Download Why did London become the main money market?

1
ECONOMIC HISTORY SOCIETY ANNUAL CONFERENCE
30 March-1 April 2007: University of Exeter
Why did London become the main money market?
Monetary Policy, Arbitrage and European Money Market Integration
in 18th century
Pilar NOGUÉS MARCO
Sciences Po, Paris
Supervisor: Marc FLANDREAU
First draft, January 2007
Please do not quote without author’s permission - All comments welcome
INTRODUCTION
How did the leading capital market start to attract international bullion? Why did
London become the main money market?
Monetary regulations, including the charges for minting money and the restrictions on
bullion exchange, have played the key role in defining the direction of the flow of
international bullion. Countries that abolished minting charges and permitted the free
movement of bullion were able to attract international bullion, and countries that
applied minting taxes suffered an outflow of bullion. In these cases monetary authorities
tried to limit bullion movement through prohibitions on domestic bullion exchange at a
free price, and tariffs and quantitative restrictions on bullion exports.
The paper illustrates the logic of international monetary flow in the 18th century, using
empirical evidence for England, France and Spain. The first section defines and
measures monetary policy, and the second section introduces minting charges into the
arbitrage equation in order to explain the logic of bullion flow between the pairs of
nations England-France, England-Spain and France-Spain. The conclusion emphasises
the importance of monetary policy in the creation of leading money markets.
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SECTION 1: WHAT DID MONETARY POLICY MEAN IN EARLY MODERN
AGES?
In commodity money systems, alterations in minting charges known as seigniorage
represent monetary policy. Models for measuring seigniorage were pioneered by
Cipolla (1982), and recently developed by Sussman (1993), Rolnick, Velde and Weber
(1996) and Redish (2000).
I measure monetary policy as follows:
L
Q
Suppose we have one ingot of pure
metal (gold or silver) denoted by L.
S
Then:
Q denotes the quantity of metal in coins
received by the owner of the ingot L.
S denotes the quantity of the ingot
retained by the mint in the minting
process.
An accounting standard P defines value for the physical quantity of metal:
L·P = Q·P + S·P = ME
(1)
Mint Equivalent (ME) is the mint value of the quantity of coins received by the owner
of the ingot (Q) plus the quantity of coins retained by the mint (S)
Q·P = MP
(2)
Mint Price (MP) is the mint value of the quantity of coins received by the owner of the
ingot (Q)
Graphs 1-3 summarise monetary policy in England, France and Spain in the very long
run. I homogenised data for comparing results: L is one kilogram of pure metal, and P is
sterling pounds for England, livre tournois for France and maravedís for Spain.
The simultaneous increments of MP and ME represent nominal debasements
(devaluations), that is, increments of the accounting standard P; and the increase in the
gap between MP and ME represents metallic debasement, that is, increase in
seigniorage charges S.
Graphs 1-3 show the relative stability in nominal debasement in the 18th century
compared to previous periods. However, there were notable differences in metallic
debasement among countries. England abolished seigniorage in 1666, France applied
seigniorage taxes of around 5% for silver and 6% for gold for most of the 18th century,
and Spain increased silver seigniorage charges to 14% and gold seigniorage tax from
2% to 6% during the century. The following section demonstrates the effect of these
differences in seigniorage on bullion flow.
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Graph 1: English Monetary Policy, 1343-1848
MP and ME (sterling pounds/kilogram of pure silver)
MP and ME (sterling pounds/kilogram of pure gold)
40
35
30
25
20
15
10
5
0
silver mint equivalent
silver mint price
gold mint equivalent
Silver metallic seigniorage = ME-MP (%)
gold mint price
Gold metallic seigniorage = ME-MP (%)
12%
10%
70%
60%
50%
40%
30%
20%
10%
0%
-10%
8%
6%
Source: Redish (2000), pp. 89-92.
1823
1791
1759
1727
1695
1663
1631
1599
1567
1535
1503
1471
1439
1407
1375
0%
-2%
1343
1838
1805
1772
1739
1706
1673
1640
1607
1574
1541
1508
1475
1442
1409
1376
1343
4%
2%
1837
1811
1785
1759
1733
1707
1681
1655
1629
1603
1577
1551
1525
1499
1473
1447
1421
1395
1369
1343
1847
1823
1799
1775
1751
1727
1703
1679
1655
1631
1607
1583
1559
1535
1511
1487
1463
1439
1415
1391
1367
1343
140
120
100
80
60
40
20
0
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Graph 2: French Monetary Policy, 1360-1793
MP and ME (livre tournois/kilogram of pure silver)
MP and ME (livre tournois/kilogram of pure gold)
6,000
400
350
300
250
200
150
100
50
0
5,000
4,000
3,000
2,000
1752
1780
1780
1724
1696
1668
1640
1612
1584
1556
1528
1500
1724
1696
1668
1640
1612
1584
1556
1528
1500
1472
1416
1388
1360
1780
1752
-10%
1724
-10%
1696
-5%
1668
0%
1640
0%
1612
10%
1584
5%
1556
20%
1528
10%
1500
30%
1472
15%
1444
40%
1416
20%
1388
gold mint price
Gold metallic seigniorage = ME-MP (%)
50%
1360
1472
gold mint equivalent
1752
silver mint price
Silver metallic seigniorage = ME-MP (%)
Source: Redish (2000), p. 93-97.
1444
1416
1388
1360
1792
1765
1738
1711
1684
1657
0
1444
silver mint equivalent
1630
1603
1576
1549
1522
1495
1468
1441
1414
1387
1360
1,000
5
Graph 3: Spanish Monetary Policy, 1497-1848
MP and ME (maravedís/kilogram of pure silver)
MP and ME (maravedís/kilogram of pure gold)
700,000
45,000
40,000
35,000
30,000
25,000
20,000
15,000
10,000
5,000
0
600,000
500,000
400,000
300,000
200,000
silver mint equivalent
silver mint price
gold mint equivalent
Silver metallic seigniorage = ME-MP (%)
1827
1805
1783
1761
1739
1717
1695
1673
1651
1629
1607
1585
1563
1541
1497
1519
0
1842
1819
1796
1773
1750
1727
1704
1681
1658
1635
1612
1589
1566
1543
1520
1497
100,000
gold mint price
Gold metallic seigniorage = ME-MP (%)
8%
16%
14%
12%
10%
8%
6%
4%
2%
0%
-2%
6%
4%
2%
1839
1820
1801
1782
1763
1744
1725
1706
1687
1668
1649
1630
1611
1592
1573
1554
1535
1516
-2%
1497
1837
1820
1803
1786
1769
1752
1735
1718
1701
1684
1667
1650
1633
1616
1599
1582
1565
1548
1531
1514
1497
0%
Sources: calculated in accordance with Spanish legislation: Recopilación de las Leyes de Indias (1681), Códigos Españoles concordados y
anotados-Nueva Recopilación (1851) and Reales Decretos-Colección Legistativa de España (1814-1848) (Biblioteca Nacional de España).
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SECTION 2: THE LAW OF ONE PRICE FOR MEASURING BULLION FLOW
The single arbitrage equation measures bullion flow between two countries A and B for a
metal i (Flandreau, 2004, p. 59):
PA
PA
(3)
(1  ciAB ) i B  X AB  (1  ciAB ) i B
Pi
Pi
where i denotes metal i (gold or silver); Pi A is the price of metal i in market A; Pi B is the price
of metal i in market B; X AB denotes the spot exchange rate between A and B; and ciAB is the
cost of trading bullion between both markets.
PA
Then, if (1  ciAB ) i B  X AB , exporting metal i from country B to A is profitable; and if
Pi
(1  ciAB )
Pi A
 X AB , exporting metal i from A to B is profitable.
B
Pi
Neal & Quinn (2001) have focused on information and transaction costs ( c iAB ) as the variable
which explains arbitrage in 18th century. But, in that period, at equal cost, bullion flow was
profitable from one country with a seigniorage tax and to another without seigniorage.
Therefore, the countries that eliminated seigniorage first attracted international bullion,
leading to the creation of money markets. Differences in costs started to assume the key role
in bullion arbitrage only when all countries had abolished seigniorage.
For the purposes of this demonstration, I do not take into account the costs in equation (3) and
focus directly on the Law of One Price, which measures gross profit:
Pi A
Law of One Price: B  X AB
(4)
Pi
Pi A
I define both variables, B and X AB , for a system that includes seigniorage:
Pi
 PA 
What were bullion prices in a system with seigniorage?  i B  :
 Pi 
Bullion exchange at a free price was illegal in systems with seigniorage taxes, in order to
force agents to sell bullion exclusively in mints and thus to maximise revenue. Only when
seigniorage had been abolished in England did bullion start to trade at a free price, under the
condition that it had been stamped in the Goldsmith’s Hall. In France free bullion trade was
forbidden until the Revolution and in Spain until the monetary reform of 1848.
Bullion prices in the 18th century in France and Spain are thus Mint Prices, and the Mint
Price for England in the 18th century represents the minimum market price, because if the
market price falls below the Mint Price it becomes more profitable to buy metal at its market
price and have it minted (Flandreau, 2004, p. 30). Then, I consider:
Pi  MPi
(5)
where MP is the Mint Price defined in equation (2).
Results represent the minimum gross profit for exporting bullion to England.
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What was the spot exchange rate in a system with seigniorage? ( X AB ):
The spot exchange rate is the relative spot market value between two accounting standards
defined in bills of exchange, which fluctuates around the legal par. The legal par is fixed by
the Mint Equivalent relative values defined in equation (1).
Therefore, in a system without seigniorage, the exchange rate fluctuated around the Mint
Equivalent ratio:
ME A
(6)
X AB 
(1  x )
ME B
where x measures the fluctuation, that is, the gap between the Mint Equivalent par and the
exchange rate value.
The exchange rate is defined in the unit of account. Mint Equivalent par is the relative
proportion of the metal contained in the two coins measured at the domestic unit of account.
So, in a bimetallic system with seigniorage, what is the Mint Equivalent: gold or silver?
- if seigniorage charges for gold and silver are proportional in both countries:
MPg ME g
, where index g denotes gold and index s silver,

MPs
ME s
that is, the bimetallic ratio for bullion (MPg/MPs) maintains the same proportion as the
bimetallic ratio of coins (MEg/MEs), so the Mint Equivalent par for gold and for silver
coincides. Mint Equivalent par in a system with proportional seigniorage is equal to that of
Mint Equivalent par in a system without seigniorage (equation 6).
- but, if seigniorage charges for gold and silver are not proportional in one country, then:
MPj
ME j  S j ME j


where j denotes the metal with a higher seigniorage tax (Sj>Si)
MPi
ME i  S i ME i
So the bimetallic ratio for ingots is smaller than for coins, so coin j is overvalued in regard to
coin i. According to the standard definition of Gresham's Law, bad money -overvalued money
- drives out good money - undervalued money - and therefore the exchange rate fluctuates
around the overvalued coin par (coin with a higher seigniorage tax).
Thus equation (6) can be rewritten for the specific gold and silver Mint Equivalent pares,
supposing no-proportional seigniorage in country B:
 AB ME A
 ME iA ME jA  
i
1  xi    B  B  
X 
B
ME
ME j   B
i

 ME i
B
(7)

S j  S i
A
 AB ME j

 X  ME B 1  x j 

j


 ME iA ME jA 
where  ME B  ME B  is the premium for the undervalued coin.
i
j 

If S Bj  SiB , premium is zero; so equation (6) is a restriction on equation (7) when seigniorage
is proportional S B  S B or when there is not seigniorage S B  S B  0 .
j
i
j
i




8
Graph 4 shows long-term legal bimetallic ratios for England, France and Spain. England kept
silver coins overvalued until the abolition of seigniorage in 1666, France alternated periods of
gold and silver overvaluation, and Spain overvalued gold until the reform of 1728, when it
started to overvalue silver.
Graph 4: Bimetallic ratios
Bimetallic ratio in England (1343-1847)
16
11
6
bimetallic ratio coins
1839
1823
1807
1791
1775
1759
1743
1727
1711
1695
1679
1663
1647
1631
1615
1599
1583
1567
1551
1535
1519
1503
1487
1471
1455
1439
1423
1407
1391
1375
1359
1343
1
bimetallic ratio ingots
Bimetallic ratio in France (1360-1793)
1776
1789
1833
1845
1763
1750
1737
1724
1711
1685
1761
1698
1672
1659
1646
1633
1620
1607
1749
bimetallic ratio coins
1594
1581
1568
1555
1542
1529
1516
1503
1490
1477
1464
1451
1438
1425
1412
1399
1386
1373
1360
19
17
15
13
11
9
7
5
3
1
bimetallic ratio ingots
Bimetallic ratio in Spain (1497-1847)
bimetallic ratio coins
Sources: see graphs 1-3
bimetallic ratio ingots
1821
1809
1797
1785
1773
1737
1725
1713
1701
1689
1677
1665
1653
1641
1629
1617
1605
1593
1581
1569
1557
1545
1533
1521
1509
1497
20
18
16
14
12
10
8
6
9
Price convergence measures integration. The Law of One Price for metal i is the indicator of
money market integration between two countries:
- if there is no seigniorage, combining equations (4) + (5) + (6):
A
MP A ME A
MPi A ME

(8)

(1  x )  X AB

B
B
B
B
MP
ME
MPi
ME
the Law of One Price is in balance, and the bullion market for metal i is integrated between
countries A and B. In this model only a fluctuation in exchange rate (x) creates opportunities
for arbitrage.
- but, if there is seigniorage in country B, combining equations (4) + (5) + (7):
A

 MP A
ME iA
ME iA  ME iA ME j  ME iA
AB
i





x

X


B
ME iB  S i ME iB  ME iB ME Bj  ME iB

 MPi

S j  S i
A
A
A
A
MP
ME
ME
ME


j
j
j
j
AB
 MP B  ME B  S  ME B  ME B x  X

j
j
j
j
j


(9)
the Law of One Price is out of balance, and the bullion market between countries A and B for
metal i is not integrated. In this case arbitrage from B to A is always profitable, even if there is
no fluctuation in the exchange rate (x=0). Seigniorage (Sj) makes arbitrage profitable for
A
overvalued metal j and seigniorage (Si) plus premium  ME iA ME j  makes arbitrage

 ME B ME B 
profitable for undervalued metal i.
i
j 

Graphs 5-7 show results for the Law of One Price for the pairs London-Paris, London-Cadiz
and Paris-Cadiz.
MPi data is taken from data in graphs 1-3.
Contemporaries registered exchange rate data only at two months maturity ( A AB ) for the
whole sample1. Spot exchange rate ( X AB ) should be deduced according to capitalization of
the value (Flandreau et al., 2006, p. 20):
AB
AB
 coinA 
 1 
A AB  X AB 1  rB  , where A and X are measured in 
(10)
 coinB 
 6 
and rB is the interest rate in country B.
But r data is not available for the whole sample. Therefore, two months maturity exchange
rate ( A AB ) is used, which means the cost of the time spent on arbitrage operation is taken into
account. Pure gross profit, therefore, is not being compared, but the prices between the two
mints, including the time required to move the bullion from one country to the other.
Calculations start from the first year when exchange rate is available.
Combining equations (9) + (10):
MPi ,Aj
MPi ,Bj
1

ME iA, j
ME iB, j  S i , j

ME iA, j
ME iB, j
 ME iA, j ME jA  ME iA, j



x  A AB
B 
B
 ME B
ME j  ME i , j
i, j

S j  S i
(11)
Data of exchange rate in London on Paris and Cadiz in The Price of Merchandise in London (Nederlandsch
Economisch-Historisch Archief), The Course of the Exchange and Lloyd’s List (British Library), and data of
exchange rate in Paris on Cadiz in Affiches (Bibliothèque Nationale de France). Results are calculated using
annual average monthly observations.
10
Graphs 5-7 show gross arbitrage profits caused by disintegration of the Law of One Price
(equation 11). Gross profit is divided into the two reasons for disintegration: seigniorage and
premium. Seigniorage profit for metal i,j measures gross profitability caused by Si,j effect,
supposing the exchange rate fluctuates around the band of metal i,j respectively, and premium
profit for metal i,j measures gross profitability caused by premium effect when the exchange
rate for metal i fluctuates around band j, whether it is Sj>Si.
Graph 5 shows arbitrage results for London-Paris (1663-1793). Before England abolished
seigniorage, France was exporting silver and importing gold, and when England eliminated
seigniorage in 1666, France continued importing gold because of its negative seigniorage tax
(?), that is, a subsidy for gold coinage. In the 18th century (1725-1792), after the Mississippi
bubble and the stabilization of the livre tournois, France started to export both gold and silver,
until the Revolution.
Graph 6 shows arbitrage results for London-Cadiz (1681-1847). Cadiz exported both gold and
silver to London. Silver arbitrage in the 17th century responded to the gold premium, and in
the 18th century to seigniorage tax. Gold arbitrage responded to seigniorage tax, and when
seigniorage tax was reduced (1731-1786), it basically responded to the silver premium.
Graph 7 shows arbitrage results for Paris-Cadiz (1763-1776). Cadiz exported both gold and
silver to Paris. Silver arbitrage was originated by the seigniorage tax. Gold arbitrage from
Cadiz to Paris was profitable from 1763-1771, although seigniorage was higher in France than
in Spain, because of the silver premium. From 1771 to 1776, gold arbitrage was profitable
because France reduced gold seigniorage.
Gross profitability gives us an idea of the geography of arbitrage in the 18th century: Spain
exported bullion to France and England, and France exported bullion to England. Spain was a
net exporter, a system only sustainable without suffering a "money famine" because it was a
productive country. France was a bullion importer from Spain and an exporter to England,
and England was the net receiver of gold and silver, which made London the main money
market.
11
Graph 5: Silver and gold arbitrage between London and Paris (1663-1793)
MP par, ME par and exchange rates
(pounds sterling/livre tournois per kg silver- data normalised at 0.05=1)
silver mint price par
silver mint equivalent par
exchange rate
1788
1783
1778
1773
1768
1763
1758
1753
1748
1743
1738
1733
1728
1723
1718
1713
1708
1703
1698
1693
1688
1683
1678
1673
1668
1663
2.00
1.80
1.60
1.40
1.20
1.00
0.80
0.60
0.40
0.20
gold mint equivalent par
MP par, ME par and exchange rates
(pounds sterling/livre tournois per kg gold- data normalised at 0.05=1)
1787
1791
1783
1779
1775
1771
1767
1763
1789
exchange rate
1759
1755
1751
1747
1743
1739
1735
1731
1727
1723
1719
1715
1711
gold mint equivalent par
1780
gold mint price par
1707
1703
1699
1695
1691
1687
1683
1679
1675
1671
1667
1663
2.00
1.80
1.60
1.40
1.20
1.00
0.80
0.60
0.40
0.20
silver mint equivalent par
Gold gross profit (% )
Silver gross profit (%)
20
15
10
5
0
-5
-10
-15
-20
20
10
0
-10
seigniorage profit
Sources: see text.
premium profit
seigniorage profit
1771
1762
1753
1744
1735
1726
1717
1708
1699
1690
1681
1672
1663
1791
1783
1775
1767
1759
1751
1743
1735
1727
1719
1711
1703
1695
1687
1679
1671
1663
-20
premium profit
12
Graph 6: Silver and gold arbitrage between London and Cadiz (1681-1847)
MP par, ME par and exchange rates
(pounds sterling/maravedis per kg silver - data normalised at 0.0003=1)
2.0
1.8
1.6
1.4
1.2
1.0
0.8
1846
1841
1836
1831
1826
1821
1816
1811
1806
1831
exchange rate
1801
1796
1791
1786
1781
1776
1771
1766
1761
1756
1751
1746
1741
silver mint equivalent par
1825
silver mint price par
1736
1731
1726
1721
1716
1711
1706
1701
1696
1691
1686
1681
0.6
gold mint equivalent par
MP par, ME par and exchange rates
(pounds sterling/maravedis per kg gold - data normalised at 0.0003=1)
2.0
1.8
1.6
1.4
1.2
1.0
0.8
gold mint price par
gold mint equivalent par
exchange rate
Sources: see text.
premium profit
1843
1837
1819
1813
1807
1801
seigniorage profit
premium profit
1846
1835
1824
1813
1802
1791
1780
1769
1758
1747
1736
1725
1714
1703
1692
46
35
18
24
18
18
13
02
18
91
18
80
17
69
17
58
17
47
17
36
17
17
25
14
17
17
03
17
92
16
seigniorage profit
1681
50
40
30
20
10
0
-10
-20
50
40
30
20
10
0
-10
-20
81
silver mint equivalent par
Gold gross profit (%)
Silver gross profit (%)
16
1795
1789
1783
1777
1771
1765
1759
1753
1747
1741
1735
1729
1723
1717
1711
1705
1699
1693
1687
1681
0.6
13
Graph 7: Silver and gold arbitrage between Paris and Cadiz (1763-1776)
MP par, ME par and exchange rates
(livre tournois/maravedis per kg silver - data normalised at 0.0075=1)
1.20
1.15
1.10
1.05
1.00
0.95
0.90
1763 1764 1765 1766 1767 1768 1769 1770 1771 1772 1773 1774 1775 1776
silver mint price par
silver mint equivalent par
exchange rate
MP par, ME par and exchange rates
(livre tournois/maravedis per kg gold - data normalised at 0.0075=1)
1.20
1.10
1.00
0.90
1763 1764 1765 1766 1767 1768 1769 1770 1771 1772 1773 1774 1775 1776
mint price par
exchange rate
gold mint equivalent par
silver mint equivalent par
Gold gross profit (% )
Silver gross profit (%)
20
15
15
10
10
5
5
0
seigniorage profit
Sources: see text.
seigniorage profit
premium profit
1775
1773
1771
1769
1767
1765
-5
1763
1775
1773
1771
1769
1767
1765
1763
0
14
CONCLUSION
How did the leading capital market start to attract international bullion? Monetary policy is
the key element for explaining international bullion flow in the 18th century. In the terms of
Obstfeld's open macroeconomy trilemma (1998, pp. 14-15): “a country cannot simultaneously
maintain fixed exchange rates and an open capital market while pursuing a monetary policy
oriented toward domestic goals”. Countries that applied high seigniorage taxes suffered
imbalances in the Law of One Price, which caused bullion outflow. Monetary authorities tried
to limit bullion movement through the prohibition of domestic bullion exchange at a free
price, and tariffs and quantitative restrictions on bullion exports, which in turn led to
smuggling. Illegal bullion outflow created an external bullion market for countries with
relative higher seigniorage tax, and countries that abolished seigniorage attracted international
bullion. Empirical evidence for England, France and Spain in the 18th century shows that
seigniorage was higher in Spain than in France, and higher in France than in England.
Consequently money markets were not integrated, and bullion moved from Spain to France
and England, and from France to England.. England was the net receiver of bullion and that
was where the leading money market was established.
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