Free vs Regulated Banking—Addendum to a History of the Bank of England: Do Modern Central Bankers Really Abide By Bagehot’s Dictum?

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8 MIN READ - From the Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff

In the Economics Correspondent’s previous series on banking instability in England we learned that the first two centuries of the Bank of England's establishment and a slew of destructive banking regulations imposed by British Parliament led England to weather no fewer than seventeen financial crises. 

Ultimately a proposal for stability was penned by banker and The Economist editor Walter Bagehot (pronounced “badge-it”) in his famous 1873 book “Lombard Street.”

Bagehot blamed the Bank of England itself, its centralization of gold reserves, and the banknote monopoly bestowed upon it by Parliament for repeated systemic financial crises. Further he recommended throwing out the central bank and emulating the decentralized, deregulated, and nearly laissez-faire Scottish private banking system of 1716-1845 that had produced not a single crisis during its 129 years.

However Bagehot knew that it was politically impossible to dismantle the Bank of England since it had become so ingrained in the British psyche. Therefore his next best solution, assuming the central bank was to be upheld, was that it clean up its own mess, acting in a lender of last resort (LOLR) capacity: lending freely and early to solvent but illiquid banks at high interest rates during times of crisis.

Since then central bankers the world over have lauded Bagehot as a visionary, pioneer, and champion of central banking, and they’ve cited Bagehot’s Rule repeatedly as justification for their aggressive bailouts of troubled institutions.

In his book “The Courage to Act,” former Federal Reserve Chairman Ben Bernanke recounts the 2008 financial crisis and cites Bagehot more than any other nonliving economist (including Milton Friedman), justifying the Fed’s aggressive emergency lending programs by invoking Bagehot’s name over and over. 

Bernanke even goes so far as to suggest that if Bagehot were alive today he would wholeheartedly approve of such massive bailout programs. After detailing not only emergency lending and asset purchases for banks, but also TALF program lending on millions of auto loans, student loans, small business loans, and credit card loans he writes “Walter Bagehot would have been pleased.” (p. 469)

There’s no shortage of other central bankers asserting they were only following Bagehot’s antidotes and that Bagehot himself would have approved.

It may be no surprise to CO Nation that the Economics Correspondent disagrees.

BAGEHOT’S RULE ITSELF

We don’t have to look far to see what’s wrong with Bernanke’s characterization of archangelic Bagehot smiling down upon the 2008 Fed with patrimonial approval. We only need look closer for a moment at Bagehot’s Rule itself. 

The Federal Reserve’s website defines Bagehot’s Rule as:

“[T]o avert panic, central banks should lend early and freely (ie without limit), to solvent firms, against good collateral, and at 'high rates.”

This is an accurate summation, and even Bernanke himself states:

“To calm panic, Bagehot advised central bankers to lend freely at a high interest rate, against good collateral, a principle now known as Bagehot’s dictum.” (p. 45)

Why did Bagehot recommend that central bankers “lend freely (without limit),” to “solvent firms,” “against good collateral,” and “at high rates?”

-“Lending freely” is obvious. If many banks fail simultaneously due to illiquidity then panic and widespread depositor withdrawals could spread. Thus Bagehot argued the central bank should not skimp on short term lending assistance to bolster liquidity.

-As for “solvent firms” and “against good collateral,” that’s not too hard to understand either. 

Bagehot didn’t want the central bank pouring good money after bad into banks with negative equity. If banks were well managed but failing due to a simple liquidity run in times of panic, then the central bank would help savable institutions with its loans secured on good collateral. But for the minority of banks that were just badly managed and effectively bankrupt, they should be allowed to fail and not take central bank money down with them in the process.

-And “high rates” (sometimes referred to as “punitive rates”) were to ensure that illiquid banks regretted having managed their reserves so poorly. If they remembered paying so high a price for liquidity loans they were less likely to repeat their mistakes in the future (ie. moral hazard).

Also a punitive rate of interest ensured only truly needy banks would take central bank loans. If the interest rate was too low, healthy liquid banks would take advantage of the crisis to grab cheap funding and impose unnecessary leverage upon the central bank’s balance sheet.

As Bagehot himself wrote, a punitive rate of interest “will prevent the greatest number of applications by persons who do not require it… …that the [central] Banking reserve be protected as far as possible.” (p. 97)

-Finally it’s important to know Bagehot defined “solvent firms” as commercial banks only. (White, 2014)

BREAKING THE RULES

So just how faithfully did Bernanke, the Fed, and the world’s central bankers adhere to Bagehot’s Rule in 2008?

1) “Lend freely (without limit).” 

There’s no question they adopted this policy and took it to new heights. Not only did the Fed lend trillions of dollars to troubled banks, it gladly allowed investment banks, insurance companies, and other nonbanking firms to change to commercial bank status overnight and secure bailout lending. General Electric comes to mind, having hurriedly bought a tiny Connecticut community bank in the depths of the crisis and then receiving a $16 billion Fed loan that dwarfed its newly acquired bank’s entire balance sheet.

Major insurers also changed their status such as The Hartford, Lincoln Financial, Genworth, and most famously AIG. And as Bernanke points out in his book, the lending extended to hundreds of billions of dollars for auto loans, student loans, small business loans, and credit card loans.

2) “Lend… …to solvent firms.”

Not only were the largest, most troubled institutions in 2008 illiquid, many were also insolvent. Loaded up to the hilt with nonperforming mortgages and bad securitized loans, firms like Citigroup, Merrill Lynch, countless regional and superregional banks, and nonbank institutions all received huge discount loans from the Fed despite their solvency coming into question or simply being bankrupt.

As evidence the Fed advanced credit to several commercial and investment banks that ultimately failed anyway or had to be saved through acquisition such as Washington Mutual (failed) and Wachovia (failed) or Bear Stearns, Merrill Lynch, and National City (all acquired).

But if the Fed loaned to many firms that were insolvent and never acquired, why are some of them still with us today? Because the Fed not only granted emergency liquidity loans, it also purchased their lousy mortgage securities in open market operations, the first time in its century-long history that the central bank bought mortgage paper instead of traditional, safer U.S. Treasuries.

Buying assets directly from banks, particularly lousy assets, was never on Bagehot’s list of remedies either.

Finally extending massive loans to non-commercial banking institutions, even solvent ones, violates another tenet of Bagehot’s Rule.

3) “Lend… on good collateral.” 

Obviously lending to banks that are offering failing subprime and Alt-A mortgages as collateral directly violates Bagehot’s Rule also.

And…

4) “Lend… …at high rates [of interest].” 

As everyone already knows, the Fed loaned hundreds of billions of dollars through its discount window at nearly zero percent.

https://fred.stlouisfed.org/graph/?g=yD9r

One can hardly call zero or even 0.5% interest a high or punitive rate, and in fact securing so much money so cheaply would have been impossible during the preceding boom years.

And with Fed lending rates so low, countless healthy and liquid banks lined up for cheap credit, something Bagehot specifically wished to avoid. Even banks that didn’t want rescue money were coerced into taking it, most famously Wells Fargo whose CEO was threatened with punitive government action if his bank didn’t accept a $25 billion TARP injection that the bank ultimately repaid with interest.

So if Bagehot were alive today, he’d perceive the world’s central bankers fulfilling only one of the four commandments of his doctrine while brazenly contravening the other three—all in his name.

MORE BAGEHOT DISAPPROVAL

Furthermore, if we look closer into Bagehot’s book we find he was a staunch hard-money gold standard advocate who hated any suggestion of unbacked or overissued paper money. Bagehot went out of his way to criticize central banker John Law’s 1719 Mississippi Company paper money scheme that inflated world history’s first stock market bubble in Paris which burst and threw France into a protracted depression.

He also sneered at the unbacked paper "greenbacks" circulating in America during and following the Civil War, although Congress began redeeming greenbacks for gold two years after Bagehot's death (1879).

And as we’ve already mentioned, Bagehot wanted to get rid of the Bank of England completely, but reluctantly accepted that doing so was politically impossible. His argument in “Lombard Street” is rather lengthy but here are key corroborating passages:

“I shall have failed in my purpose if I have not proved that the system of entrusting all our reserve to a single board, like that of the Bank [of England] directors, is very anomalous; that it is very dangerous; that its bad consequences, though much felt, have not been fully seen; that they have been obscured by traditional arguments and hidden in the dust of ancient controversies.”

“But it will be said ‘What would be better? What other system could there be?’ We are so accustomed to a system of banking, dependent for its cardinal function on a single bank [the Bank of England], that we can hardly conceive of any other. But the natural system that which would have sprung up if Government had let banking alone is that of many banks of equal or not altogether unequal size. In all other trades competition brings the traders to a rough approximate equality…”

“I shall be at once asked ‘Do you propose a revolution? Do you propose to abandon the one-reserve System and create anew a many-reserve system [private competitive Scottish system of 1716-1845]?’ My plain answer is that I do not propose it. I know it would be childish. Credit in business is like loyalty in Government. You must take what you can find of it, and work with it if possible…”

“…Just so, an immense system of credit, founded on the Bank of England as its pivot and its basis, now exists. The English people, and foreigners too, trust it implicitly... …Nothing would persuade the English people to abolish the Bank of England; and if some calamity swept it away, generations must elapse before at all the same trust would be placed in any other equivalent. A many-reserve system, if some miracle should put it down in Lombard Street, would seem monstrous there. Nobody would understand it, or confide in it…”

“…On this account, I do not suggest that we should return to a natural or many-reserve system of banking. I should only incur useless ridicule if I did suggest it.”

-Lombard Street, pp.32-34.

So in conclusion, whatever one thinks of the emergency measures employed in 2008, the claims by Bernanke and modern central bankers that they were only doing Bagehot’s bidding fall flat in light of even a cursory glance at the evidence.

They only followed one of the four conditions of Bagehot’s Rule while blatantly breaking the other three.

And while the gold standard or animus towards monopoly central banks is not addressed directly in Bagehot’s Rule, his unwavering support of the gold standard is present throughout his writings, and his calls for abolishment of the Bank of England in favor of a private, decentralized, competitive banking system appear within “Lombard Street” itself. 

Bagehot would have expressed outrage and indignation at the Fed and particularly the Bank of England issuing unbacked fiat paper monies and computerized reserves without gold backing, blowing up the very asset bubbles he had blamed the monopoly central bank for inflating in his own time.

So after scrutinizing Bernanke’s claims of devotion to Bagehot’s Rule a bit more closely, we can safely conclude that “No Mister Chairman, Walter Bagehot would not have been pleased. He would have been very, very displeased by the conduct of central banks not only in 2008, but for many decades prior.”

Free vs Regulated Banking: British Parliament and the Bank of England (Part 3 of 3)

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5 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff concludes with the third and final installment examining the history and failings of England’s crisis-prone banking system.

V. BAGEHOT CLEANS UP

With each successive suspension of the 1844 Peel Act’s banknote restriction the Bank of England gradually adopted a policy of providing liquidity to strained private banks by lending its notes on a short-term basis. Each new ensuing crisis, while still serious and disruptive to the economy, ended progressively faster and with less economic damage than the great panics of 1825 and 1837.

By 1873 banker and The Economist editor Walter Bagehot (pronounced “badge-it”) could see clearly both the causes of and remedies to England's now-fifteen banking panics stretching back to 1694 and outlined two proposals for monetary reform in his seminal book “Lombard Street: A Description of the Money Market.”

In Bagehot’s opinion the Bank of England’s banknote monopoly was at the root of the problem. England, he said, should do away with the central bank completely and move towards a free, unrestricted, competitive and decentralized banking system like that which Scotland had enjoyed without a single crisis from 1716 to 1845.

But the Bank of England was now so engrained in English culture for nearly two centuries, Bagehot opined, that it had become as impossible an institution to remove as the Queen herself.

Thus his second best solution was for the Bank to use its considerable powers to clean up its own mess. 

When the central bank creates a crisis, he argued, it should stand ready to help solvent but temporarily illiquid private banks weather the storm by lending generously on good collateral at high rates of interest, a prescription famously referred to today as “Bagehot’s Dictum” or “Bagehot’s Rule.” After the crisis abates and returning depositors replenish the banks’ reserves, he said, they can then settle their emergency loans with the central bank.

Bagehot’s book was well received by the public, the industry, and lawmakers and the Bank of England officially assumed the “lender of last resort” policy, the first adopted nationwide anywhere.

Although U.S Treasury Secretary Alexander Hamilton and English economist Henry Thornton were believed to have anticipated and proposed similar remedies in 1792 and 1802, Bagehot gets official credit having both articulated it so well in 1873 and providing impetus for the policy’s official adoption in Great Britain.

England suffered an incipient crisis in 1878 and one last brief but shallow crisis in 1890 (the Barings Crisis) which was only a blip on the radar compared to the Great Crises of 1825, 1837, and even 1857. Both emergencies were quickly stemmed by Bank of England liquidity loans. 

Further strengthening the industry were the continued expansions and mergers of small country banks into stronger, widely branched and highly diversified national banks—a trend that had begun with the Banking Copartnership Act of 1826. 

Hundreds of country banks operating only five branches on average in 1844 consolidated into fewer than 100 banks with 58 branches on average by 1899 (Turner, 2014). 

In 1900 25% of all U.K. deposits were controlled by the emergent “Big Five” banks including Barclays, Lloyds, Midland, and National Provincial. The Big Five’s market share grew to 40% by World War I (Turner).

Combined with an effective lender of last resort policy, England successfully avoided panics for 118 years following the Barings Crisis and its banking system even weathered the Great Depression without a crisis.

The contrast is striking. At least seventeen banking crises from 1694 to 1890, then zero from 1891 to 2007 with the scourge only returning in 2008.

VI. SUMMARY

So what lessons do we learn from the English banking experience of 1694-1890?

Far from unregulated laissez-faire, English banking was beset by a government-granted monopoly, perverse regulations, and legal restrictions on bank expansion for well over a century—regulations that were the root cause of the nation’s multiple financial crises.

At first private banks were kept small by Parliament’s Six Partner Rule, tying their hands, making them unable either to widely branch or diversify their loan portfolios and deposit bases, and excluding the most competent businessmen from entering banking.

But even as Six Partner Rule restrictions were relaxed, the central bank was granted an absolute banknote monopoly and assumed an indomitable role in the issuance of national credit. This artificially imposed pre-eminence led to a single institution’s credit policy expanding and contracting money and lending across the entire country, amplifying the boom-bust cycle.

All these dysfunctional, counterproductive regulations were imposed on the private sector for the first 126 years for the benefit of the British government itself—providing it with a reliable banker and compulsory credit line that would never be diminished by competing upstarts. 

The Bank of England and its directors would also continue to benefit from the monopoly and suppression of competition for another century-plus, profiting from its close relationship with government benefactors in a prime example of mercantilism—or what so many of us today refer to as “crony capitalism.”

The central bank was nationalized in 1946 and instead of enriching private shareholders its operating profits were transferred to the British government, just as the U.S. Federal Reserve diverts its earnings after member bank dividends to the U.S. Treasury today.

Later on the English experience teaches us that even the destabilizing effects of the monopoly central bank’s machinations can still be reasonably contained provided that:

-It’s constrained by an honest gold standard (such as the classical gold standard).

-Its directors are competent, apolitical, and act honestly.

-It acts quickly as lender of last resort to mitigate crises of its own creation.

-The private banking system is allowed to freely operate branch networks and conduct its own lending policies with minimal interference from government.

-The private banking system is allowed to reap the profits or losses of its policies, free from government privileges, guarantees, bailouts, and regulations that introduce moral hazard or otherwise distort market incentives.

Such an arrangement was Walter Bagehot’s next best blueprint for stability—second only to dissolving the central bank itself—and the formula promoted soundness in English banking for 118 years, even when Great Britain abandoned the gold standard in 1931.

Unfortunately in today’s era of fiat money, zero and subzero interest rates, “Greenspan puts,” “Too Big to Fail” doctrines, mortgage-hoarding and repackaging GSE’s, and Parliaments and Congresses commanding banks to lower lending standards for the benefit of special interest groups and uncreditworthy homebuyers, Bagehot’s rule can no longer stave off panic as the United Kingdom painfully learned during the 2008 global financial crisis.

In upcoming chapters we’ll examine the parallel history of Scotland, England’s northern neighbor that allowed the closest to a laissez-faire, unregulated banking system the post-Renaissance world has ever seen. 

With no central bank and no restrictions on shareholders, branching, note issuance, liability, or geographic scale, Scotland experienced not a single banking crisis during its “free banking” era of 1716-1845 while its larger neighbor to the south was crippled again and again by repeated waves of financial turmoil.

Free vs Regulated Banking: British Parliament and the Bank of England (Part 2 of 3)

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6 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff continues with a brief history of repeated crises and failures in 19th century England’s regulated banking system—in stark contrast to the resilience and stability of Scotland’s unregulated one.

Parliament repeatedly debates Bank of England reform
during the 19th century

III. 1825-1873: ENGLAND UNEVENLY ADDRESSES ITS BANKING PROBLEMS

After Napoleon’s 1815 defeat at Waterloo Britain and France finally cemented a lasting peace after 127 years of on-again, off-again war. As the century-long era of Pax Britannica began, Parliament’s focus on the Bank of England’s mission shifted from that of longtime war financier to steward of economic development.

After another crushing banking panic and depression in 1825 (which Scotland again avoided), Parliament fiercely debated reforms to impose upon the Bank in exchange for its charter renewal.

Lord Liverpool, conservative Prime Minister and proponent of reform, argued the right of joint-stock banking should be extended to all private banks. 

According to Professor Andreades’ classic 1909 history, Liverpool “criticised severely… …the Act of 1709, which limited the number of partners in a bank of issue to six, so that any small provincial tradesman, a fruiterer, a grocer or a butcher, might open a bank whilst the right of issue was refused to genuine companies, well deserving of confidence.”

In the House of Commons conservative MP and future Prime Minister Sir Robert Peel urged his fellow ministers to learn from the deregulated free Scottish banking system which had suffered not a single crisis since its first private bank—the Bank of Scotland—received its charter in 1695. 

Here Andreades records that Peel “contrasted the monopoly which existed in England with the free Scotch system. He pointed out that in England 100 banks had failed in 1793, 157 between 1810 and 1817, and 76 during the recent crisis… …whilst in Scotland, on the contrary, there was only a single bank failure on record, and even in that case the creditors had ultimately been paid in full.” 

Furthermore Peel lamented that “the Bank of England’s monopoly lay like a dead hand on the organization of credit in this country, and demonstrated the superiority of the Scottish system.”

Parliament relaxed the Six Partner Rule in 1826, ending 118 years of crippling legal restrictions and finally permitting joint-stock banking across all of England except within the critical 65 mile radius around London. By 1833 joint-stock banking was finally permitted everywhere and the central bank’s longstanding monopoly on London banknotes was ended. 

But the Bank of England warned it would not do business with any bank that attempted to issue notes within London. As the small country banks would require several years to grow and eventually compete with the Bank of England head-on, the central bank’s threat alone kept the circulation of its own notes paramount for a while longer, particularly in the capital and financial center.

And in a foreshadowing of eventual abandonment of the liberalization trend, the 1833 charter renewal bestowed Bank of England notes legal tender status for redemption of private/country banknotes. Having long been treated as a de facto reserve asset by private banks, the central bank’s notes were now a de jure monetary reserve and became a form of high-powered money. 

Nevertheless progress slowly began. Freed from 125 years of Six Partner Rule constraints, well-managed small banks undertook expansion, several of them eventually into successful conglomerates. 

Taylors and Lloyds, a small Birmingham bank founded in 1765, eventually grew into Lloyds Bank, a modern household name. 

In 1736 a small non-issuance London bank took on a Quaker businessman named James Barclay as partner and renamed itself “Freame, Gould and Barclay.” Once permitted to add more than six capital partners the bank grew over time to become British multinational Barclays plc.

Unfortunately the 1833 reforms didn’t come in time to prevent another major panic just four years later, brought on by the statutory treatment of Bank of England notes as a reserve and such incompetent central bank negligence that Scottish economist Henry Dunning Macleod lamented “Of all the acts of mismanagement in the whole history of the Bank, this is probably the most astonishing.”

To address the causes of the Crisis of 1837 Parliament should have encouraged and waited for the small country banks to expand into a system of large, nationally branched note issuing institutions whose scale would diminish the Bank of England’s outsized influence. 

Instead the British government took a major step backwards and enacted the ill-advised Peel Act of 1844.

IV. PEEL’S ACT

It was thought that the continued panics were caused by overissuance of notes by both the Bank of England and private country banks. But the applied remedy was to prohibit private banknote issuance altogether and grant a complete monopoly to the Bank of England. Furthermore, the central bank’s note issuances would be limited to the balance of its government debt holdings and no more than 100% of the Bank’s gold reserves.

Prime Minister Robert Peel had himself forgotten the experience of the Scottish system he had championed in 1826. For free and universal note issuance had been allowed in Scotland for 128 years and in all that time never once destabilized the money trade. 

Unlike in England, Scotland was ruled by unfettered market forces, free from government-backed monopolies and Six Partner Rules, and it was market competition that prevented Scottish banks from overissuing. The constant threat of redemption calls, often from competing banks, and an efficient private clearinghouse system kept them all in line.

Moreover Peel and Parliament were persuaded by the Bank of England governor and deputy governor that the tight regulatory straitjacket foisted upon both central and private banknote issuance would solve the problem. The directors favored a statutory reassertion of their bank’s dominance and according to economist Lawrence H. White “had been searching for a simple non-discretionary rule that would govern their circulation in such a way as to insulate the bank from public criticism of its monopoly.”

Hence the general trend of steady liberalization that had prevailed from 1826 to 1844 was reversed with a dose of heavy-handed government control over national finance.

With the Act’s passage Parliament adopted a de facto national credit policy dictated entirely by the Bank of England. Whereas before national credit had been incidentally influenced by the central bank, now it would be completely regulated by it.

With private banks no longer able to issue banknotes and forced to accept Bank of England paper as reserves, the entire banking system began to expand and contract credit in perfect concert with the central bank. As Bank of England note circulation increased so did private bank lending and interest rates fell. When Bank of England note circulation contracted, private credit dried up, interest rates rose, and panic and depression ensued.

This arrangement, a pyramiding where private banks amplify the credit movements of the monopoly central bank, is much like that of today’s relationship between U.S. commercial banks and the Federal Reserve System.

Most perversely of all, whenever depositors became nervous and increased their cash holdings, private banks were forced to crawl begging on knee to the Bank of England for more of its exclusive notes. But the Peel Act forbade the central bank from accommodating since it was prohibited from issuing beyond 100% of its gold reserves. 

Unable to obtain paper money to meet customer demands, and restricted from issuing their own, many perfectly solvent English banks failed needlessly due to short-term illiquidity.

Thus even with the Six Partner Rule repealed, Peel’s Act restrictions and a renewed consolidation of the Bank of England’s note monopoly continued to ferment crises in 1847, 1857, 1866, 1878, and 1890, bringing the number of crises since the Bank’s founding to at least seventeen (post-Peels’ Act plus crises in 1696, 1715, 1721, 1745, 1772, 1783, 1793, 1797, 1810, 1815, 1825, and 1837).

So bad a problem had the Peel Act created that on four occasions Parliament was forced to suspend its own law—the 100% gold reserve note restriction—starting with the Crisis of 1847 and lastly at the onset of World War I. 

With each suspension the Bank of England was briefly permitted to purchase assets or loan cash beyond the value of its gold holdings, and the Bank’s directors slowly adopted the institutional role of lender of last resort—albeit by happenstance—a subject we will cover in the last installment on England.

Free vs Regulated Banking: British Parliament and the Bank of England (Part 1 of 3)

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7 MIN READ - As part of his new series on the success and failure of free versus regulated banking systems the Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff offers a brief history of the Bank of England. 

The history you are about to read here is noncontroversial. Any monetary economic historian worth his or her salt is fully aware of these events as evidenced by the Bank of England’s own website attached below.

England’s perversely regulated banking system, which bore roughly seventeen banking crises over two centuries, stands in stark contrast to deregulated Scotland which experienced none during its own 129 year “free banking” era.

I. THE BANK OF ENGLAND’S FOUNDING: A ROCKY START

The Bank of England was established in 1694, the conception of a king and parliament desperately in need of funds to wage war against France.

The Glorious Revolution (1688) had deposed King James II and nearly a century of House of Stuart Catholics from the English throne. The crown was transferred to James’ protestant daughter Mary and her husband the Dutch King William III, aka. William and Mary.

Unfortunately, the deposed James was also first cousin to French monarch and fellow catholic Louis XIV and his ousting undid England’s alliance with France. War broke out, but the Royal Navy was inferior to the French at that time and was soundly beaten at the Battle of Beachy Head (1690).

With Anglo-French conflicts erupting in North America and alliances being forged with continental European nations, a new era of longer, more protracted, more global, and more expensive wars was beginning. Nations were learning that money was as important in war as battlefield strategy.

As one contemporary English financier and Treasury advisor wrote:

"If we in England can put our affairs into such a posture, as to be able to hold out in our expense longer than France, we shall be in a condition to give the peace; but if otherwise, we must be contented to receive it.”

“For war is quite changed from what it was in the time of our forefathers when in a hasty expedition, and a pitched field, the matter was decided by courage. But now the whole art of war is in a manner reduced to money and now-a-days, that prince, who can bell find money to feed, clothe, and pay his army, not he that has the most valiant troops, is surest of success and conquest."

-Charles Davenant, "An Essay Upon Ways and Means for Supplying the War" (1695)

Unfortunately the English public of 1694 was already overtaxed and tax evasion was rife. The government’s credit among its own citizenry was poor. As a revenue workaround there were attempts to implement a poll tax, a lottery, and a failed land bank, all of which fell far short of raising the estimated £1,200,000 believed needed to effect the war.

Hence the Bank of England scheme was proposed by a brilliant and patriotic financier named William Paterson and championed by King William's Chancellor of the Exchequer Charles Montagu.

The Bank’s founders would launch today’s equivalent of an IPO, with the added incentive of patriotic exhortations, and those funds raised would be loaned to the government. Queen Mary herself subscribed to £10,000 as part of a marketing drive that enticed not only the Bank’s directors and wealthy merchants but also everyday citizens to invest.

The share offering was a success. The Bank quickly raised the £1,200,000 it sought, mostly in silver coinage (ie. specie), and loaned its new paid-in capital to the government primarily as written banknotes which served as claims on specie. In exchange the Bank received government bonds which it used as security against additional private commercial loans it issued while holding a smaller gold and silver reserve.

The Bank’s first several years were tumultuous and it suffered several crises and suspensions, although some of these can be blamed on interventions by both the English and overseas governments. 

An ill-conceived silver recoinage in 1696 led to a brief shortage of coins and a run on Bank of England specie, forcing it into an embarrassing suspension of its banknotes’ convertibility into precious metal. 

Jealous goldsmiths hoarded Bank of England notes and then demanded simultaneous redemption to ruin the Bank, leading to another suspension as the directors scrambled to call in loans and secure more silver. 

Multiple attempted invasions by the deposed Catholic king’s son James Edward Francis Stuart (James III or “The Old Pretender”) fermented panic and rumors of his army landing in Scotland caused a run on the Bank.

And the Bank’s own worst enemy was King William himself who demanded more and more loans, each larger than the previous, stretching the Bank’s finances so thin that it was left with an increasingly inadequate and vulnerable silver reserve. In one particularly brazen act William demanded another large advance of banknotes, then resubmitted them to the Bank for redemption nearly bankrupting it of its silver coinage.

II. THE DIRECTORS DEMAND REDRESS: THE “SIX PARTNER RULE”

When the Bank’s charter came up for renewal in 1707 the directors argued they had accommodated the government up to the point of near ruin on multiple occasions and demanded some sort of concession in return for their loyalty to the Crown.

So in a series of quid-pro-quo arrangements between business and government which were so common in those days of mercantilism, Parliament granted the Bank a monopoly on joint-stock banking. Written into the Bank of England Act of 1708 was the so-called “Six Partner Rule” decreeing:

“It shall not be lawful for any body politic, or corporate whatsoever… … exceeding the number of six persons, in that part of Great Britain called England, to borrow or take up any sum or sums of money on their bills or notes payable at demand, or at any less time than six months from the borrowing thereof."

This monopoly, the original and only definition of monopoly that reigned for over three hundred years before Standard Oil—the sole right to operate in a market at the exclusion of any would-be competitor, enforced by the power of the State—would set the stage for a series of financial crises and bank failures that would plague England for well over a century.

The Bank was also given a total monopoly on note issuance within a 65-mile radius of London making it the only source of paper money in the business and financial center.

The Act’s desired and very successful objective was to prevent any competing bank from gaining enough scale and influence to challenge the Bank of England, thus preventing funds from moving elsewhere and depriving Parliament of its handpicked source of reliable and ample wartime credit. While other private banks could not raise capital from any more partners (ie. shareholders) than six, the Bank of England’s shareholder base was unlimited.

Thus outside of London the English countryside was scattered with dozens, and eventually hundreds of tiny banks that, even where well-managed, were legally restricted from growing to any meaningful size or servicing any large geographic area.

The preponderance of small country banks gave rise to at least four destabilizing factors:

1. Small banks with limited geographic scale were unable to diversify their loan portfolios. Dependent on only the local industry or crop, a downturn in a single economic sector could ruin a bank since it had no loans from any other industry or region.

2. Small banks were also unable to diversify their depositors. Dependent on only the local community, a single wealthy depositor could bring down a bank with one large withdrawal, something even more likely to occur during times of trouble.

3. The restriction precluded the most capable businessmen from entering banking. Successful entrepreneurs in the textiles, agricultural, machinery, or overseas trades were excluded from finance as their lucrative enterprises were already joint-stock companies, thus leaving banking to less competent upstarts. As William Dodgson Bowman’s Bank history (1937) tells us…

“In the provinces, people of many different occupations took up the trade—grocers, bakers, drapers, graziers, chemists and tailors,” but only a few banks “were founded by prudent business men, who understood the business and were alive to the importance of maintaining an adequate cash reserve against their paper issues.”

and…

“A number of the banks were run by people with inadequate capital, with little knowledge of banking principles and methods. These mushroom concerns were responsible for large issues of notes, which were found to be merely wastepaper as soon as there was a sudden demand for cash.”

4. The legal restrictions placed on the size of country banks made each bank’s notes issuance small and localized. Thus Bank of England notes so dominated English circulation that they came to be treated as a reserve themselves, much as Federal Reserve Notes were legal reserves during the Fed gold standard era of 1914-1933 and remain fiat paper legal reserves today. This added an additional macroeconomic destabilizer as the entire country’s credit policy tended to expand and contract with that of the Bank of England, leading to larger and more widespread boom-bust cycles.

In the span of 125 years from the enactment of the Six Partner Rule to its final repeal in 1833, England suffered from no less than ten banking panics including major ones in 1721, 1772, 1797, 1815, and 1825.

Meanwhile north of the border in Scotland, where neither the Six Partner Rule nor any central bank existed, a nearly 100% unregulated system of private, competitive, nationally branched and highly diversified banks experienced no financial crises during the same 125 year period (sole exception: the Napoleonic Wars suspension which will be explained in a chapter on Scotland).

Nonetheless, Parliament did nothing to reform the Six Partner Rule as its overriding concern was guaranteeing itself a reliable source of credit to finance England’s century-plus series of on-again, off-again conflicts with France. Economic and financial stability consistently came second to war.

Stay tuned for next week’s second chapter on lessons learned from the experience of Parliament and the Bank of England.

Bank of England’s history at bankofengland.co.uk:

https://www.bankofengland.co.uk/about/history

Free vs Regulated Banking: Introduction and Orthodoxy

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3 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff launches a new series of historical articles challenging the popular assertion that private banks competing in a truly free-market environment—devoid of government financial regulation, privileges, bailouts, protectionism and restrictions—inevitably produce financial instability and systemic banking panics.

It’s widely accepted by policymakers, academics, and even the general public that banks must be regulated and guided by government oversight to avoid catastrophes like the 2008 financial crisis. After all banks make loans which are inherently risky and given undisciplined greed must be controlled by impartial experts at America’s various bank regulatory agencies: the Federal Reserve, OCC, and FDIC.

New York Times columnist and economist Paul Krugman gives us an articulate summary of the mainstream position, writing that:

“History tells us that banking is and always has been subject to occasional destructive ‘panics,’ which can wreak havoc with the economy as a whole… … It’s clear, then, that we need to restore the sorts of safeguards [ie. regulations] that gave us a couple of generations without major banking panics.”

-“Why We Regulate,” New York Times, May 13, 2012

But a serious study of history shows that some countries have never experienced a banking panic at all, that the most deregulated banking systems have actually been the most stable, and that virtually every banking crisis in history can be traced directly back to some perverse government regulation.

History also provides us with another insight: those very same destabilizing bank regulations are nearly always enacted either to raise revenue for the government itself or to tilt the playing field in favor of some politically connected banks at the expense of others, or to benefit certain interest groups at the expense of the general public.

As evidence, far from “always being subject to destructive panics” Scotland and Canada, the two least regulated banking systems in the history of the industrialized world, suffered zero crises during their respective century-plus “free banking” eras of 1716-1845 and 1817-1935.

That’s 129 and 118 crisis-free years despite almost no regulations in Scotland and very few regulations in Canada.

Meanwhile England and the United States, far more regulated than their northern neighbors, suffered from roughly ten and thirteen crises.

1) Great Britain during Scottish free banking (1716-1845):

-Scottish crises: None

-English crises: 1721, 1745, 1772, 1783, 1793, 1797, 1810, 1815, 1825, 1837

2) North America during Canadian free banking (1817-1935):

-Canadian crises: None

-U.S. crises: 1819, 1837, 1839, 1857, 1873, 1884, 1890, 1893, 1896, 1907, 1930, 1931, 1933

Furthermore during the Great Depression the United States, operating in what Paul Krugman calls a “deregulated” era (it wasn’t as we shall see) with a supervisory central bank, suffered over 10,000 bank failures. Meanwhile in Canada, with scant few regulations and no central bank, not a single bank failed.

That wasn’t “Canada avoided a crisis.” It was “No Canadian banks failed during the Great Depression and 10,000 American banks did.”

It’s also important to note that in this age where governments regulate banks more than ever, and central banks dominate banking systems with vast powers like never before, the world is in an unprecedented age of crisis.

According to Charles Calomiris of Columbia University and Steven Haber of Stanford, between 1970 and 2010 no less than 83 countries have experienced a financial crisis with 19 countries experiencing two crises and two more countries three and four crises each—at total of 107.

During the allegedly unstable, deregulated age of the classical gold standard (1875-1913), only five countries experienced a total of ten financial crises with the United States—the most regulated banking system in the world at that time—accounting for five of them with three more countries experiencing the remaining five.

That’s a comparison of two periods of roughly 40 years each:

1) The deregulated classical gold standard era (1875-1913): 5 countries with 10 crises.

2) The regulated fiat era (1970-2010): 83 countries with 107 crises.

Already just a cursory look at the historical track records of free and regulated banking systems casts Krugman’s evidence-free assertion into doubt as well as the conventional wisdom that’s been disseminated by the media, politicians, and of course the regulators themselves.

In a new series of articles on the history of banking and financial instability, the Economics Correspondent will tell the important stories of Anglo-American banking that the New York Times and its loyal readers appear to be completely unaware of: finance in England, Scotland, Canada, and the United States.

There will be many chapters in these histories, and the Correspondent will give readers at minimum a “break” between the European record and North America’s.

The chapters on England will be first in forthcoming columns.

Biden’s Stimulus Proposal: What’s In It and Where's It Going?

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6 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff wants to resist the temptation to bash anything Biden economics in the first contentious weeks and months of the White House transition. Here we take a look at the basics of his proposed $1.9 trillion stimulus.

Biden’s Stimulus Proposal: What’s In It and Where's It Going?

Last Thursday President-elect Joe Biden unveiled a general outline of his proposal for a $1.9 trillion Covid stimulus package.

Keeping in mind it first has to get through Congress (more on that in a moment), it contains:

-$1 trillion in direct assistance payments to households and a $400 monthly unemployment benefits supplement

-$160 billion for vaccine procurement and distribution

-$130 billion to “help schools reopen”

-More controversially, $350 billion for state and local government assistance

-The remaining $260 billion is a hodgepodge of miscellaneous benefits for households and small business

-A proposal to raise the federal minimum wage to $15 per hour

There was no mention of student debt forgiveness or tax hikes in the proposal.

Details here at CNBC article:

https://www.cnbc.com/2021/01/14/bidens-stimulus-plan-includes-1400-dollar-checks-enhanced-unemployment.html

A FEW MORE DETAILS

1) The $1 trillion in direct assistance effectively adds to President Donald Trump’s December package (after Congress got through with it) that set aside $286 billion for $600 direct payments to households and $300 unemployment supplements.

The Biden plan adds another $1,400 in direct payments and $100 in unemployment supplements, raising the household payment to the same $2,000 Trump asked for.

It also expands payments to non-child dependents such as college students, the disabled, and one-immigrant parent households (likely legal and illegal both), increasing the price tag from roughly $700 billion were it proportional increases in Trump’s requested items to $1 trillion.

2) The $160 billion for vaccine distribution and $130 billion to help schools reopen are consistent with what Biden said he supported during his presidential debates. However given that slowdowns in vaccine distribution among states seems to be more the product of bureaucratic disorganization, the Economics Correspondent questions whether throwing more money at the problem will speed up immunizations any faster than simply cutting through the state-level red tape.

3) Excluding federal assistance to state and local governments, the remainder includes money for household rental and utilities payment and food assistance. There are also small business relief funds.

4) Among the more controversial elements, the $350 billion for state and local governments is being criticized as a bailout for profligate states and municipalities that were already in fiscal difficulty for years before Covid struck. 

While the Economics Correspondent believes the package will ultimately serve to line the coffers of irresponsible state and local governments, $350 billion is hardly going to be enough to solve the enormous problems of their own creation. 

California’s state and local government debts alone were estimated at $486 billion in 2019, *before* the Covid pandemic had even begun and surely over half a trillion by now.

The combined debts of California, New York, and Illinois exceeded $1 trillion in 2019 or 28.6% of all state/local debt nationwide for only 21.6% of the national population.

The 24 states that Biden officially won outright owed $1.6 trillion in 2019.

5) Finally the $15 per hour minimum wage will be the most controversial element of all and the Correspondent believes it will do nothing to promote recovery other than unemploy well over a million workers whose hourly marginal revenue productivity is less than $15 per hour but more than the current minimum wage in their state. 

For example, if a young or inexperienced worker in Louisiana’s skills can only secure an additional $8 in revenue per hour worked, he/she will be gainfully employed at that state’s minimum wage of $7.25/hour.

However, if the federal government forces the minimum wage up to $15/hour the employer will lose $7 for every hour he/she continues to pay the same worker. The math will quite simply lead to job losses for what economists call low “marginal revenue product” workers referring to the marginal (additional) revenue the next employee hired can raise for the company.

Raising minimum wage above lower-skilled workers’ marginal revenue product explains, for example, why in 2017 when the Correspondent went to a California Panera Bread he had to use one of the eight kiosks at the ordering counter and most of the counter/cashier employees he had seen previously had disappeared. 

It also explains why when the Correspondent visited Louisiana on a business trip shortly after he entered another Panera Bread where there were no kiosks whatsoever and a counter full of friendly employees waiting to take his order.

Same restaurant chain (albeit perhaps a franchise). Two locations. California location has to pay $15 per hour, has a skeleton workforce and a lobby full of kiosks. Louisiana location has to pay $7.25 per hour, has no kiosks and a counter full of human employees.

And restaurants and many other low-skilled labor businesses have been decimated by Covid and lockdowns. Driving their employee wages up to $15 per hour will have an even more damaging effect than in 2017 when the business climate was generally very good.

The Correspondent may write more about the economics of minimum wage (aka. wage floors) in the future.

WHAT COMES NEXT?

Keep in mind these are all preliminary proposals by Biden and that the bill will have to run through Congress before getting to his desk by which point it may be dramatically altered.

And even after it passes, Biden has promised it’s only a “first step” in his administration’s plans to promote economic recovery.

On first glance the Biden package seems “moderate.” A lot of it is stuff Donald Trump asked for, only more of it, with a few added Democratic priorities: $350 billion for state/local governments, about $200 billion more in expanded assistance payments to non-child dependents and immigrants, and $130 billion for schools.

Removing the partisan items the price tag would be close to $1.2 trillion instead of $1.9 trillion.

But using 2009 as a guide, the Correspondent is not optimistic about prospects moving forward and thinks it’s only going to get worse from here. Because the package has to go through a Democratically controlled Congress full of radical members who want student debt forgiveness, a Green New Deal, universal basic income, socialized medicine, more regulations on business, and enormous tax hikes. And like 2009 they have a “never let a crisis go to waste” mentality.

In 2009, as Barack Obama entered office during an economic slump his own stimulus proposal was descended upon by Congressional Democrats in a fevered orgy of special interest pork spending add-ons. Many Republicans, both RINO’s and even those considered solidly conservative, jumped into the frenzy to pile on their own pork programs while the getting was good. After all, they could secure money to send home and then blame Obama and the Democrats for signing the spending bill into law.

It was truly a drug-induced fever-swamp gala of bipartisan spending.

Congressional Democrats will almost certainly try to raise the amount of aid to state and local governments above $350 billion. We know they will probably try to add tens of billions for student debt forgiveness and other woke initiatives. Who knows, The Squad may very well try to attach socialized medicine and the Green New Deal to the package.

And don’t forget tax hikes—probably the most likely demand of all. If there’s one thing that unifies the Democratic Party it’s their ceaseless infatuation with raising taxes and they will not miss the opportunity to strike while the iron is hot.

As for how it plays out politically, the Economic Correspondent sees two different paths: The first is Congressional Democrats balloon the tab to well over $2 trillion and Biden signs it, but puts on a public front of dutiful reluctance—something akin to “This bill is not perfect and I object [at least when the cameras are on] to all these wasteful provisions but I cannot in good conscience refuse to sign it and let Americans go hungry.”

The second is Biden cuts a deal whereby Congressional Democrats keep the package around the same size to appear as if he is in control of his party and exerting fiscal discipline, but only because he plans to approve all the other pork and pet projects in a Round 2 stimulus a few months later.

After all, he has already stated the $1.9 trillion package is only a “first step,” and all his party’s tax hikes, regulations, UBI, Green new Deal initiatives, student debt forgiveness, and other woke programs will define the second and third installments.

Hopefully it doesn’t turn out either way and future spending sprees stop right here. Unfortunately history gives us all good reason to be pessimistic, so let's hope for the best but prepare for the worst.

ps. 

An Inflationary Critique of MMT

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6 MIN READ - The Cautious Optimism Correspondent for Economic Affairs and Other Egghead Stuff closes out his now finished series on inflation and deflation fallacies by saying a few words about Modern Monetary Theory (MMT) and some of its own fallacies that relate specifically to inflation (preview link for illustrative purposes).

MMT proponent Stephanie Kelton

CO himself has posted many articles about MMT over the last year or two, and now that neither Bernie Sanders nor Alexandria Ocasio-Cortez will be sworn in as president anytime soon, the media’s recent MMT blitz has thankfully died down.

There’s no shortage of problems with MMT to criticize, but today's focus is a particularly gaping contradiction in the theory that he hasn’t yet heard articulated by other economists. That said, as much as he’d like to think he’s happened upon an original idea, someone else has probably thought of it already so anyone in CO Nation who happens to find it elsewhere please feel free to post in comments.

MMT’S OPEN SESAME: NO TAX HIKES?

Two of the many policy soundbites that MMT’ers like to recite are:

“A government can no more run out of dollars than a carpenter can run out of inches”

...and...

“Taxes don’t finance government spending”

The first (dollars, carpenters, and inches) is meant to convey that so long as a government controls the issuance of its own sovereign currency and has few debt obligations in another currency (which qualifies the USA, UK, Japan, Canada, Australia, etc…) then it can never run out of money.

Ironically, a carpenter may not be able to run out of inches either, but he can easily run out of wood which perfectly exposes a huge problem with the “can’t run out of dollars” jingle. That is, yes a government can print money ad infinitum but that doesn’t lead to the creation of real physical resources ad infinitum. There may not be a dollar restraint (actually there is as we’ll see) but there is always a real resource constraint.

Sophisticated MMT proponents such as economists Stephanie Kelton and L. Randall Wray are aware of the resource constraint problem, but promote the slogan anyway which their less informed readers then repeat in social circles and online.

The second soundbite (“taxes don’t finance government spending”) is a paradoxical proverb meant to convey another novel MMT insight: governments can simply instruct their central banks to create and lend them all the money they wish to spend, and taxes only serve the purpose of ensuring the currency’s continued use since governments can require/force their citizens to pay their taxes in that currency. Hence, the public can never completely refuse to use the money and governments can finance their spending programs with borrowing from the central bank’s fountain of paper instead of new taxes or spending cuts (those two fiscal tightening methods being so politically difficult to sell to the public).

Put these two together and we now have the foundation behind the third and crucial MMT claim:

“We can have a Green New Deal, universal basic income, universal socialized medicine, free college education, a government high wage job guarantee, and all sorts of other expensive progressive goodies without raising taxes.”

Not only is this one of MMT’s linchpin selling points, as it promises a huge something for nothing, but it also lays the groundwork for one of the MMT’ers’ favorite rhetorical traps.

When MMT’ers declare the government has no constraint on spending for programs that will literally cost dozens or even hundreds of trillions of dollars—from a current federal budget of only about $4.4 trillion annually—and skeptics retort that “you’ll have to raise taxes sky high to pay for all that,” they savor the opportunity to pounce on the uninformed neanderthals: “Don’t you realize taxes don’t pay for government spending?” The Economics Correspondent has seen many an MMT disciple beam with self-satisfaction believing they have stumped their opponents with such an intricate enigma.

So let’s assume this claim is correct—that government doesn’t have to raise taxes but can still provide a gigantic cornucopia of expensive social programs through massive moneyprinting and borrowing. And whenever debt loads appear to be getting too high, it’s no problem because “a government can never run out of dollars” and the central bank will keep lending whatever it takes to service the debt.

INFLATION

The obvious problem with this theory—quickly recognized by even the layman—is that the moment government spends the new money and it enters circulation the economy will experience price inflation. And when confronted with this problem, many MMT’ers will claim that their visionary form of government financing isn’t inflationary.

One response they use draws from traditional Phillips Curve Keynesianism: If the economy is not at their definition of full employment (which is far below the conventional 5% definition) and idle capacity still lies unused, all that new money won’t be inflationary because it will stimulate more production. Now we already saw that theory flop during the 1970’s stagflation era but let’s grant them for the moment that they really can print away with no consequence so long as unemployment remains above their definition of full employment.

Once their definition of full employment is reached, MMT’ers will argue that there’s still far more room to print money without inflation because everyone is underestimating the extent to which government can stimulate more production with all its deficit spending. Although given that inflation reached double digits in the 1970’s even with stubbornly high unemployment, I’m not as willing to just accept that claim as an article of faith.

The Economics Correspondent was even told once by an online MMT sycophant that printing money isn’t even a source of inflation at all. When confronted with the Equation of Exchange (mv = py) he simply declared the formula invalid without providing a shred of evidence. That’s all it took. Like saying “The law of gravity is not valid, let’s all jump off the Brooklyn Bridge now that I’ve proven there’s no danger.” With the wave of his hand, this one ingenious commenter single-handedly overturned a law of monetary economics that no academic has been able to disprove for well over a century.

BTW, sophisticated academic MMT’ers don’t argue that money doesn’t cause inflation or that the Equation of Exchange isn’t valid “because I said so.” This is also the domain of their fervent disciples.

That said, when you press MMT’ers hard enough, especially the trained academics, they will finally admit that there are limits to how far a government can go printing money before inflation becomes a problem. They rarely express this limitation voluntarily, preferring to lead their followers into believing the printing press can deliver endless gifts to society, and one often has to push and push and push the issue and not let it go like a pit bull. 

But eventually after enough persistence they will finally concede “Well OF COURSE there are real resource constraints. We would never say you can print money forever without eventually causing inflation.”

EVEN INFLATION IS NO PROBLEM. REALLY?

Once an academic MMT’er is forced to admit that there is a limit to how much money the central bank can print and lend to the government before inflation becomes a problem the remedy, almost as if automatically on cue, is “But if inflation becomes a problem, government can always tax the money out of the economy to restrain price pressures.”

As evidence:

“Taxes are one tool governments can use to control inflation. They take money out of the economy, which keeps people from bidding up prices.”

-“Modern Monetary Theory, Explained,” Vox

“Government taxes can be used to keep inflation under control, to control our behaviour (via fees and levies and rates), and to get us to produce things the government needs.”

-“ Modern Monetary Theory: How MMT is challenging the economic establishment,” ABC News Australia

OK we’ve almost reached the punchline. Up until now this is standard MMT doctrine and every economist who has scrutinized MMT has heard this line of reasoning. The final closing criticism is up next:

So as we’ve seen, the big marketing promotion for MMT, perhaps *the* biggest, is that we can have our cake and eat it too. Washington can spend $100 trillion, even $200 trillion on Green New Deals, socialized medicine, free college, universal basic income, and every other democratic socialist’s dream program “without raising taxes or cutting spending.”

But when MMT’ers are pushed hard enough on the inevitable (they say it’s not inevitable, but it is) consequence of higher inflation, they say “Not a problem because government can tax the money out of the economy.”

And therein lies the gaping hole. In the end, the free lunch proposition is false. Ultimately all the programs will require higher taxes after all—despite their promises that taxes don't have to rise—only with the added central bank middleman that prints gobs of money first.

MORE DREAMING

And if anyone thinks those tax hikes will be tiny think again. During the stagflation 1970’s, a monetary expansion that will be small compared to what MMT’ers want for their enormous social programs, inflation hit 15% during some years. If prices rise 15% a year, imagine how large a share of the entire money supply Congress will have to remove through taxation to stop it—and the size of tax hikes needed to do it.

For perspective, consider that federal tax revenues today constitute about 16% of nominal GDP, yet 100% of GDP this year would become 117% or 118% in nominal terms next year, mostly due to inflation. So to get nominal GDP down to a more reasonable level of 102% or 103% of the previous year (this assumes MMT’ers don’t produce a recession with their inflation and taxes), 15% to 16% of nominal GDP will have to be taxed out of the economy atop the 16% of GDP Washington already taxes today.

The math is a little more complicated than just adding fifteen points to the tax rate but yes, Americans’ federal tax burden would nearly double across the board just to control an inflation that will appear tiny compared to what MMT’ers will produce.

In fact, historically every time governments have resorted to the printing press to pay for spending programs they quickly lose control of prices and inflation reaches rates of 25%, 50%, 100% per annum or even higher. To stop a price inflation of 50% per year, Washington would have to tax away a full one-third of nominal GDP on top of the current level of taxation, year after year after year.

And the higher monetary velocity rises, the logical consequence of rising inflation, the greater the share of the money supply the government will have to tax away to get prices under control.

Who knows, perhaps a huge tax hike is really the secret endgame of some MMT proponents. After all, MMT’ers are heavily aligned with ultra far-left progressive movements and even Paul Krugman accuses them of going too far with their big government largesse.

And there’s two more problems with the MMT panacea of taxing inflationary money out of the economy: First, it assumes Congress can even find the wherewithal to raise taxes without being thrown out of office. Raising taxes under MMT will be more politically unpopular than it is now. How many politicians will tell their constituents, already angry at rising prices, that their taxes are going up?

And assuming Congress and the White House can get the tax hikes passed without a revolt then the second and probably most preposterous assumption is that once Congress gets its hands on a huge share of the nation’s money supply elected politicians will dutifully destroy the money in the name of fighting inflation.

Anyone who thinks Congress and even presidents, when given trillions or even tens of trillions of new dollars in tax revenues to play with, won’t resort to spending it to subsidize their districts and buy votes needs to have his head checked. In fact, the Correspondent predicts that the least disciplined and most profligate spenders of that new tax revenue will be the MMT proponents themselves—the likes of Bernie Sanders, AOC, Ilhan Omar, and the rest of The Squad.

So the final result of MMT will be the worst of both worlds: higher taxes *and* higher inflation.

CATO monetary economist George Selgin, of whom the Correspondent is a huge fan, likens MMT’ers to road show salesmen promoting their latest perpetual motion machine. They promise limitless mechanical motion and energy, but when you ask them about the wire running under the tablecloth into the wall they assure you it’s nothing important. If you continue to press them hard enough and force them to answer, eventually they admit it’s an electrical cord but that it doesn’t change the novelty of their new invention. In the end, according to Selgin: “There’s nothing new that’s true, and nothing true that’s new in MMT.”