Table of Contents
The Ascent of Money by Niall Ferguson is the story of how money developed throughout history- and how the world was shaped and reshaped by the many financial innovations that accompanied our dependence on money. There have been countless failures in finance, but the general trend has consistently been upwards.
The Foundations of Finance
In the 16th century, Spain went through price inflation because of the influx of silver into its economy from South America. Like other resource rich nations in history, they suffered economically because revenues were not reinvested in productive activity.
A couple of centuries earlier, Fibonacci used Indian and Arabic mathematical innovations that mirrored natural world properties, he introduced these to Europe through “The Book of Calculation.” He gave Europe the decimal system and showed how it could apply to bookkeeping, and to interest. But Venice took these theories and applied them practically. But this was a cultural by-product, as depicted in the Merchant of Venice by Shakespeare.
Money lenders had to deal with a trade-off, be be too lenient, and people will exploit you, be too rough and they will call the police. They resolved this by growing large and powerful enough to make sure they got paid.
The Medicis were the first money lenders to translate financial success to hereditary power, they did so by learning an important lesson: In finance, smaller is rarely beautiful. By diversifying their lending, they reduced their chance of default.
The Biggest Innovations in the 17th Century in Finance
- Cashless intrabank transaction
- Fractional reserve banking
- Central bank monopolies on note issue
These changed the nature of money, from precious metal being dug up, it became known as the sum of specific liabilities, deposits and reserves incurred by banks. Credit was the total of a bank’s assets, its loans – most of this money would be made up of invisible money in deposit account statements and money being exchanged in the marketplace.
The industrial revolution and the banking revolution caused the growth of both sectors exponentially.
The relationship between money being circulated and money held in the bank was debated for decades. The solution was the convertibility of money into precious metals – the basis of money.
Paper notes are money because they represent precious metals. But if the UK depended on this relationship (which they did for a while) for longer, it would not have experienced growth in the 19th century. It was the proliferation of new kinds of bank that took deposits, which made monetary expansion possible. When savers handed deposits, new possibilities of lending were created. The U.S was very resistant to this system of banking (central banking) until 1913.
Bankruptcy
In the U.S, people had the ability to walk away from unsustainable debts and start again – this has been a hallmark of American finance. American law existed to encourage entrepreneurship, and to give them a break when things didn’t go well, even after multiple failures.
Heinz and Ford were beneficiaries of this system, since they failed before they succeeded. But indebtedness, not entrepreneurship, were causes of bankruptcy. To understand the causes of household indebtedness, and its consequences, we must understand the bond market, stock market, real estate market, insurance market, and the globalization of all of these over the past few decades.
Banks were created to move money from where it is to where it is most needed. They have been taking in more deposits and lending out more money, thus reducing bank capital. Since the 1950’s, the dollar bill has lost its purchasing power relative to Consumer Price Index (lost 87 percent).
Bonds
The bond market was another development that changed how well money could be reallocated, particularly for governments. The market’s real power is its ability to punish governments by raising the price of borrowing.
Consider how an indebted nation could react to this: it could raise taxes, default on its debt, or reduce spending. In the worst times, the lenders dictate the conditions of these nations.
Nathan Rothschild tried to make money from Napoleon’s war in Waterloo but failed because of the war’s abrupt end.
The confederate army’s cotton bank bonds became too cheap because of cotton’s availability elsewhere. Hyper-inflation destroyed the southern U.S economy during the civil war.
Germany’s economy also collapsed because of hyper inflation during the first World War, and so did Austria, Russia and Poland. Germany, Hungary, and Greece experienced hyper inflation again post World War 2. When hyper inflation is sensed, government bonds are the first to lose value.
Argentina’s economic failure can also be attributed to inflation and debt default, but politics had much to do with it. Military coups by its leaders that promised growth by devaluing the currency resulted in inflation. Argentina eventually defaulted on its debt in 2001 (100 billion dollars) but saw subsequent economic growth. Since 1816, it has defaulted 8 times on its debt.
Ever since worldwide inflation has been reduced to single digits, we have seen the most bullish bond market in history, and in most of the developed world, pension funds hold large amounts of bonds, which has also contributed to its increased value.
The Company
The invention of the company made it possible for long term ventures that required vast sums of money to be launched, and this before profits can be realized. Joint stock limited liability companies were the next stage in the evolution of finance, after banking.
Stock markets are mirrors of the human psyche, they reflect depression or euphoria.
The collapse of the Dutch East India Company was not a bubble, it took place over a century.
Crashes
The Great Depression was a result of the increase of American protectionism and German post-first World War reparations, but there was also a psychological dimension to the crisis.
In 2007, Bank CEO’s were paid tens of millions of dollars, and Soros made 2.9 billion dollars, while the average person was not much better off.
Despite the outrage one may have at the financial system, the ascent of money has been responsible for the ascent of man.
Probability, Bernoulli’s principle, the normal curve, the utility curve and inference (prob of event * payoff) were some theories by mathematicians that underline the insurance industry, yet it took Christian ministers (Wallace and Webster) to put these ideas into practice.
Hedging
The origins of hedging are agricultural. Famers were the first hedgers, they bought futures contracts that made merchants buy from them at the same price in the future.
The most successful development of the New Deal was in housing. Federal deposit insurance made it safe for buyers to take out mortgages. This reinvented the mortgage market. A secondary market developed as a result; Fannie May was born.
Some black people paid more for these mortgages (8% vs 7% for whites), Detroit’s 12th street riots were a reaction to this discrimination.
By bundling up mortgages, and selling them as bonds, a new way of hedging was born. Subprime mortgage loans are aimed at families with bad credit history. Subprime lending worked as long as people worked, and real estate value increased.
CDO’s (Collateralized Debt Obligations) were repackaged bundles of mortgages that were traded on Wallstreet – big banks were the buyers. When the subprime mortgage market collapsed in 2007, hedge funds were wiped out and banks lost hundreds of millions of dollars.
Housing is not a safe investment. Like anything, it has the potential to rise or fall in price, and it is not liquid.
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Reform
From 1975 to 1982, the bankers chose to lend the Middle Eastern petrol dollars to South America. Their debt increased from 75 Billion to over 300 Billion dollars. Mexico defaulted on its debt.
The Washington Consensus was developed by the IMF and the World Bank to outline a standard list of ten principles for sound economic recovery – the package was designed for South America’s recovery in the 1980’s.
The IMF and World Bank would lend countries money, but on the condition that these countries implement the outlined reforms.
Anti-globalization movements in the 1990’s accused these organizations of helping finance U.S goods (weapons) to keep dictators in power.
The rise of hedge funds was the biggest development in the financial world since World War 2.
Soros made money by betting on oil, governments, and weapon expenditure. He made these bets by observing world events and deducing plausible effects in the future. He also bet against the electronic herd.
LTCM
In 1993, two maths geniuses, Scholes and Black developed a new way of pricing options – they partnered with Meriwether and created Long Term Capital Management (LTCM). They had over a hundred billion in borrowed money but were not worried, since they believed that their diversified betting would protect them.
In 1998, LTCM began its decline and eventual crash. Global volatility was its highest, in large part due to Russian instability. According to the quants, this wasn’t supposed to happen.
In the short term, markets can be illogical longer than you can be liquid, even though they are more rational in the long term. LTCM only used the last 5 years of data, if they used more past data, they would have avoided disaster.
Chimerica
Chinese households and companies are notorious savers. Capital no longer flows from West to East, but from East to West. The U.S has sold billions of dollars of bonds to China and have enjoyed significantly lower interest rates than they would have elsewhere.
It wasn’t just Hedge Funds that reoriented finance post 1998, but also Sovereign Wealth Funds, which were funds that resulted from countries running a large surplus.