Reconsidering English Mercantilism

One of the great things about reading old books is that they transport you away from the zeitgeist of the modern era. At any point in time, there are lots of ideas floating around in people's heads that are largely taken for granted, and not seriously examined as to their likely truth content. When you read writings from someone steeped in a totally different tradition, it forces you to reconsider your perspectives on things. 

On matters of how society ought to be organised, those of us of a reactionary bent are likely to find much to agree with in the books of old. Yet in some sense, the best issues on which to read old writings are those where you are genuinely agnostic – where there is a real prospect of genuine progress in understanding, but also significant gaps in our knowledge.

To me, that field is macroeconomics. I consider myself a macro agnostic, with sympathies towards monetarism in some forms. But it's hard not to see enormous shifts in fashions in macro that don't seem to coincide with great increases in understanding. A century ago, everyone with a brain believed that governments needed to maintain a gold standard. Now we all believe that the optimal system is to have pieces of paper not backed by anything, managed by a central bank trying to target 2% inflation, even though most of the real money is electronic and sits on a computer. Also, the existence of the paper tends to cause us problems when a crisis hits, because we can't lower interest rates below zero. I tend to think that monetary policy is useful, if done right (though even on that I'm not certain). Still, let's just say I'm not entirely convinced we've reached the optimal set of institutions.

Then again, there has been enormous and genuine advancement in economic understanding. Trade theory, specialisation and division of labour, the marginal revolution, modern finance, behavioral economics – these things just didn't really exist 250 years ago. So while there may be wisdom in the ancients, it's also likely there was a lot that they didn't understand.

This came up recently in a discussion with some friends about the 16th through 18th century English policy of mercantilism. This is described quite well in Ernst Graf Zu Reventlow's "Vampire of the Continent", which I discuss here. Essentially, England wanted to monopolise trade, not only between itself and its colonies, but also in foreign ports. Reventlow cites an English desire to basically make Antwerp a de facto English port, for instance. In addition, when it came to dealing with foreign powers, it favoured one-way trade deals. You have to be open to free trade, but we get to have complete restrictions on trade. You can see this in the Siege of Havana. The English destroyed the Spanish Navy at Havana, and then conquered the city. But then, two years later, in the Treaty of Paris, they just gave it back. They did, however, extract concessions that they would be able to trade with the port, which they previously were denied. It's possible they just traded the city back because they thought they couldn't hold it, or to avoid endless war. But still, it's a strange move. And it's not just Spain. The Opium Wars were similar, except in this case fought not over the right to trade in general, but specifically the right to sell opium to the Chinese. Which looks pretty damn predatory, with the benefit of hindsight, but that's mostly because it was opium. They wanted to sell stuff to you, and their gun boats were going to turn up if you didn't like it. 

In other words, their ideal situation was that they would sell their goods to you, but you couldn't sell your goods to them. And often they would be willing to go to war over this principle.

Now, from the perspective of modern economics, this is quite weird on a number of levels.

First, these days we don't want to crush the economies of other countries. There's a pretty strong agreement that if a major country enters recession, even if it's a country you don't really like, that's bad news for your economy. Believe me, even the most ardent China skeptics wouldn't be celebrating a major Chinese depression, as soon as they looked at their 401k portfolio and the rising US unemployment rate. The reason is trade theory – there really are gains from trade, and the economy isn't zero sum. Because of this, trying to crush one's enemies may make sense politically or militarily, but it's likely to be counterproductive economically.

Second, not only is trade generally good, but at some point you actually want to consume things. Another name for mercantilism is running a trade surplus – we sell to you more stuff than you sell to us. But what this means is that the other country gets to consume a lot more stuff, while the things you produce end up being consumed by the Spanish. Maybe the wealth England receives is transformed into more productive assets so their economy grows more, but this is not obvious. The standard view of worthless consumption goods versus valuable investment goods is a large part of the reason that the otherwise brilliant Paul Samuelson kept incorrectly predicting decade after decade that the Soviet economy was about to grow like crazy and soon overtake the US. Because they didn't give a damn about consumption for the peasants, all their production was going into valuable investment goods, which would expand out their production possibility frontier. And yet somehow, the US with their frivolous consumption kept outpacing them. This is probably related to the fact that when US consumers stop purchasing their worthless hamburgers and flat screen TVs, that's called a recession, and it's usually considered a disaster. Maybe they could switch to being happy purchasing machine tools instead, but it's not obvious. Same thing with the English centuries earlier. In other words, they thought they were getting rich by their policy, but it's not at all obvious that they were right. Another reading is that they were just financing Spanish consumption, and consuming less themselves. 

A related aspect to all this is that there was a very different idea of what wealth was. These days, we understand it mostly in terms of GDP – the total productive output of the economy. When it grows, you become richer. Money is just the means by which we denominate the value of goods. If you own a factory, or a large corporation, you are rich. You don't need to actually hold the dollar bills. The productive output is the real wealth anyway, and the dollar bills are just the means of transforming your output into someone else's output.

But at the time, I think these guys thought that the wealth was actually the gold and silver they were accumulating. They weren't in the business of measuring economic output. GDP didn't even really exist as a concept. So instead they just maximised a number they called wealth, without wondering if this was the thing they really should be targeting.

So far, mercantilism looks pretty stupid. But is there some way to resurrect it, at least partially? Even if the practitioners didn't understand it at the time?

I think there actually is. 

The reason is that you can't understand mercantilism without understanding the gold-based currency. This is not gold-backed currency, where you hold a piece of paper that can be redeemed for gold, and which can be devalued (though at a large reputational cost). Rather the coins themselves really were made of precious metals, like the Spanish Escudo or the Spanish Dollar. And from my limited understanding, essentially all European countries were using some kind of precious metal as currency.

This has two effects. Firstly, as is commonly understood, countries don't have control over their money supply, inasmuch as the supply of gold and silver is very inelastic. So if you have less money floating around, you're pretty much just stuck. This has its modern equivalents, like Hong Kong having its dollar pegged to the US dollar – you end up with essentially whatever monetary policy the US happens to be implementing at the time, regardless of whether it's appropriate for the state of your economy.

But more strangely, another effect occurs when everyone is on the same currency. Everyone is linked in the same global money supply (except for the minor variant that some places used more silver, and others used more gold). Which means that if the amount of gold (and hence gold coins) is essentially fixed in the short run, then countries really have a zero sum competition over the money supply.

As a consequence, in a world where everyone uses gold coins, you can't separate trade policy from monetary policy. Mercantilism doesn't mean that you're richer in terms of GDP, at least in the short term. But it does mean you end up holding a larger fraction of the money supply.

And if you think, like me, that monetary policy matters, this can end up being important. If the Spanish colonies keep buying off the English, eventually they may face a sufficiently large contraction in the local money supply that it ends up harming local economic output. Of course, if you're not tracking GDP, you won't necessarily know this. You'll just find that it becomes harder to get tax revenue out of the local population, and they start complaining about a lack of coin. 

We can't imagine this complaint, because we've been so thoroughly used to fiat money, whose supply is endless. We can imagine a surplus of money, like in a banana republic going through hyperinflation. But a deficit? What would that even look like? As it turns out, it's people not being able to engage in useful trades, because they have to revert to barter, which is notoriously inefficient. You want to imagine a real recession? Imagine that in order to get bread, the baker has to want your accounting services that day, or be willing to take an IOU.

You actually see this in the story of one of the early experiments in fiat money, in New France. After initially having a beaver pelt based economy (yes, really), they started using coin. But at some point coin become so scarce that they couldn't pay the soldiers, which threatens the whole enterprise. So the governor switched to a currency of playing cards. Which, if you read between the lines of the article, worked pretty damn well.

Without this though, a persistent trade deficit would be experienced as a persistent contraction in the money supply, probably leading to local recession. Meanwhile, England would have a continually expanding money supply. It's not like this immediately leads to economic booms, otherwise everyone would just set interest rates at zero and print money like crazy (hmm, maybe they largely do...). But expansionary monetary policy generally does grow the economy, usually at the cost of inflation. Though since in those days deflation was approximately as common as inflation, this doesn't seem to be a first order concern. So to that extent, I can imagine that mercantilism ended up having some positive effects on the English economy, and negative effects on the Spanish economy, primarily through money supply channels. 

Which was assuredly not the justification that was being used at the time. But if Chesterton's Fence means anything, it's that people often can end up implementing reasonable policies without really understanding why. 

All of this raises a fascinating hypothetical. What if the Spanish (or the French, or whoever) had just decided to respond to English mercantilism by... switching to fiat currency? Fiat currency gets a bad name in this period because its introduction tends to occur by bankrupt governments who can't or won't close a persistent budget deficit, and thus they introduce fiat in order to print like crazy and inevitably end up with a worthless currency. 

But modernity indicates that this doesn't have to be the case. We could imagine a Spanish King who had a stable budget situation switching to pesos. What would happen?

Well, the first thing to note is that they'd have the freedom to implement monetary policy. To the extent that this is economically beneficial if done well, it would be a big help for getting the economy out of recession. Then again, since they didn't understand monetarism, it's not clear this would actually happen. Before you get to this point, you'd need a coherent understanding of "recession", and a way to measure it, neither of which they had.

Still, there would be other benefits. Notably, it would immediately neutralise the effects of English mercantilism. Havana is now operating in pesos. Which means you can let the place trade with the English as much as you like! Why? Because just like in a modern economy, currency movements will act to counteract a trade deficit. Suppose, as seems likely, English merchants keep demanding payment in gold coins. Well, there's going to be some exchange rate between pesos and gold. If Spain as a whole keeps buying foreign goods and supplying pesos in exchange for gold, its currency will depreciate. This will make English imports expensive, until the local population stops buying them all on their own. Gun boats or not, they simply won't have the money, and the population in Havana will find it much cheaper to buy domestic goods. Meanwhile, the same currency movement will make Spanish exports extremely competitive. The mercenary English merchants and smugglers will start buying Spanish goods to sell to England, government policy be damned, because it's suddenly extremely profitable. Spanish exporters don't mind being paid in cheaper pesos, since they work just fine in their local currency. Meanwhile, the extra demand helps to boost the local economy. 

And more importantly, you don't need to fight to keep the English out of your ports! An entire casus belli can be given up at a stroke, at almost no cost. Plus, since the English don't really understand economics at the time either, they'll probably view it as a great victory. Let them. Moving to positive sum trade would be useful in general, but neutralising the English weapon of contracting your money supply would be even better. They only have the weapon because you gave it to them, by using the same currency as them, and one which you don't control the supply of.

This wouldn't solve all of Spain's problems. Because Spain did in fact have a lot of silver coming in from mines in the New World, so a shortage of money wasn't its main issue. In part, it didn't invest the silver into anything other than consumption, cathedrals, and other things. Samuelson may have gotten the Soviet Union wrong, but that doesn't mean the point is wholly incorrect. You really do need to buy investment goods and not just consumption, especially imported consumption.

This is all a hypothetical, of course, and one we don't have great historical analogies to guide us on. When countries abandoned the gold standard, they mostly did so all at once, such as with the collapse of Bretton Woods in 1971. Which means there isn't a clear example of a functional, budget-neutral major power adopting fiat money while all other major countries, including their trading partners, stayed on gold or silver. The Swedes did it in the 1700s, but they ran a huge budget deficit and drove themselves into a ditch. But I don't think this is particularly strong evidence. It's like trying to evaluate whether credit cards are a good idea when the only evidence available is for chronic gamblers and alcoholics. It's not necessarily a good guide to what will happen when John the accountant gets one.

Without that evidence though, I don't really blame the monarchs of the time for not wanting to roll the dice. The whole idea seems weird, and to the extent it's been tried, it's mostly associated with fraudulent, bankrupt governments and terrible outcomes. And they just didn't understand the economics well enough. Maybe we still don't understand it fully. But at least we know something they didn't know. It's possible to have fiat currency without immediately leading to hyperinflation and national ruin. 

We also have a fair idea, thanks to Milton Friedman, that monetary policy is actually important, even when a country is using gold or a gold standard as currency. They didn't know that, but you can't blame them. 

Sometimes, like Bitcoin, you've got to just run the experiment and see what happens, because there is no clear precedent for what's going to happen. All you've got is theory, and the hope that your understanding is correct.

It's enough to make you wonder what economists in 100 years time will marvel at us for doing today.