Money (15 page)
Authors: Felix Martin
One result of this changing organisation of commerce was a gradual evolution in the nature of the mercantile fairs. Once upon a time, a fair like Lyons had operated for its duration as a great pyramid, incorporating the mass of local retail trade at the base, the commerce of wholesalers and international traders in the middle, and the netting out of the accounts accumulated at these lower levels at its apex. But over time, these periodic gatherings of Europe’s merchant class came, as the great French historian Fernand Braudel put it, “to concentrate on credit rather than commodities, on the tip of the pyramid rather than the base.”
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Less and less were they opportunities for the physical exchange of goods. More and more, they were occasions for the clearing and settlement of credit and debit balances accumulated in the course of international trade over the preceding months. Between fairs,
payments for international imports were generally made not in coin, but on credit, using bills of exchange—credit notes sold by the pan-European merchant houses to their clients, who could then present them to their suppliers in foreign cities in payment for goods. By 1555, the primary role of the fair of Lyons was as a clearing house for the credit and debit balances accrued by the merchant houses of Europe against one another in issuing these bills of exchange to finance trade. It had become the most important market in Europe not for goods, but for money.
This was the system of which the paper-pushing Italian was a part—and it was every bit as mysterious and confusing to the uninitiated as the global financial markets of today. In place of the vigorous and venial atmosphere of the fairs of yesteryear—the ambience of a gigantically exaggerated local market day, complete with fireworks and bonfires, gambling and girls, tumblers, tightrope walkers, and tooth-pullers—there were merely the etiolated shades of the merchant bankers with their ink-stained fingers and incomprehensible account books. Nothing real changed hands except bundles of bills. Commerce had become a branch of mathematics. The standard textbook on the subject, published in Venice in 1494 by the Franciscan friar Luca Pacioli, was called
De Arithmetica
—“On Arithmetic.” Most observers found the activities of its practitioners “a difficult cabbala to understand”: the fact that it led so mysteriously but inexorably to enrichment without apparent exertion was baffling.
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Five hundred years later, the reaction of one fictional everyman to the most recent financial revolution was uncannily similar:
Her English husband Ossie, now he’s rich-for-life but he works in money, in pure money. His job has nothing to do with anything except money, the stuff itself. No fucking around with stocks, shares, commodities, futures. Just money. Sitting in his spectral towers on Sixth Avenue and Cheapside, blond Ossie uses money to buy and sell money. Equipped with only a telephone, he buys money with money, sells money with money. He works in the cracks and vents of currencies, buying and selling on the margin,
riding the daily tides of exchange. For these services he is rewarded with money. Lots of it.
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The merchant banker, for whom commerce had become a branch of mathematics, depicted in a sixteenth-century German print.
As the scandal of 1555 demonstrated, bafflement could easily turn to resentment. However difficult to understand in its details, the system of credit regulated by the fairs and their participants was commonly understood to be the pinnacle of the new system of monetised exchange that was increasingly governing even the humblest farmer’s life. But such a general understanding only went so far. Numerous questions remained to nag the suspicious mind. What exactly did the merchants do with their bills of exchange, and why did it give them such enormous influence over the lives of people who never set eyes on their exclusive conclaves? How and why did it make them so rich? And how did the emergence of these powerful and unaccountable parliaments of merchants relate to the
established political powers of the day—the sovereign, the nobility, and the church? It took better informed and more financially literate observers to solve such riddles.
These were few and far between; but they did exist. Claude de Rubys—a retired crown official who wrote a history of the Lyons fair in 1604—observed that the most remarkable feature of the great fair at Lyons was the way in which it enabled such a huge volume of trade to be settled without the use of cash. It was not unusual, he wrote, to see “a million pounds paid in a morning, without a single sou changing hands.”
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In other words, tens of millions of pounds’ worth of business was being done, with the sovereign’s money almost nowhere to be seen. The great merchant houses of Europe had rediscovered the art of banking—how to produce and manage private money on an industrial scale.
The new medieval mercantile classes faced in essence the very same problem that their modern counterparts faced in the disintegrating Soviet Union, in Argentina after its crisis, or in Greece today: how to operate a monetary economy when the sovereign’s interests diverged from their own. They too yearned for a Utopia in which there would always be just enough money to satisfy the needs of trade, and in which the sovereign would not take advantage of his seigniorage prerogatives to extract unwarranted revenue. They had tried persuasion, in the guise of Oresme’s ingenious arguments, but that had not worked.
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The alternative, as in the latter-day cases of the Monetary Maquis, was rebellion.
The obvious means of escape was via the creation and clearing of private networks of mutual credit. Wherever merchants had dealings, it was natural for them to accumulate credit and debit balances against their clients and suppliers—and as far as possible to offset them and carry forward the residuals on an ongoing basis, rather than to settle every invoice back and forth using the sovereign’s coin. As we saw, though, the problem with such mutual credit networks is
that natural limits to commercial and personal familiarity and the fragility of confidence impose constraints on scale. They cannot function as mechanisms to organise a whole economy: in the real world, only the money of the sovereign enjoys sufficient currency for that. This was the unfortunate problem that had confronted the sponsors of Nicolas Oresme. They might not have liked the way the sovereign managed his money—but the only alternative was hardly up to supporting the growth of the new commercial economy.
As their operations increased in size and complexity, the great merchant houses of Europe realised that there was, however, an intermediate option. What they rediscovered was the possibility of a hierarchical organisation of credit. A local tradesman’s promise to pay might not be worth much beyond his small circle of suppliers and clients. But the promise of one of the international merchant houses, with their much larger volume of trade, their great stocks of reserves, and their long histories of success, was a different matter. If a great merchant substituted his word for that of a local tradesman, an IOU that might previously have circulated at most within the local economy could be transformed into one that could circulate anywhere where the great merchant’s prestige was acknowledged. A pyramid of credit could be constructed, with the obligations of local tradesmen as the base, larger wholesalers in the middle, and the most exclusive, well-known, and tight-knit circle of international merchants at the top. The international merchant house could interpose itself, in other words, between local merchants and their ultimate counterparties—and in doing so, transform inert, bilateral promises to pay into liquid liabilities that could easily be assigned from creditor to creditor and so circulate as money wherever the great house’s credit was current. The private trade credit of even the humblest local merchant, in other words, could break its parochial bounds and, endorsed by a cosmopolitan mercantile name, become good to settle payments on the other side of Europe, where its original issuer and his business were entirely unknown.
It was here—in the creation of a private payments system—that the invention of modern banking originated. Such a humble birth
may sound disappointing. Today, the banking sector’s unglamorous routine of providing payment services takes a distant second place in the popular imagination to the exciting businesses of lending and trading. But their ability to finance and settle payments is the more fundamental activity. This is banks’ specifically monetary role, and what makes them special. A bank is in essence an institution which writes IOUs on the one hand—these are its deposits, its bonds, its notes; generically, its liabilities—and accumulates IOUs on the other—its loans and its securities portfolio; generically, its assets. Every business has some promises to pay outstanding to suppliers, and owns some promises to pay from customers. But for most businesses, these financial assets and liabilities—the firm’s accounts receivable and payable, as they are called in the book-keepers’ jargon—are dwarfed by the value of the business’ real assets: its plant, its premises, its inventory, and so on. In a bank, it is the other way round. The mysterious Italian at the fair of Lyons is entirely representative. A bank’s real assets are always negligible. The balance sheets of modern banks are vast: in 2007 the balance sheet of a single British bank, the Royal Bank of Scotland, was larger than the GDP of the entire U.K. No manufacturing business could ever accumulate assets of this magnitude. The reason that a bank can do so is that almost all its assets are nothing but promises to pay, and almost all its liabilities likewise.
As we have seen, any IOU has two fundamental characteristics: its creditworthiness—how likely it is that it will be paid when it comes due—and its liquidity—how quickly it can be realised, either by sale to a third party or simply by coming due if no sale is sought. The risks associated with any promise to pay depend upon these two characteristics. Accepting a promise to pay in a year’s time entails more risk than accepting a promise to pay tomorrow: a lot more can go wrong in year than in twenty-four hours. This is the dimension of liquidity risk—so called because unless it can be sold in the meantime, a private promise to pay only becomes liquid at the moment it is settled in sovereign money. Then there is the possibility that the IOU’s issuer will not be able to pay at all, regardless of the time frame. Accepting a promise to pay from a NINJA—the banking industry acronym
for someone with No Income and No Job or Assets—is more risky than accepting a promise to pay from Warren Buffett. This is the dimension of credit risk.
The whole business of banking resolves into the management of these two types of risk, as they apply both to a bank’s assets and to its liabilities. Banks transform uncreditworthy and illiquid claims on the assets and income of borrowers into less risky and more liquid claims—claims which are so much less risky and so much more liquid that they are widely accepted in settlement of debts. They achieve this miraculous transformation through their management of the credit and liquidity risks of the loans they make to governments, companies, and individuals, on one side, and of the credit and liquidity risks of the obligations they owe to their depositors and bondholders on the other.
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The management of credit risk—working out which borrowers are NINJAs and which are Warren Buffetts, devising the best combination of borrowers in the overall portfolio, and monitoring borrowers over the lifetime of their loans—is the most obvious part of what banks do. But it is not the most important part.
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Strip a bank’s balance sheet back to its bare bones, and the simplest form of banking, the form practised by the most risk-averse of banks, is the short-term financing of trade. In this kind of banking, credit risk is minimal: loans are usually extended simply to cover the purchase and transport of goods for which a sale has already been agreed, and the goods themselves are often used as collateral. With sufficient insurance, the bank might even eliminate the credit risk altogether. The risk it can never get rid of, however, is liquidity risk. Even in the short-term financing of trade, when the loan is only for the days or weeks it takes to bring the goods from the producer to market, the banker is making a commitment for a definite length of time. And on the other side of its balance sheet it has its own liabilities—its deposits, bills, and bonds—which are coming due. When the higher complications of credit risk are absent, the essence of the banker’s art comes into focus. It is nothing more than ensuring the synchronisation, in the aggregate, of incoming and outgoing payments due on his assets and
liabilities—which are themselves, of course, the aggregated liabilities and assets of all his borrowers and creditors. This was the art that the great international merchants of the Middle Ages had rediscovered.
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Within domestic economies, the effects of this rediscovery began to be felt as early as the twelfth century. By the end of that century, in the Italian maritime city state of Genoa, merchants had founded local banks that both kept accounts for clients and maintained accounts with one another, so that payments could be made across the system, from the client of one bank to the client of another.
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By the fourteenth century, payment via such bank transfers was the preferred method of making any sizeable payment in Florence; and there were as many as eighty banks offering the service.
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To the extent that the account-holders were required to present themselves at their bank to approve payments—as was the case, for example, in Venice—the system remained limited by a degree of inconvenient centralisation. But by the mid-fourteenth century, payment by cheques and other written IOUs was becoming common in the city states of Tuscany, in Genoa, and in Barcelona. Such written instruments could circulate amongst the merchant community without notarisation at the bank, before being presented for redemption. Thus they facilitated fully decentralised clearing, just as the sovereign’s coinage did. The first example that survives—a cheque drawn by the aristocratic Tornaquinci family of Florence on their bankers the Castellani—dates from 1368, less than a decade after Oresme addressed his
Treatise
to the Dauphin Charles.
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Even as Oresme was pleading for more equitable management of the sovereign’s money, the new mercantile class was devising ways to escape its tyranny altogether.