Reading The Making of Modern Finance as an Invitation to Critical Uses of History

Samuel Knafo aims at a difficult target in his splendid new book, The Making of Modern Finance. His goal is to demolish the almost intractable assumption so frequently attached to liberal financial governance – the notion that the state is essentially a reactive actor, one that operates to undergird market dynamics.

Knafo’s target is a favorite one for many of us and, at times, we convince ourselves that we have damaged if not shredded it.  Many accounts expose the vital role that states play ‘in engineering our socio-economic reality’, as Knafo recognises.  But he reminds us that the constructivist critique – that the market depends essentially on political decisions, social forces, and legal institutions – is far from fatal. To the contrary, it leaves the myth that states are largely reactive while economic actors drive the action largely intact in the popular imagination and in influential disciplinary enclaves, most notably economics. Indeed, the critique may even feed into the myth: as accounts about the way the state constructs the market accumulate, it comes to seem appropriate, and even natural, that the state should act to engender and protect a market order.

Knafo’s approach is to subvert a fundamental assumption we hold about the liberal state.  He selects the truism that the breakthrough to modern modes of financial governance came with the commitment to ‘sound money’. ‘Sound money’ in the economic imaginary represents the government’s resolve not to raid the value of money by debasing or deliberately depreciating a currency. Relatedly, the trope evokes the ‘credible commitment’ by authorities to pay off public debt. The take-away is the message common to both those pledges:  the liberal state takes form when it observes the property and contract rights of constituents – when, that is, the state exercises restraint and allows private exchange to flourish.

Knafo’s challenge to the conventional teleology is powerful.  As his history demonstrates, English adherence to sound money principles had a long history; they did not originate in the 18^th or 19^th centuries. If adherence to sound money was a long-standing commitment, it cannot distinguish liberal financial governance (or LFG) as a governing philosophy built upon restraint from earlier regimes. Rather, writes Knafo, the most famous era of sound money – the 19^th century Gold Standard – was distinctive not for invention of sound money, but for innovation of central banking.

Knafo changes the way that we think of central banking. He exposes a new history about how the imperative imposed by the government on the Bank to maintain convertibility produced a counter-intuitive result. Pressed by an evidently active government in ways that rendered it vulnerable, the Bank innovated methods to control the financial market, including open market operations, the calculated use of the discount window, and the manipulation of colonial monetary arrangements. Particularly compelling is Knafo’s argument that the international Gold Standard arrived as a somewhat unintended consequence. As countries adopted gold convertibility to discipline domestic money creation by commercial banks, they created unanticipated constraints:  trade imbalances and capital flows regularly endangered gold reserves. Central banks in turn deployed the tools they were developing to mitigate the pressures on home economies. Rather than converging on the ‘rules of the game’, central banks and governments were instead expanding their defensive capacities.

As Knafo concludes here, he seeks ‘to convey concretely how much of a leap the advent of central banking was’.  In that way, he aims to move beyond the message that ‘there was nothing preordained’. Rather, the point is to undermine the standing myth more significantly. Once we see that the advent of central banking was actually fused with and in many ways engendered by the Gold Standard, we will also understand that the liberal state must be ‘defined . . . in terms of power, as a form of discipline which always applies on certain market actors and which will contribute in reshaping their practices’.

I could not agree more:  Knafo’s new history should reframe our approach to liberal financial governance in ways that redefine liberal agency.  But the issue remains: will his revision stick or will it be swamped by reiterations of the received (and illusory) wisdom?  In the rest of my post, I want to treat Knafo’s book as an invitation to think seriously about how we might build towards a cumulatively new paradigm of financial governance.  I propose three strategies that I believe he either practices or implies – 1) reframing the facts; 2) recognising economic irresolution; and 3) challenging existing theory, all with a critical use of history.  I illustrate each with an example.

1) Reframing the facts

We can start with Knafo’s chosen approach.  Historical inquiry, undertaken without liberal blinders, can write a new reality, one that subverts basic premises of the conventional account. That is a cumulative project, as Knafo (and Thomas Kuhn) would surely agree. Thus Knafo has targeted one of the tropes of liberal financial governance – sound money – but he has left other tropes for the rest of us. There is lots of space for critical work on those narratives, some of which are absolutely elemental to classical and neoclassical models.

Take, for example, the premise that exchange between private individuals – deal-making by decentralised agents – is the activity that constitutes the “real economy” at a fundamental level. Historical orthodoxies, fictional as they may be, establish priority for the premise. Most notable is the story used to explain money’s origins.  Money, according to this fable, arose out of the spontaneous activity of bartering individuals, who converged on a conventional medium of exchange.  If so, private action is antecedent to the coordinating mechanism that makes markets possible and, indeed, is sufficient to produce that coordination. It is hard to get more primal than this.

The story, slightly modified, is deployed in many accounts to explain the development of bank-issued money.  The basic notion is that bankers began producing representations of specie held by them for depositors, and people began to pass around those representations, eventually producing paper money. If so, individual agency in creating credit is the active force; governments only get involved to regulate that phenomenon.

But the English experience, approached without preconception, looks entirely different. Political authority likely engendered coinage as money and reappears again as the enabling force behind early modern note issue. Thus, activity by enterprising private bankers failed throughout the 17^th century to produce a significant medium between strangers, certainly one that acted as a retail cash. It was instead a public grant of money-issuing authority to the Bank of England that established the first generally accepted paper currency.  Tax receivability, along with easy legal transferability, enabled notes to circulate widely rather than remaining within limited networks. After all, every one would take a note that the government itself had pledged to accept. In turn, the Bank’s success enabled the innovation of viable (if not reliably stable) commercial banking by enlarging the clearing medium (increasing the money supply in units of account), anchoring the money market in London, and contributing an inconvertible currency clearly based on public credit in times of emergency.

The story is much more complicated, and I provide the detail and evidence for it in my book Making Money:  Coin, Currency, and the Coming of Capitalism. In part, I hope that narrative will convince Knafo to scrap the way he currently describes the relationship of private and public agents at the dawn of coinage and in the critical moment when bank notes became cash. He currently relies on histories that cast individuals as the authors of both coin and generally circulating bank notes and assumes governments then take control of those inventions – i.e., individuals initiate and sovereigns react. But it is virtually impossible to avoid the existing narratives altogether; for Knafo, these origin stories are merely stepping stones to the era of the Gold Standard, where he will make his most dramatic intervention. My underlying point is that many deep postulates of liberal financial governance need to be re-examined and it takes a concerted effort to do that.   In dialogue, we can recover an increasingly compelling portrait of financial governance to problematise additional and inadequate tropes.

2) Recognising economic irresolution

Second, I propose a methodological twist or gloss on the strategy of subverting basic premises of the myth:  we should interrogate the tensions and fundamental conflicts revealed when we readjust our histories. The depth of those tensions make constant political-legal agency necessary to maintain a working market. Documenting the essential work done by public decision makes it harder for the myth (passive state-dynamic market) to re-coalesce and submerge the historical critique that disrupted its apparently cohesive structure.

An example follows from the discussion above. As indicated there, the fact that the notes of the Bank were receivable in taxes gave those bills cash-like quality; it created widespread demand for them. In that sense, paper currency was based from the start on public authority in general and on public debt in particular. At this very period, English law changed to privilege the rights of public creditors [The Bankers’ Case (1700)]; scholars looking for “credible commitment” as the sine qua non of modern financial systems could point to that doctrinal development.

But the four corners of the bond did not fully contain the contract between the public and its creditors. A sovereign could meet the obligations of that instrument to the letter in a currency that had been debased or devalued. That, too, was valid English law. It had long been established that the public welfare might at times require recalibrating monetary value. Moreover, the decision when to do so was fundamentally political – a matter that lay outside the purview of the courts (The Case of Mixed Money (1605)).

The modern monetary system depends, then, on a kind of cash that depends on public debt. But the value of public debt depends in turn on the value attributed to cash. In other words, there is an irreducibly political aspect to the most basic medium of the market. There is no working exchange without a governance decision (and constant re-decision) about the value of money.

The observation returns us to Samuel Knafo’s history because the Gold Standard was an attempt to broker the tension between money as a matter of stable value and money as publicly calibrated medium. As Knafo argues, the Gold Standard should not be understood as a method of disciplining the state, but as a state maneuver to constrain the banks. That seems absolutely right; such a constraint promised to stabilise monetary value. Further, the bank-based system of money creation was itself a function of the state’s determination to share its monopoly over authoring money with the Bank of England. Once it established a system that institutionalised endogenous credit creation in the unit of account, it also invited problems that would regularly crash the system.  (Here, I accept the Bank of England’s recent description of fractional reserve banking and the boom-bust patterns that Hyman Minsky mapped most famously). Short of recalibrating the value of money, the Bank would need to assume modern management techniques.

The Gold Standard was thus a governance design formulated to manage conflicting public responsibilities – to public creditors and a wider, tax-paying public – in highly selective and, indeed, ideologically loaded ways.   There is no market possible without constant political resolution of those tensions, as I believe Knafo agrees. But that reality was obscured by the rhetoric of an active market and passive state perfected during the Gold Standard, which touted the sufficiency of private agency. We would gain enormously from Knafo’s insight about why and how the liberal rhetoric became entrenched, who gained when it diverted attention from the public determinations underlying money creation, and how it afterwards shaped debate over the monetary order.

3) Challenging existing theory

Lastly, it is possible to test formal economic theory against the insights generated by our histories. The aim would be to undermine faith in those structures that do not hold up. The Walrasian auction, a proposition that provides the conceptual anchor for general equilibrium models, provides an example. According to that construct, we can imagine a perfectly competitive market as one in which every real item has a value relative to every other real value, according to every individual agent making trades. Accounting money is one such real item within the closed universe of commodities. It is distinctive only in the fact that it provides the terms in which every other commodity is valued. Note that there is no time in the construct. Rather, we imagine every relative value (the value of relative pairs) as a matter that exists at a given instant in light of every other valuation. Nor is there any collective action in the event of the auction. Rather, every agent making trades acts independently.

But there’s a logical problem here, one exposed when we think about money as an entity created by communities over time. The Walrasian construct imputes the world it will then analyse: it is a world in which every real thing has a value at every given moment in terms of every other real thing. Money is then defined in such a way as to make that vision work:  it is the term of value that expresses the real relations that exist independent of it. But in this example, a completely liquid world (the auction) has been used to define the means that made it liquid (money).

Our histories contradict the construct in principle. They consider money as a matter made by political collectives over time. To take the simplest example, Bank of England notes became units of account because they held value on future taxes and offered cash services in the meantime, as I argue in Making Money. Theorists from Adam Smith to Henry Thornton recognised that reality. They also voiced concern that, given money’s nature, elites and officials could lose control over the medium insofar either political majorities or banks acting at a decentralised level overwhelmed their management. The Gold Standard was, as Knafo in effect demonstrates, a marketing effort. It advertised money as a commodity with value independent of political authority, rather than as a unit of account with value dependent on a public credit over time. But the marketing effort eventually supplied the definition of money used in classical economic models. By contrast, Knafo’s history recovers the fact that the Bank’s privileged place rested (and still rests) on ability that the Bank and the English state together deployed to manipulate the money supply as a fiat reality.

The implications are arresting. They suggest that it is profoundly misleading to imagine the economy as a world in which every real thing has an abstract value relative to every other real thing, agent-by-agent. Rather, the instrument that allows participants to assess value in commensurable terms appears to a publicly produced marker, one that individuals demand against a certain time horizon. It may be that value, including relative value, only takes shape for people sequentially, as a collectively engineered money supply allows particular exchanges to be conceptualised.

If that is so, then we would have to discard the formulaic thinking that Knafo targets at the outset. “The market” could not be conceived without both collective action and processes that unfolded over time. The fact that Knafo’s work can displace old and familiar theory is a happy indication that it can also take us into strange new worlds. Exploring those worlds would be an excellent way to escape worn-out pathways in our thought.