Monday, December 26, 2016

History of Central Banks Tutorial - Before Central Banks II

As promised, one more installment on the history of central banks, and why the early Italian (and Spanish and Dutch) public banks were not seen as central banks. We must start with Italian banking. Even though the Medici Bank is probably the most well-known of the Italian banks of the Renaissance period the two key cities to understand the development of modern banking, and the precursors of central banks, are Genoa and Venice. And as noted before, central to the story is the emergence of public debt, one of the few innovations that was not known in antiquity.

The records for the floating of public debt go back to 1149 in Genoa and to 1164 for Venice. Local governments essentially sold the rights to collect taxes for a determinate period in exchange for a fixed amount of money. Public debt was originally compulsory,  since the city-states were always hard-pressed for funds, and constantly fighting for their very survival in economic and political terms, in the complicated and unstable political disputes between the Papacy and the Holy Roman Empire. Public debt was also relatively illiquid, since it was difficult to transfer the tax farming rights.

Over time public debt become voluntary, rather than compulsory, perpetuities were issued, and secondary markets for government bonds developed.  In other words, public debt was an early and persistent feature of the Italian financial markets. The importance of public debt was that it provided a relatively secure asset for the functioning of the financial system, even when in reality there were periods of crises and situations in which interest payments were interrupted and consolidations of older debt took place frequently. Unlike private debt in which there is little recourse in case of default, the latter was considerably less likely in the case of public debt. Historically disputes between creditors and debtors are at the center of class conflict. Debt peonage, were the creditor coerces the debtor to repay with work, or debtor’s prisons, for those unable to repay, were common solutions for the problem of private default until the 19th century (see David Graeber's Debt).

Public debt was denominated in local currency, and a formal commitment from the local government to match taxes to the required needs to service debt was relatively easy to obtain, in particular since the merchant class and bankers, the creditors of the state, had a hand in the administration of the city-state.  Except perhaps in the case of the complete collapse of the economy, associated to military defeat, the possibility of default was limited. Public debt could be sold and bought in secondary markets and it could be used as collateral by the banking system.

Banks, then, reemerged in Europe after the crusades in the context of the commercial revolution, which connected long distant trade between the Levant and the fairs in Champagne and other northern European markets through the Italian city-states.  In the context of pre-modern Europe, with political and economic fragmentation, and with a significant large number of currencies, one of the central activities of early bankers was to provide foreign exchange.  Traders required not only exchange services, but also the ability to transfer funds from one place to the other, and the international settlement of accounts was useful not just for traders with business in many cities, but also for the church.

Moneychangers and bankers operated in a world with an extensive number of currencies, and coins that were often debased, with an actual metallic content below its face value.  As noted by Peter Suppford in Money and Its Use in Medieval Europe, not only there were a myriad of coins, but also, and more importantly, there were as many units of account. In fact, many coins that actually disappeared continued to be used as units of account, what Spufford refers to as ‘imaginary money.’

The necessity of a unit of account to make economic calculation possible was certainly one of the reasons for the development of public banks, after all money is as noted by John Maynard Keynes essentially money of account. In this sense, money developed not as a device to facilitate transactions, i.e. the means of exchange, but as a result of the power of city-states, and merchant bankers to determine the unit of account (for the chartal origins of modern money see Rochon and Vernengo, 2003). The introduction of a unit of account, and a relatively safe asset were central not so much because they were needed to provide a payments system, as noted by some mainstream authors, although that was a positive externality, but because the determination a unit of account provided the ability to create a relatively safe asset, reduce the risk of default and support the expansion of the of the mercantile activities that were seen as required for the survival of the city state.

Public banks were the culmination of a process by which the state tried to both fund its activities at a relatively low cost, creating in the process a secure asset to anchor financial markets, and that a unit of account was established by the Prince. The question then is why the public banks that preceded the Bank of England (BoE) are not often seen as central banks in the proper acceptation of the word.

One reason for the neglect of the previous public banks derives from a certain view of what central banks do, which, in turn, results from a particular perspective about the functioning of macroeconomic variables. In the conventional view, central banks must provide banknotes, a means of payments, to facilitate exchange but cannot provide too much of them, otherwise inflation would follow. But given the risks of bank runs they must be willing to provide liquidity in moments of crisis (lender of last resort function, LOLR). That is why banknotes and the LOLR function are often seen as the hallmarks of central banking.

Presumably the reason why the initial public banks are not considered central banks is that they were not emission banks. Early public banks provided a centralized clearing system that was guaranteed by the state. In the case of the Banco Giro, the successor to the Rialto in Venice, and the Bank of Amsterdam they had a monopoly over the clearing mechanism. However, there was an active exchange of the lire de paghe, the money of account, of the Banco di San Giorgio as bank money, and, hence, at least some precedent to the emission banks. Besides a giro system, in which credit and debit accounts are centrally cleared might be as powerful to provide liquidity as a system of banknotes.

In that sense, it is a bit arbitrary to consider the BoE, or the Bank of Sweden for that matter, as the first central banks. The most likely reason why that has become common sense is that all the other public banks vanished in the post-Napoleonic Wars period. The reasons for their disappearance, is certainly tied to the disappearance of autonomous municipalities, but the causes are more profound. Note that the rise of public banks follows more or less the evolution of control of trade with Asia, first the Mediterranean control of trade with the Levant, and subsequently the transfer of the dynamic center to the Atlantic, once the Portuguese had opened the trade routes around Africa. In other words, what city-states did not have was an edge in the process that was central for economic development, the control of the trade routes with the East. Also, there were technical problems associated with the printing of paper currency (Eric Helleiner in his The Making of National Money, shows that only in the late 19th century, with the technical advances in counterfeiting is that the State could impose territorial currencies)

In addition, neither the Mediterranean city-states, which were politically fragile, nor the Dutch Republic, which was under constant threat of the Spanish and French crowns, controlled a large domestic economy that could rival with the emergent nation states in terms of political and military power. England, on the other hand, was the first nation state with a public bank large enough to benefit from the positive effects of the expansion of international trade with the Orient, and that could challenge the military hegemony of other European powers.

More importantly, with the advantage of hindsight, it is clear that the financial revolution in England in the 18th century, even if it was in part an evolution of a long process of development of financial practices and institutions in Western Europe, was indeed groundbreaking, and occurred right before the Industrial Revolution. It is the eventual victory in the Napoleonic Wars, and the rise to global hegemonic power that made the Bank of England, retrospectively, the first central bank. By then the rules of what a central bank should actually do where changing according to the interests of the British industrialists and merchants, and that view, the Victorian view of central banks became dominant. And history, including the history of central banks, is written by the victors.

PS: To read the first two posts in the Tutorial series just click on the label below History of central banks.


  1. Prof. Vernengo,

    Thank you for this fascinating series.

    I have a couple of questions tangentially related to the subject. It's okay if you haven't considered any of this, as it's only tangentially related to your main subject.

    (1) Have you considered the relationship between the developments you mention and the evolution of accounting, the development of maths (introduction of positional number notation, Hindu-Arabian numerals, and algebra) and maths education?

    All of them are also connected to the financial and trade activities developed originally around the Mediterranean basin, but that eventually expanded to North-West Europe (chiefly, the Netherlands and Germany).

    In this context, my second question:

    (2) You speak of assets. No doubt, from our 21st century perspective, money, deposits, loans are all legitimately considered assets (financial assets, to be precise). But I am not sure people in 12th century Genoa or Venice would have understood them as we do today. I am not suggesting they didn't: I'm just asking whether we can be sure they did?

    After all, the earliest historical example of double-entry accounting seems to come from the 14th century. And the systematization of DEB had to way to the 15th century, with Luca Pacioli.

    1. Hi Magpie:
      Yes, both math education, and the role of Arabic numerals in mathematical training, and accounting were central. Fibonacci's Liber Abaci as well as Lucca Pacioli's Summa, as you note, were important.
      The question, of course, is whether innovations in management, including double entry accounting did not simply result from the revival of trade and the financial revolution that followed. I don't think I can speculate about how late medieval, early modern merchants considered different assets. It is clear that interest was seen as usury, and not acceptable, but still widespread (even if disguised in other forms). Other than that I can't venture to say much.

  2. «And as noted before, central to the story is the emergence of public debt, one of the few innovations that was not known in antiquity.»

    Clay tablets with tax arrears inscribed on them were routinely negotiated in Sumer 5,000 years ago.

    What Genoa and Venice brought about was greater scale, and more importantly international negotiation of government debt, thanks to the wide acceptability of the genoese "genovino" and the venetian "zecchino" as means of payment, which also depended on the vast branch networks of genoese and venetian merchants on which bills of exchange could be drawn, payable in those hard currencies.

    1. As far as I know it's a well establish consensus that public debt is an European, late medieval innovation. Settling deferred tax payments with the Temple/Ruler in a particular token was about the creation of money, not public debt. Can you provide the source for your claim?

  3. "Public money" & "public debt" are two words for the same thing, or at least one can call public money a kind of public debt. People used to consciously understand that, but only the MMTers & fellow travelers still seem to. So Blissex is right - in any case these mean "public debt is an European, late medieval innovation" is logically impossible. Modern banking is about a novel relation and view of public debt and private debt, not the invention of either. Ingham's The Nature of Money is a good reference.

    1. Oops. Sorry for the delay in posting and replying. Yes, on some level money is very much like debt. But the point is I think clear. Like paper money and banknotes, which are also not from antiquity. A public debt funded with the promise of future tax revenues is definitely a Genoese/Venetian invention. Coinage is a Greek one in antiquity, and money per se, the unit of account, in the Western world is from ancient Mesopotamia.


Godley versus Tobin on Monetary Matters by Marc Lavoie

  The 4th Godley-Tobin Lecture given by Marc Lavoie, a co-author of Wynne Godley, and one of the leading Post Keynesian authors.