Motivation
behind the book
Niall Ferguson, in his book The Ascent of Money,
has compared the rise of this “portable power” to the Ascent of man. Going back
in time he takes the reader on a journey that starts in the 1500’s with the
Inca Empire and ends with the disturbing conclusions on the recent global
financial crisis, showing how money has underpinned the rise and fall of
empires and even civilizations.
Through a series of events buried under layers of
time to show how the prudent use of money helped the Duke of Wellington win
their war against Napoleon, how the Spaniards recognized that silver was more
than “Tears of Moon” and extracted and minted more than 2 billion ounces of
silver during their reign only to see a rapid decline in the value of the asset
itself – giving us a glimpse of what we today call inflation, how the
inscriptions on the bank notes seen today have their origins in civilizations
that existed more than four thousand years ago in Baghdad where similar
carvings were made on pieces of clay, how money has existed in form of clay, seashells,
precious metals, grains and how it simply became just numbers on a computer
screen – money as we know today might be different in its form but its power
has been unprecedented – which makes the case for understanding its journey
over time. As Ferguson argues, understanding financial history is not just of
academic interest – it is something that can explain us the existence of even
the most exotic financial products that exist today such as the CDO and the CDS
– how they came to being and how it has touched the lives of every individual –
whether a reckless banker or a retiree in Iceland.
The origins of
Banking – The Medici’s in the 1400’s
One of the most fascinating analogies that
Ferguson has managed to establish are those between the ways in which banking
was done in the 1400’s and the way banking is done today. Scouring through the
rich history of Florence he explains how Medici’s were much more than the
Godfathers of the great period of renaissance. He shows how one man, Giovanni
di Medici, established the concept of debits and credits, the ledgers and the
interest rate differentials – laying the foundations of what we know today as
banking. Ferguson claims that these later became the hotbeds of financial
innovation and attributes the birth of modern banking to them. In the process,
it is no wonder that they came to become the richest and the most powerful
family in Europe. More than three queens and two popes in that period came from
the Medici family. They became the unofficial rulers of Europe – the people who
ran the show from behind the scenes.
It is again interesting how this manifests itself
even today when we see the top bankers of the world (Alan Greenspan, Hank
Paulson etc.) having deep connections in the most powerful circles in US – what
one might call today as lobbying. So how did the Medici’s do it?
Going back
further in time – The Merchant of Venice
Before Giovanni Di Medici laid the foundations of
Modern banking, money lending was considered a nasty business. In this famous
excerpt below one can see how cautious lenders were when they gave money to
people. The Merchant of Venice, demands a pound of flesh from Bassanio as collateral. In case he fails to repay
it, he is likely to lose a body part.
Go with me to a notary, seal me there
Your single bond; and, in a merry sport,
If you repay me not on such a day,
In such a place, such sum or sums as are
Express'd in the condition, let the forfeit
Be nominated for an equal pound
Of your fair flesh, to be cut off and taken
In what part of your body pleaseth me
Ferguson has drawn on similar cases in Glasgow
where such Merchants exist even today and are known in the modern world as Loan
sharks. He demonstrates how he has known these loan sharks going to the extent
of resorting to torcher to extract the money from borrowers. Extreme caution is
exercised by them when it comes to lending. So
it is hard to imagine a world where banks no longer care about the risk they
face in lending. What made them comfortable in lending to people without any
collateral – let alone a pound of flesh? How could banks lend money at such
attractive rates without hurting themselves when the lenders in Glasgow were
charging more than 11 million percent annual interest from borrowers? Did they
really not care?
The
genius of Giovanni Di Medici
The Medici’s managed to transform the job of money
lending in to the well-respected job of banking. They realized that in finance
small is seldom beautiful. By introducing the idea of interest differentials,
the Medici paid low interest to people who wanted to deposit money in their
banks and charged a commission from people who needed funds for their business.
By becoming a crucial link between the borrowers and lenders, they became the
facilitators of trade and development. The Medici’s were not only bankers but
innovators in financial accounting. At one point, the Medici’s managed most of the
great fortunes in the European world, from members of royalty to
merchants.
How did they do it? They mixed banking with
trading. Being exporters of wool and silk, the Medici bank lent to English
sheep farmers or wool merchants, in return for lower prices. This could be then
exported at higher prices and helped them pocket the profit. This was also one
way for banks to circumvent the church's ban on the charging of interest –
considered a sin by Christianity.
Another was to use foreign currency: the bank
could lend, or accept a bill of exchange, in one currency and collect its debt
in another, building a hidden rate of interest into the exchange rate. Their
acumen and understanding of currency trading enabled them to make money from
borrowing and lending in subtle ways. In its prime it became the most
profitable institution and made the Medici family the most powerful family in
Europe.
However, this bank which at one point became
extremely big, also became vulnerable. Greed has existed since humans have and
this was the reason the bank collapsed in the 1500’s. Overgenerous lending by
the bank to people who subsequently defaulted led to a severe liquidity crunch.
In short the bank went bankrupt due to practices which are now known to us,
famously or infamously, as Subprime
lending.
It is fascinating to see how little we have learnt
from history. However, arrogance or ignorance – just like greed – is also age
old and hard-wired into us. The investment bankers and the financial engineers
today create a plethora of exotic
instruments that are supposed to eliminate such risks. But could such
mathematical and financial wizardry really have solved the perennial problems
that banks face? Could it really have stopped mattering whether you lent money
to a prince or a pauper? Have the modern bankers been smarter than the
Medici’s?
Ferguson goes on to say that the collapse of such
banking institutions seems rather paradoxical in the wake of exotic instruments
such as CDO’s. To resolve this one needs to first look at the second pillar of
modern finance – the bond markets.
Human
“Bond”age
The rise of bond markets have been paralleled with
the demise of other markets for finance. Governments have borrowed money at
unprecedented levels through these instruments. More so, the decline in the
stock market since the summer of 2007 has made the bond markets even more
important as these were seen as safe heavens. This not only increased the
reliance of the world economy on these markets but also placed unprecedented
power in the hands of bond traders like Bill Gross at PIMCO, who managed 700
billion $ worth of bonds – astonishingly a tiny fraction of this 75 trillion $
segment.
Wars and Bonds in the 18th century
The historical importance of bonds have been
equally important. Before the advent of the present day instruments bonds not
only financed wars but also determined the outcomes – prudent use of these
instruments gave the countries a big edge in terms of weapons and army.
Ferguson cites the classic example of the
Rothschild’s as they truly epitomize the power held by bond traders. During the
battle of waterloo, the British government was in desperate need of funds. To
fund this they required a form of currency which could be readily accepted so
that they could pay their allies, finance the weapons and feed their troops.
They recruited Nathan Rothschild – one of the most astute bond traders in
history – to mobilize gold. In the process, Nathan hoarded vast amounts of gold
expecting a rise in the value of the bullion as he speculated the victory of
Napoleon. A loss would increase the need for gold as the government would need
to bear the costs of wars. However, an English victory completely backfired and
the Rothschild were sitting on a mountain of gold that was declining in value.
In-spite of all this they became one of the wealthiest and most powerful
families in the 18th century. How did they do it? By trading bonds.
After the war was won, Rothschild began buying
bonds. These were the instruments that were used by the government to raise
money. A victory in the war ensured that these bonds would subsequently rise in
value as the trust of the general public with respect to interest payments
would rise. After holding them for oven an year, he sold them at high prices –
pocketing about 600 million pounds in present day terms. All this was based on a
simple logic – bonds were not just means of raising money. One could speculate
on their prices, trade on them and make a hell lot of money.
How the south used cotton-backed bonds to finance
the civil war gives us a glimpse into how financial innovation in the bond
markets had begun in the 18th century itself. In addition to this,
being the major producers of cotton, they artificially increased the value of
these bonds by restricting the supply of cotton in the world – creating a
man-made cotton famine. It is a different story of how the strategy backfired
as the countries secured new supplies from Asia and ultimately forced south
into unimaginable levels of inflation. The
power bonds to propel the economies and then bring them crashing down is
beautifully exemplified in this instance.
Bond markets today
The belief in bond markets have however taken a
hit in the recent times. Classic examples include the hyperinflation in
Argentina where the government failed to raise enough money through the bond
sales amidst worries of inflation. With inflation being one of the biggest
sources of worry for not just buyers but bond sellers (prices of bonds fall as
real anticipated coupon payments decline with increasing inflation) it was
natural that another market for investing money arose – The stock markets.
However, Ferguson argues in the second part of the book as to why have we
learnt so little about investing in this highly speculative instruments
in-spite of their dubious history which goes back to more than 500 years (tulip
bubble in the 1600’s). As Robert Shiller, in his classic book Irrational
exuberance argues, somehow we have collectively developed this notion that
stock prices can move in just one direction – up. The massive bubble bursts in
the recent history shows that we could not be more wrong! The bond markets then
played a central role in the securitization process where-in almost any kind of
debt (such as mortgages) through bonds or as they are known more fancily CDO’s.
Blowing Bubbles
The 15th and the 16th
century saw a revolution in money and credit largely attributed to the genius
of the Medici. The 18th century saw a rise in the bond markets. The next step
in the story ascent of money was the rise of the Joint Stock Company and
the Stock
market.
The amazing ability of Ferguson to take us 300
years back in time and present it as if it were happening today – laying bare
for the reader the analogies for the reader to ponder upon are at display in
this chapter.
He goes back to Venice and starts the journey by
visiting the resting place of the man who first made it large in the stock
markets – John Law. Describing him as a compulsive gambler, a convicted
murderer and a flawed financial genius he describes the ascent and the decent
of John Law and how he lost everything in the first ever stock market crash. One cannot ignore how this mirrors the lives
of so many people who pursue the dream of making it big in the stock markets,
even in the 21st century.
The first company and the beginnings of the
stock market
The turn-around in the fortunes of John Law were
largely and indirectly related to the formation of the first company in the 1800’s.
The Dutch families collaborated and formed the first company which was in the business
of trading spices with countries like India and China. The general public was
allowed to be a part of this venture by buying stock in the company. This would give them a share in the company’s
future profits. The world’s first share certificate was issued by them 400
years ago. These ultimately culminated into the formation of the formation of
first stock market where people started actively trading in the shares of the
company.
As the company grew bigger and more efficient it
established a virtual monopoly in spice trade. The shareholders grew richer and
everyone was a winner. This was not just seen as a great opportunity by John
Law but he went on to form the Mississippi
Company. By convincing the French rulers to use paper money instead of gold
and silver with the assurance that this would help their precarious debt
conditions. The lure of gold and silver that the company would trade in made
the investors flock in huge numbers when the company first issued its shares.
This simultaneously transferred the massive public debt into shares and stocks.
The company’s shares soared. Climbing more than
900% in the first few days it seemed that everyone would be a millionaire (a word invented during that
period). John law, an ex-professional gambler and a womanizer, was now the
richest and the most powerful man in France.
However, these proved to be mere castles in the
air. Built on speculation, the company that law formed was hardly doing any
business. The geography of Louisiana made it impossible to do so. As the news
travelled to Paris, people realized that what Law was doing was nothing but
running a massive Ponzi scheme. This news popped the confidence of the
investors and sent the share price into a freefall as they fell to 10% of their
value in a matter of weeks. John Law fled the country – never to be seen again.
The country was thrown into a recession.
The John Laws of 19th and 20th
Century
Time and again, Ferguson has drawn on history and
exemplified how herd behaviour and financial engineering has caused stock
market crashes. In this process, he has also laid bare the inability of humans
to learn and think rationally. Should we be astonished then that these stock
market crashes happen so often - when they should ideally happen just once in a million years.
One might not appreciate the outcome of what Law
did – but one can also not ignore the genius of creating something out of
nothing – something that the financial world has become increasingly adept at.
In the 20th century, only one company did things that could parallel
the work of John Law – Enron.
When in the early 2000 the shares of the company
went through the roof – only a glimpse at what had happened 280 years ago with
the Mississippi Company should have
made the investors in the company really worried – it did not. They believed in
the John Laws they saw at the helm of Enron – Ken Lay and Jeff Skilling. Their
fate – not surprisingly – was the same. People
like Lay, Skilling and Greenspan who deserved execution received acclamation!
Risky
Business
Taleb in his famous book, Black Swan, talks about
the futility of prediction. He talks about how our future is not shaped by
small slightly-uncertain events but high impact and completely unpredictable
events.
The example of Katrina when it hit New Orleans
shows how insurance is pointless when you really need it. It shows us how we
might think we are insured when we are not. It completely torn the place apart
and such risks are more commonplace today. One black swan event and the whole
system went for a toss. Why should then people invest in insurance at all?
History of
Insurance funds – Walter Scott
in 1800’s invented the concept of Insurance and premiums which grew to become a
big industry. He set up the Scottish Widow’s fund.
Japan saw destruction in World war and one third
of the population lost their houses. The insurance was nationalized after this
as the welfare state covered them for all adverse events. This propelled Japan
to the top. The welfare state covered everyone. However, these models could not
work in UK as Milton Friedman showed when they faced stagflation in the absence
of incentives. With insurance failing in some countries like Japan, a new
concept to manage risk came about – Hedging. With them came Hedge Funds.
The concept of how these funds help people manage
their risks is aptly highlighted by Ferguson. The birth of Futures and Options
become the bridge to the later arguments on how it was these complex
derivatives, the led to the compete downturn.
What arguments do the Hedge fund managers give?
This is supposed to help people protect themselves and worry about risks that
they should be managing. However, he shows how adverse market movements have
wiped out big insurance providers such as AIG and hedge funds and is not really
the answer to the risks that we want to reduce.
The safe
houses – It seemed as if
people had found a new and safe way to insure themselves. Buy a house. However,
in hindsight it is evident that this would prove to be a disaster. When one
thinks about it, it is apparent that the greed and the flawed incentive systems
propelled the use of derivatives to satisfy the massive needs of mortgage that
would come about. Merit based allocation of resources was forgotten and
everybody had a house. But were people safe in their houses? Or had they
exposed themselves to an even bigger risk?
The
government has encouraged people to own houses in US and UK. One of the
motivations behind this was the massive in equality
seen during the great depression. The setting up of large mortgage lenders such
as Fannie Mae exemplifies how USA has been trying to encourage the mortgage market
– propelling the mortgage loans volumes. Moreover, the problems that place like
Detroit faced due to racial discrimination when it came to home lending turning
US states highly liberal when it came to mortgages.
The first Mortgage
Bust – S&L crisis
The ubiquity of mortgages in the 1980’s was
paralleled with the deregulation of the US markets (rising interest rates to
combat inflation). The rising interest rates created a pressure on these
S&L institutions as they had to now pay higher interests on deposits but
were forbidden by the regulation to increase it on the deposits. However with lobbying and deregulation,
Savings and Loans institutions were able to raise interest rates they paid to
the depositors so as to attract more money. This could then be lent out to
satisfy the growing demand for home ownership and mortgages. The savers
deposits were insured by the government – “thus” seriously distorting the
incentives of the S&L institutions (as they were not worried about default
on loans).
The first bust came with the collapse of Empire
savings and loans. The alluring interest rates increased the deposits at the
company from 12 million to 250 million in 2 years – all due to deregulation.
The vast supply of credit and the deregulation ultimately reminded them of the
simple law of supply and demand – if supply exceeds the demand – prices fall!
The idea of property owing democracy seemed flawed. After the loans were
written off – more than 75% of these institutions were wiped out. However, we
did not learn yet again. A bigger and
worse mortgage crisis awaited us.
The Sub-prime Bust
of 2008
Taking the example of the II Duke of England shows
how houses were not nearly as safe as they were thought to be. When the Duke
used his property as a cash cow it finally backfired in the wake of declining
revenues from the agricultural business. This has been paralleled in time and
time again – in the 1980’s and in the near past during the recent financial
crisis.
However the situation was a bit different in 2008
compared to the 1980’S. The deposits in the banks were no longer insured. This
meant that sub-prime lending could lead to bankruptcies and severe liquidity
crunch. However, financial engineering came to the rescue as the lenders with
the help of greedy banks found a way to take these mortgages off their balance
sheets, do some slicing and dicing and sell them to investors far away in other
countries through the process of securitization. Thanks to Mr. Greenspan, a low
interest rate environment meant that people were more likely to honour their
payments. However, it this amazing business model had one fundamental flaw –
house prices were not to rise forever! Rising
interest rates, Rising unemployment and falling home prices became the perfect
recipe for disaster.
Citing the example of Argentina where encouraging
property ownership was supposed to be the key to wealth generation as it would
allow people to take loans with the home as collateral to start business professor
Ferguson shows how the model has serious limitations. The model has not worked
in these countries as what really matters is a stable income. In contrast,
countries like Bolivia the idea of microfinance has worked really well.
Entrepreneurs – mostly women (who are thought to be better money managers) –
have been given small loans without any collateral. The lenders have not faced
any default and the borrowers have seen rising incomes.
The property owning democracy model exported by
the west has done poorly in these countries. It led to even a worse outcome in
the country of origin itself – mainly due to the “excessively well -developed
financial industry” that dreamt of
transforming this into a money making machine.
How did they do it? The answer was – Derivatives
and Globalization.
Financial Globalization - Chimerica
The re-emergence of International finance happened
in the 1960’s with the setting up of the World Bank and the IMF. These
institutions were supposed to ensure tight control over international capital
flows. However, with the rise in investable funds in the Middle East (as oil
prices soared) the western banks ensured that these regulations were relaxed
and money flowed in as deposits with them. However, countries like Mexico and
Argentina borrowed heavily and were thrown into a recession when they were
unable to service these obligations.
The stringent regulations imposed by the WB and
IMF were not taken positively by many countries as they revolted. This was also
paralleled by the rise of Hedge Funds who invested in these countries and their
currencies on speculative basis – made famous by the investment made by George
Soros against the British pound. Its subsequent devaluation gave him a profit
of more than a billion dollars.
With the increase in sophistication of the
financial industry such speculation need not be based on gut instinct. It could
now be priced and given a value thanks to one of the most famous formulas
thrown by the academic worlds at the Wall Street – The Black – Scholes model to
price options. A new breed of speculators who used math to speculate and make
money was born. However, even these Nobel Laureates could not save their
company against a wild movement in the economy of Russia - a black swan event
meant that LTCM lost almost everything on the massive put options it had sold.
Reality it seemed was far from what the equations told them. Their speculative
investments on securities in other countries brought them down. As Ferguson
puts it –
“These noble
laureates were good in mathematics but poor in history. Lost in the beauty of
planet finance they were unaware of the reality of planet earth.”
The most recent crisis was preceded by booming
markets amidst rising interest rates, rising trade imbalances and growing
political risks. These paradoxical developments can be explained by the
development in China which financed its development not from foreign money but
from its own savings. The excessive savings in China has reversed the capital
flow from East to West. The excessive lending has been due to the country’s aim
at keeping its currency slightly devalued against the dollar to promote its
trade.
These lending landed up in the US banks – becoming
one of the primary reasons for sub-prime lending that US witnessed and the
subsequent crisis. Bernanke called it the “Savings Glut” – which pushed foreign
capital into US.
Conclusions
The book has successfully brought forward many
points that have become increasingly relevant in the financial world today. The
emergence of ideas such as irrational exuberance and Black swan events have
demonstrated the futility of our efforts to model the complexity of planet
finance. Moreover, it is saddening to see how little we have learnt from our
past. The failure of the Mississippi Company to the Savings and Loans crisis to
the demise of the Medici’s in the 1700’s bear testimony to this. Ferguson has
managed to not only give us a glimpse of the ascent of money, the rise and fall
of bond and stock markets and the demise of mortgage markets but has liked it
beautifully to how relevant they are and will be today. The precarious
conditions of US and the unstable state of international finance paint a
disturbing picture of the future.
The one biggest take away from the book is that
history matters. It will show itself time and time again – disguising itself in
various forms. It is our job to look beyond the surface and not fall into the
same traps again.
