Issue #36: The Genesis of “Ledger Money” and the Modern Financial System
from Mesopotamian Tablets to Digital Blockchains
For as long as humans have engaged in economic transactions, there has been a need and desire to record those transactions for personal and posterity’s sake. The development and maintenance of trust among the individuals in a community, and between different communities, as well as the documentation and preservation of economic transactions, are the fundamental building blocks of a functioning economy.
More than 5000 years ago, the ancient Mesopotamians started to record quantities in proto-cuneiform on clay tablets. The original purpose of this was to keep track of the vast amounts of goods and labor that were produced and traded around 3200-3000 BC, when Uruk became the world’s first major metropolitan and economic region.
The earliest written records that we have today are these ancient Mesopotamian inscriptions that simply recorded historical economic data. Wealthy merchants have been recording the size of their flock of sheep, the price they paid for a bushel of wheat on a given day, and their daily economic activities, before there was oral storytelling, written legislations/regulations, or anything else. This was the advent of “single-entry” accounting.
Single-entry accounting is named as such because it relies on a single-sided ledger. A single-sided ledger would be like a receipt that one receives from purchasing goods or services at any regular store, with a list of items, the prices of the items, and the date of the purchase. While this system works fine for simply recording the historical values of items, it is relatively prone to failure and not very robust. What happens when there are disputes as to the historical prices of goods and services? What happens when the accountant cannot be trusted to provide an accurate account of all past transactions? With such a system, one must blindly trust that the historical record was recorded properly and was not tampered with in any way over time.
In 15th century Italy, during the height of the Renaissance, a monk by the name of Luca Pacioli, who is widely known as the father of modern accounting, wrote Summa de Arithmetica, Geometria, Proportioni et Proportionalita.In his book, he described what would eventually be called “double-entry” accounting. By separating “debits” (uses of funds) from “credits” (sources of funds), he created an accounting ledger that is both far more useful and far less prone to fraud. By ensuring that each and every use of funds is matched with a corresponding source of funds, he made it far more difficult to conduct blatant fraud through the manipulation of accounting entries, since debits and credits form an elegant interlocking system of receivables and payables.
Double-entry accounting not only made accounting ledgers much less prone to fraud and much more robust – it also introduced the modern form of credit. In fact, what constitutes “money creation” in the modern economy is still defined as such, because “money creation” involves both sides of an entity’s balance sheet (i.e. its assets and its liabilities/equity) increasing. With the ability to create money out of thin air, “by the stroke of the bookkeeper’s pen,” a common monetary system was born, as people utilized credit provided by the various Italian banker families. This allowed economic expansion, as the quantity of money available to engage in economic transactions was no longer limited by the supply of some precious metal commodity but, instead, by the prudent decision of a cartel of Italian banker families (and also the willingness of people to acknowledge/accept credit from these Italian banker families).
Generally, most people confuse paper money with credit money, and consider that it was pure convention that permitted the gradual transition from metallic money to ledger money. In doing so, they do not explain why and how credit money itself came into existence, nor do they explain how this transition happened in conceptual terms. They fail to see that what was at stake was a transformation of the fundamental rules of money – a change in its dimension, not just a change in its support. The claims of the old commodity money have basically become modern credit-based money. Moreover, because this extra dimension is credit and because modern money is credit-based, our modern monetary system is really a credit system, whose rules determine the mechanics of the medium of exchange function of money. Many theoretical problems in the field of economics can be traced back to a confusion of the different dimensions of money.
In the latter half of the 20th century, the global Eurodollar banking system emerged, bringing with it the next major monetary revolution. This is a topic that I have already covered quite thoroughly in various previous issues of Monetary Mechanics. In summary, money went from being credit-based, arising only from the accounting ledgers of a few Italian banking families, to being global and globally interoperable.
If the ancient Mesopotamians invented “single-entry” accounting, then we could identify the second iteration of accounting as private ledger “double-entry” accounting, because ledgers remained only within the hands of a single banking family and were generally not reconcilable with the ledgers of other banking families.
Under the same logic, we could identify the third iteration of accounting, Eurodollar banking, as shared ledger “double-entry” accounting, because the fundamental features of the global Eurodollar banking system were that it was flexible, fluid, and seamlessly interoperable with financial institutions from all across the world.
The global Eurodollar banking system facilitated yet another step function improvement in the complexity of human economic activity. Like the way that the birth of double-entry accounting contributed to the beginning of the Renaissance, the birth of Eurodollar banking contributed to the globalization of the economy in the post-WWII period. However, the Eurodollar banking system, while much more decentralized than its predecessors, still relied on a relatively small number of centralized market participants to uphold and update the global economic ledger. If one was not a globally active dealer bank, then one would have to blindly trust that the marks were accurate – there was no real method of validation or recourse.
While this scenario might seem a bit far-fetched, perhaps even conspiratorial, there are numerous anecdotes of dealer banks refusing to properly mark positions to market. One particularly (in)famous example of this that would be familiar to most people is Michael Burry’s experiences with the markings of his credit default swaps, something that was featured in the book and film The Big Short:
By early 2007 Michael Burry found himself in a characteristically bizarre situation. He’d bought insurance on a lot of truly crappy subprime mortgage bonds, created from loans made in 2005, but they were his credit default swaps. They weren’t traded often by others … they were “off the run.” […] Burry sent his list of credit default swaps to Goldman Sachs and Bank of America and Morgan Stanley with the idea they would show it to possible buyers, so he might get some idea of the market price. That, after all, was the dealers’ stated function: middle-men. Market makers. That is not the function they served, however. […] The fate of Scion capital turned on these bets, but that fate was not, in the short run, determined by an open and free market. It was determined by Goldman Sachs and Bank of America and Morgan Stanley, who decided each day whether Mike Burry’s credit default swaps had made or lost money. […] Wall Street firms [dictated] to him the market price. With no one else buying and selling, there was no hard evidence what these things were worth – so they were worth whatever Goldman Sachs and Morgan Stanley said they were worth.
Another (funny) example from a former macro hedge fund manager:
So, what part do blockchains play in this narrative? Instead of being forced to rely on a few centralized financial intermediaries to faithfully record transactions and maintain transparent markets (and on auditors to audit those financial intermediaries), blockchains introduce universal transparency and accountability to the system, through consensus mechanisms that cryptographically verify each and every transaction.
One could call blockchains distributed ledger “triple-entry” accounting. The concept of triple-entry accounting is not entirely novel – it was envisioned by Yuji Ijeri in the early 1980s as a way to establish a shared environment among all participating entities to ensure the authenticity of all transactions.
Ian Grigg, a financial cryptographer who was an early proponent of the precursor to modern cryptocurrencies, stated that:
The digitally signed receipt, an innovation from financial cryptography, presents a challenge to classical double entry bookkeeping. Rather than compete, the two melded together [to] form a stronger system. Expanding the usage of accounting into the wider domain of digital cash gives 3 local entries for each of 3 roles. This system creates bullet proof accounting systems for aggressive uses and users. It not only lowers costs by delivering reliable and supported accounting. It makes much stronger governance possible in a way that positively impacts on the future needs of corporate and public accounting.
Consequently, it is the degree of decentralization that fundamentally differentiates the concept of “distributed ledgers” from the concept of “shared ledgers.”
Shared ledgers are shared only among a select group of counterparties, who collectively determine the authenticity of records of economic transactions. There are also many conditions and certifications that formally or informally control and restrict the ability to read and write to these shared ledgers.
Distributed ledgers, on the other hand, are widely available and accessible for anyone online to view, validate, or read and write to. Hence, they are truly distributed across the general public, uncensored and uncensorable, resulting in a revolution in the very conceptualization of money, a rare kind of revolution that has occurred only a handful of times in all of (recorded) human history.
While some people may think that improvements in accounting methods are uninteresting or relatively unimportant in the grand scheme of things, it is certain that the language of accounting designates the scale and scope of utility that money can have in society. Each successive wave of innovations in accounting methods has created novel uses of money that have changed how humans relate to one another at a fundamental level. This is because accounting is not just about recording profits and losses and keeping books – accounting governs how economic transactions relate to the larger world, much analogous to the relationship between mathematics and science.
I really enjoyed the entire article and comments section. It had been a question that I have been asking myself "How the whole finance system evolved through the way it is now?", since the answer might provide clues about the crypto and DeFi's future.
The biggest problem to overcome is how to create the authority so that it crypto "money" can have a future value by having a borrower and lender relationship. Up to now, I have seen no project that enables anyone to borrow any single crypto "money", without breaking the chain of decentralization. There are a few example projects that claims they lend with crypto, however crypto becomes a media like gold, dollar, or anything you may want to name. This is mainly because they also require borrower to reveal its identity and the entire process become a borrowing-lending action in accordance with today's legislation.
In short, the hardest thing (which I believe impossible) is to overcome a need of an authority throughout this borrowing-lending action and still make it decentralized. How borrower can ensure to take his money back if the loan is unpaid, is still requires a regulative authority. And this is the biggest obstacle that seems unachievable without having an authority. Thus, this situation blocks creating the "future" value of the cryptos.
Even in the past, old Italian bankers know that, if their loans are unpaid, they have government authority which enables them to either appointing a trustee to the institution or confiscating the property.
Hey, you've done some great work with these issues. A lot of confusion still abounds when it comes to money. For the most part, most historical accounts do go as far back as 5000 years ago and even further, and I do not think there is much debate as to how it worked back then.
What I would like to ask you is, have you delved into the period during the middle ages where a lot of Europe was 'reset' so to speak into what is known as early feudalism and how money was also 'reset' in many cases?
Historical evidence is scarce I'll admit, but I believe the current money system we use today was born during the early feudal times where primitive feudalism, i.e. the period where most relations were feudal in nature (vertical) and when fees were paid 'in kind', transitioned into a money system by the issue of coins by local feudal lords to pre-acquire fees 'in kind'. These coins acted as proof that fees had already been paid when collection time came around. This 'proof of payment' gave these coins their value (not any precious metals in them, at least not locally) and enabled people to use them in exchange; i.e. this enabled exchange and even markets to open up, even if only locally in the beginning. You could call this type of money single entry, but the issuer did assume the obligation of accepting them back as fees already paid which gave them their value in the hands of the one holding them. It would be safe to assume here that the value of the coins in relation to how much 'in kind' fees they represented was 'set' by the issuer, just as in a similar fashion, all forms of money during the early times of the United States was set by legislature, for example x amount of beaver skins were worth y amount of US or Spanish dollars or British Pounds.
Whilst historically we look to the Italian bankers as the beginning of credit money (they would have still accepted metal coins as deposits even though not lending out actual coins), it does not mean that more locally people did not set up the same type of depositories for local coins and issue notes as promises to pay back said coins, and hence the creation of bank notes or paper money of some sort. Heck, these could also have been used to pay the landlord at collection time.
I can imagine that as populations grew, neighbouring lands were conquered and so forth, and by each 'expansion' so to speak, local money systems were subsumed into larger ones. One can see the history of the Swiss Franc as a prime example where it is quoted in wiki:
"Before 1798, about 75 entities were making coins in Switzerland, including the 25 cantons and half-cantons, 16 cities, and abbeys, resulting in about 860 different coins in circulation, with different values, denominations and monetary systems."
As I see the current money system from this perspective, this is how I describe it:
Countries such as the US, UK, Aust, NZ, Canada, Japan, Switzerland etc all issue their own notes and coins, which are accepted as payment of taxes.
Whilst these countries no longer set the value of this money (they let the market do it now), they do set the taxation rates on things like exchanges and incomes.
Most people accept this form of money, if it is offered, in exchange for goods and services.
Banks also accept this form of money as deposits. Every deposit of notes/coins becomes a double ledger money in the sense that banks now assume a liability to return notes and coins on demand if the account holder so chooses to exercise that right.
However, banks also allow account holders to make exchanges with other economic agents using these promises of the bank rather than notes/coins. These promises take the form of checks (spelt cheques in Aust), bank notes, and most commonly, electronic transfers.
This allows banks to increase the money supply by making loans. They do not loan out notes/coins but rather increase electronic account size and at the same time increase their obligation to convert into notes/coins on demand (even though most people will never exercise this right).
The total size of the 'accounts', or promises of the banks to convert into notes/coons on demand is anywhere from 95-99% of the total money supply, with the remaining 1-5% being actual notes/coins. Suffice to say, if everyone tried to convert their accounts into notes/coins at the same time, only the first few % would get actual notes/coins; the rest would get nothing.
Bank reserves, those issued by central banks, are promises of the central bank to convert into notes/coins on demand when and if banks exercise such right (to fill up ATM's, for xmas etc), but for the most part, they are merely used to settle between banks.
All forms of money you can think of, describe, etc, whether it be treasuries, crypto, and essentially all financial assets, have at their core, the humble notes/coins that these govts issue, and who are obligated to accept as payment for taxes. This, at the end of the day is what gives all these monies their value, and this current system, it is my contention, began during the primitive feudal times during the middle ages.
I should also point out in closing, the precious metals used in early times would have had value to those operating outside of these local feudal relations, such as merchants, and hence why Gold etc has always been an international money.