The borrowing needs of governments usually exceed what any one creditor is able to lend. For centuries, governments have worked around this by selling bonds with standardized terms to investors, millions of them. However common this practice is today, it was absent in most ancient and medieval civilizations. It was not until the Late Middle Ages, in the city states of Northern Italy, that we see governments borrowing against future revenues through the issuance of standardized ‘shares’ in the public debt, which then traded freely in a secondary market.
You may wonder how an even older society, like that of the earlier great Italian civilization, Ancient Rome, financed its state debts? The short answer is it didn’t; when the state needed extra money, it usually simply debased the coinage. The result was the inflation the Roman Empire was known for. Unlike aqueducts, sports arenas, and public baths, government bonds are an example of something the Romans didn’t have that medieval civilizations did.
The Late Medieval State
The Black Plague, famine, wars, and peasant revolts across Europe in the 14th century formed the backdrop to innovations in public finance. Like the goldsmith-bankers in 17th century England, financial innovation was coming in a time of crisis. The demands on Europe’s medieval nations in the 1300s saw the centralization of power, the waning of feudalism, and the creation of the modern state. Along with this consolidation was a reform of the way governments were financed. The wars of the 14th century saw the increased use of paid professional armies and mercenaries as opposed to unpaid armies under the older system of feudal conscription. The need to pay these armies resulted in increased taxation and forced loans.
The Late Middle Ages were also a period of increased urbanization. Cities, especially coastal cities in the south of Europe, grew more rapidly than they ever had since the fall of Rome in the 5th century. Among these were Venice and Genoa; Venice, the great trading city facing south on Italy’s Adriatic coast, was a gateway to the eastern Mediterranean while Genoa was a gateway to the western Mediterranean. Both were cities that saw tremendous financial innovations in the 13th and 14th centuries and both were city-states almost continuously at war, very often with each other. The need to finance these conflicts and their financial savvy drove the creation of the first freely trading sovereign bonds.
Venice had grown in wealth and power in the 12th and 13th centuries, so much so that in the early 1200s, the city conspired to help an exiled Byzantine emperor recapture his throne in Constantinople. When the emperor refused to pay the amount he promised for their help, Venice aided in the capture of the famously well-fortified city of Constantinople during the Fourth Crusade. When it lost control of that city in 1261, the loss was a financial shock to the Italian city-state. Thus, the following year, Venice consolidated its state debt, made up of bonds called prestiti.
The bonds actually originated in forced loans the state required of wealthy citizens who were said to have preferred forced loans to higher taxes. However, after the state debt was consolidated in 1262, an active secondary market for the prestiti grew. As such, they were no longer like the loans of old, but were tradable securities like the sovereign bonds of today.
The prestiti were perpetual obligations, with no fixed maturity date, though the Venetian government would repay the principal from time to time by redeeming the bonds. For over a century, from 1262 to 1371, annual interest on the prestiti were fixed at 5%, paid semiannually. As with any other bond, the actual yields on the bonds depended on their prices. Market prices derived from historical records have been used to calculate what the yields on the bonds were. They show yields rising in the late 13th century; in 1299, they rose to over 8% as the bonds’ prices fell. This is perhaps partially the consequence of a military defeat to Genoa which destroyed much of the Venetian navy the previous year at the Battle of Curzola off the coast of modern-day Croatia.
A worthwhile read, Sidney Homer and Richard Sylla’s work on interest rates through the centuries (“A History of Interest Rates,” the most recent edition of which was published in 2005) even show how the yields on the prestiti fluctuated with changes in new debt issuance. When the Venetian state would force more loans, increasing the supply of bonds, the price of the prestiti fell, and when it made large repayments the price sometimes exceeded par value. Nonetheless, following the late 13th century spike, the general trend in yields was downward until continued war with Genoa caused substantial reform of the state finances in 1377.
So, what about Genoa itself? It was often at war with Venice and it too had a need for innovative borrowing; not at all a coincidence. Genoa was a financial center of Northern Italy; already by the Late Middle Ages, it was home to one of the earliest banks and was also a center for currency trading, especially during periodic fairs which brought together merchants from other European kingdoms.
After the wars with Venice greatly indebted the state, Genoa consolidated its public debt. The debt burden was then divided into shares called luoghi, which were freely tradable by their owners. Because of the fact that people trusted that the increasingly powerful Genoese state would honor its debts, people were also able to use the luoghi as collateral for their own borrowing. In the 1300s, they were Europe’s collateral instrument of choice.
Later, in 1407, Genoa’s Bank of Saint George was hired to consolidate the public debt which was again rising after further wars with Venice. The Bank, perhaps one of the earliest examples of a European investment bank, placed new luoghi on behalf of the state with investors who bought them voluntarily. These luoghi were similar to their Venetian counterparts in some respects; like the prestiti, they were perpetual obligations.
Unlike the prestiti, they had a variable as opposed to a fixed interest rate. The luoghi were paid something like a dividend; specifically, the ‘interest’ was established as a fraction of the amount of taxes collected by the government after any fee payments to the Bank of Saint George. This feature made the luoghi interesting even by modern standards; with variable payments, the luoghi looked more like ‘state equity’ than sovereign bonds. Their yields were correspondingly more volatile and higher. Along with the Bank of Saint George, the luoghi of Genoa would continue to exist in European debt markets until the fall of Genoa to the French in the wars following the French Revolution.
Thanks to the survival of sufficient records, there is actually a substantial amount to learn from the world’s earliest bond markets. Some have combined what we know about the yields on medieval Italian state bonds with the yields of later instruments to create a kind of history of risk-free interest rates going back centuries. This data could help broaden our view of the nature of the bond market and its cycles; a long-term view can be based on centuries of historical returns and not just decades, the best we can achieve for equities.
Very sensibly, some people question how useful this financial archaeology is to economists and financiers today. Yet, regardless of its utility to making policy and investment decisions, the information that does survive about these medieval bonds is a wonderful illustration of fixed income investment principals in action, including the mathematical relationship between bond yields and prices.
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1. Felloni, Giuseppe. “Genoa and the History of Finance: a Series of FIRSTS?: Chapter 2.” Giuseppe Felloni.
2. Homer, Sidney, and Richard Eugene. Sylla. A History of Interest Rates. 4th ed., Wiley, 2005.
3. Schmelzing, Paul Ferdinand. “Eight Centuries of the Risk-Free Rate: Bond Market Reversals from the Venetians to the VaR Shock.” Bank of England: Staff Working Paper No. 686, Oct. 2017, doi:10.2139/ssrn.3062498.
4. Taylor, Bryan. “Birds, Boats And Bonds In Venice: The First AAA Government Issue.” Globalfinancialdata.com, Global Financial Data, 16 Dec. 2013.