• About Oren
  • Edited Anthologies
    • The Odds Are Against Us
  • Fiction by Oren Litwin
  • Lagrange Books
    • Calls for Submissions
      • The Future of Audience-Driven Writing
      • Archives
        • Call for Submissions— “Asteroids” Science-Fiction Anthology
        • Call for Submissions— “Family” Fantasy Anthology
        • Call for Submissions—Military Fiction Anthology
        • Call for Submissions—”Ye Olde Magick Shoppe” Fantasy Anthology
    • The Wand that Rocks the Cradle: Magical Stories of Family
    • Ye Olde Magick Shoppe
  • Politics for Worldbuilders
  • Scholarship

Building Worlds

~ If You Don't Like the Game, Change the Rules

Building Worlds

Tag Archives: medieval banking

Bills of Exchange, Banking, and the Little Things

05 Tuesday Jun 2012

Posted by Oren Litwin in Credit, Economics, Finance, History

≈ Leave a comment

Tags

bill of exchange, Borrowing, interest rates, islamic finance, Medici, medieval banking, Middle ages, seigniorage

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.

Recent Posts

  • New Release! Telling the Stories of Women Veterans
  • Group Identities in Politics: Ethnic Groups
  • Building an Economy: Capital
  • Building an Economy: The Struggle Between Urban and Rural
  • Building an Economy: Types of Cities

Meta

  • Register
  • Log in
  • Entries feed
  • Comments feed
  • WordPress.com

Not a fan of RSS? Enter your email address to follow this blog and receive notifications of new posts by email.

Join 228 other followers

Follow me on Twitter

My Tweets

Archives

  • July 2022
  • June 2022
  • May 2022
  • April 2022
  • March 2022
  • January 2022
  • December 2021
  • November 2021
  • August 2021
  • July 2021
  • June 2021
  • June 2020
  • May 2020
  • November 2019
  • September 2019
  • August 2019
  • May 2019
  • April 2019
  • March 2019
  • February 2019
  • January 2019
  • December 2018
  • October 2018
  • August 2018
  • July 2018
  • June 2018
  • May 2018
  • April 2018
  • March 2018
  • February 2018
  • July 2017
  • February 2017
  • December 2016
  • December 2015
  • December 2014
  • November 2013
  • August 2013
  • May 2013
  • April 2013
  • January 2013
  • November 2012
  • October 2012
  • September 2012
  • August 2012
  • July 2012
  • June 2012
  • May 2012

Categories

  • Better Fantasy
  • Credit
  • Economics
  • Education
  • Finance
  • Health
  • History
  • Homeschooling
  • Investing
  • Lagrange Books
  • Manifesto
  • Military
  • NaNoWriMo
  • Politics
  • Politics for Worldbuilders
  • Real Estate
  • Revolution
  • Self-Actualization
  • Self-Promotion
  • State Formation
  • Uncategorized
  • War
  • Weapons
  • Writing

Blogroll

  • Discuss
  • Get Polling
  • Get Support
  • Learn WordPress.com
  • My Other Blog
  • Theme Showcase
  • WordPress.com News

Personal Webpages

  • My Other Blog

Writing Resources

  • Ralan—Publishing Market List
Links on this site may lead to products for which the owner may receive compensation.

Website Powered by WordPress.com.

Privacy & Cookies: This site uses cookies. By continuing to use this website, you agree to their use.
To find out more, including how to control cookies, see here: Cookie Policy
  • Follow Following
    • Building Worlds
    • Join 228 other followers
    • Already have a WordPress.com account? Log in now.
    • Building Worlds
    • Customize
    • Follow Following
    • Sign up
    • Log in
    • Report this content
    • View site in Reader
    • Manage subscriptions
    • Collapse this bar