LIQUIDITY TRAP

 A liquidity trap is a macroeconomic condition in which injecting additional money and liquidity into an economy exerts very little impact on overall price levels, output, or employment. It is a macroeconomic phenomenon, meaning that it applies to the economy as a whole and not to industries individually. Only an economy at a low point in a business cycle is at risk of developing a liquidity trap. During a recession, a liquidity trap can become a major hindrance to economic recovery, considerably complicating the task of designing an effective economic policy.

The liquidity trap at first seems more of a puzzle than a trap. It seems paradoxical that the money stock can grow without commiserate growth in spending. Theories of inflation assume that money stock growth does lead to comparable growth in spending, and the growth in spending drives inflation. Only economies experiencing deflation or near deflation seem to be at risk of developing a liquidity trap.

A liquidity trap becomes possible because money, particularly bank balances, can act as a substitute for stocks and bonds, and may even become an attractive substitute if interest rates drop to very low levels. Money pays little or no interest, but it is the most liquid of all financial assets. Liquidity confers certain advantages. It puts one in a position to exploit speculative opportunities or handle financial emergencies. To offset the advantages of liquidity, stocks and bonds pay dividends and higher interest. The danger of a liquidity trap occurs when interest rates reach very low levels, probably lower than 1 percent. Unusually low interest rates of this order occurred in the United States during the 1930s, and again in Japan in the 1990s. Extremely low interest rates, coupled with fear of deflation, makes bank balances a highly attractive financial asset compared to much less liquid stocks and bonds. Low interest rates involve the expectation that interest rates will be higher in the future. Investors do not want to lock in a low interest rate by purchasing longer term financial assets when interest rates are low.

The practical significance of a liquidity trap is that it leaves the monetary authority powerless to stimulate the economy by increasing the money supply. The main ingredient of a monetary stimulus is the purchase of government bonds with newly printed money. Called “open-market operations,” this action makes the bond market more of a seller’s market, meaning bond sellers can sell bonds at lower expected yields. In other words, interest rates fall. In a liquidity trap, the preference for holding bank balances over bonds becomes so strong that open-market operations can no longer reduce interest rates. Falling interest rates no longer accompany above average growth in the money supply.

As a recession unfolds, the market for used capital goods is likely to see severe deflation, which will undercut the prices of new capital goods. Businesses become hesitant to purchase capital goods if they come to expect that capital goods can be purchased at lower prices in the future. Falling demand for finished goods further undermines the willingness to purchase capital goods. With the liquidity trap acting as a floor under interest rates, openmarket operations cannot push interest rates low enough to stem the tide of falling investment spending. The economy sinks deeper into recession.

The cure for a liquidity trap involves a high level of government deficit spending to compensate for the absence of business investment spending. In the 1990s, the Japanese government baulked at enlarging the public debt on the scale needed to lift Japan out of the liquidity trap. The Japanese economy languished in recession during much of the 1990s.

See also: Open Market Operations

Lydian Coinage

Writing at mid-fifth century b.c. the Greek historian Herodotus in his History observes of the Lydians, “So far as we have any knowledge, they were the first nation to introduce the use of gold and silver coin, and the first who sold goods by retail.” Subsequent research suggests that China may have edged out Lydia as the birthplace of round coins, but Lydia still receives priority for beginning the coinage of money that has evolved down to the present day. The date when Lydia hammered or struck the first true coins cannot be identified with certainty, but was probably around 800 b.c.

The kingdom of Lydia lay on the western coast of what is now Turkey, separated from ancient Greece by the Aegean Sea. Sardis, the capital of Lydia, was a clearinghouse for trade between Mesopotamia and Greek cities along the coast. According to Herodotus, “Lydia, unlike most other countries, scarcely offers any wonders for the historian to describe, except the gold dust, which is washed down from the range of Tmolus” (Herodotus, 1952). According to Greek myth the river Pactolus, near Sardis, owed its rich deposits of gold to Midas, who bathed in it to wash away his fateful golden touch that even turned his food to gold. Lydian rivers washed a natural amalgam of gold and silver down from the mountains, and left deposits of silt that the Lydians panned, capturing a light yellow precious metal that was called electrum because of its amber cast. Later the Lydians learned to separate the gold and silver content of electrum. They also substantially advanced the art of ascertaining the gold content of metal.

The main purpose of the first coins was to facilitate trade by providing state authentication of the purity and weight of precious metals, an important medium of exchange. The ancestor to the Lydian coins was a bean-shaped dump of electrum that served as Lydian coins at the opening of the seventh century. Soon these dumps acquired a punch mark on one side and, later, an inscribed mark on the other side, signifying that the government vouched for the purity and weight of the precious metal content. By midcentury these dumps began to take on the characteristics of round coins, stamped on both sides with clearly identifiable figures. One side of the coins bore the resemblance of a lion’s head, the symbol of the ruling Mermnad dynasty of Lydia.

The development of coinage in Lydia did not end the production of gold bars of uniform size. Herodotus (1952) tells of a Lydian king, Croesus, who, a century after the appearance of the first coins, caused “a vast quantity of gold to be melted down, and ran it into ingots, making them six palms long, three palms broad, and one palm in thickness.”

From Lydia the production of finished coins passed to Greece, where it developed very rapidly. Athens was minting coins by 575 b.c. and by the fifth century b.c. minted coins in Greece had come to rival other art forms in their beauty. From Greece the coinage of money passed to Rome and Western Europe and for the next 2,000 years money to most people in the Western world meant coins. By the twentieth century, Western Europe had spread the practice of coining money to the rest of the world, making coinage one of the epochal innovations in financial history.

Lombard Banks

Lombard banks were banks that accepted deposits of goods and issued credits on account. These credits could pass from one person’s account to another’s as a medium of exchange. The term Lombard probably came from the importance of Italian bankers in the early history of the London financial market, sometimes referred to as Lombard Street, just as Wall Street signifies the financial center of New York. In early English history, Lombard was another name for “Italian.” According to Webster’s dictionary Lombard, broadly speaking, can refer to a banker, moneylender, bank, or pawnshop.

In 1661 Francis Cradocke published a pamphlet, Wealth Rediscovered, in which he proposed the establishment of banks secured by things other than precious metals or financial assets. Among the commodities he advanced as possible securities were jewels, “rich pictures or hangings,” silks, iron, sugar, wines, tobacco, and land. He recommended dividing the kingdom into a hundred districts, and each district would have a “standing and constant Bank or Registry” that registered all lands, houses, and rents, and granted credit upon the basis of land, goods, or pawns.

In 1676 Robert Murray published a proposal for a Lombard banking scheme, entitled A Proposal for the Advancement of Trade, in which he argued for the establishment of a “Bank and Lombard united.” Under his plan people would deposit their “dead stock” in magazines, and receive credit on account that could be exchanged as money. He recommended awarding credit on account up to “two-thirds or three-fourths of their value according to the quality thereof.” In explaining the credit on account, Murray explained that:

[N]o more is required than what is already practised in Banks here and abroad, where men deposite Money and obtain the Bank-Credit, which generally passeth in Receipts and Payments without the real issuing of Money, the Money remaining as a Pawn or Ground of Security in the Cash-Chest, or else imployed by the Banker to his own Benefit.

(Richards, 1929)

The most famous economist of the era, William Petty, put in a good word for Lombard banks in his Treatise of Taxes and Contributions (1662). He wrote, “If public Loan Banks, Lombards, or Banks of Credit upon deposited Plate, Jewel, Cloth, Wooll, Silke, Leather, Linnen, Mettals, and other durable Commodities were erected, I cannot apprehend how there could be above one-tenth part of the Law-suits and Writings as now there are” (Richards, 1929). Lombard banks were sometime called Banks of Credit.

In 1682 the city of London established the Bank of the City of London, which acted primarily as a Lombard bank. Despite the noble mission of the bank, which was to pay down the city’s debt to the Orphans’ Fund, the experiment collapsed suddenly.

Lombard banks were a hybrid of pawnshops and deposit banks. Unlike pawnshops of today, Lombard banks issued credits that could circulate as money, adding to the money supply. Although pawnshops, called Lombards, had a long history, it is not clear that Lombard banks of the sort proposed in the seventeenth century ever developed far beyond the theory stage. Nevertheless, the Bank of England, created by an act of Parliament in 1694, was authorized to conduct a pawnbroker’s business, reflecting the influence of Lombard banking schemes at the time.

Liverpool Act of 1816 (England)

The Liverpool Act of 1816 officially put England on the gold standard and provided for a subsidiary silver coinage to complement the gold coinage and bank notes that dominated England’s money supply. It gave silver a role to play in a monetary system in which the monetary standard was defined in terms of gold. During the eighteenth century England was technically on a bimetallic standard, but the market price of silver stood above the mint price for most of that era, and consequently no silver was brought to the mint for coinage. England had in practice settled into a gold standard and silver coins were in short supply. After 1785 the market price of silver tumbled, and silver flowed to the mint in large amounts for coinage, threatening to upset an unofficial gold standard that met with the approval of the English government. Parliament hastily enacted legislation that prohibited the mint from purchasing silver for coinage, circumventing the possibility that silver would oust gold as the predominant monetary metal. By 1797 the financial stringencies of war with Revolutionary France had forced England onto an inconvertible paper standard that lasted until 1821, encompassing the period of the Napoleonic Wars. As pressure mounted for a return to the gold standard, a complementary movement gathered strength to reform the silver coinage. As early as 1798 the government had appointed the Committee of the Privy Council on the State of the Coinage, but the committee failed to reach quick agreement and chose not to make recommendations until the war ended. In 1816 the committee made its report, recommending the coinage of both gold and silver, but also recommending that the monetary standard be defined in terms of gold only, thus officially ratifying a century-old gold standard. The committee’s recommendations left the weight and denominations of gold coins unchanged. The committee recommended a return to silver coins, but only as a subsidiary coinage. Silver coins were to be regarded as representative coins, legal tender for payments of no more than 40 shillings. The committee recommended that the mint purchase silver for 62 shillings per pound, but coin the silver at a rate of 66 shillings per pound. That is, the face value of the silver coins struck from a pound of silver was equal to 66 shillings. The committee hoped that the slight increase in face value per unit of silver weight would make the melting down and export of silver coins unprofitable. Also, the remaining silver content, which was still significant, would discourage counterfeiters. The government adopted the committee’s recommendations without delay in the Liverpool Act of 1816. This act made silver coins an important component of England’s money supply until 1947, when England removed all precious metal content from its “silver” coinage. Beginning in 1947 England’s “silver” coinage has been composed of cupro-nickel alloy, a copper and nickel alloy.

Liquor Money

Perhaps some measure of the importance of stimulants and depressants to civilization can be seen in the use of these goods as money. Stimulants such as coffee, tobacco, and cocoa beans have served as money, and alcohol—a depressant—has also fulfilled the functions of money in some societies.

During the nineteenth century, gin circulated as money in Nigeria. A bishop reported that it was impossible to buy food in parts of the Nigerian Delta, unless one could offer gin in payment. Bottles of gin changed hands for years, eluding human consumption. Members of a commission on native races, visiting the home of a chief in the central province, saw a stockpile of cases of gin, some cases exceeding 30 years of age. Gin functioned as a store of value, with chiefs holding large stocks of gin as a treasure. Gin owed part of its popularity as a form of wealth to the government’s practice of steadily raising the taxes on imported spirits, rendering domestic stocks more valuable. Although there is no evidence that prices were fixed in gin, signifying gin as a standard of value, gin served as a medium of exchange and store of value. The government banned the importation of spirits during World War I, ending the use of gin money, and opening a period of a silver currency shortage.

In Australia rum served as the medium of exchange of choice during the late eighteenth and early nineteenth centuries, a time in Australian history known as the “period of the rum currency.” Metallic currency was in short supply, a common problem among remote colonies, including the 13 American colonies along the eastern seaboard. Adding to the currency shortage in Australia was the thinking among English authorities that a convict colony did not need to be provided with money. Trade brought in a limited number of Spanish dollars that were used to pay for imports, and rum could be found in the cargo of every ship that came into port.

Rum met the need for a domestic medium of exchange in Australia. Farmers sold their produce for rum, workers expected to be paid in rum, convicts performed additional work for payment in rum, and law enforcement authorities offered rewards in rum for the apprehension of criminals. Rum functioned better as a medium of exchange than as a store of value. Its value fluctuated with the size of the last shipment, and its owners often fell prey to the temptation to drink it, rather than save it to buy other goods. Although Europeans accepted rum in payment for goods and wages, there no evidence that the aborigines accepted rum in payment, unlike the American Indians who were reported to have had a fondness for whiskey.

Beer has found a place among the ranks of currencies. Some tribes in Uganda are reported to have made payments in homemade beer, and tribal workers to have accepted beer in payment of wages. The consecration of a goat or the manufacture of a shield cost a pot of beer, and the barber charged a pot of beer and one chicken. There is no evidence that these tribes used beer as a store of value, but there is some evidence in Angola that during the 1980s imported beer served as a store of value.

The use of liquor as money gives added meaning to the New Testament admonishment that the “love of money is the root of all evil.” One would expect liquor money to challenge the physical and moral strength of a society in ways that other currencies would not. Many societies have held up objects of reverence as money, such as whales’ teeth on the Fiji Islands, or even gold and silver in ancient Western societies. In Angola the cynicism of war may deserve some credit for the use of imported beer as money. Also, colonial domination by other cultures may be a factor in the use of liquor money in Australia and Nigeria.

Lex Flaminia of 217 b.c. (Rome)

The famous English economist, John Maynard Keynes, wrote in his Treatise on Money, Vol. I (1930):

Nor am I aware of any chartalist change of standard, expressly designed to benefit the State at the expense of the public, earlier than the second Punic War—Rome being the first original to add this instrument to the armoury of statecraft. From that time on chartalist changes of standard, generally in the form of debasement, sometimes for one purpose and sometimes for another, are the favorite theme of historians.

As early as the sixth century b.c. Athens had changed its monetary standard to relieve debtors, but not to benefit the government. Although a thorough study of ancient history would probably turn up earlier examples of currency debasement for the benefit of a government, historians have cited the Roman debasement during the Punic Wars as the fateful beginning of a series of currency debasements that had completely debauched the Roman currency by the second and third centuries a.d.

In 338 b.c. the Roman government issued copper coinage to replace cattle as the medium of exchange. The unit of measure was the as, equal to one pound of copper. The coins bore the image of an ox, a sheep, or a hog, and were called pecunia, from pecos, the Latin word for “cattle.” In a.d. 269 the government minted two silver coins: the denarius, equal to 10 asses, and the sestertius, representing 2 1/2 asses.

There is sketchy evidence of currency manipulation during the First Punic War. According to Pliny, the Roman government eliminated its public debt during the time of the First Punic War (268–241 b.c.) by reducing the aes to two ounces of copper. A. R. Burns (1927) states that “the only certain and important currency reduction under the Republic was made during the second Punic War (218–201 b.c.).”

The Lex Flaminia of 217 b.c. provided for the reduction of the legal weight of the as from two ounces to one, and for the reduction of the legal weight of the denarius, decreasing it from one-seventy-second to one-eighty-fourth of a pound of silver. Also, the law raised the value of the denarius from 10 asses to 16 asses, and for military pay a denarius was to be paid for every 10 asses due.

Later, during the Second Punic War, the government issued silver-plated copper coins that passed for denarii। These coins left the mint looking just like sterling silver coins, but even the barbarians that traded with Rome preferred the older silver coins. By mid-second century the Roman Republic was issuing full-bodied metal coins. The Roman Empire hastened its own deterioration with currency debasements, climaxing in a brief episode ऑफ़ wage and price controls at the beginning of the fourth century.

The spread of state-managed paper money made currency debasements an obsolete method of financing government expenditures in excess of tax revenue.

Lex Aternia-Tarpeia of 454 b.c. (Rome)

With the Lex Aternia-Tarpeia of 454 b.c., sometimes called the Tarpeian law, the Romans took a historic step toward replacing livestock money with metallic currency. In 454 b.c. Rome sent three commissioners to Athens to study Athenian laws. Before Solon’s reform of Athenian law in 600 b.c. the laws of Draco had provided for payment of fines in cattle and sheep. One of Solon’s contributions to Athenian law was a provision that allowed fines expressed in cattle and sheep to be paid in metallic money. Among the outcomes of the Roman commissioners’ visit was the Tarpeian law. Prior to the Tarpeian law the Romans fixed fines in livestock. Culprits guilty of minor offenses paid a fine of 2 sheep, while grave offenses drew fines ranging up to 30 oxen.

According to the Tarpeian law, payments defined in oxen could be paid in copper asses. The Roman aes or as began as a pound of copper, although it suffered the fate of many metallic currencies as the copper content was steadily reduced by law. It may have been measured in lengths of rods and was not coined until the fourth century b.c. The Tarpeian law valued an ox at 100 copper asses, and a sheep at 10 asses. In 452 b.c. the Romans drew up a constitution, the Twelve Tables of Law, which again called for penalties to be paid in copper and gold units without mentioning cattle.

Probably a major factor pushing the Romans toward greater reliance on metallic currency was the need to pay soldiers and government expenses in a more acceptable currency. Coins had circulated in Greece since the eighth century b.c. and Athens had begun coining money at the end of the seventh century.

Nearly 20 years after the Tarpeian law, in 430 b.c., the Roman Senate enacted the Lex Julia-Papiria, which mandated that metallic currencies replace payments in cattle. According to Cicero, this law came about because “the Censors had, through the vigorous imposition of fines of cattle, converted many private herds to the public use,” and therefore “a light tax in lieu of a fine of cattle was substituted.”

Compared to other Mediterranean societies, the Romans were slow to adopt metallic currency and coinage. Nevertheless, copper slowly superseded cattle as the principal standard of value, and the Romans sought to preserve the link between the cattle standard and the copper standard by stamping the first Roman copper coins with figures of cattle. The copper standard of the ancient Romans has left some vestige in modern language. In English the words “estimate” and “esteem” are derived from the Latin word astimare, which originated from expressing values in copper asses.

Legal Tender

Money is legal tender when creditors are legally obliged to accept it in payment of debts. The words “This note is legal tender for all debts, private and public,” appears on all Federal Reserve Notes, meaning that these notes are acceptable in payment of taxes or other obligations owed to the government and also that creditors must accept the notes in payment of all private debts.

In the expression legal tender the word tender means “offer,” as when an individual tenders his resignation. The term tender with reference to money arose out of actions of creditors against debtors in English courts. A debtor could “tender” to the creditor the amount he or she thought was owed to the creditor. If the creditor thought the sum tendered unacceptable, the debtor could deposit the sum with the court, which would decide if the tender met the debtor’s obligation.

The legal-tender quality of a unit of money can be restricted. The American colonies issued paper money that was acceptable for the payment of public debts, but not private debts. The colonial governments committed themselves to accepting the money in payment of taxes, but did not require private creditors to accept it in payment of debts. Currently in the United States the dime is legal tender for all debts up to $10.

English sovereigns arrogated to themselves the privilege of coining money and stipulated penalties for refusing to accept the king’s coinage at face value. Orders from the crown went so far as to require the acceptance of pennies that had been halved and demanded that anyone refusing to accept half pennies should be seized for contempt of the king’s majesty, imprisoned, and exposed to public ridicule in a pillory.

Although the English government threw the full weight of its sovereign power behind its coinage, disputes between creditors and debtors continued to raise questions, leaving with the courts the final authority for establishing the legal-tender quality of money. An important court case in 1601, The Case of Mixt Monies, set the legal-tender quality of money on firm footing when it demonstrated that creditors had to accept in payment for debts the money that was legal tender when the debt was paid, as opposed to the money that was legal tender when the debt was incurred.

The Constitution of the United States specifies that: “No state shall coin money; make anything but gold and silver coin a legal tender in payment of debts.” Prior to 1862 no paper money in the United States commanded the legal-tender status. Never-theless the government often accepted bank notes and treasury notes in payment of taxes and public land sales, giving the paper money some legal-tender qualities. In 1862, amidst the fiscal crisis of the Civil War, the United States government issued paper money that was legal tender for all private debts, and many, but not all, public debts. The power of the government to issue legal-tender paper money was challenged in the courts, but the wartime crisis clouded the issue at first. When paper money continued to circulate after 1878 the legal-tender issue came before the Supreme Court, and in 1883 the Court ruled in favor of the power of the federal government to issue legal-tender paper money. In 1890 the federal government issued the first paper money that was legal tender in payment of all private debts and all payments owed to the government.

Economists have not always written approvingly of governments using their power to adjudicate disputes to render money legal tender. The famous economist John Stuart Mill wrote in his Principles of Political Economy (Book III, chapter vii):

Profligate governments having until a very modern period never scrupled for the sake of robbing their creditors to confer upon all other debtors a license to rob theirs by the shallow and impudent artifice of lowering the standard; that least covert of all modes of knavery, which consists in calling a shilling a pound that a debt of a hundred pounds may be canceled by the payment of one hundred shillings.

When governments become major debtors they have an incentive to change the standard to pay off the debts, and in the twentieth century governments have printed up legal-tender paper money to cancel large public debts, the post–World War I government of Germany being the most notorious case. Despite the latent possibility for abuse, governments worldwide issue legal-tender paper money, which poses no problems as long as the supply is restricted to noninflationary levels.

Legal Reserve Ratio

A legally required reserve ratio is one of the important central bank instruments for changing the stock of money in circulation. The reserve ratio is the fraction of customer deposits banks hold in the form of assets that satisfy a legal definition of reserves. In the United States only vault cash or deposits at a Federal Reserve Bank may legally serve as reserves. A reduction in the legally required reserve ratio, allowing banks to loan out more depositor funds, leads to an expansion of the money stock. Raising this ratio reduces the money stock.

Commercial banks accept deposits of funds from customers. On a given day the fresh deposits approximately offset withdrawals from earlier deposits, leaving the bank with an average level of deposits available for loans to customers. Banks keep a fraction of these deposits as reserves to keep the bank solvent during those intervals when fresh deposits fall short of withdrawals. Without government regulation of reserve requirements, banks often fall prey to the temptation to trim reserves too thinly and come up short of funds if depositors suddenly place heavy demands for cash withdrawals. Because reserves are funds that are not invested, and therefore not earning income, banks have an incentive to hold reserves to a minimal level.

In the United States the Banking Act of 1935 authorized the Board of Governors of the Federal Reserve System to vary the legally required reserve ratio within prescribed limits. Before the Act of 1935 legal reserve ratios were set by statute. From 1935 until 1980 the Board of Governors could change the reserve requirements of commercial banks that were members of the Federal Reserve System, which included all commercial banks with national charters. State banks remained subject to state statutory reserve requirements until 1980. The Depository Institution Deregulation and Monetary Control Act of 1980 gave the Board of Governors authority to set reserve requirements for all depository institutions. The legal reserve ratio is usually set well below 20 percent. In 1992 the Board of Governors reduced the ratio from 12 to 10 percent.

If the level of deposits in a bank rises by $1,000, and the legal reserve ratio is 10 percent, the bank has to retain only $100 as reserves and can loan out the other $900. If the reserve ratio is cut for all banks, each bank can immediately loan out more funds.

Furthermore, as deposits at each bank grow from the lending at other banks, each bank can loan out a share of new deposits. The cumulative effect of these actions on the ratio of customer deposits to vault cash and deposits at the Federal Reserve Banks can be dramatic. If the legal reserve ratio decreased from 20 percent to 10 percent, the ratio of customer deposits to vault cash and deposits at the Federal Reserve Banks could double. Because bank deposits account for the lion’s share of money supply measures, a reduction in the legal reserve ratio can sharply increase the money stock. An increase in the legal reserve ratio can have an equally blunt impact on the money stock in the opposite direction.

Significant controversy arose out of one of the early policy actions using legal reserves requirements. In 1936 commercial banks were flush with reserves, representing a potential for substantial increase in lending and monetary growth. The United States economy was still inching out of the depression, but the banking system brimming over with reserves aroused inflationary fears. The Board of Governors virtually doubled reserve requirements to mop up excess reserves. In 1937 the recovery stalled out, nosing the economy over into another recession, and many observers put the blame at the feet of the improper use of legal reserve requirements by the Board of Governors.

Today legal reserve ratios are one of the less important means of regulating monetary growth. Small changes in legal reserve ratios have powerful effects and create management difficulties for banks. Open market operations have become the most important means of regulating the money stock in the United States. Open market operations have to do with central bank purchases and sale of government bonds. When a central bank purchases bonds with new funds, the money stock increases.

Leather-Wrapped Money of Ancient Carthage

The city of Carthage, an ancient Phoenician city in North Africa near the present site of Tunis, was the major rival to Rome during the third and second centuries b.c. It was destroyed by Rome in 146 b.c. in the third and last of the famous Punic Wars. Aeschines, an immediate disciple of Socrates in the fifth century b.c., wrote in his Dialogues of Socrates:

The Carthaginians made use of the following kind (of money): in a small piece of leather, a substance is wrapped of the size of a piece of four-drachmae; but what this substance is, no one knows except the maker. After this, it is sealed (by the state) and issued for circulation.

(Angell, 1929)

Apparently, removing the leather wrapping rendered the pieces worthless. Other classical authors make reference to the leather-wrapped money of Carthage, but make no mention of the nature of the mysterious substance inside the wrapping. More recent scholars have speculated that the “leather” was more likely a parchment, and that the enwrapped substance was either tin or a compound of tin and copper. Perhaps the government of Carthage maintained the value of this fiat money by restricting its supply.

The murky history of the leather-wrapped money of Carthage reveals little about the dates of its circulation, or its success as a stable currency. In the third century b.c. Carthage was the richest Mediterranean city, but no history of Carthage written by Carthaginians has come down to us. This wrapped money may have been the short-lived product of the exigencies of war. Presumably, the Carthaginians no longer needed a fiat money after the opening of the gold and silver mines in Spain early in the fifth century. Carthaginian conquest of Sicily, from which Carthage learned coinage, and control of western Mediterranean sea trade brought on a century-long duel to the death between Rome and Carthage.

The metal currency of the Carthaginians was undistinguished, particularly in light of the high standards set by Greek coinage. The Carthaginians do deserve credit for introducing the equivalent of a paper money in the ancient world of the Mediterranean. In the history of Western civilization the ancients understood the debasement of metal coinage exceedingly well, but only Carthage is credited with developing anything resembling a paper money. China may have predated Carthage in paper money development, but well-documented evidence of paper money in China occurs after the Carthaginian innovation of leather-wrapped money.

Leather Money

Leather money should perhaps be regarded as the most immediate precursor of paper money. It was usually issued as an emergency measure under the stress of war.

The extinct city of ancient Carthage issued a leather-wrapped money before the wars with Rome. The leather wrapping was sealed and the substance inside the wrapping remained a mystery.

Better documentation exists for the use of leather money in France and Italy as an emergency measure. In Normandy Philippe I (1060–1108) used as money pieces of leather with a small silver nail in the middle. Leather currencies also appeared under Louis IX (1266–1270), John the Good (1350–1364), and Charles the Wise (1364–1380). It is not clear whether these leather currencies bore an official stamp. Foreign ransoms had impoverished France of its metallic currencies, necessitating the development of an inferior substitute.

In 1122 Doge Domenico Michaele, ruler of Venice, financed a crusade by paying his troops and fleets in money made of leather with an official stamp. In 1237 the emperor Frederick II of Sicily, one of the first European monarchs to reestablish gold coinage after the long hiatus of the Middle Ages, paid his troops in stamped leather money during the sieges of Milan and Faventia. In 1248 at the siege of Parma he again paid troops in leather money. Frederick’s money was converted into silver at a later date.

Leather money bearing an official stamp bore a close kinship to modern paper money. English history furnishes a few references to leather money. In a speech to Parliament in 1523 Thomas Cromwell commented in referring to the expenses of sending an expedition to France:

Thus we should soon be made incapable of hurting anyone, and be compelled, as we once did to coin leather. This, for my part, I could be content with; but if the King will go over in person and should happen to fall into the hands of the enemy—which God forbid—how should we be able to redeem him? If they will naught for their wine but gold they would think great scorn to take leather for our Prince.

(Einzig, 1966)

Reports exist of leather money on the Isle of Man during the sixteenth and maybe seventeenth centuries. A description of the Isle of Man published in 1726 states that leather currency had a history on the Island of Man, and that men of substance were allowed to make their own money up to a limit.

Law, John

In the Wealth of Nations (1776) Adam Smith observed that “[t]he idea of the possibility of multiplying paper money to almost any extent was the real foundation of what is called the Mississippi scheme, the most extravagant project of banking and stock-jobbing that perhaps the world ever saw.” John Law was the author of the Mississippi scheme. He was a Scottish financier who felt that Scottish industry languished from a lack of money. He conceived the notion that a bank could issue paper money equal in value to all the land in a country. The Scottish Parliament was not interested, but the new regent of France, Philippe d’Orleans, saw Law’s theories as a way out of the bankrupt finances of France. Philippe authorized Law to establish the Banque Generale (1716). Among other things, this was the first bank to issue legal-tender paper money. It accepted deposits, paid interest, and made loans. The value of its paper money was defined in terms of a fixed weight of silver. In April 1717 taxes were made payable in the bank’s paper money.

In 1717 Law secured a royal charter to launch the Mississippi Company. This was a trading company organized to exploit the Mississippi basin. Law sold 200,000 shares of this new company to the public. The price stood at 500 livres per share, but three-fourths of the payment could be made with government notes at face value. These government notes were then worth one-third of their face value. The shares found a ready market in holders of depreciating government notes eager for a piece of a profit-making enterprise. Law became bolder with success and instructed his bank to buy the royal tobacco monopoly and all French companies devoted to foreign trade. These companies he combined with the Mississippi Company for the complete monopolization of French foreign trade.

In 1718 Law’s bank was reorganized as the Banque Royal, and the government made the bank’s paper money legal tender. By 1720 the combination of trading companies known as the Mississippi Company was amalgamated with the bank. The Banque Royal bought up the national debt by exchanging it for shares in the Mississippi Company. Turning the national debt into shares of the Mississippi Company set the example that was soon copied by the South Sea Company in England. The prices of the shares in the Mississippi rose to fantastic heights on a wave of speculative frenzy. Law’s bank continually increased the supply of paper money, much of which was used to bid up the shares in the Mississippi Company. When prices of commodities rose 100 percent and wages 75 percent between 1716 and 1720, the public lost faith in the value of paper money.

In the meantime things were not going well for the Mississippi Company. There were no precious metals to be found and no attraction could induce families to emigrate to the Mississippi basin. Profits fell far short of expectations.

In 1719 the price of the stock peaked and the downward spiral began. Those in the know sold their stock at the peak and redeemed their bank paper money with gold. As the sell-off gained momentum Law’s bank issued paper money to buy the shares of stock. Holders of paper money besieged the bank, demanding silver or gold and several people were killed in the confusion. Law himself was forced to leave France and he passed his declining years as a professional gambler in Venice.

The Mississippi Bubble left a deep distrust of paper money and big banks in the mind of the French people. Nearly a century elapsed before France was willing to try paper money again. Learning the pitfalls of paper money has been a slow process in modern capitalist countries. Angola, Argentina, and Bolivia rank among the countries that have experienced hyperinflation in the post–World War II era.

Latin Monetary Union

One of the early efforts to establish a uniform and universal coinage, equally acceptable in all countries, led to the formation of the Latin Monetary Union. The union itself came to life through the work of a conference held in Paris, France, in 1865. In addition to France, three other countries, Italy, Switzerland, and Belgium, participated in the conference, all three of which were on the French bimetallic system. This conference was the first international meeting on monetary affairs.

Under a bimetallic system silver and gold coins circulated as money and the government set the value of silver relative to gold at a fixed ratio. Before the conference the value of silver was rising, causing holders of silver to buy gold and leading to the disappearance of silver. Switzerland debased the value of its silver coins to address the problem, and France responded by banning the acceptance of Swiss coins in public offices. The immediate technical problem facing the conference participants was the overvaluation of silver. Under the bimetallic system of the Latin Monetary Union, 15.5 ounces of silver stood equal to 1 ounce of gold in all member countries.

The conference participants saw the treaty creating the Latin Monetary Union put into effect on 1 August 1866. The States of the Church (the lands in central and north-central Italy that were ruled by the pope) joined the union later in 1866, followed by Bulgaria and Greece in 1867. Member countries minted gold pieces in denominations only of 100, 50, 20, 10 and 5 francs. They also minted silver pieces in denominations of 5, 2, and 1 francs and 50 and 20 silver centimes. Each country minted coins that were made legal tender and circulated throughout the union.

In 1867 France called another conference to discuss the establishment of a uniform world monetary system. Hopes of expanding French influence and prestige may have supplied the motive that pushed Louis Napoleon to call the conference. The need to keep the bimetallic monetary standard alive and working in the face of competition from England’s gold standard may also have been a contributing factor.

The United States accepted the concept of a world monetary union and made a case for France to begin minting a 25-franc gold piece. Spokesmen for the United States, whose arguments for the 25-franc piece fell on deaf ears in France, observed that:

[S]uch a coin will circulate side by side everywhere and in perfect equality with the half eagle of the United States and the sovereign of Great Britain. These three gold coins, types of the great commercial nations, fraternally united and differing only in emblems, will go hand in hand around the globe freely circulating through both hemispheres without recoinage, brokerage, or other impediments. This opportune concession of France to the spirit of unity will complete the work of civilization she has had so much at heart and will inaugurate that new monetary era, the lofty object of the international conference, and the noblest aim of the concourse of nations, as yet without parallel in the history of the world.

(Chown, 1994)

The conference ended without reaching an agreement, only passing a resolution to meet again. England had refused to support the plan for a world monetary union, but did establish a Royal Commission on International Coinage to study the findings of the conference. The commission acknowledged the advantages of an international currency, citing that:

Small manufacturers and traders are deterred from engaging in foreign transactions by the complicated difficulties of foreign coins by the difficulty in calculating the exchanges, and of remitting small sums from one country to another. Anything tending to simplify these matters would dispose them to extend their sphere of operations.

(Chown, 1994)

Nevertheless, the commission cited numerous practical considerations that stood in the way of forming an international currency.

The commercial success of Great Britain persuaded the major trading partners of the world that the gold standard was the wave of the future। The fate of the bimetallic system of the Latin Monetary Union was sealed when France lost the Franco-Prussian War and had to pay war reparations to Germany. The war reparations enhanced Germany’s gold reserves, giving Germany the wherewithal to follow England’s example and adopt the gold standard. The value of silver dropped sharply, and the members of the Latin Monetary Union had to restrict the coinage of silver. The union wobbled on until the 1920s when the strains of war and diverging gold and silver prices put an end to the system.

The idea of a European monetary union, complete with a European central bank, became a reality on 1 January 1999 when the European Central Bank launched the euro. The euro does not presently circulate as bank notes or coins, but only as money of account. It will eventually circulate as bank notes and coins, and will replace major European currencies, such as the German mark and the French franc. This monetary union with its uniform currency will end the risk of fluctuations in foreign exchange rates and the inconvenience of converting domestic money into foreign exchange, thus easing the path for the growth of international trade.

Larin

The larin was a Persian coin that acted as international currency in the Indian Ocean trading area in the sixteenth through eighteenth centuries. For reasons unknown, the city of Lar in Iran gave its name to the larin, but the coin seems never to have been minted in that city. The larin was a silver coin.

As coins go the larin was a bit unusual, even for a period as early as the sixteenth century. Rather than a coin struck from a circular blank of metal, the larin was made of a strip of silver wire, bent in two, and stamped with circular or rectangular dies. The Safavid Shah Tahmasp, ruler of Hormuz, now southern Iran, struck the first larins during the mid-sixteenth century. India and Ceylon also minted larins, as did Arabia under the Ottomans, but the larins struck by the Safavids traded at a premium, owing to the purity of their silver metal.

In the sixteenth and seventeenth centuries larins were overvalued in terms of silver content, and silver flowed into Persia from European trade with the Levant. The law required Persian merchants receiving foreign coins to bring all these coins to the mint to be restruck as larins. The merchants had to pay the mint charge but the overvaluation of the larin offset these costs.

During the seventeenth century the Spanish real, forebear to the U.S. dollar, began to displace the larin in Indian Ocean and Far Eastern trade. Persian merchants smuggled in Spanish reales and Persian caravans and sea-going vessels laden with reals left Persia for trade with India. Early in the eighteenth century the Iranian and Indian currency was unified and the new currency was called the rupee, but by then Spanish reals dominated world trade.

Land Bank System (American Colonies)

During the first half of the eighteenth century, land banks infused paper currency into the economies of the American colonies, helping to relieve the shortage of money that hampered trade and industry. Aside from two short-lived exceptions, these were public banks, functioning under the auspices of colonial governments.

Land banks loaned paper money to citizens who put up collateral in the form of some sort of real estate, such as farmland or houses in town. Borrowers ran the risk of forfeiting their property in the event of default, although the land banks, as public institutions, enjoyed reputations for extending the terms for debtors in difficulty. The real estate nevertheless stood as security maintaining the value of the paper money, and foreclosure was a legitimate weapon. When foreclosure failed to produce sufficient revenue to redeem the paper currency, then governments were usually obliged to make good the paper money. The borrowers paid interest on the loans, which in most colonies went to pay governmental expenses. Often a local public board of property-owning citizens acted as a loan board, approving and disapproving loans as it saw fit. In other cases provincial officials at a higher level made these decisions. These boards or officials received an allotment of paper currency for issuance in a given locality.

During the seventeenth century several proposals were floated for organizing private land banks in the American colonies, particularly in Massachusetts, but invariably the colonial assemblies refused to grant charters for these private ventures. In 1712 South Carolina led the way in the land bank movement when it established the first public land bank in the American colonies. Other colonies quickly followed the example set by South Carolina. Massachusetts founded a land bank in 1714, Rhode Island in 1715, New Hampshire in 1717, New Jersey and Pennsylvania in 1723, North Carolina in 1729, Maryland in 1731, Connecticut in 1732, and New York in 1737.

The English government viewed all colonial paper money as a threat to English creditors who faced severe loses if colonists sought to wipe out debts with a round of inflation. In 1720 royal governors in America received orders from London to suspend the operation of any land bank, pending approval from the Privy Council. Both American and English officials, however, were slow to take action. The land bank in Massachusetts remained in operation until 1730 and the land banks in the other colonies until 1740.

The saga of the land banks is another chapter in the struggle of the American colonies to fill the vacuum in the colonial money supply left by the outflow of hard specie in payment for European imports. England aggravated the money shortage by squashing efforts to mint coins in the colonies and severely restricting the authority of colonial governments to issue paper money. After the American Revolution, the Articles of Confederation granted state governments authority to establish mints and issue paper currency. The United States Constitution gave Congress sole authority to coin money and regulate the money supply.

Labor Notes

Labor notes, a unique monetary experiment in early nineteenth-century England, bore a face value equivalent to a certain number of hours of work. The notes were the brainchild of Robert Owen (1771–1858), a successful textile manufacturer in England who rose to fame as a utopian socialist reformer at the beginning of the Industrial Age. He is famous in the United States for involvement with New Harmony, Indiana. In 1825 Owen purchased 30,000 acres of land in Indiana and launched New Harmony as a cooperative society, a project that would cost him 80 percent of his fortune before he abandoned it.

In 1832 Owen was publishing a penny journal, The Crisis, in which he publicized his plan to form an association for the exchange of all commodities upon the principle of the numbers of hours of labor embodied in each commodity. All commodities that required the same amount of labor to produce were to be traded evenly, and other commodities were to be exchanged at ratios ruled by the number of hours of labor required to produce each one. If it took two hours of labor to produce product A and one hour of labor to produce product B, then it took two units of product B to purchase one unit of product A. Owen adapted his plan from the labor theory of value, a widely accepted concept among nineteenth-century economists, which held that all value comes from labor.

To carry out his plan, Owen opened the Equitable Labor Exchange on 3 September 1832 at a building called the Bazaar on Gray’s Inn Road, London. Producers and manufacturers brought goods to the exchange, and received in return labor notes equal to the amount of labor required to produce the goods. The labor notes could be used to buy other goods at the exchange, which were priced based upon the hours of labor that went into producing each good. Exchanges opened in different regions, and one of the largest was in Birmingham, where two series of labor notes were issued in denominations of 1, 2, 5, 10, 50, and 80 labor-hours.

The exchanges were short-lived. It was a utopian idea that could not compete with a market system that incorporates all the available information that affects the prices of goods and services. Owens closed down the London exchange in March 1834 and paid off a 2,000-pound deficit the exchange had run up.