The first credit crisis : Roman Edition

In such an extensively monetised economy, it is hardly surprising that the Romans were also well acquainted with another familiar feature of modern finance: the credit crisis. Occasionally, the similarities with the modern age are nothing short of eerie. In AD 33, the Emperor Tiberius’ financial officials were persuaded that the recent boom in private lending had become excessive. It was decided that regulation must be tightened in order to extinguish this irrational exuberance. After a brief review of the statutes, it was discovered that none other than the father of the dynasty, Julius Caesar, had in his wisdom instituted a law many decades before specifying strict limits on how much of their patrimony wealthy aristocrats could farm out in loans.9 He had, in other words, introduced a rigorous capital adequacy requirement for lenders. The law was clear enough: but not for the first time in history, industrious lenders had proved remarkably skilled at circumventing it. Their ingenious evasions, the historian Tacitus reported, ‘though continually put down by new regulations, still, through strange artifices, reappeared’.10 Now the emperor decreed the game was up: the letter of the old dictator’s law would be enforced. The consequences were chaotic. As soon as the first ruling was made, it was realised with some embarrassment that most of the Senate was in breach of it. All the familiar features of a modern banking crisis followed. There was a mad scramble to call in loans in order to comply. Seeing the danger, the authorities attempted to soften the edict by relaxing its terms and announcing a generous transitional period. But the measure came too late. The property market collapsed as mortgaged land was fire-sold to fund repayments. Mass bankruptcy threatened to engulf the financial system. With Rome in the grip of a credit crunch, the emperor was forced to implement a massive bailout. The Imperial treasury refinanced the overextended lenders with a 100-million sesterces programme of three-year, interest-free loans against security of deliberately overvalued real estate. To the Senate’s relief, it all ended happily: ‘Credit was thus restored, and gradually private lending resumed.’

Excerpted from “Money: an unauthorized biography” by Felix Martin

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What is money?

MONEY IN AN ECONOMY WITHOUT BANKS

On 4 May 1970, a prominent notice appeared in Ireland’s leading daily newspaper, the Irish Independent, with a simple but alarming title: ‘CLOSURE OF BANKS’. The announcement – placed by the Irish Banks’ Standing Committee, a group representing all of Ireland’s main banks – informed the public that as a result of the severe breakdown in industrial relations between the banks and their employees, ‘a position has now been reached where it is impossible for the undermentioned banks to provide even the recent restricted service in the Republic of Ireland’. ‘In these circumstances it is with regret,’ the notice continued, ‘that these banks must announce the closure of all their offices in the Republic of Ireland on and from Friday, 1st May, until further notice.’

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It may come as a shock to learn that virtually the entire banking system in an advanced economy could have shut down overnight as recently as in 1970. At the time, however, this development was widely expected – not least because it had happened once before, in 1966. The matter of dispute between the banks and their employees was a familiar one in the Europe of the late 1960s: the extent to which pay was keeping up with prices. High inflation throughout 1969 – by the autumn, the cost of living had risen by more than 10 per cent over the previous fifteen months – had prompted a demand by the employees’ union for a new pay settlement. The banks had refused, and the Irish Bank Officials’ Association had voted to strike.

From the beginning, it was expected that the banks’ closure would not be short-lived, so preparations were made. The first reaction of businesses was to stockpile notes and coins. The Irish Independent reported that:

There were massive withdrawals of cash throughout the country as firms built up their reserves in anticipation of a shutdown. Insurance companies, safe dealers, and security firms are expected to do brisk business while banks remain closed. Factories and other concerns with large payrolls have arranged to obtain ready cash from large retailers such as supermarkets and department stores to meet wage bills.31

But in the first month of the crisis, it became apparent that things might not turn out quite as badly as feared. The Central Bank of Ireland had deliberately accommodated the additional demand for cash in March and April, so there were about £10 million more notes and coins in circulation in May than usual. There was an inevitable tendency for the stream of payments to give rise to gluts of small change in some places – generally shops and other retail operations – and dearths in others – usually wholesalers and public institutions which had no reason to take in cash in the course of their daily business. The Central Bank even made a vain plea to the state-owned bus company to have it distribute cash to passengers. But these blockages in the circulation of coins and notes proved a relatively minor inconvenience.

The reason was that the vast majority of payments continued to be made by cheque – in other words, by transfer from one individual’s or business’ current account to another’s – despite the fact that the banks at which these accounts were all held were shut. In its review of the whole affair, the Central Bank of Ireland noted that prior to the closure ‘some two-thirds of aggregate money holdings are in the form of credit balances on current accounts, the remainder consisting of notes and coin.’32 The critical question, therefore, was whether this ‘bank money’ would continue to circulate. For individuals in particular, there was really no other option: for any expenses in excess of the cash they had in hand when the banks shut their doors on 1 May, their only hope was to write IOUs in the form of cheques and hope that they would be accepted.

Remarkably, as the summer wore on, transactions continued to take place and cheques to be exchanged almost exactly as usual. The one difference, of course, was that none of the cheques could be submitted to the banks. Normally, this facility is what relieves sellers of most of the risk of accepting credit payments: cheques can be cashed at the end of every business day. With the banking system shut, however, cheques were for the time being just personal or corporate IOUs. Sellers who accepted them were doing so on the basis of their own assessment of buyers’ credit. The main risk, therefore, was of abuse of the improvised system. Since cheques were not being cleared, there was nothing in principle to prevent people writing cheques for amounts that they did not have. For the system to work, payees would have to take it on trust that payers’ cheques were not going to bounce – and all this when they had no clear idea when the banks would reopen and allow them to find out. The Times of London was following events over the Irish Sea with interest – and in July it noted both the extraordinary fact that nothing much seemed to have changed, and the apparent fragility of the situation. ‘Figures and trends which are available indicate that the dispute has not had an adverse effect on the economy so far,’ wrote its correspondent. ‘This has been due to a number of factors, not least of which is the prudence which business has exercised against overspending.’ But could the balancing act continue? ‘There is now, however, a psychological risk that if the dispute drags on, caution will be cast aside, particularly by smaller businesses.’33

Sure enough, cracks did begin to appear here and there. A month into the closure, there was a scare when some livestock markets announced that they would no longer accept private cheques.34 In July, a farmer from Omagh who had been convicted of smuggling seven pigs into the Republic was unable to pay the £309 fine handed down to him, for want of ready cash.35 And over the summer, the business lobby – encouraged by the banks and exasperated by the expenses they were incurring to find ways round the closure – began planting scare stories in the newspapers claiming, for example, that ‘a rapidly growing paralysis is spreading through the economy because of the banks dispute’.36 But the evidence collated by the Central Bank of Ireland once the crisis was finally resolved in November 1970 showed quite the opposite. Their review of the closure concluded not only that ‘the Irish economy continued to function for a reasonably long period of time with its main clearing banks closed for business’, but that ‘the level of economic activity continued to increase’ over the period.37 Both before and after the event, it seemed unbelievable – but somehow, it had worked: for six and a half months, in one of the then thirty wealthiest economies in the world, ‘a highly personalized credit system without any definite time horizon for the eventual clearance of debits and credits substituted for the existing institutionalized banking system’.38

In the end, the main impediment imposed by this highly successful system turned out to be logistical. By the time the banks and their employees finally reached a new pay settlement, and it was announced that the banks would reopen on 17 November 1970, an enormous volume of uncleared cheques had accumulated with individuals and businesses. Advertisements were placed in the newspapers warning customers not to submit all of them at once, and forewarning that it was unlikely that account balances would be reconciled fully for several weeks. It was another three months – until mid-February, 1971 – before matters had returned completely to normal. By then, a total of over £5 billion of uncleared cheques written during the period of the closure had been submitted for clearing. This was the money that the Irish public had made for itself while its banks were on strike.

How had this apparent miracle of spontaneous economic co-operation come to pass? The general consensus after the event was that several features of Irish social life were uniquely conducive to its success: not least, that most famous feature of all, the Irish public house. The basic challenge was that of screening the creditworthiness of those paying by unclearable cheque. Ireland had an advantage in that communities, both in the countryside and in the cities, were close-knit. Individuals had personal knowledge of most of the people they transacted with, and so were comfortable forming judgements as to their creditworthiness. But by 1970 Ireland was nevertheless a diverse and developed economy, so this could not always be the case. It was here that the Republic’s pubs and small shops came into their own, by serving as nodes in the system, collecting, endorsing, and clearing cheques like an ersatz banking system. ‘It appears,’ concluded the Irish economist Antoin Murphy, with admirable circumspection, ‘that the managers of these retail outlets and public houses had a high degree of information about their customers – one does not after all serve drink to someone for years without discovering something of his liquid resources.’39

THE HEART OF THE MATTER

The case of the Irish bank closure provides an unusually useful opportunity to understand more clearly the nature of money. Like Furness’ report from Yap, it forces us to reconsider what is essential to the functioning of a monetary system. But because the Irish case is so much closer in time and technology to our own, it is much more suitable for economic triangulation. The story of Yap showed that the conventional theory of the origins and nature of money is confused. The story of the Irish bank closure helps point the way to a more realistic alternative.

The story of Yap stripped away a central, misleading preconception about the nature of money that had bedevilled economists for centuries: that what was essential was the currency, the commodity coinage, which functioned as a ‘medium of exchange’. It showed that in a primitive economy like Yap, just as in today’s system, currency is ephemeral and cosmetic: it is the underlying mechanism of credit accounts and clearing that is the essence of money. We were left with a very different picture of the nature and origins of money from the one painted by the conventional theory. At the centre of this alternative view of money – its primitive concept, if you like – is credit. Money is not a commodity medium of exchange, but a social technology composed of three fundamental elements. The first is an abstract unit of value in which money is denominated. The second is a system of accounts, which keeps track of the individuals’ or the institutions’ credit or debt balances as they engage in trade with one another. The third is the possibility that the original creditor in a relationship can transfer their debtor’s obligation to a third party in settlement of some unrelated debt.

This third element is vital. Whilst all money is credit, not all credit is money: and it is the possibility of transfer that makes the difference. An IOU which remains for ever a contract between just two parties is nothing more than a loan. It is credit, but it is not money. It is when that IOU can be passed on to a third party – when it is able to be ‘negotiated’ or ‘endorsed’, in the financial jargon – that credit comes to life and starts to serve as money.Money, in other words, is not just credit – but transferable credit. As the nineteenth-century economist and lawyer Henry Dunning Macleod put it:

These simple considerations at once shew the fundamental nature of a Currency. It is quite clear that its primary use is to measure and record debts, and to facilitate their transfer from one person to another; and whatever means be adopted for this purpose, whether it be gold, silver, paper, or anything else, is a currency. We may therefore lay down our fundamental Conception that Currency and Transferable Debt are convertible terms; whatever represents transferable debt of any sort is Currency; and whatever material the Currency may consist of, it represents Transferable Debt, and nothing else.40

As we shall see, this innovation of the transferability of debts was a critical development in the history of money. It is this, rather than the graduation from a mythical barter economy, which has historically revolutionised societies and economies. In fact, it is barely an exaggeration – if we make allowance for the unmistakable overtone of Victorian melodrama – to say, as Macleod did:

If we were asked – Who made the discovery which has most deeply affected the fortunes of the human race? We think, after full consideration, we might safely answer – The man who first discovered that a Debt is a Saleable Commodity.41

The recognition of this third fundamental element of money is important. It explains what determines money’s value – and why money, even though it is nothing but credit, cannot just be created at will by anyone. For sellers to accept buyers’ IOUs in payment, they must be convinced of two things. They must have reason to believe that the debtor whose obligation they are about to accept will, if it comes to it, be able to satisfy their claim: they must believe, in other words, that the money’s issuer is creditworthy. This much would be enough to sustain the existence of bilateral credit. The test for money is more stringent. For credit to become money, sellers must also trust that third parties will be willing to accept the debtor’s IOU in payment as well. They must believe that it is, and will remain indefinitely, transferable – that the market for this money is liquid. Depending on how powerful are the reasons to believe these two things, it will be easier or harder for an issuer’s IOUs to circulate as money.

It is because of this third critical element of transferability that money issued by governments, or by the banks which governments endorse and backstop, is thought to be special. Indeed, there is an influential school of thought – known as chartalism – which argues that governments and their agents are the only viable issuers of money.42 But the story of the Irish bank closure exposes this as another misleading preconception. The closure of the Irish banks showed that the system of credit creation and clearing need not be the officially sanctioned one. The official system – the banks – was suspended for the best part of seven months. But money did not disappear. Like the infamous fei that sank to the bottom of the sea, the associated banks suddenly vanished – and with them the official apparatus of credit accounts and clearing – and yet money continued to exist.

The Irish bank closure demonstrates that the official paraphernalia of banks and credit cards and solemnly printed notes with unforgeable insignia is not what is essential to money. All of this can disappear and yet money still remains: a system of credit and debt, ceaselessly expanding and contracting like a beating heart, sustaining the circulation of trade. What matters is only that there are issuers whom the public considers creditworthy, and a wide enough belief that their obligations will be accepted by third parties. For governments and banks to fulfil those two criteria is generally easy; whereas for companies, let alone individuals, it is generally hard. But as the Irish example goes to show, these rules of thumb do not apply universally. When the official monetary arrangements disintegrate, it is surprising how effective society is at improvising an alternative.

EXCERPTED FROM “MONEY: THE UNAUTHORIZED BIOGRAPHY” by Felix Martin

Simplistic history of money and fractional reserve banking

The sovereign’s capacity to issue money afforded one specific benefit: the creation of seigniorage, the ability to profit directly from the issuance of currency. These days, seigniorage arises because of the interest-free loan that a government obtains by printing money on comparatively worthless pieces of paper. But when currencies were associated with particular weights of precious metals, monarchs exploited this power through more overt methods. Many would “clip” gold or silver coins to melt down and redeem the value of the shavings. Before coins were assigned specific numerical values, rulers would “cry down” the arbitrarily assigned value of a specific coin—by declaring that it could now buy less of a certain useful commodity or contribute less than previously to the settlement of a tax bill. In effect, the monarch was recanting on a promise to honor IOUs at a certain rate and so got to write off his or her debts in accordance with the size of the cry-down. By the same token, the crown’s subjects were forced to come up with more money to meet their debts. Needless to say, this irritated the moneyed classes—the nobles and aristocrats, and later the bourgeoisie, for whom the periodic, arbitrary depreciations could amount to significant reductions in wealth. As their resistance to this abuse of power grew, it gave rise to some of the great liberal ideas upon which modern democracy is based, ideas behind the founding of America and the French Revolution. Now, this same spirit of resistance is found among bitcoin evangelists.

Well before the medieval European monarchs even had coins to tinker with, Chinese emperors were taking money into its next phase of technological development. In the ninth century A.D., when regions such as Szechuan experienced shortages of the bronze they’d used for coins, government officials began experimenting with letters of credit that functioned as a form of paper money. Then, in 1023, the Song dynasty issued full-blown sovereign-issued paper money across the kingdom.

In Europe, the struggle between the private and the public sectors for control over money has a much deeper history. While many complained about the sovereign’s constant debasement of the currency, some developed work-arounds that created de facto private money.

The most impressive of these was the écu de marc, a form of currency developed and used by the merchant bankers who emerged out of the Italian Renaissance and which allowed them to expand their business internationally. Based on an exchange rate jointly agreed upon by the merchants, the écu de marc allowed the exchange of bills of trade from different banks in different countries. The sovereigns in each land kept tight control over their currencies, but this banking class was developing its own international exchanges through the wonder of credit creation. The bills financed shipments—say of shoes made in Venice to an importer in Bruges—that enriched the manufacturer, but the real profit spinner lay in trading the paper, a lesson that would be passed down through generations of bankers to the present day. “For the first time, a private-sector community had come up with a de facto money-creation machine. This direct threat to the sovereignty of monarchs gave rise to a political clash as the kings and queens of Europe feared that their monopoly powers were being eroded.

But the bankers didn’t want political power per se. They were pragmatic businessmen, as they would prove to be for centuries afterward. They would use the leverage of private money to strike deals with governments, sometimes as a threat but mostly to wheel and deal their way to more wealth.

This negotiation between the sovereign and these new private generators of money would find its ultimate expression in the royal charter that founded the Bank of England in 1694. The BOE, as bond traders in London’s City now call it, was formed at the behest of King William III, who wanted to build a world-class navy to take on France, then the dominant power on the high seas. “The privately owned bank—the BOE was not nationalized until after the Second World War—would lend the Crown £1.2 million, a massive sum for its time, and could then issue banknotes against that debt, effectively relending the money. Then, to give the banknotes value as a de facto currency, the sovereign agreed to accept them in payment of taxes. In one fell swoop, the agreement created a form of paper money effectively endorsed by the sovereign, established fractional-reserve banking—a guiding principle of modern banking that allows regulated banks to relend most of the money they take in as deposits—and conceived the idea of a central bank. The Bank of England had, in effect, been given a license to print money.

This was the dawn of modern banking, and it had a profound impact on England’s economy. The new financial architecture not only helped the kingdom develop a top-class naval fleet with which it would rule the world from pole to pole, but also financed the industrial revolution. Bank credit effectively became money, since it was deemed to be backed by the sovereign. This new definition of money has prevailed ever since.

Excerpt From: Vigna, Paul. “The Age of Cryptocurrency.” St. Martin’s Press.