5. Yellow Brick Road
Money transformed cities and entire countries. Financial centers replaced industrial and trading districts in importance. New York, London, Frankfurt, Tokyo, Hong Kong, and Singapore emerged as major financial centers. Because trading is electronic, location did not matter. The convergence of financiers to particular locations reflected English economist Alfred Marshall’s 1890 observation: “The mysteries of the trade become no mystery, but are, as it were, in the air.”1
The players did not make things or trade goods. Instead, they traded trillions of dollars, euros, yen, bonds, shares, commodities, and derivatives. Much of the activity did not generate true value or represent direct additions to the goods and services produced in the economy. It increased debt and the circulation of money, as well as trading and speculation.
In 2009 Paul Volcker, a former chairman of the Federal Reserve, questioned the role of finance: “I wish someone would give me one shred of neutral evidence that financial innovation has led to economic growth—one shred of evidence.... [U.S. financial services increased its share of value-added from 2 percent to 6.5 percent] Is that a reflection of your financial innovation, or just a reflection of what you’re paid?”2 The only financial innovation over the past 20 years that impressed Volcker was the automated teller machine.
In the financial centers, high rewards enjoyed by people associated with finance trickled down. Entire cities and districts became gentrified, with bustling streets, chi-chi restaurants, trendy bars, and luxury label retailers. The financial centers were at the epicenter of this new self-confident, Starbucks society.
Monumental Money
In New York, a 70-story tower at 40 Wall Street, originally the home of Bank of Manhattan Trust that became Chase Manhattan Bank, was briefly the world’s tallest office building. It was quickly eclipsed by the Chrysler Building, an art deco masterpiece celebrating the dominance of America’s industrial economy. The iconic Seagram and General Motors Building paid homage to America’s industrial power.
Marking the shift from industry to finance, new hallmark buildings were increasingly built for financial institutions. In 1977, the 59-floor, 915-foot (279-meter) CitiGroup Center, featuring a 45°-angled top and a unique stilt-style base, opened as the group’s headquarters. The location in mid-town Manhattan was immortalized by The Ramones, the punk rock band, in 53rd and 3rd, a song that refers to this famous meeting place for male prostitution.
In London, Swiss Reinsurance created its infamous “Gherkin.” Near Madrid, Banco Santander, a major Spanish bank, built a vast campus. The Frankfurt skyline was dominated by the Deutsche Bank building whose twin towers were dubbed “debit” and “credit.”
The CitiGroup Center was initially structurally unsound, being too weak to withstand 70-mph (113 km/h) winds. The problem was corrected. Later the building was reinforced against possible terrorist attack. CitiGroup itself was not reinforced against financial turmoil.
The Battle of the “Pond”
In London, the City or the Square Mile is synonymous with the UK’s financial services industry. But the City is not in the City any more. Hedge funds congregate in Mayfair around Curzon Street, St James’s Square, or Berkeley Square. A few miles away the Docklands financial industry is centered around Canary Wharf.
Canary Wharf is located on the site of the West India Docks on the Isle of Dogs, once one of the busiest ports in the world. In the 1980s, Michael von Clemm, former chairman of Credit Suisse First Boston, promoted the idea of converting the run-down, unused docks into a new business district. Today, major banks, along with legal, accounting, and media firms that support the financial services industry, occupy its glass towers. Canary Wharf symbolizes the changed economic geography of the UK and London’s growth as a financial center.
New York’s FiDi (Financial District) is similarly diffuse. For American journalist H.L. Mencken, Wall Street was “a thoroughfare that begins in a graveyard and ends in a river.” Many Wall Street firms and hedge funds now congregate in Mid-Town. Others are based in Stamford, Connecticut, an hour from New York’s Grand Central Station.
Wall Street is an idea—the power of money. The contrast between Wall Street and the Main Street symbolizes the clash between the interests of money and business and the interests of ordinary individuals. Steve Fraser subtitled his book on Wall Street America’s Dream Palace, acknowledging its deep financial, political, ethical, and cultural significance.
New York focuses on the large domestic American market, its large companies, and investors. It raises money from American investors for foreign companies or helps foreign investors make American investments. New York has huge volumes in share trading; the New York Stock Exchange is the world’s biggest market for trading stocks. America controls around 40 percent of the global investment management business, insurance companies, pension funds, mutual funds, and hedge funds. America has some of the world’s largest commodities and derivative exchanges.
London is an entrepôt center—a trading post where goods were imported and exported, usually without paying duties. The City’s origins are in its overseas trading network developed over centuries. London acts as a center matching borrowers and investors, most of whom are located outside the UK. London’s métier is innovation and flexibility, especially in structured finance, complex derivatives, cross-border financing, and hybrid products combining insurance and banking.
London profits from its proximity to and capability to take advantage of legal, tax, and regulatory differentials in Europe and other places. The London Stock Exchange proclaims itself to be the most international capital market, with hundreds of international companies listed on its main market. London dominates European share trading, as well as global currency and derivatives trading.
London’s role is all the more remarkable given that the UK’s industrial power waned almost a century ago. Two world wars and the loss of empire inflicted physical, human, and economic damage.
Michael Lewis, describing Salomon Brothers’ London office in the 1980s, identified a cultural problem:
Our Englishmen...tended to be the refined products of the right schools...work was not an obsession or even...a concern.... [They] had a reputation...of sleeping late, taking long liquid lunches, and stumbling through their afternoons. One New York trader referred to them as Monty Python’s Flying Investment Bankers.3
The feeling was mutual. One English merchant banker described Goldman Sachs as: “nothing more than high-priced interlopers who produce a massive stream of impractical ideas that have no relevance.” The banker gave the Americans credit only “for making a lot of noise.”4
Cool Britannia
Under Margaret Thatcher, things changed. Exchange controls were abandoned in 1979. Freer capital movements allowed London to recapture its position as an international market. In 1989 the government implemented the Big Bang, reforms ending the City’s archaic practices. Financial regulations were overhauled, becoming more market friendly. In 2001 a single regulator—the Financial Services Authority (FSA)—was created to oversee financial markets.
London’s resurgence was helped by Wall Street’s stumbles. John F. Kennedy’s interest equalization tax (closing access to the U.S. market for foreign borrowers) prompted the creation of the London based euro dollar market—attributed to Siegmund Warburg. Tighter regulations and accounting rules, such as the Sarbane-Oxley (SOX) laws passed in the aftermath of the Internet stock scandals, discouraged foreign companies from listing on American stock exchanges or raising money there.
London had two priceless advantages—location in the right time zone between the growing markets of Asia and the United States, and the primacy of English law in international finance.
The success of London as a financial center mirrors the prestigious annual Wimbledon Tennis Championships. The tournament is held in England, staffed by Englishmen (eastern Europeans and South Asians actually), contested and won generally by foreigners but generates wealth and cultural standing for the UK. The last English man and woman to have won a major title are Fred Perry in 1936 and Virginia Wade in 1977. London is a leading center for international finance where almost all the major players were American, European, Japanese, or Asian. A governor of the Bank of England suggested that this was precisely how things ought to be.5
London and the financial services sector became the engine for UK’s growth and prosperity, supplanting the commercial and trading activity of the British Empire. Gordon Brown, the chancellor of the Exchequer under Tony Blair and then prime minister, harbored secret dreams of a Scandinavian-style social welfare state with low taxes funded by the growth of the City. In 2007, he told bankers: “What you have achieved for...financial services we...now aspire to achieve for the whole of the British economy.” Alistair Darling, Gordon Brown’s successor as chancellor, was no less loquacious describing financial services as “absolutely critical” to the economy. Ed Balls, when economic secretary to the Treasury, perhaps harking back to his days as a journalist, was triumphal: “I have absolutely no hesitation when I say to you that London is—now, today—the world’s greatest global financial center.”6 The mainly foreign bankers applauded.
Superlatives celebrated the new age:
Italian derivative traders, American corporate financiers, Lebanese arbitrageurs, Dutch brokers, Moroccan rocket scientists, German bond salesman, Swiss equity market makers, Japanese swappers and even the stray Essex forex boy. There is no other financial center in the world with a talent pool to match that of the City.7
In the sixteenth century, Tome Pires, a Portuguese apothecary in Suma Oriental, an account of his travels, wrote similarly about the magical city of Malacca, then one of the most important trading ports in the world. Pires records no less than 84 languages being spoken in Malacca, more than equal to modern financial centers like London and New York.8
Barbarian Invasions
Minor financial centers also developed, usually concentrating in specific areas. Chicago became a dominant force in commodity and derivatives trading. Bets on currencies, shares, and bonds could be placed next to bets on corn, wheat, live hogs, and pork bellies. Geneva and Zurich emphasized discrete private banking and wealth management, augmented by favorable secrecy, tax, and regulatory regimes.
Asia and the Middle East built hubs from scratch. In the bubble economy of the 1980s, foreign banks flocked to Tokyo, dazzled by the large domestic market and the world’s largest pool of savings. When the bubble burst in 1989 and the Japanese economy entered a prolonged recession, Tokyo slipped off the international radar.
Hong Kong and Singapore pursued ambitious programs built around their proximity to growing Asian markets, especially China and India. Shanghai and Mumbai increasingly aspired to this role. Shang Kong, a combination of Shanghai and Hong Kong, was mooted as a joint financial center providing a gateway to China.
Dubai drew on the Middle East’s vast oil wealth, petro-dollars, to create the Dubai International Financial Centre (DIFC), offering freedom from tax, unrestricted foreign ownership, free movement of money and things unavailable in the region—alcohol and female companionship.
The DIFC, a 110-acre (45-hectare) city within a city, is dominated by the high-rise, architectural signature of money, especially the distinctive 15-story Gate building housing the executive offices of the DIFC Authority, regulators, and leading international financial institutions. The DIFC was not vaguely Arabic. Most of the businesses and workers were foreign, attracted by fairy tales of mythical wealth and tax-free salaries. The Emirates in United Arab Emirates seemed to stand for English-managed Indian-run Arabs taking excessive salaries.
As the financial crisis hit, a belief that the emerging markets would be immune from the malaise led banks to seek refuge in new centers. Unemployed and underemployed bankers were told: “It’s either Shanghai, Dubai, Mumbai or good-bye!”9 In 2010, as Dubai experienced its own financial crisis, the DIFC’s rents, once the second-most expensive after London, fell by two-thirds in a desperate effort to make the district more attractive.
Unlikely Centers
Ireland, historically a poor, agrarian economy, reinvented itself. In the 1970s, Ireland entered the European Union (EU) (then known as the European Economic Community). Influx of EU money, a well-educated population, low taxes, limited regulations, and business-friendly governments transformed Ireland into the Celtic tiger. In the late 1980s, Ireland established a financial center in Dublin—creatively named the International Financial Centre. Continental banks, especially from Germany, set up units in Dublin, raising money that was then channeled into various investments. Money flowed in and out, and profits were transferred back to the parent. The proximity to London helped.
Indigenous Irish banks grew rapidly, and a seemingly endless supply of easy money drove the Irish economy. Between 1997 and 2001, growth averaged around 9 percent per annum, faster than other comparable European countries. Output per person rose from $17,200 in 1995 to $33,000 in the early 2000s, 20 percent above the EU average.
The new prosperity centered on property, fueled by cheap and abundant debt. House prices spiraled ever higher, feeding a construction boom. Derelict parts of Dublin were converted into cultural facilities, eating and drinking places catering to the new financial classes.
If Ireland is an island off an island off the coast of Europe, then Iceland is an island off an island off an island off Europe. Iceland, too, reinvented itself through financial services. In 2003, the three largest banks in Iceland had assets equal to the country’s modest annual domestic production. In the years that followed, the banks’ assets grew to $140 billion, over eight times Iceland’s domestic production. The banks raised money overseas and lent it to buy stocks and real estate.
Between 2003 and 2007 the Icelandic stock market increased by around 900 percent, while Reykjavik house prices tripled. Icelanders’ wealth grew by around three times. Icelandic entrepreneurs fanned out across the globe, buying companies and making investments. The Icelandic banking system drove this unprecedented growth.
Financial centers, and the mobile, cosmopolitan financiers who worked in them, dominated the economies of developed nations. Federico García Lorca, the Spanish poet, once captured the essence of the cities of money:
Rivers of gold flow there from all over the Earth, and death comes with it. There, as nowhere else, you feel a total absence of the spirit: herds of men who cannot count past three, herds more who cannot get past six, scorn for pure science and demoniacal respect for the present. And the terrible thing is that the crowd that fills the street believes that the world will always be the same and that it is their duty to keep that huge machine running, day and night, forever.10
History shows that financial centers are ephemeral. Pingyao, in the province of Shanxi, was China’s banking capital in the nineteenth century under the Qing dynasty. At the height of the city’s history, many banks operated in Pingyao, financing trade in silk, tea, and wool. Today, the Rishengchang, meaning “sunrise over prosperity,” reputedly the first bank in China, is a museum. On display are the remains of opium dens and mahjong rooms where prostitutes, hired by the banks, were once used to win business from potential customers.
El-Dollardo Economics
Money also shaped the developing world in complex ways. Historically, many emerging countries were colonial properties of developed countries. El-Dorado economics emphasized conquest and plunder, especially of gold and silver that could be coined into money. All natural resources were exploited, including people, who could be enslaved or used as cheap labor. Colonialism was driven by its profits, expanding the power of the developed nations and spreading their religious and political philosophy.
Colonizers argued they brought civilization to indigenous populations. The reality was death, subjugation, displacement, or destruction of cultures and civilization, sometimes ancient. Commenting on the devastation wrought on the New World by transmission of Western diseases, one observer noted: “Europe had much to give and little to receive in the way of human infections.”11
Following decolonization after the Second World War, former colonial powers established zones of influence using emerging nations as cheap sources of resources or labor or markets for Western goods. Over time, some countries with high rates of savings became sources of capital for developed countries. El-Dollardo economics now ruled a world of globalized trade and capital flows.
The Unbalanced Bicycle
China exemplified this new global monetary order. Under Deng Xiaoping, leader of the Communist Party from 1978, China undertook Gaige Kaifang (reforms and openness)—changing domestic, social, political, and economic policy. The centerpiece was economic reforms that combined socialism with elements of the market economy. In embracing markets, Deng famously observed: “It doesn’t matter if a cat is black or white, so long as it catches mice.”
Robert Hart, nineteenth-century British trade commissioner for China, once wrote: “[The] Chinese have the best food in the world, rice; the best drink, tea; and the best clothing; cotton, silk, fur. Possessing these staples and their innumerable native adjuncts, they do not need to buy a penny’s worth elsewhere.”12 China now engaged with the global economy, reversing the traditional policy of economic self-reliance.
Modeled on the post-war recovery of Japan, China used trade to accelerate the growth and modernization of its economy. Special economic zones (SEZ), for example in Shenzen, located strategically close to Hong Kong, were established to encourage investment and industry, taking advantage of China’s large, cheap labor force. Benefiting from rising costs in neighboring Asian countries, China attracted significant foreign investment, technology, management, and trading skills, from countries keen to outsource manufacturing to lower cost locations.
Parts of China became the world’s factory of choice. Imported resources and parts were assembled or processed and then shipped out again. A buoyant global economy ensured a growing market for China’s exports.
Deng represented a change in philosophy: “Poverty is not socialism. To be rich is glorious.” The strategy proved startlingly effective, bringing about profound change. By 2011, Colonel Sanders and KFC were better recognized than Chairman Mao in China.
The strategy was decidedly trickle-down economics, as Deng himself acknowledged: “Let some people get rich first.” Later, Deng would grouse: “Young leading cadres have risen up by helicopter. They should really rise step by step.”
Foreign Treasure
China exported more than it imported, creating large foreign reserves that by 2011 totaled over $2.7 trillion. The Asian crisis of 1997–8 encouraged China to build even larger surpluses as protection against the destabilizing volatility of short-term foreign capital flows that almost destroyed many Asian countries. A history of political instability and the absence of extensive social welfare systems forced the Chinese to save a large portion of their income. The reserves and savings became a giant lending scheme, allowing China to finance and boost global trade, accelerating its own growth.
The build-up of foreign reserves in central banks of emerging markets and developing countries was really a liquidity creation scheme reliant on the U.S. dollar’s position in trade and as a reserve currency in the post-Bretton-Woods era.13
Dollars received from exports and foreign investment have to be exchanged into Chinese renminbi. To maintain the competitiveness of exporters, China invested the foreign currency overseas to mitigate upward pressure on the renminbi. As reserves grew, China invested 60–70 percent of its reserves in dollar-denominated investments, primarily U.S. Treasury bonds and other high-quality securities. Only the large, liquid dollar money markets could accommodate China’s large investment requirements. The historically unimpeachable credit quality of the United States was attractive. The recycled dollars flowed back to the United States, helping finance America’s large trade and budget deficits.
Thomas Mun, a director of the East India Company, argued that the purpose of trade was to export more than you imported. Countries should amass foreign treasure, using it to acquire foreign colonies to control essential natural resources. The strategy required reducing domestic consumption and imports while increasing export of goods manufactured with imported foreign raw materials. China had followed Mun’s seventeenth-century mercantilist policies.14
Global trade and investment (much of it export related) now drove China’s economy. In 2007, Chinese Premier Wen Jiabao warned that Chinese growth was becoming increasingly “unstable, unbalanced, uncoordinated and ultimately unsustainable.” China was not alone, as other countries such as Germany, Japan, South Korea, and Taiwan used similar strategies to boost growth.
Chinese funds helped keep American interest rates low, encouraging increasing levels of borrowing, especially among consumers. The increased debt fueled further consumption, housing, and stock market bubbles, enabling consumers to decrease savings as the paper value of investments rose. The consumption fed increased imports from China, creating further outflows of dollars via the growing trade deficit. The overvalued dollar and an undervalued renminbi exacerbated U.S. demand for imported goods.
Low U.S. interest rates also drove American pension funds and investors to seek out more risky investments. This fed the market for junk bonds, securitized debt, private equity, and hedge funds, which promised the higher returns needed to finance retirement income.
According to Andy Warhol, such behavior was innate: “Buying is...American.... In Europe and the Orient people like to trade—buy and sell, sell and buy—they’re basically merchants...[Americans] really like...to buy—people, money, countries.”15 In 2006, the economic historian Niall Ferguson and economist Moritz Schularick termed this symbiotic relationship Chimerica. The neologism combined the two countries but also referred to the legendary chimera—a grotesque monster of the imagination.16
Fool’s Gold
An economic order where some nations save and others borrow this money to fund consumption, buying goods from the savers, is inherently unstable. China had effectively lent Americans the money to purchase its goods and now faced the prospects that the loans would never be repaid.
Deterioration in the U.S. economy and additional borrowing placed increasing pressure on the U.S. government’s debt rating, reducing the value of Treasury bonds and the currency. The inscription on dollar bills—“In God we trust”—probably needed to read “I hope my redeemer liveth.”17 Premier Wen Jiabao expressed China’s concern: “If anything goes wrong in the U.S. financial sector, we are anxious about the safety and security of Chinese capital.”18
China’s trillions in foreign currency reserves, a large proportion denominated in dollars, could not be sold without massive losses because of their sheer size, far larger than the normal trading volumes. China was learning Keynes’ famous observation: “If I owe you a pound, I have a problem; but if I owe you a million, the problem is yours.”
China tried to reduce the purchase of dollars, switching into real assets like commodities. But China was forced to purchase more dollars and U.S. Treasury bonds to preserve the value of existing holdings. Forty years ago, John Connally, then the U.S. Treasury secretary, accurately identified China’s problem: “It may be our currency, but it’s your problem.”19
In investing its reserves and savings heavily in dollars, China had stepped on a bounding mine, which does not explode when you step on it but when you step off. The Chinese used to refer to dollars affectionately as mei jin, literally “American gold.” China’s dollar investments were not the real thing—merely iron pyrite, fool’s gold.
Liquidity Vortex
Money was now central to everything. Global money flows were built on traditional domestic banks, which pushed leverage to extreme levels. Off-balance-sheet structures added to the supply of money. The foreign exchange treasure maintained by China and other nations were another part of the global credit process. The export of savings, such as Japanese savings via the yen carry trade, was a further part.
This money pulsed through the world, pumping up the price of assets to create the illusion of wealth, transforming individual lives, businesses, cities, and entire countries. Through prices, financial markets provided a real-time poll on government policies and corporate decisions. But as Charles Mackay observed in 1841: “Money...has often been a cause of the delusion of the multitudes. Sober nations have all at once become desperate gamblers, and risked almost their existence upon the turn of a piece of paper.”20 John Maynard Keynes, too, warned about speculation:
Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill done.21
As the financial crisis hit, it became clear that the power of money to transform economies, business, and lives had been greatly over-estimated. The amount of money available was also far less than thought. It had just been the same money that had flowed around ever faster. When asked what happened to his fortune, the soccer star George Best responded: “I spent 90 percent of my money on women, drink and fast cars. The rest I wasted!” Slowly, the world awoke to the realization that it had wasted a staggering amount of wealth that did not exist in the first place.