Rulers, Religion, and Riches: Why the West Got Rich and the Middle East Did Not (Cambridge Studies in Economics, Choice, and Society)
Page 14
These outcomes contrast with those found in Western Europe, where the legitimizing relationship between political and religious authorities changed dramatically in the late medieval period. Perhaps the oddest fact that can be accounted for within this framework is that interest restrictions were maintained in Christianity in the twelfth and thirteenth centuries. On the surface, the rationale for the Church’s attitude is not obvious – why would the Church maintain the prohibition just as access to credit was beginning to lubricate commerce?
Prior to the Commercial Revolution, most loans were taken for consumption purposes, and interest restrictions barely hampered the economy. It was only after commercial opportunities began to grow in the late tenth century – and to a much greater extent at the height of the Commercial Revolution in the twelfth and thirteenth centuries – that restrictions on interest became detrimental. The growth of commerce thus changed the incentives faced by Western European rulers. As alternatives to interest became more widely employed, rulers had greater incentive to legalize moderate interest, which they did throughout the continent (see Table 4.1). Unlike in the Middle East, where the benefits to legalizing interest were outweighed by the costs associated with the loss of religious legitimacy, the legitimizing relationship was much weaker in Western Europe. The costs of permitting interest were therefore not nearly as great. Western European rulers responded to the growth of commerce by relaxing interest regulations in spite of religious condemnation.
With so many individuals flagrantly violating the Church’s dictates, its capacity to legitimize was undermined. As more profitable commercial opportunities became available, merchants further evaded the Church’s dictates and sought further protection from secular authorities. This provided all the more incentive for rulers to legalize interest – and enact other pro-commercial measures – while it further decreased the importance of religious legitimacy. Hence, the Church’s loss of power vis-à-vis secular rulers was both a cause and a consequence of the rise of commerce and the resulting interactions between the economic and political elite.
The Church’s initial reaction to its reduced role in propagating rule was to attempt to change the justification for Christian kingship and thereby reaffirm its role in propagating rule (see Chapter 3). Beginning in the late eleventh century with Pope Gregory VII (r. 1073–1085) and lasting through the middle of the thirteenth century, the Church – for the first time – claimed the rights to bestow kingship and depose rulers. These claims occurred precisely at the time the Church strengthened its anti-usury stance. This makes sense in the context of the framework proposed in this book. Since the Church was attempting to bolster its capacity to propagate rule, it would have been foolish for it to simultaneously reinterpret its doctrine. This would have undermined belief in the eternalness of Christian doctrine, which is a key component affecting its capacity to legitimize.
The ultimate failure of the Church to alter the justification for Christian kingship affected its position on lending at interest. The logic of the framework suggests that the Church should have relaxed interest restrictions only after its legitimizing power was undermined. And indeed, it was only after the importance of the Church’s capacity to legitimize rule eroded in the mid-thirteenth century that political authorities relaxed their restrictions, and the Church followed suit over subsequent centuries. The “campaign against usury” halted in the late fourteenth and fifteenth centuries, and the Church slowly began to permit alternatives to interest thereafter.
In comparison, commercial pressures to relax interest restrictions existed earlier in the Middle East than in Western Europe. Hence, the initial relaxation of interest restrictions happened earlier in the Middle East. Yet, due to the greater importance of religious legitimacy in the Middle East, interest restrictions were never fully alleviated in Islam, and the endogenous processes that eventually undermined both Christian interest restrictions and more generally the Church’s capacity to legitimize rulers never occurred in the Middle East.
This logic helps explain why interest restrictions were ultimately relaxed in Western Europe but not in the Middle East. These histories also draw attention to the more general differences in propagating arrangements between the two regions and the resulting economic outcomes therein. It is now worthwhile to turn back to the puzzle posed at the beginning of this chapter: Why did a banking system never arise indigenously in the Middle East? Did the diverging paths of interest restrictions in the Middle East and Western Europe play a role in encouraging banking in the latter but not the former? While it is difficult to imagine a Western banking system without interest, it is also true that interest restrictions were easily evaded in both regions throughout history. So, how did interest restrictions stifle the growth of Middle East banking, if at all?
Path-Dependent Consequences
Ultimately, modern banking and financial operations emerged in Western Europe, while at the same time Middle Eastern lending remained largely confined to known relations. How did it come to this? It is by no means obvious that interest restrictions had anything to do with the divergence in financial institutions in the two regions: lenders easily evaded the restrictions in both regions, and lending at moderate interest was common as long as they employed some ruse. While it is well outside the scope of this book to trace the entire history of modern banking in Western Europe – this would take many volumes – comparing how bills of exchange evolved in the two regions sheds light on some of the dynamic consequences of interest restrictions. Bills of exchange were an important financial instrument in Western Europe – Edwin S. Hunt and James M. Murray describe them as “the most important financial innovation of the High Middle Ages.”36 An instrument very similar to the bill of exchange, the suftaja (plural safatij), was widely employed in the medieval Middle East. The fact that similar – but different – instruments existed in the two regions allows for an analysis of the more general forces affecting the divergence. What were the differences between these instruments? Why did they differ? What effect did this have on long-run economic outcomes, especially in relation to the growth of Western banking?
European bills of exchange were debt instruments issued in one place and remitted in another, in a different currency payable at the market exchange rate quoted in the locale of issue with a stated maturity corresponding to a duration between one and six months. Bills of exchange worked as follows. A lender bought a bill for ready cash from a borrower, who drew on one of his correspondents abroad. At maturity, this correspondent paid an amount in a different currency to the lender’s correspondent. They originally emerged to help facilitate trade. They enabled merchants to avoid the costs (armed guards) and risks (robbery) associated with moving specie. Such costs were far from trivial – for example, the charge for moving bullion from Naples to Rome ranged between 8 percent and 12 percent of the cargo’s value.37 Bills of exchange also enabled much quicker movement of funds. For example, it took twenty-one days to deliver coins collected in Rouen to Avignon, whereas a courier could deliver a bill in eight days.38
The Genoese used the earliest bills of exchange in the mid-twelfth century, but bills did not become widespread until the following century when merchants at the Champagne fairs began to use them regularly. They became ubiquitous in subsequent centuries, primarily in Italy, evolving into financial instruments that enabled lenders to make profits via differences in exchange rates.39 Lenders were able to make profits by having their correspondent take the proceeds of a freshly remitted bill and buy a new bill, payable in the lender’s homeland, from another borrower. Because the second transaction took place in a distant land, the lender purchased the second bill at a different exchange rate than the first one. The rate differential permitted lenders a chance to profit on exchange transactions.40 To see how this works, consider the following hypothetical modern exchange transaction. Say that a bill purchased in London and redeemable in Florence is available at a rate £1:0.5€, while a bill purchased in Florence and redeemable in L
ondon is available at a rate 1€:£3. One could buy a bill in London for £100 and remit it in Florence for 50€, then use this 50€ to buy a bill that yields £150 in London, generating a 50 percent profit. Likewise, one could start by buying a bill in Florence for 100€ and remit it in London for £300 then use this £300 to buy a bill that yields 150€ in Florence – also a 50 percent profit.41
Medieval Middle Eastern merchants also employed long-distance credit instruments. These included transfers of debt (hawala), orders of payment (sakk and ruq’a),42 and bills of exchange (suftaja). Safatij existed since at least the eighth century CE, well before European used similar credit instruments.43 Safatij were written obligations issued by and drawn on well-known merchants, with the feature (unlike European bills) that repayment occurred in the same type of currency paid to the issuing agent.44 Like European bills of exchange, safatij were generally employed in trade but were also used for other purposes. For example, the Abbasid financial administration used safatij to transfer funds between provincial treasuries and Baghdad, subjects paid bribes to officials via safatij, and tax farmers used safatij to pay the royal treasuries. Safatij were widely employed and enforced throughout the Ottoman period, where they facilitated transactions between Anatolia, the Aegean islands, Crimea, Syria, Egypt, and Iran.45
Unlike European bills of exchange, which involved four parties, safatij involved only three parties and worked as follows. A lent a sum of money to B in return for a suftaja, which was given to C, who resided elsewhere and paid A the same sum in the same currency. A typical suftaja read as follows: “Abu Mansur asked me to take from him 25 dinars and 2 qirats, which I did and for which I wrote him a bill drawn on you.”46 Safatij were neither transferable nor negotiable and were immediately redeemable upon presentation. The issuer (borrower) charged a fee, which was sometimes significant but could be as low as 1 percent of the suftaja’s value. If the agent on whom the suftaja was drawn delayed payment, he incurred a steep penalty that the suftaja holder could claim if not paid via lawsuit in an Islamic court.47
Like European bills of exchange, safatij were written documents that extended credit and helped merchants avoid risk in transport. However, unlike European bills, safatij did not involve a currency exchange – the bill merely permitted merchants in one region to make payments in the same currency in another region. While some Muslim jurists permitted safatij, they forbade lenders from profiting on the exchange transaction itself.48 Instead, only borrowers could profit from dealing in safatij (through the issue fee).
The bill of exchange differed in the Middle East and Western Europe largely because lending at interest was legal in the latter, even if the Church did not recognize the validity of bills until the fifteenth century. Because Western European lenders could make an enforceable return on exchange transactions, they were encouraged to employ bills of exchange as substitutes for guaranteed interest-bearing loans, in turn avoiding religious and social sanctions associated with manifest usury. Indeed, bills of exchange became a widespread financial instrument in the late thirteenth and early fourteenth centuries, soon after secular rulers relaxed interest restrictions. On the other hand, both rulers and religious authorities forbade Middle Eastern lenders from profiting on the exchange transaction itself, and safatij, where legal, remained confined to their original purpose: facilitating long-distance transport without the use of specie. While profiting from exchange transactions was legal in Islamic law – otherwise, money-changing would not have been a viable profession – Muslim religious and political authorities forbade profiting from exchange in conjunction with lending.49 Islamic law considered profit beyond fees stemming from exchange transactions to be usurious. Wealthy lenders could not profit by using instruments similar to European bills of exchange, as such transactions were voidable in Islamic courts.
This raises the question: Why did Islamic religious authorities not create a hila by which Muslim lenders could use safatij to profit from differences in exchange rates? There are two reasons why jurists never formulated such a hila. First, although safatij and exchange transactions were both licit, combining them would have entailed the creation of an illicit instrument, as its sole purpose would have been to make a usurious gain. This is different from the double sale, which combined two licit but separate transactions. Secondly, one could then ask: Why did Islamic authorities not set up a hila that simulated a European bill of exchange yet kept the suftaja and exchange transactions separate?50 If there were differences in exchange rates in places A and B, then this could give a low-risk profit to the lender, as it did in Europe. However, this series of transactions would also have been illicit under Islamic law. The reason is that where clerics permitted the suftaja, they permitted it only as an instrument of trade.51 Islamic jurists were suspicious of the suftaja due to its usurious nature; hence, they forbade any use of the suftaja outside of facilitating trade. Unlike the double sale, which followed the letter but not the spirit of the law by combining two licit transactions, such a transaction would not have followed even the letter of Islamic law, as it would have turned the suftaja into an illicit instrument.52
The upshot is that the additional element of currency exchange associated with European bills – but not Middle Eastern bills – allowed wealthy European lenders to profit from the exchange transaction. Since this profit derived from two transactions that exploited variations in exchange rates in different cities, lenders who purchased bills of exchange were necessarily involved in interregional commerce with multiple agents. This seemingly innocuous element of Western European bills had important path dependent consequences for the formation of Western European financial institutions. Specifically, it encouraged the formation of institutions capable of supporting interregional finance. For instance, merchants in Florence and Genoa organized fifteenth-century fairs in Lyons and Besançon, respectively, in order to provide opportunities for credit transactions.53 More importantly, trade in bills of exchange facilitated the formation of interregional organizational forms suited to impersonal lending, a process exemplified by the Medici enterprise.
Headquartered in Florence, the Medici “bank” expanded in the fifteenth century into a decentralized matrix of partnership branches throughout Europe, all dealing to some extent in interregional finance and bills of exchange. The Medici House consisted of a series of partnership branches that were separate legal entities, much like a modern-day holding company.54 These branches all dealt in exchange operations. For example, in the preamble of the Medici contract with the Bruges branch, which was indicative, the purpose of the partnership was to “deal in exchange and in merchandise in the city of Bruges in Flanders.”55 To take advantage of opportunities afforded by dealing in bills of exchange, branches of the Medici banks acted as both principals and agents of other branches. The Medicis had branches or correspondents in all of the major financial centers of Europe, allowing the network to stay informed of fluctuations in exchange rates and money markets.56
The Medici “hub-and-spoke” system emerged as a response to the incentives imposed on those dealing in finance. The profitability of bills of exchange incentivized enterprises like the Medici bank to establish interregional branches to take advantage of exchange rate differences and capital scarcity, while at the same time diversifying portfolios to shield against risk. In an era before credit scores and international finance laws, these complex networks permitted capital-rich entrepreneurs in Italy to invest in all of the major financial centers of Europe. Although the Medicis conducted transactions primarily with semi-personal relations – those known to be good credit risks – the extension of the credit network achieved by the branching system allowed less personal credit relations to arise. From the viewpoint of the primary capital holders (the Medici family in Florence), most financial activities were conducted with unknown relations.
The branching system pioneered by the Medici enterprise was a key step on the pathway to the emergence of the banking system in Western Europe. Through branchi
ng, the Medicis focused capital more toward its most highly valued use. If the capital-wealthy Florentine Medicis saw a profitable opportunity for investment in Bruges, branching increased the likelihood that they would invest their money there, since a branch partner could verify the trustworthiness of the potential borrower as well as apply financial sanctions (i.e., cutting off future funds) to a borrower who was late in repayment. Indeed, the branch partner could make the Medicis aware of such an opportunity in the first place. In other words, the advent of branching was a key step on the path to impersonal finance – finance conducted with previously unknown relations – which is one of the hallmarks of the modern banking system.
Such institutions simply did not emerge in the Middle East, and most exchange operations remained confined to personal interactions between acquaintances and families.57 Without the element of currency exchange, there was little incentive for wealthy lenders to employ safatij as an instrument of finance. Instead, traveling merchants – not investors – remained the primary lenders, and safatij remained relegated to facilitating trade. Foreign agents were unnecessary as long as the borrower-banker had confidence in his business partner, to whom he generally had some social or personal connection. Capital-rich Muslims could not earn returns by buying safatij, so there was little incentive to establish networks dealing in safatij.58
Numerous scholars have employed the widespread presence of interest-bearing lending via ruse in the Islamic world as evidence that the interest ban had no practical effect. The history of bills of exchange suggests, however, that such arguments suffer from focusing on first-order, micro-level observations. It sheds light on an avenue through which religious interest restrictions carried macro-level, path-dependent consequences – outcomes that are not observable at any one point in time but can accumulate over time on the margin. Employing Joel Mokyr’s terminology, this analysis suggests that the interaction of the unraveling of interest restrictions with Western European politico-legal institutions encouraged a series of financial “microinventions” – marginal changes that led, over time, to very different outcomes in the Middle East and Western Europe.59