The Ascent of Money is an essay in financial history. Do you think the current crisis is due in part to the lack of a historical sense?
It’s a central theme of the book that ignorance of financial history can be a cause of financial crisis. I think the rise of quantitative econometrics and a highly mathematical approach to risk management was the obverse of a decline in interest in financial history. This crisis is history’s revenge on quantitative finance.
You spend some time discussing the collapse in 1998 of the hedge fund Long-Term Capital Management (LTCM). Do you see that episode as an intimation of the present crisis?
I think in many ways this crisis is a vast reprise of LTCM – but this time with the big banks playing the lead role, rather than just one big hedge fund. Interestingly, the big banks were there on the stage in 1998, as major investors in LTCM, and some of the actors reappeared ten years later, having gone from being the bailers-out to the bailed-out. It’s hard to think of a more spectacular failure to learn from history. Just ten years apart, some of the same individuals involved, and much the same problem of movements in prices destroying strategies of diversification. And, above all, excess leverage. LTCM was leveraged at a pretty high ratio, and that was the strategy later adopted by the investment banks and the commercial banks.
So, part of the problem is that people’s memories are too short?
Yes. You’ve got this problem that if no one is taught financial history at any point, they’re relying entirely on their own experience.
Risk models are a substitute for historical knowledge, because they tend to work with just three years’ worth of data. But three years is not a long time in financial history. If, for instance, you were working with three years’ worth of data in 2007, your risk model would have told you there was no risk at all, because the world had become perfectly safe and everybody was going to make money for ever more, and there was never going to be another recession. So there was no check on that kind of thing. Nobody was saying, “Well, what about 1973? Or what about 1931?” It just wasn’t happening. But don’t forget the role that China played in all this. It would have been hard to have the credit bubble and housing bubble without the availability of Asian savings, and the fact that they were being recycled into the US economy through the People’s Bank of China’s reverse-accumulation strategy.
Do you think governments across the world are drawing the right lessons from the crisis?
What I fear is that we may be overdoing the monetary and fiscal response to the crisis. We’re kind of acting as if it’s a Great Depression, but it may just be a big recession. There’s a danger of printing so much money in order to avoid a second Great Depression, that you end up bringing back the inflation that so bedevilled the 1970s.
You emphasise the fundamental instability of financial systems and the extent to which they are subject to the vicissitudes of human behaviour. Can we detect the influence of behavioural economics on your analysis?
Yes. The importing of behavioural psychology into the economic mainstream has been one of the major benefits of the crisis. The great thing about behavioural psychology and economics is that they help us to see that there are actually pretty good reasons why human beings swing from greed to fear, and why we’re not really calculating machines or utility-maximisers. We are, in fact, rather clueless gamblers.
Is this crisis a definitive refutation of the efficient markets hypothesis, therefore?
Yes. What’s so seductive about the efficient markets hypothesis is that it applies nine years out of ten. A lot of the time it works. But when it stops working, you blow up. Much of the time it looks like you’re in the Bell Curve, and then something happens that your model tells you will happen only once in a million years, but which history tells you happens about once every 50 years.
Interview by Jonathan Derbyshire
Niall Ferguson is Laurence A Tisch Professor
of History at Harvard University and William Ziegler Professor at Harvard Business School. “The Ascent of Money: a Financial History of the World” is published by Penguin (£9.99)