Government borrowing creates intergenerational conflicts our system wasn't built to handle, but how do we curb debt?
As far as revolutions go, the world is still reeling from the publication of Sir Isaac Newton’s Principia Mathematica on July 5, 1687. By identifying and offering proofs for an impressive number of calculations and three laws of motion that established the foundations of classical mechanics in physics, Newton provided a powerful means for unlocking and then quantifying nature’s secrets. Nothing would be spared the ramifications of Newton’s discoveries.
Revolutions have a way of begetting other radical changes. The Scientific Revolution fueled Enlightenment debates about religion, reason, and how the natural sciences related to other realms of inquiry. Truly unforeseen, however, was how Newton’s revelations would spark an upheaval in how we think about money. That is the thesis proposed by Thomas Levenson in his new and very readable book, Money for Nothing: The Scientists, Fraudsters, and Corrupt Politicians Who Reinvented Money, Panicked a Nation, and Made the World Rich (2020).
As established decades ago by economic historians like Raymond de Roover and Eric Jones as well as the Jesuit economist Thomas F. Divine, the world’s first financial revolution occurred in the Middle Ages. Their researches showed that, thanks to a confluence of factors—a growth in the availability of capital; theologians wrestling with the usury question; the development of sophisticated financial instruments for managing risk, to name just a few—extensive commercial banking emerged in regions like Northern Italy, Flanders, and Southern England. None of this was planned from the top-down. Nevertheless it set the scene for a spectacular growth in European political, economic, and military power as modernity dawned.
Levenson’s story is a similar one. Starting with Newton’s breakthroughs in calculus and the study of motion between 1665 and 1667, Levenson shows how the emergence of contemporary financial markets and public finance can be traced to the application to the material world of mathematical models and quantitative methods developed in the early Enlightenment. But Levenson also illustrates how these events combined with late-17th century British politics to produce several momentous, albeit unintended consequences. These included the formation of the Bank of England in 1694 but also economic catastrophes like the South Sea Bubble in 1720.
From Enlightened Science to Risk Management
Newton was no stranger to the world of money. In 1696, he was appointed by King William III as Warden and then Master of the Royal Mint. Perhaps because of his long-standing interest in alchemy, Newton strove for mathematical precision in the purity of coinage throughout Britain.
Newton wasn’t, however, the only person with a passion for scientific exactness during this period. Others sought to apply the new learning’s mathematical dimension to increasing understanding of society and the possibilities for improving it. Early members of the Royal Society like Sir William Petty even strove to enhance humans’ ability to predict and shape political outcomes. “Political Arithmetick,” as Petty called it, involved gathering and then analyzing rudimentary statistics to attain knowledge which could be weighed, counted, and measured. Government officials became interested in this empirical information because it gave them more accurate insight into the resources at their disposal and therefore enhanced capacity to estimate more precisely their ability to fight wars over extended time-periods.
Therein lay, Levenson writes, “the critical step.” The desire to anticipate the future politically and militarily raised the question of how “to put a price on it.” Identifying the future costs associated with different choices about use of available resources was as complex a question as any of those tackled by Newton. The man who rose to the occasion, Levenson argues, was the astronomer, inventor, and demographer Edmond Halley (of Halley’s Comet fame).
Halley has good claim to be the architect of the mathematics that underlie modern life insurance. For Halley did more than just identify mathematical patterns in his detailed studies of birth and mortality rates. He used these patterns as a basis, Levenson writes, for assessing “the dimension of chance, of risk in the modern sense,” which is central to calculating a human life’s monetary worth at any future moment in time.
Halley’s efforts to quantify the odds of life-expectancy and to use it to assess risk involved “asking what mathematical relationship could connect an expectation that could come true years or decades down the road thanks to a decision made in the here and now.” Ironically, it took decades for the insurance industry to wake up to the full significance of this for their everyday work. But it dawned on many merchants that the new analytical tools used to assess the price of a life over time could be applied to other goods, most notably money itself. Instead of viewing money as a fixed sum, it could also be thought about as a quantity whose value—like life—could be tracked, studied and modelled mathematically through time. And thus a new science of money was born.
Coffee Changes Everything
It wasn’t, however, only merchants who foresaw new possibilities for profit through this innovative understanding of money. So did the hard-headed men of British politics then engaged in a religiously-charged and prolonged war with the greatest European power of the time, Louis XIV’s France. As always, war turned out to be the mother of invention.
In the 17th century’s last decade, Britain’s struggle against France was faltering. The problem wasn’t a lack of good generals, soldiers, or naval prowess. Britain was running out of money. This owed much to coinage issues, something that Newton’s reforms of the Mint helped resolve. But the stock of money was still inadequate because this war with France was on an entirely different scale than those fought previously. The government consequently needed to borrow. That in itself was hardly unusual. The pressures of the time, however, meant that Treasury officials started turning to ideas spawned by the Financial Revolution to rectify the situation.
One such idea was to create the world’s first true and permanent national debt and to establish the Bank of England as a monopoly-lender to the government. This allowed the British state to raise more and larger loans at a faster rate. The resultant growth in government debt and its buying and selling stimulated the growth of a modern financial market. Britain started to outstrip other nations’ ability to fund wars, a factor that accelerated its rise to superpower status in the 18th century.
There was, however, another unanticipated ingredient which influenced these developments—coffee.
Coffee-houses first opened in London about 1652, just 200 yards away from the Royal Exchange. They introduced, Levenson writes, Londoners to more than just an exotic drink. Coffee-houses became places in which members of the Royal Society mixed with the new traders in money to converse informally about numerous topics. That included how new concepts spawned by the Scientific Revolution might be applied to commerce and finance. Among the many ideas which arose from this interspersing of mathematical discoveries with the desire for profit was the joint-stock structure.
Joint-stock companies had existed in England since 1553. But under the impetus of the scientific and financial revolutions, the concept of a joint-stock structure underwent substantive revisions. As Levenson explains,
[it became] more complicated, and more powerful: a way to translate a process in the world into numbers on paper, the idea of a thing and not the thing itself. The joint-stock concept in use by the late seventeenth century thus echoes the essential insight of the natural philosophers: bringing an ever-growing range of different phenomena—buying and selling instead of planets—into a form that could be analyzed, compared, quantified, and, most importantly, readily bought and sold.
The result was an explosion in the number of joint-stock companies which sought capital and traded in shares and debt—including shares in the new national debt.
Keeping track of the going price of stocks and shares in these circumstances was extremely difficult—until, that is, a French Huguenot refugee named John Castaing who operated from premises in London known as “Jonathan’s Coffee-house” realized he could introduce greater certainty by providing a regular and dependable record of the market’s aggregative conclusions at any one moment in time. The result was more numbers: mathematical figures which provided images of England’s stock market in motion to which stockjobbers could refer as they decided what shares and commodities to buy and sell. Jonathan’s Coffee-house thus became London’s first stock exchange. Once again, this wasn’t planned. It just happened.
It All Falls Down
Britain’s ongoing global struggle with France in the 1700s meant that its national debt continued to swell. Even London’s new dynamic money-markets struggled to supply the country’s war-chest. Intellectual and political creativity was needed to resolve the problem.
Of the many solutions floated, one gained particular traction. It involved integrating two of the Financial Revolution’s children: the national debt and the joint-stock company. In simple terms, it worked like this: 1) government debt obligations would be transferred to such a company; 2) those who had lent their money to the Treasury would be given shares in the new company; and 3) the company would use this capital to fund the business it had been created to pursue.
In modern parlance, we call this a debt-for-equity swap. In 1711, the British government adopted this model by creating a new joint-stock enterprise. Dreamed up by the Chancellor of the Exchequer, Robert Harley, and a leading private banker, John Blunt, this private-public partnership required all holders of the national debt to relinquish it to a new enterprise called the South Sea Company. In return, they would be issued shares at the same nominal value as the debt which they had held. To convince others to invest and buy shares, the South Sea Company was given trade privileges with specific towns in South America and a monopoly of the supply of African slaves to the sub-continent, a highly profitable business at the time.
In retrospect, the South Sea Company was doomed from the start. First, Britain remained at war with Spain until 1713. This made trade in the South Atlantic impossible for two full years after the Company’s founding. Second, those running the Company turned out to be lousy slave-traders. Spanish and Portuguese colonial officials didn’t hesitate to cheat Company representatives at every turn. The Company also found itself obstructed by British planters in the Caribbean who opposed its slave-trade monopoly.
Given the subsequent meager profits, the South Sea Company refocused its efforts upon buying and selling government debt. Moreover, its slave-trade monopoly and close association with the government meant that South Sea Company shares were highly sought-after. Whig grandees, Tory gentry, London merchants, and more humble folk like porters and ladies maids were among the buyers. The greater the popularity of such shares, the more the Company issued them. By 1720, Company officials were resorting to the all-too-common technique of using rumors of potential profits to inflate share-prices.
Eventually, reality crushed fantasy. Among other things, it became apparent that the Company had done little actual trading in the South Seas and wasn’t likely to do so. Its shares turned out to be built on nothing. Not even the cleverest financial device or mathematical formula could prevent the implosion of the South Sea Bubble in 1720. Thousands were ruined, including banks, goldsmiths, aristocrats, and even rural laborers who, like everyone else, had followed the speculative herd. Subsequent investigations revealed widespread corruption and insider trading among MPs, government officials, and company directors. The crisis, however, also fueled the rise of Robert Walpole as Britain’s first de facto prime minister, primarily by dint of his successful management of the meltdown. This marked the beginning of a 22 year-long premiership, one in which Britain remained at peace for 19 years and successfully consolidated its power. That too was unexpected.
So what can we learn from Levenson’s account of how Newton and the new sciences helped ignite a revolution in money?
The changes in the concept of money certainly produced miracles, not least by making the renting of money as an idea expressed in mathematical symbols easier and faster. Nonetheless while the Financial Revolution enhanced the ability to manage risk, nothing could eliminate it. In fact, the new financial tools often lulled investors into a false sense of security—just as, in our day, the mathematical complexity of modern securitization helped disguise the weakness of devices like mortgage-backed securities which ended up wreaking havoc in the 2008 Financial Crisis.
In other words, the Financial Revolution’s insight that “money and its elaborations are mathematical objects” could not eliminate human ignorance and confusion. Indeed, it encouraged a certain amount of hubris. The message with which Levenson concludes is a sobering one: that history underscores how “a probabilistic risk of destructive crashes follows from each significant new wave of financial engineering.”
Just as a world without the natural sciences would mean much suffering, we would not want to be without the financial innovations of the late-17th century. As economic statesmen ranging from Jacques Necker to Alexander Hamilton and Jacques Rueff have recognized, modern finance can help create wealth and liberate us from poverty. But we should not put all our economic faith in it. Life is simply too unpredictable. Radical uncertainty—whether stemming from war, disease, or love of coffee—will always prevail.