The Third Pillar

by Raghuram Rajan

  THE POWERFUL INTERESTS

  Moreover, the monarch was now an interested party. With the increase in the expense of fighting wars, he needed additional sources of revenue. The merchants, artisans, and moneylenders in the growing towns could be taxed, but yet more tax revenue could be obtained if they were freed somewhat from Church regulations concerning the just price at which transactions could be done or the interest that could be charged, and allowed to make larger taxable profits.

  Furthermore, when rulers still needed funds after squeezing all they could out of the taxpayer, debasing the currency, and seizing the estates of weak lords, they had to make their way to the moneylender. There was always a danger that the king could turn on his lenders, labeling them usurers and refusing to repay. The few who did lend did so at high rates. They kept the impecunious monarch on a tight leash so that if he defaulted, he risked shutting off further recourse to loans, which might especially weaken his ability to fight off his enemies. So monarchs repaid enough to keep the loan spigot open, and were inclined to look for ways to permit such lending.

  There was also a mighty potential lender: the Church itself. It had become rich, in part because of the way it had shaped rules governing usury and inheritance. Church treasuries were full of reliquaries, candlesticks, and vessels made of precious metals, which not only increased the grandeur of Church services, but also could easily be melted down, coined, and loaned. The French historian Henri Pirenne asserts that “the Church was the indispensable moneylender of the period.”31

  With both monarchs and the Church administration inclined to allow some borrowing and lending, ways had to be found. Many in the Church were not comfortable with violating what they believed was a Scriptural ban. Financial innovation helped satisfy those in the Church looking for a fig leaf that the letter of the interest prohibition was not breached. For example, bills of exchange allowed a borrower to pay interest to a lender provided the borrowing was done in one currency and repayment in the other. The interest payment was hidden in the rate at which one currency was exchanged for the other, but could also be justified as a compensation for the exchange rate risk the lender bore.32

  Similarly, the Church, following Roman law, allowed a penalty imposed for late payment, poena detentori. It was then a simple matter to lend with a fixed date for repayment and an implicit agreement that the borrower would not repay by that day. When he paid a few days later, a penalty was tacked on, which surprisingly approximated the market interest that ordinarily would have been charged by less conscientious lenders! When there is a will, the market finds a way around impediments; financial innovation helped finesse the Scriptures, much as it helps aggressive financiers avoid regulations today.

  THE STATE MOVES AGAINST THE CHURCH

  Not only was the Catholic Church inclined to turn a blind eye to some types of lending, it was becoming weaker politically once again. Its pronouncements, including on usury, began to carry less weight. The Church’s wealth made it an attractive target for monarchs. They preferred their subjects’ wealth to stay within their control rather than be transferred into the hands of a distant, and possibly antagonistic, Rome.33

  Much as social media today has allowed politicians to reach people directly, bypassing the filters of the mainstream press, Gutenberg’s movable-type printing press allowed critics of the Church, abetted by the local prince, to gain direct access to the masses. The reduced cost of printing pamphlets, as well as the spread of literacy, especially among the growing business community, ensured that the Church could be challenged and the arguments would reach many more people than in the past. Indeed, conservatives at that time warned that “printed books and broadsheets would undermine religious authority, demean the work of scholars and scribes, and spread sedition and debauchery.”34 They were right! For instance, over three hundred thousand copies of Martin Luther’s theses against the Catholic Church were circulated between 1517 and 1520, something that would not have been possible without the press.35

  Additional pressure for reform came from secular law and secular courts that increasingly competed with the Church to try usury cases. Over time, though, as commercial and state activity necessitated the charging of interest, secular courts became willing to enforce loan contracts, especially when interest rates were moderate. French and English monarchs adopted the legal fiction that their moneylenders, both lay and clergy, were to be considered Jews for legal purposes, and came under secular law courts.36 Judges, however, needed more than workarounds. Scholarly arguments were made to support the practical judgments of secular courts. As monarchs grew more powerful and independent of the Church, this meant more protection to usury.

  As selective violations of usury prohibitions, such as royal or commercial borrowing as well as Church lending, increased, usury prohibitions became ever more difficult to justify as a purely religious matter. As the historian Richard Tawney has argued, the religious arguments for the prohibition on usury, by their very nature as moral arguments, had to apply universally, even though they were meant primarily for consumption loans to the poor. With the emerging range of new, seemingly defensible, reasons for lending at interest, the Church faced questions about how general the religious arguments really were.37

  THE CHURCH REFORMS ITS ATTITUDES TOWARD BUSINESS AND INTEREST

  As the Reformation swept across Europe, scholars proposed new doctrines to rationalize the expanding markets and growing prosperity, as well as the needs of the emerging powerful monarchs. Perhaps the most important of these from a commercial perspective was the sixteenth-century French theologian and pastor John Calvin, who fled Catholic France for the Swiss city of Geneva, where he became extremely influential. Indeed, in The Protestant Ethic and the Spirit of Capitalism, the German social historian Max Weber attributed the rise of the archetypal capitalist to the teachings of John Calvin.

  In Weber’s view, the true capitalist is not the flamboyant gambler who risks all or the unscrupulous speculator who wheedles his way to riches, but the temperate, reliable, hardworking businessman, “with strictly bourgeois opinions and principles.”38 The essence of modern capitalism is the steady accumulation of wealth, not because of the pleasures it can buy or the material needs it can satisfy, but for its own sake. Indeed, far from unbridled greed and debauchery, rational capitalism combines a single-minded focus on accumulation with a frugal lifestyle. What Calvin did for capitalism, according to Weber, was to provide it a moral legitimacy in a world where avarice was a sin.

  Calvin emphasized the notion of calling, or predestination—that God has chosen some to be saved from damnation, and that their moral obligation is to do their duty in the world. Rather than abandoning the world, as was the Catholic monastic ideal, one had to embrace it. The practicing Calvinist had to have faith that he was one of the chosen, and had to demonstrate this faith through worldly activity. Business success was a sign of being one of the elect. Therefore, the accumulation of wealth was no longer to be condemned as avarice, but instead celebrated. Indeed, it was condemned only if wealth was spent on luxuries and high living—not only did conspicuous consumption reduce the savings necessary for investment, but it was also a waste of time, detracting from man’s true calling. The Calvinist vision of capitalist society was austere—and Geneva under the Calvinists was a harsh dull place—but it gave the single-minded entrepreneur a moral compass and justification that he did not have before. Various Protestant sects influenced by Calvinism then spread to Scotland, the Netherlands, and England, and thence to New England in the United States.

  Calvin’s views on usury were consistent with his arguments about business. He maintained that the arguments against usury in the Old Testament were so that “mutual and brotherly affection should prevail among the Israelites,” so that they could trade conveniently among one another without conflict.39 It was an argument for a different age and different community circumstances, and could not be deemed universal—even in the Old Tes
tament, usury had been permitted to strangers. Therefore, usury was permissible “if it is not injurious to one’s brother.”

  Taking on Aristotle, Calvin asserted that money was barren only if unused. If used productively—invested in land or trade—the borrower is not defrauded when he pays a portion of his profits for the use of money. Thus all interest need not be condemned for otherwise “we would impose tighter fetters on the conscience than God himself.”40 Nor, Calvin argued, do the Scriptures prohibit a reasonable charge for money. Observing that the Hebrew word for interest, neshek, meant “to bite,” Calvin argued that the Bible prohibits only “biting” interest, which oppresses the poor.41

  So while Calvin’s theology sanctified the pursuit of wealth and removed the associated taint of avarice, it also created a space for saving and lending at moderate interest rates. Such a positive interest rate was necessary to give the accumulative capitalist the incentive to be ascetic in his spending and save. It was also a pragmatic recognition that the needs of capitalistic business differed from those of the penurious household. While urging continued protections for the poor, Calvin opened the way for ordinary business lending.

  Weber argues that Calvin also paved the way for the rise of capitalism. Instead, Calvinism may simply have been a rationalization and legitimization of emerging business practices rather than the wellspring for capitalism. Nevertheless, by transforming business from a furtive activity done in dark corners hidden from religious authorities to one that was publicly praiseworthy and indeed a route to salvation, Calvinism did much to encourage the further growth of business. Calvin may have imbued the bourgeoisie of Western Europe in the sixteenth century with a sense of being chosen and predestined, much as Marx anointed the proletariat of the nineteenth century.42

  In sum, from about the middle of the fourteenth century, the Church’s attitude toward usury softened, probably as much by necessity as by conviction.43 Usurers were allowed to be buried once again in church graveyards, and various kinds of contracts involving interest were declared non-usurious, with only excessive interest being deemed sinful. While the Church’s views of business were not irrelevant after the Reformation, its influence certainly diminished greatly.

  Moreover, religion was no longer a significant unifying national force in the emerging Western European nation-states—some nations had both sizable Catholic and Protestant populations, while nations with predominantly Catholic populations needed an identity that differentiated them from coreligionists elsewhere. As we will see in the next chapter, a new form of devotion, nationalism, started edging out religious zeal across Europe. It too would affect attitudes toward business and finance, as well as the community.

  CONCLUSION

  Around the end of the first millennium in the Common Era, commerce and finance started stirring once again in Europe. As monetary transactions started undermining the stability of the feudal community, the community via the Church struck back and imposed severe limitations on the behavior permitted in finance and goods markets. Over time, and as both the unifying power of the monarch and the size of the market grew, some of the restrictions on business and finance started impinging on economic activity as well as on the monarch’s finances. The antibusiness scholarly ideology protecting the feudal community and constraining the market gave way to a more tolerant view, which gave individuals greater freedom to transact—the dominant scholarly view changed with public need, as it invariably does, even though theoretical reasoning is not supposed to have such flexibility! Trade, land sales, and debt weakened reciprocal feudal obligations and replaced them with market transactions. The state and the market grew together, even as the feudal community weakened.

  The Church’s power also declined, leaving the nation-state in ascendancy. However, its period of power had served a purpose—to push the state, at least in some parts of Western Europe, to acknowledge the possibility of a higher law, and to prod it into developing a more rational legal system. Two struggles now became more salient. One was the struggle for supremacy within a country as the king attempted to subdue the few powerful landed magnates who had the ability to match the king’s military spending. An equally fierce struggle was between the emerging nation-states in Europe, as each tried to establish its dominance over others. These two struggles were the crucibles in which the constitutionally limited state and modern markets were forged.44

  2

  THE RISE OF THE STRONG BUT LIMITED STATE

  In the last chapter, we saw how new military technologies such as siege cannons developed to overcome traditional fortifications and unify territories. No longer could every town or manor stand up to the king’s men simply because it had strong walls. (I will use “king,” since they were mostly kings, with due apologies to queens like Mary Tudor and Elizabeth I.) The emerging nation-state’s military power was too much for the traditional feudal community and broke its protections down. The centralizing of governance powers had begun, though limited by the difficulty of governance at a distance in times when the fastest means of communication was through bonfires or via riders on horseback.

  The nation-state still had to accomplish at least three tasks before it came to even remotely resemble today’s strong state. The first was for the king to obtain a monopoly of military power within his territory so that it was a unified whole with a common market. To do this, he had to suppress the large magnates—the domestic dukes and princes—who had the lands and revenues to rival his military power. We will see that this took different forms, but in England, it was achieved through direct confiscation as well as, interestingly, through competition in markets.

  The second task was to create an identity that would replace religion—since religion did not distinguish one nation-state from another in Europe. That identity had to give people a sense of larger purpose. Increasingly, an identity that suited many requirements, including the king’s need to lead a unified country, was identification with the nation.

  Even after unifying the land under his power, the king faced external threats. Some European country was always trying to establish supremacy—first Spain, then France, and in modern times, Germany and Russia. Any European country risked subjugation if it was not militarily powerful. As his feudal vassals’ obligations to supply arms and men waned with the demise of feudalism, the king needed money to maintain a strong military to defend the country against these external threats. Much of the subsequent development of the state can be seen as a consequence of steps taken to enhance its ability to raise revenues—the third task.

  The nation-state that emerged had somewhat contradictory powers. It was strong in its ability to defend itself against external enemies and defeat internal threats to the state, yet it was compelled to respect the private property rights of its citizens. The constitutionally limited state was an important milestone in the path towards free markets. The security of private property did away with the need for private players to protect themselves through anti-competitive medieval business associations, such as guilds. It allowed them to compete as individuals. Greater competition raised efficiency and output, increasing the economic power of the nation-state that could foster it. The markets pillar and the state pillar now fortified each other.

  Since different nation-states went through these developments in different ways, and my intent is to illustrate, not be exhaustive, I will focus on the path England followed, primarily because it was the first large nation-state with a constitutionally limited government. The process of stabilizing governance in the English nation-state took the Crown over two hundred years, spanned the reigns of two houses—the Tudors and the Stuarts—and involved substantial amounts of chance. Even though England’s path to constitutionally limited government and freer markets was unplanned and idiosyncratic, through war it imposed competitive pressures on other European countries to change if they wanted to survive. Eventually, many reached the same endpoint, albeit in their own ways.

  THE
DECLINE OF THE MAGNATES

  As we have seen, the new military technologies required scale. At the outset of nation building, the monarch was not personally much wealthier than the most powerful of the landed aristocracy. He needed to build his own power as well as reduce theirs. In the process of eliminating the threat of the high aristocracy, the English king unleashed market forces that would help create entities that would eventually curtail his own freedom of action. Interestingly, as the king lost the ability to act willfully and outside the law, as his identity was submerged in the broader apparatus of the state, the state’s access to financing from its citizens increased. It could now expand in ways, such as maintaining a large army, which would earlier have raised public apprehension about the monarch’s intentions. Somewhat paradoxically, the limited state became strong and improved its capabilities even while bolstering the confidence of the citizenry in the security of their property. Let us see how this happened.1

  Henry VII, the first Tudor monarch, was the last king of England to win his crown on the battlefield in 1485. There were others who had some right to the throne, so Henry’s claim to be monarch other than by “right of conquest” was questionable, at best. From the outset, therefore, the Tudors had to dominate other aristocrats through sheer power. This was not a simple or quick task, and spanned the reigns of successive monarchs.

  The monarch’s problem was complicated in two different ways. First, the landed aristocracy had built militias out of their armed servants, and could also summon their vassals and tenants to fight for them. Even as Henry VII passed a series of Acts asserting that the prime loyalty of every subject was first to the Crown and only then to his lord, feudal tradition militated otherwise.2 The monarch only had control over a small militia, and was otherwise reliant on conscription. This meant that in any emergency requiring a prompt response, such as an internal rebellion by one of the lords, he needed the help of the other lords to defeat it. Second, the king did not have a large bureaucracy to collect taxes. He depended on the high lords to collect and pass taxes on to the royal treasury. With the king so dependent on the aristocrats, he simply could not take them all on at the same time.