Wednesday, November 30, 2011

The Fed Gooses: Dutch Finance or French Finance?

Today the markets have soared in response to the Fed's latest ploy: making dollars available to foreign banks.  But it hasn't solved the problem.
At best, analysts said the move could buy the 17 nations of the euro zone a little more time to agree on a broader plan to stabilize financial markets.
Why is that?  Because all the Fed has done is solve the liquidity problem.  It has not solved the solvency problem.

The solvency problem is that a number of European nations have run up debts that cannot be repaid.  There will be sovereign default, and there will be haircuts for bondholders, and there will be welfare state spending cuts.

Why are these nations in this mess?  The reason is quite simple.  They follow the principles of what I call "French Finance."

The modern era has two models of national finance.  There is Dutch Finance, invented by the Dutch Republic in its war with Spain back in the 16th century.  Then there is French Finance, invented by John Law in France in the early 18th century.

The difference is simple, and understandable by any of us financial ignoramuses.  Let's start with French Finance.

In French Finance the resident wizard, be he John Law or Benjamin Strong or Alan Greenspan or Ben Bernanke, manipulates the financial system to get the government out of its latest jam.  You get inflation, government-sponsored companies like the Mississippi Company and Fannie and Freddie.  It always ends in tears. And the reason is pretty simple.  The credit system runs on trust (credit means faith).  It requires the participants to believe that the other participants can be trusted.  Obviously, under French Finance with its John Laws and Alan Greenspan and Ben Bernankes the question always is: how can I manipulate the markets so my political masters can coast through to the next election?  They spend and borrow and don't give a damn about the long term.  And in the long term the government ends up with debts that cannot be serviced.  After the election comes the deluge.

But what about Dutch Finance?  Now you are talking.  The idea of Dutch Finance is that you take all the government's mess of IOUs and convert them into long-term government bonds.  Then you create a tax and allocate it to the payment of interest on the bonds.  The tax is big enough that the market has confidence that the interest can be paid,.  And paid, and paid.  The result is a big boom, because the government's rock-solid bonds become the best kind of collateral for individuals and the best kind of reserves for banks.  The Dutch did it, and then they invaded Britain in 1688 and set up the same system up with the Bank of England and the "funds," i.e., the National Debt "funded" with earmarked taxes.  If you read your naval fiction you will find that your Jack Aubreys always put their prize money in the "funds."  Alexander Hamilton gave the US Dutch Finance in 1792 when he converted all the Revolutionary War debt into government bonds serviced by import tariffs and excise taxes.  Pretty soon the US had actually paid off its National Debt.

There is always a temptation for governments to cheat, to pretend that they are doing Dutch Finance when they are actually veering towards French Finance.  The Germans had their fill of French Finance in the first half of the 20th century with hyperinflations that reduced money to zero twice after defeat in war.  They want a financial system that will never again ruin the German people.

In the present crisis, as the Wall Street Journal opines, everyone wants the Germans to write a blank check for the defaulters.  The German people, perhaps more than their leaders, are dead set against it.  And who can blame them?

No doubt we will soon get to the end game on this mess, and nobody knows how wide the damage will be.  Will the contagion spread to the US and push the economy back into recession?  Nobody knows.

But one thing we do know.  French Finance always ends in tears.  Dutch Finance is different.  It leads to peace and prosperity.

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