Allan H. Meltzer reviews The Ascent of Money: A Financial History of the World, by Niall Ferguson.

Visiting Scholar Allan H. Meltzer

The Ascent of Money is yet another in Niall Ferguson's series of very readable and enjoyable books. As the subtitle suggests, the book is not about money per se, but about financial development, tracing it from the earliest times to the present.

Ferguson says that people are ignorant about money and finance, and he wants to educate them. He cites three specific lessons he learned while writing the book. First, contrary to what many believe, "poverty is not about rapacious financiers exploiting the poor [but] has much more to do with the lack of financial institutions." Second, people swing from exuberance to despair, and this amplifies booms and busts. Third, "few things are harder to predict accurately than the timing and magnitude of financial crises." All three are important lessons; if members of Congress learned them, they might stop looking for scapegoats.

Major episodes from financial history illustrate these themes without insisting on them. Ferguson is a good storyteller and a disciplined historian, so the narrative is both rich and accurate. He details, for example, how the gold that the Spanish took from the New World enriched Spain, but was not used to build productive capital. Ferguson could have made even more of Spain's failure in this regard: Because the Spanish didn't understand the importance of building productive institutions, much of the Spanish treasure ended up wasted, sunk to the bottom of the English Channel.

The ascent of finance starts with the moneylenders. Ferguson tells the story of Shylock and the Christian and Islamic prohibition of interest to illustrate the early detestation of finance and financiers. By our era, financiers had become Masters of the Universe, so clever that they invented financial instruments that few could understand. How did they get here, from such inauspicious beginnings? A big step forward came in the 17th century, with the development of fractional-reserve banking, which greatly increased the incentive to engage in finance. Central banking gained ground in the 19th century.

Walter Bagehot, an economist and editor of a magazine called The Economist that survives to this day, described the workings of financial markets and proposed an explicit rule for central banks operating in a financial crisis: "Lend freely at a penalty rate" to those with acceptable collateral, and let the others fail. No less important, Bagehot urged the Bank of England (and others) to announce the Bagehot policy and follow it. The Bank followed Bagehot's policy for almost 100 years, with great success. Bankers knew the rule and understood the penalty for excessive risk-taking. In contrast, the U.S. Federal Reserve has never stated any rule and acts inconsistently. Some receive direct assistance; some are allowed to fail; and some are helped to find lenders. Uncertainty increases, and bankers believe that they can be spared or bailed out if they have political support. The famous 18th-century financier John Law could not have produced his financial "bubble" without support from public authorities. (Ferguson does seem to stretch things a bit, however, when he compares John Law to Kenneth Lay and Enron.)

Ferguson says the oft-repeated story about Nathan Rothschild at the London Stock Exchange immediately following the battle of Waterloo--that advance knowledge of the British victory permitted him to speculate successfully on British government securities, and was the source of his great wealth--is not true. In fact, the family fortune was founded on consistent good judgment and broader access to information. Rothschild brothers communicated from all the major European cities. They had an early understanding of the value of information that much later became the centerpiece of the efficient-markets theory of finance.

Ferguson points up the destructive role of political intervention--by, for example, successive Argentine governments that did more damage than a great war would have done. (And they continue to do this, with a few, brief interruptions of financial sanity.) Argentina offers lessons for others, including us. Early in our history, Tocqueville warned that the weakest point of democratic government was the opportunity presented for confiscation of wealth and capital by proponents of redistribution.

One of the climactic events of monetary history occurred in Germany after World War I. The Weimar Republic financed large budget deficits by printing money. The result was the world's most famous hyperinflation. Ferguson follows many others in suggesting that the government thought that inflation would lower the exchange rate, thereby increasing exports that would satisfy the reparations demands of the victors. Here and elsewhere, but not everywhere, Ferguson does not distinguish real and nominal values. The nominal exchange rate fell rapidly but domestic prices rose at least as rapidly, so the exchange rate relevant to foreigners, the real (inflation-adjusted) exchange rate, did not promote exports. Ferguson points out that imports surged, suggesting that Germans found imports cheaper than domestically produced goods despite currency depreciation. He fails to draw the correct conclusion about the real exchange rate.

The book brings financial development up to the current housing crisis. Here and in his discussion of the savings-and-loan debacle of the 1980s, Ferguson blames deregulation and rogues for the problem. This is popular but wrong. Inflation and interest-rate ceilings for deposits (Regulation Q) were at the root of the savings-and-loan crisis. There were a few rogues, but their chief importance was as scapegoats for a Congress anxious to avoid responsibility for combining inflation and interest-rate ceilings. As inflation rose, lending rates far exceeded the rates the thrift associations paid to borrow. This was not a mystery; economists pointed repeatedly to the problem. By the time Congress acted, much of the damage had been done. The Reagan-Volcker disinflation gave the coup de grâce. Short-term rates at which the thrifts borrowed soared far above the historic mortgage rates that thrifts earned on their portfolios. Most failed, especially if they speculated on risky assets knowing that losses would go to the taxpayers and gains, if large, would go to the thrifts.

The central lesson is that financial institutions borrow at short-term rates and lend at long-term rates. Whenever there are large, unforeseen changes in the economic environment, problems occur. A history of money is incomplete if it fails to reach this conclusion.

As for the current housing crisis, it would have been mild or nonexistent but for congressional actions. Ferguson points out the destructive role government had in this crisis: The Community Reinvestment Act (1977) gave local interest groups a lever with which to push banks into making loans to low-income families. The American Dream Downpayment Act (2003) subsidized credit for low-income groups. When the latter was passed, Pres. George W. Bush said that it was in the national interest to have more people own their own homes--but he neglected to add, "if they can pay for them." Despite repeated warnings from many sides, Congress encouraged Fannie Mae and Freddie Mac to support these housing programs by buying subprime and other risky mortgages.

In the last chapter of the book, Ferguson comments on the symbiotic relation between a rising China and a declining United States: They save and we spend; they export and we import. He too readily accepts the common story that China's rapid growth will continue. I am more skeptical. China's policy of export-led growth reminds me of earlier successes in Japan and Korea: High growth continued as long as labor moved from low-productivity jobs in agriculture to higher-productivity jobs in industry. But high growth ended when national productivity increases slowed with the end of the movement from country to city. This will happen in China.

China demonstrates that mercantilism is alive and well. Import-led consumption by the United States has been essential for the success of that strategy. The future will probably be very different. Despite the enormous success of free trade in raising living standards in all parts of the globe, restrictions on trade by the developed countries seem more likely at present than moves toward freer trade.

Allan H. Meltzer is a visiting scholar at AEI.