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Follow the Money

John Bradley

A Concise History of International Finance: From Babylon to Bernanke, by Larry Neal, Cambridge University Press, 361 pp, £19.99, ISBN: 978-110762121

A question can often be more revealing than an answer. On a visit to the London School of Economics in November 2008, Queen Elizabeth famously asked a professor why, since the global financial crisis was so large, it took so many economics experts by surprise. Attempting to explain the origins and effects of the crisis, the professor told the queen: “At every stage, someone was relying on somebody else and everyone thought they were doing the right thing.” But the sorry and inescapable fact was that the financial crisis and the ensuing global recession took the economics profession, policy-makers and just about everyone else by surprise. It was not predicted, other than by a few Cassandra voices, who were ignored, and even ridiculed, at the time. The economics profession ‑ including Alan Greenspan, the guru-like chairman of the US Federal Reserve System in office during the pre-crisis decades ‑ whose members should have known better, was blind to the emergence, rapid growth and toxic implications of a vast shadow international banking industry, even as it grew to many times the size of the world economy.

Professor Neal opens his book with another question, posed in September 2008, after the collapse of Lehman Brothers, by former president George W Bush to his treasury secretary, Henry Poulson, and the then relatively new Fed chair, Ben Bernanke, who had replaced Greenspan:

Someday you guys are going to need to tell me how we ended up with a system like this ... we’re not doing something right if we’re stuck with these miserable choices.

Neal’s book is an effort to explain to Bush how the world ended up “stuck with these miserable choices”. But in the light of the well-documented short attention span of former president Bush, and his notorious lack of interest in anything intellectual, the explanation is unlikely to be of much use. Neal’s book is a masterly and exhaustive exposition of the origins and evolution of the role played by international finance in generating and sustaining local and global growth and development as well as funding warfare and conquest, from the time of the Babylonians to the rise of the euro and the recent sub-prime crisis. My guess is that he would have lost Bush at the Babylonians.

The origins of this concise history lie in graduate courses Neal taught in financial history in both the US and the UK which heavily influenced the nature of his exposition of this fascinating subject. This is likely to restrict his success in communicating with a wider “lay” audience. The mood of the book is serious, the style of exposition pedagogic, and the focus narrowly on the core aspects of financial history to the exclusion of much by way of wider entertaining consideration of the role played by historical actors or the quirks of personalities and events. There are many graphs, but no pictures, and even the graphs are not always fully integrated into the text as aids to the exposition of complex issues. Graduate teaching by Professor Neal is more like an invitation to try to understand complex issues rather than any simple explanation. Students (and readers) are expected to be active participants rather than passive observers.

On a first reading, the going is tough and one finds oneself yearning for the kind of popular writing exemplified by Niall Ferguson’s entertaining account The Ascent of Money: A Financial History of the World, published just before the latest crisis in 2006, with its copious pictures and pen-portraits of the geniuses and rogues who, since time began, were attracted to finance like moths to a bright light. One also fondly recalls the acerbic writing style and ironic wit of JK Galbraith in his classic Money: Whence it Came, Where it Went, dating back to the seemingly simpler age of 1975. And if you are only interested in the history of finance from the perspective of catastrophic failure, try This Time is Different: Eight Centuries of Financial Folly, by Carmen Reinhart and Kenneth Rogoff, published in 2009. But if you are prepared to put in some time, and to get out from under entertaining accounts of the more spectacular and often disastrous episodes of the history of finance, you will find that Neal’s book pays big dividends in terms of deep insights and understanding.

The driving logic of Larry Neal’s study is that at its best, innovation in financial systems since the earliest recorded history has dramatically increased trade, enabled long-term investments in technical progress and served to improve general standards of living. He rejects the widely held view that finance is simply the passive handmaiden of industry, not a prime mover. But he emphasises that it is very difficult to keep national financial systems coordinated effectively while financial innovations are taking place or when warring armies ravage the land. Failures of coordination can lead to disaster. The core task of wise policy-makers is the identification of effective solutions to crises and to learn enough to avoid repeating them.

Just as generals tend to fight today’s war using the lessons of yesterday’s, so policy-makers and analysts tend invariably to interpret today’s financial or economic crisis in terms of the last crisis of comparable seriousness. When the global crisis of 2008 hit, there was a flurry of renewed interest in the Great Depression of 1929-1933 and its dreadful aftermath. At the time of the Great Depression, the financial panic of 1907 guided actions (after the failure of the largest trust company in the US, with contagion spilling over to London, Paris, Berlin and Milan). And in 1907, people looked back to the Baring Crisis of 1890 (when the London-based Barings Bank almost failed because of its over-exposure to South American loans and had to be rescued by the Bank of England). One can continue to go back in time: to the post-Napoleonic War crises of 1819 and 1825; to the earlier Mississippi and South Sea bubbles of 1719 and 1720; to the Dutch Tulip Mania of 1636-1637. As Neal says:

So the search for historical analogies is as much a feature of financial crises as the condemnation of financiers held responsible for the collapse in asset values and the consequent regulatory responses by public authorities.

If there is a single important message in Neal’s book, it is that understanding how the financial system evolved and how crises occurred requires one to start at the beginning and to work forward, rather than at the end and work backwards. In the beginning, when the first records of financial transactions were made, which are now available to students of history, life was simpler:

Two factors have led to the rise of finance historically: long-distance trade and long-lived productive assets. Markets for goods and services and markets for assets both require some form of finance to bridge the time between when agreement on a trade is reached and when actual delivery occurs or when the structure is completed.

The description of the evolution of finance from these simple beginnings in the lower Euphrates valley around 3000 BC to the complex financial systems of today provides the fascinating core of Neal’s book. This was never a smooth process but was regularly interrupted by rogues, wars and natural catastrophes. Modern finance, in the sense that we can understand it today, originated in the Italian city-states in the period from the collapse of the Roman empire in the West to the end of the sixteenth century. However, international financial capitalism only took off in the seventeenth century, with the rise of the Dutch Republic and the emerging political rivalry between France and Britain:

The financial innovations in France, England, and the Netherlands after 1720 had international repercussions that proved important for the outcomes of the successive wars and revolutions that followed, right up to the Treaty of Vienna in 1815.

It is in developing these themes that Neal requires one to reverse the usual way of thinking about politics and finance. Normally we think of wars having financial implications, such as enriching the victor and impoverishing the loser. But Neal sees the financial system itself as having political implications that can pre-determine the outcomes of wars.

Had Napolean fully understood the possibilities of Dutch finance for financing and provisioning his armies, he might have been able to establish his empire over Continental Europe. As it turned out, despite his brilliant efforts at reshaping French public finances and re-organizing the French military, he failed to coordinate successfully banks, capital markets, and financial regulation for France and paid scant attention to the financial institutions in satellite kingdoms.

Perhaps more strikingly, he observes that

With his decisive victory at Austerlitz in December 1805, however, Napoleon returned triumphant to Paris only to find his financial system in total disarray.

This is a change in historical perspective that takes a while to understand and partially accept. We would all like to believe that finance is merely the handmaiden of politics and can be bent to the will of benign policy-makers for the betterment of mankind in general. After reading Neal’s book, one is forced to re-examine that comforting hypothesis and to accept that the forces inherent in the financial system, be they national or international, can often pre-determine political and economic outcomes. This kind of pre-determination is not always bad, particularly when viewed in the broad historical perspective of Neal’s narrative. In particular, it may be better than the drastic alternative, that is the overthrow of capitalism in its entirety. But it can give rise to morally dubious attitudes and actions. For example, in this perspective the Irish Famine appears as just a minor disruption to the British financial system:

As the demands for cash from the Bank grew sharply after 1845 due to the combined effects of dealing with the Irish famine, harvest shortfalls on the Continent, the fall in prices of railroad securities that had been floated at the height of the railway mania in Britain, and the trade credit crisis of 1847, the Bank had to ask for waiver of the note cover for the Issue Department in order to accommodate the demands on it for cash in the Banking Department.

In a book of this kind, where matters about which one knows very little are being explained and where one does not have direct access to original sources, accuracy is very important. The fear is that of falsus in uno, falsus in omnibus. Consequently, it is a little disturbing to note a few minor, but irritating, errors. For example, Hitler was appointed chancellor on January 30th, 1933 and not in 1932. Greece joined the European Common market in 1981 and not in 1979. But perhaps the most disturbing error concerns Neal’s discussion of the consequences for Ireland of joining the EMS in 1978. Recall that the EMS was a precursor to EMU and the adoption of the euro on January 1st, 1999.

The British decision to stay out of the EMS forced Ireland and Denmark, two small open economies whose major trading partner had traditionally been Great Britain before they entered the Common Market in 1973, to decide where their future lay. Both opted to stick with Germany and to take their chances on trade with Britain. That proved costly as the pound floated with respect to the Deutsche Mark and fell sharply in terms of the latter and even relative to the US dollar. In the short run, the decision to peg the Irish punt to the Deutsche Mark proved especially painful for Ireland, as it found itself priced out of much of its traditional British market and not yet competitive in the rest of the EC. No doubt the Irish government judged the economic costs worth bearing for the political independence from Britain it gained by committing its future to Continental Europe.

On a personal note, on March 30th, 1979 I experienced the break in the link between the Irish punt and sterling with a ringside seat in the dealing room in the Central Bank of Ireland. The break, when it came, was an interesting development, both economically and psychologically. When Ireland joined the EMS in 1978 there had been hope that it would still prove possible to maintain the punt’s value at par with sterling while still remaining within the fluctuation limits imposed by membership of the EMS, even with sterling outside the EMS. But the strength of sterling in the aftermath of the EMS, buoyed up as it was by the start of North Sea oil revenues and by the tight monetary policy of the new Thatcher administration, put paid to that hope. It is arguable that a continuation of the sterling link into the early 1980s would have proved politically unsupportable, considering the loss of competitiveness that it might have entailed at a time of rapidly growing unemployment associated with the fiscal adjustment of those years. Only much later, in the early 1990s, for a brief period the Irish pound did rise above the old parity.  

This is not an easy book to read. But in an age of instant commentary and fractious debate, it makes a good case for dispassionate (perhaps too dispassionate?) analysis of the complex world of international finance. For only armed with a knowledge of the historical background of how international finance came into being and evolved over time can one legitimately rage against the self-serving bankers and indolent regulators who perverted a system that had such potential to increase welfare and ease human suffering.

1/4/2016

John Bradley was for many years a research professor at the ESRI and now works as an international consultant in the area of economic and industrial strategy. He regularly advises the European Commission, the World Bank and other international organisations and governments on policy issues related to promoting long-term economic growth and development. This essay is a revised form of words spoken at the Dublin launch of A Time to Speak in November last year. Results from the IFI-supported North-South project referred to in the text are reported in The two economies of Ireland: Public policy, growth and employment, Bradley, J (ed) (1995), Irish Studies in Management. Dublin: Oak Tree Press in association with University College Dublin, Graduate School of Business.

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