Ha-Joon Chang - Economics - The User's Guide

We now take it for granted that countries have only one bank that issues its notes (and coins) – that is, the central bank, such as the US Federal Reserve Board or the Bank of Japan. In Europe in Adam Smith’s day, most banks (and even some big merchants) issued their own notes.

These notes (or bills, if you are in the US) were not notes in the modern sense. Each note was issued to a particular person, had a unique value and was signed by the cashier issuing it. [24] All the information on the Bank of England banknotes is from the website of the Bank of England. See: http://www.bankofengland.co.uk/banknotes/Pages/about/history.aspx . It was only in 1759 that the Bank of England started issuing fixed-denomination notes (the £10 note in this case – the £5 note came only in 1793, three years after Adam Smith died). And it wasn’t until two generations after Smith (in 1853) that fully printed notes, with no name of the payee and no signature by issuing cashiers, were issued. But even these fixed-denomination notes were not notes in the modern sense, as their values were explicitly linked to precious metals like gold or silver that the issuing bank possessed. This is known as the Gold(or Silver or other) Standard.

The Gold (Silver) Standard is a monetary system in which the paper money issued by the central bank is freely exchangeable with a specified weight of gold (or silver). This did not mean that the central bank had to have in reserve an amount of gold equal to the value of the currency that it had issued; however, the convertibilityof paper money into gold made it necessary for it to hold a very large gold reserve – for example, the US Federal Reserve Board kept gold equivalent to 40 per cent of the value of currency it issued. The result was that the central bank had little discretion in deciding how much paper money it could issue. The Gold Standard was first adopted by Britain in 1717 – by Isaac Newton, [25] Yes, that’s the scientist, who also doubled as an alchemist and a stock market speculator. the then head of the Royal Mint – and adopted by the other European countries in the 1870s. This system played a very important role in the evolution of capitalism in the next two generations, but that is a subject for later: see Chapter 3.

Use of banknotes is one thing, but saving with and borrowing from banks – namely, banking– is another. This was even less developed. Only a small minority had access to banking. Three-quarters of the French population did not have access to banks until the 1860s – nearly a century after TWON . Even in Britain, whose banking industry was far more developed than that of France, banking was highly fragmented, with the interest rates being different in different parts of the country well into the twentieth century.

Stock markets, where company shares (stocks) are bought and sold, had been in existence for a couple of centuries or so by Smith’s time. But, given that few companies issued shares (as mentioned above, there was only a small number of limited liability companies), the stock market remained a sideshow to the unfolding capitalist drama. Worse, many people considered stock markets to be little more than gambling dens (some would say they still are). Stock market regulation was minimal and hardly enforced; stockbrokers were not obliged to reveal much information about the companies whose shares they were selling.

Other financial markets were even more primitive. The market for government bonds, that is, IOUs that can be transferred to anyone, issued by a government borrowing money (the very market that is at the centre of the Euro crisis that has shaken the world since 2009), existed only in a few countries, such as Britain, France and the Netherlands. The market for corporate bonds(IOUs issued by companies) was not very developed even in Britain.

Today, we have a highly developed – some would say over-developed – financial industry. This is made up of not just the banking sector, the stock market and bond markets, but increasingly the markets for financial derivatives (futures, options, swaps) and the alphabet soup of composite financial products like MBS, CDO and CDS (don’t worry, I will explain what all these are in Chapter 8). The system is ultimately backed by the central bank, which acts as the lender of last resortand lends without limits during financial crises, when no one else wants to lend. Indeed, the absence of a central bank made the management of financial panic very difficult back in Smith’s time.

Unlike in Smith’s time, today there are a lot of rules on what actors in the financial market can do – how many multiples of their equity capital they can lend, what kind of information about themselves companies selling shares need to reveal, what kinds of assets different financial institutions are allowed to hold (e.g., pension funds are not allowed to hold risky assets). Despite this, the multiplicity and complexity of financial markets have made their regulation difficult – as we have learned since the 2008 global financial crisis.

Concluding Remarks: Real-world Changes and Economic Theories

As these contrasts show, capitalism has undergone enormous changes in the last two and a half centuries. While some of Smith’s basic principles remain valid, they do so only at very general levels.

For example, competition among profit-seeking firms may still be the key driving force of capitalism, as in Smith’s scheme. But it is not between small, anonymous firms which, accepting consumer tastes, fight it out by increasing the efficiency in the use of given technology. Today, competition is among huge multinational companies, with the ability not only to influence prices but to redefine technologies in a short span of time (think about the battle between Apple and Samsung) and to manipulate consumer tastes through brand-image building and advertising.

However great an economic theory may be, it is specific to its time and space. To apply it fruitfully, therefore, we require a good knowledge of the technological and institutional forces that characterize the particular markets, industries and countries that we are trying to analyse with the help of the theory. This is why, if we are to understand different economic theories in their right contexts, we need to know how capitalism has evolved. This is the task we turn to in the next chapter.

H.-J. CHANG

Kicking Away the Ladder: Development Strategy in Historical Perspective (London: Anthem, 2002).

R. HEILBRONER AND W. MILBERG

The Making of Economic Society , 13th edition (Boston: Pearson, 2012).

G. THERBORN

The World: A Beginner’s Guide (Cambridge: Polity, 2011).

‘ Mrs Lintott : Now. How do you define history, Mr Rudge?

Rudge : Can I speak freely, Miss? Without being hit?

Mrs Lintott : I will protect you.

Rudge : How do I define history? It’s just one fucking thing after another.’

ALAN BENNETT, THE HISTORY BOYS

Many readers probably feel the same way about history as young Rudge in The History Boys – Alan Bennett’s hit play and 2006 film about a bunch of bright but underprivileged Sheffield boys trying to gain admission to Oxford to study history.