The origins of money

We have learned that one major cause of productivity increase in pre-industrial economies is the gains from division of labour resulting from occupational diversification in an economy where regions and nations exploit their comparative advantages. But these gains cannot be reaped without exchange between increasingly specialized producers. Money, as a means of exchange, developed alongside the occupational and regional division of labour. The first money, some five or six thousand years ago, did not consist of stamped coins, but rather of standardized ingots of metal which were generally accepted as a means of payment. The Chinese and Greek civilizations introduced coins which were stamped like a modern coin. To understand the advantages of money it is worth looking at its historical antecedent and alternative. Direct bilateral exchange of one commodity for another, so-called barter, requires coincidence of wants between trading partners. It means that if you want to exchange a pair of shoes for wheat you have to find someone who has wheat and wants a pair of shoes. The matching process necessary to detect coincidence of wants will be very time-consuming, and time matters because it is scarce and has alternative uses. Barter will not only be associated with high search costs, but will also reduce the volume of trade to below its potential level because trade must be balanced. However, the volumes participants want to trade need not balance and in those cases the ‘minimum’ trader will determine the volume of trade. For example, a weaver might find a baker willing to exchange bread for cloth at an agreed price, but the weaver might not be willing to buy as much bread as the baker wants to sell. After all, bread is more perishable than cloth and is typically bought daily in small quantities. The volume traded when relying on bilateral balanced trade will thus, in this particular example, be constrained by the cloth maker, the ‘minimum’ trader.

This book evolved over the years from the lectures I have given and give to my students at the Department of Economics in Copenhagen. I have, however, attempted to write a book for a wider audience who are searching for a very concise introduction to European economic history which is in tune with recent research. I make use of a few basic and simple economic tools which turn out to be very effective in the interpretation of history. The book offers a panoramic view rather than close-ups. However, the analytical framework will be useful in further studies of the specialized literature. For readers with little background knowledge in economics I provide a glossary defining key concepts, which are marked in bold, for example barter. Economic ideas demanding more attention are explained in the text or in appendices.

This is a work of synthesis, but it attempts to give challenging and new insights. I am indebted to generations of economic historians as well as to a great many of my contemporaries. That normally shows itself in endless footnotes, which not only interrupt the narrative flow but also drown the general historical trends amidst all the details. Instead, I have chosen to end each chapter with a selective list of references which is also a suggestion for further reading. Authors I am particularly influenced by are referred to in the main text.

A large number of colleagues have guided me. Cormac Ó Gráda has as usual been a very stimulating critic and Paul Sharp has not only saved me from embarrassing grammatical errors but is also the co-author of two chapters. I would also like to thank Carl-Johan Dalgaard, Bodil Ejrnæs, Giovanni Federico, Christian Groth, Tim Guinnane, Ingrid Henriksen, Derek Keene, Markus Lampe, Barbro Nedstam and Jacob Weisdorf for helpful comments and suggestions.

Mette Bjarnholt was my research assistant during the initial phase of the project and Marc Klemp and Mekdim D. Regassa in the final stage and they have all been enthusiastic and good to have around.

Markov processes are useful for modeling a variety of dynamical systems. Often questions involving the long-time behavior of such systems are of interest, such as whether the process has a limiting distribution, or whether time averages constructed using the process are asymptotically the same as statistical averages.

Examples with finite state space

Recall that a probability distribution π on S is an equilibrium probability distribution for a time-homogeneous Markov process X if π = πH(t) for all t. In the discrete-time case, this condition reduces to π = πP. We shall see in this section that under certain natural conditions, the existence of an equilibrium probability distribution is related to whether the distribution of X(t) converges as t → ∞. Existence of an equilibrium distribution is also connected to the mean time needed for X to return to its starting state. To motivate the conditions that will be imposed, we begin by considering four examples of finite state processes. Then the relevant definitions are given for finite or countably infinite state space, and propositions regarding convergence are presented.

Example 6.1 Consider the discrete-time Markov process with the one-step probability diagram shown in Figure 6.1. Note that the process can't escape from the set of states S1 = {a, b, c, d, e}, so that if the initial state X(0) is in S1 with probability one, then the limiting distribution is supported by S1. Similarly if the initial state X(0) is in S2 = {f, g, h} with probability one, then the limiting distribution is supported by S2. Thus, the limiting distribution is not unique for this process. The natural way to deal with this problem is to decompose the original problem into two problems. That is, consider a Markov process on S1, and then consider a Markov process on S2.

Does the distribution of X(0) necessarily converge if X(0) ∈ S1 with probability one? The answer is no.

Why is an international monetary system necessary?

In Chapter 7, we discussed why money is important for economies – without it, all trade is based on barter and is limited due to the need for coincidence of wants. The same is true on an international scale. Normally, countries do not share currencies (although the euro, which we will return to below, is an important exception to this rule). Nevertheless, they must be able to convert their currencies if trade is not to be restricted to barter. Hence the need for an international monetary system.

In fact, without an international monetary system, trade will normally be restricted to balanced bilateral trade. Suppose for example that Denmark wishes to import 10 billion kroner worth of goods from Norway. It is important that the countries are able to barter, i.e. that Norway actually desires goods from Denmark in return. Even if this is the case, it might be that Norway only desires 5 billion kroner worth of goods from Denmark. In the absence of an international monetary system it is impossible for Norway to lend the difference to Denmark, i.e. there are no channels for international credit, and Denmark's imports are thus restricted to just 5 billion kroner. Trade is thus restricted, and countries are disadvantaged, since they cannot realize fully the gains from trade and specialization discussed in the previous chapter.

There are additional advantages to an international monetary system. In particular, as explained in Box 9.1, without a well-functioning international monetary system, domestic saving must equal domestic investment and thus foreign investment is impossible. Foreign investment is desirable, either by domestic investors abroad, or by foreign investors at home, if the return to investments differs at home and abroad.

History provides plenty of evidence for the disadvantages of the restrictions placed on the world economy by poorly functioning international monetary systems: at these times trade volumes and foreign investment have suffered.

The geo-economic continuity of Europe

The formation of Europe was a long historical process which involved political, cultural and economic forces. The most striking fact is the geo-economic persistence and continuity of Europe during the last two millennia. We will deal with the integrative impact of trade as well as its border-maintaining effect in shaping and maintaining Europe. Trade was the cohesive force when political, religious and military conflicts threatened to tear Europe apart.

If we let the core of Europe be defined by the borders of the European Union, we can trace back the origins of that geographical entity to the Roman and Carolingian empires, the latter emerging in the ninth century, several centuries after the collapse of the Roman Empire. (See Maps 1.1–1.3.) About 80 per cent of the total population of the Roman Empire around the year 100 AD lived within the present (2010) borders of the European Union. It stretched from the Atlantic coast to the Black Sea. Ireland, the northern periphery of Europe, Scandinavia and Russia were touched by neither the Roman nor the Carolingian rulers. Russia's relationship to Europe has remained ambivalent throughout its history, with periods of self-imposed isolation as well as enthusiastic embracing of European ideals, and Scandinavia was late in joining the European Union; in fact Norway is still making up its mind whether to join or not.

The Carolingian Empire represented the revival of political order after the disintegration of the Roman Empire, and also the emergence on the political scene of Germanic peoples, who amalgamated their own traditions with the adopted culture, law and language of their Roman predecessors in their south and westward push. Germanic tribes also advanced towards the east, but kept their own language and pushed the Slavic languages back eastward when they subjected the indigenous peoples and their land.

Understanding pre-industrial growth

We will now combine elements in Malthusian and Smithian explanations as developed in Chapters 2 and 3 to enhance our understanding of the nature of pre-industrial economic growth in those critical phases when the land constraint actually became binding at least locally, say, before the Black Death and in the seventeenth to nineteenth centuries. This new view acknowledges diminishing returns from labour in agriculture as the rural population grows and if the tilled land/labour ratio falls, but we also explicitly acknowledge technological change, that is, the useful application of new knowledge. Furthermore there are Smithian gains from specialization triggered off by division of labour stimulated by increasing ‘the extent of the market’, that is an increase in aggregate demand. If we have resource constraints and technological change the story will become fundamentally different. Technological growth is present if we can produce more goods today than were produced yesterday, with the resources used in production held constant. Technological progress and division of labour enable the economy to have both positive population growth and constant or increasing per capita income. The intuition here is that the effects of diminishing returns are offset by technological change. Figure 4.1 below explains in a simple way how the mechanism works.

Positive population growth has two effects with opposing signs, plus or minus, as to the impact on output or income per head. If the economy is using all available land there will be diminishing returns from labour, which will affect output and income per head negatively. However, as long as positive population growth is increasing aggregate demand (= income per head times the number of people) in the economy, division of labour will be stimulated and hence income per head. There are good reasons to believe that population growth actually increases aggregate demand because, as we noted in Chapter 3, there is strong persistence in wage levels.

The comparative advantage argument for free trade and its consequences

David Ricardo (1772–1823) put forward the idea that countries trade in order to gain from their comparative advantages. In his model, countries differed only in the productivity of their labour for producing different goods, and the country that was relatively efficient at producing something should export this good. So, for example, England should export cloth to Portugal and import wine. An important implication of this theory is that countries should trade even if they do not have an absolute advantage in the production of goods: it is not whether a country is better at producing something than another that decides whether or not it should export it, but whether it is relatively better in comparison with other goods. The argument relates to the concept of opportunity costs and is the same idea as that we met in Chapters 2 and 4 as one of the bases of pre-industrial growth. When population or the ‘extent of the market’ expands, specialization is possible. Trade allows the ‘extent of the market’ to cross international borders and for countries to specialize.

The concept of comparative advantage is often considered to be one of the most difficult to grasp in economics, and yet its understanding is crucial. In short, producing a good diverts labour from producing other goods, which are thus lost (the opportunity cost). Of course, in the absence of trade it is necessary to produce all goods, and this is unavoidable. However, with trade it is best for a country to focus on the goods it produces relatively well, because by so doing it can produce most. This extra output can then be traded for the goods it is relatively poor at producing and hence enhance the level of consumer welfare. This is the classic idea of ‘gains from trade’. A numerical example is given in the appendix.

Efficiency in the use of resources shapes the wealth of nations

Economic history is concerned with how well mankind, over time, has used resources to create wealth, food and shelter, bread and roses. Nature provides resources and man transforms these resources into goods and services to meet human needs. Some resources remain in fixed supply, such as land, but the fertility of land can and must be restored after harvest. Over thousands of years of agriculture, mankind learned how animal dung, rotation of crops and the introduction of nitrogen-fixing crops could increase the yearly harvest. Natural resources such as coal, oil and iron ore are, however, non-renewable. Other resources are made by mankind. Capital, for example factory buildings and machinery and tools, is therefore renewable. Labour, finally, is a resource whose supply relies on how well mankind uses the other resources at hand. But labour has been in increasing supply since the transition from hunter-gatherer technology to agriculture about ten thousand years ago. The skills of labour, so-called human capital, were primarily based on learning by doing, and it is only since the nineteenth century that formal education has played an important role.

Efficiency is determined by the technology of production and by the institutions that give access to the use of resources. A convenient way of measuring efficiency is total factor productivity. The more output you get from a given amount of resources the higher the level of total factor productivity in an economy. You can measure the growth of total factor productivity by the growth in output which is not caused by an increase in inputs in production. Total factor productivity growth is caused by better use of resources due to new technological knowledge and better organization of production.

Institutions can be understood as the rules of the game for economic life. Institutions or principles such as the Rights of Man matter because if labour is not free to move it is unlikely that labour will find its most productive employment.

Light in the Dark Ages

The Dark Ages in Europe, the centuries after the decline of the Roman Empire, were not as dark as we used to think, although they did not possess the political, cultural and economic grandeur of the Roman Empire. Nor did Europe match Muslim civilization in terms of wealth and technical ingenuity. Products and technologies for the manufacture of sugar, paper, cotton and fine fabrics, chemicals for dying and glassmaking, would be imported during subsequent centuries. However, modern historians are now rewriting the history of the sixth to ninth centuries, and the prevailing pessimistic view is giving way to a more nuanced view of what happened after the decline of the Roman Empire. Settlements were abandoned and cities lost population and skills; roads deteriorated because of lack of proper maintenance; political maps were redrawn and social order was difficult to maintain; money was scarce and uniform coinage was lacking; income fell for ordinary people as well as the rich. Income declined because traditional trade links had been disrupted and because the social disorder and declining population could not support the infrastructure of public institutions and roads, markets and fairs, or the division of labour and specialization of the previous centuries. Income per head did not attain the peak level reached in the Roman period until the twelfth or thirteenth century in the most advanced parts of Europe.

In one respect this age remains dark: we do not have much written documentation, so we have to rely on archaeological evidence which is difficult to interpret. Historians use numismatic evidence, deposits of pottery and metal utensils; they analyse the nature and extension of settlements and of course the few written documents that are available. By locating coins you can, with a critical eye, trace trade links, for example. The extension of a market network can be revealed by the diffusion of specific types of pottery, jewellery and coins.

Institutions and efficiency

Institutions are the rules of the game. Some are upheld by law, others by mutual and spontaneous consent and quite a few by the (brute) force of privileged elites. Some institutions are informal, such as trust and commitment, while others – say, the limited liability corporation – needed coordinated action by lawmakers to get established as they did by the end of the nineteenth century.

Modern economic historians tend to explain institutions by pointing at their efficiency-enhancing effects. That works well for a large number of institutions and this is how we shall explain the emergence and persistent use of money as well as the evolution of banks in Chapter 7. Welfare State institutions are explained by the way they resolve potential market failures in private insurance and capital markets (Chapter 10). Private property rights can be seen as solving the inefficiencies of communal property rights; this is known as the tragedy of the commons. The tragedy of the commons is a metaphor for the waste of resources that may occur if there are no restrictions on the use of resources. If all have access to a resource – a forest, say – it will be over-exploited unless there are centrally planned restrictions on its use. The over-exploitation stems from the fact that each individual user generates a cost to others, what is technically known as an externality. If an individual logs timber for her own use, she will reduce the future availability of timber not only for herself but for others as well. But the cost to others does not affect or restrain the individual user because that cost does not enter as a private cost. The social costs of individual action are larger than the private costs. Deforestation is a serious problem in large parts of Africa at present because households need wood for cooking their meals.

Economy and politics at the close of the nineteenth century

In the last third of the nineteenth century, a number of Western European economies started to catch up with Britain (see Chapter 6), and participated in a phase of modern economic growth. It was an era of the minimal state. Government expenditure, central as well as local, as a share of GDP was around 10 per cent and most public expenditure was consumed by the military, law and order and civil administration. Public education, state-funded health and assistance to the poor and elderly amounted to less than half of government expenditure. The role of the state was to set the rules of the game, i.e. to enact laws and regulation for industry and trade, which might include legislation about maximum hours of work and safety standards for industrial workers. Poor relief actually stagnated in the nineteenth century and did not surpass 1 per cent of GDP until democracy gave the poor more say. In some nations, unemployment insurance was introduced with the help of the state, but trade unions were instrumental in setting them up. State subsidies were resisted in other nations on liberal grounds. A liberal consensus emerged, although attitudes to free trade differed when the losers from trade liberalization triggered off a protectionist backlash in the 1880s. However, the role of government was limited.

Money supply was left to the banking system and ultimately to central banks when they were granted a monopoly on note issuance. Macroeconomic management by using deliberate changes in taxation and expenditure to influence the business cycle had not been heard of. The first use of the word macroeconomics stems from the early 1940s. An economic orthodoxy which viewed the economy as a self-regulating entity dominated the minds of the ruling elite. It was thought that shocks to the economy could be absorbed through changes in prices and wages and would therefore have no real effects even in the short to medium term.