Spending a windfall

Two shocks hit the world during the 1500s: a technological shock and a monetary shock. The technological shock was the decrease in trading costs obtained with new sea routes between Europe and Asia. The monetary shock was the discovery of gold and silver in America. Portugal had a prominent participation in these events. The difficulty is to isolate the effects of the precious metals from the effects of the sea routes.

This article creates a model in which Europe and Asia trade subject to trading costs and in which the population values services provided by money. New sea routes are simulated with a decrease in trading costs. A roundtrip from Europe to Asia took three years overland. Using the new sea routes, it took months. The voyage was safer, cheaper, and carried more cargo. The discovery of precious metals is simulated with injections of money directed to Europe. The production of precious metals from 1500 to 1800 corresponds to windfall of almost twenty times initial per capita holdings. To compare, the increase in per capita M1 (a measure of money suppyl) from 2008 to 2012, during quantitative easing, was of 1.5 times.

The figure shows the results of simulations of imports of Asian goods by Europe. With the model, the authors can switch off the shock to precious metals and simulate the economic scenario from the shock to new routes. Imports of Asian goods increase by twenty times in comparison with the scenario before sea routes and precious metals. Without precious metals, the sea routes alone would have increased imports seven times. These are imports of silk, tea and porcelain. The conclusion is that precious metals played an important role in the increase in imports from Asia.

It is possible to draw a parallel between the results of the paper and the current foreign reserves of China. In the past, the discovery of gold and silver allowed Europe to incur into trade deficits with Asia. Today, the equivalent of a discovery of gold and silver is the confidence in the dollar and in treasury bills. With the difference that this confidence was acquired over time with the management of monetary policy. Data from the World Bank reveals that foreign reserves of China were $3.3 trillion in 2022. As dollars and treasury bills are accepted widely, the US has the privilege of paying small interest rates when borrowing and receiving high returns when lending. Borrowing under small interest rates and lending with high returns allows the maintenance of trade deficits. China accumulated gold and silver in the past. Today, China accumulates treasury bills. It will continue to finance until the confidence on the dollar continues and until the internal savings in China allow the accumulation of large reserves.

Click here to go to the paper by Nuno Palma and Andre C. Silva.