Deflation Made Simple (Part I)
A falsely vilified phenomenon (Image 074)
Hendrik’s ride home on the following day was pleasant, and he was well received by his family and servants. There were many questions and many answers, and they went both ways.
Hendrik had spent three nights in Amsterdam in order to correct his error, and he would not miss his payment — not this time, or ever again, if he could help it. After much discussion he arranged to meet with his friend’s uncle to say thanks for his introduction to the Amsterdam broker. Hendrik had brought with him a present from Amsterdam: four long-stemmed tulip glasses and a bottle of oude jenever. Hendrik was a grateful person. No, there was no FedEx, but the additional burden on his horse was light, and the present was well-appreciated. Hendrix was learning how to conduct good business.
Hendrik had no idea that he had been responsible for initiating the first trade in what would one day become one of the world’s largest financial markets. Still he had learned a little about negotiation and a whole lot about the lion’s ROR. The key to Hendrik’s discovery was how to price a bond so that it could be traded along side other financial instruments of completely different character.
When his supplier arrived several days later, Hendrik paid and said nothing about his adventure to Amsterdam. Hendrik was now curious about whether he could convince a supplier to accept a bond as collateral for late payment. He knew so much more about finance than he did before, and the future is always uncertain. So, he planned an experiment. After saving enough to purchase another bond and still have enough to meet his estate’s payment, he would purchase and offer the bond as collateral to his supplier and see what would happen.
Unlike Hendrik, Hendrik’s broker understood the potential ramifications of what he had done and was now on the alert for anyone on The Exchange who held a bond. No, Hendrik’s broker did not know how many bonds the government had issued, but he was aware of the size of the proposed canal, and the market value of one bond. So, he divided the value of the bond into the estimated cost of the project and calculated thereby an approximate number for the bonds outstanding. It was several hundred. Already one informed investor had made a purchase, and surely there would be other Hendrik-like liquidity shortfalls in the future. What is more, the broker surmised that, if the provincial government had succeeded once in raising money without having to tax or take out a loan, surely it would try again? He was not wrong in this regard.
The bond offered better security than a share in the VOC with forever fluctuating share prices and dividend payments, but not as much security as a time-deposit with a reputable banker whom one could prosecute in a court of law, if the promised repayment with fixed principal and interest were not forthcoming. Then too, the bond had an important advantage over a time deposit — the promise to repay could be traded. Indeed, if you needed Hendrik-like liquidity, you had simply to find a broker on The Exchange who dealt in government bonds, and you could be fairly well sure that you would be able to retrieve a sizable amount of what was owed on the bond, if not the whole of it, or even more — depending on the financial outlook of the VOC and other investment opportunities at the time. More importantly, you did not have to wait until the bond had reached maturity.
Hendrik’s broker wished to be the broker whom you could always find on The Exchange, and he was now well-poised for the job.
The rate-of-return on a bond would eventually come to be known as obligatie rendement (yield on an obligation, or more simply, bond yield). For Hendrik’s broker it was simply the rendement (rate-of-return) and the general formulation was
(coupon rate x bond principal) ÷ bond price = bond yield
Only when the bond price was equal to the par value (principal) of the bond would the bond yield and coupon rate be the same. And, because the coupon rate of a bond, like its par value, was fixed bond prices and bond yields always moved in opposite directions. When the price of the bond went up, the yield on the bond went down, and vice versa.
The bonds issued by the provincial government of Holland were fundamentally different from the promissory notes of the banks of Seville (Images 24-27). On the one hand, the promissory notes were inflationary, as they increased the available supply of currency (real money plus real-money surrogates — i.e., counterfeit) at little or no cost. On the other hand, the promissory notes were used as money-in-exchange, not money-in-use. They offered no interest or rate-of-return — once traded their ownership was forfeited. Indeed, their value was determined solely by their purchasing power — what they could fetch in the market place in terms of goods and services. And, unfortunately for anyone who was not close to their original point of issue, the more of them that were issued, the smaller became their power to purchase. Recall the School of Salamanca (Image 27).
When the provincial government of Holland borrowed money, it had no effect on the money supply, for it borrowed real money unlike the counterfeit currency that is issued today when governments borrow from their central banks. Indeed, the stadtholder was not permitted to create something out of nothing! He had no magical power, and if he behaved like a witch, his destiny was clear — à la mort sur le bûcher (Image 54).
No, you could not sue a stadtholder in a court of law, but you could surely make him sorry for having performed wrong!
In the larger scheme of things, what the stadtholder purchased others could no longer. There was no overall change in the amount of goods and services traded, for the purchasing power had only traded hands. Indeed, the demand for money-in-use had suddenly risen, and this would push the price of money-in-use upward, and make it more difficult for everyone else to borrow.
If the matter is still not clear, hang in there, because as the story evolves things begin to change in a very profound manner.
In liberty, or not at all,
Roddy A. Stegemann, First Hill, Seattle 98104