Sunday, May 22, 2016

The Problem with Promissory Notes

This week, I noted that Saudi Arabia is discussing the use of promissory pay various companies conducting work within the country, for their actions.....instead of cash or normal currency.  The chief reason is the oil pricing and continued use by Saudi Arabia to spend it's reserve capital (which lessens every month).

Promissory notes are tricky things.  Once you engage in add risk to a fragile economy.

In 1932....still in the Weimar Republic period.....Germany had reached a stage with the worldwide depression where they had to take significant action.

So, Öffa bills were created.....a basic German promissory note.  What was discussed in the beginning stages with this vehicle was that it was a fund-creation effort for infrastructure projects (roads, bridges, buildings, etc), and by pushing toward these agenda'd have a shovel-ready (I hate using the term but even in 1932....people were that stupid) project that would invent jobs out of thin air.

The Reichsbank at the time (the state bank) went along with the idea. The note would support the Deutsche Gesellschaft fur offentliche Arbeiten AG (basically a state-run works organization).  To be honest.....if you examine it in's just a fake company.

Debate starts at this point over success.  The note did generate interest....thus creating projects that hired people....and those people were paid a salary which they took home.

The one positive of this note was that it's life span was written down for three months.  The reality is that it could have gone on for several years.  In a way, it was simply a jump-start creation....that faked the economic community, the infrastructure folks, and the general public.  They all saw something being built and money moving around, with people being hired for work.  Stimulation was existing, even if it was fake.

So, it's at this point that one ought to bring up inflation.....because promissory notes always create inflation.  The more notes created.....the more inflation.  Some inflation is OK.  Massive inflation is not.

The economic minds controlling the Offa bills had a design in mind upon creating them.....there would be a very limited supply.

There would be a phase one for the short duration Offa bills, which did more or less what it was designed to do.

Then they would move to a phase two, trying to repeat the success and continue this jump-start episode.

Then we move to the end of 1932.....where the Nationalists Socialists (Nazi) Party wins the election. Throughout 1933, there's talk of big plans and changes coming.  The Nazis want to rebuild their military and that costs money.

So the promissory note business is examined.   Because of the success of the Offa bills....the idea is to take this onto the next level.....making a promissory bill for military growth.  There's almost nothing written about the German national bank and it's opinion of such a note.  You'd look at the economic side of this.....a fake currency to generate public infrastructure....and create jobs....would be a positive.

In this Nazi are simply creating military hardware...creating jobs....and it doesn't lead onto any big advancements for the German economy.

This new era will involve the Mefo bills.  They were also created around a fake company (just like the Offa bills).  The company?  Metallurgische Forschungsgesellschaft (Metallurgical Research Corporation).

One must note at this point, because it was approved by the government, that this was a legitimate fraud vehicle....unlike the illegitimate fraud vehicle that Bernie Madoff created in the early 1960s.  One might laugh but it helps to have the government backing a fraud.

Why funnel this through the fake company?  Well, there's this problem in dealing with the Treaty of Versailles which dictates what Germany can do to rebuild its military.  It had strict language about what the government could fund or build.  It had no language over a private company building ships, tanks or weapons.

The Offa bills had a limited life and were supposed to be a stop-gap measure....with some success.

The Mefo bills went on, and on, and on.  By 1939....the general estimate was that at least ten billion Reischmarks existed within this promissory note business.

One could say that goods and services were being generated throughout the 1930s (after the November 1932) election, and the public felt growth was going on, with jobs in abundance.  The general problem is that the Mefo bills fed an ever growing problem for the end point....with inflation and some massive recession yet to come.

The Hitler government never had to deal with political fallout over a massive recession....thankfully because of the war.

Looking over the Saudi idea of a promissory note?  They are dependent on oil prices eventually recovering.  As each day goes by and they spend more of their reserves, there's a question of a massive recession in the works and political fallout, IF the curve back to higher oil prices doesn't occur.  If their short-term usage of a promissory note works....then fine.  If this turns into a long-term the Mefo bill...there's trouble ahead.

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