Category Archives: Credit

Trading with Bandits

13 Sunday Nov 2022

Posted by in Credit, Economics, Politics, Politics for Worldbuilders, Writing

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Suppose you were a merchant going into the mountains, seeking to trade for rare spices. The local clans know where the spices are; but they would much rather kill you and take all of your trade goods than part with their own valuable spices, even in a profitable exchange. You know this, and they know you know this. Is there any way that you can trade with the locals anyway, and escape with your life and a good profit?

There are a few ways to entice the locals to trade peacefully. One is to invest in military strength to deter attack—hiring bodyguards or improving your own martial skill. Another is to offer the possibility of repeated interactions, meaning that you will keep coming back with more trade goods if each trip goes well. Therefore, if the locals behave peacefully they will end up making far more profit over time than if they simply plunder your caravan. (This strategy only works if the locals trust you to come back, and if their time preference isn’t heavily weighted to short-term gains rather than long-term gains. If they need lots of money today, they might be willing to plunder you and sacrifice the long-term profit.)

Another method was to threaten the bandits with retribution from your allies, even if they are not present at the time. Your own weakness could be counterbalanced by the strength of your allies. This was one of the perks of being a Roman citizen, for example—everyone knew that a Roman was inviolate. If you harmed a Roman, you could expect legionnaires to be knocking on your door in short order. This did not prevent banditry entirely, but it certainly kept it to a much lower level.

All well and good; but let’s spice things up a bit. What if the merchant were the bandit, and the local clan were too weak to resist? And what if the clan had a permanent village, so they couldn’t simply escape from the traveling merchants until they had passed by? The merchants have powerful weapons, and while they wouldn’t mind striking a fair bargain if they needed to, they would cheerfully sack the village and take all of its valuables and people as booty if they thought it worthwhile.

If the weaker party is immobile and cannot escape, the above methods to induce peaceful trade no longer work. By assumption, the village is unable to invest in greater strength. And since the merchants are mobile, the village cannot easily threaten it with retribution from its allies. Repeated interactions are trickier too; merchant expeditions are expensive, and the merchants would want a high enough profit margin to be worth the bother.

So what is there to do?

I shamelessly stole the title of this post from the journal article it is based on, by Peter Leeson. Leeson, who would later enjoy some fame for his work on the economics of pirate ships, investigated our second case with the dangerous merchants and weak village, and gained some insights by looking at trading patterns in Central Africa. There, trade networks would connect producer villages deep in the interior with the European trade outposts on the coasts. The producer villages were at constant risk of being attacked by the merchant caravans, so they developed two major strategies to protect themselves.

The first strategy, paradoxically enough, was to demand that the merchants paid their side of the bargain upfront, and extend credit to the village. The village would then provide its own goods to the merchants the next time they came by. This allowed the village to reduce its stores of plunderable goods during the merchants’ first visit, since they wouldn’t need to pay right away. That way, the merchants would have less reason to plunder the village, since there would be little booty to plunder. And when the merchants came back, they had already paid for their goods and would have little incentive to use violence—unless the village tried to cheat them and withhold payment.

Since the merchants were stronger than the village, they could safely extend credit and know that they could punish the village for cheating if they needed to. (The reverse would not have been true; the village could not dare pay goods up front—that is, lend money—to the merchants, because they could not possibly enforce the bargain.) And the merchants had an incentive to play along: if the village didn’t think it was safe to stockpile its trade goods, it would simply produce no goods for trade and only enough to subsist on. That would make it unprofitable for traveling merchants to come all the way out and plunder them, discouraging violence.

But there was still a problem: what if the village makes a bargain with one set of merchants, then produces the trade goods that it owes, only to be attacked by another set of merchants?

To mitigate this risk, the village would expect the merchants that it bargained with to protect the village from other merchants. That is, part of what the village was trading for was protection. It was worth it for the merchants; they would lose out if their precious trade goods were stolen by some other group of merchants.

Still, the whole business was touch and go. For the system to work as described, the merchants had to be sufficiently patient to prefer long-term riches to short-term plunder, and be able to protect the village and enforce exclusivity against other merchants—and the village had to be able to reduce its stock of trade goods to unprofitable levels for the merchant, to make plundering a poor proposition and induce the merchant to offer credit. If the village’s trade goods were of the sort that was difficult to deplete or hide (such as livestock, or slaves or people who might be enslaved), then the village would have a difficult time indeed avoiding attack.

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In your own worldbuilding, you might not necessarily have these specific situations. But the concepts involved are delicious for generating story conflict. Stakes are high, incentives can balance on the edge of a knife, and much will depend on the characters involved. A good deal can be messed up by an impatient character, or implacable enemies might recognize an alignment of interests that can encourage the first tentative steps toward peace.

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(This post is part of Politics for Worldbuilders, an occasional series. Many of the previous posts in this series eventually became grist for my handbook for authors and game designers, Beyond Kings and Princesses: Governments for Worldbuilders. The topic of this post belongs in the planned second book in this series, working title Wealth for Worldbuilders. No idea when it will be finished, but it should be fun!)

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Different Kinds of Finance

01 Tuesday Nov 2022

Posted by in Credit, Finance, Politics for Worldbuilders

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Some fictional stories involve finance, of the high or low varieties. Other stories really ought to mention finance of some kind, due to the way that the setting is constructed, but the author never does—perhaps because the author is not comfortable with the subject. Finance is something that everyone is affected by, but few people understand deeply. Fortunately, the basic concepts are not difficult; and you might find them useful in your writing.

It often happens that someone wants to launch a business venture or some other project needing a lot of money; and other people who have money want to put it to work profitably, but have other people handle the details of executing. When the person with the money (“the investor,” let’s say) funds the person with the venture (“the founder”), hoping to earn a profit, that is what we call “finance.”

The two basic types of investment finance are debt and equity. (There are a few more exotic varieties, but they are fairly marginal and we can safely skip them.) Equity can take a few forms, but essentially, the investor and the founder are joint partners, and the investor is entitled to some fraction of the profits from the business. Exactly how much profit will depend on many factors—not least of which, how easy is it for the founder to find investment capital, and how much risk does either party want to take?

In a pure equity investment, the fortunes of the investor rise and fall with those of the venture. The investor can lose the entire investment if the venture fails, or make incredible amounts of money if the venture takes off. The investor’s interests are therefore closely aligned with those of the founder (at least in broad terms).

Debt, on the other hand, is more adversarial. If the founder borrows money from the investor, he is promising to return the money and the finance charge whether or not the business is profitable. And the investor maximum return is limited by the agreed-upon finance charge; the investor will make the same amount of money if the business is a modest success, spectacularly profitable, or even mildly unprofitable (as long as there is enough to cover the loan payments). Obviously, the investor would prefer that the business succeed, so that the founder has enough money to repay the loan. But a lender’s main interest will be safety, and he will not necessarily pursue the chance of high returns if it means taking high risks. He will also try to get his money back even if it means sucking the venture dry.

Lenders are happier when they can lend against some kind of collateral—some valuable good which can be seized if the loan is not repaid. This could be many things: a house, a car, a horse, family jewelry, or the rights to future royalties from sales of Harry Potter. The better the collateral, the less risk the lender is taking. In a well-functioning society, the lender will therefore charge less interest on a secured loan than an unsecured loan, because the chance of losses is smaller. (That is why you can still get a mortgage in America for less than 10% interest, while credit cards typically charge 15% and up.)

This also means that if you don’t have collateral—for example, if you are starting some sort of business venture and have nothing to show for it yet—it is very hard to get debt financing. Equity finance is better at handling business ventures without tangible assets.

But equity finance poses special problems: how do you keep track of how much money the business made, and the investors are entitled to? It is very easy for the management of a venture to hide profits from the investors, without a very complex infrastructure of laws, public data, and accountants to try and keep people honest. It took centuries of slow accumulated experience and trial-and-error before we arrived at the system for securities markets that we have today, and it is by no means perfect. But in previous times, equity investment was typically limited to partners who knew, and trusted, each other. Equity was thus on a relatively small scale, businesses were very hard to start, economies were relatively stagnant, and economic growth was slow.

Debt, on the other hand, is fairly easy to deal with. How much you owe is fixed by agreement; and the lender doesn’t need to know anything about how you made the money, only that you are able to repay on time. Debt was therefore the most common form of finance by far throughout history; and it is only recently that equity investments have been possible on a large scale.

However, even in ancient times it was possible to combine the two methods of investing. For example, the Babylonian Talmud records a common form of partnership in which half of an investment was considered equity, and half was debt. The founder thus had to repay half (but only half) of the investment regardless of the venture’s success or failure, along with a portion of the profits if there were any. Interests were better aligned between the partners, and the investor still had some degree of safety.

To summarize, when thinking about some sort of business venture that needs investor capital, like a caravan to the Far East, or a merchant ship, or a band of mercenaries sent to plunder the fabled City of Gems, you can think about useful investment structures with the following questions:

  • Who is taking the risk of irregular profits, and how much risk?
  • How well can the investor monitor the founder?
  • What kind of collateral is there?
  • Does the legal system or other external structures provide protections for either side, or make one kind of investing more attractive than the other?

*****

(This post is part of Politics for Worldbuilders, an occasional series. Many of the previous posts in this series eventually became grist for my handbook for authors and game designers, Beyond Kings and Princesses: Governments for Worldbuilders. The topic of this post belongs in the planned second book in this series, working title Wealth for Worldbuilders. No idea when it will be finished, but it should be fun!)

Random Fiction Excerpt #5

22 Thursday Nov 2012

Posted by in Credit, Economics, NaNoWriMo, Writing

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From my current NaNo:

“The news had gone out that Morris had gone deeply, staggeringly into debt in order to pay for his new mansion, and his reputation had correspondingly skyrocketed up into rarified territory. Estimates on how long he would have to work at his current income to pay down the debt ranged from a hundred years to nearly three hundred, depending on which prediction of future interest rates you went by. With this move, a master-stroke of commitment, Morris had demonstrated the depth of his loyalty to the socio-political system, on which he was now totally dependent in order to stay solvent.”

Ways to Improve Peer-to-Peer Lending

30 Sunday Sep 2012

Posted by in Credit, Economics, Finance, Investing

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For a long time now, I’ve been interested in the potential for Peer-to-Peer lending (P2P). Rather than people depositing money with a bank, which then turns around and lends the money to borrowers while keeping most of the profit, in P2P lending some service matches borrowers and lenders directly. Ideally, this allows borrowers to get loans at a cheaper rate, while still giving lenders a better rate of return. It also allows nontraditional borrowers to get funded, if they can tell a good enough story. But there are problems with P2P, to which I would like to propose some solutions.

Right now, the biggest names in American P2P lending are Lending Club, and Prosper.com, where I was a small lender back around 2007 or so. When I participated on Prosper, I was able to see instances where the model worked perfectly, and other instances where the model caused problems. Among the advantages were that groups of people who knew each other (whether In Real Life or on the internet) could provide each other with funds at below-market rates, as an expression of their fellowship. This is something I liked a lot, since Judaism tends to frown on lending money at interest anyway. (More on that topic in another post…) Additionally, some borrowers whose credit score was relatively low were able to convince borrowers that they were a good risk anyway, because of factors that their credit score did not reflect.

The bad news came from several sources. First of all, because all money had to be provided by the individual lenders, as opposed to a centralized source of funds like a bank, many otherwise-attractive borrowers who didn’t know how to market themselves went unfunded. Second, the need to market yourself in the first place can be a turn-off. Borrowing from people you know can lead to tension and a loss of privacy. One of the biggest advantages of the modern system of bank or credit-card lending (as opposed to borrowing from friends and family, as the “unbanked” tend to do) is that banks can lend functionally unlimited amounts of money if they choose to, and your financial circumstances are strictly between yourself and your banker. With Prosper as it stands now, neither of these two factors are at work.

The next problem was due to greed. In the early years, lenders were attracted to the high rates paid by low-quality borrowers, particularly “HR” or high-risk borrowers who could be made to pay up to 30% interest per year. The problem was that in most cases, these borrowers were staggeringly bad risks; those of us who jumped in with both feet ended up losing quite a bit of money when the loans were not repaid. Ultimately, we lacked the knowledge and temperament to tell a good borrower from a bad one, and to resist the lure of fat profits for taking unacceptable risks. There is a reason that (until the era of government bailouts) bankers had a reputation for sobriety, prudence, and conservatism. Bankers who lacked these qualities soon ceased to be bankers.

Note that Prosper responded, ultimately, by excluding the lowest-quality borrowers from the market. This managed to improve default rates; but the fundamental problem remains, that lending decisions are being made by amateurs, many of whom do not understand the risks well enough.

Another institution that claims to be P2P, the British institution Zopa, avoids this second problem by soliciting investor capital and simply making all the lending decisions itself, as a traditional lender would. But in this case, there is no actual interaction between borrower and individual “lenders”; Zopa is actually something like a mutual fund for lending with investor funds, rather than bank capital. It is not really a true peer-to-peer vehicle.

Is there a way to mitigate the problems of P2P without going to the other extreme and quashing the social aspect altogether?

Suppose that you have a Lender institution, a depositor (David) who wants to earn some money, and several borrowers (Brad, Ben, and Betty). David puts a chunk of money (say $5000) into his bank account with the Lender. The Lender then asks David if he is willing to lend money to particular people, at any point in the future, and at what minimum interest rate. David knows Brad, Ben and Betty; he decides that he would be willing to spot Brad up to $500 at a time, but only at the market interest rate—he’s not a close friend or anything. Betty, on the other hand, is someone that David likes, so while he’d only trust her with $200, he’s willing to lend the money to her at a nominal 1% interest to cover fees. He knows that Ben is irresponsible with his money, so he’d rather not risk his own money on Ben.

Note that during this process, David does not know if Brad or Betty are actually trying to borrow money right now. That information is kept from him. So Brad and Betty get to keep their privacy. If Brad or Betty should choose to lobby David for more money, that’s their choice. In the meanwhile, money that’s not specifically earmarked for particular borrowers can be treated like a normal bank deposit, earning some amount of money for David and having some level of guarantees.

Now suppose that Betty finally decides to borrow $20,000 for a new car. The Lender can see her credit score, and other such raw numbers; but it also can see that David, and several other depositors, are willing to trust Betty with money. This does two things: first of all, it shows Lender that people trust her, which can be an additional factor in the Lender’s decision to lend or not. Second, it means that they have to risk less of their own money for the same profit, because they can use money from the depositors who know Betty while still earning servicing fees.

The final decision is the Lender’s; if Betty remains a bad risk, Lender can protect the depositors from her. But on the flip side, if people who know her only pony up $5000, the Lender would be able to make up the difference with its own funds if they like Betty as a borrower, instead of letting her languish in social-lending purgatory. The portion of the money coming from depositors directly could be at below-market interest rates if they like, keeping the social aspect of P2P lending. The balance, coming from Lender, would be at market rates.

Obviously, such a system would not be for everyone. Some people would do well enough on Prosper.com or similar sites, even without such a system. Others might prefer Zopa, or even a traditional bank. Still, I think that the proposed system would make P2P borrowing and lending more attractive for a lot of people, mitigating some of the problems while keeping most of the advantages.

(Anyone who likes can implement this system. I only ask that you drop me a note or a comment letting me know, if you got the idea from this post.)

An Idea for How to Make Renting Homes Better

01 Sunday Jul 2012

Posted by in Credit, Economics, Finance, Investing, Real Estate

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Many fortunes are made in real estate. And, lured by those stories of success, lots of people have tried their hand at real-estate investing as well, with highly variable results. Meanwhile, many people who cannot buy homes of their own decide to rent instead.

But the present rental market has a lot of flaws in its structure. Take, for example, a common strategy used by new investors who don’t want to sink a lot of capital into a house. They will instead rent a place, perhaps for a long term to bring down their monthly rent, and then turn around and sublet it out to someone else for a higher price.

Now, these people are certainly providing a service of some kind. They are providing income to the owner of the property; if they chose a longer rental term, they are also providing a guarantee of long-term occupancy. But the eventual renter is paying a higher rate for his home than the owner is receiving. It’s possible that the renter has low credit and would not otherwise qualify, or perhaps would not have heard about the apartment without the marketing efforts of the investor-renter; but still, it seems that there ought to be more opportunities for mutual benefit.

One thing that’s always struck me about renting is that most landlords do not allow you to prepay your rent. There are good legal reasons for this, but it still seems to be a missed opportunity. The typical landlord carries a mortgage with an interest rate of more than 5%, sometimes much more. By contrast, 10-year Treasury notes are yielding around 1.6%. If a renter could sink extra cash into prepaying rent, with an annualized discount of (let’s say) 3%, and the landlord used the extra cashflow to pay down the mortgage, it would benefit both sides. All that is necessary is to create the appropriate legal structure.

When you think about the components of a property’s value, you could break it down into two parts: the right to live in a place for a given time, and the actual ownership of the property. Suppose you actually broke them into separate pieces. For example, I could have a house I wanted to rent out, but I wasn’t interested in collecting a rent check every month. Instead, I created a product: the right to live in my house for ten years. I then assigned that product a value, just like a piece of real estate. Say the house itself is worth $100,000; I then value ten years of use at, say, $40,000. If I find a buyer, I can get all that cash upfront and not have to worry about collecting rent every month. At the end of the term, I still own the house and can benefit from its price appreciation, tax depreciation, and so on.

Now suppose I’m a renter, or investor-renter. Buying a ten-year lease gives me a discounted price, compared to having to pay for it month by month. It also lets me lock in the price for the entire term, giving me stability. Plus, since I don’t actually own the house, I don’t have to worry about property taxes. But how might I come up with all that cash up front? If this becomes the norm, it ought to be easy to borrow that money from the bank—especially when you consider that a ten-year rental term is an asset like property is, and can be used to sublet the house in turn, or repossessed by the bank if necessary.

It would be easier for a bank to repossess rental rights than a full property, meanwhile. At all times, there is an actual owner who is interested in maintaining the value of the property, as opposed to home foreclosures that often sit vacant and get trashed, destroying massive amounts of value. And it is easier to rent a property than to sell it, and lots of managers that the bank can call upon to fill up their newly-repossessed asset. Finally, it ought to be easier to appraise use-rights than the actual underlying property, making underwriting easier. So from the bank’s perspective, this might be an attractive asset class.

Subletting a rental-agreement house will provide more gains from trade, in this scenario. I, the investor-renter, have provided the benefits of upfront capital, allowing me to get a good price. I can then sublet to a traditional renter, who does not have to provide upfront capital but can still pay a price comparable to the going rate. I make money from the difference between my discounted upfront payment, and the month-by-month payments of the renter, without having to “overcharge” as subletting investors must do today.

This all will need fleshing out, of course. Navigating the legal minefields alone will be an effort, not one that I care to undertake right now, and people would have to work out the practical problems involved with any new asset class. And this kind of structure will not be appropriate in many cases. Still, its mere existence would cause ripple effects out into the market that would benefit everyone. And perhaps someone more enterprising can see this idea and make use of it.

Coordinated versus Liberal Market Economies

11 Monday Jun 2012

Posted by in Credit, Economics, Finance

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[Welcome! If you enjoy worldbuilding, check out my handbook for authors and game designers, Beyond Kings and Princesses: Governments for Worldbuilders.]

Capitalist economies (not the same thing as free-market economies, necessarily) depend on those with money providing capital to firms that need it. For most of human history, most actual investment was done by a small number of people, those with the skills and inclination to form relationships with businesses. Vast amounts of money was economically sterile, being hoarded as gold or silver treasures in the vault of some nobleman or other (just as today one might stuff hundred-dollar bills into a mattress). For the economy to grow and develop, somehow a mechanism needed to be set up to allow savings to be automatically channeled into investment.

This mechanism was the banks. When you deposit money in a bank account, the bank then turns around and lends it to someone who wishes to borrow. The bank serves as an intermediary between you, the saver who wants nothing more than a safe place to store your money (with maybe a little interest on top), and the borrower. Thus, savings that were previously useless to the economy are now being recirculated. (This can lead to systemic fragilities, of course, but those must wait for another post.)

Most bank-dominated systems work in a style called relationship banking. A company forms a long-term exclusive relationship with a bank, that will provide access to capital in exchange for a large degree of control over the company’s decisions—the bank wants to make sure that the company isn’t going to waste the money, after all. This sort of system relies on personal relationships and insider knowledge more than on things like a credit score, which only came into common use in the 1980s or so.

Some economies, such as those in much of Europe, take this logic even further and structure their entire economy around such long-term relationships between firms. Business contracts, decisions on who to hire and how to train them, and access to capital are all made through a close-knit network of powerful executives; insider knowledge and relationships are the key factors here. This is called a coordinated market economy, and you can read a fuller description of it in Hall and Soskice’s Varieties of Capitalism. (Amazon link here.)

Coordinated market economies have some advantages over the American/British system of comparatively liberal market economies. The system in general is more stable; you don’t get the day-to-day disruptions common in the US economy, for example, because everything is based on long-term relationships. In particular, new upstarts find it very difficult to break into such a system, because they can’t get access to capital and they can’t win contracts from existing businesses. While this may seem bad to the American ear, it has the advantage that firms in such an economy can specialize in extremely narrow niches of production, leading to incremental innovation. This is why German companies are known for their precision manufacturing, for example: because they have the luxury of intense specialization in their particular areas.

On the other hand, because it is so difficult for new firms to compete, a continuing hazard of such economies is that the whole system begins to stagnate. Disruptive innovations find it hard to survive in such systems, and instead gravitate to the more open liberal market economies like the United States.

In a liberal market economy, access to capital for big firms is usually gained via the public markets: the stock market and bond market. This means that the long-term relationships typical of Continental economies are less important here. Instead, decisions about who to invest in are driven by the release of public data, for example in annual reports or tax filings. Using such data, market participants decide who to channel their capital to.

There are drawbacks to this system. Particularly in the last thirty years, company executives can be driven to chase quarterly targets at the expense of long-term viability. The business environment is volatile and always changing, making it extremely difficult to plot long-term strategy and to pursue incremental improvement.

On the other hand, this system is much more hospitable to disruptive innovation, as we can see just in the last decade or two. While it can be gut-wrenching while you’re in the middle of it, overall it leads to a more dynamic and healthy economic system over time; stagnation is less of a threat here.

The main difference between these two systems is in the ability to get investment capital without sucking up to a bank. From that relatively minor difference, massive differences in total economic structure can develop. (More details in the Hall/Soskice link.)

Again, institutions matter. And seemingly small differences in institutions can lead to major differences in outcomes.

Bills of Exchange, Banking, and the Little Things

05 Tuesday Jun 2012

Posted by in Credit, Economics, Finance, History

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Jared Rubin writes about the diverging history of the Christian and Muslim systems of finance back in the Middle Ages. At the time, both Christianity and Islam was enforcing restrictions on lending at interest; Islam also had a ban on financial speculation in general. At the same time, the Islamic world had a financial tool called the bill of exchange, which was meant to facilitate the movement of money between cities. When this tool spread into the Christian world, it became the basis for an explosion of international banking unlike anything seen in the world before then. Why? And why did it not have this effect in the Islamic world?

Bills of exchange worked like this.  Suppose you were a merchant traveling from Baghdad to Basra, to buy trade goods there. However, you don’t want to carry a great deal of money with you; to do so, you would need to hire bodyguards, not to mention the pack animals necessary to carry the precious metal itself (remember, silver and gold are quite heavy). This could be quite expensive; for example, the cost of moving gold bullion from Rome to Naples in this period has been estimated at between 8% and 12% of its value. So you deposit your money with an associate in Baghdad, and receive a bill of exchange for its value. This you must present to your Baghdad associate’s business partner in Basra, who will then give you cash. In this way, you don’t need to physically transport cash. And later, the business partners in Baghdad and Basra can settle their own balance, perhaps with a similar bill of exchange going the opposite direction.

Now, one can think of this transaction in two ways, which are not mutually exclusive. First, the business partners in Baghdad and Basra are clearly providing a service to you, the merchant, who can avoid the danger and expense of transporting your money. But remember too that you are fronting money to the issuer of the bill of exchange. Looked at this way, the bill issuer is borrowing your money.

Islamic law came down firmly on the side of the first understanding. The law required the merchant to pay a fee to the bill issuer—that is, the bill issuer is effectively being paid to borrow money. Furthermore, bills of exchange were dated, and needed to be redeemed by the specified date. If a bill were redeemed late, the merchant would be forced to pay a cumulative penalty. Unscrupulous businessmen sometimes exploited this by refusing to redeem bills of exchange on time, inflicting the penalty on the hapless merchant.

What this meant was that it was extremely risky to deal with bills of exchange from people you didn’t trust. Furthermore, you had little incentive to expand the network of people whose bills you used, since you were being forced to pay for the privilege. So bills of exchange, while useful in certain circumstances, did not stimulate the creation of the sprawling banking networks that grew in Europe later.

To understand the effect of the bill of exchange in Europe, we must understand the difference in conditions.

European trade was made particularly difficult because the different lands each had their own currencies. Furthermore, kings and princes often imposed bans on importing foreign coins into their lands. These bans existed for the good of the ruler alone: when the ruler issues his own currency, he earns seigniorage, the difference between the value of the silver or gold in a coin and its face value. So the more of his coins a ruler can impose on a captive populace, the more money he makes. (Worse, it was a depressingly common practice for rulers in need of cash to debase their currency, reducing its silver content so that each coin was worth less in reality.)

So to trade across lands, a European merchant needed a way to convert currencies—without paying the massive fees that local princes usually demanded. The bill of exchange answered the need. A merchant would deposit money with a banker in Florence, let’s say, and receive a bill of exchange payable in Lyons. The difference was that the bill of exchange was for a different currency than was deposited.

This was prohibited in Islamic lands, where currency swaps of this kind were viewed as speculation. But speculation was not banned in Christianity. So merchants were able to evade capital controls by creative use of debt contracts. Even better, merchants could take advantage of the predictable shifts of currency rates so that they would be repaid in more valuable money than they had lent out, effectively earning “stealth” interest and evading the Christian prohibition on usury.

Thus, Christian merchants and bankers had a huge incentive to expand their ties with other cities, since every additional city offered more opportunities to issue bills of exchange and therefore to lend money profitably. This is how the fabled Medici banking network was built up, for example: by establishing subsidiaries in cities across Europe and transacting bills of exchange between them, at considerable profit.

The upshot was that the creative use of bills of exchange supercharged international trade in Europe (while stunting intra-national trade, since there was no profit to be made in exchanging currencies), where its effects in Islamic lands had been more modest. And in Europe it led to the creation of the first international banking empires, where it did nothing of the sort in Islamic lands. All because of a few seemingly minor details: the Muslim prohibition of speculating in currencies, and Islamic law allowing the bill issuer to charge the lender instead of the other way around.

What lessons can we take away from this? First of all, the little things can have big effects. Second, there’s no way to predict the systemic outcome of a given tool, once human ingenuity gets turned loose to play. Third, the history of finance is pretty cool.