Competition Is Necessary In All Areas, Including Money

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When William of Orange became King William III of England in 1689, he set the European world into upheaval. Deposing James II, William from Holland with his wife Mary sought to protect the realm from James' tendency toward Catholicism, especially the army. Known as the "Glorious Revolution", William's actions kicked off the Nine Years' War, once again pitting England in armed conflict with France. As James fled to Ireland to regroup and raise a Catholic army, Louis XIV of France anticipated a civil war in England and saw an opportunity to acquire Dutch territory in the Rhineland.

The ensuing conflict caused a shortage in England of, among other things, hollow ground swords and the craftsmen to make them. This particular kind of weapon was imported from France, largely being crafted by the Huguenots, at the time under severe persecution in the Catholic realm. In 1691, Sir Stephen Evance, a goldsmith, arranged for some Huguenot workers to be relocated to England in order to take up their domestic manufacture. To do so legally he chartered the Governor and Company for Making Hollow Sword Blades in England. As condition for the charter being granted, the company was to "loan" the English government £50,000.

That was the normal course of business in that age. A corporate charter was only granted with a money concession, but that conferred upon the company distinct rights, including monopoly rights. In the case of the Hollow Sword Company, they were granted sole rights to manufacture hollow ground swords, even to the point of being able to confiscate foreign imports (if they could find them). But more powerful and valuable than the monopoly, the Hollow Sword Company was granted the ability to acquire land and to issue an unlimited number of shares.

Those two seemingly extraneous abilities were central to the manufacture and finance of any industrious company, but were only granted to a small number of companies. At the time there were only an estimated 15 - 25 joint stock companies under charter in England. That number was set to grow robustly, however, as the needs of the Nine Years' War and the imprint of the Glorious Revolution put a financial strain into the Exchequer's coffers. It became clear to the politicians of the age that the growing desire for company-based commerce was creating an opportunity to unlock "value" vested into the King.

In 1694, the Bank of England was chartered and capitalized not as a central bank but as a private bank in the service of servicing the government's finances. William's government was finding itself unable to raise funds after a devastating naval defeat at Beachy Head at the hands of the French. Even offering a princely interest rate of 8%, the Exchequer remained unable to float the debt. So the Governor and Company of the Bank of England was chartered with the monopoly over the government's finances.

The bank would sell shares in the company to private investors, and then invest said capital as lent money to the government, performing a manner of equity-conversion in government debt. The government loan would pay that 8% which would be used to fund dividend payments to shareholders. The added incentive of the monopoly authority increased the perceived value of the shares. Not only would the bank act as the world's first "primary dealer", it was also given monopoly over issuing notes and currency (paper money).

The Bank obtained £1.2 million from 1,509 investors in about 12 days.

After the death of William in 1702, the Hollow Sword Company found itself increasingly unable to make hollow ground swords profitably. Evance committed suicide and the company was sold and moved to London. The sale itself was not intended as a means to continue to manufacture arms, but as the right to acquire property and issue shares retained some considerable worth.

After the defeat of James and the Jacobite army in 1691 in Ireland, William confiscated estates and territories in the Irish realm. This created an opportunity. The former maker of hollow ground swords became a financial concern by raising £200,000 in 1703 to purchase army debt attached to those confiscated properties. In essence, the Hollow Sword Company could issue shares to purchase the army debt, acquiring rights to the properties. Since the English government accepted its own debt as payment for the land (retiring the debt), the transaction of exchanging shares for an income stream (rental income from the land) turned the company into a financial firm.

Now as a landholder, the Hollow Sword Company branched into mortgages, deposits and even issuing currency (paper notes) in direct violation of the Bank of England's monopoly grant. The bank countered through political means of enforcing its charter. The government was in need of new funds, and the Bank of England was eager to help with a new subscription at a reduced interest rate.

The horses were out of the barn, so to speak, so the Bank of England's monopoly grew somewhat crowded, as the government began cashing in on the value of monopoly rights. It seems even governments understood the "value" in competition, even for financing itself. In 1711, The Governor and Company of Merchants of Great Britain, Trading to the South Sea and Other Parts of America, and for the Encouragement of Fishing was chartered with monopoly rights to trade to South America. Known colloquially as the South Sea Company, the charter again provided for this transcription of equity shares to be used to finance government debt positions. In many important ways, the monopoly trade rights were nothing more than a ruse.

At the time, the Exchequer was concerned about the ability to roll over about £9 million of loans and debt without any obvious means to do so. It had already obtained £1.2 million in financing in 1708 from extending the East India Company's charter, while at the same time getting cash advances from the Bank of England on shorter-term credit paper. To avoid a liquidity/rollover crisis, the government forced those individual lenders to exchange their debt for shares in the South Sea Company, where the government would pay 6%. The incentive to convert to shares was supposedly the potential value of the monopoly trade rights to South America.

By 1712, the South Sea Company had been joined to the Hollow Sword Blade Company as its banker (there were political rivalries, as you might expect, where the Bank of England was controlled mainly by Whigs, and the Tories in the South Sea/Hollow Sword side). With all these erstwhile trading companies and arms manufacturers in the employ of marketing government debt through conversion, there ended up three distinct pools of government financing systems - the private lenders, the Bank of England and the South Sea Company.

The development of this "primary dealer" network was fully possible only after the first issuance of permanent debt securities in 1693. The English government had created an annuity system that allowed for the trade and transfer of official public debt. These annuities were essentially permanent, a distinct break from the short-term nature of government credit before then. Even in the late 17th century did financiers understand the dangers of rollover risk, but since this annuity program was run exclusively by the Exchequer it was highly illiquid and often unwieldy.

The desire to expand the permanent debt facility was obvious and evident in the advantages to financing government. Liquidity would increase the depth and breadth of the subscription pool, so tying together these monopoly rights to what were really fundraising schemes was in some ways inevitable. The combination of monopoly powers that would add potential profit "value" to the debt exchange plus the potential for liquidity and appreciation in the debt to equity conversion meant an ability to reduce the cost of government financing. Both ends of the process win, and investors are given an alternate means of an interest-bearing and relatively safe store of value.

In 1714, the 6% cost of subscribing debt to the South Sea Company was proving even then too much of a burden, so the English government hit upon a scheme to create a permanent structure for the service of the various debt pools. By act of Parliament, the stated rate of interest on government debt was reduced to 5%, but the government still needed to induce the holders of 6% debt to convert.

Since there was some political unrest left over from the years of the Glorious Revolution and the intermittent Jacobite unrests, the Exchequer was directed to create three separate funds (one for each class of debt-owner) and direct the collection of specified taxes to first endow these funds for payment of interest. Any additional tax collections above the need for interest service would be used to reduce principal balances. The direction of taxation specifically to cover interest services made these funding vehicles a permanent source to government (and made the need to repay outstanding debt essentially moot).

Both the South Sea Company and the Bank of England created a liquidity backstop of about £42 million to purchase any 6% debt that did not convert. Their collective desire to increase the level of 5% debt was not related to the interest reduction nor really the creation of permanent tax facilities, they had both seen their share prices rise and were looking to capture more financing market share. That liquidity backstop proved unneeded as the 6% debt was fully tendered without issue.

The South Sea Company was in the midst of a speculative boom born from rather unreasonable expectations of profit from its area of monopoly. After the War of the Spanish Succession ended in 1713, the terms of trade from Spain, which controlled South America, were severely restricted, contrary to the rather optimistic initial expectations, and the South Sea Company was never able to make a profit from that trade. When another war with Spain came in 1717, officially declared in 1718, the Spanish confiscated all of the South Sea Company assets in their theater.

It mattered little to the stock as it went on to become the first massive bubble in recorded history. Without the trading profits as part of the "value" of company, South Sea simply turned itself back into a full-time banking concern. It began converting more annuities into shares, something in such high demand that share prices were well above debt conversion prices. The process became a positive feedback loop once share prices rose far enough - South Sea and the government both benefited from profits of any share sales at prices above par value. Therefore both had reason to keep the process moving along (including misleading and nefarious means).

First, South Sea began to directly compete with the Bank of England in subscribing government debt. Now given some scale and credibility as a debt dealer/convertor, the company used its political affiliations to undercut Bank of England bids on new debt issues. Second, by 1719 joint stock companies were forming to take advantage of the growing bubble. Concerned about the total capital subscriptions required to fund these new businesses, South Sea and its political benefactors pushed the Royal Exchange and London Assurance Corporate Act of 1719 through Parliament.

The law came to be known as the Bubble Act of 1720 (it was proposed in 1719 but passed in June 1720). It limited the creation of joint liability stock companies to just two, the maritime insurance companies denoted in the official 1719 title. By limiting competition for share capital, South Sea was guaranteeing its place as primary dealer to the English expansion of debt, and thus the continuation of this profitable exchange of debt into equity. Between 1719 and 1720, South Sea share prices doubled.

In almost every case at the time, valuations of share prices were not being driven, as they had initially, by profitability in potential trading zones (South Sea) or manufactures of specific goods (Hollow Swords) but on the various schemes to subscribe and transform government debt into a liquid, portable format. For South Sea and the English, it would end very badly as mania set in to drive share prices to £1,000 per share (10 times par value of the debt in hand). It was as typical as most asset bubbles, including the phase where South Sea began lending money to people to buy its own stock (those borrowers simply hoping a greater fool would immediately buy the shares from them at a higher price allowing for excess profits after the debt was retired - the house flippers of their day). And since the more government debt was issued, the more stock would be raised for conversion, there was a direct linkage between government borrowing and the mania phase.

The resulting collapse created widespread financial carnage across England. There was an investigation in Parliament, finding that fraud was committed by company directors, cabinet ministers and personnel in the government with a view toward keeping share prices artificially elevated. Eventually the company's stock, and its subscription/conversion powers, was divided between the East India Company and the Bank of England.

In 1691, before the first issuance of permanent debt securities, the English government owed about £3.1 million to private sources. That debt was always subject to rollover risk as there was no guarantee that private cash owners would continue to finance government operations. That was uniquely true in that time period since the political situation was far from assured, always, it seemed, fluctuating from one war or monarchical crisis to another. But given the dramatic transformation in the financing system that took place in the decades after, by 1750 the government owed about £78 million (with an estimated 93% permanently funded), and £101 million by 1760.

A 2,416% increase (5.5% compounded annually) in debt and credit is only possible where the goals and aspirations of the finance system and the government closely align. On its own, the English government of that age could never have funded so much liability, certainly not at a decreasing interest cost. In 1749, the government again reduced its borrowing cost to only 3%.

These types of indications are not unique in history; in fact we are well acquainted with the phenomena of fast rising government debt at increasingly lower interest costs. That is actually a staple of the 21st century. And it was likewise the product of financial innovation that brought about these coincident trends. But innovation in both periods was constrained by the monopoly given by the government in the arena of portable currency. Because of that constraint, innovation is inwardly focused solely on expanding the government's monopoly. The banks and the government's finances are intermingled directly and intentionally.

Any system with competing private currency or money would never end up with massive government expansion. There would simply be no need as government has no profitability function, and thus cannot compete with those systems (business arrangements) that successfully make money. Take away the monopoly and governments would be left solely with taxation as a means to financing.

Imagine a business that issued its own currency that attached interest payments based on its profit margins (there is no reason to suggest money cannot pay interest, the only barrier is legal). That would mean the better the business performed, the greater the interest paid to the money holder. Government would never be able to keep up - governments must always diminish interest costs. The attractiveness of government "investments" as "safe" and liquid stores of value would be massively reduced. The relative "value" proposition of money would shift completely toward the private sector, as the government would be forced to live within its taxation means.

Most of all, however, a private system of money would mean financial innovation would be directed outward toward benefiting the real economic system at large, not the narrowing confines of government financing (and accounting rules). Public monopolies of money will always benefit mostly the governments doing the monopolizing. That does not mean that society does not reap some benefit or "progress", but that any benefits are simply incidental. Nowhere is this more evident than those jurisdictions where government economic footprints are largest - made possible by the monopoly of money. Governments cannot compete, so they shut down competition at the point of a gun, growing unchecked by cowered or co-opted politicians (or outright fraud).

We should strive for competition in all things, including money. In a truly free society, it is the only way to maintain the people's power (money) over the increasingly remote political arena.

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

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