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The Power of Money

Going back in history, we find the oldest advanced monetary system in China. It lasted for several hundred years, until the era of Mongolian rule. It is at this time that a detailed description was delivered to Europe in the form of Marco Polo's report of his twenty years spent in Kublai Khan's China in the late thirteenth century. Marco Polo was a trained merchant, and his book 'The Travels' is full of information and insights concerning the Chinese economy. He did not fail to give an account of the most advanced monetary system at the time. The world's first paper money was launched in the tenth century in China by the ruling Sung Dynasty. In this advanced monetary system, there was no doubt about what money was: the paper money issued by the emperor and stamped by his seal. He was the central bank. No other institution was allowed to create money, on penalty of death. The emperor was directly in control of the money supply. This meant that he could stimulate demand by creating more paper money, or cool the economy by taking paper out of circulation. He also determined who could gain control over food, raw material, weapons, and the latest technology, by creating and allocating paper money at will. He was an absolute ruler in every sense, in control of all the resources of his empire. Marco Polo vividly describes this advanced monetary system, which had been in place when he visited China under the rule of Kublai Khan:

It is in this city of Khan-balik that the Great Khan has his mint; and it is so organized that you might well say that he has mastered the art of alchemy. I will demonstrate this to you here and now. You must know that he has money made for him by the following process, out of the bark of trees - to be precise, from mulberry trees (the same whose leaves furnish food for silkworms). The fine bast between the bark and the wood of the tree is stripped off. Then it is crumbled and pounded and flattened out with the aid of glue into sheets like sheets of cotton paper, which are all black. When made, they are cut up into rectangles of various sizes, longer than they are broad .... And all these papers are sealed with the seal of the Great Khan. The procedure of issue is as formal and as authoritative as if they were made of pure gold or silver. On each piece of money several specially appointed officials write their names, each setting his own stamp. When it is completed in due form, the chief of the officials deputed by the Khan dips in cinnabar the seal or bull assigned to him and stamps it on the top of the piece of money so that the shape of the seal in vermilion remains impressed upon it. And then the money is authentic. And if anyone were to forge it, he would suffer the extreme penalty. Of this money the Khan has such a quantity made that with it he could buy all the treasure in the world. With this currency he orders all payments to be made throughout every province and kingdom and region of his empire. And no one dares refuse it on pain of losing his life. And I assure you that all the peoples and populations who are subject to his rule are perfectly willing to accept these papers in payment, since wherever they go they pay in the same currency, whether for goods or for pearls or precious stones or gold or silver. With these pieces of paper they can buy anything and pay for anything.

Marco Polo also describes what today we would call open market operations conducted by the Great Khan through purchases of gold, silver, precious metals, or other supplies from his subjects.

The Alchemy of Banking

Several times a year parties of traders arrive with pearls and precious stones and gold and silver and other valuables, such as cloth of gold and silk, and surrender them all to the Great Khan. The Khan then summons twelve experts, who are chosen for the task and have special knowledge of it, and bids them examine the wares that the traders have brought and pay for them what they judge to be their true value. The twelve experts duly examine the wares and pay the value in the paper currency of which I have spoken. The traders accept it willingly, because they can spend it afterwards on the various goods they buy throughout the Great Khan's dominions .... Let me tell you further that several times a year a fiat goes forth through the towns that all those who have gems and pearls and gold and silver must bring them to the Great Khan's mint. This they do, and in such abundance that it is past all reckoning; and they are all paid in paper money. By this means the Great Khan acquires all the gold and silver and pearls and precious stones of all his territories. And all the Khan's armies are paid with this sort of money. I have now told you how it comes about that the Great Khan must have, as indeed he has, more treasure than anyone else in the world. I may go further and affirm that all the world's great potentates put together have not such riches as belong to the Great Khan alone. Marco Polo's description seemed wildly exaggerated to his fellow Europeans. We now know, however, that he was giving what amounts to an accurate description of the monetary system prevailing at this time in the Mongolian Empire. Even his estimation of the Khan's wealth as far exceeding that of his counterparts in the rest of the world might well have been accurate. At the time, European kings and princes could only dream of such wealth or such power over the economy and their dominions. Things had developed quite differently for them in Europe. The rulers there failed to understand the true nature of money. To them, only gold or other precious metals could be money. But if gold is the main currency, it is impossible for a ruler to control the money supply. Gold cannot be created at will. Rulers tried, though in vain. Thanks to their efforts, chemistry got an early start in the form of the doomed attempts at creating gold through alchemy. Compared to their colleagues in China, European rulers could not really be considered fully in charge. They could not control the resources in their countries. Kings had to compete with their own subjects for resources. A government that does not control the money supply has hardly any influence over its economy. Such a government is not sovereign. The great Kublai Khan, emperor of China and the Mongolian Empire, would probably have shaken his head in disbelief if he had known that European rulers could not issue money to implement public sector projects. Instead, European governments had to rely on taxes. Often tax levels were already close to the pain threshold, and money was still needed for government investments or expenditures. If the kings and princes still wanted to build roads, hospitals, and castles or raise an army to defend their country, more often than not they had to borrow money. No matter how absolutist or all-powerful they may have called themselves, when it came to money most European rulers had to ask for help.

The Goldsmiths' Alchemy

So who was in control in Europe? It seemed that whoever had accumulated a lot of gold would be able to stake the biggest claim on resources. In reality things were a little subtler. Although precious metals were the main means of payment, it turned out that they were too heavy and too cumbersome, and it was too dangerous to transport them each time when going shopping for larger items. Gold wasn't even safe at home. Soon the richer merchants and landowners started to look for safe places to store their gold and silver. Who better to entrust one's gold to than the goldsmiths, whose job was to work with gold and jewels and who therefore had safe storage places? They were well established and independently rich, so there was little risk that they would make off with anyone's gold. When gold was deposited with a goldsmith, he would write a receipt to certify that it was in his custody. Depositors found this convenient: Why bother taking out the gold for each purchase when the new owner of the gold would deposit the gold back with the goldsmith again anyway? Since the goldsmith was well known, soon the deposit receipts themselves were accepted in lieu of payment. The deposit receipts had become money. By about the thirteenth century, paper money therefore also had its debut in Europe. However, it was crucially different in its form, function, and implications from China's paper money. It was issued not by the government but by a private group of businessmen.

The Biggest Trick in History

Most crafts in medieval times were organized in trade guilds. So were the goldsmiths. At their regular meetings they must have discussed the phenomenon of a lot of gold lying idly in their vaults as many depositors used the receipts as money. They probably realized fairly quickly that they could make extra profits if they lent out the gold in the meantime. The risk of getting caught without gold was low if they helped each other in case of unexpected withdrawals. The moment the goldsmiths lent out some of the deposited gold to earn extra interest, two things happened. First, the goldsmiths committed fraud. Their deposit receipts guaranteed that the gold was deposited with them. Their customers relied on the fact that the gold was there. But it was gone, lent out. So the goldsmiths strove to keep this from the public. As long as the public did not know or did not understand, there was no problem. Second, new purchasing power was created. While the receipts for the gold were used to purchase goods in the economy, the gold itself, when lent out, provided someone else with additional purchasing power that had not previously existed. The total amount of purchasing power in the economy increased. The goldsmiths had expanded the money supply. But unlike in China, where the gov- ernment made the decision over creation and allocation of purchasing power, in Europe it was the goldsmiths who could dictate who would receive money. Though unknown to the public, the goldsmiths' actions affected everyone. As they created more money, the number of claims on scarce resources increased. Things became even better for the goldsmiths. They found that demand for loans remained steady. When they had already lent out most of their gold, they were unwilling to let the opportunity slip to earn more interest. So they figured that they could further expand their lending by giving their borrowers deposit receipts instead of gold. Put simply, the goldsmiths could "print" money! By doing so, they could provide purchasing power to whomever they liked. This time, three things happened: First, the number of claims on resources, the money supply, increased further. This created a larger potential for economic booms or inflation of consumer or asset prices. Second, the fraud reached significant proportions, as they issued fictitious deposit receipts far in excess of the gold left in their vaults. This created even larger profits - borrowers would pay back in real money what the goldsmiths had not owned. It also created a larger potential for crises when depositors would demand their money back. Third, banking was born.

Penniless Monarchs in the Bankers' Kingdom

The goldsmiths soon gave up working with gold and jewels. They had hit on a far easier and far more lucrative business. They charged interest for issuing paper slips that cost them nothing to produce! They became wealthier and henceforth would be known as bankers. The bankers had managed to do what kings, emperors, and alchemists had failed to do - they were creating money. They had found the philosopher's stone. They were the central bank of their time. This had fundamental implications that were to change the course of history, for it meant that the allocation of new purchasing power was not under the control of the government. Europe's monarchs did not see through the deception. They naively believed that the bankers had large amounts of gold. When governments needed money and could not raise taxes further, they too thought they had to borrow from the bankers. The irony was that the bankers were just doing what the kings could have done themselves: issue paper money. Yet because the monarchs came to rely on their bankers to fund large ventures, ultimately the bankers gained great influence over national policies. Soon it became doubtful who was really in charge of the country. The Old Testament says that "the borrower is servant to the lender." Thus it came that the kings often had become servants. Bankers were the masters who created and allocated purchasing power. The bankers, of course, had their own interests to look after. Greatest opportunities beckoned when a monarch spent a lot of money - and hence created national debt. Some princes were wise and failed to borrow. Then the bankers had to wait for helpful circumstances such as wars between princes. Wars are a prime cause of borrowing and national debt. In times of war even the thriftiest prince would be in need of money. Was it surprising if, in exchange for their invaluable services, bankers would ask not only for interest payments but also for special privileges, rights, titles, and lands? If the monarch was recalcitrant, his war fortunes could suddenly falter. Those bankers would do particularly well who had connections to colleagues in other countries, including to bankers on the other side of the front lines, who funded the ruler of the enemy country. Then the temptation must on occasion have arisen to collude with the enemy's bankers, because such "rational" behavior would maximize their joint benefit. Together, they could then decide which king was going to win - the one who had granted them the greatest privileges. They could simply issue more money to their favorite and, with deepest regrets, report to the other that they had run out of cash. If the latter didn't believe them that there was no more money he could simply be shown their empty vaults. After his defeat the spoils could then be divided. Too bad for all those soldiers who had died in the process. While Kublai Kahn and his predecessors were absolutely in control of their country through their control of the money supply, in Europe it was the reverse: The rulers came to be controlled by money and by those who were in charge of its issuance. Not the kings, but their financiers were in charge.

Werner, Richard A. Princes of the Yen. Routledge, 2015. Pages 39-44.