End of a theory

Print edition : April 09, 2010

Is finance the critical engine of economic growth or the perennial source of instability to the global economy? In this highly topical debate, Niall Ferguson, a renowned British historian, comes to the defence of finance with a brilliantly crafted new book The Ascent of Money, which has also been adapted into a television documentary. The books central proposition is that the ascent of money has been one of the driving forces behind human progress.

Ever since the birth of banking, money has come to include credit also. The world of money expanded further with the emergence of bond markets in the 13th century and of stock markets in the 17th century. Insurance and pension funds first appeared in the 18th century; options and futures made their entry in the 19th; and a market for real estate came to be established by the 20th century. Each of these developments, according to Ferguson, represents successive waves of financial innovation that came as part of an evolutionary process.

As money keeps reinventing itself over time, old empires have toppled and given way to new centres of power. The Incan empire of 16th century Latin America was overpowered by the Spaniards who had understood the monetary potential of silver. For the Incans silver was just a shining, beautiful metal tears of the moon as they called it. The Spaniards minted tonnes and tonnes of silver in Potosi in Upper Peru, in lands conquered from the Incans, employing indigenous Indians and African slaves under extremely harsh conditions. But the metal was produced in such large quantities that the value of silver as money drastically declined, and with it fell the glory of the Spanish empire.

The demise of Spains supremacy of the world was largely because of its failure to catch up with the new wave of financial innovation: banking. Money is not all silver as the Spaniards, blinded by their own success, failed to recognise. Money is also trust underlying credit-debit relations between individuals, upon which stands the institution of banking. Italy and later cities such as Amsterdam, London and Stockholm understood this and they became the new centres of power.

The next stage in the evolution of money is bonds, which are debt papers issued by governments (or large corporations) to raise finances from the public. Originally an instrument of support for Italian states in their internecine warfare in the 13th century, the bond market continued to influence the outcomes of wars and the course of history for several centuries to come. Thus, according to Ferguson, the Battle of Waterloo in 1815, in which the French army under Napolean was defeated by the British, was also a contest between two rival financial systems. Britain ended up on the winning side because its thriving bond market provided financial muzzle to its war efforts. The French, by contrast, had not developed similar debt markets. In the American Civil War, the southern confederates did not have the backing of the bond market and they were defeated. The outcome of the First World War could possibly have been different if the German war machinery had been ably aided by the bond market.

Ferguson concedes that despite its powers to build or break empires, finance has had a chequered history, marked as it has been by ups and downs, bubbles and busts, manias and panics, shocks and crashes. The fickleness of finance and of human behaviour is what is captured in the zigzag moves of stock markets, which also represent the next stage in the ascent of money.

It was the Dutch who invented the idea of a joint stock company as well as of trading of stocks when they set up the United Dutch Chartered East India Company, or VOC, in 1602. During the next 100 years, VOCs share prices rose gradually, by almost eight times, reflecting the companys powerful position in Europes trade with Asia.

The bubble-bust cycles in stock markets are frequently the result of manipulation by fraudulent insiders, be they John Law in 18th century France or Kenneth Lay of Enron in 20th century America. Ferguson argues that the irrational euphoria in stock markets is also due to two other factors. They are hot money flows between financial centres and the actions of monetary authorities such as Alan Greenspan in the 1990s who inject too much liquidity into the economy.

As the tale of money reaches the present times, Ferguson introduces its new power centre as Chimerica, or the wonderful dual country of China and America. An average American is 22 times richer than an average Chinese. Yet capital flows from China to the United States, and it is Chinese savings that fuel American consumption. What explains this anomaly? It arises from Chinas attempts to maintain export competitiveness by avoiding an appreciation of its currency. With this objective, China purchases dollar-denominated bonds in large quantities year after year, and in the process, finances a good part of Americas bulging current account deficits.

According to Ferguson, the arrangement has worked well so far as Chinese imports kept down U.S. inflation; Chinese savings kept down U.S. interest rates; Chinese labour kept down U.S. wage cost.It has also resulted in a lending spree and fed into the global liquidity expansion in the early years of the 21st century. Hedge funds, private equities and the U.S. mortgage market have all exploded. But how long will the good times last? Will the mutually beneficial relations between China and the U.S. mutate into rivalry over political irritants, just as it happened to the relations between Britain and Germany 100 years ago?

The writing of this book was completed in June 2008 but the true extent of the troubles affecting global finance came to light only a few weeks later, in September 2008. Financial innovation, the main driver of economic advance, according to Ferguson, is today a thoroughly discredited term, even while the world economy is showing some signs of recovery. The timing of the book may have been one of its selling points, but there is no denying that Fergusons central thesis about financial innovation is considerably weakened by the turn of events after the books publication. The future is always a difficult territory to tread on, but can we fully sympathise with Fergusons interpretations of the past? Was finance more crucial a variable than trade or technology in igniting the spark for the British and European industrial revolutions?

If finance had been the decisive determinant of industrial success as Ferguson argues, why did the Dutch industrialisation lag behind the British, despite Amsterdam being the leading financial centre of the 17th century world? Eric Hobsbawm, in his magisterial work Industry and Empire (1968), examines the question why industrial revolution first occurred at the end of the 18th century and in Britain. According to him, the spurt for industrial revolution came from the massive expansion in international trade and commerce between West European empires and their overseas colonies during the 18th century. Britain was more successful than other Western powers in expanding its colonies and building the empire, and this indeed led to its emergence as the first industrialised country.

In his two earlier works Empire (2003) and Colossus (2004), Ferguson wrote sympathetically of the British and the U.S. imperial projects respectively. In The Ascent of Money, he expresses the view that Britains imperial expansion went hand in hand with its overseas investments in faraway colonies. Further, Ferguson dismisses the charge of neo-imperialism in the policies of the World Bank and the International Monetary Fund (IMF) towards Third World countries.

On the questions of imperialism and neoliberal economic policies, Ferguson should have engaged in more serious debates, recognising the diverse points of views on these topics.

For instance, with respect to British imperialism in India, scholarly studies have shown that Britains investments in India began only by the middle of the 19th century and that too as part of the imperial expansion project. At the same time, from the mid-18th century, British colonialism resulted in a drain of wealth from India to Britain, and, subsequently, in the destruction of Indian handicraft production and deindustrialisation of India. Similarly, there is a large body of evidence on how the policies of IMF and World Bank have aggravated economic crises in many parts of the Third World, including Latin America in the 1980s and 1990s and East Asia in 1997. Ferguson has not taken any serious notice of such evidence, which does not go well with his main arguments.

Ferguson eulogises the economic reforms in Chile in the 1970s under the military regime of General Pinochet, which was driven by the monetarist ideology espoused by a group of young Chilean economists widely known as Chicago boys. But Ferguson fails to note that these economic policies also resulted in widening inequalities and declining living standards for the majority of the population in that country.

In fact, the book has little to say about the people dispossessed, jobs lost and industries harmed by financial crises that have surfaced time and again in different parts of the world. At the same time, the lives and times of a few individuals who made it big in the world of finance such as the Medici family, Nathan Rothschild, John Lay, and George Soros are all presented in rich and interesting detail. John Lay, the 18th century fraudster, occupies 24 pages of the book. Clearly, the books presentation style is dictated by the demands of the television documentary that was produced along with it, but one wonders whether such a style does full justice to the books sub-title A Financial History of the World.

Notwithstanding its limitations, the books greatest contribution is that it makes the arcane world of money and finance intelligible and interesting to a wide audience.

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