ECON120: Monetary History

Disciplinary Constraint

The most important characteristic of the first layer of money is the disciplinary constraint it applies to layers underneath it. Here's an example. Goldsmiths in fifteenth century England weren't meager craftsmen. They also fulfilled the role of banker because of their ability to securely store precious metals better than anybody else. Let's say that an English gold- smith issues a piece of paper called a deposit for each gold coin he agrees to store. If all deposit holders suddenly ask for their gold coins back, he will easily satisfy the redemption requests because his deposits are fully reserved, meaning there is a one-to-one relationship between gold coins and gold deposits.

Let's take this opportunity to introduce the word cash. Monetary instruments like the gold deposits issued by trusted and reputable goldsmiths often functioned as cash. Cash is defined by anything we use as a form of money that others accept at face value, even if it's a bare piece of paper with counterparty risk and no guarantee of final payment. For something to work as cash, people have to trust the issuer, or whoever has made the promise to pay.

Back to the goldsmith. Let's say his deposits gain credibility and start circulating as cash because people trust that they are redeemable for gold. He gets greedy and decides to capitalize on his newfound trustworthiness. He issues gold deposits to himself without properly reserving the corresponding gold in his vault and spends these deposits as cash into circulation. The goldsmith will then default if ever faced with a full redemption request. This type of activity is called fractional reserve banking, as opposed to full reserve banking when all deposits have corresponding gold in a vault. Gold exists as the goldsmith's disciplinary constraint, serving as motivation not to abuse the power of money creation that comes with the public's confidence in his deposits as a form of cash. Second-layer money is therefore inherently unstable, as the power to create it will always be subject to human abuse, similar to our example of the English goldsmith who abused the public's confidence in his creditworthiness.

The hierarchy of money is dynamic, meaning that it's a set of relationships in constant flux. When credit is expanding, the money pyramid expands as the second layer grows in size. When confidence runs high, a gold coin and a gold deposit have almost no observable difference. People freely accept gold certificates as money because they trust the issuer's ability to satisfy redemption. Certificates result in convenience, as final settlement of coin and bullion can be arduous, cumbersome, and potentially dangerous. This reverses when the money pyramid enters contraction and the objective difference between money and money-like instruments is suddenly pronounced. Instruments that previously had a high degree of perceived trust are no longer desired, and their owners dump them for instruments higher in the hierarchy, such as gold coins. Contractions can result in redemption requests, called bank runs, and eventually financial crises. These crises can be more easily thought of as attempts to climb the pyramid of money, as holders of lower-layer money scramble to secure a superior, higher-layer form of money.

The Clearance Problem

As layered money evolved to solve problems with coin-money, new problems arose. Forms of second-layer money were all different from each other. Yet, what happened during the sixteenth century in Antwerp changed this forever: a market entirely dedicated to trading second-layer money was born. Layered money increased its velocity by bringing a tremendous advancement in the safety of its transfer: funds couldn't be lost or stolen when transferred through a banking network. Fraud and insolvency notwithstanding, the enormous reduction in shipment of coins was a huge victory for international trade. Merchant bankers sent money around the continent effortlessly by using their balance sheets and professional net- work instead of by shipping physical gold and silver coins. The amount of outright risk a business owner took in sending physical metal during this time cannot be underestimated. Piracy was rampant, and maritime insurance apparatuses were in their infancy. Increased usage of deferred settlement increased money velocity, as final settlement could be postponed indefinitely with only the balancing of debits and credits.

A flood of new banking liabilities and second-layer money introduced the issue of clearance, the process of settling transactions. No clearance system for bills of exchange existed yet. Bills weren't treated as cash due to their lack of standardization. They were promises to pay gold and silver, but they weren't fungible with each other. Customized currencies and maturity dates made each bill a static instrument that in no way resembled cash; no two bills looked alike. People weren't willing to swap letters of intent with each other because the letters' terms were all incongruent. A culture of counterparty trust hadn't yet evolved.

Slowly but surely, bill of exchange maturity dates started to gain uniformity in the fifteenth century. Dates that chronologically aligned with the European merchant fair calendar were chosen because bankers followed merchants to provide them financial services. These fairs took place throughout Europe - from France to Flanders. Merchants of cloth and silk, pepper and spices, and coins and bills gathered together seasonally to trade. The fairs were the perfect opportunity for merchant bankers from all around Europe to come and cancel out tabs with each other, or clear (as in clearance) off setting debits and credits. The fairs' seasonal patterns, however, limited bill of exchange clearance to about four sessions per annum. That meant the second layer of money traded approximately four times per year, an objectively infrequent rate of turnover.

In the end, the second layer of money lacked liquidity: it couldn't easily and readily be rendered for cash. During this interval, cash and coins were synonymous, meaning that the only form of money considered to function as cash were precious metal coins themselves. Bills of exchange didn't readily convert to precious metal unless presented to the appropriate underwriters upon their maturity date. A market where bills could change hands at prices determined by buyers and sellers on location didn't exist. Th is would all change when the market for second-layer money left a life of quarterly clearance at traveling fairs for its first year-round home in Antwerp.

A Continuous Fair

The creation of the Antwerp Bourse in 1531 revolutionized money because it birthed the money market. At the time, the money market described the market for second-layer monetary instruments such as bills of exchange, gold deposits, and other promises to pay precious metal. The word bourse came from nearby Bruges, which previously served as the hub of northern European commerce before losing its crown when English cloth merchants decided to center their trade in Antwerp in 1421. The Bruges Bourse was a quiet meeting place for financial clearance, but the Antwerp Bourse was a place for boisterous traders and became the world's first modern financial exchange. Bourse went on to become synony- mous with financial exchanges around the world; the word for "stock exchange" is bourse in French and börse in German.

Financial exchanges, like the original Antwerp Bourse, are places of trade where price discovery happens. Price discovery is exactly what it sounds like: the process by which an asset discovers its price by being bought and sold in a market. The price of an asset emerges, or is discovered, when observing transactions between buyers and sellers. If trade is allowed to freely occur, the price of anything can be discovered. Antwerp prided itself in its regulation-free environment, wherein the trade between first-layer coins and second-layer bills, and between bills themselves, didn't require licenses and wasn't subject to taxes. It was a haven for merchants from every country across Europe and was considered the center of the global economy during the sixteenth century. Merchants from Portugal, Spain, England, and Germany descended upon the hustling and bustling international trade hub. Antwerp's spring and autumn fairs featured English cloth, East Indian pepper peddled by the Portuguese, American silver peddled by the Spanish, and other German, Italian, and French trades. All this trade attracted merchant bankers and a litany of second-layer money issuance. When the Antwerp Bourse opened, it was known as the "Continuous Fair," depicting the evolution of financial clearance from seasonal to real-time.

Within the halls of the Antwerp Bourse the money market was born, a market that transitioned our understanding of cash from metal to paper. Bankers accomplished this by formalizing two major innovations in the evolution of layered money: discounting and note issuance. Bankers in the new Bourse didn't walk around juggling hundreds of coin- currencies all day. Coins were a detriment to money velocity, and only a combination of deferred settlement, accounting, and paper had the potential to bolster it. Initially, money market trading in the Antwerp Bourse occurred almost exclusively in bills of exchange. Money market traders gave bills of exchange liquidity, something they never had previously. Th is drastically increased money velocity. Before the opening of the Bourse, second-layer money was issued in quarterly increments and designed to bridge debts until the next fair. But in Antwerp, second-layer money began to develop cash-like characteristics.

Source: Nik Bhatia: Layered Money
This work is licensed under a Creative Commons Attribution-ShareAlike 4.0 License.