The Ascent of Money

An excellent book. A must read for those in the financial field whether as a teacher or advisor. As a side note: I have been simultaneously reading "Great Irish Tales of Horror". There must be some Freudian significane to that! I will not be putting any notes on the blog for that kind of book as I seldom take notes for such a genre.

Niall Ferguson, “The Ascent Of Money” (A Financial History of The World), The Penguin Press, 2008, 358 Pages

The author is one of Britain’s most renowned historians. He teaches at Harvard University, Oxford, and Stanford. He also writes regularly for newspapers and magazines all over the world. He has written four other books concerning financial topics.

In The Ascent of Money, Ferguson shows that finance is in fact the foundation of human progress. He goes on to reveal financial history as the essential backstory behind all history. The evolution of credit and debt was as important as any technological innovation in the rise of civilization. And the most important lesson of financial history is that sooner or later every bubble bursts—sooner or later the bearish sellers outnumber the bullish buyers, sooner or later greed flips into fear. This book came out in May 2008, just before the investment banks started failing.

Pg. 5: In 1947 the total value added by the financial sector to US gross domestic product was 2.3%; by 2005 its contribution had risen to 7.7% of GDP. In other words, approximately $1 of every $13 paid to employees in the US now goes to people working in finance. Finance is even more important in Britain, where it accounted for 9.4% of GDP in 2006.

Pg. 10: One purpose of this book is to educate. It is a well established fact that a substantial proportion of the general public in the English-speaking world is ignorant of finance. According to one 2007 survey, four in ten American credit card holders do not pay the full amount due every month on the card they use most often, despite the punitively high interest rates charged by credit card companies. (29% said they had no idea what the interest rate on their card was). Two thirds of Americans do not know how compound interest works. Fully 59% of graduating seniors did not know the difference between a company pension, Social Security and a 401(k) plan.

Pg. 13: The author while writing this book found three insights in particular that stand out: 1). 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. Only when borrowers have access to efficient credit networks can they escape from the clutches of loan sharks, and only when savers can deposit their money in reliable banks can it be channeled from the idle rich to the industrious poor. This point applies not just to the poor countries of the world. It can also be said of the poorest neighborhoods in supposedly developed countries.
2). Second insight has to do with equality and its absence. The financial system reflects and magnifies what we human beings are like. As we are learning from a growing volume of research in the field of behavioral finance, money amplifies our tendency to overreact, to swing from exuberance when things are going well to deep depression when they go wrong. The rewards for ‘getting it’ have never been so immense. And the penalties for financial ignorance have never been so stiff.
3). Third, and last, few things are harder to predict accurately than the timing and magnitude of financial crises. So many of the relationships within finance are non-linear, even chaotic. Financial history looks like a classic case of evolution in action, albeit in a much tighter time-frame than evolution in the natural world.

Pg. 29: Today’s electronic money can be moved from our employer, to our bank account, to our favorite retail outlets without ever physically materializing. It is this ‘virtual’ money that now dominates what economists call the money supply. Cash in the hands of ordinary Americans accounts for just 11% of the monetary measure known as M2. The intangible character of most money today is perhaps the best evidence of its true nature. 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 honors his checks or transfers. Money is not metal. It is trust inscribed. And it does not seem to matter much where it is inscribed: on silver, on clay, on paper, on a liquid crystal display.

Pg. 49: To understand three modern currency concepts, MBA students at Harvard play a simplified money game. It begins with a notional central bank paying the professor $100 on behalf of the government, for which he has allegedly done some work. The professor takes the banknotes to a bank notionally operated by one of his students and deposits them there, receiving a deposit slip. Assuming, for the sake of simplicity, that this bank operates a 10% reserve ratio (that is, it wishes to maintain the ratio of its reserves to its total liabilities at 10%), it deposits $10 with the central bank and lends the other $90 to one of its clients. While the client decides what to do with his loan, he deposits the money in another bank. This bank also has a 10% reserve rule, so it deposits $9 at the central bank and lends out the remaining $81 to another of its client. After several more rounds, the professor asks the class to compute the increase in the supply of money. This allows him to introduce two of the core definitions of modern monetary theory: Mo (also known as the monetary base or high-powered money), which is equal to the total liabilities of the central bank, that is, cash plus the reserves of private sector banks on deposit at the central bank; and M1 (also known as narrow money), which is equal to cash in circulation plus demand or ‘sight’ deposits. By the time money has been deposited at three different student banks, Mo is equal to $100 but M1 is equal to $271 ($100 + $90 + $81), neatly illustrating how modern fractional reserve banking allows the creation of credit and hence of money.
The professor then springs a surprise on the first student by asking for his $100 back. The student has to draw on his reserves and call in his loan to the second student, setting of a domino effect that causes M1 to contract as swiftly as it expanded. This illustrates the danger of a bank run. Since the first bank had only one depositor, his attempted withdrawal constituted a call ten times larger than its reserves. The survival of the first banker clearly depended on his being able to call in the loan he had made to his client, who in turn had to withdraw all of his deposit from the second bank, and so on. When making their loans, the bankers should have thought more carefully about how easily they could call back the money—essentially a question about the liquidity of the loan.

Pg. 64: The evolution of banking was the essential first step in the ascent of money. The financial crisis that began in August 2007 had relatively little to do with traditional bank lending or, indeed, with bankruptcies, which (because of a legal change) actually declined in 2007. Its prime cause was the rise and fall of ‘securitized lending’, which allowed banks to originate loans but then repackage and sell them. And that was only possible because the rise of banks was followed by the ascent of the second great pillar of the modern financial system: the bond market. The third pillar was the rise of the joint-stock, limited-liability corporation: joint stock because the company’s capital was jointly owned by multiple investors; limited-liability because the separate existence of the company as a legal ‘person’ protected the investors from losing all their wealth if the venture failed. Their liability was limited to the money invested.

Pg. 118: The Clinton administration had actually controlled the budget and was running a surplus. Since Bush entered the White House, his administration has run a budget deficit in seven out of eight years. The federal debt has increased from $5 trillion to more than $9 trillion.

Pg. 163: From the collective efforts of economists to understand the cause(s) of the great depression, the most important lesson derived is that inept or inflexible monetary policy in the wake of a sharp decline in asset prices can turn a correction into a recession and a recession into a depression.

Pg. 165: The stock market does not fluctuate like a bell curve (normal distribution). If stock market movements followed the normal distribution, like human heights, an annual drop of 10% or more would happen only once every 500 years, whereas it actually happens about once every five years. Stock market plunges of 20% or more would be unheard of—rather like people just a foot tall—yet there have been nine such crashes in the past century.

Pg. 241: Home Owning. Before the 1930’s, little more than two fifths of American households were owner-occupiers. Unless you were a farmer, mortgages were the exception, not the rule. The few people who did borrow money to buy their own houses in the 1920’s found themselves in deep difficulties when the Great Depression struck. Mortgages were short-term, usually for three to five years, and they were not amortized. Instead you had a balloon payment at the end of the three or five year period. When the economy nosedived, nervous lenders simply refused to renew the loan. In 1932 and 1933 there were over a half million foreclosures. By mid 1933, over a thousand mortgages were being foreclosed every day. House prices plummeted by more than a fifth. Land in the countryside lost one-half its value.

Pg. 246: Roosevelt structured portions of the New Deal to pioneer the idea of a property-owning democracy as an antidote to a red revolution. A new Home Owners’ Loan Corporation stepped in to refinance mortgages on longer terms, up to fifteen years. A Federal Home Loan Bank Board was set up in 1932 to encourage and oversee local mortgage lenders known as Savings and Loans. Roosevelt then introduced the FDIC; in theory this would stop any future bank runs (and it did).

Pg. 248: The FHA reinvented the mortgage market by providing federally backed insurance for mortgage lenders covering up to 80% of the purchase price on twenty-year mortgages (no longer 3 to 5 years). With the US government now effectively underwriting the mortgage market, property ownership--and mortgage debt--soared after WWII driving up the home ownership rate from 40% to 60% by 1960.

Pg. 250: In the wake of the Civil Rights legislation of the 1960’s, new steps were taken to broaden access to home ownership. In 1968 Fannie Mae was split in two: the Government National Mortgage Association (Ginnie Mae), which was to cater to poor borrowers like military veterans, and a rechartered Fannie Mae, now a privately owned government sponsored enterprise (GSE), which was permitted to buy conventional as well as government guaranteed mortgages. Two years later, to provide some competition in the secondary market, the Federal Home Loan Mortgage Corporation (Freddie Mac) was set up.

Pg. 254: Savings and Loan business under threat. S&L’s had deposits up to $40,000 fully insured and there was a 5.5% ceiling on deposit rates, a quarter of a per cent more than banks were allowed to pay. In the late 1970’s, this sleepy sector was hit first by double-digit inflation—which reached 13.3%in 1979—and then by sharply rising interest rates as Federal Reserve Chairman Paul Volcker sought to break the wage-price spiral by slowing monetary growth. This double punch was lethal. The S&Ls were simultaneously losing money on long-term fixed-rate mortgages, because of inflation, and losing deposits to higher interest money market funds. The response in Washington from both the Carter and Reagan administrations was to try to salvage the entire sector with tax breaks and deregulation, in the belief that market forces could solve the problem. S&L’s could now invest in whatever they liked, not just long-term mortgages. Commercial property, stocks, junk bonds, credit cards: anything was allowed. They could pay depositors whatever interest rate they liked. Deposits up to $100K were now covered by government insurance. It appeared the best way to rob a bank now was to own a S&L.

Pg. 259: For American taxpayers, the S&L debacle was a hugely expensive lesson in the perils of ill-considered deregulation. The dust was not yet settled when a group of investment bankers at Salomon’s saw new opportunities from the S&L mess. The idea was to reinvent mortgages by bundling thousands of them together as the backing for new and alluring securities that could be sold as alternatives to traditional government and corporate bonds—in short, to convert mortgages into bonds. Once lumped together, the interest payments due on the mortgages could be subdivided into ‘strips’ with different maturities and credit risks. The first issue of this new kind of mortgage-backed security (known as a collateralized mortgage obligation “CDO”) happened in June 1983.
The process was called securitization and once again the federal government stood ready to pick up the tab in a crisis. The majority of mortgages continued to enjoy an implicit guarantee from the government-sponsored trio of Fannie, Freddie or Ginnie, meaning that bonds which used those mortgages as collateral could be represented as virtually government bonds, and hence ‘investment grade’. Between 1980 and 2007 the volume of such GSE-backed mortgage-backed securities grew from $200 million to $4 trillion. With the advent of private bond insurers, firms like Salomon could also offer to securitize so-called non-conforming loans not eligible for GSE guarantees. Once there had been meaningful social ties between mortgage lenders and borrowers, no more. Twenty years later the implications of this separation would become apparent.

Pg. 266: Between 1997 and 2006, US consumers withdrew an estimated $9 trillion in cash from the equity in their homes. By the first quarter of 2006 home equity extraction accounted for nearly 10% of disposable personal income.
Hedge Funds: the term was first used in 1966 to describe the long-short fund set up by Alfred Winslow Jones in 1949 (which took both long and shor positions on the US stock market), most hedge funds have been limited liability partnerships. As such they have been exdempted from the provisions of the 1933 Securities Act and the 1940 Investment Company Act, which restrict the operations of mutual funds and investment banks with respect to leverage and short selling. Like the rise of China, the even more rapid rise of the hedge funds has been one of the biggest changes the global economy has witnessed since WWII.
George Soros is probably the most successful Hedge Fund manager. According to Soro’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. It is the feedback effect—as investors’ biases affect market outcomes, which in turn change investors’ biases, which again affect market outcomes—that Soros calls reflexivity.

Pg. 316: Originally devised to hedge against market risk with short positions, a hedge fund provided the perfect vehicle for Soros to exploit his insights about reflexive markets. Soros know how to make money from long positions too. In 1969 he was long real estate. Three years later he backed bank stocks to take off. He was long Japan in 1971. He was long oil in 1972. A year later, when these bets were already paying off, he deduced from Israeli complaints bout the quality of US supplied hardware in the Yom Kippur War that there would need to be some heavy investment in America’s defense industries. So he went long defense stocks too. Right, right, right, right and right again. But Soros’s biggest coups came from being right about losers, not winners: for example, the telegraph company Western Union in 1985, as fax technology threatened to destroy its business, as well as the US dollar, which duly plunged after the Group of Five’s Plaza accord of September 1985. But the greatest of all his shorts was shorting the British currency.
Soros reasoned that the rising costs of German reunification would drive up interst rates and hence the Deutschmark. This would make the Conservative government’s policy of shadowing the German currency—formalized when Britain had joined the European Exchange Rate Mechanism (ERM) in 1990—untenable. As interest rates rose, the British economy would tank. Sooner or later, the government would be forced to withdraw from the ERM and devalue the pound. So sure was Soros that the pound would drop that he ultimately bet $10 billion in transactions which shorted the pound. His fund made more than 1 billion dollars in 1992. George Soros instincts seemed unbeatable. But what if instincts could be replaced by mathematics.
This leads us to the next fiasco: the 1998 LTCM debacle.

Pg. 320: Imagine another planet without all the complicating frictions caused by subjective, sometimes irrational human beings. One where the inhabitants were omniscient and perfectly rational; where they instantly absorbed all new information and used it to maximize profits; where they never stopped trading; where markets were continuous, frictionless and completely liquid. Financial market on this planet would follow a ‘random walk’. The returns on the planet’s stock market would be normally distributed; a six standard deviation sell-off would be about as common as a person shorter than one and a half feet in our world. It would happen only once in four million years of trading. This was the planet imagined by some of the most brilliant financial economists of modern times. Their formula is referred to as the Black Scholes model of options. In October 1997, as if to prove that LTCM really was the ultimate Brains Trust, Merton and Scholes were awarded the Nobel Prize in economics. Many things began to shake up this world but the Russian currency default did it in for good. The Federal Reserve Bank of New York, afraid that LTCM’s failure could trigger a generalized meltdown on Wall Street, brokered a $3.6 billion bail-out by fourteen Wall Street banks. But people like the University of Pittsburgh saw their holding cut from $4.9 billion to just $400 million.

Pg. 348: If any field has the potential to revolutionize our understanding of the way financial markets work, it must be the discipline of behavioral finance. It is far from clear how much of the body of work derived from the efficient markets hypothesis can survive this challenge.
Experiments show we 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 the have happened than we did before they happened;
3. 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 vents of 90% probability will all occur, while underestimating the probability that at least one of seven events of 10% 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;
6. Contamination effects, whereby we allow irrelevant but proximate information to influence a decision;
7. The affect heuristic, whereby preconceived value-judgments 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;
9. Overconfidence in calibration, which leads us to under-estimate the confidence intervals within which our estimates will be robust (e.g. to conflate the ‘best case’ scenario with the ‘most probable’); and
10. Bystander apathy, which incline us to abdicate individual responsibility when in a crowd.