The Origin of Paper Money 7

It’s here that we finally get to what’s really the heart of this entire series of posts, which is this: in the West, paper money has been an instrument of revolution.

Both the American and French Revolutions were funded via paper money, and it’s very likely they could not have succeeded without it. It allowed new and fledgling regimes to command necessary resources and fund their armies, which allowed them to take on established states. While such states have mints, a tax base, ownership of natural resources, the ability to write laws, etc.; a rebellion against an established order has none of these things. So, to raise funds, the ability to issue IOUs as payment makes being able to start a revolution far more likely. As we’ve already seen, just about every financial innovation throughout history came about due to the costs of waging wars. Paper money was no exception.

One might even go so far as to say that the American, French and Russian Revolutions would never have been able to happen at all without the invention of paper money!

Washington Crossing the Delaware by Emanuel Leutze, MMA-NYC, 1851.jpg

1. The United States

Earlier we looked at the financial innovations that the colonies undertook to deal with the lack of precious metals in circulation. Wherever paper money and banks had been created, commerce and prosperity increased.

Then it all came to a screeching halt.

The British government passed laws which forbade the issuing and circulation of paper money in the colonies. The monetary experiments came to an end. As you might expect, the domestic economy shrank, and commerce was severely constricted. Of course, the colonists became quite angry at this turn of events.

British authorities initially viewed colonial paper currency favorably because it supported trade with England, but following New England’s “great inflation” in the 1740s, this view changed. Parliament passed the Currency Act of 1751 to strictly limit the quantity of paper currency that could be issued in New England and to strengthen its fiscal backing.

The Act required the colonies to retire all existing bills of credit on schedule. In the future, the colonies could, at most, issue fiat currencies equal to one year’s worth of government expenditures provided that they retired the bills within two years. During wars, colonies could issue larger amounts, provided that they backed all such issuances with taxes and compensated note holders for any losses in the real value of the notes, presumably by paying interest on them.

As a further important constraint on the colonies’ monetary policies, Parliament prohibited New England from making any fiat currency legal tender for private transactions. In 1764, Parliament extended the Currency Act to all of the American colonies.

Paper Money and Inflation in Colonial America (Owen F. Humpage, Economic Commentary, May 13, 2015)

To get around the prohibition on governments issuing paper notes as IOUs, banking may have filled the void. But that option was also cut off by the British government. Last time we saw that the South Sea Bubble, along with a panoply of related schemes, had nearly taken down the entire British economy (as it had done in France). In response, Parliament passed the Bubble Act, which forbade any chartered corporations except those expressly authorized by a Royal Charter. This effectively put the kibosh on banking as an alternative source of paper money in the American colonies.

Given their instinct for experiment in monetary matters, it would have been surprising if the colonists had not discovered or invented banks. They did, and their enthusiasm for this innovation would have been great had it not also been systematically curbed.

In the first half of the eighteenth century the New England colonies, along with Virginia and South Carolina, authorized banking institutions. The most famous, as also the most controversial of these, was the magnificently named Land Bank Manufactory Scheme of Massachusetts which, very possibly, owed something to the ideas of John Law.

The Manufactory authorized the issue of bank notes at nominal interest to subscribers to its capital stock – the notes to be secured, more or less, by the real property of the stockholders. The same notes could be used to pay back the loan that their issue had incurred. This debt could also be repaid in manufactured goods or produce, including that brought into existence by the credit so granted.

The Manufactory precipitated a bitter dispute in the colony. The General Court was favorable, a predisposition that was unquestionably enhanced by the award of stock to numerous of the legislators. Merchants were opposed. In the end, the dispute was carried to London.

In 1741, the Bubble Acts – the British response, as noted, to the South Sea Company and associated promotions and which outlawed joint-stock companies not specifically authorized by law – were declared to apply to the colonies. It was an outrageous exercise in post-facto legestlation, one that helped inspire the Constitutional prohibition against such laws. However, it effectively ended the colonial banks. (Galbraith, pp. 56-57)

Benjamin Franklin, as we have seen, was a longstanding advocate of paper money. He wrote treatises on the subject, and even printed some of it on behalf of the government of Pennsylvania. It was this paper money, he argued, that was the cause of the colonies’ general prosperity in contrast to the widespread poverty and discontent he witnessed everywhere in England:

Before the war, the colonies sent Benjamin Franklin to England to represent their interests. Franklin was greatly surprised by the amount of poverty and high unemployment. It just didn’t make sense, England was the richest country in the world but the working class was impoverished, he wrote “The streets are covered with beggars and tramps.”

It is said that he asked his friends in England how this could be so, they replied that they had too many workers. Many believed, along with Malthus, that wars and plague were necessary to rid the country from man-power surpluses.

“We have no poor houses in the Colonies; and if we had some, there would be nobody to put in them, since there is, in the Colonies, not a single unemployed person, neither beggars nor tramps.” – Benjamin Franklin

He was asked why the working class in the colonies were so prosperous.

“That is simple. In the Colonies, we issue our own paper money. It is called ‘Colonial Scrip.’ We issue it in proper proportion to make the goods and pass easily from the producers to the consumers. In this manner, creating ourselves our own paper money, we control its purchasing power and we have no interest to pay to no one.” – Benjamin Franklin

Soon afterward, the English bankers demanded that the King and Parliament pass a law that prohibited the colonies from using their scrip money. Only gold and silver could be used which would be provided by the English bankers. This began the plague of debt based money in the colonies that had cursed the English working class.

The first law was passed in 1751, and then a harsher law was passed in 1763. Franklin claimed that within one year, the colonies were filled with unemployment and beggars, just like in England, because there was not enough money to pay for the goods and work. The money supply had been cut in half.

Hidden History: According to Benjamin Franklin, the real reason for the Revolutionary War has been hid from you (Peak Prosperity)

A good comment to the above article notes other factors which were also at work:

The timing of the shift in British policy toward colonial scrip (1763) also encompasses…the end of the Seven Years’ War, better known in the United States as the French and Indian War.

William Pitt’s prosecution of the war was conducted by running up government debt, and the settlement of this debt after the war’s conclusion required the raising of taxes by Parliament. Since, from Britain’s view, the war had been fought in order to protect its colonies, it felt that it was only fair that the colonies bore some of the financial burden. Colonial scrip was useless to Parliament in this regard, as was barter. The repayment of British lenders to the Crown could only be done in specie.

The colonies, as you correctly pointed out, did not have this in any significant quantity, although in the view of British authorities this was the colonies’ problem and not theirs. This policy also came on the heels of the approach of benign neglect conducted by Robert Walpole as Prime Minister, under which the colonies were allowed to do pretty much as they pleased so long as their activities generally benefited the British Crown. It should also be noted here that demands of payment of taxes in hard currency is a common tactic for colonial powers to undermine local economies and customs. It played that role in fomenting the American Revolution as well as the Whiskey Rebellion of the new Constitutional republic, not to mention how it was used in South Africa to compel natives participating in a traditional economy to abandon their lands and take up work as laborers in the gold mines.

Hidden History: According to Benjamin Franklin, the real reason for the Revolutionary War has been hid from you (Peak Prosperity)

Now, it would be unreasonable to say that this was THE cause of the American Revolution. In school, we’re taught that that taxes were the main cause: “No taxation without representation” went the slogan (and precipitated the Boston Tea Party). We’re also told that the colonists were much aggrieved by high customs duties, such as those of the unpopular Stamp Act.

But the suppression of paper money and local currency issuance by the British government appears to have been just as much of a cause, although it is probably unknown by the vast majority of Americans. The reason for this strange omission is unexplained. Galbraith thinks that that more conservative attitudes towards money creation in modern times have caused even American historians to argue that the British authorities were largely correct in their actions!

English historian, John Twells, wrote about the money of the colonies, the colonial Scrip:

“It was the monetary system under which America’s Colonies flourished to such an extent that Edmund Burke was able to write about them: ‘Nothing in the history of the world resembles their progress. It was a sound and beneficial system, and its effects led to the happiness of the people.

In a bad hour, the British Parliament took away from America its representative money, forbade any further issue of bills of credit, these bills ceasing to be legal tender, and ordered that all taxes should be paid in coins. Consider now the consequences: this restriction of the medium of exchange paralyzed all the industrial energies of the people. Ruin took place in these once flourishing Colonies; most rigorous distress visited every family and every business, discontent became desperation, and reached a point, to use the words of Dr. Johnson, when human nature rises up and assets its rights.”

Peter Cooper, industrialist and statesman wrote:

“After Franklin gave explanations on the true cause of the prosperity of the Colonies, the Parliament exacted laws forbidding the use of this money in the payment of taxes. This decision brought so many drawbacks and so much poverty to the people that it was the main cause of the Revolution. The suppression of the Colonial money was a much more important reason for the general uprising than the Tea and Stamp Act.”

Our Founding Fathers knew that without financial independence and sovereignty there could be no other lasting freedoms. Our freedoms and national sovereignty are being lost because most people do not understand our money system…

Hidden History: According to Benjamin Franklin, the real reason for the Revolutionary War has been hid from you (Peak Prosperity)

If paper money was the cause of the American Revolution, it was also the solution. The Continental Congress issued IOUs to pay for the war – called ‘Continental notes’ or ‘Continental scrip’:

With independence the ban by Parliament on paper money became, in a notable modern phrase, inoperative. And however the colonies might have been moving towards more reliable money, there was now no alternative to government paper…

Before the first Continental Congress assembled, some of the colonies (including Massachusetts) had authorized note issues to pay for military operations. The Congress was without direct powers of taxation; one of its first acts was to authorize a note issue. More states now authorized more notes.

It was by these notes that the American Revolution was financed….

Robert Morris, to whom the historians have awarded the less than impeccable title of ‘Financier of the Revolution’, obtained some six-and-a-half million dollars in loans from France, a few hundred thousand from Spain, and later, after victory was in prospect, a little over a million from the Dutch. These amounts, too, were more symbolic than real. Overwhelmingly the Revolution was paid for with paper money.

Since the issues, Continental and state, were far in excess of any corresponding increase in trade, prices rose – at first slowly and that, after 1777, at a rapidly accelerating rate…Eventually, in the common saying, ‘a wagon-load of money would scarcely purchase a wagon-load of provisions’. Shoes in Virginia were $5000 a pair in the local notes, a full outfit of clothing upwards of a million. Creditors sheltered from their debtors like hunted things lest they be paid off in worthless notes. The phrase ‘not worth a Continental’ won its enduring place in American language. (Galbraith, pp. 58-59)

Despite this painful bout of hyperinflation, as Galbraith notes, there was simply no other viable alternative to fund the Revolutionary War at the time:

Thus the United States came into existence on a full tide not of inflation but of hyperinflation – the kind of inflation that ends only in the money becoming worthless. What is certain, however, is the absence of any alternative.

Taxes, had they been authorized by willing legislators on willing people, would have been had, perhaps impossible to collect in a country of scattered population, no central government, not the slightest experience in fiscal matters, no tax-collection machinery and with its coasts and numerous of its ports and customs houses under enemy control.

And people were far from willing. Taxes were disliked for their own sake and also identified with foreign oppression. A rigorous pay-as-you-go policy on the part of the Continental Congress and the states might well have caused the summer patriots (like the monetary conservatives) to have second thoughts about the advantages of independence.

Nor was borrowing an alternative. Men of property, then the only domestic source, had no reason to think the country a good risk. The loans from France and Spain were motivated not by hope of return but by malice towards an ancient enemy.

So only the notes remained. By any rational calculation, it was the paper money that saved the day. Beside the Liberty Bell there might well be a tasteful replica of a Continental note. (Galbraith, p. 60)

While this is often used as yet another cautionary tale of “government money printing” by libertarians and goldbugs, a couple of things need to be noted. The first, and most obvious is the fact that: without government money printing there would be no United States. That seems like an important point to me.

The second is a take from Ben Franklin himself. He argued that inflation is really just a sort of tax by another name. And, as opposed to “conventional” government taxation, the inflationary tax falls more broadly across the population, meaning that it was actually a more even-handed and fair method of taxation!

And you can kind of see his point. With legislative taxes, government always has to decide who and what to tax—and how much. This inevitably means that the government picks winners and losers by necessity. Sometimes this can be done wisely, but in practice it often is not. But an inflationary tax cannot be easily controlled by government legislation to favor privileged insiders, unlike more conventional methods of direct taxation, where the rich and well-connected are often spared much of the burden thanks to undue influence over legislators:

From 1776 to 1785 Franklin serves as the U.S. representative to the French court. He has the occasion to write on one important monetary topic in this period, namely, the massive depreciation of Congress’ paper money — the Continental dollar — during the revolution. In a letter to Joseph Quincy in 1783, Franklin claims that he predicted this outcome and had proposed a better paper money plan, but that Congress had rejected it.

In addition, around 1781 Franklin writes a tract called “Of the Paper Money of America.” In it he argues that the depreciation of the Continental dollar operated as an inflation tax or a tax on money itself. As such, this tax fell more equally across the citizenry than most other taxes. In effect, every man paid his share of the tax according to how long he retained a Continental dollar between the time he received it in payment and when he spent it again, the intervening depreciation of the money (inflation in prices) being the tax paid.

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

I’m not sure that many people would agree with that sentiment today, but it is an interesting take on the matter.

Once the war was won, and with the Continental notes inflating to zero, the new fledgling government could now issue money for real. The first government building constructed by the new government was the mint. The power to tax was authorized by Congress.

Although the war ended in 1783, the finances of the United States remained somewhat chaotic through the 1780s. In 1781, successful merchant Robert Morris was appointed superintendent of finance and personally issued “Morris notes”—commonly called Short and Long Bobs based on their tenure or time to maturity—and thus began the long process to reestablish the government’s credit.

In 1785, the dollar became the official monetary unit of the United States, the first American mint was established in Philadelphia in 1786, and the Continental Congress was finally given the power of taxation to pay off the debt in 1787, thus bringing together a more united fiscal, currency, and monetary policy.

Crisis Chronicles: Not Worth a Continental—The Currency Crisis of 1779 and Today’s European Debt Crisis (Liberty Street)
One of the more common silver coins used all over the world at this time was the Maria Theresa thaler (or taler), issued by the Holy Roman Empire from its silver mines in Joachimsthal, hence the name (today the town of Joachimsthal is known as Jáchymov and is located in the Czech Republic).

“Taler” became a common name for currency because so many German states and municipalities picked it up. During the sixteenth century, approximately 1,500 different types of taler were issued in the German-speaking countries, and numismatic scholars have estimated that between the minting of the first talers in Jáchymov and the year 1900, about 10,000 different talers were issued for daily use and to commemorate special occasions.

The most famous and widely circulated of all talers became known as the Maria Theresa taler, struck in honor of the Austrian empress at the Gunzberg mint in 1773…The coin…became so popular, particularly in North Africa and the Middle East that, even after she died, the government continued to mint it with the date 1780, the year of her death.

The coin not only survived its namesake but outlived the empire that had created it. In 1805 when Napoleon abolished the Holy Roman Empire, the mine at Gunzberg closed, but the mint in Vienna continued to produce the coins exactly as they had been with the same date, 1780, and even with the mintmark of the closed mint. The Austro-Hungarian government continued to mint the taler throughout the nineteenth century until that empire collapsed at the end of World War I.

Other countries began copying the design of the Maria Theresa taler shortly after it went into circulation. They minted coins of a similar size and put on them a bust of a middle-aged woman who resembled Maria Theresa. Of they did not have a queen of their own who fit the description, they used an allegorical female such as the bust of Liberty that appeared on many U.S. coins of the nineteenth century.

The name dollar penetrated the English language via Scotland. Between 1567 and 1571, King James VI issued a thirty-shilling piece that the Scots called the sword dollar because of the design on the back of it. A two-mark coin followed in 1578 and was called the thistle dollar.

The Scots used the name dollar to distinguish their currency, and thereby their country and themselves, more clearly from their domineering English neighbors to the south. Thus, from very early usage, the word dollar carried with it a certain anti-English or antiauthoritarian bias that many Scottish settlers took with them to their new homes in the Americas and other British colonies. The emigration of Scots accounts for much of the subsequent popularity of the word dollar in British colonies around the world… (Weatherford, History of Money, pp. 115-116)

In 1782, Thomas Jefferson wrote in his Notes on a Money Unit of the U.S. that “The unit or dolar is a known coin and most familiar of all to the mind of the people. It is already adopted from south to north.”

The American colonists became so accustomed to using the dollar as their primary monetary unit that, after independence, they adopted it as their official currency. On July 6, 1785, the Congress declared that “the money unit of the United States of America be one dollar.” Not until April 2, 1792, however, did Congress pass a law to create an American mint, and only in 1794 did the United States begin minting silver dollars. The mint building, which was started soon after passage of the law and well before the Capitol or White House, became the first public building constructed by the new government of the United States. (Weatherford, History of Money, p. 118)

In the nineteenth century, there were strong arguments around the establishment of a central bank in the United States. One was, in fact, chartered, and then its charter was later revoked. We’ll talk a little about this in the final entry of this series next time, but for now, it is beyond the scope of this post.

Scene from the French Revolution

2. France

In the late eighteenth century, France’s financial circumstances were still very dire. It constantly needed to raise money for its perennial wars with England who, as we saw earlier, successfully funded its own wars with paper money and state borrowing via the Bank of England an—option not available to France in the wake of the Mississippi Bubble’s collapse and the failure of John Law’s Banque Royale. France’s generous loan to the United States’ revolutionaries may have been well appreciated by us Americans, but in retrospect, it was probably not the best move considering France’s fiscal situation (plus the fact that Revolution would soon engulf it; something the French aristocracy obviously had no way of knowing at the time).

In the aftermath of the Revolution, the National Assembly repudiated the King’s debts. It also suspended taxation. But it still badly needed money, especially since many of the countries surrounding France (e.g. Austria, Prussia, Great Britain, Spain and several other monarchies) declared war on it soon after the King met the guillotine. The answer they came up with was, once again, monetizing land. In this case, it was the land seized from the Catholic Church by the Revolutionary government. “[T]he National Assembly agreed that newly nationalised properties in the form of old church land could be purchased through the use of high-denomination assignats, akin to interest-bearing government bonds, mortgaged (assignée) on the property.”

The Estates-General had been summoned in consequence of the terrible fiscal straits of the realm. No more could be borrowed. There was no central bank which could be commanded to take up loans. All still depended on the existence of willing lenders or those who could be apprehended and impressed with their duty.

The Third Estate could scarcely be expected to vote new or heavier levies when its members were principally concerned with the regressive harshness of those then being collected. In fact, on 17 June 1789 the National Assembly declared all taxes illegal, a breathtaking step softened by the provision that they might be collected on a temporary basis.

Meanwhile memories of John Law kept Frenchmen acutely suspicious of ordinary paper money; during 1788, a proposal for an interest-bearing note issue provoked so much opposition that it had to be withdrawn. But a note issue that could be redeemed in actual land was something different. The clerical lands were an endowment by Heaven of the Revolution.

The decisive step was taken on 19 December 1789. An issue of 400 million livres was authorized; it would, it was promised, ‘pay off the public debt, animate agriculture and industry and have the lands better administered’. These notes, the assignats, were to be redeemed within five years from the sale of an equivalent value of the lands of the Church and the Crown.

The first assignats bore interest at 5 per cent; anyone with an appropriate amount could use them directly in exchange for land. In the following summer when a new large issue was authorized, the interest was eliminated. Later still, small denominations were issued.

There were misgivings. The memory of Law continued to be invoked. An anonymous American intervened with Advice on the Assignats by a Citizen of the United States. He warned the Assembly against the assignats out of the rich recent experience of his own country with the Continental notes. However, the initial response to the land-based currency was generally favourable.

Had it been possible to stop with the original issue or with that of 1790, the assignats would be celebrated as a remarkably interesting innovation. Here was not a gold, silver or tobacco standard but one based solidly and logically on the good soil of France.

Purchasing power in the first years had stood up well. There was admiring talk of how the assignats had put land into circulation. And business had improved, employment had increased and sales of the Church and other public lands had been facilitated. On occasion, sales had been too good. In relation to annual income, the prices set were comparatively modest; speculators clutching large packages of the assignats had arrived to take advantage of the bargains.

However, in France, as earlier in America, the demands of revolution were insistent. Although the land was limited, the claims upon it could be increased.

The large issue of 1790 was followed by others – especially after war broke out in 1792. Prices denominated in assignats now rose; their rate of exchange for gold and silver, dealing in which had been authorized by the Assembly, declined sharply. In 1793 and 1794, under the Convention and the management of Cambon, there was a period of stability. Prices were fixed with some success. What could have been more important, the supply of assignats was curtailed by the righteous device of repudiating those that had been issued under the king. In those years they retained a value of around 50 per cent of their face amount when exchanged for gold and silver.

Soon, however, need again asserted itself. More and more were printed. In an innovative step in economic warfare, Pitt, after 1793, allowed the royalist emigres to manufacture assignats for export to France. This, it was hoped, would hasten the decay.

In the end, the French presses were printing one day to supply the needs of the next. Soon the Directory halted the exchange of good real estate for the now nearly worthless paper – France went off the land standard. Creditors were also protected from having their debts paid in assignats. This saved them from the ignominy of having (as earlier in America) to hide out from their debtors. (Galbraith, pp. 64-66)

The lands of aristocrats who had fled France was confiscated as well and used to back further issuances of paper currency. Despite this, as with the Continentals, the value of the assignats soon inflated away to very little. France then issued a new paper money, the mandats territoriaux, also carrying an entitlement to land, in an attempt to stabilize the currency. But distrust in the paper currency (and in the government) was so endemic that the mandats began to depreciate even before they were issued:

With the sale of the confiscated property, a great debtor class emerged, which was interested in further depreciation to make it cheaper to pay back debts. Faith in the new currency faded by mid-year 1792. Wealth was hidden abroad and specie flowed to surrounding countries with the British Royal Mint heavily purchasing gold, particularly in 1793 and 1794.

But deficits persisted and the French government still needed to raise money, so in 1792, it seized the land of emigrants and those who had fled France, adding another 2 billion livres or more to French assets. War with Belgium that year was largely self-funded as France extracted some rents, but not so for the war with England in 1793. Assignats no longer circulated as a medium of payment, but were an object of speculation. Specie was scarce, but sufficient, and farmers refused to accept assignats, which were practically demonetized. In February 1793, citizens of Paris looted shops for bread they could no longer afford, if they could find it at all.

In order to maintain its circulation, France turned to stiff penalties and the Reign of Terror extended into monetary affairs. During the course of 1793, the Assembly prohibited buying gold or silver at a premium, imposed a forced loan on a portion of the population, made it an offense to sell coin or differentiate the price between assignats and coin, and under the Law of the Maximum fixed prices on some commodities and mandated that produce be sold, with the death penalty imposed for infractions.

France realized that to restore order, the volume of paper money in circulation must decrease. In December 1794, it repealed the Law of the Maximum. In January 1795, the government permitted the export of specie in exchange for imports of staple goods. Prices fluctuated wildly and the resulting hyperinflation became a windfall for those who purchased national land with little money down. Inflation peaked in October 1795. In February 1796, in front of a large crowd, the assignat printing plates were destroyed.

By 1796, assignats gave way to specie and by February 1796, the experiment ended. The French tried to replace the assignat with the mandat, which was backed by gold, but so deep was the mistrust of paper money that the mandat began to depreciate before it was even issued and lasted only until February 1797…

Crisis Chronicles: The Collapse of the French Assignat and Its Link to Virtual Currencies Today (Liberty Street)

…In February 1797 (16 Pluvoise year V), the Directory returned to gold and silver. But by then the Revolution was an accomplished fact. It had been financed, and this the assignats had accomplished. They have at least as good a claim on memory as the guillotine. (Galbraith, p. 66)

FRA-A73-République Française-400 livres (1792) 2.jpgEventually, France’s money system stabilized once its political situation more-or-less stabilized, but entire books have been written about that subject. The military dictatorship of Napoleon Bonaparte sold off the French lands in North America to the United States to raise money for its wars of conquest on the European continent. Napoleon also finally established a central bank in France based on the British model.

In 1800, the lingering suspicion of the French of such institutions had yielded to the financial needs of Napoleon. There had emerged the Banque de France which, in the ensuing century, developed in rough parallel with the Bank of England. In 1875, the former Bank of Prussia became the Reichsbank. Other countries had acquired similar institutions or soon did…(Galbraith, p. 41)

It might to be going too far to say that without paper money, neither the American or French revolutions would have ever happened. But nor is entirely absurd to say that this may well be the case. It’s certainly doubtful that they would have succeeded. It’s difficult to imagine how much history would be different today had it not been for paper money and its role in revolution.

Paper money would continue to play that role throughout the Age of Revolutions well into the Twentieth Century, as Galbraith notes:

Paper was similarly to serve the Soviets in and after the Russian Revolution. By 1920, around 85 per cent of the state budget was being met by the manufacture of paper money…

In the aftermath of the Revolution the Soviet Union, like the other Communist states, became a stern defender of stable prices and hard money. But the Russians, no less than the Americans or the French, owe their revolution to paper.

Not that the use of paper money is a guarantee of revolutionary success. In 1913, in the old Spanish town of Chihuahua City, Pancho Villa was carrying out his engaging combination of banditry and social reform. Soldiers were cleaning the streets, land was being given to the peons, children were being put in schools and Villa was printing paper money by the square yard.

This money could not be exchanged for any better asset. It promised nothing. It was sustained by no residue of prestige or esteem. It was abundant. Its only claim to worth was Pancho Villa’s signature. He gave this money to whosoever seemed to be in need or anyone else who struck his fancy. It did not bring him success, although he did, without question, enjoy a measure of popularity while it lasted. But the United States army pursued him; more orderly men intervened to persuade him to retire to a hacienda in Durango. There, a decade later, when he was suspected by some to be contemplating another foray into banditry, social reform, and monetary policy, he was assassinated. (Galbraith, pp. 66-67)

3. Conclusions

Given that both the Continentals and the assignats both suffered from hyperinflation towards the end, they have been often held up as a cautionary tale: governments are inherently profligate and can not be trusted with money creation; only by strictly pegging paper money issuance to a cache of gold stashed away in vault somewhere can hyperinflation be avoided.

As Galbraith notes, this is highly selective. Sure, if you look just for instances of paper money overissuance and inflation you will find them. But this is also deliberately ignoring instances–often lasting for decades if not for centuries–that paper money functioned exactly as intended all across the globe; from ancient China, to colonial America, to modern times. It emphasizes the inflationary scare stories, but intentionally ignores the very real stimulus to commercial activity that paper money has provided, as opposed to the extreme constraints of a precious metal standard. It also totally ignores any extenuating circumstances in hyperinflations, such as Germany’s repayment of war debt in the twentieth century, or persistent economic warfare in the case of Venezuela today.

So the attitude that “government simply can’t be trusted” is more of a political opinion than something based on historical facts.

…in the minds of some conservatives…there must have been a lingering sense of the singular service that paper money had, in the recent past, rendered to revolution. Not only was the American Revolution so financed. So also was the socially far more therapeutic eruption in France. If the French citizens had been required to act within the canons of conventional finance, they could not, any more than the Americans, acted at all. (Galbraith, pp. 61-62)

The desire for a gold standard comes from a desire to anchor the value of money in something outside of the control of governments. But, of course, pegging the value of currency to a certain arbitrary amount of gold is a political choice. Nor does it guarantee price stability–the value of gold fluctuates. A gold standard is more of a guarantee of the stability of the price of gold than the stability of the value of money. Also, in almost every case of war and economic depression in modern history, the gold standard is immediately chucked into the trashbin.

The other thing worth noting is that the worth of paper money is related to both issues of supply AND demand. Often, it’s not just that there is too much supply of currency. It’s that people refuse to accept the currency, leading just as assuredly to a loss in value.

And the lack of acceptance is usually driven by a lack of faith in the issuing government. You can see why this might be the case for assignats and Continentals. Both were revolutionary governments whose very stability and legitimacy was in question, particularly in France. If the government issuing the currency (which are IOU’s, remember) may not be around a year from now, then how willing are you to accept that currency? James Madison pointed out that the value of any currency was mostly determined by faith in the credit of the government issuing the currency. That’s why he and other Founding Fathers worked so hard to reestablish the credit of the United States following the Continental note debacle.

As Rebecca Spang—the author of “Stuff and Money in the Time of the French Revolution”—notes, many people in revolutionary France were vigorously opposed to the seizing of Church property. Thus, they would not accept the validity of notes based on their value. This led to a lack of acceptance which contributed just as much to hypernflation as did any profligacy on the part of the government:

Revolutionary France became a paradigm case for the quantity theory of money, the view that prices are directly and proportionately correlated with the amount of money in circulation, and for the deleterious consequences of letting the latter run out of control.

Yet Spang shows that such neat economic interpretations are inadequate. At times, for example, prices rose first and politicians boosted the money supply in response.

Spang reiterates that the first assignats were neither a revolutionary policy nor a form of paper money. But as her stylishly crafted narrative makes clear, this soon changed. Politicians made the cardinal error of thinking that the state could be stabilised by in effect destabilising its money.

Popular distrust of the “real” worth of assignats prompted a contagion of fraud, suspicion and uncertainty. How could one tell a fake assignat, when technology couldn’t replicate them precisely? How could they even be used, when there was no compulsion beyond patriotic duty for sellers to accept them as payment? Small wonder that so many artists made trompe l’oeil images out of them — what looked solid and real was anything but…

‘Stuff and Money in the Time of the French Revolution’, by Rebecca Spang (Financial Times)

Note that the situation of a stable government is totally different. Britain’s government was eminently stable compared to the United States and France at that time, hence its money retained most of its value, even when convertibility was temporarily suspended. This also underlies the value of Switzerland’s currency today, since they have a legendarily stable, neutral government (and really not that much in the way of actual  resources).

So those who argue that America’s “fiat” money is no good would somehow have to make the case that the United States government is somehow more illegitimate or more unstable than the governments of other wealthy, industrialized nations. To my mind, this is tangential to treason. Yet no one ever calls them out on this point. From that standpoint, the biggest threat to the money supply comes not from overissuance (hyperinflation is nowhere to be seen), but from undermining the faith in, and credit of, the United States government. That’s been done exclusively by Republicans in recent years by grandstanding over the debt ceiling—an artificial borrowing constraint imposed during the United States’ entry into World War One. Really, this should be considered an unpatriotic and treasonous act. It almost certainly would have been perceived as such by the Founding Fathers.

I always have the same response to libertarians who sneer at the “worthlessness” of government fiat money. My response is this: if you truly believe it is worthless, then I will gladly take it off your hands for you. Please hand over all the paper money you have in your wallet right now at this very moment, as well as all the paper money you may have lying around your house. If you want, you can even take out some “worthless” paper money from the nearest ATM and hand it over to me too; I’ll gladly take that off your hands as well. You can give me as much as you like.

To date, I have yet to have a libertarian take me up on that offer. I wonder why?

Next: The Civil War finally establishes a national paper currency for the U.S.

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 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)

Outrageous Historical Myths


Not that long ago, I ran across someone on Reddit espousing the old historical myth that Medieval people walked around 365 days covered in dirt and filth, and never saw the inside a bathtub their entire life.

I didn’t have the following link at the time, but I’ve bookmarked it in order to deploy it the next time someone brings up this old, ridiculous chestnut that refuses to die:

I assure you, medieval people bathed. (Going Medieval)

Although I didn’t have that link, I did post the following paragraphs from Lewis Mumford’s book, The Culture of Cities, which does an amazing job demolishing this myth with actual historical facts:

Two other matters closely connected with hygiene remain to he discussed: the bath and the drinking water supply. Even as early as the thirteenth century the private bath made its appearance: sometimes with a dressing room, as we learn from a sixteenth century Nürnberg merchant’s household book. In 1417, indeed, hot baths in private houses were specially authorized by the City of London. If anything were needed to establish the medieval attitude toward cleanliness the ritual of the public bath should be sufficient.

Bathhouses were characteristic institutions in every city, and they could he found in every quarter: complaint was even made by Guarinonius that children and young girls from ten to eighteen years of age ran shamelessly naked through the streets to the bathing establishment. Bathing was a family enjoyment. These bath-houses would sometimes be run by private individuals; more usually, perhaps, by the municipality.

In Riga as early as the thirteenth century bath-houses are mentioned, according to von Below; in the fourteenth century there were 7 such houses in Würzburg; and at the end of the Middle Ages there were 11 in Ulm, 12 in Nürnberg, 15 in Frankfurt-am-Main, 17 in Augsburg, and 29 in Wien. Frankfurt had 29 bath-house keepers as early as 1387. So widespread was bathing in the Middle Ages that the bath even spread as a custom back into the country districts, whose inhabitants had been reproached by the writers of the early Fabliaux as filthy swine. What is essentially the medieval bath lingers in the Russian or Finnish village today.

Bathing in the open, in a pool in the garden or by a stream in the summer time of course remained in practice. Public baths however were for sweating and steaming and thorough cleanliness: it was customary to take such a purging of the epidermis at least every fortnight. In time, the bath-house came to serve again as it had in Roman times; it was a place where people met for sociability, as Dürer plainly shows in one of his prints, a place where people gossiped and ate food, as well as attended to the· more serious business of being cupped for pains or inflammatory conditions. As family life in the late medieval town deteriorated, the bath-houses became the resort of loose women, looking for game, and of lecherous men, looking for sensual gratification: so that the medieval word for bath-house, namely, stew, comes down to us in English as a synonym for brothel: indeed, it is so used as early as Piers Plowman.

–LEWIS MUMFORD, The Culture of Cities, 1938 pp. 46-47

Mumford goes on to describe how all of these tropes about the Middle Ages were actually much more accurate in describing the dirty and crowded conditions in the late eighteenth and all of the nineteenth centuries—the “insensate” early industrial towns of the Industrial Revolution.

Why do these lies persist? Where did they come from? As I’ve said so often before, one of the ways we are brainwashed into believing how much better off we are today than at any other time before the present is through controlling knowledge of the past. In other words, there is clearly a political agenda behind it. No doubt the proliferation such idiocy derives in part from our abominable education system. These outrageous myths are easy to debunk with a bit of knowledge. Consider this my small contribution.

And, just as a reminder, everyone didn’t drop dead at age 30 in the past, either.

The Origin of Religion – Part 1

The BBC published its second of two posts on the origin of religion, and it’s a doozy. The first article explored the deep roots of religion in the behavior of various non-human species: How and why did religion evolve? (BBC)

This second part takes on why religious thought exists in humans specifically, drawing on a variety of theories and disciplines, from evolutionary psychology, to anthropology, to sociology, to neuroscience. The thinkers the author reference in the article include Pascal Boyer, Daniel Dennett, Andrew Newberg, Justin Barrett, Robin Dunbar, and Robert Bellah.

I’m going to pair this with an older article from The Atlantic, Is God and Accident?, which posits that religion was, in essence, an “accident” due to the unique way our brains have evolved to process information, and covers some of the same ground. I’ll supplement these with other sources.

Two Theories

Two common theories of why religion developed are: 1.) religion evolved to calm our existential fear of death, and 2.) religion evolved to create intragroup cohesion via shared concepts and rituals (i.e. to bind people together). Or, religious beliefs are shibboleths: they evolved to divide the social world into “us” and “them.”

But there are a few problems with these narratives. When you take a look at most primitive religions, there is no “big picture” philosophical explanation for the mystery of human existence. There is no “country club” afterlife that people are looking forward to as in Western (particularly American Protestant) Christianity. There is no “better place” after death—just a different one. In many ancestor-veneration cultures (which I have proposed as the original form of religion), the ancestors simply dwell “under the earth”. It’s hardly a pleasant afterlife.

This chthonic idea—that spirits dwell somewhere below the earth—is so universal that I think there must be something fundamental to it. It was present in all the Near Eastern religions, and is implicit in the Hebrew term for the grave, sheol (Heaven and Hell are conspicuously absent from the Old Testament). It was present in Greek culture too. Even the remote Pirahã of the Amazon believe the spirits of their departed ancestors dwell somewhere beneath the earth.

My guess is that this comes from our tradition of disposing with dead bodies by ritually burying them, which goes all the way back to the dawn of cognitively modern humans. Burials—especially with grave goods—are used by archaeologists as a proxy for when something like religion first emerged.

Here’s a good description of death rituals and beliefs in the Ancient Near East (ANE):

In death a person gave up his or her breath and became a ghost (etemmu). The bodies of the deceased were sometimes buried under a special section of their own house rather than in a separate tomb. As in other ANE cultures, the oldest son was responsible for maintaining such duties as providing the dead with food and drink and other supplies; he was also expected to regularly pronounce their names to ensure that the dead were not forgotten by the living.

Particularly important in this regard was the kipsu banquet, to which dead ancestors would be invited and from whom blessing on the living would be sought. As in other ANE thought, the living could contact the dead (through a medium or necromancer) and the ghosts of the dead could affect the circumstances of the living. Restless ghosts were considered particularly malevolent and were thus especially feared. Accordingly, imitative magic and numerous spells were designed to ward off such malevolent ghosts or demons, such as those thought to attack people sexually at night, or those who were considered responsible for what we refer to as cot death or sudden infant death syndrome. p. 12

The underworld itself was commonly referred to as ‘the Great City’, ‘the Great Below’, or ‘the Land of No Return.’ It was believed to have three tiers: the lowest level was the court of the gods of the underworld; the middle level was the watery realm of the deity Apsu; and the upper level immediately under the earth’s surface was the ‘residence of the spirits of men’. The entrance was supposedly in the west, where Shamash (the sun god) was believed to go down at night and travel under the earth before resurfacing in the east the following morning. To access the underworld, the dead had to cross a river with the aid of a boatman called Remove-hastily. Presumably the sooner he carried out his task the better! [1]

Meanwhile, in ancient Greek tribal culture:

At death the psyche or soul, which entered the body at birth, leaves again like a puff of wind and – so long as the deceased has been properly buried – goes to the underworld. Here the dead exist as insubstantial ‘shades’ or ‘shadows’ of their former selves, without strength or pleasure. While normally confined to the realm of the dead, the deceased may occasionally reappear as ghosts who can haunt or communicate with the living. As in the ANE, proper care of the dead was therefore paramount; indeed, improper care could bring their ghosts back to haunt the negligent, because in Greek mythology the unburied dead were not allowed to enter Hades.

[Hades] is portrayed as a remote place, far below the earth, dark and dismal, and utterly devoid of hope. For the most part, all the dead, regardless of social rank or status, share the same experience; this was clearly not a happy one – even for the heroic dead. Achilles, for example, famously remarks that he would rather be the hired servant of a poor farmer on earth than lord of all the withered dead in the underworld’ (Od. 11.489-491). Yet this was not perceived as a place of punishment or retributive justice; rather, it was simply the grim and gloomy destiny that all men would inevitably share. There was no hope of any physical return from death; the only hope of immortality lay in making a name for oneself, one that would be perpetually remembered by those on earth. So all in all, Homer’s view of death and the afterlife is almost entirely negative. ibid.

And China, with its long (and enduring) tradition of ancestor worship, was quite similar:

According to ancient beliefs, each person had a spirit which required the offering of sacrifices, not just royal figures. It was thought that an individual had two souls. After death, one of these souls, the po, rose to heaven while the other one, the hun, remained in the body of the deceased. It was this second soul that required regular offerings of nourishment. Eventually, the hun soul would migrate to the fabled Yellow Springs of the afterlife, but until that time, if the family did not want the spirit of their dead relation to trouble them as a wandering hungry ghost, they had to take certain precautions. The first was to bury the dead with all the essential daily objects (or models of them) they would need in the next life from food to tools. Next, to ensure the corpse remained at peace, it was necessary to offer appropriate and regular offerings.

Ancestor Worship in Ancient China (Ancient History Encyclopedia)

In The Ancient City, Fustel de Coulanges, who also argued for ancestor worship as primordial form of religion and the key to understanding ancient cultural institutions, notes the similarities between Greek, Roman and Hindu ancestor worship:

The Hindu, like the Greek, regarded the dead as divine beings, who enjoyed a happy existence; but their happiness depended on the condition that the offerings made by the living should be carried to them regularly. If the Śrāddha for a dead person was not offered regularly, his soul left its peaceful dwelling, and became a wandering spirit, who tormented the living; so that, if the dead were really gods, this was only whilst the living honored them with their worship.

The Greeks and Romans had exactly the same belief. If the funeral repast ceased to be offered to the dead, they immediately left their tombs, and became wandering shades, that were heard in the silence of the night. They reproached the living with their negligence; or they sought to punish them by afflicting them with diseases, or cursing their soil with sterility. In a word, they left the living no rest till the funeral feasts were re-established. The sacrifice, the offering of nourishment, and the libation restored them to the tomb, and gave them back their rest and their divine attributes. Man was then at peace with them…

These human souls deified by death were what the Greeks called demons, or heroes. The Latins gave them the name of Lares, Manes, Genii. “Our ancestors believed,” says Apuleius “that the Manes, when they were malignant, were to be called larvae; they called them Lares when they were benevolent and propitious.” Elsewhere we read, “Genius and Lar is the same being; so our ancestors believed.” And in Cicero, “Those that the Greeks called demons we call Lares.” The  Ancient City, p. 17

So, it turns out that most ancient religions weren’t all that reassuring when it came to life after death after all! Nor was any kind of supernatural reward or punishment involved. Mostly, it seems, the dead were just ephemeral ghosts who had to be buried with the proper rituals and appeased through regular feasts and commemorations so that they wouldn’t come back to haunt the living. As Bruce Carpenter remarked of Balinese ancestor worship, “It’s like having a representative in Congress,” describing the ongoing reciprocal relationship between families and their departed ancestors.

This seems to be almost universal in the large cultures we are familiar with. We see it all over the world. The concepts of Heaven or Paradise (along with Hell) came much, much later in history, and mostly in Western monotheistic cultures (the word Paradise comes from Persia and signifies a walled garden). You will find little of this cushy afterlife in say, for example, traditional Chinese or Japanese religions, much less in other more remote cultures.

[As an aside, I had this thought: Is it possible that cultures that buried their dead saw them as dwelling underneath the earth, whereas cultures who cremated their dead saw them as ascending up to heaven, which is what smoke does when bodies are cremated in the open air? The symbolism of smoke representing a release of the soul floating upwards has been used in some belief systems. This is worthy of exploration.]

Similarly, while it’s true that religious beliefs do often serve as a kind of cultural glue which binds societies together, it does not explain the proliferation of supernatural entities, from ancestral spirits to hungry ghosts to malevolent demons to guardian angels to tutelary deities, to capricious gods. Nor does it explain these diverse approaches to the afterlife, or why there should even be an afterlife at all! In fact, many religious beliefs and practices actually seem counterproductive. Often relatives go deeply into debt to perform funeral rites that look silly to outsiders, just so their dead relatives are sated and don’t curse them with bad luck. As the anthropologist Lionel Tiger remarked, “As a social scientist I wanted a deeper explanation for this otherwise remarkable activity. When you think of the cost of religion—the buildings, the tax exemptions, the weekly offering—it’s not trivial, it’s simply not trivial. If only out of respect, one has to pay attention to this.”

Also recall that primitive religions pretty much never feature either Moralizing High Gods (MHG), not Broad Supernatural Punishment (BSP); two key features of doctrinal monotheistic religions. As we saw above, most invisible entities are potentially mischievous, petty, and cruel, and require constant appeasement. There is no greater existential “reason for existence” articulated by any of these religions. You live, and then you die, and that’s pretty much it; and the afterlife isn’t much better than this one—maybe even worse!

(Of course, some have proposed that the very wastefulness of religion is a form of honest signaling—”skin in the game,” as it were. If we have to contribute something costly to participate, and have something significant to lose, the thinking goes, we are less like to be a cheater or a free rider. Of course, this doesn’t explain the reasons for supernatural entities or an afterlife.)

Thus, neither the “religion as anodyne/opiate” nor the “religion as social glue/fraternity/shibboleth” ideas satisfy all the questions surrounding the origin of religious belief, especially the ones we are most interested in. Something else must be at work. But what?

[T]he religion-as-opiate theory fits best with the monotheistic religions most familiar to us. But what about those people (many of the religious people in the world) who do not believe in an all-wise and just God? Every society believes in spiritual beings, but they are often stupid or malevolent.

Many religions simply don’t deal with metaphysical or teleological questions; gods and ancestor spirits are called upon only to help cope with such mundane problems as how to prepare food and what to do with a corpse—not to elucidate the Meaning of It All.

As for the reassurance of heaven, justice, or salvation, again, it exists in some religions but by no means all. (In fact, even those religions we are most familiar with are not always reassuring. I know some older Christians who were made miserable as children by worries about eternal damnation; the prospect of oblivion would have been far preferable.)

So the opiate theory is ultimately an unsatisfying explanation for the existence of religion.

The major alternative theory is social: religion brings people together, giving them an edge over those who lack this social glue. Sometimes this argument is presented in cultural terms, and sometimes it is seen from an evolutionary perspective: survival of the fittest working at the level not of the gene or the individual but of the social group. In either case the claim is that religion thrives because groups that have it outgrow and outlast those that do not.

In this conception religion is a fraternity, and the analogy runs deep. Just as fraternities used to paddle freshmen on the rear end to instill loyalty and commitment, religions have painful initiation rites—for example, snipping off part of the penis.

Also, certain puzzling features of many religions, such as dietary restrictions and distinctive dress, make perfect sense once they are viewed as tools to ensure group solidarity. The fraternity theory also explains why religions are so harsh toward those who do not share the faith, reserving particular ire for apostates…

This theory explains almost everything about religion—except the religious part. It is clear that rituals and sacrifices can bring people together, and it may well be that a group that does such things has an advantage over one that does not. But it is not clear why a religion has to be involved. Why are gods, souls, an afterlife, miracles, divine creation of the universe, and so on brought in? The theory doesn’t explain what we are most interested in, which is belief in the supernatural.

Is God an Accident? (The Atlantic)

Hence the “accidental” (or side effect) theory of religion. As the Atlantic article states, “Enthusiasm is building among scientists for a quite different view—that religion emerged not to serve a purpose but by accident…” : In the terminology of evolutionary biology, “religion is either a spandrel or an exaption.”

.. the term “spandrels” [is] a structure that merely follows from the existence of some other (evolved) structures, without itself being an adaptation. “Exaptation” refers to new roles played by evolutionarily old features that are adaptations in the strict sense of the term. Adaptations in this sense are features that are selected to perform their current function. [2]…Standard examples are the reptilian bones of the jaw that get adopted for the middle ear by mammals. Our ability to do mathematics is an exaption of various syntax-modules and modules that do trivial combinatories (“Are any of my babies missing?”). The ability to get embroiled in fictional worlds is an exaption of our ability to conduct thought-experiments as a part of forward planning. [3]

These “spandrels” and “exaptions” became co-opted by our brains to create religion. And, once that happened, religion, in turn, encouraged reciprocal altruism to evolve. In other words, we used religion—a by-product of our own cognitive evolutionary legacy—to bootstrap our way into becoming the unusually cooperative species we are today.

When one thinks of the many pages that have been written about religion uniting people into a moral community, it is not particularly surprising to learn that some anthropologists, biologists, and philosophers now claim that it is precisely religion that has helped reciprocal altruism to evolve. Ferren MacIntyre, for example, argues that religious affiliations have acted as a kind of “kinship surrogate” that helped our ancestors to develop cooperation among large groups of nonkin.

In the “standard model” of the cognitive science of religion, however, religion is instead a by-product based on “runaway” evolutionary processes extended beyond their initial domain. Evolution has built certain structures and mechanisms of mind that are adaptations to certain Pleistocene conditions; religion is made possible by these structures and mechanisms, although they did not originally develop for this purpose. [2]

Basically, according to this theory, the core characteristics of all religions boil down to two primary things:

First, we perceive the world of objects as essentially separate from the world of minds, making it possible for us to envision soulless bodies and bodiless souls. This helps explain the ubiquitousness of belief in disembodied souls, or “spirits”, in whatever cultural form they happen to take. Even nineteenth-century rationalists made serious attempts to contact the dead (e.g. William James and Arthur Conan Doyle)

Purely physical things, such as rocks and trees, are subject to the pitiless laws of Newton. Throw a rock, and it will fly through space on a certain path; if you put a branch on the ground, it will not disappear, scamper away, or fly into space. Psychological things, such as people, possess minds, intentions, beliefs, goals, and desires. They move unexpectedly, according to volition and whim; they can chase or run away. There is a moral difference as well: a rock cannot be evil or kind; a person can…

Understanding of the physical world and understanding of the social world can be seen as akin to two distinct computers in [the] brain, running separate programs and performing separate tasks. The understandings develop at different rates: the social one emerges somewhat later than the physical one. They evolved at different points in our prehistory; our physical understanding is shared by many species, whereas our social understanding is a relatively recent adaptation, and in some regards might be uniquely human…

For those of us who are not autistic, the separateness of these two mechanisms, one for understanding the physical world and one for understanding the social world, gives rise to a duality of experience. We experience the world of material things as separate from the world of goals and desires. The biggest consequence has to do with the way we think of ourselves and others. We are dualists; it seems intuitively obvious that a physical body and a conscious entity—a mind or soul—are genuinely distinct. We don’t feel that we are our bodies. Rather, we feel that we occupy them, we possess them, we own them.

This duality is immediately apparent in our imaginative life. Because we see people as separate from their bodies, we easily understand situations in which people’s bodies are radically changed while their personhood stays intact. Kafka envisioned a man transformed into a gigantic insect; Homer described the plight of men transformed into pigs; in Shrek 2 an ogre is transformed into a human being, and a donkey into a steed; in Star Trek a scheming villain forcibly occupies Captain Kirk’s body so as to take command of the Enterprise; in The Tale of the Body Thief, Anne Rice tells of a vampire and a human being who agree to trade bodies for a day; and in 13 Going on 30 a teenager wakes up as thirty-year-old Jennifer Garner. We don’t think of these events as real, of course, but they are fully understandable; it makes intuitive sense to us that people can be separated from their bodies, and similar transformations show up in religions around the world. [4]

Second, our system of social understanding overshoots, inferring goals and desires where none exist. This makes us intuitive animists and creationists.

In 1944 the social psychologists Fritz Heider and Mary-Ann Simmel made a simple movie in which geometric figures—circles, squares, triangles—moved in certain systematic ways, designed to tell a tale. When shown this movie, people instinctively describe the figures as if they were specific types of people (bullies, victims, heroes) with goals and desires, and repeat pretty much the same story that the psychologists intended to tell. Further research has found that bounded figures aren’t even necessary—one can get much the same effect in movies where the “characters” are not single objects but moving groups, such as swarms of tiny squares.

Stewart Guthrie, an anthropologist at Fordham University, was the first modern scholar to notice the importance of this tendency as an explanation for religious thought. In his book Faces in the Clouds, Guthrie presents anecdotes and experiments showing that people attribute human characteristics to a striking range of real-world entities, including bicycles, bottles, clouds, fire, leaves, rain, volcanoes, and wind. We are hypersensitive to signs of agency—so much so that we see intention where only artifice or accident exists. As Guthrie puts it, the clothes have no emperor. [4]

As a direct consequence of the evolution of the human social brain, and owing to the importance of our theory-of-mind skills in that process, we sometimes can’t help but see intentions, desires, and beliefs in things that haven’t even a smidgeon of a neural system. In particular, when inanimate objects do unexpected things, we sometimes reason about them just as we do for oddly behaving—or misbehaving—people. More than a few of us have kicked our broken-down vehicles in the sides and verbally abused our incompetent computers. Most of us stop short of actually believing these objects possess mental states—indeed, we would likely be hauled away to an asylum if we genuinely believed that they held malicious intent—but our emotions and behaviors toward such objects seem to betray our primitive, unconscious thinking: we act as though they’re morally culpable for their actions.

So it would appear that having a theory of mind was so useful for our ancestors in explaining and predicting other people’s behaviors that it has completely flooded our evolved social brains. As a result, today we overshoot our mental-state attributions to things that are, in reality, completely mindless. And all of this leads us, rather inevitably, to a very important question: What if I were to tell you that God’s mental states, too, were all in your mind?…[5]

As we became smarter and our brains larger, we dragged along this “cognitive baggage” of our evolutionary past. It remains with us to this day, and forms the basis of many of the idiosyncratic beliefs we associate with religious belief, and superstition more broadly.

But there’s still a bit more to it than that. With the help of that BBC article, we’ll take a closer look at some of the “cognitive modules” that helped religious belief evolve. My understanding is that while each of these modules is important in the construction of religious thought, none of them by themselves is sufficient to account for religion. Rather, it is the intersection of all of them that gives rise to the uniquely human phenomenon we call “religion” (although ancient societies would have not made any such distinction between religion and other aspects of their social and cultural lives).

[1] “Death and the Afterlife – Biblical perspectives on ultimate questions,” by Paul R Williamson, p. 13

[2] Supernatural Agents: Why We Believe in Souls, Gods, and Buddhas, by Iikka Pyysiainen, p. 31

[3] Thomas Forster Tries to Understand Julian Jaynes, p. 5 (PDF)

[4] Is God an Accident? The Atlantic, December 2005

[5] Are You There God? It’s Me, Brain. Slate Magazine, February 2011