Deflation Made Simple (Part I)
A falsely vilified phenomenon (025)
In our last image we showed that the issue of promissory notes by the banks of Seville was a reaction to the King’s forced-loan program implemented in the name of the Christian faith and the Holy Roman Empire. In addition, we mentioned that the issue of promissory notes — though innocent in intent — resulted in a perversion of the monetary system that amounted to the legitimization of counterfeit and the inflation in which the counterfeit resulted Let us now examine more closely the interconnection between these two phenomena and their further ramifications.
Firstly, the money taken by the king had no direct effect on the world’s real money supply. The IOUs that he left behind were merely documentation of his promise to return what he had taken. The money was transferred from the banker’s vault to the King’s treasury — an act of theft legitimized by royal prerogative.
Further, the immediate, direct effect of the king’s action on the real economy was little different than a large number of savers suddenly withdrawing their savings and spending it on consumption. In other words, there was a sudden increase in trade activity and an overall diminution in the amount of real wealth brought about by the sudden increase in consumption (Image 8) — a great festive celebration, if you will.
However, this celebration was no ordinary grand festive party, for the wealth consumed as the savings diminished was used to destroy — at least, in part — some of the wealth that would be used during peacetime to replace what had been consumed.
Alas, in the short-run there was an increase in economic activity resulting in an overall diminution in total real wealth. In the long-run, however, the wealth destruction would be much greater than a simple withdrawing of savings to furbish a large military adventure.
No, the idea was not to diminish one’s own group’s ability to produce; rather, it was to preserve it and, at times, even to increase one’s wealth at the expense of the enemy group. Once a war begins, however, its outcome is rarely easy to predict. Whether one is the attacking or defending party to the conflict, it will almost always be the case that both sides have to engage in both offensive and defensive activities in order to prevail. Furthermore, once on the defensive the destruction of one’s own wealth is less a matter for consideration, for one is often prepared to expend everything in an effort to avoid defeat.
Secondly, although the issue of promissory notes by the bankers to their depositors had no effect on the real money supply, it increased the amount of consumptive activity in the same way that an increase in the supply of real money would. In effect, for every withdrawal of savings for the purpose of consumption in Seville, an equal amount was consumed by the King and his generals at home and in some distant corner of the empire. It was, as if the same value in promissory notes issued in Seville and spent somewhere in the proximate region were twice spent at the same time!
As the devastation from war continued to spread across Europe, an increasing number of European locales were effected. Also, while the city of Seville continued to prosper, the economy of Spain began to shrink. It was simultaneous prosperity and impoverishment by royal decree (fiat)!
What is worse, nearly all of this was performed out of necessity in reaction to the King’s need.
For the citizenry of Seville it was just a matter of getting use to paper over coin — a matter easily achieved by most.
For the bankers of Seville it was a matter of not issuing more value in promissory notes than that promised by the king in the form of IOU’s. So, most banks continued as if the King’s IOU’s were the real money of their depositors.
No matter one’s perspective, it was, as if the effective money supply (the combination of real money and promissory notes issued in Seville) had essentially doubled.
Thirdly, because the banks were now reluctant to hold precious metals in their vaults, they could no longer reasonably require a fee for the safe-keeping of others’ deposits. This provided an important incentive for them to increase their lending activity — an activity that further exhausted what little real savings were left in the system. This, of course, exacerbated the problem of ever-increasing consumption (Images 16-19). Indeed, where there should have been a shortage of savings, and the cost of borrowing should have gone up, the banks were now too eager to lend (Image 18). The pressure to issue more value in promissory notes than the King had promised to return in real money was extraordinary.
And, as always, real investment — the building of ships, the funding of trade expeditions, and port expansions — required material sacrifice in the moment that these projects were undertaken. The act of saving puts a hold on the consumption of the saver, and makes what he does not consume available to the borrowing entrepreneur to meet the expenses of his workers until the project is complete.
Fourthly, because everyone did not trust the promissory notes that were issued by the banks of Seville, the city’s real money supply shrank even further (Images 3 and 5).
When a foreign banker or merchant was presented with a locally issued promissory note in payment for a debt or some number of goods in trade, the foreign banker or merchant, respectively, would demand more in promissory notes than what he would have accepted had an equivalent amount of gold and/or silver been presented. Similarly, when gold and silver entered into Seville from the Americas, it was traded for more value in promissory notes than that promised by the notes.
In effect, the promissory notes were discounted in value by foreign merchants and bankers resident in Seville. Alternatively stated, real money was traded at a premium over its substitute — the promissory notes.
The real economic consequences of this financial manipulation of the real money supply were widespread. ‘Till next time!
In liberty, or not at all,
Roddy A. Stegemann