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Course Information
Course Unit Title : Global Financial Crises
Course Unit Code : 02ISL6158
Type of Course Unit : Optional
Level of Course Unit : Second Cycle
Year of Study : Preb
Semester : 255.Semester
Number of ECTS Credits Allocated : 6,00
Name of Lecturer(s) : ---
Course Assistants :
Learning Outcomes of The Course Unit : 1 Analyze the economic crises
2 Suggest possible policies can be applied in times of crisis
3 Interpret the economic and political decisions taken
4 Interpret the current stabilization programs
5 Predict the crisis
Mode of Delivery : Face-To-Face
Prerequisities and Co-requisities Courses : Unavailable
Recommended Optional Programme Components : Unavailable
Course Contents : 1 The origin and spread of financial crises
2 The world crisis of the past and the applied economic policies
3 Financial conditions and monetary policy
4 Lender of last resort
5 Policy rules and privacy
6 Managing expectations
7 The difficulty of establishing the basis of policy
8 Regulation
9 Costs of financial crises
10 The future of regulation and financial system
11 Possible long-term economic and political practices
12 Evaluation of the crises in Turkey
13 Evaluation of the crises in the world
14 The current issues and evaluation
Languages of Instruction : Turkish-English
Course Goals : Reasons for the emergence of the conceptual framework and financial crisis, the crisis indicators, models attempting to explain the financial crises, financial crises prevention, prediction and management.
Course Aims : Financial crises, with the ability to identify and propose solutions aimed at bring.
Recommended or Required Reading
Textbook : NIALL FERGUSON, "The Ascent of Money A Financial History of the World", Penguin Group (USA) Inc., New York, The Penguin Press, New York 2008, U.S.A.
Additional Resources : Bread , cash, dosh, dough , loot: Cal l it wha t yo u like ,
it matters . To Christians , love o f it is th e root o f all
evil . To generals , it's th e sinew s o f war . To revolu ­
tionaries , it's th e chain s o f labor. Bu t i n The Ascent of
Money, Nial l Ferguso n show s that financ e is i n fact
th e foundatio n o f huma n progress. What' s more , h e
reveal s financia l histor y as th e essentia l backstor y
behin d all history.
Th e evolutio n o f credit an d debt wa s as impor ­
tant as an y technologica l innovatio n i n th e ris e o f
civilization, from ancien t Babylo n to th e silver mine s
o f Bolivia . Bank s provide d th e materia l basis for th e
splendor s o f th e Italian Renaissanc e whil e th e bon d
marke t wa s th e decisiv e factor i n conflicts from th e
Seve n Years ' Wa r to th e America n Civi l War .
Wit h th e clarit y an d verv e for whic h h e is
known , Ferguso n explain s wh y th e origin s o f th e
Frenc h Revolutio n li e i n a stoc k marke t bubbl e
cause d b y a convicte d Scot s murderer . H e show s
ho w financia l failur e turne d Argentin a fro m th e
world' s sixt h riches t countr y int o a n inflation -ridde n baske t case?an d ho w a financia l revolutio n
is propellin g th e world' s mos t populou s countr y
from povert y to powe r i n a singl e generation .
Yet th e mos t importan t lesson o f th e financia l
histor y is that soone r o r late r ever y bubbl e bursts
?soone r o r late r th e bearis h sellers outnumbe r th e
bullis h buyers , soone r o r late r gree d flips int o fear.
An d that's why , whethe r you'r e scraping b y o r rolling
i n it, there's neve r bee n a bette r tim e to understan d
th e ascen t o f money .
Nial l Ferguso n is on e o f Britain' s mos t renowne d
historians . H e is Laurenc e A . Tisc h Professo r o f
Histor y at Harvar d University , a Senio r Researc h
Fello w o f Jesu s College , Oxfor d University , an d a
Senio r Fello w o f th e Hoove r Institution , Stanfor d
University . Th e bestsellin g autho r of Paper and Iron,
The House of Rothschild, The Pity of War, The Cash
Nexus, Empire, Colossus an d The War of the World, h e
also write s regularl y for newspaper s an d magazine s
all over the world . H e has writte n an d presented four
highl y successful televisio n documentar y series for
Channe l 4: Empire, American Colossus, The War of the
World and, most recently, The Ascent of Money. He , his
wif e an d thre e childre n divid e thei r tim e betwee n
th e Unite d Kingdo m an d th e Unite d States.
Jacket painting: Lais Corinthiaca, 152 6 (oil on limewood),
by Hans Holbein the Younger, Offentliche Kunstsammlung, Basel,
Switzerland/The Bridgeman Ar t Library
375 Hudso n Street , Ne w York , N.Y . 1001 4 m | Printe d i n U.S.A .
Praise for
Twentieth-Century Conflict and the Descent of the West
" A heartbreaking, serious and thoughtful survey o f huma n evil that is utterl y
fascinating and dramatic .. . superb narrative history."
?Simo n Seba g Montefiore , The New York Times Book Review
"Wielding at once the encyclopedic knowledge o f an accomplished scholar and
the engaging prose o f a master storyteller, Ferguson commendably brings fresh
insights to a history b y no w familiar... . A tou r de force."
?San Francisco Chronicle
" A fascinating read, thanks t o Ferguson's gifts as a write r o f clear, energetic
narrative history." ?Jame s F. Hodge , Jr. , The Washington Post
Praise for
How Britain Made the Modern World
"Ferguson .. . is a wonderfull y fluent writer , weavin g tellin g details and vivi d
anecdotes seamlessly int o his narrative. . . . Sur e t o b e a chilling assertion t o
both those in Washington eager to deny imperial ambitions and those in the
Ara b worl d suspicious o f America's motives."
?Michik o Kakutani , The New York Times
'Fluently written , engaging, beautifully designed and spectacularly illustrated .. .
Empire is a model o f ho w to d o popular history." ?The Economist
"An entertaining, engaging romp through four centuries o f British imperialism."
?Los Angeles Times
ISBN 978-1-59420-192-9
The Ascent of Money
Paper and Iron
Th e House of Rothschild
The Pity of Wa r
Th e Cash Nexu s
Th e Wa r of the Worl d
The Ascent
of Money
A Financial History of the World
The Penguin Press
New York
Published by the Penguin Group
Penguin Group (USA) Inc., 37 5 Hudson Street,
New York, New York 10014 , U.S.A.
Penguin Group (Canada), 90 Eglinton Avenue East, Suite 700,
Toronto, Ontario, Canada M4P 2Y 3
(a division of Pearson Penguin Canada Inc.)
Penguin Books Ltd, 80 Strand, London WC2 R oRL , England
Penguin Ireland, 25 St. Stephen's Green, Dublin 2, Ireland
(a division of Penguin Books Ltd)
Penguin Books Australia Ltd, 250 Camberwell Road, Camberwell,
Victoria 3124 , Australia
(a division of Pearson Australia Group Pty Ltd)
Penguin Books India Pvt Ltd, 1 1 Community Centre, Panchsheel Park,
New Delhi?11 0 017 , India
Penguin Group (NZ) , 67 Apollo Drive, Rosedale, North Shore 0632 ,
New Zealand (a division of Pearson New Zealand Ltd)
Penguin Books (South Africa) (Pty) Ltd, 24 Sturdee Avenue,
Rosebank, Johannesburg 2196 , South Africa
Penguin Books Ltd, Registered Offices:
80 Strand, London WC2 R oRL , England
First published in 2008 by The Penguin Press,
a member of Penguin Group (USA) Inc.
12345678 9 1 0
Copyright © Niall Ferguson, 2008
All rights reserved
ISBN 978-1-59420-192- 9
Printed in the United States of America
Without limiting the rights under copyright reserved above, no part of this publication may
be reproduced, stored in or introduced into a retrieval system, or transmitted, in any form
or by any means (electronic, mechanical, photocopying, recording or otherwise), without the
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purchase only authorized electronic editions and do not participate in or encourage electronic
piracy of copyrightable materials. Your support of the author's rights is appreciated.
Introduction i
1 Dreams of Avarice 1 7
2 Of Human Bondage 65
3 Blowing Bubbles 11 9
4 The Return of Risk 17 6
5 Safe as Houses 23 0
6 From Empire to Chimerica 283
Afterword: The Descent of Money 34 1
Acknowledgements 35 9
Notes 363
List of Illustrations 399
Index 403

Bread, cash, dosh, dough, loot, lucre, moolah, readies, the where­
withal: call it what you like, money matters. T o Christians, the
love of it is the root of all evil. T o generals, it is the sinews of
war; to revolutionaries, the shackles of labour. But what exactly
is money? Is it a mountain of silver, as the Spanish conquistadors
thought? Or will mere clay tablets and printed paper suffice?
Ho w did we come to live in a world where most money is
invisible, little more than numbers on a computer screen? Where
did money come from? And where did it all go?
Last year (2007) the income of the average American (just
under $34,000) went up by at most 5 per cent.1 But the cost of
living rose by 4. 1 per cent. So in real terms M r Average actually
became just 0.9 per cent better off. Allowing for inflation, the
income of the median household in the United States has in fact
scarcely changed since 1990, increasing by just 7 per cent in
eighteen years.2 No w compare M r Average's situation with that
of Lloyd Blankfein, chief executive officer at Goldman Sachs, the
investment bank. In 2007 he received $68. 5 million in salary,
bonus and stock awards, an increase of 25 per cent on the
previous year, and roughly two thousand times more than Jo e
Public earned. That same year, Goldman Sachs's net revenues of
$46 billion exceeded the entire gross domestic product (GDP )
of more than a hundred countries, including Croatia, Serbia
and Slovenia; Bolivia, Ecuador and Guatemala; Angola, Syria
and Tunisia. The bank's total assets for the first time passed
the $ i trillion mark.3 Ye t Lloyd Blankfein is far from being the
financial world's highest earner. The veteran hedge fund manager
George Soros made $2. 9 billion. Ken Griffin of Citadel, like the
founders of two other leading hedge funds, took home more than
$ 2 billion. Meanwhile nearly a billion people around the world
struggle to get by on just $ 1 a day.4
Angry that the world is so unfair? Infuriated by fat-cat cap­
italists and billion-bonus bankers? Baffled by the yawning chasm
between the Haves, the Have-nots - and the Have-yachts? You
are not alone. 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 rather than stability. And it is
partly because, for centuries, financial services in countries all
over the world were disproportionately provided by members of
ethnic or religious minorities, who had been excluded from land
ownership or public office but enjoyed success in finance because
of their own tight-knit networks of kinship and trust.
Despite our deeply rooted prejudices against 'filthy lucre', how­
ever, money is the root of most progress. T o adapt a phrase
from Jaco b Bronowski (whose marvellous television history of
scientific progress I watched avidly as a schoolboy), the ascent of
money has been essential to the ascent of man. Far from being
the work of mere leeches intent on sucking the life's blood out of
indebted families or gambling with the savings of widows and
orphans, financial innovation has been an indispensable factor in
man's advance from wretched subsistence to the giddy heights of
material prosperity that so many people know today. The evo­
lution of credit and debt was as important as any technological
innovation in the rise of civilization, from ancient Babylon to
present-day Hong Kong. Banks and the bond market provided
the material basis for the splendours of the Italian Renaissance.
Corporate finance was the indispensable foundation of both the
Dutch and British empires, just as the triumph of the United
States in the twentieth century was inseparable from advances in
insurance, mortgage finance and consumer credit. Perhaps, too,
it will be a financial crisis that signals the twilight of American
global primacy.
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 such a boom in the
market for art and architecture because Italian bankers like the
Medici made fortunes by applying Oriental mathematics to
money. The Dutch Republic prevailed over the Habsburg Empire
because having the world's first modern stock market was finan­
cially preferable to having the world's biggest silver mine. 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. It was Nathan Rothschild as much as the Duke
of Wellington who defeated Napoleon at Waterloo. It was finan­
cial folly, a self-destructive cycle of defaults and devaluations,
that turned Argentina from the world's sixth-richest country in
the 1880s into the inflation-ridden basket case of the 1980s.
Read this book and you will understand why, paradoxically,
the people who live in the world's safest country are also the
world's most insured. Yo u will discover when and why the
English-speaking peoples developed their peculiar obsession with
buying and selling houses. Perhaps most importantly, you will
see how the globalization of finance has, among many other
things, blurred the old distinction between developed and emer­
ging markets, turning China into America's banker - the Com­
munist creditor to the capitalist debtor, a change of epochal
At times, the ascent of money has seemed inexorable. In 2006
the measured economic output of the entire world was around
$4 7 trillion. The total market capitalization of the world's stock
markets was $5 1 trillion, 1 0 per cent larger. The total value of
domestic and international bonds was $68 trillion, 50 per cent
larger. The amount of derivatives outstanding was $47 3 trillion,
more than ten times larger. Planet Finance is beginning to dwarf
Planet Earth. And Planet Finance seems to spin faster too. Every
day two trillion dollars change hands on foreign exchange
markets. Every month seven trillion dollars change hands on
global stock markets. Every minute of every hour of every day of
every week, someone, somewhere, is trading. And all the time
new financial life forms are evolving. In 2006, for example, the
volume of leveraged buyouts (takeovers of firms financed by
borrowing) surged to $75 3 billion. An explosion of 'securitiz­
ation', whereby individual debts like mortgages are 'tranched'
then bundled together and repackaged for sale, pushed the total
annual issuance of mortgage backed securities, asset-backed
securities and collateralized debt obligations above $ 3 trillion.
The volume of derivatives - contracts derived from securities,
such as interest rate swaps or credit default swaps (CDS ) - has
grown even faster, so that by the end of 2007 the notional value
of all 'over-the-counter' derivatives (excluding those traded on
public exchanges) was just under $600 trillion. Before the 1980s,
such things were virtually unknown. Ne w institutions, too, have
proliferated. The first hedge fund was set up in the 1940s and, as
recently as 1990 , there were just 61 0 of them, with $3 8 billion
under management. There are now over seven thousand, with
$1. 9 trillion under management. Private equity partnerships have
also multiplied, as well as a veritable shadow banking system of
'conduits' and 'structured investment vehicles' (SIVs), designed
to keep risky assets off bank balance sheets. If the last four
millennia witnessed the ascent of man the thinker, we now seem
to be living through the ascent of man the banker.
In 194 7 the total value added by the financial sector to US
gross domestic product was 2.3 per cent; by 2005 its contribution
had risen to 7.7 per cent of GDP . In other words, approximately
$ 1 of every $1 3 paid to employees in the United States now goes
to people working in finance.5 Finance is even more important in
Britain, where it accounted for 9.4 per cent of GD P in 2006. The
financial sector has also become the most powerful magnet in the
world for academic talent. Back in 197 0 only around 5 per cent
of the men graduating from Harvard, where I teach, went into
finance. By 1990 that figure had risen to 1 5 per cent.* Last
year the proportion was even higher. According to the Harvard
Crimson, more than 20 per cent of the men in the Class of 2007,
and 1 0 per cent of the women, expected their first jobs to be at
banks. And who could blame them? In recent years, the pay
packages in finance have been nearly three times the salaries
earned by Ivy League graduates in other sectors of the economy.
At the time the Class of 2007 graduated, it certainly seemed as
if nothing could halt the rise and rise of global finance. No t
* Revealingly, the increase for female graduates was from 2.3 to 3.4 per cent.
The masters of the universe still outnumber the mistresses.
terrorist attacks on Ne w Yor k and London. No t raging war in
the Middle East. Certainly not global climate change. Despite the
destruction of the World Trade Center, the invasions of Afghani­
stan and Iraq, and a spike in extreme meteorological events,
the period from late 2001 until mid 2007 was characterized by
sustained financial expansion. True, in the immediate aftermath
of 9/11 , the Do w Jones Industrial Average declined by as much
as 1 4 per cent. Within just over two months, however, it had
regained its pre -9/1 1 level. Moreover, although 2002 was a dis­
appointing year for US equity investors, the market surged ahead
thereafter, exceeding its previous peak (at the height of the
'dot com' mania) in the autumn of 2006. By early October 2007
the Do w stood at nearly double the level it had reached in the
trough of five years before. No r was the US stock market's per­
formance exceptional. In the five years to 3 1 July 2007, all but
two of the world's equity markets delivered double-digit returns
on an annualized basis. Emerging market bonds also rose strongly
and real estate markets, especially in the English-speaking world,
saw remarkable capital appreciation. Whether they put their
money into commodities, works of art, vintage wine or exotic
asset-backed securities, investors made money.
Ho w were these wonders to be explained? According to one
school of thought, the latest financial innovations had brought
about a fundamental improvement in the efficiency of the global
capital market, allowing risk to be allocated to those best able to
bear it. Enthusiasts spoke of the death of volatility. Self-satisfied
bankers held conferences with titles like 'The Evolution of Excel­
lence'. In November 2006 I found myself at one such conference
in the characteristically luxurious venue of Lyford Cay in the
Bahamas. The theme of my speech was that it would not take
much to cause a drastic decline in the liquidity that was then
cascading through the global financial system and that we should
be cautious about expecting the good times to last indefinitely.
M y audience was distinctly unimpressed. I was dismissed as an
alarmist. One of the most experienced investors there went so far
as to suggest to the organizers that they 'dispense altogether with
an outside speaker next year, and instead offer a screening of
Mary Poppins'.6 Yet the mention of Mar y Poppins stirred a child­
hood memory in me. Julie Andrews fans may recall that the plot
of the evergreen musical revolves around a financial event which,
when the film was made in the 1960s, already seemed quaint: a
bank run - that is, a rush by depositors to withdraw their money
- something not seen in London since 1866 .
The family that employs Mar y Poppins is, not accidentally,
named Banks. M r Banks is indeed a banker, a senior employee
of the Dawes, Tomes Mousley, Grubbs, Fidelity Fiduciary Bank.
At his insistence, the Banks children are one day taken by their
new nanny to visit his bank, where M r Dawes Sr. recommends
that M r Banks's son Michael deposit his pocket-money (tup­
pence). Unfortunately, young Michael prefers to spend the money
on feeding the pigeons outside the bank, and demands that M r
Dawes 'Give it back! Gimme back my money!' Even more unfor­
tunately, some of the bank's other clients overhear Michael's
request. The result is that they begin to withdraw their money.
Soon a horde of account holders are doing the same, forcing the
bank to suspend payments. M r Banks is duly sacked, prompting
the tragic lament that he has been 'brought to wrack and ruin in
his prime'. These words might legitimately have been echoed by
Adam Applegarth, the former chief executive of the English bank
Northern Rock, who suffered a similar fate in September 2007
as customers queued outside his bank's branches to withdraw
their cash. This followed the announcement that Northern Rock
had requested a 'liquidity support facility' from the Bank of
The financial crisis that struck the Western world in the
summer of 2007 provided a timely reminder of one of the peren­
nial truths of financial history. Sooner or later every bubble
bursts. Sooner or later the bearish sellers outnumber the bullish
buyers. Sooner or later greed turns to fear. As I completed my
research for this book in the early months of 2008, it was already
a distinct possibility that the US economy might suffer a reces­
sion. Was this because American companies had got worse at
designing new products? Had the pace of technological inno­
vation suddenly slackened? No . The proximate cause of the econ­
omic uncertainty of 2008 was financial: to be precise, a spasm in
the credit markets caused by mounting defaults on a species of
debt known euphemistically as subprime mortgages. So intricate
has our global financial system become, that relatively poor
families in states from Alabama to Wisconsin had been able to
buy or remortgage their homes with often complex loans that
(unbeknown to them) were then bundled together with other,
similar loans, repackaged as collateralized debt obligations
(CDOs ) and sold by banks in Ne w Yor k and London to (among
others) German regional banks and Norwegian municipal auth­
orities, wh o thereby became the effective mortgage lenders. These
CDO s had been so sliced and diced that it was possible to claim
that a tier of the interest payments from the original borrowers
was as dependable a stream of income as the interest on a ten-year
US Treasury bond, and therefore worthy of a coveted triple-A
rating. This took financial alchemy to a new level of sophisti­
cation, apparently turning lead into gold.
However, when the original mortgages reset at higher interest
rates after their one- or two-year 'teaser' periods expired, the
borrowers began to default on their payments. This in turn sig­
nalled that the bubble in US real estate was bursting, triggering
the sharpest fall in house prices since the 1930s. What followed
resembled a slow but ultimately devastating chain reaction. All
kinds of asset-backed securities, including many instruments not
in fact backed with subprime mortgages, slumped in value. Insti­
tutions like conduits and structured investment vehicles, which
had been set up by banks to hold these securities off the banks'
balance sheets, found themselves in severe difficulties. As the
banks took over the securities, the ratios between their capital
and their assets lurched down towards their regulatory minima.
Central banks in the United States and Europe sought to alleviate
the pressure on the banks with interest rate cuts and offers of
funds through special 'term auction facilities'. Yet , at the time of
writing (May 2008), the rates at which banks could borrow
money, whether by issuing commercial paper, selling bonds or
borrowing from each other, remained substantially above the
official Federal funds target rate, the minimum lending rate in the
US economy. Loans that were originally intended to finance
purchases of corporations by private equity partnerships were
also only saleable at significant discounts. Having suffered enor­
mous losses, many of the best-known American and European
banks had to turn not only to Western central banks for short-term assistance to rebuild their reserves but also to Asian and
Middle Eastern sovereign wealth funds for equity injections in
order to rebuild their capital bases.
All of this may seem arcane to some readers. Ye t the ratio of a
bank's capital to its assets, technical though it may sound, is of
more than merely academic interest. After all, a 'great contrac­
tion' in the US banking system has convincingly been blamed for
the outbreak and course of the Great Depression between 192 9
and 1933 , the worst economic disaster of modern history.7 If U S
banks have lost significantly more than the $25 5 billion to which
they have so far admitted as a result of the subprime mortgage
crisis and credit crunch, there is a real danger that a much larger
- perhaps tenfold larger - contraction in credit may be necessary
to shrink the banks' balance sheets in proportion to the decline
in their capital. If the shadow banking system of securitized debt
and off-balance-sheet institutions is to be swept away completely
by this crisis, the contraction could be still more severe.
This has implications not just for the United States but for the
world as a whole, since American output presently accounts
for more than a quarter of total world production, while many
European and Asian economies in particular are still heavily
reliant on the United States as a market for their exports. Europe
already seems destined to experience a slowdown comparable
with that of the United States, particularly in those countries
(such as Britain and Spain) that have gone through similar hous­
ing bubbles. The extent to which Asia can ride out an American
recession, in the way that America rode out the Asian crisis of
1997-8 , remains uncertain. What is certain is that the efforts of
the Federal Reserve to mitigate the credit crunch by cutting inter­
est rates and targeting liquidity at the US banking system have
put severe downward pressure on the external value of the dollar.
The coincidence of a dollar slide and continuing Asian industrial
growth has caused a spike in commodity prices comparable not
merely with the 1970s but with the 1940s. It is not too much to
say that in mid-2008 we witnessed the inflationary symptoms of
a world war without the war itself.
Anyone wh o can read a paragraph like the preceding one
without feeling anxious does not know enough financial history.
One purpose of this book, then, is to educate. It is a well-established fact, after all, 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. Nearly a third
(29 per cent) said they had no idea what the interest rate on their
card was. Another 30 per cent claimed that it was below 1 0 per
cent, when in reality the overwhelming majority of card com­
panies charge substantially in excess of 1 0 per cent. Mor e than
half of the respondents said they had learned 'not too much' or
'nothing at all' about financial issues at school.8 A 2008 survey
revealed that two thirds of Americans did not understand how
compound interest worked.9 In one survey conducted by re­
searchers at the University of Buffalo's School of Management,
a typical group of high school seniors scored just 5 2 per cent
in response to a set of questions about personal finance and
economics.1 0 Only 1 4 per cent understood that stocks would
tend to generate a higher return over eighteen years than a US
government bond. Less than 23 per cent knew that income tax is
charged on the interest earned from a savings account if the
account holder's income is high enough. Fully 59 per cent did
not know the difference between a company pension, Social
Security and a 40 1 (k) plan.* No r is this a uniquely American
phenomenon. In 2006, the British Financial Services Authority
carried out a survey of public financial literacy which revealed
that one person in five had no idea what the effect would be on
the purchasing power of their savings of an inflation rate of 5 per
cent and an interest rate of 3 per cent. One in ten did not know
which was the better discount for a television originally priced at
£250: £3 0 or 1 0 per cent. As that example makes clear, the
questions posed in these surveys were of the most basic nature.
* 40i(k) plans were introduced in 1980 as a form of defined contribution
retirement plan. Employees can elect to have a portion of their wages or
salaries paid or 'deferred' into a 401 (k) account. They are then offered choices
as to how the money should be invested. With a few exceptions, no tax is
paid on the money until it is withdrawn.
1 1
1 2
It seems reasonable to assume that only a handful of those polled
would have been able to explain the difference between a 'put'
and a 'call' option, for example, much less the difference between
a CD O and a CDS .
Politicians, central bankers and businessmen regularly lament
the extent of public ignorance about money, and with good
reason. A society that expects most individuals to take responsi­
bility for the management of their own expenditure and income
after tax, that expects most adults to own their own homes and
that leaves it to the individual to determine how much to save
for retirement and whether or not to take out health insurance,
is surely storing up trouble for the future by leaving its citizens
so ill-equipped to make wise financial decisions.
The first step towards understanding the complexities of
modern financial institutions and terminology is to find out where
they came from. Only understand the origins of an institution or
instrument and you will find its present-day role much easier to
grasp. Accordingly, the key components of the modern financial
system are introduced sequentially. The first chapter of this book
traces the rise of money and credit; the second the bond market;
the third the stock market. Chapter 4 tells the story of insurance;
Chapter 5 the real estate market; and Chapter 6 the rise, fall
and rise of international finance. Each chapter addresses a key
historical question. When did money stop being metal and mutate
into paper, before vanishing altogether? Is it true that, by setting
long-term interest rates, the bond market rules the world? What
is the role played by central banks in stock market bubbles and
busts? Why is insurance not necessarily the best way to protect
yourself from risk? D o people exaggerate the benefits of investing
in real estate? And is the economic inter-dependence of China and
America the key to global financial stability, or a mere chimera?
In trying to cover the history of finance from ancient Mesopota-
mia to modem microfinance, I have set myself an impossible task,
no doubt. Much must be omitted in the interests of brevity and
simplicity. Yet the attempt seems worth making if it can bring
the modern financial system into sharper focus in the mind's eye
of the general reader.
I myself have learned a great deal in writing this book, but
three insights in particular stand out. 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 channelled 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 neigh­
bourhoods in supposedly developed countries - the 'Africas
within' - like the housing estates of my birthplace, Glasgow,
where some people are scraping by on just £6 a day, for every­
thing from toothpaste to transport, but where the interest rates
charged by local loan sharks can be over eleven million per cent
a year.
M y 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. But finance also exaggerates the differ­
ences between us, enriching the lucky and the smart, impover­
ishing the unlucky and not-so-smart. Financial globalization
means that, after more than three hundred years of divergence,
the world can no longer be divided neatly into rich developed
countries and poor less-developed countries. The more integrated
the world's financial markets become, the greater the opportuni­
ties for financially knowledgeable people wherever they live -and the bigger the risk of downward mobility for the financially
illiterate. It emphatically is not a flat world in terms of overall
income distribution, simply because the returns on capital have
soared relative to the returns on unskilled and semi-skilled labour.
The rewards for 'getting it' have never been so immense. And the
penalties for financial ignorance have never been so stiff.
Finally, I have come to understand that few things are harder
to predict accurately than the timing and magnitude of financial
crises, because the financial system is so genuinely complex and
so many of the relationships within it are non-linear, even chaotic.
The ascent of money has never been smooth, and each new
challenge elicits a new response from the bankers and their ilk.
Like an Andean horizon, the history of finance is not a smooth
upward curve but a series of jagged and irregular peaks and
valleys. Or, to vary the metaphor, financial history looks like a
classic case of evolution in action, albeit in a much tighter time­
frame than evolution in the natural world. 'Just as some species
become extinct in nature,' remarked US Assistant Secretary of
the Treasury Anthony W. Rya n before Congress in September
2007, 'some new financing techniques may prove to be less suc­
cessful than others.' Such Darwinian language seems remarkably
apposite as I write.
Are we on the brink of a 'great dying' in the financial world
- one of those mass extinctions of species that have occurred
periodically, like the end-Cambrian extinction that killed off
90 per cent of Earth's species, or the Cretaceous-Tertiary catas­
trophe that wiped out the dinosaurs? It is a scenario that many
biologists have reason to fear, as man-made climate change
1 4
wreaks havoc with natural habitats around the globe. But a great
dying of financial institutions is also a scenario that we should
worry about, as another man-made disaster works its way slowly
and painfully through the global financial system.
For all these reasons, then - whether you are struggling to
make ends meet or striving to be a master of the universe - it has
never been more necessary to understand the ascent of money
than it is today. If this book helps to break down that dangerous
barrier which has arisen between financial knowledge and other
kinds of knowledge, then I shall not have toiled in vain.
1 5

Imagine a world with no money. For over a hundred years,
Communists and anarchists - not to mention some extreme reac­
tionaries, religious fundamentalists and hippies - have dreamt of
just that. According to Friedrich Engels and Karl Marx , money
was merely an instrument of capitalist exploitation, replacing all
human relationships, even those within the family, with the cal­
lous 'cash nexus'. As Mar x later sought to demonstrate in Capital,
money was commoditized labour, the surplus generated by honest
toil, appropriated and then 'reified' in order to satisfy the capi­
talist class's insatiable lust for accumulation. Such notions die
hard. As recently as the 1970s, some European Communists were
still yearning for a moneyless world, as in this Utopian effusion
from the Socialist Standard:
Money will disappear .. . Gold can be reserved in accordance with
Lenin's wish, for the construction of public lavatories .. . In commu­
nist societies goods will be freely available and free of charge. The
organisation of society to its very foundations will be without money
.. . The frantic and neurotic desire to consume and hoard will dis­
appear. It will be absurd to want to accumulate things: there will no
longer be money to be pocketed nor wage-earners to be hired .. . The
new people will resemble their hunting and gathering ancestors who
Dreams of Avarice
trusted in a nature which supplied them freely and often abundantly
with what they needed to live, and who had no worry for the
morrow . .
Ye t no Communist state - not even North Korea - has found it
practical to dispense with money.2 And even a passing acquaint­
ance with real hunter-gatherer societies suggests there are con­
siderable disadvantages to the cash-free life.
Five years ago, members of the Nukak-Mak u unexpectedly
wandered out of the Amazonian rainforest at San José del
Guaviare in Colombia. The Nuka k were a tribe that time forgot,
cut off from the rest of humanity until this sudden emergence.
Subsisting solely on the monkeys they could hunt and the fruit
they could gather, they had no concept of money. Revealingly,
they had no concept of the future either. These days they live in
a clearing near the city, reliant for their subsistence on state
handouts. Asked if they miss the jungle, they laugh. After lifetimes
of trudging all day in search of food, they are amazed that perfect
strangers now give them all they need and ask nothing from them
in return.3
The life of a hunter-gatherer is indeed, as Thomas Hobbes said
of the state of nature, 'solitary, poor, nasty, brutish, and short'. In
some respects, to be sure, wandering through the jungle bagging
monkeys may be preferable to the hard slog of subsistence agricul­
ture. But anthropologists have shown that many of the hunter-gatherer tribes who survived into modern times were less placid
than the Nukak . Among the Jivaro of Ecuador, for example,
nearly 60 per cent of male deaths were due to violence. The figure
for the Brazilian Yanomam o was nearly 40 per cent. When two
groups of such primitive peoples chanced upon each other, it
seems, they were more likely to fight over scarce resources (food
and fertile women) than to engage in commercial exchange.
1 8
1 9
Hunter-gatherers do not trade. They raid. No r do they save,
consuming their food as and when they find it. They therefore
have no need of money.
The Money Mountain
More sophisticated societies than the Nuka k have functioned
without money, it is true. Five hundred years ago, the most
sophisticated society in South America, the Inca Empire, was also
moneyless. The Incas appreciated the aesthetic qualities of rare
metals. Gold was the 'sweat of the sun', silver the 'tears of the
moon'. Labour was the unit of value in the Inca Empire, just as
it was later supposed to be in a Communist society. And, as under
Communism, the economy depended on often harsh central plan­
ning and forced labour. In 1532 , however, the Inca Empire was
brought low by a man who, like Christopher Columbus, had
come to the Ne w World expressly to search for and monetize
precious metal.*
The illegitimate son of a Spanish colonel, Francisco Pizarro
had crossed the Atlantic to seek his fortune in 1502. 4 One of the
first Europeans to traverse the isthmus of Panama to the Pacific,
he led the first of three expeditions into Peru in 1524 . The terrain
was harsh, food scarce and the first indigenous peoples they
encountered hostile. However, the welcome their second ex­
pedition received in the Tumbes region, where the inhabitants
hailed them as the 'children of the sun', convinced Pizarro and
* The conquistadors came looking for both gold and silver. Columbus's first
settlement, La Isabela in Hispaniola (now the Dominican Republic), was
established to exploit local deposits of gold. He also believed he had found
silver, but the only traces have subsequently been shown to have been in the
sample ores Columbus and his men had brought from Spain.
his confederates to persist. Having returned to Spain to obtain
royal approval for his plan 'to extend the empire of Castile'* as
'Governor of Peru', Pizarro raised a force of three ships, twenty-seven horses and one hundred and eighty men, equipped with the
latest European weaponry: guns and mechanical crossbows.5 This
third expedition set sail from Panama on 2 7 December 1530 . It
took the would-be conquerors just under two years to achieve
their objective: a confrontation with Atahuallpa, one of the two
feuding sons of the recently deceased Incan emperor Huayna
Capac. Having declined Friar Vincente Valverd's proposal that
he submit to Christian rule, contemptuously throwing his Bible
to the ground, Atahuallpa could only watch as the Spaniards,
relying mainly on the terror inspired by their horses (animals
unknown to the Incas), annihilated his army. Given how out­
numbered they were, it was a truly astonishing coup.6 Atahuallpa
soon came to understand what Pizarro was after, and sought to
buy his freedom by offering to fill the room where he was being
held with gold (once) and silver (twice). In all, in the subsequent
months the Incas collected 13,42 0 pounds of 2 2 carat gold and
26,000 pounds of pure silver.7 Pizarro nevertheless determined
to execute his prisoner, who was publicly garrotted in August
1533. 8 With the fall of the city of Cuzco, the Inca Empire was
torn apart in an orgy of Spanish plundering. Despite a revolt led
by the supposedly puppet Inca Manc o Capac in 1536 , Spanish
rule was unshakeably established and symbolized by the construc­
tion of a new capital, Lima. The Empire was formally dissolved
in 1572 .
Pizarro himself died as violently as he had lived, stabbed to
death in Lima in 154 1 after a quarrel with one of his fellow
* From the marriage of Ferdinand and Isabella in 147 4 until the eighteenth
century, the country we call Spain was technically the union of two kingdoms:
Aragon and Castile.
conquistadors. But his legacy to the Spanish crown ultimately
exceeded even his own dreams. The conquistadors had been
inspired by the legend of El Dorado, an Indian king wh o was
believed to cover his body with gold dust at festival times. In
what Pizarro's men called Upper Peru, a stark land of mountains
and mists where those unaccustomed to high altitudes have to
fight for breath, they found something just as valuable. With a
peak that towers 4,824 metres (15,82 7 feet) above sea level, the
uncannily symmetrical Cerro Rico - literally the 'rich hill' - was
the supreme embodiment of the most potent of all ideas about
money: a mountain of solid silver ore. When an Indian named
Diego Gualpa discovered its five great seams of silver in 1545 , he
changed the economic history of the world. 9
The Incas could not understand the insatiable lust for gold and
silver that seemed to grip Europeans. 'Even if all the snow in the
Andes turned to gold, still they would not be satisfied,' com­
plained Manco Capac. 1 0 The Incas could not appreciate that, for
Pizarro and his men, silver was more than shiny, decorative metal.
It could be made into money: a unit of account, a store of value
- portable power.
T o work the mines, the Spaniards at first relied on paying
wages to the inhabitants of nearby villages. But conditions were
so harsh that from the late sixteenth century a system of forced
labour (la mita) had to be introduced, whereby men aged between
1 8 and 50 from the sixteen highland provinces were conscripted
for seventeen weeks a year. 1 1 Mortality among the miners was
horrendous, not least because of constant exposure to the mer­
cury fumes generated by the patio process of refinement, whereby
ground-up silver ore was trampled into an amalgam with mer­
cury, washed and then heated to burn off the mercury.1 2 The air
down the mineshafts was (and remains) noxious and miners had
to descend seven-hundred-foot shafts on the most primitive of
2 1
The Cerro Rico at Potosi: the Spanish Empire's mountain of money
steps, clambering back up after long hours of digging with sacks
of ore tied to their backs. Rock falls killed and maimed hundreds.
The new silver-rush city of Potosi was, declared Domingo de
Santo Tomâs, 'a mouth of hell, into which a great mass of people
enter every year and are sacrificed by the greed of the Spaniards
to their "god". ' Rodrigo de Loaisa called the mines 'infernal pits',
noting that 'if twenty healthy Indians enter on Monday, half may
emerge crippled on Saturday'.1 3 In the words of the Augustinian
monk Fray Antonio de la Calancha, writing in 1638 : 'Every peso
coin minted in Potosi has cost the life of ten Indians wh o have
died in the depths of the mines.' As the indigenous workforce
was depleted, thousands of African slaves were imported to take
their places as 'human mules'. Even today there is still something
hellish about the stifling shafts and tunnels of the Cerro Rico.
A place of death for those compelled to work there, Potosi was
where Spain struck it rich. Between 155 6 and 1783 , the 'rich hill'
yielded 45,000 tons of pure silver to be transformed into bars
and coins in the Casa de Moneda (mint), and shipped to Seville.
Despite its thin air and harsh climate, Potosi rapidly became one
of the principal cities of the Spanish Empire, with a population
at its zenith of between 160,000 and 200,000 people, larger than
most European cities at that time. Valer un potosi, 'to be worth
a potosi', is still a Spanish expression meaning to be worth a
fortune. Pizarro's conquest, it seemed, had made the Spanish
crown rich beyond the dreams of avarice.
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 con­
ducted over long periods as well as geographical distances. T o
perform all these functions optimally, money has to be available,
affordable, durable, fungible, portable and reliable. Because they
fulfil most of these criteria, metals such as gold, silver and bronze
were for millennia regarded as the ideal monetary raw material.
The earliest known coins date back as long ago as 600 B C and
were found by archaeologists in the Temple of Artemis at Ephesus
(near Izmir in modern-day Turkey). These ovular Lydian coins,
which were made of the gold-silver alloy known as electrum and
bore the image of a lion's head, were the forerunners of the
Athenian tetradrachm, a standardized silver coin with the head
of the goddess Athena on one side and an owl (associated with
her for its supposed wisdom) on the obverse. By Roman times,
coins were produced in three different metals: the aureus (gold),
the denarius (silver) and the sestertius (bronze), ranked in that
order according to the relative scarcity of the metals in question,
but all bearing the head of the reigning emperor on one side, and
the legendary figures of Romulus and Remus on the other. Coins
were not unique to the ancient Mediterranean, but they clearly
arose there first. It was not until 22 1 B C that a standardized
bronze coin was introduced to China by the 'first Emperor', Qin
Shihuangdi. In each case, coins made of precious metal were
associated with powerful sovereigns who monopolized the
minting of money partly to exploit it as a source of revenue.
The Roman system of coinage outlived the Roman Empire
itself. Prices were still being quoted in terms of silver denarii in
the time of Charlemagne, king of the Franks from 768 to 814 .
The difficulty was that by the time Charlemagne was crowned
Imperator Augustus in 800, there was a chronic shortage of silver
in Western Europe. Demand for money was greater in the much
more developed commercial centres of the Islamic Empire that
dominated the southern Mediterranean and the Near East, so
that precious metal tended to drain away from backward Europe.
So rare was the denarius in Charlemagne's time that twenty-four
of them sufficed to buy a Carolingian cow. In some parts of
Europe, peppers and squirrel skins served as substitutes for cur­
rency; in others pecunia came to mean land rather than money.
This was a problem that Europeans sought to overcome in one
of two ways. They could export labour and goods, exchanging
slaves and timber for silver in Baghdad or for African gold in
Cordoba and Cairo. Or they could plunder precious metal by
making war on the Muslim world. The Crusades, like the con­
quests that followed, were as much about overcoming Europe's
monetary shortage as about converting heathens to Christianity.1 4
Crusading was an expensive affair and the net returns were
modest. T o compound their monetary difficulties, medieval and
early modern governments failed to find a solution to what
economists have called the big problem of small change: the
difficulty of establishing stable relationships between coins made
of different kinds of metal, which meant that smaller denomi­
nation coins were subject to recurrent shortages, yet also to
depreciations and debasements.1 5 At Potosi, and the other
places in the Ne w World where they found plentiful silver (not­
ably Zacatecas in Mexico), the Spanish conquistadors therefore
appeared to have broken a centuries-old constraint. The initial
beneficiary was, of course, the Castilian monarchy that had spon­
sored the conquests. The convoys of ships - up to a hundred at
a time - which transported 17 0 tons of silver a year across the
Atlantic, docked at Seville. A fifth of all that was produced was
reserved to the crown, accounting for 44 per cent of total royal
expenditure at the peak in the late sixteenth century.1 6 But the
way the money was spent ensured that Spain's newfound wealth
provided the entire continent with a monetary stimulus. The
Spanish 'piece of eight', which was based on the German thaler
(hence, later, the 'dollar'), became the world's first truly global
currency, financing not only the protracted wars Spain fought
in Europe, but also the rapidly expanding trade of Europe with
And yet all the silver of the Ne w World could not bring the
rebellious Dutch Republic to heel; could not secure England for
the Spanish crown; could not save Spain from an inexorable
economic and imperial decline. 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 affec­
ted all of Europe from the 1540 s 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 which we
have the best price data) the cost of living increased by a factor
of seven in the same period; not a high rate of inflation these days
(on average around 2 per cent per year), but a revolutionary
increase in the price of bread by medieval standards. Within
Spain, the abundance of silver also acted as a 'resource curse',
like the abundant oil of Arabia, Nigeria, Persia, Russia and Vene­
zuela in our own time, removing the incentives for more pro­
ductive economic activity, while at the same time strengthening
rent-seeking autocrats at the expense of representative assemblies
(in Spain's case the Cortes).1 7
What the Spaniards had failed to understand is that the value
of precious metal is not absolute. Money is worth only what some­
one 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.
There was in fact no reason other than historical happenstance
that money was for so long equated in the Western mind with
metal. In ancient Mesopotamia, beginning around five thousand
years ago, people used clay tokens to record transactions in­
volving agricultural produce like barley or wool, or metals such
as silver. Rings, blocks or sheets made of silver certainly served
as ready money (as did grain), but the clay tablets were just as
important, and probably more so. A great many have survived,
reminders that when human beings first began to produce written
records of their activities they did so not to write history, poetry
or philosophy, but to do business.1 8 It is impossible to pick up
such ancient financial instruments without a feeling of awe.
Though made of base earth, they have endured much longer than
the silver dollars in the Potosi mint. One especially well-preserved
token, from the town of Sippar (modern-day Tell Abu Habbah
in Iraq), dates from the reign of King Ammi-ditana (1683-164 7
BC ) and states that its bearer should receive a specific amount of
barley at harvest time. Another token, inscribed during the reign
of his successor, King Ammi-saduqa, orders that the bearer
should be given a quantity of silver at the end of a journey.1 9
If the basic concept seems familiar to us, it is partly because a
modern banknote does similar things. Just take a look at the
magic words on any Bank of England note: 'I promise to pay the
bearer on demand the sum of. . .'. Banknotes (which originated
in seventh-century China) are pieces of paper which have next to
no intrinsic worth. They are simply promises to pay (hence their
original Western designation as 'promissory notes'), just like the
clay tablets of ancient Babylon four millennia ago. 'In Go d We
Trust' it says on the back of the ten-dollar bill, but the person
you are really trusting when you accept one of these in payment
is the successor to the man on the front (Alexander Hamilton,
the first Secretary of the US Treasury), who at the time of writing
A clay tablet from second millennium BC
Mesopotamia, front (above) and rear (opposite). The inscription
states that Amil-mirra will pay 330 measures of barley to the
bearer of the tablet at harvest time.
happens to be Lloyd Blankfein's predecessor as chief executive
of Goldman Sachs, Henry M. Paulson, Jr. When an American
exchanges his goods or his labour for a fistful of dollars, he
is essentially trusting 'Hank' Paulson (and by implication the
Chairman of the Federal Reserve System, Ben Bernanke) not to
repeat Spain's error and manufacture so many of these things
that they end up being worth no more than the paper they are
printed on.
Today, despite the fact that the purchasing power of the dollar
has declined appreciably over the past fifty years, we remaIn
more or less content with paper money - not to mention coins
that are literally made from junk. Stores of value these are not.
Even more amazingly, we are happy with money we cannot even
see. Today's electronic money can be moved from our employer,
to our bank account, to our favourite 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 I I per cent 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
honours his cheques 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.
Anything can serve as money, from the cowrie shells of the
Maldives to the huge stone discs used on the Pacific islands of
Yap. 2 0 And now, it seems, in this electronic age nothing can serve
as money too.
The central relationship that money crystallizes is between
lender and borrower. Loo k again at those Mesopotamian clay
tablets. In each case, the transactions recorded on them were
repayments of commodities that had been loaned; the tablets
were evidently drawn up and retained by the lender (often in a
sealed clay container) to record the amount due and the date of
repayment. The lending system of ancient Babylon was evidently
quite sophisticated. Debts were transferable, hence 'pay the
bearer' rather than a named creditor. Clay receipts or drafts were
issued to those wh o deposited grain or other commodities at
royal palaces or temples. Borrowers were expected to pay interest
(a concept which was probably derived from the natural increase
of a herd of livestock), at rates that were often as high as 20 per
cent. Mathematical exercises from the reign of Hammurabi
(1792-175 0 BC ) suggest that something like compound interest
could be charged on long-term loans. But the foundation on
which all of this rested was the underlying credibility of a bor­
rower's promise to repay. (It is no coincidence that in English the
root of 'credit' is credo, the Latin for 'I believe'.) Debtors might
periodically be relieved - indeed the Laws of Hammurabi pre­
scribed debt forgiveness every three years - but this does not
appear to have deterred private as well as public lenders from
doing business in the reasonable expectation of getting their
money back.2 1 On the contrary, the long-term trend in ancient
Mesopotamia was for private finance to expand. By the sixth
century BC , families like the Babylonian Egibi had emerged as
powerful landowners and lenders, with commercial interests as
far afield as Uruk over a hundred miles to the south and Persia
to the east. The thousands of clay tablets that survive from that
period testify to the number of people who at one time or another
were in debt to the Egibi. The fact that the family thrived for five
generations suggests that they generally collected their debts.
It would not be quite correct to say that credit was invented
in ancient Mesopotamia. Most Babylonian loans were simple
advances from royal or religious storehouses. Credit was not
being created in the modern sense discussed later in this chapter.
Nevertheless, this was an important beginning. Without the foun­
dation of borrowing and lending, the economic history of our
world would scarcely have got off the ground. And without
the ever-growing network of relationships between creditors and
debtors, today's global economy would grind to a halt. Contrary
to the famous song in the musical Cabaret, money does not
literally make the world go round. But it does make staggering
quantities of people, goods and services go around the world.
The remarkable thing is how belatedly and hesitantly the idea
of credit took root in the very part of the world where it has
flourished most spectacularly.
Loan Sharks
Northern Italy in the early thirteenth century was a land subdiv­
ided into multiple feuding city-states. Among the many remnants
of the defunct Roman Empire was a numerical system (i, ii, iii,
iv ... ) singularly ill-suited to complex mathematical calculation,
let alone the needs of commerce. Nowhere was this more of a
problem than in Pisa, where merchants also had to contend with
seven different forms of coinage in circulation. By comparison,
economic life in the Eastern world - in the Abassid caliphate or
in Sung China - was far more advanced, just as it had been in the
time of Charlemagne. T o discover modern finance, Europe
needed to import it. In this, a crucial role was played by a young
mathematician called Leonardo of Pisa, or Fibonacci.
The son of a Pisan customs official based in what is now Bejaia
in Algeria, the young Fibonacci had immersed himself in what he
called the 'Indian method' of mathematics, a combination of
Indian and Arab insights. His introduction of these ideas was to
revolutionize the way Europeans counted. Nowadays he is best
remembered for the Fibonacci sequence of numbers (o, i , i , 2,
3 , 5, 8, 13 , 2 1 . . .), in which each successive number is the sum
of the previous two, and the ratio between a number and its
immediate antecedent tends towards a 'golden mean' (around
1.618) . It is a pattern that mirrors some of the repeating proper­
ties to be found in the natural world (for example in the fractal
geometry of ferns and sea shells).* But the Fibonacci sequence
was only one of many Eastern mathematical ideas introduced to
Europe in his path-breaking book Liber Abaci, 'The Book of
Calculation', which he published in 1202 . In it, readers could
find fractions explained, as well as the concept of present value
(the discounted value today of a future revenue stream).2 2 Most
important of all was Fibonacci's introduction of Hindu-Arabic
numerals. He not only gave Europe the decimal system, which
makes all kinds of calculation far easier than with Roman
numerals; he also showed how it could be applied to commercial
* The Fibonacci sequence appears in The Da Vinci Code, which is probably
why most people have heard of it. However, the sequence first appeared,
under the name mâtrâmeru (mountain of cadence), in the work of the Sanskrit
scholar Pingala.
3 2
bookkeeping, to currency conversions and, crucially, to the cal­
culation of interest. Significantly, many of the examples in the
Liber Abaci are made more vivid by being expressed in terms
of commodities like hides, peppers, cheese, oil and spices. This
was to be the application of mathematics to making money and,
in particular, to lending money. One characteristic example
A man placed 10 0 pounds at a certain [merchant's] house for 4 denarii
per pound per month interest and he took back each year a payment
of 3 0 pounds. One must compute in each year the 3 0 pounds reduction
of capital and the profit on the said 3 0 pounds. It is sought how many
years, months, days and hours he will hold money in the house . . .
Italian commercial centres like Fibonacci's home town of Pisa
or nearby Florence proved to be fertile soil for such financial
seeds. But it was above all Venice, more exposed than the others
to Oriental influences, that became Europe's great lending labora­
tory. It is not coincidental that the most famous moneylender
in Western literature was based in Venice. His story brilliantly
illuminates the obstacles that for centuries impeded the transla­
tion of Fibonacci's theories into effective financial practice. These
obstacles were not economic, or political. They were cultural.
Shakespeare's play The Merchant of Venice is based on a story
in a fourteenth-century Italian book called i7 Pecorone ('The
Dunce'), a collection of tales and anecdotes written in 137 8 by
Giovanni Fiorentino. One story tells of a wealthy woman who
marries an upstanding young gentleman. Her husband needs
money and his friend, eager to help, goes to a moneylender to
borrow the cash on his friend's behalf. The moneylender, like
Shylock a Jew , demands a pound of flesh as security, to be handed
over if the money is not paid back. As Shakespeare rewrote it,
the Jewish moneylender Shylock agrees to lend the lovelorn suitor
Bassanio three thousand ducats, but on the security of Bassanio's
friend, the merchant Antonio. As Shylock says, Antonio is a
'good' man - meaning not that he is especially virtuous, but that
his credit is 'sufficient'. However, Shylock also points out that
lending money to merchants (or their friends) is risky. Antonio's
ships are scattered all over the world, one going to North Africa,
another to India, a third to Mexico , a fourth to England:
.. . his means are in supposition: he hath an argosy bound to Tripolis,
another to the Indies; I understand moreover, upon the Rialto, he
hath a third at Mexico, a fourth for England, and other ventures he
hath, squandered abroad. But ships are but boards, sailors but men:
there be land-rats and water-rats, water-thieves and land-thieves, I
mean pirates, and then there is the peril of waters, winds and rocks.
That is precisely why anyone who lends money to a merchant,
if only for the duration of an ocean voyage, needs to be compen­
sated. We usually call the compensation interest: the amount paid
to the lender over and above the sum lent, or the principal.
Overseas trade of the sort that Venice depended on could not
have happened if its financiers had not been rewarded in some
way for risking their money on mere boards and men.
But why does Shylock turn out to be such a villain, demanding
literally a pound of flesh - in effect Antonio's death - if he cannot
fulfil his obligations? The answer is of course that Shylock is one
of the many moneylenders in history to have belonged to an
ethnic minority. By Shakespeare's time, Jews had been providing
commercial credit in Venice for nearly a century. They did their
business in front of the building once known as the Banco Rosso,
sitting behind their tables - their tavule - and on their benches,
their band. But the Banco Rosso was located in a cramped ghetto
some distance away from the centre of the city.
There was a good reason why Venetian merchants had to
come to the Jewish ghetto if they wanted to borrow money. For
Christians, lending money at interest was a sin. Usurers, people
who lent money at interest, had been excommunicated by the
Third Lateran Council in n 79. Even arguing that usury was not
a sin had been condemned as heresy by the Council of Vienna in
1311-12 . Christian usurers had to make restitution to the Church
before they could be buried on hallowed ground. They were
especially detested by the Franciscan and Dominican orders,
founded in 120 6 and 121 6 (just after the publication of Fibon­
acci's Liber Abaci). The power of this taboo should not be under­
estimated, though it had certainly weakened by Shakespeare's
time.2 3
In Florence's Duomo (cathedral) there is a fresco by Domenico
di Michelino that shows the great Florentine poet Dante Alighieri
holding his book the Divine Comedy. As Dante imagined it in
Canto XVI I of his masterpiece, there was a special part of the
seventh circle of Hell reserved for usurers:
Sorrow . . . gushed from their eyes and made their sad tears flow;
While this way and that they flapped their hands, for ease
From the hot soil now, and now from the burning snow,
Behaving, in fact, exactly as one sees
Dogs in the summer, scuffing with snout and paw
When they're eaten up with gnats and flies and fleas.
I looked at many thus scorched by the fiery flaw,
And though I scanned their faces with the utmost heed,
There was no one there I recognized; but I saw
How, stamped with charge and tincture plain to read,
About the neck of each a great purse hung,
Whereon their eyes seemed still to fix and feed.
Jews , too, were not supposed to lend at interest. But there
was a convenient get-out clause in the Old Testament book of
Deuteronomy: 'Unto a stranger thou mayest lend upon usury;
but unto thy brother thou shalt not lend upon usury.' In other
words, a Je w might legitimately lend to a Christian, though not
to another Jew . The price of doing so was social exclusion.
Jew s had been expelled from Spain in 1492 . Along with many
Portuguese conversos, Jew s who were forced to adopt Christ­
ianity by a decree of 1497 , they sought refuge in the Ottoman
Empire. From Constantinople and other Ottoman ports they
then established trading relationships with Venice. The Jewish
presence in Venice dates from 1509 , when Jews living in Mestre
sought refuge from the War of the League of Cambrai. At first
the city's government was reluctant to accept the refugees, but it
soon became apparent that they might prove a useful source of
money and financial services, since they could be taxed as well as
borrowed from.2 4 In 151 6 the Venetian authorities designated a
special area of the city for Jew s on the site of an old iron foundry
which became known as the ghetto nuovo (getto literally means
casting). There they were to be confined every night and on
Christian holidays. Those who stayed in Venice for more than
two weeks were supposed to wear a yellow O on their backs or
a yellow (later scarlet) hat or turban.2 5 Residence was limited to
a stipulated period on the basis of condotte (charters) renewed
every five years.2 6 A similar arrangement was reached in 154 1
with some Jew s from Romania, who were accorded the right to
live in another enclave, the ghetto vecchio. By 159 0 there were
around 2,500 Jew s in Venice. Buildings in the ghetto grew seven
storeys high to accommodate the newcomers.
Throughout the sixteenth century, the position of the Venetian
Jew s remained conditional and vulnerable. In 1537 , when war
broke out between Venice and the Ottoman Empire, the Venetian
Senate ordered the sequestration of the property of 'Turks, Jew s
and other Turkish subjects'. Another war from 157 0 to 157 3 led
to the arrest of all Jew s and the seizure of their property, though
they were freed and had their assets returned after peace had
been restored.2 7 T o avoid a repetition of this experience, the Jew s
petitioned the Venetian government to be allowed to remain free
during any future war. They were fortunate to be represented by
Daniel Rodriga, a Jewish merchant of Spanish origin wh o proved
to be a highly effective negotiator. The charter he succeeded in
obtaining in 158 9 granted all Jew s the status of Venetian subjects,
permitted them to engage in the Levant trade - a valuable privi­
lege - and allowed them to practise their religion openly. Never­
theless, important restrictions remained. They were not allowed
to join guilds or to engage in retail trade, hence restricting them
to financial services, and their privileges were subject to revo­
cation at eighteen months' notice. As citizens, Jew s now stood
more chance of success than Shylock in the Venetian law courts.
In 1623 , for example, Leon Voltera sued Antonio dalla Donna,
who had stood security for a knight wh o had borrowed certain
items from Voltera and then vanished. In 1636-7 , however, a
scandal involving the bribery of judges, in which some Jew s
were implicated, seems once again to have raised the threat of
expulsion.2 8
Though fictional, the story of Shylock is therefore not entirely
removed from Venetian reality. Indeed, Shakespeare's play quite
accurately illustrates three important points about early modern
money-lending: the power of lenders to charge extortionate inter­
est rates when credit markets are in their infancy; the importance
of law courts in resolving financial disputes without recourse to
violence; but above all the vulnerability of minority creditors to
a backlash by hostile debtors who belong to the ethnic majority.
For in the end, of course, Shylock is thwarted. Although the court
recognizes his right to insist on his bond - to claim his pound of
flesh - the law also prohibits him from shedding Antonio's blood.
And, because he is an alien, the law requires the loss of his goods
and life for plotting the death of a Christian. He escapes only by
submitting to baptism. Everyone lives happily ever after - except
The Merchant of Venice raises profound questions about econ­
omics as well as anti-Semitism. Why don't debtors always default
on their creditors - especially when the creditors belong to unpop­
ular ethnic minorities? Why don't the Shylocks always lose out?
Loan sharks, like the poor on whom they prey, are always with
us. They thrive in East Africa, for example. But there is no need
to travel to the developing world to understand the workings
of primitive money-lending. According to a 2007 report by the
Department of Trade and Industry, approximately 165,000
households in the U K use illegal moneylenders, borrowing in
aggregate up to £40 million a year, but repaying three times
that amount. T o see just why one-man moneylenders are nearly
always unpopular, regardless of their ethnicity, all you need do
is pay a visit to my home town, Glasgow. The deprived housing
estates of the city's East End have long been fertile breeding
grounds for loan sharks. In districts like Shettleston, where my
grandparents lived, there are steel shutters over the windows of
derelict tenements and sectarian graffiti on the bus shelters. Once,
Shettleston's economic life revolved around the pay packets of
the workers employed at Boyd's ironworks. No w it revolves
around the benefit payments made into the Post Office accounts
of the unemployed. Male life expectancy in Shettleston is around
64, thirteen years less than the U K average and the same as in
Pakistan, which means that a newborn boy there typically will
not live long enough to collect his state pension.
Such deprived areas of Glasgow are perfect hunting grounds
for loan sharks. In the district of Hillington, Gerard La w was for
twenty years the number one loan shark. He used the Argosy pub
on Paisley Roa d West as his office, spending most working days
there, despite himself being a teetotaller. Law' s system was
simple. Borrowers would hand over their benefit books or Post
Office cashcards to him in return for a loan, the terms of which
he recorded in his loan book. When a benefit cheque was due,
La w would give the borrower back his card and wait to collect
his interest. The loan book itself was strikingly crude: a haphazard
compilation of transactions in which the same twenty or thirty
names and nicknames feature again and again alongside sums of
varying sizes: 'Beardy Al 15' , 'Jibber 100', 'Bernadett 150' , 'Wee
Caffy 1210' . The standard rate of interest La w charged his clients
was a staggering 25 per cent a week. Typically, the likes of Beardy
Al borrowed ten pounds and paid back £12.5 0 (principal plus
interest) a week later. Often, however, Law' s clients could not
afford to make their scheduled repayments; hardly surprising
when some people in the area have to live on as little as £5.90 a
day. So they borrowed some more. Soon some clients owed him
hundreds, even thousands, of pounds. The speed with which they
became entirely trapped by their debts is scarcely surprising.
Twenty-five per cent a week works out at over 1 1 million per
cent compound interest a year.
Over the very long run, interest rates in Europe have tended
to decline. So why do some people in Britain today pay eight-digit interest rates on trivial loans? These, surely, are loans you
would be mad not to default on. Some of Law' s clients were in
fact mentally subnormal. Yet there were evidently reasons
why his sane clients felt it would be inadvisable to renege on
their commitments to him, no matter how extortionate. As the
Scotsman newspaper put it: 'many of his victims were terrified to
II ···-·~~---: :. -.-~-;.
The arrest of a loan shark: Gerard Law is led away by police
officers of Glasgow's Illegal Money-Lending Unit
risk missing a payment due to his reputation' - though it is not
clear that Law ever actually resorted to violence.29 Behind every
loan shark, as the case of Shylock also shows, there lurks an
implicit threat.
It is easy to condemn loan sharks as immoral and, indeed,
criminal. Gerard Law was sentenced to ten months in prison for
his behaviour. Yet we need to try to understand the economic
rationale for what he did. First, he was able to take advantage of
the fact that no mainstream financial institution would extend
credit to the Shettleston unemployed. Second, Law had to be
rapacious and ruthless precisely because the members of his small
clientele were in fact very likely to default on their loans. The
fundamental difficulty with being a loan shark is that the business
is too small-scale and risky to allow low interest rates. But the
high rates make defaults so much more likely that only intimi­
dation ensures that people keep paying. So how did moneylenders
learn to overcome the fundamental conflict: if they were too
generous, they made no money; if they were too hard-nosed, like
Gerard Law , people eventually called in the police?
The answer is by growing big - and growing powerful.
The Birth of Banking
Shylock was far from the only moneylender to discover the
inherent weakness of the creditor, especially when the creditor is
a foreigner. In the early fourteenth century, finance in Italy had
been dominated by the three Florentine houses of Bardi, Peruzzi
and Acciaiuoli. All three were wiped out in the 1340 s as a result
of defaults by two of their principal clients, King Edward III
of England and King Robert of Naples. But if that illustrates
the potential weakness of moneylenders, the rise of the Medici
illustrates the very opposite: their potential power.
Perhaps no other family left such an imprint on an age as the
Medici left on the Renaissance. Tw o Medici became popes (Leo
X and Clement VII); two became queens of France (Catherine and
Marie); three became dukes (of Florence, Nemours and Tuscany).
Appropriately, it was that supreme theorist of political power,
Niccolô Machiavelli, who wrote their history. Their patronage
of the arts and sciences ran the gamut of genius from Michel­
angelo to Galileo. And their dazzling architectural legacy still
surrounds the modern-day visitor to Florence. Only look at the
villa of Cafaggiolo, the monastery of San Marco , the basilica of
San Lorenzo and the spectacular palaces occupied by Duke
Cosimo de' Medici in the mid sixteenth century: the former Pitti
Palace, the redecorated Palazzo Vecchio and the new city offices
4 1
(Uffizi) with their courtyard running down to the River Arno. 3 0
But what were the origins of all this splendour? Where did the
money come from that paid for masterpieces like Sandro Botti­
celli's radiant Birth of Venus? The simple answer is that the
Medici were foreign exchange dealers: members of the Arte de
Cambio (the Moneychangers' Guild). They came to be known as
bankers (banchieri) because, like the Jew s of Venice, they did
their business literally seated at benches behind tables in the
street. The original Medici bank (stall would be a better descrip­
tion) was located near the Cavalcanti palace, at the corner of the
present-day via dia Porta Rossa and the Via dell' Arte della Lana,
a short walk from the main Florentine wool market.
Prior to the 1390s , it might legitimately be suggested, the
Medici were more gangsters than bankers: a small-time clan,
notable more for low violence than for high finance. Between
134 3 and 136 0 no fewer than five Medici were sentenced to death
for capital crimes.3 1 Then came Giovanni di Bicci de' Medici. It
was his aim to make the Medici legitimate. And through hard
work, sober living and careful calculation, he succeeded.
In 138 5 Giovanni became manager of the Roman branch of
the bank run by his relation Vieri di Cambio de' Medici, a
moneylender in Florence. In Rome, Giovanni built up his repu­
tation as a currency trader. The papacy was in many ways the
ideal client, given the number of different currencies flowing in
and out of the Vatican's coffers. As we have seen, this was an age
of multiple systems of coinage, some gold, some silver, some
base metal, so that any long-distance trade or tax payment was
complicated by the need to convert from one currency to another.
But Giovanni clearly saw even greater opportunities in his native
Florence, whence he returned in 1397 . By the time he passed on
the business to his eldest son Cosimo in 1420 , he had established
a branch of the bank in Venice as well as Rome; branches were
A banker on his bench: Quentin Massys, The Banker (15 14)
later added in Geneva, Pisa, London and A vignon. Giovanni had
also acquired interests in two Florence wool factories.
Of particular importance in the Medici's early business were
the bills of exchange (cambium per literas) that had developed in
the course of the Middle Ages as a way of financing trade. 32
one merchant owed another a sum that could not be paid in cash
until the conclusion of a transaction some months hence, the
creditor could draw a bill on the debtor and either use the bill as
a means of payment in its own right or obtain cash for it at a
discount from a banker willing to act as broker. Whereas the
charging of interest was condemned as usury by the Church, there
was nothing to prevent a shrewd trader making profits on such
transactions. That was the essence of the Medici business. There
were no cheques; instructions were given orally and written in
the bank's books. There was no interest; depositors were given
discrezione (in proportion to the annual profits of the firm) to
compensate them for risking their money.3 3
The libro segreto - literally the secret book* - of Giovanni di
Bicci de' Medici sheds fascinating light on the family's rise.3 4 In
part, this was simply a story of meticulous bookkeeping. By
modern standards, to be sure, there were imperfections. The
Medici did not systematically use the double-entry method,
though it was known in Genoa as early as the 1340s. 3 5 Still, the
modern researcher cannot fail to be impressed by the neatness
and orderliness of the Medici accounts. The archives also contain
a number of early Medici balance sheets, with reserves and
deposits correctly arranged on one side (as liabilities or vostro)
and loans to clients or commercial bills on the other side (as
assets or nostro). The Medici did not invent these techniques, but
they applied them on a larger scale than had hitherto been seen
in Florence. The real key to the Medicis' success, however, was
not so much size as diversification. Whereas earlier Italian banks
had been monolithic structures, easily brought down by one
defaulting debtor, the Medici bank was in fact multiple related
partnerships, each based on a special, regularly renegotiated con­
tract. Branch managers were not employees but junior partners
who were remunerated with a share of the profits. It was this
* The term was used for books which recorded income and profits as well as
specific agreements or contracts of importance. The other books kept by the
Medici were the libro di entrata e uscita (book of income and expenditures)
and the libro dei debitori e creditori (book of debtors and creditors).
Detail from a ledger of the Medici bank
decentralization that helped make the Medici bank so profitable.
With a capital of around 20,000 florins in 1402 and a payroll of at
most seventeen people, it made profits of 151,820 florins between
1397 and 1420 - around 6,326 florins a year, a rate of return of
32 per cent. The Rome branch alone was soon posting returns
of over 30 per cent.36
The proof that the model worked can be
seen in the Florentine tax records, which list page after page of
Giovanni di Bicci's assets, totalling some 9 1 ,000 florins. 37
When Giovanni died in 1429 his last words were an exhor-tation to his heirs to maintain his standards of financial acumen.
His funeral was attended by twenty-six men of the name Medici,
all paying homage to the self-made capo della casa. By the time
Pius II became pope in 1458, Giovanni's son Cosimo de' Medici
effectively was the Florentine state. As the Pope himself put it:
'Political questions are settled at his house. The man he chooses
holds office ... He it is who decides peace and war and controls
the laws .. . He is King in everything but name.' Foreign rulers
were advised to communicate with him personally and not to
waste their time by approaching anyone else in Florence. The
Florentine historian Francesco Guicciardini observed: 'He had a
reputation such as probably no private citizen has ever enjoyed
from the fall of Rome to our own day.' One of Botticelli's most
popular portraits - of a strikingly handsome young man - was
actually intended as a tribute to a dead banker. The face on
the medal is that of Cosimo de' Medici, and alongside it is the
inscription pater patriae-, 'father of his country'. By the time
Lorenzo the Magnificent, Cosimo's grandson, took over the bank
in 1469 , the erstwhile Sopranos had become the Corleones - and
more. And it was all based on banking.
Mor e than anything else, it is Botticelli's Adoration of the Magi
that captures the transfiguration of finance that the Medici had
achieved. On close inspection, the three wise men are all Medici:
the older man washing the feet of the baby Jesus is Cosimo the
Elder; below him, slightly to the right, are his two sons Piero (in
red) and Giovanni (in white). Also in the picture are Lorenzo
(in a pale blue robe) and, clasping his sword, Giuliano. The
painting was commissioned by the head of the Bankers' Guild as
a tribute to the family. It should perhaps have been called The
Adoration of the Medici. Having once been damned, bankers
were now close to divinity.
The subjugation of the Florentine republic to the power of one
super-rich banking family inevitably aroused opposition.
Between October 143 3 and September 143 4 Cosimo and many
of his supporters were exiled from Florence to Venice. In 147 8
Lorenzo's brother Giuliano was murdered in the Pazzi family's
brutal attempt to end Medici rule. The bank itself suffered as a
result of Lorenzo's neglect of business in favour of politics.
Branch managers like Francesco Sassetti of Avignon or Tommaso
Portinari of Bruges became more powerful and less closely super­
vised. Increasingly, the bank depended on attracting deposits; its
earnings from trade and foreign exchange grew more volatile.
Expensive mistakes began to be made, like the loans made by the
Bruges branch to Charles the Bold, the Duke of Burgundy, or by
the London branch to King Edward IV, which were never wholly
repaid. T o keep the firm afloat, Lorenzo was driven to raid the
municipal Monte delle Dote (a kind of mutual fund for the pay­
ment of daughters' dowries).3 8 Finally, in 1494 , amid the chaos
of a French invasion, the family was expelled and all its property
confiscated and liquidated. Blaming the Medici for the town's
misfortunes, the Dominican preacher Girolamo Savonarola
called for a purgative 'Bonfire of the Vanities', a call answered
when a mob invaded the Medici palace and burned most of the
bank's records. (Black scorch marks are still visible on the papers
that survived.) As Lorenzo himself had put it in a song he
composed in the 1470s: Tf you would be happy, be so. / There is
no certainty about tomorrow.'
Yet when the wealthy elite of Florence contemplated the fire­
brand Savonarola and the plebeian mob as alternatives to Medici
rule they soon began to feel nostalgic for the magnificent family.
In 1537 , at the age of 17 , Cosimo de' Medici (the Younger) was
summoned back to Florence and in 156 9 was created Grand Duke
of Tuscany. The ducal line endured for more than two hundred
years, until 1743 . The coin-like palle (pills) on the Medici coat of
arms served as an enduring reminder of the family's origins.
Though others had tried before them, the Medici were the first
bankers to make the transition from financial success to heredi­
tary status and power. They achieved this by learning a crucial
lesson: in finance small is seldom beautiful. By making their
bank bigger and more diversified than any previous financial
institution, they found a way of spreading their risks. And by
engaging in currency trading as well as lending, they reduced
their vulnerability to defaults.
The Italian banking system became the model for those North
European nations that would achieve the greatest commercial
success in the coming centuries, notably the Dutch and the Eng­
lish, but also the Swedes. It was in Amsterdam, London and
Stockholm that the next decisive wave of financial innovation
occurred, as the forerunners of modern central banks made their
first appearance. The seventeenth century saw the foundation of
three distinctly novel institutions that, in their different ways,
were intended to serve a public as well as a private financial
function. The Amsterdam Exchange Bank (Wisselbank) was set
up in 1609 to resolve the practical problems created for mer­
chants by the circulation of multiple currencies in the United
Provinces, where there were no fewer than fourteen different
mints and copious quantities of foreign coins. By allowing mer­
chants to set up accounts denominated in a standardized cur­
rency, the Exchange Bank pioneered the system of cheques and
direct debits or transfers that we take for granted today. This
allowed more and more commercial transactions to take place
without the need for the sums involved to materialize in actual
coins. One merchant could make a payment to another simply
by arranging for his account at the bank to be debited and the
counterparty's account to be credited.3 9 The limitation on this
system was simply that the Exchange Bank maintained something
close to a 100 per cent ratio between its deposits and its reserves
of precious metal and coin. As late as 1760 , when its deposits
stood at just under 1 9 million florins, its metallic reserve was
over 1 6 million. A run on the bank was therefore a virtual
impossibility, since it had enough cash on hand to satisfy nearly
all of its depositors if, for some reason, they all wanted to liqui-
date their deposits at once. This made the bank secure, no doubt,
but it prevented it performing what would now be seen as the
defining characteristic of a bank, credit creation.
It was in Stockholm nearly half a century later, with the founda­
tion of the Swedish Riksbank in 1656 , that this barrier was
broken through. Although it performed the same functions as
the Dutch Wisselbank, the Riksbank was also designed to be a
Lanebank, meaning that it engaged in lending as well as facili­
tating 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. Since depositors were highly unlikely to
ask en masse for their money, only a fraction of their money
needed to be kept in the Riksbank's reserve at any given time.
The liabilities of the bank thus became its deposits (on which it
paid interest) plus its reserve (on which it could collect no inter­
est); its assets became its loans (on which it could collect interest).
The third great innovation of the seventeenth century occurred
in London with the creation of the Bank of England in 1694 .
Designed primarily to assist the government with war finance (by
converting a portion of the government's debt into shares in the
bank), the Bank was endowed with distinctive privileges. From
1709 it was the only bank allowed to operate on a joint-stock
basis (see Chapter 3); and from 174 2 it established a partial
monopoly on the issue of banknotes, a distinctive form of prom­
issory note that did not bear interest, designed to facilitate pay­
ments without the need for both parties in a transaction to have
current accounts.
T o understand the power of these three innovations, first-year
MB A students at Harvard Business School play a simplified
money game. It begins with a notional central bank paying the
professor $10 0 on behalf of the government, for which he has
done some not very lucrative consulting. 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 1 0 per cent reserve
ratio (that is, it wishes to maintain the ratio of its reserves to its
total liabilities at 1 0 per cent), it deposits $1 0 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 1 0 per cent reserve rule, so it deposi 3
$9 at the central bank and lends out the remaining $8 1 to another
of its clients. 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: M o (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 M i (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, M o is equal to $10 0 but M i is equal to $27 1
($10 0 + $90 + $81) , neatly illustrating, albeit in a highly simpli­
fied way, 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 $10 0 back. The student has to draw on his reserves
and call in his loan to the second student, setting off a domino
effect that causes M i 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.
Definitions of the money supply have, it must be acknowl­
edged, a somewhat arbitrary quality. Some measures of M i in­
cluded travellers' cheques in the total. M 2 adds savings accounts,
money market deposit accounts and certificates of deposit. M 3
is broader still, including eurodollar deposits held in offshore
markets, and repurchase agreements between banks and other
financial intermediaries. The technicalities need not detain us
here. The important point to grasp is that with the spread
throughout the Western world of a) cashless intra-bank and inter­
bank transactions b) fractional reserve banking and c) central
bank monopolies on note issue, the very nature of money evolved
in a profoundly important way. N o longer was money to be
understood, as the Spaniards had understood it in the sixteenth
century, as precious metal that had been dug up, melted down
and minted into coins. No w money represented the sum total of
specific liabilities (deposits and reserves) incurred by banks.
Credit was, quite simply, the total of banks' assets (loans). Some
of this money might indeed still consist of precious metal, though
a rising proportion of that would be held in the central bank's
vault. But most of it would be made up of those banknotes and
token coins recognized as legal tender along with the invisible
money that existed only in deposit account statements. Financial
innovation had taken the inert silver of Potosi and turned it
into the basis for a modern monetary system, with relationships
between debtors and creditors brokered or 'intermediated' by
increasingly numerous institutions called banks. The core func­
tion of these institutions was now information gathering and
5 1
risk management. Their source of profits lay in maximizing the
difference between the costs of their liabilities and the earnings
on their assets, without reducing reserves to such an extent that
the bank became vulnerable to a run - a crisis of confidence in a
bank's ability to satisfy depositors, which leads to escalating
withdrawals and ultimately bankruptcy: literally the breaking of
the bank.
Significantly, even as Italian banking techniques were being im­
proved in the financial centres of Northern Europe, one country
lagged unexpectedly far behind. Cursed with an abundance of
precious metal, mighty Spain failed to develop a sophisticated
banking system, relying instead on the merchants of Antwerp for
short-term cash advances against future silver deliveries. The idea
that money was really about credit, not metal, never quite caught
on in Madrid. Indeed, the Spanish crown ended up defaulting on
all or part of its debt no fewer than fourteen times between 155 7
and 1696 . With a track record like that, all the silver in Potosi
could not make Spain a secure credit risk. In the modern world,
power would go to the bankers, not the bankrupts.
The Evolution of Banking
Financial historians disagree as to how far the growth of banking
after the seventeenth century can be credited with the acceleration
of economic growth that began in Britain in the late eighteenth
century and then spread to Western Europe and Europe's off­
shoots of large-scale settlement in North America and Austra­
lasia.4 0 There is no question, certainly, that the financial
revolution preceded the industrial revolution. True, the decisive
breakthroughs in textile manufacturing and iron production,
which were the spearheads of the industrial revolution, did not
rely very heavily on banks for their financing.4 1 But banks played
a more important role in continental European industrialization
than they did in England's. It may in fact be futile to seek a
simplistic causal relationship (more sophisticated financial insti­
tutions caused growth or growth spurred on financial develop­
ment). It seems perfectly plausible that the two processes were
interdependent and self-reinforcing. Both processes also exhibited
a distinctly evolutionary character, with recurrent mutation (tech­
nical innovation), speciation (the creation of new kinds of firm)
and punctuated equilibrium (crises that would determine which
firms would survive and which would die out).
In the words of Adam Smith, 'The judicious operation of bank­
ing, by substituting paper in the room of a great part of .. . gold
and silver . . . provides .. . a sort of waggon-way through the air.'
In the century after he published The Wealth of Nations (1776) ,
there was an explosion of financial innovation which saw a wide
variety of different types of bank proliferate in Europe and North
America. The longest-established were bill-discounting banks,
which helped finance domestic and international trade by dis­
counting the bills of exchange drawn by one merchant on
another. Already in Smith's day London was home to a number
of highly successful firms like Barings, who specialized in trans­
atlantic merchant banking (as this line of business came to be
known). For regulatory reasons, English banks in this period
were nearly all private partnerships, some specializing in the
business of the City, that square mile of London which for cen­
turies had been the focus for mercantile finance, while others
specialized in the business of the landowning elite. These latter
were the so-called 'country banks', whose rise and fall closely
followed the rise and fall of British agriculture.
A decisive difference between natural evolution and financial
evolution is the role of what might be called 'intelligent design' -though in this case the regulators are invariably human, rather
than divine. Gradually, by a protracted process of trial and error,
the Bank of England developed public functions, in return for the
reaffirmation of its monopoly on note issue in 1826 , establishing
branches in the provinces and gradually taking over the country
banks' note-issuing business.* Increasingly, the Bank also came
to play a pivotal role in inter-bank transactions. More and more
of the clearing of sums owed by one bank to another went
through the Bank of England's offices in Threadneedle Street.
With the final scrapping in 183 3 or " tn e usury laws that limited
its discount rate on commercial bills, the Bank was able fully
to exploit its scale advantage as the biggest bank in the City.
Increasingly, its discount rate was seen as the minimum short-term interest rate in the so-called money market (for short-term
credit, mostly through the discounting of commercial bills).
The question that remained unresolved for a further forty years
was what the relationship ought to be between the Bank's reserves
and its banknote circulation. In the 1840s the position of the
Governor, J . Horsley Palmer, was that the reserve should essen­
tially be regulated by the volume of discounting business, so long
as one third of it consisted of gold coin or bullion. The Prime
Minister, Sir Robert Peel, was suspicious of this arrangement,
believing that it ran the risk of excessive banknote creation and
inflation. Peel's 184 4 Bank Charter Act divided the Bank in two:
a banking department, which would carry on the Bank's own
commercial business, and an issue department, endowed with
£1 4 million of securities and an unspecified amount of coin and
bullion which would fluctuate according to the balance of trade
* Technically, the monopoly applied only within a 6 5 -mile radius of London
and, as in the eighteenth century, private banks were not prohibited from
issuing notes.
between Britain and the rest of the world. The so-called fiduciary
note issue was not to exceed the sum of the securities and the
gold. Repeated crises (in 1847,185 7 and 1866) made it clear that
this was an excessively rigid straitjacket, however; in each case the
Act had to be temporarily suspended to avoid a complete collapse
of liquidity. * It was only after the last of these crises, which saw the
spectacular run that wrecked the bank of Overend Gurney, that
the editor of The Economist, Walter Bagehot, reformulated the
Bank's proper role in a crisis as the 'lender of last resort', to lend
freely, albeit at a penalty rate, to combat liquidity crises.4 2
The Victorian monetary problem was not wholly solved by
Bagehot, it should be emphasized. He was no more able than the
other pre-eminent economic theorists of the nineteenth century
to challenge the sacred principle, established in Sir Isaac Newton's
time as Master of the Mint, that a pound sterling should be
convertible into a fixed and immutable quantity of gold according
to the rate of £3 17 s ioH d per ounce of gold. T o read contempor­
ary discussion of the gold standard is to appreciate that, in many
ways, the Victorians were as much in thrall to precious metal as
the conquistadors three centuries before. 'Precious Metals alone
are money,' declared one City grandee, Baron Overstone. 'Paper
notes are money because they are representations of Metallic
Money. Unless so, they are false and spurious pretenders. One
depositor can get metal, but all cannot, therefore deposits are not
money.'4 3 Had that principle been adhered to, and had the money
supply of the British economy genuinely hinged on the quantity
* Illiquidity is when a firm cannot sell sufficient assets to meet its liabilities.
It has the right amount of assets, but they are not marketable because there
are too few potential buyers. Insolvency is when the value of the liabilities
clearly exceeds the value of the assets. The distinction is harder to draw than
is sometimes assumed. A firm in a liquidity crisis might be able to sell its
assets, but only at prices so low as to imply insolvency.
of gold coin and bullion in the Bank of England's reserve, the
growth of the U K economy would have been altogether choked
off, even allowing for the expansionary effects of new gold dis-coveries in the nineteenth century. So restrictive was Bank of
England note issuance that its bullion reserve actually exceeded
the value of notes in circulation from the mid 1890s until the
First World War. It was only the proliferation of new kinds of
bank, and particularly those taking deposits, that made monetary
expansion possible. After 1858 , the restrictions on joint-stock
banking were lifted, paving the way for the emergence of a few
big commercial banks: the London ÔC Westminster (founded in
1833) , the National Provincial (1834) , the Birmingham &
Midland (1836) , Lloyds (1884) and Barclays (1896). Industrial
investment banks of the sort that took off in Belgium (Société
Générale), France (the Crédit Mobilier) and Germany (the Darm-stàdter Bank) fared less well in Britain after the failure of Overend
Gurney. The critical need was not in fact for banks to buy large
blocks of shares in industrial companies; it was for institutions
that would attract savers to hand over their deposits, creating an
ever expanding basis for new bank lending on the other side of
the balance sheet.
In this process an especially important role was played by the
new savings banks that proliferated at the turn of the century.
By 191 3 British savings bank deposits amounted to £25 6 million,
roughly a quarter of all U K deposits. The assets of German
savings banks were more than two and a half times greater
than those of the better known 'great banks' like Darmstàdter,
Deutsche, Dresdner and the Disconto-Gesellschaft. All told,
by the eve of the First World War, residents' deposits in British
banks totalled nearly £1. 2 billion, compared with a total bank-note circulation of just £45. 5 million. Money was now primarily
inside banks, out of sight, even if never out of mind.
Although there was variation, most advanced economies essen­
tially followed the British lead when it came to regulation through
a monopolistic central bank operating the gold standard, and
concentration of deposit-taking in a relatively few large insti­
tutions. The Banque de France was established in 1800 , the Ger­
man Reichsbank in 1875 , tn e Bank of Japa n in 188 2 and the
Swiss National Bank in 1907 . In Britain, as on the Continent,
there were marked tendencies towards concentration, exemplified
by the decline in the number of country banks from a peak of
75 5 in 1809 to just seventeen in 1913 .
The evolution of finance was quite different in the United
States. There the aversion of legislators to the idea of over-mighty
financiers twice aborted an embryonic central bank (the first and
second Banks of the United States), so that legislation was not
passed to create the Federal Reserve System until 1913 . Up until
that point, the US was essentially engaged in a natural experiment
with wholly free banking. The 186 4 National Bank Act had
significantly reduced the barriers to setting up a privately owned
bank, and capital requirements were low by European standards.
At the same time, there were obstacles to setting up banks across
state lines. The combined effect of these rules was a surge in the
number of national and state-chartered banks during the late
nineteenth and early twentieth centuries, from fewer than 12,000
in 1899 to more than 30,000 at the peak in 1922 . Large numbers
of under-capitalized banks were a recipe for financial instability,
and panics were a regular feature of American economic life -most spectacularly in the Great Depression, when a major bank­
ing crisis was exacerbated rather than mitigated by a monetary
authority that had been operational for little more than fifteen
years. The introduction of deposit insurance in 193 3 did much
to reduce the vulnerability of American banks to runs. However,
the banking sector remained highly fragmented until 1976 , when
Maine became the first state to legalize interstate banking. It was
not until 1993 , after the Savings and Loans crisis (see Chapter
5), that the number of national banks fell below 3,600 for the
first time in nearly a century.
In 192 4 John Maynard Keynes famously dismissed the gold stan­
dard as a 'barbarous relic'. But the liberation of bank-created
money from a precious metal anchor happened slowly. The gold
standard had its advantages, no doubt. Exchange rate stability
made for predictable pricing in trade and reduced transaction
costs, while the long-run stability of prices acted as an anchor for
inflation expectations. Being on gold may also have reduced the
costs of borrowing by committing governments to pursue prudent
fiscal and monetary policies. The difficulty of pegging currencies
to a single commodity based standard, or indeed to one another,
is that policymakers are then forced to choose between free capi­
tal movements and an independent national monetary policy.
They cannot have both. A currency peg can mean higher volatility
in short-term interest rates, as the central bank seeks to keep the
price of its money steady in terms of the peg. It can mean
deflation, if the supply of the peg is constrained (as the supply of
gold was relative to the demand for it in the 1870s and 1880s).
And it can transmit financial crises (as happened throughout the
restored gold standard after 1929) . By contrast, a system of
money based primarily on bank deposits and floating exchange
rates is freed from these constraints. The gold standard was a
long time dying, but there were few mourners when the last
meaningful vestige of it was removed on 1 5 August 1971 , the day
that President Richard Nixo n closed the so-called gold 'window'
through which, under certain restricted circumstances, dollars
could still be exchanged for gold. From that day onward, the
centuries-old link between money and precious metal was broken.
Bankrupt Nation
Memphis, Tennessee, is famous for blue suede shoes, barbecues
and bankruptcies. If you want to understand how today's bankers
- the successors to the Medici - deal with the problem of credit
risk created by unreliable borrowers, Memphis surely is the place
to be.
On average, there are between one and two million bankruptcy
cases every year in the United States, nearly all of them involving
individuals who elect to go bust rather than meet unmanageable
obligations. A strikingly large proportion of them happen in
Tennessee. The remarkable thing is how relatively painless this
process seems to be - compared, that is, with what went on
in sixteenth-century Venice or, for that matter, some parts of
present-day Glasgow. Most borrowers who run into difficulties
in Memphis can escape or at least reduce their debts, stigma-free
and physically unharmed. One of the great puzzles is that the
world's most successful capitalist economy seems to be built on
a foundation of easy economic failure.
When I visited Memphis for the first time in the early summer
of 2007 I was fascinated by the ubiquity and proximity of both
easy credit and easy bankruptcy. All I had to do was to take a
walk down a typical street near the city centre. First there were
the shopping malls and fast food joints, which is where Tennes-seans do much of their spending. Right next door was a 'tax
advisor' ready to help those short of cash to claim their low-earners' tax credits. I saw a shop offering loans against cars
and, next door to it, a second-mortgage company, as well as a
cheque-cashing shop offering advances on pay packets (at 200 per
cent interest), not to mention a pawnshop the size of a department
store. Conveniently located for those who had already pawned
all their possessions was a Rent-A-Cente r offering cheap furni­
ture and televisions for hire. And next door to that? The Plasma
Center, offering $5 5 a go for blood donations. Modern Memphis
gives a whole new meaning to the expression 'bled dry'. A pint
of blood may not be quite as hard to give up as a pound of flesh,
but the general idea seems disconcertingly similar.
Ye t the consequences of default in Memphis are far less grave
than the risk of death Antonio ran in Venice. After the Plasma
Center, my next stop was the office of George Stevenson, one of
the lawyers who make a living by advising bankrupts at the
United States Bankruptcy Court Western District of Tennessee.
At the time of my trip to Tennessee, the annual number of bank­
ruptcy filings in the Memphis area alone was around 10,000, so
I wasn't surprised to find the Bankruptcy Court crowded with
people. The system certainly appears to work very smoothly.
One by one, the individuals and couples who have fallen into
insolvency sit down with a lawyer who negotiates on their behalf
with their creditors. There is even a fast-track lane for speedy
bankruptcies - though on average only three out of five bankrupts
are discharged (meaning that an agreement is reached with their
The ability to walk away from unsustainable debts and start all
over again is one of the distinctive quirks of American capitalism.
There were no debtors' prisons in the United States in the early
1800s, at a time when English debtors could end up languishing
in jail for years. 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 plans go wrong, even for the second
time, thereby allowing the natural-born risk-takers to learn
through trial and error until they finally figure out how to make
that million. After all, today's bankrupt might well be tomorrow's
successful entrepreneur.
At first sight, the theory certainly seems to work. Man y of
America's most successful businessmen failed in their early
endeavours, including the ketchup king John Henry Heinz, the
circus supremo Phineas Barnum and the automobile magnate
Henry Ford. All of these men eventually became immensely rich,
not least because they were given a chance to try, to fail and to
start over. Yet on closer inspection what happens in Tennessee is
rather different. The people in the Memphis Bankruptcy Court
are not businessmen going bust. They are just ordinary indi­
viduals who cannot pay their bills - often the large medical bills
that Americans can suddenly face if they are not covered by
private health insurance. Bankruptcy may have been designed to
help entrepreneurs and their businesses, but nowadays 98 per
cent of filings are classified as non-business. The principal driver
of bankruptcy turns out to be not entrepreneurship but indebted­
ness. In 2007 US consumer debt hit a record $2 . 5 trillion. Back in
1959 , consumer debt was equivalent to 1 6 per cent of disposable
personal income. No w it is 24 per cent.* One of the challenges
for any financial historian today is to understand the causes of
this explosion of household indebtedness and to estimate what
the likely consequences will be if, as seems inevitable, there is an
increase in the bankruptcy rate in states like Tennessee.
Before we can answer these questions properly, we need to
introduce the other key components of the financial system: the
* In the same period mortgage debt has risen from 54 per cent of disposable
personal income to 14 0 per cent.
6 1
bond market, the stock market, the insurance market, the real
estate market and the extraordinary globalization of all these
markets that has taken place over the past twenty years. The root
cause, however, must lie in the evolution of money and the banks
whose liabilities are its key component. The inescapable reality
seems to be that breaking the link between money creation and
a metallic anchor has led to an unprecedented monetary expan­
sion - and with it a credit boom the like of which the world has
never seen. Measuring liquidity as the ratio of broad money to
output* over the past hundred years, it is very clear that the trend
since the 1970s has been for that ratio to rise - in the case of
broad money in the major developed economies from around
70 per cent before the closing of the gold window to more than
100 per cent by 2005. 4 4 In the eurozone, the increase has been
especially steep, from just over 60 per cent as recently as 1990 to
just under 90 per cent today. At the same time, the capital
adequacy of banks in the developed world has been slowly but
steadily declining. In Europe bank capital is now equivalent to
less than 1 0 per cent of assets, compared with around 25 per cent
at the beginning of the twentieth century.4 5 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.
Today, banking assets (that is, loans) in the world's major econo­
mies are equivalent to around 15 0 per cent of those countries'
combined GDP. 4 6 According to the Bank for International Settle­
ments, total international banking assets in December 2006
were equivalent to around $2 9 trillion, roughly 63 per cent of
world GDP. 4 7
Is it any wonder, then, that money has ceased to hold its value
* A ratio known to economists as Marshallian k after the economist Alfred
Marshall. Strictly speaking, k is the ratio of the monetary base to nominal
10 111 1 111111111111111111111111111111111111111111111111111111111 1 1 11111 1 1111 1
3 1 Jan 3 1 Jan 3 r J a n 3!J a n 3 1 J a n 3 J Ja n
1908 192 8 194 8 1968 1988 zoo8
in the way that it did in the era of the gold standard? The
modern-day dollar bill acquired its current design in 1957. Since
then its purchasing power, relative to the consumer price index,
has declined by a staggering 87 per cent. Average annual inflation
in that period has been over 4 per cent, twice the rate Europe
experienced during the so-called price revolution unleashed by
the silver of Potosi. A man who had exchanged his $1,00 0 of
savings for gold in 1970 , while the gold window was still ajar,
would have received just over 26.6 ounces of the precious metal.
At the time of writing, with gold trading at close to $1,00 0 an
ounce, he could have sold his gold for $26,596 .
A world without money would be worse, much worse, than our
present world. It is wrong to think (as Shakespeare's Antonio
did) of all lenders of money as mere leeches, sucking the life's
blood out of unfortunate debtors. Loan sharks may behave that
way, but banks have evolved since the days of the Medici precisely
in order (as the 3rd Lord Rothschild succinctly put it), to 'facilitate
The New York closing price of gold ($ per oz., log scale), 1908-200 8
1,000 -
the movement of money from point A , where it is, to point B ,
where it is needed'.4 8 Credit and debt, in short, are among the
essential building blocks of economic development, as vital to
creating the wealth of nations as mining, manufacturing or
mobile telephony. Poverty, by contrast, is seldom directly attribu­
table to the antics of rapacious financiers. It often has more to
do with the lack of financial institutions, with the absence of
banks, not their presence. It is only when borrowers in places like
the East End of Glasgow have access to efficient credit networks
that they can escape from the clutches of the loan sharks; only
when savers can put their money in reliable banks that it can be
channelled from the idle to the industrious.
The evolution of banking was thus 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 'securi-tized lending', which allowed banks to originate loans but then
repackage and sell them on. 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.
Early in Bill Clinton's first hundred days as president, his cam­
paign manager James Carville made a remark that has since
become famous. T 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. Yo u can intimidate everybody.'
Rather to his surprise, bond prices had risen in the wake of the
previous November's election, a movement that had actually
preceded a speech by the president in which he pledged to reduce
the federal deficit. 'That investment market, they're a tough
crowd,' observed Treasury Secretary Lloyd Bentsen. 'Is this a
credible effort [by the president] ? Is the administration going to
hang in there pushing it? They have so judged it.' If bond prices
continued to rally, said Federal Reserve Chairman Alan Green­
span, it would be 'by far the most potent [economic] stimulus
that I can imagine.'1 What could make public officials talk with
such reverence, even awe, about a mere market for the buying
and selling of government IOUs?
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
Of Human Bondage
Japanese government ten-year bonds, complete with coupons
banks. Take the example of a Japanese government ten-year bond
with a face value of 100,000 yen and a fixed interest rate or
'coupon' of 1.5 per cent - a tiny part of the vast 838 trillion yen
mountain of public debt that Japan has accumulated, mostly
since the 1980s. The bond embodies a promise by the Japanese
government to pay 1.5 per cent of 100,000 yen every year for the
next ten years to whoever owns the bond. The initial purchaser
of the bond has the right to sell it whenever he likes at whatever
price the market sets. At the time of writing, that price is around
102,333 yen. Why? Because the mighty bond market says so.
From modest beginnings in the city-states of northern Italy
some eight hundred years ago, the market for bonds has grown
to a vast size. The total value of internationally traded bonds
today is around $1 8 trillion. The value of bonds traded dom­
estically (such as Japanese bonds owned by Japanese investors)
is a staggering $5 0 trillion. All of us, whether we like it or not
(and most of us do not even know it), are affected by the bond
market in two important ways. 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. When bond prices fall, interest rates soar, with painful
consequences for all borrowers. The way it works is this. Someone
has 100,000 yen they wish to save. Buying a 100,000 yen bond
keeps the capital sum safe while also providing regular payments
to the saver. T o be precise, the bond pays a fixed rate or 'coupon'
of 1.5 per cent: 1,500 yen a year in the case of a 100,000 yen
bond. But the market interest rate or current yield is calculated
by dividing the coupon by the market price, which is currently
102 ,33 3 yen: 1,500 -r 102 ,33 3 = J -4 7 P e r cent.* No w imagine a
scenario in which the bond market took fright at the huge size of
the Japanese government's debt. Suppose investors began to
worry that Japan might be unable to meet the annual payments
to which it had committed itself. Or suppose they began to worry
about the health of the Japanese currency, the yen, in which
bonds are denominated and in which the interest is paid. In such
circumstances, the price of the bond would drop as nervous
investors sold off their holdings. Buyers would only be found at
a price low enough to compensate them for the increased risk of
a Japanese default or currency depreciation. Let us imagine the
* This should not be confused with the yield to maturity, which takes account
of the amount of time before the bond is redeemed at par by the issuing
price of our bond fell to 80,000. Then the yield would be 1,500 -r
80,000 =1.8 8 per cent. At a stroke, long-term interest rates for
the Japanese economy as a whole would have jumped by just
over two fifths of one per cent, from 1.4 7 per cent to 1.88. People
who had invested in bonds for their retirement before the market
move would be 2 2 per cent worse off, since their capital would
have declined by as much as the bond price. And people who
wanted to take out a mortgage after the market move would find
themselves paying at least 0.41 per cent a year (in market par­
lance, 4 1 basis points) more. In the words of Bill Gross, who
runs the world's largest bond fund at the Pacific Investment
Management Company (PIMCO) , '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.'
From a politician's point of view, the bond market is powerful
partly because it passes a daily judgement on the credibility of
every government's fiscal and monetary policies. But its real
power lies in its ability to punish a government with higher
borrowing costs. Even an upward move of half a percentage point
can hurt a government that is running a deficit, adding higher debt
service to its already high expenditures. As in so many financial
relationships, there is a feedback loop. The higher interest pay­
ments make the deficit even larger. The bond market raises its eye­
brows even higher. The bonds sell off again. The interest rates go
up again. And so on. 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? The
bond market began by facilitating government borrowing. In a
crisis, however, it can end up dictating government policy.
So how did this 'M r Bond' become so much more powerful
than the M r Bond created by Ian Fleming? Why, indeed, do both
kinds of bond have a licence to kill?
Mountains of Debt
'War', declared the ancient Greek philosopher Heraclitus, 'is the
father of all things.' It was certainly the father of the bond market.
In Pieter van der Heyden's extraordinary engraving, The Battle
about Money, piggy banks, money bags, barrels of coins, and
treasure chests - most of them heavily armed with swords, knives
and lances - attack each other in a chaotic free-for-all. The Dutch
verses below the engraving say: 'It's all for money and goods, this
fighting and quarrelling.' But what the inscription could equally
well have said is: 'This fighting is possible only if you can raise
the money to pay for it.' The ability to finance war through a
market for government debt was, like so much else in financial
history, an invention of the Italian Renaissance.
For much of the fourteenth and fifteenth centuries, the medieval
city-states of Tuscany - Florence, Pisa and Siena - were at war
with each other or with other Italian towns. This was war waged
as much by money as by men. Rather than require their own
citizens to do the dirty work of fighting, each city hired military
contractors (condottieri) who raised armies to annex land and
loot treasure from its rivals. Among the condottieri of the 1 3 60s
and 1 3 70s one stood head and shoulders above the others. His
commanding figure can still be seen on the walls of Florence's
Duomo - a painting originally commissioned by a grateful Floren­
tine public as a tribute to his 'incomparable leadership'. Unlikely
though it may seem, this master mercenary was an Essex boy
born and raised in Sible Hedingham. So skilfully did Sir John
Pieter van der Heyden after Pieter Bruegel the Elder, The Battle
about Money, after 1570. The Dutch inscription reads: 'It's all
for money and goods, this fighting and quarrelling.'
Hawkwood wage war on their behalf that the Italians called him
Giovanni Acuto, John the Acute. The Castello di Montecchio
outside Florence was one of many pieces of real estate the Floren-tines gave him as a reward for his services. Yet Hawkwood was
a mercenary, who was willing to fight for anyone who would pay
him, including Milan, Padua, Pisa or the pope. Dazzling frescos in
Florence's Palazzo Vecchio show the armies of Pisa and Florence
clashing in 1364, at a time when Hawkwood was fighting for
Pisa. Fifteen years later, however, he had switched to serve
Florence, and spent the rest of his military career in that city's
employ. Why? Because Florence was where the money was.
The cost of incessant war had plunged Italy'S city-states into
crisis. Expenditures even in years of peace were running at double
7 1
tax revenues. T o pay the likes of Hawkwood , Florence was
drowning in deficits. Yo u can still see in the records of the Tuscan
State Archives how the city's debt burden increased a hundred­
fold from 50,000 florins at the beginning of the fourteenth century
to 5 million by 1427. 2 It was literally a mountain of debt - hence
its name: the monte commune or communal debt mountain.3 By
the early fifteenth century, borrowed money accounted for nearly
70 per cent of the city's revenue. The 'mountain' was equivalent
to more than half the Florentine economy's annual output.
From whom could the Florentines possibly have borrowed
such a huge sum? The answer is from themselves. Instead of paying
a property tax, wealthier citizens were effectively obliged to lend
money to their own city government. In return for these forced
loans (prestanze), they received interest. Technically, this was not
usury (which, as we have seen, was banned by the Church) since
the loans were obligatory; interest payments could therefore be
reconciled with canon law as compensation (damnum emergens)
for the real or putative costs arising from a compulsory invest­
ment. As Hostiensis (or Henry) of Susa put it in around 1270 :
If some merchant, who is accustomed to pursue trade and the commerce
of fairs, and there profit from, has, out of charity to me, who needs it
badly, lent money with which he would have done business, I remain
obliged to his interesse [note this early use of the term 'interest'] . . . 4
A crucial feature of the Florentine system was that such loans
could be sold to other citizens if an investor needed ready money;
in other words, they were relatively liquid assets, even though the
bonds at this time were no more than a few lines in a leather-bound ledger.
In effect, then, Florence turned its citizens into its biggest
investors. By the early fourteenth century, two thirds of house­
holds had contributed in this way to financing the public debt,
though the bulk of subscriptions were accounted for by a few
thousand wealthy individuals.5 The Medici entries in the 'Ruolo
delle prestanze' testify not only to the scale of their wealth at this
time, but also to the extent of their contributions to the city-state's
coffers. One reason that this system worked so well was that
they and a few other wealthy families also controlled the city's
government and hence its finances. This oligarchical power struc­
ture gave the bond market a firm political foundation. Unlike
an unaccountable hereditary monarch, who might arbitrarily
renege on his promises to pay his creditors, the people who issued
the bonds in Florence were in large measure the same people
who bought them. No t surprisingly, they therefore had a strong
interest in seeing that their interest was paid.
Nevertheless, there was a limit to how many more or less
unproductive wars could be waged in this way. The larger the
debts of the Italian cities became, the more bonds they had to
issue; and the more bonds they issued, the greater the risk that
they might default on their commitments. Venice had in fact
developed a system of public debt even earlier than Florence, in
the late twelfth century. The monte vecchio (Old Mountain) as
the consolidated debt was known, played a key role in funding
Venice's fourteenth-century wars with Genoa and other rivals. A
new mountain of debt arose after the protracted war with the
Turks that raged between 146 3 and 1479 : the monte nuovo.6
Investors received annual interest of 5 per cent, paid twice yearly
from the city's various excise taxes (which were levied on articles
of consumption like salt). Like the Florentine prestanze, the
Venetian prestiti were forced loans, but with a secondary market
which allowed investors to sell their bonds to other investors for
cash.7 In the late fifteenth century, however, a series of Venetian
military reverses greatly weakened the market for prestiti. Having
stood at 80 (20 per cent below their face value) in 1497 , the
7 2
bonds of the Venetian monte nuovo were worth just 5 2 by 1500 ,
recovering to 75 by the end of 150 2 and then collapsing from
10 2 to 40 in 1509 . At their low points in the years 150 9 to 1529 ,
monte vecchio sold at just 3 and monte nuovo at io. 8
Now , if you buy a government bond while war is raging you
are obviously taking a risk, the risk that the state in question may
not pay your interest. On the other hand, remember that the
interest is paid on the face value of the bond, so if you can buy a
5 per cent bond at just 1 0 per cent of its face value you can earn
a handsome yield of 50 per cent. In essence, you expect a return
proportional to the risk you are prepared to take. At the same
time, as we have seen, it is the bond market that sets interest rates
for the economy as a whole. If the state has to pay 50 per cent,
then even reliable commercial borrowers are likely to pay some
kind of war premium. It is no coincidence that the year 1499 ,
when Venice was fighting both on land in Lombardy and at sea
against the Ottoman Empire, saw a severe financial crisis as bonds
crashed in value and interest rates soared.9 Likewise, the bond
market rout of 150 9 was a direct result of the defeat of the
Venetian armies at Agnadello. The result in each case was the
same: business ground to a halt.
It was not only the Italian city-states that contributed to the
rise of the bond market. In Northern Europe, too, urban polities
grappled with the problem of financing their deficits without
falling foul of the Church. Here a somewhat different solution
was arrived at. Though they prohibited the charging of interest
on a loan (mutuum), the usury laws did not apply to the medieval
contract known as the census, which allowed one party to buy a
stream of annual payments from another. In the thirteenth century,
such annuities started to be issued by northern French towns like
Douai and Calais and Flemish towns like Ghent. They took
one of two forms: rentes heritables or erfelijkrenten, perpetual
revenue streams which the purchaser could bequeath to his heirs,
or rentes viagères or lijfrenten, which ended with the purchaser's
death. The seller, but not the buyer, had the right to redeem the
rente by repaying the principal. By the mid sixteenth century, the
sale of annuities was raising roughly 7 per cent of the revenues
of the province of Holland.1 0
Both the French and Spanish crowns sought to raise money in
the same way, but they had to use towns as intermediaries. In the
French case, funds were raised on behalf of the monarch by the
Paris hôtel de ville-, in the Spanish case, royal juros had to be
marketed through Genoa's Casa di San Giorgio (a private syndi-cate that purchased the right to collect the city's taxes) and Ant-werp's heurs, a forerunner of the modern stock market. Yet
investors in royal debt had to be wary. Whereas towns, with their
oligarchical forms of rule and locally held debts, had incentives
not to default, the same was not true of absolute rulers. As we
saw in Chapter 1 , the Spanish crown became a serial defaulter in
the late sixteenth and seventeenth centuries, wholly or partially
suspending payments to creditors in 1557 , 1560 , 1575 , 1596 ,
1607 , 1627 , 1647 , 165 2 and 1662. 1 1
Part of the reason for Spain's financial difficulties was the
extreme costliness of trying and failing to bring to heel the rebel-lious provinces of the northern Netherlands, whose revolt against
Spanish rule was a watershed in financial as well as political
history. With their republican institutions, the United Provinces
combined the advantages of the city-state with the scale of a
nation-state. They were able to finance their wars by developing
Amsterdam as the market for a whole range of new securities: not
only life and perpetual annuities, but also lottery loans (whereby
investors bought a small probability of a large return). By 165 0
there were more than 6 5,000 Dutch rentiers, men who had invested
their capital in one or other of these debt instruments and thereby
helped finance the long Dutch struggle to preserve their indepen­
dence. As the Dutch progressed from self-defence to imperial
expansion, their debt mountain grew high indeed, from 50 million
guilders in 163 2 to 250 million in 1752 . Yet the yield on Dutch
bonds declined steadily, to a low of just 2.5 per cent in 174 7 - a
sign not only that capital was abundant in the United Provinces,
but also that investors had little fear of an outright Dutch default.1 2
With the Glorious Revolution of 1688 , which ousted the Cath­
olic James II from the English throne in favour of the Dutch
Protestant Prince of Orange, these and other innovations crossed
the English Channel from Amsterdam to London. The English
fiscal system was already significantly different from that of the
continental monarchies. The lands owned by the crown had been
sold off earlier than elsewhere, increasing the power of parliaments
to control royal expenditure at a time when their powers were
waning in Spain, France and the German lands. There was already
an observable move in the direction of a professional civil service,
reliant on salaries rather than peculation. The Glorious Revolution
accentuated this divergence. From now on there would be no more
regular defaulting (the 'Stop of Exchequer' of 1672 , when, with
the crown deep in debt, Charles II had suspended payment of his
bills, was still fresh in the memories of London investors). There
would be no more debasement of the coinage, particularly after the
adoption of the gold standard in 1717 . There would be parliamen­
tary scrutiny of royal finances. And there would be a sustained
effort to consolidate the various debts that the Stuart dynasty had
incurred over the years, a process that culminated in 174 9 with the
creation by Sir Henry Pelham of the Consolidated Fund*.1 3 This
was the very opposite of the financial direction taken in France,
* Hence the name 'consols' for the new standardized British government
where defaults continued to happen regularly; offices were sold
to raise money rather than to staff the civil service; tax collection
was privatized or farmed out; budgets were rare and scarcely
intelligible; the Estates General (the nearest thing to a French
parliament) had ceased to meet; and successive controllers-general struggled to raise money by issuing rentes and tontines
(annuities sold on the lives of groups of people) on terms that
were excessively generous to investors.1 4 In London by the mid
eighteenth century there was a thriving bond market, in which
government consols were the dominant securities traded, bonds
that were highly liquid - in other words easy to sell - and attrac­
tive to foreign (especially Dutch) investors.1 5 In Paris, by contrast,
there was no such thing. It was a financial divergence that would
prove to have profound political consequences.
Since it was arguably the most successful bond ever issued, it is
worth pausing to look more closely at the famed British consol.
By the late eighteenth century it was possible to invest in two
types: those bearing a 3 per cent coupon, and those bearing a
5 per cent coupon. They were otherwise identical, in that they
were perpetual bonds, without a fixed maturity date, which could
be bought back (redeemed) by the government only if their
market price equalled or exceeded their face value (par). The
illustration opposite shows a typical consol, a partially printed,
partially handwritten receipt, stating the amount invested, the
face value of the security, the investor's name and the date:
Received this 2 2 Day of January 179 6 of Mrs. Anna Hawes the Sum
of One hundred and one pounds being the Consideration for One
hundred pounds Interest or Share in the Capital or Joint Stock of Five
per Cent Annuities, consolidated July 6th, 178 5 . . . transferable at
the Bank of England .. .
A 5 per cent con sol purchased by Anna Hawes in January 1796
Given that she paid £101 for a £100 consol, Mrs Hawes was
securing an annual yield on her investment of 4.95 per cent. This
was not an especially well-timed investment. April that year saw
the first victory at Montenotte of a French army led by a young
Corsican commander named Napoleon Bonaparte. He won again
at Lodi in May. For the next two decades, this man would pose
a greater threat to the security and financial stability of the British
Empire, not to mention the peace of Europe, than all the
Habsburgs and Bourbons put together. Defeating him would lead
to the rise of yet another mountain of debt. And as the mountain
rose, so the price of individual consols declined - by as much as
30 per cent at the lowest point in Britain's fortunes.
The meteoric rise of a diminutive Corsican to be Emperor of
F ranee and master of the European continent was an event few
could have predicted in 1796, least of all Mrs Anna Hawes. Yet
an even more remarkable (and more enduring) feat of social
mobility was to happen in almost exactly the same timeframe.
Within just a few years of Napoleon's final defeat at Waterloo, a
man who had grown up amid the gloom of the Frankfurt ghetto
had emerged as a financial Bonaparte: the master of the bond
market and, some ventured to suggest, the master of European
politics as well. That man's name was Nathan Rothschild.
The Bonaparte of Finance
Master of unbounded wealth, he boasts that he is the arbiter of
peace and war, and that the credit of nations depends upon his nod;
his correspondents are innumerable; his couriers outrun those of
sovereign princes, and absolute sovereigns; ministers of state are in
his pay. Paramount in the cabinets of continental Europe, he aspires
to the domination of our own.1 6
Those words were spoken in 182 8 by the Radical M P Thomas
Dunscombe. The man he was referring to was Nathan Mayer
Rothschild, founder of the London branch of what was, for most
of the nineteenth century, the biggest bank in the world. 1 7 It was
the bond market that made the Rothschild family rich - rich
enough to build forty-one stately homes all over Europe, among
them Waddesdon Mano r in Buckinghamshire, which has been
restored in all its gilded glory by the 4th Lord Rothschild,
Nathan's great-great-great-grandson. His illustrious forebear,
according to Lord Rothschild, was 'short, fat, obsessive, ex­
tremely clever, wholly focused .. . I can't imagine he would have
been a very pleasant person to have dealings with.' His cousin
Evelyn de Rothschild takes a similar view. 'I think he was very
ambitious,' he says, contemplating Nathan Rothschild's portrait
in the boardroom at the offices of N . M . Rothschild in London's
St Swithin's Lane, 'and I think he was very determined. I don't
think he suffered fools lightly.'
Though the Rothschilds were compulsive correspondents, rela­
tively few of Nathan's letters to his brothers have survived. There
is one page, however, that clearly conveys the kind of man
he was. Written, like all their letters, in almost indecipherable
Judendeutsch (German transliterated into Hebrew characters), it
epitomizes what might be called his Jewish work ethic and his
impatience with his less mercurial brothers:
I am writing to you giving my opinion, as it is my damned duty to
write to you .. . I am reading through your letters not just once but
maybe a hundred times. You can well imagine that yourself. After
dinner I usually have nothing to do. I do not read books, I do not play
cards, I do not go to the theatre, my only pleasure is my business and
in this way I read Amschel's, Salomon's, James's and Carl's letters . . .
As far as Carl's letter [about buying a bigger house in Frankfurt] is
concerned .. . all this is a lot of nonsense because as long as we have
good business and are rich everybody will flatter us and those who
have no interest in obtaining revenues through us begrudge us for it
all. Our Salomon is too good and agreeable to anything and anybody
and if a parasite whispers something into his ear he thinks that all
human beings are noble minded[;] the truth is that all they are after
is their own interest.18
Small wonder his brothers called Nathan 'the general in chief.
'All you ever write', complained Salomon wearily in 1815 , 'is pay
this, pay that, send this, send that.'1 9 It was this phenomenal
drive, allied to innate financial genius, that propelled Nathan
from the obscurity of the Frankfurt Judengasse to mastery of the
London bond market. Once again, however, the opportunity for
financial innovation was provided by war.
On the morning of 1 8 June 1815 , 67,000 British, Dutch and
German troops under the Duke of Wellington's command looked
out across the fields of Waterloo, not far from Brussels, towards
an almost equal number of French troops commanded by the
French Emperor, Napoleon Bonaparte. The Battle of Waterloo
was the culmination of more than two decades of intermittent
conflict between Britain and France. But it was more than a battle
between two armies. It was also a contest between rival financial
systems: one, the French, which under Napoleon had come to be
based on plunder (the taxation of the conquered); the other, the
British, based on debt.
Never had so many bonds been issued to finance a military
conflict. Between 179 3 and 181 5 the British national debt in­
creased by a factor of three, to £74 5 million, more than double
the annual output of the U K economy. But this increase in the
supply of bonds had weighed heavily on the London market.
Since February 1792 , the price of a typical £10 0 3 per cent consol
had fallen from £96 to below £60 on the eve of Waterloo, at one
time (in 1797 ) sinking below £50. These were trying times for
the likes of Mrs Anna Hawes.
According to a long-standing legend, the Rothschild family
owed the first millions of their fortune to Nathan's successful
speculation about the effect of the outcome of the battle on the
price of British bonds. In some versions of the story, Nathan
witnessed the battle himself, risked a Channel storm to reach
London ahead of the official news of Wellington's victory and,
by buying bonds ahead of a huge surge in prices, pocketed
between £2 0 and £13 5 million. It was a legend the Nazis later
did their best to embroider. In 194 0 Joseph Goebbels approved
the release of Die Rothschilds, which depicts an oleaginous
Nathan bribing a French general to ensure the Duke of Welling­
ton's victory, and then deliberately misreporting the outcome in
London in order to precipitate panic selling of British bonds,
which he then snaps up at bargain-basement prices. Ye t the
reality was altogether different.2 0 Far from making money from
Wellington's victory, the Rothschilds were very nearly ruined
by it. Their fortune was made not because of Waterloo, but
despite it.
After a series of miscued interventions, British troops had been
fighting against Napoleon on the Continent since August 1808 ,
when the future Duke of Wellington, then Lieutenant-General Sir
Arthur Wellesley, led an expeditionary force to Portugal, invaded
by the French the previous year. For the better part of the next
six years, there would be a recurrent need to get men and matériel
to the Iberian Peninsula. Selling bonds to the public had certainly
raised plenty of cash for the British government, but banknotes
were of little use on distant battlefields. T o provision the troops
and pay Britain's allies against France, Wellington needed a cur­
rency that was universally acceptable. The challenge was to trans­
form the money raised on the bond market into gold coins, and
to get them to where they were needed. Sending gold guineas
from London to Lisbon was expensive and hazardous in time of
war. But when the Portuguese merchants declined to accept the
bills of exchange that Wellington proffered, there seemed little
alternative but to ship cash.
The son of a moderately successful Frankfurt antique dealer
and bill broker, Nathan Rothschild had arrived in England only
in 179 9 and had spent most of the next ten years in the newly
industrializing North of England, purchasing textiles and ship­
ping them back to Germany. He did not go into the banking
business in London until 1811 . Why, then, did the British govern­
ment turn to him in its hour of financial need? The answer is that
Nathan had acquired valuable experience as a smuggler of gold
to the Continent, in breach of the blockade that Napoleon had
8 1
imposed on trade between England and Europe. (Admittedly, it
was a breach the French authorities tended to wink at, in the
simplistic mercantilist belief that outflows of gold from England
must tend to weaken the British war effort.) In January 1814 , the
Chancellor of the Exchequer authorized the Commissary-in-Chief, Joh n Charles Herries, to 'employ that gentleman [Nathan]
in the most secret and confidential manner to collect in Germany,
France and Holland the largest quantity of French gold and silver
coins, not exceeding in value £600,000, which he may be able
to procure within two months from the present time.' These
were then to be delivered to British vessels at the Dutch port
of Helvoetsluys and sent on to Wellington, who had by now
crossed the Pyrenees into France. It was an immense operation,
which depended on the brothers' ability to tap their cross-Channel credit network and to manage large-scale bullion trans­
fers. They executed their commission so well that Wellington was
soon writing to express his gratitude for the 'ample . . . supplies
of money'. As Herries put it: 'Rothschild of this place has
executed the various services entrusted to him in this line admir­
ably well, and though a Je w [sic], we place a good deal of confi­
dence in him.' By Ma y 181 4 Nathan had advanced nearly £1. 2
million to the government, double the amount envisaged in his
original instructions.
Mobilizing such vast amounts of gold even at the tail end of a
war was risky, no doubt. Yet from the Rothschilds' point of
view, the hefty commissions they were able to charge more than
justified the risks. What made them so well suited to the task was
that the brothers had a ready-made banking network within the
family - Nathan in London, Amschel in Frankfurt, James (the
youngest) in Paris, Carl in Amsterdam and Salomon roving wher­
ever Nathan saw fit. Spread out around Europe, the five Roths­
childs were uniquely positioned to exploit price and exchange
rate differences between markets, the process known as arbitrage.
If the price of gold was higher in, say, Paris than in London,
James in Paris would sell gold for bills of exchange, then send
these to London, where Nathan would use them to buy a larger
quantity of gold. The fact that their own transactions on Herries's
behalf were big enough to affect such price differentials only
added to the profitability of the business. In addition, the Roths-childs also handled some of the large subsidies paid to Britain's
continental allies. By June 1814 , Herries calculated that they had
effected payments of this sort to a value of 12 . 6 million francs.
'M r Rothschild', remarked the Prime Minister, Lord Liverpool,
had become 'a very useful friend'. As he told the Foreign Secretary
Lord Castlereagh, 'I do not know what we should have done
without him . . .'. By now his brothers had taken to calling
Nathan the master of the Stock Exchange.
After his abdication in April 1814 , Napoleon had been exiled
to the small Italian island of Elba, which he proceeded to rule as
an empire in miniature. It was too small to hold him. On 1 March
1815 , to the consternation of the monarchs and ministers gath-ered to restore the old European order at the Congress of Vienna,
he returned to France, determined to revive his Empire. Veterans
of the grande armée rallied to his standard. Nathan Rothschild
responded to this 'unpleasant news' by immediately resuming
gold purchases, buying up all the bullion and coins he and his
brothers could lay their hands on, and making it available to
Herries for shipment to Wellington. In all, the Rothschilds pro-vided gold coins worth more than £ 2 million - enough to fill 884
boxes and fifty-five casks. At the same time, Nathan offered to
take care of a fresh round of subsidies to Britain's continental
allies, bringing the total of his transactions with Herries in 181 5
to just under £9.8 million. With commissions on all this business
ranging from 2 to 6 per cent, Napoleon's return promised to
make the Rothschilds rich men. Yet there was a risk that Nathan
had underestimated. In furiously buying up such a huge quantity
of gold, he had assumed that, as with all Napoleon's wars, this
would be a long one. It was a near fatal miscalculation.
Wellington famously called the Battle of Waterloo 'the nearest
run thing you ever saw in your life'. After a day of brutal charges,
countercharges and heroic defence, the belated arrival of the
Prussian army finally proved decisive. For Wellington, it was a
glorious victory. No t so for the Rothschilds. N o doubt it was
gratifying for Nathan Rothschild to receive the news of Napo­
leon's defeat first, thanks to the speed of his couriers, nearly
forty-eight hours before Major Henry Percy delivered Welling­
ton's official despatch to the Cabinet. N o matter how early it
reached him, however, the news was anything but good from
Nathan's point of view. He had expected nothing as decisive so
soon. No w he and his brothers were sitting on top of a pile of
cash that nobody needed - to pay for a war that was over. With
the coming of peace, the great armies that had fought Napoleon
could be disbanded, the coalition of allies dissolved. That meant
no more soldiers' wages and no more subsidies to Britain's war­
time allies. The price of gold, which had soared during the war,
would be bound to fall. Nathan was faced not with the immense
profits of legend but with heavy and growing losses.
But there was one possible way out: the Rothschilds could use
their gold to make a massive and hugely risky bet on the bond
market. On 2 0 July 181 5 the evening edition of the London
Courier reported that Nathan had made 'great purchases of
stock', meaning British government bonds. Nathan's gamble was
that the British victory at Waterloo, and the prospect of a
reduction in government borrowing, would send the price of
British bonds soaring upwards. Nathan bought more and, as the
price of consols duly began to rise, he kept on buying. Despite
The price of consols (UK perpetual bonds), 1812-182 1
Jan Jan Jan Jan Jan Ja n Jan Jan Jan Jan Ja n Jan
181 1 181 3 181 4 181 5 181 6 181 7 181 8 181 9 181 0 i8i i 181 2 182 3
his brothers' desperate entreaties to realize profits, Nathan held
his nerve for another year. Eventually, in late 1817 , with bond
prices up more than 40 per cent, he sold. Allowing for the effects
on the purchasing power of sterling of inflation and economic
growth, his profits were worth around £600 million today. It was
one of the most audacious trades in financial history, one which
snatched financial victory from the jaws of Napoleon's military
defeat. The resemblance between victor and vanquished was not
lost on contemporaries. In the words of one of the partners at
Barings, the Rothschilds' great rivals, 'I must candidly confess
that I have not the nerve for his operations. They are generally
well planned, with great cleverness and adroitness in execution -but he is in money and funds what Bonaparte was in war.' 2 1
T o the Austrian Chancellor Prince Metternich's secretary, the
Rothschilds were simply die Finanzbonaparten.22 Others went
still further, though not without a hint of irony. 'Money is- the
god of our time,' declared the German poet Heinrich Heine in
March 1841 , 'and Rothschild is his prophet.'2 3
T o an extent that even today remains astonishing, the Rothschilds
went on to dominate international finance in the half century
after Waterloo. So extraordinary did this achievement seem to
contemporaries that they often sought to explain it in mystical
terms. According to one account dating from the 1830s, the
Rothschilds owed their fortune to the possession of a mysterious
'Hebrew talisman' that enabled Nathan Rothschild, the founder
of the London house, to become 'the leviathan of the money
markets of Europe'. 2 4 Similar stories were being told in the Pale
of Settlement, to which Russian Jews were confined, as late as
the 1890s. 2 5 As we have seen, the Nazis preferred to attribute the
rise of the Rothschilds to the manipulation of stock market news
and other sharp practice. Such myths are current even today.
According to Song Hongbing's best-selling book Currency Wars,
published in China in 2007, the Rothschilds continue to control
the global monetary system through their alleged influence over
the Federal Reserve System.2 6
The more prosaic reality was that the Rothschilds were able to
build on their successes during the final phase of the Napoleonic
Wars to establish themselves as the dominant players in an
increasingly international London bond market. They did this by
establishing a capital base and an information network that were
soon far superior to those of their nearest rivals, the Barings.
Between 181 5 and 1859 , it has been estimated that the London
house issued fourteen different sovereign bonds with a face value
of nearly £43 million, more than half the total issued by all
banks in London. 2 7 Although British government bonds were
the principal security they marketed to investors, they also sold
French, Prussian, Russian, Austrian, Neapolitan and Brazilian
bonds.2 8 In addition, they all but monopolized bond issuance by
the Belgian government after 1830 . Typically, the Rothschilds
would buy a tranche of new bonds outright from a government,
charging a commission for distributing these to their network of
brokers and investors throughout Europe, and remitting funds to
the government only when all the instalments had been received
from buyers. There would usually be a generous spread between
the price the Rothschilds paid the sovereign borrower and the
price they asked of investors (with room for an additional price
'run up' after the initial public offering). Of course, as we have
seen, there had been large-scale international lending before, not­
ably in Genoa, Antwerp and Amsterdam.2 9 But a distinguishing
feature of the London bond market after 181 5 was the Roths­
childs' insistence that most new borrowers issue bonds denomi­
nated in sterling, rather than their own currency, and make
interest payments in London or one of the other markets where
the Rothschilds had branches. A new standard was set by their
181 8 initial public offering of Prussian 5 per cent bonds, which
- after protracted and often fraught negotiations* - were issued
not only in London, but also in Frankfurt, Berlin, Hamburg and
Amsterdam.3 0 In his book On the Traffic in State Bonds (1825) ,
the German legal expert Johann Heinrich Bender singled out this
as one of the Rothschilds' most important financial innovations :
* At one point, when the Director of the Prussian Treasury, Christian Rother,
attempted to modify the terms after the loan contract had been signed,
Nathan exploded: 'Dearest friend, I have now done my duty by God, your
king and the Finance Minister von Rother, my money has all gone to you in
Berlin .. . now it is your turn and duty to yours, to keep your word and not
to come up with new things, and everything must remain as it was agreed
between men like us, and that is what I expected, as you can see from my
deliveries of money. The cabal there can do nothing against N . M . Rothschild,
he has the money, the strength and the power, the cabal has only impotence
and the King of Prussia, my Prince Hardenberg and Minister Rother should
be well pleased and thank Rothschild, who is sending you so much money
[and] raising Prussia's credit.' That a Jew born in the Frankfurt ghetto could
write in these terms to a Prussian official speaks volumes about the social
revolution Nathan Rothschild and his brothers personified.
'Any owner of government bonds .. . can collect the interest at
his convenience in several different places without any effort.'3 1
Bond issuance was by no means the only business the Rothschilds
did, to be sure: they were also bond traders, currency arbitra­
geurs, bullion dealers and private bankers, as well as investors in
insurance, mines and railways. Yet the bond market remained
their core competence. Unlike their lesser competitors, the Roths­
childs took pride in dealing only in what would now be called
investment grade securities. N o bond they issued in the 1820s
was in default by 1829 , despite a Latin American debt crisis in
the middle of the decade (the first of many).
With success came ever greater wealth. When Nathan died in
1836 , his personal fortune was equivalent to o. 62 per cent of British
national income. Between 181 8 and 1852 , the combined capital of
the five Rothschild 'houses' (Frankfurt, London, Naples, Paris and
Vienna) rose from £1. 8 million to £9.5 million. As early as 182 5
their combined capital was nine times greater than that of Baring
Brothers and the Banque de France. By 1899 , at £4 1 million, it
exceeded the capital of the five biggest German joint-stock banks
put together. Increasingly the firm became a multinational asset
manager for the wealth of the managers' extended family. As
their numbers grew from generation to generation, familial unity
was maintained by a combination of periodically revised con­
tracts between the five houses and a high level of intermarriage
between cousins or between uncles and nieces. Of twenty-one
marriages involving descendants of Nathan's father Mayer
Amschel Rothschild that were solemnized between 182 4 and
1877 , no fewer than fifteen were between his direct descendants.
In addition, the family's collective fidelity to the Jewish faith, at
a time when some other Jewish families were slipping into apos­
tasy or mixed marriage, strengthened their sense of common
identity and purpose as 'the Caucasian [Jewish] royal family'.
Old Mayer Amschel had repeatedly admonished his five sons:
'If you can't make yourself loved, make yourself feared.' As they
bestrode the mid-nineteenth-century financial world as masters
of the bond market, the Rothschilds were already more feared
than loved. Reactionaries on the Right lamented the rise of a new
form of wealth, higher-yielding and more liquid than the landed
estates of Europe's aristocratic elites. As Heinrich Heine dis­
cerned, there was something profoundly revolutionary about the
financial system the Rothschilds were creating:
The system of paper securities frees .. . men to choose whatever place
of residence they like; they can live anywhere, without working, from
the interest on their bonds, their portable property, and so they gather
together and constitute the true power of our capital cities. And we
have long known what it portends when the most diverse energies can
live side by side, when there is such centralization of the intellectual
and of social authority.
In Heine's eyes, Rothschild could now be mentioned in the
same breath as Richelieu and Robespierre as one of the 'three
terroristic names that spell the gradual annihilation of the old
aristocracy'. Richelieu had destroyed its power; Robespierre had
decapitated its decadent remnant; now Rothschild was providing
Europe with a new social elite by
raising up the system of government bonds to supreme power . . .
[and] endowing money with the former privileges of land. To be sure,
he has thereby created a new aristocracy, but this is based on the most
unreliable of elements, on money .. . [which] is more fluid than water
and less steady than the air . . , 3 2
Meanwhile, Radicals on the Left bemoaned the rise of a new
power in the realm of politics, which wielded a veto power over
government finance and hence over most policy. Following the
success of Rothschild bond issues for Austria, Prussia and Russia,
Nathan was caricatured as the insurance broker to the 'Hollow
Alliance', helping to protect Europe against liberal political fires.3 3
In 182 1 he even received a death threat because of 'his connexion
with foreign powers, and particularly the assistance rendered to
Austria, on account of the designs of that government against the
liberties of Europe'. 3 4 The liberal historian Jules Michelet noted
in his journal in 1842 : 'M . Rothschild knows Europe prince by
prince, and the bourse courtier by courtier. He has all their
accounts in his head, that of the courtiers and that of the kings;
he talks to them without even consulting his books. T o one such
he says: "You r account will go into the red if you appoint such a
minister." ' 3 5 Predictably, the fact that the Rothschilds were Jew­
ish gave a new impetus to deep-rooted anti-Semitic prejudices.
N o sooner had the Rothschilds appeared on the American scene
in the 1830 s than the governor of Mississippi was denouncing
'Baron Rothschild' for having 'the blood of Judas and Shylock
flow[ing] in his veins, and . . . unit[ing] the qualities of both his
countrymen.' Later in the century, the Populist writer 'Coin'
Harvey would depict the Rothschild bank as a vast, black octopus
stretching its tentacles around the world. 3 6
Ye t it was the Rothschilds' seeming ability to permit or prohibit
wars at will that seemed to arouse the most indignation. As
early as 1828 , Prince Piickler-Muskau referred to 'Rothschild .. .
without whom no power in Europe today seems able to make
war'. 3 7 One early-twentieth-century commentator* pointedly
posed the question:
* This was J . A. Hobson, author of Imperialism: A Study (1902). Though
still renowned as one of the earliest liberal critics of imperialism, Hobson
articulated a classically anti-Semitic hostility towards finance: 'In handling
large masses of stocks and shares, in floating companies, in manipulating
fluctuations of values, the magnates of the Bourse find their gain. These
Does anyone seriously suppose that a great war could be undertaken
by any European State, or any great State loan subscribed, if the house
of Rothschild and its connexions set their face against it?3 8
It might, indeed, be assumed that the Rothschilds needed war.
It was war, after all, that had generated Nathan Rothschild's
biggest deal. Without wars, nineteenth-century states would have
had little need to issue bonds. As we have seen, however, wars
tended to hit the price of existing bonds by increasing the risk
that (like sixteenth-century Venice) a debtor state would fail to
meet its interest payments in the event of defeat and losses of
territory. By the middle of the nineteenth century, the Rothschilds
had evolved from traders into fund managers, carefully tending
to their own vast portfolio of government bonds. Now , having
made their money, they stood to lose more than they gained from
conflict. It was for this reason that they were consistently hostile
to strivings for national unity in both Italy and Germany. And it
was for this reason that they viewed with unease the descent of
the United States into internecine warfare. The Rothschilds had
decided the outcome of the Napoleonic Wars by putting their
financial weight behind Britain. No w they would help decide the
outcome of the American Civil War - by choosing to sit on the
great businesses - banking, broking, bill discounting, loan floating, company
promoting - form the central ganglion of international capitalism. United by
the strongest bonds of organisation, always in closest and quickest touch
with one another, situated in the very heart of the business capital of every
State, controlled, so far as Europe is concerned, chiefly by men of a single
and peculiar race, who have behind them many centuries of financial experi­
ence, they are in a unique position to control the policy of nations.'
9 i
Driving Dixie Down
In Ma y 1863 , two years into the American Civil War, Major-General Ulysses S. Grant captured Jackson, the Mississippi state
capital, and forced the Confederate army under Lieutenant-General John C. Pemberton to retreat westward to Vicksburg
on the banks of the Mississippi River. Surrounded, with Union
gunboats bombarding their positions from behind, Pemberton's
army repulsed two Union assaults but they were finally starved
into submission by a grinding siege. On 4 July, Independence Day,
Pemberton surrendered. From now on, the Mississippi was firmly
in the hands of the North. The South was literally split in two.
The fall of Vicksburg is always seen as one of the great turning
points in the war. And yet, from a financial point of view, it was
really not the decisive one. The key event had happened more
than a year before, two hundred miles downstream from Vicks­
burg, where the Mississippi joins the Gulf of Mexico. On 29 April
186 2 Flag Officer David Farragut had run the guns of Fort Jack­
son and Fort St Philip to seize control of Ne w Orleans. This was
a far less bloody and protracted clash than the siege of Vicksburg,
but equally disastrous for the Southern cause.
The finances of the Confederacy are one of the great might-have-beens of American history.3 9 For, in the final analysis, it was
as much a lack of hard cash as a lack of industrial capacity or
manpower that undercut what was, in military terms, an impress­
ive effort by the Southern states. At the beginning of the war, in
the absence of a pre-existing system of central taxation, the fledg­
ling Confederate Treasury had paid for its army by selling bonds
to its own citizens, in the form of two large loans for $1 5 million
and $10 0 million. But there was a finite amount of liquid capital
available in the South, with its many self-contained farms and
relatively small towns. T o survive, it was later alleged, the Con­
federacy turned to the Rothschilds, in the hope that the world's
greatest financial dynasty might help them beat the North as they
had helped Wellington beat Napoleon at Waterloo.
The suggestion was not altogether fanciful. In Ne w York , the
Rothschild agent August Belmont had watched with horror as
the United States slid into Civil War. As the Democratic Party's
national chairman, he had been a leading supporter of Stephen
A. Douglas, Abraham Lincoln's opponent in the presidential elec­
tion of i860. Belmont remained a vocal critic of what he called
Lincoln's 'fatal policy of confiscation and forcible emanci­
pation'.4 0 Salomon de Rothschild, James's third son, had also
expressed pro-Southern sympathies in his letters home before the
war began.4 1 Some Northern commentators drew the obvious
inference: the Rothschilds were backing the South. 'Belmont, the
Rothschilds, and the whole tribe of Jew s .. . have been buying
up Confederate bonds,' thundered the Chicago Tribune in 1864 .
One Lincoln supporter accused the 'Jews, Jeff Davis [the Confed­
erate president] and the devil' of being an unholy trinity directed
against the Union.4 2 When he visited London in 1863 , Belmont
himself told Lionel de Rothschild that 'soon the North would
be conquered'. (It merely stoked the fires of suspicion that the
man charged with recruiting Britain to the South's cause, the
Confederate Secretary of State Judah Ben j amin, was himself a Jew . )
In reality, however, the Rothschilds opted not to back the
South. Why? Perhaps it was because they felt a genuine distaste
for the institution of slavery. But of at least equal importance
was a sense that the Confederacy was not a good credit risk
(after all, the Confederate president Jefferson Davis had openly
advocated the repudiation of state debts when he was a US
senator). That mistrust seemed to be widely shared in Europe.
When the Confederacy tried to sell conventional bonds in
European markets, investors showed little enthusiasm. But the
Southerners had an ingenious trick up their sleeves. The trick
(like the sleeves themselves) was made of cotton, the key to the
Confederate economy and by far the South's largest export. The
idea was to use the South's cotton crop not just as a source of
export earnings, but as collateral for a new kind of cotton-backed
bond. When the obscure French firm of Emile Erlanger and Co .
started issuing cotton-backed bonds on the South's behalf, the
response in London and Amsterdam was more positive. The most
appealing thing about these sterling bonds, which had a 7 per
cent coupon and a maturity of twenty years, was that they could
be converted into cotton at the pre-war price of six pence a
pound. Despite the South's military setbacks, they retained their
value for most of the war for the simple reason that the price of
the underlying security, cotton, was rising as a consequence of
increased wartime demand. Indeed, the price of the bonds actually
doubled between December 186 3 and September 1864 , despite
the Confederate defeats at Gettysburg and Vicksburg, because
the price of cotton was soaring.4 3 Moreover, the South was in the
happy position of being able to raise that price still further - by
restricting the cotton supply.
In i86 0 the port of Liverpool was the main artery for the
supply of imported cotton to the British textile industry, then the
mainstay of the Victorian industrial economy. More than 80 per
cent of these imports came from the southern United States. The
Confederate leaders believed this gave them the leverage to bring
Britain into the war on their side. T o ratchet up the pressure, they
decided to impose an embargo on all cotton exports to Liverpool.
The effects were devastating. Cotton prices soared from 6%d per
pound to 27%d. Imports from the South slumped from 2.6 million
bales in i86 0 to less than 72,000 in 1862 . A typical English
cotton mill like the one that has been preserved at Styal, south of
Confederate cotton bond with coupons, only the first four of
which have been clipped
Manchester, employed around 400 workers, but that was just a
fraction of the 300,000 people employed by King Cotton across
Lancashire as a whole. Without cotton there was literally nothing
for those workers to do. By late 1862 half the workforce had
been laid off; around a quarter of the entire population of Lanca-shire was on poor relief.44 They called it the cotton famine. This,
however, was a man-made famine. And the men who made it
seemed to be achieving their goal. Not only did the embargo
cause unemployment, hunger and riots in the north of England;
the shortage of cotton also drove up the price and hence the value
of the South's cotton-backed bonds, making them an irresistibly
attractive investment for key members of the British political
elite. The future Prime Minister, William Ewart Gladstone,
bought some, as did the editor of The Times, John Delane.45
Ye t the South's ability to manipulate the bond market
depended on one overriding condition: that investors should be
able to take physical possession of the cotton which underpinned
the bonds if the South failed to make its interest payments. Col­
lateral is, after all, only good if a creditor can get his hands on it.
And that is why the fall of Ne w Orleans in April 186 2 was the
real turning point in the American Civil War. With the South's
main port in Union hands, any investor who wanted to get hold
of Southern cotton had to run the Union's naval blockade not
once but twice, in and out. Given the North's growing naval
power in and around the Mississippi, that was not an enticing
If the South had managed to hold on to Ne w Orleans until the
cotton harvest had been offloaded to Europe, they might have
managed to sell more than £3 million of cotton bonds in London.
Mayb e even the risk-averse Rothschilds might have come off the
financial fence. As it was, they dismissed the Erlanger loan as
being 'of so speculative a nature that it was very likely to attract
all wild speculators .. . we do not hear of any respectable people
having anything to do with it'.4 6 The Confederacy had overplayed
its hand. They had turned off the cotton tap, but then lost the
ability to turn it back on. By 186 3 the mills of Lancashire had
found new sources of cotton in China, Egypt and India. And now
investors were rapidly losing faith in the South's cotton-backed
bonds. The consequences for the Confederate economy were
With its domestic bond market exhausted and only two paltry
foreign loans, the Confederate government was forced to print
unbacked paper dollars to pay for the war and its other expenses,
1. 7 billion dollars' worth in all. Both sides in the Civil War had
to print money, it is true. But by the end of the war the Union's
'greenback' dollars were still worth about 50 cents in gold,
A Confederate 'greyback' State of Louisiana five-dollar bill
whereas the Confederacy's 'greybacks' were worth just one cent,
despite a vain attempt at currency reform in 1864.47 The situation
was worsened by the ability of Southern states and municipalities
to print paper money of their own; and by rampant forgery, since
Confederate notes were crudely made and easy to copy. With ever
more paper money chasing ever fewer goods, inflation exploded.
Prices in the South rose by around 4,000 per cent during the Civil
War.48 By contrast, prices in the North rose by just 60 per cent.
Even before the surrender of the principal Confederate armies
in April 1865, the economy of the South was collapsing, with
hyperinflation as the sure harbinger of defeat.
The Rothschilds had been right. Those who had invested in
Confederate bonds ended up losing everything, since the victori-ous North pledged not to honour the debts of the South. In the
end, there had been no option but to finance the Southern war
effort by printing money. It would not be the last time in history
that an attempt to buck the bond market would end in ruinous
inflation and military humiliation.
The Euthanasia of the Rentier
The fate of those who lost their shirts on Confederate bonds was
not especially unusual in the nineteenth century. The Confederacy
was far from the only state in the Americas to end up dis­
appointing its bondholders; it was merely the northernmost de­
linquent. South of the Ri o Grande, debt defaults and currency
depreciations verged on the commonplace. The experience of Latin
America in the nineteenth century in many ways foreshadowed
problems that would become almost universal in the middle of
the twentieth century. Partly this was because the social class that
was most likely to invest in bonds - and therefore to have an interest
in prompt interest payment in a sound currency - was weaker there
than elsewhere. Partly it was because Latin American republics
were among the first to discover that it was relatively painless
to default when a substantial proportion of bondholders were
foreign. It was no mere accident that the first great Latin Ameri­
can debt crisis happened as early as 1826-9 , when Peru, Col­
ombia, Chile, Mexico , Guatemala and Argentina all defaulted on
loans issued in London just a few years before.4 9
In many ways, it was true that the bond market was powerful.
By the later nineteenth century, countries that defaulted on their
debts risked economic sanctions, the imposition of foreign con­
trol over their finances and even, in at least five cases, military
intervention.5 0 It is hard to believe that Gladstone would have
ordered the invasion of Egypt in 188 2 if the Egyptian government
had not threatened to renege on its obligations to European
bondholders, himself among them. Bringing an 'emerging market'
under the aegis of the British Empire was the surest way to remove
political risk from investors' concerns.5 1 Even those outside
the Empire risked a visit from a gunboat if they defaulted, as
Venezuela discovered in 1902 , when a joint naval expedition by
Britain, Germany and Italy temporarily blockaded the country's
ports. The United States was especially energetic (and effective)
in protecting bondholders' interests in Central America and the
Caribbean.5 2
But in one crucial respect the bond market was potentially
vulnerable. Investors in the City of London, the biggest inter­
national financial market in the world throughout the nineteenth
century, were wealthy but not numerous. In the early nineteenth
century the number of British bondholders may have been fewer
than 250,000, barely 2 per cent of the population. Ye t their
wealth was more than double the entire national income of the
United Kingdom; their income in the region of 7 per cent of
national income. In 182 2 this income - the interest on the national
debt - amounted to roughly half of total public spending, yet
more than two thirds of tax revenue was indirect and hence fell
on consumption. Even as late as 187 0 these proportions were
still, respectively, a third and more than half. It would be quite
hard to devise a more regressive fiscal system, with taxes imposed
on the necessities of the many being used to finance interest
payments to the very few. Small wonder Radicals like William
Cobbett were incensed. ' A national debt, and all the taxation and
gambling belonging to it,' Cobbett declared in his Rural Rides
(1830), 'have a natural tendency to draw wealth into great masses
.. . for the gain of a few.'53 In the absence of political reform, he
warned, the entire country would end up in the hands of 'those
who have had borrowed from them the money to uphold this
monster of a system .. . the loan-jobbers, stock-jobbers . . . Jew s
and the whole tribe of tax-eaters'.5 4
Such tirades did little to weaken the position of the class known
in France as the rentiers - the recipients of interest on government
bonds like the French rente. On the contrary, the decades after
10 0
183 0 were a golden age for the rentier in Europe. Defaults became
less and less frequent. Money, thanks to the gold standard,
became more and more dependable.5 5 This triumph of the rentier,
despite the generalized widening of electoral franchises, was
remarkable. True, the rise of savings banks (which were often man­
dated to hold government bonds as their principal assets) gave new
segments of society indirect exposure to, and therefore stakes
in, the bond market. But fundamentally the rentiers remained an
elite of Rothschilds, Barings and Gladstones - socially, politically,
but above all economically intertwined. What ended their domi­
nance was not the rise of democracy or socialism, but a fiscal and
monetary catastrophe for which the European elites were them­
selves responsible. That catastrophe was the First World War.
'Inflation', wrote Milton Friedman in a famous definition, 'is
always and everywhere a monetary phenomenon, in the sense
that it cannot occur without a more rapid increase in the quantity
of money than in output.' What happened in all the combatant
states during and after the First World War illustrates this pretty
well. There were essentially five steps to high inflation:
1 . War led not only to shortages of goods but also to
2. short-term government borrowing from the central bank,
3 . which effectively turned debt into cash, thereby expanding
the money supply,
4. causing public expectations of inflation to shift and the
demand for cash balances to fall
5. and prices of goods to rise.*
* In the language of economics the relationships can be simplified as M V =
PQ where M is the quantity of money in circulation, V is the velocity of
money (frequency of transactions), P is the price level and Q is the real value
of total transactions.
Pure monetary theory, however, cannot explain why in one
country the inflationary process proceeds so much further or
faster than in another. No r can it explain why the consequences
of inflation vary so much from case to case. If one adds together
the total public expenditures of the major combatant powers
between 191 4 and 1918 , Britain spent rather more than Germany
and France much more than Russia. Expressed in terms of dollars,
the public debts of Britain, France and the United States increased
much more between April 191 4 and March 191 8 than that of
Germany.5 6 True, the volume of banknotes in circulation rose by
more in Germany between 191 3 and 191 8 (1,040 per cent) than
in Britain (708 per cent) or France (386 per cent), but for Bulgaria
the figure was 1,11 6 per cent and for Romania 96 1 per cent.5 7
Relative to 1913 , wholesale prices had risen further by 191 8 in
Italy, France and Britain than in Germany. The cost-of-living
index for Berlin in 191 8 was 2.3 times higher than its pre-war
level; for London it was little different (2.1 times higher).5 8 Why,
then, was it Germany that plunged into hyperinflation after the
First World War? Why was it the mark that collapsed into worth-lessness? The key lies in the role of the bond market in war and
post-war finance.
All the warring countries went on war bonds sales-drives during
the war, persuading thousands of small savers wh o had never
previously purchased government bonds that it was their patriotic
duty to do so. Unlike Britain, France, Italy and Russia, however,
Germany did not have access to the international bond market
during the war (having initially spurned the Ne w Yor k market
and then been shut out of it). While the Entente powers could
sell bonds in the United States or throughout the capital-rich
British Empire, the Central powers (Germany, Austria-Hungary
and Turkey) were thrown back on their own resources. Berlin
and Vienna were important financial centres, but they lacked the
10 1
10 2
depth of London, Paris and Ne w York . As a result, the sale of
war bonds grew gradually more difficult for the Germans and
their allies, as the appetite of domestic investors became sated.
Much sooner, and to a much greater extent than in Britain, the
German and Austrian authorities had to turn to their central
banks for short-term funding. The growth of the volume of Treas­
ury bills in the central bank's hands was a harbinger of inflation
because, unlike the sale of bonds to the public, exchanging these
bills for banknotes increased the money supply. By the end of the
war, roughly a third of the Reich debt was 'floating' or unfunded,
and a substantial monetary overhang had been created, which
only wartime price controls prevented from manifesting itself in
higher inflation.
Defeat itself had a high price. All sides had reassured tax­
payers and bondholders that the enemy would pay for the war.
No w the bills fell due in Berlin. One way of understanding the
post-war hyperinflation is therefore as a form of state bankruptcy.
Those wh o had bought war bonds had invested in a promise of
victory; defeat and revolution represented a national insolvency,
the brunt of which necessarily had to be borne by the Reich's
creditors. Quite apart from defeat, the revolutionary events
between November 191 8 and January 191 9 were scarcely calcu­
lated to reassure investors. No r was the peace conference at
Versailles, which imposed an unspecified reparations liability on
the fledgling Weimar Republic. When the total indemnity was
finally fixed in 1921 , the Germans found themselves saddled
with a huge new external debt with a nominal capital value of
13 2 billion 'gold marks' (pre-war marks), equivalent to more
than three times national income. Although not all this new debt
was immediately interest-bearing, the scheduled repar­
ations payments accounted for more than a third of all Reich
expenditure in 192 1 and 1922 . N o investor who contemplated
Germany's position in the summer of 192 1 could have felt opti­
mistic, and such foreign capital as did flow into the country after
the war was speculative or 'hot' money, which soon departed
when the going got tough.
Yet it would be wrong to see the hyperinflation of 192 3 as a
simple consequence of the Versailles Treaty. That was how the
Germans liked to see it, of course. Their claim throughout the
post-war period was that the reparations burden created an
unsustainable current account deficit; that there was no alterna­
tive but to print yet more paper marks in order to finance it; that
the inflation was a direct consequence of the resulting depreci­
ation of the mark. All of this was to overlook the domestic
political roots of the monetary crisis. The Weimar tax system was
feeble, not least because the new regime lacked legitimacy among
higher income groups who declined to pay the taxes imposed
on them. At the same time, public money was spent recklessly,
particularly on generous wage settlements for public sector
unions. The combination of insufficient taxation and excessive
spending created enormous deficits in 191 9 and 192 0 (in excess
of 1 0 per cent of net national product), before the victors had
even presented their reparations bill. The deficit in 1923 , when
Germany had suspended reparations payments, was even larger.
Moreover, those in charge of Weimar economic policy in the
early 1920s felt they had little incentive to stabilize German fiscal
and monetary policy, even when an opportunity presented itself
in the middle of 1920. 5 9 A common calculation among Germany's
financial elites was that runaway currency depreciation would
force the Allied powers into revising the reparations settlement,
since the effect would be to cheapen German exports relative
to American, British and French manufactures. It was true, as
far as it went, that the downward slide of the mark boosted
German exports. What the Germans overlooked was that the
10 3
10 4
inflation-induced boom of 1920-22 , at a time when the US and
U K economies were in the depths of a post-war recession, caused
an even bigger surge in imports, thus negating the economic
pressure they had hoped to exert. At the heart of the German
hyperinflation was a miscalculation. When the French cottoned
on to the insincerity of official German pledges to fulfil their
reparations commitments, they drew the conclusion that repar­
ations would have to be collected by force and invaded the indus­
trial Ruhr region. The Germans reacted by proclaiming a general
strike ('passive resistance'), which they financed with yet more
paper money. The hyperinflationary endgame had now arrived.
Inflation is a monetary phenomenon, as Milton Friedman said.
But hyperinflation is always and everywhere a political phenom­
enon, in the sense that it cannot occur without a fundamental
malfunction of a country's political economy. There surely were
less catastrophic ways to settle the conflicting claims of domestic
and foreign creditors on the diminished national income of post­
war Germany. But a combination of internal gridlock and exter­
nal defiance - rooted in the refusal of many Germans to accept
that their empire had been fairly beaten - led to the worst of
all possible outcomes: a complete collapse of the currency and of
the economy itself. By the end of 192 3 there were approxi­
mately 4.97 x io 2 0 marks in circulation. Twenty-billion mark
notes were in everyday use. The annual inflation rate reached a
peak of 18 2 billion per cent. Prices were on average 1.2 6 trillion
times higher than they had been in 1913 . True, there had been
some short-term benefits. By discouraging saving and encourag­
ing consumption, accelerating inflation had stimulated output
and employment until the last quarter of 1922 . The depreciating
mark, as we have seen, had boosted German exports. Yet the
collapse of 192 3 was all the more severe for having been post­
poned. Industrial production dropped to half its 191 3 level.
The price of hyperinflation: a German billion mark note from
November 1923
Unemployment soared to, at its peak, a quarter of trade union
members, with another quarter working short time. Worst of all
was the social and psychological trauma caused by the crisis.
'Inflation is a crowd phenomenon in the strictest and most con-crete sense of the word,' Elias Canetti later wrote of his experi-ences as a young man in inflation-stricken Frankfurt. '[It is] a
witches' sabbath of devaluation where men and the units of their
money have the strongest effects on each other. The one stands
for the other, men feeling themselves as "bad" as their money;
and this becomes worse and worse. Together they are all at its
mercy and all feel equally worthless.,6o
Worthlessness was the hyperinflation's principal product. Not
only was money rendered worthless; so too were all the forms of
wealth and income fixed in terms of that money. That included
bonds. The hyperinflation could not wipe out Germany's external
debt, which had been fixed in pre-war currency. But it could and
did wipe out all the internal debt that had been accumulated
during and after the war, levelling the debt mountain like some
devastating economic earthquake. The effect was akin to a tax: a
tax not only on bondholders but also on anyone living on a fixed
cash income. This amounted to a great levelling, since it affected
primarily the upper middle classes: rentiers, senior civil servants,
professionals. Only entrepreneurs were in a position to insulate
themselves by adjusting prices upwards, hoarding dollars, invest­
ing in 'real assets' (such as houses or factories) and paying off
debts in depreciating banknotes. The enduring economic legacy
of the hyperinflation was bad enough: weakened banks and
chronically high interest rates, which now incorporated a sub­
stantial inflation risk premium. But it was the social and political
consequences of the German hyperinflation that were the most
grievous. The English economist John Maynard Keynes had theo­
rized in 192 3 that the 'euthanasia of the rentier' through inflation
was preferable to mass unemployment through deflation -'because it is worse in an impoverished world to provoke
unemployment than to disappoint the rentier'.6 1 Yet four years
earlier, he himself had given a vivid account of the negative
consequences of inflation:
By a continuing process of inflation, governments can confiscate,
secretly and unobserved, an important part of the wealth of their
citizens. By this method, they not only confiscate, but they confiscate
arbitrarily-, and, while the process impoverishes many, it actually
enriches some. The sight of this arbitrary rearrangement of riches
strikes not only at security, but at confidence in the equity of the
existing distribution of wealth. Those to whom the system brings
windfalls . . . become 'profiteers', who are the object of the hatred of
the bourgeoisie, whom the inflationism has impoverished not less than
of the proletariat. As the inflation proceeds .. . all permanent relations
between debtors and creditors, which form the ultimate foundation
of capitalism, become so utterly disordered as to be almost meaning­
less . . . 6 2
10 6
It was to Lenin that Keynes attributed the insight that Ther e
is no subtler, no surer means of overturning the existing basis of
society than to debauch the currency.' N o record survives of
Lenin saying any such thing, but his fellow Bolshevik Yevgeni
Preobrazhensky* did describe the banknote-printing press as
'that machine-gun of the Commissariat of Finance which poured
fire into the rear of the bourgeois system'.6 3
The Russian example is a reminder that Germany was not the
only vanquished country to suffer hyperinflation after the First
World War. Austria - as well as the newly independent Hungary
and Poland - also suffered comparably bad currency collapses
between 191 7 and 1924 . In the Russian case, hyperinflation came
after the Bolsheviks had defaulted outright on the entire Tsarist
debt. Bondholders would suffer similar fates in the aftermath of
the Second World War, when Germany, Hungary and Greece all
saw their currencies and bond markets collapse.f
If hyperinflation were exclusively associated with the costs of
losing world wars, it would be relatively easy to understand. Ye t
there is a puzzle. In more recent times, a number of countries
have been driven to default on their debts - either directly by
suspending interest payments, or indirectly by debasing the cur­
rency in which the debts are denominated - as a result of far less
serious disasters. Why is it that the spectre of hyperinflation has
not been banished along with the spectre of global conflict?
PIMC O boss Bill Gross began his money-making career as a
blackjack player in Las Vegas. T o his eyes, there is always an
* Murder rather than euthanasia was Preobrazhensky's forte; he was of all
the Bolshevik leaders the one most directly implicated in the execution of
Nicholas II and his family.
f The highest recorded inflation rate in history was in Hungary in July 1946, when
prices increased by 4.1 9 quintillion per cent (419 followed by sixteen zeros).
10 7
element of gambling involved when an investor buys a bond. Part
of that gamble is that an upsurge in inflation will not consume
the value of the bond's annual interest payments. As Gross
explains it, Tf inflation goes up to ten per cent and the value of a
fixed rate interest is only five, then that basically means that the
bond holder is falling behind inflation by five per cent.' As we
have seen, the danger that rising inflation poses is that it erodes
the purchasing power of both the capital sum invested and the
interest payments due. And that is why, at the first whiff of higher
inflation, bond prices tend to fall. Even as recently as the 1970s,
as inflation soared around the world, the bond market made a
Nevada casino look like a pretty safe place to invest your money.
Gross vividly recalls the time when US inflation was surging into
double digits, peaking at just under 1 5 per cent in April 1980. As
he puts it, 'that was very bond-unfriendly, and it produced .. .
perhaps the worst bond bear market not just in memory but in
history.' T o be precise, real annual returns on US government
bonds in the 1970s were minus 3 per cent, almost as bad as
during the inflationary years of the world wars. Today, only a
handful of countries have inflation rates above 1 0 per cent and
only one, Zimbabwe, is afflicted with hyperinflation.* But back
in 197 9 at least seven countries had an annual inflation rate
above 50 per cent and more than sixty countries, including Britain
and the United States, had inflation in double digits. Among the
countries worst affected, none suffered more severe long-term
damage than Argentina.
Once, Argentina was a byword for prosperity. The country's
very name means the land of silver. The river on whose banks
the capital Buenos Aires stands is the Rio de la Plata - in English
* At the time of writing (March 2008), a funeral in Zimbabwe costs 1 billion
Zimbabwean dollars. The annual inflation rate is 100,000 per cent.
10 8
the Silver River - a reference not to its colour, which is muddy
brown, but to the silver deposits supposed to lie upstream. In
1913 , according to recent estimates, Argentina was one of the
ten richest countries in the world. Outside the English-speaking
world, per capita gross domestic product was higher in only
Switzerland, Belgium, the Netherlands and Denmark. Between
187 0 and 1913 , Argentina's economy had grown faster than
those of both the United States and Germany. There was almost
as much foreign capital invested there as in Canada. It is no
coincidence that there were once two Harrods stores in the world:
one in Knightsbridge, in London, the other on the Avenida
Florida, in the heart of Buenos Aires. Argentina could credibly
aspire to be the United Kingdom, if not the United States, of the
southern hemisphere. In February 1946 , when the newly elected
president General Juan Domingo Perôn visited the central bank
in Buenos Aires, he was astonished at what he saw. 'There is so
much gold,' he marvelled, 'you can hardly walk through the
The economic history of Argentina in the twentieth century is
an object lesson that all the resources in the world can be set at
nought by financial mismanagement. Particularly after the Second
World War the country consistently underperformed its neigh­
bours and most of the rest of the world. So miserably did it fare
in the 1960s and 1970s, for example, that its per capita GD P
was the same in 198 8 as it had been in 1959 . By 199 8 it had sunk
to 34 per cent of the US level, compared with 7 2 per cent in
1913 . It had been overtaken by, among others, Singapore, Japan,
Taiwan and South Korea - not forgetting, most painful of all,
the country next door, Chile. What went wrong? One possible
answer is inflation, which was in double digits between 194 5 and
1952 , between 195 6 and 1968 and between 197 0 and 1974 ; and
in treble (or quadruple) digits between 197 5 and 1990 , peaking
10 9
at an annual rate of 5,000 per cent in 1989 . Another answer is
debt default: Argentina let down foreign creditors in 1982,1989 ,
2002 and 2004. Ye t these answers will not quite suffice. Argen­
tina had suffered double-digit inflation in at least eight years
between 187 0 and 1914 . It had defaulted on its debts at least
twice in the same period. T o understand Argentina's economic
decline, it is once again necessary to see that inflation was a
political as much as a monetary phenomenon.
A n oligarchy of landowners had sought to base the country's
economy on agricultural exports to the English-speaking world, a
model that failed comprehensively in the Depression. Large-scale
immigration without (as in North America) the freeing of agricul­
tural land for settlement had created a disproportionately large
urban working class that was highly susceptible to populist mobil­
ization. Repeated military interventions in politics, beginning
with the coup that installed José F. Uriburu in 1930 , paved the
way for a new kind of quasi-fascistic politics under Perôn, who
seemed to offer something for everyone: better wages and con­
ditions for workers and protective tariffs for industrialists. The
anti-labour alternative to Péron, which was attempted between
195 5 (when he was deposed) and 1966 , relied on currency devalu­
ation to try to reconcile the interests of agriculture and industry.
Another military coup in 196 6 promised technological modern­
ization but instead delivered more devaluation, and higher
inflation. Perôn's return in 197 3 was a fiasco, coinciding as it did
with the onset of a global upsurge in inflation. Annual inflation
surged to 444 per cent. Yet another military coup plunged Argen­
tina into violence as the Proceso de Reorganization National
(National Reorganization Process) condemned thousands to arbi­
trary detention and 'disappearance'. In economic terms, the junta
achieved precisely nothing other than to saddle Argentina with a
rapidly growing external debt, which by 198 4 exceeded 60 per
n o
i n
cent of GDP (though this was less than half the peak level of
indebtedness attained in the early 1900s). As so often in
inflationary crises, war played a part: internally against supposed
subversives, externally against Britain over the Falkland Islands.
Yet it would be wrong to see this as yet another case of a defeated
regime liquidating its debts through inflation. What made Argen­
tina's inflation so unmanageable was not war, but the constel­
lation of social forces: the oligarchs, the caudillos, the producers'
interest groups and the trade unions - not forgetting the impover­
ished underclass or descamizados (literally the shirtless). T o put
it simply, there was no significant group with an interest in price
stability. Owners of capital were attracted to deficits and devalu­
ation; sellers of labour grew accustomed to a wage-price spiral.
The gradual shift from financing government deficits domestically
to financing them externally meant that bondholding was out­
sourced.6 4 It is against this background that the failure of success­
ive plans for Argentine currency stabilization must be understood.
In his short story 'The Garden of Forking Paths', Argentina's
greatest writer Jorge Luis Borges imagined the writing of a
Chinese sage, Ts'ui Pen:
In all fictional works, each time a man is confronted with several
alternatives, he chooses one and eliminates the others; in the fiction
of Ts'ui Pen, he chooses - simultaneously - all of them. He creates, in
this way, diverse futures; diverse times which themselves also pro­
liferate and fork .. . In the work of Ts'ui Pen, all possible outcomes
occur; each one is the point of departure for other forkings . . . [Ts'ui
Pen] did not believe in a uniform, absolute time. He believed in
an infinite series of times, in a growing, dizzying net of divergent,
convergent and parallel times.6 5
This is not a bad metaphor for Argentine financial history in
the past thirty years. Where Bernardo Grinspun attempted debt
11 2
rescheduling and Keynesian demand management, Juan Sourrou-ille tried currency reform (the Austral Plan) along with wage and
price controls. Neither was able to lead the critical interest groups
down his own forking path. Public expenditure continued to
exceed tax revenue; arguments for a premature end to wage and
price controls prevailed; inflation resumed after only the most
fleeting of stabilizations. The forking paths finally and calami­
tously reconverged in 1989: the annus mirabilis in Eastern
Europe; the annus horribilis in Argentina.
In February 198 9 Argentina was suffering one of the hottest
summers on record. The electricity system in Buenos Aires
struggled to cope. People grew accustomed to five-hour power
cuts. Banks and foreign exchange houses were ordered to close
as the government tried to prevent the currency's exchange rate
from collapsing. It failed: in the space of just a month the austral
fell 14 0 per cent against the dollar. At the same time, the World
Bank froze lending to Argentina, saying that the government had
failed to tackle its bloated public sector deficit. Private sector
lenders were no more enthusiastic. Investors were hardly likely
to buy bonds with the prospect that inflation would wipe out
their real value within days. As fears grew that the central bank's
reserves were running out, bond prices plunged. There was only
one option left for a desperate government: the printing press.
But even that failed. On Friday 28 April Argentina literally ran
out of money. Tt's a physical problem,' Central Bank Vice-President Roberto Eilbaum told a news conference. The mint had
literally run out of paper and the printers had gone on strike. 'I
don't know how we're going to do it, but the money has got to
be there on Monday,' he confessed.
By June, with the monthly inflation rate rising above 100 per
cent, popular frustration was close to boiling point. Already in
April customers in one Buenos Aires supermarket had overturned
11 3
trolleys full of goods after the management announced over a
loudspeaker that all prices would immediately be raised by 30 per
cent. For two days in June crowds in Argentina's second largest
city, Rosario, ran amok in an eruption of rioting and looting that
left at least fourteen people dead. As in the Weimar Republic,
however, the principal losers of Argentina's hyperinflation were
not ordinary workers, who stood a better chance of matching
price hikes with pay rises, but those reliant on incomes fixed in
cash terms, like civil servants or academics on inflexible salaries,
or pensioners living off the interest on their savings. And, as in
1920s Germany, the principal beneficiaries were those with large
debts, which were effectively wiped out by inflation. Among those
beneficiaries was the government itself, in so far as the money it
owed was denominated in australes.
Yet not all Argentina's debts could be got rid of so easily. By
198 3 the country's external debt, which was denominated in US
dollars, stood at $4 6 billion, equivalent to around 40 per cent of
national output. N o matter what happened to the Argentine
currency, this dollar-denominated debt stayed the same. Indeed,
it tended to grow as desperate governments borrowed yet more
dollars. By 1989 the country's external debt was over $6 5 billion.
Over the next decade it would continue to grow until it reached
$15 5 billion. Domestic creditors had already been mulcted by
inflation. But only default could rid Argentina of its foreign debt
burden. As we have seen, Argentina had gone down this road
more than once before. In 189 0 Baring Brothers had been brought
to the brink of bankruptcy by its investments in Argentine securi­
ties (notably a failed issue of bonds for the Buenos Aires Water
Supply and Drainage Company) when the Argentine government
defaulted on its external debt. It was the Barings' old rivals the
Rothschilds who persuaded the British government to contribute
£ 1 million towards what became a £1 7 million bailout fund, on
the principle that the collapse of Barings would be 'a terrific
calamity for English commerce all over the world'. 6 6 And it was
also the first Lord Rothschild who chaired a committee of bankers
set up to impose reform on the wayward Argentines. Future loans
would be conditional on a currency reform that pegged the peso
to gold by means of an independent and inflexible currency
board.6 7 A century later, however, the Rothschilds were more
interested in Argentine vineyards than in Argentine debt. It was
the International Monetary Fund that had to perform the thank­
less task of trying to avert (or at least mitigate the effects of) an
Argentine default. Once again the remedy was a currency board,
this time pegging the currency to the dollar.
When the new peso convertible was introduced by Finance
Minister Domingo Cavallo in 1991 , it was the sixth Argentine
currency in the space of a century. Yet this remedy, too, ended in
failure. True, by 199 6 inflation had been brought down to zero;
indeed, it turned negative in 1999 . But unemployment stood at
1 5 per cent and income inequality was only marginally better
than in Nigeria. Moreover, monetary stricture was never accom­
panied by fiscal stricture; public debt rose from 35 per cent of
GD P at the end of 199 4 to 64 per cent at the end of 2001 as
central and provincial governments alike tapped the international
bond market rather than balance their budgets. In short, despite
pegging the currency and even slashing inflation, Cavallo had
failed to change the underlying social and institutional drivers
that had caused so many monetary crises in the past. The stage
was set for yet another Argentine default, and yet another cur­
rency. After two bailouts in January ($1 5 billion) and Ma y
($8 billion), the IM F declined to throw a third lifeline. On
23 December 2001 , at the end of a year in which per capita
GD P had declined by an agonizing 1 2 per cent, the government
announced a moratorium on the entirety of its foreign debt,
11 4
including bonds worth $8 1 billion: in nominal terms the biggest
debt default in history.
The history of Argentina illustrates that the bond market is less
powerful than it might first appear. The average 29 5 basis point
spread between Argentine and British bonds in the 1880s scarcely
compensated investors like the Barings for the risks they were
running by investing in Argentina. In the same way, the average
664 basis point spread between Argentine and US bonds from
1998 to 2000 significantly underpriced the risk of default as the
Cavallo currency peg began to crumble. When the default was
announced, the spread rose to 5,500; by March 2002 it exceeded
7,000 basis points. After painfully protracted negotiations (there
were 15 2 varieties of paper involved, denominated in six different
currencies and governed by eight jurisdictions) the majority of
approximately 500,000 creditors agreed to accept new bonds
worth roughly 35 cents on the dollar, one of the most drastic
'haircuts' in the history of the bond market.6 8 So successful did
Argentina's default prove (economic growth has since surged
while bond spreads are back in the 300-50 0 basis point range)
that many economists were left to ponder why any sovereign
debtor ever honours its commitments to foreign bondholders.6 9
The Resurrection of the Rentier
In the 1920s, as we have seen, Keynes had predicted the 'eutha­
nasia of the rentier\ anticipating that inflation would eventually
eat up all the paper wealth of those wh o had put their money in
government bonds. In our time, however, we have seen a miracu­
lous resurrection of the bondholder. After the Great Inflation of
the 1970s, the past thirty years have seen one country after
another reduce inflation to single digits.7 0 (Even in Argentina, the
11 5
official inflation rate is below 1 0 per cent, though unofficial
estimates compiled by the provinces of Mendoza and San Luis
put it above 20 per cent.) And, as inflation has fallen, so bonds
have rallied in what has been one of the great bond bull markets
of modern history. Even more remarkably, despite the spectacular
Argentine default - not to mention Russia's in 1998 - the spreads
on emerging market bonds have trended steadily downwards,
reaching lows in early 2007 that had not been seen since before
the First World War, implying an almost unshakeable confidence
in the economic future. Rumours of the death of M r Bond have
clearly proved to be exaggerated.
Inflation has come down partly because many of the items we
buy, from clothes to computers, have got cheaper as a result of
technological innovation and the relocation of production to
low-wage economies in Asia. It has also been reduced because of
a worldwide transformation in monetary policy, which began
with the monetarist-inspired increases in short-term rates imple­
mented by the Bank of England and the Federal Reserve in the
late 1970s and early 1980s, and continued with the spread of
central bank independence and explicit targets in the 1990s. Just
as importantly, as the Argentine case shows, some of the struc­
tural drivers of inflation have also weakened. Trade unions have
become less powerful. Loss-making state industries have been
privatized. But, perhaps most importantly of all, the social con­
stituency with an interest in positive real returns on bonds has
grown. In the developed world a rising share of wealth is held in
the form of private pension funds and other savings institutions
that are required, or at least expected, to hold a high proportion
of their assets in the form of government bonds and other fixed
income securities. In 2007 a survey of pension funds in eleven
major economies revealed that bonds accounted for more than a
quarter of their assets, substantially lower than in past decades,
11 6
11 7
but still a substantial share.7 1 With every passing year, the pro­
portion of the population living off the income from such funds
goes up, as the share of retirees increases.
Which brings us back to Italy, the land where the bond market
was born. In 1965 , on the eve of the Great Inflation, just 1 0 per
cent of Italians were aged 65 or over. Today the proportion is
twice that: around a fifth. And by 2050 it is projected by the
United Nations to be just under a third. In such a greying society,
there is a huge and growing need for fixed income securities, and
for low inflation to ensure that the interest they pay retains its
purchasing power. As more and more people leave the workforce,
recurrent public sector deficits ensure that the bond market will
never be short of new bonds to sell. And the fact that Italy has
surrendered its monetary sovereignty to the European Central
Bank means that there should never be another opportunity for
Italian politicians to print money and set off the inflationary
That does not mean, however, that the bond market rules the
world in the sense that James Carville meant. Indeed, the kind of
discipline he associated with the bond market in the 1990s has
been conspicuous by its absence under President Clinton's suc­
cessor, George W. Bush. Just months before President Bush's
election, on 7 September 2000, the National Debt Clock in Ne w
York's Times Square was shut down. On that day it read as
follows: 'Our national debt: $5,676,989,904,887. You r family
share: $73,7 3 3 . ' After three years of budget surpluses, both candi­
dates for the presidency were talking as if paying off the national
debt was a viable project. According to CN N
Democratic presidential nominee Al Gore has outlined a plan that he
says would eliminate the debt by 2012 . Senior economic advisers to
Texas Governor and Republican presidential candidate George W.
Bush agree with the principle of paying down the debt but have not
committed to a specific date for eliminating it.7 2
That lack of commitment on the latter candidate's part was
by way of being a hint. 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. The Congressional Budget Office forecasts a
continued rise to more than $1 2 trillion by 2017 . Yet, far from
punishing this profligacy, the bond market has positively re­
warded it. Between December 2000 and June 2003, the yield on
ten-year Treasury bonds declined from 5.24 per cent to 3.3 3 per
cent, and remains just above 4 per cent at the time of writing.
It is, however, impossible to make sense of this 'conundrum' -as Alan Greenspan called this failure of bond yields to respond
to short-term interest rate rises7 3 - by studying the bond market in
isolation. We therefore turn now from the market for government
debt to its younger and in many ways more dynamic sibling: the
market for shares in corporate equity, known colloquially as the
stock market.
11 8
Blowing Bubbles
The Andes stretch for more than four thousand miles like a
jagged, crooked spine down the western side of the South Ameri­
can continent. Formed roughly a hundred million years ago, as
the Nazca tectonic plate began its slow but tumultuous slide
beneath the South American plate, their highest peak, Mount
Aconcagua in Argentina, rises more than 22,000 feet above sea
level. Aconcagua's smaller Chilean brethren stand like gleaming
white sentinels around Santiago. But it is only when you are up
in the Bolivian highlands that you really grasp the sheer scale of
the Andes. When the rain clouds lift on the road from La Paz to
Lake Titicaca, the mountains dominate the skyline, tracing a
dazzling, irregular saw-tooth right across the horizon.
Looking at the Andes, it is hard to imagine that any kind of
human organization could overcome such a vast natural barrier.
But for one American company, their jagged peaks were no more
daunting than the dense Amazonian rainforests that lie to the
east of them. That company set out to construct a gas pipeline
from Bolivia across the continent to the Atlantic coast of Brazil,
and another - the longest in the world - from the tip of Patagonia
to the Argentine capital Buenos Aires.
Such grand schemes, exemplifying the vaulting ambition of
modern capitalism, were made possible by the invention of one
11 9
12 0
of the most fundamental institutions of the modern world: the
company. It is the company that enables thousands of individuals
to pool their resources for risky, long-term projects that require
the investment of vast sums of capital before profits can be real­
ized. After the advent of banking and the birth of the bond
market, the next step in the story of the ascent of money was
therefore 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 they had used to buy a stake in the company.
Smaller enterprises might operate just as well as partnerships. But
those who aspired to span continents needed the company.1
However, the ability of companies to transform the global
economy depended on another, related innovation. In theory, the
managers of joint-stock companies are supposed to be disciplined
by vigilant shareholders, who attend annual meetings, and seek
to exert influence directly or indirectly through non-executive
directors. In practice, the primary discipline on companies is
exerted by stock markets, where an almost infinite number of
small slices of companies (call them stocks, shares or equities,
whichever you prefer) are bought and sold every day. In essence,
the price people are prepared to pay for a piece of a company
tells you how much money they think that company will make
in the future. In effect, stock markets hold hourly référendums
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.
Ye t stock markets also have a life of their own. The future is
in large measure uncertain, so our assessments of companies'
future profitability are bound to vary. If we were all calculating
machines we would simultaneously process all the available infor­
mation and come to the same conclusion. But we are human
beings, and as such are prone to myopia and to mood swings.
When stock market prices surge upwards in sync, as they often
do, it is as if investors are gripped by a kind of collective euphoria:
what the former chairman of the Federal Reserve Alan Greenspan
memorably called irrational exuberance.2 Conversely, when
investors' 'animal spirits' flip from greed to fear, the bubble
of their earlier euphoria can burst with amazing suddenness.
Zoological imagery is of course an integral part of stock market
culture. Optimistic buyers of stocks are bulls, pessimistic sellers
are bears. Investors these days are said to be an electronic herd,
happily grazing on positive returns one moment, then stam­
peding for the farmyard gate the next. The real point, however,
is that stock markets are mirrors of the human psyche. Like
homo sapiens, they can become depressed. They can even suffer
complete breakdowns. Yet hope - or is it amnesia? - always
seems able to triumph over such bad experiences.
In the four hundred years since shares were first bought and
sold, there has been a succession of financial bubbles. Time and
again, share prices have soared to unsustainable heights only to
crash downwards again. Time and again, this process has been
accompanied by skulduggery, as unscrupulous insiders have
sought to profit at the expense of naive neophytes. So familiar is
this pattern that it is possible to distil it into five stages:
1 . Displacement: Some change in economic circumstances
creates new and profitable opportunities for certain com­
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
12 1
12 2
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
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 specu­
lator, based in a major financial centre, may lack the inside
knowledge of the true insider. But he is much more likely to get
his timing right - buying early and selling before the bubble bursts
- than the naive first-time investor. In a bubble, in other words,
not everyone is irrational; or, at least, some of the exuberant are
less irrational than others. Finally, and most importantly, without
easy credit creation a true bubble cannot occur. That is why
so many bubbles have their origins in the sins of omission or
commission of central banks.
Nothing illustrates more clearly how hard human beings find
it to learn from history than the repetitive history of stock market
bubbles. Consider how readers of the magazine Business Week
saw the world at two moments in time, separated by just twenty
years. On 1 3 August 1979 , the front cover featured a crumpled
share certificate in the shape of a crashed paper dart under the
headline: Th e Death of Equities: Ho w inflation is destroying the
stock market'. Readers were left in no doubt about the magnitude
of the crisis:
The masses long ago switched from stocks to investments having
higher yields and more protection from inflation. Now the pension
funds - the market's last hope - have won permission to quit stocks
and bonds for real estate, futures, gold, and even diamonds. The death
of equities looks like an almost permanent condition.5
On that day, the Do w Jones Industrial Average, the longest-running American stock market index, closed at 875 , barely
changed from its level ten years before, and nearly 1 7 per cent
below its peak of 105 2 in January 1973 . Pessimism after a decade
and half of disappointment was understandable. Yet , far from
expiring, US equities were just a few years away from one of the
great bull runs of modern times. Having touched bottom in
August 198 2 (777), the Do w proceeded to more than treble in
the space of just five years, reaching a record high of 2,700 in the
summer of 1987 . After a short, sharp sell-off in October 1987 ,
the index resumed its upward rise. After 1995 , the pace of its
ascent even quickened. On 27 September 1999 , it closed at just
under 10,395 , meaning that the average price of a major US
corporation had risen nearly twelve-fold in just twenty years. On
that day, readers of Business Week read with excitement that:
Conditions don't have to get a lot better to justify Dow 36,000, say
James K. Glassman and Kevin A. Hassett in Dow 36,000: The New
Strategy for Profiting From the Coming Rise in the Stock Market. They
argue that the market already merits 36K, and that stock prices will
advance toward that target over the next 3 to 5 years as investors come
to that conclusion, too . . . The market - even at a price-to-earnings
12 3
12 4
ratio of 30 * - is a steal. By their estimates, a 'perfectly reasonable
price' for the market.. . is 10 0 times earnings.6
This article was published less than four months before the
collapse of the dot-com bubble, which had been based on exag­
gerated expectations about the future earnings of technology
companies. By October 2002 the Do w was down to 7,286, a level
not seen since late 1997 . At the time of writing (April 2008), it
is still trading at one third of the level Glassman and Hassett
The performance of the American stock market is perhaps best
measured by comparing the total returns on stocks, assuming the
reinvestment of all dividends, with the total returns on other
financial assets such as government bonds and commercial or
Treasury bills, the last of which can be taken as a proxy for any
short-term instrument like a money market fund or a demand
deposit at a bank. The start date, 1964 , is the year of the author's
birth. It will immediately be apparent that if my parents had been
able to invest even a modest sum in the US stock market at that
date, and to continue reinvesting the dividends they earned each
year, they would have been able to increase their initial invest­
ment by a factor of nearly seventy by 2007. F° r example, $10,000
would have become $700,000. The alternatives of bonds or bills
would have done less well. A US bond fund would have gone up
by a factor of under 23 ; a portfolio of bills by a factor of just 12 .
Needless to say, such figures must be adjusted downwards to take
account of the cost of living, which has risen by a factor of nearly
* A ratio of stock prices divided by earnings including dividends. The long-run
average (since 1871 ) of the price-earnings ratio in the United States is 15.5 .
Its maximum was reached in 1999: 32.6. It currently stands at 18.6 (figures
for the Standard and Poor's 500 index, as extended back in time by Global
Financial Data).
seven in my lifetime. In real terms, stocks increased by a factor
of 10.3 ; bonds by a factor of 3.4; bills by a factor of 1.8 . Had
my parents made the mistake of simply buying $10,00 0 in dollar
bills in 1964, the real value of their son's nest egg would have
declined in real terms by 85 per cent.
N o stock market has out-performed the American over the
long run. One estimate of long-term real stock market returns
showed an average return for the US market of 4.73 per cent per
year between the 1920s and the 1990s. Sweden came next (3.71) ,
followed by Switzerland (3.03), with Britain barely in the top ten
on 2.28 per cent. Six out of the twenty-seven markets studied
suffered at least one major interruption, usually as a result of
war or revolution. Ten markets suffered negative long-term real
returns, of which the worst were Venezuela, Peru, Colombia and,
at the very bottom, Argentina (-5.3 6 per cent).7 'Stocks for the
long run' is very far from being a universally applicable nostrum.8
It nevertheless remains true that, in most countries for which
long-run data are available, stocks have out-performed bonds -by a factor of roughly five over the twentieth century.9 This can
scarcely surprise us. Bonds, as we saw in Chapter 2, are no more
than promises by governments to pay interest and ultimately
repay principal over a specified period of time. Either through
default or through currency depreciation, many governments
have failed to honour those promises. By contrast, a share is a
portion of the capital of a profit-making corporation. If the com­
pany succeeds in its undertakings, there will not only be divi­
dends, but also a significant probability of capital appreciation.
There are of course risks, too. The returns on stocks are less
predictable and more volatile than the returns on bonds and
bills. There is a significantly higher probability that the average
corporation will go bankrupt and cease to exist than that the
average sovereign state will disappear. In the event of a corporate
12 5
bankruptcy, the holders of bonds and other forms of debt will be
satisfied first; the equity holders may end up with nothing. For
these reasons, economists see the superior returns on stocks as
capturing an 'equity risk premium' - though clearly in some cases
this has been a risk well worth taking.
The Company You Keep
Behind the ornate baroque façade of Venice's San Moise church,
literally under the feet of the tens of thousands of tourists who
visit the church each year, there is a remarkable but seldom
noticed inscription:
'T o the honour and memory of John La w of Edinburgh. Most
distinguished controller of the treasury of the kings of the French.'
It is a rather unlikely resting place for the man who invented the
stock market bubble.
A n ambitious Scot, a convicted murderer, a compulsive gam­
bler and a flawed financial genius, John La w was not only respon­
sible for the first true boom and bust in asset prices. He also may
be said to have caused, indirectly, the French Revolution by
comprehensively blowing the best chance that the ancien régime
monarchy had to reform its finances. His story is one of the most
astonishing yet least well understood tales of adventure in all
financial history. It is also very much a story for our times.
Born in Edinburgh in 1671 , La w was the son of a successful
goldsmith and the heir to Lauriston Castle, overlooking the Firth
of Forth. He went to London in 1692 , but quickly began to fritter
away his patrimony in a variety of business ventures and gambling
12 6
12 7
escapades. Tw o years later he fought a duel with his neighbour,
who objected to sharing the same building as the dissolute La w
and his mistress, and killed him. He was tried for duelling and
sentenced to death, but escaped from prison and fled to
La w could not have picked a better town in which to lie
low. By the 1690s Amsterdam was the world capital of financial
innovation. T o finance their fight for independence against Spain
in the late sixteenth century, as we saw in the previous chapter,
the Dutch had improved on the Italian system of public debt
(introducing, among other things, lottery loans which allowed
people to gamble as they invested their savings in government
debt). They had also reformed their currency by creating what
was arguably the world's first central bank, the Amsterdam
Exchange Bank (Wisselbank), which solved the problem of
debased coinage by creating a reliable form of bank money (see
Chapter 1) . But perhaps the single greatest Dutch invention of all
was the joint-stock company.
The story of the company had begun a century before Law' s
arrival and had its origins in the efforts of Dutch merchants to
wrest control of the lucrative Asian spice trade from Portugal
and Spain. Europeans craved spices like cinnamon, cloves, mace,
nutmeg and pepper not merely to flavour their food but also to
preserve it. For centuries, these commodities had come overland
from Asia to Europe along the Spice Road . But with the Portu­
guese discovery of the sea route to the East Indies via the Cape of
Good Hope, new and irresistibly attractive business opportunities
opened up. The Amsterdam Historical Museum is full of paint­
ings that depict Dutch ships en route to and from the East Indies.
One early example of the genre bears the inscription: Tou r ships
sailed to go and get the spices towards Bantam and also established
trading posts. And came back richly laden to . . . Amsterdam.
Departed Ma y i , 1598 . Returned July 19,1599.' A s that suggests,
however, the round trip was a very long one (fourteen months
was in fact well below the average). It was also hazardous: of
twenty-two ships that set sail in 1598 , only a dozen returned
safely. For these reasons, it made sense for merchants to pool
their resources. By 1600 there were around six fledgling East India
companies operating out of the major Dutch ports. However, in
each case the entities had a limited term that was specified in
advance - usually the expected duration of a voyage - after which
the capital was repaid to investors.1 0 This business model could
not suffice to build the permanent bases and fortifications that
were clearly necessary if the Portuguese and their Spanish allies*
were to be supplanted. Actuated as much by strategic calculations
as by the profit motive, the Dutch States-General, the parliament
of the United Provinces, therefore proposed to merge the existing
companies into a single entity. The result was the United East
India Company - the Vereenigde Nederlandsche Geoctroyeerde
Oostindische Compagnie (United Dutch Chartered East India
Company, or VO C for short), formally chartered in 160 2 to
enjoy a monopoly on all Dutch trade east of the Cape of Good
Hope and west of the Straits of Magellan.1 1
The structure of the VO C was novel in a number of respects.
True, like its predecessors, it was supposed to last for a fixed
period, in this case twenty-one years; indeed, Article 7 of its
charter stated that investors would be entitled to withdraw their
money at the end of just ten years, when the first general balance
was drawn up. But the scale of the enterprise was unprecedented.
Subscription to the Company's capital was open to all residents
of the United Provinces and the charter set no upper limit on how
much might be raised. Merchants, artisans and even servants
* Between 158 0 and 164 0 the crowns of Spain and Portugal were united.
12 8
rushed to acquire shares; in Amsterdam alone there were 1,14 3
subscribers, only eighty of whom invested more than 10,000
guilders, and 445 of whom invested less than 1,000. The amount
raised, 6.45 million guilders, made the VO C much the biggest
corporation of the era. The capital of its English rival, the East
India Company, founded two years earlier, was just £68,37 3 -around 820,000 guilders - shared between a mere 21 9 sub­
scribers.1 2 Because the VO C was a government-sponsored enter­
prise, every effort was made to overcome the rivalry between the
different provinces (and particularly between Holland, the richest
province, and Zeeland). The capital of the Company was divided
(albeit unequally) between six regional chambers (Amsterdam,
Zeeland, Enkhuizen, Delft, Hoorn and Rotterdam). The seventy
directors (bewindhebbers), who were each substantial investors,
were also distributed between these chambers. One of their roles
was to appoint seventeen people to act as the Heeren XVII -the Seventeen Lords - as a kind of company board. Although
Amsterdam accounted for 57.4 per cent of the VOC' s total capi­
tal, it nominated only eight out of the Seventeen Lords. Among
the founding directors was Dirck Bas, a profit-oriented paterfami­
lias who (to judge by his portrait) was far from embarrassed by
his riches.1 3
Ownership of the Company was thus divided into multiple
parti j en or actien, literally actions (as in 'a piece of the action').
Payment for the shares was in instalments, due in 1603 , 1605 ,
1606 and 1607 . The certificates issued were not quite share cer­
tificates in the modern sense, but more like receipts; the key
document in law was the VO C stock ledger, where all stock­
holders' names were entered at the time of purchase.1 4 The prin­
ciple of limited liability was implied: shareholders stood to lose
only their investment in the company and no other assets in the
event that it failed.1 5 There was, on the other hand, no guarantee
12 9
The oldest share: share no. 6 of the Dutch East India Company
(not strictly speaking a share certificate but a receipt for part
payment of share, issued by the Camere Amsterdam on 27 September
I606, and signed by Arent ten Grotenhuys and Dirck van Os)
of returns; Article 17 of the VOC charter merely stated that a
payment would be made to shareholders as soon as profits equiva-lent to 5 per cent of the initial capital had been made.
The VOC was not in fact an immediate commercial success.
Trade networks had to be set up, the mode of operation estab-lished and secure bases established. Between 1603 and 1607, a
total of twenty-two ships were fitted out and sent to Asia, at a
cost of just under 3.7 million guilders. The initial aim was to
establish a number of factories (saltpetre refineries, textile facili-ties and warehouses), the produce of which would then be
exchanged for spices. Early successes against the Portuguese saw
footholds established at Masulipatnam in the Bay of Bengal and
Amboyna (today Ambon) in the Moluccas (Malukus), but in
I3 0
1606 Admiral Matelief failed to capture Malacca (Melaka) on
the Malay Peninsula and an attack on Makian (another Moluccan
island) was successfully repulsed by a Spanish fleet. An attempt to
build a fort on Banda Neira, the biggest of the nutmeg-producing
Banda islands, also failed.1 6 By the time a twelve-year truce was
signed with Spain in 1608, the VO C had made more money from
capturing enemy vessels than from trade.1 7 One major investor,
the Mennonite Pieter Lijntjens, was so dismayed by the Com­
pany's warlike conduct that he withdrew from the Company in
1605 . Another early director, Isaac le Maire, resigned in protest
at what he regarded as the mismanagement of the Company's
affairs.1 8
But how much power did even large shareholders have? Little.
When the Company's directors petitioned the government to be
released from their obligation to publish ten-year accounts in
161 2 - the date when investors were supposed to be able to
withdraw their capital if they chose to - permission was granted
and publication of the accounts and the repayment of investors'
capital were both postponed. The only sop to shareholders was
that in 161 0 the Seventeen Lords agreed to make a dividend
payment the following year, though at this stage the Company
was so strapped for cash that the dividend had to be paid in
spices. In 161 2 it was announced that the VO C would not be
liquidated, as originally planned. This meant that any share­
holders who wanted their cash back had no alternative but to sell
their shares to another investor.1 9
The joint-stock company and the stock market were thus born
within just a few years of each other. N o sooner had the first
publicly owned corporation come into existence with the first-ever initial public offering of shares, than a secondary market
sprang up to allow these shares to be bought and sold. It proved
to be a remarkably liquid market. Turnover in VO C shares was
13 1
high: by 160 7 fully on e third of the Company's stock had been
transferred from the original owners.2 0 Moreover, because the
Company's books were opened rather infrequently - purchases
were formally registered monthly or quarterly - a lively forward
market in VO C shares soon developed, which allowed sales for
future delivery. T o begin with, such transactions were done in
informal open-air markets, on the Warmoesstraat or next to the
Oude Kerk. But so lively was the market for VO C stock that in
1608 it was decided to build a covered Beurs on the Rokin, not
far from the town hall. With its quadrangle, its colonnades and
its clock tower, this first stock exchange in the world looked for
all the world like a medieval Oxford college. But what went on
there between noon and two o'clock each workday was recogniz­
ably revolutionary. One contemporary captured the atmosphere
on the trading floor as a typical session drew to a close: 'Hand­
shakes are followed by shouting, insults, impudence, pushing and
shoving.' Bulls (liefhebbers) did battle with bears (contremines).
The anxious speculator 'chews his nails, pulls his fingers, closes
his eyes, takes four paces and four times talks to himself, raises
his hand to his cheek as if he has a toothache and all this accom­
panied by a mysterious coughing'.2 1
No r was it coincidental that this same period saw the founda­
tion (in 1609) of the Amsterdam Exchange Bank, since a stock
market cannot readily function without an effective monetary
system. Once Dutch bankers started to accept VO C shares as
collateral for loans, the link between the stock market and the
supply of credit began to be forged. The next step was for banks
to lend money so that shares might be purchased with credit.
Company, bourse and bank provided the triangular foundation
for a new kind of economy.
For a time it seemed as if the VOC' s critics, led by the dis­
gruntled ex-director le Maire, might exploit this new market to
13 2
put pressure on the Company's directors. A concerted effort to
drive down the price of VO C shares by short selling on the
nascent futures market was checked by the 161 1 dividend pay­
ment, ruining le Maire and his associates.2 2 Further cash dividends
were paid in 1612 , 161 3 and 1618. 2 3 The Company's critics
(the 'dissenting investors' or Doleanten) remained dissatisfied,
however. In a tract entitled The Necessary Discourse (Nootwend-ich Discours), published in 1622 , an anonymous author lamented
the lack of transparency which characterized the 'self-serving
governance of certain of the directors', wh o were ensuring that
'all remained darkness': 'The account book, we can only surmise,
must have been rubbed with bacon and fed to the dogs.' 2 4 Direc­
torships should be for fixed terms, the dissenters argued, and all
major shareholders should have the right to appoint a director.
The campaign for a reform of what would now be called the
VOC' s corporate governance duly bore fruit. In December 1622 ,
when the Company's charter was renewed, it was substantially
modified. Directors would no longer be appointed for life but
could serve for only three years at a time. The 'chief participants'
(shareholders with as much equity as directors) were henceforth
entitled to nominate 'Nine Men ' from among themselves, whom
the Seventeen Lords were obliged to consult on 'great and impor­
tant matters', and who would be entitled to oversee the annual
accounting of the six chambers and to nominate, jointly with the
Seventeen Lords, future candidates for directorships. In addition,
in March 1623 , it was agreed that the Nine Men would be entitled
to attend (but not to vote at) the meetings of the Seventeen
Lords and to scrutinize the annual purchasing accounts. The chief
participants were also empowered to appoint auditors (rekening-opnemers) to check the accounts submitted to the States-General.2 5 Shareholders were further mollified by the decision, in
1632 , to set a standard 12 . 5 per cent dividend, twice the rate at
13 3
which the Company was able to borrow money.* The result of
this policy was that virtually all of the Company's net profits
thereafter were distributed to the shareholders.2 6 Shareholders
were also effectively guaranteed against dilution of their equity.
Amazingly, the capital base remained essentially unchanged
throughout the VOC' s existence.2 7 When capital expenditures
were called for, the VO C raised money not by issuing new shares
but by issuing debt in the form of bonds. Indeed, so good was
the Company's credit by the 1670s that it was able to act as
an intermediary for a two-million-guilder loan by the States of
Holland and Zeeland.
None of these arrangements would have been sustainable, of
course, if the VO C had not become profitable in the mid seven­
teenth century. This was in substantial measure the achievement
of Ja n Pieterszoon Coen, a bellicose young man who had no
illusions about the relationship between commerce and coercion.
As Coen himself put it: 'We cannot make war without trade,
nor trade without war.' 2 8 He was ruthless in his treatment of
competitors, executing British East India Company officials at
Amboyna and effectively wiping out the indigenous Bandanese.
A natural-born empire builder, Coen seized control of the small
Javanese port of Jakarta in Ma y 1619 , renamed it Batavia and,
aged just 30, duly became the first governor-general of the
Dutch East Indies. He and his successor, Antonie van Diemen,
systematically expanded Dutch power in the region, driving the
British from the Banda Islands, the Spaniards from Ternate and
Tidore, and the Portuguese from Malacca. By 165 7 the Dutch
controlled most of Ceylon (Sri Lanka); the following decade saw
further expansion along the Malabar coast on the subcontinent
* Technically, the removal of uncertainty about future dividends gave the
shares the character of preference shares or even bonds.
13 4
and into the island of Celebes (Sulawesi). There were also thriving
Dutch bases on the Coromandel coast.2 9 Fire-power and foreign
trade sailed side by side on ships like the Batavia - a splendid
replica of which can be seen today at Lelystad on the coast of
The commercial payoffs of this aggressive strategy were sub­
stantial. By the 1650s, the VO C had established an effective and
highly lucrative monopoly on the export of cloves, mace and
nutmeg (the production of pepper was too widely dispersed for it
to be monopolized) and was becoming a major conduit for Indian
textile exports from Coromandel.3 0 It was also acting as a hub
for intra-Asian trade, exchanging Japanese silver and copper for
Indian textiles and Chinese gold and silk. In turn, Indian textiles
could be traded for pepper and spices from the Pacific islands,
which could be used to purchase precious metals from the Middle
East.3 1 Later, the Company provided financial services to other
Europeans in Asia, not least Robert Clive, who transferred a large
part of the fortune he had made from conquering Bengal back to
London via Batavia and Amsterdam.3 2 As the world's first big
corporation, the VO C was able to combine economies of scale
with reduced transaction costs and what economists call network
externalities, the benefit of pooling information between multiple
employees and agents.3 3 As was true of the English East India
Company, the VOC' s biggest challenge was the principal-agent
problem: the tendency of its men on the spot to trade on their
own account, bungle transactions or simply defraud the com­
pany. This, however, was partially countered by an unusual com­
pensation system, which linked remuneration to investments and
sales, putting a priority on turnover rather than net profits.3 4
Business boomed. In the 1620s, fifty VO C ships had returned
from Asia laden with goods; by the 1690s the number was 156. 3 5
Between 170 0 and 175 0 the tonnage of Dutch shipping sailing
!3 5
13 6
back around the Cape doubled. As late as 176 0 it was still roughly
three times the amount of British shipping.3 6
The economic and political ascent of the VO C can be traced
in its share price. The Amsterdam stock market was certainly
volatile, as investors reacted to rumours of war, peace and ship­
wrecks in a way vividly described by the Sephardic Je w Joseph
Penso de la Vega in his aptly named book Confusion de Con-fusiones (1688). Ye t the long-term trend was clearly upward for
more than a century after the Company's foundation. Between
160 2 and 1733 , VO C stock rose from par (100) to an all-time peak of 786, this despite the fact that from 165 2 until the
Glorious Revolution of 168 8 the Company was being challenged
by bellicose British competition.3 7 Such sustained capital appreci­
ation, combined with the regular dividends and stable consumer
prices,* ensured that major shareholders like Dirck Bas became
very wealthy indeed. As early as 1650 , total dividend payments
were already eight times the original investment, implying an
annual rate of return of 2 7 per cent.3 8 The striking point, however,
is that there was never such a thing as a Dutch East India Com­
pany bubble. Unlike the Dutch tulip futures bubble of 1636-7 ,
the ascent of the VO C stock price was gradual, spread over more
than a century, and, though its descent was more rapid, it still
took more than sixty years to fall back down to 12 0 in December
1794 . This rise and fall closely tracked the rise and fall of the
Dutch Empire. The prices of shares in other monopoly trading
companies, outwardly similar to the VOC , would behave very
* A measure of the success of the Bank of Amsterdam was that consumer
price inflation fell from 2 per cent per annum between 155 0 and 1608 to
0.9 per cent p.a. between 1609 and 1658 and just 0.1 per cent p.a. between
165 9 and 1779 . The nearly eight-fold appreciation in the VO C stock price
therefore compares reasonably well with the inflation-adjusted performance
of modern stock markets.
differently, soaring and slumping in the space of just a few
months. T o understand why, we must rejoin John Law .
T o the renegade Scotsman, Dutch finance came as a revelation.
La w was fascinated by the relationships between the East India
Company, the Exchange Bank and the stock exchange. Always
attracted by gambling, La w found the Amsterdam Beurs more
exciting than any casino. He marvelled at the antics of short-sellers, who spread negative rumours to try to drive down VO C
share prices, or the specialists in windhandel, who traded specu­
latively in shares they did not themselves even own. Financial
innovation was all around. La w himself floated an ingenious
scheme to insure holders of Dutch national lottery tickets against
drawing blanks.
Yet the Dutch financial system struck La w as not quite com­
plete. For one thing, it seemed wrong-headed to restrict the
number of East India Company shares when the market was so
enamoured of them. La w was also puzzled by the conservatism
of the Amsterdam Exchange Bank. Its own 'bank money' had
proved a success, but it largely took the form of columns of
figures in the bank's ledgers. Apart from receipts issued to mer­
chants who deposited coin with the bank, the money had no
physical existence. The idea was already taking shape in Law' s
mind of a breathtaking modification of these institutions, which
would combine the properties of a monopoly trading company
with a public bank that issued notes in the manner of the Bank
of England. La w was soon itching to try out a whole new system
of finance on an unsuspecting nation. But which one?
He first tried his luck in Genoa, trading foreign currency and
securities. He spent some time in Venice, trading by day, gambling
by night. In partnership with the Earl of Islay, he also built up
a substantial portfolio on the London stock market. (As this
13 7
suggests, La w was well connected. But there remained a disrepu­
table quality to his conduct. Lady Catherine Knowles, daughter
of the Earl of Banbury, passed as his wife and was the mother of
his two children, despite the fact that she was married to another
man. In 170 5 he submitted to the Scottish parliament a proposal
for a new bank, later published as Money and Trade Considered.
His central idea was that the new bank should issue interest-bearing notes that would supplant coins as currency. It was
rejected by the parliament shortly before the Act of Union with
England.3 9 Disappointed by his homeland, La w travelled to Turin
and in 171 1 secured an audience with Victor Amadeus II, Duke
of Savoy. In The Piedmont Memorials, he again made the case
for a paper currency. According to Law , confidence alone was
the basis for public credit; with confidence, banknotes would
serve just as well as coins. 'I have discovered the secret of the
philosopher's stone, he told a friend, 'it is to make gold out of
paper.'4 0 The Duke demurred, saying 'I am not rich enough to
ruin myself.'
The First Bubble
Why was it in France that La w was given the chance to try out
his financial alchemy? The French knew him for what he was,
after all: in 170 8 the Marquis of Torcy, Louis XIV' s Foreign
Minister, had identified him as a professional joueur (gambler)
and possible spy. The answer is that France's fiscal problems were
especially desperate. Saddled with enormous public debt as a
result of the wars of Louis XIV , the government was on the brink
of its third bankruptcy in less than a century. A review (Visa) of
the crown's existing debts was thought necessary, which led to
the cancellation and reduction of many of them, in effect a partial
13 8
default. Even so, 250 million new interest-bearing notes called
billets d'état still had to be issued to fund the current déficit.
Matters were only made worse by an attempt to reduce the
quantity of gold and silver coinage, which plunged the economy
into recession.4 1 T o all these problems La w claimed to have the
In October 171 5 Law' s first proposal for a public note-issuing
bank was submitted to the royal council, but it was rejected
because of the opposition of the Duke of Noailles to Law' s bold
suggestion that the bank should also act as the crown's cashier,
receiving all tax payments. A second proposal for a purely private
bank was more successful. The Banque Générale was established
under Law's direction in Ma y 171 6 . It was licensed to issue notes
payable in specie (gold or silver) for a twenty-year period. The
capital was set at 6,000,000 livres (1,200 shares of 5,000 livres
each), three quarters to be paid in now somewhat depreciated
billets d'état (so the effective capital was closer to 2,850,000
livres).4 2 It seemed at first quite a modest enterprise, but La w
always had a grander design in mind, which he was determined
to sell to the Duke of Orleans, the Regent during the minority of
Louis XV . In 171 7 he took another step forward when it was
decreed that Banque Générale notes should be used in payment
for all taxes, a measure initially resisted in some places but effec­
tively enforced by the government.
Law's ambition was to revive economic confidence in France
by establishing a public bank, on the Dutch model, but with the
difference that this bank would issue paper money. As money
was invested in the bank, the government's huge debt would be
consolidated. At the same time, paper money would revive French
trade - and with it French economic power. 'The bank is not the
only, nor the grandest of my ideas,' he told the Regent. 'I will
produce a work which will surprise Europe by the changes which
13 9
it will effect in favour of France - changes more powerful than
were produced by the discovery of the Indies . . .' 4 3
La w had studied finance in republican Holland, but from the
outset he saw absolutist France as a better setting for what became
known as his System. T maintain', he wrote, 'that an absolute
prince who knows how to govern can extend his credit further
and find needed funds at a lower interest rate than a prince who
is limited in his authority.' This was an absolutist theory of
finance, based on the assertion that 'in credit as in military and
legislative authorities, supreme power must reside in only one
person'.4 4 The key was to make royal credit work more pro­
ductively than in the past, when the crown had borrowed money
in a hand-to-mouth way to finance its wars. In Law' s scheme,
the monarch would effectively delegate his credit 'to a trading
company, into which all the materials of trade in the kingdom
fall successively, and are amassed into one'. The whole nation
would, as he put it, 'become a body of traders, who have for
cash the royal bank, in which by consequence all the commerce,
money, and merchandise re-unite'.4 5
As in the Dutch case, empire played a key role in Law' s vision.
In his view, too little was being done to develop France's overseas
possessions. He therefore proposed to take over France's trade
with the Louisiana territory, a vast but wholly undeveloped tract
of land stretching from the Mississippi delta across the Midwest
- equivalent to nearly a quarter of what is now the United States.
In 171 7 a new 'Company of the West' (Compagnie d'Occident)
was granted the monopoly of the commerce of Louisiana (as well
as the control of the colony's internal affairs) for a period of
twenty-five years. The Company's capital was fixed at 100 million
livres, an unprecedented sum in France. Shares in the Company
were priced at 500 livres each, and Frenchmen, regardless of
rank, as well as foreigners were encouraged to buy them (in
14 0
instalments) with the billets d'état, which were to be retired and
converted into 4 per cent rentes (perpetual bonds). Law' s name
headed the list of directors.
There was some initial resistance to Law' s System, it is true.
The Duke of Saint-Simon observed wisely that:
An establishment of this sort may be good in itself; but it is only so in
a republic or in a monarchy like England, whose finances are con­
trolled by those alone who furnish them, and who only furnish as
much as they please. But in a state which is weak, changeable, and
absolute, like France, stability must necessarily be wanting to it; since
the King . . . may overthrow the Bank - the temptation to which
would be too great, and at the same time too easy.4 6
As if to put this to the test, in early 171 8 the Parlement of
Paris launched fierce attacks on the new Finance Minister René
D'Argenson (and on Law' s bank) following a 40 per cent debase­
ment of the coinage ordered by the former, which had caused,
the Parlement complained, 'a chaos so great and so obscure that
nothing about it can be known'. 4 7 A rival company, set up by
the Paris brothers, was meanwhile proving more successful in
attracting investors than Law' s Company of the West. In true
absolutist fashion, however, the Regent forcefully reasserted the
prerogatives of the crown, much to Law' s delight - and benefit.
('How great is the benefit of a despotic power', he observed, 'in
the beginnings of an institution subject to so much opposition on
the part of a nation that has not yet become accustomed to
it!')4 8 Moreover, from late 171 8 onwards the government granted
privileges to the Company of the West that were calculated to
increase the appeal of its shares. In August it was awarded the
right to collect all the revenue from tobacco. In December it
acquired the privileges of the Senegal Company. In a further
attempt to bolster Law' s position, the Banque Générale was given
14 1
the royal seal of approval: it became the Banque Royale in
December 1718 , in effect the first French central bank. T o in­
crease the appeal of its notes, these could henceforth be ex­
changed for either ecus de banque (representing fixed amounts
of silver) or the more commonly used livres tournois (a unit of
account whose relationship to gold and silver could vary). In
July, however, the ecu notes were discontinued and withdrawn,4 9
while a decree of 2 2 April 171 9 stipulated that banknotes should
not share in the periodic 'diminutions' (in price) to which silver
was subject.5 0 France's transition from coinage to paper money
had begun.
Meanwhile, the Company of the West continued to expand. In
Ma y 171 9 it took over the East India and China companies, to
form the Company of the Indies {Compagnie des Indes), better
known as the Mississippi Company. In July La w secured the
profits of the royal mint for a nine-year term. In August he
wrested the lease of the indirect tax farms from a rival financier,
who had been granted it a year before. In September the Company
agreed to lend 1. 2 billion livres to the crown to pay off the entire
royal debt. A month later La w took control of the collection
('farm') of direct taxes.
La w was proud of his System. What had existed before, he
wrote, was not much more than 'a method of receipts and dis­
bursements'. Here, by contrast, 'you have a chain of ideas which
support one another, and display more and more the principle
they flow from.'5 1 In modern terms, what La w was attempting
could be described as reflation. The French economy had been in
recession in 171 6 and Law' s expansion of the money supply with
banknotes clearly did provide a much-needed stimulus.5 2 At the
same time, he was (not unreasonably) trying to convert a badly
managed and burdensome public debt into the equity of an enor­
mous, privatized tax-gathering and monopoly trading com-14 2
pany.5 3 If he were successful, the financial difficulties of the French
monarchy would be at an end.
But La w had no clear idea where to stop. On the contrary, as
the majority shareholder in what was now a vast corporation, he
had a strong personal interest in allowing monetary expansion,
which his own bank could generate, to fuel an asset bubble
from which he more than anyone would profit. It was as if one
man was simultaneously running all five hundred of the top US
corporations, the US Treasury and the Federal Reserve System.
Would such a person be likely to raise corporation taxes or
interest rates at the risk of reducing the value of his massive share
portfolio? Moreover, Law' s System had to create a bubble or it
would fail. The acquisition of the various other companies and
tax farms was financed, not out of company profits, but simply
by issuing new shares. On 1 7 June 171 9 the Mississippi Company
issued 50,000 of these at a price of 55 0 livres apiece (though each
share had a face value of 500 livres, as with the earlier Company
of the West shares). T o ensure the success of the issue, La w
personally underwrote it, a characteristic gamble that even he
admitted cost him a sleepless night. And to avoid the imputation
that he alone would profit if the shares rose in price, he gave
existing Company of the West shareholders the exclusive right
to acquire these new shares (which hence became known as
'daughters'; the earlier shares were 'mothers').5 4 In July 171 9 La w
issued a third tranche of 50,000 shares (the 'granddaughters') -now priced at 1,000 livres each - to raise the 50 million livres he
needed to pay for the royal mint. Logically, this dilution of the
existing shareholders ought to have caused the price of an indi­
vidual share to decline. Ho w could La w justify a doubling of the
issue price?
Ostensibly, the 'displacement' that justified higher share prices
was the promise of future profits from Louisiana. That was why
14 3
The object of speculation: A one-tenth share
in the Compagnie des Indes (otherwise
known as the Mississippi Company)
Law devoted so much effort to conjuring up rosy visions of
the colony as a veritable Garden of Eden, inhabited by friendly
savages, eager to furnish a cornucopia of exotic goods for ship-ment to France. To conduct this trade, a grand new city was
established at the mouth of the Mississippi: New Orleans, named
to flatter the always susceptible Regent. Such visions, as we know,
were not wholly without foundation, but their realization lay far
in the future. To be sure, a few thousand impoverished Germans
from the Rhineland, Switzerland and Alsace were recruited to act
as colonists. But what the unfortunate immigrants encountered
when they reached Louisiana was a sweltering, insect-infested
14 5
swamp. Within a year 80 per cent of them had died of starvation
or tropical diseases like yellow fever.*
In the short term, then, a different kind of displacement was
needed to justify the 40 per cent dividends La w was now paying. It
was provided by paper money. From the summer of 171 9 investors
who wished to acquire the 'daughters' and 'granddaughters' were
generously assisted by the Banque Royale, which allowed share­
holders to borrow money, using their shares as collateral; money
they could then invest in more shares. Predictably, the share price
soared. The original 'mothers' stood at 2,75 0 livres on 1 August,
4,100 on 30 August and 5,000 on 4 September. This prompted
La w to issue 100,000 more shares at this new market price. Tw o
further issues of the same amount followed on 28 September and
2 October, followed by a smaller block of 24,000 shares two
days later (though these were never offered to the public). In the
autumn of 171 9 the share price passed 9,000 livres, reaching a
new high (10,025) on 2 December. The informal futures market
saw them trading at 12,50 0 livres for delivery in March 1720 .
The mood was now shifting rapidly from euphoria to mania.5 5
A few people smelt a rat. 'Have you all gone crazy in Paris?'
wrote Voltaire to M . de Génonville in 1719 . 'It is a chaos I cannot
fathom . . ,' 5 6 The Irish banker and economist Richard Cantillon
was so sure that Law' s System would implode that he sold up
and left Paris in early August 1719. 5 7 From London Daniel Defoe
was dismissive: the French had merely 'run up a piece of re­
fined air'. Law' s career, he sneered, illustrated a new strategy for
success in life:
You must put on a sword, kill a beau or two, get into Newgate
[prison], be condemned to be hanged, break prison if you can -* Traces of the survivors can still be found in the Acadiana parishes of
St Charles, St James and St John the Baptist.
remember that by the way - get over to some strange country, turn
stock-jobber, set up a Mississippi stock, bubble a nation, and you will
soon be a great man; if you have but great good luck . . . 5 8
But a substantial number of better-off Parisians were seduced
by Law . Flush with cash of his own making, he offered to pay
pension arrears and indeed to pay pensions in advance - a sure
way to build support among the privileged classes. By September
171 9 there were hundreds of people thronging the rue Quincam-poix, a narrow thoroughfare between the rue St Martin and the
rue St Denis where the Company had its share-issuing office. A
clerk at the British embassy described it as 'crowded from early
in the morning to late at night with princes and princesses, dukes
and peers and duchesses etc., in a word all that is great in France.
They sell estates and pawn jewels to purchase Mississippi.'5 9
Lady Mar y Wortley Montagu, who visited Paris in 1719 , was
'delighted .. . to see an Englishman (at least a Briton) absolute in
Paris, I mean Mr . Law , who treats their dukes and peers extremely
de haut en bas and is treated by them with the utmost submission
and respect - Poor souls!'6 0 It was in these heady times that the
word millionaire was first coined. (Like entrepreneurs, million­
aires were invented in France.)
Small wonder John La w was seen at Mass for the first time on
1 0 December, having converted to Catholicism in order to be
eligible for public office. He had much to thank his Maker for.
When he was duly appointed Controller General of Finances the
following month, his triumph was complete. He was now in
charge of:
the collection of all France's indirect taxes;
the entire French national debt;
the twenty-six French mints that produced the country's
gold and silver coins;
14 6
The end of the show in the rue Quincampoix, I7I9, from The
Great Scene of Folly, published in Amsterdam a year later
the colony of Louisiana;
the Mississippi Company, which had a monopoly on the
import and sale of tobacco;
the French fur trade with Canada; and
all France's trade with Africa, Asia and the East Indies.
Further, in his own right, Law owned:
the Hotel de Nevers in the rue de Richelieu (now the Bibli-otheque Nationale);
the Mazarin Palace, where the Company had its offices;
more than a third of the buildings at the place Vendome
(then place Louis Ie Grand);
14 8
more than twelve country estates;
several plantations in Louisiana; and
io o million livres of shares in the Mississippi Company.6 1
Louis XI V of France had said 'L'état, c'est moi9:1 am the state.
Joh n La w could legitimately say 'L'économie, c'est moi': I am
the economy.
In truth, John La w preferred gambling to praying. In March
1719 , for example, he had bet the Duke of Bourbon a thousand
new louis d'or that there would be no more ice that winter or
spring. (He lost.) On another occasion he wagered 10,000 to 1
that a friend could not throw a designated number with six dice
at one throw. (He probably won on that occasion, since the odds
against doing so are 66 to 1 , or 46,656 to 1.) But his biggest bet
was on his own System. Law' s 'daily discourse', reported an
uneasy British diplomat in August 1719 , was that he would 'set
France higher than ever she was before, and put her in a condition
to give the law to all Europe; that he can ruin the trade and credit
of England and Holland, whenever he pleases; that he can break
our bank, whenever he has a mind; and our East India Com-pany.' 6 2 Putting his money where his mouth was, La w had made
a bet with Thomas Pitt, Earl of Londonderry (and uncle of the
Prime Minister William Pitt), that British shares would fall in
price in the year ahead. He sold £100,000 of East India stock
short for £180,000 (that is at a price of £18 0 per share, or 80
per cent above face value) for delivery on 25 August 1720. 6 3 (The
price of the shares at the end of August 171 9 was £194 , indicating
Law' s expectation of a £1 4 price decline.)
Yet the con at the heart of Law' s confidence could not be
sustained indefinitely. Even before his appointment as Controller
General, the first signs of phase 4 of the five-stage bubble cycle -
distress - had begun to manifest themselves. When the Mississippi
share price began to decline in December 1719 , touching 7,930
livres on 1 4 December, La w resorted to the first of many artificial
expedients to prop it up, opening a bureau at the Banque Royale
that guaranteed to buy (and sell) the shares at a floor price of
9,000 livres. As if to simplify matters, on 2 2 February 172 0 it
was announced that the Company was taking over the Banque
Royale. La w also created options (primes) costing 1,000 livres
which entitled the owner to buy a share for 10,000 livres over
the following six months (that is an effective price of 11,00 0
livres - 900 livres above the actual peak price of 10,10 0 reached
on 8 January). These measures sufficed to keep the share price
above 9,000 livres until mid-January (though the effect of the
floor price was to render the options worthless; generously La w
allowed holders to convert them into shares at the rate of ten
primes per share).
Inflation, however, was now accelerating alarmingly outside
the stock market. At their peak in September 1720 , prices in Paris
were roughly double what they had been two years before, with
most of the increase coming in the previous eleven months. This
was a reflection of the extraordinary increase in note circulation
La w had caused. In the space of little more than a year he had
more than doubled the volume of paper currency. By Ma y 172 0
the total money supply (banknotes and shares held by the public,
since the latter could be turned into cash at will) was roughly
four times larger in livre terms than the gold and silver coinage
France had previously used.6 4 No t surprisingly, some people
began to anticipate a depreciation of the banknotes, and began
to revert to payment in gold and silver. Ever the absolutist, Law' s
initial response was to resort to compulsion. Banknotes were
made legal tender. The export of gold and silver was banned as
was the production and sale of gold and silver objects. By the
14 9
10, 000
The Mississippi Bubble: Money and share prices (livres)
- Mississippi Co. share price
(left-hand axis)
- End month value of banknotes
held by the French public
o ~~~~~~~++~~~~~
~ ~ ~ - ~ ~ ~ ~ ~ -1719 1719 1719 1719 1710 172.0 1720 172.0 1720 1720
1,5 00,000,000
1 , 000,000,000
1,5 00,000,000
arret of 27 February 1720, it became illegal for a private citizen
to possess more than 500 livres of metal coin. The authorities
were empowered to enforce this measure by searching people's
houses. Voltaire called this 'the most unjust edict ever rendered'
and 'the final limit of a tyrannical absurdity'.65
At the same time, Law obsessively tinkered with the exchange
rate of the banknotes in terms of gold and silver, altering the
official price of gold twenty-eight times and the price of silver
no fewer than thirty-five times between September 1719 and
December 1720 - all in an effort to make banknotes more attrac-tive than coins to the public. But the flow of sometimes contradic-tory regulations served only to bewilder people and to illustrate
the propensity of an absolutist regime to make up the economic
rules to suit itself. 'By an all new secret magic,' one observer
later recalled, 'words assembled and formed Edicts that no one
comprehended, and the air was filled with obscure ideas and
chimeras.'66 One day gold and silver could be freely exported; the
next day not. One day notes were being printed as fast as the
printing presses could operate; the next Law was aiming to cap
15 1
the banknote supply at 1. 2 million livres. One day there was a
floor price of 9,000 livres for Mississippi shares; the next day
not. When this floor was removed on 2 2 February the shares
predictably slumped. By the end of the month they were down to
7,825 livres. On 5 March, apparently under pressure from the
Regent, La w performed another U-turn, reinstituting the 9,000
livre floor and reopening the bureau to buy them at this price.
But this meant that the lid was once again removed from the money
supply - despite the assertion in the same decree that 'the banknote
was a money which could not be altered in value', and despite the
previous commitment to a 1. 2 million livre cap. 6 7 By now the
smarter investors were more than happy to have 9,000 livres in
cash for their each of their shares. Between February and Ma y 172 0
there was a 94 per cent increase in the public's holdings of bank­
notes. Meanwhile their holdings of shares slumped to less than a
third of the total number issued. It seemed inevitable that before
long all the shares would be unloaded on the Company, unleashing
a further flood of banknotes and a surge in inflation.
On 2 1 May , in a desperate bid to avert meltdown, La w induced
the Regent to issue a deflationary decree, reducing the official
price of Company shares in monthly steps from 9,000 livres to
5,000 and at the same time halving the number of banknotes in
circulation. He also devalued the banknotes, having revoked the
previous order guaranteeing that this would not happen. This
was when the limits of royal absolutism, the foundation of Law' s
System, suddenly became apparent. Violent public outcry forced
the government to revoke these measures just six days after their
announcement, but the damage to confidence in the System
was, by this time, irrevocable. After an initial lull, the share price
slid from 9,005 livres (16 May ) to 4,200 (31 May) . Angry crowds
gathered outside the Bank, which had difficulty meeting the
demand for notes. Stones were thrown, windows broken. 'The
heaviest loss', wrote one British observer, 'falls on the people of
this country and affects all ranks and conditions among them. It
is not possible to express how great and general their conster­
nation and despair have appeared to be on this occasion; the
Princes of the blood and all the great men exclaim very warmly
against it.'6 8 La w was roundly denounced at an extraordinary
meeting of the Parlement. The Regent retreated, revoking the
2 1 Ma y decree. La w offered his resignation, but was dismissed
outright on 29 May . He was placed under house arrest; his
enemies wanted to see him in the Bastille. For the second time in
his life, La w faced jail, conceivably even death. (An investigative
commission quickly found evidence that Law' s issues of bank­
notes had breached the authorized limit, so grounds existed for
a prosecution.) The Banque Royale closed its doors.
John La w was an escape artist as well as a con artist. It quickly
became apparent that no one but him stood any chance of avert­
ing a complete collapse of the financial system - which was, after
all, his System. His recall to power (in the less exalted post of
Intendant General of Commerce) caused a rally on the stock
market, with Mississippi Company shares rising back to 6,350
livres on 6 June. It was, however, only a temporary reprieve. On
1 0 October the government was forced to reintroduce the use of
gold and silver in domestic transactions. The Mississippi share
price resumed its downward slide not long after, hitting 2,000
livres in September and 1,000 in December. Full-blown panic
could no longer be postponed. It was at this moment that Law,
vilified by the people, and lampooned by the press, finally fled
the country. He had a 'touching farewell' with the Duke of
Orleans before he went. 'Sire,' said Law , 'I acknowledge that I
have made great mistakes. I made them because I am only human,
and all men are liable to err. But I declare that none of these acts
proceeded from malice or dishonesty, and that nothing of that
15 2
15 3
character will be discovered in the whole course of my conduct.'6 9
Nevertheless, his wife and daughter were not allowed to leave
France so long as he was under investigation.
As if pricked by a sword, the Mississippi Bubble had now burst,
and the noise of escaping air resounded throughout Europe. So
incensed was one Dutch investor that he had a series of satirical
plates specially commissioned in China. The inscription on one
reads: 'By God, all my stock's worthless!' Another is even more
direct: 'Shit shares and wind trade.' As far as investors in Amster­
dam were concerned, Law' s company had been trading in nothing
more substantial than wind - in marked contrast to the Dutch
East India Company, which had literally delivered the goods in
the form of spices and cloth. As the verses on one satirical Dutch
cartoon flysheet put it:
This is the wondrous Mississippi land,
Made famous by its share dealings,
Which through deceit and devious conduct,
Has squandered countless treasures.
However men regard the shares,
It is wind and smoke and nothing more.
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 La w himself,
blithely passing by castles in the air in a carriage pulled by two
bedraggled Gallic cockerels.7 0
La w himself did not walk away financially unscathed. He left
France with next to nothing, thanks to his bet with Londonderry
that English East India stock would fall to £180 . By April 172 0
the price had risen to £23 5 and it continued to rise as investors
Brokers turning coin into Mississippi stock and wind: engraving
from The Great Scene of Folly (1720)
exited the Paris market for what seemed the safer haven of
London (then in the grip of its own less spectacular South Sea
Bubble). By June the price was at £420, declining only slightly to
£345 in August, when Law's bet fell due. Law's London banker,
George Middleton, was also ruined in his effort to honour his
client's obligation. 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. The French monarchy's fiscal crisis
went unresolved and for the remainder of the reigns of Louis XV
and his successor Louis XVI the crown essentially lived from
hand to mouth, lurching from one abortive reform to another
until royal bankruptcy finally precipitated revolution. The magni-tude of the catastrophe was perhaps best captured by Bernard
Bernard Picart, Monument Consecrated to Posterity (1721)
Picart in his elaborate engraving Monument Consecrated to
Posterity (1721). On the left, penniless Dutch investors troop
morosely into the sickhouse, the madhouse and the poorhouse.
But the Parisian scene to the right is more apocalyptic. A naked
Fortuna rains down Mississippi stock and options on a mob
emanating from the rue Quincampoix, while a juggernaut drawn
by Indians crushes an accountant under a huge wheel of fortune
and two men brawl in the foreground. 71
In Britain, by contrast, the contemporaneous South Sea Bubble
was significantly smaller and ruined fewer people - not least
because the South Sea Company never gained control of the Bank
of England the way Law had controlled the Banque Royale. In
essence, his English counterpart John Blunt's South Sea scheme
was to convert government debt of various kinds, most of it
created to fund the War of the Spanish Succession, into the equity
of a company that had been chartered to monopolize trade with
the Spanish Empire in South America. Having agreed on conver­
sion prices for the annuities and other debt instruments, the
directors of the South Sea Company stood to profit if they could
get the existing holders of government annuities to accept South
Sea shares at a high market price, since this would leave the
directors with surplus shares to sell to the public.7 2 In this they
succeeded, using tricks similar to those employed by La w in Paris.
Shares were offered to the public in four tranches, with the price
rising from £300 per share in April 172 0 to £1,000 in June.
Instalment payment was permitted. Loans were offered against
shares. Generous dividends were paid. Euphoria duly gave way
to mania; as the poet Alexander Pope observed, it was 'ignomini­
ous (in this Age of Hope and Golden Mountains) not to Venture'.7 3
Unlike Law , however, Blunt and his associates had to contend
with competition from the Bank of England, which drove up the
terms they had to offer the annuitants. Unlike Law , they also had
to contend with political opposition in the form of the Whigs in
Parliament, which drove up the bribes they had to pay to secure
favourable legislation (the Secretary to the Treasury alone made
£249,000 from his share options). And, unlike Law , they were
unable to establish monopolistic positions on the stock market
and the credit market. On the contrary, there was such a rush of
new companies - 19 0 in all - seeking to raise capital in 172 0 that
the South Sea directors had to get their allies in Parliament to
pass what came to be known as the Bubble Act, designed to
restrict new company flotations.* At the same time, when the
demand for cash created by the South Sea's third subscription
* The Bubble Act made it illegal to establish new companies without statutory
authority and prevented existing companies from conducting activities not
specified in their charters.
15 6
exceeded the money market's resources, there was nothing the
directors could do to inject additional liquidity; indeed, the South
Sea Company's bank, the Sword Blade Company, ended up fail­
ing on 24 September. (Unlike the Bank of England, and unlike
the Banque Royale, its notes were not legal tender.) The mania
of Ma y and June was followed, after a hiatus of distress in July
(when the insiders and foreign speculators took their profits), by
panic in August. 'Most people thought it wou' d come,' lamented
the hapless and now poorer Swift, 'but no man prepar'd for it;
no man consider'd it would come like a Thief in the night, exactly
as it happens in the case of death.'7 4
Yet the damage caused by the bursting of the bubble was much
less fatal than on the other side of the Channel. From par to peak,
prices rose by a factor of 9.5 in the case of South Sea stock,
compared with 19. 6 in the case of Mississippi stock. Other stocks
(Bank of England and East India Company) rose by substantially
smaller multiples. When stock prices came back down to earth
in London, there was no lasting systemic damage to the financial
system, aside from the constraint on future joint-stock company
formation represented by the Bubble Act. The South Sea Com­
pany itself continued to exist; the government debt conversion
was not reversed; foreign investors did not turn away from Eng­
lish securities.7 5 Whereas all France was affected by the inflation­
ary crisis La w had unleashed, provincial England seems to have
been little affected by the South Sea crash.7 6 In this tale of two
bubbles, it was the French that had the worst of times.
Bulls and Bears
On 1 6 October 192 9 Yal e University economics professor Irving
Fisher declared that US stock prices had 'reached what looks
15 7
like a permanently high plateau'.7 7 Eight days later, on 'Black
Thursday', the Do w Jones Industrial Average declined by 2 per
cent. This is when the Wall Street crash is conventionally said to
have begun, though in fact the market had been slipping since
early September and had already suffered a sharp 6 per cent drop
on 23 October. On 'Black Monday' (28 October) it plunged by
1 3 per cent; the next day by a further 1 2 per cent. In the course
of the next three years the US stock market declined a staggering
89 per cent, reaching its nadir in July 1932 . The index did not
regain its 192 9 peak until November 1954 . What was worse, this
asset price deflation coincided with, if it did not actually cause,
the worst depression in all history. In the United States, output
collapsed by a third. Unemployment reached a quarter of the
civilian labour force, closer to a third if a modern definition is
used. It was a global catastrophe that saw prices and output
decline in nearly every economy in the world, though only the
German slump was as severe as the American. World trade shrank
by two thirds as countries sought vainly to hide behind tariff
barriers and import quotas. The international financial system
fell to pieces in a welter of debt defaults, capital controls and
currency depreciations. Only the Soviet Union, with its autarkic,
planned economy, was unaffected. Why did it happen?
Some financial disasters have obvious causes. Arguably a much
worse stock market crash had occurred at the end of July 1914 ,
when the outbreak of the First World War precipitated such a
total meltdown that the world's principal stock markets - includ­
ing Ne w York' s - simply had to close their doors. And closed
they remained from August until the end of 1914. 7 8 But that was
the effect of a world war that struck financial markets like a bolt
from the blue.7 9 The crash of October 192 9 is much harder to
explain. Page 1 of the New York Times on the day before Black
Thursday featured articles about the fall of the French premier
15 8
Aristide Briand and a vote in the US Senate about duties on
imported chemicals. Historians sometimes see the deadlock over
Germany's post-First World War reparations and the increase of
American protectionism as triggers of the Depression. But page
i also features at least four reports on the atrocious gales that
had battered the Eastern seaboard the previous day. 8 0 Mayb e
historians should blame bad weather for the Wall Street crash.
(That might not be such a far-fetched proposition. Man y veterans
of the City of London still remember that Black Monday -19 October 198 7 - came after the hurricane-force winds that
had unexpectedly swept the south-east of England the previous
Contemporaries sensed that there was a psychological dimen­
sion to the crisis. In his inaugural address, President Franklin
Roosevelt argued that all that Americans had to fear was 'fear
itself. John Maynard Keynes spoke of a 'failure in the immaterial
devices of the mind'. Yet both men also intimated that the crisis
was partly due to financial misconduct. Roosevelt took a swipe at
'the unscrupulous money changers' of Wall Street; in his General
Theory, Keynes likened the stock market to a casino.
In some measure, it can be argued, the Great Depression had
its roots in the global economic dislocations arising from the
earlier crisis of 1914 . 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 . This had made it
even harder for countries with large external war debts (including
Germany, saddled with reparations) to earn the hard currency
they needed to make interest payments to their foreign creditors.
The war had also increased the power of organized labour in
most combatant countries, making it harder for employers to cut
15 9
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. Nevertheless, the fact remains that the United States,
which was the epicentre of the crisis, was in many respects in
fine economic fettle when the Depression struck. There was no
shortage of productivity-enhancing technological innovation in
the inter-war period by companies like DuPont (nylon), Procter
ÔC Gamble (soap powder), Revlon (cosmetics), RC A (radio) and
IB M (accounting machines). ' A prime reason for expecting future
earnings to be greater,' argued Yale's Irving Fisher, 'was that we
in America were applying science and invention to industry as
we had never applied them before.'8 1 Management practices were
also being revolutionized by men like Alfred Sloan at General
Ye t precisely these strengths may have provided the initial
displacement that set in motion a classic stock market bubble.
T o observers like Fisher, it really did seem as if the sky was the
limit, as more and more American households aspired to equip
themselves with automobiles and consumer durables - products
which instalment credit put within their reach. RCA , the tech
stock of the 1920s, rose by a dizzying 939 per cent between 192 5
and 1929 ; its price-earnings ratio at the peak of the market was
73. 8 2 Euphoria encouraged a rush of new initial public offerings
(IPOs); stock worth $ 6 billion was issued in 1929 , one sixth of
it during September. There was a proliferation of new financial
institutions known as investment trusts, designed to capitalize on
the stock market boom. (Goldman Sachs chose 8 August 1929
to announce its own expansion plan, in the form of the Goldman
Sachs Trading Corporation; had this not been a free-standing
entity, its subsequent collapse might well have taken down Gold­
man Sachs itself.) At the same time, many small investors (like
Irving Fisher himself) relied on leverage to increase their stock
16 0
market exposure, using brokers' loans (which were often sup­
plied by corporations rather than banks) to buy stocks on margin,
thus paying only a fraction of the purchase price with their
own money. As in 1719 , so in 1929 , there were unscrupulous
insiders, like Charles E . Mitchell of National City Bank or Wil­
liam Crapo Durant of GM , and ingenuous outsiders, like
Groucho Marx. 8 3 As in 1719 , flows of hot money between finan­
cial markets served to magnify and transmit shocks. And, as in
1719 , it was the action of the monetary authorities that deter­
mined the magnitude of the bubble and of the consequences when
it burst.
In perhaps the most important work of American economic
history ever published, Milton Friedman and Anna Schwartz
argued that it was the Federal Reserve System that bore the
primary responsibility for turning the crisis of 192 9 into a Great
Depression.8 4 They did not blame the Fed for the bubble itself,
arguing that with Benjamin Strong at the Federal Reserve Bank
of New York a reasonable balance had been struck between
the international obligation of the United States to maintain the
restored gold standard and its domestic obligation to maintain
price stability. By sterilizing the large gold inflows to the United
States (preventing them for generating monetary expansion), the
Fed may indeed have prevented the bubble from growing even
larger. The Ne w Yor k Fed also responded effectively to the
October 192 9 panic by conducting large-scale (and unauthorized)
open market operations (buying bonds from the financial sector)
to inject liquidity into the market. However, after Strong's death
from tuberculosis in October 1928 , the Federal Reserve Board in
Washington came to dominate monetary policy, with disastrous
results. First, too little was done to counteract the credit con­
traction caused by banking failures. This problem had already
surfaced several months before the stock market crash, when
16 1
16 2
commercial banks with deposits of more than $80 million
suspended payments. However, it reached critical mass in Nov­
ember and December 1930 , when 608 banks failed, with deposits
totalling $55 0 million, among them the Bank of United States,
which accounted for more than a third of the total deposits lost.
The failure of merger talks that might have saved the Bank was
a critical moment in the history of the Depression.8 5 Secondly,
under the pre -191 3 system, before the Fed had been created, a
crisis of this sort would have triggered a restriction of con­
vertibility of bank deposits into gold. However, the Fed made
matters worse by reducing the amount of credit outstanding
(December 1930 -Apri l 1931) . This forced more and more banks
to sell assets in a frantic dash for liquidity, driving down bond
prices and worsening the general position. The next wave of bank
failures, between February and August 1931 , saw commercial
bank deposits fall by $2. 7 billion, 9 per cent of the total.8 6 Thirdly,
when Britain abandoned the gold standard in September 1931 ,
precipitating a rush by foreign banks to convert dollar holdings
into gold, the Fed raised its discount rate in two steps to 3.5 per
cent. This halted the external drain, but drove yet more US banks
over the edge: the period August 193 1 to January 193 2 saw 1,860
banks fail with deposits of $1.4 5 billion.8 7 Yet the Fed was in no
danger of running out of gold. On the eve of the pound's depar­
ture the US gold stock was at an all-time high of $4. 7 billion -40 per cent of the world's total. Even at its lowest point that
October, the Fed's gold reserves exceeded its legal requirements
for cover by more than $ 1 billion.8 8 Fourthly, only in April 1932 ,
as a result of massive political pressure, did the Fed attempt
large-scale open market operations, the first serious step it had
taken to counter the liquidity crisis. Even this did not suffice to
avert a final wave of bank failures in the last quarter of 1932 ,
which precipitated the first state-wide 'bank holidays', temporary
closures of all banks.8 9 Fifthly, when rumours that the new Roose­
velt administration would devalue the dollar led to a renewed
domestic and foreign flight from dollars into gold, the Fed once
again raised the discount rate, setting the scene for the nationwide
bank holiday proclaimed by Roosevelt on 6 March 1933 , two
days after his inauguration - a holiday from which 2,000 banks
never returned.9 0
The Fed's inability to avert a total of around 10,000 bank
failures was crucial not just because of the shock to consumers
whose deposits were lost or to shareholders whose equity was
lost, but because of the broader effect on the money supply
and the volume of credit. Between 192 9 and 1933 , the public
succeeded in increasing its cash holdings by 3 1 per cent; commer­
cial bank reserves were scarcely altered (indeed, surviving banks
built up excess reserves); but commercial bank deposits decreased
by 3 7 per cent and loans by 47 per cent. The absolute numbers
reveal the lethal dynamic of the 'great contraction'. An increase
of cash in public hands of $1. 2 billion was achieved at the cost
of a decline in bank deposits of $15. 6 billion and a decline in
bank loans of $19. 6 billion, equivalent to 19 per cent of 192 9
GDP. 9 1
There was a time when academic historians felt squeamish
about claiming that lessons could be learned from history. This
is a feeling unknown to economists, two generations of whom
have struggled to explain the Great Depression precisely in order
to avoid its recurrence. Of all the lessons to have emerged from
this collective effort, this remains the most important: 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. According to Friedman and Schwartz, the Fed
should have aggressively sought to inject liquidity into the bank­
ing system from 192 9 onwards, using open market operations on
16 3
16 4
a large scale, and expanding rather than contracting lending
through the discount window. They also suggest that less atten­
tion should have been paid to gold outflows. More recently, it
has been argued that the inter-war gold standard itself was the
problem, in that it transmitted crises (like the 193 1 European
bank and currency crises) around the world. 9 2 A second lesson of
history would therefore seem to be that the benefits of a stable
exchange rate are not so great as to exceed the costs of domestic
deflation. Anyone who today doubts that there are lessons to be
learned from history needs do no more than compare the aca­
demic writings and recent actions of the current chairman of the
Federal Reserve System.9 3
A Tale of Fat Tails
Sometimes the most important historical events are the non-events: the things that did not occur. The economist Hyman
Minsky put it well when he observed: 'The most significant econ­
omic event of the era since World War II is something that
has not happened: there has not been a deep and long-lasting
depression'.9 4 This is indeed surprising, since the world has not
been short of 'Black Days'.
If movements in stock market indices were statistically distrib­
uted like human heights there would hardly be any such days.
Most would be clustered around the average, with only a tiny
number of extreme ups or downs. After all, not many of us are
below four feet in height or above eight feet. If I drew a histogram
of the heights of the male students in my financial history class
according to their frequency, the result would be a classic bell-shaped curve, with nearly everyone clustered within around five
inches of the US average of around 51 10" . But in financial
markets, it doesn't look like this. If you plot all the monthly
movements of the Do w Jones index on a chart, there is much less
clustering around the average, and there are many more big rises
and falls out at the extremes, which the statisticians call 'fat tails'.
If stock market movements followed the 'normal distribution' or
bell curve, like human heights, an annual drop of 1 0 per cent or
more would happen only once every 500 years, whereas on the
Dow Jones it has happened about once every five years.9 5 And
stock market plunges of 20 per cent or more would be unheard
of - rather like people just a foot tall - whereas in fact there have
been nine such crashes in the past century.
On 'Black Monday', 1 9 October 1987 , the Do w fell by a
terrifying 23 per cent, one of just four days when the index has
fallen by more than 1 0 per cent in a single trading session. The
New York Times's front page the next morning said it all when
it asked 'Does 198 7 Equal 1929? ' From peak to trough, the fall
was of nearly one third, a loss in the value of American stocks of
close to a trillion dollars. The causes of the crash were much
debated at the time. True, the Fed had raised rates the previous
month from 5.5 to 6 per cent. But the official task force chaired
by Nicholas Brady laid much of the blame for the crash on
'mechanical, price-insensitive selling by a [small] number of insti­
tutions employing portfolio insurance strategies and a small
number of mutual fund groups reacting to redemptions', as well
as 'a number of aggressive trading-oriented institutions [which
tried] to sell in anticipation of further market declines'. Matters
were made worse by a breakdown in the Ne w Yor k Stock
Exchange's automated transaction system, and by the lack of
'circuit breakers' which might have interrupted the sell-off on the
futures and options markets.9 6 The remarkable thing, however,
was what happened next - or rather, what didn't happen. There
was no Great Depression of the 1990s, despite the forebodings
16 5
of Lord Rees-Mogg and others.9 7 There wasn't even a recession
in 198 8 (only a modest one in 1990-91) . Within little more than
a year of Black Monday, the Do w was back to where it had been
before the crash. For this, some credit must unquestionably be
given to the central bankers, and particularly the then novice
Federal Reserve Chairman Alan Greenspan, who had taken over
from Paul Volcker just two months before. Greenspan's response
to the Black Monday crash was swift and effective. His terse
statement on 20 October, affirming the Fed's 'readiness to serve
as a source of liquidity to support the economic and financial
system', sent a signal to the markets, and particularly the Ne w
Yor k banks, that if things got really bad he stood ready to bail
them out.9 8 Aggressively buying government bonds in the open
market, the Fed injected badly needed cash into the system, push­
ing down the cost of borrowing from the Fed by nearly 2 per cent
in the space of sixteen days. Wall Street breathed again. What
Minsky called 'It' had not happened.
Having contained a panic once, the dilemma that lurked in the
back of Greenspan's mind thereafter was whether or not to act
pre-emptively the next time - to prevent the panic altogether.
This dilemma came to the fore as a classic stock market bubble
took shape in the mid 1990s. The displacement in this case was
the explosion of innovation by the technology and software
industry as personal computers met the Internet. But, as in all
history's bubbles, an accommodative monetary policy also played
a role. From a peak of 6 per cent in June 1995 , the Federal
funds target rate* had been reduced to 5.25 per cent (January
* This is the interest rate at which banks lend balances held at the Federal
Reserve to one another, usually overnight. The Federal Open Market Com­
mittee, which is made up of the seven Federal Reserve Board governors and
the presidents of the twelve regional Federal Reserve banks, sets a target rate
at its regular meetings. The Federal Reserve Bank of New York has the job
16 7
1996-February 1997) . It had been raised to 5.5 per cent in March
1997 , but then cut in steps between September and November
1998 down to 4.75 per cent; and it remained at that level until
Ma y 1999, by which time the Do w had passed the 10,000 mark.
Rates were not raised until June 1999 .
Why did the Fed allow euphoria to run loose in the 1990s?
Greenspan himself had felt constrained to warn about 'irrational
exuberance' on the stock market as early as 5 December 1996 ,
shortly after the Do w had risen above 6,000.* Ye t the quarter
point rate increase of March 199 7 was scarcely sufficient to dispel
that exuberance. Partly, Greenspan and his colleagues seem to
have underestimated the momentum of the technology bubble.
As early as December 1995 , with the Do w just past the 5,000
mark, members of the Fed's Open Market Committee speculated
that the market might be approaching its peak. " Partly, it was
because Greenspan felt it was not for the Fed to worry about
asset price inflation, only consumer price inflation; and this, he
believed, was being reduced by a major improvement in pro­
ductivity due precisely to the tech boom. 10 0 Partly, as so often
happens in stock market bubbles, it was because international
pressures - in this case, the crisis precipitated by the Russian debt
default of August 1998 - required contrary action.10 1 Partly, it
was because Greenspan and his colleagues no longer believed it
was the role of the Fed to remove the punchbowl from the party,
of making this rate effective through open market operations (buying or
selling bonds in the New York market).
* His wording was characteristically opaque: 'Clearly, sustained low inflation
implies less uncertainty about the future, and lower risk premiums imply
higher prices of stocks .. . But how do we know when irrational exuberance
has unduly escalated asset values .. . ? We as central bankers need not be
concerned if a collapsing financial asset bubble does not threaten to impair
the real economy . . . But we should not underestimate, or become complacent
about, the complexity of the interactions of asset markets and the economy'.
16 8
in the phrase of his precursor but three, William McChesney
Martin, Jr. 10 2 T o give Greenspan his due, his 'just-in-time monet­
ary policy' certainly averted a stock market crash. Not only were
the 1930 s averted; so too was a repeat of the Japanese experience,
when a conscious effort by the central bank to prick an asset
bubble ended up triggering an 80 per cent stock market sell-off
and a decade of economic stagnation. But there was a price to
pay for this strategy. No t for the first time in stock market history,
an asset-price bubble created the perfect conditions for malfeas­
ance as well as exuberance.
The nineties seemed to some nervous observers uncannily like
a re-run of the Roaring Twenties; and indeed the trajectory of
the stock market in the 1990s was almost identical to that of the
1920s. Yet in some ways it was more like a rerun of the 1720s.
What John Law' s Mississippi Company had been to the bubble
that launched the eighteenth century, so another company would
be to the bubble that ended the twentieth. It was a company that
promised its investors wealth beyond their wildest imaginings. It
was a company that claimed to have reinvented the entire finan­
cial system. And it was a company that took full advantage of its
impeccable political connections to ride all the way to the top of
the bull market. Named by Fortune magazine as America's Most
Innovative Company for six consecutive years (1996-2001) , that
company was Enron.
In November 2001 , Alan Greenspan received a prestigious award,
adding his name to a roll of honour that included Mikhail Gorba­
chev, Colin Powell and Nelson Mandela. The award was the
Enron Prize for Distinguished Public Service. Greenspan had cer­
tainly earned his accolade. From February 199 5 until June 1999
he had raised US interest rates only once. Traders had begun to
speak of the 'Greenspan put' because having him at the Fed was
like having a 'put' option on the stock market (an option but not
an obligation to sell stocks at a good price in the future). Since
the middle of January 2000, however, the US stock market had
been plummeting, belatedly vindicating Greenspan's earlier warn­
ings about irrational exuberance. There was no one Black Day,
as in 1987 . Indeed, as the Fed slashed rates, from 6.5 per cent
down in steps to 3.5 per cent by August 2001 , the economy
looked like having a soft landing; at worst a very short recession.
And then, quite without warning, a Black Day did dawn in Ne w
York - in the form not of a financial crash but of two deliberate
plane crashes. Amid talk of war and fears of a 1914 -styl e market
shutdown, Greenspan slashed rates again, from 3.5 per cent to
3 per cent and then on down - and down - to an all-time low of
1 per cent in June 2003. More liquidity was pumped out by the
Fed after 9/1 1 than by all the fire engines in Manhattan. But it
could not save Enron. On 2 December 2001 , just two weeks
after Greenspan collected his Enron award, the company filed for
The resemblances between the careers of John Law , perpetrator
of the Mississippi bubble, and Kenneth Lay, chief executive of
Enron, are striking, to say the least. John Law' s philosopher's
stone had allowed him 'to make gold out of paper'. Ken Lay' s
equivalent was 'to make gold out of gas'. Law' s plan had been to
revolutionize French government finance. Lay' s was to revol­
utionize the global energy business. For years the industry had
been dominated by huge utility companies that both physically
provided the energy - pumped the gas and generated the elec­
tricity - and sold it on to consumers. 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.10 3 Like Law , Lay, the son of a poor
Missouri preacher, had provincial beginnings - as did Enron,
16 9
Alan Greenspan and Kenneth Lay
originally a small gas company in Omaha, Nebraska. It was Lay
who renamed the company* and relocated its headquarters to
Houston, Texas. Like Law, too, Lay had friends in high places.
Himself a long-time ally of the Texan energy industry, President
George H. W. Bush supported legislation in 1992 that deregu-lated the industry and removed government price controls.
Around three quarters of Enron's $6.6 million in political contri-butions went to the Republican Party, including $ 355,000 from
Lay and his wife in the 2000 election. Senator Phil Gramm was
Enron's second-largest recipient of campaign contributions in
1996, and a strong proponent of Californian energy deregulation.
By the end of 2000, Enron was America's fourth-largest
* The company was originally going to be called Enteron until the Wall Street
Journal pointed out that 'enteron' is a Greek-derived word for the intestines.
company, employing around 21,00 0 people. It controlled a
quarter of the US natural gas business. Riding a global wave of
energy sector privatization, the company snapped up assets all
over the world. In Latin America alone the company had interests
in Colombia, Ecuador, Peru and Bolivia, from where Enron laid
its pipeline across the continent to Brazil. In Argentina, following
the intervention of Lay's personal friend George W. Bush, Enron
bought a controlling stake in the largest natural gas pipeline
network in the world. Above all, however, Enron traded, not
only in energy but in virtually all the ancient elements of earth,
water, fire and air. It even claimed that it could trade in Internet
bandwidth. In a scene straight out of The Sting, bank analysts
were escorted through fake trading floors where employees sat in
front of computers pretending to do broadband deals. It was the
Mississippi Company all over again. And, just as in 1719 , the
rewards to investors seemed irresistible. In the three years after
1997 , Enron's stock price increased by a factor of nearly five,
from less than $2 0 a share to more than $90. For Enron execu­
tives, who were generously 'incentivized' with share options, the
rewards were greater still. In the final year of its existence Enron
paid its top 14 0 executives an average of $5. 3 million each.
Luxury car sales went through the roof. So did properties in River
Oaks, Houston's most exclusive neighbourhood. 'I've thought
about this a lot,' remarked Skilling, who became Enron chief
operating officer in 1997 , 'and all that matters is money . . . Yo u
buy loyalty with money. This touchy-feely stuff isn't as important
as cash. That's what drives performance.'10 4 'Yo u got multiples
of your annual base pay at Enron,' Sherron Watkins recalled
when I met her outside the now defunct Enron headquarters in
Houston. 'Yo u were really less thought of if you got a percentage,
even if it was 75 per cent of your annual base pay. Oh, you were
getting a percentage. Yo u wanted multiples. Yo u wanted two
17 1
times your annual base pay, three times, four times your annual
base pay, as a bonus.'10 5 In the euphoria of April 1999, the
Houston Astros even renamed their ballpark Enron Field.
The only problem was that, like John Law' s System, the Enron
'System' was an elaborate fraud, based on market manipulation
and cooked books. In tapes that became public in 2004, Enron
traders can be heard asking the El Paso Electric Company to shut
down production in order to maintain prices. Another exchange
concerns 'all the money you guys stole from those poor grand­
mothers of California'. The results of such machinations were
not only the higher prices Enron wanted, but also blackouts for
consumers. In the space of just six months after the deregulation
law came into effect, California experienced no fewer than thirty-eight rolling blackouts. (In another tape, traders watching tele­
vision reports of Californian forest fires shout 'Burn, baby, burn!'
as electricity pylons buckle and fall.) Even with such market-rigging, the company's stated assets and profits were vastly
inflated, while its debts and losses were concealed in so-called
special-purpose entities (SPEs) which were not included in the
company's consolidated statements. Each quarter the company's
executives had to use more smoke and more mirrors to make
actual losses look like bumper profits. Skilling had risen to the
top by exploiting new financial techniques like mark-to-market
accounting and debt securitization. But not even chief finance
officer Andrew Fastow could massage losses into profits indefi­
nitely, especially as he was now using SPEs like the aptly named
Chewco Investments to line his and other executives' pockets.
Enron's international business, in particular, was haemorrhaging
money by the mid 1990s, most spectacularly after the cancellation
of a major power generation project in the Indian state of Mahar­
ashtra. EnronOnline, the first web-based commodity-trading
system, had a high turnover; but did it make any money? In
17 2
17 3
Houston, the euphoria was fading; the insiders were feeling the first
symptoms of distress. Fastow's SPE s were being given increasingly
ominous names: Raptor I, Talon. He and others surreptitiously
unloaded $92 4 million of Enron shares while the going was good.
Investors had been assured that Enron's stock price would soon
hit $100 . When (for 'personal reasons') Skilling unexpectedly
announced his resignation on 1 4 August 2001 , however, the price
tumbled to below $40. That same month, Sherron Watkins wrote
to Lay to express her fear that Enron would 'implode in a wave
of accounting scandals'. This was precisely what happened. On
1 6 October Enron reported a $61 8 million third-quarter loss and
a $1. 2 billion reduction in shareholder equity. Eight days later,
with a Securities and Exchange Commission inquiry pending,
Fastow stepped down as CFO . On 8 November the company
was obliged to revise its profits for the preceding five years; the
overstatement was revealed to be $56 7 million. When Enron filed
for bankruptcy on 2 December, it was revealed that the audited
balance sheet had understated the company's long-term debt by
$2 5 billion: it was in fact not $1 3 billion but $3 8 billion. By now,
distress had turned to revulsion; and panic was hard on its heels.
By the end of 2001 Enron shares were worth just 30 cents.
In Ma y 2006 Lay was found guilty of all ten of the charges
against him, including conspiracy, false statements, securities
fraud and bank fraud. Skilling was found guilty on 1 8 out of 2 7
counts. Lay died before sentencing while on holiday in Aspen,
Colorado. Skilling was sentenced to 24 years and 4 months in
prison and ordered to repay $2 6 million to the Enron pension
fund; an appeal is pending. All told, sixteen people pled guilty to
Enron-related charges and five others (so far) have been found
guilty at trial. The firm's auditors, Arthur Andersen, were
destroyed by the scandal. The principal losers, however, were the
ordinary employees and small shareholders whose savings went
up in smoke, turned into mere 'wind', just like the millions of
livres lost in the Mississippi crash.
Invented almost exactly four hundred years ago, the joint-stock,
limited-liability company is indeed a miraculous institution, as is
the stock market where its ownership can be bought and sold.
And yet throughout financial history there have been crooked
companies, just as there have been irrational markets. Indeed the
two go hand in hand - for it is when the bulls are stampeding
most enthusiastically that people are most likely to get taken for
the proverbial ride. A crucial role, however, is nearly always
played by central bankers, who are supposed to be the cowboys
in control of the herd. Clearly, without his Banque Royale, La w
could never have achieved what he did. Equally clearly, without
the loose money policy of the Federal Reserve in the 1990s, Ken
Lay and Jeff Skilling would have struggled to crank up the price
of Enron stock to $90. By contrast, the Great Depression offers
a searing lesson in the dangers of excessively restrictive monetary
policy during a stock market crash. Avoiding a repeat of the
Great Depression is sometimes seen as an end that justifies any
means. Ye t the history of the Dutch East India Company, the
original joint-stock company, shows that, with sound money of
the sort provided by the Amsterdam Exchange Bank, stock
market bubbles and busts can be avoided.
In the end, the path of financial markets can never be as smooth
as we might like. So long as human expectations of the future
veer from the over-optimistic to the over-pessimistic - from greed
to fear - stock prices will tend to trace an erratic path; indeed, a
line not unlike the jagged peaks of the Andes. As an investor you
just have to hope that, when you have to come down from the
summit of euphoria, it will be on a smooth ski-slope and not over
a sheer cliff.
17 4
But is there nothing we can do to protect ourselves from real
and metaphorical falls? As we shall see in Chapter 4, the evolution
of insurance, from humble eighteenth-century beginnings, has
created a range of answers to that question, each of which offers
at least some protection from the sheer cliffs and fat tails of
financial history.
17 5
The Return of Risk
The most basic financial impulse of all is to save for the future,
because the future is so unpredictable. The world is a dangerous
place. No t many of us get through life without having a little bad
luck. Some of us end up having a lot. Often, it's just a matter of
being in the wrong place at the wrong time: like the Mississippi
delta in the last week of August 2005, when Hurricane Katrina
struck not once but twice. First there was the howling 140-mile-an-hour wind that blew many of the area's wooden houses clean
off their concrete foundations. Then, two hours later, came the
thirty-foot storm surge that breached three of the levees that
protect Ne w Orleans from Lake Pontchartrain and the Missis­
sippi, pouring millions of gallons of water into the city. Wrong
place, wrong time. Like the World Trade Center on 1 1 September
2001 . Or Baghdad on pretty much any day since the US invasion
of 2003. Or San Francisco when - as it one day will - a really
big earthquake occurs along the San Andreas fault.
Stuff happens, as the former Secretary of Defense Donald
Rumsfeld insouciantly observed after the overthrow of Saddam
Hussein unleashed an orgy of looting in the Iraqi capital. Some
people argue that such stuff is more likely to happen than in the
past, whether because of climate change, the rise of terrorism
or the blowback from American foreign policy blunders. The
17 6
17 7
question is, how do we deal with the risks and uncertainties of
the future? Does the onus fall on the individual to insure against
misfortune? Should we rely on the voluntary charity of our fellow
human beings when things go horribly wrong? Or should we be
able to count on the state - in other words on the compulsory
contributions of our fellow taxpayers - to bail us out when the
flood comes?
The history of risk management is one long struggle between
our vain desire to be financially secure - as secure as, say, a
Scottish widow - and the hard reality that there really is no such
thing as 'the future', singular. There are only multiple, unforesee­
able futures, which will never lose their capacity to take us by
The Big Uneasy
In the Westerns I watched as a boy I was fascinated by ghost
towns, short-lived settlements that had been left behind by the fast
pace of change on the American frontier. It was not until I went to
New Orleans in the wake of Hurricane Katrina that I encountered
what could very well become America's first ghost city.
I had happy if hazy memories of the 'Big Easy'. As a teenager
between school and university, savouring my first taste of free­
dom, I discovered it was about the only place in the United States
where I could get served beer despite being underage, which
certainly made the geriatric jazz musicians in Preservation Hall
sound good. Twenty-five years on, and nearly two years after the
great storm struck, the city is a forlorn shadow of its former self.
Saint Bernard Parish was one of the districts that was worst
affected by the storm. Only five homes out of around 26,000
were not flooded. In all, 1,83 6 Americans lost their lives as a
result of Katrina, of whom the overwhelming majority were from
Louisiana. In Saint Bernard alone, the death toll was forty-seven.
Yo u can still the see the symbols on the doors of abandoned
houses, indicating whether or not a corpse was found inside. It
invites comparison with medieval England at the time of the
Black Death.
When I revisited Ne w Orleans in June 2007, Councilman Joey
DiFatta and the rest of Saint Bernard's municipal government
were still working in trailers behind their old office building,
which the flood gutted. DiFatta stayed at his desk during the
storm, eventually retreating to the roof as the waters kept rising.
From there, he and his colleagues could only watch helplessly as
their beloved neighbourhood vanished under filthy brown water.
Angered by what they saw as the incompetence of the Federal
Emergency Management Agency (FEMA) , they resolved to re­
store what had been lost. Since then, they have worked tirelessly
to try to rebuild what was once a tightly knit community (many
of whom, like DiFatta himself, are descended from settlers who
came to Louisiana from the Canary Islands). But persuading
thousands of refugees to come back to Saint Bernard has proved
far from easy; two years later the parish still has only one third
of its pre-Katrina population. A large part of the problem turns
out to be insurance. Today, insuring a house in Saint Bernard
and other low-lying parts of Ne w Orleans is virtually impossible.
And without buildings insurance, it is virtually impossible to get
a mortgage.
Nearly all the survivors of Katrina lost property in the disaster,
since nearly three quarters of the city's total housing stock were
damaged. There were no fewer than 1.7 5 million property and
casualty claims, with estimated insurance losses in excess of
$4 1 billion, making Katrina the costliest catastrophe in modern
American history.1 But Katrina not only submerged Ne w Orleans.
17 8
New Orleans after Katrina: where insurance failed
It also laid bare the defects of a system of insurance that divided
responsibility between private insurance companies, which
offered protection against wind damage, and the federal govern-ment, which offered protection against flooding, under a scheme
that had been introduced after Hurricane Betsy in 1965. In the
aftermath of the 2005 disaster, thousands of insurance company
assessors fanned out along the Louisiana and Mississippi coast-line. According to many residents, their job was not to help
stricken policy-holders but to avoid paying out to them by
asserting that the damage their properties had suffered was due
to flooding and not to wind. * The insurance companies did not
* A typical Gulf Coast homeowner's policy has a Hurricane Deductible
Endorsement, with a percentage deduction applying to any claim for 'direct
physical loss or damage to covered property caused by wind, wind gust,
hail, rain, tornadoes, or cyclones caused by or resulting from a hurricane'.
reckon with one of their policy-holders, former US Nav y pilot
and celebrity lawyer Richard F. Scruggs, the man once known as
the King of Torts.
'Dickie' Scruggs first hit the headlines in the 1980s, when
he represented shipyard workers whose lungs had been fatally
damaged by exposure to asbestos, winning a $5 0 million settle­
ment. But that was small change compared with what he later
made the tobacco companies pay: over $20 0 billion to Mississippi
and forty-five other states as compensation for Medicaid costs
arising from tobacco-related illnesses. The case (immortalized in
the film The Insider) made Scruggs a rich man. His fee in the
tobacco class action is said to have been $1 . 4 billion, or $22,50 0
for every hour his law firm worked. It was money he used to
acquire a waterfront house on Pascagoula's Beach Boulevard,
a short commute (by private jet, naturally) from his Oxford,
Mississippi, offices. All that remained of that house after Katrina
was a concrete base plus a few ruined walls so badly damaged
that they had to be bulldozed. Although his insurance company
(wisely) paid out, Scruggs was dismayed to hear of the treatment
of other policy-holders. Among those he offered to represent was
his brother-in-law Trent Lott, the former Republican majority
leader in the Senate, and his friend Mississippi Congressman
However, there is usually an exclusion along these lines: 'We do not insure
. . . for any loss which would not have occurred in the absence of one or more
of the following excluded events', such as 'Water Damage, meaning .. . flood,
surface water, waves, tidal water, tsunami, seiche [lake wave], overflow of a
body of water, or spray from any of these, all whether driven by wind or
not'. Moreover, 'We do not insure for such loss regardless of: (a) the cause
of the excluded event; or (b) other causes of the loss; or (c) whether other
causes acted concurrently or in any sequence with the excluded event to
produce the loss; or (d) whether the event occurs suddenly or gradually ... '
This is a classic example of small print designed to limit the insurer's liability
in a way not readily intelligible to the policy-holder.
18 0
Gene Taylor, both of whom had also lost homes to Katrina and
had received short shrift from their insurers.2 In a series of cases
on behalf of policy-holders, Scruggs alleged that the insurers
(principally State Farm and All State) were trying to renege on
their legal obligations.3 He and his 'Scruggs Katrina Group ' con­
ducted detailed meteorological research to show that nearly all
the damage in places like Pascagoula was caused by the wind,
hours before the floodwaters struck. Scruggs was also approached
by two whistle-blowing insurance adjusters, who claimed the
company they worked for had altered reports in order to attribute
damage to flooding rather than wind. The insurance companies'
record profits in 2005 and 2006 only whetted Scruggs's appetite
for redress. * As he told me when we met in the wasteland where his
house used to stand: 'This [town] was home for fifty years; where I
raised my family; what I was proud of. It makes me somewhat
emotional when I see this.' By that time, State Farm had already
settled 640 cases brought by Scruggs on behalf of clients whose
claims had initially been turned down, paying out $8 0 million; and
had agreed to review 36,000 other claims.4 It seemed as if the
insurers were retreating. Scruggs's campaign against them col­
lapsed in November 2007, however, when he, his son Zachary and
three associates were indicted on charges of trying to bribe a state-court judge in a case arising from a dispute over Katrina-related
legal fees, t Scruggs now faces a prison sentence of up to five years.5
* US property and casualty insurance companies had net after-tax income of
$43 billion in 2005 and $64 billion in 2006, compared with an average of
less than $24 billion in the preceding three years.
f Scruggs's associate Timothy Balducci was taped offering $40,000 to Judge
Lackey. 'The only person in the world outside of me and you that has
discussed this is me and Dick,' Mr Balducci told Lackey. 'We, uh, like I say,
it ain't but three people in this world that know anything about this . . . and
two of them are sitting here, and the other one, uh, being Scruggs .. . He and
I, um, how shall I say, for over the last five or six years there, there are bodies
18 1
It may sound like just another story of Southern moral laxity
- or proof that those wh o live by the tort, die by the tort. Yet,
regardless of Scruggs's descent from good fellow to bad felon,
the fact remains that both State Farm and All State have now
declared a large part of the Gulf of Mexico coast a 'no insurance'
zone. Why risk renewing policies here, where natural disasters
happen all too often and where, after the disaster, companies
have to contend with the likes of Dickie Scruggs? The strong
implication would seem to be that providing coverage to the
inhabitants of places like Pascagoula and Saint Bernard is no
longer something the private sector is prepared to do. Yet it is far
from clear that American legislators are ready to take on the
liabilities implied by a further extension of public insurance.
Total non-insured damages arising from hurricanes in 2005 are
likely to end up costing the federal government at least
$10 9 billion in post-disaster assistance and $8 billion in tax relief,
nearly three times the estimated insurance losses.6 According to
Naom i 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.7 In the
face of such ruinous bills, what is the right way to proceed? When
insurance fails, is the only alternative, in effect, to nationalize
all natural disasters - creating a huge open-ended liability for
Of course, life has always been dangerous. There have always
been hurricanes, just as there have always been wars, plagues and
buried that, that you know, that he and I know where.' On 1 November
2007 Balducci called Scruggs to tell him that the Judge now felt 'a little more
exposed on the facts and the law than he was before' and to ask if Scruggs
'would do a little something else, you know, to 'bout 1 0 or so more'. Scruggs
said he would 'take care of it'.
18 2
famines. And disasters can be small private affairs as well as big
public ones. Every day, men and women fall ill or are injured and
suddenly can no longer work. We all get old and lose the strength
to earn our daily bread. An unlucky few are born unable to fend
for themselves. And sooner or later we all die, often leaving one
or more dependants behind us. The key point is that few of these
calamities are random events. The incidence of hurricanes has a
certain regularity like the incidence of disease and death. In every
decade since the 1850s the United States has been struck by
between one and ten major hurricanes (defined as a storm with
wind speeds above 11 0 mph and a storm surge above 8 feet). It
is not yet clear that the present decade will beat the record of the
1940s, which saw ten such hurricanes.8 Because there are data
covering a century and a half, it is possible to attach probabilities
to the incidence and scale of hurricanes. The US Army Corps
of Engineers described Hurricane Katrina as a i-in-396 storm,
meaning that there is a 0.25 per cent chance of such a large
hurricane striking the United States in any given year.9 A rather
different view was taken by the company Risk Management Sol­
utions, which judged a Katrina-sized hurricane to be a once-in-forty-years event just a few weeks before the storm struck.1 0 These
different assessments indicate that, like earthquakes and wars,
hurricanes may belong more in the realm of uncertainty than of
risk properly understood.* Such probabilities can be calculated
with greater precision for most of the other risks that people face
mainly because they are more frequent, so statistical patterns are
easier to discern. The average American's lifetime risk of death
from exposure to forces of nature, including all kinds of natural
disaster, has been estimated at 1 in 3,288 . The equivalent figure
* For a further discussion of this crucial distinction see the Afterword,
pp. 343-4 -18 3
for death due to a fire in a building is i in 1 ,358 . The odds of the
average American being shot to death are 1 in 3 14 . But he or she
is even more likely to commit suicide (1 in 119) ; more likely still
to die in a fatal road accident (1 in 78); and most likely of all to
die of cancer (1 in 5). 1 1
In pre-modern agricultural societies, nearly everyone was at
substantial risk from premature death due to malnutrition or
disease, to say nothing of war. People in those days could do
much less than later generations in the way of prophylaxis. They
relied much more on seeking to propitiate the gods or God who,
they conjectured, determined the incidence of famines, plagues
and invasions. Only slowly did men appreciate the significance of
measurable regularities in the weather, crop yields and infections.
Only very belatedly - in the eighteenth and nineteenth centuries
- did they begin systematically to record rainfall, harvests and
mortality in a way that made probabilistic calculation possible.
Yet , even before they did so, they understood the wisdom of
saving: putting money aside for the proverbial (and in agricultural
societies literal) extreme rainy day. Most primitive societies at
least attempt to hoard food and other provisions to tide them
over hard times. And our tribal species intuitively grasped from
the earliest times that it makes sense to pool resources, since there
is genuine safety in numbers. Appropriately, given our ancestors'
chronic vulnerability, the earliest forms of insurance were prob­
ably 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.) Saving in advance of probable future adversity remains
the fundamental principle of insurance, whether it is against
death, the effects of old age, sickness or accident. The trick is
knowing how much to save and what to do with those savings
to ensure that, unlike in Ne w Orleans after Katrina, there is
18 4
18 5
enough money in the kitty to cover the costs of catastrophe when
it strikes. But to do that, you need to be more than usually canny.
And that provides an important clue as to just where the history
of insurance had its origins. Where else but in bonny, canny
Taking Cover
They say we Scots are a pessimistic people. Mayb e it has to do
with the weather - all those dreary, rainy days. Mayb e it's the
endless years of sporting disappointment. Or maybe it was the
Calvinism that Lowlanders like my family embraced at the time
of the Reformation. Predestination is not an especially cheering
article of faith, logical though it may be to assume that an
omniscient God already knows which of us ('the Elect') will go
to heaven, and which of us (a rather larger number of hopeless
sinners) will go to hell. For whatever reason, two Church of
Scotland ministers deserve the credit for inventing the first true
insurance fund more than two hundred and fifty years ago, in
1744 -It is true that insurance companies existed prior to that date.
'Bottomry' - the insurance of merchant ships' 'bottoms' (hulls) -was where insurance originated as a branch of commerce. Some
say that the first insurance contracts date from early fourteenth-century Italy, when payments for securitas begin to appear in
business documents. But the earliest of these arrangements had
the character of conditional loans to merchants (as in ancient
Babylon), which could be cancelled in case of a mishap, rather
than policies in the modern sense;1 2 in The Merchant of Venice,
Antonio's 'argosies' are conspicuously uninsured, leaving him
exposed to Shylock's murderous intent. It was not until the 1 3 50s
that true insurance contracts began to appear, with premiums
ranging between 1 5 and 20 per cent of the sum insured, falling
below 1 0 per cent by the fifteenth century. A typical contract in
the archives of the merchant Francesco Datini (c. 1335-1410 )
stipulates that the insurers agree to assume the risks 'of God, of
the sea, of men of war, of fire, of jettison, of detainment by
princes, by cities, or by any other person, of reprisals, of arrest,
of whatever loss, peril, misfortune, impediment or sinister that
might occur, with the exception of packing and customs' until
the insured goods are safely unloaded at their destination.1 3
Gradually such contracts became standardized - a standard that
would endure for centuries after it became incorporated into the
lex mercatoria (mercantile law). These insurers were, however,
not specialists, but merchants who also engaged in trade on their
own account.
Beginning in the late seventeenth century, something more like
a dedicated insurance market began to form in London. Minds
were doubtless focused by the Great Fire of 1666 , which
destroyed more than 13,00 0 houses.* Fourteen years later
Nicholas Barbon established the first fire insurance company. At
around the same time, a specialized marine insurance market
began to coalesce in Edward Lloyd's coffee house in London's
Tower Street (later in Lombard Street). Between the 1730 s and
the 1760s, the practice of exchanging information at Lloyd's
became more routinized until in 177 4 a Society of Lloyd's was
formed at the Roya l Exchange, initially bringing together seventy-* The human propensity to shut stable doors after horses have bolted is well
illustrated by the history of fire insurance. It was after the New York fire of
183 5 that American states began to insist that insurance companies maintain
adequate reserves. It was after the Hamburg fire of 184 2 that reinsurance
was developed as a way for insurance companies to share the risk of major
18 6
nine life members, each of whom paid a £1 5 subscription. Com­
pared with the earlier monopoly trading companies, Lloyd's was
an unsophisticated entity, essentially an unincorporated associ­
ation of market participants. The liability of the underwriters
(who literally wrote their names under insurance contracts, and
were hence also known as Lloyd's Names) was unlimited. And
the financial arrangements were what would now be called pay
as you go - that is, the aim was to collect sufficient premiums in
any given year to cover that year's payments out and leave a
margin of profit. Limited liability came to the insurance business
with the founding of the Sun Insurance Office (1710) , a fire
insurance specialist and, ten years later (at the height of the South
Sea Bubble), the Royal Exchange Assurance Corporation and
the London Assurance Corporation, which focused on life and
maritime insurance. However, all three firms still operated on a
pay-as-you-go basis. Figures from London Assurance show pre­
mium income usually, but not always, exceeding payments out,
with periods of war against France causing huge spikes in both.
(This was not least because before 179 3 it was quite normal for
London insurers to sell cover to French merchants.1 4 In peacetime
the practice resumed, so that on the eve of the First World War
most of Germany's merchant marine was insured by Lloyd's. 15 )
Life insurance, too, existed in medieval times. The Florentine
merchant Bernardo Cambi's account books contain references to
insurance on the life of the pope (Nicholas V) , of the doge of
Venice (Francesco Foscari) and of the king of Aragon (Alfonso
V) . It seems, however, that these were little more than wagers,
comparable with the bets Cambi made on horse races.1 6 In
truth, all these forms of insurance - including even the most
sophisticated shipping insurance - were a form of gambling.
There did not yet exist an adequate theoretical basis for evalu­
ating the risks that were being covered. Then, in a remarkable
18 7
18 8
rush of intellectual innovation, beginning in around 1660 , that
theoretical basis was created. In essence, there were six crucial
1 . Probability. It was to a monk at Port-Royal that the French
mathematician Blaise Pascal attributed the insight (published in
Pascal's Ars Cogitandi) that 'fear of harm ought to be pro­
portional not merely to the gravity of the harm, but also to the
probability of the event.' Pascal and his friend Pierre de Fermât
had been toying with problems of probability for many years,
but for the evolution of insurance, this was to be a critical point.
2. Life expectancy. In the same year that Ars Cogitandi appeared
(1662) , John Graunt published his 'Natural and Political Obser­
vations . . . Made upon the Bills of Mortality', which sought to
estimate the likelihood of dying from a particular cause on the
basis of official London mortality statistics. However, Graunt's
data did not include ages at death, limiting what could legiti­
mately be inferred from them. It was his fellow member of the
Roya l Society, Edmund Halley, who made the critical break­
through using data supplied to the Society from the Prussian
town of Breslau (today Wroclaw in Poland). Halley's life table,
based on 1,23 8 recorded births and 1,17 4 recorded deaths, gives
the odds of not dying in a given year: 'It being 10 0 to 1 that a
Ma n of 20 dies not in a year, and but 38 to 1 for a Ma n of
50 . . .' This was to be one of the founding stones of actuarial
mathematics.1 7
3. Certainty. Jaco b Bernoulli proposed in 170 5 that 'Under simi­
lar conditions, the occurrence (or non-occurrence) of an event in
the future will follow the same pattern as was observed in the
past.' His La w of Large Numbers stated that inferences could be
drawn with a degree of certainty about, for example, the total
contents of a jar filled with two kinds of ball on the basis of a
sample. This provides the basis for the concept of statistical
significance and modern formulations of probabilities at specified
confidence intervals (for example, the statement that 40 per cent
of the balls in the jar are white, at a confidence interval of 95 per
cent, implies that the precise value lies somewhere between 3 5
and 45 per cent - 40 plus or minus 5 per cent).
4. Normal distribution. It was Abraham de Moivre who showed
that outcomes of any kind of iterated process could be distributed
along a curve according to their variance around the mean or
standard deviation. Tho ' Chance produces Irregularities,' wrote
de Moivre in 1733 , process of Time, those Irregularities will bear no proportion to
recurrency of that Order which naturally results from Original
Design.' The bell curve that we encountered in Chapter 3 rep­
resents the normal distribution, in which 68.2 per cent of outcomes
are within one standard deviation (plus or minus) of the mean.
5. Utility. In 173 8 the Swiss mathematician Daniel Bernoulli
proposed that 'The value of an item must not be based on its
price, but rather on the utility that it yields', and that the 'utility
resulting from any small increase in wealth will be inversely
proportionate to the quantity of goods previously possessed' - in
other words $10 0 is worth more to someone on the median
income than to a hedge fund manager.
6. Inference. In his 'Essay Towards Solving a Problem in the
Doctrine of Chances' (published posthumously in 1764) , Thomas
Bayes set himself the following problem: 'Given the number of
times in which an unknown event has happened and failed;
Required the chance that the probability of its happening in a
single trial lies somewhere between any two degrees of probability
that can be named.' His resolution of the problem - 'The prob­
ability of any event is the ratio between the value at which an
expectation depending on the happening of the event ought to be
computed, and the chance of the thing expected upon it's [sic]
18 9
happening' - anticipates the modern formulation that expected
utility is the probability of an event times the payoff received in
case of that event.1 8
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.
Greyfriars Kirkyard, on the hill that is the heart of Edinburgh's
Old Town , is best known today for Greyfriars Bobby, the loyal
Skye terrier who refused to desert his master's grave, and also for
the grave robbers - the so-called 'Resurrection Men ' - who went
there in the early nineteenth century to supply the medical school
at Edinburgh University with corpses for dissection. But Grey-friars's importance in the history of finance lies in the earlier
mathematical work of its minister, Robert Wallace, and his friend
Alexander Webster, who was minister of Tolbooth. Along with
Colin Maclaurin, Professor of Mathematics at Edinburgh, it
was their achievement to create the first modern insurance fund,
based on correct actuarial and financial principles, rather than
mercantile gambling.
Living in Auld Reekie, as the distinctly smelly Scottish capital
was then known, Wallace and Webster had a keen sense of the
fragility of the human condition. They themselves lived to ripe
old ages: 74 and 7 5 respectively. But Maclaurin died at the age
of just 48, having fallen from his horse and suffered exposure
while trying to evade the Jacobites during the 174 5 rising.
Invasions of Papist Highlanders were only one of the hazards
inhabitants of Edinburgh faced in the mid eighteenth century.
Average life expectancy at birth is unlikely to have been better
than it was in England, where it was just 3 7 until the 1800s . It
may even have been as bad as in London, where it was 23 in the
late eighteenth century - perhaps even worse, given the Scottish
19 0
The spirit of insurance: Alexander Webster
preaching in Edinburgh
capital's notoriously bad hygiene. 19
For Wallace and Webster,
one group of people seemed especially vulnerable to the conse-quences of premature death. Under the Law of Ann (1672), the
widow and children of a deceased minister of the Church of
Scotland received only half a year's stipend in the year of the
minister's death. After that, they faced penury. A supplementary
scheme had been set up by the Bishop of Edinburgh in 1711,
but on the traditional pay-as-you-go basis. Wallace and Webster
knew this to be unsatisfactory.
We tend to think of Scottish clergymen as the epitome of
prudence and thrift, weighed down with an anticipation of
impending divine retribution for every tiny transgression. In
reality, Robert Wallace was a hard drinker as well as a mathe­
matical prodigy, who loved to knock back claret with his bibulous
buddies at the Rankenian Club, which met in what used to be
Ranken's Inn.* Alexander Webster's nickname was Bonum Mag­
num; it was said to be 'hardly in the power of liquor to affect Dr
Webster's understanding or his limbs'. Yet no one was more sober
when it came to calculations of life expectancy. The plan Webster
and Wallace came up with was ingenious, reflecting the fact that
they were as much products of Scotland's eighteenth-century
Enlightenment as of the Calvinist Reformation that had preceded
it. Rather than merely having ministers pay an annual premium,
which could be used to take care of widows and orphans as and
when ministers died, they argued that the premiums should be
used to create a fund that could then be profitably invested.
Widows and orphans would be paid out of the returns on the
investment, not just the premiums themselves. All that was
required for the scheme to work was an accurate projection of
how many beneficiaries there would be in the future, and how
much money could be generated to support them. Modern actu­
aries still marvel at the precision with which Webster and Wallace
did their calculations.2 0 'It is experience alone & nice calculation
that must determine the proportional sum the widow is to have
after the husband's death,' wrote Wallace in an early draft, 'but
a beginning may be made by allowing triple the sum the husband
payed [sic] in [yearly] during his life . . .' Wallace then turned to
the evidence that he and Webster had been able to gather from
presbyteries all over Scotland. It seemed that there tended to be
'93 0 ministers in life at all times':
* Wallace was also a member of the Philosophical Society of Edinburgh, to
which he presented his 'Dissertation on the Numbers of Mankind in Ancient
and Modern Times', a work which in some respects anticipated Thomas
Malthus's later Essay on the Principle of Population.
19 2
. . . 'tis found by a Medium of 20 years back, that 27 [of 930] ministers
die yearly, 18 of them leave Widows, 5 of them Children without a
Widow, 2 of them who leave Widows, leave also Children of a former
Marriage, under the Age of 16; and when the whole Number of
Widows shall be complete, 3 Annuitants will die, or marry, leaving
Children under 16.
Wallace originally estimated the maximum number of widows
living at any one time to be 279 ; but Maclaurin was able to
correct this, pointing out that it was wrong to assume a constant
mortality rate for the widows, since they would not all be the
same age. T o arrive at the correct, higher figure, he turned to
Halley's life tables.2 1
Time was to be the test of their calculations. According to
the final version of the scheme, each minister was to pay an
annual premium of between £ 2 12 s 6d and £ 6 1 i s 3d (there were
four levels of premium to choose from). The proceeds would
then be used to create a fund that could be profitably invested
(initially in loans to younger ministers) to yield sufficient income
to pay annuities to new widows of between £1 0 and £25 ,
depending on the level of premium paid, and to cover the fund's
management costs. 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 maxi­
mum principle, with capital being accumulated until interest and
contributions would suffice to pay the maximum amount of
annuities and expenses likely to arise. If the projections were
wrong, the fund would either overshoot or, more problem­
atically, undershoot the amount required. After at least five
attempts to estimate the rate of growth of the fund, Wallace
and Webster agreed figures that projected a rise from £18,62 0 at
the inception in 174 8 to £58,34 8 in 1765 . They were out by just
19 3
Calculations for the original Scottish Ministers'
Widows' Fund (r)
Calculations for the original Scottish Ministers' Widows'
Fund (2)
19 5
one pound. The actual free capital of the fund in 176 5 was
£58,347 . Both Wallace and Webster lived to see their calculations
In 193 0 the German insurance expert Alfred Manes concisely
defined insurance as:
An economic institution resting on the principle of mutuality, estab­
lished for the purpose of supplying a fund, the need for which arises
from a chance occurrence whose probability can be estimated.22
The Scottish Ministers' Widows' Fund was the first such fund,
and its foundation was truly a milestone in financial history. It
established a model not just for Scottish clergymen, but for every­
one who aspired to provide against premature death. Even before
the fund was fully operational, the universities of Edinburgh,
Glasgow and St Andrews had applied to join. Within the next
twenty years similar funds sprang up on the same model all over
the English-speaking world, including the Presbyterian Ministers'
Fund of Philadelphia (1761 ) and the English Equitable Company
(1762) , as well as the United Incorporations of St Mary' s Chapel
(1768) , which provided for the widows of Scottish artisans. By
181 5 the principle of insurance was so widespread that it was
adopted even for those men who lost their lives fighting against
Napoleon. A soldier's odds of being killed at Waterloo were
roughly 1 in 4. But if he was insured, he had the consolation of
knowing, even as he expired on the field of battle, that his wife
and children would not be thrown out onto the streets (giving a
whole new meaning to the phrase 'take cover'). By the middle of
the nineteenth century, being insured was as much a badge of
respectability as going to Church on a Sunday. Even novelists,
not generally renowned for their financial prudence, could join.
Sir Walter Scott2 3 took out a policy in 182 6 to reassure his
creditors that they would still get their money back in the event
of his death.* 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. Although it is now just another financial services pro­
vider, having been taken over by Lloyds Bank in 1999 , Scottish
Widows is still seen as exemplifying the benefits of Calvinist
thrift, thanks in no small measure to one of the most successful
advertising campaigns in financial history, f
What no one anticipated back in the 1740 s was that by constantly
increasing the number of people paying premiums, insurance
companies and their close relatives the pension funds would rise
to become some of the biggest investors in the world - the so-called institutional investors who today dominate global financial
markets. When, after the Second World War, insurance com­
panies were allowed to start investing in the stock market, they
quickly snapped up huge chunks of the British economy, owning
* Scott was a victim of the financial crisis triggered by the first Latin American
debt crisis (see Chapter 2). Perhaps he was also a victim of his own appetite
for real estate. To help finance the cost of his beloved country seat at Abbots-ford, the author had become a sleeping partner in the printers that published
his books, James Ballantyne and Co., and the associated publishing house of
John Ballantyne & Co. He was also an investor in his own publisher, Archi­
bald Constable, believing that the returns on these equity stakes would be
superior to traditional royalties. He kept these business interests secret, be­
lieving them to be incompatible with his standing as a Clerk to the Court
of Sessions and a Sheriff. The failure of Ballantyne and Constable in 182 5
left Scott with debts of between £117,00 0 and £130,000 . Rather than sell
Abbotsford, Scott vowed to write his way back into the black. He succeeded,
but at considerable cost to his own health, dying in 1832 . Had he died earlier,
the creditors would have been the beneficiaries of the Scottish Widows policy,
f The original 1986 advertisement was photographed by David Bailey with
the actor Roger Moore's daughter Deborah as the improbably alluring Scot­
tish Widow.
19 6
Sir Walter Scott's life insurance policy
around a third of major U K companies by the mid 1950s. 2 4 Today
Scottish Widows alone has over £10 0 billion under management.
Insurance premiums have risen steadily as a proportion of gross
domestic product in developed economies, from around 2 per
cent on the eve of the First World War to just under 1 0 per cent
As Robert Wallace realized more than 25 0 years ago, size
matters in insurance because the more people who pay into a
fund the easier it becomes, by the law of averages, to predict
what will have to be paid out each year. Although no individual's
date of death can be known in advance, actuaries can calculate
the likely life expectancies of a large group of individuals with
astonishing precision using the principles first applied by Wallace,
Webster and Maclaurin. In addition to how long the policy­
holders are likely to live, insurers also need to know what the
investment of their funds will bring in. What should they buy with
the premiums their policy-holders pay? Relatively safe bonds, as
recommended by Victorian authorities such as A . H . Bailey, head
actuary of the London Assurance Corporation? Or riskier but
probably higher yielding stocks? Insurance, in other words, is
where the risks and uncertainties of daily life meet the risks
and uncertainties of finance. T o be sure, actuarial science gives
insurance companies an in-built advantage over policy-holders.
Before the dawn of modern probability theory, insurers were the
gamblers; now they are the casino. The case can be made, as it
was by Dickie Scruggs before his fall from grace, that the odds
are now stacked unjustly against the punters/policy-holders. But
as the economist Kenneth Arro w long ago pointed out, most of
us prefer a gamble that has a 10 0 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 10 0 per
cent chance of a small gain (no premiums) but an uncertain
19 8
19 9
chance of a huge loss (no payout after a disaster). That is why
the guitarist Keith Richards insured his fingers and the singer
Tina Turner her legs. Only if insurance companies systematically
fail to pay out to those who have placed their bets will their
long-standing reputation for Scottish prudence become a repu­
tation for stinginess and lack of scruple.
Yet there remains a puzzle. It may seem appropriate that, as
the inventors of modern insurance, the British remain the
world's most insured people, paying more than 1 2 per cent of
GD P on premiums, roughly a third more than Americans spend
on insurance and nearly twice what the Germans spend.2 5 A
moment's reflection, however, prompts the question, why should
that be? Unlike the United States, Britain rarely suffers extreme
weather events; the nearest thing to a hurricane in my lifetime
was the storm of October 1987 . N o British city stands on a
fault-line, as San Francisco does. And, compared with Germany,
Britain's history since the foundation of Scottish Widows has
been one of almost miraculous political stability. Why, then, do
the British take out so much insurance?
The answer lies in the rise and fall of an alternative form of
protection against risk: the welfare state.
From Warfare to Welfare
N o matter how many private funds like Scottish Widows were
set up, there were always going to be people beyond the reach of
insurance, who were either too poor or too feckless to save for
that rainy day. Their lot was a painfully hard one: dependence
on private charity or the austere regime of the workhouse. At
the large Marylebone Workhouse on London's Northumberland
Street, the 'poor being lame impotent old and blind' numbered
up to 1,900 in hard times. When the weather was bitter, work
scarce and food dear, men and women 'casuals' would submit to
a prison-like regime. As the Illustrated London News described
it in 1867 :
They are washed with plenty of hot and cold water and soap, and
receive six ounces of bread and a pint of gruel for supper; after
which, their clothes being taken to be cleaned and fumigated, they are
furnished with warm woollen night-shirts and sent to bed. Prayers are
read by Scripture-readers; strict order and silence are maintained all
night in the dormitory . . . The bed consists of a mattress stuffed with
coir, a flock pillow, and a pair of rugs. At six o'clock in the morning
in summer, and at seven in winter, they are aroused and ordered to
work. The women are set to clean the wards, or to pick oakum; the
men to break stones, but none are detained longer than four hours
after their breakfast which is of the same kind and quantity as their
supper. Their clothes, disinfected and freed of vermin, being restored
to them in the morning, those who choose to mend their ragged
garments are supplied with needles, thread, and patches of cloth for
that purpose. If any are ill, the medical officer of the workhouse
attends to them; if too ill to travel, they are admitted into the infirmary.
The author of the report concluded that 'the "Amateur Casual"
would find nothing to complain of .. . A board of Good Samar­
itans could do no more.' 2 6 By the later nineteenth century, how­
ever, a feeling began to grow that life's losers deserved better.
The seeds began to be planted of a new approach to the problem
of risk - one that would ultimately grow into the welfare state.
These state systems of insurance were designed to exploit the
ultimate economy of scale, by covering literally every citizen from
birth to death.
We tend to think of the welfare state as a British invention. We
also tend to think of it as a socialist or at least liberal invention.
Two scenes from a London workhouse, 1902: Oakum-picking
involved teasing fibres out of old hemp ropes for re-use in
In fact, 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. No r 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 wh o has a pension for his old age is .. . much easier to deal
with than a man without that prospect.' T o the surprise of his
liberal opponents, Bismarck openly acknowledged that this was
'a state-socialist idea! The generality must undertake to assist the
unpropertied.' But his motives were far from altruistic. 'Whoever
embraces this idea', he observed, 'will come to power.' 2 7 It was
not until 190 8 that Britain followed the Bismarckian example,
when the Liberal Chancellor of the Exchequer David Lloyd
George introduced a modest and means-tested state pension for
those over 70 . A National Health Insurance Act followed in
1911 . Though a man of the Left, Lloyd George shared Bismarck's
insight that such measures were vote-winners in a system of
rapidly widening electoral franchises. The rich were outnumbered
by the poor. When Lloyd George raised direct taxes to pay for
the state pension, he relished the label that stuck to his 190 9
budget: 'The People's Budget.'
If the welfare state was conceived in politics, however, it grew
to maturity in war. The First World War expanded the scope
of government activity in nearly every field. With German sub­
marines sending no less than 7,759,000 gross tons of merchant
shipping to the bottom of the ocean, there was clearly no way
that war risk could be covered by the private marine insurers.
The standard Lloyd's policy had in fact already been modified
(in 1898 ) to exclude 'the consequences of hostilities or warlike
20 2
Men dining in the St Marylebone workhouse. God's justice and
goodness may not have been immediately obvious to the inmates
20 3
operations' (the so-called f.c.s. clause: 'free of capture and seiz­
ure'). But even those policies that had been altered to remove that
exclusion were cancelled when war broke out.2 8 The state stepped
in, virtually nationalizing merchant shipping in the case of the
United States,2 9 and (predictably) enabling insurance companies
to claim that any damage to ships between 191 4 and 191 8 was
a consequence of the war. 3 0 With the coming of peace, politicians
in Britain also hastened to cushion the effects of demobilization
on the labour market by introducing an Unemployment Insurance
Scheme in 1920. 3 1 This process repeated itself during and after
the Second World War. The British version of social insurance
was radically expanded under the terms of the 194 2 Report of
the Inter-Departmental Committee on Social Insurance and Allied
Services, chaired by the economist William Beveridge, which
recommended a broad assault on 'Want, Disease, Ignorance,
Squalor and Idleness' through a variety of state schemes. In a
March 194 3 broadcast, Churchill summarized these as: 'national
compulsory insurance for all classes for all purposes from the
cradle to the grave'; the abolition of unemployment by govern­
ment policies which would 'exercise a balancing influence upon
development which can be turned on or off as circumstances
require'; 'a broadening field for State ownership and enterprise';
more publicly provided housing; reforms to public education and
greatly expanded health and welfare services.3 2
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'.3 3 State insurance exploited econo­
mies of scale, in other words; so why not make it as comprehen-204
sive as possible? The enthusiasm with which the Beveridge Report
was greeted not just in Britain but around the world helps explain
why the welfare state is still thought of as having 'Mad e in Britain'
stamped on it. However, the world's first welfare superpower,
the country that took the principle furthest and with the greatest
success, was not Britain but Japan. Nothing illustrates more
clearly than the Japanese experience the intimate links between
the welfare state and the warfare state.
Disaster kept striking Japan in the first half of the twentieth
century. On i September 1923 , a huge earthquake (7.9 on the
Richter scale) struck the Kantô region, devastating the cities of
Yokohama and Tokyo . More than 128,00 0 houses completely
collapsed, around the same number half-collapsed, 900 were
swept away by the sea and nearly 450,000 were burnt down in
fires that broke out almost immediately after the quake. 3 4 The
Japanese were insured; between 187 9 and 191 4 their insurance
industry had grown from nothing into a vibrant sector of the
economy, offering cover against loss at sea, death, fire, conscrip-tion, transport accident and burglary, to name just some of the
thirteen distinct forms of insurance sold by more than thirty
companies. In the year of the earthquake, for example, Japanese
citizens had purchased ¥699,634,00 0 ($32 8 million) worth of
new life insurance for 1923 , with an average policy amount of
¥1,28 0 ($6oo). 3 5 But the total losses caused by the earthquake
were in the region of $4. 6 billion. Six years later the Great
Depression struck, pushing some rural areas to the brink of star-vation (at this time 70 per cent of the population was engaged in
agriculture, of whom 70 per cent tilled an average of just one and
a half acres).3 6 In 193 7 the country embarked on an expensive
and ultimately futile war of conquest in China. Then, in December
1941 , Japan went to war with the world's economic colossus, the
United States, and eventually paid the ultimate price at Hiroshima
and Nagasaki. Quite apart from the nearly three million lives lost
in Japan's doomed bid for empire, by the end in 194 5 tn e value
of Japan's entire capital stock seemed to have been reduced to
zero by American bombers. In aggregate, according to the US
Strategic Bombing Survey, at least 40 per cent of the built-up
areas of more than sixty cities had been destroyed; 2.5 million
homes had been lost, leaving 8.3 million people homeless.3 7
Practically the only city to survive intact (though not wholly
unscathed) was Kyoto, the former imperial capital - a city
which still embodies the ethos of pre-modern Japan, as it is
one of the last places where the traditional wooden townhouses
known as machiya can still be seen. One look at these long, thin
structures, with their sliding doors, paper screens, polished beams
and straw mats, makes it clear why Japanese cities were so vulner­
able to fire.
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. ) 3 8 With the best will
in the world, individuals could not be expected to insure them­
selves against the US Air Force. The answer adopted more or less
everywhere was for the government to take over, in effect to
nationalize risk. When the Japanese set out to devise a system of
universal welfare in 1949 , their Advisory Council for Social Secur­
ity acknowledged a debt to the British example. In the eyes of Bunji
Kondo, a convinced believer in universal welfare coverage, it was
time to have bebariji no nihonhan: Beveridge for the Japanese.3 9
But they took the idea even further than Beveridge had intended.
The aim, as the report of the Advisory Council put it, was to create
a system in which measures are taken for economic security for sick­
ness, injury, childbirth, disability, death, old age, unemployment, large
families and other causes of impoverishment through . . . payment by
governments .. . [and] in which the needy will be guaranteed the
minimum standard of living by national assistance.4 0
From now on, the welfare state would cover people against all
the vagaries of modern life. If they were born sick, the state would
pay. If they could not afford education, the state would pay. If
they could not find work, the state would pay. If they were too
ill to work, the state would pay. When they retired, the state
would pay. And when they finally died, the state would pay their
dependants. This certainly chimed with one of the objectives of
the post-war American occupation: 'T o replace a feudal economy
by a welfare economy'.4 1 Yet it would be wrong to assume (as a
number of post-war commentators did) that Japan's welfare state
was 'imposed wholesale by an alien power'. 4 2 In reality, the Japan­
ese set up their own welfare state - and they began to do so
long before the end of the Second World War. It was the mid
twentieth-century state's insatiable appetite for able-bodied
young soldiers and workers, not social altruism, that was the real
driver. As the American political scientist Harold D . Lasswell put
it, Japan in the 1930 s became a garrison state.4 3 But it was one
which carried within it the promise of a 'warfare-welfare state',
offered social security in return for military sacrifice.
There had been some basic social insurance in Japa n before the
1930s : factory accident insurance and health insurance (intro­
duced for factory workers in 1927) . But this covered less than
two fifths of the industrial workforce.4 4 Significantly, the plan for
a Japanese Welfare Ministry (Kôseishô) was approved by Japan's
imperial government on 9 July 1937 , just two months after the
outbreak of war with China.4 5 Its first step was to introduce a new
system of universal health insurance to supplement the existing
programme for industrial employees. Between the end of 193 8
and the end of 1944 , the number of citizens covered by the scheme
increased nearly a hundred-fold, from just over 500,000 to over
40 million. The aim was explicit: a healthier populace would
ensure healthier recruits to the Emperor's armed forces. The
wartime slogan of 'all people are soldiers' (kokumin kai hei) was
adapted to become 'all people should have insurance' {kokumin
kai hoken). And to ensure universal coverage, the medical pro­
fession and pharmaceutical industry were essentially subordi­
nated to the state.4 6 The war years also saw the introduction of
compulsory pension schemes for seamen and workers, with the
state covering 1 0 per cent of the costs, while employers and
employees each contributed 5.5 per cent of the latter's wages.
The first steps towards the large-scale provision of public housing
were also taken. So what happened after the war in Japan was in
large measure the extension of the warfare-welfare state. No w
'all people should have pensions', kokumin kai nenkin. No w
there should be unemployment insurance, rather than the earlier
paternalistic practice of keeping workers on payrolls even in lean
times. Small wonder some Japanese tended to think of welfare in
nationalistic terms, a kind of peaceful mode of national aggrand­
isement. The 195 0 report, with its British-style recommendations,
was in fact rejected by the government. Only in 1961 , long after
the end of American control, were most of its recommendations
adopted. By the late 1970 s a Japanese politician, Nakagawa
Yatsuhiro, could boast that Japan had become 'The Welfare
Super-Power' (fukusbi cbôdaikoku), precisely because its system
was different from (and superior to) Western models.4 7
There was in fact nothing institutionally unique about Japan's
system, of course. Most welfare states aimed at universal, cradle-to-grave coverage. Yet the Japanese welfare state seemed to be a
miracle of effectiveness. In terms of life expectancy, the country
led the world. In education, too, it was ahead of the field. Around
90 per cent of the population had graduated from high school in
the mid seventies, compared with just 3 2 per cent in England.4 8
Japan was also a much more equal society than any in the West,
with the sole exception of Sweden. And Japan had the largest
state pension fund in the world, so that every Japanese who
retired could count on a generous bonus as well as a regular
income throughout his (generally rather numerous) years of well-earned rest. The welfare superpower was also a miracle of parsi­
mony. In 197 5 just 9 per cent of national income went on social
security, compared with 3 1 per cent in Sweden.4 9 The burden of
tax and social welfare was roughly half that in England. Run on
this basis, the welfare state seemed to make perfect sense. Japan
had achieved security for all - the elimination of risk - while at
the same time its economy grew so rapidly that by 196 8 it was
the second largest in the world. A year before, Herman Kahn
had predicted that Japan's per capita income would overtake
America's by 2000. Indeed, Nakagaw a Yatsuhiro argued that,
when fringe benefits were taken into account, 'the actual income
of the Japanese worker [was already] at least three times more
than that of the American'.5 0 Warfare had failed to make Japan
Top Nation, but welfare was succeeding. The key turned out to
be not a foreign empire, but a domestic safety net.5 1
Yet there was a catch, a fatal flaw in the design of the post-warfare welfare state. The welfare state might have worked
smoothly enough in 1970 s Japan. But the same could not be said
of its counterparts in the Western world. Despite their superficial
topographical and historical resemblances (archipelagos off
Eurasia, imperial pasts, buttoned-up behaviour when sober) the
Japanese and the British had quite different cultures. Outwardly,
their welfare systems might seem similar: state pensions financed
out of taxation on the old pay-as-you-go model; standardized
retirement ages; universal health insurance; unemployment
benefits; subsidies to farmers; quite heavily restricted labour
markets. But these institutions worked in quite different ways in
the two countries. In Japa n egalitarianism was a prized goal of
policy, while a culture of social conformism encouraged com­
pliance with the rules. English individualism, by contrast, inclined
people cynically to game the system. In Japan, firms and families
continued to play substantial supporting roles in the welfare
system. Employers offered supplementary benefits and were
reluctant to fire workers. As recently as the 1990s, two thirds of
Japanese older than 64 lived with their children.5 2 In Britain, by
contrast, employers did not hesitate to slash payrolls in hard
times, while people were much more likely to leave elderly parents
to the tender mercies of the National Health Service. The welfare
state might have made Japan an economic superpower, but in the
1970s it appeared to be having the opposite effect in Britain.
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. Between 193 0 and 1980, social
transfers in Britain had risen from just 2.2 per cent of gross
domestic product to 1 0 per cent in i960, 1 3 per cent in 197 0 and
nearly 1 7 per cent in 1980 , more than 6 per cent higher than
in Japan. 5 3 Health care, social services and social security were
consuming three times more than defence as a share of total
managed government expenditure. Yet the results were dismal.
Increased expenditure on U K welfare had been accompanied by
low growth and inflation significantly above the developed world
average. A particular problem was chronically slow productivity
growth (real GD P per person employed grew by just 2.8 per cent
between i96 0 and 1979 , compared with 8.1 per cent in Japan), 5 4
21 0
21 1
which in turn seemed closely related to the bloody-minded bar­
gaining techniques of British trade unions ('go slows' being a
favourite alternative to outright 'downing tools'). Meanwhile,
marginal tax rates in excess of 10 0 per cent on higher incomes
and capital gains discouraged traditional forms of saving and
investment. The British welfare state, it seemed, had removed the
incentives without which a capitalist economy simply could not
function: the carrot of serious money for those wh o strove, the
stick of hardship for those who slacked. The result was 'stag­
flation': stagnant growth plus high inflation. Similar problems
were afflicting the US economy, where expenditure on health,
Medicare, income security and social security had risen from
4 per cent of GD P in 195 9 to 9 per cent in 1975 , outstripping
defence spending for the first time. In America, too, productivity
was scarcely growing and stagflation was rampant. What was to
be done?
One man, and his pupils, thought they knew the answer.
Thanks in large measure to their influence, one of the most pro­
nounced economic trends of the past twenty-five years has been
for the Western welfare state to be dismantled, reintroducing
people with a sharp shock to the unpredictable monster they
thought they had escaped from: risk.
The Big Chill
In 197 6 a diminutive professor working at the University of
Chicago won the Nobel Prize in economics. Milton Friedman's
reputation as an economist rested in large measure on his
reinstatement of the idea that inflation was due to an excessive
increase in the supply of money. As we have seen, he co-wrote
perhaps the single most important book on US monetary policy
Milton Friedman
of all time, firmly laying the blame for the Great Depression on
mistakes by the Federal Reserve.55 But the question that had come
to preoccupy him by the mid-seventies was: what had gone wrong
with the welfare state? In March 1975, Friedman flew from
Chicago to Chile to answer that question.
Only eighteen months earlier, in September 1973, tanks had
rolled through the capital Santiago to overthrow the government
of the Marxist President Salvador Allende, whose attempt to turn
Chile into a Communist state had ended in total economic chaos
and a call by the parliament for a military takeover. Air force
jets bombed the presidential Moneda Palace, watched from the
balcony of the nearby Carera Hotel by opponents of Allende
who celebrated with champagne. Inside the palace, the president
21 3
himself fought a hopeless rearguard action armed with an AK4 7
- a gift from Fidel Castro, the man he had sought to emulate. As
the tanks rumbled towards him, Allende realized it was all over
and, cornered in what was left of his quarters, shot himself.
The coup epitomized a world-wide crisis of the post-war wel­
fare state and posed a stark choice between rival economic
systems. With output collapsing and inflation rampant, Chile's
system of universal benefits and state pensions was essentially
bankrupt. For Allende, the answer had been full blown Marxism,
a complete Soviet-style takeover of every aspect of economic
life. The generals and their supporters knew they were against
that. But what were they actually for, since the status quo was
clearly unsustainable? Enter Milton Friedman. Amid his lectures
and seminars, he spent three quarters of an hour with the new
president General Pinochet and later wrote him an assessment
of the Chilean economic situation, urging him to reduce the
government déficit that he had identified as the main cause of
the country's sky-high inflation, then running at an annual rate
of 900 per cent.5 6 A month after Friedman's visit, the Chilean
junta announced that inflation would be stopped 'at any cost'.
The regime cut government spending by 27 per cent and set
fire to bundles of banknotes. But Friedman was offering more
than his patent monetarist shock therapy. In a letter to Pinochet
written after his return to Chicago, he argued that 'this
problem' of inflation arose 'from trends toward socialism that
started forty years ago, and reached their logical - and terrible -climax in the Allende regime'. As he later recalled, 'The general
line I was taking .. . was that their present difficulties were due
almost entirely to the forty-year trend toward collectivism,
socialism, and the welfare state . . .' 5 7 And he assured Pinochet:
'The end of inflation will lead to a rapid expansion of the capital
market, which will greatly facilitate the transfer of enterprises
21 4
and activities still in the hands of the government to the private
sector.'5 8
For tendering this advice Friedman found himself denounced
by the American press. After all, he was acting as a consultant to
a military dictator responsible for the executions of more than two
thousand real and suspected Communists and the torture of nearly
30,000 more. As the New York Times asked: '.. . if the pure
Chicago economic theory can be carried out in Chile only at the
price of repression, should its authors feel some responsibility?'*
Chicago's role in the new regime consisted of more than just
one visit by Milton Friedman. Since the 1950s , there had been a
regular stream of bright young Chilean economists studying
at Chicago on an exchange programme with the Universidad
Catôlica in Santiago, and they went back convinced of the need
to balance the budget, tighten the money supply and liberalize
trade.5 9 These were the so-called Chicago Boys, Friedman's foot-soldiers: Jorge Cauas, Pinochet's finance minister and later econ­
omics 'superminister', Sergio de Castro, his successor as finance
minister, Miguel Kast, labour minister and later central bank
chief, and at least eight others who studied in Chicago and went
on to serve in government. Even before the fall of Allende, they
had devised a detailed programme of reforms known as El
Ladrillo (The Brick) because of the thickness of the manu­
script. The most radical measures, however, would come from a
Catholic University student who had opted to study at Harvard,
not Chicago. What he had in mind was the most profound
challenge to the welfare state in a generation. Thatcher and
* Friedman noted in 1988 that he had given much the same advice on inflation
to the Chinese government, yet found that he received no 'avalanche of
protests for [his] having been willing to give advice to so evil a government',
despite the fact that it 'has been and still is more repressive than the Chilean
military junta'.
21 5
Reagan came later. The backlash against welfare started in Chile.
For José Pinera, just 24 when Pinochet seized power, the invi­
tation to return to Chile from Harvard posed an agonizing
dilemma. He had no illusions about the nature of Pinochet's
regime. Yet he also believed there was an opportunity to put into
practice ideas that had been taking shape in his mind ever since
his arrival in Ne w England. The key, as he saw it, was not just
to reduce inflation. It was also essential to foster that link between
property rights and political rights which had been at the heart
of the successful North American experiment with capitalist
democracy. There was no surer way to do this, Pinera believed,
than radically to overhaul the welfare state, beginning with the
pay-as-you-go system of funding state pensions and other
benefits. As he saw it:
What had begun as a system of large-scale insurance had simply
become a system of taxation, with today's contributions being used
to pay today's benefits, rather than to accumulate a fund for future
use. This 'pay-as-you-go' approach had replaced the principle of thrift
with the practice of entitlement . . . [But this approach] is rooted in
a false conception of how human beings behave. It destroys, at
the individual level, the link between contributions and benefits. In
other words, between effort and reward. Wherever that happens on a
massive scale and for a long period of time, the final result is disaster.6 0
Between 197 9 and 1981 , as minister of labour (and later minis­
ter of mining), Pinera created a radically new pension system for
Chile, offering every worker the chance to opt out of the state
pension system. Instead of paying a payroll tax, they would
put an equivalent amount (1 0 per cent of their wages) into an
individual Personal Retirement Account, to be managed by
private and competing companies known as Administradora de
Fondos de Pensiones (AFPs). 6 1 On reaching retirement age, a
participant would withdraw his money and use it to buy an
annuity; or, if he preferred, he could keep working and contri­
buting. In addition to a pension, the scheme also included a
disability and life insurance premium. The idea was to give the
Chilean worker a sense that the money being set aside was really
his own capital. In the words of Hernân Buchi (who helped Pinera
draft the social security legislation and went on to implement the
reform of health care), 'Social programmes have to include some
incentive for individual effort and for persons gradually to be
responsible for their own destiny. There is nothing more pathetic
than social programmes that encourage social parasitism.'6 2
Pinera gambled. He gave workers a choice: stick with the old
system of pay-as-you-go, or opt for the new Personal Retirement
Accounts. He cajoled, making regular television appearances to
reassure workers that 'Nobody will take away your grand­
mother's cheque' (from the old state system). He held firm, sar­
castically dismissing a proposal that the country's trade unions,
rather than individual workers, should be responsible for choos­
ing their members' AFPs . Finally, on 4 November 1980 , the
reform was approved, coming into effect at Pifiera's mischievous
suggestion on 1 May , international Labour Day, the following
year. 6 3 The public response was enthusiastic. By 199 0 more than
7 0 per cent of workers had made the switch to the private
system.6 4 Each one received a shiny new book in which the contri­
butions and investment returns were recorded. By the end of
2006, around 7.7 million Chileans had a Personal Retirement
Account; 2.7 million were also covered by private health schemes,
under the so-called ISAPR E system, which allowed workers to
opt out of the state health insurance system in favour of a private
provider. It may not sound like it, but - along with the other
Chicago-inspired reforms implemented under Pinochet - this
represented as big a revolution as anything the Marxist Allende
21 6
had planned back in 1973 . Moreover, the reform had to be
introduced at a time of extreme economic instability, a conse­
quence of the ill-judged decision to peg the Chilean currency to
the dollar in 1979 , when the inflation dragon appeared to have
been slain. When US interest rates rose shortly afterwards, the
deflationary pressure plunged Chile into a recession that threat­
ened to derail the Chicago-Harvard express altogether. The econ­
omy contracted 1 3 per cent in 1982 , seemingly vindicating the
left-wing critics of Friedman's 'shock treatment'. Only towards
the end of 198 5 could the crisis really be regarded as over. By
199 0 it was clear that the reform had been a success: welfare
reforms were responsible for fully half the decline of total govern­
ment expenditure from 34 per cent of GD P to 2 2 per cent.
Was it worth it? Was it worth the huge moral gamble that the
Chicago and Harvard boys made, of getting into bed with a
murderous, torturing military dictator? The answer depends on
whether or not you think these economic reforms helped pave
the way back to a sustainable democracy in Chile. In 1980 , just
seven years after the coup, Pinochet conceded a new constitution
that prescribed a ten-year transition back to democracy. In 1990 ,
having lost a referendum on his leadership, he stepped down as
president (though he remained in charge of the army for a further
eight years). Democracy was restored, and by that time the econ­
omic miracle was under way that helped to ensure its survival.
For the pension reform not only created a new class of property-owners, each with his own retirement nest egg. It also gave the
Chilean economy a massive shot in the arm, since the effect was
significantly to increase the savings rate (to 3 0 per cent of GD P
by 1989 , the highest in Latin America). Initially, a cap was
imposed that prevented the AFP s from investing more than 6 per
cent (later 1 2 per cent) of the new pension funds outside Chile. 6 5
The effect of this was to ensure that Chile's new source of savings
21 7
was channelled into the country's own economic development.
In January 2008 I visited Santiago and watched brokers at the
Banco de Chile busily investing the pension contributions of
Chilean workers in their own stock market. The results have been
impressive. The annual rate of return on the Personal Retirement
Accounts has been over 1 0 per cent, reflecting the soaring per­
formance of the Chilean stock market, which has risen by a factor
of 1 8 since 1987 .
There is a shadow side to the system, to be sure. The adminis­
trative and fiscal costs of the system are sometimes said to be too
high.6 6 Since not everyone in the economy has a regular full-time
job, not everyone ends up participating in the system. The self-employed were not obliged to contribute to Personal Retirement
Accounts, and the casually employed do not contribute either.
That leaves a substantial proportion of the population with no
pension coverage at all, including many of the people living in La
Victoria, once a hotbed of popular resistance to the Pinochet
regime - and still the kind of place where Che Guevara's face is
spray-painted on the walls. On the other hand, the government
stands ready to make up the difference for those whose savings
do not suffice to pay a minimum pension, provided they have
done at least twenty years of work. And there is also a Basic
Solidarity pension for those who do not qualify for this.6 7 Above
all, the improvement in Chile's economic performance since the
Chicago Boys' reforms is very hard to argue with. The growth
rate in the fifteen years before Friedman's visit was 0.1 7 per cent.
In the fifteen years that followed, it was 3.28 per cent, nearly
twenty times higher. The poverty rate has declined dramatically
to just 1 5 per cent, compared with 40 per cent in the rest of Latin
America.6 8 Santiago today is the shining city of the Andes, easily
the continent's most prosperous and attractive city.
It is a sign of Chile's success that the country's pension reforms
21 8
have been imitated all across the continent, and indeed around
the world. Bolivia, El Salvador and Mexic o copied the Chilean
scheme to the letter. Peru and Colombia introduced private pen­
sions as an alternative to the state system.6 9 Kazakhstan, too, has
followed the Chilean example. Even British MP s have beaten a
path from Westminster to Pinera's door. The irony is that the
Chilean reform was far more radical than anything that has been
attempted in the United States, the heartland of free market
economics. Yet welfare reform is coming to North America,
whether anyone wants it or not.
When Hurricane Katrina struck Ne w Orleans, it laid bare some
realities about the American system that many people had been
doing their best to ignore. Yes , America had a welfare state. No ,
it didn't work. The Reagan and Clinton administrations had
implemented what seemed like radical welfare reforms, reducing
unemployment benefits and the periods for which they could be
claimed. But no amount of reform could insulate the system from
the ageing of the American population and the spiralling cost of
private health care.
The US has a unique welfare system. Social Security provides
a minimal state pension to all retirees, while at the same time the
Medicare system covers all the health costs of the elderly and
disabled. Income support and other health expenditures push up
the total cost of federal welfare programmes to n per cent of
GDP . American healthcare, however, is almost entirely provided
by the private sector. At its best it is state-of-the-art, but it is very
far from cheap. And, if you want treatment before you retire,
you need a private insurance policy - something an estimated
47 million Americans do not have, since such policies tend to be
available only to those in regular, formal employment. The result
is a welfare system which is not comprehensive, is much less
21 9
redistributive than European systems, but is still hugely expen­
sive. Since 199 3 Social Security has been more expensive than
National Security. Public expenditure on education is higher as a
percentage of GD P (5.9 per cent) than in Britain, Germany or
Japan. Public health expenditures are equivalent to around 7 per
cent of GDP , the same as in Britain; but private health care
spending accounts for more (8.5 per cent, compared with a paltry
1. 1 per cent in Britain).7 0
Such a welfare system is ill prepared to cope with a rapid
increase in the number of claimants. But that is precisely what
Americans face as the members of the so-called 'Baby Boomer'
generation, born after the Second World War, begin to retire.7 1
According to the United Nations, between now and 2050 male
life expectancy in the United States is likely to rise from 75 to 80.
Over the next forty years, the share of the American population
that is aged 65 or over is projected to rise from 1 2 per cent to
nearly 2 1 per cent. Unfortunately, many of the soon-to-be-retired
have made inadequate provision for life after work. According
to the 2006 Retirement Confidence Survey, six in ten American
workers say they are saving for retirement and just four in ten
say they have actually calculated how much they should be
saving. Man y of those without sufficient savings imagine that
they will compensate by working for longer. The average worker
plans to work until age 65 . But it turns out that he or she actually
ends up retiring at 62; indeed, around four in ten American
workers end up leaving the workforce earlier than they planned.7 2
This has grave implications for the federal budget, since those
wh o make these miscalculations are likely to end up a charge on
taxpayers in one way or another. Today the average retiree
receives Social Security, Medicare and Medicaid benefits totalling
$21,00 0 a year. Multiply this by the current 36 million elderly
and you see why these programmes already consume such a large
proportion of federal tax revenues. And that proportion is bound
to rise, not only because the number of retirees is going up but
also because the costs of benefits like Medicare are out of control,
rising at double the rate of inflation. The 2003 extension of
Medicare to cover prescription drugs only made matters worse.
According to one projection, by the aptly named Medicare Trus­
tee Thomas R . Saving, the cost of Medicare alone will
absorb 24 per cent of all federal income taxes by 2019 . Current
figures also imply that the federal government has much larger
unfunded liabilities than official data imply. The Government
Accountability Office's latest estimate of the implicit 'exposures'
arising from unfunded future Social Security and Medicare
benefits is $3 4 trillion.7 3 That is nearly four times the size of the
official federal debt.
Ironically, there's only one country where the problem of an
ageing population has more serious economic implications than
the United States. That country is Japan. So successful was the
Japanese 'welfare superpower' that by the 1970 s life expectancy
in Japan had become the longest in the world. But that, combined
with a falling birth rate, has produced the world's oldest society,
with more than 2 1 per cent of the population already over the
age of 65. According to Nakamae International Economic
Research, the elderly population will be equal to that of the
working population by 2044. 7 4 As a result, Japan is now grap­
pling with a profound structural crisis of its welfare system, which
was not designed to cope with what the Japanese call the longevity
society (chôju shakai).75 Despite raising the retirement age, the
government has not yet resolved the problems of the state pension
system. (Matters are not helped by the fact that many self-employed people and students - not to mention some eminent
politicians - are failing to make their required social security
contributions.) Public health insurers, meanwhile, have been in
22 1
The demographics of a welfare crisis: Japan, 1950-2.050
(percentage shares of population by age group)
1950 1960 1970 1980 1990 2.000 2.010 2020 20)0 2040 2.050
deficit smce the early 1990S.76 Japan's welfare budget is now
equal to three quarters of tax revenues. Its debt exceeds one
quadrillion yen, around 170 per cent of GDP.77 Yet private sector
institutions are in no better shape. Life insurance companies have
been struggling since the 1990 stock market crash; three major
insurers failed between 1997 and 2000. Pension funds are in
equally dire straits. As most countries in the developed world are
moving in the same direction, it gives a new meaning to that old
1980s pop song about 'turning Japanese'. Assets at the world's
largest pension funds (which include the Japanese government's
own fund, its Dutch counterpart and the California Public
Employees' fund) now exceed $10 trillion, having risen by 60 per
cent between 2004 and 2007.78 But are their liabilities ultimately
going to grow so large that perhaps even these huge sums will
not suffice?
Longer life is good news for individuals, but it is bad news for
the welfare state and the politicians who have to persuade voters
to reform it. The even worse news is that, even as the world's
population is getting older, the world itself may be getting more
dangerous.7 9
The Hedged and the Unhedged
What if international terrorism strikes more frequently and/or
lethally, as Al Qaeda continues its quest for weapons of mass
destruction? There is in fact good reason to fear this. Given the
relatively limited impact of the 200 1 attacks, A l Qaeda has a
strong incentive to attempt a 'nuclear 9/11'. 8 0 The organization's
spokesmen do not deny this; on the contrary, they openly boast
of their ambition 'to kill 4 million Americans - 2 million of them
children - and to exile twice as many and wound and cripple
hundreds of thousands'.8 1 This cannot be dismissed as mere
rhetoric. According to Graham Allison, of Harvard University's
Belfer Center, 'if the US and other governments just keep doing
what they are doing today, a nuclear terrorist attack in a major
city is more likely than not by 2014' . In the view of Richard
Garwin, one of the designers of the hydrogen bomb, there is
already a '2 0 per cent per year probability of a nuclear explosion
with American cities and European cities included'. Another esti­
mate, by Allison's colleague Matthew Bunn, puts the odds of a
nuclear terrorist attack over a ten-year period at 29 per cent.8 2
Even a small 12.5-kiloton nuclear device would kill up to 80,000
people if detonated in an average American city; a 1.0 megaton
hydrogen bomb could kill as many as 1.9 million. A successful
biological attack using anthrax spores could be nearly as lethal.8 3
What if global warming is increasing the incidence of natural
disasters? Here, too, there are some grounds for unease. Accord­
ing to the scientific experts on the Intergovernmental Panel on
Climate Change 'the frequency of heavy precipitation events has
increased over most areas' as a result of man-made global warm­
ing. There is also 'observational evidence of an increase in intense
tropical cyclone activity in the North Atlantic since about 1970' .
The rising sea levels forecast by the IPC C would inevitably
increase the flood damage caused by storms like Katrina.8 4 Not
all scientists accept the notion that hurricane activity along the
US Atlantic coast is on the increase (as claimed by Al Gore in his
film An Inconvenient Truth). But it would clearly be a mistake
blithely to assume that this is not the case, especially given the
continued growth of residential construction in vulnerable
states. For governments that are already tottering under the
weight of ever-increasing welfare commitments, an increase in
the frequency or scale of catastrophes could be fiscally fatal. The
insurance (and reinsurance) losses arising from the 9/1 1 attacks
were in the region of $30-5 8 billion, close to the insurance losses
due to Katrina.8 5 In both cases, the US federal government had to
step in to help private insurers meet their commitments, providing
emergency federal terrorism insurance in the aftermath of 9/11 ,
and absorbing the bulk of the costs of emergency relief and
reconstruction along the coast of the Gulf of Mexico. In other
words, just as happened during the world wars, the welfare state
steps in when the insurers are overwhelmed. But this has a per­
verse result in the case of natural disasters. In effect, taxpayers in
relatively safer parts of the country are subsidizing those who
choose to live in hurricane-prone regions. One possible way of
correcting this imbalance would be to create a federal reinsurance
programme to cover mega-catastrophes. Rather than looking to
taxpayers to pick up the tab for big disasters, insurers would
charge differential premiums (higher for those closest to hurricane
zones), laying off the risk of another Katrina by reinsuring the
risk through the government.8 6 But there is another way.
Insurance and welfare are not the only way of buying protection
against future shocks. The smart way to do it is by being hedged.
Everyone today has heard of hedge funds like Kenneth C. Griffin's
Chicago-based Citadel. As founder of the Citadel Investment
Group, now one of the twenty biggest hedge funds in the world,
Griffin currently manages around $1 6 billion in assets. Among
them are many so-called distressed assets, which Griffin picks up
from failed companies like Enron for knock-down prices. It
would not be too much to say that Ken Griffin loves risk. He
lives and breathes uncertainty. Since he began trading convertible
bonds from his Harvard undergraduate dormitory, he has feasted
on 'fat tails'. Citadel's main offshore fund has generated annual
returns of 2 1 per cent since 1998. 8 7 In 2007 , when other financial
institutions were losing billions in the credit crunch, he personally
made more than a billion dollars. Among the artworks that decor­
ate his penthouse apartment on North Michigan Avenue is Jasper
Johns's False Start, for which he paid $8 0 million, and a Cézanne
which cost him $6 0 million. When Griffin got married, the wed­
ding was at Versailles (the French château, not the small Illinois
town of the same name).8 8 Hedging is clearly a good business in
a risky world. But what exactly does it mean, and where did it
come from?
The origins of hedging, appropriately enough, are agricultural.
For a farmer planting a crop, nothing is more crucial than the
price it will fetch after it has been harvested and taken to market.
But that could be lower than he expects or higher. A futures
contract allows him to protect himself by committing a merchant
to buy his crop when it comes to market at a price agreed when
the seeds are being planted. If the market price on the day of
delivery is lower than expected, the farmer is protected; the mer­
chant who sells him the contract naturally hopes it will be higher,
leaving him with a profit. As the American prairies were ploughed
22 5
and planted, and as canals and railways connected them to the
major cities of the industrial Northeast, they became the nation's
breadbasket. But supply and demand, and hence prices, fluctu­
ated wildly. Between January 185 8 and Ma y 1867 , partly as a
result of the Civil War, the price of wheat soared from 5 5 cents
to $2.8 8 per bushel, before plummeting back to 7 7 cents in
March 1870 . The earliest forms of protection for farmers were
known as forward contracts, which were simply bilateral agree­
ments between seller and buyer. A true futures contract, however,
is a standardized instrument issued by a futures exchange and
hence tradable. With the development of a standard 'to arrive'
futures contract, along with a set of rules to enforce settlement
and, finally, an effective clearinghouse, the first true futures
market was born. Its birthplace was the Windy City: Chicago.
The creation of a permanent futures exchange in 187 4 - the
Chicago Produce Exchange, the ancestor of today's Chicago
Mercantile Exchange - created a home for 'hedging' in the US
commodity markets.8 9
A pure hedge eliminates price risk entirely. It requires a specu­
lator as a counter-party to take on the risk. In practice, however,
most hedgers tend to engage in some measure of speculative
activity, looking for ways to profit from future price movements.
Partly because of public unease about this - the feeling that
futures markets were little better than casinos - it was not until
the 1970 s that futures could also be issued for currencies and
interest rates; and not until 198 2 that futures contracts on the
stock market became possible.
At Citadel, Griffin has brought together mathematicians, physi­
cists, engineers, investment analysts and advanced computer tech­
nology. Some of what they do is truly the financial equivalent of
rocket science. But the underlying principles are simple. Because
they are all derived from the value of underlying assets, all futures
22 6
contracts are forms of 'derivative'. Closely related, though dis­
tinct from futures, are the financial contracts known as options.
In essence, the buyer of a call option has the right, but not the
obligation, to buy an agreed quantity of a particular commodity
or financial asset from the seller ('writer') of the option at a
certain time (the expiration date) for a certain price (known as
the strike price). Clearly, the buyer of a call option expects the
price of the commodity or underlying instrument to rise in the
future. When the price passes the agreed strike price, the option
is 'in the money' - and so is the smart guy who bought it. A put
option is just the opposite: the buyer has the right, but not the
obligation, to sell an agreed quantity of something to the seller
of the option. A third kind of derivative is the swap, which is
effectively a bet between two parties on, for example, the future
path of interest rates. A pure interest rate swap allows two parties
already receiving interest payments literally to swap them,
allowing someone receiving a variable rate of interest to exchange
it for a fixed rate, in case interest rates decline. A credit default
swap, meanwhile, offers protection against a company's
defaulting on its bonds. Perhaps the most intriguing kind of
derivative, however, are the weather derivatives like natural
catastrophe bonds, which allow insurance companies and others
to offset the effects of extreme temperatures or natural disasters
by selling the so-called tail risk to hedge funds like Fermât Capital.
In effect, the buyer of a 'cat bond' is selling insurance; if the
disaster specified in the bond happens, the buyer has to pay out
an agreed sum or forfeit his principal. In return, the seller pays
an attractive rate of interest. In 2006 the total notional value of
weather-risk derivatives was around $4 5 billion.
There was a time when most such derivatives were standardized
instruments produced by exchanges like the Chicago Mercantile,
which has pioneered the market for weather derivatives. Now ,
22 7
however, the vast proportion are custom-made and sold 'over-the-counter' (OTC) , often by banks which charge attractive
commissions for their services. According to the Bank for Inter­
national Settlements, the total notional amounts outstanding of
OT C derivative contracts - arranged on an ad hoc basis between
two parties - reached a staggering $59 6 trillion in December
2007 , with a gross market value of just over $14. 5 trillion.*
Though they have famously been called financial weapons of
mass destruction by more traditional investors like Warren
Buffett (who has, nonetheless, made use of them), the view in
Chicago is that the world's economic system has never been better
protected against the unexpected.
The fact nevertheless remains that this financial revolution has
effectively divided the world in two: those who are (or can be)
hedged, and those who are not (or cannot be). Yo u need money
to be hedged. Hedge funds typically ask for a minimum six- or
seven-figure investment and charge a management fee of at least
2 per cent of your money (Citadel charges four times that) and
20 per cent of the profits. That means that most big corporations
can afford to be hedged against unexpected increases in interest
rates, exchange rates or commodity prices. If they want to, they
can also hedge against future hurricanes or terrorist attacks by
selling cat bonds and other derivatives. By comparison, most
ordinary households cannot afford to hedge at all and would not
know how to even if they could. We lesser mortals still have to
rely on the relatively blunt and often expensive instrument of
insurance policies to protect us against life's nasty surprises; or
hope for the welfare state to ride to the rescue.
There is, of course, a third and much simpler strategy: the old
* That is to say, the notional amount outstanding if all derivatives paid out
is roughly four and a half times the contracts' estimated market value.
one of simply saving for that rainy day. Or, rather, borrowing to
buy assets whose future appreciation in value will supposedly
afford a cushion against calamity. For many families in recent
years, making provision for an uncertain future has taken the
very simple form of an investment (usually leveraged, that is
debt-financed) in a house, the value of which is supposed to keep
increasing until the day the breadwinners need to retire. If the
pension plan falls short, never mind. If you run out of health
insurance, don't panic. There is always home, sweet home.
As an insurance policy or a pension plan, however, this strategy
has one very obvious flaw. It represents a one-way, totally
unhedged bet on one market: the property market. Unfortunately,
as we shall see in the next chapter, a bet on bricks and mortar is
very far from being as safe as houses. And you do not need to
live in Ne w Orleans to find that out the hard way.
Safe as Houses
It is the English-speaking world's favourite economic game: prop­
erty. N o other facet of financial life has such a hold on the popular
imagination. N o other asset-allocation decision has inspired so
many dinner-party conversations. The real estate market is unique.
Every adult, no matter how economically illiterate, has a view on
its future prospects. Even children are taught how to climb the
property ladder, long before they have money of their own.* And
the way we teach them is literally to play a property game.
The game we know today as Monopoly was first devised in
190 3 by an American woman, Elizabeth ('Lizzie') Phillips, a
devotee of the radical economist Henry George. Her Utopian
dream was of a world in which the only tax would be a levy on
land values. The game's intended purpose was to expose the
iniquity of a social system in which a small minority of landlords
profited from the rents they collected from tenants. Originally
known as The Landlord's Game, this proto-Monopoly had a
number of familiar features - the continuous rectangular path,
the G o to Jail corner - but it appeared too complex and didactic
* Arousing expectations which it may be impossible to fulfil. The fifteen-fold
increase of house prices in England between 197 5 and 2006 has put home
ownership out of reach for nearly all those first-time buyers who cannot get
financial assistance from their parents.
23 0
to have mass appeal. Indeed, its early adopters included a couple
of eccentric university professors, Scott Nearing at Wharton and
Guy Tugwell at Columbia, who modified it for classroom use. It
was an unemployed plumbing engineer named Charles Darrow
who saw the game's commercial potential after he was introduced
by friends to a version based on the streets of Atlantic City, the
Ne w Jersey seaside resort. Darrow redesigned the board so that
each property square had a brightly coloured band across it and
hand-carved the little houses and hotels that players could 'build'
on the squares they acquired. Darrow was good with his hands
(he could turn out a single game in eight hours), but he also had
the salesman's 'moxie', persuading the Philadelphia department
store John Wanamaker and the toy retailer F. A . O. Schwartz to
buy his game for the 193 4 Christmas season. Soon he was selling
more than he could make by himself. In 193 5 the board-games
company Parker Brothers (which had passed on the earlier Land­
lord's Game) bought him out.1
The Great Depression might have seemed an unpropitious time
to launch what had by now mutated into a game for would-be
property owners. But perhaps all that fake multicoloured money
was part of Monopoly's appeal. 'As the name of the game sug­
gests,' announced Parker Brothers in April 1935 :
the players deal in real estate, railroads and public utilities in an
endeavor to obtain a monopoly on a piece of property so as to obtain
rent from the other players. Excitement runs high when such familiar
problems are encountered as mortgages, taxes, a Community Chest,
options, rentals, interest money, undeveloped real estate, hotels, apart­
ment houses, power companies and other transactions, for which scrip
money is supplied.2
The game was a phenomenal success. By the end of 193 5 a
quarter of a million sets had been sold. Within four years, versions
23 1
had been created in Britain (where Waddington's created the
London version that I first played), France, Germany, Italy and
Austria - though fascist governments were at best ambivalent
about its now unapologetically capitalist character.3 By the time
of the Second World War, the game was so ubiquitous that British
intelligence could use Monopoly boards supplied by the Red
Cross to smuggle escape kits - including maps and genuine Euro­
pean currencies - to British prisoners of war in German camps.4
Unemployed Americans and captive Britons enjoyed Monopoly
for the same reason. In real life, times may be hard, but when we
play Monopoly we can dream of buying whole streets. What the
game tells us, in complete contradiction to its original inventor's
intention, is that it's smart to own property. The more you own,
the more money you make. In the English-speaking world par­
ticularly, it has become a truth universally acknowledged that
nothing beats bricks and mortar as an investment.
'Safe as houses': the phrase tells you all you need to know
about why people all over the world yearn to own their own
homes. But that phrase means something more precise in the
world of finance. It means that there is nothing safer than lending
money to people with property. Why? Because if they default on
the loan, you can repossess the house. Even if they run away, the
house can't. As the Germans say, land and buildings are 'immo­
bile' property. So it is no coincidence that the single most impor­
tant source of funds for a new business in the United States is a
mortgage on the entrepreneur's house. Correspondingly, financial
institutions have become ever less inhibited about lending money
to people who want to buy property. Since 1959 , the total mort­
gage debt outstanding in the US has risen seventy-five fold.
Altogether, American owner-occupiers owed a sum equivalent to
99 per cent of US gross domestic product by the end of 2006,
compared with just 38 per cent fifty years before. This upsurge
23 2
in borrowing helped to finance a boom in residential investment,
which reached a fifty-year peak in 2005 . For a time, the supply
of new housing seemed unable to keep pace with accelerating
demand. About half of all the growth in US GD P in the first half
of 2005 wa s housing related.
The English-speaking world's passion for property has also
been the foundation for a political experiment: the creation of
the world's first true property-owning democracies, with between
65 and 83 per cent of households owning the home they live in.*
A majority of voters, in other words, are also property owners.
Some say this is a model the whole world should adopt. Indeed,
in recent years it has been spreading fast, with house price booms
not only in the 'Anglosphere' (Australia, Canada, Ireland, the
United Kingdom and the United States), but also in China, France,
India, Italy, Russia, South Korea and Spain. In 2006 nominal
house price inflation exceeded 1 0 per cent in eight out of eighteen
countries in the Organization for Economic Cooperation and
Development. The United States did not in fact experience an
exceptional housing bubble between 2000 and 2007 ; prices rose
further in the Netherlands and Norway. 5
But is property really as safe as houses? Or is the real estate
game more like a house of cards?
* Ireland leads the field with 83 per cent of households owning their own
homes, followed by Australia and the United Kingdom (both 69 per cent),
Canada (67 per cent) and the United States (65 per cent). The figure for Japan
is 60 per cent, for France 54 per cent and for Germany 43 per cent. Note,
however, that these figures are for 2000. Since then, the figure for the United
States has risen to above 68 per cent. Note also the regional variation:
Midwesterners and Southerners are significantly more likely to own their
own homes (72 per cent do) than people living in the West and the Northeast.
Housing is more affordable in the Midwest and South. 78 per cent of West
Virginians own their own homes; just 46 per cent of New Yorkers do.
23 3
The Property-owning Aristocracy
Home ownership is now the exception only in the poorest parts
of Britain and the United States, like the East End of Glasgow or
the East Side of Detroit. For most of history, however, it was the
exclusive privilege of an aristocratic elite. Estates were passed
down from father to son, along with honorific titles and political
privileges. Everyone else was a mere tenant, paying rent to their
landlord. Even the right to vote in elections was originally a
function of property ownership. In rural England before 1832 ,
according to statutes passed in the fifteenth century, only men
who owned freehold property worth at least forty shillings a year
in a particular county were entitled to vote there. That meant, at
most, 435,00 0 people in England and Wales - the majority of
whom were bound to the wealthiest landowners by an intricate
web of patronage. Of the 51 4 Members of Parliament rep­
resenting England and Wales in the House of Commons in the
early 1800s , about 37 0 were selected by nearly 18 0 land-owning
patrons. Mor e than a fifth of MP s were the sons of peers.
In one respect, not much has changed in Britain since those
days. Around forty million acres out of sixty million are owned
by just 189,00 0 families.6 The Duke of Westminster remains the
third-richest man in the UK , with estimated assets of £ 7 billion;
also in the top fifty of the 'rich list' are Earl Cadogan (£2.6 billion)
and Baroness Howard de Walden (£1. 6 billion). The difference
is that the aristocracy no longer monopolizes the political system.
The last aristocrat to serve as Prime Minister was Alec Douglas-Home, the 14t h Earl of Home, who left office in 196 4 (defeated by,
as he put it, 'the 14t h M r Wilson'). Indeed, thanks to the reform of
the House of Lords, the hereditary peerage is in the process of
finally being phased out of the British parliamentary system.
23 4
The decline of the aristocracy as a political force has been
explained in many ways. At its heart, however, was finance. Until
the 183o s fortune smiled on the elite, the thirty or so families
with gross annual income from their lands above £60,000 a year.
Land values had soared during the Napoleonic Wars, as the
combination of demographic pressure and wartime inflation
caused the price of wheat to double. Thereafter, industrialization
brought windfalls to those who happened to be sitting on coal­
fields or urban real estate, while the aristocratic dominance of
the political system ensured a steady stream of remuneration
from the public purse. As if that were not enough, the great
magnates took full advantage of their ability to borrow to the
hilt. Some did so to 'improve' their estates, draining fields and
enclosing common land. Others borrowed to finance a lifestyle
of conspicuous consumption. The Dukes of Devonshire, for
example, spent between 40 and 5 5 per cent of their annual income
on interest payments, so enormous were their borrowings during
the nineteenth century. 'All that you want,' complained one of
their solicitors, 'is the power of self-restraint.'7
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 inves­
tors - local solicitors, private banks and insurance companies -were attracted to mortgages as a seemingly risk-free investment.
* 'Life is always uncertain, Miss Demolines.'
'You're quizzing now, I know. But don't you feel now, really, that City
money is always very chancy? It comes and goes so quick.'
'As regards the going, I think that's the same with all money,' said Johnny.
'Not with land, or the funds. Mamma has every shilling laid out in a
first-class mortgage on land at four per cent. That does make one feel so
secure! The land can't run away.' (Ch. 25)
23 5
23 6
By contrast, the borrower's sole security against the loss of his
property to such creditors is his income. Unfortunately for the great
landowners of Victorian Britain, that suddenly fell away. From the
late 1840 s onwards, the combination of increasing grain pro­
duction around the world, plummeting transport costs and falling
tariff barriers - exemplified by the repeal of the Corn Laws in 184 6
- eroded the economic position of landowners. As grain prices slid
from a peak of $ 3 a bushel in 184 7 to a nadir of 50 cents in 1894 ,
so did the income from agricultural land. Rates of return on rural
property slumped from 3.65 per cent in 184 5 t o J us t 2 -5 I P e r cen t
in 1885. 8 As The Economist put it: 'N o security was ever relied
upon with more implicit faith, and few have lately been found
more sadly wanting than English land.' For those with estates in
Ireland, the problem was compounded by mounting political
unrest. This economic decline and fall was exemplified by the for­
tunes of the family that built Stowe House, in Buckinghamshire.
There is something undeniably magnificent about Stowe
House. With its sweeping colonnades, its impressive Vanbrugh
portico and its delightful 'Capability' Brown gardens, it is one
of the finest surviving examples of eighteenth-century aristocratic
architecture. Yet there is something missing from Stowe today -or rather many things. In each of the alcoves of the elliptical
Marble Saloon, there was once a Romanesque statue. The splen­
did Georgian fireplaces in the State Rooms have been replaced
by cheap and diminutive Victorian substitutes. Rooms that
were once crammed full of the finest furniture now lie empty.
Why? The answer is that this house once belonged to the most
distinguished victim of the first modern property crash, Richard
Plantagenet Temple-Nugent-Brydges-Chandos-Grenville, 6th
Viscount Cobham and 2nd Duke of Buckingham.
Stowe was only part of the vast empire of real estate acquired
by the Duke of Buckingham and his ancestors, who had propelled
Stowe House: aristocratic grandeur, mortgaged to the hilt
themselves from a barony to a dukedom in the space of 125 years
by a combination of political patronage and strategic marriage. 9
In all, the Duke owned around 67,000 acres in England, Ireland
and Jamaica. It seemed a more than adequate basis for his ex-travagant lifestyle. He spent money as if it might go out of
fashion: on mistresses, on illegitimate children, on suing his
father-in-Iaw's executors, on buying his way into the Order of
the Garter, on opposing the Great Reform Bill and the Repeal of
the Corn Laws - on anything he felt was compatible with his
standing as a duke of the realm and the living embodiment of
The Land. He prided himself on 'resisting any measure injurious
to the agricultural interests, no matter by what Government it
should be brought forward'. Indeed, he resigned as Lord Privy
Seal in Sir Robert Peel's government rather than support Corn
Law Repea1. 1o By 1845, however - even before the mid-century
slump in grain prices, in other words - his debts were close to
overwhelming him. With a gross annual income of £72,000 , he
was spending £109,14 0 a year and had accumulated debts of
£1,027,282. 1 1 Most of his income was absorbed by interest pay­
ments (with rates on some of his debts as high as 1 5 per cent)
and life insurance premiums on a policy that was probably his
creditors' best hope of seeing their money.1 2 Yet there was to be
one final folly.
In preparation for a much-sought-after visit by Queen Victoria
and Prince Albert in January 1845, tn e Duke refurbished Stowe
House from top to bottom. The entire house was filled with the
very latest in luxury furniture. There were even tiger skins in the
royal bathroom. Queen Victoria remarked waspishly: T have no
such splendour in either of my two palaces.' As if that were not
enough, the Duke called out the entire Regiment of Yeomanry
(at his own expense) to fire welcoming salvoes of artillery as the
Queen and her Consort entered his estate. Four hundred tenants
lined up on horseback to greet them, as well as several hundred
smartly dressed labourers, three brass bands and a special detach­
ment of police brought down from London for the day.1 3 It was
the last straw for the ducal finances. T o avert the complete ruin
of the family, Buckingham's son, the Marquis of Chandos, was
advised to take control of his father's estates as soon as he came
of age. After painful legal wrangles, the son won the upper hand.1 4
In August 1848 , to the Duke's horror, the entire contents of
Stowe House were auctioned off. No w his ancestral stately home
was thrown open for throngs of bargain hunters to bid for the
plate, the wine, the china, the works of art and the rare books,
for all the world (as The Economist sneered) as if the Duke were
'a bankrupt earthenware dealer'.1 5 The total proceeds from the
sale were £75,000 . Nothing could better have symbolized the
new age of aristocratic decline.
TO P LEFT: Richard Grenville,
Ist Duke of Buckingham
TOP RIGHT: Richard Grenville,
2nd Duke of Buckingham
BOTTOM LEFT: Richard Grenville,
3 rd Duke of Buckingham
Divorced by his long-suffering, much-betrayed Scottish wife,
whose entire wardrobe had been seized by sheriff's officers in
London, the Duke was forced to move out of Stowe House into
rented lodgings. He eked out his days at his London club, the
Carlton, writing a succession of highly unreliable memoirs and
incorrigibly chasing actresses and other men's wives. Accustomed
to what had once seemed a limitless overdraft facility, he bitterly
grumbled that his son allowed him 'scarcely the pay of an officer
upon full pay of my own rank who has nothing beyond his own
expenses to pay for': 1 6
In the hour of distress [he] forced his Father into the world, neglected,
forsaken & persecuted . . . Having got possession of his estates &
property, [he] held them to his detriment & loss, & against every
principle of honour and justice, & .. . lived to witness his Father's
dishonour and degradation.1 7
'Yo u find me poisoned and robbed,' he lamented to anyone at
the Carlton who would listen.1 8 When the Duke finally expired
in 186 1 he was living at his son's expense in the Great Western
Hotel at Paddington railway station. Symbolically, his more par­
simonious son was by now chairman of the London and North­
western Railway Company. 1 9 In the modern world, it turned out,
a regular job mattered more than an inherited title, no matter
how many acres you owned.
The fall of the Duke of Buckingham was a harbinger of a new,
democratic age. Electoral reform acts in 1832 , 186 7 and 188 4
eroded what remained of the aristocratic stranglehold on British
politics. By the end of the nineteenth century, paying £1 0 a year
in rent qualified you to vote just as legitimately as earning £1 0 a
year from property. The electorate now numbered 5.5 million -40 per cent of adult males. In 191 8 that last economic qualifica­
tion was finally removed and after 192 8 all adults, male and
female, had the vote. Yet the advent of universal suffrage did not
mean that property ownership had become universal. On the
contrary: as late as 1938 , less than a third of the U K housing
stock was in the hands of owner-occupiers. It was on the other
side of the Atlantic that the first true property-owning democracy
would emerge. And it would come out of the deepest financial
crisis ever known.
Home-owning Democracy
An Englishman's home is his castle, or so the saying goes. Ameri­
cans, too, know that (as Dorothy says in The Wizard of Oz)
there's no place like home - even if the homes do all look rather
similar. But the origins of the Anglo-American model of the
highly geared home-owning family lie as much in the realm of
government policy as in the realm of culture. If the old class
system based on elite property ownership was distinctively
British, the property-owning democracy was made in America.
Before the 1930s , little more than two fifths of American house­
holds were owner-occupiers. Unless you were a farmer, mort­
gages 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,
especially if the main breadwinner was among the millions who
lost their jobs and their incomes. Mortgages were short-term,
usually for three to five years, and they were not amortized. In
other words, people paid interest, but did not repay the sum they
had borrowed (the principal) until the end of the loan's term, so
that they ended up facing a balloon-sized final payment. The
average difference (spread) between mortgage rates and high-grade corporate bond yields was about two percentage points
24 1
during the 1920s , compared with about half a per cent (50 basis
points) in the past twenty years. There were substantial regional
variations in mortgage rates, too. 2 0 When the economy nose­
dived, nervous lenders simply refused to renew. In 193 2 and 193 3
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.2 1 The construction indus­
try collapsed, revealing (as in all future recessions of the twentieth
century) the extent to which the wider US economy relied on
residential investment as an engine of growth.2 2 While the effect of
the Depression was perhaps most devastating in the countryside,
where land prices fell below half of their 192 0 peak, the predica­
ment of America's cities was little better. Tenants, too, struggled
to pay the rent when all they had coming in was the dole. In
Detroit, for example, the automobile industry employed only half
the number of workers it had in 1929 , and at half the wages. The
effects of the Depression are scarcely imaginable today: the abject
misery of ubiquitous unemployment, the wretchedness of the
soup kitchens, the desperate nomadic search for non-existent
work. By 193 2 the dispossessed of the Depression had had
On 7 March 193 2 five thousand unemployed workers laid off
by the Ford Motor Company marched through central Detroit
to demand relief. As the unarmed crowd reached Gate 4 of the
company's River Rouge plant in Dearborn, scuffles broke out.
Suddenly the factory gates opened and a group of armed police
and security men rushed out and fired into the crowd. Five
workers were killed. Days later, 60,000 people sang Th e Inter­
nationale' at their funeral. The Communist Party newspaper
accused Edsel Ford, son of the firm's founder Henry, of allowing
a massacre: 'You , a patron of the arts, a pillar of the Episcopal
Church, stood on the bridge at the Rouge Plant and saw the
24 2
workers killed. Yo u did not lift a hand to stop it.' Could anything
be done to defuse what was beginning to seem like a revolutionary
In a remarkable gesture of conciliation, Edsel Ford turned to
the Mexican artist Diego Rivera, who had been invited by the
Detroit Institute of Arts to paint a mural that would show
Detroit's economy as a place of cooperation, not class conflict.
The site chosen for the work was the Institute's imposing Garden
Court, a space which so appealed to Rivera that he proposed to
paint not just two of its panels, as had originally been suggested,
but all twenty-seven. Ford, impressed by Rivera's preliminary
sketches, agreed to fund the entire scheme, at a cost of around
$25,000 . Work began in Ma y 1932 , just two months after the
clashes at the River Rouge plant, and by March 193 3 Rivera had
finished. As Ford well knew, Rivera was a Communist (though an
unorthodox Trotskyite who had been expelled from the Mexican
Party).2 3 His ideal was of a society in which there would be no
private property; in which the means of production would be
commonly owned. In Rivera's eyes, Ford's River Rouge plant
was the very opposite: a capitalist society where the workers
worked and the property owners, who reaped the rewards from
their efforts, just stood and watched. Rivera also sought to
explore the racial divisions that were such a striking feature of
Detroit, anthropomorphizing the elements necessary to make
steel. As he himself explained the allegory:
The yellow race represents the sand, because it is most numerous.
And the red race, the first in this country, is like the iron ore, the first
thing necessary for the steel. The black race is like coal, because it has
a great native aesthetic sense, a real flame of feeling and beauty in its
ancient sculpture, its native rhythm and music. So its aesthetic sense
is like the fire, and its labor furnished the hardness which the carbon
Hunger march in Detroit, March 1932
Police use tear gas against the hunger marchers
'Smash Ford-Murphy Police Terror': protest following the deaths
of five demonstrators
in the coal gives to steel. The white race is like the lime, not only
because it is white, but because lime is the organizing agent in the
making of steel. It binds together the other elements and so you see
the white race as the great organizer of the world.
When the murals were unveiled in 1933, the city's dignitaries
were appalled. In the words of Dr George H. Derry, president of
Marygrove College:
Senor Rivera has perpetrated a heartless hoax on his capitalist
employer, Edsel Ford. Rivera was engaged to interpret Detroit; he has
foisted on Mr Ford and the museum a Communist manifesto. The
key panel that first strikes the eye, when you enter the room, betrays
the Communist motif that animates and alone explains the whole
ensemble. Will the women of Detroit feel flattered when they realize
that they are embodied in the female with the hard, masculine, unsexed
face, ecstatically staring for hope and help across the panel to the
languorous and grossly sensual Asiatic sister on the right?2 4
One city councillor argued that whitewash was too good for
the murals, as it could still be removed in future. He wanted
Rivera's work to be completely stripped off as 'a travesty on the
spirit of Detroit'. That was more or less what happened to
Rivera's next commission - to decorate the walls of Ne w York's
Rockefeller Center for Joh n D . Rockefeller Jr . - after the artist
insisted on including a portrait of Lenin as well as Communist
slogans like 'Dow n With Imperialistic Wars!', 'Workers Unite!'
and, most shocking of all, 'Free Money!' These were to be carried
by demonstrators marching down Wall Street itself. A scandalized
Rockefeller ordered the mural to be destroyed.
The power of art is a wonderful thing. But clearly something
more powerful than art was going to be needed to put together a
society that had been split in two by the Depression. Many other
countries swung to the extremes of totalitarianism. But in the
United States the answer was the Ne w Deal. Franklin D. Roose­
velt's first administration saw a proliferation of new federal
government agencies and initiatives intended to re-inject confi­
dence into the prostrate US economy. In the flood of acronyms
the Ne w Deal produced, it is easy to miss the fact that its most
successful and enduring component was the new deal it offered
with respect to housing. By radically increasing the opportunity
for Americans to own their own homes, the Roosevelt adminis­
tration pioneered the idea of a property-owning democracy. It
proved to be the perfect antidote to red revolution.
At one level, the Ne w Deal was an attempt by government to
step in where the market had failed. Some Ne w Dealers favoured
the increased provision of public housing, the model that was
adopted in most European countries. Indeed, the Public Works
Administration spent nearly 1 5 per cent of its budget on low-cost
homes and slum clearance. But of far more importance was the
Roosevelt administration's lifeline to the rapidly sinking mort­
gage market. A new Home Owners' Loan Corporation stepped
in to refinance mortgages on longer terms, up to fifteen years. A
Federal Home Loan Bank Board had already been set up in
193 2 to encourage and oversee local mortgage lenders known as
Savings and Loans (or thrifts), mutual associations like British
building societies, which took in deposits and lent to home
buyers. T o reassure depositors, who had been traumatized by the
bank failures of the previous three years, Roosevelt introduced
federal deposit insurance. The idea was that putting money in
mortgages would be even safer than houses, because if borrowers
defaulted, the government would simply compensate the savers.2 5
In theory, there could never be another run on a Savings and
Loan like the run on the family-owned Bailey Building & Loan
which George Bailey (played by Jimmy Stewart) struggled to keep
afloat in Frank Capra's classic 194 6 movie If s a Wonderful Life.
'You know, George,' his father tells him, 'I feel that in a small
way we are doing something important. Satisfying a fundamental
urge. It's deep in the race for a man to want his own roof and
walls and fireplace, and we're helping him get those things in our
shabby little office.' George gets the message, as he passionately
explains to the villainous slum landlord Potter after Bailey
senior's death:
[My father] never once thought of himself . . . But he did help a few
people get out of your slums, Mr Potter. And what's wrong with that?
Doesn't it make them better citizens? Doesn't it make them better
customers? . . . You said .. . they had to wait and save their money
before they even ought to think of a decent home. Wait! Wait for
what? Until their children grow up and leave them? Until they're so
It'5 a Wonderful Life: Frank Capra's celebration of the virtues of
the local 'thrift' or Savings and Loan, with Jimmy Stewart as the
lovable mortgage lender
old and broken-down that they ... Do you know how long it takes a
working man to save five thousand dollars? Just remember this, Mr
Potter, that this rabble you're talking about ... they do most of the
working and paying and living and dying in this community. Well, is
it too much to have them work and pay and live and die in a couple
of decent rooms and a bath?
This radical affirmation of the virtue of home ownership was
new. But it was the Federal Housing Administration that really
made the difference for American homebuyers. By providing fed-erally backed insurance for mortgage lenders, the FHA sought
to encourage large (up to 80 per cent of the purchase price), long
(twenty-year), fully amortized and low-interest loans. This did
more than merely revive the mortgage market; it reinvented it.
By standardizing the long-term mortgage and creating a national
system of official inspection and valuation, the FH A laid the
foundation for a national secondary market. This market came
to life in 1938 , when a new Federal National Mortgage Associ­
ation - nicknamed Fannie Ma e - was authorized to issue bonds
and use the proceeds to buy mortgages from the local Savings
and Loans, which were now restricted by regulation both in terms
of geography (they could not lend to borrowers more than fifty
miles from their offices) and in terms of the rates they could offer
depositors (the so-called Regulation Q, which imposed a low
ceiling). Because these changes tended to reduce the average
monthly payment on a mortgage, the FH A made home ownership
viable for many more Americans than ever before. Indeed, it is
not too much to say that the modern United States, with its
seductively samey suburbs, was born here.
From the 1930 s onwards, then, the US government was effec­
tively underwriting the mortgage market, encouraging lenders
and borrowers to get together. That was what caused property
ownership - and mortgage debt - to soar after the Second World
War, driving up the home ownership rate from 40 per cent to 60
per cent by i960 . There was only one catch. No t everyone in
American society was entitled to join the property-owning party.
In 194 1 a real estate developer built a six-foot high wall right
across Detroit's 8 Mile district. He had to build it to qualify for
subsidized loans from the Federal Housing Administration. The
loans were to be given out for construction only on the side of the
wall where the residents were mainly white. In the predominantly
black part of town, there was to be no federal lending, because
African-Americans were regarded as uncreditworthy.2 6 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
25 0
not accidental, but a direct consequence of government policy.
Federal Home Loan Bank Board maps showed the predominantly
black areas of Detroit - 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.2 7 As a
result, when people in D areas wanted to take out mortgages,
they paid significantly higher interest rates than the people from
areas A to C. In the 1950s , one in five black mortgage-borrowers
paid 8 per cent or more, whereas virtually no whites paid more
than 7 per cent.2 8 This was the hidden financial dimension of the
Civil Rights struggle.
Detroit was home to successful black entrepreneurs like Berry
Gordy, the founder of the Motow n record label, which appropri­
ately enough had its very first hit in i96 0 with Barrett Strong's
'Money, That's What I Want'. Other Motow n stars like Aretha
Franklin and Marvin Gaye still lived in the city. Yet throughout
the 1960 s the prejudice persisted that black neighbourhoods were
a bad credit risk. Anger at such economic discrimination lay
behind the riots that broke out in Detroit's 12t h Street on 23 July
1967 . In five days of mayhem after a police raid on a 'blind pig'
(an unlicensed bar), forty-three people were killed, 467 injured,
over 7,200 arrested and nearly 3,000 buildings looted or burned
- a potent symbol of black rejection of a property-owning democ­
racy that still treated them as second-class citizens.2 9 Even today,
you can still see the empty lots that the riots left in their wake. It
took regular army troops with tanks and machine-guns to quell
what was officially recognized as an insurrection.
As in the 1930s , the challenge of violence brought a political
response. In the wake of the Civil Rights legislation of the 1960s ,
new steps were taken to broaden access to home ownership. In
196 8 Fannie Ma e 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. Tw o years later, to provide some compe­
tition in the secondary market, the Federal Home Loan Mortgage
Corporation (Freddie Mac) was set up. The effect was once again
to broaden the secondary market for mortgages, and in theory at
least to lower mortgage rates. Red-lining on the basis of racial
discrimination did not cease overnight, needless to say; but it
became a federal offence.3 0 Indeed, with the Community
Reinvestment Act of 1977 , American banks came under statutory
pressure to lend to poorer minority communities. With the US
housing market now underwritten by what sounded like a finan­
cial version of the Mamas and the Papas - Fannie, Ginnie and
Freddie - the political winds were set fair for the property-owning
democracy. Those who ran Savings and Loans could live by the
comfortable 3-6-3 rule: pay 3 per cent on deposits, lend money at
6 per cent and be on the golf course by 3 o'clock every afternoon.
The rate of home ownership caught up more slowly with the
representation of the people on the other side of the Atlantic. In
post-war Britain the conventional wisdom among Conservative
as well as Labour politicians was that the state should provide or
at least subsidize housing for the working classes. Indeed, Harold
Macmillan sought to out-build Labour with a target of 300,000
(later 400,000) new houses a year. Between 195 9 and 1964 ,
roughly a third of new houses in Britain were built by local
councils, rising to half in the subsequent six years of Labour rule.
The ugly and socially dysfunctional tower blocks and housing
'estates' that today blight most of Britain's cities can be blamed
25 1
on both parties. The only real difference between Right and Left
was the readiness of the Conservatives to deregulate the private
rental market, in the hope of encouraging private landlords, and
the equal and opposite resolve of Labour to reimpose rent con­
trols and stamp out 'Rachmanism' (exploitative behaviour by
landlords), exemplified by Peter Rachman, who used intimidation
to evict the sitting tenants of rent-controlled properties, replacing
them with West Indian immigrants who had to pay market
rents.3 1 As late as 1971 , fewer than half of British homes were
In the United States, where public housing was never so impor­
tant, mortgage interest payments were always tax deductible,
from the inception of the federal income tax in 1913. 3 2 As Ronald
Reagan said when the rationality of this tax break was challenged,
mortgage interest relief was 'part of the American dream'.* It
played a much smaller role in Britain until 1983 , when a more
radically Conservative government led by Margaret Thatcher
introduced Mortgage Interest Relief At Source (MIRAS ) for the
first £30,00 0 of a qualifying mortgage. When her Chancellor of
the Exchequer Nigel Lawson sought to limit the deduction (so
that multiple borrowers could not all take advantage of it for
a single property), he soon 'ran up against the brick wall of
Margaret [Thatcher]'s passionate devotion to the preservation of
every last ounce of mortgage interest relief'.3 3 No r was MIRA S
the only way that Thatcher sought to encourage home ownership.
By selling off council houses at bargain-basement prices to a
million and a half aspirant working-class families, she ensured
that more and more British men and women had a home of their
own. The result was a leap in the share of owner-occupiers from
* Today, around 37 million American individuals and couples claim the
deduction on mortgages of up to $1,000,000, at a cost of $76 billion to the
US Treasury.
25 2
54 per cent in 1 9 8 1 to 67 per cent ten years later. The stock of
owner-occupied properties has soared from just over 1 1 million
in 198 0 to more than 1 7 million today.3 4
Up until the 1980s , government incentives to borrow and buy
a house made a good deal of sense for ordinary households.
Indeed, the tendency for inflation rates to rise above interest rates
in the late 1960 s and 1970 s gave debtors a free lunch as the
real value of their debts and interest payments declined. While
American home purchasers in the mid seventies anticipated an
inflation rate of at least 1 2 per cent by 1980 , mortgage lenders
were offering thirty-year fixed-rate loans at 9 per cent or less.3 5
For a time, lenders were effectively paying people to borrow
their money. Meanwhile, property prices roughly trebled between
196 3 and 1979 , while consumer prices rose by a factor of just
2.5 . But there was a sting in the tail. The same governments
that avowed their faith in the 'property-owning democracy' also
turned out to believe in price stability, or at least lower inflation.
Achieving that meant higher interest rates. The unintended conse­
quence was one of the most spectacular booms and busts in the
history of the property market.
From S&L to Subprime
Take a drive along Interstate 3 0 from Dallas, Texas, and you
cannot fail to notice mile after mile of half-built houses and
condominiums. Their existence is one of the last visible traces of
one of the biggest financial scandals in American history, a scam
that made a mockery of the whole idea of property as a safe
investment. What follows is a story not so much about real estate
as about surreal estate.
Savings and Loan (S&L ) associations - the American version
25 3
of Britain's building societies - were the foundation on which
America's property-owning democracy had come to rest. Owned
mutually by their depositors, they were simultaneously protected
and constrained by a framework of government regulation.3 6
Deposits of up to $40,00 0 were insured by government for a
premium of just one twelfth of one per cent of total deposits. On
the other hand, they could lend only to home buyers within fifty
miles of their main office. And from 1966 , under Regulation Q,
there was a ceiling of 5.5 per cent on their deposit rates, a quarter
of a per cent more than banks were allowed to pay. In the late
1970s , this sleepy sector was hit first by double-digit inflation -which reached 13. 3 per cent in 197 9 - and then by sharply rising
interest rates as the newly appointed Federal Reserve Chairman
Paul Volcker sought to break the wage-price spiral by slowing
monetary growth. This double punch was lethal. The S&L s were
simultaneously losing money on long-term fixed-rate mortgages,
because of inflation, and haemorrhaging 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.3 7 When the new
legislation was passed, President Reagan declared: 'All in all, I
think we hit the jackpot.'3 8 Some people certainly did.
On the one hand, S&L s could now invest in whatever they
liked, not just long-term mortgages. Commercial property,
stocks, junk bonds: anything was allowed. They could even issue
credit cards. On the other, they could now pay whatever interest
rate they liked to depositors. Yet all their deposits were still
effectively insured, with the maximum covered amount raised
* The crucial legislation was the Depository Institutions Deregulation and
Monetary Control Act of 1980 and the Garn-St Germain Depository Insti­
tutions Act of 1982 .
from $40,000 to $100,000 . And, if ordinary deposits did not
suffice, the S&L s could raise money in the form of brokered
deposits from middlemen, who packaged and sold 'jumbo'
$100,00 0 certificates of deposit.3 9 Suddenly the people running
Savings and Loans had nothing to lose - a clear case of what
economists call moral hazard.4 0 What happened next perfectly
illustrated the great financial precept first enunciated by William
Crawford, the Commissioner of the California Department of
Savings and Loans: 'The best way to rob a bank is to own
one.'4 1 Some S&L s bet their depositors' money on highly dubious
projects. Many simply stole it, as if deregulation meant that the
law no longer applied to them. Nowhere were these practices
more rife than in Texas.
When they weren't whooping it up at their Southfork-style
ranches, the Dallas property cowboys liked to do their deals at
the Wise Circle Grill. 4 2 Regulars for Sunday brunch included Don
Dixon, whose Vernon S& L was nicknamed Vermin by regu­
lators,4 3 Ed McBirney of Sunbelt ('Gunbelt') and Tyrell Barker,
owner and CE O of State Savings and Loan, who liked to tell
property developers: 'Yo u bring the dirt, I bring the money.'4 4
One individual who brought both dirt and money was Mari o
Renda, a Ne w York broker for the Teamsters Union who alleg­
edly used Savings and Loans to launder Mafia funds. When he
needed more cash, he even advertised in the New York Times:
If you want to build a property empire, why not just say so?
For one group of Dallas developers, it was Empire Savings and
Loan that offered the perfect opportunity to make a fortune out
of thin air - or, rather, flat Texan earth. The surrealism began
when Empire chairman Spencer H . Blain Jr . teamed up with
James Toler, the mayor of the town of Garland, and a flamboyant
high school dropout turned property developer named Danny
Faulkner, whose speciality was extravagant generosity with other
people's money. The money in question came in the form of
brokered deposits, on which Empire paid alluringly high interest
rates. Faulkner's Point, located near the bleak artificial lake
known as Lake Ra y Hubbard, twenty miles east of Dallas, was
the first outpost of a property empire that would later encompass
Faulkner Circle, Faulkner Creek, Faulkner Oaks - even Faulkner
Fountains. Faulkner's favourite trick was 'the flip', whereby he
would acquire a plot of land for peanuts, and then sell it on at
vastly inflated prices to investors, who borrowed the money from
Empire Savings and Loan. One parcel of land was bought by
Faulkner for $ 3 million and sold just a few days later for $4 7
million. Danny Faulkner claimed to be illiterate. He was certainly
not innumerate.
By 198 4 development in the Dallas area was out of control.
There were new condos under construction for miles along Inter­
state 30 . The city's skyline had been transformed with what locals
referred to as 'see-through' office buildings - see-through because
they were still mostly empty. The building just kept on going,
paid for by federally insured deposits that were effectively going
straight into the developers' pockets. On paper at least, the assets
of Empire had grown from $1 2 million to $25 7 million in just
over two years. By January 198 4 they stood at $30 9 million.
Man y investors never even got a chance to view their properties
close up; Faulkner would simply fly them over in his helicopter
without landing. Everyone was making money: Faulkner with his
$ 4 million Lear jet, Toler with his white Rolls-Royce, Blain with
his $4,00 0 Role x - not to mention the property appraisers, the
sports star investors and the local regulators. There were gold
25 6
The master of the real estate 'flip': Danny Faulkner with
his helicopter
bracelets for the men and fur coats for the wives.46 'It was', one
of those involved acknowledged, 'like a money machine, and all
of it was geared to what Danny needed. If Danny needed a new
jet, we did a land deal. If Danny wanted to buy a new farm, we
did another. Danny ran the whole thing for Danny, right down
to the last detail. ,47 The line between thrift and theft is supposed
to be a wide one. Faulkner & Co. reduced it to a hair's breadth.
The trouble was that the demand for condos on Interstate 30
could never possibly have kept pace with the vast supply being
built by Faulkner, Blain and their cronies. By the early 1980s
estate agents were joking that the difference between venereal
disease and condominiums was that you could get rid of YD.
Moreover, the mismatch between the assets and liabilities of most
Savings and Loans had now become disastrous, with ever more
long-term loans being made (to insiders) using money borrowed
short-term (from outsiders). When the regulators belatedly sought
to act in 1984 , these realities could no longer be ignored. On
1 4 March Edwin J . Gray, then chairman of the Federal Home Loan
Bank Board, ordered the closure of Empire. The cost to the Federal
Savings and Loan Insurance Corporation, which was supposed to
insure S& L deposits, was $30 0 million. But this was just the begin­
ning. As other firms came under scrutiny, legislators hesitated, par­
ticularly those wh o had received generous campaign contributions
from S&Ls. * Ye t the longer they waited, the more money got
burned. By 198 6 it was clear that the FSLI C was itself insolvent.
In 1991 , after two trials (the first of which ended with a hung
jury), Faulkner, Blain and Toler were convicted of civil racket­
eering and looting $16 5 million from Empire and other S&L s
through fraudulent land deals. Each was sentenced to twenty
years in jail and ordered to pay millions of dollars in restitution.
One investigator called Empire 'one of the most reckless and
fraudulent land investment schemes' he had ever seen.4 8 Much
the same could be said for the Savings and Loans crisis as a
whole; Edwin Gray called it 'the most widespread, reckless and
fraudulent era in this nation's banking history'. In all, nearly five
hundred S&L s collapsed or were forced to close down; roughly
the same number were merged out of existence under the auspices
of the Resolution Trust Corporation set up by Congress to clear
up the mess. According to one official estimate, nearly half of the
insolvent institutions had seen 'fraud and potentially criminal
* The most notorious case was that of Charles Keating, whose Lincoln
Savings and Loan in Irvine, California, received support from five Senators,
among them John McCain, when it came under pressure from the Federal
Home Loan Bank. McCain had previously accepted political contributions
from Keating but was cleared of acting improperly by the Senate Ethics
conduct by insiders'. By Ma y 1991 , 764 people had been charged
with a variety of offences, of whom 55 0 were convicted and 32 6
sentenced to jail. Fines of $8 million were imposed.4 9 The final
cost of the Savings and Loans crisis between 198 6 and 199 5 was
$15 3 billion (around 3 per cent of GDP) , of which taxpayers had
to pay $12 4 billion, making it the most expensive financial crisis
since the Depression.5 0 Strewn all over Texas are the archaeolog­
ical remains of the debacle: derelict housing estates, built on the
cheap with stolen money, and subsequently bulldozed or burned
down. Twenty-four years later, much of the I-30 corridor is still
just another Texan wasteland.
For American taxpayers, the Savings and Loans debacle was a
hugely expensive lesson in the perils of ill-considered deregu­
lation. But even as the S&L s were going belly up, they offered
another very different group of Americans a fast track to mega-bucks. T o the bond traders at Salomon Brothers, the Ne w Yor k
investment bank, the breakdown of the Ne w Deal mortgage
system was not a crisis but a wonderful opportunity. As profit-hungry as their language was profane, the self-styled 'Big Swing­
ing Dicks' at Salomon saw a way of exploiting the gyrating
interest rates of the early 1980s . It was the chief mortgage trader
Lewis Ranieri at Salomon who stepped up when desperate
Savings and Loans began to sell their mortgages in a vain bid to
stay solvent. Needless to say, 'Lou ' bought them up at rock-bottom prices. With his broad girth, cheap shirts and Brooklyn
wisecracks, Ranieri (who had started working for Salomon in
the mailroom) personified the new Wall Street, the antithesis
of the preppie investment bankers in their Brooks Brothers
suits and braces. The idea was to reinvent mortgages by bund­
ling 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) happened in June 1983. 5 1 It was the dawn of a new
era in American finance.
The process was called securitization and it was an innovation
that fundamentally transformed Wall Street, blowing the dust off
a previously sleepy bond market and ushering in a new era in
which anonymous transactions would count for more than per­
sonal relationships. Once again, however, it was the federal
government that stood ready to pick up the tab in a crisis. For
the majority of mortgages continued to enjoy an implicit guaran­
tee from the government-sponsored trio of Fannie, Freddie or
Ginnie, meaning that bonds which used those mortgages as col­
lateral could be represented as virtually government bonds, and
hence 'investment grade'. Between 198 0 and 2007 the volume of
such GSE-backe d mortgage-backed securities grew from $20 0
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 GS E guarantees. By 2007 pri­
vate pools of capital sufficed to securitize $ 2 trillion in residential
mortgage debt.5 2 In 198 0 only 1 0 per cent of the home mortgage
market had been securitized; by 2007 it had risen to 56 per cent.*
It was not only human vanities that ended up on the bonfire
* At the end of 2006 the GSEs held the largest share of mortgages, amounting
to 30 per cent of the total debt outstanding. Commercial banks held 22
per cent; residential mortgage-backed securities (RMBS), CDOs and other
asset-backed securities accounted for 1 4 per cent of the total; savings insti­
tutions for 1 3 per cent; state and local governments for 8 per cent of the
total; and life insurance companies for 6 per cent. Individuals held the rest.
that was 1980 s Wall Street. It was also the last vestiges of the
business model depicted in If s a Wonderful Life. Once there
had been meaningful social ties between mortgage lenders and
borrowers. Jimmy Stewart knew both the depositors and the
debtors. By contrast, in a securitized market (just like in space)
no one can hear you scream - because the interest you pay on
your mortgage is ultimately going to someone who has no idea
you exist. The full implications of this transition for ordinary
homeowners would become apparent only twenty years later.
We tend to assume in the English-speaking world that property
is a one-way bet. The way to get rich is to play the property
market. In fact, you're a mug to invest in anything else. The
remarkable thing about this supposed truth is how often reality
gives it the lie. Suppose you had put $100,00 0 into the US prop­
erty market back in the first quarter of 1987 . According to either
the Office of Federal Housing Enterprise Oversight index or the
Case-Shiller national home price index, you would have roughly
trebled your money by the first quarter of 2007 , t o between
$275,00 0 and $299,000 . But if you had put the same money into
the S& P 500 (the benchmark US stock market index), and had
continued to reinvest the dividend income in that index, you
would have ended up with $772,00 0 to play with, more than
double what you would have made on bricks and mortar. In
the U K the differential is similar. If you had put £100,00 0 into
property in 1987 , according to the Nationwide house price index,
you would have more than quadrupled your money after twenty
years. But if you had put it in the FTS E All Share index you would
be nearly seven times richer. There is, of course, an important
difference between a house and a stock market index: you cannot
live inside a stock market index. (On the other hand, local prop­
erty taxes usually fall on real estate not financial assets.) For the
26 1
sake of a fair comparison, allowance must therefore be made for
the rent you save by owning your house (or the rent you can
collect if you own two properties and let the other out). A simple
way to proceed is simply to strip out both dividends and rents.
In that case the difference is somewhat reduced. In the two
decades after 198 7 the S& P 500, excluding dividends, rose by a
factor of just over five, still comfortably beating housing. The
differential is also narrowed, but again not eliminated, if you add
rental income to the property portfolio and include dividends on
the stock portfolio, since average rental yields in the period
declined from around 5 per cent to just 3.5 per cent at the peak of
the real estate boom (in other words, a typical $100,00 0 property
would have brought in an average monthly rent of less than
$416). 5 3 In the British case, by contrast, stock market capitaliz­
ation has grown less slowly than in the US , while dividends have
been a more important source of income to investors. At the same
time, restrictions on the supply of new housing (such as laws
protecting 'greenbelt' areas) have bolstered rents. T o omit divi­
dends and rents is therefore to remove the advantage of stocks over
property. In terms of pure capital appreciation between 198 7 and
2007 , bricks and mortar (up by a factor of 4.5) out-performed
shares (up by a factor of just 3.3) . Only if one takes the story
back to 197 9 do British stocks beat British bricks.*
There are, however, three other considerations to bear in mind
when trying to compare housing with other forms of capital asset.
* In the long-standing argument I have had with my wife about the unwisdom
of a large-scale leveraged play on the UK property market (her favoured
financial strategy), she therefore emerges as the winner on the assumption
that I would have preferred to live in rented university accommodation and
played the UK stock market. The optimal strategy would of course have been
to own a diversified portfolio of real estate and global stocks, financed with
a moderate amount of leverage.
26 2
US stocks versus real estate, 1987-2007
9 00
800 - S&P/Case-Shiller index level
- S&P 500 (q uarterly ave rage)
March March March March March March March March March March March
1987 1989 1991 1993 1995 1997 1999 J,003 1.005 2.007
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).
Yet that is not to say that house prices have never deviated from
a steady upward path. In Britain between I989 and I995, for
example, the average house price fell by I8 per cent or in real,
inflation-adjusted terms by more than a third (37 per cent). In
London the real decline was closer to 47 per cent. 54 In Japan
between I990 and 2000, property prices fell by over 60 per cent.
And, of course, in the time that I have been writing this book,
property prices in the United States - for the first time in a
generation - have been going down. And down. From its peak in
July 2006, the Case-Shiller 'composite 20' index of home prices
in twenty big American cities had declined I5 per cent by Febru-ary 2008. In that month the annualized rate of decline reached
I3 per cent, a figure not seen since the early I930S. In some cities
- Phoenix, San Diego, Los Angeles and Miami - the total decline
was as much as a fifth or a quarter. Moreover, at the time of
writing (May zoo8), a majority of experts still anticipated further
In depressed Detroit, the housing slide started earlier, in
December 2005 , and had already dragged house prices down
by more than ten per cent when I visited the city in July 2007.
I went to Detroit because I had the feeling that what was hap­
pening there was the shape of things to come in the United States
as a whole and perhaps throughout the English-speaking world.
In the space of ten years, house prices in Detroit - which prob­
ably possesses the worst housing stock of any American city
other than Ne w Orleans - had risen by nearly 50 per cent; not
much compared with the nationwide bubble (which saw average
house prices rise 18 0 per cent), but still hard to explain given
the city's chronically depressed economic state. As I discovered,
the explanation lay in fundamental changes in the rules of
the housing game, changes exemplified by the experience of
Detroit's West Outer Drive, a busy but respectable middle-class
thoroughfare of substantial detached houses with large lawns
and garages. Once the home of Motown's finest, today it is just
another street in a huge sprawling country within a country: the
developing economy within the United States,5 5 otherwise known
as Subprimia.
'Subprime' mortgage loans are aimed by local brokers at
families or neighbourhoods with poor or patchy credit histories.
Just as jumbo mortgages are too big to qualify for Fannie Mae's
seal of approval (and implicit government guarantee), subprime
mortgages are too risky. Ye t it was precisely their riskiness that
made them seem potentially lucrative to lenders. These were not
the old thirty-year fixed-rate mortgages invented in the Ne w
Deal. On the contrary, a high proportion were adjustable-rate
mortgages (ARMs ) - in other words, the interest rate could vary
according to changes in short-term lending rates. Man y were
also interest-only mortgages, without amortization (repayment
of principal), even when the principal represented 10 0 per cent
of the assessed value of the mortgaged property. And most had
introductory 'teaser' periods, whereby the initial interest pay­
ments - usually for the first two years - were kept artificially
low, back-loading the cost of the loan. All of these devices were
intended to allow an immediate reduction in the debt-servicing
costs of the borrower. But the small print of subprime contracts
implied major gains for the lender. One particularly egregious
subprime loan in Detroit carried an interest rate of 9.75 per cent
for the first two years, but after that a margin of 9.12 5 percentage
points over the benchmark short-term rate at which banks lend
each other money: conventionally the London interbank offered
rate (Libor). Even before the subprime crisis struck, that already
stood above 5 per cent, implying a huge upward leap in interest
payments in the third year of the loan.
Subprime lending hit Detroit like an avalanche of Monopoly
money. The city was bombarded with radio, television, direct-mail advertisements and armies of agents and brokers, all offering
what sounded like attractive deals. In 2006 alone, subprime lend­
ers injected more than a billion dollars into twenty-two Detroit
ZI P codes. In the 4823 5 ZI P code, which includes the 510 0
block of West Outer Drive, subprime mortgages accounted for
more than half of all loans made between 200 2 and 2006. Seven
of the twenty-six households on the 510 0 block took out sub-prime loans.5 6 Note that only a minority of these loans were going
to first-time buyers. They were nearly all refinancing deals, which
allowed borrowers to treat their homes as cash machines, con­
verting their existing equity into cash. Most used the proceeds to
pay off credit card debts, carry out renovations or buy new
consumer durables.* Elsewhere, however, the combination of
declining long-term interest rates and ever more alluring mort­
gage deals did attract new buyers into the housing market. By
2005 , 69 per cent of all US households were home-owners, com­
pared with 64 per cent ten years before. Around half of that
increase can be attributed to the subprime lending boom. Signifi­
cantly, a disproportionate number of subprime borrowers
belonged to ethnic minorities. Indeed, I found myself wondering
as I drove around Detroit if subprime was in fact a new financial
euphemism for black. This was no idle supposition. According to
a study by the Massachusetts Affordable Housing Alliance, 5 5 per
cent of black and Latino borrowers in metropolitan Boston who
had obtained loans for single-family homes in 2005 had been
given subprime mortgages, compared with just 1 3 per cent of
white borrowers. More than three quarters of black and Latino
borrowers from Washington Mutual were classed as subprime,
compared with just 1 7 per cent of white borrowers.5 7 According
to the Department of Housing and Urban Development (HUD),
minority ownership increased by 3. 1 million between 2002 and
2007 .
Here, surely, was the zenith of the property-owning democracy.
The new mortgage market seemed to be making the American
dream of home ownership a reality for hundreds of thousands of
people who had once been excluded from mainstream finance by
credit-rating agencies and thinly veiled racial prejudice.
Criticism would subsequently be levelled at Alan Greenspan
for failing adequately to regulate mortgage lending in his last
years as Federal Reserve chairman. Yet, despite his notorious
* Between 1997 and zoo6, 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 1 0 per cent of disposable personal
(and subsequently retracted) endorsement of adjustable-rate
mortgages in a 2004 speech, Greenspan was not the principal
proponent of wider home ownership. No r is it credible to blame
all the excesses of recent years on monetary policy.
'We want everybody in America to own their own home,'
President George W. Bush had said in October 2002 . Having
challenged lenders to create 5.5 million new minority home­
owners by the end of the decade, Bush signed the American
Dream Downpayment Act in 2003 , a measure designed to subsid­
ize first-time house purchases among lower income groups.
Lenders were encouraged by the administration not to press sub-prime borrowers for full documentation. Fannie Ma e and Freddie
Ma c also came under pressure from HU D to support the sub-prime market. As Bush put it in December 2003 : 'It is in our
national interest that more people own their home.'5 8 Few dis­
sented. Writing in the New York Times in November 2007 ,
Henry Louis ('Skip') Gates Jr. , Alphonse Fletcher University Pro­
fessor at Harvard and Director of the W. E . B . Du Bois Institute
for African and African-American Research, appeared to wel­
come the trend, pointing out that fifteen out of twenty successful
African-Americans he had studied (among them Oprah Winfrey
and Whoopi Goldberg) were the descendants of 'at least one line
of former slaves who managed to obtain property by 1920' .
Heedless of the bursting of the property bubble months before,
Gates suggested a surprising solution to the problem of 'black
poverty and dysfunction' - namely 'to give property to the people
who had once been defined as property':
Perhaps Margaret Thatcher, of all people, suggested a program that
might help. In the 1980s, she turned 1.5 million residents of public
housing projects in Britain into homeowners. It was certainly the
most liberal thing Mrs Thatcher did, and perhaps progressives should
borrow a leaf from her playbook .. . A bold and innovative approach
to the problem of black poverty . . . would be to look at ways to turn
tenants into homeowners . . . For the black poor, real progress may
come only once they have an ownership stake in American society.
People who own property feel a sense of ownership in their future
and their society. They study, save, work, strive and vote. And people
trapped in a culture of tenancy do not. . , 5 9
Beanie Self, a black community leader in the Frayser area of
Memphis, identified the fatal flaw in Gates's argument: 'The
American Dream is home ownership, and one of the things that
concerns me is - while the dream is wonderful - we are not
really prepared for it. People don't realize you have a real estate
industry, an appraisal industry, a mortgage industry now that
can really push to put people into houses that a lot of times they
really can't afford.'6 0
As a business model subprime lending worked beautifully - as
long as interest rates stayed low, as long as people kept their jobs
and as long as real estate prices continued to rise. Of course, such
conditions could not be relied upon to last, least of all in a city
like Detroit. But that did not worry the subprime lenders. They
simply followed the trail blazed by mainstream mortgage lenders
in the 1980s . Instead of putting their own money at risk, they
pocketed fat commissions on signature of the original loan con­
tracts and then resold their loans in bulk to Wall Street banks. The
banks, in turn, bundled the loans into high-yielding residential
mortgage-backed securities (RMBS ) and sold them on to inves­
tors around the world, all eager for a few hundredths of a per­
centage point more return on their capital. Repackaged as
collateralized debt obligations (CDOs) , these subprime securities
could be transformed from risky loans to flaky borrowers into
triple-A rated investment-grade securities. All that was required
was certification from one of the two dominant rating agencies,
Moody's or Standard & Poor's, that at least the top tier of these
securities was unlikely to go into default. The lower 'mezzanine'
and 'equity' tiers were admittedly more risky; then again, they
paid higher interest rates.
The key to this financial alchemy was that there could be
thousands of miles between the mortgage borrowers in Detroit
and the people who ended up receiving their interest payments.
The risk was spread across the globe from American state pension
funds to public health networks in Australia and even to town
councils beyond the Arctic Circle. In Norway , for example, the
municipalities of Rana, Hemnes, Hattjelldal and Narvik invested
some $12 0 million of their taxpayers' money in CDO s secured
on American subprime mortgages. At the time, the sellers of these
'structured products' boasted that securitization was having the
effect of allocating risk 'to those best able to bear it'. Only later
did it turn out that risk was being allocated to those least able to
understand it. Those who knew best the flakiness of subprime
loans - the people who dealt directly with the borrowers and
knew their economic circumstances - bore the least risk. They
could make a 10 0 per cent loan-to-value 'NINJA ' loan (to some­
one with N o Income N o Jo b or Assets) and sell it on the same
day to one of the big banks in the CD O business. In no time at
all, the risk was floating up a fjord.
In Detroit the rise of subprime mortgages had in fact coincided
with a new slump in the inexorably declining automobile industry
that cost the city 20,000 jobs. This anticipated a wider American
slowdown, an almost inevitable consequence of a tightening of
monetary policy as the Federal Reserve raised short-term interest
rates from 1 per cent to 5 34 per cent; this had a modest but
nevertheless significant impact on average mortgage rates, which
went up by roughly a quarter (from 5.34 to 6.66 per cent). The
effect on the subprime market of this seemingly innocuous change
in credit conditions was devastating. As soon as the teaser rates
expired and the mortgages reset at new and much higher interest
rates, hundreds of Detroit households swiftly fell behind with
their mortgage payments. As early as March 2007 , about one in
three subprime mortgages in the 482 3 5 ZI P code were more than
sixty days in arrears, effectively on the verge of foreclosure. The
effect was to burst the real estate bubble, causing house prices to
start falling for the first time since the early 1990s . As soon as
this began to happen, those who had taken out 10 0 per cent
mortgages found their debts worth more than their homes. The
further house prices fell, the more homeowners found themselves
with negative equity, a term familiar in Britain since the early
1990s . In this respect, West Outer Drive was a harbinger of a
wider crisis of the American real estate market, the ramifications
of which would rock the financial system of the Western world
to its foundations.
On a sultry Friday afternoon, shortly after arriving in Memphis
from Detroit, I watched more than fifty homes being sold off on
the steps of the Memphis courthouse. In each case it was because
mortgage lenders had foreclosed on the owners for failing to
keep up with their interest payments. * No t only is Memphis the
bankruptcy capital of America (as we saw in Chapter 1) . By the
summer of 2007 it was also fast becoming the foreclosure capital.
* It is an important feature of American law that in many states (though not
all) mortgages are generally 'no recourse' loans, meaning that when there is
a default the mortgage lender can only collect the value of the property and
cannot seize other property (e.g. a car or money in the bank) or put a lien on
future wages. According to some economists, this gives borrowers a strong
incentive to default.
27 0
Over the last five years, I was told, one in four households in the
city had received a notice threatening foreclosure. And once again
subprime mortgages were the root of the problem. In 2006 alone
subprime finance companies had lent $46 0 million to fourteen
Memphis ZI P codes. What I was witnessing was just the begin­
ning of a flood of foreclosures. In March 200 7 the Center for
Responsible Lending predicted that the number of foreclosures
could reach 2.4 million.6 1 This may turn out to have been an under­
estimate. At the time of writing (May 2008), around 1.8 million
mortgages are in default, but an estimated 9 million American
households, or the occupants of one in every ten single-family
homes, have already fallen into negative equity. About 1 1 per
cent of subprime ARM s are already in foreclosure. According to
Crédit Suisse, the total number of foreclosures on all types of
mortgages could end up being 6.5 million over the next five years.
That could put 8.4 per cent of all American homeowners, or 12. 7
per cent of those with mortgages, out of their homes.6 2
Since the subprime mortgage market began to turn sour in the
early summer of 2007 , Shockwaves have been spreading through
all the world's credit markets, wiping out some hedge funds and
costing hundreds of billions of dollars to banks and other finan­
cial companies. The main problem lay with CDOs , over half a
trillion dollars of which had been sold in 2006, of which around
half contained subprime exposure. It turned out that many of
these CDO s had been seriously over-priced, as a result of
erroneous estimates of likely subprime default rates. As even
triple-A-rated securities began going into default, hedge funds
that had specialized in buying the highest-risk CD O tranches
were the first to suffer. Although there had been signs of trouble
since February 2007, when HSB C admitted to heavy losses on
US mortgages, most analysts would date the beginning of the
subprime crisis from June of that year, when two hedge funds
27 1
owned by Bear Stearns* were asked to post additional collateral
by Merrill Lynch, another investment bank that had lent them
money but was now concerned about their excessive exposure to
subprime-backed assets. Bear bailed out one fund, but let the
other collapse. The following month the ratings agencies began
to downgrade scores of RMB S CDO s (short for 'residential
mortgage-backed security collateralized debt obligations', the
very term testifying to the over-complex nature of these prod­
ucts). As they did so, all kinds of financial institutions holding
such assets found themselves staring huge losses in the face.
The problem was greatly magnified by the amount of leverage
(debt) in the system. Hedge funds in particular had borrowed
vast sums from their prime brokers - banks - in order to magnify
the returns they could generate. The banks, meanwhile, had
been disguising their own exposure by parking subprime-related
assets in off-balance-sheet entities known as conduits and stra­
tegic investment vehicles (SIVs, surely the most apt of all the
acronyms of the crisis), which relied for funding on short-term
borrowings on the markets for commercial paper and overnight
interbank loans. As fears rose about counterparty risk (the danger
that the other party in a financial transaction may go bust),
those credit markets seized up. The liquidity crisis that some
commentators had been warning about for at least a year struck
in August 2007 , when American Home Mortgage filed for bank­
ruptcy, BN P Paribas suspended three mortgage investment funds
and Countrywide Financial drew down its entire $1 1 billion
credit line. What scarcely anyone had anticipated was that
defaults on subprime mortgages by low-income households in
cities like Detroit and Memphis could unleash so much financial
* One of which gloried in the name High-Grade Structured Credit Strategies
Enhanced Leverage Fund.
27 2
havoc:* one bank (Northern Rock) nationalized; another (Bear
Stearns) sold off cheaply to a competitor in a deal underwritten
by the Fed; numerous hedge funds wound up; 'write-downs' by
banks amounting to at least $31 8 billion; total anticipated losses
in excess of one trillion dollars. The subprime butterfly had
flapped its wings and triggered a global hurricane.
Among the many ironies of the crisis is that it could ultimately
deal a fatal blow to the government-sponsored mother of the
property-owning democracy: Fannie Mae. 6 3 One consequence
of government policy has been to increase the proportion of
mortgages held by Fannie Ma e and her younger siblings Freddie
and Ginnie, while at the same time reducing the importance of
the original government guarantees that were once a key com­
ponent of the system. Between the 195 5 and 2006 the proportion
of non-farm mortgages underwritten by the government fell from
3 5 to 5 per cent. But over the same period the share of mortgages
held by these government-sponsored enterprises rose from 4 per
cent to a peak of 43 per cent in 2003. 6 4 The Office of Federal
Housing Enterprise Oversight has been egging on Fannie and
Freddie to acquire even more RMB S (including subprime-backed
securities) by relaxing the rules that regulate their capital/assets
ratio. But the two institutions have only $84 billion of capital
between them, a mere 5 per cent of the $1. 7 trillion of assets on
their balance sheets, to say nothing of the further $2. 8 trillion of
RMB S that they have guaranteed.6 5 Should these institutions get
into difficulties, it seems a reasonable assumption that govern­
ment sponsorship could turn into government ownership, with
major implications for the federal budget.t
So no, it turns out that houses are not a uniquely safe investment.
* Few dissented when the International Monetary Fund called it 'the largest
financial shock since the Great Depression'.
f Events subsequent to this writing have indeed borne this out.
Their prices can go down as well as up. And, as we have seen,
houses are pretty illiquid assets - which means they are hard to
sell quickly when you are in a financial jam. House prices are
'sticky' on the way down because sellers hate to cut the asking
price in a downturn; the result is a glut of unsold properties and
people who would otherwise move stuck looking at their For Sale
signs. That in turn means that home ownership can tend to reduce
labour mobility, thereby slowing down recovery. These turn out
to be the disadvantages of the idea of property-owning democ­
racy, appealing though it once seemed to turn all tenants into
homeowners. The question that remains to be answered is
whether or not we have any business exporting this high-risk
model to the rest of the world.
As Safe as Housewives
Quilmes, a sprawling slum on the southern outskirts of Buenos
Aires, seems a million miles from the elegant boulevards of the
Argentine capital's centre. But are the people who live there really
as poor as they look? As Peruvian economist Hernando de Soto
sees it, shanty towns like Quilmes, despite their ramshackle
appearance, represent literally trillions of dollars of unrealized
wealth. De Soto has calculated that the total value of the real
estate occupied by the world's poor amounts to $9.3 trillion.
That, he points out, is very nearly the total market capitalization
of all the listed companies in the world's top twenty economies -and roughly ninety times all the foreign aid paid to developing
countries over between 197 0 and 2000. The problem is that the
people in Quilmes, and in countless shanty towns the world over,
do not have secure legal title to their homes. And without some
kind of legal title, property cannot be used as collateral for a
loan. The result is a fundamental constraint on economic growth,
de Soto reasons, because if you can't borrow, you can't raise the
capital to start a business. Potential entrepreneurs are thwarted.
Capitalist energies are smothered.6 6
A large part of the trouble is that it is so bureaucratically
difficult to establish legal title to property in places like South
America. In Argentina today, according to the World Bank, it
takes around thirty days to register a property, but it used to be
much longer. In some countries - Bangladesh and Haiti are the
worst - it can take closer to three hundred days. When de Soto
and his researchers tried to secure legal authorization to build a
house on state-owned land in Peru, it took six years and eleven
months, during which they had to deal with fifty-two different
government offices. In the Philippines, formalizing home owner­
ship was until recently a 1 68-ste p process involving fifty-three
public and private agencies and taking between thirteen and
twenty-five years. In the English-speaking world, by contrast, it
can take as little as two days and seldom more than three weeks. In
de Soto's eyes, bureaucratic obstacles to securing legal ownership
make the assets of the poor so much 'dead capital .. . like water
in a lake high up in the Andes - an untapped stock of potential
energy'. Breathing life into this capital, he argues, is the key to
providing countries like Peru with a more prosperous future.
Only with a working system of property rights can the value of
a house be properly established by the market; can it easily be
bought and sold; can it legally be used as collateral for loans; can
its owner be held to account in other transactions he may enter into.
Moreover, excluding the poor from the pale of legitimate property
ownership ensures that they operate at least partially in a grey or
black economic zone, beyond the reach of the state's dead hand.
This is doubly damaging. It prevents effective taxation. And it
reduces the legitimacy of the state in the eyes of the populace.
Poor countries are poor, in other words, because they lack secure
property rights, the 'hidden architecture' of a successful economy.
'Property law is not a silver bullet,' de Soto admits, 'but it is the
missing link . . . Without property law, you will never be able to
accomplish other reforms in a sustainable manner.' And poor
countries are also more likely to fail as democracies because they
lack an electorate of stakeholders. 'Property rights will eventually
lead to democracy,' de Soto has argued, 'because you can't sustain
a market-oriented property system unless you provide a demo­
cratic system. That's the only way investors can feel secure.'6 7
T o some - like the Maoist terrorist group Shining Path, who
tried to assassinate him in 199 2 in a bomb attack that killed three
people - de Soto is a villain.6 8 Other critics denounced him as the
Rasputin behind the now disgraced Peruvian President Alberto
Fujimori. T o others, de Soto's efforts to globalize the property-owning democracy have made him a hero. Former President Bill
Clinton has called him 'probably the greatest living economist',
while his Russian counterpart, Vladimir Putin, has called de
Soto's achievements 'extraordinary'. In 2004 the American liber­
tarian think-tank the Cato Institute awarded him the biennial
Milton Friedman Prize for work that 'exemplifies the spirit and
practice of liberty'. De Soto and his Institute for Liberty and
Democracy have advised governments in Egypt, El Salvador,
Ghana, Haiti, Honduras, Kazakhstan, Mexico, the Philippines
and Tanzania. The critical question is, of course, does his theory
work in practice?
Quilmes provides a natural experiment to find out if de Soto
really has unravelled the 'mystery of capital'. It was here in 198 1
that a group of 1,800 families defied the military junta then
ruling Argentina by occupying a stretch of wasteland. After the
restoration of democracy the provincial government expropriated
the original owners of the land to give the squatters legal title to
27 6
their homes. However, only eight of the thirteen landowners
accepted the compensation they were offered; the others (one of
whom settled in 1998 ) fought a protracted legal battle. The result
was that some of the Quilmes squatters became property owners
by paying a nominal sum for leases, which, after ten years, became
full deeds of ownership; while others remained as squatters.
Today you can tell the owner-occupied houses from the rest by
their better fences and painted walls. The houses whose owner­
ship remains contested are, by contrast, seedy shacks. As everyone
(including 'Skip' Gates) knows, owners generally take better care
of properties than tenants do.
There is no doubt that home ownership has changed people's
attitudes in Quilmes. According to one recent study, those wh o
have acquired property titles have become significantly more
individualist and materialist in their attitudes than those who are
still squatting. For example, when asked 'D o you think money is
important for happiness?', the property owners were 34 per cent
more likely than the squatters to say that it was. 6 9 Yet there seems
to be a flaw in the theory, for owning their homes has not made
it significantly easier for people in Quilmes to borrow money.
Only 4 per cent have managed to secure a mortgage.7 0 In de Soto's
native Peru, too, ownership alone doesn't seem to be enough to
resuscitate dead capital. True, after his initial recommendations
were accepted by the Peruvian government in 1988 , there was a
drastic reduction in the time it took to register a property (to just
one month) and an even steeper 99 per cent cut in the costs of
the transaction. Further efforts were made after the creation of
the Commission for the Formalization of Informal Property in
199 6 so that, within four years, 1. 2 million buildings on urban
land had been brought into the legal system. Ye t economic pro­
gress of the sort de Soto promised has been disappointingly slow.
Out of more than 200,000 Lima households awarded land titles
27 7
in 199 8 and 1999 , only around a quarter had secured any kind
of loans by 2002 . In other places where de Soto's approach
has been tried, notably Cambodia, granting legal title to urban
properties simply encouraged unscrupulous developers and
speculators to buy out - or turf out - poor residents.7 1
Remember: it's not owning property that gives you security; it
just gives your creditors security. Real security comes from having
a steady income, as the Duke of Buckingham found out in the
1840s , and as Detroit homeowners are finding out today. For
that reason, it may not be necessary for every entrepreneur in the
developing world to raise money by mortgaging his house. Or
her house. In fact, home ownership may not be the key to wealth
generation at all.
I met Betty Flores on a rainy Monday morning in a street market
in El Alto, the Bolivian town next to (or rather above) the capital
L a Paz. I was on my way to the El Alto offices of the microfinance
organization Pro Mujer, but I was feeling tired because of the
high altitude and suggested we stop for some coffee. And there
she was, busily brewing up and distributing pots and cups of
thick, strong Bolivian coffee for shoppers and other stall-keepers
throughout the market. I was immediately struck by her energy
and vivacity. In marked contrast to the majority of indigenous
Bolivian women, she seemed quite uninhibited about talking to
an obvious foreigner. It turned out that she was in fact one of
Pro Mujer's clients, having taken out a loan to enlarge her coffee
stall - something her husband, a mechanic, had not been able to
do. And it had worked; I only had to look at Betty's perpetual
motion to see that. Did she plan any further expansion? Yes
indeed. The business was helping her put their daughters through
Betty Flores is not what would conventionally be thought of
as a good credit risk. She has modest savings and does not own
her own home. Yet she and thousands of women like her in poor
countries around the world are being lent money by institutions
like Pro Mujer as part of a revolutionary effort to unleash female
enterpreneurial energies. The great revelation of the microfinance
movement in countries like Bolivia is that women are actually a
better credit risk than men, with or without a house as security
for their loans. That certainly flies in the face of the conventional
image of the spendthrift female shopper. Indeed, it goes against
the grain of centuries of prejudice which, until as recently as the
1970s , systematically rated women as less creditworthy than
men. In the United States, for example, married women used to
be denied credit, even when they were themselves employed, if
their husbands were not in work. Deserted and divorced women
fared even worse. When I was growing up, credit was still
emphatically male. Microfinance, however, suggests that credit­
worthiness may in fact be a female trait.
The founder of the microfinance movement, the Nobel prize
winner Muhammad Yunus, came to understand the potential of
making small loans to women when studying rural poverty in
his native Bangladesh. His mutually owned Grameen ('Village')
Bank, founded in the village of Jobra in 1983 , has made micro-loans to nearly seven and a half million borrowers, nearly all of
them women who have no collateral. Virtually all the borrowers
take out their loans as members of a five-member group (koota),
which meets on a weekly basis and informally shares responsibil­
ity for loan repayments. Since its inception, Grameen Bank has
made microloans worth more than $ 3 billion, initially financing
its operations with money from aid agencies, but now attracting
sufficient deposits (nearly $65 0 billion by January 2007) to be
entirely self-reliant and, indeed, profitable.7 2 Pro Mujer, founded
in 199 0 by Lynne Patterson and Carmen Velasco, is among the
most successful of Grameen Bank's South American imitators.*
Loans start at around $20 0 for three months. Most women use
the money to buy livestock for their farms or, like Betty, to fund
their own micro-businesses, selling anything from tortillas to
By the time I tore myself away from Betty's coffee stall, the Pro
Mujer offices in El Alto were already a hive of activity. I found it
hard not to be impressed by the sight of dozens of Bolivian
women, nearly all in traditional costume (each with a miniature
bowler hat, pinned at a jaunty angle), lining up to make their
regular loan payments. As they told stories about their experi­
ences, I began wondering if it might just be time to change an
age-old catchphrase from 'As safe as houses' to 'As safe as house­
wives'. For what I saw in Bolivia has its equivalents in poor
countries all over the world, from the slums of Nairobi to the
villages of Andhra Pradesh in India. And not only in the
developing world. Microfinance can also work in enclaves of
poverty in the developed world - like Castlemilk, in Glasgow,
where a whole network of lending agencies called credit unions
has been set up as an antidote to predatory lending by loan sharks
(of the sort we encountered in Chapter 1) . In Castlemilk, too, the
recipients of loans are local women. In both El Alto and Castle­
milk I heard how men were much more likely to spend their
wages in the pub or the betting shop than to worry about making
interest payments. Women, I was told repeatedly, were better at
managing money than their husbands.
Of course, it would be a mistake to assume that microfinance
is the holy grail solution to the problem of global poverty, any
more than is Hernando de Soto's property rights prescription.
* So impressed have Bill and Melinda Gates been by Pro Mujer that their
Foundation is giving the organization $3. 1 million.
Roughly two fifths of the world's population is effectively outside
the financial system, without access to bank accounts, much
less credit. But just giving them loans won't necessarily consign
poverty to the museum, in Yunus's phrase, whether or not you
ask for collateral. No r should we forget that some people in the
microfinance business are in it to make money, not to end pov­
erty.7 3 It comes as something of a shock to discover that some
microfinance firms are charging interest rates as high as 80 or
even 12 5 per cent a year on their loans - rates worthy of loan
sharks. The justification is that this is the only way to make
money, given the cost of administering so many tiny loans.
Glasgow has come a long way since my fellow Scotsman Adam
Smith wrote the seminal case for the free market, The Wealth of
Nations, in 1776 . Like Detroit, it rose on the upswing of the
industrial age. The age of finance has been less kind to it. But in
Glasgow, as in North and South America, and as in South Asia,
people are learning the same lesson. Financial illiteracy may be
ubiquitous, but somehow we were all experts on one branch of
economics: the property market. We all knew that property was
a one-way bet. Except that it wasn't. (In the last quarter of 2007 ,
Glasgow house prices fell by 2. 1 per cent. The only consolation
was that in Edinburgh they fell by 5.8 per cent.) In cities all over
the world, house prices soared far above what was justified in
terms of rental income or construction costs. There was, as the
economist Robert Shiller has said, simply a 'widespread percep­
tion that houses are a great investment', which generated a 'classic
speculative bubble' via the same feedback mechanism which has
more commonly affected stock markets since the days of John
Law . In short, there was irrational exuberance about bricks and
mortar and the capital gains they could yield.7 4
This perception, as we have seen, was partly political in origin.
But while encouraging home ownership may help build a political
28 1
constituency for capitalism, it also distorts the capital market by
forcing people to bet the house on, well, the house. When financial
theorists warn against 'home bias', they mean the tendency for
investors to keep their money in assets produced by their own
country. But the real home bias is the tendency to invest nearly
all our wealth in our own homes. Housing, after all, represents
two thirds of the typical US household's portfolio, and a higher
proportion in other countries.7 5 From Buckinghamshire to
Bolivia, the key to financial security should be a properly diversi­
fied portfolio of assets.7 6 T o acquire that we are well advised to
borrow in anticipation of future earnings. But we should not be
lured into staking everything on a highly leveraged play on the
far from risk-free property market. There has to be a sustainable
spread between borrowing costs and returns on investment, and
a sustainable balance between debt and income.
These rules, needless to say, do not apply exclusively to house­
holds. They also apply to national economies. The final question
that remains to be answered is how far - as a result of the process
we have come to call globalization - the biggest economy in the
world has been tempted to ignore them. What price, in short, a
subprime superpower?
From Empire to Chimerica
Just ten years ago, during the Asian Crisis of 1997-8 , it was
conventional wisdom that financial crises were more likely to
happen on the periphery of the world economy - in the so-called
emerging markets (formerly known as less developed countries)
of East Asia or Latin America. Yet the biggest threats to the
global financial system in this new century have come not from
the periphery but from the core. In the two years after Silicon
Valley's dot-com bubble peaked in August 2000, the US stock
market fell by almost half. It was not until Ma y 2007 that inves­
tors in the Standard & Poor's 500 had recouped their losses.
Then, just three months later, a new financial storm blew up, this
time in the credit market rather than the stock market. As we have
seen, this crisis also originated in the United States as millions of
American households discovered they could not afford to service
billions of dollars' worth of subprime mortgages. There was a
time when American crises like these would have plunged the rest
of the global financial system into recession, if not depression.
Yet at the time of writing Asia seems scarcely affected by the
credit crunch in the US . Indeed, some analysts like Ji m O'Neill,
Head of Global Research at Goldman Sachs, say the rest of the
world, led by booming China, is 'decoupling' itself from the
American economy.
If O'Neill is correct, we are living through one of the most
astonishing shifts there has ever been in the global balance of
financial power; the end of an era, stretching back more than a
century, when the financial tempo of the world economy was set
by English-speakers, first in Britain, then in America. The Chinese
economy has achieved extraordinary feats of growth in the past
thirty years, with per capita GD P increasing at a compound
annual growth rate of 8.4 per cent. But in recent times the pace
has, if anything, intensified. When O'Neill and his team first
calculated projections of gross domestic product for the so-called
BRIC s (Brazil, Russia, India and China, or Big Rapidly Indus­
trializing Countries), they envisaged that China could overtake
the United States in around 2040. 1 Their most recent estimates,
however, have brought the date forward to 2027. 2 The Goldman
Sachs economists do not ignore the challenges that China un­
doubtedly faces, not least the demographic time bomb planted
by the Communist regime's draconian one-child policy and the
environmental consequences of East Asia's supercharged indus­
trial revolution.3 They are aware, too, of the inflationary pressures
in China, exemplified by soaring stock prices in 2007 and surging
food prices in 2008. Ye t the overall assessment is still strikingly
positive. And it implies, quite simply, that history has changed
direction in our lifetimes.
Three or four hundred years ago there was little to choose
between per capita incomes in the West and in the East. The
average North American colonist, it has been claimed, had a
standard of living not significantly superior to that of the average
Chinese peasant cultivator. Indeed, in many ways the Chinese
civilization of the Ming era was more sophisticated than that of
early Massachusetts. Beijing, for centuries the world's largest city,
dwarfed Boston, just as Admiral Zheng He's early-fifteenth-century treasure ship had dwarfed Christopher Columbus's Santa
Maria. The Yangtze delta seemed as likely a place as the Thames
Valley to produce major productivity-enhancing technological
innovations.4 Yet between 170 0 and 195 0 there was a 'great diver­
gence' of living standards between East and West. While China
may have suffered an absolute decline in per capita income in that
period, the societies of the North West - in particular Britain and
its colonial offshoots - experienced unprecedented growth thanks,
in large part, to the impact of the industrial revolution. By 182 0
per capita income in the United States was roughly twice that of
China; by 1870 , nearly five times higher; by 191 3 nearly ten times;
by 195 0 nearly twenty-two times. The average annual growth
rate of per capita GD P in the United States was 1.5 7 per cent
between 182 0 and 1950 . The equivalent figure for China was
-0.2 4 per cent.5 In 197 3 the average Chinese income was at best
one twentieth of the average American. Calculated in terms of
international dollars at market exchange rates, the differential
was even wider. As recently as 2006, the ratio of US to Chinese
per capita income by this measure was still 22.9 to 1 .
What went wrong in China between the 1700 s and the 1970s ?
One argument is that China missed out on two major macroecon-omic strokes of good luck that were indispensable to the North-West's eighteenth-century take-off. The first was the conquest of
the Americas and particularly the conversion of the islands of the
Caribbean into sugar-producing colonies, 'ghost acres' which
relieved the pressure on a European agricultural system that
might otherwise have suffered from Chinese-style diminishing
returns. The second was the proximity of coalfields to locations
otherwise well suited for industrial development. Besides cheaper
calories, cheaper wood and cheaper wool and cotton, imperial
expansion brought other unintended economic benefits, too. It
encouraged the development of militarily useful technologies -clocks, guns, lenses and navigational instruments - that turned
out to have big spin-offs for the development of industrial
machinery.6 Man y other explanations have, needless to say, been
offered for the great East-West divergence: differences in top­
ography, resource endowments, culture, attitudes towards science
and technology, even differences in human evolution.7 Yet there
remains a credible hypothesis that China's problems were as
much financial as they were resource-based. For one thing, the
unitary character of the Empire precluded that fiscal competition
which proved such a driver of financial innovation in Renaissance
Europe and subsequently. For another, the ease with which the
Empire could finance its deficits by printing money discouraged
the emergence of European-style capital markets.8 Coinage, too,
was more readily available than in Europe because of China's
trade surplus with the West. In short, the Middle Kingdom had far
fewer incentives to develop commercial bills, bonds and equities.
When modern financial institutions finally came to China in the
late nineteenth century, they came as part of the package of
Western imperialism and, as we shall see, were always vulnerable
to patriotic backlashes against foreign influence.9
Globalization, in the sense of a rapid integration of inter­
national markets for commodities, manufactures, labour and
capital, is not a new phenomenon. In the three decades before
1914 , trade in goods reached almost as large a proportion of
global output as in the past thirty years.1 0 In a world of less
regulated borders, international migration was almost certainly
larger relative to world population; more than 1 4 per cent of the
US population was foreign born in 191 0 compared with less
than 1 2 per cent in 2003. 1 1 Although, in gross terms, stocks of
international capital were larger in relation to global GD P during
the 1990 s than they were a century ago, in net terms the amounts
invested abroad - particularly by rich countries in poor countries
- were much larger in the earlier period.1 2 Over a century ago,
enterprising businessmen in Europe and North America could see
that there were enticing opportunities throughout Asia. By the
middle of the nineteenth century, the key technologies of the
industrial revolution could be transferred anywhere. Communi­
cation lags had been dramatically reduced thanks to the laying of
an international undersea cable network. Capital was abundantly
available and, as we shall see, British investors were more than
ready to risk their money in remote countries. Equipment was
affordable, energy available and labour so abundant that manu­
facturing textiles in China or India ought to have been a hugely
profitable line of business.1 3 Yet, despite the investment of over
a billion pounds of Western funds, the promise of Victorian
globalization went largely unfulfilled in most of Asia, leaving a
legacy of bitterness towards what is still remembered to this day
as colonial exploitation. Indeed, so profound was the mid-century
reaction against globalization that the two most populous Asian
countries ended up largely cutting themselves off from the global
market from the 1950 s until the 1970s .
Moreover, the last age of globalization had anything but a
happy ending. On the contrary, less than a hundred years ago, in
the summer of 1914 , it ended not with a whimper, but with a
deafening bang, as the principal beneficiaries of the globalized
economy embarked on the most destructive war the world had
ever witnessed. We think we know why international capital
failed to produce self-sustaining growth in Asia before 1914 . But
was there also some connection between the effects of global
economic integration and the outbreak of the First World War?
It has recently been suggested that the war should be understood
as a kind of backlash against globalization, heralded by rising
tariffs and immigration restrictions in the decade before 1914 ,
and welcomed most ardently by Europe's agrarian elites, whose
position had been undermined for decades by the decline in
agricultural prices and emigration of surplus rural labour to the
Ne w World. 1 4 Before blithely embracing today's brave, new and
supposedly 'post-American' world, 1 5 we must be sure that similar
unforeseen reactions could not pull the geopolitical rug out from
under the latest version of globalization.
Globalization and Armageddon
It used to be said that emerging markets were the places where
they had emergencies. Investing in far-away countries could make
you rich but, when things went wrong, it could be a fast track to
financial ruin. As we saw in Chapter 2, the first Latin American
debt crisis happened as long ago as the 1820s . It was another
emerging market crisis, in Argentina, that all but bankrupted
the house of Baring in 1890 , just as it was a rogue futures trader
in Singapore, Nick Leeson, who finally finished Barings off
10 5 years later. The Latin American debt crisis of the 1980 s and
the Asian crisis of the 1990 s were scarcely unprecedented events.
Financial history suggests that many of today's emerging markets
would be better called re-emerging markets.* These days, the
ultimate re-emerging market is China. According to Sinophile
investors like Ji m Rogers, there is almost no limit to the amount
of money to be made there.1 6 Yet this is not the first time that
foreign investors have poured money into Chinese securities,
dreaming of the vast sums to be made from the world's most
populous country. The last time around, it is worth remembering,
they lost as many shirts as Hong Kong's famous tailors can stitch
together in a month.
* The term 'emerging markets' was first used in the 1980s by the World Bank
economist Antoine van Agtmael.
The key problem with overseas investment, then as now, is
that it is hard for investors in London or Ne w Yor k to see what
a foreign government or an overseas manager is up to when
they are an ocean or more away. Moreover, most non-Western
countries had, until quite recently, highly unreliable legal systems
and differing accounting rules. If a foreign trading partner
decided to default on its debts, there was little that an investor
situated on the other side of the world could do. In the first era
of globalization, the solution to this problem was brutally simple
but effective: to impose European rule.
William Jardine and James Matheson were buccaneering Scots­
men who had set up a trading company in the southern Chinese
port of Guangzhou (then known as Canton) in 1832 . One of
their best lines of business was importing government-produced
opium from India. Jardine was a former East India Company
surgeon, but the opium he was bringing into China was for
distinctly non-medicinal purposes. This was a practice that the
Emperor Yongzheng had prohibited over a century before, in
1729 , because of the high social costs of opium addiction. On
1 0 March 183 9 an imperial official named Lin Zex u arrived in
Canton under orders from the Daoguang Emperor to stamp out
the trade once and for all. Lin blockaded the Guangzhou opium
godowns (warehouses) until the British merchants acceded to
his demands. In all, around 20,000 chests of opium valued at
£ 2 million were surrendered. The contents were adulterated to
render it unusable and literally thrown in the sea. 1 7 The Chinese
also insisted that henceforth British subjects in Chinese territory
should submit to Chinese law. This was not to Jardine's taste at
all. Known to the Chinese as 'Iron-Headed Old Rat' , he was in
Europe during the crisis and hastened to London to lobby the
British government. After three meetings with the Foreign Secre­
tary, Viscount Palmerston, Jardine seems to have persuaded him
'Iron-Headed Old Rat': William Jardine, co-founder of
Jardine, Matheson
that a show of strength was required, and that 'the want of power
of their war junks' would ensure an easy victory for a 'sufficient'
British force. On 20 February 1840 Palmerston gave the order.
By June 1840 all the naval preparations were complete. The Qing
Empire was about to feel the full force of history's most successful
narco-state: the British Empire.
Just as Jardine had predicted, the Chinese authorities were
James Matheson, Jardine's partner in the opium trade
no match for British naval power. Guangzhou was blockaded;
Chusan (Zhoushan) Island was captured. After a ten-month stand
off, British marines seized the forts that guarded the mouth of the
Pearl River, the waterway between Hong Kong and Guangzhou.
Under the Convention of Chuenpi, signed in January 1841 (but
then repudiated by the Emperor), Hong Kong became a British
possession. The Treaty of Nanking, signed a year later after
another bout of one-sided fighting, confirmed this cession and
also gave free rein to the opium trade in five so-called treaty
ports: Canton, Amoy (Xiamen), Foochow (Fuzhou), Ningbo and
Shanghai. According to the principle of extraterritoriality, British
subjects could operate in these cities with complete immunity
from Chinese law.
For China, the first Opium War ushered in an era of humili-
ation. Drug addiction exploded. Christian missionaries destabil­
ized traditional Confucian beliefs. And in the chaos of the Taiping
Rebellion - a peasant revolt against a discredited dynasty led by
the self-proclaimed younger brother of Christ - between 20 and
40 million people lost their lives. But for Jardine and Matheson,
wh o hastened to acquire land in Hong Kong and soon moved
their head office to the island's East Point, the glory days of
Victorian globalization had arrived. Jardine's Lookout, one of
the highest points on Hong Kong island, was where the company
used to keep a watchman permanently stationed, to spy the sails
of the firm's clippers as they sailed in from Bombay, Calcutta or
London. As Hong Kong flourished as an entrepôt, opium soon
ceased to be the company's sole line of business. By the early
1900 s Jardine, Matheson had its own breweries, its own cotton
mills, its own insurance company, its own ferry company and
even its own railways, including the Kowloon to Canton line,
built between 190 7 and 1911 .
Back in London, an investor had myriad foreign investment
opportunities open to him. Nothing illustrates this better than
the ledgers of N . M . Rothschild & Sons, which reveal the extra­
ordinary array of securities that the Rothschild partners held in
their multi-million-pound portfolio. A single page lists no fewer
than twenty different securities, including bonds issued by the
governments of Chile, Egypt, Germany, Hungary, Italy, Japan,
Norway , Spain and Turkey, as well as securities issued by eleven
different railways, among them four in Argentina, two in Canada
and one in China.1 8 No r was it only members of the rarefied
financial elite who could engage in this kind of international
diversification. As early as 1909 , for the modest outlay of 2s 6d,
British investors could buy Henry Lowenfeld's book Investment:
An Exact Science, which recommended 'a sound system of
averages, based upon the Geographical Distribution of Capital'
as a means of 'reducing] to a minimum the taint of specu­
lation from the act of investment'.1 9 As Keynes later recalled,
in a justly famous passage in his Economic Consequences of the
Peace, it required scarcely any effort for a Londoner of moder­
ate means to 'adventure his wealth in the natural resources
and new enterprises of any quarter of the world, and share,
without exertion or even trouble, in their prospective fruits and
advantages'.2 0
At that time there were around forty foreign stock exchanges
scattered throughout the world, of which seven were regularly
covered in the British financial press. The London Stock Exchange
listed bonds issued by fifty-seven sovereign and colonial govern­
ments. Following the money from London to the rest of the world
reveals the full extent of this first financial globalization. Around
45 per cent of British investment went to the United States,
Canada and the Antipodes, 20 per cent to Latin America, 1 6 per
cent to Asia, 1 3 per cent to Africa and 6 per cent to the rest of
Europe.2 1 If you add together all the British capital raised through
public issues of securities between 186 5 and 1914 , you see that
the majority went overseas; less than a third was invested in
the United Kingdom itself.2 2 By 191 3 an estimated $15 8 billion
in securities were in existence worldwide, of which around
$45 billion (28 per cent) were internationally held. Of all the
securities quoted on the London Stock Exchange in 191 3 nearly
half (48 per cent) were foreign bonds.2 3 Gross foreign assets in
191 3 were equivalent to around 15 0 per cent of U K GD P and
the annual current account surplus rose as high as 9 per cent of
GD P in 191 3 - evidence of what might now be called a British
savings glut. Significantly, a much higher proportion of pre-191 4
capital export went to relatively poor countries than has been the
case more recently. In 1913 , 25 per cent of the world's stock of
foreign capital was invested in countries with per capita incomes
of a fifth or less of US per capita GDP ; in 199 7 the proportion
was just 5 per cent.2 4
It may be that British investors were attracted to foreign
markets simply by the prospect of higher returns in capital-poor
regions.2 5 It may be that they were encouraged by the spread of
the gold standard, or by the increasing fiscal responsibility of
foreign governments. Yet it is hard to believe there would have
been so much overseas investment before 191 4 had it not been
for the rise of British imperial power. Somewhere between two
fifths and half of all this British overseas investment went to
British-controlled colonies. A substantial proportion also went to
countries like Argentina and Brazil over which Britain exercised
considerable informal influence. And British foreign investment
was disproportionately focused on assets that increased London's
political leverage: not only government bonds but also the securi­
ties issued to finance the construction of railways, port facilities
and mines. Part of the attraction of colonial securities was the
explicit guarantees some of them carried.2 6 The Colonial Loans
Act (1899 ) and the Colonial Stock Act (1900) also gave colonial
bonds the same trustee status as the benchmark British govern­
ment perpetual bond, the consol, making them eligible invest­
ments for Trustee Savings Banks. 2 7 But the real appeal of colonial
securities was implicit rather than explicit.
The Victorians imposed a distinctive set of institutions on their
colonies that was very likely to enhance their appeal to investors.
These extended beyond the Gladstonian trinity of sound money,
balanced budgets and free trade to include the rule of law
(specifically, British-style property rights) and relatively non-corrupt administration - among the most important 'public
goods' of late-nineteenth-century liberal imperialism. Debt con­
tracts with colonial borrowers were, quite simply, more likely to
be enforceable than those with independent states. This was why,
as Keynes later noted, 'Southern Rhodesia - a place in the middle
of Africa with a few thousand white inhabitants and less than a
million black ones - can place an unguaranteed loan on terms
not very different from our own [British] War Loan', while inves­
tors could prefer 'Nigeria stock (which has no British Govern­
ment guarantee) [to] .. . London and North-Eastern Railway
debentures'.2 8 The imposition of British rule (as in Egypt in 1882 )
practically amounted to a 'no default' guarantee; the only uncer­
tainty investors had to face concerned the expected duration
of British rule. Before 1914 , despite the growth of nationalist
movements in possessions as different as Ireland and India, politi­
cal independence still seemed a distinctly remote prospect for
most subject peoples. At this point even the major colonies of
white settlement had been granted only a limited political auton­
omy. And no colony seemed further removed from gaining its
independence than Hong Kong.
Between 186 5 and 191 4 British investors put at least £7 4 million
into Chinese securities, a tiny proportion of the total £4 billion
that they held abroad by 1914 , but a significant sum for impover­
ished China.2 9 N o doubt it reassured investors that, from 1854 ,
Britain not only ruled Hong Kong as a crown colony but also
controlled the entire Chinese system of Imperial Maritime Cus­
toms, ensuring that at least a portion of the duties collected at
China's ports was earmarked to pay the interest on British-owned
bonds. Yet even in the European quarters of the so-called treaty
ports, where the Union Jack fluttered and the taipan sipped his
gin and tonic, there were dangers. N o matter how tightly the
British controlled Hong Kong, they could do nothing to prevent
China from becoming embroiled first in a war with Japan in
1894-5 , tne n m tn e Boxer Rebellion of 190 0 and finally in the
revolution that overthrew the Qing dynasty in 191 1 - a revolution
partly sparked by widespread Chinese disgust at the extent of
foreign domination of their economy. Each of these political
upheavals hit foreign investors where it hurts them the most: in
their wallets. Much as happened in later crises - the Japanese
invasion of 194 1 or, for that matter, the Chinese takeover in
199 7 - investors in Hong Kong saw steep declines in the value
of their Chinese bonds and stocks.3 0 This vulnerability of early
globalization to wars and revolutions was not peculiar to China.
It turned out to be true of the entire world financial system.
The three decades before 191 4 were golden years for inter­
national investors - literally. Communications with foreign
markets dramatically improved: by 1911 , a telegraphic message
took just thirty seconds to travel from Ne w York to London, and
the cost of sending it was a mere 0.5 per cent of the 186 6 level.
Europe's central banks had nearly all committed themselves to
the gold standard by 1908 ; that meant that they nearly all had to
target their gold reserves, raising rates (or otherwise intervening)
if they experienced a specie outflow. At the very least, this simpli­
fied life for investors, by reducing the risk of large exchange rate
fluctuations.3 1 Governments around the world also seemed to be
improving their fiscal positions as the deflation of the 1870 s and
1880 s gave way to gentle inflation from the mid 1890s , which
reduced debt burdens in real terms. Higher growth also raised
tax revenues.3 2 Long-term interest rates nevertheless remained
low. Although the yield on the benchmark British consol rose by
over a percentage point between 189 7 anc ^ I 9 I 4? tna t wa s f ro m
an all-time nadir of 2.25 per cent. What we would now call
emerging market spreads narrowed dramatically, despite major
episodes of debt default in the 1870 s and 1890s . With the excep­
tion of securities issued by improvident Greece and Nicaragua,
none of the sovereign or colonial bonds that were traded in
London in 191 3 yielded more than two percentage points above
consols, and most paid considerably less. That meant that anyone
who had bought a portfolio of foreign bonds in, say, 188 0 had
enjoyed handsome capital gains.3 3
The yields and volatility of the bonds of the other great powers,
which accounted for about half the foreign sovereign debt quoted
in London, also declined steadily after 1880 , suggesting that
political risk premiums were falling too. Before 1880 , Austrian,
French, German and Russian bonds had tended to fluctuate quite
violently in response to political news; but the various diplomatic
alarums and excursions of the decade before 1914 , like those
over Morocco and the Balkans, caused scarcely a tremor in the
London bond market. Although the U K stock market remained
fairly flat following the bursting of the 1895-190 0 Kaffir (gold
mine) bubble, the volatility of returns trended downwards. There
is at least some evidence to connect these trends with a long-run
rise in liquidity, due partly to increased gold production and,
more importantly, to financial innovation, as joint-stock banks
expanded their balance sheets relative to their reserves, and
savings banks successfully attracted deposits from middle-class
and lower-class households.3 4
All these benign economic trends encouraged optimism. T o
many businessmen - from Ivan Bloch in Tsarist Russia to Andrew
Carnegie in the United States - it was self-evident that a major
war would be catastrophic for the capitalist system. In 189 8
Bloch published a massive six-volume work entitled The Future
of War which argued that, because of technological advances in
the destructiveness of weaponry, war essentially had no future.
Any attempt to wage it on a large scale would end in 'the bank­
ruptcy of nations'.3 5 In 1910 , the same year that Carnegie estab­
lished his Endowment for International Peace, the left-leaning
British journalist Norman Angell published The Great Illusion,
in which he argued that a war between the great powers had
become an economic impossibility precisely because of 'the deli­
cate interdependence of our credit-built finance'.3 6 In the spring
of 191 4 an international commission published its report into the
outrages committed during the Balkan Wars of 1912-13 . Despite
the evidence he and his colleagues confronted of wars waged à
l'outrance between entire populations, the commission's chair­
man noted in his introduction that the great powers of Europe
(unlike the petty Balkan states) 'had discovered the obvious truth
that the richest country has the most to lose by war, and each
country wishes for peace above all things'. One of the British
members of the commission, Henry Noel Brailsford - a staunch
supporter of the Independent Labour Party and author of a fierce
critique of the arms industry (The War of Steel and Gold) -declared:
In Europe the epoch of conquest is over and save in the Balkans and
perhaps on the fringes of the Austrian and Russian empires, it is as
certain as anything in politics that the frontiers of our national states
are finally drawn. My own belief is that there will be no more wars
among the six great powers.3 7
Financial markets had initially shrugged off the assassination
by Gavrilo Princip of the heir to the Austrian throne, the Arch­
duke Franz Ferdinand, in the Bosnian capital Sarajevo on 28 June
1914 . No t until 2 2 July did the financial press express any serious
anxiety that the Balkan crisis might escalate into something bigger
and more economically threatening. When investors belatedly
grasped the likelihood of a full-scale European war, however,
liquidity was sucked out of the world economy as if the bottom
had dropped out of a bath. The first symptom of the crisis was a
rise in shipping insurance premiums in the wake of the Austrian
ultimatum to Serbia (which demanded, among other things, that
Austrian officials be allowed into Serbia to seek evidence of
Belgrade's complicity in the assassination). Bond and stock prices
began to slip as prudent investors sought to increase the liquidity
of their positions by shifting into cash. European investors were
especially quick to start selling their Russian securities, followed
by Americans. Exchange rates went haywire as a result of efforts
by cross-border creditors to repatriate their money: sterling and
the franc surged, while the ruble and dollar slumped.3 8 By 30 July
panic reigned on most financial markets.3 9 The first firms to come
under pressure in London were the so-called jobbers on the Stock
Exchange, who relied heavily on borrowed money to finance
their purchases of equities. As sell orders flooded in, the value of
their stocks plunged below the value of their debts, forcing a
number (notably Derenberg & Co.) into bankruptcy. Also under
pressure were the commercial bill brokers in London, many of
whom were owed substantial sums by continental counterparties
now unable or unwilling to remit funds. Their difficulties in turn
impacted on the acceptance houses (the elite merchant banks),
who were first in line if the foreigners defaulted, since they had
accepted the bills. If the acceptance houses went bust, the bill
brokers would go down with them, and possibly also the larger
joint-stock banks, which lent millions every day short-term to the
discount market. The joint-stock banks' decision to call in loans
deepened what we would now call the credit crunch.4 0 As every­
one scrambled to sell assets and increase their liquidity, stock
prices fell, compromising brokers and others who had borrowed
money using shares as collateral. Domestic customers began to
fear a banking crisis. Queues formed as people sought to ex­
change banknotes for gold coins at the Bank of England.4 1 The
effective suspension of London's role as the hub of international
credit helped spread the crisis from Europe to the rest of the
Perhaps the most remarkable feature of the crisis of 191 4 was
the closure of the world's major stock markets for periods of up
to five months. The Vienna market was the first to close (on
27 July) . By 3 0 July all the continental European exchanges
had shut their doors. The next day London and Ne w York felt
compelled to follow suit. Although a belated settlement day went
ahead smoothly on 1 8 November, the London Stock Exchange
did not reopen until 4 January 1915 . Nothing like this had hap­
pened since its foundation in 1773. 4 2 The Ne w York market
reopened for limited trading (bonds for cash only) on
28 November, but wholly unrestricted trading did not resume
until 1 April 1915. 4 3 No r were stock exchanges the only markets
to close in the crisis. Most US commodity markets had to suspend
trading, as did most European foreign exchange markets. The
London Royal Exchange, for example, remained shut until
1 7 September.4 4 It seems likely that, had the markets not closed,
the collapse in prices would have been as extreme as in 1929 , if
not worse. N o act of state-sponsored terrorism has had greater
financial consequences than Gavrilo Princip's in 1914 .
The near-universal adoption of the gold standard had once
been seen as a comfort to investors. In the crisis of 1914 , however,
it tended to exacerbate the liquidity crisis. Some central banks
(notably the Bank of England) actually raised their discount rates
in the initial phase of the crisis, in a vain attempt to deter
foreigners from repatriating their capital and thereby draining
gold reserves. The adequacy of gold reserves in the event of an
emergency had been hotly debated before the war; indeed, these
debates are almost the only evidence that the financial world had
given any thought whatever to the trouble that lay ahead.4 5 Yet
the gold standard was no more rigidly binding than today's infor­
mal dollar pegs in Asia and the Middle East; in the emergency
of war, a number of countries, beginning with Russia, simply
suspended the gold convertibility of their currencies. In both
Britain and the United States formal convertibility was maintained,
but it could have been suspended if that had been thought neces­
sary. (The Bank of England was granted suspension of the 184 4
Bank Act, which imposed a fixed relationship between the Bank's
reserve and note issue, but this was not equivalent to suspending
specie payments, which could easily be maintained with a lower
reserve.) In each case, the crisis prompted the issue of emergency
paper money: in Britain, £ 1 and 10 s Treasury notes; in the United
States, the emergency currency that banks were authorized to
issue under the Aldrich-Vreeland Act of 1908. 4 6 Then, as now,
the authorities reacted to a liquidity crisis by printing money.
Nor were these the only measures deemed necessary. In London
the bank holiday of Monday 3 August was extended until Thurs­
day the 6th. Payments due on bills of exchange were postponed
for a month by royal proclamation. A month-long moratorium
on all other payments due (except wages, taxes, pensions and the
like) was rushed onto the statute books. (These moratoria were
later extended until, respectively, 1 9 October and 4 November.)
On 1 3 August the Chancellor of the Exchequer gave the Bank of
England a guarantee that, if the Bank discounted all approved
bills accepted before 4 August (when war was declared) 'without
recourse against the holders', then the Treasury would bear the
cost of any loss the Bank might incur. This amounted to a govern­
ment rescue of the discount houses; it opened the door for a
massive expansion of the monetary base, as bills poured into
the Bank to be discounted. On 5 September assistance was also
extended to the acceptance houses.4 7 Arrangements varied from
country to country, but the expedients were broadly similar and
quite unprecedented in their scope: temporary closures of
markets; moratoria on debts; emergency money issued by govern­
ments; bailouts for the most vulnerable institutions. In all these
respects, the authorities were prepared to go much further than
they had previously gone in purely financial crises. As had hap­
pened during the previous 'world war ' (against revolutionary and
then Napoleonic France more than a century before), the war of
191 4 was understood to be a special kind of emergency, justifying
measures that would have been inconceivable in peacetime,
including (as one Conservative peer put it) 'the release of the
bankers .. . from all liability'.4 8
The closure of the stock market and the intervention of the
authorities to supply liquidity almost certainly averted a cata­
strophic fire-sale of assets. The London stock market was already
down 7 per cent on the year when trading was suspended, and
that was before the fighting had even begun. Fragmentary data
on bond transactions (conducted literally in the street during the
period of stock market closure) give a sense of the losses investors
had to contemplate, despite the authorities' efforts. By the end of
1914 , Russian bonds were down 8.8 per cent, British consols
9.3 per cent, French rentes 13. 2 per cent and Austrian bonds
23 per cent.4 9 In the words of Patrick Shaw-Stewart of Barings,
it was 'one of the most terrific things London had been up against
since finance existed'.5 0 This, however, was merely the beginning.
Contrary to the 'short war ' illusion (which was more widespread
in financial than in military circles), there were another four years
of carnage still to go, and an even longer period of financial
losses. Any investor unwise or patriotic enough to hang on to
gilt-edged securities (consols or the new U K War Loans) would
have suffered inflation-adjusted losses of -4 6 per cent by 1920 .
Even the real returns on British equities were negative (-2 7 per
cent).5 1 Inflation in France and hyperinflation in Germany inflicted
even more severe punishment on anyone rash enough to maintain
large franc or Reichsmark balances. By 192 3 holders of all kinds
of German securities had lost everything, though subsequent
revaluation legislation restored some of their original capital.
30 2
Those with substantial holdings of Austrian, Hungarian, Ottoman
and Russian bonds also lost heavily - even when these were gold-denominated - as the Habsburg, Ottoman and Romanov empires
fell apart under the stresses of total war. The losses were especially
sudden and severe in the case of Russian bonds, on which the
Bolshevik regime defaulted in February 1918 . By the time this
happened, Russian 5 per cent bonds of the 190 6 vintage were
trading at below 45 per cent of their face value. Hopes of some
kind of settlement with foreign creditors lingered on throughout
the 1920s , by which time the bonds were trading at around 20
per cent of par. By the 1930 s they were all but worthless.5 2
Despite the best efforts of the bankers, who indefatigably
floated loans for such unpromising purposes as the payment
of German reparations, it proved impossible to restore the old
order of free capital mobility between the wars. Currency
crises, defaults, arguments about reparations and war debts and
then the onset of the Depression led more and more countries
to impose exchange and capital controls as well as protectionist
tariffs and other trade restrictions, in a vain bid to preserve
national wealth at the expense of international exchange. On
1 9 October 1921 , for example, the Chinese government declared
bankruptcy, and proceeded to default on nearly all China's exter­
nal debts. It was a story repeated all over the world, from Shang­
hai to Santiago, from Mosco w to Mexic o City. By the end of the
1930s , most states in the world, including those that retained
political freedoms, had imposed restrictions on trade, migration
and investment as a matter of course. Some achieved near-total
economic self-sufficiency (autarky), the ideal of a de-globalized
society. Consciously or unconsciously, all governments applied
in peacetime the economic restrictions that had first been imposed
between 191 4 and 1918 .
The origins of the First World War became clearly visible - as
soon as it had broken out. Only then did the Bolshevik leader
Lenin see that war was an inevitable consequence of imperialist
rivalries. Only then did American liberals grasp that secret diplo­
macy and the tangle of European alliances were the principal
causes of conflict. The British and French naturally blamed the
Germans; the Germans blamed the British and French. Historians
have been refining and modifying these arguments for more than
ninety years now. Some have traced the origins of the war back
to the naval race of the mid 1890s ; others to events in the Balkans
after 1907 . So why, when its causes today seem so numerous and
so obvious, were contemporaries so oblivious of Armageddon
until just days before its advent? One possible answer is that their
vision was blurred by a mixture of abundant liquidity and the
passage of time. The combination of global integration and
financial innovation had made the world seem reassuringly safe
to investors. Moreover, it had been thirty-four years since the
last major European war, between France and Germany, and that
had been mercifully short. Geopolitically, of course, the world
was anything but a safe place. Any reader of the Daily Mail could
see that the European arms race and imperial rivalry might one
day lead to a major war; indeed, there was an entire subgenre of
popular fiction based on imaginary Anglo-German wars. Yet the
lights in financial markets were flashing green, not red, until the
very eve of destruction.
There may be a lesson here for our time, too. The first era of
financial globalization took at least a generation to achieve. But
it was blown apart in a matter of days. And it would take more
than two generations to repair the damage done by the guns of
August 1914 .
Economic Hit Men
From the 1930 s until the late 1960s , international finance and the
idea of globalization slumbered - some even considered it dead.5 3
In the words of the American economist Arthur Bloomfield,
writing in 1946 :
It is now highly respectable doctrine, in academic and banking circles
alike, that a substantial measure of direct control over private capital
movements, especially of the so-called hot money varieties, will be
desirable for most countries not only in the years immediately ahead
but also in the long run as well. . . This doctrinal volte-face represents
a widespread disillusionment resulting from the destructive behaviour
of these movements in the interwar years.5 4
At Bretton Woods, in Ne w Hampshire's White Mountains, the
soon-to-be-victorious Allies met in July 194 4 to devise a new
financial architecture for the post-war world. In this new order,
trade would be progressively liberalized, but restrictions on capi­
tal movements would remain in place. Exchange rates would be
fixed, as under the gold standard, but now the anchor - the
international reserve currency - would be the dollar rather than
gold (though the dollar itself would notionally remain convertible
into gold, vast quantities of which sat, immobile but totemic, in
Fort Knox). In the words of Keynes, one of the key architects of
the Bretton Woods system, 'control of capital movements' would
be 'a permanent feature of the post-war system'.5 5 Even tourists
could be prevented from going abroad with more than a pocketful
of currency if governments felt unable to make their currencies
convertible. When capital sums did flow across national borders,
they would go from government to government, like the Marshall
Aid* that helped revive devastated Western Europe between 1948
and 1 9 5 2. 5 6 The two guardian 'sisters' of this new order were
to be established in Washington, DC , the capital of the 'free
world': the International Monetary Fund and the International
Bank for Reconstruction and Development, later (in combination
with the International Development Association) known as the
World Bank. In the words of current World Bank President
Robert Zoellick, 'The IM F was supposed to regulate exchange
rates. What became the World Bank was supposed to help re­
build countries shattered by the war. Free trade would be revived.
But free capital flows were out.' Thus, for the next quarter cen­
tury, did governments resolve the so-called 'trilemma', according
to which a country can choose any two out of three policy
1 . full freedom of cross-border capital movements;
2. a fixed exchange rate;
3. an independent monetary policy oriented towards dom­
estic objectives.5 7
Under Bretton Woods, the countries of the Western world
opted for 2 and 3. Indeed, the trend was for capital controls to
be tightened rather than loosened as time went on. A good
example is the Interest Equalization Act passed by the United
* The total amount disbursed under the Marshall Plan was equivalent to
roughly 5.4 per cent of US gross national product in the year of General
George Marshall's seminal speech, or 1. 1 per cent spread over the whole
period of the programme, which dated from April 1948, when the Foreign
Assistance Act was passed, to June 1 9 52, when the last payment was made.
If there had been a Marshall Plan between 2003 and 2007, it would have
cost $55 0 billion. By comparison, actual foreign economic aid under the Bush
administration between 2001 and 2006 totalled less than $15 0 billion, an
average of below 0.2 per cent of GDP .
States in 1963 , which was expressly designed to discourage
Americans from investing in foreign securities.
Yet there was always an unsustainable quality to the Bretton
Woods system. For the so-called Third World, the various
attempts to replicate the Marshall Plan through government-to-government aid programmes proved deeply disappointing. Over
time, American aid in particular became hedged around with
political and military conditions that were not always in the best
interests of the recipients. Even if that had not been the case, it is
doubtful that capital injections of the sort envisaged by American
economists like Walt Rostow* were the solution to the problems
of most African, Asian and Latin American economies. Much aid
was disbursed to poor countries, but the greater part of it was
either wasted or stolen.5 8 In so far as Bretton Woods did succeed
in generating new wealth by expediting the recovery of Western
Europe, it could only frustrate those investors who saw the risk
in excessive home bias. And, in so far as it allowed countries to
subordinate monetary policy to the goal of full employment, it
created potential conflicts even between options 2 and 3 of the
trilemma. In the late 1960s , US public sector deficits were neglig­
ible by today's standards, but large enough to prompt complaints
from France that Washington was exploiting its reserve currency
status in order to collect seigniorage from America's foreign
creditors by printing dollars, much as medieval monarchs had
exploited their monopoly on minting to debase the currency. The
decision of the Nixo n administration to sever the final link with
the gold standard (by ending gold convertibility of the dollar)
* Rostow, the author of The Stages of Economic Growth: A Non-Communist
Manifesto (i960), offered economic and strategic advice in roughly equal
measure to the Democratic administrations of the 1960s . As the equivalent
of National Security Adviser to Lyndon Johnson, he was closely associated
with the escalation of the Vietnam War.
30 7
sounded the death knell for Bretton Woods in 1971. 5 9 When the
Arab-Israeli War and the Arab oil embargo struck in 1973 , most
central banks tended to accommodate the price shock with easier
credit, leading to precisely the inflationary crisis that General de
Gaulle's adviser Jacques Rueff had feared.6 0
With currencies floating again and offshore markets like the
Eurobond market flourishing, the 1970 s saw a revival of non­
governmental capital export. In particular, there was a rush by
Western banks to recycle the rapidly growing surpluses of the
oil-exporting countries. The region where the bankers chose to
lend the Middle Eastern petrodollars was an old favourite.
Between 197 5 and 1982 , Latin America quadrupled its borrow­
ings from foreigners from $7 5 billion to more than $31 5 billion.
(Eastern European countries also entered the capital debt market,
a sure sign of the Communist bloc's impending doom.) Then, in
August 1982 , Mexic o declared that it would no longer be able to
service its debt. An entire continent teetered on the verge of
declaring bankruptcy. Yet the days had gone when investors
could confidently expect their governments to send a gunboat
when a foreign government misbehaved. No w the role of financial
policing had to be played by two unarmed bankers, the Inter­
national Monetary Fund and the World Bank. Their new watch­
word became 'conditionality': no reforms, no money. 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 adminis­
trator a hundred years before.* Number one was to impose fiscal
* Here is a brief overview of the ten points, based on John Williamson's
original 1989 formulation: 1 . Impose fiscal discipline; 2. Reform taxation;
3. Liberalize interest rates; 4. Raise spending on health and education;
5. Secure property rights; 6. Privatize state-run industries; 7. Deregulate
discipline to reduce or eliminate deficits. The tax base was to be
broadened and tax rates lowered. The market was to set interest
and exchange rates. Trade was be liberalized and so, crucially,
were capital flows. Suddenly 'hot' money, which had been out­
lawed at Bretton Woods, was hot again.
T o some critics, however, the World Bank and the IM F were
no better than agents of the same old Yankee imperialism. Any
loans from the IM F or World Bank, it was claimed, would simply
be used to buy American goods from American firms - often
arms to keep ruthless dictators or corrupt oligarchies in power.
The costs of 'structural adjustment' would be borne by their
hapless subjects. And Third World leaders who stepped out of
line would soon find themselves in trouble. These became popular
arguments, particularly in the 1990s , when anti-globalization
protests became regular features of international gatherings.
When articulated on placards or in rowdy chants by crowds of
well-fed Western youths such notions are relatively easy to dis­
miss. But when similar charges are levelled at the Bretton Woods
institutions by former insiders, they merit closer scrutiny.
When he was chief economist of the Boston-based company
Chas. T. Main, Inc., John Perkins claims he was employed to
ensure that the money lent to countries like Ecuador and Panama
by the IM F and World Bank would be spent on goods supplied by
US corporations. 'Economic hit men' like himself, according to
Perkins, 'were trained .. . to build up the American empire .. .
to create situations where as many resources as possible flow into
this country, to our corporations, and our governments':
This empire, unlike any other in the history of the world, has been
built primarily through economic manipulation, through cheating,
markets; 8. Adopt a competitive exchange rate; 9. Remove barriers to trade;
10 . Remove barriers to foreign direct investment.
through fraud, through seducing people into our way of life, through
the economic hit men . . . My real job . . . was giving loans to other
countries, huge loans, much bigger than they could possibly repay .. .
So we make this big loan, most of it comes back to the United States,
the country is left with debt plus lots of interest, and they basically
become our servants, our slaves. It's an empire. There's no two ways
about it. It's a huge empire.6 1
According to Perkins's book, The Confessions of an Economic
Hit Man, two Latin American leaders, Jaime Roldôs Aguilera of
Ecuador and Omar Torrijos of Panama, were assassinated in
198 1 for opposing what he calls 'that fraternity of corporate,
government, and banking heads whose goal is global empire'.6 2
There is, admittedly, something about his story that seems a
little odd. It is not as if the United States had lent much money
to Ecuador and Panama. In the 1970 s the totals were just
$9 6 million and $19 7 million, less than 0.4 per cent of total US
grants and loans. And it is not as if Ecuador and Panama were
major customers for the United States. In 199 0 they accounted
for, respectively, 0.1 7 per cent and 0.22 per cent of total US
exports. Those do not seem like figures worth killing for. As Bob
Zoellick puts it, 'The IM F and the World Bank lend money to
countries in crisis, not countries that offer huge opportunities to
corporate America.'
Nevertheless, the charge of neo-imperialism refuses to go away.
According to Nobel prize-winning economist Joseph Stiglitz, who
was chief economist at the World Bank between 199 7 and 2000,
the IM F in the 1980 s not only 'champion[ed] market supremacy
with ideological fervour' but also 'took a rather imperialistic
view' of its role. Moreover, Stiglitz argues, 'many of the policies
that the IM F has pushed, in particular premature capital market
liberalization, have contributed to global instability .. . Jobs have
31 0
Jaime Rold6s Aguilera of Ecuador ...
. . . and Omar Torrijos of Panama: Allegedly
victims of the 'economic hit men'
3 11
been systematically destroyed .. . [because] the influx of hot
money into and out of the country that so frequently follows
after capital market liberalization leaves havoc in its wake .. .
Even those countries that have experienced some limited growth
have seen the benefits accrue to the well-off, and especially the
very well-off.'6 3 In his animus against the IM F (and Wall Street),
Stiglitz overlooks the fact that it was not just those institutions
that came to favour a return to free capital movements in the 1980s .
It was actually the Organization for Economic Cooperation and
Development that blazed the liberalizing trail, followed (after the
conversion of French socialists like Jacques Delors and Michel
Camdessus) by the European Commission and European Coun­
cil. Indeed, there was arguably a Paris Consensus before there was
a Washington Consensus (though in many ways it was building on
a much earlier Bonn Consensus in favour of free capital
markets).6 4 In London, too, Margaret Thatcher's government
pressed ahead with unilateral capital account liberalization with­
out any prompting from the United States. Rather, it was the
Reagan administration that followed Thatcher's lead.
Stiglitz's biggest complaint against the IM F is that it responded
the wrong way to the Asian financial crisis of 1997 , lending
a total of $9 5 billion to countries in difficulty, but attaching
Washington Consensus-style conditions (higher interest rates,
smaller government deficits) that actually served to worsen the
crisis. It is a view that has been partially echoed by, among
others, the economist and columnist Paul Krugman.6 5 There is no
doubting the severity of the 1997- 8 crisis. In countries such as
Indonesia, Malaysia, South Korea and Thailand there was a
very severe recession in 1998 . Ye t neither Stiglitz nor Krugman
offers a convincing account of how the East Asian crisis might
have been better managed on standard Keynesian lines, with
currencies being allowed to float and government deficits to rise.
31 2
In the acerbic words of an open letter to Stiglitz by Kenneth
Rogoff, who became chief economist at the IM F after the Asian
Governments typically come to the IM F for financial assistance when
they are having trouble finding buyers for their debt and when the
value of their money is falling. The Stiglitzian prescription is to raise
. . . fiscal deficits, that is, to issue more debt and to print more money.
You seem to believe that if a distressed government issues more cur­
rency, its citizens will suddenly think it more valuable. You seem to
believe that when investors are no longer willing to hold a govern­
ment's debt, all that needs to be done is to increase the supply and it
will sell like hot cakes. We at the - no, make that we on planet Earth
- have considerable experience suggesting otherwise. We earthlings
have found that when a country in fiscal distress tries to escape by
printing more money, inflation rises, often uncontrollably . . . The
laws of economics may be different in your part of the gamma quad­
rant, but around here we find that when an almost bankrupt govern­
ment fails to credibly constrain the time profile of its fiscal deficits,
things generally get worse instead of better.66
No r is it clear that Malaysia's temporary imposition of capital
controls in 199 7 made a significant difference to the economy's
performance during the crisis. Krugman at least acknowledges
that the East Asian financial institutions, which had borrowed
short-term in dollars but lent out long-term in local currency
(often to political cronies), bore much of the responsibility for
the crisis. Yet his talk of a return of Depression economics now
looks overdone. There never was a Depression in East Asia
(except perhaps in Japan, which could hardly be portrayed as a
victim of IM F malfeasance). After the shock of 199 8 all the
economies affected returned swiftly to rapid growth - growth so
rapid, indeed, that by 2004 some commentators were wondering
31 3
if the 'two sisters' of Bretton Woods any longer had a role to play
as international lenders.6 7
In truth, the 1980 s saw the rise of an altogether different kind
of economic hit man, far more intimidating than those portrayed
by Perkins precisely because they never even had to contemplate
resorting to violence to achieve their objective. T o this new gener­
ation, making a hit meant making a billion dollars on a single
successful speculation. As the Cold War drew to its close, these
hit men had no real interest in pursuing an American imperialist
agenda; on the contrary, their stated political inclinations were
more often liberal than conservative. They did not work for
public sector institutions like the IM F or the World Bank. On
the contrary, they ran businesses that were entirely private, to the
extent that they were not even quoted on the stock market. These
businesses were called hedge funds, which we first encountered
as an alternative form of risk manager in Chapter 4. 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
the Second World War. As pools of lightly regulated,* highly
mobile capital, hedge funds exemplify the return of hot money after
the big chill that prevailed between the onset of the Depression and
the end of Bretton Woods. And the acknowledged capo dei capi
of the new economic hit men has been George Soros. It was no
coincidence that when the Malaysian prime minister Mahathir
bin Mohamad wanted to blame someone other than himself for
* Since the term was first used, in 1966 , to describe the long-short fund set
up by Alfred Winslow Jones in 194 9 (which took both long and short
positions on the US stock market), most hedge funds have been limited
liability partnerships. As such they have been exempted from the provisions
of the 193 3 Securities Act and the 194 0 Investment Company Act, which
restrict the operations of mutual funds and investment banks with respect to
leverage and short selling.
George Soros: hedge fund cupo dei capi
and master of reflexivity
the currency crisis that struck the ringgit in August I997, it was
Soros rather than the IMF that he called 'a moron'~
A Hungarian Jew by birth, though educated in London, George
Soros emigrated to the United States in I956. There he made his
reputation as an analyst and then head of research at the vener-able house of Arnhold & S. Bleichroeder (a direct descendant
of the Berlin private bank that had once managed Bismarck's
money).68 As might be expected of a Central European intellectual
- who named his fund the Quantum Fund in honour of the
physicist Werner Heisenberg's Uncertainty Principle - Soros
regards himself as more a philosopher than a hit man. His book
The Alchemy of Finance (1987 ) begins with a bold critique of
the fundamental assumptions of economics as a subject, reflecting
the influence on his early intellectual development of the philos­
opher Karl Popper.6 9 According to Soros's pet theory of 'reflex-ivity', 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 partici­
pants 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.'7 0 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. As he puts it in his most
recent book:
. . . markets never reach the equilibrium postulated by economic
theory. There is a two-way reflexive connection between perception
and reality which can give rise to initially self-reinforcing but eventu­
ally self-defeating boom-bust processes, or bubbles. Every bubble con­
sists of a trend and a misconception that interact in a reflexive manner.71
Originally devised to hedge against market risk with short
positions,* which make money if a security goes down in price,
a hedge fund provided the perfect vehicle for Soros to exploit his
insights about reflexive markets. Soros knew how to make money
from long positions too, it should be emphasized - that is, from
buying assets in the expectation of future prices rises. In 196 9 he
* Technically, according to the US Securities and Exchange Commission, a
short sale is 'any sale of a security which the seller does not own or any sale
which is consummated by the delivery of a security borrowed by, or for the
account of, the seller'.
31 6
31 7
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 about the quality of US-supplied hard­
ware in the Yo m Kippur War that there would need to be some
heavy investment in America's defence industries. So he went
long defence stocks too. 7 2 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 2 2 September 1985. 7 3 That year was an
annus mirabilis for Soros, who saw his fund grow by 12 2 per
cent. But the greatest of all his shorts proved to be one of the
most momentous bets in British financial history.
I admit I have a vested interest in the events of Wednesday
1 6 September 1992 . In those days, moonlighting as a newspaper
leader writer while I was a junior lecturer at Cambridge, I became
convinced that speculators like Soros could beat the Bank of
England if it came to a showdown. It was simple arithmetic: a
trillion dollars being traded on foreign exchange markets every
day, versus the Bank's meagre hard currency reserves. Soros
reasoned that the rising costs of German reunification would
drive up interest rates and hence the Deutschmark. This would
make the Conservative government's policy of shadowing the
German currency - formalized when Britain had joined the Euro­
pean 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
ER M and devalue the pound. So sure was Soros that the pound
would drop that he ultimately bet $1 0 billion, more than the
entire capital of his fund, on a series of transactions whereby he
The force of destiny: Chancellor the Exchequer Norman Lamont
announces sterling's exit from the European Exchange Rate
Mechanism, 16 September 1992
effectively borrowed sterling in the UK and invested in German
currency at the pre-I6 September price of around 2.95 Deutsch-marks}.74 I was equally sure that the pound would be devalued,
though all I had to bet was my credibility. As it happened, the
City editor of the newspaper I wrote for disagreed. That night,
having been given something of a browbeating at the leader
writers' morning conference with the editor, I went to the English
National Opera, to hear Verdi's The Force of Destiny. It proved
a highly appropriate choice. Someone announced at the interval
that Britain had withdrawn from the ERM. How we all cheered
- and no one louder than me (except possibly George Soros). His
fund made more than a billion dollars as sterling slumped -ultimately by as much as 20 per cent - allowing Soros to repay
the sterling he had borrowed but at the new lower exchange rate
3 IB
and to pocket the difference. And that trade accounted for just
40 per cent of the year's profits.7 5
The success of the Quantum Fund was staggering. If someone
had invested $100,00 0 with Soros when he established his second
fund (Double Eagle, the earlier name of Quantum) in 196 9 and
had reinvested all the dividends, he would have been worth
$13 0 million by 1994 , an average annual growth rate of 3 5 per
cent.7 6 The essential differences between the old and the new econ­
omic hit men were twofold: first, the cold, calculating absence of
loyalty to any particular country - the dollar and the pound could
both be shorted with impunity; second, the sheer scale of the money
the new men had to play with. 'Ho w big a position do you have?'
Soros once asked his partner Stanley Druckenmiller. 'One billion
dollars,' Druckenmiller replied. 'Yo u call that a position?' was
Soros's sardonic retort.7 7 For Soros, if a bet looked as good as his
bet against the pound in 1992 , then maximum leverage should
be applied to it. His hedge fund pioneered the technique of
borrowing from investment banks in order to take speculative
long or short positions far in excess of the fund's own capital.
Yet there were limits to the power of the hedge funds. At one
level, Soros and his ilk had proved that the markets were mightier
than any government or central bank. But that was not the same as
saying that the hedge funds could always command the markets.
Soros owed his success to a gut instinct about the direction of the
'electronic herd'. However, even his instincts (often signalled by a
spasm of back pain) could sometimes be wrong. Reflexivity, as he
himself acknowledges, is a special case; it does not rule the markets
every week of the year. What, then, if instincts could somehow
be replaced by mathematics? What if you could write an infallible
algebraic formula for double-digit returns? On the other side of
the world - indeed on the other side of the financial galaxy - it
seemed as if that formula had just been discovered.
31 9
Short-Term Capital Mismanagement
Imagine another planet - a planet without all the complicating fric­
tions 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 markets on this planet would follow a 'random walk',
meaning that each day's prices would be quite unrelated to the
previous day's but would reflect all the relevant information avail­
able. The returns on the planet's stock market would be normally
distributed along the bell curve (see Chapter 3) , with most years
clustered closely around the mean, and two thirds of them within
one standard deviation of the mean. In such a world, 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.7 8 This was the planet imagined by
some of the most brilliant financial economists of modern times.
Perhaps it is not altogether surprising that it turned out to look like
Greenwich, Connecticut, one of the blandest places on Earth.
In 199 3 two mathematical geniuses came to Greenwich with a
big idea. Working closely with Fisher Black of Goldman Sachs,
Stanford's Myro n Scholes had developed a revolutionary new
theory of pricing options. No w he and a third economist, Harvard
Business School's Robert Merton, hoped to turn the so-called
Black-Scholes model into a money-making machine. The starting
point of their work as academics was the long-established finan­
cial instrument known as an option contract, which (as we saw
in Chapter 4) works like this. If a particular stock is worth, say,
$10 0 today and I believe that it may be worth more in the future,
32 0
say, in a year's time, $200 , it would be nice to have the option to
buy it at that future date for, say, $150 . If I am right, I make a
profit. If not, well, it was only an option, so forget about it. The
only cost was the price of the option, which the seller pockets.
The big question was what that price should be.
'Quants' - the mathematically skilled analysts with the PhDs -sometimes refer to the Black Scholes model of options pricing as
a black box. It is worth taking a look inside this particular box.
The question, to repeat, is how to price an option to buy a
particular stock on a particular date in the future, taking into
account the unpredictable movement of the price of the stock in
the intervening period. Work out that option price accurately,
rather than just relying on guesswork, and you truly deserve the
title 'rocket scientist'. Black and Scholes reasoned that the
option's value depended on five variables: the current market
price of the stock (S), the agreed future price at which the option
could be exercised (X), the expiration date of the option (T), the
risk-free rate of return in the economy as a whole (r) and - the
crucial variable - the expected annual volatility of the stock, that
is, the likely fluctuations of its price between the time of purchase
and the expiration date (0 - the Greek letter sigma). With
wonderful mathematical wizardry, Black and Scholes reduced the
price of the option (C) to this formula:
Feeling a bit baffled? Can't follow the algebra? T o be honest,
I am baffled too. But that was just fine by the quants. T o make
C SN(d,) - Xe~] N(d2)
and d2 = dx~ o\TT
32 1
money from this insight, they needed markets to be full of people
who didn't have a clue how to price options but relied instead on
their (seldom accurate) gut instincts. They also needed a great
deal of computing power, a force which had been transforming
the financial markets since the early 1980s . All they required now
was a partner with some market savvy and they could make the
leap from the faculty club to the trading floor. Struck down by
cancer, Fisher Black could not be that partner. Instead, Merton
and Scholes turned to John Meriwether, the former head of the
bond arbitrage group at Salomon Brothers, who had made his
first fortune out of the Savings and Loans meltdown of the late
1980s . The firm they created in 199 4 wa s called Long-Term
Capital Management.
It seemed like the dream team: two of academia's hottest quants
teaming up with the ex-Salomon superstar plus a former Federal
Reserve vice-chairman, David Mullins, another ex-Harvard pro­
fessor, Eric Rosenfeld, and a bevy of ex-Salomon traders (Victor
Haghani, Larry Hilibrand and Hans Hufschmid). The investors
LTC M attracted to its fund were mainly big banks, among them
the Ne w Yor k investment bank Merrill Lynch and the Swiss
private bank Julius Baer. A latecomer to the party was another
Swiss bank, UBS. 7 9 The minimum investment was $1 0 million.
As compensation, the partners would take 2 per cent of the assets
under management and 25 per cent of the profits (most hedge
funds now charge 2 and 20, rather than 2 and 25). 8 0 Investors
would be locked in for three years before they could exit. And
another Wall Street firm, Bear Stearns, would stand ready to
execute whatever trades Long-Term wanted to make.
In its first two years, the fund managed by LTC M made mega-bucks, posting returns (even after its hefty fees) of 43 and 4 1 per
cent. If you had invested $1 0 million in Long-Term in March
1994 , it would have been worth just over $4 0 million four
32 2
years later. By September 199 7 the fund's net capital stood at
$6.7 billion. The partners' stakes had increased by a factor of
more than ten. Admittedly, to generate these huge returns on an
ever-growing pool of assets under management, Long-Term had
to borrow, like George Soros. This additional leverage allowed
them to bet more than just their own money. At the end of August
199 7 the fund's capital was $6. 7 billion, but the debt-financed
assets on its balance sheet amounted to $126. 4 billion, a ratio of
assets to capital of 1 9 to i. 8 1 By April 199 8 the balance sheet had
reached $13 4 billion. When we talk about being highly geared,
most academics are referring to their bicycles. But when Merton
and Scholes did so, they meant Long-Term was borrowing most
of the money it traded with. No t that this pile of debt scared
them. Their mathematical models said there was next to no risk
involved. For one thing, they were simultaneously pursuing mul­
tiple, uncorrelated trading strategies: around a hundred of them,
with a total of 7,600 different positions.8 2 One might go wrong,
or even two. But all these different bets just could not go wrong
simultaneously. That was the beauty of a diversified portfolio -another key insight of modern financial theory, which had been
formalized by Harry M . Markowitz, a Chicago-trained econom­
ist at the Rand Corporation, in the early 1950s , and further
developed in William Sharpe's Capital Asset Pricing Model
(CAPM). 8 3
Long-Term made money by exploiting price discrepancies in
multiple markets: in the fixed-rate residential mortgage market;
in the US , Japanese and European government bond markets; in
the more complex market for interest rate swaps* - anywhere, in
* A swap is a kind of derivative: a contractual arrangement in which one
party agrees to pay another a fixed interest rate, in exchange for a floating
rate (usually the London interbank offered rate, or Libor), applied to a
notional amount.
32 3
fact, where their models spotted a pricing anomaly, whereby
two fundamentally identical assets or options had fractionally
different prices. But the biggest bet the firm put on, and the one
most obviously based on the Black-Scholes formula, was selling
long-dated options on American and European stock markets; in
other words giving other people options which they would exer­
cise if there were big future stock price movements. The prices
these options were fetching in 199 8 implied, according to the
Black-Scholes formula, an abnormally high future volatility of
around 2 2 per cent per year. In the belief that volatility would
actually move towards its recent average of 10-1 3 per cent,
Long-Term piled these options high and sold them cheap. Banks
wanting to protect themselves against higher volatility - for
example, another 1987-style stock market sell-off - were happy
buyers. Long-Term sold so many such options that some people
started calling it the Central Bank of Volatility.8 4 At peak, they
had $4 0 million riding on each percentage point change in US
equity volatility.8 5
Sounds risky? The quants at Long-Term didn't think so.
Among Long-Term's selling points was the claim that they were
a market neutral fund - in other words they could not be hurt by a
significant movement in any of the major stock, bond or currency
markets. So-called dynamic hedging allowed them to sell options
on a particular stock index while avoiding exposure to the index
itself. What was more, the fund had virtually no exposure to
emerging markets. It was as if Long-Term really was on another
planet, far from the mundane ups and downs of terrestrial
finance. Indeed, the partners started to worry that they weren't
taking enough risks. Their target was a risk level corresponding
to an annual variation (standard deviation) of 20 per cent of their
assets. In practice, they were operating at closer to half that
(meaning that their assets were fluctuating up and down by no
more than 1 0 per cent).8 6 According to the firm's Value at Risk
models, it would take a ten-sigma (in other words, ten standard
deviation) event to cause the firm to lose all its capital in a single
year. But the probability of such an event, the quants calculated,
was i in io 2 4 - effectively zero.8 7
In October 1997 , as if to prove that LTC M really was the
ultimate Brains Trust, Merton and Scholes were awarded the
Nobel Prize in economics. So self-confident were they and their
partners that on 3 1 December 199 7 they returned $2. 7 billion to
outside investors (strongly implying that they would much rather
focus on investing their own money).8 8 It seemed as if intellect
had triumphed over intuition, rocket science over risk-taking.
Equipped with their magic black box, the partners at LTC M
seemed poised to make fortunes beyond even George Soros's
wildest dreams. And then, just five months later, something
happened that threatened to blow the lid right off the Nobel
winners' black box. For no immediately apparent reason, equity
markets dipped, so that volatility went up instead of down. And
the higher volatility went - it hit 27 in June, more than double
the Long-Term projection - the more money was lost. Ma y 199 8
was Long-Term's worst month ever: the fund dropped by 6.7 per
cent. But this was just the beginning. In June it was down 10. 1
per cent. And the less the fund's assets were worth, the higher its
leverage - the ratio of debt to capital - rose. In June it hit 3 1
to i. 8 9
In evolution, big extinctions tend to be caused by outside
shocks, like an asteroid hitting the earth. A large meteor struck
Greenwich in July 1998 , when it emerged that Salomon Smith
Barney (as Salomon Brothers had been renamed following its
takeover by Travelers) was closing down its US bond arbitrage
group, the place where Meriwether had made his Wall Street
reputation, and an outfit that had been virtually replicating
32 5
LTCM' s trading strategies. Clearly, the firm's new owners did
not like the losses they had been seeing since May . Then, on
Monday 1 7 August 1998 , that was followed by a giant asteroid
- not from outer space, but from one of earth's flakiest emerging
markets as, weakened by political upheaval, declining oil rev­
enues and a botched privatization, the ailing Russian financial
system collapsed. A desperate Russian government was driven
to default on its debts (including rouble-denominated domestic
bonds), fuelling the fires of volatility throughout the world's
financial markets.9 0 Coming in the wake of the Asian crisis of the
previous year, the Russian default had a contagious effect on
other emerging markets, and indeed some developed markets
too. Credit spreads blew out.* Stock markets plunged. Equity
volatility hit 29 per cent. At peak it reached 45 per cent, which
implied that the indices would move 3 per cent each day for the
next five years.9 1 Now , that just wasn't supposed to happen, not
according to the Long-Term risk models. The quants had said
that Long-Term was unlikely to lose more than $4 5 million in a
single day. 9 2 On Friday 2 1 August 1998 , it lost $55 0 million -1 5 per cent of its entire capital, driving its leverage up to 42:1. 9 3
The traders in Greenwich stared, slack-jawed and glassy-eyed, at
their screens. It couldn't be happening. But it was. Suddenly
all the different markets where Long-Term had exposure were
moving in sync, nullifying the protection offered by diversifi­
cation. In quant-speak, the correlations had gone to one. By the
end of the month, Long-Term was down 44 per cent: a total loss
of over $1. 8 billion.9 4
August is usually a time of thin trading in financial markets.
Mos t people are out of town. John Meriwether was on the other
* For example, the spread over US Treasuries of the J P Morgan emerging
market bond index rose from 3.3 per cent in October 1997 , to 6.6 per cent
in July 1998, to 17.0 5 per cent on 1 0 September 1998.
32 6
side of the world, in Beijing. Dashing home, he and his partners
desperately sought a white knight to rescue them. They tried
Warren Buffett in Omaha, Nebraska - despite the fact that just
months before LTC M had been aggressively shorting shares in
Buffett's company Berkshire Hathaway. He declined. On
24 August they reluctantly sought a meeting with none other
than George Soros.9 5 It was the ultimate humiliation: the quants
from Planet Finance begging for a bail-out from the earthling
prophet of irrational, unquantifiable reflexivity. Soros recalls that
he 'offered Meriwether $50 0 million if he could find another
$50 0 million from someone else. It didn't seem likely... ' J P
Morgan offered $20 0 million. Goldman Sachs also offered to
help. But others held back. Their trading desks scented blood. If
Long-Term was going bust, they just wanted their collateral, not
to buy Long-Term's positions. And they didn't give a damn if
volatility went through the roof. In the end, fearful that Long-Term's failure could trigger a generalized meltdown on Wall
Street, the Federal Reserve Bank of Ne w Yor k hastily brokered a
$3,62 5 billion bail-out by fourteen Wall Street banks.9 6 But the
original investors - who included some of the self-same banks,
but also some smaller players like the University of Pittsburgh -had meanwhile seen their holdings cut from $4.9 billion to just
$400 million. The sixteen partners were left with $3 0 million
between them, a fraction of the fortune they had anticipated.
What had happened? Why was Soros so right and the giant
brains at Long-Term so wrong? Part of the problem was precisely
that LTCM' s extraterrestrial founders had come back down to
Planet Earth with a bang. Remember the assumptions underlying
the Black-Scholes formula? Markets are efficient, meaning that
the movement of stock prices cannot be predicted; they are con­
tinuous, frictionless and completely liquid; and returns on stocks
follow the normal, bell-curve distribution. Arguably, the more
32 7
traders learned to employ the Black-Scholes formula, the more
efficient financial markets would become.9 7 But, as John Maynard
Keynes once observed, in a crisis 'markets can remain irrational
longer than you can remain solvent'. In the long term, it might
be true that the world would become more like Planet Finance,
always coolly logical. Short term, it was still dear old Planet
Earth, inhabited by emotional human beings, capable of flipping
suddenly from greed to fear. When losses began to mount, many
participants simply withdrew from the market, leaving LTC M
with a largely illiquid portfolio of assets that couldn't be sold at
any price. Moreover, this was an ever more integrated Planet
Earth, in which a default in Russia could cause volatility to spike
all over the world. 'Mayb e the error of Long Term', mused Myron
Scholes in an interview, 'was . . . that of not realizing that the
world is becoming more and more global over time.' Meriwether
echoed this view: 'The nature of the world had changed, and we
hadn't recognized it.'9 8 In particular, because many other firms
had begun trying to copy Long-Term's strategies, when things
went wrong it was not just the Long-Term portfolio that was hit;
it was as if an entire super-portfolio was haemorrhaging." There
was a herd-like stampede for the exits, with senior managers at
the big banks insisting that positions be closed down at any price.
Everything suddenly went down at once. As one leading London
hedge fund manager later put it to Meriwether: 'John, you were
the correlation.'
There was, however, another reason why LTC M failed. The
firm's value at risk (VaR) models had implied that the loss Long-Term suffered in August was so unlikely that it ought never to
have happened in the entire life of the universe. But that was
because the models were working with just five years' worth of
data. If the models had gone back even eleven years, they would
have captured the 198 7 stock market crash. If they had gone
back eighty years they would have captured the last great Russian
default, after the 191 7 Revolution. Meriwether himself, born in
1947 , ruefully observed: 'If I had lived through the Depression, I
would have been in a better position to understand events.'10 0 T o
put it bluntly, the Nobel prize winners had known plenty of
mathematics, but not enough history. They had understood the
beautiful theory of Planet Finance, but overlooked the messy past
of Planet Earth. And that, put very simply, was why Long-Term
Capital Management ended up being Short-Term Capital Mis­
It might be assumed that after the catastrophic failure of LTCM ,
quantitative hedge funds would have vanished from the financial
scene. After all, the failure, though spectacular in scale, was far
from anomalous. Of 1,308 hedge funds that were formed
between 198 9 and 1996 , more than a third (36.7 per cent) had
ceased to exist by the end of the period. In that period the average
life span of a hedge fund was just forty months.10 1 Ye t the very
reverse has happened. Far from declining, in the past ten years
hedge funds of every type have exploded in number and in the
volume of assets they manage. In 1990 , according to Hedge Fund
Research, there were just over 600 hedge funds managing some
$3 9 billion in assets. By 2000 there were 3,873 funds with
$490 billion in assets. The latest figures (for the first quarter of
2008) put the total at 7,60 1 funds with $1. 9 trillion in assets.
Since 199 8 there has been a veritable stampede to invest in hedge
funds (and in the 'funds of funds' that aggregate the performance
of multiple firms). Where once they were the preserve of 'high
net worth' individuals and investment banks, hedge funds are
now attracting growing numbers of pension funds and university
endowments.10 2 This trend is all the more striking given that
the attrition rate remains high; only a quarter of the 600 funds
reporting in 199 6 still existed at the end of 2004. In 2006, 71 7
ceased to trade; in the first nine months of 2007, 409. 10 3 It is not
widely recognized that large numbers of hedge funds simply fizzle
out, having failed to meet investors' expectations.
The obvious explanation for this hedge fund population
explosion is that they perform relatively well as an asset class,
with relatively low volatility and low correlation to other invest­
ment vehicles. But the returns on hedge funds, according to Hedge
Fund Research, have been falling, from 1 8 per cent in the 1990s
to just 7.5 per cent between 2000 and 2006. Moreover, there is
increasing scepticism that hedge fund returns truly reflect 'alpha'
(skill of asset management) as opposed to 'beta' (general market
movements that could be captured with an appropriate mix of
indices).10 4 An alternative explanation is that, while they exist,
hedge funds enrich their managers in a uniquely alluring way. In
200 7 George Soros made $2. 9 billion, ahead of Ken Griffin of
Citadel and James Simons of Renaissance, but behind John Paul­
son, who earned a staggering $3. 7 billion from his bets against
subprime mortgages. As John Ka y has pointed out, if Warren
Buffett had charged investors in Berkshire Hathaway ' 2 and 20' ,
he would have kept for himself $5 7 billion of the $6 2 billion his
company has made for its shareholders over the past forty-two
years. 10 5 Soros, Griffin and Simons are clearly exceptional fund
managers (though surely not more so than Buffett). This explains
why their funds, along with other superior performers, have
grown enormously over the past decade. Today around 390 funds
have assets under management in excess of $ 1 billion. The top
hundred now account for 75 per cent of all hedge fund assets;
and the top ten alone manage $32 4 billion.10 6 But a quite
mediocre conman could make a good deal of money by setting
up a hedge fund, taking $10 0 million off gullible investors and
running the simplest possible strategy:
33 0
1 . He parks the $10 0 million in one-year Treasury bills yielding
4 per cent.
2. This then allows him to sell for 1 0 cents on the dollar
io o million covered options, which will pay out if the S& P
500 falls by more than 20 per cent in the coming year.
3. He takes the $1 0 million from the sale of the options and buys
some more Treasury bills, which enables him to sell another
1 0 million options, which nets him another $ 1 million.
4. He then takes a long vacation.
5. At the end of the year the probability is 90 per cent that the
S& P 500 has not fallen by 20 per cent, so he owes the
option-holders nothing.
6. He adds up his earnings - $1 1 million from the sale of the
options plus 4 per cent on the $11 0 million of T-bills - a
handsome return of 15. 4 per cent before expenses.
7. He pockets 2 per cent of the funds under management
($2 million) and 20 per cent of the returns above, say, a
4 per cent benchmark, which comes to over $4 million gross.
8. The chances are nearly 60 per cent that the fund will run
smoothly on this basis for more than five years without the
S& P 500 falling by 20 per cent, in which case he makes
$1 5 million even if no new money comes into his fund, and
even without leveraging his positions.10 7
Could an LTCM-styl e crisis replay itself today, ten years on -only this time on such a scale, and involving so many such bogus
hedge funds, that it would simply be too big to bail out? Are the
banks of the Western world now even more exposed to hedge fund
losses, and related counterparty risks, than they were in 1998? *
* It is surely no coincidence that it was reports of losses at hedge funds
run by Bear Stearns and by Goldman Sachs that signalled the onset of the
credit crunch in the summer of 2007.
33 1
33 2
And, if they are, then who will bail them out this time around? The
answers to those questions lie not on another planet, but on the
other side of this one.
T o many, financial history is just so much water under the bridge
- ancient history, like the history of imperial China. Markets
have short memories. Man y young traders today did not even
experience the Asian crisis of 1997-8 . Those who went into
finance after 2000 lived through seven heady years. Stock markets
the world over boomed. So did bond markets, commodity
markets and derivatives markets. In fact, so did all asset classes
- not to mention those that benefit when bonuses are big, from
vintage Bordeaux to luxury yachts. But these boom years were
also mystery years, when markets soared at a time of rising
short-term interest rates, glaring trade imbalances and soaring
political risk, particularly in the economically crucial, oil-exporting regions of the world. The key to this seeming paradox
lay in China. 10 8
Chongqing, on the undulating banks of the mighty earth-brown River Yangtze, is deep in the heart of the Middle Kingdom,
over a thousand miles from the coastal enterprise zones most
Westerners visit. Ye t the province's 3 2 million inhabitants are as
much caught up in today's economic miracle as those in Hong
Kong or Shanghai. At one level, the breakneck industrialization
and urbanization going on in Chongqing are the last and greatest
feat of the Communist planned economy. The thirty bridges, the
ten light railways, the countless towerblocks all appear through
the smog like monuments to the power of the centralized one-party state. Yet the growth of Chongqing is also the result of
unfettered private enterprise. In many ways, Wu Yajun is the
personification of China's newfound wealth. As one of Chong­
qing's leading property developers, she is among the wealthiest
women in China, worth over $9 billion - the living antithesis of
those Scotsmen who made their fortunes in Hong Kong a century
ago. Or take Yin Mingsha. Imprisoned during the Cultural Revol­
ution, M r Yi n discovered his true vocation in the early 1990s ,
after the liberalization of the Chinese economy. In just fifteen
years he has built up a $90 0 million business. Last year his Lifan
company sold more than 1. 5 million motorcycle engines and
bikes; now he is exporting to the United States and Europe. Wu
and Yin are just two of more than 345,00 0 dollar millionaires
who now live in China.
Not only has China left its imperial past far behind. So far, the
fastest growing economy in the world has also managed to avoid
the kind of crisis that has periodically blown up other emerging
markets. Having already devalued the renminbi in 1994 , and
having retained capital controls throughout the period of econ­
omic reform, China suffered no currency crisis in 1997-8 . When
the Chinese wanted to attract foreign capital, they insisted that it
take the form of direct investment. That meant that instead of
borrowing from Western banks to finance their industrial devel­
opment, as many other emerging markets did, they got foreigners
to build factories in Chinese enterprise zones - large, lumpy assets
that could not easily be withdrawn in a crisis. The crucial point,
though, is that the bulk of Chinese investment has been financed
from China's own savings (and from the overseas Chinese
diaspora). Cautious after years of instability and unused to the
panoply of credit facilities we have in the West, Chinese house­
holds save an unusually high proportion of their rising incomes,
in marked contrast to Americans, who in recent years have saved
almost none at all. Chinese corporations save an even larger
33 3
proportion of their soaring profits. So plentiful are savings that,
for the first time in centuries, the direction of capital flow is now
not from West to East, but from East to West. And it is a mighty
flow. In 2007 , the United States needed to borrow around $800
billion from the rest of the world; more than $4 billion every
working day. China, by contrast, ran a current account surplus
of $26 2 billion, equivalent to more than a quarter of the US
deficit. And a remarkably large proportion of that surplus has
ended up being lent to the United States. In effect, the People's
Republic China has become banker to the United States of
At first sight, it may seem bizarre. Today the average American
earns more than $34,00 0 a year. Despite the wealth of people like
Wu Yajun and Yi n Mingsha, the average Chinese lives on less than
$2,000 . Why would the latter want, in effect, to lend money to the
former, who is twenty-two times richer? The answer is that, until
recently, the best way for China to employ its vast population
was through exporting manufactures to the insatiably spendthrift
US consumer. T o ensure that those exports were irresistibly
cheap, China had to fight the tendency for the Chinese currency to
strengthen against the dollar by buying literally billions of dollars
on world markets - part of a system of Asian currency pegs
that some commentators dubbed Bretton Woods II. 10 9 In 2006
Chinese holdings of dollars almost certainly passed the trillion
dollar mark. (Significantly, the net increase of China's foreign
exchange reserves almost exactly matched the net issuance of US
Treasury and government agency bonds. ) From America's point of
view, meanwhile, the best way of keeping the good times rolling
in recent years has been to import cheap Chinese goods. More­
over, by out-sourcing manufacturing to China, US corporations
have been able to reap the benefits of cheap labour too. And,
crucially, by selling billions of dollars of bonds to the People's Bank
33 4
Net national savings as a percentage of gross national income, 1970-2006
o +o-.~-.~-.~-.~-.~-.~-.~-.~-..-~.-~.-~~
1970 1975 1990 1995 2000 2005
of China, the United States has been able to enjoy significantly
lower interest rates than would otherwise have been the case.
Welcome to the wonderful dual country of 'Chimerica' - China
plus America - which accounts for just over a tenth of the world's
land surface, a quarter of its population, a third of its economic
output and more than half of global economic growth in the past
eight years. For a time it seemed like a marriage made in heaven.
The East Chimericans did the saving. The West Chimericans did
the spending. Chinese imports kept down US inflation. Chinese
savings kept down US interest rates. Chinese labour kept down
US wage costs. As a result, it was remarkably cheap to borrow
money and remarkably profitable to run a corporation. Thanks
to Chimerica, global real interest rates - the cost of borrowing,
after inflation - sank by more than a third below their average
over the past fifteen years. Thanks to Chimerica, US corporate
profits in 2006 rose by about the same proportion above their
average share of GDP . But there was a catch. The more China
was willing to lend to the United States, the more Americans were
willing to borrow. Chimerica, in other words, was the underlying
cause of the surge in bank lending, bond issuance and new deriva­
tive contracts that Planet Finance witnessed after 2000. It was
the underlying cause of the hedge fund population explosion. It
was the underlying reason why private equity partnerships were
able to borrow money left, right and centre to finance leveraged
buyouts. And Chimerica - or the Asian 'savings glut', as Ben
Bernanke called it 11 0 - was the underlying reason why the US mort­
gage market was so awash with cash in 2006 that you could get a
10 0 per cent mortgage with no income, no job or assets.
The subprime mortgage crisis of 2007 was not so difficult to
predict, as we have already seen. What was much harder to
predict was the way a tremor caused by a spate of mortgage
defaults in America's very own, home-grown emerging market
would cause a financial earthquake right across the Western
financial system. No t many people understood that defaults on
subprime mortgages would destroy the value of exotic new
asset-backed instruments like collateralized debt obligations. Not
many people saw that, as the magnitude of these losses soared,
interbank lending would simply seize up, and that the interest
rates charged to issuers of short-term commercial paper and
corporate bonds would leap upwards, leading to a painful squeeze
for all kinds of private sector borrowers. Not many people
foresaw that this credit crunch would cause a British bank to
suffer the first run since 186 6 and end up being nationalized.
Back in July 2007 , before the trouble started, one American
hedge fund manager had bet me 7 to 1 that there would be
no recession in the United States in the next five years. 'I bet that
the world wasn't going to come to an end,' he admitted six
months later. 'We lost.' Certainly, by the end of Ma y 2008, a US
33 6
33 7
recession seemed already to have begun. But the end of the world?
True, it seemed unlikely in Ma y 2008 that China (to say
nothing of the other BRICs ) would be left wholly unscathed by
an American recession. The United States remains China's biggest
trading partner, accounting for around a fifth of Chinese exports.
On the other hand, the importance of net exports to Chinese
growth has declined considerably in recent years. 11 1 Moreover,
Chinese reserve accumulation has put Beijing in the powerful
position of being able to offer capital injections to struggling
American banks. The rise of the hedge funds was only a part of
the story of the post-199 8 reorientation of global finance. Even
more important was the growth of sovereign wealth funds, enti­
ties created by countries running large trade surpluses to manage
their accumulating wealth. By the end of 200 7 sovereign wealth
funds had around $2. 6 trillion under management, more than all
the world's hedge funds, and not far behind government pension
funds and central bank reserves. According to a forecast by
Morgan Stanley, within fifteen years they could end up with
assets of $2 7 trillion - just over 9 per cent of total global financial
assets. Already in 2007 , Asian and Middle Eastern sovereign
wealth funds had moved to invest in Western financial companies,
including Barclays, Bear Stearns, Citigroup, Merrill Lynch,
Morgan Stanley, UB S and the private equity firms Blackstone
and Carlyle. For a time it seemed as if the sovereign wealth
funds might orchestrate a global bail-out of Western finance; the
ultimate role reversal in financial history. For the proponents of
what George Soros has disparaged as 'market fundamentalism',
here was a painful anomaly: among the biggest winners of the
latest crisis were state-owned entities. *
* Some sovereign wealth funds in fact have a relatively long history. The Kuwait
Investment Authority was set up in 1 9 5 3 ; Singapore's Temasek in 1974 ; A D I A ,
the United Arab Emirates' fund, in 1976 ; Singapore's GI C in 1981 .
And yet there are reasons why this seemingly elegant, and
quintessentially Chimerican, resolution of the American crisis has
failed to happen. Part of the reason is simply that the initial
Chinese forays into US financial stocks have produced less than
stellar results.* There are justifiable fears in Beijing that the worst
may be yet to come for Western banks, especially given the
unknowable impact of a US recession on outstanding credit
default swaps with a notional value of $6 2 trillion. But there is
also a serious political tension now detectable at the very heart
of Chimerica. For some time, concern has been mounting in
the U S Congress about what is seen as unfair competition and
currency manipulation by China, and the worse the recession gets
in the United States, the louder the complaints are likely to grow.
Ye t US monetary loosening since August 2007 - the steep cuts in
the federal funds and discount rates, the various auction and
lending 'facilities' that have directed $15 0 billion to the banking
system, the underwriting of J P Morgan's acquisition of Bear
Stearns - has amounted to an American version of currency
manipulation.11 2 Since the onset of the American crisis, the dollar
has depreciated roughly 25 per cent against the currencies of
its major trading partners, including 9 per cent against the
renminbi. Because this has coincided with simultaneous demand
and supply pressures in nearly all markets for commodities, the
result has been a significant spike in the prices of food, fuel and
raw materials. Rising commodity prices, in turn, are intensifying
inflationary pressures for China, necessitating the imposition of
* Having paid $5 billion for a 9.9 per cent stake in Morgan Stanley in
December 2007, the China Investment Corporation's chairman Lou Jiwei
compared the opportunity to a rabbit appearing in front of a farmer. 'If we
see a big fat rabbit,' he said, 'we will shoot at it.' But he added (referring to
the subsequent decline in Morgan Stanley's share price), 'Some people may
say we were shot by Morgan Stanley.'
price controls and export prohibitions and encouraging an extra­
ordinary scramble for natural resources in Africa and elsewhere
that, to Western eyes, has an unnervingly imperial undertone.11 3
Maybe, as its name was always intended to hint, Chimerica is
nothing more than a chimera - the mythical beast of ancient
legend that was part lion, part goat, part dragon.
Perhaps, on reflection, we have been here before. A hundred
years ago, in the first age of globalization, many investors thought
there was a similarly symbiotic relationship between the world's
financial centre, Britain, and continental Europe's most dynamic
industrial economy. That economy was Germany's. Then, as
today, there was a fine line between symbiosis and rivalry. 11 4
Could anything trigger another breakdown of globalization like
the one that happened in 1914 ? The obvious answer is a deterior­
ation of political relations between the United States and China,
whether over trade, Taiwan, Tibet or some other as yet subliminal
issue.11 5 The scenario may seem implausible. Ye t it is easy to see
how future historians could retrospectively construct plausible
chains of causation to explain such a turn of events. The advo­
cates of 'war guilt' would blame a more assertive China, leaving
others to lament the sins of omission of a weary American titan.
Scholars of international relations would no doubt identify the
systemic origins of the war in the breakdown of free trade, the
competition for natural resources or the clash of civilizations.
Couched in the language of historical explanation, a major con­
flagration can start to seem unnervingly probable in our time,
just as it turned out to be in 1914 . Some may even be tempted to
say that the surge of commodity prices in the period from 2003
until 2008 reflected some unconscious market anticipation of the
coming conflict.
One important lesson of history is that major wars can arise
even when economic globalization is very far advanced and the
33 9
hegemonic position of an English-speaking empire seems fairly
secure. A second important lesson is that the longer the world
goes without a major conflict, the harder one becomes to imagine
(and, perhaps, the easier one becomes to start). A third and final
lesson is that when a crisis strikes complacent investors it causes
much more disruption than when it strikes battle-scarred ones.
As we have seen repeatedly, the really big crises come just seldom
enough to be beyond the living memory of today's bank execu­
tives, fund managers and traders. The average career of a Wall
Street CE O is just over twenty-five years, 11 6 which means that
first-hand memories at the top of the US banking system do not
extend back beyond 198 3 - ten years after the beginning of the
last great surge in oil and gold prices. That fact alone provides a
powerful justification for the study of financial history.
The Descent of Money
Today's financial world is the result of four millennia of economic
evolution. Money - the crystallized relationship between debtor
and creditor - begat banks, clearing houses for ever larger aggre­
gations of borrowing and lending. From the thirteenth century
onwards, government bonds introduced the securitization of
streams of interest payments; while bond markets revealed the
benefits of regulated public markets for trading and pricing
securities. From the seventeenth century, equity in corporations
could be bought and sold in similar ways. From the eighteenth
century, insurance funds and then pension funds exploited econo­
mies of scale and the laws of averages to provide financial protec­
tion against calculable risk. From the nineteenth, futures and
options offered more specialized and sophisticated instruments:
the first derivatives. And, from the twentieth, households were
encouraged, for political reasons, to increase leverage and skew
their portfolios in favour of real estate.
Economies that combined all these institutional innovations -banks, bond markets, stock markets, insurance and property-owning democracy - performed better over the long run than
those that did not, because financial intermediation generally
permits a more efficient allocation of resources than, say, feudal­
ism or central planning. For this reason, it is not wholly surprising
34 1
that the Western financial model tended to spread around the
world, first in the guise of imperialism, then in the guise of
globalization.1 From ancient Mesopotamia to present-day China,
in short, the ascent of money has been one of the driving forces
behind human progress: a complex process of innovation, inter­
mediation and integration that has been as vital as the advance
of science or the spread of law in mankind's escape from the
drudgery of subsistence agriculture and the misery of the Malthu-sian trap. In the words of former Federal Reserve Governor
Frederic Mishkin, 'the financial system [is] the brain of the econ­
omy .. . It acts as a coordinating mechanism that allocates capital,
the lifeblood of economic activity, to its most productive uses by
businesses and households. If capital goes to the wrong uses or
does not flow at all, the economy will operate inefficiently, and
ultimately economic growth will be low.' 2
Yet money's ascent has not been, and can never be, a smooth
one. On the contrary, financial history is a roller-coaster ride of
ups and downs, bubbles and busts, manias and panics, shocks
and crashes.3 One recent study of the available data for gross
domestic product and consumption since 187 0 has identified 14 8
crises in which a country experienced a cumulative decline in
GD P of at least 1 0 per cent and eighty-seven crises in which
consumption suffered a fall of comparable magnitude, implying
a probability of financial disaster of around 3.6 per cent per
year.4 Even today, despite the unprecedented sophistication of
our institutions and instruments, Planet Finance remains as vul­
nerable as ever to crises. It seems that, for all our ingenuity, we
are doomed to be 'fooled by randomness'5 and surprised by 'black
swans'.6 It may even be that we are living through the deflation
of a multi-decade 'super bubble'.7
There are three fundamental reasons for this. The first is that
so much about the future - or, rather, futures, since there is never
34 2
a singular future - lies in the realm of uncertainty, as opposed to
calculable risk. As Frank Knight argued in 1921 , 'Uncertainty
must be taken in a sense radically distinct from the familiar notion
of Risk, from which it has never been properly separated .. . A
measurable uncertainty, or "risk" proper .. . is so far different
from an unmeasurable one that it is not in effect an uncertainty at
all.' T o put it simply, much of what happens in life isn't like a game
of dice. Again and again an event will occur that is 'so entirely
unique that there are no others or not a sufficient number to make
it possible to tabulate enough like it to form a basis for any inference
of value about any real probability . . .' 8 The same point was brilli­
antly expressed by Keynes in 1937 . 'By "uncertain" knowledge,'
he wrote in a response to critics of his General Theory,
.. . I do not mean merely to distinguish what is known for certain
from what is only probable. The game of roulette is not subject, in
this sense, to uncertainty . . . The expectation of life is only slightly
uncertain. Even the weather is only moderately uncertain. The sense
in which I am using the term is that in which the prospect of a
European war is uncertain, or .. . the rate of interest twenty years
hence .. . About these matters there is no scientific basis on which to
form any calculable probability whatever. We simply do not know.*
Keynes went on to hypothesize about the ways in which inves­
tors 'manage in such circumstances to behave in a manner which
saves our faces as rational, economic men':
* As Peter Bernstein has said, 'We pour in data from the past .. . but past
data . . . constitute a sequence of events rather than a set of independent
observations, which is what the laws of probability demand. History provides
us with only one sample of the .. . capital markets, not with thousands of
separate and randomly distributed numbers.' The same problem - that the
sample size is effectively one - is of course inherent in geology, a more
advanced historical science than financial history, as Larry Neal has observed.
(1 ) We assume that the present is a much more serviceable guide to
the future than a candid examination of past experience would show
it to have been hitherto. In other words we largely ignore the prospect
of future changes about the actual character of which we know
(2) We assume that the existing state of opinion as expressed in prices
and the character of existing output is based on a correct summing
up of future prospects . . .
(3) Knowing that our own individual judgment is worthless, we
endeavor to fall back on the judgment of the rest of the world which
is perhaps better informed. That is, we endeavor to conform with the
behavior of the majority or the average.9
Though it is far from clear that Keynes was correct in his
interpretation of investors' behaviour, he was certainly thinking
along the right lines. For there is no question that the heuristic
biases of individuals play a critical role in generating volatility in
financial markets.
This brings us to the second reason for the inherent instability
of the financial system: human behaviour. As we have seen, all
financial institutions are at the mercy of our innate inclination to
veer from euphoria to despondency; our recurrent inability to
protect ourselves against 'tail risk'; our perennial failure to learn
from history. In a famous article, Daniel Kahneman and Amos
Tversky demonstrated with a series of experiments the tendency
that people have to miscalculate probabilities when confronted
with simple financial choices. First, they gave their sample group
1,000 Israeli pounds each. Then they offered them a choice
between either a) a 50 per cent chance of winning an additional
1,000 pounds or b) a 10 0 per cent chance of winning an
additional 500 pounds. Only 1 6 per cent of people chose a);
everyone else (84 per cent) chose b). Next, they asked the same
group to imagine having received 2,000 Israeli pounds each and
confronted them with another choice: between either c) a 50 per
cent chance of losing 1,000 pounds or b) a 10 0 per cent chance
of losing 500 pounds. This time the majority (69 per cent) chose
a); only 3 1 per cent chose b). Yet, viewed in terms of their payoffs,
the two problems are identical. In both cases you have a choice
between a 50 per cent chance of ending up with 1,000 pounds
and an equal chance of ending up with 2,000 pounds (a and c)
or a certainty of ending up with 1,50 0 pounds (b and d). In this
and other experiments, Kahneman and Tversky identify a striking
asymmetry: risk aversion for positive prospects, but risk seeking
for negative ones. A loss has about two and a half times the
impact of a gain of the same magnitude.1 0
This 'failure of invariance' is only one of many heuristic biases
(skewed modes of thinking or learning) that distinguish real
human beings from the homo oeconomicus of neoclassical eco­
nomic theory, who is supposed to make his decisions rationally,
on the basis of all the available information and his expected
utility. Other experiments show that we also succumb too readily
to such cognitive traps as:
1 . Availability bias, which causes us to base decisions on infor­
mation 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 they have happened (ex post) than we did
before they happened (ex ante)-,
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 events of
90 per cent probability will all occur, while underestimating
the probability that at least one of seven events of 1 0 per cent
probability will occur;
5. Confirmation bias, which inclines us to look for confirming
evidence of an initial hypothesis, rather than falsifying evi­
dence 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-judgements
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. Over confidence 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 inclines us to abdicate individual
responsibility when in a crowd. 1 1
If you still doubt the hard-wired fallibility of human beings,
ask yourself the following question. A bat and ball, together, cost
a total of £1.1 0 and the bat costs £ 1 more than the ball. How
much is the ball? The wrong answer is the one that roughly
one in every two people blurts out: 1 0 pence. The correct answer
is 5 pence, since only with a bat worth £1.0 5 and a ball worth
5 pence are both conditions satisfied.1 2
If any field has the potential to revolutionize our understanding
of the way financial markets work, it must surely be the bur­
geoning discipline of behavioural finance.1 3 It is far from clear
how much of the body of work derived from the efficient markets
hypothesis can survive this challenge.1 4 Those who put their faith
in the 'wisdom of crowds' 1 5 mean no more than that a large group
of people is more likely to make a correct assessment than a small
group of supposed experts. But that is not saying much. The old
joke that 'Macroeconomists have successfully predicted nine of
the last five recessions' is not so much a joke as a dispiriting truth
about the difficulty of economic forecasting.1 6 Meanwhile, serious
students of human psychology will expect as much madness as
wisdom from large groups of people.1 7 A case in point must be
the near-universal delusion among investors in the first half of
2007 that a major liquidity crisis could not occur (see Introduc­
tion). T o adapt an elegant summation by Eliezer Yudkowsky :
People may be overconfident and over-optimistic. They may focus on
overly specific scenarios for the future, to the exclusion of all others.
They may not recall any past [liquidity crises] in memory. They may
overestimate the predictability of the past, and hence underestimate
the surprise of the future. They may not realize the difficulty of
preparing for [liquidity crises] without the benefit of hindsight. They
may prefer . . . gambles with higher payoff probabilities, neglecting
the value of the stakes. They may conflate positive information about
the benefits of a technology [e.g. bond insurance] and negative infor­
mation about its risks. They may be contaminated by movies where the
[financial system] ends up being saved.. . Or the extremely unpleasant
prospect of [a liquidity crisis] may spur them to seek arguments that
[liquidity] will not [dry up], without an equally frantic search for
reasons why [it should]. But if the question is, specifically, 'Why aren't
more people doing something about it?', one possible component is
that people are asking that very question - darting their eyes around
to see if anyone else is reacting .. . meanwhile trying to appear poised
and unflustered.18
Most of our cognitive warping is, of course, the result of evolu­
tion. The third reason for the erratic path of financial history is
also related to the theory of evolution, though by analogy. It is
commonly said that finance has a Darwinian quality. Th e sur­
vival of the fittest' is a phrase that aggressive traders like to use;
as we have seen, investment banks like to hold conferences with
titles like Th e Evolution of Excellence'. But the American crisis of
2007 has increased the frequency of such language. US Assistant
Secretary of the Treasury Anthony W. Ryan was not the only
person to talk in terms of a wave of financial extinctions in the
second half of 2007 . Andrew Lo , director of the Massachusetts
Institute of Technology's Laboratory for Financial Engineering,
is in the vanguard of an effort to re-conceptualize markets as
adaptive systems.1 9 A long-run historical analysis of the develop­
ment of financial services also suggests that evolutionary forces
are present in the financial world as much as they are in the
natural world. 2 0
The notion that Darwinian processes may be at work in the
economy is not new, of course. Evolutionary economics is in fact
a well-established sub-discipline, which has had its own dedicated
journal for the past sixteen years.2 1 Thorstein Veblen first posed
the question 'Why is Economics No t an Evolutionary Science?'
(implying that it really should be) as long ago as 1898. 2 2 In a
famous passage in his Capitalism, Socialism and Democracy,
which could equally well apply to finance, Joseph Schumpeter
characterized industrial capitalism as 'an evolutionary process':
This evolutionary character .. . is not merely due to the fact that
economic life goes on in a social and natural environment which
changes and by its change alters the data of economic action; this
fact is important and these changes (wars, revolutions and so on)
often condition industrial change, but they are not its prime movers.
Nor is this evolutionary character due to quasi-autonomic increase in
population and capital or to the vagaries of monetary systems of
which exactly the same thing holds true. The fundamental impulse
that sets and keeps the capitalist engine in motion comes from the
new consumers' goods, the new methods of production or trans­
portation, the new markets, the new forms of industrial organization
that capitalist enterprise creates .. . The opening up of new markets,
foreign or domestic, and the organizational development from
the craft shop and factory to such concerns as US Steel illustrate
the same process of industrial mutation - if I may use the biological
term - that incessantly revolutionizes the economic structure from
within, incessantly destroying the old one, incessantly creating a new
one. This process of Creative Destruction is the essential fact about
A key point that emerges from recent research is just how much
destruction goes on in a modern economy. Around one in ten U S
companies disappears each year. Between 198 9 and 1997 , to be
precise, an average of 611,00 0 businesses a year vanished out of
a total of 5.73 million firms. Ten per cent is the average extinction
rate, it should be noted; in some sectors of the economy it can
rise as high as zo per cent in a bad year (as in the District of
Columbia's financial sector in 1989 , at the height of the Savings
and Loans crisis).2 4 According to the U K Department of Trade
and Industry, 30 per cent of tax-registered businesses disappear
after three years.2 5 Even if they survive the first few years of
existence and go on to enjoy great success, most firms fail eventu­
ally. Of the world's 10 0 largest companies in 1912 , 29 were
bankrupt by 1995 , 48 had disappeared, and only 1 9 were still in
the top ioo. 2 6 Given that a good deal of what banks and stock
markets do is to provide finance to companies, we should not be
surprised to find a similar pattern of creative destruction in the
financial world. We have already noted the high attrition rate
among hedge funds. (The only reason that more banks do not
fail, as we shall see, is that they are explicitly and implicitly
protected from collapse by governments.)
What are the common features shared by the financial world
and a true evolutionary system? Six spring to mind:
- 'Genes', in the sense that certain business practices perform
the same role as genes in biology, allowing information to be
stored in the 'organizational memory' and passed on from
individual to individual or from firm to firm when a new firm
is created.
- The potential for spontaneous mutation, usually referred to
in the economic world as innovation and primarily, though
by no means always, technological.
- Competition between individuals within a species for re­
sources, with the outcomes in terms of longevity and prolifer­
ation determining which business practices persist.
- A mechanism for natural selection through the market
allocation of capital and human resources and the possibility
of death in cases of under-performance, i.e. 'differential
-Scop e for speciation, sustaining biodiversity through the
creation of wholly new species of financial institutions.
- Scope for extinction, with species dying out altogether.
Financial history is essentially the result of institutional
mutation and natural selection. Random 'drift' (innovations/
mutations that are not promoted by natural selection, but just
happen) and 'flow' (innovations/mutations that are caused when,
say, American practices are adopted by Chinese banks) play a
part. There can also be 'co-evolution', when different financial
species work and adapt together (like hedge funds and their
prime brokers). But market selection is the main driver. Financial
organisms are in competition with one another for finite
35 0
resources. At certain times and in certain places, certain species
may become dominant. But innovations by competitor species, or
the emergence of altogether new species, prevent any permanent
hierarchy or monoculture from emerging. Broadly speaking, the
law of the survival of the fittest applies. Institutions with a 'selfish
gene' that is good at self-replication and self-perpetuation will
tend to proliferate and endure.2 7
Note that this may not result in the evolution of the perfect
organism. A 'good enough' mutation will achieve dominance if
it happens in the right place at the right time, because of the
sensitivity of the evolutionary process to initial conditions; that
is, an initial slim advantage may translate into a prolonged period
of dominance, without necessarily being optimal. It is also worth
bearing in mind that in the natural world, evolution is not
progressive, as used to be thought (notably by the followers of
Herbert Spencer). Primitive financial life-forms like loan sharks
are not condemned to oblivion, any more than the microscopic
prokaryotes that still account for the majority of earth's species.
Evolved complexity protects neither an organism nor a firm
against extinction - the fate of most animal and plant species.
The evolutionary analogy is, admittedly, imperfect. When one
organism ingests another in the natural world, it is just eating;
whereas, in the world of financial services, mergers and acquisi­
tions can lead directly to mutation. Among financial organisms,
there is no counterpart to the role of sexual reproduction in the
animal world (though demotic sexual language is often used to
describe certain kinds of financial transaction). Mos t financial
mutation is deliberate, conscious innovation, rather than ran­
dom change. Indeed, because a firm can adapt within its own
lifetime to change going on around it, financial evolution (like
cultural evolution) may be more Lamarckian than Darwinian in
character. Tw o other key differences will be discussed below.
35 1
Nevertheless, evolution certainly offers a better model for under­
standing financial change than any other we have.
Ninety years ago, the German socialist Rudolf Hilferding pre­
dicted an inexorable movement towards more concentration of
ownership in what he termed finance capital.2 8 The conventional
view of financial development does indeed see the process from
the vantage point of the big, successful survivor firm. In Citi­
group's official family tree, numerous small firms - dating back
to the City Bank of Ne w York , founded in 181 2 - are seen to
converge over time on a common trunk, the present-day conglom­
erate. However, this is precisely the wrong way to think about
financial evolution over the long run, which begins at a common
trunk. Periodically, the trunk branches outwards as new kinds
of bank and other financial institution evolve. The fact that a
particular firm successfully devours smaller firms along the way
is more or less irrelevant. In the evolutionary process, animals eat
one another, but that is not the driving force behind evolutionary
mutation and the emergence of new species and sub-species. The
point is that economies of scale and scope are not always the
driving force in financial history. More often, the real drivers are
the process of speciation - whereby entirely new types of firm are
created - and the equally recurrent process of creative destruc­
tion, whereby weaker firms die out.
Take the case of retail and commercial banking, where there
remains considerable biodiversity. Although giants like Citigroup
and Bank of America exist, North America and some European
markets still have relatively fragmented retail banking sectors.
The cooperative banking sector has seen the most change in recent
years, with high levels of consolidation (especially following the
Savings and Loans crisis of the 1980s) , and most institutions
moving to shareholder ownership. But the only species that is
now close to extinction in the developed world is the state-owned
35 2
bank, as privatization has swept the world (though the nationaliz­
ation of Northern Rock suggests the species could make a come­
back). In other respects, the story is one of speciation, the
proliferation of new types of financial institution, which is just
what we would expect in a truly evolutionary system. Man y new
'mono-line' financial services firms have emerged, especially in
consumer finance (for example, Capital One). A number of new
'boutiques' now exist to cater to the private banking market.
Direct banking (telephone and Internet) is another relatively
recent and growing phenomenon. Likewise, even as giants have
formed in the realm of investment banking, new and nimbler
species such as hedge funds and private equity partnerships have
evolved and proliferated. And, as we saw in Chapter 6, the rapidly
accruing hard currency reserves of exporters of manufactured
goods and energy are producing a new generation of sovereign
wealth funds.
Not only are new forms of financial firm proliferating; so too
are new forms of financial asset and service. In recent years,
investors' appetite has grown dramatically for mortgage-backed
and other asset-backed securities. The use of derivatives has also
increased enormously, with the majority being bought and sold
'over the counter', on a one-to-one bespoke basis, rather than
through public exchanges - a tendency which, though profitable
for the sellers of derivatives, may have unpleasant as well as
unintended consequences because of the lack of standardization
of these instruments and the potential for legal disputes in the
event of a crisis.
In evolutionary terms, then, the financial services sector appears
to have passed through a twenty-year Cambrian explosion, with
existing species flourishing and new species increasing in number.
As in the natural world, the existence of giants has not precluded
the evolution and continued existence of smaller species. Size isn't
35 3
everything, in finance as in nature. Indeed, the very difficulties
that arise as publicly owned firms become larger and more com­
plex - the diseconomies of scale associated with bureaucracy, the
pressures associated with quarterly reporting - give opportunities
to new forms of private firm. What matters in evolution is not
your size or (beyond a certain level) your complexity. All that
matters is that you are good at surviving and reproducing your
genes. The financial equivalent is being good at generating returns
on equity and generating imitators employing a similar business
In the financial world, mutation and speciation have usually
been evolved responses to the environment and competition, with
natural selection determining which new traits become widely
disseminated. Sometimes, as in the natural world, the evolution­
ary process has been subject to big disruptions in the form of
geopolitical shocks and financial crises. The difference is, of
course, that whereas giant asteroids (like the one that eliminated
85 per cent of species at the end of the Cretaceous period) are
exogenous shocks, financial crises are endogenous to the financial
system. The Great Depression of the 1930 s and the Great
Inflation of the 1970 s stand out as times of major discontinuity,
with 'mass extinctions' such as the bank panics of the 1930 s and
the Savings and Loans failures of the 1980s .
Could something similar be happening in our time? Certainly,
the sharp deterioration in credit conditions in the summer of
200 7 created acute problems for many hedge funds, leaving them
vulnerable to redemptions by investors. But a more important
feature of the recent credit crunch has been the pressure on banks
and insurance companies. Losses on asset-backed securities and
other forms of risky debt are thought likely to be in excess of $ 1
trillion. At the time of writing (May 2008), around $31 8 billion
of write-downs (booked losses) have been acknowledged, which
35 4
means that more than $60 0 billion of losses have yet to come to
light. Since the onset of the crisis, financial institutions have raised
around $22 5 billion of new capital, leaving a shortfall of slightly
less than $10 0 billion. Since banks typically target a constant
capital/assets ratio of less than 1 0 per cent, that implies that
balance sheets may need to be shrunk by as much as $ 1 trillion.
However, the collapse of the so-called shadow banking system of
off-balance-sheet entities such as structured investment vehicles
and conduits is making that contraction very difficult indeed.
It remains to be seen whether the major Western banks can
navigate their way through this crisis without a fundamental
change to the international accords (Basel I and II)* governing
capital adequacy. In Europe, for example, average bank capital
is now equivalent to significantly less than 1 0 per cent of assets
(perhaps as little as 4), compared with around 25 per cent towards
the beginning of the twentieth century. The 200 7 crisis has dashed
the hopes of those who believed that the separation of risk origin­
ation and balance sheet management would distribute risk opti­
mally throughout the financial system. It seems inconceivable
that this crisis will pass without further mergers and acquisitions,
as the relatively strong devour the relatively weak. Bond insur­
ance companies seem destined to disappear. Some hedge funds,
* Under the Basel I rules agreed in 1988, assets of banks are divided into five
categories according to credit risk, carrying risk weights ranging from zero
(for example, home country government bonds) to 10 0 per cent (corporate
debt). International banks are required to hold capital equal to 8 per cent of
their risk-weighted assets. Basel II, first published in 2004 but only gradually
being adopted around the world, sets out more complex rules, distinguishing
between credit risk, operational risk and market risk, the last of which
mandates the use of value at risk (VaR) models. Ironically, in the light of
2007-8, liquidity risk is combined with other risks under the heading
'residual risk'. Such rules inevitably conflict with the incentive all banks have
to minimize their capital and hence raise their return on equity.
35 5
35 6
by contrast, are likely to thrive on the return of volatility.* It also
seems likely that new forms of financial institution will spring up
in the aftermath of the crisis. As Andrew L o has suggested: 'As
with past forest fires in the markets, we're likely to see incredible
flora and fauna springing up in its wake.' 2 9
There is another big difference between nature and finance.
Whereas evolution in biology takes place in the natural environ­
ment, where change is essentially random (hence Richard
Dawkins's image of the blind watchmaker), evolution in financial
services occurs within a regulatory framework where - to borrow
a phrase from anti-Darwinian creationists - 'intelligent design'
plays a part. Sudden changes to the regulatory environment are
rather different from sudden changes in the macroeconomic
environment, which are analogous to environmental changes in
the natural world. The difference is once again that there is
an element of endogeneity in regulatory changes, since those
responsible are often poachers turned gamekeepers, with a good
insight into the way that the private sector works. The net effect,
however, is similar to climate change on biological evolution.
Ne w rules and regulations can make previously good traits
suddenly disadvantageous. The rise and fall of Savings and Loans,
for example, was due in large measure to changes in the regu­
latory environment in the United States. Regulatory changes in
the wake of the 2007 crisis may have comparably unforeseen
The stated intention of most regulators is to maintain stability
within the financial services sector, thereby protecting the con­
sumers whom banks serve and the 'real' economy which the
* In Andrew Lo's words: 'Hedge funds are the Galapagos Islands of finance
. . . The rate of innovation, evolution, competition, adaptation, births and
deaths, the whole range of evolutionary phenomena, occurs at an extraordi­
narily rapid clip.'
industry supports. Companies in non-financial industries are seen
as less systemically important to the economy as a whole and less
critical to the livelihood of the consumer. The collapse of a major
financial institution, in which retail customers lose their deposits,
is therefore an event which any regulator (and politician) wishes
to avoid at all costs. An old question that has raised its head since
August 2007 is how far implicit guarantees to bail out banks
create a problem of moral hazard, encouraging excessive risk-taking on the assumption that the state will intervene to avert
illiquidity and even insolvency if an institution is considered too
big to fail - meaning too politically sensitive or too likely to
bring a lot of other firms down with it. From an evolutionary
perspective, however, the problem looks slightly different. It may,
in fact, be undesirable to have any institutions in the category of
'too big to fail', because without occasional bouts of creative
destruction the evolutionary process will be thwarted. The experi­
ence of Japan in the 1990 s stands as a warning to legislators and
regulators that an entire banking sector can become a kind of
economic dead hand if institutions are propped up despite under-performance, and bad debts are not written off.
Every shock to the financial system must result in casualties.
Left to itself, natural selection should work fast to eliminate the
weakest institutions in the market, which typically are gobbled
up by the successful. But most crises also usher in new rules and
regulations, as legislators and regulators rush to stabilize the
financial system and to protect the consumer/voter. The critical
point is that the possibility of extinction cannot and should
not be removed by excessively precautionary rules. As Joseph
Schumpeter wrote more than seventy years ago, 'This economic
system cannot do without the ultima ratio of the complete
destruction of those existences which are irretrievably associated
with the hopelessly unadapted.' This meant, in his view, nothing
35 7
less than the disappearance of 'those firms which are unfit to
live'. 3 0
In writing this book, I have frequently been asked if I gave it
the wrong title. The Ascent of Money may seem to sound an
incongruously optimistic note (especially to those who miss the
allusion to Bronowski's Ascent of Man) at a time when a surge
of inflation and a flight into commodities seem to signal a literal
descent in public esteem and purchasing power of fiat moneys like
the dollar. Ye t it should by now be obvious to the reader just how
far our financial system has ascended since its distant origins
among the moneylenders of Mesopotamia. There have been great
reverses, contractions and dyings, to be sure. But not even the worst
has set us permanently back. Though the line of financial history
has a saw-tooth quality, its trajectory is unquestionably upwards.
Still, I might equally well have paid homage to Charles Darwin
by calling the book The Descent of Finance, for the story I have
told is authentically evolutionary. When we withdraw banknotes
from automated telling machines, or invest portions of our
monthly salaries in bonds and stocks, or insure our cars, or
remortgage our homes, or renounce home bias in favour of
emerging markets, we are entering into transactions with many
historical antecedents.
I remain more than ever convinced that, until we fully under­
stand the origin of financial species, we shall never understand
the fundamental truth about money: that, far from being 'a mon­
ster that must be put back in its place', as the German president
recently complained,3 1 financial markets are like the mirror of
mankind, revealing every hour of every working day the way we
value ourselves and the resources of the world around us.
It is not the fault of the mirror if it reflects our blemishes as
clearly as our beauty.
Though writing is a solitary activity, no book is a solo venture. I am
grateful to the staff at the following archives: the Amsterdam Historical
Museum; the National Library, Paris; the British Museum, London; the
Cotton Museum at the Memphis Cotton Exchange; the Dutch National
Archives, The Hague; the Louisiana State Museum, Ne w Orleans; the
Medici Archives, Florentine City Archive; the National Archives of Scot­
land, Edinburgh; the National Library, Venice; the Rothschild Archive,
London; and the Scottish Widows Archive, Edinburgh. A number of
scholars and librarians generously responded to my requests for assist­
ance. In particular, I would like to thank Melanie Aspey, Tristram Clarke,
Florence Groshens, Francesco Guidi-Bruscoli, Greg Lambousy, Valerie
Moar, Liesbeth Strasser, Jonathan Taylor and Lodewijk Wagenaar. I have
had invaluable research assistance from Andrew Novo .
Special thanks go to the select group of financial experts who agreed
to be interviewed on the record: Domingo Cavallo, Joseph DiFatta, John
Elick, Kenneth Griffin, William Gross, José Pinera, Lord Rothschild, Sir
Evelyn de Rothschild, Richard Scruggs, George Soros, George Stevenson,
Carmen Velasco, Paul Volcker, Sherron Watkins and Robert Zoellick. I
have also learned much from informal conversations with participants at
events organized by Morgan Stanley and GL G Partners.
This is a Penguin book on both sides of the Atlantic. In Ne w York it
was a pleasure and privilege to be edited for the first time by Ann Godoff.
In London Simon Winder made sure that no unintelligible jargon made
it into print. Michael Page did a superb job as copy-editor. Thanks are
also due to Richard Duguid, Ruth Stimson, Rosie Glaisher, Alice Dawson,
Helen Fraser, Stefan McGrath, Ruth Pinkney and Penelope Vogler.
Like my last three books, The Ascent of Money was from its earliest
inception a television series as well as a book. At Channel 4 I owe debts
to Julian Bellamy, Ralph Lee, Kevin Lygo and, above all, Hamish Mykura.
Our occasional tensions were always creative. At W-NET/Channel 1 3 in
Ne w York Stephen Segaller has been an invaluable supporter. I am especi­
ally grateful to the Channel 1 3 fund-raising team, led by Barbara Banti-voglio, for all their efforts. Neither series nor book could have been made
without the extraordinary team of people assembled by Chimerica Media:
Dewald Aukema, our peerless cinematographer, Rosalind Bentley, our
researcher, Vaughan Matthews, our additional cameraman, Paul Paragon
and Ronald van der Speck, our occasional sound men, Joanna Potts,
our assistant producer, Vivienne Steel, our production manager, and
Charlotte Wilkins, our production co-ordinator - not forgetting her pre­
decessor Hedda Archbold. As for Melanie Fall and Adrian Pennink, my
fellow Chimericans, suffice to say that without them The Ascent of Money
would never have got off the ground.
Among the many people who helped us film the series, a number of
'fixers' went out of their way to help. M y thanks go to Sergio Ballivian,
Rudra Banerji, Matias de Sa Moreira, Makarena Gagliardi, Laurens
Grant, Juan Harrington, Fernando Mecklenburg, Alexandra Sanchez,
Tiziana Tortarolo, Khaliph Troup, Sebastiano Venturo and Eelco
Vijzelaar. M y friend Chris Wilson ensured that I missed no planes.
I am extremely fortunate to have in Andrew Wylie the best literary
agent in the world and in Sue Ayton his counterpart in the realm of
British television. M y thanks also go to James Pullen and all the other
staff in the London and Ne w York offices of the Wylie Agency.
A number of historians, economists and financial practitioners gener­
ously read all or part of the manuscript in draft or discussed key issues. I
would like to thank Raw i Abdelal, Ewen Cameron Watt, Richart Carty,
Rafael DiTella, Mohamed El-Erian, Benjamin Friedman, Brigitte Gran­
ville, Laurence Kotlikoff, Robert Litan, George Magnus, Ian Mukherjee,
Greg Peters, Richard Roberts, Emmanuel Roman, William Silber, André
Stern, Lawrence Summers, Richard Sylla, Nassim Taleb, Peter Temin and
36 1
James Tisch. Needless to say, all errors of fact and interpretation that
remain are my fault alone.
This book was researched and written at a time of considerable personal
upheaval. Without the understanding and support of three academic
institutions it would quite simply have been impossible. At Oxford Uni­
versity I would like to thank the Principal and Fellows of Jesus College,
their counterparts at Oriel College and the librarians of the Bodleian. At
the Hoover Institution, Stanford, I owe debts to John Raisian, the Direc­
tor, and his excellent staff, particularly Jeff Bliss, William Bonnett,
Noel Kolak, Richard Sousa, Celeste Szeto, Deborah Ventura and Dan
Wilhelmi. Hoover Fellows who have helped or inspired this work include
Robert Barro, Stephen Haber, Alvin Rabushka and Barry Weingast.
M y biggest debts, however, are to my colleagues at Harvard. It would
take much too long to thank every member of the Harvard History
Department individually, so let me confine myself to those who directly
contributed to this project. Charles Maier has been a constant source of
inspiration and friendship. Jim Hankins offered hospitality and help in
Florence. I would also like to thank David Armitage, Erez Manela, Ernest
Ma y and Daniel Sargent (now, alas, lost to Berkeley) for establishing
International History as the perfect milieu for interdisciplinary historical
research. Andrew Gordon and his successor James Kloppenberg have
chaired the Department with exceptional skill and sensitivity. And with­
out Janet Hatch and her staff, at least one of the three spinning plates
of administration, research and teaching would have crashed to the
At the Centre of European Studies I have been lucky to share space and
thoughts with, among others, David Blackbourn, Patricia Craig, Paul
Dzus, Patrice Higonnet, Stanley Hoffman, May a Jasanoff, Katiana Orluc,
Anna Popiel, Sandy Selesky, Cindy Skach, Michelle Weitzel and Daniel
It was above all my colleagues at Harvard Business School who had to
take the strain during 2006-7 . First and foremost, I thank Dean Ja y Light
for being so kind to me at a time of crisis. But I am equally grateful to all
the members of the Business and Government in the International Econ­
omy unit for tolerating my unscheduled absences, in particular Richard
Vietor, whom I left in the lurch, as well as Raw i Abdelal, Laura Alfaro,
Diego Comin, Arthur Daemmrich, Rafael DiTella, Catherine Duggan,
Lakshmi Iyer, Noel Maurer, David Moss, Aldo Musacchio, Forest
Reinhardt, Julio Rotemberg, Debora Spar, Gunnar Trumbull, Louis Wells
and Eric Werker. Za c Pelleriti has provided vital administrative assistance.
Thanks are also due to Steven Bloomfield and his colleagues at the
Weatherhead Center for International Affairs; Graham Allison and every­
one at the Belfer Center for Science and International Affairs; Claudia
Goldin and other participants at the Workshop in Economic History;
and, last but not least, Dorothy Austin and Diana Eck and all the other
denizens of Lowell House.
Finally, I thank all my students on both sides of the Charles River,
particularly those in my classes iob , 1961,196 4 and 1965.1 have learned
from their many papers and from the countless formal and informal
conversations that make working at Harvard such a joy.
In the time that this book was written, my wife Susan fought her way
back from a severe accident and other reverses. T o her and to our children,
Felix, Freya and Lachlan, I owe the biggest debt. I only wish that I were
able to repay them in a sounder currency.
Cambridge, Massachusetts, June 2008
36 2
1 . To be precise, this was the increase in per capita disposable personal
income between the third quarter of 2006 and the third quarter of
2007. It has since been static, rising barely at all between March
2007 and March 2008. Data from Economic Report of the President
2008, table B-31 :
2. Carmen DeNavas-Walt, Bernadette D . Proctor and Jessica Smith,
Income, Poverty and Health Insurance Coverage in the United States:
2006 (Washington, DC , August 2007), p. 4.
3. We See Opportunity: Goldman Sachs 2007 Annual Report (New
York, 2008).
4. Paul Collier, The Bottom Billion: Why the Poorest Countries Are
Failing and What Can Be Done About It (Oxford, 2007).
5. David Wessel, 'A Source of our Bubble Trouble', Wall Street Journal,
1 7 January 2008.
6. Stephen Roach, 'Special Compendium: Lyford Cay 2006', Morgan
Stanley Research (2 1 November 2006), p. 4.
7. Milton Friedman and Anna J . Schwartz, A Monetary History of the
United States, 1867-1960 (Princeton, 1963) .
8. Princeton Survey Research Associates International, prepared for
the National Foundation for Credit Counseling, 'Financial Literacy
Survey', 1 9 April 2007: Summary
Report ToplineFinal.pdf.
NOTE S T O PP . II -2 5
9. Alexander R . Konrad, 'Finance Basics Elude Citizens', Harvard
Crimson, 2 February 2008.
0. Associated Press, 'Teens Still Lack Financial Literacy, Survey Finds',
5 April, 2006:
i. Dreams of Avarice
1 . ' A World without Money', Socialist Standard (July 1979) . The pass­
age was a translated extract from 'Les Amis de Quatre Millions de
Jeune Travailleurs', Un Monde sans Argent: Le Communisme (Paris,
1975-é) :
2. Indeed, Mar x and Engels had themselves recommended not the aboli­
tion of money but 'Centralization of credit in the hands of the state,
by means of a national bank with state capital and an exclusive
monopoly': clause 5 of The Communist Manifesto.
3. Juan Forero, 'Amazonian Tribe Suddenly Leaves Jungle Home', 1 1 May
4. Clifford Smyth, Francisco Pizarro and the Conquest of Peru (White-fish, Montana, 2007 [1931]) .
5. Michael Wood, Conquistadors (London, 2001) , p. 128 .
6. For a vivid account from the conquistadors' vantage point, which
makes it clear that gold was their prime motive, see the November
153 3 letter from Hernando Pizarro to the Royal Audience of Santo
Domingo, in Clements R. Markham (ed.), Reports on the Discovery
of Peru (London, 1872) , pp. 113-27 .
7. M . A. Burkholder, Colonial Latin America (2nd edn., Oxford, 1994) ,
p. 46.
8. J . Hemming, Conquest of the Incas (London, 2004), p. 77 .
9. Ibid., p. 355 .
0. Wood, Conquistadors, pp. 38 , 148 .
1 . Hemming, Conquest, p. 392 .
2. P. Bakewell, A History of Latin America (2nd edn., Oxford, 2004),
p. 186 .
3. Hemming, Conquest, pp. 3 5 6ff.
4. See Alexander Murray, Reason and Society in the Middle Ages
(Oxford, 2002), pp. 25-58 .
NOTE S T O PP . 25-3 6
15 . See Thomas J . Sargent and François R . Velde, The Big Problem of
Small Change (Princeton, NJ , 2002).
16 . Bakewell, History of Latin America, p. 182 .
17 . Mauricio Drelichman and Hans-Joachim Voth, 'Institutions and the
Resource Curse in Early Modern Spain', paper presented at the
CIA R Institutions, Organizations, and Growth Program Meeting in
Toronto, 16-1 8 March 2007.
18 . Hans J . Nissen, Peter Damerow and Robert K . Englund, Archaic
Bookkeeping: Early Writing and Techniques of Economic Adminis­
tration in the Ancient Near East (London, 1993) .
19 . I am grateful to Dr John Taylor of the British Museum for his expert
guidance and assistance with deciphering the cuneiform inscriptions.
I also learned much from Martin Schubik's 'virtual museum' at Yale:
20. Glyn Davies, A History of Money: From Ancient Times to the Present
Day (Cardiff, 1994) ; Jonathan Williams, with Jo e Cribb and Eliza­
beth Errington (eds.), Money: A History (London, 1997 )
21 . See Marc Van De Mieroop, Society and Enterprise in Old Babylonian
Ur (Berlin, 1992 ) and the essays in Michael Hudson and Mar c Van
De Mieroop (eds.), Debt and Economic Renewal in the Ancient Near
East, vol. Ill (Bethesda, MD , 1998) ; Jac k M . Sassoon, Gary Beckman
and Karen S. Rubinson, Civilizations of the Ancient Near East, vol.
Ill (London, 2000).
22 . William N . Goetzmann, 'Fibonacci and the Financial Revolution',
NBE R Working Paper 1035 2 (March 2004).
23 . John H. Munro, 'The Medieval Origins of the Financial Revolution:
Usury, Rentes, and Negotiability', International History Review, 25 ,
3 (September 2003), pp. 505-62 .
24. On the advantages to Italian cities of nurturing Jewish communities,
see Maristella Botticini, ' A Tale of "Benevolent" Governments: Pri­
vate Credit Markets, Public Finance, and the Role of Jewish Lenders
in Renaissance Italy', journal of Economic History, 60, 1 (March
2000), pp. 164-189 .
25 . Frederic C. Lane, Venice: A Maritime Republic (Baltimore, 1973) ,
p. 300.
26. Idem, 'Venetian Bankers, 1496-1533 ^ Study in the Early Stages of
NOTE S T O PP . 37-4 8
Deposit Banking', Journal of Political Economy, 45 , 2 (April 1937) ,
pp. 187-206 .
27 . Benjamin C. I. Ravid, 'The First Charter of the Jewish Merchants of
Venice', AJS Review, 1 (1976) , pp. i9off.
28. Idem, 'The Legal Status of the Jewish Merchants of Venice, 1541 -1638' , Journal of Economic History, 3 5, 1 (March 1975) , pp. 274-9 .
29. Rhiannon Edward, 'Loan Shark Charged n m per cent Interest',
Scotsman, 1 8 August 2006.
30 . John Hale, The Civilization of Europe in the Renaissance (London,
1993) , P- 83 .
31 . Gene A . Brucker, 'The Medici in the Fourteenth Century', Speculum,
32 , 1 (January 1957) , P- 13 ?
32 . John H . Munro, 'The Medieval Origins of the Financial Revolution:
Usury, Rentes, and Negotiability', International History Review, 25 ,
3 (September 2003) , pp. 505-62 .
3 3. Richard A . Goldthwaite, 'The Medici Bank and the World of Floren­
tine Capitalism', Past and Present, 11 4 (Feb. 1987) , pp. 3-31 . On
the background to the Medicis' rise, see Raymond de Roover, The
Rise and Decline of the Medici Bank, 1397-1494 (Cambridge, MA ,
1963) , PP. 9-34 .
34 . Venetian State Archives, Mediceo Avanti Principato, MA P 133,134 ,
153 .
35 . Franz-Josef Arlinghaus, 'Bookkeeping, Double-entry Bookkeeping',
in Christopher Kleinhenz (ed.), Medieval Italy: An Encyclopedia, vol.
1 (New York , 2004). The first book to describe the method was
Benedetto Cotrugli's / / libro dell'arte di mercatura, published in 14 5 8.
3 6. Raymond de Roover, 'The Medici Bank: Organization and Manage­
ment', Journal of Economic History, 6, 1 (May 1946) , pp. 24-52 .
37 . Venetian State Archives, Archivio del Monte, Catasto of 1427. 1 am
grateful to Dr Francesco Guidi for his guidance regarding the Medici
papers in the Florence State Archives.
38. Raymond de Roover, 'The Decline of the Medici Bank', Journal of
Economic History, 7, 1 (May 1947) , pp. 69-82 .
3 9. Stephen Quinn and William Roberds, 'The Big Problem of Large Bills :
The Bank of Amsterdam and the Origins of Central Banking', Federal
Reserve Bank of Atlanta Working Paper, 2005-1 6 (August 2005).
NOTE S T O PP . 52-7 2
40. See for example Peter L . Rousseau and Richard Sylla, 'Financial
Systems, Economic Growth, and Globalization', in Michael D . Bordo,
Alan M . Tayor and Jeffrey G. Williamson (eds.), Globalization in
Historical Perspective (Chicago / London, 2003 ), pp. 373-416 .
41 . See Charles P. Kindleberger, A Financial History of Western Europe
(London, 1984) , p. 94.
42 . Walter Bagehot, Lombard Street: A Description of the Money Market
(London, 1873) .
43 . Quoted in Kindleberger, Financial History, p. 87.
44. Niall Ferguson and Oliver Wyman, The Evolution of Financial
Services: Making Sense of the Past, Preparing for the Future
(London / New York, 2007), p. 34. See also p. 40 for a composite
measure of global liquidity.
45 . Ibid., p. 63 .
46. Ibid., p. 48.
47. httpdlwww.his.orglstatisticslhankstats.htm.
48. Lord [Victor] Rothschild, Meditations of a Broomstick (London,
1977) , P- i7 -2. Of Human Bondage
1 . David Wessel and Thomas T. Vogel Jr. , 'Arcane World of Bonds is
Guide and Beacon to a Populist President', Wall Street Journal,
25 February 1993 , p. Ai .
2. Raymond Goldsmith, Premodern Financial Systems (Cambridge,
1987) , pp. i57ff., 164-9 .
3. See M . Veseth, Mountains of Debt: Crisis and Change in Renaissance
Florence, Victorian Britain and Postwar America (New York /
Oxford, 1990) .
4. John H. Munro, 'The Origins of the Modern Financial Revolution:
Responses to Impediments from Church and State in Western Europe,
1200-1600' , University of Toronto Working Paper, 2 (6 July 2001) ,
p. 7.
5. James Macdonald, A Free Nation Deep in Debt: The Financial Roots
of Democracy (New York, 2003) , pp. 8 iff.
6. Jean-Claude Hocquet, 'City-State and Market Economy', in Richard
NOTE S T O PP . 72- 9
Bonney (éd.), Economie Systems and State Finance (Oxford, 1995) ,
pp. 87-91 .
7. Jean-Claude Hocquet, 'Venice', in Richard Bonney (éd.), The Rise of
the Fiscal State in Europe, c. 1200-1815 (Oxford, 1999) , p. 395 .
8. Frederic C. Lane, Venice: A Maritime Republic (Baltimore, 197 3 ), p. 3 23 .
9. Idem, 'Venetian Bankers, 1496-1533 : A Study in the Early Stages of
Deposit Banking', Journal of Political Economy, 45 , 2 (April 1937) ,
pp. i97f.
0. Munro, 'Origins of the Modern Financial Revolution', pp. 15 L
1 . Martin Kôrner, 'Public Credit', in Richard Bonney (ed.), Economic
Systems and State Finance (Oxford, 1995) , pp. 52of., 524 ^ See also
Juan Gelabert, 'Castile, 1504-1808' , in Richard Bonney (ed.), The Rise
of the Fiscal State in Europe, c. 1200-181$ (Oxford, 1999), pp. 2o8ff.
2. Marjolein 't Hart, 'The United Provinces 1579-1806' , in Richard
Bonney (ed.), The Rise of the Fiscal State in Europe, c. 1200-181$
(Oxford, 1999) , pp. 3 1 iff.
3. Douglass C . North and Barry R . Weingast, 'Constitutions and Com­
mitment: The Evolution of Institutions Governing Public Choice in
Seventeenth-Century England', Journal of Economic History, 49, 4
(1989) , pp. 803-32 . The classic account of Britain's financial revol­
ution is P. G . M . Dickson, The Financial Revolution in England: A
Study in the Development of Public Credit, 1688-1756 (London,
1967) .
4. The best account of the financial crisis of the ancien régime is J . F.
Bosher, French Finances, 1770-1795 (Cambridge, 1970) .
5. Larry Neal, The Rise of Financial Capitalism: International Capital
Markets in the Age of Reason (Cambridge, 1990) .
6. Hansard, Ne w Series, vol. XVIII , pp. 540-43 .
7. For a detailed account, see Niall Ferguson, The World's Banker: The
History of the House of Rothschild (London, 1998) . See also Herbert
H. Kaplan, Nathan Mayer Rothschild and the Creation of a Dynasty:
The Critical Years, 1806-1816 (Stanford, 2006).
8. Rothschild Archive, London, XI/109 , Nathan Rothschild to his
brothers Amschel, Carl and James, 2 January 1816 .
9. Rothschild Archive, London, XI/109/2/2/156 , Salomon, Paris, to
Nathan, London, 29 October 1815 .
NOTE S T O PP . 81-9 0
20. See Lord [Victor] Rothschild, The Shadow of a Great Man (London,
1982) .
21 . Philip Ziegler, The Sixth Great Power: Barings, 1762-1929 (London,
1988) , pp. 94f.
22 . Heinrich Heine, Ludwig Borne - ein Denkschrift: Sàmtliche
Schriften, vol. IV (Munich, 1971) , p. 27 .
23 . Heinrich Heine, 'Lutetia', in Sàmtliche Schriften, vol. V (Munich,
1971) , pp. 32iff., 353 .
24. Anon., The Hebrew Talisman (London 1840) , pp. 28ff.
25 . Henry Iliowzi, 'In the Pale': Stories and Legends of the Russian Jews
(Philadelphia, 1897) .
26. Richard McGregor, 'Chinese Buy into Conspiracy Theory', Financial
Times, 26 September 2007.
27. Marc Flandreau and Juan H. Flores, 'Bonds and Brands: Lessons
from the 1820s' , Center for Economic Policy Research Discussion
Paper, 6420 (August 2007).
28. For a more complete list of all the bond issues with which the
Rothschilds were in any way associated, see J . Ayer, A Century of
Finance, 1804 to 1904: The London House of Rothschild (London,
1904) , pp. 14-4 2
29. On Amsterdam, see James C. Riley, International Government
Finance and the Amsterdam Capital Market (Cambridge, 1980) ,
pp. 119-94 .
30. Niall Ferguson, 'The first "Eurobonds": The Rothschilds and the
Financing of the Holy Alliance, 1818-1822' , in William N . Goetz-mann and K . Geert Rouwenhorst (eds.), The Origins of Value: The
Financial Innovations that Created Modern Capital Markets
(Oxford, 2005), pp. 311-23 .
31 . Johann Heinrich Bender, Uber den Verkehr mit Staatspapieren in
seinen Hauptrichtungen .. . Als Beylageheft zum Archiv fur die
Civilist[ische] Praxis, vol. VIII (Heidelberg, 1825) , pp. 6ff.
32 . Heine, Ludwig Borne, p. 28.
33 . Alfred Rubens, Anglo-Jewish Portraits (London, 1935) , p. 299.
34. The Times, 1 5 January 1821 .
35 . Bertrand Gille, Histoire de la Maison Rothschild, vol. I: Des origines
à 1848 (Geneva, 1965) , p. 487.
NOTE S T O PP . 90-9 8
36. Richard Hofstadter, The Age of Reform from Bryan to F.D.R.
(London, 1962) , pp. 75ff.
37 . Hermann Fûrst Puckler, Briefe eines Verstorbenen, ed. Heinz Ohff
(Kupfergraben, 1986) , p. 7.
38. J . A. Hobson, Imperialism: A Study (London, 1902) , Part I, ch. 4.
39 . See e.g. Douglas B . Ball, Financial Failure and Confederate Defeat
(Urbana, 1991) .
40. Irving Katz, August Belmont: A Political Biography (New York,
1968) , esp. pp. 96-9 .
41 . S. Diamond (éd.), A Casual View of America: The Home Letters of
Salomon de Rothschild, 1859-1861 (London, 1962) .
42 . See Rudolf Glanz, 'The Rothschild Legend in America', Jewish Social
Studies, 1 9 (1957) , pp. 3-28 .
43 . Marc D . Weidenmier, 'The Market for Confederate Cotton Bonds',
Explorations in Economic History, 37 (2000), pp. 76-97 . See also
idem, 'Turning Points in the U.S. Civil War: Views from the Gray back
Market', Southern Economic Journal, 68, 4 (2002), pp. 875-90 .
44. See W. O. Henderson, The Lancashire Cotton Famine: 1861-1865
(Manchester, 1934) ; Thomas Ellison, The Cotton Trade of Great
Britain (New York, 196 8 [1886]).
45 . Marc D . Weidenmier, 'Comrades in Bonds: The Subsidized Sale
of Confederate War Debt to British Leaders', Claremont McKenna
College Working Paper (February 2003).
46. Richard Roberts, Schroders: Merchants and Bankers (Basingstoke,
1992) , pp. 66f.
47 . Richard C. K . Burdekin and Marc D. Weidenmier, 'Inflation is
Always and Everywhere a Monetary Phenomenon: Richmond vs.
Houston in 1864' , American Economic Review, 91 , 5 (December
2001) , pp. 1621-30 .
48. Richard Burdekin and Marc Weidenmier, 'Suppressing Asset Price
Inflation: The Confederate Experience, 1861-1865' , Economic
Inquiry, 41 , 3 (July 2003) , 420-32 . Cf. Eugene M . Lerner, 'Money,
Prices and Wages in the Confederacy, 1861-65' ? > Journal of Political
Economy, 63, 1 (February 1955) , pp. 20-40 .
49. Frank Griffith Dawson, The First Latin American Debt Crisis
(London, 1990) .
37 0
NOTE S T O PP . 98 -II I
50. Kris James Mitchener and Marc Weidenmier, 'Supersanctions and
Sovereign Debt Repayment', NBE R Working Paper 1147 2 (2005).
51 . Niall Ferguson and Moritz Schularick, 'The Empire Effect: The Deter­
minants of Country Risk in the First Age of Globalization, 1880 -1913' , Journal of Economic History, 66,2 (June 2006), pp. 283-312 .
5 2. Kris James Mitchener and Marc Weidenmier, 'Empire, Public Goods,
and the Roosevelt Corollary', Journal of Economic History, 65
(2005), pp. 658-92 .
53 . William Cobbett, Rural Rides (London, 198 5 [1830]) , p. 117 .
54. Ibid., pp. 34, 53 .
55 . M . de Cecco, Money and Empire: The International Gold Standard,
1890-1914 (Oxford, 1973) .
56. Theo Balderston, 'War Finance and Inflation in Britain and Germany,
1914-1918' , Economic History Review, 42 , 2 (May 1989) , pp. 222 -44.
57. Calculated from B. R. Mitchell, International Historical Statistics:
Europe, 1750-1993 (London, 1998) , pp. 358ff.
58. Ja y Winter and Jean-Louis Robert (eds.), Capital Cities at War:
Taris, London, Berlin 1914-1919, Studies in the Social and Cultural
History of Modern Warfare, No . 2 (Cambridge, 1997) , p. 259 .
59. Gerald D . Feldman, The Great Disorder: Politics, Economy and
Society in the German Inflation, 1914-1924 (Oxford / Ne w York,
1997) , pp. 211-54 -60. Elias Canetti, Crowds and Power (New York, 1988) , p. 186 .
61 . John Maynard Keynes, A Tract on Monetary Reform, reprinted in
Collected Writings, vol. IV (Cambridge, 1971) , pp. 3, 29, 36.
62. John Maynard Keynes, The Economic Consequences of the Peace
(London, 1919) , pp. 220-33 .
63. Frank Whitson Fetter, 'Lenin, Keynes and Inflation', Economica, 44,
17 3 (February 1977) , p. 78.
64. William C. Smith, 'Democracy, Distributional Conflicts and Macro-economic Policymaking in Argentina, 1983-89' , Journal of Inter-american Studies and World Affairs, 32 , 2 (Summer 1990) , pp. 1 -42 . Cf. Rafael Di Telia and Ingrid Vogel, 'The Argentine Paradox:
Economic Growth and Populist Tradition', Harvard Business School
Case 9-702-00 1 (2001) .
37 1
NOTE S T O PP . III -2 0
65 . Jorge Luis Borges, 'The Garden of Forking Paths', in idem, Laby­
rinths: Selected Stories and Other Writings, ed. Donald A. Yates and
James E . Irby (Harmondsworth, 1970) , pp. 5off.
66. Ferguson, World's Banker, ch. 27.
67. Further details in Gerardo della Paolera and Alan M . Taylor, Strain­
ing at the Anchor: The Argentine Currency Board and the Search for
Macroeconomic Stability, 1880-1935 (Chicago, 2001) .
68. ' A Victory by Default', Economist, 3 March 2005 .
69. For a recent discussion of the issue, see Michael Tomz, Reputation
and International Cooperation: Sovereign Debt across Three
Centuries (Princeton, 2007).
70 . On the Great Inflation, see Fabrice Collard and Harris Delias, 'The
Great Inflation of the 1970s' , Working Paper (1 October 2003);
Edward Nelson, 'The Great Inflation of the Seventies: What Really
Happened?', Federal Reserve Bank of St Louis Working Paper, 2004-00 1 (January 2004); Allan H . Meltzer, 'Origins of the Great
Inflation', Federal Reserve Bank of St Louis Review, Part 2 (March /
April 2005), pp. 145-75 -71 . The eleven markets are Australia, Canada, France, Germany, Hong
Kong, Ireland, Japan, Netherlands, Switzerland, the United Kingdom
and the United States. See Watson Wyatt, 'Global Pension Fund
Assets Rise and Fall':
72 . CNN , 9 July 2000.
73 . Testimony of Chairman Alan Greenspan, Federal Reserve Board's
semi-annual Monetary Policy Report to the Congress, before the
Committee on Banking, Housing, and Urban Affairs, US Senate,
1 6 February 2005 .
3. Blowing Bubbles
1 . For a recent contribution to a vast literature, see Timothy Guinnane,
Ron Harris, Naomi R. Lamoreaux, and Jean-Laurent Rosenthal,
'Putting the Corporation in its Place', NBE R Working Paper 1310 9
(May 2007).
37 2
NOTE S T O PP . I2.I - 9
37 3
2. See especially Robert J . Shiller, Irrational Exuberance (2nd edn.,
Princeton, 2005).
3. See Charles P. Kindleberger, Manias, Panics and Crashes: A History
of Financial Crises (3rd edn., Ne w York / Chichester / Brisbane /
Toronto / Singapore, 1996) , pp. 12-16 . Kindleberger owed a debt
to the pioneering work of Hyman Minsky. For two of his key essays,
see Hyman P. Minsky, 'Longer Waves in Financial Relations: Finan­
cial Factors in the More Severe Depressions', American Economic
Review, 54, 3 (May 1964) , pp. 324-35 ; idem, 'Financial Instability
Revisited: The Economics of Disaster', in idem (ed.), Inflation,
Recession and Economic Policy (Brighton, 1982) , pp. 117-61 .
4. Kindleberger, Manias, p. 14 .
5. 'The Death of Equities', Business Week, 1 3 August 1979 .
6. 'Dow 36,000', Business Week, 27 September 1999 .
7. William N . Goetzmann and Philippe Jorion, 'Global Stock Markets
in the Twentieth Century', journal of Finance, 54, 3 (June 1999) ,
pp. 953-80 .
8. Jeremy J . Siegel, Stocks for the Long Run: The Definitive Guide to
Financial Market Returns and Long-Term Investment Strategies
(New York, 2000).
9. Elroy Dimson, Paul Marsh and Mike Stanton, Triumph of the Opti­
mists: 101 Years of Global Investment Returns (Princeton, 2002) .
0. Paul Frentrop, A History of Corporate Governance 1602-2002
(Brussels, 2003) , pp. 49-51 .
1 . Ronald Findlay and Kevin H. O'Rourke, Power and Plenty: Trade,
War, and the World Economy in the Second Millennium (Princeton,
2007), p. 178 .
2. Frentrop, Corporate Governance, p. 59.
3. On the ambivalence of the Calvinist capitalist Dutch Republic, see
Simon Schama, The Embarrassment of Riches: An Interpretation of
Dutch Culture in the Golden Age (New York , 199 7 [1987]) .
4. John P. Shelton, 'The First Printed Share Certificate: An Important
Link in Financial History', Business History Review, 39 , 3 (Autumn
1965) , P. 396.
5. Shelton, 'First Printed Share Certificate', pp. 40of.
NOTE S T O PP . 131- 6
1 6 . Engel Sluiter, 'Dutch Maritime Power and the Colonial Status Quo,
1585 -1641' , Pacific Historical Review, 11 , 1 (March 1942) , p. 33 .
17 . Ibid., p. 34 .
18 . Frentrop, Corporate Governance, pp. 6$i.
19 . Larry Neal, 'Venture Shares of the Dutch East India Company', in
William N . Goetzmann and K . Geert Rouwenhorst (eds.), The
Origins of Value: The Financial Innovations that Created Modern
Capital Markets (Oxford, 2005), p. 167 .
20 . Neal, 'Venture Shares', p. 169 .
21 . Schama, Embarrassment of Riches, p. 349.
22 . Ibid., p. 339 .
23 . Neal, 'Venture Shares', p. 169 .
24. Frentrop, Corporate Governance, p. 85.
25 . Ibid., pp. 95f.
26. Ibid., p. 103 . Cf. Neal, 'Venture Shares', p. 171 .
27 . Neal, 'Venture Shares', p. 166 .
28. Findlay and O'Rourke, Power and Plenty, p. 178 .
29. Ibid., pp. 179-83 . Cf. Sluiter, 'Dutch Maritime Power', p. 32 .
30 . Findlay and O'Rourke, Power and Plenty, p. 208.
31 . Femme S. Gaastra, 'War, Competition and Collaboration: Relations
between the English and Dutch East India Company in the Seven­
teenth and Eighteenth Centuries', in H. V. Bowen, Margarette
Lincoln and Nigel Ribgy (eds.), The Worlds of the East India Com­
pany (Leicester, 2002), p. 51 .
32 . Gaastra, 'War, Competition and Collaboration', p. 58.
33 . Ann M . Carlos and Stephen Nicholas, '"Giants of an Earlier
Capitalism": The Chartered Trading Companies as Modern Multi­
nationals', Business History Review, 62, 3 (Autumn 1988) , pp. 398 -419 .
34 . Gaastra, 'War, Competition and Collaboration', p. 51 .
35 . Findlay and O'Rourke, Power and Plenty, p. 183 .
36 . Ibid., p. 185 , figure 4.5 .
37 . Gaastra, 'War, Competition and Collaboration', p. 55 .
38 . Ja n de Vries and A . van der Woude, The First Modern Economy:
Success, Failure and Perseverance of the Dutch Economy, 1500 -181 5 (Cambridge, 1997) , p. 396.
37 4
NOTE S T O PP . 138-4 8
39 . Andrew McFarland Davis, 'An Historical Study of Law' s System',
Quarterly Journal of Economics, 1 , 3 (April 1887) , p. 292 .
40 . H. Montgomery Hyde, John Law: The History of an Honest Adven­
turer (London, 1969) , p. 83 .
41 . Earl J . Hamilton, 'Prices and Wages at Paris under John Law' s
System', Quarterly Journal of Economics, 51 , 1 (November 1936) ,
p. 43 .
42 . Davis, 'Law's System', p. 300 .
43 . Ibid., p. 305 .
44 . Thomas E. Kaiser, 'Money, Despotism, and Public Opinion in Early
Eighteenth-Century Finance: John La w and the Debate on Royal
Credit', Journal of Modern History, 63 , 1 (March 1991) , p. 6.
45 . Ma x J . Wasserman and Frank H . Beach, 'Some Neglected Monetary
Theories of John Law' , American Economic Review, 24, 4 (December
1934) , p. 653 .
46 . James Macdonald, A Free Nation Deep in Debt: The Financial Roots
of Democracy (New York, 2003) , p. 192 .
47 . Kaiser, 'Money', p. 12 .
48 . Ibid., p. 18 .
49 . Hamilton, 'Prices and Wages', p. 47 .
50 . Davis, 'Law' s System', p. 317 .
51 . Antoin E . Murphy, John Law: Economic Theorist and Policy-Maker
(Oxford, 1997) , p. 233 .
52 . Hamilton, 'Prices and Wages', p. 55 .
53 . Murphy, John Law, p. 201 .
54 . Ibid., p. 190 .
55 . See Larry Neal, The Rise of Financial Capitalism: International Capi­
tal Markets in the Age of Reason (Cambridge, 1990) , p. 74 .
56 . Kaiser, 'Money', p. 22 .
57 . For evidence of English speculators exiting Paris in November and
December, see Neal, Financial Capitalism, p. 68 .
58 . Murphy, John Law, pp. 213f .
59 . Ibid., p. 205 .
60. Lord Wharncliffe (ed.), The Letters and Works of Lady Mary
Wortley Montagu (Paris, 1837) , pp. 32if .
61 . Earl J . Hamilton, 'John La w of Lauriston: Banker, Gamester,
37 5
NOTE S T O PP . 148-6 1
37 6
Merchant, Chief?', American Economic Review, 57, 2 (May 1967) ,
p. 273 .
62. Murphy, John Law, pp. 201-2 .
63 . Hamilton, 'John Law' , p. 276 .
64. Murphy, John Law, p. 239 . Cf. Hamilton, 'Prices and Wages', p. 60.
65 . Kaiser, 'Money', pp. 16 , 20.
66. Ibid., p. 22 .
67. Murphy, John Law, p. 235 .
68. Ibid., p. 250 .
69. Hyde, Law, p. 159 .
70 . Schama, Embarrassment of Riches, pp. 366ff.
71 . Ibid., pp. 367ff.
72 . For contrasting accounts see Neal, Financial Capitalism, pp. 89 -117 ; Edward Chancellor, Devil Take the Hindmost: A History of
Financial Speculation (London, 1999) , pp. 58-95 .
73 . Chancellor, Devil Take the Hindmost, p. 64.
74. Ibid., p. 84.
75 . Neal, Financial Capitalism, pp. 90, 1 1 if. As Neal has observed, an
investor who had bought South Sea stock at the beginning of 172 0
and sold it at the end of the year, ignoring the intervening bubble,
would still have realized a $6 per cent annual return.
y6. Julian Hoppitt, 'The Myths of the South Sea Bubble', Transactions
of the Royal Historical Society, 1 2 (2002), pp. 141-65 .
77 . Tom Nicholas, 'Trouble with a Bubble', Harvard Business School
Case N9-807-14 6 (28 February 2007), p. 1 .
78. William L . Silber, When Washington Shut Down Wall Street: The
Great Financial Crisis of 1914 and the Origins of America's Monet­
ary Supremacy (Princeton, 2006).
79 . Niall Ferguson, 'Political Risk and the International Bond Market
between the 184 8 Revolution and the Outbreak of the First World
War', Economic History Review, 59, 1 (February 2006), pp. 70 -112 .
80. New York Times, 23 October 1929 .
81 . Nicholas, 'Trouble with a Bubble', p. 4.
82 . Ibid., p. 6.
83 . Chancellor, Devil Take the Hindmost, pp. 199ft.
NOTE S T O PP . l6l-6
37 7
84. See Milton Friedman and Anna J . Schwartz, A Monetary History of
the United States, 1867-1960 (Princeton, 1963) , pp. 299-419 . This
chapter, 'The Great Contraction', should be required reading for all
financial practitioners.
85. Ibid., pp. 309^ , n. 9. Anyone who reads this footnote will understand
why the Fed moved so swiftly and open-handedly to ensure that J P
Morgan bought Bear Stearns in March 2007 .
86. Ibid., p. 315 .
87. Ibid., p. 317 .
88. Ibid., p. 396.
89. Ibid., p. 325 .
90. Ibid., p. 328 .
91 . US Department of Commerce Bureau of the Census, Historical
Statistics of the United States: Colonial Times to 1970 (Washington,
DC , 1975) , p. 1019 .
92. Barry Eichengreen, Golden Fetters: The Gold Standard and the Great
Depression, 1919-1939 (New York / Oxford, 1992) . See also idem,
'The Origins and Nature of the Great Slump Revisited', Economic
History Review, 45 , 2 (May 1992) , pp. 213-39 .
93 . See e.g. Ben S. Bernanke, 'The Macroeconomics of the Great
Depression: A Comparative Approach', NBE R Working Paper 481 4
(August 1994)-94. Hyman P. Minsky, 'Introduction: Can "It" Happen Again? A
Reprise', in idem (ed.), Inflation, Recession and Economic Policy
(Brighton, 1982) , p. xi .
95 . The index has fallen by 1 0 per cent or more in 23 out of 11 3 years.
96. See Nicholas Brady, James C . Cotting, Robert G. Kirby, John R.
Opel and Howard M . Stein, Report of the Presidential Task Force
on Market Mechanisms, submitted to the President of the United
States, the Secretary of the Treasury and the Chairman of the Federal
Reserve Board (Washington, DC , January 1988) . Of especial interest
to the historian is the comparison with 1929 : see Appendix VIII,
pp. 1-13 .
97. James Dale Davidson and William Rees-Mogg, The Great Reckoning:
How the World Will Change in the Depression of the 1990's (London,
1991) .
NOTE S T O PP . 166-8 2
98. For Greenspan's own version of events, see Alan Greenspan, The
Age of Turbulence: Adventures in a New World (New York, 2007),
pp. IOO-IIO.
99. Greenspan, Age of Turbulence, p. 166 .
100 . Ibid., p. 167 .
ioi.Ibid. , pp. 190-5 .
102 . Ibid., pp. 20of.
103.Th e best account remains Bethany McLean and Peter Elkind, The
Smartest Guys in the Room: The Amazing Rise and Scandalous Fall
of Enron (New York, 2003) .
104 . Ibid., p. 55 .
105 . See her own account of events in Mimi Swartz and Sherron Watkins,
Power Failure: The Inside Story of the Collapse of Enron (New
York, 2003) .
4. The Return of Risk
1 . Rawle O. King, 'Hurricane Katrina: Insurance Losses and National
Capacities for Financing Disaster Risks', Congressional Research
Service Report for Congress, 3 1 January 2008, table 1 .
2. Joseph B . Treaster, ' A Lawyer Like a Hurricane: Facing Off Against
Asbestos, Tobacco and No w Home Insurers', New York Times,
1 6 March 2007.
3. For details, see Richard F. Scruggs, 'Hurricane Katrina: Issues and
Observations', American Enterprise Institute-Brookings Judicial
Symposium, 'Insurance and Risk Allocation in America: Economics,
La w and Regulation', Georgetown La w Center, 20-2 2 September
4. Details from Katrina Recovery.shtml,
html and
5. Peter Lattman, 'Plaintiffs Laywer Scruggs is Indicted on Bribery
Charges', Wall Street Journal, 29 November 2007; Ashby Jones
and Paulo Prada, 'Richard Scruggs Pleads Guilty', ibid., 1 5 March
6. King, 'Hurricane Katrina', p. 4.
37 8
NOTE S T O PP . 182-9 5
37 9
7. Naomi Klein, The Shock Doctrine: The Rise of Disaster Capitalism
(New York, 2007).
9. John Schwartz, 'One Billion Dollars Later, Ne w Orleans is Still at
Risk', New York Times, 1 7 August 2007.
10 . Michael Lewis, 'In Nature's Casino', New York Times Magazine,
26 August 2007.
11 . National Safety Council, 'What are the Odds of Dying?': http:// For the cancer statistic, see the
National Cancer Institute, 'SEE R Cancer Statistics Review, 1975 -2004', table I-17 : http' The precise life­
time probability of dying from cancer in the United States between
2002 and 2004 was 21.2 9 per cent, with a 95 per cent confidence
12 . Florence Edler de Roover, 'Early Examples of Marine Insurance',
Journal of Economic History', 5, 2 (November 1945) , pp. 172-200 .
13 . Ibid., pp. i88f.
14 . A. H. John, 'The London Assurance Company and the Marine
Insurance Market of the Eighteenth Century', Economica, Ne w
Series, 25 , 98 (May 1958) , p. 130 .
15 . Paul A. Papayoanou, 'Interdependence, Institutions, and the Balance
of Power', International Security, 20, 4 (Spring 1996) , p. 55 .
16 . Roover, 'Early Examples of Marine Insurance', p. 196 .
17 . M . Greenwood, 'The First Life Table', Notes and Records of the
Royal Society of London, 1 , 2 (October 1938) , pp. 70-2 .
18 . The preceding paragraph owes a great debt to Peter L . Bernstein,
Against the Gods: The Remarkable Story of Risk (New York , 1996) .
19 . Gregory Clark, A Farewell to Alms: A Brief Economic History of the
World (Princeton, 2007).
20. See the essays in A. Ian Dunlop (ed.), The Scottish Ministers' Widows'
Fund, 1743-1993 (Edinburgh, 1992 ) for details.
21 . The key documents are to be found in the Robert Wallace papers,
National Archives of Scotland: CH/9/17/6-13 .
22 . G. W. Richmond, 'Insurance Tendencies in England', Annals of the
American Academy of Political and Social Science, 161 (May 1932) ,
p. 183 .
NOTE S T O PP . 195-20 6
23 . A . N . Wilson, A Life of Walter Scott: The Laird of Abbotsford
(London: Pimlico, 2002), pp. 169-71 .
24. G. Clayton and W. T. Osborne, 'Insurance Companies and the
Finance of Industry', Oxford Economie Papers, New Series, 10 , 1
(February 1958) , pp. 84-97 .
25 . 'American Exceptionalism', Economist, 1 0 August 2006.
27 . Lothar Gall, Bismarck: The White Revolutionary, vol. II: 1S79 -1898, trans. J . A . Underwood (London, 1986) , p. 129 .
28. H . G. Lay, Marine Insurance: A Text Book of the History of Marine
Insurance, including the Functions of Lloyd's Register of Shipping
(London, 1925) , p. 137 .
29. Richard Sicotte, 'Economic Crisis and Political Response: The Politi­
cal Economy of the Shipping Act of 1916' , Journal of Economic
History, 59, 4 (December 1999) , pp. 861-84 .
30 . Anon., 'Allocation of Risk between Marine and War Insurer',
Yale Law Journal, 51 , 4 (February 1942) , p. 674; C , 'War Risks in
Marine Insurance', Modern Law Review, 10 , 2 (April 1947) ,
pp. 211-14 .
31 . Alfred T. Lauterbach, 'Economic Demobilization in Great Britain
after the First World War', Political Science Quarterly, 57, 3 (Sep­
tember 1942) , pp. 376-93 .
32 . Correlli Barnett, The Audit of War (London, 2001) , pp. 3 if.
33 . Richmond, 'Insurance Tendencies', p. 185 .
34 . Charles Davison, 'The Japanese Earthquake of 1 September', Geo­
graphical Journal, 65 , 1 (January 1925) , pp. 42f.
35 . Yoshimichi Miura, 'Insurance Tendencies in Japan', Annals of the
American Academy of Political and Social Science, 16 1 (May 1932) ,
pp. 215-19 .
36 . Herbert H . Gowen, 'Living Conditions in Japan', Annals of the
American Academy of Political and Social Science, 12 2 (November
1925) , p. 163 .
37 . Kenneth Hewitt, 'Place Annihilation: Area Bombing and the Fate of
Urban Places', Annals of the Association of American Geographers,
73 (1983) , P- 2-63.
NOTE S T O PP . 206 -I 2
38 1
38. Anon., 'War Damage Insurance', Yale Law Journal, 51 , 7 (May
1942) , pp. 1160-1 . It made $21 0 million, having collected premiums
from 8 million policies and paid out only a modest amount.
39. Kingo Tamai, 'Development of Social Security in Japan', in Misa
Izuhara (ed.), Comparing Social Policies: Exploring New Perspec­
tives in Britain and Japan (Bristol, 2003) , pp. 35-48 . See also
Gregory J . Kasza, 'War and Welfare Policy in Japan' , Journal of
Asian Studies, 61 , 2 (May 2002), p. 428 .
40. Recommendation of the Council of Social Security System (1950) .
41 . W. Macmahon Ball, 'Reflections on Japan' , Pacific Affairs, 21 , 1
(March 1948) , pp. i5f.
42 . Beatrice G. Reubens, 'Social Legislation in Japan' , Ear Eastern Sur­
vey, 18 , 23 (1 6 November 1949) , p. 270 .
43 . Keith L. Nelson, 'The "Warfare State": History of a Concept', Pacific
Historical Review, 40, 2 (May 1971) , pp. i38f.
44. Kasza, 'War and Welfare Policy', pp. 4i8f.
45 . Ibid., p. 423 .
46. Ibid., p. 424.
47. Nakagawa Yatsuhiro, 'Japan, the Welfare Super-Power', Journal of
Japanese Studies, 5, 1 (Winter 1979) , pp. 5-51 .
48. Ibid., p. 21 .
49. Ibid., p. 9.
50. Ibid., p. 18 .
51 . For comparative studies, see Gregory J . Kasza, One World of Wel­
fare: Japan in Comparative Perspective (Ithaca, 2006) and Neil Gil­
bert and Ailee Moon, 'Analyzing Welfare Effort: An Appraisal of
Comparative Methods', Journal of Policy Analysis and Management,
7, 2 (Winter 1988) , pp. 326-40 .
52 . Kasza, One World of Welfare, p. 107 .
53 . Peter H. Lindert, Growing Public: Social Spending and Economic
Growth since the Eighteenth Century (Cambridge, 2004), vol. I,
table 1.2.
54. Hiroto Tsukada, Economic Globalization and the Citizens' Welfare
State (Aldershot / Burlington / Singapore / Sydney, 2002) , p. 96.
55 . Milton Friedman and Anna J . Schwartz, A Monetary History of the
United States, 1867-1960 (Princeton, 1963) .
NOTE S T O PP . 2I2-2 0
56. Milton Friedman and Rose D . Friedman, Two Lucky People:
Memoirs (Chicago / London, 1998) , p. 399.
57 . Ibid., p. 400.
58. Ibid., p. 593 .
59. Patricio Silva, 'Technocrats and Politics in Chile: From the Chicago
Boys to the CEIPLA N Monks', Journal of Latin American Studies,
23 , 2 (May 1991) , pp. 385-410 .
60. Bill Jamieson, '2 5 Years On, Chile Has a Pensions Message for
Britain', Sunday Business, 1 4 December 2006.
61 . Rossana Castiglioni, 'The Politics of Retrenchment: The Quandaries
of Social Protection under Military Rule in Chile, 1973-1990' , Latin
American Politics and Society, 43 , 4 (Winter 2001) , pp. 39ff.
62. Ibid., p. 55 .
63 . José Pinera, 'Empowering Workers: The Privatization of Social
Security in Chile', Cato Journal, 15 , 2- 3 (Fall / Winter 1995/96) ,
pp. 155-166 .
64. Ibid., p. 40.
65 . Teresita Ramos, 'Chile: The Latin American Tiger?', Harvard
Business School Case 9-798-092 (2 1 March 1999) , p. 6.
66. Laurence J . Kotlikoff, 'Pension Reform as the Triumph of Form over
Substance', Economists' Voice (January 2008), pp. 1-5 .
67. Armando Barrientos, 'Pension Reform and Pension Coverage in
Chile: Lessons for Other Countries', Bulletin of Latin American
Research, 15 , 3 (1996) , p. 312 .
68. 'Destitute N o More' , Economist, 1 6 August 2007.
69. Barrientos, 'Pension Reform', pp. 309 ^ See also Raul Madrid, 'The
Politics and Economics of Pension Privatization in Latin America',
Latin American Research Review, 37 , 2 (2002), pp. 159-82 .
70 . All figures are for 2004, the latest comparative data available from
the World Bank's World Development Indicators database.
71 . I am indebted here to Laurence J . Kotlikoff and Scott Burns, The
Coming Generational Storm: What You Need to Know about
America's Economic Future (Cambridge, 2005). See also Peter G.
Peterson, Running on Empty: How the Democratic and Republican
Parties Are Bankrupting Our Future and What Americans Can Do
about It (New York, 2005).
38 2
NOTE S T O PP . 220-2 4
72 . Ruth Herman, Craig Copeland and Jac k VanDerhei, 'Will More
of Us Be Working Forever? The 2006 Retirement Confidence
Survey', Employee Benefit Research Institute Issue Brief, 29 2 (April
73 . Gene L. Dodaro, Acting Comptroller General of the United States,
'Working to Improve Accountability in an Evolving Environment',
address to the 2008 Maryland Association of CPAs ' Government
and Not-for-profit Conference (1 8 April 2008).
74. James Brooke, ' A Tough Sell: Japanese Social Security', New York
Times, 6 Ma y 2004.
75 . See Mutsuko Takahashi, The Emergence of Welfare Society in Japan
(Aldershot / Brookfield / Hong Kong / Singapore / Sydney, 1997) ,
pp. 185 ^ See also Kasza, One World of Welfare, pp. 179-82 .
76. Alex Kerr, Dogs and Demons: The Fall of Modern Japan (London,
2001) , pp. 261-66 .
77 . Gavan McCormack, Client State: Japan in the American Embrace
(London, 2007), pp. 45-69 .
78. Lisa Haines, 'World's Largest Pension Funds Top $1 0 Trillion',
Financial News, 5 September 2007.
79. 'Living Dangerously', Economist, 2 2 January 2004.
80. Philip Bobbitt, Terror and Consent: The Wars for the Twenty-first
Century (New York, 2008), esp. pp. 98-179 .
81 . Suleiman abu Gheith, quoted in ibid., p. 119 .
82. Graham Allison, 'Time to Bury a Dangerous Legacy, Part 1' , Yale
Global, 1 4 March 2008. Cf. idem, Nuclear Terrorism: The Ultimate
Preventable Catastrophe (Cambridge, MA , 2004).
83. Michael D . Intriligator and Abdullah Toukan, 'Terrorism and
Weapons of Mass Destruction', in Peter Kotana, Michael D . Intrilig­
ator and John P. Sullivan (eds.), Countering Terrorism and WMD:
Creating a Global Counter-terrorism Network (New York, 2006),
table 4. 1 A.
84. See IPCC , Climate Change 2007: Synthesis Report (Valencia, 2007) .
8 5. Robert Looney, 'Economic Costs to the United States Stemming from
the 9/1 1 Attacks', Center for Contemporary Conflict Strategic Insight
(5 August 2002).
86. Robert E . Litan, 'Sharing and Reducing the Financial Risks of Future
NOTE S T O PP . 225 -4 O
Mega-Catastrophes', Brookings Issues in Economic Policy, 4 (March
87. William Hutchings, 'Citadel Builds a Diverse Business', Financial
News, 3 October 2007 .
88. Marcia Vickers, ' A Hedge Fund Superstar', Fortune, 3 April 2007.
89. Joseph Santos, ' A History of Futures Trading in the United States',
South Dakota University MS , n.d.
5. Safe as Houses
1 . Philip E . Orbanes, Monopoly: The World's Most Famous Game -And How It Got That Way (New York, 2006), pp. 10-71 .
2. Ibid., p. 50.
3. Ibid., pp. 86f.
4. Ibid., p. 90.
5. Robert J . Shiller, 'Understanding Recent Trends in House Prices
and Home Ownership', paper presented at Federal Reserve Bank of
Kansas City's Jackson Hole Conference (August 2007).
7. David Cannadine, Aspects of Aristocracy: Grandeur and Decline in
Modern Britain (New Haven, 1994) , p. 170 .
8. I am grateful to Gregory Clark for these statistics.
9. Frederick B . Heath, 'The Grenvilles, in the Nineteenth Century: The
Emergence of Commercial Affiliations', Huntington Library Quar­
terly, 25 , 1 (November 1961) , p. 29.
10 . Heath, 'Grenvilles', pp. 32f.
11 . Ibid., p. 35 .
12 . David Spring and Eileen Spring, 'The Fall of the Grenvilles', Hunting­
ton Library Quarterly, 19 , 2 (February 1956) , p. 166 .
13 . Ibid., pp. i77f .
14 . Details in Spring and Spring, 'Fall of the Grenvilles', pp. 169-74 .
15 . Ibid., p. 185 .
16 . Heath, 'Grenvilles', p. 39 .
17 . Spring and Spring, 'Fall of the Grenvilles', p. 183 .
18 . Heath, 'Grenvilles', p. 40.
NOTE S T O PP . 240-5 4
19 . Ibid., p. 46.
20. Ben Bernanke, 'Housing, Housing Finance, and Monetary Policy',
speech at the Kansas City Federal Reserve Bank's Jackson Hole
Conference (3 1 August 2007).
21 . Louis Hyman, 'Debtor Nation: Ho w Consumer Credit Built Postwar
America', unpublished Ph.D. thesis (Harvard University, 2007) ,
ch. 1 .
22 . Edward E . Learner, 'Housing and the Business Cycle', paper pre­
sented at Federal Reserve Bank of Kansas City's Jackson Hole Con­
ference (August 2007).
23 . Saronne Rubyan-Ling, 'The Detroit Murals of Diego Rivera', History
Today, 46, 4 (April 1996) , pp. 34-8 .
24. Donald Lochbiler, 'Battle of the Garden Court', Detroit News,
1 5 July 1997 .
25 . Hyman, 'Debtor Nation', ch. 2.
26. Thomas J . Sugrue, The Origins of the Urban Crisis: Race and
Inequality in Postwar Detroit (Princeton, 1996) , p. 64.
27. Ibid., pp. 38-43 .
28. Hyman, 'Debtor Nation', ch. 5.
29. Sugrue, Origins of the Urban Crisis, p. 259 .
30. For a recent case in Detroit, see Ben Lefebvre, 'Justice Dept. Accuses
Detroit Bank of Bias in Lending', New York Times, 20 Ma y 2004.
31 . Glen O'Hara, From Dreams to Disillusionment: Economic and
Social Planning in 1960s Britain (Basingstoke, 2007) , ch. 5.
32 . Bernanke, 'Housing, Housing Finance, and Monetary Policy'. See
also Roger Loewenstein, 'Who Needs the Mortgage-Interest Deduc­
tion?', New York Times Magazine, 5 March 2006.
33 . Nigel Lawson, The View from No. 11 : Memoirs of a Tory Radical
(London, 1992) , p. 821 .
34. Living in Britain: General Household Survey 2002 (London, 2003) ,
p. 3o:
35 . Ned Eichler, 'Homebuilding in the 1980s : Crisis or Transition?',
Annals of the American Academy of Political and Social Science, 465
(January 1983) , p. 37 .
36. Maureen O'Hara, 'Property Rights and the Financial Firm', Journal
of Law and Economics, 24 (October 1981) , pp. 317-32 .
NOTE S T O PP . 254-6 0
37 . Eichler, 'Homebuilding', p. 40. See also Henry N . Pontell and Kitty
Calavita, 'White-Collar Crime in the Savings and Loan Scandal',
Annals of the American Academy of Political and Social Science, 525
(January 1993) , PP- 31?45 ; Marcia Millon Cornett and Hassan Teh-ranian, 'An Examination of the Impact of the Garn-St Germain
Depository Institutions Act of 1 9 8 2 on Commercial Banks and Savings
and Loans', Journal of Finance, 45, 1 (March 1990) , pp. 95- 1 n .
38 . Henry N . Pontell and Kitty Calavita, 'The Savings and Loan Indus­
try', Crime and Justice, 1 8 (1993) , p. 211 .
39 . Ibid., pp. 2o8f.
40. F. Stevens Redburn, 'The Deeper Structure of the Savings and Loan
Disaster', Political Science and Politics, 24, 3 (September 1991) ,
p. 439 .
41 . Pontell and Calavita, 'White-Collar Crime', p. 37 .
42 . Allen Pusey, 'Fast Money and Fraud', New York Times, 23 April 1989 .
43 . K . Calavita, R. Tillman, and H. N . Pontell, 'The Savings and Loan
Debacle, Financial Crime and the State', Annual Review of Sociology,
2-3 (1997) , P- 2.3.
44. Pontell and Calavita, 'Savings and Loans Industry', p. 215 .
45 . Calavita, Tillman and Pontell, 'Savings and Loan Debacle', p. 24.
46. Allen Pusey and Christi Harlan, 'Bankers Shared in Profits from
I?30 Deals', Dallas Morning News, 29 January 1986 .
47 . Allen Pusey and Christi Harlan, T-3 0 Real Estate Deals: A "Virtual
Money Machine" ', Dallas Morning News, 26 January 1986 .
48. Pusey, 'Fast Money and Fraud'.
49. Pontell and Calavita, 'White-Collar Crime', p. 43 . See also Kitty
Calavita and Henry N . Pontell, 'The State and White-Collar Crime:
Saving the Savings and Loans', Law Society Review, 28, 2 (1994),
pp. 297-324 .
50. The losses were initially feared to be higher. In 199 0 the General
Accounting Office foresaw costs of up to $50 0 billion. Others esti­
mated costs of a trillion dollars or more: Pontell and Calavita, 'Sav­
ings and Loan Industry', p. 203 .
51 . For a vivid account, see Michael Lewis, Liar's Poker (London, 1989) ,
pp. 78-124 .
52 . Bernanke, 'Housing, Housing Finance, and Monetary Policy'.
NOTE S T O PP . 262-7 7
38 7
53 . I am grateful to Joseph Barillari for his assistance with these calcu­
lations. Morris A. Davisa, Andreas Lehnert and Robert F. Martin,
'The Rent-Price Ratio for the Aggregate Stock of Owner-Occupied
Housing', Working paper (December 2007).
54. Shiller, 'Recent Trends in House Prices'.
55 . Carmen M . Reinhart and Kenneth S. Rogoff, Ts the 2007 Sub-Prime
Financial Crisis So Different? An International Historical Compari­
son', Draft Working Paper (1 4 January 2008).
56. Mark Whitehouse, 'Debt Bomb: Inside the "Subprime" Mortgage
Debacle', Wall Street Journal, 30 Ma y 2007, p. Ai .
57. See Kimberly Blanton, ' A "Smoking Gun " on Race, Subprime Loans',
Boston Globe, 1 6 March 2007.
58. 'U.S. Housing Bust Fuels Blame Game', Wall Street Journal,
1 9 March 2008. See also David Wessel, 'Housing Bust Offers
Insights', Wall Street Journal, 1 0 April 2008.
59. Henry Louis Gates Jr. , 'Forty Acres and a Gap in Wealth', New York
Times, 1 8 November 2007.
60. Andy Meek, 'Frayser Foreclosures Revealed', Daily News, 2 1 Sep­
tember 2006.
61 .'itemID-32032031.
62. Credit Suisse, 'Foreclosure Trends - A Sobering Reality', Fixed
Income Research (23 April 2008).
63. See Prabha Natarajan, 'Fannie, Freddie Could Hurt U.S. Credit',
Wall Street Journal, 1 5 April 2008.
64. Economic Report of the President 2007, tables B-77 and B-76: httpdl
65. George Magnus, 'Managing Minsky', UB S research paper, 27 March
66. Hernando de Soto, The Mystery of Capital: Why Capitalism Tri­
umphs in the West and Fails Everywhere Else (London, 2001) .
67. Idem, 'Interview: Land and Freedom', New Scientist, 27 April 2002 .
68. Idem, The Other Path (New York, 1989) .
69. Rafael Di Telia, Sebastian Galiani and Ernesto Schargrodsky, 'The
Formation of Beliefs: Evidence from the Allocation of Land Titles to
Squatters', Quarterly Journal of Economics, 122, 1 (February 2007),
pp. 209-41 .
NOTE S T O PP . 277-8 6
70 . 'The Mystery of Capital Deepens', The Economist, 26 August 2006.
71 . See John Gravois, 'The De Soto Delusion', Slate, 29 January 2005:
httpillstate. msn. com/id/2112 79 2/.
72 . The entire profit is transferred to a Rehabilitation Fund created to
cope with emergency situations, in return for an exemption from
corporate income tax.
73 . Connie Black, 'Millions for Millions', New Yorker, 30 October 2006,
pp. 62-73 .
74. Shiller, 'Recent Trends in House Prices'.
75 . Edward L . Glaeser and Joseph Gyourko, 'Housing Dynamics',
NBE R Working Paper 1278 7 (revised version, 3 1 March 2007).
76. Robert J . Shiller, The New Financial Order: Risk in the 21st Century
(Princeton, 2003) .
6. From Empire to Chimerica
1 . Dominic Wilson and Roopa Purushothaman, 'Dreaming with the
BRICs : The Path to 2050' , Goldman Sachs Global Economics Paper,
99 (1 October 2003) . See also Jim O'Neill, 'Building Better Global
Economic BRICs' , Goldman Sachs Global Economics Paper, 66
(30 November 2001) ; Jim O'Neill, Dominic Wilson, Roopa Purusho­
thaman and Anna Stupnytska, 'Ho w Solid are the BRICs?' , Goldman
Sachs Global Economics Paper, 13 4 (1 December 2005).
2. Dominic Wilson and Anna Stupnytska, 'The N-n : More than an
Acronym', Goldman Sachs Global Economics Paper, 15 3 (28 March
3. Goldman Sachs Global Economics Group, BRICs and Beyond
(London, 2007) , esp. pp. 45-72 , 103-8 .
4. The argument is made in Kenneth Pomeranz, The Great Divergence:
China, Europe and the Making of the Modern World Economy
(Princeton / Oxford, 2000). For a more sceptical view of China's
position in 1700 , see inter alia Angus Maddison, The World Econ­
omy: A Millennial Perspective (Paris, 2001) .
5. Calculated from the estimates for per capita gross domestic product
in Maddison, World Economy, table B-21 .
6. Pomeranz, Great Divergence.
NOTE S T O PP . 286- 9
7. Among the most important recent works on the subject are Eric
Jones, The European Miracle: Environments, Economies and Geo­
politics in the History of Europe and Asia (Cambridge, 1981) ; David
S. Landes, The Wealth and Poverty of Nations: Why Some are So
Rich and Some So Poor (New York, 1998) ; Joel Mokyr , The Gifts
of Athena: Historical Origins of the Knowledge Economy (Princeton,
2002); Gregory Clark, A Farewell to Alms: A Brief Economic History
of the World (Princeton, 2007).
8. William N . Goetzmann, 'Fibonacci and the Financial Revolution',
NBE R Working Paper 1035 2 (March 2004).
9. William N . Goetzmann, Andrey D . Ukhov and Ning Zhu , 'China
and the World Financial Markets, 1870-1930 : Modern Lessons from
Historical Globalization', Economic History Review (forthcoming).
0. Nicholas Crafts, 'Globalisation and Growth in the Twentieth Cen­
tury', International Monetary Fund Working Paper, 00/44 (March
2000). See also Richard E . Baldwin and Philippe Martin, 'Tw o Waves
of Globalization: Superficial Similarities, Fundamental Differences',
NBE R Working Paper 6904 (January 1999) .
1 . Barry R. Chiswick and Timothy J . Hatton, 'International Migration
and the Integration of Labor Markets', in Michael D . Bordo, Alan M .
Taylor and Jeffrey G. Williamson (eds.), Globalization in Historical
Perspective (Chicago, 2003) , pp. 65-120 .
2. Maurice Obstfeld and Alan M . Taylor, 'Globalization and Capital
Markets', in Michael D. Bordo, Alan M . Taylor and Jeffrey G. William­
son (eds.), Globalization in Historical Perspective (Chicago, 2003),
pp. 1731 .
3. Clark, Farewell, chs. 13 , 14 .
4. David M . Rowe , 'The Tragedy of Liberalism: Ho w Globalization
Caused the First World War', Security Studies, 14 , 3 (Spring 2005) ,
pp. 1-41 .
5. See for example Fareed Zakaria, The Post-American World (New
York, 2008) and Parag Khanna, The Second World: Empires and
Influence in the New Global Order (London, 2008).
6. Jim Rogers, A Bull in China: Investing Profitably in the World's
Greatest Market (New York, 2007).
7. Robert Blake, Jardine Matheson: Traders of the Far East (London,
NOTE S T O PP . 2.92-6
1999) , p. 91 . See also Alain Le Pichon, China Trade and Empire:
Jardine, Matheson & Co. and the Origins of British Rule in Hong
Kong, 1827-1843 (Oxford / Ne w York, 2006).
18 . Rothschild Archive London, RFamFD/i3A/i ; 13B/1 ; 13C/1 ; 13D/1 ;
13D/2 ; 13/E .
19 . Henry Lowenfeld, Investment: An Exact Science (London, 1909) ,
p. 61 .
20. John Maynard Keynes, The Economic Consequences of the Feace
(London, 1919) , ch. 1 .
21 . Maddison, World Economy, table 2-26a.
22 . Lance E . Davis and R . A. Huttenback, Mammon and the Pursuit of
Empire: The Political Economy of British Imperialism, 1860-1912
(Cambridge, 1988) , p. 46.
23 . Ranald Michie, 'Reversal or Change? The Global Securities Market
in the 20th Century', New Global Studies (forthcoming).
24. Obstfeld and Taylor, 'Globalization'; Niall Ferguson and Moritz
Schularick, 'The Empire Effect: The Determinants of Country Risk
in the First Age of Globalization, 1880-1913'' , Journal of Economic
History, 66, 2 (June 2006). But see also Michael A. Clemens and
Jeffrey Williamson, 'Wealth Bias in the First Global Capital Market
Boom, 1870-1913' , Economic Journal, 114 , 2 (2004), pp. 304-37 .
25 . The definitive study is Michael Edelstein, Overseas Investment in the
Age of High Imperialism: The United Kingdom, 1850-1914 (New
York , 1982) .
26. Michael Edelstein, 'Imperialism: Cost and Benefit', in Roderick Floud
and Donald McCloskey (eds.), The Economic History of Britain
since 1700, vol. II (2nd edn., Cambridge, 1994) , pp. 173-216 .
27 . John Maynard Keynes, 'Foreign Investment and National Advan­
tage', in Donald Moggridge (ed.), The Collected Writings of John
Maynard Keynes, vol. XI X (London, 1981) , pp. 275-84 .
28. Idem, 'Advice to Trustee Investors', in ibid., pp. 202-6 .
29. Calculated from the data in Irving Stone, The Global Export of
Capital from Great Britain, 1865-1914 (London, 1999) .
30 . See the very useful stock market index for Shanghai Stock Exchange
between 187 0 and 194 0 at
31 . Michael Bordo and Hugh Rockoff, 'The Gold Standard as a "Good
NOTE S T O PP . 296-30 2
39 1
Housekeeping Seal of Approval" ', Journal of Economic History, 56,
2 (June 1996) , pp. 389-428 .
3 2. Marc Flandreau and Frédéric Zumer, The Making of Global Finance,
1880-1913 (Paris, 2004).
33 . Ferguson and Schularick, 'Empire Effect'. , pp. 283-312 .
34. For a full discussion of this point, see Niall Ferguson, 'Political Risk
and the International Bond Market between the 184 8 Revolution and
the Outbreak of the First World War', Economic History Review, 59,
1 (February 2006), pp. 70-112 .
35 . Jean de [Ivan] Bloch, Is War Now Impossible?, trans. R . C . Long
(London, 1899) , p. xvii.
36. Norman Angell, The Great Illusion: A Study of the Relation of
Military Power in Nations to their Economic and Social Advantage
(London, 1910) , p. 31 .
37 . Quoted in James J . Sheehan, Where Have all the Soldiers Gone?
(New York: Houghton Mifflin Co. , 2007) , p. 56.
38. O. M . W. Sprague, 'The Crisis of 191 4 in the United States', Ameri­
can Economic Review, 5, 3 (1915) , pp. 505ff.
39. Brendan Brown, Monetary Chaos in Europe: The End of an Era
(London / New York, 1988) , pp. 1-34 .
40. John Maynard Keynes, 'War and the Financial System', Economic
Journal, 24, 95 (1914) , pp. 460-86 .
41 . E . Victor Morgan, Studies in British Financial Policy, 1914-1915
(London, 1952) , pp. 3-11 .
42 . Ibid., p. 27 . See also Teresa Seabourne, 'The Summer of 1914' , in
Forrest Capie and Geoffrey E . Wood (eds.), Financial Crises and the
World Banking System (London, 1986) , pp. 78, 88f.
43 . Sprague, 'Crisis of 1914' , p. 532 .
44. Morgan, Studies, p. 19 .
45 . Seabourne, 'Summer of 1914' , pp. 8off.
46. See most recently William L. Silber, When Washington Shut Down
Wall Street: The Great Financial Crisis of 1914 and the Origins of
America's Monetary Supremacy (Princeton, 2007) .
47. Morgan, Studies, pp. 12-23 .
48. David Kynaston, The City of London, vol. Ill: Illusions of Gold,
1914-1945 (London, 1999) , p. 5.
NOTE S T O PP . 302-31 2
39 2
49. Calculated from isolated prices quoted in The Times between August
and December 1914 .
50. Kynaston, City of London, p. 5.
51 . For details see Niall Ferguson, 'Earning from History: Financial
Markets and the Approach of World Wars', Brookings Papers in
Economic Activity (forthcoming).
52 . See Lyndon Moore and Jakub Kaluzny, 'Regime Change and Debt
Default: The Case of Russia, Austro-Hungary, and the Ottoman
Empire following World War One', Explorations in Economic His­
tory, 4 2 (2005), pp. 237-58 .
53 . Maurice Obstfeld and Alan M . Taylor, 'The Great Depression as a
Watershed: International Capital Mobility over the Long Run', in
Michael D . Bordo, Claudia Goldin and Eugene N . White (eds.),
The Defining Moment: The Great Depression and the American
Economy in the Twentieth Century (Chicago, 1998) , pp. 353-402 .
54. Raw i Abdelal, Capital Rules: The Construction of Global Finance
(Cambridge, M A / London, 2007), p. 45 .
55 . Ibid., p. 46.
56. Greg Behrman, The Most Noble Adventure: The Marshall Plan and
the Time when America Helped Save Europe (New York, 2007).
57 . Obstfeld and Taylor, 'Globalization and Capital Markets', p. 129 .
58. See William Easterly, The Elusive Quest for Growth: Economists'
Adventures and Misadventures in the Tropics (Cambridge, M A. , 200 2 ).
59. Michael Bordo, 'The Bretton Woods International Monetary System:
A Historical Overview', in idem and Barry Eichengreen (eds.), A
Retrospective on the Bretton Woods System: Lessons for Inter­
national Monetary Reform (Chicago / London, 1993) , pp. 3-98 .
60. Christopher S. Chivvis, 'Charles de Gaulle, Jacques Rueff and French
International Monetary Policy under Bretton Woods', Journal of
Contemporary History, 41 , 4 (2006), pp. 701-20 .
61. Interview with Amy Goodman:
article.plfsid-o 4/11/09/15 26251.
62. John Perkins, Confessions of an Economic Hit Man (New York,
2004), p. xi .
63 . Joseph E . Stiglitz, Globalization and Its Discontents (New York,
2002) , pp. 12 , 14 , 15 , 17 .
NOTE S T O PP . 312-2 5
64. Abdelal, Capital Rules, pp. 50L., 57-75 .
65. Paul Krugman, The Return of Depression Economies (London, 1999) .
66. 'The Fund Bites Back', The Economist, 4 July 2002 .
67. Kenneth Rogoff, 'The Sisters at 60', The Economist, 2 2 July 2004.
Cf. 'Not Even a Cat to Rescue', The Economist, 20 April 2006.
68. See the classic study by Fritz Stern, Gold and Iron: Bismarck, Bleich-rôderandthe Building of the GermanEmpire (Harmonds worth, 1987) .
69. George Soros, The Alchemy of Finance: Reading the Mind of the
Market (New York, 1987) , pp. 27-30 .
70. Robert Slater, Soros: The Life, Times and Trading Secrets of the
World's Greatest Investor (New York , 1996) , pp. 48L.
71 . George Soros, The New Paradigm for Financial Markets: The Credit
Crash of 2008 and What It Means (New York , 2008), p. x .
72 . Slater, Soros, p. 78.
73 . Ibid., pp. 105 , i07ff.
74. Ibid., p. 172 .
75 . Ibid., pp. 177 , 182 , 188 .
76. Ibid., p. 10 .
77 . Ibid., p. 159 .
78. Nicholas Dunbar, Inventing Money: The Story of Long-Term Capital
Management and the Legends Behind It (New York , 2000), p. 92 .
79. Dunbar, Inventing Money, pp. 168-73 .
80. André F. Perold, 'Long-Term Capital Management, L.P. (A)', Har­
vard Business School Case 9-200-007 (5 November 1999) , p. 2.
81 . Perold, 'Long-Term Capital Management, L.P. (A)', p. 13 .
82. Ibid., p. 16 .
83. For a history of the efficient markets school of finance theory, see
Peter Bernstein, Capital Ideas: The Improbable Origins of Modern
Wall Street (New York, 1993) .
84. Dunbar, Inventing Money, p. 178 .
85. Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management (New York, 2000), p. 126 .
86. Perold, 'Long-Term Capital Management, L.P. (A)', pp. nf. , 17 .
87. Lowenstein, When Genius Failed, p. 127 .
88. André F. Perold, 'Long-Term Capital Management, L.P. (B)', Har­
vard Business School Case 9-200-08 (27 October 1999) , p. 1 .
NOTE S T O PP . 325-3 1
89. Lowenstein, When Genius Failed, pp. 133-8 .
90. Ibid., p. 144 .
91.1 owe this point to André Stern, who was an investor in LTCM .
92 . Lowenstein, When Genius Failed, p. 147 .
93 . André F. Perold, 'Long-Term Capital Management, L.P. (C)', Har­
vard Business School Case 9-200-09 (5 November 1999) , pp. 1 , 3.
94. Idem, 'Long-Term Capital Management, L.P. (D)', Harvard Busi­
ness School Case 9-200-1 0 (4 October 2004), p. 1 . Perold's cases
are by far the best account.
95 . Lowenstein, When Genius Failed, p. 149 .
96. 'All Bets Are Off: Ho w the Salesmanship and Brainpower Failed at
Long-Term Capital', Wall Street Journal, 16 November 1998 .
97. See on this point Peter Bernstein, Capital Ideas Evolving (New York,
2007) .
98. Donald MacKenzie, 'Long-Term Capital Management and the Soci­
ology of Arbitrage', Economy and Society, 32 , 3 (August 2003),
P- 374-99. Ibid., passim.
100 . Ibid., p. 365 .
101 . Franklin R . Edwards, 'Hedge Funds and the Collapse of Long-Term
Capital Management', Journal of Economic Perspectives, 13 , 2
(Spring 1999) , pp. i92f. See also Stephen J . Brown, William N .
Goetzmann and Roger G. Ibbotson, 'Offshore Hedge Funds: Sur­
vival and Performance, 1989-95' , Journal of Business, 72 , i(Janu-ary 1999) , 91-117 -102 . Harry Markowitz, 'Ne w Frontiers of Risk: The 360 Degree Risk
Manager for Pensions and Nonprofits', The Bank of New York
Thought Leadership White Paper (October 2005), p. 6.
103 . 'Hedge Podge', The Economist, 16 February 2008.
104 . 'Rolling In It', The Economist, 16 November 2006.
105 . John Kay, 'Just Think, the Fees You Could Charge Buffett', Financial
Times, 1 1 March 2008.
106 . Stephanie Baum, 'Top 10 0 Hedge Funds have 75 % of Industry
Assets', Financial News, 2 1 Ma y 2008.
107 . Dean P. Foster and H. Peyton Young, 'Hedge Fund Wizards', Econo­
mists' Voice (February 2008), p. 2.
NOTE S T O PP . 332-4 2
io8.Nial l Ferguson and Moritz Schularick, '"Chimerica " and Global
Asset Markets', International Finance 10 , 3 (2007), pp. 215-39 .
109 . Michael Dooley, David Folkerts-Landau and Peter Garber, 'An
Essay on the Revived Bretton-Woods System', NBE R Working
Paper 997 1 (September 2003) .
no . Ben Bernanke, 'The Global Saving Glut and the U.S. Current
Account Deficit', Homer Jones Lecture, St Louis, Missouri (1 5 April
in . 'From Ma o to the Mall', The Economist, 1 6 February 2008.
112 . For a critique of recent Federal Reserve policy, see Paul A. Volcker,
'Remarks at a Luncheon of the Economic Club of Ne w York '
(8 April 2008). In Volcker's view, the Fed has taken 'actions that
extend to the very edge of its lawful and implied powers'.
113 . See e.g. Jamil Anderlini, 'Beijing Looks at Foreign Fields in Plan to
Guarantee Food Supplies', Financial Times, 9 Ma y 2008.
114 . In the absence of the First World War, it may be conjectured, Ger­
many would have overtaken Britain in terms of world export market
share in 1926 : Hugh Neuburger and Houston H. Stokes, 'The Anglo-German Trade Rivalry, 1887-1913 : A Counterfactual Outcome
and Its Implications', Social Science History, 3, 2 (Winter 1979) ,
pp. 187-201 .
115 . Aaron L. Friedberg, 'The Future of U.S.-China Relations: Is Conflict
Inevitable?', International Security, 30 , 2 (Fall 2005) , pp. 7-45 .
116 . The average length of the financial careers of the current chief execu­
tive officers of Citigroup, Goldman Sachs, Merrill Lynch, Morgan
Stanley and J P Morgan is just under twenty-five and a half years.
Afterword: The Descent of Money
1 . For some fascinating insights into the limits of globalization, see
Pankaj Ghemawat, Redefining Global Strategy: Crossing Borders in
a World Where Differences Still Matter (Boston, 2007).
2. Frederic Mishkin, Weissman Center Distinguished Lecture, Baruch
College, Ne w York (1 2 October 2006).
3. Larry Neal, 'A Shocking View of Economic History', Journal of
Economic History, 60, 2 (2000), pp. 317-34 .
NOTE S T O PP . 342- 7
4. Robert J . Barro and José F. Ursûa, 'Macroeconomic Crises since
1870' , Brookings Papers on Economic Activity (forthcoming). See
also Robert J . Barro, 'Rare Disasters and Asset Markets in the Twen-tieth Century', Harvard University Working Paper (4 December
5. Nassim Nicholas Taleb, Fooled by Randomness: The Hidden Role
of Chance in Life and in the Markets (2nd edn., Ne w York, 2005)
6. Idem, The Black Swan: The Impact of the Highly Improbable
(London, 2007).
7. Georges Soros, The New Paradigm for Financial Markets: The Credit
Crash of 2008 and What It Means, (New York, 2008), pp. 9 1 ff.
8. See Frank H . Knight, Risk, Uncertainty and Profit (Boston, 1921) .
9. John Maynard Keynes, 'The General Theory of Employment', Eco-nomic Journal, 51 , 2 (1937) , p. 214 .
0. Daniel Kahneman and Amos Tversky, 'Prospect Theory: An Analysis
of Decision under Risk', Econometrica, 47 , 2 (March 1979) , p. 273 .
1 . Eliezer Yudkowsky, 'Cognitive Biases Potentially Affecting Judgment
of Global Risks', in Nick Bostrom and Milan Cirkovic (eds.), Global
Catastrophic Risks (Oxford University Press, 2008), pp. 91-119 . See
also Michael J . Mauboussin, More Than You Know: Finding Financial
Wisdom in Unconventional Places (New York / Chichester, 2006).
2. Mar k Buchanan, The Social Atom: Why the Rich Get Richer,
Cheaters Get Caught, and Your Neighbor Usually Looks Like You
(New York, 2007) , p. 54.
3. For an introduction, see Andrei Shleifer, Inefficient Markets: An
Introduction to Behavioral Finance (Oxford, 2000). For some practi-cal applications see Richard H. Thaler and Cass R. Sunstein, Nudge:
Improving Decisions About Health, Wealth, and Happiness (New
Haven, 2008).
4. See Peter Bernstein, Capital Ideas Evolving (New York, 2007).
5. See for example James Surowiecki, The Wisdom of Crowds (New
York, 2005); Ian Ayres, Super crunchers: How Anything Can Be
Predicted (London, 2007) .
6. Daniel Gross, 'The Forecast for Forecasters is Dismal', New York
Times, 4 March 2007 .
7. The classic work, first published in 1841 , is Charles MacKay, Extra-
NOTE S T O PP . 347-5 8
ordinary Popular Delusions and the Madness of Crowds (New York,
2003 [1841]) .
18 . Yudkowsky, 'Cognitive Biases', pp. nof .
19 . For an introduction to Lo's work, see Bernstein, Capital Ideas Evolv­
ing, ch. 4. See also John Authers, 'Quants Adapting to a Darwinian
Analysis', Financial Times, 1 9 Ma y 2008.
20. The following is partly derived from Niall Ferguson and Oliver
Wyman, The Evolution of Financial Services: Making Sense of the
Past, Preparing for the Future (London / Ne w York , 2007) .
21 . The Journal of Evolutionary Economics. Seminal works in the field
are A. A. Alchian, 'Uncertainty, Evolution and Economic Theory',
Journal of Political Economy, 58 (1950) , pp. 211-22 , and R . R.
Nelson and S. G. Winter, An Evolutionary Theory of Economic
Change (Cambridge, MA , 1982) .
22 . Thorstein Veblen, 'Why is Economics Not an Evolutionary Science?'
Quarterly Journal of Economics, 1 2 (1898) , pp. 373-97 .
23 . Joseph A. Schumpeter, Capitalism, Socialism and Democracy
(London, 198 7 [1943]) , PP- 80-4 .
24. Paul Ormerod, Why Most Things Fail: Evolution, Extinction and
Economics (London, 2005), pp. i8off.
25 . Jonathan Guthrie, 'Ho w the Old Corporate Tortoise Wins the Race',
Financial Times, 1 5 February 2007 .
26. Leslie Hannah, 'Marshall's "Trees" and the Global "Forest": Were
"Giant Redwoods" Different?', in N . R . Lamoreaux, D . M . G. Raff
and P. Temin (eds.), Learning by Doing in Markets, Firms and
Countries (Cambridge, MA , 1999) , pp. 253-94 .
27. The allusion is of course to Richard Dawkins, The Selfish Gene (2nd
edn., Oxford, 1989) .
28. Rudolf Hilferding, Finance Capital: A Study of the Latest Phase of
Capitalist Development (London, 2006 [1919]) .
29. 'Fear and Loathing, and a Hint of Hope', The Economist,
16 February 2008.
30. Joseph Schumpeter, The Theory of Economic Development (Cam­
bridge, MA , 1934 ) 5 P- *53 -31 . Bertrand Benoit and James Wilson, 'German President Complains of
Financial Markets "Monster"' , Financial Times, 1 5 Ma y 2008.

List of Illustrations
Photographic acknowledgements are given in parentheses. Every effort
has been made to contact all copyright holders. The publishers will be
happy to make good in future editions any errors or omissions brought
to their attention.
p. 22 : The Cerro Rico at Potosi (Sergio Ballivian)
p. 28: Clay tablet from Mesopotamia, c. 2nd millennium B C (Trustees of
the British Museum)
p. 29: Clay tablet (reverse side) from Mesopotamia, c. 2nd millennium
B C (Trustees of the British Museum)
p. 40: The arrest of Gerard La w (Mirrorpix)
p. 43 : Quentin Massys The Banker (1514) , (photo RMN )
p. 45 : Page from the 'secret book' of the Medici (Archive di Stato di
p. 66: Japanese government ten-year bond (Embassy of Japan in the UK )
p. 70: Pieter van der Heyden after Pieter Breugel the Elder, The Battle
about Money, after 157 0 (Metropolitan Museum of Art)
p. 77: A 5 per cent consol (July 1785 ) (Hersh L . Stern, Annuity Museum)
p. 95: Confederate cotton bond with coupons (Michael Vidler)
p. 97: Confederate 'greyback' State of Louisiana $ 5 bill (Louisiana State
p. 105 : A German billion mark note from 192 3 (Ron Wise)
p. 130 : The oldest share (1606) , (
p. 144 : A share in the Compagnie des Indes (Bibliothèque Nationale)
p. 147 : Scene in the rue Quincampoix, 171 9 (Historic New Orleans
p. 154 : Engraving from The Great Scene of Folly (1720 ) (Historic New
Orleans Collection)
p. 155 : Bernard Picart, Monument Consecrated to Posterity (1721 ) (Har-vard Business School)
p. 170 : Alan Greenspan and Kenneth Lay (PA Images)
p. 179 : Ne w Orleans after Katrina (Adrian Pennink)
p. 191 : Alexander Webster preaching in Edinburgh (Dawn Mcquillan)
p. 194 : Calculations for the original Scottish Ministers' Widows' Fund
(National Archives, Scotland)
p. 197 : Sir Walter Scott's life insurance policy (Scottish Widows)
p. 201 : Women and men in the workhouse (Ramsay Macdonald Papers,
National Archives)
p. 203 : Men dining in the St Marylebone workhouse (Peter Higgin-botham)
p. 212 : Milton Friedman (University of Chicago)
p. 237 : Stowe House (National Trust)
p. 239 : Three generations of aristocracy: the first, second and third Dukes
of Buckingham (Stowe House Preservation Trust: Stowe School photo-graphic archives)
p. 244: Hunger marchers in Detroit (Walter P. Reuther Library)
p. 245 : 'Smash Ford-Murphy Police Terror' protest (Walter P. Reuther
p. 248: Ifs A Wonderful Life (PA Images)
p. 257 : Danny Faulkner with his helicopter (Dallas Morning News)
p. 290: William Jardine (Jardine, Matheson)
p. 291 : James Matheson (Jardine, Matheson)
p. 311 : Jaime Roldôs Aguilera of Ecuador and Omar Torrijos of Panama
p. 315 : George Soros (Soros)
p. 318 : Chancellor of the Exchequer, Norman Lamont (PA Images)
1 . Page from Fibonacci's Liber Abaci, published 120 2 (reproduced by
kind permission of the Ministero per i Beni e le Attivita Culturali,
Italy, Biblioteca Nazionale Centrale Firenze)
2. Botticelli's Adoration of the Magi (Alinari)
3. Nathan Mayer Rothschild (N.M . Rothschild & Sons)
4. Cartoon from Le Rire (Mary Evans Picture Library)
5. Union gunships on the Mississippi (Museum of the Confederacy)
6. The Dutch Empire (Dutch National Archives)
7. Emanuel de Witte, Beurs van Amsterdam, 165 3 (Rijksmuseum
8. Portrait of John La w (Louisiana State Museum)
9. Ma p of Louisiana (Louisiana State Museum)
10 . Louisiana (Louisiana State Museum)
11 . Tokyo earthquake
12 . Richard 'Dickie' Scruggs (New York Times)
13 . Ken Griffin, founder and CE O of Citadel (Citadel)
14 . Grenville diptych
15 . Diego Rivera's Garden Court Mural, North wall (Detroit Institute of
16 . Diego Rivera's Garden Court Mural, South wall (detail) (Detroit
Institute of Arts)
17 . Details from Charles Darrow's original Atlantic City Monopoly
18 . The original M r Monopoly
19 . Old Chongqing (photograph by G. H . Thomas, author of An Ameri­
can in China: 1936-1939)
20. Modern Chongqing
40 1

Pages with illustrations are shown in italic.
Abassid caliphate 3 2
Acadia 145 m
acceptance houses 299, 30 1
Acciaiuoli family 4 1
actuarial principles 188 , 190 ,
192-5 , 19 8
adaptive systems, markets as 348
ADI A 337 ^
advertising 19 6
Afghanistan 6
aid to 307
British investment in 293
China and 338- 9
gold trade 25
slaves from 23
African-American people 249-50 ,
267- 8
'Africas within' 1 3
age see pensions
East-West comparison 285
finance and 2, 53 , 184 , 34 2
forward and future contracts
22 6
'improvements' 23 5
and migration no , 288
rising and declining prices 53 ,
226 , 235 , 236-8 , 287
and risk 18 4
Agtmael, Antoine van 288
Aguilera, Jaime Roldôs 310-11
conditions on 30 7
limited usefulness 30 7
and microfinance 279
to developing countries 274 ,
30 7
Aldrich-Vreeland Act 30 1
Algeria 3 2
Allende, Salvador 212-13 , 214 ,
216-1 7
Allison, Graham 22 3
All State insurance company
181- 2
Al Qaeda 223
Alsace 14 4
Amboyna 130 , 13 4
American Civil War 91-7 , 22 6
American Dream Downpayment
Act 267
American Home Mortgage 27 2
Americas, conquest of 285
Amsterdam 127 , 132 , 136 , 13 7
as financial centre 74-5 , 87,
12 7
Amsterdam Exchange Bank
(Wisselbank) 48-9 , 127 , 132 ,
137 , 17 4
anarchists 1 7
Andersen (Arthur) 17 3
Andhra Pradesh 280
Angell, Norman 297
Angola 2
annuities 73-4 , 76, 19 3
anthrax 22 3
anti-Darwinians 35 6
Antipodes 293
anti-Semitism 38 , 90-1 , 93
Antwerp 52 , 74, 87
Applegarth, Adam 7
mathematics 3 2
oil 26, 308
Arab-Israeli war 308
arbitrage 83 , 88
Argentina 98, 108-15 , 274- 7
British investment in 294
currencies 11 4
default crisis no , 113 , 114-16 ,
Enron and 17 1
inflation 3, 108-1 6
past prosperity 3, 108- 9
stock market 12 5
aristocracy 89, 234-4 0
ARM s see mortgages, adjustable-rate
arms/defence industry 298, 304,
309, 317 . see also
technological innovation
art markets 6
aid and international
investment 287, 293 , 307
Asian crisis (1997-8 ) 10 , 283 ,
288, 312-14 , 326 , 332 , 33 3
and credit crunch 283
dependence on exports to US 1 0
dollar pegs 300
European trade 26, 127 , 13 5
industrial growth and
commodity prices 1 0
low-wage economies,
production by 116 , 33 4
savings glut 33 6
sovereign wealth funds 9, 33 7
asset-backed securities 6, 260,
353,35 4
and sub-prime mortgages 9,
33 6
asset markets 163 , 167 , 33 2
need for diversified portfolio
262 , 282 , 32 3
new types 35 3
asymmetric information 12 2
Atahuallpa 20
Australasia 5 2
Australia 233 , 269
Austria/Austro-Hungarian empire
90, 232 , 298
bonds 86, 90, 297, 302- 3
currency collapses 10 7
and First World War 101 , 298- 9
autarky 303
automobiles 160 , 269
Avignon 43 , 46
Babylonia see Mesopotamia
Baer (Julius) bank 32 2
Bagehot, Walter 5 5
Baghdad 17 6
Bahamas see Lyford Cay
Bailey, A. H. 19 8
Bailey, David i96n.
balance sheets 44, 35 5
Balducci, Timothy i8i-2n .
Balkan states 297-8 , 304
Balkan Wars 298
Ballantynes 19 6
Bangladesh 275 , 279
Bank of America 35 2
Bank Charter Act 54-5 , 30 1
Bank of England:
banking and issue departments,
separation of 54, 30 1
clearing role 54
creation and development of
49,54- 5
discount rate 54
lender of last resort 5 5
reserves 56, 31 7
short-term rates 11 6
and South Sea Bubble 155- 7
and war finance 49
and First World War 5 6,3 00- 3 o 1
Bank for International Settlements
62, 228
Bank of Japan 57
bank runs see banks
banknotes see paper money
bankruptcies 349
in American crisis 59-61 , 64,
272 , 349
Chinese government 303
risk to shareholders 12 5
in United States 59-61 , 349
and 'American crisis' 354 , 35 7
assets vs. deposits 35 5
bio-diversity in 3 5 2
boutique 35 3
capital adequacy 62 , 35 5
capital vs. assets 62 , 35 5
complacency 6
cooperative 35 2
as creators of credit 49-5 0
decentralization 45
direct (phone and internet) 35 3
failures: in credit crunch 272 ,
336 , 357 ; Great Depression
162-3 , 2 47 5 panics of 1930 s
354 ; protection from 349 ,
356- 7
guarantees to bail out 35 7
and hedge funds 331-2 , 35 3
history of 5, 34-64, 341 ;
Australasia 5 2; Britain and
Northern Europe 48-9 ,
52-8,352 ; Italy 34 , 42-8 ,
52 ; North America 52-3 ,
57-8 , 161-3 , 165-7 , 35 2
and hyperinflation 10 6
banks - cont.
as information gatherers and
risk managers 5 2
interbank transactions 54, 272 ,
33 6
international 355 m
Law' s proposals for 138-4 1
loans for purchasing shares 13 2
merchant banks 53 , 299
nationalized/state-owned 272 ,
336 , 35 2
new types of 53 , 56, 35 2
and oil-exporting countries 308
and OT C derivatives 228
private 54, 235 , 35 3
as private partnerships 5 3
raising new capital 354- 5
recruitment to 5
regulation of 53 , 355 , 356- 7
reserves and deposits ratio 48- 9
retail and commercial 35 2
runs on 7, 50-51 , 52 , 57- 8
shadow banking system (off-balance-sheet entities) 5,
9-10 , 272 , 35 5
shareholder ownership 35 2
stocks 31 7
and subprime loans 8-10 , 268,
269, 272 , 27 3
surge in lending 33 6
under-capitalization of in US 57
and First World War 299-30 4
Bank of United States 16 2
Banque de France 57 , 88
Banque Royale (originally Banque
Générale) 139 , 141-2 , 145 ,
149 , 151-2 , 155 , 17 4
Barbon, Nicholas 18 6
Barclays Bank 56, 33 7
Bardi family 4 1
Barings bank 53 , 85, 86, 88, 100 ,
288, 30 2
and Argentina 113-14 , 115 ,
Barker, Tyrell 25 5
Barnum, Phineas 6 1
barter 23
Bas, Dirck 129 , 13 6
Basel banking accords (I and II)
35 5
Batavia 134 , 13 5
Bayes, Thomas 18 9
bears (stock market) 121 , 13 2
Bear Stearns 272 , 273 , 322 ,
33m. , 337 , 338 , 37 6
behavioural finance 13 , 346
Beijing 284
Belgium 56, 86
bell curves 164-5 , z^9i 3 2 0
Belmont, August 93
Bender, Johann Heinrich 87- 8
Benjamin, Judah 93
Bentsen, Lloyd 65
Berkshire Hathaway 327 , 33 0
Berlin 10 1
Bernanke, Ben 28, 33 6
Bernoulli, Daniel 18 9
Bernoulli, Jacob 188- 9
Bernstein, Peter 343n.
Beveridge Report 204-5 , 2 ° 6
biases 316 , 345- 6
bill brokers 299
bill-discounting banks 53
billets d'état 139 , 14 1
bills, commercial 54
bills of exchange (cambium per
literas) 43-4 , 53 , 8 1
Birmingham 8c Midland 56
Bismarck, Otto von 20 2
Black, Fisher 320-2 2
black box see Black-Scholes model
'Black' days 164 , 16 9
black (or grey) economic zones
'Black Mondays':
1929 : 15 8
198 7 see financial crises
black people see African-American people
Black-Scholes model (black box)
320-4 , 325 , 327- 8
Blackstone 33 7
'black swans' 34 2
'Black Thursday' 15 8
Blain, Spencer H., Jr . 256- 8
Blankfein, Lloyd 1-2 , 28
Bleichroeder (Arnhold & S.) 31 5
Bloch, Ivan 297
Bloomfield, Arthur 305
Blunt, John 155- 6
BN P Paribas 27 2
Bolivia 2, 119 , 171 , 219 , 278- 9
Bolsheviks 107 , 303 , 304
bonds and bond markets 64,
65-118,34 1
benefits of 3, 34 1
bond insurance companies 347 ,
35 5
boom 332 , 33 6
bundled mortgages see
collateral for 94, 96
compared with mortgages
(spread) 241- 2
compared with stock markets
124- 5
cotton-backed 94-6
crises and defaults 73 , 97,
98-100 , no , 113 , 114-16 ,
12 5
definitions 65-9 , 73 , 76- 7
emerging market bonds see
emerging markets
face value (par) 73 , 76
future of 115-1 6
government see government
history 65-7 , 71-8 , 81-3 ,
86- 7
importance and power of 67-9 ,
73 , 76 , 89-90 , 34 1
inflation and 105 , 108 , 115-1 6
insurance companies and 19 8
interest rates 67, 73 , 33 6
liquidity 71 , 76
and mortgage rates 68
and pensions 67, 68, 116-17 ,
12 3
perpetual bonds 76
Right- and Left-wing critics of
89-9 0
Rothschilds and 80-9 1
and savings institutions 11 6
and taxes 68, 99
vulnerability of 99, 12 5
war and 69-75 , 77 , 79 , 80-83 ,
90-1,93-7,98,100-107,11 1
widening access to 100 , 10 1
bonds and bond markets - cont.
and First World War 297 , 302- 3
Bonn Consensus 31 2
bookkeeping 44-5 , 47
Borges, Jorge Luis i n
borrowing see credit; debt
Boston 266, 284
Botticelli, Sandro 42 , 46
'bottomry' 18 5
Brady, Nicholas 16 5
Brailsford, Henry Noel 298
Brazil 18 , 86, 171 , 294. see also
Bretton Woods 305-8 , 31 4
Bretton Woods II 33 4
Briand, Aristide 15 9
BRIC s (Brazil, Russia, India,
China: Big Rapidly
Industrializing Countries)
2.84, 33 7
and American Civil War 94- 5
banknotes 27
banks and industrialization
48-9 , 52- 4
business failures 349
colonies see British Empire
compared with France 14 1
compared with Japan 209-1 1
cost of living 26
cotton industry 94- 6
East Indies trade 134 , 136 ; see
also East India Company
economy 210-1 1
finances for Napoleonic wars
80-8 4
financial ignorance 11-1 2
financial sector's contribution
to GD P 5
fiscal system 75
foreign investment 287 ,
288-90 , 292- 6
foreign investment in 76
Glorious Revolution 75-6 , 13 6
house prices and property
ownership 10 , 23on., 233 ,
263 , 28 1
housing policies 251-3 , 262
inflation 10 8
institutional investors and
196- 8
and insurance 4, 19 9
mortgage interest relief 25 2
national debt 80, 99
pensions see welfare state below
poverty in 13 , 38-4 1
savings glut 293
Spanish Empire and 26
stock market 125 , 159 , 261- 3
and sub-prime mortgages 8
voting rights 234
welfare state 199 , 200-202 ,
204-6 , 208-11 , 21 9
and First World War 101-2 ,
299-30 4
see also British Empire; English-speaking countries; Scotland
British Empire:
and bond market 10 1
control of colonies 294-6 , 308
corporate finance as foundation
of 3
and investment 98-9 , 294
as narco-state 290
nationalist and independence
movements 295
see also Britain
broad money 62
brokers 153-4
Bronowski, Jacob 2, 3 5 8
bronze 24
Bruegel, Pieter the Elder 70
Bruges 47
Bubble Act 156 , 15 7
asset-price 163 , 167-8 , 35 7
five stages of 8, 121-2 , 148 ;
displacement 143-4 , 145 ,
16 0
history of 121-2 , 126 , 13 6
international pressures and 16 7
Kaffir (gold mine) 297
Mississippi 126-7 , I43~57
monetary policy and 166-7 ,
17 4
property price 233 , 264, 267,
281- 2
reflexivity of 31 6
South Sea 154 , 155-7 ,
super 34 2
technology ( 6, 124 ,
166-8,28 3
see also financial crises
Bùchi, Hernân 21 6
Buckingham, Dukes of 236-40,
Buenos Aires 98, 108 , 112 , 274- 7
Buffett, Warren 228, 327 , 33 0
building societies 247. see also
mutual associations
Bulgaria 10 1
bulls (stock market) 121,132,17 4
Bunn, Matthew 223
bureaucracy 275 , 35 3
burial societies 18 4
Bush, President George W.
117-18 , 170 , 306m
budget deficit and federal debt
117-1 8
and Enron 170-7 1
and home ownership 267
businesses see companies;
Business Week 122- 3
Calais 73
Calancha, Fray Antonio de la 23
Californian energy deregulation
170 , 17 2
California Public Employees' fund
22 2
call options 12 , 22 7
Cambi, Bernardo 18 7
Cambodia 278
Camdessus, Michel 31 2
Canada 147 , 233 , 292 , 293
cancer 18 4
Canetti, Elias 10 5
Cantillon, Richard 14 5
Canton see Guangzhou
adequacy see banks
appreciation 125 , 26 2
controls 303 , 305-6 , 313 , 33 3
'dead' 275 , 27 7
export/mobility 122 , 293-7 ,
303 , 305-6 , 308, 309 , 333- 4
market see capital market
Capital Asset Pricing Model
(CAPM ) 32 3
and accumulation 1 7
and the company 119-2 0
evolutionary processes in 348- 9
and hyperinflation 10 6
and money 1 7
and war 297- 8
and welfare state 21 1
capital market:
alleged improvement 6
liberalization 310-1 2
Capital One 35 3
CAP M see Capital Asset Pricing
Capra, Frank 247
Caribbean countries 99, 285
Carlyle 33 7
Carnegie, Andrew 297
Carter, Jimmy 254
Carville, James 65 , 11 7
Case-Shiller index 261 , 263
absence of see electronic money;
moneyless societies
'nexus' 1 7
in people's hands 29
see also coins; paper money
Castile 20, 25 . see also Spain
Castlemilk 280
Castlereagh, Lord 83
Castro, Fidel 21 3
Castro, Sergio de 21 4
catastrophes see disasters
cat bonds 227 , 228
Cato Institute 27 6
Cauas, Jorge 21 4
Cavallo, Domingo 114-1 5
CDO s see collateralized
CD S see credit default swaps
census (contract) 73
Center for Responsible Lending
270-7 1
Central America 99
central banks 49-50 , 58, 33 7
and Black Monday (1987) 16 6
and bubbles 122 , 17 4
establishment of 57
explicit targets 11 6
independence of 11 6
and irrational markets 17 4
monarchs and 14 1
monopolies on note issue 49,
5i> 5 4
and oil price rises 308
and subprime crisis 9
and war 10 0
see also Bank of England etc.
central planning 19 , 332 , 34 1
Cerro Rico 21- 3
certainty 188-189 . see also
charity 19 9
Charlemagne 24, 3 2
Charles the Bold, Duke of
Burgundy 47
Charles II, King 75
cheques 48
Chewco Investments 17 2
Chicago Boys 214 , 21 8
economic theories 214 , 216-1 7
41 0
futures market in 226- 8
Chicago Mercantile Exchange
226, 227- 8
Chile 98, 109 , 212-19 , 292
'Chimerica' 12 , 332 , 335- 9
China 32 , 86, 153 , 205 , 207,
295-6 , 332- 9
as America's banker 4, 12 , 283 ,
2-84, 333- 9
banknotes and coinage 24, 27 ,
bankruptcy and default (1921 )
cotton trade 96
and currency crisis (1997-8 )
33 3
decline after 170 0 285- 6
demographic and
environmental challenges 284
employment 33 4
enterprise zones 332 , 33 3
export prohibitions 338
exports 333 , 334-5 , 33 7
financial constraints 286
foreign exchange reserves 334 ,
33 7
foreign investment in 287,
288-9 , 2.9*, 295-6 , 33 3
and globalization 287, 296
gold and silk 13 5
history 284-7 , 289-9 2
imperialist undertones 33 9
incomes 333- 5
industrialization and
urbanization 332- 3
inflationary pressures 284, 338
liberalization of economy 33 3
millionaires 33 3
natural resources scramble
338- 9
opium wars 289-9 2
price controls 33 8
private enterprise 332- 3
property price boom 23 3
railways 292
renminbi 333 , 33 8
repression 214 m
revolution of 191 1 295- 6
savings 333- 5
stock market 284
and technology 285- 6
and US recession prospects
336- 7
wars with Japan see Japan
see also BRICs ; Hong Kong
China Investment Corporation
33 8n .
Chongqing 332- 3
in China 29 2
and money 1 , 25
and usury 35 , 44, 71 , 73- 4
Churchill, Sir Winston 204
Citadel Investment Group 2, 225 ,
226 , 228
Citigroup 337 , 352 , 395
City Bank of Ne w York 35 2
civil rights 25 0
civil services 75- 6
class conflicts 243
clay tokens and tablets 27-3 1
clergymen 191- 2
climate change 14-15 , 176 ,
223-4,35 6
41 1
Clinton, Bill 65 , 219 , 27 e
Clive, Robert 13 5
coal 235 , 28 5
Cobbett, William 9 9
Coen, Ja n Pieterszoon 13 4
co-evolution 35 0
cognitive traps 345- 7
coins/coinage 24-5 , 29 , 31,42,4 7
alternatives to 25 , 27 , 30 ; see
also clay tokens and tablets;
electronic money; paper
debasements, shortages and
depreciations 25 , 75 , 127 ,
139 , 141 , 150 , 307 ; see also
currency devaluations
shortages 2 5
collateral see shares
collateralized obligations:
debt (CDOs ) 8, 12 , 260 ,
268-9 , 2.71-2. , 33 6
mortgage 26 0
Colombia 18 , 98 , 125 , 171 , 21 9
Colonial Loans Act 29 4
colonial securities 293- 4
Colonial Stock Act 29 4
Columbus, Christopher 1 9
commercial banks 5 6
Commission for the Formalization
of Informal Property 27 7
commodity markets and prices 10 ,
22 6
surge in (2000s) 6, 10 , 332 ,
338 , 33 9
and war 10 , 300 , 33 9
communications, improvements in
287 , 29 6
Communists 1 7
and Great Depression 242 , 243 ,
24 6
and money 17-18 , 36 4
Communist states:
and capital debt market 30 8
central planning 19 , 33 2
and labour 18-1 9
and money 1 8
Community Reinvestment Act 25 1
conglomeration 35 2
creation of 61 , 15 6
extinction among 349-50 , 35 1
invention and development of
12 0
new types 352-4 , 35 6
regulation of 156 , 356- 7
Company of the Indies
{Compagnie des Indes) see
Mississippi Company
Company of the West (Compagnie
d'Occident) 140 , 141- 2
competition 35 0
computers 116 , 16 6
concentration of ownership 351 ,
352 .
condottieri 69-7 1
conduits 5 , 9, 27 2
Confederacy 92- 8
confidence intervals 189 , 346 , 37 9
conglomerates 35 2
conjunction fallacy 345- 6
conquistadors 1 , 19-23 , 29 , 5 5
Conservative party:
housing policies 251- 2
and welfare state 21 0
41 2
Consolidated Fund 75
consols 76-7 , 80, 84-5 , 294, 297 ,
30 2
Constable (Archibald) 19 6
Constantinople 36
construction industry 24 2
consumer durables 16 0
consumer finance and credit 3, 61 ,
160 , 35 3
consumption, falls in 34 2
convertibility see currency
cooperatives see banks
Corn Law Repeal 236 , 23 7
Coromandel 13 5
corporate finance 3
corruption 294
cost of living, rises 26, 124- 5
cotton 94- 6
council housing 251-252 . see also
public housing
counterparty risks 272 , 33 1
country banks 53 , 57
Countrywide Financial 27 2
coupon 67
crashes see financial crises
Crawford, William 25 5
creationism 35 6
borrowing against future
earnings 28 2
essential for growth 31 , 64
instalment 16 0
origins of 30- 1
ratings 249-50 , 266
as total of banks' assets 5 1
see also debt; microfinance
credit card holders 10-1 1
credit crunches:
1914:29 9
2007-8 : see financial crises
credit default swaps (CDS) 4, 12 ,
22 7
credit markets:
crisis (2007) 272 , 283 , 35 4
infancy 3 7
Crdit Mobilier 56
Credit Suisse 27 1
credit unions 280
creditworthiness 51 , 278-8 0
crises see financial crises
Croatia 2
cross-border capital flows see
capital (export)
crowds 346- 7
Crusades 25
conversion problems 42 , 48
convertibility 300-1 , 305
first global (Spanish) 25- 6
manipulation 33 8
pegs 58, 114 , 11 5
reform: Amsterdam 48, 127 ;
Argentina 11 2
see also coins/coinage; exchange
currency devaluations/crises/
collapses 67, 125 , 33 3
Argentina no-11 , 12 5
medieval monarchs 307
sterling devaluation (1992 )
317-1 8
after First World War 107 ,
current accounts 49
41 3
Dallas 253 , 255- 9
Dante Alighieri 3 5
Darmstàdter Bank 5 6
Darrow, Charles 23 1
Darwin, Charles 358
Darwinian processes in financial
system 14 , 348-5 8
Datini, Francesco 18 6
Da Vinci Code, The 32m
Davis, Jefferson 93
Dawkins, Richard 35 6
Dearborn 24 2
death, causes of 183- 4
debtors' prisons 60
debt vs. income balance 28 2
moratoria 30 1
mountain image 7 1
origins of see credit
securitization see securitization
transferability (pay the bearer) 30
unreliability and hostility of
debtors 2 , 37-8 , 59-6 1
decimal system 3 2
defence see arms
deficits, government 118 , 307 ,
308-9 , 312 , 31 3
deflation 106 , 164 , 296
Defoe, Daniel 145- 6
Delane, John 95
Delors, Jacques 31 2
democracies see property-owning
democracies; representative
Department of Housing and
Urban Development (HUD)
266- 7
deposit insurance 57
depreciation 263
depressions 16 3
absence of after Second World
War 164- 6
Depression economics 31 3
see also financial crises; Great
Derenberg & Co . 299
derivatives 4-5 , 227-8 , 35 3
dangers of 228 , 35 3
'over-the-counter' (OTC ) 4-5 ,
228,35 3
surge in 228 , 332 , 33 6
see also futures contracts; swaps
Derry, Dr George H. 245- 6
de Soto, Hernando 274- 8
Detroit 234 , 242-6 , 249-51 ,
264-6 , 268, 269-70 , 272 ,
278,28 1
Deuteronomy 36
developed countries 4, 13-1 4
developing countries see emerging
markets; 'Third World'
Devonshire, Dukes of 23 5
diamonds 12 3
DiFatta, Joseph 17 8
'Disaster Capitalism Complex'
18 2
disasters 6, 176-86 , 199 , 205 ,
223- 4
hedge funds and 227- 8
discount houses 30 1
discount window 16 4
discrezione 44
distribution curves 154-5 , 18 9
dividends 125 , 262
41 4
Dixon, Don 255
bills 27-8 , 63, 96- 7
China and 334 , 337 , 33 8
falling value 10 , 28, 63 , 317 ,
as international reserve
currency 305 , 307
origin of word 25
pegs 300 mania 6, 124 , 283 . see
also bubbles
Douai 73
Double Eagle 31 9
Dow Jones Industrial Average 6,
123-4 , 16 5
1929 : 15 8
1987 : 165- 6
1995-7 : 16 7
falls 6, 16 5
and 9/11 : 6
Druckenmiller, Stanley 31 9
drug addiction 292
Dunscombe, Thomas, M P 78
DuPont 16 0
Dutch East India Company see
Dutch East Indies 134- 5
Dutch Empire 3, 136 , 140 . see
also Netherlands, The; United
Dutch Republic see United
earthquakes 176 , 183 , 205
East Africa 38, 18 4
East Asia 283 , 284. see also Asia
Eastern Europe 112 , 308
East India companies 128 , 142 .
see also VO C
East India Company (British) 129 ,
134 , 135 , 148 , 153-4 , 15 7
East Indies 12 7
economic hit men 309-11 , 314 ,
31 9
economies of scale and scope 35 2
Chicago and Harvard theorists
214,216-1 7
economic forecasting 34 7
evolutionary economics 348
and Great Depression 163- 4
and real humans 34 5
and stock market 12 6
Ecuador 2 , 18 , 171 , 309-11
Edinburgh 190-1, 28 1
education 209, 22 0
Japan 207, 209, 22 0
public expenditure on 22 0
Edward IV, King 47
Egibi family 3 1
Egypt 96, 98, 276 , 292 , 295
Eilbaum, Roberto 11 2
El Alto 278 , 280
El Dorado 2 1
electoral reform:
in Britain 99, 202 , 234 , 237 ,
240-4 1
in Europe 10 0
see also property-owning
electricity industry 169-7 2
electronic herd see investors
electronic money 29-30 , 5 1
41 5
El Salvador 219 , 27 6
emergency currency 30 1
emerging markets/developing
countries 4, 13-14 , 274-81 ,
283 , 288, 307 , 309, 324 ,
333 , 336 , 358
emerging market bonds 6, 116 ,
see also poverty and poor
empires 294, 309-310 , 339 . see
also imperialism
Empire Savings and Loan 255- 8
employment policies 307 . see also
energy industry 169-7 3
deregulation 170 , 17 2
fuel price rises 308, 33 8
see also gas; oil
Engels, Friedrich 17 , 364
England see Britain
English-speaking countries 10-12 ,
no , 284, 339 . see also
Enron 168-74 , 22 5
enterprise zones 332 , 33 3
and bankruptcy 6 1
and capital 274
and hyperinflation 10 6
and mortgages 232 , 278
origin of term 14 6
women 278-80 , 33 3
environmental issues 223-4 , 284.
see also climate change;
Ephesus 24
equal societies 209
equities see shares
returns on 354
risk premium 12 6
Erlanger (Emile) and Co . 94, 96
ER M see European Exchange
Rate Mechanism
ethnic minorities, providing
financial services 2, 34, 37-8 ,
4 i
see also race divisions
Eurobond market 308
eurodollar deposits 5 1
alliances as cause of conflict
banks and industrialization 53
Bretton Woods and 307
British investment in 293
and exports to US 1 0
government bonds 32 3
government borrowing 73- 6
great powers and war 298,
see also Eastern Europe
European Central Bank 11 7
European Exchange Rate
Mechanism (ERM ) 317-1 8
eurozone 62
evolution, financial history and
14-15 , 53-4 , 347-5 8
exchange rates:
exchange controls 303
fixed 305- 7
floating 58, 308, 31 2
set by market 309
41 6
stability 58, 164 , 296
and First World War 299
see also European Exchange
Rate Mechanism
excise see taxes
extraterritoriality 29 1
Falkland Islands i n
famines 183 , 18 4
Fannie Mae (Federal National
Mortgage Association) 249,
251 , 260, 264, 267, 273
fascist and totalitarian
governments 232 , 246
Fastow, Andrew 172- 3
fat tails 165 , 225
Faulkner, Danny 256-8
Les. ('free of capture and seizure')
Federal Emergency Management
Agency (FEMA ) 17 8
Federal Home Loan Bank Board
250 , 258
Federal Home Loan Mortgage
Corporation see Freddie Ma c
Federal Housing Administration
(FHA) 248-5 0
Federal National Mortgage
Association see Fannie Ma e
Federal Open Market Committee
166- 7
Federal Reserve Bank of Ne w
York 16 1
Federal Reserve System:
and 1990s euphoria 167-8 , 17 4
and Black Monday (1987 )
165- 6
criticisms ofi6i~3,39 5
founding of 57
increases in short-term rates
11 6
and Long Term Capital bail-out
32 7
and mortgages 266
Rothschilds' alleged influence
on 86
target rate 9, 166- 7
and Wall Street Crash/Great
Depression 161-4 , 21 2
Federal Savings and Loan
Insurance Corporation
(FSLIC)25 8
Fermât, Pierre de 18 8
Fermât Capital 22 7
feudalism 34 1
FH A see Federal Housing
Fibonacci (Leonardo of Pisa)
32.-3» 35
fiction 195 , 304
fiduciary note issues 5 5
financial crises 2, 3, 64, 158 , 164 ,
342-, 35 4
'American crisis'/credit crunch
8, 225 , 272 , 283 , 33m. , 338 ,
347 , 348 , 354- 5
Asian see Asia
'Black Monday' (1987 ) 159 ,
165-6 , 32 4
escaping investors' memory-span 332 , 340
and fiscal deficits 31 3
frequency and unpredictability
of 2, 14 , 332 , 340 , 342 , 34 7
41 7
financial crises - cont.
international effects of 283 ,
339-4 0
Keynes on 328
first Latin American debt crisis
(1826-9 ) 88, 98, i96n., 288
second Latin American debt
crisis (1980s) 288, 308
likely locations for 283
liquidity crises 55 , 300 , 34 7
Savings & Loan 253-60 , 322 ,
349, 352 , 354 , 35 6
in First World War 299-30 4
see also bubbles; Great
Depression; inflation
financial history 10-15 , 343n .
financial innovations see financial
financial services see financial
financial system:
absolutist theories 14 0
benefits of 2-3 , 34 2
evolutionary extinctions and
destruction in 14-15 , 53-4 ,
59-61 , 272 , 348-9 , 351-3 ,
354 , 355 , 357- 8
financial services 353 , 356- 7
'great dying' scenario 14-1 5
ignorance of 10-12 , 316 ,
innovations 3, 6, 53 , 297 ,
304, 341 , 350 , 352 , 35 3
instability of 316 , 342-5 8
integration of financial markets
1 4
'intelligent design' in 54, 35 6
'monster' or mirror of mankind
see also regulation
gender imbalance 5
graduates and 5
hostile views of 2, 1 3
fire 186- 7
firms see companies
Fisher, Irving 157 , 16 0
Flanders 74
Florence 33 , 35 , 41 , 69-72 , 18 7
and bonds 69-7 2
under the Medici 41- 7
taxes and financial records 45 ,
71 , 7 2
Flores, Betty 278- 9
flotations 15 6
food prices 26, 235 , 284, 338 . see
also grain
Ford, Edsel 242- 3
Ford, Henry 61 , 24 2
Ford Motor Company 242- 3
forecasting see economists
foreclosures see mortgages
foreign exchange dealers and
markets 4
early 42 , 47, 48
and First World War 300
forgery 97
forward contracts 226
40i(k ) plans 1 1
fractional reserve banking 49, 50,
5 i
France 232 , 304
banks 56,14 2
bonds 86, 101-2 , 297, 30 2
41 8
currency 142 , 15 4
financial difficulties in Ci 8 3,
75-6 , 126-7 , i3 8 -5 6
government bankruptcies 13 8
under Napoleon 80-85 ; see also
Napoleonic Wars
overseas possessions and trade
140 , 147 ; see also Louisiana
property price boom 23 3
rentes 73-4 , 99, 30 2
Revolution 126 , 15 4
royal funding 3, 74, 75 , 138-9 ,
153- 5
stock market 15 4
taxes 76, 142 , 14 6
and US 307- 8
and First World War 101 ,
103-4 , 302., 304
franchise, widening of see
electoral reform
fraud and misconduct:
bubbles and 168-7 4
causing hostility 2
hedge funds 330-3 1
Savings and Loan 255- 9
stock market 122 , 15 9
see also Enron
Freddie Ma c (Federal Home Loan
Mortgage Corporation) 251 ,
260,267,27 3
free trade 306, 339 . see also
French Revolution see France
Friedman, Milton 211-1 4
and Chile 213-14 , 21 7
and China 2i4n .
on Great Depression 161,163- 4
on inflation 100 , 104 , 21 1
and welfare state 212 , 21 3
FSLI C see Federal Savings and
Loan Insurance Corporation
FTS E All Share index 26 1
fuel see energy industry
Fujimori, Alberto 27 6
fungibility of money 24
fur trade 14 7
futures contracts 225 , 226 , 34 1
as derivatives 22 7
pension funds and 12 3
'to arrive' contracts 22 6
Garwin, Richard 223
gas industry 119 , 169-7 1
Gates, Bill and Melinda 28on.
Gates, Henry Louis ('Skip') Jr .
267-8,27 7
GD P see gross domestic product
gearing (assets vs. capital) 32 3
General Motors 16 0
'genes' in financial system 3 50, 3 5 1
Geneva 43
Genoa 44, 72 , 74, 87,13 7
geology, compared with financial
history 343 m
George, Henry 23 0
Germany 88, 144 , 209, 232 , 292
banks 56
bonds and securities 297 , 302 ,
and British financial system
187 , 33 9
exports 103 , 395
hyperinflation and slump
101-7 , 113 , 158 , 30 2
41 9
Germany - cont.
insurance 187 , 19 9
national unity movements 9 1
property and land investments
23 2
Reichsbank 57
reparations 102-4 , 159 , 303
reunification costs 31 7
royal finance 75
and subprime mortgages 8
thaler 25
Weimar Republic 102-4 , 11 3
welfare system 200-20 2
and First World War 101 , 302 ,
3°4 , 395
Ghana 27 6
Ghent 73
ghost towns 17 7
GI C 33711 .
gilt-edged securities 302 . see also
Ginnie Ma e (Government
National Mortgage
Association) 251 , 260, 273
Giovanni Fiorentino 3 3
Gladstone, W. E . 95 , 98, 10 0
Glasgow 234 , 280, 281- 2
loan sharks 13 , 38-41 , 59, 64,
need for credit networks 13 , 40,
Glassman, James K . 123- 4
globalization 4, 62 , 282 , 33 7
and conflict 339-4 0
denned 286
first era of 286-7 , 2.89, 2.92.-4,
296, 304, 33 9
opposition to 309
see also sovereign wealth funds
global warming see climate change
Goebbels, Joseph 80
gold 56, 88, 109 , 149 , 296, 2997
coins 24, 299
conquistadors and 19-2 0
and Great Depression 162- 4
Incas and 19-2 0
increased production 56, 297
as international reserve
currency 305
and Mississippi Bubble 149-50 ,
15 2
in Napoleonic Wars 81- 4
pension funds and 12 3
reserves 56, 162-4 , 300, 305
see also gold standard
Goldberg, Whoopi 267
golden mean 3 2
Goldman Sachs 1-2 , 28, 160 ,
283 , 284, 320 , 327 , 33m. ,
gold standard 58, 63 , 294
Britain and 55-6 , 58, 75 , 16 2
and crisis of 191 4 300
inter-war years 161 , 162 ,
16 4
Keynes on 58
and rentes 10 0
spread of 294, 296, 300
US abandonment of 307
and Wall Street Crash 16 1
Gordy, Berry 25 0
Gore, Al 11 7
An Inconvenient Truth 224
government bonds 65-72 , 86,
42 0
ioo , 115 , 292-4 , 296-7 ,
323,34 2
Government National Mortgage
Association see Ginnie Ma e
government sponsored enterprises
(GSEs) 251 , 260
graduates 5
grain 27, 226 , 235 , 236- 8
Grameen ('Village') Bank 279-8 0
Gramm, Senator Phil 17 0
Graunt, John 18 8
Gray, Edwin J . 258
Great Depression 9, 57 , 158-61 ,
174 , 205 , 231 , 259 , 303 ,
3*9, 354
and home ownership 241- 6
see also unemployment
Great Fire (1666) 18 6
Great Inflation see inflation
Great Scene of Folly, The 147,
1S 3-4
Greece 296
Greenspan, Alan:
and Black Monday (1987 ) 16 6
on bond market 65, 11 8
and Enron 168-70
on 'irrational exuberance' 121 ,
167 , 169 , 28 1
and mortgage crisis 266
successes of 168- 9
and technology bubble 167- 8
Greenwich, Connecticut 3 20
Griffin, Kenneth C. 2, 225-6 , 33 0
Grinspun, Bernardo i n
Gross, William 68, 107- 8
gross domestic product (GDP) :
financial sectors and 5, 19 8
international data 210-11 ,
284-5 , 34 2
growth (economic) 31 , 64, 34 2
GSE s see government sponsored
Gualpa, Diego 2 1
Guangzhou (Canton) 289-9 1
Guatemala 2, 98
Guicciardini, Francesco 46
Habsburg Empire 3, 303
Haghani, Victor 32 2
'haircuts' 11 5
Haiti 275 , 27 6
Halley, Edmund 188 , 19 3
Hamburg i86n .
Hamilton, Alexander 27- 8
Hammurabi 30
Harvard 5, 223
economic theories 214-15 , 21 7
money game 49-5 0
Harvey, 'Coin' 90
Hassett, Kevin A . 123- 4
Hawes, Mr s Anna 76- 7
Hawkwood , Sir John 69-7 1
health insurance 184 , 200-202 ,
219 , 229
'Hebrew talisman' 86
hedge funds 2 , 5, 225-8 , 319 ,
322 , 328 , 329 , 33 6
dynamic hedging 3 24
evolutionary change 356m
explosion of 5, 314 , 329-32 ,
336 , 33 7
funds of funds 3 29
history 5, 226 , 349
outlook for 330-2 , 355- 6
42 1
hedge funds - cont.
and prime brokers 35 0
quantitative 322- 9
and subprime loans 271- 3
Heine, Heinrich 85, 89
Heinz, John Henry 6 1
Heisenberg, Werner 31 5
Heraclitus 69
Herries, John Charles 82- 3
heuristic biases 344 , 346
Hey den, Pieter van der 69-7 0
Hilferding, Rudolf 35 2
Hilibrand, Larry 3 2 2
Hispaniola 1 9
Hobbes, Thomas 1 8
Hobson, J . A . 90-9 1
Holland see Dutch Empire;
Netherlands, The; United
Home, Alec Douglas-Home, 14th
Earl of 23 4
home biases 281-2 , 30 7
home equity extraction 265
Honduras 27 6
Hong Kong 291-2 , 295-6 , 332- 3
Hostiensis (Henry) of Susa 7 1
hot money 103 , 161 , 305 , 309,
312 , 31 4
household debt and income 61 ,
282 , 341 . see also consumer
house prices see property/real
Houston 170-7 2
HSB C 27 1
HU D see Department of Housing
and Urban Development
Hufschmid, Hans 3 2 2
Hungary 107 , 292 , 303
hunger marches 242 , 244
hunter-gatherers 17-1 9
hurricanes 176-83 , 199 , 224
Hussein, Saddam 17 6
hyperinflation 97, 101-7 , 302 . see
also inflation
IB M 16 0
illiquidity 55 , 273 , 35 7
IM F see International Monetary
imitators, generating 354
immigration 286, 287
imperialism 294, 304, 309, 342 .
see also empires; neo-imperialism
Incas 19-2 3
incomes (personal):
international data 1-2 , 284-5 ,
2-93-4, 333- 5
providing security 278
British Empire and 287, 295
Enron and 17 2
exports 96, 289
and globalization 287
'Indian method' of mathematics
3 2
international investment in 172 ,
microfinance in 280
property prices 23 3
textiles 135 , 287
see also BRIC s
Indonesia 31 2
42 2
industrial investment banks 56
industrial revolution 52.-3 , 285 ,
industry/industrialization 235 ,
349,35 7
conditions for 284- 6
evolutionary processes in 349
finance and 2, 52-3 , 56
inference 189-9 0
in American Civil War 97
asset-price vs. consumer price
167- 8
and bonds see bonds and bond
definition 10 0
fall in 115-1 6
Great Inflation (1970s) 108 ,
11 5
historic 26, 63, 136m , 296
and Mississippi Bubble 149-5 1
and money supply 100 , 21 1
and mortgages 25 3
and oil price rises 308
and pensions 11 7
political causes 104 , no-1 1
rates 63, 107 , 10 8
and stock markets 136 m
and war 10 , 100-107 , 30 2
and First World War 100-107 ,
30 2
see also hyperinflation;
initial public offerings (IPOs) 16 0
insider dealings 121-2 , 16 1
insolvency 55 , 357 . see also
Institute for Liberty and
Democracy 27 6
institutional investors 19 6
insurance 176-229 , 34 1
accident 18 4
and 'American crisis' (2007)
35 4
cat bonds as 22 7
contracts 18 6
federal deposit 247- 9
fire 186- 7
health see health insurance
history 185-98 , 205
insurance companies as
investors 196-8 , 23 5
life 18 7
maximum principle 19 3
most insured country (Britain)
4, 19 9
mutuality principle 19 5
and old age 18 4
pay-as-you-go basis 187 , 191 ,
210 , 21 5
policy-holders disadvantaged
180-81 , 198- 9
premiums as proportion of
GD P 198 , 19 9
property and casualty 178-8 2
public/state 179 , 182 , 202 , 204
risk evaluation 187-9 0
shipping see marine insurance
small-print exclusions i79~8on .
for soldiers 19 5
and US economic triumph 3
war and 187 , 202-4 , 224
welfare state and 199 , 228
see also hedge funds
42 3
'intelligent design' in financial
evolution 54, 35 6
interbank transactions see banks
calculation of 30 , 32.-3
as compensation for risk 34
origins of 30 , 7 1
rates see interest rates
securitization of 34 1
Interest Equalization Act 306- 7
interest rates:
China and 334- 5
extortionate 37 , 38-41 , 28 1
falling 39 , 33 5
and hyperinflation 10 6
and property ownership 253 ,
268, 269
set by market 309
swaps 4, 227 , 32 3
International Bank for
Reconstruction and
Development see World Bank
International Development
Association see World Bank
International Monetary Fund
(IMF) :
and Argentina 11 4
and Asian crisis (1997-8 ) 31 2
founding of 306
loans and conditions 308-1 0
opposition to 309-1 4
as US agents 308-1 1
Internet 16 6
banking 35 3
Enron and 171 , 17 2
see also
invariance, failure of 34 5
international 288-9 , 292-3 ,
296-303 , 306-8 , 33 3
trusts 16 0
Investment Company Act 3i4n .
investment grade securities 88
as 'electronic herd' 121 , 31 9
and financial crises 7, 340
and mortgages 235-6 , 262 , 34 1
private 122 , 160 , 235 , 292-3 ,
297, 34 1
volatility and biases of 7, 13 ,
316 , 344- 6
IPOs see initial public offerings
Iraq 6, 17 6
Ireland 233 , 295
irrational exuberance see
Greenspan, Alan
Islamic Empire 24- 5
Israel 308, 31 7
Italy 3, 232 , 292
ageing population 11 7
banking system 3, 48, 52
bond market 66, 69-73 , 11 7
and European Central Bank 11 7
financial history 31-8 , 41-8 ,
101 , 11 7
insurance 185- 6
national unity movements 9 1
property price boom 23 3
It's a Wonderful Life 247-8 ,
26 1
James II, King 75
Japan 57 , 66, 135 , 205-10 , 313 ,
31 7
ageing population and pensions
208-10 , 221- 2
economy 66, 168 , 209, 222 ,
35 7
government bonds 66-8, 292 ,
32 3
insurance 205-1 1
property prices 263
wars with China 205 , 207 , 295
welfare state 205-10 , 221- 2
in Second World War 205-6 ,
Jardine, Matheson 289-9 2
Jardine, William 289-9 2
Jews 8711., 99
moneylenders 33-5 , 36
Rothschilds see Rothschild
in Venice 33- 8
see also anti-Semitism
Jivaro people 1 8
jobbers 299
joint-stock banks/companies 49,
56, 120 , 127-31 , 174 , 297,
Jones, Alfred Winslow 314 m
Kaffir (gold mine) bubble 297
Kahn, Herman 209
Kahnemann, Daniel 344- 5
Kast, Miguel 21 4
Katrina (Hurricane) 176-83 , 219 ,
Kay, John 33 0
Kazakhstan 219 , 276
Keating, Charles 2 58n.
Kenya 280
Keynes, John Maynard/
Keynesianism 58, 106 , 159 ,
2-93, *95 , 305 , 3*8
on inflation 106 , 11 5
Keynesian policies 112 , 31 2
on uncertainty 343- 4
Klein, Naomi 18 2
Knight, Frank 343
Kondo, Bunji 206
Krugman, Paul 31 2
Kuwait Investment Authority
337 m
Kyoto 206
in Asia 287
forced 19 , 21- 2
mobility 14 , 274 , 288
money as chains of 1
organized see trade unions
rural 288
as unit of value 18-1 9
unskilled and semi-skilled 1 4
Labour party 251- 2
Lackey, Judge i8i-2n .
Lamarckian evolution 35 1
Lamont, Norman 31 8
Landlord's Game 230-3 1
landlords, negative views of 230 ,
247-8,25 2
Lasswell, Harold D . 207
Latin America:
aid to 307
British investment in 293
debt crises and currency
depreciations 88, 98, 19611. ,
288, 308
42 5
Latin America - cont.
Enron and 17 1
pensions 21 9
poverty rates 21 8
see also South America
Latino borrowers 266
La w of Ann 19 1
law, finance and 37 , 342 . see also
Law , Gerard 39-41
Law , John 126-7 , 137~57,
169-71 , 28 1
absolutism 140 , 141 , 149 ,
15 1
and banks see banks
and paper money 138-9 , 142 ,
149-50 , 16 9
and pensions 14 6
Lay, Kenneth 169-74
Leeson, Nick 288
Left wing 89, 20 2
see also Labour party; socialists
Lelystad 13 5
le Maire, Isaac 131 , 132- 3
lending see banks; debt; loans;
Lenin, V. I. 246
alleged insight on currency
devaluation 10 7
on imperialist rivalries and war
and money 1 7
less-developed countries 14 , 283 .
see also emerging markets
leveraging 4, 160 , 229 , 262m,
33 6
lex mercatoria 18 6
limited see limited-liability
unlimited 18 7
liberal imperialism 294
capital market 310-1 2
economic 33 3
trade 305 , 309
Liberal party 202
liberals 89-9 0
Libor 265 , 32 3
Lifan company 33 3
life annuities 74
life expectancy 188 , 190 , 192 ,
198 , 209, 220 , 22 1
Lima 27 7
limited-liability companies 120 ,
129,174,18 7
Lincoln, Abraham 93
Lincoln Savings and Loan 258n.
liquidity 6, 51 , 55 , 355". , 35 7
crises 55 , 300, 347 ; see also
financial crises
ratios 62
and First World War 297, 298,
300, 304
Liverpool 94
Liverpool, Lord (Prime Minister)
Lloyd George, David 202
Lloyd's (London) 186-7 , 202
Lloyds Bank 56, 19 6
Loaisa, Rodrigo de 23
Lo , Andrew 348, 35 6
conditional 18 5
forced 71- 3
liquidity of 5 1
see also debt
loan sharks 13 , 38-41 , 63 , 280 ,
281,35 1
London 6c Westminster Bank 5 6
City of 53,99 , 154 , 18 6
as financial centre 29 9
insurance market 186- 7
life expectancy in 19 0
Medici bank in 43 , 4 7
London Assurance Corporation
19 8
Londonderry, Thomas Pitt, Earl
of 148,15 3
London Inter-Bank Offered Rate
(Libor) 265 , 323n .
long positions 316-1 7
Long Term Capital Management
(LTCM ) 322-9 , 33 1
Los Angeles 26 4
lottery loans 74 , 12 7
Lott, Trent 180-8 1
Louisiana 140 , 143-5 , 147-8 ,
17 8
Louis XIV , King 138 , 14 8
Louis XVI , King 15 4
Louis XV , King 139 , 15 4
Lou Jiwei 338n .
Lowenfeld, Henry 292- 3
LTC M see Long Term Capital
Lyford Cay 6- 7
M o (monetary base or high-powered money) 5 0
M i (narrow money) 50-5 1
M2 : 29 , 5 1
M 3 : 5 1
McBirney, Ed 25 5
McCain, John 2 5 8n.
Machiavelli, Niccol 4 1
Maclaurin, Colin 190 , 193 ,
19 8
Macmillan, Harold 26 1
macroeconomics 347 , 35 6
Mafia 25 5
Maharashtra 17 2
Main (Chas. T.), Inc. 30 9
Maine 5 7
Malacca (Melaka) 13 1
Malaysia 312 , 313 , 314-1 5
Maldives 3 0
malfeasance see fraud and
Malthus, Thomas i92n. , 34 2
management practices, revolution
in 16 0
Manco Capac 20-2 1
Manes, Alfred 19 5
manufacturing see industry
Maoists 27 6
marine insurance 185 , 187 ,
202-4 , 29 8
Markowitz, Harry M . 32 3
mark-to-market accounting 17 2
Marshall, Alfred 62n .
Marshall, General George 306 m
Marshallian k ratio 62 m
Marshall Plan 305- 7
Martin, William McChesney J r
16 8
Marx , Groucho 16 1
42 7
Marx , Karl/ Marxism 17 , 213 ,
Marylebone Workhouse 199-203
Mary Poppins 7
Massachusetts Affordable
Housing Alliance 266
Massys, Quentin 43
Masulipatnam 13 0
applied to finance and insurance
3, 30-33 , 188-90 , 31 9
Chinese 3 2
history of 30-3 2
Oriental 3, 3 2
Matheson, James 289-92
Medicare and Medicaid 211 ,
219-2 1
Medici family 3, 41-7 , 63 , 7 2
diversification 44-6 , 47- 8
libro segreto 44-5
Medici, Cosimo (C15 ) 42 , 45- 6
Medici, Duke Cosimo de' (Ci6 )
4i,4 7
Medici, Giovanni di Bicci de' 42 ,
44- 5
Medici, Lorenzo the Magnificent
46- 7
Mediterranean 24- 5
Memphis 59-60 , 268, 270 , 27 2
mercenaries 69-7 1
merchant banks 53 , 299
Merchant of Venice see
Shakespeare, William
mergers and acquisitions 351 , 35 5
Meriwether, John 322 , 325 ,
326-7 , 328 , 329
Merrill Lynch 272 , 322 , 337 , 395
Merton, Robert 320 , 322-3 , 32 5
Mesopotamia/Babylonia 27-31 ,
185 , 342 , 358
metals, link with money 1 , 21-7 ,
29-30 , 48, 51 , 55-6 , 58, 62
Mexico 25 , 98, 219 , 276 , 303 ,
Miami 264
Michelet, Jules 90
micro-businesses 280
microfinance 13 , 279-8 1
Middle East 135 , 300, 308
sovereign wealth funds 9, 33 7
war in 6, 308
migration 286, 303
Milan 70
millionaires 14 6
Minsky, Hyman 164 , 16 6
MIRA S see Mortgate Interest
Relief At Source
misconduct see fraud
Mishkin, Frederic 34 2
Mississippi 90, 92 , 96. see also
bubbles; Katrina
Mississippi Company (former
Company of the Indies,
Compagnie des Indes)
I41-57* !68 , 171 , 17 4
Mohamad, Mahathir bin 31 4
Moivre, Abraham de 18 9
Moluccas 130-3 1
monarchs see royal funding
monetary policy:
and decline in asset prices 163 ,
167- 8
and domestic objectives 306- 7
and mortgage crisis 266, 338
transformation of 11 6
monetary theory IOO-IOI
criteria for 23-4 , 26, 29-3 0
driving force behind progress
34 2
as god 85
market 54
potential excess of 64
prejudices against 1- 2
as representation of: belief and
trust 29-30 ; commoditized
labour 17 ; relationship
between debtor and creditor
34 1
tokens as 27
as total of specific liabilities
incurred by banks 5 1
see also coins; electronic money;
paper money
hostility to 2 , 33-41 , 63- 4
illegal see loan sharks
vulnerability to defaults 37-8 ,
41,4 8
moneyless societies 17-19 , 63- 4
money supply:
definitions 50-5 1
increasing 26, 28, 14 2
and war 100 , 10 2
'mono-line' financial services
35 3
monopolies 135 , 136 , 140-42 ,
Monopoly (game) 230-3 2
Montagu, Lady Mary Wortley
14 6
Moody' s 268
Moore, Deborah 196 m
moral hazard 25 5
Morgan (J. P.) 326m , 327 , 338 ,
376 , 395
Morgan Stanley 337 , 338m ,
Morocco 297
mortality statistics iSS. see also
life expectancy
Mortgage Interest Relief At
Source (MIRAS ) 25 2
mortgages 8-9 , 232-3 , 235 ,
241-2 , 247-53 , 2-59-61 ,
2-77, 35 3
adjustable-rate (ARMs ) 264,
27 1
discrimination in 248-5 1
and economic downturns 8,
24 2
federal government and 247 ,
260-1 , 264, 27 3
fixed-rate residential 264, 32 3
foreclosures 242 , 269-7 1
in Great Depression/New Deal
247 , 264
history 8-9 , 241-2 , 247-9 ,
259-6 1
indebtedness 61 , 232-3 , 249
'no recourse' 27on.
securitization see securitization
subprime see subprime lending
and US economic triumph 3
Motown 250 , 264
Mullins, David 32 2
mutations (in economies) 349 ,
350 -5 I
mutual associations 247 , 254 . see
also building societies;
Savings & Loan
Nairobi 280
Nanking, Treaty of 29 1
Naples 86
Napoleon Bonaparte 3 , 77-8 ,
80-8 5
Napoleonic Wars 80-86 , 91 , 187 ,
235 , 30 2
National Bank Act 57
national debts 80, 99, 117-1 8
National Health Service see
Britain (welfare state)
nationalization see banks
National Provincial Bank 56
Nationwide house price index 26 1
natural and market selection
350-5I , 357- 8
natural resources see resources
Nazis 80, 86
Neal, Larry 343 m
Nearing, Scott 23 1
negative equity 270-7 1
neo-imperialism 309-1 4
Netherlands, The:
financial and commercial
success 3, 48, 75 , 13 6
Holland (province) 74
pension fund 22 2
property price bubble 23 3
see also United Provinces
network externalities 13 5
Ne w Deal 246-8 , 259
Ne w Orleans 96, 144 , 177-9,
229 , 264. see also Katrina
Ne w York 101 , 166-7 , i86n.
Ne w York Stock Exchange 300
Nicaragua 296
Nicholas II, tsar i07n .
Nigeria 26, 114 , 295
9/1 1 attack 6, 169 , 176 , 223 ,
NINJ A (No Income N o Jo b or
Assets) 269
Nixon, Richard 58, 30 7
Northern Rock 7, 273 , 336 ,
35 3
North Korea 1 8
Norway 292
property prices 23 3
and subprime loans 8, 269
nuclear attacks 223
Nukak-Makoe people 17-1 8
number systems 31- 3
OEC D see Organization for
Economic Cooperation and
off-balance-sheet entities 5, 9-10 ,
272 , 35 5
Office of Federal Housing
Enterprise Oversight 261 ,
27 3
offshore markets 308
oil 26, 308, 317 , 33 2
O'Neill, Jim 283- 4
Open Market Operations 161 ,
16 3
opium 289-9 2
options/option contracts 149 ,
227-8 , 320-22 , 341 . see also
call options; put options
43 0
options pricing see Black-Scholes
Organization for Economic
Cooperation and
Development 233 , 31 2
Oriental influences 3, 32 , 33
Orleans, Duke of (Regent) 139 ,
141 , 144 , 151 , 15 2
OT C contracts see derivatives
Ottoman Empire 303
collapse 303
Jews in 3 6
and Venice 36, 72- 3
see also Turkey
outsiders 16 1
Overend Gurney bank 55 , 56
Overstone, Baron 5 5
'over-the-counter' contracts see
overtrading 12 1
Pacific Investment Management
Company see PIMC O
Pacific islands 13 5
Padua 70
Palmer, J . Horsley 54
Palmerston, Viscount 289-9 0
Panama 309-11
Papacy 42 , 70
paper markets, commercial 27 2
paper money 27-30 , 53 , 55 , 286,
Bank of England monopoly 49,
and hyperinflation 10 7
and First World War 30 1
see also dollar (bills); Law , John
Paris 74
Consensus 31 2
rue Quincampoix 146-7 , 153 ,
Parker Brothers 23 1
parliaments 75 , 76, 23 4
partnerships 44, 12 0
Pascal, Blaise 18 8
Patterson, Lynne 279
Paulson, Henry M. , J r ('Hank') 28
Paulson, John 33 0
pawnshops 60
pecunia 25
Peel, Sir Robert 54
peerage 234 . see also aristocracy
pegs see currency; dollar
Pelham, Sir Henry 75
Peninsular War 8 1
pension funds 337 , 34 1
as investors 116 , 123 , 196 , 218 ,
32 9
pensions (old age):
ageing populations 117 , 219-2 2
Chile 215-1 9
history 146 , 200-202 , 220-2 3
Japan 207 , 208-10 , 221- 2
property purchase and 229
see also bonds and bond
markets; pension funds
Penso de la Vega, Joseph 13 6
pepper 25,13 5
Perkins, John 309-10 , 31 4
Perôn, General Juan Domingo
109-1 0
Persia 26, 3 1
Peru 19-21 , 98, 125 , 171 , 219 ,
275- 7
43 1
Peruzzi family 4 1
petrodollars 308
Philadelphia 19 5
Philippines 275 , 27 6
Phillips, Elizabeth ('Lizzie')
23 0
Phoenix 264
Picart, Bernard 154- 5
pieces of eight 25
PIMC O (Pacific Investment
Management Company) 68,
10 7
Pinera, José 215-16 , 21 9
Pingala 32m
Pinochet, Augusto 213 , 215-1 8
Pisa 32-3,43 , 69, 70
Pius II, Pope 45- 6
Pizarro, Francisco 19-2 1
plagues 182 , 18 4
Poland 10 7
political reform see electoral
politicians 12 , 221 , 222 , 35 7
Pope, Alexander 15 6
Popper, Karl 31 6
population issues 192m , 342 . see
also pensions, ageing
Portinari, Tommaso 46- 7
Portugal 8 1
exploration and East Indies
trade 127-8 , 130 , 13 4
and Jew s 36
'post-American' era 3, 288
Potosi 22-3 , 25 , 27 , 51 , 63
pound sterling 55 , 317-18 . see
also gold standard
poverty and poor countries:
causes of 2, 13 , 64
incomes 2
and international investment
286-7 , 293-4» 307
lack of financial institutions and
credit 13 , 64, 280
loan sharks and 13 , 38-4 1
and microfinance 280-8 1
and property ownership 267-8 ,
274- 7
real estate occupied by 274
see also aid; emerging markets;
incomes; workhouses
pre-modern societies 18 4
Preobrazhensky, Yevgeni 10 7
prestanze and prestiti 71- 2
price controls 338
price-earnings ratios 123-4 ,
16 0
'price revolution' 26, 63
price rises 26, 100 , 235 , 284, 308,
33 8
Princip, Gavrilo 298, 300
private equity partnerships/firms
5,9»336 , 337»35 3
privatization 116 , 171 , 213-14 ,
35 2
probability 188-90 , 198 , 343- 6
Proctor &c Gamble 16 0
productivity 210 , 21 1
promissory notes 27 , 49. see also
paper money
Pro Mujer 278-8 0
property-owning democracies
233 , 241-51 , 266, 274 , 276 ,
43 2
34 1
property/real estate-access to ownership 23on.,
250-51 , 253 , 267-8 , 275-7 ,
34 1
compared with stock market
261- 3
developers 277 , 33 3
English-speaking world's
passion for 4, 6, 230-33 ,
establishing ownership/title
274-6 , 27 7
home ownership: Britain 23on.,
241 , 251-3 ; US A 241-2 ,
249-51 , 265-6 , 270-7 1
illiquidity 273 , 35 7
investment in 123 , 235-6 ,
261-70 , 273-4 , 281- 2
law 274-7 , 294
and political power 234 , 251 ,
276, 28 1
price indexes 261- 3
price rises and downturns 8,
230 , 233 , 253 , 263 , 264-5 ,
270 , 273-4 , 281- 2
regional variations in prices
233n .
unsafe investment bet 229 ,
235-6 , 273-4 , 278, 281- 2
protectionism 159 , 303 . see also
free trade
Prussian government bonds 86,
87, 90
public housing 246-7 , 251- 2
publicly owned firms 35 3
Public Works Administration
246- 7
Puckler-Muskau, Prince 90
Putin, Vladimir 27 6
put options 12 , 169 , 22 7
'quants' 321- 7
Quantum Fund 31 9
Quilmes 274 , 276- 7
race divisions 243-6 , 249-51 ,
252 , 266-8 . see also anti-Semitism; ethnic minorities
Rachman, Peter 25 2
railways 226 , 29 2
Rand Corporation 32 3
random drift 350 , 35 1
randomness 34 2
'random walk' 32 0
Ranieri, Lewis 259
rating agencies 268
raw materials see resources
RC A 16 0
Reagan, Ronald 252 , 254
and capital account
liberalization 31 2
and S&L s 254
welfare reforms 21 9
real estate see property
recessions 103-4 , I 6 3
prospects of 8, 336- 8
recourse 270m, 30 1
recovery, economic 274 , 30 7
red-lining (credit rating) 250 , 25 1
re-emerging markets 288
Rees-Mogg, Lord 16 6
reflation 14 2
reflexivity 316 , 31 9
Reform Bills see electoral reform
43 3
Regulation Q 249, 254
regulation/regulators 54, 249,
*54> *59 , 356~7
and change 356- 7
deregulation 170 , 17 2
Reichsmark, collapse of 101 - 5
religious minorities 2
Renaissance 3
Renaissance (company) 33 0
Renda, Mario 25 5
renminbi 333 , 338
rented accommodation:
private 230 , 242 , 252 , 27 7
public see council housing;
landlords; public housing
rentes!rentiers 73-4 , 76, 99-100 ,
106 , 115 , 14 1
reparations see Germany
reporting, pressures of 35 4
representative governments 26
repression (political) 21 4
Republican Party 17 0
reserve ratio 48- 9
residential mortgage-backed
collateralized debt obligations
(RMB S CDOs ) 27 2
residential mortgage-backed
securities (RMBS ) 26on.,
268, 27 2
Resolution Trust Corporation 258
allocation 34 1
competition for 338-9 , 350-5 1
as 'curses' 26
see also commodity markets
retirement ages 220 . see also
Revlon 16 0
revolutionaries 1
Richelieu, Cardinal 89
Right wing:
and bond markets 89-9 0
and welfare state 202
Riksbank 49
aversion and seeking 345 ,
calculability of 343 , 344- 5
encouraged by state guarantees
35 7
management of 177 , 34 1
optimal distribution 6, 3 5 5
welfare state and 200, 209,
21 1
see also uncertainty; volatility
Risk Management Solutions 18 3
Rivera, Diego 243- 6
RMB S see residential mortgage-backed securities
Robespierre, Maximilien 89
Rockefeller, John D., Jr . 246
Rockefeller Center 246
Rodriga, Daniel 37
Rogers, Jim 288
Rogoff, Kenneth 31 3
Romania 36, 10 1
Romanov empire see Russia
ancient 24-5 , 31- 2
Medici bank in 42 , 45
Roosevelt, Franklin D . 159 , 163 ,
246- 7
Rosario 11 3
Rostow, Walt 307
Rothschild family and firm 78-86 ,
88, 90, 100 , 292
and American Civil War 91 , 93 ,
96- 7
and Argentina 113-14 , 292
Jewishness 82, 87n., 88, 90
myths about 85- 6
political power 82, 87m, 89-9 1
and US 90
Rothschild, 1st Baron (Nathan)
11 4
Rothschild, 3rd Baron 63- 4
Rothschild, 4th Baron 78
Rothschild, Amschel 79, 82
Rothschild, Carl 79, 82
Rothschild, Sir Evelyn de 78
Rothschild, James 79, 82, 93
Rothschild, Lionel de 93
Rothschild, Mayer Amschel 88,
Rothschild, Nathan Mayer 3,
78-8 8
Rothschild, Salomon 79, 82
Rothschild, Salomon de 93
Royal Exchange 300
royal funding 52 , 74, 75 , 138-9 ,
153- 5
Royal Society 18 8
Rueff, Jacques 308
Rumsfeld, Donald 17 6
Bolshevik regime 107 , 303
bonds 86, 90, 297, 302-3 ,
32 6
Communist bloc's impending
doom 308
currency convertibility 300
debt default (1998) 116 , 167 ,
326 , 328
Jews in 86
oil as 'resource curse' 26
property price boom 23 3
Russian/Romanov Empire 298,
unaffected by Great Depression
15 8
and First World War and
aftermath 101 , 107 , 299,
300, 302-3 , 328
see also BRIC s
Ryan, Anthony W. 14 , 348
S&L s see Savings & Loan
S& P see Standard and Poor's
Saint-Simon, Duke of 14 1
Salomon Smith Barney (formerly
Salomon Brothers) 259 , 260,
322 , 32 5
San Diego 264
San Francisco 176 , 19 9
Sanskrit mathematics 3 2n.
Santiago (Chile) 218 , 303
Santo Tornas, Domingo de 23
Sassetti, Francesco 46
Saving, Thomas R . 22 1
against future surprises 229
discouraged by taxes 21 1
gluts 293 , 33 6
international comparisons
333- 5
need for banks 5 6, 64
pre-modern societies 18 4
property purchase as 229
43 5
savings - cont.
see also savings banks
savings banks 56 , 100 , 29 7
and bonds 100 , 29 4
British 56 , 29 4
Savings & Loan (S&L )
associations ('thrifts') 247-9 ,
251 , 253-60 , 322 , 349 , 352 ,
35 4
regulatory environment of 254 ,
258 , 35 6
Savonarola, Girolamo 4 7
Savoy, Victor Amadeus II, Duke
of 13 8
Scholes, Myron 320-23 , 325 , 32 8
Schumpeter, Joseph 348-9 , 357- 8
Schwartz, Anna 161 , 163- 4
science 342 . see also technological
scope issues 346 , 350 , 35 1
Scotland 138 , 185 , 190-98. see
also Glasgow
Scottish Ministers' Widows Fund
Scottish Widows 196 , 198 , 19 9
Scott, Sir Walter 195-7
Scruggs, Richard F. ('Dickie')
180-82 , 19 8
sea levels 22 4
securitas 18 5
new types 74 , 35 3
see also asset-backed securities;
assets; securitization
Securities Act 314 m
Securities and Exchange
Commission 3i6n .
securitization 4, 64 , 259-60 , 34 1
of debt 10 , 17 2
federal government and 260 ,
27 3
perils of 261 , 26 9
private bond insurers and 26 0
segregation 250-5 1
Self, Beanie 26 8
Senegal Company 14 1
Serbia 2 , 298- 9
sexual language 35 1
shadow banking see banks
Shakespeare, William, The
Merchant of Venice 33-4 , 35 ,
37 , 63,90 , 18 5
Shanghai 30 3
shanty towns 27 4
shares (or stocks or equities):
as collateral 13 2
displacement 143-4 , 14 5
features of 120-26 , 12 9
Law' s System and 14 3
shareholders' meetings 12 0
and First World War 30 2
see also options; stock markets
Sharpe, William 32 3
Shaw-Stewart, Patrick 30 2
shells 3 0
Shettleston 38-4 0
Shiller, Robert 28 1
Shining Path 27 6
ships/shipping 127-8 , 135 . see
also marine insurance
short positions 31 6
short selling 13 7
Shylock 33-5 , 37 , 90 , 18 5
sidecars 22 7
43 6
Siena 69
Silicon Valley see
silver 19-26 , 27 , 109 , 14 2
and Mississippi Bubble 149-50 ,
15 2
Spanish and 1 , 19-25 , 52
Simons, James 33 0
Singapore 337 m
SIVs see structured investment
Skilling, Jeffrey K . 169 , 171-3 ,
17 4
and home ownership 267
Rothschilds and 93
slave trading 25
Sloan, Alfred 16 0
Slovenia 2
Smith, Adam 53 , 28 1
and bond markets 89-9 0
and liberalization 31 2
and welfare state 200-202 , 21 3
Socialist Standard 17-1 8
Song Hongbing 86
Soros, George 3I4~i9, 3 2 3 > 3 2 5 >
32 7
income 2, 33 0
on 'market fundamentalism'
33 7
Sourrouille, Juan 11 2
South America 18-26 , 279
gas pipelines 11 9
property law 274- 6
see also Latin America
Southern Rhodesia 295
South Korea 233 , 31 2
South Sea Bubble see bubbles
sovereign wealth funds 9, 337 ,
35 3
Soviet-style economics 21 3
Soviet Union see Russia/USSR
Spain 36 , 127-8 , 292
declining empire 26, 52 , 74 ,
127 , 13 4
and gold and silver 1 , 19-23 ,
25-6 , 5 1
property price boom 10 , 23 3
royal funding 52 , 74 , 75
Spanish Succession, War of the
15 6
special-purpose entitities (SPEs)
172- 3
speciation 53 , 352 , 35 3
speculators 122 , 132 , 226 . see
also futures contracts
Spencer, Herbert 35 1
spices 127 , 130-31 , 13 5
spreads 241 , 32 6
squatters 276-7 , 27 7
squirrel skins 25
Sri Lanka 13 4
stagflation 21 1
Standard and Poor's (S&P) 268
Standard and Poor's 500:
124m , 261-3 , 283 , 33 1
Stanford 32 0
State Farm insurance company
181- 2
state-owned enterprises see
privatization; sovereign
wealth funds
State Savings and Loan 25 5
statistics 188- 9
43 7
sterling see pound sterling
Stevenson, George 60
Stewart, Jimmy 247-8
Stiglitz, Joseph 310-1 3
stockbrokers 153- 4
Stockholm 48- 9
stock markets and exchanges:
benefits of 34 1
bubbles 121-4 , 15 4
Chile 21 8
closure of 300 , 301- 2
compared with bond markets
124- 5
compared with property market
261- 3
crashes 121-2 , 157-66 , 174 ,
32 4
as discipline on companies 12 0
foreign stock exchanges 293
forward/futures markets 132 ,
13 3
fraud 121- 2
history of 3, 6, 74 , 121-4 ,
131-3,332 , 34 1
indices 164- 5
and inflation 12 3
insurance companies and 196- 8
international comparisons 12 5
mechanical selling 16 5
and pensions see pension funds
speculators 12 2
stock exchanges 3, 74, 131-3 ,
300 , 301- 2
and supply of credit 13 2
total capitalization of the
world's 4
volatility and risks 6, 13 ,
120-21 , 125-6 , 136 , 159 ,
167 , 174 , 321 , 324-8 , 344
war and 125 , 136 , 16 9
and First World War 297,
299-30 0
stocks see shares
Stowe House 236-40
Strong, Benjamin 16 1
'structural adjustment' 309
structured investment vehicles
(SIVs) 5,9 , 272,35 5
Styal 94
subprime lending 8-9, 264-74 ,
283,33 6
and black and Latino borrowers
266- 7
responsibility for 266-8 ,
2-73-4, 33 6
sugar 285
Sunbelt 25 5
Sun Insurance Office 18 7
swaps 4, 227 , 32 3
Sweden 48-9 , 125 , 209
Swift, Jonathan 15 7
Swiss National Bank 57
Switzerland 57 , 125 , 14 4
Sword Blade Company 15 7
Syria 2
tail risk 227 , 344
Taiwan 33 9
Tanzania 27 6
protectionist 303
rising 287
bond markets and 68, 99
British 210-11 , 25 2
collection 76, 142 , 14 6
in debtor countries 309
excise 7 2
Florentine 45 , 71 , 7 2
land 23 0
and mortgage payments 25 2
and property law reform 27 5
savings discouraged by 21 1
Taylor, Gene 18 1
Teamsters Union 25 5
technological innovation:
evolutionary 35 0
history of 8, 160 , 285- 6
and inflation 11 6
transferability 287
weaponry 285 , 297
technology companies 12 4
Temasek 337n .
tenants see landlords; rented
Tennessee 59
'term auction facilities' 9
terrorism/terrorist attacks 176 ,
223 , 276
financial consequences 5-6 ,
hedging against 228
Ne w York and London 6, 22 3
nuclear or biological 223
Texas 170 . see also Dallas
textile industry 135 , 287
Thailand 31 2
Thatcher, Margaret 252 , 267,
31 2
'Third World':
loans and aid to 307 , 309
see also emerging markets
'thrifts' see Savings & Loan
Tibet 33 9
tobacco 141 , 147 , 18 0
token coins 5 1
Toler, James 256- 8
tontines 76
Torcy, Marquis of 1 3 8
Torrijos, Omar 3 10-1 1
tourists, currency controls on
trade unions:
Argentina in , 11 6
growth and decline of power
116 , 159 , 21 1
and productivity 21 1
'tranched' debts 4
transatlantic banking 53
treaty ports 291 , 295
'trilemma' 306, 30 7
triple-A rated investment grade
securities 268, 27 1
Trollope, Anthony 23 5
Trustee Savings Banks 294
trust, money and 29-3 0
Ts'ui Pen 11 1
Tugwell, Guy 23 1
tulip bubble 13 6
Tunisia 2
Turkey/Turks 37 , 72 , 101 , 292 .
see also Ottoman Empire
Tversky, Amos 344- 5
UB S (bank) 322 , 33 7
uncertainty 183 , 343-4 . see also
certainty; risk
underwriters 18 7
unemployment 269
and credit 40
in Great Depression 160 , 24 2
and hyperinflation 105- 6
Keynes on 10 6
United Arab Emirates 33711 .
United Kingdom see Britain
United Netherlands East India
Company see VO C
United Provinces:
bond market 7 5
currencies in 48
and East India Company see
and Mississippi Bubble 153- 5
power of 3, 74- 5
rentiers in 75
rivalry between provinces 12 9
see also Netherlands, The
United States of America:
ageing population 219-2 1
'American empire' 309-1 0
banking system 57- 8
British investment in 293
budget deficit 11 8
currency policy 33 8
debt and bankruptcy in 59-6 1
defence industry 31 7
depression see depressions
divisions in society see race
France and see Louisiana
government bonds 32 3
health care and insurance 61 ,
211,219-2 1
home ownership see property/
real estate
and IM F and World Bank
309-1 2
immigration and population
286, 288
imports 10 , 33 4
incomes 1-2 , 61 , 284-5 , 333- 5
industrialization 285
inflation 108 , 211 , 33 5
insurance 19 9
international borrowing 334-5 ,
33 7
overseas aid and investment
305- 7
public ignorance about finance
10-1 2
real estate see property/real
recession prospects 8, 336- 8
savings 333- 5
social divisions see race
stock market 6, 125 , 164-8 ,
261-3,28 3
as subprime superpower 282
use of economic hit men
309-1 1
welfare system 11 , 211 , 219-2 1
and Second World War 205- 6
and First World War 101-2 ,
universities 195 , 329
Uriburu, José F. n o
Uruk 3 1
US Army Corps of Engineers 18 3
USS R see Russia/USSR
US Steel 349
usury 35-6 , 44, 54,7 1
utility companies 16 9
see also energy industry
utility and probability 189-9 0
utopianism 17-18 , 23 0
Value at Risk (VaR) models 325 ,
328 , 355 m
Vatican 42
Veblen, Thorstein 348
Velasco, Carmen 279
Venezuela 26, 99, 12 5
Venice 33-8 , 59, 72-3 , 126 , 13 7
and bonds 72-3 , 9 1
ghetto 34, 36
Medici in 42 , 46
and money-lending 33- 8
and Oriental influences 3 3
San Moise 12 6
Vernon S& L 25 5
Versailles Treaty 102- 3
Vicksburg 92 , 94
Victoria, Queen 238
Vienna 101 , 300
Vietnam War 307m
violence, in absence of money
18-1 9
'virtual' money see electronic
VO C (Dutch/United East India
Company) 128-37 , 153 ,
17 4
shares in 129-30, 131-4 , 13 6
structure 128-9 , 133- 4
alleged death of 6
projected return of 35 6
see also investors; stock markets
Volcker, Paul 166 , 395
Voltaire 145 , 15 0
voting rights see electoral reform
wage cuts 16 0
Wallace, Robert 190-95 , 19 8
Wall Street crash 158-6 3
and capitalist system 297- 8
causing 'bankruptcy of nations'
and commodity markets and
prices 10 , 300 , 33 9
conditions for 304, 339-4 0
finance for 1 , 26, 49, 79 , 140 ,
globalization and 338-4 0
and industrial change 348
and inflation see inflation
and insurance see insurance
and money 1
probabilities 183 , 298, 304,
and trade 13 4
war bonds 101- 2
and welfare state 202-4 ,
205-1 0
see also bonds and bond
War Damage Corporation 206
War Loans 295 , 30 2
Washington, D.C . 306
Washington Consensus 308, 31 2
Washington Mutual 266
Waterloo, Battle of 3, 80, 84
Watkins, Sherron 171-2 , 17 3
wealthy 26, 23 4
44 1
weapons see arms; technological
innovation; war
derivatives 227- 8
extreme 6; see also disasters
and stock markets 15 9
Webster, Alexander 190-95, 19 8
welfare state 199-21 1
backlash against 21 5
dismantling of 21 1
and economy 209-1 1
and war see war
Wellington, Duke of 80-1 , 84
Western Union 31 7
Westminster, Duke of 23 4
wheat prices see grain
widows and orphans 192- 4
William of Orange 75
Williamson, John 308m
Wilson, Harold 23 4
wine market 6, 3 3 2
Winfrey, Oprah 267
Wisselbank see Amsterdam
Exchange Bank
Wizard ofOz, The 24 1
discrimination against 5, 279
as entrepreneurs 278-9 ,
278-80 , 33 3
workers see labour
workhouses 199-203
World Bank (former International
Bank for Reconstruction and
Development and
International Development
Association) 288m, 306
and Argentina 112 , 275
founding of 306
loans and conditions 308-1 0
as US agents 308-1 0
World Trade Center attack 6,
169 , 176 , 223 , 224
World War, First 202-4 ,
296-30 4
aftermath 100-107 , 187 ,
302- 4
as backlash against
globalization 287- 8
decades preceding 296-30 4
and financial markets 158 ,
298-30 3
World War, Second 232 , 305
post-war financial system
305- 7
and social insurance 204
US aid after 306
write-downs 354
writing, first use of 27
Wu Yajun 33 3
yachts 2, 33 2
Yanomamo people 1 8
Ya p islands 30
Yatsuhiro, Nakagawa 208- 9
yen 67
Yin Mingsha 33 3
Yo m Kippur War 31 7
Yudkowsky, Eliezer 347
Yunus, Muhammad 279-8 0
Zimbabwe 10 8
Zoellick, Robert 306, 31 0
Material Sharing
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Additional Material :
Planned Learning Activities and Teaching Methods
Lectures, Practical Courses, Presentation, Seminar, Project, Laboratory Applications (if necessary)
ECTS / Table Of Workload (Number of ECTS credits allocated)
Student workload surveys utilized to determine ECTS credits.
Activity :
Number Duration Total  
Course Duration (Excluding Exam Week) :
13 3 39  
Time Of Studying Out Of Class :
13 6 78  
Homeworks :
13 3 39  
Presentation :
2 6 12  
Project :
2 6 12  
Lab Study :
0 0 0  
Field Study :
2 6 12  
Visas :
1 1 1  
Finals :
1 1 1  
Workload Hour (30) :
Total Work Charge / Hour :
Course's ECTS Credit :
Assessment Methods and Criteria
Studies During Halfterm :
Number Co-Effient
Visa :
1 40
Quiz :
1 10
Homework :
1 10
Attendance :
13 10
Application :
13 10
Lab :
0 0
Project :
0 0
Workshop :
0 0
Seminary :
13 10
Field study :
13 10
The ratio of the term to success :
The ratio of final to success :
Weekly Detailed Course Content
Week Topics  
1 The origin and spread of financial crises
2 The world crisis of the past and the applied economic policies
3 Financial conditions and monetary policy
4 Lender of last resort
5 Policy rules and privacy
6 Managing expectations
7 The difficulty of establishing the basis of policy
8 Regulation
9 Costs of financial crises
10 The future of regulation and financial system
11 Possible long-term economic and political practices
12 Evaluation of the crises in Turkey
13 Evaluation of the crises in the world
14 The current issues and evaluation