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.”
Money
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.
Bonds
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.
