Thomas Tooke

Archive for January, 2013|Monthly archive page

The best explanation of the multiplier ever. The hoarding of money and drop in multiplier requires some offsetting mechanism.

In Uncategorized on January 8, 2013 at 2:10 am

It is sometimes misunderstood that the Fed increases the amount of idle money and “it does not work” because the multiplier drops. The reality is that it is the drop in the multiplier which requires the increase in idle money. The best explanation the writer of this blog is old. It dates from 1802 from Henry Thornton but everything comes clear.

In 1802, Henry Thorton wrote.

” The quantity of circulating paper, that is, of paper capable of circulation, may be great, and yet the quantity of actual circulation may be small, or vice versa. The same note may either effect ten payments in one day, or one payment in ten days; and one note, therefore, will effect the same payments in the one case, which it would require a hundred notes to effect in the other.

The cause which lead to a variation of the rapidity of the circulation of bank noes may be several. In general, it may be observed, that a high state of confidence serves to quicken their circulation; and this happens upon a principle which shall be meant a more or less quick circulation of the whole of them on an average. Whatever encreases that reserve, for instance, of Bank of England notes which remains in the drawer of the London banker as his provision against contingencies, contributes to what will here be termed the less quick circulation of the whole. Now a high state of confidence contributes to make men provide less amply against contingencies. At such a time, they trust, that if the demand upon them for a payment, which is now doubtful and contingent, should actually be made, they shall be able to provide for it at the moment and they are loth to be at the expence of selling an article, or getting a bill discounted, in order to make the provision much before the period at which it shall be wanted. When, on the contrary, a season of distrust arises, prudence suggests that the loss of interest arising from a detention of notes for a few additional days should not be regarded. It is well know that guineas are hoarded, in times of alarm, on this principle. Notes, it is true are not hoarded to the same extent; partly because the class of persons who are the holders of notes is less subject to weak and extravagant alarms. In difficult times, however, the disposition to hoard, or rather to be largely provided with Bank of England notes, will, perhaps, prevail in no inconsiderable degree. This remark has been applied to Bank of England notes, because these are in high credit; and it ought, perhaps, to be chiefly confined to these. They constitute the coin in which the great mercantile payments in London, which are payments on account of the whole country, are effected. If therefore, a difficulty in converting bills of exchange into notes is apprehended, the effect both on bankers, merchants, and tradesmen, is somewhat the same as the effect of an apprehension entertained by the lower class of a difficulty in converting Bank of England notes or bankers´ notes into guineas.

The apprehension of the approaching difficulty makes men eager to do that to-day, which otherwise they would do t0-morrow. The truth of this observation, as applied to Bank of England notes, as well as the importance of attending to it, may be made manifest by adverting to the events of the year 1793, when through the failure of many country banks, much general distrust took place. The alarm, the first material one of the kind which had for a long time happened, was extremely great. It does not appear that the Bank of England notes, at the time in circulation, were fewer than usual. It is certain, however that the existing number became, at the period of apprehension, insufficient for giving punctuality to the payments of the metropolis; and it not the be doubted, that the insufficiency must have arisen, in some measure, from that slowness in the circulation of notes, naturally attending an alarm, which has been just described. Every one fearing lest he should not have his notes ready when the day payment should come, would endeavour to provide himself with them somewhat beforehand. A few merchants, from a natural though hurtful timidity, would keep in their own hands some of those notes, which, in other times, they would have lodged with their bankers; and the effect would be, to cause the same quantity of bank paper to transact fewer payments, or, in other words, to lessen the rapidity of the circulation of notes on the whole, and thus to encrease the number of notes wanted.

Probably, also, some Bank of England paper would be used as a substitute for country bank notes suppressed. The success of the remedy which the parliament administered, denotes what was the nature of the evil. A loan of exchequer bills was directed to be made to as many mercantile persons, giving proper security, as should apply. It is a fact, worthy of serious attention, that the failures abated greatly, and mercantile credit began to be restored, not at the period when the exchequer bills were actually delivered, but at a time antecedent to that aera. It also deserves notice, that though the failures had originated in an extraordinary demand for guineas, it was not any supply of gold which effected the cure. That fear of not being able to obtain guineas, which arose in the country, led, in its consequences, to an extraordinary demand for banknotes in London; and the want of bank notes in London became, after a time, the chief evil. The very expectation of a supply of exchequer bills, that is, or a supply of an article which almost any trader might obtain, and which it was known that he might then sell, and thus turn into bank notes, and after turning into bank notes might also convert into guineas created an idea of general solvency. This expectation cured, in the first instance, the distress of London, and it then lessened the demand for guineas in the country, through that punctuality in effecting the London payments which
it produced, and the universal confidence which it thus inspired. The sum permitted by parliament to be advanced in exchequer bills was five millions, of which not one half was taken. Of the sum taken, no part was lost. On the contrary, the small compensation, or extra interest, which was paid to government for lending its credit (for it was mere credit, and not either money or bank notes
that the government advanced), amounted to something more than was necessary to defray the charges,and a small balance of profit accrued to the public. ”

COMMENT: Obviously from this account it is the hoarding of medium of circulation because of apprehension which creates a reflexive higher level of hoarding of medium of payment and circulation and a reflexive debt deflation. By that token the increase in medium of payments does not increase in any way inflation, but just compensate for the state of idleness of the economic agents. In that sense one could say that the printing from Central banks increases in no way inflation but just offset the hoarding of medium of exchange. However when confidence comes back (higher inflation expectation), the removal of the excess injections of mean of payment if too slow can help get the inflation that the government desires to inflate its debts away. So the inflation does not occur during the hoarding but during the timid exit. Another point is that in the 1793, the sovereign lent its credit to issue exchequer bills which would be used as collateral for the restoration of commercial credit. What happens when the sovereign´s credit has been tarnished, are all the proverbial bullets been shot? Finally the promise of liquidity action was as much potent as the actions themselves, was Mario Draghi taking a page from Henry Thornton´s account of the 1793 crisis?


How to measure the accumulated commercial capital?

In Uncategorized on January 6, 2013 at 7:32 pm

In his essay “An Enquiry into the nature and effects of paper credit of Great Britain”, Henry Thornton lays some important concepts about how paper credit functions and to “exposure some popular errors which related chiefly to the suspension of the cash payments of the Bank of England, and to the influence of our paper currency on the price of provisions. ”

“It may conduce to the prevention of error, in the subsequent discussions, to define, in this place, what is meant by commercial capital. This consists, first, in the goods (part of them in the course of manufacture) which are in the hands of our manufacturers and dealers, and are in their way to consumption. The amount of these is necessarily larger or smaller in proportion as the general expenditure is more or less considerable, and in proportion, also,as commodities pass more or less quickly into the hands of the consumer. It further consists in the ships, buildings, machinery, and other dead stock maintained for the purpose of carrying on our manufactures and commerce, under which head maybe included the gold found necessary for the purposes poses of commerce, but at all times forming a very small item in this great account. It comprehends also the debts due to our traders for goods sold and
delivered by them on credit ; debts finally to be discharged by articles of value given in return.”

COMMENT: It might be understood that we are talking about the asset side of the balance sheet of corporations, however in order to measure the wealth of a country the assets held by domestic corporations outside of the country should not be counted. Henry Thornton talks first about the current assets such as inventories, but also about the long term assets which include the buildings, machinery and other “dead stock” or fixed assets in today´s parlance.  Finally the accounts receivable against merchandise are part of the identifiable capital. At the time the intellectual capital of patents was not a determining factor, but it would be essentially fall in the same category.

Continuing with Henry Thornton…

“Commercial capital, let it then be understood, consists not in paper, and is not augmented by the multiplication of this medium of payment. In one sense, indeed, it may be encreased by paper. I mean, that the nominal value of the existing goods may be enlarged through a reduction which is caused by paper in the value of that standard by which all property is estimated. The paper itself forms no part of the estimate.”

COMMENT: I guess it removes a bit of the argument of the “wealth effect” touted by Mr Greenspan recently. If you alter the circulation medium, you might increase the nominal value of the assets, by manipulating the yardstick. The money illusion is an old trick which Ivring Fisher and John Maynard Keynes wrote about extensively.

Continuing with Henry Thorton

“This mode of computing the amount of the national capital engaged in commerce, is substantially the same with that in which each commercial man estimates the value of his own property. Paper constitutes, it is true, an article on the credit side of the books of some men; but it forms an exactly equal item on the debit side of the books of others.” It constitutes, therefore, on the whole,
neither a debit nor a credit. The banker who issues twenty thousand pounds in notes, and lends in consequence twenty thousand pounds to the merchants on the security of bills accepted by them, states himself in his books to be debtor to the various holders of his notes to the extent of the sum in question ; and states himself to be the creditor of the accepters of the bills in his possession to the same amount. His valuation, therefore, of his own property, is the same as if neither the bills nor the bank notes had any existence. Again ; the merchants, in making their estimate of property, deduct the bills payable by themselves which are in the drawer of the banker, and add to their estimate the notes of the banker which are in their own drawer ; so that the valuation, likewise, of the capital of the merchants is the same as if the paper had no existence. ”

COMMENT: Here we have a few interesting concepts explained and the process of netting exposed. The cash on the balance sheet of a corporation since offset by a liability from the bank, while representing a financial asset for the corporation is a financial liability from the standpoint of the bank. The merchant when computing the property looks at all assets minus liability. If the merchant has a net cash position, this net cash position is in the end a liability from the standpoint of the bank so at a collective level, what is left is just the productive capacity of the farms, the manufacturing plants, the software code etc…etc… However it would only for the subsidiaries a given country, and would not count for the subsidiaries overseas.

Continuing with Henry Thornton

“The case of gold, on the other hand, differs from that of paper inasmuch as the possessor of gold takes credit for that for which no man debits himself. The several commercial capitals of traders, as estimated in their books, would, unquestionably, be found, if deducted from their other property and added together, to correspond, in amount, with a general estimate of the commercial stock of the country, calculated under the several heads already stated. It is true, that men, in estimating their share in the public funds of the country, add to their estimate a debt due to them which no individual deducts from his valuation. On this head, it may be observed, that the nation is the debtor. But the commercial capital, which has been described, exists independently of capital in the public funds. The man in trade has property in trade. If he has property in the stocks, he has the property in trade in addition to it. In speaking, therefore, of the commercial capital, whether of the nation or of an individual, the idea that any part of it is composed either of the paper credit or of the stocks of the country, is to be totally excluded.”

COMMENT: A country which has little net unencumbered commercial capital from domestic subsidiaries only in relation to its GDP has little wealth under this definition.

Does the knowledge of history and forewarning preclude monetary debacles from happening?

In Uncategorized on January 1, 2013 at 10:11 pm

It is sometimes touted, at least I have seen twice the case between Ray Dalio and Hugh Hendry that the central bankers know very well history and as a result they have the capacity to preclude a monetary debacle.

However I found recently an old archive document from Nicolas Bergasse from France who was a lawyer and a politician.

The document is called “Protestation contre les assignats-monnoie” which can be translated into “protestation against the assignats-currency”.

This publication is troubling because it forecasts all the ills of an irredeemable currency system.

His first line of objections is based on the well established real bills doctrine which makes Assignats unsuitable since those assets are not self-liquidating. Evidently this raises a lot of questions about the use of Treasury Bonds as a more of monetary asset, but that is another question. The world seems to repeat always the same mistakes.

Then he explains the problem of the creditors of the Church. The assignats were issued against the confiscation of the assets of the Church. The problem was that some of those assets had debt against them. In his paper, Bergasse explains that by both confiscating the assets of the church and at the same time repudiating the claims from the creditors, this would create havoc of confidence in credit. If you want a recent parallel, you could think of the two tiered payment system on the Greek debt with privilege to the ECB granted back in March 2012. In his word this action would introduce a precarious environment for property rights.

He continues to explain that the assets of the Church were indeed heavily mortgaged with different lines of debts some of general credit and other with a particular claim. One of his grievances was that a lot of clergy men and women would find themselves destitute as some of the assets of the Church were supposed to produce income to bring a subsistence to those people. Finally the last creditors were actually the poor as the Church was maintaining a fund for the poor and as a result of this confiscation the burden to fund the poor would fall back on the “Nation”, the concept which replaced the kingdom.

What is interesting is that according to Bergasse the Assemblée knew about the desperate state of Finances but was desperate itself in its actions and relying on expediency a guide for its decision process.

The other caveat of the Assignats mentioned by Bergasse was that if there is a time-frame for the sale and if the Nation has to re-imburse at a fixed date, the speculators will try to buy the assets at “prix vil” or ditressed price. You can now check what happens with the auction of state assets of Greece and wonder if those “institutions” like Blackstone are just doing what Bergasse describes. Bergasse also says that if there is no time frame for the sale of assets, there is no liquidation of those assets, and those assignats would have no difference with (John) Law´s system.

Bergasse very accurately predicted a deteriorating term of trade situation, interestingly the paper money is touted as a source revival of the trade situation at the time by Bergasse´s opponents. This runs evidently contrary to decades of strength of the German mark prior to 1990s with large trade surplus and inversely of chronic inflation and trade deficit accompanied with weakening currency for many nations in history. Fullarton and Tooke describe the phenomenon even more accurately (I leave that for another post). Finally Bergasse describes a problem created by the inability of commercial agents to price properly goods and services due to instable prices and resulting friction in commerce. He predicts as a result a crumbling of manufacturing and destruction of industry.

The flight of specie overseas is described by Bergasse in two ways, first because imports will have to be settled with specie as the paper even if it would trade at par does not travel across the borders.  To that extent today´s fiat USD have managed to travel everywhere. It sounded like a fantastic advantage in the 90s, but if it stops traveling it becomes a great problem. The second way the specie would flee overseas would be through arbitrage between billets the caisse d´escompte, shipping of PMs to London and the purchase of lettres de change.

The other problem facing France at the time aside from massive amounts of debts, was a large external debt position as mentioned by Bergasse. As a result he expects fully the Gresham law principle to take hold. He also predicts that the tanking exchange in foreign capitals is only the beginning.

Another phenomenon was the rampant emigration of skilled workers which was not witnessed since the Huguenot emigration during the period of catholic-protestant strife of the “Edit de Nantes”. Another phenomenon noted is that at the time is was not possible to pay the troops in paper but only in “numéraire” (precious metals). Decidedly the military seem to have had an old affection for specie.

Bergasse deplores that the system will favor extremely the “agiotage” of bankers and will absolutely destroy commerce.  What is assignat to him: ” Un malheur inévitable pour les créanciers, une resource infâme pour les débiteurs”, which can be translated as “a inevitable curse for creditors and an infamous resource for the debtors. It think one should look at the benefits derived by negative present value LBO debt and the permanent carry trade of Warren Buffet between insurance float financing the acquisition of corporations. As Buffet said himself one of the chief criteria for an acquisition of a company is if the company can reprice inflation for the products it sells.

He describes how the debtor will buy the Assignat at dirty price to repay his debt at par. He laments that the political process is done through intrigue, based on the violation of all forms of properties, on the destruction of all morality.

Bergasse finally decries, the “Assembly of legislators, which fouls the principles of honesty, and repudiate as mere scruples the most sacred values of justice and morality, which break the most solemn contracts, the most respected obligations, who change at their whim the nature of all commitments, and who introduce bad faith in all the classes of society, without any fear of making universal corruption a mean to pass the constitution they prepare”.  Evidently the French constitution was far from perfect and had to be retooled many times…

Finally he explains that the Assignat will not be short of supporters amongst those who will benefit from it. They will not miss an occasion to publish the triumph of Assignat; that it is wrong to doubt of the solidity of the assignat, which not only has the Church´s assets as collateral but also the guarantee of the Municipalities.

The interesting point is that despite the absence of complex modeling of economics Bergasse has almost a 20/20 foresight of the different impacts of the forced assignat paper money. The destruction of commerce, the benefit to speculators and bankers, the plunge of the currency, the worsening trade balance and terms of trade, combined with large external debt and total debt, and the corruption of the legislators, who know the situation is precarious but act with expediency.

Evidently he was proven right, yet the experience of paper money debacle was known from John Law, “whose name alone was enough to instigate fear in France” as Bergasse says. So policy makers of the time were warned, they had to know the problems of paper money in Massachusetts in 1737 yet failed to act decisively and courageously. It hard to imagine that people in Weimar Germany were unaware of the previous monetary experiences of serious monetary crisis and reforms of irredeemable currencies. So why the failure?

The conjecture is that psychology makes people in power think that this was the past and this is now. In other words overconfidence and the idea that they are better, smarter more informed, more sophisticated than their elders. This was precisely the line of argument from Mirabeau which was used to dismiss the idea that France was headed toward a repeat of the John Law episode. “This time is different!”

How did the French “livre” fair during the 1721 John Law paper money debacle. Where is the 1-15 official ratio of Gold Silver originating from.

In Inflationary Periods, Monetary depreciations on January 1, 2013 at 3:48 pm

Recently I was asked to go on assignment to find out what was the French “livre” worth back in 1708 and 1721.

After erring a bit on the assignment I found good data which are interesting and noteworthy.

First of all, it worth recalling that “livre” were a unit of account with a reference to coinage, but in fact the unit of account was on purpose not coined into one “livre” coin. The “livre” had a fluctuating reference to coinage, so indeed it was an abstraction like any other currency with reference to coinage.

The system of unit of account was inherited from the middle age under a format of 1-20-240 or 1 “livre” worth 20 “sols”, each sol worth 12 deniers. In Britain the system was similar with 1 pound worth 20 shillings and each shilling worth 12 pennies. So 240 pennies for 1 pound in Britain and 240 deniers for 1 “livre” in France under the “Ancient Regime” (before the revolution).

In fact France was operating under a dual currency system of livre “Tournois” which were used below the “Loire” and livre “Parisi” which were used above the Loire. In 1667 Louis XIV officially abolished the Livre parisi. At the time 5 “livres tournois” were needed for 4 “livres parisi”. This is for the currency parities, but it does not tell their precious metals equivalent.

In 1266 one ~livre~ corresponded really to its weight of 409 grams of Silver. In 1790, it was so debased that it was 1/18th of its weight of 1266. During the period of interest we have a lot of fluctuation in the parity to fixed coinage and new coinage of inferior weight at the same.  Fortunately there are records of constant coin parity to “livre” during the period.  One such example is the Louis d´or.

Monetary reform in 1709:

The edict of May 1709, one of the great monetary reforms of the early century, went the following for Gold Coinage “aux” 8 L 22 karats fine, 30 to the marc and current at 10 livres. The counterpart in Silver was the écu 3 couronnes, at 12 deniers “argent-le-roi”, 8 to the marc and current at 5 “livres”. The reform was new because it put a fixing between the prices of Gold and Silver. (Isaac Newton was observing floating ratios between Europe –wider– and Asia –Tigther–). The marc of Gold was put at 531 “livres” 16 “sols” 4 4/11 deniers, that of silver at 35 “livres” 9 “sols” and 1 1/11 deniers. This produced a Gold to Silver ratio of 1:15.

Given that the marc was at 244.75 grams, under this regime, we have “livre” effectively at 6.90 grams with a ratio of 5 to Silver Ecu in 1709. The ratio went to 6 in 1726 and we can infer something like 5.75 gram of Silver per nominal unit of account “livre”.

Now what was the devaluation of the unit of account “livre” in 1721 looking like? Here the constant coin is helping us. The louis d´or coing was at 10 “livres” abstract denomination in 1640. In 1709 after the many wars from Louis XIV it went to 20 livres. In 1721, due to the crisis going on, it went to 54 “livres” before the “Volcker moment” and coming back to 24 “livres”. So the Gold price of the coin measured in unit of account “livre” went up 54/20 = 2.7 times between 1709 and 1721. That translates into the weight equivalent of Silver of the “livre” going from 6.9 grams to 2.55 grams, before coming back to 5.75 grams. This is for the constant weight parity. Now the government at the time also used lower weight per écu as evidenced by weight of coins back in 1719.