War of the Nerds

Financial markets owe much to illusion. Absolute values don’t exist. Prices are relative and changing. We create our own references. Gold-topaper currency conversion served that purpose. Yet, the US snookered the world into broad acceptance of the dollar standard after severing its relationship to a tangible object. Until 1971, a foreign bank handed $35 to the US government and received an ounce of gold in return. After that, banks handed 35 dollar bills to the US government and received 35 dollar bills in exchange. That was hardly sporting, but it was honest in one respect. Secretary of the Treasury John Connally was refreshingly blunt: “[T]he dollar is our currency but your problem.” That is as true today as then.

Every generation suffers its particular fantasies. So it was a century ago. Investors had grown so immune to the consequences of war that bond markets from London to Vienna didn’t flinch after the assassination that provoked World War I. Three weeks later, in that summer of 1914, the fear premium amounted to a total of one basis point. Then, in quick order, European markets ceased to function. A notable feature of this paralysis is that nothing of substance had changed – war had not been declared by any of the parties, but by now, minds were hyperventilating.

Illusions today are such that financial imbalances and debt creation have grown to impossible proportions. Impossible, if the anchor of a gold standard still existed. In 1970, among the US, Japan, and European countries, only two (Italy and Sweden) posted government deficits greater than 0.3% of GDP. By 1994, the governments of France (-5.6%), Japan (-4.8%), Italy (-9.7%), the UK (-7.8%), Canada (-7.3%), Belgium (-7.5%), and Sweden (-12.3%) could thank their lucky stars the gold tether no longer existed. They could make fatuous promises and deliver something for nothing. The world’s bond market expanded from US$800 billion in 1970 to over US$62 trillion in 2006. In 1970, most corporate bonds were still backed by a power plant, a large construction project, or oil production. Today, corporate raiders often issue bonds (that is, new debt) to pay themselves a dividend or buy back stock to boost the value of their stock options. Financial derivatives were spawned by the rout of the gold standard. Currency hedging and interest-rate hedging moved from the blackboard to the trading pits. Thirty-five years later, the financial derivative markets top US$350 trillion – when the world’s GDP is US$43 trillion.

It is surely an illusion that derivative markets are connected to economic activity – the derivative markets are nearly ten times the volume of the world’s annual production. The most unwieldy imbalance of all grows in the US. Not the US$800 billion trade deficit or the US$500 billion federal budget deficit, but the amount of debt created compared to the amount of goods produced. Between 1920 and 1980, every dollar of growth was supported by about $1.40 of new debt. The ratio is $7.00 of borrowing to a dollar of growth today. This is economically unproductive but financially remunerative.

Derivative models are constructed in the mind – elaborate but treacherous probability estimates. The convergence of debt on production is a mathematical fact. As the wise man said: “It is an economic axiom as old as the hills that goods and services can only be paid for in goods and services.” This is no less true today, though we have done a good job of evading the consequences and concealing the axiomatic convergence: either the nonproductive debt defaults or the paper inflates to meet our production. The closer we approach this unattractive prospect, the less we seem to care. Europe produced a parallel 35-year illusion that, with the passage of time, was erased from investors’ mental probability models, yet was recognised “in a flash”.

The historian Niall Ferguson (The Cash Nexus,War of the World) has written a paper on the risk imbedded in sovereign bond spreads between 1848 and 1914: “Political Risk and the International Bond Market between the 1848 Revolution and the Outbreak of the First World War”. Published in the Economic History Review earlier this year (available on www.blackwell-synergy.com), his exhaustive study of weekly great-power bond prices (United Kingdom, France, Germany, Austria-Hungary, and Russia) comes to a surprising conclusion – the closer Europe edged towards war, the less the financial markets cared. Ferguson sees two distinct periods: from 1848 through 1880, the markets were anxious. Sovereign bonds were sold at the slightest scent of war. After 1880, the response to international tensions grew less and less pronounced.

The post-World War II period of fearful consciousness ended in 1971. Armageddon was the intolerable consequence should the US sever its obligation to sovereign states. That obligation was established at Bretton Woods towards the end of World War II. The salient feature of the Bretton Woods system was the United States’ promise to pay out one ounce of gold for every 35 US dollars presented by a foreign government. As the budget deficit, interest rates, and inflation spun out of control, Federal Reserve chairman William McChesney Martin offered the public fair warning. The Columbia University commencement speaker on June 1, 1965 instructed the graduates of unnerving similarities to 1929: private domestic debt was soaring, the supply of money and credit increased as gold was depleted, international indebtedness had risen, “and the payments position of the main reserve money center … the United States … was shaky in the extreme”. The stock market fell 10 points that day and 60 points over the next three weeks to its lowest level in nearly a year. This was known as the “Martin market”. Seeming to reserve his worst for college campuses, the Fed chairman’s speech at Yale University in 1968 foretold of the doom. In Robert P. Bremner’s biography of Martin, the author recounts: “Martin described the economy as ‘living on the edge of an abyss’ if taxes and spending were not addressed. He then observed that if nothing were done, ‘the first trouble would be some basic questions about convertibility of the dollar…. [T]he government will be forced to consider imposing direct control on wages, prices and credit.'”

Martin’s fears were too horrible to believe. Bond prices continued their multi-decade swoon, but didn’t anticipate catastrophe. Yet, all of Martin’s warnings came to fruition. The United States went off gold and would only redeem paper dollars for paper dollars. The currency spent a decade in the doghouse but rehabilitated itself in the world’s view to a respectable enough status. We have since weathered any number of financial catastrophes, made possible through the free-floating dollar and unlimited ability to pump credit into the financial system. We have done this so many times – and to no lasting ill effect – that, even the most pessimistic must ask, “Why should this happy circumstance end now?”

Ferguson found that “midnineteenth century investors tended to infer future changes in fiscal and monetary policy from political events, which were regularly reported in private correspondence, the newspapers, and later through telegraph agencies. Among the most influential bases for their inferences were four assumptions: (1) that a political move to the left would tend to loosen fiscal and monetary policy; (2) that a new and radical government would be more likely to pursue an aggressive foreign policy; (3) that any war would disrupt trade and hence lower tax revenues for all governments; and (4) that direct involvement in war would increase a state’s expenditure as well as reducing its tax revenues, leading to substantial new borrowings.”

Most important, as a parallel to our times, “All these assumptions owed much to the experience of the period between 1793 and 1815.” Investors weigh the recent past most heavily in their estimations. The French Revolution and Napoleonic Wars produced, or spawned (in future wars and revolutions), the product of these fears. In this rough estimation, investors between 1848 and 1880 sold sovereign bonds in proportion to how badly bondholders had fared. Ferguson concludes: “Indeed, the experience of the 1790s – when revolution, war, default, and inflation had sent the yields on French securities soaring from 6% to 60% – echoed, like the Marseillaise, for nearly a century. Each time Paris sneezed, to paraphrase Prince Metternich, the European markets caught cold, most obviously in 1830, 1848, and 1871.”

Ferguson goes on to describe the “biggest crisis in the European bond market in the nineteenth century”. This “occurred during the two months after the outbreak of the 1848 revolution in Paris. Austrian and French bonds were both severely hit, with yields on the London market rising by as much as 662 basis points in the former case, and 505 in the latter.”

(For purposes of orientation, a note on 19th-century bond yields: The British consol is the standard by which to judge other sovereign issues. The 3% consol was introduced in 1751 at a par value of £100. It remained the benchmark bond until 1914. Three-percent consols were perpetual issues with covenants that authorised the government to redeem if the price reached par. During the Napoleonic Wars, it traded as low as £50-1/2 to yield 5.98%. Waterloo was distant enough by 1880 that the consol finally traded at £100 and fell below the 3% mark. The perpetuals traded at 2.25% (above £113) by the mid-1890s. The British government didn’t redeem the issues, but the possibility prevented yields from dropping further. Eyeing Ferguson’s data (painstakingly retrieved from every issue of the Economist between 1848 and 1914), the non-British bonds were generally issued with a 5% coupon until 1880; from 1881 some French rentes (which were also perpetual) and Russian issues paid 3% and 4% (respectively). More importantly, except during crises, yields rarely rose above 5% during the entire 1848-1914 period. The exception was Austria; the imperial credit traded at around 6% or 7% during good times and soared into double-digits during crises. By the 1890s, the four other sovereign issuers traded at yields of 3% or below. The trend for the following 20 years was of higher yields, rising by 0.5% to 1.0%.)

Particularly notable, given the later somnolence, was that after King Louis Philippe gave a “disappointing speech to the Chamber of Deputies” in January 1848, the French market suffered a “depression” [“panic selling”, to hazard a guess]. Following the February 1848 revolution in France, the price of British consols fell 7.6%. This was an overreaction in Britain, as was General Motors trading at a price-to-earnings ratio of 5:1 with a dividend yield of 11% in 1949 – American investors who survived the Great Depression could only look back, and British investors schooled in the Napoleonic Wars could only anticipate the long-feared, cross-Channel invasion.

European bond investors suffered similar panic attacks at the outbreak of the Crimean War in 1854, at the impending Franco-Prussian War of 1870-1871, and during the Eastern Crisis of 1876-1878. Russian bond yields rose 5% in March 1878 in fear of a full-scale war between Russia and Britain. This fear, The Economist wrote, was of a “new campaign [that] would lead to a financial disaster. Although the risk of this is very small, this has, nevertheless, depressed Russian stocks.” In modern parlance, the risk-pricing models took unlikely events seriously. But, as is true today, the pricing models weigh recent events most heavily. The world knew these splendid little wars could have turned Napoleonic, but none did. The revolutions of 1830, 1848, and 1871 could have spread like wildfire across Europe, but none did.

Then markets turned a deaf ear to bedlam. In Ferguson’s summation:

Repeatedly between 1845 and 1880, then, not only war, but even the mere possibility of war pushed up the risk premia and therefore the yields on great power bonds. The puzzle is that after around 1880 the threat of war seems to have counted for much less. Indeed, the magnitude of financial responses to political crises apparently declined even as 1914 approached – the reverse of what traditional historical accounts would lead us to expect. That, at any rate, is one possible inference to be drawn from financial market data. In the decades before 1914, there was a marked convergence in the longterm interest rates of most major economies.

Ferguson discusses practical reasons why sovereign bond yields fell and converged after 1880: the widespread adoption of the gold standard, the deepening of markets and liquidity, and the rise of local savings banks lassoed to the (general) requirement that deposits be backed by government bonds. Each explanation has its virtues, but flaws persist. The gold standard, the author explains, was seen as a commitment to fiscal rectitude, but gold “was a contingent rule, or a rule with escape clauses” which could be suspended “in the event of a well-understood, exogenously produced event, such as war”.

Ferguson offers an analysis of post- 1880 bond spreads:

Spreads between British consols and approximately equivalent French, German, Russian, and Italian long-bond yields all tended to fall. For example, Italian yields, which were close to double British yields in 1894, had fallen to just 54 basis points above them by 1907. Part of this convergence was because of the rise of consol yields from their all-time nadir of 2.25 in July 1896 to 3.6 per cent in July 1914. However, the main cause was the decline in yields on the bonds of the other great powers. Even more strikingly, the magnitude of short-run fluctuations in yields also diminished. Volatility in the bond markets has also disappeared today.

We saw compression of sovereign yields in Europe when countries cooked their books in anticipation of the Euro. The wide government deficits of 1993 converged on solvency and even persist, at least in official figures. Sovereign credits of Greece trade at approximately the same yield as German debt. Even such a successful domestic investor as Sophocles would forego the local and buy the foreign bond. This willingness to invest in an illusion may find an analogue in the “contingent rule” of gold “with escape clauses”: an inconvenient truth is better dismissed in a bull market.

Let’s turn to a mythical, prototypical Serious Investor. A rookie in the late 1960s, he fears rising budget deficits, out-of-control consumption, waning physical production, an economy that survives from financial transactions and the mysterious yet oppressive influence of derivatives on the financial markets. This investor watches credit mushroom; bubbles pop and move on. He sees no-interest, no-downpayment, optional-monthly-payment mortgages hibernate in hedge-fund side pockets, which recycle the central-bank, commercial-bank, prime-broker, credit-inflation pool. Reading Professor Ferguson’s study, he won’t find the post-1880 atmosphere puzzling.

If the 1878 Russian-British showdown was the climactic event in draining Napoleonic worries from the investing conscience, the 1971 split with gold served the same function for our enlightened financial era. A clear sign of impending financial breakdown lit the trading screens in 1959. (Please forgive the anachronism.) The US balance-of payments deficit had deteriorated throughout the 1950s. In 1959, the London bullion market broke through the official trading ceiling of $35 and surged to $40.60. Gold hadn’t risen above $35 for 11 years. Fears abated after government reassurances (and not much more), but anyone with a sense of proportion knew the math didn’t work. Unless the US reversed its spendthrift ways, gold at $35 an ounce was doomed.

In 1964, Fed chairman Martin told President Johnson and Secretary of Defense McNamara that US military commitments overseas would cause a devaluation in the dollar. Their reaction reflected both their maturity and sense of responsibility: they shouted and screamed at Martin, then lied about expenditures to Secretary of the Treasury Fowler and the leaders of Congress. This made it all the easier to run the ship of state on to the rocks in a very short time. The vessel splintered so quickly it was difficult to comprehend.

The federal spending deficit was US$1 billion in 1965. By 1967, with nearly half a million US troops in Vietnam, the defence budget was expected to grow to $5.8 billion. In mid-stream, growth was recast at US$13 billion. The 1967 fiscal year deficit widened from a US$4.5 billion forecast to US$11.9 billion in August 1967. The 1968 fiscal year deficit was now expected to be US$19 billion – larger, even on a percentage basis, than during World War II. (Larger, even on a percentage basis, than today.) In October 1967, Secretary of the Treasury Fowler told Johnson the deficit could go to between US$23 and US$28 billion. The First National City Bank projected that net government borrowings could be US$20 billion in the second half of 1967, compared to US$5 billion in 1966. Institutional Investor predicted the “Death of Bonds” on its front cover just before bond traders embarked on their road to fortune.

The question remains whether this collapse of fiscal discipline was made possible by the loosening standards of the leading economists of the day. Reading through the memos and discussions over the course of the decade – particularly the first half, economic advice to the Oval Office grew less authoritarian as political circumstances (that is, elections) dictated lax standards. What alarmed investors and the general population in 1959 (through the press) went unnoticed by 1965. Alarm turns to security with the lapse of time. Yet, the problems were indeed worse. The immediate results, though, if not benign, were certainly not catastrophic – the Martin market passed and new stock market highs weren’t long in coming. Parallels to the new millennium are obvious.

Then, too, the question arises how the Bretton Woods arrangement held together as late as 1968. Like today, the arrangement survived through plenty of smoke and mirrors. Government, central bank, and money-centre bank manoeuvres manufactured an illusion. The London Gold Pool (divined in 1960 to halt gold speculation) spawned, in 1968, a parallel London Gold Pool (conjured to subdivide official trading from the market price); Special Drawing Rights introduced finance to the magical derivative world – gold was no longer to be transferred; only the “right” to do so remained. Other Rube-Goldberg measures attempted to fix what could only be fixed by fiscal and financial rectitude on the part of the US government and its citizens. This wasn’t going to happen. Yet, there was little awareness on the part of investors that US$35 gold and the purchasing power of the dollar were doomed – unless we permit the supposition that such a possibility was better ignored if you were in the market.

Then, as today, there were plenty of warnings. Martin, who spoke as the transmission of the world’s financial engine, warned the world in a well-publicised 1968 speech: “We have been living in a fool’s paradise. We face a financial crisis that is not understood by the public.” The Fed chairman said he had tried to make himself heard, but “there is no disposition on either side of the aisle in Congress to face up to the problems”. Martin apologised several times during the speech for appearing too emotional. He was cracking under the pressure.

How could he have made it clearer to sell the dollar? Yet, the charade went on for another three years before President Nixon officially closed the gold window on August 15, 1971. Gold rose to over US$800 an ounce by the end of the decade, and paper assets were an easy avenue to lose a life’s savings. Commodities, rare stamps, and Rembrandts were the assets to hold during the 1970s; Americans abroad found that Italian and Belgian hotels wouldn’t accept dollars; wages and prices were frozen by federal decree; likewise, the annual inflation rate of goods (CPI) rose to 18%, short-term Treasury bills traded at 17%, and the 30-year bond rose to a 15.49% yield. (European bond holders of the 19th century never sold off the tottering Austrian Empire to such a level.)

It was a bad decade for America. Nixon was impeached; Vietnam was lost; the Soviet Union was winning; the US federal deficit rose to US$53 billion in 1975. President Carter was elected; he donned his cardigan sweater to enliven the chagrined and the deficit rose to US$73 billion.

Yet, the currency of choice remained the US dollar. As the economy and financial markets turned up, the perfectly human tendency was to kick up one’s heels, think the world’s financial system had survived – and flourished – after gold convertibility collapsed. Those who still fretted over deficits and the paper monetary system were dismissed as cranks and lumped with the Michigan Militia.

And what was there to fear? As the various financial and economic balances wobbled farther from their gold anchor, financial crises became commonplace. We learned to take them in stride.

This might be similar to the climate after the Eastern Crisis – the rumpus in the Balkans that nearly sucked in most of Europe. Ferguson runs through some flare-ups after 1880 that could have engulfed nations, but did not. Since 1971, we have lived through a series of financial crises that could have turned climactic, but did not. He cites the British occupation of Egypt in 1881 [Citicorp’s emerging market loans, circa 1980], the Afghan Crisis of 1885 [Continental Illinois, 1984], the Bulgarian Crisis of 1886 [stock market crash, 1987], the Russian and German standoff between 1888 and 1891 [Savings and Loan crisis, 1989- 1991], the Fashoda Incident in 1898 [money centre bank crisis, early 1990s], the Boer War,1899-1902 [derivatives meltdown, 1994], the Moroccan Crisis of 1905 [Mexican peso bailout, 1995], the Anglo- German antagonism, 1906-1908 [Asian meltdown, 1997], the Balkan Crisis, 1908-1911 [Russia, 1998], the Balkan Crisis, 1912-1913 [LTCM, 1998], the British and German naval construction buildup, leading up to the War [derivatives compounding and still bursting with innovation today], and another Balkan Crisis in the summer of 1913. To offer a possibility: a fourth Balkan Crisis in the summer of 1914 may have been greeted with the same weariness as notice that Amaranth Advisers, the Greenwich-based hedge fund, lost US$6 billion in the summer of 2006. News of the collapse vanished as quickly as it appeared; other funds absorbed the derivatives positions in a matter of hours. Long-Term Capital Management was only half the size; therefore, we needn’t worry about another derivatives crisis. Q.E.D.

The Naval race between Britain and Germany sold newspapers and books in the 1890s. Aside from the prospect of war, shipbuilding programs expanded government spending. British and German bond yields rose, but not significantly. Fears still simmered and haunted in the decade before the War (Norman Angell’s The Great Illusion was a bestseller), but the popular imagination had grown accustomed to the debate. Likewise, the US survived the portfolio-insurance meltdown in the stock market crash of 1987. The theorists who devised portfolio-insurance derivatives – a prime cause of the meltdown – discovered this crash was a 20- standard deviation event and concluded: “a day like this wouldn’t be expected to happen during the lifetime of the universe.” The implosion of Long-Term Capital Management in 1998 was also dismissed as a once-in-the-history-ofthe- universe event. In May 2005, after some hedge funds were caught on the wrong side of the General Motors downgrade, this eightstandard deviation movement in prices was ignored. Considered so remote a probability in the history of human existence, it wasn’t worth considering in future derivatives modelling. Alarm turns to security with the lapse of time.

It is 2006. Our Serious Investor (Columbia, B.A. 1965; Yale LL.B., 1968) has grown calloused to once-in-the-history-of-the-universe events. Martin scared him to death. Our Investor understood the dollar was the weak link in the international payments system. Surely, the American Century was at an end. Our Investor survived the dollar crisis, the stock market collapse and deep recession of 1973-1974, the Business Week “Death of Equities” front cover, the US$250 billion federal budget deficits of the 1980s, the frequent financial and derivative crises of the past 20 years (far more prevalent than between 1950 and 1970), the current US$500 billion federal budget deficits, and the (prospective) US$1 trillion trade deficit. Our Serious Investor has prospered. He gradually learned to shrug off the deteriorating macro world. He grew accustomed to the “Greenspan put” (that is, central banks will bail out any-and-all financial meltdowns), the risky adventures of hedge funds, the abandonment of debt covenants by bond issuers, the private-equity moon shot; he has, by now, grown so accustomed to the warnings that he keeps his head down, plugs away, and diligently watches for signs that THIS IS IT.

If convinced THIS IS IT, what would he do? He’s not sure. He loses a night’s sleep. He goes to the office the next morning and pulls out a faded, 1978 clipping from U.S. News and World Report:

The mountain of debt has grown so high in this country that many economists fear the United States is unusually vulnerable if a recession occurs…. [S]ome fret that a load of personal debt will make a recession more severe than it otherwise would be. In only 3-1/2 years since the end of the last slump, Americans have added a trillion dollars to their financial obligations. Today, government, corporations and individuals owe more than 3.5 trillion dollars, equal to nearly $16,000 for every man, woman and child in the country…. The question now being raised is whether a day of reckoning is at hand.

Our Serious Investor relaxes. Yes, all of this is still true and now we add a trillion dollars of debt every three months. We have accumulated US$90,000 in debt for every man, woman, and child in the country. A day of reckoning will come. But there’s no point worrying about it. The entire credit structure and gutted economy is a shambles, but we inflated our way out of a 1978 reckoning; we may muddle through again. The emperor wears no clothes, but the architects of economic consensus and market wisdom constructed a bunker that excludes the dissidents. Official opinion is like Lenin’s tomb. The iconic face demands intensive care as the skin decays. The deception of eternal embalming grows less convincing as the emperor’s face erodes. The best minds are diverted from biotechnology labs and mathematical discoveries to design a cosmetic cloak for a dead corpse.

US financial chicanery is similar, with a twist. It bloats and must continue to do so. US engineers and mathematicians (in such demand they are now imported from China and India) must not only disguise blemishes, but perform artistic feats to match the finest trompe-l’æil artists. The asymmetrical cheekbones and mutations of the cranium demand optical illusions. Our Serious Investor knows the suspension of judgment on the part of the viewing public could dissipate in a flash, but trading rooms still watch CNBC, quote Gentle Ben, and are preoccupied with football betting pools. We will be free of thought at least through the Super Bowl.

Investors who held government bonds prior to World War I probably didn’t give much thought to the alternative investments. Financial markets had expanded by leaps and bounds over the past generation. This multiplied the ingenuity, nationality, and variety of securities, but railroad bonds issued in Vienna or London carried their own baggage. Gold was the only solution, but a poor one. (Even that was often repatriated in the war effort. US stocks might have seemed an escape hatch, but the British and French governments confiscated their citizens’ securities held in New York accounts. Taxes soared on property, and wrought iron fences were nationalised. And this was in Britain – where no battles were fought.)

Our Serious Investor holds one trump card not available to his ancestors. The derivative world offers such an extraordinary range of insurance products – puts on indexes, on stocks, even puts on puts; credit derivative protection against defaults; mutual funds that leverage short positions on bond and stock indexes – and they are extraordinarily cheap. They are cheap because volatility has disappeared from markets, and protecting the downside risk in a portfolio is generally considered a waste of money. It is also a risk to one’s career, since clients want every cent of their money chasing higher returns.

Ferguson’s narrative of the countdown to war is a splendid chronology of how quickly the world can change:

It was not until 22 July [1914] – more than three weeks after the Sarajevo assassinations – that the possibility of a European political crisis was first mentioned as a potential source of financial instability in the financial pages of The Times. A plausible inference is that continental markets were anticipating the belligerent tone of the Austrian ultimatum to Serbia, published on 23 July, which demanded official cooperation with an Austrian inquiry into the Sarajevo assassinations. This was the signal to investors that war was a real danger.

The 2-1/2% British consols rose from a 3.30% yield on July 7 to 3.31% on July 22 – a single basis point of fear. If investors now foresaw real danger, they must have believed their portfolios received a personal exemption. Tensions rose on the exchanges and grew acute on July 27 when the Vienna and Budapest exchanges closed. The Sarajevo incident could still be interpreted as a local affair, but trading slowed on the other European exchanges. Now consols rose to 3.45%. The St. Petersburg exchange closed on the 29th and The Economist considered the “Berlin and Paris bourses closed in all but name”.

It was by no means clear who would fight, or even if there would be a war. Nevertheless, British exchanges suffered a two-fold crisis. In Ferguson’s words:

First, foreigners who had drawn bills on London found it much harder to make remittances; those British banks that had accepted foreign bills suddenly faced a general default as bills fell due. At the same time, there were large withdrawals of continental funds on deposit with London banks and sales of foreign-held securities. London became, as The Economist put it, “a dumping ground for liquidation for the whole Continent of Europe”.

A wholly unanticipated domino effect now engulfed London. The bond market didn’t seem to acknowledge this vaporisation of liquidity:

Even these developments had a remarkably limited impact on great-power bond yields. Between 22 July and 30 July (the last day when quotations were published), yields on consols rose by 26 basis points; yields on French rentes by 22 basis points; and yields on German bonds by 17 basis points. The rises were twice as large for Austrian and Russian bonds, yields on which rose by nearly half a percentage point…. The Economist was especially struck by the widening of the bid-ask spread for consols (the gap between buyers’ offers and sellers’ asking prices) to a full percentage point, compared with a historic average of one-eighth of 1%….

The London market started to close on July 29. London clearing banks concentrated on funding their stock-exchange clients, eight of which failed by the end of the day. On July 30, the Bank of England raised its discount rate from 3% to 5%. On July 31, the Stock Exchange was closed and the Bank of England raised its discount rate from 5% to 8%. The week before, The Economist was preoccupied with the “continual suspense over Ulster”. (Northern Ireland dominated newsprint during the summer of 1914. It made better copy than another Balkan Crisis.) What a difference a week makes – from the August 1, 1914 Economist:

The financial world has been staggering under a series of blows such as the delicate system of international credit has never before witnessed, or even imagined…. Nothing so widespread and so world-wide has ever been known before. Nothing … could have testified more clearly to the impossibility of running modern civilisation and war together than this closing of the London Stock Exchange owing to a collapse of prices, produced not by the actual outbreak of a small war, but by fear of a war between some of the Great Powers of Europe. [My italics.]

Did The Economist or the Bank of England consider the international credit system “fragile”, under any conceivable circumstances, a year before? Five days before? Ferguson writes:

The key phrase here is “fear of a war”. Although Austria had declared war on Serbia on 28 July, it was still far from certain that the other great powers would join in; it was not until 31 July that Russia, after three days of indecision, began general mobilization, prompting the German government to issue its ultimatums to St Petersburg and Paris. The Germans did not declare war on Russia until 1 August; their declaration of war on France came two days later. Britain entered the fray only on 4 August (an event readers of The Economist had certainly not been led to expect). What happened between 22 July and 30 July was therefore no more than a sharp rise in the perceived probability of a great power war on the continent; it was still not considered a certainty when the markets had to close.

Oh, but that was the Stone Age. They didn’t have the Internet! It is worth considering though, despite the technological innovations and wonders of the Information Age, that this week’s celebrities of Wall Street are more inert than the better minds in the City a century ago. Ferguson found “even to the financially sophisticated, as far as can be judged by the financial press, the First World War came as a surprise. Like an earthquake on a densely populated fault line, its victims had long known that it was a possibility, and how dire its consequences would be; but its timing remained impossible to predict, and therefore beyond the realm of normal risk assessment.” So it goes with any probability model, designed in the head of a Rothschild or by the math nerds at JP Morgan.

As to how much we can trust the Greenspan “put”: “[T]he British and Continental financial authorities pulled every trick.” The author furnishes a list of clever, arbitrary, and confiscatory manoeuvres, but “systematic central bank interventions to maintain bond prices” only worked for a time. Government assistance “could only disguise the crisis that had been unleashed in the bond market; it could not prevent it”. Hank Paulson should forward that paragraph to The President’s Working Group on Financial Markets.

Ferguson scrapes up the debris:

For all save the holders of British consols, who could reasonably hope that their government would restore the value of their investments when the war was over, these outcomes [for Continental sovereign bond holders] were even worse than the most pessimistic pre-war commentators had foreseen. The fact that investors do not seem to have considered such a scenario until the last week of July 1914 surely tells us something important about the origins of the First World War. It seems as if, in the words of The Economist, the City only saw “the meaning of war” on July 31 – “in a flash”.

Aside from the origins of World War I, the last week of July 1914 surely tells us something important about investors today.

Fred Sheehan

January 26, 2007