THE
ASCENT OF MONEY: A FINANCIAL HISTORY OF THE WORLD
BY
NIALL FERGUSON
6. 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 May 2007
that investors 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 Jim 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 GDP 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 BRICs (Brazil, Russia, India and China, or Big Rapidly
Industrializing 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 undoubtedly
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 industrial 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. Yet 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 1700 and 1950 there was a
‘great divergence’ 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 1820 per capita income in the United States was
roughly twice that of China; by 1870, nearly five times higher; by 1913 nearly
ten times; by 1950 nearly twenty-two times. The average annual growth rate of
per capita GDP in the United States was 1.57 per cent between 1820 and 1950.
The equivalent figure for China was -0.24 per cent.5 In
1973 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 1700s and the 1970s? One argument is that China
missed out on two major macroeconomic 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 Many other
explanations have, needless to say, been offered for the great East-West
divergence: differences in topography, 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 international 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.10 In a world of less
regulated borders, international migration was almost certainly larger relative
to world population; more than 14 per cent of the US population was foreign
born in 1910 compared with less than 12 per cent in 2003.11 Although,
in gross terms, stocks of international capital were larger in relation to
global GDP during the 1990s 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.12 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. Communication 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 manufacturing textiles in China or India ought to have
been a hugely profitable line of business.13 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 1950s 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 New World.14 Before blithely
embracing today’s brave, new and supposedly ‘post-American’ world,15 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 105 years later. The Latin American
debt crisis of the 1980s and the Asian crisis of the 1990s were scarcely
unprecedented events. Financial history suggests that many of today’s emerging
markets would be better called re-emerging markets.az These
days, the ultimate re-emerging market is China. According to Sinophile
investors like Jim Rogers, there is almost no limit to the amount of money to
be made there.16 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 key
problem with overseas investment, then as now, is that it is hard for investors
in London or New York 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 Scotsmen 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 10
March 1839 an imperial official named Lin Zexu 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. 17 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 Secretary, Viscount Palmerston, Jardine seems to have persuaded him
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 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 humiliation. Drug addiction
exploded. Christian missionaries destabilized 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, who 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 1900s 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 1907 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 extraordinary 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.18Nor 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 ‘reduc[ing] to a
minimum the taint of speculation from the act of investment’.19 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 moderate 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’.20
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 governments. 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, 16 per cent to Asia, 13 per cent to Africa and 6
per cent to the rest of Europe.21If you add together all the
British capital raised through public issues of securities between 1865 and
1914, you see that the majority went overseas; less than a third was invested
in the United Kingdom itself.22 By 1913 an estimated
$158 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 1913 nearly half (48 per cent) were foreign
bonds.23 Gross foreign assets in 1913 were equivalent to
around 150 per cent of UK GDP and the annual current account surplus rose as
high as 9 per cent of GDP in 1913 - evidence of what might now be called a
British savings glut. Significantly, a much higher proportion of pre-1914
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 1997 the proportion was just 5 per cent.24
It may be
that British investors were attracted to foreign markets simply by the prospect
of higher returns in capital-poor regions.25 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 1914 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
securities 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.26 The Colonial Loans Act (1899)
and the Colonial Stock Act (1900) also gave colonial bonds the same trustee
status as the benchmark British government perpetual bond, the consol, making
them eligible investments for Trustee Savings Banks.27 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 contracts 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 investors could prefer
‘Nigeria stock (which has no British Government guarantee) [to] . . . London
and North-Eastern Railway debentures’.28 The imposition
of British rule (as in Egypt in 1882) practically amounted to a ‘no default’
guarantee; the only uncertainty 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, political
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 autonomy. And no colony seemed further removed
from gaining its independence than Hong Kong.
Between
1865 and 1914 British investors put at least £74 million into Chinese
securities, a tiny proportion of the total £4 billion that they held abroad by
1914, but a significant sum for impoverished China.29 No
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 Customs, 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. No 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, then in the Boxer Rebellion of 1900 and finally in the
revolution that overthrew the Qing dynasty in 1911 - 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 1941 or, for that matter, the Chinese takeover in 1997 -
investors in Hong Kong saw steep declines in the value of their Chinese bonds
and stocks.30 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 1914 were golden years for international investors - literally.
Communications with foreign markets dramatically improved: by 1911, a
telegraphic message took just thirty seconds to travel from New York to London,
and the cost of sending it was a mere 0.5 per cent of the 1866 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 simplified life for investors, by reducing the risk of large
exchange rate fluctuations.31Governments around the world
also seemed to be improving their fiscal positions as the deflation of the
1870s and 1880s gave way to gentle inflation from the mid 1890s, which reduced
debt burdens in real terms. Higher growth also raised tax revenues.32 Long-term
interest rates nevertheless remained low. Although the yield on the benchmark
British consol rose by over a percentage point between 1897 and 1914, that was
from 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
1870s and 1890s. With the exception of securities issued by improvident Greece
and Nicaragua, none of the sovereign or colonial bonds that were traded in
London in 1913 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, 1880 had enjoyed handsome capital gains.33
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
UK stock market remained fairly flat following the bursting of the 1895-1900
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.34
All these
benign economic trends encouraged optimism. To 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 1898 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 bankruptcy of nations’.35 In
1910, the same year that Carnegie established 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 delicate
interdependence of our credit-built finance’.36 In the
spring of 1914 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 chairman 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. 37
Financial
markets had initially shrugged off the assassination by Gavrilo Princip of the
heir to the Austrian throne, the Archduke Franz Ferdinand, in the Bosnian
capital Sarajevo on 28 June 1914. Not until 22 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.38 By
30 July panic reigned on most financial markets.39 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.40As everyone 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
exchange banknotes for gold coins at the Bank of England.41 The
effective suspension of London’s role as the hub of international credit helped
spread the crisis from Europe to the rest of the world.
Perhaps
the most remarkable feature of the crisis of 1914 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 30 July all the continental European exchanges
had shut their doors. The next day London and New York felt compelled to follow
suit. Although a belated settlement day went ahead smoothly on 18 November, the
London Stock Exchange did not reopen until 4 January 1915. Nothing like this
had happened since its foundation in 1773.42 The New
York market reopened for limited trading (bonds for cash only) on 28 November,
but wholly unrestricted trading did not resume until 1 April 1915.43 Nor
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 17 September.44 It
seems likely that, had the markets not closed, the collapse in prices would
have been as extreme as in 1929, if not worse. No 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.45 Yet the gold
standard was no more rigidly binding than today’s informal 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 necessary. (The Bank of
England was granted suspension of the 1844 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 10s Treasury notes; in the United States, the
emergency currency that banks were authorized to issue under the Aldrich-Vreeland
Act of 1908.46 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 Thursday 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,
19 October and 4 November.) On 13 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 government 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.47 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 governments; 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 happened during the previous
‘world war’ (against revolutionary and then Napoleonic France more than a
century before), the war of 1914 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’.48
The
closure of the stock market and the intervention of the authorities to supply
liquidity almost certainly averted a catastrophic 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.49 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’.50 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 UK War Loans) would have suffered
inflation-adjusted losses of -46 per cent by 1920. Even the real returns on
British equities were negative (-27 per cent).51 Inflation
in France and hyperinflation in Germany inflicted even more severe punishment
on anyone rash enough to maintain large franc or Reichsmark balances. By 1923
holders of all kinds of German securities had lost everything, though
subsequent revaluation legislation restored some of their original capital.
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 1906 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 1930s they were all but worthless.52
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 19
October 1921, for example, the Chinese government declared bankruptcy, and
proceeded to default on nearly all China’s external debts. It was a story
repeated all over the world, from Shanghai to Santiago, from Moscow to Mexico
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 1914 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 diplomacy 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
1930s until the late 1960s, international finance and the idea of globalization
slumbered - some even considered it dead.53 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-facerepresents a widespread disillusionment resulting from
the destructive behaviour of these movements in the interwar years.54
At
Bretton Woods, in New Hampshire’s White Mountains, the soon-to-be-victorious
Allies met in July 1944 to devise a new financial architecture for the post-war
world. In this new order, trade would be progressively liberalized, but
restrictions on capital 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’.55 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 Aidba that helped revive
devastated Western Europe between 1948 and 1952.56 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 IMF was supposed to
regulate exchange rates. What became the World Bank was supposed to help
rebuild countries shattered by the war. Free trade would be revived. But free
capital flows were out.’ Thus, for the next quarter century, did governments
resolve the so-called ‘trilemma’, according to which a country can choose any
two out of three policy options:
1. full
freedom of cross-border capital movements;
2. a
fixed exchange rate;
3. an
independent monetary policy oriented towards domestic objectives.57
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
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 Rostowbb 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. 58 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 negligible 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 Nixon
administration to sever the final link with the gold standard (by ending gold
convertibility of the dollar) sounded the death knell for Bretton Woods in
1971.59When 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.60
With
currencies floating again and offshore markets like the Eurobond market
flourishing, the 1970s 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 1975 and
1982, Latin America quadrupled its borrowings from foreigners from $75 billion
to more than $315 billion. (Eastern European countries also entered the capital
debt market, a sure sign of the Communist bloc’s impending doom.) Then, in
August 1982, Mexico 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. Now the role of financial
policing had to be played by two unarmed bankers, the International 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 administrator a hundred years before.bc Number
one was to impose fiscal 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 outlawed at Bretton Woods, was hot
again.
To some
critics, however, the World Bank and the IMF were no better than agents of the
same old Yankee imperialism. Any loans from the IMF 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 dismiss. 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 IMF 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, 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.61
According
to Perkins’s book, The Confessions of an Economic Hit Man, two
Latin American leaders, Jaime Roldós Aguilera of Ecuador and Omar Torrijos of
Panama, were assassinated in 1981 for opposing what he calls ‘that fraternity
of corporate, government, and banking heads whose goal is global empire’.62 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 1970s
the totals were just $96 million and $197 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 1990 they accounted for, respectively, 0.17
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 IMF 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 1997 and 2000, the IMF in the 1980s 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 IMF has
pushed, in particular premature capital market liberalization, have contributed
to global instability . . . Jobs have 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.’63 In
his animus against the IMF (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 Council. 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).64In London, too, Margaret Thatcher’s government
pressed ahead with unilateral capital account liberalization without any
prompting from the United States. Rather, it was the Reagan administration that
followed Thatcher’s lead.
Stiglitz’s
biggest complaint against the IMF is that it responded the wrong way to the
Asian financial crisis of 1997, lending a total of $95 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.65 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.
Yet 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. In the
acerbic words of an open letter to Stiglitz by Kenneth Rogoff, who became chief
economist at the IMF after the Asian crisis:
Governments typically come to the IMF 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
currency, its citizens will suddenly think it more valuable. You seem to
believe that when investors are no longer willing to hold a government’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 quadrant, but around here we find that when an almost bankrupt
government fails to credibly constrain the time profile of its fiscal deficits,
things generally get worse instead of better.66
Nor is it
clear that Malaysia’s temporary imposition of capital controls in 1997 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 IMF malfeasance). After the shock of 1998 all the economies
affected returned swiftly to rapid growth - growth so rapid, indeed, that by
2004 some commentators were wondering if the ‘two sisters’ of Bretton Woods any
longer had a role to play as international lenders. 67
In truth,
the 1980s 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. To
this new generation, 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 IMF 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,bd 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 the currency crisis that struck the ringgit in August 1997, 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 1956. There he made his reputation as an analyst and then
head of research at the venerable 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
philosopher Karl Popper.69 According to Soros’s pet
theory of ‘reflexivity’, financial markets cannot be regarded as perfectly
efficient, because prices are reflections of the ignorance and biases, often
irrational, of millions of investors. ‘Not only do market participants operate
with a bias’, Soros argues, ‘but their bias can also influence the course of
events. This may create the impression that markets anticipate future
developments accurately, but in fact it is not present expectations that
correspond to future events but future events that are shaped by present
expectations.’70 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
eventually self-defeating boom-bust processes, or bubbles. Every bubble
consists of a trend and a misconception that interact in a reflexive manner .71
Originally
devised to hedge against market risk with short positions,be 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 1969 he was
long real estate. Three years later he backed bank stocks to take off. He was
long Japan in 1971. He was long oil in 1972. A year later, when these bets were
already paying off, he deduced from Israeli complaints about the quality of
US-supplied hardware in the Yom Kippur War that there would need to be some
heavy investment in America’s defence industries. So he went long defence
stocks too.72 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 22 September 1985.73 That
year was an annus mirabilis for Soros, who saw his fund grow
by 122 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 16 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 European Exchange Rate
Mechanism (ERM) in 1990 - untenable. As interest rates rose, the British
economy would tank. Sooner or later, the government would be forced to withdraw
from the ERM and devalue the pound. So sure was Soros that the pound would drop
that he ultimately bet $10 billion, more than the entire capital of his fund,
on a series of transactions whereby he effectively borrowed sterling in the UK
and invested in German currency at the pre-16 September price of around 2.95
Deutschmarks). 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 and to pocket the difference. And that trade accounted for
just 40 per cent of the year’s profits.75
The
success of the Quantum Fund was staggering. If someone had invested $100,000
with Soros when he established his second fund (Double Eagle, the earlier name
of Quantum) in 1969 and had reinvested all the dividends, he would have been
worth $130 million by 1994, an average annual growth rate of 35 per cent .76 The
essential differences between the old and the new economic 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. ‘How big a position
do you have?’ Soros once asked his partner Stanley Druckenmiller. ‘One billion
dollars,’ Druckenmiller replied. ‘You call that a position?’ was Soros’s
sardonic retort. 77 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.
SHORT-TERM
CAPITAL MISMANAGEMENT
Imagine
another planet - a planet without all the complicating frictions caused by
subjective, sometimes irrational human beings. One where the inhabitants were
omniscient and perfectly rational; where they instantly absorbed all new
information and used it to maximize profits; where they never stopped trading;
where markets were continuous, frictionless and completely liquid. Financial
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 available. 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.78 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 1993
two mathematical geniuses came to Greenwich with a big idea. Working closely
with Fisher Black of Goldman Sachs, Stanford’s Myron Scholes had developed a
revolutionary new theory of pricing options. Now 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 financial instrument known as an
option contract, which (as we saw in Chapter 4) works like this. If a
particular stock is worth, say, $100 today and I believe that it may be worth
more in the future, 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 (σ - the Greek letter sigma). With wonderful mathematical
wizardry, Black and Scholes reduced the price of the option (C) to this
formula:
where
Feeling a
bit baffled? Can’t follow the algebra? To be honest, I am baffled too. But that
was just fine by the quants. To make 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 1994 was 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 professor, Eric Rosenfeld, and a bevy of ex-Salomon
traders (Victor Haghani, Larry Hilibrand and Hans Hufschmid). The investors
LTCM attracted to its fund were mainly big banks, among them the New York
investment bank Merrill Lynch and the Swiss private bank Julius Baer. A
latecomer to the party was another Swiss bank, UBS.79 The
minimum investment was $10 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).80 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 LTCM made mega-bucks, posting returns
(even after its hefty fees) of 43 and 41 per cent. If you had invested $10
million in Long-Term in March 1994, it would have been worth just over $40
million four years later. By September 1997 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 1997 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 19 to 1.81 By April 1998 the balance sheet had
reached $134 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. Not 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 multiple,
uncorrelated trading strategies: around a hundred of them, with a total of
7,600 different positions.82 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 economist at the Rand Corporation, in the early 1950s, and
further developed in William Sharpe’s Capital Asset Pricing Model (CAPM).83
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 swapsbf -
anywhere, in 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
exercise if there were big future stock price movements. The prices these
options were fetching in 1998 implied, according to the Black-Scholes formula,
an abnormally high future volatility of around 22 per cent per year. In the
belief that volatility would actually move towards its recent average of 10-13
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.84 At peak, they had $40 million riding on
each percentage point change in US equity volatility.85
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 10 per cent).86 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 1024 - effectively zero.87
In
October 1997, as if to prove that LTCM really was the ultimate Brains Trust,
Merton and Scholes were awarded the Nobel Prize in economics. So self-confident
were they and their partners that on 31 December 1997 they returned $2.7
billion to outside investors (strongly implying that they would much rather
focus on investing their own money).88 It seemed as if
intellect had triumphed over intuition, rocket science over risk-taking.
Equipped with their magic black box, the partners at LTCM 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. May 1998 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 31 to 1.89
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 LTCM’s trading strategies. Clearly,
the firm’s new owners did not like the losses they had been seeing since May.
Then, on Monday 17 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 revenues 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.90 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.bg 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.91 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 $45
million in a single day.92On Friday 21 August 1998, it lost
$550 million - 15 per cent of its entire capital, driving its leverage up to
42:1.93 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 diversification. 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.94
August is
usually a time of thin trading in financial markets. Most people are out of
town. John Meriwether was on the other 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 LTCM 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.95 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 $500 million if he could find another $500 million from
someone else. It didn’t seem likely . . .’ JP Morgan offered $200 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 New
York hastily brokered a $3.625 billion bail-out by fourteen Wall Street banks.96 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 $30 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 continuous, frictionless and
completely liquid; and returns on stocks follow the normal, bell-curve
distribution. Arguably, the more traders learned to employ the Black-Scholes
formula, the more efficient financial markets would become.97 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 LTCM
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. ‘Maybe 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.’98 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.99 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 LTCM 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
1987 stock market crash. If they had gone back eighty years they would have
captured the last great Russian default, after the 1917 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.’100 To
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 Mismanagement.
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 1989 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.101 Yet 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 $39 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 7,601 funds with $1.9 trillion in assets. Since 1998 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.102 This
trend is all the more striking given that the attrition rate remains high; only
a quarter of the 600 funds reporting in 1996 still existed at the end of 2004.
In 2006, 717 ceased to trade; in the first nine months of 2007, 409.103 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 investment vehicles. But the returns on hedge funds,
according to Hedge Fund Research, have been falling, from 18 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).104 An
alternative explanation is that, while they exist, hedge funds enrich their
managers in a uniquely alluring way. In 2007 George Soros made $2.9 billion,
ahead of Ken Griffin of Citadel and James Simons of Renaissance, but behind
John Paulson, who earned a staggering $3.7 billion from his bets against
subprime mortgages. As John Kay has pointed out, if Warren Buffett had charged investors
in Berkshire Hathaway ‘2 and 20’, he would have kept for himself $57 billion of
the $62 billion his company has made for its shareholders over the past
forty-two years.105Soros, 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 $324 billion.106 But
a quite mediocre conman could make a good deal of money by setting up a hedge
fund, taking $100 million off gullible investors and running the simplest
possible strategy:
1. He
parks the $100 million in one-year Treasury bills yielding 4 per cent.
2. This
then allows him to sell for 10 cents on the dollar 100 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 $10 million from the sale of the options and buys some more Treasury bills,
which enables him to sell another 10 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 - $11 million from the sale of the options plus 4 per cent
on the $110 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 $15 million even if no new money comes into his fund, and
even without leveraging his positions.107
Could an
LTCM-style 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?bh 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.
CHIMERICA
To many,
financial history is just so much water under the bridge - ancient history,
like the history of imperial China. Markets have short memories. Many 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.108
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. Yet the province’s 32 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 Chongqing’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 Revolution, Mr Yin discovered his true
vocation in the early 1990s, after the liberalization of the Chinese economy.
In just fifteen years he has built up a $900 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 345,000 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 economic 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
development, 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 households 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 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 $262 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 America.
At first
sight, it may seem bizarre. Today the average American earns more than $34,000
a year. Despite the wealth of people like Wu Yajun and Yin 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. To
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.109 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.
Moreover, 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 of China, the United States has been
able to enjoy significantly lower interest rates than would otherwise have been
the case.
Net
national savings as a percentage of gross national income, 1970-2006
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 derivative 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 it110 - was the underlying reason why the US
mortgage market was so awash with cash in 2006 that you could get a 100 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.
Not 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 1866 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 May 2008, a US recession
seemed already to have begun. But the end of the world?
True, it
seemed unlikely in May 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.111 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-1998 reorientation of
global finance. Even more important was the growth of sovereign wealth funds,
entities created by countries running large trade surpluses to manage their
accumulating wealth. By the end of 2007 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 $27 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, UBS 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.bi
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.bj 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 $62 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 US 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. Yet 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
$150 billion to the banking system, the underwriting of JP Morgan’s acquisition
of Bear Stearns - has amounted to an American version of currency manipulation.112 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 price controls and export prohibitions and
encouraging an extraordinary scramble for natural resources in Africa and
elsewhere that, to Western eyes, has an unnervingly imperial undertone.113 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.114 Could
anything trigger another breakdown of globalization like the one that happened
in 1914? The obvious answer is a deterioration of political relations between
the United States and China, whether over trade, Taiwan, Tibet or some other as
yet subliminal issue.115 The scenario may seem
implausible. Yet it is easy to see how future historians could retrospectively
construct plausible chains of causation to explain such a turn of events. The
advocates 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
conflagration 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 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
executives, fund managers and traders. The average career of a Wall Street CEO
is just over twenty-five years,116 which means that
first-hand memories at the top of the US banking system do not extend back
beyond 1983 - 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.
NOTES
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
Purushothaman and Anna Stupnytska, ‘How Solid are the BRICs?’, Goldman
Sachs Global Economics Paper, 134 (1 December 2005).
2 Dominic Wilson
and Anna Stupnytska, ‘The N-11: More than an Acronym’, Goldman Sachs Global
Economics Paper, 153 (28 March 2007).
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 Economy: 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.
7 Among the most
important recent works on the subject are Eric Jones, The European
Miracle: Environments, Economies and Geopolitics 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’, NBER Working Paper 10352
(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).
10 Nicholas Crafts,
‘Globalisation and Growth in the Twentieth Century’, International Monetary
Fund Working Paper, 00/44 (March 2000). See also Richard E. Baldwin and
Philippe Martin, ‘Two Waves of Globalization: Superficial Similarities,
Fundamental Differences’, NBER Working Paper 6904 (January 1999).
11 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.
12 Maurice Obstfeld
and Alan M. Taylor, ‘Globalization and Capital Markets’, in Michael D. Bordo,
Alan M. Taylor and Jeffrey G. Williamson (eds.), Globalization in
Historical Perspective (Chicago, 2003), pp. 173f.
13 Clark, Farewell,
chs. 13, 14.
14 David M. Rowe,
‘The Tragedy of Liberalism: How Globalization Caused the First World
War’, Security Studies, 14, 3 (Spring 2005), pp. 1-41.
15 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).
16 Jim Rogers, A
Bull in China: Investing Profitably in the World’s Greatest Market(New York,
2007).
17 Robert
Blake, Jardine Matheson: Traders of the Far East (London,
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 / New York, 2006).
18 Rothschild
Archive London, RFamFD/13A/I; 13B/1; 13C/I; 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 Peace (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 Advantage’, in Donald Moggridge
(ed.), The Collected Writings of John Maynard Keynes, vol. XIX
(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 1870 and 1940
at http://icf.som.yale.edu/sse/.
31 Michael Bordo and
Hugh Rockoff, ‘The Gold Standard as a “Good Housekeeping Seal of Approval”
’, Journal of Economic History, 56, 2 (June 1996), pp. 389-428.
32 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 1848 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 1914 in the United States’, American 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, 1914-1925 (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. 80ff.
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. III: Illusions of Gold,
1914-1945(London, 1999), p. 5.
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 History , 42 (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 Rawi
Abdelal, Capital Rules: The Construction of Global Finance (Cambridge,
MA / 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, MA., 2002).
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 International 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: http://www.democracynow.org/ article.pl?sid=04/11/09/1526251.
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.
64 Abdelal, Capital
Rules, pp. 50f., 57-75.
65 Paul
Krugman, The Return of Depression Economics (London, 1999).
66 ‘The Fund Bites
Back’, The Economist, 4 July 2002.
67 Kenneth Rogoff,
‘The Sisters at 60’, The Economist, 22 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, Bleichröder and the
Building of the German Empire (Harmondsworth, 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. 48f.
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,
107ff.
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)’, Harvard 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. 11f., 17.
87 Lowenstein, When
Genius Failed, p. 127.
88 André F. Perold,
‘Long-Term Capital Management, L.P. (B)’, Harvard Business School Case 9-200-08
(27 October 1999), p. 1.
89 Lowenstein, When
Genius Failed, pp. 133-8.
90 Ibid., p. 144.
91 I 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)’, Harvard Business School Case 9-200-09
(5 November 1999), pp. 1, 3.
94 Idem,
‘Long-Term Capital Management, L.P. (D)’, Harvard Business School Case 9-200-10
(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: How 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 Sociology 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. 192f. See also Stephen
J. Brown, William N. Goetzmann and Roger G. Ibbotson, ‘Offshore Hedge Funds:
Survival and Performance, 1989-95’, Journal of Business, 72,
1(January 1999), 91-117.
102 Harry Markowitz,
‘New 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, 11
March 2008.
106 Stephanie Baum,
‘Top 100 Hedge Funds have 75% of Industry Assets’, Financial News,
21 May 2008.
107 Dean P. Foster
and H. Peyton Young, ‘Hedge Fund Wizards’, Economists’ Voice(February
2008), p. 2.
108 Niall 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’, NBER Working Paper 9971 (September 2003).
110 Ben Bernanke,
‘The Global Saving Glut and the U.S. Current Account Deficit’, Homer Jones
Lecture, St Louis, Missouri (15 April 2005).
111 ‘From Mao to the
Mall’, The Economist, 16 February 2008.
112 For a critique of
recent Federal Reserve policy, see Paul A. Volcker, ‘Remarks at a Luncheon of
the Economic Club of New 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 May 2008.
114 In the absence of
the First World War, it may be conjectured, Germany 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 executive officers of
Citigroup, Goldman Sachs, Merrill Lynch, Morgan Stanley and JP Morgan is just
under twenty-five and a half years.
