...The Argentine case and the Dutch Golden Age suggest that the elimination of the credit multiplier (i.e. extinction of shadow banking) is more important than the asset backing a currency...
by Martin Sibileau
As we pointed in our last
letter, we have lately noticed that there is an ongoing debate on whether (or
not) the world can again embrace the gold standard. We join the debate today,
with an historical as well as technical perspective. Today’s letter will deal
with the historic part of the discussion. In the process, you will see that we
side with some popular ideas, while we challenge others.
The gold standard will be the
last option: If adopted, it will be out of necessity and in desperation
We
are not historians. In our limited knowledge, we note however that
historically, the experiment of adopting a gold standard –or a currency board
system- was usually preceded by extremely trying moments, including the loss by
a government of its legal tender amidst hyperinflation.
The
change to a commodity standard has often been then out of necessity. We
witnessed one of these episodes first-hand, in Argentina, back in 1991. The
local currency was decreed convertible into US dollars (i.e. a currency board)
at a rate of 10,000 to 1, and assigned a new name: peso argentino. The method with which this was carried out challenges the current
speculation regarding gold, according to which gold bullion would be
confiscated, in order to provide reserves to a central bank
daring to return to the gold standard. In Argentina, US dollars were not
confiscated to back the peso. There was no need do that. On the same grounds,
we don’t think gold would need to be confiscated, although one must never, ever
underestimate stupidity.
How
did Argentina implement its convertible system? The central bank adopted two
relevant measures: The first was to change its charter to prohibit holding
government debt. The second measure was to commit to
sell unlimited dollars at the established peg of 10,000 to 1. Of course, the
first measure was later violated. But that’s a discussion for another day. What it matters is that they committed to sell the asset backing
their liability (i.e. the peso), but not to buy it. From then on, nobody dared to
challenge the central bank until 1994-5, when the Mexican peso was devalued.
And even then, the system passed the test.
The
10,000:1 peg was based simply on the fact that that was back then, the amount
of local currency per each US dollar in reserves. It is very conceivable that, under an inflationary spiral, the US
government may proceed similarly. If at that time there are x thousand US
dollars per ounce of gold at the US Treasury, a peg may be established to
reflect that ratio. And just like it occurred in Argentina, we would not expect
the Fed to be challenged.
From
those years, we also remember this: When the peg
was set at 10,000:1, there were many who thought that the US dollar was still
underpriced. However, think about this: Why would the market have paid for your
US dollars more than 10,000 (Australes), when the market knew that, in the
absence of a bid, all you could get from the central bank was going to be
10,000? We
can very much foresee a similar situation where, the market price of gold
collapses from its peak to the established peg, leaving painful losses.
A gold standard with reserve requirements below 100% will not work
There
were many flaws with the currency board rehearsed by Argentina. But remember:
It was established out of necessity, without time to plan. Just like the
European Union is handling its problems today and just like the US will handle
theirs tomorrow...
The
most important flaw, in our opinion, was that it left the central bank in its
role as lender of last resort, while at the same time it allowed banks to have
reserve requirements below 100% (about 30%). Therefore, the credit multiplier
was after all still very much in place. The fact that the central bank would
later invest some of its US dollars in USD denominated (Argentine) government
debt was not critical. Nor was it relevant that banks were coerced to buy
government bonds with deposits (like they are in the Euro zone today). The crux
of the matter was that as both of these things happened, the central bank
was….well, the central bank! The lender of last resort! Had the central bank
been only a note bank for legal tender, without any other responsibilities, the
Argentine default of 2001 would have not triggered a systemic crisis. But it
was not a note bank, it was the lender of last resort and the crisis became
systemic….just like we fear will happen, if the US implements a gold standard
in a rush. Why do we fear this? Because if all plays out that way, the world
will lose faith in the gold standard for the wrong reasons.
The Bank of Amsterdam and the
Industrial Revolution of the XIX century
Popular
wisdom has the birth of the industrial revolution in XIX century England. Some,
with a technological emphasis, are willing to concede that already by the time
of the French Revolution, the years of the Enlightenment, the seeds had been
planted for the technical developments that would come later. The Napoleonic
Wars are thus regarded by these people as an interruption, a hurdle, in the
race by the West to conquer the world. Only a few point out and even admit
that, as a coincidence, during that industrial revolution and particularly at
the end of the XIX century, gold was money. But this is treated as a mere
coincidence. There are others too, who are convinced that if gold had not been
money, if Great Britain had not adopted the gold standard, the speed of the
industrial revolution would have been even more impressive.
None
of this, in our opinion, could be farther from the truth. We are not historians
and we expect many to challenge our comments today, but we offer this view: The industrial revolution did not begin in England, but in what
was then known as the Low countries, and was enabled in a decisive way by a
gold standard with 100% reserve requirement established by the city of
Amsterdam. There
are two parts in this conjecture: The first one is that the industrialization
began in the Low Countries. We side here with Henri Pirenne and suggest that this birth was brewed by
the system of Hansastädte, and in particular, in
Brugge, where very early, for instance, the Medici opened a branch.
If
our view is correct, the counterfactual argument therefore lies in proving that
the development from that stage into the XIX century would have been possible,
had the city of Amsterdam not established the Bank of Amsterdam (Amsterdamsche Wisselbank). We
leave to our readers to do their own research on this speculation.
The
Bank of Amsterdam took upon itself to accept bullion in deposit, issue notes in
exchange for circulation and charge (yes, you read well, charge!) depositors
for their bullion as well as a “liquidity” fee for making such deposits liquid,
thanks to the issuance of their (i.e. the bank’s) notes.
In
his book, “The Ascent of Money”,
Neil Ferguson makes a few interesting observations about this period:
Inflation
(don’t ask us how Mr. Ferguson measured it, but this is what we read) fell from
2% p.a. between 1550 and 1608 to 90bps pa between 1609 and 1658 and 10bps p.a.
between 1659 to 1779! This represents no less than 229 years of price
stability! With the low life expectancy of those years, this period would have
easily encompassed 9 generations. Can you even begin to picture that? In
today’s terms, this would mean that the currency held by an American living
back at the time George Washington was president would have kept its purchasing
power to this day, had a similar financial stability taken place!
In
1602, the Vereenigde Nederlansche Geoctroyeerde Oostindische Compagnie (East
India Co.) had its IPO. Between 1602 and 1733 its share price rose from par
(100) to 786, in spite of the fact that between 1652 and 1688 they had to face,
with violence, the attacks of Britain at their trading posts. By 1650, with the
dividend payments the company made, buy-and-hold IPO holders would have earned
an annual compounded rate of return of 27%. Given how popular this IPO was,
this context of financial stability brought about perhaps the most
widespread capitalization ever witnessed by a nation.
This
stability was based on a 100% reserve requirement. With it, when the East India
Co. began to fall, its decadence was gradual: It took 60 years and by 1794, it
was still worth 120 or 20% above par, in terms of a currency that had preserved
its value all along! In other words, it was still 20% up in real terms. In real
terms also, by 1690, the company was bringing back to the harbours of the
Netherlands about 156 ships per year, all loaded up with consumption goods for
the enjoyment of the Dutch people. In other words, on average, one ship every
two days was being loaded up in a trading post in Asia. There were no cranes, no
trains, no telecommunications.
In
summary, the Argentine case and the Dutch Golden Age suggest that the
elimination of the credit multiplier (i.e. extinction of shadow banking) is
more important than the asset backing a currency. The Argentine case shows what
can go wrong, when a currency is asset backed, but reserve requirements are
allowed below 100%. The Dutch case shows what can go well, when a currency is
commodity-backed and reserve requirements are held at 100%. Bear in mind that the notes of
the Bank of Amsterdam were not enforced upon the people, they were not legal
tender.
Unlike
today’s policy makers, the Dutch of the XVII century had the luxury of planning
their system, based on the collective wisdom of their merchant class. Does
anybody think that the Dutch Golden Age would have taken place had the Bank of
Amsterdam not existed? Does anybody think that England would have been able to
accumulate capital from its natural resources (wool, meat), without the demand
of the early industries of Brugge, Liege,Amsterdam or Antwerp? We don’t!
Therefore,
the question that lies before us is: How can we replicate the success of the
Bank of Amsterdam, in today’s context? How can we not fall prey to necessity,
just like Argentina fell back in 1991? That
remains the subject for our next article.
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