Download Industrial Revolution History Final Paper

Anonymous! Student
ECON X0X43
Some Semester
Dr. John Lovett!
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The Cheapening of Money and the Industrial Revolution!
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Abstract:!
Financial intermediation has been around since the early twelfth century, but due to the
costliness of a loan, the efficiency of debt is weakened. In this paper I propose that as
money became cheaper, the efficiency of a loan became greater. As the efficiency of a
loan rose, there will be a greater potential for economic growth. This paper discusses
the two main obstacles needed to be overcome in order to lower the price of money.
The first obstacle is property rights, a fundamental institution for a civil society and for
the use of collateral. Securing property rights within a legal framework will decrease
the cost of a loan by decreasing the asymmetric information that poses great risk to
the lender. The second obstacle discussed in this paper is usury. It is not the use of
usury, it is the lack there of that is the problem. This paper discusses the evolution of
the definition of usury from being a sin to what is now known as interest. It is vital to
the start of the Industrial Revolution to make financial intermediation fluid. This paper
discusses the dynamic of this system and its progressing fluidity throughout the
medieval period to the Industrial Revolution. !
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ECON 30423
The Cheapening Money and the Industrial Revolution
The Cheapening Money and the Industrial Revolution!
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By Andrew W. Homer!
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Abstract:!
Financial intermediation has been arround since the early twelfth century, but due to
the costliness of a loan, the efficiency of debt is weakened. In this paper I propose that
as money became cheaper, the efficiency of a loan became greater. As the efficiency
of a loan rose, there will be a greater potential for economic growth. This paper
discusses the two main obstacles needed to be overcome in order to lower the price of
money. The first obstacle is property rights, a fundamental institution for a civil society
and for the use of collateral. Securing property rights within a legal framework will
decrease the cost of a loan by decreasing the asymmetric information that poses great
risk to the lender. The second obstacle discussed in this paper is usury. It is not the
use of usury, it is the lack there of that is the problem. This paper discusses the
evolution of the definition of usury from being a sin to what is now known as interest. It
is vital to the start of the Industrial Revolution to make financial intermediation fluid.
This paper discusses the dynamic of this system and its progressing fluidity throughout
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the medieval period to the Industrial Revolution.!
Introduction!
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It is important to understand the beginnings of the financial system for
economics. The financial system expands the possibilities of an economy. The system
existed for many years before the Industrial Revolution. This paper attempts to explain
what problems the financial system had that made loaning money expensive. The two
issues that will be discussed are property rights and usury. The financial system is fluid
today in that it has low interest rates, one can easily borrow, and those who lend have
liquid capital. Because of these characteristics of the financial system that we take for
granted today, it is important to understand how the system came to be in the state it is
today and how to prevent it from regressing into the past. !
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The Cheapening Money and the Industrial Revolution
Property rights are a fundamental characteristic of any growing economy. This
right is necessary to have a robust financial system. Because property is used as
collateral for a loan, one must have a stable system to prove the ownership of one’s
property. This paper will use a source that describes the city of Edam in Holland as the
prime example of protecting property rights. In Edam, a legal system of property rights
is established. Because the citizens of this city are willing to give up their information to
have it publicly known that they own, for example a plot of land, there was an increase
in small loans, or it can also be called microfinance. Creating a legal system of property
rights also solves the problem of asymmetric information. If the lender can not legally
identify the owner of property he or she will asses the loan with greater risk in mind.
This thought of high risk was enough to makes loans expensive. It was identified that in
Edam, as the system of property rights strengthened, the amount of loans increased
and therefore the economy grew at a faster pace. It is important to understand this
principle right of property when assessing the strength of a financial system. !
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The prohibition of usury in the medieval period created an environment for the
financial system that made the cost of loaning high. Therefore, the cost of money was
too expensive for the lay person to have the opportunity to develop an idea that could
advance society. It was not only the church that fought against usury, the state and
political figures believed that usury is morally unjust. This paper will shed light on the
thought of usury in the preindustrial era. In the time leading up to the Industrial
Revolution, usury morphed into what we know as interest. In the beginning, people
thought usury was a mortal sin. These people believed a loan should be treated as
charity. As time passed, those who wanted to make a profit off of lending their money
found loopholes. One such loophole was turning a loan into property. Because one has
a right to receive profit from an investment because he or she owns a small part of the
investment, if a loan can be seen as property, the lender has the right to gain profit that
was made by the loan. By the time of the Industrial Revolution, it was common to find a
interest rates in societies. By eliminating the negative notion of usury and imposing
interest rates, the lender felt safer about a loan. This safety made lenders lend more,
therefore giving rise to a stronger and more fluid financial system. !
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This paper will attempt to prove that the Industrial Revolution was sparked by a
strengthening in the financial system. This strength came from the lowering of the
interest rates to allow the common preindustrial person to have the capital he or she
needed to develop an idea. Solving the problems associated with property rights and
usury both result in a stronger financial system because lenders see less risk in a loan.
This new environment that evolved allowed for the take-off of the European economy in
the Industrial Revolution.!
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The Financial System!
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Before 1600, there was not an adequate means of payment to correspond with
the growing level of commerce. This lead to the development of the deposit bank. The
sources of wealth during this period was mainly in the hands of the elite (Kohn, 1).
Though there was not a lack of saving across the board in the preindustrial society.
There was and average level of saving from 2% to 15% which is not very different from
the levels of today (Kohn, 2). The distribution of income over time leveled out. This was
because there was a need for highly liquid wealth. The elite mainly had their wealth in
land. There wealth was useful in time of rapid economic expansion because they also
owned the forests which were great sources for fuel and building material. But this
system failed when the landowners began to become a source of finance for others.
Due to their high participation in wars and crusades, their consumption exceeded their
incomes. This required them to borrow against their wealth (Kohn, 3).!
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In the early middle ages, a more liquid wealth was used. The Church over many
years obtained riches through gifts and endowments. They used this to finance
participation in wars or crusades. But the Reformation reduced the Church’s importance
as a lender (Kohn, 3).!
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In the thirteenth century, merchants became the principal source of funds for
lending. They were not as wealthy as the landowners, but their wealth was much more
liquid. This factor of liquidity is what made them successful. This allowed them to shift
their resources from those of declining profitability to those they can exploit. Merchants
though did not lend long-term. The use of short-term lending gave the security and the
ability to shift resources. As merchant lending became more developed, by the
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fourteenth century, merchants were becoming merchant bankers. Rather than using
their own profits as a source for the funds to lend, they began to lend the money of
depositors. As certain merchant bankers became large, they would collect the money of
other merchants to become what Meir Kohn calls in his paper, “Finance Before the
Industrial Revolution: An Introduction”, ‘great merchant banks’. The merchant’s largest
customer was the government. As the economy became more monetized by the use of
money to pay feudal services, feudal princes needed cash to hire professionals to fight
for them. Another use of these funds was fixed capital. The economy at this time was
made up of about 50% to 70% of fixed capital. These funds for fixed capital were used
is sectors such as agriculture and transportation. As technology progressed, so did the
need for a larger financial system. Without this development, the Industrial Revolution
would not have had the backbone to support the exponential economic advancement
later to come. (Kohn, 3-6)!
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As a strong system of lending was established, there were obstacles that came
in its way. The biggest one was usury. Kohn describes the mentality of a loan during this
period by stating that, “A loan was seen not as an economic transaction, but as an act of
charity.”(Kohn, 10) This mentality made it hard to make loaning profitable. One could
argue that activities that are profitable are more likely to be instituted. Luckily there were
loopholes. The question was, what is the definition of usury? The Venetian people
interpreted usury as an exploitative rate of interest. Interest in Venice was officially
legalized in 1217. England too adopted this same definition. Henry VIII legalized interest
in 1545. Though this notion of usury did greatly spur lending. There were many social
institutions to change as well. However, it did effects the development of the lending
process and possibly allowed for the bourgeoning of lending that will occur in the
Industrial Revolution (Kohn, 11).!
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Usury!
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The evolution of the idea of usury to the idea of interest was imperative for the
economic development of the Industrial Revolution. However, this evolution was not
smooth. The biggest obstacle the financial revolution and therefore the industrial
revolution was usury. Usury as John Munro defines it in his paper, The Medieval Origins
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of the Financial Revolutions: Usury, Rentes, and Negotiability”, is, “the exaction of
interest or of any specified return beyond the principal value of a loan” (Murno, 506).
The church had a strict ban on usury. Two religious orders, the Franciscans and the
Dominicans, lead a campaign to oppress those who practiced usury (Murno, 507). This
crusade even persuaded secular rulers to enforce the ban on usury. Canon lawyers also
joined in the fight against usury. They used the root of the word loan mutuum which
means ‘what had been mine becomes thine’ to combat usury (Murno, 509). Because the
church, the law and even the secular world were all against usury, an attempt to profit
on financial intermediation was be hard. However, not all financial intermediation used
usury. If for example, one rented a house, he or she has the right to receive rental
income. Also if one invests in a partnership or a comenda contract, he or she is entitled
to a share of profits. This is because the individual has ownership. A loan has no
ownership in the medieval mind. This allowed for a loophole. One way to disguise usury
is to cloak the loan in a sales contract that specified future payment. The church caught
on to this and deemed any hidden usury was still a mortal sin. The threat of being
convicted of usury made financial intermediation difficult. Lawrence Stone, an English
historian, once said, “Money will never become freely or cheaply available in a society
which nourishes a strong moral prejudice agains the taking of any interest at
all.” (Murno, 511-512) !
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The debate of usury and its definition was greatly discussed between Jeremy
Bentham and Adam Smith. Smith believed there should be a state-imposed cap on the
rate of interest. He believe five percent was the maximum anyone should pay in interest
on a loan. Benthan on the other hand, in his Defence of Usury, tried to get Smith to let
interest rates float. (Persky, 228) Prior to this episode in the 1780’s, medieval
churchmen in Britain starting in the 1350’s openly described usury as a practice of
requiring payment for a loan. By the 1650’s the definition broadened to the normal
business of loans. Though this new idea did not come about without a fight. Thomas
Wilson, a British judge and diplomat wrote A Discourse on Usury in 1572 to attack this
new definition of usury. His was a moral argument. (Persky, 229) !
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By the time of the eighteenth century, most British economic commentators
believed in the necessity of interest rates. In Adam Smith’s Wealth of Nations he clearly
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believed the need to have interest rates. He supported his argument by saying the an
interest rate is simply a the cost of the lender’s risk. But rather than furthering this logic
to allowing a floating interest rate and endorse the removal of legal restraints on interest
rates, Smith supported limiting the interest rate. His reasoning was that if interest rates
were too high, the elite or well connected would be able to out bid the common man.
(Persky, 230)!
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England at this time sided with Smith’s argument of caping interest rates. It can
be argued that this regulation slowed capital accumulation and growth. The first
regulation of interest in England began in 1545 with a maximum rate of 10% (Temin,
745). This is not optimal, but compared to the outlawing of interest, it is a step forward.
In 1714, the English government lowered the usury limit. Because the profit of a loan
decreased, banks needed to decrease the risk on loans. This caused banks such as
Hoare’s Bank to increase its minimum loan size (Temin, 744). As seen in Figure 1, after
the decrease in usury limits, Hoare’s Bank did begin to increase its loan size. This
Fig. 1. Hoare’s Median Lending Amount (3-year-moving average) (Source: Temin, 752)
caused discrimination towards the wealthy. In 1833, usury limits were lifted of bills of
exchange and were completely done away with in 1854 (Temin, 745). !
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The change in the usury law in 1714 caused a great change in the dynamic of
the financial system. Economic agents began to use debt as security rather than just
liquidity services. In order for this to occur, there was a need for good property rights. !
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Property Rights!
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In order to prove low risk to a bank, borrowers used collateral. It is impossible to
use collateral as a means to diminish risk if there are no property rights established.
When the usury laws changed in 1714, the use of collateral jumped to 67% from about
10% (Temin, 753).! Therefore, in order for the financial system to grow, and
subsequently for the Industrial Revolution to occur, property rights must be established. !
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Microfinance was a fundamental contribution to economic development in the
late medieval period. Holland is a prime example to support this idea. Microfinance can
be defined as “relying on the capacities of relatively poor men and women to develop
entrepreneurial activities” (Moor, Zanden, Zuijderduijn, 3). The financial revolutions that
led up to the industrial revolution all were influenced by governments borrowing money.
However, the question is; how the private sector was affected by the financial
revolution?!
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In order to understand how the average private individual in the late medieval
period were able to lend or borrow one must understand the problems that must be
resolved. The first and most fundamental problem is that potential borrowers want to
use an asset as collateral but can not because property rights are not well established.
This first problem creates the second. Because there is no or little collateral, it costs
more to borrow money due to a large amount of asymmetric information (Moor, Zanden,
Zuijderduijn, 4). Solving these problems would greatly lower interest rates and create
economic growth. !
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To make money cheaper, under these pretenses, one must protect property
rights. Property rights in Holland were clear enough to allow for an emerging capital
market. One form of collateral used is land. In Holland, land was protected by a system
based on ratification by local authorities. This system started out in the thirteenth
century as simply judges and aldermen witnessing transactions and using their memory
to vouch for someone’s right. It later developed into a system that issued contracts. This
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system is enough to solve the problem of property rights as collateral. Of course, the
system needed to work, corruption in the system could hurt microfinance. The city of
Edam in 1564 is an excellent example of this system. Edam is about 20km northeast of
Amsterdam, and had a population of 3,752 in 1563 (Moor, Zanden, Zuijderduijn, 8).
They prove that people trusted their public court to uphold their rights. During the year
of 1564, 450-500 transactions occurred, they did this even though there was a fee to
record the transaction and because it was pubic record, they were vulnerable to
taxation. The benefits of having legal property outweighed the costs. (Moor, Zanden,
Zuijderduijn, 7) This improvement in a system of property rights has the potential to
lower interest rates and spur economic growth. !
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Due to the property rights in Edam, many systems developed to finance
purchases of physical capital. One such system was called kustingen, a mortgage like
loan that was secured on realist ate and ships that lasted from 2 to 12 years (Moor,
Zanden, Zuijderduijn, 10). Also a system of losrenten and lijfrenten were developed
(Moor, Zanden, Zuijderduijn, 11). They can be related to the modern annuity. These new
systems granted the financial market flexibility which allowed it to continue to grow. !
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The level of interest rates reflects the efficiency of a capital market. Interest rates
in Holland on redeemable annuities fell from about 12 percent in the first half of the
fourteenth century to about 6 percent after 1450 (Moor, Zanden, Zuijderduijn, 17).
These lower interest rates in the private market were comparable to those in the public
market. The reason this market is so efficient is that this society was able to solve the
property rights problem. Property rights were protected because all transactions were
transparent and legal. This limited the power of the government to arbitrarily divide
property. The Holland credit market did not discriminate between rich and poor, men or
women. This allowed for all aspiring entrepreneurs to access the capital they needed.
This blind method allowed for this society to have continuous growth of GDP per capita
since the fifteenth century (Moor, Zanden, Zuijderduijn, 17). !
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Property rights are a fundamental element of a modern economy. The Industrial
Revolution would not have occurred without this important step into modernity. “The
idea that limited, representative government secures property rights and stimulates
investment continues to be an attractive one…” Stephen Quinn (Quinn, 613).!
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Conclusion!
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The link between the financial revolution and the industrial revolution is strong.
The best example of this is in England. The Financial Revolution began in the South
while the Industrial Revolution began in the North. However the link between real capital
and the financial market was not always strong. !
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Many economists believed the link between real capital and the financial market
is weak. One of these economist is David Ricardo who said “The price of funded
property is not a steady criterion by which to judge of the rate of interest” (Buchinsky,
Polak, 3). The reason to doubt the link between the capital and financial markets is
because it has been found that credit transactions tend to stay within an industry.
Comparing London long-term interest rates with data on deed registration from
Middlesex and West Yorkshire allows one to know when capital markets were
integrated. (Buchinsky, Polak, 3) !
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A decrease in the cost of money, or the interest rates means that the financial
market is more efficient. An affective way to test the link is to see if a decrease in the
interest rates affected the purchasing of buildings. Buildings are a good example
because it is a rather sensitive capital investment to interest rates. Between the years of
1730 and 1776, there was a weak relationship between the two markets. However, from
the years from 1770 to 1880 there was a large link between the markets. (Buchinsky,
Polak, 17-18) This means that because of the lowering of interest rates, people bought
more buildings. Having an economy with a characteristic of a close link between the
financial market and real capital allowed for the industrial revolution to take flight. !
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In times of uncertainty, when property rights are not secure and low interest rates
do not outweigh the amount of risk in a loan, banks lend to insiders (Brunt, 75). Insiders
are people who have some sort of link to the bank in addition to being a customer
(Brunt, 74). However, as property rights began to be enforce more effectively and
interest rates were allowed to float, the velocity of money began to increase. After 1854
when interest caps were abolished and having strong and restricted government that
protected private property allowed more freedom for banks to seek profit. This
increased loans, which increases output. But, as all logical capitalistic economies work,
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the supplier would not increase supply if they are not expecting an increase in demand
(Pollard, 217). !
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There are many credible arguments that attempt to define the spark that lit the
Industrial Revolution on fire. However, the argument of a liquid economy allows for most
of the other arguments to occur. Therefore, it can be argued that in order to have an
increase in technology to discover more resources in one’s environment, an economy
must first be liquid to allow for money to easily flow into the hands that most need it.
This fluid economy only becomes reality when the cost of risk are allowed to enter the
equation and property is secured as private. These two fundament hurdles are what
sparked the Industrial Revolution, the beginning of cheaper money. !
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Works Cited!
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Buchinsky, Moshe, and Ben Polak. "The Emergence of a National Capital Market in
England, 1710–1880." The Journal of Economic History 53.01 (1993): 1. Print.!
Kohn, Meir, Finance Before the Industrial Revolution: An Introduction (February 1999).
Dartmouth College, Department of Economics Working Paper No. 99-01.!
Munro, John H. "The Medieval Origins of the Financial Revolution: Usury, Rentes, and
Negotiability." The International History Review 25.3 (2003): 505-62. Print.!
Persky, Joseph. "Retrospectives: From Usury To Interest." Journal of Economic
Perspectives 21.1 (2007): 227-36. Print.!
Pollard, S. "Investment, Consumption And The Industrial Revolution." The Economic
History Review 11.2 (1958): 215-26. Print.!
Quinn, Stephen. "The Glorious Revolution's Effect on English Private Finance: A
Microhistory, 1680-1705." The Journal of Economic History 61.3 (2001): 593-615.
Print.!
Temin, Peter, and Hans-Joachim Voth. "Interest Rate Restrictions in a Natural
Experiment: Loan Allocation and the Change in the Usury Laws in 1714." The
Economic Journal 118.528 (2008): 743-58. Print.!
Van Zanden, J.L., Zuijderduijn, J. and De Moor, T. (2012). Small is beautiful: the
efficiency of credit markets in the late medieval Holland. European Review of
Economic History 16, pp. 3–23.!