Financial Innovation

 

Chapter 4

Financial Innovation: A Double-edged Sword

 

We have seen how the various globalist ideologies which came to fruition in the turbulent 60s have sapped U.S. economic strength. However, the final blow precipitating the Great Recession was a direct result of the marriage of social engineering with financial engineering. There has been a proliferation of new mortgage innovations prompted by pressure on the part of government departments and regulatory agencies. These were joined in a toxic combination with an array of new financial instruments. Proponents of the new options, options on futures, index futures, options on indexes and the veritable zoo of new swap contracts maintained that they were a result of the inflationary and volatile environment. These new instruments would also be a stimulus to the dynamic U.S., and global financial markets. It was believed that it would only be traders and speculators who gained or lost with neutral effects on the general economy. However, used by those who do not have an adequate appreciation of risk, these new types of mortgages and financial instruments resulted in disastrous systemic consequences. Unlike technological innovation, financial change can be quickly put into place and since they lack the protections afforded intellectual property, these spread quite rapidly. Furthermore new advanced trading and communications systems have resulted in increasingly complex and tightly coupled markets.

 

However, there can be no doubt that financial innovation, on the whole, has been a positive and a necessary factor enabling economic progress. The positive effects are undeniable; these include more efficient markets, greater liquidity, lower costs and more widely available information. The next section outlines the historical role that financial innovation has played in the process of economic development.

 

A Brief History of Financial Innovation

 

The Ancient World[1]

 

In the beginning the economies of primitive societies were characterized by the concept of reciprocal exchange. Such has been observed in the traditions of gift-giving and of the “potlatch”.  Barter was the accepted means of exchanging goods and services. The widespread specialization needed for sustained economic advancement was absent. When the system of reciprocal exchange evolved into the institution of credit, economic progress was facilitated. Credit existed long before coinage, probably going back some thousands of years to the dawn of civilization. Originally it may have consisted of a loan of seeds, animals, tools or food. With debt came the payment of interest; a number of anthropologists and historians have suggested that this began with an imitation of the reproductive cycle of crops and livestock. Loans for productive purpose as in seeds or breeding stocks could entail interest in the form of additional seeds or animal progeny. In the earliest historical records this type of loan was common. Such loans repayable in kind may have been the impetus for the development of standards of measurement and value. Loans of land or loans secured by land also developed early. These loans could have been for the payment of dowries, shipment of goods, establishment of temples and, one of the favorites, the financing of wars.

 

Also accompanying the concept of debt was that of taxation in the form of livestock, crops and the corvee.  Despite these evident economic advances there was still lacking the financial intermediaries which were needed to allocate savings efficiently. The invention of money was another important advance; however accompanying the use of metallic money was the ease of hoarding.

 

The first great commercial culture arose in Mesopotamia. The ancient river valley civilizations particularly that of Mesopotamia, pioneered a number of financial innovations vital to trade and economic expansion.  Barley was utilized as money in ancient Sumeria; however by 3000 BC ingots of copper and silver were used. As far back as the third millennium BC temples and kings functioned as rudimentary banks accepting deposits, making loans of seed, livestock and land as well as recording property transfers. Interest was collected, at first in kind at about one sixth of the harvest and later in money at between twenty and thirty percent. Granaries were also transformed into a form of agricultural bank with officials making loans of grain to cultivators who had consumed the excess that would be needed for the next planting.

 

Before 2800 BC there were records and deeds of land sales held in the custody of temples. Partnerships were known before the time of Hammurabi; share partnerships between merchants and commercial travelers were used in long distance trade. By the time of Hammurabi, ruler of Babylon, there was a form of bill of exchange some of which were negotiable: some payable to fixed creditor, some to bearer, some on demand, and some at a fixed date. There were also records of international transactions within the Mesopotamian states and with Syria, Egypt and Hatti. Hammurabi’s code was a great breakthrough in financial innovation setting out terms of ownership, employment, rent, credit, debt, hypothecation (the pledging of property as security), trade, partnerships and interest rates. Hammurabi also issued decrees of compulsory valuation to stabilize rates of exchange between commodities.

 

The river valley civilizations also pioneered new methods of public finance. The ancient kings invented bureaucracy in order to deal with the growth of taxation and finances. Taxes were paid in the form of labor levies, most intensively used in Egypt and tithes of produce. Tax payments could be also paid in textiles, jewels, precious metals and early forms of money. Tolls and duties were also common forms of taxation. The early bureaucrats developed extensive record-keeping procedures.  Data was collected on production in different localities in anticipation of revenues. In ancient Egypt and Mesopotamia the annual census was the most important event of the year; records were made of ownership, areas and crop productive potential. Under Hammurabi the bureaucracy delegated the collection of taxes to the elders of a city who delegated the task to local merchants and bankers; these were the first tax farmers in recorded history. All of these innovations made possible the rise of the great river valley civilizations.

 

Much later, around 600 BC a more advanced form of banking developed in Mesopotamia. Large loans were made to governments as well as to individuals. There was a form of the transfer of deposits on order and interest paid on deposits. There was also the purchasing of loans on land and additional methods of partnership in business ventures. These techniques paved the way for the next great commercial civilization, that of Greece. But a crucial step in facilitating trade was still to come, that being the invention of coinage.

 

In the Bronze Age the regular occurrence of collections of cowry shells, metal rings and metal spirals suggests that these might have served as a primitive form of money. Somewhat later in Sumeria and other ancient civilizations cattle, grain, barley and salt may have served as units of exchange. With standard weights of various metals the process of exchange was greatly simplified. Early Bronze Age archaeological sites have yielded copper, lead, brass, gold and silver hammered in the form of bars, disks, ingots and standardized lumps. In Mesopotamia bars of silver, copper and lead began to be stamped with the seal of the city. These ‘shekels’ greatly simplified long distance trade. Government finances were greatly simplified by the use of money and quickly led to such direct taxes as poll, income and wealth taxes. Usury also became an early concern with the use of money and was heavily regulated by many ancient law codes, the most well-known being the prohibition of interest in ancient Israel.

 

Coined money originated in 7^th century BC Lydia and was the next logical step in easing the process of exchange. The first Lydian coins, a mixture of gold and silver were followed by pure gold. These coins appear to have been legal tender for debts and taxes. The Greeks adopted and widely spread the Lydian invention.

 

The Bronze Age Greeks, like their contemporaries further east had used metal ingots of copper, gold and silver which were exchanged by weight. Minoan Crete was a maritime civilization with international trade, commercial documents and trademarks. The Mycenaean civilization succeeding the Minoan was primitive and feudal with ‘gift exchange’ as a common form of economic interaction; the early Greek kings exacted tribute and compulsory labor from their vassals and subjects. Payments were made in metals which were valued according to an oxen-based standard. The later Greeks were quick to adopt the new Lydian invention of coined money. After a series of fortuitous discoveries of silver, Greek coinage exploded. Athens resisted following the example of some its neighbors in devaluing its coinage and the Athenian owl became the ancient equivalent of a reserve currency throughout the Mediterranean.

 

An important step toward economic advancement occurred when Solon banned debt bondage in Athens, a primitive survival that probably dates to the Bronze Age. This resulted in a free market for lending and a precipitous drop in interest rates. Greek loans came in a variety of categories. There were unsecured loans to wealthy citizens usually for personal use and less palatable personal usurious loans to hard pressed borrowers. There were endowment loans paying specified rates of return, based on real estate. Some loans were for productive investments including loans to industry and commerce, probably for speculative short term ventures. Personal loans secured by real estate were common; these could be hypothecated whereby the property remained with the debtor until default making them similar to a mortgage or by a conditional sale as in the modern repurchase agreement. Sometimes these secured loans would be made by groups of individuals or lending clubs prefiguring the corporation.

 

Lending to states was unusual, except during times of war or emergencies, as Greek city states had poor credit and when they wished to borrow the lenders would require guarantees from wealthy citizens. In place of loans there existed the institution of the liturgy whereby wealthy citizens came under social pressure to finance public expenses through gifts to the state. In Hellenistic times Athens formally instituted capital levies on its wealthy citizens instead of relying on loans. The first recorded public loan occurred in 404 BC when the Spartan installed oligarchy in Athens borrowed money from Sparta to finance the ousting of the defeated democrats from their last stronghold. When the democrats returned to power they decided to honor this loan as an example of civic responsibility, though fear of the victorious Spartans may have been the real motive. In 275 BC Halicarnassus was recorded as raising money by public subscription for the building of a gymnasium. Temple treasuries were commonly the lenders to states. This was not without hazard; the temple at Delos was burned when most of its state borrowers defaulted in the 370s.

 

In connection with these early loans the Greeks pioneered many of the concepts associated with insurance. Greeks as early as the 7^th century BC developed extensive lending at interest for maritime loans. In these loans, used to finance overseas trade, the lender had security on the ship or its cargo. In the event of shipwreck the borrower was absolved from repaying the loan making them into a form of insurance. The city of Miletus invented the life annuity as a method of borrowing in 205 BC. This was the first recorded instance of a life annuity loan. This loan had very modern characteristics.  It was a long-term loan raised by voluntary subscription with a relatively low interest rate.

 

The Greeks were not the originators of banking but they considerably advanced its practice. As in Mesopotamia, temples served as the first great banks; the two most notable being those of Delos and Delphi. Industry to be sure was on a small scale but the maritime trade was important especially in Athens.  To serve that trade in the 4^th century BC professional private bankers (trapezitai – named for the tables on which they conducted their business) changed money, received deposits, made loans, made foreign remittances, collected revenues and even had primitive forms of letters of credit and checks. Class was no barrier to clever and energetic men who sought to enter the business. Some of these bankers even began their careers as young upwardly mobile slaves. The loans made by these bankers could be secured on cargo, real estate or pawned property; there were also unsecured loans. Demosthenes recognized that a good credit reputation was an important asset for borrowers and for bankers when he stated that the most productive capital for a business is confidence. By the third century Greek finance had become highly developed with real estate loans becoming more important. The increasing use of banking and credit was accompanied by a fall in interest rates. There can be no doubt that the growth of the ancient Greek maritime trade was made possible by these innovations in finance.

 

Rome the conqueror and apt pupil of the Greeks applied their financial inventions with enthusiasm. In prehistoric Italy, as elsewhere cattle and other domesticated animals were used as money. The word for herds of cattle was pecus from which the word pecuniary is derived. Later on in early Rome copper, bronze and then gold and silver served as money; the use of silver coinage followed. Commerce and banking were carried on by Greeks in the early republic. As in Greece these banks were of small scale but they lent at interest, paid interest on deposits, changed money, served as agents and issued foreign drafts. The Romans also adopted the Greek innovation of proto-corporate ownership; these were formed by Roman equestrians for the collection of taxes and construction of public works. It was common for these members of the Equestrian Order to pool their capital into a form of joint stock Company, the societates publicanorum, to share the risk of doing business in far-off provinces. Tax farming in a Roman province could be a massive enterprise with hundreds of employees and requiring large amounts of capital.

 

It was certainly the Romans who advanced the science of tax collection. In an age before branch banking tax farming provided an easy way to handle tax receipts and government expenditures without having to ship bulky quantities of metallic money. The Roman Senate adopted the practice of issuing warrants on tax farming companies to pay local debts of the government by deducting the amounts advanced locally. In this way transactions between the Senate and the tax farmers could be done on paper. Tax farmers were permitted the use of the funds they collected for a period of time before remitting them and were able to gain small amounts of short term profit; the Romans had invented ‘float’.

 

To administer these massive tax collections the early emperors instituted an information base with the aim of providing a systematic accounting of the empire’s finances. The system worked despite poorly developed bookkeeping techniques and the cumbersome Roman system of numeration. However, the Roman emperors also made advances in the technique of currency devaluation by debasing the coinage. In the early Republic the coins were almost all silver; by the end of the 3^rd century repeated debasement had reduced the silver content to four percent. Both Athens and Rome pioneered the technique of earmarking whereby tax receipts from specific sources were assigned to specific uses. Rome also followed Athens in utilizing the public audit where officials had to account for all receipts and expenditures made under their watch.

 

While many innovations were devised by their fellow Greeks and Roman conquerors, it was the Athenians, with their spirit of enterprise, who made the most important breakthroughs in finance. The importance of Athens as a center of financial innovation has been questioned by the ‘primitivist’ school of classical historians led by M.I. Finley. In his The Ancient Economy Finley views the Athenian businessmen as rentiers, not entrepreneurs, who lacked commercial ambition and were primarily interested in retiring to landed estates. He also contends that Athenian credit was predominantly informal. Of course, it is true that Athenian finance and banking were conducted on a relatively small scale, but the same was true in early modern Europe up until the Industrial Revolution. What Finley and the primitivists overlook is the fact that the informal credit economy has not vanished even in modern industrial economies. In these the lending, or gifts, exchanged between friends and relatives, especially between parents and children are large but, of course, not recorded; it is beneath the radar as far as modern statistical compilations go. Of course, the formal structure of credit looms much larger today, and this is a reversal of the situation in classical times, even with respect to a great commercial city like Athens. There the informal economy dominated loans between friends and relations, loans for non-productive purposes etc. The primitivists are quite right on that point. However, that does not diminish the fact that very sophisticated financial and business concepts did exist, were pioneered in Athens and elsewhere in the classical world and did have at least some importance; indeed Greek and Roman concepts in law and finance were the substratum on which the great economic expansion commencing in the late middle ages and Renaissance were based.

 

The true entrepreneurial spirit in the Athenian economy is found in mining and the maritime trade both of which involved assembling considerable resources and undertaking considerable risk. To assemble the needed capital and to manage the risk involved, these entrepreneurs pioneered some quite ‘modern’ financial techniques.  Athenians were willing to enter into partnerships and even occasionally made use of the corporate vehicle. Athens may have had the same device used in Renaissance Florence where people contributed short-term capital to merchants in return for fixed income. In 360 BC the Greek city state of Clazomenae also assessed the wealthier citizens for hard currency to pay off the principal on a debt to mercenaries. The city gave them worthless iron drachmas in place of their silver ones. These were declared as legal tender and were to be redeemed over five years by the interest saved on the debt. The Athenians developed the techniques of both insurance and debt leverage; however they were hampered by the technological simplicity of the time. The existence of compound interest, first used by the Greeks was a fairly advanced financial concept. Now it might have been rare; it might have been disreputable; no matter, the concept was invented by the Greeks and is of considerable sophistication. The Greeks certainly did not have a full-fledged fractional banking system but they had bankers who accepted deposits and made loans; these were not simply money changers. In the same way as ancient Greek scientists such as Democritus, Aristarchus, Archimedes and Heron anticipated discoveries made two thousand years later, the practices of ancient Athenian businessmen, while not of overwhelming importance in the everyday life of the masses of the population, did prefigure the financial and economic concepts of modernity.

 

It is true that there were many important differences between ancient and modern finance. There were few loans to states; there was no deficit financing; no large corporate borrowers; no secondary markets for loans and no large banks able to create deposit money. Hence, there was no credit market capable of efficiently allocating capital to the most productive uses. The economies of ancient Greece and Rome were less developed than modern Western economies but modern institutions and financial conceptions were present in embryonic form and were prefigured by these ancient structures. The deficiencies in these institutions and the resulting high interest rates were one impediment to economic development. The other was the institution of slavery with its deadening effect on technology and innovation.

 

It was only at the end of the middle ages and the Renaissance that modern concepts of finance arose. The question is why did Renaissance Europe initiate a much more advanced financial and economic system as compared with the classical world? In the first place the phasing out of chattel slavery largely due to Christian ideology led to an emphasis on technological innovation in industry and agriculture. The increasing use of water and wind power (mills) and improvements in agricultural efficiency resulted in large population increases and in a large migration from rural areas to urban centers. This was particularly intense in the regions of northern Italy and the Low countries (Netherlands, Belgium).

 

In Roman times the Mediterranean was one culture area. The barbarian incursions and the movement of peoples brought about a diffusion of Roman institutions and civilization into previously backward regions of northern Europe. This was accompanied by the Muslim conquest of the eastern and southern Mediterranean. These two events shifted Greco-Roman western civilization toward the north. One effect was an increase in trade routes going from southern to northern Europe. These shifting and increasing patterns of trade and of population led to the development of certain urban centers as transshipment points. Complexity theory shows that transshipment nodes result in a great increase in efficiency. This was the major distinction between the great cities of late medieval and Renaissance Europe and those of the ancient world.  In these new transshipment centers it was economically efficient to implement new financial innovations such as large scale deposit banking, negotiable notes and bonds and modern methods of public finance. In these new centers it was also easier to develop means for the protection of intellectual property resulting in an explosion of technological innovations. This process began in the great cities of northern Italy and accelerated in the cities of the Netherlands; all of them major transshipment points. Financial innovation and protection of intellectual property were then taken up in England where they attained their full modern development.

 

Middle Ages and Renaissance[2]

 

The fall of Rome and the end of classical civilization ushered in the dark ages of Western Europe. This period was dark in the history of finance; there were practically no financial mechanisms for the allocation of capital to investment. Hoarding thrived and productive investment suffered. Liquidity which allows capital to switch to greater opportunities was virtually nonexistent. However, some of the Greco-Roman financial methods undoubtedly survived in the Byzantine World and in certain trading centers in Italy. Indeed, the great compendium of Roman law, the code of Justinian, survived and contained many classical concepts of financial law.

 

Beginning in the eleventh century there was a remarkable flowering of business innovation. In late medieval times through the renaissance, the city states of Italy were the centers of financial invention. These included the bill of exchange, new methods of accounting, the check and endorsement, insurance, new types of partnership and means for the pooling of capital, advances in banking practice, trade fairs and the beginnings of funded debt. These innovations enabled savings to be activated for productive purposes curing the chronic capital shortage that afflicted past ages. The revival of Roman law and the continuing evolution of commercial law with its consequent increase in confidence made members of all classes of society willing to invest their savings in new productive enterprises.

 

Ingenious medieval minds invented a prototype of the bill of exchange. This was the instrumentum ex causa cambia which permitted a borrower who had received an advance in local currency to repay in another currency at another location.  This permitted a significant lowering of the transaction costs in international trade by allowing an easily transported piece of paper in place of the more costly transporting of specie. The 14^th century saw the origin of various types of bills of exchange which facilitated the process of long-distance trade. Assignments were often used in bills of exchange.  In order to allow the widespread use of assignments, it was necessary to establish the legal right of endorsement which ensured that in the event of default the endorser was held responsible for the debt. In 1507 the endorsement became legal in Antwerp; in 1537 it became law throughout the Netherlands. These deferred payments allowed Dutch merchants to expand their business and were a spur to the entire Dutch economy.

 

Business partnership arrangements also began to appear in the middle ages, even before the invention of the bill of exchange. As early as the tenth century the contratto di commenda, a loan-partnership hybrid, appeared in Italy whereby one party could invest in a foreign trading enterprise while remaining at home. If the trade was successful the profits would be divided. There was also the sea loan in which the borrower pledged the return of the loan conditional on the ship safely completing the voyage.  These arrangements were quite similar to the maritime loans and partnerships of ancient Athens. Later the commenda was extended to include more than one investor; all members of society with liquid funds could take part in trade. Variations on the commenda continued through the Middle Ages; similar arrangements were devised for overland trade. In some cases the active partner would insure the special partner against loss and guarantee a fixed rate of return. These contracts developed widely throughout the business community becoming a means for both credit and speculation.  These new institutional arrangements reduced information costs, spread risks and widened the capital available for economic growth.

 

Regional trade fairs were a great spur to the increase in trade and were accompanied by an array of new financial instruments. Regional fairs increased in numbers as it became evident that these could bring together widely separated sellers and buyers and simplify their financial transactions. The famous Champagne fairs beginning in the 12^th century served as an early international financial clearinghouse where Flemish and Italian financiers and merchant-bankers exchanged currencies, earned profits at arbitrage and made international loans. Accounts were settled via book entry and offsets and there were precursors to the letter of credit. Traders and bankers were brought together from long distances; English wool growers borrowed from Italian financiers. The trade fairs at Champagne and elsewhere, thus, became major markets for international trade as well as rudimentary international capital markets. At these fairs exchange rates fluctuated freely reflecting the balance of payments between regions. The fairs were the medieval equivalent of modern computer and electronic trading systems in advancing and promoting financial innovations.

 

The Italian cities, the most direct heirs of the legacy of Greece and Rome, surpassed their ancient progenitors in many ways. These were the great innovators in the area of public finance, pioneering techniques of floating debt consisting of sequences of short-term notes. But it was their invention of long-term funded debt that had the most impact on the course of financial history. By the 12^th century the cities of northern Italy gained fiscal autonomy and soon solicited public loans. Genoa was the first state in which public loans reappeared; they borrowed money in Rome in the year 1121. Venice followed Genoa’s example in 1164 and Florence did so in 1166. Venice and its rival Genoa were the first great innovators in the bond market.  In 1257 Genoa consolidated its debts at an 8% yield; Venice followed shortly thereafter. In 1262 Genoa ended its right to repurchase and a free market in bonds began. It became increasingly apparent to prospective lenders that the free Italian cities dominated by merchants and with systematic sources of revenue and continuity of republican institutions were much better credit risks than monarchs with their arbitrary exercise of power.

 

With the 13^th century Venetian prestiti the permanent funded national debt was born. The Venetians took the idea of repayable taxes via forced loans from ancient Rome but transformed it by paying regular fixed interest and partitioning the levies into standard forms that could be purchased. In the 14^th century shares in the debt of Venice could be purchased and sold on the open market.  Confidence in these instruments grew along with their long record of regular payments. The Venetian prestiti became a favored instrument for foreign investors. The right of foreigners to own them, granted by the Council of Venice, was much sought after. The Genoese soon copied the Venetian invention of consolidating loans into a single debt fund with their Casa di San Giorgio. With the Genoese compera compulsory loans were extracted from citizens based on the tax registers. Tax revenues were then allocated to the citizens so as to produce the desired yield. Genoa also farmed out its tax collections in order to receive fixed streams of income.

 

Genoa pioneered several other advances in public finance. In the 1440s the San Giorgio fund began the payment of dividends by paper notes which could then be used to settle commercial transactions and to pay taxes. Genoa was thus the first European state to get around the chronic deflation of the early fifteenth century caused by the shortage of specie through this experiment with a paper economy. The San Giorgio Bank also invented a new type of perpetual bond called the luoghi. These freely traded securities did not pay a fixed rate of interest but instead consisted of shares in tax revenues paid in fluctuating dividends. Not to be outdone by their Genoese rivals the Venetians came up with the idea of the sinking fund as a way of repaying its debt; this was funded by setting aside a portion of custom duties. Soon afterward the third great Italian city state, Florence copied the Venetian sinking fund which, however, was funded by a withholding tax on interest.

 

Furthermore, the Florentines began to surpass the other two cities in many respects. In the 14^th century their Monte Comune fund issued a number of different debt tranches at different prices. In the 1340s there was a great increase in the number of public creditors and the start of a true financial marketplace.  Citizens of Florence and foreign investors attracted by high yields learned to play the market while the municipal government learned to reduce debt by repurchasing it at a discount. In 1425 Florence set up another fund, the so-called Dowry Fund (Monte delle Doti) which allowed citizens to deposit fixed amounts with maturities ranging from five to fifteen years.

 

In sum the development of secure and regular public capital markets emerged over some two centuries in the north Italian cities. The concept of the collective guarantee of debt emerged through these quasi-banking montes. These funds eventually made loans to financially troubled citizens, provided capital for productive enterprises, disbursed city funds, guaranteed public debt and became a source of financing for various European monarchs. They also became savings and public banks, assembling capital through interest-paying deposit accounts.

 

It was indeed the advances in banking practice along with new financial instruments, innovations in business structure and nascent capital markets that helped propel late medieval Europe‘s economic breakthrough. For the first time since the fall of Rome the Western European economy was able to surpass that of the classical world.

 

Deposit banking, which originated in Greek and Roman times, was revived at the end of the 12^th century in response to a growing demand for insured safety to lower the costs of long-distance trade. Innovative techniques in deposit banking then took place in 13^th century Italy as a means of investment. Deposits of money were left with merchants and earned a return depending on the merchant’s profits. The 14^th century medieval bill of exchange with its complex structure of agents and correspondents was a spur to the advance of banking technique. A bill of exchange allowed for the purchase at one location in a particular currency and a payment to be made at another location in a foreign currency. Eventually it became common practice for small traders to maintain deposits with larger merchants on which bills of exchange could be drawn. Genoa and Florence and Bruges were early centers of exchange and deposit banking followed by Antwerp and Lyons.  In the 15^th century the Medici Bank and other merchant bankers achieved great success in the creation of additional deposits by means of loans or investments. In later times Amsterdam and London came to dominate these markets and developed still new credit forms superseding the various types of bills of exchange. An important variant of deposit banking was first developed in 15^th century Perugia and became popular in other Italian cities. This was the public pawnshop financed by charitable contributions to meet the needs of economically distressed citizens. Eventually these early forms of savings banks accepted deposits, paid interest and made loans to business.

 

Many 13^th century Italian bankers achieved success by lending to kings. Among them was the Riccardi family of Lucca who financed the campaigns of Edward I. These were soon followed by the Frescobaldi and Peruzzi of Florence. Another Florentine banking family, the Bardis were granted a banking monopoly by Edward III of England. After the 13^th century Parliament granted the king the right to collect customs duties, these prospective revenue streams would often become security for borrowing. Kings would often assure themselves of loans by granting special privileges to bankers within their kingdoms. At the end of the century another Florentine banking family, the Fransezi Brothers became prominent. Joining the Italians as bankers were various wealthy nobles, merchants, bishops, monasteries and Jewish moneylenders; often monarchs would find it advantageous to grant these lenders tax concessions or other privileges. The Knights Templar had become skilled in financial management and were pioneers in international banking techniques; they established a network of banks throughout Europe and the Near East. They were Europe’s most important providers of credit and also recipients of royal privileges. In the following two centuries a number of French bankers such as Gayle (1316) and Jacques Coeur (1438) attained prominence and the Italian Medici family rose to political as well as financial power.

 

Paradoxically, despite their role in promoting trade and industry by expanding the availability of capital, bankers found their profession to be a hazardous one. The mysterious process of credit creation from medieval times to now has always incited suspicions of secret conspiracies. It was convenient and profitable for avaricious monarchs and envious nobles to take advantage of popular resentment toward bankers. A pattern was established in both England and France of borrowing, default, confiscation of lenders property and exile or worse. This was the fate of the Jews, Italian lenders and the Knights Templars. The Jews were periodically expelled when kings and nobles found it convenient to dispense with their financial services. Many of the Italian bankers met the same sad end; their assets seized, their loans defaulted on and, finally, bankruptcy.  Early in the 14^th century the French king ordered the Templars hunted down and arrested. Their leaders were subsequently burned at the stake for heresy and the order’s wealth was confiscated. The fate of many French bankers was also unfortunate; meeting with imprisonment or execution. Louis IX expelled the renowned banker Jacques Coeur from France; two centuries later Francis I had his Finance Minister the banker de Semblancay hanged. 

 

Commercial insurance also originated in the late middle ages. These began with maritime insurance loans similar to those of the Athenians some 1,500 years before. The earliest known examples of insurance loans seem to date from the late 13^th century but the earliest documents date from the following century. In any event maritime insurance was common in many Italian coastal cities in the 14^th century with Genoa long remaining the major center for this type of contract. Eventually the concept of insurance was extended to many other activities where actuarial estimation of risk was possible.

 

Life annuities originally invented in ancient Miletus again came into use as cities north of the Alps sold rents on their revenues. They were commonly used in France, Spain, the Netherlands and England. Monarchs then often sought to convert burdensome short-term debt into perpetual annuities. In 1522 Paris raised a loan on behalf of the king by issuing perpetual annuities; this was the origin of the famous French rentes. The provinces and cities of the Netherlands borrowed using perpetual or life annuities with sinking funds. The Spanish monarchy eventually mismanaged their perpetual annuities resulting in repeated defaults. Perpetual annuities eventually became a standard means of borrowing with the Dutch losrenten, the French rentes perpetuelles and the British consol.

 

Early in medieval times when banking was virtually nonexistent royal officials would issue sticks of wood known as tallies as payment for purchases. Such tallies represented claims on anticipated royal revenues and could be sold in the marketplace. These instruments would often be sold at increased discounts with each sale as a means of risk management. This practice was, in effect, a rudimentary financial market. In later centuries the development of regular public capital markets proceeded slowly but steadily. In Venice shares in the government funds obtained through forced loans were tradable. In Genoa compere loans were often bid on by syndicates who would then sell shares publicly. With yields uncertain these instruments took on the speculative nature of stocks; the compere syndicate became an early form of the joint stock company. By the 16^th century the Antwerp Exchange dominated the markets for bills of exchange, demand notes, deposit certificates and state and city bonds. In the following century Amsterdam replaced war ruined Antwerp as the financial capital of Europe. The Dutch improved on the Italian financing techniques and developed the first modern stock exchange.

 

Many of these financial innovations were motivated by the need to evade the prohibition on usury. Much ingenuity went into devising financial instruments with usury loopholes. One early loophole was invented by monasteries in the 11^th century. For a specified sum of money they sold rent from a piece of land. The purchaser never enjoyed full ownership; the seller retained the right to repurchase the land at cost. This was probably the first instance of a repurchase agreement which in the latter half of the 20^th century was to be so beloved on Wall Street. Subsequently Italian merchants and lawyers came up with much cleverly constructed legal drafting as ways around the usury laws. Around the year 1250 they devised the sea exchange which provided for interest payments to be obscured through repayment in other currencies at a carefully calculated rate of exchange. Often a passive investor in a trading expedition would receive an exorbitant profit share as a disguised form of interest. Usury laws were also evaded through clever ways of repaying principal.  One example was the invention of loans without fixed maturity dates having easily calculable yields. Other loopholes involved the payment of damages and of gifts. This was common in Florence where payments to creditors were labeled as ‘gift and interest’. Bills of exchange were a favored device for circumventing usury laws with interest being hidden in the bill’s specified exchange rate and payment made through the transfer of a bank deposit.

 

During periodic Church crackdowns on such usury merchants, like their modern day financial successors evading regulations, devised still more intricate and obscure techniques. For example, contracts could be written specifying payment in a deliberately undervalued foreign currency thereby obtaining high interest payments in the form of exchange profits. The Italian city-states devised the method of borrowing for indefinite periods of time varying with the length of the lender’s lifetime. The loan would be paid back in repayments of principal with an additional amount labeled ‘rent’; the remaining principal would be repaid on the death of the lender. The Church obligingly referred to these payments, not as usury, but as ‘life insurance’.  So it may be that life insurance owes its origin to an evasion of the religious prohibition on usury. Borrowing from Jewish moneylenders was another favored means of getting around the usury laws. All of the monotheistic religions prohibited lending at interest to co-religionists, but there was no such prohibition across the religious divide. There were even cases in which one Jew would borrow from another using a Christian intermediary. Thus all segments of society, in splendid examples of financial religious ecumenism, could both borrow and profit from usury. Christians during the Crusades were also permitted to lend money at interest to their Saracen adversaries. One might also conjecture that since Muslim and Christian merchants were permitted to charge each other interest, some primitive versions of swap agreements would have been devised by Italian merchants trading in the eastern Mediterranean.

 

Late medieval and Renaissance innovations in record keeping and law were critical for the advance of financial technique and economic growth. Before the use of Arabic numerals and double entry bookkeeping financial records were excessively complex consisting of lists of receipts and expenditures written in Roman numerals; even trained auditors were often baffled by this cumbersome method when examining the accounts. These inflexible and unresponsive techniques made even simple financial analyses difficult. Double-entry bookkeeping arose under the influence of the algebra recently transmitted by the Arabs; algebra was originally derived from a combination of Hindu mathematics with ancient Greek geometry and Diophantine equations. The new bookkeeping techniques provided a simple, systematic and orderly means of recording and examining financial transactions. The new method also made possible knowledge of affairs where many parties are involved; an advance over the days where one merchant employed a handful of assistants.

 

Double-entry bookkeeping was apparently invented in 12^th century Genoa from whence it diffused into other Italian cities and became popular with the rising class of Italian merchant-bankers. By the 14^th century these methods were in general use throughout northern Italy. For two centuries numerous clerks working in the Italian banks refined and improved the technique. Finally in 1494 the mathematician-priest Luca Pacioli regarded as the father of modern accounting, published his famous Summa de Arithmetica containing the first treatise on the new method. The treatise included a discussion on the so-called ‘Venetian’ system of bookkeeping which recorded all transactions in two parts, as debits and credits. Some hundred years later the Dutch and the English further developed bookkeeping methodology as they founded the first joint stock trading companies, stock exchanges and Central Banks.

 

There was at that time the beginning of the body of international commercial law with procedures for contract enforcement. One other legal innovation was vital to the development of financial and economic advance. This was the patent which provided incentives to inventors. Until this device inventors could only rely on secrecy as protection for their inventions. Beginning in the thirteenth century craftsmen and mechanics would occasionally be granted royal monopolies for their new devices or techniques. It was not until 1474 that the state of Venice became the first to establish protection by statute for new inventions.

 

In addition to double-entry bookkeeping and the first patent laws, the commercial revival of late middle ages and Renaissance Italy was the center of innovation in government finance and fiscal techniques. Among these were the income tax, property tax, new forms of customs taxes and a large professional salaried bureaucracy. In ancient and early medieval times governments would levy taxes on land as a fixed proportion of produce payable in kind. As the middle ages proceeded, these land taxes were in the form of payments in money based on the assessed value of the property as is done with real estate to this day.  However, at a time that the feudal monarchies of Europe were solely dependent on land taxes, the Italian city states invented new methods of public finance. The Italian cities instituted direct taxes which, unlike the poll tax, were assessed on the wealth of citizens. This emphasis on greater equity in taxation encouraged the city of Florence to implement several progressive taxes in the 1440s with rates varying between eight and fifty percent. To deal with the problem of tax evasion Florence as early as the 14^th century compelled its merchants and bankers to submit tax returns with profit and loss statements; an innovation made possible by the new innovations in bookkeeping.  The Venetian gabelle was a tax levied on every good at every stage of its production and marketing; this was a combination custom, excise, sales and value-added tax. The Venetians earmarked the receipts from specific gabelles to pay down the public debt. The ancient method of earmarking had been revived by the French and English monarchs in the 13^th century to allocate taxes on specific land for the repayment of military loans. However, the burden placed on Italian public finance owing to the increased complexity of their tax and earmarking innovations required bureaucrats well trained in newly invented methods of fiscal administration.

 

The audit was one method of financial administration employed in medieval times. These audits, like their Athenian and Roman precursors, required a public accounting of receipts and expenditures by financial officials. With the newly invented accounting methods, these audits achieved a higher level of accuracy than their predecessors. An expense account for officials was another administrative innovation. The expense allowance was first used by Henry II of England who allowed his sheriffs to deduct their legitimate expenses from tax receipts.

 

Financial regulation, in the modern sense, began in late medieval times. These were prompted by the 14^th century debt default of England and France which drove many of the large Italian banks into bankruptcy. A reform of 1374 was an early version of Glass-Steagall; Venetian banks were forbidden to trade in speculative commodities. In 1403 Venetian banks were required to hold 40% of their assets in public debt and the first public bank examiners were tasked with supervision.

 

However, some advances in public finance and regulation were less positive. In particular there were ingenious advances in the process of currency debasement. Kings would often profit by periodically ordering the coinage turned in, melted down and reissued with a reduced gold or silver content. Royal yields of almost ten percent could be earned as debts were repaid in cheaper money and the surplus specie was retained in the treasury. The inflationary consequences of such policies were not well understood. Another temptation for a king was to reissue the coinage with a higher precious metal content just prior to a tax assessment so that sounder money could be extracted from his subjects. 

Early Modern Europe[3]

 

We have seen the emergence of recognizable forms of financial instruments and procedures beginning in the 12^th century: bills of exchange, rudimentary deposit banking as in ancient times, mortgages and annuities. Financial innovations proliferated in 15^th and 16^th century Italy: promissory notes, bank checks, pawn pledges, certificates of specie deposits with goldsmiths and the domestic equivalent of the bill of exchange (bills obligatory). All of these resulted in an expansion of the money supply facilitating economic growth. By the 17^th century these were taken up by the Dutch pioneers of finance in the active and innovative Amsterdam market. The Dutch also took up the modern methods of state finance developed by the Italian cities. Between the seventeenth and nineteenth centuries these innovations were developed into modern convenient credit instruments.

 

However, it was in England during the 17^th century that these elements of Dutch finance reached their fullest development. The English extended the Venetian invention of the patent and eliminated the last remnants of feudal servitude. There was a burgeoning of joint stock companies; between 1688 and 1695 the number of joint stock companies increased from 22 to 150. New securities and commodity markets sprang up, the Bank of England was chartered in 1694 and there were further innovations in insurance and deposit banking practice. In the early 18^th century the rise of country banking widened the market for capital by enabling London based loans to spread to wider geographical areas.  However the capital mobilization process suffered a setback with the South Sea Bubble and the following restrictive legislation. Nevertheless the process of the transformation of mercantile working capital into factory fixed capital was able to proceed and sparked the industrial revolution.

 

The two centuries preceding the industrial revolution witnessed the improvement of financial instruments developed in the Italian merchant republics. One such was the inland bill a domestic version of the bill of exchange which, along with the book transfer of funds allowed governments to move money in bulk to and from outlying areas. Another was the revenue anticipation note, a more flexible version of the tally.  These enabled governments to more easily tap into the expanding capital markets. However, it was the proliferation of annuities that was most characteristic of financial instrument innovation. 

 

As early as the 16^th century the French and Spanish monarchies raised money through the sale of annuities. Charles V of Spain sold inheritable annuities known as juros. In 1522 Francis I made use of the established credit of the city of Paris to begin selling inheritable rents. In Spain the market for such annuities was small but in France it became a useful supplement to the loans of the bankers who made short term loans at high rates. The Dutch and British followed the French example. A perpetual annuity issued by a Dutch company in 1624 was still paying interest as late as 1957. The British Consol, the oldest public debt issue still traded, began in 1754.

 

Life annuities were pioneered by the Dutch in the 17^th century.  These were made feasible by advances in statistics and the invention of mortality tables. The ancient city of Miletus had a form of life annuity but since they lacked statistical capability most of these were taken out in the name of children. The life annuity found its way into France and England in the 1690s. Even at that late date the taint of usury was still strong; such annuities had the useful characteristic of obscuring the true rate of interest. These annuities soon became so popular that one enterprising Swiss banker set up a syndicate to invest in the lives of selected healthy young girls. The health of these maidens became the topic of early financial journalism as investors would eagerly follow reports of their health. These types of third party annuity syndicates may have dominated the life annuities markets in the 1770s.

 

Early forms of financial derivatives came into existence at this time. During the 17^th century Dutch tulip mania, puts were purchased on the Amsterdam Exchange to guarantee growers a minimum price. Bullish speculators obligingly sold these options; without margin requirements the subsequent bust resulted in a debt crisis giving options a bad name for many years hence. In the 18^th century organized put and call trading began in London and later in that century option trading began in the early United States. These ‘disreputable’ instruments were subject to frequent restrictions and periodic bans.  By the 18^th century the Amsterdam Exchange, originally dealing in shares of the East India Company, began trading in such speculative instruments as futures and short sales; having learned from the tulip bubble the Exchange implemented margin requirements.  Futures must have embodied the financial spirit of the age for even in far-off and isolated Osaka Japan an organized exchange trading standardized spot and futures contracts on rice began in the 18^th century.

 

Trade in this large variety and volume of financial instruments would have been almost impossible without the rise of organized financial markets. As we have seen, money markets originated as offshoots of the great medieval trade fairs. The earliest continuously operating market at Antwerp was joined by others in the 16^th century.  In 1548 the Paris Bourse was established at the instigation of Florentine bankers; in 1555 the Grand Parti was established. Both of these markets attempted to consolidate short term debts into tradable long term securities; speculators were the engine that provided liquidity. The long-term debt market suffered a severe setback due to the series of bankruptcies by the Spanish Crown in the late 16^th and early 17^th centuries. Banks, such as the newly founded Bank of Amsterdam, picked up the slack in long-term lending but the advantages of long term credit markets were too great to do without.

 

The efficient capital markets that developed in the Low Countries enabled a substantial drop in interest rates and consequent economic expansion. The Amsterdam Exchange founded early in the 17^th century originally dealt primarily in East India Company shares, commodities and bills. By the mid-18^th century the Exchange traded home shares, foreign shares, foreign loans, state and provincial bonds, foreign exchange and bankers acceptances. Dutch investors were also important purchasers of early American debt issues. Eventually, however, the proverbial Dutch secrecy began to erode confidence in the Amsterdam Exchange and the English adopted “Dutch” finance. Thus, the London financial market became the most active in the world by the latter half of the 18^th century.

 

The rapidly growing financial markets also abetted the rise of shareholder-owned companies. These evolved out of guilds with each member trading for his own account but accepting cartel-like regulations. The 16^th century saw the rise of joint stock companies in which states shared the risk of exploration and colonization with private individuals. Monarchs subsidized the voyages of explorers and merchant-adventurers. The most renowned example is that of the discovery of America with Ferdinand and Isabella contracting with Columbus for the lion’s share of the profits. Monarchs chartered these companies and often became investors. Elizabeth I of England invested in the Africa Company and Henry IV of France was an investor in the Dutch East India Company. Monarch investors were soon joined by syndicates of private individuals whose joint stock companies were granted monopolies and given the government of colonies. These mobilized large amounts of capital with shares easily converted to cash and charters providing the likelihood of monopoly profits. English chartered companies opened up new areas for English trade in the 16^th and 17^th centuries; these included the Eastland Company with the Baltic trade, Muscovy Company with the Russian fur trade, Levant Company to bypass the Venetian monopoly in the eastern Mediterranean and the famous East India Company which challenged the Portuguese monopoly in the Indies trade.

 

The private investors in these companies, in an illustrative example of early crony capitalism, were usually close to the monarch or to government ministers. In addition to the overseas trading companies other joint ownership companies were formed to develop such infrastructure as roads, canals, water systems, and drainage of land for agriculture. Such early national banks as the Bank of Amsterdam and the Bank of England were formed and dominated by well-connected merchants who, in a great display of insider trading, would administer and allocate their governments’ debt issues.

 

Cronyism also abounded in the formation of the South Sea Company in 1711. In an early example of a debt for equity swap the holders of government notes were able to exchange them for shares in the new company. However, following the failure of the Company and the resulting loss of confidence, the Bubble Act of 1720 was passed restricting the formation of new joint stock companies. British companies were restricted to ordinary partnerships of no more than six members with unlimited liability. Mortgage financing emerged as a common substitute for raising capital. Nevertheless, speculation on shares of government debt was still rampant in the London coffee-houses and streets. In 1773 a stock exchange even opened for business in a coffee house; in 1775 the London Clearing House was founded. The business of the London Stock Exchange grew even more robustly once the Bubble Act was repealed in 1825.

 

The 17^th and 18^th centuries witnessed further progress in the development of the banking techniques first invented in the Italian city states of the late Middle Ages and Renaissance. Modern central banking, checks and savings banks were the chief innovations.  In 1609 the Bank of Amsterdam was founded; it was roughly modeled on that of Venice. Its lending was primarily to the Dutch East India Company and the City of Amsterdam. The Bank could issue deposit receipts against coin and bullion. While this function greatly enhanced trade activity it did not have a significant effect on the money supply. In 1656 the Bank of Sweden was founded. The Swedes pioneered an innovation with great ramifications for future banking; in 1661 they briefly experimented with the issuance of banknotes. Unfortunately due to mismanagement the experiment was abandoned three years later. In 17^th century France the minister of finance Colbert founded the Caisse des Emprunts which offered 5% interest on demand deposits setting the stage for the state savings banks of 19^th century Europe. After a few years the Caisse was discontinued; however it was re-established in 1702 in imitation of the newly formed Bank of England. And like the Bank of England the Caisse issued bank notes.

 

Encouraged by the ascension to the throne of their new Dutch king, William III, the English planned their own version of a central bank which was chartered in 1693. The Bank of England which opened in 1694 was an important step in the country’s rise to global financial dominance. One of its primary functions was the funding of the government debt. The Bank succeeded in creating confidence in government-funded debt and throughout the next century met the need for England’s war borrowing. First lord of the treasury, Sidney Godolphin and his successor established the operational structure of the Bank. The Bank of England accepted deposits, issued bank notes and deposit receipts and circulated interest-bearing exchequer bills. The exchequer bills circulated by endorsement, were paid by the subsequent year’s tax receipts and were accepted as tax payments. The banknotes gave the Bank the ability to directly influence the supply of money and provided a stable monetary circulation.

 

Nevertheless there was, at first, one major shortcoming.  The activities of the Bank were concentrated in London. While government and centrally based merchants and trading companies were accommodated few notes reached the rest of the country. A major obstacle to a proper system of banking was that the Bank of England was the only joint stock bank allowed.  All other banks were operated by individual proprietors or small partnerships. The first provincial bank was set up in 1716 by a mercer and a draper. Other merchants and goldsmiths followed in founding banks to meet the growing needs of provincial industry and trade. Large transactions utilized the bill of exchange which could be passed from hand to hand through endorsements.  Payments at a distance required a name with an impeccable reputation in London. The goldsmiths of London played an important part in this process. They would receive deposits and issue receipts which became payable to the bearer.  Merchant bankers developed the inland bill of exchange. This was a loan instrument used for domestic transactions and paying specified rates of interest. Checks were also developed but only for use with distant transactions where bank notes or bills of exchange were not appropriate. Industrialists ultimately followed merchants and goldsmiths into the banking business. In this way such famous banks as Lloyds and Barclays were founded. The Bubble Act kept these banks small; in addition they did not have the privilege granted to the Bank of England of issuing notes. Therefore a system of correspondent banks in London arose to serve the needs of these country banks.

 

This period was also marked by great advances in public finance and administration. As we have seen the rise of central banking facilitated the management and marketing of government debt. The modern concept of marketable long term debt which originated in the merchant-run city states of medieval Europe was adopted by the European monarchies. In the 17^th century there was no systematic view of short-term versus long-term debt. However, as monarchs and ministers climbed the learning curve, their finance policies became less erratic. Once the English in the late 17^th century adopted the methods of ‘Dutch’ finance, British financial administration surpassed all others.

 

In 1667 improved methods for debt management were instituted at the new Treasury Commission. Treasury bonds were issued secured by parliamentary guarantees earmarking specific revenues for repayment. The new procedures were also adopted, along with double-entry bookkeeping by the Bank of England. English financial managers also began the use of crude techniques for estimating future revenues.  Enlightenment concepts and Newtonian physics inspired notions of efficiency in government finance and management ultimately giving rise to the concept of the balanced annual budget. In the 1730s Britain pioneered the concept of public detailed accounts. Disclosure increased public confidence and willingness to purchase government securities. The rising private financial markets undoubtedly also benefited from this example. Britain’s progressive public finance stands in marked contrast to that of its rival across the Channel. Banking institutions and public financial administration were backward in France. Corrupt government officials, fearful that the new management and accounting techniques would reveal their expropriation of funds, hampered efficient operation of the government finances. 

 

One financial innovation of the early modern era, that cannot go unmentioned, is the advent of paper money. To be sure, paper money had been used long before in China. The monetary standard in ancient China was copper coins in strings of a thousand. But by the Tang period (618 – 907) the innovative Chinese began to employ early versions of the bill of deposit. Merchants began to keep cash on deposit in business and government offices with receipts circulating as convertible certificates of deposit. This ultimately led to the use of paper money to alleviate a chronic shortage of coin and specie. The Chinese also developed a form of bank consisting of bureaus of exchange established to make advances to farmers. There was also a type of cooperative loan society and the Buddhist monasteries practiced pawn brokering. Between the 11^th and 15^th centuries China issued paper money in the form of government printed promissory notes. However, as has unfortunately been true ever since, government finance officials were unable to resist the temptation of excessive emissions. By the 12^th century billions of these notes were in circulation resulting in a massive inflation. Under the succeeding Ming dynasty there was so little trust in this fiat money that it had to be kept in circulation by its required use for the payment of taxes. For ordinary transactions the populace resorted to barter and the experiment was ultimately abandoned in favor of a silver currency.

 

In most other areas of finance medieval Europe was far in advance of China and in the 1440s, prompted by the chronic specie shortage of the times, Genoa through its San Giorgio fund began the payment of dividends not in coin but by paper notes. These were then used to settle transactions and pay taxes making Genoa the first state in Europe with an instrument close to a form of paper money.  The early American colonies, inspired by the prestiti of Venice and the Genoese paper notes and faced by the constraints on trade due to severe shortages of coin, resorted to emissions of paper money. In 1690 the colony of Massachusetts issued notes on future revenues to finance a campaign against French Quebec.  Such policies continued in peacetime owing to fast economic growth and a consequent shortage of hard currency. Unlike Europe whose short-term paper was usually interest bearing and freely convertible into coin, the colonies issued non-convertible short term notes which were legal tender. To continue these high rates of emission the colonial governments established land banks which lent newly issued paper to landowners against mortgages on their land. These notes circulated and were declared to be legal tender. As in China the temptation to over issue led to chronic inflation.

 

The new revolutionary authorities followed the precedent set by their colonial predecessors in paper money emission. Between 1745 and 1776 the only European nation that issued such paper was Sweden. However, the French Revolution was to join the American Revolution in becoming synonymous with paper money emissions. The revolutionary government of France resorted to issuing such paper in the form of assignats backed by land seized from the Church and nobility. At first these were issued with interest but in 1790 these were made legal tender without interest. Once again, the tendency to over-issue drastically reduced the value of this paper.

 

Later Modern Europe

 

By the beginning of the 19^th century the British had surpassed the Dutch as the world leader in finance with London taking first place as the international loan center. The growth of regional industry in Britain put enormous pressure on the Bank of England to open note issuing branches outside of London. The regional banks held shares in the large public transportation enterprises and provided mortgage lending to the burgeoning small manufacturers. The rise of the London Stock Exchange also helped in the process of allocating and mobilizing the capital needed to fuel the incipient industrial revolution. The actions of the financial sector made possible the needed exchange of resources between agriculture and manufacturing. Rural England, in effect, provided foodstuffs to manufacturing centers without requiring an immediate return while the manufacturing sector provided the material for building canals and railroads for both rural and industrial areas.

 

The rise of the saving bank also contributed to the mobilization of capital for industrial purposes.

In 1817 legislation was passed permitting the establishment of savings banks throughout Britain. Thus the lower classes of society were able to safely disgorge their hoarded wealth and increase their rate of saving. The British savings bank model was soon followed throughout the Continent. France followed with its own system of savings banks and with a new financial intermediary the credit mobilier, a form of joint-stock investment bank. These credit mobilizers were imitated in Brussels with the Societe Generale and in Berlin with the Seehandlung. These institutions were a response to the desire of the Europeans to catch up with British industry by financing long term industrial development, an activity that ordinary commercial banks were reluctant to undertake.

 

By the mid-19^th century the London financial markets had taken on a decidedly modern aspect. Credit rating companies began in London in the 1850s. In the 1860s joint stock banks grew rapidly replacing private banking; they were accorded limited liability and unlike the Bank of England paid interest on deposits. The business cycle also became more pronounced; periods of prosperity were followed by crises and depressions which, in turn, were followed by renewed booms. Britain’s almost unique 1696 adoption of the gold standard proved fortuitous when the discovery of vast new silver supplies in 1870s Colorado caused silver to sink in value disrupting the traditional ratio between the metals. At the beginning of the 19th century both gold and silver had been acceptable in coins and for the backing of currency. In the late 19th century up to the outbreak of World War I, investors insisted on the soundness of the currency to finance a large national debt. Thus central banking as a means of stabilizing currencies and financial markets grew in importance. The first half of the twentieth century saw few fundamental changes in finance. However, it witnessed a vast development of financial intermediaries and an efficient international financial market capable of mobilizing capital on a worldwide basis. Moreover, the twentieth century also saw a new locus of financial innovation rise, the rapidly growing United States.

 

America[4]

 

The chronic shortage of coin prompted some very eclectic financial practices in the early American colonies. The Dutch in New Amsterdam learned the art of producing wampum made from sea shells from the local Indians. Barter and commodity money, e.g., corn, cattle, furs, tobacco and rice, were all used at one time or another. And as we have seen the American colonies have the distinction of being among the first to print paper money. The example of Massachusetts was followed by that of other colonies including Pennsylvania which was warned by Ben Franklin to keep such emissions within prudent bounds. Despite the cautions of Franklin and others the shortage of metal and the pressure of war caused excessive emissions leading to a massive depreciation in value. American importers also used bills of exchange to transfer funds to British exporters without having to ship specie. The triangular transfer of credit was frequently used whereby an individual directs a merchant on whose accounts he has a cash balance to transfer funds from this account to that of a creditor. These written orders, like checks could be endorsed and circulate as money. As in Europe colonial governments also issued tax anticipation bills; these ultimately depreciated in value so greatly as to be abandoned.

 

During the Revolution inflation caused by the over-issuance of paper in New England led to calls to restrict such emissions and to increase taxes. In addition price controls were attempted; speculators and merchants who hoarded goods were prosecuted and punished. Just as today speculators, oil companies, middlemen etc. are blamed for the lack of government monetary discipline; so at that time mass protest meetings and demonstrations were directed at merchants and dealers.

 

Moreover, colonial governments also tried other ways of raising revenue. Colonies experimented with lotteries and with requiring tax contributions in kind. New York, New Jersey and Maryland had a graduated poll tax targeting such unpopular citizens as wig wearers, rich bachelors and lawyers; a concept that we might find to be useful at this time.

 

Following the Revolution the problem of repaying the war debt became acute. In 1790, after the adoption of the Constitution, speculation caused the price of the war debts to rise rapidly. The founding fathers debated the best means for raising revenue to solve the debt crisis and of ending the speculative frenzy. Madison relied on the reasoning of the Venetians that with debt being a form of repayable taxation it was wrong to reward speculators. Therefore secondary holders of debt should only be paid back at a lower rate than the original holders; the original taxpayers should receive the benefit of the repayment. Hamilton contended that such a policy would entail a burdensome increase in the cost of administering the repayment. The original public debt formula of the Italian cities was ultimately rejected due to this expense.

 

The colonists eagerly experimented with a variety of corporate structures. Societies were established for the manufacture of textiles prefiguring the American factory system which ultimately evolved into the manufacturing corporation. In 1675 the governor of New York chartered a share issuing fishery trading company; in 1692 the governor of Pennsylvania chartered another such company. In 1722 Pennsylvania also saw the first chartered American fire insurance company; the young Ben Franklin was one of the subscribers. British trading companies were instrumental in the process of colonization; among these were Hudson’s Bay Company, Massachusetts Bay Company and the 1749 Ohio Company.

 

During and after the revolution, investors had these and other limited ways to pool their capital. In addition to maritime trading and land companies they could now purchase shares in the government debt or in the newly formed banks. With the success of the Revolution the states were no longer constrained by the Bubble Act and began enacting incorporation statutes and granting charters. Transportation, banking and insurance were the principal businesses incorporated. By 1800 states had chartered more than 300 corporations; the new republic differed vastly from England and France where there were relatively few corporations and these lacked the American emphasis on local and regional economic development. A number of corporations were chartered specifically for the purpose of constructing canals and toll roads in a drive for regional internal improvements. However, there were still just a handful of corporations devoted to manufacturing or mining.

 

There were no organized banking institutions in colonial America. With the establishment of the new republic the need for an independent system of American banks found many fervent advocates. Hamilton, Gouverneur Morris and Robert Livingston urged the revolutionary government to establish the type of public bank that existed in a number of European nations. The Bank of Pennsylvania had been established as early as June 1780. In May 1781 Congress granted a charter to the Bank of North America; this was a true commercial bank. Many subscribers to the Bank of Pennsylvania exchanged their shares for those of the new bank. In 1784 banks were established in New York and Boston. Such commercial banking lessened American economic dependence upon Britain.

 

In December 1790 Hamilton recommended to Congress that a national bank be founded along the lines of the Bank of England. In 1791 the Bank of the United States, with headquarters in Philadelphia was formally incorporated. The Bank was the fiscal agent for the Federal government, supplying a large quantity of paper currency and strengthening the functioning of other banks. However, the Bank was prohibited from purchasing the public debt or lending to the Federal government, or to any state government, more than $100,000 without specific Congressional authorization. Thus it was effectively prevented from “monetizing” the debt. In 1816 the Second Bank of the United States was chartered. Its president Nicholas Biddle made it into an effective and modern central bank along the lines of the Bank of England. However its twenty year charter was not renewed and without a central bank holding reserves of specie as a lender of last resort there was no effective mechanism in place to mitigate the subsequent series of financial panics.

 

In other respects, however, progress in banking continued unabated. The 1838 Free Banking Act of New York was an innovation in American banking with a bank-note currency backed by specified bonds and mortgages. During the following decade many private banks opened in the major cities specializing in domestic and foreign exchange operations. These banks also pioneered investment banking by marketing securities for both government and business. In 1790 there were only 4 commercial banks in the U.S. By 1860 there were some 1,600 state chartered commercial banks as well as a legion of  additional unincorporated merchants and brokers performing banking functions.  The National Bank Act of 1864 expanded protection for depositors at the national banks; deposits were now given equal liability standing with notes. Deposit credits, instead of coin, were now used for loans with checks becoming the most common form of business settlement. The Act also required that national banks hold reserves; a requirement that was soon imposed by the states in regulating their own banks.

 

The financial markets were slow to develop before the Civil War. Most securities transactions were primarily in the hands of merchants, who dealt in commercial paper, and of private individuals who bought mortgages. Nevertheless, in 1792 the security dealers of New York organized themselves into an informal stock exchange; in 1817 the members drew up a formal constitution with the name New York Stock and Exchange Board. Similarly the Philadelphia Stock Exchange informally began in 1790; in 1800 the brokers of Philadelphia were officially organized into the Board of Brokers. The exchanges grew slowly; by 1835 the NYSE listed 36 banks, 21 railroads, 32 insurance companies and 7 gas, goal or canal companies. By 1856 railroad issues doubled to 42 and for the first time some 20 newly rising manufacturing corporations were listed. These exchanges lowered the transactions costs of investing and were also sources of information essential to the functioning of efficient markets. In 1841 the process of information dissemination underwent a major breakthrough with the founding of the Mercantile Agency. This ancestor of Dun and Bradstreet and predecessor of the credit rating agencies gathered and disseminated credit information to its subscribers. The decade of the 1840s also saw the founding of bank note reporter and counterfeit detection firms which assessed the quality of credit instruments.

 

Also in the 19^th century the American free-wheeling spirit of trade found expression in the growth of financial markets specializing in derivative securities. As early as 1691 a spot market for commodities began in New York; later on futures contracts were traded. Futures markets for commodities removed uncertainty; farmers could plan knowing what the price would be ahead of time without worrying about market conditions at the time of shipping. Speculators provided the needed liquidity.  In 1836 St. Louis merchants commenced exchange dealing in commodities futures. In 1848 the Chicago Board of Trade was founded and in 1856 the Kansas City Board of Trade began dealing in commodities. In 1862 the Gold Room was opened at the NYSE as a commodity and futures market for gold; in the same year the New York Produce Exchange opened for business. In 1870 the New York Cotton Exchange opened to compete with the Liverpool cotton exchange which was established in the early 1830s and was a vital factor in Britain’s industrial growth. Following the Civil War a cotton exchange opened in New Orleans. Despite that many southern merchants preferred trading in New York, among them were the Lehman Brothers founders of the eponymous investment bank. Speculation on commodities proliferated in the 1870s as speculators learned the techniques of examining trend and economic data. On several occasions in the 1870s some of these technical analysts in Chicago made killings on grain shortages. However, it was not in the United States, but in Europe that a futures market originated that was to become of considerable importance. This was the foreign exchange forward market that arose in Vienna and Berlin in the 1880s primarily to trade Austrian and Russian currencies. In the 1890s they added Sterling and French francs and developed covered interest arbitrage.

 

Although speculators provided the fuel of liquidity that made the markets work there was a dark side to such speculation. Traders like Jay Gould made immense fortunes by cornering the supply of commodities or through coordinated short selling. Many traders and buyers were ruined in the process and the markets developed bad public reputations. The reputations of the financial markets declined further with the rise of the bucket shop. These were more gambling dens than security brokers, simply executing orders in which transactions were closed out by gains or losses determined by price quotes. These shops often traded against the investments they recommended to their customers. They profited by engaging in massive short selling against their clients’ positions much as Goldman Sachs was to do during the mortgage meltdown. Despite these shortcomings a pointed lesson in the importance of the economic service provided by speculators occurred in 1897. At that time a German law was implemented prohibiting short selling and allowing the futures markets to be used only for hedging. Without the liquidity provided by speculators the markets malfunctioned and futures traders fled en masse to Liverpool thereby damaging German commerce.

 

Owing to the stimulus of Civil War borrowing there was rapid innovation in public finance. Prior to the war most federal and state securities were sold by the issuer announcing the amount and terms of the issue and inviting bids from interested investors. The highest bidders then disposed of the securities to their own customers privately. By the time of the Civil War the conflict between Eastern financial interests and agrarian America required that any politically viable public debt be widely distributed. A Pennsylvania dealer in state bonds, Jay Cooke, undertook the task of selling government securities to patriotic domestic investors. Cooke became the Treasury’s loan agent and implemented a direct marketing strategy for the War debt. His techniques included appeals to patriotism, self-interest, pride and guilt; Cooke was the pioneer of the modern fund raising drive. Bonds were sold in denominations as low as $50 to appeal to less affluent citizens. He also promoted the creation of national banks capable of promoting his campaign and following the war helped to organize a number of new banks. Cooke played a role very similar to that of Robert Morris in the Revolution: his term as loan agent was vital to the government’s funding effort during the war and in its immediate aftermath.

 

As a result of the vision of financial innovators like Cooke the new techniques of high finance were disseminated through all sectors of the capital markets. Improved methods and the rapid pace of change in government finance inspired private financial innovation. A single national capital market resulting from the financial impetus of the Civil War emerged having government securities at their core. As the federal debt was retired state and local infrastructure borrowing increased dramatically. Due to these projects and the rapidly expanding manufacturing and transportation sectors, a multitude of new securities replaced the retiring government bonds. At the same time the growth of the national banking system and an increase in financial intermediaries led to a large increase in the volume of savings and investment. This was the engine driving the late 19^th century massive increase in U.S. manufacturing and infrastructure.

 

Thus, the Western world in the 19^th century witnessed considerable financial innovations. These included the changes in monetary arrangements particularly the growth of governmental fiat paper currencies on top of the older specie based system and the rapid growth of banking institutions and bank money. The growth of securities markets was another important part of the emerging financial system. The opening decades of the 20^th century simply saw some modifications and elaborations on the themes developed in the preceding century.

 

Among these changes was an increase in the concern of investors over maturity. The perpetual security and non-callable very long term corporate bonds characteristic of the 19^th century almost vanished. The concept of the permanent funded debt, first pioneered in the city states of Italy, spread from Europe to America. The first years of the new century witnessed progressive income taxes and a resulting market for tax exempt municipal and state securities. New investment institutions catered to an increasing concern for safety. Among these were insured checking accounts, life insurance and tax-sheltered pension funds. There was a new emphasis on consumer and mortgage credit; these were to grow explosively following the Second World War.     

 

The most important development of the early century was the creation of the Federal Reserve System in 1914; for the first time since the demise of the Second Bank of the United States there was a European-style central bank. The Federal Reserve was the banker’s bank, controlled the money supply and was the government’s fiscal agent for marketing the federal debt. The latter responsibility became particularly important during and following World War 1. The Great War firmly established the ideas of Cooke in mobilizing popular nationalism and democratic credit-based finance in the service of the national debt. Two other important American financial developments occurred shortly after the war. In 1919 the Edge Act permitted banks to open corporations for the purpose of carrying on foreign commercial banking operations and for the issuance of foreign securities. In 1926 the Supreme Court voided the 1921 Grain Futures Act’s imposition of a tax on options thereby allowing the Chicago Board of Trade to reopen trading in puts and calls.

 

Recent Developments in Financial Innovation

 

The second half of the twentieth century witnessed a bewildering array of financial innovations; a trend that accelerated in the 1960s and early 1970s. These included Eurodollars and Eurocurrency securities, variable rate mortgages, money market funds, NOW accounts, negotiable certificates of deposit, home equity lines of credit, IRAs, floating-rate loans, financial futures contracts, zero coupon bonds and mortgage pass-throughs. The late 1970s and 1980s ushered in a flood of new financial devices which flourished as a result of the trend toward deregulation and the desire of security holders to protect their net positions against rising interest rates. There was an expansion of the markets for junk bonds, futures and options. Securitized loans and collateralized mortgage obligations opened up the markets to a wider class of borrowers. These markets even extended overseas; the mid-1980s saw a rapid growth in international securities. Swaps, interest rate options, option like features and odd coupon payment patterns in bonds were in the vanguard of financial innovation in the late 80s. The decline in interest rates in the mid-80s along with the proliferation of fixed rate bonds impelled the creation of new forms of asset swaps.

 

The 1980s and 1990s also saw the rise of several important changes in the institutional structure of finance. One was the rise of the hedge fund; a category which encompassed a whole variety of alternative investment vehicles unrestricted to the older mutual funds traditional types of stocks and fixed income securities. Although hedge funds engendered some suspicion on the part of the public they, in fact, served a useful purpose in stabilizing markets:

 

Looked at in this manner, hedge funds and other speculative traders provide an economic service similar to that of retailers who try to anticipate market demand and stockpile accordingly. … Though vilified and demonized by many, hedge funds and other speculative traders are not gamblers or financial parasites. In the aggregate, by supplying capital to hold risky securities, traders and hedge funds serve to reduce market volatility and improve prices for both buyers and sellers. … The liquidity supply afforded by hedge funds and speculators will often make the difference between a market closing down only a few percentage points on the day and the market sliding abruptly into a crisis.[5]

     

In the last few years of the century, on the other hand, a new institutional change began that was to have more dire consequences for the financial system and the economy. This was a change in the traditional functioning and philosophy of investment banking from that of underwriting and advising on the issue of securities. “The shift from providing advice and counsel to ‘doing deals’ requires substantial amounts of capital to take on and manage the market risk in pricing securities.”[6] These new capital requirements caused the major houses to change from their traditional partnership form by ‘going public’. And this, in turn allowed them to engage in risky ventures with ‘other people’s money’.

 

Derivatives

 

As we have seen agricultural commodities futures have been traded on the exchanges since the 1860s. In 1954 the New York Mercantile Exchange began trading contracts on broiler chickens and frozen poultry products. Futures contracts, as was true from their inception engendered controversy; there was public pressure on legislators to correct abuses. In response to complaints from growers Congress banned onion futures trading in May 1958.[7] Foreign exchange contracts, first traded in 1880s Vienna, flourished in the new floating rate currency regime of the 1970s. Both the CME and the New York Merc began trading currency futures contracts. Moreover, during this time, gold futures contracts began trading on the Chicago Board of Trade (CBOT), the International Monetary Market (IMM, a division of the Chicago Merc) and the Commodity Exchange (COMEX, a division of the New York Merc).

 

Financial futures, which were used to hedge against interest rate risk, also began in the decade of the 1970s. And the rivalry between the different exchanges continued. In October 1975 the CBOT followed by the CBOE (Chicago Board Options Exchange) launched contracts on Ginnie Mae futures. Trading in Treasury futures also began. In 1976 the CME introduced contracts on Treasury bill futures. The CBOT followed by trading long-term 20 year Treasury bond futures in 1977; they soon had to deal with the complications brought about when the Treasury began issuing 30 year bonds.[8]

 

Another type of derivative, the options contract, arose in conjunction with futures contracts. Indeed in the mid-70s options on the delivery of futures contracts, a derivative on a derivative, were sold in some states and traded in London beyond the reach of U.S. regulators. Options had never been well regarded; even traders on the futures markets found them to be disruptive. In 1936 trading in commodity futures options was prohibited. Two of the leading experts on options, Cox and Rubinstein summarize the history of these disreputable instruments in the U.S.:

 

In the United States, puts and calls have had a history of sporadic acceptability since their first appearance in 1790. The popular misconception equating options with gambling has resulted in extensive government regulation, with puts and calls at times considered illegal. The Securities Act of 1934 empowered the Securities and Exchange Commission (SEC) to regulate options trading, and the Put and Call Brokers and Dealers Association was formed to represent option dealers. Although very small during the 1940s, options volume increased considerably during the next two decades.[9]

 

However, by the end of the 1960s options contracts trading was still minuscule due to high transactions costs and lack of a well-functioning secondary market. Times abruptly changed due to several new developments. Volatility, the mother’s milk of options trading, increased due to the inflation of the late 1960s. With increasing volatility and speculation, a number of exchanges leapt into the options listing business increasing the public availability of these instruments. Prior to this period put and call options were traded over the counter. Advances in option pricing theory, in particular the Black-Scholes model, and the increasing sophistication on the part of traders and investors in these complex instruments was another important factor. In 1969 the CBOT, as part of its continuing rivalry with the CME began to list equity put and call options. In 1973 the CBOT, under the jurisdiction of the SEC opened the Chicago Board Options Exchange. The popularity of the CBOE prompted the listing of options on the AMEX, Philadelphia Stock Exchange, Pacific Stock Exchange and Midwest Stock Exchange. By the early 80s these exchanges developed options on equity indices, precious metals and currencies; trading in the latter increased nearly eightfold almost immediately after their introduction in 1983. The exchanges with their central marketplace, active secondary market, standardized contracts, market makers and guarantees of performance by a clearinghouse allowed for a great expansion of options trading.

 

Futures contracts, particularly for commodities have a beneficial economic function. These provide price insurance so that under volatile markets producers can protect their future price from falling and processors are protected from future price rises. Option contracts also provide insurance as in the case of the export manufacturer who secures his future exchange rate on a contract or the processing company which protects its future cost of imported raw materials.[10] Options, however, provide a lot more flexibility than ordinary insurance. Strategies using various combinations of options allow investors to obtain complex patterns of returns and of hedging positions that are not available with simple ownership of securities or with futures contracts. Options perform the highly useful economic function of efficiently allocating resources by increasing the information available to market participants. Options allow investors with certain types of information to affect the stock price and contain implicit information on anticipated future volatility, dividends and interest rates.[11] Financial economists approve of options as an aid in the creation of ‘complete markets’[12].  With the increased flow of information, better linkage of fragmented markets and the ability to hedge against more future market conditions, search costs are reduced and market efficiency is enhanced.  “On balance, the financial futures and options markets probably have resulted in a modest net benefit to the financial system and to the economy. “[13]

 

Eurocurrency

 

In the 1950s large banks headquartered in London, Paris, Zurich, Tokyo and other centers began to accept deposits denominated in foreign currencies. This was prompted when the Soviets and other Communist countries that held dollars refused to deposit them in U.S. banks and made their transactions in London and Paris; thus was the Eurocurrency market born. The Eurodollar, of course, was the dominant foreign currency in the early years. It is true that a market for deposits and loans denominated in a foreign currency existed in pre-war Vienna. And at that time it was regarded as a very strange and secretive practice; one that would only be done by the less reputable merchant bankers.[14] The continued growth of the Eurodollar market was the direct result of an attempt on the part of the large banks to escape regulation. The Interest Equalization Tax of 1963, the Foreign Credit Restraint Program of 1965, the regulation Q prohibition of interest on demand deposits and the absence of reserve requirements all helped to propel the rise of the Eurodollar market. The Eurodollar market spawned the rapid growth in Note Issuance Facilities as well as long-term Euroloans with floating rates tied to LIBOR. It was inevitable that Eurodollars would spawn derivatives; in 1985 the IMM introduced option contracts on financial futures for Eurodollars.

 

The advance of the Eurocurrency and other financial markets at that time was made possible by innovations in electronic trading and banking. NASDAQ which opened in 1971 was the first electronic stock market. The NYSE in 1976 developed its automated routing system called SuperDot which facilitated the routing of buy and sell orders hitherto done by traders on the floor of the exchange. In May 1977 a Belgian cooperative SWIFT, the Society for Worldwide Interbank Financial Telecommunication began. It was the first major network for transferring foreign deposits and loans. In the 1980s the major markets became fully electronic; this decade witnessed the invention of programmed trading systems along with their unfortunate contribution to systemic instability.

 

Fixed Income

 

Innovations in fixed income in the decades up to the early 80s include: negotiable CDs, money market funds, NOW accounts, floating rate obligations, Euro-obligations, zero coupon bonds, bond options, foreign currency bonds, indexed bonds and bonds with warrants to buy additional bonds. The negotiable certificate of deposit was developed to halt the decline of the rate of growth of banks which had fallen below that of other financial intermediaries. These were first issued to institutional investors in minimum amounts of $100,000. Money market funds enabled small investors to obtain attractive rates of return previously reserved for large institutions. Banks subsequently countered with Money Market Deposit and Super Now accounts. Small investors were also served by the rapidly growing mutual funds and corporate pension funds. Inflation and rising interest rates sparked a number of bond innovations. Floating-rate notes had coupons that were tied to a particular short term rate. In 1981 the British government began to experiment with inflation indexed bonds; these became an important public finance tool in Britain but never caught on in the U.S. In the 1950s the French government was the first to issue foreign currency bonds. Some bonds were issued with built-in option like features or odd coupon payment patterns which were advantageous to certain investors. Wall Street investment banks also pioneered in the development of zero coupon bonds; one particularly imaginative type was the Liquid Yield Option Note (LYON) a corporate issue that was a combination zero coupon, convertible bond which was also callable and puttable.

 

The mortgage, once a reliable source of fixed income returns for banks and other institutional investors also underwent a variety of innovations. The traditional fixed rate mortgage provided guidelines limiting the total monthly mortgage payment as a percent (usually 25% maximum) of the borrower’s income less payments for certain other obligations. In the late 70s in response to high interest rates and galloping inflation such nontraditional mortgages as adjustable rate mortgages (ARMs) and graduated payment mortgages with installment payments rising over time were commonly adopted. These types of mortgages had previously appeared in Canada and California.

 

In addition there was the growing importance of government agencies in the mortgage market beginning in the late 1960s. The Federal National Mortgage Association (Fannie Mae), was founded in 1938 to buy and sell FHA guaranteed mortgages on the secondary market; in 1948 VA mortgages were added. In 1968 Fannie Mae split into a private entity for trading in the secondary market and the Government National Mortgage Association (Ginnie Mae) tasked with purchasing mortgages requiring government subsidies. In 1970 the Federal Home Loan Mortgage Corporation (Freddie Mac) was created with the goal of strengthening the secondary market for conventional home mortgages. These agencies were to ultimately become important enablers for the creation of collateralized mortgage obligation securities.

Innovation Explosion: The Rise of Financial Engineering

 

Starting in the decade of the 1980s and continuing right up to the eve of the great meltdown and recession, the financial markets experienced an almost parabolic rise in new innovations. As we have seen, right up to that time the process of financial invention was a highly positive spur to economic growth and prosperity. Nor is it the case that innovations over the last quarter of a century were universally negative. However, when combined with a number of social and political factors, and shortcomings on the part of those tasked with regulation, some of these new financial instruments and institutional changes were to have calamitous results. 

 

The expansion of trade and the consequent overseas expansion of the major banks was one important factor in the multitude of financial innovations of the 1980s. “One of the pervasive features of the commercial banking industry in the 1980s is that banking activities have become globalized as banks have branched out from their home countries into foreign financial centers.”[15] The increased competition that the banks were subjected to when combined with their ever-present desire to escape government regulation, was a spur to coming up with complex and opaque new instruments and contracts. The need of their large customers to hold deposits at foreign locations and in foreign currencies, a need necessitated by the growth of trade and foreign investment, opened opportunities for the banks to fulfill that desire. During the period of the late 1980s some financial analysts were ambivalent regarding these new innovations. While these might increase the micro-efficiency of financial markets they may also contribute to financial instability. On the other hand, it was possible that stability would increase since market participants were better able to respond to changing economic events and to market volatility.[16]

 

Swaps

 

The most significant development in innovation during the 1980s was the rapid growth of asset swaps. The swap market soon became the largest financial market in dollar turnover terms.  In the late 70s and early 80s the innovative Salomon Brothers began experimenting with Interest rate swaps as a way of transforming a fixed rate into a floating rate asset, and also with currency swaps. As early as 1976 Goldman Sachs and the soon to be defunct Continental Illinois Bank had arranged a currency swap between a Dutch and a British company. In 1981 currency swaps became established when Salomon Brothers arranged a DEM/SFR swap between IBM and the World Bank. The volume of currency swaps soon exceeded that of currency futures. At about the same time the first interest rate swap was initiated by the Student Loan Marketing Association.

 

Interest rate swaps allow a company to borrow in markets where they have a comparative advantage and then swap this for a different flow of interest payments more in line with the company’s preferences. This type of swap was an outgrowth of the parallel loans invented in the 1970s which allowed firms to effectively borrow in one another’s capital markets although they could not do so directly. The plain vanilla swap with firms converting their borrowing or lending from short to long is the standard template for interest rate swaps; default involves only interest payments so that risk is limited. An illustration of a plain vanilla swap is shown in Appendix 4A. Although market comparative advantage is often cited as the reason behind the multitude of interest rate swaps that occurred beginning in the mid-1980s, the decline in interest rates and the glut of fixed rate bonds appeared to be an important factor. Another determinant was the lower transactions costs of a swap as compared to retiring and replacing a bond issue. Moreover there were additional factors underlying the popularity of these swaps. “The fact that a significant number of participants trade or make markets in interest rate swaps generates considerable liquidity in the interest rate swap markets. This reflects the use of interest rate swaps as a highly flexible mechanism for positioning, arbitrage and portfolio management activities. This generates considerable liquidity as both a primary and secondary market in interest rate swaps operate.”[17]

 

A currency swap is an agreement between two parties to exchange principal and interest in one currency for that in another. As is true for interest rate swaps, comparative advantage in borrowing is the chief motivation for undertaking such a transaction. However In contrast to interest rate swaps, the currency swap market operates as a primary market with only limited secondary market activity.[18] The currency swap agreement also stipulates that default by one party ends the contract thereby limiting exposure to the net flows. During the 1980s increasingly complex variations of swaps were developed. In 1987 commodity swaps appeared; in 1989 Bankers Trust introduced equity swaps. Some of these variations succeeded while others soon failed to catch on; depending on the needs of the markets at the time. “Innovations in the swaps markets, as in other financial services areas, may be characterized as a Darwinian struggle, in which competition heats up and margins narrow as a particular kind of swap becomes accepted and widely used.”[19]

 

A swap variant, the credit default swap, originated in the early 1990s. These are, in fact, not really swaps but rather an odd form of insurance on corporate bonds. In the beginning these were used as vehicles for hedging; a bank fearful of offending a long-standing client but anxious over the large amount borrowed would purchase a credit default swap. Eventually these became instruments for speculators who wanted to bet against the future prospects of a company; such speculators lacked any insurable interest. The seller of the swap would often end up with an immense exposure in the event of a large downturn in the market. The early ones may have appeared to be innocuous at first but contained within these was the potential for the disaster realized during the mortgage meltdown.

 

Bonds and Options

 

There were a number of other ingenious financial contrivances that proliferated in the mid-1980s. These included bonds with the principal redemption linked to the bond price, bull and bear bonds with a bull tranche linked directly to an index or to a commodity price and a bear tranche inversely linked to the index or price. The 1980s also saw the rise of the junk bond. These below investment grade securities, whose marketing was pioneered by Drexel Burnham Lambert, enabled a wave of leveraged buyouts whereby a syndicate of investors seizes control of a corporation using the assets of the acquired company as collateral. These securities have also been used to facilitate mergers and by company management to fend off a hostile takeover.  

 

Options and financial strategies based on options increased in importance during the 1980s. There were a variety of range forwards and collars consisting of combinations of two options positions. Salomon Brothers, the pioneer of the Range Forward contract used the concept to generate a number of new products. One of these, the MINI-MAX, was a non-dollar instrument that provides a dollar yield varying within a range.  Another, the PIP, was a dollar denominated commercial paper instrument that provides a non-dollar yield varying within a range determined by the exchange rates. As detailed in the following sections, the financial engineers of Wall Street were highly imaginative in creating a multitude of new instruments.  Portfolio insurance, a method of hedging a portfolio of stocks against market risk, became extremely popular during the decade. These hedging techniques employed a variety of exotic options and option combinations.

 

The breakthroughs in financial innovations of the 1980s have reverberated ever since. In a similar manner to the quantum physicists who have discovered the existence of a veritable zoo of exotic new particles, the financial engineers of Wall Street have developed a multitude of new swap and option variations. This financial zoo is outlined in Appendix 4B.

 

Mortgages and Securitization

 

There were a number of new mortgage instruments arising in the last decades of the 20^th century; some of which were fraught with dire future consequences. Mortgage pass through securities issued by Ginnie Mae and Freddie Mac began in the late 1960s and early 1970s; later these were joined by issues of Fannie-Mae. Yields on the Fannie-Maes and Freddie-Macs were slightly higher than the Ginnie Maes which bore the full faith and credit of the U.S. government. These pass-throughs played a crucial role in the development and expansion of the secondary mortgage market. GNMA pass-throughs, in particular, due to good returns and absence of default risk became very desirable for bank portfolios. With pass through securities and the relatively high standards that borrowers had to conform to, mortgage prepayments caused cash flows and rates of return to vary. Thus at that time it was prepayments, rather than mortgage defaults, that were the major cause for concern. Prepayments are, in effect, the rational exercise of an option. Later on it was deemed important to expand the range of investors to those with different maturity and tax preferences and thus to lower costs. For that reason a variety of mortgage-backed bonds were devised.[20]  The consequent growth of these new Mortgage Backed Securities and their various hybrids and derivatives with obscure methods of computing yields caused much confusion on the part of investors.[21] At a later time it appears that supposedly sophisticated counterparties were to also have difficulty in assessing risk and return.

 

The standard Collateralized Mortgage Obligation was the first of these new securities to come on line. This mortgage-backed security creates separate tranches with varying maturities for different classes of bondholders. The shorter average life tranches meet the needs of investors requiring greater predictability of the timing on the return of principal. The longer tranches offer more protection against call and reinvestment risk. The CMO is a legal obligation, not of the originating institution, but rather that of a special purpose entity; investors buy bonds issued by the entity. The first CMO was introduced in June, 1983 by Freddie Mac in a deal co-managed by First Boston and Salomon Brothers. It was a three tranche offering with a guaranteed minimum sinking fund. The proponents of CMOs have cited their market broadening and cost lowering benefits. “Since many of the bonds fit investor objectives that are not suitably filled by pass-throughs, a conclusion is that CMOs have broadened the universe of investors able and willing to buy mortgage securities.”[22] The CMO, however, was to have one unfortunate consequence; it was the engine used to fund subprime mortgages.

 

In a traditional mortgage the flow went from the borrower obtaining funds from a bank or S&L who in turn were funded by their depositors. In the new marketable mortgage financing the borrower approaches a mortgage originator such as an S&L or mortgage banker who submits the loan application to a guarantor: the FHA, VA, or private insurance. If the guarantor accepts, the mortgage goes into a pool which may then be guaranteed by one of the agencies, FNMA, FHLMC or GNMA, thus providing a double layer of protection. Claims were then sold to investors through a bond, pass-through or CMO. In a pass-through security each claimant shares in any prepayments. With a CMO, or the closely related real estate investment mortgage conduit (REMIC), the prepayment risk to some investors is reduced and they receive less risk and lower returns; other investors have more prepayment risk and higher expected returns. Under securitization, credit risk is supposedly passed on to insurers while mortgage buyers assume the interest rate and prepayment risk. The banks don’t bear these risks while forgoing the greater potential profits. Through buying and selling in the mortgage market lenders were able to tailor their exposure to suit their risk preference. [23]  However, as it was to turn out some of the large banks were caught still holding some of these securities before they had a chance to sell them when the mortgage crisis struck. All in all the CMOs had disastrous results; they simply enabled the risk originating in the government sparked subprime mortgage market to be disguised and passed around to successively greater fools. See Appendix 4C for a note on some of the details of the CMO structure.

 

In any event, CMOs were an important factor in lowering mortgage origination costs and promoting the housing market boom beginning in 1983. Another factor was the deregulation of liabilities which created large deposit inflows at thrifts, thereby enabling them to return as buyers of mortgage instruments.[24] The progress of the boom was further assisted by the growth of the adjustable rate mortgage which was later to prove so troublesome. It is true that the end of the traditional mortgage and its replacement by ARMs and securitization had little justification. The traditional mortgage and its supporting post-war financial structure had proved quite reliable as a means of providing wide housing ownership in a responsible and financially supportable manner. Mortgages had been among the most dependable of the fixed income securities. Indeed, from 1972 to 1984 corporate bonds had averaged negative rates of return for 5 of those years. Over the same period the Mortgage Index produced at the least a slim return every year.[25]

 

The technique that played the leading role in ultimately overthrowing the traditional model was first pioneered by Long Beach Savings and Loan, later to become Ameriquest.  With many people shut out of the traditional market, various lenders experimented with new methods of broadening the market. Long Beach adopted the originate and sell strategy whereby the bank originator of the mortgage did not simply hold it on its balance sheet but sold it to be ultimately packaged into a bond for resale to the ultimate investor. Ameriquest, the first bank to tap into the subprime market, became the largest lender in that market until the disaster that occurred in 2007. Owing to pressure by government to expand housing ownership to those supposedly facing discrimination the originate and sell model along with securitization were widely adopted.

 

To be sure, the mortgage market was not the only one affected by the mania for securitization. In the early 1990s the ever-inventive Salomon Brothers originated “markets in bonds funded by all sorts of stuff: credit card receivables, aircraft leases, auto loans, health club dues.”[26] This was the birth of the collateralized debt obligation (CDO).  These asset-backed securities vary widely in their structure and the pool of assets held. As with the CMO a special purpose entity is constructed to hold assets as collateral for the issuance of securities to the ultimate investors.

 

Financial Engineering

 

The diversity of new financial instruments and methods was a direct result of theoretical developments in finance and the revolution in computer technology and communications.  From advances in the understanding of risk, option pricing theory, portfolio analysis and efficient market theory the new discipline of financial engineering was born. Advances in computer hardware, software and telecommunications made it possible to apply the insights of the financial engineers. The new instruments generally had many advantageous economic functions. Returns to investors increased and borrowers had their financing costs lowered. In these and other ways market friction and transactions costs are lowered, trade is expanded and economic growth facilitated. The new instruments and strategies were useful for hedging and price protection. In addition to the traditional hedging of commodity prices, there was now the ability to manage risk against sharp and unpredictable shifts in exchange and interest rates. As one experienced market analyst observes:

 

While markets for agricultural commodities would always exist, an advanced industrial society needed to begin acknowledging that basic commodities also included such things as Treasury bills, foreign exchange and long-term Treasury bonds … the fundamental commodity in society was no longer measured in bushels but rather in basis points.[27]

 

New derivative instruments made firms more flexible in confronting change and circumventing adverse market conditions. Portfolio managers found them exceptionally useful for hedging industry-related risk and allowing for more efficient diversification. The new derivatives also enabled financial managers to develop new strategies for dealing with changes in tax laws and regulations. One of financial engineers’ mottos could well have been the following. “Rules and regulations that ignore or try to suppress the basic forces of supply and demand in the financial marketplace soon will be outmoded by the ever changing technology of finance.”[28]

 

One of the principal ideas behind financial engineering was the concept of the complete market. “Complete markets are highly desirable since they allow investors to establish patterns of payouts in accordance with investor’s desired preferences.”[29] In this theoretical complete market investors can have portfolios that have the exact pattern of risks and returns they desire. Derivatives can move the financial market in the direction of completeness and thus appeal to new groups of investors. Of the many new types of instruments introduced; only a few last. The lasting types are those which provide significant value to sizable numbers of issuers or investors.

 

Many of these new derivatives and strategies would have remained strictly theoretical but for the advances in computer technology and electronic communications. While computerized trading had been around since the early 1970s, it was only in the decade of the 1980s that the markets became fully electronic. The computer based strategy for trading large aggregates of securities called program trading was instituted. Program trading was, to be sure, one of the chief causes of the great crash of 1987. With the emergence of electronic communications networks traders were able to access worldwide markets outside of the established large exchanges, and to do so on a 24 hour basis. Program trading was further enhanced with the beginning of decimal, as opposed to the traditional fractional, stock quotes. In 2005 the SEC issued a series of rules that made high frequency trading possible.[30] Of course, these alternative trading systems, quick execution times and global networks have created extreme tight coupling in the markets thereby increasing systemic risk.

 

A major impetus to financial engineering occurred in spring 1973 with the publication of “The Pricing of Options and Corporate Liabilities" by Fischer Black and Myron Scholes; they followed up on the pioneering work of Robert Merton. Prior to the Black-Scholes breakthrough option pricing models relied on individual expectations of returns, correlations and risk preferences; these tended to produce very specialized solutions with highly restrictive applicability.  With training in physics and mathematics, as well as financial economics, Black and Scholes were able to cut right to the essentials. Under a number of assumptions they obtained and solved a form of the heat transfer equation of thermodynamics. Following the original derivation other analysts obtained the same formula under the same assumptions using a binomial option pricing method. Nevertheless it is true that some of these assumptions were not altogether realistic. The risk-free interest rate is assumed to be unchanging, there are no transactions costs, the option can be exercised only at expiration, short selling is allowed and, above all, the stock volatility is assumed to remain the same. In appendix 4D, for the mathematically curious, the derivation of the Black-Scholes formula is shown. 

 

The Black-Scholes model was happily adopted by many financial firms and the authors embarked on lucrative careers on Wall Street. Myron Scholes was snatched up by Salomon Brothers, and in what turned out to be an unfortunate career move, went on to Long-Term Capital Management. The late Fischer Black proceeded on to Goldman Sachs and described how Goldman, and other financial companies, applied various techniques for valuing options and option-like derivatives. For valuing options, warrants and convertibles the analysts at Goldman Sachs relied on the Cox, Ross and Rubinstein binary tree method. For fixed Income securities a number of techniques were employed; the Black-Scholes formula, a binary tree algorithm, a modified tree with a cap, and a factor model allowing shifts in the level, slope and curvature of the yield curve.[31] Black recognized and fully acknowledged that his great invention should be applied in a careful manner:

 

The formula and the volatility estimates we put into the formula are always based on the information at hand.  The market will always have some kinds of information affecting the values of options and warrants that we don’t have. Sometimes the values given by the formula will be better than market prices; at other times the market prices will be better than the formula values.[32]

 

It is unfortunate that his fellow financial engineers did not always take this caution to heart.

 

Modern Portfolio Theory (MPT) is the other foundation stone on which the edifice of financial engineering was built. It originated in the work of H.M. Markowitz in a model put forward in 1952. MPT says that portfolio diversification by choosing stocks that do not move together will reduce risk. By analyzing the various possible portfolios of given securities and finding those whose correlation of returns is less than one, or even better negative, investors can construct risk reduction strategies. The theory shows that there are two types of risk.  Systematic risk occurs for that market risk which cannot be reduced by diversification. Risk that can be reduced by MPT’s recommended diversification is unsystematic.  The capital asset pricing model (CAPM), developed in the early 1960s was an outgrowth of MPT. It uses an estimate of an asset's sensitivity to non-diversifiable risk and the return on a risk free asset, as in the later Black-Scholes model to determine whether an asset, given its unsystematic risk, should be added to a portfolio. A mathematical representation of MPT is outlined in Appendix 4E.

 

Financial engineering including such strategies as portfolio insurance benefited greatly from the theoretical foundations built on MPT, CAPM and Black-Scholes. However, some of the instruments and techniques for obscuring the underlying financial reality were to become quite problematic; the more so when used to cover up the effects of government promoted social policy. The use of the new innovations for such purposes when combined with the economic disruption due to loss of manufacturing, mass low skilled immigration and the shrinking of the middle class produced a toxic brew. The next chapter uncovers the role played by many of the actors in the drama of the financial meltdown; the politicians, bureaucrats, bankers, financial movers and shakers and the regulators. In particular, the role of the post 1960 student cohort in the long march through Wall Street along with their attendant elitism, favoritism and destructive obsession with diversity will be explored. The myth of the scheming politically conservative banker and financier will be debunked. The involvement of politicians, including many so-called progressives, with the crony capitalism of the financial sector will be discussed; as will the betrayal of the public trust by the regulatory agencies.

 

 

 

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[1] Sources for this survey of ancient finance include the following: Carolyn Webber and Aaron Wildavsky, A History of Taxation and Expenditure in the Western World, Simon and Schuster, 1986; Sidney Homer and Richard Sylla, A History of Interest Rates, Rutgers 1991; James Macdonald, A Free Nation Deep in Debt, FSG, 2003; W. E. Thompson, The Athenian Entrepreneur, L’Antiquite Classique Vol. 51, 1982. These authors, in turn  rely on such authorities as Paul Einzig, Primitive Money; Melville Herskovitz, Economic Anthropology; Fritz Heichelheim, An Ancient Economic History; L. Delaporte, Mesopotamia; Gustave Glotz, Ancient Greece at Work; A. Andreades, A History of Greek Public Finance; H. Mitchell, The Economics of Ancient Greece; Moses Finley, The Ancient Economy; John Day, An Economic History of Athens Under Roman Domination; A. Boeckh, The Public Economy of the Athenians; J. Larsen, An Economic Survey of Ancient Rome; M. Rostovtseff, A History of the Ancient World; Frank Tenney, An Economic History of Rome.

 [2] Sources for the history of medieval and Renaissance finance include the following: Webber and Wildavsky, A History of Taxation and Expenditure in the Western World; Homer and Sylla, A History of Interest Rates; James Macdonald, A Free Nation Deep in Debt; Carlo Cipolla, Before the Industrial Revolution, New York, Norton, 1976; North & Thomas, Rise of the Western World, Cambridge, 1999.

[3] Sources for finance in Early Modern Europe are: Webber and Wildavsky, A History of Taxation and Expenditure in the Western World; Homer and Sylla, A History of Interest Rates; James Macdonald, A Free Nation Deep in Debt; North & Thomas, Rise of the Western World, T.S. Ashton, The Industrial Revolution, New York, Oxford University Press, 1969.

[4] Sources for finance in the United States are: Webber and Wildavsky, A History of Taxation and Expenditure in the Western World; Homer and Sylla, A History of Interest Rates; James Macdonald, A Free Nation Deep in Debt; Charles Geisst, Wheels of Fortune, Hoboken, NJ, Wiley, 2002; Margaret Myers, A Financial History of the United States, New York, Columbia University Press, 1970.

[5] Richard Bookstaber, A Demon of Our Own Design, Hoboken, N.J., Wiley, 2007, pp. 219-220.

[6] C. Lucas, A. Hook, C. McCurdy, R. Aderhold, M. Alvarez, S. Fogel, A. Harwood and B. Lancaster, Recent Trends in Innovations and International Capital Markets, Federal Reserve Bank of New York, March 1987, p. 10.

[7] Geisst, Wheels of Fortune, p. 151.

[8] Ibid, p. 218.

[9] John Cox and Mark Rubinstein, Options Markets, Englewood Cliffs, N.J., 1985, p. 23.

[10] Robert Tompkins, Options Analysis, Chicago, Probus, 1994, pp. 2-3.

[11] Cox and Rubinstein, Options Markets, pp. 443-44.

[12] Assume that all possible economic outcomes can be put into mutually exclusive and exhaustive states and that investors can identify which state has occurred. A market is said to be complete if a pure security exists or can be constructed for each state. Note that in set theory the union of mutually exclusive subsets is exhaustive if it equals the universal set.

[13 Peter Rose, The Financial System in the Economy, Homewood, Illinois, Dow Jones Irwin, 1989, p. 331.

[14] J. Grabbe, International Financial Markets, New York, Elsevier, 1986, p. 17.

[15] Krugman & Obstfeld, International Economics, p. 629.

[16] FRBNY, Recent Trends in Innovations and International Capital Markets, p. 51.

[17] Miles Livingston, Money and Capital Markets, Cambridge, Mass., Blackwell, 1996, p. 537.

[18] Ibid

[19] Peter Abken, “Beyond Plain Vanilla: A Taxonomy of Swaps” in Federal Reserve Bank of Atlanta, Financial Derivatives, 1993, p. 51.

[20] Kenneth Sullivan, Bruce Collins and David Smilow, Mortgage Pass-Through Securities in Frank Fabozzi and Irving Pollack, Handbook of Fixed Income Securities, Dow Jones-Irwin, 1987, p. 383,

[21] Stephen Smith, “Analyzing Risk and Return for Mortgage-Backed Securities” in FRB of Atlanta, Financial Derivatives, p.139.

[22] Gregory Parseghian, “Collateralized Mortgage Obligations” in Fabozzi and Pollack, Handbook of Fixed Income Securities, p. 421.

[23] Livingston, Money and Capital Markets, pp. 337-346.

[24] Michael Waldman and Steven Guterman, “The Historical Performance of Mortgage Securities” ” in Fabozzi and Pollack, Handbook of Fixed Income Securities, p. 423.

[25] Ibid, p. 428.

[26] Michael Lewis, The Big Short, New York, Norton, 2011, p. 8.

[27] Geisst, Wheels of Fortune, p. 192.

[28] Rose, The Financial System in the Economy, p. 486.

[29] Peter Ritchken, Options, U.S.A., Harper Collins, 1987, pp. 91-92.

[30] Arnold Ahlert, “How the Machines Took Over Wall Street”, http://frontpagemag.com/2011/09/06/how-the-machines-took-over-wall-street.

[31] Fischer Black, “Living up to the Model” in From Black-Scholes to Black Holes, London, RISK/FINEX, 1992, p. 19.

[32] Fischer Black, “How We Came Up With the Option Formula” in Whaley, R.E. ed., Interrelations Among Futures, Option, and Futures Option Markets, Chicago Board of Trade, 1992, p. 9.