Wednesday, September 6, 2017

Book Review #31: The Little Book of Value Investing: Author: Christopher H Browne



Over 176 pages and 21 Chapters,  the book 'Little Book of Value Investing' by Christopher Browne packs quite a punch. Content rich, this book has insights in almost every page. This is a kind of 'Intelligent Investor' on Steroids.
Chapter 1: Buy stocks like steaks....on sale
Value investing is an approach of buying stocks which are trading well below the intrinsic value. It is a model that will help identify good companies at attractive valuations
It is like buying items on sale
The opposite approach is the Growth Investing that focuses on the fads of the day. One normally pays higher price for growth stocks
Over any time period, Value Investing has outperformed growth investing
Chapter 2: What's it worth?
Value investing involves two fundamental principles: Intrinsic Value and Margin of Safety
This chapter focus on the Intrinsic Value
Intrinsic value can be defined as a price paid in an arms length transaction between a knowledgeable buyer and a knowledgeable seller.
Understanding of Intrinsic value helps the investor to sell Over priced stocks and buy underpriced stocks (relative to Intrinsic Value). Intrinsic value helps investor take advantage of mispricing in stocks.
Two approaches to identifying Intrinsic Value: One, Ratio method, by looking at a set of financial ratios and two, Appraisal method, analyzing like a banker appraising the value of the business.
Chapter 3: Belts and Suspenders for Stocks
The focus of this chapter is on Margin of Safety.
If you buy a stock at a significant discount to its intrinsic value, you have a margin of safety. If you buy a stock with a margin of safety, there are two ways in which you will benefit. One, as the gap between your purchase price and intrinsic value narrow and two, due to the secular increase in intrinsic value of the company.
Graham used to by stocks selling at two thirds or less of their intrinsic value. It was his margin of safety for two reasons. One, the stock could rise 50% and will still be trading around the intrinsic value. Also, if the market hit a rough patch, he had the comfort of knowing that what he owned was worth more than what he paid for.
Margin of safety also prevents investors from taking too much risks, for example, investing in companies with high amount of debt. Margin of safety also prevents the investor from excessive concentration in individual stocks by encouraging diversification. Margin of safety also allows you to be a contrarian. During negative events, when there is overall gloom around, focusing on Margin of Safety will throw up wonderful opportunities to invest in.
Finally Margin of safety not only applies to buying shares, but also applies to selling them. You sell stocks when they are priced above their intrinsic value.
Chapter 4: Buy earnings on the cheap
The starting point to find value is to identify companies trading at low PE ratio. Inverse of PE ratio is called Earnings yield which helps compare investment opportunities. The advantage of buying low PE stocks is that negative expectations are factored in and any positive news can bump up the stock price significantly. Reverse is true for high PE stocks. Good news will have no impact on their price while any bad news can bring down their share price dramatically.
Chapter 5: Buy a buck for 66 cents
Another value investing approach is to buy stocks trading below their net worth. The ratio is price to book value. This was a favorite of Ben Graham. The assumption here is that the companies will strive to improve their book value and sooner market value will catch up with the book value. This is a good ratio to evaluate companies in banking and financial services.
Chapter 6: Around the world with 80 stocks
Why should you go global? The reason is that more than 50% of the world's largest companies are outside of US. For a value investor, this is too big a market to ignore.  One of the benefits of trading in international markets is portfolio diversification. There are other advantages. One, due to legal requirements, the valuation criteria could be different, for example valuing the asset at costs as against market value. Another could be due to different valuation approaches, for example Europe follows a top down, macro economy based valuation while us follows stock specific bottom up valuation. Also country specific issues could provide value investing opportunities.
Chapter 7: You don't need to go trekking with Dr.Livingstone
While global markets provide portfolio diversification, it is not necessary that a value investor should invest in all markets. The author is comfortable investing in developed markets with democratic, capitalistic traditions. Author shuns emerging markets because of their lack of transparency and impulsive decision making. 
Chapter 8: Watch the guys in the know
Stock purchases by company insiders is an early indicator of potential value mismatch. If this is accompanied by low price to book value, it is a due sign that  things could turnaround soon. As per author selling by insiders is not as predictive. Another way companies could signal value is buy announcing a buy back. A buyback, especially when done below the book value can increase the share price. Other types of investor purchases to look out for are when someone buys more than five percent of the stocks in the company or purchases by an activist investor. Some times purchases by knowledgeable investors are the catalysts required to unlock value.
Chapter 9: Things that go bump in the market
Correction, both market and stock specific, is a great opportunity to pile on good stocks at bargain prices. Good companies with strong balance sheets tend to recover quickly from downturns. One should be careful not to catch a falling knife.
Chapter 10: Seek and you shall find
Today technology offers opportunities to identify stocks reasonable valuation. Ben graham used to trade in stocks that were selling at two thirds of their net current assets. One of the information to look for the buying history of the mutual fund managers who run value funds. Another one maybe to look for merger and acquisition in the industry. Which technology it has become much easier, and paradoxically much more difficult, to identify the new value opportunities
Chapter 11: When is a bargain not a bargain? 
One of the reasons why stocks become cheap is when they have high amount of debt on their balance sheet. As per Graham the debt to equity ratio should be less than 0.5. Another reason for low price could be when the company misses earnings estimate. Stocks in cyclical industries maybe under priced due to cyclical downtown and could take a long time for the cycle to reverse. Other reasons could be adverse labour contracts, under funded pension, increased competition, product obsolescence etc. One of the worst reasons for share price drop is corporate accounting fraud.
So how can we protect our money?
One stick to industries that we know and understand. Two, look for moat also known as competitive advantage. The favourite industries of the author are banks and consumer staples. The most important suggestion is this chapter is to set up a 'no thank you' file of big companies that you want to avoid investing in.
Chapter 12: Give the company a physical
From this chapter we are getting into the realm of financial analysis. We start by analyzing the balance sheet. The key aspects in balance sheet are liquidity and debt.  There are two ratios related to liquidity.  First is current ratio is calculated by dividing current liabilities from current assets.  The ideal value is 2. The second ratio is called the quick ratio (also called acid test ratio) which is calculated by the formula current assets minus inventory divided by current liabilities.  The ideal value is 1. These ratios should not be looked in in isolation.  It is important to to compare with peers in the the industry as well as trend within the company.  For example progressively deteriorating ratio could signal potential issue.
When it comes to debt,  the key ratios are the leverage ratios and coverage ratios. Leverage is shown by Debt by Debt to equity ratio.  This ratio could vary from industry to industry but in general the lower the ratio the better.  The important coverage ratios are interest coverage ratio and financial charges coverage ratio.  The higher the coverage ratio the better.
Ask with liquidity ratios we should look for comparative values with the peers as well as Trends within the same company.
Earlier we discussed the importance of book value. Book value is, in general, calculated as total assets minus total liabilities. The higher the value the better. While calculating the total assets one should ignore intangible assets like goodwill. If long term liabilities are growing faster than the long term assets it's a warning signal.
Balance sheet analysis is just the first step. A true balance sheet is a sign of companies strength, its ability to withstand temporary downturns. Next step analysis of income statement. 
Chapter 13: Physical exam, Part 2
First step is to look at at look at to look at at the revenues are the revenues increasing or decreasing? Also look at the segment wise revenue.  It is possible that a profitable segment is hiding the inefficiencies in other segments.
Next look at at the cost of good sold look for the trains is cost of good sold as a proportion of sales increasing and decreasing remaining stable increasing proportion of cost of good sold could indicate that the company is not able to pass on the cost the customers
The difference between the revenue and the cost of good sold is good sold is is called gross profit gross profit margin is calculated by dividing gross profit on the sales look for a steady gross profit margin
Operating profit is calculated by reducing selling and other administrative cost from the gross profit declining operating profit could indicate management that is not able to control the overheads
Other income is a key component that one should be careful about this is a non recurring income and should be removed from the net profit calculation
Net profit is calculated by reducing taxes interest and other income from the operating profit net profit margin is calculated by dividing net profit by the sales. Look for stable or increasing net profit margin.
Earnings per share is calculated by dividing the net profit by the number of shares outstanding. One should look for fully diluted earnings per share which also considers potential increases in shares outstanding through stock options or warrants. A significant difference between regular EPS and fully diluted EPS is a strong warning signal.
As discussed in the previous chapter trends are more important than standalone values
Chapter 14: Send your stocks to the Mayo Clinic
Once you identify potential investment opportunity, it is time to dig deeper by putting the company through a rigorous analysis. There are 16 groups of questions that one should ask of the company under analysis.
1.      What is the outlook of pricing for company’s products? Can company rise prices without impacting volumes?
2.      Can the company sell more without incurring additional costs?
3.      Can the company increase profits on existing sales by cutting down costs, for example. Can the company control its costs? For instance, cookie company has no control over sugar prices
4.      Can the company control expenses like SG & A?
5.      If the company raises sales, how much of it will go into bottom line? Company can increase sales by giving discounts. However, this will not improve the profitability of the company
6.      Can the company be as profitable as it used to be, at least as profitable as its competitors?
7.      Does the company have one time expenses or income that will not repeat in future?
8.      Does the company have unprofitable operations that they could shed?
9.      Is the company comfortable with wall street’s earnings estimate?
10.  How much can the company grow over the next 5 years? How will it achieve the growth? Do the management have a realistic plan to achieve the growth?
11.  What is the plan for the excess cash?
12.  What does the company expect its competitors to do?
13.  How does the company compare financially with other companies in the same business?
14.  What is the resale value of the company?
15.  Any plans to buyback its stock?
16.  What are the insiders doing?
Chapter 15: When in Rome....
If you are following a global approach to value investing, it is imperative to know the different accounting standards being followed by different countries. This accounting difference could throw out some good surprises.
Chapter 16: Trimming the hedges.
When you are investing in international markets, you are incurring three types of risks, one is the stock specific risk, two is the Systemic Market Risk and three, currency risk. Currency risk in international investing is the risk that the currency being used to invest will move in a direction that is detrimental to the investment.
Let us assume that you invest 100 USD in India Market. You covert it to INR @65 and invest 6500 in Sensex. After One year your investment has grown to 7000. You sell and convert the same to USD.
At the time of selling,
If INR / USD is 70 (INR has depreciated), you end up with 100 USD. No gain
If INR has depreciated to 60, you end up with 116 USD, a gain of 16%.
So you know that as a foreign investor, you will face losses if the home currency depreciates. You can handle this potential losses by hedging, for example by selling Indian Currency forward contracts. In this case you are both long (by buying stocks) and short (selling currency forward contracts), so that you are hedged against exchange rate risk.
Another point of view is that if you are invested for the long term, the exchange rate fluctuations tend to cancel each other out (for example in the last 4 years, INR USD has seen a high of 70 and a low of 63) and hence it does not matter if you are hedged or not.
Chapter 17: It is a marathon, not a sprint
The key point in this article is never to time the market. Do not try short term trading,  stay invested in your value picks. In a study conducted in the US market, in a span of 60 months, most of the gains have come in about 7% of time. The remaining 93% of time produced scanty returns.
(On a personal note, my investment in Sterlite Technologies is an example. I purchased this stock at around 60, 5 years ago. In these 5 years stock had jumped about 4 times to around 240 today. However, a huge part of that jump came in a span of about a month.)
Short term trader also end up losing on brokerage, commissions and taxes. World over, short term capital gains are taxed at a higher rate than long term capital gain.
So in summary, invest, do not trade.
Chapter 18: Buy and hold? Really?
This chapter considers the important aspect of asset allocation, specifically between equity and debt. Traditionally there are generic rules like ‘100 – Age’ to decide the proportional allocation between the two. If your age is 30, 70% (100 – 30) should be allocated to equity and balance to debt.
Author is not in favour of these approaches. Being a firm believer in equity investing and the power of compounding, his solution is simple. Be predominantly invested in equities. Keep a three year debt investment that will give you commensurate returns based on your expenditure expectations. Invest the remaining in equity. When the equity is increasing, use the returns from the equity to meet your monthly expenditure needs. You should dip into your debt investment (nest egg) only when equities are down. In case you take money out of your nest egg, top it up as soon as markets start moving up again. This approach will help you to capitalize yourself with equity return when the markets are going up and with debt returns when markets are going down and equity has to be conserved.
Peter Lynch, in his book ‘Beating the street’, suggests 100% allocation into equities and taking money out of equity irrespective whether market is up or down. The suggestion by the author is just a minor tweak on the suggestions by Lynch.
I like this approach. Very practical.
Chapter 19: When only a specialist will do
The secret to winning the investment game is to pick good managers and stick with them. If you are not a financial wizard who does his own investing, the chances are that you will require an investment manager sooner or later. A good manager can add significant percentage points to your returns. This chapter focus on the questions to ask while selecting the fund manager. There are four sets of questions  / criteria that you have to evaluate before you select a fund manager.
1.      Simplicity of investment approach. The manager must be able to explain his investment approach in simple language without confusing the listener with jargon. The simplicity in the answers show the clarity of thought.
2.      Track Record: You have to look at the track record through a complete market cycle to gauge the capability of the manager
3.      Is the fund manager still with the fund or the track record in point 2 above is of a different fund manager who has moved on?
4.      Investing own money: Where do fund managers invest their own money? Is the approach consistent
Chapter 20: You can lead a horse to water but....
It is beyond doubt that Value Investing has proven to be an excellent approach towards building wealth. If so, why are there very few money managers who practice this approach? First reason is that value investing is contrarian in nature. It involves buying stocks that are unpopular and holding them for a long period of time. This is a risky strategy for a money manager whose performance is evaluated on a monthly basis.
Another reason why money managers shun the value investing approach is the herd instinct. In Wall Street, if you buy the latest fad which is being chased by your peers and if you lose money, no one will criticize you. However, since value stocks are shunned by the street, a value investor will be a loner and he will be blamed for going against the herd if things go wrong.
Chapter 21: Stick to your guns.
As businesses evolve and change the criteria for identifying value investing opportunities also change accordingly. Graham who was the pioneer in value investing used to look for companies selling at two thirds of the net current assets value.  When manufacturing industry became the key industry in the United States price to book value became the criteria of choice to identify value. Soon, as services industry became prominent with their low asset base and low book values,  price to book value became meaningless and investors shifted to earnings based model of valuation.  Then came the phenomenon of leveraged buyout and the appraisal methodology became one more weapon in the armory of the value investor. Even as criteria to identify value keeps changing with the times, basic principle of value investing remains as timeless as ever.  Invest in companies trading significantly lower than their intrinsic value and then wait for market to identify its intrinsic value.  It may take time and patience.  Sometimes market may go up significantly while your investment remain lacklustre. Sometimes you may sit on cash with no value opportunity available to invest in as the market has run up considerably.  It is at these times that one must not lose faith (in the approach)  and patience. If you have done the homework properly and identified value stocks, eventually  you will be rewarded handsomely.
This is a book for the new investors. I will give it a score of 3/5

Tuesday, September 5, 2017

Book Review #30: The Little Book that Still Beats the Market: Author Joel Greenblatt

This is a sequel to the more famous book 'The Little Book that Beats the Market', by Mr.Greenblatt. This book is very easy to read and review since there is no new idea in this book. The book is a weak attempt to explain the 'Magic Formula' and is more of an effort to prove (to the sceptics) that the 'Magic Formula' works over time and over different groups of stocks.

What does an investor want? She wants to own shares of companies in the best business at very good market price. This is what Magic Formula tries to provide. Magic Formula itself is very simple. Identify the companies with the highest ROCE and the highest Earnings Yield and keep them for one year. At the end of one year, sell off them based on the tax rules prevalent in the country. High ROCE will ensure the attractiveness of the business and high earnings yield will ensure that the share is purchased at an attractive price.

How does MF work? Use a screener to screen companies with their ROCE in the financial year that just ended. Give the companies ranking from 1 thru N where 1 is given for the stock with the highest ROCE. Run another screen to identify the companies with their Earnings Yield. Use the same ranking to rank the companies based on the Earnings Yield with 1 for the highest Earnings Yield. Now sum up the ranks and buy the top 30 stocks with the highest cumulative ranks.

Magic Formula uses the following equations to calculate ROCE and Earnings Yield.

ROCE = EBIT / (Net Fixed Assets + Net Working Capital)

Earnings Yield =  EBIT / Enterprise Value (Market Value of Equity + Market Value of Debt)

The advantage of using EBIT is that it helps in comparison of performance of various companies without the complications of Taxation. The denominator in the ROCE equation is the cost of generating that EBIT.

As can be seen, Magic Formula is quite simple. However, there are some cautions.

1. If using the MF, one should have a portfolio of about 30 stocks to get the best returns. If an investor uses Magic Formula to buy one or two stock, he may end up losing. The reason is while the individual stocks within the MF may have fluctuating returns, as a whole, the formula works at a portfolio level.

2. For best results, spread the purchases of magic formula stocks. For example, buy about 7 - 8 stocks in a month for 4-5 months till you reach list of 30 stocks. This will even out the systematic risk.

3. Keep the stocks for at least one  year for the best results.

4. Do not keep stocks for more than a year (+/- a few days). Sell of loss making stocks before 365 days to get Short term capital loss benefits and sell profitable stocks immediately after 365 days to get the Long Term Capital Gain benefits.

5. Every year, run the formula again and buy the new stocks that meet the criteria.

Magic Formula works in US Contexts. For India Context, some tweaking may be required.

Mr.Greenblatt has an engaging style of writing interspersed with pithy witticisms. So the book is an easy read.  

This book did not add a lot of value to me. Probably the prequel might. However, that book is very expensive and I am waiting for a correction to buy that book.

My score is 3 / 5 for this book.

Saturday, August 26, 2017

Book Review #24: Money: The unauthorized biography: Author: Felix Martin


Overall Review 


The traditional view of evolution of money states that in the beginning there was barter. People used to exchange items they possessed with items that others had. When the requirements became more complex a need was felt for a medium of exchange. And thus was born money.

Is this a correct understanding of the evolution of money? What is money anyway? How will we measure it? Who will control it? How will we handle excesses and bubbles? What are the challenges? How has these questions been answered over the course of civilization?

Over a span of 16 Chapters, author Felix Martin, in his book 'Money - The Unauthorised Biography' takes the reader through more than 2 millennia, from ancient Greece, through early Mesopotamia, ancient China, medieval Europe, the island of Yap in the Pacific,  finally ending up with Modern economy as we know. Through this journey, the reader gets a glimpse of how countries have handled money and many examples of the consequences of its mismanagement.

Through this journey, the reader is exposed to a variety of historical incidents that makes this book very interesting. Be it the Irish Bank Crisis of the 70's, the Irish Famine, the demonetization of Pound, the rise and fall of the brokerage firm Overend, Gurney and Co in England etc. Each incident illustrates a concept related to money.

The book paints a broad canvas covering the evolution and challenges of money and monetary policy. The challenge starts with the definition of money itself. Historically there are two different broad definitions of money. As per the traditional definition, money is unit of  economic value and the standard of measuring this value depends on the confidence of the citizens over the sovereign. This view is countered by the conventional 'Commodity View' of money that considers money as a commodity and its value depends on the value of the underlying commodity. Hence the value of money is a 'Natural Fact', away from the control of the sovereign.

Throughout the ages, people implicitly understood money as a social technology. As per this understanding, there are three aspects that define money. One, concept of Universal Economic Value, two, a system of account keeping to measure the value and three, principle of decentralized transfer whereby the value can be transferred from one entity to another. 

Through their custom of sharing the spoils of war and sharing of the entrails of roasted oxen among its people, ancient Greeks implicitly understood the concept of Universal Value. Numeracy, literacy and accounting originated in ancient Mesopotamia. The interplay of Universal Economic Value and the science of accounting led to the creation of money as we know it.

One of the critical questions is who will control money? Whether it should be controlled by Sovereign or by the society. The Jinxia school of ancient China recommended that the money, its creation and transaction, should be controlled by the Sovereign. As per this school, money is a tool of sovereign, which can use this tool to redistribute wealth between the sovereign and its citizens. This view had persisted over 15 centuries. However, the excesses of Sovereigns who manipulated this power for personal gains led to resistance. One of the key ways in which Sovereigns manipulated the system was by printing / minting more money and collecting Seigniorage, which was nothing but redistribution of wealth from citizens to Sovereign.

It was a matter of time before citizens resisted the power of Sovereign to control money. Nicholas Orasme, a French intellectual, posited that since the prime user of money is the wider community, the control should lie with the community. Over time this argument became theoretical due to the rise of mercantile class with trade becoming more and more cross-border. This meant two things. One, lesser control by sovereign of any one country on the transactions and two, money slowly morphing to Transferable Credit and less dependent on coinage. As more and more trade started happening through credit, the less they needed money in the form of currency. This led to Sovereign gradually losing control over money.

The scale of influence of mercantile money was limited. Sovereign's role could not be wished away. The clash between Sovereign and Money Interest ended with the creation of a central bank with public private participation. Bank of England, tasked with the creation of money and maintenance of monetary policy was created based on this ‘Great Money Settlement’. The money interest not only had control on its creation and distribution, they also got the benefit of Seigniorage. 

This led to the new problem of crony capitalism. The reaction to this led to the design of the conventional approach to money. As per this approach pioneered by John Locke, Adam Smith and all, money was nothing but a commodity whose value was determined by the ‘facts of nature’. This approach totally removed Sovereign control on monetary policy. The value of money was fixed by natural forces. The disastrous consequence of this approach was the Irish Famine which killed more than a million people !!!

While England was experimenting with conventional approach, there were reformists in other parts of the world who were trying different approaches. John Law in France identified the central problem as Sovereign taking too much of debt, which entail fixed payments, backed by revenues which were non-linear in nature. This skewed the risks in favour of lenders. The approach followed by Law was to convert all the sovereign debt to equity.

Law also identified that economic growth can only be achieved by circulation of money. When economy tends to be bad, people become anxious and start hoarding money. This reduces the circulation of money leading to a vicious cycle of ever lowering economic growth. The only way to handle this is for the sovereign to pump in more currency so that money circulation can be increased.

The key aspect is the trust and confidence of the citizens in the stability of the economy. It is important for the sovereign to have flexibility in monetary policy to issue currency. This cannot happen if the currency is linked to a commodity. So one of the key reforms initiated by Law was the issue of currency not linked to any commodity, the so called ‘Fiat’ money.

Meanwhile, England faced a series of economic crises in the 19th Century. In about 1866, the then world’s largest brokerage firm of Overend, Gurney and Company went bankrupt. This led to huge economic crisis in the country. The editor of Economist, Walter Bagehot, analysed the crisis and came up with some path-breaking suggestions. As per him money is not a commodity since during times of crisis, while the demand for other commodities go down, the demand for money increases. The key reason, as Law understood it earlier in France, was the loss of confidence of the citizens in the entire monetary system.  

Bagehot understood that only Sovereign can bring about this confidence. So he proposed flexibility for the sovereign to fix the monetary standard. Especially at times of economic crisis, confidence is very low. Bagehot proposed that at the time of economic crisis, the banking system cannot meet the demands of the public. Bank of England (BoE) as a ‘Lender of the last resort’ is duty bound to honour the bills presented to it. BoE should honor all the bills presented to it without looking into the credit worthiness of the presenter. This will boost the confidence of the public in the monetary policy. To ensure that lenders do not misuse this facility, Bagehot recommended that the loan to the public should be done at a very high interest rate.

Bagehot’s approach differed from conventional approaches in three ways. When it comes to the role of monetary policy to handle crisis, Bagehot encouraged the role of Sovereign in setting monetary standards (since only Sovereign enjoyed political legitimacy) whereas classical economists saw no role for sovereign. When it came to cause of and handling recession, Bagehot maintained that recession is caused by the loss of demand of money and the best way to handle is to aggressively increase the lending by the central bank. As per classical economists, money has no role to play in handling recession. The only way to handle recession is to increase supply of commodities in the system.

Regarding the role of money, Bagehot believed in the role of money to spur economic growth, while classical economists considered money as incidental to the exchange of commodities.

The classical economics ultimately led to the development of Orthodox Economics focusing on demand and supply of things in the economy without any consideration of money. The principles of Bagehot led to the development of modern theories of Banking and Finance without any consideration for demand and supply of commodities.

And the twain did not meet.

In 2007, world faced a huge economic crisis, an outcome of this parallax. Across the world banking system collapsed. The reason was the explosion of credit in the system caused due to innovative new products developed by ingenious finance experts. Since none of this impacted the demand and supply of commodities, the economic world did not take notice. Only after the crisis hit that the world realized the huge direct and indirect economic impact of the crisis mainly caused by excesses in the financial system.

Immediately after the crisis hit, the regulatory authorities took a series of actions. One is to increase the capital adequacy norms. However this is not sufficient. Martin recommends multiple approaches including sharing the risk reward ratio between the sovereign and the lenders. One approach will be to issue government bonds whose interest is linked to GDP. Another approach is to curtail the role of sovereign in the banking the system. This can be done by Sovereign backing only the retail activities of the banks, leaving banks to take the risks of its market related activities.

Money is very complex topic. It has to be carefully calibrated and constantly monitored. As per Martin, most of the crisis has happened in the past due to wrong configuration of money. Only the right configuration of money can take the world out of its troubles and bring about the Freedom and Stability that money has been promising since the evolution of the civilization.

This was a very difficult book to read, understand and review. It took me five readings and copious note taking just to make sense of the overall structure of this book. The challenge is that the author do not maintain any chronological structure. For example, in Chapter 12, while talking of structural reforms in France introduced by John Law, we go back to 6th Century BC Greece to read about Solon’s views on democratization of monetary policy. Also the points are explained in a tedious and roundabout fashion. Much like needles in a haystack, key points are hidden in a verbal haystack and it needs focused reading to get them out and present them in a synopsis that this review attempts.

So, why should you read this book? The implications of various money events are explained very nicely be it Irish Banking Crisis, Irish Famine, Yap and their use of Fei, the debacle of OGC, the 2007 crisis....The reader experiences these crisis first hand as she reads them explained in this book.

Being a book that deals with the complex and controversial topic of money, there are many material out there that either praises or pans this book. It is almost like the book appeals to some views and do not appeal to others. In this polarized environment, my review aims to reach a middle ground, I hope.

I will give this book a score of 3 /5 based on a Layman’s perspective.

Given below is the Chapter Summary. I have reviewed only 15 Chapters below. The final chapter is the summary of the points covered in the book which I have summarized in the overall review above.

Chapter Summary 

Chapter 1
In the first chapter of the book, Martin provides three examples to prove that traditional view of evolution of money was wrong. First example is from the Micronesian island of Yap in the Pacific. Even as late as early 20th century this island was unknown to the world. When discovered it was found tat the people of Yap were using huge stones discs known as Fei as money. The size of the Fei denoted its value. The Fei was placed in the city centre. The transaction between people was represented by transfer of ownership of Fei.
The social status of people in Yap was determined by their proportional ownership of Fei. The symbolism of Fei as money is shown by the fact that the richest family in Yap did not even possess a Fei. The Fei they were supposed to be having was hidden deep inside the ocean having sunk in a shipwreck during its transfer to the island !!
The conventional view of money is that it is a physical commodity. However the example from Yap shows that money is nothing but a system of credit and clearing. Be that the case, how did the view of money as a commodity survive for such a long time? One of the reasons was the presence of coins that affirmed the view of money as a commodity. While coins have survived the ravages of time, other symbols of money, unfortunately, did not.
One such example is the Exchequer tallies that existed in England from 12th Century to almost the beginning of the 19th century. These tallies were used to manage the public finance of England during this period. Tallies were wooden sticks on which were inscribed with notches, the details of payment made to and from exchequer.
Once the details of the payment was recorded in a tally stick, it was split in the middle from end to end so that each party to the transaction could keep a record. The creditors half was called 'Stock' and the debtors part was called the 'Foil'. The unique grain of willow prevented a forgery while the portable nature of the tally meant that it could move from the first party to the third party to close some unrelated debt. This made them 'bearer securities' much like cheques that we issue in the current day.
Sometime in the early 19th century, England replaced Tally with proper notes. Once this was introduced, huge stock of Tally sticks with government was considered to be a public embarrassment and the entire stock of the sticks were set on fire inside the house of lords.
With the loss of tally sticks, world lost a recent evidence of use of money as an idea and a measure of economic value. The surviving metal coins thus reinforced the idea of money as a commodity.
Another reason why it is difficult to analyze money is that impassive analysis is difficult. The very nature of money, its integration with the day to day activities of each of us, makes such analysis difficult. However opportunities for such analysis occurs where extreme disorder happens in the monetary system. One such incident happened in the Irish Banking system as recently as 1970. From May 1970, the banks in Ireland were shut down for a period of about 6.5 months. Despite such long shutdown the economy of Ireland proceeded briskly due to two reasons. One was the cash withdrawals which business made before the closure that enabled salary payment. However, more importantly, most of the business was run through cheques, which moved from hand to hand in the form of IOUs.
The entire system of credit clearing and economic activity in one of the world’s top 20 economies ran smoothly for an indeterminable time period.
How did this happen?
This happened because most of economic activity in Ireland was local in nature and the system was based on people knowing each other. This was facilitated by the availability of local pubs where people used to assemble for drinks.
One final example to show that the idea of money as a commodity is wrong is the Siege of Valletta by the Turks in 1565. As the Ottoman embargo dragged on, the supply of gold and silver ran short. To overcome this the knights of Malta minted coins in copper. The motto they printed on the coin read ‘Non Aes sed Fides’ (Not the metal but trust)
The fundamental theme of first chapter is to address the question ‘What is money?’. Conventional view is that money is nothing but a commodity medium of exchange. It is nothing but the ‘Gold Standard’. As this book argues, money is not a commodity. It is a social technology comprised of three fundamental elements – an abstract unit of value, a system of accounts that keep the individual or institution credit / debit balances as they engage in trade with one another, and the ability to transfer the value from one to another. The ‘Transferability’ is what converts credit to money. In other words, money is a ‘transferable credit’. As the example of Tallies in England or the IOUs written in Ireland show, it is not the idea of money as a commodity that matter, it is the transferability of credit that determines the money. The transferability of credit depend on the trust that the society places on the debtor’s ability to deliver. In addition the third parties must also be willing to accept debtors IOU in lieu of payment.

Chapter 2
Across the history, different items has been used by people as a medium of exchange with coins being the most visible currency. What this proves (paradoxically !) is that money is not a thing. It is a social technology; a set of ideas and practices which organize the way we live together.
To illustrate the evolution of money, Martin takes that reader through three different eras in this chapter. In the age of ancient Greeks - the age of Iliad and Odyssey, there was no money. The society was hierarchical and was designed for war. So how did Greeks Organize and manage without money? For one, the needs were basic. Food, water and clothing. And it was an economy of self-sufficient households in which individual tribes man subsisted on his own produce. In addition, there were three social institutions that played important roles in organizing the community. One was the distribution of spoils of war. Two was the system of reciprocal gift exchange between chieftains and three was the sacrifice of oxen to the gods and the distribution of roast beef in equal parts to the congregation. These three worked to ensure order among a warrior society.
While ancient Greece was a warrior society, they Mesopotamia was primarily an agrarian society. Due to this sedentary style of living, they developed the first known city state. To handle the needs of a large population, they developed world's first known bureaucracy. The power was shared between king and the temples. To manage the social order and the complex needs of the public and multiplicity of transaction, they invented three most important social technology of human civilization, vis. literacy, numeracy and accounting.
Traditional view of emergence of scripts is that the scripts developed out of images of  everyday objects. However, the cuneiform scripts of ancient Mesopotamia are almost similar to the present day scripts. Literacy helped the city states to develop bureaucracy to handle the complexity.
Ancient Mesopotamia was a treasure trove for archaeologists. In between lots of rich artifacts, they also discovered clay artifacts of different sized and shapes. While initially thought to be children's play things, later they were found to be sophisticated tools used for what came to be known as 'Correspondence Counting'. Each artifact identified different type and quantity of things. So a transaction involving the sale of five cows, for example, was denoted by the use of five artifacts that represented the cow.
From use of physical artifacts to the use of pictures of artifacts was the next step. The idea of correspondence counting was the early precursor to accounting.
Even with the use of pictures, one had to draw 5 pictures of the artifact to show transaction involving 5 units of an item. Over a period of time, symbols were invented to represent numbers. So, now, instead of pictures of five artifacts, you needed to draw only two symbols, one to represent the item and the other to represent the number transacted.
It must be noted that nowhere in Mesopotamia, despite the numerous and complex transactions, the concept of money as we know it, was used.

Chapter 3
What is a dollar?
Is it something physical or is it a unit of measure. If it is the latter, what does it measure?
A dollar or a rupee measures economic value. Which means that economic value has to have universality.
In the early days of evolution of money, the idea itself was local. Each transaction was measured on its value, the so called Barter System. This chapter examines the evolution of a concept of universal economic value that revolutionized the idea of money. The idea of economic value is already universal. For example an ‘Archana’ in an Indian Temple (Spiritual Value) costs Rs.10 (economic value). Or for that matter, insurers calculate the economic value human beings to determine the policy premium.
Considering the universal applicability of the idea of economic value, can it be standardized? Here one faces challenges. Economic value is a social construct and is closely linked to the societal norms and constructs. Getting into the social realm, economic value is more political in nature. So for example, Indian food, while inexpensive in India, becomes ‘exotic’ and costs a lot in other countries. In this case, while there is an economic value for Indian food, the value is different in different contexts (non-standardized)...
Even though Mesopotamia invented the concept of accounting and numeracy, the excessive bureaucracy ensured that the other requirement of money, vis. The concept of universal value was not available. However, the ancient Greece had the concept of universal economic value but did not possess knowledge of accounting. So when this knowledge was transferred to Greeks, it is no wonder that the concept of money as we know it originated there. All pieces of jigsaw fell in place as it were !!. There are evidences that as early as the 6th century BC, Greeks were using ‘Drachma’, a currency, for transactions.
The spread of coinage accelerated the usage of money. One of the key uses of money is decentralized negotiability. The new idea of universal economic value made possible offsetting of obligations without reference to a centralized authority.
With the spread of money societies were turning into ‘monetary societies’. The age of centralized authority was ending and was being replaced by money. Social status was being measured by the amount of money one possessed. Money provided social mobility.
What about political stability? Without centralized control, won't the society collapse? Surprisingly no. Since the basis of universal economic value was the concept of universal social value, as shown by sharing of the spoils of oxen sacrifice in ancient Greece, money promised political stability, as against the chaos as predicted by vested interest.
Next question is, who will control money? This question is addressed in chapter 4.

Chapter 4
Who should control money? In other words, who should print it? Who will ensure that universal economic value?
Fascinating questions raised in chapter 4. It starts off with the example of Argentina, where in the late 90s and early 2000, the sovereign control on the currency almost failed and parallel currency called ‘Creditos’ existed, prompting stern warning from IMF. Chapter also talks about Russia of 90s where parallel economy was the norm.
Ideally Sovereign should control money supply primarily due to two reasons. One, it is the largest payer and two, it has the political authority. Political experts have long realized the predominance of sovereign in matters relating to money. Constitution of almost all countries vest the power to print currency on the sovereign
This raises some interesting questions. The role of money is to ensure freedom and stability for the ‘Society’. What if the interest of sovereign diverge from that of the society? How to ensure that the interest are aligned?
While some of these questions are being debated even today, some of these question were answered in China in 4th Century AD. Duke Huan of Qi dynasty enlisted a group of scholars (known as Jinxia school) to come up with ideas to help sovereign become powerful. The ideas on money that this group discussed were collected in a work known as Guenzi.  The findings of this group is remarkable for their universal applicability even in modern times. As per them money is a tool of the sovereign, part of the machinery of the government.
If money is a tool of sovereign, two question arise. One, how did it work? And two, to what objectives should the sovereign deploy it? Jinxia scholars developed the theory. First of all, the value of money was unrelated to the intrinsic value of the token used. Instead, money’s value was directly proportional to how much of it is in circulation, compared to the quantity of goods available. Role of sovereign was to modulate the money available in order to vary the value of the monetary standard in terms of these goods. Sovereign could pursue a deflationary policy by sucking in all the currency so that the prices of goods will fall. Or it could be inflationary, by transferring money to subjects while accumulating goods, thus causing the prices of goods to increase manifold.
Why should sovereign pursue any of these policies?
First, it would provide a powerful tool for income redistribution among sovereign’s subjects. An inflationary policy will erode the claims of creditors and eased the burden of debtors and a deflationary policy had the opposite effect. Another important redistribution was from the subjects to the Sovereign. By minting new money and putting into circulation virtually at no cost, sovereign was asking subjects to pay more for eh same amount of goods. (This is called ‘Seigniorage’ in modern economic parlance). Second, it would regulate economic activity by making the primary instrument of organization and settlement of trade more readily available.
As per Jinxia scholars, for sovereign’s power to be effective, sovereign must retain exclusive control over money.
Meanwhile, when monetary thought evolved in Europe, it was in a different direction. This is discussed in Chapter 5

Chapter 5
Ancient Roman empire had a thriving monetary economy. It was surprising to read that Rome had its own ‘Subprime crisis’ as early as 33 AD. Credit became excessive, real estate prices became very high and when Emperor implemented capital adequacy norms, the economy collapsed. The sovereign had to bail out the bankrupt lenders !
How history repeats. Again and again.
From the collapse of Roman empire in 4th century AD, the monetary economics slowly faded in Europe. However, the idea of universal economic value still persisted. In 8th Century AD, England introduced Pounds, Shillings and Pence as monetary units. However, the usage of these units stabilized in 12th Century AD. The usage of coinage was complicated by the fact that kings authority was limited. This meant that while pounds, shillings and pence remained as the coin, their value varied locally and was not standardized.
The coins were made of Silver, but did not specify any value. This gave sovereign an advantage of lowering the value of coin to impose a one-off wealth tax on the holders of the coined money. The coin would be ‘Cried Down’ and the existing coin would be presented to the mint to re-coin the cried down issue. Sovereign can, in addition, levy a charge on the re-minting operation. The sovereign could also lower the value of Silver in the coins, so called ‘Debasement’ and levy ‘one off’ tax on people.  The potential for mischief was enormous.  If the need arose, Sovereign could raise enormous sums by ‘crying down’ or even demonetizing altogether the current issue of coinage and calling it in for re-minting off a debased footing.
The remonetization of Europe over the ‘Long 13th Century’ (late 12th to mid 14th) generated two conflicting phenomena. One was the emergence of ‘money interest’, a group of individuals and institutions whose wealth was held in money and the other was the Sovereign that increasingly addicted to Seigniorage. The more activities were monetized, and the more people in the money economy, the mover was the tax base on which to levy Seigniorage. Clash was bound to ensue.
In the mid 14th Century, a French scholar, Nicholas Orasme wrote ‘A treatise on origin, nature, law and alteration of money’. In that, he tried to address two questions. One, was it right that sovereign should manipulate the monetary standards? And two, in whose interest he should do it, if at all?
As per Orasme, money was not a property of the Sovereign, but that of the entire community that use it (which was the ‘Wealthy Class’ at that time). Money was an essential service, to be operated in the interest of public at large. Since money was to serve people, money should be controlled by the public and not by the sovereign. In case any ‘debasement’ is required, that would be decided by the public, not by the sovereign.
So what was the role of the sovereign? It was to try and  discover new sources of precious metal so that new coins can be minted.
The innovative idea introduced by Oresme was the in considering monetary policy’s ability to redistribute wealth and incomes and its ability to stimulate or stifle trade, the wider community's well-being should take priority.,
All these innovative ideas remained short lived as industrial revolution and accompanying commercial class, too roots in Europe. They invented the idea of banks, an invention that upended the entire monetary thought.
This is covered in Chapter 6.

Chapter 6
The early 14th Century in Europe was characterized by the arrival of the mercantile class. Starting from handling the credits and debits related to the local trade, this class was also facing challenges related to cross border trade. While Orasme and his ilk were trying to change laws related to Seigniorage in France, the mercantile class bypassed the sovereign money altogether by creating their own ‘money’
While the banking process itself was very rudimentary, restricting to handling of credit, the scale of transactions themselves was huge involving ‘millions of pounds transacted in a day without any use of sovereign money’. The way it worked was as follows.
Some of the big business house in Europe issue ‘Bill of Exchange’, which was basically IOUs, guaranteed by the business houses. A buyer of a good in one country will but these Bills to settle his purchases with a seller. The seller of the good will in turn use this bill to settle his purchases in another country.
Every once in a while, the various buyers and sellers of these bills will use the Sales fairs at various European Cities to settle the books and carry forward the balances. To handle the ‘Exchange rates’ a new notional currency, named ‘Ecu de Marc’ was introduced. Fixing of exchange rates between sovereign currencies and the notional currency was one of the key aspects of the periodic settlement process.
One of the critical aspects of the banking system is the handling of credit risk, the so called ‘Asset Liability Mismatch’.  How did these banks handle credit risk? In the early days this risk was handled easily since both the assets and liabilities were local and short term in nature.  So they automatically matched. Liquidity risk was handled through frequent settlements.
The task of a judicious exchange banker was to transact in the first few days of the central fair so that on the day of settlement, he could perfectly offset his debit and credit balances and turn a profit. Through this self-regulated network and hierarchy of credit, they had created a viable private money on a Pan European scale.
The sovereign was not happy. It tried to impose control on the system by imposing severe penalties, but despite that the system continued.
While the banking system created huge private wealth, it also created significant political changes. This is addressed in Chapter 7

Chapter 7
One of the implications of the points discussed in the previous chapter was that the great merchant houses had discovered means of producing, international money beyond any one sovereign's control. Moreover, without any collateral to back it, this money was invisible, intangible and solely based on trust
This money had the potential of impacting the valuation of sovereign’s money. In fact, from a ‘Value 26 Flemish shillings’ in 1544, the British pound had depreciated almost 50% to 13 Flemish shillings. This got the sovereigns worried. One of the ways in which they tried to counter the shadow money influence was through direct market intervention. Through a special fund. When this did not work, sovereign resorted to coercion by mandating that the foreign currency reserves of English merchants in Antwerp be converted into a forced loan to the crown.
These were all temporary measures and an uneasy calm remained between merchants and sovereign for over four centuries. One advantage of this was that the arbitrary hold of sovereign on the money was eliminated. The existence of shadow money ensure that the sovereign control over money had lost its effectiveness.
From the Jinxia academy of 4t century which postulated money as a tool of sovereign to money as a tool to put control on the excesses of the sovereign, monetary theories had completed one full cycle.
While private money may look good on paper, practically there are challenges. One is the size which is limited to a group of people who transact based on trust. Two, private issuers could default, leaving their creditors worthless. Or, there could be unexpected events that could dent the confidence on the system. Due to all these reasons, sovereign money will continue to be the default.
While this inequillibrium continued, the sovereign needed money to fight wars. Identifying new sources of money became the challenge. The King of England tried many ways, including Lottery, to fund the war. Nothing worked.
There were two simple questions to be answered. One, how to fund the current wars by using the future income? Two, how to get private money to partner with Sovereign to fund the war chest.?
One of the suggestions was to set up a bank funded by public – private partnership. This bank will print currency, mint coins and lend to the sovereign. The money group was excited since this helped them share the Seigniorage. Government could get money to fund expenses. This bank, will, thereby help create a ‘Grand Settlement’ between money interest of the mercantile class and the interest of the sovereign.
Bank of England was born.
What is the implication to monetary thought? From Jinxia academy, where money is a tool of Sovereign and be controlled by it, to money being used as a tool to control the excesses of the sovereign, monetary thought had come a full circle. Money was social technology to help redistribute the wealth. This role of money remained constant thru ages.  Another constant was the political role of money.
This was about to change with the advent of the science of economics. The key question that economics asked and which changed the paradigm was the following.
What is the standard based on which money should be issued?
This is addressed in the next chapter.

Chapter 8
While the equilibrium established between the money interests and sovereign seemed to have stabilized, it caused a lot of concern among the supports of constitutional monarchy. They felt that the combination of a powerful sovereign and wealth money interests could use this authority to overturn the hard fought property rights of common man.
They were looking for ways to undermine the power of the grand settlement. The key concern was that the standards were not fixed behind the issue of currency by Bank of England. In theory, Bank could print excess or less currency, thereby leading to redistribution of wealth between citizens and powers that be.
One such opportunity presented itself when Bank decided to tackle the problem of silver coins.
The problem was simple as much as it was age old. The value of silver in the coin was greater than the value of the coin itself. The result was that the coins were sold off to bullion traders at the value of silver content. Whatever coins that remained in circulation were also badly mutilated to strip off as much silver content as was possible. The end result was that the silver coins which were in circulation had almost 50 percent less silver that the value of the coin itself.
This problem had been faced multiple times in history. At each point the sovereign either depreciated the currency (so called Crying Up) or reduced the quantity of silver in the coin (Debasement).
British parliament invited Mr.William Lowndes, a lifelong veteran of treasury to suggest solution to the problem. Mr.Lowndes recommended a one-time debasement of the Pound by 20%, which meant that the content of silver in the coin will be reduced by 20% bringing the value of the coin same as the value of silver content in the coin.
This was a time tested practice to handle currency stability. British parliament asked Mr.John Locke, leading intellect of the age, for his views.
Mr.Locke opposed the debasement entirely. He posited that there is no difference between the value of ‘Pound’, the coin and the value of silver content in the coin. As per him, the Pound coin was losing value not because of inflation, but because of the loss of silver content in the coin. Locke proposed recall of existing  coins and issuance of new coins with the full silver content and a fixed value.
In 1696, the parliament decreed that existing, clipped  silver coins will no longer be a legal tender and proposed replacement over a six month period. The Old coins were replaced with new coins with full silver content. As soon as it was issued, the new coins were taken out of circulation by vested interests and the same was exported as bullion. This resulted in a crippling coin shortage which ultimately led to deflation and contract in trade. Many people committed suicide.
Why did Locke insist on such a position? It is possible that as a constitution liberal, whose guiding principles were individual freedom and liberty, he was worried about giving excessive power to sovereign to determine the value of money. He probably wanted the decision to be based on natural facts.
After initial hiccups, the new currency system seemed to have attained some form of stability. However, none had predicted the arrival of new transactions.
The commercial class invented debt. The implications are covered in the next chapter.

Chapter 9
Let us summarize our understanding so far. Traditionally money was considered to be a social technology and had political ramifications. Sovereign had the flexibility to adjust the value of money, ideally in the ‘interest of society’, thereby creating a wealth redistribution between the lenders, the borrowers and the sovereign.
Then came Lock with his idea of money as a ‘fact of nature’ and whose value has to be fixed based on ‘natural Facts’. Sovereign had no control on its value and had no flexibility to adjust based on requirements. Money as a tool to handle crises, both natural and man-made, was off limits.
One of the most common and regular crisis that occur in a monetary society is what is known as ‘asset bubble’. The values of various assets are driven up to extra ordinary levels through use of excessive debt. In many cases, the institutional oversight is week (either by omission or commission) and loans are taken against collateral, which exist only on paper. Eventually one of the parties in this bubble will default on their payments and the bubble will burst. This will quickly explode into a full-fledged crisis, which if not handled quickly and effectively, can cause significant economic slowdown for years.  It is the responsibility of sovereign to handle this crisis.
Another type of crisis is natural calamity like famine. When nature fails, it is the duty of sovereign to help people who are suffering.
To handle such events, sovereign require flexibility in monetary policy since it is a tool of sovereign as per Jinxia school. This was the flexibility taken away from them through the conventional view of money as propounded by Locke.
The story of Irish potato famine is an example of disaster that can be compounded due to monetary rigidity of the conventional view. For two consecutive years Ireland faced famine. More than a million people died due to famine. The followers of conventional view of money, at that time a majority in parliament, and supported by editors of renowned magazine ‘Economist’, prevailed on the Sovereign from providing any form of support to the Irish, who, by the way were dependent on British for everything other than Farming.
(As you read this chapter and the previous one, it is surprising to see the number challenges that Britain faced due to conventional view of money and the associated monetary rigidity. If you remember the book ‘Lords of Finance’, you could see how wrong was the BoE in sticking to Gold Standard when the whole world was moving towards monetary expansion as a means to kick-start growth. The English has been wrong multiple times and the world had had to pay terrible price for their mistakes)

Chapter 10
While England in the 18th century looked at value of money as a ‘Fact of nature’ and hence not to be tampered with, money was viewed differently in different parts of the world at different times.
For example, ancient Greeks were concerned that people were putting money value as everything and acquisition of money was overshadowing other human pursuits. The question of ‘How much money is enough?’, bothered the philosophers. As the famous story of King Midas shows, Greeks considered the acquisition of wealth beyond one’s need to be ludicrous.
Greeks also observed a paradox about money. One need the help and support of other people to make money. But the same money drive the person away from the people. Once a person has the money, he no longer require the support of people who helped him in the money making endeavor.
While Greeks were bothered about limiting acquisition of money, their neighbors, Spartans, eliminated the use of money altogether. Sparta was a highly militarized, regulated society. They believed that if all other social institution are powerful enough, a society did not need any money to survive. Similar sentiments were espoused by Thomas Moore in his 16th century book ‘Utopia’.
Coming to modern era, Soviet Communists followed the strategy of ‘Containment’ of money rather than its elimination. Through this rigorous planning and widespread bureaucracy, Soviets progressively reduced the opportunities to use money. The outcome was that acquisition of money got one nowhere since there was hardly any opportunity to use the same.
As mentioned earlier, there is inherent contradiction of money. While you need society to support its acquisition, you do not need society once you have money. How do you handle the contradiction?

Chapter 11
While England was experimenting with the conventional view of money, there were reformists in different parts of the world, at different points in time, who came up with different views of money.
One such reformer was John Law, a Scotsman, who in 1705 wrote a treatise called ‘Money and trade considered, with a proposal for supplying the nation with Money’.
Unlike Locke or Lowndes, Law saw the role of money differently. As per him ‘money is not the value FOR which the goods are exchanged, but the value BY which they are exchanged’. Money, in his opinion, was just transferable credit.
If money is transferable credit, determining the standard of abstract economic value should be the most important question in economic policy for two reasons. One, standards should be such as to ensure sufficient supply of money. Two, the standards also determines the distribution of wealth between sovereign and eh subjects and more importantly in a commercial economy, between the private debtors and creditors.
For money to prime up the economy, it should circulate. However, money will not circulate by itself since people are safety conscious and will hoard money. Without circulation, money ceases to generate wealth and income and this makes people anxious and they hoard more. This becomes a vicious cycle.
Without appropriate intervention, money cannot play the role of priming up economy.
What kind of intervention? And  who will intervene?
As per Law, the sovereign issuer of money should have the authority to vary the supply of money to match the needs of private commerce, public finance and balance between private creditors and debtors. The monetary standard must allow discretion in issuance of money. This immediately ruled out gold and precious metals as a standard.
So what could be the standard?
In early 18th century, France was a basket case. Not only it had a shortage of money, but the crown was neck deep in unsustainable debt. The first challenge was to improve the money supply. Law persuaded Regent to allow him to establish a General Bank tasked with issuance of money. Initially the quantity of money issued was linked to the availability of Gold and Silver (so called Gold Standard), but over a period of time this linkage was broken. For the first time in history (of the world) France had ‘Fiat’ money.
Having attacked the first problem of Money Supply, Law focused on the next problem of excessive debt. Law convinced Regent to allow him to form a joint stock company and to award it the rights to develop French North America. Holders of sovereign bonds were invited to swap their debt claims on crown for equity share in the company.
The response was overwhelming. Every one rushed in to buy the shares in the company. The company expanded its operations and acquired many more companies and the share prices started going thru the roof. Everyone was happy.
In 1719, company acquired the rights collect Indirect taxes. Along with that it announced intention to buy up entire sovereign debt by issuing a huge tranche of equity.
The Bank was minting Fiat money, the company was reaping profits, the Sovereign debt was converted into equity and the monetary standard was exclusively under the preview of Sovereign. Law had achieved the impossible. A sort of Monetary Utopia as it were.
What could go wrong?
There was one problem, though. The entire edifice of the system was based on the ability of the company to earn profits. By 1720, doubts began to creep in about the potential losses of the company. The smart money began to sell off leading to a fall in value of the equity. This led to collapse of economy. By December 1721, Law had fled France.
What were the contribution of Law? One, he believed in the power of money to spur the economy. Two, he identified the inherent conflict between fixed value debt being serviced by uncertain revenue flow. The simplest way to handle this was to convert the fixed financial claims (debt) into variable claims (equity). By all criteria, Law’s system should have been a success.
So why did it fail?
It failed because Law believed in the authority of monarch to set the standards. Considering that money was a social technology and was used by everyone in the land, it is important that the standards were fair and transparent and socially acceptable. However an arbitrary standard made by sovereign did not meet this criteria.
It was surprising because of two reasons. One, about two centuries ago, in France itself, Nicholas Orasme had made the same point that money was a social technology and should be controlled by the community. This lesson was not heeded to. Second, the same idea was prevalent in ancient Greece as early as 600 BC. To curb the monetary excesses, Solon, a philosopher elected to the post of Chief Magistrate of Athens, enacted a series of social reforms known as ‘Shaking off of Burden’. Main among them was the cancellation of debts, not by diktat, but as a matter of political compromise, making monetary decision more democratic. In addition Solon abolished share cropping, introduced taxation by economic category rather than class and guaranteed right to trial by Jury. Finally all these were codified into a comprehensive body of Law.
How are Solon’s ideas different from that of Law? Solon believed that the only compromise of democratic politics can durably decide what is fair. The basis of the compromise was the fundamental equality of the individual. By its nature money permits social mobility and accumulation wealth and power. Any fixed standard will become obsolete. So the state must always ensure that the architecture of financial obligations must reflect fairness. Only democratic politics can furnish such an evolving standard. And only Law – its debate, codification and rules- can enact it.
Despite the presence of this enlightened view in early Greece, the conventional view has gained ascendance across the globe. Let us review the conventional understanding in some detail.

Chapter 12
In the aftermath of Lehman crisis of 2007. Lawrence Summers was asked his view on why the crisis happened and why the economists could not anticipate the same and take corrective action. He told that the vast edifice of economics built during post war years was virtually useless. However, the contributions of Walter Bagehot, Hyman Minsky and Charles Kindleberger, helped the authorities in designing an appropriate response to the crisis. And once crisis was handled and the system stabilized, the lessons learned from another great economist, Keynes, helped to kick-start the economy.
So who was Walter Bagehot? What were his contributions that helped tide over the economic crisis of 2007?
At the beginning of 19th Century, Overend, Gurney and  Co (OGC) was one of the leading bill brokering houses in England.
The original business of company was pure broking. Merchants will bring their bills to OGC. OGC will satisfy themselves with the credit potential of the merchant. Once satisfied, they will deposit the bills with a London Bank in exchange of money, which they will transfer to the merchant. OGC will collect small commission from either parties to handle this exchange. OGC was playing the role of a broker.
Over a period of time, banks started parking their excess funds with OGC. From being a broker, now OGC had become a dealer.
Soon the company went international and at one point in time was the largest Financial Services company in the world turning in a profit of 200000 pounds over a turnover of 170 Million Pounds. The name of OGC had become synonymous with England’s credit economy.
In 1836 and 1857, England faced credit crises due to overheated economy. The 1857 crisis brought a significant regulatory change that had significant impact on OGC.
Since 1825, the broking houses had enjoyed access to loans from BoE in times of crisis. On analyzing the crisis of 1857, one of the reasons identified was a tendency to rashness among the bill brokers. It was also found that lion’s share of Bank’s emergency lending was going to Brokers rather than other banks. It was felt that emergency funding was encouraging speculation. So in 1858, BoE ended bill broker’s access to BoE lending.
The above development, instead of discouraging riskier investments had the opposite effect on OGC. The firm’s portfolio was filled with speculative, long-term and high risk investments (called ‘Junk Bonds’ in modern finance parlance). In addition, the second generation of OGC started delegating much of the oversight job to professional managers.
The combination of above proved disastrous. The annual profit of 200000 turned to a loss of 500000. The new managers attempted to regain profitability by taking riskier, long-term bets funded by short term deposits from banks (asset liability mismatch)
By 1865 the situation had become desperate. New capital was required. OGC went in for an IPO and off loaded their problems on the public. Late in the year Bank rate was raised to 8%. There was anxiety and despondency everywhere.
In early 1866 an unrelated brokerage firm of ‘Overend and Watson’ went into  default. The illiterate public assumed relationship and started withdrawing their deposits. In two months 2.5 Million worth of deposits moved out of OGC.
On 9th May, the company made an appeal to BoE for emergency support. This was immediately turned down and in the afternoon of 9th of May the company suspended payments.
The economy tanked. There were runs on all the banks in the country. Only BoE was available to honor the bills which they did at hefty interest of 9%. To tide over the crisis, the bank resorted to printing new currency.
While the crisis was handled over a period of time, it took almost three years for the economy to rebound.
The questions were: How did this crisis happen? What were the causative factors? How could it have been prevented? What are the lessons for the future?
These were the question analyzed by Walter Bagehot, the then editor of the journal Economist. He published a book in 1873, titled ‘Lombard Street, or, a description of the money market’.
The two distinguishing features of this small book were as follows. One, it started explicitly from money, banking and finance, which he saw as the governing technology of modern economic system. The second was his insistence that the theory should be constructed to fit the reality of the monetary economy rather than the other way round.
The first finding of the book was that the money was not gold and silver (commodity medium of exchange), but it is transferable credit. Fundamentally different factors explain the demand for transferable credit as against the commodity. Meeting the demands of commodities can be easily done by ensuring a sufficient supply of the metal. But TC is different. In addition to volume, its demand also depends on the creditworthiness of the issuer and on the liquidity of the liability. Both these are determined by the level of trust on the economic system. As per him, credit is an opinion generated by circumstances and one needs an insight into its history, politics and psychology of the economy. None of these can be learned though mathematical formula.
This change in understanding called for alternate policies to handle crisis and recession. The first step was to understand that the obligations of sovereign are more creditworthy than the rest. Since BoE controlled all the banks and they in turn controlled the brokers, the central bank had become the ‘Lender of the last resort’.
While central bank was essential element in the modern monetary system, it did not have a properly articulated monetary policy. The first prescription made by Bagehot was that Central Banks role as a ‘lender of last resort should be made a statutory responsibility. As per Bagehot, ‘In times of panic, the Bank must advance freely and vigorously to the public out of its reserve’.
The second rule proposed by Bagehot was that in its roles as lender of last resort, the bank should not try to make nice distinctions between who is insolvent and who is illiquid. It should lend on all banking securities and as largely as public asked. The goal was to ward off alarm. The way to cause alarm is to refuse someone who has good security to offer.
But if public knows that there is a lender of last resort, wont it cause excessive speculation? To handle this Bagehot recommended that the emergency lending should be made at a high rate of interest.
Bagehot’s idea did not get much traction since the classical view of money was very entrenched. Chapter 13 addresses these in detail.

Chapter 13
Classical economists considered money as a commodity. Private credit instruments were just substitutes for money and had value only if gold or silver was available to redeem them.
There are three major differences between the classical economists and Bagehot.
First is on the use of monetary policy in crisis. Classical economists believed that since3 money is a commodity, the BoE’s role is limited. BoE should protect its assets and raise lending rate. As per Bagehot, since trust and confidence are low in a crisis, Central Bank had a unique ability to restore confidence by playing the role of lender of last resort.
Second difference is on the cause of and ways to handle recession. As per classical economists, recession is caused due to lack of supply which in turn cause lack of demand. The way to handle recession is by producing more and increasing supply, the so called ‘supply side economics’. As per Bagehot, recession was caused by lack of money. When economy fell into recession, the demand for money, unlike that of commodities, increases. So the correct way to handle a recession is by increasing money supply.
The third difference between Classical Economists and Bagehot related to the role of Money. As per classical view, money is just a medium of exchange facilitating the exchange of commodities. The economic value belong to the commodities being transferred and hence money can simply be ignored in this analysis
As per Keynes, realistic view of money should consider both fiscal and monetary policies. In the real world there is no guarantee that supply will equal demand since people can and do hoard money. Proactive policy to boost demand is by ensuring that sufficient sovereign money is available to meet the demand during the crisis. In addition, if private sector is unable to spend, government should us its money to kick-start economy. Keynes ideas seemed to have caught on in the aftermath of 2nd world war.
From the ‘moneyless’ view of classical school evolved the modern orthodox economics. By focusing on the production and consumption, economics ignored money altogether. From the practitioners of Bagehot school, evolved the discipline of finance – a framework for understanding money, banks and finance.
There you have it!!. The reason for the crash of 2008. There was no integrating framework between economics and finance. Those who knew economics did not understand finance and those who knew finance did not understand economy.

Chapter 14
In the year 2007, the world faced a major economic crisis. Northern Rock (NR) is a leading bank in the UK. The business of the bank is to provide long-term mortgage loans. The deposits of the bank consisted of short term CASA deposits. Assets (long term mortgage loans) were backed by Short term liabilities.
This was a classic ‘Asset Liability mismatch’.
At the first whiff of an impending crisis, depositors started withdrawing their deposits. This created a liquidity crisis for NR. The bank approached BoE for liquidity support.
Central Bank providing liquidity support to banks at time of crisis was a practice followed by the central bank ever since Bagehot recommended the approach. BoE agreed to provide liquidity support to NR. However, the crisis did not end there.
In case of a bank, the assets are the loans that it makes and the liability is its deposits. In normal scenario, value of Assets should be higher than that of liabilities, the difference being the equity capital of the bank.
In the case of NR, it was found that many of the loans that it had made were defaulted and the bank was in a situation where the value of assets were less than the liabilities. The equity capital had completely eroded.
NR was  in the verge of bankruptcy unless government intervened. This was a novel situation without any precedent.  While central bank providing liquidity support to handle the liquidity risk was normal response, this was different. No one knew how to handle credit risk.
The best option would have been to let NR fail due to its mismanagement. However, government was worried about the wider impact of allowing the bank to go bankrupt. So after a lot of thought, the government decided to nationalize Northern Rock.
While the general public did not understand the full significance of this move, the smart money was quick to realize the magnitude of the problem. In one shot, by nationalizing a bank,  the tax payer was owning the cost of mismanagement leaving the employees, the bond holder and the shareholder off the hook.
This was a recipe for disaster. World learned some lessons from this move of the British Government. So when Bear Sterns faced similar issue in the US, government did not intervene. It was left to another private bank, J P Morgan, to buy out Bear Sterns.
Almost immediately the US Government faced the next crisis. Lehman brothers also faced the same issue as was faced by NR and Bear Sterns. The US Government did not intervene and allowed Lehman Brothers to declare Bankruptcy.
The crisis did not end there. One by one, major banks and other financial intermediaries started approaching the Government for bailout. Soon world saw an embarrassing spectacle of US Government providing credit (equity) support for some huge banks and insurance companies (AIG).
Similar drama was getting played out in other countries as well. Almost 17 countries in the world spend close to 14 Trillion to prop up the loss making banks.
From being a ‘Lender of last resort’, the Central Bank was morphing to ‘Loss bearer of the last resort’. The impact of this was predictable. Around the world banks have grown in size, reduced their capital buffer, made riskier loans and decreased the liquidity of their assets. Tax payer end up bearing 100% of the downside while the bond holder and employees get the 100% benefit of any upside.
In earlier times, tax payers used to be the same as bond holder of banks and hence the idea of bailing out the banks would not have been contentions. However,  in modern times, two factors undermined the relationship between tax payer and bond holder. One was the class divide between wealthy bond holders(who were a minority) and others who were majority. Second was the internationalization of high finance. The tax payers  of one country were footing the bill of bank recapitalization that was benefiting foreign bond holders.
If taxpayer having to bear the credit risk of banks were bad enough, worst was yet to come. The period from 1980s had seen technology significantly impacting the market for debt. Initially debt was an agreement between a bank and the borrower.  The loan remained on the books of the bank as an asset and on the borrower’s books as a liability. However, the decade starting 80s saw the debt markets exploding in the US. Corporates were bypassing banks and issuing debt instruments directly to investors.
The years following the 90s saw technology supported financial intermediation. The nature of debt markets started undergoing significant changes. The debt instruments started moving from the Originator through various intermediaries, changing form at each intermediary, till it reached the final owner, a money market mutual fund (MMF).
For example, let us say that a bank issuing a loan. Traditionally, this loan would reside in the books of the bank. In the new paradigm, the bank immediately sold off the loan to a financial intermediary. The loan no longer existed in the books of the bank. The intermediary will package different loans  from different issuers (Securitization), create an asset backed security (called, Collateralized Debt Obligation, CDO) and sell it to a money market mutual fund (MMF).
The end investor will buy units of the MMF. Now the money will start its reverse journey, finally reaching the bank, with intermediaries taking their commissions.
The biggest problem was that in the entire cycle, somewhere the liquidity risk became hazy. On the one hand there was  a long-term , illiquid asset, the original loan created by the bank. At the other end of the cycle was the MMF promising short term cash withdrawals. Strip off the intermediaries, this was a classic ‘Asset Liability Mismatch’,  with its attendant liquidity risk and the inevitable credit risk.
Except, there was one catch...
None of the above risks were in the formal banking system. The moment it sold the loan to an intermediary, the loan had miraculously disappeared from the Banking System. When the crisis stuck, government was faced with the choice of bailing out the ‘Shadow Banking System’. In the 6 weeks between 10 September and 22 October 2008, the balance sheet of US Fed doubled and that of the BoE more than tripled.
The next chapter discusses the sovereign’s response to the crisis and the role of the regulators.

Chapter 15
Since the Grand Monetary Settlement between ‘Money Interest’ and Sovereign tilted in favour of the former leading to its misuse and the crisis of 2007, regulatory reforms (known as Basel Reforms) have been taking shape in the Bank for International Settlements (www.bis.org), based at Basel, Switzerland.
The first reform initiated by BIS was a directive requiring the banks to hold more capital and more liquid assets in their portfolio (Capital Adequacy Norms). This acts as a tax on the banks, thus discouraging excessive lending.
(Note: It is not clear how this will work since, as we saw in the previous chapter, none of the loans were in the books of the bank)
However, experts are skeptical of the efficacy of the regulatory norms. Reasons vary. First is the scale of the problem. The potential social costs of operating the monetary system as it is currently configured is simply too large to be discouraged through the system. The social costs include cost of lost GDP, of mass unemployment, and of lost capacity. It is impossible to recover these costs from the defaulting banks.
Second reason why taxation would work is the networked nature of banking system. While the banking system is international in nature, the legal jurisdiction is still national. Even if taxes have to be levied as per the rules, there is no multi-national political authority that can enforce the norms.
Third reason for the skepticism on the ability of the regulatory system to control excesses is the innovative nature of the emergent financial system that can easily circumvent the regulations.  Actually the conventional regulations proved counter-productive in the aftermath of the 2008 crisis. Forcing banks to raise the capital ratios reduced the availability of capital at the precise time that it was needed.
Here it is worth pointing out that regulations put in place around the great depression of 1929, including the Glass-Steagall act and the McFadden act went a long way in ensuring long term stability of banking system in the US. It was the relaxation of these controls in the 90s that led to the excesses that created crisis of 2007-08.
The question is, if the tax regulations are ineffective, what are the alternatives?
The Volker committee in the US and the committee headed by John Vickers in the UK, both of which were set up to look in the financial sector reform in the aftermath of 2008 crisis, recommended the segregation of the retail (deposits and payments) and wholesale (market based) activities of the banks. However, these reforms have not brought about desirable level of Financial Stability.
Why?
As per the author, the ‘Social Technology’ perspective of money could provide some answers.
Money issued by Sovereign will work since Sovereign has the political authority. Private money will become prominent only when sovereign loses confidence of its citizens. A critical prerequisite for sustainability of monetary society (Financial Stability) is a safety valve of a variable monetary standard. So long as citizens permit the sovereign a discretionary power to re-calibrate the financial distribution of risks by adjusting the standards when it becomes unfair, Sovereign money can work.
The problem is that in the modern world, all the money in circulation is issued by the Sovereign. Banks also issue money. So how do banks promise to deliver both stability and freedom that is the promise of money? As per theory, this is done by ‘Liquidity Transformation’, by transforming liquid, short-term deposits into illiquid, long-term loans. Note that no actual transformation takes place. The assets still remain illiquid and long –term and liabilities still remain liquid and short-term. The mirage of transformation is achieved through synchronization of payments in and out of the balance sheet of the bank.
When things are going fine, this will work. But as soon as crisis of confidences hits the system, banks cannot handle the increase in withdrawals since the carefully constructed balance of cash flow is no longer applicable. That is the reason why banks need Sovereign backing and authority, which the Great Monetary Settlement was to have provided.
Global banking’s current structure generates an unjust distribution of risks. The losses are socialized – tax payer funded bailouts cover the losses – while gains are reaped by banks and their investors.
Two options are suggested to handle the skewed risk-reward ratio mentioned above. First would be to privatize all the risks – restructure the system so that investors bear all the costs and reap all the rewards.
Problem with the above approach is that the conversion of debt to equity would leave economy totally at the mercy of market forces, leaving sovereign unable to intervene in times of crisis. Money would no longer be a tool of government.
Second option would be to redesign the financial system to socialize the risk and rewards. What UK did with Northern Rock (Bank Nationalization) is the template for this approach.  The problem with this approach is that instead of becoming a tool of the government, money would become the government. All benefits of decentralized decision making in finance would be gone.
It should be noted that the first option was similar to what John Law did in France. This was the spirit of the recommendation of both Volker and Vickers. US Economist Robert Schiller has long advocated the issuance of bonds that pay interest linked to GDP. This is another approach where investors bear the risk as well as the reward.
The traditional view of money provides three principles for the reform of banking system.
First, design policies that will shift more of the risks and costs to the investors.
Second, since money is a tool for organizing the society and only authority with the political legitimacy is the sovereign, any redesign must maximize room for monetary policy. Monetary tools should have the escape vale of flexible monetary standard.
Finally, set as few rules as possible to supervise the financial sector and police them rigorously. This can be done by restricting sovereign’s support for a limited range of banking activities.
As per the proposal by American Economist Irwing Fisher, any deposit that could be withdrawn or used to make payment on demand must be backed by Sovereign money, and banks which offer such deposits will be permitted do no other business. This is the concept of ‘Payment Bank’. Any other activity by the bank will neither enjoy sovereign support nor suffer sovereign supervision.
There are two advantages to the suggestions made by Fisher. One, the financial risk will be circumscribed. A clear distinction between ‘narrow banking’ and other banking activities will eliminate moral hazard from the system. Second, this will also preserve monetary policy and money’s integration with the society. The rules for narrow banks would be few but draconian.
Most of the issues in the current century are due to incorrect configuration of money and banking. And the same, correctly configured will take us out of the morass and make the world great again.