A Conversation with Jean-Laurent Rosenthal and Philip T. Hoffman

Philip T. Hoffman (left) and Jean-Laurent Rosenthal

In their new book, Dark Matter Credit: The Development of Peer-to-Peer Lending and Banking in France, Caltech professors Jean-Laurent Rosenthal and Philip T. Hoffman, along with their co-author Gilles Postel-Vinay, a professor emeritus at the Paris School of Economics, make the case that money borrowing and lending thrived in 18th- and 19th-century France without the help of banks. By sifting through archival data on 250,000 French loans, the researchers were able to uncover a pervasive “shadow” system of peer-to-peer lending. The system let nearly a third of French families borrow money in 1740; and by 1840, it funded as much mortgage debt relative to gross domestic product (GDP) as U.S. banks did in the 1950s. 

 We sat down with Rosenthal, the Rea A. and Lela G. Axline Professor of Business Economics and the Ronald and Maxine Linde Leadership Chair, Division of the Humanities and Social Sciences; and Hoffman, the Rea A. and Lela G. Axline Professor of Business Economics and History, to talk about their new book. 

Caltech magazine [CM]: What is the main message people should take away from your book? 

Jean-Laurent Rosenthal [JLR]: Credit markets in Europe were really big before banks became important players in financial markets. 

Philip T. Hoffman [PTH]:The findings were a surprise because all this lending was going on without anything like our modern credit scores or even a way to tell if property had been mortgaged. It shows how ingenious people can be under the right conditions.

CM: Do the lessons from this book have any practical applications for today’s credit markets? 

JLR: At first blush, this book is about a system of peer-to-peer lending that goes back centuries but didn’t disappear until just before World War II. In that way, it is really history. But history is full of useful lessons, and the most important one for credit markets is that they will thrive only when reliable information can flow from borrowers to lenders. Building banks when the information system is deficient will lead to little lending or, worse yet, financial crises.

PTH: The book’s lessons apply to modern peer-to-peer-lending, which is cropping up around the world thanks to the Internet. In China, it has attracted over 50 million investors, but because the firms arranging the loans misled investors, the whole market collapsed in 2018. A bit of government regulation would have helped, as in other financial markets.

CM: How did this book come about, and can you tell us more about the process of writing it? 

JLR: The book had a very slow gestation because of its data requirements. The three of us authors, in fact, wrote two other books while collecting the data for this one. When we started, we were interested in financial development and wanted to measure lending to understand why some local markets are big and others small. Collecting that data took a lot of time.

PTH: In particular, writing this book meant devising a smart way of sampling historical records that would get the data we needed in a feasible amount of time. That required a deep knowledge of how legal and tax institutions operated in the past. And to test our ideas, we also had to work out economic models of what had been happening back then. 

CM: Did you have any new revelations or insights during the course of writing the book?

JLR: When we started, we followed earlier scholars and treated each market as an isolated island; for example, borrowing money in Pasadena would involve lenders from Pasadena. After collecting some data, we discovered a recurring phenomenon: in most markets, about 15 percent of the lenders and borrowers came from a bit farther away and accounted for about a fifth or more of the lending. Our original assumption that credit markets were like isolated islands was wrong, and we had to understand how and why these markets were interlinked. That required a new theoretical model and a different data set than we had started with.

PTH: A different example involves the data on banking that we collected. We could show that banks did not outcompete peer-to-peer lenders, but that discovery cast doubt on a widespread argument in law and economics that links the prosperity of financial markets to legal systems. Markets, or so the argument goes, thrive only when judicial decisions can quickly create legal precedents to accommodate new financial transactions. That was supposedly impossible in France and many other countries with similar legal systems. But our research shows that’s not always true.

CM: What were your favorite and least favorite parts of researching and writing this book? 

JLR: The best part was working with Phil and Gilles. When we disagreed, everyone sat down and articulated how data would discriminate between our different arguments. And then we would go and collect what was needed, which was just educational and fun. My least favorite part was putting together a final database from data collected beginning in the 1990s. It took me a long time to be sure I had the best version of the data for each of the 160 localities we included.

PTH: Each of us brings something different to our research, and that is why it is a real delight to work together and figure out how to tease the data we need out of the surviving historical records. My least favorite part was going through the manuscript to check that the numbers in every table, graph, and sentence matched that final database. As we updated the data for the last time, the numbers did not change much at all, but we still had to check everything and change those errant third decimal places in some tables.

CM: Do you have any other books planned?

JLR: I have started to work on a book about wealth inequality in Paris from 1807 to the present.  

 PTH: I have a book underway on why the Industrial Revolution happened first in Europe and not somewhere else, such as China. And the three of us have another book project in mind as well about a huge financial collapse in 1740s Paris that cost powerful people a fortune. It’s a great story, worthy of a movie!