The author has been described by News Ltd as an "iconoclast", "Svengali", a pollie's "economist muse", and "pungently accurate". Fairfax says he is a "Renaissance man" and "one of Australia’s most respected analysts." Stephen Koukoulas concludes that he is "85% right", and "would make a great Opposition leader." Terry McCrann claims the author thinks "‘nuance’ is a trendy village in the south of France", but can be "scintillating" when he thinks "clearly". The ACTU reckons he’s "an enigma wrapped in a Bloomberg terminal, wrapped in some apparently well-honed abs."

Sunday, July 18, 2010

Brilliant Buttonwood: story of John Law, 18th century financial advisor to French regent

A classic tale here. Excerpts below:

"[M]any people argued that high levels of consumer debt in the 1990s and 2000s were nothing to worry about, given the high level of asset prices on the private sector balance sheet. But credit growth since the adoption of fiat money in the early 1970s has helped to push up asset prices at a rate much faster than that of nominal GDP. Houses, like shares in Law's company, were bought with borrowed money, sometimes indeed with no deposit; not even Law went that far.

The London School of Economics published a book of papers on the financial crisis today which will be the subject of my column this week. Two key points are that the banking sector's contribution to the economy has been overstated, because the banks have underestimated risk; and that bank lending these days is far less to do with channelling funds to productive business than in speculating on real estate.

The gold standard was very crude; maintaining it led to big shocks in the real economy which led to sharp rises in unemployment. That is why it was abandoned, first in the 1930s and then in 1971. But without an anchor for money, the tricky question is; how much should one create? The answer might seem obvious; enough to facilitate economic growth but not so much as to create inflation.

But if one thinks, as Law did, that monetary policy can drive economic growth, then the temptation is to create more money. And the banks will take that money and use it to finance speculation. Within the LSE book, Andrew Haldane of the Bank of England points out that, from 1900 to the end of the 1970s, the returns to finance and the returns to the rest of the economy roughly kept pace. From the late 1970s till 2007, the returns to finance exploded; hence the extraordinary rise in the sector's wages from that period.

Law could see the danger coming; the prices of property and what rose three to fourfold during the brief period his system was in place. But every time he tried to cut back, by restricting lending or paper note issuance, the share price of the Mississippi company slipped back. Since a rising share price was vital to restore confidence in his entire system, he was forced to change tack, at one stage guaranteeing to support the share price at a certain level. Similarly, today's central banks are frightened of what will happen if they raise interest rates and have created money to support asset prices.

The post-1970 period has not been as completely bubble-like as Law's system proved to be because genuine improvements in the world economy have taken place (technology, China, greater employment of women etc). But there is still a bubble-like element in property prices... Attempts to prop up these prices will fail, as Law's eventually did, since the appetite for credit has diminished. The 18th century historian Sir James Stewart remarked of Law's fall:

'The bubble no sooner burst, then the whole nation was thrown into astonishment and consternation. Nobody could conceive from whence the credit had sprung; what had created such mountains of wealth in so short a time; and by what witchcraft and fascination it had been made to disappear in an instant.'"