The Phenom of Money according to a Historian:
I’ve always been a student of history and have a high regard with historians. I believe there’s always beauty in looking at things with their historical backdrop. And I find this useful to improve my comprehension of difficult and boring subjects. So, on that account, math has a history. Someone invented accounting, not just out of necessity, but because it gave him the edge from his vicious business competitors. Someone came up with algebra to improve his algorithms of love. A gambler wanted to win big and buy his family an estate so he dabbled in statistics probabilities. Some kid imagined himself in a spaceship that would later become his theory of Relativity.
Find out the story and you’ll get a clearer picture.
With that, what’s the story of money?
I recommend you read The Ascent of Money by Prof. Niall Ferguson. If you haven’t got time to do so, watch the documentary version, as I did.
Still, if you’ll indulge me, you can read my long summary here.
I admire Prof. Ferguson for his eloquence and clarity of thought. And in the subject of the history of money, he’s a useful mediator for us—the common investors—who want to get into financial opportunities but, at the same time, are wary of risks, crises, and history repeating itself.
The Ascent of Money was all about the Great Recession of 2008-2009. How did the crisis sweep clean billions of dollars worth of assets?
Well, according to Prof Ferguson, it’s all interconnected. The short answer is that the world financial crisis began with a small malfunction in property investment in Detroit. The long, more interesting answer would be to brush up our financial history and understand why the economy keeps circling back to a crisis.
The Ascent of Money and the subsequent documentary presented, gets us through centuries of how the financial institutions have evolved—the banks, the companies, the stocks, insurance, hedge funds, real estate. Where did they all come from?
Getting an overview of them gives us the proper perspective of where we are now?
Today we are in a financial globalized era and operating under the heels of the partnership (and trade war) between China and America, aptly coined by Prof. Ferguson as Chimerica.
In all, money and how humans respond to it are the center of macro events. It begins, first and foremost, with the dreams of getting more—more gold, more silver, more power!
Ferguson coined it more appropriately as avarice, rather than the plain pursuit of wealth.
The Dreams of Avarice
The dreams of avarice are just the evolution of that dream of needing more money.
Looking at history is the best example of that illustrated by the search of more gold and silver.
Ferguson points out the arrival of the Conquistadors in South America, driven by their belief of the mythical El Dorado, and finding their way in Bolivia to mine the silver; later to mint them as coins, which Ferguson related to as a “portable [political] power” (Ferguson, 2008).
However, the idea of minting coins isn’t a novel idea by the Spaniards. As far back in Ancient Greece and Rome, coin exchanges were already used as a system to replace barter. Barter, with its money-less transactions, was much less efficient. Silver and gold were the ideal choice to mint coins and bars, but they were scarce.
Now, the Spaniards found a rich source of silver in South America, shipped the minerals to Europe and would immediately spur tremendous inflation throughout the continent. What the Spaniards or any other individual realized in those days was that the value of money is dependents on what someone else would give for it. The intrinsic value of silver, for example, may not be worth as much if the other person does not value it in equal terms with his produce (cotton, salt, spices, etc) to exchange with it—and vice-versa.
Money essentially involves a trust between two people. Fundamentally, this made the value of money intangible—it’s wholly dependent on a subjective valuation standard, which leads us to the birth of interest rates.
In the Thirteenth Century, Christians were prohibited to lend money with interest, so borrowers went to Jewish ghettos because the Jews were the only group of people willing to lend money with interest. The Jews negotiated lending prices and interests according to their standards and were often viewed as loan sharks.
The birth of banking was really rooted from hiding the sin of gaining interest from loans. The Medicis was able to accomplished this through ingenious bookkeeping and math. They were foreign exchange dealers who profited on the increase of value of currency when exchanged. And their wealth was due to creative accountancy that diversified their assets designed to prevent the default of payments by borrowers.
Through this novel idea, the Medici’s extended their credit in various European states, lending and exchanging currencies at a profit. The Medicis, in effect, overruled Christian doctrine against interest rates by going around the problem.
Fast forward in the 21st century, the same system of credit networking operates in modern America. The United States’ economy revolves around credit. Ferguson then ventures to the Memphis Tennessee where the economic model is based on the broke (Ferguson, 2008). Looking around the city, there are dozens of the unbanked institutions—pawnshops and private lenders. There are tax advisers, legal offices, and supermarkets that cater to people who subsist in the economic level of the subprime. In this city, far removed from the ideal capitalism, Americans have removed the picture of disaster in bankruptcies. They help people to start all over again. The infamous Chapter 13 Bankruptcy law have the ability reschedule debt when defaulted at the most convenient time, taking the pressure off debtors. This ability to give another chance to the bankrupt gave Americans the stimulus to become entrepreneurs and, later, innovators.
This became an ongoing trend of the Western economy, which was to keep giving business another chance, because there’s a great chance that on their 2nd attempt and onward, they would succeed. Such was the underlying philosophy behind America’s Great Depression. And so, the practice lending more and more by banks is based on that human capacity to hope and see better days ahead. At present, loans that banks have extended to major economies stand at 150% worth of their GDP—a clear indicator of credit boom.
In Human Bondage, Ferguson forwards a compelling truth that the world is really in the hands of the Bond Market. Movers of history and great events that shook the Geopolitical world were controlled by were the Bonds stake their claim. Following the footsteps of banking and credit, governments found a way to borrow large quantities of money through bonds. With this, since we’re all under the thumb of governments these days, all fortunes are linked to the Bond Market.
Bond market started with War. War can only happen when finances are able to back it up. This began again in Italy where it was once ruled by rival feudal states that often locked horns and pointed weapons against each other. To keep up with the competition, citizens were obliged to lend money to their government, at the same time, would receive interests later. This became the first government bonds. These bonds would transform into liquid assets to attract more citizens to put a stake on their governments.
In Florence, the government succeeded in turning most of its citizens to become its biggest investors. The system would have been perfect, if only the warring states if Italy had ceased their conflict. The over-extension of war had worn out citizens and their resources. The eventual lesson then was that bonds may finance war, but there must be a limit to the number of wars. If anything, bond investors are not exempt on where to stake their resource. Like in everything, why stake one’s investment on a war or an engagement that has a probability to fail.
Nathan Rothschild learned this early on. Already an established banker with banks established in various major cities in Europe in the 19th century. Rothschild basically financed the defeat of Napoleon at Waterloo, by buying as much gold throughout Europe and funneling them toward Wellington’s army. Rothschild also averted disaster when he stayed away from the supposed lucrative American South bonds during the Civil War.
If anything the bond market controls the world now as it did then. Presently the bond market is bigger than all stocks combined. It’s only kryptonite is inflation. When inflation occurs, the value of bond decreases in price and it erases room for profit.
That’s what happened in Argentina during the Crisis of 1989, Ferguson pointed out. Once the jewel city of the south, Argentina’s unstable political condition led to spikes of inflation. It went so high, the country run out of money. When it tried to print money, they run out of paper because the price of paper itself became too expensive.
At the turn of the century, Americans were so engrossed with the news of Enron that went as one of the largest companies in the world to bankruptcy almost overnight. This serves as the perfect example of bubble bursting. But Enron was not the first bubble to burst spectacularly, it only popularized it.
Enron’s was just a case of history repeating itself. Bubble bursts go back as far as the 18th century with the economist, and noted gambler/escaped Scottish murderer, John Law. Law learned the ropes in Amsterdam, where the first central bank, lottery and companies were born. Law was particularly fascinated with companies, particularly, the stock ownership of investors in the East India Company.
The first world’s stock market gave investor a piece of the action of the lucrative venture of the EIC and was paid handsomely via dividends. Stocks, Law found out, operated on the laws of supply and demand.
Law soon began his business in France and used the country as his laboratory, setting up his own banks and profit-driven organizations, wherein investors bought and sold shares of his companies. It was in Paris, through Laws first stock markets, that history first conceived the ideas of millionaires and entrepreneurs.
But John Law’s philosophy had a flaw. He basically believed that money was only a means of exchange and did not constitute wealth in itself. The fact that he put more value in stocks and gave more importance to exchange gave Law the compulsion to control the price of the stock value as he deemed fit, thus becoming the world’s first inside trader.
Law’s companies essentially turned out to be an elaborate Ponzi scheme, wherein the basis of profit depended on more investors buying stocks, rather than the business itself. Most profits of the company would go to the top tier of the hierarchy, leasing those in the bottom to have fewer and fewer profits. The only way to sustain the operation was to get more investors. In effect, Law broke the inviable law of finance: Trees don’t grow to the sky (Ferguson, 2008).
Law’s scheme involved investing in the once remote Mississippi river, irrationally attracting investors that created a bubble. Once people found out that Mississippi was just a waste land of insects, disease, swamps, and nothing more, they found out that Law’s confidence on his investments was more of a confidence trick.
Bubbles in history that eventually burst reveal so much about human psychology. No more apparent of this fact than the Great Depression in the United States.
The Great Depression was the worse depression America had ever faced. It was, however, preceded by prosperity in the early goings of the 1920s. Businesses and individuals were experiencing easy credit and unchecked optimism that shot stock prices to record highs. But these stocks were worthless and were valued only by reckless bidding.
And then the market reached its breaking point on October 29, 1929. Prices dropped catastrophically. And between September and December 1929 the total value of stocks dropped from 89.6 billion dollars to 63.5 billion dollars. It reached a record low in 1932 when their market value was only 15.6 billion dollars.
The behavior of people before the crash is simply herd psychology. Like a herd of cows, investors go where the rest goes. In the stock market, this is what is referred to as an irrational exuberance. When one of the cows panic, the rest go on a frenzy, leading to a stampede. Fear erases all irrational thinking.
The epic proportions of deceit and manipulation and outright unethical practices of Enron make it one of the vilified organizations in modern capitalist history. It begins and ends with Jeffrey Skilling and Kenneth Lay. Lay began Enron in 1985 as a natural gas provider, run by engineers and controlled by hard assets. That changed when Skilling came into the picture.
Skilling’s model was taken from the New Economy playbooks. He wiped out layers of management and hundreds of outsiders were taken in to encourage innovation and get rid of tradition-based business. The company abandoned security based salaries and replaced it with high leveraged compensation that offered huge cash bonuses and stock options to their top performers. Eventually, the company would quickly mold a culture of getting rich quick.
It appears simple enough. Enron under Skilling created an atmosphere of market euphoria and arrogance that it trickled down to individuals until it became collective greed.
No one wanted to believe the company was too good to be true. In 2001, cracks began to appear and the truth behind the company unfolded. What regulators found out was that the company used obscure methods to hide its complicated financial health and to cover the fact that its financial performance was deceiving people.
Now we go to the birth of insurance. It is a story that begins with humans determined to secure his person against future risks. The driver of this subject was the catastrophic Hurricane Katrina that laid waste to New Orleans in 2005. What this reveals that even to a seemingly perfect financial solution against risks, there is a limit to its capacity to protect claimants.
Big crises like Katrina and September 11, 2001 attacks cover more damage than private insurers can account for. And so it would not be surprising that insurance companies have become increasingly aloof against sentimental claims of risk, far apart from the origins of insurance.
In Scotland in the 19th century, Scottish ministers became concerned of the welfare of widows of their order, who ended up in the streets after the death of the husband or the father of the family. These ministers would create a system that would become the pattern of modern insurance funds. Today, it has become standard that insurances give the holder the ability to cope up with the risks of the future.
Japan became first country in the world to provide welfare for its citizen, paving the way for the first welfare superpower in the world. Japan’s welfare state became so successful—too successful in fact—that life expectancy in the country became the longest in the world. Not other countries saw the benefit of welfare state.
In Chile, it was different story, the welfare state was struck by stagflation and inflation, causing the government to become unable to meet all claimants of pensions.
Milton Friedman, an American economist from the University of Chicago and later a Nobel Prize laureate in Economics, flew in to the country and met with military dictator president Augusto Pinochet to dismantle the welfare state by giving the leeway for holders to opt out, build up their own capital and form their own personal retirement account through private institutions.
Using Chile as an example, it seems that insurance is imperfect and not the silver bullet against risks.
Future’s contracts, otherwise known as Hedge Funds, approach risk differently. Hedging involves staking a claim in the future to protect from risks absolutely. By creating a contract of the future, any changes of the market—good or bad—will not affect the contractor because he/she is protected by an agreed upon price of a commoddity. Hedge Funds is what Warren Buffet calls financial weapons of mass destruction (Ferugson, 2008) since it has created a enormous number of billionaires.
Safe as Houses
The next segment of Ascent of Money comes the often misunderstood cause of the 2008 Subprime Mortgage crisis. As we’ve learned from Ferguson and from history so far, the ascent of money is primarily dependent on a solid foundation. Get this out of the picture and it will only spell disaster.
The housing crisis disaster is rooted from the economic model of America for the broke. When Reagan signed the deregulation of savings and loans in 1982 and the unrelenting quest for home-ownership by George W. Bush in 2002, subprime loan banks such as Fannie Mae began lending money to NINJA clients (No Income, No Jobs & Assets). These NINJA loans were then financed by the biggest Wall Street banks and securitized them, hiding the bad investments into a cornucopia of other investments to appear as an A-Grade deal. When most of the ninja loaners defaulted, Wall Street buckled and the rest of the world followed.
If anything, the segment revealed that there is no guarantee in houses. In the financial world, safe as houses can be a good bet, but it can also be a spectacular bust.
The truth was a house is just a house—valued as it is. It cannot raise its price through financial alchemy. This is especially true among countries that are now running under property owning democracies.
The United States’ economy is based on debt and their biggest banker has become China. The symbiotic relationship between these two superpowers has fueled financial globalization with one end of the relationship, the United States, acting as a spender, the other, China, as the saver.
Interestingly, the numbers reveal the stark psychological contrast between the Americans and the Chinese. Americans believe that their average income should be $22,000 a year, while the Chinese think it is enough for them to earn $2,000 a year. From this picture, it is the Chinese the funds Americans, not the other way around. Ferguson fears however that the last time such relationship existed was before the Great Wars of the 20th century with Britain and Germany.
China’s spectacular rise was due its strong direct investments from its own citizens, who have saved than spend more than enough. China’s economic growth decoupled it with other superpowers and thereby is not dependent of foreign direct investments. What if China cuts off its credit line to America, Ferguson asked, will this shake the financial world? Will America survive on a mountain of debt it has accumulated for decades? This is a question that would have to wait for the future.
Ferguson, Niall. The Ascent of Money: A Financial History of the World. 2008. BBC.