The following was excerpted from: Niall Ferguson. The Cash Nexus: Money and Power in the Modern World, 1700-2000 (Kindle Locations 284-305). Kindle Edition.
Niall Ferguson’s “Square of Power”
“My intellectual debt to the theoretical work of Douglass North and others on the relationship between institutions and economics will by now be obvious to students of economics.1 The basic institutional framework I have in mind may be thought of as a square. To put it simply, the exigencies of war finance had led by the eighteenth century to the evolution of an optimal combination of four institutions. First, as illustrated in the top left-hand corner of Figure i, there was a professional tax-gathering bureaucracy. Salaried officials proved to be better at revenue raising than local property owners or private tax “farmers,” who tended to retain a larger proportion of tax revenue for themselves. Second, parliamentary institutions in which taxpayers were granted a measure of political representation tended to enhance the amount of revenue a state could raise, in that taxation could be “traded” for other legislation and the entire budgetary process legitimated. Third, a system of national debt allowed a state to anticipate tax revenues in the event of a sudden increase in expenditure, such as that caused by a war. The benefit of borrowing was that it allowed the costs of wars to be spread over time, thus “smoothing” the necessary taxation. Finally, a central bank was required not only to manage debt issuance but also to exact seigniorage from the issuance of paper money, which the bank monopolized.
Figure i. The square of power
Though each of these four institutions had deep historical roots, it was in Britain after the Glorious Revolution that their potential in combination was realized – though it should be made clear at once that Hanoverian reality fell some way short of the ideal type I have just described. The Excise, Parliament, the National Debt and the Bank of England nevertheless formed a kind of institutional “square of power” which was superior to any alternative arrangement -notably the French system of privatized tax collection based on sales of office and tax “farming,” minimal representation in the form of the parlements, a fragmented and expensive system of borrowing and no central monetary authority.
It was not just its revenue-raising property that made the British “square” superior to rival systems. It was also the more or less unintended side-effects it had on the private sector of the economy. To speak in general terms, the need for an efficient tax-gathering bureaucracy implied a need for a system of formal education, to ensure an adequate supply of civil servants who were both literate and numerate. Secondly, the existence of a parliament almost certainly enhanced the quality of legislation in the sphere of private property rights. Thirdly, the development of a sophisticated system of government borrowing through a funded national debt encouraged financial innovation in the private sector. Far from “crowding out” private investment, high levels of government bond issuance widened and deepened the capital market, creating new opportunities for the issuance and trading of corporate bonds and equities, especially in peacetime when the state no longer needed to borrow. Finally, a central bank with a monopoly over note-issue and the government’s current account was also capable of developing functions – such as manager of the exchange rate or lender of last resort – which tended to stabilize the credit system as a whole by reducing the risk of financial crises or banking panics. In these ways, institutions that initially existed to serve the state by financing war also fostered the development of the economy as a whole. Better secondary and higher education, the rule of law (especially with respect to property), the expansion of financial markets and the stabilization of the credit system: these were vital institutional preconditions for the industrial revolution.”