The Origins of Value: The Financial Innovations That Created Modern Capital Markets

by William N. Goetzmann and K. Geert Rouwenhorst
416 pages,
ISBN: 0195175719

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A History of Financial Innovation
by Christopher Ondaatje

William Goetzmann and K. Geert Rouwenhorst, two Professors of Finance at the Yale School of Management, have come together to produce a handsome volume surveying all of the significant financial innovations that have changed the world. The two editors have garnered essays by a distinguished and adventurous group of historians and economists to trace "the origins of value" through four thousand years of history. With over one hundred colour photographs of landmark financial documents (including the first paper money) this lexicon provides startling information about how the invention of interest in Mesopotamia, and the origin of paper money in China, led to the widespread use of today's financial tools (stocks, bonds, mortgages, cheques, mutual funds etc.), as well as to the creation of corporations like the Dutch East India Company and institutions like the New York Stock Exchange. The Origins of Value tells a fascinating tale of invention.
All of the contributors are interested in situating the current age of financial revolution against a historical perspective. Indeed, innovations in the modern world of finance (a continuing process) are based on a surprisingly small number of basic principles. These basic principles, the editors argue, are themselves dependent on three foundational concepts: "the intertemporal transfer of value through time, the ability to contract on future outcomes, and the negotiability of claims." These essential ideas are revisited by all of the essays in the book, each of which describes and analyses a key episode in the history of financial discovery.
The very first chapter of The Origins of Value by Marc Van De Mieroop, the Professor of Ancient Near East History at Columbia University, is about "the Invention of Interest." I found this chapter particularly engrossing because the phrase "Time is Money" captures the fact that the simplest financial arrangement is an intertemporal value transfer, i.e. a loan. The roots of finance can be traced to the roots of civilisation itself, and Van De Mieroop has identified loan contracts from Mesopotamia that are over three thousand years old. Islamic precepts against usury today may stem from the reaction to heavy penalties imposed on those unfortunate enough to have entered into loan agreements. The editors, in their Introduction, remind us that "Civilization has had an ambiguous attitude towards lending and interest," and that the Roman Catholic Church discouraged the taking of 'interest' in the 13th and 14th centuries. They tell us that the word 'finance' itself is derived from Old French and has a common root with the word 'finish', as it implied a final settlement.
There are photographs of Old Babylonian loan tablets¨surely the earliest known financial instruments. However, contracts themselves may have had an even earlier history, as far back as 3,000 BCE, in the form of clay balls called bullae. These were hollow envelopes containing small clay tokens that denoted some type of economic agreement. Signs punched into the bullae represented the tokens inside and thus could be construed as the earliest form of a contract¨perhaps even the first "bond". Babylonian mathematics was surprisingly sophisticated and was based on a sexigesimal system (illustrated here) that made ratios and multiples easy to calculate. Tablets from the Old Babylonian period (1,800ű1,600 BCE) are in the British Museum and question "how long it would take for a unit of silver to grow 64 times its value if it doubled every five years . . . " This corresponds to a 20 percent annual interest rate that compounds every five years.
Similar examples of Han dynasty (206 BCEű220 CE) retail loans in Chang-an on the Silk Road are discussed by Valeri Hansen and Ana Mata-Fink in a separate chapter. Curiously, these small loans may exemplify the first use of portable assets as loan security. Financial contracts in China in fact stretch back to the Zhon period (1027ű 221 BCE ). Bronze vessels describe early land contracts. Another discovery of documents in an Astana graveyard provides evidence of the practice of loan security by the Turfan people on the Silk Road during the T'ang Dynasty period (618ű907 BCE ).
The second foundation of finance is "the ability to contract on future chance outcomes." Life insurance is a classic example. Oscar Geldenbloom and Joost Jonker document the early development of these financial arrangements in Amsterdam and reveal that the early Dutch options are the precursor to the derivative markets of today
Negotiability is another defining characteristic of a capital market, like the New York Stock Exchange. Richard Sylla and Ned Downing explain how the Exchange's liquidity developed in response to historical forces. The editors point out that " . . . negotiability does not make finance, it makes it easier." Negotiability first developed in China and reached its most dramatic expression in the 11th century in the form of paper money. The Chinese invented paper money and also fiat money (i.e. cash that is negotiable because the government says so). The editors claim that the chapter by Richard von Glatin "is the first truly comprehensive study of the development of paper money in China." True to the editors' word, the chapter by von Glatin is by far the most illuminating. Paper money was an experiment that lasted over four hundred years, disappearing only in the 15th century. By the time the first unified empire was founded in the late 3rd century BCE the use of money had become fundamental to Chinese economic life. But unlike traditions of the Mediterranean and Near Asia, in China the monetary system was based not on precious metals (gold and silver) but on bronze coin. This was scorned by Western economists who criticised the overriding dominance of the state in Chinese economy. Von Glatin explains that "in contrast to Western monetary thought . . . Chinese monetary thought and policy was predicated on enabling the ruler to overcome the vicissitudes of dearth and plenty and to provide for the material needs of his subjects . . . by tightly controlling the supply of money to ensure stable prices and ample supplies of goods." Chinese philosophers and statesmen have always asserted that "money is an artifact of the supreme ruling authority." They believed that it was the ruler's stamp and not the intrinsic value of the monetary medium (e.g. gold and silver), that conferred value. With this belief and understanding, it is not surprising that the story of paper money began in China, in the Sung dynasty, following the fall of the T'ang dynasty in 907 BCE . Although the Sung initially intended to establish a single monetary system based on bronze coin, the scarcity of bronze caused a panic among taxpayers; the eventual move to iron coins also suffered from serious deficiencies in the early 9th century. Consequently, the T'ang government created depositories at its capital Chang'on, where merchants could deposit bronze coin in return for promissory notes known as "feiqian" that could be redeemed in provincial capitals. The Sung dynasty continued this practice, and over the next ten years these "exchange bills" gained significant credibility. There were troubles and abuse of the system, but in 1005 CE , the Prefect of Chengdu, Zhang Yong, undertook strategic reforms in an effort to stabilise the monetary system, and to regulate paper currency. Thus, the invention and institutionalisation of paper money was propelled by turbulent economic conditions, as well as by the technological innovation in paper-making and printing.
Two chapters deal with the birth of the first modern corporation, The Dutch East India Company in 1602, which provided a novel mechanism for financing the exploration and commercial expansion of European business ventures around the globe. Mutual funds were first developed in Holland in 1774 following the first financial crisis of 1772ű1773. The Dutch also cleverly created a market for Russian debt by subscribing directly to loans and issuing loan-backed bonds themselves. These same bankers repackaged the early loans of the young United States in the late 18th century. The House of Rothschild issued the first Eurobonds in 1818, when the Prussian loan was underwritten allowing the country to repay in a currency not its own. There is discussion too of King Leopold of Belgium¨a real villain¨who took corporate finance to its most extreme, inhumane boundaries by turning the Congo into a privately held corporation at the end of the 19th century. Understanding of these financial innovations and machinations has allowed scholars to trace the development of finance in The Origins of Value. Their work is of very broad scope.
This book makes for fascinating reading and provides a good grounding about the evolution of corporate capitalism, the defining economic institution of our time. "Its widespread growth in the early part of the 20th century culminated in the first great age of globalisation¨an efflorescence of markets, enterprise, infrastructure, and modernisation that touched virtually every corner of the world."
For me, an important question is how much do we really learn from the process of investigation and discovery? In one of the later chapters in the book, Robert J. Shiller writes about the invention of inflation-indexed securities in the United States¨a broader development of insurance contracts and risk hedging. A modern example of this is Fannie Mae, the mortgage insurance agency. This was particularly interesting reading because Shiller, also a Yale University economics professor, has written another well-received book, Irrational Exuberance, that warns first of the 2000 stock market collapse, and then, in a recently revised edition, of a significantly overpriced housing market which is likely to collapse in much the same way as the stock market bubble of the late 1990s. His clinical and daunting study of the psychological origins of volatility in financial markets also warns us of the extraordinary growth in the mutual funds industry¨a new name for an old idea "investor trusts", many of which became worthless in the stock market crash of 1929. The amazing disappearance of the individual stockholder as the backbone of the U.S. stockmarket has been one of the least recognised but most profound trends of the last half-century. Direct ownership of stock by American households has declined from 91percent in 1950 to just 32 percent today. The 9 percent ownership by financial institutions, like mutual funds, in 1950, became 50 percent in 1983, and now amazingly totals 68 percent of all stocks. This is a dangerous concentration of ownership. It is hard to imagine that a day when the market is dominated by individual stock ownership will ever return.
Shiller's recent unnerving warning may not belong in The Origins of Value, but it cannot be ignored. As the editors point out in their Introduction, "Innovations in the modern world of finance have come to be almost expected, financial instruments spring from the minds of investment bankers almost overnight, and then are analyzed, valued, traded, saved and hedged themselves¨sometimes to be replaced by new financial instruments, and other times to be part of the permanent toolkit of financial engineers and investors." Mankind's tireless ability to create has reached frightening levels. It seems almost inevitable that this frenzy of innovation will once again result in a catastrophic crash. If nothing else, this remarkable book gives us historical perspective from which to gauge this terrifying age of financial revolution.
Christopher Ondaatje is a retired investment banker and the recent author of Woolf in Ceylon

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