Category Archives: Economics

The Talents of Others

27 Saturday Oct 2012

Posted by in Economics, Politics

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I just began reading John Tomasi’s recent book Free Market Fairness, which is an attempt to synthesize Libertarianism’s concerns for property rights and the importance of spontaneous order (rather than top-down government control) with High Liberalism’s concerns for social justice and care for the poor. I don’t know whether Tomasi’s project will be successful, but something like it is certainly welcome. And for me, the book has already been worth the purchase for the sake of a single sentence.

Tomasi here is paraphrasing the arguments of John Rawls, and particularly that institutions should be arranged so that poorer citizens are supported from the wealth of the richer—as Rawls put it, so citizens “share one another’s fate.” Tomasi adds: “Institutions must be arranged so people can look upon the special skills and talents of their fellow citizens not as weapons to be feared but as in some sense a common bounty” (Introduction, pg. xiv).

That phrase—”weapons to be feared”—is something that struck me. And yet it is obvious that in a system of competition, one man’s advantage is another’s loss. It would seem rational, from a narrow point of view, for economic competitors to try and minimize each others’ skill and ability. But if we all did that, society would collapse and there would be little wealth left to compete over. We need other people to trade with, and they must have talents worth trading for, or else no products of any complexity would ever be created.

So in a pure competitive system, you are left in an uneasy search for the optimal level of skill in other people—just enough to support your own activities without threatening your position. In theory, you can avoid the problem by designing institutions where other people’s success contributes to your own; this is the supposed aim of redistribution. (Still, redistribution is a blunt tool that discourages activity by the most productive, and also requires oppressive political structures that create their own problems.)

What annoys me is that the political faction most in favor of redistribution is not speaking of “shared bounty” and communal unity at all. Instead, they speak of how the rich don’t deserve the wealth they have, how they have exploited others, how they have a duty to give up their wealth, and so on. In fact, the reason that Tomasi’s turn of phrase was so striking to me is precisely that I had never encountered the idea put in quite that way before. The idea that—in the absence of proper institutions—a competitive society would lead to social discord and envy floats half-formed throughout much of our discourse, but more often is expressed in precisely those envious terms that Tomasi seeks to preempt.

So what sort of institutions can lead to a sense that one person’s success contributes to everyone else’s? The first thing that comes to my mind is anything having to do with inventing new things. Inventing new medicines, or a new and better solar panel, or writing clever software, can make many people’s lives much better. Software in particular is inherently scalable; it is nothing more than information, which can easily be transmitted to many people. So the success in inventing new things can certainly help many people. (I think this is why most people don’t resent the massive wealth of, say, Apple as they might do for an investment bank—because they can readily appreciate the way in which Apple’s wealth was generated by selling products that they, as individuals, benefited from.)

Still, this doesn’t precisely address the point. Not all industries act as such powerful force-multipliers for all of humanity as science or computing can. How can we create such an alignment of interests across society? I don’t know the answer off the top of my head, but probably institutions such as workers’ co-ops point in the right direction. Still, the most important part of finding answers is asking the right questions. Tomasi’s formulation is incredibly valuable for that purpose.

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.

Tax Farming

17 Sunday Jun 2012

Posted by in Better Fantasy, Economics, Finance, History, Politics, State Formation, Writing

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April 15th is a date seared into the brains of most Americans—being the due date for us to turn in our tax returns to the Internal Revenue Service. In the modern era, most governments have wide-ranging powers to tax their populaces. Yes, you have problems with tax evasion here and there, but most urban dwellers are used to paying taxes as a matter of course (though we certainly aren’t happy about it).

When you think about it, though, the smooth collection of taxes requires a vast infrastructure of information processing, bureaucracy, and coercive enforcement if necessary. All of that came about very late in historical terms. In the United States, tax withholding from our salaries was only instituted during World War II, for example. (In a delicious bit of historical irony, the concept was developed in part by famed free-market economist Milton Friedman, when he worked for the Treasury in the early days of the war. For the rest of his life, he hoped that tax withholding would eventually be abolished.) The first income tax in the United States was a temporary measure enacted during the Civil War.

In other countries, the story was similar. The seminal work on this subject, at least in comparative politics, is Margaret Levi’s Of Rule and Revenue, a study of taxation systems throughout history. Levi’s basic argument is that rulers are constrained in how they can tax populations by their ability to coerce the people, the ease with which money can be hidden, and limitations in measuring technology. (I previously wrote of similar concerns behind the institution of English nobility.) In short, early rulers had a very hard time raising taxes directly, simply because it was next to impossible to extend their control over the populace.

So what did they do? The strategies of rulers were many, but in this piece I want to focus on a particular practice called “tax farming.” In its basic form, the ruler created some sort of tax or tariff—a 10% tax on salt, for example—but rather than collecting the taxes itself, the ruler would sell off the right to collect the tax to some private party. This was the tax farmer. The tax farmer would pay a large sum up front to the government, and in exchange would gain the right to ruthlessly apply the salt tax to anyone within his jurisdiction and pocket the proceeds.

This is not the same as modern privatized tax collection, where the private party must transmit collected taxes to the government. Here, the tax farmer is the direct beneficiary of tax revenue. In general, tax farming was incredibly lucrative for the farmer, while the state was forced to sell the future revenues at discount prices, simply because it lacked the capacity to collect taxes itself. (Here, we see another example of a principal-agent problem.)

A nice (free!) overview of tax farming in the 18th century can be found here, by the eminent scholar Eugene White. The French monarchy, for one, was heavily dependent on tax farming for revenue. This dependence was a major contributor to the French Revolution, for two reasons. First, royal revenues were always rather stunted because the tax farmers absorbed much of the take, weakening state power. Second, the tax farmers of France were notorious for harshly oppressing the populace in order to squeeze every last sou that they could. (Similar concerns were at play with the Publicans of ancient Rome; a nice overview can be found here.)

This is all very interesting, but why is it worth knowing? In fact, it is surprising just how relevant the principle of tax farming can be, even in modern society. Take casinos, for example. They pay a large sum of money to local and state governments, and in return gain the right to siphon vast amounts of money from willing gamblers. The voluntary nature of the transaction makes it more palatable, of course, but even then the addictive nature of gambling muddles things.

Even more striking is the history of the banking system. That subject is so fascinating that it deserves its own post, but for now, suffice it to say that for decades, many U.S. states raised nearly half of their revenue by selling monopoly banking charters. In return, a particular bank would be given exclusive control of its town, free to earn considerable profits from its residents.

Neither casinos nor early banks are really the same as tax farming, of course. But they are both indirect means of collecting revenue, in which private parties gain outsized profits compared to the government’s take. Other examples can be seen with only a little effort, and the idea of tax farming is a useful lens for viewing much government policy.

Aside from that, this is another opportunity to bang my hobby horse of more realistic fantasy writing. As noted, tax farming was often the cause of massive oppression of the people, and resulting political unrest. I’d bet my last cent that some budding fantasy author could spin a much more interesting story using tax farming as an ingredient, than the typical “Evil Overlord wants to oppress the peasants for the lulz.”

The key thing to remember is that a king turns to tax farming when he needs more money that he can easily extract with his own efforts. It is the hallmark of lands with difficult travel, poor communication, and weak and divided political loyalties. In time, the tax farmers can become extremely powerful in their own right, perhaps even rivaling the established authority in the same way that Italian mercenaries would often overthrow their employers. If that isn’t fertile soil for a good story, I don’t know what is.

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.

Homeschooling, Credentials, and Community Colleges

07 Thursday Jun 2012

Posted by in Economics, Education, Homeschooling, Politics

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Ever since the beginning of the homeschooling movement, homeschoolers have had a dilemma: how to get official recognition of the educational achievements of homeschooled children. Such official recognition is necessary, among other reasons, because employers need ways to discriminate between good and bad hires, and for a long time now a college diploma has been an easy signal of employee quality. (Even if the informational value of college degrees is declining in recent years… but that’s a different discussion.) Colleges, in turn, need some way to tell whether applicants are good students or not. What this means is that after having escaped the rigid quantification of traditional schools, homeschoolers need another way to signal their educational quality.

From the examples I’ve seen, many homeschoolers have addressed this problem by turning to community colleges.

Community colleges generally cater to adult students, as well as traditional students who want to take their general ed requirements more cheaply than a traditional college would cost. This eclectic student base means that entrance requirements end up being fairly permissive: if you show up, you can take a class. This is a boon to homeschoolers, who can rapidly accumulate college credits even without previous formal schooling, enabling them to get the credentials they need to go on to more prestigious colleges if they choose to.

Aside from how interesting this story is in itself, the reason I’m writing about it here is as an example of a larger tendency. Often, institutions that are set up for one reason provide unexpected possibilities, and get used by other people for reasons that no one anticipated. The idea that community colleges would be a key building block in the advancing subversion of the traditional primary education system was on nobody’s mind when they were created, I’m sure.

Similar examples in the same vein are many:  FDIC deposit guarantees, meant to protect bank deposits in the event of a bank failure, are now being used to underwrite market-traded instruments like equity-linked CDs. Agriculture subsidies ostensibly meant to defend the family farmer instead allow massive agri-processors like Monsanto and ADM to capture the market. And of course the 800-pound gorilla, the Internet, originally conceived as a way for military command-and-control to persist in the event of a nuclear strike.

The point is that a new institution creates new possibilities (or can close them off), and the new structured environment will give rise to behaviors that are hard to anticipate. This is one of the reasons why ambitious government interventions often have perverse effects: no one knows what the outcome of a policy change will be, because no one understands the full possibilities of the new system until people have a chance to play around with it. On the positive side, new institutions like the Internet or public capital markets are constantly giving rise to startling new behaviors, as innovations accumulate and interact with each other.

Homeschooling thus far hasn’t managed to compete seriously with traditional college, though it can compellingly compete with K-12 school. Part of that is because no one has yet figured out how to provide a credential that can do the job now done by a college degree. The time may not be far off, however. As college degrees become more expensive and less useful, more and more people are looking for alternatives. In one stark example, Peter Thiel is offering $100,000 fellowships for students not to go to college. Eventually, I suspect, traditional colleges will face as much competition as lower grades already do today. And the enabling factor may well be some institution whose possibilities are imperfectly comprehended today.

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.

What’s the Point of English Aristocrats, You Ask?

01 Friday Jun 2012

Posted by in Economics, History, Politics, State Formation

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I was reading an article the other day by Douglas Allen (abstract here)* attempting to explain the bizarre institution of the English aristocracy, between about 1600 and 1900. I say bizarre because to be an aristocrat at that time was to accept on yourself a large list of restrictions that seem utterly mad to the modern ear.

Readers of Jane Austen or other Victoriana will tend to have a fuzzy image of the nobility. They clearly had a lot of money, but it wasn’t clear how. They had a lot of land, but a nobleman’s land holdings were as frequently a source of expense as they were a profit center. They had large estates away from the cities; why? Our wealthy class today typically likes to cluster around cities, not to build manor houses out in the middle of nowhere. What made the English different?

Aristocrats were expected to take large tracts of their land out of production and turn them into public walks. They were also expected to build massive homes which were open to visiting aristocrats at all times, and these homes were not merely away from the cities but even away from the local village. Why?

We see that noblemen were expected to go to the right schools. Less obvious was that these schools were remarkable in deliberately avoiding “practical” learning. Nobility were taught Latin, Greek, literature, and a whole host of topics which were utterly useless at making money. Furthermore, if a would-be aristocrat had made enough money to buy land and aspire to respectability, he was expected to immediately stop practicing his profession. For an aristocrat to engage in business was considered terribly shameful.

Allen’s paper goes on to list several other practices such as dueling or the encumbrance of land, all of them seeming to keep the noble class isolated from the larger society and totally unable to support itself commercially. Allen then proposes that all of this was by design. English nobles, he argues, deliberately made themselves hostages to a particular code of honor and class behavior, in order to transform themselves into the perfect servants of the king.

This takes some explanation. We are used to a world in which things can be measured and monitored. We buy rolls of toilet paper in the store secure in the expectation that they are all the same size and weight. We have soldiers in the battlefield equipped with cameras and radios so that their every move can be tracked. In short, it is very easy to monitor someone’s performance on the job, simply by monitoring the products of the work. The epitome of this is the bureaucracy, where everything is regimented and predictable.

But before the Industrial Revolution, it was hard or impossible to monitor anything. Bureaucracies did not exist. When you sent a ship across the world with trade goods, or when you sent an army of soldiers to the Continent, you had no control over what it did, and no way to be sure that your subordinates would actually work for your interests. In short, the pre-modern world was beset with vicious principal-agent problems.

In such a world, the most valuable resource is trust. You need to know that your subordinates are reliable. But how can you ensure such reliability? Economists will tell you to create a relationship framework in which your agent finds it far more valuable to stay in your good graces, than to betray your trust and profit in the short term. This can be done in a few ways. When possible, you can harshly punish offenders. Additionally, you can use repeated interactions to offer the lucrative carrot of future rewards to those who perform well now.

Allen argues that the nobility was a classic example of such a system. The important thing to know was that nobles made nearly all of their money from salaries, by serving as royal officials—which could earn them ten times as much as the most successful businessman, at the time. They served at the king’s pleasure, and could be dismissed for any reason. To give the threat of such dismissal teeth, noblemen were expected to dissipate their wealth through lavish social events and opulent dwellings. They were also expected to cut off all ties with the non-aristocratic world; that way, if you disgraced yourself and were shunned by “gentlemanly” society, you would be utterly alone.

The expensive educations in impractical subjects, the large homes away from the rest of society, all of these were “hostage capital” that displayed your willingness to play by the rules, because breaking the rules would be so very painful. Knowing Greek would be useless in commerce; it only had value within aristocratic society, so you needed to be sure to fit in.

The upshot was that the kings of England had access to a class of loyal servants—of uncertain ability at times, true, but whose dedication was nearly unquestioned. And it was this class of nobles that won England and Britain its empire.

What made the system of nobility break down? Indeed, at the end the aristocrats gave up power willingly, by passing laws allowing the common people to vote and hold offices, and by breaking up the aristocratic barriers to selling their ancestral lands. Allen argues that not only did the Industrial Revolution make the old problem of trust less of a problem, but it also made membership in the aristocracy less valuable. Now, instead of aristocrats earning far higher salaries than businessmen, it was the reverse; corporate titans bestrode the world, not the nobility. Given that, all the trouble of keeping up appearances simply wasn’t worth it. Far better to jump the aristocratic ship and become an industrialist.

So what’s the point of spending a thousand words talking about English toffs? First, I think it’s cool. Second, the whole episode illustrates the limitless ability of people to come up with social organizations to solve their problems. Third, it also illustrates how everything is dependent on context. Once the context shifts, old institutions become less relevant.

At the same time, though, the example of the English nobility remains for us to learn from. And who knows? There may come a time when the old problems become new again, and old wine can be poured into new glasses.

*Allen, Douglas. 2009. “A Theory of the Pre-Modern British Aristocracy.” Explorations in Economic History, Vol. 46: 299-313.