I had no sooner finished lamenting our economic commentariat's ignorance of the history of economic thought and economic history when on 7 October Alan Wood, economics editor for The Australian, came out with this beautiful gem:
Did you know that the appearance of speculative asset price bubbles followed the advent of newspapers? The first newspapers appeared in the early 1600s, and no histories of speculative manias mention any before then. The notorious Dutch tulip mania was in the 1630s.
And who was the source for this nonsense? US economist Robert Shiller. The thought that the booms themselves might actually generate media hype did not enter Wood's head. Moreover, if the media can talk up a boom why can't they sink one? After all America's mainstream media has been working overtime to torpedo the Bush boom -- all to no effect. So instead of raising serious objections to Shiller's silly thesis Wood finished his piece with the observation that other factors are at work apart from any media "influence on asset prices".
If this pair had done their homework they would have learnt that booms and busts were also recorded in medieval Europe. I could be wrong about this, but I'm pretty sure there was no medieval Times, Newsweek or Herald Sun to fuel or even ignite an 'asset mania'. Fortunately for us some very illuminating work has been done on early European banking.
Let us begin with Florence where in the late twelfth century a banking system began to develop. At first these banks adhered to a 100 per cent reserve. But human nature being what it is, they started to create phony credit by dropping their reserves. (Carlo M. Cipolla, The Monetary Policy of Fourteenth Century Florence, Berkeley University of California Press, 1982). Surprise, surprise, Florence found itself enjoying a boom -- and not a single newspaper in sight -- followed by a bust that was so sever that. Cipolla compared it to the Great Depression:
From the end of the thirteenth century and the first decades of the fourteenth there occurred a series of crises comparable in their gravity (if the scale of contemporary economy is taken into account) to the crisis that struck modern economy between 1929 and 1939. It will be sufficient here to cite the famous bankruptcy of the Florentine bank-houses. These crises ushered in a downward trend which continued to 1400 or thereabouts. (Revisions in Economic History: XII. The Trends in Italian Economic History in the Later Middle Ages, Economic History Review, New Series, Vol. 2, No. 2, 1949, pp. 181-184).
Having made loans that greatly exceeded their deposits it was only a matter of time before a crisis was triggered. In this case several factors came to the fore: The banks had made heavy loans to Edward III of England who was now unable to repay them; Neapolitan princes made massive withdrawals -- perhaps they smelt a rat -- and there was an acute drop in the price Florentine government bonds. From 1341-1346 the crisis deepened and a number of the great banks collapsed. Credit was severely restricted triggering the inevitable deflation resulting in large-scale bankruptcies. Cipolla described the transition from boom to bust as thus:
The Age of 'The Canticle of the Sun' gave way to the age of the Danse Macabre (Ibid).
Unfortunately Cipolla thinks that by savagely reducing the population the Black Death brought about an economic recovery by restoring the per capita money stock to its pre-boom level. But this implies that the deflation created a shortage of money. This is where Cipolla's analysis breaks down. The deflation would have brought about recovery through the process of falling prices and the free adjustment of costs to the money stock.
Raymond de Roover provided a detailed account of the dealings of the Medici Bank and its history. (The Rise and Decline of the Medici Bank: 1397-1494 ). De Roover estimated that at one point the bank's reserves had fallen by 50 per cent, which means that the bank had used credit expansion to enlarge the money supply by twice the value of its demand deposits. After 1494 and another boom the bank encountered severe difficulties as more and more depositors began withdrawing their cash and a financial crisis emerged. The result was that the Medici Bank failed, as did its competitors who had also come to rely on fractional banking.
Abbot Payson Usher, a Harvard economist, gave an account of the development of fractional reserve banking in the late Middle Ages. According to Usher fractional banking emerged in the thirteenth century. (The Early History of Deposit Banking in Mediterranean Europe, Cambridge, Massachusetts, Harvard University Press, 1943). It's important to bear this fact in mind because credit expansion can only be produced by a fractional reserve system. And every boom has always been preceded by a rapid monetary expansion*. I do not know of a single exception.
Usher studied of the Barcelona Bank of Deposits. The bank had been founded in 1401 by the city with the aim of funding municipal expenditure and government bonds. It also made loans to members of the local aristocracy. Usher estimated that the bank's cash reserves were 29 per cent of its deposits. This meant that it could expand credit by nearly 3.5 times its reserves. Thanks to Usher's work we now know that most of its loans consisted of phony credit. Over the years the reserve ratio of cash reserves to deposits fell. Eventually its dishonesty caught up with it and in 1468 it was unable to meet its depositors' demand for cash. The response of the city burgers was exactly what one would expect. They granted the bank more privileges.
We now know that irrespective of Shiller's claims "speculative asset price bubbles" emerged centuries before anyone had thought of newspapers and long before Holland's tulip mania.
Mike Dash wrote a heavily detailed account of tulip mania in which he made the essential point that the volume of trading around promises to buy and sell during the mania "was not less than 40 million guilders" while the Dutch banking system only contained reserves of 3.5 million guilders. (Tulipomania, Random House, 2001). It ought to be clear that it was credit expansion that fuelled the mania. Without this expansion there was absolutely no way that speculation in the tulip trade could have reached such ridiculous heights. This view is confirmed by the fact that when the Dutch government decreed in 1637 that tulip bulbs were not investments but products and so had to be bought for cash bank loans collapsed and the mania imploded.
I have had some rather abusive Keynesians tell me that this is rubbish because "seventeenth century banking was too primitive for a fractional reserve system to emerge". Such critics obviously do not even have a passing knowledge of the history of banking. They certainly do not understand the ramifications fractional banking. In any case, These critics stand refuted by historical studies that clearly show the existence of medieval fractional reserve banking.
*As a rule the effects of a credit expansion would differ from those of a monetary expansion that consisted entirely of note issue.
