A History of Inflationary Money: From 1844 to Nixon
So that we can understand the financial and banking challenges ahead of us, this article provides an historical and technical background. But we must first get an important definition right, and that is the cause of the periodic cycle of boom and bust. The cycle of economic activity is not a trade or business cycle, but a credit cycle. It is caused by fractional reserve banking and by banks loaning money into existence. The effect on business is then observed but is not the underlying cause.
Modern banking has its roots in England’s Bank Charter Act of 1844, which led to the practice of loaning money into existence, commonly described as fractional reserve banking. Fractional reserve banking is defined as making loans and taking in customer deposits in quantities that are multiples of the bank’s own capital. Case law in the wake of the 1844 act, having more regard for the status quo as established precedent than for the fundamentals of property law, ruled that irregular deposits (deposits for safekeeping) were no different from a loan. Judge Lord Cottenham’s ruling in Foley v. Hill (1848) 2 HLC 28 is a judicial decision relating to the fundamental nature of a bank which held in effect that
The money placed in the custody of the banker is to all intents and purposes, the money of the banker, to do with it as he pleases. He is guilty of no breach of trust in employing it. He is not answerable to the principal if he puts it into jeopardy, if he engages in haphazardous speculation.
This was undoubtedly the most important ruling of the last two centuries on money. Today, we know of nothing else other than legally confirmed fractional reserve banking. However, sound or honest banking, with banks acting as custodians, had existed in the centuries before the 1844 act and any corruption of the custody status was regarded as fraudulent.
This decision has shaped global banking to this day. It created a fundamental flaw in the gold-backed sound-money system, whereby the Bank of England, as a prototype central bank, could only issue extra sterling backed entirely by gold while a commercial bank could loan money into existence, the drawdown of which created deposit balances. The creation of these deposits on a systemwide basis meant that any excesses and deficiencies between banks were easily reconciled through interbank lending.
Bankers’ Groupthink and the Credit Cycle
While an individual bank could expand its balance sheet, the implications of all banks doing the same may have escaped the early banking pioneers operating under the 1844 act. Thus, when their balance sheets expanded to a multiple of the bank’s own capital, there was little cause for concern. After all, so long as a bank paid attention to its reputation it would always have access to the informal interbank market. And so long as it could call in its loans at short notice, the duration mismatch between funding by cash deposits and its loan book would be minimized.
Since the Bank Charter Act, experience has shown that the expansion of bank credit leads to a cycle of credit expansion, overexpansion, and then sudden contraction. The scale of bank lending was determined by its management, with lenders tending to be as much influenced by their own crowd psychology as by a holistic view of risk. Of course, the expansion of bank credit inflates economic activity, spreading a warm feeling of improving economic prospects and feeding back into increasing the bankers’ confidence even further. It then appears safe and reasonable to take on yet more lending business without increasing the bank’s capital.
With profits rapidly increasing due to lending being a multiple of the bank’s own capital, confident bankers begin to think strategically. They reduce their lending margins to attract business they believe to be important to their bank’s long-term future, knowing they can expand credit further against a background of improving economic conditions to compensate for lower margins. They begin to protect margins by borrowing short from depositors and offering businesses term loans, reaping the benefits of a rising slope in the yield curve.
The availability of cheap finance encourages businesses to enhance their profits in turn by increasing the ratio of debt to equity and by funding expansion through debt. By this point, a bank is likely to be raking in net interest on loan business amounting to eight or ten times its own capital. This means that an interest margin of a net two percent is a 20 percent return to the bank’s shareholders.
There is nothing like profitable success to boost confidence, and the line between it and overconfidence is naturally fuzzed by hubris. The crowd psychology fueled by a successful banking business leads to an availability of credit too great for decent borrowers to avail themselves of, so inevitably credit expansion becomes a financing opportunity for poorly thought out loan propositions.
Having oversupplied the market with credit, banks begin to expand their interests in other directions. They finance businesses abroad, oblivious to the fact that they have less control over collateral and legal redress generally. They expand by entering other lines of banking-related business, assuming that their skills as bankers can be extended into those other business lines profitably. A near contemporary example was Deutsche Bank’s failed expansion into global investment banking and principal trading in foreign securities and commodities. And who can forget Royal Bank of Scotland’s bid for ABN-Amro just as the credit cycle peaked before the last credit crisis.
At the time when their balance sheets have expanded to many multiples of their own capital, the banking crowd finds itself with lending margins too low to compensate for risk. Bad debts arising from their more aggressive lending decisions begin to materialize. One bank beginning to draw in its horns as it perceives it is out on a limb can probably be weathered by the system. But other bankers will stop and think about their own risks, bearing in mind that operational gearing works two ways.
Operational gearing may be marked by an unexpected event, or just an apparent loss of bullish momentum. With bad debts beginning to have an impact, groupthink quickly takes bankers from being greedy for more business to fearful of it. Initially, banks stop offering circulating credit, the overdraft facility that lubricates business activity. But when the credit tap is turned off former lending decisions begin to be exposed as bad, and investments in foreign lands begin to reflect their true risks. Lending in the interbank market dries up for the banks with poor or marginal reputations, and banks begin to report losses. Greed turns rapidly to fear.
The cycle of bank credit expansion then descends into a lending crisis, with increasing numbers of banks exposed as having taken on bad loans and becoming insolvent. A slump in business activity ensues. With frightening rapidity, all the hope and hype created by monetary expansion is destroyed by its contraction.
Before central banking evolved into acting as the representative and regulator for licensed banks, the credit cycle described above threw up some classic examples. Overend, Gurney and Company was the largest discount house in the world, trading in bills of exchange before it made long-term investments and became illiquid. When the railway boom faltered in 1866 it collapsed. The bank rate rose to 10 percent and there were widespread failures. Then there was the Baring crisis in 1890. Poor investments in Argentina led to the bank’s near bankruptcy. The Argentine economy slumped, as did the Brazilian one, which had been experiencing its own credit bubble. This time, a consortium of other banks rescued Barings. Nathan Rothschild remarked that if Barings hadn’t been rescued the entire banking system in London would have collapsed.
Out of Barings came the precedent of a central bank acting as lender of last resort, famously foreseen and promoted by Walter Bagehot.
In the nineteenth century it became clear that crowd psychology in the banks, the balance of greed and fear over lending, drove a repeating cycle of credit boom and slump. With the passage of time, bankers recovering their poise from the previous slump forgot its lessons and rhymed the same mistakes all over again. Analysts promoting theories of stock market cycles and cycles of economic activity need look no further for the underlying cause.
In the absence of credit expansion, businesses would come and go in random fashion. The coordinated expansion of credit changed that, with businesses being bunched into being created at the same time and then all failing at the same time. The process of creative destruction went from unnoticed market evolution to becoming a periodic violent event. Monetary institutions still ignore the benefits of events being random. Instead they double down, coordinating their interventions on a global scale with the inevitable consequence of making the credit cycle even more pronounced.
It is a huge mistake to call this repeating cycle a business cycle. The name implies that it comes down to the failure of free markets, of capitalism, when in fact it is entirely due to monetary and credit inflation licensed and promoted by governments and central banks.
The Rise of Central Banking
Following the Barings crisis of 1890, the concept of a lender of last resort was widely seen to be a solution to the alleged extremes of free markets. Initially, this meant that the bank nominated by the government to represent it in financial markets and to oversee the supply of bank notes took on a role of coordinating the rescue of a bank in difficulty in order to prevent a full-blown financial crisis. When the gold standard applied, however, it comprised the practical limitation of a central bank.
This was the general situation before the First World War. But, in fact, even under the gold standard there was significant inflation of base money occurring in the background. Between 1850 and 1914, aboveground gold stocks increased from about five thousand tons to nearly twenty-four thousand tons. Not all of it became monetary gold, but the amount that did was decided by the economic actors that used money, not the monetary planners as is the case today.
It was against this background that the US Federal Reserve Bank was founded in December 1913. Following World War I, the Federal Reserve became a powerful institution under the leadership of Benjamin Strong. Those early postwar years were turbulent: due to wartime inflationary financing, wholesale prices doubled in the US between 1914 and 1920 while the UK’s trebled. This was followed by a postwar slump, and by mid-1921 unemployment in the UK had soared to 25 percent. In the US, the Fordney-McCumber tariffs of 1922 restricted European debtors from trading with America, which was necessary to pay down their dollar debts. A number of countries descended into hyperinflation, and the Dawes Plan, designed to bail out the Europeans, followed in 1924.
Although America remained on a gold standard, Britain had suspended it, only going back to it in 1925. While the politicians decided overall policy, it was left to central bankers such as Strong at the Fed and Montague Norman at the Bank of England to manage the fallout. Their relationship was the most tangible evidence of central banks beginning to collaborate in the interests of mutual financial stability.
With the backing of ample gold reserves, Strong advocated for price targeting through the management of the money supply, particularly following the 1920–21 slump. His inflationary policies assisted in the management of the dollar-sterling exchange rate, supporting sterling, which at that time was not backed by gold. Strong also made attempts to develop a discount market in the US, which inflated credit markets further. One way and another, with the Fed following expansionary money policies and commercial bankers becoming more confident in lending prospects, monetary inflation fueled what came to be known as the Roaring Twenties.
That came to a sharp halt in October 1929, when the credit cycle turned, and the stock market crashed. Top to bottom, that month saw the Dow fall 35 percent. The trigger was Congress agreeing to the Smoot-Hawley Tariff Act on October 30, widely recognized at the time as a suicide note for the economy and markets, since it raised trade tariffs to an average of 60 percent from the Fordney-McCumber average of 38 percent. President Hoover signed it into law the following June, and by mid-1932 Wall Street had fallen 89 percent.
With such a clear signal to the bankers, it is not surprising that they drew in their horns, contracting credit and indiscriminatingly bankrupting their customers. All the expansion of bank credit since 1920 was reversed by 1934. Small banks went bankrupt in the thousands, overwhelmed by bad debts, particularly in the agricultural sector, as well as through loss of confidence among their depositors.
The depression of the 1930s overshadowed politics in the capitalist economies for the next forty years. Instead of learning the lessons of the destruction wrought through cycles of bank credit, economists doubled down, arguing that more monetary and credit inflation was the solution. To help economic sentiment recover, Keynes favored deficit spending by governments to take up the slack. He recommended a move away from savers being the suppliers of capital for investment in favor of the state taking a more active role in managing the economy through deficit spending and monetary inflation.
The printing of money, particularly dollars, continued under the guise of gold convertibility with the postwar Bretton Woods system. America accumulated enormous gold reserves; by 1957 they amounted to over twenty thousand tons — one-third of estimated aboveground gold stocks at that time. It felt secure in financing first the Korean and then the Vietnam War by printing dollars for export. Unsurprisingly, this led to the failure of the London gold pool in the late 1960s and to President Nixon suspending the fig leaf of dollar convertibility into gold in August 1971.
Once the dollar was freed from the discipline of gold, the repeating cycle of bank credit was augmented by the unfettered inflation of base money, a process that has continued to this day.