Thinking about Evolution & Economics and Some Notes on the Evolution of Ideas

Part 13 - The strange tale of the Invisible Hands, Moral Sentiments, Rent Seeking, Comparative Advantage, Total Factor Productivity & Creative Destruction ... or risks, rewards & money flows?

Banking, Business Cycles & Balance Sheets.

Now God said, and I agree with him - 'a fool thinks he needs no advice, but a wise man listens to others ...'

So where did all this wealth creation & economic growth come from? And why growth? Why was there no steady state where all things bright & beautiful just existed? ... and did the 2nd Law of Thermodynamics have anything to do with it?

Hmmmm ... well, stuff always seemed to be happening and there always seemed to be a pattern & direction to the happenings, they were never random, there were always shapes & trends ... trends towards growing complexity? ...

If all the happenings evolved, then they were inherited & connected, but always inherited with random modifications, some of which differentially survived creating new interconnections ... and you can't have inheritance with new interconnections without growing complexity in the population of happenings ... can you? ... think about it? ...

But folk never understood this complex complexity business ... no wonder ... the 2nd law of thermodynamics made two things indisputable & certain -

the future was inherited from the past but it was different because entropy had increased and

it was impossible to know in advance which new differences would survive because they were new differences ... if you get my drift ...

... a double whammy ... change & ignorance ... but all was not lost because there were patterns as entropy increased ... patterns of 'micro states' which Boltzmann discovered in 1872 ...

It seemed as entropy increased, novel structures emerged, interacted & some survived ... and some of these structures were in the brains of folk and they led to behavioural traits ... and economic behaviour emerged because uneconomic behaviour didn't survive ... so economic systems evolved and vaguely emerged from the mists of deep history ... and folk recognised & remembered patterns & learned, that's how they survived ... folk learned by generating ideas & testing out new behaviours and remembering what seemed to work. They discovered & accumulated a bit of 'know how' ... that's what folk with brains did ... so this 'know how' must have been something to do with what was going on in folk's heads ... was this the dissipation of energy through neural pathways as entropy spontaneously increased? ... or something else just as bewilderingly complex? Was all this change driven by the 2nd law? ... after all this was the only known law of nature that had direction? ... there was no alternative explanation? ... what else could the change in 'know how' be? ... what else could Darwin's 'tree of life' be? ...  what else could anything be? ...

... unless ... a supernatural God did it all by himself!

But nobody knew ... folk were mainly ignorant ... ignorant of what it was they didn't know ... it's very difficult to admit nobody knows what's going on ... isn't it ?!

Unsurprisingly, mere mortal understanding of this immense complex complexity was an arrogant conceit, understanding always hurt the brain for very good reasons -

the behaviour of folk themselves was an integral coevolving part of a whole damned complex shebang

complexity, change, conflict & scarcity were always associated with the emergence of any useful behaviour

innovative behaviour was always unexpected by definition, an unintentional bifurcation & discontinuity

bottom up natural selection was not designed, the process worked because failures didn't survive and folk always found it difficult cope with failure, especially the Bishops, Princes, Generals & Bureaucrats who always thought they knew better

the universal human emotion of intention & purpose always felt 'as if' it were an imperative top down design ... ask Rene Descartes ...

and invariably the pre Darwin interpretation of history described a top down intelligent design ... there was no known alternative ... was there? ...

No wonder folk assumed things were designed by someone clever ... an omnipotent ...

Then in 1859 Darwin suggested that history was different  - a bottom up emergence of complexity ... inheritance with modification & differential survival ... so perhaps the universal assumption of human 'intention' was itself a remarkable survival aid ... an adaptation ... an attempt to make sense of the world, to understand, to explain, to rationalise human behaviour 'as if' a top down design? A strange paradox became apparent ... a strange inversion of reason ... maybe survival chances were increased if omnipotent design conspiracies were believed?

Imagine if somebody really was controlling economic activity? ... maybe in the basement of The Bank of England? ... if folk could control economic activity they could make things better? ... would such a belief make folk -

arrogantly seek power (hubris)? ... or

apathetically blame the powers that be (nemesis)? ... or

 inspired to work hard & experiment to discover for themselves what works (cartharsis)? ...

... take your pick ... or maybe all three are involved ... depending ...

So some folk learned to go with the flow as dissipating energy flowed into new structures, riding the pathways 'as if' trying hard to survive ... trialling & erroring ... and, maybe, energy dissipation pathways in the brain were just like energy dissipation pathways in steam engines? There was nothing supernatural about steam engines ... so why should there be anything supernatural about brains?

And so back to economics, the connection was clear because steam engines powered the Industrial Revolution!? ... yes? ...

And for sure the Industrial Revolution was all about folk who used their brains and discovered new physical structures - Henry Cort's reverberatory furnaces, Abraham Darby's cast iron pots, Richard Arkwright's cotton gins, Thomas Telford's bridges and Josiah Wedgewood's delicate pottery ... then burgeoning cites, and more & more folk ... an explosion of new physical structures, an explosion of complexity ...

The Industrial Revolution was a spectacular example of wealth creation and it became the focus of attention for the classical economists ... ask Adam Smith, David Ricardo, Thomas Malthus and Karl Marx about wealth creation? ... they all grappled with the stupendous puzzle of economic growth. What on earth was going on? ... they didn't know ... how could they? If this was evolution driven by the 2nd law then neither of these ideas were even half baked until much much later ... natural selection 'just happened' without anybody knowing about it ... as it had done for eons & eons before before ...

So it came to pass that after 1859 one or two economists started to change their assumptions, suppose happenings did evolve ... suppose -

economies were complex adaptive systems, 'designed' by a process of Darwinian natural selection - a process of inheritance with random modification & differential survival where what survived into the future emerged & was unknowable and us folks were just one part of the whole complex coevolving shebang.

Once this penny dropped understanding of history and economics changed fundamentally and a stream of exciting new insights emerged ... so here we go ... let's accept the mind boggling complex complexity and just assume for the moment that Darwin was on to something ...

Supply & Demand, Invisible Hands, Moral Sentiments & Adam Smith's astonishing anticipation of Charles Darwin. 

In 1776 a giant arrived on the scene, Adam Smith explained all about the industrial revolution and the wealth of nations, there was no omnipotent, no supernatural conspiracy. Self sustaining economic growth was just a hard reality.

The industrial revolution exploited survival 'know how' from synergies associated with social interactions as folk cashed in on specialisation & scale ... everyone beavered about doing deals as they learned more & more specialised skills and lived in larger & larger groups ... after all there was no point in specialising if you didn't exchange your skills with your mates ... and everyone knew about the more the merrier and economies of scale.  

Adam the Smith told stories of synergy, specialisation & scale - increasing returns in pin factories where 'division of labour was limited by the extent of the market', a positive sum game of 2 + 2 = 5 ... but most folk thought Adam was an academic joke when he talked about supply & demand where market prices cleared the goods and gluts & queues disappeared ... 'as if by an invisible hand which was not part of intention' ... 

But how were these miraculous clearing prices fixed? ... who was in charge? ...

In 1859, 83 years after Adam wrote his stories, Charles Darwin explained the process of natural selection ... perhaps this was the answer ... measured by trusted quids, bobs, tanners & pennies, millions of folk all over the place did deals which were part of an endogenous economic system which was orderly and seemed to work? It was uncanny ... a system which seemed to work without orchestration by Bishops, Princes, Generals & Bureaucrats ... no one was in control!

Funny word - 'endogenous', economists used it all the time, one dictionary defined it as -

'originating, internally from within, without external cause' ... folk had to learn what endogenous meant otherwise 'evolutionary economics' was a mystery ...

Of course lots of folk had lots of ideas about what was going on and who should do what, where, when & with whom, and lots of folk had lots of ideas about prices especially the Bishops, Princes, Generals & Bureaucrats who always wanted them higher or lower depending on the state of their own coffers ... but they would say that wouldn't they? But always when anyone tried to fix prices the gluts & queues appeared and always when market prices emerged the gluts & queues disappeared 'as if' ... by an invisible hand?

In 1874 Leon Walras added to the general confusion by developing sophisticated mathematical models which showed not only how potato markets cleared but also how all markets were interconnected and how all markets cleared ... if the prices were right. But Walras, like everyone else, had no idea how the prices were fixed. Some thought the excruciating puzzlement must have affected his brain when he suggested a mythical auctioneer was in charge of the process, he even added a new word for students to learn - 'tatonnement', prices were fixed by 'groping'? ... what madness was that?

In this way Adam's invisible hand was an astonishing anticipation of the Darwinian nature of economics. Much later it became clear to some folk that market prices weren't fixed by anyone and folk like Richard Dawkins even wrote that genes themselves did cost / benefit analysis ... otherwise they wouldn't have survived! ... just as the giraffe's long neck resulted from the death of the short necked variety ... prices that weren't right died out ... nobody could afford to be lumbered with the costs of useless gluts & queues, so they didn't! Could it be that some genes evaluated marginal utility & opportunity cost better than their competitors? Cost/benefit analysis by genetic chemistry? ... more madness?

In the face of all this mind boggling complexity folk did the only thing they could, they beavered away and trialled & errored, hoping for better deals at better prices, chasing profits and cutting losses ... more deals, more synergy, more specialisation, more scale, more wealth creation & economic growth ... but inevitably more complexity, more change, more conflict, more scarcity ...

But trial & error always seemed to involve almost as many errors as trials. So what happened when the Gods were angry and the ship sank? Why did it all go wrong so often? Who was to blame for all the ruin if no one was in charge? Why weren't synergies involved in all deals? ... were bad deals legal?... and what was a deal anyway? ... was a handshake a deal? ... was a word a bond? ... and what was a tort? ...

But Adam the Smith had already fired his second barrel. 'The Theory of Moral Sentiments' put in place the second piece of the jigsaw puzzle. Folk were social animals and the search for survival synergies was driven by instincts, by ancient unconscious emotions, survival networks & circuits deep down in the skull were mediating decisions about deals ... deals that involved trust & cooperation. Adam's insight was dramatic ... even at the right price no deals would be done without trust. There was always a counter party risk to every decision ... even when choosing a boyfriend!

So all this economic growth was an interactive social affair, there were two sides to every bargain and the instinctive moral sentiments associated with rights & obligations were a vital part of every deal. And when trust was reinforced by a generally accepted system of Tort Law, folk seemed to have an insatiable tendency 'to truck barter & exchange' ...

Doing deals was a cooperative affair where clearing prices and moral sentiments got rid of those dreadfully expensive gluts & queues ... he knew a thing or two did Adam!

Adam wrote about his double barrelled explanation of economic growth -

'Theory of Moral Sentiments' in 1759 - no trust, no cooperation = no deals !

'Wealth of Nations' in 1776 - no deals = no synergy, no wealth creation !

... it seemed both barrels were necessary ... Adam was on the ball

 this was not laissez faire where selfish greed was thought to be behavioural norm ... this was freedom within the law, no one, not one was free to harm others ... hard work, honesty & thrift were involved ...

this was not mercantilism where wealth was thought to be accumulated (or stolen! or taxed!) gold ... this was technological 'know how' where wealth was production and value determined in free exchange markets ...

So folk's salvation lay in doing deals with their mates as everybody depended on everybody else and everybody tried to imagine & secure mutual benefits - real productivity growth in the real world, real wealth creation, real economic growth as billions of deals all over the world were sealed in the hope of discovering synergies ...

But, of course, nobody said it was easy, there was complexity, change, conflict & scarcity and more -

always hopeless trust busting failures ... nobody knew in advance which deals would be profitable ...

always expensive gluts & queues ... folk persistently tried to fix prices ... 

always heinous predators & parasites ... moral sentiments were never straight forward there were plenty of folk around who tried to secure wealth by theft ...

always arrogant Bishops, Princes, Generals & Bureaucrats taxed ... tax (premium) was paid for protection (insurance) ... moral hazard escalated ... success was taxed to pay for the protection of failure ... the bailout ...

'moral hazard'? ... that's another of those strange phrases economists use? ... one dictionary defined it as -

the lack of any incentive to guard against risk when a deal exists to protect against it ...

 And keeping track of all the myriad exchange deals and synergies was a nightmare ... who owed how much of what when to whom and where how? ... and who benefitted? ... where was the synergy? ... how was it measured? ... who trusted who? ...

Things were getting real complicated ... but, of course, that's what evolution did, it always made everything more complicated ... and such complexity beggared belief ... the crunch was that nobody knew the 'right' price that cleared the markets ... clearing prices had to be discovered by trial & error, they emerged ... so how did folk decide which deals were a good investment? ... did a company Balance Sheet help? ...

Opportunity Costs, Rent Seeking, Free Trade, Synergies of Specialisation & Scale and the mystery of 'Comparative Advantage'.

By 1815 David Ricardo had learned all about the synergy benefits of specialisation & scale and the money flows which tracked them but he was sorely troubled by the English Corn Laws. It seemed folk preferred the diminishing returns from the Corn Laws to the increasing returns from the pin factories? Opportunities were being missed ... and that was a cost economists called an 'opportunity cost' ...

Ricardo felt the most odious of the parasites & predators were the rent seekers who didn't bother to search for synergies but resorted to theft to fill their coffers ... they 'cut themselves a bigger slice of the cake rather than making the cake bigger'. Protectionist import tariffs were all the rage and reflected this mercantilist worldview which encouraged greedy Bishops, Princes, Generals & Bureaucrats (and many irate folk as well) to succumb to an irresistible urge to accumulate riches without synergies, a zero sum game of 2 - 2 = 0 ... why bother with risky innovation & work if you could preserve your cosy earners and monopolies of yesteryear and blame somebody else for any losses & misfortunes? ... given half a chance the rent seekers always blamed the entrepreneurs with their risky wealth creating innovations and tried every ruse possible to confiscate their surpluses ... especially if the entrepreneurs were distant strangers overseas ... (or hated Jewish bankers?) ...

Were the rent seekers lost in a mire of envy & greed? ... or did the protection of Corn Laws really help the economy?

The Corn Laws were a demand for the impossible - the protection of privileged farmers from risk & competition, protection from change & economic growth ... there was much head burying and renting of cloth but eventually in 1846 the Corn Laws were repealed ... but Ricardo knew most folk still didn't get it ... the farmers benefitted from the output of the factories, that's why they bought Darby's pot & pans and Wedgewood's cups & plates ... the workers benefited from the higher wages in the factories, that's why they flocked to the cities for jobs ... and the strangers overseas benefited because if they didn't export their corn they couldn't import the mass produced factory output of cheap, high quality goodies ...

Perhaps 'comparative advantage' was a confusing description ... especially when arrogant folk thought some of the strangers overseas were quite backward and inefficient ... how could they possibly produce anything better than us? ... especially with all those transport costs? ...  folk understood absolute advantage and how the fastest runners won the race, but the idea that downtrodden folk folk could benefit in the economic rat race was a bit of a stretch ... but that was the way evolution worked ... genes cooperated to survive ... mitochondria cooperated in eukaryotic cells and all the giraffes ended up with long necks ... but back came the protectionists ... how could everybody benefit? ... somebody must be screwing somebody? ... there's no such thing as a free lunch? ... and why couldn't prices be fixed to protect folk from unfair competition? ... surely all they had to do was pass a law? ... but weren't there already laws against stealing and weren't parasites & predators already outlawed? ... and what exactly was it that was unlawful? ... what was 'protectionism'? ... and how was who manipulating whom? ... it just didn't make sense ... 'comparative advantage' remained an unfathomable mystery ... it really was a puzzle ...

He tried to make it simpler ... it was profitable for different folk, in different places, at different times with different opportunity costs to trade their wares and cash in, so that's what they did ... not winners and losers but mutual benefit because anybody, in any place, at any time could generate the next good idea and trade it, opportunities were not restricted to a chosen elite... trade was a double hit -

everybody benefited 'cos synergies involved wealth creation

everybody was included in 'cos everyone had different opportunity costs ... 

Ricardo was reduced to tears and endless repetition of ... hard work, honesty & thrift ... synergy ... 2 + 2 = 5 ... 2 + 2 = 5 ... 2 + 2 = 5 ... 2 + 2 = 5 ... but the concept of 'comparative advantage' remained elusive ...

Ricardo had seen it all before ... a strange failure to learn from history ... he mused that some folk would never understand the benefits of free trade from the economic synergies of specialisation & scale ... just as folk never understood the moral & mutual financial benefits of credit & interest which flowed from overturning the Act of Usury way back in 1625 ... ?

Years later economist Paul Samuelson was still trying to teach perplexed students about Ricardo's principle and mused that  -

 'thousands of important and intelligent men have never been able to grasp the principle of comparative advantage or believe it even after it was explained to them'.

The sages at The Open University had another go in 2000 -

'the principles of comparative advantage and gains from trade are the most important results in the whole of economics. They apply at national, and also individual level. If each specialises in the activity in which they have comparative advantage and engage in trade they are both better off than if each tries to be self sufficient'.

Evolution by natural selection was a natural process of innovation & growth ... an unstoppable process of discovery & accumulation ... so folk went with the flow ... driven by emotions deep down in the skull and the rights & obligations of ancient customs ... hard work, honesty & thrift ... underpinned by moral sentiments, controlled by invisible hands ... everybody participated 'cos everybody benefitted ... but were the benefits measured by the audited Balance Sheets of companies? ...

Marginal Utility, Technological 'know how', the missing Factor of Production and the enigma of 'Total Factor Productivity'.

In 1967 Robert Solow was awarded a Nobel Prize for his effort to explain the extent of our economic ignorance and he gave it a new name - 'total factor productivity' ... were economic analysts really ignorant? ... they would never admit it ... would they? ...

Robert looked at the figures ... it seemed wealth was being created on average at around 3% pa, most of the audited Balance Sheets agreed on that ... but what were the Balance Sheets measuring? ... the classical economists never agreed amongst themselves ... what was wealth? -

 David Ricardo's scarce land?

 Robert Malthus' multiplying labour?

 Karl Marx's class capital?

... the figures looked very odd ... wealth didn't seem to be about any of the traditional factors of production ... there seemed to be another significant factor involved which dwarfed all the rest?

The neo-classical economists had always considered technological 'know how' & social 'know how' to be an exogenous black box. But Bob Solow now suggested technological 'know how' was driving economic growth ... wow! ... this insight reverberated round the economic scholars ... no wonder he got a Nobel Prize ... all that effort to commandeer resources and legislate wealth and the answer to wealth creation and economic growth was 'know how'? ... and what mattered was new 'know how', innovation, which, by definition, couldn't be purchased off the shelf ... infuriatingly, there were no specifications, no blue prints and no instruction manuals for innovation ...

There was a real problem now ... for eternity Bishops, Princes, Generals & Bureaucrats had claimed credit for their policies which created wealth ... Roman Emperors had dictated prices & shot messengers, Prime Ministers had 'saved the world' & eliminated 'boom & bust' and American Presidents had 'New Deals' & 'Great Societies'  ... all were futile attempts to 'fix prices', 'pick winners' and 'beggar-thy-neighbour' as a blizzard of dirigisme was unleashed ... but all the time it was technological & social innovation which moved us out of the pits ... it seemed neither instructions nor entreaty were very helpful ... after all innovation was ... errr ... new!

Don't get me wrong Bishops, Princes, Generals & Bureaucrats could have good ideas ... but not as often as the millions of folk they tended to tyrannise & oppress ... it was a matter of statistics not 'sound judgement' ...

But this new fangled idea didn't sink in ... it was not 'resources' nor 'money' that aided the survival of folk but technological & social 'know how' ... how counterintuitive was that! ... but Darwin himself said adaptation 'was an awful stretcher' ... perhaps economists themselves added to the confusion when they talked about missing factors of production and measures of ignorance ... 'Total Factor Productivity' was another stupendous puzzle for most folk ...

The whammies mounted ... not only was it real difficult to teach folk that market prices removed gluts & queues and that comparative advantage generated trade & mutual benefit but also that unpredictable innovation was driving growth ...

The new insights were cataclysmic! How was innovation encouraged and how was interference with prices, valuations & exchange rates stopped? ... surely there was a way of helping folk? ... and the problem was getting worse as the Chinese were now in on the act with those darned surpluses ... who were they helping? ...

But if 'know how' could not be produced by soothsayers in their closets, could the benefits of ephemeral 'know how' be measured by company Balance Sheets? ...

Counterintuitive Evolution and the disturbing notion of 'Creative Destruction'.

How to find a way out of this quagmire? ... it seemed honest introspection was required ... maybe folk had to go with the flow of the 2nd law, the invisible hand, moral sentiments, comparative advantage & total factor productivity ... but these concepts were all very difficult to get your head around ... and if it was all about natural selection why bother to do anything at all? ...

Of course intractable global problems had always existed - complexity, change, conflict, scarcity ... and there had always been ignorance about the solutions ... omnipotent design was plausible but omnipotent power always seemed to lead to corruption and the associated tax burden had become a nonsense ... bribing one interest group with other people's money, it was rent seeking with no synergies in sight ... 'fixing prices', 'beggar-thy-neighbour' and 'picking winners' didn't work they just encouraged folk to forget hard work, honesty & thrift ... some economists called it 'moral hazard'? ... it's that phrase again? ...

But help was at hand ... as long ago as 1942 Joseph Schumpeter had sussed out economic growth and the associated cycles of booms & busts, Kondratieff Waves and Business Cycles, he called it 'creative destruction' ... but perhaps the ancient Greeks had cottoned on to the process years ago as the phoenix rose from the ashes? ...

So it came to pass, as they struggled to solve the puzzle of wealth creation & economic growth, some economists changed their focus from the static equilibriums of neo-classical theory to progressive change and creative destruction ... they opened up the road to Paul Romer's 'Endogenous Growth Theory' in the 1980s ... perhaps endogenous was just another name for natural selection? ... perhaps neo-classical analysis using exogenous variables was a misleading simplification which introduced new distortions as theory effected policy? ... for sure economists themselves & their theories were part of natural selection as everything interacted with everything else ... so nothing could be exogenous ... could it? ... think about it ...

Nevertheless most economists remained locked into unrealistic assumptions and bum predictions ... so Joe Schumpeter started shouting -

'the essential thing to grasp is that economic growth is an evolutionary process'!

... but, of course, the louder he shouted the fewer folk listened ... in any case the maths in the economics textbooks couldn't cope with the dynamic iterative changes of evolution ... it was the introduction of personal computers which could perform extensive  iterative calculations that sorted out the maths and demonstrated the power of time & natural selection ...

But the perennial gales of creative destruction were everywhere ... unleashed by technological & social innovation - new markets, products, equipment, sources of labour and raw materials - new methods of organization, management, inventory systems, transportation systems, communication systems, methods of advertising & marketing, financial instruments, legal strategies and even new ways to lobby politicians ...

Schumpeter's heroes were the entrepreneurs ... the creators of new technology and the destroyers of obsolete technology ...

But deep sorrowful emotions welled up every time a short necked giraffe died, folk got frightened when they killed off failures, bankruptcy was a no no ... everyone wanted everything to survive ... but that of course was impossible ... it was always the kids that survived not the old men ... funny that? ... and more kids seemed to survive when they got excited about technological innovation ... the trouble was no one liked destruction and 'creative' destruction just didn't make sense, so talking about creation and destruction in the same breath was heresy, Joe became a pariah, he was hated ...

Interestingly most folk missed the essential mechanism of Darwin's natural selection over time - changes in population frequency as failures were weeded out ... without the destruction of failures there was no space nor time for the better alternatives t grow ... economic boom required the clear out of economic bust ... but it was difficult and 'creative destruction' remained a paradox and yet another stupendous puzzle ...

60 years after Joe's impassioned plea the scientists had learned a lot more about the process of evolution and more & more of them accepted that Darwin's idea was powerful enough to explain everything, including economics -

creativity was destruction

innovation was 'know how'

Evolutionary scientists & economists began to suspect that Schumpeter's cycle of creative destruction involved real energy flows which generated real emotions which mediated real decisions which created real innovations which were accompanied by real money flows ... the whole shebang from genes, to brains, to theories, to policy, to actions was an evolving interconnected whole ... emotional cycles, activity cycles, business cycles, credit cycles ... nothing new ... just one damned innovation after another ...

The deep point about the evolutionary process of creative destruction, was that the cycle of boom & bust was the result of a cycle of emotions ... a cycle of chemistry in the brain ... a heady mix of testosterone & dopamine, in diverse proportions, a chemical cocktail which triggered the firing of neural networks ... choices of behaviour to try out ... deep deep down in the skull there were competitive emotions of excitement & fear as neural networks & circuits drove emotional flip flops which generated a diversity of ideas, which resulted in innovation actions some of which were successful as old 'know how' was replaced by new 'know how' ... endogenous emotions created diversity ... this was not about exogenous plans & instructions, but better described as Keynes' 'animal spirits', Greenspan's 'irrational exuberance' and FDR's 'nothing to fear but fear itself' ...

Here then was the essence of the evolutionary reality of economics, cycles of emotions inspired cycles of innovation -

Optimism - Excitement - Thrill - Euphoria - Suspicion - Anxiety - Denial - Fear - Desperation - Panic - Capitulation - Despondency - Depression - Hope - Relief - Optimism ...

Crucially the emotional cycles were way beyond the control of Bishops, Princes, Generals & Bureaucrats ... all these soothsayers were, of course, an integral part of the whole evolving shebang, influencing activities and creating waves but all the time they were ignorant of outcomes ... the powers that be just trialled & errored like everyone else ... not easy to accept, is it? ... after all some folk had sound judgement? ... sound judgement about the future? ...

In this way folk were driven to experiment, 'to truck, barter & exchange', whenever & wherever they saw an opportunity to discover & accumulate synergies ... whenever & wherever there was an opportunity for specialisation & scale ... whenever & wherever they found market clearing prices which avoided expensive gluts or queues ... whenever & wherever there were different opportunity costs for comparative advantage ... whenever & wherever they discovered better total factor productivity ... and whenever & wherever they discovered a new mouse trap which folk found exciting ... whenever & wherever company failures released resources for better alternatives ... whenever & wherever there was creative destruction ...

The crunch was that adaptations depended on differential survival of behavioural traits as everyone rushed around trying to survive ... there was no slothful indifference ... and perhaps the evidence was in the history of the industrial revolution? ... did self sustaining economic growth result from synergistic deals, underpinned by the rights & obligations of Tort Law, controlled by invisible hands, where everybody traded their technological innovations and where failure & cycles were manifestations of Darwin's natural selection? ... a far cry from 'fixing prices', 'beggar-thy-neighbour', 'picking winners' and 'moral hazard' ... and was it the history of the industrial revolution which suggested self sustaining economic growth was measured by the audited Balance Sheets of competitive companies? ...

A History of Money, Banking & Credit.

Once upon a time as the deals burgeoned; more specialisation, more scale, more synergies, there was also an associated explosion in the money measurement system ... synergy required exchange and exchange required some problem solving ... it was easy to see how useful money was because exchange of gifts was so risky and barter exchange was so clumsy ... money solved problems associated with -

double coincidence of wants

indivisibility of goods & services

common measure of value

pre & deferred payments

storage of wealth

Over the years all manner of bits & things had been used as money to measure & facilitate exchange deals - useful commodities like grain & salt, even cows, symbols etched on wood or stone, cowry shells, specie & gold ... even cigarettes ... and the most outrageous of all ... 'paper' money ... and then unbelievably  'electronic' money!? ... why on earth were folk willing to exchange a piece of paper? ... 'I promise to pay the bearer'? ... or 'electronic' money that folk couldn't even see! ... 

It seemed as the energy flowed, folk went with the flow and the measurement system followed, chasing the profits and cutting the losses, a money measurement system evolved which facilitated exchange -

conveniently accounted for both sides of the deals

stored value over time

The system evolved over centuries, it was a slow & risky process, there was always confusion, but five money laws were unfolding from the start -

Trust & Confidence - rights & obligations had to be generally accepted rules of behaviour ...

private property - had to be identified & protected

debt recovery - had to be quick & cheap

remedies, compensations & sanctions - had to be routine

Survival Value - the value of specialised production was determined by output of exchangeable goods & services

Money x Velocity of Circulation = Price x Output - money measured the value of production

Savings = Investment - forgoing consumption today levered production tomorrow through investment

Growth Cycled - the discovery & accumulation of wealth was driven by cycles of human emotions from excitement to fear.

Money measured & facilitated cash deals, but there were also credit deals which provided money now for repayment later ... then there were deals in money to make more money ... continuous innovations ... one money substitute after another ... cash, credit, bonds, stocks, shares, insurance, options, puts, hedges, derivatives, credit default swaps ... all at a cost, there was no free lunch ... but money was a superb product, everyone wanted it ... what excitement!

But money was always painful to produce because money was all about trust & confidence and trust & confidence had to be earned by hard work ... discovering value was hard work ... accumulating value was hard work ... everyone enjoyed instant gratification (ask the boys?) ... saving & investment was risky (ask the girls?) ... no wonder some folk went for short cuts and tried to steal ... as soon as their were stocks there were thieves ... as soon as there was cooperation there were predators & parasites ... as soon as there were coins there were coin clippers ... immunity from this treachery was impossibly difficult, it was a never ending arms race, eternal vigilance was always required ... a strong dose of 'caveat emptor' & 'due diligence' ...

So why bother about the hard work of production and exchange of useful goods & services if folk could steal stocks? ... and what happened if the king himself stole the stocks?

Then there were other money puzzles ... how was trust & confidence in money exchange generated? ... why did money constantly change, morph and cycle? ... why couldn't it just stay as cowry shells? ... why did the kings always seem to monopolise the supply of money and then debase it? ...  could trust & confidence in money be a legal requirement? ... could the kings force folk to trust them? ... why were the money lenders almost universally reviled? ... why was credit readily given to the rich but only reluctantly to the poor? ... why did the churches and the bankers become rich as the kings became poor? ... why did the kings always seem to overspend? ... why did the cycles almost invariably result in inflation? ... why did economic growth require credit? ... why was there a difference between a Bill of Exchange and a Mortgage? ... why did taxing money seem to slow down wealth creation? ...

Puzzle after puzzle ... throughout history ...

The first banks were probably in the temples where folk deposited their stocks of goodies for safe keeping ... no use eating or spending it all at once if seven lean years were to follow ... and if you couldn't trust the holy men who could you trust? ... the first civilisations in Mesopotamia, Greece and Rome all developed money & banking institutions ... specie money, gold & silver coins were easy to understand as they secured the benefits of convenience for exchange because their value was based on their weight as bullion ... especially after Archimedes and his Eureka moment solved a problem ...

But then, an enterprising development, the IOU receipts, the acknowledgements for the deposits of goodies, also began to be used for exchange ... much more convenient than using the goodies themselves and less costly ... and then once the tokens based on trust & confidence were used for exchange there was an opportunity for credit to become a commissioned service ... IOUs risked default so there was a cost associated with their use which had to be recovered ... there was no free lunch ...

Later as trust & confidence increased, another innovation, IOUs were issued without 100% backing of goodies ... more risk, more enterprise and more benefits as more synergistic trades could be financed ... at a cost ... in this way a series of money developments lubricated trades as transaction costs were reduced ... but it all depended on the reputation of the banker who signed the IOU ...

As the variety of money issues increased there was pressure for money exchanges and more uniformity & standardisation ... royal authentication of monopoly legal tender had great merit ... everybody trusted the king's money ... didn't they? ... and the value of legal tender was maintained because it was always accepted for tax payments ... but often the winners of the wars imposed legal tender on the banks and exchangers thus opening up the opportunities for debasement and Gresham's Law as bad money drove out good money ... how could reputation matter if there was an imposed monopoly? ... and canny folk always paid their taxes with bad money ... it seemed there was always an arms race between good and bad money ... it was never easy to determine the value of money ... no wonder taxes were always rising? ...

By now the holy men had another enduring problem ... usury ... they invariably believed selling money for interest was immoral ... banking was moribund for centuries ... money was strange ... but was credit even stranger?

was money simply trust & confidence? ... was credit different? ... was debt money? ... why was usury immoral?

The first money traders had problems with the incentives to save & invest because there was little protection from theft and little enthusiasm for the recovery of bad debts ... Ebenezer Scheister and Shylock produced a product everybody wanted - credit ... but it seemed common decency and the law were against them as property rights and debt recovery were not readily enforced in the courts ... the money lenders provided a service and charged commission but the hated Jews in Christendom had a problem because the Bishops (and most folk!) believed they were exploiting the poor ... usury was immoral ... the pain was almost intolerable but the Jews had learned because they were excluded out from all the other games ... they had learned about synergy & mutual benefits of trade and they had learned about credit ... in any case who else but desperate minorities would take on such risky activities ... remember how Shylock mused 'Antonio is a good man'? ... who to do deals with? ... who to trust? ... fate had dispersed the Jews but not broken their kinship and beliefs ... this turned into a strength ... in every city there was someone to trust ... another Jew!

But what happened when the cookie crumbled the other way? ... why didn't more folk just take the money and run? ... after all Shylock couldn't get his pound of flesh, the court in Venice protected the thieves? ... so what to do about those thieves?

could trust & confidence be stolen? ... could a reputation be purchased?

The Lombards of Northern Italy followed the action and provided competition for the Jewish money lenders with their new fangled pawn shops ... the medieval trade fairs presented opportunities for financing exchange deals with strangers over distances in different monies ... collateral in exchange for the different monies reduced the risk ... the pawn shops thrived ... Lombard financial skills involved enterprise, literacy & numeracy and accounting in weights & measures, they followed the trail of international trade from the land routes of the Champagne Fairs to the sea routes of the Hanseatic League, to the international trade centres in Amsterdam, London and New York ... the Lombards were busy reducing the transaction costs of international trade ... what a service St Nicholas would have been pleased! ... trades and the fairs flourished ... but as distances escalated and strangers got stranger the risks were rising ... especially when foreign lands were full of thieves and had no Contract Law and no remedies for Torts!

why did different countries have different money? ... how was trust & confidence established between different countries? ... when trust & confidence broke down could international courts protect private property and recover debts? ...

In the 12th Century not all the Knights Templar were warriors, some provided supporting financial services ... the Knights accounted for their clients property and savings in money terms as deals were done to finance the Crusades ... carrying gold to far away places was a risky business ... and cost ... safekeeping and safe stewardship of money became a valued service ... deals had to be done with strangers across borders ... so how to settle debts? ... the Knights set up a network of trusted members,  a secret society with onerous membership criteria in an attempt to keep out charlatans ... once you were 'in' your reputation was established and then written instructions to other members were all that were needed ... what a service! ... 'bills of exchange', 'letters of credit' & 'cheques' were honoured and the bullion remained safe in the vaults ...

The Jews trusted their ethnic associates and the Knights trusted their religious associates ... but what about those stranger strangers who had snake oil to sell and what about counter party risk? ... and there were rumours that some innovative snake oils actually worked and needed to be tested!

did family membership or secret societies restrict economies of scale? ... how could more folk be included in? ... were there other ways of establishing trust & confidence? ... were there always two sides to every deal? ... did every right involve an obligation? ...

From the 14th Century several families built banking systems in Florence and reputations were associated with the city ... no banker from Florence could afford to let the side down, they would have been hounded out of town ... reputations which took years to build could be destroyed in a second ...

Money lending ideas were hatched as other city states competed for economic spoils ... the business of lending money and assessing risk was not easy ... the terms the bankers imposed reflected their assessment of the risk ... the King of England was considered a good bet but in 1345 Edward III had problems ... he couldn't repay his debts and he broke the Florentine Banks dominated by the Bardi & Peruzzi families ... as Edward reneged the powerful bankers demanded control of his income streams and charged 120% with penalties of 60% if payment was not prompt ... these were called 'conditionalities' not 'interest' ... remember usury was immoral ... ...

It seemed kings always had to borrow ... and to borrow kings had to meet the costs through their capacity to tax ... and Edward soon learned that he had little control over his capacity to tax ... in Edward's case, tax came from wool exports and, hopefully, from winning wars ... but Edward couldn't cash in on the war against the French as it went on and on at exorbitant expense for 100 years ... furthermore tax revenues from wool were ravaged by the Black Death ... in a vain attempt to legislate wealth Edward enacted 'The Statute of Labourers 1351' which attempted to fix wages at low pre-plague levels to enhance profits and therefore raise tax revenues? ... the ruse failed miserably, the law of 'supply & demand' was uncontrollable as landowners competed for scarce labour driving wages up and their surplus wealth down and with it down went Edward's tax revenues ...

It was also rumoured that the Pope was rubbing salt in Edward's wound by taxing the English church and using the revenues to support the French armies! ... and, in any case, since 1215 things had changed in England and from 1265 parliament had to approve all taxes and Simon de Montford & the Forty Shilling Freeholders were none too keen on paying up for the king's pork and his wars that couldn't be won ... so Edward defaulted, the banks blew up, credit vanished and inevitably trading was decimated ...

Edward learned the hard way ... there were limits to taxing & borrowing (they were both the same thing really, just pay now or pay more later) and at the end of the day taxes always seemed to ignite crowd trouble (ask Wat Tyler?) ... and perversely tax revenues seemed to depend on economic growth (wealth it seemed had to be created before it could be taxed?) ... and more perversity ... more tax always seemed to result in less investment and less growth ... or was that the same thing? ... this was a conundrum no one had sussed out ... but it became very clear to Edward that as the banks failed, the credit financing the English wool trade also disappeared and with it Edward's tax ... a downward spiral of catastrophes which hurt the brain ...

The truth dawned ... without tax revenues kings were insignificant beggars and it was the bankers who bank rolled economic growth ... Edward's tax prospects were dependent on the bankers and the international bond markets ... were the international bond markets more powerful than the kings? ... in the grand scheme of things Edward was as helpless as Canute, his mate from way back, but Canute was smarter, he had the nous to realise his powerlessness!

were the banks too greedy? ... or was Edward too ambitious? ... why were the bankers richer than the kings? ... can wealth be created by legislation? ...

And there was more, not only the King of England but even the Pope couldn't be trusted ...

By the time of the Renaissance the Medici family had learned that if trust & confidence were established, those with the money but no ideas could finance those with the ideas but no money ...  it was a risky business but risk was managed by lending carefully to selected reliable people ... only lend to those with the good ideas? ... what a great strategy, almost as good as buying at the bottom and selling at the top!

Giovanni Medici founded the banking dynasty ...  he started with nothing but Giovanni was a smart cookie, he bet on the Pope! The family slowly built an extended social banking network, they lent to the family first and then to those committed to the family through marriage, then ... a master stroke ... they enrolled the Papacy complete with God's collateral ... and finally they extended the deals into the globally respected Renaissance movement ... this resulted in scale & diversity across the boundaries of competitive city states and beyond ... the Medicis hoped scale & diversity would reduce the risks of bad debts still further ... networks were decentralised so that lenders were close to borrowers and they could see the whites of their eyes ... they also built in checks & balances as interest rates followed risk ... but if interest rates were too high, folk defaulted and if interest rates were too low, there was no reward for risk ... it seemed interest rates were quite important ...

The family kept a meticulous recording system as ledgers with double entry book keeping tracked every deal ... it was rumoured that they had discovered the 3-6-3 system - 3% interest paid on depositor's accounts, 6% interest received from loans of depositor's money and then by 3pm they were on the golf course!

The Medicis started their lending business with the lucrative dependable flourishing trade in wool but ended up at the top with governments and the Pope ... the hard nosed traders in wool were focused on the truth & reality of every deal but once politics, faith & money enter the fray things became much more fickle ...

Maybe it was the betrayal of Galileo that started the decline & fall of the Medicis ... if Galileo could be jailed on a Papal whim what chance had a legitimate claim for the recovery of debts? ... and the interminable politics compounded the risk as there was no apology for this act of treachery until 25 October 2007! ... it seemed the most trusted of customers, the Bishops, couldn't be trusted ... was no one immune from bad debts?... the Medicis should have remembered that way back it was the Bishops in collusion with the King of France who stitched up the Knights Templar!

if all successful banks went for scale & diversify to reduce risks why did they continually get involved in state politics? ... were the banks pressurised by the powers that be to lend to the powers that be and their henchmen? ...  and who fixed the interest rates? ...

As the Florentine Bankers and then the Medicis dropped the baton the Fuggers in Germany.

 In 1525 Anton Fugger inherited his uncle's business and established an international banking dynasty which profited hugely from propicious lending to rich winners ... he was respectfully called the 'Prince of merchants' and set the course for the future of the Fugger family. He prepared the next generation of the family through the old trick of arranged marriages ... his sons and daughters were paired with the nobility.

It was a Fugger loan which supported the election campaign of the Hapsburg Charles V against the French pretender ... it seemed there was a big upside in lending to the winners of wars? ... history, of course, doesn't record what would have happened to the Fuggers if Charles had lost!

how were bad debts avoided? ... is a bad credit the same as a bad debt? ... how were the good projects sifted from the bad projects? ... why did the banks lend to rich folk but not to poor folk? ... did the bankers see a good credit risk in the whites of the eyes? ... or in the size of the arsenals? ...

In 1624, the burgeoning global trade synergies exploited by the Dutch, put unbelievable pressure on the Bishops in England ... after 50 years of agonised debate the Bishops reversed their earlier 1571 Act of Usury and decreed that the offer of credit for interest was moral & legal after all ... it seemed morality was not etched in the stones? ...

This was a fundamental change in perception about banking behaviour. In 1571 God's Law was an unquestionable revealed truth,  usury was immoral ... by 1624 morality was a matter for the individual conscience. Money lending and credit facilities had become an economic necessity because by 1624 competing with the Dutch in international trade was a matter of survival ... 

At a stroke the English banking system was rejuvenated as the legal ban on money lending for interest was lifted ... those with the money started again to share profits with those with the ideas ... a whole range of new synergies became available ... folk could diversify investments on an unprecedented scale ... and now bad debts could be recovered in the courts ... far more cost efficient than in the alternative of street fights and vendettas!

As credit exploded, at the front of the queue, as expected, were the kings who always had expensive habits which were usually associated with delusions of grandeur and expensive wars ... don't get me wrong, of course, some grandiose schemes were useful and some wars were just ... but 'just wars' didn't crowd out profitable projects ... 'just wars' were profitable projects! ...

did commercial law evolve? ... did morality itself evolve? ...

In 1694 The Bank of England was formed privately to lend £1.2 million pounds @ 8% pa to the English government ... but it was a stitch up, a monopoly in fat fees from the tax payer in return for funds for war? ... the current generation had been taxed and squeezed until the pips squeaked, but now there was an innovative borrowing device which fiddled the tax burden onto future generations ... it seemed the new morality didn't extend to tax? ...        

The English banks had had a couple of lucky breaks ... although many insisted it was not luck but the natural selection of profitable cultural traits? ... the excesses of the grandiose spending of the Kings and the associated bad debs had been curtailed by the checks & balances of 1215 & 1265 and the success of parliamentary scrutiny ... but the plumb for the banks was the industrial revolution itself which produced profitable projects in an abundance never seen before ... what investment opportunities!

why did the marginal productivity of capital depend on credit for profitable projects? ... was the industrial revolution itself dependent on the new morality of bank credit? ... or was it just a lucky break? ... were the strategies of scrutiny, diversity & scale; just luck? ... were the strategies of hard work, honesty & thrift; just luck? ...

Mayer Rothschild (1744–1812), a German Jew was born in Frankfurt, he founded of the Rothschild international banking group that became one of the most successful family businesses in history. The Rothschild's had established a modern banking system which coped with bad debts by careful and diversified lending which was decentralised across risks and across currencies ... unprecedented scrutiny, diversity & scale ... family members in different countries with different customers were trusted and financed ...  the same old story, an international network of trusted contacts ... lending was always focused on the most profitable global returns ... gold was arbitraged across different economies as clearing prices emerged ... and above all there was lending to sovereign governments ... a decentralised decision making network which involved efficient low cost central lending whenever local liquidity was a problem and central investment in human capital whenever local solvency was a problem ... the Rothchilds ran a 'central bank'!...

In 1798 Mayer's third son Nathan Rothschild was sent to England to further the family interests in textile importing. Nathan became a naturalized citizen in 1804 and established a bank in the City of London.

In 1819 anti-Semitic violence broke out in many parts of Germany. These Hep Hep riots as they were called, included an assault on the Rothschild house in Frankfurt. An act of inane stupidity, as was a further attack during the 1848 revolution ... there was no money there. The Rothschild's money was paper, circulating throughout the world ...

The Rothschilds completed a process the Jews had been working on for centuries, they had immunised their lawful property from thieving violence. Their real wealth was beyond the reach of the mobs (and beyond the reach of greedy monarchs!). Their wealth was the trust and confidence customers had in Rothschild credit. And there biggest customers were nation states. How was that sort of wealth to be stolen?

Sensibly the family took a low-key public profile, working hard, donating to charity, keeping anonymity and eschewing conspicuous displays of wealth which would only attract the attention of the tax man ... but how can you tax financial 'know how'?

Later in 1815 when Wellington won at Waterloo, the family collected their winnings ... as usual they had bet on both sides ... but they also knew the biggest cause of default was losing a war ... or revolution ... they had made the safest & biggest bet of all ... they bet on liberal democratic governments that possessed -

the technology to win wars and

cooperative citizens who paid their taxes ...

and thus  pay their bond holders ...

But, as history had shown, was this was 'counter party' risk big time? ... could liberal democratic governments be trusted with the tax & spend conundrum? ... or would they go the same way as the all the other Bishops, Princes, Generals and Bureaucrats and start coin clipping and money printing? ... and default?

... would the Rothschilds go the same way as all the ancient bankers? ...

did it always go in cycles of success & failure? ... could the banks ever hope to cope with those wretched business cycles and the short term hysteria of boom & bust? ... how did the banks cope with the greed, bribery & corruption of political intrigue and government default & inflation from the king's printing presses? ...

But what a merry go round for the Bank of England! After the Glorious Revolution it solved the government's borrowing problem with it's lending monopoly and 100 years later it was confronted with a repayment problem as the gold standard was abolished from 1797 to 1821 ...

In 1945 the British Government had a go, The Bank of England was nationalised ... and more and more was nationalised ... the war was won, now to win the peace ... economic activity was to be orchestrated from Whitehall? ... interest rates & exchange rates would be fixed and boom & bust banned? ... full employment was to be maintained by government spending, not by hard work, honesty & thrift? ... and why should the greedy Bank of England take a cut with their fat profits? ... was this political hubris? ... or a not so subtle confiscation? ... something was going on, that was for sure? ...

Well ... the government borrowed to fund the war and now government borrowed to fund tax & spend policy on the welfare state ... and the welfare state was needed to secure votes, folk loved it, and they now had confidence & trust in the government, after all the war had just been won! ... and if you couldn't trust the government who could you trust? ... although some folk did remember the real value of Consols & War Loan? ... and a few even remembered 'temporary' income tax and the discrimination involved with 16th amendment in the USA? ... and a fewer few remembered Edward III? ...

When government debt was auctioned it was always sold, the only doubt was at what price ... and price determined the interest rate cost ... and the cost determined how much tax revenue had to be diverted into servicing the debt ... so spending decisions were decoupled from funding decisions ... but most folk assumed governments would always pay the necessary interest because it was paid out of taxes and not out of the profits of risky business projects ... and governments couldn't go bankrupt ... could they? ...in this way profitable business projects tended to be crowded out of the credit markets by high interest rates and inflation ... 

Let's be fair, this was a conundrum for democracies everywhere ... folk could get their heads round borrowing to fund a war ... wars were won ... or lost ... but borrowing to fund welfare & entitlements was a whole new kettle of fish ... 'if it's free put me down for two please' ... so proudly proclaimed profligacy proliferated ... meanwhile back at the coalface Alexander Fleming had discovered penicillin ... what on earth was going on? ...

... so it came to pass that 'welfare' and 'entitlements' also created a problem in the USA, where constitutional checks & balances were supposed to protect folk from excesses? ... a powerful underlying trend had been superimposed on the business cycle ... welfare handouts in exchange for votes was a great idea, but who was going to pay? ... Ben Bernanke, Chairman of the Federal Reserve Bank quoted Herbert Stein, of The American Enterprise Institute who had had sussed it all out, Stein's Law was succinct - 'if something cannot go on forever, it will stop'!

Of course the Bishops, Princes, Generals & Bureaucrats had been interfering with money since for ever ... the success of the bankers never went unnoticed ... the kings had always tried to compete with the banks and tried again and again the age old cons and diktats of fiat money, legal tender, coin clipping & money printing ... but nothing seemed to work ... folk paid simply their taxes with clipped coins and gave upon hard work, honesty & thrift!

Nevertheless bank nationalisation had become the norm and all central banks were instruments of kings and states ... way back in 1587 The Banco di Rialto was an initiative of the Venetian state where intervention and nationalisation were used in an attempt to provide a low cost settlement service in 'superior' notes backed by the taxpayer ... the idea was that this gave a measure of security in the risky business of trade in money ... no doubt it was hoped that nationalisation would open up the opportunity for the kings to capture seigniorage and lucrative profits from the 3-6-3 system ... coin clipping was reinvented in an official new guise ... but how was it possible to nationalise the 3-6-3 system, which depended on confidence & trust and the technological innovation of customers? ... no one could legislate wealth ... could they? ... if history had been studied more thoroughly it would have been clear that nationalisation was no panacea, taxpayers were no pushover, states could also go bankrupt ... and they did!

There was even a problem with gold standards which were often thought to stabilise the money system ... but economies only grew as fast as gold production as folk just didn't like declining prices ... especially wages! ... but was inflation better? ... even in democracies it seemed that whenever governments got their hands on the banks the printing presses started to roll and helicopters dropped pork onto mesmerised folk in return for votes ...

Interference and price fixing never stopped ... that's what authorities did ... come to think of it that's what everybody did ... but the authorities fixed the prices of licensed monopolies which was a very different kettle of fish to the other poor folk who attempted to discover clearing prices by experiment ...

It seemed that whatever the ploy or the which way when; risk & debt could never be avoided ... at worst it was transferred to someone else ... a pattern seemed to emerge in the history of banking ... a virtuous circle of credit expansion always seemed to collapse into a catastrophic spiral of decline, from excitement to fear ... time after time, dynasty after dynasty ... and it always proved remarkably difficult to cope with the greed of authorities who always wanted a share of the action ... a ripe mixture of tax, nationalisation, government borrowing, legal tender laws, bad debts, inflation and imbalances always seemed to wreck the Balance Sheets ... it seemed that whatever the ploy or the which way when, the money & credit systems and their prices were endogenous adaptations which were continually hijacked by legislators who promised to design better systems ... it was uncanny ... centralised control of the 3-6-3 system couldn't work ... centralised control of natural selection was impossible ... a physical impossibility!

was the British government , like all the others, in denial in 1945? ... or did they think evolution was just some biological theory? ... was the whole charade simply inane hubris? ... were central banks powerless to stop money printing and debasement of their own currency? ... whose currency was it anyway? ... was the money measuring system private property that could be owned? ... could a bank be nationalised? ...

But nothing could stop folk learning from history ...

In 1995 Robert Lucas received a Nobel Prize when he suggested a theory of 'rational expectations' - 'you can fool some of the people some of he time or all of the people some of the time but not all the people all the time' ... folk learned & expected ... and choose options based on REAL prices ... everything else was like trying to move mountains by pushing on strings or pulling on elastic bands ... more and more folk learned of the dangers of 'fixing prices', 'beggar-thy-neighbour', 'picking winners' & 'moral hazard' ... and more & more folk learned about 'invisible hands', 'moral sentiments', 'rent seeking', 'comparative advantage', 'total factor productivity' ... and the cycle of 'creative destruction' ...

A History of Business Cycles.

The market search for clearing prices which eliminated expensive gluts & queues was particularly difficult because it was innovative technology which was driving change. And innovation was not a facile process ... but fickle ... capricious ... vacillating ...

This was evolution, inheritance with modification and differential survival, but it was the random modifications which caused the trouble. Folk could get a grip on inheritance but randomness was bewildering ... but it was the random mutations that created the new survival value ... and the random mutations were completely unpredictable, they had to be discovered by a trial & error process which was spurred by the flip flops in the cycle of emotions ... and excitement & fear were both contagious ... the trial & error process must have resulted in cycles ... mustn't it? ... think about it!

The pricing of technological innovation was scary, nobody could predict what the product was never mind its future price ... the pricing of potatoes was a little less difficult. But always when prices were too high there were gluts, and always when prices were too low there were queues. Cycles were the only way survival value and associated clearing prices could be discovered. This was a search ... heuristics with an emergent outcome ... there was no way the immensely complex synergies of specialisation &  scale and comparisons of opportunity costs & marginal utilities could be calculated ... but this never stopped the soothsayers from trying to fix prices and then blaming the adaptive process when their arrogant designs failed ... some folk got it ... survival came not from soothsayers but innovative technology ... so folk were in a cleft stick! ... folk were stuck with cycles!

It was a hit & miss affair, nobody knew what was happening, there were booms & busts, 'Kondratieff Waves' as well as Business Cycles, runs on banks, stock market crashes, asset bubbles, currency crises, sovereign defaults ... and lynch mobs, riots and crowd trouble ... how many cycles? ... all cavorting in a mad dance one on another, one with another ... crazy bewilderment ... in different places with different outputs at different times at different speeds ... as cycles interacted there were amplifications and suppressions, combinations and displacements ... big booms & busts and small booms & busts ... overshoots of euphoric experimental discovery... undershoots of frightening experimental failure ... one damn cycle after another ... prices of coffee influenced prices of tea ... and some even suspected the price of potatoes influenced the price of holidays in Benidorm ... prices seemed to be all over the place ... especially after a failure of the rain dances ... and what of the stupendous puzzle of money itself, and credit, and new cowry shells and coin clipping inflation? ... no wonder it all went wrong so often?

Immense complexity, layer after layer, distortion after distortion, impossible to simplify ... but each distortion presented an arbitrage opportunity which tended to push prices to a clearing level like a strange mimic of Le Chatilier's Principle ... and then each discovery added further complexity ... as entropy increased ...

However there was some good news ... there was a growth trend ... it seemed, relentlessly, since the industrial revolution technological innovation produced an underlying growth trend of around 3% pa. Business cycles were manifestations of creative destruction, of markets coping with the perpetual change of technological innovation by discovering clearing prices in new situations. There was no market equilibrium of classical economics orchestrated by the mythical Walras auctioneer. Increased 'know how', technological innovation, grew steadily as folk learned from the cycles of discovery. Economic growth averaged of 3% pa not in spite of cycles but because of them!

The ubiquitous inevitable cycles were easily recognised in the history of economic institutions, companies and banks all over the world ... but the cycles of discovery always seemed to be associated with knee jerk hysterical responses, which often seeded & fuelled the next cycle ... here are just a few examples -

1637 Tulip Mania - an exotic fad in tulips bubbled & crashed - the response was an attempt to fix prices & protect folk from risk as legal contracts to buy &sell were banned ... was the market messenger shot after the horse had bolted? ... who was the dafter, the owner who refused to sell or the buyer who offered the daft price?

Evolutionary economic growth was driven by emotions, the excitement of the bubble followed by the fear of the crash.

James MacKay, 'Extraordinary Popular Delusions and the Madness of Crowds'.

1725 The South Sea Bubble - Joint Stock Companies bubbled & crashed - the response was to ban companies for 100 years ... was this an attempt to deny the existence of risk & failure?

Evolutionary economic growth required failure, the bankruptcy of Joint Stock Companies.

Sir Isaac Newton, an investor in the South Sea Company, 'I can calculate the movement of the stars, but not the madness of men'.

1929 The Great Depression - traded equities bubbled & crashed - the response was an attempt to 'fix prices', 'beggar-thy-neighbour', 'pick winners' & introduce 'moral hazard' ...  was it an hysterical mixture of risk fixing (SEC), price fixing (gold & minimum wages), housing subsidises (Fannie May & Freddie Mac), import tariffs (Smoot / Hawley), spending on earmarks & pork (Tennessee Valley Authority) & bank bailouts through deposit insurance (FDIC) all of which sowed the seeds for the next bubble?     

Evolutionary economic growth could not be manipulated by bureaucrats, there was no foresight ... technological innovation continued to evolve.

Friedrich Hayek, 'The Fatal Conceit'

1972 The Great Inflation - deficit financing bubbled & crashed - the response was an attempt to justify 40 years of tax & spend to create jobs & legislate wealth ... did government spending create unemployment & inflation as skilled folk crowded into unsustainable activities invented by the political hubris of elected dictators?

Evolutionary economic growth was destroyed by money inflation, both sides of the Balance Sheets were hit. 

John Maynard Keynes, 'By a process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method, they not only confiscate, but they confiscate arbitrarily; and while the process impoverishes many, it actually enriches some'.

2001 DotCom Internet Boom - innovative technology bubbled & crashed - the response was an attempt to blame regulators & auditors as they lost their underpants by failing to spot troublesome valuations on Balance Sheets ... was this an attempt to replace the principles of 'caveat emptor' & 'due diligence'  and  bankruptcy with another layer of regulation (Sorbane / Oxley)?

Evolutionary economic growth from technological innovation could not be regulated, the next crisis always involved a different innovation.

Governor of the Bank of England, Mervyn King, 'Regulation is a delusion'.

2008 Subprime Housing Credit Crunch - credit for real estate bubbled & crashed - here we go again, but this time did the Chinese join in as the banks were screwed and prices fixed ... and the followers of Nobel Prize winners in economics still disagreed! ...

Evolutionary economic growth from technological innovation was no longer measured by the Balance Sheets of commercial and central banks, they had been bailed out and turned into zombies!

Prime Minister, Gordon Brown, 'I have banned boom & bust and saved the world'.

So many questions ... all that anguish & hysteria ... but bubbles burst, what else did they expect them to do? ... it seemed business cycles were part & parcel of a common pattern of technological evolution which involved -

natural cycles of emotion - deep down in the skull decisions were being driven by ancient neural survival circuits which generated excitement ... and fear...

frantic activity - most folk were going for betterment by chasing profits & cutting losses ... some folk were stealing ...

herding instincts - folk everywhere were social animals and ignorant, it was only hindsight that exposed which deals were daft ... everybody wanted to keep up with the Joneses ...

bottom up innovations - different products or service opportunities were involved each time ... old technology was replaced by new ...

top down regulation - each new crisis brought new regulations justified by 'market failure' ... Bishops, Princes, Generals & Bureaucrats had a vested interest in preserving their old technology by 'fixing prices', 'beggar-thy-neighbour', 'picking winners' & 'moral hazard' ...

eventually prices adjusted to the new reality as the bubble burst - nobody was willing to foot the bill for those wretched gluts & queues ... Balance Sheets had to balance ... there was no way round that ...

After all this contorted history of complexity, change, conflict & scarcity it came to pass that the soothsayers couldn't manipulate the future ... perhaps Adam the Smith got it right ... perhaps there was a market in credit and the business of business was a search for -

tort law - generally accepted rights & obligations

trade - clearing prices

technology - 'know how'

So what was the nature of this market in credit which fuelled the business of business, the banking institutions & their Balance Sheets which emerged as economic growth was tracked over the inevitable business cycles? ...

A Money Making Machine?

During generations of hard investment & risk taking and trial & error learning the Jews, the Lombards, the Knights Templars, the Bardis & Peruzzis, the Medicis, the Fuggers and the Rothschilds had refined a remarkable money making machine ...

The bankers didn't grow things or manufacture widgets, they made their money from selling money ... the 3-6-3 system ... here's how they did it - 

I promise to pay the bearer, my word is my bond ...  if the Bishops, Princes, Generals & Bureaucrats didn't run them out of town in a jealous rage ... and whenever the powers that be ran out of money and succumbed to coin clipping ... it appeared that some bankers were clever enough to secure money deals of their own ...

Firstly they established a reputation for honesty which enabled them to attract folk's goodies to their strong rooms for safe keeping ... secondly as long as their reputation remained intact the IOU receipts, the acknowledgements for the deposits of goodies could also used as money for exchange... it was all about trust & confidence but earning trust & confidence was hard work ... 'due diligence' & 'caveat emptor' were essential parts of every deal because thieves were around (often in sheep's clothing) ... deals were secured because folk with savings needed to protect them from theft (stuffing them in the mattress was not good enough) ...

Honest bankers had a reputation to protect and they were far more successful in attracting deposits and issuing IOUs than the con men ... their profits grew ...

those with ideas had no money and those with money had no ideas ... later it became clear that the depositors never wanted their riches back at the same time ... there was an opportunity for the bankers to risk lending other peoples' money to other folk with investment schemes ... and charge them for it ... but they had to be careful ... to maintain the trust & confidence of depositors they had to keep enough gold in the vaults to pay the bearers of the receipts when they pitched up to withdraw their bounty ... and to maintain their capital intact the bankers themselves had to have trust & confidence in the investment schemes they funded ... trust & confidence was sensed in the whites of the eyes of honest folk, offered as my word is my bond and confirmed with a hand shake but the deals always coevolved with cheat detection systems underpinned by Tort Law & Property Law & Contract Law ... debts & repayments ... it was no use someone 'promising to pay the bearer' if the promise was broken ...community remedies were essential if costly violence was to be avoided ... the Balance Sheet had to balance ...

There were always two parties to benefit (or lose!) from every deal ...

Darwin's natural selection of profitable projects ... the trick was to lend only to folk with profitable projects ... it was only profitable projects which ensured the interest was paid and bankers got their money back ... but it was always a risky business, unprofitable projects & bad debts were a perpetual problem ... a good reputation secured the funds but good project appraisal sifted the risk ...

Now listen ... the bankers, just like the soothsayers, were ignorant of the where, when, how, who or which of the next profitable innovation but they had a twin pronged strategy for increasing the chances of discovering better projects -

chasing profits/path dependency - good performance was not about predicting the future or technology foresight ... it was about chasing profits and cutting losses ... new credit flowed when customers had a good track record of repayments but credit soon dried up when debts went pear shaped ...

diversification/portfolio theory - but there was a complementary second prong as small amounts were lent to many and varied customers ... the net was spread far & wide by encouraging diversity & competition amongst decentralised bank managers as they did credit deals with different customers, with different projects, in different places, at different times ... no one wanted to miss the next Bill Gates lurking in some dusty Seattle garage! ...

 In the same way as short necked giraffes died out, the result of bank lending was a natural sifting of entrepreneurs & their projects and the consequence was that the marginal productivity of capital in the economy increased ... wow ... read that again! ...

excitement, deposits made reserves ... and there was more ... with an income flow from profitable investments the bankers now found they could afford to offer inducements to encourage more folk to deposit more of their savings and thus secure more funds for profitable investment ... instead of paying for a safe keeping service folk were now paid interest on their deposits ... what magic was this? ...

Benefits were growing ...

euphoria, loans made deposits ... the next trick was mesmerising ... the bankers found that the money they lent out immediately returned to the coffers ... it seemed that when ever credit was spent from one account it ended up in another account ... payments & receipts were not kept in the mattress they came back as other people's deposits ... almost in an instant ... oh my! ...

Money circulated, it was spent but it was not lost ...

endogenous growth & money supply ... now wait for it ... the bankers discovered that the money that came back as new deposits could be relent to someone else, picking up profit on the way ... the whole shebang was growing ... banks were creating money ... as credit ... and they did it without clipping coins or printing and other terrible acts of theft ... if nobody rocked the boat & didn't cheat and if they maintained the trust & confidence of savers & investors with 'prudent' liquidity reserves and 'sensible' capital ratios ... the money supply kept pace with economic growth ... automatically ... the measuring system neither stretched or shrank ... it was stable & reliable ... there was no inflation ... the Balance Sheet balanced ...

Crucially it was the deals on profitable projects where credit produced marketable goods & services that avoided 'too much money chasing too few goods & services' ... no gluts and no queues ...it was Adam the Smith again ... there was a market in credit as bankers desperately tried to attract funds to invest in profitable projects ... but price discovery was necessarily a cobbled together, complex, interacting, kludge, a messy unpredictable unavoidable cycle of boom & bust ... 

prices too low = queues for credit - low profit projects queued up for cheap loans, folk started to worry, so many harebrained projects, too much money chased too few goods, inflation, asset bubbles formed, bad debts started to rise due to low profits, deposits declined as output of unwanted goods and services flooded the market ... interest rates rose to repair the Balance Sheets ...

prices too high = gluts of credit - only a few high profit projects were financed by expensive loans, folk started to worry, so few projects, economic activity declined, asset bubbles burst, bad debts started to rise due to high borrowing costs, savings deposits rose from a dearth of investment opportunities ... interest rates declined to repair the Balance Sheets ...

In this way interest rates were determined in global markets for credit as commercial banks balanced their Balance Sheets or went bust ... there was no manipulator trying to fix prices somewhere in the basement of the Bank of England ...

Bills of Exchange & Mortgages were different ... and there was more more ... as the money always seemed to return to the coffers of the banks some enterprising folks realised that it would be possible and cheap to make payments between buyers & sellers simply by adjusting deposit 'accounts' instead of the risky business of transporting gold, coins and paper IOUs around the place ... with trust & confidence simple instructions could be issued to transfer funds from one account to another ... just a cheque or a bill of exchange, another variation of 'I promise to pay' ... cheap and less risky ... in this way central 'clearing' of IOUs started on the bank benches, on the Rialto, in the coffee houses or where ever the bankers gathered together ... and eventually clearing was done across the accounts that the commercial banks held at a central bank ... more conveniences to encourage more customers ... amazing innovations constantly reduced the transaction costs of deals ... constantly speeding up the interactions and synergies which created more real wealth ... and economic growth ... by exchanging paper promises ... would you buy a second hand car from this man? ...

All bankers knew the difference between a bill of exchange and a mortgage ...

The 3-6-3 system sounds simple but it was a complex adaptive system of trust & confidence as promises were exchanged, credit was not created out of thin air -

3% interest on deposits would be impossible unless the banks earned a trustworthy reputation

6% return on investments would be impossible unless the banks invested in profitable projects

3 pm on the golf  course, the bankers bonus, would be impossible unless the bankers were both trusted & profitable ...

The 3-6-3 system was incredibly successful ... no wonder banking took off during the industrial revolution ... no wonder comparative advantage in England moved from manufacturing to financial services ... no wonder folk chased the 'American Dream' ...

But who was driving the money machine? ... and which direction to steer? ... was there an accelerator? ... or a brake? ... with all this risk & uncertainty, complexity, change, conflict & scarcity, was there really an invisible hand? ... preposterous? ... why did anyone risk hard earned cash and deposit or invest in a bank? ... did they know where their money was? ... did the Balance Sheet keep tabs on the money? ...

How did Balance Sheets measure the 3-6-3 Banking System during the Business Cycles?

In 1494 Luca Pacioli, a mate of Leonardo da Vinci, developed a system of 'Double Entry Book Keeping' as he tried to account for the synergies of exchange deals ... he summarised all the legal rights & obligations of customary law as assets & liabilities ... Luca was a Franciscan friar and thought he knew a bit about rights & obligations ... his 'Balance Sheet' was a meticulous reflection of the trading process ... and together with  the Profit & Loss Account these reports kept the score for business investors ...

Pacioli's accounts became sifting documents, reports, for measuring all manner of deals and market adventures ... but there were all manner of problems ... did profit measure the synergies of specialisation & scale which emerged from cooperation, hard work, honesty & thrift? ... or was profit exploitation? ... could there be exploitation if there were synergies? ... what was the difference between profit & rent? ... how were assets valued? ... was capital different from revenue? ... when was income actually earned? ... was a pound today worth the same as a pound tomorrow? ... why wasn't profit the same as cash? ... what was inflation? ... how did the auditors know what was going on where, when & how? ... and who guarded the guardians? ... and were the banks different from other businesses? ... did 'due diligence' and 'caveat emptor' help untangle the mess? ... strange stuff was money and credit was even stranger ... would you buy a second hand car from this man? ... seems there was no substitute for trust & confidence? ...

So all the puzzles of invisible hands, moral sentiments, comparative advantage, total factor productivity & creative destruction were only dimly illuminated by using Pacioli's audited Balance Sheets to measure the business of business ... but from the start two things about Balance Sheets became clear -

when prices were wrong the deals weren't right!

when the left side wasn't right then the right side had nothing left!

So how did Pacioli's Balance Sheets cope with vagaries of economic growth, wealth creation & business cycles? ... well... Luca's system couldn't replace trust & confidence but it could help to chase profits & cut losses because Balance Sheets measured both sides of the deals- rights & obligations - assets & liabilities - credit & debts - profit & loss ...

So as the business cycle cycled, the Balance Sheets went something like this -

hubris - excitement - wealth creation & economic growth.

 The Balance Sheets measured synergistic business deals at prices which cleared markets ... the evolved institutions of capitalism, liberal democracy & the industrial revolution created wealth & delivered self sustaining economic growth as folk did deals of their choice in social communities where the freedom to experiment was lawfully protected and there was a tolerance of failure ... no wonder there was euphoria!

Some economists told it how it was -

Adam Smith

Moral Sentiments - cooperation in social systems was underpinned by instinctive emotions ...

Increasing Returns - synergies came from specialisation & scale (eg pin factories) ...

Invisible Hands - self organisation emerged from free market economies 'which was not part of intention' ... 

 David Ricardo

Comparative Advantage - free trade synergies of specialisation & scale extended globally  ...

Opportunity Costs - differences & diversity guaranteed trade opportunities for everyone, everywhere, every time ...

Ricardian Equivalence - there was no free lunch, risk could not be eliminated, tax now or tax later was a double whammy -

- average tax burdens introduced X-inefficiency and lowered the marginal productivity of capital and

- marginal tax introduced XS burdens and eroded effort, honesty & thrift ...

 Robert Solow

Total Factor Productivity - the discovery & accumulation of technological innovation was a much more potent explanation of wealth creation than natural endowments of land, labour & capital ... 

The upturn started ... Optimism - Excitement - Thrill - Euphoria ... entrepreneurs created a stream of technological innovations which were part of profitable business strategies, resulting in satisfied customers, good job prospects and orders for suppliers ... real productivity gains from innovative technology ...  euphoric folk embraced risk & cheap credit and purchased assets they couldn't afford, investments were made in unprofitable higher risk projects which began hogging valuable land, labour & capital and pushing asset prices up as envy & greed reinforced a spiral of increasing inflation & leverage ...

New deposits appeared on the bank Balance Sheets as businesses prospered which offered opportunities for new lending as cheap credit became available at low interest rates ...

NB - folk always voted for optimism & excitement and the hubris was exacerbated by political encouragement of low interest rate borrowing - exchange controls, legal tender laws, bank & pension fund reserve ratios, protectionism, gold restrictions, tax relief on borrowing, tax increase on saving, subsidies, affordable housing ...

nemesis - fear - extraordinary popular delusions & the madness of crowds.

In a competitive economy many experimental & innovative projects inevitably failed. Owners lost their shirts, workers lost their jobs, suppliers lost their customers and banks lost their deposits ... no wonder there was despondency!

Other scientists & economists identified the inevitability of the business cycle and the inevitability of failure -

Charles Darwin

Natural Selection / Differential Survival - long necked giraffes resulted from the death of the short necked variety ... 

 Joe Schumpeter

Creative Destruction - bankruptcy cleared out the turkeys as effort & resources were diverted into soaring eagles ...

John Maynard Keynes

Animal Spirits - 'we have nothing to fear but fear itself', 'irrational exuberance', delusions & madness, trial & error was casino capitalism ... and everybody followed the crowd over the cliff ...

The downturn & the blame game started ... Suspicion - Anxiety - Denial - Fear - Desperation - Panic - Capitulation - Despondency - Depression ... everybody rushed for scapegoats as the rational purposeful intentional planning of intelligent design failed.  Confusion & fear led to both socialism, as the poor blamed the rich, and fascism, as the rich blamed the Jews ... but most folk blamed the rich Jewish bankers ... a vortex of shame engulfed Ebenezer Scheister, Shylock of the Rialto and even Joe the Plumber was vilified for his attempt to create wealth and chase profits ...

Bad debts appeared on the bank Balance Sheets as businesses failed, opportunities for new lending dried up as credit became expensive at high interest rates ... liabilities exceeded assets and the Balance Sheets didn't balance and needed repair ... bubbles always burst ... deposits dwindled, consumption down, prices down, production down, profits down, investment down, employment down, wages down, lending down, capacity reduced, deflation ... banks went bust ... lending & borrowing was a risky business, the 'sound judgement' of the bankers only appeared with hindsight as the appropriate interest rate that was needed to attract savings for investment in profitable projects spilled over into greed & disaster ...

NB - folk always voted for a rescue, bailouts as bad debts were socialised, deposits were guaranteed, savers were blamed, money was printed ...

catharsis - optimism - long term endogenous economic growth from technological innovation.

Wealth creation & economic growth was the business of business and required the failure of businesses. Wealth creation was restored by new business initiatives as technological innovation grew by discovery & accumulation in adaptive cycles ... no wonder folk clamoured for catharsis!

Some economists focused on the miracle of wealth creation & economic growth over the long term at 3% pa compound - 

Paul Romer

Endogenous Growth -  technological innovations were discovered & accumulated in competitive R&D departments in commercial businesses,  the resultant 'know how' was -

- partly appropriable - providing rewards & incentives for hard work, honesty & thrift

- non rival - as monopolistic competition provided spillover benefits for everyone ...

Niall Ferguson & Tim Congdon

Independent Central Banks in a Free Society - agents of monetary stability, financial stability, payments system and Government debt ...

The upturn started again ... Optimism replaced Fear ... some folk, somewhere, sometime were working hard as a virtuous circle of price adjustment in markets and ongoing technological innovation restored the availability of credit to some innovative projects ... technological innovators took advantage of the clear out of failures as input prices reduced and equipment replacement was cheap ...

Balance Sheets had to balance ... there was no place to hide ... Central Banks provided liquidity to solvent Commercial Banks and insolvent banks were restructured & recapitalised or wound down. Higher interest rates replaced cheap credit to attract deposits, repair liquidity and recapitalise the Balance Sheets ... but it was economic growth that repaired the Balance Sheets of commercial and central banks.

Catharsis was a Darwinian 'bottleneck' as the system was cleansed of accumulated toxic dross ... losers lost ... there was no way round that ... institutions adjusted to losses and inflated price levels and new technological innovation grew again ...

In this way the Balance Sheet attempted to indentify & quantify, to account for, investment decisions as capital chased profits and losses were cut ... but it was the price of money, the interest rate, the market clearing price which eliminated all the gluts & queues and ensured the balance of rights & obligations ... the Balance Sheet had to balance ...  

Darwinian Economics ... not Analogy but Ontology!

Commercial Banks emerged 'as if' to chase profits through selling credit but the real business of banks was business as a vast diversity of business projects competed for limited savings ... a process of natural selection which was not part of intention but resulted in the emergence of macro economic benefits which -

balanced the flow of savings into investment ... from the mattress to the safe deposit box to project investment ...

increased the marginal productivity of capital ... decentralised, diversified profitable project investment ...

balanced the money supply with the growth of goods & services in the economy ... credit growth on a balanced Balance Sheet ...

But bank business was risky, trust & confidence was fickle, businesses failed creating bad debts, bank runs were common in illiquid banks, thieves were everywhere and envy & greed stoked resentment of the 3-6-3 system ... confidence & trust in commercial banks was eroded ... but unsurprisingly immune systems co-evolved to combat these whammies ...

Central Banks emerged 'as if' to chase profit through selling their own currency but the central bank ended up coordinating the whole banking system by protecting the commercial banks as a regulator and a lender of last resort -

solvency & financial stability - commercial banks needed capital to support the sale of credit during the business cycle because it was business deals for margin & speed that made the 3-6-3 system work ... capital was maintained intact & the marginal productivity of capital increased by a relentless focus on the discovery of profitable projects ...

The financial challenge was to manage risk by scrutiny of Audited Balance Sheets and the principles of 'caveat emptor' & 'due diligence' ... in their own interest in profit from seigniorage, central banks would not, should not & could not lend to insolvent commercial banks ... insolvent banks required orderly bankruptcy and required prior legal agreement on creditor haircuts to balance the Balance Sheets and avoid lemming like default, contagion and systemic collapse of the central bank currency ... this was endogenous self regulation by central banks ...

liquidity & monetary stability - commercial banks needed reserves at the central bank to cover the clearing of depositors cheques and enough vault cash to meet the demand for depositors withdrawals ... risks associated with borrowing short but lending long created an active interbank money market to fund short term illiquid but solvent banks and avoid bank runs ... the risk of contagion resulted in central banks becoming the lender of last resort ...

The monetary challenge was to maintain the value of currency by keeping the supply of money in balance with the availability of goods & services ... this apparently called for knowledge about global economy activity which simply did not exist and even when some data was available the experts always disagreed on how it was interpreted ... the dilemma was excruciating because the money supply, or the price of reserves, readily drove economies off track towards inflation or recession as the credit cycle cycled ... central banks reacted the only way they could, in the same way as the potato farmers did, they adjusted prices by trial & error to eliminate gluts & queues ... interest rates followed the market clearing price for credit ... market prices which were only obvious in retrospect as the gluts & queues were cleared ... there was no pushing on strings or pulling on elastic bands, central banks were reactive not proactive ...
Inflation was squeezed out of the system ... endogenous money supply by central banks ...

Additionally as custodians of currencies and at the centre of economic activity central banks were able to offer a couple of massively important services -

receipts & payments were settled cheaply & efficiently over distance & time, without the risk & cost of physical transfer of bullion, specie or fiat ... transaction costs were reduced by central clearing across depositors accounts at the central bank ...

government debt was managed without inflation at market interest rates ...

One trick after another as innovative minds discovered all manner of methods for lubrication of the wheels of commerce ... money substitutes and money extensions ... the growth of bank Balance Sheets reflected the growth of business Balance Sheets ... the banks financed the voyages of discovery and the industrial revolution as more credit became available for business enterprises which broke the monopoly of the rich and the Bishops, Princes, Generals & Bureaucrats with the power to tax ... increasing wealth creation & economic growth ...

The study of banking history & business cycle history challenged & clarified economic theory and the distinction between -

exogenous money organisation & legal tender imposed from above by legal price fixing which inevitably led to gluts & queues ... 

endogenous money organisation & credit spontaneously emerging from below as market prices avoided gluts & queues ...

In matters of trust & confidence Aristotle got it right - 'admitting ignorance is the first step in acquiring knowledge' - 'those who claim to foresee the future are lying, even if by chance they are proved right' - 'history doesn't repeat itself but it does rhyme' - evolutionary history is an imperfect guide to the future but it is the only one we have ... we learn from history ...

But don't get it wrong, history revealed how bank Balance Sheets reflected the miracles of human ingenuity but history also confirmed how easily Balance Sheets were wrecked ... in theory, theory & practice were the same, in practice, theory & practice were different ... somebody was always tying shoes laces together ... 

Pacioli's audited Balance Sheets illuminated the shenanigans of joint stock companies but did the Balance Sheet of the Central Bank expose the shenanigans of government? ... independent Central Banks couldn't do it all on their own, sure they could handle solvency & bad debts and liquidity & bank runs ... but they needed help, the biggest players of all had to conform ... government borrowing & fiscal policy had to be included in ... and history indicated that the Bishops, Princes, Generals & bureaucratic majorities had a nasty habit of unbalancing the Balance Sheets? ...

Walter Bagehot (1826-77) in 1873 wrote eloquently about the evolution of the banking system in his book 'Lombard Street'. He concluded, like all evolved systems, it was less than ideal ... but better than the alternatives which had been tried from time to time ... and could always be improved but never unravelled ... screwing the banks was not an option  -

 A system of credit which has slowly grown up as years went on, which has suited itself to the course of business, which has forced itself on the habits of men, will not be altered because theorists disapprove of it, or because books are written against it. You might as well, or better, try to alter the English monarchy and substitute a republic, as to alter the present constitution of the English money market, founded on the Bank of England, and substitute for it a system in which each bank shall keep its own reserve. There is no force to be found adequate to so vast a reconstruction, and so vast a destructions and therefore it is useless proposing them.
No one who has not long considered the subject can have a notion how much this dependence on the Bank of England is fixed in our national habits.
The direct appointment of the Governor of the Bank of England by the executive Government would not lessen our evils or help our difficulties. I fear it would rather make both worse.
We must therefore have recourse to feeble and humble palliatives such as I have suggested. With good sense, good judgment, and good care, I have no doubt that they may be enough. But I have written in vain if I require to say now that the problem is delicate, that the solution is varying and difficult, and that the result is inestimable to us all.

Such is the nature of evolved complex systems buried deep in our successful social culture ...

Unbalanced Balance Sheets?

Throughout history the money and banking systems confronted an avalanche of competitive onslaughts but there were always four big Balance Sheet wrecking problems - 

bad debts ... solvency - orderly bankruptcy

bank runs ... liquidity - lender of last resort

Competitive Central Banking systems, audited Balance Sheets and the principles of caveat emptor & due diligence ...

parasites & predators ... moral sentiments - Tort Law, Property Law & Contract Law

A generally accepted system of law, rights & obligations, as an alternative to theft & violence ...

moral hazards ... tax & spend ... taxing success & rewarding bad behaviour - folk got all messed up with an emotional aversion to failure ...

A double whammy of perverse incentives inhibiting both the -

destruction of old technology / 'know how'

discovery & accumulation of new technology / 'know how'

The titles of two outstanding books encapsulate the Balance Sheet wrecking process -

'Extraordinary Popular Delusions & the Madness of Crowds' by Charles MacKay, 1841 - it's easy to pay the wrong deal price! -- Due diligence & caveat emptor ...

'The Fatal Conceit' by Friedrich Hayek, 1988 - it impossible to calculate the right deal price! -- Darwin's trial & error ...

and Walter Bagehot's conclusion -- 'screwing the banks is not an option'!

The jargon of failure -

moral hazard ... mal-investment ... financial repression ... 'affordable' housing ... bad debts ... bailouts ... beggar-thy-neighbour ... blame games ... bribery ... bureaucracy ... coin clipping ... conflicts of interest ... corruption ... counterparty risks ... crony capitalism ... dead weight losses ... deflation ... denial ... dishing pork ... earmarks ... free riders ... haircuts ... illiquidity ... imbalances ... inflation ... insolvency ... government spending ... helicopter drops ... kick starting ... mark to market ... nationalisation ... picking winners ... price fixing ... principal/agent problem ... printing money ... protectionism ... pump priming ... quantitative easing ... red tape ... regime uncertainty ... regulation ... spend & spend ... subsidies ... stimulus ... Troubled Asset Relief Program ... Term Asset-Backed Securities Loan Facility ... tariffs ... tax & spend ... theft ... unintended consequences ... X-inefficiency ... XS burden ... 

Moral hazard - rewarding bad behaviour - a plethora of good intentions paved the way to the hell of unbalanced Balance Sheets ... the legalisation of entitlements to rewards without the obligation for consequential costs ...

Mal-investment - market distortions - capital moved, not to increase its marginal productivity, but to save tax, secure subsidy and avoid regulation ... political processes did what was popular not what was economic ... a cacophony of vain attempts to gain the votes of interest groups ... a deluded hotch potch of bribery, corruption and bureaucratic kludge of bewildering complexity ... the counterfactual was impossible to prove, soothsayers were always eager to have a go at legislating wealth ... and you only found out who was swimming naked when the tide went out ...

Financial repression - manipulation of borrowing costs - a futile attempt to replace hard work, honesty & thrift by the arrogant pulling of levers & pushing buttons of the money printing presses as scarce tax revenues persistently failed to fund constantly burgeoning expenditures ...

The Elephant in the Room

Plato's democratic conundrum 'mob rule and emasculation of the wise' reappeared in a new disguise ... because betterment came from the death of short necked giraffes, the short necked variety wouldn't vote for you ... turkeys wouldn't vote for Christmas ... so big government spent in a vain attempt to bribe voters ... and inevitably the cost of gluts & queues rose inexorably ... no wonder just before he died, Thomas Jefferson lamented, 'I wish it were possible to obtain a single amendment to our Constitution - taking from the federal government their power of borrowing'.

The Global City

Adam the Smith knew a thing or two about how folk at the sharp end were protected by 'moral sentiments' as other instinctive behavioural traits enabled technological innovation to rip and help folk survive ...

Adam the Smith knew a thing or two about supply & demand, gluts & queues and that protecting folk from competition & risk by fixing prices was impossible ... physically impossible? He thought the unthinkable and never lost sight of the real world where hard work, honesty & thrift mattered ...

Adam the Smith knew a thing or two about of the real economy ordered by an 'moral sentiments' & the 'invisible hand' of adaptation ... instincts which couldn't be manipulated by myth & magic ... or the stretching or shrinking of the measurement system which destroyed the trust & confidence necessary for doing deals ...

So there we have it, not 'Gosplan', not 'New Deals', not 'Welfare States', but evolution by natural selection ... by creative destruction ... measured on the balanced Balance Sheets of banks and businesses as -

inherited human survival emotions responded to wealth creation with excitement & hubris ... greed produced the excess ...

the associated destruction of failures was accompanied by fear nemesis ... blame produced the scarcity ...

but the optimism & catharsis of economic growth from technological innovation required this cycle of flip flopping emotions ... the discovery of market clearing prices ... 'a clear out of the turkeys giving space for the eagles to soar' ...

The evidence for these adaptations was in history ... the process was endogenous ...

The city, a vast network of billions of individual deals where interactions are far too complex for mere folk to understand let alone manipulate. There were jobs in the cities for the youngsters and they paid well so they went! This was evolution where some random innovations emerged which seemed to work and were chased, and others which didn't work were cut ... the where when what who and how were only grasped with hindsight sometime somewhere in the future. Just like the termites in Africa, beavering away at the coalface, making their contribution to survival, but with each individual having no understanding of the physical structures that are emerging. This was not analogy this was ontology!

Education, education, education ... simple rules of thumb ... chase profits and cut losses ... think the unthinkable and join Joe & his mates in hard work, honesty & thrift ... expose the myth of manipulating the emotions of the business cycle and invest your personal wealth in the innovative technology of your choice ...

Of course, if, in the fullness of time, it transpires that life and economics are not the results of Darwin's natural selection but the result of design foresight ... then there will be many red faces ... including mine!

Socrates - 'admitting one's ignorance is first stage in acquiring knowledge ...'

Joseph Addison (1711) - 'Public Credit', The Spectator ... credit is fragile ...

Adam Smith (1776) - 'Division of labour is limited by the extent of the market' ...

Charles MacKay (1841) – 'Extraordinary Popular Delusions & the Madness of Crowds'.

Walter Badgehot (1873) – 'Lombard Street'.

Richard Dawkins (1986) - 'The Blind Watchmaker' ... 

Norman Jones (1989) - 'God and the Money Lenders' ...

Paul Romer (1990) - 'Endogenous Growth Theory' ...

Carmen M Reinhart, Kenneth Rogoff (2009) - 'This Time Is Different: Eight Centuries of Financial Folly' ...

Will Hutton - 'The State We're In'  - an influential 1997 polemic reiterating the vain hope of the political regulation of economic growth, but page 312 accepts the reality - 'global financial markets are out of control & the capacity to regulate the financial system and manage the economy is increasingly constrained ...'

Alan Greenspan - 'Senator, if you think I was clear you must have misunderstood me ... the knowledge you assume I possess doesn't exist'!

Money in Market Economies - Open University - 'the money supply is determined endogenously, as a function of national income as commercial banks in the business of credit creation, meet their customers' demand for loans. The essential insight of this model is that it is commercial banks not the government that determine the money supply'!

Reiner Kümmel - 'The Second Law of Economics: Energy, Entropy, and the Origins of Wealth' - 'Nothing happens in the world without energy conversion and entropy production. These fundamental natural laws are familiar to most of us when applied to the evolution of stars, biological processes, or the working of an internal combustion engine, but what about industrial economies and wealth production, or their constant companion, pollution? Does economics conform to the First and the Second Law of Thermodynamics'?

john p birchall

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