The Birth of the Bond Market

Niall Ferguson’s book, The Ascent of Money, has a fascinating account on how bonds (those pieces of paper that give a fixed interest) came into existence. It started off in the city states of Italy – Venice, Florence, Genoa, Pisa etc – which were at constant war with each other. But of course:

“This fighting is possible only if you can pay for it.”

 

Collecting taxes wasn’t a reliable way for these Italian cities. Why not? Because, with the taxation model, if more money was needed, one would have to increase taxes (upon which the common man might revolt, and you didn’t want an internal rebellion while fighting an external enemy), and then spend effort collecting it (that takes time, which you don’t have during war time).

 

Ergo, they came up with a new system to raise money: the state would issue bonds. And expect demand that the rich families buy these “forced bonds”. After all, they had the most at stake, the most to lose if the city fell to the enemy, surely they must pay for the war effort to protect their interests…

 

In return, the city/state would pay the bond-holders interest. How come this didn’t afoul with the Church – wasn’t this usury? No, they argued like lawyers citing technicalities, this was just payment for a service (funding the state). A key feature was that the bond holder could sell the bond to other citizens, say, if one needed cash in a hurry before the bond matured. And thus it came to be:

“In effect, then, Florence turned its citizens into its biggest investors.”

 

Let’s go a bit deeper into the re-sale possibility. If you’d bought a bond for 100 florins, and it looked like Florence might lose or be unable to pay its interest obligations, well, anyone buying that bond from you would be at high risk. So he’d only be willing to pay you less than 100 florins, say 90 florins. Too risky, he’d say. And thus a market was established for trading in bonds.

 

But hadn’t kings defaulted, even refused to pay their loans in the past? Why would anyone trust these bonds? Aha, in this case, a default meant the rich would lose their money the most (After all, they’d been forced to invest the most in these bonds, remember?). And thus:

“This oligarchical power structure gave the bond market a firm political foundation… (Since it was the rich whose money was at stake), they had a strong interest in seeing that their interest was paid.”

 

But monarchies didn’t work that way. They just issued commands, and so bonds from monarchies didn’t generate any faith. This lack of faith would work severely against nations with monarchies (Spain, France) as the power of the bond markets grew. The credibility of oligarchical (run by the rich) systems, on the other hand, was higher, from the city states of Italy all the way to Britain. Who’d have known that the bond markets had a role in geopolitics from the get-go?