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September 19 - October 2, 2020
Throughout the history of Western civilization, there has been a recurrent hostility to finance and financiers, rooted in the idea that those who make their living from lending money are somehow parasitical on the ‘real’ economic activities of agriculture and manufacturing. This hostility has three causes. It is partly because debtors have tended to outnumber creditors and the former have seldom felt very well disposed towards the latter. It is partly because financial crises and scandals occur frequently enough to make finance appear to be a cause of poverty rather than prosperity, volatility
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The first is that poverty is not the result of rapacious financiers exploiting the poor. It has much more to do with the lack of financial institutions, with the absence of banks, not their presence.
My second great realization has to do with equality and its absence. If the financial system has a defect, it is that it reflects and magnifies what we human beings are like. As we are learning from a growing volume of research in the field of behavioural finance, money amplifies our tendency to overreact, to swing from exuberance when things are going well to deep depression when they go wrong. Booms and busts are products, at root, of our emotional volatility.
Hunter-gatherers do not trade. They raid. Nor do they save, consuming their food as and when they find it. They therefore have no need of money.
Money, it is conventional to argue, is a medium of exchange, which has the advantage of eliminating inefficiencies of barter; a unit of account, which facilitates valuation and calculation; and a store of value, which allows economic transactions to be conducted over long periods as well as geographical distances. To perform all these functions optimally, money has to be available, affordable, durable, fungible, portable and reliable.
Like King Midas, the Spanish monarchs of the sixteenth century, Charles V and Philip II, found that an abundance of precious metal could be as much a curse as a blessing. The reason? They dug up so much silver to pay for their wars of conquest that the metal itself dramatically declined in value – that is to say, in its purchasing power with respect to other goods. During the so-called ‘price revolution’, which affected all of Europe from the 1540s until the 1640s, the cost of food – which had shown no sustained upward trend for three hundred years – rose markedly. In England (the country for
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What the Spaniards had failed to understand is that the value of precious metal is not absolute. Money is worth only what someone else is willing to give you for it. An increase in its supply will not make a society richer, though it may enrich the government that monopolizes the production of money. Other things being equal, monetary expansion will merely make prices higher.
What the conquistadors failed to understand is that money 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.
They came to be known as bankers (banchieri) because, like the Jews of Venice, they did their business literally seated at benches behind tables in the street.
It was in Stockholm nearly half a century later, with the foundation of the Stockholms Banco in 1657, that this barrier was broken through. Although it performed the same functions as the Dutch Wisselbank, the Banco was also designed to be a Lane-bank, meaning that it engaged in lending as well as facilitating commercial payments. By lending amounts in excess of its metallic reserve, it may be said to have pioneered the practice of what would later be known as fractional reserve banking, exploiting the fact that money left on deposit could profitably be lent out to borrowers.
The ability to walk away from unsustainable debts and start all over again is one of the distinctive quirks of American capitalism. 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
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In other words, banks are not only taking in more deposits; they are lending out a greater proportion of them, and minimizing their capital base.
but banks have evolved since the days of the Medici precisely in order (as the 3rd Lord Rothschild succinctly put it), to ‘facilitate the movement of money from point A, where it is, to point B, where it is needed’.48
James Carville made a remark that has since become famous. ‘I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter,’ he told the Wall Street Journal. ‘But now I want to come back as the bond market. You can intimidate everybody.’
After the creation of credit by banks, the birth of the bond was the second great revolution in the ascent of money. Governments (and large corporations) issue bonds as a way of borrowing money from a broader range of people and institutions than just banks.
First, a large part of the money we put aside for our old age ends up being invested in the bond market. Secondly, because of its huge size, and because big governments are regarded as the most reliable of borrowers, it is the bond market that sets long-term interest rates for the economy as a whole.
‘bond markets have power because they’re the fundamental base for all markets. The cost of credit, the interest rate [on a benchmark bond], ultimately determines the value of stocks, homes, all asset classes.’
Sooner or later the government faces three stark alternatives. Does it default on a part of its debt, fulfilling the bond market’s worst fears? Or, to reassure the bond market, does it cut expenditures in some other area, upsetting voters or vested interests? Or does it try to reduce the deficit by raising taxes?
Inflation is a monetary phenomenon, as Milton Friedman said. 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 effect, stock markets hold hourly referendums on the companies whose shares are traded there: on the quality of their management, on the appeal of their products, on the prospects of their principal markets.
Displacement: Some change in economic circumstances creates new and profitable opportunities for certain companies. Euphoria or overtrading: A feedback process sets in whereby rising expected profits lead to rapid growth in share prices. Mania or bubble: The prospect of easy capital gains attracts first-time investors and swindlers eager to mulct them of their money. Distress: The insiders discern that expected profits cannot possibly justify the now exorbitant price of the shares and begin to take profits by selling. Revulsion or discredit: As share prices fall, the outsiders all stampede for
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Stock market bubbles have three other recurrent features. The first is the role of what is sometimes referred to as asymmetric information. Insiders – those concerned with the management of bubble companies – know much more than the outsiders, whom the insiders want to part from their money. Such asymmetries always exist in business, of course, but in a bubble the insiders exploit them fraudulently.4 The second theme is the role of cross-border capital flows. Bubbles are more likely to occur when capital flows freely from country to country. The seasoned speculator, based in a major financial
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Louis XIV of France had said ‘L’état, c’est moi’: I am the state. John Law could legitimately say ‘L’économie, c’est moi’: I am the economy.
A series of humorously allegorical engravings were produced and published as The Great Scene of Folly, which depicted bare-arsed stockbrokers eating coin and excreting Mississippi stock; demented investors running amok in the rue Quincampoix, before being hauled off to the madhouse; and Law himself, blithely passing by castles in the air in a carriage pulled by two bedraggled Gallic cockerels.70
During the First World War, non-European agricultural and industrial production had expanded. When European production came back on stream after the return of peace, there was chronic over-capacity, which had driven down prices of primary products long before 1929.
The war had also increased the power of organized labour in most combatant countries, making it harder for employers to cut wages in response to price falls. As profit margins were squeezed by rising real wages, firms were forced to lay off workers or risk going bust.
Lay’s big idea, supplied by McKinsey consultant Jeffrey K. Skilling, was to create a kind of Energy Bank, which would act as the intermediary between suppliers and consumers.103
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.6
Appropriately, given our ancestors’ chronic vulnerability, the earliest forms of insurance were probably burial societies, which set aside resources to guarantee a tribe member a decent interment. (Such societies remain the only form of financial institution in some of the poorest parts of East Africa.)
‘Bottomry’ – the insurance of merchant ships’ ‘bottoms’ (hulls) – was where insurance originated as a branch of commerce.
In short, it was not merchants but mathematicians who were the true progenitors of modern insurance. Yet it took clergymen to turn theory into practice.
In other words, the ‘Fund for a Provision for the Widows and Children of the Ministers of the Church of Scotland’ was the first insurance fund to operate on the maximum principle, with capital being accumulated until interest and contributions would suffice to pay the maximum amount of annuities and expenses likely to arise. If
In 1906 the German insurance expert Alfred Manes concisely defined insurance as: An economic institution resting on the principle of mutuality, established for the purpose of supplying a fund, the need for which arises from a chance occurrence whose probability can be estimated.21
A fund that had originally been intended to support the widows of a few hundred clergymen grew steadily to become the general insurance and pension fund we know today as Scottish Widows.
But as the economist Kenneth Arrow long ago pointed out, most of us prefer a gamble that has a 100 per cent chance of a small loss (our annual premium) and a small chance of a large gain (the insurance payout after disaster) to a gamble that has a 100 per cent chance of a small gain (no premiums) but an uncertain chance of a huge loss (no payout after a disaster).
the first system of compulsory state health insurance and old age pensions was introduced not in Britain but in Germany, and it was an example the British took more than twenty years to follow. Nor was it a creation of the Left; rather the opposite. The aim of Otto von Bismarck’s social insurance legislation, as he himself put it in 1880, was ‘to engender in the great mass of the unpropertied the conservative state of mind that springs from the feeling of entitlement to a pension.’ In Bismarck’s view, ‘A man who has a pension for his old age is … much easier to deal with than a man without
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The arguments for state insurance extended beyond mere social equity. First, state insurance could step in where private insurers feared to tread. Second, universal and sometimes compulsory membership removed the need for expensive advertising and sales campaigns. Third, as one leading authority observed in the 1930s, ‘the larger numbers combined should form more stable averages for the statistical experience’.31 State insurance exploited economies of scale, in other words; so why not make it as comprehensive as possible?
In Japan, as in most combatant countries, the lesson was clear: the world was just too dangerous a place for private insurance markets to cope with. (Even in the United States, the federal government took over 90 per cent of the risk for war damage through the War Damage Corporation, one of the most profitable public sector entities in history for the obvious reason that no war damage befell the mainland United States.)36
In Japan egalitarianism was a prized goal of policy, while a culture of social conformism encouraged compliance with the rules. English individualism, by contrast, inclined people cynically to game the system.
According to British conservatives, what had started out as a system of national insurance had degenerated into a system of state handouts and confiscatory taxation which disastrously skewed economic incentives.
The trouble is that property, no matter how much you own, is a security only to the person who lends you money. As Miss Demolines says in Trollope’s Last Chronicle of Barset, ‘the land can’t run away’.* This was why so many nineteenth-century investors – local solicitors, private banks and insurance companies – were attracted to mortgages as a seemingly risk-free investment. By contrast, the borrower’s sole security against the loss of his property to such creditors is his income.
It was part of a system that divided the whole city, in theory by credit-rating, in practice by colour. Segregation, in other words, was not accidental, but a direct consequence of government policy.
the Lower East Side and some so-called colonies on the West Side and 8 Mile – marked with a D and coloured red. The areas marked A, B or C were mainly white. The distinction explains why the practice of giving whole areas a negative credit-rating came to be known as red-lining.26
‘The best way to rob a bank is to own one.’40
There are, however, three other considerations to bear in mind when trying to compare housing with other forms of capital asset. The first is depreciation. Stocks do not wear out and require new roofs; houses do. The second is liquidity. As assets, houses are a great deal more expensive to convert into cash than stocks. The third is volatility. Housing markets since the Second World War have been far less volatile than stock markets (not least because of the transactions costs associated with the real estate market).
De Soto has calculated that the total value of the real estate occupied by the world’s poor amounts to $9.3 trillion.
Remember: it’s not owning property that gives you security; it just gives your creditors security. Real security comes from having a steady income,
And British foreign investment was disproportionately focused on assets that increased London’s political leverage: not only government bonds but also the securities issued to finance the construction of railways, port facilities and mines.
Their preferred mechanism was the structural adjustment programme. And the policies the debtor countries had to adopt became known as the Washington Consensus, a wish-list of ten economic policies that would have gladdened the heart of a British imperial administrator a hundred years before.*
According to Soros’s pet theory of ‘reflexivity’, financial markets cannot be regarded as perfectly efficient, because prices are reflections of the ignorance and biases, often irrational, of millions of investors. ‘Not only do market participants operate with a bias’, Soros argues, ‘but their bias can also influence the course of events. This may create the impression that markets anticipate future developments accurately, but in fact it is not present expectations that correspond to future events but future events that are shaped by present expectations.’70
