Mountains of Debt (part II)

It was not only the Italian city-states that contributed to the rise of the bond market. In Northern Europe, too, urban polities grappled with the problem of financing their deficits without falling foul of the Church. Here a somewhat different solution was arrived at. Though they prohibited the charging of interest on a loan (mutuum), the usury laws did not apply to the medieval contract known as the census, which allowed one party to buy a stream of annual payments from another. In the thirteenth century, such annuities started to be issued by northern French towns like Douai and Calais and Flemish towns like Ghent. They took one of two forms: rentes heritables or erfelijkrenten, perpetual revenue streams which the purchaser could bequeath to his heirs, or rentes viagères or lijfrenten, which ended with the purchaser's death. The seller, but not the buyer, had the right to redeem the rente by repaying the principal. By the mid sixteenth century, the sale of annuities was raising roughly 7 per cent of the revenues of the province of Holland.

Both the French and Spanish crowns sought to raise money in the same way, but they had to use towns as intermediaries. In the French case, funds were raised on behalf of the monarch by the Paris hôtel de ville-, in the Spanish case, royal juros had to be marketed through Genoa's Casa di San Giorgio (a private syndicate that purchased the right to collect the city's taxes) and Antwerp's heurs, a forerunner of the modern stock market. Yet investors in royal debt had to be wary. Whereas towns, with their oligarchical forms of rule and locally held debts, had incentives not to default, the same was not true of absolute rulers. As we saw, the Spanish crown became a serial defaulter in the late sixteenth and seventeenth centuries, wholly or partially suspending payments to creditors in 1557, 1560, 1575 , 1596, 1607, 1627, 1647, 1652 and 1662.

Mountains of Debt (part I)

'War', declared the ancient Greek philosopher Heraclitus, 'is the father of all things.' It was certainly the father of the bond market. In Pieter van der Heyden's extraordinary engraving, The Battle about Money, piggy banks, money bags, barrels of coins, and treasure chests - most of them heavily armed with swords, knives and lances - attack each other in a chaotic free-for-all. The Dutch verses below the engraving say: 'It's all for money and goods, this fighting and quarrelling.' But what the inscription could equally well have said is: 'This fighting is possible only if you can raise the money to pay for it.' The ability to finance war through a market for government debt was, like so much else in financial history, an invention of the Italian Renaissance.

Of Human Financial Bondage

Early in Bill Clinton's first hundred days as president, his campaign manager James Carville made a remark that has since become famous. "I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter," he told the Wall Street Journal. "But now I want to come back as the bond market. You can intimidate everybody." Rather to his surprise, bond prices had risen in the wake of the previous November's election, a movement that had actually preceded a speech by the president in which he pledged to reduce the federal deficit. 'That investment market, they're a tough crowd,' observed Treasury Secretary Lloyd Bentsen. 'Is this a credible effort [by the president] ? Is the administration going to hang in there pushing it? They have so judged it.' If bond prices continued to rally, said Federal Reserve Chairman Alan Greenspan, it would be 'by far the most potent [economic] stimulus that I can imagine.'1 What could make public officials talk with such reverence, even awe, about a mere market for the buying and selling of government IOUs?

Bankrupt Nation (II)

Before we can answer these questions properly, we need to introduce the other key components of the financial system: the bond market, the stock market, the insurance market, the real estate market and the extraordinary globalization of all these markets that has taken place over the past twenty years. The root cause, however, must lie in the evolution of money and the banks whose liabilities are its key component. The inescapable reality seems to be that breaking the link between money creation and a metallic anchor has led to an unprecedented monetary expansion - and with it a credit boom the like of which the world has never seen. Measuring liquidity as the ratio of broad money to output* over the past hundred years, it is very clear that the trend since the 1970s has been for that ratio to rise - in the case of broad money in the major developed economies from around 70 per cent before the closing of the gold window to more than 100 per cent by 2005.

 (NB* A ratio known to economists as Marshallian k after the economist Alfred Marshall. Strictly speaking, k is the ratio of the monetary base to nominal GDP.)

In the eurozone, the increase has been especially steep, from just over 60 per cent as recently as 1990 to just under 90 per cent today. At the same time, the capital adequacy of banks in the developed world has been slowly but steadily declining. In Europe bank capital is now equivalent to less than 10 per cent of assets, compared with around 25 per cent at the beginning of the twentieth century. In other words, banks are not only taking in more deposits; they are lending out a greater proportion of them, and minimizing their capital base.

Bankrupt Nation (I)

Memphis, Tennessee, is famous for blue suede shoes, barbecues and bankruptcies. If you want to understand how today's bankers - the successors to the Medici - deal with the problem of credit risk created by unreliable borrowers, Memphis surely is the place to be.

On average, there are between one and two million bankruptcy cases every year in the United States, nearly all of them involving individuals who elect to go bust rather than meet unmanageable obligations. A strikingly large proportion of them happen in Tennessee. The remarkable thing is how relatively painless this process seems to be - compared, that is, with what went on in sixteenth-century Venice or, for that matter, some parts of present-day Glasgow. Most borrowers who run into difficulties in Memphis can escape or at least reduce their debts, stigma-free and physically unharmed. One of the great puzzles is that the world's most successful capitalist economy seems to be built on a foundation of easy economic failure.

The Evolution of Banking (II)

In this process an especially important role was played by the new savings banks that proliferated at the turn of the century. By 1913 British savings bank deposits amounted to £256 million, roughly a quarter of all UK deposits. The assets of German savings banks were more than two and a half times greater than those of the better known 'great banks' like Darmstàdter, Deutsche, Dresdner and the Disconto-Gesellschaft. All told, by the eve of the First World War, residents' deposits in British banks totalled nearly £ 1.2 billion, compared with a total banknote circulation of just £45.5 million. Money was now primarily inside banks, out of sight, even if never out of mind.

Although there was variation, most advanced economies essentially followed the British lead when it came to regulation through a monopolistic central bank operating the gold standard, and concentration of deposit-taking in a relatively few large institutions. The Banque de France was established in 1800, the German Reichsbank in 1875, the Bank of Japan in 1882 and the Swiss National Bank in 1907. In Britain, as on the Continent, there were marked tendencies towards concentration, exemplified by the decline in the number of country banks from a peak of 755 in 1809 to just seventeen in 1913.

The Evolution of Banking (I)

Financial historians disagree as to how far the growth of banking after the seventeenth century can be credited with the acceleration of economic growth that began in Britain in the late eighteenth century and then spread to Western Europe and Europe's offshoots of large-scale settlement in North America and Australasia. There is no question, certainly, that the financial revolution preceded the industrial revolution. True, the decisive breakthroughs in textile manufacturing and iron production, which were the spearheads of the industrial revolution, did not rely very heavily on banks for their financing. But banks played a more important role in continental European industrialization than they did in England's. It may in fact be futile to seek a simplistic causal relationship (more sophisticated financial institutions caused growth or growth spurred on financial development). It seems perfectly plausible that the two processes were interdependent and self-reinforcing. Both processes also exhibited a distinctly evolutionary character, with recurrent mutation (technical innovation), speciation (the creation of new kinds of firm) and punctuated equilibrium (crises that would determine which firms would survive and which would die out).

The Birth of Banking (IV) - Practice of Fractional Reserve

To understand the power of these three innovations, first-year MBA students at Harvard Business School play a simplified money game. It begins with a notional central bank paying the professor $100 on behalf of the government, for which he has done some not very lucrative consulting. The professor takes the banknotes to a bank notionally operated by one of his students and deposits them there, receiving a deposit slip. Assuming, for the sake of simplicity, that this bank operates a 10 per cent reserve ratio (that is, it wishes to maintain the ratio of its reserves to its total liabilities at 10 per cent), it deposits $ 10 with the central bank and lends the other $90 to one of its clients. While the client decides what to do with his loan, he deposits the money in another bank. This bank also has a 10 per cent reserve rule, so it deposit $9 at the central bank and lends out the remaining $81 to another of its clients. After several more rounds, the professor asks the class to compute the increase in the supply of money. This allows him to introduce two of the core definitions of modern monetary theory: M0 (also known as the monetary base or high-powered money), which is equal to the total liabilities of the central bank, that is, cash plus the reserves of private sector banks on deposit at the central bank; and M1 (also known as narrow money), which is equal to cash in circulation plus demand or 'sight' deposits. By the time money has been deposited at three different student banks, M0 is equal to $100 but M1 is equal to $ 271 ($100 + $90 + $81), neatly illustrating, albeit in a highly simplified way, how modern fractional reserve banking allows the creation of credit and hence of money.

The Birth of Banking (III)

The subjugation of the Florentine republic to the power of one super-rich banking family inevitably aroused opposition. Between October 1433 and September 1434 Cosimo and many of his supporters were exiled from Florence to Venice. In 1478 Lorenzo's brother Giuliano was murdered in the Pazzi family's brutal attempt to end Medici rule. The bank itself suffered as a result of Lorenzo's neglect of business in favour of politics. Branch managers like Francesco Sassetti of Avignon or Tommaso Portinari of Bruges became more powerful and less closely supervised. Increasingly, the bank depended on attracting deposits; its earnings from trade and foreign exchange grew more volatile.

Expensive mistakes began to be made, like the loans made by the Bruges branch to Charles the Bold, the Duke of Burgundy, or by the London branch to King Edward IV, which were never wholly repaid. To keep the firm afloat, Lorenzo was driven to raid the municipal Monte delle Dote (a kind of mutual fund for the payment of daughters' dowries). Finally, in 1494, amid the chaos of a French invasion, the family was expelled and all its property confiscated and liquidated. Blaming the Medici for the town's misfortunes, the Dominican preacher Girolamo Savonarola called for a purgative 'Bonfire of the Vanities', a call answered when a mob invaded the Medici palace and burned most of the bank's records. (Black scorch marks are still visible on the papers that survived.) As Lorenzo himself had put it in a song he composed in the 1470s: Tf you would be happy, be so. There is no certainty about tomorrow.

The Birth of Banking (II)

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.

The libro segreto - literally the secret book* - of Giovanni di Bicci de' Medici sheds fascinating light on the family's rise.

(NB * The term was used for books which recorded income and profits as well as specific agreements or contracts of importance. The other books kept by the Medici were the libro di entrata e uscita (book of income and expenditures) and the libro dei debitori e creditori (book of debtors and creditors)). 

The Birth of Banking (I)

Shylock was far from the only moneylender to discover the inherent weakness of the creditor, especially when the creditor is a foreigner. In the early fourteenth century, finance in Italy had been dominated by the three Florentine houses of Bardi, Peruzzi and Acciaiuoli. All three were wiped out in the 1340s as a result of defaults by two of their principal clients, King Edward III of England and King Robert of Naples. But if that illustrates the potential weakness of moneylenders, the rise of the Medici illustrates the very opposite: their potential power.

Perhaps no other family left such an imprint on an age as the Medici left on the Renaissance. Two Medici became popes (Leo X and Clement VII); two became queens of France (Catherine and Marie); three became dukes (of Florence, Nemours and Tuscany). Appropriately, it was that supreme theorist of political power, Niccolô Machiavelli, who wrote their history. Their patronage of the arts and sciences ran the gamut of genius from Michelangelo to Galileo. And their dazzling architectural legacy still surrounds the modern-day visitor to Florence. Only look at the villa of Cafaggiolo, the monastery of San Marco, the basilica of San Lorenzo and the spectacular palaces occupied by Duke Cosimo de' Medici in the mid sixteenth century: the former Pitti Palace, the redecorated Palazzo Vecchio and the new city offices (Uffizi) with their courtyard running down to the River Arno.

But what were the origins of all this splendour? Where did the money come from that paid for masterpieces like Sandro Botticelli's radiant Birth of Venus? The simple answer is that the Medici were foreign exchange dealers: members of the Arte de Cambio (the Moneychangers' Guild). They came to be known as bankers (banchieri) because, like the Jews of Venice, they did their business literally seated at benches behind tables in the street. The original Medici bank (stall would be a better description) was located near the Cavalcanti palace, at the corner of the present-day via dia Porta Rossa and the Via dell' Arte della Lana, a short walk from the main Florentine wool market.

Prior to the 1390s, it might legitimately be suggested, the Medici were more gangsters than bankers: a small-time clan, notable more for low violence than for high finance. Between 1343 and 1360 no fewer than five Medici were sentenced to death for capital crimes. Then came Giovanni di Bicci de' Medici. It was his aim to make the Medici legitimate. And through hard work, sober living and careful calculation, he succeeded.

In 1385 Giovanni 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.

But Giovanni clearly saw even greater opportunities in his native Florence, whence he returned in 1397. By the time he passed on the business to his eldest son Cosimo in 1420, he had established a branch of the bank in Venice as well as Rome; branches were later added in Geneva, Pisa, London and A vignon. Giovanni had
also acquired interests in two Florence wool factories.

to be continued...

Loan Sharks (III)

Though fictional, the story of Shylock is therefore not entirely removed from Venetian reality. Indeed, Shakespeare's play quite accurately illustrates three important points about early modern money-lending: the power of lenders to charge extortionate interest rates when credit markets are in their infancy; the importance
of law courts in resolving financial disputes without recourse to violence; but above all the vulnerability of minority creditors to a backlash by hostile debtors who belong to the ethnic majority. For in the end, of course, Shylock is thwarted. Although the court recognizes his right to insist on his bond - to claim his pound of flesh - the law also prohibits him from shedding Antonio's blood. And, because he is an alien, the law requires the loss of his goods and life for plotting the death of a Christian. He escapes only by submitting to baptism. Everyone lives happily ever after - except Shylock.

The Merchant of Venice raises profound questions about economics as well as anti-Semitism. Why don't debtors always default on their creditors - especially when the creditors belong to unpopular ethnic minorities? Why don't the Shylocks always lose out?

Loan Sharks (II)

That is precisely why anyone who lends money to a merchant, if only for the duration of an ocean voyage, needs to be compensated. We usually call the compensation interest: the amount paid to the lender over and above the sum lent, or the principal. Overseas trade of the sort that Venice depended on could not have happened if its financiers had not been rewarded in some way for risking their money on mere boards and men.

But why does Shylock turn out to be such a villain, demanding literally a pound of flesh - in effect Antonio's death - if he cannot fulfil his obligations? The answer is of course that Shylock is one of the many moneylenders in history to have belonged to an ethnic minority. By Shakespeare's time, Jews had been providing commercial credit in Venice for nearly a century. They did their business in front of the building once known as the Banco Rosso, sitting behind their tables - their tavule - and on their benches, their band. But the Banco Rosso was located in a cramped ghetto some distance away from the centre of the city.

There was a good reason why Venetian merchants had to come to the Jewish ghetto if they wanted to borrow money. For Christians, lending money at interest was a sin. Usurers, people who lent money at interest, had been excommunicated by the Third Lateran Council in n 79. Even arguing that usury was not a sin had been condemned as heresy by the Council of Vienna in 1311-12 . Christian usurers had to make restitution to the Church before they could be buried on hallowed ground. They were especially detested by the Franciscan and Dominican orders, founded in 1206 and 1216 (just after the publication of Fibonacci's
Liber Abaci). The power of this taboo should not be underestimated, though it had certainly weakened by Shakespeare's time.

Loan Sharks (I)

Northern Italy in the early thirteenth century was a land subdivided into multiple feuding city-states. Among the many remnants of the defunct Roman Empire was a numerical system (i, ii, iii, iv . . . ) singularly ill-suited to complex mathematical calculation, let alone the needs of commerce. Nowhere was this more of a problem than in Pisa, where merchants also had to contend with seven different forms of coinage in circulation. By comparison, economic life in the Eastern world - in the Abassid caliphate or in Sung China - was far more advanced, just as it had been in the time of Charlemagne. To discover modern finance, Europe needed to import it. In this, a crucial role was played by a young mathematician called Leonardo of Pisa, or Fibonacci. The son of a Pisan customs official based in what is now Bejaia in Algeria, the young Fibonacci had immersed himself in what he called the 'Indian method' of mathematics, a combination of Indian and Arab insights. His introduction of these ideas was to revolutionize the way Europeans counted. Nowadays he is best remembered for the Fibonacci sequence of numbers (o, i , i , 2, 3, 5, 8, 1 3 , 21 . . .), in which each successive number is the sum of the previous two, and the ratio between a number and its immediate antecedent tends towards a 'golden mean' (around 1.618). It is a pattern that mirrors some of the repeating properties to be found in the natural world (for example in the fractal geometry of ferns and sea shells).*

(NB * The Fibonacci sequence appears in The Da Vinci Code, which is probably why most people have heard of it. However, the sequence first appeared, under the name mâtrâmeru (mountain of cadence), in the work of the Sanskrit scholar Pingala.)

The Money Mountain (V)

The central relationship that money crystallizes is between lender and borrower. Look again at those Mesopotamian clay tablets. In each case, the transactions recorded on them were repayments of commodities that had been loaned; the tablets were evidently drawn up and retained by the lender (often in a sealed clay container) to record the amount due and the date of repayment. 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 per cent. Mathematical exercises from the reign of Hammurabi (1792 - 1750 BC) suggest that something like compound interest could be charged on long-term loans. But the foundation on which all of this rested was the underlying credibility of a borrower's promise to repay. (It is no coincidence that in English the root of 'credit' is credo, the Latin for 'I believe'.) Debtors might periodically be relieved - indeed the Laws of Hammurabi prescribed debt forgiveness every three years - but this does not appear to have deterred private as well as public lenders from doing business in the reasonable expectation of getting their money back. On the contrary, the long-term trend in ancient Mesopotamia was for private finance to expand. By the sixth century BC, families like the Babylonian Egibi had emerged as powerful landowners and lenders, with commercial interests as far afield as Uruk over a hundred miles to the south and Persia to the east. The thousands of clay tablets that survive from that period testify to the number of people who at one time or another were in debt to the Egibi. The fact that the family thrived for five generations suggests that they generally collected their debts.