“The Ascent of Money” by Niall Ferguson

In a nutshell

If you are interested in the history of finance, its visionaries and innovators, the financial products whether toxic and otherwise, explanation of financial terms, and how the financial industry through its greed and stupidity almost (at least for now) plunged us into the next Great Depression, read Niall Ferguson’s “Ascent of Money”. (By the way if you enjoy this book and have an even slight liking of history, Ferguson is a historian, and you might also want to read his “War of the World”, essentially a 20^thcentury world history perhaps starting from the late 1800s. A little long, but fascinating perspective, which includes the scary observation that we have been lulled into an illusion of a (relatively) peaceful world due to one of the unusual and longest periods of global peace for over 60 years since WWII.)

The details

Some of the topics covered from a historical perspective are:

-banking evolution from payment facilitation to credit creation to central bank (monopoly on banknote issue, gold standard and convertibility, lender of last resort, deposit insurance, floating exchange rate

-bankruptcy: as an enabler of new business creation, by allowing one to walk away and start over again

-the power of the bond markets, which Pimco’s Gross says is because “they are fundamental for all markets. The cost of credit ultimately determines the price of stocks, homes, all asset classes.”

-bonds, stocks, insurance, and real estate markets and their recent globalization, and why the 2007-2008 crisis was not due to traditional bank lending, but “securitized lending”

-reasons why Germany went into hyperinflation after WWI, whereas London did not (all related to bond market and nature of debt used by each). More importantly, that inflation is a monetary phenomenon (Friedman), but hyperinflation is a political one (essentially a confiscation of assets by the government as it wipes out all internal debt, equivalent to a tax on bondholders and those living on fixed cash income, like pensioners; entrepreneurs were able to adjust prices.) Also explains how Argentina descended into poverty from being one of the wealthiest countries in 1913.

-the stock market as the only discipline imposed on a company (which is a joint stock limited liability entity) which is an hourly referendum on the management, products and prospects of the company

-real total return between 1964-2007 for stock market, bond market and T-Bills was 10.3x, 3.4x and 1.8x respectively, whereas the buying power of $1 dropped $0.15

-the crash of 1929 was due to overcapacity, power of labor, excessive speculation and leverage (we have them all today, except the power of labour)

-the financial markets are modeled by the normal distribution, despite the fact that ‘fat tails’ are a recurring phenomenon

-risk and uncertainty is the certainty of the future; risk management is the struggle for financial security in the realization that the future is unpredictable

-insurance is one of the means of dealing with risk and uncertainty. Americans’ risk of death is one in: 3288 by force of nature, 1358 by fire in a building, 314 being shot to death, 119 by suicide, 78 by fatal accident and 5 by cancer.

-for protection in the past, approaches used were: “saving for a rainy day”, safety in numbers, burial societies, insurance (death, old age, sickness, and accident)

-life insurance started out as a form of gambling; then it was based on probability, life expectancies, certainty, normal distribution of longevity, utility. Life insurance was formalized in Scotland (‘Law of Ann’ and evolved into Scottish Widows company) in the form of an annuity for widows and children of ministers and it was the first insurance fund to operate on the ‘maximum principle (i.e. capital accumulated until interest and contributions are enough to pay the maximum amount of annuities likely to arise)

-in 1906 Alfred Manes defined insurance as an “economic institution resting on the principle of mutuality, established for the principle of supplying a fund, the need for which arises from chance occurrence whose probability can be estimated” (how things have changed in the past 10-20 years, especially since demutualization; perhaps it might be time to look at re-mutualization again)

-insurance premiums today are about 10% of GDP! Britain 12%, US 9%, Germany 6% (the difference is explainable by the protection offered by the welfare state…Ferguson spends considerable time discussing the relevant cultural differences in Germany, Britain, Japan, Sweden, Chile and how/why the welfare state worked in some countries and failed in others) After Allende, Chile was the start of the backlash against the welfare state

-“pay-as-you-go” pension system is really a form of taxation and has “replaced the principle of thrift with the practice of entitlement (Pinera)” and it destroys the link between contributions and benefits, or “effort and reward”. Pinera introduced a radically new pension system (>30 years ago) where a payroll tax was (voluntarily) replaced  with an IRA-like  fund managed by private competing companies and on retirement the individual has the option to take an annuity or cash or continue contributing …it also included life and disability insurance, with each worker setting aside his own capital

-hedging via derivatives is another form of insurance; in 2007 OTC derivative contracts had notional value of $596T and $14.5T market value

-beside insurance and hedging, the third approach is the old fashioned “saving for a rainy day”, which most recently took the form of buying a house with leverage

-houses: in the English speaking world 65-83% of the household own homes they live in; however, “property is a security only to the person who lends you the money…by contract the borrower’s sole security against loss of his property to creditors is his income”!

-after during depression there were 1000 foreclosures/day, Roosevelt’s “new deal” introduced encouragement for “property owning democracy” via agencies to refinance mortgages, FDIC, federally backed mortgage insurance, 20 year amortization on 80% of property value, FNMA, Freddie Mac, GNMA

-Ferguson also covers history of S&Ls (Resolution Trust) to subprime mortgages (in progress today), private mortgage insurance which permitted securitization of mortgages not qualifying for GSE guarantees (by 2007 56% of mortgages were securitized)

-mortgage “innovations”: subprime, jumbo, ARM, interest only, zero down, non-recourse loans, NINJA, RMBS and CDOs transformed risky loans to AAA investment grade with the seal of approval of rating agencies like Moody’s and S&P…and job losses, negative equity and non-recourse loan started driving forecloses and walk-aways leading to Bear Stearns, Northern Rock, etc

-current globalization is not a first; similar has occurred in 30 years leading up to WWI

-Bretton Woods was the post WWII financial architecture, with trade liberalized but capital movements restricted and exchange rates fixed to US$ (not gold)

-1980’s saw emergence of hedge funds in general and Soros-like in particular (Soros called real estate (1969), oil (1972), defense spending (1973), US$ (1985) and British pound (1992). Less successful was LTCM where Nobel prize winner ‘quants’ using  19:1 leverage imploded, because the Nobel prize winners knew lots of  mathematics but not enough history (they didn’t include in their database data going back to 1929 or even 1987! The number of hedge funds still kept growing, because they were able to generate returns with low correlations with other asset classes; however the returns dropped from 18% (1980s) to 7.5% (2000-2006)

-Chimerica (China+America) have world’s 1/10 of land, ¼ of population, 1/3 of economic output, and ½ global growth during past 8 years. US needs $1T borrowing per year and China has surpluses; China currency kept low to generate exports, US imports from and outsources jobs to China…China savings high, whereas US saving low. Chimerica tension is rising: competition for commodities, China inflationary pressures and “there is a fine line between symbiosis and rivalry”. Ferguson asks if we could be leading to a 1914-like breakdown of globalization.

Ferguson concludes with “financial markets are like the mirror of mankind, revealing every hour of every working day the way we value ourselves and the resources around us…it is not the fault of the mirror if it reflects our blemishes as clearly as our beauty”.

(P.S. Thanks to Sol R. for suggesting the book for my reading pleasure)