by Kabir Sehgal
So Kublai started over. In 1287, the state issued a new currency, zhiyuan chao, which was set at five times the value of the old currency, an effort to devalue the old currency into extinction.51 Up until this point, soft money was paper backed by metal. Kublai’s new currency was declared inconvertible to hard money. Soft money had lost its anchor. It was, in the words of economists, fiat money: issued by the state, circulated on faith, and rendered worthless when people lost trust in it.
To increase adoption of the new currency, the state again banned the use of gold and silver in transactions. But that led to further depreciation of the new currency as these precious metals were hoarded, reprising Gresham’s law. The state even banned private vouchers and coupons, anything that could be a threat to the new currency.52 Instead of the old currency vanishing, it circulated in the shadows, and eventually alongside the new currency because in theory it still was backed by silver.
People lost faith in Kublai’s currencies, especially as budget deficits grew. Kublai’s successors experimented with creating new currencies, but it wasn’t enough to restore faith in the monetary system. In 1311, the dual monetary system was restored. Prices were listed in zhongtong chao, and it became the monetary standard, since it was supposedly convertible to silver. The currency of daily transactions was the zhiyuan chao. The reprised system helped to foster years of relative economic calm, until the power of his successors of the Yuan Dynasty eroded in the middle of the century.53
Chinese monetary history illustrates that the stronger the state, the more credible its institutions, the softer the money. The value of money wasn’t derived from its intrinsic metal worth. People had faith in, or even feared, its issuer. A strong leader like Kublai Khan could make monetary decisions without compunction. Yet these early experiments in soft money demonstrate the Faustian bargain. Despite initially having the confidence of its people, issuers fell victim to the temptation of overproduction, which led to higher spending and rampant inflation. The rise and fall of soft money took decades in China. In another part of the world, it would take only four short years.
A Man in France
Some of what we know about Kublai Khan comes from Venetian explorer Marco Polo, who shared stories about how paper money was used in these distant lands. His discoveries may have been what inspired Europe to adopt similar monetary instruments in the fourteenth century. But the West didn’t engage in its elaborate experiment of using soft money to rescue a flagging economy until much later. In one telling example, the French monetary system of the 1710s, different institutions worked together to reboot a sluggish economy. Yet, as was the case in the East, an unchecked soft monetary system precipitated a decline in the value of the currency and high inflation.
The man who orchestrated an early experiment had a colorful background. Born to a goldsmith near Edinburgh, John Law was educated at top schools, developed a fondness for gambling, and was a notorious womanizer. In 1694, at the age of twenty-three, he even killed an opponent in a duel over a woman. He was subsequently arrested, and sentenced to death.54 But with the help of prominent friends, he escaped on a boat that was headed to continental Europe.55
He eventually wound up in Amsterdam, a bustling financial hub, where he learned firsthand of financial innovations like foreign exchange banking, joint stock companies, the stock market, and paper money.56 The Amsterdamsche Wisselbank, or Exchange Bank of Amsterdam, didn’t charge customers for deposits but for withdrawing coins, as much as 2.5 percent to cover the operating costs of the bank. These fees discouraged withdrawals. In 1683, the bank tried to make withdrawals easier and issued receipts against the coins a customer had on deposit. Over time, the bank prevented customers from withdrawing coins, and these receipts turned into a tradable currency. The change enabled the bank to loan money more easily to large borrowers like the Dutch East India Company.57 The bank’s decision wasn’t widely questioned, as outsiders including Adam Smith thought it had a large reserve of precious metals. Already possessing a mind adept in mathematics, John Law now had an idea that he could reformulate elsewhere.58
In 1705, he wrote about this idea in his book Money and Trade Considered, with a Proposal for Supplying the Nation with Money, which he circulated in Scotland with the help of his aunt, who was a publisher. He tried to connect the dots between money and trade, arguing that more money in circulation would lead to more commercial activity. In addition, he linked the money supply with price levels by pointing out that Europe’s importing of precious metals, hard money, would generate an increase in prices. He advocated for countries that were suffering from shortages of money and depressed prices to increase their supply of it. The most expedient way was to abandon hard money for soft, a new twist on alchemy, to turn paper into gold.59 To be sure, paper money wasn’t new to Europe, since its origins have been traced to medieval Italy. John Law synthesized other people’s ideas and proposed the creation of a state bank, analogous to the Exchange Bank of Amsterdam, to issue paper money.60
But no country wanted what he had packaged and was selling. That changed with the death of Louis XIV, who left France with a monetary and financial crisis.61 The Sun King’s incessant wars and profligate spending generated heavy debt, exorbitant interest rates, and high unemployment. France faced bankruptcy and default. Moreover, it lacked enough precious metals to mint coins at levels necessary to facilitate an adequate level of trade. France was enduring a currency famine.62
The Duke of Orleans, who had been elevated to regent, the head of state, invited John Law to France to help resolve the monetary crisis. Law’s prescriptions for France were right there in the title of his book: money and trade. He thought France needed more money, which would end the currency famine. And he believed France needed a large trading company that could absorb the national debt, promote commerce, and mitigate the financial crisis.
In 1716, he put his plan into action by founding Banque Générale, which functioned as a traditional bank in that it accepted deposits and issued loans. It had friends in high places, as the regent was also a customer. The bank was permitted to issue banknotes that were convertible to hard money. In 1717, the state allowed tax payments to be made using these notes, immediately broadening their use value, making them legal tender and a currency.63
In 1718, the regent took over Law’s bank because of its tremendous profitability and turned it into the official state bank, Banque Royale. The new bank issued notes known as livres, the French currency at the time. Law welcomed the takeover because it strengthened his proximity to power, which would give him more leeway to implement the ideas described in his book. Law knew that the stronger the state, the more money could be governed by fiat. Just like in Kublai Khan’s court, the French government prohibited the trade of gold and silver. By 1720, just four years after Law’s arrival, his system had increased the money supply by a factor of four. The currency famine was over, and prices were on the rise.64
But there was still the concern of France’s large debt and high interest rates. Law looked to absorb the national debt into another institution, a company of which he took control and modeled on a Dutch joint stock trading company. In 1717, Law became the head of Compagnie d’Occident (Company of the West), which was financed with 100 million livres.65 Historian Niall Ferguson explains Law’s plan: “He was (not unreasonably) trying to convert a badly managed and burdensome public debt into the equity of an enormous, privatized tax-gathering and monopoly trading company.”66 The company had procured exclusive rights to commercial activity in Louisiana. In exchange, it was to assume part of the French national debt. At first, it seemed like a fair deal. The Louisiana territories at that time stretched north to Canada and held great promise of copious minerals and precious metals—future revenue with which to repay investors. The regent helped the company by giving it plum opportunities to merge with companies that operated in Africa and Asia. The resulting conglomerate was known as the Mississippi Company.67
Banque Royale and the Mississ
ippi Company were intertwined in Law’s system, and they even merged in 1720. Banque Royale was akin to a central bank, and issued money that people used to buy stock in the company. The Mississippi Company continued to sell shares, which were scooped up by the hungry public. The share price doubled. Law experimented with new ways to promote the shares, such as allowing deferred payment plans, as well as pricing the shares at levels affordable to the common man. Eventually, an options market appeared that provided investors opportunities to buy shares with less money up front. To keep demand strong, Law trumpeted the promise of Louisiana, even planning a city named New Orleans in honor of the regent.68
Meanwhile, in mid-1719, Law saw an opportunity to advance his system and oversee a broader portfolio of France’s economy. The Mississippi Company, flush with investors’ cash, loaned the state money to repay the debt balance. The state had lowered the interest rate on its debt issuance from 30 percent to less than 4.69 Investors who held government debt were steered toward buying shares in the Mississippi Company, and its share price again almost doubled in just two weeks. In just two years, a share had risen in price from 150 livres to 10,000 livres. Investors had seen their holdings appreciate considerably, and the term millionaire was first used in 1719.70 The prospect of getting rich quick generated a market mania in which poor and rich folks alike lined up to buy shares. In a sign of the times, a man suffering from a hunchback condition made 35,000 livres by charging traders to use his back as a table, and subsequently bought shares for himself.71
Law’s system was firing on all cylinders: The money supply had expanded, and the share price of his company had exploded. The monetary stimulus worked, in four short years. The renewed confidence in the state spilled over to the French private sector, which was becoming a leader in international trade and commerce. For having turned around France’s economic fortunes, Law was bestowed the title Duke of Arkansas. He converted to Catholicism because he was to become a public official, the Contrôlleur Générale des Finances, similar to the US Treasury secretary, in charge of tax collection and the nation’s finances.72 This Scottish man set an example that inspired others as the British South Sea Company followed a similar course of action, converting state debt for corporate equity.
Everything that goes up must come down, and the markets began to feel the gravitational force of reality. Because the money supply had expanded drastically, there was runaway spending and high inflation, and the value of the French currency depreciated considerably. The faith in fiat money had started to wobble, and more people began to return to dealing in hard money. To make matters worse, Law’s zigzagging policy of whether to allow or ban the use of hard money led to uncertainty. The share price of the Mississippi Company also declined as more people realized that the area resembled more of a muggy swamp than a Promised Land of minerals and precious metals. Louisiana, at that point, was a risky, subprime asset. It wasn’t generating the income to support the high stock price.
Investors panicked. Law tried to slow the decline of the share price, using the bank’s capital to support price levels. But the market had tipped from bull to bear, and the stock price halved. The state issued an edict that steadily lessened the value of paper money and shares, like letting the air out of a balloon. But that only angered investors and quickened the selling.73 Investors wanted out, and the public demanded Law be jailed. To stop the selling, he oversaw open bonfires in which paper money was burned to reduce the money supply and jack up the currency’s value. But it was too late. Law fled France, and left it with a financial mess that slowed its future economic progress.74
Law is the real-life devil who presents the Faustian bargain of soft money to the regent. His system was short-lived, but the interconnectedness of institutions and reliance on paper money provided a glimmer of what was to come.
All About the Benjamins
Born in Boston, Benjamin Franklin moved to Philadelphia at the spry age of seventeen, in 1723. Coincidentally, it was the same year that the Pennsylvania Provincial Assembly first issued paper money. There was a shortage of coins because the colonies didn’t have abundant deposits of precious metals. The British also prohibited the minting of coins in the colonies. To procure coins, the colonies traded goods with nearby Spanish territories for silver coins known as pesos, or Spanish dollars.75
The shortage of money dampened trade and business activity in Philadelphia. The Pennsylvania Assembly decided to experiment with paper money to see if it could help ameliorate the economic situation. But it realized the perils of soft money, which could generate rapid inflation. In order to prevent overissuance of paper notes, the state backed its notes with future taxes and the land of citizens who borrowed notes from it.76 It also put an expiration date on them. The paper money helped to revive the economy as it stimulated manufacturing, construction, and trade. Though he didn’t play an active role in the adoption of these notes, young Benjamin Franklin recognized how paper money was instrumental in reinvigorating the local economy.
As the expiration date of these notes approached, wealthy Philadelphians didn’t want the state to renew them. They recognized the potential dangers of soft money: Overissuance of notes could lead to spending, high inflation, and a depreciated currency.77 Benjamin Franklin defended paper money in a 1729 pamphlet that he wrote, anonymously titled A Modest Enquiry into the Nature and Necessity of a Paper Currency.78 He echoes the viewpoint found in John Law’s book—paper money abets trade. Franklin writes:
As we have already experienced how much the Increase of our Currency by what Paper Money has been made, has encouraged our Trade… And since a Plentiful Currency will be so great a Cause of advancing this Province in Trade and Riches, and increasing the Number of its People… Upon the Whole it may be observed, That it is the highest Interest of a Trading Country in general to make Money plentiful.79
Not only did Franklin believe that paper currency spurred commerce; he also thought it could be more stable than precious metals. Economist Farley Grubb notes that Franklin understood the risks of soft money. It wasn’t enough for money to be backed by something abstract, like faith in government. Because Philadelphia notes were backed by land, he believed that a land bank could ensure that it didn’t issue too many.80 Franklin’s pamphlet helped to convince the legislature to issue more paper money of this kind. Franklin also benefited personally since his printer was selected to make the notes. Over the years, he even helped to improve the notes by inventing new printing technologies and methods.
Franklin thought that paper currency could help all the colonies, not just Pennsylvania. He suggested a common colonial currency backed by land. Yet he recommended that the British operate the land bank and use the accrued interest to finance the British efforts in the French and Indian War. The colonists didn’t want the British to meddle with local monetary affairs, and his plan was not adopted. Grubb points out that Franklin’s proposal was the first to advocate a “national” paper currency across all the colonies.
In the mid-eighteenth century, some colonies, for example New Jersey, were already using paper money or “bills of credit” that weren’t convertible to hard money or backed by land. Facing currency shortages, more colonies like Virginia introduced these types of bills. Many notes were denominated in British units such as pounds, but various colonies had different standards for what constituted a pound.81 The colonies increasingly relied on these bills to finance their debts, like those that arose from military campaigns of the French and Indian War.
The colonies were exhibiting more independence in terms of monetary affairs. But what was happening in the colonial courts irritated British merchants, as well as Adam Smith, who accused colonists of cheating creditors. The courts began to enforce legal tender laws during debt cases. This meant that colonial money could be used for payments to British creditors, with amounts calculated on the basis of the face value of the notes, even though the current market value was lower than the face value.82 The British didn’t want to be ripped
off.
The British usurped the monetary power of the colonies. Parliament enacted a series of Currency Acts to prohibit the use of these legal tender laws, which prevented colonists from paying British merchants in these notes. In addition, the British Board of Trade prevented colonies from issuing paper money backed by land. This type of system allowed colonies to use the accrued interest to pay for various administration costs.83 But when it was banned, the colonies had to raise money by direct taxation. The colonists grew angry at these British measures, as well as the prohibitions of trade with other territories.84 In time, these economic grievances added up, and some were listed in the Declaration of Independence, such as “For cutting off our Trade with all parts of the world.”85
Franklin’s vision of a unified currency was soon realized, but it wasn’t exactly as he imagined. American financiers wanted a common currency to unite the colonies and finance the military during the Revolutionary War. The Continental Congress authorized the creation of Continental currency, or “continentals,” which were theoretically convertible in terms of Spanish dollars on certain dates: They were structured like zero-coupon US savings bonds with the full face value realized only at a set future date, so they traded for less than their face value.86 Colonists had transacted in Spanish dollars and were familiar with their consistent and reliable value. The plates used to mint the money were designed in part by Benjamin Franklin.87 However, continentals weren’t backed by land but by the future taxing power of the government—but that future was in doubt.
