Who invented the theory of money
About the moneyThe invention of money
What exactly is money, how is its value defined and who guarantees it? In times of crisis, questions are asked about what otherwise seems to be taken for granted with regard to the existence of means of payment and the role of banks in economic activity. The "instruments of trade and finance are inventions, products of the human imagination", which depend heavily on trust in them, says John Lanchester in his essay on the "invention of money". This fascinating journey through time through the evolution of the financial system bridges the gap between Marco Polo's reports on the introduction of paper money under Kublai Khan in the 13th century, via King Wilhelm III. and the birth of the Bank of England up to the establishment of crypto currencies such as Bitcoin or Facebook's Libra.
The idea of the central bank and the financial system
Particular attention is paid to two prominent protagonists in the history of money. On the one hand there is the Victorian banker and financial theorist Walter Bagehot, who promoted the idea of the central bank and had a great influence on English politics. And on the other hand, the Scottish economist John Law, who - in order to save the French crown from bankruptcy - established a financial system for Louis XIV that is not so dissimilar to today's and who was considered the richest entrepreneur of his time before luck him left again.
British writer and journalist John Lanchester was born in Hamburg in 1962 and grew up in East Asia before initially working as an editor (Penguin Books, later London Review of Books) in England; In 1996 his first novel "The Debt to Pleasure" was published, which received numerous awards. In his later works he turned increasingly to the subject of finance and the causes and effects of the global economic crisis. The essay "The Invention of Money" appeared for the first time in August 2019 in the "New Yorker".
When the Venetian merchant Marco Polo came to China in the second half of the 13th century, he saw many wonders there: gunpowder and coal, glasses and china. One of the things that amazed him most was a new invention introduced by Kublai Khan, a grandson of the great conqueror Genghis, in 1260 - paper money. Polo couldn't believe his eyes when he saw what the Khan was doing:
"He creates his money according to his own ideas. He extracts a certain bark, namely that of the mulberry tree, the leaves of which are the food of the silkworms. These trees are so numerous that they fill entire districts.
Money from leaves of the mulberry tree
A kind of fine, white bast or a skin that lies between the wood of the tree and the thick outer bark is removed. This creates something that resembles a sheet of paper, but is black.
Once these leaves are prepared, they are cut into pieces of various sizes and given out with as much solemnity and authority as if they were made of pure gold or silver. Each is named and sealed by a variety of designated officials.
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And when everything has been properly prepared, the captain authorized by the khan smears the seal entrusted to him with cinnabar and presses it onto the paper, so that the shape of the seal remains printed in red. The money is therefore real and anyone who forges it will be punished with death. "
Those who did not accept banknotes were killed
This last point was very important. The problem with many new forms of money is that people are reluctant to accept them. Genghis Khan's grandson did not have this problem. He took steps to ensure the authenticity of his currency. And those who did not use them, who did not want to trade them in, or who preferred to use gold or silver, copper or iron bars or pearls or salt or coins, or one of the older forms of payment used in China, were killed. This clarified the question of acceptance.
Marco Polo was rightly astonished. The instruments of trade and finance are inventions as are works of art and scientific discoveries - products of the human imagination. Paper money backed by the authority of the state was an amazing innovation that changed the world. Which is easily forgotten. We get used to the way we pay our bills and get paid for our work, the dance of numbers on our accounts and credit card statements.
Searching for new types of money not completed
Only when the system collapses do we begin to wonder why these things are worth what they seem to be worth. The 2008 credit crunch caused panic as people across the financial system wondered if the numbers on the balance sheets mean what they should mean. As a direct reaction to this crisis, Satoshi Nakamoto - whoever is behind this pseudonym - published the whitepaper in October 2008 that outlined the idea of Bitcoin, a new form of money based solely on the power of cryptography.
The search for new types of money is not over. In June of this year, Facebook presented "Libra", a global currency based on the Bitcoin architecture. The idea behind this is that the value of the new money does not depend on a state's permission to print, but on a combination of mathematics, global connectivity and trust in the largest social network in the world. At least that is the plan. But how safe is it? How do we know what libras or bitcoins are worth, or whether they are worth anything at all? Satoshi Nakamoto's followers would immediately ask the counter-question: How do you know what the money in your pocket is worth?
The problem of financing the war
The current timing of financial innovation therefore has some similarities with the time when money was created as we know it today - a paper currency backed by government guarantees. The hero of this origin story is the nation state. In every good story, the hero wants to achieve something, but faces an obstacle. In the case of the nation state, he wants to wage war, but does not know how to finance it.
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The modern system for dealing with this problem originated in England during the reign of King William. The Dutch king, a Protestant, had been placed on the English throne in 1689 to replace the unacceptable Catholic King Jacob II. Wilhelm was a capable ruler, but he carried heavy baggage - a protracted argument with King Louis XIV of France. Soon after, England and France were embroiled in a new phase in what is now seen as part of a centuries-old conflict between the two countries. At that time, however, it was known as the Nine Years War or "King William's War". This war posed a well-known problem for the rulers: how should they finance it?
Banknotes as good as gold money
King Wilhelm's government came up with a novel idea. They wanted to borrow a large sum of money and use taxes to repay the interest accrued over time. In 1694 the English government raised £ 1.2 million at a rate of eight percent, financed by taxes on shipments, beer and liquor. In return, the lenders were allowed to merge as a new company, the Bank of England. The bank had the right to accept gold deposits from the public and - a second major innovation - to print "banknotes" as receipts for the deposits. These new deposits were then loaned to the king. Secured by the deposits, these banknotes were as good as gold money and quickly became a generally accepted new currency.
This system is still in use, not just in England. However, its general acceptance has not been an uninterrupted success story. Some difficulties are described in James Buchan's fascinating biography, John Law: A Scottish Adventurer of the Eighteenth Century. Law was born in Edinburgh to a goldsmith who later retrained to be a banker. He moved to London in 1692, where he witnessed a miraculous new concept of government funded by long-term debt and paper money. One of the most important effects of this paper money was the way it stimulated borrowing, lending and trading. Law had an instinctive understanding of finance coupled with a love of risk, and it is tempting to imagine what would have happened if he had served the English government. But on April 9, 1694, fate took a different turn.
Law studied options trading and short selling
Law killed a man in a duel or a brawl - the difference, as Buchan explains, was obscure. "Back then, duels weren't the tournaments of the Middle Ages or a matter of honor in later years, which were regulated by written codes of conduct and carried out at dawn with pistols in a snow-covered forest clearing," said Buchan. They were immediately carried out "with a rapier or a short sword in a heated or barely cooled mind. Often hardly seconds went by before the weapons were drawn and the difference to an assassination attempt or robbery was hardly noticeable". Law was arrested and awaited a murder trial. As was customary for prisoners with the appropriate means at the time, he used his connections to escape and fled abroad as an outlaw.
For the next few years he roamed Europe doing research on gambling and finance and wrote a short book "Money and Trade Considered", which is modern in many ways Anticipates monetary theories. And he got rich. Like Littlefinger in Game of Thrones, Law seems to have been one of those men who had the gift of "rubbing two golden dragons together to breed a third". He bought an elegant house in The Hague and studied the numerous Dutch innovations in finance such as options trading and short selling. In 1713 he came to France. Difficulties were plagued there, and Law was exactly the right man to solve them.
In 1715 the French government was bankrupt
France's King Louis XIV was the most powerful monarch in Europe, but his government was crippled by debt. In addition to the usual war costs, there were huge expenses for annuities: lifelong interest payments to process old loans. By 1715 the king received 165 million livres from taxes and duties. Buchan does the math: "Expenditures for the army, palaces, court and public administration left only 48 million livres to pay interest on the debts left by the glorious kings of the past." Unfortunately, the annual cost of pensions and lifelong wages was 90 million livres. In addition, there were outstanding promissory notes totaling 900 million livres from various past wars. If the king did not pay interest on these promissory notes, he could not borrow any more money. However, that interest would add up to an additional 50 million livres per year. The French government was broke.
In September 1715, Louis XIV died and his nephew, the Duke of Orléans, became regent of the underage King Louis XV. placed at the head of the country. The Duke was something special. "He was bored from birth," remarked the great diarist Saint-Simon, a childhood friend of the Duke. "He could only live if he threw himself into business, at the head of an army, in the administration of its supplies, or in the glitz and sparkle of debauchery." Faced with the French state's financial crisis, the Duke began to listen to John Law's ideas. These ideas - more or less conventional politics nowadays - were completely new by the standards of the 18th century.
Forerunner of today's "minimum reserve system"
In Law's opinion, the most important thing about money wasn't its inherent value. He didn't think it had one. "Money is not the value for which goods are exchanged, but the value for which they are exchanged," he wrote. That is, money is the means by which one exchanges one thing for another thing. The key, according to Law, is to let money flow into the economy and use it to stimulate trade and commerce. As Buchan writes, "Money must be put at the service of commerce, and it is at the discretion of the Prince or Parliament to vary the flow of money according to the needs of commerce. Such an idea - for the past fifty years as conventional, perhaps even considered boring - was considered diabolical in the seventeenth century. "
This thought led Law to the idea of a new French national bank, which accepted gold and silver from the population and issued it again in the form of paper money. The bank also took deposits in the form of national debts, cleverly allowing people to claim the full value of those debts that were traded at high discounts: anyone who owned a piece of paper that said the king owed you 1,000 livres could pay for it the free market only got, say, 400 livres. However, Laws Bank would credit the entire 1,000 livres in paper money. The bank's paper values thus far exceeded the actual gold it had in store and made it a forerunner of today's "minimum reserve system". By one estimate, Laws Bank had about four times as much paper money in circulation as its gold and silver reserves were worth. According to modern banking standards, this is a cautious approach. US banks with assets of less than $ 124 million are required to hold a cash reserve of only three percent.
Debt swept away by "new financing system"
The new paper money had an attractive property: it was traded against a guaranteed weight of silver and, unlike coins, could not be melted down or devalued. Soon afterwards, the banknotes were traded for a value higher than their silver value, and Law was appointed "Contrôleur général des finances", that is, the chief financial controller. Now in charge of the entire French economy, he convinced the government to grant him a trade monopoly with the French settlements in North America in the form of the Mississippi Company. Law financed the company the same way he financed the bank, exchanging public deposits for shares. Then he used the value of these stocks, which skyrocketed from 500 to 10,000 livres, to buy up the French king's debts. The French economy, built on all of this interest, annuity and wage payments, was swept away and replaced by what Law called his "new financing system". The use of gold and silver was banned. Paper money became the compulsory currency, underpinned solely by the authority of the bank. It was estimated that the company had twice the production capacity of France during the high season. As Buchan points out, this is the highest rating a company has ever achieved in the world.
The Mississippi Company started making profits
The whole thing ended in disaster. The population began to wonder whether these suddenly lucrative investments were really worth what they should be. At first there was concern, then people panicked. Eventually they asked for their money back and began to revolt when they were refused repayment. Gold and silver were reinstated as currency, the company was dissolved, and Law was sacked after 145 days in office. He was ruined. In 1720 he fled France, moved from Brussels to Copenhagen, on to Venice, from there to London and back to Venice. John Law died there in 1729, completely penniless.
The great irony of his life is that, from today's perspective, his ideas were largely correct. The ships going overseas on behalf of his Mississippi Company began to make profits. An auditor who looked through the books concluded that the company was completely solvent. This is not surprising when you consider that the land the company owned in America is now producing trillions of dollars in economic value.
Risks from uncontrollable credit underestimated
Today we live in a version of Law's system. Every industrialized nation has a central bank that issues paper money, manipulates the credit supply in the interests of trade, uses minimum reserves and provides stock corporations with dividend payments. All of this brought Law to France in a short period of time. His big and likely inevitable mistake was to underestimate the volatility his inventions brought with it, especially the risks that uncontrollable credit can pose.
The years of its outstanding success in France left only two monuments. One was created by the Duke of Bourbon, who redeemed his shares in the company and used the unexpected profit to build the "Great Stables" at Chantilly Castle. "John Law envisioned a well-fed, working population whose stores were full of domestic and foreign goods," notes Buchan. "His memorial is a cathedral to the horse." Law's second legacy is the word "millionaire," which was first coined in Paris to describe the early beneficiaries of his mind-boggling ideas.
Bagehot as the spiritual father of the bank bailouts of 2008
But how did these once bold ideas become part of our modern financial and governance structures? Through trial and error. It would be wrong to assume that bright minds would have found and implemented all the solutions in one fell swoop. The modern economic system developed, and part of evolution is innovation, repetition, failure and dead ends. When it comes to finance, we speak of bankruptcies, panic and crashes because, as James Grant writes in his stimulating new biography of Victorian banker and journalist Walter Bagehot: "In finance and in business, we keep stepping on the same rake."
Bagehot knew all about these rakes. He grew up in the west of England in a family that had close ties to the well-run local bank - Stuckey's. After studying and gaining experience as a lawyer, he turned to journalism and banking, the latter career funding the first. He married the daughter of James Wilson, who founded The Economist in 1843. Bagehot became its third editor and lived a life that, from the outside, seemed rather uneventful. The interest in Bagehot stems from his colorful, witty and eloquent writing style, especially in his two key works "The English Constitution" (1867), which summarizes the unwritten order of the political institutions of Great Britain, and "Lombard Street" (1873), which explains how banks work. These books are still legible today, but were of interest primarily to experts, until Ben Bernanke identified Bagehot as a key influence on the idea behind the bank bailouts of 2008. This led to a resurgence of interest and the eventual publication of James Grant's book, Walter Bagehot: The Life and Times of the Greatest Victorian.
The well-groomed impression of seriousness
To call Bagehot the "greatest" - the greatest - is exaggerated, especially since Grant - among other things founder of the magazine "Grants Interest Rate Observer" - makes it clear that Bagehot was a shameless misogynist, a racist and an accomplished hypocrite. The last quality was very useful from a journalistic point of view. Bagehot was brilliant at switching sides without ever admitting that he had changed his mind. For example, he described a Confederation victory in the American Civil War as "a certain fact" and President Lincoln as "dishonest and stupid". A firm view that did not prevent Bagehot from declaring after the Union victory that "panic did not for a moment undermine the iron courage of American democracy". His subsequent elegy for Lincoln is a truly beautiful text: "Difficulties didn't bother him as they do with most men. Instead, they increased his confidence in patience. Resistance didn't cause stomach ulcers, it just made him more tolerant and more determined. "
In a way, this cocky hypocrisy and lack of principles are the real essence of bagehots. His work on the English constitution focused on a paradox: the glory and glory of the monarchy had an important function precisely because the monarch had no real power, according to Bagehot. His work on banking also focused on the difference between appearance and reality. In particular, the gap between the impression of solidity and seriousness maintained by Victorian banks and the obvious fact that they kept collapsing and going bust. There were massive banking crises in 1797, 1825, 1847 and 1857, all caused by the oldest and most trivial cause of financial bankruptcy: lending money to people who cannot repay it.
Gold - the real money
In theory, all of the money in circulation during the Victorian banking era was backed by gold deposits. One pound of paper money was equivalent to 123.25 grains of gold. In practice, however, this was not implemented. There have been a few occasions - usually related to the cost of the old classic, the war against France - when the government suspended the convertibility of paper money to gold. In addition, the banks could print their own money. They often did not have enough gold to maintain the value of their banknotes in case customers came to the bank and asked for an exchange. This phenomenon, the dreaded "bank storm", was a direct result of the minimum reserve system prophesied by John Law. A system in which banks do not hold cash reserves to match their outstanding loans can only work well until too many customers come to the bank at the same time and want to exchange their money for its gold value. Unfortunately, this kept happening and the banks kept going bust. This was about the same topics that shaped John Law's career and that are still being considered today: What is money? Where does it derive its value from? Finally, who guarantees the value of debt and credit?
Bagehot had answers to all of these questions. He believed that gold, and only gold, was real money. All other forms of currency were just different types of credit. These were essential to a functioning economy and made everyone rich, but ultimately, by strict definition, only gold was legal tender: money that cannot be refused to pay off a debt. (The fact that the US currency is legal tender makes it immediately obvious to everyone. It is clearly stated on the front of the banknotes.)
The less equity, the greater the profits
Bagehot loved paradoxes, and this was one. All credit was essential to the economy, but it wasn't money because it wasn't gold that made all things worth.
But where was all the gold now? In the Bank of England. The role of this once private company had evolved. Bagehot said it was the Bank of England's job to store the gold treasure so that all the smaller banks didn't have to do it. Instead, these smaller banks took out deposits, granted loans, and issued paper money. If they got into trouble - which it regularly did - the big bank would save them. And why shouldn't every bank store its own gold and take care of its own solvency? Bagehot, banker and writer, wrote openly about the reasons. "The main source of the profitability of mainstream banking is the scarcity of capital required". Nowadays we speak of banks' return on equity in these cases. The less equity the bank had to keep as a margin of safety, the more money it could lend and the greater its profits. Gold was essential to guarantee the stability of the currency, but the bankers didn't want it to take up valuable space on their balance sheets. They preferred to leave this to the government, represented by the Bank of England.
Modern machinery of nationalized financial risk
Today we still have a version of that system in which government guarantees back bank profitability. The central bank's crucial role is to lend freely in times of crisis - as a so-called "lender of last resort". Grant, claiming "a libertarian bias", sees this doctrine as the seeds of "deposit insurance, the systemic principle and the rest of the modern machinery of nationalized financial risk."
Like John Law and Walter Bagehot, I am the son of a bank employee, and as such I had the typical question of a banker's son in mind as I read Grant's entertaining book: What happened to Bagehot's bank? The answer: Stuckey's was taken over by another bank called Parr's in 1909. Parr's was part of the larger National Westminster Bank, which was acquired by the Royal Bank of Scotland in 2000. The R.B.S., as it is called somewhat undercooled in Great Britain, grew through takeovers and in the early years of this century became the largest company in the world, measured by the size of its balance sheet.
The knowledge of those responsible
Then came the credit crunch and the familiar moment - in a new guise - when it turned out that things did not have the value they should have. According to its director, the world's largest bank was only "a few hours" from complete collapse. The result was a huge bailout and the nationalization of the R.B.S. at a cost of £ 45 billion to the UK taxpayer. Not much about this story would have surprised John Law or Walter Bagehot. But perhaps both - the man who nearly bankrupted a country, as well as the top bank bailout - would be amused at how little we learned. And regarding the question of what to do with the bankers responsible for the crash, Kublai Khan might have had one or the other idea.
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