Sample Chapter


From Florence to Houston

After the collapse of Long-Term Capital Management (LTCM) in 1998, Gary Weiss wrote, "Slap a Limit on Leverage – Now," in Business Week. "What is really to blame here," he wrote, "is the excessive use of leverage, especially when investing in derivatives and currency. Whether such leverage be employed by a hedge fund or trading desks at a bank or securities firm, it is currently almost entirely unregulated."

In 2009, Weiss dusted off that column and quoted it at length in the widely-followed blog "Seeking Alpha," with the suggestion that leverage was again the culprit in the much broader crisis of 2007-08.

Weiss uses this contention to ward off culpability for the financial press. He writes, "Sure, the media didn't do a particularly good job of writing about the conditions that led to the financial crisis, such as out-of-control leverage. But even if we did, no one paid attention or cared."

I admire Weiss – he has a lot of value to say – but on this point he is indulging in a common error. Leverage (which simply means 'debt') is no more problematic in itself than is speculation. Nor are the two problematic in combination. I hope to convey to the reader my own confidence that speculation is no vice, that borrowing is no vice, and that gambling with borrowed chips shares the innocence of each of its components.

In the west, the mutually implicated practices of borrowing and lending money – of paying and of receiving interest for that money – had a good deal to do with setting off the two tumults that created the modern world – the Renaissance and the Reformation. I will discuss those tumults now, with malice aforethought – with the goal of prejudicing you in favor of their catalyst. In due course, this history lesson will lead to an understanding of why debt, and the payment of interest, are such dynamic, calalytic, and ineradicable institutions: of why they are on the side of the angels.

Theology, Damnation and Evasion

In the high middle ages, among the learned of Christendom, there was no doubt but that lending out money for a contracted return was a sin, and that this sin, usury, was of an especially dire variety. It was a sin against nature, kin to sodomy. Dante put sodomites and usurers in the same circle of hell – the one group for making fruitful that which ought to be sterile, the other for making sterile that which out to be fruitful.

Thomas Aquinas, in his Summa Theologica, written circa 1270, had expressed more prosaically the view that money ought to be sterile. He wrote: "It is by its very nature unlawful to take payment for the use of money lent, which payment is known as usury: and just as man is bound to restore ill-gotten gains, so is he bound to restore the money which he has taken in usury."

Aquinas' language makes it very clear that the sin is not a matter of over-charging. He is not concerned with finding a demarcation line between legitimate bondholders on the one hand a "sharks" on the other. No – any payment is over-payment – all interest is usury, because "payment for the use of money lent" is itself the sin.

Are the borrower and the lender both sinning, or only the latter? (The transaction requires two, after all.) Oddly, Aquinas tells us that sometimes it is lawful to borrow from a usurer. There are two conditions for this: justifiable borrowing must involve getting the money "from a man who is ready to do so and is a usurer by profession," i.e. one must not tempt into usury someone who would not otherwise indulge in that vice. Secondly, the borrower must "have a good end in view, such as the relief of his own or another's need."

Consider the case, then, of a gambler who gets a loan from a bank and then spends the money at a casino. Does his action deserve condemnation given Aquinas' reasoning? Insofar as he cadged the money from a banker, someone in this infernal business anyway, he satisfies the first condition. Might the second not also be satisfied? How sympathetic a story would one have to tell about the life of the croupier whom he keeps gainfully employed in this way, in order to satisfy the second condition?

Other perplexities soon arose as the Thomistic doctrine was interpreted and applied in the subsequent centuries. There was, for example, the question of public finance. Could not a prince rightly borrow money to finance a war? If we suppose the war itself a just one, must we not also suppose that a contract to pay interest on bonds in order to make it possible for the prince to wage this war is also just?

Canon law went through stages here, but eventually arrived at the conclusion that neither the borrower nor the lender was doing anything sinful when a legitimate government borrows money and agrees to pay back more than it took.

More broadly, canon lawyers came to recognize poena detentori as a virtuous payment. This was a punishment or fine for a late return of the principal. If William lends $1,000 to James on Saturday, on the promise that James will give it back by Tuesday, but on the further condition that if James fails to give it back on time then as of Wednesday James owes William $1,100, that extra $100 is a lawful charge for an injury.

This proved an important exception, because as soon as the lender doesn't really expect payment before Wednesday anyway, the purported distinction disappears. Consider 21st century credit card late fees.


Still other distinctions and exceptions developed, but we need not chronicle them here. Let us place ourselves instead in the city of Florence in 1491. Florence was a republic in form, the principality of Lorenzo de Medici in matter. In Lent of 1491 a Dominican monk, Girolamo Savonarola, employed the pulpit of the Duomo to attack the rottenness of the Medici fortune and the family's public stewardship. In the course of this assault he condemned his parishioners also, telling them: "No one can persuade you that usury is sinful, you defend it at the peril of your souls."

There was no room in Savonarola's mind for subtle distinctions and exceptions. His view was Dante's: to hell with bankers!

A movement was underway in other cities in Italy at this time that aimed at driving pawn brokers – the most-despised, most vulnerable, largely Jewish, low-margin end of the usury business – out of their livelihood, replacing them with a "compassionate mountain" ( Monte di Pietà) of the money collected from generous Christians and lent to the needy on terms that were not usurious. These Monti were established with the relevant city government's sponsorship, though usually without any claim on the public purse.

Though the Medici were on the high-end of the usury spectrum, Lorenzo believed that pawn brokers were useful folk to have around. He was certainly uninterested in driving them out of town, and during his lifetime no Monte di Pietà came to Florence. In 1492, though, Lorenzo died. Two years later, his family had to flee Florence, and Savonarola took over.

With Savonarola's support, a Monte opened in Florence in 1495. It was not a success. In the words of the eminent Renaissance scholar Richard A. Goldthwaite, it “lacked the financial stability to make much headway and limped along at a very modest level of activity.” As to its desired effect, Goldthwaite writes that “Jewish pawn banks remained in business alongside the Monte di Pietà, a testimony to their essential role in the urban economy as a credit institution serving the general population, as well as, undoubtedly, a source of revenue for the state.”

Intriguingly, a Medici was Pope at the time (1517) that the German analog to Savonarola, Martin Luther, nailed his theses against indulgences to the door of the Church at Wittenberg. Lorenzo's second son, Giovanni, had become Pope Leo X in 1513. Leo was absorbed by Europe's Big Picture, he spent his papacy making deals with the French King on the one hand and with the Greek Orthodox Church on the other, so he can perhaps not be faulted for failing to look north or to pay heed to details of the controversy over indulgences developing there.

The North of Europe

Luther, like Savonarola before him, despised usury, and understood it in a broad and deliberately unsubtle sense. If usurious practices "shall continue for another hundred years" he wrote, "Germany cannot possibly have a penny left and we shall certainly have to devour one another. The devil invented the practice and the Pope, by confirming it, has injured the whole world."

Yet history moves in unexpected ways. The Reformation that Luther begat created room for new thought, and this new thought came to include thoughts of which Luther disapproved. The rallying-cry of sola scriptura undermined the significance of the wriitngs of theologians such as Aquinas, who after all drew upon the work of pagans such as Aristotle. To the extent scholastic authority stood behind the rejection of interest-bearing contracts, the Reformers strengthened the forces of commerce and their ever-bolder obliviousness to canon law.

One of the directions that the Reformation took was a rejection of ostentatiousness. One should work hard in pursuit of one's calling and save up money earned thereby – and one should be very cautious about using any of that money. Certainly one should not use it to make one's life comfortable or surround one's self with objects of beauty. Should one spend it, then, on building up one's Church in its physical, architectural manifestation? Not at all, answers the puritan/pietistic element in Protestantism – for that amounts would amount to the worship of icons.

Thus, one is supposed to work hard, make money, and save it. What does "saving" mean in such a context? Inevitably, it cane to mean something more than putting it in a sack and keeping the sack in the ground (a practice rather specifically discouraged by one of Jesus' parables). Protestantism came, over time, to the idea that savings is investment. One good way to save money is to put it in the keeping of someone who has specific ideas for what to do with it: to lend it to this person at interest.

It was John Calvin who clearly extended the consequences of the break with Rome to a break with the condemnation of interest-bearing contracts. In a letter to a friend, Claude de Sachin, in 1545, Calvin looked at the passage in the New Testament most often cited as a condemntaion of usury, Luke 6:35, where Jesus is reported as saying: "But love ye your enemies, and do good, and lend, hoping for nothing again." (KJV).

Calvin understood this thus: "Christ wished to restrain men's abuse of lending, commands them to lend to those from whom there is no hope of receiving or regaining anything; and his words ought to be interpreted, that while he would command loans to the poor without expectation of repayment or the receipt of interest, he did not mean at the same time to forbid loans to the rich with interest, any more than the injunction to invite the poor to our feasts did not imply that the mutual invitation of friends to feasts is in consequence prohibited."

Also, the Old Testanment verses usually cited against usury were "political," Calvin says. They were the internal affair of the Kingdom of Israel. He is "certain that by no testimony of Scripture is usury wholy condemned." This was of course important, because if one's faith is to be determined by sola scriptura, rather than by the philosophical reasonings of an Aquinas, and if scripture does not condemn usury broadly, than faith provides no rejection thereof.

Yet Calvin in the same letter addresses the philosophical arguments, too. He quotes a common saying among the medieval theologians, "money does not beget money," and replies that a rented house does not "beget money" either! Yet one can charge money to those who live in one's house, and interest does not seem less natural than such a rent.

The letter also employs words of caution. Surely, Calvin did not say to money-lenders "full steam ahead!" He thought their activities required careful monitoring by Christian magistrates. Still, this discussion marks a shift in what lawyers might call the burden of proof in learned Europe's thinking about interest. No longer would those who wished to charge or to pay interest in the conduct of their business affairts have to find the right justification or exemption in canon or civil law. Hereafter, their critics would have to find the right argument against a particular practice.


For historical reasons I shall avoid, the people of the low countries converted to Calvinism in large numbers, and (not I think coincidentally) Holland entered its Golden Age as a center of commerce soon thereafter.
In 1602, the first "stock exchange" in the modern sense of that phrase opened for business. One could go to the Amsterdam Stock Exchange to buy shares in the Dutch East India Company, and thereafter share in that company's prosperity, or in its travails. One could even do so with borrowed money, after committing to pay one's lender interest.

Fittingly, perhaps, Holland also became the scene of that archetype of a financial boom-and-bust, the tulipmania of 1636-37. This wasn't even, or chiefly, an increase in the value of rare bulbs, sought by collectors. No, even the commonest variety of bulbs increased by many times and then collapsed in price to just one-twentieth of their peak. The price of tulip bulbs shot up one autumn to the amount of money necessary to buy and fully furnish a house, then utterly collapsed the following February. For centuries, this rise and fall has served as an object lesson. "See what happens when irrational speculation takes hold?"

A better take-away though, would be "see what happens when a money supply unexpectedly increases?" Money, at the time, meant the supply of precious metals. That supply dramatically increased as the Spanish Empire discovered extraordinary reserves of silver in Peru. This silver flowed out of Spain toward Amsterdam, given Amsterdam's prominance in pan-European commerce. Indeed, some of the 'Spanish' silver never even got to Spain. In 1628, for example, Admiral Piet Heyn captured a Spanish treasure fleet on the high seas and Holland received the booty – roughly 89 tons of silver.

This will not be the last time we'll notice a connection between 'quantitative easing' and an asset-price bubble. The increased availability of currency doesn't answer the question "why tulips," but it helps us understand why some asset's prices were bound to undergo such a parabolic development at that time. In the next chapter, we will provide a more formal definition of what a "bubble" is, and discuss the connection between asset bubbles and a broader inflationary spiral.

Seventeenth century Holland also understood arbitrage: the purchase of an asset in one market for immediate resale in another, in order to exploit a discrepancy in its value in the two markets. It arises at this point in our historical survey because when silver arrived in Holland (whether through the front door of trade or the back door of war and plunder hardly matters) it seldom tarried. Much of it was soon sent off to China. Silver was worth twice as much in gold, and so in anything gold could buy, in China than in Europe.

British Isles

We must not tarry either. The British isles are our next station. The period of the civil war between Stuart and Parliament brought to prominence a monarchist pamphleteer named Claudius Salmasius, who also gave a good deal of careful thought to economics. In writings between 1630 and 1645 he argued that there is no valid reason to prohibit usury, either from reason or from revelation. The lending of money is a business like any other, and it will earn a reward depending on the degree of competition, as is true for shoes or corn. Thus, Salmasius concluded: if you want a lower rate of usury, you should hope for a larger number of usurers.

That civil war also provided the backdrop for the creation of the Society of Friends, the Quakers established by George Fox in the 1640s. One of the foremost ideas of the Friends was, and remains, their "testimony of simplicity," that disdain for luxury or affectation that is important for our present (secular) purposes chiefly because it avoids expenses. It thereby allows money to accumulate – and that accumulated money, as we have noted above, looks for an outlet in trustworthy borrowers.

Sensibly, then, the Quakers had no aversion to banking. John Freame, a late 17th century Quaker, set up one of the early London banks. In 1695, the London Yearly Meeting of the Friends deposited one than 1,000 pounds with his firm, known as Freame & Gould. This was the operation that would later become known as Barclays, after Freame's eventual son-in-law, James Barclay.

The English were a bit behind the Dutch in adopting the ways of modern finance, but they were eager pupils. London merchants were exchanging shares of companies in coffee houses beginning in the late 1680s. Soon enough they had their own bubble (in the infamous "South Sea Co.) too.

What one must understand about the late 17th and early 18th centuries in the British isles is that there was no presumption yet that science and religion, or reason and revelation, are in conflict. Subsequent authors have harmed our understanding of the period considerably by trying to read that conflict back into it. Cotton Mather's response to Isaac Newton's writing will teach us better with concision. Mather wrote, "Gravity leads us to God and brings us very near to Him." So, for that matter, might the growing understanding of economics.

American Colonies

There were usury laws in England throughout the 17th and 18th centuries, and the colonies founded by that country on the western side of the North Atlantic inherited that institution. But no one in this time or place thought of characetrizing all interest payments as usury, nor were such laws written as a list of exceptions to the backdrop of a ban. No ... the usury laws at this time amount to the creation of an arbitrary ceiling: 'One may charge this much for allowing someone else to use your money, and no more.'

A complex array of attitudes about debt developed among the colonies. Ben Franklin spoke for many along the mid-Atlantic when he wrote to a "young tradesman" friend in 1748: "Remember, that time is money. He that can earn ten shillings a day by his labor, and goes abroad, or sits idle, one half of that day, though he spends but sixpence during his diversion or idleness, ought not to reckon that the only expense; he has really spent, or rather thrown away, five shillings besides.[...]Remember, that money is of the prolific, generating nature. Money can beget money, and its offspring can beget more, and so on. Five shillings turned is six, turned again is seven and threepence, and so on, till it becomes a hundred pounds. The more there is of it, the more it produces every turning, so that the profits rise quicker and quicker. He that kills a breeding sow, destroys all her offspring to the thousandth generation. He that murders a crown, destroys all that it might have produced, even scores of pounds."

Money is of the "prolific, generating nature," as is a breeding sow. That idea is a critical one. Also critical is the wording: Franklin stated this not as an analogy but as an identity.

By late colonial times attitudes toward indebtedness had become a feature of a widening cultural split between the governing elites of the northern and southern colonies. Among southern gentleman, status required the maintenance of a proper estate. This could be an enormously expensive enterprise, well beyond what the sale of the gentleman's cash crops could cover. Thus, the southern elites were always falling into debt and, amongst them, there was no stigma to indebtedness. They might have found themselves stigmatized, rather, had they cut corners to avoid it.

In the northern colonies, wealth didn't mean primarily land or the human chattel to work the land. The northern elite owned both land and slaves, but their conception of wealth involved something less tangible, words and numbers written on paper.

The United States

The new Constitution drafted in 1787 was in many respects frankly pro-creditor. With regard to the developing cultural division between north and south, the ratification of the Constitution was very much a victory for the evolving mercantile/financial elite of the north, against the landed elite of the south, as the latter fantasized about preserving something like the European feudalism they read about in their favorite novels, and the former looked to their ledgers.

Indeed, the framers of the Constitution debated a clause, proposed by George Mason of Virginia, that would have disqualified from federal office any individual who did not own land. James Madison (also of course of Virginia, but in some respects a northern mind) objected, explaining that "landed possessions" were no "certain evidence of real wealth" because there is a class of men who enjoy such possessions "who were more in debt than they were worth."

It is not our business to describe the U.S. constitution's confirmation, the westward movement of the country, or even the war that tested whether it would endure. Our business is, rather, with business: with the development of ideas about debt and the justification of interest payments thereon. One fascinating idea in this connection appeared in the post-bellum writings of Henry George, the land-value tax advocate.

A Frenchman, Frederic Bastiat, had earlier suggested that interest is not essentially tied in with currency. It is possible to charge interest in a barter economy. To illustrate, Bastiat asked his readers to consider two carpenters, James and William. James has built himself a plane, and has lent it to William for a year. Would James be satisfied with the return of the plane, even if in equally fine form, a year hence? Surely not! He'd expect a board along with it, as interest. Bastiat said that James had given William over that year "the power, inherent in the instrument, to increase the productivity of his labor." The board would serve as payment for that service.

Henry George did not accept this explanation. He wrote, "I am inclined to think that if all wealth consisted of such things as planes, and all production was such as that of carpenters -- that is to say, if wealth consisted but of the inert matter of the universe, and production of working up this inert matter into different shapes, that interest would be but the robbery of industry, and could not long exist." But some wealth is inherently fruitful, like that breeding sow that Franklin had mentioned in just this context, or like a vat of grape juice soon to ferment into wine. Planes and other sorts of inert matter (and the most lent item of all—- money itself) earn interest indirectly, by being part of the same "circle of exchange" with fruitful forms of wealth such as those, so that tying up these forms of wealth over time incurs an opportunity cost.

Indeed, after this much of history I submit we can set out a "theory of interest." First, interest is at its root a bribe for patience. How does the bribery work? There are two issues here: demand and supply. Why will James demand the board? on the one hand, and how is it that the Williams of the world are regularly in a position to supply one? on the other.

The answer to the question about demand is simply that human beings have lives of limited duration and during the course of those lives we age in something more than a purely nominal sense. Our bodies obey the second law of thermodynamics.

Thus, if you are a 20 year old with a chance at a professional athletic contract, it is a good idea (ceteris paribus) for you to take it now rather than next year. Nobody can predict with certainty the number of years during which your body will be able to play at a competitive level, but anyone can predict that there won't be an unlimited supply if them. So you prefer to get started. If someone wants you to wait a year, you will ask, "in return for what?".

Notice that that example isn't about consumption. It is about a particular employment relationship and one's suitability for it. Accordingly, it is about production, although what one is producing in this particular case is a spectacle rather than anything more tangible. The demand-side reason for time preference, whether it appears to either a consuming or producing capacity, is aging, with all that entails. Or, if you prefer, finitude.

The supply-side reason is as Franklin, George, and many others have suggested, the fact that life is creative. The metabolic processes of our fellow inhabitants of the globe -- animals, plants, and fermentation-generating bacteria – produce results that we value, so long as they have enough time in which to work toward those results. New boards become available because new trees grow to harvestable size. Life doesn't merely succumb to the second law of thermodynamics – it resists that law.

Living generates a demand for interest, because organisms decay, and it generates the ground for the supply of interest, because organisms resist decay. This pleasing symmetry gives us all the theoretical underpinning a theory of interest should require.


Nor, I submit, is there any rational basis for placing a limit on indebtedness. No planning authority can say, "this amount of leverage thou mayst incur, but not one penny more" without imposing all the inconveniences that arbitrary dictates are accustomed to impose upon productive activity.

We might bring our story into the late 20th and early 21st century, acknowledging that yes, the tales of LTCM in Greenwich, Connecticut and of Enron in Houston, Texas make good dramatic narratives of rise and fall. They seem to tell us hubris and its deserved punishment.

Worse even than learning no lessons from such events, though, is the danger of learning the wrong lessons. And the lesson that I quoted at the start of this chapter, Gary Weiss' appeal to "slap a limit on leverage," is precisely the wrong one.

A better lesson is that there are limits to the value of abstraction, that the monetary environment can allow some entities to outrun those limits, and that those that succumb to that temptation are asking for trouble.

What, after all, was Enron? In its beginnings it was a pipeline company. There's nothing abstract or esoteric about a pipeline: it's a chunk of metal manufactured into a useful cylinder. There's nothing abstract about a power plant, either, though a description would be a bit more complicated.

In Enron's glory days (1993 to 1999) it created an international presence, building power plants or laying pipelines around the world: India, the Philippines, Colombia....Enron was in the business of creating valuable physical assets. Matters of execution it could botch, but it was doing the right sort of thing. Further, it was engaged in what Austrian economists sometimes call "roundabout processes." It was creating stuff that would be used to create stuff that would be used to create still other stuff.

It was during this period that this idea of building physical things became a contentious issue within the company, for these were the years of the rise of Jeffrey Skilling. Skilling, a fervent believer in a gravity-defying "asset light" sort of corporation, in time muscled aside vice chairman Rebecca Mark and other enthusiasts of heavy assets.

Skilling evangelized that the old-line industrial giants were going to split into small pieces, and the new action was going to be in "intellectual capital." In other words, a 21st century corporation could stay large only by abandoning bricks and mortars, pipelines and power plants, in favor of computer terminals, the desks to run them on, and the intellectual know-how to do interesting things at those desks. In the 1990s, such ideas were all too common.

A remark often attributed to Mark, and assigned to the heat of her rivalry with Skilling, seems prescient.

"Sure, the trading operation uses no capital," she said. "It just consumes the entire balance sheet of the company."

By 1999, Enron was easing Mark out the door. The company's golden age was over, and with hindsight we can say that the debacle of the autumn of 2001 was assured.

The right lesson, then, is that there are real dangers when finance becomes too disconnected from the physical world, when an excess of liquidity gives rise to dreams of infinite leverage.

The wisest society, the one with the best grasp of its own interests, will be one that imposes no artificial limits on either speculation or leverage, except to require that both of those good things work themselves out in a stable monetary and credit environment. In such an environment, bubbles prick themselves before they can do a lot of harm.

Another lesson we might draw from Enron's sudden collapse is that one much-maligned species of speculator, the short seller, performs a valuable ecological function holding corporate managers accountable to the broader investing public. More of that in our next chapter.

Knowledge is warranted belief -- it is the body of belief that we build up because, while living in this world, we've developed good reasons for believing it. What we know, then, is what works -- and it is, necessarily, what has worked for us, each of us individually, as a first approximation. For my other blog, on the struggles for control in the corporate suites, see