Allister Heath
SURVIVAL OF THE FITTEST
The Ascent of Money: A Financial History of the World
By Niall Ferguson (Allen Lane/The Penguin Press 441pp £25)

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Behind every major historical phenomenon and every great civilisation lies a financial secret. Such is the starting point of Niall Ferguson's wonderfully accessible new book, a perfectly timed primer for the many seeking enlightenment on economic history during these difficult times.

The rise of ancient Babylon was intimately tied to the evolution of credit and debt; without banks and the bond markets, the splendours of the Italian Renaissance would never have materialised; corporate finance was the foundation of the Dutch and later British empires; the ultra-sophisticated Wall Street financial engineering which has now come crashing down is intractably linked with America's global primacy. And now, of course, the new-found geopolitical power of many emerging economies, such as China, comes from their embrace of modern finance and creation of huge sovereign wealth funds.

Especially fascinating is Ferguson's discussion of the rush of intellectual innovation, beginning in the 1660s, that created the theoretical basis for life insurance, one of the most important financial inventions of all time. First, probability theory was invented, with the great French mathematician Blaise Pascal attributing the founding insight to a monk at Port-Royal. Then came work from John Graunt and Edmond Halley, who pioneered the estimation of life expectancy and laid the foundation stones for actuarial mathematics. Next came research by Jacob Bernoulli on confidence intervals, which gave us a measurement of certainty; then Abraham de Moivre's normal distribution, Daniel Bernoulli's invention of utility, and Thomas Bayes's discovery of statistical inference.

Without mathematics, there would be no finance; and without finance, there would be no sophisticated, advanced economies. We would still be living in small, poor communities; the industrial and post-industrial revolutions would be impossible, as of course would globalisation.

But how does all of this fit in with the credit crunch, the first phases of which are covered by Ferguson? As ever, there are plenty of lessons from the past. In one of the strongest passages in his book, the author explains how financial history is essentially the result of institutional mutation and natural selection. And just like the mass extinctions that eliminated 85 per cent of the earth's species at the end of the Cretaceous period when asteroids hit the earth, the credit crunch stands out as a period of major discontinuity in the world of finance. Numerous banks and entire sub-species of financial institutions are dying off. This happens regularly in financial history, with the bank panics of the 1930s and the savings and loans failures of 1980s America cases in point.

Ferguson enumerates the common features shared by the financial world and an evolutionary system; in doing so, he paints a remarkable portrait of the past two decades of financial innovation. Finance has its very own 'genes', in the sense of certain business practices, and it boasts a potential for spontaneous mutation thanks to technological innovation. There is competition between firms for resources; a mechanism for natural selection, with weaker practices, firms and individuals wiped out; scope for speciation, with the creation of wholly new species of financial institutions a key feature of the past few years; and scope for extinction, with species dying out altogether.

Where I disagree with Ferguson is his assertion that the difference between the natural world and the financial world is that big disruptions in the former case are exogenous while those in the latter are endogenous. While it is not currently fashionable to say so, monetary mismanagement by the authorities has been at the heart of every boom and bust since the establishment of central banks; in other words, the origins of the present crisis derive largely from outside Wall Street and the City.

It is always easier to blame bankers, spivs and short sellers when things go wrong. In reality, however, it is central bankers and governments that deserve to be in the dock. Investment bankers, private equity funds and financiers tend to believe that they are the masters of the universe; but in reality they are usually little more than the (admittedly highly remunerated) conduit for monetary policy.

A central bank that keeps interest rates too low and allows excess credit to build up in the economy will eventually trigger a bubble in the prices of assets, such as property, bonds or shares, and a feeding frenzy in the City. For a few years, everybody is happy: the bankers pocket large bonuses and the rest of us enjoy a huge increase in the value of our homes. But in the end the credit bubble always pops, with devastating consequences.

A minority of British and US economists were doing their best to point this out during the boom years of the late 1990s, which led to the dot-com bubble, and during the noughties, when excessively loose monetary policy triggered the mother of all property bubbles. Those who saw this coming included City types such as Tim Congdon, some members of the Institute of Economic Affairs and of the shadow monetary policy committee, economists at the Bank for International Settlements, and members of the Austrian School of economics. Alan Greenspan, in particular, will eventually be remembered as one of the figures most responsible for fuelling an era of mass irresponsibility.

But Niall Ferguson is spot on when he concludes that far from being 'a monster that must be put back in its place', as the German president recently complained, finance is the mirror of mankind. And as he notes, the mirror can hardly be blamed if it reflects our blemishes just as much as our beauty.

Allister Heath is editor of 'City A.M.'