The Cash Nexus: Money and Politics in Modern History, 1700-2000

by Niall Ferguson

  THE CASH NEXUS UNTIED

  But was it the economy? In the chapters that follow, I have set out to re-examine the link – the nexus, in Carlyle’s phrase – between economics and politics, in the aftermath not only of the failure of socialism but also the apparent triumph of the Anglo-American model of capitalism. In his latest book, Francis Fukuyama confidently declares that ‘in the political and economic sphere’ history has turned out to be ‘progressive and directional’; what he calls ‘liberal democracy’ has emerged as ‘the only viable alternative for technologically advanced societies’.27 Are capitalism and democracy – to borrow an analogy from the field of genetics – the ‘double helix’ of the modern world? Or might there be sources of friction between the two which we ignore at our peril?

  But first a caveat. The allusion to DNA prompts a simple but important reminder about human nature. As evolutionary biologists have demonstrated, Homo sapiens is not Homo economicus. Human beings – as Carlyle knew – are motivated by much more than profit maximization: ‘Cash is a great miracle; yet it has not all power in Heaven, nor even on Earth … Cash-payment is not the sole relation of human beings.’

  Within economic theory, there are in any case quite different assumptions about individual behaviour. Some neo-classical models assume that individuals’ expectations are rational, that is, they draw economically optimal conclusions from available information. In other models, expectations are more slowly ‘adaptive’, or there is uncertainty about the future. Yet experimental research shows that most people are remarkably bad at assessing their own economic best interest, even when they are given clear information and time to learn. Faced with a simple economic dilemma, people are quite likely to make the wrong decision because of ‘bounded rationality’ (the effect of misleading preconceptions or emotions) or basic computational mistakes (the inability to calculate probabilities and discount rates).28 Psychologists have also identified the phenomenon of ‘myopic discounting’: our tendency to prefer a large reward later to a small reward soon – a preference we then switch as the small reward becomes irresistibly imminent.29 Prospect theorists have shown that people are risk-averse when choosing between a certain gain and a possible bigger gain – they will choose the certain but smaller gain – but not when offered a choice between a certain loss and a possible bigger loss.30

  Most economic institutions, if they depend on credit, also depend in some measure on credibility. But credibility can be based on credulity. In late nineteenth-century France, Thérèse Humbert enjoyed a glittering career on the basis of a chest supposedly containing a hundred million francs in bearer bonds, which it was claimed she had inherited from her natural father, a mysterious Portuguese (later American) millionaire named Crawford. Borrowing against these securities, she and her husband were able to buy a luxurious hôtel in the avenue de la Grande Armée, to gain a controlling interest in a Parisian newspaper and to engineer his election as a socialist deputy. Ten thousand people gathered outside the house when the box was finally opened in May 1902. It was found to contain ‘nothing but an old newspaper, an Italian coin and a trouser button’.31

  Even when we are not miscalculating – as the Humberts’ creditors plainly did – our economic calculations are often subordinated to our biological impulses: the desire to reproduce, rooted (according to neo-Darwinian theories) in our ‘selfish genes’,32 the capacity for violence against rivals for mates and sustenance – to say nothing of the erotic or morbid forms of behaviour analysed by Freud, which cannot always by explained by evolutionary biology.33 Man is a social animal whose motivations are inseparable from his cultural milieu. As Max Weber argued, even the profit motive has its roots in a not wholly rational asceticism, a desire to work for its own sake which is as much religious as economic.34 Under different cultural conditions, human beings may prefer leisure to toil. Or they may win the esteem of their fellows by economically ‘irrational’ behaviour; for social status is seldom the same as mere purchasing power.35

  And man is also a political animal. The groups into which human beings divide themselves – kinship groups, tribes, faiths, nations, classes and parties (not forgetting firms) – satisfy two fundamental needs: the desire for security (safety, both physical and psychological, in numbers) and what Nietzsche called the will to power: the satisfaction that comes from dominating other weaker groups. No theory has adequately described this phenomenon, not least because individuals are plainly capable of sustaining multiple, overlapping identities; and of tolerating the proximity of quite different groups, and indeed co-operating with them. Only occasionally, and for reasons which seem historically specific, are people willing to accept an exclusive group identity. Only sometimes – but often enough – does the competition between groups descend into violence.

  The guiding assumption of The Cash Nexus is that these conflicting impulses – call them, for the sake of simplicity, sex, violence and power – are individually or together capable of over-riding money, the economic motive. In particular, political events and institutions have often dominated economic development – and indeed explain its far from even trend. (Note that I say ‘often’: sometimes the economic motive does prevail, or complements rather than conflicts with the other motives.) Economists know this, but naturally shy away from it. Often they use the generic term ‘shock’ to describe events that are ‘exogenous’ to their carefully constructed models. Yet the notion that a war is comparable with a meteorological disaster is hardly satisfactory to the historian, who has the daunting task of trying to explain shocks as well as market equilibria.36

  Political scientists, it is true, have sought to construct models of political change. And this book owes almost as much to their work as to the work of economists. In the historian’s mind, however, the attempt to construct and test equations to explain (for example) the incidence of war, the spread of democracy or the outcomes of elections inspires almost as much scepticism as admiration. Nothing can be said against the method which constructs formal hypotheses and then tests them against empirical evidence; it is the best way of debunking would-be ‘laws’ of human behaviour. But we must be deeply suspicious of any equation that seems to pass the empirical test. For human beings are not atoms. They have consciousness, and that consciousness is not always rational. In his Notes from Underground, Dostoevsky derides the economists’ assumption that man acts out of self-interest, and satirizes the notion of a deterministic theory of human behaviour:

  You seem certain that man himself will give up erring of his own free will… that … there are natural laws in the universe, and whatever happens to him happens outside his will … All human acts will be listed in something like logarithm tables, say up to the number 108,000, and transferred to a timetable … They will carry detailed calculations and exact forecasts of everything to come … But then, one might do anything out of boredom … because man … prefers to act in the way he feels like acting and not in the way his reason and interest tell him … One’s own free, unrestrained choice, one’s own whim, be it the wildest, one’s own fancy, sometimes worked up to a frenzy – that is the most advantageous advantage that cannot be fitted into any table … A man can wish upon himself, in full awareness, something harmful, stupid and even completely idiotic … in order to establish his right to wish for the most idiotic things.

  History may be ‘grand’ and ‘colourful’, but for Dostoevsky its defining characteristic is irrational violence: ‘They fight and fight and fight; they are fighting now, they fought before, and they’ll fight in the future…. Soyou see, you can say anything about world history…. Except one thing, that is. It cannot be said that world history is reasonable.’37

  This book’s central conclusion is that money does not make the world go round, any more than the characters in Crime and Punishment act according to logarithm tables. Rather, it has been political events – above all, wars – that have shaped the institutions of modern economic life: tax-collecting bureaucracies, central banks, bond markets,
stock exchanges. Moreover, it has been domestic political conflicts – not only over expenditure, taxation and borrowing, but also over non-economic issues like religion and national identity – that have driven the evolution of modern political institutions: above all, parliaments and parties. Though economic growth may promote the spread of democratic institutions, there is ample historical evidence that democracy is capable of generating economically perverse policies; and that times of economic crisis (such as those caused by war) may be equally conducive to democratization.

  The book is divided into fourteen chapters, each of which deals with a specific aspect of the relationship between economics and politics. It falls into four sections: ‘Spending and Taxing’, ‘Promises to Pay’, ‘Economic Politics’ and ‘Global Power’. The first three chapters are concerned with the political origins of the basic fiscal institutions associated with expenditure and revenue. Chapter 1 shows how the main impetus for the development of the state as a fiscal institution has come – until very recently – from war. Though the chapter challenges the widely held notion that the cost of war has tended to rise over the long run, it emphasizes that military expenditures have been the principal cause of fiscal innovation for most of history. Chapter 2 traces the development of taxation and other forms of revenue in response to the costs of warfare, showing how the proportions of indirect and direct taxation have varied over time and from country to country. The third chapter explores the relationship between direct taxation and political representation. Although rising taxation has been associated in some contexts with parliamentarization and democratization, the exigencies of revenue-raising have also tended to increase the scale of bureaucracy. The first section concludes with an explanatory sketch of the evolution of the welfare state – in which redistribution rather than defence becomes the prime function of government.

  The second section is concerned with the evolution of the institution of the public debt. Chapter 4 considers the theoretical and empirical significance of national debts. The next chapter then considers the various ways in which crises of excessive indebtedness have been dealt with, concentrating principally on default and inflation, and describing the evolution of the central bank as an institution of debt and monetary management. Chapter 6 brings interest rates – and particularly bond yields – into the argument, and offers an explanation for the fluctuations and differentials between the interest rates paid by states on their debts.

  My intellectual debt to the theoretical work of Douglass North and others on the relationship between institutions and economics will by now be obvious to students of economics.38 The basic institutional framework I have in mind may be thought of as a square. To put it simply, the exigencies of war finance had led by the eighteenth century to the evolution of an optimal combination of four institutions. First, as illustrated in the top left-hand corner of Figure 1, there was a professional tax-gathering bureaucracy. Salaried officials proved to be better at revenue raising than local property owners or private tax ‘farmers’, who tended to retain a larger proportion of tax revenue for themselves. Second, parliamentary institutions in which taxpayers were granted a measure of political representation tended to enhance the amount of revenue a state could raise, in that taxation could be ‘traded’ for other legislation and the entire budgetary process legitimated. Third, a system of national debt allowed a state to anticipate tax revenues in the event of a sudden increase in expenditure, such as that caused by a war. The benefit of borrowing was that it allowed the costs of wars to be spread over time, thus ‘smoothing’ the necessary taxation. Finally, a central bank was required not only to manage debt issuance but also to exact seigniorage from the issuance of paper money, which the bank monopolized.

  Though each of these four institutions had deep historical roots, it was in Britain after the Glorious Revolution that their potential in combination was realized – though it should be made clear at once that Hanoverian reality fell some way short of the ideal type I have just described. The Excise, Parliament, the National Debt and the Bank of England nevertheless formed a kind of institutional ‘square of power’ which was superior to any alternative arrangement – notably the French system of privatized tax collection based on sales of office and tax ‘farming’, minimal representation in the form of the parlements, a fragmented and expensive system of borrowing and no central monetary authority.

  Figure 1. The ‘square of power’

  It was not just its revenue-raising property that made the British ‘square’ superior to rival systems. It was also the more or less unintended side-effects it had on the private sector of the economy. To speak in general terms, the need for an efficient tax-gathering bureaucracy implied a need for a system of formal education, to ensure an adequate supply of civil servants who were both literate and numerate. Secondly, the existence of a parliament almost certainly enhanced the quality of legislation in the sphere of private property rights. Thirdly, the development of a sophisticated system of government borrowing through a funded national debt encouraged financial innovation in the private sector. Far from ‘crowding out’ private investment, high levels of government bond issuance widened and deepened the capital market, creating new opportunities for the issuance and trading of corporate bonds and equities, especially in peacetime when the state no longer needed to borrow. Finally, a central bank with a monopoly over note-issue and the government’s current account was also capable of developing functions – such as manager of the exchange rate or lender of last resort – which tended to stabilize the credit system as a whole by reducing the risk of financial crises or banking panics. In these ways, institutions that initially existed to serve the state by financing war also fostered the development of the economy as a whole. Better secondary and higher education, the rule of law (especially with respect to property), the expansion of financial markets and the stabilization of the credit system: these were vital institutional preconditions for the industrial revolution.

  The third section of the book explores three hypotheses which relate the fiscal institutions already described in the previous sections to politics. The first is the argument of the early classical economists and the Marxists that the fundamental social conflict within modern societies was between landowners, capitalists and workers (the earners respectively of rents, profits and wages). Chapter 7 suggests two alternative models of social conflict, one based on strictly fiscal categories (state employees, taxpayers, bondholders and welfare-recipients), the other based on generations. An obvious source of weakness for the ideal state depicted above arises from conflicts between such groups. A state which accumulates a large national debt and then services that debt out of revenue derived mainly from indirect taxation may face political opposition from poorer consumers because of the regressive distributional consequences of its fiscal policy. On the other hand, a state which effectively defaults on its debt or inflates it away may precipitate an equally formidable reaction if the bondholders are numerous enough.

  Chapter 8 concentrates on a second source of weakness: the temptation all governments feel to manipulate fiscal and (if they control it) monetary policy to enhance their own power. How far does the popularity of democratic governments depend on economic success; and can governments really manipulate the business cycle to promote their own chances of re-election? Here it is possible to show with much more precision the relationship between political popularity and the management of fiscal and monetary policy, and to question the simplistic notion that re-election is a function of economic success. It is equally obvious, however, that politicians continue to believe in this notion.

  Turning from public finance to the finances of political parties themselves, Chapter 9 considers the consequences of the rising cost of election campaigns. Does it matter that the key institutions of the democratic process can no longer rely on the revenue generated by mass memberships, and are therefore increasingly dependent on donations from wealthy individuals or taxpayers? And is the phenomenon of co
rruption – ‘sleaze’ – explicable in economic rather than moral terms? Here again I am concerned to show how the ‘square of power’ can be undermined from within – in this case by the decrepitude of those peripheral but still vital institutions, the political parties, which compete for control of the legislature and thereby make democratic choice a reality.

  Thus far the argument has largely been confined to the development of institutions within states. The fourth and final section of the book extends the analysis to the international level. Chapter 10 considers the extent of financial globalization in historical perspective, and in particular asks how the development of an international bond market served to export the ‘square of power’ model to other countries. In theory, the liberalization of the capital market, if it is accompanied by a comparable liberalization of the international markets for goods and labour, should increase aggregate growth. However, past experience of globalization suggests that free flows of capital are liable to substantial fluctuations in response to international political events, while free flows of goods and people can generate domestic political reactions.

  Chapter 11 considers two ways of limiting the volatility of international financial markets: through systems of fixed exchange rates or international monetary unions. In particular the chapter asks how long such ‘financial architecture’ can endure when nation states remain more or less free to determine their own fiscal policies.

  Chapter 12 then turns to consider the globalization of democracy: specifically, the relationship between economic growth and the spread of democratic institutions. As we have seen, it is often assumed that growth and democratization are mutually reinforcing. But is their relationship more tangential than the ‘double helix’ model implies? Or to put it in institutional terms: how far does the democratization of the parliamentary corner of the ‘square of power’ create problems for the other institutions and the model as a whole?