With this lecture, I start to look at the second great puzzle of macroeconomics. How does the financial sector affect the real economy? Before one can answer that question one needs to examine the fundamental role of money and credit. In this lecture, I suggest that they are closely linked to government power.
Imagine yourself in the environment, which existed until about 300 years ago, in which the overwhelming challenge was to obtain food. Not many people can make a living in art, science, education, or software development, because people need to eat. So you have to be engaged in primary food production. That means you need land, and you can't live close to a lot of people. There are not many people to trade with. There is very little surplus to trade. Maybe every six months or so you have a festival where you get together with people from miles around, get drunk, and swap a few bowls, to give future archaeologists something to get excited about.
If you're really sophisticated and disciplined, maybe you organize an army that conquers lots of farmers. They pay taxes (in the form of food), you use the taxes to feed soldiers and slaves. The latter build cities. Some of the children of the elite soldiers, knowing that their parents will feed them, go into art, science, software development, and so on, which gets the future archaeologists even more pumped up.
I don't think of pre-modern economies as market economies, in the sense of people voluntarily specializing in production for sale. Instead, I see individuals focused on subsistence, and organized groups focused on war, financed by plunder.
A standard textbook starts by assuming a market economy, explains how money makes such an economy more effective, and then incidentally introduces a role for government in regulating money and banking.
My skewed view is the opposite. For me, money and credit start out as tools of government, and they get incidentally adopted by the market.
Imagine that you're a warlord leading a band of soldiers. Your business model is that your soliders prey on farmers, taking plunder and tribute. To help motivate your soldiers, you promise them a share of the booty.
When the band of warriors is small, the promises can be verbal and informal. However, in order to organize a large army, you need formal, written contracts. Lacking lawyers and xerox machines, you make little carvings on metal, hand them out to soldiers, and say, "After the battle, turn this in to the clerk and we'll give you a share of captured slaves and grain and stuff."
In this simple model, governments exist to make war or to subjugate populations. The warlords sometimes pay their warriors on credit, using coins or other means. The warrior knows that the warlord will redeem the coins for booty.
Eventually, the coins can start to circulate in a secondary market. As warriors start to accumulate slaves and goods, they sometimes trade with one another. Every once in a while, instead of exchanging a slave for a few bottles of wine, you might exchange the slave for some coins.
Keep in mind that the standard view is that a market needs money as a medium of exchange. Suppose that the person selling grain wants shoes, the person selling shoes wants wine, the person selling wine wants olive oil, and the person selling olive oil wants grain. There is no two-way trade that works (we say there is no "double-coincidence of wants"), but a four-way trade is clearly possible. Using money as a medium of exchange makes it a lot easier for this complex trade to take place.
In the standard view, if you did not have a market economy, with lots of specialized production and consumption, then you would not need money. If people are just living on subsistence or making occasional bilateral trades, money would not emerge.
In the skewed view, money can exist even without a market economy. A big-time warlord needs to be able to procure soldiers on credit, and the warlord issues credit instruments that act as money. Maybe if the warlord builds a really big organization and accumulates a lot of plunder and tribute (think of the Roman empire), you start to see markets where different types of plunder are exchanged, and money serves as a medium of exchange along the modern textbook lines.
Money's value reflected the military power of the warlord. A really strong warlord's coins would be widely accepted. A shaky warlord might have trouble getting his coins accepted. You can imagine that there are strong positive feedback loops. A rising warlord has a more powerful currency, which buys more soldiers, who deliver more plunder, which strengthens the warlord, which makes his currency more in demand, and so forth. When the warlord falters, the process goes into reverse. A warlord needs a good financial operation as well as a good military operation.
If somebody is good at accumulating money but not so skilled with a sword, he can form a symbiotic relationship with a warlord. The warlord needs the money maven to help finance expeditions, and the money maven wants the warlord to protect his wealth. Hanging over this relationship is the threat that the warlord will steal the money maven's wealth or that the money maven will switch sides and bankroll the warlord's enemies. One can imagine a variety of incentive mechanisms that would be devised to sustain the relationship, including land grants by warlords to money mavens, marriages arranged among children of money mavens and children of warlords, and so on.
I can imagine that until quite modern times, the typical person had only occasional contact with money or credit. Instead, money and credit were instruments of rulers and the warriors needed to sustain rule.
It could be that for the typical person, the use of money was coerced. A farmer might be ordered to accept money for grain. With the exchange rate of money for grain dictated by the wardlord rather than determined in a fair market, this would be a convenient form of taxation.
The government need not use a particular grain-for-coin price to take advantage of seignorage. An alternative approach would be to require that taxes be paid in coins. That would force the farmer to acquire coins, trading grain for coins at whatever price the market generates.
From the skewed perspective, one would expect to find finance and government power closely linked. In the world at large, military strength should correlate with the acceptance of a government's financial instruments. Within a country, the wealthy need political power in order to preserve their financial position, and governmental leaders need financial resources in order to preserve their political power.
According to the skewed view, there was never a state of nature in which financial institutions roamed free in the wild, to be later tamed by regulators. Instead, financial institutions were fundamentally institutions of government. Entrepreneurial finance is a modern development, and its separation from government may always be tentative.
The early United States, in this as in other things, seems exceptional. Our frontier society was resistant to government and engaged in some experiments with banking that was quite independent of the Federal government. Eventually, the Federal government consolidated its hold in the United States, and "free banking" was no more. (I am not an expert in this history of free banking, but I suspect that at the state level there were lots of ties between banks and government during the "free banking" era.)
In the contemporary situation, we want to find a neat dividing line between government and finance. However, this is proving difficult. From the skewed perspective, it comes as no surprise that we are having a hard time creating a financial architecture that clearly separates the roles of government and private institutions.