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INVESTMENT INSIGHTS ARCHIVE
Originally posted in March 2016

In Medieval Europe, which was predominately illiterate and constantly short of physical money, the split tally was a technique used to record bilateral exchange and debts. A stick (squared Hazelwood ones were the most common) was marked with a system of notches and then split lengthwise. With this method, the two halves recorded the same notches and each party to the transaction received one half of the marked stick as proof. This technique was refined in various ways, such as making the two halves of the stick different lengths, until it became virtually tamper proof. The longer part was called the stock and given to the party that had advanced the money. This is where “stockholder” derives from, when we refer to modern day equity owners. The shorter half was called the foil and was retained by the party that had received the goods or funds. Both parties therefore had an identifiable and tamper proof record of the transaction.

In AD 1100, King Henry I came to the English throne and adopted the tally stick method of recording tax payments. By the time of Henry II, taxes were paid twice a year and tally sticks that recorded partial payment made at Easter soon began to circulate in a secondary discount market. These tally sticks were accepted as payment for goods and services at a discount, since they could be later presented to the treasury as proof of taxes paid. It didn’t take long for the King and his treasurer to realise that they could actually issue tally sticks in advance to finance war and other royal spending. The selling of these claims to future tax revenue created the market for government debt, an essential part of today’s fiat money system as well.

Medieval England also saw the emergence of the goldsmith banker. Since no actual banks existed at this time, merchants and noblemen who had received gold specie in exchange for goods and services rendered, entrusted their wealth with a London goldsmith. In exchange for each deposit of the precious metal, the goldsmiths issued paper receipts that certified the quantity and purity of the metal being held on deposit. The goldsmith receipts, like the tally sticks, soon began to circulate as a safe and convenient form of money, backed by gold and silver in the goldsmiths’ vaults. Once again, it didn’t take long for the goldsmiths to realise that they could temporarily lend deposits out and collect interest on such loans. The temptation was too much and before long, they began issuing additional receipts for gold, even if they were not backed by a deposit. This came to be known as ‘fractional reserves banking’ — lending out far more money than one actually has on deposit — and the road to banking ruin was firmly in place.

The government and central bank of the day were still in the hands of the monarchy, apart from a short Cromwellian experiment in the early 17th century. By 1660, Charles II was raising taxes, although he did have to get parliament’s permission. He immediately went to cash in the future tax receipts by selling tally sticks to the goldsmiths at a discount. The introduction of making debt payable to the bearer allowed the goldsmiths to sell it in the secondary market in order to raise funds for more lending to the King. In order to attract more funds, higher interest rates were paid to the depositors. At that stage of the game the goldsmiths had a good thing going for them, since the King was the equivalent of a triple A rated sovereign borrower, who could always be relied upon to cover his debt with future tax receipts.

Despite the fact that the vaults soon contained more wooden sticks than gold, and the King had begun to issue tally sticks as he pleased, no one thought it problematic, especially as this increase in wooden stick production had started a seemingly prosperous credit boom. The natural limit to debt expansion occurs when your creditors are no longer willing to lend you more money, despite higher interest rates. By 1671, the annual discount on the King’s debt had reached 10% and new funds were barely enough to cover maturing loans. Time was running out. A cunning plan was called for and — with some legal advice — the ‘discovery’ was made that usury was still illegal; all interest rates in excess of 6% were not permissible. All of the recent loans were now declared illegal and payment was stopped. Overnight, the King’s tally sticks reverted back to their real worth — firewood. The King’s creditors, the goldsmiths and their customers had “drawn the short end of the stick” (the origin of a still used expression).

What the tally stick system, and its application by Charles II, shows us is that a fiat money system can work for many years where worthless pieces of wood or paper are deemed to have the same value as gold, as long as there is complete faith in the government to not increase the supply of wood. Unfortunately in our history to date, no government has been able to resist the temptation to spend the future’s productivity for today’s consumption.

This historical anecdote was taken from an article I wrote in 2008, entitled ‘Nothing new in banking’.

In most countries banking is seen as the lifeblood of the economy, as its ability to lend to businesses or individuals is part of nearly every aspect of our lives, not just property and employment. Over the last year, most bank stocks across the globe have suffered considerably with the EuroStoxx banking index having fallen 35%. With high weightings in the main country indices, such as the UK FTSE or the German DAX, this has been a key driver on the poor returns that has received far less attention than the dramatic decline in oil prices. As of today, Royal Dutch Shell is actually up 6% on the year versus Royal Bank of Scotland’s 25% loss. Is another banking crisis really possible after the last one?

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