VoxEU Column Financial Markets

Toxic assets in the 18th century

Problems of regulation appear whenever financial innovations change the ways capital markets operate. This column describes the 18th century emergence of the inconvertible banknote, a "toxic asset” ended by government regulation. The lesson is that free financial markets promote financial innovation, but government must provide adequate regulation keeping the market on track.

The global financial crisis has revived the old debate on optimal regulation in the money and credit markets. The current debate is centred on how to regulate highly sophisticated financial markets, yet the pros and cons are similar to those observed a few centuries ago, when paper money emerged and became the state of the art in the money market. Actually, problems of regulation appear whenever financial innovations change the ways capital markets operate. Looking at this history, e.g. the study of Davis (1896) on banking in Massachusetts, can help us understand the turbulent recent developments. In recent work, we touch on these issues by studying the evolution of paper money and its influence on economic efficiency and financial stability (Levintal and Zeira 2009).

Financial innovation in the 18th century

The evolution of money is, in some sense, a story of the development of financial technology. In the pre-banking era, gold and silver coins were the main media of exchange. Transactions were made with coins because purchases on credit were very risky (and barter was almost always impossible). When banks emerged during the medieval ages, they started to lend silver and gold. It was much cheaper to borrow money from a bank, which could exploit economies of scale to diversify the risk of default, than borrowing from a single risk-averse lender. Hence, the introduction of money lending by bankers reduced borrowing costs and facilitated trade.

The problem with lending silver or gold coins is the burden of reserves. Since lending and trade occur in different locations and different times, the bank must hold large reserves for loans. To see this, consider a simple model with a buyer, a seller, and a bank. At first, the buyer borrows silver from the bank. Then, he goes to the market to buy goods and pays the seller with his silver coins. The seller receives the silver and decides whether to hold it, deposit in the bank, or repay his bank loans. Note that silver flows into the bank only after the trade is executed (through deposits or loan repayments by sellers). Since the bank lends silver to buyers before trade, it faces a liquidity problem that imposes a reserve constraint on its lending. Namely, in order to be able to lend each morning, the bank has to carry silver reserves from the previous day, which is costly.

A better instrument of lending would be an asset that is available right at the moment of lending, without the need to hold it in advance. This type of asset emerged in the form of convertible notes or paper money. Convertible notes were issued by private banks and could be converted into silver or gold on demand. From the bank’s point of view, lending notes was cheaper than lending silver, because silver had to be held in advance while notes could be issued by the bank at no cost. Actually, the bank still had to hold some reserves because the notes were not perfect substitutes for silver. Some note-holders continued to demand silver for various reasons. However, most of the notes were not converted because agents used them as a medium of exchange.

Convertible bank notes spread through the economy, as they enabled easier lending. This phenomenon happened toward the end of the middle ages and the beginning of the modern period. But that was not the end of the story. Banks realised that they could further reduce their lending costs by issuing inconvertible notes. If the notes were not convertible on demand, the bank did not have to hold reserves at all. We show in our paper that inconvertible banknotes emerge endogenously in a model of money and banking. The value of these notes is stable as long as there is competition with other forms of money, such as silver or notes issued by other banks. Competition imposes discipline on the issuing banks, because agents can always move to other forms of money. However, if some bank becomes the dominant issuer of notes (as was the case many times) and if silver is scarce, these notes face little competition. Thus, the issuing bank has incentive to over-issue notes, which might lead to inflation. This happened in several episodes of free banking and ultimately led to government intervention.

Inconvertible note crises

A very interesting example of inconvertible bank notes happened in Boston in 1740. In those days, the economy suffered from a chronic shortage of specie and a lack of appropriate substitutes. Several attempts were made to establish a bank that would supply an alternative medium of exchange. All of these schemes, described in detail by Davis (1896), proposed to issue notes that were not convertible into silver on demand, contradicting the practice of convertible notes prevailing in Europe. The intense debate and the greater scarcity of specie led to the establishment of two private corporations, the Land Bank and the Silver Bank. These banks issued notes that were not convertible on demand. The notes of the Land Bank could be redeemed only after twenty years into certain "manufactures" whose quality and value remained vague. The Silver Bank promised to redeem its notes within fifteen years into silver. The structure of the notes enabled the banks to operate without large reserves, because they were not obliged to convert on a daily basis. The notes circulated for less than two years. Many opposed their circulation, especially the Land Bank notes, but others favoured them. The operation of the banks was outlawed in 1741 by an Act of Parliament.

Another example of inconvertible notes was the famous "optional clause" in Scotland. The Scottish banking system in the 18th century comprised many private banks that issued convertible notes with an optional clause. The clause allowed the issuing bank to suspend payments of specie for six months and pay an additional interest of 2.5%. The exercise of the clause culminated in the years 1762-1765 where convertibility was practically abandoned, even beyond the six-month suspension. At some point, banks refrained from paying specie altogether, "confirming Scottish dependence upon paper" (Checkland 1975). The period was characterised by chronic inflation, exchange crises, and specie shortage. The public strongly protested against the option clause and the inability to receive specie, calling for government intervention. Eventually, in 1765, the option clause was outlawed and all the notes were required to be convertible on demand.

These examples demonstrate the endogenous development of inconvertible money issued by private banks, which served as a tool to minimise the stock of bank reserves. They also clarify why and how the government had to intervene. Evidently, all the free-banking episodes terminated with government regulation. Indeed, free and competitive money markets motivated the invention of new forms of money. Yet it also led to the emergence of a "toxic" asset (the inconvertible banknote) that had adverse effects on the economy and required government regulation. This story should sound familiar to the current observer, with banknotes replaced by asset-backed securities and toxic mortgages playing the role of the villain. The lesson is the same – free financial markets enhance financial innovation but can also have a somewhat shady side. The role of the government is to identify the risks and provide adequate regulation keeping the market on track.


Checkland, S. G. (1975), Scottish Banking: A History, 1695-1973, Glasgow: Collins, 1975.

Davis, A.M. (1896), “Currency Discussion in Massachusetts in the Eighteenth Century” The Quarterly Journal of Economics, Vol. 11, No. 1. (Oct., 1896), pp. 70-91.

Levintal, O. and J. Zeira (2009), “The Evolution of Paper Money”, CEPR Discussion Paper 7362, July.

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