The Ascent of Money

We have always believed that history—and particularly economic and market history—tends to follow long cycles. For this reason we find a lot of value in reading economic history books. One well-researched economic history book can add clarity that can get lost in the daily barrage of newspaper and magazine articles. The problem is that many are mind-numbingly dry or, like Charles Mackey’s classic Extraordinary Popular Delusions and the Madness of Crowds, written in an English vocabulary from the Victorian period and incredible dense to read.

Once in a while, you find a real gem that is both insightful and eminently readable. We would put Niall Ferguson’s recent book in that category. The Ascent of Money: A Financial History of the World is exactly what it claims to be. It is a comprehensive history of the development and rise of the financial industry and its impact on the world. As Ferguson writes,

Behind each great historical phenomenon there lies a financial secret, and this book sets out to illuminate the most important of these. For example, the Renaissance created a boom in the market for art and architecture because Italian bankers like the Medici made fortunes by applying Oriental mathematics to money [starting as far back as 1202 with the publication of Fibonacci’s Liber Abaci and climaxing in the high Renaissance of the 1500s].

The Dutch Republic prevailed over the Habsburg Empire because having the world’s first modern stock market was financially preferable to having the world’s biggest silver mine [in the Dutch independence wars from 1568-1648]. The problems of the French monarchy could not be resolved without a revolution because a convicted Scots murderer had wrecked the French financial system by unleashing the first stock market bubble and bust [in 1719-1720]. It was Nathan Rothschild [and his bond trading] as much as the Duke of Wellington who defeated Napoleon at Waterloo [in 1815]. [See “Sorting Though the Rubble in Spain” for the SIL’s comments on Rothschild.]

Financial history is a long recurring cycle in which power shifts alternatively from creditors to debtors. The same can be said of the cyclical nature of the reputation of financiers. During boom times, “masters of the universe” are viewed as virtual gods and as the bringers of bountiful prosperity, but during busts—as the present Federal suit against Goldman Sachs attests—they are vilified and hunted down.

In his study of financial bubbles over the centuries, Ferguson identifies five typical stages :

1. Displacement: Some change in economic circumstances creates new and profitable opportunities for certain companies.
2. Euphoria or overtrading: A feedback process sets in whereby rising expected profits lead to rapid growth in share prices.
3. Mania or bubble: The prospect of easy capital gains attracts first-time investors and swindlers eager to mulct them of their money.
4. Distress: The insiders discern that expected profits cannot possibly justify the now exorbitant price of the shares and begin to take profits by selling.
5. Revulsion or discredit: As share prices fall, the outsiders all stampede for the exits, causing the bubble to burst altogether

Though the focus of this analysis was the stock market, the same insights would hold true in the most recent housing and mortgage bubble and burst. “Revulsion” and “discredit” are words that aptly describe public views of investment real estate, mortgage lending, and the financial sector in general.

Of course, it could be worse. The boom and subsequent bust that has caused so much misery today is nothing compared to those that afflicted France in the early 1700s. After decades of warfare under Louis XIV, the French crown was burdened by an unmanageable debt load. The French government found itself at risk of bankruptcy—for the third time in less than a century.

Desperate times called for desperate measures, and the French crown turned to a smooth-talking Scottish gambler by the name of John Law for a solution. His plan—later called the Mississippi Land Scheme—brought a temporary boom to France, but the aftermath was years of economic contraction, deflation, and a general feeling of mistrust towards financiers that arguably persists in France to this day.

Though his newly chartered bank, the Banque Générale (which would eventually evolve in the France’s first central bank, the Banque Royale), Law would monetize the debts of the French crown, using government debt to provide the bulk of the bank’s capital base. The bank issued paper banknotes which were declared to be legal tender, thus creating a surge in the money supply—and an inflationary boom in the process.

Much of newly created money went directly into the shares of the second part of Law’s scheme, the Company of the West (later called the Mississippi Company). The Mississippi Company was France’s answer to the Dutch East India Company, but with one critical difference: the Dutch company actually had profitable trading routes. The French trading company had the mosquito-infested swamp we today call Louisiana and little else.

In addition to accepting cash, Law allowed investors to trade in their existing French government bonds for shares in the new company; a rather creative way to retire outstanding debts. But the true excesses were yet to come.

Law’s central bank allowed investors to borrow money at low interest rates using their Mississippi shares as collateral. This would be like the Federal Reserve lending you money directly to buy shares of a new, unproven technology start-up company…using your existing shares of the company as collateral, creating something of a self-contained Ponzi scheme of sorts. (Our own recent excesses in the mortgage markets, in which government-sponsored entities like Fannie Mae and Freddie Mac provided almost unlimited capital for additional mortgage loans on increasingly generous terms shows that, as the French say, “Plus ça change, plus c’est la même chose.”)

Not surprisingly, speculative mania swept the country, sending the value of Mississippi shares up by a factor of 19.6 (making the 1990s Nasdaq bubble look mild in comparison).

When the bubble finally burst, the loss of wealth—which had been illusory, having been created by financial alchemy—proved to be catastrophic for France. The collapse of the Mississippi Company and the Banque Royale wiped out much of the aristocracy and middle classes. But, as Ferguson writes, “The losses to France, however, were more than just financial. Law’s bubble and bust fatally set back France’s financial development, putting Frenchmen off paper money and stock markets for generations.” Furthermore, the French crown was weakened and thoroughly discredited, making the bloody French Revolution possible before the end of the century.

Furthermore, the crash brought with it a period of prolonged deflation. And this is the most important point that we would take from Ferguson’s book. Niall Ferguson is one of the few economic commentators that shares our view that deflation—not inflation—will be the threat going forward. The end result of all bubbles is a prolonged period of deflationary weakness in which the excesses of the boom are worked off. In the wake of the Internet bubble and bust we did not see large-scale consumer or producer price deflation, but we did see severe deflation in the areas most directly affected. As Thomas Friedman explained in The World Is Flat, the massive price deflation in fiber optic communications is what make the boom in Indian outsourcing possible.

So, while we would expect continued deflation in the housing sector for years to come, there will likely be some residual benefits. The oversupply of housing will mean that young families in the years ahead will get phenomenal bargains on their homes, values perhaps not enjoyed in a generation.

As the history of bubbles has proven, it is deflation that accompanies a bust, not inflation. And the broader the scope of the bubble, the more likely it is that deflation spreads to consumer prices in general.