BEQUES PER A ESTADES DE RECERCA FOR A DE CATALUNYA - MEMÒRIA

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BEQUES PER A ESTADES DE RECERCA FOR A DE CATALUNYA - MEMÒRIA

Why did London become the main money market?

Monetary Policy, Arbitrage and European Money Market Integration in 18^th century

Pilar NOGUÉS MARCO [email protected]

INDEX

Introduction 1 Section 1: What did monetary policy mean in Early Modern Ages? 2

Section 2: The Law of One Price for measuring bullion flow 6

Conclusions 14 References 14

INTRODUCTION

How did the leading capital market start to attract international bullion? Why did London become the main money market?

Monetary regulations, including the charges for minting money and the restrictions on bullion exchange, have played the key role in defining the direction of the flow of international bullion. Countries that abolished minting charges and permitted the free movement of bullion were able to attract international bullion, and countries that applied minting taxes suffered an outflow of bullion. In these cases monetary authorities tried to limit bullion movement through prohibitions on domestic bullion exchange at a free price, and tariffs and quantitative restrictions on bullion exports.

The paper illustrates the logic of international monetary flow in the 18^th century, using empirical evidence for England, France and Spain. The first section defines and measures monetary policy, and the second section introduces minting charges into the arbitrage equation in order to explain the logic of bullion flow between the pairs of nations England-France, England-Spain and France-Spain. The conclusion emphasises the importance of monetary policy in the creation of leading money markets.

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SECTION 1: WHAT DID MONETARY POLICY MEAN IN EARLY MODERN AGES?

In commodity money systems, alterations in minting charges known as seigniorage represent monetary policy. Models for measuring seigniorage were pioneered by Cipolla (1982), and recently developed by Sussman (1993), Rolnick, Velde and Weber (1996) and Redish (2000).

I measure monetary policy as follows:

L Suppose we have one ingot of pure metal (gold or silver) denoted by L.

Then:

Q denotes the quantity of metal in coins received by the owner of the ingot L.

S denotes the quantity of the ingot retained by the mint in the minting process.

An accounting standard P defines value for the physical quantity of metal:

L·P = Q·P + S·P = ME (1)

Mint Equivalent (ME) is the mint value of the quantity of coins received by the owner of the ingot (Q) plus the quantity of coins retained by the mint (S)

Q·P = MP (2)

Mint Price (MP) is the mint value of the quantity of coins received by the owner of the ingot (Q)

Graphs 1-3 summarise monetary policy in England, France and Spain in the very long run. I homogenised data for comparing results: L is one kilogram of pure metal, and P is sterling pounds for England, livre tournois for France and maravedís for Spain.

The simultaneous increments of MP and ME represent nominal debasements (devaluations), that is, increments of the accounting standard P; and the increase in the gap between MP and ME represents metallic debasement, that is, increase in seigniorage charges S.

Graphs 1-3 show the relative stability in nominal debasement in the 18th century compared to previous periods. However, there were notable differences in metallic debasement among countries. England abolished seigniorage in 1666, France applied seigniorage taxes of around 5% for silver and 6% for gold for most of the 18th century, and Spain increased silver seigniorage charges to 14% and gold seigniorage tax from 2% to 6% during the century. The following section demonstrates the effect of these differences in seigniorage on bullion flow.

Q S

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Graph 1: English Monetary Policy, 1343-1848

MP and ME (sterling pounds/kilogram of pure silver) MP and ME (sterling pounds/kilogram of pure gold)

Silver metallic seigniorage = ME-MP (%) Gold metallic seigniorage = ME-MP (%)

Source: Redish (2000), pp. 89-92.

0 5 10 15 20 25 30 35 40

1343 1367 1391 1415 1439 1463 1487 1511 1535 1559 1583 1607 1631 1655 1679 1703 1727 1751 1775 1799 1823 1847

silver mint equivalent silver mint price

0 20 40 60 80 100 120 140

1343 1369 1395 1421 1447 1473 1499 1525 1551 1577 1603 1629 1655 1681 1707 1733 1759 1785 1811 1837

gold mint equivalent gold mint price

-10%

0%

10%

20%

30%

40%

50%

60%

70%

1343 1376 1409 1442 1475 1508 1541 1574 1607 1640 1673 1706 1739 1772 1805 1838

-2%

0%

2%

4%

6%

8%

10%

12%

1343 1375 1407 1439 1471 1503 1535 1567 1599 1631 1663 1695 1727 1759 1791 1823

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Graph 2: French Monetary Policy, 1360-1793

MP and ME (livre tournois/kilogram of pure silver) MP and ME (livre tournois/kilogram of pure gold)

Source: Redish (2000), p. 93-97.

0 50 100 150 200 250 300 350 400

1360 1387 1414 1441 1468 1495 1522 1549 1576 1603 1630 1657 1684 1711 1738 1765 1792

0 1,000 2,000 3,000 4,000 5,000 6,000

1360 1388 1416 1444 1472 1500 1528 1556 1584 1612 1640 1668 1696 1724 1752 1780

-10%

0%

10%

20%

30%

40%

50%

1360 1388 1416 1444 1472 1500 1528 1556 1584 1612 1640 1668 1696 1724 1752 1780

-10%

-5%

0%

5%

10%

15%

20%

1360 1388 1416 1444 1472 1500 1528 1556 1584 1612 1640 1668 1696 1724 1752 1780

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Graph 3: Spanish Monetary Policy, 1497-1848

MP and ME (maravedís/kilogram of pure silver) MP and ME (maravedís/kilogram of pure gold)

Sources: calculated in accordance with Spanish legislation: Recopilación de las Leyes de Indias (1681), Códigos Españoles concordados y anotados-Nueva Recopilación (1851) and Reales Decretos-Colección Legistativa de España (1814-1848) (Biblioteca Nacional de España).

0 5,000 10,000 15,000 20,000 25,000 30,000 35,000 40,000 45,000

1497 1520 1543 1566 1589 1612 1635 1658 1681 1704 1727 1750 1773 1796 1819 1842

0 100,000 200,000 300,000 400,000 500,000 600,000 700,000

1497 1519 1541 1563 1585 1607 1629 1651 1673 1695 1717 1739 1761 1783 1805 1827

-2%

0%

2%

4%

6%

8%

1497 1516 1535 1554 1573 1592 1611 1630 1649 1668 1687 1706 1725 1744 1763 1782 1801 1820 1839

-2%

0%

2%

4%

6%

8%

10%

12%

14%

16%

1497 1514 1531 1548 1565 1582 1599 1616 1633 1650 1667 1684 1701 1718 1735 1752 1769 1786 1803 1820 1837

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SECTION 2: THE LAW OF ONE PRICE FOR MEASURING BULLION FLOW

The single arbitrage equation measures bullion flow between two countries A and B for a metal i (Flandreau, 2004, p. 59):

B i

A AB i i AB

B i

A AB i

i P

c P P X

c )P (1 )

1

( − ≤ ≤ + (3)

where i denotes metal i (gold or silver);P_iÂ is the price of metal i in market A; P_i^B is the price of metal i in market B; XÂB denotes the spot exchange rate between A and B; and c_iÂB is the cost of trading bullion between both markets.

Then, if _B ^AB

i A i AB

i X

P c P >

− )

1

( , exporting metal i from country B to A is profitable; and if

AB B

i A i AB

i X

P c P <

+ )

1

( , exporting metal i from A to B is profitable.

Neal & Quinn (2001) have focused on information and transaction costs (c_i^AB) as the variable which explains arbitrage in 18th century. But, in that period, at equal cost, bullion flow was profitable from one country with a seigniorage tax and to another without seigniorage.

Therefore, the countries that eliminated seigniorage first attracted international bullion, leading to the creation of money markets. Differences in costs started to assume the key role in bullion arbitrage only when all countries had abolished seigniorage.

For the purposes of this demonstration, I do not take into account the costs in equation (3) and focus directly on the Law of One Price, which measures gross profit:

Law of One Price: _B ^AB

i A

i X

P

P = (4)

I define both variables, _B

i A i

P

P and X ^AB, for a system that includes seigniorage:

What were bullion prices in a system with seigniorage? ⎟⎟⎠

⎜⎜ ⎞

⎝

⎛

B i

A i

P P :

Bullion exchange at a free price was illegal in systems with seigniorage taxes, in order to force agents to sell bullion exclusively in mints and thus to maximise revenue. Only when seigniorage had been abolished in England did bullion start to trade at a free price, under the condition that it had been stamped in the Goldsmith’s Hall. In France free bullion trade was forbidden until the Revolution and in Spain until the monetary reform of 1848.

Bullion prices in the 18^th century in France and Spain are thus Mint Prices, and the Mint Price for England in the 18^th century represents the minimum market price, because if the market price falls below the Mint Price it becomes more profitable to buy metal at its market price and have it minted (Flandreau, 2004, p. 30). Then, I consider:

i

i MP

P = (5)

where MP is the Mint Price defined in equation (2).

Results represent the minimum gross profit for exporting bullion to England.

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⎟⎟

⎠

⎞

⎜⎜

⎝

⎛ − _B

j A j B

i A i

ME ME ME

ME

B i B

j S

S =

What was the spot exchange rate in a system with seigniorage? (X ):

The spot exchange rate is the relative spot market value between two accounting standards defined in bills of exchange, which fluctuates around the legal par. The legal par is fixed by the Mint Equivalent relative values defined in equation (1).

Therefore, in a system without seigniorage, the exchange rate fluctuated around the Mint Equivalent ratio:

) 1 ( x ME

X ME_B

A

AB = ± (6)

where x measures the fluctuation, that is, the gap between the Mint Equivalent par and the exchange rate value.

The exchange rate is defined in the unit of account. Mint Equivalent par is the relative proportion of the metal contained in the two coins measured at the domestic unit of account.

So, in a bimetallic system with seigniorage, what is the Mint Equivalent: gold or silver?

- if seigniorage charges for gold and silver are proportional in both countries:

s g

ME ME MP

MP = , where index g denotes gold and index s silver,

that is, the bimetallic ratio for bullion (MPg/MPs) maintains the same proportion as the bimetallic ratio of coins (MEg/MEs), so the Mint Equivalent par for gold and for silver coincides. Mint Equivalent par in a system with proportional seigniorage is equal to that of Mint Equivalent par in a system without seigniorage (equation 6).

- but, if seigniorage charges for gold and silver are not proportional in one country, then:

i j

i i

j j

i j

ME ME S

ME S ME MP

MP <

−

= − where j denotes the metal with a higher seigniorage tax (Sj>Si)

So the bimetallic ratio for ingots is smaller than for coins, so coin j is overvalued in regard to coin i. According to the standard definition of Gresham's Law, bad money -overvalued money - drives out good money - undervalued money - and therefore the exchange rate fluctuates around the overvalued coin par (coin with a higher seigniorage tax).

Thus equation (6) can be rewritten for the specific gold and silver Mint Equivalent pares, supposing no-proportional seigniorage in country B:

( )

B i B j

B j j A AB j

B j A j B

i A i B i

i A AB i

S S ME x

X ME

ME ME ME

x ME ME

X ME

>

∀

⎪⎪

⎭

⎪⎪

⎬

⎫

⎪⎪

⎩

⎪⎪

⎨

⎧

±

=

⎟⎟

⎠

⎞

⎜⎜

⎝

⎛ −

−

±

=

1 1

(7)

where is the premium for the undervalued coin.

If , premium is zero; so equation (6) is a restriction on equation (7) when seigniorage is proportional or when there is not seigniorage .

(

i^B

)

B

j S

S =

(

⁼ i^B ⁼⁰

)

B

j S

S

(8)

Graph 4 shows long-term legal bimetallic ratios for England, France and Spain. England kept silver coins overvalued until the abolition of seigniorage in 1666, France alternated periods of gold and silver overvaluation, and Spain overvalued gold until the reform of 1728, when it started to overvalue silver.

Graph 4: Bimetallic ratios Bimetallic ratio in England (1343-1847)

Bimetallic ratio in France (1360-1793)

Bimetallic ratio in Spain (1497-1847)

Sources: see graphs 1-3

1 6 11 16

1343 1359 1375 1391 1407 1423 1439 1455 1471 1487 1503 1519 1535 1551 1567 1583 1599 1615 1631 1647 1663 1679 1695 1711 1727 1743 1759 1775 1791 1807 1823 1839

bimetallic ratio coins bimetallic ratio ingots

6 8 10 12 14 16 18 20

1497 1509 1521 1533 1545 1557 1569 1581 1593 1605 1617 1629 1641 1653 1665 1677 1689 1701 1713 1725 1737 1749 1761 1773 1785 1797 1809 1821 1833 1845

bimetallic ratio coins bimetallic ratio ingots 1

3 5 7 9 11 13 15 17 19

1360 1373 1386 1399 1412 1425 1438 1451 1464 1477 1490 1503 1516 1529 1542 1555 1568 1581 1594 1607 1620 1633 1646 1659 1672 1685 1698 1711 1724 1737 1750 1763 1776 1789

bimetallic ratio coins bimetallic ratio ingots

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⎥⎦⎤

⎢⎣⎡ coinB coinA money market integration between two countries:

- if there is no seigniorage, combining equations (4) + (5) + (6):

B A

B i

A i

ME ME MP

MP =

Æ _B ^AB

A

B A

X ME x

ME MP

MP ≈ (1± )= (8)

the Law of One Price is in balance, and the bullion market for metal i is integrated between countries A and B. In this model only a fluctuation in exchange rate (x) creates opportunities for arbitrage.

- but, if there is seigniorage in country B, combining equations (4) + (5) + (7):

i j AB

B j A j B

j A j

j B j

A j B

j A j

AB B

i A i B

j A j B

i A i B

i A i

i B i

A i B

i A i

S S X

ME x ME ME

ME S

ME ME MP

MP

X ME x

ME ME

ME S

ME ME MP

MP

>

∀

⎪⎪

⎭

⎪⎪

⎬

⎫

⎪⎪

⎩

⎪⎪

⎨

⎧

=

±

− >

=

⎟±

⎟

⎠

⎞

⎜⎜

⎝

⎛ −

−

− >

=

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the Law of One Price is out of balance, and the bullion market between countries A and B for metal i is not integrated. In this case arbitrage from B to A is always profitable, even if there is no fluctuation in the exchange rate (x=0). Seigniorage (Sj) makes arbitrage profitable for overvalued metal j and seigniorage (Si) plus premium makes arbitrage profitable for undervalued metal i.

Graphs 5-7 show results for the Law of One Price for the pairs London-Paris, London-Cadiz and Paris-Cadiz.

MP data is taken from data in graphs 1-3. i

Contemporaries registered exchange rate data only at two months maturity (A^AB) for the whole sample¹. Spot exchange rate (X^AB) should be deduced according to capitalization of the value (Flandreau et al., 2006, p. 20):

⎟⎠

⎜ ⎞

⎝⎛ +

= ^AB _B

AB X r

A 6

1 1 , where A^ABand X^AB are measured in (10)

and ^r^B is the interest rate in country B.

But r data is not available for the whole sample. Therefore, two months maturity exchange rate (A^AB) is used, which means the cost of the time spent on arbitrage operation is taken into account. Pure gross profit, therefore, is not being compared, but the prices between the two mints, including the time required to move the bullion from one country to the other.

Calculations start from the first year when exchange rate is available.

Combining equations (9) + (10):

i j AB

B j i

A j i B

j A j B

j i

A j i B

j i

A j i j

i B

j i

A j i B

j i

A j

i x A S S

ME ME ME

ME ME

ME S

ME ME MP

MP ⎟⎟± = ∀ >

⎠

⎞

⎜⎜

⎝

⎛ −

−

− >

=

, , ,

, ,

, , ,

, (11)

1 Data of exchange rate in London on Paris and Cadiz in The Price of Merchandise in London (Nederlandsch Economisch-Historisch Archief), The Course of the Exchange and Lloyd’s List (British Library), and data of exchange rate in Paris on Cadiz in Affiches (Bibliothèque Nationale de France). Results are calculated using annual average monthly observations.

⎟⎟

⎠

⎞

⎜⎜

⎝

⎛ − _B

j A j B

i A i

ME ME ME

ME

(10)

Graphs 5-7 show gross arbitrage profits caused by disintegration of the Law of One Price (equation 11). Gross profit is divided into the two reasons for disintegration: seigniorage and premium. Seigniorage profit for metal i,j measures gross profitability caused by Si,j effect, supposing the exchange rate fluctuates around the band of metal i,j respectively, and premium profit for metal i,j measures gross profitability caused by premium effect when the exchange rate for metal i fluctuates around band j, whether it is Sj>Si.

Graph 5 shows arbitrage results for London-Paris (1663-1793). Before England abolished seigniorage, France was exporting silver and importing gold, and when England eliminated seigniorage in 1666, France continued importing gold because of its negative seigniorage tax (?), that is, a subsidy for gold coinage. In the 18^th century (1725-1792), after the Mississippi bubble and the stabilization of the livre tournois, France started to export both gold and silver, until the Revolution.

Graph 6 shows arbitrage results for London-Cadiz (1681-1847). Cadiz exported both gold and silver to London. Silver arbitrage in the 17^th century responded to the gold premium, and in the 18^th century to seigniorage tax. Gold arbitrage responded to seigniorage tax, and when seigniorage tax was reduced (1731-1786), it basically responded to the silver premium.

Graph 7 shows arbitrage results for Paris-Cadiz (1763-1776). Cadiz exported both gold and silver to Paris. Silver arbitrage was originated by the seigniorage tax. Gold arbitrage from Cadiz to Paris was profitable from 1763-1771, although seigniorage was higher in France than in Spain, because of the silver premium. From 1771 to 1776, gold arbitrage was profitable because France reduced gold seigniorage.

Gross profitability gives us an idea of the geography of arbitrage in the 18^th century: Spain exported bullion to France and England, and France exported bullion to England. Spain was a net exporter, a system only sustainable without suffering a "money famine" because it was a productive country. France was a bullion importer from Spain and an exporter to England, and England was the net receiver of gold and silver, which made London the main money market.

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MP par, ME par and exchange rates

(pounds sterling/livre tournois per kg silver- data normalised at 0.05=1)

(pounds sterling/livre tournois per kg gold- data normalised at 0.05=1)

Sources: see text.

Silver gross profit (% )

-20 -15 -10 -5 0 5 10 15 20

1663 1671 1679 1687 1695 1703 1711 1719 1727 1735 1743 1751 1759 1767 1775 1783 1791

seigniorage profit premium profit

Gold gross profit (% )

-20 -10 0 10 20

1663 1672 1681 1690 1699 1708 1717 1726 1735 1744 1753 1762 1771 1780 1789

seigniorage profit premium profit 0.20

0.40 0.60 0.80 1.00 1.20 1.40 1.60 1.80 2.00

1663 1668 1673 1678 1683 1688 1693 1698 1703 1708 1713 1718 1723 1728 1733 1738 1743 1748 1753 1758 1763 1768 1773 1778 1783 1788 silver mint price par silver mint equivalent par exchange rate gold mint equivalent par

0.20 0.40 0.60 0.80 1.00 1.20 1.40 1.60 1.80 2.00

1663 1667 1671 1675 1679 1683 1687 1691 1695 1699 1703 1707 1711 1715 1719 1723 1727 1731 1735 1739 1743 1747 1751 1755 1759 1763 1767 1771 1775 1779 1783 1787 1791

gold mint price par gold mint equivalent par exchange rate silver mint equivalent par

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Graph 6: Silver and gold arbitrage between London and Cadiz (1681-1847)

(pounds sterling/maravedis per kg silver - data normalised at 0.0003=1)

(pounds sterling/maravedis per kg gold - data normalised at 0.0003=1)

Sources: see text.

Silver gross profit (%)

-20 -10 0 10 20 30 40 50

1681 1692

170 3

1714 1725 1736

1747 1758

1769 1780

179 1

1802 1813 1824

1835 1846

Gold gross profit (%)

-20 -10 0 10 20 30 40 50

1681 1692 1703 1714 1725 1736 1747 1758 1769 1780 1791 1802 1813 1824 1835 1846

seigniorage profit premium profit 0.6

0.8 1.0 1.2 1.4 1.6 1.8 2.0

1681 1686 1691 1696 1701 1706 1711 1716 1721 1726 1731 1736 1741 1746 1751 1756 1761 1766 1771 1776 1781 1786 1791 1796 1801 1806 1811 1816 1821 1826 1831 1836 1841 1846

silver mint price par silver mint equivalent par exchange rate gold mint equivalent par

0.6 0.8 1.0 1.2 1.4 1.6 1.8 2.0

1681 1687 1693 1699 1705 1711 1717 1723 1729 1735 1741 1747 1753 1759 1765 1771 1777 1783 1789 1795 1801 1807 1813 1819 1825 1831 1837 1843

gold mint price par gold mint equivalent par exchange rate silver mint equivalent par

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(livre tournois/maravedis per kg silver - data normalised at 0.0075=1)

(livre tournois/maravedis per kg gold - data normalised at 0.0075=1)

Sources: see text.

Silver gross profit (%)

0 5 10 15 20

1763 1765 1767 1769 1771 1773 1775

seigniorage profit

Gold gross profit (% )

-5 0 5 10 15

1763 1765 1767 1769 1771 1773 1775

0.90 0.95 1.00 1.05 1.10 1.15 1.20

1763 1764 1765 1766 1767 1768 1769 1770 1771 1772 1773 1774 1775 1776 silver mint price par silver mint equivalent par exchange rate

0.90 1.00 1.10 1.20

1763 1764 1765 1766 1767 1768 1769 1770 1771 1772 1773 1774 1775 1776 mint price par gold mint equivalent par

exchange rate silver mint equivalent par

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CONCLUSION

How did the leading capital market start to attract international bullion? Monetary policy is the key element for explaining international bullion flow in the 18th century. In the terms of Obstfeld's open macroeconomy trilemma (1998, pp. 14-15): “a country cannot simultaneously maintain fixed exchange rates and an open capital market while pursuing a monetary policy oriented toward domestic goals”. Countries that applied high seigniorage taxes suffered imbalances in the Law of One Price, which caused bullion outflow. Monetary authorities tried to limit bullion movement through the prohibition of domestic bullion exchange at a free price, and tariffs and quantitative restrictions on bullion exports, which in turn led to smuggling. Illegal bullion outflow created an external bullion market for countries with relative higher seigniorage tax, and countries that abolished seigniorage attracted international bullion. Empirical evidence for England, France and Spain in the 18th century shows that seigniorage was higher in Spain than in France, and higher in France than in England.

Consequently money markets were not integrated, and bullion moved from Spain to France and England, and from France to England.. England was the net receiver of bullion and that was where the leading money market was established.

REFERENCES

- Cipolla, C. M. (1982): The Monetary Policy of fourteenth-century Florence, University of California, Berkeley.

- Flandreau, M. (2004): The Glitter of Gold. France, Bimetallism, and the Emergence of the International Gold Standard, 1848-1837, Oxford University Press, Oxford.

- Flandreau, M.; Galimard, C.; Jobst, C.; and Nogués Marco, P. (2006): "The Bell Jar:

Commercial Interest Rates between Two Revolutions, 1688-1789", CEPR Discussion Papers, No. 5940, November 2006.

- Obstfeld, M. (1998). "The Global Capital Market: Benefactor or Menace?", The Journal of Economic Perspectives, vol. 12(4), pp. 9-30.

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