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August 20, 2009

Ruining Public Credit with Imaginary Money
by Adrian Ash

"Expect more 'imaginary money - with or without negative bank rates - often and soon..."

IT'S NOT OFTEN that Sweden gets to lead the world. Saab mimicked BMW. Ericsson improved on Motorola. Abba took The Carpenters and added a hi-hat.

In monetary matters, however, Sweden remains an occasional trail-blazer. The world's first central bank, beating even the Bank of England by 26 years, the Riksbank then copied the Old Lady by when it abandoned the Gold Standard in September 1931. But the Swedes chose to mimic Great Britain before anyone else, quitting the metal within two weeks of London's monetary bomb-blast.

That's why, according to academic consensus, Sweden recovered from the Great Depression before anyone else. (A more likely cause, we guess here at BullionVault, was the resulting 30% drop in the Krona, but economists hate publicly backing competitive devaluation today.) And Sweden really did break new ground in the Thirties by making an explicit rate of inflation its target - six decades before New Zealand, the UK, Eurozone and US caught up.

Inflation targeting wasn't the first or last time the Riksbank got ahead of its colleagues. But it did prove the least disastrous to date.

"A charge was drawn up against Goertz, who was accused of speculation, of having ruined public credit by imaginary money, of having formed a design to destroy the king..."

Thus relates a 19th century history of the first central banker ever to lose his head to an axe, rather than merely losing his head to some new tom-fool theory. Baron George Heinrich de Goertz, a successful minister in the early 18th century, was dumped into the Riksbank to fix more than 100 years of monetary madness.

Sadly for Goertz, his madness served to cap the whole show.

"He minted a representative currency in copper, validated with the king's head and a legal tender face value of a Daler," wrote Paul Tustain, director of BullionVault, on his popular Galmarley gold site back in 2004. "Goertz did not limit the issue, nor ensure the quality of the coins, which were beneath the technical capabilities of the day. Moreover, he attempted this exercise on behalf of an administration which had lost virtually all financial credit with its population, and compounded the error by allowing to develop a widely-held belief that at some unspecified time in the future, collectors would refuse the coins as legal tender payment of taxes.

"In other words he broke every rule in the central banker's book. The coins were detested, and sloshed around the Swedish economy depreciating rapidly"

Poor Goertz! His scheme collapsed with the death of his King and protector, Charles XII, in 1718. The new monarch - Charles' sister, Ulrica Elenora - abolished Goertz' paper money, and had his copper coins re-minted at something approaching their true commodity-price value. Forced to a show trial and denied counsel in court, he tried but failed to defend himself against execution, beheaded in front of a cheering crowd on 3rd March, 1719.

Just like today (as we'll see in a moment), such monetary madness was hardly unique at the time. Destroying public credit with imaginary money was also ruining both England and France, where John Blunt's South Sea Bubble and John Law's Mississippi Bubble would explode in due course in 1720. But just like 2009, the Riksbank was only just ahead of the game. Because the success of its thinking still clearly impresses today.

"The UK should follow the Swedish model," said ex-Bank of England policy-maker Charles Goodhart at a forum last week, "so that for commercial banks reserves held at the central bank of above, say 2%, they are charged 0.5% to hold their balances.

"This would then encourage the banks to buy short-dated gilts or commercial paper, increasing liquidity."

Simple, right? It's now six weeks since Sweden's central-bank governor, Lars Svensson - a great pal of Ben Bernanke's at Princeton - "broke the zero bound" on monetary policy. Yet the world still turns on its axis, despite the Riksbank knocking the interest paid to its commercial-bank users down below nothing, into a brave new world of negative rates.

Cash-hoarding in London is also more weighty at £161 billion ($264bn) than Sweden's own stock - now down 19% from SEK 48 million ($6.7m) just before the fateful decision. And like the US Fed's hoard of commercial bank cash, which rose 40 times over in 2008, the consensus view is that unused bank money is  "socially useless" to quote another former Old Lady, Willem Buiter of the Financial Times.

But there's way more at stake, we fear, if the US and UK choose to buck history and now follow the Swedes. Starting with the outright monetization of their government debt.

"There have been suggestions that the Bank of England could introduce negative interest rates on deposits to encourage the commercial banks to lend as the Swedes have done," says one London analyst, RBC Capital's Russell Jones

"This could also encourage banks to buy more short-term gilts."

As it was at the start of this month, the latest Bank of England policy-vote shocked the currency and bond markets by unleashing a fresh £50 billion of imaginary money for use in its Quantitative Easing. Analysts, investors and savers already fear it's simply funding state debt, passing the new cash straight to the government and walking us all straight to hyper-inflation. Yet today's release of the policy-team's minutes, however, showed the governor - one-time inflation hawk Mervyn King - actually voting for a still-greater injection of money from nowhere, hiking the Bank's total money creation to £200 billion.

That would been equal to half the entire government gilt market, and greater than this year's entire UK state deficit - currently forecast at £175bn, precisely where the Bank of England capped its money creation for now. Still deflation looms, Dr.King said this week, and still the Pound rises...back above $1.65 to the Dollar today.

If this central banker's scheme works, and he keeps his head until, say, the end of this year, how might the US Fed or ECB answer? On both sides of the Atlantic, and all across Europe we guess, expect more "imaginary money" - with or without negative bank rates - often and soon.

Adrian Ash
BullionVault.com

Head of research at BullionVault.com, the fastest growing gold bullion service online, Adrian Ash is also City correspondent for The Daily Reckoning in London, and a regular contributor to MoneyWeek magazine.

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