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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.