CHAPTER 7:
MONEY, CREDIT
AND BANKING
THE ORIGINS OF MONEY
• Occupational diversification when regions and nations exploit their comparative advantages productivity increases
• But this requires exchange
• Money developed alongside specialization
• First money 5 or 6,000 years ago was standardized ingots of metal, not stamped coins
• Why is money so important?
COINCIDENCE OF WANTS
• Without money barter is necessary
– To exchange a pair of shoes for some wheat you need to find someone who has wheat and wants shoes
– Matching process is very time consuming
– Will reduce trade volumes since trade must be balanced:
minimum trader determines volume of trade
– Prices are not transparent, no single unit of account
– Money solves the problem of non-coincidence of wants
EVOLUTION OF WHEAT AS MONEY WITH NO
COINCIDENCE OF WANTS
COMMODITY MONEY
• For most of history money has been commodity money
– Money with alternative uses, an intrinsic value
• Gold, silver, pearls, shells
• Some commodities are better than others!
• Should be:
1. Medium of exchange
2. Store of value (non-perishable) 3. Unit of account
COINS AND BILLS OF EXCHANGE
• After Roman Empire, Europe lost its monetary system
• Revival with Carolingian Empire, based on silver
– 1.7g of silver = 1 penny
• Could take silver to the mint to get it minted, although mint took a 5-10 % seigniorage fee
• Governments debased coins to fund expenditure
• After Carolingian Empire, local mints spread, many types of coins bills of exchange for long distance trade
MONEY MARKET INTEGRATION
• Increasing integration (trade and money) law of one price for gold/silver ratio
• Problem with small-denominations solved in 19th century with token coins, without intrinsic value
• Long distance trade required innovations
– Commodity money risky and cumbersome to use – Introduction of credit
– Bill of exchange (promise from debtor to pay creditor) – Money changers and banks, legal procedures in cities
FRACTIONAL RESERVE BANKING
• Deposit banks accumulated liabilities to their creditors, but only held part of the deposits as reserves, invested the rest or gave loans
– Started in Italy in 14th century, and spread
• Frequent bankruptcies, vulnerable to bank runs
– Held too small share of deposits as reserves – Difficult to monitor borrowers
• Leading financial centres developed public clearing banks… or banned fractional reserve banking
USURY AND INTEREST RATES IN THE LONG RUN
• Church saw interest as usury, prohibited by political authorities
– Can be interpreted as protection against exploitation
• But Church supported public pawnshops, much lower interest rates (Montes pietatis in Italy)
– Interest interpreted as payment for storage of goods
• Opportunity cost of money came to be interpreted as legitimate ground for interest
• Interest rates fell
THE EMERGENCE OF PAPER MONEY
• No intrinsic value, mutation of bill of exchange
• Fiat or fiduciary money emerged spontaneously
– Goldsmith or moneychanger receipts
• Relied on reputation of the issuing bank
• Until 20th century kept a link to commodity money, since could be converted on demand to coins
• Regulated since banks were profit-maximizing and customers did not have full information on their
solvency
DEVELOPMENT OF NOTE-ISSUING BANKS
• First by Stockholms Banco (1657-68), ended by run on the bank
• Bank of England founded in 1694
• Spread to the continent at uneven speed
• By end of 19th century the state and its central bank monopolized issuing of notes in most nations
• Contributed to monetarization of the economy
• Fractional reserve increased monetary supply
WHY DID FIAT MONEY SPREAD SO SLOWLY?
• Requires trust from the public that too many notes will not be issued
– Hence convertibility of banknotes to specie
• Danger of free banking is that the collective reputation of the banking system could encourage free riding
– Collapse of one bank could lead to contagion
• So banks have interest in a supervisory agency and a lender of last resort central banks
CENTRAL BANKS
• Contain market failures which lead to banking panics, common in Europe among private note-issuing banks
• Establishment often linked to specific crises
• Fractional reserve banking means banks will always be vulnerable to bank runs lender of last resort
• But central banks could be pressured to lend to government, fueling inflation
• Solutions: gold standard, independent central banks
WHAT DO BANKS DO?
THE IMPACT OF BANKS ON ECONOMIC GROWTH
• Impact on the saving ratio
– Increased opportunity cost of hoarding
• Impact on efficiency of use of savings
– Match savers and borrowers (importance of savings banks for low and middle-income earners)
• Increased monetarization of the economy
– Fractional reserve banking increased the money supply
FINANCIAL AND BANKING CRISES
• Liquidity crisis
– The bank is solvent, but cannot meet customers’ demand for cash (result of fractional reserve banking)
– Solved by lenders of last resort, central banks
• Solvency crisis
– Usually after financial bubbles, shocks to the value of assets – Has been solved by nationalizing then privatizing banks
• One often leads to the other
TRANSACTION BANKING VS.
RELATIONSHIP BANKING
• Transaction banking (UK): discount of bills, provision of short-term credit, etc.
• Relationship banking (Germany): as above, but also
investment banking, mortgage lending, some with close relationship with firms, ‘universal banks’
• Have been seen as reason for the rapid German catch-up
– German banks invested in firms at technological frontier
• There is some evidence that UK banks did not invest optimally, but relationship banking also bares risks!
BANKS VS. STOCK MARKETS
• Stock markets introduced in late 19th century
• Similar functions to banks, but different means
– Savers can diversify risk, have liquid assets – Borrowers get long-term commitment
• Mutual funds allow savers to diversify, and enjoy economies of scale in information
• Emerged at same time as banks: different sources of inefficiencies
– Banks fail, stock market bubbles, etc.
REFLECTIONS ON RECENT FINANCIAL CRISES
• Severe financial crises reduce GDP by around 5%, and economies are below trend for 5 or more years
• All financial crises over last 150 years preceded by very fast credit growth after deregulation or sloppy oversight
• After crisis more regulation… history repeats itself
– Deposit insurance, capital requirements, separation of investment banking
• ‘Too big to fail’: banks might overinvest in risky assets if they know they will be rescued
SUMMARY
• Development of monetary instruments and financial intermediaries gave social savings over time
• Costs of recurrent banking crises dwarfed by gains from a sophisticated banking system
• Can a system of regulation be developed which prevents financial crises?
• History suggests not!
