The Ascent of Money: A Financial History of the World

Chapter 4 deals with insurance, which was devised to address not only the ups and downs of the financial markets but the ups and downs of life, as well. Since there’s no way for us to know the future, whether good or bad, insurance is a way to help blunt the bad things that come along.

“The Big Uneasy”

Ferguson uses the example of Hurricane Katrina, which hit New Orleans and surrounding areas in 2005, to begin the discussion of insurance. Almost 75% of the city’s housing stock was damaged, and insurance claims totaled more than $41 billion, “making Katrina the costliest catastrophe in modern American history” (178). The aftermath of the storm also demonstrated the limits of private insurance, as many homeowners faced a struggle in trying to collect damages. For example, if a house was covered by insurance against wind damage but not flooding, some companies falsely determined the latter to have created the damage in order to avoid paying out on some policies.

A lawyer named Richard Scruggs, who owned a house on the Gulf shore, took legal action against the companies and won millions in damages for his clients. The federal government, however, still picked up the tab for those who fell through the cracks of insurance coverage. Ferguson wonders, then, what the right balance is between private insurance and public obligations by governments. He argues that life has always been dangerous, and the future unknown; in the past, the main method of softening the blow–when it came–was by saving for a rainy day. The question is “knowing how much to save and what to do with those savings” (184).

“Taking Cover”

The first modern insurance system was created in 1744, by two ministers with the Church of Scotland, Robert Wallace and Alexander Webster. Limited forms of insurance had existed before, but they were often more like loans or pay-as-you-go plans. Then, in the middle of the 17th century, a series of theoretical breakthroughs occurred in statistics and economics that would allow for insurance as we know it to develop. They involved probability, life expectancy, certainty, normal distribution, utility, and inference. Wallace and Webster’s idea stemmed from the fact that the families of clergymen who died were often left in dire straits. They came up with a system, called the Scottish Ministers’ Widows’ Fund, that collected premiums, invested them, and then paid out as necessary from the profits of the investments. They used statistical information about deaths, along with actuarial and financial principles, to determine the amount of premiums. The idea took off and became the model for insurance plans that sprung up throughout the rest of the 18th century.

“From Warfare to Welfare”

This section discusses an alternative form of insurance—one provided by the state, rather than private companies. Since companies cannot account for all potential calamities, and since some people never take out insurance, a safety net of some kind is needed. The first pensions and health insurance came from Germany, under Otto von Bismarck. Britain extended it in the early 20th century and then much more so in the 1940s. Prime Minister Winston Churchill envisioned it as insurance for everyone, from birth to death. However, it was Japan that was “the world’s first welfare superpower, the country that took the principle furthest and with the greatest success” (205). Its origin in 1937 was to provide a measure of protection to a nation that was on a total-war footing and asked for a large sacrifice from its citizens. Ferguson writes that “[t]he aim was explicit: a healthier populace would ensure healthier recruits to the Emperor’s armed forces” (208). Health insurance, pensions, and public housing all began during war. Afterward, unemployment insurance was created in an attempt to provide universal welfare.

This worked well in Japan (so long as its economy was growing) because equality and conformity to the rules were valued. In addition, the family and employers continued to provide strong support. However, in the West (particularly Britain and America), welfare states did not fare as well. Ferguson attributes this to greater individualism, which led more people to “game the system”; employers that were more apt to cut workers; and lack of family support for the elderly (210). The 1970s were also a period of economic stagnation coupled with high inflation (or “stagflation”), and the Western welfare states themselves seemed to be in need of welfare.

“The Big Chill”

As a result of the above, a trend began in the West to scale back the welfare state and allow risk to once again return to the fore. This was led by Milton Friedman, an economist at the University of Chicago who won the Nobel Prize in economics in 1976. He tested his theories about inflation in the country of Chile, which at that time had an annual rate of inflation of 900%. Chile had gone from a democratically-elected Marxist president, Salvador Allende, to a conservative dictator, General Augusto Pinochet, as the result of a military coup in 1973. Friedman counseled the new leader on how to reduce inflation by dismantling the welfare state. Chilean economists who had studied at the University of Chicago, known as the “Chicago Boys,” held posts in Pinochet’s government and helped to carry out Friedman’s ideas.

The most influential of these officials, however, had studied at Harvard, and became the minister of labor at the end of the 1970s. His name was José Piñera. He thought the key to success was to recreate the sense of ownership that the welfare state had removed by returning to a system in which people contributed to their own Personal Retirement Accounts. This money would be held and invested by competing private companies. He gave workers the choice of staying with the old system or switching to the new one; ten years after it was instituted in 1980, over 70% belonged to the new, private system. Overall, Chile’s economy improved drastically from the period preceding the reforms: the growth rate was almost twenty times higher and the poverty rate had fallen sharply.

Ferguson ends this section by comparing such a system to the welfare system in the United States, where an old-age pension and medical costs of the elderly are included but health insurance is not (at the time this was written). As a result of certain factors, the system in the United States is less comprehensive than that found in most European countries, but still extremely expensive. At the same time, the “Baby Boomer” generation is poised to reach retirement age soon, which will add further pressure on a system that makes up a large share of the federal budget. Ironically, the only country in worse shape, he concludes, is Japan, the former “superpower” of welfare states. Greater longevity and declining birth rates have put a strain on their welfare system, and the economy has slowed from its high point in the 1970s and 1980s. “Longer life is good news for individuals,” Ferguson concludes, “but it is bad news for the welfare state and the politicians who have to persuade voters to reform it” (222).

“The Hedged and the Unhedged”

This final section of the chapter considers hedge funds, which Ferguson calls “the smart way” to guard against future risks (225). He explains the agricultural origins of hedging, which were a way to protect farmers from the uncertainty of the market. Rather than wait until the harvest and just take one’s chances on the going price of any given crop, a futures contract sets the price in advance. When the market price happens to be lower at the time of selling, the farmer is protected by making out better; when the opposite happens, the holder of the contract makes a profit. As a tradable asset, a futures contract is a kind of security known as a derivative (because they are “derived” from the value of other assets). Two other kinds of derivatives are options and swaps. The former are simply what their name implies, an option to either buy or sell something at a given time. If the price is right, the holder exercises the option to his or her benefit; if not, it is simply not acted upon. A swap is merely an agreement to switch benefits of financial instruments. The example Ferguson gives is one party receiving a variable interest rate and swapping it for a fixed rate. The main thing about hedge funds, however, is that you must be rich to participate, as most require an investment amount starting in six figures. Thus, the average person tries to protect themselves against financial uncertainty by investing in property: their home.