Finance and Development, June 2016


Finance and Development, June 2016

Money, It’s a Hit

William N. Goetzmann

Money Changes Everything

How Finance Made Civilization Possible

Princeton University Press, Princeton, New Jersey, 2016, 600 pp., $35.00 (cloth).

A five-year 3.78 percent loan between two businessmen in 1796 may not seem remarkable, but it turns out that’s 1796 BCE, and the businessmen lived in the ancient Sumerian city of Ur. William N. Goetzmann’s sprawling Money Changes Everything spans ancient Mesopotamia to 20th century America, China, and Europe, with excursions through classical Greece and Rome, ancient and imperial China, and centers of financial innovation in medieval and Renaissance Europe.

Goetzmann aims to show the enabling role finance played in the development of human society, culture, and knowledge. His core thesis is that financial innovations through the ages have overridingly had a civilizing influence. Today, when financiers are so often seen as malign influences, such a view may seem contentious, but Goetzmann makes a strong case.

His method of persuasion is to deluge the reader with a wealth of historical detail. The sheer density can overwhelm at times, but he leavens his account with fascinating historical episodes and characters and personal tales of discovery (for example, his role in unearthing the 1372 founding charter of the Honor del Bazacle in Toulouse, France—a corporation that survived into the 20th century).

The book starts in the Mesopotamian city of Uruk, where markings on clay tokens that served as financial records evolved into cuneiform, one of the earliest forms of writing. Early financial innovations influenced humanity’s concept of time. A 360-day Sumerian calendar did not correspond in any way to astronomical time, but 360 is a number divisible into many whole numbers, ideal for parceling time into even ratios convenient for financial contracts. (In fact, the 360-day year is still used in calculating modern-day bond interest accruals.)

Conceptions of time in medieval financial contracts may have been a counterpoint to ecclesiastical notions, contributing to a clash between the church and commercial society. Arm’s-length financial transactions—and therefore a level of trust in a financial system that could substitute for the personal relationships that prevailed in traditional societies—were critical to increasing population densities.

Finance fostered the capacity for abstract thought.

Finance also fostered the capacity for abstract thought. Most students of finance recognize its role in the development of mathematics and probability theory, but Goetzmann also points out the degree of abstraction needed to understand, for example, the concept of financial claims as a form of non-physical wealth that had to be tracked through accounting entries.

Such an all-encompassing tableau frequently delivers the jolting shock of familiarity that is one of the great pleasures of reading history. For example, in the Mesopotamian city of Dilmun, ordinary citizens could participate passively in ventures by contributing capital of a bracelet, much as a modern household might buy a share or two of Google stock. Thirteenth century Venetians eagerly bought prestiti, the first true government bonds. Such financial inclusion gave people passive, liquid stakes in diversified income-generating activities that could provide a measure of economic security, as well as a stake in the state’s economic expansion.

The book also explores how financial markets continually found ways to liquefy apparently illiquid assets. The records of a 7th century Chinese pawnshop reveal that just about anything with resale value could be used as security for a loan; in the 15th century, a speculative futures market developed in the dividends of the Casa di San Giorgio, an entity formed to handle the finances of the city of Genoa.

The development of corporate structures gets an in-depth look, in particular the importance of liquid, limited-liability claims in fostering necessary risk taking and of the development of public finance (the Genoese government was financed through equity-like instruments long before the development of modern-day GDP- and commodity-price-linked bonds). Coinage (for example, in Greece and Rome) and paper money (in China) are shown to be solutions to specific problems at specific times.

Goetzmann does not ignore the dark side of finance, including financial crises in ancient Rome (33 CE) and the more familiar tales of the South Sea and Mississippi bubbles of the 18th century. He attributes the bursting of financial bubbles as frequently to government intervention (for example, the Bubble Act of 1720) as to irrational behavior among overleveraged investors.

A remarkable work of synthesis and scholarship, the book affords a deep perspective to anyone trying to grapple with current problems in the role of finance and financial regulation in a civilized society.

Elie Canetti

Advisor, IMF Western Hemisphere Department

Robbing Hood

Kenneth Scheve and David Stasavage

Taxing the Rich

A History of Fiscal Fairness in the United States and Europe

Princeton University Press, Princeton, New Jersey, 2016, 288 pp., $29.95 (cloth).

Visiting a depressed Welsh village in the 1930s, the future British King Edward VII famously remarked that “something must be done.” Current agonizing over rising inequality has a similarly plaintive feel. Will anything actually be done about it, in the form of much greater tax progressivity? This admirable book gives a clear answer: probably not.

This is just one implication of the authors’ big idea: a distinctive theory of what drives strongly progressive taxation. To arrive at it, they first elegantly dispose of two alternative explanations. One is that progressive taxation comes about as an application of ability-to-pay arguments: the rich should pay a higher tax rate because it hurts them less. But the authors show that higher top tax rates have generally not resulted from higher pretax inequality. The other is that increased progressivity has come from extension of suffrage, with the numerically dominant poor voting to extract resources from the outnumbered rich. But the authors conclude that this story doesn’t work either.

What remains is their “compensatory” theory—the idea that strongly progressive personal tax systems are most likely to emerge when, in democracies, there is some fundamental state-induced unfairness that cannot be removed by other means and when, in particular, “the deck is stacked in favor of the rich, and the government did the stacking.”

Such unfairness can take several forms, such as broad-based commodity taxes needed for revenue reasons. But the most important source, at the center of their argument, is mass mobilization for war. The U.S. Civil War fits the bill, for example, with mass levies and widespread sentiment that this was a “rich man’s war and a poor man’s fight.” Sure enough, both sides introduced a progressive income tax. (That the federal income tax was soon removed is consistent with a further implication of the compensatory view: progressivity fades once the fundamental unfairness subsides.) The same broad narrative fits the two world wars, which the book examines in detail. But the world, and the technology of warfare in particular, has changed. It is the shift toward hightech warfare rather than fighting with mass armies that makes the authors believe that further bouts of steep progressivity comparable to those of the 20th century are unlikely.

The book is a methodological model. The authors develop their arguments through a broad array of methods: econometrics, laboratory experiments, textual analysis, and historical narratives. Especially worth mentioning is the data set (at the heart of their analytics) they have assembled on top income tax and inheritance tax rates in 20 countries during 1800–2013.

Kenneth Scheve and David Stasavage give us much to think about. There do, for instance, seem to be contradictory cases of mass mobilization that did not give rise to sharply more progressive income or inheritance taxation. One is the era of the French Revolution, when, the authors argue, other progressive taxes were levied instead. Another case may be Israel, where the top income tax rate (relating too to forced loans) increased by about 10 percentage points in the seven years around the 1967 war—but the lowest rate increased by about 12. Conversely, progressivity sometimes increased without mobilization: the authors point to noncombatant democracies during World War I. Systematically identifying and analyzing apparent counterexamples could lead to a better understanding of both the power and possible limits of the compensatory view.

High-tech warfare makes further bouts of steep progressivity unlikely.

Perhaps the most fundamental task the book leaves us, however, is unpacking the underlying notion of state-induced unfairness. The case made for the importance and power of compensatory arguments in public discourse on these issues is wholly compelling. But what raises these arguments to a level at which they make a strong mark on policy? In World War I, for instance, the British officer class had a far higher death rate than did ordinary soldiers from poorer backgrounds. And might it be that the rich are willing to make unusual concessions in wartime because they have more at stake in not losing (the “rich man’s war”)? Why has resentment at the combination of bailouts and austerity over the past few years not (yet) led to much greater progressivity?

The authors make the force of the compensatory view clear. Judging by the apparent success of the rhetoric during the 2016 U.S. presidential primaries that speaks of a system rigged to favor the rich, the compensatory theory has not gone unnoticed by political strategists.

Michael Keen

Deputy Director, IMF Fiscal Affairs Department

Yours and Mine

Arun Sundararajan

The Sharing Economy

The End of Employment and the Rise of Crowd-Based Capitalism

MIT Press, Cambridge, Massachusetts, 2016, 256 pp., $26.95 (cloth).

The sharing economy is transforming commerce right before our eyes. Thousands are skipping the hassle of standing on a corner in the rain to hail a cab and are simply summoning an Uber or Lyft to whisk them to the airport. Others are selling their knitting on Etsy, letting strangers stay in their home through Airbnb, or having their weeds pulled by a gardener hired via TaskRabbit. Countless “workers” are flocking to Amazon’s Mechanical Turk to complete “Human Intelligence Tasks” for just pennies.

Sharing economy expert and New York University Stern School of Business professor Arun Sundara-rajan tackles the myriad issues these developments have spawned in his path-breaking book.

Sundararajan knows his stuff. He’s an award-winning scholar who writes with a clarity that masks the complexity of his subject. Citing his own research and that of many others, he explains how organizations whose main purpose is to create the supply needed to meet consumer demand are driving today’s economy. He explores how these developments spell the end of employment as we know it and what society should do to shield the American worker from the worst Darwinian aspects of crowd-based capitalism.

Sundararajan divides the book into two logical parts, cause and effect, with each of eight main chapters addressing a concrete topic. If you’re befuddled by the notion of blockchain technology and bitcoin or wonder exactly how a “platform” differs from a “hierarchy,” you’ll find the answers in this enormously helpful and comprehensive book.

Sundararajan identifies five core characteristics of the sharing economy. It’s largely market based, puts underutilized capital to use, relies on crowd-based networks, and blurs the lines not just between the personal and the professional, but also between employment and casual work.

What generated this crowd-based capitalism? Apple’s Steve Jobs and the iPod, says Sundararajan. The iPod was the first successful mass-market product developed primarily for consumers, rather than for business or government, and ever since, the most important innovations—think the iPhone, iPad, and Facebook—have centered on the consumer.

Trust is essential to this economy. Our 20th century relatives would have been reluctant to allow strangers to drive their cars or stay in their homes while they were on vacation on a mere promise to pay. Yet thousands of people do these things every day because the digital economy has created a network we can trust.

It has generated positive spillover effects by putting underused assets to work and expanding economic opportunity. Yet it has also spawned negative externalities—your neighbor might not like the comings and goings of your Airbnb “guests”—and weak regulation has certainly helped the sharing economy grow. For example, Airbnb might struggle to survive if its casual hosts had to meet the same fire, safety, and other regulations that govern conventional hotels.

Sundararajan advocates giving regulatory responsibility to the peer-to-peer marketplace and allowing new self-regulatory organizations to fill the gap. But he may be overestimating the private sector’s ability to provide sufficient consumer protection. Although keeping government regulators at bay may seem necessary to incubate the sharing economy, consumers may have to suffer through lots of dangerous rides, filthy apartments, and ruined gardens before the “collaborative” market sorts things out.

Trust is essential to the sharing economy.

I would have liked to see additional data on compensation. For example, Sundararajan asserts that workers can generally expect to earn a higher hourly wage through freelance assignments than through traditional channels, citing plumbers in San Francisco as evidence. But this assertion is misleading for two reasons. First, hourly wage data don’t include benefits, which typically account for 20 to 30 percent of total compensation. Second, it’s one thing to earn a wage premium for an hour or so of freelancing, but it’s another to find a year’s worth of freelance work at that rate. Many freelancers would love to make the kind of money—about $66,500 a year—San Francisco’s plumbers earn.

This point doesn’t detract from the high quality of Sundararajan’s book, which is essential to understanding how today’s crowd-based capitalism beats yesterday’s industrial revolution. In Adam Smith’s world, the market’s invisible hand led supply and demand to intersect. In Sundararajan’s world, the invisible hand is still at work. It’s just that it now has help from peer-to-peer funding, impersonal platforms, blockchain technology, and those ubiquitous apps.

Joann M. Weiner

Director, MA in Applied Economics, The George Washington University Author, Company Tax Reform in the European Union

Finance and Development, June 2016
Author: International Monetary Fund. External Relations Dept.