Dollar Debasement Explains Our Lack Of Innovation

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In the 1830's, Samuel Morse perfected a means of sending electric telegraph pulses through copper wires. There had been other telegraphy systems and processes prior to Morse's work, but he had found a way to make the telegraph system conducive to broad usage. By 1842, he was petitioning, successfully, the US government for $30,000 "capital" to wire the country.

By 1851, a new company had been incorporated, the New York and Mississippi Valley Printing Telegraph to Western Union, in the race to add network capacity. Only a decade later, Western Union, as it came to be known, had completed the first trans-continental telegraph line across North America, beating the railroads by eight years (despite the fact telegraph lines were largely built along rail lines). The pace of telegraph and communication expansion had not been lost on the business and investing public, and by the late 1860's, various legal efforts were undertaken to gain control of such a lucrative business.

One such effort was sponsored by Gardiner Greene Hubbard, a Boston lawyer and erstwhile railway mail inspector. He proposed to have the US Congress nationalize all telegraph lines and place them under the supervision and business direction of the Postal Service. As he saw it, the delivery of electric communication was much like the delivery of the mail, and thus warranted the same treatment. Fortunately, Mr. Hubbard was not successful and his bill was never passed out of committee.

Hubbard went back to Boston from Washington with innovation and communication on his mind. He had already helped establish water service in Cambridge, MA, along with founding the Cambridge Gas Company. Since his middle daughter Mabel had been deaf from scarlet fever, Hubbard contributed to the establishment of the Clarke School for the Deaf in 1867 - the first school in the United States dedicated to teaching and diagnosing hearing impaired children.

In March 1872, with a recommendation from his inventor father, Alexander Graham Bell received an offer from the Boston Board of Education to teach at Clarke. Bell was a skilled teacher of "visible language", but he was an inventor by nature. By this time he had come to believe that telegraphy was only one step into a wider technological world. Fortunately, his work with one of his pupils at the Clarke School, Georgie Sanders, brought him to the attention of the boy's father, Thomas Sanders. Thomas offered to let Bell stay with the Sanders family in Salem where Bell would be given the use of the Sanders' basement as a lab for experimentation.

In addition to association with Thomas Sanders, Bell became close with another student, Mabel Hubbard. The two would eventually get married, but their relationship brought Bell to the attention of none other than Gardiner Hubbard. Both Sanders and Hubbard recognized something in Bell. By 1874, Hubbard had traveled to Washington to conduct a patent search for any similar inventions to the musical/harmonic telegraph that Bell had designed.

Having been satisfied with his efforts and with the potential in Bell, Hubbard and Sanders agreed to finance Bell's inventive process. On February 27, 1875, the three formed the Bell Patent Association. In return for equal shares of any successful patents, Hubbard and Sanders would provide everything Bell needed to bring communication advancement to fruition. That included moving from the Sanders basement to renting a room from Charles Williams, an electrical engineer and manufacturer. It also meant Bell could hire a young repair mechanic, Thomas Watson.

By March 1875, Bell had made a prototype of a "harmonic telegraph" and traveled to Washington to consult with patent attorneys. In June of that year, he and Watson had stumbled upon a further breakthrough - trying to repair a screw holding a wire in their harmonic telegraph assembly, Watson tightened it too much and produced a "twang" that Bell heard through the device. From that point, Bell was convinced that he could send full audio, even voices, over wires.

Not long after the famous scene played out where he reportedly called, "Mr. Watson, come here. I want to see you.", Alexander Graham Bell on February 14, 1876, applied for a patent for his new telephone (only hours before the attorney for another inventor, Elisha Gray, filed for a similar device). On March 7, 1876, the US Patent Office registered patent #174,465, often called the most valuable patent ever issued.

As valuable as that patent may have turned out to be, it did not lead directly to wealth. There were patent battles to be fought, and a brand new industry to finance largely from scratch. On the opposing side of the patent battle was Western Union, armed with patents from such luminaries as Thomas Edison, and including Elisha Gray. There was some irony here to the dispute, particularly since Hubbard actually offered to sell the Bell patent to Western Union not long after its issue. Legend has it that William Orton, president of Western Union, dismissed the device as a mere "toy" (other forms of the story are more believable, in that Orton was far more confident that his patents would eventually hold up and the Bell device would be worthless, and thus not worth payment).

On the business side, Hubbard became the business promoter while Sanders its treasurer. Bell, the device's inventory, was merely "chief electrician". On July 9, 1877, the three principal members of the Bell Patent Association formed the Bell Telephone Company of Massachusetts. At the time there were only 778 telephones in existence, and all of them were being made in Charles Williams' shop, one at a time.

Thomas Sanders is reported to have said that he sunk $100,000 of his own money into Bell before ever seeing a single dollar returned. There were the patent defense costs and the need to purchase inventory and manufacturing capabilities. By late 1877, the company was desperate for financial resources. They turned to a new business strategy of granting exclusive rights to the technology in exchange for royalty payments. They also reorganized and brought in outside shareholders, infusing the company with much needed funds. The new name was American Bell.

On March 3, 1885, American Bell formed American Telephone and Telegraph (AT&T) as a subsidiary to drive the growth of inter-network service, or what became known as long distance. After having won court cases against Western Union, AT&T and Bell were an unchallenged monopoly, licensing out telephones to local exchanges all over the country. The business growth and royalty model financed the innovation into network and inter-network expansion.

AT&T had upgraded capacity to allow it to reach from New York to Chicago by 1892. With the invention of loading coals, the network's capabilities stretched 2,000 miles, followed by the invention of vacuum tube amplifiers (repeaters). With the adoption of repeaters, there was no physical limitation to telephone service - and by 1915 AT&T had established transcontinental telephone service.

Bell's original patents had lost exclusivity in the 1890's, with the second of his "valuable" patents coming off protection in 1894. Between 1894 and 1904, 6,000 telephone companies were formed to challenge AT&T (AT&T took over the parent company, American Bell, in 1899, itself becoming the parent company of the Bell Telephone System). It did not matter because AT&T had by then established the network innovations and engineering needed to maintain its dominance. The small telephone exchanges and companies could wire new ground, expanding into towns and villages that AT&T could not profitably on its own, but all that did was expand the potential client base for AT&T's network service. It was so successful that even competition was a net gain.

One innovative idea and patent sprung into many others, combined with business acumen and some legal luck, creating entirely new industries while advancing the economic course of the United States and the world. The network advances here in the 19th century would form the backbone of what became the internet revolution a century later (after having undergone a full-blown monopoly phase owing to telephone technology in the 1910's and 1920's, but that's another story).

It is easy to see the enticement of monetary engineering in these types of cases. While all the different pieces aligned and fell into place for Bell and his partners, there was no guarantee at any point that they were going to succeed; indeed the endeavor was fraught with tremendous risk at nearly every step. Western Union itself spent countless sums trying to assure Bell's corporate demise (including stories of Western Union "sympathizers" cutting Bell wires if needed). If Western Union had won that battle, there is no way to tell how innovation and economic advancement might have turned out - perhaps Western Union would have buried the telephone in its technology portfolio to better profit from its extensive telegraph investments. We simply don't know.

I would like to think that even if Western Union had tried to bury the telephone, the market desire and innovative spirit would have forced their hand at some point. But in that counterfactual, it is tempting to see why there is this modern appeal to debt and credit stimulation. With a steady supply of cheap "capital", the Bell Patent Association, it is assumed, never really struggles to succeed since they are not so reliant on the accumulated savings of only Thomas Sanders.

But that confuses the case to a great degree. In that historical arrangement, Alexander Graham Bell's innovation and potential is the "capital"; Sanders and Hubbard's cumulative savings only provide the finance or "money" to realize true capital formation. Hubbard and Sanders themselves are the intermediaries of their own savings.

It is true intermediation that makes this entire capital/money system work, efficiently creating economic progress and expansion. Hubbard and Sanders could have invested in any number of projects and/or securities, but there existed at that time limited outlets for private speculation. The only real alternatives for these two investors/intermediaries were stocks and bonds, both of which served as a means to obtain financial income (not speculative appreciation), or bank liabilities. To get rich required the creation of actual capital from the "ground floor". You had to build a real business, not scalp asset inflation from the churn of dollar debasement.

Had the current financialization of today existed then, Hubbard and Sanders may not have gone to the trouble, the countless hours of toil and effort, and risk of losing everything on an uncertain technology under such dangerous legal and business pressures. It may have been easier just to buy some Western Union stock and watch it double every few years (until it inevitably crashed and then repeated the process once monetary "stimulation" was applied). Western Union was, after all, one of the original eleven Dow stocks and owned quite the technology portfolio and prowess.

The monetary system that had existed in that time, one that valued scarcity, was closely aligned with the real economy - by design. Wealth was earned, not traded. If innovation is the only real means for financial gain, then the profit motive of everyone is moving in that same direction. The addition of so much finance and cheap money only serves to reduce and weaken the link between profits and intermediation directed to the real economy and modernization.

Central banks in the late 20th and early 21st centuries sought to replicate that earlier innovative process by substituting money and cheap debt for capital. Instead of creating a million Hubbards and Sanders to unlock an equal number of Alexander Graham Bells, they instead pulled the intermediaries into the web of finance through the allure of asset inflation. Creating new technology was far too difficult and risky compared to securitization and leverage. Dollar debasement is the new "capital", and I don't find it coincidental that the age of financialization has corresponded with a lack of truly revolutionary innovation. Far too many Hubbards and Sanders turned to day trading and real estate flipping, while banks became hedge funds and government-driven rent-seekers. Speculators themselves went from the foundation of capital innovation to being branded "evil" as they endlessly trade paper back and forth (well at least only when they speculate on oil and energy; stock speculation is still afforded a "heavenly" place).

In far too many stories like this of innovation and advancement, there is almost always a close relationship between intermediation and capital formation for it to be just a random accident of divine intervention. By that I mean that true intermediation is not remote, it is driven by close connections between humans. Hubbard and Sanders saw something in Bell that caused them to take tremendous risk with their own personal "capital", something that likely never would have happened if the Bell Patent Association was just some random SME (to borrow the ECB's terminology) applying for a bank loan to be securitized into a collateralized ABS scheme.

Modern finance and cheap credit are made for mass production and remoteness. There is no intermediation because intermediation is not the goal - volume and flow are. We have been monetarized and standardized into homogenous "capital", the antithesis of capitalism itself. The emergence of the banking cartel, through the Federal Reserve's actions and policies in close relationship with the government, means that money and debt are more and more remote. Even among the smaller banks where relationships can still matter greatly, deposits and money flow upward toward the behemoths (small banks cannot compete in size, volume or leverage, so they turn their liabilities into assets of other, larger banks, funneling money up the size scale). Smaller financial institutions in this system are nothing more than liability conduits, not the seeds of loan and capital growth.

Of course, the dependence on counterfactuals here can render this all unpersuasive. There is no real way to tell one way or the other how the system would have performed in the 19th century under the thumb of monetarism - just as we will never know if we could have uncovered a new revolutionary economic age of prosperity free of asset bubbles. But in the context of a global economic system that cannot grow despite unimaginable "stimulation", as if all of that money was just chasing other money instead of the next AT&T, it makes some good measure of sense to consider how changing money and capital may change the nature of economic circumstances in a very big picture sense.

With that in mind, it is far easier to see that there can exist a time when asset prices skyrocket, but there are no jobs and no meaningful economic advancement. It is nothing more than dollar debasement/inflation by other means - opportunity cost.

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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