Bankers in historical booms and busts

This is the fourth part in a six part series that looks at whether bankers are good or bad for society:

• Part One: Why Bankers are essential for society
• Part Two: A Bankers pivotal role between good and bad
• Part Three: A Bankers' role in religion
• Part Four: Bankers in historical booms and busts
• Part Five: Bankers today
• Part Six: Bankers tomorrow

[If you just want to get the slides and download the
whole speech, click here]

In
this entry, we study the role bankers have in historical booms and bubbles, specifically four of the biggest boom-bust crisis of the past – the fall and rise of the Roman Empire, Renaissance Italy, the South Sea Bubble and the Great Depression. In each instance, bankers were a major force for good in creating these booms, and bad in allowing them to bust.

Banking for Good or for Bad

From the earliest example of Jesus throwing the moneychangers out of the Temple, society was transforming from Pagan cultures in villages to Christian, Islamic, Jewish and Buddhist cities of civilisation. It was a period of major commercial and Empire expansionism, fuelled by a clear work ethic and rewarded by riches of wealth based upon early banking practices.

The ability to build, develop, acquire and grow requires funds and bankers provide the ability to connect those who need funds with those who can provide them.

This is where banking is a force for good – in enabling growth, progress, development and expansionism – and was clearly illustrated by the building of the Roman Empire.

The Rise and Fall of the Roman Empire

Roman society grew to be the most powerful because it was a very paternal and organised society and structure. It is where the whole concept of patronage came from, and you were either a patrician or a plebeian. The plebeians were dependent on the patricians, because the patricians supported them financially and legally in exchange for their services.

Religion was also very important to the rise of Rome, as the Senate would not allow any other form of worship. The Senate used religion to control the lives of Romans as a way to prevent personal freedom.

Finally, Rome became an Empire because of the acquisition of lands after the wars against its neighbour’s cities. Becoming geographically larger, Rome became more powerful socially, politically, and economically over the conquered cities and the financial and political order of Rome based upon patronage and the Senate were at its heart.

Why did Rome fail?

Many historians speculate that the rapid growth of the empire over a relatively short period of time and the economic inflation that followed could have contributed substantially to the empire's decay.

Due to the incredible size of the empire, it required a huge budget to maintain many key elements in its survival such as roads which were essential for communication, transportation and the moving of armies, and aqueducts as Rome's cities relied on the water such aqueducts provided.

At the time the empire was fighting enemies on all sides due to its expansion into their territories and was already contributing huge sums of silver and gold in order to keep up its armies. In order to try and combat both problems, the empire was forced to raise taxes frequently causing inflation to skyrocket. This in turn caused the major economic stress that many attribute as one of the major causes for Rome's decline.

So, in simple terms, the rise and fall of the Roman Empire was facilitated by bankers who helped to fuel its growth through financing but sourced its failure by the same token, in this case by expanding too far and fast for financing to be sustainable. In other words, they were over-leveraged.

This boom bust cycle of empire building and expansion fuelled by financial leverage leading to empire implosion and contraction caused by over-leverage can be seen time and time again throughout history.

But without such expansionism supported by financial innovation, we would see little expansionism or progress at all.

Turmoil creates innovation and banking creates progress as proven again a thousand years later as the origins of modern banking developed in the merchant banks of Renaissance Italy .

The Rise and Fall of Renaissance Italy

Visit Italy’s major cities of Rome, Florence and Venice, and you can still see the opulence and grandeur of the merchant banking revolution of the Renaissance.

In particular, if you look beyond the facades of the river and seaport buildings, you can literally see the direct origins of our modern economy. Italy housed the first private corporations, insurance companies and banking conglomerates.

For over 500 years, Venetian traders and bankers dominated European commerce with, at their peak, over 3,300 merchant ships and 36,000 merchant marines. They forged long-lasting business relationships throughout the Mediterranean and beyond.

They built the first capitalist empire, and the evidence is everywhere.

By the 14th century, there were over 140 Italian banks, mostly in Venice, and the biggest bank was run by the Medicis.

The Medicis had long been involved in banking and were innovators in accounting. At one point the Medicis managed most of the great fortunes in the world, from royalty to merchants. There was even a time when the currency issued by the Medicis was accepted and used throughout Europe as the preferred currency.

Founded in 1397, the bank expanded quickly such that, by 1427, the Rome branch had approximately 100,000 florins on deposit from the State; in comparison, the total capitalization of the entire Medici bank was about 25,000 gold florins.

Then the decline of the bank began in the 1460s. This is because many of the banks were run by families and would last a single or few generations as father to son expertise could not always be handed down or replicated.

However, a specific cause was defaults on loans with ‘trusted clients’, such as King Edward the Fourth of England who had been fighting the War of the Roses between the Houses of York and Lancaster. In 1467, the King owed 10,500 pounds sterling to the Medici Bank; the nobility had borrowed 1,000 pounds; and another 7,000 pounds were tied up in various illiquid assets.

The Wars of the Roses rendered Edward IV unable to repay the loans, and all of them defaulted.

The London branch of the Medici Bank closed in 1478, with total losses of 51,533 gold florins.

Many of the other Italian banks went through a similarly turbulent rise and fall. For example, the Peruzzi Bank loaned 600,000 florins to the English King Edward whilst Bardi Bank loaned him 900,000. When King Edward reneged on his debts, both of these powerful banks went bust. Today, the only surviving bank from that period is the Bank of Monte Paschi di Sienna, established in 1478.

One of the key lessons that came out of this period is that Italy’s merchant banking dreams were crushed by complacency.

Even after Venice passed its peak, its merchants and investors saw only blue skies ahead. They underestimated the growing power of foreign competition. They failed to participate in the new markets opening up in the 16th and 17th centuries with the discovery of the new world and new trade routes to Asia.

They didn’t understand the importance of the Spanish awash in gold from South America, England and France settling North America, or the Portuguese making inroads in “the Japans.”

Venetian dominance was broken. And by the time Venice woke up to the change, it was too late. The world’s first capitalist empire declined, and today all we can see are its glamorous remnants.

But yet again, it is just an illustration of the boom and bust cycle created by economic strengths where bankers are good for society – how would Italy have ever enjoyed its Renaissance without them? – and bad for society – the Empire was crushed because of poor credit risk management in giving loans to people who wouldn’t repay them.

Does any of this sound familiar?

But also take note the rise and fall of Renaissance Italy, fuelled and fooled by bankers, was a vibrant and successful period of massive progress. As Orson Welles makes clear in the film the Third Man.

In Italy, for 30 years under the Borgias, they had warfare, murder and bloodshed, but they produced Michelangelo, Leonardo da Vinci, and the Renaissance. In Switzerland they have brotherly love. They had 500 years of democracy and peace, and what did that produce? - The cuckoo clock!
Harry Lime, the Third Man

So bankers are good for society when creating progress and development.

Moving on, in tracking our case for whether banks are good or bad for society, we find the next serious market implosion in the early 18th century when Britain experienced the boom and bust of the South Sea Bubble.

The South Sea Bubble

The South Sea Bubble takes us from the age of commercial banking innovations of the Renaissance to investment banking innovations during the European Empire Building of the 17th and 18th Century.

You could not launch massive overseas colonisation exploits without capital, and companies that were being created to leverage these new trade routes needed a lot of it.

As a result, investors created the earliest stock exchanges for raising capital in the late 1600s and in 1711, after a war which left Britain by 10 million pounds in debt, the government proposed a deal with the South Sea Company to allow Britain’s debt to be financed in return for 6% interest. In order to sweeten the deal, the government added another benefit: sole trading rights in the South Seas.

Because of their monopolistic position and strength with government backing, shares in the South Sea Company were incredibly popular and their value rose to ten times their initial public offering price.

Seeing the success of the first issue of shares, the South Sea Company quickly issued more.

Again, the stock was rapidly consumed by the voracious appetite of the investors.

Investors saw that the stock was going to the stratosphere and they wanted in.

Equally, many investors were impressed by the lavish corporate offices the Company had set up even though, at the time, they had not even started trading in the South Seas.

The extent of the South Sea bubble can be seen by the fact that 462 members of the House of Commons and 112 Peers had some sort of stake in the South Sea Company.

Everyone bought into the stock.

Then the 'bubble' burst because people discovered that the South Sea Company, after several years of trading, had yet to actually deliver any goods or produce from the South Seas.

The shares had been valuable on paper, but worthless in reality.

Hence, the herd mentality that caused this madness of crowds suddenly sobered up and everyone pulled their money out of the markets.

People all over the country lost all of their money. Porters and ladies maids who had bought their own carriages became destitute almost overnight. The Clergy, Bishops and the Gentry lost their life savings. The whole country suffered a catastrophic loss of money and property.

There was even a call in Parliament to resurrect the Roman punishment of Lex Pompeii, where bankers and those involved in this disaster would be tied in sacks with snakes and thrown into the Thames.

The South Sea Company Directors were arrested and their estates forfeited and frantic bankers thronged the lobbies at Parliament.

We read about the South Sea Bubble today and maybe wonder how so many people got involved in such a dubious undertaking.

Or maybe not as, today, we have seen other bubbles – such as the internet and house market bubbles – which has also burst.

The lesson is always the same: if you find a get rich quick scheme, you’ll find a get poor scheme just as quickly.

What is surprising is that the basic knowledge of the herd mentality and the madness of crowds was summarised clearly by Robert Mackay back in the 1840s with his book, Extraordinary Popular Delusions and the Madness of Crowds, which studied the South Sea bubble along with the Mississippi Company bubble of 1719–1720 and the Dutch tulip mania of the early seventeenth century.

This text is well read amongst finance professionals so you would think we would know better wouldn’t you?

And this is the point.

You don’t have progress without bankers to facilitate it, but equally progress fails when society moves from developing to destroying value. And nothing destroys value faster than a get rich scheme, otherwise known as a bubble.

But without such bubbles of wealth generation, we would not have seen the rise and fall of the Roman, Italian and Medieval Societies nor would we have had civilisation, cities, empires, colonisation and progress.

Were bankers to blame for ruining Georgian society?

Yes and no, as the expansionism and colonisation of countries and continents led to the Industrial Revolution and became the core of Britain’s Empire building a century later.

Without the leverage the banking system gave to such trading; without the oiling of the system of commerce that enabled growth; without learning basic lessons of raising capital and moving money from those who have it to those who need it and are willing to pay for the privilege; without these things, none of the Industrial Revolution would have happened as quickly and dramatically as it did.

So bankers were good for British Society by enabling the origins of capital markets that led to the South Sea Bubble, and were bad for society by having the love of money which allowed greed to take over from the effective management of the risks inherent therein.

This is exactly the same lesson that the merchant bankers experienced and the Romans before them.

The Great Depression

Finally, and briefly, it is worth looking at the last and most recent phenomena of financial crisis: the Great Depression.

As mentioned in my opening remarks, the Great Depression began exactly eighty years ago today.

The crash was caused by the policies created just after the Great War, when governments encouraged monetary policy to be loosened such that markets expanded rapidly resulting in the 1920s being a boom period.

For example, leading up the October 1929 stock market crash, US margin requirements for financial firms was set at only 10% so that firms could lend $9 for every $1 an investor had deposited, and lend they did. Bear in mind that this was a great period for manufacturing and industry, with one of the biggest revolutions being the introduction of mass access to the automobile thanks to the launch of the Model T Ford and similar vehicles.

Roads needed to be built, and everyone should have access to money to buy cars according to the governments’ rules, so banks pretty much gave loans to anyone wanting a car.

This free access to credit created the automobile revolution and led to a boom economy.

Unfortunately, by the end of that decade, as with most booms, the markets bust due to the total collapse of US stock market prices on October 29th, 1929, known as Black Tuesday, and the ensuing loss of confidence in the banking system.

The Depression kicked off full force from 1931 onwards when banks called in the loans they had pretty much been giving away and forcing on people, only to find they could not be paid back.

The result was that over 9,000 banks failed during the 1930s and, by April 1933, around $7 billion in deposits had been frozen in failed banks.

What the Great Depression taught us is that the boom cycle, in this case from industry and manufacturing, is facilitated by finance. If the financiers loosen monetary control too far however, as was the case with lending during the 1920s, then you will create a false boom and the bigger the boom, the bigger the bust.

We should have learned our lessons but, without the Great Depression, we would not have experienced a Second World War which led to the creation of the World Trade Organisation, the Bretton Woods agreement, the European Common Market and over sixty years of relative world peace.

Equally, we would not have created the foundations of the next great revolution: the office worker and the technology boom of the last century.

And so these booms and busts of the past have always created foundations for the next great wave of the future.

Sumeria enabled Athens and then Rome to build Empires.

Empires led to Colonisation and Exploration further afield.

After we circumnavigated this planet, we then began to harness its resources moving from agriculture to industry and from industry to intellect.

And all of these revolutions in society and structure were enabled by financiers who were able to use money to facilitate progress.

So bankers are good for society, in enabling progress, but bad for society if they allow such progress to be created at the cost of the value it is built upon.

Each rise was driven by expansionism supported by finance. Each fall was fuelled by financial controls becoming too loose, or too risky or unfocused to allow progress to continue.

Regardless of your views, the lessons leading up to each crash once again reverberates with today’s issues.

Which finally brings me to today’s crisis.

The fifth and penultimate part of this series studies what we should have learnt in preparation for this crisis and what we have learnt as a result of it.