Railway Financing and the Shape of China’s Future: Some Lessons from American Economic History

By , Permalink

Report for the Robert Schalkenbach Foundation

“Is it British wealth we want when we desire to develop our resources or build railroads? No, we do not need the wealth, for at this moment we are the richest nation on the face of the globe. We need the money.” – John Brown, Parasitic Wealth, or Money Reform (1898:34)

These words were written over a century ago by an American who saw that it was money that put the nation’s tangible wealth, its natural resources and labor, in motion. Recognizing that money was essentially a social and legal institution, a creation of the state, the author urged the government to finance the railroads by printing its own money rather than borrowing from private banks and investors. This would have saved the economy from having to pay interest charges on public credit. The shape of America’s economy would have been different and less financially polarized. One may say the same thing for China today.

Giveaways of America’s public domain, mineral deposits, forests and the radio spectrum created hereditary fortunes that helped make wealth distribution more extreme in the United States than in almost any other country – much more so than in England, Germany or Japan. (Only where the Washington Consensus is being applied, as in Russia and Chile, does one find similar concentrations of wealth. Edward N. Wolff has shown that the richest 1 percent of the population controls about 40 percent of U.S. wealth, compared to only 17 percent in Britain.) Part of the reason for this polarization is financial: In addition to being left much more in private hands than in Europe, American railroads, power utilities and other infrastructure were financed largely by debt. While Europe provided economic infrastructure at cost or at subsidized rates, the private development of infrastructure in the United States required that it charge high enough user-fees to pay dividends and interest. Indeed, the railroads’ exorbitant fares were ratcheted up by interest payments on bonds that stock manipulators simply printed and issued to themselves, factoring the interest charges into their fare structures as if they were a bona fide cost of production. Such stock waterings were an early American version of zaitech, financial engineering by sophisticated operators to benefit themselves at society’s expense.

Most Washington Consensus policy-makers dismiss economic and financial polarization as “external economies” and deem them to be extraneous. The limited range of calculations and social concerns taken into account by the norms of project evaluation now being spread throughout the world reflects the degree to which today’s global economic philosophy has come to be dominated by financial and real estate interests and their distinct world view. They lobby Congress as a matter of course (some of the early railroad magnates bragged about the senators and congressmen on their payroll) and also have subsidized academic economics to the point where today’s business schools serve largely as public relations media to proselytize economic doctrines claiming that this pattern of development has all been for the best.

Once a vested interest is established, academic economics tends to follow suit to endorse it. One role of today’s creditor-oriented monetarist economics has been to exclude alternative approaches from serious public discussion. The neoliberal Thatcher-Reagan revolution now acts in its own right as a force of inertia making government financing more difficult than ever before (to say nothing of outright public ownership). Modes of public enterprise, public financing and public regulation that look promising on their own merits are not the path of political least resistance in today’s world. The power of wealth built up by past financial and real estate privatizations makes their legacy of dysfunctional policies hard to reverse.

The wide-ranging discussions extending from the end of the 19th century through World War I show that today’s prevalent “American-type” banking, finance and public development philosophy was by no means inevitable. Other choices were available but were not taken, largely because of the political power wielded by money made by privatizing public wealth and the right to create credit. Politicians and judges bought by the railroads, land speculators and large financiers shaped the way in which America’s West was developed. Today, these vested financial and rentier interests would foreclose a discussion of how broad the range of options is with regard to how public infrastructure may be financed.

To show the degree to which its financial diplomats are advising China and other countries to “Do as we say, not as we ourselves have done,” this memo summarizes the choices that America itself took, and examines how some of the alternative choices that were debated might have been superior. It concludes by reviewing what options remain available today for China and other countries.

Credit creation as a means of financing wars and public infrastructure development

The principles of how nations may finance wars, public infrastructure and social security are essentially the same, yet the mode of financing usually has been different in each case, above all in the United States. These differences are the outcome of hard-fought debates among politicians and economists in every major industrial nation. Advocates of the Washington Consensus speak as if there is no alternative to a mode of financing that happens to maximize the benefits to global financial institutions while minimizing the host-country’s public benefit. But the controversies that have occurred in America itself show that today’s pro-financial monetarism is neither the most desirable path nor an inevitable one.

Most discussions about how to finance wars, public infrastructure and social security focus on the inflationary impact under the following four alternatives:

  1. Governments print the currency to pay for these programs and circulate it as money;
  2. Governments or private companies borrow from domestic savers;
  3. Domestic bankers create credit freely and lend it to the governments or private companies; and
  4. Governments or private companies borrow dollars or other foreign exchange from foreign lenders.

Regardless of how the government or private owners of railroads and other infrastructure raise the money, it must be spent on labor, materials and equipment one way or another. The impact on wages and prices thus should be similar in all cases. The idea that private credit or money creation is less inflationary than government credit is thus a false issue. If labor and resources are under-employed, the printing of currency, creation of domestic credit or foreign borrowing will not be inflationary. Prices even may be reduced, to the extent that the infrastructure holds down costs by increasing productivity or supplying new essential transport or other public utility inputs. Conversely, at full employment wages may be bid up regardless of whether foreign credit is borrowed or domestic money created. (Wage increases may be offset by the productivity and subsidy benefits of the infrastructure being financed, to be sure.)

The differences in the above four modes of financing concern (a) the balance-of-payments impact in the case of foreign borrowing, and (b) the alternative use of savings, in the case of borrowing from domestic savers. Suppose that a railroad costs $10 billion to build, of which $7 billion represents domestic labor and materials costs, and $3 billion foreign-currency costs for imported equipment and expertise. Let us start with the fourth alternative above. This is what the Washington Consensus advocates, as foreigners have surplus savings and can create credit in unlimited quantities (especially in the United States), which they are eager to lend to China.

China would receive a $10 billion dollar inflow if the entire project is financed abroad, or $3 billion if it borrows only the foreign exchange needed. Converting these dollars into yuan will support the currency’s exchange rate, if the central bank sells dollars and buys yuan on the foreign exchange market. But more likely it simply will create yuan-credit, holding the dollars as an asset and maintaining the pre-existing rate by turning around and using the dollars to buy U.S. Treasury bonds. This will give the central bank a dollar asset matching China’s dollar liability to the foreign lenders for the project’s credit.

U.S. Treasury bonds yield a lower rate than must be paid for the foreign borrowing, especially when taking into account the financial underwriting charges of 2 to 3.5 percent of the principal. These charges are not insignificant. Over the course of the loan or bond issues, financial charges may amount to as much as 40 percent of the project’s overall cost. This means that while an initial $10 billion dollar inflow into yuan would support the currency, the ensuing foreign-exchange outflow, including interest charges, would entail a $14 billion outflow.

Why is it necessary to borrow foreign exchange at all? This question was raised in Russia in 1996-98, when IMF and U.S. advisors argued that it would be inflationary to pay wage arrears to workers unless the budget deficit were financed by borrowing an equivalent volume of dollars. The central bank obediently issued GKOs (government treasury bills) paying interest rates higher than 100 per cent annually, subsequently scaled back to a more “Latin American-type” level of about 25 percent. (The market effectively was limited to close friends of the Yeltsin and Clinton administrations.) Russian labor still went unpaid as the oligarchs converted their roubles into dollars at the exchange rate subsidized by the IMF loans and investment inflows into GKO bills and stocks in the natural resource companies being privatized. Capital flight from Russia was widely estimated to average about $25 billion annually throughout the 1990s.

The argument for borrowing abroad to pay workers rests on the assumption that all wages are spent on imports. In the United States about 3 percent of national income is spent on imports; in Europe the proportion may rise to 20 or 25 percent. This “leakage” rises for small economies and falls for large ones and for countries that are largely self-sufficient in food. This means that China will have a relatively small balance-of-payments drain from new domestic spending. As it has substantial foreign-exchange reserves, this need not be a major consideration at present. Under today’s the unstable foreign-exchange conditions, balance-of-payments effects are best handled by short-term central bank operations rather than by long-term investment programs.

Unless China is seeking a long-term foreign-exchange inflow to support the yuan’s dollar parity, there is no reason why it should let billions of dollars in interest charges accrue to foreign economies. Whether or not it borrows abroad, domestic credit will have to be created. The actual cost of doing so is negligible.

Foreign lenders seek to justify their financial charges by claiming to act as wise and honest brokers who decide what is a fair, non-inflationary amount for debtor countries to borrow. But in practice they have shown that they have no workable models. All they really want is the loan business. What euphemistically is called “credit management” merely concerns the legal department’s calculations of whether they can be paid in full with all the interest charges, and what collateral they can take if the loan is not paid. Usually they bring pressure to bear for the debtor government or the IMF to bail them out of bad or reckless loan decisions.

One of the rare times foreign borrowing really is necessary has been in war emergencies, when arms need to be bought with foreign exchange beyond the belligerent country’s ability to pay out of existing reserves. This was the situation in which European powers found themselves in World War I and II. But no such life-and-death emergency concerns today’s infrastructure spending for China or other countries. Under normal conditions most borrowing therefore should be done domestically, so as to keep the interest accruals at home, where they will accumulate to build up the domestic savings available to finance new investment. The question is whether governments will create the credit, or whether they will rely on private bankers to create and supply it.

When large amounts of money are needed rapidly, as in war situations, most governments have simply printed the money. This is the lowest-cost source of credit, as it does not entail any interest payments. It is largely for this reason that private lenders oppose such credit creation. In war situations it is deemed unpatriotic to take such a stand, but when there is time to undertake a more leisurely debate, creditors boldly assert that government budget deficits and money creation are inherently inflationary as compared to private-sector credit creation.

There is scant historical evidence for this claim. It is put forth as an article of faith rather than as a maxim whose validity needs to be demonstrated. One of the major financial debates occurred with regard to America’s issue of Greenbacks as a Civil War measure starting in 1862. The U.S. experience may be enlightening for today’s post-socialist countries, as the Greenbacks avoided serious inflation while saving the government from having to pay interest charges.

How America’s Greenbacks saved the government from paying interest charges

In his book The Lost Science of Money, Stephen Zarlenga has traced the following monetary history of the civil war greenbacks (through the Campbell paragraph below). Civil War broke out in April 1861. Treasury Secretary Salmon Chase estimated that the war effort would cost $380 million, of which he proposed to levy $80 million in taxes and to borrow the remaining $300 million. But inasmuch as Northern banks only had about $100 million of gold and silver coinage or bullion, it was clear that most of the money would have to be created de novo. In fact, the gold market was closed for two weeks after the banks suspended redemption of their notes for coin on December 28, 1861 so as to prevent a run on gold.

Congressman E. G. Spaulding of Buffalo, New York, proposed that the government simply print the money. Voicing what since has been called the State Theory of Money, he explained that the value of these “Greenbacks” would be established by the government’s willingness to accept them for taxes and other public fees. It was this agreement to receive gold and silver, after all, that established their value; the same principle would establish the value of paper money. “Without the government stamp gold and silver would be simple commodities, depending for their value upon the demand for use in trade and manufacture,” wrote Spaulding (A Resource of War, p. 37). “Why then should we go into Wall Street [in New York], State Street [in Boston], Chestnut Street [in Philadelphia], or any other street, begging for money? Their money is not as secure as Government money. … I am unwilling that this Government should be left in the hands of any class of men, bankers or moneylenders, however respectable or patriotic they may be. The Government is much stronger than any of them … They issue only promises to pay.”

Senator Howe of Wisconsin made the same point in supporting Spaulding’s bill. Emphasizing that government money did not have to pay interest charges, he pointed out that credit was created out of thin air whether it was done by the government or by private bankers. “The Government may be able to borrow from the banks, but the Government cannot borrow coinage of the banks. If it borrows anything of them, it must borrow, not their money, but their promises to pay money” (quoted in Spaulding, ibid.:108).

On February 25, 1862, the Greenbacks were made legal tender for all public and private debts, replacing the Treasury notes that had been redeemable in coin since 1812. They were not paper promises to pay “money” later, but were themselves money. They were not borrowed, but issued as needed to pay for the government’s wartime purchases. Functionally speaking, they were a debt liability in name only, for nobody expects currency itself to be repaid. (When they later were made redeemable in gold – and at the prewar price, to boot – this was accused of being a giveaway to the bankers and speculators.) Inasmuch as the government did not have to pay interest on them, the Greenbacks did not add to the interest-bearing debt. In this respect printing money is a free ride for the issuer. The world is now re-learning this principle with regard to the U.S. dollars held by central banks outside of the United States.

The Greenbacks were given value by declaring them receivable for all public dues and taxes except import duties, which still had to be paid in coin (inasmuch as imports entailed a balance-of-payments outflow). To prevent inflation, Congress limited their volume to $450 million on June 30, 1864. As $449,338,902 already had been issued, the amount never rose further. Whereas monetarists argue that what gave the Greenbacks their value was their purchasing power in terms of gold, what actually stabilized their value and saved them from further decline after mid-1864 was this quantitative limit on their supply.

By the same token, the Civil War inflation did not stem from the fact that the government itself issued greenbacks, but that the credit had to be issued at all under the economic strains of war. As Studenski and Kroos summarize in their Financial History of the United States (p. 148): “Some writers have ascribed the price inflation almost entirely to the issuance of greenbacks, but this is a mistaken view. Even if the greenbacks had not been issued and bonds had been sold at whatever price they would bring in the market, inflation would have taken place. It would merely have taken another form – that of the monetization of debt through the issue of bank currency or the creation of bank credit.” It was the government’s need to spend money for war material that caused the inflation. This would have resulted whether the money was borrowed from public savers (internationally or at home), created by private banks as credit (loans on their books) or printed by the government itself.

As a concession to the banks, holders of Greenbacks were entitled to deposit them with the government and receive 6 percent compound-interest bonds, redeemable after five years and payable in full in twenty years. Congress initially authorized $500 million of such bonds. Their interest was to be paid in specie, but their principal in Greenbacks.

Subsequent critics of the Greenbacks who argue that they were inflationary have measured inflation in terms of the price of gold as it stood early in 1862 when the notes began to be issued. By the end of 1862 the Greenback’s gold value fell to 58 cents. It recovered to 82 cents by mid-1863, but then fell to a low of 36 cents on July 16, 1864, reflecting the heat of the battle between North and South. The value moved up steadily as Northern victory became more certain, to an average 39 cents in August, 45 cents in September, and 48 cents in October 1864. By December 1865 their value rose to 68 cents, and in 1874, Congress passed the Resumption Law calling for the currency to become freely convertible into gold at the prewar rate, as of January 1879.

Meanwhile, the National Banking Act of 1864 had created a system of National Banking Associations under the supervision of the Treasury’s newly created Comptroller of the Currency. Notes of these banks were made acceptable for most U.S. dues, and were to be received by all member banks at full value. The circulation of state-chartered bank notes dropped from $179.2 million down to $l9.9 million after a 10 percent tax was levied on them, but national banks were permitted to create $1.49 in their own currency for every Greenback they were able to obtain and turn in to the Government. As Dewey (p. 324) has described: “The banks were accused of absorbing the government notes as fast as they were issued and of putting out their own notes in substitution, and then at their convenience converting the notes into bonds on which they earned interest,” payable in gold. As Treasury Secretary Chase complained: “It is a struggle on the part of the banking institutions of the country to bleed the government of the U.S. to the tune of 6% on every dollar which it is necessary for the government to use in carrying on this struggle for our independence and our life.”

There was no inherent reason why the government could not have simply printed this currency rather than leaving it to private bankers to convert into interest-bearing debt. The shift from public to private money was a giveaway to the financial interests. And the more money the banks made, the stronger their political lobby became. Judge Rufus P. Raney warned Americans to “consider how much danger there was in a system that had replaced the (2nd) Bank of the United States. If with its $35 million in capital the old Bank had [dominated] the press and Congress ‘what are we to think of the numerous banks with their hundreds of millions in capital?’” (quoted by Irwin Unger, The Greenback Era [Princeton 1964]).

Illinois Congressman Alexander Campbell (in his book, The True Greenback [Chicago 1868]) suggested a convertible bond plan designed to end special privileges for bankers by making the Greenbacks permanent, using them to pay for all Government expenses, including interest and principal on the existing debt. Private bank notes were to be called in, to be exchanged for the U.S. Government bonds the banks already had deposited at the U.S. Treasury as reserves against their own notes under the 1864 Act. This is what ultimately would evolve, but it was rejected at the time as outrageous.

The best analysis of the Greenbacks by a Civil War contemporary was written by a Canadian-American astronomer, Simon Newcomb. It is to him that Milton Friedman dedicated his Studies in the Quantity Theory of Money. But Newcomb’s Critical Examination of our Financial Policy during the Southern Rebellion (New York: 1865) went beyond today’s monetarists by comparing the consequences of debt financing to those that might be expected to result from simply printing the money. He was clear that wars (and by logical extension, public infrastructure and old-age pensions) always are paid for by the generation that fights the wars, builds the infrastructure or creates the output on which welfare-income transfer payments are spent. There is no way that issuing bonds or taking bank loans can push the direct burden of financing these programs onto posterity. The effect of financing these expenditures by bonds rather than taxation or by printing money resulted from creating a flow of payments from taxpayers to creditors.

“The generation that wages the war must be the one to shed its blood, feed its armies, and cast the shot and shell which its armies are to use,” Newcomb explained (1865:66ff.). “Food, clothing, shot and shell are the real expenses of war. In running to debt for these articles, we do indeed bequeath to posterity the work of raising the money to pay for them. But posterity not only raises, the money, but also receives the pay, so that we may as logically say that posterity gets paid for the war as to say that it pays for it.” Every generation must pay the “real” costs of fighting its wars, building internal improvements or social security to its retired workers and other elderly. Wars are fought with armaments, not with money, but the traditional maxim also is true: “The sinews of war are money.” The question facing governments in peacetime or in war is why not simply print this money? Why borrow from banks and let them create the credit at will? For that matter, why borrow from foreigners, except as an indirect way of obtaining foreign exchange to support the domestic currency’s parity?

Financing the war by loans had serious political implications for future income distribution, “by causing an antagonism of interests between the East and the West.” It thus would be specious to say that the debt did not matter because “we owe it to ourselves,” as “different sections may have entirely different pecuniary interests.” Some 80 per cent of the debt would be held in the Eastern states “while more than half the taxes will have to be paid by the States which own the other fifth.” Labor and capital in the South and West would be taxed to pay Eastern bondholders.

Newcomb pointed out (p. 114) that as an alternative to taxation or bond issues, governments could print the money to cover their expenditures, and indeed could extinguish the entire public debt overnight simply by stamping each bond “legal-tender as money.” He worried that this would be inflationary, but other writers found that printing money was no more inflationary than was credit creation by private banks or spending the stock of savings. Reviewing Newcomb’s “Financial Policy” (North American Review 100 [1865:605]), Francis Bowen of Harvard observed that the Bank of England had suspended specie payments for over twenty years during Britain’s 1798-1815 warfare with France without suffering a depreciation of more than six or seven per cent during the war’s first seven or eight years. The key, he pointed out, lay in the volume of currency issued.

Monetarists would limit the money supply to the volume that will maintain price stability (and indeed, foreign-exchange stability), without regard to the effect on employment and economic growth. This advocacy of a “neutrality of money” in terms of prices often turns out to be a euphemism for credit austerity, and holds back industrial growth. The major American economist of the mid-19th century, Henry Carey, warned that a return to specie payments at the prewar price of gold would impose a price deflation that would hurt industrialists and other debtors. The lack of sufficient money to establish the necessary “societary circulation” would cause unemployment of labor and capital. He thought that industrialists should benefit, not the financiers. (I review this debate in Economics and Technology in 19th-Century American Thought [New York 1975]:295-310.)

In a reply to his critics published in the North American Review (102 [January 1866]:100-116), Newcomb granted, “The community will always have enough of the medium of exchange, because any transportable commodity can be used as such.” As much activity would be conducted at an inflated price level as at a lower one. Whereas Carey would have argued that an even higher level would be achieved as inflation favored the industrial debtors and workers at the expense of rentier financiers, Newcomb felt that deflation would favor saving. Under the modern creditary approach, however, governments do not really need saving (except as an accounting book-entry), inasmuch as their own currency creation can promote direct investment.

China’s financial choices as to how to pay for infrastructure and social security

China and other countries today are in a situation similar to that of America in the 19th century. There was a general view that money had to be obtained through international trade – gold or its proxy, sterling in an epoch when world finance was dominated by the leading industrial power, Britain. Faced with that situation, the United States left its railroads and other public infrastructure to be developed in private hands primarily because the government did not want to finance them by borrowing from Britain. The main source of taxation was the tariff, providing little scope for general taxes. And there was scant congressional discussion of the third alternative, for the government simply to print the money needed to build up a national infrastructure.

As matters turned out, the money indeed was created out of thin air, but this was done by private bankers. They promoted the idea that only they were able to create credit responsibly, via a monetary system whose interest charges would belong to them rather than to society. Seeking to keep the public sector off their profitable turf, they promoted the idea that governments were irresponsible operators of the monetary printing press. There is scant historical evidence for this prejudice.

Hardly anyone pointed out how similar the financing of public infrastructure was to that of wars. For many centuries Britain and other countries were obliged to fund wars by creating new excise taxes to pledge to foreign lenders to ensure the payment of interest on each new bond issue. Under these emergency conditions there was little thought of private enterprise conducting the war as a profit-making investment.

Social security and medical insurance occupy an intermediate position in North America and Europe. A regressive payroll tax has been imposed on wage earners and the proceeds invested in government bonds. Functionally speaking, this is the same thing as taxation, but it is disguised by paying money to one arm of government (the social security administration) to turn over to another, receiving a matching security (or deposit) to be paid off some time in the future. These securities (or deposits) then serve as an effective political limit on the money that can be paid out as social security over and above future tax inflows earmarked for this purpose.

There is no intrinsic reason why this kind of tax needs to be levied at all in a way that is distinct from general taxation, except that it falls much more heavily on wage-earners than does the income tax. In America especially, the payroll tax has burdened the lower-income brackets disproportionately, as public funding of retirees and medical welfare has been turned into an excuse to tax wage earners much more regressively than occurs under the graduated income tax. The government securities issued to fund this economic welfare spending in turn may be viewed as the resulted of governments refraining from taxing wealth to balance their budgets. The reality is that Governments could just as well create the credit directly by (as Newcomb put it) printing “legal tender” on their IOUs and circulating these as money.

As a legacy of their socialist tradition of running society in general without securitizing financial claims on wealth, China still organizes its social welfare system on a pay-as-you-go basis. Such systems can be funded readily without building up any fund of “savings” in the form of securities to sell to pay pensions in decades to come. Washington Consensus advisors point out that like Japan and many Western countries, China has a rising proportion of elderly relative to the work force. One way or another, this aging population that must be supported by the current work force. (Over half the nation’s population will be over 50 by 2045.) The question is, should this be done by taxation, government credit creation, or borrowing?

At the present time, taxation is relatively difficult, for China. The government collects only 13 percent of its GDP in taxes (compared to 20 percent for developing countries as a whole). Seeing this fact as a potential opening into China’s economy, large Western financial institutions are urging that unless China increases its tax collections, it should build up public pension funds to invest in the stock market, selling off shares to pay its retirees in years to come.

In the process, it is argued, China’s social security tax may provide funds for new enterprises to invest. And if the pension funding set-asides exceed the volume of new stock and bond issues, the inflow of funds into the emerging financial market will bid up stock prices to create a boom. A rosy image of self-reinforcing growth is thus conjured up.

China will be asked to pay a price to be led along this path, of course. Western financial institutions are offering to step in and provide the management expertise for a suitable (3 to 5 percent) commission. At today’s stock-price and dividend levels, commissions of this size will absorb the entirety of dividends paid by the stock investments, and then some.

Why should the wages of Chinese workers be debited at the present time, to be invested in the stock market to be sold off and the proceeds paid out s pensions nearly half a century hence? If governments can pay social security on a pay-as-you-go credit-creation basis (or even by taxing directly), why can they not also pay for infrastructure in this way?

There does not seem to be any inherent reason why one generation should buy Treasury securities to be sold later, except to provide a surreptitious way of taxing labor unduly. And as for the stock market, the effect would be to create a boom, from which speculators no doubt would profiteer by riding the wave of social security and pension inflows into the market. The effect in either case would be to tax a few generations heavily, to buy securities that later will be sold in such large quantities as to lower their price, creating a chronic stock market depression (or bond-market slump) that raises interest rates – unless the central bank monetizes the sale. But if the Treasury is to monetize the sale, why not do this in the first place? Why is it deemed necessary to tax labor’s current income at all, when the economy does not need to shrink domestic demand but to build up the market? Evidently industrial and financial interests are dissimilar here.

The reason is to finance a stock-market boom, and also to create political pressure for the government to sell off public enterprises so as to provide securities for the social security and pension systems to buy. Labor is to be taxed to provide a flow of investment into the stocks of new companies, or to bid up prices for existing stocks and bonds. Whether the money is invested productively will depend on how closely the stock market is coupled to the process of new direct investment. In the United States today, it seems to have become largely decoupled, which does not seem promising for China.

On the other hand, a growing role for China’s finance, insurance and real estate (FIRE) sectors may be expected to have an effect similar to that in the West. The shift of employment away from the classical “productive” sectors to the service sectors threatens to reduce the work force that is supposed to provide the food, clothing, housing, basic consumer goods, transport, power and other essential needs of the elderly. They must be supported in the same sense that wars must be supplied by the generation fighting them and producing their armaments, devoting their labor and lives, material and output to waging the war’s direct (“real”) costs. No matter how many government bonds are held by China, this basic production problem will exist. Retirees are not supported by government securities, stocks and bonds as such, but by tangible output.

In his history of money and credit, Stephen Zarlenga points out that if “warfare has become associated with ‘getting the economy moving,’ it wasn’t the warfare but the accompanying monetary and production activity that were responsible.” If that is indeed the case, why shouldn’t China achieve a similar economic boom by monetizing its social security and public infrastructure investment? Why divert this revenue to saving, and why channel such saving into the stock market?

China’s industry is heavily financed by bank loans. Indeed, for East Asia as a whole, bank loans accounted for some 80 percent of enterprise debt during 1997-99, compared to only 22 percent in the United States. The problem in North America and England, of course, is that banking never has been closely linked to direct industrial investment, but rather to mortgage lending, short-term trade financing, and more recently to consumer debt, third world debt and financial speculation. Advocates of funding social security and medical insurance systems promise that diverting labor’s consumption spending to the stock market will provide investment funds, but this assumption is countered by the stock market’s decoupling from direct investment in America, especially since the 1980s. It has been turned into a vehicle for asset stripping rather than financing new long-term direct investment, research and development. The listed firms have downsized their labor force, sold off their real estate and cut back direct investment, not built themselves up. Their idea of “wealth creation” has been simply to increase the prices of their stocks (often by using their cash flow to buy their own shares) rather than to fund tangible new investment.

China’s immediate economic task is to build up its internal market and set in motion the positive feedback between rising living standards and rising labor productivity that has propelled the U.S. economy forward for the past century. Already in the mid-19th century the “Economy of High Wages” doctrine held that each increase in living standards served to raise labor’s productivity (along with “human capital” in the form of education and culture) more than proportionately.

A securitized pension system funded by compulsory payroll-tax deductions would counter this phenomenon. One could make a case that a diversion of labor’s wage revenue into the stock market might well be perverted into speculative lending and even downsizing of the labor force and a cutback in long-term research and development projects rather than promoting new direct investment and hiring.


This set of papers has traced how China may create its own credit to finance its infrastructure and other public spending, including construction of an East-West railway. The logic may be summarized as follows:

(1) Whether or not China borrows dollars abroad, its central bank, provincial bank or commercial banks will create the domestic money that must be spent. Borrowing foreign funds is no less inflationary than creating new credit at home, except indirectly to the extent that the inflow is used to bolster the currency’s exchange rate and thus holds down import prices. But by the same token, foreign borrowing adds to the economy’s cost structure over the longer term by imposing interest and amortization charges that will bring the yuan under balance-of-payments pressure. If the currency depreciates, the yuan-cost of servicing dollar-denominated debts will rise proportionally. This is what plagued East Asia in the 1998 currency crisis, and what wrecked the budgets of Canadian municipalities in the 1970s.

No doubt some credit will be spent on imports and thus become a balance of payments drain, but China has sufficient reserves to sustain this credit creation. In any event some of the credit will serve to employ labor that produces output which displaces imports, thereby saving foreign exchange. John Law, James Steuart and Josiah Tucker saw (and David Hume admitted when discussing the quantity theory of money) that when there is unemployment, the effect of new money creation is to employ labor more than to increase prices. (I review the early literature in my survey of theories of Trade, Development and Foreign Debt [London: Pluto Press, 2 vols. 1992].) Government spending probably will create some additional demand that may begin to bid up wage levels, but such spending still may save China money as compared to the interest charges that would push up costs if it were left to private banks or foreign institutions to create.

(2) The State Theory of Money has long established that what gives money its value: the government’s willingness to accept it in payment for taxes and other public fees. Federal or local authorities may print currency, create their own bank credit or issue bonds whose value is established by being accepted for public payments.

The government may or may not levy taxes to absorb the purchasing power created by public spending. It may prefer to see an acceptable degree of inflation result from infrastructure investment than to collect enough taxes to fully absorb its spending.

There certainly is no need for deflationary austerity to support the value of government money, bonds and other debt. As Gunnar Tomasson has observed: “The Creditary View of Money holds that what ultimately gives money value is the Debtor’s ability to honor the terms of his Loan Contract.” The State Theory of Money affords the primary case, inasmuch as the government serves as the ultimate guarantor of credit. It always can “print the money.” This is what makes the government most able to make good on its loans. This also explains how money historically has spread from public debt to private borrowers (including banks themselves).

(3) The value of bonds or other public credit may be secured by the anticipated flow of fiscal revenues. If a Rent-Yuan were issued against rent collection or taxation, its value would be established in the same way as that of a mortgage or corporate bond: by the prospective cash flow accruing to the monetary authority.

(4) Historically, the land has served as the major tax base for nearly every economy. It certainly is the easiest and most straightforward and visible way to levy taxes in post-socialist economies in which sophisticated commercial enterprises are able to avoid reporting taxable incomes. (Russia is a case in point, with its mineral resources and land representing the only assets that can be taxed without raising their production costs.)

In antiquity agricultural land was the major means of production for food, wool and other raw materials. But today urban land – and indeed, land in general – has become the economy’s major speculative asset. Buyers vie with one another to obtain real property, so eager to borrow money to obtain it that they are willing to pledge its rental income as interest to lenders. As real estate comes to be burdened with more and more debt, its rental cash flow is pledged to the financial sector. This makes it unavailable to the government to tax without depriving the banking system of the rental flow that has been pledged to it as interest, as backing for its own deposits.

The same revenue cannot be paid both to the bankers and to the government. If rental revenue is burdened with interest charges, the government’s own fiscal position must suffer – or else, the financial sector will be squeezed. To avoid this Western fiscal/financial problem, China should avoid treating interest as a tax deductible expense in calculating the land’s taxable yield (or that of industry, for that matter). If the nation accepts the premise that labor and industrial capital must form the foundation for economic development, then it should not give the financial, insurance and real estate sectors the special fiscal favoritism that they have got in Western finance-capitalist economies.

(5) Financing public spending by credit creation rather than taxation will enhance the domestic market, leaving more money in the hands of labor and thereby helping it raise its productivity. Meanwhile, prosperity will increase the land’s value, for this is what most people want to buy (or rent) with their available net income.

Within this overall prosperity, new transportation and other infrastructure will increase the rental site value of particular locations. Rent-Yuan bonds are a symmetrical way to finance transport infrastructure under these conditions, as public investment will increase site values along the routes. (The fiscal theory underlying this policy is called “value recapture.”) The idea is for the public sector to collect the site value created by public spending, rather than leaving this gain to private individuals.

(6) Basing fiscal revenue on a land tax also will enable the government to free labor and industry from an equivalent amount of tax. This will help China remain a low-cost competitor in global trade. Also, public collection of the land’s rental value (which needs to be re-appraised frequently in dynamically growing economies) will deter mortgage lending for land speculation, because the rental flow will be owed to the government and hence unavailable to borrow against. The effect will be to limit real estate lending to loans for the actual construction or purchase of buildings and other capital improvements, i.e., for tangible capital formation. By preventing a real estate bubble, this will hold down the economy’s housing and commercial space-rental charges, thereby adding doubly to China’s creation of a structural cost advantage over industrial economies that have turned into finance-capitalist economies dominated by the FIRE sectors rather than industry.