John Law and Alan Greenspan – The Great Inflationists

It was, unfortunately, another historic week for the greatest speculative bubble ever. Leading the charge, the Philadelphia semiconductor and AMEX Biotech indices surged 17% and 14%, increasing year-to-date gains to a stunning 72% and 94%. The NASDAQ Composite jumped 7%, increasing it 2000 gain to 21%. The NASDAQ100 gained 6%, and the Morgan Stanley High Tech and NASDAQ Telecommunications indices 7%. The small cap Russell 2000 also rose 7%, increasing its year to date gain to 18%. The blue chips rallied strongly as well, with the Dow surging 505 points, or 5%. The S&P500 advanced 6%, the Transports 4%, and the Morgan Stanley Cyclical, Morgan Stanley Consumer and Utility indices 2%. The financial stocks also had a big week. The S&P Bank index increased 3%, the Bloomberg Wall Street index 10% and the AMEX Securities broker/dealer index 16%.

The credit market was relatively calm this week, although yields quietly moved higher. Five-year Treasury yields jumped 12 basis points to 6.59%, while 10-year yields increased 6 basis points to 6.38%. Off-the-run 10-year notes, however, sport yields of between 6.50% and 6.60%. Spreads did contract somewhat this week but remain extraordinarily wide. We thought today’s action very telling. After getting a strong boost from weaker than expected job growth data, bond prices drifted lower throughout the day before closing largely unchanged. The bond remains acutely vulnerable with this overheated economy much a “runaway freight train.” We fully anticipate higher interest rates going forward, all along the yield curve.

After a week like this one, we will look to history for insight. We will begin with a few pertinent quotes.

“There are good reasons to think that the nature of money is not yet rightly understood.” John Law 1720 (with the collapse of the Mississippi Bubble)

“Irredeemable paper money has almost invariably proved a curse to the country employing it.” Irving Fisher 1911

“There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.” John Maynard Keynes 1920

“Since the time when President Richard Nixon broke the final tenuous link between the dollar and gold in 1971, no major currency, for the first time in history, has any connection to a commodity. Every currency is now a fiat currency…” Milton Friedman 1991

We very much believe that, if you have a debased currency, that you will have a debased economy. The difficulty is in defining what part of our liquidity structure is truly money. Alan Greenspan 2000

As we have stated previously, we are of the strong opinion that the current monetary system has completely run amuck and this breakdown is responsible for fueling historic pricing distortions in US asset markets and devastating imbalances to the US economy. The reckless monetary policy of benign neglect for the stability of the US financial system that is now the hallmark of the Greenspan Federal Reserve should be recognized as nothing but an unmitigated disaster. Indeed, since the break from gold backing in the early 1970’s, and the through the process of haphazard financial deregulation since that time, our policymakers have been engaged in the greatest monetary experiment since John Law’s fateful introduction of paper money to France in the early 1700’s. It is our view that Greenspan has now lost complete control of this “experiment,” just as John Law did. Wall Street has assumed the reins of money and credit creation – the lunatics now run the asylum. With this in mind, it is our view that by revisiting some of the issues related to John Law’s failed attempt to create a paper money monetary regime considerable pertinent insight is provided into today’s extraordinary experiment in electronic money.

The New Palgrave Dictionary of Economics puts it this way: “John Law of Lauriston has been regarded by some observers as a monetary crank, by others as a precursor of modern schemes of managed money and Keynesian full-employment policies. He was the originator of the Mississippi Bubble, perhaps the greatest speculative bubble of all time.”

The essence of John Law’s theory was that the regulation of the money supply through bank issuance of paper money could simultaneously stimulate trade and economic activity while also maintaining general price stability. That by increasing the quantity of money, great economic wealth could be unleashed and wondrous prosperity created. In theory, skilled authorities would regulate the issuance of paper money, increasing its quantity to foster desired economic growth, as well as contracting its supply to temper overheating and maintain stable prices. That is, that the supply of paper money would be regulated precisely to meet the demands of real commerce. In short, John Law believed in both the power of the “money spigot” and the ability to properly manage it.

Quoting John Law: “This paper money will not fall in value as silver money has fallen or may fall…But the commission giving out what sums are demanded, and taking back what sums are offered to be returned; this paper money will keep its value, and there will always be as much money as there is occasion or employment for, and no more.”

In John Law’s view, it was the goal to foster the creation of money supply to accommodate demands for increased trade. Additional money would match an increase in commerce and the value of money would be held constant. In several respects, Law’s monetary regime was much more sophisticated than that of the contemporary Federal Reserve. Certainly, from his writings on monetary theory, it is clear that he possessed a deeper understanding of money than today’s economists. If he were alive today, he would look askance at a system where unfettered money creation is left to its own devices, apparently as long as the government’s basket of goods and services does not demonstrate in aggregate notable prices increases. The apologists refer to this as the “Price Rule.” We view the notion of a “Price Rule” with considerable derision as history has many examples of disastrous booms and busts where money and credit excess fed asset bubbles while leaving general consumer prices unaffected – the US in the 1920’s and Japan in the 1980’s as clear examples.

As for John Laws’ theories, there proved to be some very serious flaws. For one, it was premised on the authorities’ willingness at times to withdraw money to protect against circulation beyond the needs of trade. Booms are, after all, both powerful and extremely seductive to bankers, businessmen, investors, speculators and central bankers. “Authorities” during Law’s bubble were as reluctant to end the party, as the Federal Reserve and Treasury have been to end the Greenspan bubble. Certainly, after what has transpired throughout the current boom, we will never trust the Keynesian view that government policy will temper the upside of business cycles. In Law’s monetary system, the issuance of bank notes came to increasingly overwhelm the needs of actual commerce, profoundly disturbing pricing mechanisms, particularly with regard to a rampant inflation in stock prices. Increased money supply stoked stock prices and an historic stock market mania ensued. As the monetary system and economy came to be dominated by lending secured by inflating asset prices, the “authorities” efforts were increasingly directed at sustaining the bubble with frenetic money issuance and market manipulations. Today, very similar dynamics fuel an even greater mania.

John Law’s monetary theory also assumed, quoting the late economist Douglas Vickers, “that businessmen’s demands for currency for trade purposes could be regarded as independent of the actions of the monetary authorities.” Importantly, as it was during the Law regime, as well as Greenspan’s, there is, in fact, a very tight interrelationship between businesses’ demand for money and the willingness of the monetary authority to accommodate heightened money issuance. Or, said another way: “If money is “easy,” demand for money will be augmented, fostering a strong proclivity of self-feeding money supply and business borrowing excess.” For too many years over liquefied financial markets have fostered excessive borrowings with misdirected business spending and a regrettable misallocation of resources. Today, it is quite likely that the Fed would like to maintain money and credit growth for business but restrict it for financial speculation. Unfortunately, the overwhelming business of our country has become financial speculation.

Interestingly, real estate played a key role in John Law’s monetary regime. Quoting the great French economist Charles Rist, one of “Law’s ideas deserves our attention…that of securing money on land. It is an idea which recurs periodically among currency cranks.” To stimulate trade, Law proposed to create additional money by allowing landowners to mortgage their property. It was Law’s and previous theorists contention that the unique stability of land values provided ideal security for “paper” money. Why deal with the limited supply and price variations of gold and silver when there is an enormous asset of land values to capture?

The momentous flaw in this analysis, however, was that by monetizing land values, the additional money supply created only works to distort pricing relationships, certainly inciting inflation in land prices and disequilibrium in prices generally. As additional money is issued, rising land prices provide greater collateral for additional borrowings, hence money creation. As such, monetary systems secured by land assets would potentially accommodate virtually unlimited monetary expansion and asset inflation. In what should be obvious today, certainly after hundreds of years of history, such systems are inherently unstable. In this regard, Law’s monetary system was patently conducive to creating an asset bubble. Not only could speculators borrow against land, they could also use stock issues as collateral. And as stock prices rose, additional collateral was available to borrow against, used extensively to purchase additional stock. For several years, Law’s system functioned marvelously as a terrific commercial boom emerged in France after decades of depression. Over time, however, with stock prices having risen steadily, a wild speculative fervor took hold and became the focal point of the boom and Law’s monetary experiment. Importantly, Law’s monetary regime had inadequate safeguards against over-issuance of money. As rampant money supply expansion and a self-feeding stock market advance stoked public confidence, Law completely lost control of his monetary system to the bubble mania. Indeed, it took only a brief period for egregious money and credit issuance combined with a spectacular stock market bubble to completely destroy his system.

As Vickers stated, “In the first place, the essence of Law’s scheme was his proposal for the monetization of certain existing assets.” We strongly argue that the monetization of existing assets, largely real estate and stocks, is the essence of the Greenspan boom. This prosperity is not about productivity, but about unprecedented asset inflation. It is furthermore our strong contention that a monetary system dominated by asset monetization, in conjunction with Federal Reserve policy accommodating unlimited money supply expansion, is an absolute recipe for disaster. In fact, it is a senseless replay of John Law’s fiasco.

Clearly, inflated prices of real estate and stock certificates have fueled rampant money and credit excesses. This monetization is unmistakable in recent margin debt data. During the four months between October 1998 and January 2000, margin debt increased $61 billion, or 34%. We are told that a significant component of this unprecedented margin debt expansion is related to company insiders monetizing stock gains. As for real estate, recent data from Freddie Mac also confirm our belief of a massive monetization of housing inflation. According to Freddie Mac, during “the fourth quarter of 1999, 77% of refinances resulted in new mortgages at least 5% higher than the original mortgages…this contrasts with 45% in the fourth quarter of 1998.” This report also disclosed that “the growth in the value of housing, on a national average, to be about 25.4% over the past 5 years.”

Clearly augmented by an additional $300 billion of broad money supply growth during the final four months of 1999, the US stock market entered a Mississippi Bubble-style hyperinflation. Since October lows, the Russell 2000 has surged 47%, NASDAQ 87%, the Morgan Stanley High Tech index 85%, The Street.com Internet index 93%, the NASDAQ Telecommunications index 96%, the Philadelphia Semiconductor index 154% and the AMEX Biotech index 220%. A full-fledged mania has been allowed to develop and is now an uncontrollable monster. This is a tragedy that should never have happened. If Greenspan actually believed he could control this situation with gradual insignificant increases in interest rates, add this to his growing list of miscalculations. If he thought he could manage financial system liquidity to ensure both stable credit and equity markets, he must now recognize that the liquidity necessary to keep the credit bubble intact guarantees excessive liquidity for stock market speculation. If Greenspan thought he could use tempered liquidity to manage a “soft landing” for the stock market bubble, he should now understand that the preponderance of even reduced liquidity will find its way directly to the speculative sectors of the marketplace at the expense of many solid companies and the financial system and economy generally. If Greenspan thought there was an equity bubble and fragile financial system in 1994, what must he think today? It is impossible to know what he is thinking, but we are quite sure economic historians will see Greenspan as the greatest inflationist. In this respect, he is second to none, not even to John Law.