An End to Alchemy?

Michael Lewis, the author of various illuminating accounts of the events and progressions of the great financial crisis of 2008 – one of which became an Oscar-winning Hollywood movie – this time provides us with an illuminating account of someone else’s book – Mervyn King’s newly published The End of Alchemy. The thesis is a familiar one: the banking system is fundamentally flawed, and this is the cause of most if not all of our economic misery.

As befits a governor of the Bank of England (2003-2013), King is of course a veteran of the various banking vicissitudes of the 21st century. It is on the basis of this tenure that he writes this book, analyzing problems and offering remedies. But he does not wish to come across as someone with all the answers. As he writes in the introduction, “Many accounts and memoirs of the crisis have already been published. Their titles are numerous, but they share the same invisible subtitle: ‘How I saved the world.’” King may not want to save the world, but he certainly wishes to subject the banking system to a thorough reworking.

This is because the situation is that bad. What was behind the Great Crash of 2008? “Bad incentives that are still baked into money and banking – and so quite likely to create another, possibly even greater, crisis.” Still baked into: for, despite the (“arguably”) biggest financial crisis in history, nothing that addresses fundamental problems has changed. Shareholder limited liability encourages risk-taking, as shareholders take advantage of that absence of liability; deposit insurance encourages depositors to lodge money with banks, without regard to the riskiness of said banks’ lending policies; too-big-to-fail remains entrenched, encouraging gigantic risks to be run in the knowledge that if they turn sour, a bailout will be forthcoming.

Furthermore, the steps that have been taken ostensibly to mitigate the problem have only served to conceal it. Or, as Lewis puts it, “it’s being used to disguise how little has actually been done to fix that system.” Lewis quotes King: “Much of the complexity reflects pressure from financial firms. By encouraging a culture in which compliance with detailed regulation is a defense against a charge of wrongdoing, bankers and regulators have colluded in a self-defeating spiral of complexity.”

On this score we have a framework that seems designed for failure. There is the problem of moral hazard, which basically refers to the fact that when something is insured for, it is actually fostered or encouraged. Insurance against risk actually encourages risk. This problem is not restricted to the banking sector; it is endemic to any form of insurance. And then there is the web of ineffective regulation that seems to make a mockery of attempts to improve the situation.

King has an alternative. It is to revamp the banking system so as to eliminate risk-taking with other people’s money. “Deposits and short-term loans to banks simply need to be separated from other bank assets. Against all of these boring assets, banks would be required to hold government bonds or reserves at the central bank in cash. That is, there should be zero risk that there won’t be sufficient cash on hand to repay people wanting to flee any bank at a moment’s notice.”

So these deposits would be kept separate from other bank assets. These latter indeed could be used to finance the risky business of trading. These assets would have to be acceptable to the lender of last resort, the central bank, in case of financial crisis. And this acceptability will have been determined beforehand. “The riskier assets from which banks stand most to gain (and lose) would … be vetted by the central bank, in advance of any crisis, to determine what it would be willing to lend against them in a pinch if posted as collateral. Common stocks, mortgage bonds, Australian gold mines, credit default swaps and whatever else.”

The upshot is what Lewis calls “the King Rule.” As Lewis describes it, a bank must have on its balance sheet enough assets to cover withdrawals of its short-term liabilities (deposits plus short-term loans to the bank (one year or less)). But of course, you say, of course it has assets to cover those liabilities – that’s what double-entry bookkeeping is all about: every liability on the balance sheet has a corresponding asset. But here’s the rub: in the process described above, of the central bank vetting collateral, these assets would be given a “haircut” – assigned a discount at which the central bank would be willing to rediscount (buy) the asset, in case of a liquidity shortage. And it is this “haircut” valuation that banks in future would have to respect before putting funds out in quest for returns.

How exactly would this work? In the example Lewis provides from King’s book, a bank has $100 million in assets. Of these, $10 million are reserves deposited with the central bank, $40 million are “relatively liquid securities” and $50 million are “illiquid loans to businesses.” The central bank values these assets at 100%, 90%, and 50% of full value, respectively – these are their “haircuts.” Thus, in the eyes of the central bank, the bank’s assets “in a pinch” are worth $71 million, not $100 million. And therefore it cannot have more than $71 million in short-term liabilities. What other liabilities are there that could fill the $29 million gap? Lewis answers, “a lot more equity and long-term debt” than currently is the case.

With all due respect to both Mr. Lewis and a former governor of the Bank of England, I don’t think this is how banks really work. The suggestion is that banks receive deposits and short-term loans and turn around and invest them, sometimes in riskier material, sometimes less risky. So that banks don’t do anything except play with “other people’s money.” But banking doesn’t work that way. The very fact that they engage in what is referred to as fractional-reserve banking, in which they are allowed to “create” a multiple of amount of reserves they hold at the central bank, belies the notion that they only act as passive receivers of money.

In the case referred to above, the bank with $50 million in “illiquid loans to businesses” has on its asset side these loans; but on the liability side, it has deposits it created when it made the loans. That $50 million was not already in its coffers, waiting to be lent out. Not all of it, at any rate. Much if not all of it wasn’t there at all.

This is not to say that banks do not receive deposits. Of course they do. But these deposits, in turn, had to come from somewhere. Those funds weren’t always “just there.” It was in fact created, in the very process of credit extension. This is what Joseph Schumpeter clearly saw, and integrated it into his theory of economic development.

Unlike the deposits created by the bank to lend to businesses (“illiquid loans”), these deposits do run the risk of being removed and placed with another bank, and for that eventuality the bank has to have a contingency plan, e.g., only use that money in ways that can be quickly recovered. But for the loans to businesses, that money will always be replenished: the businesses will be depositing future income even as they withdraw for expenses, and this will remain in a rough balance. This is not the danger to the banking system, and it is hard to see why, on the face of it, these loans should require such a “haircut” as 50%. They are long-term investments by the bank. They are the beating heart of the capitalist system. They are not the problem. The problem lies elsewhere.

The argument of King’s book, then, is to put an “end” to “alchemy.” But this “alchemy” is already built into the very nature of the system. It cannot be gotten around by mandating certain levels of “safe” asset holdings. The focus on quality of collateral is good, but it needs to be done properly. Banks certainly need to ensure that the collateral they accept is marketable, is liquid. But that is easier said than done: because this is not a function of banks, but of markets. And market dysfunctionality goes far beyond bank policies.

There has been a glut of liquidity on world markets in recent decades. Lewis himself knows this all too well: he himself chronicled it in his excellent book Boomerang. Another excellent chronicler and serious economist to boot, Michael Pettis, in his book The Volatility Machine, shows just how this liquidity deranges markets. We like to think of markets as being driven by economic fundamentals, but Pettis shows how, rather than this, they are liquidity-driven, tossed about by massive flows of funds in pursuit of shrinking returns. And banks, together with the burgeoning shadow banking system, are at the forefront of trying to place these funds, running ever increasing risks in the process. This is the dysfunctionality, not so much “illiquid loans to businesses.”

The effect of liquidity-driven markets is to make market valuations go awry. We get asset bubbles and collapses, gyrating valuations, and therefore gyrating bank balance sheets. The collateral-based banking system is struck in its heart. But this is not the banking system’s fault per se, but an ever-increasing oversupply of liquidity.

Where did this global liquidity glut come from? A good portion of it has been the result of the collusion of transnational corporate interests with governments (and central banks!) of low-wage countries by which exchange rates are pegged to favor export industries. The method by which this is accomplished is sterilization – the practice of preventing foreign-exchange earnings from being converted into domestic currency. This has resulted in trillions of excess dollars. Japan and China have been at the forefront of this. The accompanying graphs tell that tale.

Figure 19: China's Foreign Exchange Holdings, 1997-2016
China’s Foreign Exchange Holdings, 1997-2016
Figure 14:  Japan's Foreign Exchange Holdings, 1975-2016
Japan’s Foreign Exchange Holdings, 1975-2016

For the rest, the very existence of debt overhang that afflicts the global economy also spells excess liquidity. The so-called law of reflux explains why. In a nutshell, when debt is repaid, liquidity is extinguished in the same amount. This is a function of the way our banking system creates money. So then, when debt is left unrepaid and instead is constantly rolled over, that liquidity is not withdrawn from the system. It lingers. Hence, excess liquidity.

To make a long story short: what we need is not so much an end to alchemy but an end to the range of toxic fiscal and monetary policies intended to rig the system in favor of various interests. Debt rollover is one of those, as it is simply a result of the too-big-to-fail approach. All of these interests are conflicting. But they have now coalesced in a globalist order that enriches the few at the expense of both workers and entrepreneurs, in both the developed and the less-developed worlds. That’s where we need to focus our attention.

National Economy?

At first glance the notion of a national economy would seem to be self-evident. After all, the lion’s share of economic data comes in the form of “national accounts,” which treat the nation as a self-contained economic entity, like a business. And the talk, when it comes to the economy, is always of how the nation is doing, or how other nations or countries are doing. Likewise, history revolves around the nations and their economic progress, as with the US and its “manifest destiny.”

But the idea of a national economy does not extend to the level of theoretical category. Economic theory does not take it into consideration. It comes into play because of political, not economic, considerations. The fact of the matter is, because politics is concentrated at the national level, so also is fiscal and monetary policy. And this factual state of affairs determines the subject matter. It is at the national level that both fiscal and monetary policy takes place; it is the level at which results from these policies are expected.

Economic theory, however, is not discussed in terms of the nation but in terms of abstractions: the “market,” “business,” “consumers,” etc. This is, or at least it used to be, referred to as “microeconomics.” Then we have “macroeconomics,” which is essentially the economic role of the state with its aforementioned fiscal and monetary policies; in this way we smuggle the nation in through the back door, as it were.

But the nation never functions as a subject of economic theory in its own right. Economic practice, of course, cannot avoid it – the sovereign democratic state is the way things are, it delimits the subject matter at the “macro” level.

The unexamined presupposition in all of this is, what is the locus of the economy? It is actually a question of the utmost importance, because only in this way can we come to grips with crucially important notions – and realities that, like it or not, we have to deal with – like the “global” economy.

One person who, thankfully, did not leave this presupposition unexamined is Jane Jacobs. In her book Cities and the Wealth of Nations,[1] she puts the notion of a national economy, which she takes to be the reigning doctrine, squarely in the cross-hairs. In her view, such an economy is an artificial imposition: the real economy is city-oriented. Cities, not nations, form the watersheds of an economy. Which is to say, cities are the focus of integrated, mixed economies, involving all major sectors from agriculture to industry to finance. Within the city and its supply regions, a stable and integral economy is maintained.[2]

Therefore exporting and importing takes place between cities, not nations. By extension, cities perform the vital economic function of import-replacing: the replacement of imported goods with goods of their own making. In Jacobs’ model, it is this import-replacing function that is the basic motor of economic growth.[3]

Jacobs adds to this import/export functionality the logical corollary: currencies. Currencies function as feedback mechanisms: they provide economies with information with respect to their productivity vis-a-vis other economies. A rise in an economy’s currency indicates that it is more productive than other economies the currencies of which are falling in relative terms, while a fall indicates the reverse condition.

So then Jacobs draws the obvious conclusion. Since cities are the basic units of import and export, currencies, in order to best perform their function, should be geared to the city economy itself; their rise and fall would thus trigger the appropriate response in the city economy, because this currency fluctuation acts as both tariff barrier and export subsidy (a falling currency acts as an export subsidy, a rising currency as a tariff barrier). Cities should maintain their own currencies.[4]

This also indicates a problem with this entity known as the national economy. A larger political unit such as a nation-state, when it imposes a common currency on a multiplicity of cities, short-circuits this feedback function of currencies. It favors the economies of some cities at the expense of others. Since cities not only import and export to foreign nations but also to sister cities in the same nation,[5] the automatic feedback information provided by the currency does nothing to allow cities within the range of the currency to adjust their economies to each other. They receive none of the feedback information that a city-based currency would provide them. Therefore, the cities whose economic position is favored by the national currency continue to grow, while the others stagnate.[6]

Clearly Jacobs is no friend of the nation-state. “Virtually all national governments, it seems fair to say, and most citizens would sooner decline and decay unified, true to the sacrifices by which their unity was won, than prosper and develop in division.”[7] And she takes classical economics, especially as exemplified in Adam Smith’s tellingly titled Inquiry into the Nature and Causes of the Wealth of Nations, to task for this. Smith “accepted without comment the mercantilist tautology that nations are the salient entities for understanding the structure of economic life. As far as one can tell from his writings, he gave that point no thought but took it so much for granted that he used it as his point of departure.”[8] Smith’s unthinking assumption of this assumption was subsequently passed from generation to generation without any further thought on the matter. “Ever since, that same notion has continued to be taken for granted. How strange; surely no other body of scholars or scientists in the modern world has remained as credulous as economists, for so long a time, about the merit of their subject matter’s most formative and venerable assumption.”[9]

So Jacobs agrees with us that the locus of the economy is an unexamined proposition. Nevertheless, her thesis that the nation was the focal point of classical economic theory is debatable. In fact, it is contradicted by an early proponent of “The National System of Political Economy,” Friedrich List.[10] List certainly does not figure as an unthinking follower of Adam Smith. His description of Smith’s school is telling: he calls it “the Cosmopolitical System.” By which he means that, pace Jacobs, it is the antithesis of a “national system” of economics.

In line with the influential vision of “Perpetual Peace” put forward in the late 18th century by the celebrated Abbé St. Pierre, this “cosmopolitical system” of economics presupposes harmony and peace between the nations. In such a situation, nations per se have no interests; the human race is joined together as one; and for this reason, “for the most part the measures of governments for the promotion of public prosperity are useless; and that to raise a State from the lowest degree of barbarism to the highest state of opulence, three things only are necessary, moderate taxation, a good administration of justice, and peace.[11] Free trade is then the norm, and indeed, can only truly be implemented under the auspices of such a universal peace. But, argues List, this is to confuse a hypothetical goal toward which the nations should work, with a standing condition already attained.

The [classical] School has admitted as realized[,] a state of things to come. It presupposes the existence of universal association and perpetual peace, and from it infers the great benefits of free trade. It confounds thus the effect and the cause. A perpetual peace exists among provinces and states already associated; it is from that association that their commercial union is derived : they owe to perpetual peace in the place they occupy, the benefits which it has procured them. History proves that political union always precedes commercial union. It does not furnish an instance where the latter has had the precedence. In the actual state of the world, free trade would bring forth, instead of a community of nations, the universal subjection of nations to the supremacy of the greater powers in manufactures, commerce, and navigation. [12]

While Smith and the other proponents of the classical school did recognize the existence of nations and national interests, List correctly assesses the basic orientation of the system. Much of this was inchoate; Lists’s strictures served to stir up debate, generate criticism, and give rise to critical schools of economic theory, such as the so-called Historical School.

This is evident not only in the advocacy of free trade generally as panacea for all economic ills, but also, importantly, in the advocacy of free trade in the area of currency. As we explored in this earlier post, leaving currency to the free market is a key element in a cosmopolitan system that deemphasizes nations as economic actors and subjugates sovereignty, in order to establish a “center-periphery” system of exploitation. And Adam Smith’s classical system established commodity money as a cornerstone of its economic order. As such, in its essentials List’s construct holds true.

List is correct to point out that mercantilism, the target of the classical school’s vituperation, took the nation to be the focus of economics. The system of commodity money, established to overcome mercantilism, is thus a product of the cosmopolitan system. Indeed, the latter found its justification in the fact that it overcame mercantilism, with its supposed framework of conflict of interests and the struggle between nations.

The system of commodity money came to be embodied in the gold standard. As I have argued elsewhere (Follow the Money, ch. 14: “The Great Transformation”), that system ended up in the shipwreck of two world wars and a great depression. As such, it is forever a thing of the past.

Since then, we have had national currencies; and since 1971, ostensibly free-floating national currencies. Jacobs’ polemic against the current system of national currencies has this to say for it, that it understands the role of currencies as feedback mechanisms. Furthermore, the understanding of economies as things that are city-oriented and city-generated. Where Jacobs goes astray is in her exclusive focus on currencies as the only way imbalances are rectified.

As I outline in the accompanying course, economic regions within national boundaries, which thus share the same currency, adapt to each other and resolve imbalances between each other by changes in wages and prices. These changes trigger flows between the economic regions, which are called factor flows: flows of mobile factors of production. Two such factors are labor and capital. They flow back and forth between economic regions, depending on such things as wage levels, price levels, and interest rates.

In the cosmopolitan system, these flows take place not only within countries but between countries. The world is then viewed as a unified, universal jurisdiction of provinces, with the free flow of mobile factors of production settling up regional imbalances.

The problem with this system is, of course, that it does not take nations into account as inescapable realities with inescapable, differentiated, often conflicting characteristics. Nations have different cultures, languages, religions, mores, values, levels of material development, and certainly different approaches to and attitudes towards getting and spending. This leads to evident differentials in things like rates of economic growth.

There is more. Nations have an unsettling penchant: inner drive to establish sovereignty. This was one of the great insights of the German Calvinist statesman and political philosopher Johannes Althusius (1563-1638). At the time, the doctrine of sovereignty was for the first time being fully developed in its modern form as the power that cannot be gainsaid, the power that stands above all other human institutions and authorities and “speaks the law” to them in a final manner. The Frenchman Jean Bodin (1530-1596), coincidentally one of the forerunners of the theory of commodity money, was also the developer of this new theory of sovereignty, which he located squarely in the ruler, whether king or national assembly of whatever sort.

Althusius accepted Bodin’s doctrine of sovereignty but turned it on its head, as it were. It was not the ruler, but the nation as a whole which was the bearer and locus of sovereignty. The ruler was simply the administrator thereof, who exercised its power in the name of and in trust to the true sovereign, the people or nation.

I have attributed the rights of sovereignty, as they are called, not to the supreme magistrate, but to the commonwealth or universal association. Many jurists and political scientists assign them as proper only to the prince and supreme magistrate to the extent that if these rights are granted and communicated to the people or commonwealth, they thereby perish and are no more. A few others and I hold to the contrary, namely, that they are proper to the symbiotic body of the universal association to such an extent that they give it spirit, soul, and heart. And this body, as I have said, perishes if they are taken away from it. I recognize the prince as the administrator, overseer, and governor of these rights of sovereignty. But the owner and usufructuary of sovereignty is none other than the total people associated in one symbiotic body from many smaller associations. These rights of sovereignty are so proper to this association, in my judgment, that even if it wishes to renounce them, to transfer them to another, and to alienate them, it would by no means be able to do so, any more than a man is able to give the life he enjoys to another. For these rights of sovereignty constitute and conserve the universal association.[13]

This key consideration is something that Jacobs and economists in general overlook. Sovereignty is a legal and political doctrine that fixes economic reality in a determinate and conclusive manner. It transcends economics while also acting as a basic datum that real-world economics must take into consideration. And it is nations that exercise sovereignty. As such, it is nations that establish and maintain a common law, the determiner of economic reality: hence, common-law economics. Currency, for one thing, is a function of this common law. No nations, no sovereignty; and no sovereignty, no common law. As this piece is already long enough, I will spare the reader any further elucidations. But this on-site article can serve to fill the gap.


[1] Jane Jacobs, Cities and the Wealth of Nations: Principles of Economic Life (New York: Random House, 1984).

[2] Ibid., ch. 2.

[3] “Whenever a city replaces imports with its own production, other settlements, mostly other cities, lose sales accordingly. However, these other settlements – either the same ones which have lost export sales or different ones – gain an equivalent value of new export work. This is because an import-replacing city does not, upon replacing former imports, import less than it otherwise would, but shifts to other purchases in lieu of what it no longer needs from outside. Economic life as a whole has expanded to the extent that the import-replacing city has everything it formerly had, plus its complement of new and different imports. Indeed, as far as I can see, city import-replacing is in this way at the root of all economic expansion.” Ibid., p. 42.

[4] Ibid., ch. 11.

[5] Ibid., p. 43.

[6] Ibid., ch. 11.

[7] ch. 13; the quotes are from pp. 212, 215-16.

[8] Ibid., p. 30.

[9] Ibid., p. 31.

[10] As elaborated in his book The National System of Political Economy,  first published in German in 1841. The English translation was first published in 1856.

[11] National System of Political Economy (1856 ed.), p. 191.

[12] Ibid., p. 200.

[13] Frederick S. Carney (trans. and ed.), The Politics of Johannes Althusius (London: Eyre & Spottiswoode, 1965), p. 10. Emphasis added.

Capitalism and the “Modern World System”

World system analysis was first developed in the early 1970s as an alternative to the traditional nation-state-oriented analysis of the global economy. In its initial form (which has since been expanded – even, significantly, to ancient Mesopotamia[1]) the focus was put on the modern world system, as evidenced by the title of the pioneering work of the genre, by Immanuel Wallerstein: The Modern World-System. According to this version of events, the world system developed in the transition from medieval to modern times, with the key period being the 16th century.

What characterizes a world system is what is called a center-periphery relation. The center determines the flows and the rationale, while the periphery provides the means and materials. The center is the “why,” the periphery is the “how.” The whole thing exists for the benefit of the center; the periphery may derive some advantages from the relationship, but these are adventitious.

Wallerstein argues that such a system was set up by the Western colonial powers. Prior to this, the structure for economically connecting various regions was empire – a political method, not an economic one. In the imperial model, there is likewise a center-periphery relation, but it functions differently. Such empires “guaranteed economic flows from the periphery to the center by force (tribute and taxation) and by monopolistic advantages in trade.”[2] That was the good news; the bad news was that these forced contributions required massive outlays in coercive apparatus in order to be sustained. “The bureaucracy made necessary by the political structure tended to absorb too much of the profit, especially as repression and exploitation bred revolt which increased military expenditures;” the upshot is that empire was only “a primitive means of economic domination.”[3]

As such, the new method of world system was a great improvement exploitation-wise. “It is the social achievement of the modern world, if you will, to have invented the technology that makes it possible to increase the flow of the surplus from the lower strata to the upper strata, from the periphery to the center, from the majority to the minority, by eliminating the ‘waste’ of too cumbersome a political superstructure.”[4]

It was capitalism that enabled this great leap forward. Capitalism does not require political hegemony to realize these economic flows between the center and the periphery; rather, it makes use of political power to attain favorable terms of trade. “The state becomes less the central economic enterprise than the means of assuring certain terms of trade in other economic transactions.” It stacks the deck in favor of the center, to ensure the center’s superiority. Trade is the medium for accomplishing this. Not free trade, to be sure, but managed trade. “The operation of the market (not the free operation but nonetheless its operation) creates incentives to increased productivity and all the consequent accompaniment of modern economic development.”[5]

“The world-economy is the arena within which these processes occur.”[6] And so globalism came into being.

There have been many critiques of this framework. For one thing, was this really the first time such a world system has come about? There is good reason to believe that such a world system was already established in ancient Mesopotamia (at least, a far-reaching center-periphery arrangement based in capitalism and trade rather than conquest).

For another, does capitalism necessarily form such a world system? It can be argued that there are different forms of capitalism. Was it not a form of capitalism that participated in Wallerstein’s empire? It would seem that capitalism of some form was alive and well in, e.g., the Roman Empire. And cannot capitalism function just as well within a domestic economy, under the thumb of sovereignty?

Indeed, if there is a term subject to equivocal use, it is capitalism. Schumpeter referred to capitalism as “that word which good economists always try to avoid,” precisely because of the range of meanings attributed to it. For his part, Schumpeter defined it as “that form of private property economy in which innovations are carried out by means of borrowed money, which in general, though not by logical necessity, implies credit creation.” Those familiar with Schumpeter’s theory of economic development will recognize the emphasis he puts on this function; those who aren’t, might profit from the course in economics available elsewhere on this website, which highlights this functionality. For his part, Schumpeter defends the importance he attaches to it. “It undoubtedly appears strange at a first reading, but a little reflection will satisfy the reader that most of the features which are commonly associated with the concept of capitalism would be absent from the economic and from the cultural process of a society without credit creation.”[7]

Be that as it may, world system analysis is important, not as just another critique of capitalism, but as a critique of the form capitalism can take and the way in which trade, banking, etc., can be used to establish hegemonic exploitative regimes on a transnational basis.

One of the important aspects of world system analysis is the perspective it opens to the way sovereignty can be manipulated, even hijacked. For the center of the system is less a political power center than an amorphous, protean nerve center. Fernand Braudel, not quite a world-system analyst but a kindred spirit nevertheless, depicted this kind of capitalism quite starkly. From early on, he wrote, the great capitalists have seated themselves astride the currents of domestic and international trade; they have been able to make things happen for themselves in a major way.  “This commanding position at the pinnacle of the trading community was probably the major feature of capitalism in view of the benefits it conferred: legal or actual monopoly and the possibility of price manipulation.”[8]

Thus, “active social hierarchies” were constructed atop the market economy, and those at the pinnacles could call the tune in the great national and international markets. The esoteric privileged area of large-scale and international trade represented a “shadowy zone” atop the market economy.  “Certain groups of privileged actors were engaged in circuits and calculations that ordinary people knew nothing of.  Foreign exchange for example, which was tied to distant trade movements and to the complicated arrangements for credit, was a sophisticated art, open only to a few initiates at most.” For Braudel, this transnational perch is the linchpin of the arrangement. “To me, this second shadowy zone, hovering above the sunlit world of the market economy and constituting its upper limit so to speak, represents the favoured domain of capitalism.”[9]

This understanding opens the door to a critique of this world-system analysis. The core-periphery framework with which it works, demands strong states at the core and weak states at the periphery. “The world-economy develops a pattern where state structures are relatively strong in the core areas and relatively weak in the periphery. Which areas play which roles is in many ways accidental. What is necessary is that in some areas the state machinery be far stronger than in others.”[10]

In the early-modern period, according to Wallerstein, it was absolute monarchy which provided the strong state, benefiting the two main power groups, the so-called capitalist bourgeoisie and the feudal aristocracy. “For the former, the strong state in the form of the ‘absolute monarchies’ was a prime customer, a guardian against local and international brigandage, a mode of social legitimation, a preemptive protection against the creation of strong state barriers elsewhere. For the latter, the strong state represented a brake on these same capitalist strata, an upholder of status conventions, a maintainer of order, a promoter of luxury.”[11]

But as I have written elsewhere,[12] it was not any of the absolute monarchies but the Great Exception, the Dutch Republic, that functioned as the core of the budding world system. This was not an absolute monarchy but a country in which the very concept of sovereignty and its location was unclear. It was a country the political power of which was divided between a stadhouder (a viceroy without a king) and a city-oriented gentry which might serve as the poster children of Wallerstein’s capitalist bourgeoisie.

As I explained in a previous post, the Dutch Republic was able to establish its trading network basically by poaching the silver circulation of its neighboring “absolute monarchies,” which is one reason France invaded the country in 1672. In other words, it worked to undermine the sovereign attributes of its neighbors to establish this network. It also e.g. circumvented trade restrictions established by its more powerful neighbors. In other words, the world system functioned by weakening, not strengthening, national sovereignty.

This characteristic is overlooked by Wallerstein’s analysis. It recurs on a regular basis. The entire commodity-money framework which the Dutch Republic and then England worked to establish on a world-wide basis, the monetary framework that fostered the world system such as it was, takes money entirely out of the hands of the state and puts in in the hands of a private capitalist elite.

Del Mar’s scathing denunciation serves to highlight just how opposite to the notion of a “strong core state” this new monetary regime actually was:

From the remotest time to the seventeenth century of our æra, the right to coin money and to regulate its value (by giving it denominations) and by limiting or increasing the quantity of it in circulation was the exclusive prerogative of the State. In 1604, in the celebrated case of the Mixed Moneys, this prerogative was affirmed under such extraordinary circumstances and with such an overwhelming array of judicial and forensic authority as to occasion alarm to the moneyed classes of England, who at once sought the means to overthrow it. These they found in the demands of the East India Company, the corruption of Parliament[,] the profligacy of Charles II., and the influence of Barbara Villiers. The result was the surreptitious mint legislation of 1666-7: and thus a prerogative, which, next to the right of peace or war, is the most powerful instrument by which a State can influence the happiness of its subjects, was surrendered or sold for a song to a class of usurers, in whose hands it has remained ever since.[13]

In a similar vein, the core of John Hobson’s critique of British colonialism (taken over by Lenin in his Imperialism: the Highest Stage of Capitalism) is that colonialism serves the interests neither of the mother country nor of the colonies, but only the interests of certain specific parties who profit from the arrangement. It follows that such a world system is not necessarily benefiting the core countries at all – it might even be a serious drain on them. Qui bono? The answer is not so simple as the world system analysis might lead us to believe.

Fast forward to the contemporary situation. The arrangement in which we find ourselves, which has been gestating since the end of World War II and has settled into a familiar pattern since the 1980s, cannot be described in terms of this center-periphery arrangement. In fact, the argument can be made (and forcefully) that it has been the periphery which has taken advantage of the core. This has been accomplished mainly by pegging exchange rates at levels advantageous to exports from the periphery (production) paid for by the core (consumption). In this arrangement, the United States is referred to as the “consumer of last resort,” the place where excess production can be most efficaciously offloaded.

This hollows out the production capacity of the consumption-oriented countries running the trade deficit. Obviously, this is not good for workers in those countries. Nor is it beneficial to the workers in the producing and exporting economies. As Michael Pettis makes clear in his extremely important book The Great Rebalancing, it is by a form of forced “savings” (i.e., expropriation) imposed on households and thus workers that this trade advantage is maintained. Qui bono? Not the workers, neither in the exporting nor in the consuming countries. Rather, it is our familiar friend, Braudel’s “shadowy zone” of behind-the-scenes capitalist power brokers, which benefits from its “commanding position at the pinnacle of the trading community” to steer the profits in its direction and the losses to both ends of the trading network. In this arrangement, there is no core and no periphery – there are only regions of exploitation. The difference is in the form the exploitation takes.

Having covered these arrangements more extensively in the accompanying course, I direct the reader there for further background. In the meantime, it is enough to confirm that the seismic rumblings now being felt among the various electorates in the West have a solid basis in reality. It is only to be hoped that the powers that be take heed of these rumblings and make the appropriate adjustments, before they turn into actual political earthquakes.


 

[1] For example: Barry Gills, Andre Gunder Frank (eds.), The World System: Five Hundred Years Or Five Thousand? (London and New York: Routledge, 2014).

[2] Immanuel Wallerstein, The Modern World-System I: Capitalist Agriculture and the Origins of the European World-Economy in the Sixteenth Century, with a New Prologue, vol. 1 (Berkeley, CA: University of California Press, 2011 [1974]), p. 15.

[3] Ibid.

[4] Ibid., pp. 15-16.

[5] Ibid., p. 16.

[6] Ibid.

[7] Joseph Schumpeter, Business Cycles: A Theoretical, Historical, and Statistical Analysis of the Capitalist Process (New York: McGraw-Hill Book Company, Inc., 1939), vol. 1, pp. 223-224.

[8] Civilization & Capitalism, 15th-18th Century: Vol. II, The Wheels of Commerce (New York: Harper & Row, 1984 [1979]), p. 374.

[9] Civilization & Capitalism, 15th-18th Century: Vol. I, The Structures of Everyday Life (New York: Harper & Row, 1981 [1979]), p. 24.

[10] Wallerstein, The Modern World-System, p. 355.

[11] Ibid.

[12] See my Follow the Money: The Money Trail Through History (Aalten: WordBridge, 2013), pp. 84ff.

[13] Alexander Del Mar, Barbara Villiers: or, a History of Monetary Crimes (New York: Cambridge Encyclopedia Co, 1899), p. 7.

Isaac Newton and the Alchemy of Finance

Western Christendom experienced a sea change in the late 17th century. On one side of that divide was theological dogmatics, scholastic philosophy, the divine right of kings and priests, and, seemingly in their train, wars of religion; on the other side, there was theological indifference, mechanical philosophy, government by consent of the governed, latitudinarian and sectarian church polity, and the political balance of power. Not that these things came all at once; but the tendencies were clear. The mood and temper of the peoples had swung; religion lost its position of overriding importance, to be replaced by economic and political considerations, reason of state, and the wealth of nations.

A pantheon of figures has been elevated to apostolic status as trailblazers in the transition from the Darkness of the one side of this great divide to the Enlightenment of the other. Hugo Grotius, Rene Descartes, Baruch Spinoza, John Locke, Pierre Bayle, Montesquieu, Voltaire, all figure in enumerations of enlightened progenitors of the new era. Paired with these names was a new theoretical orientation which determined the mindset, the Zeitgeist, the Weltanschauung of this new dawn: a new science putting the categories “nature” and “natural law” on a new footing, providing the essential authoritative basis for the new order.

Thus “nature” was the determining factor. The “imperative of nature” came to dominate all areas of inquiry and practical philosophy. The “state of nature” became the orientating condition; rights in a state of nature came to be the touchstone of all just legal and political order; natural religion, religion in accordance with the dictates of nature, came to be touchstone to judge revelation, or at least to form a stand-alone, autonomous body of knowledge alongside revelation; and a new school of thought, economics, arose from out of the disarray of “mercantilist” controversy, basing itself upon – you guessed it – nature, with the initial iteration provided by Richard Cantillon and François Quesnay, and which issued forth as “physiocracy”: the rule of nature.

Perhaps one figure above all others represented and personified this trend. That would be Isaac Newton, the progenitor of the paradigm that anchored all these areas of thought in terms of a unified theoretical construct. Newton put science on a new plane, providing an integrated theoretical explanation for phenomena that had stumped scientists for generations; and it was upon this foundation that the orders of religion, law, politics, and economics were shunted. Alexander Pope’s well-known “Epitaph on Sir Isaac Newton” was, if anything, an understatement of the sentiment of the age:

Nature and Nature’s Laws lay hid in Night:

God said, “Let Newton be!” and all was light.

Christian theology became wedded to Newtonian physics, which in particular served as a tool of apologetics.[1] The philosophy of law and politics, already argued in terms of the individual and consent, received a powerful support from the notion of an atomistic universe. And this very same Newtonian construct likewise served to buttress the budding school of classical economics with all of its “natural laws” of wealth and poverty centering on the individual and self-interest.

In all of these areas, Newton’s philosophy, the “settled science” of the day, supplied a powerful sanction. But this is not everything there is to know about Newton. Some areas of his labor, to which he devoted at least as much time as his scientific investigations, have come to light of late, after having languished in the obscurity they were left in by hagiographic biographers determined to highlight the rational character of one of the chief developers of the scientific method, while ignoring what they deemed to be irrational. And Newton exhibited this “irrationalism” in spades.

One of these areas was biblical study. Newton devoted a great deal of time and effort to biblical chronology and to deciphering the Temple of Solomon. The latter in particular he held to be an expression of hidden truth to be unraveled by the initiate. This interest in the Bible and in theology, along with Newton’s clear belief in the biblical version of events regarding, e.g., six-day creation and the Flood, were enough to put a serious dent in Newton’s reputation as the objective enlightened scientist. But the most egregious offense in this regard was provided by the realization that Newton dabbled in alchemy. More than that: he spent a major portion of his investigative life, not in scientific experimentation, but in alchemic explorations, pursuing the transmutation of elements.

It was John Maynard Keynes who first lifted the lid on this aspect of Newton’s legacy. “Newton was not the first of the age of reason,” Keynes wrote in his posthumously published and delivered lecture, “Newton the Man.” Rather, “He was the last of the magicians, the last of the Babylonians and Sumerians, the last great mind which looked out on the visible and intellectual world with the same eyes as those who began to build our intellectual inheritance rather less than 10,000 years ago.”

Keynes discovered the “real” Newton while perusing a box of forgotten documents he obtained at an auction in 1936. This led to a radical reevaluation on his part. “In the eighteenth century and since, Newton came to be thought of as the first and greatest of the modern age of scientists, a rationalist, one who taught us to think on the lines of cold and untinctured reason. I do not see him in this light. I do not think that any one who has pored over the contents of that box which he packed up when he finally left Cambridge in 1696 and which, though partly dispersed, have come down to us, can see him like that.”

That box revealed Newton the alchemist. Alchemy is the pursuit of transmutation, and Newton avidly pursued it. What the alchemists were after was gold. What one needed for that was the philosopher’s stone; with that in one’s possession, one might convert base metal into the precious yellow metal.

It goes without saying that Newton never came into the possession of such a stone, nor did he ever successfully transform base metal into gold. But it cannot be said that he was altogether unsuccessful in his manipulations in favor of the yellow metal. And here comes the part of the story that is never told, because insufficiently understood. It is the story of how Newton participated in one of the great transformations of world history: the shift of England’s currency from silver to gold, which precipitated the change from a coinage- to a banking-based monetary system. He did so as Master of the Mint, a position he occupied from 1699 until his death in 1727.

A little background is in order at this point. The 16th century witnessed the development of a new order of trade, or, in Immanuel Wallerstein’s terminology,[2] a world-system integrating far-flung areas of the world into a trading network. At the center of this trade network was the fledgling Dutch Republic. In the face of the mercantilist imperative – policies to maximize the retention of precious metals in order to maintain a viable domestic circulation – the Dutch Republic instituted a novel arrangement with regard to currency, dictated by this trading network.

This arrangement facilitated trade with the East. This was because the West ran a chronic trade deficit with the East. There was nothing new about this; from the early medieval period on, the West basically had nothing to offer the more advanced East than such things as furs and slaves, the latter until the slave supply from the Western countries dried up. But there was great demand in the West for what the East had to offer: for instance, silks and spices. How to finance the importation of these luxury goods? Silver.

The one thing the West had that the East wanted, especially since Spain’s discoveries in the New World, was silver. Silver in the East carried a premium vis-à-vis the West, making it profitable to export: this was what made it effective as a means to settle up the trade deficit.

Thanks to new mining techniques and Christopher Columbus, silver became abundant in the 16th century, precipitating the so-called Price Revolution of that century. But in the 17th century the supply began drying up, one of the factors behind the so-called General Crisis of the 17th century and one of the spurs to the spate of policy proposals and implementations summed up in the term “mercantilism.” For one thing, the mines of New Spain were not producing as much as they once did. For another, the flow of silver to the East, primarily China – that bottomless pit, “the World’s Silver Sink”[3] – was beginning to have its effect.

The Dutch Republic served as the funneling mechanism for this flow. Its counter-mercantilist policy allowing the free import and export of specie, and the demand for silver for export exerted a magnetic attraction from all over Europe, with the resulting abundance of coin even precipitating the Tulip Mania of the 1630s.[4] Much of it simply went to offset the burgeoning import business.

English merchants watched all of this with proverbial Argus eyes. They looked on as the Dutch East India Company established its trading network, helped by its special advantage of readily available specie. They sought ways to get around the royal prohibition on the export of currency, and chafed under the restriction.

The breakthrough came in 1663, with the passage of legislation establishing a regime of free coinage. Del Mar finds the impetus for this legislation in the intrigues of Barbara Palmer, Duchess of Cleveland, Charles II’s mistress.[5] With this opening, the East India Company worked diligently to build its own trading network. The needed silver it obtained, among other places, from the domestic circulation, precipitating a dearth of coin. Together with the wars against Louis XIV conducted by “King Billy,” the Dutch stadhouder become King of England, this precipitated an economic and budgetary crisis.

This decimated the coinage, which suffered from debasement at minting as well as the techniques of clipping and sweating. As a remedy, the wise men of the age recommended a restoration of the coinage to the condition it enjoyed under Queen Elizabeth a century earlier. According to Whig historiography, the great men who recommended this measure, occupants of the Enlightened Pantheon, men like John Locke, here once again displayed their sagacity. Post-Whig reassessment has been less kind.[6]

The attempt to restore the coinage to the silver content of days when silver was abundant had, as its detractors predicted it would, a strongly deflationary effect. And it had the opposite result than hoped, for it simply provided a prime source of silver for export. Full-weight silver coins were simply too juicy to let pass. On these terms, it was quite simply more profitable to export silver than allow it to continue in circulation.

So the result of the so-called Great Recoinage was virtually to establish gold as the currency standard for England.[7] Here is where Newton comes in. As Master of the Mint, Newton ensured the continuation of this trend, maintaining a ratio of silver to gold (15 ½ to 1) that upheld the continued priority of gold over silver. By pricing gold favorably against silver, this ratio ensured that the export of silver in favor of gold would continue to be profitable. Both Newton and Locke indicated the direction that the natural philosophy was going to take with regard to economics: the commodification of money, with all the consequences that this would entail.

But the establishment of gold at the heart of the English currency system had another consequence of a different order: it established fractional-reserve banking in place of coinage as the “money method.” This system of banking had a magical working. It turned paper into gold, or gold into paper, for it multiplied a bank’s specie holdings and circulated a currency “as good as gold” albeit many times the actual amount of gold. This alchemical process actually worked, contrary to Newton’s experiments with the philosopher’s stone. And so Newton stood at the cradle of a new alchemy with far-reaching consequences.

It is one of those curious coincidences of history that Keynes, considered by many to be the modern progenitor of the alchemy of finance, was the first to discover and publicize Newton’s own alchemical wizardries. Keynes’ alchemy consisted in the magical transformation of fiat currency into productivity, growth, and wealth, simply by wielding “effective demand.” Newton’s consisted in the more mundane magic of the multiplication of gold reserves. “Their works follow after them,” for their alchemy lives on. In our day and age, the paradigm of alchemical transmutation has crossed over even into biology and gender. As such, it is the pulsating heartbeat of the age in which we live, all pretensions of scientific rationality notwithstanding.


 

[1] See in particular Margaret C. Jacob, The Newtonians and the English Revolution 1689-1720 (Ithaca, NY: Cornell University Press, 1976).

[2]  Immanuel Wallerstein, The Modern World-System I: Capitalist Agriculture and the Origins of the European World-Economy in the Sixteenth Century, with a New Prologue, vol. 1 (Berkeley, CA: University of California Press, 2011 [1974]).

[3] Dennis O. Flynn and Arturo Giráldez, “Born with a ‘Silver Spoon’: The Origin of World Trade in 1571,” Journal of World History, Vol. 6, No. 2 (Fall, 1995), p. 206.

[4] Doug French, “The Dutch Monetary Environment During Tulipmania,” in The Quarterly Journal of Austrian Economics (Vol. 9, No. 1, Spring 2006), pp. 3-14.

[5] Alexander Del Mar, Barbara Villiers: or, a History of Monetary Crimes (New York: Cambridge Encyclopedia Co, 1899).

[6] For instance: Peter Laslett, “John Locke, the Great Recoinage, and the Origins of the Board of Trade: 1695-1698,” in The William and Mary Quarterly, Vol. 14, No. 3 (July 1957), pp. 370-402.

[7] A recent article making this case is Charles James Larkin, “The Great Recoinage of 1696: Charles Davenant’s Developments in Monetary Theory” (2006), available at https://goo.gl/JtcWCH.