The Origin of Money 10 – The Birth of Modern Finance

 Money Becomes Metal

It is one of the great ironies of history that at the same time the modern financial system and banking was being invented, Enlightenment thinkers discarded thousands of years of monetary history and declared money to be based on the intrinsic value of precious metals alone.

Events like the Kipper and Wipperzeit had convinced scholars in Europe that a stable value of coins depended on issuing coins with constant and fixed amounts of precious metal. This, they reasoned, would prevent the rapid hyperinflation and deflation that were wreaking havoc on monetary systems throughout Europe.

…This monetary terrorism had its roots in the economic problems of the late 16th century and lasted long enough to merge into the general crisis of the 1620s caused by the outbreak of the Thirty Years’ War, which killed roughly 20 percent of the population of Germany. While it lasted, the madness infected large swaths of German-speaking Europe, from the Swiss Alps to the Baltic coast, and it resulted in some surreal scenes: Bishops took over nunneries and turned them into makeshift mints, the better to pump out debased coinage; princes indulged in the tit-for-tat unleashing of hordes of crooked money-changers, who crossed into neighboring territories equipped with mobile bureaux de change, bags full of dodgy money, and a roving commission to seek out gullible peasants who would swap their good money for bad. By the time it stuttered to a halt, the kipper- und wipperzeit had undermined economies as far apart as Britain and Muscovy, and—just as in 1923—it was possible to tell how badly things were going from the sight of children playing in the streets with piles of worthless currency.

“Kipper und Wipper”: Rogue Traders, Rogue Princes, Rogue Bishops and the German Financial Meltdown of 1621-23 (Smithsonian Magazine)

In England, this concept was most forcibly argued by John Locke. A pound was a specific amount of silver, he declared, and should be held inviolable.

The reason he did this was because he wanted to argue that property rights were natural and absolute phenomena, and did not rest on any sort of monarchial authority or social contract. In line with this reasoning, he needed money to also be a “natural thing” not anchored in social relations and certainly not under the control of a sovereign.

At this time, England’s coinage was in rough shape. Much of the coinage had remained unchanged in a hundred years and clipped coins circulated alongside newer issues. People tended to save the good coins and spend the clipped ones, causing a loss of faith in the currency.

It was increasingly clear that the Mint had to offer recoinage …But at what rate? Mercantilists, who tended to be inflationist, clamoured for debasement, that is, recoinage at the lighter weight, devaluating silver coin and increasing the supply of money. In the meanwhile, the monetary problem was aggravated by a burst of bank credit inflation created by the new Bank of England, founded in 1694 to inflate the money supply and finance the government’s deficit. As the coinage problem came to a head in that same year, William Lowndes (1652–1724), secretary of the treasury and the government’s main monetary expert, issued a “Report on the Amendment of Silver Coin” in 1695, calling for accepting the extant debasement and for officially debasing the coinage by 25 percent, lightening the currency name by a 25 percent lower weight of silver.

[John] Locke had denounced debasement as deceitful and illusionist: what determined the real value of a coin, he declared, was the amount of silver in the coin, and not the name granted to it by the authorities. Debasement, Locke warned…is illusory and inflationist: if coins, for example, are devalued by one-twentieth, “when men go to market to buy any other commodities with their new, but lighter money, they will find 20s of their new money will buy no more than 19 would before.” Debasement merely dilutes the real value, the purchasing power, of each currency unit.

Threatened by the Lowndes report, Locke’s patron, John Somers, who had been made Lord Keeper of the Great Seal in a new Whig ministry in 1694, asked Locke to rebut Lowndes’s position before the Privy Council. Locke published his rebuttal later in the year 1695…Locke superbly put his finger on the supposed function of the Mint: to maintain the currency as purely a definition, or standard of weight of silver; any debasement, any change of standards, would be as arbitrary, fraudulent, and unjust as the government’s changing the definition of a foot or a yard. Locke put it dramatically: “one may as rationally hope to lengthen a foot by dividing it into fifteen parts instead of twelve, and calling them inches.”

…Locke’s view triumphed, and the recoinage was decided and carried out in 1696 on Lockean lines: the integrity of the weight of the silver denomination of currency was preserved. In the same year, Locke became the dominant commissioner of the newly constituted board of trade. Locke was appointed by his champion Sir John Somers, who had become chief minister from 1697 to 1700. When the Somers regime fell in 1700, Locke was ousted from the board of trade, to retire until his death four years later. The Lockean recoinage was assisted by Locke’s old friend, the great physicist Sir Isaac Newton (1642–1727) who, while still a professor of mathematics at Cambridge from 1669 on, also became warden of the Mint in 1696, and rose to master of the Mint three years later, continuing in that post until his death in 1727. Newton agreed with Locke’s hard-money views of recoinage.

John Locke vs. the Mercantilists and Inflationists (Mises Institute)

Because the price paid by the Royal Mint for gold and silver was fixed and no longer allowed to adjust freely based on supply and demand, the effect this had was for gold to be shipped to England, where the Mint paid a premium for it, and silver to leave the country for continental Europe, where it was worth more. This led to a shortage of silver coins in England, causing economic contraction.

…the Bank of England’s formation also coincided with the reconceptualization of money as simply precious metal in another form—a fable told most prominently by John Locke. In earlier centuries, everyone accepted that kings could reduce the metal content of coins and, indeed, there were good economic reasons to do so. Devaluing coins (raising the nominal price of silver) increased the money supply, a constant concern in the medieval and early modern periods, while revaluing coins (keeping the nominal price of silver but calling in all old coins to be reminted) imposed deflation on the economy. But Locke was the most prominent spokesperson for hard money—maintaining the metal content of coins inviolate. The theory was that money was simply metal by another name, since each could be converted into the other at a constant rate.

The practice, however, was that the vast majority of money—Bank of England notes, bills of exchange issued by London banks, and bank notes issued by country banks—could only function as fiat money. This had to be the case because the very policy of a constant mint price had the effect of driving silver out of coin form, vacuuming up the coin supply. If people actually wanted to convert their paper money into silver or gold, a financial crisis could be prevented only through a debt-financed expansion of the money supply by the Bank of England—or by simply suspending convertibility, as England did in the 1790s.

… at the same time that the English political system invented the modern monetary system, liberal theorists like Locke obscured it behind a simplistic fetishization of gold. The fable that money was simply transmutated gold went hand in hand with the fable that the economy was simply a neutral market populated by households and firms seeking material gain. This primacy of the economic over the political—the idea that government policy should simply set the conditions for the operation of private interests—is, of course, one of the central pillars of the capitalist ethos. Among other things, it justified the practice of allowing private banks to make profits by selling liquidity to individuals (that’s what happens when you deposit money at a low or zero interest rate)—a privilege that once belonged to sovereign governments.

Mysteries of Money (The Baseline Scenario)

The Great Monetary Settlement

By the late 1600’s two major forms of currency circulated: the government money issued in coin form, and the capitalist credit money issued by private bankers. Both were forms of transferable debt, but were used in very different spheres of exchange:

By the late seventeenth century, the two forms of money were available but unevenly spread across Europe – private credit and public metallic coinage. However, they remained structurally distinct and their respective producers – that is, states and capitalist traders – remained in conflict…England was best placed…to effect any integration of the different interests that were tied to the different moneys…[1]

Unlike its cousins on the continent, England’s finances were fairly stable, and its debt manageable. That is until 1672, when the Stop of the Exchequer was declared by King James II. This was essentially a default by England on its debts. The crown refuted the tallies owed to them, causing tally sticks to fall into disrepute and clearing the way for paper instruments to replace them as signifiers of state debt:

Charles II’s debt default in 1672 was critically important in hastening the adoption of public banking as a means of state finance and credit money creation. Since the fourteenth century, English kings had borrowed, on a small scale, against future tax revenues. The tally stick receipts for these loans achieved a limited degree of liquidity ‘which effectively increased the money supply beyond the limits of minting’.

However, compared with state borrowing in the Italian and Dutch republics, English kings, like all monarchs, were disadvantaged by the very despotic power of their sovereignty. Potential creditors were deterred by the monarch’s immunity from legal action for default and their successors’ insistence that they could not be held liable for any debts that a dynasty might have accumulated. [2]

The rising Whig merchant class wanted a monarch who would put the country’s finances on a more sound basis. Since they were overwhelmingly Protestant, they decided that putting a Protestant on the throne in place of the Catholic James Stuart would be the perfect excuse for overthrowing the monarchy. It was, in essence, a coup d’etat by the banking and merchant classes.

With an impending war with the Dutch, an annual Crown income of less than £2 million, and accumulated debts of over £1.3 million, Charles II defaulted on repayment to the tally holders in the Exchequer Stop of 1672. This event…culminated in the invitation to William of Orange to invade and claim the throne…[3]

An alliance of the Whigs and Tories got the husband of James’ sister Mary, the Dutch prince William of Orange, for the job. William and Mary took the throne in the last major invasion of England. It was a mostly bloodless revolution, but not entirely peaceful, and all sorts of rebellions would roil parts of the British Isles for decades (the Jacobite risings), mainly in the outer regions of the empire (e.g. Scotland, Ireland, etc.)

The bloodless coup would have profound effects for the history of the financial system. William brought “Dutch finance” across the channel to England, where it would be used to reorganize the state’s finances.

Because the revolution had been backed and funded by Whig parliamentarians, they called the shots. It was the end of England’s absolute monarchy and the beginning of the “king-in-parliament,” an unusual fusion of monarchial power and public accountability. They made William sign a “Bill of Rights” in 1689 and one of the things it specified was that the ability to raise funds would be strictly delegated to parliament. In other words, no more arbitrary taxes or defaults.

William subsequently dragged England into several wars on the continent:

Roey Sweet: “So the reason why the national debt is rising at this time, and by 1714 it’s about 48 million [pounds], is that Britain’s been involved in two long and expensive wars. Following the Glorious Revolution, William of Orange brings Britain into the Nine Years War against Louis the 14th, and then from 1701 Britain’s been involved in the War of the Spanish Succession which is a battle essentially to try and prevent the Bourbons from gaining ascendancy in Europe by uniting the Spanish and the French empires. So Britain has been fighting this, and it’s seen as a Whig war…and there’s a suspicion that it’s being prolonged purely for Whig interests. And so [Chancellor of the Exchequer Robert] Harley wants to try and end the war and also to get the debt into manageable proportions.” [4]

William needed to borrow to fight his wars, and his credit score was awful. His debt load from conducting the Glorious Revolution was already very high, meaning that no one wanted to loan to him. The interest rates he was looking at were in the neighborhood of modern-day credit cards—18-20 percent.

The prevention of any recurrence of default was a paramount consideration which parliament put to the new Dutch king in the constitutional settlement of 1689. In the first place, William was intentionally provided with insufficient revenues for normal expenditure and, consequently, was forced to accept dependence on parliament for additional funds. Second with William’s approval, and the expertise of his Dutch financial advisors, the government adopted long-term borrowing in the form of annuities (Tontines). These were funded by setting aside specific tax revenues for the interest payments. [5]

England managed its debt in a variety of ways, many of them similar to the methods used on the continent. But one new technique was coming to bear. By this time, in order to exploit the resources of the New Word and conduct trading operations where long-term investments were required, Europeans had invented the joint-stock company—a company where ownership was diversified among a group of unrelated individuals and ownership could be bought and sold at will.

The legal ingredients that comprise a corporation came together in a form we would recognise in England, on New Year’s Eve, in 1600. Back then, creating a corporation didn’t simply involve filing in some routine forms – you needed a royal charter. And you couldn’t incorporate with the general aim of doing business and making profits – a corporation’s charter specifically said what it was allowed to do, and often also stipulated that nobody else was allowed to do it. The legal body created that New Year’s Eve was the Honourable East India Company, charged with handling all of England’s shipping trade east of the Cape of Good Hope. [6]

Joint-stock companies had been originally formed to undertake long-distance trading expeditions and to exploit the resources of the New World. Now they would be pressed into service to reorganize and manage the nation’s debt. The idea was to use such  companies to manage the state’s finances. They would be chartered for this purpose:

Melvin Bragg: How was the government handling its debt before the South Sea Company was set up?

Anne Murphy: The government is handling its debt in three ways.

It’s created lottery schemes which are very popular, and they’re attractive to a broad spectrum of individuals. So it can raise money that way.

It sells annuities which again are very popular, but they’re very costly, and they’re quite inflexible.

And the government is also using the moneyed companies to support its debt raising activities. The first one of those is called the Bank of England which is set up in 1694. The Bank of England does two things: it lends to government, and also it’s one of the first companies that does the debt for equity swaps that the South Sea Company is to become so famous for, later.


Melvin Bragg: Was that seen at the time as something that was okay; that a private company taking over part of a national debt was fine?

Anne Murphy: It’s actually just a change of lender, really. What’s being switched here is the many, many lenders–the individuals who bought annuities or who bought lottery tickets from the government–for one lender: the Bank of England or the South Sea Company. So it’s not that a private company is in essence taking over the debt. What it’s doing is just consolidating the debt in one set of hands rather than many sets of hands.

And this helps because it makes administration easier and it brings costs down, and that’s what the government wants. So it’s a desirable thing to do. [7]

The modern money system began when governments started using joint-stock corporations to manage their finances in exchange for “special” privileges–specifically the privilege of extending credit denominated in the government’s official currency. The government, in essence, became a debtor to these private corporations, which are the ancestors of our modern banks. The debt was then monetized and circulates to this day as money. The Bank of England, funded by the subscribers from the merchant classes, bought the state’s debt and used it as backing for their banking operations. The merchant bankers, in essence, kidnapped the state’s money for their own uses.

From 1694 to 1697, the directors of the new Bank of England laid the true foundations for the financial revolution by lending the government £1.2 million, at the then attractive rate of 8 per cent, in order to secure their monopoly on joint-stock banking, raising the funds by selling Bank stock. Though redeemable on one year’s notice from 1706, the loan was in fact perpetual. In 1698, the New East India Company made a similar 8 per cent perpetual loan to secure its charter, as did the newly merged United East India Company in 1709.

From 1704 to 1710, the exchequer also issued irredeemable annuities…and…a series of highly popular lottery loans. Meanwhile, in 1711, the newly formed South Sea Company bought up…short-term floating debts and converted them into so-called perpetual stock with a 5 per cent return; and in 1720, it converted another £13.99 million in other loans and annuities into 5 per cent perpetual stock, a venture that led to its collapse in 1721 in the famous ‘Bubble’. Thereafter, while redeeming £6.5 million in South Sea stock and annuities, the Bank of England, on behalf of the government, issued several series of redeemable ‘stock’, many containing the popular lottery provisions, with generally lower rates of interest…

The Bank of England wasn’t the world’s oldest bank, nor even was it the first state bank. But what made it unique was the idea of the merchant classes loaning to the government, and in return gaining a measure of control over the nation’s finances. The multiple and conflicting systems of money and borrowing would be fused together for the first time in one supranational institution. Felix Martin calls this “The Great Monetary Settlement:”

The Bank’s primary role would … be to put the sovereign’s credit and finances on a surer footing. Indeed, its design, governance, and management were to be delegated to the mercantile classes precisely in order to ensure confidence in its operations and credit control. But in return the sovereign was to grant important privileges. Above all, the Bank was to enjoy the right to issue banknote-a licence to put into circulation paper currency representing its own liabilities, which could circulate as money. There was to be, quite literally, a quid pro quo. [8]
… the idea of the hybrid Bank of England found a powerful group of supporters in the circle of ambitious Whig grandees who were soon to dominate the first party-political administration of the country. They realised that [Projector William] Paterson’s Project could deliver a Great Monetary Settlement.

If they and the private money interest they represented would agree to fund the king on terms over which they, as the Directors of the new Bank, would have a statutory say, then the king would in tum allow them a statutory share in his most ancient and jealously guarded prerogative: the creation of money and the management of its standard. To be granted the privilege of note issue by the crown, which would anoint the liabilities of a private bank with the authority of the sovereign-this, they realised, was the Philosopher’s Stone of money. It was the endorsement that could liberate private bank money from its parochial bounds. They would lend their credit to the sovereign-he would lend his authority to their bank. What they would sow by agreeing to lend, they would reap a hundredfold in being allowed to create private money with the sovereign’ s endorsement. Henceforth, the seigniorage would be shared. [9]

With the foundation of the Bank of England, the money interest and the sovereign had found an historic accommodation…This compromise is the direct ancestor of the monetary systems that dominate the world today: systems in which the creation and man agement of money are almost entirely delegated to private banks, but in which sovereign money remains the “final settlement asset, the only credit balance with which the banks on the penultimate tier of the pyramid can be certain of settling payments to one another or to the state. Likewise, cash remains strictly a token of a credit held against the sovereign, but the overwhelming majority of the money in circulation consists of credit balances on accounts at private banks. The fusion of sovereign and private money born of the political compromise struck in 1694 remains the bedrock of the modern monetary world.  [10]

This effectively created modern finance. The state’s debt was monetized by private banks, who gained the ability to loan the state’s “official” money through the extension private credit. No longer would money creation and manipulation be exclusively a tool of the sovereign. The two different money systems—government coinage and bills of exchange, were fused into one here for the first time. Because it was backed by state debt (and ultimately tax revenue), the bank’s money became by far the most trustworthy legal means of settlement, and soon it became the predominant one—the final “money thing” at the apex of the pyramid.

In effect, the privately owned Bank of England transformed the sovereign’s personal debt into a public debt and, eventually in turn, into a public currency.

This fusion of the two moneys, which England’s political settlement and rejection of absolutist monetary sovereignty had made possible, resolved two significant problems that had been encountered in the earlier applications of the credit-money social technology.

First, the private money of the bill of exchange was ‘lifted out’ from the private mercantile network and given a wider and more abstract monetary space based on an impersonal trust and legitimacy…

Second, parliament sanctioned the collection of future revenue from taxation and excise duty to service the interest on loans…The new monetary techniques conferred a distinct competitive advantage, which, in turn, eventually ensured the acceptability of England’s high levels of taxation and duties for the service of the interest on the national debt.

The most important, but unintended, longer-term consequence of the establishment of the Bank of England was its monopoly to deal in bills of exchange. Ostensibly, the purchase of bills at a discount before maturity was a source of monopoly profits for the Bank. But it also proved to be the means by which the banking system as a whole became integrated and the supply of credit money (bills and notes), influenced by the Bank’s discount rate.

The two main sources of capitalist credit money that had originated in Italian banking practice -that is, the public debt in the form of state bonds and private debt in the form of bills of exchange – were now combined for the first time in the operation of a single institution. But of critical importance, these forms of money were introduced into an existing sovereign monetary space defined by an integrated money of account and means of payment based on the metallic standard. [11]

The bank of England would issue banknotes, which were liabilities of the bank that could circulate as money. Banknotes were originally records of deposits of coin (sterling) redeemable at the banks. Eventually banknotes simply became records of deposits unlinked to any other coins or commodities. They circulated as paper records of debits and credits, similar to the tally sticks which they replaced (the old tallies were burned en masse):

In 1694, the Bank of England stepped in. Originally a private company, it was founded to create money backed by its gold holdings that could be exchanged for Treasury pledges over future taxes. In contrast to the old tally stick system, these pledges, known as ‘gilt-edged’ stock, or gilts, came with redemption dates and paid a fixed rate of interest.

These changed characteristics of a fixed date and rate of return made the pledges resemble debts. However, the difference is that these pledges are ownership claims created by an individual over his own income, whereas a debt claim is created by one individual over another individual’s income. The correct analogy is to think of gilt-edged stock as akin to interest-bearing shares or equity bought by investors in UK Incorporated, with a redemption date.

The position today is quite similar, except that the Bank of England is now State owned and the pound sterling is not backed by gold but by faith alone.

The fiscal myth of tax and spend shared by virtually all schools of economics is that tax is first collected and then spent. This has never been the case: the reality… has always been that government spending has come first and taxation later. The reality is that taxation acts to remove money from circulation and to prevent inflation: it does not fund and never has funded public spending.

The Myth of Debt (UCL)

The second method to finance the debt mentioned above was a debt-for-equity swap. This was tried in both England and France. While it failed in a bursting stock bubble in both countries, the differences would have profound consequences for world history.

In England, the monetary system would remain fairly intact. In France, by contrast, it would take down the entire financial system and cripple the nation economically for a generation. The end result would be an Industrial Revolution in England, and revolt, revolution and dictatorship in France.

Remarkably, this would all take place in just 4 years–from 1716 to 1720. One result would be the issuance of the first true paper money in Europe. The other would be the first major stock bubble and collapse.

John Law’s System

John Law was the son of an Edenborough goldsmith. Goldsmiths, like pawnbrokers before them, functioned as low-level proto-bankers. The issued receipts against the gold deposited with them. Occasionally they would issue receipts in excess of the gold stored in their vaults, knowing that not everyone would wish to redeem their gold at the same time. These receipts circulated as proto-money, but are not the direct ancestor of the banknotes we use today as some have claimed.

In 1694, when the Bank of England was being founded, John Law killed a man in a duel over a woman. Law was living large in England at the time. Now an outlaw, he first went to hide out in Scotland, and when the Acts of Union were passed in 1707, he fled for the continent. He made his way to Genoa, and then to Amsterdam, where he was able to observe their financial systems and banking practices first hand.

Eventually he made his way to France where he became a professional gambler, dandy, and bon-vivant. Through an unlikely series of circumstances and networking, he wound up being a personal friend of Phillip II, the Duc de Orleans, a high-ranking aristocrat who was the regent of France for Louis 15th, the future heir to the throne of France, who was still a teenager.

Just as in England, the finances of the French state were a disaster due to funding  wars all over the continent and the profligacy of the king. Versailles didn’t come cheap.

Europe’s most powerful nation had several major financial problems: 1.) There was not enough money in circulation because of a shortage of coins (a ‘liquidity crisis’) 2.) The French government’s debt was effectively unpayable. The interest rates were staggering and the billets d’etat were what we might today call “junk bonds” and 3.) The privatized and localized tax system was horribly inefficient, preventing the state from collecting taxes effectively. It was riddled with graft and corruption—only a fraction of what was collected made its way into state coffers. The rest ended up in the hands of a corrupt money interest, who resisted any attempts at reform.

When Louis the 14th, the “Sun King,” died, France was in a state of bankruptcy. Continuous warfare had left France short of money and facing a sizeable state debt. Furthermore, the tax revenue collection system had been farmed out to the private sector, leaving the financiers (gens de finance)…the veritable controllers of the financial system. They exerted control by managing the tax farms and lending money to the state. In effect, the state was heavily mortgaged to the financiers. [12]

Law used his friendship with the regent to propose a radical reorganization of the French state finances. Law had seen the English system at work. When he fled Scotland, he spent time in both Genoa and Amsterdam and was able to observe up-close the functioning of their banking and financial systems. This gave him the foundation for his own ideas.

[Law’s] theory consisted in two propositions. One was that the world had insufficient supplies of metal money to do business with. The other was that, by means of a bank discount, a nation could create all the money it required, without depending on the inadequate metallic resources of the world…Law did not invent this idea. He found the germs of it in a bank then in existence— the Bank of Amsterdam. This Law got the opportunity to observe when he was a fugitive from England.

The Bank of Amsterdam, established in 1609, was owned by the city. Amsterdam was the great port of the world. In its marts circulated the coins of innumerable states and cities. Every nation, many princes and lords, many trading cities minted their own coins. The merchant who sold a shipment of wool might get in payment a bag full of guilders, drachmas, gulden, marks, ducats, livres, pistoles, ducatoons, piscatoons, and a miscellany of coins he had never heard of.

This is what made the business of the moneychanger so essential. Every moneychanger carried a manual kept up to date listing all these coins. The manual contained the names and valuations of 500 gold coins and 340 silver ones minted all over Europe. No man could know the value of these coins, for they were being devalued continually by princes and clipped by merchants. To remedy this situation the Bank of Amsterdam was established.

Here is how it worked. A merchant could bring his money to the bank. The bank would weigh and assay all the coins and give him a credit on its books for the honest value in guilders. Thereafter that deposit remained steadfast in value. It was in fact a deposit. Checks were not in use. But it was treated as a loan by the bank with the coins as security. The bank loaned the merchant what it called the bank credit. Thereafter if he wished to pay a bill he could transfer to his creditor a part of his bank credit. The creditor preferred this to money. He would rather have a payment in a medium the value of which was fixed and guaranteed than in a hatful of suspicious, fluctuating coins from a score of countries. So much was this true that a man who was willing to sell an article for a hundred guilders would take a hundred in bank credit but demand a hundred and five in cash.

One effect of this was that once coin or bullion went into this bank it tended to remain there. All merchants, even foreigners, kept their cash there. When one merchant paid another, the transaction was effected by transfer on the books of the bank and the metal remained in its vaults. Why should a merchant withdraw cash when the cash would buy for him only 95 per cent of what he could purchase with the bank credit? And so in time most of the metal in Europe tended to flow into this bank.

It was…a one hundred percent bank–[f]or every guilder of bank credit or deposits there was a guilder of metal money in the vaults. In 1672 when the armies of Louis XIV approached Amsterdam and the terrified merchants ran to the bank for their funds, the bank was able to honor every demand. This established its reputation upon a high plane. The bank was not supposed to make loans. It was supported by the fees it charged for receiving deposits, warehousing the cash, and making the transfers.

There was in Amsterdam another corporation—the East India Company. A great trading corporation, it was considered of vital importance to the city’s business. The city owned half its stock. The time came when the East India Company needed money to build ships. In the bank lay that great pool of cash. The trading company’s managers itched to get hold of some of it. The mayor, who named the bank commissioners, put pressure on them to make loans to the company—loans without any deposit of money or bullion. It was done in absolute secrecy. It was against the law of the bank. But the bank was powerless to resist.

The bank and the company did this surreptitiously. They did not realize the nature of the powerful instrument they had forged. They did not realize they were laying foundations of modern finance capitalism. It was Law who saw this…Here is what Law saw. It is an operation that takes place in our own banks daily. The First National Bank of Middletown has on deposit a million dollars. Mr. Smith walks into the bank and asks for a loan of $10,000. The bank makes the loan. But it does not give him ten thousand in cash. Instead the cashier writes in his deposit book a record of a deposit of $10,000. Mr. Smith has not deposited ten thousand. The bank has loaned him a deposit. The cashier also writes upon the bank’s books the record of this deposit of Mr. Smith. When Mr. Smith walks out of the bank he has a deposit of ten thousand that he did not have when he entered. The bank has deposits of a million dollars when Mr. Smith enters. When he leaves it has deposits of a million and ten thousand dollars. Its deposits have been increased ten thousand dollars by the mere act of making the loan to Mr. Smith. Mr. Smith uses this deposit as money. It is bank money.

That is why we have today in the United States about a billion dollars in actual currency in the banks but fifty billion in deposits or bank money. This bank money has been created not by depositing cash but by loans to the bank depositors. This is what the Bank of Amsterdam did by its secret loans to the East India Company, which it hoped would never be found out. This is what Law saw, but more important, he saw the social uses of it. It became the foundation of his system…[13]

He argued that money was not any particular object, in his words, it was not the value for which goods are exchanged but by which goods are exchanged. For that reason, it could be anything. Law reasoned that the demand for money was greater than the supply, and like any other commodity the supply needed to be increased. An increase in the money supply would cause economic expansion and drive down interest rates. To get around the supply and demand problems encountered with gold and silver, he would retire them and replace them with paper instead.Phase one of Law’s plan would increase the amount of money circulating by introducing paper money in place of metal. Law’s bank would take the coins and issue paper money based on the deposits. The paper money would then retain its value. This was the beginning of true paper money as we know it today:

…his new proposal laid out plans for a private bank, funded by himself and other willing investors, which would issue notes backed by deposits of gold and silver coins and redeemable at all times in coins equivalent to the value of the coin at the time of the notes’ issue, “which could not be subject to any variation.” Thus, Law pledged, his notes would be more secure than metal money, a hedge against currency vacillations, and therefore a help to commerce. Moreover, paper notes would increase the amount of circulating money and trade would be boosted. In short, he vowed, his bank would offer hope and the promise of a better future. [14]

The regent helped by making his well-publicized deposits and ensured that everyone knew he was using the bank for foreign transactions. Foreigners followed his lead, and at last found somewhere in Paris to discount their bills of exchange with ease and at reasonable prices. The influx of foreign cur rency alleviated the shortage of coins, and, with the slow trickle of banknotes Law printed and issued to depositors, boosted the money supply sufficiently for commerce to begin to pick up. Traders liked the banknotes because the guarantee of being paid in coin of fixed value meant that they knew exactly what something would cost or what price they would receive. The notes began to command a premium, like those issued by the Bank of Amsterdam. [15]

The bank was a success, expanding the money supply and goosing the French economy as planned. In 1717 the regent ordered that all public funds be deposited in the Banque Generale. The notes of the bank became authorized for payment of taxes. The center of French finance moved from Lyon to Paris. Law controlled the issuance of banknotes so that at least 25 percent of the circulating value of the notes could be redeemed in gold or silver. To further remove the link with metal, it was forbidden for most people to own specie or use it for transactions. The Bank was eventually bought out by the government and renamed the royal bank (Banque Royale).

In December 17 18, the Banque Generale became the Banque Royale, the equivalent of a nationalized industry today. Law continued to direct it, and under his leadership over the next months, the finances of France leaned more heavily on it. New branches opened in Lyon, La Rochelle, Tours, Orleans, and Amiens. To ensure that everyone made use of paper money, any transactions of more than 600 livres were ordered to be made in paper notes or gold. Since gold was in short supply, this obliged nearly everyone to use paper for all major transactions. Meanwhile. for the leap of confidence they had shown in purchasing shares in the bank in its early uncertain days, and perhaps to buy his way into their world, Law rewarded investors lavishly. Shares that they had partly bought with devalued government bonds were paid out in coin. Both he and the regent had been major shareholders and were among those who profited greatly from the bank’s takeover.

Few recognized the dangers signaled by the bank’s new royal status. Hitherto Law had kept careful control of the numbers of notes issued. There had always been coin reserves of around 25 percent against circulating paper notes. Now, with royal ownership and no shareholders to ask awkward questions, the bank became less controllable. The issuing and quantity of printed notes and the size of reserves would be decided by the regent and his advisers. The temptation to print too much paper money too quickly would thus be virtually unchecked.

Within five months of its royal takeover…eight printers, each of whom earned only 500 livres a year, were employed around the clock printing 100-, 50- and 10· livre notes. A further ominous change followed: notes were no longer redeemable by value at date of issue but according to the face value, which would change along with coins if the currency was devalued: the principle that underpinned public confidence in paper had been discarded and one of Law’s most basic tenets breached. But as the eminent eighteenth-century economist Sir James Steuart later incredulously remarked, “nobody seemed dissatisfied: the nation was rather pleased; so familiar were the variations of the coin in those days, that nobody ever considered anything with regard to coin or money, but its denomination… this appears wonderful; and yet it is a fact.” [16]

Once the bank was established, phase two was to create a joint-stock company to acquire, manage, and ultimately retire, the state’s debt. It would also take over tax collection and the management of state monopolies.

The growing success of the General Bank enabled Law to address the second crisis, management of the national debt. A new radical plan was necessary to restructure France’s financial situation. Law decided that the best way to accomplish this was to convert the government debt into the equity of a huge conglomerate trading company. To do so he needed to establish a trading company along the lines of British trading companies such as the East India Company and the South Sea Company. [17]

While the monarchy was cash poor, it did possess one major asset whose value was almost limitless—a huge chunk of the North American continent. Law’s solution for the debt problem was to use that to create a monopoly company with exclusive rights over the settlement and development of North America, and have investors trade their debt for equity in that company; what today is called a “debt for equity swap.” Instead of unpayable debt, investors could trade that in for shares in a company that offered seemingly unlimited potential. Once again Law and the royal court would be early investors, prompting everyone else to jump on the bandwagon. To make the shares more attractive, Law initiated a “buy now pay later’ scheme—only 10% down would get you a share. Even the general public could buy in, and an informal stock market in trading Mississippi Company shares sprang up on the Rue Quincampoix in Paris outside Law’s apartment.

The company went on a mergers-and-acquisitions spree, buying up all the rival trading companies. It also bought the rights to collect the taxes from the rival financiers. It gained permission to run several state monopolies.

Law was granted a charter to create the Compagnie de la Louisiane ou d’Occident (Company of Louisiana and the West). This company was given a twenty-five year exclusive lease to develop the vast French territories along the Mississippi in North America. This meant exploitation of the Mississippi region, which in the French point of view, represented all of North America watered by the Mississippi River and its tributaries. As part of the deal, Law was required to settle 6,000 French citizens and 3,000 slaves in the territory. To sweeten the transaction the company was awarded a monopoly for the growing and selling of tobacco. [18]

In May 1719 [the Company of the West] took over the East India and China companies, to form the Company of the Indies (Compagnie des Indes), butter known as the Mississippi company. In July Law secured the profits of the royal mint for a nine-year term. In August he wrested the lease of the indirect tax farms from a rival financier, who had been granted it a year before. In September the Company agreed to lend 1.2 billion livres to the crown to pay off the entire royal debt. A month later law took control of the collection (‘farm’) of direct taxes. [19]

Finally, the Banque Royale and the Mississippi Company merged. Essentially all of the French state’s finances were managed by this one huge conglomerate, owned by the government, with Law at the helm. It issued money, collected the taxes, managed the state’s debt, and owned much of North America.

In 1719, the French government allowed Law to issue 50,000 new shares in the Mississippi Company at 500 livres with just 75 livres down and the rest due in nineteen additional monthly payments of 25 livres each. The share price rose to 1,000 livres before the second installment was even due, and ordinary citizens flocked to Paris to participate. Based on this success, Law offered to pay off the national debt of 1.5 billion livres by issuing an additional 300,000 shares at 500 livres paid in ten monthly installments.

Law also purchased the right to collect taxes for 52 million livres and sought to replace various taxes with a single tax. The tax scheme was a boon to efficiency, and the price of some products fell by a third. The stock price increases and the tax efficiency gains spurred foreigners to Paris to buy stock in the Mississippi Company.

By mid-1719, the Mississippi Company had issued more than 600,000 shares and the par value of the company stood at 300 million livres. That summer, the share price skyrocketed from 1,000 to 5,000 livres and it continued to rise through year-end, ultimately reaching dizzying heights of 15,000 livres per share. [20]

Law’s System reached its apex, and the price of the Company’s share peaked, at the beginning of 1720. Two main elements crowned the system. The first was a virtual takeover of the French government, by which the Company substituted the liabilities (shares) for the national debt. The second was the substitution of the Company’s other liabilities (notes) for metallic currency. At the end of the operation, the Company, owned by the former creditors of the State, collected all the taxes, owned or managed most overseas colonies, monopolized all overseas trade, and freely issued fiat money which was sole legal tender. Its CEO also became minister of finance on January 5, 1720. [21]

The government debt was retired, the money supply was expanded, and interest rates fell. But there was a problem.

Pop Go The Bubbles

John Law’s newly nationalized state bank was extending credit in order to buy Mississippi Company shares far in excess of the amount of gold and silver it had stashed in its vaults, and his enemies knew it. The excess money from all the shares floating around began to leak into the wider financial system, causing inflation. The value of the banknotes was no longer fixed but allowed to float. Confidence in the system was always thin.

The old guard sensed their opportunity. They demanded the gold and silver back in return for their paper money, causing a run on the bank. When faith in the Bank disintegrated, so too did faith in Mississippi Company stock (since both were now one in the same institution).

Some early investors, realizing that their hopes of getting rich in Mississippi were greatly exaggerated, began to sell their shares and exchange their paper currency for gold, silver and land. As share prices soared throughout the summer of 1719 some of the more level-headed realized that the bull market was based on little more than “smoke and mirrors” and the ever increasing production of paper notes. Feeling that a crash would sooner or later be inevitable, they cashed in.

… When in early 1720 two royal princes decided to cash in their shares of the Mississippi Company, others followed their example. The downward spiral had begun. Law had to print 1,500,000 livres in paper money to try to stem the tide. By late 1720 a sudden decline in confidence occurred which sent share prices down as rapidly as they had risen. When panic set in, investors sought to redeem their bank and promissory notes en masse and convert them into specie. The “bubble” burst when the Banque Royale could no longer redeem their notes for lack of gold and silver coin. Bankruptcy followed. Political intrigue and the actions of rival bankers contributed to the downfall of the scheme. Those not quick enough to redeem their shares were ruined.

In an effort to slow the run on the Bank Royale, officials resorted to various nefarious schemes. These included counting the money out slowly and only in small denomination coins, inserting clerks in the line who would return the money they withdrew, and by shortening banking hours. At one point the bank refused to accept anything but 10 livre notes. None of these expedients were able to build confidence or to slow the panic-stricken investors for long. In a last-ditch effort to restore confidence in the bank, Law ordered the public burning of bank notes as they came in for redemption. This was meant to convince the public, that because of their growing scarcity, they would be worth more. A huge enclosure was set up outside the bank for this purpose. Several times a day, with great ceremony, the notes were consigned to the flames. This went on during the months of July and August 1720 while paper money continued to lose its value throughout the Summer.

The general public turned on Law and would have lynched him if they could. He was burned in effigy and the mere mentioning of his name could arouse a fury. In October, a coachman was slapped by a passenger during an argument over a disputed fare. The cabbie had the wit to denounce his fare as John Law, whereupon the crowd pounced upon the passenger. The poor man barely saved himself by hiding from his pursuers in a church. [22]

The fall of the company managing the government’s finances caused massive damage to the French economy. Money went back to being metal.

By June 1720 the note issue of the Banque Royale had reached a staggering 2,696,000,000 livres. This sum was approximately twice the money in circulation before Law’s bank opened its doors. The increase in the money in circulation created an inflationary spiral which could not be reversed once the population became leery of Law’s Mississippi Scheme. The entire complex development of the bank’s other schemes for colonial companies, monopolies and tax collection came into question. Law’s plan for his bank and the issue of paper money was sound in and of itself; however, the issue was carried to tremendous sums that Law had never anticipated.

At the end in 1721 the notes had ceased to circulate and specie gradually took their place. The country painfully returned to a specie footing as in years past. This severe lesson in paper money inflation had permanent and long lasting effects upon France. The popular distrust of paper money and big banks kept France financially backward for many years thereafter. France was not to see circulating paper money again until the French Revolution of 1789-1795 necessitated it. [24]

Because France’s finances were not on a firm foundation, it could no longer borrow to expand the money supply. The only remaining option was to raise taxes. But in order to do this, they needed to call a meeting of France’s “parliament,”–a body which did not meet on a regular basis. While English nobility remained primarily in their own estates in the countryside, most of the French nobility was in the French court, totally segregated from the commoners. They had no idea what they were unleashing:

“The immediate precipitating cause of the French Revolution is a lot of political grandstanding around the monarchy’s debt and deficit. This is very much like the debt ceiling crisis that we saw in 2011. The issue was less about whether the monarchy’s finances were actually viable, and more about people using the subject of money to push their political point.”

“So at the point at which the king basically has no money left in the coffers, and can’t persuade the establishment to verify and approve new taxes, he called the first meeting of the Estates General, a body that hasn’t met in 175 years, so that they can produce some new taxes. And that’s really generally considered to be the beginning of the French Revolution. So the French Revolution starts in a crisis about budgets and taxes.” [25]

Much of the money fleeing Paris found its way to England where it inflated the South Sea Bubble. Like the Mississippi Company, it was also the use of a joint-stock company to consolidate, and ultimately retire, the state’s debt. Instead of taxes, it was backed by exclusive contracts from the government to conduct trade in the South Seas. It met a similar fate:

…after the re-coinage, silver continued to flow out of Britain to Amsterdam, where bankers and merchants exchanged the silver coin in the commodity markets, issuing promissory notes in return. The promissory notes in effect served as a form of paper currency and paved the way for banknotes to circulate widely in Britain. So when panicked depositors flocked to exchange banknotes for gold coin from the Sword Blade Bank (the South Sea Company’s bank), the bank was unable to meet demand and closed its doors on September 24. The panic turned to contagion and spread to other banks, many of which also failed. [26]

It’s shares also cratered in value, yet the bubble had “only” seen a tenfold rise in share prices instead of the twentyfold rise in France. Because the South Sea company remained separate from the Bank of England and the Treasury (unlike in France, where they were all one in the same), the damage to the British Economy was limited:

When stock prices finally came back to earth in London, there was no lasting systemic damage to the financial system, aside from the constraint on future joint-stock company formation represented by the Bubble Act. The South Sea Company itself continued to exist; the government debt conversion was not reverse; foreign investors did not turn away from English securities. Whereas all France was affected by the inflationary crisis Law had unleashed, provincial England seems to have been little affected by the South Sea crash. [24]

The Bank of England acquired the South Sea Company’s stock. Unlike France, Britain’s currency held its value, and it was able to pay back its debts. Money flowed into England, including from overseas. British debt was widely marketed and held both domestically and internationally:

Finally, between 1749 and 1752, the chancellor of the exchequer…began to convert all outstanding debt and annuity issues – those not held by the Bank of England, the East India Company, and the reconstituted South Sea Company – into the Consolidated Stock of the Nation, popularly known as Consols…

Consols were fully transferable and negotiable, marketed on both the London Stock Exchange and the Amsterdam bourse; along with Bank of England and East India Company stock, they were the major securities traded on the London Stock Exchange in the late eighteenth and early nineteenth centuries. Though Consols were both perpetual but redeemable annuities, thus identical to Dutch losrenten, their instant and longenduring popular success was attributable to the firmly held belief, abroad as well as at home, that the government would not exercise its option to redeem them…Unchanged to this day, they continue to trade on the London Stock Exchange…

The result of the financial revolution was a remarkably stable and continuously effective form of public finance, which achieved an unprecedented reduction in the costs of government borrowing: from 14 per cent in 1693 to 3 per cent in 1757. [25]

The Aftermath

Two things ensured Britain’s predominance in financial affairs: the last major pitched battle fought on British soil was the Battle of Culloden in 1746. Britain was peaceful, unified, and politically stable far longer than just about anywhere else on earth at the time. The second was the invention of the heat engine and the exploitation of England’s vast coal reserves. The triangular trade and vast amount of cotton allowed Britain to set up factories and industrialize. In fact, government debt may have funded the Industrial Revolution:

Only twice in the period from 1717 to 1931, did the British suspend the convertibility of their currency. Each time they needed more money to fight a war than the tight hand of convertibility would permit. They suspended the convertibility to fight Napoleon and to fight the Kaiser. Each war produced paper money and inflation, as wars tend to do.

After Waterloo, sterling met every test of a key currency. The government was stable, the institutions honored and intact. The Royal Navy sailed the world: trade followed the flag. Britain was first into the industrial revolution, so its manufactured goods spread over the world. The battles were always at the fringes of the empire.

Every time there was a small crisis about the pound, the monetary authorities would raise the interest rates sharply. That might depress the domestic economy, but the high interest rates would draw in foreign exchange, and the pound would retain its value. Britain bought the raw materials, the commodities. and sent back the manufactured goods; and since the price of raw materials gradually declined. The pound increased in value.

The British government issued “consols,” perpetual bonds. Fathers gave them to their sons, and those sons gave them to their sons, and the bonds actually increased in value as time went on. “Never sell consols,’ said Soames Forsyte, Galsworthy’s man of property.

The world brought its money to London and changed it into sterling. London banked it and insured it. Cartographers colored Britain pink on world maps, and the world was half pink, from the Cape to Cairo, from Suez to Australia, In 1897, at Victoria’s Diamond Jubilee, the fleet formed five lines, each five miles long, and it took. four hours for it to pass in review at Spithead.

British capital went everywhere. It financed American railroads and great ranches in the western United States. British investors held not only American ranches. but Argentine ones, too. Their companies mined gold in South Africa and tin in Malaya, grew hemp in Tanganyika and apples in Tasmania, drilled for oil in Mexico, and ran the trolley lines in Shanghai and the’ Moscow Power and Light Company. [26]

Carroll Quigley saw the Napoleonic Wars as a battle of the old mercantile, bullion-based monetary system, based around agriculture and handicrafts, versus the British system of commercial bank credit money and industrial manufacturing. With the final defeat of Napoleon, the British money system became the basis for all the money in the world today:

This new technique of monetary manipulation became one of the basic factors in the Age of Expansion in the nineteenth century and made the fluctuations of economic activity less responsive to the rate of bullion production from mines, by making it more responsive to new factors reflecting the demand for money (such as the interest rate). This new technique spread relatively slowly in the century between the founding of the Bank of England and Napoleon’s creation of the Bank of France in 1803. The Napoleonic Wars, because of the backward, specie-based, financial ideas of Napoleon were, on their fiscal side, a struggle between the older, bullionist, obsolete system favored by Napoleon and the new fractional-reserve banknote system of England. [27]

In order to facilitate international trade, Britain instituted the gold standard. The gold standard was an agreement among nations to convert their currencies to gold at fixed rates, thus ensuring money earned overseas would hold its value relative to domestic currencies. The idea was that shipping gold bars from trade deficit countries to trade surplus countries would allow domestic money supplies to “self-adjust.” Trade deficits would be settled by shipping gold from deficit countries to surplus ones. Since the amount of money in your economy was based on how much gold you had, countries shipping gold out would have less money circulating, leading to deflation. This would make their exports more attractive. On the other hand, countries gaining gold reserves would issue more money causing inflation making their exports less attractive relative to the deficit counties on the world market. Over time, everything would just sort of balance out. That was the theory, anyway:

Britain adopted the gold standard in 1844 and it became the common system regulating domestic economies and trade between them up until World War I. In this period, the leading economies of the world ran a pure gold standard and expressed their exchange rates accordingly. As an example, say the Australian Pound was worth 30 grains of gold and the USD was worth 15 grains, then the 2 USDs would be required for every AUD in trading exchanges.

The monetary authority agreed to maintain the “mint price” of gold fixed by standing ready to buy or sell gold to meet any supply or demand imbalance. Further, the central bank (or equivalent in those days) had to maintain stores of gold sufficient to back the circulating currency (at the agreed convertibility rate).

Gold was also considered to be the principle method of making international payments. Accordingly, as trade unfolded, imbalances in trade (imports and exports) arose and this necessitated that gold be transferred between nations (in boats) to fund these imbalances. Trade deficit countries had to ship gold to trade surplus countries. For example, assume Australia was exporting more than it was importing from New Zealand. In net terms, the demand for AUD (to buy the our exports) would thus be higher relative to supply (to buy NZD to purchase imports from NZ) and this would necessitate New Zealand shipping gold to us to fund the trade imbalance (their deficit with Australia).

This inflow of gold would allow the Australian government to expand the money supply (issue more notes) because they had more gold to back the currency. This expansion was in strict proportion to the set value of the AUD in terms of grains of gold. The rising money supply would push against the inflation barrier (given no increase in the real capacity of the economy) which would ultimately render exports less attractive to foreigners and the external deficit would decline.

From the New Zealand perspective, the loss of gold reserves to Australia forced their Government to withdraw paper currency which was deflationary – rising unemployment and falling output and prices. The latter improved the competitiveness of their economy which also helped resolve the trade imbalance. But it remains that the deficit nations were forced to bear rising unemployment and vice versa as the trade imbalances resolved.

The proponents of the gold standard focus on the way it prevents the government from issuing paper currency as a means of stimulating their economies. Under the gold standard, the government could not expand base money if the economy was in trade deficit. It was considered that the gold standard acted as a means to control the money supply and generate price levels in different trading countries which were consistent with trade balance. The domestic economy however was forced to make the adjustments to the trade imbalances.

Gold standard and fixed exchange rates – myths that still prevail (billy blog)

The gold standard, the self-regulating market, and haute finance were the foundations of the Hundred Year’s Peace lasting up until the First World War.The Hundred Year’s Peace ushered in the final transition from civil society to a fully-fledged market society. Rather than being a sideshow, all of society’s relations now became coordinated by the market. The moral economy was crushed (by force if necessary), and the market and money based capitalist one replaced it. Millions died in this transition, whitewashed from history as “moral failures” even as the suffering under Communism is constantly referred to. Money and banking were at the center of the nexus. Controlling the money supply became absolutely necessary to the smooth functioning of this system. Unfortunately, it was not managed well.

The prevention of providing adequate currency caused panics and depressions throughout the nineteenth century. However, it did engender a hundred years’ of relative peace between the great powers. Nations broke into trading spheres, and the violence was the violence of empire, as well as the institutional violence imposed by the market system itself (hunger, homelessness, starvation, poverty, prisons, jails, alienation, conscription, etc.). In wartime and depressions, however, the gold standard tended to be abandoned. It always rested on peaceful international relations and government agreements; in no was was gold ever “natural” money.

Nineteenth-century civilization rested on four institutions. The first was the balance-of-power system which for a century prevented the occurrence of any long and devastating war between the Great Powers. The second was the international gold standard which symbolized a unique organization of world economy. The third was the self-regulating market which produced an unheard-of material welfare. The fourth was the liberal state. Classified in one way, two of these institutions were economic, two political. Classified in another way, two of them were national, two international. Between them they determined the characteristic outlines of the history of our civilization.

Of these institutions the gold standard proved crucial; its fall was the proximate cause of the catastrophe. By the time it failed, most of the other institutions had been sacrificed in a vain effort to save it. [28]

Mismanagement of the “new” market society was the proximate cause of two World Wars and the Cold War, killing millions. Once again, it threatens to tear the world apart. But that’s a story for another time.

Next: Concluding notes.

[1] Wray, et. al.; Credit and State Theory of Money, p. 209

[2] ibid.

[3] ibid.

[4] In Our Time – The South Sea Bubble (BBC)

[5] Wray, et. al.; Credit and State Theory of Money, p. 210

[6] How a creative legal leap helped create vast wealth (BBC)

[7] In Our Time – The South Sea Bubble (BBC)

[8] Felix Martin; Money, the Unauthorized Biography, pp. 116-117

[9] Felix Martin; Money, the Unauthorized Biography, pp. pp. 117-118

[10] Felix Martin; Money, the Unauthorized Biography, p. 120

[11] Wray, et. al.; Credit and State Theory of Money, p. 211

[12] William N. Goetzmann and K. Geert Rouwenhorst, eds. The Origins of Value: The Financial Innovations that Created Modern Capital Markets, pp. 230-231

[13] John Flynn’s Biography of John Law, pp. 5-7

[14] Janet Gleeson; Millionaire: The Philanderer, Gambler, and Duelist Who Invented Modern Finance, p. 113

[15] Janet Gleeson; Millionaire: The Philanderer, Gambler, and Duelist Who Invented Modern Finance, p. 116-117

[16] Janet Gleeson; Millionaire: The Philanderer, Gambler, and Duelist Who Invented Modern Finance,  pp. 132-133

[17] William N. Goetzmann and K. Geert Rouwenhorst, eds. The Origins of Value: The Financial Innovations that Created Modern Capital Markets, p. 231

[18] John Flynn’s Biography of John Law, p. 5-6

[19] Niall Ferguson; The Ascent of Money, p. 141

[20] Crisis Chronicles: The Mississippi Bubble of 1720 and the European Debt Crisis (Liberty Street)

[21] Francois R. Velde; Government Equity and Money: John Law’s System in 1720 France, p. 21

[22] John E. Sandrock; John Law’s Banque Royale and the Mississippi Bubble, pp. 8-9

[23] Niall Ferguson; The Ascent of Money, p. 157

[24] John E. Sandrock; John Law’s Banque Royale and the Mississippi Bubble, p. 13

[25] Rebecca Spang: Stuff and Money in the Time of the French Revolution – MR Live – 2/21/17 (YouTube)

[26] Adam Smith; Paper Money, pp. 116-117

[27] Carroll Quigley; The Evolution of Civlizations, p. 377

[28] Karl Polanyi; The Great Transformation, chapter one.

The Origin of Money 9 – Bonds and the Invention of the ‘National Debt’

The Venetian government is the first we know of which became a debtor to its own citizens, or conversely, where citizens became creditors on the government. As with most innovations in finance, it was the need to raise funds for war that drove the need to raise revenue quickly.

Other city-states had to compete with Venice, and the system spread, first to Genoa, and then to other republics in Northern Italy like Florence, Milan and Sienna. These city-states were all expanding militarily, and they needed money to do it. Since they were republics, they had advantages that the absolute monarchies of Northern Europe did not have, including accountability to their citizens. The merchant classes essentially borrowed from themselves to fund the wars.

These methods of short and long term debt financing spread to Northern Europe but were done on the municipal, not state level, since states were largely still absolute monarchies who could, and did, repudiate their debts on a regular basis.

In Northern Europe tax collection was highly decentralized during the Middle Ages, and national governments relied on municipal and provincial tax receipts for revenue. Many localities in Western Europe turned to securities (annuities, lotteries, tontines, etc.) for short-term and long-term borrowing which were allowable under the Church’s ban on usury. Both France and Spain eventually incorporated these into the nation’s overall financial structure, however, these were still primarily local, not state liabilities. Both governments used debt instruments for borrowing, but these were intermediated by banks and unlike the Italian republics, borrowing costs were high because they were less reliable. The kings of France and Spain, unrestrained by effective parliaments, were serial defaulters.

The Seven United Provinces (today’s Belgium and the Netherlands), which, like the Italian City-states, were trading empires run by a wealthy merchant oligarchy, used these new methods of financing and banking to fund their rebellion against Spain as well as expand their burgeoning overseas trading empire. These securities eventually became negotiable, and markets emerged for buying, selling, and trading these debts. The United Provinces is likely the first place where these became national liabilities. The center of financial innovation shifted from Northern Italy to Holland.

From there “Dutch finance” spread across the Channel to England during the Glorious Revolution of 1688. To manage his mounting war debt, William of Orange took out a loan from the merchant bankers of England in exchange for certain prerogatives from the crown. England was the first major country to consolidate its debt, nationalize it, and monetize it, therefore setting the stage for the public/private hybrid system of money creation and banking that we use today.

Italy Invents the State Bank

It all started with the Crusades. Seaports like Venice and Genoa were launching points for the armies marching south to conquer the Holy Land. The vast amounts of money flowing into these cities during this time allowed them to remove themselves from the feudal order and become self-governing communes. The shipping expertise gained by ferrying soldiers back and forth to the Middle East allowed the Venetians and Genoese to develop the skills to become Europe’s primary merchants and traders, importing exotic goods from the Islamic world into western Europe, and becoming fabulously wealthy in the process.

It was through the Islamic trade centered around the Silk Road and the Indian ocean—the first modern “global economy”–that the Italians learned all sort of innovations that we saw last time, from paper to base-10 place notation, to algebra, to checks, to bills of exchange. These ideas would be used to usher in the “commercial revolution” of the late Middle Ages. They would also make Northern Italy the crucible for European banking and finance.

To fund their expansion, these thassalocracies needed money. Trading empires, as Paul Colinveax would remind us, require superior military technique. At this time, military empires relied mainly not on conscripts (most people in these republics were merchants and artisans), but on professional soldiers, i.e. mercenaries. As Carroll Quigley put it, “the existence of mercenary armies made money equivalent to soldiers and thus to power.” (p. 373)

For much of the fourteenth and fifteenth centuries, the medieval city-states of Tuscany – Florence, Pisa and Siena – were at war with each other or with other Italian towns. This was war wages as much by money as by men. Rather than require their own citizens to do the dirty work of fighting, each city hired military contractors (condottieri) who raised armies to annex land and loot treasure from its rivals. [2]

The main way states raised money during this period, as we saw last time, were taxes and seignorage. Taxes were levied almost exclusively on commercial activity for most of history (since most other activity took place outside of the commercial/money economy). This was unlikely to be as effective in an entrepot dependent upon shipping and trade. Feudal rents and dues were levied by kings, but were less available to city-states outside of the feudal system. Siegnorage was a major way of raising revenue as we saw previously, but for a merchant-based society, devaluing the currency was less likely to be helpful or popular.

The solution arrived at was to borrow money from the city’s wealthy merchant and banking classes.

During the thirteenth and fourteenth centuries major cities such as Florence, Genoa, Milan, and Venice were able to extend their territorial control; those of Venice and Genoa attained the importance of maritime empires.

The formation of a territorial state came at enormous costs. How did urban governments raise the money needed to cover such expenses? Since increasing or raising new taxes required time and, above all, public acceptance, the easiest way was to borrow from the wealthiest citizens.[3]

Despite the ban on usury, no medieval European government – municipal, territorial, or national – was able to function without borrowing, given that its powers to tax and exact rents were limited, while it was often engaged in costly wars. But such loans were usually for short terms, often at punitive rates of interest.

During the twelfth century, the Italian progenitors of the ongoing Commercial Revolution developed what became a system of municipally funded debts, debts that subsequently became permanent. Genoa took the lead, in 1149, when it agreed to give a consortium of the city’s lenders control over a compera, a consolidated fund of tax revenues to be used in paying the city’s creditors.

Venice followed suit in 1164, by securing a loan of 1,150 silver marci against the tax revenues from the Rialto market for twelve years. In 1187, in return for a loan of 16,000 Venetian lire, to finance the doge’s siege of Zara, creditors were given control over the salt tax and certain house rents for thirteen years; thereafter, the Salt Office was made responsible for all such loan payments…by 1207, the Venetians had adopted what had already become the hallmark of public finance in the Italian republics: a system of forced loans, known locally as prestiti, whose interest charges were financed by additional taxes on salt, the Rialto market, and the weigh-house.

Between 1262 and 1264, the Venetian Senate consolidated all of the state’s outstanding debts into one fund later called the Monte Vecchio – mountain of debt – and decreed that debt-holders should receive annual interest at 5 per cent, which the Ufficiale degli Prestiti was required to pay twice yearly from eight specified excise taxes. These prestiti debt claims (with interest payments) were assignable through the offices of the procurator of San Marco and, by 1320 at the latest, a secondary market for them had developed. [4]

A loophole in the medieval prohibition on usury allowed this to take place. Although we regard usury and interest as one in the same, in fact medieval law made a distinction between the two:

Usury is sometimes equated with the charging of interest, but by the thirteenth century it was recognised that the two ideas were different.

Usury derives from the Latin usura, meaning ‘use’, and referred to the charging of a fee for the use of money. Interest comes from the Latin intereo, meaning ‘to be lost’, and originated, in the Roman legal codes as the compensation someone was paid if they suffered a loss as a result of a contract being broken. So a lender could charge interest to compensate for a loss, but they could not make a gain by lending.

It is easier to understand this with a simple example. A farmer lends a cow to their cousin for a year. In the normal course of events, the cow would give birth to a calf and the cousin would gain the benefit of the cow’s milk. At the end of the loan, the farmer could expect the cow and the calf to be returned. The interest rate is 100%, but it is an interest since the farmer, if they had not lent the cow to their cousin, would have expected to end the year with a cow and a calf. Similarly, if the farmer lent out grain, they could expect to get the loan plus a premium on the basis that their cousin planted the grain, he would reap a harvest far greater than the sum lent. [5]

These concepts gave birth to the idea of the medieval census:

A census originated in the feudal societies as an “obligation to pay an annual return from fruitful property”. What this means is that the buyer of the census would pay a landowner, for example, for the future production from the land, such as wheat or wine, over a period of time.

As economic life in western Europe became based on money transactions rather than barter transactions, censii lost the link to specific produce, cartloads of wheat or barrels of wine. The buyer of the census would accept regular cash payment instead of the actual produce, and this was legitimate in the eyes of the canon lawyers as long as the lump-sum paid buy [sic] the buyer ‘equated’ with the value of the ‘fruitful property’ being produced by the seller.

Anyone who could became involved in censii. A labourer might sell a census based on the future revenue from their labour, states sold them based on the future revenue from taxes and monopolies, and the Church invested bequests by buying censii. Censii issued by governments, usually linked to specific tax revenues, became known as rentes. Censii could be ‘temporary’, lasting a few years, or ‘permanent’, until one of the parties died.

In today’s terms, temporary censii resemble modern mortgages, permanent censii resemble the ‘annuities’ pensioners live off today. They could be ‘redeemable’, by one or both parties, meaning that the contract could be cancelled. [6]

The Venetian government required a “forced loan” from their wealthiest citizens in line with their income (i.e. it was progressive) to fund the war effort. Since the loans were forced loans, interest was compensation for the lost money, which was allowable under the Church’s anti-usury doctrine. The government paid an “interest” of 5 percent per year in biannual installments of 2.5 percent to compensate for the lost money. To do this, the government allocated dedicated revenue streams from commercial taxes to pay the interest.

Prestiti were a development from the rentes created by states. Around the twelfth century the Italian city-states of Venice, Genoa and Florence began to forcefully sell temporary rentes to their rich citizens. By the mid-thirteenth century the different issues of rentes were consolidated into a mons (mountain) and everyone who had been made to buy a rente was given a share, proportionate to their contribution, in the mons. [7]

The loans were basically irredeemable—there was no pledge by the government to pay back the principal in a fixed amount of time. These were not bearer bonds; rather, the names of the creditors were recorded in government ledgers at the loan office (Camera degli imprestiti). They were assignable in that the revenue stream could be transferred to a third party with the consent of the owner, but they were not negotiable, however, at least at first. You could not simply sell your bonds on the open market without the knowledge of the original debtor (the government), i.e. they were not easily transferable. Nor were they legal tender which could be used in lieu of cash.

Venice created its mons, the monte vecchio, in 1262 and the shares, known as prestiti, entitled the holder to be paid 5%, a year, of the sum they lent, which was written on the prestiti and known as the ‘face value’. While there was no obligation for the states to pay the coupon, the annual payment, there was an expectation that they would if it could be afforded and the mountain itself was paid back as and when funds allowed. [8]

Eventually, as borrowing costs grew to encompass more and more of state revenue, dedicated agencies were established in order to manage the consolidated debt these states owed to their citizens and others:

During the last quarter of the thirteenth century the demand for loans on Venetian citizens grew: they had to deposit a part of their assessed wealth into state coffers, the sums were registered on public books, and tax revenues were devoted to paying interest. By 1274 Genoa adopted a similar measure, and some loans were consolidated and managed by a single state agency.

The republics of Venice and Genoa were thus the first to transform their floating debt into a consolidated debt; later, some Tuscan communities would follow suit.
The main features of such a system were extraordinary financing through irredeemable forced loans; moderate interest rates; credits that were heritable, negotiable and usable payment; an amount consolidated and managed by a specific authority; and specific tax revenues designated for paying interest. [9]

The Genoese set up a dedicated private bank to manage the public debt around 1400 called the Casa di San Giorgio. Today it is recognized by financial historians as the first modern state bank, and in time, it became more powerful than the state itself! Many European monarchs regularly used it for borrowing, and it even funded some of the first expeditions to the New World (Christopher Columbus’ childhood home was nearby):

On March 2 1408, eight men gathered in the great hall of the Casa di San Giorgio, a trading house on what was then the main street in Genoa, a few metres from where the waters of the Ligurian Sea lap the Italian shore. They were merchants, rich and powerful representatives of the city’s most influential families, and they were meeting to discuss a matter of the utmost gravity. The once-glorious republic of Genoa had fallen on hard times. After years of war with Venice and a crushing defeat at the battle of Chioggia in 1381, the state was effectively bankrupt. The task was to rescue it.

A few months earlier, towards the end of 1407, Genoa’s Council of Ancients had authorised the Casa di San Giorgio to carry out this job. It would be accomplished by creating a bank that would facilitate the repayment of Genoa’s debts in return for interest at 7 per cent and the right to collect taxes and customs owed to the city. The purpose of the meeting that spring day was to declare the Banco di San Giorgio open for business.

..The Banco di San Giorgio would, in time, become as powerful as the republic that created it – more powerful, according to Niccolò Machiavelli. It would survive for nearly 400 years. It would become the world’s first modern, public bank, not just a forerunner of the Bank of England but its prototype…in a short space of time, it became so entwined with the republic of Genoa that the bank and the state were indistinguishable.

Machiavelli described the relationship as “a state within a state”. The Banco di San Giorgio grew so influential that it replaced the Fuggers, the German banking dynasty, as the source of financing for Europe’s cash-starved, perpetually warring monarchs. A century and a half after it was created it had restored Genoese power and influence as a maritime and commercial state to such an extent that the period from 1557 to 1627 was termed the Age of Genoa by Fernand Braudel, the great French historian…Christopher Columbus, Genoa’s most illustrious son, would be a customer…[10]

The management of state finances became increasingly concentrated in the hands of a professional bureaucracy which was separate from direct control by the state. The republics made very sure that the money was paid back reliably. This made loaning to them much more reliable than loaning to monarchs, and they were able to raise more revenue for their operations:

One reason that this system worked so well was that they and a few other wealthy families also controlled the city’s government and hence its finances. This oligarchical power structure gave the bond market a firm political foundation. Unlike an unaccountable hereditary monarch, who might arbitrarily renege on his promises to pay his creditors, the people who issued the bonds in Florence were in large measure the same people who bought them. Not surprisingly, they therefore had a strong interest in seeing that their interest was paid. [11]

Because of their dependability, these government-backed IOUs soon became highly desirable places for rich merchants and nobles to store their wealth, much as they are today, secured by the government’s promises to pay. The guaranteed returns provided a reliable income stream for those able to purchase the bonds. The merchant classes and various institutions bought up the bonds and used them as collateral, endowments for charities, even gifts and dowries, and passed them down to their assignments and heirs.

Over time, as issuing bonds became more common, more and more people became dependent on bonds for their income. Much like today, many of the holders of bonds were not just individuals but institutions and endowments who relied on the bonds as a source of income. This parallels today, where holders of bonds are often institutional holders like retirement accounts and insurance companies:

Throughout the sixteenth and seventeenth centuries it seems that most of the bonds were in the hands of guilds and ecclesiastical and charitable institutions that looked to state debt to assure a sound, even if relatively low, return. The economic importance of the redistribution of money through the government debt can not be neglected…Both in Florence and Genoa, government creditors drew a significant share (about one-fifth) of their income from bonds. Accordingly, a flow of money spread through the city and revived the local economy. [12]

Initially, only citizens of the Republic could buy bonds, but over time, bonds were issued to outside sources. Nonetheless, it appears that the debt in Italian city-states was held mainly by its own citizens, and not by foreign creditors. Buying bonds was seen as a sort of civic duty for the city’s wealthy individuals:

To loan to the commune was regarded as a duty, part of belonging to the urban community. Loans were connected, to a certain extent, with the concept of charity and gifts to the res publica.

Some governments, such as Florence, at first forbade foreigners to held state bonds, while it seems that in Venice since the thirteenth century foreigners were allowed to buy government credits. Some devices, nevertheless, were adopted in order to bypass such prohibitions; the easiest solution was to grant citizenship to those who were willing to buy government bonds…At any rate, the foreign presence among bondholders seems to have been a limited phenomenon: by the early fifteenth century about one tenth of the Florentine debt was held by foreigners; in 1629, 92 percent of the principal of S. Giorgio belonged to Genoese citizens and institutions…Unlike some Italian princely states, such as Milan and the papal state, and German cities, the urban governments of Venice, Florence and Genoa succeeded in raising enormous amounts of money from their citizens and very seldom borrowed from foreigners…[13]

Today, governments sell bonds directly to the public in what is called a primary market. From there, they are traded by investors in secondary markets. At this time, there was no primary market for bonds—only a select few insiders could loan to governments. But soon a thriving secondary market emerged where such debts were bought and sold. The prices of bonds varied, depending on the reliability of the debtor (the state). Because interest was paid on the face value of the bond, if you could buy a bond on the cheap, you would be assured a nice payout. This was effectively an end-run around the Church’s ban on usury:

Quickly a market for Prestiti emerged, where holders who needed ready cash would trade them with people who had a surplus of cash and wanted to save. During times of peace and prosperity they had a high price, but during war and uncertainty, they traded at a low price.

For example, Venetian prestiti traded for their face value around 1340 when the Republic paid off a lot of the mons, but in 1465, during a disastrous war with the Ottoman Turks, they fell to 22% of face. The Florentine prestiti actually had a built in facility where a holder could go to the state and sell them for 28% of their face value, however their market price was never so low as to make this profitable.

The legitimacy of the prestati was debated by the canon lawyers. On the one hand the coupons, the regular cash payments can be seen as compensation for the forced nature of the original loan. The lender had no choice and so does suffer a loss. However, if a prestiti with a face of 100 ducats was sold for 22 ducats, the buyer would be receiving interest at a rate of 5∕22 = 23%; in what way had this buyer of the prestiti been forced to enter into the contract? An interest payment of 23% in these circumstances seemed to be “asking for more than what was given”.

Prestiti are important in that are one of the earliest representations of an actively traded financial instrument. The prestiti does not represent bushels of wheat or barrels of oil, it is a contract where by a state promises to pay a specified amount of money. Whether or not the state does pay out on the contract, is unknown and uncertain, hence the value of the contract is also unknown and uncertain. [14]

In the end, the ability to have people voluntarily lend to the government provided advantages that were simply too great to ignore. Such governments were able to raise large amounts of cash quickly; they were able to raise money from a much wider circle than just the immediate tax base; and they were able to overcome limitations in the amount of specie circulating. This made state borrowing very effective and the places that engaged in it very powerful. In addition, bonds provided reliable places for wealthy citizens to store wealth outside of banks, and the interest payments helped local economies flourish. Money was becoming an important source of military power, too. Luciano Pezzolo summarizes the advantages of bond issuance by Italian city-states:

First, the enormous concentration of capital in some Italian cities allowed governments to transform, through public credit, private wealth into military power, to build a territorial state, and to control a wider economic area…Italian governments collected money from taxpayers at 5 to 7 percent, whereas the major European monarchies of the Renaissance were compelled to borrow at a much higher price.

Second, the debts took on a political function. To be creditors in the government meant sharing the destiny of the regime, and consequently supporting it. In Florence, the Medicean regime tied itself to an oligarchy that profited from the management of government debt. Thus, debt helped create stability.

Third, the social structure was supported by state debt: the considerable bond income drawn by charitable and social institutions and redistributed it the poor maintained a paternalistic policy that was a pillar of the urban political and social system.

Fourth, both government bonds and interest provided an effective surrogate of cash money in the later Middle Ages during a period of bullion shortage. The trade of bonds and interest claims opened up sophisticated forms of speculation and implemented financial techniques that are quite familiar to modern brokers.

Finally, the means devised by governments to finance the deficit offered new forms of social security and investment (dowries, life annuities, lotteries) that are at the roots of [the] later financial system. [15]

In this, we can discern something like David Graeber’s military-coinage-slavery complex emerging around the bond markets:

1.) Governments would raise money for military operations by dedicating future expected revenue streams to loan repayments, effectively becoming debtors to their citizens. That is, they could borrow against future revenues.

2.) The proceeds from the territorial/commercial expansion would be used to pay interest on the loans.

3.) The interest money would then flow back into the domestic economy, causing economic expansion at home, as more people became dependent on the government debt as a store of value and a source of income.

4.) Economic expansion abroad and at home would allow governments to deliver better services to its citizens, ensuring broad popular support.

5.) The dependency on regular payouts by lenders would encourage them to support the political stability of the regime.

6.) City-states which avoided default were able to gain a fundraising advantage over their rivals. Hence, there was a strong incentive to make reliable payments and not to default.

Thus, the concept of the “national debt” was born. This gave rise to a brand new “money interest” whose wealth was held in government debt rather than coin.

Debt Financing Spreads to Northern Europe

Now contrast this with Northern Europe. Most nation-states were still under the feudal system. It would have made no sense for a ruler to borrow from himself, since they theoretically “owned” everything in the kingdom. Instead of borrowing from their citizens, therefore, these kingdoms continued to rely upon other sources of income.

Under the feudal system tax collection was highly decentralized and done mainly at the local level. Wealthy kingdoms, such as France, used tax farming (publican) methods very similar to those of ancient Rome:

Fiscal revenues consisted of a mixture of direct (income or wealth) taxes, indirect (consumption) taxes, and feudal dues arising from the royal demesne. The assessment and collection of these revenues was decentralized. For direct taxes, a global amount was set by the government, and then broken down into assessments for each province, where local authorities would proceed with the next level of assessment, and so on to the local level.

For indirect taxes, collection was carried out by tax farmers on behalf of the government. The procedure was much like the one in place since Medieval times for running the royal mints. The right to collect a given tax was auctioned to the highest bidder. The bidder offered a fixed annual payment to the king for the duration of the lease. Meanwhile, he took upon himself to collect the tax, hiring all the necessary employees. Any shortfall in revenues from the promised sum was made up by the entrepreneur; conversely, any revenue collected above and beyond the price of the lease was retained as profit by the entrepreneur…

Spending is decentralized as well to various treasurers. Each tax had an associated bureaucracy of collectors and treasurers, either government employees or officers (direct taxes) or employees of the tax farmer. The treasurers spent some of the monies they collected, upon presentation of payment orders emanating from the government, and turned over the remainder, if any, to the royal treasury in Paris. [16]

Although it’s anathema under modern economic dogma, government monopolies on various business activities were considered a legitimate way to raise revenue.

Government monopolies, such as salt and recently introduced tobacco, were also farmed out in the same fashion. Indeed, the ability to create monopolies was one of the king’s resources; one of the more outlandish examples being the exclusive right to sell snow and ice in the district of Paris, sold for 10,000L per year in 1701. [17]

Another method was through the sale of political offices. Governments would create offices and sell them at a profit, and the salary paid was essentially interest on the lump sum payment for the original position:

An officer was someone who held a government position not on commission or at the king’s leave, but as of right, and enjoyed various privileges attached to the position (in particular the collection of fees related to his activities). Offices were sold, and the king paid interest on the original sale price, which was called the wages of the office (gages). A wage increase was really a forced loan, requiring the officer to put up the additional capital. Officers could not be removed except for misconduct; however, the office itself could be abolished, as long as the king repaid the original sum. Thus, offices as a form of debt also carried the same repayment option as annuities. [18]

And, as in Italy, the census evolved into annuities which were sold by municipalities as a way of long-term borrowing.

Offices and annuities (which I will generically call bonds, and whose owners I will call bondholders) could be transferred or sold, but with fairly high transaction costs. Both were considered forms of real estate, and could be mortgaged. In the late 17th century the French government, like others in Europe, had begun experimenting with life annuities, tontines, and lottery loans, but on a limited basis, and had not yet issued bearer bonds. Even the short-term debt described above was registered in the sense that the payee’s name was on the instrument, and could be transferred only by endorsement.

A final form of borrowing combined tax creation and lending. The procedure consisted in creating a new tax for some limited time and immediately farming its collection in exchange for a single, lump-sum payment representing the tax’s net present value. [20]

Besides, absolute monarchs could always repudiate their debts, and there was not much recourse for creditors since monarchs had their own armies and made the laws. The kings who did take out loans for military campaigns ended up paying very high interest rates for this reason.

By the early sixteenth century, the Habsburg Emperor, French kings, and princes in the Low Countries had all affirmed their powers to regulate municipal public finances, especially rentes, and the municipal taxes that were used to pay annual rent charges. But this method of financing governments still remained municipal, because only municipalities sold rentes, so that the national institutions required for a funded, permanent public debt had yet to be created…the first national monarchy to establish a permanent, funded national debt based on rentes, by the early sixteenth century, was … the newly unified Habsburg kingdom of Spain.

Both the French and Spanish crowns sought to raise money … but they had to use towns as intermediaries. In the French case, funds were raised on behalf of the monarch by the Paris hôtel de ville-, in the Spanish case, royal juros had to be marketed through Genoa’s Casa di San Giorgio (a private syndicate that purchased the right to collect the city’s taxes) and Antwerp’s heurs, a forerunner of the modern stock market. Yet investors in royal debt had to be wary. Whereas towns, with their oligarchical forms of rule and locally held debts, had incentives not to default, the same was not true of absolute rulers. [21]

Despite this ability to borrow, by the 1500-1600’s France and Spain had become serial defaulters.

…the Spanish crown became a serial defaulter in the late sixteenth and seventeenth centuries, wholly or partially suspending payments to creditors in 1557 , 1560, 1575 , 1596, 1607, 1627 , 1647, 1652 and 1662. [22]

The Netherlands, by contrast, used these financial techniques to fund their war of independence from Spain and in the process became the financial center of northern Europe.

Part of the reason for Spain’s financial difficulties was the extreme costliness of trying and failing to bring to heel the rebellious provinces of the northern Netherlands, whose revolt against Spanish rule was a watershed in financial as well as political history. With their republican institutions, the United Provinces combined the advantages of the city state with the scale of a nation-state. They were able to finance their wars by developing Amsterdam as the market for a whole range of new securities: not only life and perpetual annuities, but also lottery loans (whereby investors bought a small probability of a large return). By 1650 there were more than 6 5,000 Dutch rentiers, men who had invested their capital in one or other of these debt instruments and thereby helped finance the long Dutch struggle to preserve their independence. [23]

The center of European trade moved from the Mediterranean to the North Atlantic starting in the mid-1400’s with the advent of pelagic shipping vessels and the discovery of new routes to Asia by circumnavigating Africa. Portugal and Spain took the lead here. Spain’s “discovery” of the American continent ensured that trade would now be centered on the Atlantic coast, and the Islamic trade in the Mediterranean withered and became less significant, especially after the fall of Constantinople to the Turks in 1453. Eventually, European maritime trade became centered in Antwerp. When the Spanish conquered the southern Netherlands, what we now call Belgium, in 1585, they took Antwerp, which was the main port for Northern Europe. Many of the more highly skilled merchants fled to Amsterdam, which would then become ground zero for the financial revolution.

The reason for the primacy of the Dutch Republic in trading and finance might simply boil down to geography. Holland and the Netherlands are below sea level, which is why they are called the Low Countries. The land had forcibly been reclaimed from the sea by dykes over the centuries. This made the Dutch dependent upon fishing, shipping and trading far more than just about anywhere else, since the water table was too high for farming and there was not much arable land. Yet at the same time the population density of these areas was quite high. So their entire economy had to be dependent almost exclusively on shipping and trade since there were no other options, unlike in France, Spain, Portugal and England.

The Dutch utilized much of the same methods of borrowing as the rest of Europe, but much more effectively:

The Netherlands successfully liberated itself from Spain between 1568 and 1648. The Dutch established the Dutch east India Company in 1602 and the Dutch West India Company in 1621. The Netherlands didn’t have to pay for an expensive court, fought their wars at home rather than abroad, profited from international trade, and saved money. The Amsterdam Exchange dealt not only in shares of the Dutch East India Company and Dutch West India Company, but in government bonds as well.

Most securities were in the form of Annuities issued by the individual provinces, the United Provinces and the towns. This is the essential way in which Dutch lending differed from Italian lending. The Italian credit system relied upon a system of private international banking. The Medicis and other commercial bankers would lend their funds to states, knowing the risks involved. The Italians also had officially chartered banks that intermediated deposits and loans.

Outside of the Italian city-states, loans to heads of state were basically personal loans that clearly ran the risk of default. Spanish, French and English kings borrowed when they had to, defaulted when they couldn’t pay, but had no system of drawing upon the savings of the public. The Dutch, on the other hand, developed state finance based upon the government’s ability to pledge its revenues against the annuities they had issued. Having no royal court, and relying upon local governments, the Dutch paid off loans on time with little risk of default. As risk declined, interest rates fell to 4%, the lowest they had ever been in history, and a rate consistent with the low level of default risk that governments enjoy today. [24]

The Dutch also set up a bourse where national debts could be traded as negotiable securities. They set up a state bank to manage trade. They also developed the modern corporation, where corporate shares were freely tradable, hence establishing the first stock market (the Amsterdam exchange).

The Dutch Republic became the main place where international debts could be bought and sold in secondary markets. While it was neither the first bank or exchange, what made it unique was the fact that this was consolidated in one specific location, with government backing, as well as the scale of operations. Securities from all over became speculative commodities. This was the beginning of trading debts and money that engendered speculative bubbles like Tulip mania. In fact, you could even gamble with assets that you didn’t actually own, setting up the stage for the modern Casino Capitalism.

The novelty at the beginning of the seventeenth century was the introduction of a stock market in Amsterdam. Government stocks and the prestigious shares in the Dutch East India Company had become the objects of speculation in a totally modern fashion. It is not quite accurate to call this the first stock market, as people often do. State loan stocks had been negotiable at a very early date in Venice, in Florence before 1328, and in Genoa, where there was an active markets in the luoghi and paghe of the Casa di San Giorgio, not to mention the Kuxen shares in the German mines which were quoted as early as the fifteenth century at the Leipzig fairs, the Spanish juros, the French rentes sur l’Hotel de Ville (municipal stocks) (I522) or the stock market in the Hanseatic towns from the fifteenth century. The statutes of Verona in 1318 confirm the existence of the settlement or forward market (mercato a termine). In 1428, the jurist, Bartolomeo de Bosco protested against the sale of forward loca in Genoa. All this evidence points to the Mediterranean as the cradle of the stock market.

But what was new in Amsterdam was the volume, the fluidity of the market and the publicity it received, and the speculative freedom of transactions. Frenetic gambling went on here – gaming for gaming’s sake: we should not forget that in about 1634, the tulip mania sweeping through Holland meant that a bulb ‘of no intrinsic value’ might be exchanged for ‘a new carriage, two grey horses and a complete harness’! Betting on shares however, in expert hands, could bring in a comfortable income… Exchanges and growing rich while the merchants said they Were becoming poorer. In every centre, Marseilles or London, paris or Lisbon, Nantes or Amsterdam, brokers, who were little hampered by the regulations, took many liberties with them.

But is is also true that speculation on the Amsterdam Stock Exchange had reached a degree of sophistication and abstraction which made it for many years a very special trading-centre of Europe, a place where people were not content simply to buy and sell shares, speculating on their possible rise or fall, but where one could by means of various ingenious combinations speculate without having any money or shares at all. This was where the brokers came into their own… All the same, such practices had not yet attained the scale they were to reach during the following century, from the time of the Seven Years War, with the increased speculation in shares in the British East India Company, the Bank of England and the South Sea, above all in English government loans…Share prices were not oficially published until 1747 however, whereas the Amsterdam Exchange had been billing commodity prices since 1585.

Several other changes took place as well. To resolve the multiple currencies circulating, state banks became established by governments, and monetary exchange ever more centered around bank credits rather than government-issued monies. You would deposit your coins in the bank and be given a credit for it, which would hold its value, protected from the arbitrary currency fluctuations decreed by sovereigns. Credit creation led to fractional reserve banking. Joint-stock companies were applied to banking, and even made loans to governments.

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.

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…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…

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; 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. [25]

This last innovation – the use of private corporations such as banks to consolidate and manage the government’s debt, is at the heart of the modern financial system. The money we use is the government’s liability, backed by its ability to collect taxes. Yet now private banks would continue to be allowed to create credit by extending loans denominated in the same unit of account that the government required to pay the taxes, the ultimate form of financial settlement.

We’ll take a look at how that happened next time.


[1] Not used.
[2] Niall Ferguson; The Ascent of Money, p. 69
[3] William N. Goetzmann and K. Geert Rouwenhorst, eds.: The Origins of Value: The Financial Innovations that Created Modern Capital Markets, p. 147
[4] John H. Munro: The medieval origins of the ’Financial Revolution’: usury, rentes, and negotiablity. p. 514
[6] ibid.
[7] ibid.
[8] ibid.
[9] ibid.
[11] Niall Ferguson; The Ascent of Money, p. 72
[12] William N. Goetzmann and K. Geert Rouwenhorst, eds.: The Origins of Value: The Financial Innovations that Created Modern Capital Markets, p. 147
[13] ibid., p. 158
[15] William N. Goetzmann and K. Geert Rouwenhorst, eds.: The Origins of Value: The Financial Innovations that Created Modern Capital Markets, p. 163
[16] Francois R. Velde; Government Equity and Money: John Law’s System in 1720 France, p. 5-6
[17] Francois R. Velde; Government Equity and Money: John Law’s System in 1720 France, p. 5-6
[18] Francois R. Velde; Government Equity and Money: John Law’s System in 1720 France, p. 8
[19] Niall Ferguson; The Ascent of Money, pp. 73-74
[20] Francois R. Velde; Government Equity and Money: John Law’s System in 1720 France, p. 8
[21] John H. Munro: The medieval origins of the ’Financial Revolution’: usury, rentes, and negotiablity. p. 73-74
[22] Niall Ferguson; The Ascent of Money, p. 74
[23] Niall Ferguson; The Ascent of Money, pp. 74-75
[24a] Fernand Braudel: Civilization and Capitalism Volume 2: The Wheels of Commerce, pp 100-102
[25] Niall Ferguson; The Ascent of Money, p.Pp. 48-49