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     Dec 22, 2011

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Back to the future
By Chris Cook

Problems of the 21st century problems cannot be solved with 20th century solutions. Martin Hutchinson recently wrote an interesting and entertaining article in which he suggested that we must go back to 1693 in order to find solutions. He advocated not only a return to the gold standard, but also to a system of "free banking", whereby private banks would create gold-backed credit - without interference from Treasuries or central banks - in order to re-base and re-boot our economy. (See Back to 1693, Asia Times Online, November 24, 2011).

It was stirring stuff, and in my view he was right to suggest we look for solutions prior to 1693, but not necessarily the ones he proposes. ...

Economy 1.0
The first economic paradigm - Economy 1.0, where buyers and sellers were physically present in the market - was decentralized

but disconnected. The price of corn in one town's corn exchange would have been different to that of the next town's corn exchange, never mind corn exchanges in other regions or countries.

An intellectual battle is currently raging among economists, historians and even anthropologists in relation to whether this Economy 1.0, which existed for thousands of years, involved primitive forms of credit or whether it was based upon barter transactions.

The answer is that both mechanisms were in use: firstly, units of currency - objects of value - which were accepted in exchange because they were perceived as a store of value which would be accepted in turn by others; secondly, credit was routinely extended by sellers who created - in exchange for value provided - obligations by counter-parties to provide something of value in exchange.

Currency - Forms of currency developed which were mutually acceptable forms of value or money's worth, such as standard amounts of silver and gold, but other forms of value have been generally accepted over the years from cowrie shells to copper, and from cigarettes to salt (hence the word salary).

Governments provided standardization, so that currency became understood as a pricing reference or unit of account; and also quality control, in the case of gold and other precious metals, by assaying, weighing, and minting coins as a standard unit of currency.

Credit Instruments - The first form of credit instrument or IOU was the tally stick. A tally stick was a wooden stick, marked with notches which recorded the value of a transaction. It was split lengthways, and part of it - the "stock" - was given to a creditor who had provided value in exchange. The debtor retained the "counter-stock" or "foil", and undertook to provide value in exchange when the stock was returned to him for redemption by whoever held it - ie, the bearer.

In order for "stock" to be generally acceptable in payment, it had to be issued by a creditworthy counter-party. This would typically be a merchant of good standing (hence merchant banker), or an institution like a temple which levied tithes on the population, or a sovereign who levied and collected taxes.

Economy 2.0
The second economic paradigm, which evolved over a period of several hundred years, is the present centralized but connected economy, where transactions take place at a distance, through middlemen, ie intermediaries, who aim to make transaction profit and put capital at risk to do so.

The development of regional, national and international trade was driven by the growth of generally accepted and trusted currencies and documentary credits and from the Middle Ages, the innovation of double entry book-keeping and accounting.

The second great innovation was the creation of the corporate body, which enabled productive assets to be owned over generations, and was initially developed by the church and by municipalities - such as London's City Corporation. Such corporations eventually came to be created for commercial purposes as an enterprise agreement between individuals with a view to profit.

The first of these "Joint Stock Companies" in which individuals shared risk collectively - but not, as with partnerships, also individually - was the British East India Company in 1600 - but the Dutch East India Company was the first to issue "Stock" to raise investment. This was a credit instrument that gave permanent rights of asset ownership and to the fruits of ownership, and which was typically divided into "Shares" denominated in the national currency.

Private credit - There were essentially two sources of documentary credits. Firstly, traders who deposited their bullion and coins on "bancs" in goldsmiths' vaults for safe-keeping began to use the goldsmith's receipt as currency instead of the gold itself. The goldsmiths - realizing that the gold they held was rarely withdrawn - began to create additional receipts and loan them for a period of time at interest. This essentially fraudulent practice of private credit creation formed the basis of modern-day banking, and was subject to a breakdown in confidence in the bank - "runs on the bank" - and hence bankruptcy.

The second form of documentary credit was the issue of "bills of exchange" by merchants, which began to be accepted by third parties through an endorsement or assignment, often many times over, before the bill of exchange found its way back to the issuer to be exchanged for value. Trust in the issuer was key.

These forms of credit enabled the flow of goods and services to take place, oiling the wheels of commerce, and were essentially based upon the capacity of people, individually and collectively to provide goods and services.

Public credit - The historic role of public credit has been almost forgotten. From the 12th century onwards, the Exchequer of English sovereigns would pledge the sovereign's credit - against value received - through the issue of stock which was later returned by the eventual holder in payment for taxes. The very phrase "rate of return" alludes to this long forgotten practice of returning stock to the issuer for cancellation.

The important role of stock in UK public finances may be gauged by the fact that by 1694, when the Bank of England was privately incorporated, more than 17 million pounds worth of government stock in the form of tally sticks were still in circulation, at a time when the cost of running the government was 2 to 3 million pounds per year.

But by this time, the Exchequer had also - in order to finance public expenditure, particularly military - begun to issue stock in documentary form. Issue of interest-bearing perpetual annuities, also known as stock, met a need for a "risk free" investment bearing a reasonable return. In order for interest to be paid, registers of entitlements were usually kept, although some documentary instruments carried coupons, which could be detached and presented to collect payment of interest.

Privatization begins - The Bank of England was a private UK Joint Stock Company incorporated by Royal Charter and it began to create and provide credit on the basis of gold deposited with it. The Bank of England began to finance the UK government by purchasing its interest-bearing stock and annuities and indeed had a monopoly on this activity.

In 1705, the remarkable Scottish gambler and adventurer, John Law, proposed in Scotland a form of money backed by land rentals, which came to nothing, but his proposal contained some remarkable insights as to the nature of money and credit. By 1716, Law had become the trusted adviser to the French prince regent, and after many successful economic reforms in France as controller general he created the Banque Generale.

The credit created by this private bank created the first modern-day bubble, which was not directly in land value but in the shares of the French Mississippi Company, which had a monopoly on trade in the French territories which then formed almost a third of the modern US land-mass, right up to the Canadian border.

The collapse of the Mississippi Bubble ruined the French economy, and a very similar bubble in shares of the South Sea Company, which collapsed in 1720, and had been fueled by credit from the Bank of England, caused similar widespread ruination in the UK.

Twin Peaks
Since that time, the "Twin Peaks" of finance capital - investment through Joint Stock Companies and debt created by private banks - have driven the development of the modern industrialized world, assisted by further innovations such as the privilege of free limited liability for Joint Stock Company investors in 1855.

In the mid 19th century, a number of failures/bankruptcies of private Free Banks - which had issued their own bank notes but were unable to provide gold when these were presented for redemption - led to the Bank of England being given a monopoly on bank note issuance, which at that time was a very significant part of credit in circulation.

A sophisticated system of wholesale and retail banking has since evolved, central to which is the relationship between the Treasury and the Central Bank, and a vast pyramid of credit was built upon a tiny base of gold. In 1971, even the technical ability to demand gold was dispensed with, and the present day system of public and private financing and funding reached its final form, at the heart of which is a Black Hole.

A very secret agent
The myth underpinning virtually all schools of economics is that the Treasury has a banking relationship with the central bank. The pervasive belief is that the central bank lends money to the Treasury and is therefore a creditor of the Treasury.

This is a myth. The central bank is actually the fiscal agent of the Treasury, and it creates credit on behalf of the Treasury either in note form or by crediting clearing bank accounts with new fiat currency.

The truth of this is demonstrated in the United States by the fact that a few million US Treasury Notes (credit issued by the US Treasury) still circulate alongside Federal Reserve Notes (credit created by the Federal Reserve Bank) and they spend exactly the same. US Treasury Notes are to all intents and purposes modern day US paper stock, since they are accepted by the Treasury in payment of taxes. 

Continued 1 2  

Wall St likes your amnesia (Dec 10, '11)

A very secret agent (Jul 27, '11)

Peak credit and a flight to simplicity (Apr 3, '08)




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