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Chapter II
Through Wars and Depressions: The Story of Bonds
Part I: Italian Wars and the birth of Bonds
For a large part of the 14th and 15th Centuries, the various cities of medieval Italy: - Florence,
Pisa, Sienna, Venice, and others were at each other’s' neck. War requires resources: soldiers,
food supplies, equipment, which are a pretty costly affair and could wreak havoc on the
country's finances if a war stretches. One characteristic of this war is that it was fought on
behalf of these city-states by war contractors’ condottieri (and not by citizens
themselves) to loot wealth and lands.
Financing a war can be difficult; there is a limit to which the government can levy a tax on the
people to pay for the war. However, the city of Florence came up with an idea that was going
to change the world. So how did Florentines raise money? The answer is - From themselves.
Thus, the foundation of what we call 'bonds' was placed. The citizens were urged and
sometimes forced to purchase bonds, and in return, they were promised a fixed return
percentage every year, and the principal amount was to be paid after specified maturity date.
One defining feature of these schemes was that that the citizens could also buy and purchase
these bonds among themselves, thus making bonds highly liquid assets and attractive
investment instruments. In a way, Florentines became the government's biggest investor.
Sovereign debt, which stood at 50,000 Florins at the start of the 14th Century, exploded to
about 5 million florins by the end of 1427. Hence this debt was called Mounte Commune,
which translates into Mountain of Debt. Because of this revolutionary scheme, Florence
flourished in sciences, art, culture, architecture. These funds allowed the government to invest
in creative pursuits and saved its citizens from the bloodshed. These were the times of
Michelangelo, Botticelli, Da Vinci, etc., the anchors of the Italian Renaissance.
However, by the end of the 15th Century, a series of plagues decline in fertility rates, and failed
conquests severely affected the government to pay back the obligations. The government cut
interest rates. The prices of the bond fell sharply, and the confidence was severely hit. Bonds
turned into illiquid assets. The debt capital, which was diverted from production to as
consumption i.e., Churches, Castles, and Mausoleums, remained; however, the prosperity and
status of Florence was lost. For many good years of the 16th Century, Florence tumbled into a
deep depression. The engine of Florence's development Mount Commune had collapsed into
itself.
Part II - War of bonds: Confederate States of America Vs United States
of America
Even before Abraham Lincoln took over the presidency (USA), seven southern states had
seceded from the Union to form the Confederate States of America (CSA). For those who are
unaware of American history, the American Civil War was fought between Union and
Confederate over the abolition of Slavery.
To fund the war, both sides resorted to all means necessary viz. increased taxation, borrowing,
printing money. Initially, the newly formed confederates lacked hard currency; so instead of
money, they took payments in the form of agriculture produce cotton, tobacco, etc. The interest
payment on these bonds was done through levying taxes on exports of cotton to Europe.
While the northern states (USA) were able to maintain their agriculture and industrial
productivity, southern states hobbled. Confederates floated first offshore bonds in Europe
where the bonds were greeted with scepticism. Confederates thus decided to back these bonds
with the supply of cotton to repose investors' confidence. Cotton was a highly demanded
commodity in Europe. Most of the cotton trade used to happen from the port of New Orleans
which was captured by the USA in June 1862. Losing a major trade route, CSA could no longer
float these cotton-backed bonds in Europe.
Both countries were also printing money, however, facing serious crunch of funds CSA started
doing it disproportionately. Printing money resulted in uncontrollable inflation, the biggest
enemy of the bonds. Inflation was the death knell on the dreams of CSA, now there were no
takers for the bond, and the Confederates' ability to raise money was severely impaired. This
finally, along with other factors, led to the defeat of Confederates and the nationwide abolition
of slavery.
Part III: Defeat of Great Depression: Bonds to the rescue
In the mid-1920s, the Fed (Federal Reserve) kept interest rates artificially low at 2% to boost
economic output, which sent inflation flying to as high as 10%. In low interest and high
inflation regime borrowing to invest makes more sense. People were forced to buy assets and
expand to keep up with the competition. The invention of Radio and broadcast media,
aeroplanes, rapid industrialisation (worthy to note that Ford’s T-Model concept also happened
during this time). Economy was zooming. Most likely to manage the inflation, the US Fed
suddenly decided to raise interest rates in 1929; people found themselves unable to pay
mortgages. Assets put up for sale found no buyers. Banks collapsed and money supply in the
economy reduced by almost 30%. The economy went into a deflationary spiral. Insiders who
knew about Fed's move converted their holdings to cash while everyone else suffered.
In 1932 central government intervened and purchased bonds worth $1 billion across four
months to supply liquidity in the economy and to expand bank credit. This step helped to revive
to declining US Economy.
Glass-Steagall Act was introduced which forced Banks to separate their commercial banking
operation from Investment banking operations. The same act is responsible for the Break-up of
banks like JP Morgan, forcing it to spin-off its commercial banking operation as Morgan
Stanley. The popular FDIC (Federal deposit Insurance Scheme) which was emulated all over
the world guaranteeing Deposit Insurance in case of Bank-Run was implemented. In a way this
crisis was responsible to develop modern finance and banking principles. Wouldn’t come as
wonder to note that Keynes’s breakthrough text General theory of Employment, Interest and
Money was published in 1935 after the depression. The book stresses on government
intervention rather than having a Laissez-faire approach.
Part IV: World War and Marketing of bonds
The pictures and video speak for themselves, nothing more to be said!
https://www.youtube.com/watch?v=92hJjW5n6ZQ&feature=emb_logo
Part V: The bust of 2008
The start of the millennia was an unusual time. US had just recently gone through a dastardly
terrorist attack. Dotcom bubble had just burst; there were a couple of accounting scandals. The
economy was going through a mild recession. To keep the recession at bay US Federal Reserve
cut bank rate 11 times from 6.5% to 1.75% between May 2001 and December 2001. This step
flooded the economy with cheap money. Everybody's dream of owning a home can now be a
reality. Housing prices were practically rising, like anything. Seizing the opportunity
Investment bank packaged all the debt (student loans, car loans, home loans, credit card loans,
etc.) and sold them to investors. Investors believed that home prices are going to rise
perpetually, and their investment is safe. Mortgages backed these bonds hence also called
Mortgage-backed securities (MBS).
Since the lenders had no incentives to check the creditworthiness of the homeowners, they
started lending money to borrowers who had no income, no assets, and no jobs. Such loans
were called sub-prime mortgages. With the saturation of the housing market and Fed hiking its
rates again in 2005, homeowners could no longer afford to pay mortgages, and housing prices
crashed. Bond prices crashed. Many big lenders and those having positions on Mortgage-
backed securities were facing bankruptcy by the end of 2007. The contagion spread throughout
the US and world.US government created a corpus of $700 billion to purchase distressed assets,
especially the MBS. Each government came up with its bailout packages. Some governments
nationalized the debt and provided a sovereign guarantee. Insiders who knew about the
impending crisis sold their position at highs, some purchased Credit Default Swaps (Instrument
to bet against bond prices). These people earned sweet profits from the crisis while the whole
world suffered.
Bonds are one of the most significant financial innovations of all time, enabling the allocation
of wealth for even more productive use. It is intrinsically a simple instrument; you get interest
on the money you lend, that's it. However, changing environment, human greed, and jargon
makes them complicated. The story of bonds from Italian wars to financial crises sums up
major characteristics of bonds and how various factors influence them. In our daily life, we are
fascinated by the stock market, but it would be surprising to note that the value of bonds is
much higher as compared to the stocks. So next time, if you come across the word treasury,
bonds, debt, interest rate, inflation, or central bank, I am hopeful that you'll remember this
article.
The article is written only for informative purposes. The
author does not claim to have the historical facts right and
may have chosen to select the information which appeals to
the context. The inference drawn from the information is
entirely personal.