December 29, 2008
Under Consideration: The Ascent of Money: A Financial History of the World, by Niall Ferguson, Penguin Press (2008), 442 pages.
In The Pity of War, Niall Ferguson asked a penetrating question: What would have happened had Britain remained neutral during World War I? Agree with his answer”history would probably have turned out better”or not, of one thing there can be little doubt. Ferguson showed that he possessed an outstanding historical imagination. He did not practice what Herbert Butterfield called “Whig history,” that is, history as a progressive unfolding toward the glorious present. A more realistic approach to history recognizes, as Ferguson did in his earlier book, that people have often confronted genuine alternatives.
Unfortunately, Ferguson’s historical imagination has deserted him in The Ascent of Money. He traces the history of finance, from the origin of money to the derivatives and hedge funds of today. Though he describes in his vivid style the panics and disasters that have often characterized this development, for him the path has been onward and upward. Through a Darwinian process, superior financial institutions survive and inferior ones perish. This is one reason he speaks in his title of “ascent”: “It should 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.”
Unquestionably? I hardly think so. Several of the steps in Ferguson’s story have no place in a free society. Ferguson is certainly right that modern civilization could not exist without money. A world in which people exchange goods and services is vastly more productive than one in which persons have to produce everything they need themselves; and trade through barter faces strict limitations. People cannot make an exchange unless they find someone who wants what they have and has what they want: in economists” jargon, there must be a double coincidence of wants. Once money exists, achieving this happy state of affairs becomes much less of a problem. Almost everyone will accept money”precisely because everyone believes that everyone else will accept it.
So far, so good for Ferguson’s tale of ascent; and he makes a good case for his next step as well. Companies often need to raise more money for their projects than they have immediately available. To do so, they can issue bonds, that is, promises of an annual return in return for a loan. These bonds can usually be cashed in and sold, and modern economies could not get along without them.
But now the trouble begins. Ferguson counts it as progress that the state can issue bonds. State bonds, though, differ fundamentally from private bonds. A state-issued bond is a future tax: people must come up with the money to redeem the state’s pledges to pay interest and to cash in the bonds. Often, these taxes impose a crushing burden on the economy. Of course, the state can default, but this plays havoc with economic conditions.
Ferguson himself notes a severe problem that state bonds generate. If people lose confidence in the government, bond prices will go down. This makes the rate of interest go up, which crowds out investment. “In the words of Bill Gross, who runs the world’s largest bond fund at the Pacific Investment Management Company (PIMCO), “bond markets have power because they”re the fundamental basis for all markets. The cost of credit, the interest rate [on a benchmark bond], ultimately determines the value of stocks, homes, all asset classes.”
But there is a yet more severe problem. Of the phenomenon in question, Ferguson shows himself well aware; but he refuses to view it as a difficulty”nothing must interfere with his story of progressive ascent! The problem is that state-created debt massively increases the scale on which the state can engage in war. As Ferguson notes, “The ability to finance war through a market in government debt was, like so much in financial history, an invention of the Italian Renaissance”; and since then, the scope and scale of debt and war have increased together. As if this were not bad enough, war has been the principal means by which the power of the state has grown. (In the American context, Robert Higgs has documented to the hilt this connection in Crisis and Leviathan).
Here an objection requires response. If one says that the state should not be able to get into debt, does this lead to pacifism? What if war is unavoidable? In Belloc’s lines, “Pale Ebenezer thought it wrong to fight / But roaring Bill, who killed him, thought it right.” Would a policy that renounced state debt commit a nation that adopted it to surrender?
I do not think so. As Ludwig von Mises noted, war must always be paid for with current resources. “All the materials needed for the conduct of a war must be provided by restriction of civilian consumption, by using up a part of the capital available and by working harder. The whole burden of warring falls on the living generation.” Bonds create the illusion that the burdens of a war can be passed to future generations. By insisting that wars be paid for through taxes, we can impose a much-needed check to unnecessary aggression. If it must rely on taxes, a government will go to war only if it can convince people to pay.
Ferguson also wrongly sees progress in another area in financial evolution. When people deposit money in a bank, the bank will not keep all of the deposit money on hand. It will lend out the money and retain only enough to meet the anticipated demands of depositors for their money. In this way, the bank earns money through interest payments on the loans it makes. But what if people lose confidence in the banks? If a large number of depositors converge on a bank, the bank will be unable to meet its obligations. If bank runs spread, a nation’s economy can be completely disrupted.
Would we not be better off without fractional reserve banking? Ferguson might answer that bank runs no longer pose a serious problem. Nowadays, through deposit insurance, one of Franklin Roosevelt’s manifold blessings, people no longer fear that they will lose their money.
But deposit insurance raises problems of its own. First, this is a costly program, and the money for it must be provided through taxation or an increase in the government’s debt. Further, if banks no longer fear runs, or at least do so to a much lesser extent, they will be more likely to make risky loans. They need not fear that doing so will create problems for them with their depositors. Deposit insurance, further, increases the power of the government over the supply of money. This is all the more so, if, as is always the case, deposit insurance forms part of a system of centrally directed banking. Is this not an odd dialectic? One starts with fractional reserve banking. This produces instability, owing to the possibility of runs. To cure this, deposit insurance and centralized banking, e.g., the Federal Reserve System, are introduced. Why go through this whole rigmarole? If banks could not lend demand deposits, the problem of runs would not exist. When the bank lends money in excess of its reserves, it in effect creates money out of nothing. Why should banks be allowed to do this?
And there is yet another problem with fractional reserve banking. What causes depressions? According to the Austrian theory of the business cycle, developed by Mises and Friedrich von Hayek, credit expansion lowers the money rate of interest below the “natural” rate, determined by people’s preference for present over future goods. Businesses, presented with new opportunities to borrow money, expand production, especially in capital goods. Once the banks cease expanding, the rate of interest rises to its former, natural, rate. The new investments cannot no longer be sustained. In the Austrian view, this process of liquidation is the depression. There is on the unhampered free market no natural tendency to depression. Business cycles come about through a government-initiated expansion of credit, which in the absence of fractional reserve banking could not take place. (Some Austrians countenance a very limited amount of fractional reserve banking, but nothing like what is practiced under centralized systems like the Federal Reserve. Murray Rothbard is the foremost champion of the 100% reserve requirement.)
Unfortunately, Ferguson never mentions the Austrian theory. For him the Great Depression of October 1929 did not arise through the Federal Reserve’s policy of monetary expansion during the 1920’s, a key thesis of Rothbard’s America’s Great Depression. Quite the contrary, “in perhaps the foremost work of American economic history ever published, Milton Friedman and Anna Schwartz.. .did not blame the Fed for the bubble itself, arguing that with Benjamin Strong at the Federal Reserve Bank of New York a reasonable balance had been struck between the international obligation of the United States to maintain the restored gold standard and its domestic obligation to maintain price stability.”
Ironically, Strong, along with his friend and ally Montagu Norman, the Governor of the Bank of England, was for Rothbard the chief villain. Owing to increased production during the 1920’s, prices unaccompanied by monetary expansion would have fallen. The very fact appealed to by Ferguson, i.e., the relative price stability of the period, is a sign that inflationary forces were at work. In Rothbard’s interpretation, Strong orchestrated an American monetary expansion in order to help relieve pressure on the British, who had restored the gold standard at an unduly high rate for the pound.
Ferguson would no doubt reject this account, but he does not have a competing account of the origin of the Depression to offer. Instead, again following Friedman and Schwartz, he blames the unprecedented severity of the Depression on the Fed’s contraction of the money supply in response to the stock market crash”an explanation Rothbard would dispute. But even if Friedman and Schwartz are right about post-1929 Fed policy, this does not speak to the Depression’s origins. To Ferguson, apparently, the Crash was just “one of those things”; the Austrian theory explains it.
Even if the Austrian theory of the cycle is right, though, can a modern economy do without fractional reserve banking? Ferguson thinks that it cannot. “”Precious Metals alone are money,” declared one City [of London] grandee, Baron Overstone. Paper notes are money because they are representations of Metallic Money. Unless so, they are false and spurious pretenders. One depositor can get metal, but all cannot, therefore deposits are not money.” Had that principle been adhered to, and had the money supply of the British economy genuinely hinged on the quantity of gold coin and bullion in the Bank of England’s reserve, the growth of the UK economy would have been altogether choked off, even allowing for the expansionary effects of new gold discoveries in the nineteenth century.” For this claim, Ferguson offers no evidence whatever. He assumes that a growing economy requires a greater quantity of money, but this the Austrians vehemently dispute. In their view, any quantity of money suffices to transact business in an economy, since the price level will adjust to match goods with the money available. This of course raises the specter of deflation, but Austrians do not fear it. Deflation, so long as it is not induced through government manipulation, has often been accompanied by prosperity. Ferguson could learn a lesson from Baron Overstone.
Ferguson would no doubt answer that he refuses to assume, as I have done, the correctness of the Austrian theory. Even on his own evidence, though, his claim that a growing economy would be choked off without adequate monetary expansion does not withstand examination. Britain in the early nineteenth century greatly restricted the emission of bank credit, but the economy was surely growing during that period. As he notes, Sir Robert Peel was suspicious of “excessive banknote creation” and his Bank Charter Act of 1844 restricted the bank’s fiduciary note issue with what Ferguson calls “an excessively rigid straitjacket, “ though one which fell short of a 100% reserve requirement. Ferguson asserts, in my opinion wrongly, that this act led to several liquidity crises, compelling a modification of the system. But even if he is right, this is not the point in dispute. Rather, contrary to Ferguson, a restrictive monetary policy that remained in effect through the 1860s proved quite entirely compatible with remarkable economic growth. The great majority of years when the Act was in effect were not marked by crisis; and in them economic growth was certainly not “choked off.”
I have so far been critical of Ferguson, but on some topics he is excellent. He explains very well how the modern welfare state developed in tandem with militarization. If the state sought more soldiers for a bellicose policy, it had to provide for them: “If the welfare state was conceived in politics, it grew to maturity in war. The First World War expanded the scope of government activity in nearly every field. . .This process repeated itself during and after the Second World War.”
War greatly expanded the welfare state; can it continue at such high levels in peacetime? In some instances, Ferguson thinks that it can. The Japanese welfare state has been very successful: “There was in fact nothing institutionally unique about Japan’s system, of course. Most welfare states aimed at universal, cradle-to-grave coverage. Yet the Japanese welfare state seemed to be a miracle of effectiveness.”
But this success, he thinks, depends on particular aspects of the Japanese character, and for contemporary Western societies, such as the United States and Britain, the prospects of the welfare state are bleak. Comparing Japan with Britain, Ferguson says: “In Japan egalitarianism was a prized goal of policy, while a culture of social conformism encouraged compliance with the rules. English individualism, by contrast, inclined people cynically to game the system. … Health care, social services and social security [in Britain] were consuming three times more than defence as a share of total managed government expenditure [in 1980]. Yet the results were dismal. Increased expenditure on UK welfare had been accompanied by low growth and inflation significantly above the developed world average.”
Ferguson commands a vast array of data and writes clearly. If, for instance, you want a concise account of the rise of the Rothschilds, Ferguson will not disappoint you.
I did note a few mistakes, however. Napoleon was not “Emperor of France” (p.77; p.80 lists him correctly as “French Emperor”). Arnauld and Nicole, not Pascal, wrote, the Ars Cogitandi (p.188). Ferguson’s comments on Thomas Bayes are confused; he fails to state that Bayes” Theorem is about determining conditional probabilities. (pp.189-90) Risk aversion for positive prospects together with risk aversion for negative ones is not an example of “the tendency people have to miscalculate probabilities when confronted with simple financial choices.” (p.344) Why is this behavior irrational? No argument is given that one cannot rationally view identical payoffs through different perspectives.
Readers of The Ascent of Money will learn a great deal about monetary history. They would be well advised to accompany their reading with a perusal of Rothbard’s What Has Government Done to Our Money? Doing so will provide a grasp of the essence of monetary theory, needed to understand the facts about which Ferguson writes in effortless abundance.