Money plays the most important role in our lives. It has performed a terrifyingly dominant role in carving the fates of kingdoms, families, dynasties and now countries.
From ancient Mesopotamia to the modern banks on Wall street, the ascent of money has been an indispensable part in the ascent of man. From the fluctuating prices of the homes we own to the high speed industrialization in China and India, the power of Finance is vivid wherever we look at.
500 years ago, the powerful Inca empire of pre Colombian America (South America) had no real concept of money. The Inca Empire appreciated the aesthetic qualities of rare metals. Gold was the sweat of the Sun, Silver was the tears of the moon, Labor was the unit of value in the Inca society. But in 1532, the Inca empire run across a man whose hunger for money lead him across the Oceans in search for it.
Francisco Pizarro had come from Spain to upper Peru attacking and defeating the Inca army. He struck it rich by discovering the Cerro Rico (rich hill). Towering nearly 16,000 feet above sea level, it was a money mountain where silver could be found. In the 250 years of Spanish rule, more then 2 billion ounces of silver(1 ounce = 28 gms, the current price of silver hovers around 30 USD for an ounce) were extracted from those mines. The Inca’s could not understand why the Europeans had such a lust for gold and silver. What they failed to foresee was the shiny Silver metal could be more than just a souvenir for the Europeans. It could be made into money, a store of value, a unit of account, portable power. The silver was refined with mercury and shipped to Europe In the form of bars and coins. Cerro Rico made the Spanish rich beyond their dreams.
And yet all the silver in Cerro Rico could not hold the inexorable economic and political decline of Spain’s Empire. The reason is that the Spaniards had dug up such an excessive amount of Silver, that the metal itself faced a sharp decline in value and all those silver coins didn’t make Spain richer. Instead it only made prices higher as an increased quantity of money chased the same amount of goods. The Spaniards failed to understand one important underlying principle that governs modern finance even today, “Money’s worth is only equivalent to what other people are ready to give for it”. And this has remained constant 500 years afterwards, whether money is in the form of Gold bullions, silver coins or bank loans of today.
Even lumps of clay can work in a similar way, if people have confidence in them. In Ancient Mesopotamia, nearly 4000 years ago people used clay tablets to commit themselves to particular financial transactions. Hence the clay tablet represented the debt that was to be paid to the one who possessed it. This was in essence the same concept as our present day paper money. It was a promise to pay, just like the notes of today.
In today’s World we are just not happy with money in the format of a paper but one that exists in our bank accounts, technically in an intangible shape. The backbone to this entire structure is trust. Money is about trust, even faith. Trust in the person paying you the money, trust in the central bank issuing the money, trust in the commercial bank that honors the cheques and so on.
Money isn’t metal, its trust inscribed and it doesn’t matter on what it is inscribed on (paper, clay, silver etc), provided the recipient believes in it. It was this idea of trust that lead to credit, where you could rely on people to borrow money from you and pay it back on a certain future date. That’s why credit comes from the Latin word Credo, which means “I believe”. Without the invention of credit, the entire economic history of our present new world would have been impossible. Credit literally doesn’t make the world go around, but it definitely does make vast quantities of people, goods and services go around the world.
The world however has not always been very nice to money lenders. Early money lenders were not thanked for their services, but were highly disregarded and looked down upon. This is depicted in the famous William Shakespeare’s novel “Merchant of Venice”, wherein Shylock is depicted as a blood sucking hungry money lender who demands for a pound of flesh from Antonio, as collateral for the money loaned out. Jews who stayed in Venice had to wear a yellow hat and they were confined to a stay in a ghetto. The reason why the Italians accepted the Jews was simple. The Jews could provide a service that Christian merchants were forbidden to do. Lending money at an interest was a sin as per Catholic law.
The medieval churches laws on Usury made it difficult for finance to grow rapidly in Eastern Europe, as no god-fearing Christian would risk the barbarity of hell. The price the Jews paid for performing this service was social exclusion. Money lenders were hated people, because not only did they charge interest for what they loaned out, but also the risk that the borrower went through for defaulting on a loan was severe. Money lenders on the other hand had to be ruthless, since the risk of even a single person defaulting would incur a huge loss for them. They had to find an answer to the dilemma they faced. If they were too generous they didn’t make any profits and if they were too hard-nosed then that would increase the chances of the lender defaulting. The answer was to get bigger and more powerful. It was time to invent banks.
In 15th century Italy, the key financial service of providing credit moved out of the “ghetto” to become the legitimate preserve of banks. This transition was symbolized by the rise of the Medici family. With their rise, money lending ceased to be disreputable. It became glorious and a foundation of a new kind of power.
It was Giovanni di Bicci de’ Medici aim to make money lending legal that led to modern day banking. He was an Italian banker, a member of Medici family of Florence and the founder of Medici Bank. He is credited with devising an ingenious bit of creative accounting that helped him succeed and get the Medici off the hook of the anti usury laws. The Medici was basically comprised of foreign exchange traders profiting from commercial bills for financing foreign trade. The church prohibited the collection of interests on loans, but there was nothing to prevent a trader from involving in transactions that involved multiple currencies. There was no interest and hence, no sin.
There was simply a commission or deduction for the conversion of one currency into another. The commission varied depending on the time frame and amount that was loaned to the trader. In addition to this, depositors, that included church dignitaries, great nobles, political figures, put their money into the Medici bank. Such deposits were not usually payable on demand but were either explicitly or implicitly time deposits on which interests, or rather “discrezione” were paid.
The bankers argued that discrezione was a free gift and not a contractual obligation. This was credit payment in simple words but with the interest payment discretely concealed. Now for the first time, money lending had evolved into Banking. The key to the Medici bank success was diversification. Earlier, European banks had been monolithic and very vulnerable to default by a single bad borrower. But the Medici bank was made up of multiple interlocking partnerships, each in some way independent from the rest. It was this decentralization that lead to their astonishing profits. Under Giovanni guidance, the Medici bank improved its network from Florence to Venice and also to Rome. The scale and diversity of the bank was the key to reducing the risks of money lending, and therefore the costs to the borrowers.
This was the main difference between a loan shark and a bank. While a loan shark is free to quote the interest rate based on his/her free will, the Medici bank worked towards a common aim of lowering the borrowing costs for traders. The rise of the banks had begun and it was now one of the most profitable and respectable business. In 150 years the Medici transformed themselves from backstreet money lenders to the most powerful financial force in Europe. Having once being damned, bankers were now close to divinity.
The business model used by the Medici bank involved used scale and diversity to spread out risks. Also by focusing on currency trading rather then just lending they reduced their exposure to defaulters. However, they were not invulnerable and faced losses because of over generous debts and blue blooded defaulters. But more importantly the Medici left a permanent mark in the financial industry, giving rise to modern day banking. He gave the banking industry a logical business model to diversify risks and reduced interest rates, that govern our lives and our countries future in the most important ways.
The ascent of banks was followed by the ascent of the second pillar of the modern financial system, the bond market. Bonds provided the magical link between the world of high finance and the world of political power. Government normally spend a lot more than they collect in taxes and make up the difference by selling bonds that pay interest. But the magic with bonds is that if you want to get rid of them, the government doesn’t have to give you the cash back.
You can simply go to a bond market to sell it. The birth of the bond market was the next big revolution in the history of finance. It paved a new way for the government to raise money. It funded the wars that plagued Italy 600 years ago, dictated the outcome of the Battle of Waterloo, decided the outcome of the Civil war in United States, and in more recent history have made powerful nations such as Argentina come crashing down.
In the 14th and 15th century the medieval city states of Florence, Vienna and Tuscany were at war with each other. And these wars required financing and large volumes of money. Rather then requiring their citizens to fight, each city state hired military contractors or “condottieri” that raised and lead armies to another land and loot treasures. These condottieri required money in abundance and the armies were ready to fight for anyone who paid them. The costs of these incessant wars plunged Italy city states into crisis. Expenditures even in days of peace were more than double the money collected from taxation.
Bonds were a way for a country or kingdom to turn its citizens to its biggest investors. It looked like the problem of debt was solved but there was another that creep ed in. How much money can be raised through bonds? The more number of bonds that were issued, the less valuable they would be to the investors. At the same time, it’s the bond market that sets interest rates for the economy as a whole. If the country has an effect to pay 50 percent, so do all the other borrowers. Thus bonds dictated the outcome of the countries future deciding the fates of many other historic events such as the Civil war and the Battle of Waterloo. This proved to be an important milestone in the history of the financial world.