What Went Wrong: Finance

government doesn't know how to manage the economy

Now that the educated-class era is done, and the commoner era has barely begun, it’s a good time to rehearse what went wrong in the educated class era, what I would call the Age of Gutenberg up to the present and the birth of the Age of the Internet.

Perhaps the most important thing that Went Wrong was Finance: money and credit. And money and credit are inextricably linked to rulers and their wars.

If we say that money is precious metal processed into coins, then the first thing we note is that the coin usually bears the image of the ruler. So government and finance go together like ham and eggs.

The other thing to note is that coins are heavy and subject to theft. So paper money is a good way to save on weight and theft losses. This is what made the bill of exchange so useful in the medieval fairs, such as the Champagne Fairs in France.

Developed in the 13th century by Italian merchant-bankers, bills of exchange were an alternative to making payments in bulky coins... Records dating to the era of the medieval fair show that merchants only conducted a small part of their trade in coin. Dealing in bills reduced the risk of loss or theft and were generally more convenient.

So you see that paper money started with the convenience of not carrying precious coin around. Originally, no doubt, all bills of exchange were backed by actual coins in the vault. But then…

The only problem is that while ordinary people and merchants need money for trade and exchange, rulers always need money for their wars. In the old days they would “debase” their coinage by reducing the precious metal content. And then they would borrow from the Italian bankers. For instance, England’s King Edward III borrowed from the Bardi and Peruzzi families to fund the Hundred Years War, and when he failed to repay his loans he broke their banks.

And don’t talk about Henry VIII and the multiple debasements and financial crises of his reign.

But then the Dutch figured out how to have a financial system and a war finance system at once. They did it in the Dutch revolt against Spain with the Amsterdam Exchange Bank that created a market in government debt.

The Dutch brought their central banking idea to England with William of Orange in 1688, and the Bank of England was founded in 1692. The result was a Second Hundred Years War with France ending in the victory of the Battle of Waterloo and British national debt at 250% of GDP.

The US has had an on-again off-again central bank. Alexander Hamilton created the Bank of the United States to buy all the Revolutionary War debt and service it with federal taxes. President Andrew Jackson came to power to stop central banking.

In 1873 Walter Bagehot published Lombard Street and decreed that the central bank should act as “lender of last resort.” The point is that when there’s a financial crisis the central bank should keep the banks afloat with emergency loans.

Thus by the 20th century all was ready for US Progressives to legislate a central bank and an income tax in 1912 to set the United States up for world war and a worldwide empire if it chose. President Wilson did so choose in 1917 and then went to Europe to direct traffic in the Treaty of Versailles and its punitive peace and to found the American Empire.

Then things started to go wrong. In 1929 Wall Street crashed and the Federal Reserve failed to act as lender of last resort. In 1929-33 something like 6,000 banks failed in the US. Then of course, President Roosevelt enacted the New Deal that failed to restart the US economy.

The cycle of war and peace down the centuries created havoc on Main Street. Each war resulted in inflation, which was bad for bondholders and good for debtors. But after the war governments typically implemented a policy of “resumption” to restore the currency to its pre-war value. This created hardship for ordinary people and sparked riots and rebellion. Britain after the Napoleonic War saw several uprisings. The US after the Civil War experienced the Long Depression and many strikes. The Free Silver was an attempt to reinflate and reverse the deflation. Again, after World War I the US and UK returned to their pre-war currency valuation causing deflation and strikes.

Starting in the 1930s western governments began using central banking and government debt to finance the welfare state and manipulate the economy with routine expenditures to provide pensions and allowances to individuals, and monetary and fiscal “stimulus” to reverse unemployment in the aftermath of recessions. The result has been an enormous expansion of government debt and expenditure, and a constant inflation from the dollar at $20 per ounce in 1924 to the present $2,600 per ounce in 2024. That is to say: the US dollar today is worth less than one percent of its value a century ago.

Obviously, a government that reduced the purchasing power of its money by 99 percent is not managing the economy in the interest of its people.

After World War II John Maynard Keynes and Harry Dexter White performed magic financial tricks at Bretton Woods and avoided a deflation after the war. But their game ended in the 1970s when the US went off the Gold Exchange Standard and voted for inflation until Paul Volcker as Chairman of the Fed stopped inflation with high interest rates starting in 1979. Various financial shenanigans and mortgage subsidies led to the Crash of 2008 when the Fed under Ben Bernanke failed to act as “lender of last resort” with respect to the failed investment bank Lehman Brothers.

In 2020 the US financed the War on COVID with a 40% expansion of the M2 money supply and unleashed inflation in the subsequent years.

The story of government with respect to money and finance suggests that government is mainly interested in financing its wars and in financing its government programs. Governments seem to be less concerned with the prosperity and economic stability of the individual citizen.

But there is an additional consideration. Does government understand what it is doing with respect to finance and the economy? Here is a chart of federal interest outlays, payment on the national debt, from usgovernmentspending.com. The actual net inerest outlay is shown in yellow. It shows that federal budgeteers forecast no surge in interest outlays in the FY2022 budget released in early 2020, which was before the war on COVID. But what of the forecast for net interest outlays for FY2024, that ended September 30, 2024? The net interest outlay for FY2024 was forecast at $368 billion in the FY 2022 budget, at $476 billion in the FY 2023 budget, at $789 billion in the FY 2024 budget, at $889 billion in the FY 2025 budget. But actual net interest outlay outcome for FY2024 was $966 billion. Obviously, the federal government is unable to make a reasonable forecast of its interest outlays two or three years in the future.

Here is a chart of inflation forecasts in the federal budget from usgovernmentspending.com — against the actual inflation outcome in yellow. It shows that federal budgeteers forecast no new inflation in the FY2022 budget released in early 2020, which was before the war on COVID. But in the FY2023 budget, when actual inflation was 5.3 percent, the budgeteers forecast a return to 2.3 percent in 2022, when actual inflation came in at 7.4 percent. Only in the FY2024 budget did the budgeteers make a close one year forecast of inflation in 2023.

The record of the federal government in forecasting the impact of its policies on the economy are dismal. It fails to forecast the interest cost on its debt even our a couple of years. And it is singularly unable to forecast the impact of its money creation, as in the COVID era.

Clearly, governments should limit their impact on the economy unless engaged upon a necessary war. One recalls the cry of the escaped Negro slave Frederick Douglass in 1865:

Do nothing with us! Your doing with us has already played the mischief with us. Do nothing with us!

In the 160 years since Douglass’s cry, nothing has changed. We must understand that, in the area of money, finance, and the economy, governments tend to make things worse.