There’s been a lot of discussion about the causes of the global financial crisis. Observers point to factors such as lack of regulation, globalisation, capitalism, incomprehensible derivatives, paper money, and even good old greed.
You won’t catch me telling you that “greed is good”, and nor will you hear me railing against the evils of global capitalism, as George Soros did recently. I’m an unalloyed fan of global capitalism and assume that greed is a given, whatever system we choose to follow. Regulation comes and goes. As for George, we’ll deal with him later.
There is one factor which is present in every financial crisis. That factor is excessive and unbalanced growth of money which leads to further and unsustainable growth of credit, wild asset price booms followed by deep and often long-lasting recessions. I will draw on examples from the Dutch tulip mania of the seventeenth century through to the Japan phenomenon of the 1980s. I will talk a little about the central role of China in the current crisis and make some suggestions as to what the world, including China, needs to do to avert another Japan crisis, this time in China. I will also point to some historical examples where gold and silver in excess, what some people call “real” money, contributed to the excess growth in money. There is always credit expansion and, to a surprising extent, derivatives have been with us ever since man cut his first goose quill and dipped it in lamp black. But too much silver can do the job too.
The Dutch tulip mania started in the early 1630s when the Dutch population spent inordinate amounts of time and money on trading tulip bulbs, and tulip prices rose to giddy heights. The mania had its origins when the Holy Roman Empire’s ambassador to the Ottoman Empire brought back some bulbs in the late sixteenth century and handed them to the Flemish botanist Charles de l’Écluse, who raised them at the University at Leiden. The tulip rapidly became a status symbol and prices boomed. Tulips caught the attention of the entire nation. In 1635, it was reported that forty bulbs had been exchanged for 100,000 florins. Clearly the market was out of control. Then, in 1637, the market collapsed.
There have been many explanations for the tulip mania, including the argument that crowds often act in unison and irrationally. This begs a number of important questions, most importantly: Where did the money come from to pay these delusionary prices? That is the key question in all such episodes, including the current global financial crisis.
The answer is, from many sources. What divides this episode from many others is that most of the money was specie, gold and silver.
During the early seventeenth century, the amount of gold and silver coined in the Dutch provinces expanded at an enormous rate. There were three main sources of this money. The first was the stability and attractiveness of the Dutch banks, the second was the Dutch monopoly on Japanese silver, and the third was Dutch piracy.
Dutch banks had a policy of free coinage. Under this policy, the City of Amsterdam, Holland’s strongest city, constituted the Bank of Amsterdam, which undertook to coin metal brought in by any person provided the metal followed strict purity and weight criteria. The bank then issued paper which by law was 100 per cent backed by specie. The confidence generated by this act was such that gold and silver from all over Europe rushed to Amsterdam. Generally speaking, paper money trades at a discount to its specie backing. But Amsterdam was different. The policy of total backing by specie was so well trusted that Bank of Amsterdam paper money traded at a surplus to its specie backing, reflecting the convenience of using paper. The output of gold coins from the South Netherlands Mint rose from 153,010 guilders in 1628–29 to 2,917,826 guilders in 1636–37 (the peak of the boom) and of silver coins from 2,643,732 guilders in 1628–29 to 20,172,257.
The second source was the Dutch monopoly on Japanese silver. In the seventeenth century, the main sources of silver were mines in Peru and Japan. In 1614, the Shogunate proscribed Christianity and expelled the Portuguese, who had previously had a near-monopoly of trade with Japan. The Dutch, being enemies of the Portuguese, became the sole outsiders in the truncated Japan trade. The Dutch captured at least half the Japanese export of silver.
The third source was Dutch piracy on the Spanish treasure fleets. Silver output from the American mines rose from 150,000 grams in 1521 to a peak of 2.2 billion grams between 1611 and 1620. Much of it was shipped to Spain. In 1628, the privateer Piet Heyn captured the Spanish treasure fleet and brought 15 million guilders into the Dutch economy. Note that in 1628, the total mint output of the South Netherlands Mint was 2.8 million guilders. This rapidly rose to 17 million.
So at the time when the price of tulips was booming, the money supply in Holland had also exploded.
Derivatives aren’t new either. The Dutch speculated in tulip futures. Initially the crop was pre-sold at the beginning of the season with an obligation to take physical delivery. The contracts involved minimal deposits and with prices rising rapidly, this constituted a significant monetary expansion. In 1637, the obligation to take physical delivery fell away. A small fee was all that was payable. In all booms of this nature, the practical requirements of the business are always seen as a nuisance.
The Victorian land boom started on the goldfields. Gold was discovered near Melbourne in 1851. This was followed by multiple discoveries within 100 miles of Melbourne and a great rush to riches ensued. Ballarat became the largest gold producer in the world. At the peak of the rush, two tons of gold per week was being deposited in the Treasury Building in Melbourne. At current prices that’s the equivalent of $100 million a week made out of nothing in a place which at the beginning of the rush in 1851 had a population of 25,000 souls. The under-population didn’t last for long. People from all over the world rushed to “Marvellous Melbourne” and Melbourne became the second-biggest city in the British Empire and one of the ten biggest cities in the world.
Fuelled by gold, land development and the building of new suburbs became a mania. Railways were essential for a new suburb and soon lines were snaking out into the flat land to Melbourne’s west, and brand new stations stood proudly amongst flocks of sheep.
Prices followed. Victoria used the pound sterling as its currency but didn’t follow the British economic cycle so, in local terms, interest rates were notably low. Land prices went through the sky in the suburbs and would-be suburbs of Melbourne. You might like to compare this situation with the recent boom in Ireland when the euro meant that there were effectively negative interest rates and property prices moved accordingly. As in all booms, the mantra was that it would be “different this time”. Melbourne was the new paradigm city, the like of which had never been seen before, and there was no place for prices to go but up. If you owned an apple orchard round the outskirts of Melbourne, you were suddenly a paper millionaire. Between 1880 and 1884, land in the eastern suburb of Surrey Hills went from 15 shillings a foot to £15, and in neighbouring Burwood, from £7 an acre to £300. The banking sector boomed and lent money on that safest of security, land, but a security which, in times of rapid price rises, had feet of clay. Keep this factor in mind because we will encounter it again when we look at the Japanese banks in the 1990s.
Land developers got in on the act by turning their companies into the so-called land banks. They took deposits and issued their own notes on the basis of the supposed value of their land holdings. Once again we also see the issue by these land banks of derivatives in the form of options to buy land, each one effectively an expansion of credit since the objective of the derivative is to share in the profit from the sale of land without actually having to bother with the minutiae and annoyances of ownership.
The end came quickly and bitterly. Melbourne was part of a financial system based on London. In 1890, Barings Bank collapsed as the result of the collapse of a railway boom in Argentina. In the panic which followed, a consortium of banks guaranteed Barings’ loans and the London terror subsided. But there was no appetite left for investment in distant and possibly dangerous places like Argentina and Australia. The asset price collapse of 1888 in Melbourne left the Victorian banks shaky and without visible means of support, especially since the value of their security, their land mortgages, had disappeared. In 1891, twenty major financial institutions in Melbourne collapsed. Melbourne became depressed and depopulated. One view is that the city did not fully recover from this bust until the 1960s.
To understand the role of the increase in the price of bullion in the Great Depression it is important to understand the mechanisms of the gold standard and the changing role of the USA. The gold standard involved a complex series of settlements including large-scale physical transfers of specie. London was the centre of this system, mainly because the United Kingdom was the richest country in the world. Gold movements tended to follow trade movements. The USA was mainly a debtor nation, going to the London banks to finance its trade.
The First World War put an end to this very international system. The continental powers and Britain were forced to finance their war effort by issuing credit notes and paper money and by the end of the war all other currency market rates against gold had declined deeply. The USA, which did not enter the war until 1917, was effectively the only country still on the gold standard. The rapid development of manufacturing in America, the fact that its population was not mobilised, and the relative safety of its industry compared to the rest of the world, caused a sudden trade boom. In accordance with the workings of the gold standard, gold flowed into the USA. There was massive monetary expansion in America during the war but the corresponding inflow of gold meant that America alone was still compliant with the gold standard. The situation was confirmed in 1917 when President Wilson embargoed gold exports. By 1919, the USA stood strong and alone. Other countries had currencies debased by inflation and paper issuance to pay for the war. The USA had gold, and one commentator was of the view that “all the world’s bullion” was in America, something which became fact during the 1930s when Roosevelt locked it up in Fort Knox.
Many other factors played their part in the Great Depression. Loose monetary policy always seems to be with us when such disasters occur. It was the newly formed Fed which soiled the footpath here. The most relevant episode of monetary loosening occurred in 1926 when the governors of the Bank of England, the Reichsbank and the Bank of France came cap in hand to their former debtor and pleaded for lower interest rates. The combination of gold, a sound economy and high interest rates made the USA a more attractive deposit destination and this was hindering their attempts to restore the gold standard. Unofficial trading during the war demonstrated clearly that the market had significantly devalued the European currencies against gold, but the governments were wedded to the pre-war gold values. They were prepared to take any step other than devaluing their currencies against gold.
During the 1920s share prices boomed as gold flowed into America and looked for an outlet. During boom times, stockbrokers often match banks as financial institutions and have a role in further monetary expansion. The mechanism for this is the margin loan. Suppose you have a portfolio of shares worth $10,000 whose stock certificates are held by your broker as a custodian. Depending on his expectations of market movement (always up during booms) your broker may be prepared to lend you a proportion, say $6000 or 60 per cent to buy more stock. The unlent 40 per cent or $4000 is the broker’s margin. Your shares are held as security. Notice the resemblance to the land banks in Victoria, where the value of land was the financial basis of the institution. Margin loans in booms usually represent major expansions in credit. Margin loans are normal and fine in favourable markets but can be disastrous in rapidly falling markets. If prices fall, brokers call on their clients to deposit cash with them to cover the reduced security. If the fall is precipitate, finding cash can be impossible and institutions may crash as a result.
Margin loans grew during the period. The stock market had been growing at a rate much higher than the deposit rate for some years. When the Fed dropped the discount rate, margin loans suddenly became a no-brainer. During the early 1920s, outstanding margin loans had been steady at roughly $1.5 billion. In 1926 they suddenly grew to $2.5 billion, then $3.5 billion in 1927, before peaking at $6 billion in 1928. Fateful numbers indeed.
A land boom took place in Florida during the 1920s. The extra money had to go somewhere. One form of “land investment” was “binders”, the right to buy land with a deposit of 10 per cent but without any of the inconvenience of ownership. These were freely traded.
You can see the pattern. Massive increases in money lead to competitive investment which leads to enormous asset price increases. Banks and stockbrokers lend on the basis of the value of their mortgages and of clients’ stock. This creates more money. Then the merry-go-round stops. Suddenly the value on which the financial system was relying no longer exists.
John Law and the Louisiana Company
Let me briefly touch on another crisis which was mainly brought about by massive and rapid expansion in paper, the collapse of the Louisiana Company in 1720. Some would say that this was the first such crisis, although there are interesting examples in China of twelfth-century Song dynasty money expansion based on paper, and I’m sure that research into ancient Mesopotamian finance will unearth evidence of people railing against clay tablet money.
In the early eighteenth century, the French Treasury was in deep trouble. Louis XIV died in 1715 leaving a legacy of twenty-five years of almost constant war and an empty Treasury. At this stage a Scotsman, John Law, entered the scene.
Law was born in 1671 in Fife into a family of bankers and goldsmiths. In his youth he was considered to be “good at arithmetic”. He theorised about the first central banks which would have the power to issue paper money and have a monopoly of finance and trade. In this way he hoped to retire the national debt using the time-honoured method of inflating it away.
Law was unsuccessful in promoting his ideas in Scotland and, with the law hot on his heels after he killed a man in a duel, he fled to Amsterdam and subsequently to France. There he caught the ear of the Duc d’Orléans, who was regent for the infant Louis XV. Law convinced the Duc that paper money backed only by the promise of the state was the answer to France’s money problems. Thus was born the Banque Générale, headed by Law, with a capital of 6 million French livres. This capital was divided into 1200 shares of 5000 livres payable in four instalments, one quarter gold coin and the rest in billets d’état. When you consider that the bank was issuing its own paper on top of this, this was a massive expansion in money, exacerbated by the fact that the regent had decreed that the bank’s paper would be accepted in payment of tax. Under these stimuli, interest rates dropped to 4.5 per cent and the bank’s note issue rapidly rose to 60 million livres backed by a mere 1.5 million livres in gold. In 1718 the bank was renamed the Banque Royale, with its notes guaranteed by the king.
In 1717, Law was authorised to form the Louisiana Company to develop the resources of French America. The company was authorised to issue shares and notes. All French chartered trading companies were brought under Law’s control, as was the national mint and the collection of taxes.
It doesn’t take a lot of imagination to guess the result of so much new money concentrated in the Louisiana Company. In 1719 shares of the company rose from 500 livres to 18,000. Being based in a little-known wilderness, the new paradigm of its day, the company gave its shareholders little return beyond the increase in share value. At the end of 1720, the bubble burst and Law fled to Venice, where he died in penury. French finances did not recover for the rest of the eighteenth century.
So much smarter
During the 1980s and early 1990s, the Japanese economy was the envy of the world. Right up until the early 1970s Japan had been considered a developing country, until the first oil shock forced an upward revaluation of the Japanese yen which went from 360 to the dollar to 250 to the dollar. Remember these numbers when you’re next talking about the right rate for the Chinese yuan against the US dollar. Suddenly Japan was not just a “developed” economy—it was the richest country on earth.
When the crash came in October 1987, the Nikkei kept on keeping on and everybody started to think that Japan was invincible and that they must be smarter than the rest of us. The Nikkei was steady at over 40,000 and land prices in Japan were astronomical. Then came, not a crash, but a gradual dribbling away of value for the next twenty years. If you invested 4,000,000 yen in the Nikkei in 1987, it is now worth about 900,000 yen. And the collapse of large numbers of unwise Japanese investments around the world demonstrated that the Japanese were just as stupid as anybody else in history who found themselves with too much money in a boom.
So how did it happen? Once again we are talking about massive and rapid increases in money. But this time, the source of the money wasn’t gold, or piracy, or loose monetary policy, although that played its role. It was a series of massive trade surpluses with the rest of the world. There is a lesson for China here.
Japan’s wealth was based on mercantilist policies. It sold goods to the rest of the world. The government gave total priority to exports and did everything in its power to hold down the value of the yen to preserve Japan’s price advantages. Imports were discouraged by tariff and non-tariff barriers. Sound familiar?
This resulted in a massive transfer in wealth to Japan from the rest of the world. During the early 1980s, Japan’s foreign reserves remained stable at approximately $25 billion. But as Japan’s trade surplus widened in the late 1980s the foreign reserves exploded. Between 1986 and 1987 they grew from $26 billion to $42 billion, peaking in 1988 at $97.7 billion. In 1988 it was estimated that M3, the broadest measure of money in Japan, grew by 44 per cent, mostly as a result of the enormous trade surplus. CPI remained stable but asset prices hit astronomical levels. Between January 1985 and January 1989, Japanese stocks rose by 240 per cent and land prices by 245 per cent. The land on which the Imperial Palace was built in Tokyo was alleged to be worth more than the whole of California. Central Tokyo’s Chiyoda-ku district was said to be worth more than Canada. There were some interesting sidelines to this boom. In 1990, nine of the world’s top ten banks by market cap were Japanese. By 2012 only one would remain in the top twenty, Mitsubishi Bank at eighteenth. Is it invidious to point out that their place has been taken by American banks with dubious balance sheets and Chinese banks which have been recapitalised several times in the past twenty years? If we include HSBC as a Chinese bank, four of the world’s five biggest banks by market cap are now Chinese. (Should I mention that three of Australia’s four major banks are in the top twenty by market cap? This from an economy one tenth the size of the US economy, one quarter the size of Japan’s, indeed similar in size to Spain’s.)
The role of the banks in the boom follows traditional lines, expanding their lending on their ever-expanding security value bank. But with the collapse of asset prices in the 1990s, most Japanese banks were technically bankrupt. In an interesting parallel to the “too big to fail” phenomenon in the USA during the last decade, Japan Inc refused to allow this problem to solve itself and kept on supporting the banks. The mechanism used was quite frightening. It had been calculated that as long as the Nikkei stayed above 14,000, technically the banks were still solvent, so the government used the Post Office Savings Bank, where the savings of ordinary Japanese were kept without interest, to ramp the market. If somebody had bitten the bullet earlier and taken the pain, Japan’s suffering might have been shorter lived.
Crouching boom, hidden bust?
So where does this leave China? The parallels between China and Japan as regards foreign exchange reserves and undervalued currency are well known. The question which arises is: Are there the seeds of disaster in this situation?
In 1997 the yuan was the best-managed currency in the region. Its management, like so many things in China, had evolved gradually. Ten years previously it had been totally unconvertible and at least three times overvalued at three yuan to the dollar.
This started to change in 1986 as a result of Zhu Rongji’s investigations into problems at the Beijing Jeep Joint Venture. Zhu, who subsequently became a successful prime minister, recommended that the official rate be maintained, but that swap centres be established where people with too many dollars or yuan could exchange them at a market rate. Almost immediately the market rate dropped to eleven yuan to the dollar. The market grew rapidly. It wasn’t Wall Street but it was very deep. In 1994 all pretence was dropped and the exchange rate was unified at the market rate. The market exchange rate was strengthening in recognition of the attractiveness of Chinese exports. And the outlook was that it would definitely continue to strengthen.
Then came the Asian financial crisis of 1997. George Soros had a particular role in what followed. Yes, George Soros, the one who thinks that the current crisis was caused by greed and the evils of capitalism.
In 1997 hedge funds, including Soros’s, attacked a number of Asian currencies. These currencies had been pegged to the US dollar at unrealistically high rates. One by one they fell. The Thai baht fell from twenty-five to the dollar to fifty to the dollar. The Indonesian rupiah collapsed totally from 2400 to the dollar to, at the bottom, 17,000 to the dollar. The Malaysian government made the ringgit unconvertible and declared it all to be a Jewish plot. The Taiwanese government issued a special decree that “any person co-operating with Soros funds” would be charged with a criminal offence. And there was a much bigger and much more serious consequence of this episode which continues to affect all of us.
In 1997 Soros decided to attack the yuan. He lumped it together with the other Asian currencies as being pegged to the dollar, undervalued and vulnerable. Actually it was none of those.
Soros’s threat spooked the Chinese government. Getting to a situation where all currency transactions took place at a market rate with its attendant flexibility was a very long and gradual process. Not everybody in the Chinese government was in favour of this. Soros’s attack gave strength to the arms of the anti-market forces and everybody pulled their heads in. Exchange rate policy was taken over totally by government bodies and the yuan was pegged at a rate of about eight to the US dollar and there it resolutely stayed.
Let’s look at what happened to China’s foreign exchange reserves subsequently. In 1995 they stood at $53 billion. By 2000 they had grown to $166 billion. By the end of 2005 they were at $889 billion. In mid-2012 they stood at $3305 billion not counting Hong Kong’s mere $295 billion. Even with relatively weak import demand, China is currently running a monthly trade surplus at around $20 billion. These are shocking figures.
I don’t intend to go round making predictions of doom. But I will make the point that China’s capital stock by international standards is small and there remains significant room to use all or part of this money for productive investment. But some very serious issues remain.
The first is that in my view China’s massive accumulation of foreign reserves is one cause, if not the major cause, of the current financial crisis. China didn’t consume its surplus in the domestic market. It invested it in US Treasury bonds at low rates of interest. The US government was happy to borrow in a profligate way from the Chinese to fund its deficit, thus inflating its assets with results which closely match those in the other crises which I have enumerated here. Alan Greenspan’s Pollyanna approach to the “tech wreck” didn’t help. Reduced interest rates and expensive wars can be a scary combination.
The second is the question of how an international trading system can continue to operate when the second-largest participant doesn’t play by the rules. Look at an interesting current dilemma faced by the Japanese government. The yen is too strong, as the dollar retraces its value boom of the past twenty years. But that is only part of the problem. The yuan has strengthened against the dollar, but not nearly as much as it should against the yen. Some in Japan talk of unilateral re-pegging of the yen against the dollar. Imagine the disaster if they devalued the yen and pegged it against the yuan. Imagine a unilateral devaluation and pegging of the US dollar against the yuan.
So where do we go from here?
Many thoughtful people have said, quite rightly in my view, that we need a new Bretton Woods. And as part of a full package I think that’s a good idea. But remember that Bretton Woods didn’t save the world by itself. It was a very imperfect vehicle which was followed by innumerable financial crises through to the 1970s. Just look at the history of Sterling throughout that period. Eventually Nixon caved in in 1972 and unpegged the US dollar from gold, replacing the gold peg with a system of floating exchange rates. Nobody really liked it. The British in particular hated it. The US economy didn’t collapse. Things got cheaper for American consumers. Not perfect, no. And international negotiations where money is involved are notoriously difficult. But the current system is broken and needs urgent attention.
The message from this seems clear. A new reserve mechanism is required and the countries which control the world’s surpluses are best positioned to call the shots here. And those who call the shots will be the most powerful nations of the next decades in every respect. China is one of those countries.
There is another reality to be recognised. Henry Ford knew that if he was going to mass-produce his cars, he’d need buyers. So he priced them so his assembly-line workers could afford them and paid his workers accordingly. The point is that if the surplus countries expect Americans and others to be able to buy their goods, they should not beggar them to the extent that they can only afford them by borrowing surplus funds. The current situation shows clearly that such a policy has the means to beggar everybody.
We should also look at our inputs as well as our outputs when deciding trade and exchange-rate policies. The price of resources has recently exercised the minds of Chinese policy-makers. Is it simplistic to point out that a large proportion of the high cost can be accounted for by where we set our exchange rate? A strong exchange rate combined with a position of financial strength resulting from a reserve currency was one of the sources of American strength over the past sixty years. The other source in the 1950s at least was the ownership of most of the world’s manufacturing.
When looking at exchange rates and international money movements we should also be conscious of the fact that big surpluses aren’t always a blessing for the country holding the surpluses. They can be great curses. We know what happened to Japan. Be warned.
Ted Rule is a writer and investment banker based in Shenzhen, China.