Quinn S. and Roberds W. (2006) When financial innovation’s good for the economy

Quinn, Stephen and Willam Roberds (2006) “An Economic Explanation of the Early Bank of Amsterdam, Debasement, Bills of Exchange and the Emergence of the First Central Bank”, Federal Bank of Atlanta. Working Papers Series, 13: 50p.*

Picture 25Picture 26Picture 4

This paper is available online.

Introduction

The United Provinces suffered from what Adam Smith termed the “small state” problem: it was awash in foreign coin and had little control over their quality, thus suffered from their constant debasement (p.1). Debtors always have an incentive to pay their due with debased coins. But this practice is only viable if the seigniorage he pays to the mint is lower than the amount of silver he saves in the operation. De facto, there is collusion between the mint and the debtor against the creditor (p.4).

“The uncertain value of any sum”

Picture 21The creditor had expensive remedies at his disposal, so if the debasement pattern was “mild but persistent”, he would never find it cost-efficient over a single operation to object (p.6). The sheer scarcity of coins in Amsterdam prevented the problem from being solved by private means: there always were incentives to debase further. Finally, the business community had to turned to the authorities who reacted by drafting the Wisselbank in January 1609 (p.8).

Not only were 14 government and 40 private legal mints involved in a race to the bottom, but “a great deal of light coins was minted in the southern Netherlands and shipped to the Dutch Republic” (p.10). Importantly, the authors remark that it was not an arbitrage trade going on but “a type of tax [levied by the mints] whereby legal recognition of light coins denies creditors expected silver” (p.11).

Heavy coins are no small problem

In theory, an actor can either melt or mint his precious metal:

  1. the ‘minting point’ indicates ratio tale value (i.e. value fixed by government for a given coin) to intrinsic value that is high enough to make the conversion into coins beneficial,
  2. the ‘melting point’ indicates the ratio tale value to intrinsic value that is low enough to make bullion preferable to means of payment (p.12).

Melting point (= demonetization) < 1:1 + minting costs + seigniorage < Minting point (= inflation)

There should a self-adjusting process between the two: minting causes inflation which decreases the buying power of the precious metal, which makes bullion more profitable compared to money and thus increases the melting point (p.16). Debasing diminishes the money stock (M) and thus according to the MV = PG equation, if it is not matched by an increase of volatility and/or minimal deflation, industrial production (G) will suffer (guesstimate at ⅓ to ½ GDP point per year in 17th-century Holland; p.17).

The Wisselbank

The role of the exchange bank was to correctly estimate the value of coins and thus make debasement less profitable. In theory, debt settled via the bank would shield the creditors from their debtors’ opportunistic debasement (p.18). This required constant adjustment, in particular the market price of heavy coins had to rise in pace with debasement to keep them in circulation (Gresham’s law; p.20). But this in turn exposed the banks’ clients to the negative effects of debasement since if the market price had increased after their deposit, when they withdrew their fund they would receive comparatively less precious metal (p.21).

Regulatory mayhem

To solve this dilemma, regulators and clients had to agree that “the value of coins at the Wisselbank should differ from the value of the same coins in general circulation” (p.22). During the first 40 years of existence of the bank, regulators tried numerous strategies to protect the clients and guarantee its stability, mostly by fixing the tale value of a large number of coins.

Despite never finding the silver bullet, they managed to shield their depositors from a “substantial domestic inflation”. Testimony of this success, the number of deposits at the bank grew rapidly during the period (p.29). However in 1640-1, debasement pressure was such that the Wisselbank had to resort to ‘light’ coins (patagons) to cover the withdrawl (p.32); as a sign of the clients discontent the number of deposits decreased markedly (p.33).

A new dynamic

Fig.4 p.38

Fig.4 p.38

After tab.3 p.35

After tab.3 p.35

To avoid withdrawal fees, a secondary market for the bank’s deposits appeared. The banks’ receipts were exchanged against cash. Ex-cashiers specialized as intermediaries on this new market. The exchange rate between the deposits’ market value and their nominal value in the bank was known as the Agio (p.34). “The Agio allowed systemic adjustment while keeping the metal value of the Wisselbank deposits constant Debasement of circulating coins could be met with a virtually simultaneous increase in the Agio” (p.36).

Finally in 1659, the decision was taken that the Dutch Republic would issue coins mimicking those coming from the south (p.39). This “change ushered in an era of stable coinage”.

Conclusion

To allow a greater stability of coinage, the administration had to take two paradoxical decisions: embrace a floating exchange rate (letting the market decide thus avoiding “regulatory missteps” and get involve directly in the production of coins (p.40). The Wisselbank had a key role in both. Evidence of the institution’s importance: the volume of it’s turned over transactions over six weeks equaled the country’s GDP (p.41).

Disclaimer: this summary is written by the contributors of the blog and not by the author of the article. Any mistake is Manuel’s fault (and he shall be punished).

* A version of this paper is also available in Atack, Jeremy and Larry Neal, eds. (2009) The Origin and Development of Financial Markets and Institutions. From the Seventeenth Century to the Present, Cambridge: Cambridge University Press, 32-70.

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