the colour of money

How much reliance do you place on promises? Do you, for example, expect them to be kept? Before you answer, you might want to consider the following:

The Hongkong and Shanghai Banking Corporation Limited promises to pay the bearer on demand at its office here ONE HUNDRED HONG KONG DOLLARS.

Inscription on HK$100 banknote.

This statement is meaningless. Assuming that the bank isn’t going to exchange your $100 note for another, I can’t help but wonder what it thinks the promise means. It’s obviously not going to exchange your $100 banknote for one $70 and two $15 notes, although it might as well given that this so-called promise is no more than a form of words. A piece of paper bearing such a promise is essentially worthless. Money is only as good as the confidence that people have in it, and paper money, it turns out, is no more than a gigantic fraud perpetrated against willing victims.

Until the First World War, it was possible to go into the head office of a note-issuing bank in most industrial countries and exchange such a promissory note for its equivalent value in gold. The war put paid to that practice. In even earlier times, silver (or gold), neatly fashioned into convenient units, was the only kind of money. Its value was real and instantly recognizable. Now all the ‘silver’ coins are cupronickel, which, if not intrinsically worthless, has a value that is a mere fraction of the amount engraved on the coin. Gold coins still exist, but they are not for everyday commercial transactions: they are simply bullion, a convenient way to amass and store wealth.

When humans first began to coalesce into settled agricultural communities, there was no money, and any inter-community trade would have been via the medium of barter. This would have worked well enough between small communities with broadly similar products to offer and similar needs, but as villages became towns and towns became cities, the need for a more efficient system would have become increasingly apparent. Hence the invention of coins, which resolved the obvious difficulty of finding someone who was willing to exchange their cattle directly for a wagon, or a sack of grain for a bolt of cloth.

Unfortunately, anyone receiving a gold or silver coin could not be sure what they were getting: coins might be of their proclaimed weight and therefore value, or they might be less. They might also contain an unknown amount of a base metal. Over time, a coin’s intrinsic value would be related to the perceived reliability of the issuing authority. In other words, money would either be reliable but scarce or unreliable but relatively plentiful. In both cases, uncertainty would be built in: uncertainty over opportunities for earning money, or uncertainty over what that money, once earned, would buy.

However, ingenuity didn’t stop with the invention of coins. The next innovation was the establishment of banks, which were used principally as repositories for accumulated wealth. They flourished first in the Roman Empire and reached a high level of development in the Italian city-states of the Renaissance. However, the first major innovation in banking practice took place in Amsterdam in the early seventeenth century. The majority of coins in circulation at that time were appallingly deficient in weight and/or purity, so the city’s merchants created a bank that was owned by the city—an embryonic central bank. The Bank of Amsterdam solved the problem of quality by going back to a system that had preceded the invention of coins: weighing. A merchant could bring all the coins that he had received in the course of business to the bank, and after they had been weighed their total value would be credited to his account.

This turned out to be a reliable form of money, because the merchant could then transfer some of that credit to a fellow merchant, and the recipient could be sure that he was getting honest weight. It wasn’t long before payments through the bank commanded a premium over conventional transactions. But then came an interesting discovery: the money deposited with the bank didn’t have to sit idly; the bank could lend that money. The borrower then had an amount that could be spent, but the original deposit could also be spent. There is an obvious difficulty here: the borrower and the depositor must not come for their money at the same time. They must trust the bank, trust it as far as believing that it isn’t doing what it does as a matter of routine.

One of the recurring themes in the history of money is that every system for its creation and management contains within itself the seeds of some unforeseen future abuse. It was thus with coins, clipped, ‘sweated’ with acid and otherwise debased until faith in their value had been eroded almost beyond repair. And so it was with the Bank of Amsterdam, which lent huge sums to the Dutch East India Company. The men who ran the bank were often the same men who ran the company, and over time the scrutiny given to loans grew increasingly lax. Times became harder for the company: there was war with Britain, and ships didn’t come back. One by one, loans went into default. As noted above, a bank can operate only if its depositors do not come for their money all at once. However, if they even suspect that they won’t be able to withdraw their money, they are sure to come. And they did. The Bank of Amsterdam was wound up in 1819.

However, long before the Bank of Amsterdam finally closed its doors, a far more spectacular example of banking malfeasance had occurred in France. Louis XIV had died in 1715, leaving the country bankrupt after a long and extravagant reign marked by a succession of largely pointless wars with much of the rest of Europe, and an heir only five years old. The country was therefore left in the hands of the regent, the Duc d’Orléans, a dissolute character with an expensive lifestyle and a big problem. The treasury was empty.

Apparently hopeless situations such as these offer opportunities for a scoundrel, and it wasn’t long before one appeared. John Law was the son of an Edinburgh goldsmith who, in 1716, obtained permission from the regent to open the Banque Générale. As part of the deal, Law’s bank took over the debts of the regent, and therefore of the country. In 1718, the bank became the Banque Royale, meaning that notes issued by the bank were guaranteed by the king; these notes were, in essence, promises to pay their holders their face value in silver or gold. It is not difficult to see why the regent was so easily persuaded.

In 1717, Law had acquired the Mississippi Company to support the French colony of Louisiana and to mine the ‘unlimited’ supplies of precious metals to be found there. However, as would soon become apparent to holders of the bank’s notes, the gold and silver backing the notes was in mines as yet undiscovered in the unexplored parts of the colony, which extended well beyond the boundaries of the modern American state, north to Minnesota, west to the Rockies and east to the Alleghenies.

By 1719, Law’s notes were being issued in the hundreds of millions. Government creditors who were paid off in the notes rushed to buy stock in the Mississippi Company and the Banque Royale. From the proceeds of these sales, more money could be lent to the government, more notes could be issued, and yet more stock could be sold. It was in effect a closed system for recycling worthless paper in which everyone involved was getting rich, on paper. The word ‘millionaire’ first appears during this episode.

Inevitably, doubts began to surface about the reality of the gold and silver, and people started to bring in their banknotes for redemption. By no stretch of the imagination was there enough gold and silver to pay off the notes, so payment was suspended. Law was lucky to get out of Paris alive.

However, there is another side to this story. In his role as comptroller general of France, Law had directed large sums into building canals and other useful public works. His mistake was not in issuing paper money but in issuing too much of it. Could the system be made to work if used in moderation?

The Bank of England had been set up in similar circumstances in 1694. The king, William of Orange, was also in debt, not as a result of succeeding Louis XIV but as a result of fighting him. He was persuaded that such a bank would solve his problems. Rich private subscribers put up the cash he needed, in return for which they were allowed to issue notes backed by the king’s promise to pay. This evolved into a system whereby these original subscribers, goldsmiths and the like, issued banknotes secured against the bullion in their vaults. When the Bank of England received such notes, it returned them for redemption, thus ensuring that these early bankers weren’t reckless in their issuing of banknotes.

As noted above, this remained the paradigm for the management of money until after the First World War, by which time the issuing of banknotes had become the prerogative of central banks. However, around this time the private banks discovered that they could make more money and therefore more profit not by lending money but by investing it. And therein lay the seeds of further abuse. Where investment had once been in stocks and shares, it metamorphosed into another system for recycling worthless paper: ‘structured investment vehicle’ sounds very impressive, until you realize that this was the label attached to an investment backed by American sub-prime mortgages. Which swindler thought that one up?