THE
ASCENT OF MONEY: A FINANCIAL HISTORY OF THE WORLD
BY
NIALL FERGUSON
AFTERWORD:
THE DESCENT OF MONEY
Today’s
financial world is the result of four millennia of economic evolution. Money -
the crystallized relationship between debtor and creditor - begat banks,
clearing houses for ever larger aggregations of borrowing and lending. From the
thirteenth century onwards, government bonds introduced the securitization of
streams of interest payments; while bond markets revealed the benefits of
regulated public markets for trading and pricing securities. From the
seventeenth century, equity in corporations could be bought and sold in similar
ways. From the eighteenth century, insurance funds and then pension funds
exploited economies of scale and the laws of averages to provide financial
protection against calculable risk. From the nineteenth, futures and options
offered more specialized and sophisticated instruments: the first derivatives.
And, from the twentieth, households were encouraged, for political reasons, to
increase leverage and skew their portfolios in favour of real estate.
Economies
that combined all these institutional innovations - banks, bond markets, stock
markets, insurance and property-owning democracy - performed better over the
long run than those that did not, because financial intermediation generally
permits a more efficient allocation of resources than, say, feudalism or
central planning. For this reason, it is not wholly surprising that the Western
financial model tended to spread around the world, first in the guise of
imperialism, then in the guise of globalization.1 From
ancient Mesopotamia to present-day China, in short, the ascent of money has
been one of the driving forces behind human progress: a complex process of
innovation, intermediation and integration that has been as vital as the
advance of science or the spread of law in mankind’s escape from the drudgery
of subsistence agriculture and the misery of the Malthusian trap. In the words
of former Federal Reserve Governor Frederic Mishkin, ‘the financial system [is]
the brain of the economy . . . It acts as a coordinating mechanism that
allocates capital, the lifeblood of economic activity, to its most productive
uses by businesses and households. If capital goes to the wrong uses or does
not flow at all, the economy will operate inefficiently, and ultimately
economic growth will be low.’2
Yet
money’s ascent has not been, and can never be, a smooth one. On the contrary,
financial history is a roller-coaster ride of ups and downs, bubbles and busts,
manias and panics, shocks and crashes.3 One recent study
of the available data for gross domestic product and consumption since 1870 has
identified 148 crises in which a country experienced a cumulative decline in
GDP of at least 10 per cent and eighty-seven crises in which consumption suffered
a fall of comparable magnitude, implying a probability of financial disaster of
around 3.6 per cent per year.4 Even today, despite the
unprecedented sophistication of our institutions and instruments, Planet
Finance remains as vulnerable as ever to crises. It seems that, for all our
ingenuity, we are doomed to be ‘fooled by randomness’5 and
surprised by ‘black swans’.6 It may even be that we are
living through the deflation of a multi-decade ‘super bubble’.7
There are
three fundamental reasons for this. The first is that so much about the future
- or, rather, futures, since there is never a singular future - lies in the
realm of uncertainty, as opposed to calculable risk. As Frank Knight argued in
1921, ‘Uncertainty must be taken in a sense radically distinct from the
familiar notion of Risk, from which it has never been properly separated . . .
A measurable uncertainty, or “risk” proper . . . is so far
different from an unmeasurable one that it is not in effect an
uncertainty at all.’ To put it simply, much of what happens in life isn’t like
a game of dice. Again and again an event will occur that is ‘so entirely unique
that there are no others or not a sufficient number to make it possible to
tabulate enough like it to form a basis for any inference of value about any
real probability . . .’8 The same point was brilliantly
expressed by Keynes in 1937. ‘By “uncertain” knowledge,’ he wrote in a response
to critics of his General Theory,
. . . I
do not mean merely to distinguish what is known for certain from what is only
probable. The game of roulette is not subject, in this sense, to uncertainty .
. . The expectation of life is only slightly uncertain. Even the weather is
only moderately uncertain. The sense in which I am using the term is that in
which the prospect of a European war is uncertain, or . . . the rate of
interest twenty years hence . . . About these matters there is no scientific
basis on which to form any calculable probability whatever. We simply do not
know.bk
Keynes
went on to hypothesize about the ways in which investors ‘manage in such
circumstances to behave in a manner which saves our faces as rational, economic
men’:
(1) We
assume that the present is a much more serviceable guide to the future than a
candid examination of past experience would show it to have been hitherto. In
other words we largely ignore the prospect of future changes about the actual
character of which we know nothing.
(2) We
assume that the existing state of opinion as expressed in
prices and the character of existing output is based on a correct summing
up of future prospects . . .
(3)
Knowing that our own individual judgment is worthless, we endeavor to fall back
on the judgment of the rest of the world which is perhaps better informed. That
is, we endeavor to conform with the behavior of the majority or the average.9
Though it
is far from clear that Keynes was correct in his interpretation of investors’
behaviour, he was certainly thinking along the right lines. For there is no
question that the heuristic biases of individuals play a critical role in
generating volatility in financial markets.
This
brings us to the second reason for the inherent instability of the financial
system: human behaviour. As we have seen, all financial institutions are at the
mercy of our innate inclination to veer from euphoria to despondency; our
recurrent inability to protect ourselves against ‘tail risk’; our perennial
failure to learn from history. In a famous article, Daniel Kahneman and Amos
Tversky demonstrated with a series of experiments the tendency that people have
to miscalculate probabilities when confronted with simple financial choices.
First, they gave their sample group 1,000 Israeli pounds each. Then they
offered them a choice between either a) a 50 per cent chance of winning an
additional 1,000 pounds or b) a 100 per cent chance of winning an additional
500 pounds. Only 16 per cent of people chose a); everyone else (84 per cent)
chose b). Next, they asked the same group to imagine having received 2,000
Israeli pounds each and confronted them with another choice: between either c)
a 50 per cent chance of losing 1,000 pounds or b) a 100 per cent chance of
losing 500 pounds. This time the majority (69 per cent) chose a); only 31 per
cent chose b). Yet, viewed in terms of their payoffs, the two problems are
identical. In both cases you have a choice between a 50 per cent chance of
ending up with 1,000 pounds and an equal chance of ending up with 2,000 pounds
(a and c) or a certainty of ending up with 1,500 pounds (b and d). In this and
other experiments, Kahneman and Tversky identify a striking asymmetry: risk
aversion for positive prospects, but risk seeking for negative ones. A loss has
about two and a half times the impact of a gain of the same magnitude.10
This
‘failure of invariance’ is only one of many heuristic biases (skewed modes of
thinking or learning) that distinguish real human beings from the homo
oeconomicusof neoclassical economic theory, who is supposed to make his
decisions rationally, on the basis of all the available information and his
expected utility. Other experiments show that we also succumb too readily to
such cognitive traps as:
1. Availability
bias, which causes us to base decisions on information that is more readily
available in our memories, rather than the data we really need;
2. Hindsight
bias, which causes us to attach higher probabilities to events after they
have happened (ex post) than we did before they happened (ex ante);
3. The
problem of induction, which leads us to formulate general rules on the
basis of insufficient information;
4. The
fallacy of conjunction (or disjunction), which means we tend to
overestimate the probability that seven events of 90 per cent probability
will all occur, while underestimating the probability
that at least one of seven events of 10 per cent probability
will occur;
5. Confirmation
bias, which inclines us to look for confirming evidence of an initial
hypothesis, rather than falsifying evidence that would disprove it;
6. Contamination
effects, whereby we allow irrelevant but proximate information to influence
a decision;
7. The
affect heuristic, whereby preconceived value-judgements interfere with our
assessment of costs and benefits;
8. Scope
neglect, which prevents us from proportionately adjusting what we should be
willing to sacrifice to avoid harms of different orders of magnitude;
9. Overconfidence
in calibration, which leads us to underestimate the confidence intervals
within which our estimates will be robust (e.g. to conflate the ‘best case’
scenario with the ‘most probable’); and
10. Bystander
apathy, which inclines us to abdicate individual responsibility when in a
crowd.11
If you
still doubt the hard-wired fallibility of human beings, ask yourself the
following question. A bat and ball, together, cost a total of £1.10 and the bat
costs £1 more than the ball. How much is the ball? The wrong answer is the one
that roughly one in every two people blurts out: 10 pence. The correct answer
is 5 pence, since only with a bat worth £1.05 and a ball worth 5 pence are both
conditions satisfied.12
If any
field has the potential to revolutionize our understanding of the way financial
markets work, it must surely be the burgeoning discipline of behavioural
finance.13 It is far from clear how much of the body of
work derived from the efficient markets hypothesis can survive this challenge.14Those
who put their faith in the ‘wisdom of crowds’15 mean no
more than that a large group of people is more likely to make a correct
assessment than a small group of supposed experts. But that is not saying much.
The old joke that ‘Macroeconomists have successfully predicted nine of the last
five recessions’ is not so much a joke as a dispiriting truth about the
difficulty of economic forecasting.16 Meanwhile, serious
students of human psychology will expect as much madness as wisdom from large
groups of people.17 A case in point must be the
near-universal delusion among investors in the first half of 2007 that a major
liquidity crisis could not occur (see Introduction). To adapt an elegant
summation by Eliezer Yudkowsky:
People
may be overconfident and over-optimistic. They may focus on overly specific
scenarios for the future, to the exclusion of all others. They may not recall
any past [liquidity crises] in memory. They may overestimate the predictability
of the past, and hence underestimate the surprise of the future. They may not
realize the difficulty of preparing for [liquidity crises] without the benefit
of hindsight. They may prefer . . . gambles with higher payoff probabilities,
neglecting the value of the stakes. They may conflate positive information
about the benefits of a technology [e.g. bond insurance] and negative
information about its risks. They may be contaminated by movies where the
[financial system] ends up being saved . . . Or the extremely unpleasant
prospect of [a liquidity crisis] may spur them to seek arguments that
[liquidity] will not [dry up], without an equally frantic
search for reasons why [it should]. But if the question is, specifically, ‘Why
aren’t more people doing something about it?’, one possible component is that
people are asking that very question - darting their eyes around to see if
anyone else is reacting . . . meanwhile trying to appear poised and
unflustered.18
Most of
our cognitive warping is, of course, the result of evolution. The third reason
for the erratic path of financial history is also related to the theory of
evolution, though by analogy. It is commonly said that finance has a Darwinian
quality. ‘The survival of the fittest’ is a phrase that aggressive traders like
to use; as we have seen, investment banks like to hold conferences with titles
like ‘The Evolution of Excellence’. But the American crisis of 2007 has
increased the frequency of such language. US Assistant Secretary of the Treasury
Anthony W. Ryan was not the only person to talk in terms of a wave of financial
extinctions in the second half of 2007. Andrew Lo, director of the
Massachusetts Institute of Technology’s Laboratory for Financial Engineering,
is in the vanguard of an effort to re-conceptualize markets as adaptive
systems.19 A long-run historical analysis of the
development of financial services also suggests that evolutionary forces are
present in the financial world as much as they are in the natural world.20
The notion
that Darwinian processes may be at work in the economy is not new, of course.
Evolutionary economics is in fact a well-established sub-discipline, which has
had its own dedicated journal for the past sixteen years.21 Thorstein
Veblen first posed the question ‘Why is Economics Not an Evolutionary Science?’
(implying that it really should be) as long ago as 1898.22 In
a famous passage in his Capitalism, Socialism and Democracy, which
could equally well apply to finance, Joseph Schumpeter characterized industrial
capitalism as ‘an evolutionary process’:
This
evolutionary character . . . is not merely due to the fact that economic life
goes on in a social and natural environment which changes and by its change
alters the data of economic action; this fact is important and these changes
(wars, revolutions and so on) often condition industrial change, but they are
not its prime movers. Nor is this evolutionary character due to quasi-autonomic
increase in population and capital or to the vagaries of monetary systems of
which exactly the same thing holds true. The fundamental impulse that sets and
keeps the capitalist engine in motion comes from the new consumers’ goods, the
new methods of production or transportation, the new markets, the new forms of
industrial organization that capitalist enterprise creates . . . The opening up
of new markets, foreign or domestic, and the organizational development from
the craft shop and factory to such concerns as US Steel illustrate the same
process of industrial mutation - if I may use the biological term - that
incessantly revolutionizes the economic structure from within,
incessantly destroying the old one, incessantly creating a new one. This
process of Creative Destruction is the essential fact about capitalism.23
A key
point that emerges from recent research is just how much destruction goes on in
a modern economy. Around one in ten US companies disappears each year. Between
1989 and 1997, to be precise, an average of 611,000 businesses a year vanished
out of a total of 5.73 million firms. Ten per cent is the average extinction
rate, it should be noted; in some sectors of the economy it can rise as high as
20 per cent in a bad year (as in the District of Columbia’s financial sector in
1989, at the height of the Savings and Loans crisis).24 According
to the UK Department of Trade and Industry, 30 per cent of tax-registered
businesses disappear after three years.25Even if they survive
the first few years of existence and go on to enjoy great success, most firms
fail eventually. Of the world’s 100 largest companies in 1912, 29 were bankrupt
by 1995, 48 had disappeared, and only 19 were still in the top 100.26Given
that a good deal of what banks and stock markets do is to provide finance to
companies, we should not be surprised to find a similar pattern of creative
destruction in the financial world. We have already noted the high attrition
rate among hedge funds. (The only reason that more banks do not fail, as we
shall see, is that they are explicitly and implicitly protected from collapse
by governments.)
What are
the common features shared by the financial world and a true evolutionary
system? Six spring to mind:
•
‘Genes’, in the sense that certain business practices perform the same role as
genes in biology, allowing information to be stored in the ‘organizational
memory’ and passed on from individual to individual or from firm to firm when a
new firm is created.
• The
potential for spontaneous mutation, usually referred to in the economic world
as innovation and primarily, though by no means always, technological.
•
Competition between individuals within a species for resources, with the
outcomes in terms of longevity and proliferation determining which business
practices persist.
• A
mechanism for natural selection through the market allocation of capital and
human resources and the possibility of death in cases of under-performance,
i.e. ‘differential survival’.
• Scope
for speciation, sustaining biodiversity through the creation of wholly new
species of financial institutions.
• Scope
for extinction, with species dying out altogether.
Financial
history is essentially the result of institutional mutation and natural
selection. Random ‘drift’ (innovations/ mutations that are not promoted by
natural selection, but just happen) and ‘flow’ (innovations/mutations that are
caused when, say, American practices are adopted by Chinese banks) play a part.
There can also be ‘co-evolution’, when different financial species work and
adapt together (like hedge funds and their prime brokers). But market selection
is the main driver. Financial organisms are in competition with one another for
finite resources. At certain times and in certain places, certain species may
become dominant. But innovations by competitor species, or the emergence of
altogether new species, prevent any permanent hierarchy or monoculture from
emerging. Broadly speaking, the law of the survival of the fittest applies.
Institutions with a ‘selfish gene’ that is good at self-replication and
self-perpetuation will tend to proliferate and endure.27
Note that
this may not result in the evolution of the perfect organism. A ‘good enough’
mutation will achieve dominance if it happens in the right place at the right
time, because of the sensitivity of the evolutionary process to initial
conditions; that is, an initial slim advantage may translate into a prolonged
period of dominance, without necessarily being optimal. It is also worth
bearing in mind that in the natural world, evolution is not progressive, as
used to be thought (notably by the followers of Herbert Spencer). Primitive
financial life-forms like loan sharks are not condemned to oblivion, any more
than the microscopic prokaryotes that still account for the majority of earth’s
species. Evolved complexity protects neither an organism nor a firm against
extinction - the fate of most animal and plant species.
The
evolutionary analogy is, admittedly, imperfect. When one organism ingests
another in the natural world, it is just eating; whereas, in the world of
financial services, mergers and acquisitions can lead directly to mutation.
Among financial organisms, there is no counterpart to the role of sexual
reproduction in the animal world (though demotic sexual language is often used
to describe certain kinds of financial transaction). Most financial mutation is
deliberate, conscious innovation, rather than random change. Indeed, because a
firm can adapt within its own lifetime to change going on around it, financial
evolution (like cultural evolution) may be more Lamarckian than Darwinian in
character. Two other key differences will be discussed below. Nevertheless,
evolution certainly offers a better model for understanding financial change
than any other we have.
Ninety
years ago, the German socialist Rudolf Hilferding predicted an inexorable
movement towards more concentration of ownership in what he termed finance
capital.28 The conventional view of financial
development does indeed see the process from the vantage point of the big,
successful survivor firm. In Citigroup’s official family tree, numerous small
firms - dating back to the City Bank of New York, founded in 1812 - are seen to
converge over time on a common trunk, the present-day conglomerate. However,
this is precisely the wrong way to think about financial evolution over the
long run, which begins at a common trunk. Periodically, the
trunk branches outwards as new kinds of bank and other financial institution
evolve. The fact that a particular firm successfully devours smaller firms
along the way is more or less irrelevant. In the evolutionary process, animals
eat one another, but that is not the driving force behind evolutionary mutation
and the emergence of new species and sub-species. The point is that economies
of scale and scope are not always the driving force in financial history. More
often, the real drivers are the process of speciation - whereby entirely new
types of firm are created - and the equally recurrent process of creative
destruction, whereby weaker firms die out.
Take the
case of retail and commercial banking, where there remains considerable
biodiversity. Although giants like Citigroup and Bank of America exist, North
America and some European markets still have relatively fragmented retail
banking sectors. The cooperative banking sector has seen the most change in
recent years, with high levels of consolidation (especially following the
Savings and Loans crisis of the 1980s), and most institutions moving to
shareholder ownership. But the only species that is now close to extinction in the
developed world is the state-owned bank, as privatization has swept the world
(though the nationalization of Northern Rock suggests the species could make a
come-back). In other respects, the story is one of speciation, the
proliferation of new types of financial institution, which is just what we
would expect in a truly evolutionary system. Many new ‘mono-line’ financial
services firms have emerged, especially in consumer finance (for example,
Capital One). A number of new ‘boutiques’ now exist to cater to the private
banking market. Direct banking (telephone and Internet) is another relatively
recent and growing phenomenon. Likewise, even as giants have formed in the
realm of investment banking, new and nimbler species such as hedge funds and
private equity partnerships have evolved and proliferated. And, as we saw in
Chapter 6, the rapidly accruing hard currency reserves of exporters of
manufactured goods and energy are producing a new generation of sovereign
wealth funds.
Not only
are new forms of financial firm proliferating; so too are new forms of
financial asset and service. In recent years, investors’ appetite has grown
dramatically for mortgage-backed and other asset-backed securities. The use of
derivatives has also increased enormously, with the majority being bought and
sold ‘over the counter’, on a one-to-one bespoke basis, rather than through
public exchanges - a tendency which, though profitable for the sellers of
derivatives, may have unpleasant as well as unintended consequences because of
the lack of standardization of these instruments and the potential for legal
disputes in the event of a crisis.
In
evolutionary terms, then, the financial services sector appears to have passed
through a twenty-year Cambrian explosion, with existing species flourishing and
new species increasing in number. As in the natural world, the existence of
giants has not precluded the evolution and continued existence of smaller
species. Size isn’t everything, in finance as in nature. Indeed, the very
difficulties that arise as publicly owned firms become larger and more complex
- the diseconomies of scale associated with bureaucracy, the pressures
associated with quarterly reporting - give opportunities to new forms of
private firm. What matters in evolution is not your size or (beyond a certain
level) your complexity. All that matters is that you are good at surviving and
reproducing your genes. The financial equivalent is being good at generating
returns on equity and generating imitators employing a similar business model.
In the
financial world, mutation and speciation have usually been evolved responses to
the environment and competition, with natural selection determining which new
traits become widely disseminated. Sometimes, as in the natural world, the
evolutionary process has been subject to big disruptions in the form of
geopolitical shocks and financial crises. The difference is, of course, that
whereas giant asteroids (like the one that eliminated 85 per cent of species at
the end of the Cretaceous period) are exogenous shocks, financial crises are
endogenous to the financial system. The Great Depression of the 1930s and the
Great Inflation of the 1970s stand out as times of major discontinuity, with
‘mass extinctions’ such as the bank panics of the 1930s and the Savings and
Loans failures of the 1980s.
Could
something similar be happening in our time? Certainly, the sharp deterioration
in credit conditions in the summer of 2007 created acute problems for many
hedge funds, leaving them vulnerable to redemptions by investors. But a more
important feature of the recent credit crunch has been the pressure on banks
and insurance companies. Losses on asset-backed securities and other forms of
risky debt are thought likely to be in excess of $1 trillion. At the time of
writing (May 2008), around $318 billion of write-downs (booked losses) have
been acknowledged, which means that more than $600 billion of losses have yet
to come to light. Since the onset of the crisis, financial institutions have
raised around $225 billion of new capital, leaving a shortfall of slightly less
than $100 billion. Since banks typically target a constant capital/assets ratio
of less than 10 per cent, that implies that balance sheets may need to be
shrunk by as much as $1 trillion. However, the collapse of the so-called shadow
banking system of off-balance-sheet entities such as structured investment
vehicles and conduits is making that contraction very difficult indeed.
It
remains to be seen whether the major Western banks can navigate their way
through this crisis without a fundamental change to the international accords
(Basel I and II)bl governing capital adequacy. In
Europe, for example, average bank capital is now equivalent to significantly
less than 10 per cent of assets (perhaps as little as 4), compared with around
25 per cent towards the beginning of the twentieth century. The 2007 crisis has
dashed the hopes of those who believed that the separation of risk origination
and balance sheet management would distribute risk optimally throughout the
financial system. It seems inconceivable that this crisis will pass without
further mergers and acquisitions, as the relatively strong devour the
relatively weak. Bond insurance companies seem destined to disappear. Some
hedge funds, by contrast, are likely to thrive on the return of volatility.bm It
also seems likely that new forms of financial institution will spring up in the
aftermath of the crisis. As Andrew Lo has suggested: ‘As with past forest fires
in the markets, we’re likely to see incredible flora and fauna springing up in
its wake.’29
There is
another big difference between nature and finance. Whereas evolution in biology
takes place in the natural environment, where change is essentially random
(hence Richard Dawkins’s image of the blind watchmaker), evolution in financial
services occurs within a regulatory framework where - to borrow a phrase from
anti-Darwinian creationists - ‘intelligent design’ plays a part. Sudden changes
to the regulatory environment are rather different from sudden changes in the
macroeconomic environment, which are analogous to environmental changes in the
natural world. The difference is once again that there is an element of
endogeneity in regulatory changes, since those responsible are often poachers
turned gamekeepers, with a good insight into the way that the private sector
works. The net effect, however, is similar to climate change on biological
evolution. New rules and regulations can make previously good traits suddenly
disadvantageous. The rise and fall of Savings and Loans, for example, was due
in large measure to changes in the regulatory environment in the United States.
Regulatory changes in the wake of the 2007 crisis may have comparably
unforeseen consequences.
The
stated intention of most regulators is to maintain stability within the
financial services sector, thereby protecting the consumers whom banks serve
and the ‘real’ economy which the industry supports. Companies in non-financial
industries are seen as less systemically important to the economy as a whole
and less critical to the livelihood of the consumer. The collapse of a major
financial institution, in which retail customers lose their deposits, is
therefore an event which any regulator (and politician) wishes to avoid at all
costs. An old question that has raised its head since August 2007 is how far
implicit guarantees to bail out banks create a problem of moral hazard,
encouraging excessive risk-taking on the assumption that the state will
intervene to avert illiquidity and even insolvency if an institution is
considered too big to fail - meaning too politically sensitive or too likely to
bring a lot of other firms down with it. From an evolutionary perspective,
however, the problem looks slightly different. It may, in fact, be undesirable
to have any institutions in the category of ‘too big to fail’, because without
occasional bouts of creative destruction the evolutionary process will be
thwarted. The experience of Japan in the 1990s stands as a warning to
legislators and regulators that an entire banking sector can become a kind of
economic dead hand if institutions are propped up despite under-performance,
and bad debts are not written off.
Every
shock to the financial system must result in casualties. Left to itself,
natural selection should work fast to eliminate the weakest institutions in the
market, which typically are gobbled up by the successful. But most crises also
usher in new rules and regulations, as legislators and regulators rush to
stabilize the financial system and to protect the consumer/voter. The critical
point is that the possibility of extinction cannot and should not be removed by
excessively precautionary rules. As Joseph Schumpeter wrote more than seventy
years ago, ‘This economic system cannot do without the ultima ratio of
the complete destruction of those existences which are irretrievably associated
with the hopelessly unadapted.’ This meant, in his view, nothing less than the
disappearance of ‘those firms which are unfit to live’.30
In
writing this book, I have frequently been asked if I gave it the wrong
title. The Ascent of Money may seem to sound an incongruously
optimistic note (especially to those who miss the allusion to Bronowski’s Ascent
of Man) at a time when a surge of inflation and a flight into commodities
seem to signal a literal descent in public esteem and purchasing power of fiat
moneys like the dollar. Yet it should by now be obvious to the reader just how
far our financial system has ascended since its distant origins among the
moneylenders of Mesopotamia. There have been great reverses, contractions and
dyings, to be sure. But not even the worst has set us permanently back. Though
the line of financial history has a saw-tooth quality, its trajectory is
unquestionably upwards.
Still, I
might equally well have paid homage to Charles Darwin by calling the book The
Descent of Finance, for the story I have told is authentically
evolutionary. When we withdraw banknotes from automated telling machines, or
invest portions of our monthly salaries in bonds and stocks, or insure our
cars, or remortgage our homes, or renounce home bias in favour of emerging
markets, we are entering into transactions with many historical antecedents.
I remain
more than ever convinced that, until we fully understand the origin of
financial species, we shall never understand the fundamental truth about money:
that, far from being ‘a monster that must be put back in its place’, as the
German president recently complained,31 financial
markets are like the mirror of mankind, revealing every hour of every working
day the way we value ourselves and the resources of the world around us.
It is not
the fault of the mirror if it reflects our blemishes as clearly as our beauty.
NOTES
1 For some
fascinating insights into the limits of globalization, see Pankaj
Ghemawat, Redefining Global Strategy: Crossing Borders in a World Where
Differences Still Matter (Boston, 2007).
2 Frederic Mishkin,
Weissman Center Distinguished Lecture, Baruch College, New York (12 October
2006).
3 Larry Neal, ‘A
Shocking View of Economic History’, Journal of Economic History,
60, 2 (2000), pp. 317-34.
4 Robert J. Barro
and José F. Ursúa, ‘Macroeconomic Crises since 1870’, Brookings Papers
on Economic Activity (forthcoming). See also Robert J. Barro, ‘Rare
Disasters and Asset Markets in the Twentieth Century’, Harvard University
Working Paper (4 December 2005).
5 Nassim Nicholas
Taleb, Fooled by Randomness: The Hidden Role of Chance in Life and in
the Markets (2nd edn., New York, 2005)
6 Idem, The
Black Swan: The Impact of the Highly Improbable (London, 2007).
7 Georges
Soros, The New Paradigm for Financial Markets: The Credit Crash of 2008
and What It Means, (New York, 2008), pp. 91 ff.
8 See Frank H.
Knight, Risk, Uncertainty and Profit (Boston,
1921).
9 John Maynard
Keynes, ‘The General Theory of Employment’, Economic Journal, 51, 2
(1937), p. 214.
10 Daniel Kahneman
and Amos Tversky, ‘Prospect Theory: An Analysis of Decision under Risk’, Econometrica,
47, 2 (March 1979), p. 273.
11 Eliezer
Yudkowsky, ‘Cognitive Biases Potentially Affecting Judgment of Global Risks’,
in Nick Bostrom and Milan Cirkovic (eds.), Global Catastrophic Risks (Oxford
University Press, 2008), pp. 91-119. See also Michael J. Mauboussin, More
Than You Know: Finding Financial Wisdom in Unconventional Places (New
York / Chichester, 2006).
12 Mark
Buchanan, The Social Atom: Why the Rich Get Richer, Cheaters Get
Caught, and Your Neighbor Usually Looks Like You (New York, 2007), p.
54.
13 For an
introduction, see Andrei Shleifer, Inefficient Markets: An Introduction
to Behavioral Finance (Oxford, 2000). For some practical applications
see Richard H. Thaler and Cass R. Sunstein, Nudge: Improving Decisions
About Health, Wealth, and Happiness (New Haven, 2008).
14 See Peter
Bernstein, Capital Ideas Evolving (New York, 2007).
15 See for example
James Surowiecki, The Wisdom of Crowds (New York, 2005); Ian
Ayres, Supercrunchers: How Anything Can Be Predicted (London,
2007).
16 Daniel Gross,
‘The Forecast for Forecasters is Dismal’, New York Times, 4 March
2007.
17 The classic work,
first published in 1841, is Charles MacKay, Extraordinary Popular
Delusions and the Madness of Crowds (New York, 2003 [1841]).
18 Yudkowsky,
‘Cognitive Biases’, pp. 110f.
19 For an
introduction to Lo’s work, see Bernstein, Capital Ideas Evolving ,
ch. 4. See also John Authers, ‘Quants Adapting to a Darwinian Analysis’, Financial
Times, 19 May 2008.
20 The following is
partly derived from Niall Ferguson and Oliver Wyman, The Evolution of
Financial Services: Making Sense of the Past, Preparing for the Future(London
/ New York, 2007).
21 The Journal of
Evolutionary Economics. Seminal works in the field are A. A. Alchian,
‘Uncertainty, Evolution and Economic Theory’, Journal of Political
Economy, 58 (1950), pp. 211-22, and R. R. Nelson and S. G. Winter, An
Evolutionary Theory of Economic Change (Cambridge, MA, 1982).
22 Thorstein Veblen,
‘Why is Economics Not an Evolutionary Science?’ Quarterly Journal of
Economics, 12 (1898), pp. 373-97.
23 Joseph A.
Schumpeter, Capitalism, Socialism and Democracy (London, 1987
[1943]), pp. 80-4.
24 Paul
Ormerod, Why Most Things Fail: Evolution, Extinction and Economics(London,
2005), pp. 180ff.
25 Jonathan Guthrie,
‘How the Old Corporate Tortoise Wins the Race’, Financial Times, 15
February 2007.
26 Leslie Hannah,
‘Marshall’s “Trees” and the Global “Forest”: Were “Giant Redwoods” Different?’,
in N. R. Lamoreaux, D. M. G. Raff and P. Temin (eds.), Learning by
Doing in Markets, Firms and Countries (Cambridge, MA, 1999), pp.
253-94.
27 The allusion is
of course to Richard Dawkins, The Selfish Gene (2nd edn.,
Oxford, 1989).
28 Rudolf
Hilferding, Finance Capital: A Study of the Latest Phase of Capitalist
Development (London, 2006 [1919]).
29 ‘Fear and
Loathing, and a Hint of Hope’, The Economist, 16 February 2008.
30 Joseph
Schumpeter, The Theory of Economic Development (Cambridge, MA,
1934), p. 253.
31 Bertrand Benoit
and James Wilson, ‘German President Complains of Financial Markets “Monster”
’, Financial Times, 15 May 2008.
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