HISTORY LESSONS: Ferguson shares his views on the global financial crisis with an attentive crowd at the Harvard Book Store in Cambridge.

Photo by Keri D. Mabry/Harvard Crimson

Professor Niall Ferguson, born in Glasgow and educated at Oxford and Cambridge universities, argues in this Q&A that the current global economic crisis developed largely as a result of widespread ignorance of financial history.

When you began working on this book, did you see a global financial crisis coming?

When I began in 2006, I was certain that a major liquidity crisis was imminent and that when it struck, most people would be completely baffled. So the point of the book was to explain where this extraordinary system came from and to explain it component by component so that readers could understand the financial system as the product of history, and as one of the key factors in history.

The events of recent months proved your hunch was right.

I certainly anticipated something very large because the parallels are not just with the Great Depression but with the financial crisis of 1914, which in many ways was more spectacular. So, this was a case of history informing judgments about the future. And I have to say, history provided a better guide than certain other disciplines that are sometimes regarded as more rigorous, like economics, for example.

Economists with their more mathematical approach to social science conspicuously failed to anticipate this crisis, whereas a sense of history made it clear that we were vulnerable to a liquidity shock because of the extent of leverage, of debt that had emerged in the system.

So the lack of knowledge about financial history, in your view, contributed to the current global financial crisis?

I really believe that. It’s very striking that the majority of people, whether investors, households, or masters of the universe on Wall Street, rely on their own personal experience when forming judgments about the financial future. That means the average chief executive of an investment bank was working on data going back no further than, say, 1980, which was just completely insufficient to prepare for what was coming. My view is that you need at least 100 years of data to have a sense of the potential risks that globalization runs.

Do business schools teach enough financial history?

My impression of the major business schools in the United States is that there is not sufficient emphasis on financial history or indeed any kind of history. Finance is often taught as a branch of mathematics in a rather technical way without adequate reference to past experience. I think HBS is actually in the best position here because the case method is essentially a historical approach. And so, a lot of what is taught by our finance faculty — I’m thinking here of André Perold’s work — is in fact historically focused. His cases on Long-Term Capital Management are the best things written on that subject.

But elsewhere, I think the emphasis is much more on quantitative techniques. This is something we really need to reexamine because so many of the problems that we’ve seen in this crisis can be traced back to the application of mathematical models in an inappropriate way to financial risk management.

Do you expect that mathematical modeling will fall into disfavor for a while?

That whole approach to investment has a huge question mark over it now. And I’m not the only person who thinks that. Nassim Nicholas Taleb’s book The Black Swan has been a bestseller and deservedly so. From a very different disci-plinary background as a former trader and statistician, he saw flaws in the quantitative approach. There are many admirable things about the way in which finance became more statistically sophisticated over the past twenty or thirty years. But many of the assumptions on which the more elaborate mathematical models are based turn out not to be real-world assumptions. The obvious case is that many models assume constant liquidity. And, of course, that’s an assumption no historian would make.

Why didn’t the collapse of Long-Term Capital Management in 1998 ring any alarm bells for this type of investment approach?

What’s extraordinary is that the approach, instead of being discredited by what happened to LTCM in 1998, went on to be replicated by a 100 or even a 1,000 different hedge funds. And so we actually have a 1,000 LTCMs out there right now at death’s door. It’s a curious case of nothing quite succeeding like failure.

Have governments been too eager to throw money at the current financial crisis in hopes of solving it?

I draw a parallel between the natural world and the financial world in the concluding part of the book and sketch out a rough evolutionary theory of finance. And the bottom line is there has to be natural selection. Not everybody can be too big to fail. The distinction that needs to be made here is between systemic risk and a kind of arbitrary bailout scheme. Systemic risk we know from the Great Depression is very great if there are mass bank failures. If you lose thousands of banks, your monetary system implodes. That’s exactly what happened in the early 1930s. The Fed today has acted rightly in trying to avoid an implosion by injecting trillions of dollars of liquidity into the financial system.

But there’s a distinction between that and handing money out indiscriminately or arbitrarily to any company that says it’s in trouble. Here, of course, I’m thinking of the Big Three automobile manufacturers. They, of course, are only the first of many companies that will line up in Washington saying, “We need a bailout because otherwise we’re going to have to lay off our workforce, and you don’t want that, do you?” This is not a systemic risk.

The reality is that these companies are inefficient producers that have consistently lost out to foreign-owned competition. They’ve had years to get their house in order and they failed. And what we now need to do is to manage their liquidation. I would say we’re likely to end up not with a Big Three but with a Big One in a year or two because there’s obviously excess capacity, and it’s hard to see how all three automakers can survive.

I think it’s right to avoid a complete shutdown and mass layoffs right now. But the kind of money that’s being offered is only going to buy a month or two more of survival. The question here is how do you merge these companies into one? How do you salvage what is worth salvaging rather than propping up dinosaurs on life support? And dinosaurs on life support is really the image that I keep coming back to. It’s not healthy for the long-term development of an economy to channel taxpayers’ money into companies that are clearly not viable over the medium term.

So the Washington bailout won’t ensure the automakers’ future?

No, it will be a very, very brief stay of execution. I think we’re really engaged in a kind of hospice-like arrangement here where we try to ease the pain of the death of at least one, possibly two, of these companies. That’s wise because it would be a tremendous shock to confidence if unemployment was to suddenly leap up by a million or more. But the long-term future of Detroit must be a significant scaling down, because these companies clearly are incapable of competing with Japanese-owned companies that are simply producing better cars at lower cost.

Won’t we continue to have a U.S. auto industry? It’s just that the manufacturers will produce Toyotas and Hondas?

Welcome to being Britain. We had an extremely inefficient automobile sector, and we tried to prop it up through the 1970s with tons of money. In the end, it failed, and what’s left of car manufacturing in Britain is almost entirely foreign-owned.

— Roger Thompson

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