The ascent of money

To Christians, love of it is the root of all evil. To generals, it’s the sinews of war. To revolutionaries, it’s the chains of labor. But Ferguson shows that finance is in fact the foundation of human progress. What’s more, he reveals financial history as the essential backstory behind all history.

The evolution of credit and debt was as important as any technological innovation in the rise of civilization. Banks provided the material basis for the splendors of the Italian Renaissance while the bond market was the decisive factor in conflicts.

Yet the most important lesson of the financial history is that sooner or later every bubble bursts — sooner or later the bearish sellers outnumber the bullish buyers, sooner or later greed flips into fear.

Nearly 1B people around the world struggle to get by on just $1/day.

Throughout the history of Western civilization, there has been a recurrent hostility to finance and financiers, rooted in the idea that those who make their living from lending money are somehow parasitical on the “real” economic activities of agriculture and manufacturing. This hostility has 3 causes.

It is partly because debtors have tended to outnumber creditors and the former have seldom felt very well disposed towards the latter.

It is partly because financial crises and scandals occur frequently enough to make finance appear to be a cause of poverty rather than prosperity, volatility rather than stability.

And it is because, for centuries, financial services in countries all over the world were disproportionately provided by members of ethnic or religious minorities, who had been excluded from land ownership or public office but enjoyed success in finance because of their own tight-knit networks of kinship and trust.

The Renaissance created such a boom in the market for art and architecture because Italian bankers like the Medici made fortunes by applying Oriental mathematics to money. The Dutch Republic prevailed over the Habsburg Empire because having the world’s first modern stock market was financially preferable to having the world’s biggest silver mine.

In 2006, the measured economic output of the entire world was around $47T. The total market cap of the world’s stock markets was $51T, 10% larger. The total value of domestic and international bonds was $68T, 50% larger. The amount of derivatives outstanding was $473T, more than 10 times larger.

Self-satisfied bankers held conferences with titles like “The evolution of excellence.”

Less than 23% knew that income tax is charged on the interest earned from a savings account if the account holder’s income is high enough. Fully 59% did not know the difference between a company pension, Social Security and a 401(k) plan.

The first step towards understanding the complexities of modern financial institutions and terminology is to find out where they came from. Only understand the origins of an institution or instrument and you will find its present-day role much easier to grasp.

The first is that poverty is not the result of rapacious financiers exploiting the poor. It has much more to do with the lack of financial institutions, with the absence of banks, not their presence. Only when borrowers have access to efficient credit networks can they escape from the clutches of loan sharks, and only when savers can deposit their money in reliable banks can it be channeled from the idle rich to the industrious poor.

My second great realization has to do with equality and its absence. If the financial system has a defect, it is that it reflects and magnifies what we human beings are like. Money amplifies our tendency to overreact, to swing from exuberance when things are going well to deep depression when they go wrong. Booms and busts are products, at root, of our emotional volatility. But finance also exaggerates the differences between us, enriching the lucky and the smart, impoverishing the unlucky and not-so-smart.

Few things are harder to predict accurately than the timing and magnitude of financial crises, because the financial system is so genuinely complex and so many of the relationships within it are nonlinear, even chaotic.

According to Engels and Marx, money was merely an instrument of capitalist exploitation, replacing all human relationships, even those within the family, with the callous “cash nexus.” Money was commoditized labor, the surplus generated by honest toil, appropriated and then “reified” in order to satisfy the capitalist class’s insatiable lust for accumulation.

Yet no Communist state — not even NK — has found it practical to dispense with money. And even a passing acquaintance with real hunter-gatherer societies suggests there are considerable disadvantages to the cash-free life.

When 2 groups of such primitive peoples chanced upon each other, it seems, they were more likely to fight over scarce resources (food and fertile women) than to engage in commercial exchange. Hunter-gatherers do not trade. They raid. Nor do they save, consuming their food as and when they find it. They therefore have no need of money.

Labor was the unit of value in the Inca Empire, just as it was later supposed to be in a Communist society. And, as under Communism, the economy depended on often harsh central planning and forced labor.

The Incas could not appreciate that, for Pizarro and his men, silver was more than shiny, decorative metal. It could be made into money: a unit of account, a store of value — portable power.

Every peso coin minted in Potosi has cost the life of 10 Indians who have died in the depths of the mines. As the indigenous workforce was depleted, thousands of African slaves were imported to take their places as “human mules.”

Within Spain, the abundance of silver also acted as a “resource curse,” like the abundant oil of Arabia, Nigeria, Persia, Russia and Venezuela in our time, removing the incentives for more productive economic activity, while at the same time strengthening rent-seeking autocrats at the expense of representative assemblies.

What the Spaniards had failed to understand is that the value of precious metal is not absolute. Money is worth only what someone else is willing to give you for it. An increase in its supply will not a society richer, though it may enrich the government that monopolizes the production of money. Other things being equal, monetary expansion will merely make prices higher.

Banknotes (which originated in 7th-century China) are pieces of paper which have next to intrinsic worth. They are simply promises to pay (hence their original Western designation as “promissory notes”), just like the clay tablets of ancient Babylon 4K years ago.”

Borrowers were expected to pay interest (a concept which was probably derived from the natural increase of a herd of livestock).

But the foundation on which all of this rested was the underlying credibility of a borrower’s promise to repay. (It is no coincidence that the root of “credit” is credo, the Latin for “I believe.”)

Many of his victim were terrified to risk missing a payment due to his reputation — though it is not clear that Law ever actually resorted to violence. Behind every loan shark there lurks an implicit threat.

It is easy to condemn loan sharks as immoral and, indeed, criminal. Yet we need to try to understand the economic rationale for what Law did. First, he was able to take advantage of the fact that no mainstream financial institution would extend credit to the Shettleston unemployed. Second, Law had to be rapacious and ruthless precisely because the members of his small clientele were in fact very likely to default on their loans. The fundamental difficulty with being a loan shark is that the business is too small-scale and risky to allow low interest rates.

How did moneylenders learn to overcome the fundamental conflict: if they were too generous, they made no money; if they were too hard-nosed, people eventually called in the police?

The answer is by growing big — and growing powerful: the birth of banking.

Shylock was far from the only moneylender to discover the inherent weakness of the creditor, especially when the creditor is a foreigner. In the early 14th century, 3 Florentine houses were wiped out as a result of defaults by 2 of their principal clients, King of England and King of Naples. But if that illustrates the potential weakness of moneylenders, the rise of the Medici illustrates the very opposite: their potential power.

Prior to the 1390s, it might legitimately be suggested, the Medici were more gangsters than bankers: a small-time clan, notable more for low violence than for high finance.

By the time Pius II became pope in 1458, Cosimo Medici effectively was the Florentine state. As the Pope himself put it: “Political questions are settled at his house. The man he chooses holds office. He it is who decides peace and war and controls the laws. He is King in everything but name.” Foreign rulers were advised to communicate with him personally and not to waste their time by approaching anyone else in Florence.

Though others had tried before them, the Medici were the 1st bankers to make the transition from financial success to hereditary status and power. They achieved this by learning a crucial lesson: in finance small is seldom beautiful. By making their bank bigger and more diversified than any previous financial institution, they found a way of spreading their risks. And by engaging in currency trading as well as lending, they reduced their vulnerability to defaults.

A run on the bank on the bank was therefore a virtual impossibility, since it had enough cash on hand to satisfy nearly all of its depositors if, for some reason, they all wanted to liquidate their deposits at once. This made the bank secure, no doubt, but it prevented it performing what would now be seen as the defining characteristic of a bank, credit creation.

The 3rd great innovation of the 17th century occurred in London with the creation of the BoE in 1694. Designed primarily to assist the government with war finance (by converting a portion of the government’s debt into shares in the bank), the Bank was endowed with distinctive privileges. From 1709 it was the only bank allowed to operate on a joint-stock basis; and from 1742 it established a partial monopoly on the issue of banknotes.

Now money represented the sum total of specific liabilities (deposits and reserves) incurred by banks. Credit was, quite simply, the total of banks’ assets (loans). Some of this money might indeed still consist of precious metal, though a rising proportion of that would be held in the central bank’s vault. But most of it would be made up of those banknotes and token coins recognized as legal tender along with the invisible money that existed only in deposit account statements. Financial innovation had taken the inert silver of Potosi and turned it into the basis for a modern monetary system, with relationships between debtors and creditors brokered or “intermediated” by increasingly numerous institutions called banks. The core function of these institutions was now information gathering and risk management. Their source of profits lay in maximizing the difference between the costs of their liabilities and the earnings of their assets, without reducing reserves to such an extent that the bank became vulnerable to a run — a crisis of confidence in a bank’s ability to satisfy depositors, which leads to escalating withdrawals and ultimately bankruptcy: literally the breaking of the bank.

The idea that money was really about credit, not metal, never quite caught on in Madrid. Indeed, the Spanish crown ended up defaulting on all or part of its debt no fewer than 14 times between 1557-1696. With a track record like that, all the silver in Potosi could not make Spain a secure credit risk.

It was only after the last of these crises that Walter Bagehot reformulated the Bank’s proper role in a crisis as the “lender of last resort,” to lend freely, albeit at a penalty rate, to combat liquidity crises.

The Victorians were as much in thrall to precious metal as the conquistadors 3 centuries before. “Precious metals alone are money. Paper notes are money because they are representations of metallic money. Unless so, they are false and spurious pretenders.”

Illiquidity is when a firm cannot sell sufficient assets to meet its liabilities. It has the right amount of assets, but they are not marketable because there are too few potential buyers. Insolvency is when the value of the liabilities clearly exceeds the value of the assets. The distinction is harder to draw than is sometimes assumed. A firm in a liquidity crisis might be able to sell its assets, but only at prices so low as to imply insolvency.

So restrictive was BoE note issuance that its bullion reserve actually exceeded the value of notes in circulation from the mid 1890s until WW1. It was only the proliferation of new kinds of bank, and particularly those taking deposits, that made monetary expansion possible.

By the eve of WW1, residents’ deposits in British banks totaled nearly £1.2B, compared with a total banknote circulation of just £45.5M. Money was now primarily inside banks, out of sight, even if never out of mind.

Large numbers of under-capitalized banks were a recipe for financial instability, and panics were a regular feature of American economic life — most spectacularly in the Great Depression. The introduction of deposit insurance in 1933 did much to reduce the vulnerability of American banks to runs.

The Plasma Center offers $55 a go for blood donations. A pint of blood may not be quite as hard to give up as a pound of flesh, but the general idea seems disconcertingly similar.

The ability to walk away from unsustainable debts and start all over again is one of the distinctive quirks of American capitalism. There were no debtors’ prisons in the US in the early 1800s, at a time when English debtors could end up languishing in jail for years.

The people in the Memphis Bankruptcy Court are not businessmen going bust. They are just ordinary individuals who cannot pay their bills — often the large medical bills that Americans can suddenly face if they are not covered by private health insurance. Bankruptcy may have been designed to help entrepreneurs and their businesses, but nowadays 98% of filings are classified as non-business.

The modern-day dollar bill acquired its current design in 1957. Since then its purchasing power, relative to the CPI, has declined by a staggering 87%.

Credit and debt, in short, are among the essential building blocks of economic development, as vital to creating the wealth of nations as mining, manufacturing or mobile telephony. Poverty, by contrast, is seldom directly attributable to the antics of rapacious financiers. It often has more to do with the lack of financial institutions, with the absence of banks, not their presence. It is only when borrowers have access to efficient credit networks that they can escape from the clutches of the loan sharks; only when savers can put their money in reliable banks that it can be channelled from the idle to the industrious.

The financial crisis of 2007 had little to do with traditional bank lending or bankruptcies. Its prime cause was the rise and fall of “securitized lending,” which allowed banks to originate loans but then repackage and sell them on. And that was only possible because the rise of banks was followed by the ascent of the 2nd great pillar of the modern financial system: the bond market.

What could make public officials talk with such reverence, even awe, about a mere market for the buying and selling of government IOUs?

After the creation of credit by banks, the birth of the bond was the 2nd great revolution in the ascent of money. Governments (and large corporations) issue bonds as a way of borrowing money from a broader range of people and institutions than just banks.

The bond embodies a promise by the Japanese government to pay 1.5% of 100K yen every year for the next 10 years to whoever owns the bond. The initial purchaser of the bond has the right to sell it whenever he likes at whatever price the market sets.

All of us, whether we like it or not, are affected by the bond market in 2 important ways. First, a large part of the money we put aside for our old age ends up being invested in the bond market. Secondly, because of its huge size, and because big governments are regarded as the most reliable of borrowers, it is the bond market that sets long-term interest rates for the economy as a whole. When bond prices fall, interest rates soar, with painful consequences for all borrowers.

Bond markets have power because they’re the fundamental base for all markets. The cost of credit, the interest rate on a benchmark bond, ultimately determines the value of stocks, homes, all asset classes.

From a politician’s point of view, the bond market is powerful partly because it passes a daily judgement on the credibility of every government’s fiscal and monetary policies. But its real power lies in its ability to punish a government with higher borrowing costs. Even an upward move of half a percentage point can hurt a government that is running a deficit, adding higher debt service to its already high expenditures. As in so many financial relationships, there is a feedback loop. The higher interest payments make the deficit even larger. The bond market raises its eyebrows even higher. The bonds sell off again. The interest rates go up again. And so on. Sooner or later the government faces 3 stark alternatives. Does it default on a part of its debt, fulfilling the bond market’s worst fears? Or, to reassure the bond market, does it cut expenditures in some area, upsetting voters or vested interests? Or does it try to reduce the deficit by raising taxes? The bond market began by facilitating government borrowing. In a crisis, however, it can end up dictating government policy.

For much of the 14th and 15th centuries, the medieval city-states of Tuscany — Florence, Pisa and Siena — were at war with each other or with other Italian towns. This was war waged as much by money as by men. Rather than requiring their own citizens to do the dirty work of fighting, each city hired military contractors who raised armies to annex land and loot treasure from its rivals.

From whom could the Florentines possibly have borrowed such a huge sum? The answer is from themselves. Instead of paying a property tax, wealthier citizens were effectively obliged to lend money to their own city government. In return for these forced loans, they received interest. Technically, this was not usury since the loans were obligatory; interest payments could therefore be reconciled with canon law as compensation.

A crucial feature of the Florentine system was that such loans could be sold to other citizens if an investor needed ready money.

One reason that this system worked so well was that they and a few other wealthy families also controlled the city’s government and hence its finances. This oligarchical power structure gave the bond market a firm political foundation. Unlike an unaccountable hereditary monarch, who might arbitrarily renege on his promises to pay his creditors, the people who issued the bonds in Florence were in large measure the same people who bought them. Not surprisingly, they therefore had a strong interest in seeing that their interest was paid.

On the other hand, remember that the interest is paid on the face value of the bond, so if you can buy a 5% bond at just 10% of its face value, you can earn a handsome yield of 50%. In essence, you expect a return proportional to the risk you are prepared to take.

Yet investors in royal debt had to be wary. Whereas towns, with their oligarchical forms of rule and locally held debts, had incentives not to default, the same was not true of absolute rulers.

Within just a few years of Napoleon’s final defeat at Waterloo, a man had emerged as a financial Bonaparte: the master of bond market and, some ventured to suggest, the master of European politics as well. That man’s name was Nathan Rothschild.

In some versions of the story, Nathan witnessed the battle himself, risked a Channel storm to reach London ahead of the official news of Wellington’s victory and, by buying bonds ahead of a huge surge in prices, pocketed between £20-135M.

Selling bonds to the public had certainly raised plenty of cash for the British government, but banknotes were of little use on distant battlefields. To provision the troops and pay Britain’s allies against France, Wellington needed a currency that was universally acceptable. The challenge was to transform the money raised on the bond market into gold coins, and to get them to where they were needed. Sending gold guineas from London to Lisbon was expensive and hazardous in time of war.

Why did the British government turn to him in its hour of financial need? The answer is that Nathan had acquired valuable experience as a smuggler of gold to the Continent, in breach of the blockade that Napoleon had imposed on trade between England and Europe. (Admittedly, it was a breach the French authorities tended to wink at, in the simplistic mercantilist belief that outflows of gold from England must tend to weaken the British war effort).

What made them so well suited to the task was that the brothers had a ready-made banking network within the family — in London, Frankfurt, Paris, Amsterdam. Spread out around Europe, the 5 Rothschilds were uniquely positioned to exploit price and exchange rate differences between markets, the process known as arbitrage.

In the words of one of the partners at Barings, the Rothschilds’ great rivals, “I must candidly confess that I have not the nerve for his operations. They are generally well planned, with great cleverness and adroitness in execution — but he is in money and funds what Bonaparte was in war.”

Money is the god of our time and Rothschild is his prophet.

To be sure, he has thereby created a new aristocracy, but this is based on the most unreliable of elements, on money, which is more fluid than water and less steady than the air.

It might, indeed, be assumed that the Rothschilds needed war. It was war, after all, that had generated Nathan Rothschild’s biggest deal. Without wars, 19th-century states would have had little need to issue bonds. However, wars tended to hit the price of existing bonds by increasing the risk that a debtor state would fail to meet its interest payments in the event of defeat and losses of territory. By the middle of the 19th century, the Rothschilds had evolved from traders into fund managers, carefully tending to their own vast portfolio of government bonds. Now, having made their money, they stood to lose more than they gained from conflict. It was for this reason that they were consistently hostile to strivings for national unity in both Italy and Germany.

The most appealing thing about these sterling bonds, which had a 7% coupon and a maturity of 20 years, was that they could be converted into cotton at the pre-war price of 6 pence a pound. Despite the South’s military setbacks, they retained their value for most of the war for the simple reason that the price of the underlying security, cotton, was rising as a consequence of increased wartime demand. Moreover, the South was in the happy position of being able to raise that price still further — by restricting the cotton supply.

Yet the South’s ability to manipulate the bond market depended on one overriding condition: that investors should be able to take physical possession of the cotton which underpinned the bonds if the South failed to make its interest payments. Collateral is, after all, only good if a creditor can get his hands on it.

Both sides of the Civil War had to print money, it is true. But by the end of the war the Union’s “greenback” dollars were still worth about 50 cents in gold, whereas the “greybacks” were worth just 1 cent.

The experience of Latin America in the 19th century in many ways foreshadowed problems that would become almost universal in the middle of the 20th century. Partly this was because the social class that was most likely to invest in bonds — and therefore to have an interest in prompt interest payment in a sound currency — was weaker there than elsewhere. Partly it was because Latin American republics were among the first to discover that it was relatively painless to default when a substantial proportion of bondholders were foreign.

Bringing an “emerging market” under the aegis of the British Empire was the surest way to remove political risk from investors’ concerns.

There were essentially 5 steps to high inflation:

War led not only to shortages of goods but also to
short-term government borrowing from the central bank,
which effectively turned debt into cash, thereby expanding the money supply,
causing public expectations of inflation to shift and the demand for cash balances to fall
and prices of goods to rise.

Defeat itself had a high price. All sides had reassured taxpayers and bondholders that the enemy would pay for the war. Now the bills fell due in Berlin. One way of understanding the post-war hyperinflation is therefore as a form of state bankruptcy.

The Weimar tax system was feeble, not least because the new regime lacked legitimacy among higher income groups who declined to pay the taxes imposed on them. At the same time, public money was spent recklessly, particularly on generous wage settlements for public sector unions.

A common calculation among Germany’s financial elites was that runaway currency depreciation would force the Allied powers into revising the reparations settlement, since the effect would be to cheapen German exports relative to American, British and French manufactures. It was true that the downward slide of the mark boosted German exports. What the Germans overlooked was that the inflation-induced boom of 1920-22, at a time when the US and UK economies were in the depths of a post-war recession, caused an even bigger surge in imports, thus negating the economic pressure they had hoped to exert. At the heart of the German hyperinflation was a miscalculation. When the French cottoned on to the insincerity of official German pledges to fulfill their reparations commitments, they drew the conclusion that reparations would have to be collected by force and invaded the industrial Ruhr region. The German reacted by proclaiming a general strike (“passive resistance”), which they financed with yet more paper money. The hyper-inflationary endgame had now arrived.

Inflation is a monetary phenomenon. But hyperinflation is always and everywhere a political phenomenon, in the sense that it cannot occur without a fundamental malfunction of a country’s political economy.

True, there had been some short-term benefits. By discouraging saving and encouraging consumption, accelerating inflation had stimulated output and employment until the last quarter of 1922. The depreciating mark had boosted German exports. Yet the collapse of 1923 was all the more severe for having been postponed.

Worthlessness was the hyperinflation’s principal product. Not only was money rendered worthless; so too were all the forms of wealth and income fixed in terms of that money. That included bonds.

By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method, they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. As the inflation proceeds, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless.

It was to Lenin that Keynes attributed the insight that “There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency.”

He described the banknote-printing press as “that machine-gun of the Commissariat of Finance which poured fire into the rear of the bourgeois system.”

Even as recently as the 1970s, as inflation soared around the world, the bond market made a Nevada casino look like a pretty safe place to invest your money.

The economic history of Argentina in the 20th century is an object lesson that all the resources in the world can be set at nought by financial mismanagement.

Large-scale immigration without (as in NA) the freeing of agricultural land for settlement had created a disproportionately large urban working class that was highly susceptible to populist mobilization.

What made Argentina’s inflation so unmanageable was not war, but the constellation of social forces: the oligarchs, the caudillos, the producers’ interest groups and the trade union — not forgetting the impoverished underclass. To put it simply, there was no significant group with an interest in price stability. Owners of capital were attracted to deficits and devaluation; sellers of labor grew accustomed to a wage-price spiral. The gradual shift from financing government deficits domestically to financing them externally meant that bondholding was outsourced. It is against this background that the failure of successive plans for Argentine currency stabilization must be understood.

As in the Weimar Republic, however, the principal losers of Argentina’s hyperinflation were not ordinary workers, who stood a better chance of matching price hikes with pay rises, but those reliant on incomes fixed in cash terms, like civil servants or academics on inflexible salaries, or pensioners living off the interest on their savings. The principal beneficiaries were those with large debts, which were effectively wiped out by inflation. Among those beneficiaries was the government itself, in so far as the money it owed was denominated in australes.

After painfully protracted negotiations (there were 152 varieties of paper involved, denominated in 6 different currencies and governed by 8 jurisdictions) the majority of approximately 500K creditors agreed to accept new bonds worth roughly 35 cents on the dollar, one of the most drastic “haircuts” in the history of the bond market. So successful did Argentina’s default prove that many economists were left to ponder why any sovereign debtor ever honors its commitments to foreign bondholders.

Inflation has come down partly because many of the items we buy, from clothes to computers, have got cheaper as a result of technological innovation and the relocation of production to low-wage economies in Asia.

In such a greying society, there is a huge and growing need for fixed income securities, and for low inflation to ensure that the interest they pay retains its purchasing power.

On 7 Sep 2000, it read: “Our national debt: $5T. Your family share: $73K.”

It is the company that enables thousands of individuals to pool their resources for risky, long-term projects that require the investment of vast sums of capital before profits can be realized. After the advent of banking and the birth of the bond market, the next step in the story of the ascent of money was therefore the rise of the joint-stock, limited-liability corporation.

In theory, the managers of joint-stock companies are supposed to be disciplined by vigilant shareholders, who attend annual meetings, and seek to exert influence directly or indirectly through non-executive directors. In practice, the primary discipline on companies is exerted by stock markets, where an almost infinite number of small slices of companies are bought and sold every day. In essence, the price people are prepared to pay for a piece of a company tells you how much money they think that company will make in the future. In effect, stock markets hold hourly referendums on the companies whose shares are traded there: on the quality of their management, on the appeal of their products, on the prospects of their principal markets.

If we were all calculating machines we would simultaneously process all the available information and come to the same conclusion. But we are human beings, and as such are prone to myopia and to mood swings. When stock market prices surge upwards in sync, as they often do, it is as if investors are gripped by a kind of collective euphoria: what Alan Greenspan memorably called irrational exuberance.

Investors these days are said to be an electronic herd, happily grazing on positive returns one moment, then stampeding for the farmyard gate the next. The real point, however, is that stock markets are mirrors of the human psyche. Like homo sapiens, they can become depressed. They can even suffer complete breakdowns. Yet hope — or is it amnesia? — always seems able to triumph over such bad experiences.

Stock markets bubbles have 3 other recurrent features. Insiders — those concerned with the management of bubble companies — know much more than the outsiders, whom the insiders want to part from their money. Such asymmetries always exist in business, of course, but in a bubble the insiders exploit them fraudulently. The 2nd theme is the role of cross-border capital flows. Bubbles are more likely to occur when capital flows freely from country to country. The seasoned speculator, based in a major financial center, may lack the inside knowledge of a true insider. But he is much more likely to get his timing right — buying early and selling before the bubble bursts — than the naive 1st-time investor. Finally, and most importantly, without easy credit creation a true bubble cannot occur. That is why so many bubbles have their origins in the sins of omission or commission of central banks.

Bonds are no more than promises by governments to pay interest and ultimately repay principal over a specified period of time. Either through default or through currency depreciation, many governments have failed to honor those promises. By contrast, a share is a portion of the capital of a profit-making corporation. If the company succeeds in its undertakings, there will not only be dividends, but also a significant probability of capital appreciation. There are of course risks, too. The returns on stocks are less predictable and more volatile than the returns on bonds and bills. There is a significantly higher probability that the average corporation will go bankrupt and cease to exist than that the average sovereign state will disappear. In the event of a corporate bankruptcy, the holders of bonds and other forms of debt will be satisfied first; the equity holders may end up with nothing.

The round trip was a very long one (14 months was in fact well below the average). It was also hazardous: of 22 ships set sail in 1598, only 12 returned safely.

This was in substantial measure the achievement of Coen, a bellicose young man who had no illusions about the relationship between commerce and coercion. “We cannot make war without trade, nor trade without war.”

Technically, the removal of uncertainty about future dividends gave the shares the character of preference shares or even bonds.

Fire-power and foreign trade sailed side by side on ships like the Batavia.

The VOC’s biggest challenge was the principal-agent problem: the tendency of its men on the spot to trade on their own account, bungle transactions or simply defraud the company. This, however, was partially countered by an unusual compensation system, which linked renumeration to investments and sales, putting a priority on turnover rather than net profits.

“I maintain that an absolute prince who knows how to govern can extend his credit further and find needed funds at a lower interest rate than a prince who is limited in his authority.” This was an absolutist theory of finance, based on the assertion that “in credit as in military and legislative authorities, supreme power must reside in only one person.”

But what the unfortunate immigrants encountered when they reached Louisiana was a sweltering, insect-infested swamp. Within a year 80% of them had died of starvation or tropical diseases like yellow fever.

But the flow of sometimes contradictory regulations served only to bewilder people and to illustrate the propensity of an absolutist regime to make up the economic rules to suit itself. One day gold and silver could be freely exported; the next day not. One day notes were being printed as fast as the printing presses could operate; the next Law was aiming to cap the banknote supply at 1.2M livres.

There was no shortage of productivity-enhancing technological innovation in the inter-war period by companies like DuPont (nylon), P&G (soap powder), Revlon (cosmetics), RCA (radio) and IBM (accounting machines). “A prime reason for expecting future earnings to be greater was that we in America were applying science and invention to industry as we had never applied them before.” Management practices were also being revolutionized by men like Alfred Sloan at GM.

There was a time when academic historians felt squeamish about claiming that lessons could be learned from history. This is a feeling unknown to economists, 2 generations of whom have struggled to explain the Great Depression precisely in order to avoid its recurrence. Of all the lessons to have emerged from this collective effort, this remains the most important: that inept or inflexible monetary policy in the wake of a sharp decline in asset prices can turn a correction into a recession and a recession into a depression. According to Friedman and Schwartz, the Fed should have aggressively sought to inject liquidity into the banking system from 1929 onwards, using open market operations on a large scale, and expanding rather than contracting lending through the discount window.

Partly, it was because Greenspan felt it was not for the Fed to worry about asset price inflation, only consumer price inflation; and this, he believed, was being reduced by a major improvement in productivity due precisely to the tech boom

Not only were the 1930s averted; so too was a repeat of the Japanese experience, when a conscious effort by the central bank to prick an asset bubble ended up triggering an 80% stock market sell-off and a decade of economic stagnation.

Lay’s was to revolutionize the global energy business. For years the industry had been dominated by huge utility companies that both physically provided the energy — pumped the gas and generated the electricity — and sold it on to consumers. Lay’s big idea was to create a kind of Energy Bank, which would act as the intermediary between suppliers and consumers.

I’ve thought about this a lot. And all that matters is money. You buy loyalty with money. This touchy-feely stuff isn’t as important as cash. That’s what drives performance.

A crucial role, however, is nearly always played by the central bankers, who are supposed to be the cowboys in control of the herd.

In the end, the path of financial markets can never as smooth as we might like. So long as human expectations of the future veer from the over-optimistic to the over-pessimistic — from greed to fear — stock prices will tend to trace an erratic path.

Should we rely on the voluntary charity of our fellow human beings when things go horribly wrong? Or should we be able to count on the state — in other words on the compulsory contributions of our fellow taxpayers — to bail us out when the flood comes?

Nearly all the survivors of Katrina lost property in the disaster, since nearly three quarters of the city’s total housing stock were damaged. Estimated insurance losses in excess of $41B.

The average American’s lifetime risk of death from exposure to forces of nature, including all kinds of natural disaster, is 1 in 3,288.

Death due to a fire in a building: 1 in 1,358.
Shot to death: 1 in 314.
Commit suicide: 1 in 119.
Fatal road accident: 1 in 78.
Die of cancer: 1 in 5.

Predestination is not an especially cheering article of faith, logical thought it may be to assume that an omniscient God already knows which of us will go to heaven, and which of us will go hell.

The earliest of these arrangements had the character of conditional loans to merchants, which could be cancelled in case of a mishap, rather than policies in the modern sense.

The liability of the underwriters (who literally wrote their names under insurance contracts) was unlimited.

In truth, all these forms of insurance — including even the most sophisticated shipping insurance — were a form of gambling. There did not yet exist an adequate theoretical basis for evaluating the risks that were being covered.

The value of an item must not be based on its price, but rather on the utility that it yields. And the utility resulting from any small increase in wealth will be inversely proportionate to the quantity of goods previously possessed — in other words $100 is worth more to a normal person than to a hedge fund manager.

In addition to how long the policyholders are likely to live, insurers also need to know what the investment of their funds will bring in. What should they buy with the premiums their policyholders pay?

Most of us prefer a gamble that has a 100% chance of a small loss (our annual premium) and a small chance of a large gain (insurance payout) to a gamble that has a 100% chance of small gain but an uncertain chance of a huge loss.

By the later 19th century, a feeling began to grow that life’s losers deserved better. The seeds began to be planted of a new approach to the problem of risk — one that would ultimately grow into the welfare state. These state systems of insurance were designed to exploit the ultimate economy of scale, by covering literally every citizen from birth to death.

The generality must undertake to assist the unpropertied. Whoever embraces this idea will come to power.

The arguments for state insurance extended beyond mere social equity. First, state insurance could step in where private insurers feared to tread. Second, universal and sometimes compulsory membership removed the need for expensive advertising and sales campaign. Third, the larger numbers combined should form more stable averages for the statistical experience.

It was the mid-20th-century state’s insatiable appetite for able-bodied young soldiers and workers, not social altruism, that was the real driver. Japan offered social security in return for military sacrifice.

Despite their superficial topographical and historical resemblances, the Japanese and the British had quite different cultures. In Japan egalitarianism was a prized goal of policy, while a culture of social conformism encouraged compliance with the rules. English individualism, by contrast, inclined people cynically to game the system. The welfare state might have made Japan an economic superpower, but in the 1970s it appeared to be having the opposite effect in Britain.

According to British conservatives, what had started out as a system of national insurance had degenerated into a system of state handouts and confiscatory taxation which disastrously skewed economic incentives.

The British welfare state, it seemed, had removed the incentives without which a capitalism economy simply could not function: the carrot of serious money for those who strove, the stick of hardship for those who slacked. The result was “stagflation”: stagnant growth plus high inflation.

One of the most pronounced economic trends of the past 25 years has been for the Western welfare state to be dismantled, reintroducing people with a sharp shock to the unpredictable monster they thought they had escaped from: risk.

For tendering this advice Friedman found himself denounced by the American press. After all, he was acting as a consultant to a military dictator responsible for the execution of more than 2K real and suspected Communists and the torture of nearly 30K more.

For Pinera, the invitation to return to Chile from Harvard posed an agonizing dilemma. He had no illusions about the nature of Pinochet’s regime. Yet he also believed there was an opportunity to put into practice ideas that had been taking shape in his mind ever since his arrival in New England.

What had begun as a system of large-scale insurance had simply become a system of taxation, with today’s contributions being used to pay today’s benefits, rather than to accumulate a fund for future use. This “pay-as-you-go” approach had replaced the principle of thrift with the practice of entitlement. But this approach is rooted in a false conception of how human beings behave. It destroys, at the individual level, the link between contributions and benefits. In other words, between effort and reward.

Social programs have to include some incentive for individual effort and for persons gradually to be responsible for their own destiny. There is nothing more pathetic than social programs that encourage social parasitism.

Social Security provides a minimal state pension to all retirees, while at the same time the Medicare system covers all the health costs of the elderly and disabled. American healthcare, however, is almost entirely provided by the private sector. At its beset it is state-of-the-art, but it is very far from cheap.

Insurance and welfare are not the only way of buying protection against future shocks. The smart way to do it is by being hedged.

A pure hedge eliminates price risk entirely. It requires a speculator as a counter-party to take on the risk. In practice, however, most hedgers tend to engage in some measure of speculative activity, looking for ways to profit from future price movements.

At Citadel, Griffin has brought together mathematicians, physicists, engineers, investment analysts and advanced computer technology. Some of what they do is truly the financial equivalent of rocket science.

The fact nevertheless remains that this financial revolution has effectively divided the world in 2: those who are (or can be) hedged, and those who are not (or cannot be). You need money to be hedged. Hedge funds typically ask for a minimum 6- or 7-figure investment and charge a management fee of at least 2% of your money (Citadel charges 4 times that) and 20% of the profits.

About half of all the growth in US GDP in the 1st half of 2005 was housing related.

By radically increasing the opportunity for Americans to own their own homes, the Roosevelt administration pioneered the idea of a property-owning democracy. It proved to be the perfect antidote to red revolution.

In the US, where public housing was never so important, mortgage interest payments were always tax deductible, from the inception of the federal income tax in 1913. Mortgage interest relief was “part of the American dream.”

Up until the 1980s, government incentives to borrow and buy a house made a good deal of sense for ordinary households. Indeed, the tendency for inflation rates to rise above interest rates in the late 1960s and 1970s gave debtors a free lunch as the real value of their debts and interest payments declined.

For a time, lenders were effectively paying people to borrow their money. Meanwhile, property prices roughly trebled between 1963-79, while consumer prices rose by a factor of just 2.5. But there was a sting in the tail. The same governments that avowed their faith in the “property-owning democracy” also turned out to believe in price stability, or at least lower inflation. Achieving that meant higher interest rates. The unintended consequence was one of the most spectacular booms and busts in the history of the property market.

Strewn all over Texas are the archaeological remains of the debacle: derelict housing estates, built on the cheap with stolen money, and subsequently bulldozed or burned down.

The idea was no reinvent mortgages by bundling thousands of them together as the backing for new and alluring securities that could be sold as alternatives to traditional government and corporate bonds — in short, to convert mortgages into bonds. Once lumped together, the interest payments due on the mortgages could be subdivided into “strips” with different maturities and credit risks.

Once again, it was the federal government that stood ready to pick up the tab in a crisis. For the majority of mortgages continued to enjoy an implicit guarantee from the government-sponsored trio of Fannie, Freddie or Ginnie, meaning that bonds which used those mortgages as collateral could be represented as virtually government bonds, and hence “investment grade.”

The first is depreciation. Stocks do not wear out and require new roofs; houses do. The second is liquidity. As assets, houses are a great deal more expensive to convert into cash than stocks. The third is volatility.

Yet it was precisely their riskiness that made them seem potentially lucrative to lenders. These were not the old 30-year fixed-rate mortgages invented in the New Deal. On the contrary, a high proportion were adjustable-rate mortgages (ARMs) — in other words, the interest rate could vary according to changes in short-term lending rates.

People who own property feel a sense of ownership in their future and their society. They study, save, work, strive and vote. And people trapped in a culture of tenancy do not.

At the time, the sellers of these “structured products” boasted that securitization was having the effect of allocating risk “to those best able to bear it.” Only later did it turn out that risk was being allocated to those least able to understand it.

As soon as the teaser rates expired and the mortgages reset at new and much higher interest rates, hundreds of Detroit households swiftly fell behind with their mortgage payments.

Mortgages are generally “no recourse” loans, meaning that when there is a default the mortgage lender can only collect the value of the property and cannot seize other property or put a lien on future wages. According to some economists, this gives borrowers a strong incentive to default.

House prices are “sticky” on the way down because sellers hate to cut the asking price in a downturn; the result is a glut of unsold properties and people who would otherwise move stuck looking at their For Sale signs. That in turn means that home ownership can tend to reduce labor mobility, thereby slowing down recovery.

Property rights will eventually lead to democracy because you can’t sustain a market-oriented property system unless you provide a democratic system. That’s the only way investors can feel secure.

Today you can tell the owner-occupied houses from the rest by their better fences and painted walls.

The great revelation of the microfinance movement in countries like Bolivia is that women are actually a better credit risk than men, with or without a house as security for their loans.

Microfinance can also work in enclaves of poverty in the developed world where a whole network of lending agencies called credit unions has been setup as an antidote to predatory lending by loan sharks.

In 1820 per capita income in the US was roughly twice that of China. By 1870, nearly 5 times higher; by 1913 nearly 10 times; by 1950 nearly 22 times.

The key problem with overseas investment, then as now, is that it is hard for investors in London or NY to see what a foreign government or an overseas manager is up to when they are an ocean or more away. Moreover, most non-Western countries had, until quite recently, highly unreliable legal systems and differing accounting rules. If a foreign trading partner decided to default on its debts, there was little that an investor situated on the other side of the world could do. In the 1st era of globalization, the solution to this problem was brutally simple but effective: to impose European rule.

Somewhere between two fifths and half of all this British overseas investment went to British-controlled colonies. A substantial proportion also went to countries like Argentina and Brazil over which Britain exercised considerable informal influence. And British foreign investment was disproportionately focused on assets that increased London’s political leverage: not only government bonds but also the securities issued to finance the construction of railways, port facilities and mines.

Yet the gold standard was no more rigidly binding than today’s informal dollar pegs in Asia and the Middle East; in the emergency of war, a number of countries simply suspended the gold convertibility of their currencies.

Arrangements varied from country to country, but the expedients were broadly similar and quite unprecedented in their scope: temporary closures of markets; moratoria on debts; emergency money issued by governments; bailouts for the most vulnerable institutions. In all these respects, the authorities were prepared to go much further than they had previously gone in purely financial crises. The war of 1914 was understood to be a special kind of emergency, justifying measures that would have been inconceivable in peacetime, including “the release of the bankers from all liability.”

Inflation in France and hyperinflation in Germany inflicted even more severe punishment on anyone rash enough to maintain large franc or Reichsmark balances. By 1923 holders of all kinds of Germany securities had lost everything.

In 1921, the Chinese government declared bankruptcy, and proceeded to default on nearly all China’s external debts. By the end of the 1930s, most states in the world had imposed restrictions on trade, migration and investment as a matter of course. Some achieved near-total economic self-sufficiency (autarky), the ideal of a de-globalized society.

The origins of WW1 became clearly visible — as soon as it had broken out. Only then did Lenin see that war was an inevitable consequence of imperialist rivalries. Only then did American liberals grasp that secret diplomacy and the tangle of European alliances were the principal causes of conflict. The British and French naturally blamed the Germans; the Germans blamed the British and French. Historians have been refining and modifying these arguments for more than 90 years now. Some have traced the origins of the war back to the naval race of the mid 1890s; others to events in the Balkans after 1907. Why, when its causes today seem so numerous and so obvious, were contemporaries so oblivious of Armageddon until just days before its advent?

Exchange rates would be fixed, as under the gold standard, but now the anchor — the international reserver currency — would be the dollar rather than gold. In the words of Keynes, “control of capital movements” would be “a permanent feature of the post-war system.” Even tourists could be prevented from going abroad with more than a pocketful of currency if governments felt unable to make their currencies convertible.

The IMF was supposed to regulate exchange rates. What became the WB was suppose to help rebuild countries shattered by the war. Free trade would be revived. But free capital flows were out.

A country can choose any 2 out of 3:

Full freedom of cross-border capital movements.
A fixed exchange rate.
An independent monetary policy oriented towards domestic objectives.

Under Bretton Woods, the countries of the Western world opted for 2 and 3.

The total amount disbursed under the Marshall Plan was equivalent to roughly 4.5% of US GDP in the year of Marshall’s seminal speech, or 1.1% spread over the whole period of the program, which dated from April 1948 to June 1952. If there had been a Marshall Plan between 2003-7, it would have cost $550B.

In the late 1960s, US public sector deficits were negligible by today’s standards, but large enough to prompt complaints from France that Washington was exploiting its reserve currency status in order to collect seigniorage from America’s foreign creditors by printing dollars, much as medieval monarchs had exploited their monopoly on minting to debase the currency.

In 1982, Mexico declared that it would no longer be able to service its debt. An entire continent teetered on the verge of declaring bankruptcy. Yet the days had gone when investors could confidently expect their governments to send a gunboat when a foreign government misbehaved. Now the role of financial policing had to be played by 2 unarmed bankers, the IMF and the WB. Their new watchword became “conditionality”: no reforms, no money. Their preferred mechanism was the structural adjustment program. And the policies the debtor countries had to adopt became known as the Washington Consensus, a wishlist of 10 economic policies that would have gladdened the hart of a British imperial administrator a hundred years before.

Impose fiscal discipline.
Reform taxation.
Liberalize interest rates.
Raise spending on health and education.
Secure property rights.
Privatize state-run industries.
Deregulate markets.
Adopt a competitive exchange rate.
Remove barriers to trade.
Remove barriers to FDI.

To some critics, the WB and IMF were no better than agents of the same old Yankee imperialism. Any loans from the IMF or WB, it was claimed, would simply be used to buy American goods from American firms — often arms to keep ruthless dictators or corrupt oligarchies in power. The cost of “structural adjustment” would be borne by their hapless subjects.

Perkins claims he was employed to ensure that the money lent to countries like Ecuador and Panama by the IMF and WB would be spent on goods supplied by US corporations. Economic hitmen like himself were “trained to build up the American empire, to create situations where as many resources as possible flow into this country, to our corporations, and our governments.”

This empire, unlike any other in the history of the world, has been built primarily through economic manipulation, through cheating, through fraud, through seducing people into our way of life, through the economic hit men. My real job was giving loans to other countries, huge loans, much bigger than they could possibly repay. So we make this big loan, most of it comes back to the US, the country is left with debt plus lots of interest, and they basically become our servants, our slaves. It’s an empire. There’s no two way about it. It’s a huge empire.

Governments typically come to the IMF for financial assistance when they are having trouble finding buyers for their debt and when the value of their money is falling.

Like the rise of China, the even more rapid rise of the hedge funds has been one of the biggest changes in the global economy has witnessed since WW2. As pools of lightly regulated, highly mobile capital, hedge funds exemplify the return of hot money after the big chill that prevailed between the onset of the Depression and the end of Bretton Woods.

According to Soros’s pet theory of “reflexivity,” financial markets cannot be regarded as perfectly efficient, because prices are reflections of the ignorance and biases, often irrational, of millions of investors. “Not only do market participants operate with a bias but their bias can also influence the course of events. This may create the impression that markets anticipate future development accurately, but in fact it is not present expectations that correspond to future events but future events that are shaped by present expectations.” It is the feedback effect that Soros calls reflexivity.

Markets never reach the equilibrium postulated by economic theory. There is a 2-way reflexive connection between perception and reality which can give rise to initially self-reinforcing but eventually self-defeating boom-bust processes, or bubbles. Every bubble consists of a trend and a misconception that interact in a reflexive manner.

Admittedly, to generate these huge returns on an ever-growing pool of assets under management, Long-Term had to borrow, like George Soros. This additional leverage allowed them to bet more than just their own money. At the end of August 1997 the fund’s capital was $6.7B, but the debt-financed assets on its balance sheet amounted to $126B, a ratio of assets to capital of 19 to 1.

A swap is a kind of derivative: a contractual arrangement in which one party agrees to pay another a fixed interest rate, in exchange for a floating rate (usually the London interbank offered rate, or Libor), applied to a notional amount.

Keynes once observed, in a crisis markets can remain irrational longer than you can remain solvent.

There was, however, another reason why LTCM failed. The firm’s value at risk (VaR) models had implied that the loss Long-Term suffered in August was so unlikely that it ought never to have happened in the entire life of the universe. But that was because the models were working with just 5 years’ worth of data.

To put it bluntly, the Nobel prize winners had known plenty of mathematics, but not enough history.

It is not widely recognized that large numbers of hedge funds simply fizzle out, having failed to meet investors’ expectations.

There is increasing skepticism that hedge fund returns truly reflect “alpha” (skill of asset management) as opposed to “beta” (general market movements). An alternative explanation is that, while they exist, hedge funds enrich their managers in a uniquely alluring way.

To many, financial history is just so much water under the bridge — ancient history, like the history of imperial China. Markets have short memories. Many young traders today did not even experience the Asian crisis of 1997-8. Thoes who went into finance after 2000 live through 7 heady years.

Having already devalued the renminbi in 1994, and having retained capital controls throughout the period of economic reform, China suffered no currency crisis in 1997-8. When the Chinese wanted to attract foreign capital, they insisted that it take the form of direct investment. That meant instead of borrowing from Western banks to finance their industrial development, they got foreigners to build factories in Chinese enterprise zones — large, lumpy assets that could not easily be withdrawn in a crisis. The crucial point, though, is that the bulk of Chinese investment has been financed from China’s own savings (and from the overseas Chinese diaspora).

Yet US monetary loosening since August 2007 — the steep cuts in the federal funds and discount rates, the various auction and lending “facilities” that have directed $150B to the banking system — has amounted to an American version of currency manipulation. Since the onset of the American crisis, the dollar has depreciated roughly 25% against the currencies of its major trading partners.

From the 13th century onward, government bonds introduced the securitization of streams of interest payments; while bond markets revealed the benefits of regulated public markets for trading and pricing securities. From the 17th century, equity in corporations could be bought and sold in similar ways. From the 18th century, insurance funds and then pension funds exploited economies of scale and the law of averages to provide financial protection against calculable risk. From the 19th, futures and options offered more specialized and sophisticated instruments: the first derivatives. And, from the 20th, households were encouraged, for political reasons, to increase leverage and skew their portfolios in favor of real estate.

Economies that combined all these institutional innovations performed better over the long run than those that did not, because financial intermediation generally permits a more efficient allocation of resources than, say, feudalism or central planning.

The financial system is the brain of the economy. It acts as a coordinating mechanism that allocates capital, the lifeblood of economic activity, to its most productive uses by businesses and households. If capital goes to the wrong uses or does not flow at all, the economy will operate inefficiently, and ultimately economic growth will be low.

Around 1 in 10 US companies disappears each year.

In the natural world, evolution is not progressive, as used to be thought. Primitive financial life-forms like loan sharks are not condemned to oblivion, any more than the microscopic prokaryotes that still account for the majority of earth’s species. Evolved complexity protects neither an organism nor a firm against extinction — the fate of most animal and plant species.

Economies of scale and scope are not always the driving force in financial history. More often, the real drivers are the process of speciation — whereby entirely new types of firm are created — and the equally recurrent process of creative destruction, whereby weaker firms die out.

As in the natural world, the existence of giants has not precluded the evolution and continued existence of smaller species. Size isn’t everything, in finance as in nature. Indeed, the very difficulties that arise as publicly owned firms become larger and more complex — the diseconomies of scale associated with bureaucracy, the pressures associated with quarterly reporting — give opportunities to new forms of private firm. What matters in evolution is not your size or (beyond a certain level) your complexity. All that matters is that you are good at surviving and reproducing your genes. The financial equivalent is being good at generating returns on equity and generating imitators employing a similar business model.