The Ascent Of Money – Summary Chapter 2 Of human bondage

Of human bondage

Although less exciting than the later stock market, bond markets have shown very relevant and very powerful. States issue large bonds, often at a 5-10 or longer, at a fixed interest rate. The future expected payments and the face value will determine its valuation. The power lies in here: depending on the credibility of their actions, a government bond will be bought and sold above or below their original value. On top of that, a country’s bond market long term rate will set the rate for the economy as a whole. If a government lost too much credibility, it will have to issue bonds yielding a higher interest rate and thereby significantly increasing the cost to the state. After a while, that government will have to choose between defaulting on its debts or making severe cuts in spending.

The roots of modern bonds lie in Northern Italy, where sovereign city states sold bonds to their rich inhabitants (sometimes forced to buy). The money raised was used to pay mercenaries, e.g. Florence paying Giovanni Acuto. Venice famously had an old mountain of debt and had to add to that a new mountain to combat the Turks (Monte Vecchio – Monte Nuovo). Also Northern France and Flanders had systems of selling annuities to individuals, designed as “compensation” to the investor to avoid charges of usury. Several other countries tried this, the Spanish Crown very often defaulting on its debts, and the Dutch provinces raising money to fund their self defense against Spain, later funding its imperialism.

Nathan Rothschild was a German Jew who started his career with the Napoleonic wars in the background. An experienced gold smuggler, Rothschild had built up the connections to raise and transport gold, at a moment the British needed to transport it throughout Europe to fund their war against Bonaparte. He raised 1.2 Million GBP by 1814 and got a good commission for it. Through his network of other Rothschilds in the different parts of Europe he was also able to arbitrage on the price discrepancies between say Madrid and Paris. The biggest bet he made was at the moment Napoleon escaped from Elba. Rothschild bought all the gold he could find in the assumption it would be needed in another long war. But Napoleons quick defeat in Waterloo prohibited the gold price from soaring. Rothschild then bet on a surge in British government bonds, called consols. He bought, from 1815 to 1817, and sold in late 1817 realising about 600 Million GBP in profits. From then the Rothschild dominated Europe’s finance, serving as the intermediate between governments issuing bonds and the eventual buyer. The banking and information network they developed helped the liquidity of securities, they made a point of only trading in “investment grade” securities and they ventured as investors in different businesses like mining and railways.

At the moment the American civil war broke out, the South was using the same old technique of selling bonds to finance their war. But because the Confederate South was believed to be a bad credit risk, it had trouble raising the monies it needed. Certainly the Rothschilds did not invest in them. An ingenious trick helped the Confederates; they issued bonds which, after the next crop harvest, could get converted into cotton at the pre-war price. Because of the war, the cotton had been increasing in price, so the bond had a very interesting collateral. Furthermore the South restricted the export of cotton, leading to massive unemployment in the UK. The Unionist North blocked the port of New Orleans, thereby eliminating the possibility of every investor to collect his collateral if needed, thus rendering the bonds worthless, and turning the war in their favour.

Not only in the civil war did bond owners lose their shirt. Some Latin American countries and Egypt defaulted in the years after that as well. Both UK and US were quick to invade and force the defaulting countries to pay back the debt, thereby contributing to the stability and reliability of the bond, allowing some to live off their bond yields.

With the first World War, this changed. Governments had to rapidly increase their supply of money, which fueled inflation. Especially Germany and its allies did not have access to the world’s bond market and found it increasingly difficult to raise money. After their defeat, a weak authority and great spending lead to a surge in inflation and a drop in the currency rate. While this served to boost exports and consumption, on the long term it was offset by higher import costs and hyperinflation. Between 1913 and 1923 prices rose by 1.3 trillion percent. Also Russia, Poland and Hungary suffered similar hyperinflation. However, not only war is a cause for hyperinflation. One of the factors is that, at the sign of increased inflation, bond markets tend to fall. Zimbabwe and at the time Argentina are examples of this. Argentina, with a number of military coups, shows us that hyperinflation is a consequence of a fundamentally flawed political system. Only by pegging the Argentinean currency to the dollar inflation was stopped. Immediately, unemployment rose to 15%. Argentina defaulted once more, creditors accepted a major cutback and the economy is now on its way.

Inflation seems to be better under control than a few decades ago, because commodities have become cheaper, privatisation and weaker trade unions. As more and more retirees want to live of what is essentially fixed revenue streams from bond investments, low inflation is more and more essential.

Source: “The Ascent of Money“, by Niall Ferguson

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In life there are generalists and specialists. Although your job pushes you down towards a certain specialization, I feel it's important to keep your eyes and mind open for new stimuli. And I want to share my journey through arts, literature and sciences with other knowledge workers and managers. You don't have time to read. Let me do that for you and present only the best of the best in my blog!
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