The Cash Nexus: Money and Politics in Modern History, 1700-2000

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The Cash Nexus: Money and Politics in Modern History, 1700-2000 Page 34

by Niall Ferguson

A political market in which there were no restrictions on overt private donations and minimal public subsidies would not necessarily breed corruption: it might well reduce it by removing the need for subterfuge. This is not to recommend a return to Trollope’s Silverbridge; but rather to suggest that Western politics is already uncomfortably close to a new kind of corruption every bit as bad for democracy as that which thwarted Trollope’s political ambitions.

  SECTION FOUR

  GLOBAL POWER

  10

  Masters and Plankton: Financial Globalization

  The Masters of the Universe were a set of lurid, rapacious plastic dolls that his otherwise perfect daughter liked to play with…. They were unusually vulgar, even for plastic toys. Yet one fine day, in a fit of euphoria, after he had picked up the telephone and taken an order for zero-coupon bonds that had brought him a $50,000 commission, just like that, this very phrase had bubbled up into his brain. On Wall Street he and a few others – how many? – three hundred, four hundred, five hundred? – had become precisely that … Masters of the Universe.

  TOM WOLFE, Bonfire of the Vanities.1

  TERRIFYING EVERYBODY

  Early in Bill Clinton’s first, unsteady hundred days as President, his campaign manager James Carville remarked that, if there was such a thing as reincarnation, he wanted to come back, not as the President or the Pope, but as the bond market – because that was what really ruled the world. ‘That way’, as he put it, ‘you can terrify everybody.’2 He was alluding to the market’s (mildly) nervous reaction to the arrival at the White House of the first Democrat president since Jimmy Carter. In the two months before Clinton’s election, as his chances of success grew, the markets had pushed up US long-term bond yields by 35 basis points3 at a time when yields in most other major economies were declining. Early Clinton initiatives on health care and homosexual soldiers were not reassuring to the masters of the universe.

  The global bond market is certainly terrifyingly big. Between 1982 and 1997 it increased in size by a factor of six, to around $25 trillion.4 By mid-1999 the total value of bonds outstanding had reached $34 trillion. That exceeds not only the total capitalization of all the world’s stock markets ($27.5 trillion in 1999) but also the total GDP of all the world’s countries ($30.1 trillion in 1997). More than half of all bonds in 1999 were issued by governments or other public sector agencies. And just under half of all bonds were of American origin.

  The rise – or rather, renaissance – of the bond market in the 1980s is often associated with the mercurial career of Salomon Brothers.5 Salomon’s star has since waned; but American institutions remained the principal market makers in the 1990s. In 1997 around 90 per cent of total bond issuance was issued by just twenty firms (of which Merrill Lynch, Morgan Stanley and J.P. Morgan accounted for around a fifth).6 The point of Carville’s remark was, however, that despite its dominance by American banks, the bond market is not the president’s to command – even a president who has just won a decisive election victory. There are too many individual and institutional investors with too much money – and too many of them are not American. At the time of Clinton’s inauguration, more than 13 per cent of US federal government bonds were in foreign hands.

  The extraordinary growth of the bond market has to be seen in the context of a broader process of financial ‘globalization’. Flows of capital have increased dramatically in the past twenty years. In 1980 cross-border transactions in bonds and equities (shares issued by companies) were equivalent to just 8 per cent of Japanese GDP; in 1998 the figure was 91 per cent. For the United States, the increase has been even greater: from 9 per cent to 230 per cent. German cross-border transactions have risen from 7 per cent to 334 per cent of GDP.7 International bank lending too has expanded exponentially. Between 1993 and 1997 gross international bank claims rose from $315 billion to $1.2 trillion. Though the growth of lending was lower in 1998, the total outstanding stock of international bank claims still reached a record high of $11 trillion at the end of that year.8 The daily turnover on the world’s foreign exchange markets rose from $1.6 trillion in 1995 to $2.0 trillion in 1998, implying annual flows of more than $400 trillion.9 And the growth of international derivatives markets has been even more rapid. The total amount of futures and options instruments traded on exchanges rose from $7.8 trillion at the end of 1993 to $13.5 trillion at the end of 1998. The amount of so-called ‘over-the-counter’ (OTC) instruments traded outside established exchanges rose from $8.5 trillion to an astonishing $51 trillion.10 The OTC derivatives market is now by any measure the biggest financial market in the world – more ‘terrifying’ even than the $34 trillion bond market.

  Table 14. Foreign holdings of developed countries’ national debts, circa 1993

  * * *

  Country

  Foreign debt as percent of total debt

  * * *

  Austria

  19.1

  Belgium

  15.8

  Finland

  65.1

  Germany

  48.7

  Italy

  14.5

  Netherlands

  21.3

  Spain

  17.0

  Norway

  29.9

  Sweden

  50.5

  US

  14.2

  UK

  16.6

  * * *

  Source: Eichengreen and Wyplosz, ‘Stability Pact’, p. 103, except US (Federal Reserve Bank of St Louis) and UK (Bank of England).

  Strictly speaking, only around 14 per cent of bonds are international; around $29 trillion were classified as domestic in 1999, meaning they were issued within the borrowing country (see Appendix C). Moreover, the public sector accounts for less than a third of international bonds. But the proportion of government bonds that are held by foreign investors is still remarkably high. Even in the early 1990s, as Table 14 shows, external debts amounted to between a sixth and a half of the national debts of most major economies. In Britain and the United States the trend has been clearly upwards since the end of the 1970s. Non-residents hold 19 per cent of UK long-term bonds (‘gilts’ for short) in 1999, compared with less than 6 per cent in 1979. Foreigners held 23 per cent of the gross US federal debt in 1998, nearly double the proportion fifteen years before. That represents more than 14 per cent of American GNP. For most of the 1990s, foreign purchases of US long-term bonds (usually known as ‘Treasuries’) played a crucial part in financing the American balance of payments deficit, which in 1999 reached its highest level since 1960 (3.9 per cent of GNP). Net foreign investment in the United States also reached a record level in 1999 at 14.6 per cent of GNP.11

  Is this financial globalization unprecedented, as cheerleaders of the ‘new economy’ would have us believe?12 Does the bond ‘mountain’ pose ‘a latent threat to the global financial system’, as some have warned?13 And does it matter that the world’s only superpower is so heavily indebted to foreigners – in stark contrast to the net creditor position of Great Britain in her heyday? This chapter shows how the institutions of public debt management described in Section Two were internationalized in the course of the nineteenth century; and draws some historical lessons from the way the international bond market functioned – and then malfunctioned – in the first age of globalization.

  CAPITAL FLOWS: BETWEEN POLITICS AND THE MARKET

  International capital flows are not a new phenomenon. They have always occurred when there have been large-scale international movements of goods and people.

  For most of modern history, capital export has been motivated by a mixture of economics and politics. The economic rationale of capital export is to secure higher returns than would be possible from a domestic investment. Even short-term credits would not have been granted to foreign merchants in medieval times if there had not been the prospect of better profits than from internal trade. Yet from the time of the Hundred Years War, if not before, cross-border capital flows also tended to be necessitated by
overseas military campaigns. The English kings who laid claim to all or part of France sent armies across the Channel to enforce their claim. Only a fraction of their supplies could be shipped over from England; it was always easier to transport money and buy provisions where the action was. It was better still, as later governments realized, to pay another state already on the right side of the Channel to do the fighting for you. Both operations necessitated the transfer of funds from London to an overseas theatre of war. A very large part of the history of international capital markets is bound up with this basic military exigency.

  In theory, it ought to be possible to distinguish between private, profit-motivated capital export and public, strategically motivated capital export. In practice, however, the categories tend to overlap. Often, private overseas investment has been officially sanctioned and has sometimes therefore come with political strings attached. There are numerous cases of loans intended to help foreign governments reform themselves – if only to turn them into more dependable allies. The most obvious examples in the late nineteenth century were the immense French loans to Russia, which were designed not only to finance the Russian railway network but also to secure Russia’s allegiance in the event of a war with Germany.14 For investors, on the other hand, their own government’s backing has the attraction of reducing the risk of default by the foreign borrower. Sir Ernest Cassel said of the Rothschilds – who accounted for roughly a quarter of all foreign government bond issues in London between 1865 and 1914 – that they ‘would hardly take up anything that did not have the British government guarantee about it’.15 This was an exaggeration, but a pardonable one. When the German banker Max Warburg was approached by the Japanese government to float a loan in 1904, during the Russo-Japanese War, he ‘did what any sound banker has to do in such a case: I went to the Foreign Office in Berlin’.16

  There are three fundamental problems with foreign (as opposed to domestic) investment as a purely economic proposition – though they are also part of its allure. It is harder to ensure that a foreign borrower honours his obligations than to ensure payment of interest and capital from a borrower living under the same national jurisdiction as the lender. Defaults present more serious problems for foreign than for domestic bondholders, because the former have no voice in representative institutions and may be less able to use the legal system to press their claims against the government.17 It is also harder to be sure that a foreign borrower will put overseas funds to good use: what economists call ‘informational asymmetries’ are generally greater the further the lender is from the borrower. Finally – though this has not always been the case – lending across borders can involve an additional risk quite distinct from default risk; namely the risk that the exchange rate of the currencies of lender and borrower may unexpectedly change, to the disadvantage of one of the parties depending on the terms of the loan contract.

  At the same time, there are three fundamental problems with the idea of conditional foreign lending as a political lever. The first is that, as with the basic problem of lending, it is far from easy to oblige a foreign borrower to carry out any promised reforms or international obligations. Indeed, once money has been handed over, it may allow a bad government to resume or even worsen its wicked ways. (This was the perennial problem of lending to the Ottoman Sultan.) The second problem is that the costs of debt service may, particularly when a tax system is regressive, generate revolutionary political developments within the borrower country which are the very opposite of those desired by the lender. Thirdly, there is the possibility that, for purely economic reasons of the sort described above, capital may be withdrawn at short notice despite the political arguments for continued lending. The deleterious effects of sudden capital outflows may undo the benefits of previous inflows. Only if a loan is effectively nationalized – as happened when the United States government took over Britain’s war debts from J. P. Morgan in 1917 – can the political rationale prevail over the economic.

  Underlying this analysis, of course, is the assumption that there will be one or more capital-exporting powers with a political or strategic agenda. As we shall see, this has usually been the case. What makes the late twentieth century unusual is the absence of such a financially hegemonic power.

  ORIGINS OF THE BOND MARKET

  Though medieval monarchs often turned to foreign bankers for loans,18 and some Italian cities allowed obligations to be sold to non-citizens,19 an international bond market in the modern sense did not begin to emerge until the sixteenth century.20 Philip II and Philip III did not finance their wars simply by moving bullion from the Americas via Spain to the Netherlands; they also relied on the development of an international market in asientos and juros to fill the perennial gap between tax revenue and military expenditure.21 As early as the reign of Elizabeth I, a substantial proportion of the English crown’s debt was also financed in Antwerp;22 though London began to develop as an international financial centre in its own right during the seventeenth century.

  By the middle of the eighteenth century there was a high degree of integration between the London and Amsterdam markets. Shares in the Dutch and British East India companies, the Bank of England, the South Sea Company and later British consols were traded with minimal price differentials or time-lags in both centres. The bubbles of the 1720s inflated and burst in all the major financial centres with remarkable synchronization.23 Evidence of market integration can also be found in the registers of shareholders’ names. By 1750 total foreign holdings in the big three British companies stood at over 19 per cent. A significant proportion of the total national debt – in the region of 14 per cent – was also held by foreigners, mainly Dutch investors, a figure which rose above 16 per cent by 1776.24 Frankfurt meanwhile played a comparable role in financing the debt of the Habsburg Empire and channelling the capital of the wealthy Elector of Hesse-Kassel into a variety of European bonds.25 Austrian bonds were also sold and traded in Antwerp, Amsterdam, London, Geneva and Genoa.26

  Hanoverian Britain had long made war indirectly by subsidizing continental allies. Between 1757 and 1760, for example, Frederick the Great had received British subsidies worth £670,000 a year.27 But the scale, duration and cost of the wars of the period between the Declaration of American Independence and the Battle of Waterloo meant that such transfers spiralled upwards. Between 1793 and 1815 Britain paid £65.8 million in the form of subsidies to her allies, half of it in the last five years of the war.28 That represented between a fifth and a quarter of a year’s national income. By 1823 the total advances to Austria alone amounted to £23.5 million, of which the government ultimately had to write off all but £2.5 million.29 The combined cost of such payments and the need to put ever larger British armies in the field necessitated enormous cross-border transactions. These could not have been achieved without the existence of two complementary markets: the market for government bonds and the market for commercial bills.30

  Bonds might raise funds internally in advance of taxation; but they could not be sold to foreigners in sufficient quantities to facilitate transfers to the actual theatres of war. In the Seven Years War the Exchequer purchased bills of exchange from London merchants which were drawn on their correspondents abroad; these were then sent to the quartermasters in the field who could use them to pay troops and purchase supplies. Foreigners were happy to accept bills drawn on London, because they could be exchanged for sought-after British manufactures and colonial goods. Napoleon’s continental system was an attempt to thwart this by choking off British exports to the continent. But continental merchants were generally happy to hold on to their bills on London, or to invest their balances in consols, in the expectation of an ultimate British victory.31 When bills could no longer be used in payment other than at ruinous discounts, Nathan Rothschild stepped in, using his own extensive credit network to buy up bullion wherever he could and then advancing it to the British government. In 1815 alone Rothschild and his four brothers lent the government a total of £9.8 millio
n which they paid directly to Britain’s armies and allies.32 As soon as this operation ceased to be profitable, they invested the proceeds in consols, in the correct expectation that prices would appreciate as the pound was restored to convertibility and the budget restored to balance.

  Britain’s foes were capable of similar transactions, though they could not match the scale of Rothschild operations. Of the $77 million of 6 per cent bonds issued by Alexander Hamilton to fund the deficit of the new-born United States, $12 million were purchased by foreigners; nearly half the US debt was in foreign hands by 1803. Indeed, the Louisiana purchase would have been impossible if Napoleon had not been willing to accept such bonds in payment.33 The Emperor also invested a million francs of his own in a Prussian state loan; in 1811 he put over three million in Saxon bonds.34 But Napoleon preferred to conquer and tax rather than to borrow money from abroad; and this limited his resources just as it ultimately limited Hitler’s after him. There was a certain complementary quality to the British and French systems: the British lent the Austrians money, the Austrians lost in battle and Napoleon then seized some of the originally British funds by imposing an indemnity.35 Yet Napoleon might have got more out of his victories – for example, if he had tapped rather than choked the Amsterdam capital market. By 1803 per capita taxation in the ‘Batavian’ Republic – as the conquered Netherlands were renamed – was more than four times higher than in France; but the bourse which had once been the world’s largest was prostrate.36

 

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