The Origin of Paper Money 6

1. France

France ended up conducting its own monetary experiment with paper money at around the same time as the American colonies in the early 1700s. Unlike the American experiment, it was not successful. It would be initiated by an immigrant Scotsman fleeing a murder charge (and gambling addict) by the name of John Law. (Jean Lass in French).

At this time—the early 1700’s—France was having much the same conversation around the money supply as in the Anglo-Saxon world. There, the problem was not so much a shortage of  coins, but an excess of sovereign debt due to the wild spending sprees of France’s rulers on foreign wars and luxury lifestyles.

Despite being probably the most wealthy and powerful nation in Western Europe, France’s debts (really, the King’s debts) exceeded its assets by quite a bit, at least on paper. The country struggled to raise enough funds via its antiquated and inefficient feudal tax system to pay the interest on its bonds; France’s debt traded in secondary markets as what we might today call junk bonds (i.e. low odds of repayment).

Louis XIV, having lived too long, had died the year before Law’s arrival. The financial condition of the kingdom was appalling: expenditures were twice receipts, the treasury was chronically empty, the farmers-general of the taxes and their horde of subordinate maltôtiers were competent principally in the service of their own rapacity.

The Duc de Saint-Simon, though not always the most reliable counsel, had recently suggested that the straightforward solution was to declare national bankruptcy – repudiate all debt and start again. Philippe, Duc d’Orleans, the Regent for the seven-year-old Louis XV, was largely incapable of thought or action.

Then came Law. Some years earlier, it is said, he had met Philippe in a gambling den. The latter ‘had been impressed with the Scotsman’s financial genius.’ Under a royal edict of 2 May 1716, law, with his brother, was given the right to establish a bank with capital of 6 million livres, about 250,000 English pounds…
(Galbraith, pp. 21-22)

…The creation of the bank proceeded in clear imitation of the already successful Bank of England. Under special license from the French monarch, it was to be a private bank that would help raise and manage money for the public debt. In keeping with his theories on the benefits of paper money, Law immediately began issuing paper notes representing the supposedly guaranteed holdings of the bank in gold coins.

Law’s…bank that took in gold and silver from the public and lent it back out in the form of paper money. The bank also took deposits in the form of government debt, cleverly allowing people to claim the full value of debts that were trading at heavy discounts: if you had a piece of paper saying the king owed you a thousand livres, you could get only, say, four hundred livres in the open market for it, but Law’s bank would credit you with the full thousand livres in paper money. This meant that the bank’s paper assets far outstripped the actual gold it had in store, making it a precursor of the “fractional-reserve banking” that’s normal today. Law’s bank had, by one estimate, about four times as much paper money in circulation as its gold and silver reserves…

The new paper money had an attractive feature: it was guaranteed to trade for a specific weight of silver, and, unlike coins, could not be melted down or devalued. Before long, the banknotes were trading at more than their value in silver, and Law was made Controller General of Finances, in charge of the entire French economy.

The Invention of Money (The New Yorker)

It’s also worth noting that banknotes were denominated in the unit of account, unlike coins which typically were not. Coins’ value usually fluctuated against the unit of account (what prices were expressed in), sometimes by the day. What a silver sovereign or gold Louis d’Or was worth on one day might be different that the next, especially since the monarchs liked to devalue the currency in order to decrease the amount of their debts. However, if you brought, say, 10 livres, 18 sous worth of coins to Law’s bank, the paper banknote would be written up for the equivalent amount the coins were worth at that time: 10 livres, 18 sous.

By buying back the government’s debt, Law was able to “retire” it. Thus, the money circulating was ultimately backed by government debt (bonds), just like our money today. Law’s promise to redeem the notes for specie gave users the confidence to use them. Later on, the government will decree the notes of the Banque Generale as the “official” money to be used in payment of taxes and settlement of all debts, legitimizing their value by fiat. Law later attempted to sever the link to gold and silver by demonetizing the latter. He was not successful; paper money was far too novel at the time for people to trust its value in the absence of anything tangible backing it.

Not much of what transpired was that unusual for today, but it was pretty radical for the early 1700s. Had Law stopped at this point, it’s likely that all of this would have been successful, as Galbraith points out:

In these first months, there can be no doubt, John Law had done a useful thing. The financial position of the government was eased. The bank notes loaned to the government and paid out by it for its needs, as well as those loaned to private entrepreneurs, raised prices….[and] the rising prices…brought a substantial business revival.

Law opened branches of his bank in Lyons, La Rochelle, Tours, Amiens and Orleans; presently, in the approximate modern language, he went public. His bank became a publicly chartered company, the Banque Royale.

Had Law stopped at this point, he would be remembered for a modest contribution to the history of banking. The capital in hard cash subscribed by the stockholders would have sufficed to satisfy any holders of notes who sought to have them redeemed. Redemption being assured, not many would have sought it.

It is possible that no man, having made such a promising start, could have stopped…
(Galbraith, pp. 22-23)

Trading government debt for paper money helped lower the government’s debts, but on paper, France’s liabilities still exceeded its assets. But it had one asset that had not yet been monetized—millions of acres of land on the North American continent. So Law set out to monetize that land by turning it into shares in a joint-stock company called the Mississippi Company (Compagnie d’Occident). The Mississippi Company had a monopoly on all trading with the Americas. Buying a share in the company meant a cut of the profits (i.e. equity) of trading with North America.

The first loans and the resulting note issue having been visibly beneficial – and also a source of much personal relief – the Regent proposed and additional issue. If something does good, more must do better. Law acquiesced.

Sensing the need, he also devised a way of replenishing the reserves with which the Banque Royale backed up its growing volume of notes. Here he showed that he had not forgotten his original idea of a land bank.

His idea was to create the Mississippi Company to exploit and bring to France the very large gold deposits which Louisiana was thought to have as subsoil. To the metal so obtained were also to be added the gains of trade. Early in 1719, the Mississippi Company (Compagnie d’Occident), later the Company of the Indies, was gives exclusive trading privileges in India, China and the South Seas. Soon thereafter, as further sources of revenue, it received the tobacco monopoly, the right to coin money and the tax farm. (Galbraith, p. 23)

Law—or the Duc d’Arkansas as he was now known—talked up the corporation so well that the value of the shares skyrocketed—probably the world’s very first stock bubble (but hardly the last). Gambling fever was widespread and contagious, as the desire to get rich by doing nothing is a human universal. The term “millionaire” was coined. Law took advantage of the inflated share price to buy back more of the government’s debt. And the money to buy the shares at the inflated prices was printed by the bank itself. Knowing that there was far more paper than gold and silver to back it in the kingdom, Law then tried to break the link between paper money and specie by demonetizing gold and silver; at one point making it illegal to even hold precious metals.

He was unsuccessful. Paper money was still too new, and people were unwilling to trust it without the backing of previous metal, causing a loss of faith in the currency. Later suspensions of convertibility were done after generations of paper money use. Law’s entire scheme (from origin to collapse) took place over the course of less than a year.

[Law] funded the [Mississippi] company the same way he had funded the bank, with deposits from the public swapped for shares. He then used the value of those shares, which rocketed from five hundred livres to ten thousand livres, to buy up the debts of the French King. The French economy, based on all those rents and annuities and wages, was swept away and replaced by what Law called his “new System of Finance.”

The use of gold and silver was banned. Paper money was now “fiat” currency, underpinned by the authority of the bank and nothing else. At its peak, the company was priced at twice the entire productive capacity of France…that is the highest valuation any company has ever achieved anywhere in the world.

Galbraith and Weatherford summarize the shell game that Law’s “system” ended up becoming:

To simplify slightly, Law was lending notes of the Banque Royale to the government (or to private borrowers) which then passed them on to people in payment of government debts or expenses. These notes were then used by the recipients to buy stock in the Mississippi Company, the proceeds from which went to the government to to pay expenses and pay off creditors who then used the notes to buy more stock, the proceeds from which were used to meet more government expenditures and pay off more public creditors. And so it continued, each cycle being larger than the one before. (Galbraith, p. 24)

The Banque Royale printed paper money, which investors could borrow in order to buy stock in the Mississippi company; the company then used the new notes to pay out its bogus profits. Together the Mississippi Company and the Banque Royale were producing paper profits on each other’s accounts. They bank had soon issued twice as much paper money as there was specie in the whole country; obviously it could no longer guarantee that each paper note would be redeemed in gold. (Weatherford, p. 131)

Such a scheme couldn’t last, of course. Essentially the entire French economy—its central bank, its money supply, its tax system, and the monopoly on land in North America—were in the hands of one single, giant conglomerate run by one man. That meant that when one part of the system failed, all the rest went down like ascending mountain climbers roped together.

Because the central bank owned the Mississippi company, it had an incentive to loan out excess money to drive the share price up—in other words, to inflate a stock bubble based on credit. This is always a bad idea. Finally, Law’s exaggeration of the returns on investments in the Mississippi Company inflated expectations far beyond what was realistic.

The popping of the Mississippi stock bubble, followed by a run on the bank, was enough to bring the whole thing crashing down.

People started to wonder whether these suddenly lucrative investments were worth what they were supposed to be worth; then they started to worry, then to panic, then to demand their money back, then to riot when they couldn’t get it.

Gold and silver were reinstated as money, the company was dissolved, and Law was fired, after a hundred and forty-five days in office. In 1720, he fled the country, ruined. He moved from Brussels to Copenhagen to Venice to London and back to Venice, where he died, broke, in 1729.

The Invention of Money (The New Yorker)

As Law must have known, if you gamble big, sometimes you lose big.

Some of the death of the Bank was murder, not suicide. As part of his System, one of Law’s initiatives was to simplify and modernize the inefficient and antiquated French tax system. Taxes were collected by tax farmers (much as in ancient Rome), and Law threatened to overturn their apple cart. He also attempted to end the sale of government offices to the highest bidder. This made him a lot of enemies among the moneyed classes, who thrived on graft and corruption. Such influential people (notably the financiers the Paris brothers), were instrumental in the run on the bank and the subsequent loss of confidence in the money system:

[Law] set about streamlining a tax system riddled with corruption and unnecessary complexity. As one English visitor to France in the late seventeenth century observed. “The people being generally so oppressed with taxes, which increase every day, their estates are worth very little more than what they pay to the King; so that they are, as it were, tenants to the Crown, and at such a rack rent that they find great difficulty to get their own bread.” The mass of offices sold to raise money had caused one of Louis XIV’s ministers to comment, “When it pleases Your Majesty to create an office, God creates a fool to purchase it.” There were officials for inspecting the measuring of cloth and candles; hay trussers; examiners of meat, fish and fowl. There was even an inspector of pigs’ tongues.

This did nothing for efficiency, Law deemed, and served only to make necessities more expensive and to encourage the holders of the offices “to live in idleness and deprive the state of the service they might have done it in some useful profession, had they been obliged to work.” In place of the hundreds of old levies he swept away (over forty in one edict alone), Law introduced a new national taxation system called the denier royal, based on income. The move caused an outcry among the holders of offices, many of whom were wealthy financiers and members of the Parliament, but delight among the public. “The people went dancing and jumping about the streets,” wrote Defoe. “They now pay not one farthing tax for wood, coal, hay, oats, oil, wine, beer, bread, cards, soap, cattle, fish.” (Janet Gleeson, Millionaire; pp. 155-156

Michel Aglietta, in his magisterial work on money, notes that Law…

…wanted to introduce the logic of capitalism in France, based on providing credit through money creation. Money creation had to be based on expected future wealth, and no longer on the past wealth accumulated in precious metals. (Aglietta, p. 206, emphasis in original)

The danger is, if this wealth fails to materialize; or if people lose the belief that it will materialize, confidence in the system is lost, and failure soon follows.

Although John Law has come down in history as a grifter, and his ideas as fundamentally unsound, many of his ideas eventually became fundamental tenets of modern global finance:

The great irony of Law’s life is that his ideas were, from the modern perspective, largely correct. The ships that went abroad on behalf of his great company began to turn a profit. The auditor who went through the company’s books concluded that it was entirely solvent—which isn’t surprising, when you consider that the lands it owned in America now produce trillions of dollars in economic value.

Today, we live in a version of John Law’s system. Every state in the developed world has a central bank that issues paper money, manipulates the supply of credit in the interest of commerce, uses fractional-reserve banking, and features joint-stock companies that pay dividends. All of these were brought to France, pretty much simultaneously, by John Law.

The Invention of Money (The New Yorker)

Law’s efforts left a lingering suspicion of paper money in France. Unfortunately, the revenues problem was not definitively solved. Going back on a specie standard delivered a huge blow to commerce. While England’s paper money system flourished, France stagnated economically. Eventually, the revenues situation of the government became so dire that the King had no choice but to call an Estates General—the extremely rare parliamentary session that kicked off the French Revolution—in 1789.

Once the Mississippi bubble burst, a lot of the capital in France needed some new outlet to invest in. Much of that capital fled across the channel to England, which at the time was inflating a stock bubble of its own:

France’s ruin was England’s gain. Numerous bruised Mississippi shareholders chose to reinvest in English South Sea shares.
The previous month, with a weather eye to developments in France, the South Sea Company managed to beat its rival the Bank of England and secure a second lucrative deal with the government whereby it took over a further $48 million of national debt and launched a new issue of shares. A multitude of English and foreign investors were now descending on London as they had flocked less than a year earlier to Paris “with as much as they can carry and subscribing for or buying shares.”

In Exchange Alley–London’s rue Quincampoix–the sudden surce of new money also bubbled a plethora of alternative companies launched to capitalize on the new fashion for financial fluttering… (Gleeson, p, 200)

2. England

Britain chose a different tack – sovereign debt would be monetized and circulate as money. It too utilized the joint-stock company model that had been invented in the previous centuries to enable the Europeans to raise the funds to exploit and colonize the rest of the world. A bank was founded as a chartered company to take in money through subscribed shares and loan out that money to the King. That debt—and not land—would securitize the notes issued by the bank. The notes would then circulate as money, albeit alongside precious metal coins and several other forms of payment. As with the original invention of sovereign debt in northern Italy, it was used to raise the necessary funds for war:

The modern system for dealing with [the] problem [of funding wars] arose in England during the reign of King William, the Protestant Dutch royal who had been imported to the throne of England in 1689, to replace the unacceptably Catholic King James II.

William was a competent ruler, but he had serious baggage—a long-running dispute with King Louis XIV of France. Before long, England and France were involved in a new phase of this dispute, which now seems part of a centuries-long conflict between the two countries, but at the time was variously called the Nine-Years’ War or King William’s War. This war presented the usual problem: how could the nations afford it?

King William’s administration came up with a novel answer: borrow a huge sum of money, and use taxes to pay back the interest over time. In 1694, the English government borrowed 1.2 million pounds at a rate of eight per cent, paid for by taxes on ships’ cargoes, beer, and spirits. In return, the lenders were allowed to incorporate themselves as a new company, the Bank of England. The bank had the right to take in deposits of gold from the public and—a second big innovation—to print “Bank notes” as receipts for the deposits. These new deposits were then lent to the King. The banknotes, being guaranteed by the deposits, were as good as gold money, and rapidly became a generally accepted new currency.

The Invention of Money (The New Yorker)

From this point forward, money would be circulating government debt. Plus, it’s value would be based on future revenues, as Aglietta noted above, and not just on the amount of gold and silver coins floating around.

The originality of the Bank of England was that it was not a deposit bank. Unlike for the Bank of Amsterdam, the coverage for the notes issued was very low (3 percent in the beginning). These notes, the counterparty to its loans to the state, replaced bills of exchange and became national and international means of payment for the bank’s customers.

They were not legal tender until 1833. But the securities issued by the bank, bringing interest on the public debt, became legal tender for all payments to the government from 1697 onwards. (Aglietta, pp. 136-137)

Why did the King of England have to borrow at all? Well, for a couple reasons. The power to raise taxes had been taken away from the King and given to Parliament as a consequence of the English Revolution. That revolutionary era also witnessed the inauguration goldsmith banking (such as that undertaken by John Law’s own family of goldsmiths). These goldsmith receipts were the forerunners of the banknote:

The English Civil War…broke out because parliament disputed the king’s right to levy taxes without its consent. The use of goldsmith’s safes as secure places for people’s jewels, bullion and coins increased after the seizure of the mint by Charles I in 1640 and increased again with the outbreak of the Civil War. Consequently some goldsmiths became bankers and development of this aspect of their business continued after the Civil War was over.

Within a few years of the victory by the parliamentary forces, written instructions to goldsmiths to pay money to another customer had developed into the cheque (or check in American spelling). Goldsmiths’ receipts were used not only for withdrawing deposits but also as evidence of ability to pay and by about 1660 these had developed into the banknote.

Warfare and Financial History (Glyn Davies, History of Money online)

By this time, control over money had passed into the hands of a rising mercantile class, who—thanks to the staggering wealth produced by globalized trade—possessed more wealth than mere princes and kings, but lacked the ability to write laws or to print money, which they strongly coveted. It was these merchants and “moneyed men” (often members of the Whig party in Parliament) who backed the Dutch staadtholder William of Orange’s claim to the English throne in 1688.

The banknotes began to circulate widely, displacing coins and bills of exchange. And it didn’t stop there: more money was quickly needed, and the Bank acquired more influence. Part of this was due to England being a naval—rather than an army—power. Warships require huge expenditures of capital to build. They also require a vast panoply of resources, such as wood, nails, iron, cloth, stocked provisions, and so forth; whereas land-based armies just require paying soldiers and provisions (which can be commandeered). Thus, financial means to mobilize these resources were much more likely in naval powers such as Holland and England than in continental powers like France, Austria and Spain.

This important post from the WEA Pedagogy blog uses excerpts from Ellen Brown’s Web of Debt to lay out the creation of the Bank of England, and, consequently, central banking in general (and is well-worth reading in full):

William was soon at war with Louis XIV of France. To finance his war, he borrowed 1.2 million pounds in gold from a group of moneylenders, whose names were to be kept secret. The money was raised by a novel device that is still used by governments today: the lenders would issue a permanent loan on which interest would be paid but the principal portion of the loan would not be repaid.

The loan also came with other strings attached. They included:

– The lenders were to be granted a charter to establish a Bank of England, which would issue banknotes that would circulate as the national paper currency.

– The Bank would create banknotes out of nothing, with only a fraction of them backed by coin. Banknotes created and lent to the government would be backed mainly by government I.O.U.s, which would serve as the “reserves” for creating additional loans to private parties.

– Interest of 8 percent would be paid by the government on its loans, marking the birth of the national debt.

The lenders would be allowed to secure payment on the national debt by direct taxation of the people. Taxes were immediately imposed on a whole range of goods to pay the interest owed to the Bank.

The Bank of England has been called “the Mother of Central Banks.” It was chartered in 1694 to William Paterson, a Scotsman who had previously lived in Amsterdam. A circular distributed to attract subscribers to the Bank’s initial stock offering said, “The Bank hath benefit of interest on all moneys which it, the Bank, creates out of nothing.” The negotiation of additional loans caused England’s national debt to go from 1.2 million pounds in 1694 to 16 million pounds in 1698. By 1815, the debt was up to 885 million pounds, largely due to the compounding of interest. The lenders not only reaped huge profits, but the indebtedness gave them substantial political leverage.

The Bank’s charter gave the force of law to the “fractional reserve” banking scheme that put control of the country’s money in a privately owned company. The Bank of England had the legal right to create paper money out of nothing and lend it to the government at interest. It did this by trading its own paper notes for paper bonds representing the government’s promise to pay principal and interest back to the Bank — the same device used by the U.S. Federal Reserve and other central banks today.

Note that the interest on the loan is paid, but never the loan itself. That meant that tax revenues were increasingly funneled to a small creditor class to whom the government was indebted. Today, we call such people bond holders, and they exercise their leverage over governments through the bond markets. For all intents and purposes, this system ended government sovereignty and tied the hands of even elected governments being able to spend tax money on the domestic needs of their own people. Control over the state’s money was lost forever.

An interesting couple of notes: William Paterson was, like John Law, a Scotsman—giving credence to the claim that it was the Scots who “invented Capitalism” (Adam Smith and James Watt were also Scots). It also raises the idea (to me, anyway) that the modern financial system was started by instinctive hustlers and gamblers. We’ve already referred to John Law’s expertise at the gambling tables of Europe and ability to inspire confidence in his schemes. Patterson, upon returning to Scotland, began raising funds via stock for an ambitious scheme to develop a society in Central America. This scheme ended up being on of the worst disasters in history. Not only that, but the Darien scheme collapsed so badly that Scotland’s entire financial health was devastated, and is considered to be a factor in Scotland signing the Acts of Union, politically joining with England to the south.

For an overview of the Darien scheme, see this: Scotland’s lessons from Darien debacle (BBC)

The WEA Pedagogy blog than adds some additional details:

Some more detail of interest is that the creation of Bank of England was tremendously beneficial for England. The King, no longer constrained, was able to build up his navy to counter the French. The massive (deficit) spending required for this purpose led to substantial progress in industrialization.

Quoting Wikipedia on this: “As a side effect, the huge industrial effort needed, including establishing ironworks to make more nails and advances in agriculture feeding the quadrupled strength of the navy, started to transform the economy. This helped the new Kingdom of Great Britain – England and Scotland were formally united in 1707 – to become powerful. The power of the navy made Britain the dominant world power in the late 18th and early 19th centuries”

The post then summarizes the history of the creation of central banking:

…It is in this spirit that we offer a “finance drives history” view of the creation of the first Central Bank. The history above can be encapsulated as follows:

1. Queen Elizabeth asserted and acquired the sovereign right to issue money.
2. The moneylenders (the mysterious 0.1% of that time) financed and funded a revolution against the king, acquiring many privileges in the process.
3. Then they financed and funded the restoration of the aristocracy, acquiring even more privileges in the process.
4. Finally, when the King was in desperate straits to raise money, they offered to lend him money at 8% interest, in return for creating the Bank of England, acquiring permanently the privilege of printing money on behalf of the king.

The process by which money was created by the Bank of England is extremely interesting. They acquired the debt of the King. This debt was used as collateral/backing for the money they created. The notes they issued were legal tender in England. Whenever necessary, they were prepared to exchange them for gold, at the prescribed rates. However, when the confidence of the public is high, the need for actual gold as backing is substantially reduced.

Origins of Central Banking (WEA Pedagogy Blog)

As I noted above, the importance of the Navy in the subsequent industrialization of England is often overlooked. There have been a few scholars who have argued that it was Britain’s emphasis on naval power which was a factor in England (and not somewhere else) becoming the epicenter of the Industrial Revolution. Many of its key inventions were sponsored by the government in order to more effectively fight and navigate at sea (from accurate clocks and charts to canned food). Even early mass production was prompted by the needs of the British Navy: pulley blocks were mass-produced by engineers and were one of the first items made this way via mechanization.

Just like in other countries, the needs of war caused the Bank to issue more and more notes, greatly increasing to the national debt. However, the vast profits of industrialization and colonialism were enough to support it. When convertibility was finally temporarily suspended in the mid 1800s by necessity, paper money continued to carry the trust of the public, unlike in France. Galbraith sums up the subsequent history of the Bank of England:

In the fifteen years following the granting of the original charter the government continued in need, and more capital was subscribed by the Bank. In return, it was accorded a monopoly of joint-stock, i.e., corporate, banking under the Crown, one that lasted for nearly a century. In the beginning, the Bank saw itself merely as another, though privileged, banker.

Similarly engaged in a less privileged way were the goldsmiths, who by then had emerged as receivers of deposits and sources of loans and whose operations depended rather more on the strength of their strong boxes than on the rectitude of their transactions. They strongly opposed the renewal of the Bank’s charter. Their objections were overcome, and the charter was renewed.

Soon, however, a new rival appeared to challenge the Bank’s position as banker for the government. This was the South Sea Company. In 1720, after some years of more routine existence, it came forward with a proposal for taking over the government debt in return for various concessions, including, it was hoped, trading privileges to the Spanish colonies, which, though it was little noticed at the time, required a highly improbable treaty with Spain.

The Bank of England bid strenuously against the South Sea Company for the public debt but was completely outdone by the latter’s generosity, as well as by the facilitating bribery by the South Sea Company of Members of Parliament and the government. The rivalry between the two companies did not keep the Bank from being a generous source of loans for the South Sea venture. All in all, it was a narrow escape.

For the enthusiasm following the success of the South Sea Company was extreme. In the same year that Law’s operations were coming to their climax across the Channel, a wild speculation developed in South Sea stock, along with that in numerous other company promotions, including one for a wheel for perpetual motion, one for ‘repairing and rebuilding parsonage and vicarage houses’ and the immortal company ‘for carrying on an undertaking of great advantage, but nobody to know what it is’. All eventually passed into nothing or something very near.
In consequence of its largely accidental escape, the reputation of the Bank for prudence was greatly enhanced.

As Frenchmen were left suspicious of banks, Englishmen were left suspicious of joint-stock companies. The Bubble Acts (named for the South Sea bubble) were enacted and for a century or more kept such enterprises under the closest interdict.

From 1720 to 1780, the Bank of England gradually emerged as the guardian of the money supply as well as of the financial concerns of the government of England. Bank of England notes were readily and promptly redeemed in hard coin and, in consequence, were not presented for redemption. The notes of its smaller competitors inspired no such confidence and were regularly cashed in or, on occasion, orphaned.
By around 1770, the Bank of England had become nearly the sole source of paper money in London, although the note issues of country banks lasted well into the following century. The private banks became. instead, places of deposit. When they made loans, it was deposits, not note circulation, that expanded, and, as a convenient detail, cheques now came into use. (Galbraith, 32-34)

By a complete accident, Britain was able to escape France’s fate. When the South Sea bubble popped, the Bank of England was able to reliably take up the slack and manage the government’s debt—an option that France did not have, since the central bank and the Company were all part of the same organization, and that organization had a monopoly over loans to the government, tax collection, and money creation.

Next time: An Instrument of Revolution.

The Origin of Paper Money 5

As noted last time, the issuance of printed money by Pennsylvania was highly successful. It increased trade and greatly expanded the economy.

One person who noticed this was a young printer by the name of Benjamin Franklin. At the age of only 23, he wrote a treatise strongly advocating the benefits of printing paper money to increase the domestic money supply.

Franklin arrived in Philadelphia the year paper money was first issued by Pennsylvania (1723), and he soon became a keen observer of and commentator on colonial money…Franklin noted that after the legislature issued this paper money, internal trade, employment, new construction, and the number of inhabitants in the province all in-creased. This feet-on-the-ground observation, this scientific empiricism in Franklin’s nature, would have a profound effect on Franklin’s views on money throughout his life. He will repeat this youthful observation many times in his future writings on money.

Benjamin Franklin and the Birth of a Paper Money Economy

Franklin had noted the effects that the chronic shortage of precious metal coins had on the local economy. Something needed to be done, he thought. Franklin, of course, being a printer by trade, felt that his printing presses might be the solution to this problem.

Franklin’s proposal–and this was key–was that paper money could not be backed by silver and gold; because the lack of silver and gold was what the paper money was designed to rectify in the first place!

Franklin also noted a point that critics of the gold standard have made ever since: the value of gold and silver is not stable, but fluctuates over time with supply and demand, just like everything else! Backing one’s currency by specie was no guarantee of stable prices or a stable money supply. As was seen in Europe, a sudden influx could send prices soaring, and a dearth would send prices crashing. As we’ll see, this was a major problem with precious metal standards throughout the nineteenth century—a point conspicuously ignored by goldbugs. Instead, he proposed a land bank, which, as we saw earlier, was a very popular idea at this time. Even though the colonies didn’t have sources of previous metals—and couldn’t mint them even if they did—they did have an abundant supply of real estate, far more than Europe, in fact. Land could be mortgaged, and the mortgages would act as backing for the new government-issued currency.

Economist (and Harry Potter character) Farley Grubb has written a definitive account of Franklin’s proposal:

Franklin begins his pamphlet by noting that a lack of money to transact trade within the province carries a heavy cost because the alternative to paper money is not gold and silver coins, which through trade have all been shipped off to England, but barter. Barter, in turn, increases the cost of local exchange and so lowers wages, employment, and immigration. Money scarcity also causes high local interest rates, which reduces investment and slows development. Paper money will solve these problems.

But what gives paper money its value? Here Franklin is clear throughout his career: It is not legal tender laws or fixed exchange rates between paper money and gold and silver coins but the quantity of paper money relative to the volume of internal trade within the colony that governs the value of paper money. An excess of paper money relative to the volume of internal trade causes it to lose value (depreciate). The early paper monies of New England and South Carolina had depreciated because the quantities were not properly controlled.

So will the quantity of paper money in Pennsylvania be properly controlled relative to the demands of internal trade within the province?

First, Franklin points out that gold and silver are of no permanent value and so paper monies linked to or backed by gold and silver, as with bank paper money in Europe, are of no permanent value. Everyone knew that over the previous 100 years the labor value of gold and silver had fallen because new discoveries had expanded supplies faster than demand. The spot value of gold and silver could fluctuate just like that of any other commodity and could be acutely affected by unexpected trade disruptions. Franklin observes in 1729 that “we [Pennsylvanians] have already parted with our silver and gold” in trade with England, and the difference between the value of paper money and that of silver is due to “the scarcity of the latter.”

Second, Franklin notes that land is a more certain and steady asset with which to back paper money. For a given colony, its supply will not fluctuate with trade as much as gold and silver do, nor will its supply be subject to long-run expansion as New World gold and silver had been. Finally, and most important, land cannot be exported from the province as gold and silver can. He then points out that Pennsylvania’s paper money will be backed by land; that is, it will be issued by the legislature through a loan office, and subjects will pledge their lands as collateral for loans of paper money.

Benjamin Franklin and the Birth of a Paper Money Economy

Franklin argued that the amount of money circulating would be self-correcting. If too little was issued, he said, falling prices would motivate people to mortgage their land to get their hands on more bills. If too much money was circulating, its value would fall, and mortgagees would use the cheaper notes to buy back their land, thus retiring the notes from circulation and alleviating the oversupply.

Finally, Franklin argues that “coined land” or a properly run land bank will automatically stabilize the quantity of paper money issued — never too much and never too little to carry on the province’s internal trade. If there is too little paper money, the barter cost of trade will be high, and people will borrow more money on their landed security to reap the gains of the lowered costs that result when money is used to make transactions. A properly run land bank will never loan more paper money than the landed security available to back it, and so the value of paper money, through this limit on its quantity, will never fall below that of land.

If, by chance, too much paper money were issued relative to what was necessary to carry on internal trade such that the paper money started to lose its value, people would snap up this depreciated paper money to pay off their mortgaged lands in order to clear away the mort-gage lender’s legal claims to the land. So people could potentially sell the land to capture its real value. This process of paying paper money back into the government would reduce the quantity of paper money in circulation and so return paper money ’s value to its former level.

Automatic stabilization or a natural equilibrium of the amount of paper money within the province results from decentralized market competition within this monetary institutional setting. Fluctuations in the demand for money for internal trade are accommodated by a flexible internal money supply directly tuned to that demand. This in turn controls and stabilizes the value of money and the price level within the province.

Benjamin Franklin and the Birth of a Paper Money Economy

Given that the United States was the major pioneer in the Western world for a successful paper fiat currency, it is ironic that we have become one of the centers for resistance to the very idea today. This in large part due to the bottomless funding by billionaire libertarian cranks to promote shaky economic ideas in the United States, such as Austrian Economics, whereas in the rest of the world common-sense prevails. Wild, paranoid conspiracy theories about money (and just about everything else) also circulate widely in the United States, much more widely than the rest of the developed world which has far better educational systems.

Returning to the gold standard is—bizarrely—appropriated by people LARPing the American Revolution today in tri-corner hats, proclaiming themselves as the only true “patriots”. Yet, as we’ve seen, the young United States was the world’s leading innovator in issuing paper money not backed by gold–i.e. fiat currency. And this led to its prosperity. Founding Father Benjamin Franklin was a major advocate of paper money not backed by gold. This is rather inconvenient for libertarians (as is most of actual history).

The young have always learned that Benjamin Franklin was the prophet of thrift and the exponent of scientific experiment. They have but rarely been told that he was the advocate of the use of the printing press for anything except the diffusion of knowledge. (Galbraith, p. 55)

That’s right, Ben Franklin was an advocate of “printing money.” Something to remember the next time a Libertarian glibly sneers at the concept. Later advocates of “hard money”, i.e. goldbugs like Andrew Jackson, would send the U.S. economy crashing to its knees in the early nineteenth century by returning to a gold standard.

Here’s Galbraith describing the theory behind paper money:

There is very little in economics that invokes the supernatural. But by one phenomenon many have been tempted. In looking at a rectangular piece of paper, on frequent occasion of indifferent quality, featuring a national hero or monument or carrying a classical design with overtones of Peter Paul Rubens, Jacques Louis David or a particularly well-stocked vegetable market and printed in green or brown ink, they have been assailed by the question: Why is anything intrinsically so valueless so obviously desirable? What, in contrast to a similar mass of fibres clipped from yesterday’s newspaper, gives it the power to command goods, enlist service, induce cupidity, promote avarice, invite to crime? Surely some magic is involved; certainly some metaphysical or extraterrestrial explanation of its value is required. The priestly reputation and tendency of people who make a profession of knowing about money have been noted. Partly it is because such people are thought to know why valueless paper has value.

The explanation is wholly secular; nor is magic involved.

Writers on money have regularly distinguished between three types of currency:

(1) that which owes its value, as do gold and silver, to an inherent desirability derived from well-established service to pride of possession, prestige of ownership, personal adornment, dinner service or dentistry;

(2) that which can be readily exchanged for something of such inherent desirability or which carries the promise, like the early Massachusetts Bay notes, of eventual exchange; and

(3) currency which is intrinsically worthless, carries no promise that it will be redeemed in anything useful or desirable and which is sustained, at most, by the fiat of the state that it be accepted.

In fact, all three versions are variations on a single theme.

John Stuart Mill…made the value of paper money dependent on its supply in relation to the supply of things available for purchase.
Were the money gold or silver, there was little chance, the plethora of San Luis Potosí or Sutter’s Mill apart, for the amount to increase unduly. This inherent limit on supply was the security that, as money, it would be limited in amount and so retain its value.

And the same assurance of limited supply held for paper money that was fully convertible into gold and silver. As it held for paper that could not be converted into anything for so long as the supply of such paper was limited. It was the fact of scarcity, not the fact of intrinsic worthlessness, that was important. The problem of paper was that, in the absence of convertibility, there was nothing to restrict its supply. Thus it was vulnerable to the unlimited increase that would diminish or destroy its value.

The worthlessness of paper is a detail. Rock quarried at random from the earth’s surface and divided into units of a pound and upward would not serve very happily as currency. So great would be the potential supply that the weight of rock for even a minor transaction would be a burden. But rock quarried on the moon and moved to the earth, divided and with the chunks duly certified as to the weight and source, though geologically indistinguishable from the earthbound substance, would be a distinct possibility, at least for so long as the trips were few and the moon rock retained the requisite scarcity. pp. 62-64

NEXT: England and France get on the paper money train. England succeeds; France fails.

The Origin of Paper Money 4

What’s often considered to be the first recorded issuance of government-backed paper money in the Western world was in Colonial America, and it was quite by accident.

There had been precedents, but they were very limited, and we only know about them through historical records. Paper money tends to disappear in the archaeological record, while coins survive, which means that earlier experiments in paper money may simply be lost to history.

Repeatedly in the European records we find mention of money made from leather during times of warfare and siege. Reports indicate that European monarchs occasionally used paper money during periods of crisis, usually war, and they do maintain that in Catalonia and Aragon, James I issued paper money in 1250, but no known examples have survived. Then, when the Spanish laid siege to the city of Leyden in the Lowlands in 1574, Burgomeister Pieter Andriaanszoon collected all metal, including coins, for use in the manufacture of arms. To replace the coins, he issued small scraps of paper.

On July 1661, Sweden’s Stockholm Bank issued the first bank note in Europe to compensate for a shortage of silver coins. Although Sweden lacked silver, it possessed bountiful copper resources, and the government of Queen Christina (1634-1654) issued large copper sheets called platmynt (plate money), which weighed approximately 4 pounds each. In 1644 the government offered the largest coins ever issued: ten-daler copper plates, each of which weighed 43 pounds, 7 1/4 ounces. To avoid having to carry such heavy coins, merchants willingly accepted the paper bills in denominations of one hundred dalers. one such bill could be submitted for 500 pounds of copper plates. (Weatherford, p. 130)

For an example of platmynt, see this link: Swedish “plate money” (TYWKIIDBI)

The issuance was by Massachusetts in 1690. It was in the form of government IOU’s issued to pay for a failed raid on Quebec which was successfully repelled. Due to the failure of the raid, the expected booty to pay for the cost of the expedition did not materialize. The government, reluctant to raise taxes to pay for an expedition that was a failure, issued IOU’s instead. Due to the shortage of metal coins, these IOU’s began circulating at their face value as a substitute for coins. And thus, by accident, paper money was created in the Western world:

The first issue of paper money was was by the Massachusetts bay Colony in 1690; it has been described as ‘not only the origin of paper money in America, but also in the British empire, and almost in the Christian world’. It was occasioned, as noted, by war.

In 1690, Sir William Phips – a man whose own fortune and position had been founded on the gold and silver retrieved from a wrecked Spanish galleon near the shores of what is now Haiti and the Dominican Republic – led an expedition of Massachusetts irregulars against Quebec. The loot from the fall of the fortress was intended to pay for the expedition. The fortress did not fall.

The American colonies were operating on negligible budgets…and there was no enthusiasm for levying taxes to pay the defeated heroes. So notes were issued to the soldiers promising eventual payment in hard coin. Redemption in gold or silver, as these were returned in taxes, was promised, although presently the notes were also made legal tender for taxes. (Galbraith, pp. 51-52)

The colonial government intended to quickly redeem the certificates with tax revenues, but the need for money was so great that the certificates began changing hands, like money…[1]…For the next twenty years the notes circulated side by side with gold and silver of equivalent denomination. Notes and metal being interchangeable, there was pro tanto, no depreciation. (p. 52)…

The practice quickly caught on among the colonies as a means of supplying a circulating currency. The issuances were to be temporary, in fixed amounts, and accompanied by taxes and custom duties to redeem them. [1]

To retire these bills on credit, the colonial governments accepted them—along with specie—in payment of taxes, fines and fees. As with “bills on loan” the governments used any specie that they received in tax payments to retire and then burn the notes. Also like “bills on loan,” the notes circulated freely within the colonies that issued them and sometimes in adjacent colonies. [1]

[1] Paper Money and Inflation in Colonial America

This circulation of these paper IOUs gave cash-strapped governments an idea. Governments could issue IOUs (hypothetically redeemable in gold and silver coins) in lieu of levying taxes to enable the government to pay for stuff. Such IOUs could then circulate as cash money—valuable because they would theoretically be redeemed by governments for gold and silver, or be used to discharge debt obligations to the state like taxes, fines and fees. As noted above, when gold and silver did come into the state’s coffers, they could buy back the notes.

Unlike modern paper money, these IOUs typically had an expiration date. By redeeming the issued notes, the government could remove paper from circulation, lowering its debt obligations, while at the same time preventing paper money from losing too much of its value. (Note similarities with the Chinese system).

And so, as the 1700’s dawned, colonial governments started commonly issuing paper money—colonial scrip—in lieu of taxes to goose the domestic economy by increasing the amount of money in circulation. Since precious metals were in short supply, most of these schemes were based on the land banking concept (i.e. monetizing land):

The Pennsylvania legislature issued its first paper money in 1723 — a modest amount of £15,000 (the equivalent of just over 48,000 Spanish silver dollars), with another £30,000 issued in 1724. This paper money was not linked to or backed by gold and silver money. It was backed by the land assets of subjects who borrowed paper money from the government and by the future taxes owed to the government that could be paid in this paper money…after the legislature issued this paper money, internal trade, employment, new construction, and the number of inhabitants in the province all increased…The initial paper money issued in 1723 was due to expire in 1731. (Typically, paper money was issued with a time limit within which it could be used to pay taxes owed to the issuing government — the money paid in being removed from circulation.)

Benjamin Franklin and the Birth of a Paper Money Economy (PDF)

In addition to funding military spending, one major driver behind colonial governments issuing IOUs as currency came from the extreme recalcitrance of the colonists in paying their allotted taxes, which means that this unfortunate tendency was present in America from the very beginning, as Galbraith notes:

A number of circumstances explain the pioneering role of the American colonies in the use of paper money. War, as always, forced financial innovation. Also, paper money…was a substitute for taxation, and, where taxes were concerned, the colonists were exceptionally obdurate; they were opposed to taxation without representation, as greatly remarked, and the were also, a less celebrated quality, opposed to taxation with representation. ‘That a great reluctance to pay taxes existed in all the colonies, there can be no doubt. it was one of the marked characteristics of the American people long after their separation from England.’ (Galbraith, pp. 46-47)

In subsequent years, the various colonial governments would rely on more and more on issuing paper money. And when they did, it was noted, the volume of trade increased, and local economies expanded. There was always, however, the looming threat of too much colonial scrip being issued by governments, leading to depreciation:

Inevitably, however, it occurred to the colonists that the notes were not a temporary, one-time expedient but a general purpose alternative to taxation. More were issued as occasion seemed to require, and the promised redemption was repeatedly postponed.

Prices specified in the notes now rose; so, therewith did the price of gold and silver. By the middle of the eighteenth century the amount of silver or gold for which the note could be exchanged was only about a tenth of what it had been fifty years before. Ultimately the notes were redeemed at a few shillings to the pound from gold sent over to pay for the colonial contribution to Queen Anne’s War.

Samuel Eliot Morison has said of the notes issued by Massachusetts to pay off the soldiers back from Quebec that they were ‘a new device in the English-speaking world which undermined credit and increased poverty’. Other and less judicious historians have reflected the same view. But it is also known that rising prices stimulate the spirits of entrepreneurs and encourage economic activity just as falling prices depress both.

Were only so much paper money issued by a government as to keep prices from falling or, at most, cause a moderate increase, its use could be beneficial. Not impoverishment, but an increased affluence would be the result.

The question, obviously, is whether there could be restraint, whether the ultimate and impoverishing collapse could be avoided. The Law syllogism comes ominously to mind: If some is good, more must be better. (Galbraith, pp. 52–53)

The use of paper money as an alternative to government borrowing began to spread. More and more colonial governments (there obviously was no national government back then) would issue IOUs as a way to get around chronic shortages of gold and silver coins, and to avoid raising taxes. Meanwhile, although Europe had begun to experiment with paper money, it was still tied to amounts of gold and silver, limiting its application.

The results in the colonies were highly mixed. Some experiments were highly successful; other less so:

…the other New England colonies and South Carolina had also discovered paper money…Restraint was clearly not available in Rhode Island of South Carolina or even in Massachusetts. Elsewhere, however, it was present to a surprising extent. The Middle Colonies handled paper money with what must now be regarded as astonishing skill and prudence…The first issue of paper money there was by Pennsylvania in 1723. Prices were falling at the time, and trade was depressed. Both recovered, and the issue was stopped.

There appear to have been similar benefits from a second issue in 1729; the course of business and prices in England in the same years suggests that, in the absence of such action, prices would have continued down. Similar issues produced similarly satisfactory results in New York, New Jersey, Delaware and Maryland. As in Pennsylvania, all knew the virtue of moderation. (Galbraith, pp. 52-53)

Perhaps the most intriguing experiment was done by the state of Maryland. It had a combination of what looks like a UBI scheme, coupled with a public banking system (à la North Dakota):

The most engaging experiment was in Maryland. Elsewhere the notes were put into circulation by the simple device of using them to pay public expenses. Maryland, in contrast, declared a dividend of thirty shillings to each taxable citizen and, in addition, established a loan office where worthy farmers and businessmen could obtain an added supply which they were required to repay.

Remarkably, this dividend was a one-time thing; as in the other Middle Colonies the notes so issued were ultimately redeemed in hard money. A near contemporary historian with a near-gift for metaphor credited the experiment with ‘feeding the flame of industry that began to kindle’. A much later student has concluded that ‘this was the most successful paper money issued by any of the colonies’.

Two centuries later during the Great Depression a British soldier turned economic prophet, Major C.H. Douglas, made very nearly the same proposal. This was Social Credit. Save in much distant precincts as the Canadian Prairies, he acquired general disesteem as a monetary crank. He was two hundred years too late. (Galbraith, pp. 53-54)

Interestingly, we see some of those ideas once again being floated once again today.

As Galbraith notes, later economic historians would focus exclusively on the failures of such early experiments, and deliberately ignore the places were it was successful. Much of this was based on the “gold is real money” ideology, along with the ideas around the “inherent profligacy of governments” which would invariably cause inflation. In other words, the groupthink of the economics priesthood:

Towards the end of the nineteenth century expanding university facilities, an increased interest in the past and a pressing need for subjects on which to do doctoral theses and other scholarly research all led to a greatly expanded exploration of colonial economic history. By then, among historians and economists, the gold standard had become an article of the highest faith. Their research did not subordinate faith to fact.

By what amounted to a tacit understanding between right-thinking men the abandoned tendencies of Rhode Island, Massachusetts and South Carolina were taken to epitomize the colonial monetary experience. The different experience of the Middle Colonies was simply ignored.

A leading modern student of colonial monetary experience has noted that: ‘One looks in vain for any discussion of these satisfactory currency experiments in the standard works on American monetary and financial history.’ Another has concluded that ‘…generations of historical scholarship have fostered a mistaken impression of the monetary practices of the colonies’. (Galbraith, pp. 54-55)

History repeats itself: today we once again have an economics caste wedded to orthodoxy and unwilling to consider alternative points of view. The MMT school of economics is fighting a lonely battle against this tendency today.

Next: Ben Franklin discovers money printing

The Origin of Paper Money 3

Despite paper instruments like bills of exchange having existed for centuries, for most ordinary people, money was exclusively the gold and silver coins minted by various national governments. Gold was used for high-value transactions, and silver for smaller ones. When the precious metals from the New World began flowing into Europe, the amount of coins dramatically increased, leading to a continent-wide bout of inflation.

The Spanish, the major beneficiaries of this increased money supply from silver mines of Bolivia and Mexico, used the money to purchase all sorts of things from abroad and live large. Because they became so filthy rich with very little effort (the enslaved Native Americans did all the hard work of digging out the silver), the Spanish failed to develop any domestic industries or innovate much, and thus were passed over by the more industrious Northern Europeans—much like a wealthy, spoiled heir who never learns any practical skills until the money runs out—and by then it’s too late.

There were many in Europe after 1493 who knew only distantly of the discovery and conquest of lands beyond the ocean seas, or to whom this knowledge was not imparted at all. There were few, it can be safely said, who did not feel one of its principal consequences.

Discovery and conquest set in motion a vast flow of precious metal from America to Europe, and the result was huge rise in prices – an inflation occasioned by an increase in the supply of the hardest of hard money.

Almost no one in Europe was so removed from market influences that he did not feel some consequence in his wage, in what he sold, in whatever trifling thing he had to buy.

The price increases occurred first in Spain where the metal first arrived; then, as they were carried by trade (or perhaps in lesser measure by smuggling or for conquest) to France, the Low Countries and England, inflation followed there.

In Andalusia, between 1500 and 1600, prices rose perhaps fivefold. In England, if prices during the last half of the fifteenth century, i.e. before Columbus, are taken as 100, by the last decade of the sixteenth century they were roughly at 250; eighty years later, by the decade of 1673 through 1682, they were around 350, up by three-and-a-half times from the level before Columbus, Cortez and the Pizarros. After 1680, they levelled off an subsided, as much earlier they had fallen in Spain. (Galbraith, pp. 8-9)

Prior to this era, Europe had dealt with ongoing, chronic shortages of precious metals for coins, because much of the continent’s silver leaked out through trading with the Arab world, especially after the Crusades. This is why much of the European economy remained unmonetized for so long. In fact, northern Italian bankers had invented banking and bills of exchange specifically to deal with this problem. Thus, markets in Europe remained confined to specific market towns and “ports of trade” and were subject to strict regulations by rulers. It was not a lack of desire for profits on the part of rulers, but a lack of coins that kept capitalism in embryo.

The vast increase in the money supply from New World silver and gold is what made capitalism possible in Western Europe, but that’s a story for another time.

At its peak in the early 17th century, 160,000 native Peruvians, slaves from Africa and Spanish settlers lived in Potosí to work the mines around the city: a population larger than London, Milan or Seville at the time. In the rush to exploit the silver, the first Spanish colonisers occupied the locals’ homes, forgoing the typical colonial urban grid and constructing makeshift accommodation that evolved into a chaotic mismatch of extravagant villas and modest huts, punctuated by gambling houses, theatres, workshops and churches.

High in the dusty red mountains, the city was surrounded by 22 dams powering 140 mills that ground the silver ore before it was moulded into bars and sent to the first Spanish colonial mint in the Americas. The wealth attracted artists, academics, priests, prostitutes and traders, enticed by the Altiplano’s icy mysticism. “I am rich Potosí, treasure of the world, king of all mountains and envy of kings” read the city’s coat of arms, and the pieces of eight that flowed from it helped make Spain the global superpower of the period.

Potosí: The mountain of silver that was the world’s first global city (Aeon)

How silver turned Potosí into ‘the first city of capitalism’ (The Guardian)

This price spike led to an important realization that people started to have after prices finally leveled off in the late 1600’s: the number of economic transactions (and hence the overall size of the economy and the capacity to specialize) was dependent on the amount of money in circulation. In other words, the volume of trade is determined by the amount of currency in circulation.

Today this is known as the quantity theory of money.

This newfound abundance of silver in Europe caused rising prices–the so-called “Price Revolution”. For the first time there was enough money to create a new class of people whose wealth consisted primarily of money as oppose to land: moneyed men, or the merchant caste. It also caused Spanish coins to be widely used and distributed, function as the world’s first global currency from the Americas to the Middle East to Asia:

The silver of the America made possible a world economy for the first time, as much of it was traded not only to the Ottomans but to the Chinese and East Indians as well, bringing all of them under the influence of the new silver supplies and standardized silver values. Europe’s prosperity boomed, and its people wanted all the teas, silks, cottons, coffees, and spices which the rest of the world had to offer. Asia received much of this silver, but it too experienced the silver inflation that Europe underwent. In China, silver had one-fouth the value of gold in 1368, before the discover of America, but by 1737 the ratio plummeted to twenty to one, a decline of silver to one-fifth of its former value. This flood of American silver came to Asia directly from Acapulco across the pacific via Manila in the Philippines, whence it was traded to China for spices and porcelain. (Weatherford, Indian Givers, pp. 16-17)

The so-called “Price Revolution” taught Europeans another important lesson: What constituted money didn’t change, but it’s purchasing power did. Therefore, they concluded, the value of money depended on how much of it there was in circulation, and not on some intrinsic quality. If there was a shortage of cash, it was worth a lot (i.e. it had high purchasing power). If there was a surplus, it wasn’t worth nearly as much (i.e. it had lower purchasing power). They had seen this first-hand.

In other words, the value of money had to do with how much of it there was, more than any intrinsic, magical quality. The value attributed gold and silver was merely a cultural artifact.

In fact, money had to be useless, since if it were more useful as a commodity than as money, then that’s what it would be used for, and there would be perennial shortages of currency causing the economy to contract.

This led to the following conclusions: If money has no inherent value, but was merely an expedient for spot transactions, than why not paper? But it does have to be backed by something, otherwise people will lose confidence in it. Although precious metal coins could be devalued by government edicts, their worth could never fall to zero, since there was always a commodity market for gold and silver for things like jewelry and tea sets. Precious metals tended to flow from where they were undervalued to countries where the commodity price was higher, causing perennial spot shortages throughout Europe, along with the requisite economic chaos.

The basic problem people were struggling with was that, since all money at the time was dependent on precious metals, how could you increase the supply of money without stumbling upon new sources of precious metal, as the Spanish had done? The money in circulation had to be increased—that was obvious to a growing number of people. But the low-hanging fruit of gold and silver had already been harvested. And with vast new material wealth continuing to flow into Europe from the Americas, how could the money supply be increased enough to take advantage of this?

Paper was an obvious solution. Paper had come to Europe in the Middle Ages from China. After the Black Death, many of the cotton clothes worn by the deceased were turned into pulp, which helped spread the use of paper, and indirectly drive the commercial revolution of the Middle Ages, along with innovations like Arabic numerals and double-entry bookkeeping (aka the “Venetian method”). The printing press, invented in Mainz in 1502 by Gutenberg, further enhanced the power of paper printing. But the real use of paper was in banking:

In the West, paper found its most important use as a means of keeping ledgers in banks. Long before it was used as a means of printing more money, it was used by bankers to increase the money supply. Only later did it gradually emerge as a replacment for coins in daily commerce. The initial development and circulation of monetary bills of paper came about as a side effect of banking. (Weatherford, p. 128)

Paper instruments of credit were already widely circulating throughout Europe, such as Bills of Exchange. Yet, underneath it all, money was still ultimately tied to finite amounts of precious metal. Paper checks were simply transfers of monies from one account to another, similar to giro banking in the ancient world, while Bills of exchange were:

“…essentially a written order to pay a fixed sum of money at a future date. Bills of exchange were originally designed as short-term contracts but gradually became heavily used for long-term borrowing. They were typically rolled over and became de facto short-term loans to finance longer-term projects…bills of exchange could be re-sold, with each seller serving as a signatory to the bill and, by implication, insuring the buyer of the bill against default…”

Crisis Chronicles: The Commercial Credit Crisis of 1763 and Today’s Tri-Party Repo Market (Liberty Street)

One solution was just to issue credit in excess of the amount of gold and silver stored in your vaults—the so-called “goldsmith’s trick.” This became especially common around the time of he English Revolution, where goldsmiths acted as moneylenders and bankers. As long as there was enough gold and silver sitting in the vault to cover the amount people showing up to exchange their paper, you were all right. But if more paper was redeemed than the gold and silver you had at any one point, you were doomed. This is why governments were reluctant to embrace such a solution (later, this idea would underpin fractional reserve banking).

The question ultimately boiled down to, if not gold and silver, then what would give paper money its value? And what would limit its supply? Otherwise, any enterprising printer could just print up money in any amount and give it to himself. Ultimately, the answers would come down to some sort of government authority to regulate the issuance of such bills, and back it up with the government’s credit.

One very common idea floating around in the late 1600s and early 1700s were proposals for a land bank–essentially monetizing land. Such banks wouldn’t take deposits in gold or silver; Rather, they would issue government-backed paper money securitized by mortgages on land. “In these early cases the term “bank” meant simply the collection or batch of bills of credit issued for a temporary period. If successful, reissues would lead to a permanent institution or bank in the more modern sense of the term.” After all, even if a country didn’t have gold and silver mines, it did always have land. Land was valuable, and inherently limited in supply–even moreso than gold and silver (“Buy land – they aren’t making any more if it,” said Mark Twain). This was a variant of the idea of paper money as a claim on real resources. However, the problem was much the same as with the goldsmith’s trick: what happens if you print money in excess of the underlying resources?

[I]f we look at the world through the lens of the late 17th century…[m]oney was made of metal, and there was therefore no scope for creating more money without finding new supplies of silver and gold. There were two types of wealthy individual: moneyed men and landed men.

The land bank proponents were early contributors to the economic debate. In their pamphlets the principal problem that they identified was the sluggish economy. They all agreed that the situation could be improved and saw the best means of improvement as an increase in the supply of money.

Rather than doing this as the Spanish and Portuguese did by sailing to the new world and bringing back vast quantities of precious metals, they proposed using the banking model that had succeeded in Amsterdam and Venice. According to Schumpeter, they “fully realised the business potentialities of the discovery that money – and hence capital in the monetary sense of the term – can be manufactured or created”.

Britain, which was not rich in terms of gold and silver, had plenty of potential in its land. Therefore, a land bank appeared to be a sensible suggestion. None of the land banks that were set up succeeded…

Land Bank Proposals 1650-1705 (PDF)

Land banks had already been established in the American Colonies in a limited fashion:

In 1686, Massachusetts established the first American land bank. Others soon followed.

Despite the name, these were not true banks; they did not accept deposits. Instead, they issued “banks” or notes, or “bills on loan,” to borrowers who put up land as collateral with the bank.

To fortify confidence in the notes, colonial governments promised to issue only a fixed amount of notes and for a set term and to secure their loans with collateral typically equal to twice the amount of the loan.

These notes soon became legal tender for all public and private debts. Principal and interest payments were due annually, but the bank often delayed the first principal payment for a few years. Payments had to be made in notes or in specie.

While the notes furnished a circulating currency, the interest payments provided a revenue stream to the colonial governments.

Paper Money and Inflation in Colonial America (Owen F. Humpage)

National land banks were proposed in the early 1700’s by two people who would become very influential in the history of paper money: John Law (for France) and Benjamin Franklin (for Pennsylvania). Later on, this idea would be used by the revolutionary French government to back its own paper currency called assignats. They used the land seized from the Catholic Church and some aristocrats to back the money. And there was a lot of this land—the Church owned an estimated one-fifth of all the land in France prior to the Revolution.

We can think of this as the very earliest rumblings of today’s Modern Monetary Theory (MMT). Money wasn’t gold and silver after all—rather, it was any means of exchange by which trade was conducted. The medium could be anything, so long it retained its value in exchange. What really mattered was the supply of it: that it was somewhat commensurate with the amount of economic transactions desired. The Scotsman John Law, who would establish the first paper money system in France, had seen people at the gambling tables of England using bills of exchange, stocks, bonds, banknotes, IOUs—any sort of valuable paper instrument—as de facto money in a pinch. This gave him the essential insight that any paper people believed had intrinsic value could be used as money, not just gold and silver coins:

[John] Law thought that the important thing about money wasn’t its inherent value; he didn’t believe it had any. “Money is not the value for which goods are exchanged, but the value by which they are exchanged,” he wrote. That is, money is the means by which you swap one set of stuff for another set of stuff. The crucial thing, Law thought, was to get money moving around the economy and to use it to stimulate trade and business.

As Buchan writes, “Money must be turned to the service of trade, and lie at the discretion of the prince or parliament to vary according to the needs of trade. Such an idea, orthodox and even tedious for the past fifty years, was thought in the seventeenth century to be diabolical.”

The Invention of Money (The New Yorker)

What was undeniable was that the growing economies of the North Atlantic needed more money, and lots of it; far in excess of what any gold and silver mines anywhere in the world could reasonably provide.

Next: The first (Western) paper money

The Origin of Paper Money 2

When it comes to paper money in the West, the foremost innovator was the United States, as John Kenneth Galbraith points out:

If the history of commercial banking belongs to the Italians and of central banking to the British, that of paper money issued by a central government belongs indubitably to the Americans. (Galbraith, p. 45)

The reason the American colonies had to experiment with paper money was simple: “official” money in the American Colonies was gold and silver coins, and there was a perennial shortage of such coins.

The American colonies had no rich deposits of gold of silver, unlike the Spanish in Latin America. There were no mines, and, to make things worse, there no mints allowed in North America. And, to top it all off, the British government forbade the colonies from chartering banks, “Thus bank notes, the obvious alternative to government notes, were excluded.” (Galbraith, p. 47). Colonists used whatever coins they could get their hands on, most of which came from the Spanish colonies to the south. In particular, this meant the Spanish Peso de Ocho Reales, or Piece of Eight: the world’s first global currency. This was also the origin of the famed dollar $ign. Foreign coins would continue to circulate as money in the United States until after the Civil War.

The curious origin of the dollar symbol (BBC)

Since the colonies couldn’t mint their own coins, if you wanted to get your hands on gold and silver coins, you had no other choice but to trade with the outside world. If you didn’t trade with the outside world, then getting sufficient coins was really difficult, severely limiting internal trade. This wasn’t accidental—the British, like all colonial powers, wanted the colonies to be sources of raw materials for their domestic manufacturing industries, and not to be economically self-sufficient.

To help alleviate the ongoing shortage of previous metal coins, local authorities might have passed laws to restrict the export of gold and silver–what we would today call capital controls—but such laws were expressly forbidden by the British government. In the mercantilist world of the 1600-1700s, the strength of a nation lay in the amount of gold and silver stashed away in its vaults—probably a holdover from the time when gold and silver paid for mercenaries in Europe before the era of professional standing armies.

And so there was a perennial, ongoing shortage of currency for transactions. This was an anchor around the leg of the domestic economy of the colonies.

…the British colonies in North America suffered from a constant shortage of all coins. The mercantile policies then in vogue in London sought to increase the amount of gold and silver money in Britain and to do whatever was practical in order to prohibit its export, even to its own colonies.

Beginning in 1695, Britain forbade the export of specie to anywhere in the world, including to its own colonies. As a result, the American colonies were forced to use foreign silver coins rather than British pounds, shillings, and pence, and they found the greatest supply of coins in the neighboring Spanish colony of Mexico, which operated one of the world’s largest mints.

Because of the great wealth produced in Mexico and Peru, Spanish coins became the most commonly accepted currency in the world…The most common Spanish coin in use in the British colonies in 1776 was the pillar dollar, so named because the obverse side showed the Eastern and Western hemispheres with a large column on either side.

In Spanish imperial iconography, the columns represented the Pillars of Hercules, or the narrow strait separating Spain from Morocco and connecting the Mediterranean with the Atlantic. A banner hanging from the columns bore the words plus ultra, meaning “more beyond.” The Spanish authorities began issuing this coin almost as soon as they opened the mint in Mexico with the intent of publicizing the discovery or America, which was the plus ultra, the land out beyond the Pillars of Hercules.

Some people say that the modern dollar sign is derived from this pillar dollar. According to this explanation, the two parallel lines represent the columns and the S stands for the shape of the banner hanging from them. Whether the sign was inspired by this coin or not, the pillar dollar can certainly be called the first American silver dollar. (Weatherford, pp. 117-118)

Another thing the colonists did to get around this chronic shortage of metal coins was barter, which led to settling accounts with all sorts of things other than previous metal coins. They might settle accounts, for example, with so-called “county pay” or “country money,” typically cash crops: cod, tobacco, rice, grain, cattle, indigo, whiskey, brandy–whatever was at hand. During 1775 in North Carolina as many as seventeen different forms of money were declared to be legal tender.

Without the convenience of money, colonists resorted to many less-efficient methods of trading. Barter, of course, was common, particularly in rural areas, but individuals often had to accept goods that they did not particularly need or want only because they had no other way to complete a transaction. They accepted these goods hoping to pass them on in future trades. Some items, most famously tobacco in Virginia and Maryland, worked well in this way and became commodity monies directly or as backing for warehouse receipts. Various other types of warehouse receipts, bills of exchange against deposits in London, and individuals’ promissory notes might also circulate as money. In addition, shopkeepers and employers sometimes issued “shop notes,” a type of scrip—often in small denominations—redeemable at a specific store.

Out of necessity, merchants and wealthy individuals frequently extended credit to others. In an economy that depended heavily on barter, however, one could end up holding debts against many individuals and across a broad array of goods. People naturally hoped to net out some of these debts, but this is extremely difficult under barter. Fortunately, colonial creditors could tally debts in British pounds or colonial currencies even if these currencies were not readily available. In this way, money acted as a unit of account. By attaching a value to things, money accommodated the netting out of debts.

Paper Money and Inflation in Colonial America (Cleveland Fed)
One of the most popular substitutes in North America could be obtained domestically: beads made from marine sea shells called wampum, which were used extensively in the tribute economy of the the Iroquois nations. Wampum is a member of the huge amount of currencies all over the globe that were made from sea shells, including cowrie shells and dentalium. Since these were regarded as valuable by Native American tribes, they had the added advantage of being able to be traded for animal pelts bagged by the Native Americans (who soon stripped the forest bare in order to get more wampum—and hence more prestige). In 1664 Pieter Stuyvesant arranged a loan in wampum worth over 5,000 guilders for paying the wages of workers constructing the New York citadel. They were even subject to a form of counterfeiting:

The first substitute was taken over from the the Indians. From New England to Virginia in the first years of settlement, the wampum or shells used by the Indians became the accepted small coinage. In Massachusetts in 1641, it was made legal tender, subject to some limits as to the size of the transaction, at the rate of six shells to the penny.

However, within a generation or two it began to lose favor. The shells came in two denominations, black and white, the first being double the value of the second. It required by small skill and a smaller amount of dye to convert the lower denomination of currency into the higher.

Also, the acceptability of wampum depended on its being redeemed by the Indians in pelts. The Indians, in effect, were the central bankers for the wampum monetary system, and beaver pelts were the reserve currency into which the wampum could be converted. This convertibility sustained the purchasing power of the shells.

As the seventeenth century passed and settlement expanded, the beavers receded to the evermore distant forests and streams. Pelts ceased to be available; wampum ceased, accordingly, to be convertible and thus, in line with expectation, it lost in purchasing power. Soon it disappeared from circulation except as small change. (Galbraith, pp. 47-48)

Another very popular domestic currency in use was tobacco leaf. In fact, tobacco’s reign as currency in America lasted longer than gold’s:

Tobacco, although regionally more restricted, was far more important than wampum. It came into use as money in Virginia a dozen years after the first permanent settlement in Jamestown in 1607. Twenty-three years later, in 1642, it was made legal tender by the General Assembly of the colony by the interestingly inverse device of outlawing payments that called for payment in gold or silver.

The use of tobacco money survived in Virginia for nearly two centuries and in Maryland for a century and a half – in both cases until the Constitution made money solely the concern of the Federal government. The gold standard, by the common calculation, lasted from 1879 until the cancellation of the final attenuated version by Richard Nixon in 1971. Viewing the whole span of American history, tobacco, though more confined as to region, had nearly twice as long a run as gold. (Galbraith, p. 48)

And such practices might be where Adam Smith came up with his erroneous notion of primitive barter economies, which continues to plague economics and economic history to this day.

Early American Colonists Had a Cash Problem. Here’s How They Solved It (Time)

This illustrates another dictum about money: barter tends to occur in fully monetized market economies where the medium of exchange is in short supply. This is because internal exchanges in market economies take the form spot transactions among anonymous competing strangers. Anthropologists now know that pre-monetary economies were embedded in social relations and took the forms of reciprocity, redistribution, householding, and ceremonial exchange, rather than constant efforts to “truck, barter and exchange.” Anthropologists have never found an example of a barter economy anywhere in the world (e.g. “I’ll give you ten chickens for that cow”).

People in North America and other remote regions were using things like cod, tobacco, grain, brandy, and shells to settle accounts, sure—but these were fully monetized economies that just happened to have a chronic shortage of coins! To get around this, certain items which were particularly valuable because they could be traded with the outside world—like cod in Newfoundland, or tobacco in Virginia, were used to settle accounts. Or, because some items were particularly valuable inside the community, they could be used in subsequent trades as a medium of exchange (like iron nails in Scotland, another Smith example). One might include the “cigarette money” used in prisons in this category. A contemporary example is the use of spruce tips in remote Alaskan towns: spruce tips can only be harvested during a few weeks in the spring and are used in all sorts of exported products (beer, tea, soap, etc.) that are traded with the outside world.

A year after moving to Skagway, Alaska, John Sasfai walked into Skagway Brewing Co. and ordered the signature Spruce Tip Blonde Ale. But instead of pulling out his wallet, the guide for Klondike Tours put a sack of spruce tips on the bar to pay his tab. That’s because in this town, the bounty he foraged from trees near Klondike Gold Rush National Historical Park serves as a currency.

This village, with a year-round population just shy of 1,000, is notably remote – it’s about 100 miles north of Juneau and 800 miles south-east of Anchorage by car. And though stampeders established Skagway during the late-19th-Century gold rush, these days the nuggets of value are plucked from the forest, not panned or mined. While spruce tips – the buds that develop on the ends of spruce tree branches – are only good for cash at Skagway Brewing Co., bartering with spruce tips for food, firewood or coffee (which are delivered by barge once a week) is not uncommon.

The Alaska town where money grows on trees (BBC)

However, in all of Smith’s cases, prices were denominated in standard units of account, but people settled their debts in whatever was at hand. But none of these things were the origin of prices and money, as Smith incorrectly claimed.

To start, with Adam Smith’s error as to the two most generally quoted instances of the use of commodities as money in modern times, namely that of nails in a Scotch village and that of dried cod in Newfoundland, have already been exposed [as fraudulent] … and it is curious how, in the face of the evidently correct explanation … Adam Smith’s mistake has been perpetuated.

In the Scotch village the dealers sold materials and food to the nail makers, and bought from them the finished nails the value of which was charged off against the debt. The use of money was as well known to the fishers who frequented the coasts and banks of Newfoundland as it is to us, but no metal currency was used simply because it was not wanted.

In the early days of the Newfoundland fishing industry there was no permanent European population; the fishers went there for the fishing season only, and those who were not fishers were traders who bought the dried fish and sold to the fishers their daily supplies. The latter sold their catch to the traders at the market price in pounds, shillings and pence, and obtained in return a credit on their books, with which they paid for their supplies. Balances due by the traders were paid for by drafts on England or France.

A moment’s reflection shows that a staple commodity could not be used as money, because ex hypothesi, the medium of exchange is equally receivable by all members of the community. Thus if the fishers paid for their supplies in cod, the traders would equally have to pay for their cod in cod, an obvious absurdity. In both these instances in which Adam Smith believes that he has discovered a tangible currency, he has, in fact, merely found—credit.

Then again as regards the various colonial laws, making corn, tobacco, etc., receivable in payment of debt and taxes, these commodities were never a medium of exchange in the economic sense of a commodity, in terms of which the value of all other things is measured. They were to be taken at their market price in money. Nor is there, as far as I know, any warrant for the assumption usually made that the commodities thus made receivable were a general medium of exchange in any sense of the words. The laws merely put into the hands of debtors a method of liberating themselves in case of necessity, in the absence of other more usual means. But it is not to be supposed that such a necessity was of frequent occurrence, except, perhaps in country districts far from a town and without easy means of communication.

What is money? (Alfred Mitchell-Innes)

All of this experience showed colonists that multiple things could be used as money, if needed. There was no more magic to a gold standard, then to a cowrie standard, or a tobacco standard, a grain standard, or a cattle standard, or anything else for that matter. This would prove to be an instrumental lesson in the creation of paper money in the colonies.

Galbraith, for his part, gives an alternative explanation for the chronic lack of precious metals in the American colonies:

Many countries or communities had gold and silver in comparative abundance without mines. Venice, Genoa, Bruges had no Mother Lode (Nor today does Hong Kong or Singapore.) While the colonists were required to pay in hard coin for what they brought from Britain, they also had products – tobacco, pelts, ships, shipping services – for which British merchants would have been willing, and were quite free, to expend gold and silver.

Much more plausibly, the shortage of hard money in the colonies was another manifestation of Gresham. From the very beginning the colonists experimented with substitutes for metal. The substitutes, being less well regarded than gold or silver, were passed on to others and this were kept in circulation. The good gold or silver was kept by those receiving it or used for those purchases, including those in the mother country, for which the substitutes were unacceptable. (p. 47)

So the colonists were forced by economic necessity to experiment with paper money, and that’s why the United States is the cradle of rolling out this innovation. As Galbraith notes of the above cases, “None of these substitutes was important as compared with paper money.” (Galbraith p. 51).

Next: Europe rethinks money

The Origin of Paper Money 1

Where did paper money come from? That’s the question behind this article from The New Yorker: The Invention of Money. It’s a review of recent biographies of John Law and Walter Bagehot. The author concludes:

The present moment in financial invention therefore has some similarities with the period when money in the form we currently understand it—a paper currency backed by state guarantees—was first created. The hero of that origin story is the nation-state. In all good stories, the hero wants something but faces an obstacle. In the case of the nation-state, what it wants to do is wage war, and the obstacle it faces is how to pay for it.

At the same time, I’ve been reading a few popular books on monetary history. One is Jack Weatherford’s The History of Money. Weatherford, best known for his books about Genghis Khan, is eminently readable, and hits most of the major developments. However, he is clearly in the Ron Paul school of economics: gold alone is money, governments are profligate and can’t be trusted, free banking is good, central banks are bad, etc. There are also a number of basic factual errors in the book, which leads me to recommend it only if you take it as a brief survey that gets many things wrong and is a bit outdated.

Weatherford’s major reference for his chapter on paper money is John Kenneth Galbraith’s: Money, Whence It Came and Where It Went. So I decided to go directly to the source. Galbraith, a lauded economist, has a view that is much more authoritative and nuanced than Weatherford’s. Galbraith’s book concentrates mainly on the origins of banking and the modern money system, and not so much on the deep history of money in the ancient world or the Medieval period.

I’d like to take these (and others) and give an account of how the money system works today. While Modern Monetary theory is a good descriptor of how money works in nation states in the present, it often doesn’t describe how that system initially came about, and what makes it so radically different from how the money system functioned in ancient economies.

But first, I’d like to say a few brief words on why any of this matters.

Like it or not, money runs the world. If you want to understand how the world works—and how to change it—it’s important to know how the systems comprising it work. Money may seem like a boring topic (sorry!), but I would argue that no knowledge is more fundamental and useful for trying to make things marginally better. I can’t tell you how many people I’ve met who call themselves “Socially liberal but fiscally conservative.” And what do they mean by “fiscally conservative?” Nine times out of ten, it’s this: money is inherently scarce; debt is evil; and government budgets should be balanced down to the penny. You also have libertarian Bitcoin cranks, who are convinced that algorithms will save mankind once the state somehow withers away. These views are extraordinarily resistant to any kind of challenge, almost as if they were a de facto religion (in fact, they are probably even more resistant to rational analysis that most people’s religious faith!) Such people would be amenable to a more progessive message if not for the universal brainwashing about what money is, and what it does. History can provide a useful guide.

China’s False Start

All paper money all rests on the same fundamental basis: they are circulating IOU’s. The name of the creditor backing them and what’s used to securitize them changes over time, however. Sometimes it’s a particularly reputable member of the community. Sometimes it’s a king or other ruler. Sometimes it’s a democratically-elected government–or more precisely, the future anticipated revenues of that government. Sometimes it’s backed by something tangible, like silver, gold, or real estate (the most common options). Sometimes it’s not. Nowadays, sovereign money is usually backed by the government’s ability to redistribute and to impose binding liabilities on its citizens  (and, by extension, it’s monopoly on the use of legitimate force).

Paper money began where papermaking began: in China. The usual sources were hemp and mulberry bark, and printing blocks were made of wood or metal. Because of China’s strong imperial state structure, centrality, and geographic reach, it could command officially stamped pieces of paper to be accepted by its citizens as currency in lieu of precious metals. The story is told in this excellent podcast by Tim Harford on the origins of paper money: Paper Money (50 Things that Made the Modern Economy)

In Harford’s telling, paper money begins in Sichuan province, where iron coins were used rather than gold and silver in order to keep specie from leaking out of China to the hostile territories surrounding China, such as those of the Jurchen. Iron coins had holes in the middle and were carried around on cords, called cash.
The problem, as you might expect, was that these strings of heavy iron coins were extremely cumbersome. You would be turning over larger weights of coins that the weight of the things you were trying to buy: 10 pounds of coins for a five pound chicken, or something like that.

Sichuan’s iron currency suffered from serious deficiencies. The low intrinsic value of iron coins, worth no more than a tenth of the equivalent amount of bronze coin, imposed a great burden on merchants who needed to convey their purchasing capital from one place to another, and on ordinary consumers as well. A housewife would have to bring a pound and a half of iron coin to the marketplace to buy a pound of salt, and a merchant from the capital would receive ninety-one and a quarter pounds of iron coin in exchange for an ounce of silver.

Of course, the inconvenience of transporting low-value coin affected bronze currency as well. In the early ninth century, the Tang government created depositories at its capital of Chang’an where merchants could deposit bronze coin in return for promissory notes (known as feiqian, or “flying cash”) that could be redeemed in provincial capitals. “Flying cash” was especially popular among tea merchants who wished to return their profits from the sale of tea in the capital to the distant tea-growing areas of southeastern China. The Song dynasty continued this practice under the rubric of “convenient cash” (bianqian), accepting payments of gold, silver, coin, or sil in return for notes denominated in bronze coin. (The Origins of Value, pp. 67-68)

In the mid-990s, Sichuan was captured by rebels (partly angered by depreciating currency), who shut down the mint. It remained shut even after the government regained control of the province. This prompted some private merchants to issue their own paper bills to compensate for the acute shortage of coins. Such bills represented debt—the debt of the private merchant, of course. These bills soon began to circulate, and people began using them in place of iron coins, as Harford describes:

Instead of carrying around a wagonload of iron coins, a well-known and trusted merchant would write an IOU, and promise to pay his bill later when it was more convenient for everyone.

That was a simple enough idea. But then there was a twist, a kind of economic magic. These “jiaozi”, or IOUs, started to trade freely. Suppose I supply some goods to the eminently reputable Mr Zhang, and he gives me an IOU. When I go to your shop later, rather than paying you with iron coins – who does that? – I could write you an IOU.

But it might be simpler – and indeed you might prefer it – if instead I give you Mr Zhang’s IOU. After all, we both know he’s good for the money. Now you, and I, and Mr Zhang, have together created a kind of primitive paper money – it’s a promise to repay that has a marketable value of its own – and can be passed around from person to person without being redeemed.

This is very good news for Mr Zhang, because as long as people keep finding it convenient simply to pass on his IOU as a way of paying for things, Mr Zhang never actually has to stump up the iron coins. Effectively, he enjoys an interest-free loan for as long as his IOU continues to circulate. Better still, it’s a loan that he may never be asked to repay.

No wonder the Chinese authorities started to think these benefits ought to accrue to them, rather than to the likes of Mr Zhang. At first they regulated the issuance of jiaozi, but then outlawed private jiaozi and took over the whole business themselves. The official jiaozi currency was a huge hit, circulating across regions and even internationally. In fact, the jiaozi even traded at a premium, because they were so much easier to carry around than metal coins.

How Chinese mulberry bark paved the way for paper money (BBC)

Over the next ten years, these “exchange bills” became important in China’s intraregional trade, but the problem of bogus private bills issued by unscrupulous traders remained an ongoing problem for government officials. There were growing calls for government to get more involved in the circulation of bills. Enter the new prefect of Chengdu, one Zhang Yong. He issued a series of government reforms to address this problem in 1005. He:

1.) reopened Sichuan’s mints and introduced a new large iron coin that was equivalent to ten small iron coins, or two bronze coins;

2.) restricted the right to issue exchange bills to a consortium of sixteen merchant houses in Chengdu that were known to have sufficient financial resources to back the bills up, and;

3.) standardized the bills by mandating that they be issued in a specified size, color and format, using government-supplied labor and materials (although merchants could add their own watermark).

There were no standard denominations; rather, the merchants ascribed the value of the note in ink as needed. A three percent fee was charged for cashing in the notes. There was no limit on the number of bills issued. The amount of bills in circulation tended to vary with the seasons: more bills were issued in the early summer when new silk reached the market and in the fall during the rice harvest.

There were still problems with the paper currency, however, such as counterfeiting and overissuance of bills without sufficient backing. In 1024 under a new governor, Xue Tian, the government took over the issuance of jiaozi. A state-run Jiaozi Currency Bureau was established in Chengdu and given exclusive rights to issue jiaozi. The bills had the same format, but were issued in fixed denominations: one and ten guan. Most significantly, the bills had an expiration date of two years, exchangeable for fresh ones, giving the government a modicum of control over the amount issued and preventing the counterfeiting of worn or outdated bills. Also, quotas were established for the issue of the currency. Tea merchants engaged in intraregional and international trade were the most enthusiastic users of the currency, as it eliminated the need to transport heavy coins and prevented robbery by bandits (note that the needs of traveling merchants were also instrumental in the creation of Bills of Exchange issued by banks in medieval Europe centuries later).

Yet there were still problems. The government issued notes to procure military supplies from the merchants; and the ongoing costs of wars on the frontier led to their overissue. Plus, a new emperor nationalized the tea industry, meaning that the major consumers of jiaozi—the tea merchants—no longer had as much use for them. This loss of demand alongside oversupply caused a sharp depreciation in the value of the currency in the market. Instead of trading at a ten percent premium, the bills were now accepted at a ten percent discount. In 1107 the government issued a new paper currency—the qianyin—at a rate of 1:4 to the old, depreciating the earlier jiaozi bills in effort to reduce the supply.

The rest of the history of China’s bills is basically a cycle of the same thing: issuing new bills, overspending due to military needs on the frontier, rampant counterfeiting, bills depreciating, demonetizing old notes, new dynasties issuing new bills, etc. Bills were still in use in trade when Marco Polo vistied China. This is the description from the fourteenth century by the Arab Traveller ibn Battuta:

The Chinese use neither [gold] dinars nor [silver] dirhams in their commerce. All the gold and silver that comes into their country is cast by them into ingots, as we have described. Their buying and selling is carried on exclusively by means of pieces of paper, each of the size of the palm of the hand, and stamped with the sultan’s seal. Twenty-five of these pieces of paper are called a balisht, which takes the place of the dinar with us [as the unit of currency]

This demonstrates some of the essential dictums of Modern Monetary Theory.

The first is Hyman Minsky’s dictum: Anyone can create money, the secret is in getting it accepted.

The second is Felix Martin’s definition of money: Money is tradeable debt.

The other is the observation that that: The credit that is bears highest reputation is typically that of the sovereign. Gresham’s Law being what it is, this usually means that sovereign’s money will drive out all competitors, as we’ll see much later in the United States during the Civil War.

As a reminder, Gresham’s Law is this: Bad money drives out good, or perhaps, more accurately, people spend “lesser” money if they can, and hoard “greater” money for themselves.

Gresham’s Law…is perhaps the only economic law that has never been challenged, and for the reason that there has never been a serious exception. Human nature may be an infinitely variant thing. But it has it’s constants. One is that, given a choice, people keep what is best for themselves, i.e. for those whom they love the most. (Galbraith, p. 8)

A similar rationale led to the establishment of banks and banking in Northern Europe during the Age of Sail. You deposited coins and got a receipt for the amount of coins stashed in the vault. These receipts could be used to pay for things, with the value equivalent to the coins traded (in fact, the notes were more valuable, since they couldn’t be melted down or devalued).

A final interesting note: overissuance of paper currencies and lavish spending by the Yongle emperor Zhu Di (on wars, but also notably on the Chinese treasure ship voyages) led to China going back onto a silver standard just in time for the European discovery and conquest of the New World. The Chinese demand for silver is what fueled the European trade with the Far East, since the Europeans had nothing else that the Chinese wanted to exchange for goods like silks and porcelain. Without that silver standard, who knows what would have happened?

The sizable deficits incurred by Yongle’s costly foreign expeditions, including the famous maritime explorations of Admiral Zheng He and his fleet, and the emperor’s decision to relocate the Ming capital from Nanjing to Beijing were abated, albeit temporarily, by printing more money. Finally, in the 1430s, the Ming yielded to economic realities, abandoning its paper currency and capitulating to the dominance of silver in the private economy. The Ming state gradually converted its most import and sources of revenue payments in silver, while suspending emission of paper money and minting in bronze coin.

Though still uncoined, silver prevailed as the monetary standard of the Ming and subsequent Qing dynasty (1644-1911), fueled from the sixteenth century onward by the import of vast quantities of foreign silver from Japan and the Spanish colonies in the Americas. In times of fiscal crisis, such as on the eve of the fall of the Ming dynasty in 1644 and during the worldwide depression of the 1830s to 1840s, appeals to restore paper currency were renewed, but ignored. In the nineteenth century private banks, both Chinese and foreign, began to issue negotiable bills, but the weakness of the central government after its defeat in the Opium War precluded the emergence of a unified currency…Not until 1935, under the Republic of China, did China once again have a unified system of paper currency. (The Origins of Value, p. 87-89)

Although paper money first originated in China, the paper money we use today has no direct lineage with these systems. Government-issued paper money was invented independently in Western Europe, and under very different circumstances. We’ll take a look at that next time.

Despite the importance of paper money in Chinese history, the modern world system of paper money did not develop in China, or even in the Mediterranean homeland of Marco Polo or ibn-Batuta. It evolved in the trading nations around the North Atlantic. (Weatherford, p. 129)