We saw last time that seignorage was used by medieval sovereigns to raise revenue. But this led to all sorts of problems because the values of the coinage were constantly being adjusted against the monetary standard. Even where there was a consistent monetary standard, there was no “official” currency equivalent to that standard, so a multitude of different coins circulated, with a multitude of shifting values. We also saw that when bullion and exchange values got too far out of whack, this led to chronic shortages of coins. This made trade difficult.
To overcome both the shortage of circulating money, and the constant variations in the value of the coins issued by states, what the merchant classes did was create a private, parallel currency system based around trade credit. This was done using bills of exchange, which were discounted by a clique of pan-European bankers centered mainly in Italy.
The net effect of this was the creation of a parallel money system based around debits and credits recorded by bankers in their ledgers using double-entry bookkeeping, without any coins changing hands. These credits would circulate as paper documents and be periodically settled at trade fairs. The bills could be converted into the local currencies at varying exchange rates. The volume of trade in late medieval Europe was far to great for the circulating coins to be adequate. Bills of exchange allowed trade to take place without using government-issued coins, which were clunky and cumbersome, not to mention uncertain.
The modern bill of exchange originated in Islamic trade and most certainly entered Europe through the Italian maritime city states during the thirteenth century.
In basic terms, exchange by bill required two networks – one of traders and one of bankers. A trader would draw a bill on a local banker, which he would then use as a means of payment for the specific goods imported from outside the local economy. The exporter of the goods would then present the bill for payment to his local representative of the banking network.
In their simplest form, the bills directly represented the value of the goods in transit. Their adoption facilitated long-distance trade, but there is nothing in these economic advantages themselves that would suggest that the bills would develop into credit money. Indeed, this is precisely what did not happen in Islam.
Exchange by bill per arte was the means by which the ‘nations’ of bankers enriched themselves by exploiting the unique opportunities afforded by the particular structure of the late mediaeval geopolitical and monetary systems. In doing so they expanded the early capitalist trading system. The bill of exchange system allowed an increase in trade without any increase in the volume or velocity of coins in the different countries; but this was an unintended systemic consequence of the exchange bankers’ entirely self-interested exploitation of the particular circumstances…Exchange by bill was also one of the practices that eventually led to issue of credit money by states…
Bilateral exchange agreements had existed since Classical times, but until the advent of written contracts, they could not be disconnected from their original context and used as a means of third-party settlement.
Bills of exchange were documented in a “pure” unit of account, and thus were disconnected from precious metals and coins. That meant they could be issued without the limitations of gold and silver.
But until they could be used in the settlement of third-party debts outside of the limited network of exchange bankers, they could not function as a true currency. During the sixteenth century, some bills began to “leak” out of the banking system and be used in the settlement of other debts. Eventually a rule change allowed for the transferability of liabilities of the bill of exchange, making drawing a bill a more widely used means of payment after 1600.
But before any of this could happen, however, two relatively mundane and overlooked innovations had to be established. These were paper, and double-entry bookkeeping.
Paper and Double-Entry Bookkeeping
Before paper, people in medieval Europe wrote on parchment, which was made from the skins of animals. Parchment was expensive—a single bible required the skins of 250 sheep. However, most people didn’t couldn’t read (because they were farmers and didn’t need to), so there wasn’t much call for books. The main book was the Bible, meticulously handcopied by monks in monasteries, so the limited supply of writing media was no big deal.
Paper, like so many medieval innovations, was invented in China and came to Europe through the Arab world. It could be produced much more cheaply, and as a commercial class arose, the need for paper became more acute, leading to mass production:
The oldest known piece of paper was made in Shangsi Province in China around 49 BC. That’s about the same time sheepskin was replacing papyrus in the Roman world. So what is paper, really?
You make paper by spreading out a slurry of organic fibers and draining off the water. Paper is a kind of felt made of overlapping fibers. At first the Chinese made paper from hemp. They used it for wrapping and decoration — not for writing. They’d already been wrapping themselves in felt clothing.
In AD 105, one Ts’ai Lun used paper to replace bamboo blocks as a writing surface. He made it from fibers of bark, bamboo, and hemp. By AD 500, the Chinese had experimented with rattan and mulberry and had finally settled on bamboo paper…
Pergamon, in western Turkey, had become a parchment-based intellectual center, and parchment would become Europe’s writing material. But, in the 8th century, intellectual ascendancy passed to Baghdad, and it came to rest on the new writing medium of paper.
Historian Jonathan Bloom drives home the importance of that fact. Before we had cheap and abundant paper, arithmetic involved erasing and shifting numbers — operations that could be done on slate, but not paper. In AD 952, Arab mathematician al-Uqlidisi used Indian algorithms to create neat once-through methods that could be done on paper. Paper drove the creation of our methods for doing multiplication and long division.
The use of paper slowly crept westward. Cairo was making paper by the 10th century, Tunisia and Islamic Spain by the 11th. Paper didn’t cross the Pyrenees into Europe. Rather, it entered by way of Islamic Sicily. It was being made in Italy by 1268.
Both Hebrew and Islamic scripture had first been put on parchment. Both religions were reluctant to put scripture on anything so modest as paper, despite its strength and durability. The flow of paper into Europe was also slowed by Christians, who called it an infidel technology. Central Europe didn’t take up paper until the 14th century, and England only at the end of the 15th.
No. 894: INVENTING PRINTING (Engines of Our Ingenuity)
No. 1456: PAPER IN SAMARKAND (Engines of Our Ingenuity)
The mass production of paper may have spurred the development of mechanization of production in Europe:
When Christian Europeans finally did embrace paper, they created arguably the continent’s first heavy industry. Initially they made paper from pulped cotton. This requires some kind of chemical to break down the raw material. The ammonia from urine works well, so for centuries the paper mills of Europe stank as soiled garments were pulverized in a bath of human piss. The pulping also needs a tremendous amount of mechanical energy. One of the early sites of paper manufacture, Fabriano in Italy, used fast-flowing mountain streams to power massive drop hammers. Once finally macerated, the cellulose from the cotton breaks free and floats in a kind of thick soup. The soup is then thinly poured and allowed to dry where the cellulose reforms as a strong, flexible mat.
50 Things that made the modern economy – Paper (BBC)
One of the very first things the Europeans did on this new, cheap material was carry out mathematical operations with the new Hindu/Arabic number system which was being imported the Arab world. This was popularized by one Leonardo Bonacci of Pisa, better known as Fibonacci:
Leonardo’s father, Guglielmo Bonacci, was a merchant looking after the Pisan interests in the Algerian port of Bejaia. While we might not imagine that medieval finance was very sophisticated, we would be wrong. The historian Alfred Crosby describes a series of transactions undertaken by an Italian merchant, Datini, which, although they took place two hundred years later, would have been similar to the types of transactions Guglielmo Bonacci would have been involved in…Datini would have engaged in forward contracts, loan agreements and transactions in at least five currencies (Arogonese, Pisan, Florentine, Venetian, North African). To make a profit, he needed to be an expert at ‘commercial arithmetic’, or financial mathematics.
Leonardo was born in Pisa around 1170 and educated, not only in Bejaia but, as far afield as, Egypt, Syria, Constantinople and Provence. He would write a number of books on mathematics, but his first and most influential was the Liber Abaci (‘Book of Calculation’), which appeared in 1202. The Liber was heavily influenced by the Arabic book ‘The Comprehensive Book on Calculation by Completion and Balancing’ written around 825 CE by al-Khwarizmi, who was himself motivated to write the book because
men constantly require in cases of inheritance, legacies, partition, law-suites and trade [a number]
and his book provided the easiest way of arriving at that number, using al-gabr (‘restoration’) and al-muqabala (‘balancing’). Fibonacci collated these Arabic techniques into a single textbook for merchants…facing the increasingly complex financial instruments and transactions emerging at the time.
The impact of the Liber Abaci was enormous. Fibonacci became an adviser to the most powerful monarch of the time, Frederick II, Holy Roman Emperor and King of Sicily. More significant, Abaco or rekoning [sic] schools sprang up throughout Europe teaching apprentice merchants how to perform the various complex calculations needed to conduct their business. [Luca] Pacioli, who taught Leonardo da Vinci maths, was a well known graduate. Less well known is the fact that Copernicus came from a merchant family and in 1526, seventeen years before his more famous, “epoch-making” ‘On the Revolutions of the Heavenly Spheres’, he wrote ‘On the Minting of Coin’ about finance.
The practical usefulness of the reckoning schools was that, by using positional numbers and algebra, merchants could execute complex financial calculations that would typically include an illicit interest charge, hidden from the mathematically unsophisticated, university based, Church scholars. The merchant bankers were using mathematics to keep one step ahead of the regulator and the effectiveness of the non-university mathematics would not have been lost on the sharper scholastics, observing market practice.
Who was the first Quant? (Magic, Maths and Money)
It’s difficult to imagine the financial techniques noted above without the use of our arithmetic calculations being able to be carried out on cheap, accessible paper. These two inventions—paper and base-ten positional notation, were to be fused into the invention that made modern accounting possible: double-entry bookkeeping. This allowed accounts to once again be free of cumbersome gold and silver, or even hazelwood tally sticks.
You’re a medieval businessman — trading wool, pepper, cloth. Money is owed you, you have debts, and it all needs to be recorded. But there’s a problem. You track it with a diary, using Roman numerals. For arithmetic you have only some finger-counting methods. Your records would curl a modern accountant’s hair.
Alfred Crosby writes about an explosion of trade in the High Middle Ages. No longer was European trade a mere matter among farmers and villagers. By 1400, after the Plague, Europe was enormously capital-intensive — its ships moved goods internationally. None of that could happen without bringing money under control.
And so there developed, according to one historian, an atmosphere of calculation. Scholars were learning the new mathematics of algebra — that game where quantities are balanced across an equal sign — where quantities are positive on one side and negative on the other.
So Crosby goes looking for the invention of the new algebra of record keeping — the method called double-entry bookkeeping, where we list debits on one side and credits on the other. It’s the method marked by the absolute requirement that those two columns sum to zero. It’s the basis for tracking all our vast financial affairs today. He finds that, in 1300, a Florentine bookkeeper began listing debits and receipts in different ledgers. In 1340, an accountant from Genoa listed payouts and receipts on the left and right sides of a single page. For two centuries, the method slowly evolved.
No. 1229: DOUBLE-ENTRY BOOKKEEPING (Engines of Our Ingenuity)
Economic historians can pinpoint roughly when this occurred by using the record books of Francesco Datini, which survive to the present day. Datini’s books show the process of changing over from a diary to a sophisticated accounting of inputs and outputs, escribed on paper:
Datini’s meticulously kept account books span almost fifty years and clearly show the transition from single-entry to double-entry bookkeeping. His surviving ledgers from 1367 to 1372 do not use the double-entry system, while those from 1390 onward do.
Datini was innovative not just in his early adoption of the new style of bookkeeping; when in 1398 he and a partner opened a bank in Florence, they accepted a new form of payment only just coming into Europe: cheques. Like many business practices new to medieval Europe, the cheque had long been used by Arab merchants, who gave us the English word ‘cheque’. As early as the ninth century a Muslim merchant could cash a cheque in China drawn on his bank in Baghdad.
Datini also dealt in bills of exchange, which were notes for the exchange at a future date of florins for one of the many different currencies circulating in Europe at this time, when every city minted its own coins. These bills first appeared in Europe in the twelfth century and became a powerful new financing tool. In Datini’s day, charging interest on a loan at a fixed rate was outlawed by the Church, which deemed it usurious (demanding interest rates on loans was no permitted anywhere in Europe until 1545, when Henry VIII legalised it in England.) Bills of exchange became popular because, while they attracted a profit, the eluded the Church’s ban on usury.
Paradoxically, their popularity rested on their unreliability. Bills of exchange were effectively gambles on exchange-rate variations, and the chance of making a profit from them was so uncertain, so precarious, that the Church did not recognize their profits as interest and therefore allowed their use.
Datini was one of the new breed of Italian international merchant bankers who in the fourteenth century created vast trading empires and networks of credit from London to Constantinople. In the next century these Italian international merchant bankers, most notably the Medici of Florence, would use their immense wealth to commission works of architecture, art and scholarship–and effectively finance the Renaissance. 
It was in Venice that Arabic numerals and double-entry bookkeeping first became commonplace, hence this method came to be known throughout Europe as the “Venetian method” of finance:
…By the 1430s the merchants of Venice had perfected a system of double-entry account keeping in two columns which became known as bookkeeping el modo de vinegia or alla viniziana: the Venetian method. It is this Venetian method that, through its extraordinary resilience and mutability, has come down to us today, transformed over several centuries from a rudimentary business tool into an efficient calculating machine. 
This system was popularized and spread by Renaissance Man Luca Pacioli, a close friend and confidant of Leonardo da Vinci.
The man responsible for its codification and preservation–the author of the world’s first printed bookkeeping treatise–is Luca Bartolomeo de Pacioli, Renaissance mathematician, monk, magician, constant companion of Leonardo da Vinci. As the origin of all subsequent bookkeeping treatises throughout Europe, Luca Pacioli’s bookkeeping tract is not only the source of modern accounting but also ensured the medieval Venetian method survived into our own times. And so accountants have named Luca Pacioli the ‘father of accounting’…
While this was the beginning of the sophisticated use of double-entry bookkeeping in Europe using ledgers and Arabic numerals, the concept goes back a long way:
Double entry is used because of the basic fact that every movement of value has two aspects, and both should be recorded in a proper set of accounts. For the giver of value the transaction is a credit, for by giving value he has earned a credit, he is owed the equivalent. For the receiver the transaction is a debit, because he is a debtor for the value.
The basic rules of double-entry bookkeeping are as follows:
1) debit value in, credit value out;
2) debit receipts, credit payments;
3) debit assets, credit liabilities;
4) debit losses, credit profits.
Every transaction has to be recorded twice, or a multiple of twice, in any set of accounts, each as a debit and as a credit. There are no exemptions to this rule. The need to record things twice seems to have occurred to those responsible for accounts at least 4,000 years ago. When a sheep was due to the temple from a peasant, the temple would record the sheep as owed by the peasant, and list it as a part of the income of the temple. When the sheep actually appeared, the peasant’s record would be credited, the debt wiped out, and the temple would add the sheep to the list of the sheep it owned.
The accounts of that era went no further along the road of developing the full sophistication of a modern accounting system, but, as has been mentioned earlier, the basic element of a double record seems to have been there. 
These techniques were deployed by Italian bankers all across the continent, and it’s no coincidence that most financial centers in Europe such as London have a “Lombard Street” in their financial district even today.
Finance and Science
According to Tim Johnson, the sophisticated mathematical techniques engendered by finance at this time pushed forward the development of mathematics in Northern Europe, and eventually led to the scientific revolution.
Fibonacci’s mathematics revolutionised European commercial practice. Prior to the Liber Abaci, merchants would perform a calculation, using an abacus, and then record the result. The introduction of Hindu/Arabic numbers in the Liber enabled merchants to “show their working” as an algorithm, and these algorithms could be discussed and improved upon. Essentially after Fibonacci mathematics ceased to be simply a technique of calculation but became a rhetorical device, a language of debate.
Lady Credit (Magic, Maths and Money)
Financial techniques had to be sophisticated, due to not only the church’s ban on usury but also the multitude of shifting currencies all over Western Europe. As Johnson notes, many of the mathematicians who made great strides in mathematics and physics at this time came out of the financial system. Leonardo of Pisa’s treatise on math was explicitly described as helping merchants and traders carry out business transactions. Many advancements were attempts at calculating probabilities.
The most influential single Abaco graduate has to be the Dutchman, Simon Stevin. Stevin, who was born in 1548 in Bruges, had originally worked as a merchant’s clerk in Antwerp then as a tax official back back in Bruges, where he wrote his first book Tafelen van Interest (‘Tables of interest’) which he published in 1582, before moving to the University of Leiden in 1583. About this time, he was appointed as adviser to Prince Mauritz of Nassau, who was leading the Dutch revolt against the Spanish, and eventually became the Dutch Republic’s Finance Minister.
As well as being active in government, Stevin carried out scientific experiments, and it is believed his bookeeping [sic] inspired his physics. His most famous experiment showed that heavy and light objects fell to the earth, in the absence of air resistance, at the same speed, an experiment that disproved a belief of Aristotle and is usually attributed to Galileo dropping things from the Tower at Pisa some years later.
One of Stevin’s most important posts was as the director of the Dutch Mathematical School, established in 1600 by Mauritz to train military engineers. In this capacity, in 1605, he published a textbook for the School, the ‘Mathematical Tradition’, which was a comprehensive overview of mathematics and included a whole section on ‘Accounting for Princes in the Italian manner’.
In a very short period, the Dutch Mathematical School became the centre for merchants’ training in north western Europe. This success, in turn, forced the authorities at the University of Leiden, which provided the School with its facilities, to take practical sciences, in particular maths, a bit more seriously. The Dutch Mathematical School would inspire the soldier Descartes to study maths and would train Huygens and a whole generation of European scientists.
In addition, it was Stevin’s promotion of the use of decimals, to aid accounting, that inspired Newton to think of functions as power-series, giving birth to the discipline of Analysis. Newton essentially finished his work in physics with the publication of Principia in 1687, his last significant work, Optiks, published in English in 1704, was based substantially on research undertaken in the early 1670s. After almost a decade of troubles, Newton moved into finance in April 1696 when he was appointed Warden of the Royal Mint. This was a largely ceremonial post, but Newton took to it so much that he became the Mint’s operational manager, its Master, in 1699.
Johnson attributes this to “reverse Quants”: instead of highly-trained mathematicians going to work in finance, at this time it financial mathematicians who went to work in academia. This allowed academia to push forward calculations that applied to the real world much further in Europe than elsewhere. Both Copernicus and Isaac Newton worked in the money system.
…the migration from academic careers in science to finance appear to be embedded, it is not a modern phenomena. However, possibly more significant is the less well-appreciated role of the ‘reverse-quants’ in the development of science. The influence is captured by events in France in 1304-1305 when economic instability and a market failure led the French King, Philip the Fair, to issue decrees fixing the price of bread. His decrees failed spectacularly, and this was seen by contemporary observers as evidence that ‘nature’ ruled, and not the authority of the King, and that market prices where an objective, ‘scientific’ measure. This enabled the likes of [Thomas] Bradwardine to re-assess the role of mathematics in science. Later, people trained in commercial arithmetic – financial mathematics – such as Copernicus and Stevin, were able to challenge the authority of Aristotelian science, and argue that the Earth revolved around the Sun and that heavy and light objects fall at the same speed.
We saw this before, when the use of money spurred the ideas of Greek science and philosophy–the idea of an unlimited, underlying substance underpinning all phenomena. He concludes:
European science did not start in the Renaissance, it existed in the High Middle Ages. The ‘renaissance’ of the ‘long twelfth century’ resulted in what the historian Joel Kaye describes as the transformation of the conceptual model of the natural world ,…, [which] was strongly influenced by the rapid monetisation of European society taking place [between 1260-1380]. and played a pivotal role in the development of European science. Thirteenth century scholars [were] more intent on examining how the system of exchange actually functioned than how it ought to function..
Who was the first Quant? (Magic, Maths and Money)
Some Debt Becomes Money
Alfred Mitchell-Innes described the “primitive law of commerce” as the exchange of a commodity for a credit. It was this that was at the heart of the private money creation scheme developed by Italian bankers. Debts and credits would always match up, meaning that theoretically the amount of money circulating would always equal the value of goods in transit.
It has been observed time and time again in the last 400 years that banks can create credit very freely, because they know that the drawing down of a loan automatically creates the deposit which balances the lending. When a bank has agreed to lend, the moment that the loan is drawn down by the payment of a cheque drawn upon it, a deposit to match it is also created at the receiving bank. Therefore the moment a borrowing takes effect, the saving to match it must arise as well. Even if the borrowing is to finance a capital project, the saving to match that capital investment must come into being automatically the moment the loan is drawn down to make a payment. As all money is effectively transferable debt, then money can be created by creating debt. Once it is realised that all money is some form of debt, it becomes obvious that money can only be created by creating debts…
In the aggregate the accounts of banks are always in balance. So in theory a bank can grant unlimited loans in the knowledge that the amount lent will always appear somewhere as a deposit to balance the lending. The snag for the bank granting the loan would seem to be that the deposit might be made in another bank. Actually this is no problem at all. If one bank has a loan not backed by a deposit, another bank will have a deposit which is unlent. The two have to meet up; the bank with the excess lending will borrow, directly or indirectly, the excess deposit from the other bank….’A banker is one who centralises the debts of mankind and cancels them against one another. Banks are the clearing houses of commerce.’ To put it in the simple words of the treasurer of a large modern bank, ‘If we are short, we know the money has to be somewhere. Our only problem is to find it, and pay the price asked for it.'
Felix Martin describes the basics of this system:
The system was simple. An Italian merchant wishing to import goods from a supplier in the Low Countries could purchase a credit note known as a bill of exchange from one of the great Florentine merchant houses. He might pay for this note either in the local sovereign money or on credit.
By buying such a bill of exchange, the Italian merchant achieved two things. First, he accessed the miracle of banking: he transformed an IOU backed by only his own puny word for one issued by a larger, more creditworthy house, which would be accepted across Europe. He transformed his private credit into money.
His second achievement was to exchange a credit for a certain amount of Florentine money into one for a certain amount of the money of the Low Countries where he was making his purchase. 
The bill of exchange itself was denominated in a private monetary unit created specially for the purpose by the network of exchange bankers: the ecu de marc. There were no sovereign coins denominated in this ecu de marc. It was a private monetary standard of the exchange-bankers alone, created so that they could haggle with one another over the value of the various sovereign moneys of the continent. Somewhat bizarrely to modem eyes, the foreign exchange transaction included in the bill of exchange therefore involved two exchange rates-one between Florentine money and the ecu de marc, the other between the ecu de marc and the money of the Low Countries…
The end result was to overcome a previously insurmountable series of obstacles. The exchange-banker would accept the importer’s credit in payment, knowing him and his business well from the local market. Meanwhile, the supplier in the Low Countries would accept the exchange-banker’s credit as payment, knowing that it would be good in its tum to settle either a bill for imports or for some local transaction-and satisfied that he was being paid in the local money.
Of course, the banker ran the risk that the exchange rates of the two sovereign moneys against the imaginary ecu de marc might change in between his issuing the bill of exchange and its being cashed in the Low Countries, but he made sure that his fees and commissions made this a risk worth taking. 
This wasn’t a sideshow: vast amounts of trade were conducted all over the continent using this method. This puts a wrinkle in the whole “money is gold” approach. With the bills of exchange we see that, fundamentally, money is credit and it always had been. From the stone money of Yap, to the tally sticks of Europe, we see that:
Money, then, is credit and nothing but credit. A’s money is B’s debt to him, and when B pays his debt, A’s money disappears. This is the whole theory of money: Debts and credits are perpetually trying to get into touch with one another, so that they may be written off against each other, and it is the business of the banker to bring them together. 
This is the essence of banking. As Felix Martin notes, “Strip away all the mystery of banking, and what are left with is an institution that matched debts and credits. It makes money by one of two ways: by discounting bills and by issuing loans.”
Here’s Alfred Mitchell-Innes description of the process of discounting bills of exchange. You might have to reread this a number of times in order to “get it”; I know I did! But once you do, you’ll see that it’s clear that this is the underlying process behind money and banking, and not storing or exchanging gold and silver:
The process of discounting bills is as follows: A sells goods to B, C and D, who thereby become A’s debtors and give him their acknowledgments of indebtedness, which are technically called bills of exchange, or more shortly bills. That is to say A acquires a credit on B, C and D.
A buys goods from E, F and G and gives his bill to each in payment. That is to say E, F and G have acquired credits on A. If B, C and D could sell goods to E, F and G and take in payment the bills given by A, they could then present these bills to A and by so doing release themselves from their debt. So long as trade takes place in a small circle, say in one village or in a small group of near-by villages, B, C and D might be able to get hold of the bills in the possession of E, F and G.
But as soon as commerce widened out, and the various debtors and creditors lived far apart and were unacquainted with one another, it is obvious that without some system of centralizing debts and credits commerce would not go on. Then arose the merchant or banker, the latter being merely a more specialized variety of the former.
The banker buys from A the bills held by him on B, C and D, and A now becomes the creditor of the banker, the latter in his turn becoming the creditor of B, C and D. A’s credit on the banker is called his deposit and he is called a depositor. E, F and G also sell to the banker the bills which they hold on A, and when they become due the banker debits A with the amount thus cancelling his former credit. A’s debts and credits have been “cleared,” and his name drops out, leaving B, C and D as debtors to the bank and E, F and G as the corresponding creditors.
Meanwhile B, C and D have been doing business and in payment of sales which they have made, they receive bills on H, I and K. When their original bills held by the banker become due, they sell to him the bills which H, I and K have given them, and which balance their debt. Thus their debts and credits are “cleared” in their turn, and their names drop out, leaving H, I and K as debtors and E, F and G as creditors of the bank and so on.
The modern bill is the lineal descendant of the medieval tally, and the more ancient Babylonian clay tablet…
Loans are simply a variation on the same process, except they anticipate future sales:
Now let us see how the same result is reached by means of a loan instead of by taking the purchaser’s bill and selling it to the banker. In this case the banking operation, instead of following the sale and purchase, anticipates it. B, C and D before buying the goods they require make an agreement with the-banker by which he undertakes to become the debtor of A in their place, while they at the same time agree to become the debtors of the banker: Having made this agreement B, C and D make their purchases from A and instead of giving him their bills which he sells to the banker, they give him a bill direct on the banker. These bills of exchange on a banker are called cheques or drafts.
If this is familiar, it should be. As far back as the ancient Near East, promissory notes promised not to pay a specific person, but the bearer of the financial instrument (usually a stone tablet). This meant that liabilities could be transferred, and the stone tablet became a kind of proto-money, without the need of any sort of circulating medium like coins. As long as there was a unit of account, an agreement, and away for debts and credits to pair up, commerce could take place. The antecedent to the Bill of Exchange already existed in Babylon in 2500 B.C.:
The lending system of ancient Babylon was evidently quite sophisticated. Debts were transferable, hence ‘pay the bearer’ rather than a named creditor. Clay receipts or drafts were issued to those who deposited grain or other commodities at royal palaces or temples. Borrowers were expected to pay interest (a concept which was probably derived from the natural increase of a herd of livestock), at rates that were often as high as 20 percent. Mathematical exercises from the reign of Hammurabi (1792-1750 BC) suggest that something like compound interest could be charged on long-term loans…
It would not be quite correct to say that credit was invented in ancient Mesopotamia. Most Babylonian loans were simple advances from royal or religious storehouses. Credit was not being created in the modern sense…Nevertheless, this was an important beginning. Without the foundation of borrowing and lending, the economic history of our world would scarcely have got off the ground. And without the ever-growing network of relationships between creditors and debtors, today’s global economy would grind to a halt…
As Geoffrey Gardiner notes, “If an obligation is assignable, it can be used both as a medium of exchange and as a store of value. If the obligation is not only assignable but is expressed in terms of the standard measure of value, it can properly be regarded as money…by nature all money is assignable debt. A pound note is theoretically a debt of the Bank of England. A bank deposit is a debt of the bank. A holding of gold is a portable form of debt.”  In fact, he argues that monetization of trade credit was the primary form of money since the very beginnings of civilization, a role that has been tragically ignored by conventional economists due to their focus on precious metals:
The process of converting a debt into a means of exchange can be called ‘monetising debts.’ If one looks at the history of economics one can surely see that the monetising of debts, usually trade debts, has been the most important process, the most important invention, in the history of commerce, ever since differentiation of labour first took place sometime in prehistory. One must agree with Mitchell Innes that gold and silver were not the essentials of a money system. That role was fulfilled by the documentary credit which originated in trade credit 
The petty loan sharks and money changers like the Medici scaled up to become rich and influential banking houses by using the power of the Venetian method and bills of exchange to underwrite international commerce.
In 1385 Giovanni [De Medici] became manager of the Roman branch of the bank run by his relation Vieri di Cambio de’ Medici, a moneylender in Florence. In Rome, Giovanni built up his reputation as a currency trader. The papacy was in many ways the ideal client, given the number of different currencies flowing in and out of the Vatican’s coffers. As we have seen, this was an age of multiple systems of coinage, some gold, some silver, some base metal, so that any long-distance trade or tax payment was complicated by the need to convert from one currency to another…
Of particular importance in the Medici’s early business were the bills of exchange (cambium per literas) that had developed in the course of the Middle Ages as a way of financing trade. If one merchant owed another a sum that could not be paid in cash until the conclusion of a transaction some months hence, the creditor could draw a bill on the debtor and either use the bill as a means of payment in its own right or obtain cash for it at a discount from a banker willing to act as broker.
Whereas the charging of interest was condemned as usury by the Church, there was nothing to prevent a shrewd trader making profits on such transactions. That was the essence of the Medici business. There were no cheques; instructions were given orally and written in the bank’s books. There was no interest; depositors were given discrezione (in proportion to the annual profits of the firm) to compensate them for risking their money. 
Though others had tried before them, the Medici were the first bankers to make the transition from financial success to hereditary status and power. They achieved this by learning a crucial lesson: in finance small is seldom beautiful. By making their bank bigger and more diversified than any previous financial institution, they found a way of spreading their risks. And by engaging in currency trading as well as lending, they reduced their vulnerability to defaults. 
In time, bills of exchange became disconnected from the initial issuer and the connection to specific goods. allowing it to circulate as proto-money. What really made bills of exchange into money was a change in the law allowing for its transferability. The Joint Liability Rule meant that the bill would always find someone willing to cover its liability, preventing the bills from becoming worthless. Bills began to spread beyond just the bilateral transactions mediated by merchant bankers thanks to the Joint Liability Rule:
“The term Bill of Exchange (BofE) refers to a financial instrument whereby a merchant (the issuer) ordered his agent abroad (the payer) to make a payment in a different currency on his behalf to another merchant (the beneficiary), often in a third location, at a set date in the future. The beneficiary could further transfer his claim to another party, an endorser, in exchange for currency, debt or merchandise.
…a seventeenth century legal innovation, the Joint Liability Rule (JLR), enabled the medieval BofE to develop into the dominant means of payment and credit in the early modern period. The JLR specified that in case of default, all endorsers, in addition to the issuer and payer, could be held legally liable for reimbursement. Through the endorsement on the back of the bill, each successive endorser not only surrendered his financial claim to the bill but also acknowledged his full liability for reimbursement in the event of default.
…the powerful mechanism of Joint Liability permitted merchants to conduct a larger volume of trade through BofE than would have been possible otherwise. My findings uncovered an European-wide and anonymous market for bills of exchange that provided liquidity and credit to a local merchant house. Bills originated and were settled in a geographic area that extended all over Europe, north of Africa, Ottoman Empire up to Syria, and the Caribbean Islands. Despite evidence of ongoing problems of adverse selection and moral hazard, I showed that bills worked to broaden trade in the sense that agents used them across business networks…
Bills of exchange displaced state currencies for the payment among the merchant classes. In essence, it was a competing currency system run through private banks, and one that posed a threat to state finance as more and more capital concentrated in the hands of the merchants.
My Fair Lady
In Babylonia, debt and credits were matched up by the temples. In Rome, they were matched up in the banks along the Via Sacra. In the Middle Ages, they were matched up at the great trade fairs.
Economic historians look at the great trade fairs of the middle ages which took place in the towns like Champagne, Lyon and Piacenza as the beginnings of capitalism. Goods were brought from all over the world and sold to a new class of wealthy townsfolk, i.e. the burghers or “bourgeoisie” who relied on money transactions rather than social relations to conduct their business affairs. And they were always looking to increase their money. In these “free towns,” the feudal system disintegrated, and social relations were coordinated by money and prices. Most medieval free cities had a market, a mint, and a fairground. They also had a class of money-changers who would eventually become merchant bankers.
The debts and credits were settled at the conto, which was held on the final day of the fairs:
As they continually wrote and accepted bills of exchange to finance trade between the great European cities, the exchange bankers would accumulate credit and debit balances.
The circle of exchange-bankers was a close-knit one, and willingness to allow outstanding balances to build up was therefore high. Nevertheless, to ensure a clear picture of who owed what to whom, it was necessary to have periodic offsets. These could be done bilaterally on an ad hoc basis; but the regular fairs provided a natural opportunity for a more generalised clearing-and this is precisely what they gradually became.
Every quarter, the clique of great merchant houses would meet at the central fair of Lyons in order to square their books. On the first two days of the fair there was a frenzy of buying and selling, of writing new bills or cancelling old ones, at the end of which all delegates’ books were closed for the quarter and the resulting balances between the houses were verified. The third day-the of Exchange” – was the heart of proceedings. The exclusive cadre of exchange-bankers would convene alone to agree on the conto: the schedule of exchange rates between the ecu de marc and the various sovereign moneys of Europe.
This schedule was the pivot of the entire financial system, since it was at these exchange rates that any outstanding balances had to be settled on the final day of the fair the “Day of Payments”-either by agreement to carry over balances to the next settlement date, or by payment in cash. 
In fact, it is sometimes argued that the primary purpose of the fairs was not buying and selling at all! Rather, periodic trade fairs originated as meeting places where debt and credits were assessed and settled. Over time, an ever-increasing trade in goods grew up around them, which eventually came to obscure the historical origins of the fairs. In other words, the buying and selling was a peripheral development to the main activity of settling accounts. It was not gold or silver that was changing hands, so much as trade credits!
In these “economic zones” market exchanges prevailed, walled off by authorities through strict laws and regulations from the prevailing social forms of the countryside, which were more based in custom and tradition. Far from being “free trade,” such places were heavily regulated by authorities to ensure fair dealing.
Such concepts go back very far indeed, all the way back to the ritual temples and plazas of the Stone Age where suchexchanges took place. We’ve seen that feasting events were typically where the settling of debts and credits took place in pre-agricultural societies, for example the Sepik Coast Exchange in Papua New Guinea. In one memorable passage, Alfred Mitchell-Innes describes the role of fairs from ancient times in the development of money and commerce:
The clearing houses of old were the great periodical fairs, whither went merchants great and small, bringing with them their tallies, to settle their mutual debts and credits…The origin of the fairs…is lost in the mists of antiquity. Most of the charters of which we have record, granting to feudal lords the right to hold a fair, stipulate for the maintenance of the ancient customs of the fairs, thus showing that they dated from before the charter which merely legalized the position of the lord or granted him a monopoly. So important were these fairs that the person and property of merchants traveling to them was everywhere held sacred. During war, safe conducts were granted to them by the princes through whose territory they had to pass and severe punishment was inflicted for violence offered to them on the road.
It was a very general practice in drawing up contracts, to make debts payable at one or other of the fairs, and the general clearance at which the debts were paid was called the pagamentum. Nor was the custom of holding fairs confined to medieval Europe. They were held in ancient Greece under the name of panegyris and in Rome they were called nundinae, a name which in the middle ages was also frequently used. They are known to have been held in Mesopotamia and in India. In Mexico they are recorded by the historians of the conquest, and not many years ago at the fairs of Egypt, customs might have been seen which were known to Herodotus.
At some fairs no other business was done except the settlement of debts and credits, but in most a brisk retail trade was carried on. Little by little as governments developed their postal systems and powerful banking corporations grew up, the value of fairs as clearing houses dwindled, and they ceased to be frequented for that purpose, long remaining as nothing but festive gatherings until at last there linger but few, and those a mere shadow of their golden greatness.
The relation between religion and finance is significant…The fairs of Europe were held in front of the churches, and were called by the names of the Saints, on or around whose festival they were held. In Amsterdam the Bourse, was established in front of or, in bad weather, in one of the churches. They were a strange jumble, these old fairs, of finance and trading and religion and orgy…There is little doubt to my mind that the religious festival and the settlement of debts were the origin of all fairs and that the commerce which was there carried on was a later development. If this is true, the connection between religion and the payment of debts is an additional indication if any were needed, of the extreme antiquity of credit. 
The great French historian Fernand Braudel describes the role these fairs played in the Middle Ages in the transition from feudalism to capitalism:
…the real business of the fairs, economically speaking, was the activity of the great merchant houses. They it was who perfected this instrument and made the fairs the meeting-place for large-scale trade. Did the fairs invent, or re-invent credit?…it is certainly the case that the fairs developed the use of credit… The fairs were effectively a settling of accounts, in which debts met and cancelled each other out, melting like snow in the sun: such were the miracles of scontro, compensation. A hundred thousand or so ‘ecus d’ or en or’ – that is real coins – might at the clearing-house of Lyons settle business worth millions; all the more so as a good part of the remaining debts would be settled either by a promise of payment on another exchange (a bill of exchange) or by carrying over payment until the next fair: this was the deposito which was usually paid for at 10% a year ‘(2,5% for three months). So the fair itself created credit.
If the fair is envisaged as a pyramid, the base consists of the many minor transactions in local goods, usually perishable and cheap, then one moves up towards the luxury goods, expensive and transported from far away: at the very top of the pyramid came the active money market without which business could not be done at all- or any rate not at the same pace. It does seem that the fairs were developing in such way as, on the whole, to concentrate on credit rather than commodities, on the tip of the pyramid rather than the base. 
This goes to our core point: money is transferable credit (or debt). Once these debits and credits could circulate, that is, pass from once person to another, then you’ve got money. Once again, money is a tool to discharge social obligations, in this case, it allowed merchants and creditors to settle their accounts with one other.
These fairs took place all over Europe, but typically one major “financial center” for these dominated, the location of which changed over time with the volume of trade. Eventually, as trade expanded, the fairs declined, replaced by permanent institutions located in the trading cities. The first place this happened was Amsterdam in the Netherlands. Amsterdam established a permanent merchant bank. It would later establish the first joint-stock companies and stock market as well (the Amsterdam Exchange).
The fairs were linked together, and communicated with each other. Whether handling goods or credit” they had been organized to make circulation easier…Goods, money and credit were caught up in this circular movement. Money was of course at the same time providing the energy for other, larger circuits and usually tended towards a central point, from which it would set off again. In the West, where a dear recovery began with the eleventh century, ‘ .. one centre finally came to dominate the European system of payments. In the thirteenth century it was the Champagne fairs…the system reconstituted itself as best it could around Geneva in the fifteenth century, then at Lyons; and as the sixteenth century drew to a close, around the Piacenza fairs, that is around Genoa. Nothing so much reveals the functions of these successive systems as the breaks marking the changeover from one to another.
After 1622 however, no single fair would ever constitute the obligatory centre of economic life, dominating the rest, For it was now that Amsterdam, which had never really been a city of fairs, began to assert itself, taking over the previous superiority of Antwerp: it was becoming organized as a permanent commercial and financial centre. The fortune of Amsterdam marks the decline if not of the commodity fairs of Europe, at any rate of the great credit fairs. The age of fairs had seen its best days. 
The place where payments cleared passed from itinerant bankers at fairs to the stately colonnaded buildings in classical style as commerce became ever-more important to the European economy. Once banks became essential to commerce, they eventually became essential to states to conduct their fiscal operations as well. The modern world begins when governments access the miracle of banking to fund their own operations, especially war funding. In so doing, they caused private banknotes to become “official” currencies, backed by the state’s debt.
This happened first in the Italian City-states immediately prior to the Renaissance during 1100-1400. These city states, run by merchants and bankers, turned to the burgeoning financial markets to fund their operations, especially wars—remember that soldiers are mainly professional mercenaries at this time, and not citizen-soldiers (which comes under Napoleon). So any aspiring empire needed money to pay for war and mercenaries.
The way their got it was to borrow from their wealthiest citizens. And in so doing, they created the notion of “national debt.” That’s what we’ll be looking at next time.
 Wray; credit and state theory of Money, pp. 198-199
 Jane Gleeson-White; Double Entry: How the Merchants of Venice Created Modern Finance, pp.24-26
 Jane Gleeson-White; Double Entry: How the Merchants of Venice Created Modern Finance, pp.24-26
 Jane Gleeson-White; Double Entry: How the Merchants of Venice Created Modern Finance, pp. 27-28
 Wray; credit and state theory of Money, p. 134
 Wray; credit and state theory of Money, pp. 151-152
 Wray; credit and state theory of Money, pp. 136-137
 Felix Martin; Money: The Unauthorized Biography, p. 106
 Felix Martin; Money: The Unauthorized Biography, pp 106-107
 Wray; Credit and state theory of Money, pp. 239
 Wray; Credit and state theory of Money, pp. 45-46
 Wray; Credit and state theory of Money, p. 132
 Niall Ferguson; The Ascent of Money, p. 30-31
 Wray; Credit and state theory of Money, pp. 169-170
 Niall Ferguson; The Ascent of Money, p. 43
 Niall Ferguson; The Ascent of Money, pp. 47-48
 Felix Martin; Money: The Unauthorized Biography, p. 107
 Wray; Credit and state theory of Money, pp. 40-41
 Fernand Braudel; The Wheels of Commerce, pp. 90-91
 Fernand Braudel; The Wheels of Commerce, p. 92