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Tuesday, 31 March 2009

Going Dutch, The Benefits of Sound Money

Dutch Cunning

In the second half of the seventeenth century the tiny Dutch Republic was besieged by all of the great nations of the time. Yet, despite being continually faced with invasion by Spain and France and naval blockade by England, the Hollanders survived and prospered aided by a cunning and thoroughly deceitful strategy.

They always paid their debts.

Money is the Main Commodity

Of all the commodities that a country may possess the most valuable, by far, is money. Money is freely convertible into “stuff” – goods, raw materials, services, maraudering mercenaries and so forth. It’s much more valuable than any of the “stuff” itself. So the more money a government can raise the wealthier the country.

By and large the amount of money a country can borrow is dependent on its creditworthiness. The better this is the lower the interest rate lenders will charge it and the more money it can raise for a given, fixed income. Which leads us to conclude that the moneylenders of the Middle Ages had decided that tiny, poor, besieged Holland was a better credit risk than the much larger economies attacking it. Either the medieval merchant banking community’s risk assessment skills were on a par with those of our own credit rating agencies or they knew something that’s not obviously apparent.

Medieval Credit Ratings

The moneylenders had quite a lot to lose by getting their lending wrong. Ears, noses, fingers and, ahem, other things not mentionable on a family blog. Plus all their money of course.

Moreover they had lots of adverse experience in lending to governments which, at the time, usually meant a King of some kind. Various Spanish rulers defaulted on their debt thirteen times between 1557 and 1696. The French were creditable runners up with twelve defaults between 1559 and 1797. British monarchs trailed in a disappointing third with only a handful of defaults, although Edward III, in the 1340's, managed to take out most of the European banking system in one fell swoop.

Expensive Habits

The Kings’ problem was that they had expensive habits and no regular income. Their main hobby was invading other countries on some pretext such as their cousin’s uncle had once slept with their nanny which, obviously, meant they were the rightful leader of the nation next door. Mounting invasions and defending against them was expensive what with all the weapons, travel insurance and suchlike.

Revenues, on the other hand, were sporadic. Income taxes were unknown largely on account of the fact that the majority of people had no income. Other taxes were difficult to raise and unreliable in their frequency. Monarchs often resorted to selling monopolies or outright robbery and when those methods failed they just defaulted. Understandably moneylenders were wary of lending to their rulers but were often persuaded by a phalanx of torturers whose techniques would make many modern governments proud. So instead of refusing to lend they simply racked up the interest rates.

The same equation that applies today applied then – higher risk required higher rates of return and untrustworthy Kings were about as high a risk as you could get. Especially as they kept charging off on crusades and wars to foreign parts and having people fire arrows and stuff at them. Medieval life insurance was rubbish as well.

Feudalism – Poverty for All

At root the problem for the Kings was one of their own making. They sat atop the feudal system, a vast pyramid of privilege in which all power and land derived from the monarch, passing down to local landowners who controlled the peasants tending the land under conditions of virtual slavery.

These people worked the land for their lords, worked their own land to give themselves enough to eat, paid taxes in agricultural produce to the King and were tithed on their own produce by the Church upon pain of eternal damnation. To be frank, there wasn’t much opportunity for the average serf to make much of their lives, let alone produce extra revenue for their cash strapped, war-mongering monarchs. Most people lived lives of quiet desperation and died before they reached forty.

Rulers were caught on the horns of a dilemma. On one hand they needed money, and lots of it, to go to war. On the other they had no regular income to pay off their debts. The obvious solution – don’t go to war – was largely eschewed in much the same way a modern CEO refuses to chase takeover targets. Neither Kings nor CEO’s lack for animal spirits. With lots of calls for their cash and no visible income streams, Kings frequently ran out of money and repudiated their debts. The moneylenders jacked their rates up, making it harder for the monarchs to afford their debts. So the vicious circle continued.

A North Sea Takeover

Meanwhile, over in Holland something strange was happening. The Dutch had found a way of growing their nation. Literally.

Aided by advances in windmill technology, dyke building and canal creation the Dutch were reclaiming land from the North Sea, the so called polders – a land of fabulous agricultural wealth. The polders had another attribute that was to cause a revolution in monetary history: no one owned the land apart from the men who reclaimed it.

This land was not controlled by a feudal lord and the men who did own it had every reason to work it as hard as possible because they gained fully the fruit of their labours. The Dutch freemen of the polders were, moreover, willing to pay taxes to maintain defences against both Spain and the sea. The Dutch, uniquely, had a regular source of tax revenue to pledge against their debts.

1689 and All That

As moneylenders realised that Holland was good for its debts money flooded in and interest rates plummeted. The Dutch borrowed at half the rate of the Spanish, bought mercenaries to defend themselves and established a navy capable of reaching across the world. They created trade networks that made their ports the busiest the planet had ever seen. With cheap capital, an unrivalled transport network of canals, technical innovation and private, motivated ownership of land the Dutch kick-started the economic revolution that led to the modern world.

And in 1689 this revolution spread across the Channel when the tiny Dutch Republic conquered mighty England.

The Glorious Invasion

We English refer to this as the “Glorious Revolution” and are rather vague about the whole question of conquest. The reality of it is that William of Orange landed an army, marched on London, captured it and kept it under martial law for two years while King James ran away.

Accepted, this is only part of the story.

The march on London was more a gentle meander through the leafy swards of Southern England, stopping at various English country houses to enjoy tea and a small port before bedtime. William, whose wife was James’ Protestant daughter and next in line to the English throne, had been invited to “visit” by a bunch of Protestant English lords whose noses had been put out of joint by the aged Catholic King having an unexpected son and heir. In London William was met rapturously by a huge crowd of supporters, an experience only slightly tarnished by him missing the whole thing because he was doing the tourist thing around the art galleries.

Good Governance Means Good Credit

Still, it was a revolution which should never have happened. James had the best equipped fleet afloat, easily capable of destroying the Dutch invasion force. Or he would have, had it actually been afloat. Decades of work by his loyal Navy Secretary, Sam Pepys, was undone as the fleet was moored up because – guess what? Yep, the King had run out of money to pay his sailors.

The arrival of William in London led to a new constitution where tax raising powers were delegated to an elected Parliament stuffed with businessmen who liked to see their debts repaid. The introduction of Dutch monetary initiatives followed and as moneylenders realised that the English monarch was as good for his debts as the Dutch, English interest rates dropped precipitously.

Based on an economy four times larger than Holland’s it’s no exaggeration to suggest that the rise of the British Empire dates from these events, because in the years ahead the ability of the British to borrow twice as much as their opponents on the same income was to be crucial. Wars are won as much in the banks as on the battlefield. The soundness of British money was a major factor in the creation of a global empire and that empire foundered only when that soundness was finally undermined.

For all our sakes it’s a lesson that today’s world leaders might care to bear in mind in the years ahead.


Related Posts: Dear Auntie, Why Are My Bonds Bubbling?, The End of the Age of Retirement

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