A very important period of our history that paved way for the advanced world we live in today was industrial revolution.
Just as bankers of Florence were behind the epic Italian renaissance, financial innovators had a strong influence in making industrial revolution happen. Although historians disagree as to how far financial institutions can be directly credited for industrialisation as the decisive breakthroughs in textile manufacturing and iron production, which were the spearheads of the industrial revolution, did not rely very heavily on banks for their financing. But the fact that financial revolution preceded industrial revolution gives us very strong hint that it were the brilliant innovations in finance of 17th century that made room for exponential success in industry known as industrial revolution.
Let’s explore this further to uncover the hidden influence of these financial geniuses behind one of the most remarkable revolution of human history.
Financial revolution (1668)
In 17th century three major innovations in finance took place which proved very important for the future of banking. Their effect was so profound that this period is known as financial revolution.
The first of the three was cashless transactions. During the Dutch Golden Age in the late-16th and early 17thcenturies, the Dutch Republic dominated world trade. Merchants from around the world brought goods here to trade. This resulted in problem of multiple currencies which made trading process complex. There were no fewer than fourteen different coins which were involved in the trading process. To solve this problem Amsterdam exchange bank also known as Wisselbank was setup in 1609. This bank allowed merchants to setup their accounts in a standardised currency and to make a transaction, they simply made adjustments to account balances of two parties involved, by debiting their account and crediting counterparty’s account. This allowed more and more commercial transactions to take place without the need for physical transfer of coins. This Exchange Bank pioneered the system of cheques and direct-debits that we take so for granted today.
Development of this exchange bank led to the second most important innovation in finance in 17th century when the bankers observed that never do the depositors come at once to withdraw all their cash and deposits are uselessly kept by the bank as reserves. Which if loaned out could become a source of earning for the bank. This practise was officially carried out a half century later in Stockholm by Swedish Riksbank. Although it performed the same functions as the Dutch Wisselbank, the Riksbank was designed to be engaged in lending as well as facilitating commercial payments. By lending amounts in excess of its metallic reserve, it may be said to have pioneered the practice of what would later be known as ‘fractional reserve banking’, exploiting the fact that money left on deposit could profitably be lent out to borrowers. Since depositors were highly unlikely to ask for all their money at once, only a fraction of their money needed to be kept in the Riksbank’s reserve at any given time.
Now if banks are to keep only 10% as reserves (which is normally the case) and lend out 90% of deposits, this technique can increase money supply in the market by a good 1000% (10 times). Imagine if an economy had 10 times more money than its current cash reserves, how much more economic activity it will be able to carry out? That’s how banks boosted economies of western countries in 17th century (where industrial revolution took place).
The third great innovation of the seventeenth century occurred in London with the creation of the Bank of England in 1694. This bank had a monopoly on the issue of banknotes that were designed to facilitate payments without the need for both parties in a transaction to have current accounts. Due to this the very nature of money evolved in a profoundly important way. No longer was money to be understood as precious metal that had been dug up, melted down and minted into coins. Money now mostly consisted of banknotes recognized as legal tender along with the invisible money that existed only in deposit account statements. Some of this money might still be in form of precious metal, though majority of which would be held in the central bank’s vault and not in circulation.
This transformation of money from precious metals to figures in bank account statements and paper notes provided an infrastructure for rapid exchange of goods. Exactly what was required for something like industrial revolution to take place. Industrial revolution was about mass production, and what is use of mass production if there can’t be mass consumption? This new form of paper and invisible money allowed quick transfer of goods from producers to consumers and hence made industrial revolution so successful. Bankers of 14th century made Italian renaissance happened, bankers of 17th century made an environment which allowed an event like industrial revolution to take place.
There may not be a direct and visible impact of financial revolution on industrial revolution but it seems perfectly plausible that the two processes were interdependent and self-reinforcing. And it will not wrong to say that without financial revolution, industrial revolution might not have taken place or to the very least, not have been as significant as it was.
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Originally published at haq.life, Financial Innovations series is an essay divided in 7 parts which should be read in sequence for better understanding. Click on the links below to navigate to other parts of this series:
Table of Contents
