Deflation Made Simple (Part I)

A falsely vilified phenomenon (Image 024)

Seville had become the new financial capitol of Spain and Europe. But, when King Charles V, the Holy Roman Emperor and devout, militant Catholic, turned to Seville’s bankers in search of funding he was met with stiff resistance.

War is a resource-exhausting enterprise and a relentless state of existential crisis whose material and spiritual demands are endless until victory or defeat is finally achieved. What is more, the king’s demand for money appeared insatiable, and his cause — defense of the Faith — was difficult to refute. Without money his generals could not hire soldiers and purchase the munitions and supplies needed to sustain and retain them wherever they were needed across the empire.

At the time, the closest thing to paper money was the letter of credit — a promise created at the point of origin of an established trade route to transfer money from the account of the buyer to that of the seller upon receipt of goods at the point of destination at the other end of the route. The king, however, had nothing to sell, but the Faith and his own good will and determination. Moreover, he had exhausted his collateral among the Hapsburg-friendly bankers in Austria, Italy, and the Spanish Netherlands to the north of France. Indeed, the King was in search of an open line of credit and could offer only his promise to repay, his reputation, and the expectation that gold and silver would continue to flow from the Americas into La Casa — the same organization on which the many newly formed banks of Seville depended for their business.

When the King came begging there was hardly a bank in the city without a large amount of gold and silver coin and bullion in its vault.

The likelihood of the King’s repayment was not only questionable, but the time of repayment would be uncertain, for the flow of gold and silver from the Americas was barely regular. Moreover, the money that the King demanded was not intended for investment; there was no promise of a return. Everything lent would be spent on soldiers, munitions, and other supplies that would be exhausted in war. Satisfying the king’s demand was would be wealth-destructive, not wealth-generating. Alas, it was not the kind of lending that even banks of the 16th-century generally entertained (Image 20, 22 and 23). And, what were these bankers to tell their depositors when these latter arrived in search of what was rightfully theirs, and all that the bankers could offer was what they had been promised by the king?

Still, the king persisted, the banks relented, and their vaults were all, but emptied.

When the banks depositors arrived to claim their money, the bankers of Seville offered them what the king had offered the bankers — the promise that what belonged to the bank’s depositors would eventually be returned, just not today.

Initially, the idea was very poorly received, but no one had a choice. There was only one King of Spain.

There was another problem as well. Many of the bankers’ clients were local; but many others were from all over Europe. Accepting a paper promise as a substitute for money requires trust. Europe had always been a continent of many allegiances, but these were growing in number and with increasing tension. In 1521 Martin Luther was excommunicated from the Catholic Church by Pope Leo X and declared an enemy of the state by King Charles V, Emperor of the Holy Roman Empire. Gold and silver coin once received could be spent anywhere; it did not depend on political allegiance for its value in trade. Paper was different.

And, so it was that Seville bankers and their customers reluctantly settled on a combination of precious metal and promissory notes — formal IOUs with the seal of the issuing bank placed on the face of each IOU. The paper would circulate in Seville, and the gold and silver would be used to settle international obligations. All other money that flowed into the bank would be lent out as soon as it arrived. In effect, the banks would hold only enough gold and silver for the purpose of overseas transaction, but not enough to make it worthwhile for the king to come begging for more.

On the one hand, the emperor-king would have to wait for a new shipment of gold and silver from the Americas just like everyone else, and his imperials armies would have to make due with what they had, find another source of funding, or delay their military ventures all together. On the other hand, the warehouse function of Seville banks all but disappeared.

No, promissory notes were not real money, but they were easy to carry and they bridged an important temporal gap. Moreover, like all things human, refinements were undertaken. The printing press had been around for about a half century and sophisticated bank seals made counterfeited notes difficult to create and pass as genuine. What is more, unlike real money a promissory note could be written on the spot for any amount, and multiple notes could be written that would sum to a much larger single sum. In effect, the unit-of-account was now very flexible.

Then too, despite its increasing number of inhabitants Seville was reasonably isolated — far upriver from the ocean —, and all trade with the Americas that was carried on Spanish ships was made to pass through the city. There was a sense of built-in trust that greatly facilitated the circulation of the notes.

Important to our story of the development of money was that the amount of currency (real money and paper notes) in circulation suddenly increased even above that resulting from the irregular shipments of gold and silver flowing in from the Americas. Accordingly, the idea that value-in-exchange could be created out of nothing, but a promise had taken hold, and all of its perverse economic ramifications would soon be felt for the first time.

In liberty, or not at all,
Roddy A. Stegemann