I finished reading the fascinating book Capital and Finance in the Age of the Renaissance: A Study of the Fuggers and Their Connections by Richard Ehrenberg, translated by H. M. Lucas (New York: Harcourt Brace & Co., 1928) which is available for free download from archive.org. This is one of the few books that provide a detailed description of banking and credit outside of Italy and the Anglophone world, and there is a lot to chew on in this book. The story of the Fuggers is fascinating in its own right, as is the evolution of European sovereign credit during the sixteenth and seventeenth centuries.
But what I want to focus on is the emergence of the risk free asset or what Gorton calls “informationally insensitive” assets (Gorton, G., 2017. The History and Economics of Safe Assets. Annual Review of Economics, 9, pp.547-586). Gorton uses a standard neoclassical framework and attributes the safety of the asset to large amounts of high quality collateral in the case of privately issued safe assets. In the case of sovereign safe assets, Gorton relies on the practically unlimited taxing power of the state. Ehrenberg traces a very different arc that focuses on standardization and rational inattention (Maćkowiak, B., Matějka, F. and Wiederholt, M., 2023. Rational Inattention: a Review. Journal of Economic Literature, 61(1), pp.226-273).
Ehrenberg states (page 318-19:
In the case of individual isolated credit transactions, that is, in those not effected through a market, every person who gives credit has to form an independent judgment as to the credit-worthiness of the person to whom he gives it. The Bourse, on the other hand, was most important for commercial credit transactions because Bourse opinion furnished commercial credit with the idea of the good solvent Bourse firm, or Ditta di Borsa, as a positive permanent conception which could be turned to account in business.
The Bourse opinion of the international Bourses of the sixteenth century held as ‘good’ beyond all doubt a large number of business houses of different nationalities, whose representatives did business on the Bourse every day and borrowed largely. In this way individual lenders were spared the difficult task of examining the credit-worthiness of these houses, if they gave them credit. It is obvious that this greatly facilitated the development on the Bourse of a regular large business in bills and commercial loan capital. For in this business the fact that credit-worthiness had been established acted as an authoritative decision as to the quality of the object dealt in. From now onwards there was a large mass of commercial claims all similar in quality standardized, and these formed the object of a regular Boiuse business. As the credit-worthiness of a sufficient number of Bourse firms had been considered as above suspicion (even if this was not so in actual fact), the parties, disregarding the difficult question of quality, could concentrate on settling the prices of bills and loan capital, and these prices could become real Bourse prices.
Of course, a firm that was Ditta di Borsa at one point of time could cease to be so at a later date and vice versa. But during the time it was Ditta di Borsa, its credit-worthiness was considered as above suspicion (Gorton’s No Questions Asked or NQA). The critical point is that as the above quote explicitly points out, the firm’s credit might not have been that good in actual fact. By treating all the Ditta di Borsa as fungible, there were enough bids and offers for the Bourse to determine a “risk free” interest rate, and this market interest allowed the bills to become very liquid. In a sense, Ditta di Borsa was the AAA credit rating of the sixteenth century.
This process of lumping together disparate assets and treating them as fungible is more clearly visible in the case of sovereign debt which in those days was riskier than commercial credit (page 326):
The Bourse rate of interest applied only to the Ditte di Borsa; other debtors paid higher rates. This is true especially of Bourse loans to princes, the rate of which regularly was far in excess of the Bourse rate. This was, however, rather apparent than real. The rate itself was not higher, but only the insurance against risk. For a long time the fluctuations here were very wide. In the case of these loans, even on the Bourses, the price was made as an isolated instance. It was only from 1542 onwards that it assumed a Bourse character, and thenceforward the rate for the princely loans on the Bourse was fairly parallel with the ordinary Bourse rate. For every kind of princely or other public loan (Bonds of the Receivers General, Court Bonds, Obligations of the English Crown, etc.) Bourse opinion fixed a rate of insurance against risk which depended on the view taken of the quality of the kind of loan. The amount of this premium varied only within bearable limits.
Ehrenberg describes the standardization of sovereign debt and rational inattention as follows (page 319-20):
What we have just said of commercial credit holds good also of public credit. In this case also Bourse opinion had the effect of leveling or standardizing the differences of quality between the different debts. Here, however, there were certain deviations due to the special nature of public credit in early times. As we have seen, most princes in the ‘Age of the Fugger’ had originally very little personal credit. Accordingly, the quality of a debt owed by a prince was not determined, in the first place, by the credit-worthiness of the debtor, but by the kind of security which he offered the creditor, i.e. the nature of the guarantee or the pledged revenues. This quality was extremely various in the different debts.
While on the one hand the dissimilarity of the different princely loans tended to keep princes’ loans in the stage of isolated transactions outside the market, this was in the long run impossible because the task of estimating the real value of the different loans was too much even for the largest isolated firms.
This situation tended steadily to standardize the business in royal loans and to concentrate it on the Bourse, a development which we can follow in sufficient detail in the case of Antwerp and Lyons.
Ehrenberg summarizes the rational inattention as follows (page 326):
Bourse opinion, generally speaking, no longer troubled much about the special securities which had given the individual lenders so much anxious thought. What it considered important was the debtor’s general capacity to pay and good will, rightly judging that in the last resort these points were decisive in the case of credit to be given to princes. Bourse opinion could not act otherwise; for the news which reached the Bourses in great quantity was not of a kind to render easier any special judgment as to the security of individual princely notes of hand, but rather to help a general judgment as to the political and economic situation or the financial condition of princes. Bourse opinion was a better judge of these general conditions than the individual business house, and this is specially so in the case of the conclusions to be drawn as to the future. The Bourses of Antwerp and Lyons foresaw in time the impending crisis of 1557, but this did not prevent the South German merchants from lending right up to the bitter end enormous amounts of capital to the Kings of France and Spain who had long been really bankrupt.
Ehrenberg also provides a Hayekian (Hayek, F.A., 1945. The Use of Knowledge in Society. The American Economic Review, 35(4), pp.519-530.) perspective on how markets create knowledge (page 325-6):
Bourse opinion is not like perhaps, for instance, scientific opinion, meant to serve truth, but to serve trade. The Bourse habitues want to make money. That is their private economic aim. In order to carry out their private purpose they form a market and so discharge a public economic duty.
The money-making instinct which Bourse opinion is formed to serve is guided by intellect. The Bourse habitues try before concluding their transactions to get clear as to all the points telling for or against the attainment of their business objective. Such points are, however, only to a very small extent of such a nature as to allow conclusions to be drawn which are both sure and instantly realizable. For the most part they are only of a kind to produce guesses, opinions on which the Bourse opinion bases itself.
The evolution that Ehrenberg describes can be summarized as follows. Initially, borrowings by Fugger were distinguished from that of other great merchants like Welser or Hochstetter. At a later point of time, the Bourse stopped discriminating between them and started treating loans to all these great merchant-financiers as safe assets (Ditta di Borsa). The job of the Bourse then became that of assessing the level of liquidity, the supply of savings, and the demand for credit in Western Europe as a whole and determining the appropriate risk free interest rate accordingly. No individual market participant (not even the largest house like the Fugger) had a complete picture of all these complex factors, but the market in Hayekian fashion combined the information scattered across numerous individuals into a market wide interest rate which could serve as a signal of the scarcity or abundance of money in the whole region. The precondition for this was a liquid market, and this liquidity could be created only when scattered loans to different merchant were treated as fungible and lumped together into a single category of “AAA” credits. Attention is limited, and the only way for the market to pay attention to the all important issue of the continent-wide supply of savings and demand for credit was to stop paying attention to the identity of the borrower (so long as it was Ditta di Borsa). This is rational inattention at its best.
The evolution of sovereign credit is a little more complex. At a time when Kings borrowed in their personal capacity and not in the name of the Kingdom itself, their credit was very poor. They could borrow only by pledging specific revenues for example, a customs duty or a salt tax), and the great financiers bargained hard to secure the most valuable pledge. As Kings became adept at pledging the same revenue to multiple lenders, and sovereign credit gradually became a little less personal and a little more institutional, rational inattention demanded that lenders stop paying attention to the security and start focusing on the overall fiscal health and liquidity of the King. Once again, even the largest merchant houses realized that they did not possess all the information required to make this assessment. Only the market could perform this task of information aggregation and assimilation, and the market could do this only when all loans to say the King of Spain were treated as fungible regardless of minor details like the nature of the pledge backing the loan.
Modern financial markets also rely on rational inattention all the time. During the US-Iran hostilities this year, the whole world was focused on the price of crude oil. The fascinating thing here is that the chemical composition of the crude flowing out of each oil well is different, and similarly every refinery is optimized to process crude oil coming from specific oil fields. The crude oil futures markets (Brent or WTI) abstract from all this, and through a process of rational inattention produce a Hayekian price signal for the global supply-demand imbalance of crude. There are of course exceptional situations where the rational inattention ceases to be rational. During the Covid pandemic, for example, people who forgot how the WTI futures price was tied to the storage capacity and pipeline capacity at Cushing, Oklahama lost a lot of money. As I explained in a blog post at that time, all the financial engineering in the world fails to hide the intense physicality of a commodity when it comes to the crunch.
Stock index futures and index mutual funds are also examples of rational inattention: we do not want to think about individual stocks, but want to focus on the stock market as a whole. These devices work admirably most of the time, but occasionally, the inconvenient hidden reality breaks through this layer of abstraction. An example that comes to mind is the recent controversy about whether Space X should be included in the index immediately after its IPO with different index providers taking divergent stands on this issue.
Securitization which Gorton discusses at length is also about rational inattention. By pooling together thousands of mortgages (and then slicing and dicing them skilfully), we can stop thinking about each mortgage and focus on a broad view of the likely future trend of real estate prices in the region. This usually works without a glitch. Combining this with another rational inattention device (credit rating) allowed investors to stop thinking about the real estate price index as well, and this worked out very badly.
What all these examples demonstrate is that rational inattention is always at risk of morphing into irrational inattention, because the very process of rational inattention leads to an atrophy of the skills that allow us to pay attention when needed.