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

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