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Source: http://www.powells.com/review/2009_01_05


Powell's Review-a-Day
Monday, January 5, 2009
New York Review of Books
The Ascent of Money: A Financial History of the World
by Niall Ferguson

Can You Spare a Dime?
A Review by Robert Skidelsky


1.

The historian Alan Taylor used to say, mischievously, that the only 
point of history is history. The idea that one could use it to predict 
the future, still more to avoid past mistakes, was pure illusion. Niall 
Ferguson's The Ascent of Money , a history of financial innovation 
written as a television documentary as well as a book, offers a neat 
test of Taylor's theory. Ferguson can claim some powers of anticipation. 
History convinced him in 2006 that the good times could not last 
"indefinitely." This was an insight to which the Nobel Prize--winning 
mathematical economists who devised the Black-Scholes formula -- the 
complicated model for pricing share options used by the highly leveraged 
firm Long-Term Capital Management, which famously crashed in 1998 -- 
were oblivious. Their formula persuaded them that a massive sell-off 
could occur only once in four million years.

History has alerted Ferguson to the perils of the state relying on the 
bond market for its financing. On Lou Dobbs Tonight on November 13, 
2008, he said:

     How much can the international bond market absorb of new ten-year 
treasuries?... And if yields go up, the cost of government borrowing 
goes up, and the thing begins to spiral out of control....That's why you 
need the historical perspective....

Between the two opposed views that history can teach us nothing and that 
the future is simply a reflection of the past lies the sensible middle 
position that history, like any other way of experiencing the past, can 
give us "vague" knowledge of what may lie in store for humanity. Only 
history-free economists could have bought the "efficient market 
hypothesis," which claims that the market will price shares correctly, 
with deviations from accurate prediction occurring only at random. But 
knowledge of history would not have enabled anyone to predict the timing 
and extent of the present meltdown. Above all, history cannot settle the 
question of what our attitude should be toward money, which is at root a 
moral question.

The Ascent of Money is a superb book, which illustrates both the 
strengths and the weaknesses of history for understanding what is 
happening now. It is written with the narrative flair, eye for detail, 
range of reference, and playfulness of language that we have come to 
expect from this exceptionally versatile historian. Ferguson is clearly 
fascinated by the subject of finance, knows a huge amount about it, and 
communicates his enthusiasm to the reader. Many parts of the story will 
be familiar enough to specialists, but Ferguson has a special ability to 
color even the familiar with strange and unusual examples, and he weaves 
together the separate strands of the financial tapestry with great 
skill. Some of the financial material is quite technical, but there is 
no attempt to "dumb down." The book is an all too rare example of good, 
even dense, scholarship finding a way to engage the larger public.

Ferguson's strategically themed structure starts with the origins of 
money, and shows, in successive chapters, how money found a way of 
multiplying itself through the development of banking, bond, equity, and 
insurance markets, and derivative instruments of all kinds until the 
world economy came to resemble what Charles Morris has called an 
inverted pyramid of debt resting on an increasingly narrow base of real 
assets. The large claim Ferguson makes is that we owe our prosperity 
more to finance than to technology. Throughout history men have been 
more ingenious at finding ways to make money than to make things. As 
Gibbon shrewdly noted, without the "incitement" given by money to the 
"powers and passions of human nature," societies could scarcely have 
emerged "from the grossest barbarism. "

Money, according to Ferguson, is not a thing but a relationship -- above 
all, a relationship between creditor and debtor. As soon as time and 
distance start to elapse between exchanges of things of value -- which 
happened at the start of civilization -- people needed something more 
than barter. Farmers needed to borrow while they waited for the harvest 
to ripen; merchants needed to borrow while they waited for shipments to 
arrive; above all governments needed to borrow to finance their wars. 
The three functions of money -- as a means of exchange, a unit of 
accounting, and a store of value -- developed to bridge the interval 
between purchase and payment. Bills of exchange or "promises to pay" 
seem to have been used for the settlement of debts from the earliest 
times to overcome the inconvenience of shipping the precious metals.

Primitive banks, or safe depositories, must also have existed from the 
earliest times. The actual word "bank" originated from the Italian 
banca, or bench, at which the medieval moneychangers sat to do their 
business. Bankers soon learned how to augment their profits by lending 
out their deposits at interest. The Medici of fifteenth-century Florence 
were the first famous banking family. They made their fortune by buying 
and selling "bonds," the debts issued by cash-strapped monarchs. These 
bits of paper bound the borrower to repay within a specified period of 
time. The bond market started when these bonds became tradable. The bond 
market, the first truly modern financial market, was perfected in 
eighteenth-century England; great merchant bank underwriters of loans 
like the Rothschilds dominated the public finance of nineteenth-century 
Europe. Fractional reserve banking, an early innovation, starting with 
Sweden's Riksbank in 1656, enabled banks to make loans in excess of the 
money deposited with them -- on the assumption that "depositors were 
highly unlikely to ask en masse for their money. "

Ferguson rightly points out that the early growth of European finance 
was driven more by the needs of the state than by those of commerce. His 
thesis, familiar from his two volumes on the Rothschilds, is that state 
policy determines the development of finance, not vice versa. This 
reverses the usual Marxist argument that finance controls governments. 
The Rothschilds started as court bankers. The Bank of England was 
created in 1694, mainly to help the government with war finance, by 
converting a portion of the government's debt into shares, in return for 
which the bank was given special privileges, such as a partial monopoly 
on issuing banknotes.

England's rise to world power in the eighteenth century was based on the 
ability of the British government to borrow larger sums at cheaper rates 
than any of its rivals; hence the importance for the nineteenth-century 
public mind of maintaining the state's creditworthiness by balancing the 
government budget. In the twentieth century it was the eagerness of 
democratic governments to extend home ownership -- as an antidote to 
revolution -- that later led to the practice by which home mortgages are 
converted into securities and sold around the world.

Long-term investment needed a different financing structure, and this 
was found in the development of the joint-stock, limited-liability 
company and the emergence of stock markets. By enabling many individuals 
to pool their resources by buying shares of a particular enterprise, 
while protecting them from losing everything if the project failed, the 
limited-liability company was one of the greatest innovations in 
financial history. The Dutch East India Company, formally chartered in 
1602, was the first company to issue its own stock and bonds through the 
Amsterdam Stock Exchange. Over its two-hundred-year history the average 
dividend it paid out to its 358 shareholders was 18 percent a year. It 
helped that it was a chartered monopoly, with the power of the 
government behind it.

Ferguson notes that the history of stock markets has been punctuated by 
spectacular bubbles and crashes. Some of these have been caused by 
fraudulent company promoters: Kenneth Lay of Enron had a worthy 
predecessor in John Law, whose Mississippi Company went spectacularly 
bust in 1720. Many fraudsters, like Ivar Kreuger, the "Swedish match 
king" who committed suicide in 1932, were men of vision who turned to 
crime only to rescue great projects that had gone wrong. But the 
fraudsters could get away with it--for a time -- because of what Alan 
Greenspan called the "irrational exuberance" of investors. Why are stock 
markets so volatile? Ferguson believes it is because they 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.

This is a good analogy, but, as I shall argue, it is not an explanation.

As Ferguson tells it, volatility is inherent in financial markets, but 
bad monetary policy can make it worse. Central banks were created, in 
part, to stop the "over-issue" of notes by private banks, and to act as 
"lender of the last resort." Following Milton Friedman, Ferguson 
believes that the Great Depression of 1929--1933 was caused by bad 
monetary policy -- money was kept so cheap that a huge stock market 
bubble formed, and, when it burst, the Federal Reserve Board failed to 
provide the banking system with sufficient liquidity. This view that 
monetary policy alone is sufficient to keep economies relatively stable 
is unlikely to survive its harsh confrontation with present reality.

The next step in money's ascent is the development of insurance markets 
to guard against risk. Ferguson tells the story through three central 
episodes. The start of insurance depended on the work of the 
mathematicians at Port-Royal in eighteenth-century France, who laid the 
basis for the modern theory of probability. Provided that the relative 
frequency of an occurrence was known from past information, it would be 
possible to insure people against the risk of it happening to them. This 
insight was applied by the two clergymen founders of the Scottish 
Ministers' Widows' Fund in Glasgow (Ferguson's hometown) in 1743. They 
worked out the premiums required to create a fund that, when invested, 
would cover payments to beneficiaries on the deaths of their husbands. 
As conditions of life eased, and people demanded greater protection 
against its hazards, insurance and pension funds "would rise to become 
some of the biggest investors in the world -- the so-called 
institutional investors who today dominate global financial markets. "

 From the late nineteenth century onward, the state increasingly took on 
the "insurance" function, providing social security and health benefits 
to the whole population through the tax system. This was because private 
insurance companies left a sizable fraction of the population uninsured 
and uninsurable. Ferguson unusually, but effectively, uses Japan rather 
than Germany or Britain as his main example of the way the state 
nationalized risk -- mainly, one suspects, because it bests illustrates 
his favorite thesis that financial systems grew up to serve the military 
needs of the state. Social security, in this view, was the reward for 
military sacrifice. This was particularly so in Japan.

Ferguson's third example comes from Chile, which he uses to illustrate 
the return from government social insurance to private -- albeit 
compulsory -- insurance. The tax-financed welfare state had never been 
fully accepted by conservatives, who believed it rotted the character by 
removing the incentive to save and by separating benefit from individual 
contribution. Influenced by Milton Friedman and the "Chicago boys," Jose 
Pinera, General Augusto Pinochet's minister of labor from 1979 to 1981, 
privatized Chile's cumbersome state pension scheme. According to 
Piñera, "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. "

The Chilean reform encouraged workers to opt out of tax-financed state 
pensions into personal retirement accounts, managed by licensed but 
competing pension funds, and financed by compulsory deductions from 
wages. Although most Western countries remained wedded to their 
traditional single-payer welfare states, set up during and after World 
War II, the Chilean model was imitated across Latin America and emerging 
market economies. Despite what he calls its "shadow side" -- it "leaves 
a substantial proportion of the population with no pension coverage at 
all" -- Ferguson clearly approves of the Chilean reform, traveling to 
Santiago to see firsthand what he considers its beneficent results. It 
will be interesting to see whether the provision for universal health 
care promised by the Obama administration follows the European model -- 
by extending tax-financed Medicare for everyone along the lines proposed 
by Paul Krugman -- or the Chilean/Singapore model in which compulsory 
insurance premiums, paid out of wages, provide the contributors with 
individual entitlements.

Land and the buildings on it -- or in modern parlance "bricks and 
mortar" -- have played a crucial part in the development of the 
financial (and economic) system, because "the land can't run away," and 
is therefore easy to use as collateral. Mortgaging their property became 
the way improvident landowners maintained extravagant lifestyles and, in 
later, more sober times, the way house owners raised money to start 
businesses. The spread of home ownership in the twentieth century -- 
largely promoted by government in an attempt to make capitalism more 
popular -- made possible a vast expansion of collateralized debt, and 
was the main stimulus to the development of the conversion of debt into 
securities.

Ferguson points out that property "is a security only to the person who 
lends you money.... By contrast, the borrower's sole security against 
the loss of his property to such creditors is his income." This is not 
quite true. The lender's security also depends on the income -- actual 
or expected -- of the borrower, because, although the property cannot 
"run away," it may lose its value, or it may be costly, and even 
impossible, for the creditor to get possession of it. Ferguson might 
have told the story of the costly mistake made by France's Credit 
Lyonnais, which set up its own proprietary credit-rating agency in the 
late nineteenth century. Its mistake was to rate the credit-worthiness 
of governments not on their debt-to-income but on their debt-to-property 
ratios. The imperial government of Russia got top rating, because, 
despite its disordered finances, of all governments it owned the most 
property. On the basis of this rating, French investors snapped up 
tsarist bonds. They lost all their money, not because the property 
disappeared but because the government did. Credit Lyonnais failed to 
take into account "political risk. "

The tsarist government would now be considered a subprime borrower. Yet 
today's vastly more sophisticated credit-rating agencies made the same 
mistake in giving triple-A ratings to bonds that took no account of the 
income of the borrowers -- what the professionals called "toxic waste." 
Ferguson notes that a disproportionate number of sub-prime borrowers 
were ethnic minorities and wonders whether subprime is a new euphemism 
for black. Both Democratic and Republican administrations brought 
pressure on lenders to relax their rules in order to spread home 
ownership -- for example, not to press borrowers for full documentation. 
And indeed home ownership -- or bank ownership of homes -- did expand 
greatly in the last ten years. The bubble burst in 2007 when a rise in 
the federal funds rate from 1 percent to 5.4 percent coincided with the 
expiring of the enticing "teaser" rate periods that lenders had offered 
subprime borrowers. Repayments were then set at much higher interest 
rates and many could not pay.

The sober conclusion Ferguson draws from this fascinating story of 
financial incontinence and skullduggery is that property ownership is 
not the "magic bullet" it is often claimed to be. This is the basis of 
his criticism of the exaggerated claim of the economist Hernando de Soto 
that the path to Latin American prosperity lies in secure property 
rights. "In short, there was irrational exuberance about bricks and 
mortar and the capital gains they could yield. "

Ferguson's last chapter, "From Empire to Chimerica," argues convincingly 
that it was the investment of billions of dollars of Chinese savings in 
US Treasury bonds that fueled the US debt binge, by enabling Greenspan 
to keep money so cheap for so long. In a bravura passage that rounds off 
his story of money's ascent, Ferguson writes:

     "Chimerica" -- China plus America -- seemed like a marriage made in 
heaven. The East Chimericans did the saving. The West Chimericans did 
the spending. [Cheap] Chinese imports kept down US inflation. Chinese 
savings kept down US interest rates. Chinese labour kept down US wage 
costs. As a result, it was remarkably cheap to borrow money and 
remarkably profitable to run a corporation. Thanks to Chimerica, global 
real interest rates...sank by more than a third below their average over 
the past fifteen years. Thanks to Chimerica, US corporate profits in 
2006 rose by the same proportion above their average share of GDP....

     The more China was willing to lend to the United States, the more 
Americans were willing to borrow. Chimerica, in other words, is the 
underlying cause of the surge in bank lending, bond issuance and new 
derivative contracts that Planet Finance witnessed after 2000. It was 
the underlying cause of the hedge fund population explosion. [It] was 
the underlying reason why the US mortgage market was so awash with cash 
in 2006 that you could get a 100 per cent mortgage with no income, no 
job or assets.

2.

In the long sweep of history, the failures of money seem trivial in 
comparison with its triumphs, mere incidents on the road of financial 
innovation that leads to universal prosperity. Yet the failures have 
been extremely damaging to the generations that experienced them. The 
famous criticism made by John Maynard Keynes about the economics of his 
day can be applied to Ferguson's history:

     In the long run we are all dead. Economists set themselves too 
easy, too useless a task if in tempestuous seasons they can only tell us 
that when the storm is long past the ocean is flat again.

Ferguson, of course, is aware of the storms -- in fact he writes 
brilliantly about them -- but he never doubts that the journey has been 
worth it. The "ascent" of which he writes owes more to Reagan-Thatcher 
triumphalism than to the more sober assessments of the performance of 
markets currently in vogue. It also leaves out an important part of the 
drama of finance -- the constant struggle between financial innovation 
and government attempts to protect populations from financial rapacity.

It is not till he comes to his "Afterword," interestingly, if 
ambiguously, entitled "The Descent of Money," that Ferguson seriously 
considers the question of why the "ascent" of money he celebrates is 
linked to extreme financial instability. Here he pays brief homage to 
the distinction made by the economist Frank Knight (and also Keynes) 
between "risk" and "uncertainty" -- with risk referring to a situation 
in which the probabilities of different random outcomes can be 
determined, as in roulette, whereas uncertainty pertains when no such 
probabilities are possible, such as the prospect of a future war. And he 
concedes that Keynes may have been "thinking along the right lines" when 
he talked of investors falling back on "conventions" to disguise from 
themselves the fact that they do not know what the future will bring -- 
the main convention being to behave like everyone else is behaving.

But he fails to follow up these crucial insights. The distinction 
between "uncertainty" and "risk" is essential, in my view, to a proper 
understanding not only of the present crisis but of the whole 
"roller-coaster ride of ups and downs, bubbles and busts, manias and 
panics, shocks and crashes" that have punctuated economic history. The 
point is that the future cannot be decomposed into measurable risk, 
however much risk is spread across intermediary instruments. The 
illusion that it can be blinds investors to the ever-present possibility 
that the world may change in ways which set all their calculations at 
nought. The credit mountain was built on the belief that house prices 
would always go up; when they started to fall the balloon was pricked.

Ferguson realizes that mainstream economics is flawed, but then veers 
away to what I think is the dead end of "behavioral economics" and false 
analogies between financial evolution and Darwinian natural selection. 
Behavioral economics claims that we are "wired" to behave 
"irrationally"; theories purporting to derive from Darwinism claim that 
finance follows the law of the "survival of the fittest," whereby firms 
fitted to their environment flourish and weaker ones go to the wall -- a 
process that inevitably involves "creative destruction." These attempts 
to explain the rise of money in terms of natural processes strike me as 
being both morally and philosophically naive.

Ferguson's mistake, I suggest, comes from an incomplete appreciation of 
the role of money. Evidently money is more than just a facilitator of 
trades. It is a way of coping with changing views about an uncertain 
future. Why, Keynes asked, should any rational person wish to "hold 
money" rather than spend it? Precisely because it is a way of postponing 
spending when confidence is low and the "conventions" promising a secure 
future have broken down. Keynes writes:

     The desire to hold money as a store of wealth is a barometer of the 
degree of our distrust of our own calculations and conventions 
concerning the future.... It operates, so to speak, at a deeper level of 
our motivation. It takes charge at the moments when the higher, more 
precarious conventions have weakened. The possession of actual money 
lulls our disquietude; and the premium which we require to make us part 
with money is the measure of the degree of our disquietude.

Even a (modestly) depreciating currency may at moments of high 
uncertainty seem more "secure" (carry a higher premium) than any other 
asset. We are seeing the truth of this today. The failure to take 
account of this aspect of money is the missing dimension from an 
otherwise splendid book.

A final reflection on Ferguson as a historian. He is overimpressed by 
economics. Many historians feel that history is in some way inferior to 
the more exact sciences; the thought that he can "do" economics gives 
the historian an expanding sense of mastery. I know the feeling, because 
I've lived through it myself. Economics, especially in its 
mathematicized form, purveys a peculiar vision of society. Society to 
the mathematicians is a market imperfection. Among other imperfections, 
the idea is that allocation of resources is not as efficient and 
information for making choices is not as complete as they should be.

This delusive, but powerful, idea suggests that behind the imperfection 
lies perfection, a world in which the future will be perfectly known and 
therefore hold no surprises. Mathematics is the inheritor of the 
platonic ideal; and mathematically driven financial innovation is its 
handmaiden. At one time philosophers projected their utopias, and the 
early economists followed suit. Keynes was perhaps the last one who 
indulged in utopia building. In his essay "Economic Possibilities for 
Our Grandchildren" (1930), he looked forward to a time when the economic 
problem was solved and an age of abundance and leisure had arrived in 
which people would cultivate the arts of life.

Instead, Keynes's grandchildren face a rerun of the Great Depression, 
and President-elect Obama promises a new New Deal. On December 6, he 
pledged to create an estimated 2.5 million jobs in the first two years 
of his administration by large-scale investments in infrastructure 
projects, including bridges, mass transit, and electrical grids. 
Estimates of the costs by members of Congress range from $400 to $700 
billion.

Having taken on $7.8 trillion in financial obligations over the last 
year -- roughly half the size of the entire American economy -- the US 
government is now represented in some form on the boards of most major 
American companies. Obama has promised to help those facing foreclosure 
on their mortgages and those hit by the relocation of jobs overseas. He 
has vowed to curb the excesses enjoyed by those at the pinnacle of 
deregulated credit. While not addressing the fundamental direction of 
economic theory, ad hoc policies such as these may help to ensure that 
the ascent of money does not lead to the descent of man.


Robert Skidelsky is Emeritus Professor of Political Economy at Warwick 
University, England. The single-volume abridgment of his three-volume 
biography of John Maynard Keynes was published in 2007 in the US. He is 
currently completing a short history of Britain in the twentieth century.