By Niall Ferguson, The Penguin Press HC, November 13, 2008, 978-1594201929
The first part of The Ascent of Money is quite excellent. Niall Ferguson explains the history of how money and finance came to be what it is today. Ferguson tells it like it is and was without sugar coating. He writes clearly and well. He speaks about places with authority, because he has done his homework. This book is well researched. I also like the personal connections he makes with the material.
At least, that’s what happened in the first half of the book. Once Ferguson moves to the more direct causes of the crisis of 2008, I find his facts are lacking and his reasoning speculative.
[k470] Jews, too, were not supposed to lend at interest. But there was a convenient get-out clause in the Old Testament book of Deuteronomy: ‘Unto a stranger thou mayest lend upon usury; but unto thy brother thou shalt not lend upon usury.’ In other words, a Jew might legitimately lend to a Christian, though not to another Jew. The price of doing so was social exclusion.
[k801] Since 1898, it has been every American’s right to file for Chapter VII (liquidation) or XIII (voluntary personal reorganization). Rich and poor alike, people in the United States appear to regard bankruptcy as an ‘unalienable right’ almost on a par with ‘life, liberty and the pursuit of happiness’. The theory is that American law exists to encourage entrepreneurship - to facilitate the creation of new businesses. And that means giving people a break when their plans go wrong, even for the second time, thereby allowing the natural-born risk-takers to learn through trial and error until they finally figure out how to make that million.
[k1028] Rothschild family rich - rich enough to build forty-one stately homes all over Europe, among them Waddesdon Manor in Buckinghamshire, which has been restored in all its gilded glory by the 4th Lord Rothschild, Nathan’s great-great-great-grandson. His illustrious forebear, according to Lord Rothschild, was ‘short, fat, obsessive, extremely clever, wholly focused . . . I can’t imagine he would have been a very pleasant person to have dealings with.’ His cousin Evelyn de Rothschild takes a similar view. ‘I think he was very ambitious,’ he says, contemplating Nathan Rothschild’s portrait in the boardroom at the offices of N. M. Rothschild in London’s St Swithin’s Lane, ‘and I think he was very determined. I don’t think he suffered fools lightly.’
[k1045] It was this phenomenal drive, allied to innate financial genius, that propelled Nathan from the obscurity of the Frankfurt Judengasse to mastery of the London bond market. Once again, however, the opportunity for financial innovation was provided by war.
[k1050] Bonaparte. The Battle of Waterloo was the culmination of more than two decades of intermittent conflict between Britain and France. But it was more than a battle between two armies. It was also a contest between rival financial systems: one, the French, which under Napoleon had come to be based on plunder (the taxation of the conquered); the other, the British, based on debt. Never had so many bonds been issued to finance a military conflict. Between 1793 and 1815 the British national debt increased by a factor of three, to GBP 745 million, more than double the annual output of the UK economy.
[k1056] According to a long-standing legend, the Rothschild family owed the first millions of their fortune to Nathan’s successful speculation about the effect of the outcome of the battle on the price of British bonds. In some versions of the story, Nathan witnessed the battle himself, risked a Channel storm to reach London ahead of the official news of Wellington’s victory and, by buying bonds ahead of a huge surge in prices, pocketed between GBP 20 and GBP 135 million. It was a legend the Nazis later did their best to embroider. In 1940 Joseph Goebbels approved the release of Die Rothschilds, which depicts an oleaginous Nathan bribing a French general to ensure the Duke of Wellington’s victory, and then deliberately misreporting the outcome in London in order to precipitate panic selling of British bonds, which he then snaps up at bargain-basement prices. Yet the reality was altogether different. Far from making money from Wellington’s victory, the Rothschilds were very nearly ruined by it. Their fortune was made not because of Waterloo, but despite it.
[k1108] Not so for the Rothschilds. No doubt it was gratifying for Nathan Rothschild to receive the news of Napoleon’s defeat first, thanks to the speed of his couriers, nearly forty-eight hours before Major Henry Percy delivered Wellington’s official despatch to the Cabinet. No matter how early it reached him, however, the news was anything but good from Nathan’s point of view. He had expected nothing as decisive so soon. Now he and his brothers were sitting on top of a pile of cash that nobody needed - to pay for a war that was over. With the coming of peace, the great armies that had fought Napoleon could be disbanded, the coalition of allies dissolved.
[k1114] But there was one possible way out: the Rothschilds could use their gold to make a massive and hugely risky bet on the bond market. On 20 July 1815 the evening edition of the London Courier reported that Nathan had made ‘great purchases of stock’, meaning British government bonds. Nathan’s gamble was that the British victory at Waterloo, and the prospect of a reduction in government borrowing, would send the price of British bonds soaring upwards. Nathan bought more and, as the price of consols duly began to rise, he kept on buying. Despite his brothers’ desperate entreaties to realize profits, Nathan held his nerve for another year. Eventually, in late 1817, with bond prices up more than 40 per cent, he sold. Allowing for the effects on the purchasing power of sterling of inflation and economic growth, his profits were worth around 600 million today. It was one of the most audacious trades in financial history, one wich snatched financial victory from the jaws of Napoleon’s military defeat.
[k1850] According to Law, confidence alone was the basis for public credit; with confidence, banknotes would serve just as well as coins. ‘I have discovered the secret of the philosopher’s stone, he told a friend, ‘it is to make gold out of paper.’ The Duke demurred, saying ‘
[k1847] Considered. His central idea was that the new bank should issue interest-bearing notes that would supplant coins as currency. It was rejected by the parliament shortly before the Act of Union with England. Disappointed by his homeland, Law travelled to Turin and in 1711 secured an audience with Victor Amadeus II, Duke of Savoy. In The Piedmont Memorials, he again made the case for a paper currency. According to Law, confidence alone was the basis for public credit; with confidence, banknotes would serve just as well as coins. ‘I have discovered the secret of the philosopher’s stone, he told a friend, ‘it is to make gold out of paper.’ The Duke demurred, saying ‘I am not rich enough to ruin myself.’
[k2162] First, too little was done to counteract the credit contraction caused by banking failures. This problem had already surfaced several months before the stock market crash, when commercial banks with deposits of more than $80 million suspended payments. However, it reached critical mass in November and December 1930, when 608 banks failed, with deposits totalling $550 million, among them the Bank of United States, which accounted for more than a third of the total deposits lost. The failure of merger talks that might have saved the Bank was a critical moment in the history of the Depression.
[k2168] However, the Fed made matters worse by reducing the amount of credit outstanding (December 1930-April 1931). This forced more and more banks to sell assets in a frantic dash for liquidity, driving down bond prices and worsening the general position.
[k2355] The history of risk management is one long struggle between our vain desire to be financially secure - as secure as, say, a Scottish widow - and the hard reality that there really is no such thing as ‘the future’, singular. There are only multiple, unforeseeable futures, which will never lose their capacity to take us by surprise.
[k2359] In the Westerns I watched as a boy I was fascinated by ghost towns, short-lived settlements that had been left behind by the fast pace of change on the American frontier. It was not until I went to New Orleans in the wake of Hurricane Katrina that I encountered what could very well become America’s first ghost city.
[k2387] ‘Dickie’ Scruggs first hit the headlines in the 1980s, when he represented shipyard workers whose lungs had been fatally damaged by exposure to asbestos, winning a $50 million settlement. But that was small change compared with what he later made the tobacco companies pay: over $200 billion to Mississippi and forty-five other states as compensation for Medicaid costs arising from tobacco-related illnesses. The case (immortalized in the film The Insider) made Scruggs a rich man. His fee in the tobacco class action is said to have been $1.4 billion, or $22,500 for every hour his law firm worked.
[k2414] Total non-insured damages arising from hurricanes in 2005 are likely to end up costing the federal government at least $109 billion in post-disaster assistance and $8 billion in tax relief, nearly three times the estimated insurance losses. According to Naomi Klein, this is symptomatic of a dysfunctional ‘Disaster Capitalism Complex’, which generates private profits for some, but leaves taxpayers to foot the true costs of catastrophe. In the face of such ruinous bills, what is the right way to proceed? When insurance fails, is the only alternative, in effect, to nationalize all natural disasters - creating a huge open-ended liability for governments?
[k2428] The US Army Corps of Engineers described Hurricane Katrina as a 1-in-396 storm, meaning that there is a 0.25 per cent chance of such a large hurricane striking the United States in any given year. A rather different view was taken by the company Risk Management Solutions, which judged a Katrina-sized hurricane to be a once-in-forty-years event just a few weeks before the storm struck. These different assessments indicate that, like earthquakes and wars, hurricanes may belong more in the realm of uncertainty than of risk properly understood. Such probabilities can be calculated with greater precision for most of the other risks that people face mainly because they are more frequent, so statistical patterns are easier to discern.
These statistics seem pretty accurate to me. What I like is the comparison of the forecast and ex facto values for Katrina-like disasters.
[k2434] The equivalent figure for death due to a fire in a building is 1 in 1,358. The odds of the average American being shot to death are 1 in 314. But he or she is even more likely to commit suicide (1 in 119); more likely still to die in a fatal road accident (1 in 78); and most likely of all to die of cancer (1 in 5).
It would be good to know more about the shadow side of the Chilean pension system and more about social conformism. Is Chile more like Japan or Britain? Does it work because the country is small, viz Switzerland?
[k2858] There is a shadow side to the system, to be sure. The administrative and fiscal costs of the system are sometimes said to be too high.
America is unique in many ways, including a high degree of medical innovation and entrepreneurialism. I am not convinced by the jump from Chilean pensions to American healthcare. The two are quite unrelated, because Chile is a small, relatively homogoneous country and the US is neither.
[k2878] But no amount of reform could insulate the system from the ageing of the American population and the spiralling cost of private health care.
These numbers are in stark contrast to actuarials Ferguson provided earlier. You cannot predict the probability of an event happening before anything of its kind has happened. This is why financial disasters like Madoff, Enron, etc. are unpredictable. You can neither predict the scale (bio, nuclear, airplane, …) nor the time/place (Mumbai, London, Oklahoma City, …). What you can know is that something is going to happen, some time, and the Boy Scout’s motto applies at all times.
[k2932] According to Graham Allison, of Harvard University’s Belfer Center, ‘if the US and other governments just keep doing what they are doing today, a nuclear terrorist attack in a major city is more likely than not by 2014’. In the view of Richard Garwin, one of the designers of the hydrogen bomb, there is already a ‘ per cent per year probability of a nuclear explosion with American cities and European cities included’. Another estimate, by Allison’s colleague Matthew Bunn, puts the odds of a nuclear terrorist attack over a ten-year period at 29 per cent.
[k2947] In both cases, the US federal government had to step in to help private insurers meet their commitments, providing emergency federal terrorism insurance in the aftermath of 9/11,
This is another example of a successful government enterprise (earlier Ferguson cited US government insurance during WWII). It’s unreasonable to compare disaster relief the government provides with normal insurance policiies. Insurance is a savings plan, and government operates disaster relief with a pay-as-you-go model which we know does not work. The point of this book thus far seems to have been that you save for rainy days and you use credit when you get an unexpectedly strong storm. Hurricanes in Louisiana occur yearly, and it’s important to save for them like a rainy day.
[k2949] the costs of emergency relief and reconstruction along the coast of the Gulf of Mexico.
Citadel lost 53% in 2008. Citadel limits redemptions, which means Griffen can overcome liquidity problems, unlike the banks which are holding illiquid but possibly viable mortgages. Time is Griffin’s friend and not banks.
[k2957] Among them are many so-called distressed assets, which Griffin picks up from failed companies like Enron for knock-down prices. It would not be too much to say that Ken Griffin loves risk. He lives and breathes uncertainty. Since he began trading convertible bonds from his Harvard undergraduate dormitory, he has feasted on ‘fat tails’. Citadel’s main offshore fund has generated annual returns of 21 per cent since 1998.87 In 2007, when other financial institutions were losing billions in the credit crunch,
It is interesting at this point in the book to see the subprime mortgages explained in great detail 9including their relation to civil rights) and here we aren’t seeing any numbers about the typical leverage being used by hedge funds and banks.
[k3556] Hedge funds in particular had borrowed vast sums from their prime brokers - banks - in order to magnify the returns they could generate. The banks,
Price drops of 2.1% per quarter are fine if you have the time. The problem is that with leverage: you can lose more than you bet. Property is a good bet in general without leverage and given enough time. Stocks were a good bet up until two years ago. Time and liquidity are the factors which affect any investment.
[k3685] Financial illiteracy may be ubiquitous, but somehow we were all experts on one branch of economics: the property market. We all knew that property was a one-way bet. Except that it wasn’t. (In the last quarter of 2007, Glasgow house prices fell by 2.1 per cent. The only consolation was that in Edinburgh they fell by 5.8 per cent.) In cities all over the world,
The only reason to borrow against future earnings is if you have an edge by buying that particular investment. Property is so transparent that there is almost no edge. You borrow money to buy property, because you can, since it is asset-backed. Borrowing to increase a business’s revenues makes sense as long as you can know how that money will affect growth. Mortgages by themselves have no effect on growth.
The other interesting point (below) is that the problem is not that people are buying houses, rather it is that they have stopped saving. Therefore, property as a proportion of US household portfolios is going up due to low savings rates, not just high house prices.
[k3695] Housing, after all, represents two thirds of the typical US household’s portfolio, and a higher proportion in other countries. From Buckinghamshire to Bolivia, the key to financial security should be a properly diversified portfolio of assets. 76 To acquire that we are well advised to borrow in anticipation of future earnings. But we should not be lured into staking everything on a highly leveraged play on the far from risk-free property market. There has to be a sustainable spread between borrowing costs and returns on investment, and a sustainable balance between debt and income.
Here’s an example of unnecessary (and it turns out, incorrect) speculation.
[k3711] There was a time when American crises like these would have plunged the rest of the global financial system into recession, if not depression. Yet at the time of writing Asia seems scarcely affected by the credit crunch in the US. Indeed, some analysts like Jim O’Neill, Head of Global Research at Goldman Sachs, say the rest of the world, led by booming China, is ‘decoupling’ itself from the American economy.
[k4003] There may be a lesson here for our time, too. The first era of financial globalization took at least a generation to achieve. But it was blown apart in a matter of days. And it would take more than two generations to repair the damage done by the guns of August 1914.
[k4075] According to Perkins’s book, The Confessions of an Economic Hit Man, two Latin American leaders, Jaime Roldos Aguilera of Ecuador and Omar Torrijos of Panama, were assassinated in 1981 for opposing what he calls ‘that fraternity of corporate, government, and banking heads whose goal is global empire’. There is, admittedly, something about his story that seems a little odd. It is not as if the United States had lent much money to Ecuador and Panama. In the 1970s the totals were just $96 million and $197 million, less than 0.4 per cent of total US grants and loans. And it is not as if Ecuador and Panama were major customers for the United States. In 1990 they accounted for, respectively, 0.17 per cent and 0.22 per cent of total US exports. Those do not seem like figures worth killing for. As Bob Zoellick puts it, ‘The IMF and the World Bank lend money to countries in crisis, not countries that offer huge opportunities to corporate America.’ Nevertheless, the charge of neo-imperialism refuses to go away. According to Nobel prize-winning economist Joseph Stiglitz, who was chief economist at the World Bank between 1997 and 2000, the IMF in the 1980s not only ‘champion[ed] market supremacy with ideological fervour’ but also ‘took a rather imperialistic view’ of its role. Moreover, Stiglitz argues, ‘many of the policies that the IMF has pushed, in particular premature capital market liberalization, have contributed to global instability . . . Jobs have been systematically destroyed . . . [because] the influx of hot money into and out of the country that so frequently follows after capital market liberalization leaves havoc in its wake . . . Even those countries that have experienced some limited growth have seen the benefits accrue to the well-off, and especially the very well-off.’
Even if it was the OECD what of it? The question is to me should we be loaning money to countries at all? Should it not be left to corporations to invest and reap the rewards of their risk? I can not think ofa single case where the countries who made the loans have profited from them. Certainly corporations have profited from liberaliAtion induced by the loans, but that is precisely my point: let those who bear the risk reap the profits.
[k4090] It was actually the Organization for Economic Cooperation and Development that blazed the liberalizing trail, followed (after the conversion of French socialists like Jacques Delors and Michel Camdessus) by the European Commission and European Council. Indeed, there was arguably a Paris Consensus before there was a Washington Consensus (though in many ways it was building on a much earlier Bonn Consensus in favour of free capital markets). In London, too, Margaret Thatcher’s government pressed ahead with unilateral capital account liberalization without any prompting from the United States. Rather, it was the Reagan administration that followed Thatcher’s lead.
[k4097] Stiglitz’s biggest complaint against the IMF is that it responded the wrong way to the Asian financial crisis of 1997, lending a total of $95 billion to countries in difficulty, but attaching Washington Consensus-style conditions (higher interest rates, smaller government deficits) that actually served to worsen the crisis. It is a view that has been partially echoed by, among others, the economist and columnist Paul Krugman.
[k4108] You seem to believe that when investors are no longer willing to hold a government’s debt, all that needs to be done is to increase the supply and it will sell like hot cakes. We at the - no, make that we on planet Earth - have considerable experience suggesting otherwise. We earthlings have found that when a country in fiscal distress tries to escape by printing more money, inflation rises, often uncontrollably . . . The laws of economics may be different in your part of the gamma quadrant,
[k4176] The success of the Quantum Fund was staggering. If someone had invested $100,000 with Soros when he established his second fund (Double Eagle, the earlier name of Quantum) in 1969 and had reinvested all the dividends, he would have been worth $130 million by 1994, an average annual growth rate of 35 per cent . The essential differences between the old and the new economic hit men were twofold: first, the cold, calculating absence of loyalty to any particular country - the dollar and the pound could both be shorted with impunity; second, the sheer scale of the money the new men had to play with. ‘
This is the essence of my argument about governments. They do not use all the tools at there disposal. Instead of intervening in the liquidity crisis by injecting capital, governments could have fozen time by suspending all CDS transactions. This could have been coordinated by Western governments and simply imposed by fiat. However the people in the current and former administrations are not thinking outside the box. They are using the tools of capital to solve a crisis that can only be resolved by the tools of power (government wields power not capital). This would be a bank holiday for the rich, not the poor.
[k4184] Yet there were limits to the power of the hedge funds. At one level, Soros and his ilk had proved that the markets were mightier than any government or central bank. But that was not the same as saying that the hedge funds could always command the markets.
This is known as table limits, or more practically, capital-at-risk limits.
[k4306] But, as John Maynard Keynes once observed, in a crisis ‘markets can remain irrational longer than you can remain solvent’. In the long term, it might be true that the world would become more like Planet Finance, always coolly logical. Short term, it was still dear old Planet Earth, inhabited by emotional human beings, capable of flipping suddenly from greed to fear.
[k4338] Moreover, there is increasing scepticism that hedge fund returns truly reflect ‘alpha’ (skill of asset management) as opposed to ‘beta’ (general market movements that could be captured with an appropriate mix of indices). An alternative explanation is that, while they exist, hedge funds enrich their managers in a uniquely alluring way. In 2007 George Soros made $2.9 billion, ahead of Ken Griffin of Citadel and James Simons of Renaissance, but behind John Paulson, who earned a staggering $3.7 billion from his bets against subprime mortgages. As John Kay has pointed out, if Warren Buffett had charged investors in Berkshire Hathaway ‘ and 20’, he would have kept for himself $57 billion of the $62 billion his company has made for its shareholders over the past forty-two years. Soros, Griffin and Simons are clearly exceptional fund managers (though surely not more so than Buffett).
[k4347] But a quite mediocre conman could make a good deal of money by setting up a hedge fund, taking $100 million off gullible investors and running the simplest possible strategy: 1. He parks the $100 million in one-year Treasury bills yielding 4 per cent. 2. This then allows him to sell for 10 cents on the dollar 100 million covered options, which will pay out if the S&P 500 falls by more than 20 per cent in the coming year. 3. He takes the $10 million from the sale of the options and buys some more Treasury bills, which enables him to sell another 10 million options, which nets him another $1 million. 4. He then takes a long vacation. 5. At the end of the year the probability is 90 per cent that the S&P 500 has not fallen by 20 per cent,
[k4355] 6. He adds up his earnings - $11 million from the sale of the options plus 4 per cent on the $110 million of T-bills - a handsome return of 15.4 per cent before expenses. 7. He pockets 2 per cent of the funds under management ($2 million) and 20 per cent of the returns above, say, a 4 per cent benchmark, which comes to over $4 million gross. 8. The chances are nearly 60 per cent that the fund will run smoothly on this basis for more than five years without the S&P 500 falling by 20 per cent, in which case he makes $15 million even if no new money comes into his fund, and even without leveraging his positions.
This is a joke. Options are leverage. And, this particular strategy would have yielded huge losses in just a few months after he wrote this. By holding such large positions in a single leveraged investment, he would have forced the same type of “correlation” he pointed out that caused the LTCM debacle.
[k4504] As Frank Knight argued in 1921, ‘Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated . so far different from an unmeasurable one that it is not in effect an uncertainty at all.’ To put it simply, much of what happens in life isn’t like a game of dice. Again and again an event will occur that is ‘so entirely unique that there are no others or not a sufficient number to make it possible to tabulate enough like it to form a basis for any inference of value about any real probability . . .’ The same point was brilliantly expressed by Keynes in 1937. ‘By “uncertain” knowledge,’ he wrote in a response to critics of his General Theory, . . . I do not mean merely to distinguish what is known for certain from what is only probable.
[k4511] The expectation of life is only slightly uncertain. Even the weather is only moderately uncertain. The sense in which I am using the term is that in which the prospect of a European war is uncertain, or . . . the rate of interest twenty years hence . . . About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know.
[k4525] As we have seen, all financial institutions are at the mercy of our innate inclination to veer from euphoria to despondency; our recurrent inability to protect ourselves against ‘tail risk’; our perennial failure to learn from history. In a famous article,
[k4539] Other experiments show that we also succumb too readily to such cognitive traps as: 1. Availability bias, which causes us to base decisions on information that is more readily available in our memories, rather than the data we really need; 2. Hindsight bias, which causes us to attach higher probabilities to events after they have happened (ex post) than we did before they happened (ex ante);
- The problem of induction, which leads us to formulate general rules on the basis of insufficient information; 4. The fallacy of conjunction (or disjunction), which means we tend to overestimate the probability that seven events of 90 per cent probability will all occur, while underestimating the probability that at least one of seven events of 10 per cent probability will occur; 5. Confirmation bias, which inclines us to look for confirming evidence of an initial hypothesis, rather than falsifying evidence that would disprove it; Contamination effects,
[k4549] The affect heuristic, whereby preconceived value-judgements interfere with our assessment of costs and benefits; 8. Scope neglect, which prevents us from proportionately adjusting what we should be willing to sacrifice to avoid harms of different orders of magnitude; Overconfidence in calibration, which leads us to underestimate the confidence intervals within which our estimates will be robust (e.g. to conflate the ‘best case’ scenario with the ‘most probable’); and Bystander apathy, which inclines us to abdicate individual responsibility when in a crowd.
Death is missing in financial systems. There is no ultimate test. Replication in financial systems is not subject to accidental mutation. Changes are by design. This essence of evolution is totally missing from financial systems.
[k4584] A long-run historical analysis of the development of financial services also suggests that evolutionary forces are present in the financial world as much as they are in the natural world.
The meaning of they selfish gene is: unconscious, unintelligent, replication with minute perturbations. Hedge fund operators are good at self-perpetuation through self-promotion, which is not something a gene can do.
[k4626] Broadly speaking, the law of the survival of the fittest applies. Institutions with a ‘selfish gene’ that is good at self-replication and self-perpetuation will tend to proliferate and endure.
Evolution is an all-or-nothing theory. Either the model applies exactly, or it cannot be called evolution, and you cannot rely on the myriad of evidence that backs real evolution.
[k4634] The evolutionary analogy is, admittedly, imperfect.
[k4637] Indeed, because a firm can adapt within its own lifetime to change going on around it, financial evolution (like cultural evolution) may be more Lamarckian than Darwinian in character.
[k4639] Nevertheless, evolution certainly offers a better model for understanding financial change than any other we have.
[k4665] In evolutionary terms, then, the financial services sector appears to have passed through a twenty-year Cambrian explosion, with existing species flourishing and new species increasing in number. As in the natural world,
[k4669] What matters in evolution is not your size or (beyond a certain level) your complexity.
Size matters tremedously. See J. B. S. Haldane’s “On Being the Right Size”.
[k4670] The financial equivalent is being good at generating returns on equity and generating imitators employing a similar business model.
What does he mean by authentically evolutionary?
[k4724] Still, I might equally well have paid homage to Charles Darwin by calling the book The Descent of Finance, for the story I have told is authentically evolutionary.