Understanding: Modern Finance

In the final article of his three-part "Understanding" series, Tom Marrs explains the concept of modern finance. 

“He is well paid that is well satisfied”

(IV.i.433) Portia, in The Merchant of Venice.

Introduction

In this article, the origins of both prior and modern financial and monetary systems will be reviewed in an attempt to understand how we reached our current stage of currency and finance; with reference to key historical sources in order to substantiate all points made. The three core concepts that will be explored in this article are; the technological advancements in the world of finance in a chronological format, to emphasise the recurring theme of faster transactions and ease of access; alongside the ideology of mutual trust as we know it, in both its origins and evolution transitioning to its place in the modern economic system we have to date. Following this, the new technologies themselves will be dissected to answer the following questions; what are the new technologies specifically?; how are they used with regard to modern financial systems?; and finally, in what way can their presence or applications be deemed beneficial or disruptive?.

How did money become so important and dominant in modern society, despite its lack of intrinsic value?

Historically speaking, financial transactions occurred for millennia prior to the invention of fiscal currency. Archaeological discoveries and analysis have revealed that in ancient Mesopotamia, roughly 4000 years ago in what is now the middle east, the natives used clay tablets to provide proof of a commitment to a specific financial transaction. This emerged naturally as during this time the populace used clay tablets for a variety of reasons including literature or art, but primarily arose solely for the concept of accounting.

The tablet itself would depict the specifics of the transaction; what was borrowed, to be repaid, and the date of repayment. This early technology made early accounting and financial transactions a possibility. Using the barter system in its purest form is immediate, but without the ability to track transactions or payments over time would have been much more difficult without the clay tablet. The clay tablets themselves would use standardised units of account similar to modern currency denominations like dollars or euros, such as grain or wool. This is the primary focus of money, being able to store value or favours to cash in at a later date. When you do wish to cash in, money is the perfect medium of exchange to swap something you have for something you want. However, the aforementioned is only possible if everybody trusts the value of each unit used for said financial transactions.

What is the role of ‘mutual trust’ in finance and monetary systems?

The original substantiation of mutual trust and fiscal responsibility for political or economic decisions was one of the core reasons society has the economic system that it does to date. When considering the early concept of money, one would imagine commodities, barterable objects such as the Mesopotamian wool or grain, alongside gold and silver, that allow you to store value as stated. However, to achieve a commodity one would have to earn it, make it, or steal it. A key example of this is when the Spanish Conquistadors travelled to Central America in search of ‘El Dorado’ (The Golden City) in the 16th century. In Peru, following the defeat of the native Inca Empire, the Spanish enslaved the populace to mine for silver and gold, which would then fund their wars of conquest both in Europe and the Americas. Yet this did nothing to prevent the decline of the Spanish Empire in the following century. The Spanish had dug up so much silver to finance their wars of conquest that they unintentionally caused its value to decline significantly.

The Spanish failed to understand that when they had a lesser quantity of a commodity, it was worth more in value. As a result, when they then sourced more of it, in this case silver, they assumed its value would either increase or remain at similar levels in stagnant fashion. Instead, it caused inflation and a drop in value. This is an early example of the core economic principle found in modern society, supply versus demand. This principle is key to understanding the concept of mutual trust — and how this allows people to have a shared concept of value and worth in a specific item, product, or service.

A modern example of monetary inflation would be that of Weimar Republic of Germany following World War One. In order to meet the reparations payment demands of its former enemies during the war, the Weimar Government opted to simply printed more money. As a result, every time they printed more money, the currency itself reduced in value. In short, the German economy went through a period of severe hyperinflation between 1921–1923. It was only once they issued a new currency that inflation levels decreased in the following years.

In addition to the supply versus demand theory in conceptualising mutual trust, medieval Italian city-states were vital in their role for both financial institutional development and international trade.

How did the introduction of a decentralised foreign exchange system help international trade and finance to progress?

For centuries throughout the middle ages and onwards, Italian city-states were constantly at war with one another. This caused strife for merchants and traders as they would have to use several different forms of coinage, and due to the ever-changing geopolitical landscape at the time, the value of each city-state’s coinage contrasted to another was hard to pinpoint. Soon emerged the foreign exchange market, dominated by the Medici family. Where prior private institutions had failed to monopolise on the concept, such as the Peruzzi or Bardi, due to the canon law against usury enforced in medieval Italian city-states — a creditor charging interest on a loan to a debtor — they did so successfully by simply assisting in the exchange of coinages and adding on surcharges for their services. This rise to financial dominance and consequential political influence they are recognised for most notably began with Giovanni di Bicci de’ Medici prior to and following the turn of the 15th century.

Side note: The canon law against usury, implemented by the Catholic Church, is the same law that led merchants to seek out Jewish money-lenders — such as the character of Shylock in Shakespeare’s ‘The Merchant of Venice’ — to finance expeditions or other transactions, at the cost of extortionate interest rates. As a result, such loansharking became known as ‘Shylocking’, and is often historically attributed as the source or heavily contributing factor for the stereotype of Jewish people’s involvement in both finance and financial institutions.

As they expanded and controlled ‘branches’ in several cities such as Florence, Venice, and Rome, they could allow a client to store his wealth in one of their banks, issue a receipt, so that when the client would arrive in another city he could receive a portion of his prior deposit in a different branch. This ‘I owe you’ style receipt, similar to the Mesopotamian clay tablet, was one of the first forms of paper money. This was the first instance of decentralisation.

However, as this concept grew and witnessed the expansion of other private institutions across the world at that time, the value of the coinage being traded was dependent on the nation’s political and economic stability, causing said nations to accept responsibility for and the consequences of their actions — both domestically or internationally. This is known as ‘currency depreciation’.

A modern example would be following the 2008 crash, when Greece’s inability to maintain economic security, followed by bailouts from the World Bank and the International Monetary Fund (IMF), caused the euro to depreciate in value as investors in the currency believed it would make it less valuable in contrast to other currencies. The consequence was Greek economic austerity. Another example would be the depreciation of the GBP (UK’s Pound Sterling), which has been continually declining in value since the Brexit referendum of July 2016, in which the United Kingdom voted to leave the European Union. Almost overnight, the currency depreciated severely against both the US Dollar and the Euro. Both examples are vital in understanding the downside to a lack of mutual trust in a unit’s value.

Granted, nations still draw themselves into a variety of situations that lead to that would otherwise devalue the currency through declining mutual trust, however said nations often deploy countermeasures as a result. China for example, has been known to manipulate its currency and employ protectionist measures to make its exports more competitive internationally and imports more costly — leading to increased productivity and reinvestment, substantiating the value of the currency over time. A key instance of this was following China’s introduction to the World Trade Organisation (WTO) as a member in December 2001, when they went against the WTO’s core principle of free trade almost immediately.

Honourable Mention

Regarding financial innovation and technological advancements, Leonardo de Pisa (Fibonacci) deserves an honourable mention for introducing Europe to the Arabic numerical system he acquired an understanding of in northern morocco, during the 12th century. This understanding is embodied in his book ‘Liber Abaci’. Whilst Christian nations of the western world were suffering from the 7th to 13th century, Arabic speaking countries were in what is now entitled by historians as the Islamic Golden Age for financial and technological advancements, among other inventions and tools of development. In Europe, as a result of the legacy from the Roman Empire, the majority of people involved in contemporary financial systems used the Latin numerical system. This system was obsolete and did not successfully pair with financial technological advancements of the time.

What evolutionary processes first catalysed modern finance during the 20th century, as a result of technological advancements?

In a rather large leap forward, during the 1960s credit cards were introduced. The earlier version of the concept required business clerks handling the financial transaction in question, to make a phone call to a bank teller from the institution that issued the card, then requiring said teller to comb through paper records and ledgers to confirm whether the cardholder held sufficient funds to make the purchase. Gradually, as technological innovations occurred, banks were able to install early computation machines that could hold all prior paper copies of information regarding a cardholder’s finances, in the same manner, the businesses in question could now use card machines to allow the two computers plugged into the same network to confirm and authorise payments. Whilst removing human error, it increased efficiency and speed in which transactions could be made. This was an early form of digital networks that were improved and tweaked from this point on until we reached our current financial technological level.

Such innovation also allows these digital networks to track, record and predict previous and potential consumer behaviour so that when there is a risk of credit card theft or stolen identity in that somebody can use your information to make purchases, the network can have some level of understanding as to whether it is you making that purchase. Whilst increasing transaction speed, it also allowed the original concept of mutual trust in commodity value as conceptualised earlier, to be transitioned into a digital format that has since triggered a modern technological golden age for advancement. However, it also caused distrust due to the high risk for high reward mentality of modern finance — emphasised by the introduction of cryptocurrencies.

What is the place of Cryptocurrency in the modern financial system?

All previously discussed digital innovations, used currency as we have traditionally understood it; Government issued and substantiated by private institutions and businesses. However, following the economic crisis seen from 2007 onwards, a significant level of distrust in financial institutions arose — highlighted in cinematic productions such as ​Margin Call ​and ​The Big Short. ​

To understand the key differences between cryptocurrencies and traditional currencies, it must be stated that the former does not have a centralised database stored at a headquarters, or on an individual digital network that all of its computers or machines are plugged into — such as VISA or Mastercard. Bitcoin uses the ‘blockchain’ method. In which every computer plugged into the network, including that of anybody who uses the currency i.e. Bitcoin, cooperates in maintaining one giant ledger. Technically everybody has a copy of the ledger that contains all transactions on the blockchain network, and the ledger is only updated once the system runs its own personalised security checks to ensure it hasn’t been breached or records have been altered.

While traditional currency and currency networks operate with the concept of trust in the government institutions and any bank that operates within traditional financial boundaries by the people themselves; bitcoin operates using the concept that nobody trusts anybody. Granted, such a concept may appear cynical on the surface, but it is well-founded. The economic crash of 2007–2008 substantiated the argument that centralised banks could not be entrusted with currency.

Context on the 2007–2008 Crash: The US Glass-Steagall Act of 1933, separated investment banks and commercial banks in order to ensure the protection of commercial banks should the investment banks fail. Consequently, commercial banks were no longer allowed to use the funds of their clients (the general public) to make risky investments. This was introduced following the failure of banks due to risky practices, as witnessed during the Great Depression. As a result, it restored faith in the US banking system and allowed the currency to recover gradually through re-developed mutual trust — leading to what historians note to be one of the greatest instances of economic expansion in world history, or the US economic golden age (1945–1970s). In 1999, the Glass-Steagall Act was repealed. Some investment and commercial banks began to merge and used their client’s funds to make increasingly risky investments. This is what allowed a mortgage default crisis to become a complete economic meltdown.

Whilst as a currency itself, bitcoin does not retain any economic substance to be a revolutionary currency change that will transition consumers into a new financial age, however as a financial network in contrast to VISA or Mastercard, it opens up many new concepts and ideas for further financial innovation and technological advancement — more specifically for those who wish to become merchants on such an open platform without strict regulations and middleman payments required in standard currency networks.

Are these modern technological advancements, such as cryptocurrencies, beneficial or disruptive for financial systems in contrast to their former historical counterparts?

Overall, a consistent trend of evolutionary development can be noted from the picture presented in this analysis, with regard to financial progress caused by technological and ideological innovation. Primarily, it has caused governments and nation-states to accept responsibility in their respective economies, in order to maintain a sustained and substantiated currency value — by understanding the consequences for brash actions. Furthermore, it has allowed private investors and smaller businesses to thrive in situations that would not have been possible centuries prior — therefore boosting the economy overall by increased trade, productivity, and flow of revenue, leading to the global expansion of the middle class in modern times. Finally, transactions are now more efficient and simpler than previously seen by the use of digital networks. Whilst there is a varying level of risk attached to all transactions, this risk allows for overall growth in the long term.

One must conclude, that said new technologies are not disruptive for current financial systems but help push forth innovation to achieve new heights, as seen in a historically chronological fashion throughout this analysis.

Disclaimer: This article was originally submitted and graded as a university paper at Universitat Pompeu Fabra (UPF) and has since been edited for publication on the Young Fabians blog.

Thomas Marrs is a final year History & Hispanic Studies student at the University of Liverpool, with a focus on Muslim & Christian Relations during the Crusades. He is an independent writer and researcher in; history, international relations & foreign policy. His writing can be found at https://medium.com/@marrsdthomas

He tweets at @marrsdthomas

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