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Financial Alchemy: How to Turn Trash Into Gold - History of Finance V
14-03-2023
AXO

It’s fitting that Don Quixote, the crazy knight who fought windmills, was the first to say that one shouldn’t put all of one’s eggs in one basket.

It sometimes takes a madman to realize that there is great risk in continuing to do things as we have been doing. In this article, we will be exploring how investors started trying to protect themselves from the evolving complexity and crashes of the first modern financial markets. This was done through securitization, by pooling their assets together and creating financial instruments that represented a whole variety of projects and thereby offsetting the risk of any single component.

This article is the fifth in our series of history articles. You are welcome to start from the beginning, but this is not a university course. Each article is self-contained, and while it might be advisable to read them in chronological order, it’s certainly not a requirement.

For now, we will begin our story near 1720, when France was about to undergo an implosion that would put the average citizen off of the stock market and from accepting paper money for quite some time.

Picking up the pieces

For thousands of years, mystics and charlatans alike tried their hand at alchemy — where they attempted to purify substances to their essential nature, turning abundant but worthless materials into the valuable and rare. In more ways than one, the eighteenth century is when alchemy finally worked.

In the literal sense, we had Augustus II, King of Poland and Elector of Saxony, imprisoning an alchemist — who claimed to be able to turn rubbish into gold — until he showed how his craft worked. The claims were a sham, but imprisoned in the laboratory and desperate, he tried random experiments. Years later, he discovered how to turn dirt into porcelain — which to European society at the time was just as good as gold, as it was a rare material whose secret China had defended for hundreds of years [1].

In the more metaphorical sense, the eighteenth century is when we learned that by grouping assets together, represented by a single financial instrument, you could create a wholly different, more stable, and more liquid asset class.

This financial alchemy came to be known as “securitization,” but like any complex behavior, the activity emerges, and then the scholars are left to quibble over the definitions. In the eighteenth century, we saw the first attempts to pool assets together.

It initially came in the form of “stable” investments and currencies, which were purported to be exchangeable for some unit of value. In France, a man known as John Law created the Banque Générale Privée, which was among the first banks to issue paper money in return for deposits of gold and silver.

John Law

The ability to magic up capital at a moment’s notice and efficiently be able to service financial instruments proved to be a decisive advantage. Merchants were charged less interest than in other banks, and hence John Law’s bank began to outcompete his rivals and gain their business. So effective was this model that the Banque Générale Privée became the Banque Royale, and John Law’s paper notes became the government-issued currency [2] (it didn’t hurt matters that among John Law’s early investors were prominent aristocrats and the then regent of the country, trying to find a means to usurp power from the 5-year old king).

This wasn’t something that the wider public was happy about, especially as the government’s involvement brought limitations on certain uses of gold and silver. Self-custody of precious metals, while not immediately banned, was certainly frowned upon by the powers that be [3]. It just seemed like a matter of time before paper money was the norm, but the public would need more convincing.

In order to do this, John Law took over the Mississippi Company, a corporation holding a business monopoly in the French colonies of North America and the West Indies. He then made paper banknotes exchangeable for shares at a fixed rate, effectively linking the value of the shares and the French economy. Meanwhile, everyone in power used every trick in the book to convince people that Mississippi was a land of untold potential and riches. Expeditions were mounted, the newspapers would write about potential riches, and settlers were offered promising rewards for establishing colonies [4].

This had two effects, firstly it backed the worth of paper money and increased its desirability, and secondly, it paid off the overwhelming debts that France had.

It’s easy to write off what John Law was doing as being a scam, but that would not necessarily be the most sincere interpretation. Years prior to achieving power he had written essays on the potential of securitizing land into currency. It fit all the notions of good money, after all, it’s divisible, verifiable, durable, and transferable. But his ideas would need a different audience to work.

In either case, the real estate he was securitizing with French banknotes & shares was swampland with dubious economic value and little came of it. So eventually, once enough large depositors came demanding gold and silver, the game was up. It was a Luna-esque crash, where banknotes were printed to prop up share prices, and shares were sold to back redemptions. The market was flooded, and both depositors and investors were left holding paper.

France was left in tatters, and the trust in the government was irreparably shattered — the lords tried their best to claw back their wealth from the people by going feudal, and over the next few decades this would set the stage for what would become the French Revolution.

It would take many generations before Europeans properly trusted paper money again, yet on the other side of the Atlantic, the story was very different. North America was a land rich in resources, but without the economic means to fully take advantage of it, hence they had to get creative.

The American dream

Over in the North American territories, there were huge swathes of land, and owing to smallpox wiping out a significant amount of the native population, there was little comparative resistance to European settlement.

John Law dreamt of replacing currency with commonly owned stock representing revenue derived from the new land; thereby completely redefining the nature of France’s economy. Given the prevailing sentiment and economic realities, this didn’t seem that far-fetched at the time. After all, it wouldn’t be until the late 19th century that the US vision of “Manifest Destiny” would come to fruition.

The nature of the slave triangle (between Africa, the “New World” and Europeans), and being a colony, meant that a lot of money left the North American territories, but it didn’t come back. North America was thus rich in natural resources but chronically underpopulated and lacking in official currency. Even to this day, if you compare land mass and divide it by population, the USA has 0.0276 square kilometers per person while the EU has 0.00898 square kilometers per person.

This disparity was so pronounced centuries ago that it was one of the attractors of the North American colonies. For hundreds of years, in the lands that would become the USA, it wasn’t uncommon to just give land away for free.

When entire populations are drawn to North America for opportunity and riches, it’s only natural that they will then attempt to use their newfound wealth in financial transactions. Hence, paper money — especially currency backed by land — had considerably more appeal in the colonies than in Europe [5].

The problem is that land is far more difficult to value than a gold coin. After all, every property is different. Not only that, but there was just so much land that it was difficult to value — how much is land worth when there’s nobody around for the next few hundred kilometers?

If you start packaging huge swathes of land together into notes that you can redeem, the system is rife for abuse, speculation, and bubbles. Unsustainable Ponzi schemes involving land speculation are as American as apple pie (arguably even more so, as it took time to transplant suitable apple varieties from the old country). One of the reasons apples — and by extension pie — were so popular to have in the US, was that settlers were legally obliged to “improve” their land, or they could have it taken away from them. One of the easiest ways to meet the criteria was simply to plant apple trees [6].

In either case, both from an economic stability and governance point of view, the colonial powers weren’t fond of the newfound independence of their subjects. In 1741, Britain tried clamping down on paper money issued by the land banks by extending the anti-competitive practices of the Bubble Act, which we discussed in the last article. The colonies adapted in their own way, Maryland in 1766 got around the regulation by creating financial instruments that were redeemable for British Pounds, with the major caveat being that you could only exchange them in the UK [7]. Effectively, it was paper money in everything but name, despite the ruler’s wishes.

It was a game of whack-a-mole where no sooner had the regulators patched an oversight in their laws, another loophole was exploited. Financial alchemy through securitization was just too strong of a tool to abandon, and it became the norm.

Strength through unity

The idea would prove to be far too powerful of a magnet and even Europe would follow in the financial experimentation of its colonies. In the UK & Dutch Republic, it became commonplace to securitize several different loans and create a financial instrument with a predictable return. The logic was that through diversification, and the law of large numbers, the returns on investment would be predictable and safe.

However, investors would regularly not know what was contained in these packages either, they simply took it in good faith that the bankers selling these securitized financial instruments knew what they were doing [8]. The speculation during this period bordered on crypto degen levels — bankers would fake volume to get more credit with which to buy loans on margin at an enormous scale [9].

Unsurprisingly, a few decades later, this caused what came to be known as the “British credit crisis of 1772–1773”, which set the stage for the soon-to-come American revolutionary war by straining the relationship with the colonies, and had a ripple effect all throughout Europe, triggering bankruptcies and even nationalizations [10][11].

If this sounds an awful lot like the Great Recession of 2008 to you, with its Collateralized Mortgage Obligation (CMOs), negligent bankers, and whatnot, you’re not alone. There have been entire papers written on the matter — the critical difference between the two crises was that the bankers did take personal responsibility and lost money in 1773, as opposed to our recent crisis which absolved them of paying any loss [12].

History does not repeat itself, but it certainly does rhyme. A year after the 2008 crisis, the spotlight was on a new asset class — crypto. While Bitcoin wasn’t the first crypto to exist, it was the culmination of research that had been in the scholarly consciousness for the last few decades. For there to not be any confusion as to the purpose of this technology, embedded in the transaction that created the first 50 Bitcoins, there was a message, a newspaper headline from that day: “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks” [13].

It was a declaration of war against the status quo, equivalent to Martin Luther’s nailing of the 95 Theses on the church door when he outlined the system’s abuses. And it now has the potential to completely upturn everything we deemed certain prior to its invention.

In much the same way, a little more than two centuries ago, a year after the crisis caused by mass securitization, we had the birth of the first-ever mutual fund — a managed pool of investor resources used to purchase a diverse portfolio of hopefully uncorrelated assets. From then on, it wouldn’t be faceless bankers, but accountable boards of directors, experts, who would take the decision of what investors should put their money in. This was the solution to the wild markets, to hire people whose sole job was to find opportunities and scorn the scams. This first fund had an appropriate name “Unity Creates Strength.”

This was almost prophetic, as this asset class would come to dominate the centuries to come — the idea of pooling assets according to some logic, to some guiding principles, would prove to be a powerful idea. Now, funds account for trillions of dollars alone and it would be difficult to imagine what the financial landscape would even look like without them.

Would it be too presumptuous to ask whether the same might be the case with cryptocurrencies?

Bibliography

1 Burns, William E. (2003). Science in the enlightenment: An encyclopedia Santa Barbara: ABC-Clio. pp. 38–39. ISBN 978–1–57607–886–0

2 Goetzmann, William N. “Money changes everything.” Money Changes Everything. Princeton University Press, 2017. p355

3 Ibid p.359

4 Beattie, Andrew. “What burst the Mississippi Bubble?

5 Goetzmann, William N. “Money changes everything.” Money Changes Everything. Princeton University Press, 2017. p386–387

6 Smithsonian Magazine. “Apple Pie Is Not All That American.” Smithsonian.com, Smithsonian Institution, 12 May 2017, https://www.smithsonianmag.com/smart-news/why-apple-pie-linked-america-180963157/.

7 Goetzmann, William N. “Money changes everything.” Money Changes Everything. Princeton University Press, 2017. p386–388

8 Hoonhout, Bam. “The crisis of the subprime plantation mortgages in the Dutch West Indies, 1750–1775.” Leidschrift: Verraderlijke rijkdom. Economische crisis als historisch fenomeen 28.September (2013): 85–99

9 Sheridan, Richard B. “The British credit crisis of 1772 and the American colonies.” The Journal of Economic History 20.2 (1960): 161–186.

10 Ibid

11 Wilson, C. Anglo-Dutch Commerce and Finance in the 18th Century (1966) Cambridge: Cambridge University Press, p. 17

12 Ibid

13 Sherry, Benjamin. “What Is the Genesis Block in Bitcoin Terms?” Investopedia, Investopedia, 30 July 2022, https://www.investopedia.com/news/what-genesis-block-bitcoin-terms/