EC120 The World Economy in Historical Perspective

Transcription

1 Reading: get started with Kindleberger, C. P. & R. Z. Aliber Manias, Panics and Crashes, 6th ed, Palgrave Macmillan, 2011, chapters 1, 7, 8 Note: refer back to week 05 Commercial Expansion: Mercantilism and finance, which focuses on the earlier period. Key issues: What are the main features of monetary systems (from an economic/historical perspective)? How did the role of banks in the financial system change from medieval times to c1850? What are Bills of Exchange and what role did they play in commercial development? What was the South Sea Bubble? How did it affect the financial system and the economy? What were the main features of economic and financial crises, c1700 c1850? How were they related to one another? Did financial development help or hinder economic development? Key concepts: seigniorage; Gresham s Law; specie and bullion; inflation and deflation; depreciation and appreciation; debasement; circulating and fixed capital; debt and equity; financial innovation; Bubble Act, 1720 EC120, week 10 0

2 In economics: money is what money does, i.e. defined by its functions, which are usually: medium of exchange, unit of account, store of value. (In other subjects money has all sorts of mystical properties, irrelevant in economics.) Confidence: a crucial factor that has been, and is, always relevant is the confidence that holders have in the money. If holders are confident about the money s future value (how many goods and services, or other currencies it will buy), it will be held. If not, the money s value will decline (by inflation or depreciation), perhaps to zero. Historically money has taken many different forms. From antiquity to 19C, precious metals (mostly silver and gold, sometimes copper) predominated. Specie = money as coin. Bullion = bars of specific weight/standard. Governments have always played a role in minting coins, typically insisting on a monopoly (death penalty for counterfeiting). A source of tax revenue: seigniorage, a fee for minting the metal. Throughout history, governments have succumbed to the temptation to debase the coinage (reduce the precious metal content) an extra source of revenue, until prices catch up (inflation). But use of precious metals ( full-bodied coinage) restrains governments paper currency ( fiat money is cheaper to create). The temptation remains ever present. Gresham s Law: Bad money drives out good (if the two monies cannot be distinguished, or have a fixed exchange rate). Classic example: a monarch (Henry VIII) reduced the silver content of newly minted coins. The new (debased, bad) coins circulated but the old (good) coins disappeared were hoarded or melted down. More generally monetary authorities have difficulty in maintaining fixed exchange rates between different monies (precious metals or otherwise). EC120, week 10 1

3 Debt and ownership (equity) contracts have existed for millennia though the functions they perform are expressed in evolving institutions and financial instruments. Much was to change from 16C, Europe taking the lead. Forces driving change: Expansion in trade, especially long-distance trade Growth of large-scale business, beyond the wealth of any single person, with returns that (a) could take years to realise and (b) were risky Increasing pool of investable capital spread (unevenly) among families and more well defined property rights, especially in land Governments ever present need for revenue, especially to fund increasingly expensive conflict on land and at sea Debt: takes many forms, essentially contractual agreements between borrower and lender; commonly bearing interest (restricted by usury laws); rarely tradable (e.g. bonds that could be bought or sold) until after mid-18c but could form collateral for other debt. Equity: common ownership in an enterprise (e.g. partnership); unlimited liability of partners, except in special legally sanctioned circumstances. Joint Stock companies, issuing shares became more common, but very slowly, to finance trading ventures (e.g. East India Company) or infrastructure (18C onwards), with uncertain legal status without a Royal Charter or special Act of Parliament (e.g. to confer limited liability for shareholders). Gradually becomes more marketable ; Amsterdam Stock Exchange, early 17C, followed later in the 17C by London, with emergence of informal trading in coffee houses. EC120, week 10 2

4 Multiple monies (1): when all (or many) states use the same metal (e.g. gold), exchange rates can be fixed according to precious metal weight of coins (parities) this is the essence of the classical Gold Standard (covered later in EC120). For most of history, international monetary arrangements have been a variegated mixture of standards, currencies and units of account, with different states adopting different metals, debasing the currencies from time to time and attempting to choose parities with more than one metal (see below). But banks have coped, often very well, by creating money-substitutes, even creating monies of account that have no physical representation at all, allowing the market value of official money (typically coins) to be adjusted according debasement, etc, of the official money. Only during the period c was there relative stability with all major trading nations adopting the Gold Standard (successfully!). During the 20th 21st centuries various attempts have been made to achieve stability, with at best partial success. Multiple monies (2): governments often minted more than one metal, e.g. both gold and silver, typically fixing the relative mint value of the two metals bimetallism. For bimetallism to succeed, the relative market price of the metals must approximately equal the relative mint value. If the two diverge by more than a small amount from the mint value, then the metal that is undervalued at the mint will disappear from circulation (coins melted down). Thus bimetallism can work only if the fixed mint value effectively forces the relative market price to be the same, perhaps because the monetary reserves are an overwhelming proportion of total world stocks of at least one metal. This can work but is prone to instability one or other metal disappears from circulation. Bimetallic systems have been adopted for a number of reasons, one being to cope with the problem of small change. This occurs because a single metal is unsuitable for transactions of all amounts, e.g. gold coins in small denominations would be too tiny to use; copper coins for large transactions would incur unacceptable transport costs. Hence choose two (or more metals) for coins of different denominations (thus fixing the relative prices of the two metals). This always proved difficult to sustain. The problem was overcome from the early 19C, when technological advances allowed the creation of token currencies, coins minted from base metal alloys worth less than the face value and which were difficult to counterfeit. Money substitutes: from medieval times and particularly from the 18C (with the expansion of trade) banks have created securities (financial instruments) that fulfil all or most of the functions of money. The most obvious form is privately issued bank-notes but there have been others, especially bank deposits (early 19C onwards). Despite repeated attempts, Governments have enjoyed at best limited and temporary success in controlling the volume of money substitutes. The incentive to create money substitutes does not render monetary policy impossible, but can make it more challenging and hard to measure the money stock too. EC120, week 10 3

5 Banks include a wide range of institutions that function as financial intermediaries, providing services for lenders and borrowers. Classic function of banks: asset transformation. Banks obtain cash (creating their liabilities) which they `transform into other assets by lending it to borrowers. Historically, many banks evolved from merchants (esp. renaissance Italy) providing short-term credit (e.g. 3 months) to finance trade. Also, at times made longer term loans mostly to Governments (which often defaulted) and privately via mortgages secured on land. Textbook (partly accurate, historically): banks evolved from goldsmiths which held gold coin for safety, issuing bank notes (banks liabilities) that then served as money. The gold formed a reserve for making bank loans. Do banks create money this way? Inasmuch as their liabilities are accepted as money, yes. But note: (a) banks differ in their riskiness; (b) bank deposits also function as money and largely replaced notes in 19C (legal restrictions). Bank runs (note holders and depositors try to retrieve their cash) have occurred intermittently throughout history, in crises of confidence, when banks solvency is doubted. Examples before 2007: 1930/31 USA; London in 1825 (and various other times in 18C and 19C). Banking systems have been historically fragile vulnerable to credit crises (sparked by a variety of historical events, typically involving a loss of confidence in one or more banks). EC120, week 10 4

6 Credit to support trade expansion: 1. Goods travel longer distances, which takes time weeks for domestic trade, 3 months or more for overseas trade. 2. As production processes (e.g. textiles) become more complicated, raw materials have to be acquired months before finished goods can be sold. The Bill of Exchange (`bill ) evolved from medieval times to enable loans (credit) to be obtained while goods are in transit or during production. The crucial motivation for the parties (buyer and seller) is to provide evidence that the transaction is genuine and that neither side will default on the bargain, most importantly that the buyer will make payment, typically at a future date, as stated in the contract. As the buyer (importer) and seller (exporter) may have no basis for trust, a third party is commonly sought to guarantee creditworthiness: banks tended to perform this function, because they were able to assess the reliability of their clients. Banks evolved as entities (individuals, partnerships, companies) with enough wealth, knowledge (e.g. about their clients) and reputation to support credibility as guarantors. Also the origin (seller) and destination (buyer) may be separated by location, legal system, or jurisdiction. But banks are more likely to have trustworthy contacts to facilitate payments, e.g. a bank in New York may have an agent in London (to transact with UK banks), or a bank in London may have an agent in New York, or both. Finally, payments across borders could be (and were increasingly) netted out, resulting in only small shipments of cash (precious metals, before 20th century). All the above evolved in a haphazard way, in parallel with the expansion of commerce and especially as communications improved (e.g. the telegraph from c1840) and transport costs declined (especially from 1820/40). EC120, week 10 5

7 Example (remember that Bills could be used in many different ways): A buyer, The Importing Co, draws a bill instructing its bank, William Caxton & Co in London to pay 5000 in three months to the bill s owner at that date. Caxton accepts the bill and returns it to the drawer (The Importing Co.). Caxton is prepared to do this because it has information about The Importing Co s creditworthiness, i.e. confidence that sufficient funds will be available by the Bill s expiry. Effectively Caxton has guaranteed the Bill. The Importing Co. can now sell, or discount, the Bill to obtain funds right away, i.e. obtain a loan (e.g. to pay for the wool). Note that the bill is sold for less 5000, i.e. at a discount. The Importing Co. is said to Endorse the bill when it sells it (signs on the back of the bill). The discounter of the Bill, who now owns it, could hold on to it, until it matures, then collect the funds, or sell (discount) the bill by endorsing it. This could take place several times. Eventually, at maturity, someone will own the Bill, and will present it to William Caxton & Co. for payment. If William Caxton & Co. defaults, the bill s owner can sue each of the endorsers in turn to obtain the The bill is worthless only if all of them default. Notice how Bills could become cash substitutes (function as money): a seller could agree to take a Bill in settlement of a debt (the buyer endorses a Bill he/she owns). Even at maturity, the Bill may be presented in settlement of a debt rather than for cash. This did occur, most famously in Lancashire c1790 c1830, when other media of payments were in short supply (well documented in Ashton, T.S. The Bill of Exchange and Private Banks in Lancashire, Economic History Review, vol. 15, 1945). The lesson: Money substitutes emerge according to market incentives (i.e. need). Governments have less control than you think (often they try to suppress substitutes, why?). EC120, week 10 6

8 Mortgages developed from 17C as a way of making loans on the security of land: took a variety of legal forms, supporting short-term as well as long-term borrowing, mainly to allow the land-owner to obtain cash in order to settle a debt, rather than to sell the land outright (which may have been constrained for legal reasons). But mortgages did not provide tradable securities. Capital markets for tradable securities emerge informally during 17C (e.g. London coffee houses) expand in 18C for govt. debt and shares in joint-stock trading ventures (e.g. East India Company, South Sea Company). Govt. debt (gilt-edged stock in Britain) grew in order to the numerous wars of 18C; long-term debt, e.g. consols, expanded from 1750s. Britain s Golden Sword willingness of investors to hold Govt. debt, strengthened financial mobilisation in times of war. Market for shares of joint-stock companies restricted by Bubble Act, 1720, but did not disappear. Chartered companies, each requiring an Act of Parliament, remain increasing numbers from mid-18c for funding infrastructure, e.g. turnpike trusts, canals. Suspicion remained of joint-stock companies (fraud/incompetence). Corporate finance: apart from infrastructure and large trading companies, most businesses (including banks) were partnerships; tended to be small scale, each partner with unlimited liability for the debts of the partnership. Capital raised mostly from partners personal wealth or from friends and relatives. Banks assisted with short-term trade credit, e.g. discounting bills of exchange, or making advances (loans) for short periods. Apart from infrastructure projects, demand for long-term capital (e.g. to finance factories) grew only from late 18C, with industrialization. Apart from Dutch republic, much of Europe lagged British financial development by up to a century before catching up in 19C. North American development not unlike UK, though less federal government involvement until 19C, and then mostly post-bellum. EC120, week 09 7

9 Confidence in the value of assets is vital for the stability of financial systems: if disturbed for whatever reason, a crisis is likely. Expectations of future asset payoffs drive confidence, hence investors willingness to hold assets, hence (in)stability. As holdings of financial assets became more extensive (in Dutch republic and Britain) from mid 17C, so the potential for financial crises became more evident. British Banking system in 18C: Highly fragmented with London as the hub, focusing on international finance of trade as much as `internal British trade Bank of England dominated discount market for bills of exchange From c1750s `country banks become widespread Local partnerships, with unlimited liability, highly risky Many issued notes (paper currency), negotiated bills of exchange (trade credit) and arranged mortgages Scotland: joint-stock banks, multiple branches, but unlimited liability Banking elsewhere in Europe: closely aligned with trade as it developed from Medieval times. Hence, by 17C emphasis shifts to northern Europe especially with formation of public banks, e.g. Bank of Amsterdam, that accepted deposits. Crises in long-term capital markets: apart from South-Sea bubble, 1720, most crises were associated with Government experiments in raising war finance hence crises often associated with onset of wars or possibility of Govt. default on war debt. Otherwise, as a consequence of restrictions on formation of Joint Stock companies (especially after 1720), stock market crises became evident only from early/mid 19C. Crises in other markets: e.g. Tulipmania in Holland during late 1630s was associated with speculative trading in tulip bulbs (for growing flowers). EC120, week 10 8

10 Economic fluctuations were pervasive but dominated by harvest abundance or failure (mostly the latter) until late 18C, or beyond, in much of Europe. Hence fluctuations tended to be intermittent regular Trade Cycles become more identifiable in 19C. With the expansion of trade (long but uneven trend from 16C) and industry (from mid 18C in parts of Britain and N. Europe, later elsewhere), fluctuations originating in these had increasingly widespread impact. Events in the financial system partly reflect fluctuations in other sectors (trade, industry, Government) and partly impacted on the those sectors (effectively the whole economy). Separating cause from effect is difficult, and not fully understood. While holdings of financial instrument were concentrated among narrow groups in specific locations (e.g. financiers in London), repercussions from financial crises tended to be muted, if not absent. This seems to have been the case for long-term capital (mainly Govt. debt and a few Joint Stock Companies) until mid 18C. But with larger and more diverse long-term capital markets, the economy-wide impact became more pronounced, particularly from mid/late 19C (i.e. not much until after the Industrial Revolution). But the expansion of trade was accompanied by parallel expansion in trade credit, hence more widespread. Here causation between economic fluctuations and financial crises probably operated in both directions, resulting in more widespread distress. Thus a harvest failure or losses from a trading venture could result in a cascade of bankruptcies spreading into the financial sector, and beyond. Crises originating within the financial system itself (e.g. fraud), however, probably had a less severe impact on the wider economy until the use of credit (to finance commercial and/or private needs) became more widespread. Here there has been increasing, but uneven, growth to the present day with many interruptions, mainly following on from financial crises themselves. EC120, week 10 9

11 Currency: gold & silver coin and notes Legal constraints on note issue: minimum denomination ( 5 until 1797) 1797: `The Restriction Bank of England notes not convertible into gold 1819: gradual return to gold standard convertibility Effective prohibition of private issue from 1844, when Bank Charter Act, awarded monopoly to Bank of England, notes backed by gold reserves. This established the purest form of the gold standard that has ever been observed in practice. Consolidation/amalgamation of banks, esp. after 1844 Joint-stock banking expands from 1826 (but unlimited liability until 1858) Development of large-scale branch banking networks Banks focus on taking deposits; invest mainly in short-term loans to business (rather than investment banking, with long-term security dealing) Merchant (investment) banks: specialised, focus on international finance Bank of England emerges as `Lender of Last Resort : lend freely in times of panic, but at a high (punitive) discount rate EC120, week 10 10

12 Incorporation (despite setbacks, e.g. Bubble Act, 1720) was ultimately pivotal for capital market development: Corporations: separate legal identity, with transferable share ownership (possibly without limited liability); enabled pooling of capital; indefinite life-span; could own property, sue and be sued in its own name. Bubble Act repealed in 1825, but expansion of joint stock companies is slow at first, mainly in banking from 1826, with unlimited liability (limited liability followed later. Railway development (from 1830s) required large scale investment, financed via joint stock companies, formed & regulated each with its own private Act of Parliament Limited liability became more widespread from 1856 (new legislation): Company registration allowed (special Act of Parliament now unnecessary) Reporting requirements and improved communications technology reduced `asymmetric information : investors better able to assess companies risks Equity versus debt: debt provides a fixed income unlike equity (dividends on shares vary with profit) but more debt increases chance of bankruptcy: Restrictions were imposed on railway companies borrowing (1836) But bonds become more popular (both for holders and issuers) `Preferred shares become popular from 1840s (secure income with partial ownership rights) London became a dominant international centre (esp. long-term bonds) EC120, week 10 11

13 Governments have always had an incentive to support the financial systems of their jurisdictions, mainly (a) because they need revenue, but also (b) because failure of the system ( meltdown ) commonly has adverse economy-wide consequences. Historically the latter became increasingly important with expansion in the use of financial instruments (to support trade and industry) and as governments became more democratically accountable both long, albeit uneven, trends for centuries. European experience: Trade: gathering pace during 17C and 18C, major expansion in 19C and 20C, interrupted by wars in much of 18C, culminating in , and two world wars of 20C, with shorter interruptions associated with intermittent financial crises. Industry: finance of large-scale enterprises increasingly important from mid/late 19C (mostly infrastructure projects before this). Financial performance: Financial institutions: especially important because failure of one often cascades to the failure of many, with wider repercussions. From mid-19c governments (via central banks) came to intervene with lender of last resort support, and other bailouts. State capacity, to borrow or tax: Govt. needs ways to acquire resources to support the financial system. Sovereign default does occur (outright or indirectly) but has negative repercussions undermines trust, reducing state capacity; political unrest, revolution. Democratic accountability: Before mid/late 19C, Govt s were accountable to narrow elites and special interest groups (e.g. Royal advisers or City financiers). But with the extension of suffrage, Govt s took account of the well-being of those allowed to vote. International co-operation: increasingly important from mid-19c as capital flows grew (e.g. among central banks credits to one another). Arguably, hegemony of a leading state was necessary to foster co-operation (e.g. Britain in late 19C, USA in mid/late 20C). EC120, week 10 12