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The First Financial Innovations: From Capital to Credit

Before there could be access to capital, which would be used to create wealth, someone had to come up with the idea of capital as a factor of production. In ancient times, goods were traded through barter or, in rare cases, paid for with bars of gold, silver, bronze, copper, or other metals. In these cases, buyers and sellers had to confirm the weight and quality of the metal, a practice that existed in Mesopotamia and Egypt at the beginning of the first millennium B.C.

Access to capital in these ancient societies was limited to rulers, priests, craftsmen, and merchants. The first three groups were admired (and feared), but the merchants were considered a disreputable lot (after all, they didn't actually create anything—they just moved goods from point A to point B). The vast majority of people were peasants who tilled plots of land owned by the monarchs in Egypt and Mesopotamia. Wealth to them meant land, not metal bars. The thought of ever accumulating wealth was beyond their imagining. They caught glimpses of wealth in temples and palaces, and nowhere else.

However, a would-be merchant knew he could turn a profit by taking goods from areas where they were cheap to areas where they were expensive. He might have started out as a pottery maker, a fabricator of armor, a weaver of cloth, or a breeder of cattle, and then, by selling his products, emerge with those bars of metal and, later, the coins. For the most part, he had to rely upon his own capital. He might be able to obtain credit, but interest rates were sky-high because of the scarcity of capital and the risks associated with ventures. During the first half of the first millennium B.C., interest rates in Mesopotamia, Egypt, and southern Europe were rarely less than 30%. Transaction costs were oppressive, so simply moving up to the status of merchant was a major accomplishment.

The arrival of coinage, which was introduced in Lydia in Asia Minor sometime around 650 B.C., began to simplify and standardize transactions. The issuer guaranteed the weight and purity of the coins—but even so, they were eyed with a fair degree of suspicion, since shady types engaged in counterfeiting and shaving coins. The Athenians had an elaborate system of coinage, though they did not use the paper money, credit, securities, or joint-stock companies seen in Mesopotamia.

In Athens and other Greek cities, money changers eventually came on the scene to make small loans and act as middlemen. These "trapezites" would borrow then loan these borrowed funds to others who were willing to pay higher rates. Trapezites were not exactly bankers, but rather loan brokers. Merchants borrowed money from these individuals to purchase goods in distant lands, using their reputations and the cargos as security. They could also sell a contract to deliver the cargo at a specified price, receiving payment in advance. When the merchant returned with his cargo, he would sell it in the marketplace. If the price was higher than that of the futures contract, he would pocket the difference. If not, he would have to make up the loss.

The next great change came courtesy of Alexander the Great, who took control of Macedonia in northern Greece at the age of 20. In 334 B.C., he crossed into Asia with 40,000 troops and swept through Persia, seizing the vast wealth he found there. As a result of the Persian victories alone, he captured 180,000 talents of gold and silver (the modern-day equivalent of approximately $500 million). He immediately poured a good deal of this money into construction projects, especially temple reconstruction and road building. Irrigation canals were dredged, and sailing fleets were built. But perhaps most important, a great store of capital that previously had been unproductive entered the monetary stream, promoting further trade and industry (call it the ancient world's version of a stimulus package). This had the initial effect of lowering interest rates, which further sparked economic activity. Business loans at 6% became fairly common, although loans to cities were somewhat higher (presumably because the lender wielded more muscle over private citizens than municipalities). This was the economic underpinning inherited by Rome, the first great universal empire, one in which the merchant and the banker were honored and achieved power.10

The moral of this story? When transaction costs are lowered and capital can be obtained more easily, economic activity quickens and prosperity widens. Without these elements, economies languish and the standard of living declines.11

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