The Nature of Money (Part II)

It started innocently enough, at least in Western Europe. I can’t speak to the Caliphate, China, or India. Vincenzo, a goldsmith living somewhere, most likely in Italy, built a vault to hold his stock of precious metal and perhaps even hired a solider or two to guard his stash. Bumpus, his neighbor, had two gold coins buried under the hog trough. Bumpus, while suffering from insomnia one night, thought, “Perhaps my gold might be safer in the goldsmith’s vault.” He offered Vincenzo three chickens and two dozen eggs to store his gold coins in the vault. Vincenzo accepted the offer, took the coins, issued Bumpus a signed receipt for his gold, and locked it up in the vault.

Time passes. Bumpus prospers and wants to buy a small piece of land adjacent to his pathetic farm. After the negotiations are complete, the landowner wants Bumpus to pay the agreed upon price, two pieces of gold. The peasant shows the landowner his receipt from Vincenzo. The landowner, knowing Vincenzo to be a man of his word, accepts the paper, goes down to the vault, verifies its validity, and walks home happy to leave his gold right where it sits. Two peasants and a goldsmith have just invented paper money.

Time passes. Vincenzo’s son, Ludovico now runs the family business. The Count of Bahjoria, the local bigwig, has a wife who wants to build an addition to their castle but he can’t get enough money out of tax revenues. He calls Ludovico to his office and offers a portion of his tax revenues plus a return of principal if the goldsmith would kindly lend him enough of his gold stash to complete the project. This is going to take more money than Ludovico personally owns, but being a more sophisticated businessman than his father, Ludovico writes the Count a bill for more gold than he owns but less than is held in his vault. They have just invented fractional reserve banking.

Time passes. The agreement with the Count worked so well Ludovico bought a grand estate just outside of town and sent his son to the University of Paris. His neighbors eyed the goldsmith’s change in lifestyle and grew suspicious. They thought, “What is that rascal, Ludovico, doing with my gold.” They all marched down to the vault and demanded to see their coins. Of course they weren’t there. Not wishing to be lynched, Ludovico explained what was going on and offered to cut his customers in on his profits. Ludovico and the lynch mob have just invented the savings account.

Time passes. Alessandro, Ludovico’s son, now wealthier than the Count, has left the goldsmith business and owns what has become the First Bank of Bahjoria. Wishing to become a nobleman himself, he offers a bribe to the Pope that exceeds his entire stock of gold. He gets away with this for a while, but the Pope wants to field an army against the Baron of Badburg. On the way to the crusades, the Baron decided looting Italy was more rewarding and safer than fighting the Arabs in the Holy Lands. The Italian soldiers want gold. Count Alessandro the Magnificent doesn’t have enough to cover his promissory notes. Word gets out and the lynch mob hangs Alessandro. The Pope, the lynch mob, and Alessandro have just invented a run on the bank.

This sad story has been repeated thousands of times in the last 500 years in locations all over the world. It is pretty much what happened at Citibank and Bear Sterns last year. Although the sons and daughters of Vincenzo are far more sophisticated and are dealing with sums so vast, Galileo himself probably couldn’t comprehend such numbers, nothing has really changed but the faces and the names of the financial instruments. If we return to the original model, a customer paying a banker to store his gold in the banker’s vault, there will not be any money to fuel economic growth. Capitalism needs good debt to survive. The money to create a new industry, like the automobile at the start of the Twentieth Century, simply does not exist. It must be created through some combination of bonds, common or preferred stock, or outright loans. All of these are debt instruments of some sort. As long as everybody behaves ethically everything works just fine. However, history has proven again and again that always some sharp character is going to get a little too greedy and issue bad debt, most recently Collateralized Debt Obligations on bad mortgages and Structured Investment Vehicles that function as banks while avoiding regulations. Eventually this bad debt is discovered, lives are ruined, fortunes are destroyed, and real people like you and me suffer.

Psalm 73

[1] Truly God is good to Israel, even to such as are of a clean heart.
[2] But as for me, my feet were almost gone; my steps had well nigh slipped.
[3] For I was envious at the foolish, when I saw the prosperity of the wicked.
[4] For there are no bands in their death: but their strength is firm.
[5] They are not in trouble as other men; neither are they plagued like other men.
[6] Therefore pride compasseth them about as a chain; violence covereth them as a garment.
[7] Their eyes stand out with fatness: they have more than heart could wish.
[8] They are corrupt, and speak wickedly concerning oppression: they speak loftily.
[9] They set their mouth against the heavens, and their tongue walketh through the earth.
[10] Therefore his people return hither: and waters of a full cup are wrung out to them.
[11] And they say, How doth God know? and is there knowledge in the most High?
[12] Behold, these are the ungodly, who prosper in the world; they increase in riches.
[13] Verily I have cleansed my heart in vain, and washed my hands in innocency.
[14] For all the day long have I been plagued, and chastened every morning.
[15] If I say, I will speak thus; behold, I should offend against the generation of thy children.
[16] When I thought to know this, it was too painful for me;
[17] Until I went into the sanctuary of God; then understood I their end.
[18] Surely thou didst set them in slippery places: thou castedst them down into destruction.
[19] How are they brought into desolation, as in a moment! they are utterly consumed with terrors.
[20] As a dream when one awaketh; so, O Lord, when thou awakest, thou shalt despise their image.
[21] Thus my heart was grieved, and I was pricked in my reins.
[22] So foolish was I, and ignorant: I was as a beast before thee.
[23] Nevertheless I am continually with thee: thou hast holden me by my right hand.
[24] Thou shalt guide me with thy counsel, and afterward receive me to glory.
[25] Whom have I in heaven but thee? and there is none upon earth that I desire beside thee.
[26] My flesh and my heart faileth: but God is the strength of my heart, and my portion for ever.
[27] For, lo, they that are far from thee shall perish: thou hast destroyed all them that go a whoring from thee.
[28] But it is good for me to draw near to God: I have put my trust in the Lord GOD, that I may declare all thy works.