The Ascent of Money: A Financial History of the World

Chapter 6 discusses globalization and the rise of China’s economy to become intertwined in the American economy such that the author calls the phenomenon “Chimerica.” The East and the West were roughly equal in terms of per capita income 300-400 years ago, and in many ways China was much more advanced. But “between 1700 and 1950 there was a ‘great divergence’ of living standards between East and West” (285). Of the many possible reasons for this, Ferguson focuses on financial differences. Conditions in China prevented the need for the financial innovation that previous chapters have shown took place in Europe. When such innovations did come to China, they were part of a colonial episode and thus were identified with imperialism. As a result, by the mid-20th century, both China and India had largely disengaged from global markets.

“Globalization and Armageddon”

This section examines the globalization that began in the 19th century in China. Ferguson begins with the story of the first Opium War that began in 1839. The British trading company named Jardine and Matheson had been importing opium from India to the southern Chinese city of Guangzhou (then called Canton by Westerners). This was in violation of Chinese law, though they were able to continue doing so for some time. However, a new official in Canton named Lin Zexu was ordered by the emperor to crack down on the trade, and impounded and destroyed a large supply of opium.

Jardine returned to London, where he persuaded the British government to attack China in response. After Britain won the battles that followed, it imposed a number of concessions on the Chinese government, such as the creation of several “treaty ports,” where the British could trade freely in goods, including opium. Jardine and Matheson went on to great success during the century, diversifying their business, which they headquartered in Hong Kong (one of the ports taken from China). “For China,” Ferguson writes, “the first Opium War ushered in an era of humiliation” (291-92).

From the middle of the 19th century until World War I began was the first great era of globalization, as investment was possible around the world. Ferguson gives detailed examples of this, including a page from a Rothschild ledger listing securities from multiple countries and the fact that almost half of the securities on the London Stock Exchange in 1913 were foreign bonds. He argues that the power of British empire had much to do with investors’ confidence in such far-flung trading. Not only was its navy able to intervene like it did in China, but also the colonies under its power were set up with British institutions that were deemed trustworthy. Still, events happened outside their control to influence investments. China, for example, became involved in a war with Japan just before the turn of the century and then had a political revolution prior to World War I. As Ferguson notes, “This vulnerability of early globalization to wars and revolutions was not peculiar to China. It turned out to be true of the entire world financial system” (296).

Investors had reasons for confidence in the years leading up to the war. Many factors, including improved communications, had improved the conditions for investing, fostering optimism. Above all, many people thought that war on a large scale would not be possible precisely because of globalization: countries were too interconnected economically and financially for that to happen. When war did break out following the assassination of the Austrian Archduke Franz Ferdinand in the early summer of 1914, markets did not react much right away. Later that summer, however, reality set in and droves of investors tried to sell to improve their cash situation. The effect was that “liquidity was sucked out of the world economy as if the bottom had dropped out of a bath” (298). Stock markets around the world closed for several months. The gold standard, which had once been considered a stabilizing factor, was now seen as a destabilizing factor: it added to the liquidity crisis when so many people wanted to convert their notes to gold, which was safer. To counteract this, both Britain and the United States printed money and increased the supply in circulation. The war dragged on for four years and was hugely destructive; hyperinflation and currency crises wreaked more havoc after the war ended. Governments retracted to try to repair and insulate themselves from the damage, and the era of globalization ceded to “the ideal of a de-globalized society” (303). Numerous causes of the war seemed apparent after the fact, so Ferguson ponders why it was not predicted. One answer, which has implications for today, is that a generation had passed since the last war in Europe: short memories led people to be overconfident.

“Economic Hit Men”

In a reaction to the war, the period of the 1930s to the late 1960s saw very little financial globalization. Near the end of World War II, leaders of the Allied countries met in Bretton Woods, New Hampshire, to craft a financial vision for the postwar period. Strong restrictions were placed on the flow of capital between countries; when it did happen, it involved transfers between governments, as in the Marshall Plan, which sent American funds to rebuild countries in Western Europe. To oversee and regulate this, two institutions were created: the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (later known as the World Bank).

While the Marshall Plan was successful, aid to Latin America and developing countries proved to be more controversial. The United States imposed other conditions (political, for example) along with the aid, which some saw as heavy-handed attempts at control. Restrictions on capital were eased in the 1970s, and once again international investment took off. Borrowing by Latin American countries soared; Mexico defaulted on its debts. When further aid came, it did so with conditions for economic reform, which critics saw as “the same old Yankee imperialism” in the guise of the IMF and the World Bank (309). What’s more, some argued that the recipient countries were pressured to use the aid to purchase American goods. One economist even claimed that the leaders of Ecuador and Panama were assassinated in 1981 for opposing this system, although Ferguson dismisses this as unlikely.

Hedge fund managers symbolize well this new era of freely flowing capital in the 1970s and 1980s. Unlike the above institutions, they had no allegiance to a particular country or political system. The example Ferguson gives is George Soros, who founded the Quantum Fund in 1973. His theory about markets is something he calls “reflexivity,” in which the biases of current investors influence the market, and what happens in the market influences investors’ biases, starting the cycle anew. Soros invested wisely, and correctly, making tidy profits in the 1970s and 1980s. But in 1992 he had his greatest success when he bet—and won—big on a drop in the value of the British pound. From 1969 to 1994, the average annual rate of return for Soros’s two hedge funds was 35%. The success of Soros relied more or less on his instincts; soon, others devised a mathematical formula to represent the behavior of the market.

“Short-Term Capital Management”

In 1994, Myron Scholes, Robert Merton, and John Meriwether created the firm Long-Term Capital Management (LTCM). Working with another economist named Black, Scholes had devised a complex formula to predict options, which came to be known as the “Black-Scholes model” of options pricing. Scholes and Merton adapted it for LTCM, which made millions at a quick clip: returns in each of its first two years were over 40%. One of their larger investment bets was selling options on American and European stocks in the long term. That is, the options could be exercised if there were large changes in stock prices. The Black-Scholes model indicated there would not be. Also, LTCM had almost no investments in emerging markets, so they felt both confident in their model and safe.

Scholes and Merton were awarded the Nobel Prize in economics in 1997 for their model, but within months its infallibility was put to the test. Stocks started going down in May 1998 and fell more throughout the summer. The 1997 financial crisis in Asia, combined with the collapse of the Russian economy in 1998, struck fear in investors everywhere: as stocks fell past a certain point, the options that LTCM had sold in large quantities were exercised. This resulted in losses in the hundreds of millions, and LTCM soon failed. In part, they hadn’t realized how interconnected the world had become again, so that crises in emerging economies could affect the markets in developed countries. Also, however, they hadn’t gone back far enough for the data they used in their model, as it hadn’t included the 1987 crash. Ferguson writes that “Meriwether himself, born in 1947, ruefully observed: ‘If I had lived through the Depression, I would have been in a better position to understand events.’ To put it bluntly, the Nobel prize winners had known plenty of mathematics, but not enough history” (329). Hedge funds have continued since then, but their returns have not been as spectacular as in the early decades.

“Chimerica”

The key to the economy of the 21st century has been the rise of China, along with that country’s symbiotic relationship with America. Ferguson refers to the two countries as a single entity: Chimerica. America has relied on borrowing money from China to finance its deficits. The relationship has worked like this: China used manufacturing exports to develop its economy, relying on cheap labor to attract foreign investment. In return, American companies get reduced expenses (lower paid workers) and American consumers get cheaper products in the marketplace. To help keep China’s exports cheaper than American goods, the Chinese government has kept its currency from rising in value by buying up US dollars. The resulting trade imbalance in China’s favor gives them money to buy US government bonds, which finances American deficits and keeps interest rates down. Ferguson compares this situation to that of Britain and Germany preceding World War I. At that time, London was the financial center, and Germany the manufacturing power.