Support?

The king and the soldier

29 October 2017, translated from Dutch by the author, using DeepL and bilingual postediting.

Ancient times

Let’s go back in time, to the days when treasury and central bank could be considered one whole. The central bank was there to finance the plans of a monarch, a prince, a king, a duke or count, no matter what his exact title was. That’s how De Nederlandsche Bank started, founded in 1814 by King William I of the Netherlands. Much earlier, in 1694, the Bank of England was founded by another William of Orange.

Feudal monarchs probably did not have to pay much of their staff. The farmers who worked their land paid a tenancy, or a portion of the yield, and lived off the rest. The kitchen staff had board and lodging. But if a prince felt like he had to go to war, like yet another William of Orange in 1568, mercenaries were hired and had to be paid. Otherwise, they would rise in mutiny.

So I was wrong?

Now moving a little bit forward in history: if that sovereign, through his own Central Bank, had granted himself the monopoly to have banknotes printed and issue them, and he paid the soldiers with those banknotes, money would come into circulation that wasn’t there before, and the sovereign would pay with that for services. That is paying with money created from thin air, isn’t it?

Who was that again, who wrote that that isn’t possible, paying for something by means of money creation? That was me. So I was wrong, obviously. Or wasn’t I?

No, not really. Or really not, actually. That’s because those banknotes are IOUs, I owe you’s, they are acknowledgements of debt. The king or prince does not actually pay his soldiers, but promises to pay later. He pays with a promise, with a commitment. In fact, he is borrowing that money from the soldiers. But because people believe in the creditworthiness of the monarch, because they think he will be able to pay back, the banknotes are transferrable and the soldiers can pay others with them.

Hammering away at accounting

I do not know if William of Orange already paid a bookkeeper to keep records in a double-entry bookkeeping, complete with an audited annual report. But I think he should have. Suppose the mercenaries were paid first with coins. That assumes the prince should own such coins. Obtained through taxes, maybe by confiscating a gold or silver mine in some distant colony (well no, that was later in history), or by having silver robbed from some other colonial power (that too happened only later; but what matters now is principles and mechanisms).

Be that as it may, in the left column of the balance sheet were those precious metals and coins minted from them, as assets; on the right was equity or capital. Now when the prince paid his soldiers with silver or gold coins, that means those left the treasury. In a double-entry bookkeeping system, in any entry there must always be at least two items that balance each other. So the counterpart is a cost entry, also on the left, debit, but as an increase rather than a decrease.

So what we see is this: initially, before the soldiers have been paid:

Description Debit (assets) Credit (liabilities)
Gold and silver coins 10 000
Equity 10 000

Then the changes from paying the mercenaries – I don’t mention amounts here, but only indicate increases with plus signs, and decreases with minus signs:

Debit (assets) Credit (liabilities)
Treasury / central bank:
− Gold and silver coins
+ Costs of warfare

The stock of coins in the treasury decreases as a result of the payments. At the end of the financial year, proceeds (like from taxes) and costs must be booked to equity (the princely company does not distribute profits). Costs reduce equity. If costs exceed income, the company incurs losses.

So if war continues for a long time and income is low, both the general ledger account for coins in the treasury, and equity will eventually go to zero. The prince will go bankrupt.

Now the same story but involving banknotes, so with printed money created out of thin air. Can the monarch, thanks to this money creation, continue to wage war forever, for example for 80 years, for free? This too we can check, thanks to the utterly useful system of double-entry accounting.

The initial situation is the same as before. The changes in the accounts however are different:

Debit (assets) Credit (liabilities)
Treasury / central bank:
Gold and silver coins
Banknotes +
+ Costs of warfare

For clarity, I did mention the gold and silver coins again, but without a plus or minus. The coins remain available in the treasury. In fact, the prince does not pay. Instead, the prince promises that he will one day pay, by issuing banknotes which in fact are IOUs. Such promises have value and can be used as money, in the hands of others.

In terms of the costs of warfare, and their annual settlement with the company’s capital (equity), paying with banknotes is no different from paying with coins. Paying with coins eventually emptied the treasury’s vaults, in the absence of sufficient state income; paying with banknotes creates a liability that offsets the value of the coins. In both cases, equity will eventually reach zero, and with more expenditure, will become negative, which in fact means bankruptcy.

Measures

It will not really happen that a prince, a king, even an entire country, will go bankrupt. It is always possible to levy more tax. If at least there is a functioning economy, so that there is something to levy, and if there is an efficient tax collection system, and not too much tax evasion. All these points were a problem in the Greek debt crisis.

Another possibility is devaluation of the currency. The banknotes, which in the scenario I have outlined, grew to a value equal or greater than that of the available stock of precious metals, are then simply devalued by the state. That causes revaluation proceeds, which avert state bankruptcy. This is only possible if the state or sovereign does indeed have its own currency (the Greeks did not, they had and still have the euro).

Such devaluation of the currency is in fact a form of expropriation: it deprives the banknote holders of part of their claim on the monarch, which is simply a form of taxation. Just levying taxes is much clearer and fairer.

Conclusion

Paying through money creation is possible (other than I first stated), but it isn’t real payment. Instead it involves a promise to pay, so essentially: borrowing. More money means more debt for the issuer of that money. So I certainly was right after all. Money creation is not a panacea that allows a government to continue to impose too low taxes and spend too much money. Money creation increases public debt and is not a solution for the budget deficit.


Copyright © 2017 R. Harmsen. All rights reserved.

Colours: Neutral Weird No preference Reload screen