Explore the limits of fiat money with the Bank of Amsterdam as a case study. Learn how negative equity and asset illiquidity can impact trust in fiat money and the role of fiscal support and central bank capital in sustaining it. Discover the unique break point where fiat money loses credibility with the recent publication from Bank for International Settlements (BIS) Working Paper.
Let's first understand what is fiat money and how it works.
What is Fiat Money or Fiat Currency?
Fiat money, also known as legal tender, is a currency that is issued and backed by a government or central authority. Unlike commodity money, such as gold or silver, fiat money is not backed by a physical commodity and has no intrinsic value. Instead, its value is derived from the trust and belief in the issuing authority.
Fiat money has been used throughout history, dating back to ancient China and Rome. However, it was not until the 20th century that fiat money became the dominant form of currency. Today, the vast majority of money in circulation is fiat money.
The issuance of fiat money is controlled by a central bank, such as the Federal Reserve in the United States or the European Central Bank in Europe. These institutions are responsible for controlling the money supply and ensuring that inflation remains in check.
One of the key advantages of fiat money is that it can be easily created and destroyed. This allows for monetary policy to be used as a tool to stabilize the economy. In times of recession, for example, a central bank can increase the money supply in order to stimulate economic activity.
However, there are also drawbacks to fiat money. The most significant is that it is subject to inflation, which can erode the purchasing power of money over time. Additionally, fiat money is often subject to political manipulation, as governments may be tempted to print money in order to finance their expenses.
To know more about fiat money read this Understanding Fiat Money: What It Is, How It Works, Examples, Advantages and Disadvantages.
The Bank of Amsterdam and the limits of fiat money
This working paper by Wilko Bolt, Jon Frost, Hyun Song Shin, and Peter Wierts explores the history of the Bank of Amsterdam and its role in the monetary system. Let's break down the working paper and understand it.
The Bank of Amsterdam, also known as the Wisselbank or "Exchange Bank," was a public giro or payments bank owned by the municipality of Amsterdam. The paper examines how the Bank's shift from a rigid to an elastic structure paved the way for its success in supporting wholesale payments and international trade. However, after a severe economic shock and in the absence of fiscal backing, the same network effects that had initially sustained trust in the Bank guilder ultimately led to its downfall. The paper uses a global games model to formalize the conditions under which trust in fiat money can evaporate and identify the unique break point where negative equity and asset illiquidity render fiat money worthless. Ultimately, the paper draws lessons on the role of fiscal support and central bank capital in sustaining trust in fiat money.
Bullet Points Summary
The Bank of Amsterdam was a public giro or payments bank owned by the municipality of Amsterdam.
- It was founded in the context of a large number of circulating metal coins in the early 17th century, and the debasement of those coins.
- The Bank of Amsterdam's mandate was to “check all agio (of the current money) and confusion of coin, and to be of use to all persons who are in need of any kind of coin in business”.
- The Bank of Amsterdam started issuing fiat money in 1683 and engaged in liquidity operations familiar to modern central banks.
- The Bank of Amsterdam's main function was to stabilize the value of the agio by purchasing and selling assets.
- The Bank of Amsterdam was highly successful and resilient for many decades.
- The resilience came under pressure in the late 1770s due to the war with England, and the Bank started to depart from sound practice.
- Unlike a modern central bank, the Bank of Amsterdam lacked fiscal backing, and public sector ownership by the city of Amsterdam was not sufficient.
- The pivotal event was the shock of the Fourth Anglo-Dutch war (1780-84) which led to extensive naval confrontations between the Dutch Republic and England.
- The conflict was an economic shock that strained the VOC, which had become the main borrower of the Bank of Amsterdam, and led to the bank's downfall.
The Bank of Amsterdam was a public giro or payments bank owned by the municipality of Amsterdam. It was founded in the early 17th century to address the issue of debased metal coins in circulation. The Bank operated by allowing customers to deposit metal coins and record the balances in a central ledger. These deposit balances could be transferred to other account holders without cost or withdrawn for a small fee. Over time, the Bank expanded its operations to include liquidity operations and lending, and in 1683, it started issuing fiat money. However, this shift was not complete as the Bank still had a separate "receipt" system in place. The Bank also engaged in asset purchases and sales to stabilize the value of the agio and sought to keep it in a target range of 4-5% to ensure Bank guilders could serve as a stable unit of account. However, the Bank's success came under pressure in the late 1770s due to economic stresses caused by the war with England and its lack of fiscal backing. The pivotal event was the Fourth Anglo-Dutch war, which led to a dramatic decline in trade and shipping volumes, and the Bank's decision to grant larger overdrafts to the Dutch East India Company (Verenigde Oostindische Compagnie, VOC). As a result, the credit exposure of the Bank rose and the Bank was unable to recover from the economic shock, leading to a breakdown in trust and eventual downfall.
The Bank of Amsterdam (Wisselbank, or “Exchange Bank”) was a public giro or payments bank owned by the municipality of Amsterdam. The Bank was founded in the context of a large number of circulating metal coins in the early 17th century, and the debasement of those coins by the deliberate mixing of base metals into gold and silver coins.
In the Bank’s founding decree, it was given a mandate to “check all agio (of the current money) and confusion of coin, and to be of use to all persons who are in need of any kind of coin in business”.
The Bank operated as follows. Customers would physically deposit metal coins with the Bank and account balances were recorded in a central ledger. These deposit balances could be transferred to other account holders without cost, or withdrawn for a small fee. In this sense, the early Bank of Amsterdam guilder resembled what we now know as a stablecoin - where account-based money is backed by assets of stable value.
Over time, the Bank departed from the strict application of full backing. It engaged in liquidity operations familiar to modern central banks, as well as outright lending. A key date is 1683 when the Bank ended the policy of redeemability of deposits into coins. In this sense, the Bank started issuing fiat money. This change was crucial for the role the Bank would play at the heart of the international payment system.
However, the shift from a rigid to an elastic structure was not a complete shift. At the same time as removing the redeemability of deposits into coins, the Bank introduced a separate “receipt” system that allowed coin holders to sell their coins to the Bank with the option to repurchase the same coins after a fixed period. As part of its monetary operations, the Bank of Amsterdam engaged in asset purchases and sales to stabilize the value of the agio. The Bank expanded the money stock through the purchase of coins when the agio rose, and contracted the money stock through the sale of coins when the agio fell. The Bank of Amsterdam sought to keep the agio of Bank guilders to current guilders (metal coins) in a target range between 4 and 5%, and thus to ensure Bank guilders could serve as a stable unit of account.
The resilience of the Bank of Amsterdam and its success over many decades came under pressure in the late 1770s. Under the economic stresses generated by the war with the English, the Bank departed more seriously from sound practice by lending on a more substantial scale to the VOC, in a sustained and non-transparent way. Crucially, unlike a modern central bank that has the fiscal backing of the sovereign, the Bank of Amsterdam lacked fiscal backing. While the Bank’s public sector ownership by the city of Amsterdam gave it some degree of fiscal support from the city tax authorities (and also the ability to mutualise losses across segments of Amsterdam society), this was not sufficient for the large scale of activities of the Bank given the large volume of international trade through Amsterdam.
The pivotal event was the shock of the Fourth Anglo-Dutch war (1780-84) which led to extensive naval confrontations between the Dutch Republic and England in several theatres of conflict - in European, West Indian and Asian waters. This conflict was an economic shock that strained the VOC, which had become the main borrower of the Bank of Amsterdam. Shipping volumes by the VOC fell dramatically; sales of trade goods in the Netherlands dropped from 20.9 million guilders in 1780 to only 5.9 million in 1781.
Amid dire and deteriorating economic conditions, the Bank commissioners made the fateful decision to start granting even larger overdrafts to the VOC. As a result, the credit exposure of the Bank rose from 0 in June 1779 to 4.8 million guilders in 1781. The Bank then temporarily stopped new lending, but the stock of loans to the VOC remained high. The slump in the VOC trade continued. High losses of ships meant that loans that were already extended could no longer be repaid.
Throughout 1782, the Bank steadily ramped up its lending to the VOC; outstanding loans rose to a peak of 7.8 million guilders in February 1783. As loans increased (to a full 71% of the Bank’s assets), the metal stock fell, from 17.6 million guilders in 1776 to 7.8 million in 1783. This was because account holders with receipts redeemed coins by allowing their receipts to expire. During the first half of 1783, the Bank responded to downward pressure on the agio by selling 3.5 million worth of guilder coins into the market. By the summer of 1783, guilders were now only backed by metal coins for 28% of their value, from 97% just four years earlier.
With the conclusion of the war in May 1784, the Bank had accumulated a large credit exposure which soon become non-performing. The Bank’s insolvency - and the inability of the city authorities to recapitalise it - are important elements in its downfall.
The downfall of the Bank of Amsterdam has important implications for modern central banks. The bank's failure highlights the importance of fiscal backing and the need for adequate safeguards in times of economic stress. Additionally, it shows that when trust in a fiat currency breaks down, the move from one regime (high trust) to another (breakdown of trust) can be swift and precipitous. Understanding the incentives and governance underlying monetary institutions can be a fruitful avenue for further research. Overall, the experience of the Bank of Amsterdam provides valuable lessons for understanding the monetary systems of today.
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