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Finance History Inheritance Mass Rentiers Politics Society

Central Banks or The Gold Mine of Monsieur de Cantillon

Unconventional Policies, Quantitative Easing, Monetary Bazooka: the last twelve years in economics have been dominated by a flood of new money aimed at creating inflation. And yet there is a puzzle: why is the money meant for everyone only showing up in the stock market? Where is the inflation? Why wages do not go up? Commentators believe this is an unprecedented situation. Well, it is not.

“Everybody agrees that the abundance of money, or an increase in its use in exchange, raises the price of everything. This truth is substantiated in experience by the quantity of money brought to Europe from America for the last two centuries.”

This words are by Richard Cantillon, author of the famous Essai, written sometime in the 1720s but published posthumously in 1755. In his time, as today, economists were convinced that all prices go up together when money is created: the so called “neutral money theory”, first exposed by no less than the philosopher John Locke.

Cantillon noted in his time, as we see today, that the reality was not following the theory: changes in the money supply have different and uneven consequences depending on where the new money is injected — and who the early receivers are. As the first receivers can spend the money at not-yet-adjusted prices for goods and services, they get an (unfair) advantage over later recipients whose incomes lag the increase in prices. In effect, by introducing new money into the system, early receivers are benefited at the expense of late receivers.

“If the increase in actual money comes from a state’s gold and silver mines, the mines’ owner, the entrepreneurs, the smelters, the refiners, and generally all those who work in them will increase their expenditure in line with their gains. At home they will consume more meat and wine or beer than they used to, and they will become accustomed to having better clothes, finer linen, and more ornate houses and other sought-after commodities.”

In contrast to those beneficiaries of new gold, he explicitly identifies the losers:

“Those who suffer first from this dearness and the increase in consumption will be the landlords during the term of their leases, then their servants and all the workers or people on fixed wages on which their families depend. All of them will have to reduce their expenditure in proportion to the new consumption.”

Cantillon concluded that who benefits when the state prints money is based on the institutional setup of that state. In the 18th century, this meant that the closer you were to the king and the wealthy, the more you obtained, and the further away you were, the more you were harmed. Money, in other words, is not neutral. This general observation, that money printing has distributional consequences that operate through the price system, is known as the “Cantillon Effect.”

In Cantillon’s day, the basis of money was gold, so he wrote about what happened when a nation-state discovered a gold mine in its territory. Increasing the amount of gold in the realm would not just increase price levels, he observed, but would change who had wealth and who did not. As he put it, “doubling the quantity of money in a state, the prices of products and merchandise are not always doubled. The river, which runs and winds about in its bed, will not flow with double the speed when the amount of water is doubled.”

Cantillon went on to discuss how money would flow, basically noting that rich people near the mine would spend it on 18th century luxuries like servants and meat pies, prompting a general rise in prices. Eventually the money would get out to the populace, but until it did, working people would have to pay higher prices without access to the new money that mine owners had. So there would be inflation, with uneven distribution of purchasing power.

This theory does not imply that money creation is always biased towards the powerful, only that how money travels matter. There is no inherent money neutrality, such neutrality must be constructed by institutional arrangements.


The Gold Mine today

Today who is close to the Central Banks’ printer gets rich, exactly as who had a new mining privilege granted by the Crown became rich in Cantillon’s time. The only difference is that nowadays new rich do not spend all their gold in beer and meat, instead they invest in stocks and become even richer.

The rich cannot buy every service and product on the market, because they are satisfied with a few luxury items: so their money goes directly from the money printer (Cantillon’s gold mine) to the stock exchange. We can see it clearly in money aggregates and money velocity graphs: money is not moving, is buried minutes after it is born.

Money stock increases parabolically…
…but money velocity slows down and suddenly stops.

Central Banks create money and money has to travel through institutions, and right now, the institutions function well only for the top 1%. Eventually, some money will get to the rest of the population, but in the interim period before that money fully circulates, the wealthy can use their access to money to buy up physical or financial assets. Authorities and politicians celebrate stock markets’ records, but that is beneficial only for the top 1%. The bottom 50% does not get anything because they have no stocks at all.

Top 1% owns the majority of Corporate Stocks. The rest belongs the top 10%. Bottom 90% remains on the sidelines.

Central Banks usually see their role as printing money and distributing it to the economy, largely by moving money to banks and assuming they will in turn increase the amount of money available to everyone else equally. When faced with the harsh reality of increasing inequality, they reply that politicians should do their job through fiscal policy and alleviate the middle- and low-class sufferings.

Central banks just keep pushing bond and loan markets, but since most of population does not have access to substantial borrowings (a minority gets a mortgage to buy a house, but they cannot buy real estate every year) only the rich owners of corporations really benefit.

Loans to households are stable, only loans to firms seem sensible to stimulus by the central banks….
…along with public debt.

Southern Europeans countries use an unorthodox strategy to spill money to the population: public deficit. Since states are granted by the ECB a generous access to low or even negative rates, they pile up debt, and use it for public spending that should benefit the whole population.

But now, after Bitcoin breakthrough, a new solution would be possible: creating a digital counterpart of fiat currencies and filling an online wallet with money for every citizen. That would benefit everybody equally (even more the lower classes in proportion).

Public support and central banks digital helicopter money: in the future most of the advanced economies population could rely on a small rent.


Zombie banking and the future of work

Central bankers continue to present a future path of sustainable growth and inflation through zero or even negative interest rates, but what is happening in reality is that middle classes are destroyed.

As seen above they do not get money from banks, that instead have an incentive to convince companies to launch new investment projects with a low expected return. In theory, even a new project with a nominal return of zero (e.g. cash hoarding) is advantageous because the bank and the company save on negative interests.

This zombie projects and zombie companies bring with them decreasing productivity and income losses for the workers. Because productivity gains are the basis for real wage increases, negative interest rates become a burden for the young people, whose wages tend to decline in comparison to former generations.

Again, the younger generations will get only pain if they chase prosperity through an old-style career: the only way out of the crisis is joining the top 1% at their own table, investing and getting a rent. The real job of the future is to play the scarcity game and then, sitting on non-inflatable assets, do the work you love.

Categories
Finance History Inheritance Literature Politics Society

A History of Bubbles

Piketty, as we have seen before, states very clearly that workers are getting poorer and enjoy no mobility due to r > g: return on capital goes from 4 to 5% whereas GDP growth is stuck between 0 and 1%.

What if you do not want to wait for the Government to do something about it? What if you want to repair the mobility elevator at least for yourself? In this case, financial markets offer a very powerful but also dangerous tool, a sort of nuclear lift: asset bubbles.

Riding a bubble, your small capital can increase a hundredfold in a short time. But you could also lose everything.

The usual narrative about bubbles is that bubbles are evil and they must be recognized to be avoided: they are like the Big Bad Wolf for the Little Red Riding Hood investor. That is often true of course, but tells only a part of the story. Bubbles, as any investment, represent a risk and an opportunity at the same time, require much knowledge and preparation to be managed, technical skills but also psychological ones; financial competences are not enough, a thorough knowledge of the business/product/industry in question must be acquired. 

Let us learn something about bubbles analysing a few of the most famous ones in history.


The Dutch Tulip Mania

GETTY IMAGES

Historical accounts are still under discussions for this very first and iconic bubble (1). We can underline a few facts: 

  • Tulips were a new asset class and as an asset class they did not last long.
  • Being a new asset class, a lack of historical data gave way to large swings in prices.
  • In a way, tulip bulbs were prototypes of something new and unknown, and as a technological breakthrough they inspired hopes that could not be limited by experience.
  • Only a small group of merchants was involved in the market, the effects on the overall economy of the boom and bust were negligible.
  • As a flower they proved really extraordinary: the Netherlands are still famous for their tulips!

The South Sea Bubble

The “night singer of shares” sold stock on the streets during the South Sea Bubble (Amsterdam, 1720)

At the very origin of the word ‘bubble’ (2), the South Sea crash gives us plenty of good lessons:

  • Business was not particularly new or innovative: only the financial formula changed.
  • A crucial active role was played by legislators, that were hired as testimonials and guarantors, and even passed a law to block any other competing ‘bubble’ (i.e. corporation).
  • A financial innovation swiftly mutated into a fraud.
  • The affluent classes were widely involved.
  • An economic crisis followed the crash.

There is a special story in the story: documents revealed for certain that even the great Isaac Newton incurred in heavy losses during the market frenzy (3):

“at the beginning of 1720, Newton had around 40% of his considerable wealth (comparable, based on average earnings, to around $30 million today) in South Sea stock, which can be thought of as a book-entry equivalent of shares. This stake had been acquired over some years, mostly at considerably lower prices.

But then, as the bubble was inflating, in April and May 1720, he sold most of that, at prices that were three to four times his cost. This liquidation appears to have stretched roughly over the period shown in the price chart. However, a few weeks after the last of those sales, in mid-June 1720, he appears to have jumped back into the market, at prices about double those at which he had sold. He then continued making further investments for himself until the end of August, just before the collapse of the bubble.

There had to be vigorous debates among all the executors and Hall about the prospects of the South Sea venture, with Hall likely the most fervent enthusiast. Those debates, together with the rapidly rising market price, apparently led Newton to change his mind.

It should be noted that Newton did become a truly ardent believer in the bubble, more ardent that other people in his circle, even though he started out as a sceptic and was slow to change his views. The Hall estate made some purchases of South Sea stock as late as the middle of September, when prices were in a free-fall and about half their peak level. However, this estate did keep a substantial fraction of its assets in a more stable investment, that of the Bank of England. On the other hand, Newton appears to have put all of his assets into South Sea stock.”

Newton in 1702 by Godfrey Kneller

Even one the greatest scientists in history and for sure a very rational man, under the pressure of continuous discussions, news, and an astonishing price rise, lost his principal. We then learn that a plan is necessary from the beginning. Probably if Newton did not liquidate completely his first very lucky investment, he would not have entered later.

In the same period, the great writer Daniel Defoe ran The Commentator, a newspaper that was likely subsidized by the government. He attacked the similar bubble plan designed by John Law in France and was vociferous in his condemnation of the various visionary London schemes, such as a company “For extracting Silver from Lead.” He called them various names, such as a “lunacy” caused by the “bubble infection.” (3)


The Railway Mania

‘Can you tell me how to make £10,000 HONESTLY in Railways?

The first high tech bubble, Railway Mania was really close to modern day disruptive technologies markets (4)(5)(6), but still the similarities with the South Sea were even more striking:

  • Strong role of the legislators: railroads were not centrally planned in Britain as in the rest of the world. Companies were required to submit a Bill to Parliament for approval of new railroad lines, there were no limits on the number of railroad companies and nearly anyone could form a railroad company and submit a Bill to Parliament. Financial viability of railroad lines was not a requirement for Parliament’s approval and most Bills were approved due to the fact that many Members of Parliament were heavily invested in railroad companies.
  • A technological innovation swiftly mutated into a fraud, with many impossible railway projects, that just worked in enriching their initiators.
  • Low interest rates, abundant liquidity in the system, was a key factor.
  • A rising pressure on the middleclass through newspapers news, discussions among peers and a constant rise of price: as railroad company shares continued to rise, investors became increasingly wrapped up in the speculative fervour and many middleclass families invested all of their savings into them. Many famous figures became involved in railroad stock speculation including Charles Darwin, Charles Babbage, John Stuart Mill, the Brontë sisters and Benjamin Disraeli.
  • An economic crisis followed the crash.
  • In the long run. railroad companies became lucrative in the strong hands of the big investors that bought them after they went bust.

As is noted on Wikipedia: 

“Unlike some stock market bubbles, there was a net tangible result from all the investment: a vast expansion of the British railway system, though perhaps at an inflated cost. Amongst the high number of impractical, overambitious and downright fraudulent schemes promoted during the mania were a good number of practical trunk routes (most notably the initial part of the Great Northern Railway and the trans-Pennine Woodhead route) and important freight lines (such as large parts of what would become the North Eastern Railway). These projects all required vast amounts of capital all of which had to be raised from private enterprise. The speculative frenzy of the mania made people much more willing to invest the large sums required for railway construction than they had been previously or would be in later years. Even many of the routes that failed when the mania collapsed became viable (if not lucrative) when each was in the hands of the larger company that had purchased it. A total of 6,220 miles (10,010 km) of railway line were built as a result of projects authorised between 1844 and 1846—by comparison, the total route mileage of the modern UK railway network is around 11,000 miles (18,000 km).”

The money lost by many small investors became, in a way, an unearned income for the next generations. And the technology did not die, it prospered and we still use it today.


Lessons learned

Bubbles are usually lucrative for a few and disastrous for many. The key elements that we have learned from history to assess new market trends are:

  • Retail involvement: is everyone already in?
  • Legislator role: is the price rise influenced positively or even caused by laws?
  • Liquidity and leverage: how much money is in the system? Is it sustainable? Do people invest their own money or borrowed capitals?
  • Asset class: is it totally new? If not, what do historical data tell?
  • News: how much hype is around?
  • Product: is there a technological and/or financial innovation? How will it impact people’s lives? Is there still room for improvement/adoption?
  • Investing plan: do people invest following a plan and/or generic prudency or are they under psychological pressure? And you, do you have a plan?

ReLLANPI is our swiss knife to analyse (and build plans for) today’s bubbles.


(1) https://en.wikipedia.org/wiki/Tulip_mania

(2) https://en.wikipedia.org/wiki/South_Sea_Company

(3) http://www.dtc.umn.edu/~odlyzko/doc/mania13b.pdf

(4) https://en.wikipedia.org/wiki/Railway_Mania

(5) http://www.makingthemodernworld.org.uk/stories/the_age_of_the_engineer/01.ST.04/?scene=11

(6) http://www.dtc.umn.edu/~odlyzko/doc/hallucinations.pdf

Categories
Finance History Inheritance Literature

Monsieur De Norpois’ bad advice

Since the 19th century, investors were faced with the choice between different asset classes. Psychologically, people prefer a fixed income: in their eyes, this stock does not fluctuate in value. Unfortunately they are brutally wrong. A very juicy portrait of a doubtful investor and a bad advisor is given in Marcel Proust’s In Search of Lost Time. Probably the most important novel of the 20th century, it is like a treatise in a poem, or better many treatises, including a small one on investments.

The second volume of this majestic work is In the Shadow of Young Girls in Flower (À l’ombre des jeunes filles en fleurs). In this book the Narrator receives an inheritance, after the death of his aunt Léonie. His father, a diplomat, consults his friend, colleague and role-model Marquis de Norpois, a very experienced diplomat, that considers himself also the best of judges in art, literature, and investments of course.

My father, who was trustee of this estate until I came of age, now consulted M. de Norpois with regard to a number of investments. He recommended certain stocks bearing a low rate of interest, which he considered particularly sound, notably English consols and Russian four per cents. “With absolutely first-class securities such as those,” said M. de Norpois, “even if your income from them is nothing very great you may be certain of never losing your capital.”

English consols yielded from 2 to 3%, depending on the emission, whereas Russian bonds, considered less safe, guaranteed a 4% fixed income. Not much, but those were times of gold standard, deflation and low interest rates (sounds familiar?)

More than three thousand pages later, at the end of the sixth volume The Fugitive (Albertine disparue), the Narrator has spent much money for his beloved Albertine. The affair is over (no spoiler), and he finds himself quite in lack of argent. This sad consideration follows:

But time had passed; the wisest judgments of the previous generation had been proved unwise by this generation, as had occurred in the past to M. Thiers who had said that railways could never prove successful. The stocks of which M. de Norpois had said to us: “even if your income from them is nothing very great, you may be certain of never losing any of your capital,” were, more often than not, those which had declined most in value.

A World War and revolutions across the globe provoked devaluations of bonds that seemed impossible in the previous years. French investors in particular lost gargantuan sums of money on Russian bonds that were repudiated by the new Soviet Union. The matter is still not solved after more than a century!

Whereas in 1996 The Chicago Tribune wrote emphatically (1):

For nearly eight decades Russia’s Imperial Bonds decorated European bathrooms and children’s playrooms as colorful but worthless wallpaper.

Sometimes the bonds surfaced at antique stores or as curios in the flea markets of Europe.

When Vladimir Lenin’s Bolsheviks unilaterally declared the debt on the czarist bonds null and void in 1918 they were rendered worthless.

This week, however, French families were rummaging through attics in a frantic search for the once-useless certificates their great-grandparents might have bought, then tossed into a dark corner in disgust.

Russian President Boris Yeltsin agreed Tuesday to repay a nominal value of between $80 and $100 for each of the 4 million czarist bonds believed to remain in circulation in France or to have survived the European wallpaper fad, for a total payout of around $400 million

Many descendants of the bondholders are still looking for money today (2):

Around 400,000 people are seeking 30 billion euros from Russia in payments for the bonds issued by the tsarist government (…)

Between 1880 and 1917 French citizens bought a total of 30 million Russian bonds. In January 1918 the head of the new revolutionary government Vladimir Lenin refused to pay off the bonds.

However, in the mid-1990s Russia signed an agreement with France over the Romanov government’s debts and paid Paris 330 million euros. Moscow asserts that the issue is over and there are no grounds to discuss any new payments.

Meanwhile, descendants of the original bond owners argue that this sum should be 100 times bigger.

Well, M. de Norpois’ advise did not prove very useful indeed. Today most investors make the same mistake: accepting low interest rates from Sovereign Issuers that are politically unstable, or in a constant economic recession. There is a sort of blindness in fixed income by investors. Most think that fixed income is risk free, but the risk is still there, many risks indeed: currency devaluation, inflation rise, interest rates rise, default.

The SEC itself seems to agree that investors’ awareness of bond risks is quite low:

Interest rate risk, a bulletin by the Office of Investor Education and Advocacy of the SEC

The only real rentier investment is the investment at technological frontier. Proust mentions railroads, that was high tech in the 1800s and old story in the next century. Every century has its own railroad: we will talk about this in a next post.

(1) https://www.chicagotribune.com/news/ct-xpm-1996-11-28-9611280180-story.html

(2) https://www.rbth.com/lifestyle/327261-french-still-waiting-for-debts-payment

Categories
Finance History Inheritance Literature Mass Rentiers

A universal truth

It is a truth universally acknowledged that a single man in possession of a good fortune must be in want of a wife.

This is one of the most famous incipits in English literature: “Pride and Prejudice” by Jane Austen. We will focus on the fortune side of the equation, as money, that is unearned accumulated capital, plays a fundamental role in her books.

The novels by Jane Austen are set at the very beginning of the Industrial Revolution. In those times growth rate was around 0 percent and slowly accelerated to 1.5 percent during the 19th century. But compared to a rate of return of 5 percent, the gap between the rate of return and the growth rate did not change dramatically as compared to pre-industrial society.

Wealth was just perpetuated from one generation to the next generation, keeping the structure of society unchanged. There was always some sort of limited mobility – some people dilapidated the wealth or some people gained access to wealth through connections or other means.

This phenomenon has been explained with vast echo by French economist Thomas Piketty in his book “Capital in the Twenty-first Century.”

Piketty’s thesis is that when the rate of return on capital (r) is greater than the rate of economic growth (g) over the long term, the result is concentration of wealth, and this unequal distribution of wealth causes social and economic instability

Piketty argues that in the 20th century, very unusual shocks altered this logic. The succession of World War I, the Great Depression and World War II reduced the return to capital to a very low level because of capital destruction, inflation and taxation to finance the war, and so the rate of return to capital between 1940 and 1945 was not 4 or 5 percent anymore: it fell to 1 percent or very close to 0 percent.

Then the growth rate after World War II increased enormously: many countries experienced growth rates of 4 or 5 percent per year in the 1950s, 1960s and 1970s, in particular USA, Japan and Western Europe, that were largely due to the post-war recovery. Very high growth rates made it easier to accumulate wealth and, for the first time in history, there was really significantly higher upward mobility.

The unusually high level of upward mobility during the post-war period was greatly facilitated by the large growth rate of labour income during these decades. But starting around 1980, a growth slowdown was experienced due to the fact that the post-war recovery was over and productivity growth rate fell around 1 to 1.5 percent — closer to the pre-World War I productivity growth rate.

Growth rate in the economy is a function of the growth rates of productivity and population. So there are two ways to make GDP rise: higher productivity, higher population (more people working) or both. Historically both have been very important. Having more people who can work comes from immigration and fertility and life expectancy increasing. But this part of growth is now going down, because people are having fewer children.

There is still very substantial growth as compared to pre-industrial societies, but this is not enough to counteract the fact that the rate of return to capital earnings can typically be 4 or 5 percent. In Piketty’s view we are back to 19th century at least.

Chart adapted by The New Yorker from the original in Thomas Piketty’s “Capital in the Twenty-first Century.”

Piketty calls for action, but it is evident that these forces are beyond the control of individuals and even of political powers. In the foreseeable future, demographics will be negative in rich countries and productivity will not increase very fast. 

And so, what can we do? If we surrender to the logic that our wealth will be a function of productivity and demographics, i.e. forces that we can not influence in any way, we are set to be powerless and in the end victims of the economic system. And yet we can fight.

First of all, even the poorest worker in an advanced economy is a Mr Darcy compared to the average worker of a poor country. Piketty forgets this simple fact: we live in a globalised world, where a middle class Lebanese family can hire a Sudanese to take care of the house, and a Slovakian manager can pay a Filipino to assist his ageing parents. The world is the stage now, and many, who Piketty laments are getting poorer, are still on the wealthy side.

Second, we do not depend on land or paper to accumulate wealth. We have digitalized financial markets, we can own shares of companies, obligations and currencies with a common mobile phone and an internet connection. It is incredibly simple to manage an estate today, and, although it is not easy to save money working, we can all round up our income with some unearned income.

Jobs, that traditional economists like Piketty believe to be the only way to earn a living, may be the hardest path to affluency. The easiest one is to understand how to invest fruitfully the unearned capital we already possess, and then do a job that we love.

We must change our mentality: stop thinking as working class heroes, and act instead like decadent aristocrats who want to stay on top. Because that is what we are.