With this lecture, I start to look at the second great puzzle of macroeconomics. How does the financial sector affect the real economy? Before one can answer that question one needs to examine the fundamental role of money and credit. In this lecture, I suggest that they are closely linked to government power.
I have a very skewed view of economic history.
Imagine yourself in the environment, which existed until about 300 years ago, in which the overwhelming challenge was to obtain food. Not many people can make a living in art, science, education, or software development, because people need to eat. So you have to be engaged in primary food production. That means you need land, and you can’t live close to a lot of people. There are not many people to trade with. There is very little surplus to trade. Maybe every six months or so you have a festival where you get together with people from miles around, get drunk, and swap a few bowls, to give future archaeologists something to get excited about.
If you’re really sophisticated and disciplined, maybe you organize an army that conquers lots of farmers. They pay taxes (in the form of food), you use the taxes to feed soldiers and slaves. The latter build cities. Some of the children of the elite soldiers, knowing that their parents will feed them, go into art, science, software development, and so on, which gets the future archaeologists even more pumped up.
I don’t think of pre-modern economies as market economies, in the sense of people voluntarily specializing in production for sale. Instead, I see individuals focused on subsistence, and organized groups focused on war, financed by plunder.
A standard textbook starts by assuming a market economy, explains how money makes such an economy more effective, and then incidentally introduces a role for government in regulating money and banking.
My skewed view is the opposite. For me, money and credit start out as tools of government, and they get incidentally adopted by the market.
Imagine that you’re a warlord leading a band of soldiers. Your business model is that your soliders prey on farmers, taking plunder and tribute. To help motivate your soldiers, you promise them a share of the booty.
When the band of warriors is small, the promises can be verbal and informal. However, in order to organize a large army, you need formal, written contracts. Lacking lawyers and xerox machines, you make little carvings on metal, hand them out to soldiers, and say, “After the battle, turn this in to the clerk and we’ll give you a share of captured slaves and grain and stuff.”
In this simple model, governments exist to make war or to subjugate populations. The warlords sometimes pay their warriors on credit, using coins or other means. The warrior knows that the warlord will redeem the coins for booty.
Eventually, the coins can start to circulate in a secondary market. As warriors start to accumulate slaves and goods, they sometimes trade with one another. Every once in a while, instead of exchanging a slave for a few bottles of wine, you might exchange the slave for some coins.
Keep in mind that the standard view is that a market needs money as a medium of exchange. Suppose that the person selling grain wants shoes, the person selling shoes wants wine, the person selling wine wants olive oil, and the person selling olive oil wants grain. There is no two-way trade that works (we say there is no “double-coincidence of wants”), but a four-way trade is clearly possible. Using money as a medium of exchange makes it a lot easier for this complex trade to take place.
In the standard view, if you did not have a market economy, with lots of specialized production and consumption, then you would not need money. If people are just living on subsistence or making occasional bilateral trades, money would not emerge.
In the skewed view, money can exist even without a market economy. A big-time warlord needs to be able to procure soldiers on credit, and the warlord issues credit instruments that act as money. Maybe if the warlord builds a really big organization and accumulates a lot of plunder and tribute (think of the Roman empire), you start to see markets where different types of plunder are exchanged, and money serves as a medium of exchange along the modern textbook lines.
Money’s value reflected the military power of the warlord. A really strong warlord’s coins would be widely accepted. A shaky warlord might have trouble getting his coins accepted. You can imagine that there are strong positive feedback loops. A rising warlord has a more powerful currency, which buys more soldiers, who deliver more plunder, which strengthens the warlord, which makes his currency more in demand, and so forth. When the warlord falters, the process goes into reverse. A warlord needs a good financial operation as well as a good military operation.
If somebody is good at accumulating money but not so skilled with a sword, he can form a symbiotic relationship with a warlord. The warlord needs the money maven to help finance expeditions, and the money maven wants the warlord to protect his wealth. Hanging over this relationship is the threat that the warlord will steal the money maven’s wealth or that the money maven will switch sides and bankroll the warlord’s enemies. One can imagine a variety of incentive mechanisms that would be devised to sustain the relationship, including land grants by warlords to money mavens, marriages arranged among children of money mavens and children of warlords, and so on.
I can imagine that until quite modern times, the typical person had only occasional contact with money or credit. Instead, money and credit were instruments of rulers and the warriors needed to sustain rule.
It could be that for the typical person, the use of money was coerced. A farmer might be ordered to accept money for grain. With the exchange rate of money for grain dictated by the wardlord rather than determined in a fair market, this would be a convenient form of taxation.
The government need not use a particular grain-for-coin price to take advantage of seignorage. An alternative approach would be to require that taxes be paid in coins. That would force the farmer to acquire coins, trading grain for coins at whatever price the market generates.
From the skewed perspective, one would expect to find finance and government power closely linked. In the world at large, military strength should correlate with the acceptance of a government’s financial instruments. Within a country, the wealthy need political power in order to preserve their financial position, and governmental leaders need financial resources in order to preserve their political power.
According to the skewed view, there was never a state of nature in which financial institutions roamed free in the wild, to be later tamed by regulators. Instead, financial institutions were fundamentally institutions of government. Entrepreneurial finance is a modern development, and its separation from government may always be tentative.
The early United States, in this as in other things, seems exceptional. Our frontier society was resistant to government and engaged in some experiments with banking that was quite independent of the Federal government. Eventually, the Federal government consolidated its hold in the United States, and “free banking” was no more. (I am not an expert in this history of free banking, but I suspect that at the state level there were lots of ties between banks and government during the “free banking” era.)
In the contemporary situation, we want to find a neat dividing line between government and finance. However, this is proving difficult. From the skewed perspective, it comes as no surprise that we are having a hard time creating a financial architecture that clearly separates the roles of government and private institutions.
Previous lectures in this series:
1. Introduction
2. Misconceptions about Labor Markets
3. Unemployment as an Adjustment Problem
4. Why Wage Cuts are Rarely Used
5. The Dotcom Recession was, by one indicator, rather severe
6. Labor Markets in the Post-industrial Economy
READER COMMENTS
Aaron Durst
Nov 20 2008 at 11:30am
The problem is the evidence does not support the claim that money is closely linked to government power. For evidence, look at prisons, and prisoner of war camps (may I suggest watching Stalag 17). Informal money supplies always spring up in such situations. Generally, cigarettes become the dominant form of money in such settings (I understand that cigarettes have been banned in federal prisons, and the prisoners now use packs of Mackerel as the form of currency). It is not because there is some “quasi” government power in such settings that creates the money supply. Instead, individual prisoners want some store of value to easily trade their goods and services.
burger flipper
Nov 20 2008 at 11:31am
Many thanks for this series. Learning Economics is now on my Xmas list. Been reading the GMU mafia for about a year and while I was drawn in by the cute/counter-intuitive faction, I think I’ve learned the most from your postings.
Arnold Kling
Nov 20 2008 at 11:43am
Aaron,
I am aware of the prison examples. I don’t think they offer decisive evidence, though. A prison is not a production economy. It’s an exchange economy, where the goods arrive like manna from outside. Dump a lot of goods on a dense population and, yeah, you will get a medium of exchange.
I don’t think that’s a good way to model how economies developed historically.
Thomas DeMeo
Nov 20 2008 at 11:58am
“The Sovereign Individual” (by James Davidson and William Rees-Mogg) explores the relationship of violence, economics and sovereignty in some very interesting ways.
scott clark
Nov 20 2008 at 12:30pm
Hey Doc,
You better call Mark Cuban and let him know he is going to need to get in bed with the Feds since “the wealthy need political power in order to preserve their financial position.”
Dennis Mangan
Nov 20 2008 at 1:26pm
Arnold, you write “A really strong warlord’s coins would be widely accepted. A shaky warlord might have trouble getting his coins accepted.” But, until quite recently, a coin’s face value just was what the precious metal it consisted of was worth. Governments that tried to make coins that were worth more than the actual precious metal were said to be “debasing” the currency. Therefore, that a “warlord needs a good financial operation” doesn’t seem to follow. His coinage is either good, or not.
Arnold Kling
Nov 20 2008 at 2:24pm
Dennis,
They why were gold coins issued with pictures of rulers on them? Why couldn’t Joe Shmo issue gold coins? If the value is intrinsic to the coin, then a coin engraved with Joe Shmo’s picture ought to be just as valuable as a coin with the emperor’s picture engraved on it.
Dennis Mangan
Nov 20 2008 at 2:46pm
Perhaps because the Joe Schmoes of the world didn’t own gold mines, and if they did, the government would confiscate it. Furthermore, at certain times coins were accepted in places whose ruler did not match the face on the coin; for instance Spanish pieces of eight in the American colonies. That would not be the case if it was “finance” that made the coin valuable; it would only be accepted for the precious metal content.
Derek Christiansen
Nov 20 2008 at 5:44pm
Dennis,
Perhaps because the Joe Schmoes of the world didn’t own gold mines, and if they did, the government would confiscate it.
Precious metals have no intrinsic value other than
the effort to retrieve them from their natural state as ore.
Example: many idiots still think gold is valuable and is REAL money…even though it is now produced by slicing mountains and then washing the dirt with sodium cyanide…the higher the price of gold, the more marginal mountains get sliced down to be acid washed for Au. (people used to think it was sunlight made physical, and as such was God’s blood).
Money is the stuff of self; nobles, warlords, kings and Warren Buffet types have more manna in
the eyes of most, and hence have more self.
The modern world now recognizes that each and every person has a self, and a corresponding amount of self.
Hence, real freedom is when each of us gets to participate in the real economy without the lame
magic money of metals (or culturally specific magic paper squares).
Our problem right now is that we don’t have a universal currency, but several that can be played off each other by central government banks.
Tell me how the self of a Japanese person is different in kind from an American or European?
There is no difference, why should the money be different?
Trade surpluses, balances of payments, public debt as policy are all part of the fake game of believing in “magic money’s” proxies rather than the stuff underneath.
Mark Seecof
Nov 20 2008 at 6:01pm
Often coins didn’t have rulers’ pictures on them (look up “florin”) and even when they did, it was often for egoboo/propaganda and as a trademark of quality (like the “jolly green giant” on a can of peas).
Rulers did generally take over the minting of coins in their territories so they could make a (steady but small, except during waves of debasement) profit on the seignorage. Rulers would take over any concentration of economic activity (often by a “monopoly/licensing” scheme) for the same purpose. Rulers would sell towns licenses to hold market-days, for example. In the pre-punchcard era, tax collecting was such an administrative bother that monopolization for the purpose of rent extraction seemed to many rulers the most effective approach.
While it was common for rulers to demand tax payments in their own coins, they would trade those coins for only slightly more metal in other coins/forms–seignorage again. The metal itself determined the value of a coin in extra-territorial trade– no one outside a ruler’s territory would accept his coin at some arbitrary value just because of his picture on it.
While it is certainly true that rulers routinely manipulated money, I don’t think your story shows that money would not exist but for rulers creating it.
Alex J.
Nov 20 2008 at 6:28pm
I don’t think of pre-modern economies as market economies, in the sense of people voluntarily specializing in production for sale. Instead, I see individuals focused on subsistence, and organized groups focused on war, financed by plunder.
It was certainly the case that people were primarily concerned with subsistence, but I think completely discounting commerce is mistaken. The Athenians had banks and operated with letters of credit. Herodotus reported that the Phonecians traded with tribes along the North African coast with minimal contact. (The tribesmen were afraid to get too close b/c the Phonecians were slavers. They still managed to trade.) There were ancient greek pirates before the Athenians came to prominence which implies that there was trade for them to prey upon.
Both Athens and Rome grew large enough that they couldn’t feed themselves and had to exchange for grain. You could make the case that this was plunder. In the case of the Greeks at least, much of their grain came from prosperous Greek colonies in more fertile lands.
you make little carvings on metal, hand them out to soldiers
If this was the case, the coins would be tokens designed to be difficult to counterfeit. Instead, coinage in the early middle ages was a flat lump with a stamp. It was “counted” by weight rather than by counting up the coins. This seems to me to indicate that the value of the coinage was primarily the metal content.
A big-time warlord needs to be able to procure soldiers on credit
I’m pretty sure they just promised shares of the loot. Pirates worked that way. I believe William the Conqueror rewarded his henchmen with land grants in the conquered territories.
The Greeks formed colonies where they just chased off the few locals who were under-using the land and went to work farming and trading.
A really strong warlord’s coins would be widely accepted.
Look at the history of Roman coinage. When the Romans were up and coming, there coinage was sound and accepted. When they were weakening, their coinage became debased and useless.
In the early middle ages, coinage was used to pay off the strong, rather than issued by the strong. France became denuded of coinage because of all of the Danegeld. IIRC, the lack of coinage became a problem. (And not just in the sense of not being able to pay off the vikings the next time.)
Entrepreneurial finance is a modern development
Parable of the talents
Instead, money and credit were instruments of rulers and the warriors needed to sustain rule.
The Florin had much more influence economically that Florence had militarily. The wikipedia article mentions the Hungarian forint being prominent because Hungary was a source of gold (not b/c of its military.) And apparently, the first Florin didn’t have a picture of a ruler on it.
Within a country, the wealthy need political power in order to preserve their financial position, and governmental leaders need financial resources in order to preserve their political power.
If all relationships are those of subjugation and domination, this is true. It leaves out voluntary trade. There was plenty of voluntary trade before the modern era, even though there was plenty of domination and subjugation too.
In the God of the Machine, Paterson claims that the Carthaginians were merchants who strangled commerce in order to extract all that they could from it. In contrast the Romans were farmers and warriors who overlooked commerce because of a fundamental disinterest in it. Trade thrived in neglect. I’m not certain that Paterson is a great source, but the idea seems plausible to me.
Our frontier society was resistant to government
The frontier was far from the stationary bandits in the East. The mobile bandits were not such a problem. Why the modern world is afflicted with mobile bandits in all of the places that there isn’t much in the way of stationary bandits seems like an important question to me.
Mark Seecof
Nov 20 2008 at 6:34pm
With respect to the value of rulers’ coins in trade outside their territories, I should note that coins have (at least) two values: “intrinsic” value (that is, whatever local price a coin’s substance (e.g., metal) will bring), and “value in trade.” If you offer me a coin from Burplestan here in Belchistan, I may offer you some approximation to the Belchistan value of the goods I can buy with that coin in Burplestan, discounted for the cost and trouble of sending that coin back to Burplestan and bringing Burplestani goods to Belchistan. By remarking a moment ago on the intrinsic value of coins, I didn’t mean to deny the existence of value in trade. For, e.g., paper money, the value in trade is all– the bills have near-zero intrinsic value.
A sufficiently forceful ruler can give his coins a value in trade; as Dr. Kling pointed out, he can just treat each of his coins as an IOU for a certain quantity of goods (to be reaved from subjects or victims of war).
By demanding tax payments in coin (fiat money) of the realm then managing the supply of same, a ruler can fix the value-in-trade of his coins (bills) subject only to constraints of the wealth in goods and services at the mercy of the ruler’s force.
Some rulers (e.g., those of the USSR) have maintained multiple currencies with different values in trade (e.g., ordinary and “certificate” rubles) based on the degree of force the ruler applies to their values.
James
Nov 20 2008 at 9:49pm
Arnold,
Your economic history seems to defy arithmetic. Before the warlord’s victims are subjugated, they aren’t productive enough to feed themselves and also produce enough extra stuff to trade and also produce the first steps toward modernity. After they are subjugated, they are productive enough to feed themselves and produce enough extra to trade and produce the first steps toward modernity and still they can even provide consumption goods for the warlord’s troops.
If arithmetic is not enough to convince you, what would you accept as evidence against your view of economic history?
You already know the answer to your question about why governments put pictures of their leaders on money. Nearly everything governments do is intended to celebrate their leaders’ own sense of importance or to increase their ability to spend. Putting Ceasar’s image on a coin makes Caesar feel important and increases his spending power as currency can be debased in ways that plain metals cannot.
Econ Student
Nov 20 2008 at 11:06pm
Very impressive. I really enjoyed the use of imagery to explain where you believe markets begin. It is a somewhat unique analogy that makes a point well. I’ve been studying the economy recently and we have not touched on this. Thanks for your thoughts.
hacs
Nov 21 2008 at 3:27am
Perhaps the government power question with relation to money and credit could be secondary.
A MARKET ECONOMY IN THE EARLY ROMAN EMPIRE
by Peter Temin
http://econ-www.mit.edu/files/1238
Tsgt Fisher
Nov 21 2008 at 8:05am
You are ignoring that throughout the world peaceful cultures innovate money in various forms, coffee beans, salt, seashells, ect. One missionary I was talking to told me about a tribe he visited in the mountains who used seashells as their primary currency. These were subsistence farmers stunted in growth by malnutrition and the thin air of the mountains, not warlords, but currency arose naturally.
These seashells were found in abundance down the mountain at the shore and the missionary had thought about bringing a bucketful up. Luckily, he thought that through and decided against it.
Money is a naturally occurring phenomenon.
Michael
Nov 22 2008 at 10:20pm
Very interesting lecture. I’m really interested to hear how you think the financial sector effects the real economy. Thanks for these lectures!
Tsgt Fisher
Nov 24 2008 at 8:03am
Ok, how about post WW2 Germany using cigarettes as de facto currency. This was talked about in one of Milton Friedman’s books (Free to Choose or Capitalism and Freedom). I think he lists other examples also.
jimbo
Nov 24 2008 at 3:47pm
This is what I love about economists. Why do any actual reading in history, archeology, etc. when you can just theorize about how it “must have been”? After all, you’re an economist, and everyone knows economists know more than the people in those other departments that look at actual, y’know, data and documents and stuff. Why, look at their papers! Just a lot of words, with hardly any equations at all!
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