With the Great Recession of 2007–2014 (and counting), the US appeared once again to be the epicenter of global financial crises as it was in the Great Depression of 1929–1933. Just as the stock market panic in New York on October 29, 1929 is a convenient marker for the start of the Great Depression worldwide, so the bankruptcy of Lehman Brothers investment bank on September 15, 2008 marks when the crisis in pricing sub-prime mortgages in the US caused global financial turmoil. It is natural in both cases to blame the US and the failures of its policy makers for the global economic difficulties that followed. Later analyses of the sequence of events leading up to and following the stock market crash of 1929, however, have painted quite a different picture of the Great Depression. As noted in previous chapters, Britain, France, and Germany all had important roles to play in initiating the Great Depression as well as prolonging it. Subsequent analysis of the sub-prime crisis that brought down Lehman Brothers in 2008 and caused worldwide financial panic may also identify other, deeper causes than simply a series of missteps by US policy makers.
For example, the first signs of trouble in the international financial system in 2007 showed up in Germany, just as they had with the Great Depression of 1929–1933. In early August 2007, IKB Deutsche Industriebank in Germany had to get a capital injection of $4.8 billion from a consortium of German banks. IKB's Special Investment Vehicle (SIV) had invested in an exotic Collateralized Debt Obligation (CDO) created by Goldman Sachs in the US, which it now found was worthless. (Eventually, the Goldman Sachs trader who had sold the CDO to IKB, Fabrice Tourre, was convicted of fraudulent felonies, barred from the securities industry, and fined $825,000 for his misdeeds. Avoiding a prison sentence somehow, he decided to work on a PhD at the University of Chicago as of August 2014.)
The exotic financial product that Tourre had put together to appeal to European investors like IKB combined high yields with certification by a reputable intermediary. IKB, coping with the new financial market created by the EMU, was searching for higher-yielding investments than were available in the European markets.
The Eighty Years War between Spain and the Netherlands began in 1568, with resistance by the towns in the Low Countries to the increased taxes levied by Philip II's regent, and then continued off and on until 1648, when the seven northern provinces were recognized as an independent republic in the Treaty of Westphalia (1648). The intensity of the religious conflicts that motivated each side – Philip and his successors as defenders of the Catholic orthodoxy and styled as “Most Catholic Majesties” opposed to Protestants represented by a range of dissenters from pacifist Quakers to assertive Anabaptists – culminated with the Thirty Years War (1618–1648). Under the duress of war finance, the combination of corporate bodies issuing long-term debt and facilitating large-scale transfers of funds across multiple currency borders, a symbiosis that had begun in Italy under papal guidance, now spread into northern Europe. From there, the instruments and organizations for modern international finance would spread across the Atlantic, but with distinctive differences among the European imperial powers and within their colonies in the Americas.
The Thirty Years War completed the financial reorganization of western Europe and laid the basis for the rise of the modern nation-state. In the Treaty of Westphalia, the monarchies of the belligerents recognized the legitimacy of self-governing republics in the United Provinces of the Netherlands and the Helvetian Confederacy of Switzerland. The distraction of Spanish and Austrian rulers from maintaining authority over their overseas possessions allowed the Dutch, English, and French trading enterprises to expand across the Atlantic, making their well-to-do merchants and gentry aware of the possibilities of trade in sugar, tobacco, and slaves while holding out always the allure of possible silver and gold mines, given the Spanish success in Mexico and Peru.
Within the battlefields of central Europe, on the other hand, cities and towns learned to create their own municipal debts by forcing loans from their citizens to pay off the marauding armies who threatened otherwise to burn their wooden walls and dwellings. So-called “brenngeld” became the basis of long-standing municipal debts thereafter known as “Kontributionen,” which were calibrated to the estimated replacement value of the buildings in the city (Redlich 1959).
The accumulated expenses of the War of the Spanish Succession (1701–1714) left each of the great powers of Europe with unprecedented burdens of government debt. The overlapping Great Northern War (1700–1721) also encumbered Sweden and Russia with pressing financial problems. The competitive experiments with ways to deal with their amassed debts among the emerging nation-states of Europe over the next decade ended with Britain alone holding the key to success in war finance. Spain retreated from European expansion to focus on its increasingly productive colonies in Latin America while strengthening mercantile ties with France and allowing provincial elites to regain their local authority over both taxes and coinage. Austria focused on exploiting the trade and finance possibilities through its acquisition of the remaining provinces of the southern Netherlands, which meant renewing the privileges of the city authorities there as well. The Netherlands found that the resources of Holland no longer sufficed to maintain its role among the Great Powers, and the Dutch merchant capitalists turned instead to invest in emerging powers, first Britain, then Germany, Russia, and finally even the new republic calling itself the United States of America. France, having dallied with an attempt to imitate the financial successes of the Netherlands and Great Britain under the tutelage of John Law during the years 1716–1720, reverted to its previous reliance on domestic financiers to sustain both royal authority and provincial aristocracy.
Britain alone among the contesting military powers of Europe in the eighteenth century succeeded in convincing a large and diverse number of individuals to hold onto their claims against the government. Especially important were the foreigners holding British sovereign debt, which included not only the expatriate community of French Huguenots and Sephardic Jews settled in London after the Acts of Toleration in 1689, but also Dutch and German merchant elites, and even the Swiss city of Basel. In the first generation of British financial innovation after 1688, Parliament created a unique combination of chartered corporations to hold most of the national debt created by war finance.
All the industrial core of the Atlantic economy and much of the European periphery were joined financially in the classical gold standard, 1880–1914. The US formally adopted the gold standard in 1879, but already in fact had kept the Civil War greenback dollar at par since 1873. Germany and the Scandinavian Monetary Union had switched from silver to gold in 1871. France and the other members of the Latin Monetary Union soon joined as well. Even the Ottoman empire declared its commitment in 1881. The standard justification for general adoption of the gold standard at the time was that it facilitated the expansion of international trade. Commitment to a gold standard implied as well a commitment to fixed exchange rate with the other countries on the gold standard, which in turn promoted a multilateral settlement of trade imbalances: a country's bilateral trade deficit with one trading partner could be offset by its surplus with a third trading partner.
But international trade had already expanded rapidly in the thirty years before the widespread adoption of the gold standard. In response to the free trade initiatives of Great Britain in 1849 and the continued drop in freight rates, due to the application of steam power both on land and sea, trade had grown globally in all basic commodities. Further, commodity prices had converged across the trading world as had never before been possible (O'Rourke and Williamson 2005). The Anglo-French Commercial Treaty of 1860 with its most-favored nation clause had promulgated a general round of tariff reductions throughout Europe. Each succeeding negotiation between any pair of countries that included a reduction in tariffs had to include the same reduction with the countries whose previous treaties had included the proviso that their future tariff barriers would never be higher than that of the “most favored nation.” The free trade movement, however, started to lose momentum just when the gold standard spread within Europe and eventually beyond to Russia and Japan in 1895.
There was a general rise in tariff barriers, led initially by the US and Germany and eventually even France, the major countries responsible for moving from bimetallism or silver to a gold standard in the first place.
The Bretton Woods Conference in 1944 was an ambitious initiative by the US to reshape the post-war international economy in ways that would avoid the confusion and obvious mistakes that had been made after the First World War. This time, instead of withdrawing into isolation from the problems of post-war adjustments and inadvertently making them worse by setting unrealistic goals, the Roosevelt administration was determined to maintain in peacetime the leadership it had acquired during the war. A piece of doggerel on a scrap of paper found after one of the meetings, “Said Lord Halifax to Lord Keynes, they have the money bags, but we have the brains!” expressed another view. From the British perspective, the US would benefit from the imperial experience of the mother country on how to use its economic hegemony constructively. For Keynes, this meant providing international liquidity in a structured way rather than the ad hoc procedures that had eventually been cobbled together after the First World War. But even that fragile structure had then led to five good years of international prosperity, so it seemed worth constructing something similar but sooner and more solidly.
In Keynes' view, countries could commit to fixed exchange rates with each other by buying into the capital stock of an international bank, set up to issue its own currency, the bancor, which would have a fixed value in terms of gold. Each country with accounts denominated in bancor could use them to settle international accounts with each other. (Readers of Chapter 3 will recall how the Wisselbank in Amsterdam created just such a system for financing European international trade in the seventeenth and eighteenth centuries with its schellingen banco defined in terms of silver and gold.) The US negotiators in Washington from the Treasury were suitably impressed by this vision (Harry Dexter White, Assistant Secretary of the Treasury, had written his PhD thesis on the French experience with the gold standard in the nineteenth century), but they insisted that the US, which necessarily would be the largest shareholder with the largest existing stock of gold on hand and with the US dollar still fixed at $35.00 per ounce of gold, would have to keep control of the purse strings.
Essential features of the 1825 crisis
Problems of adverse selection in the London credit markets arose in intensified form during the 1824–1825 bubble on the London stock market. Yields for the various funds comprising British national debt – EIC stock, Bank of England stock, and the various perpetual annuities mostly in the Three Percent Consols – moved apart after the pressures of war finance had abated. Especially striking is the initial convergence and then wide dispersion of yields on the various Latin American government bonds. Clearly, information asymmetry, always present in financial markets, became especially severe in the London markets in the years leading to the crash of 1825. Asymmetric information is the usual situation where borrowers know more about the actual investment projects they are carrying out than do the lenders. Lenders, knowing this, charge a premium proportional to the uncertainty they feel about the borrowers and the projects in question. Charging risk premiums on loans, however, creates the problem of adverse selection – higher-quality borrowers are reluctant to pay the high interest rates imposed by the market and withdraw while lower-quality borrowers are willing to accept higher rates and to default in case of failure. In an expanding market, which the London Stock Exchange certainly was in the boom years 1806–1807 and again in the early 1820s, the availability of loanable funds at premium rates will attract lemons to the market (e.g. Mexican mines), and discourage borrowing by sound enterprises (e.g. Brazilian diamonds). High-quality borrowers revert to internal sources of funds or to a compressed circle of lenders who know their superior quality and are willing to extend credit at lower rates.
In the case of British firms in the 1820s, the compressed circle of knowledgeable, low-interest lenders was the web of country banks that had arisen in the past three decades. The continued access of high-quality firms to credit, however, depended in each case upon the continued liquidity of the small, local financial intermediaries. Their willingness to continue lending at preferential rates was limited increasingly by the risk of withdrawals by depositors wishing to participate in the high-interest, high-risk investments available in the national financial market.
The end of the Bretton Woods era had long been predicted. In 1958, the Belgian–American economist, Robert Triffin, had spelled out what became known as the “Triffin dilemma.” The dilemma was that as international demand for a reserve currency rose with the expansion of world trade, the nation supplying the reserve currency would have to keep running balance of payments deficits on current account, which would make its currency worth less (Triffin 1958). The death throes of the Bretton Woods System over the period from August 15, 1971 to February 12, 1973 foreshadowed two monetary phenomena that became permanent parts of the international financial system thereafter:
flexible exchange rates, with the US dollar sometimes falling and occasionally rising against all other currencies, and
rising prices of gold internationally, accompanied by rising rates of inflation for most countries.
Both phenomena were natural outcomes of the Triffin dilemma, and various economists had predicted that the dilemma would eventually be resolved either by flexible exchange rates or by international agreement to raise the price of gold. What was not analyzed and could not have been foreseen were the effects of the successive oil shocks in 1973 and 1979. Especially remarkable was the resurgence of financial globalization that mimicked in many ways the earlier period of globalization during the classical gold standard of the late nineteenth century. How did the three phenomena – floating exchange rates, rising price of gold, and sudden increases in oil prices – interact to create financial globalization again, but under quite different background conditions than under the classical gold standard? The answer lies in the various ways that the trilemma of open macroeconomics can be resolved. One of the three desirable policies for a country open to foreign trade has to be given up, whether it is fixed exchange rates, monetary independence, or access to foreign capital. The classical gold standard resolved the trilemma by each participating country forfeiting monetary independence. The central banks were left to do whatever was needed to maintain fixed exchange rates with the other countries on the gold standard. This led to an unprecedented surge of international capital flows at the time (Obstfeld and Taylor 2004).
All Italian scholars insist that the origins of modern international finance arose among the Italian city-states that eventually established self-rule during the centuries following the collapse of the Roman Empire in the West (Fratianni and Spinelli 2006). Italian merchants perfected the foreign bill of exchange to finance trade throughout medieval Europe into the North and Baltic Seas, as well as with the ancient ports of the Mediterranean and Black Seas. Their home cities also developed the precursors of sovereign debt in the form of perpetual annuities. Both financial instruments – the bill of exchange and perpetual annuities – have been studied in terms of the way they circumvented the religious prohibitions on usury in Christian Europe (de Roover 1963; Munro 2013), but our emphasis here will be on the way they interacted to create viable and effective markets in international finance. The innovative pressures of war finance for the Italian city-states throughout the Middle Ages were critical for the development of new financial instruments and techniques. Their usefulness in promoting the expansion of trade and production in non-military pursuits after the religious wars of the sixteenth and seventeenth centuries led to the further rise of financial capitalism, first in the Low Countries and then in Great Britain (Chapter 4).
But which of the several Italian city-states that emerged on the peninsula after the demise of the Roman empire and then the division of Charlemagne's Holy Roman Empire should claim pride of precedence? Florence has long held sway, thanks to the stunning art and public monuments financed by the fabulous Medici family during the Renaissance, and whose bank was extolled by de Roover (1963). Later economic historians have asserted the greater importance of Venice, which remains a comparable tourist attraction to Florence (Lane and Mueller 1985; Mueller 1997; Pezzolo 2013a, 2013b). The role of Genoa's Casa di San Giorgio, however, has recently taken pride of place (Felloni 2006; Fratianni and Spinelli 2006; Marsilio 2013). While acknowledging its significance, this chapter will make an argument for the financial innovations made by the crusading popes of the Middle Ages (cf. Caselli 2008, 2013).
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. Expanded trade and improved standards of living that result from the beneficial uses of finance, however, more often than not have led to increased conflict with outsiders or even with traditional power elites inside an economy. Preserving the benefits of finance in the long run, therefore, is and always has been very hard. Ultimately, the operations of finance through institutions (banks) or through markets (stock exchanges) have to be supported by and meet the approval of government authorities (regulators). Coordination of the innovations that arise spontaneously in banking, capital markets, or government powers is necessarily difficult. While these observations seem painfully obvious to observers of the ongoing financial travails after the crisis of 2008, they also help to clarify our understanding of the rise and fall of ancient civilizations and the vagaries that afflicted pre-industrial societies.
Rise of cities and the beginnings of finance
The archaeologist and historian of the ancient Near East, Marc Van de Mieroop, begins his history with the establishment of Uruk, the first city known to history, around 3000 BC (Van der Mieroop 2005, p. 23). The location of Uruk on the lower Euphrates River just north of the marshes that extend into the Persian Gulf probably arose after thousands of preceding years of settled agriculture and villages scattered throughout the alluvial plain known as the Fertile Crescent. These early residents had access to a variety of fish and shellfish, primitive grains, and possibly domesticated animals. They had developed pottery, along with permanent dwellings usually arranged around a central temple (or market or meeting place). The creation of an impressive stepped temple (ziggurat) with its surrounding precincts covering over 100 hectares by 3000 BC, clearly implied a central authority with the ability to sustain a population large enough to have specialized functions. These surely included soldiers and priests, but also construction workers, boatmen, farmers, shepherds, craftsmen for textiles and pottery, and trade.
The outbreak of the Great War in the summer of 1914 created a whirlpool of financial disturbances that disrupted completely the global financial market. Until then, international finance, operating both through banks with foreign branches and correspondents and securities markets open to corporations and customers both domestic and foreign, had been expanding worldwide. When Austria declared war on Serbia on Tuesday July 28, stock exchanges in Montreal, Toronto and Madrid closed, followed on Wednesday July 29, by the closure of exchanges in Vienna, Budapest, Brussels, Antwerp, Berlin, and Rome. On July 30, St. Petersburg and all South American countries closed, as did the Paris Bourse; first on the Coulisse (the bankers’ market) and then on the Parquet (the official exchange). When even the London Stock Exchange shut down on Friday morning July 31, only the exchanges in New York remained as markets where the world's panic could vent. All this happened before the Great Powers themselves got around to declaring war.
As with the outbreak of wars in the past, there was an immediate scramble for liquidity and the pound sterling rose sharply on the foreign exchanges (Keynes 1914). The shock of universal sell orders on all the world's stock exchanges was completely predictable, but two aspects were new and cause for future concern whenever the hostilities ended. First was the extent to which foreigners with open positions on the London Stock Exchange and with the London discount houses were unable to meet their obligations. The importance of the London money market for the finance of international trade meant that the outbreak of general hostilities inflicted what we now call “counterparty risk” upon the entire financial community of London. As the bulk of the world's international trade at the time was then financed through the London money market, whether a British firm was actually involved in the trade or not, counterparty risk reverberated throughout the world.
The second problem encountered in London was the pusillanimity with which the London banking community met the systemic liquidity crisis (Keynes 1914, pp. 461–462).
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.
Ever since the financial crisis of 2008, doubts have been raised about the future of capitalism. Certainly, seven years of doubtful recovery from the recession of 2007 and then another recession in 2012 in several European countries generated pessimism about the ability of capitalist economies to deal effectively with the persistent instability of the global financial system. At the heart of this pessimistic outlook is a deeper concern over the perils of international finance, compounded by confusion over the proliferation of exotic financial products marketed by hedge funds, venture capitalists, and assorted niche firms that make up the “shadow banking” community. No wonder new studies appear almost daily that try to explain to the wider public, as well as overwhelmed policy makers, what went wrong and what should be done now and in the future to avoid a repeat disaster. As President Bush remarked to his top economic policy makers, Henry Paulson, US Secretary of the Treasury, and Ben Bernanke, chairman of the Federal Reserve System of the US, at the height of the crisis in September 2008, “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.”
This book joins a long list of historical works designed precisely to explain to former President Bush (and the rest of us) just how we ended up “stuck with these miserable choices.” Most studies to date provide detailed indictments of the apparent perpetrators of the crisis, beginning with the prime movers – variously profligate politicians, indifferent regulators, or opportunistic financiers – then move on to the propagators of the crisis – rampant greed, ignorance, or indifference of the general public. Few note the international elements; most prefer to focus outrage on the villains near at hand or, most persuasively, on the US with its complex financial system and overwhelming wealth at the center of the international financial system since the Second World War.
With hindsight, economic historians now acknowledge that 1848 divides the economic and financial history of the world into separate epochs. Before 1848, international trade was rising faster than ever before and was connecting all regions of the world into new patterns of trade. But it was only after 1848 that enough price competition arose for the same international commodities around the world that a truly global market emerged (O'Rourke and Williamson 1999; Williamson 2011). Financial innovations appeared hand in hand with the revolutionary adoption of steam power for both land and water transport systems combined with the new information technology of the telegraph. The exclamations made in the 1850 edition of Fortune's Epitome of the Stocks and Public Funds about the rise of securities marketed on the London Stock Exchange over the 1840s, dominated by the railroad booms in Britain and the US, were modest compared to the ecstatic remarks made by his successor, R. L. Nash, in the 1876 edition of Fenn's Compendium of the English and Foreign Funds:
Upon this question of indebtedness hangs a world of vitality and progress with which the future well-being of mankind is signally identified; and it would be a very narrow view of a very mighty question if we could regard it in any other light. Humanly speaking, we are only at the commencement of a new era … [T]here can be no question – that with this modernized system of credit the world has acquired light, health, progress, and prosperity; that every man has more of the world's goods than could have been boasted of a century ago; that every man is better educated; that every man is a better citizen; and that if these are the results of indebtedness, we may fairly leave the solution of the problem to the future with that confidence which experience well earned amply justifies.
Essential features of the international crises, 1847–1849
The financial crisis of 1847 helped initiate a number of far-reaching policy changes in Britain especially, and then in Europe generally, with repercussions that were even more important in the future for the rest of the world as modern capitalism spread globally.
Had Napoleon 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 re-shaping 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. To finance his imperial ambitions, however, Napoleon did appreciate the merits of Britain's financial innovations that had stymied the advances of the French revolutionary armies on the Continent. After assuming power in the coup of 18 Brumaire (November 9–10, 1799), he quickly imitated the essential features of British finance, at least as he saw them. He established the Banque de France in 1800, re-vitalized the Caisse d'amortissement pour la dette publique, and reconstituted the Bourse de Paris. With these three organizations, Napoleon mimicked the financial structure of Britain with its Bank of England, sinking fund (Commissioners for the Reduction of the National Debt), and London Stock Exchange. All of these had proven their worth in helping Britain finance its successful wars against France over the past century. But, like John Law nearly a century earlier, Napoleon felt that all these financial organizations would function even more effectively if he kept them under central control, whether by himself or by trusted civil servants. His constant intervention in the management of the national debt continually frustrated his minister in charge, Count Mollien. Further, his insistence on levying massive annual contributions from satellite kingdoms raised by new, heavier taxes undercut the legitimacy of the new regimes he created throughout Continental Europe.
Despite his incomprehension of the subtleties of British public finance, anchored in deeply rooted commercial finance both at home and abroad, Napoleon clearly understood the importance for the economic system he created on the European Continent of enforcing impersonal exchanges through constant monitoring by individuals connected to each other through a multitude of relationships. At the same time his armies occupied a country, he created a network of personal enforcers of exchanges. By installing members of his family or trusted generals as rulers of unified kingdoms throughout Continental Europe, Napoleon mimicked in many ways the networks of trusted correspondents that merchant bankers in Europe had established in previous centuries.
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