THE
ASCENT OF MONEY: A FINANCIAL HISTORY OF THE WORLD
BY
NIALL FERGUSON
1
DREAMS
OF AVARICE
Imagine a
world with no money. For over a hundred years, Communists and anarchists - not
to mention some extreme reactionaries, religious fundamentalists and hippies -
have dreamt of just that. According to Friedrich Engels and Karl Marx, money
was merely an instrument of capitalist exploitation, replacing all human
relationships, even those within the family, with the callous ‘cash nexus’. As
Marx later sought to demonstrate in Capital, money was commoditized
labour, the surplus generated by honest toil, appropriated and then ‘reified’
in order to satisfy the capitalist class’s insatiable lust for accumulation.
Such notions die hard. As recently as the 1970s, some European Communists were
still yearning for a moneyless world, as in this Utopian effusion from
the Socialist Standard:
Money will disappear . . . Gold can be reserved
in accordance with Lenin’s wish, for the construction of public lavatories . .
. In communist societies goods will be freely available and free of charge. The
organisation of society to its very foundations will be without money . . . The
frantic and neurotic desire to consume and hoard will disappear. It will be
absurd to want to accumulate things: there will no longer be money to be
pocketed nor wage-earners to be hired . . . The new people will resemble their
hunting and gathering ancestors who trusted in a nature which supplied them
freely and often abundantly with what they needed to live, and who had no worry
for the morrow . . .1
Yet no
Communist state - not even North Korea - has found it practical to dispense
with money.2 And even a passing acquaintance with real
hunter-gatherer societies suggests there are considerable disadvantages to the
cash-free life.
Five
years ago, members of the Nukak-Makú unexpectedly wandered out of the Amazonian
rainforest at San José del Guaviare in Colombia. The Nukak were a tribe that
time forgot, cut off from the rest of humanity until this sudden emergence.
Subsisting solely on the monkeys they could hunt and the fruit they could
gather, they had no concept of money. Revealingly, they had no concept of the
future either. These days they live in a clearing near the city, reliant for
their subsistence on state handouts. Asked if they miss the jungle, they laugh.
After lifetimes of trudging all day in search of food, they are amazed that
perfect strangers now give them all they need and ask nothing from them in
return.3
The life
of a hunter-gatherer is indeed, as Thomas Hobbes said of the state of nature,
‘solitary, poor, nasty, brutish, and short’. In some respects, to be sure,
wandering through the jungle bagging monkeys may be preferable to the hard slog
of subsistence agriculture. But anthropologists have shown that many of the
hunter-gatherer tribes who survived into modern times were less placid than the
Nukak. Among the Jivaro of Ecuador, for example, nearly 60 per cent of male
deaths were due to violence. The figure for the Brazilian Yanomamo was nearly
40 per cent. When two groups of such primitive peoples chanced upon each other,
it seems, they were more likely to fight over scarce resources (food and
fertile women) than to engage in commercial exchange. Hunter-gatherers do not
trade. They raid. Nor do they save, consuming their food as and when they find
it. They therefore have no need of money.
THE
MONEY MOUNTAIN
More
sophisticated societies than the Nukak have functioned without money, it is
true. Five hundred years ago, the most sophisticated society in South America,
the Inca Empire, was also moneyless. The Incas appreciated the aesthetic
qualities of rare metals. Gold was the ‘sweat of the sun’, silver the ‘tears of
the moon’. Labour was the unit of value in the Inca Empire, just as it was
later supposed to be in a Communist society. And, as under Communism, the
economy depended on often harsh central planning and forced labour. In 1532,
however, the Inca Empire was brought low by a man who, like Christopher
Columbus, had come to the New World expressly to search for and monetize
precious metal.c
The
illegitimate son of a Spanish colonel, Francisco Pizarro had crossed the
Atlantic to seek his fortune in 1502.4 One of the first
Europeans to traverse the isthmus of Panama to the Pacific, he led the first of
three expeditions into Peru in 1524. The terrain was harsh, food scarce and the
first indigenous peoples they encountered hostile. However, the welcome their
second expedition received in the Tumbes region, where the inhabitants hailed
them as the ‘children of the sun’, convinced Pizarro and his confederates to
persist. Having returned to Spain to obtain royal approval for his plan ‘to
extend the empire of Castile’d as ‘Governor of Peru’,
Pizarro raised a force of three ships, twenty-seven horses and one hundred and
eighty men, equipped with the latest European weaponry: guns and mechanical
crossbows.5 This third expedition set sail from Panama
on 27 December 1530. It took the would-be conquerors just under two years to
achieve their objective: a confrontation with Atahuallpa, one of the two
feuding sons of the recently deceased Incan emperor Huayna Capac. Having declined
Friar Vincente Valverd’s proposal that he submit to Christian rule,
contemptuously throwing his Bible to the ground, Atahuallpa could only watch as
the Spaniards, relying mainly on the terror inspired by their horses (animals
unknown to the Incas), annihilated his army. Given how outnumbered they were,
it was a truly astonishing coup.6 Atahuallpa soon came
to understand what Pizarro was after, and sought to buy his freedom by offering
to fill the room where he was being held with gold (once) and silver (twice).
In all, in the subsequent months the Incas collected 13,420 pounds of 22 carat
gold and 26,000 pounds of pure silver.7 Pizarro
nevertheless determined to execute his prisoner, who was publicly garrotted in
August 1533.8 With the fall of the city of Cuzco, the
Inca Empire was torn apart in an orgy of Spanish plundering. Despite a revolt
led by the supposedly puppet Inca Manco Capac in 1536, Spanish rule was
unshakeably established and symbolized by the construction of a new capital,
Lima. The Empire was formally dissolved in 1572.
Pizarro
himself died as violently as he had lived, stabbed to death in Lima in 1541
after a quarrel with one of his fellow conquistadors. But his legacy to the
Spanish crown ultimately exceeded even his own dreams. The conquistadors had
been inspired by the legend of El Dorado, an Indian king who was believed to
cover his body with gold dust at festival times. In what Pizarro’s men called
Upper Peru, a stark land of mountains and mists where those unaccustomed to
high altitudes have to fight for breath, they found something just as valuable.
With a peak that towers 4,824 metres (15,827 feet) above sea level, the
uncannily symmetrical Cerro Rico - literally the ‘rich hill’ - was the supreme
embodiment of the most potent of all ideas about money: a mountain of solid
silver ore. When an Indian named Diego Gualpa discovered its five great seams
of silver in 1545, he changed the economic history of the world.9
The Incas
could not understand the insatiable lust for gold and silver that seemed to
grip Europeans. ‘Even if all the snow in the Andes turned to gold, still they
would not be satisfied,’ complained Manco Capac.10 The
Incas could not appreciate that, for Pizarro and his men, silver was more than
shiny, decorative metal. It could be made into money: a unit of account, a
store of value - portable power.
To work
the mines, the Spaniards at first relied on paying wages to the inhabitants of
nearby villages. But conditions were so harsh that from the late sixteenth
century a system of forced labour (la mita) had to be introduced,
whereby men aged between 18 and 50 from the sixteen highland provinces were
conscripted for seventeen weeks a year.11 Mortality
among the miners was horrendous, not least because of constant exposure to the
mercury fumes generated by the patio process of refinement, whereby ground-up
silver ore was trampled into an amalgam with mercury, washed and then heated to
burn off the mercury.12 The air down the mineshafts was
(and remains) noxious and miners had to descend seven-hundred-foot shafts on
the most primitive of steps, clambering back up after long hours of digging
with sacks of ore tied to their backs. Rock falls killed and maimed hundreds.
The new silver-rush city of Potosí was, declared Domingo de Santo Tomás, ‘a
mouth of hell, into which a great mass of people enter every year and are
sacrificed by the greed of the Spaniards to their “god”.’ Rodrigo de Loaisa
called the mines ‘infernal pits’, noting that ‘if twenty healthy Indians enter
on Monday, half may emerge crippled on Saturday’.13 In
the words of the Augustinian monk Fray Antonio de la Calancha, writing in 1638:
‘Every peso coin minted in Potosí has cost the life of ten Indians who have
died in the depths of the mines.’ As the indigenous workforce was depleted,
thousands of African slaves were imported to take their places as ‘human
mules’. Even today there is still something hellish about the stifling shafts
and tunnels of the Cerro Rico.
A place
of death for those compelled to work there, Potosí was where Spain struck it
rich. Between 1556 and 1783, the ‘rich hill’ yielded 45,000 tons of pure silver
to be transformed into bars and coins in the Casa de Moneda (mint), and shipped
to Seville. Despite its thin air and harsh climate, Potosí rapidly became one
of the principal cities of the Spanish Empire, with a population at its zenith
of between 160,000 and 200,000 people, larger than most European cities at that
time. Valer un potosí, ‘to be worth a potosí’, is still a Spanish
expression meaning to be worth a fortune. Pizarro’s conquest, it seemed, had
made the Spanish crown rich beyond the dreams of avarice.
Money, it
is conventional to argue, is a medium of exchange, which has the advantage of
eliminating inefficiencies of barter; a unit of account, which facilitates
valuation and calculation; and a store of value, which allows economic
transactions to be conducted over long periods as well as geographical
distances. To perform all these functions optimally, money has to be available,
affordable, durable, fungible, portable and reliable. Because they fulfil most
of these criteria, metals such as gold, silver and bronze were for millennia
regarded as the ideal monetary raw material. The earliest known coins date back
as long ago as 600 BC and were found by archaeologists in the Temple of Artemis
at Ephesus (near Izmir in modern-day Turkey). These ovular Lydian coins, which
were made of the gold-silver alloy known as electrum and bore the image of a
lion’s head, were the forerunners of the Athenian tetradrachm, a standardized
silver coin with the head of the goddess Athena on one side and an owl
(associated with her for its supposed wisdom) on the obverse. By Roman times,
coins were produced in three different metals: the aureus (gold), the denarius
(silver) and the sestertius (bronze), ranked in that order according to the
relative scarcity of the metals in question, but all bearing the head of the
reigning emperor on one side, and the legendary figures of Romulus and Remus on
the other. Coins were not unique to the ancient Mediterranean, but they clearly
arose there first. It was not until 221 BC that a standardized bronze coin was
introduced to China by the ‘first Emperor’, Qin Shihuangdi. In each case, coins
made of precious metal were associated with powerful sovereigns who monopolized
the minting of money partly to exploit it as a source of revenue.
The Roman
system of coinage outlived the Roman Empire itself. Prices were still being
quoted in terms of silver denarii in the time of Charlemagne, king of the
Franks from 768 to 814. The difficulty was that by the time Charlemagne was
crowned Imperator Augustus in 800, there was a chronic
shortage of silver in Western Europe. Demand for money was greater in the much
more developed commercial centres of the Islamic Empire that dominated the
southern Mediterranean and the Near East, so that precious metal tended to
drain away from backward Europe. So rare was the denarius in Charlemagne’s time
that twenty-four of them sufficed to buy a Carolingian cow. In some parts of
Europe, peppers and squirrel skins served as substitutes for currency; in
others pecunia came to mean land rather than money. This was a
problem that Europeans sought to overcome in one of two ways. They could export
labour and goods, exchanging slaves and timber for silver in Baghdad or for
African gold in Cordoba and Cairo. Or they could plunder precious metal by
making war on the Muslim world. The Crusades, like the conquests that followed,
were as much about overcoming Europe’s monetary shortage as about converting
heathens to Christianity.14
Crusading
was an expensive affair and the net returns were modest. To compound their
monetary difficulties, medieval and early modern governments failed to find a
solution to what economists have called the big problem of small change: the
difficulty of establishing stable relationships between coins made of different
kinds of metal, which meant that smaller denomination coins were subject to
recurrent shortages, yet also to depreciations and debasements.15 At
Potosí, and the other places in the New World where they found plentiful silver
(notably Zacatecas in Mexico), the Spanish conquistadors therefore appeared to
have broken a centuries-old constraint. The initial beneficiary was, of course,
the Castilian monarchy that had sponsored the conquests. The convoys of ships -
up to a hundred at a time - which transported 170 tons of silver a year across
the Atlantic, docked at Seville. A fifth of all that was produced was reserved
to the crown, accounting for 44 per cent of total royal expenditure at the peak
in the late sixteenth century.16 But the way the money
was spent ensured that Spain’s newfound wealth provided the entire continent
with a monetary stimulus. The Spanish ‘piece of eight’, which was based on the
German thaler (hence, later, the ‘dollar’), became the world’s
first truly global currency, financing not only the protracted wars Spain
fought in Europe, but also the rapidly expanding trade of Europe with Asia.
And yet
all the silver of the New World could not bring the rebellious Dutch Republic
to heel; could not secure England for the Spanish crown; could not save Spain
from an inexorable economic and imperial decline. Like King Midas, the Spanish
monarchs of the sixteenth century, Charles V and Philip II, found that an
abundance of precious metal could be as much a curse as a blessing. The reason?
They dug up so much silver to pay for their wars of conquest that the metal
itself dramatically declined in value - that is to say, in its purchasing power
with respect to other goods. During the so-called ‘price revolution’, which
affected all of Europe from the 1540s until the 1640s, the cost of food - which
had shown no sustained upward trend for three hundred years - rose markedly. In
England (the country for which we have the best price data) the cost of living
increased by a factor of seven in the same period; not a high rate of inflation
these days (on average around 2 per cent per year), but a revolutionary
increase in the price of bread by medieval standards. Within Spain, the
abundance of silver also acted as a ‘resource curse’, like the abundant oil of
Arabia, Nigeria, Persia, Russia and Venezuela in our own time, removing the
incentives for more productive economic activity, while at the same time
strengthening rent-seeking autocrats at the expense of representative
assemblies (in Spain’s case the Cortes).17
What the
Spaniards had failed to understand is that the value of precious metal is not
absolute. Money is worth only what someone else is willing to give you for it.
An increase in its supply will not make a society richer, though it may enrich
the government that monopolizes the production of money. Other things being
equal, monetary expansion will merely make prices higher.
There was
in fact no reason other than historical happenstance that money was for so long
equated in the Western mind with metal. In ancient Mesopotamia, beginning
around five thousand years ago, people used clay tokens to record transactions
involving agricultural produce like barley or wool, or metals such as silver.
Rings, blocks or sheets made of silver certainly served as ready money (as did
grain), but the clay tablets were just as important, and probably more so. A
great many have survived, reminders that when human beings first began to
produce written records of their activities they did so not to write history,
poetry or philosophy, but to do business.18 It is
impossible to pick up such ancient financial instruments without a feeling of
awe. Though made of base earth, they have endured much longer than the silver
dollars in the Potosí mint. One especially well-preserved token, from the town
of Sippar (modern-day Tell Abu Habbah in Iraq), dates from the reign of King
Ammi-ditana (1683-1647 BC) and states that its bearer should receive a specific
amount of barley at harvest time. Another token, inscribed during the reign of
his successor, King Ammi-saduqa, orders that the bearer should be given a
quantity of silver at the end of a journey.19
If the
basic concept seems familiar to us, it is partly because a modern banknote does
similar things. Just take a look at the magic words on any Bank of England
note: ‘I promise to pay the bearer on demand the sum of . . .’. Banknotes
(which originated in seventh-century China) are pieces of paper which have next
to no intrinsic worth. They are simply promises to pay (hence their original
Western designation as ‘promissory notes’), just like the clay tablets of
ancient Babylon four millennia ago. ‘In God We Trust’ it says on the back of
the ten-dollar bill, but the person you are really trusting when you accept one
of these in payment is the successor to the man on the front (Alexander
Hamilton, the first Secretary of the US Treasury), who at the time of writing
happens to be Lloyd Blankfein’s predecessor as chief executive of Goldman
Sachs, Henry M. Paulson, Jr. When an American exchanges his goods or his labour
for a fistful of dollars, he is essentially trusting ‘Hank’ Paulson (and by
implication the Chairman of the Federal Reserve System, Ben Bernanke) not to
repeat Spain’s error and manufacture so many of these things that they end up
being worth no more than the paper they are printed on.
Today,
despite the fact that the purchasing power of the dollar has declined
appreciably over the past fifty years, we remain more or less content with
paper money - not to mention coins that are literally made from junk. Stores of
value these are not. Even more amazingly, we are happy with money we cannot
even see. Today’s electronic money can be moved from our employer, to our bank
account, to our favourite retail outlets without ever physically materializing.
It is this ‘virtual’ money that now dominates what economists call the money
supply. Cash in the hands of ordinary Americans accounts for just 11 per cent
of the monetary measure known as M2. The intangible character of most money
today is perhaps the best evidence of its true nature. What the conquistadors
failed to understand is that money is a matter of belief, even faith: belief in
the person paying us; belief in the person issuing the money he uses or the
institution that honours his cheques or transfers. Money is not metal. It is
trust inscribed. And it does not seem to matter much where it is inscribed: on
silver, on clay, on paper, on a liquid crystal display. Anything can serve as
money, from the cowrie shells of the Maldives to the huge stone discs used on
the Pacific islands of Yap.20 And now, it seems, in this
electronic age nothing can serve as money too.
The
central relationship that money crystallizes is between lender and borrower.
Look again at those Mesopotamian clay tablets. In each case, the transactions
recorded on them were repayments of commodities that had been loaned; the
tablets were evidently drawn up and retained by the lender (often in a sealed
clay container) to record the amount due and the date of repayment. The lending
system of ancient Babylon was evidently quite sophisticated. Debts were
transferable, hence ‘pay the bearer’ rather than a named creditor. Clay
receipts or drafts were issued to those who deposited grain or other
commodities at royal palaces or temples. Borrowers were expected to pay
interest (a concept which was probably derived from the natural increase of a
herd of livestock), at rates that were often as high as 20 per cent.
Mathematical exercises from the reign of Hammurabi (1792-1750 BC) suggest that
something like compound interest could be charged on long-term loans. But the
foundation on which all of this rested was the underlying credibility of a
borrower’s promise to repay. (It is no coincidence that in English the root of
‘credit’ is credo, the Latin for ‘I believe’.) Debtors might
periodically be relieved - indeed the Laws of Hammurabi prescribed debt
forgiveness every three years - but this does not appear to have deterred
private as well as public lenders from doing business in the reasonable
expectation of getting their money back.21 On the
contrary, the long-term trend in ancient Mesopotamia was for private finance to
expand. By the sixth century BC, families like the Babylonian Egibi had emerged
as powerful landowners and lenders, with commercial interests as far afield as
Uruk over a hundred miles to the south and Persia to the east. The thousands of
clay tablets that survive from that period testify to the number of people who
at one time or another were in debt to the Egibi. The fact that the family
thrived for five generations suggests that they generally collected their
debts.
It would
not be quite correct to say that credit was invented in ancient Mesopotamia.
Most Babylonian loans were simple advances from royal or religious storehouses.
Credit was not being created in the modern sense discussed later in this
chapter. Nevertheless, this was an important beginning. Without the foundation
of borrowing and lending, the economic history of our world would scarcely have
got off the ground. And without the ever-growing network of relationships
between creditors and debtors, today’s global economy would grind to a halt.
Contrary to the famous song in the musical Cabaret, money does not
literally make the world go round. But it does make staggering quantities of
people, goods and services go around the world.
The
remarkable thing is how belatedly and hesitantly the idea of credit took root
in the very part of the world where it has flourished most spectacularly.
LOAN
SHARKS
Northern
Italy in the early thirteenth century was a land subdivided into multiple
feuding city-states. Among the many remnants of the defunct Roman Empire was a
numerical system (i, ii, iii, iv . . .) singularly ill-suited to complex
mathematical calculation, let alone the needs of commerce. Nowhere was this
more of a problem than in Pisa, where merchants also had to contend with seven
different forms of coinage in circulation. By comparison, economic life in the
Eastern world - in the Abassid caliphate or in Sung China - was far more
advanced, just as it had been in the time of Charlemagne. To discover modern
finance, Europe needed to import it. In this, a crucial role was played by a
young mathematician called Leonardo of Pisa, or Fibonacci.
The son
of a Pisan customs official based in what is now Bejaia in Algeria, the young
Fibonacci had immersed himself in what he called the ‘Indian method’ of
mathematics, a combination of Indian and Arab insights. His introduction of
these ideas was to revolutionize the way Europeans counted. Nowadays he is best
remembered for the Fibonacci sequence of numbers (0, 1, 1, 2, 3, 5, 8, 13, 21 .
. .), in which each successive number is the sum of the previous two, and the
ratio between a number and its immediate antecedent tends towards a ‘golden
mean’ (around 1.618). It is a pattern that mirrors some of the repeating
properties to be found in the natural world (for example in the fractal
geometry of ferns and sea shells).e But the Fibonacci
sequence was only one of many Eastern mathematical ideas introduced to Europe
in his path-breaking book Liber Abaci, ‘The Book of Calculation’,
which he published in 1202. In it, readers could find fractions explained, as
well as the concept of present value (the discounted value today of a future
revenue stream).22 Most important of all was Fibonacci’s
introduction of Hindu-Arabic numerals. He not only gave Europe the decimal
system, which makes all kinds of calculation far easier than with Roman
numerals; he also showed how it could be applied to commercial bookkeeping, to
currency conversions and, crucially, to the calculation of interest.
Significantly, many of the examples in the Liber Abaci are made
more vivid by being expressed in terms of commodities like hides, peppers,
cheese, oil and spices. This was to be the application of mathematics to making
money and, in particular, to lending money. One characteristic example begins:
A man placed 100 pounds at a certain
[merchant’s] house for 4 denarii per pound per month interest and he took back
each year a payment of 30 pounds. One must compute in each year the 30 pounds
reduction of capital and the profit on the said 30 pounds. It is sought how many
years, months, days and hours he will hold money in the house . . .
Italian
commercial centres like Fibonacci’s home town of Pisa or nearby Florence proved
to be fertile soil for such financial seeds. But it was above all Venice, more
exposed than the others to Oriental influences, that became Europe’s great
lending laboratory. It is not coincidental that the most famous moneylender in
Western literature was based in Venice. His story brilliantly illuminates the
obstacles that for centuries impeded the translation of Fibonacci’s theories
into effective financial practice. These obstacles were not economic, or
political. They were cultural.
Shakespeare’s
play The Merchant of Venice is based on a story in a
fourteenth-century Italian book called Il Pecorone (‘The
Dunce’), a collection of tales and anecdotes written in 1378 by Giovanni
Fiorentino. One story tells of a wealthy woman who marries an upstanding young
gentleman. Her husband needs money and his friend, eager to help, goes to a
moneylender to borrow the cash on his friend’s behalf. The moneylender, like
Shylock a Jew, demands a pound of flesh as security, to be handed over if the
money is not paid back. As Shakespeare rewrote it, the Jewish moneylender
Shylock agrees to lend the lovelorn suitor Bassanio three thousand ducats, but
on the security of Bassanio’s friend, the merchant Antonio. As Shylock says,
Antonio is a ‘good’ man - meaning not that he is especially virtuous, but that
his credit is ‘sufficient’. However, Shylock also points out that lending money
to merchants (or their friends) is risky. Antonio’s ships are scattered all
over the world, one going to North Africa, another to India, a third to Mexico,
a fourth to England:
. . . his means are in supposition: he hath an
argosy bound to Tripolis, another to the Indies; I understand moreover, upon
the Rialto, he hath a third at Mexico, a fourth for England, and other ventures
he hath, squandered abroad. But ships are but boards, sailors but men: there be
land-rats and water-rats, water-thieves and land-thieves, I mean pirates, and
then there is the peril of waters, winds and rocks.
That is
precisely why anyone who lends money to a merchant, if only for the duration of
an ocean voyage, needs to be compensated. We usually call the compensation interest:
the amount paid to the lender over and above the sum lent, or the principal.
Overseas trade of the sort that Venice depended on could not have happened if
its financiers had not been rewarded in some way for risking their money on
mere boards and men.
But why
does Shylock turn out to be such a villain, demanding literally a pound of
flesh - in effect Antonio’s death - if he cannot fulfil his obligations? The
answer is of course that Shylock is one of the many moneylenders in history to
have belonged to an ethnic minority. By Shakespeare’s time, Jews had been
providing commercial credit in Venice for nearly a century. They did their
business in front of the building once known as the Banco Rosso, sitting behind
their tables - their tavule - and on their benches,
their banci. But the Banco Rosso was located in a cramped ghetto
some distance away from the centre of the city.
There was
a good reason why Venetian merchants had to come to the Jewish ghetto if they
wanted to borrow money. For Christians, lending money at interest was a sin.
Usurers, people who lent money at interest, had been excommunicated by the
Third Lateran Council in 1179. Even arguing that usury was not a sin had been
condemned as heresy by the Council of Vienna in 1311-12. Christian usurers had
to make restitution to the Church before they could be buried on hallowed
ground. They were especially detested by the Franciscan and Dominican orders,
founded in 1206 and 1216 (just after the publication of Fibonacci’s Liber
Abaci). The power of this taboo should not be underestimated, though it had
certainly weakened by Shakespeare’s time.23
In
Florence’s Duomo (cathedral) there is a fresco by Domenico di Michelino that
shows the great Florentine poet Dante Alighieri holding his book the Divine
Comedy. As Dante imagined it in Canto XVII of his masterpiece, there was a
special part of the seventh circle of Hell reserved for usurers:
Sorrow . . . gushed from their eyes and made
their sad tears flow;
While this way and that they flapped their
hands, for ease
From the hot soil now, and now from the burning
snow,
Behaving, in fact, exactly as one sees
Dogs in the summer, scuffing with snout and
paw
When they’re eaten up with gnats and flies and
fleas.
I looked at many thus scorched by the fiery
flaw,
And though I scanned their faces with the
utmost heed,
There was no one there I recognized; but I saw
How, stamped with charge and tincture plain to
read,
About the neck of each a great purse
hung,
Whereon their eyes seemed still to fix and
feed.
Jews,
too, were not supposed to lend at interest. But there was a convenient get-out
clause in the Old Testament book of Deuteronomy: ‘Unto a stranger thou mayest
lend upon usury; but unto thy brother thou shalt not lend upon usury.’ In other
words, a Jew might legitimately lend to a Christian, though not to another Jew.
The price of doing so was social exclusion.
Jews had
been expelled from Spain in 1492. Along with many Portuguese conversos,
Jews who were forced to adopt Christianity by a decree of 1497, they sought
refuge in the Ottoman Empire. From Constantinople and other Ottoman ports they
then established trading relationships with Venice. The Jewish presence in
Venice dates from 1509, when Jews living in Mestre sought refuge from the War
of the League of Cambrai. At first the city’s government was reluctant to
accept the refugees, but it soon became apparent that they might prove a useful
source of money and financial services, since they could be taxed as well as
borrowed from.24 In 1516 the Venetian authorities
designated a special area of the city for Jews on the site of an old iron
foundry which became known as the ghetto nuovo (getto literally
means casting). There they were to be confined every night and on Christian
holidays. Those who stayed in Venice for more than two weeks were supposed to
wear a yellow O on their backs or a yellow (later scarlet) hat or turban.25 Residence
was limited to a stipulated period on the basis of condotte (charters)
renewed every five years.26 A similar arrangement was
reached in 1541 with some Jews from Romania, who were accorded the right to
live in another enclave, the ghetto vecchio. By 1590 there were
around 2,500 Jews in Venice. Buildings in the ghetto grew seven storeys high to
accommodate the newcomers.
Throughout
the sixteenth century, the position of the Venetian Jews remained conditional
and vulnerable. In 1537, when war broke out between Venice and the Ottoman
Empire, the Venetian Senate ordered the sequestration of the property of
‘Turks, Jews and other Turkish subjects’. Another war from 1570 to 1573 led to
the arrest of all Jews and the seizure of their property, though they were
freed and had their assets returned after peace had been restored.27 To
avoid a repetition of this experience, the Jews petitioned the Venetian
government to be allowed to remain free during any future war. They were
fortunate to be represented by Daniel Rodriga, a Jewish merchant of Spanish
origin who proved to be a highly effective negotiator. The charter he succeeded
in obtaining in 1589 granted all Jews the status of Venetian subjects,
permitted them to engage in the Levant trade - a valuable privilege - and
allowed them to practise their religion openly. Nevertheless, important
restrictions remained. They were not allowed to join guilds or to engage in
retail trade, hence restricting them to financial services, and their
privileges were subject to revocation at eighteen months’ notice. As citizens,
Jews now stood more chance of success than Shylock in the Venetian law courts. In
1623, for example, Leon Voltera sued Antonio dalla Donna, who had stood
security for a knight who had borrowed certain items from Voltera and then
vanished. In 1636-7, however, a scandal involving the bribery of judges, in
which some Jews were implicated, seems once again to have raised the threat of
expulsion.28
Though
fictional, the story of Shylock is therefore not entirely removed from Venetian
reality. Indeed, Shakespeare’s play quite accurately illustrates three
important points about early modern money-lending: the power of lenders to
charge extortionate interest rates when credit markets are in their infancy;
the importance of law courts in resolving financial disputes without recourse
to violence; but above all the vulnerability of minority creditors to a
backlash by hostile debtors who belong to the ethnic majority. For in the end,
of course, Shylock is thwarted. Although the court recognizes his right to
insist on his bond - to claim his pound of flesh - the law also prohibits him
from shedding Antonio’s blood. And, because he is an alien, the law requires
the loss of his goods and life for plotting the death of a Christian. He
escapes only by submitting to baptism. Everyone lives happily ever after -
except Shylock.
The
Merchant of Venice raises
profound questions about economics as well as anti-Semitism. Why don’t debtors
always default on their creditors - especially when the creditors belong to
unpopular ethnic minorities? Why don’t the Shylocks always lose out?
Loan
sharks, like the poor on whom they prey, are always with us. They thrive in
East Africa, for example. But there is no need to travel to the developing
world to understand the workings of primitive money-lending. According to a
2007 report by the Department of Trade and Industry, approximately 165,000
households in the UK use illegal moneylenders, borrowing in aggregate up to £40
million a year, but repaying three times that amount. To see just why one-man
moneylenders are nearly always unpopular, regardless of their ethnicity, all you
need do is pay a visit to my home town, Glasgow. The deprived housing estates
of the city’s East End have long been fertile breeding grounds for loan sharks.
In districts like Shettleston, where my grandparents lived, there are steel
shutters over the windows of derelict tenements and sectarian graffiti on the
bus shelters. Once, Shettleston’s economic life revolved around the pay packets
of the workers employed at Boyd’s ironworks. Now it revolves around the benefit
payments made into the Post Office accounts of the unemployed. Male life
expectancy in Shettleston is around 64, thirteen years less than the UK average
and the same as in Pakistan, which means that a newborn boy there typically
will not live long enough to collect his state pension.
Such deprived
areas of Glasgow are perfect hunting grounds for loan sharks. In the district
of Hillington, Gerard Law was for twenty years the number one loan shark. He
used the Argosy pub on Paisley Road West as his office, spending most working
days there, despite himself being a teetotaller. Law’s system was simple.
Borrowers would hand over their benefit books or Post Office cashcards to him
in return for a loan, the terms of which he recorded in his loan book. When a
benefit cheque was due, Law would give the borrower back his card and wait to
collect his interest. The loan book itself was strikingly crude: a haphazard
compilation of transactions in which the same twenty or thirty names and
nicknames feature again and again alongside sums of varying sizes: ‘Beardy Al
15’, ‘Jibber 100’, ‘Bernadett 150’, ‘Wee Caffy 1210’. The standard rate of
interest Law charged his clients was a staggering 25 per cent a week.
Typically, the likes of Beardy Al borrowed ten pounds and paid back £12.50
(principal plus interest) a week later. Often, however, Law’s clients could not
afford to make their scheduled repayments; hardly surprising when some people
in the area have to live on as little as £5.90 a day. So they borrowed some
more. Soon some clients owed him hundreds, even thousands, of pounds. The speed
with which they became entirely trapped by their debts is scarcely surprising.
Twenty-five per cent a week works out at over 11 million per cent compound
interest a year.
Over the
very long run, interest rates in Europe have tended to decline. So why do some
people in Britain today pay eight-digit interest rates on trivial loans? These,
surely, are loans you would be mad not to default on. Some of
Law’s clients were in fact mentally subnormal. Yet there were evidently reasons
why his sane clients felt it would be inadvisable to renege on their
commitments to him, no matter how extortionate. As the Scotsman newspaper
put it: ‘many of his victims were terrified to risk missing a payment due to
his reputation’ - though it is not clear that Law ever actually resorted to
violence.29 Behind every loan shark, as the case of
Shylock also shows, there lurks an implicit threat.
It is
easy to condemn loan sharks as immoral and, indeed, criminal. Gerard Law was
sentenced to ten months in prison for his behaviour. Yet we need to try to
understand the economic rationale for what he did. First, he was able to take
advantage of the fact that no mainstream financial institution would extend
credit to the Shettleston unemployed. Second, Law had to be rapacious and
ruthless precisely because the members of his small clientele were in fact very
likely to default on their loans. The fundamental difficulty with being a loan
shark is that the business is too small-scale and risky to allow low interest rates.
But the high rates make defaults so much more likely that only intimidation
ensures that people keep paying. So how did moneylenders learn to overcome the
fundamental conflict: if they were too generous, they made no money; if they
were too hard-nosed, like Gerard Law, people eventually called in the police?
The
answer is by growing big - and growing powerful.
THE
BIRTH OF BANKING
Shylock
was far from the only moneylender to discover the inherent weakness of the
creditor, especially when the creditor is a foreigner. In the early fourteenth
century, finance in Italy had been dominated by the three Florentine houses of
Bardi, Peruzzi and Acciaiuoli. All three were wiped out in the 1340s as a
result of defaults by two of their principal clients, King Edward III of
England and King Robert of Naples. But if that illustrates the potential
weakness of moneylenders, the rise of the Medici illustrates the very opposite:
their potential power.
Perhaps
no other family left such an imprint on an age as the Medici left on the
Renaissance. Two Medici became popes (Leo X and Clement VII); two became queens
of France (Catherine and Marie); three became dukes (of Florence, Nemours and
Tuscany). Appropriately, it was that supreme theorist of political power,
Niccolò Machiavelli, who wrote their history. Their patronage of the arts and
sciences ran the gamut of genius from Michel-angelo to Galileo. And their
dazzling architectural legacy still surrounds the modern-day visitor to
Florence. Only look at the villa of Cafaggiolo, the monastery of San Marco, the
basilica of San Lorenzo and the spectacular palaces occupied by Duke Cosimo de’
Medici in the mid sixteenth century: the former Pitti Palace, the redecorated
Palazzo Vecchio and the new city offices (Uffizi) with their courtyard running
down to the River Arno.30But what were the origins of all
this splendour? Where did the money come from that paid for masterpieces like
Sandro Botticelli’s radiant Birth of Venus? The simple answer is
that the Medici were foreign exchange dealers: members of the Arte de
Cambio (the Moneychangers’ Guild). They came to be known as bankers (banchieri)
because, like the Jews of Venice, they did their business literally seated at
benches behind tables in the street. The original Medici bank (stall would be a
better description) was located near the Cavalcanti palace, at the corner of
the present-day via dia Porta Rossa and the Via dell’ Arte della Lana, a short
walk from the main Florentine wool market.
Prior to
the 1390s, it might legitimately be suggested, the Medici were more gangsters
than bankers: a small-time clan, notable more for low violence than for high
finance. Between 1343 and 1360 no fewer than five Medici were sentenced to
death for capital crimes.31 Then came Giovanni di Bicci
de’ Medici. It was his aim to make the Medici legitimate. And through hard
work, sober living and careful calculation, he succeeded.
In 1385
Giovanni became manager of the Roman branch of the bank run by his relation
Vieri di Cambio de’ Medici, a moneylender in Florence. In Rome, Giovanni built
up his reputation as a currency trader. The papacy was in many ways the ideal
client, given the number of different currencies flowing in and out of the
Vatican’s coffers. As we have seen, this was an age of multiple systems of
coinage, some gold, some silver, some base metal, so that any long-distance
trade or tax payment was complicated by the need to convert from one currency
to another. But Giovanni clearly saw even greater opportunities in his native
Florence, whence he returned in 1397. By the time he passed on the business to
his eldest son Cosimo in 1420, he had established a branch of the bank in
Venice as well as Rome; branches were later added in Geneva, Pisa, London and
Avignon. Giovanni had also acquired interests in two Florence wool factories.
Of
particular importance in the Medici’s early business were the bills of exchange
(cambium per literas) that had developed in the course of the Middle
Ages as a way of financing trade.32 If one merchant owed
another a sum that could not be paid in cash until the conclusion of a
transaction some months hence, the creditor could draw a bill on the debtor and
either use the bill as a means of payment in its own right or obtain cash for
it at a discount from a banker willing to act as broker. Whereas the charging
of interest was condemned as usury by the Church, there was nothing to prevent
a shrewd trader making profits on such transactions. That was the essence of
the Medici business. There were no cheques; instructions were given orally and
written in the bank’s books. There was no interest; depositors were given discrezione (in
proportion to the annual profits of the firm) to compensate them for risking
their money.33
The libro
segreto - literally the secret bookf - of Giovanni
di Bicci de’ Medici sheds fascinating light on the family’s rise.34 In
part, this was simply a story of meticulous bookkeeping. By modern standards,
to be sure, there were imperfections. The Medici did not systematically use the
double-entry method, though it was known in Genoa as early as the 1340s.35 Still,
the modern researcher cannot fail to be impressed by the neatness and
orderliness of the Medici accounts. The archives also contain a number of early
Medici balance sheets, with reserves and deposits correctly arranged on one
side (as liabilities or vostro) and loans to clients or commercial
bills on the other side (as assets or nostro). The Medici did not
invent these techniques, but they applied them on a larger scale than had
hitherto been seen in Florence. The real key to the Medicis’ success, however,
was not so much size as diversification. Whereas earlier Italian banks had been
monolithic structures, easily brought down by one defaulting debtor, the Medici
bank was in fact multiple related partnerships, each based on a special,
regularly renegotiated contract. Branch managers were not employees but junior
partners who were remunerated with a share of the profits. It was this
decentralization that helped make the Medici bank so profitable. With a capital
of around 20,000 florins in 1402 and a payroll of at most seventeen people, it
made profits of 151,820 florins between 1397 and 1420 - around 6,326 florins a
year, a rate of return of 32 per cent. The Rome branch alone was soon posting
returns of over 30 per cent.36 The proof that the model
worked can be seen in the Florentine tax records, which list page after page of
Giovanni di Bicci’s assets, totalling some 91,000 florins.37
When
Giovanni died in 1429 his last words were an exhortation to his heirs to
maintain his standards of financial acumen. His funeral was attended by
twenty-six men of the name Medici, all paying homage to the self-made capo
della casa. By the time Pius II became pope in 1458, Giovanni’s son Cosimo
de’ Medici effectively was the Florentine state. As the Pope himself put it:
‘Political questions are settled at his house. The man he chooses holds office
. . . He it is who decides peace and war and controls the laws . . . He is King
in everything but name.’ Foreign rulers were advised to communicate with him
personally and not to waste their time by approaching anyone else in Florence.
The Florentine historian Francesco Guicciardini observed: ‘He had a reputation
such as probably no private citizen has ever enjoyed from the fall of Rome to
our own day.’ One of Botticelli’s most popular portraits - of a strikingly
handsome young man - was actually intended as a tribute to a dead banker. The
face on the medal is that of Cosimo de’ Medici, and alongside it is the
inscription pater patriae: ‘father of his country’. By the time
Lorenzo the Magnificent, Cosimo’s grandson, took over the bank in 1469, the
erstwhile Sopranos had become the Corleones - and more. And it was all based on
banking.
More than
anything else, it is Botticelli’s Adoration of the Magi that
captures the transfiguration of finance that the Medici had achieved. On close
inspection, the three wise men are all Medici: the older man washing the feet
of the baby Jesus is Cosimo the Elder; below him, slightly to the right, are
his two sons Piero (in red) and Giovanni (in white). Also in the picture are
Lorenzo (in a pale blue robe) and, clasping his sword, Giuliano. The painting
was commissioned by the head of the Bankers’ Guild as a tribute to the family.
It should perhaps have been called The Adoration of the Medici.
Having once been damned, bankers were now close to divinity.
The
subjugation of the Florentine republic to the power of one super-rich banking
family inevitably aroused opposition. Between October 1433 and September 1434
Cosimo and many of his supporters were exiled from Florence to Venice. In 1478
Lorenzo’s brother Giuliano was murdered in the Pazzi family’s brutal attempt to
end Medici rule. The bank itself suffered as a result of Lorenzo’s neglect of
business in favour of politics. Branch managers like Francesco Sassetti of
Avignon or Tommaso Portinari of Bruges became more powerful and less closely
supervised. Increasingly, the bank depended on attracting deposits; its
earnings from trade and foreign exchange grew more volatile. Expensive mistakes
began to be made, like the loans made by the Bruges branch to Charles the Bold,
the Duke of Burgundy, or by the London branch to King Edward IV, which were
never wholly repaid. To keep the firm afloat, Lorenzo was driven to raid the
municipal Monte delle Dote (a kind of mutual fund for the payment of daughters’
dowries).38 Finally, in 1494, amid the chaos of a French
invasion, the family was expelled and all its property confiscated and
liquidated. Blaming the Medici for the town’s misfortunes, the Dominican
preacher Girolamo Savonarola called for a purgative ‘Bonfire of the Vanities’,
a call answered when a mob invaded the Medici palace and burned most of the
bank’s records. (Black scorch marks are still visible on the papers that
survived.) As Lorenzo himself had put it in a song he composed in the 1470s:
‘If you would be happy, be so. / There is no certainty about tomorrow.’
Yet when
the wealthy elite of Florence contemplated the fire-brand Savonarola and the
plebeian mob as alternatives to Medici rule they soon began to feel nostalgic
for the magnificent family. In 1537, at the age of 17, Cosimo de’ Medici (the
Younger) was summoned back to Florence and in 1569 was created Grand Duke of
Tuscany. The ducal line endured for more than two hundred years, until 1743.
The coin-like palle (pills) on the Medici coat of arms served
as an enduring reminder of the family’s origins.
Though
others had tried before them, the Medici were the first bankers to make the
transition from financial success to hereditary status and power. They achieved
this by learning a crucial lesson: in finance small is seldom beautiful. By
making their bank bigger and more diversified than any previous financial
institution, they found a way of spreading their risks. And by engaging in
currency trading as well as lending, they reduced their vulnerability to
defaults.
The
Italian banking system became the model for those North European nations that
would achieve the greatest commercial success in the coming centuries, notably
the Dutch and the English, but also the Swedes. It was in Amsterdam, London and
Stockholm that the next decisive wave of financial innovation occurred, as the
forerunners of modern central banks made their first appearance. The seventeenth
century saw the foundation of three distinctly novel institutions that, in
their different ways, were intended to serve a public as well as a private
financial function. The Amsterdam Exchange Bank (Wisselbank) was set up
in 1609 to resolve the practical problems created for merchants by the
circulation of multiple currencies in the United Provinces, where there were no
fewer than fourteen different mints and copious quantities of foreign coins. By
allowing merchants to set up accounts denominated in a standardized currency,
the Exchange Bank pioneered the system of cheques and direct debits or
transfers that we take for granted today. This allowed more and more commercial
transactions to take place without the need for the sums involved to materialize
in actual coins. One merchant could make a payment to another simply by
arranging for his account at the bank to be debited and the counterparty’s
account to be credited.39 The limitation on this system
was simply that the Exchange Bank maintained something close to a 100 per cent
ratio between its deposits and its reserves of precious metal and coin. As late
as 1760, when its deposits stood at just under 19 million florins, its metallic
reserve was over 16 million. A run on the bank was therefore a virtual
impossibility, since it had enough cash on hand to satisfy nearly all of its
depositors if, for some reason, they all wanted to liquidate their deposits at
once. This made the bank secure, no doubt, but it prevented it performing what
would now be seen as the defining characteristic of a bank, credit creation.
It was in
Stockholm nearly half a century later, with the foundation of the Swedish
Riksbank in 1656, that this barrier was broken through. Although it performed
the same functions as the Dutch Wisselbank, the Riksbank was also
designed to be a Lanebank, meaning that it engaged in lending as
well as facilitating commercial payments. By lending amounts in excess of its
metallic reserve, it may be said to have pioneered the practice of what would
later be known as fractional reserve banking, exploiting the fact that money
left on deposit could profitably be lent out to borrowers. Since depositors
were highly unlikely to ask en masse for their money, only a
fraction of their money needed to be kept in the Riksbank’s reserve at any
given time. The liabilities of the bank thus became its deposits (on which it
paid interest) plus its reserve (on which it could collect no interest); its
assets became its loans (on which it could collect interest).
The third
great innovation of the seventeenth century occurred in London with the
creation of the Bank of England in 1694. Designed primarily to assist the
government with war finance (by converting a portion of the government’s debt
into shares in the bank), the Bank was endowed with distinctive privileges.
From 1709 it was the only bank allowed to operate on a joint-stock basis (see
Chapter 3); and from 1742 it established a partial monopoly on the issue of
banknotes, a distinctive form of promissory note that did not bear interest,
designed to facilitate payments without the need for both parties in a
transaction to have current accounts.
To
understand the power of these three innovations, first-year MBA students at
Harvard Business School play a simplified money game. It begins with a notional
central bank paying the professor $100 on behalf of the government, for which
he has done some not very lucrative consulting. The professor takes the
banknotes to a bank notionally operated by one of his students and deposits
them there, receiving a deposit slip. Assuming, for the sake of simplicity,
that this bank operates a 10 per cent reserve ratio (that is, it wishes to
maintain the ratio of its reserves to its total liabilities at 10 per cent), it
deposits $10 with the central bank and lends the other $90 to one of its
clients. While the client decides what to do with his loan, he deposits the
money in another bank. This bank also has a 10 per cent reserve rule, so it
deposits $9 at the central bank and lends out the remaining $81 to another of
its clients. After several more rounds, the professor asks the class to compute
the increase in the supply of money. This allows him to introduce two of the
core definitions of modern monetary theory: M0 (also known as the monetary base
or high-powered money), which is equal to the total liabilities of the central
bank, that is, cash plus the reserves of private sector banks on deposit at the
central bank; and M1 (also known as narrow money), which is equal to cash in
circulation plus demand or ‘sight’ deposits. By the time money has been
deposited at three different student banks, M0 is equal to $100 but M1 is equal
to $271 ($100 + $90 + $81), neatly illustrating, albeit in a highly simplified
way, how modern fractional reserve banking allows the creation of credit and
hence of money.
The
professor then springs a surprise on the first student by asking for his $100
back. The student has to draw on his reserves and call in his loan to the
second student, setting off a domino effect that causes M1 to contract as
swiftly as it expanded. This illustrates the danger of a bank run. Since the
first bank had only one depositor, his attempted withdrawal constituted a call
ten times larger than its reserves. The survival of the first banker clearly
depended on his being able to call in the loan he had made to his client, who
in turn had to withdraw all of his deposit from the second bank, and so on.
When making their loans, the bankers should have thought more carefully about
how easily they could call back the money - essentially a question about the
liquidity of the loan.
Definitions
of the money supply have, it must be acknowledged, a somewhat arbitrary
quality. Some measures of M1 included travellers’ cheques in the total. M2 adds
savings accounts, money market deposit accounts and certificates of deposit. M3
is broader still, including eurodollar deposits held in offshore markets, and
repurchase agreements between banks and other financial intermediaries. The
technicalities need not detain us here. The important point to grasp is that
with the spread throughout the Western world of a) cashless intra-bank and
inter-bank transactions b) fractional reserve banking and c) central bank
monopolies on note issue, the very nature of money evolved in a profoundly
important way. No longer was money to be understood, as the Spaniards had
understood it in the sixteenth century, as precious metal that had been dug up,
melted down and minted into coins. Now money represented the sum total of
specific liabilities (deposits and reserves) incurred by banks. Credit was,
quite simply, the total of banks’ assets (loans). Some of this money might
indeed still consist of precious metal, though a rising proportion of that
would be held in the central bank’s vault. But most of it would be made up of
those banknotes and token coins recognized as legal tender along with the
invisible money that existed only in deposit account statements. Financial
innovation had taken the inert silver of Potosí and turned it into the basis
for a modern monetary system, with relationships between debtors and creditors
brokered or ‘intermediated’ by increasingly numerous institutions called banks.
The core function of these institutions was now information gathering and risk
management. Their source of profits lay in maximizing the difference between
the costs of their liabilities and the earnings on their assets, without
reducing reserves to such an extent that the bank became vulnerable to a run -
a crisis of confidence in a bank’s ability to satisfy depositors, which leads
to escalating withdrawals and ultimately bankruptcy: literally the breaking of
the bank.
Significantly,
even as Italian banking techniques were being improved in the financial centres
of Northern Europe, one country lagged unexpectedly far behind. Cursed with an
abundance of precious metal, mighty Spain failed to develop a sophisticated
banking system, relying instead on the merchants of Antwerp for short-term cash
advances against future silver deliveries. The idea that money was really about
credit, not metal, never quite caught on in Madrid. Indeed, the Spanish crown
ended up defaulting on all or part of its debt no fewer than fourteen times
between 1557 and 1696. With a track record like that, all the silver in Potosí
could not make Spain a secure credit risk. In the modern world, power would go
to the bankers, not the bankrupts.
THE
EVOLUTION OF BANKING
Financial
historians disagree as to how far the growth of banking after the seventeenth
century can be credited with the acceleration of economic growth that began in
Britain in the late eighteenth century and then spread to Western Europe and
Europe’s offshoots of large-scale settlement in North America and
Australasia. 40There is no question, certainly, that the
financial revolution preceded the industrial revolution. True, the decisive
breakthroughs in textile manufacturing and iron production, which were the
spearheads of the industrial revolution, did not rely very heavily on banks for
their financing.41 But banks played a more important
role in continental European industrialization than they did in England’s. It
may in fact be futile to seek a simplistic causal relationship (more
sophisticated financial institutions caused growth or growth spurred on
financial development). It seems perfectly plausible that the two processes
were interdependent and self-reinforcing. Both processes also exhibited a
distinctly evolutionary character, with recurrent mutation (technical
innovation), speciation (the creation of new kinds of firm) and punctuated
equilibrium (crises that would determine which firms would survive and which
would die out).
In the
words of Adam Smith, ‘The judicious operation of banking, by substituting paper
in the room of a great part of . . . gold and silver . . . provides . . . a
sort of waggon-way through the air.’ In the century after he published The
Wealth of Nations (1776), there was an explosion of financial innovation
which saw a wide variety of different types of bank proliferate in Europe and
North America. The longest-established were bill-discounting banks, which
helped finance domestic and international trade by discounting the bills of
exchange drawn by one merchant on another. Already in Smith’s day London was
home to a number of highly successful firms like Barings, who specialized in
transatlantic merchant banking (as this line of business came to be known). For
regulatory reasons, English banks in this period were nearly all private
partnerships, some specializing in the business of the City, that square mile
of London which for centuries had been the focus for mercantile finance, while
others specialized in the business of the landowning elite. These latter were
the so-called ‘country banks’, whose rise and fall closely followed the rise and
fall of British agriculture.
A
decisive difference between natural evolution and financial evolution is the
role of what might be called ‘intelligent design’ - though in this case the
regulators are invariably human, rather than divine. Gradually, by a protracted
process of trial and error, the Bank of England developed public functions, in
return for the reaffirmation of its monopoly on note issue in 1826,
establishing branches in the provinces and gradually taking over the country
banks’ note-issuing business.g Increasingly, the Bank
also came to play a pivotal role in inter-bank transactions. More and more of
the clearing of sums owed by one bank to another went through the Bank of
England’s offices in Threadneedle Street. With the final scrapping in 1833 of
the usury laws that limited its discount rate on commercial bills, the Bank was
able fully to exploit its scale advantage as the biggest bank in the City.
Increasingly, its discount rate was seen as the minimum short-term interest
rate in the so-called money market (for short-term credit, mostly through the
discounting of commercial bills).
The
question that remained unresolved for a further forty years was what the
relationship ought to be between the Bank’s reserves and its banknote
circulation. In the 1840s the position of the Governor, J. Horsley Palmer, was
that the reserve should essentially be regulated by the volume of discounting
business, so long as one third of it consisted of gold coin or bullion. The
Prime Minister, Sir Robert Peel, was suspicious of this arrangement, believing
that it ran the risk of excessive banknote creation and inflation. Peel’s 1844
Bank Charter Act divided the Bank in two: a banking department, which would
carry on the Bank’s own commercial business, and an issue department, endowed
with £14 million of securities and an unspecified amount of coin and bullion
which would fluctuate according to the balance of trade between Britain and the
rest of the world. The so-called fiduciary note issue was not to exceed the sum
of the securities and the gold. Repeated crises (in 1847, 1857 and 1866) made
it clear that this was an excessively rigid straitjacket, however; in each case
the Act had to be temporarily suspended to avoid a complete collapse of
liquidity.h It was only after the last of these crises,
which saw the spectacular run that wrecked the bank of Overend Gurney, that the
editor of The Economist, Walter Bagehot, reformulated the Bank’s
proper role in a crisis as the ‘lender of last resort’, to lend freely, albeit
at a penalty rate, to combat liquidity crises.42
The
Victorian monetary problem was not wholly solved by Bagehot, it should be
emphasized. He was no more able than the other pre-eminent economic theorists
of the nineteenth century to challenge the sacred principle, established in Sir
Isaac Newton’s time as Master of the Mint, that a pound sterling should be
convertible into a fixed and immutable quantity of gold according to the rate
of £3 17s 10½d per ounce of gold. To read contemporary discussion of the gold
standard is to appreciate that, in many ways, the Victorians were as much in
thrall to precious metal as the conquistadors three centuries before. ‘Precious
Metals alone are money,’ declared one City grandee, Baron Overstone. ‘Paper
notes are money because they are representations of Metallic Money. Unless so,
they are false and spurious pretenders. One depositor can get metal, but all
cannot, therefore deposits are not money.’43 Had that
principle been adhered to, and had the money supply of the British economy
genuinely hinged on the quantity of gold coin and bullion in the Bank of
England’s reserve, the growth of the UK economy would have been altogether
choked off, even allowing for the expansionary effects of new gold discoveries
in the nineteenth century. So restrictive was Bank of England note issuance
that its bullion reserve actually exceeded the value of notes in circulation
from the mid 1890s until the First World War. It was only the proliferation of
new kinds of bank, and particularly those taking deposits, that made monetary
expansion possible. After 1858, the restrictions on joint-stock banking were
lifted, paving the way for the emergence of a few big commercial banks: the
London & Westminster (founded in 1833), the National Provincial (1834), the
Birmingham & Midland (1836), Lloyds (1884) and Barclays (1896). Industrial
investment banks of the sort that took off in Belgium (Société Générale),
France (the Crédit Mobilier) and Germany (the Darmstädter Bank) fared less well
in Britain after the failure of Overend Gurney. The critical need was not in
fact for banks to buy large blocks of shares in industrial companies; it was
for institutions that would attract savers to hand over their deposits,
creating an ever expanding basis for new bank lending on the other side of the
balance sheet.
In this
process an especially important role was played by the new savings banks that
proliferated at the turn of the century. By 1913 British savings bank deposits
amounted to £256 million, roughly a quarter of all UK deposits. The assets of
German savings banks were more than two and a half times greater than those of
the better known ‘great banks’ like Darmstädter, Deutsche, Dresdner and the
Disconto-Gesellschaft. All told, by the eve of the First World War, residents’
deposits in British banks totalled nearly £1.2 billion, compared with a total
banknote circulation of just £45.5 million. Money was now primarily inside
banks, out of sight, even if never out of mind.
Although
there was variation, most advanced economies essentially followed the British
lead when it came to regulation through a monopolistic central bank operating
the gold standard, and concentration of deposit-taking in a relatively few
large institutions. The Banque de France was established in 1800, the German
Reichsbank in 1875, the Bank of Japan in 1882 and the Swiss National Bank in
1907. In Britain, as on the Continent, there were marked tendencies towards
concentration, exemplified by the decline in the number of country banks from a
peak of 755 in 1809 to just seventeen in 1913.
The
evolution of finance was quite different in the United States. There the
aversion of legislators to the idea of over-mighty financiers twice aborted an
embryonic central bank (the first and second Banks of the United States), so
that legislation was not passed to create the Federal Reserve System until
1913. Up until that point, the US was essentially engaged in a natural
experiment with wholly free banking. The 1864 National Bank Act had
significantly reduced the barriers to setting up a privately owned bank, and
capital requirements were low by European standards. At the same time, there
were obstacles to setting up banks across state lines. The combined effect of
these rules was a surge in the number of national and state-chartered banks
during the late nineteenth and early twentieth centuries, from fewer than
12,000 in 1899 to more than 30,000 at the peak in 1922. Large numbers of
under-capitalized banks were a recipe for financial instability, and panics
were a regular feature of American economic life - most spectacularly in the
Great Depression, when a major banking crisis was exacerbated rather than
mitigated by a monetary authority that had been operational for little more
than fifteen years. The introduction of deposit insurance in 1933 did much to
reduce the vulnerability of American banks to runs. However, the banking sector
remained highly fragmented until 1976, when Maine became the first state to
legalize interstate banking. It was not until 1993, after the Savings and Loans
crisis (see Chapter 5), that the number of national banks fell below 3,600 for
the first time in nearly a century.
In 1924
John Maynard Keynes famously dismissed the gold standard as a ‘barbarous
relic’. But the liberation of bank-created money from a precious metal anchor
happened slowly. The gold standard had its advantages, no doubt. Exchange rate
stability made for predictable pricing in trade and reduced transaction costs,
while the long-run stability of prices acted as an anchor for inflation
expectations. Being on gold may also have reduced the costs of borrowing by
committing governments to pursue prudent fiscal and monetary policies. The
difficulty of pegging currencies to a single commodity based standard, or
indeed to one another, is that policymakers are then forced to choose between
free capital movements and an independent national monetary policy. They cannot
have both. A currency peg can mean higher volatility in short-term interest
rates, as the central bank seeks to keep the price of its money steady in terms
of the peg. It can mean deflation, if the supply of the peg is constrained (as
the supply of gold was relative to the demand for it in the 1870s and 1880s).
And it can transmit financial crises (as happened throughout the restored gold
standard after 1929). By contrast, a system of money based primarily on bank
deposits and floating exchange rates is freed from these constraints. The gold
standard was a long time dying, but there were few mourners when the last meaningful
vestige of it was removed on 15 August 1971, the day that President Richard
Nixon closed the so-called gold ‘window’ through which, under certain
restricted circumstances, dollars could still be exchanged for gold. From that
day onward, the centuries-old link between money and precious metal was broken.
BANKRUPT
NATION
Memphis,
Tennessee, is famous for blue suede shoes, barbecues and bankruptcies. If you
want to understand how today’s bankers - the successors to the Medici - deal
with the problem of credit risk created by unreliable borrowers, Memphis surely
is the place to be.
On
average, there are between one and two million bankruptcy cases every year in
the United States, nearly all of them involving individuals who elect to go
bust rather than meet unmanageable obligations. A strikingly large proportion
of them happen in Tennessee. The remarkable thing is how relatively painless
this process seems to be - compared, that is, with what went on in
sixteenth-century Venice or, for that matter, some parts of present-day
Glasgow. Most borrowers who run into difficulties in Memphis can escape or at
least reduce their debts, stigma-free and physically unharmed. One of the great
puzzles is that the world’s most successful capitalist economy seems to be built
on a foundation of easy economic failure.
When I
visited Memphis for the first time in the early summer of 2007 I was fascinated
by the ubiquity and proximity of both easy credit and easy bankruptcy. All I
had to do was to take a walk down a typical street near the city centre. First
there were the shopping malls and fast food joints, which is where Tennesseans
do much of their spending. Right next door was a ‘tax advisor’ ready to help
those short of cash to claim their low-earners’ tax credits. I saw a shop
offering loans against cars and, next door to it, a second-mortgage company, as
well as a cheque-cashing shop offering advances on pay packets (at 200 per cent
interest), not to mention a pawnshop the size of a department store.
Conveniently located for those who had already pawned all their possessions was
a Rent-A-Center offering cheap furniture and televisions for hire. And next
door to that? The Plasma Center, offering $55 a go for blood donations. Modern
Memphis gives a whole new meaning to the expression ‘bled dry’. A pint of blood
may not be quite as hard to give up as a pound of flesh, but the general idea
seems disconcertingly similar.
Yet the
consequences of default in Memphis are far less grave than the risk of death
Antonio ran in Venice. After the Plasma Center, my next stop was the office of
George Stevenson, one of the lawyers who make a living by advising bankrupts at
the United States Bankruptcy Court Western District of Tennessee. At the time
of my trip to Tennessee, the annual number of bankruptcy filings in the Memphis
area alone was around 10,000, so I wasn’t surprised to find the Bankruptcy
Court crowded with people. The system certainly appears to work very smoothly.
One by one, the individuals and couples who have fallen into insolvency sit
down with a lawyer who negotiates on their behalf with their creditors. There
is even a fast-track lane for speedy bankruptcies - though on average only
three out of five bankrupts are discharged (meaning that an agreement is
reached with their creditors).
The
ability to walk away from unsustainable debts and start all over again is one
of the distinctive quirks of American capitalism. There were no debtors’
prisons in the United States in the early 1800s, at a time when English debtors
could end up languishing in jail for years. Since 1898, it has been every
American’s right to file for Chapter VII (liquidation) or XIII (voluntary
personal reorganization). Rich and poor alike, people in the United States
appear to regard bankruptcy as an ‘unalienable right’ almost on a par with
‘life, liberty and the pursuit of happiness’. The theory is that American law
exists to encourage entrepreneurship - to facilitate the creation of new
businesses. And that means giving people a break when their plans go wrong,
even for the second time, thereby allowing the natural-born risk-takers to
learn through trial and error until they finally figure out how to make that
million. After all, today’s bankrupt might well be tomorrow’s successful
entrepreneur.
At first
sight, the theory certainly seems to work. Many of America’s most successful
businessmen failed in their early endeavours, including the ketchup king John
Henry Heinz, the circus supremo Phineas Barnum and the automobile magnate Henry
Ford. All of these men eventually became immensely rich, not least because they
were given a chance to try, to fail and to start over. Yet on closer inspection
what happens in Tennessee is rather different. The people in the Memphis
Bankruptcy Court are not businessmen going bust. They are just ordinary
individuals who cannot pay their bills - often the large medical bills that
Americans can suddenly face if they are not covered by private health
insurance. Bankruptcy may have been designed to help entrepreneurs and their
businesses, but nowadays 98 per cent of filings are classified as non-business.
The principal driver of bankruptcy turns out to be not entrepreneurship but
indebtedness. In 2007 US consumer debt hit a record $2.5 trillion. Back in
1959, consumer debt was equivalent to 16 per cent of disposable personal
income. Now it is 24 per cent.i One of the challenges
for any financial historian today is to understand the causes of this explosion
of household indebtedness and to estimate what the likely consequences will be
if, as seems inevitable, there is an increase in the bankruptcy rate in states
like Tennessee.
Before we
can answer these questions properly, we need to introduce the other key
components of the financial system: the bond market, the stock market, the
insurance market, the real estate market and the extraordinary globalization of
all these markets that has taken place over the past twenty years. The root
cause, however, must lie in the evolution of money and the banks whose
liabilities are its key component. The inescapable reality seems to be that
breaking the link between money creation and a metallic anchor has led to an
unprecedented monetary expansion - and with it a credit boom the like of which
the world has never seen. Measuring liquidity as the ratio of broad money to
outputj over the past hundred years, it is very clear
that the trend since the 1970s has been for that ratio to rise - in the case of
broad money in the major developed economies from around 70 per cent before the
closing of the gold window to more than 100 per cent by 2005.44 In
the eurozone, the increase has been especially steep, from just over 60 per
cent as recently as 1990 to just under 90 per cent today. At the same time, the
capital adequacy of banks in the developed world has been slowly but steadily
declining. In Europe bank capital is now equivalent to less than 10 per cent of
assets, compared with around 25 per cent at the beginning of the twentieth
century.45 In other words, banks are not only taking in
more deposits; they are lending out a greater proportion of them, and
minimizing their capital base. Today, banking assets (that is, loans) in the
world’s major economies are equivalent to around 150 per cent of those
countries’ combined GDP.46 According to the Bank for
International Settlements, total international banking assets in December 2006
were equivalent to around $29 trillion, roughly 63 per cent of world GDP.47
Is it any
wonder, then, that money has ceased to hold its value in the way that it did in
the era of the gold standard? The modern-day dollar bill acquired its current
design in 1957. Since then its purchasing power, relative to the consumer price
index, has declined by a staggering 87 per cent. Average annual inflation in
that period has been over 4 per cent, twice the rate Europe experienced during
the so-called price revolution unleashed by the silver of Potosí. A man who had
exchanged his $1,000 of savings for gold in 1970, while the gold window was
still ajar, would have received just over 26.6 ounces of the precious metal. At
the time of writing, with gold trading at close to $1,000 an ounce, he could
have sold his gold for $26,596.
The New
York closing price of gold ($ per oz., log scale), 1908-2008
A world
without money would be worse, much worse, than our present world. It is wrong
to think (as Shakespeare’s Antonio did) of all lenders of money as mere
leeches, sucking the life’s blood out of unfortunate debtors. Loan sharks may
behave that way, but banks have evolved since the days of the Medici precisely
in order (as the 3rd Lord Rothschild succinctly put it), to ‘facilitate the
movement of money from point A, where it is, to point B, where it is needed’.48 Credit
and debt, in short, are among the essential building blocks of economic
development, as vital to creating the wealth of nations as mining,
manufacturing or mobile telephony. Poverty, by contrast, is seldom directly
attributable to the antics of rapacious financiers. It often has more to do
with the lack of financial institutions, with the absence of banks, not their
presence. It is only when borrowers in places like the East End of Glasgow have
access to efficient credit networks that they can escape from the clutches of
the loan sharks; only when savers can put their money in reliable banks that it
can be channelled from the idle to the industrious.
The
evolution of banking was thus the essential first step in the ascent of money.
The financial crisis that began in August 2007 had relatively little to do with
traditional bank lending or, indeed, with bankruptcies, which (because of a
legal change) actually declined in 2007. Its prime cause was the rise and fall
of ‘securitized lending’, which allowed banks to originate loans but then
repackage and sell them on. And that was only possible because the rise of
banks was followed by the ascent of the second great pillar of the modern
financial system: the bond market.
NOTES
1 ‘A World without
Money’, Socialist Standard (July 1979). The passage was a
translated extract from ‘Les Amis de Quatre Millions de Jeune
Travailleurs’, Un Monde sans Argent: Le Communisme (Paris,
1975-6): http://www.geocities.com/~johngray/stanmond.htm.
2 Indeed, Marx and
Engels had themselves recommended not the abolition of money but
‘Centralization of credit in the hands of the state, by means of a national
bank with state capital and an exclusive monopoly’: clause 5 of The
Communist Manifesto.
3 JuanForero,‘Amazonian
Tribe Suddenly Leaves Jungle Home’, 11 May 2006: http://www.entheology.org/edoto/anmviewer.asp?a=244.
4 Clifford Smyth, Francisco
Pizarro and the Conquest of Peru (Whitefish, Montana, 2007 [1931]).
5 Michael
Wood, Conquistadors (London, 2001), p. 128.
6 For a vivid
account from the conquistadors’ vantage point, which makes it clear that gold
was their prime motive, see the November 1533 letter from Hernando Pizarro to
the Royal Audience of Santo Domingo, in Clements R. Markham (ed.), Reports
on the Discovery of Peru (London, 1872), pp. 113-27.
7 M. A.
Burkholder, Colonial Latin America (2nd edn., Oxford, 1994),
p. 46.
8 J. Hemming, Conquest
of the Incas (London, 2004), p. 77.
9 Ibid., p. 355.
10 Wood, Conquistadors,
pp. 38, 148.
11 Hemming, Conquest,
p. 392.
12 P.
Bakewell, A History of Latin America (2nd edn., Oxford, 2004),
p. 186.
13 Hemming, Conquest,
pp. 356ff.
14 See Alexander
Murray, Reason and Society in the Middle Ages (Oxford, 2002),
pp. 25-58.
15 See Thomas J.
Sargent and François R. Velde, The Big Problem of Small Change(Princeton,
NJ, 2002).
16 Bakewell, History
of Latin America, p. 182.
17 Mauricio Drelichman
and Hans-Joachim Voth, ‘Institutions and the Resource Curse in Early Modern
Spain’, paper presented at the CIAR Institutions, Organizations, and Growth
Program Meeting in Toronto, 16-18 March 2007.
18 Hans J. Nissen,
Peter Damerow and Robert K. Englund, Archaic Bookkeeping: Early Writing
and Techniques of Economic Administration in the Ancient Near East(London,
1993).
19 I am grateful to
Dr John Taylor of the British Museum for his expert guidance and assistance
with deciphering the cuneiform inscriptions. I also learned much from Martin
Schubik’s ‘virtual museum’ at Yale: http://www.museumofmoney.org/babylon/.
20 Glyn
Davies, A History of Money: From Ancient Times to the Present Day (Cardiff,
1994); Jonathan Williams, with Joe Cribb and Elizabeth Errington (eds.), Money:
A History (London, 1997)
21 See Marc Van De
Mieroop, Society and Enterprise in Old Babylonian Ur (Berlin,
1992) and the essays in Michael Hudson and Marc Van De Mieroop (eds.), Debt
and Economic Renewal in the Ancient Near East, vol. III (Bethesda, MD,
1998); Jack M. Sassoon, Gary Beckman and Karen S. Rubinson, Civilizations
of the Ancient Near East, vol. III (London, 2000).
22 William N.
Goetzmann, ‘Fibonacci and the Financial Revolution’, NBER Working Paper 10352
(March 2004).
23 John H. Munro,
‘The Medieval Origins of the Financial Revolution: Usury, Rentes, and
Negotiability’, International History Review, 25, 3 (September
2003), pp. 505-62.
24 On the advantages
to Italian cities of nurturing Jewish communities, see Maristella Botticini, ‘A
Tale of “Benevolent” Governments: Private Credit Markets, Public Finance, and
the Role of Jewish Lenders in Renaissance Italy’, Journal of Economic
History, 60, 1 (March 2000), pp. 164-189.
25 Frederic C.
Lane, Venice: A Maritime Republic (Baltimore, 1973), p. 300.
26 Idem,
‘Venetian Bankers, 1496-1533: A Study in the Early Stages of Deposit
Banking’, Journal of Political Economy, 45, 2 (April 1937), pp.
187-206.
27 Benjamin C. I.
Ravid, ‘The First Charter of the Jewish Merchants of Venice’, AJS
Review, 1 (1976), pp. 190ff.
28 Idem, ‘The
Legal Status of the Jewish Merchants of Venice, 1541- 1638’, Journal of
Economic History, 35, 1 (March 1975), pp. 274-9.
29 Rhiannon Edward,
‘Loan Shark Charged 11m per cent Interest’, Scotsman, 18 August
2006.
30 John Hale, The
Civilization of Europe in the Renaissance (London, 1993), p. 83.
31 Gene A. Brucker,
‘The Medici in the Fourteenth Century’, Speculum, 32, 1 (January
1957), p. 13.
32 John H. Munro,
‘The Medieval Origins of the Financial Revolution: Usury, Rentes, and
Negotiability’, International History Review, 25, 3 (September
2003), pp. 505-62.
33 Richard A.
Goldthwaite, ‘The Medici Bank and the World of Florentine Capitalism’, Past
and Present, 114 (Feb. 1987), pp. 3-31. On the background to the Medicis’
rise, see Raymond de Roover, The Rise and Decline of the Medici Bank,
1397-1494(Cambridge, MA, 1963), pp. 9-34.
34 Venetian State
Archives, Mediceo Avanti Principato, MAP 133, 134, 153.
35 Franz-Josef
Arlinghaus, ‘Bookkeeping, Double-entry Bookkeeping’, in Christopher Kleinhenz
(ed.), Medieval Italy: An Encyclopedia, vol. 1 (New York, 2004).
The first book to describe the method was Benedetto Cotrugli’s Il libro
dell’arte di mercatura, published in 1458.
36 Raymond de
Roover, ‘The Medici Bank: Organization and Management’, Journal of
Economic History, 6, 1 (May 1946), pp. 24-52.
37 Venetian State
Archives, Archivio del Monte, Catasto of 1427. I am grateful to Dr Francesco
Guidi for his guidance regarding the Medici papers in the Florence State Archives.
38 Raymond de
Roover, ‘The Decline of the Medici Bank’, Journal of Economic History,
7, 1 (May 1947), pp. 69-82.
39 Stephen Quinn and
William Roberds, ‘The Big Problem of Large Bills: The Bank of Amsterdam and the
Origins of Central Banking’, Federal Reserve Bank of Atlanta Working Paper,
2005-16 (August 2005).
40 See for example
Peter L. Rousseau and Richard Sylla, ‘Financial Systems, Economic Growth, and
Globalization’, in Michael D. Bordo, Alan M. Tayor and Jeffrey G. Williamson
(eds.), Globalization in Historical Perspective (Chicago /
London, 2003), pp. 373-416.
41 See Charles P.
Kindleberger, A Financial History of Western Europe (London,
1984), p. 94.
42 Walter
Bagehot, Lombard Street: A Description of the Money Market (London,
1873).
43 Quoted in
Kindleberger, Financial History, p. 87.
44 Niall Ferguson
and Oliver Wyman, The Evolution of Financial Services: Making Sense of
the Past, Preparing for the Future (London / New York, 2007), p. 34.
See also p. 40 for a composite measure of global liquidity.
45 Ibid., p. 63.
46 Ibid., p. 48.
47 http://www.bis.org/statistics/bankstats.htm.
48 Lord [Victor]
Rothschild, Meditations of a Broomstick (London, 1977), p. 17.
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