Book review - Ascent of money!

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 18^th 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 18^th 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 18^th 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 15^th and the 16^th 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 21^st 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 19^th and 20^th 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 20^th 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.