The Power of Gold: The History of an Obsession

by Peter L. Bernstein

  The most curious aspect of this whole sequence of events was what happened to the value of gold itself, and silver along with it. The precious metals were no more immune than anything else to the inexorable influences of the law of supply and demand. The European supply of gold in the sixteenth century expanded rapidly, as the deluge of gold imports from America joined with the flow of gold from new mines and improved mining technology in eastern Europe and especially in Hungary.

  Consequently, although the price of gold rose along with everything else in the course of the Price Revolution, the gold price changes were much more subdued. For example, the price of gold in England, reported in shillings, climbed from forty to sixty shillings an ounce between 1492 and 1547, a rise of 50 percent, then was stable for the next fifty years, and then had a further modest increase to 74 shillings by 1611." That was a total advance of 85 percent-way below the increases in wages, clothing, or food. Although the English had no gold resources of their own in the Americas or anywhere else to draw upon, there is reason to believe that the supply of gold in England increased at a rapid pace nevertheless, thanks to huge gains of treasure through piracy and war.5°

  Adam Smith provides ingenious insights into this phenomenon. The quantity of any commodity, he asserts, regulates itself in every country according to the demand of those who are willing to pay enough to bring it to market. No commodity regulates itself "more easily or more exactly" by this rule than gold or silver, because their high value and small bulk make it so easy to transport them from the places where they are cheap to the places where they are expensive. This physical relationship explains why gold prices are so much more stable than the prices of commodities "that are hindered by their bulk from shifting their situation." Therefore, "When the quantity of gold and silver imported into any country exceeds the effectual demand, no vigilance of government can prevent their exportation. All the sanguinary laws of Spain and Portugal are not able to keep their gold and silver at home. The continual importations from Peru and Brazil ... sink the price of those metals there below those in neighboring countries."51 Therewith, Smith provides an additional insight into the inability of the Spaniards to hold on to their precious gold.

  The Price Revolution and the discovery of the copious gold resources of America were abrupt shifts from the past, but additional significant economic innovations were at work during the sixteenth century. Indeed, the trade fair, a traditional institution, now began to play a more important role in the economic scene, initiating a mutation in the role of gold that has continued to the present day. The expansion of this institution is notable for its civilized character, which made a dramatic contrast to the warfare, religious controversy, pillage, and plunder that persisted throughout these centuries.

  Beginning in the Middle Ages, the trade fair developed into an essential institution for doing business-displaying wares, buying them, and selling them in a world where most towns were tiny places, without a bank on every street corner and without a supermarket just a fiveminute automobile drive from the house. It was also a world without telephones, Federal Express, the Internet, or news services that could quote or advertise the prices of goods, financial instruments, and foreign exchange. Without central gathering places, merchants could not supply themselves or were limited to only one or perhaps two local sources; large customers could not locate the merchandise-and, more often, the bankers-they needed; the multiplicity of monies and of credit instruments could not be settled to pay the obligations that accumulated in the course of thousands of transactions. In today's world, the annual Frankfurt book fair, the colorful expos in Las Vegas for the high-tech industry, and the longstanding Leipzig fair for industrial machinery are pale shadows of this vital and essential institution of earlier times. Furthermore, most of these modem fairs meet annually, whereas the fairs that concern us here met at least twice a year; Lyons, one of the major locations, held its fair four times a year.

  Unlike local situations, where merchants exchanged wares with their neighbors, transactions at trade fairs would permit a merchant to buy without necessarily having something to sell, or vice versa. One-sided purchases often require financing, because the buyer is not making an offsetting sale. The format of the fairs thus became increasingly elaborate, and during the sixteenth century, financing the purchases at the fairs became as important as merchandise itself. In many instances, the transactions were financial without regard to any movements of goods." Although fairs took place in many centers in Europe, both geographical and political factors determined the locations of the key towns where the major players met and where kings provided special protection and facilities for foreigners; at Lyons, the great preponderance of foreigners were from Florence, Milan, Lucca, and Genoa.53 At the great fairs, the merchants and financiers were dominant, with representatives of municipal or royal institutions playing a subordinate role. The popularity of the fairs rose and fell as trade patterns and political hegemonies varied over time-the Champagne area, Antwerp in the fifteenth century, then Geneva, from which a French king lured the fair to Lyons, and then to the eastern French town of Besancon and finally Piacenza. In Piacenza, the fairs were known as Bisenzone, an Italianization of Besancon.

  Many booths at the fairs were occupied by the money changers; in the fair of Medina del Campo in Spain, trading in promissory notes drawn in different nations' currencies, called bills of exchange, was the only activity. The money changers must have had a busy time indeed. One authority lists 48 different kinds of gold coins circulating in Europe in the sixteenth century, including eleven from Italian cities, nine from the Netherlands, six from England, and smaller numbers from Spain, France, Portugal, and Hungary."

  Merchants struggling to deal with this multiplicity of monies were the targets of many popular jokes. In Chaucer's "Shipman's Tale," the merchant is so involved with his counting board that he leaves word not to be disturbed, no matter what. A young monk takes advantage of this situation to make advances on the merchant's lusty wife, who bangs on her husband's door crying,

  Nevertheless, the money changers were much less involved with developments in coinage than with the increasing substitution of papermoney instruments for the inconvenience and complications of payment in coin. The principal vehicle for these kinds of payment was the bill of exchange, an instrument developed by the Italians in the thirteenth century, perhaps earlier. This was a remarkable financial innovation that lent itself to a wide variety of uses and formats.se

  Here is a simple example of how a bill of exchange worked.* Two transactions take place: Franco in Italy buys wool from Berthold in Flanders, while David in Flanders buys wine from Carlo in Italy. Franco, however, does not pay Berthold directly, and David does not pay Carlo directly. Instead, Carlo "draws" a bill of exchange on David, a sheet of paper declaring that David owes him such-and-such an amount of Italian money for the wine. Carlo sells this bill to Franco, which means that Franco's purchase of the bill has satisfied Carlo. In order to pay Berthold for the wool, Franco now sends that bill to Berthold, who turns around and sells it to David, which means that David's purchase of the bill has satisfied Berthold. Thus, both shippers, Berthold and Carlo, have been paid, but by the other fellow's customer rather than by their own: Franco has paid Carlo instead of Berthold, while David has paid Berthold instead of Carlo. The wine, the wool, and the bill that Carlo has drawn on David move across the borders, but no money goes from Italy to Flanders or vice versa.

  This is an oversimplified explanation, but it indicates the essence of the process. In reality, there is no reason to believe that each transaction will precisely equal the other, or even that Franco and Carlo or Berthold and David will readily find each other. In order to settle up these differences, a lively market built up in the trading of bills of exchange. In 1585, for example, bills drawn on merchants and bankers in Amsterdam were trading in Antwerp, Cologne, Danzig, Hamburg, Lisbon, Lubeck, Rouen, and Seville.51

  In these markets, dealers rather than principals
would buy the bills and then would settle up the balances among themselves; dealers often acted as bankers by advancing payments to suppliers of merchandise and collecting later from the buyers of the merchandise. By settling differences rather than gross amounts and by making the business one in which a large number of dealers participated, these bill markets significantly reduced the need for coins to settle bilateral differences. On one occasion, a million livres tournois changed hands without a single penny being disbursed .5" That entire process, however, could not have functioned as well without the institution of the trade fairs, where the dealers and money changers could meet with one another, buying and selling bills back and forth, and working out their payments in foreign exchange as Italians settled with Flemish dealers, the Flemish settled with the English, and so on.

  Remarkable changes developed from these arrangements. Merchants no longer had to travel to settle up their accounts, and when they did travel they went to centers with trading posts where transactions could be settled most efficiently. Consequently, the centralized operations of the fairs attracted an increasing volume of financial transactions. Merchant firms became more diversified as a result and in time turned into the great family firms that grew up in this age, such as the Fuggers in the Holy Roman Empire, the Medici of Florence, and later the Rothschilds and Baring Brothers.

  The whole concept of money was being transformed. The traditional public money of the prince in the form of coins stamped or engraved as official government issue now shared the money circulation with private money in the form of credit instruments that served as means of payment in transactions involving both merchants and bankers. When an individual in the modern world engages in the dominant form of doing business by writing a check instead of paying with paper currency, that is private money at work. That arrangement first developed during the fifteenth and sixteenth centuries with the growing use of the bill of exchange and the trade fairs where transactions were cleared and settled and where foreign exchange trading became a major activity.-59

  The private money had to be expressed in some kind of denomination, just as people keep money in bank deposits or write checks today denominated in dollars or sterling or euros. Nobody issues a check denominated in a given number of specified gold coins or weight of gold bullion, any more than someone in the sixteenth century who drew a bill of exchange would denominate it in a number of coins or weight of bullion. Money in the private world had to be expressed in terms of a unit of account, such as dollars or euros, which was a convenient numeraire for defining the size of the transaction and the local money used by the parties to settle up. A unit of account is an abstract concept-you cannot see the dollars that a check transfers, nor can you feel them, bite into them, or weigh them. The only concern of the owner of private money is that the prince so regulate the supply of public money that the integrity of the unit of account is stable instead of withering away in the fires of inflation.

  If we extrapolate these developments through the centuries, they define much of the subsequent history of gold as money in Europe and the United States. Over time, gold coins circulated less frequently and gold bullion served only to settle up very large transactions or to cover the unfavorable balance of trade between Europe and the Far East. This does not mean that gold became less of a fixation or less valuable-we have only to think of the drama of the gold rushes of the nineteenth century to understand that-but the nature of its role in the system did begin to change.

  Furthermore, India and the nations of the Pacific looked on gold in a fashion quite different from how it was perceived by people in the West. The view from China, Japan, and India is interesting in its own right, but, as we shall see in the next chapter, the attitudes of those nations raise profound questions about the nature of money and the role of wealth.

  fter all the convoys, piracy, and plunder had brought the gold and silver from the New World to Europe, almost none of that massive movement of precious metals ended up where the Europeans expected it to end up. The entire flow lingered only briefly in Europe and then continued eastward to Asia. There is even some evidence that the outflow of gold and silver to the Far East may have exceeded the total imports from America between 1600 and 1730.' During the first 25 years after the establishment of the East India Company in 1600, bullion accounted for 75 percent of all the cargo shipped eastward.

  Asia turned out to be a sponge for gold and silver. Only a tiny quantity ever came back to Europe. The reasons for this one-way movement are not obvious, and one is tempted to agree with Kipling that east is east and west is west and let it go at that. But what happened is not that trivial.

  The Europeans may have grumbled about the loss of their beloved gold and silver to the East, but their desire for the spices, tea, silk, and other luxuries of Asia was so insatiable that they had no alternative. The people in Asia clearly considered gold and silver to be more desirable than the tin, lead, mercury, woolens, and furs that the Europeans offered for sale. That the one-way trade continued for so long is perhaps evidence enough of how satisfactory it was to the Asians, but another revealing piece of evidence is available: the prices of goods in China, Japan, and India varied very little relative to the precious metals.' If the process had been an unstable one, the Asians would have refused to continue selling their products to Europe or would have demanded a far larger quantity of gold and silver relative to the physical volume of tea, silks, and spices shipped out.

  If you believe that the Asians had a peculiar set of priorities, you will have to concede that the priorities of the Europeans were just as strange. Europeans also put the highest value on the precious metals. They would have considered themselves much wealthier if they could have retained the gold and silver and shipped out the useful stuff like iron, tin, and furs. Even as wise an observer as the Scotch philosopher and historian David Hume fell into this trap when he wrote in 1752 that "The skill and ingenuity of EUROPE in general surpasses perhaps that of CHINA, with regard to the manual arts and manufactures; yet we are never able to trade thither without grave disadvantage."3

  More than one hundred years before Hume, Thomas Mun, son of a moneyer, master merchant, and key executive of the East India Company, had a keener sense of the reality of this trade: "If those nations which send out their monies do it because they have few wares of their own, how come they have so much Treasure.... I answer, Even by trading with their money; for by what other means can they get it, having no mines of Gold or Silver?"4 Mun was responding to criticism of the East India Company for shipping so much in precious metals eastward, but in fact the transactions proved to be highly favorable to the Europeans. We have already noted that, in contrast to Asia, the price of gold in Europe fell relative to the prices of other commodities. Hence, it was an illusion that the Europeans were getting the worst of the bargain. With the Asians so accommodating by accepting gold and silver, the discovery of America now enabled Europe to satisfy, to a much greater extent than in the past, the longstanding hunger for the products of Asia. Spices cannot be grown anywhere but in Asia, because their development depends on the monsoon rains, while silkworms and tea plants also require a particular kind of climate. The Europeans did learn to convert their earth into fine white china and to execute beautiful designs on it, but the products of the Far East were still esteemed for the mark of status they provided and for the adventure implicit in having obtained them.

  Even the Europeans far away in the American colonies were infected with the import virus. The Peruvian silver city of Potosi and the port city of Lima were famous for their displays of silk, porcelain, lacquer ware, precious stones, and pearls from China, while Mexicans paraded around in cottons from the Philippines, silks from China, and calicos from India.'

  With all that gold and silver pouring in from the New World, the Europeans were behaving precisely as classical economic theory would have predicted. It was the Asian sponge that was in defiance of theory. The patterns of predictable responses to fresh inflows of mone
y were first set forth in systematic fashion by early economists such as Thomas Mun and William Petty in the first part of the seventeenth century. In 1752, however, David Hume developed the theory more fully in an essay titled "Of the Balance of Trade." According to Hume, the movement of money from one area to another is inherently unsustainable and destined to reverse itself. The money piling up in the pockets of the citizens of the gaining country will encourage them to go out and buy things, while the loss of purchasing power in the losing country will lead its citizens to tighten their belts and buy less; prices will rise in the gaining country and fall in the losing country. This shift in demand will in time reverse the flow of money back to the country that first suffered the outflow. As a result, Hume argued, "It is impossible to heap up money, more than any other fluid, beyond its proper level."6

  The sequence of events related to the ransoming of the sons of Francis I was a perfect illustration of Hume's theory-the gold moved from France to Spain in payment of the ransom, squeezing French citizens in the process but simultaneously encouraging the Spanish to spend more money abroad. No wonder, then, that Spain's newly acquired treasure found its way back to France.

  Hume used his theory to explain why Spain and Portugal failed to hold on to the gold and silver they imported from their colonies overseas. "Can one imagine," he asked, with his own peculiar use of uppercase lettering, "that it had ever been possible by any laws, or even any art of industry, to have kept all the money in SPAIN, which the galleons had brought from the INDIES? Or that all the commodities would be sold in FRANCE for a tenth of the price they would yield on the other side of the PYRENEES, without finding their way thither and draining from that immense treasure?"7 Hume's theory would also explain why the countries that accumulated gold by exporting to Spain would in turn display a voracious appetite for imports from the East (they were under no obligation to import from Spain), especially as Europeans were able to keep replenishing their supply of precious metals after 1500 from both New World sources and increased domestic production. Thus, the Europeans played according to Hume's rules.