The Wealth of Nations: A Financial Approach

Brad DeLong’s recent post on “Where was China?” [in the history of modern growth] calls to mind an essay I wrote many years ago on a financial explanation for modern growth which I thought I’d post. For good measure, I’ve tacked another essay onto this post that addresses the problem of method in economics and was written, I believe, in May 2006.

The Wealth of Nations:  A Financial Approach

By Carolyn Sissoko
First Draft:  5/1/03
Current Draft:  3/13/06

“Why are some countries rich while others remain poor?” is the question that lies at the heart of economic growth theory.  Here I argue that to find the answer, one must first reframe the question and ask:  How is it that some countries managed to become so very rich in such a short period of time?

To illustrate the miracle of growth that has changed the lives of a select segment of the globe over the past century or two, one need only picture a woman squatting by a riverside washing her family’s clothes by hand.  For how many millennia have this and innumerable other mundane and laborious tasks defined life for the vast majority of the world’s population?  And yet in the United States in the 21st century life without the miracle that is a washing machine is unimaginable.  There is not a family in any developing country that cannot understand the value of a washing machine.  By the same token a few centuries ago in North America the value of a washing machine, if it could have been imagined, was always evident.  The demand for technological innovation has always existed, it is the means that were lacking – until recently.  During the past two centuries in some countries the economy changed dramatically leading to a sustained path of technological advance, but in some countries it did not change.  Until we gain an understanding of the foundations of growth in developed countries, we can not hope to understand lack of growth in less developed countries.

My preferred explanation for the growth that underlies the wealth of rich countries is based on institutional change and I tend to focus on change in monetary and financial institutions.[1]  The collapse of the bronze monetary system in China created a demand for precious metals with which to build a new money supply. [2]  This was possibly the most important driving force in world trade during the latter half of the Middle Ages and into the modern era.  The famous silk and spice trade was paid for by the export of precious metals from Europe.  Precious metals were, however, also the basis of Europe’s money supply during this period.  I argue that the difficulties created by the export of her money supply pushed Europe onto a path of monetary and financial innovation that would completely change the nature of economic relations.

The European ports that exported silver and gold coin to the Levant where caravans would carry it East had a problem.  Storms meant that sailing eastwards on the Mediterranean was a seasonal activity.  Since silver and gold ships could only sail on a seasonal basis, the coin available for use in local trade would be increasing for months and then all but disappear when the ships departed.  These cities had a money supply that fluctuated dramatically and predictably.   To smooth the money supply (and indeed make trade possible when specie was scarce) both Venice and Barcelona developed deposit banking systems which allowed trade to take place on the basis of what were effectively checking accounts.  Not surprisingly the reserves of these banks were at their lowest when the specie ships left port, with the result that the amount of bank money increased when coin was particularly scarce.  Together with the development of “checking” accounts came the development of clearing of claims on the banks and this meant that a lot of trade could take place without any underlying coin whatsoever.[3]

The rest of Europe had a problem too.  While there was quite a bit of intra-European trade, specie had a tendency to flow from mines to ports.  In order to keep the flow of European trade moving, Italian merchant-bankers developed the bill of exchange.  A bill could be purchased from a merchant-bank in one city and would be repaid after a few weeks by another branch of the bank in a different city.  If we take the example of an English woolens merchant selling his wares in the Low Countries, we can see that by purchasing a bill of exchange in Bruges for payment to his correspondent in London, the English merchant can remit his earnings home and possibly finance another shipment of woolens.  Of course, if the merchant-banker actually had to pay every bill in specie, the bill of exchange wouldn’t have solved the problem of drainage of specie to the ports.  In practice, first at the fairs in Champagne and then through deposit banking systems in all the major trading centers, most of the bills were cleared rather than paid in cash.  At the same time and in the same centers, money markets (that carefully skirted usury laws) developed so that a merchant banker who didn’t have the cash to pay his balance after clearing could borrow from someone who did have cash.  These financial innovations allowed intra-European trade to take place with minimal use of specie.

In the process of re-organizing their trade to operate on the basis of paper claims rather than on the basis of commodity money, Europeans built up a plethora of institutions to support long-distance trade that took place on the basis of reputation.  Both merchant and deposit bankers had to be trusted to pay according to contract.  To promote a city as a trading center rulers often had to cede jurisdiction over commercial matters to Merchant Law, which was a kind of common law based on usage and judged by a jury of peers carefully balanced in terms of nationality.[4]  For a long time any default, fraudulent or not, was likely to result in exclusion from the local merchant community.  Of course, the high profits of banking gave value to a reputation for repayment – names like Medici, Fugger and Rothschild belong to merchant bankers.

Before the modern era begins around 1500, the institutional structures that allowed international trade to take place on the basis of clearing in trade centers rather than via cash settlement were well established in Europe.  By 1700 an innovation in the form of the endorsement of the bill of exchange, allowing it to be passed from one merchant to another before redemption, would revolutionize European financial markets.[5]  Endorsement allowed clearing to take place outside a banking system.  Merchants were using bills drawn on the major Dutch banking houses to make purchases in the Americas, in Russia and in India.  All over the world, merchants who would never set foot in Europe were using claims on the Dutch banking system to finance international trade.

Endorsement also revolutionized local trade.  Since bills were easily transferable, deposit banks began to discount them.  This led to a situation where a merchant or tradesman who maintained a good relationship with a reputable local banker could write an IOU to anyone and the recipient would be able to take it to the local bank and get cash on it (at a discount based on the maturity date of the bill or note).  Amsterdam was the first city to successfully exploit this system of secondary markets in commercial paper,[6] and interests rates paid by local merchants fell as low as 3% per year.  The low costs of finance allowed Dutch merchants to offer generous credit terms to their trading partners and helped them out-compete the English through the first half of the 18th century.[7]

Unfortunately the complex credit networks that Europe had developed could prove extremely unstable.  The Dutch came face to face with this problem first in 1763 and then in 1773.  In both cases the short-term credit on which the economy operated evaporated.  In 1763 the end of the Seven Years War came with tight money in Germany that would have caused major merchant banking houses involved in the finance of the war to collapse.  Because the fall of the Dutch houses would have caused problems for London banks which had funneled money into Germany for the war, the Bank of England allowed London bankers to draw gold out of the Bank to support their correspondents in Amsterdam.  At this juncture the Bank of England’s reserves fell below 5%.  In 1773 the cause of the crisis was speculation and the Dutch received no support from the English with the result that two of the three largest banking houses in Amsterdam collapsed.  A secondary result was that Amsterdam lost its position in the finance of international trade and London took the position over.[8]

Earlier banking collapses had punctuated the European experience of trading on the basis of paper money, and the founders of the Bank of England appear to have had these problems in mind at its birth in 1694.  When they offered cash to the British government in exchange for a perpetual debt, regular interest payments and a Bank charter, they wanted to establish a bank “without the hazard of bankruptcies.”[9]  Within half a century the Bank had become the sole manager of the nation’s debt, and indeed the government could not afford for the Bank to go bankrupt.  In the meanwhile the Bank of England note became the high-powered money of the London merchant community, which relied on the Bank’s discount facilities when in need of cash.  In 1797 the Bank of England suspended the convertibility of its notes into gold, and the British economy shifted smoothly onto an inflationary fiat money standard.  Thus, in 1797 the Bank of England demonstrated that it was in fact a bank that could not go bankrupt.  The fiat money standard lasted for over a quarter of a century, before the economy was put through a deflation-driven recession and the Bank resumed convertibility at the 1797 level, its reputation untarnished.

But what in the end does all this institutional development have to do with growth, you may ask?  Right around 1763 when the Bank of England was letting the world know that it could not go bankrupt, by emptying its vaults to support the Dutch through their financial crisis, domestic banking in England took off.  Banks in the towns of England went from less than 12 in 1750 to over 100 in 1775 to well over 300 in 1800.  These banks were opened throughout the length and breadth of England, so that by 1800 only one county was without a bank.  These were discount banks that, when they were illiquid could turn for support to their London correspondents, which could in turn use the discount facilities of the Bank of England when need be.  The role played by the Bank of England in the late 18th and 19th centuries would demonstrate that a source of funds that could not go bankrupt was indeed a stabilizing mechanism for the domestic banking system.[10]

Important to growth, however, is what the banks in the English countryside were doing.  By offering discounts (or credit lines) to merchants and tradesmen in country towns, the banks for the first time made access to working capital fairly easy for them.  By strictly enforced usury laws the maximal interest rate a bank could charge was 5% per annum, so working capital was not just accessible, but also cheap.  This was possible because country bank connections with London meant that the bills issued by tradesmen in the countryside could be discounted in London, so small town producers were connected with the deep secondary markets of the capital.  The banks often had small capital bases themselves and were able to keep their need for specie to a minimum by clearing the trade of the local economy on their books.

The terms of a discount were not dissimilar to those of a modern credit card (except at much lower interest).  An individual with no credit history could get only a small line of credit, but as a good history of repayment was built up the credit line could grow quite large.  Anyone who overdrew his credit line or did not make timely payments would face a penalty, and repeated infractions would result in the loss of the credit line.  The credit offered was short-term, but sufficient for a firm to cover wages and rent while readying a product for sale.  None of the firms that grew up during England’s Industrial Revolution failed to make use of these facilities.  Boulton and Watts, the inventors of the steam engine, relied heavily on bank finance, as did the woolens industry, and the import and export trades.[11]

The crux of my argument is this: countries that are rich have environments in which a banking system uses its clearing facilities to make working capital cheap and accessible, so an individual with a good idea can implement it.  This environment breeds a dynamic economy with innovative firms and technological development.  In countries that are poor working capital is much less accessible.  Middle income countries may offer credit facilities to firms in large urban centers, but rarely extend banking services to the countryside – and therefore to the general populace.  In the poorest countries even in the capital city medium and small size firms can not raise working capital through banks.

This brief review of European history tells us that even an ideal form of globalization, in which developed country subsidies to agriculture and other distortions of free trade are absent, is unlikely to result in high levels of growth in the less developed countries without domestic institutional reform.  The history of England indicates that a stable banking system relies on a central bank that the people of the country trust to practice a conservative and non-inflationary monetary policy.  Trust in the central bank gives it the flexibility to “overissue” either to support the banking system or to finance a welfare-improving government policy (like a defensive war).  Because rich countries have trustworthy central banks, they can “suspend convertibility” or, in other words, float their currencies.  When we see that a country has difficulty maintaining a floating currency, we have evidence that the country’s central bank is considered unreliable.  Until low income countries find a way to establish trustworthy central banks, or find a substitute for them, their banking systems will be too unstable to support the growth we associate with developed countries.

[1] Legal institutions and in particular the definition of property rights tend to change along with monetary and financial institutions.   I don’t find it productive to take a stand on the importance of legal versus financial institutions.  They accompany each other and their effects can not be easily distinguished.  My story, however, focuses on financial institutions.

[2] India had a similar and possibly equally important demand for precious metals at this time.  On money in China during this period see Richard von Glahn’s Fountain of Fortune, 1996, University of California Press.

[3] See Reinhold Mueller’s The Venetian Money Market: Banks, Panics and the Public Debt, 1200-1500, 1997, Johns Hopkins University Press for Venice and Abbott Usher’s “Deposit Banking in Barcelona, 1300-1700,” Journal of Economic and Business History, 1931 for Barcelona.

[4] See John Monroe, “The international Law Merchant and the evolution of negotiable credit in late-medieval England and the Low Countries,” in Banchi pubblici, banchi privati e monti di pietà nell’Europa preindustriale, 1990, Atti del convegno, Genoa.

[5] On endorsement see Herman van der Wee, “The influence of banking on the rise of capitalism in north-west Europe, fourteenth to nineteenth century,” in Alice Teichova, Ginette Hentenryk and Dieter Ziegler ed. Banking, Trade and Industry:  Europe, America and Asia from the thirteenth to the twentieth century, 1997, Cambridge University Press.

[6] Endorsement actually was developed in Antwerp, but shortly after the development war between France and Spain interfered with Antwerp’s role as a center of trade and finance with the result that many merchants moved to Amsterdam, which became the new center of trade in the Low Countries.

[7] On Dutch interest rates and their effect on commerce see Violet Barbour, Capitalism in Amsterdam in the 17th Century, 1963, reprint University of Michigan Press, Ann Arbor, in particular p. 85.

[8] On the crises in Amsterdam see Charles Wilson, Anglo-Dutch Commerce and Finance in the Eighteenth Century, 1977 reprint of 1941 edition, Arno Press, New York.

[9] Adam Anderson, An Historical and Chronological Deduction of the Origin of Commerce, 1801, reprint of 1764 edition, London, volume 2 p. 602.

[10] On the domestic role of the Bank of England see John Clapham, The Bank of England: A History, volumes I and II, 1945, Cambridge University Press, Cambridge.  For the details of this argument see Carolyn Sissoko, “The political economy of private paper money: Institutional development in Europe up to 1800,” UCLA mimeo.

[11] On the role of country banks in the 18th and 19th century English economy see L.P. Pressnell, Country Banking in the Industrial Revolution, 1956, Oxford University Press.

Economics:  A challenge for the profession

Carolyn Sissoko
May 2006

Where did all the economists go? 

There are probably more economists – in the sense of individuals who have earned PhDs in economics – now than at any time in the past.  However, it is no longer clear that those who call themselves economists actually feel that it is their job to try to understand the economy.

Why do some economies hum along with extraordinary consistency, while others roar for a few years only to come suddenly to a complete stop, and some never seem to get the engine running at all?  Outsiders assume that economists spend their time mastering the mechanics of the economic engine and are invariably surprised to discover that most economists don’t consider the economy per se to be their field of study.


Economics is a field of both extraordinary importance and extraordinary difficulty.  Like the sciences where breakthroughs can lead to the development of antibiotics and nuclear fusion, economics is a field where advances have the ability to transform the very nature of the world we live in.  (For anyone who has difficulty coming up with examples, consider the progress made in central banking over the past two centuries.)  Unlike the sciences, however, economics is a field where controlled experimentation is impossible, drawing firm conclusions is often difficult and applying economic knowledge to a particular problem is consequently even harder.

Thus the nature of economics itself generates a form of uncertainty principle:  the closer one approaches the fundamental questions of economics, the harder it is to reach concrete and well-defined answers to the questions.  The closer one comes to a solid answer to an economic question, the farther the question is from the core economic issues.

In response to their dilemma the profession has chosen to pursue the answers at the expense of the questions.  A good research topic is composed of a very narrow question and a concrete, provable conclusion.  The focus of current research in economics is on the methodology by which narrow questions can be addressed.  Economics is increasingly a field composed of career-oriented technicians, not professional intellectuals.

In short economists have failed to come to terms with the fact that the mechanics of the economic engine will never be understood with scientific precision.  Uncertainty and subjectivity lie at the very heart of the profession and cannot be escaped.  For each question there is a whole series of answers consistent with the data.  To fathom the full spectrum of these answers requires skills which are not taught in economics departments.

It is the humanities that face unblinkingly the problems of uncertainty and subjectivity in research.  Students of literature and history are taught to take an episode and rotate it, looking at it from many vantage points, before sitting down to write.  They must be cognizant of the paths not taken and of the existence of paths not even considered.  Into this nebula of potential meaning, the researcher shines a light that carefully picks out selected regions in a process, subjective though it is, that can illuminate a form with a clarity and unexpectedness that astounds.


The cost to the economics profession of the effort to escape the intrinsic nature of the field is huge.  The mechanics of the economic engine are not well understood and the two main theories of its function are both more than half a century old.  Keynes’ seventy-year old view is now considered out of date.  When modern economic theory attempts to explain the mechanics of the engine, it refurbishes 19th century models of competition and general equilibrium.  Far from recognizing a need to generate new theories, many economists identify the field itself with its 19th c. antecedents.[12]

Unfortunately 19th c. economics is like 18th century physics.  The competitive general equilibrium model is a theory of gravity without a theory of friction.  Just as it is obvious that an object in motion most definitely does not stay in motion, so it is obvious that a price system does not effortlessly move goods – even those that don’t generate externalities – to their highest value use.

By focusing the profession’s efforts on narrow questions with concrete answers, the profession has reneged on its responsibility to develop a set of theories that provide a context explaining how general equilibrium theory applies to real world phenomena.  Is it a good model of the economic engine?  If so, then what are the conditions that differentiate economies that run smoothly from those that start and stop and from those that never get started at all?  A good understanding of the frictions that can interfere with the operation of the engine is essential, and the study of these frictions will in all likelihood neither validate nor invalidate classical theory.  Instead, the proper study of economics will allow us to see more clearly under what conditions we can expect the theory to be a good predictor of observed economic behavior and under what conditions we can expect it to fail.

In the process of developing a context for competitive theory, the profession will have to develop a set of theories explaining economic frictions.  And in the process of developing these theories the profession will refine them.  And, maybe, just maybe, the profession will succeed in making a nonsense of this essay by fully and definitively explaining the mechanics of the economic engine.  But one thing is certain:  the profession has a lot of work to do before it proves me wrong.

[12] All right, it’s true:  I am overemphasizing the lack of progress in the profession.  Game theory has done wonders for expanding the horizons of economic theory, and a big segment of the profession is confident that it will play an important role in the development of new theories.  On the other hand, you and I both know plenty of economists who don’t think game theory is all that important.   And, of course, this essay is really about the big macroeconomic questions.  These have only just begun to be addressed using game theory.


3 thoughts on “The Wealth of Nations: A Financial Approach”

  1. re: game theory

    On the afternoon of the Nobel announcement, Nash said that he had won for game theory and that he felt that game theory was like string theory, a subject of great intrinsic intellectual interest that the world wishes to imagine can be of some utility.

    He said it with enough skepticism in his voice to make it funny.

    A Beautiful Mind

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

%d bloggers like this: