Week 1-History of Finance

Week 1: History of Finance

Learning Outcomes

• Understand the history of Money

• Explain the events leading to the emergence of banks

• Describe the characteristics of the international monetary system

Introduction

• Overview of fiat money and its significance in human history over thousands of years.

• Importance of understanding money's role for comprehending modern digital transaction systems.

Barter and Commodity Money

Barter System

• Definition: Exchange of goods and services directly without the use of money.

• The term 'barter' originates from Old French, indicating trading practices.

Transition to Commodity Money

• As societies progressed from hunter-gatherers to food producers, the need for a reliable exchange mechanism emerged.

The Problems with Bartering

• Difficulty in finding exact goods needed by both parties simultaneously.

• Lack of a standard unit of value led to complications during exchanges.

The Solution: Commodity Money

• Scarcity and monitorable circulation items were adopted:

  • Cowrie shells (used in Indian and Pacific Oceans)

  • Wampum and beads (North America)

  • Whale's teeth (Fiji Islands)

• Characteristics of early items:

  • Widely accepted medium of exchange

  • Store of value

  • Unit of account

• Challenges remained: Some commodities were hard to transport or store.

Precious Metals

• Superior attributes made precious metals preferred:

  • High saleability and acceptance across different nations.

  • Distribution across regions, easy extraction, durability, and low transportation cost.

• Emergence driven not by governments, but by social trends, leading to enhancements through coinage.

Transition to Paper Money

Global Context

• Money as a crucial human invention, differentiating from natural systems.

Origins in China

• Marco Polo highlighted Chinese paper money to Europe.

• Timeline:

  • Tang Dynasty (A.D. 807): Flying money

  • Song Dynasty (A.D. 960): Convenient money

  • Ming Dynasty (1368-1644): Various exchanges

  • Qing Dynasty (1890s): Yuan

Transition to Paper Money in Europe

• First use in Sweden (17th century), led by Stockholm Banco (1661).

• Popularity of paper currency surged, offering convenience over metals.

• Foundation of modern economies laid by paper money over the last 150 years.

Emergence of Banks

Templars (1118)

• Origin of banking traced back to Templars in Jerusalem, leveraging military and business operations.

• Accumulated wealth led to lending practices and transactions across different currencies.

Italian Banking Families

• Post-Templar era prompted wealthy families in Northern Italy to establish private banks.

• Operated from marketplaces, lending and payment services emerged.

• Concept of 'bank' derived from the Italian word for bench and introduced double-entry accounting.

Bank of England (1694)

• Established as a modern banking prototype with banknotes replacing coins.

• Gained acceptance due to profitability and spurred private banking growth despite government constraints.

Banking in America

• Bank of North America (1781) established based on the British model amid difficulties of the Revolutionary War.

• Encouraged formation of additional banks like Massachusetts Bank and Bank of New York.

• Precedent for future central banking with the First Bank of the United States (1791).

Central Banking

• Functions:

  • Fiscal agent for the government.

  • Control and monopolize currency issuance.

  • Manage credit at a macro scale.

• Post-WWI shifts towards domestic stabilization and deposit security.

• Challenges posed by technological innovations discussed in later chapters.

International Monetary Systems

• Network of institutions for settling international payments and determining currency exchange rates.

• Evolution of exchange rate systems:

  • Fixed exchange rate system: Government-determined rates.

  • Floating exchange rate: Based on supply and demand.

  • Managed exchange rate: A hybrid of previous systems.

Gold Standard (1717-1933)

• Fixed exchange rate system tied to gold reserves; dictated currency value.

• Promoted monetary discipline and balance in money supply and demand.

Disadvantages of the Gold Standard

• Limited governments' ability to implement monetary policies.

• Restrained economic growth due to fixed gold supply alongside increasing global trade.

Weakening of the Gold Standard

• Pre-World War II fluctuations in adherence to the gold standard.

• Shift to floating rates after the Great Depression.

• 1944 Bretton Woods Conference established IMF and World Bank to stabilize global finance.

Dominance of USD

• Post-Bretton Woods, USD became central to global economy; treated as equivalent to gold.

• System established a two-tier market with USD pegged to gold, while other currencies pegged to USD.

Nixon Shock (1971)

• Suspension of USD's convertibility to gold initiated floating exchange rates.

• USD remains dominant, driving around half of foreign exchange transactions.

• Advent of digital money and cryptocurrencies reshaping financial technology and policies.