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It was one of the greatest heists in history

Story by MATT COLLINS

The scene!  London 1660.  The perpetrator!  King Charles the II...of England. The loot?  All the gold he could con out of the country's goldsmiths, bankers and businessmen in a lifetime.  The tool!

A stick..  A Tally Stick!.

Tally Sticks were a brilliant invention. But they were also insidious, as they formed the foundation for the fiat currency systems we still have today. This was a system where, the root, of a currency's value stems from the promise.   This was a promise from a faceless institution and not in the actual value of an object.

Counterfeit-proof Receipts for an Illiterate Public

Put into use about a thousand years ago, they were a common sense solution for a young, "gold and goods" economy where gold was scarce. By the time of the heist they were used in everyday transactions.

Here's how it worked. When a loan was made, the debt was carved in a standard fashion on the surface of a small (preferably hazel-wood) stick, and then the stick was split in half through the center of the carving. The longer end of the IOU was given to the purchaser, and its handle was called the ‘stock'...the root of the word's use in today's markets.

Even a mostly illiterate public could read the amount scratched into the wood, and the stick would only fit perfectly with its original other half. That way, when the debtor returned with the money (or goods) owed, the sticks would be matched and the debt would be ‘tallied.'

In that fundamental use, they worked perfectly. But of course - as is governments' way - the King was tempted to stretch those bounds.

 

King Chuck to the Rescue...of nobody

Charles II ruled at a time when royal power was still based on a ‘divine mandate'. His government and institutions - and indeed he himself - saw the King as a "Chosen One."

It was a real shame for him, because it bound him to the laws of Christendom. And Christianity at the time still forbade lending or borrowing with ‘usury' (interest). So he had trouble in terms of "living like a king" and financing several failing wars against various neighbors.

Instead he turned to the trusted tally...and the keen idea of selling his (government) tallies (debt) at a discount. That way he could allow his lenders to profit without charging interest...it's the basis for government debt being sold at a discount today.

And he could issue advance tallies for ‘emergency spending'...an idea that proved all too tempting. He sold the tallies collected by his Excheqeur (tax collector) from the country's Sheriffs, essentially trading future tax receipts to the country's goldsmiths (bankers) for quick cash.

The tallies were receipts for taxes to be paid later in the year...and this is a crucial part of the story. They weren't trading on the value of the objects being traded, but on the cost of waiting for a return and the government's ability to collect taxes & keep honest. If the government is not honest, this is an outright Ponzi scheme...one where new debt issue could theoretically pay for passing bills. For a while.

The King realized that he'd stumbled onto something big. He could wage all the war he wanted and pay his bills with the gold he got for hazel-wood. The King spent and spent, and the goldsmith's vaults filled up with more and more sticks.

But didn't the goldsmiths get wise?

Well, yes and no. Yes, they did get wise - which we'll talk about shortly - but they also had a reason to play along.

As we discussed in the last ‘lies' report, goldsmiths were handing out certificates for fractional gold reserves and inflating the young economy in a con all their own. And since the King played along with their early building of a banking system, they played along with the ‘sticks-for-gold investment strategy.'

But as mentioned above, they did get wise. At least the market did. Buyers started attaching larger and larger discounts to the King's debt to offset the perceived risk in loaning money to the King. The discounts prompted the King to issue even more tallies, promising out more future tax revenues just to meet his short-term spending desires. But remember only the discount was changing here. So the mountain of taxes to be redeemed in order to pay off his debts grew in comparison, soon overwhelming the King's income.

By the time the whole Ponzi scheme came to an end, the King's sticks were trading at a 10% discount (to put that into perspective, short-term T-Bills are currently trading with discounts of one-tenth of one percent or less). The payments on his newer issues trading at that discount soon outmatched all the Kingdom's tax revenues, effectively bankrupting his Excheqeur and threatening to put the monarchy in the poorhouse.

So with the stroke of a pen, the King simply declared those debts illegal and ceased payment.

With that single stroke he stole a huge amount of the country's gold - having already spent it - and forced the young economy to fall flat on its face. The King's various creditors ended up on ‘the short end of the stick' (again, this is the source of that expression) and all credit in the country evaporated pretty much overnight.

But wait until you hear what happened to the sticks...

The sticks were still in use for over a century afterward...the Bank of England even had some on their books when they opened in 1694. But in 1834, Parliament ordered all the sticks to be destroyed and the system to finally be retired.

The men at the furnace were happy to comply...and so too - apparently - were the sticks themselves. The fire overwhelmed the Parliament building's basement furnace and burnt the building to the ground.

I'm not kidding. You think that might've been a sign?

 

This is the history of government debt. And it's important to remember that even government debt is not risk-free. Governments have been known to default on debt. Russia, Ecuador, Chile...and many more have defaulted just in the last century.

Why don't you hear about it? Why are government bonds always called "risk-free" or "Inflation-Protected Securities"? Why don't they come out and tell you that government debt has a reckless - even disastrous - past?

Because it's bad for business

And it really kills the Ponzi scheme. If a government is facing serious trouble, it's almost a universal truth that they need (or desire) more money. But if they're honest about their troubles, the market might affix a greater discount to their debt...leaving them with less money.

So it's best for business just to tell them that everything's okay. Just tell them you're "fundamentally sound," or "well-capitalized.", unless you're Hank Paulson, Ben Bernanke or George W. Bush that'll do the trick.

Our economy today is much more robust, and the systems for handling government debt are much more sophisticated. But these threats still exist...and we shouldn't assume that any of their consequences are impossible.

MATT COLLINS, A-Letter Editor