The financial crisis that began in August 2007 and reached its crescendo in
the past month has seen all kinds of asset plummet in price: houses,
mortgage-backed securities, shares in banks, corporate bonds, not to mention
commodities. Panicking investors have turned instead to gold, cash - and
hyperbole. “The end of the world.” “Armageddon.” “Apocalypse now.”
I have heard all these phrases and more in recent weeks. Even the normally
staid International Monetary Fund called it “the largest financial shock
since the Great Depression”. The question I have been asked most often this
year is: shouldn't you have called your book The Descent of Money?
That would be a good title for a book about the last 15 months, I agree -
though it would mislead the reader in one respect. Many financial indicators
are indeed descending steeply, but money isn't one of them. On the contrary:
the frantic efforts of central banks to inject liquidity into the financial
system has led to a surge in the supply of money. But my book is about
financial history from the earliest times. And, seen in a long-term
perspective, this is just the latest of many crises. We face a serious
recession as a result of the credit crunch, no doubt. But we are not about
to be catapulted back to ancient Mesopotamia.
Today's financial world is the result of four millennia of economic evolution.
Money - the crystallised relationship between debtor and creditor - begat
banks, clearing houses for ever-larger aggregations of borrowing and
lending. From the 13th century onwards, government bonds introduced the
securitisation of streams of interest payments; while bond markets revealed
the benefits of regulated public markets for trading and pricing securities.
From the 17th century, equity in corporations could be bought and sold in
similar ways. From the 18th 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 19th, futures and options
offered more specialised and sophisticated instruments: the first
derivatives. And from the 20th, 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 globalisation. From ancient Mesopotamia to present-day
China, 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 to
mankind's escape from the drudgery of subsistence agriculture and the misery
of the Malthusian trap.
Yet money's ascent has not been, and can never be, a smooth one. On the
contrary, financial history is a rollercoaster ride of ups and downs,
bubbles and busts, manias and panics, shocks and crashes. 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 87 crises in which consumption
suffered a fall of comparable magnitude, implying a probability of financial
disaster of around 3.6 per cent per year.
Even today, despite the unprecedented sophistication of our institutions and
instruments - or perhaps because of it - Planet Finance remains as
vulnerable as ever to crises. It may even be that, as George Soros argues,
we are living through the deflation of a multi-decade “super bubble”.
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. To put it
simply, much of what happens in life isn't like a game of dice.
The point was brilliantly expressed by John Maynard 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 20 years hence ... About these matters there is no
scientific basis on which to form any calculable probability whatever. We
simply do not know.”
Keynes went on to hypothesise about the ways in which investors try to “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 endeavour to
fall back on the judgment of the rest of the world which is perhaps better
informed. That is, we endeavour to conform with the behaviour of the
majority or the average.”
Though it is far from clear that Keynes was correct in his interpretation of
investors' behaviour, he was thinking along the right lines. For there is no
question that the subjective 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 in recent months, all
financial institutions are at the mercy of our innate tendency to veer from
euphoria to despondency; our recurrent inability to protect ourselves
against what the statisticians call “tail risk” (rare but high-impact events
in the “tails” of the bell-shaped curve that plots events according to their
frequency); above all, our perennial failure to learn from financial
history.
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 five pence, since only with a bat worth £1.05 and a ball
worth five pence are both conditions satisfied.
If any field has the potential to revolutionise our understanding of the way
financial markets work, it must surely be the burgeoning discipline of
behavioural finance. Those who put their faith in the “wisdom of crowds”
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 such a joke
but a dispiriting truth about the difficulty of economic forecasting.
Meanwhile, serious students of human psychology will expect as much madness
as wisdom from large groups of people. 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.
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 aggressive traders like to use;
investment banks used to hold conferences with titles such as “The Evolution
of Excellence”. But the current crisis has increased the frequency of such
language.
The notion that Darwinian processes may be at work in the economy is not new,
of course. Thorstein Veblen first posed the question “Why is Economics not
an Evolutionary Science?” (implying that it really should be) as long ago as
1898.
A key point that emerges from recent research is just how much destruction
goes on in a modern economy. According to the UK Department of Trade and
Industry, 30 per cent of tax-registered businesses disappear after three
years. Even if they survive the first few years of existence and go on to
enjoy great success, most firms fail eventually. Of the 1912 list of the
world's 100 largest companies, 29 were bankrupt by 1995, 48 had disappeared,
and only 19 were still in the top 100. Given that a good deal of what banks
and stock markets do is to provide finance to companies, we should not be
surprised to find a similar pattern of creative destruction in the financial
world.
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 endure and proliferate.
The evolutionary analogy is, admittedly, imperfect. Nevertheless, evolution
certainly offers a better model for understanding financial change than any
other we have.
The real story of recent years has been one of speciation, the proliferation
of new types of financial institution, which is just what we would expect in
a truly evolutionary system. Not only have new forms of financial firm -
notably hedge funds - proliferated; so too have new forms of financial asset
and service.
In recent years, investors' appetite grew insatiably for mortgage-backed and
other asset-backed securities. The use of derivatives also increased
enormously, with the majority being bought and sold “over the counter”, on
an ad hoc, one-to-one basis, rather than through public exchanges - a
tendency which, though initially profitable for the sellers of derivatives,
has turned out to have unpleasant as well as unintended consequences.
In evolutionary terms, then, the financial services sector experienced a
20-year “Cambrian explosion”, with existing species flourishing and new
species increasing in number. The problem is that, as in the natural world,
the evolutionary process is subject to occasional big disruptions. 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 or self-inflicted. The
Great Depression of the 1930s and the Great Inflation of the 1970s stand out
as times of major financial disruption, which were both followed by “mass
extinctions”: bank panics in the former case, the Savings and Loans crisis
in the latter.
We are now living through something comparable. Call it the Great Repression:
a financial crisis which had the potential to be as severe as that of the
early Thirties, but which the monetary and fiscal authorities have repressed
by injecting a mind-blowing amount of emergency funding. Despite their
efforts, it has not been possible to avert a “Great Dying” of financial
institutions - and even the extinction of an entire species: the US
investment banks that were once the titans of Wall Street.
This 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 along with the investment banks. Some hedge funds may thrive on
the return of volatility, but many more will vanish as investors rush for
the exits. The reality is, however, that the crisis would have been far more
devastating - would indeed have been a second Depression - had it not been
for official intervention. And this reveals 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 that of climate change on biological
evolution. New rules and regulations can make previously “good” traits
suddenly disadvantageous. The Savings and Loans crisis, for example, was due
in large measure to changes in the regulatory environment in the United
States. Regulatory changes in the wake of the current crisis may have
comparably perverse consequences.
We have just witnessed frantic improvisation by finance ministries around the
world as it became clear that purely monetary measures - interest rate cuts
and various central bank credit facilities - would not suffice to avert a
rash of bank failures. Belatedly, the state has stepped in, brokering
mergers, offering to buy “toxic” assets and finally (with Britain taking the
lead)investing taxpayers' money in preferred shares to recapitalise the
banks directly.
But the question remains how far implicit or explicit guarantees to bail out
banks create a problem of moral hazard,encouraging excessive risk-taking on
the assumption that the state will always 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. To prevent that, legislators and regulators will almost certainly
seek to limit bank risktaking in the aftermath of this crisis. We can look
forward to stricter rules on capital adequacy being imposed, to say nothing
of caps on executive compensation and new accounting rules.
From an evolutionary perspective, however, 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.
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 70 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 un-adapted”.
This meant, in his view, nothing less than the disappearance of “those firms
which are unfit to live”. The fate of Lehman Brothers, the only major
institution that the US Treasury has so far allowed to fail, illustrates
just how painful that process can be.
But anyone who thinks that turning banks into highly regulated public
utilities will prevent financial crises has forgotten the 1970s. Back then,
the financial sector was highly regulated. Capital controls were
commonplace. Bankers lived by the boring 3-6-3 rule: pay 3 per cent on
deposits, take 6 per cent on loans and be on the golf course by 3 o'clock.
Yet the Seventies were scarcely an era of financial stability. On the
contrary, excessive government control of the financial system led to
double-digit inflation in most developed economies. There remains a distinct
and disquieting danger that we shall end up going back to the 1970s out of
fear of repeating the 1930s.
The Ascent of Money may seem to sound an incongruously optimistic note
(especially to those who miss the intentionally ironic allusion to
Bronowski's Ascent of Man) at a time when banks are on life-support and
stock markets in freefall. Yet there is no denying 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 re-mortgage 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, 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.
© Niall Ferguson 2008. Extracted from The Ascent of Money
(Penguin, £25). Copies can be ordered for £22.50 with free delivery from The
Times BooksFirst on 0870-1608080.
