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JOHN Law was a professional gambler and a banker. In some ways, a great visionary, when given the opportunity to put his theories about public finance into practice in France, between 1716 – 1720, he created what historians call the Mississippi Bubble.
In much the same way as William Paterson’s Darien Scheme was intended to turn Scotland into a colonial power, Law’s plan was to expand the French colonies in the Mississippi delta, aiming to provide France with the means of extending its political influence into what is now the Midwest of the USA.
Issuing paper money for the first time in France, Law set up a scheme where his bank financed the purchase of the shares in his trading company. The shares soared in value as investors believed there would be almost infinite profits in the new colonies.
Failing to foresee fully the importance of retaining the trust of investors in his system, Law’s scheme failed. The Mississippi Company’s shares collapsed, and bank notes were withdrawn. For the next 80 years, France would use only gold and silver as currency. Law became bankrupt, fled to England, then moved to Venice, supporting himself by gambling.
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Economic historians continue to debate just how near Law came to succeeding with his plans for credit financed economic growth. His career is otherwise treated as a reminder of the extent to which governments need to be trusted in the management of the public finances.
So, to the reader who, in effect, asked how much public debt Scotland could issue after independence, I answer that while that depends to some extent on the government’s ability to make interest payments, the maximum feasible debt-to-income ratio is ultimately a question of the extent of public trust in government.
Not the trust of financiers. Not the trust of institutions like the IMF. Not even the trust of other governments. Simply the trust of the general population – and in a democracy, that means the voters who can turn rascals and incompetent fools out of power.
To that small group of readers who fear that Scotland after independence might conform to some neo-liberal orthodoxy, I simply assert that voters understand intuitively that sound public finances are necessary for a country to prosper. It is a foundation on which other schemes can build.
In practice, governments have three ways of financing their expenditure: they compel the public to pay taxes; they invite the public to lend them money; and they run up an overdraft with the central bank. Economists often describe the process of the central bank making payments on behalf of the government as ‘creating money.’ In general, when banks allow payments to be made by borrowing from them, this increases the amount of money circulating in the economy. Banks create money whenever they lend. There is nothing special about the government creating money by borrowing from the central bank.
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Governments seem to have an unlimited capacity to create money. The Bank of England, for example, cannot refuse a request from the UK Government to make payments on its behalf. But government should not necessarily use that capacity. As John Law found out, unlimited money creation can easily destroy public trust.
Governments in advanced economies are so large that how they manage the public finances affects the whole economy. When governments put up taxes such as VAT, the economy’s private sector will shrink – except for those parts benefitting from additional government spending.
When governments borrow, that puts upward pressure on interest rates. Private investment will fall, as it is crowded out by government spending. This can reduce future economic growth.
In comparison, monetary expansion seems relatively innocuous. It should allow private sector growth in the short run – as happened in the first three years of Law’s reforms of French public finances.
Remember that money is valuable because everyone agrees that it is valuable and we all use it to buy goods and services. Its value can easily change over time. When the value of money falls, prices increase – more money will be needed to buy the same basket of goods – and there is inflation in the economy.
When the government increases the money supply, the capacity of the economy to produce goods and services may not change. More money is used to buy the same quantity of goods and services.
Of course, suppliers of services may be able to meet that demand by using resources more efficiently. They might run machines for longer periods. They might hire more workers, reducing unemployment. They might reduce the quality of the inputs which they use.
With the government buying more goods and services, it could be that producers will be operating at full capacity and still not be able to meet all the demand which exists. Inflation is then a pressure valve. Prices need to rise to choke off the excess demand.
This matters because inflation can become a substantial source of uncertainty in the economy. Once it has emerged, it may not easily subside. Uncertainty about future inflation can lead to higher interest rates, making it more difficult for the government to borrow. Those higher interest rates can also reduce private investment, reducing the growth of the economy in future.
This is only part of the story. That additional government spending could increase the economy’s productive capacity. But that will have to wait until next week.
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