Wednesday, January 15, 2014

The Ascent of Money – “Planet finance is beginning to dwarf planet earth.”

In 2008, Niall Ferguson, has written a great about the history of finance. In “The Ascent of Money” the author explains the evolution of financial instruments and traces the history of important bubbles in financial history. Niall wants us to better understand the complexities of today's modern financial institutions and terminology by digging into the origins of finance.

The book is fantastic; reading “The Ascent of Money” should be mandatory for everyone working in the industry.

In the first part of his book, Niall Ferguson discusses the reputation of finance, money, banks, credit, and bonds.

The reputation of finance

Why has finance bad reputation? Niall gives three reasons:

  • Debtors tend to outnumber creditors.
  • Financial crisis and scandals occur frequently.
  • For centuries, financial services have been disproportionately provided by members of ethnic and religious minorities.

In Niall's view, finance doesn't deserve a bad reputation:

“People are poor because of the absence of banks and reliable financial institutions, not because of their presence.”

“A world without money would be worse, much worse, than our present world. It is wrong to think of all lenders of money as mere leeches, sucking the life's blood out of unfortunate debtors.”


Can you imagine a world without money? Until about 600 BC, the world did not know coins. They were first introduced, at that time, in the temple of Artemis at Ephesus (near today's Izmir in Turkey).

Why is money important? Because

  • , as a medium of exchange, it eliminates the inefficiencies of barter;
  • , as a unit of account, it facilitates valuation and calculation;
  • , as a store of value, it allows to conduct economic transactions over long periods as well as geographical distances.

To fulfill these functions, money must be available, affordable, durable, fungible, portable, and reliable.

In ancient Rome, coins were made out of three metals: aureus (gold), denarius (silver), and sestertius (bronze). Its value was a function of the commodities' increasing scarcity, from bronze, to silver, to gold. As a consequence, the value of money was directly linked to the commodity it was made of. The author describes the development of the Spanish currency to the state of a world currency. As a matter of fact, the Spanish colonialist Diego Gualpa discovered the South American Silver mine in Potosi in 1545. The depletion of this Potosi mine until 1783 allowed Spain to create smaller units of accounts of its currency (compared to the more valuable gold), raising it to the status of a world currency.

In the same vein, Niall Ferguson says that the idea of crusades was not only religious but also had the purpose to overcome Europe's monetary shortage.

The next step in the evolution of money is its gradual detachment from the value of its underlying commodity.

“Money is worth only what someone else is willing to give you for it.”

Banknotes, whose intrinsic value is close to zero, first occurred in China in the seventeenth century.

“Money is a matter of belief, even faith: belief in the person issuing the money he uses or the institution that honors his cheques or transfers. Money is not metal. It is trust inscribed.”

Banks and credit

A central evolution in the world of finance is obviously granting of credit. The term is derived from the latin term credo (= I believe). Banks play a central role here.

In his book, Niall Ferguson traces the development of major banking institutions:

From 1385 on, the Medici bank developed, in a multi-currency environment, namely through currency trading and issuing bills of exchange (cambium per literas). Both were closely intertwined at that time, because currency transfers were, due to their physical expression in base metals, complicated to put in place. A systematic use of balance sheets, its partnership structure, and risk diversification were other success factors for the Medici bank.

“It was decentralization that helped make the Medici bank so profitable.”

“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.”

The Amsterdam Exchange Bank (Wisselbank), created in 1609, developed trade payment systems substantially: The bank allowed merchants to set up accounts denominated in a standardized currency, to deposit cheques, and to make direct debits and transfers. This meant that commercial transactions could take place without materializing actual coins. A merchant could pay another merchant simply by debiting his account and crediting the other merchant's account.

After its foundation in Stockholm in 1656, the Swedish Riksbank introduced another fundamental precept of modern finance. The bank lend amounts in excess of its metallic reserves and, thereby, allowed the creation of additional credit. Today, this system is known as fractional reserve banking.

1694 saw the creation of the Bank of England. It was the first bank that kept, from 1742 on, a monopoly on the issue of banknotes and, thus, the first central bank. Even though its primary purpose was to convert government debt into bank equity to finance wars, it also played a central role in the development of cashless intra-bank and inter-bank payments. The bank also developed the concept of the “lender of last resort” for banks.

Other central banks followed the path of the Bank of England: The Banque de France from 1800 on, the German Reichsbank from 1875 on, the Bank of Japan from 1882 on, the Swiss National Bank from 1907 on, and the U.S. Federal Reserve System from 1913 on.


For governments and large corporations, issuing bonds is a way of borrowing money from a broader range of people and institutions than just banks. Bond markets were developed 800 years ago in the city-states of northern Italy. As Niall explains in his book, bonds were essentially invented to finance wars.

“War, declared the ancient Greek philosopher Heraclitus, is the father of all things. It was certainly the father of the bond market.”

It was the Rothschild bank that played a particularly important role in the development of bond markets. The author delivers a very detailed description of the history of this institution, from its foundation by Nathan Rothschild (“the Bonaparte of Finance”) to their development in the United Stated since 1830.

The Rothschild family was at the heart of several important contributions to the development of bonds:

  • The bank used price differences in European bond markets to do arbitrage.
  • After 1830, the bank put up a system of issue/distribution of bonds: It bought tranches of new bonds outright and charged a commission (in form of a spread between the subscription and the distribution price) for distributing the bonds to their network of brokers and investors throughout Europe.
  • Bondholders were allowed to collect interest on the bonds in different locations of the Rothschild network.

Bonds provided also the platform for the invention of another major financial innovation – Collateral. In May 1863, two years into the American civil war, the South, through the French firm Emile Erlanger and Co., issued cotton-backed bonds in London and Amsterdam.

The bonds were convertible into cotton at the pre-war price of 6 pence a pound. Investors, however, quickly realized that the issuer could himself influence the value of the collateral by restricting or raising the supply of cotton. In addition, as the Union finally blocked the ports, creditors could no more obtain their collateral, making it ultimately worthless.

“Collateral is, after all, only good if a creditor can get his hands on it.”

Investors loosing faith in the South's cotton-backed bonds was the turning point in the American civil war and lead to the fall of New Orleans and its port in 1862.

Niall Ferguson also discusses some famous sovereign bond debt defaults of the financial history:

Germany's default and hyperinflation after the first world war can be traced back to the following sequence of events: Germany raised money through bond issues to finance the war. During the war time, however, the country had no access to international capital markets. As a consequence, the country had to turn to central bank funding much earlier than other war participants. Short-term central bank funding essentially turned German Government debt into cash, thereby creating inflation. Insufficient taxation, excessive spending, and enormous budget deficits in 1919 and 1920 finally triggered hyperinflation.

“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.”

In 1913, Argentina was, due to its huge natural resources, one of the ten richest countries in the world. But, after the second world war, the country consistently underperformed its neighbors and most of the rest of the world. In addition, it mismanaged high inflation periods between 1945 and 1952, 1956 and 1968, 1970 and 1974, and 1975 and 1990. When international lenders disappeared, the country's currency devaluated and Argentina turned to central bank funding, leading to inflation. Recurrent debt defaults in 1982, 1989, 2002, and 2004 were the consequence.

“To put it simply, there was no significant group with an interest in price stability [in Argentina].”

To be continued in the next post.