Global Financial Evolution

A Project Submitted to
University of Mumbai for partial completion of the degree of
Bachelor in Commerce (Financial Markets)
Under the Faculty of Commerce

By

Aaryan Jignesh Bhagat

Under the Guidance of

HARESH SIR
KJ SOMAIYA COLLEGE OF ARTS ANDS COMMERCE
Mahul Rd, Vidyanagar, Vidya Vihar East, Ghatkopar East, Mumbai, Maharashtra 400077

MAY 2022

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 Global Financial Evolution

A Project Submitted to
University of Mumbai for partial completion of the degree of
Bachelor in Commerce (Financial Markets)
Under the Faculty of Commerce

By

Aaryan Jignesh Bhagat

Under the Guidance of

HARESH SIR
KJ SOMAIYA COLLEGE OF ARTS ANDS COMMERCE
Mahul Rd, Vidyanagar, Vidya Vihar East, Ghatkopar East, Mumbai, Maharashtra 400077

MAY 2022

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 Index
Sr.no. Particulars Page no.
1 Introduction 7
2 History of Finance 8-60
3 Present day finance 60-70
4 Future of Finance 70-73
5 Conclusion 73-75

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 KJ SOMAIYA COLLEGE OF ARTS ANDS COMMERCE
Mahul Rd, Vidyanagar, Vidya Vihar East, Ghatkopar East, Mumbai, Maharashtra 400077

Certificate
This is to certify that Ms/Mr _____________________________________has worked and duly
completed her/his Project Work for the degree of Bachelor in Commerce (Financial Markets) under the
Faculty of Commerce in the subject of ________________________________________ and her/his
project is entitled, “____________________________________________________” under my
supervision.
I further certify that the entire work has been done by the learner under my guidance and that no part of it
has been submitted previously for any Degree or Diploma of any University.
It is her/ his own work and facts reported by her/his personal findings and investigations.

Name and Signature of Guiding Teacher

Date of submission:

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 Declaration by learner
I the undersigned Miss / Mr. ____________________________ here by, declare that the work embodied
in this project work titled
“_________________________________________________________________________”, forms my
own contribution to the research work carried out under the guidance of
________________________________ is a result of my own research work and has not been previously
submitted to any other University for any other Degree/ Diploma to this or any other University.
Wherever reference has been made to previous works of others, it has been clearly indicated as such and
included in the bibliography.
I, here by further declare that all information of this document has been obtained and presented in
accordance with academic rules and ethical conduct.

Name and Signature of the learner

Certified by
Name and signature of the Guiding Teacher

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 Acknowledgment
To list who all have helped me is difficult because they are so numerous and the depth is so enormous.
I would like to acknowledge the following as being idealistic channels and fresh dimensions in the
completion of this project.
I take this opportunity to thank the University of Mumbai for giving me chance to do this project.
I would like to thank my Principal, __________for providing the necessary facilities required for
completion of this project.
I take this opportunity to thank our Coordinator_______________, for her moral support and guidance.
I would also like to express my sincere gratitude towards my project guide _____________ whose
guidance and care made the project successful.
I would like to thank my College Library, for having provided various reference books and magazines
related to my project.
Lastly, I would like to thank each and every person who directly or indirectly helped me in the
completion of the project especially my Parents and Peers who supported me throughout my project.

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 1. Introduction

In preindustrial economies, finance was largely concerned with the development of a medium of
exchange.
Barter was inefficient, transaction costs were high, and the lack of a medium of exchange limited the
extent of the market and the opportunity for specialization.
With the growth of nonlocal trade, the development of payment media became linked to the financing of
trade. Otherwise, apart from the financing of governments and seaborne trade, borrowing and lending
were mostly informal and on a small scale.
The spread of urban society, and above all the advent of large-scale industrialization in the second half of
the nineteenth century, altered the role that finance had to play.
Finance was now concerned with mobilizing resources for large infrastructure projects and for
investments with heavy capital requirements that exceeded the capabilities of small family firms.
The systems that emerged often suffered from fraud and mismanagement. They proved unstable and
experienced frequent crises. Speculative manias, fuelled by financial institutions, caused mounting
concern, and after the Great Depression of the 1930s governments began to supervise their financial
systems more closely. But government intervention was by no means entirely successful. It made the
financial system less flexible, and although it reduced fraud it did not eliminate it.
Moreover, economic agents proved adept at getting around the regulations. In recent years the focus has
shifted back to deregulation, partly in response to financial innovation and partly to promote competition
and efficiency. The evolution of financial systems ought to cast light on two questions that are of interest
to policymakers in developing countries. What role should financial systems play in promoting
industrialization and development? And what role should governments play in creating such systems?

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 2. A Brief History of Finance

Today it would be difficult to survive a few days without money, but before the industrial revolution most
people had livestock and grew the food that they consumed. They also generally lived in family housing
that was passed down through the generations.

As towns grew in size most people were paid money that was used to buy essential food and
accommodation.

In today's capitalist society consumers are offered the possibility of obtaining a bewildering choice of both
essential and non-essential goods.
Methods of payment include:
a) Physical cash,
b) Electronic money
c) Legally binding contracts (such as a mortgages).

Formerly it was only the rich who were concerned with investing money, but now money is used like a
commodity (rather like sheep and goats were in agrarian societies several hundred years ago) and it is
important for all citizens to understand it.

The search for an efficient medium of exchange gradually led to the monetization of precious metals. As
a result, the payment mechanism became simpler and safer. The new monies facilitated trade and
provided a store of value and a unit of account. Governments played an important part in this change by
owning and regulating mints and thus ensuring the quality and acceptability of coins. But they were also
frequently responsible for debasing coins by lowering their weight or adulterating them with less precious
metals, such as copper.

Metallic payment was a big step forward. Gradually, however, paper-based instruments, which were
cheaper and more convenient, came to replace coins and bullion. Payment orders, letters of credit, and
negotiable bills of exchange evolved 41 with the expansion of nonlocal trade in Europe. These were
particularly useful in triangular trade, because only net settlements had to be made in specie. Commercial
bills known as hundi were developed in India. In Japan, the need for cash was reduced by the use of bills
and rice warehouse warrants and by the development of clearing facilities.

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 Trade and Commerce in India

Ancient India

During the period of the Harappan Civilization the trading network, both within the country (internal)
and foreign (external) was a significant characteristic of the Harappan urban economy. A village- town
(urban- rural) interrelationship developed due to the dependency of the urban population for the supply of
food and many other necessary products on the surrounding countryside. In the similar fashion, the
craftsmen belonging to urban areas required markets to sell their goods in other areas; it necessitated the
contact between the towns.

As various kinds of metals and precious stones, which were needed by craftsmen to make goods, were not
available locally, they had to be brought from outside. Lapis-lazuli, the precious stones used for making
beads, was located in Badakshan mines in North-east Afghanistan. Turquoise and Jade have been
brought from Central Asia.

In the field of external trade, the people of the Harappan Civilization were engaged with Mesopotamia
largely through Oman and Bahrain in the Persian Gulf. This has been confirmed by the presence of
artefacts, belonging to the Harappan Civilization, such as beads, seals, dice, etc. in these regions;
in Mesopotamia cities like Susa, Ur, etc. about two dozen of Harappan seals have been found. Apart
from seals, other artefacts belonging to the Harappan Civilization which have been discovered comprise
potteries, etched carnelian beads and dices with Harappan features.

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Medieval India

Interregional trade played an important role in the Mauryan Empire. The Political unity and military
security that was rising in the empire at the time helped develop a common economic system, increased
agricultural productivity, and enhanced trade and commerce. The Mauryan Empire benefited from
expanded contact from the different regions of the world resulting from trade throughout West Asia and
the Roman Empire. The trade relied on seaports, the Silk Road, and Khyber Pass, which were all the
important main routes of exchange. Trade benefited the peoples of the empire because they would
exchange their abundant resources for the supplies that were in high demand. The resources that were
often trades were ivory, cotton, silks, and spices for the resources they needed including, lead and wine
and other new products to the empire that were found useful. Chandragupta Maurya established a single
currency across India, which made trade easier. As well as establishing a single currency, Mauryan used
Camel labour because it was a useful and effective tool for trading to their distant neighbours across the
Silk Road in China. Trade overall influenced both the empires culture to change within its self and its
own culture be spread throughout the world.

The increase in India’s trade led to the rise of bankers and financiers among the citizens of the empire.
This is because the bankers and financers gave support to monarchies and landlords short on cash.
Families in banking and commerce extended their enterprises into as many urban centres as they could in
India and even beyond. This increase in trade brought a rise in intellectual activity among the people of
the Mauryan Empire, just as trade had among the Greeks, Romans and countless other empires across the
world. Science and the arts flourished as well. Buddhism, a religion born in the empire spread throughout
the world. Overall, trade had gone beyond the original roots of exchanging goods. People, technology,
religion, crops, and animals all developed along the way as a successful network of communication and
exchange.

From the years 185 BCE to CE 300, the Mauryan Empire had faced many problems. Surprisingly enough,
trade was hardly affected by the troubles and trade continued, with more being sold to the Roman Empire
than was being imported. In India, Roman coins were piling up. At the time, India was being invaded by
the Kushan empire, however the Kushan invaders were absorbed by the empire, Kushan kings adopting
the manners and language of the empire and intermarrying with Mauryan Empires royal families. The
power of the region had bounced around hands dramatically between north and south India. The southern
kingdom of Andhra conquered Magaha in 27 BCE, ending the Sunga dynasty in Magadha. While Andhra
extended its power in the Ganges Valley, creating a new bridge between the north and the south.
However, this came to an end as Andhra and two other southern kingdoms weakened themselves by
warring against each other. By the early 300s CE, power in India was returning to the Magadha region,
and India was entering what would be called its classical age.

The economy of the Mauryan was an overall accomplishment due to trade. The Indo-Greek friendship
treaty was the empires key to a successful trade operation. The Silk Road as well as the sea routes
provided a way to get their goods to other areas, and the Khyber Pass, located on the modern border of
Pakistan and Afghanistan, developed into a strategically important place of trade and contact with the rest
of the world. Through the Khyber Pass on the Silk Road and the sea routes the Mauryan could trade with
Greece, Hellenic kingdoms, China and the Malay Peninsula in West Asia. The main exports sent to those
empires were silk, textiles, spices and exotic foods. While at the same time the Mauryan Empire was
gaining resources valuable to them. Technology and science ideas were also exchanged with Europe and
West Asia. This peace and tranquillity that the Mauryan dynasty was experiencing, resulted in internal
trade within the empire flourished as well, such as beliefs and religion. The political unity allowed people
from different areas of Mauryan India to travel and sell their merchandise at markets around their domain.
Immigration of people from the Mauryan Empire spreading the culture across the world also occurred.
The trade and economy of the Mauryan dynasty was one of the empires most influential achievements.

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Pre-British India

Delhi Sultanate Economy

• Under the Delhi Sultanate, certain land reforms were introduced in the revenue department. The
lands were categorised into three classes-
• Iqta land – the lands which were allotted to the officials as iqtas instead of payment for
their services.
• Khalisa land – it was directly under the control of the Sultan and the revenue generated
was utilised for maintaining the royal court and royal household.
• Inam land – it was allotted to religious institutions or religious leaders.
• The farmers paid 1/3rd of their produce as land revenue and sometimes even half of the produce.
They also had to pay other taxes and lived miserable lives. However, Sultans like Muhammad Bin
Tughlaq and Firoz Tughlaq provided better irrigation facilities and also takkavi loans which
helped in the increased agricultural production. They also promoted the cultivation of crops like
wheat rather than barley. A separate agriculture department, Diwan-i-Kohi was set up by
Muhammad Bin Tughlaq. Firoz Tughlaq promoted the growth of the horticulture sector.
• A number of cities and towns had grown during this period which led to rapid urbanisation. The
important cities were – Multan, Lahore (north-west), Anhilwara, Cambay, Broach (west),
Lakhnauti and Kara (east), Jaunpur, Daulatabad and Delhi. Delhi was the largest city in the east. A
large number of items were exported to the Persian Gulf countries and West Asia and also to
Southeast Asian countries. Overseas trade was dominated by Khurasanis (Afghan Muslims) and
Multanis (mostly Hindus). Inland trade was under the control of Gujarati, Marwari and Muslim
Bohra merchants. These merchants were rich and lived luxurious lives.
• Roads were built and maintained for facilitating smooth transport and communication. The royal
roads were especially kept in good shape. In addition to the royal road from Peshawar to
Sonargaon, Muhammad Bin Tughlaq built a road to Daulatabad. Sarai’s or rest houses were
constructed on the highways for the benefit of the travellers.
• During the Delhi Sultanate, the silk and the cotton textile industry thrived. The introduction of
sericulture on a large scale made India less reliant on other countries for the import of raw silk.
Paper was widely used from the 14th and 15th centuries which led to the growth of the paper
industry. Other crafts like carpet weaving, leather making and metal crafts also flourished due to
the rise in their demand. The goods needed by the Sultan and his household were supplied by the
royal karkhanas. Expensive articles made of gold and silver were produced by the royal
karkhanas. The nobles were paid well and they copied the lifestyle of the Sultans and lived a
pleasurable life.
• The system of coinage had also boomed during the Delhi Sultanate. Several types of tankas were
issued by Iltutmish. During the Khalji rule, one tanka was divided into 48 jitals and 50 jitals
during the Tughlaq rule. After the south Indian conquests by Alauddin Khalji, gold coins or dinars
became popular. Copper coins were fewer in number and dateless. Muhammad Bin Tughlaq
experimented with token currency and also issued different types of gold & silver coins. The coins
were minted at different places. At least twenty-five different types of gold coins were issued by
him.
• The Turks popularised a number of crafts and techniques like the use of iron stirrup, use of armour
(for both the rider and the horse), improvement of Rahat (Persian wheel which helped in lifting the
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 water from deeper levels), the spinning wheel and an improved loom for carpet weaving, use of
superior mortar, which helped to erect magnificent buildings based on the arch and dome, etc.

Pre Independence Period

The first bank of India was the “Bank of Hindustan”, established in 1770 and located in the then Indian capital,
Calcutta. However, this bank failed to work and ceased operations in 1832.
During the Pre Independence period over 600 banks had been registered in the country, but only a few
managed to survive.
Following the path of Bank of Hindustan, various other banks were established in India. They were:

• The General Bank of India (1786-1791)

• Oudh Commercial Bank (1881-1958)
• Bank of Bengal (1809)
• Bank of Bombay (1840)
• Bank of Madras (1843)
During the British rule in India, The East India Company had established three banks: Bank of Bengal, Bank
of Bombay and Bank of Madras and called them the Presidential Banks. These three banks were later
merged into one single bank in 1921, which was called the “Imperial Bank of India.”
The Imperial Bank of India was later nationalised in 1955 and was named The State Bank of India, which is
currently the largest Public sector Bank.
Given below is a list of other banks which were established during the Pre-Independence period:

Pre-Indepence Banks in India

Bank Name Year of Establishment

Allahabad Bank 1865

Punjab National Bank 1894

Bank of India 1906

Central Bank of India 1911

Canara Bank 1906

Bank of Baroda 1908

If we talk of the reasons as to why many major banks failed to survive during the pre-independence period,
the following conclusions can be drawn:

• Indian account holders had become fraud-prone

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 • Lack of machines and technology
• Human errors & time-consuming
• Fewer facilities
• Lack of proper management skills
Following the Pre-Independence period was the post-independence period, which observed some significant
changes in the banking industry scenario and has till date developed a lot.

Post Independence Period (1947-1991)

At the time when India got independence, all the major banks of the country were led privately which was a
cause of concern as the people belonging to rural areas were still dependent on money lenders for financial
assistance.
With an aim to solve this problem, the then Government decided to nationalise the Banks. These banks were
nationalised under the Banking Regulation Act, 1949. Whereas, the Reserve Bank of India was nationalised
in 1949.
Candidates can check the list of Banking sector reforms and Acts at the linked article.
Following it was the formation of State Bank of India in 1955 and the other 14 banks were nationalised
between the time duration of 1969 to 1991. These were the banks whose national deposits were more than
50 crores.
Given below is the list of these 14 Banks nationalised in 1969:

1. Allahabad Bank
2. Bank of India
3. Bank of Baroda
4. Bank of Maharashtra
5. Central Bank of India
6. Canara Bank
7. Dena Bank
8. Indian Overseas Bank
9. Indian Bank
10. Punjab National Bank
11. Syndicate Bank
12. Union Bank of India
13. United Bank
14. UCO Bank

In the year 1980, another 6 banks were nationalised, taking the number to 20 banks. These banks included:

1. Andhra Bank
2. Corporation Bank
3. New Bank of India
4. Oriental Bank of Comm.
5. Punjab & Sind Bank
6. Vijaya Bank

Apart from the above mentioned 20 banks, there were seven subsidiaries of SBI which were nationalised in
1959:

1. State Bank of Patiala

2. State Bank of Hyderabad
3. State Bank of Bikaner & Jaipur

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 4. State Bank of Mysore
5. State Bank of Travancore
6. State Bank of Saurashtra
7. State Bank of Indore

All these banks were later merged with the State Bank of India in 2017, except for the State Bank of
Saurashtra, which merged in 2008 and State Bank of Indore, which merged in 2010.

Impact of Nationalisation
There were various reasons why the Government chose to nationalise the banks. Given below is the impact
of Nationalising Banks in India:

• This lead to an increase in funds and thereby increasing the economic condition of the country
• Increased efficiency
• Helped in boosting the rural and agricultural sector of the country
• It opened up a major employment opportunity for the people
• The Government used profit gained by Banks for the betterment of the people
• The competition decreased, which resulted in increased work efficiency
This post Independence phase was the one that led to major developments in the banking sector of India and
also in the evolution of the banking sector.

Liberalisation Period (1991-Till Date)

Once the banks were established in the country, regular monitoring and regulations need to be followed to
continue the profits provided by the banking sector. The last phase or the ongoing phase of the banking
sector development plays a hugely significant role.
To provide stability and profitability to the Nationalised Public sector Banks, the Government decided to set up
a committee under the leadership of Shri. M Narasimham to manage the various reforms in the Indian
banking industry.
The biggest development was the introduction of Private sector banks in India. RBI gave license to 10 Private
sector banks to establish themselves in the country. These banks included:

1. Global Trust Bank

2. ICICI Bank
3. HDFC Bank
4. Axis Bank
5. Bank of Punjab
6. IndusInd Bank
7. Centurion Bank
8. IDBI Bank
9. Times Bank
10. Development Credit Bank

The other measures taken include:

• Setting up of branches of the various Foreign Banks in India

• No more nationalisation of Banks could be done
• The committee announced that RBI and Government would treat both public and private sector banks
equally
• Any Foreign Bank could start joint ventures with Indian Banks

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 • Payments banks were introduced with the development in the field of banking and technology
• Small Finance Banks were allowed to set their branches across India
• A major part of Indian banking moved online with internet banking and apps available for fund transfer
Thus, the history of banking in India shows that with time and the needs of people, major developments have
been brought about in the banking sector with an aim to prosper it.

The Greeks

The first official coinage was made from a mixture of gold as silver and was minted in Lydia during the
seventh century BC. In Greece from the sixth century BC to the first century AD there were the following
six types of loans:

1. Loans for personal or productive use; similar to bank loan to a small business.
2. Loans secured on real estate.
3. Loans to cities.
4. Endowments invested and paying specified rate of return.
5. Loans to industry and commerce - these were probably speculative short-term loans.
6. Personal and miscellaneous loans - these could be as high as 48% per month.

There is also mention of the first option contract dating back to 624 BC - 546 BC. According to Aristotle,
Thales predicted, through studying the stars during the winter, that there would be a great harvest of
olives in the following year. He then bought the rights to use all the olive presses in Chios and Miletus; he
did this at a low price because no one bid against him. Thales’ forecast turned out to be correct. The
ensuing abundant harvest meant that there was a great demand for olive presses, and Thales was able to
sell the rights to use the presses at a great profit, see Aristotle's Politics, Book I, Chapter 11.

Medieval Europe Around the time of the first crusade (1095-1099) Genoa emerged as a major sea power
and trading centre and its fairs attracted traders from around the Mediterranean. To deal with the issue of
different currencies a forum was established for arbitrating the exchange rates to use. On the third day of
each fair a representative body composed of recognized merchant bankers would assemble and determine
the exchanges that would prevail. The process involved each banker suggesting a rate and, after some
discussion, a vote would determine the currency exchange rates. Similar practices were later adopted at
other medieval fairs. For example, at Lyon, Florentine, Genoese and Lucca bankers would meet to
determine exchange rates. Fairs at different locations would typically have different exchange rates, and
these provided an opportunity to profit from the variation. Bills of exchange were developed during the
Middle Ages as a means of transferring funds and making payments over long distances without
physically moving large quantities of precious metals. Thirteenth-century Italian merchants, bankers, and
foreign exchange dealers, developed the bill of exchange into a powerful financial tool, enabling short-
term credit transactions as well as foreign exchange transactions, for more detail see Smith (1776/1952).

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The following example shows the usefulness of bills of exchange: Assume that a merchant in Flanders
sold goods to a Venetian merchant and accepted in payment a bill of exchange drawn on the Venetian
merchant promising to pay an agent of the Flemish merchant in Venice at a certain date in the future, and
in a certain currency. The bill of exchange allowed the Venetian merchant to accept delivery of the goods
from Flanders, sell them, and take the proceeds to redeem the bill of exchange in Venice, probably in
Venetian currency. Bills of exchange were also instruments for foreign exchange transactions. Merchants
in Italy and major trading centres in Europe bought bills of exchange payable at future dates, in other
places, and different currencies. In the example above, the Flemish merchant could sell the bill of
exchange to an exchange dealer for currency of his own choosing. In turn, the exchange dealer could sell
the bill of exchange to a Flemish merchant engaged in buying goods in Venice. When the bill came due
for payment in Venice, the Flemish merchant would use it to buy goods in Venice where the bill of
exchange was paid. While this process seems complicated, it substantially reduced the transportation of
precious metals. In our example, a Venetian merchant bought goods from Flanders, and a Flemish
merchant bought goods from Venice without any foreign currency leaving Venice or Flanders. Bills of
exchange also allowed bankers to evade usury laws by hiding interest charges in exchange rate
adjustments that governed foreign exchange transactions.

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Over the centuries, trade routes have been established that connected places where goods were produced
with people living in other places who wanted to buy these items. Often, specific goods such as salt and
spices were scarce and in high demand. People wanted and needed these things, so they were willing to
travel to get them or to pay others to get them and bring them back. The creation of trade networks
involved roads between points, and these roads many times became well-travelled. Not only were goods
transported over these roads, but people also shared knowledge, ideas, religious practices, and even
illness in some cases.

The Silk Road

The Silk Road may be the most famous ancient trade route. This route connected China and the ancient
Roman Empire, and people traded silk along this pathway. In exchange for the silk, the Chinese got gold,
silver, and wool from Europe. Not only was the Silk Road used for transportation of goods, it was also the
way that people shared ideas, knowledge, religion, and technology with each other. Along the route,
trading centres began popping up, which became places where people shared knowledge and ideas.

The Silk Road started in China and followed along the Great Wall until it crossed into Afghanistan
through the Pamir Mountains. From there, goods were loaded onto ships that sailed for Mediterranean
ports. Usually people passed off the goods to others along the 4,000-mile route, not traveling the whole
thing themselves. When the Roman Empire fell in the fourth century CE, people stopped using the Silk
Road. It was later revived by the Mongols in the 13th century, and Marco Polo used it when he became
one of the first Europeans to go to China. Researchers guess that the Silk Road was a major way that the
Black Death plague was passed during this time, too.

The Spice Routes

The Spice Routes were maritime routes, which means they were routes taken by ships over the seas.
Europeans wanted spices such as cloves, cinnamon, nutmeg, and pepper. Before the 15th century, Arabs
and North Africans controlled trade between the East and West for these goods, so spices were very rare
and expensive. When the Age of Exploration hit in the 15th century, global trade became possible for
people to sail for long distances, so Europeans began sailing and making new global trade relationships
with people in China, Japan, and Indonesia. The Dutch and English were very active in spice trading with
Indonesia, especially with an area called the Spice Islands. This was the only place people could get
cloves and nutmeg at that time. The spice trade was responsible for the colonization of lands, wars fought,
and personal fortunes made.
The Amber Road
The Amber Road connected the Baltics with Europe. Researchers estimate that people began trading
amber in 3000 BCE, because archaeological evidence has uncovered amber beads from the Baltics in
Egypt. The Romans valued amber both as medicine and for decorative purposes. Amber deposits are
present under the Baltic Sea, and they formed millions of years ago. Slowly, amber washes up on the
shores where people harvest it from the sand. The crusades of the 12th and 13th centuries were a time
when the Baltic Sea was a major source of income for the Teutonic Knights. The Knights had control of
this region, and they persecuted local Prussians if they tried to harvest or sell the amber. Remnants of the
old Amber Road are still present in Poland.
The Incense Route
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The Incense Route was created as frankincense and myrrh were transported by camel from the Arabian
Peninsula to the Mediterranean. Both frankincense and myrrh come from tree sap dried in the sun. The
resulting nuggets might be used as perfume or as incense to be burned. Egyptians, Greeks, and Romans
began using frankincense and myrrh in big quantities. As trading increased along the Incense Route, as
much as 3,000 tons of incense may have been moved along the route every year. It may have taken about
two months from start to finish, and there were points along the route where settlements charged taxes to
allow caravans to pass through. Eventually, traders began moving the incense by waterways instead of
over land, though.
The Salt Route
Salt has been in high demand for centuries. Salt helps preserve and flavour food, and it’s also used as an
antiseptic. It wasn’t easy to harvest salt, so areas that were rich in salt became big trading centres. Routes
sprang up to connect salt trading centres with other settlements. The Salt Route connected a point near
Rome with the Adriatic coast, running through Italy. Salt was so scarce and precious that part of Roman
soldiers’ pay was salt. A different Salt Route called Old Salt Road started in northern Germany and
extended to Lubeck on the northern German coast. Fishing fleets leaving Germany for Scandinavia during
the Middle Ages needed salt, and they got it from the Old Salt Road.
The Tin Route
The Tin Route was a major road from the Bronze Age to the Iron Age, making it possible for people to
transport tin. Metal-making required tin for making bronze, because it made it stronger. Cornwall in
southwestern Britain had tin mines. The Tin Route connected Cornwall through France, Greece, and
beyond. Historians discovered the Tin Route because of hill-forts that were built along the route, used as
trading posts. There are no written records left to study, but archaeological records suggest that art and
technology of the period also moved along the Tin Route.

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 2.1 Role of Government

The direct role of governments in creating paper-based credit instruments was limited although they
provided the legal framework that was necessary for their use. Governments played a greater part in the
development of paper money.

They were involved either directly (as in China) or indirectly (which was more common), through
granting the right to issue paper money to private bankers. China invented paper money in the ninth
century.

The ruler, acutely aware of the problems of paper money, enforced acceptance with the threat of death
and by strictly limiting issuance (see Box 3.1), although there were many later instances of overissue.

Paper money was subsequently introduced in Japan.

In Europe, bank notes (representing promises to pay on demand) were issued in the seventeenth century
by goldsmiths, notaries, and merchants, who gradually developed into bankers. Banks created by special
charter, such as the Bank of England, also issued notes.

In the colonies of North America, a chronic shortage of bullion led to the issue of land-backed
certificates, which circulated as paper money. The overissue of bank notes often undermined the
credibility of paper money and led to financial crises and the suspension of the notes' convertibility into
bullion. This happened in the American Carolinas and France in the eighteenth century, and in several
European and Latin American countries in the nineteenth century. Attempts in the nineteenth century to
regulate the supply of gold backed bank notes in England stimulated the use of checks drawn on bank
deposits to make payments and thus promoted the spread of a more efficient and versatile instrument of
payment.

The growing use of bank notes issued by different bankers led to the creation of clearing facilities, which
were later extended to cover the clearing of checks. As central banks evolved to cope with the recurring
financial crises of the latter part of the nineteenth century, they came to monopolize the note issue.

This led to the eventual adoption of fiat money that is, paper (and later credit) money not backed by
bullion. Fiat money solved the problem of loss of confidence in bank notes issued by individual banks,
but not the problem of overissue of paper money by the central bank.

Many countries in Asia, Europe, and Latin America suffered episodes of hyperinflation after
governments had used the central bank's printing presses to finance their deficits. The twentieth century
has seen further innovation in payment instruments, including plastic cards and electronic transfers. These
were developed primarily to improve the efficiency of payments rather than to promote expansion of
trade.

19 | P a g e
 In most countries, central banks now play an important role in the payment system: they provide clearing
and settlement facilities to banks and to other institutions that offer payment services.

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The early Dutch Republic experienced a monetary problem called incremental debasement, for mints
repeatedly reduced the precious metal content of coins by small amounts. Adam Smith termed this the
“small-state” problem because small, open economies often made substantial use of foreign coins, so
debased foreign mints flowed into ports like Amsterdam. Around 1600,

The Dutch Republic was awash in foreign coins and these were widely used as media of exchange.1 The
fragmented nature of minting authority within the Dutch Republic meant that debasement had a domestic
component as well. Whether foreign or domestic, a debasement led to uncertainty in the value of
payments, creating transaction costs that hampered commerce. The Dutch authorities attempted to deal
with this debasement problem through laws and regulations, but these were often slow and ineffective. It
took decades, for example, for the Republic to establish full control over its numerous independent mints.
By contrast, laws assigning coin values were enacted early and often, but these did not solve the problem
of debasement. While these were intended to simplify the use of coins by giving them a known value
(tale) in terms of a unit of account, we argue that these laws, called mint ordinances, had the unintended
consequence of making the situation worse.

21 | P a g e
The disconnect between legal and intrinsic value encouraged people to bring old coins with high intrinsic,
but low legal value to the mint in order to repay their debts with newly debased coins. The mints
benefited as well from the consequent increase in business and their government owners benefited from
the increase in seigniorage. Then as now, there was no free lunch, as the garnering of seigniorage through
debasement imposed an onerous burden on the Dutch economy. Another regulatory approach was the
creation of an exchange bank or Wissel bank. Exchange banks were intended to address the debasement
problem by limiting deposits to coins above a certain quality. When debt was settled through the
exchange bank, lenders were protected from repayment in debased coin. To generate participation,
municipalities, starting with Amsterdam in 1609, required that commercial debts embodied in bills of
exchange had to be settled through the city’s exchange bank. Because such bills were the dominant
vehicle for international trade credit, merchants were compelled to open an account with the exchange
bank.2 This chapter argues that the creation of the exchange bank, known as the Bank of Amsterdam or
Amsterdamsche Wissel bank, was effective at reducing debasement.3 The settlement of bills in bank
money blunted debasement incentives by, ultimately, decoupling the connection between common coins
and their ordinance value in the Dutch unit of account called the florin.4 By shielding creditors – the
beneficiaries (also called payees) of bills of exchange – from payment in debased coins, the exchange
bank diminished the mints’ ability to extract profits from these beneficiaries. The initial success of the
Wissel bank, however, was less than complete because much of the Republic’s payment system remained
outside the Republic’s control. The final stabilization of Dutch coinage required the emergence of
effective control by the central government over the domestic mints. Also, the regulations controlling the
exchange bank were initially adjusted in unhelpful ways, so the development of the payment system took
unexpected turns.
One noteworthy, though unintended, consequence of the Wisselbank’s success and peculiar regulatory
changes was the creation of a new, parallel unit of account for major commercial transactions. A receipt
for ten florins held in banco (the term for exchange bank money) came to represent more money than ten
florins current (the term for local money). Though unwieldy to modern eyes, this system of parallel units
of account seemed to have worked extremely well in practice.6 Another unintended consequence of the
Wisselbank took even longer to evolve, but was ultimately even more revolutionary in nature: the
emergence of bank money as a fiat monetary standard. By the late seventeenth century, exchange bank
money lost the right of redemption into coins altogether, and the Wisselbank came to have no obligation
to redeem its deposits on demand. Anticipating today’s fiat money regimes, the predominant unit of
account, the bank florin, was then no longer bound to any particular coin. Instead, the value of balances
held at the Wisselbank derived from their ability to discharge debts. This development represented a
historic shift in the nature of money, one that leads us to characterize the Wisselbank as the first true
“central bank.”

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 2.1A. History Snippets

Marco Polo discovers paper money

"In this city of Kanbalu Beijing is the mint of the Great Khan, who may truly be said to possess the secret
of the alchemists, as he has the art of producing money . . . He causes the bark to be stripped from…
mulberry-trees . . . This . . . is made into paper, resembling, in substance, that which is manufactured from
cotton, but quite black. When ready for use, he has it cut into pieces of money of different sizes, nearly
square, but somewhat longer than they are wide . . . The coinage of this paper money is authenticated with
as much form and ceremony as if it were actually of pure gold or silver; for to each note a number of
officers, specially appointed, not only subscribe their names, but affix their seals also . . . The act of
counterfeiting it is punished as a capital offence. When thus coined in large quantities, this paper currency
is circulated in every part of the Great Khan's dominions; nor dares any person at the peril of his life,
refuse to accept it in payment. All his subjects receive it without hesitation, because, wherever their
business may call them, they can dispose of it again in the purchase of merchandise they may require;
such as pearls, jewels, gold, or silver. With it, in short, every article may be procured." Marco Polo:

The Travels of Marco Polo, Book II, Chapter 24 (Komroff 1926, pp. 156-57)

Trade financing in Renaissance Italy

The businessmen and bankers of northern Italy's Renaissance city-states particularly Genoa, Florence, and
Venice developed many of the fundamental practices of modern finance.

Their innovations included double-entry bookkeeping and the provision of credit through discounted
promissory notes. One of their most important innovations, however, was trade credit. Suppose that a
Florentine textile manufacturer received a potentially profitable order from Barcelona and had the means
to fill it. Two things might keep him from accepting the business. First, the importer might not pay until
he received the goods perhaps not even until he had sold them. Meanwhile, the exporter would have to
pay for materials, labour, storage, and shipment. Second, having produced and shipped his goods, the
exporter would have to bear the risk that the importer might simply fail to pay. And there was no court to
which the exporter could take the Barcelona merchant. Commercial banks that is, banks which specialize
in financing commerce came into being to solve such problems.

By providing short-term finance (working capital), commercial banks enabled such merchants to pay for
materials and labour in advance. They solved the second problem by having trusted agents in major cities.
For a fee, the bank could pay the exporter as soon as the shipment embarked. The importer would then
pay the bank's agent adding a few when the shipment arrived. For an additional fee the same bank might
even insure the shipment. Over time, the Italian banks developed this vital trade-financing function. The
leading Florentine banking family, the Medici, acquired agents or correspondents in Europe's trading
cities and made itself indispensable in the continent's commerce. Probably in the thirteenth or fourteenth
century, the bankers invented a variation that limited the degree to which their own capital was tied up
over the course of the transaction. This was the "acceptance," or "four-name paper."

The Barcelona agent (name 1) would sign a document "accepting" the liability of the importer (name 2) to
the exporter (name 3), and the document would be conveyed to the banker in Florence

23 | P a g e
 Development of trade finance

In preindustrial economies, governments borrowed to pay for wars, and seaborne trade was financed, as it
had been since classical times, by so called bottomry loans (a combination of loan and insurance contract,
which was repayable upon the safe completion of the voyage). Otherwise, borrowing and lending were
mostly on a small scale and were limited to trade credit, short-term loans to farmers, and loans for non-
business purposes. The financial system comprised money changers and moneylenders and a few private
bankers who dealt mostly with wealthy individuals, accepting deposits for safekeeping and providing
loans. In addition, tax farmers helped to administer the tax system by collecting and transferring taxes,
and various religious establishments offered their services as safe keepers. The expansion of commerce
was driven by the spread of trade fairs from medieval times and by advances in maritime technology in
the fifteenth century. It led to the accumulation of large personal fortunes in Europe. Deposit banking and
general and maritime insurance evolved to meet the growing needs of merchants and wealthy individuals.
The creation of trading companies with special charters and limited liability gave rise to the issue and
informal trading of company securities. The pace of financial development differed from country to
country; the city-states of northern Italy, for instance, made significant advances in trade finance.
Apart from granting charters to trading companies and note-issuing banks, governments promoted
financial development indirectly, through the preservation of peace or the waging of wars and through
their success or failure in maintaining macroeconomic stability. War finance was the spur for many of the
innovations of this period the creation of the Bank of England and other chartered banks, for example,
and the issue of government bonds. Urbanization and the capital requirements of infrastructure projects
toward the end of the eighttenth century created a need to mobilize new financial resources. But the onset
of the Industrial Revolution had relatively little impact on finance: the capital requirements of early
industrial enterprises were small. Many owners came from prosperous trading or artisan families that
were diversifying into manufacturing; such owners provided most of the capital from their own resources.
Families, friends, and wealthy private investors provided the balance. Banks supplied mainly shortterm
working capital, which was routinely rolled over. Even so, bankers and industrialists (foundry owners,
brewers, textile manufacturers, and so on) developed close relationships, mainly through cross
partnerships.

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The impact of large-scale industrialization

Financial development accelerated with the expansion of the railways and, especially, with the advent of
large-scale industrialization in the second half of the nineteenth century. Advances in mechanical and
electrical engineering and the increasing scale of production of electricity and chemicals meant that
industrial enterprises needed more capital. This required a big change in industrial finance. The
possibility of incorporating joint-stock companies with limited liability made it easier for enterprises to
attract the capital they needed to grow. Stock exchanges evolved to facilitate the issue and trading of
debentures and shares. Banks and insurance companies expanded their operations. Several new types of
institution were formed, including occupational pension funds and investment companies, although these
were small to begin with. Savings banks, credit cooperatives, and farmer banks, mortgage banks, building
societies, and savings and loan associations began to meet the financial needs of farmers, traders, savers,
and homeowners, all of whom had been neglected by the commercial banks. Most of the financial
institutions that we are familiar with today appeared before the end of the past century. Different
institutional structures and financial practices emerged among the industrializing countries. These have
had a pervasive impact on the functioning of financial systems and have given rise to a persistent debate
about the role of financial systems in promoting industrialization and economic development. But except
in the United States, where chartering provisions prohibited interstate banking and prevented the
emergence of nationwide banking, governments' involvement in shaping the organization of financial
systems was limited to changing the legal framework to allow the creation of joint-stock banks and
nonfinancial corporations and enacting subsequent regulatory changes to govern the operations of large
corporations (see Chapter 6). In Germany, several other continental European countries, and Japan, the
banking sector became an important source of finance for industry. Banks operated as "universal" banks,
engaging in both commercial and investment banking: they accepted deposits, made long-term loans,
issued and underwrote corporate securities, and took equity positions in industry. Universal banking first
appeared in Belgium and France, but it was more successful in Germany and Switzerland, where its
introduction coincided with the expansion of technologically advanced industries. In these countries, the
leading commercial banks developed close links with industry and played a crucial role in raising long-
term industrial finance and promoting industrial concentration and efficiency. In Japan, major legal and
regulatory reforms were implemented after the Meiji Restoration in 1868. The aim was to modernize
Japan's economy and promote industrialization. Traditional trading houses, such as Mitsui and Sumitomo,
were able to develop into large banks alongside newly established banking groups. The emergence of
zaibatsu groups family-based conglomerates with wideranging interests in industry, commerce, banking,
and finance speeded economic development. Initially, leading banks within zaibatsu groups provided
long-term finance to their partner enterprises and only short-term credit to others. Later on, as the zaibatsu
firms became more self-sufficient financially, their banks provided longterm finance to other enterprises
and in effect became universal banks like those in Germany. In Britain, the preference of the big joint-
stock banks for short-term self-liquidating investments limited their provision of long-term finance for
industry. A relatively high concentration of private wealth fuelled equity and bond finance, initially
through informal channels but later through organized securities markets. But weaknesses in the British
securities markets (and especially the use of misleading prospectuses by undercapitalized and often
unscrupulous company promoters) undermined investors' confidence in new industries such as electricity
and chemicals. This delayed large-scale industrialization. Traditional industries that could finance their
investment from internal funds continued to prosper, however. As noted above, chartering restrictions
prevented commercial banks from developing into nationwide institutions in the United States. As a
result, the New York Stock Exchange became a substantial source of finance for industry. The repayment
of the federal debt after the American Civil War and the accumulation of bank balances and trust funds in
New York increased the supply of investment funds. Private banks, which were allowed to operate as
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universal banks, maintained considerable influence well into the twentieth century. They assisted in the
formation of America's big industrial groups, as did the large New York joint-stock banks and the trust
and life insurance companies. Until at least the turn of the century, leading American commercial banks
operated more like German universal banks than British deposit banks, and their relations with industry
were much closer than in Britain. Stock exchanges developed from informal trading in the shares and
debentures of chartered trading companies, which appeared in Britain, the Netherlands, and other
countries in the sixteenth and seventeenth centuries. By the middle of the nineteenth century, stock
exchanges were dominated by domestic and foreign government bonds and, to a lesser extent, by the
bonds and shares of railway and other public utilities. The securities of industrial companies were
relatively unimportant, except on the New York Stock Exchange. However, all the major countries had
informal sources of equity and long-term debt finance for industry. Stock exchanges became a more
important source of industrial finance as industry's capital requirements grew in the second half of the
nineteenth century. At the turn of the century, bond and equity markets were already well developed in
Britain and the United States. But much like the present situation in most developing countries, the
financial systems of the big industrial economies were dominated by commercial banks. Insurance
companies and other institutions accounted for only small shares of total financial assets

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Financial crises In preindustrial economies financial crises were usually caused by war, natural disaster,
or the debasement of the currency although in the few centuries before the Industrial Revolution, the
failure of private or state-chartered banks had sometimes precipitated wider financial instability. With the
growth of banking and the expansion of securities markets in the nineteenth century, however, a system's
stability began to depend on the soundness of its institutions. Ways therefore had to be found to provide
liquidity to institutions in distress. Bigger and more complicated loans, extended over longer maturities,
increased the risks of default and fraud on both sides. This underlined the need for prudential regulation
and for laws to make financial contracts easily enforceable. Financial crises often began as speculative
manias, linked as a rule to foreign conquest; discoveries of land, gold, and other natural resources;
technological breakthroughs; or economic deregulation. Sometimes financial swindles were the cause, as
in the first recorded insider-trading scandal, the South Sea Bubble of 1720 (see Box 3.3). Spectacular
crises were common during the nineteenth and early twentieth centuries. In 1816 and again in 1825 banks
failed in England when they were unable to redeem their notes or meet the withdrawals of their
depositors. In 1857 many banks collapsed in the United States. In 1866 the failure of Overend, Guerney,
one of the largest discount houses in the City of London, caused a crisis that had extensive repercussions
throughout the world. In 1873 major banking crises occurred in both Germany and the United States. In
1890, Baring Brothers, a British private bank that suffered losses from underwriting a failed issue of
Argentine securities, came close to collapse. In 1931-33 a massive crisis devastated the banking system of
the United States. Banks in several European countries also failed. To contain the damage caused by such
crises, central banks (notably the Bank of England and the Bank of France) developed the lender-of-last-
resort facility. Initially, they acted as bankers to the government but not to other banks. Gradually,
prompted by the need to provide liquidity in times of trouble, they evolved during the nineteenth century
into bankers' banks. The development of the lender-of-last-resort facility was bedevilled by 46 the
conflicting requirements of providing support to the system without bailing out imprudent or fraudulent
banks. After the Great Depression, governments in several countries introduced new regulations. The
toughest measures were taken in the United States. New rules prevented banks from holding equities in
industrial and commercial companies on their own account, from engaging in investment banking, and
from paying interest on demand deposits. The Federal Deposit Insurance Corporation was created to
provide insurance for depositors' funds, and the Securities and Exchange Commission was set up to
supervise the securities markets. Coupled with continuing restrictions on bank mergers and branching,
these measures constrained the growth of commercial banks, which remained fragmented and were
unable to meet the long-term financing requirements of American business. Instead, these were largely
met by the securities markets. Other countries (including Canada, France, and Italy) also separated
investment from commercial banking and imposed maturity controls on the lending and deposits of
commercial banks. In contrast, neither Germany nor Japan (prior to World War II) prohibited universal
banking, and in Britain such measures were irrelevant because the big commercial banks had specialized
in deposit banking of their own accord. Germany did enact detailed prudential controls, but universal
banking continued. The big commercial banks substantially increased their involvement in industry
during the 1920s and 1930s, when widespread company failures caused many debts claims to be
converted into equity. The American banking crisis of the 1930s and its impact on the Great Depression
have been much debated. Some have argued that the crisis and its economic repercussions were
exacerbated by the failure of the Federal Reserve System to provide adequate liquidity to stem the
collapse of small banks. Others have stressed the banks' weak loan portfolios, which were concentrated in
agriculture and real estate. The pattern of recent bank failures in the United States, which is quite similar
to that of the 1930s, underlines the threat posed by poor loan diversification and excessive speculative
financing of real estate both of which can be attributed to restrictions on interstate banking and inadequate
supervision of the banks. Recent studies have also shown that security underwriting and investment
banking had little to do with the bank failures of the 1930s. The present worldwide trend toward universal

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banking argues for the abolition of the legal separation of commercial and investment banking. At the
same time there is a growing recognition that effective prudential regulation and supervision are essential.

TULIPMANIA

Tulips grew wild in Central Asia. By the early 1500s, Turks were cultivating “the flower of God” in the
Ottoman Empire. Hundreds of varieties emerged, many with beautiful colors and shapes. The flower
grows from a tulip bulb. New multiple colors, showy markings, and unusual petal shapes sometimes
occur on a flower. The rarest tulip flowers display spectacular markings of “flames” or “flares.” The
brilliance and unpredictability of tulips caught the attention of European flower collectors. The first tulips
reached the Dutch Republic in 1562. The most important Dutch province was Holland, with its major
seaport of Amsterdam. Holland grew into the centre of a rich Dutch commercial empire that stretched
from Asia to the Americas. In the 1600s, its trading ships outnumbered those of all other European
countries combined. Holland excelled at the spice trade, shipbuilding, cloth manufacturing, and banking.
Amsterdam had its own active stock exchange. While the rest of Europe stagnated in feudalism, the
Dutch Republic entered its Golden Age and became a pioneer in modern capitalism.

As many Dutch merchants became rich, they looked for ways to enjoy their new wealth. They built grand
houses, hired artists to paint their portraits, and collected things like tulips. The Tulip Bubble Tulip
trading became a fad among rich Dutch merchants. They bought and sold tulip bulbs among themselves,
planted them in September, and anxiously awaited their blooms in April and May. They collected tulips
as they did works of art, to enjoy their beauty and rarity. For years, only wealthy Dutch merchants traded
tulips. But in the 1630s, tulips became fashionable in France. With a developing export market for tulip
bulbs and the continuing demand from collectors, other well-off Dutch merchants saw a chance to get rich
in the tulip trade. These tulip bulb traders, called “florists,” were only interested in making a profit. They
never intended to grow the beautiful flowers. The Dutch tulip business expanded. Growers opened new
gardens to produce the highly desired bulbs. Soon, the profit-minded florists were buying and selling tulip
bulbs at ever-higher prices, especially for the rare varieties.
The first economic bubble in modern capitalism began to inflate. Economic bubbles occur when buyers
and sellers rapidly drive up the price of some asset, like stocks, houses, or even tulip bulbs, far beyond
their apparent worth. Tulip trading took place in the summer. Collectors bought and sold individual tulips
among themselves when the bulbs were lifted from the ground and dried to prevent rotting. The
speculating florists not only traded by the bulb, but also by a bulb’s weight. The florists hated that they
could only trade in the summer. By 1636, they created a special written contract for buying and selling in
the wintertime when the bulbs were planted underground. For example, in December, a tulip grower
might agree to sell a particular bulb for 500 guilders (a Dutch unit of gold money) when it was lifted after
blooming in the spring. The buyer was betting that by then the tulip would be selling for more, say 700
guilders, on the open market. He would pay the grower 500 guilders and make a nice profit of 200
guilders. This was an odd contract. When the deal was made in December, the seller did not have the bulb
in hand, and the buyer usually did not pay him any money. The actual exchange of bulb for guilders
would occur in the future, in the summer after the bulb had bloomed and been lifted. Today, we call this
kind of agreement a “futures contract.” The florists usually conducted their futures trading in taverns.
They formed organizations called “colleges” to oversee their auctions. Members of these tavern colleges
not only bid on actual bulbs, but also bought and sold futures contracts. In the winter of 1636–37, bidding
in the taverns reached a frenzy. The prices of individual tulip bulbs rose to incredible levels. On February
5, a public tulip bulb auction took place in Alkmaar, Holland. One bulb sold for 4,203 guilders (roughly
$50,000 in today’s purchasing power). The entire collection of 124 bulbs (still in the ground) sold for a
total of 90,000 guilders, equal to about $1 million today. This was the bubble’s peak. On the same day as
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the Alkmaar auction, Haarlem florists 15 miles away were having second thoughts about the high
bidding. If they bid high prices for bulbs, they would have to find people in the spring who would pay
even higher prices. It dawned on them that this was unlikely. Suddenly, bulb demand dropped in the
tavern colleges, prices collapsed, and the tulip bubble popped. Panic spread among the florists in other
towns. Futures contracts were always risky. If a contract called for a buyer to pay a seller 500 guilders for
a bulb at lifting time but the market price for it had dropped to 200 guilders, the buyer still owed the seller
500 guilders. The buyer would have to take a loss of 300 guilders. This situation repeated itself among the
florists as tulip prices crashed. If the buyer did not have the money to pay his obligation, the seller could
keep his bulb and sell it for the depressed market price. But he would feel cheated. The buyer had
promised to pay him the full agreed price. When the price of bulbs collapsed, many sellers went to court,
demanding the buyers pay what they agreed to pay. But the Dutch Republic had passed laws banning
futures contracts, and the courts refused to enforce them. The sellers turned to the Dutch government, but
it refused to act and referred the issue to the town governments. The problem of what to do about the
futures contracts remained at a standstill until a year later when the Haarlem city council ruled that buyers
could cancel their contracts by paying 3.5 percent of the original contract’s sale price. The seller would
get this money and keep ownership of the bulbs. Most other Dutch towns adopted this compromise. By
1639, the tulip bubble crisis was over. Tulip mania was the first major economic bubble in modern
capitalism. Because it was limited in scope, it did not cause a great deal of economic damage. Other
bubbles have proved far more devastating

The South Sea Bubble

The South Sea Bubble has been called: the world’s first financial crash, the world’s first Ponzi scheme,
speculation mania and a disastrous example of what can happen when people fall prey to ‘group think’.
That it was a catastrophic financial crash is in no doubt and that some of the greatest thinkers at the time
succumbed to it, including Isaac Newton himself, is also irrefutable. Estimates vary but Newton
reportedly lost as much as £40 million of today’s money in the scheme.

It all began when a British joint stock company called ‘The South Sea Company’ was founded in 1711 by
an Act of Parliament. It was a public and private partnership that was designed as a way of consolidating,
controlling and reducing the national debt and to help Britain increase its trade and profits in the
Americas. To enable it to do this, in 1713 it was granted a trading monopoly in the region. Part of this
was the asiento, which allowed for the trading of African slaves to the Spanish and Portuguese Empires.
The slave trade had proved immensely profitable in the previous two centuries and there was huge public
confidence in the scheme, as many expected slave profits to increase dramatically, especially when the
War of the Spanish Succession came to an end and trade could begin in earnest. It didn’t quite play out
like that however…

The South Sea Company began by offering those who bought stocks an incredible 6% interest. However,
when the War of the Spanish Succession came to an end in 1713 with the Treaty of Utrecht, the expected
trade explosion did not happen. Instead, Spain only allowed Britain a limited amount of trade and even
took a percentage of the profits. Spain also taxed the importation of slaves and put strict limits on the
numbers of ships Britain could send for ‘general trade’, which ended up being a single ship per year. This
was unlikely to generate anywhere close to the profit that the South Sea Company needed to sustain it.

However, King George himself then took governorship of the company in 1718. This further inflated the
stock as nothing instils confidence quite like the endorsement of the ruling monarch. Incredibly, soon
afterwards stocks were returning one hundred percent interest. This is where the bubble began to wobble,
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as the company itself was not actually making anywhere near the profits it had promised. Instead, it was
just trading in increasing amounts of its own stock. Those involved in the company began encouraging –
and in some cases bribing – their friends to purchase stock to further inflate the price and keep demand
high.

Then, in 1720, parliament allowed the South Sea Company to take over the national Debt. The company
purchased the £32 million national debt at the cost of £7.5 million. The purchase also came with
assurances that interest on the debt would be kept low. The idea was the company would use the money
generated by the ever-increasing stock sales to pay the interest on the debt. Or better yet, swap the stocks
for the debt interest directly. Stocks sold well and in turn generated higher and higher interest, pushing up
the price and demand for stocks. By August 1720 the stock price hit an eye-watering £1000. It was a self-
perpetuating cycle, but as such, lacked any meaningful fundamentals. The trade had never materialised,
and in turn the company was just trading itself against the debt that it had bought.

Then in September of 1720, some would say an inevitable disaster struck. The bubble burst. Stocks
plummeted, down to a paltry £124 by December, losing 80% of their value at their height. Investors were
ruined, people lost thousands, there was a marked increase in suicides and there was widespread anger
and discontent in the streets of London with the public demanding an explanation. However, even
Newton himself couldn’t explain the ‘mania’ or ‘hysteria’ that had overcome the populous. Perhaps he
should have remembered his apple. The House of Commons, wisely, called for an investigation and when
the sheer scale of the corruption and bribery was unearthed, it became a parliamentary and financial
scandal. Not everyone had succumbed to the ‘group think’ or ‘speculation mania’ however. A vociferous
pamphleteer by the name of Archibald Hutcheson had been extremely critical of the scheme from the
beginning. He had placed the actual value of the stock at around £200, which subsequently turned out to
be about right.

The person that came to the fore to sort out the issue was none other than Robert Walpole. He was made
Chancellor of the Exchequer and there is no doubt that his handling of the crisis contributed to his rise to
power. In an effort to prevent an event such as this from happening again, the Bubble Act was passed by
parliament in 1720. This forbade the creation of joint-stock companies such as the South Sea Company
without the specific permission of a royal charter. Somewhat incredibly, the company itself persisted in
trading until 1853, albeit after a restructuring. During the ‘bubble’ around 200 ‘bubble’ companies had
been created, and whilst many of them were scams, not all were nefarious. The Royal Exchange and
London Assurance survive to this very day.

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Banking Before 1750
Before 1750, the traditional ‘start date’ for the Industrial revolution, paper money and
commercial bills were used in England, but gold and silver were preferred for major
transactions and copper for daily trading. There were three tiers of banks already in
existence, but only in limited numbers. The first was the central Bank of England. This
has been created in 1694 by William of Orange to fund wars and had become a foreign
exchange storing foreign country’s gold. In 1708 it was given the monopoly on Joint
Stock Banking (where there’s more than 1 shareholder) to try and make it more
powerful, and other banks were limited in size and resources. Joint stock was declared
illegal by the Bubble Act of 1720, a reaction to the great losses of the collapse of the
South Sea Bubble.

A second tier was provided by less than thirty Private Banks, which were few in number
but growing, and their main customer was merchants and industrialists. Finally, you had
the county banks which operated in a local area, e.g., just Bedford, but there were only
twelve in 1760. By 1750 private banks were increasing in status and business, and some
specialization was occurring geographically in London.

The Role of Entrepreneurs in the Industrial Revolution

Malthus called entrepreneurs the ‘shock troops’ of the industrial revolution. This group
of individuals whose investment helped spread the revolution were based mainly in the
Midlands, a center for industrial growth. Most were middle class and well educated, and
there were a substantial number of entrepreneurs from non-conformist religions like the
Quakers. They have been characterized as feeling they had to be challenged, had to
organize and succeed, although they ranged in size from major captains of industry to
small-scale players. Many were after money, self-improvement, and success, and many
were able to buy into the landowning elite with their profits.

The entrepreneurs were capitalists, financiers, works managers, merchants, and

salesmen, although their role changed as the business developed and the nature of
enterprise evolved. The first half of the industrial revolution saw just one individual
running the companies, but as time went on shareholders and joint stock companies
emerged, and management had to change to cope with specialized positions.

Sources of Finance
As the revolution grew and more opportunities presented themselves, there was a
demand for more capital. While technology costs were coming down, the infrastructure
demands of large factories or canals and railways were high, and most industrial
businesses needed funds to start up and get started.

Entrepreneurs had several sources of finance. The domestic system, when it was still in
operation, allowed for capital to be raised as it had no infrastructure costs and you could
reduce or expand your workforce rapidly. Merchants provided some circulated capital, as
did aristocrats, who had money from land and estates and were keen to make more
money by assisting others. They could provide land, capital, and infrastructure. Banks
could provide short-term loans, but have been accused of holding the industry back by
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the legislation on liability and joint-stock. Families could provide money, and were
always a trusted source, as here the Quakers, who funded key entrepreneurs like the
Darbys (who pushed forward Iron production.)

The Development of the Banking System

By 1800 private banks had increased in number to seventy, while county banks increased
rapidly, doubling from 1775 to 1800. These were set up mainly by businessmen who
wanted to add banking to their portfolios and satisfied a demand. During the Napoleonic
Wars, the banks came under pressure from panicking customers making cash
withdrawals, and the government stepped in to restrict withdrawals to just paper notes,
no gold. By 1825 the depression which followed the wars had caused many banks to fail,
leading to a financial panic. The government now repealed the Bubble Act and allowed
joint-stock, but with unlimited liability.

The Banking Act of 1826 restricted the issuing of notes—many banks had issued their
own—and encouraged the formation of joint stock companies. In 1837 new laws gave
joint-stock companies the ability to acquire limited liability, and in 1855 and 58 these
laws were expanded, with banks and insurance now given limited liability which was a
financial incentive for investment. By the end of the nineteenth century, many local
banks had amalgamated to try and take advantage of the new legal situation.

Why the Banking System Developed

Long before 1750 Britain had a well-developed money economy with gold, copper, and
notes. But several factors changed. The growth in wealth and business opportunities
increased the need for both somewhere for money to be deposited, and a source of loans
for buildings, equipment and—most crucially—circulating capital for everyday running.
Specialist banks with knowledge of certain industries and areas thus grew up to take full
advantage of this situation. Banks could also make a profit by keeping a cash reserve and
lending out sums to gain interest, and there were many people interested in profits.

Did Banks Fail Industry?

In the US and Germany, industry used their banks heavily for long-term loans. Britons
didn’t do this, and the system has been accused of failing industry as a result. However,
America and Germany started at a higher level, and needed much more money than
Britain where banks weren’t required for long-term loans, but instead for short-term
ones to cover small shortfalls. British entrepreneurs were skeptical of banks and often
preferred older methods of finance for start-up costs. Banks evolved along with British
industry and were only a part of the funding, whereas America and Germany were diving
into industrialization at a much more evolved level.

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The Global Financial System before the War↑

Global finance in the first decade of the 20th century was based on the gold standard, a hybrid
public-private system. It was public insofar as it underpinned the national currencies of
sovereign countries—59 nations were part of the system in July 1914—and set the boundaries
within which private businesses, banks, and individuals could access trade, finance, and
markets. Yet, the central banks whose coordination and mutual assistance kept the gold
standard operational were nominally private entities. Moreover, in the decade before the war,
the importance of large financial institutions (especially the large clearing banks of the City of
London) grew as their gold reserves and lending behavior exercised a larger influence on global
financial market conditions. The public and private elements of the system supported each other
in stable times, but they could come into conflict in times of crisis. In the event of a crisis central
banks would find themselves torn between two responsibilities. The first was to defend their
currency’s parity with gold and thereby the entire edifice of the international gold standard. This
required raising interest rates and keeping the total volume of money and credit under control,
often with contractionary effects. The other responsibility was to act as a lender of last resort for
their banking system by supplying emergency liquidity. This necessitated an expansion of credit
and a lowering of interest rates.

As Europe mobilized for war in August 1914, these tasks came into conflict with one another.
Given the demands of early wartime mobilization, states that were on the gold standard faced a
choice. On the one hand, they could remain within the system at the cost of economic
contraction and a prolonged paralysis of the credit system. On the other hand, they could “go
off” gold for the duration of the war, but thereby push the costs of regaining parity forward into
an uncertain future. Britain and the United States, determined to uphold the exchange rate
between the pound sterling and the dollar in the interest of easy borrowing, picked the former
option. France, Russia, Germany, and Austria-Hungary chose to abandon the gold standard,
either to obtain the flexibility to fight the war more effectively or because they were economically
too weak to mobilize militarily while remaining on gold.

London was the linchpin of the global financial system. The architecture of the gold standard
and the reach of British imperial power were important prerequisites for this. But it was the
scale, power, and international reach of its private financial sector that made London
preeminent. The City of London possessed a global empire of its own, with a geography even
more diverse than the Commonwealth.[1] The most prestigious institutions were the five great
merchant banks: Rothschilds, Barings, Morgans, Kleinworts, and Schröders. They were

33 | P a g e
involved in all the most daring and profitable investment ventures worldwide. But the biggest
entities were the joint-stock banks, institutions with large balance sheets such as Westminster
(£104m), Lloyds (£107m), and Midland (£109m) that had millions of depositors and connected
long-term capital with short-term money markets. London possessed the largest and most liquid
markets and was the prime location for the discounting of bills of exchange to finance trade, for
the trade in acceptances, which freed up funds when bills were sold or “accepted” in the
secondary market, as well as for the extension of long- and short-term loans, the closing of
insurance contracts, and the trade in foreign exchange. In 1912 the City of London financed
over 60 percent of the world’s trade through its discount markets for bills of exchange. [2] Over £7
million in such bills were drawn per day on London acceptance houses, which had over £300
million in bills of exchange on their books at any given point. [3] Some two thirds of global
maritime insurance contracts were handled in Britain.[4] Nor was this financial hegemony a
completely virtual presence. It rested on a formidable commercial and industrial base and was
boosted by British direct or indirect control over the physical infrastructure of world trade. 70
percent of the global telegraph cable network was composed of lines operated by British
companies; UK shipping companies carried 55 percent of the world’s seaborne trade (by
comparison, American and French shipping constituted a quarter of the total); and Britain
controlled about three quarters of the coking coal annually used by the world’s cargo vessels. [5]

The hierarchical division of labor found in the City of London was the most developed financial
system in the world, but the pattern was replicated at a smaller scale in national financial
sectors across Europe. Generally, a few specialized and extremely international investment
banks would operate at the apex of the financial hierarchy, below which a core group of large
joint-stock or universal banks combined capital and money market functions; these market-
makers, who brought together suppliers and buyers of credit, would in turn be connected to a
larger nation-wide network of regional savings banks and trusts, and would also draw on the
services of a diverse array of moneylenders, stockbrokers, discount and acceptance houses,
and insurers. The financial ecosystem of Paris centered around the banques d’affaires: the
Crédit Lyonnais (at £113m in 1913, the largest financial institution in the world), the Société
Générale (£95m), and the Comptoir National d’Escompte de Paris (£75m), which competed with
a coterie of older but smaller hautes banques focused on government finance and foreign
investment in real assets around the world. In Berlin, Europe’s third financial center, the main
actors were Deutsche Bank (£112m), Disconto Gesellschaft (£58m), and Dresdner Bank
(£72m), which were heavily involved in trade finance and lending to industry, while sovereign
lending was the prerogative of a small clique of private investment houses such as

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Mendelssohn & Co. and Bleichröder.[6] On the whole, however, Germany had a much less
concentrated financial system, and regional and local savings banks comprised the vast
majority of finance capital in the Reich. In the United States, the financial system was similarly
vast and regionalized. On Wall Street, the power of the major national banks, the Bankers Trust,
the National City Bank (£57m), and the Guaranty Trust Co. of New York (£47m), was evident
through their role in industrial financing, in which they directly competed with the preeminent
investment banks, a group led by the indomitable J.P. Morgan & Co., but which also included
Kidder Peabody & Co., Lee Higginson & Co., Kuhn, Loeb & Co., Speyer & Co., and J. & W.
Seligman & Co.[7] These banks would prove instrumental in the international financing of the
Entente—and the relative lack of external debt finance for the Central Powers.

National Approaches to War Financing↑

Within national war efforts, one can distinguish between the fiscal, debt-related, and monetary
aspects of war finance. Taxation was the most direct and traditional way to pay for increased
expenditures on war. However, it played a subordinate role for almost every country involved.
Taxes paid for at most a quarter of the actual expenses of fighting in Britain and the United
States.[8] For most belligerents they were even less significant. In Germany and Italy between 6
and 15 percent of war spending in real terms was financed from taxes.[9] In Austria-Hungary,
Russia, and France none of the ongoing costs of the war were paid out of taxes, which were
already committed to covering ordinary peacetime budget outlays. [10] Nonetheless, taxation was
important to the theory of war finance everywhere. Its served to control inflation and to uphold
the creditworthiness of governments in the eyes of their creditors. By removing excess money
supply from the civilian economy, taxation would reduce the strong upward pressure on prices
caused by increased spending and money issuance. In addition, new taxes created new income
streams for the government that would reassure lenders that a cash flow would be available to
service the financial assets that they acquired by lending to the sovereign.

Borrowing was therefore the main method of financing the war. There are two dimensions of
borrowing that are important to understanding the dynamics of war finance in the First World
War. The first is the temporal dimension that distinguishes short-term and long-term
government borrowing. Whereas short-term or “floating” debt was largely contracted with the
central banks or with private banks, and therefore represented a claim on the state by the
financial sector, long-term debt could be issued to private banks, firms, and citizens. War loans

35 | P a g e
were large credits to the government to which private individuals and entities could subscribe by
putting in their own money. In the hope that they would mobilize large sums of money from the
public, governments publicized the war loans as patriotic contributions to the war effort—a
financial substitute for serving in the field. War loans were the most high-profile form of
government borrowing, but they usually contributed to the war effort only temporarily and their
issuance was often timed to coincide with battlefield successes or the anticipation of military
victories, all to solicit maximum subscriptions from citizens. Long-term debt was more secure
because it could be repaid after the war and—if raised through war loans—rested on a
fundamental, if contested, social compact between the government and its citizens. Short-term
debt was easier to mobilize, but its liquidity also meant that its price was more volatile and that it
would circulate as a means of payment. These instruments were also often used as collateral
for further borrowing and money creation. Short-term borrowing thus tended to spur large credit
expansion and inflation, both of which would eventually become sources of serious economic
instability if they were left unaddressed. In addition, short-term debt was generally not spent on
constructive investments that increased production; and it was overwhelmingly provided by the
financial sector, which meant that popular influence over public finance and government policy,
insofar as it existed, was further reduced.

The second dimension of borrowing that mattered was whether credit came from domestic
individuals and businesses or from lenders abroad. Foreign borrowing activated a field of power
relations that was distinct from the distributional politics of domestic borrowing in that it
depended on a country’s position in the global economic hierarchy. Unlike the large volumes of
international borrowing before the war—most of which was long-term capital invested in
railways, canals, factories, and other real assets—external borrowing in wartime was almost
always short-term and meant to cover ongoing expenditures.[11]

Finally, several countries increased the amount of money in circulation, either by “monetizing”
the government debt—using the central bank to buy government bonds from a national
treasury—or expanding the money supply directly by altering gold reserves, reserve
requirements, and note issuance. Money and credit creation was an autonomous process,
enabled by a country’s suspension of gold convertibility, as well as a byproduct of government
borrowing, since highly-rated government securities could become reserves against which new
private and public money could be created.

Most belligerents used a combination of these three methods. The composition of the war
financing mix depended on the domestic distribution of political and economic power as well as
strategic capabilities and considerations. Most financial mobilization plans were premised on the
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strategic scenario of a few months of conflict—at most a year. There was a discrepancy
between expectations of a short war and the realities of long-term war finance, however. The
Franco-Russian alliance, which in terms of fighting power was the military core of the Entente,
was particularly hamstrung by a short strategic horizon. As powers with major gold reserves,
France and Russia planned to pay for part of the initial mobilization expenses from their
accumulated gold reserves, which at $840 million and $750 million were the largest in
Europe.[12] The Banque de France saw its gold as a “war chest” (trésor de guerre), and after
1911 prepared in the event of war to advance the government 2.9 billion francs in short-term
credits in return for three-month treasury bills.[13] The French and Russians worried about the
exhaustion of physical resources and commodity stocks as much as about money. They were
right to assume that states rarely stop fighting because of insufficient funds. Yet, such a cash-
strapped total war economy could be maintained only through severe state intervention in the
form of requisitioning, coercive labor practices such as corvée duty, consumption cuts, and
various economic controls on prices, capital, and profits. In France the political and social
compact of the Union sacrée provided some democratic legitimation for such sacrifices, but in
autocratic Russia the government responded to economic exhaustion and deprivation with
increasingly arbitrary rule.

Britain entered the war intending to maintain a more normal civil society and economic freedom;
this included relative freedom for business and no conscription unless necessary. The orthodox
economic view was therefore that war was like any other expenditure—without the money to
pay for it, it could not be done. Britain had traditionally funded its wars one third by tax increases
and two thirds by borrowing.[14] British war finance was brought onto a relatively more
sustainable long-term footing early in the war. The UK benefited enormously from the pre-war
reform of its fiscal system, which had introduced a permanent income tax and an efficient
collection apparatus.[15] This was partially because London expected that its public finances and
stocks of private wealth would enable it to outlast Germany, and partially because its grand
strategic posture depended less on offensive speed and more on the attrition of concentric
military offensives and the blockade of Central Europe. Yet as we shall see, Britain also needed
this margin of financial strength, since it would be forced to assume growing responsibilities for
the conduct of a global war as chief conductor of the Entente until 1917, and thereafter as
partner to Washington.

Germany pursued an idiosyncratic approach to war finance due to political constraints. The
German economy was fast-growing and wealthy, but the Reich lacked a federal fiscal structure
capable of levying direct taxes to fund its war expenditures. Berlin remained dependent on the
37 | P a g e
individual German states for most of its revenues other than customs duties and a one-off
wealth tax passed in 1913.[16] Since the General Staff was hoping for a short war, however,
the Reich Treasury and the Reichsbank prioritized speed over sustainability in the mobilization
of funds. The establishment of a localized system of regional loan banks (Darlehenskassen)
overcame the fiscal weakness of the Reich by enabling enormous decentralized liquidity
creation and monetizing of the government debt. These Darlehenskassen were local institutions
created to surmount the liquidity shortage of the initial mobilization process. They were
maintained thereafter, taking in short-term deposits of between three and six months and
making short-term loans. Unable to fund rising expenditures through long-term debt taken out
by the imperial government, the governments of German states and communes borrowed
heavily from the Darlehenskassen. By 1917, three quarters of their 7.7 billion-mark balance
sheet consisted of loans to state and local
governments.[17] These Darlehenskassenscheine started to be used as a medium of exchange,
but because they were not legal tender they were not counted in the official money supply;
moreover, the Reichsbank and private banks could use these highly volatile short-term
securities as a reserve against which to issue yet more money. By the end of the war this
enormous uncontrolled surge in liquidity had created the preconditions for later hyperinflation,
although increased hoarding kept a lid on runaway prices for the time being.

The Central Powers and the Allies as Financial Alliances↑

The Central Powers↑

The ability of the Central Powers to act as a global financial player was much constrained by the
Allied blockade. The loss of export earnings and shipping income caused by the blockade was
reinforced by the ejection of German and Austro-Hungarian firms and businesses from the
London and Paris markets and the confiscation of private and business assets through British,
French, and Russian legislation that prohibited trading with the enemy. Expropriation at the
hands of its opponents was much more painful for Germany than the Entente. At least half of
the 21-25 billion marks worth of foreign investment that the Reich held around the world in 1914
was in enemy territories, whereas just 10-12 percent of the French and a mere 1.3 percent of
the British capital stock was under enemy control.[19] Although it still had access to
the neutral economies of the Netherlands, Scandinavia, and Switzerland, Germany was thus

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from an early stage much more constrained than the Entente, both in its capacity to obtain
external financing and in its ability to draw on its foreign wealth.

On Wall Street, US banks were not enthusiastic to lend to Germany, partly because of inherent
pro-Entente sympathies, partly because of discouragement from the Wilson Administration.
Between 1914 and 1917 the Germans only managed to obtain $35 million in private credits
through New York.[20] Nor did the smaller European neutrals offer much elasticity in foreign credit
provision. Swiss banks provided $170 million to all foreign borrowers for the duration of the war.
The Dutch financial sector extended 440 million guilders ($220 million) in credits, of which about
two thirds went to the Central Powers and the remainder largely to Britain.[21] From 1916
onwards the Anglo-French blockade became more comprehensive, entailing not only more
pressure on neutral countries to reduce exports to the Central Powers, but also increased
controls on financial flows. City bankers assisted the British Ministry of Blockade in identifying
suspicious international transactions that might hide German attempts to sell foreign assets or
repatriate overseas profits via countries like Spain, Norway, or the Netherlands. Threats to
blacklist banks and firms transacting with Germany were effective in closing off Wall Street as a
source of funds for the Reich by the end of the year.[22] The main way for Berlin to obtain funds
abroad was thereby to sell off its foreign capital stock.

The Reichsbank sold $470 million worth of foreign securities on the New York stock exchange
in 1915-1916, and in subsequent years brought in $250 million by selling securities in other
neutral countries and about $490 million through the sale of German corporate shares and the
export of gold—altogether about five billion marks worth of wealth, or one fifth of the foreign
capital stock.[23] In its dealings with neutrals, the German priority was increasingly to obtain
adequate supplies of physical commodities and inputs to sustain the war effort rather than
funds. In this sense, German external war finance was more directly subordinated to war
production. It did not function, as it did for the Entente, as a resource that could be used to
leverage the larger alliance’s strategic room for manoeuver.

Despite the strictures imposed on its global position by its enemies, the Reich found itself in the
position of a dominant partner among the four Central Powers. Although Austria-Hungary had
its own financial sector, which included some large banks such as the Credit-Anstalt and the
Anglo-Österreichische Bank, it was handicapped by the small amount of capital available in
Vienna. The Dual Monarchy was a creditor only towards the Balkans, where its banks supplied
about one fifth of Serbia’s and two fifths of Bulgaria’s long-term foreign loans.[24] Moreover, the
dualist administrative structure of the empire meant that its Austrian and Hungarian halves had
their own finance ministers and were autonomous in matters of taxation and bond issuance. At
39 | P a g e
the start of the war, three quarters of public debt was held domestically, but over the course of
the war Germany became more and more crucial to the creditworthiness and external funding of
Vienna and Budapest. German banks enabled the Austro-Hungarian army to stay in the field.
By early 1918, Germany owned 71 percent of the external Austro-Hungarian debt.[25] In addition,
over the course of the war the Austro-Hungarian Bank sold three quarters of its gold reserve to
the Reichsbank to finance imports, a larger loss of bullion than the central bank of any other
belligerent.[26]

In the late 19th century, the Ottoman Empire had been in a subordinate position to the European
Great Powers, which controlled the empire’s finances through the Ottoman Public Debt
Administration. During the war, however, Constantinople managed its financial relations with
Germany cleverly by exploiting its position as an essential partner. In return for deploying their
armies against the British Empire in the Middle East and Russia in the Caucasus, the Turks
received gold shipments and mark loans, rather than exporting gold to Berlin as the Austro-
Hungarians did. In a roundabout way, Austria-Hungary was therefore supplying the Ottomans
with gold. Ottoman foreign debt rose from 161 million Turkish pounds in 1914 to 454 million
Turkish pounds by 1918. Due to price inflation, the real value of the debt was relatively low, and
because only one war loan was launched, Ottoman society remained remarkably untouched in
fiscal terms.[27]

Bulgaria’s entry into the war on the side of the Central Powers was motivated by strategy mixed
with finance. As a relatively undeveloped country in the early 20 th century, Bulgaria had to be
willing to accept credits from whomever would offer them on good terms. Great Power interest
in the Balkans endowed the Bulgarians with the occasional ability to negotiate more favorable
terms. However, after its defeat in the Second Balkan War (1913), the country was left with a
large debt burden which it owed to French, Russian, and Austro-Hungarian banks and desired
to consolidate on a more secure footing. When in the summer of 1914 the German Disconto-
Gesellschaft offered a fifty-year credit of 120 million francs in return for a hand in the country’s
industrial development and 5 percent interest, the Bulgarians thus gladly accepted. Attempts by
the French to woo Bulgaria into joining the Entente by promising to buy its entire harvest were
tempting but insufficient, and in September 1915 Sofia joined the Central Powers—a decision
immediately rewarded with a monthly revolving credit from Disconto backed by the Reich.[28]

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The Entente↑

The Entente achieved much better coordination in its international financial assistance than the
Central Powers. In the first year of the war, the Franco-Russian military alliance bore the brunt
of the fighting while Britain arranged the logistics and the money. [29] When Italy joined the
Entente in May 1915 this added not only strategic weight but also an additional financial burden.
As the war entered its second year, London increased its direct military participation and
became increasingly reliant on Wall Street as an ultimate backstop. As the alliance expanded,
its financial center of gravity moved westward. By 1916-1917 the core of the Entente’s war
finance system was the Wall Street-City of London axis. While the Bank of England did
everything in its power to preserve the sterling-dollar exchange rate—it would spend over $2
billion in reserves just to maintain parity—the British and French treasuries used American
money and capital markets to obtain credit for themselves as well as for Russia, Italy,
Serbia, Greece, Portugal, and Belgium.[30] If the United States was increasingly the ultimate
provider of funds, Britain was the main orchestrator of their distribution, allocating credit to its
allies and matching funds with the strategic and operational requirements of warfare on several
fronts. Altogether, without the trans-Atlantic link the Entente would have been unable to develop
a war-winning multi-front strategy of attrition.

Between 1914 and 1918, the total amount of foreign credit taken out by the Entente totaled $16
billion. This was an enormous amount of borrowing, as much as the entire British foreign capital
stock before the war. The United States was the largest wartime creditor, lending a total of $7
billion, of which $3.7 billion went to Britain, $1.9 billion to France, and $1 billion to Italy. Britain
came a close second with a total credit provision of $6.7 billion, largely to Russia ($2.5 billion),
Italy ($1.9 billion), and France ($1.6 billion). France lent $2.2 billion, almost of half of which
($955 million) was to Russia, $535 million to Belgium, and the remainder to smaller Allies.
Britain and France were therefore both big lenders and borrowers at the same time, although
the British balance sheet matched debts and assets much more evenly. As the only government
that never had to fund itself through external debt, the United States was the backstop of this
global credit pyramid. At the far ends of the credit hierarchy were debtors such as Italy, which
owed $3 billion, and Russia, which owed $3.6 billion.[31]

The French slide into dependency, first on London and subsequently on Wall Street, may seem
surprising considering its wealth and well-developed financial sector, the third-largest in the
world. However, France was constrained by several factors. Already before the war
its government debt constituted more than 70 percent of GDP, one of the highest debt burdens

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among all belligerents.[32] It had introduced an income tax only in June 1914. Moreover, the
destruction and loss of industry and agricultural land in the north and east was compounded by
military conscription, both reducing the fiscal base. Finally, much of French foreign wealth was
long-term capital investment in Central and Eastern Europe that could not be liquidated quickly
to raise money.[33] As a result, France borrowed 83.5 percent of its wartime expenditure through
a wide variety of debt instruments: national defence bonds, treasury bills (bons du trésor), war
loans for public subscription, and foreign borrowing.[34] Starting in October 1914, France tapped
into American markets, first for its own needs, but soon also on behalf of its allies. When the
war ended, France was a debtor to the US and the UK but a creditor to Russia, Serbia,
Belgium, and Greece.

Italy’s overall budget and balance of payments position was in better shape than that of France
when it entered the war in May 1915. However, since the two main sources of earnings on the
current account—emigrants’ remittances and income from tourism—fell away due to the war,
Italy lacked the income to cover its imports of foodstuffs, coal, and crucial inputs for war
industry. Italian borrowing, then, was mainly a temporary compensation to finance imports. An
initial £60 million loan from the Bank of England was followed by a monthly British credit of £10
million. By late 1915 Rome began to place its treasury bonds in the American market. For 1916
the British Treasury fixed Italy’s allotment at a total of £122 million, of which £65 million could be
spent in the United States. In addition, the British government provided the Banca d’Italia with
£1m a month to support the lira on foreign exchange markets. [35] Italian dependency on trans-
Atlantic finance thus deepened, and by the summer of 1917 virtually its entire food and energy
supply was financed through London, Paris, and New York. Most Italian debt remained
domestic, however: by the end of the war the public debt stood at 119 percent of GDP, of which
a quarter was owed to Britain, the US, and France, and the rest held within the country.[36] The
problem was that the lira had depreciated more than 40 percent, which made these foreign
debts proportionally much harder to repay than the government’s obligations to its Italian private
creditors, which had been hollowed out by inflation.

If one country’s dependence on trans-Atlantic finance stands out, however, it is neither France
nor Italy but Russia. The Russian empire’s financial integration had always been a strategic as
well as a financial enterprise for the West. For France especially, the prospect of tying down
German military resources in the east had made its immense investments in Russia since the
mid-1890s a sound long-term plan. Ironically, Russia’s rapid industrialization facilitated a military
buildup that in fact heightened the Austro-Hungarian and German anxieties that contributed to
the outbreak of war.[37] Besides this self-fulfilling quality, however, foreign investment in Russia
42 | P a g e
was also self-perpetuating: once large amounts of capital had been sunk into the empire, giving
up the alliance with the Tsar would come at a massive political, financial, and strategic cost.
Despite its perceived military prowess, Russia required enormous additional amounts of credit
to mobilize and sustain the war against the Central Powers. Its very backwardness in economic
development thus sucked in French and British lenders more deeply as the war continued.
Wartime borrowing significantly exceeded pre-war borrowing, and over the course of the conflict
Russia’s indebtedness to Britain rose by 5.1 billion rubles, to France by 1.34 billion rubles, and
to the United States and Italy by another 2 billion rubles. [38] Over 70 percent of Anglo-French
borrowing on Wall Street between 1914 and 1917 was undertaken on Petrograd’s behalf. [39]

When, in the wake of the October Revolution, the Bolsheviks announced that they would take
Russia out of the war and would not honor tsarist-era debts, consternation gripped both
Western capitals and Western capital. The official repudiation of tsarist debt in January 1918
was the largest debt default in history up to that point, wiping out over $5 billion in debt to
foreign creditors. For Britain, which had a very diverse portfolio of foreign investments in every
continent, this was a serious setback but not a crippling blow. But for France, which owned 43
percent of the 9.4 billion-ruble total that was repudiated—its Russian assets represented a
quarter of all French foreign investment—it was disastrous.[40] France went from being a net
creditor to a net debtor as a result. Moreover, three quarters of the French-held Russian debt
was in the possession of a group of 1.5 million middle-class private investors. Unlike in other
countries, in France the emprunts russes became a highly contested political and electoral
issue and a major source of popular anti-Communism among the French public.[41] During the
war, all financial roads had led to Petrograd. Now that the Russians were out of the war and
temporarily out of the international financial system, rebalancing public finances after the war
relied even more than before on exacting an overwhelming victory against the Central Powers.

There was one notable outlier within the wider Allied coalition: Japan. As the main Asian ally of
the Entente, Japan fought only briefly and managed to increase its economic and financial
stature considerably during the conflict. At the outset of the war it had been a net debtor with
only small gold reserves, but by 1919 the Japanese net foreign asset position, boosted by a
wartime export and shipping boom, showed a 1.39 billion-yen surplus; 1 billion yen worth of
foreign investments was accumulated by firms and banks during the war. The private sector and
government also held 236 million yen in loans to the Chinese government, making Japan the
chief foreign lender to its East Asian neighbor. Owing to the gravity of the logistical and financial
crisis of Entente war finance in 1916, the Japanese even started to lend to Britain, France, and
Russia; by war’s end they had 575 million yen in outstanding loans to Entente governments.[42]
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Several smaller Entente partners received credits from London and Paris (often sourced
through New York) to sustain auxiliary campaigns against the Central Powers. Alliances with
peripheral European countries had played a role in British imperial containment strategies
against continental Great Powers since the Napoleonic Wars. Portugal joined the war in March
1916 in return for a British loan of $14.1 million and sent expeditionary forces to fight the
Germans on the Western Front as well as in its African colonies. Greece took both Entente and
German loans in 1914-1916 before siding with the Allies in June 1917. For an Anglo-French-
American credit of $150 million the Greeks deployed nine divisions in the Balkans. [43] By war’s
end, Portugal and Greece owed, respectively, $220 million and $155 million to France, and $78
million and $90 million to Britain. These loans procured the assistance of small armies in the
encirclement of Central Europe at relatively little expense, while they further tilted the balance of
economic and military power against Germany and its allies. However, the Allies also lost large
amounts of money that they lent to small countries that were overrun by the Central Powers
during the war, such as Belgium ($1.1 billion) and Serbia ($400 million). [44] The continuation of
credit to these countries reflected the cost of maintaining governments-in-exile, armies, and
refugees; and, in the case of Belgium, providing the civilian food supply for a population under
occupation.

Public and Private Actors in the War Finance System↑

War finance was undertaken by a mix of public and private actors. The war erupted in a world in
which the reach and liquidity of private interests in finance, trade, and industry had in many
ways outstripped the power of the state to regulate them. For contemporaries such as John
Hobson (1858-1940) and Vladimir Lenin (1870-1924) this was proof that capitalism had attained
an imperialist stage. The influence enjoyed by the presidents of large financial institutions,
holding companies, and industrial conglomerates was certainly enormous. In August 1914, J.P.
Morgan & Co. partner Henry Davison (1867-1922) travelled to London to arrange a deal with
the Bank of England that made his bank the official sponsor of all credits to the British
government floated on American markets. J.P. Morgan & Co. underwrote $1.5 billion in war
loans to London over the course of the war. As an investment bank, Morgan was not the largest
American bank, but it was the most well-connected.[45] It had already floated credit for London
once before, during the Boer War in 1900. The influence of private investment bankers was not
unlimited, however. In the fall of 1914, for example, the US government initially barred Morgan
from floating French government loans in New York, forcing Paris to look to the City of London
for credits instead. However, by the spring of 1915, France too was funding itself on Wall Street.
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Once Russia also picked Morgan as the intermediary for its borrowings on the American
market, the House of Morgan had become the credit-broker to the entire Entente. For its
services to the alliance it obtained an 8.3 percent commission, which netted it over $200 million
in profits.[46]

Thereafter Washington allowed private financing of Entente war credits in the US, but kept a
very close watch on this public-private credit relationship. There was considerable tension
between the Federal Reserve and the Wilson administration over how generous America should
be with its money and credit. Fed chairman Benjamin Strong (1872-1928) had personal
connections with his European counterparts and was a firm supporter of trans-Atlantic
coordination.[47] On the other hand, Woodrow Wilson (1856-1924) was keen to discipline what he
saw as intra-European imperial recklessness by withholding money, thereby forcing the
belligerents to seek a negotiated peace and reaffirming America’s commitment to neutrality and
international peace. American pressure reached a peak when, in late November 1916, Wilson
ordered the Fed to instruct American banks and investors to halt foreign currency loans and
purchases of foreign securities—a clear counsel against further private lending to London,
Paris, and Petrograd.[48] Mere days before Morgan planned to float a 1.5 billion-dollar Anglo-
French bond to raise money for the military offensives scheduled for 1917, this move brought
the Entente’s delicate trans-Atlantic private financing structure to the brink of collapse.[49] Wilson
was determined that if the United States entered the war, it would do so on its own terms and as
the undisputed economic leader of the alliance. When Washington declared war on Germany in
April 1917, private financing of Entente loans in the US was replaced by funding provided
directly by the American government.

The reliance of London and Paris on J.P. Morgan & Co. was replicated at a smaller level in the
Anglo-Russian and Franco-Russian alliances. Petrograd relied on Baring Brothers for loans
from London and on the Banque de Paris et des Pays-Bas (Paribas) to finance its debt on
Parisian markets. Here too, however, the involvement of private banks did not mean that profit
trumped strategy. At crucial moments the terms of the credits that sustained the war effort
would be set by the British, French, and Russian finance ministers based on essentially political
considerations; private bankers lost influence in relative terms as the war dragged on.

Effects of Global War Finance↑

Shifts in Income and Wealth Distribution↑

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The general trend towards expansionary deficit financing of the war effort strengthened big
business, especially industry and the parts of the banking system involved in short-term money
market lending to sovereigns. Yet, it curtailed much of the thriving international financial
ecosystem that had existed before the war; investment banks in every country except America
were hard-hit, as were banks that financed trade and export-oriented industries such as
shipping, textiles, and other consumer goods.

More important, however, were the enormous costs imposed on populations at large by the
imbalances and exigencies of war finance. The war was highly lucrative for a small but powerful
set of firms involved in armaments production and related manufacturing and service industries.
There was a widespread and justified feeling that capitalists were ‘war profiteers’ who were
raking in undue earnings at the expense of the population. Several governments capitalized on
these sentiments by introducing a tax on excess profits. In Britain, the United States, and Italy,
this tax was levied only on firms; in France and Germany, individuals as well as companies
could become liable to pay it.[50] Nonetheless, excess profits taxes could not prevent big shifts in
the distribution of income, the dynamics of which were driven not just by real production but by
general price level rises. Producers and owners of real assets gained at the expense of savers
and rentiers living off fixed incomes. In general, the price of goods on the (black) market rose far
more quickly than incomes.

Global inflation↑

The First World War created a global rise in prices. Taking the price level of the last pre-war
year, 1913, as a benchmark level of 100, the increases were significant everywhere. In all
economies that were at officially war, prices had risen at least twofold by 1918: from 196 in
Japan and 203 in the USA to 235 in Great Britain, 217 in Germany (soon to cascade into
dangerous hyperinflation), 340 in France, and 409 in Italy. Shortages of raw materials, excess
liquidity spillovers, and foreign import binges also affected the neutrals, most of which saw the
1913 price levels more than triple.[51] Since European central banks also controlled currency and
securities circulating in their colonial economies, deficit financing in the metropole caused
inflation in the periphery. Because colonial subjects lacked rights and democratic institutions,
this inflation fueled social unrest and anti-colonial uprisings. In Central Europe, town-country
exchange was breaking down by the end of the war, causing famine in urban centers; Asian
peasants from the Indian Ocean to the Pacific confronted a rice crisis that would persist for
three years after the end of the war.[52] The way that these high price levels were brought down
was through a sustained, purposeful deflation of the global money supply, initiated by the
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Federal Reserve’s hiking of interest rates in March 1920 and (due to America’s leading role in
the return to the gold standard) thereafter forcibly followed by most central banks around the
world. The economic result was a sharp worldwide recession in 1920-1921. This monetary
consolidation was accompanied by a wave of violent political repression and
counterrevolution—a “world-wide Thermidor” that ended the revolutionary aftermath of the
Great War.[53]

Hegemonic Transition↑

All the European belligerents experienced the Great War as a war of financial attrition. In just
four years the three major European pre-war creditors, Britain, France, and Germany, lost or
burned through more than $12 billion of foreign assets, over a third of the total external
investment that they had built up over the course of the 19th century.[54] At the commanding
heights of the global financial system, the war marked the beginning of the end of the
hegemony of the City of London and the ascendancy of Wall Street to a position of global
dominance. This shift was far from complete by 1919. Britain retained the largest overall foreign
capital stock of any country. Yet the quick emergence of America’s strong net creditor position
was a powerful sign that the Victorian and Edwardian heyday of British financial supremacy was
approaching its end. During the conflict it became clear that the American state was better able
to cooperate with its private financial sector and possessed a more activist and powerful central
bank in Benjamin Strong’s Federal Reserve.

A second shift caused by the war’s financial effects on the world economy was the prominence
of well-developed financial centers in European neutrals—chiefly Amsterdam, Zurich, and
Stockholm. These hubs were a major beneficiary of the financial exhaustion of the larger
nations surrounding them. They established themselves as attractive conduits of capital for
reconstruction, and for most of the 1920s would punch above their weight as British, French,
and German banks struggled to regain their pre-war footing.[55]

Finally, the financial weakening of large European empires and shifts in creditor-debtor
relationships within the core of the global economy led to increased pressure on economies in
Latin America, Africa, Middle East, and East Asia. Before the war, the boom in globalization had
meant that plentiful capital had been available for investment, often in high-yielding ventures
such as railways and infrastructure that spurred economic growth. With reconstruction at home
a paramount objective, intercontinental financial flows were reduced in scale, although this by
no

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