The ECB And John Law

Last week, the ECB extended its monetary madness by pushing deposit rates yet more negative. It is extending quantitative easing from sovereign debt into non-financial investment grade bonds, while increasing the pace of acquisition to €80bn per month. The ECB also promised to pay the banks to take credit from it in “targeted longer-term refinancing operations”.

Any Frenchman with a knowledge of his country’s history should hear alarm bells ringing. The ECB is running the Eurozone’s money and assets in a similar fashion to that of John Law’s Banque Generale Privée (renamed Banque Royale in 1719), which ran those of France in 1716-20. The scheme at its heart was simple: use the money-issuing monopoly granted to the bank by the state to drive up the value of the Mississippi Company’s shares using paper money created for the purpose. The Duc d'Orleans, regent of France for the young Louis XV, agreed to the scheme because it would provide the Bourbons with much-needed funds.

This is pretty much what the ECB is doing today, except on a far larger Eurozone-wide basis. The need for government funds is of primary importance today, as it was then.

In Law’s day, France did not have a central bank, such as the Bank of England, managing the issue of government debt, let alone a functioning government bond market. The profligate spending of Louis XIV had left the state three billion livres in debt, which was the equivalent of 1,840 tonnes of gold. This was about 85% of the world’s estimated gold stock at that time, at the livre’s conversion rate into Louis d’Or. John Law would almost double that by June 1720, with unbacked livre notes issued by his bank.

Today, the assets being overvalued for the governments’ benefit are government bonds themselves, but the principal is the same. There is no need to use a separate, Mississippi-style vehicle, because there is a fully functioning government bond market.

Banque Generale created the bank credit for France’s upper and middle classes to buy Mississippi Company shares, driving up the price and making yet higher prices a certainty. Law had set up a money-making machine for those with a modicum of wealth, but the ten per cent down-payment required to subscribe for Mississippi shares made speculation available to the servant classes as well. The result was virtually everyone in Paris was caught up in the speculative fever, and Mississippi shares increased from the 15 livres deposit to 18,000 livres fully paid at the peak in June 1720. The term “millionaire” dated from that time.

Today, the ECB is doing things a little differently, creating money to buy government bonds from the banks, enabling governments to continue to spend without the threat of a funding crisis. Basel III banking regulations, which exempt banks from having to apply a risk weighting to government bonds, ensures that the bonds are also in great demand as collateral, further guaranteeing that the banks will continue to buy them.

However, in common with Law’s scheme, the ECB needs new suckers all the time to keep the market from stalling, so the ECB is extending the scheme beyond sovereign debt by buying up investment grade bonds as well. And since it can conjure up money out of thin air, it will also pay the commercial banks interest to borrow from it, ensuring the yields on all bonds purchased with this finance will continue to fall in line with negative interest rates.

As was surely the case in 1720, the expansion of credit is commonly believed to be a very good thing, as necessary for the welfare of the Eurozone states today as it was for France three hundred years ago. But don’t be fooled. For the scheme to continue, more credit has to be issued, and more bonds bought to stop the bond bubble from deflating. That is the real reason behind the ECB’s action. And because it cannot be continued for ever, that is why ultimately the bubble will pop.

The Mississippi bubble came to an end when France ran out of sufficient buyers to keep it inflating. There always comes a point where the temptation to cash in some profit to buy those other things long desired, such as a country estate and a smart Paris residence, becomes too great to resit. And when the Mississippi bubble lost its mojo, the selling escalated. By late 1720, the Banque Royale, as it had been renamed, faced angry note-holders unable to redeem them for specie. Once the run started, the whole scam rapidly imploded.

It seems extraordinary that in economics, wishful thinking trumps reasoned analysis and common sense so often.  The fallacies that have brought the ECB to implement its delusional policies are broadly the same as those in which John Law believed. In both cases, they started by assuming that the state has a duty to ensure money and credit are freely available, unchaining the population from the constraints of free markets. In both cases, their beliefs inevitably adjusted as a result of problems that subsequently arise as the by-products of monetary expansion. And in both cases, yet further monetary expansion then became the only solution to apply as a cure-all for the problems themselves. Unsound money has come to be deployed simply to keep bankrupt governments going.

We should put to one side all other reasons, justifications and excuses for what has happened, because it was the French state that employed Law to run its bank, and the Eurozone governments that created the ECB. The servant always serves the master. Banque Royale succumbed to a run, while the ECB is still nursing a banking system, that on a reversal of the asset bubble, will almost certainly collapse. In this respect, the ECB is not quite at the Banque Royale’s tipping point, but it is edging closer.

Everyone in the Eurozone believes that the ECB is all-powerful, because to believe otherwise is unthinkable. This was also true of Banque Royale, until it faltered. It was not a loss of confidence in the bank that was responsible for the collapse, it happened as a result of the difficulties encountered in sustaining the bubble. The lesson is that it need not take a loss of confidence in the ECB to start its destruction.

Let’s imagine for a moment, that the bond-market bubble ends and prices start to normalise. We know that it won’t take much to create losses that will wipe out the capital of some critically important commercial banks, but we like to think the ECB is on top of this problem. Very few people seem to be are aware of the crisis that falling bond prices would create for the ECB itself.

The ECB’s equity capital at 31 December 2015 was €7.74bn, supporting a balance sheet of €256.645bn, a gearing ratio of over 33 times. The wider euro-system’s accounts, where the asset purchases accumulate, has capital and reserves of €98bn supporting a balance sheet of €2,872bn, a gearing ratio of 29 times and rising. As a rough guide, an interest rate increase of less than two per cent, to as little as one and a half per cent, would undermine the value of bonds and related risks at both the ECB and in the euro-system, to the point where they would require further capital injections. For some context, if the yield to maturity on a five-year bond rises by 2%, the price falls roughly 10%.

Now we are getting to the truth as to why the ECB’s debt bubble must be sustained. It is no longer to support economic growth. A deflating asset bubble will take down the ECB and the wider euro-system, just as the Mississippi bubble took down Banque Royale. And in both cases, the confidence vested in these institutions is reflected in the purchasing power of the money they have issued.

It may not be long before foreign holders of euros begin to visualise Mr Draghi in a full-bottomed wig, lace jabot and long velvet coat. Their problem will be looking for safety, because the ghosts of eighteenth-century monetary economists can also be imagined at the helm of the other major central banks. In John Law’s day, the solution was simple, as the private banker, Richard Cantillon showed. He cashed in early, selling livres for gold.

Cantillon, who was the equivalent of today’s investment banker, not only punted the Mississippi bubble successfully, but he loaned large quantities of fiat livres to the wealthy in Paris, taking in Mississippi stock as collateral. Before the crash, he had the prescience to sell all his own stock for gold. It is said that he also secretly sold all the collateral he had had pledged to him, again settling for gold. Cantillon then removed himself across the border to Italy with his stash of Louis d’Or to await developments.

After the crash, he returned, and demanded repayment of the outstanding debts from his clients. Cantillon probably became the richest commoner in history, and immensely unpopular in Paris to boot. Rather like the investment bankers of today, he made his fortune while nearly everyone else was impoverished.

We cannot say for sure what will trigger the end for the ECB and the euro. It could be a member state, like Italy, Spain or even France, running into financial or political trouble. It could be the threatened break-up of the European Union, if the Brexit polls swing in favour of Britain leaving, and the blow that it would impart to European unity. The Moslem immigration problem is often cited as a threat to the European project. It could be developments on the other side of the world, perhaps China driving up commodity prices, leading to future price inflation in the Eurozone, so leaving Eurozone bond markets exposed to the threat of rising interest rates.

Equally, it might not be an identifiable event. Rather like the Mississippi scam, it could end when the Eurozone’s bond markets just run out of steam.

Alasdair Macleod

HEAD OF RESEARCH• GOLDMONEY