Introduction
The 2007 financial crisis exposed widespread financial illiteracy despite finance being central to modern life, making financial history essential for understanding both the benefits and dangers of our complex financial system.
- Financial illiteracy is pervasive in developed countries, with surveys showing that two-thirds of Americans don’t understand compound interest and four in ten credit card holders don’t know their interest rates
- According to a 2007 survey, 29% of Americans had no idea what interest rate they paid on credit cards, while another 30% claimed it was below 10% when most companies charge substantially more
- A 2008 survey revealed that two thirds of Americans did not understand how compound interest worked
- In Britain, one person in five had no idea what effect 5% inflation and 3% interest would have on their savings’ purchasing power
- The 2007 financial crisis began with subprime mortgage defaults by low-income American households but spread globally through complex securitized products, demonstrating how interconnected modern finance has become
- Relatively poor families in states from Alabama to Wisconsin bought complex loans that were bundled into collateralized debt obligations and sold to German banks and Norwegian municipalities
- What followed resembled a slow but ultimately devastating chain reaction affecting institutions worldwide
- By May 2008, write-downs by banks amounted to at least $318 billion with total anticipated losses exceeding one trillion dollars
- Finance amplifies human psychological tendencies, creating boom and bust cycles because money reflects our emotional volatility and tendency to swing from overoptimism to deep pessimism
- “Money amplifies our tendency to overreact, to swing from exuberance when things are going well to deep depression when they go wrong” —the author
- “Booms and busts are products, at root, of our emotional volatility” —the author
- “The financial system reflects and magnifies what we human beings are like” —the author
- Financial globalization creates a world divided between the financially knowledgeable who benefit from global opportunities and the financially illiterate who face greater risks of downward mobility
- The world can no longer be divided neatly into rich developed countries and poor less-developed countries after more than three hundred years of divergence
- The more integrated the world’s financial markets become, the greater the opportunities for financially knowledgeable people wherever they live
- “The rewards for ‘getting it’ have never been so immense. And the penalties for financial ignorance have never been so stiff” —the author
- Financial crises are inherently unpredictable due to the complex, non-linear nature of the financial system, making them like natural disasters that evolve according to Darwinian principles
- Few things are harder to predict accurately than the timing and magnitude of financial crises, because the financial system is so genuinely complex
- Financial history looks like a classic case of evolution in action, albeit in a much tighter timeframe than evolution in the natural world
- “Just as some species become extinct in nature, some new financing techniques may prove to be less successful than others” —Anthony W. Ryan
Dreams of Avarice
Money evolved from ancient Mesopotamian clay tablets recording debt relationships to modern electronic currency, with the Spanish discovery of American silver demonstrating that money’s value depends on trust and scarcity rather than precious metal content.
- Hunter-gatherer societies like the recently discovered Nukak-Makú tribe of Colombia demonstrate that moneyless societies are characterized by extreme poverty, violence, and inability to plan for the future
- The Nukak had no concept of money and no concept of the future either, living in a state that was ‘solitary, poor, nasty, brutish, and short’
- Among primitive tribes like the Jivaro of Ecuador, nearly 60% of male deaths were due to violence, while for Brazilian Yanomamo it was nearly 40%
- “Hunter-gatherers do not trade. They raid. Nor do they save, consuming their food as and when they find it” —the author
- The Spanish conquistadors’ exploitation of the Cerro Rico silver mountain in Bolivia generated massive wealth for Spain but ultimately caused inflation that undermined Spanish economic power, demonstrating that abundant precious metal can be economically destructive
- Between 1556 and 1783, the ‘rich hill’ yielded 45,000 tons of pure silver, making Potosí one of the world’s largest cities with 160,000-200,000 inhabitants
- “Every peso coin minted in Potosí has cost the life of ten Indians who have died in the depths of the mines” —Fray Antonio de la Calancha
- The ‘price revolution’ saw food costs in England increase sevenfold between 1540s and 1640s as silver flooded European markets
- Ancient Mesopotamian clay tablets from 5,000 years ago show that money fundamentally represents trust-based relationships between creditors and debtors rather than precious metal, with the earliest written records being financial transactions
- When human beings first began to produce written records of their activities they did so not to write history, poetry or philosophy, but to do business
- One clay tablet from King Ammi-ditana’s reign states that its bearer should receive a specific amount of barley at harvest time
- “The central relationship that money crystallizes is between lender and borrower” —the author
- “Money is trust inscribed. And it does not seem to matter much where it is inscribed: on silver, on clay, on paper, on a liquid crystal display” —the author
- The Medici family transformed from violent criminals to Europe’s most powerful bankers by developing diversified financial networks and professional accounting methods, showing how finance could create legitimate political power
- Between 1343 and 1360 no fewer than five Medici were sentenced to death for capital crimes
- Giovanni di Bicci de’ Medici’s bank made profits of 151,820 florins between 1397 and 1420 with capital of just 20,000 florins, achieving a 32% rate of return
- “He is King in everything but name” —Pope Pius II
- “The man he chooses holds office… He it is who decides peace and war and controls the laws” —Pope Pius II
- Modern fractional reserve banking allows banks to create money by lending out deposits while keeping only a fraction in reserve, fundamentally changing money from precious metal to credit relationships managed by banks
- The Amsterdam Exchange Bank pioneered cheques and direct transfers by allowing merchants to set up accounts in standardized currency
- The Swedish Riksbank in 1656 became the first to practice fractional reserve banking, lending amounts in excess of its metallic reserve
- By the money game’s end, M0 equals $100 but M1 equals $271, illustrating how fractional reserve banking allows credit creation
- Modern bankruptcy procedures in cities like Memphis demonstrate how contemporary capitalism socializes financial risk while privatizing profits, with easy bankruptcy encouraging risk-taking behavior
- On average, there are between one and two million bankruptcy cases every year in the United States, with Memphis seeing around 10,000 annual filings
- The ability to walk away from unsustainable debts and start all over again is one of the distinctive quirks of American capitalism
- US consumer debt hit a record $2.5 trillion in 2007, rising from 16% of disposable income in 1959 to 24% currently
Of Human Bondage
Government bonds evolved from medieval Italian city-states’ war financing needs and became powerful enough to influence government policy, with the Rothschild family dominating 19th-century international finance before bond markets proved vulnerable to inflation and war.
- Medieval Italian city-states like Florence invented government bonds out of necessity to finance costly mercenary wars, creating the first modern securities markets where citizens became creditors to their own governments
- Florence’s debt burden increased one hundred-fold from 50,000 florins at the beginning of the fourteenth century to 5 million by 1427
- By the early fifteenth century, borrowed money accounted for nearly 70% of the city’s revenue, with the ‘mountain’ equivalent to more than half the Florentine economy’s annual output
- Two thirds of Florentine households had contributed to financing the public debt, though the bulk was from a few thousand wealthy individuals
- The bond market’s power to influence government policy stems from its daily judgment of fiscal credibility and its ability to punish governments with higher borrowing costs, creating feedback loops that can force policy changes
- “I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody” —James Carville
- Even an upward move of half a percentage point can hurt a government running a deficit, adding higher debt service to already high expenditures
- “The bond market began by facilitating government borrowing. In a crisis, however, it can end up dictating government policy” —the author
- Nathan Rothschild built the world’s largest banking empire by exploiting the Napoleonic Wars’ financial chaos, making his fortune not from Waterloo’s outcome but from a massive post-war bet on British government bonds
- Between 1815 and 1859, the London house issued fourteen different sovereign bonds worth nearly £43 million, more than half the total issued by all London banks
- Nathan bought more British bonds and held his nerve for another year until late 1817, when bond prices had risen 40%, earning profits worth around £600 million in today’s money
- “Money is the god of our time, and Rothschild is his prophet” —Heinrich Heine
- “They are in money and funds what Bonaparte was in war” —Barings partner
- The Confederate States’ attempt to finance the Civil War through cotton-backed bonds failed when Union forces captured New Orleans, demonstrating how military control of collateral determines bond market success
- The Confederacy issued cotton-backed bonds that could be converted into cotton at pre-war prices of six pence a pound
- The fall of New Orleans in April 1862 was the real turning point because investors could no longer take physical possession of cotton backing their bonds
- By 1863 Confederate ‘greybacks’ were worth just one cent compared to Union ‘greenback’ dollars worth 50 cents in gold
- German hyperinflation of 1923 destroyed bondholders while demonstrating that hyperinflation is fundamentally a political phenomenon rather than merely an economic one, requiring institutional breakdown to occur
- By the end of 1923 there were approximately 4.97 × 10²⁰ marks in circulation with twenty-billion mark notes in everyday use
- The annual inflation rate reached a peak of 182 billion per cent with prices 1.26 trillion times higher than in 1913
- “Hyperinflation is always and everywhere a political phenomenon, in the sense that it cannot occur without a fundamental malfunction of a country’s political economy” —the author
- “There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency” —attributed to Lenin
- Argentina’s repeated cycles of inflation and default from the 1970s onward illustrate how political divisions and weak institutions prevent countries from maintaining stable monetary policy even when economic solutions are known
- Argentina declined from the world’s sixth-richest country in the 1880s to suffering 5,000% annual inflation in 1989
- In February 1989 Argentina literally ran out of money when the mint ran out of paper and printers went on strike
- The 2001 default on $81 billion in foreign debt was the biggest in nominal terms in history, with creditors accepting bonds worth roughly 35 cents on the dollar
Blowing Bubbles
Stock markets create wealth by allowing companies to raise capital but are prone to recurring bubbles driven by human psychology, from the 1720 Mississippi and South Sea bubbles to modern crashes like Enron, following predictable five-stage patterns of displacement, euphoria, mania, distress, and revulsion.
- Stock market bubbles follow a consistent five-stage pattern regardless of time period or technology involved, driven by human psychology rather than rational economic calculation
- Displacement: Some change in economic circumstances creates new profitable opportunities
- Euphoria: A feedback process where rising expected profits lead to rapid growth in share prices
- Mania: The prospect of easy capital gains attracts first-time investors and swindlers
- Distress: Insiders realize profits cannot justify exorbitant prices and begin selling
- Revulsion: As prices fall, outsiders stampede for exits, causing the bubble to burst
- John Law’s Mississippi Company bubble in 1720 France demonstrated how a single individual could manipulate an entire economy by controlling money creation, securities issuance, and government finance simultaneously
- Law combined control of the French central bank, the Mississippi Company monopolizing trade with Louisiana, and collection of all France’s taxes
- “I have discovered the secret of the philosopher’s stone, it is to make gold out of paper” —John Law
- By 1719 the original ‘mother’ shares stood at 5,000 livres before reaching a peak of 10,025 on 2 December
- The word millionaire was first coined during these heady times
- The Dutch East India Company represented a successful long-term corporate model that avoided bubble dynamics through genuine profitable operations, diversified management structure, and gradual price appreciation over 130 years
- Between 1602 and 1733, VOC stock rose from par (100) to an all-time peak of 786, sustained capital appreciation combined with regular dividends
- By 1650, total dividend payments were already eight times the original investment, implying an annual rate of return of 27%
- “We cannot make war without trade, nor trade without war” —Jan Pieterszoon Coen
- There was never such a thing as a Dutch East India Company bubble, unlike tulip futures or other contemporary speculations
- The 1929 Wall Street crash and subsequent Great Depression resulted primarily from Federal Reserve policy mistakes that turned a stock market correction into economic catastrophe, rather than from the crash itself
- Between 1929 and 1933, around 10,000 banks failed while commercial bank deposits decreased by 37% and loans by 47%
- An increase of cash in public hands of $1.2 billion was achieved at the cost of a decline in bank deposits of $15.6 billion
- “The most significant economic event of the era since World War II is something that has not happened: there has not been a deep and long-lasting depression” —Hyman Minsky
- “The Fed should have aggressively sought to inject liquidity into the banking system from 1929 onwards” —Milton Friedman
- The Enron scandal of 2001 paralleled John Law’s Mississippi scheme in using complex financial engineering to hide losses while executives enriched themselves, demonstrating how accounting fraud enables modern bubble companies
- Enron’s executives used special-purpose entities to conceal debts and losses while reporting fake profits quarter after quarter
- In the final year of its existence Enron paid its top 140 executives an average of $5.3 million each
- “All that matters is money… You buy loyalty with money. This touchy-feely stuff isn’t as important as cash” —Jeffrey Skilling
- By November 2007 it was revealed that the audited balance sheet had understated long-term debt by $25 billion
- Stock market volatility exhibits ‘fat tails’ with extreme movements occurring much more frequently than normal distribution would predict, making major crashes statistically inevitable rather than aberrant
- If stock market movements followed the normal distribution, an annual drop of 10% would happen only once every 500 years, whereas it happens about once every five years
- Stock market plunges of 20% or more would be unheard of like people just a foot tall, whereas there have been nine such crashes in the past century
- On ‘Black Monday’, 19 October 1987, the Dow fell by 23%, yet within little more than a year it was back to pre-crash levels
The Return of Risk
Insurance evolved from Scottish ministers’ widow funds to modern welfare states, but rising costs of aging populations and natural disasters are challenging both private insurance and government safety nets, leading to new risk management approaches including microfinance and hedge fund strategies.
- Hurricane Katrina’s aftermath revealed the failure of America’s bifurcated insurance system, where private companies covered wind damage while the federal government covered flooding, leading to widespread disputes and coverage gaps
- There were 1.75 million property and casualty claims with estimated insurance losses exceeding $41 billion, making Katrina the costliest catastrophe in American history
- Insurance companies avoided paying by asserting that damage was due to flooding rather than wind, leading to thousands of disputes
- Total non-insured damages cost the federal government at least $109 billion in post-disaster assistance, nearly three times the estimated insurance losses
- Scottish ministers Robert Wallace and Alexander Webster created the first modern insurance fund in 1744 by applying mathematical principles to calculate premiums and build capital reserves, establishing the actuarial foundation of all subsequent insurance
- Wallace and Webster calculated that 930 ministers were alive at all times, with 27 dying yearly and 18 leaving widows
- They projected the fund would grow from £18,620 in 1748 to £58,348 in 1765 and were off by just one pound - the actual amount was £58,347
- “An economic institution resting on the principle of mutuality, established for the purpose of supplying a fund, the need for which arises from a chance occurrence whose probability can be estimated” —Alfred Manes
- “It is experience alone & nice calculation that must determine the proportional sum the widow is to have” —Robert Wallace
- The welfare state emerged from warfare needs but created unsustainable demographics as aging populations and healthcare costs overwhelmed pay-as-you-go systems designed for younger societies with shorter lifespans
- “Otto von Bismarck introduced the first compulsory state health insurance and pensions to create ’the conservative state of mind that springs from the feeling of entitlement to a pension’” —Otto von Bismarck
- Japan achieved the most successful welfare system by 1975, spending just 9% of national income on social security compared to 31% in Sweden
- Between now and 2050, the share of Americans aged 65 or over is projected to rise from 12% to nearly 21% of the population
- According to one projection, Medicare alone will absorb 24% of all federal income taxes by 2019
- Milton Friedman’s Chilean pension reform experiment replaced a failing pay-as-you-go system with individual retirement accounts managed by private companies, achieving economic growth at the political cost of supporting a military dictatorship
- José Piñera created Personal Retirement Accounts allowing workers to invest 10% of wages with private fund managers instead of paying payroll taxes
- By 1990 more than 70% of Chilean workers had switched to the private system, each receiving a book recording their contributions and returns
- The growth rate in the fifteen years before Friedman’s visit was 0.17%; in the fifteen years after, it was 3.28%, nearly twenty times higher
- “Their present difficulties were due almost entirely to the forty-year trend toward collectivism, socialism, and the welfare state” —Milton Friedman
- Modern hedge funds like Kenneth Griffin’s Citadel represent a new class of sophisticated risk managers who profit from volatility and uncertainty rather than trying to eliminate it, creating a divide between the hedged and unhedged
- Kenneth Griffin’s Citadel manages around $16 billion in assets and generated annual returns of 21% since 1998
- In 2007, when other financial institutions were losing billions in the credit crunch, Griffin personally made more than a billion dollars
- The world’s economic system has never been better protected against the unexpected through derivatives and other risk management tools
- Hedge funds typically ask for minimum six or seven-figure investments and charge management fees of at least 2% plus 20% of profits
- Microfinance organizations like Pro Mujer demonstrate that women in developing countries are better credit risks than men, challenging traditional assumptions about creditworthiness and gender roles in financial services
- Muhammad Yunus’s Grameen Bank has made microloans worth more than $3 billion to nearly seven and a half million borrowers, nearly all women with no collateral
- Pro Mujer loans start at around $200 for three months, with women using the money to buy livestock or fund micro-businesses
- Men were much more likely to spend their wages in the pub or betting shop than worry about making interest payments
- Some microfinance firms charge interest rates as high as 80 or even 125% per year, rates worthy of loan sharks
Safe as Houses
The property-owning democracy emerged from government policies promoting home ownership through mortgage subsidies and insurance, but the 2007 subprime crisis revealed that real estate is not inherently safe, while property rights alone cannot guarantee economic development as shown by experiences from Argentina to China.
- The board game Monopoly, originally designed to critique landlord exploitation, became a celebration of property ownership that shaped popular attitudes about real estate as the ultimate investment strategy
- Elizabeth Phillips created The Landlord’s Game in 1903 to expose the iniquity of a system where landlords profited from rents collected from tenants
- Charles Darrow redesigned it for commercial appeal during the Great Depression, and by 1935 a quarter million sets had been sold
- “What the game tells us, in complete contradiction to its original inventor’s intention, is that it’s smart to own property. The more you own, the more money you make” —the author
- Franklin D. Roosevelt’s New Deal created the modern American mortgage system through government agencies like the FHA and Fannie Mae, making home ownership politically attractive as an alternative to socialist revolution
- Before the 1930s, mortgages were short-term for 3-5 years without amortization, requiring balloon payments that caused massive foreclosures during the Depression
- The Federal Housing Administration standardized long-term, fully amortized, low-interest loans up to 80% of purchase price
- “You know, George, I feel that in a small way we are doing something important. Satisfying a fundamental urge. It’s deep in the race for a man to want his own roof and walls and fireplace” —Bailey Sr. in It’s a Wonderful Life
- Home ownership rates rose from 40% to 60% by 1960 as government underwriting made mortgages widely available
- The Savings and Loan crisis of the 1980s demonstrated how deregulation without proper oversight enables massive fraud, with operators like Danny Faulkner in Texas using federally insured deposits to fund speculative real estate schemes
- One parcel of land was bought by Faulkner for $3 million and sold just a few days later for $47 million in artificial price inflation
- “You bring the dirt, I bring the money” —Tyrell Barker
- “The best way to rob a bank is to own one” —William Crawford
- The final cost of the Savings and Loans crisis was $153 billion, of which taxpayers paid $124 billion, making it the most expensive financial crisis since the Depression
- Wall Street’s securitization revolution, pioneered by Lewis Ranieri at Salomon Brothers, transformed mortgages into tradeable bonds but eliminated the personal relationships that had previously governed lending decisions
- Lewis Ranieri bought up mortgages from desperate Savings and Loans at rock-bottom prices and bundled them into mortgage-backed securities
- Between 1980 and 2007, GSE-backed mortgage-backed securities grew from $200 million to $4 trillion
- In a securitized market, no one can hear you scream because the interest you pay goes to someone who has no idea you exist
- It was the dawn of a new era where anonymous transactions would count for more than personal relationships
- The subprime mortgage crisis originated in cities like Detroit where predatory lenders targeted minority communities with complex loans, creating a global crisis when these mortgages were securitized and sold worldwide
- In Detroit’s 48235 ZIP code, subprime mortgages accounted for more than half of all loans made between 2002 and 2006
- 55% of black and Latino borrowers in Boston received subprime mortgages compared to just 13% of white borrowers
- “We want everybody in America to own their own home” —George W. Bush
- Norwegian municipalities invested $120 million in CDOs secured on American subprime mortgages, allocating risk to those least able to understand it
- Hernando de Soto’s theory that property rights alone can unlock economic development has shown mixed results in practice, as demonstrated in places like Quilmes, Argentina, and Peru, where formal ownership hasn’t automatically led to increased access to credit
- De Soto calculated that the total value of real estate occupied by the world’s poor amounts to $9.3 trillion, nearly equal to the market capitalization of the world’s top twenty stock markets
- In Quilmes, only 4% of property owners have managed to secure mortgages despite having legal title
- Out of more than 200,000 Lima households awarded land titles in 1998-99, only around a quarter had secured loans by 2002
- “Property law is not a silver bullet, but it is the missing link… Without property law, you will never be able to accomplish other reforms” —Hernando de Soto
From Empire to Chimerica
The first era of globalization ended catastrophically in 1914 despite financial integration, while today’s ‘Chimerica’ - the symbiotic relationship between Chinese savings and American consumption - may face similar political tensions that could destabilize the current global financial system.
- The first era of financial globalization before 1914 featured unprecedented capital mobility and integration, with British investors holding foreign assets equivalent to 150% of UK GDP, yet ended abruptly in the catastrophe of World War I
- By 1913, $158 billion in securities existed worldwide, of which $45 billion (28%) were internationally held
- 25% of the world’s foreign capital in 1913 went to countries with per capita incomes one-fifth or less of US levels, compared to just 5% in 1997
- The Victorians imposed property rights, rule of law, and non-corrupt administration as ‘public goods’ of liberal imperialism
- By 1911, a telegraphic message took just thirty seconds from New York to London at 0.5% of the 1866 cost
- British firms like Jardine Matheson used military force to open Chinese markets for opium trade, establishing the principle that imperial power could enforce investment security through ‘gunboat diplomacy’
- William Jardine convinced Lord Palmerston to use military force after China destroyed £2 million worth of opium and demanded British subjects submit to Chinese law
- The Treaty of Nanking in 1842 ceded Hong Kong to Britain and opened five treaty ports where British subjects operated with complete immunity from Chinese law
- Between 1865 and 1914, British investors put at least £74 million into Chinese securities, though this was tiny compared to total £4 billion held abroad
- The outbreak of World War I in July 1914 caused the first global financial meltdown, forcing the closure of all major stock markets for months and requiring unprecedented government intervention to prevent complete collapse
- The Vienna market closed on 27 July, followed by all continental European exchanges by 30 July, then London and New York on 31 July
- The London Stock Exchange remained closed until 4 January 1915, the first such closure since its founding in 1773
- Russian bonds fell 8.8%, British consols 9.3%, French rentes 13.2% and Austrian bonds 23% by end of 1914
- “No act of state-sponsored terrorism has had greater financial consequences than Gavrilo Princip’s assassination of Archduke Franz Ferdinand” —the author
- George Soros proved that hedge funds could defeat central banks through massive speculation, as demonstrated when he broke the Bank of England in 1992 by betting $10 billion against the pound’s membership in the European Exchange Rate Mechanism
- Soros reasoned that rising German reunification costs would drive up interest rates and the Deutschmark, making Britain’s currency peg untenable
- “How big a position do you have? One billion dollars. You call that a position?” —George Soros
- His fund made more than a billion dollars as sterling slumped by as much as 20%, earning 40% of the year’s profits from this single trade
- “Markets never reach the equilibrium postulated by economic theory due to reflexive connections between perception and reality” —George Soros
- Long-Term Capital Management’s spectacular failure in 1998 demonstrated the dangers of applying mathematical models based on limited historical data to complex financial markets prone to extreme events
- Myron Scholes and Robert Merton won the Nobel Prize in October 1997, just months before their fund nearly collapsed
- LTCM’s models said there was a 1 in 10^24 probability of losing all capital in a single year, effectively zero risk
- On Friday 21 August 1998, LTCM lost $550 million - 15% of its entire capital - driving leverage up to 42:1
- “If I had lived through the Depression, I would have been in a better position to understand events” —John Meriwether
- ‘Chimerica’ - the symbiotic economic relationship between China and America - created the conditions for the 2007 financial crisis by flooding global markets with cheap credit from Chinese savings directed toward American consumption
- China ran a current account surplus of $262 billion in 2007, over a quarter of the US deficit of around $800 billion
- The average American earns $34,000 per year while the average Chinese lives on less than $2,000, yet China lends money to America
- Thanks to Chimerica, global real interest rates sank by more than a third below their fifteen-year average
- Chimerica was the underlying reason why the US mortgage market was so awash with cash in 2006 that you could get a 100% mortgage with no income, job or assets
- The rise of sovereign wealth funds represents a potential reversal of financial power from West to East, with state-owned entities from Asia and the Middle East becoming major investors in struggling Western financial institutions
- By end of 2007, sovereign wealth funds had around $2.6 trillion under management, more than all hedge funds combined
- According to Morgan Stanley forecasts, within fifteen years they could control assets of $27 trillion - just over 9% of total global financial assets
- “If we see a big fat rabbit, we will shoot at it. Some people may say we were shot by Morgan Stanley” —Lou Jiwei
- For the proponents of ‘market fundamentalism’, here was a painful anomaly: among the biggest winners were state-owned entities
Afterword: The Descent of Money
Financial systems have evolved like biological species through mutation, natural selection, and extinction, with today’s credit crisis representing another evolutionary pressure that will eliminate weak institutions while creating new financial life forms.
- Financial history follows Darwinian evolutionary principles, with institutions undergoing mutation through innovation, competing for resources, and facing extinction through market forces rather than central planning
- Financial organisms are in competition with one another for finite resources, with market selection as the main driver
- “Just as some species become extinct in nature, some new financing techniques may prove to be less successful than others” —Anthony W. Ryan
- Around one in ten US companies disappears each year, with 611,000 businesses vanishing annually out of 5.73 million firms
- Of the world’s 100 largest companies in 1912, 29 were bankrupt by 1995, 48 had disappeared, and only 19 remained in the top 100
- Human cognitive biases systematically distort financial decision-making, as demonstrated by experiments showing people miscalculate probabilities and exhibit asymmetric risk preferences that favor losses over equivalent gains
- Daniel Kahneman and Amos Tversky found people exhibit risk aversion for positive prospects but risk seeking for negative ones
- A loss has about two and a half times the impact of a gain of the same magnitude on human psychology
- Common cognitive traps include availability bias, hindsight bias, confirmation bias, and overconfidence in calibration
- A bat and ball cost £1.10 total with the bat costing £1 more than the ball - roughly half of people incorrectly answer that the ball costs 10 pence rather than 5 pence
- Financial crises occur in the realm of uncertainty rather than calculable risk, as Frank Knight and John Maynard Keynes argued, because many future events are genuinely unprecedented and cannot be predicted using historical data
- “Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk… A measurable uncertainty is not in effect an uncertainty at all” —Frank Knight
- “About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know” —John Maynard Keynes
- “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 twenty years hence” —John Maynard Keynes
- We are doomed to be ‘fooled by randomness’ and surprised by ‘black swans’ despite unprecedented sophistication
- The 2007-2008 financial crisis represents an evolutionary pressure that could eliminate weak financial institutions while creating new species, with potential losses exceeding $1 trillion requiring massive balance sheet contractions
- Around $318 billion of write-downs have been acknowledged, meaning more than $600 billion of losses have yet to come to light
- Banks typically target a constant capital/assets ratio of less than 10%, implying balance sheets may need to shrink by $1 trillion
- “As with past forest fires in the markets, we’re likely to see incredible flora and fauna springing up in its wake” —Andrew Lo
- “This economic system cannot do without the ultima ratio of the complete destruction of those existences which are irretrievably associated with the hopelessly unadapted” —Joseph Schumpeter
- Financial markets serve as mirrors of human nature rather than monsters to be controlled, reflecting both our virtues and flaws while facilitating the essential function of allocating capital to productive uses
- “The financial system is the brain of the economy… It acts as a coordinating mechanism that allocates capital to its most productive uses” —Frederic Mishkin
- Financial intermediation generally permits a more efficient allocation of resources than feudalism or central planning
- “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” —the author
- “It is not the fault of the mirror if it reflects our blemishes as clearly as our beauty” —the author