In this interview, Harvard historian Niall Ferguson discusses the turbulent history of money, the inevitability of financial crises and the fatal influence mathematicians have on the monetary system. Ferguson is an author, as well as a noted observer of financial markets. His "The Ascent of Money" was published last November.
Professor Ferguson, can you show us the contents of your wallet?
If you like, sure. Have a look. I have about a hundred dollars on me.
Why do people consider such green-printed pieces of paper to be so valuable?
These pieces of paper are also promissory notes. Four thousand years ago in ancient Babylon, clay tablets fulfilled this role. Nowadays we use banknotes. They are only worth what other people are willing to give you in exchange for them. Money is about trust, no matter what form it takes, be it clay, gold, paper, or a computer monitor with a liquid crystal display.
The dollar has lost about 86 percent of its purchasing power in the last half-century. Why doesn't depreciation of this scale shatter confidence in paper money?
It's simple: Because paper money is so easy to use. It gives people an exchangeable commodity and a mathematical unit that is standardized and generally accepted. That's something we're willing to accept a certain amount of inflation for. It's the price we pay for having a system of paper money.
The purely paper-based system is not all that old. The dollar was pegged to gold until 1971. Aren't precious metals a far better form of payment?
It does indeed appear attractive to have gold in your portfolio these days, and gold does have a special allure. I recently saw the death mask of Agamemnon in Athens. Although it was made in the 16th century before Christ, it's lost none of its splendor. Nevertheless, I don't think gold will ever have a monetary role again. For example, think how impractical it would have been if you'd had to pay for your flight to Boston using gold. How much was it?
Just under 400 euros.
At current prices, that's the equivalent of almost half an ounce of gold, that is, about 15 grams. Now just imagine you had to pay for a single apple.
And yet there was a close relationship between money and precious metals for centuries -- millenia even. Why was the link broken?
Because it proved to be an extremely inflexible system. If the overall volume of money depends on the availability of precious metals, it can't simply be increased. So a shortage of gold or silver can limit economic growth. The link to gold brings with it a danger of deflation, in other words a constant drop in prices which would hobble the economy. The gold standard was one of the causes of the deflation Germany suffered in the early 1930s, for example.
You mean that the demise of the Weimar Republic was caused in part by financial factors?
Germany's financial history played a significant part in Adolf Hitler's rise to power. At the beginning of the 20th century Germany had the world's best education system, a democratic tradition of sorts, and universal suffrage. Why then did fascism spread in Germany? To a large extent because of the series of financial traumas the country had suffered in quick succession: The hyperinflation of 1922-23 and the deflation that accompanied the global financial crisis of 1929.
Then what role, if any, does money play in our history?
The ascent of Man is coupled with an increase in the importance of money. Barter -- the direct exchange of one commodity for another -- was not particularly efficient. The shortcomings began to appear with the division of labor, when some people became farmers, some craftsmen, and others traders. Money helped them do business with one another. I believe that money is the source -- or rather the midwife -- of nearly every advance throughout history.
That's an interesting theory. Can you prove it?
The glory of Florence, the boom in architecture and in the art market during the Renaissance, for instance, was based on the fact that the Medicis were bankers and had made their fortune exchanging money. Without the Medicis, Botticelli might not have got the opportunity to paint some of his most famous paintings. Or take the French Revolution. This was at least indirectly a consequence of the financial straits the monarchy had got into because of "Sun King" Louis XIV's military campaigns. Napoleon's defeat at Waterloo in 1815 is another example. The battle was partly a clash between two financial systems. The French financed their military conflicts through plunder, while the British used the bond market and took out loans. This helped Britain develop into a superpower.
It sounds as if much of the history of money revolves around funding warfare.
The demands of war did indeed play a major role. Perhaps states first started taking out loans when the Venetians discovered in the 13th century that they could finance their wars more easily by borrowing money from their citizens rather than taxing them. Therein lie the roots of the bond market. There's a financial secret behind every major historical event.
Surely there must also be other influences on the progression of history; technical innovation, for example. Doesn't money tend to exert a more destructive influence?
I think the development of monetary systems can best be compared to a mountain range. The ascent is never entirely straight, and there are drops -- some of them steep -- in between, but in the long run the direction is clearly upward. Even Germans who had lived through the great inflation, the deflation, and the 1948 currency reforms subsequently experienced greater prosperity than at the start of the 20th century.
You could just as easily claim that the history of money is a series of disasters, state bankruptcies, and loss of value, couldn't you?
If you do that, you're only focusing on the crisis-ridden moments in history. That's understandable because stock-market crashes and currency plunges are headline-grabbing. However the reality is that those sort of events are the exception, and stability is the rule, even though it makes for far more boring reading.
But wouldn't you say that our life is primarily shaped by individual disasters, whose origins may also be financial in nature? Aren't such crises inevitable?
It's hard to imagine a financial system that would never be threatened with collapse. That's mainly because of human nature. We often make false assumptions about the future. Our brains are not exactly on a par with 21st-century computers. We're better suited to hunting wild animals in the Serengeti. Our perception is extremely selective, and our attitudes change sporadically. One minute we're greedy, the next we're afraid.
Is such irrational behavior the reason we recognize the symptoms of crises too late?
In most cases. Instability has been a part of the financial system ever since the ancient Mesopotamians started calculating the price of grain based on how good they expected the next harvest to be. As you know, the experts also got their predictions wrong about the present financial crisis.
What aspects of the current financial crisis are similar to earlier ones?
The source of the crisis is typical: It began with a glut of cheap money, loans were easy to get, and a bubble developed -- in this case in the U.S. housing market -- that eventually burst.
Could this bubble have been prevented?
It's hard to say when exactly a bubble has got too big. Some bubbles don't burst at all, but merely remain at about the same size. Others keep expanding for a long time, and then burst with a real bang. In 1996 the then chairman of the U.S. Federal Reserve, Alan Greenspan, warned about "irrational exuberance," but the Internet bubble continued to grow for another four years.
Experts had also been warning about the U.S. housing bubble for years, but few people could have guessed what global consequences its collapse would bring. What's special about this crisis in particular?
Firstly, derivatives played an exceptional role, especially credit default swaps. Secondly, the rating agencies made a remarkable error: They gave only a handful of companies the top credit rating, but rated as harmless thousands of structured financial products that turned out to be extremely dubious.
What's going to happen to the financial system? How will it change?
As far as I understand it, financial history is essentially the result of natural selection. The crisis is a part of this evolutionary process, and natural selection within the market is its driving force. Changing conditions may cause complex systems to collapse. Just like the dinosaurs, the major financial institutions are now also having difficulties coping with a dramatic change in their environment.
So you believe that, just like in nature, only the fittest and most adaptable survive in the financial world?
In principle, yes. The players are competing for limited resources. Some of them succeed through innovation and thus prevent a monoculture from developing.
But this process is rather painful. Couldn't greater state control have prevented the worst excesses? Is deregulation therefore to blame for the financial crisis?
That is the popular argument. I think it's nonsense. The process of deregulation began as far back as the early 80s, and the global economy has experienced a huge upswing since then. Apart from that there were also financial problems in the decades before that, when the markets were far more tightly regulated. Overall, banks are some of the most tightly-controlled institutions, and yet that's where the crisis began. Mortgage bank Fannie Mae, for example, operates under direct oversight from the U.S. Congress. It's therefore not about more regulation, but about better regulation.
What should banking regulators watch out for?
They should pay closer attention to liquidity. The banks issued longterm loans, but could only procure the money for themselves on a short-term basis. Many institutions racked up huge debts -- sometimes 30 or 40 times more than their equity capital. If you then get a bottleneck in short-term credit, such behavior inevitably leads to a collapse. In addition, the regulators mustn't let banks get too big. Right now, many major institutions are practically bankrupt. They are zombie banks: half dead, but also half alive thanks to cash injections from the state. We have to think seriously about how long we can afford to continue this policy.
Are you suggesting the state should let problem banks fail?
Some are probably too big for that. But they should be wound up in a controlled manner. If they keep receiving state aid, the subsidies will distort the competition. The success of the financial system is gauged by its innovativeness. We need new banks. And we must look for ways to develop our monetary system.
What do you mean by that?
The fates of many of the world's economies are pegged to the development of the dollar at the present time. If the dollar loses value, which is highly likely, it will be particularly painful for countries like Japan and Germany, whose exports will become more expensive.
What might such a new system look like?
Perhaps a little like the situation in the 19th century, when there were several reserve currencies: sterling, the U.S. dollar, the German mark, and the French franc. As such, the dollar's dominance could well diminish in favor of the euro, the Japanese yen, or the Chinese currency; the yuan.
Does that mean that we can learn from the history of financial crises and that of money?
Of course we can learn from the past. Ever since the Great Depression we have known how dangerous banking crises are. We can thank our lucky stars that the U.S. Federal Reserve is chaired by Ben Bernanke, a man who spent his entire academic career studying the minutiae of the 1930s Depression. That's why he knew exactly what to do when crisis hit.
But not every banker or manager has the benefit of such historic insight.
Precisely. Companies are filled with mathematicians who sometimes calculate 'Value at risk' on the basis of as little as three years of data. If the models don't even follow the timeframe of a normal business cycle or take account of all the players, but merely focus on the share price at the end of the quarter, it's hardly surprising when people decide there is no risk. The lessons of history were ignored at every level.
So do you think companies should employ more historians and fewer mathematicians?
It wouldn't hurt. Financial history should at least be a significant part of every business studies course. This kind of knowledge is too important to leave to specialists like me. Unfortunately most of the people who read about financial history are retired bankers. It would have been better if they had read these books earlier.
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