The Origins of Central Banking

Ben Bernanke must think he’s an amateur entertainer.  Tomorrow, after 98 years of silence, the Fed Chairman will give the central bank’s first-ever press conference.

Here at the Economic Prism we’ll be watching with wide eyes and anticipation…hoping for the sort of gut busting comedy that comes from a night at the Laugh Factory.  From our perspective we are more interested in the questions Bernanke gets than the answers he gives.

No doubt, most of the questions will be predictable drivel about the federal funds rate, inflation expectations, and the end of quantitative easing.  Still, we hope someone, somewhere, someway, will ask a question that is completely and utterly unexpected, unpredictable, and uncouth.  Something like, “What are your thoughts on John Law?”

Of the many professions out there, earning one’s living as a central banker of a paper money standard is one of the more devious ventures one can pursue.  In this modern world, where smartphones keep getting smarter and waist lines keep getting wider, the business of central banking is as ridiculous as the day it was invented.

For all the conceit out there about inflation targeting, liquidity traps, and scientific management of the economy, when it comes down to it, central banking is still the work of carnival magicians.  To show you what we mean we must take a gander back at the origins of central banking.  That is the burden of today’s musings.

John Law’s Marvelous Theory

In 1716 a gambling Scotchman named John Law persuaded the Regent of France, Philippe d’Orléans, to make him Controller of France’s General Finances.  From the get go Law and the Regent were a match made in hell.  For Law had a marvelous theory about how to bring wealth to a nation with the use of paper money…and the Regent’s political ambitions were grandiose enough, and France’s finances dreadful enough, to give it a try.

According to Law physical specie, like gold and silver, was too scarce.  Paper money, because of its availability, would better facilitate trade.  But from where would paper money derive its value?

Law’s answer, and the same answer that Bernanke would offer today, was that paper money is backed by the government’s promise to pay with the future tax revenues of the state.

On May 5, 1716, the Banque Général was founded with 6 million livres of capital and the Regent declared that all taxes from this day forward must be paid with paper money issued by Law’s bank.  Soon after, with the issuance of paper money, the scarcity of specie problem seemed to have been solved.  France’s economy improved, confidence was established, and, in just one year, Law’s notes rose to a 15 percent premium while the nation’s debts contracted.

Of course, nothing fails like success.  And with the initial success of Law’s paper money experiment, Law and the Regent hatched their next scheme — issuing paper currency in the form of shares in the Mississippi Company.  The affair is recounted in Charles Mackay’s, Extraordinary Popular Delusions & the Madness of Crowds…

The Origins of Central Banking

“Law commenced the famous project which has handed his name down to posterity.  He proposed to the Regent, who could refuse him nothing, to establish a company, that should have the exclusive privilege of trading to the great river Mississippi and the province of Louisiana, on its western bank.  The country was supposed to abound in the precious metals, and the company, supported by the profits of their exclusive commerce, were to be the sole farmers of the taxes, and sole coiners of money.  Letters patent were issued, incorporating the company, in August 1717.  The capital was divided into two hundred thousand shares of five hundred livres each….

“It was now that the frenzy of speculating began to seize upon the nation.”

Similar to buying shares of dot com stocks in companies without earnings in the late 20th century, the public went mad for something that didn’t really exist.  The story of Louisiana was just a lot of hot air.  There were no profits coming out of Mississippi but it didn’t matter…a wild mania followed…

Shares rose from 500 livres in 1719, to 15,000 livres in the first half of 1720 – a 3000 percent increase.  Naturally, everyone thought they were getting rich.  But by the summer of 1720 the shares were exposed to be worthless.  That was precisely the time when something completely unexpected happened; they stopped going up.  In fact, shares crashed 97 percent overnight as the public attempted – in mass — to convert them into physical specie.

The sudden collapse ruined countless people and caused an economic crisis in France and across Europe.  Nevertheless, even with these disastrous results Law’s paper money experiment became the prototype for modern day central banking.

In other words, today’s financial system is based on an absurdity: That paper money, when backed by the government’s promise to pay with the future tax revenues of the state, preserves value even when those future tax revenues will be paid in paper money issued by the government.  What’s more, all these years later no one has ever effectively resolved its other fundamental flaw…

Central bankers can issue as much paper money as they want, until, eventually, and often after bending to intense political will, they issue too much.

Sincerely,

MN Gordon
for Economic Prism

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