The Infinite Elasticity of Credit

“Beautiful credit! The foundation of modern society. Who shall say this is not the age of mutual trust, of unlimited reliance on human promises? That is a peculiar condition of modern society which enables a whole country to instantly recognize point and meaning to the familiar newspaper anecdote, which puts into the speculator in lands and mines this remark: “I wasn’t worth a cent two years ago, and now I owe two million dollars.”

Mark Twain (1873), The Gilded Age: A Tale of Today


I wanted to put our current predicament into historical context, and to demonstrate that the situation we find ourselves in is not novel. It differs quantitatively, but not qualitatively, from what has gone before – many times before in fact. Great cycles of expansion and contraction are part of the human condition, and there are patterns of boom and bust that continually repeat themselves, as they are thoroughly grounded in human nature.

Collective human optimism and pessimism are extremely powerful drivers, acting over very long time scales. They are powerful enough to drive tremendous cycles of socioeconomic expansion and contraction. As population grows and optimism increases during a long expansion phase, pressure emerges that can only be relieved by increasing the elasticity of the money supply, often in spite of existing rules intended to prevent this very dynamic in the name of maintaining sound money.


As a historical generalisation, it can be said that every time the authorities stabilise or control some quantity of money M, either in absolute or volume or growing along a predetermined trend line, in moments of euphoria, more will be produced.

Or if the definition of money is fixed in terms of particular liquid assets, and the euphoria happens to ‘monetise’ credit in new ways that are excluded from the definition, the amount of money defined in the old way will not grow, but its velocity will increase [..]

….My contention is the the process is endless: fix any M(i) and the market will create new forms of money in periods of boom to get around the limit and create the necessity to create a new variable M(j).

Charles Kindleberger, Manias, Panics and Crashes


There have been many examples of this process throughout history and it is instructive to look at such periods. For instance, the medieval expansion of the eleventh and twelfth centuries had very much this character.

Sound money was insufficient, hence pressure to expand the money supply in line with what the population wanted to achieve was growing. At first the expansion maintained its connection with underlying real wealth, while still managing to expand the definition (and therefore the supply) of money.


The only major economic problem was the so-called ‘money-famine’ of the eleventh and twelfth centuries – an event that would occur in most eras of price equilibrium throughout modern history.

The growth of population and prosperity had created demand for a larger circulating medium. With precious metals in short supply, the people of Europe began to use what historian David Herlihy calls ‘substitute money’ – not barter or commodity money, but liquid assets of high value called ‘mobilia’, such as silver jewelry, furs, fine textiles and even books.

By the year 1100, the hunger for specie was so great that the cannons of Pistoia’s St Zeno Cathedral melted down their great crucifix and used it for money. German princes sold their imperial seals. English nobles exchanged their silver sword mounts, and french bishops converted their golden chalices into cash.

David Hackett Fischer, The Great Wave


Inevitably, however, a transition began from using hard assets to back money toward using credit instruments, thereby resorting to stretching the money supply beyond any kind of natural limit with virtual wealth.

This is typical for the latter stages of a credit expansion, and indicates the coming exhaustion of the upward trend, as it amounts to hollowing out the substance of an economic structure even as the shell continues its superficial expansion. The quality of debt deteriorates under expansionary pressure, even though the quantity of money may superficially appear to be growing only at a limited rate.


Despite these increases, historian Carlo Cipolla observes, “the supply of precious metals proved to be relatively inelastic throughout the whole period, and the growth of demand for silver for monetary purposes exceeded the supply.” To solve this problem, a variety of other monetary expedients were adopted. Commodities were used as money in addition to gold and silver. Pepper, for example, became a form of currency in the seaport cities of southern Europe. New credit instruments such as contracts of exchange and bank transfers expanded rapidly.

David Hackett Fischer, The Great Wave

As early as the 13th century, innovative practices had been developed to smooth the unpredictable and unreliable cash flows experienced by large institutions and governments. Much of this ingenuity was driven by the need to circumvent restrictions on charging interest (reflecting the religious disapproval of usury). Examples include the use of forward contracts in the wool market between monasteries in England and Italian merchant societies, where cash loans would be repaid in wool, and the provision of pension schemes by religious institutions.

The heart of the new medieval financial industry was merchant banking, including government finance. In effect, Edward I had an early form of current account with the Ricciardi of Lucca, Italy, that incorporated an extensive overdraft facility.

Edward was able to use this easy access to credit to fund the armies and castles that helped conquer Wales. To meet Edward’s demands, the Ricciardi could raise additional funds from other merchant societies across Europe, in the same way as modern banks turn to the interbank lending markets.

At any one time, most of this capital was committed to various ventures, including loans to governments and private borrowers, as well as investment in goods for trade.

This was normally profitable, since this money was earning a good return, but it meant that the merchants only retained a small buffer of liquid capital. This was not ordinarily a problem, since most transactions could be carried out through credit, offsetting or balance transfers between merchants.

When actual cash was needed beyond their own reserves, it could be raised from other merchants, either as a loan or by selling assets. For instance, the Ricciardi often acted as brokers raising loans for the king from a cartel of their fellow merchant societies. We can perhaps describe this as an early variant of the ‘Northern Rock’ business model, in that the Ricciardi relied on wholesale or interbank lending to fund their loans to the king.


Financial innovation (Ponzi finance) is by no means a modern invention requiring quants with super-computers. It is the driving human impetus towards short-term profit and money-for-nothing that matters. Throughout history, where there was an expansionist drive, people found a way to increase the elasticity of the money supply for short-term gain (at the cost of long-term pain).


All this demonstrates a precocious ability to price and market financial products. Our research demonstrates that medieval merchants, using abaci and roman numerals, were just as capable of calculating forward prices and interest as modern financiers using mathematical models and computer spreadsheets.


Specifically, periods of monetary expansion have proceeded despite rules (of various degrees of stringency) intended to prevent it. The problem is that monetary rules have focused on the traditional money supply, as measured in varying degrees of broadness (ie degrees of removal from underlying real wealth).

They have tended to neglect the vital role of credit, or virtual wealth, in the expansion of the effective money supply relative to available goods and services. Indeed monetarist thinkers continue to do so today, concentrating on conventional money supply measures while regarding private debt as inconsequential.

Neglecting the vital role of ephemeral credit in the composition of the effective money supply in manic times is a major omission, as it is the virtual nature of credit that defines such periods, and its abrupt loss that leads to the severity of the depression conditions that inevitably follow.

Ultimately, great socioeconomic expansions sow the seeds of their own destruction. Being swings of positive feedback, the initial virtuous circle of increasing prosperity that monetary expansion enables becomes a vicious circle, as the consequences of divorcing the money supply from the constraints of reality rapidly become apparent.

Vicious circles begin with a credit crunch, or period of acute illiquidity, as liquidity in a financial system is a reflection of confidence. Without confidence, there is no credit, and without credit there is no price support at anything like the levels achieved during a long expansion. This was as true in medieval times as it is today.


We have identified a ‘credit crunch’ in 1294, which shares remarkable parallels with today’s difficulties – the main cause being a lack of liquidity in the money market. In the 1280s, there had been a glut of easy money as merchant societies managed large sums of clerical taxes raised for the Pope, enabling them to lend money to kings and each other.

In the early 1290s, the Pope called in much of his money and the French king levied a huge tax on the Italian merchants in France. The final straw was the unexpected outbreak of war between England and France in 1294.

Edward I called on his bankers to raise the money needed to fund his armies. Unfortunately for the Ricciardi, they were unprepared for this eventuality as their assets were tied up in loans and trade. In normal times, the Ricciardi would have sought to raise short-term loans from their fellow merchants but in 1294, like today, the wholesale money markets were frozen.

Worse still, the Anglo-French war had cut communications between England and Italy, undermining the merchants’ ability to transfer credit or update their account books. The resultant uncertainty, combined with the fear that Edward would default on his debts, meant that merchant societies were unwilling to lend to each other.


This event was merely the first crunch point of a long series of bank failures of the major Italian banks that had been at the centre of European finance.


In the late thirteenth century, a major crisis led to the disruption of credit and banking in the western world. The great Italian banks dangerously overextended themselves by lending heavily to monarchs and private borrowers. These loans were highly lucrative – for a time. They brought prosperity to the north of Italy, and especially to the city of Siena, which in the words of one leading historian was “for 75 years the main banking centre for Europe.”

In the year 1298, Siena’s banking boom came suddenly to an end, with the failure of its greatest bank, the Gran Tavola of the Buonsignori. This was a world bank, with agents throughout Europe and the Mediterranean basin. Among its borrowers were great merchants, cities, nobles, kings and even the Pope himself. Increasing numbers of these loans went sour. In the year 1298, a banking panic began in Siena.

The big Florentine banks made foreign loans to the kings of England and Naples. This was a dangerous business. Once it had begun, the loans grew inexorably larger. The banks could not call them in for fear of default or confiscation. The results were inexorable. Early in the 14th century, Florentine banks began to fail.

David Hackett Fischer, The Great Wave


This period of bank failures marked the end of the long expansion of the eleventh and twelfth centuries, and the beginning of a long period of unstable contraction that historian Barbara Tuchman has referred to as “the disastrous fourteenth century” in her book of the same name. A series of calamities befell the population of Europe, the impact of which was magnified by the negative and suspicious mindset characteristic of contractionary periods.

In such times people are much less inclined to maintain a constructive mindset or to behave in a cooperative manner, which aggravates the effects on the population of poverty, hunger and disease. As this was a time of persistent crop failures and the Black Death, the impact would have been considerable in any case.

With the population falling, and collective psychology no longer supportive of economic expansion, the pressure to increase the money supply disappeared. Credit evaporated, the remaining money supply contracted substantially, and prices fell.


Money began to disappear. Europe’s stock of silver and gold contracted sharply during the late 14th century.

After 1390, a severe money famine developed. In France, the low point was reached during the year 1402, when the minting of money virtually came to an end….This money famine was part of a deep economic depression that continued to the end of the 14th century.

The decline of population and scarcity of money had a powerful effect on European prices…..Houses and estates fell empty; rents and land values declined roughly in proportion to the loss of population……Prices surged and declined in great swings. The rural population shrank, arable lands began to be abandoned, and peasants grew poorer.

David Hackett Fischer, The Great Wave


The parallels between the medieval credit crunch and our current predicament are considerable. In both cases the money supply increased in response to the expansionist pressure of unbridled optimism. In both cases the expansion proceeded to the point where a substantial over-hang of credit had been created – a quantity sufficient to generate systemic risk that was not recognised at the time. In the fourteenth century, that risk was realised, as it will be again in the 21st century.


The reactions of bankers to both medieval and modern credit crunches are strikingly similar. In 1294, the Ricciardi said that “it seems that money has disappeared”. Seven centuries later, in September 2008, a senior banker lamented in The Times that “there is no capital left in the world”.


Keynes described the collective psychology of banking well in 1931:

A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional and orthodox way along with his fellows, so that no one can really blame him.

John Maynard Keynes (1931), The Consequences to the Banks of the Collapse of Money Values

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