Life After the Credit Depression

If you have any doubts about how historic these times are we live in, lay them aside for a moment. We’d ask you to lay your cares aside too. But we can’t do that. There is too much to care about. More on that in just a second.

First comes the news that the Bank of England has lowered interest rates to their lowest level in 314 years. Now that is something to write home about. Or to write you about! But what does it mean?

Well, a brief history is in order. If we’re going to make the argument that the institutions for providing public debt and funding the modern welfare/warfare state are reaching a breaking point, then we have to properly understand the origin of those institutions.

The Bank of England emerged as the winner in a three-way contest to fund the debt of the English state. The Tories favoured the land banks while the Whigs put their weight behind the Bank of England.

More on land banks next week. We think the idea is worth another look because it suggests that capital must be securitised by a real asset (like farm land) and not say, tax revenues (which are functions of economic growth, trade, a whole apparatus for confiscating and spending them). In a world with less credit and energy, you wouldn’t be that surprised to see a massive reverse migration, where people leave densely populated (but ultimately unsustainable cities) and go back to work on the farm, growing their own food.

But we’ll leave the new feudalism and its implications until next week. Life after the credit depression (or LACD, as we now call it) is going to be very challenging. It’s a subject that deserves a lot more thought. So we promise more to come. But our main point today is that the institutional keystone of the modern state is, well, crumbling. Why? Go back to 1694 when the British were in perpetual war with the French while trying to build a commercial empire AND kick off an Industrial Revolution.

Access to long-term credit, funding the interest payments through direct taxation, was arguably THE single most important financial innovation of the early modern period. It’s what makes the Nation State itself viable. Without this one-two combination, the rise of the English state, its triumph over France militarily (and the Dutch commercially) would not have been possible.

“Somehow,” we cull from a chapter in a book whose title we failed to note at the time, “(perhaps more by necessity than foresight) England’s Tudor and Stuart dynasties avoided the proliferation of taxes and accumulation of royal debt that afflicted rival Portuguese, Spanish, Dutch and French powers during the sixteenth and seventeenth centuries.

“Coming late to European power politics and acting as a ‘free rider’ upon Iberian and Dutch investments in colonisation and commerce overseas, the English state possessed untapped potential for taxation that the traumatic experience of civil war and an interlude of restored stability and institutional innovation brought on stream.”

That “institutional innovation” was the creation of the Bank of England in 1694. With the government’s finances under the control of the Parliament (and not the monarchy, after the Glorious Revolution of 1688), improved tax collection made it possible for the government to issue long-term bonds and fund the interest payments with taxes. Thus the funded national debt.

The Bank of England institutionalised this arrangement and took on the main functions of a central bank. It managed the government’s debts and became the lender of last resort. Practically, though, it linked up London’s growing capital market with the government’s need to fund its foreign wars. Thus the link at birth between the fiscal state and war.

Interestingly enough, though the Bank of England is famous for the gold (it used to have) in its vaults, the Bank itself was capitalised by government debt, not gold. Private creditors pooled their resources in 1694 and made the government a loan of 1.2 million pounds at eight percent. The loan was secured by customs and excise revenues, which the state commands of course, upon pain of death.

You might recall that two other institutions used this process-the incorporation of public debt-to capitalise themselves around the same time. The New East India Company loaned the government a couple of million pounds and also received 8% in exchange.

But the more famous competitor to the Bank of England was the South Sea Company, formed up in 1711. The company was also capitalised by government debt (securitised with taxes on trade with South America). But the company also performed a little alchemy. The short-term government debt was converted into tradeable equity.

Debt and equity can both trade at a premium. But equity in the South Sea Company looked especially enticing because the government had granted the company an exclusive charter to loot the riches of South America (in the fashion the Spanish and Portuguese had already done so well).

We will not get into the South Sea Bubble here. But it’s important to point out that of the three schemes that competed to manage and fund long-term public debt (land bank, central bank, joint stock company), the Bank of England eventually won out.

Is there a modern situation where a new bank or financial institution could be capitalised by turning a big pile of debt into tradable equity. You bet there is. More on that soon. Until then!

Dan Denning

January 14, 2009

The Daily Reckoning