with different customers were trusted and financed ... the same old story, an international network of trusted contacts ... lending was always focused on the most profitable global returns ... gold was arbitraged across different economies as clearing prices emerged ... and above all there was lending to sovereign governments ... a decentralised decision making network which involved efficient low cost central lending whenever local liquidity was a problem and central investment in human capital whenever local solvency was a problem ... the Rothchilds ran a 'central bank'!...
In 1798 Mayer's third son Nathan Rothschild was sent to England to further the family interests in textile importing. Nathan became a naturalized citizen in 1804 and established a bank in the City of London.
In 1819 anti-Semitic violence broke out in many parts of Germany. These Hep Hep riots as they were called, included an assault on the Rothschild house in Frankfurt. An act of inane stupidity, as was a further attack during the 1848 revolution ... there was no money there. The Rothschild's money was paper, circulating throughout the world ...
The Rothschilds completed a process the Jews had been working on for centuries, they had immunised their lawful property from thieving violence. Their real wealth was beyond the reach of the mobs (and beyond the reach of greedy monarchs!). Their wealth was the trust and confidence customers had in Rothschild credit. And their biggest customers were nation states. How was that sort of wealth to be stolen?
Sensibly the family took a low-key public profile, working hard, donating to charity, keeping anonymity and eschewing conspicuous displays of wealth which would only attract the attention of the tax man ... but how can you tax financial 'know how'?
Later in 1815 when Wellington won at Waterloo, the family collected their winnings ... as usual they had bet on both sides ... but they also knew the biggest cause of default was losing a war ... or revolution ... they had made the safest & biggest bet of all ... they bet on liberal democratic governments that possessed -
the technology to win wars and
cooperative citizens who paid their taxes ...
and thus pay their bond holders ...
But, as history had shown, was this was 'counter party' risk big time? ... could liberal democratic governments be trusted with the tax & spend conundrum? ... or would they go the same way as the all the other Bishops, Princes, Generals and Bureaucrats and start coin clipping and money printing? ... and default?
... would the Rothschilds go the same way as all the ancient bankers? ...
did it always go in cycles of success & failure? ... could the banks ever hope to cope with those wretched business cycles and the short term hysteria of boom & bust? ... how did the banks cope with the greed, bribery & corruption of political intrigue and government default & inflation from the king's printing presses? ...
But what a merry go round for the Bank of England!
After the Glorious Revolution the bankers solved the problem of funding the industrial revolution and the government's borrowing problem but 100 years later the bank was confronted with a repayment problem as the gold standard was abolished from 1797 to 1821 ...
NB. Some problems with taxation - economic, military or political -
1. discrimination and dead weight burdens.
2. discrimination and double taxation of rainy day funds.
3. trade synergies targeted. Global benefits of comparative advantage local inequalities.
4. services competitive and fugitive. Emotional preferences or 'ealf 'n' saftey.
5. uneconomic 'Buy British' and 'Self Sufficiency' rhetoric.
6. DFI but not the Royal Mail.
7. WTO dispute resolution or national sovereignty.
8. Sales taxed as VAT. Companies taxed as profit and dividends but not debt. Intellectual property taxed as residence.
Money for Business & Profit
'Investment in Profitable Projects'. The Industrial Revolution.
6,000 years of history exposed repeatedly the severe problems associated with the accumulation of capital. It appeared slavery, tribute, tithes and taxation didn't cut the mustard.
Peter Mathias was adamant -
'It seems clear that no shortage of saving relative to the demand for productive investment threatened to constrain the process of economic growth in 18th century Britain'.
Surpluses from the farms flowed into land & transport improvements and productive manufactories as innovative landowners and merchants became bankers. Tax and profligacy was replaced by save & invest. The learning curve had been tough, ostentation was unavoidable and the South Sea Bubble put paid to joint stock companies for 100 years. Progress was slow and evolutionary; institutions had to overcome social and political constraints.
John Freame had shown the way to lend successfully to business but others followed. John Freame was a Quaker but his business was not based on religious doctrine but on value systems favourable to enterprise = hard work (idleness) honesty (moral sentiments) & thrift (abstention) -
'The same idea underlines Adam Smith's conception of capital being the result of parsimony - of saving from consumption'.
The merchants had long since provided finance as credit for working capital and initially fixed capital requirements were relatively modest. Business finance started with family & friends, sleeping partners, kinship groups, clubs and local attorneys and local banks as intermediaries. Savings were no longer hoarded.
Surpluses from trade & business meant an opportunity to move into the more lucrative banking business. The country banks all had a London agent as trade deals were financed by a 'bill on London' whenever specie was impracticable and until bank notes became established.
Once respectable bank notes were established they were drawn naturally into circulation and the banks also became deposit takers. With hindsight a logical evolutionary process. At the time, of course, it was all about cooperating with trusted colleague to secure synergies from exchange. Peter Mathias -
'From being note issuers, through providing accommodation and discounts, the country bankers, like the London bankers, gradually grew into being deposit bankers. This was naturally an evolution because only when a banker was trusted in the local community would people entrust their savings to him, rather than seeking credit from him. Cheques were certainly a way of doing business on deposit accounts from the early days; but bills of exchange remained the dominant means of effecting inland as well as overseas business transactions until the second half of the 19th century. Deposit banking mobilised the savings of the nation, hitherto sterilised in hoards, into the banks, which then put them to active use by lending at a profit'.
It naturally followed that the Bank of England held all the gold reserves and became a lender of last resort ...
This was the system described by Walter Bagehot in 1873.
Working capital = Short term credit - buying on tick - discounting Bills of Exchange - shortage of specie for wages resulted in tokens.
Fixed capital = Renting & Mortgages - plough back (ostentatious consumption came with the second generation!) - merchants became manufacturers.
1825 Repeal of the Bubble Act and 18?? Limited Liability ... and finance for industry was no longer a problem. Current profits provided the funding for future profitable projects?
Peter Mathias -
'By the 1870s the British banking system was divorced from long term industrial investment, in great contrast to France & Germany'.
Money for Command & Control & Regulation .
The industrial revolution was a game changer, a financial game changer; finance was readily available to fund productive investment in self sustaining economic growth which resulted in technological & organisational innovations which also won wars. Sure the French wars from 1793 had cost £1,000 million, expropriated in sorrow ... whereas the railways cost £250 million, managed with alacrity.
In 1945 the British Government had a go, cock a hoop after winning the war perhaps now we could win the peace? The Bank of England was nationalised ... and more and more was nationalised in the euphoria ... economic activity was to be orchestrated from Whitehall? ... interest rates & exchange rates would be fixed and boom & bust banned? ... full employment was to be maintained by government spending, not by hard work, honesty & thrift? ... and why should the greedy Bank of England take a cut with their fat profits? ... was this political hubris? ... or a not so subtle confiscation? ... something was going on, that was for sure? ...
Well ... the government borrowed to fund the war and now government borrowed to fund tax & spend policy on the welfare state ... and the welfare state was needed to secure votes, folk loved it, and they now had confidence & trust in the government, after all the war had just been won! ... and if you couldn't trust the government who could you trust? ... although some folk did remember the real value of Consols & War Loan? ... and a few even remembered 'temporary' income tax and the discrimination involved with 16th amendment in the USA? ... and a fewer few remembered Edward III? ...
When government debt was auctioned it was always sold, the only doubt was at what price ... and price determined the interest rate cost ... and the cost determined how much tax revenue had to be diverted into servicing the debt ... so spending decisions were decoupled from funding decisions ... but most folk assumed governments would always pay the necessary interest because it was paid out of taxes and not out of the profits of risky business projects ... and governments couldn't go bankrupt ... could they? ...in this way profitable business projects tended to be crowded out of the credit markets by high interest rates and inflation ...
Let's be fair, this was a conundrum for democracies everywhere ... folk could get their heads round borrowing to fund a war ... wars were won ... or lost ... but borrowing to fund welfare & entitlements was a whole new kettle of fish ... 'if it's free put me down for two please' ... so proudly proclaimed profligacy proliferated ... meanwhile back at the coalface Alexander Fleming had discovered penicillin ... what on earth was going on? ...
... so it came to pass that 'welfare' and 'entitlements' also created a problem in the USA, where constitutional checks & balances were supposed to protect folk from excesses? ... a powerful underlying trend had been superimposed on the business cycle ... welfare handouts in exchange for votes was a great idea, but who was going to pay? ... Ben Bernanke, Chairman of the Federal Reserve Bank quoted Herbert Stein, of The American Enterprise Institute who had had sussed it all out, Stein's Law was succinct -
'if something cannot go on forever, it will stop'!
Of course the Bishops, Princes, Generals & Bureaucrats had been interfering with money since for ever ... the success of the bankers never went unnoticed ... the kings had always tried to compete with the banks and tried again and again the age old cons and diktats of fiat money, legal tender, coin clipping & money printing ... but nothing seemed to work ... folk paid simply their taxes with clipped coins and gave upon hard work, honesty & thrift!
The hysteria was not mal intent it was ignorance of diverse complexity!
Bank nationalisation had become the norm and all central banks were instruments of kings and states ... way back in 1587 The Banco di Rialto was an initiative of the Venetian state where intervention and nationalisation were used in an attempt to provide a low cost settlement service in 'superior' notes backed by the taxpayer ... the idea was that this gave a measure of security in the risky business of trade in money ... no doubt it was hoped that nationalisation would open up the opportunity for the kings to capture seigniorage and lucrative profits from the 3-6-3 system ... coin clipping was reinvented in an official new guise ... but how was it possible to nationalise the 3-6-3 system, which depended on confidence & trust and the technological innovation of customers? ... no one could legislate wealth ... could they? ... if history had been studied more thoroughly it would have been clear that nationalisation was no panacea, taxpayers were no pushover, states could also go bankrupt ... and they did!
There was even a problem with gold standards which were often thought to stabilise the money system ... but economies only grew as fast as gold production as folk just didn't like declining prices ... especially wages! ... but was inflation better? ... even in democracies it seemed that whenever governments got their hands on the banks the printing presses started to roll and helicopters dropped pork onto mesmerised folk in return for votes ...
Interference and price fixing never stopped ... that's what authorities did ... come to think of it that's what everybody did ... but the authorities fixed the prices of licensed monopolies which was a very different kettle of fish to the other poor folk who attempted to discover clearing prices by experiment ...
It seemed that whatever the ploy or the which way when; risk & debt could never be avoided ... at worst it was transferred to someone else ... a pattern seemed to emerge in the history of banking ... a virtuous circle of credit expansion always seemed to collapse into a catastrophic spiral of decline, from excitement to fear ... time after time, dynasty after dynasty ... and it always proved remarkably difficult to cope with the greed of authorities who always wanted a share of the action ... a ripe mixture of tax, nationalisation, government borrowing, legal tender laws, bad debts, inflation and imbalances always seemed to wreck the Balance Sheets ... it seemed that whatever the ploy or the which way when, the money & credit systems and their prices were endogenous adaptations which were continually hijacked by legislators who promised to design better systems ... it was uncanny ... centralised control of the 3-6-3 system couldn't work ... centralised control of natural selection was impossible ... a physical impossibility!
was the British government, like all the others, in denial in 1945? ... or did they think evolution was just some biological theory? ... was the whole charade simply inane hubris? ... were central banks powerless to stop money printing and debasement of their own currency? ... whose currency was it anyway? ... was the money measuring system private property that could be owned? ... could a bank be nationalised? ...
The hysteria was not mal intent it was ignorance of diverse complexity!
But nothing could stop folk learning from history ...
In 1995 Robert Lucas received a Nobel Prize when he suggested a theory of 'rational expectations' - 'you can fool some of the people some of he time or all of the people some of the time but not all the people all the time' ... but folk always learned & expected and chose options based on REAL prices which cleared markets ... everything else was like trying to move mountains by pushing on strings or pulling on elastic bands ... more and more folk learned of the dangers of 'fixing prices', 'beggar-thy-neighbour', 'picking winners' & 'moral hazard' ... and more & more folk learned about 'invisible hands', 'moral sentiments', 'rent seeking', 'comparative advantage', 'total factor productivity' ... and the cycle of 'creative destruction' ...
J K Galbraith in 'The Great Crash' 1975 -
'There is merit in keeping alive the memory of those days, for it is neither public regulation not the improving moral tone of corporate promoters, brokers, customer's men, market operators, bankers and mutual fund managers which prevents these recurrent outbreaks and their aftermath. It is the recollection of how, on some past occasion, illusion replaced reality and people got rimmed'
Edmund Burke -
'Those who don't learn from the mistakes of history are doomed to repeat them' ...
Richard Epstein grasped the 'Fatal Conceit' of government intervention -
in attempting to improve on the evolved rules of engagement, the powers that be meddle and inevitably unintended consequences invite further corrective interventions which clog up the local bureaucracy and the global market place.
Bureaucracies deliver a cast of thousands and analysis paralysis.
Evolutionary economics produces a self correcting business cycle as firms go bankrupt and a self sustaining economic growth trend as 'know how' accumulates.
The Money Making Machine - 3-6-3?
During generations of hard investment & risk taking and trial & error learning the Jews, the Lombards, the Knights Templars, the Bardis & Peruzzis, the Medicis, the Fuggers and the Rothschilds had refined a remarkable money making machine ...
The bankers didn't grow things or manufacture widgets, they made their money from selling money at the right price ... the system ... here's how they did it -
I promise to pay the bearer, my word is my bond ... if the Bishops, Princes, Generals & Bureaucrats didn't run them out of town in a jealous rage ... and whenever the powers that be ran out of money and succumbed to coin clipping ... it appeared that some bankers were clever enough to secure money deals of their own ...
Firstly they established a reputation for honesty which enabled them to attract folk's goodies to their strong rooms for safe keeping ... secondly as long as their reputation remained intact the IOU receipts, the acknowledgements for the deposits of goodies could also used as money for exchange... it was all about trust & confidence but earning trust & confidence was hard work ... 'due diligence' & 'caveat emptor' were essential parts of every deal because thieves were around (often in sheep's clothing) ... deals were secured because folk with savings needed to protect them from theft (stuffing them in the mattress was not good enough) ...
Honest bankers had a reputation to protect and they were far more successful in attracting deposits and issuing IOUs than the con men ... their profits grew ... the con men went bankrupt ...
those with ideas had no money and those with money had no ideas ... later it became clear that the depositors never wanted their riches back at the same time ... there was an opportunity for the bankers to risk lending other peoples' money to other folk with investment schemes ... and charge them for it ... but they had to be careful ... to maintain the trust & confidence of depositors they had to keep enough gold in the vaults to pay the bearers of the receipts when they pitched up to withdraw their bounty ... and to maintain their capital intact the bankers themselves had to have trust & confidence in the investment schemes they funded ... trust & confidence was sensed in the whites of the eyes of honest folk, offered as my word is my bond and confirmed with a hand shake but the deals always coevolved with cheat detection systems underpinned by Tort Law & Property Law & Contract Law ... debts & repayments ... it was no use someone 'promising to pay the bearer' if the promise was broken ...community remedies were essential if costly violence was to be avoided ... the Balance Sheet had to balance ...
There were always two parties to benefit (or lose!) from every deal ... benefits were mutual, win win, with synergy
Darwin's natural selection of profitable projects ... the trick was to lend only to folk with profitable projects ... it was only profitable projects which ensured the interest was paid and bankers got their money back ... but it was always a risky business, unprofitable projects & bad debts were a perpetual problem ... a good reputation secured the funds but good project appraisal sifted the risk ...
Now listen ... the bankers, just like the soothsayers, were ignorant of the where, when, how, who or which of the next profitable innovation but they had a twin pronged strategy for increasing the chances of discovering better projects -
chasing profits/path dependency - good performance was not about predicting the future or technology foresight ... it was about chasing profits and cutting losses ... new credit flowed when customers had a good track record of repayments but credit soon dried up when debts went pear shaped ...
diversification/portfolio theory - but there was a complementary second prong as small amounts were lent to many and varied customers ... the net was spread far & wide by encouraging diversity & competition amongst decentralised bank managers as they did credit deals with different customers, with different projects, in different places, at different times ... no one wanted to miss the next Bill Gates lurking in some dusty Seattle garage! ...
In the same way as short necked giraffes died out, the result of bank lending was a natural sifting of entrepreneurs & their projects and the consequence was that the marginal productivity of capital in the economy increased ... wow ... read that again! ...
Unprofitable project investment had to be written off, unprofitable Banks had to go bankrupt.
excitement, deposits made reserves ... and there was more ... with an income flow from profitable investments the bankers now found they could afford to offer inducements to encourage more folk to deposit more of their savings and thus secure more funds for profitable investment ... instead of paying for a safe keeping service folk were now paid interest on their deposits ... what magic was this? ...
Benefits were growing ...
euphoria, loans made deposits ... the next trick was mesmerising ... the bankers found that the money they lent out immediately returned to the coffers ... it seemed that when ever credit was spent from one account it ended up in another account ... payments & receipts were not kept in the mattress they came back as other people's deposits ... almost in an instant ... oh my! ...
Money circulated, it was spent but it was not lost ...
endogenous growth & money supply ... now wait for it ... the bankers discovered that the money that came back as new deposits could be relent to someone else with a profitable project, picking up profit on the way ... the whole shebang & caboodle was growing ... banks were creating money ... as credit ... to finance profitable projects and they did it without clipping coins or printing and other terrible acts of theft ... if nobody rocked the boat & didn't cheat and if they maintained the trust & confidence of savers & investors with 'prudent' liquidity reserves and 'sensible' capital ratios ... the money supply kept pace with economic growth ... automatically ... the measuring system neither stretched or shrank ... it was stable & reliable ... there was no inflation ... the Balance Sheet balanced ...
Crucially it was the deals on profitable projects where credit produced marketable goods & services that avoided 'too much money chasing too few goods & services' ... no gluts and no queues ...it was Adam the Smith again ... there was a market in credit as bankers desperately tried to attract funds to invest in profitable projects ... but discovering the price of credit (the interest rate) was necessarily a cobbled together, complex, interacting, kluge, a messy unpredictable unavoidable cycle of boom & bust ... as the Bank of England it was a data driven response to the market in credit ...
prices too low = queues for credit - low profit projects queued up for cheap loans, folk started to worry, so many harebrained projects, too much money chased too few goods, inflation, asset bubbles formed, bad debts started to rise due to low profits, deposits declined as output of unwanted goods and services flooded the market ... interest rates rose to repair the Balance Sheets ...
prices too high = gluts of credit - only a few high profit projects were financed by expensive loans, folk started to worry, so few projects, economic activity declined, asset bubbles burst, bad debts started to rise due to high borrowing costs, savings deposits rose from a dearth of investment opportunities ... interest rates declined to repair the Balance Sheets ...
In this way interest rates were the price of money which avoided gluts & queues, and they were determined in global markets for credit as commercial banks balanced their Balance Sheets or went bust ... there was no manipulator trying to fix prices somewhere in the basement of the Bank of England ...
The Bank of England tried to explain it all to a mystified Joe Sixpack.
Banks trade in profitable projects or go bankrupt - because nobody knew in advance the process was to discover by trial & error -
the profitable project which generated an income stream and economic growth and
the right price which avoided the costs of gluts & queues
Folk became disturbed when FX trade was 100 times the trade in goods and services? But the more price points over time the more likely the 'right' profitable price would be discovered ... and bankruptcy avoided. How else were 'right' prices discovered? After all the Bishops, Princes, Generals & Bureaucrats had always thought they knew better and their attempts to fix prices always produced those costly gluts & queues.
Bills of Exchange & Mortgages were different ... and there was more more ... as the money always seemed to return to the coffers of the banks some enterprising folks realised that it would be possible and cheap to make payments between buyers & sellers simply by adjusting deposit 'accounts' instead of the risky business of transporting gold, coins and paper IOUs around the place ... with trust & confidence simple instructions could be issued to transfer funds from one account to another ... just a cheque or a bill of exchange, another variation of 'I promise to pay' ... cheap and less risky ... in this way central 'clearing' of IOUs started on the bank benches, on the Rialto, in the coffee houses or where ever the bankers gathered together ... and eventually clearing was done across the accounts that the commercial banks held at a central bank ... more conveniences to encourage more customers ... amazing innovations constantly reduced the transaction costs of deals ... constantly speeding up the interactions and synergies which created more real wealth ... and economic growth ... by exchanging paper promises ... would you buy a second hand car from this man? ...
All bankers knew the difference between a bill of exchange and a mortgage ...
All money was credit but all credit was not money ... all Bankers knew the difference was valued trust in exchange!
The 3-6-3 system sounds simple but it was a complex adaptive system of trust & confidence as promises were exchanged, credit could never be created out of thin air -
3% interest on deposits would be impossible unless the banks earned a trustworthy reputation
6% return on investments would be impossible unless the banks invested in profitable projects
3 pm on the golf course, the bankers bonus, would be impossible unless the bankers were both trusted & profitable ...
Walter Bagehot eloquently described this system of 'endogenous money' which insured that society's currency was always backed by productive assets, not gold but productive assets. A system of credit which suited itself to the course of business (see Bagehot below).
Crucially real money cannot be created out of nothing!
Recap - Business AND Money -
‘Know how’ = knowledge = innovation = technological
advance, labour productivity, infrastructure, education, health & poverty
Innovation works on existing capital stock & new capital -
1. applying state-of-the-art knowledge to the
quantity and quality of investments
2. ‘creative destruction’
Schumpeter = innovation was a dynamic process & the impossible gap needed finance before any revenue stream materialised. The industrial revolution confirmed that finance was central to the innovation process in companies, not only to fund the impossible gap but also to overcome resistance to change spurred by an innate ‘loss aversion’ bias
Keynes = entrepreneurs were driven by 'animal spirits' and the perceptions of where the future technological and market opportunities might be discovered. Investment in profitable projects created the surplus which spurred savings. Was credit, savings?
Minsky = the whole shebang
was inherently unstable, the business cycle cycled because of the
unknowable innovation process and the financial
perceptions of hubris, nemesis & catharsis.
Made worse by financial innovations where making money out of money was directed outside the sphere of production. But still underpinned by the same income stream generated from production. There were parasite and predators everywhere!
The 3-6-3 system was incredibly successful ... no wonder banking took off during the industrial revolution ... no wonder comparative advantage in England moved from manufacturing to financial services ... no wonder folk chased the 'American Dream' ...
But who was driving the money machine? ... and which direction to steer? ... was there an accelerator? ... or a brake? ... with all this risk & uncertainty, complexity, change, conflict & scarcity, was there really an invisible hand? ... preposterous? ... why did anyone risk hard earned cash and deposit or invest in a bank? ... did they know where their money was? ... and what about the right price of money to avoid those damned gluts and queues? ... did the Balance Sheet keep tabs on the money?
The Business Cycle Cycled - hubris / nemesis / catharsis
A History of Business Cycles.
The market search for clearing prices which eliminated expensive gluts & queues was particularly difficult because it was new fangled innovative technology which was driving evolutionary change. And innovation & evoluion were not facile processes ... but fickle ... capricious ... vacillating ... hitherto unconnected connections ...
This was evolution, all about inheritance with random modification and differential survival, but it was the random modifications which caused the trouble. Folk could get a grip on inheritance but randomness was bewildering ... but it was the random mutations that created the new survival value ... and the random mutations were completely unpredictable, nobody knew where the next good idea was coming from. In such abject innorance about the future new ideas had to be discovered and then accumulated by testing against the rigors of reality ... this trial & error process was spurred by the flip flops in the cycle of emotions, instinctive excitement & fear ... and excitement & fear were both contagious ... the trial & error process must have resulted in cycles ... mustn't it? ... think about it!
In this way the pricing of technological innovation was scary, nobody could predict what the best product would be never mind its future price. Sure, the pricing of potatoes was a little less difficult as it always seemed that when prices were too high there were gluts, and always when prices were too low there were queues. Cycles were the only way survival value and associated clearing prices could be discovered. This was a search ... heuristics with an emergent outcome ... there was no way the immensely complex synergies of specialisation & scale and comparisons of opportunity costs & marginal utilities could be calculated ... but this never stopped the soothsayers from trying to fix prices and then blaming the adaptive process when their arrogant designs failed ... some folk got it ... survival came not from soothsayers but innovative technology ... so folk were in a cleft stick! ... folk were stuck with cycles!
It was a hit & miss affair, everybody was guessing, nobody knew what was happening, but there was always excitement & fear ... and business cycles. 'Kondratieff Waves', booms & busts, as well as runs on banks, stock market crashes, asset bubbles, currency crises, sovereign defaults ... and lynch mobs, riots and crowd trouble ... how many cycles? ... all cavorting in a mad dance one on another, one with another ... crazy bewilderment ... in different folk, in different places, at different times, at different speeds with different outputs ... as cycles interacted there were amplifications & suppressions, combinations & displacements ... big booms & busts and small booms & busts ... overshoots of euphoric experimental discovery... undershoots of odious experimental failure ... one damn cycle after another ... prices of coffee influenced prices of tea ... and some even suspected the price of potatoes influenced the price of holidays in Benidorm ... prices seemed to be all over the place ... especially after a failure of the rain dances ... and what of the stupendous puzzle of money itself, and credit, and new cowry shells and coin clipping inflation? ... no wonder it all went wrong so often?
Immense complexity, layer after layer, distortion after distortion, impossible to simplify ... but each distortion presented an arbitrage opportunity which tended to push prices to a clearing level like a strange mimic of Le Chatilier's Principle ... and then each discovery added further complexity ... as entropy increased ... oh gawd ...
However there was some good news ... there was a growth trend ... it seemed, relentlessly (some said paticularly since the industrial revolution) technological innovation produced an underlying growth trend of around 3% pa. Business cycles were manifestations of creative destruction, of markets coping with the perpetual change of technological innovation by discovering clearing prices in new situations. There was no efficient market theory, no market equilibrium of classical economics orchestrated by the mythical Walras auctioneer.
Increased 'know how', technological innovation, grew steadily as folk learned from the cycles of discovery & accumulation. Economic growth averaged of 3% pa not in spite of cycles but because of them!
The ubiquitous inevitable cycles were easily recognised in the history of economic institutions, companies and banks all over the world ... but the cycles of discovery always seemed to be associated with knee jerk hysterical responses, which often seeded & fuelled the next cycle ...
The hysteria was not mal intent it was ignorance of diverse complexity!
Here are just a few examples -
1637 Tulip Mania - an exotic fad in tulips bubbled & crashed - the response was an attempt to fix prices & protect folk from risk as legal contracts to buy & sell were banned ... was the market messenger shot after the horse had bolted? ... who was the crazy one, the owner who refused to sell at the daft price or the buyer who offered the daft price?
Evolutionary economic growth was driven by emotions, the excitement of the bubble followed by the fear of the crash.
James MacKay, 'Extraordinary Popular Delusions and the Madness of Crowds'.
1725 The South Sea Bubble - Joint Stock Companies bubbled & crashed - the response was to ban companies for 100 years ... was this an attempt to deny the existence of risk & failure?
Evolutionary economic growth required failure, the bankruptcy of Joint Stock Companies.
Sir Isaac Newton, an investor in the South Sea Company -
'I can calculate the movement of the stars, but not the madness of men'.
1929 The Great Depression - traded equities bubbled & crashed - the response was an attempt to 'fix prices', 'beggar-thy-neighbour', 'pick winners' & introduce 'moral hazard' ... was it an hysterical mixture of risk fixing (SEC), price fixing (gold & minimum wages), housing subsidises (Fannie May & Freddie Mac), import tariffs (Smoot / Hawley), spending on earmarks & pork (Tennessee Valley Authority) & bank bailouts through deposit insurance (FDIC) all of which sowed the seeds for the next bubble?
Evolutionary economic growth could not be manipulated by bureaucrats, fighting complexity with more complexity was nonsense, there was no foresight ... technological innovation continued to evolve.
Friedrich Hayek -
'The Fatal Conceit'
1972 The Great Inflation - deficit financing bubbled & crashed - the response was an attempt to justify 40 years of tax & spend to create jobs & legislate wealth ... did government spending create unemployment & inflation as skilled folk crowded into unsustainable activities invented by the political hubris of elected dictators?
Evolutionary economic growth was destroyed by money inflation, both sides of the Balance Sheets were hit.
John Maynard Keynes -
'By a process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method, they not only confiscate, but they confiscate arbitrarily; and while the process impoverishes many, it actually enriches some'.
2001 DotCom Internet Boom - innovative technology bubbled & crashed - the response was an attempt to blame regulators & auditors as they lost their underpants by failing to spot troublesome valuations on Balance Sheets ... was this an attempt to replace the principles of 'caveat emptor' & 'due diligence' and bankruptcy with another layer of regulation (Sorbane / Oxley)?
Evolutionary economic growth from technological innovation could not be regulated, the next crisis always involved a different innovation.
Governor of the Bank of England, Mervyn King -
'Regulation is a delusion'.
2008 Subprime Housing Credit Crunch - credit for real estate bubbled & crashed ... here we go again ... but this time did the Chinese join in as the banks were screwed and prices fixed? ... and the followers of Nobel Prize winners in economics still disagreed! ...
Evolutionary economic growth from technological innovation was no longer measured by the Balance Sheets of commercial and central banks, they had been bailed out and turned into zombies!
Prime Minister, Gordon Brown -
'I have banned boom & bust and saved the world'.
So many questions ... all that anguish & hysteria ... but bubbles burst, what else were they expected to do? ... it seemed business cycles were part & parcel of a common pattern of technological evolution which involved -
natural cycles of emotion - deep down in the skull
decisions were being driven by ancient neural survival circuits which generated
excitement ... and fear...
frantic activity - most folk were going for betterment by chasing profits & cutting losses ... some folk were stealing ...
herding instincts - folk everywhere were social animals and ignorant, it was only hindsight that exposed which deals were daft ... everybody wanted to keep up with the Joneses ...
bottom up innovations - different products or service opportunities were involved each time ... old technology was replaced by new ...
top down regulation - each new crisis brought new regulations justified by 'market failure' ... Bishops, Princes, Generals & Bureaucrats had a vested interest in preserving their old technology by 'fixing prices', 'beggar-thy-neighbour', 'picking winners' & 'moral hazard' ...
eventually prices adjusted to the new reality as the bubble burst - nobody was willing to foot the bill for those wretched gluts & queues ... Balance Sheets had to balance ... there was no way round that ...
After all this contorted history of complexity, change, conflict & scarcity it came to pass that the soothsayers couldn't manipulate the future ... perhaps Adam the Smith got it right ... perhaps there was a market in credit and the business of business was a search for -
tort law - generally accepted rights & obligations
trade - clearing prices
technology - 'know how'
So what was the nature of this market in credit which fuelled the business of business, the banking institutions & their Balance Sheets which emerged as economic growth was tracked over the inevitable business cycles?
Money Measurement - Balanced Balance Sheets
How did The Balance Sheet measure the 3-6-3 Banking System during the Business Cycles?
In 1494 Luca Pacioli, a mate of Leonardo da Vinci, developed a system of 'Double Entry Book Keeping' as he tried to account for the synergies of exchange deals ... he summarised all the legal rights & obligations of customary law as assets & liabilities ... Luca was a Franciscan friar and thought he knew a bit about rights & obligations ... his 'Balance Sheet' was a meticulous reflection of the trading process ... and together with the Profit & Loss Account these reports kept the score for business investors ...
Pacioli's accounts became sifting documents, reports, for measuring all manner of deals and market adventures ... but there were all manner of problems ... did profit measure the synergies of specialisation & scale which emerged from cooperation, hard work, honesty & thrift? ... or was profit exploitation? ... could there be exploitation if there were synergies? ... what was the difference between profit & rent? ... how were assets valued? ... was capital different from revenue? ... when was income actually earned? ... was a pound today worth the same as a pound tomorrow? ... why wasn't profit the same as cash? ... what was inflation? ... how did the auditors know what was going on where, when & how? ... and who guarded the guardians? ... and were the banks different from other businesses? ... did 'due diligence' and 'caveat emptor' help untangle the mess? ... strange stuff was money and credit was even stranger ... would you buy a second hand car from this man? ... seems there was no substitute for trust & confidence? ...
So all the puzzles of invisible hands, moral sentiments, comparative advantage, total factor productivity & creative destruction were only dimly illuminated by using Pacioli's audited Balance Sheets to measure the business of business ... but from the start two things about Balance Sheets became clear -
when prices were wrong the deals weren't right!
when the left side wasn't right then the right side had nothing left!
So how did Pacioli's Balance Sheets cope with vagaries of economic growth, wealth creation & business cycles? ... well... Luca's system couldn't replace trust & confidence but it could help to chase profits & cut losses because Balance Sheets measured both sides of the deals- rights & obligations - assets & liabilities - credit & debts - profit & loss ...
hubris - excitement - wealth creation & economic growth.
The Balance Sheets measured synergistic business deals at prices which cleared markets ... the evolved institutions of capitalism, liberal democracy & the industrial revolution created wealth & delivered self sustaining economic growth as folk did deals of their choice in social communities where the freedom to experiment was lawfully protected and there was a tolerance of failure ... no wonder there was euphoria!
Some economists told it how it was -
Moral Sentiments - cooperation in social systems was underpinned by instinctive emotions ...
Increasing Returns - synergies came from specialisation & scale (eg pin factories) ...
Invisible Hands - self organisation emerged from free market economies 'which was not part of intention' ...
Comparative Advantage - free trade synergies of specialisation & scale extended globally ...
Opportunity Costs - differences & diversity guaranteed trade opportunities for everyone, everywhere, every time ...
Ricardian Equivalence - there was no free lunch, risk could not be eliminated, tax now or tax later was a double whammy -
- average tax burdens introduced X-inefficiency and lowered the marginal productivity of capital and
- marginal tax introduced XS burdens and eroded effort, honesty & thrift ...
Total Factor Productivity - the discovery & accumulation of technological innovation was a much more potent explanation of wealth creation than natural endowments of land, labour & capital ...
The upturn started ... Optimism - Excitement - Thrill - Euphoria ... entrepreneurs created a stream of technological innovations which were part of profitable business strategies, resulting in satisfied customers, good job prospects and orders for suppliers ... real productivity gains from innovative technology ... euphoric folk embraced risk & cheap credit and purchased assets they couldn't afford, investments were made in unprofitable higher risk projects which began hogging valuable land, labour & capital and pushing asset prices up as envy & greed reinforced a spiral of increasing inflation & leverage ...
New deposits appeared on the bank Balance Sheets as businesses prospered which offered opportunities for new lending as cheap credit became available at low interest rates ...
NB - success was exciting, folk voted for optimism and the hubris was exacerbated by encouragement of low interest rate borrowing - exchange controls, legal tender laws, bank & pension fund reserve ratios, protectionism, gold restrictions, tax relief on borrowing, tax increase on saving, subsidies, affordable housing ...
nemesis - fear - extraordinary popular delusions & the madness of crowds.
In a competitive economy many experimental & innovative projects inevitably failed. Owners lost their shirts, workers lost their jobs, suppliers lost their customers and banks lost their deposits ... no wonder there was despondency!
Other scientists & economists identified the inevitability of the business cycle and the inevitability of failure -
Natural Selection / Differential Survival - long necked giraffes resulted from the death of the short necked variety ...
Creative Destruction - bankruptcy cleared out the turkeys as effort & resources were diverted into soaring eagles ...
John Maynard Keynes
Animal Spirits - perceptions in the imagination, 'we have nothing to fear but fear itself', 'irrational exuberance', delusions & madness, casino capitalism ... and everybody followed the crowd over the cliff ...
The downturn & the blame game started ... Suspicion - Anxiety - Denial - Fear - Desperation - Hatred - Panic - Capitulation - Despondency - Depression ... everybody rushed for scapegoats as the rational purposeful intentional planning of intelligent design failed. Confusion & fear led to both socialism, as the poor blamed the rich, and fascism, as the rich blamed the Jews ... but most folk blamed the rich Jewish bankers ... a vortex of shame engulfed Ebenezer Scheister, Shylock of the Rialto and even Joe the Plumber was vilified for his attempt to create wealth and chase profits ...
Bad debts appeared on the bank Balance Sheets as businesses failed, opportunities for new lending dried up as credit became expensive at high interest rates ... liabilities exceeded assets and the Balance Sheets didn't balance and needed repair ... bubbles always burst ... deposits dwindled, consumption down, prices down, production down, profits down, investment down, employment down, wages down, lending down, capacity reduced, deflation ... banks went bust ... lending & borrowing was a risky business, the 'sound judgement' of the bankers only appeared with hindsight as the appropriate interest rate that was needed to attract savings for investment in profitable projects spilled over into greed & disaster ...
NB - failure was anathema, folk voted for a rescue, bailouts as bad debts were socialised, deposits were guaranteed, savers were blamed, money was printed ...
catharsis - optimism - long term endogenous economic growth from technological innovation.
Wealth creation & economic growth was the business of business and required the failure of businesses. Wealth creation was restored by new business initiatives as technological innovation grew by discovery & accumulation in adaptive cycles ... no wonder folk clamoured for catharsis!
Some economists focused on the miracle of wealth creation & economic growth over the long term at 3% pa compound -
Endogenous Growth - technological innovations were discovered & accumulated in competitive R&D departments in commercial businesses, the resultant 'know how' was -
- partly appropriable - providing rewards & incentives for hard work, honesty & thrift
- non rival - as monopolistic competition provided spillover benefits for everyone ...
Lombardy Street - Free Banking - Independent Central Banks in a Free Society - agents of monetary stability, financial stability, payments system and Government debt ...
The upturn started again ... Optimism replaced Fear ... some folk, somewhere, sometime were working hard as a virtuous circle of price adjustment in markets and ongoing technological innovation restored the availability of credit to some innovative projects ... technological innovators took advantage of the clear out of failures as input prices reduced and equipment replacement was cheap ...
Balance Sheets had to balance ... there was no place to hide ... Central Banks provided liquidity to solvent Commercial Banks and insolvent banks were restructured & recapitalised or wound down. Higher interest rates replaced cheap credit to attract deposits, repair liquidity and recapitalise the Balance Sheets ... but it was economic growth that repaired the Balance Sheets of commercial and central banks.
Catharsis was a Darwinian 'bottleneck' as the system was cleansed of accumulated toxic dross ... losers lost ... there was no way round that ... institutions adjusted to losses and inflated price levels and new technological innovation grew again ...
In this way the Balance Sheet attempted to identify & quantify, to account for, investment decisions as capital chased profits and losses were cut ... but it was the price of money, the interest rate, the market clearing price which eliminated all the gluts & queues and ensured the balance of rights & obligations ... the Balance Sheet had to balance ...
This ebb & flow of creative destruction worked as Darwinian natural selection ... death by bankruptcy was essential ...
Darwinian Economics ... not Analogy but Ontology!
Darwin told the story of economics, and everything else, a different way.
The central theme of Darwin's idea of natural selection was, failure. Those less responsive to their environment 'simply' died out. The giraffe's long neck resulted from the death of the short necked varieties.
An inevitable conclusion was that to progress faster, we should make our mistakes faster, and learn from the outcomes.
But folk didn't like the idea of a host of expensive failed experiments being a prerequisite for each successful breakthrough.
This heuristic trial & error approach to ignorance went against the grain, it was more comfortable to believe in supernatural, deliberate, rational, purposeful, intentional, planning ... it seemed that following the emergence of self-consciousness, human intention & the arrogance of supernatural design disguised the universal process of natural selection. Bureaucratic command & control by elites was far more acceptable to the uneducated.
Learning from empirical failures was not on. Folk just didn't want costly failures and were wooed by the promise of intelligent designs ... but the intelligent designs turned out to be zombies which were too big to fail ... and nobody would talk about Darwin & the elephant in the room ... bad debts were failures but they survived under the carpet ... and they survived to wreck the balance sheets ...
Darwin's ideas were about evidential science where giraffes had to strive for nourishing technology which grew high in the trees, where differences & inequality guaranteed the process of change that Darwin called natural selection ... the short necked variety had fewer off springs and the longer necks had more and more as the giraffe population waxed ... the 'trick' of differential growth transformed short necks into long necks and helped the whole of the giraffe population to reach the nourishing technology ... this was not analogy but ontology!
Thomas Jefferson's Liberal Democracy was always consistent with Darwin's natural selection where the long necked giraffes were not designed but were the inevitable result of fewer short necked giraffes in the population ... it was all about the agricultural revolution, the industrial revolution and the emergent global city ... an evolved complex adaptive system ... folk didn't get it!
Nobody was teaching evolution by natural selection ... by creative destruction ... a heuristic approach to ignorance ... measured on the balanced Balance Sheets of banks and businesses as emotions cycled -
excitement & hubris - inherited human survival emotions responded to wealth creation ... greed produced excess ...
fear & nemesis - associated destruction of failures was accompanied by ... blame produced scarcity ...
optimism & catharsis - economic growth from diverse technological innovation required this cycle of flip flopping emotions ... creative destruction discovered market clearing prices and space for wealth creation ... centralisation produced to big to fail ...
Adaptation required the heuristic trial & error approach to ignorance, the boom & bust of flip flopping human emotions was necessary; excitement drove the booming experiments and fear drove learning from the busts of failure ...
The evidence for these adaptations was in history ... the process was endogenous ... folk were not zombies they were emotional social human beings seeking betterment for their kids ...
Balanced Balance Sheets ... Walter Bagehot, the evolution of banking!
Commercial Banks originally emerged 'as if' to chase profits & cut losses by selling credit but the real business of banks was business. They provided a service to businesses as a vast diversity of business projects competed for limited savings ... some customers saved, some customers borrowed and bankers selected investment projects ... some projects were profitable and grew ... some projects failed in ignominious bankruptcy ...
A process of natural selection which resulted in the emergence of macro economic benefits which were not part of intention but emerged from the micro activity of earning a living selling credit -
balanced the flow of savings into investment ... from the mattress to the safe deposit box to project investment ...
increased the marginal productivity of capital ... decentralised, diversified profitable project investment ...
balanced the money supply with the growth of goods & services in the economy ... credit growth on a balanced bank Balance Sheet 'controlled' inflation and preserved the measurement system ...
But the bank business was risky, trust & confidence was fickle, businesses failed creating bad debts, insolvent banks went bankrupt, illiquid banks faced the ignominy of a bank run, thieves were everywhere and envy & greed stoked resentment of the 3-6-3 system ... confidence & trust in commercial banks was eroded ... but unsurprisingly immune systems co-evolved to combat these whammies ...
Central Banks emerged 'as if' to chase profits & cut losses through selling their own currency but the central banks ended up coordinating the whole banking system by protecting the commercial banks as a regulators and a lenders of last resort -
solvency & financial stability - commercial banks needed capital, loss absorbing capacity, to support the sale of credit during the business cycle because it was business deals for margin & speed that made the 3-6-3 system work ... and some businesses went bust ...capital was maintained intact & the marginal productivity of capital increased by a relentless focus on the discovery of profitable projects ...
The financial challenge was to manage risk by scrutiny of Audited Balance Sheets and the principles of 'caveat emptor' & 'due diligence' ... in their own interest in profit, central banks would not, should not & could not lend to insolvent commercial banks ... orderly bankruptcy was necessary for insolvent banks and this required prior legal agreement on creditor haircuts to balance the Balance Sheets and avoid lemming like default, contagion and systemic collapse of the central bank currency ... this was endogenous self regulation by central banks ...
liquidity & monetary stability - commercial banks needed reserves at the central bank to cover the clearing of depositors cheques and enough vault cash to meet the demand for depositors withdrawals ... risks associated with borrowing short but lending long created an active interbank money market to fund short term illiquid but solvent banks and avoid bank runs ... the risk of contagion resulted in central banks becoming the lender of last resort ...
The monetary challenge was to maintain the value
of currency by keeping the
supply of money in balance with the availability of goods & services ...
this apparently called for knowledge about global economy activity
which simply did not exist and even when some data was available
the experts always disagreed on how it was
interpreted ... the dilemma was excruciating because the money supply, or
the price of reserves,
readily drove economies off track towards inflation or recession as the
credit cycle cycled ... central banks reacted the only way they could, in the same way as the potato farmers
did, they adjusted
prices by trial & error to eliminate gluts & queues ... interest
rates followed the market clearing price for credit ... market prices
which were only obvious in retrospect as the gluts & queues were
cleared ... there was no pushing on strings or pulling on elastic bands, central
banks were reactive not proactive ...
Inflation was squeezed out of the system ... this was endogenous money supply by central banks ...
Additionally as custodians of currencies and at the centre of economic activity central banks were able to offer a couple of massively important services -
receipts & payments were settled cheaply & efficiently over distance & time, without the risk & cost of physical transfer of bullion, specie or fiat ... transaction costs were reduced by central clearing across depositors accounts at the central bank ...
government debt was managed without inflation at market interest rates ...
One trick after another as innovative minds discovered all manner of methods for lubrication of the wheels of commerce ... money substitutes and money extensions ... the growth of bank Balance Sheets reflected the growth of business Balance Sheets ... the banks financed the voyages of discovery and the industrial revolution as more credit became available for business enterprises which broke the monopoly of the rich and the Bishops, Princes, Generals & Bureaucrats with the power to tax ... increasing wealth creation & economic growth ...
The study of banking history & business cycle history challenged & clarified economic theory and the distinction between -
exogenous money organisation & legal tender imposed from above by legal price fixing which inevitably led to gluts & queues ...
endogenous money organisation & credit spontaneously emerging from below as market prices avoided gluts & queues ...
In matters of trust & confidence Aristotle got it right -
'admitting ignorance is the first step in acquiring knowledge'
'those who claim to foresee the future are lying, even if by chance they are proved right'
'history doesn't repeat itself but it does rhyme'
Evolutionary history is an imperfect guide to the future but it is the only one we have ... we learn from history ...
But don't get it wrong, history revealed how bank Balance Sheets reflected the miracles of human ingenuity but history also confirmed how easily Balance Sheets were wrecked ... in theory, theory & practice were the same, in practice, theory & practice were different ... somebody was always tying shoes laces together ...
Pacioli's audited Balance Sheets illuminated the shenanigans of joint stock companies but did the Balance Sheet of the Central Bank expose the shenanigans of government? ... independent Central Banks couldn't do it all on their own, sure they could handle solvency & bad debts and liquidity & bank runs ... but they needed help, the biggest players of all had to conform ... government borrowing & fiscal policy had to be included in ... and history indicated that the Bishops, Princes, Generals & bureaucratic majorities had a nasty habit of unbalancing the Balance Sheets? ...
Walter Bagehot (1826-77) was on the ball in 1872 when he established himself as a champion of Darwinian thinking. In his book 'Physics & Politics' he applied Darwin's insights into evolution and natural selection to political economy.
In 1873 Bagehot wrote his masterpiece about the evolution of the banking system; 'Lombard Street'. He concluded that, like all evolved systems, it was less than ideal ... but better than the alternatives which had been tried from time to time ... and could always be improved but never unraveled ... screwing the banks was not an option -
'A system of credit which has slowly grown up as
years went on, which has suited itself to the course of business, which has
forced itself on the habits of men, will not be altered because theorists
disapprove of it, or because books are written against it. You might as well, or
better, try to alter the English monarchy and substitute a republic, as to alter
the present constitution of the English money market, founded on the Bank of
England, and substitute for it a system in which each bank shall keep its own
reserve. There is no force to be found adequate to so vast a reconstruction, and
so vast a destructions and therefore it is useless proposing them.
No one who has not long considered the subject can have a notion how much this dependence on the Bank of England is fixed in our national habits.
The direct appointment of the Governor of the Bank of England by the executive Government would not lessen our evils or help our difficulties. I fear it would rather make both worse.
We must therefore have recourse to feeble and humble palliatives such as I have suggested. With good sense, good judgment, and good care, I have no doubt that they may be enough. But I have written in vain if I require to say now that the problem is delicate, that the solution is varying and difficult, and that the result is inestimable to us all'.
An interesting update on Walter Bagehot's system - 'Public and Private Money Creation: Reform the Banks, not the System' by Diarmid Weir, 2011. The paper seeks to clarify misunderstandings about the nature of money and its creation but must never be used to claim understanding about policy options, such are only concerned with trial & error as Darwin explained -
All money is issued as the result of a
promise to provide a loan in exchange
for a share of the benefit of future production. Whether created by the
state or by private banks, adjusting money stocks to reconcile the needs of
production and the needs of exchange requires mechanisms to withdraw created
money from the economy. These ‘burdens’, must exist with any form of money;
taxation and bond issue for state created money, and loan repayment and debt
write offs for private bank created money.
State money is no more burden free than private money.
The decentralised issue and burdens associated with private money can improve efficiency of production by enabling focused welfare enhancing contracts between a relatively small number of different agents with different minority projects without requiring the existence and matching of pre existing money surpluses and limiting the capacity to take advantage of value-creating opportunities and facilitating value creation in the real economy.
The existing structure of the monetary and banking system is perfectly suited to the role of time and uncertainty in the creation of value and its exchange.
The problem is unbalanced balance sheets.
Regulation of moral hazard and risk management misses the problem. Regulation removes the discretion of private banking institutions to create money as they issue loans to borrowers for future profitable projects.
Money is the credible sharing of future value from new value creation opportunities spotted by any agent or agents, including the state.
Money is not created ‘out of nothing’!
The quantity of money created to initiate production depends on the efficient quantity to be produced between batches being marketed and revenue received.
The apparent seignorage opportunity arises from the addition to the stock of private money BUT this is matched by a liability increase; private debt.
Costs to banks of loan defaults and the charge to equity that may result,
with its potential risk of insolvency cannot be ignored.
Growth results from the surplus created by profitable projects. The growth imperative in capitalist monetary economies originates from the motives and incentives intrinsic to the ownership and control of capitalist firms.
Private banking does not directly restrict the ability of the public sector to issue money for its own expenditure. Public monetary flow through the economy gives the government the power to incentivise particular behaviours, redistribute wealth and provide public goods and services to individuals and sectors that are unlikely to be able to attract monetary incomes and revenues. The ultimate basis for this power in a democracy is popular consent which depends on the value of government production.
In balance sheet terms the asset side of productive potential can be increased but this must be balanced by issuing acceptable liabilities that represent goods to be produced. When government spending does not achieve gains in widely exchangeable wealth the burden of adjustment falls on all taxpayers. This may make it difficult for the government to justify spending that benefits relatively narrow sectors of society and produces polarisation.
Bagehot was clear the existing structure has evolved for good reasons and has the ability to operate efficiently for the provision of social benefit, and if abolished would probably resurrect itself less safely.
Money has no purpose if it is not a claim; yet a claim must have something over which it can be exercised.
Proposals to change the structure of the banking and monetary system, even when coherent, are unlikely to be able to produce the benefits claimed for them and would impose major efficiency costs.
The key to protecting the current system is immunity from parasites & predators.
The rest is mind games, messing with animal spirits, risk aversions and con tricks.
Such is the nature of evolved complex systems buried deep in our successful social culture ... Bagehot was eloquently describing a system of 'endogenous money' which insured that society's currency was always backed by productive assets.
On one side of the Balance Sheet - profitable projects
on the other side - sources of the finance
The Political Cycle - tax & spend / debt / print
How did it all go wrong? ... Unbalanced Balance Sheets !!
The elephant turned into a zombie.
The Elephant in the Room - Government Licensed Monopolies & the illusion of Command & Control - the national debt
Historical evidence confirmed the principles Darwinian economics ... and unbalanced Balance Sheets -
Walter Bagehot described the evolution of a generally accepted system of
human behaviour based on moral sentiments and encompassing customary common law, rights &
obligations. The system focused on wealth creation in businesses as synergies emerged as cost effective alternatives to violence &
theft. And with
it co-evolved a competitive money & central banking system with audited Balance Sheets
and the principles of caveat emptor & due diligence.
Walter Bagehot -
'free banking, the natural system, would have sprung up if Government had let banking alone'
but Government didn't let banking alone
there was always
a creeping imperative ...
Government, of what ever persuasion, throughout history, needed to borrow & regulate to
win wars and protect folk from failure if they were to get elected.
But universal human behaviour evolved by essential failure of bad behaviour but governments tried to reward bad behaviour to get elected and a complex mess resulted.
Henry Kaufman, Dr Doom of Salomon Brothers in 2004 -
'the trouble with Wall Street is that everything has become so complex, nobody at the top can possibly know what is going on down below'.
Plato's democratic conundrum -
'mob rule and emasculation of the wise' but 'who guards the guardians'
The same ancient problem constantly reappeared in a new disguise ... a fundamental of political shenanigans & perverse incentives -
'a tendency in modern democracies of successive governments to pile up debt by making unaffordable spending promises to voters; bribes which build up unfunded future commitments which do not appear on the government's balance sheet, which simply cannot be honoured from the existing tax base nor by borrowing from future generations' ...
Thomas Jefferson's Liberal Democracy was about 'checks & balances', Tort Law and the 10th Amendment ... culminating in the UDHR; it was never supposed to be about empowering 'kleptocrats', 'rent seeking elites' and 'winner takes all' euphoria where -
Votes led to majority dictatorships where
Vetoes and discriminative coercion on minorities proliferated and the
Violence of the state was used to enforce arbitrary new taxes & statutes.
Thomas Jefferson knew a thing or two about 'checks & balances', no wonder just before he died, he lamented, 'I wish it were possible to obtain a single amendment to our Constitution - taking from the federal government their power of borrowing'
Benjamin Franklin also suggested that Democracy was not two wolves and a lamb voting on what to eat at their banquet!
And much later Lord Hailsham was clear Democracy was not an elective dictatorship with the potential for tyranny!
But things transpired differently. In a vain attempt to bribe Joe Sixpack for his vote 'the powers that be' offered spending promises on 'free lunches' paid for by discriminatory taxes on 'others'/'the rich' ... but spending promises proved unaffordable and tax receipts proved inadequate which led inexorably to increased debt ...
Surprise surprise Joe voted the smart way ... he had a wife & family to support -
Yes to 'free lunches' - 'if it's free put me down for two please' ...
No to 'discriminatory taxes' - 'get your shovel out of my store' ...
The powers that be were in a cleft stick. Just like all the top pecks that had tried to solve Plato's conundrum throughout history ... they always ran out of money - tax & spend was a misnomer it transmogrified into spend & spend ... and then just promise & promise ...
The hysteria was not necessarily mal intent it was ignorance of the diverse complexity of Complex Adaptive Systems! But it was kleptocracy!
The sequence -
tax & spend
discrimination = promises of benefits to interest groups paid for by taxes on other interest groups
Voters were bribed with spending promises for some interest groups paid for by taxes on the disenfranchised minorities ... minorities with fewer votes ... the hated Jews, the bloody foreigners, the filthy rich ... or better still companies who didn't vote at all ...
The 'free lunch' messed things up something rotten; everybody wanted one ... and there were alarming unintended consequences ... under-writing standards were eroded and credit sold cheaply to 'men in string vests' ...
Tax & spend distorted democracy by discriminatory taxes on other folk and discriminatory spending on interest groups ...
Tax & spend distorted prices which resulted in additional costs of the gluts & queues and who was to pay for the additional 'dead weight' output loss which stifled growth ...
Business needed fiscal discipline, not necessarily low taxes but avoidance of arbitrary taxes & spending and the feeling of escalation and complex distortions.
There was an immoral clamour for more & more tax revenues to be wasted on ego trips which was demolished by the moral imperative to spend other people's means wisely on innovation & diversity as Darwin had taught.
tax revenues decline = output reduced, bureaucracy costs rise, compliance costs rise, windows blocked up
Tax revenues inevitably declined, future generations who didn't vote, were unethically committed to fund the gap ... there were votes in borrowing from others to fund current consumption ...
Spending inexorably rose and taxes inevitably declined and borrowing off the gullible at increasingly high interest rates became a norm ... then they printed their promises on paper ... then they borrowed from future generations ... then they just promised! More money was needed just to pay the debt interest, there was no skin in the game, underwriting standards declined and bad debts piled up.
Bad debts destabilised Balance Sheets ...
Business needed savings and investment, not necessarily low interest rates but avoidance of subsidised lethal debt and associated bad debts.
fake money created out of nothing =
Inflation was deliberately created to erode debt & savings when credit worthiness declined and debt servicing became onerous ... debt was never to be repaid! What magic was this?
The same old con trick, the Romans clipped coins; in 2008 money was printed, 'created out of nothing'.
Printing debased the currency ...
Business needed competitive currencies, not necessarily a single currency but simply an avoidance of currency manipulation and associated volatility and gluts & queues.
Printing money and low interest rates led inexorably to low productivity -
1. financial engineering replaced profitable projects as managers were rewarded for messing with the measurement system; bonuses, valuations, dividends, share buybacks rather than the technological investment which delivered productivity improvements.
2. zombie low productivity companies were kept alive instead of going bankrupt.
3. unproductive asset values were boosted and sucked in resources. Easy credit inflated real estate prices with on productivity increase.
But there were no votes in privatisation, markets & equity ... it appeared promise & promise with associated spend & spend was the only way to get elected ... nobody talked about the elephant and folk forgot all about hard work, honesty & thrift and the economic activity involved with doing synergy deals with your mates ...and the production of useful tings & widgets ... the elephant had become a zombie ...
A bubble in debt funded subsidised houses eventually collapsed as prices exceeded value and folk went under water. To retain votes, money was printed to bailout the debt with negative interest rates, profitable projects were squeezed as resources & clever people accumulated in zombies as the inefficient were no longer weeded out by Darwinian bankruptcy and growth & innovation ceased. Productivity and real wages declined and tax revenues declined. Growth was kick started as pumps were primed with fiscal deficits to maintain effective demand in subsidised houses. To maintain social spending as real wages declined tax rates were raised but tax revenues declined in a vicious downward spiral ...
Funding of the industrial revolution was by savings & investment ... (this was also the 1942 Beveridge plan for insurance from an investment fund in profitable projects)
Funding of the welfare state was by taxing & spending ... (inevitably funding did not come from insurance premiums which was the original Beveridge idea but in 1948 the Attlee funding of the Welfare State came from 'general taxation')
Once successive Governments became locked into an election cycle where the incentives were focused on short term 4 years of tax & spend, not on long term savings & investment in innovative profitable projects ... and savings for a rainy day and R&D were compromised ... why bother with long term risks?
There was occasionally some cross party consensus on the importance of defence and some long term R&D was untouched ... but slowly even the consensus on defence was eroded by the imperative of bribes for voters. There was no mechanism for state funding of long term R&D ... no rewards for long term risks ... an alternative funding system for long term investment was essential. An entrepreneurial state selling, at a profit, the fruits of long term R&D?
Instead an avalanche of statutes, regulations and destructive onslaughts from 'rent seeking' elites confronted the evolved system which had funded the industrial revolution ... it was a grab raid on seigniorage ... of doubtful legality and awash with ignorance ... money was nationalised and homogenised; the was 'no skin in the game' & 'no one kicked the tyres' ...
There followed 'too big to fail' state licensed monopolies and four big Balance Sheet wrecking issues -
solvency problem -
bad debts required a response -
improved underwriting standards & orderly bankruptcy
NOT handouts & bailouts & kicking the can down the road - the tax system favoured and encouraged debt over equity. During the 2008 debt crisis, equity markets continued to function but the debt markets froze ... losses were inevitable but there was insufficient loss absorbing capacity in the system
liquidity problem -
bank runs required a back stop for solvent banks -
commercial lenders of last resort
NOT closed doors & panic - there was no market in derivatives and a separate regulation system failed to establish trusted asset valuations, with depleted reserves, depleted tax revenues and depleted credit ratings ... the central banks had little choice but to explode their Balance Sheets.
moral sentiments problem - parasites & predators
required a response - trust in debt recovery in Tort Law, Property Law & Contract Law
enhancing deep emotional propensities for cooperation
NOT polarisation, fighting & violence - bank incentive structures involved cash bonuses and instant gratification required by the short term electoral system and not long term equity investment options.
funding problem - tax & spend
required sourcing - wealth creation & economic growth from the synergies of technological innovation, specialisation
NOT debt & printing fiat currencies, legal tender laws & nationalisation of the central banks which led inexorably to outcomes economists described as; moral hazard, mal-investment & financial repression -
moral hazard ... Adam the Smith knew a thing or two about how folk at the
sharp end were protected by 'moral sentiments' as other instinctive
traits enabled technological innovation to rip and help folk
survive ... Moral hazard -
rewarding bad behaviour - a plethora of good intentions
paved the way to the hell of unbalanced Balance Sheets ...
the legalisation of entitlements to rewards without the obligation for
consequential costs ...
Tort Law & competing alternatives NOT red tape - a structural democratic problem
'family rainy day' investments NOT entitlements - a structural security problem
mal Investment ... Adam the Smith knew a thing or two about supply &
demand, gluts & queues and that protecting folk from competition & risk by
fixing prices was impossible ... physically impossible ...
market distortions - capital moved, not to increase its marginal productivity, but to
save tax, secure subsidy and avoid regulation ... political processes did what
was popular not what was economic ... a
cacophony of vain attempts to gain the votes of interest groups ... a deluded hotch
potch of bribery, corruption and bureaucratic kluge of bewildering complexity
... the counterfactual was impossible to prove,
soothsayers were always eager to have a go at legislating wealth ...
and you only found out who was swimming naked when the tide went out
'chapter 11' bankruptcy NOT bailouts - a structural growth problem
financial repression ... Adam the Smith knew a thing or two about of
the real economy ordered by 'moral sentiments' & the 'invisible hand' of adaptation
... instincts which could not
be manipulated by myth, mirrors & magic ... nor the stretching or shrinking of the
measurement system which destroyed the trust & confidence necessary for
doing deals ... Financial repression -
manipulation of borrowing costs - a futile attempt
to replace hard work, honesty & thrift by the arrogant pulling of levers &
pushing buttons of the money printing presses as scarce tax revenues
persistently failed to fund constantly burgeoning expenditures ...
compound interest equity investments NOT financial repression - a structural debt problem
The evidence was in history -
old technology / 'know how' was protected in zombie institutions by preserving & bailing out failures
discovery & accumulation of new technology / 'know how' was inhibited by taxing & regulating success
No decentralisation, no diversity, no skin in the game, just a bureaucratic nightmare of moral hazard and destruction of ethics & value by populist taxes on others, debt for everyone and money printing ... instead of hard work, honesty & thrift there was arrogance, delusion, denial & debt ...
A maze of problems and unwanted consequences which had been minimised by Walter Bagehot's system during the industrial revolution relentlessly reared their ugly heads. The liberal democracies which had originally nurtured economic growth, started re-imposing the old 'political cycle' of the Bishops, Princes & Generals as the new bureaucratic majorities seized a winner takes all opportunity for command and control.
It seemed folk got all messed up with an emotional aversion to Darwin's natural selection as populist politicos propped up the failures by taxing success, piling up debt and printing money. Failure was a necessary part of Darwin's evolution. Failure was natural selection. It was 'natural' and unavoidable but the whammies of perverse incentives piled up ... it seemed like everything and everybody was trying to stop Darwin's creative destruction ... nobody liked it ... it was 'as if' there was a vain attempt to overcome the 2nd law of thermodynamics, yet all the scientists agreed hard work was the only way to create a local niche in the universe ...
The titles of three outstanding books of ancient origin encapsulate the Balance Sheet wrecking process -
'Extraordinary Popular Delusions & the Madness of Crowds' by Charles MacKay, 1841 - it's easy to pay the wrong deal price! - due diligence & caveat emptor were necessary ...
'Lombard Street' by Walter Bagehot, 1873 - 'free banking, the natural system, which would have sprung up if Government had let banking alone. As in all other trades competition would bring the traders to a rough approximate equality where no single bank would permanently obtain an unquestioned predominance. I shall have failed in my purpose if I have not proved that the system of entrusting all our reserves to a single board, like that of the Central Bank directors, is very anomalous; that it is very dangerous; that its ' ...
'The Fatal Conceit' by Friedrich Hayek, 1988 - it was impossible to calculate the right deal price! - Darwin's trial & error was necessary, regulating Complex Adaptive Systems was impossible myth ...
And recently a 'heuristic approach to risk & uncertainty' ...
'Antifragile: Things That Gain From Disorder' by Nassim Nicholas Taleb, 2012 - decentralisation, diversity and skin in the game were necessary ... 'we have the wrong model of reality' ... centralisation, monopoly, regulation & protection from risk = moral hazard ...
'Other People's Money: Masters of the Universe or Servants of the People' by John Kay, 2015 - bankruptcy and balanced Balance Sheets were necessary ... a complex adaptive system was could not be regulated from above the key was the ownership of the income streams from profitable projects.
Walter Bagehot's conclusion -
'bad consequences, hidden in the dust of ancient controversies'!
In short, a con trick - governments pretend to promise to pay the bearer in gold but offer only paper ... and banks pretend to pay depositors safety but offer only risk ...
Enter the Zombies
Why should competitive businesses risk investment for profit when handouts, bailouts and printed money were readily available?
Profitable projects became a problem not a solution. Profit became a cost. As market share was taken by the unprofitable alternative Zombies who were kept alive by low interest rates but could not repair their Balance Sheets ... Zombies stuck in limboland.
Bankruptcy & administration sifted the good profitable projects from the bad failures resulting in economic growth and real jobs ... but the subsidised zombies twisted the story ... the politicos voted for bailouts to avoid unemployment and inequality? ... and the zombies went underwater and became to big to fail.
Wow! Read that paragraph again!
In 2008 history recycled as Balance Sheets unbalanced ... debt was lethal ... the jargon of failure -
lethal bad debts ... imbalances ... not only, moral hazard ... mal-investment ... financial repression ... but also, affordable housing ... bailouts ... beggar-thy-neighbour ... blame games ... bribery ... bureaucratic despotism ... coin clipping ... conflicts of interest ... corrosive corruption ... counterparty risks ... crippling complexity ... crony capitalism ... dead weight losses ... deflation ... denial ... dishing pork ... Doha ... earmarks ... elected dictatorships ... fog of diagnosis ... free riders ... gridlock ... haircuts ... illiquidity ... imbalances ... inflation ... insolvency ... government spending ... helicopter drops ... kick starting ... kick the can down the road ... kleptocracy ... mark to market ... nationalisation ... negative interest rates ... petty party politics ... picking winners ... polarisation ... ponzi finance ... price fixing ... principal/agent problem ... printing money ... protectionism ... pump priming ... quantitative easing ... red tape ... regime uncertainty ... regulation ... rent seeking ... sclerosis ... secular stagnation ... spend & spend ... Stability & Growth Pact ... subsidies ... sugar highs ... stimulus ... stop the clock ... Troubled Asset Relief Program ... Term Asset-Backed Securities Loan Facility ... tariffs ... tax & spend ... theft ... too big too fail ... underwater ... underwriting standards ... unintended consequences ... X-inefficiency ... XS burden ... zombies ...
... no wonder the Balance Sheets were unbalanced?
But Charles Darwin had been ignored as too difficult to understand ... diversity & failure were necessary for economic growth -
'It struck me that favourable variations would tend to be preserved and unfavourable ones tend to be destroyed'.
And Joseph Schumpeter had been ignored as too painful to contemplate ... economic growth was creative destruction -
'The essential point to grasp is that in dealing with capitalism we are dealing with an evolutionary process'.
... Darwin focused on death not design!
There must be another crisis. Don't know where don't know when. No law can prevent it. No regulation can foresee it ... but we can learn from it ... may be independent decentralised global cities could provide the necessary fiscal discipline, diversity and competition ... after all Schenzen did well?
The Business Cycle - profitable projects / wealth creation / economic growth
What then is to be done? ... Balance The Balance Sheets !!
The impotent Nation State & the reality of Complex Adaptive Systems - creative destruction
Historical evidence confirmed the inevitable Boom & Bust of the Business Cycle -
Panic during Bust but what an opportunity for structural reforms
Spend during the Boom but what an opportunity for structural reforms
But when all was said and done (and much more was said than done!) ... there was no evidence to challenge the fundamental insights of Darwin, Jefferson and Smith and the understanding of the synergies of specialisation & scale -
Evolutionary Economics of Charles Darwin and Genetic Cost / Benefit Analysis which helped survival
Democracy of Thommy Jeffers and Human Rights which helped avoid to costly violence
Markets of Adam the Smith and Moral Sentiments which underpinned the beneficial behaviour of social animals
Real money cannot be created out of nothing!
PS 1 - Alan Walters (1926-2009) and the IEA described the grandiose Euro scheme as 'half baked' -
Economic growth required market prices including wages & FX to avoid gluts & queues -
Bank bailouts led to sovereign bailouts and debt zombies -
Macho Men of System always meddled with unintended consequences. -
Privatised solutions result in growth from bankruptcies not design - 'too big to fail' was too big -
'Austerity' was required to cut existing public debt BECAUSE public debt is 'always' spent on grandiose ego trips which were growth-damaging. Debt invested in profitable projects were always growth promoting and MUST be diversified to enable sifting as Darwin explained in 1859. Folk will cannot borrow more to repair balance sheets they need profitable projects.
PS 2 - In 2015 John Kay hit the nail on the head when he suggested that the evidence of history revealed that human social activity routinely became too complex to manage rather than too big to fail ... this was at the heart of the case for business and the role of bankruptcy.
PS 3 - A most successful businessman of the time
supported the President -
'The President was not anti-business, hadn't he saved General Motors and rescued the banks?'
So there we have it; business policy was one of the grandiose designs of Nation States just like 'Gosplans', 'New Deals', 'Great Societies', 'Great Leaps Forward', 'Welfare States' & 'European Unions' ... which lead inexorably via , tax, borrowing & printing to the bailout and too big to fail ... the ultimate arrogance; there were no votes in dreaded failure; failure had to be banned by edict ...
And had not the President shown the Insurance companies how to operate by selling insurance to everyone regardless of risk at premiums they could not afford and did not pay?
And had not the President rubbished Bain Capital who focused on chasing profitable projects cutting losses?
PS 4 - In 2016 ... 8 years after the 2008 crisis lethal debt still loomed large in 6 numbers which summarised the chaos in European Banks -
'Audited’ Balance Sheets –
$1.9 trillion assets included $850 billion non-performing loans
On the markets since 2008 –
$200bn new investment in $350 market capitalisation
From the regulators Sept 2016 -
Brussels $14billion tax on Apple - Washington $14billion fine on Deutsche Bank ... think about it?
PS - In 2016 The Central Bank President had another go. Structural reforms of institutions were needed, monetary policy just destroyed the institutional transmission mechanisms ... prices were 'fixed'. Banks must channel funds into profitable projects or go bankrupt. Go for Jobs not immigration. Services not goods. Brains not m/cs. Fairness of Shares & Resentment of Cheats not equality of outcomes. Hard Work, Honesty & Thrift not polarised 51% v. 49%.
Structural & Cultural Reforms for Economic Growth = how to change from m/cs making bikes to folk mixing bytes?
productivity (more growth) - bankruptcy/weeding out failures - labour & capital investment in growth companies ... no picking of hopeful winners.
participation (more jobs) - education/skill acquisition - high value wages & the middle class bulge ... no subsidies for zombies.
It's the economy stoopid, this time was not different, it was creative destruction not well intentioned interventions ... bubbles must burst ... if a thing can't go on for ever it will stop ... from bankruptcy to education to the middle class bulge.
'Know How' was always on the charge and nobody knew where the next good idea was coming from.
Real money was never created out of nothing!
Socrates - 'admitting one's ignorance is first stage in acquiring knowledge' ...
Joseph Addison (1711) - 'Public Credit', The Spectator ... credit is fragile ...
Adam Smith (1776) - 'Division of labour is limited by the extent of the market' ...
Charles MacKay (1841) - 'Extraordinary Popular Delusions & the Madness of Crowds' ...
Walter Bagehot (1873) - 'Lombard Street' ...
Hyman Minsky (1975) - 'John Maynard Keynes' ...
Jane Jacobs (1984) - 'Cities and the Wealth of Nations' ...
Richard Dawkins (1986) - 'The Blind Watchmaker' ...
Norman Jones (1989) - 'God and the Money Lenders' ...
Paul Romer (1990) - 'Endogenous Growth Theory' ...
Carmen M Reinhart, Kenneth Rogoff (2009) - 'This Time Is Different: Eight Centuries of Financial Folly' ... 'good' debt or 'bad' debt ... ?
Edward Glaeser (2011) - 'The Triumph of the City'. Paul Romer 'Urbanisation as Opportunity'.
Nassim Nicholas Taleb (2012) - 'Antifragile: Things That Gain From Disorder' ... 'a heuristic approach to uncertainty' ...
Ilya Somin (2012) - 'Foot Voting, Federalism & Political Freedom', George Mason University School of Law.
Daron Acemoglu, James A Robinson (2012) - 'Why Nations Fail: The Origins of Power, Prosperity and Poverty', Random House.
Burgis, Tom (2015) - 'The Looting Machine', William Collins.
Chayes, Sarah (2015) - 'Thieves of State', W W Norton.
John Kay (2015) - 'Other People's Money: Masters of the Universe or Servants of the People', Profile Books.
Mervyn King (2016) - 'The End of Alchemy: Money, Banking & the Future of the Global Economy', Little Brown.
Tony Blair - 'The socialism of centralised state control of industry and production, is dead. It misunderstood the nature and development of a modern market economy. It failed to recognise that the state and public sector can become a vested interest capable of oppression as much as the vested interests of wealth and capital'. Ethics, Marxism and True Socialism, Fabian Pamphlet 565, London, 1994.
Will Hutton - 'The State We're In' - an influential 1997 polemic reiterating the vain hope of the political regulation of economic growth, but page 312 accepted the reality - 'global financial markets are out of control & the capacity to regulate the financial system and manage the economy is increasingly constrained ...'
Alan Greenspan - 'Senator, if you think I was clear you must have misunderstood me ... the knowledge you assume I possess doesn't exist'!
Money in Market Economies - Open University - 'the money supply is determined endogenously, as a function of national income as commercial banks in the business of credit creation, meet their customers' demand for loans. The essential insight of this model is that it is commercial banks not the government that determine the money supply'!
Reiner Kümmel - 'The Second Law of Economics: Energy, Entropy, and the Origins of Wealth' - 'Nothing happens in the world without energy conversion and entropy production. These fundamental natural laws are familiar to most of us when applied to the evolution of stars, biological processes, or the working of an internal combustion engine, but what about industrial economies and wealth production, or their constant companion, pollution? Does economics conform to the First and the Second Law of Thermodynamics'?
Niall Ferguson - 'Only a truly free society can foster genuine innovation and the creative destruction that is its corollary'.
john p birchall
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