A great deal of nonsense about the 2008 financial crisis has been written, virtually all of it utterly worthless. Apart from the absurd calls that we should learn from Marx’ fallacious trade cycle theory1 there is also Robert Shiller’s opinion that there was
a speculative bubble driven by excessive optimism, driven by public inattention to risks of such an eventuality2.
Completely missing from the commentary on the global financial crisis, at least in the numerous articles I read, was any historical perspective. Although economists, unlike physicists or chemists, cannot perform experiments they do have the next best thing and that is economic history. That so few of them draw on this invaluable source is to be deeply regretted. Equally regrettable is the unfortunate fact that of those few members of the economic commentariat who sometimes try to use this tremendous pool of material virtually all of them fail to apply it effectively.
It is a little known historical fact, particularly among economists, that financial crises originating in the banking system existed in medieval times. Fortunately for us illuminating work has been done on early European medieval banking. For example, the financial crises that afflicted fourteenth century Florence provide an outstanding example of banking gone wrong. As Carlo Cippola graphically put it:
From the end of the thirteenth century and the first decades of the fourteenth there occurred a series of crises comparable in their gravity (if the scale of contemporary economy is taken into account) to the crisis that struck modern economy between 1929 and 1939. It will be sufficient here to cite the famous bankruptcy of the Florentine bank-houses. These crises ushered in a downward trend which continued to 1400 or thereabouts3.
In the twelfth century these sophisticated bankers developed fractional reserve banking by creating deposits in excess of their cash reserves. These excess deposits were aptly called “ink money” by a Florentine chronicler4. Having made loans that greatly exceeded their deposits it was only a matter of time before a crisis was triggered. Florentine banking was already experiencing financial strains in the early 1340s. By1343 a number of bankers had gone under: Neapolitan nobles started withdrawing their deposits and in 1345 Edward III defaulted on his huge debts to the Florentine bankers Bardi and Peruzzi. The following year they too declared bankruptcy5. This was followed by another wave of bank collapses. “[C]reating money” had built an unsustainable credit structure that was bound to result in a monetary contraction and a severe price decline, particularly in real estate, which is precisely what happened6. As Kenneth Clark put it7:
The result was one of the first classic crashes in the history of capitalism.
With respect to fractional reserve banking Raymond de Roover provided a detailed account of the dealings of the Medici Bank and its history. He estimated that the de Medici bank operated “on a tenuous cash reserve” of less than 10 per cent of liabilities8. What this meant in practice was illustrated by the state of the Tavalo bank, a de Medici subsidiary, which was operating on a 5 per cent reserve9. At one point the reserves of the London branch were 50 per cent of demand liabilities10. After 1494 and another the de Medici bank encountered severe difficulties as more and more depositors began withdrawing their cash, thus sparking a financial crisis. The result was that the bank failed and a general crisis, spreading through most of Europe. Despite de Roover’s detailed knowledge of the banking activities of the time he still arrived at the puzzling conclusion that “the cause of this crisis remains a mystery”11.
Abbot Payson Usher, a Harvard economist, gave an account of the development of fractional reserve banking in the late Middle Ages. According to Usher fractional banking emerged in the thirteenth century. He made a detailed study of the Barcelona Bank of Deposits, a study that put paid to any idea that medieval banking was too primitive to successfully engage in credit expansion. As Usher clearly put it:
Deposit banking is clearly demonstrated when we find items credited to depositors that did not originate in an explicit deposit of lawful specie by that depositor or some other depositor. The accounts of the bank [Barcelona] will show more deposits than cash… Credit creation, as thus defined. Is clearly attested in Mediterranean Europe by decisive documentary evidence at the beginning of the thirteenth century12.
Furthermore it is
important to recognise, however, that the difference between primitive and modern deposit banking can easily be exaggerated. There was considerable centralisation of clearance in the early period and extensive credit creation13. [Emphasis added.]
Usher examined the bank’s books for January 23, 1433, and found that it’s cash reserves were about 29 per cent of its deposits which meant “that the bank was capable of extending credit [meaning its “ink money”] in the ratio of 3.3 times the reserves on hand”14.
Over the years the bank’s ratio of cash reserves to deposits fell even further. Eventually its financial recklessness caught up with it and in 1468 it found itself unable to meet its depositors’ demand for cash. The response of the city burgers was exactly what one would expect. They granted the bank more privileges.
Mike Dash wrote a detailed account of tulip mania15, taking particular note of the huge credit transitions that drove the speculation. What he failed to see is that it is impossible for a speculation of that scale to appear without being produced by a very large monetary expansion16. So where did the money come from?
In 1628 occurred the famous capture of the Spanish treasure fleet by Piet Heyn, which netted 177,537 lbs. weight of silver, besides jewels and valuable commodities, the total estimated to come to 11½ to 15 million florins. More important than such occasional windfalls was the share of Dutch merchants in the new silver brought twice a year to Cadiz from the mines of Mexico and Peru, a share which represented in part the profits of trade with Spain and through Spain with the New World. Just what that share was from year to year we do not know. Only a few fragmentary estimates for non-consecutive years in the second half of the century have come to light. According to these the Dutch usually carried off from 15 to 25 percent of the treasure brought by the galleons and the flota, their share sometimes exceeding, sometimes falling below the amounts claimed by France or Genoa; ordinarily exceeding the respective portions of English, Flemish, and Hanseatic merchants17.
This sudden influx of gold and silver (of which Dash is apparently unaware) quickly expanded the money supply and by “1631 or 1632” created what Dash called a “feverish boom” where “there was more money around than ever before”18. Sooner or later surplus money finds an outlet and the market for tulips became one of those outlets. The demand for tulips started to slowly rise. In 1635 promissory notes emerged and tulips began to be exchanged for credit instruments instead of cash. The result was that tulip prices boomed, jumping by more than 200 per cent in 1636. The frenzied speculation that had gripped the market evaporated in early February 1637 when tulip prices collapsed rendering promissory notes worthless.
It was the sudden inflow of a large amount of Spanish gold and silver that drove the increased demand for tulips but it was the introduction of promissory notes that mainly fuelled the mania. Without the use of these credit instruments it’s difficult to see how the feverish speculation could have been maintained for any length of time. One thing is clear: though credit instruments can act as a medium of exchange and are capable of even raising prices they are still not money and therefore they cannot sustain a general price increase19, 20.
Ashton called the South Sea Bubble “the greatest speculative boom and crisis of the century”21. But was it? In 1711 the foundations for the ‘crisis’ were laid. It was in that year that the South Sea Company was established with the aim of funding the floating debt, eventually becoming its sole holder. In return the Government promised to pay 6 per cent. interest. The company had also been granted a monopoly on trading in the South Seas. Innocent enough, to begin with. Its shares gradually rose despite the fact that it did little trading.
All were not happy with the arrangements and the market’s immediate response. Walpole was one of a number of prominent figures to publicly warn that the arrangement “was an evil of the first magnitude.” (Evil or not he made a fortune dealing in South Sea stock by knowing when to sell.) By May the company’s stock had jumped to 550, five days later it was 890 but within hours it dropped to 640, indicating that people were getting nervous. The company primed demand by buying its own shares, raising them to 750 by the evening. This helped to restore confidence, which the company reinforced with rumours of imminent prosperity for shareholders. Come August, the stock stood at 1000, despite more stock having been issued. But it was becoming obvious to a growing number of people that their shares were grossly overvalued. This emerging awareness saw the stock fall to 400 by the middle of September and to 121 by December.
The thing to note is the crisis was focussed on a single company. It is true that rabid speculation in the company’s shares created opportunities for the emergence of speculative ventures that disappeared nearly as quickly as they appeared. But a national financial crisis requires rapidly expanding credit and rising asset prices, particularly real estate prices, throughout the country and yet the crisis was confined to London. The note issue was the principle means of credit expansion. Therefore, if there had been a boom the Bank of England’s accounts would show a significant increase in its note issue. For the years 1718 and 1721 the Bank’s note issue grew from £1,829,000 to £2,054,000222, a 12 per cent increase over a four-year period.
The boom in shares was narrowly based and funded by very narrow section of British society. The speculation was further fuelled by an inflow foreign money eager to join the herd. It is sometimes pointed out that number of London goldsmiths were bankrupted by the bubble, as if this was evidence of a genuine boom. But all it shows is that a handful of goldsmiths made bad financial decisions. It is true that there were large withdrawals of gold from the Bank and that the price of gold temporarily jumped from £3 10s to £4 10s 6d. But a flight to gold was the norm in times of financial panic. What matters is that there was no general financial collapse, no country-wide banking crisis, no inflation and no apparent effect on domestic trade or foreign trade and no monetary contraction. Therefore, the crash did not signify a general credit crunch.
It now appears that the South Sea Bubble was not a not a national financial crisis but a very localised affair, the economic effects of which rapidly assumed mythical proportions.
John Law’s Mississippi Company is an entirely different story, one too well known to require a detailed description. Suffice to say that Law was a Scottish economist, and avid gambler, who in 1716 obtained the permission of the French crown to establish the Banque Générale (later becoming the Banque Royale) which would issue bank notes redeemable in silver and whose issue became legal tender. John Law’s privileged position as head of the bank enabled him to implement his own economic ideas. The result was a boom, the Mississippi Company‘s share prices rocketed, as did real estate prices, while the annual inflation rate went as high 1,200 per cent or more. Then in I720 came the economic collapse and Law had to flee.
What is usually missed in the telling of this sorry tale is that Law was a proto-Keynesian. He wrote an interesting book, of which I have a copy, in which he revealed some remarkable economic insights as well as expressing proto-Keynesian fallacies. With respect to demand deficiency he asserted that
an addition to the money, whether the employer gains or not, [emphasis added] adds to the national wealth, eases the country of a number of poor or idle, proportioned to the money added, enables them to live better, and to bear a share in the public with the other people23.
It’s obvious from this quote alone why he thought expanding the note issue would expand the French economy and raise the demand for labour. His fallacious views on money, growth and the demand for labour led him to believe that it was the scarcity of money that made Scotland poorer than Holland24. He was led to this dangerous conclusion by his belief the rate of interest was a monetary phenomenon and that therefore interest rates were low in Holland because the country had an abundance of money. But interest rates were low because the Dutch were heavy savers, a trait for which they were well known25.
Unfortunately, our right have still not learnt the lesson of history. With reference to the 2008 financial crisis Des Moore, a former deputy head of the Treasury, stated that
while this is a very serious economic crisis, history suggests that human nature has a natural tendency to swing between optimistic and pessimistic attitudes almost regardless of the type of economic organisation prevailing in a country. But such swings have occurred quite frequently in countries that increasingly adopted free market type arrangements after about 180026.
This is terribly wrong on two accounts, both of which I shall return to in a later article. Suffice to say that the one thing our right has not learnt is those lessons of history that cast a true light on financial crises.
1Marx, Karl, Theories of Surplus Value, Part 2, ch. 17, Lawrence & Wishart London 1969.
3Revisions in Economic History: XII. Cippola: The Trends in Italian Economic History in the Later Middle Ages, Economic History Review, New Series, Vol. 2, No. 2, 1949, p. 181).
4Cipolla, Carlo, M, Before the Industrial Revolution: European Society and Economy 1000-1700, W. W. Norton & Co., 1994, p. 180.
5Cipolla, Carlo, M, The Monetary policy of Fourteenth Century Florence, University of California Press, 1982, pp. 8-10.
6ibid p. 13
7Clark, Kenneth, Civilisation: A Personal View, Harper & Row, 1969, p.
8De Roover, Raymond, The Rise and Decline of the Medici Bank:1397-1494, W. W. Norton & Company, 1966, p. 371
12Usher, Abbott Payson, The Early History of Deposit Banking in Mediterranean Europe, Cambridge, Massachusetts, Harvard University Press, 1943, p. 3
15Dash, Mike, Tulipomania, Random House, 2001,
16It was noted that credit instruments moved in tandem with the money supply.
Norman, George Warde, Letter to Charles Wood, Esq., M. P., on Money, and the Means of Economizing the Use of It, Pelman Richardson, 1841, pp. 4, 47.
Arbuthnot, George, Sir Robert Peel’s Act Of 1844, Regulating The Issue Of Bank Notes, Vindicated, Longman, Brown, Green, Longmans, and Roberts, 1857, pp. 27, 29-30.
Bagehot, Walter, Lombard Street: A Description of the Money Market, John Murray, Albemarle Street, 1920, pp. 141-142.
17Barbour, Violet, Capitalism in Amsterdam in the 17th Century, Ann Arbor: University of Michigan Press, 1963, p. 50.
18Dash, p. 127
19George Warde Norman, an executive of the Bank of England, explained why credit instruments are not money and why they cannot, “except for a short period, keep the level of general prices elevated above their real money range.” Oddly enough, he thought demand deposits were not money but merely transfers of credit.
Norman, George Warde, pp. 41, 37.
20Colonel Robert Torrens provided an invaluable, and possibly original, definition of money and why it is a mistake to think of credit instruments as money. He did a devastating take-down of Mill for accepting Thomas Tooke’s proto-MMT theory that money is self-creating.
The Principles and Practical Operation of Sir Robert Peel’s Act of 1844, second edition, Longman, Brown, Green, Longmans, and Roberts, 1857, Chapters I and III.
21Ashton, T. S., Economic Fluctuations in England 1700-1800. Oxford University Press, p.119.
23Law, John, Money and Trade Considered: With a Proposal for Supply the Nation with Money, R. & A. Foulis, 1750 (first published 1705), p. 123.
26Observations on Government Policies, 27th May 2009.