Bookshelf: Medici Money and Renaissance Currency Exchange

Medici Money: Banking, Metaphysics, and Art in Fifteenth-Century Florence by Tim Parks is the third financial history book I've read so far this summer, and easily the most historical thus far. A relatively short book at around 250 pages of text, Medici Money chronicles the rise and fall of the famous Medici family and their elaborate banking system in 15th century Florence.

Image from Google Image search.

As Parks explains in the opening pages, "This book is a brief reflection on the Medici of the fifteenth century--their bank; their politics; their marriages, slaves, and mistresses; the conspiracies they survived; the houses they built and the artists they patronized. The attempt throughout will be to suggest how much their story has to tell us about the way we experience the relationship between high culture and credit cards today, how far it informs our continuing suspicions with regard to international finance and its dealings with religion and politics." A sweeping goal, to be sure, but an important one as well--few historians have endeavored to connect the Medici and their banking with modern-day finance.

The book begins with a well-written look at the historical environment of the Medici, focusing on how the metaphysics and morality--or lack thereof--of the Catholic Renaissance era affected the exchange of money. After spending some time investigating the important topic of usury, Parks moves into a broad examination of Renaissance finance, noting how the central financial and religious importance of Rome created a steep economic imbalance in Renaissance Europe. Much of the flow of expensive goods was from the south (Italy) to the north (England, Germany, Belgium), but the return flow of currency back to Italy was often slower and more difficult. The result was a massive financial imbalance within Europe in favor of Italy, while at the same time huge trading deficits in the countries of northern Europe, who were often deep in debt to the local branches of Italian banks.

Despite this complex and inefficient environment, Italian bankers such as the Medici still found plenty of ways to make a profit, mainly from international currency exchange. While the Medici were merchants as well as bankers, and made some money by speculating on and selling various commodities and consumer goods, they amassed most of their wealth through currency exchange. A merchant would come to a Medici bank and asks for 1,000 florins, offering in return an exchange deal in London, where he will be exchanging florins into pounds sterling. In return for the loan, the merchant would write out a cambiale, or bill of exchange, instructing the Medici be paid 1,000 florins at 40 pence to the florin, as is the custom. While the "how" of the repayment has been clearly defined, this last phrase was very important, since it defined the "when," or the length of validity of the bill of exchange. "As is the custom" meant the standard length of the journey from Florence to London, which at the time was 90 days or three months.

Since currency values and exchange rates fluctuated daily then just as they do now, yet modern communication and financial data systems hadn't yet been invented, one may wonder how on earth the Medici were able to consistently profit from international currency exchange. The answer is that, at the time, currencies were always worth more in their country of issues, due to the complex and inefficient exchange market of the time. As a result, the florin was always worth 4 pence more in Florence than it was in London. So returning to the aforementioned transaction: our merchant would take his 1,000 florins and convert them to 40,000 pence in London, three months after departing Florence. He then sought out a local client or fellow merchant who wanted to pay him back in florins--perhaps someone speculating on English wool who thinks it will be worth more in Italy. Thus a second bill of exchange would be written, stating a payment of 40,000 pence at a rate of 36 pence to the florin. If all went well and the bill made it back to Italy in time, the Medici bank then collected 40,000/36, or 1,111 florins, resulting in a profit of 111 florins and an annualized interest rate of 22%. Not a bad rate of return.

Italian Renaissance bill of exchange, 1398. From http://arttattler.com/archivemoneyandbeauty.html.

By making hundreds of these deals, the Medici were able to augment their income from commercial merchant activity and ecclesiastical incomes from church bishops and cardinals. Thus, they built a diversified and global financial base upon which to expand their banking system and, over time, their power and influence within Florence. The downfall of the Medici banking system, and thus their family, came when they began ignoring the fundamentals of finance to spend enormous sums on ensuring political prestige. This led to bankruptcy, liquidity crises, the breakdown of cooperation between their various European bank branches, and, ultimately, the closing of the entire bank and the expulsion of the Medici from Florence. Yet not before the Medici family had been able to create a glorious, if rather brief, "golden age" that forever linked Florence with the pinnacle of Renaissance art, architecture, and culture. And it was all of it--from the sculptures of Donatello to the political theory of Machiavelli--paid for with Medici money. After all, as Cosimo de Medici once said, "The poor man is never able to do good works."

From Russia, With Default: Russian Debt Crises and Global Finance

I finished reading The Ascent of Money while sitting in New York City's Bryant Park last Saturday, with the mammoth Bank of America Merrill Lynch tower as a backdrop, the Lord of War soundtrack as background music, and the occasional stray ping pong ball to bring me back to my surroundings. After three long days of investment banking networking and meetings with various IU alumni in the city, it was nice to sit and take in the somewhat paradoxical combination of parks & rec and metropolitan mayhem that New York has to offer, all while reading about the history of finance.

One of the themes throughout Niall Ferguson's book is the inherently international nature of finance and banking, and how seemingly unconnected transactions and events can have disastrous ripple effects leading to global crisis. This is something that became all too obvious between 2007 and 2009, when the U.S. subprime mortgage and CDO meltdown led to not only an American but also a global recession from which international markets are still struggling to recover. Indeed, while the cover of the current issue of The Economist announces "Wall Street is Back," the British newspaper doubts that investment banks will ever fully regain the levels of profit and success they attained prior to 2007.

Yet massive global crises caused by national-level defaults and instability, far from being a 21st century phenomenon, have been a variation on a theme for at least a century now. Two instances that I find particularly intriguing, given my interest in Russia and Eastern Europe, are the Russian defaults in 1918 and 1998. In both cases, national-level financial problems in Russia led to global financial pandemic.

The assassination of Archduke Franz Ferdinand, which led to the outbreak of hostilities in the Balkans and ultimately triggered World War I, did not cause any financial reaction until late July of 1914. Once investors and financiers realized the impending likelihood of global war, however, they were quick to react, and one of the first victims was the Russian economy. Although Russia had one of the largest standing armies in Europe at the time, its financial and political systems were not regarded as very stable, and a massive selloff of Russian securities ensued. This in turn led to a drastic drop in value for the ruble, followed by a similar slump in the dollar once American securities were unloaded by Europeans as well. 

Global meltdown quickly ensued, as British banks were flooded with sell orders. Soon most financial systems in Europe faced a mounting liquidity crisis, which the unfolding war did nothing to help. To staunch the financial bleeding, the world's major stock markets completely shut down for several months. It was an unprecedented event and one that has not been repeated since; but it succeeded in averting a full-blown global crash that likely would have been at last as bad as the one that kicked off the Great Depression in 1929.

Returning to Russia, however, the Tsar's government simply suspended the gold standard and any convertibility of rubles into gold, which led Russian bond prices to collapse, followed in short order by the Romanov dynasty itself. In 1918 the new Bolshevik regime defaulted on all of its bond debt, and by the 1920s Russian bonds were trading around 20% of face value. It was only through forced, Soviet economic management that the Russian financial system was brought back to a semblance of life and was able to grow during the subsequent depression era of the late 1920s and early 1930s.

Russian Freedom bond, 1917. Image courtesy of Wikipedia.

Russian default precipitated a similar global crisis in 1998, again due primarily to overarching economic and political reasons. Following the collapse of the Soviet Union and the "opening" and "freeing" of Russian markets to the rest of the world, Russia's supposed emerging economy entered a tumultuous period dominated by oligarchs and overly reliant on oil revenues. Overwhelmed with political turmoil and botched attempts at privatization, Russia defaulted on its foreign and even rouble-denominated domestic bond debt in August of 1998.

The shockwaves were immediate and devastating. While the limitations and weaknesses of the Russian economy were known at the time, the Russian default blew out bond spreads, caused equity volatility to spike, and crashed market indices. Perhaps the most damaging and most (in)famous results of the Russian default, however, was its central role in the collapse of hedge fund Long-Term Capital Management. Using complex and sterilized mathematical modeling, LTCM had bet big that the markets would never lose more than $45 million in a single day. The Russian default caused the markets to los $550 million on August 21, 1998 alone. The continued losses drove up LTCM's leverage and crashed its supposed infallible modeling, leading to the collapse of the hedge fund and a massive Wall Street bailout that would foreshadow the more recent bailouts following the 2008 financial crisis.

The 1918 and 1998 Russian defaults were separated by 90 years of supposed financial evolution and progress, yet history certainly seemed to repeat itself. In both instances, the supposed financial invincibility and hubris of investors (whether Western Europeans or LTCM) was reduced to panic due to events half a world away, in a country and financial system regarded even today as tangential. The lesson to be drawn--from these incidents and from Niall Ferguson's book in general--is that as integral as international finance has been to the interconnected ascent of man and money, the key to establishing a successful financial history of your own is knowing and understanding the history of finance. In the grand scheme of things, global dynamics and international events can often be far more important than technical valuations and mathematical models.

Bookshelf: The Ascent of Money

A lot has happened since my last post. I have finished final exams (in effect becoming a senior in college); moved out of my fraternity house and back home; and lately have been preparing for my upcoming trip to NYC this week with the rest of the Investment Banking Seminar Class of 2014.

I've also begun reading the highly recommended and critically acclaimed book The Ascent of Money, by Niall Ferguson. More history than hardcore finance, the book has been fascinating thus far, and I'm only 30-odd pages in so far. I think I'll use the book as the first in a series of new blog posts entitled "Bookshelf," which will cover what I'm currently reading or books I'd recommend to my readers.

At the risk of over-quoting from the book, I'd like to share two of the main points from the introductory chapter: 1) poverty is not the result of rich financiers exploiting the poor; 2) modern finance amplifies the effects of human nature, human ignorance, and hard work.

"I myself have learned a great deal in writing this book, but three insights in particular stand out. The first is that poverty is not the result of rapacious financiers exploiting the poor. It has much more to do with the lack of financial institutions, with the absence of banks, not their presence. Only when borrowers have access to efficient credit networks can they escape from the clutches of loan sharks, and only when savers can deposit their money in reliable banks can it be channelled from the idle to the industrious or from the rich to the poor. ...

"My second great realization has to do with equality and its absence. If the financial system has a defect, it is that it reflects and magnifies what we human beings are like. As we are learning from a growing volume of research in the field of behavioural finance, money amplifies our tendency to overreact, to swing from exuberance when things are going well to deep depression when they go wrong. Booms and busts are products, at root, of our emotional volatility. But finance also exaggerates the differences between us, enriching the lucky and the smart, impoverishing the unlucky and no-so-smart. Financial globalization means that . . . The more integrated the world's financial markets become, the greater the opportunities for financially knowledgable people wherever they live--and the bigger the risk of downward mobility for the financially illiterate. It emphatically is not a flat world in terms of overall income distribution, simply because the returns on capital have soared relative to the returns on unskilled and semi-skilled labour. The rewards for 'getting it' have never been so immense. And the penalties for financial ignorance have never been so stiff" (pgs. 15-16; bold emphasis added).

Important thoughts to ponder.