The Death of a Reserve Currency
Tom Heintjes: Hello, and welcome back to another episode of the Economy Matters podcast. I'm Tom Heintjes, managing editor of the Atlanta Fed's Economy Matters magazine. Today, we're speaking with Will Roberds, an economist at the Atlanta Fed. Thanks for being with us here today, Will.
Will Roberds: Happy to be here.
Heintjes: We're going do a little time travel today, back to the 17th and 18th centuries. Will has researched the role of the Bank of Amsterdam and the European economy of that era, and his Atlanta Fed research paper, "Death of a Reserve Currency," chronicles the rise and fall of the Dutch bank florin.
Will, throughout history and up to the present we've seen numerous examples of reserve currencies, including the euro and dollar today. But before the dollar, the British pound and the German mark were reserve currencies, there was the Dutch bank florin.
Roberds: Yes, the bank florin was an important currency in the late 17th and early 18th centuries in most of Europe. It was, I should say, not a reserve currency in the modern sense of a currency that was kept by other countries as a backing currency for their own currency, but it was a reserve currency in the sense of being used for transactions all over Europe.
Heintjes: Will, could you briefly explain the role of a reserve currency in the economies that use it?
Roberds: Specifically, the role of the Dutch bank florin was as a settlement medium for cross-border transactions. Let's say you were a merchant in 18th century Scotland and you wanted to import something from Poland or France or Italy, or somewhere else in Europe. The way that you would do it often times is you would draw a bill of exchange on a merchant bank in Amsterdam that would be payable through the Bank of Amsterdam, which was a public bank with a role and function quite similar to what modern central banks have today.
Heintjes: Now, historically, what qualities does a currency possess to enable it to achieve the status of a reserve currency?
Roberds: Well, I would say the number one quality was stability of value, which was certainly at that time quite rare in Europe. Also, liquidity. The Amsterdam financial markets were, throughout most of the 18th century, the most liquid markets in Europe, and they were markets characterized by absence of capital controls, which was also quite important for the bank florin's function as a reserve currency.
Heintjes: In your paper you examine developments in the 17th and 18th centuries, and I should note we have a link to Will's paper on the Economy Matters page—frbatlanta.org/economy-matters. By this time in the late 17th and early 18th centuries, the Dutch tulip bulb mania that we all know about of the early 1630s had already occurred and was a fading memory. But that burst bubble hadn't really dented the credibility of the Dutch economic authorities, had it?
Roberds: That bubble was an early 17th century phenomenon, and that was mostly what we would call a "retail" phenomenon. It was a lot of speculation by small players but, according to my understanding, that did not seriously impact the credibility and function of Amsterdam's financial markets.
Heintjes: I wanted to show our audience some examples of a Dutch bank florin, but when I asked you if we could get any pictures to show, you said that that currency existed only as entries on the ledgers of the Bank of Amsterdam. How is it that a physically nonexistent currency never actually in general circulation achieved reserve currency status across much of Europe in the 18th century?
Roberds: Well, the role of the ledger money in the Bank of Amsterdam, and most of the pre-19th century central banks, is quite similar to money that exists in reserve accounts in central banks across the world today. Just as that money plays an important role in terms of payments through Fedwire and similar large-value payment systems today, transfers of ledger money over the books of the Bank of Amsterdam were quite vital to the functioning of the 18th century European economy.
Heintjes: You mentioned that the Bank florin was not redeemable in coin. Was it one of the first examples of what we would today call "fiat money," and was this concept a significant innovation for its time?
Roberds: I would say that it was revolutionary. And let me qualify that phrase "not redeemable in coin." It was possible to withdraw coin from the Bank of Amsterdam. To do that, one had to have what was called a "receipt," and a receipt is what one gained by selling certain classes of coin to the Bank of Amsterdam. If you had a receipt from that transaction, you could redeem that receipt for a small fee for the coin that had been sold to the bank, but there was no inherent right of redeemability that was attached to money in the accounts in the Bank of Amsterdam. That change in the structure of the Bank of Amsterdam occurred quite early—1683, according to research that I've done with Steve Quinn at Texas Christian University.
Heintjes: Who tended to open accounts at the Bank of Amsterdam, and roughly how many accounts are we talking about here?
Roberds: Well the bank was open to anybody. Anyone with sufficient means could open an account at the bank. But in practical terms its use was restricted to the very top income and wealth tier in the city of Amsterdam. We're talking about 1 to 2 percent of Amsterdam's population, which was about 200,000 during this time period. I think at its very peak, the bank had 3,000 accounts.
Heintjes: The Bank of Amsterdam, you note in your research, was founded in 1609, and its principal role was simply to provide, as you noted before, a stable money for the settlement of bills of exchange payable in Amsterdam. What role did this play in the larger European economy at the time?
Roberds: It was an absolutely essential and vital role, because in most of Europe at that time, there were very few or very underdeveloped deposit banks, banks as we know them today. So if you wanted to move money, the way you did it was through bills of exchange, which are quite similar to today's commercial paper. Bills of exchange had to be settled in some asset, ultimately paid out in some asset, and that asset in the case of Amsterdam was balances on the books of the Bank of Amsterdam. So a lot of commercial credit—the great bulk of commercial credit, the great bulk of large commercial payments—moved through bills of exchange, and in Amsterdam the functioning of the bank was quite essential to that system.
Heintjes: In 1683, you note the bank began issuing receipts, which provided a stable currency. Had these conditions existed in Europe previously?
Roberds: Yes and no. People think of periods where there was commodity money, which was the world of the 17th and 18th century, of course, being periods of stable monetary value. But if you look at the actual record of these commodity money systems, they tended not to be that stable because of the practice of the issuers of coins of periodically debasing the coin, reducing the metal content as a way of extracting revenue from circulating money. What the bank did was to insist on, essentially, the deposit of very high-quality coins. And by doing so, and by creating ledger money that was backed principally by high-quality coins, it was able to create a very stable monetary asset and unit of account that was popular all over Europe as a result.
Heintjes: Will, in your career as an economist, you've done a good bit of research into the Bank of Amsterdam. What is it about this institution in particular that has fascinated you for so long?
Roberds: Well, it's an interesting mixture of the very ancient and the very modern. The sort of ancient aspect of the bank—it was a bank that was backed primarily by metallic assets rather than government securities. This is true for central banks today. I would say the most fascinating modern aspect of the bank is how much of its stability and function was insured by open market operations, which my coauthor Steve Quinn and I have found to be prevalent throughout all of the bank's history that we've been able to look at. And there is a huge amount of history that's available to researchers through the archives at the bank.
Heintjes: I want to follow up on that point. When was it that you realized the Bank of Amsterdam was an innovator in open market operations, or what we sometimes call OMO?
Roberds: When Steve Quinn and I got a crack at the early ledgers of the bank. These are from the 1660s—let me give credit to Steve, who recognized that a lot of the transactions that we observed in the ledgers could only be explained as open market operations—so this was some time ago.
Heintjes: Following up on that point, in your research you note that the Bank of Amsterdam engaged in many of the same practices as central banks today such as OMO, and it provided liquidity and generally stabilized market conditions. You note that playing this role is largely what transformed the bank florin into—and I'm quoting you here—"a bellwether currency for much of the 17th and 18th centuries."
Roberds: Basically what we've found—and we're in the process of documenting this a little more carefully—is that when the bank was able to engage in these stabilizing open market operations, then the value of its money was also characterized by a lot of stability. There were some periods in the bank's history when, for various reasons, it was unable to conduct these same operations. And during those periods, the value of its money tended to fluctuate in an uncontrolled fashion. So in a way, it wasn't advertised as sort of a modern central bank. But what's interesting is, just by accident, it ended up acting a lot like central banks do today, in terms of the way that it ensured that the value of its money would be stable over time.
Heintjes: You note that by 1783, the value of the bank florin began to suffer, but you write that that pressure became especially acute in 1790, after the outbreak of the French Revolution.
Roberds: Well, ultimately, the way the bank got into trouble was by lending to what we would now call a government-sponsored enterprise, and that was the Dutch East India Company. This was a huge corporation that was involved in transporting goods from Asia back to the Netherlands. Ultimately, they would be sold all around Europe. When I say "huge," I mean that at its peak it had at least 50,000 employees, which is a little bit mind-boggling to think of a corporation that size in the 17th and 18th century.
Heintjes: That's remarkable.
Roberds: During a conflict known in the Netherlands as the Fourth Anglo-Dutch War—over here, we call it the American Revolution—the East India Company got into trouble thanks to interference from the British Navy, and the bank was more or less forced to loan lots and lots of money to the bank. And as a result, the bank basically ran out of resources with which to stabilize its own money. That was the beginning of the bank's problem in the early 1780s. In 1789, after the outbreak of the French Revolution, there was a lot of demand for metal—precious metal—out of Amsterdam to finance all of the war activity that was beginning to take place in Europe. And as a result, the value of bank money plunged even further to the point where, in 1791, the city was forced to try and recapitalize the bank to reestablish its credibility.
Heintjes: Did the demise of the bank florin also spell the end of the Bank of Amsterdam?
Roberds: The Bank of Amsterdam was not formally liquidated until after the Napoleonic Wars. The actual liquidation was in 1820. But as a player in European and world financial markets, it was basically done with by the early 1790s, and certainly by 1795, once France invaded the Netherlands.
Heintjes: Let me ask you this: does the failure of the Dutch bank florin tell us anything about central banking more generally?
Roberds: I think it does, because one can go through and do estimates of the ability of the Bank of Amsterdam to absorb fiscal shocks, to undertake unconventional policies, and when you do that, you find that the Bank of Amsterdam was operating, over much of its history, a bit at the edge of its capacity. Its capacity was fairly large but finite. The events of the Fourth Anglo-Dutch War, or the American Revolution, sort of pushed the Bank of Amsterdam beyond its fiscal limits, and that was the end of its credibility as a reserve currency.
Heintjes: During the period you examine in your paper, the Bank of England was often less liquid than the Bank of Amsterdam. Yet the Bank of England's credibility was not called into question. Why was this?
Roberds: The Bank of England was an entirely different type of institution from the Bank of Amsterdam. The principal role of the Bank of England from its very beginning was to finance government debt. My understanding of the early history of the Bank of England is that everyone, including everyone in the financial market, understood that the bank was operating with that function in mind. The Bank of Amsterdam, by contrast, was not really supposed to be doing any financing activity at all. It was just supposed to be providing a stable asset for settlement of bills of exchange. It sort of got involved in the government-sponsored enterprise financing business through the back door and ultimately got in over its head.
Heintjes: One thing led to another. Although the design of the Bank of Amsterdam was in some ways comparable to modern central banks, including the Fed, there was a key difference, wasn't there?
Roberds: There were a number of differences. I would say perhaps the biggest one was that the Bank of Amsterdam was not a note issuer. It never issued any kind of circulating media, which I should explain, that was kind of a radical idea in the world of central banking or public banking in the 18th century. The fact that the Bank of England was doing that was, at the time, still an experiment. Inability to issue banknotes and lack of access to the stream of revenue that would have been provided through banknote issue meant that the Bank of Amsterdam was financially more fragile than a similar-sized institution that would have been able to issue banknotes.
Heintjes: After the demise of the bank florin, how was the larger European economy affected?
Roberds: Well, I should explain that the fall and demise of the Bank of Amsterdam was not an isolated event in the history of central banking. There were somewhere between 25 and 30 public or semipublic banks operating in Europe towards the end of the 18th century, and virtually all of them failed or had to be massively restructured during the Napoleonic period. The Bank of Amsterdam was perhaps the most prominent casualty. The Tyrannosaurus rex among the dinosaurs, if you will.
A notable survivor of the Napoleonic period—an institution that came out in very good shape—was the Bank of England, and I think the success of the Bank of England led to its being widely imitated in the 19th and 20th centuries as sort of a model for subsequent central banks worldwide.
Heintjes: Speaking of which, did later central banks take any lessons from the Bank of Amsterdam's experience that made them stronger?
Roberds: I think part of the problem with the Bank of Amsterdam was that there was no clear role, even though the Bank of Amsterdam had a national role in the Netherlands and essentially functioned as a central bank for all of the Netherlands and much of Europe during its heyday. There was no sort of clear line of financial responsibility for the bank, from the national government to the bank. So the fact that there was no clear national fiscal backing for the bank, I think, detracted from its efficacy. During the 19th century, people got away from the model of banks operated by municipalities, which had been, I would say, prevalent before the 19th century. It went more to national institutions, where there was some clear line of fiscal responsibility for the bank's operation.
Heintjes: I guess that would be one of the lessons learned from the Bank of Amsterdam's experience. Are there any other what we might call cautionary tales for central bankers today from the bank's experience?
Roberds: Well, another important reason or cause of the bank's demise was the fact that it was fiscally exploited in a not-too-transparent way by the city of Amsterdam, which was the owner of the bank. In practice, that meant that as long as the bank made money, the city would seize the bank's profits. Whenever the bank made losses, the losses were the bank's to recover. Although that system worked reasonably well for most of a hundred years, ultimately that caught up with the bank. I would say an asymmetric allocation of profits and losses was another problematic feature of the design of the Bank of Amsterdam that I think modern central banks should pay attention to.
Heintjes: And that brings us back to the present. Will, this has been a fascinating discussion, and I want to thank you for taking the time to talk with us today.
Roberds: Thank you.
Heintjes: Again, I'm Tom Heintjes, managing editor of the Atlanta Fed's Economy Matters magazine. Thanks for spending some time with us today. I encourage you to visit Economy Matters at frbatlanta.org/economy-matters and read the many interesting features we have for you there, including Will's paper, which is a very interesting snapshot of an important time in monetary history. When we get together next month for another Economy Matters podcast, we'll talk to Mike Johnson, senior vice president in the Atlanta Fed's supervision and regulation division, about the state of southeastern banking in 2015. Thanks again for listening.