300 years of money printing - How countries dispose of their debts

In our October 2020 Capital Market Outlook, we examined the sinister role of the state in the biggest equity crashes of the last 30 years. Government incentives were used to trigger bad private investments in order to disguise minor economic or political inconveniences compared to today. Investment controls, such as those currently being initiated against the backdrop of the fight against global warming, initially triggered high increases in share or real estate prices with far less noble motives (shares and real estate in Japan 1985-1989, real estate in East Germany 1990-1994, technology and telecom shares, particularly in the USA until 2000, and US subprime real estate loans until 2006).

The problems were almost ridiculous compared to today:

• Disadvantages for Japanese export companies due to a high exchange rate enforced by the USA (1985-1989)
• dilapidated real estate in East Germany, which private investors were encouraged to renovate with tax benefits in order to convince East German voters of the qualities of the Kohl government with chic city centers (successfully, the CDU won the election in 1994)
• Government authorization of accounting tricks in the years up to 2000, with which technology companies in particular were able to polish up their profits in order to prevent a sell-off of these already then last icons of the US economy to the Japanese and Europeans
• Falling real wages of the US lower class, who were to be given easier access to real estate loans. With the help of government-sanctioned embellished ratings for these loans to financially weak borrowers, four-digit billion sums were collected to finance these "subprime" loans at home and abroad.

In all cases, a brief pseudo-boom was followed by many years of weakness in the economy as a whole, which could only be countered by government support for the economy and new government debt. After the subprime crisis from 2008, the new government debt necessary to support the economy had to be secured for the first time by printing money and buying government bonds in order to prevent rising interest rates.

We are now facing much bigger problems, not just in individual countries, but worldwide:

• Weak demographics and thus structurally growing government deficits for financing pensions
• Hardly any productivity growth left, even in China
• Unemployment and collapse of some sectors (tourism, gastronomy, culture) due to corona
• Global warming, which requires huge sums of money to be invested in mitigating it
• And to top it all off, historically unprecedented global debt (government, companies, private households, financial sector). According to the latest figures (International Monetary Fund IMF, Bank for International Settlements BIS, source: Daniel Stelter, bto, Nov. 2020), this amounted to a massive USD 272,000 billion or 362% of global national income in the third quarter of 2020. In developed countries, the figure is as high as 432%.

You probably already know our (long-standing) assessment that the enormous debt will by no means lead to an imminent collapse of the capital markets. After all, from February 2020, governments once again took advantage of the central banks' ability to create unlimited amounts of money, indirectly borrowed huge amounts from the central bank and pumped the money into the reeling economy. Despite new mountains of debt, the central banks bought so many bonds with the freshly printed money that interest rates were able to fall even further, as you can see below using the example of the USA.

When government debt is high (1946 and from 2008), the government and central bank put massive pressure on interest rates so that the government and private debtors remain solvent. In 2020, however, unlike in 1946, there is not just one huge problem (world war), but many more in addition to corona

Our long-term positive assessment of real assets such as equities, investment funds, (residential) real estate and gold is based on the assumption that the extremely low interest rates will increasingly force even risk-averse investors into these riskier forms of investment.

To back up this thesis, this time we have taken a look at the financial history of the last 300 years and found several cases in which individual states, just like almost all states today, got into major financial difficulties that could no longer actually be resolved - mostly due to expensive wars, but sometimes also quite modern due to wasteful mismanagement. As we will see, even then politicians supported the same ideas as today, namely a strong expansion of the circulation of banknotes without any cover, e.g. through precious metals. This was then used to buy up government debt and devalue it in the subsequent inflation. Then as now, investors' confidence in the stable value of all this fresh money was kept alive for as long as possible. The same consequences for the capital markets underpin our above-mentioned expectation.

Due to the costs of the War of the Spanish Succession (1701 to 1714), France, which was also burdened by the absurdly high court maintenance costs of the "Sun King" Louis XIV, had accumulated an enormous national debt, namely around 20 times the total state revenue. The interest on this debt (averaging around 4%) ate up well over half of the state's revenue, meaning that ever higher deficits had to be financed at rising interest rates; bankruptcy was foreseeable. Lawsuits against tax collectors, who were accused of corruption and embezzlement, brought no significant relief. From 1716, a Scotsman named John Law of Lauriston, who had become rich through inheritance and gambling, appeared on the scene. He was not only charming and handsome, but also highly gifted in mathematics and was therefore able to calculate the probability of victory better than his fellow players. He had made a name for himself with the new French ruler, the Duke of Orléans, through intensive networking, but also through a proposal to stimulate the economy by issuing banknotes, which is still rightly praised today. He obtained a state license for a bank (Banque Générale), which was allowed to issue banknotes for the first time in France. His quite innovative insight was that these were easier to multiply and could circulate faster than the eternally scarce precious metal, the usual basis of currencies at the time. Banknotes thus appeared to be much better suited to financing trade and production to promote growth than coins made of precious metal. John Law can certainly be compared to Ben Bernanke, the head of the US Federal Reserve during the 2008 financial crisis. After the Lehman bankruptcy, he drew on his earlier research into the Great Depression of 1929 to 1932 and had money printed on a massive scale. The economy and the financial system recovered much faster in the USA than in the eurozone, where it was not until 2011 that it was realized that the problems of an over-indebted economy could no longer be solved without printing money. It was not until 2012 that Mario Draghi, then head of the European Central Bank, helped John Law's ideas, which were fundamentally correct in such a situation, to achieve a breakthrough.

John Law became head of the French "central bank" almost 300 years earlier because he was immediately successful thanks to three good ideas

The banknotes of John Law's Banque Générale were readily accepted because they could be exchanged for a fixed amount of precious metal at any time and because the tax authorities accepted them for tax payments; they became legal tender. This was the first brilliant idea, because shortly before, the government had reduced the precious metal content of its coins by 30%, the usual form of money multiplication and thus currency devaluation since the Roman Emperor Nero. Banknotes thus appeared to be more attractive than coins. The fact that more banknotes were issued from the outset than there was precious metal cover was not noticed by investors for the time being - today, fortunately, they no longer know from central banks and governments that money once had a certain amount of cover (in the form of precious metals). The second idea of the not at all stingy Scotsman was to use the banknotes to pay for current government spending (in 2020, central banks are also effectively financing governments directly by rapidly buying up new government bonds due to the coronavirus, which comes very, very close to the alleged ban on the direct assumption of government spending). The purchase of existing government bonds of the almost bankrupt state was also part of the business model and brought more banknotes into circulation, which the sellers received. In this way, John Law noticeably eased the government's financial problems and the economy also revived in view of the increased money in circulation. The state now took over the successful bank, which changed its name to "Banque Royale" and thus effectively became the central bank. However, as only a small part of the national debt had been bought up to that point, John Law expanded the business model. The permanent printing of banknotes would at some point have raised the question of whether the notes were backed by precious metals and thus whether they retained their value. So he founded - the third idea - the Compagnie d'Occident, which received the state license to exploit the gold treasures suspected - without any basis - in Louisiana. The prospect of mountains of gold from the then French colony was fueled by paid journalists and aroused the interest of small investors. To get their money, the company's capital, which was already enormous when it was founded, was divided into 200,000 shares at just 500 livre; Banque Générale shares had cost 5,000 livre when they were first issued. Within a few months, the share price rose 20-fold (see chart below) and the company's capital was massively increased by issuing new shares at ever higher prices.

With the prospect of huge gold deposits in Louisiana (at that time almost half the area of the future USA), the share price exploded, which was used for such high capital increases that the company was able to buy up a large part of France's national debt

The Compagnie d'Occident invested a very small part of this windfall in further trading rights and in the development of Louisiana. Most of the money went into buying more government bonds. This was very sensible in that it solved the national debt problems and no gold was found in Louisiana. The only thing the soil yielded was black stinking mud, which could only be used 150 years later - now called oil. In February 1720, the Compagnie d'Occident then took over the state "central bank" Banque Royale. This meant that the government's debt was now largely owned by the government's own "central bank" (as in Japan, the USA and the eurozone today), and investors held insubstantial shares in the Compagnie d'Occident instead. The whole of France and many wealthy foreigners speculated in the paper and the word millionaire was invented. As the chart above shows, the problems began when the share price stopped rising. The first disappointed settlers had returned from Louisiana and reported all kinds of difficulties, but not gold. Investors began to sell. To halt the fall in the share price, John Law issued masses of new banknotes and bought back shares. This stabilized the price for a few months, but now more and more investors wanted out. The savings capital of the French, which had originally been invested in government bonds, had first been converted into Compagnie d'Occident shares, which never had any substance worth mentioning but only achieved temporary price gains, and then into banknotes without cover. The money supply had therefore exploded and people suddenly wanted to invest the proceeds from the sale of shares in a way that would retain their value. As a result, the prices of many tangible assets rose sharply, e.g. real estate prices quadrupled. Consumer goods prices also multiplied (fuel by a factor of two, candles and coffee by a factor of around 30). In order to at least make it more difficult for savings capital to flee into precious metals, their possession and even the wearing of jewelry was banned. However, this could not prevent the collapse of the Compagnie d'Occident shares.

The following chart from a study of 57 hyperinflations over the last 150 years shows that this sudden flight into tangible assets and consumer goods was the actual trigger for all inflation, after years of increases in the money supply had only moderately driven up inflation rates.

After three (six) years of 41% (19%) annual money supply growth, prices in Poland (Hungary) rose by 33% (14%) p.a. in the 1920s, then the next year inflation exploded to 636% (85%)

Now let's compare this 300-year-old story with the current situation

The two world wars had left most European countries, Japan and the USA in almost insoluble financial difficulties, comparable to those in France in the early 18th century. All countries had to introduce paper money to prevent national bankruptcy. After 1945, John Law's first idea was adopted everywhere and currencies were pegged to the US dollar, which still had a certain amount of gold backing; $35 could be exchanged for an ounce of gold at any time. In addition, the banknotes issued by the respective central banks were considered legal tender. Just as in France at the time, savers did not realize that the Americans in particular were issuing far more banknotes from the 1960s onwards than there was precious metal cover, mainly because of the Vietnam War. The French were the first to try to exchange US dollars for gold bars. The then US President Nixon then stopped the delivery of gold. Gold backing was then abandoned worldwide in 1973. However, the fiction of the value stability of paper currencies could be maintained for years, as the economy generated high tax revenues due to a growing workforce and high productivity increases and government spending for social purposes, particularly pension payments, was still relatively low. By 1980, government debt had fallen sharply relative to national income, e.g. in the USA from 120% to less than 35% of national income.

John Law's second idea of printing money to buy government bonds was also cleverly implemented indirectly, with central banks (until 2008) not buying their own government's bonds, but those of other governments. If a country's currency fell too sharply, the other countries saw their export industry at risk and their central banks stabilized the weak currency by buying foreign currency with freshly printed money. This is how the high foreign exchange reserves of the Bundesbank, the Japanese and later the Chinese came about, which were invested in government bonds of the supported currencies and thus stabilized their exchange rates. Central banks only started buying their own government bonds on a large scale from 2008, when financial stability had already been severely damaged by the financial crisis, and then on an even larger scale in 2020 due to the coronavirus crisis. The so-called Modern Monetary Theory, which is supported by parts of the Democrats of US election winner Joe Biden, calls for the direct financing of government spending by the central bank. John Law had already done this 300 years ago with his Banque Royale. In fact, all major central banks have been doing the same since the coronavirus crisis.

The third idea of the ingenious Scotsman (this is not meant ironically!) was also implemented in a more refined form. Unlike back then, the states did not set up companies themselves, in whose shares investors were to speculate eagerly instead of thinking about the value of the large amounts of fresh money. Instead, the money from private investors (Eastern real estate boom 1991 to 1994, technology share boom until 2000), companies (Japan boom until 1989) and banks, insurance companies and pension funds (subprime boom until 2006) was channeled into speculative investments with massive incentives. This meant that the problems, which were small in comparison to today, could be resolved without straining the state's finances, although not without considerable losses for investors who had fallen for the state's tricks. However, the most effective legal regulation was directly comparable to the government bond purchases of the Compagnie d'Occident, which used the high share prices to increase capital and used the proceeds to buy up further government bonds. Government bonds - even those from Greece or Italy - were declared by law to be completely default-proof. Since then, banks and insurance companies have been allowed to buy such bonds without limit and finance them with huge amounts of investors' savings and other bank deposits. They do this because they can rely on the central banks to buy their government bonds when they need money. This is the only way that government bonds are actually safe. These purchases caused bond prices to rise so incredibly high that yields fell below zero - even before the coronavirus crisis began. Governments were once again able to run up huge debts in 2020 and interest rates fell even lower (in the US from 1.9% at the start of 2020 to 0.9% currently, in Germany from -0.2% to -0.6%) because central banks were buying and investors continued to increase their savings deposits with banks due to the coronavirus, enabling them to buy more bonds. The rising share prices of the actually insubstantial Compagnie d'Occident, which bought even more government bonds via capital increases at rising prices and did not invest in the development of Louisiana, had a similar effect at the time. When Deutsche Bank amassed assets of €2,000 billion (with only €40 billion in equity) during the 2008 financial crisis, 4% of the assets were loans to companies - the actual purpose of the banking business; 96% were used for speculation, including with government bonds. The Compagnie d'Occident's balance sheet probably looked similar.

These astonishing parallels show how little innovation both politics and finance have seen since then. A contemporary of John Law's, the blacksmith and mine owner Thomas Newcomen, developed an extremely primitive first form of steam engine over 300 years ago - it used 75% of the hard coal that could be extracted in English mines from 1712 onwards thanks to its pumping power when the water came in. However, with its cylinder, which turned the steam generated by the coal into a very useful powerful pump, it was absolutely innovative and revolutionary at the time, just like John Law's financial system. To this day, engineers have not only turned it into highly efficient combustion engines for cars, trucks and power generators. Electric motors, steam, diesel and electric locomotives, airplanes and infinitely more have also been developed on this basis since then. The only innovation of today's financial policymakers compared to John Law was that after the gold backing of the currency was abolished in 1973, they used freshly printed money to buy up the bonds of other governments rather than their own (see above), until this fig leaf was also dropped in 2008.

Since politicians and bankers have obviously been using the same tricks for three centuries and investors are falling for them, we can confidently draw the conclusion mentioned at the beginning that the phase of massive purchases of government bonds will be followed by a boom in real assets (which has already begun in the technology sector, see the chart below) and then increased inflation in consumer goods prices.

Here we see the best investment of each of the last five decades since the beginning of the 1970s, when the gold backing of currencies was finally abolished. The squares of the same color show where the price decline ended after the end of the boom; in each case, the former top investment was particularly weak for years. The decade since 2010 has produced two only seemingly different winners: the major technology stocks from the US, but also from China (Tencent, Alibaba), as well as many smaller stocks, including European stocks and Bitcoin. Both were swept up by admiration for new, complex technology. Bitcoin has the added attraction of exoticism and rarity, comparable only to the famous tulip mania in Holland until February 1637. At that time, tulips were simply rare, colorful flowers. For some reason, prices began to rise and soon the whole of Holland was speculating on the bulbs, which at their peak were worth as much per piece as an Amsterdam merchant's house. Today, Bitcoin (current price $18,000) is worth no more than a tulip bulb (after 1637, mind you); like the tulip, it can be multiplied at will and, just like back then, an extensive service and advertising industry has established itself around the tulip. Bitcoin fans will object that, for technological reasons, there can only be a maximum of 21 million Bitcoins and therefore they cannot be multiplied indefinitely. Unfortunately, however, thousands of other so-called cryptocurrencies have been created since its invention; there can be no question of scarcity. Moreover, central banks are now planning to introduce such currencies and will provide legal and stable-value competition to Bitcoin, which is actually only suitable for criminal purposes such as money laundering, capital flight or tax evasion. Politicians will not allow privately produced money such as Bitcoin to steal the opportunities to solve financial problems with paper money. Just as the tulip is now a sought-after export for the Dutch economy, blockchain technology, the technical basis of Bitcoin, will increasingly be used for useful purposes and will therefore certainly survive - Bitcoin, which consumes huge amounts of energy, will find this difficult to achieve.

Finally, in view of the growing practical relevance, it remains to be clarified what could happen if government bonds were not only bought up by a central bank, but also canceled. This is exactly what the ECB is increasingly calling for in Italy, for example, and will probably even carry out in the next crisis. The central banks of Switzerland and the UK have already declared debt cancellation feasible after the financial crisis, as a central bank can never go bankrupt. The appropriate comparison in history this time is a war that was won, namely the Franco-Prussian War from 1870 to 1871. The victorious German states led by Prussia received a lavish compensation of 5 billion gold francs from the loser. The good Germans had the supposedly good idea of using it to repay all their national debts immediately. Suddenly, the government bond, which was already beloved by industrious German savers at the time, was no longer available, but rather high account balances. The ensuing investment crisis was mercilessly exploited by resourceful financial professionals; there was a huge mass of often fraudulent share issues - today we would call them start-ups and IPOs, as the next chart shows:

After the victory, numerous new stock corporations, many of them fraudulent, were founded for the euphoric investors. The slump in share prices from the fall of 1873 was followed by a long slump on the stock market and in the economy. The state did not help at the time.

Even if it is not the central bank but, as in this case, the government itself that buys back its government bonds with precious metal-backed money and thus cancels them, the described boom in tangible assets occurs; share prices in the new German Empire rose by over 60% in two years, only to collapse by over 50%.

A (small) selection of other examples of money printing, asset booms and inflation are the first years after the French Revolution in 1789 or the hyperinflation of the Weimar Republic in 1923.

In our Capital Market Outlook in June 2020, we explained that many conditions are currently in place for higher inflation rates to emerge:

• High debt due to mismanagement
• Technical ability to produce any amount of money, perhaps even through central bank cryptocurrencies in the future
• De facto dependence of central banks on their governments
• Increased regulation of the economy
• Demographically induced global decline in the share of the labor force in the total population
• Populism (this factor has since been weakened by the departure of Trump and the self-inflicted problems of Erdogan and Boris Johnson)

We have now shown that 300 years ago, a financially strapped government used the opportunity to create paper money and ultimately make some of its debts disappear in a flood of paper money. This has been done successfully (for the state, not for savers) ever since. There are numerous parallels to the way politicians operate today.

We therefore continue to assume that inflation rates and asset prices will rise again in a few years' time.