The Ascent of Money: A Financial History of the World

Citation

Zubair Abbasi, M. (2010), "The Ascent of Money: A Financial History of the World", International Journal of Law and Management, Vol. 52 No. 4, pp. 332-335. https://doi.org/10.1108/17542431011059359

Niall Ferguson's primary aim for writing The Ascent of Money: A Financial History of the World is to educate the general public as substantial number of people in English speaking world is ignorant of finance. After reading this book, I am convinced that Niall has succeeded in achieving his aim. Although the book deals with the complexities of finance involving subtle theories and intricate techniques, some chapters bear the magnetic spell of a suspense novel as the history of the rise of banks, bonds and stock markets, joint‐stock and insurance companies, and hedge funds unfolds itself.

Niall, who is a history professor at Harvard University, draws three major conclusions from his study of the financial history of the world. First, poverty is not the result of “rapacious financiers exploiting the poor” rather it is because of the lack of financial institutions – “the absence of banks, not their presence”. Banks can channel money from the idle rich to the hardworking poor. To strengthen his argument, Niall cites the example of micro finance, which has enabled millions of poor of the poorest (especially housewives) to get rid of their poverty. Second, financially knowledgeable are disproportionately rewarded against “unlucky and not‐so‐smart” illiterates. This knowledge gap creates huge differences because of human tendency to overreact at ups and downs in markets. Thus, the financial booms and busts are a product of “emotional volatility”. Third, it is virtually impossible to predict financial crisis because of genuine complexity. However, financial history looks like a classic case of evolution where some financial techniques survive and the other perish. As in natural world survival of the fittest is the rule likewise in financial world species of financial instruments and types of firms appear and extinct by way of natural selection.

The evolutionary paradigm for understanding the financial history of the world is further elaborated in the last chapter of the book. Niall asserts that evolutionary economics is a well‐established sub‐discipline. However, through out the book, he adopts a narrative style and does not analyse the impact of historical developments in terms of evolution. As Niall believes that the ascent of money in the world is evolutionary, it should have been appropriate had he analysed the historical developments under this paradigm. A general reading of his book reveals that although the evolutionary paradigm is helpful in analysing the financial history at a very general level, we still need other paradigms to understand certain phenomenon as Niall regards Milton Friedman and Anna Schwartz's analysis of the Great Depression of 1929 as “the most important work of American economic history ever published”. This work does not view the financial crisis of 1929 in terms of survival of institutional species by way of natural selection rather it is the Federal Reserve System that is blamed for the crisis. Second, Niall admits the key difference in nature and finance as financial evolution occurs within a regulatory framework where “intelligent design” plays a vital role. Therefore, his suggestion in the wake of current credit crisis that the weak institutions should be allowed to be eliminated and possibility of their extinction should not be removed by precautionary rules does not seem proper. The fact is that the law has always been chasing the financial innovations and a regulation has quite often succeeded rather than preceded the economic crisis. The Enron debacle and current credit crisis show that such events result from the failure of effective regulation. The financial crises have more or less been caused by unregulated innovations in the financial markets. The Dutch East India Company and the Dutch financial system worked effectively and did not face the busting of bubbles as was the case in France and England. In France, the system was destined to fall as John Law was running the whole economic system. Niall compares the total fall of French economic system with the busting of South Sea Company, which did not cause the collapse of English economy as the Bank of England was not implicated in the bubble of South Sea Company.

Niall writes that the ascent of money is related with the rise of civilisation as the savage hunters do not need money because they never trade nor do they save, consuming their food when they find it. “The evolution of credit and debt was as important as any technological innovation in the rise of civilisation, from ancient Babylon to present‐day Hong Kong. Banks and the bond market provided the material basis for the splendour of the Italian Renaissance. Corporate finance was the indispensable foundation of both the Dutch and British empires, just as the triumph of the USA in the twentieth century was inseparable from advances in insurance, mortgage finance and consumer credit. Perhaps, too, it will be a financial crisis that signals the twilight of American global primacy.” (p. 3).

Niall then raises the question: what is money? He explains that it is a medium of exchange, which replaces the deficiencies of barter; a unit of account which facilitates valuation and calculation; and a store of value that facilitates economic transactions over long periods of time and geographical distances. To perform all these functions optimally, money has to be available, affordable, durable, fungible, portable, and reliable. Metals such as gold, silver, and bronze fulfilled all these requirements and served as money for centuries before being replaced by paper money. However, historical experience reveals that the metal is not the money in fact. That is, one reason that has given rise to phenomenal “resource curse” which has inflicted the countries with large natural resources, diminishing the incentives for productive economic activity, and strengthening the hands of rent‐seeking autocrats. Money in fact is a

matter of belief, even faith: belief in the person paying us; belief in the person issuing the money he uses or the institution that honours his cheques or transfers. Money is not metal. It is trust inscribed: on silver, on clay, on paper, on a liquid crystal display… (p. 30).

Niall observes that the banks played an important role in the evolution of money by institutionalising the practice of lending and borrowing. At the same time, negotiable instruments like bills of exchange were also invented. The origin of credit is traced in ancient Mesopotamia; however, the banks originated in the Europe of late fourteenth century with the rise of Medici Bank. But the most important feature of banks is credit creation by holding a small amount of deposit and lending the bigger chunk to its customers. It transformed the concept of money, which now represented the sum total of specific assets and liabilities of the banks. With just $100 the banks can create a credit worth thousands of dollars by simply reserving a portion of original amount and lending the rest to multiple borrowers. The source of banking profits lies in maximising the difference between the costs of their liabilities and the earnings on their assets. This is where the confidence of depositors in banks becomes vital because a crisis of confidence might have triggered the run for withdrawal of deposits and failure of banks which reserve only a portion of their deposits in liquid form.

Thus, answer to the first question of the book “when did money stop being metal and mutate into paper, before vanishing altogether?” is that with the advent of banks, which facilitate the flow of money from, where it is, to, where it is needed. The practice of credit and debt is essential for economic development as much as industry and production. And the whole superstructure of banking system based on money relies upon the confidence and trust of general public in the financial system itself and its capacity to not only maintain this confidence but also to innovate such techniques which may reduce risk.

The birth of bond markets is the second milestone in the ascent of money after the creation of credit by banks. Both the governments and large corporations issue bonds in order to raise capital from the general public. Since the borrower is liable to pay not only the original amount but also interest, it gives the lender upper hand. Thus the bond markets which assist the government borrowing have the potential to dictate it in times of crisis. However, historically when it comes to repayments the governments have been the poor debtors, frequently defaulting causing the fall of creditors. Still the success of the governments depended on their ability to finance the wars through congenial relationship with the bankers as was the case of British government's dependence on Jewish Rothschild family to finance its war against Napoleon Bonaparte and by effectively benefiting from the bond markets without falling into the traps of inflation as was the case in American Civil War where hyperinflation preceded the military fall of the South. But complete repayments of debts has scarcely been in the scheme of most governments as some states like Argentina and pre‐WWII Germany survived several defaults. Therefore, it is hard to say that the bond markets rule the world by setting long‐term interest rates. However, the price of default can be quite high for a developing country which may lead it into the clutches of IMF where the government's monetary policy in fact is dictated by the donors.

What is the role played by central banks in stock market bubbles and busts? Is the third thesis question of the book. Thus the writer introduces us with the third stage of ascent of money: the rise of limited liability joint‐stock company, which pooled up large resources for risky and long‐term projects. The joint‐stock companies were financed through stock markets where the shareholders held the shares. The share prices are determined by the prospects of profitability of the companies and stock markets assess their quality of management and success on hourly basis. The investors, who inject their money in the markets in the hope of earning profits, are ordinary human beings and substantial asymmetries of information exist among them. The outsiders are often misled by the insiders about the future prospects of companies, it gives rise to booms and busts. Since the prices of stocks rise only upon the basis of future profitability, it allures so many people, a great number of whom take loan in the hope of getting their money manifolds. This is where a link is created between the market bubbles and credit creation.

The Federal Reserve System is regarded to bear the primary responsibility for the Great Depression of 1929 as it failed to control the credit contraction caused by banking failure. It was the inept and inflexible monetary policy in the wake of a sharp decline in asset prices that turned a market correction into a recession and a recession into a depression. History repeated itself once again when Enron bubble busted in the wake of 9/11. The career of Enron CEO, Kenneth Lay bears close resemblance with that of John Law. Law had attempted to make gold out of paper and Lay tried to carve gold out of gas. Under Lay, the small gas company became the fourth largest USA Company in less than a decade thanks to his political connections with Bush family, which facilitated deregulation. However, soon it was realised that the company was not the worth investors' expectations and its share which was about to hit $100 in the mid of 2001 remained just 30 cents at the end of the year.

It leads us towards the next stage of financial system. If investment in financial markets is fraught with so many hazards, do we have a protection against it? Insurance is regarded as a mechanism for protection against risk. However, it is not the only protective measure against risk. The welfare state is the biggest protector against risks. Other mechanisms include hedging by mutual funds which use derivatives to distribute risk but only a few people have access to it. Real estate, especially houses are considered as safe investment. It was the idea of securitisation which revolutionised the American finance by converting mortgages into bonds. Thousands of mortgages were bundled up together as the backing for new and alluring securities that could be sold as alternatives to traditional government and corporate bonds. The interest payments due on the mortgages could also be subdivided into “strips” with different maturities and credit risks. Subprime mortgage loans were granted to the families and neighbourhoods with poor credit histories. In order to qualify for a loan you did not need to have a property or job. The local lenders sold these loans in bulk to Wall Street banks. The banks bundled the loans into high‐yielding residential mortgage‐backed securities and sold them on to investors around the world. Repackaged as collateralised debt obligations, the risk associated with subprime securities was spread all over the globe from institutional investors to town councils. Therefore, when the subprime butterfly flapped its wings, it triggered a global storm.

Historical evidence exhibits that the real security comes from having a steady income. The success of microfinance all over the world proves this fact as the poor women have proved themselves better debtor even without collateral.

Since economic stability is pegged to political stability, the final question of the book is: Is the economic inter‐dependence of China and America the key to global financial stability, or a mere chimera? To find its answer, Niall explores the financial history of rising economic giant China and also analyses the economic causes and consequences of WWI. He draws three, rather disturbing, lessons from financial history: major wars can arise even when economic globalisation is very far advanced and the hegemonic position of an English‐speaking empire seems fairly secure; the longer the world goes without a major conflict, the harder one becomes to imagine; and when a crisis strikes complacent investors it causes much more destruction than when it strikes battle‐scared one.

Before reading this book, I had never imagined that finance can be that interesting as Niall has made it. He has managed to capture the major historical events of the world by raising six major questions, each dealt with in a separate chapter. The subtitle of the book is: A Financial History of the World. Niall, however, has not taken into account the financial developments in medieval India and the Middle East. The whole continent of Africa does not even rate a passing comment. It might be because his target audience are in the English‐speaking world. It is partially the reason why he did not mention Islamic finance, which is presented as an alternate to conventional finance because the credit creation under Islamic finance does not put all risk upon one party.