ECON120: Monetary History

After a second layer of money emerged, governments moved to take control of the pivotal position between the first and second layers. In the seventeenth and eighteenth centuries, the Bank of Amsterdam and Bank of England inserted themselves into the money pyramid, giving their governments unprecedented power over the peoples' monetary affairs. By mandating the use of their own second- layer monies, governments and their new central bank charters removed the ability for people to have freedom of currency denomination. Governments and currencies are inextricably linked today because governments established a monopoly on second-layer money and used it to their own benefit, starting with the Bank of Amsterdam in 1609. When examining these two central banks that invented practically every aspect of what we today think of as central banking, it is essential to consider to what degree their monetary innovations served only to advance the agenda of their governments. These banks also gave us a look at what it meant to issue what the rest of the world considered to be its reserve currency. Central banks, world reserve currencies, and the arrival of third-layer money will be explored further in this chapter.

Instant Settlement

The Bank of Amsterdam (BoA) was only created thanks to the world's first joint-stock company, the Dutch East India Company (Vereenigde Oostindische Compagnie, or VOC). The VOC's tale begins in 1585 when the Dutch swiftly ended Antwerp's position as the center of international trade by closing off the Scheldt River and blocking access to the sea. The blockade occurred amidst the Dutch Revolt, an eighty- year struggle for Dutch freedom from the Spanish monarchy. Politically motivated, the Dutch Revolt is credited with inspiring a shift away from monarchy toward more representative forms of government in England, France, and the United States of America. The revolt resulted in the formation of the United Provinces of the Netherlands, commonly called the Dutch Republic. The founding of this new republic preceded a financial centralization that changed the face of money and business forever. The next century of the money market and all of finance concentrated in Amsterdam.

At the turn of the seventeenth century, Dutch traders were commissioning ships to the Indonesian island of Java in order to buy spices and sell them back in Europe at handsome profits. Profits attracted additional entrepreneurs, and soon a collective of international merchants started to identify with each other. Subsequent pursuits of cinnamon and ginger led to deeper profits, and soon these merchants realized their efforts could greatly multiply by joining forces and attracting capital as a unified body. The result was the first ever joint-stock company formed in 1602, the VOC. We take it for granted today, but the VOC was the first example of equity investors providing capital in exchange for a share of ownership in the form of a paper certificate. The Dutch government gave the VOC a monopoly on trade in Asia as well as the authority to hire troops and wage war on its mission to extract profit from foreign trade. The company's ability to pool capital gave it leverage to compound on its trading success. Shares in the VOC were extremely sought- after assets. As the shares increased in value, original investors wanted to realize gains by selling them for cash to new investors, and that is how the first stock market was born. The Amsterdam Bourse, named after its predecessor in Antwerp, was founded shortly after the first signs of a market for VOC shares. It was created by the VOC itself in order to facilitate the exchange of its shares on a secondary market, and with it came the ability to surveil all trading activity. Creating the Bourse allowed the VOC to observe, under its own roof, the trafficking of its shares.

The inception of the stock market led to an enormous increase in financial transactions, which demanded a settlement mechanism superior to anything that then existed. As general interest in VOC shares increased, trading increased. All share sales were simultaneous purchases of money, but what money would shareholders accept in return? They would demand cash, but accepting a bag full of random gold and silver coins wouldn't be conducive to a smoothly functioning  exchange. Up to a thousand different types of coinage circulated in the new international trade hub of Amsterdam, a monetary situation too cumbersome for a city with the world's first stock market. A monetary instrument was desperately desired for payment and settlement for all these trading transactions. In 1609, the Bank of Amsterdam, or Wisselbank, was founded as an organic progression of financial institutions following the rise of the Amsterdam Bourse; the circulation of VOC shares necessitated an advancement in the settlement of money. Using the unit of account guilder, also called the Dutch florin, the Bank of Amsterdam launched a platform for free and instant settlement for all its depositors. The newly formed Dutch Republic needed its own second-layer money to support its ragingly successful colonial venture.

The BoA's first order of business was to outlaw cashiers and their notes and mandate all gold and silver coins throughout the city be deposited at the bank. Cashiers, until their activities were made illegal, were the money changers of Amsterdam. They held custody of gold and silver coins and issued paper claims against it. Cashiers were the principal actors between first- and second-layer money in Amsterdam, so in order for the BoA to attract capital, it had to do so by decree. All cashiers were forced to surrender precious metal to the Bank of Amsterdam and were issued BoA deposits in return. Cashiers were allowed to reopen business years after their ban but were only allowed to have possession of coins for a single day before being required to deposit them at the Bank of Amsterdam. The BoA was able to successfully monopolize the issuance of second-layer money by eliminating public access to first-layer money.

The BoA's deposits became a preferred money through- out Europe, especially due to Amsterdam's status as the inter- national hub of commerce. The VOC's commodity conquests in Asia and the subsequent popularity of its groundbreaking joint-stock corporate structure unleashed a flood of capital into the city. This enabled the first true innovation of the Bank of Amsterdam: its ability to effect instant transfers among its depositors. For transactions small and large, transfers between BoA depositors became thoroughly frictionless. In order to increase the likelihood of use, the BoA didn't charge a fee for internal transfers. Transfers also did not require any exchange of coins or paper. They were solely Bank of Amsterdam accounting ledger adjustments. This all meant that with a growing number of denomination subscribers from within and outside of the Netherlands, money transfers became unimaginably easy when compared to using coins or even paper. Due to the innovation of instant settlement on the second layer of money, the Bank of Amsterdam was the first central bank, because by law the bank was central to all money dealings. The task of clearance, or settling transfers between depositors, was the foundation of central banking. The Bank of Amsterdam was a regulatory response to stock trading and a way for the government to monitor every single transaction taking place amongst its depositors. It had absolute financial surveillance over the economy because it centrally routed all of its transactions and gained a purview into the financial relationships between its patrons.

Demand for the BoA's denomination grew from around Europe while Amsterdam elevated its position as the continent's axis of capital. The guilder was considered the world reserve currency during the seventeenth century because merchants and businesses from all over Europe held it in reserve due to uncompromising trust in its issuer. Its status as world reserve currency lasted well into the eighteenth century.

 

Privileged Lending

On the Bank of Amsterdam's agenda was more than just a subtle advance in financial settlement. A closer examination suggests that the VOC positioned itself at the top of the money pyramid in order to extract power and resources. Shortly after its founding, the Bank of Amsterdam lent money to the VOC and classified the loans as assets on its balance sheet, a standard double-entry accounting practice. The BoA credited the VOC with deposits, essentially creating money and issuing it to a borrower of privilege. These loans landed right alongside gold and silver coins on the first layer of money. The VOC's creditworthiness existed on par to precious metal itself. The money created on the second layer was fractionally reserved because its corresponding first-layer asset was a loan to the VOC instead of precious metal deposited at the Bank of Amsterdam. In Figure 6, take a look at the money pyramid under the influence of the Bank of Amsterdam, portraying loans to the VOC on the first layer of money. This was a critical moment for the evolution of layered money; for the first time ever, precious metals weren't alone atop the money pyramid.

Figure 6

With a monopolization of the second layer, the BoA eventually eliminated the ability to withdraw precious metal altogether yet managed to maintain the public's trust in its second-layer money. The significance of this cannot be understated. By suspending convertibility to first-layer money, the Bank of Amsterdam proved that precious metal wasn't necessarily required to operate a monetary and financial system. It depended on its own disciplinary constraint to stay sufficiently reserved, and more importantly it depended on the peoples' trust in that discipline. People of Europe did trust that the Bank of Amsterdam was properly reserved and didn't issue deposits in egregious excess of its holdings of precious metal, and that trust underpinned demand for BoA deposits as money.

The Bank of Amsterdam was able to suspend convertibility by inventing another hallmark of modern-day central banking called open market operations, market activities by the BoA to ensure a consistent and liquid market for its deposits. By maintaining a healthy market between its deposits and other high-quality forms of cash, the BoA was able to support the value of its liabilities without ever having to surrender precious metal. This potent and unprecedented combination of instant settlement, privileged lending, and convertibility suspension had astronomic implications for the future of finance and directly influenced the creation of the Bank of Amsterdam's successor as issuer of the world's reserve currency, the Bank of England.

Bank of England

Another revolt against an unfavored monarchy preceded the Bank of England's creation. The Glorious Revolution of 1688 replaced the Catholic monarch James II with his Protestant daughter Mary and her Dutch husband, William of Orange. Although not a full transition from monarchy to republic like in the Netherlands, the Glorious Revolution in England significantly shifted power away from the monarchy toward Parliament. English jealously of and admiration for Dutch representative government and financial prowess led to a comprehensive overhaul, modernization, and centralization of the English financial system.

Nothing about the money market was centralized in England in those days. Goldsmiths fulfilled all the major roles of banking and mirrored a lot of the activity of Antwerp's first money market traders. English goldsmiths issued deposits, circulated notes, and discounted bills. The need to finance a war eventually drove the English crown to replace this decentralized system by capturing the role of sole actor between the first and second layer of money.

The English navy had freshly suffered a crushing defeat at the hands of the French and in its effort to rebuild, the government borrowed money by issuing debt. In 1694, the Bank of England (BoE was created with the express purpose to purchase these new government bonds, and the next great central bank was born. The government and BoE drew from the privileged lending precedent set by the VOC and Bank of Amsterdam and utilized the issuance of second-layer money.

The Bank of England was additionally tasked with taking custody of precious metal, issuing deposits, effecting transfers between depositors, and circulating notes as cash. Most importantly, the BoE discounted bills of exchange and increased liquidity in the London money market. Unlike Amsterdam's monopoly on second-layer money, London was more friendly to competing versions of paper money, and the BoE's willingness and ability to discount bills when liquidity was needed the most would eventually set it apart as the archetype of central banking today.

The Gold Standard

Pound sterling has been the currency denomination of England since 1158 when King Henry introduced a silver coin of 92.5% purity. The currency represented a weight in silver until England started minting a gold coin in 1663 called guinea, which was named after the part of West Africa from which the gold was mined. The guinea subjected the pound to the plaguing complications of bimetallism when both the guinea and the English silver coin called shilling carried official values in pounds. But shortly after the creation of the Bank of England, English mathematician and physicist Sir Isaac Newton as Master of the Mint permanently altered the course of bimetallism around the world by setting a new exchange rate between gold guineas and silver shillings in 1717. Newton studied the fl ow of gold and silver throughout Europe and the exchange rates set forth in other countries' bimetallic standards, specifically France, the Netherlands, and Germany. He used his findings to determine a new exchange rate between gold and silver he thought to be more representative of each metal's intrinsic value. The new exchange rate made it profitable for arbitrageurs to export silver and import gold, and before long silver stopped being used as money in England. Newton's alteration, whether premeditated or accidental, eventually brought the world under one money pyramid with only gold at the top.

Figure 7

Although silver was driven from usage in England shortly after Newton's alteration, it took over a century for a full gold standard, with which the pound became valued only in gold, to become law. England's gold standard reverberated throughout the world and eventually pulled every major country's currency into the same sphere. Figure 7 shows a layered interpretation of the international gold standard around the beginning of the twentieth century.

The Third Layer of Money

Up until now, we have extensively examined the relationship between the first and second layer of money and the financial actors that have come between them, but now we must add another layer to our framework for understanding monetary systems. Bills of exchange, from earlier examples of money pyramids, were second-layer monetary instruments that were promises to pay first-layer gold. During the Bank of England era, however, bills were promises not to pay gold but to pay pounds and therefore existed on the third layer of money. In this book we'll use the term "private sector" to describe banks, businesses, and entrepreneurs that are non-government entities. In Figure 8, we can see the private sector issues promises to pay second-layer money, placing it one layer below the Bank of England in the hierarchy of balance sheets. Liabilities of the private sector therefore exist on the third layer of money. In Figure 9, the traditional balance sheet representation is also included to orient you to the new three-layer model. Third-layer money isn't necessarily subject to more abuse than second-layer money, but it is in fact further away from the safety of a counterparty-free asset like gold coins. For example, if an Englishwoman feared her bank to be in a jeopardized financial position and wanted gold coins instead of third-layer bank deposits, she would require two transactions. She'd have to convert her deposits into BoE notes before converting those notes into gold. If she owned second-layer BoE notes, she would transact only once to secure the desired gold coins.

 Even though the Bank of Amsterdam laid the frame-work for central banking, the Bank of England would eventually establish the central banking model for the world. It didn't come easily or from inception. The BoE's initial charter, issued in 1694, only guaranteed it a life of eleven years. When each charter expired, negotiations were held between the BoE and the government. In the negotiations, the government's primary concern was always to finance its spending, and the BoE's motivation was to increase its share price due to the fact that it had private shareholders motivated by profit. The BoE's shares usually appreciated sizably after charter renewals, as each one granted an extension of monetary power.

Figure 8

Figure 9

In the charter renewal of 1742, the BoE cemented its monopoly specifically over note issuance in England. The private sector was no longer allowed to issue second-layer notes that promised to pay the bearer gold on demand, relegating the private sector permanently to the third layer of money. The BoE faced several more charter renewals and legislation changes before finally achieving permanent status in 1844.

Elasticity and Fragility

Let's see how the elasticity of money increases as we travel lower in layers. On the second layer of money, Bank of England notes are elastic because they are fractionally reserved; they are issued in excess of the gold held in the BoE vault. This elasticity is compounded when the private sector issues deposits that promise to pay BoE notes, and those deposits themselves are only fractionally reserved by said notes. As the pyramid of money grows, lower layers in the pyramid have the most elasticity but also the most fragility as a by-product. With the backdrop of money elasticity, we can look at how the Bank of England dealt with financial panics, or the act of people scrambling up the money pyramid in order to secure more qualitatively certain forms of money.

Lender of Last Resort

Bank of England notes were demanded as cash because of their ascribed convertibility to gold coin and the creditworthiness of the sovereign. Nevertheless, the notes were still second-layer money, and the distinction between BoE notes and gold became accentuated during a particular financial crisis. The Panic of 1796, triggered by the bursting of a land bubble across the Atlantic in the newly formed United States of America, resulted in a wave of British defaults and eventually a run on the Bank of England's gold deposits. This rush out of second-layer money into first-layer gold coins would have utterly depleted the Bank of England of its gold if not for the Bank Restriction Act of 1797. The act suspended gold convertibility for all BoE notes, a suspension which lasted for over two decades. Financial panics like this one were guaranteed in a money pyramid constructed with elasticity and in a fractionally reserved manner. But the Bank of England swatted away gold's attempt to provide discipline and sent a strong message that its second-layer money could stand on its own. The fact that the BoE's liabilities could stand tall without convertibility implied that in a crisis, it could use its power to create second-layer money without undermining the currency denomination or risk losing its precious metal holdings.

The Bank of England had a way to protect its possession of gold, but it also needed a way to face crises starting in the third layer of money, for example if private sector bills of exchange suddenly lost liquidity in the money market. The BoE was willing and able to provide liquidity to the bill market by actively discounting paper that otherwise would struggle to find a price floor in crisis. In any such panic, it had to act as the ultimate backstop in an elastic system if the currency denomination were to survive.

In 1873, famed British writer and founder of the Economist magazine Walter Bagehot wrote a seminal book called Lombard Street: A Description of the Money Market that demystified how the bill market worked, and how the Bank of England should be operated in order to ensure it assuages crises. Bagehot's book is primarily cited for nominating central banks as the "lender of last resort" within a financial system. His solution was for the Bank of England to lend cash freely against creditworthy bills at punitive yet reasonable interest rates:

Financial crises during the era corresponded with sudden surges in the demand for cash, whereupon those either issuing or holding third-layer money required liquidity in the form of second-layer Bank of England notes. When the demand for cash swelled, Bagehot explained that second- layer money must be created by the central bank in order to satisfy that demand. It should fl ex its power of elasticity while still maintaining discipline in order not to encourage moral hazard, which occurs when a financial institution takes on excessive risk because it anticipates being rescued by the government or central bank if its financial position sours. The BoE would provide liquidity by discounting bills they deemed to be temporarily in need of support, not bills that were destined for default regardless of the financial climate. If elasticity wasn't flexed when needed, a cascade of defaults could ripple through the third layer of money. He concluded that the central bank must ultimately create second-layer money in abundance when the system needs it most, underpinning the modus operandi of central banking ever since. The power to create money came with the responsibility, when necessary, to do whatever it took to preserve the currency denomination. The pound sterling spent the nineteenth century as the world reserve currency as other nations procured it as a savings vehicle due to the British Empire's stature and stability. As the Empire expanded to cover half the Earth's surface, the Bank of England faced the enormous challenge of maintaining a domestic denomination used by participants around the world. Pound sterling wouldn't be the last currency to suffer from this conundrum. Across the Atlantic, the next world reserve currency was waiting in the wings.