Getting and spending

<strong>The Ascent of Money: a Financial History of the World</strong>

Niall Ferguson


With all this talk of derivatives, collateralised debt obligations, option contracts, default swaps and so on, you might think finance was like quantum physics, a fearfully abstruse subject beyond the grasp of ordinary mortals. Well, it isn't, not really. Everything on the financial markets revolves around four simple things, with which nearly all of us are familiar: debt, investment, gambling and, above all, risk.

These have all been around for centuries (even millennia) and modern financiers have merely invented more sophisticated versions, complete with algebraic equations, largely in order to fool other people as to their true nature. Now they have proved the folk wisdom that generations of parents handed down to their children: debts have to be paid eventually, money doesn't grow on trees, what goes up must come down, and if anything can go wrong it will.

Niall Ferguson doesn't put it quite like that. He is, after all, a right-wing historian and fervent admirer of capitalism, particularly its American variant. But don't let that put you off. He has written a lucid and racy account of financial history. Admittedly, he completed most of it before the worst effects of the credit crunch became apparent and his rather desperate afterword, trying to take account of the latest developments, descends into neo-Darwinist mumbo-jumbo. All the same, you will have a better understanding of what happened this autumn after reading his book. What matters is his knowledge of history, not his right-wingness.

Much of what goes on in the financial markets is about buying and selling risk: the trick is to value it correctly

Ferguson's account of how one of the first big hedge funds, Long-Term Capital Management, crashed in the late 1990s is particularly instructive. Hedging is a way of minimising risk or, more precisely, passing it on to somebody who is in a better position to bear it, as we all do when we buy insurance. It started in agriculture where a farmer, after planting crops, agreed a sale price with a merchant regardless of market prices at harvest time. The farmer thus protected himself against low prices, while missing out on unusually high prices. Since then, "futures markets" have developed for all sorts of things. Big corporations hedge against changes in interest rates, exchange rates or commodity prices. Insurance companies themselves hedge against extreme risks. For example, they sell catastrophe bonds to offset the risks of the extreme temperatures or other natural disasters that might follow global warming. Buyers get high interest but have to pay when the mega-hurricane hits. Global warming deniers, such as Melanie Phillips and Nigel Lawson, should stock up.

Much of what goes on in the financial markets is about buying and selling risk: the risk, for example, that somebody who owes you money won't in the end pay up (default) or the risk that your shares will plunge. The trick is to value risk correctly, which is easy if you're selling life insurance where you've got mortality tables to help you. Ferguson recalls how the two clergymen who in 1748 started Scottish Widows for the dependants of deceased Church of Scotland ministers - it was the world's first life insurance fund - based the premiums on a calculation that they would need £58,348 by 1765 to pay the promised annuities while covering costs. They were out by just £1.

Long-Term Capital Management tried, in effect, to put an accurate price on stock-market risk. Even life insurance calculations can be upset by a pandemic or by war, but shares are notoriously volatile. The founders of Long-Term, who both won Nobel Prizes for economics and for a time made annual gains of more than 40 per cent, came up with a mathematical formula - Ferguson prints it, but admits he doesn't understand it - that supposedly took account of the volatility. They calculated that events to cause the loss of all their capital could happen less than once in the lifetime of the known universe.

Unfortunately, the data they used to factor in market volatility didn't go back to the Big Bang: it went back only five years and, therefore, took no account even of the 1987 crash, much less the 1929 crash or the Russian debt default of 1918. That was why the Russian debt default of 1998, sending stock markets into a tailspin, took them by surprise and led to Long-Term's collapse. "The Nobel prizewinners," concludes Ferguson, "had known plenty of mathematics, but not enough history."

Yet the lessons were forgotten almost immediately. Far from falling out of fashion, hedge funds, at the beginning of this year, had assets of nearly $2.7trn, against $490bn in 2000. Their losses contributed to the banks' present plight. As for the now famous sub-prime mortgages, it is a similar story. The lenders sold the loans to Wall Street banks, which in turn sold them to investors on the international markets. The risks weren't unknown, but high rates of interest supposedly accounted for them. Besides, the loans were restructured into packages that always included a number of relatively safe bets and, even if borrowers did default, rising property values would ensure repossessed houses were sold at a profit.

Somewhere along the line, the risk was, as George W Bush might say, misunderestimated. If you think about it - as the financial services industry and its regulators clearly didn't - the outcome was inevitable. Each time the risks were passed on, the vendors had an incentive to pretend they were safer than they really were. All the purchasers saw was fat interest payments. Yet any fool knows - or so any fool will now tell you - that property booms always end in busts. That brings to mind another piece of folk wisdom: a fool and his money are soon parted. In this latest crash, most of us have been made fools of and, because we let governments get away with bailing out banks that continue to pay ridiculous bonuses to top executives, we still are.

I don't think the author would agree - but even if you are a diehard lefty, Ferguson's beautifully written book is a marvellous primer on how money markets work. Just one warning: skip the section on Chile.

Peter Wilby was editor of the Independent on Sunday from 1995 to 1996 and of the New Statesman from 1998 to 2005. He writes the weekly First Thoughts column for the NS.

This article first appeared in the 01 December 2008 issue of the New Statesman, How safe is your job?