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Dr. John Lovett! The Cheapening of Money and the ! Abstract:! Financial intermediation has been around since the early twelfth century, but due to the costliness of a loan, the efficiency of debt is weakened. In this paper I propose that as money became cheaper, the efficiency of a loan became greater. As the efficiency of a loan rose, there will be a greater potential for economic growth. This paper discusses the two main obstacles needed to be overcome in order to lower the price of money. The first obstacle is rights, a fundamental institution for a civil society and for the use of collateral. Securing property rights within a legal framework will decrease the cost of a loan by decreasing the asymmetric information that poses great risk to the lender. The second obstacle discussed in this paper is usury. It is not the use of usury, it is the lack there of that is the problem. This paper discusses the evolution of the definition of usury from being a sin to what is now known as interest. It is vital to the start of the Industrial Revolution to make financial intermediation fluid. This paper discusses the dynamic of this system and its progressing fluidity throughout the medieval period to the Industrial Revolution. ECON 30423 The Cheapening Money and the Industrial Revolution 2

The Cheapening Money and the Industrial Revolution! By Andrew W. Homer Abstract:! Financial intermediation has been arround since the early twelfth century, but due to the costliness of a loan, the efficiency of debt is weakened. In this paper I propose that as money became cheaper, the efficiency of a loan became greater. As the efficiency of a loan rose, there will be a greater potential for economic growth. This paper discusses the two main obstacles needed to be overcome in order to lower the price of money. The first obstacle is property rights, a fundamental institution for a civil society and for the use of collateral. Securing property rights within a legal framework will decrease the cost of a loan by decreasing the asymmetric information that poses great risk to the lender. The second obstacle discussed in this paper is usury. It is not the use of usury, it is the lack there of that is the problem. This paper discusses the evolution of the definition of usury from being a sin to what is now known as interest. It is vital to the start of the Industrial Revolution to make financial intermediation fluid. This paper discusses the dynamic of this system and its progressing fluidity throughout the medieval period to the Industrial Revolution.! Introduction! ! It is important to understand the beginnings of the financial system for . The financial system expands the possibilities of an economy. The system existed for many years before the Industrial Revolution. This paper attempts to explain what problems the financial system had that made loaning money expensive. The two issues that will be discussed are property rights and usury. The financial system is fluid today in that it has low interest rates, one can easily borrow, and those who lend have liquid capital. Because of these characteristics of the financial system that we take for granted today, it is important to understand how the system came to be in the state it is today and how to prevent it from regressing into the past. ECON 30423 The Cheapening Money and the Industrial Revolution 3

Property rights are a fundamental characteristic of any growing economy. This right is necessary to have a robust financial system. Because property is used as collateral for a loan, one must have a stable system to prove the ownership of one’s property. This paper will use a source that describes the city of Edam in Holland as the prime example of protecting property rights. In Edam, a legal system of property rights is established. Because the citizens of this city are willing to give up their information to have it publicly known that they own, for example a plot of land, there was an increase in small loans, or it can also be called microfinance. Creating a legal system of property rights also solves the problem of asymmetric information. If the lender can not legally identify the owner of property he or she will asses the loan with greater risk in mind. This thought of high risk was enough to makes loans expensive. It was identified that in Edam, as the system of property rights strengthened, the amount of loans increased and therefore the economy grew at a faster pace. It is important to understand this principle right of property when assessing the strength of a financial system. The prohibition of usury in the medieval period created an environment for the financial system that made the cost of loaning high. Therefore, the cost of money was too expensive for the lay person to have the opportunity to develop an idea that could advance society. It was not only the church that fought against usury, the state and political figures believed that usury is morally unjust. This paper will shed light on the thought of usury in the preindustrial era. In the time leading up to the Industrial Revolution, usury morphed into what we know as interest. In the beginning, people thought usury was a mortal sin. These people believed a loan should be treated as charity. As time passed, those who wanted to make a profit off of lending their money found loopholes. One such loophole was turning a loan into property. Because one has a right to receive profit from an investment because he or she owns a small part of the investment, if a loan can be seen as property, the lender has the right to gain profit that was made by the loan. By the time of the Industrial Revolution, it was common to find a interest rates in societies. By eliminating the negative notion of usury and imposing interest rates, the lender felt safer about a loan. This safety made lenders lend more, therefore giving rise to a stronger and more fluid financial system. ECON 30423 The Cheapening Money and the Industrial Revolution 4

This paper will attempt to prove that the Industrial Revolution was sparked by a strengthening in the financial system. This strength came from the lowering of the interest rates to allow the common preindustrial person to have the capital he or she needed to develop an idea. Solving the problems associated with property rights and usury both result in a stronger financial system because lenders see less risk in a loan. This new environment that evolved allowed for the take-off of the European economy in the Industrial Revolution. The Financial System! Before 1600, there was not an adequate means of payment to correspond with the growing level of commerce. This lead to the development of the deposit bank. The sources of during this period was mainly in the hands of the elite (Kohn, 1). Though there was not a lack of saving across the board in the preindustrial society. There was and average level of saving from 2% to 15% which is not very different from the levels of today (Kohn, 2). The distribution of income over time leveled out. This was because there was a need for highly liquid wealth. The elite mainly had their wealth in land. There wealth was useful in time of rapid economic expansion because they also owned the forests which were great sources for fuel and building material. But this system failed when the landowners began to become a source of finance for others. Due to their high participation in wars and crusades, their consumption exceeded their incomes. This required them to borrow against their wealth (Kohn, 3). In the early middle ages, a more liquid wealth was used. The Church over many years obtained riches through gifts and endowments. They used this to finance participation in wars or crusades. But the Reformation reduced the Church’s importance as a lender (Kohn, 3). In the thirteenth century, merchants became the principal source of funds for lending. They were not as wealthy as the landowners, but their wealth was much more liquid. This factor of liquidity is what made them successful. This allowed them to shift their resources from those of declining profitability to those they can exploit. Merchants though did not lend long-term. The use of short-term lending gave the security and the ability to shift resources. As merchant lending became more developed, by the ECON 30423 The Cheapening Money and the Industrial Revolution 5 fourteenth century, merchants were becoming merchant bankers. Rather than using their own profits as a source for the funds to lend, they began to lend the money of depositors. As certain merchant bankers became large, they would collect the money of other merchants to become what Meir Kohn calls in his paper, “Finance Before the Industrial Revolution: An Introduction”, ‘great merchant banks’. The merchant’s largest customer was the government. As the economy became more monetized by the use of money to pay feudal services, feudal princes needed cash to hire professionals to fight for them. Another use of these funds was fixed capital. The economy at this time was made up of about 50% to 70% of fixed capital. These funds for fixed capital were used is sectors such as agriculture and transportation. As technology progressed, so did the need for a larger financial system. Without this development, the Industrial Revolution would not have had the backbone to support the exponential economic advancement later to come. (Kohn, 3-6) As a strong system of lending was established, there were obstacles that came in its way. The biggest one was usury. Kohn describes the mentality of a loan during this period by stating that, “A loan was seen not as an economic transaction, but as an act of charity.”(Kohn, 10) This mentality made it hard to make loaning profitable. One could argue that activities that are profitable are more likely to be instituted. Luckily there were loopholes. The question was, what is the definition of usury? The Venetian people interpreted usury as an exploitative rate of interest. Interest in Venice was officially legalized in 1217. too adopted this same definition. Henry VIII legalized interest in 1545. Though this notion of usury did greatly spur lending. There were many social institutions to change as well. However, it did effects the development of the lending process and possibly allowed for the bourgeoning of lending that will occur in the Industrial Revolution (Kohn, 11). Usury! The evolution of the idea of usury to the idea of interest was imperative for the of the Industrial Revolution. However, this evolution was not smooth. The biggest obstacle the financial revolution and therefore the industrial revolution was usury. Usury as John Munro defines it in his paper, The Medieval Origins ECON 30423 The Cheapening Money and the Industrial Revolution 6 of the Financial Revolutions: Usury, Rentes, and Negotiability”, is, “the exaction of interest or of any specified return beyond the principal value of a loan” (Murno, 506). The church had a strict ban on usury. Two religious orders, the Franciscans and the Dominicans, lead a campaign to oppress those who practiced usury (Murno, 507). This crusade even persuaded secular rulers to enforce the ban on usury. Canon lawyers also joined in the fight against usury. They used the root of the word loan mutuum which means ‘what had been mine becomes thine’ to combat usury (Murno, 509). Because the church, the law and even the secular world were all against usury, an attempt to profit on financial intermediation was be hard. However, not all financial intermediation used usury. If for example, one rented a house, he or she has the right to receive rental income. Also if one invests in a partnership or a comenda contract, he or she is entitled to a share of profits. This is because the individual has ownership. A loan has no ownership in the medieval mind. This allowed for a loophole. One way to disguise usury is to cloak the loan in a sales contract that specified future payment. The church caught on to this and deemed any hidden usury was still a mortal sin. The threat of being convicted of usury made financial intermediation difficult. Lawrence Stone, an English historian, once said, “Money will never become freely or cheaply available in a society which nourishes a strong moral prejudice agains the taking of any interest at all.” (Murno, 511-512) The debate of usury and its definition was greatly discussed between Jeremy Bentham and Adam Smith. Smith believed there should be a state-imposed cap on the rate of interest. He believe five percent was the maximum anyone should pay in interest on a loan. Benthan on the other hand, in his Defence of Usury, tried to get Smith to let interest rates float. (Persky, 228) Prior to this episode in the 1780’s, medieval churchmen in Britain starting in the 1350’s openly described usury as a practice of requiring payment for a loan. By the 1650’s the definition broadened to the normal business of loans. Though this new idea did not come about without a fight. Thomas Wilson, a British judge and diplomat wrote A Discourse on Usury in 1572 to attack this new definition of usury. His was a moral argument. (Persky, 229) By the time of the eighteenth century, most British economic commentators believed in the necessity of interest rates. In Adam Smith’s Wealth of Nations he clearly ECON 30423 The Cheapening Money and the Industrial Revolution 7 believed the need to have interest rates. He supported his argument by saying the an interest rate is simply a the cost of the lender’s risk. But rather than furthering this logic to allowing a floating interest rate and endorse the removal of legal restraints on interest rates, Smith supported limiting the interest rate. His reasoning was that if interest rates were too high, the elite or well connected would be able to out bid the common man. (Persky, 230) England at this time sided with Smith’s argument of caping interest rates. It can be argued that this slowed capital accumulation and growth. The first regulation of interest in England began in 1545 with a maximum rate of 10% (Temin, 745). This is not optimal, but compared to the outlawing of interest, it is a step forward. In 1714, the English government lowered the usury limit. Because the profit of a loan decreased, banks needed to decrease the risk on loans. This caused banks such as Hoare’s Bank to increase its minimum loan size (Temin, 744). As seen in Figure 1, after the decrease in usury limits, Hoare’s Bank did begin to increase its loan size. This

Fig. 1. Hoare’s Median Lending Amount (3-year-moving average) (Source: Temin, 752) caused discrimination towards the wealthy. In 1833, usury limits were lifted of bills of exchange and were completely done away with in 1854 (Temin, 745). ECON 30423 The Cheapening Money and the Industrial Revolution 8

The change in the usury law in 1714 caused a great change in the dynamic of the financial system. Economic agents began to use debt as security rather than just liquidity services. In order for this to occur, there was a need for good property rights. Property Rights! In order to prove low risk to a bank, borrowers used collateral. It is impossible to use collateral as a means to diminish risk if there are no property rights established. When the usury laws changed in 1714, the use of collateral jumped to 67% from about 10% (Temin, 753). Therefore, in order for the financial system to grow, and subsequently for the Industrial Revolution to occur, property rights must be established. Microfinance was a fundamental contribution to economic development in the late medieval period. Holland is a prime example to support this idea. Microfinance can be defined as “relying on the capacities of relatively poor men and women to develop entrepreneurial activities” (Moor, Zanden, Zuijderduijn, 3). The financial revolutions that led up to the industrial revolution all were influenced by governments borrowing money. However, the question is; how the private sector was affected by the financial revolution? In order to understand how the average private individual in the late medieval period were able to lend or borrow one must understand the problems that must be resolved. The first and most fundamental problem is that potential borrowers want to use an asset as collateral but can not because property rights are not well established. This first problem creates the second. Because there is no or little collateral, it costs more to borrow money due to a large amount of asymmetric information (Moor, Zanden, Zuijderduijn, 4). Solving these problems would greatly lower interest rates and create economic growth. To make money cheaper, under these pretenses, one must protect property rights. Property rights in Holland were clear enough to allow for an emerging capital market. One form of collateral used is land. In Holland, land was protected by a system based on ratification by local authorities. This system started out in the thirteenth century as simply judges and aldermen witnessing transactions and using their memory to vouch for someone’s right. It later developed into a system that issued contracts. This ECON 30423 The Cheapening Money and the Industrial Revolution 9 system is enough to solve the problem of property rights as collateral. Of course, the system needed to work, corruption in the system could hurt microfinance. The city of Edam in 1564 is an excellent example of this system. Edam is about 20km northeast of Amsterdam, and had a population of 3,752 in 1563 (Moor, Zanden, Zuijderduijn, 8). They prove that people trusted their public court to uphold their rights. During the year of 1564, 450-500 transactions occurred, they did this even though there was a fee to record the transaction and because it was pubic record, they were vulnerable to taxation. The benefits of having legal property outweighed the costs. (Moor, Zanden, Zuijderduijn, 7) This improvement in a system of property rights has the potential to lower interest rates and spur economic growth. Due to the property rights in Edam, many systems developed to finance purchases of physical capital. One such system was called kustingen, a mortgage like loan that was secured on realist ate and ships that lasted from 2 to 12 years (Moor, Zanden, Zuijderduijn, 10). Also a system of losrenten and lijfrenten were developed (Moor, Zanden, Zuijderduijn, 11). They can be related to the modern annuity. These new systems granted the financial market flexibility which allowed it to continue to grow. The level of interest rates reflects the efficiency of a capital market. Interest rates in Holland on redeemable annuities fell from about 12 percent in the first half of the fourteenth century to about 6 percent after 1450 (Moor, Zanden, Zuijderduijn, 17). These lower interest rates in the private market were comparable to those in the public market. The reason this market is so efficient is that this society was able to solve the property rights problem. Property rights were protected because all transactions were transparent and legal. This limited the power of the government to arbitrarily divide property. The Holland credit market did not discriminate between rich and poor, men or women. This allowed for all aspiring entrepreneurs to access the capital they needed. This blind method allowed for this society to have continuous growth of GDP per capita since the fifteenth century (Moor, Zanden, Zuijderduijn, 17). Property rights are a fundamental element of a modern economy. The Industrial Revolution would not have occurred without this important step into modernity. “The idea that limited, representative government secures property rights and stimulates investment continues to be an attractive one…” Stephen Quinn (Quinn, 613). ECON 30423 The Cheapening Money and the Industrial Revolution 10 Conclusion The link between the financial revolution and the industrial revolution is strong. The best example of this is in England. The Financial Revolution began in the South while the Industrial Revolution began in the North. However the link between real capital and the financial market was not always strong. Many economists believed the link between real capital and the financial market is weak. One of these economist is David Ricardo who said “The price of funded property is not a steady criterion by which to judge of the rate of interest” (Buchinsky, Polak, 3). The reason to doubt the link between the capital and financial markets is because it has been found that credit transactions tend to stay within an industry. Comparing London long-term interest rates with data on deed registration from Middlesex and West Yorkshire allows one to know when capital markets were integrated. (Buchinsky, Polak, 3) A decrease in the cost of money, or the interest rates means that the financial market is more efficient. An affective way to test the link is to see if a decrease in the interest rates affected the purchasing of buildings. Buildings are a good example because it is a rather sensitive capital investment to interest rates. Between the years of 1730 and 1776, there was a weak relationship between the two markets. However, from the years from 1770 to 1880 there was a large link between the markets. (Buchinsky, Polak, 17-18) This means that because of the lowering of interest rates, people bought more buildings. Having an economy with a characteristic of a close link between the financial market and real capital allowed for the industrial revolution to take flight. In times of uncertainty, when property rights are not secure and low interest rates do not outweigh the amount of risk in a loan, banks lend to insiders (Brunt, 75). Insiders are people who have some sort of link to the bank in addition to being a customer (Brunt, 74). However, as property rights began to be enforce more effectively and interest rates were allowed to float, the velocity of money began to increase. After 1854 when interest caps were abolished and having strong and restricted government that protected allowed more freedom for banks to seek profit. This increased loans, which increases output. But, as all logical capitalistic economies work, ECON 30423 The Cheapening Money and the Industrial Revolution 11 the supplier would not increase supply if they are not expecting an increase in demand (Pollard, 217). There are many credible arguments that attempt to define the spark that lit the Industrial Revolution on fire. However, the argument of a liquid economy allows for most of the other arguments to occur. Therefore, it can be argued that in order to have an increase in technology to discover more resources in one’s environment, an economy must first be liquid to allow for money to easily flow into the hands that most need it. This fluid economy only becomes reality when the cost of risk are allowed to enter the equation and property is secured as private. These two fundament hurdles are what sparked the Industrial Revolution, the beginning of cheaper money. ECON 30423 The Cheapening Money and the Industrial Revolution 12

Works Cited Buchinsky, Moshe, and Ben Polak. "The Emergence of a National Capital Market in England, 1710–1880." The Journal of Economic History 53.01 (1993): 1. Print. Kohn, Meir, Finance Before the Industrial Revolution: An Introduction (February 1999). Dartmouth College, Department of Economics Working Paper No. 99-01. Munro, John H. "The Medieval Origins of the Financial Revolution: Usury, Rentes, and Negotiability." The International History Review 25.3 (2003): 505-62. Print. Persky, Joseph. "Retrospectives: From Usury To Interest." Journal of Economic Perspectives 21.1 (2007): 227-36. Print. Pollard, S. "Investment, Consumption And The Industrial Revolution." The Economic History Review 11.2 (1958): 215-26. Print. Quinn, Stephen. "The 's Effect on English Private Finance: A Microhistory, 1680-1705." The Journal of Economic History 61.3 (2001): 593-615. Print. Temin, Peter, and Hans-Joachim Voth. "Interest Rate Restrictions in a Natural Experiment: Loan Allocation and the Change in the Usury Laws in 1714." The Economic Journal 118.528 (2008): 743-58. Print. Van Zanden, J.L., Zuijderduijn, J. and De Moor, T. (2012). Small is beautiful: the efficiency of credit markets in the late medieval Holland. European Review of Economic History 16, pp. 3–23.