Monthly Archives: January 2019

A Short History of Financial Euphoria – Galbraith

113 pages, Penguin, 1993

Book Blurb

How is it that, with all the financial know-how and experience of the wizards on Wall Street and elsewhere, the market still goes boom and bust? How come people are so willing to get caught up in the mania of speculation when history tells us that a collapse is almost sure to follow?

In A Short History of Financial Euphoria, renowned economist John Kenneth Galbraith reviews, with insight and wit, the common features of the great speculative episodes of the last three centuries–the seventeenth-century craze in Western Europe for investing in an unusual commodity: the tulip; Britain’s South Sea Bubble and the eighteenth century’s fascination with the joint-stock company, now called the corporation; and, more recently, the discovery of leverage in the form of junk bonds. Along the way, Galbraith explains the newfangled types of debt that different generations have dreamt up, and he entertains with anecdotes about the ingenuity with which some of the more notorious charlatans have convinced people to invest in financial ciphers.

Galtraith calls this book “a hymn of caution” for good reason. He wars that the time will come when the public hails yet another financial wizard. In that case, the reader will do well to remember the Galbraithian adage: “Financial genius is before the fall.” The appearance of the next John  Law, Robert Campeau, or Michael Milken may well be, after all, a harbinger of disaster.

Author Blurb

john Kenneth Galbraith is the Paul M. Warburg Professor of Economics Emeritus at Harvard University and was the U.S. ambassador to India during the Kennedy administration. His works The Great Crash 1929, The Affluent Society, The New Industrial State, and Economics and the Public Purpose are landmarks of political and economic analysis.

Quotes from A Short History of Financial Euphoria

Foreword to the 1993 Edition

“Recurrent speculative insanity and the associated financial deprivation and larger devastation are, I am persuaded, inherent in the system.” “In London, tourists going down the Thames to the Tower will extend their journey to encompass the Canary Wharf development, perhaps the most awesome recent example of speculative dementia.” Perhaps in 1992 when Olympia & York went bust. But fast forward nineteen years to 2015 and it’s a different story: Canary Wharf was sold to Brookfield for 2.6 billion pounds. “They think it will be an estimated twenty-six years in Boston, forty-six years in New York and fifty-six years in San Antonio [for real estate to recover from the excesses of the late eighties].” Unbeknownst to Galbraith, who was writing in 1993, the market would recover remarkably quickly, in about twelve years. Then the speculative excess would begin again in the events that would lead up to the Great Recession of 2008.

Chapter 1: The Speculative Episode

“Speculation buys up, in a very practical way, the intelligence of those involved.” “The price of the object of speculation goes up. Securities, land, objets d’art, and other property, when bought today are worth more tomorrow. This increase and the prospect attract new buyers; the new buyers assure a further increase. Yet more are attracted; yet more buy; the increase continues. The speculation building on itself provides its own momentum.

Chapter 2: The Common Denominators

“The rule will often be here reiterated: financial genius is before the fall.” Although Galbraith was writing before the collapse of Long-Term Capital Management in 1998, his words are prescient. Two of the founders of LTMC, Myron Scholes and Robert Merton, would collect their Nobel Prize in economics several months before the fund lost close to five billion dollars. The real loss was an order of magnitude larger, since, assured by their genius of success, they had leveraged their assets, borrowing over 124 billion dollars to jack-up their returns. The Fed eventually had to intervene to stabilize the cascading disaster. “The final and common feature of the speculative episode is what happens after the inevitable crash. There will be scrutiny of the previously much-praised financial instruments and practices–paper money; implausible securities issues; insider trading; market rigging; more recently, program and index trading–that have facilitated and financed the speculation. There will be talk of regulation and reform. What will not be discussed is the speculation itself or the aberrant optimism that lay behind it.”

Chapter 3: The Classic Cases, I: The Tulipomania; John Law and the Banque Royale

First great speculative episode begins with first modern stock market in seventeenth century Netherlands: the Tulipomania. Tulipomania started in 1630 and crashed in 1637. First great speculative episode where we know names happens with John Law in France. In 1716 he establishes the Banque Royale, which issued notes to pay government expenses: Louis XIV had recently died, leaving the treasury bankrupt. The Banque Royale notes would be backed by the Mississippi Company, which would mine the unproven gold reserves in Louisiana. Instead of mining gold, income from the notes went to refinance the bankrupt treasury. The end came in 1720, when the Prince de Conti, annoyed by the ability to buy stock, decided to turn in his notes for gold. When the notes proved to be inconvertible, a run on the stock took place. Term “millionaire” originated with the Banque Royale bubble. In the aftermath of the bubble, “those who had lost their minds as well as their money and made the speculation spared themselves all censure.” The blame fell squarely on John Law and the Banque Royale rather than the spirit of speculation.

Chapter 4: The Classic Cases, II: The Bubble

Robert Harley, Earl of Oxford and John Blunt found the South Sea Company, a new-fangled “joint-stock company” in 1711. Like France in 1716, pressing government debt spurred financial innovation. The South Sea Company took over government debt from the War of Spanish Succession. In return, the government paid the company 6% interest and gave it the right to conduct British trade in the Americas. In 1720, the stock shot up from 128 to 1000 pounds. The success of the South Sea Company led to a rash of joint-stock companies being founded. Like with others bubbles, leverage amplified the losses and deepened the oncoming recession. Nice quote from Charles Mackay book:

In the autumn of 1720, public meetings were held in every considerable town of the empire, at which petitions were adopted, praying the vengeance of the legislature upon the South-Sea directors, who, by their fraudulent practices, had brought the nation to the brink of ruin. Nobody seemed to imagine that the nation itself was as culpable as the South-Sea company–the degrading lust of gain…or the infatuation which had made the multitude run their heads with such frantic eagerness into the net held out for them by scheming projectors. These things were never mentioned.

Chapter 5: The American Tradition

In Maryland and Southern colonies, notes against security of tobacco served as currency for two centuries in seventeenth and eighteenth centuries. A failed expedition in 1690 to take the fortress of Quebec led to Sir William Phipps issuing paper notes backed on gold. State banks begin issuing notes following the War of 1812 and the Second Bank of the United States was chartered in 1816 (the First Bank lost its charter in 1810 due to its refusal to issue easy money) to oversee the boom. In 1819, however, a collapse in housing prices ended the boom. 1837 witnessed the next American crash, which was, again, rooted in land speculation. This bust, did, however, leave behind a useful canal network. Insufficient reserves were a culprit: one New England bank had $500,000 in notes outstanding and a specie reserve of $86.48 in hand.

Chapter 6: 1929

1920s were a decade of excess, beginning with the Florida real estate boon which saw the rise and fall of Charles Ponzi in 1926. New York stock exchange prices started rising in 1924 before finally collapsing in 1929. Leverage was again a culprit, as speculators could chase stocks on 10 percent margin. Again, in the 1929 crash “nothing was said or done or, in fact, could be done about the decisive factor–the tendency to speculation itself.”

Chapter 7: October Redux

Financial memory of bubbles lasts twenty years. After that time, a new generation enters the scene, enamoured of its own innovative genius. After 1929, the next major bubble would surface in the 60s under the name of Investors Overseas Services, founded by Bernard Cornfeld. His pitch was: “Do you sincerely want to be rich?” The son of FDR, Sir Eric Syndham White (the secretary-general of GATT), and Dr. Erich Mende (vice-chancellor of the German Federal Republic) were all swindled. Leverage came back in the 80s in the form of leveraged buyouts, corporate takeovers, and junk bonds. The SEC report of the 1987 crash “found innocent those individuals, speculative funds, pension funds, and other institutions that had so unwisely, in naiveté and high expectation, repaired to the casino.

Chapter 8: Reprise

Individuals and institutions are captured by the wondrous satisfaction from accruing wealth. The associated illusion of insight is protected, in turn, by the oft-noted public impression that intelligence, one’s own and that of others, marches in close step with the possession of money. Out of that belief, thus instilled, then comes action–the bidding up of values, whether in land, securities, or, as recently, art. The upward movement confirms the commitment to personal and group wisdom. And so on to the moment of mass disillusion and the crash. This last, it will now be sufficiently evident, never comes gently. It is always accompanied by a desperate and largely unsuccessful effort to get out.

So, what can be done?

Yet beyond a better perception of the speculative tendency and process itself, there probably is not a great deal that can be done. Regulation outlawing financial incredulity or mass euphoria is not a practical possibility. If applied generally to such human condition, the result would be an impressive, perhaps oppressive, and certainly ineffective body of law.

The Review…

I like his style. Short sentences. Concise. He has thought the issues through for a long, long time. They are worked out in his head. At just over a hundred pages, this book reads fast and can be finished in one sitting. Galbraith writes with a dry sense of humour. It is almost as if he finds it amusing that the cycle of boom and bust will repeat again and again. In the first edition, he hopes that readers of his book will be inured against the cycle of boom and bust. Three years later in the 1993 edition, he is no longer so sure: he had overestimated the power of the rational mind to overcome the allure of wealth. All that glitters is gold.

This is an uncommonly common sense book. With all the soul-searching on the events leading up to the Great Recession, Galbraith’s A Short History of Financial Euphoria has something to say. He would say that: 1) rising house values were based on real factors, 2) once people got wind of how money can be made of flipping houses, the speculation began, 3) as the mania increased, speculators resorted to using more and more leverage, 4) when housing prices fell, as they do from time to time, there was a mad rush to get out, which led to a bust, 5) the blame for the bust falls on the speculators as much as it does on the banks or capitalism, 6) there was nothing that the regulators could have done, and 7) it will happen again, and soon.

What Galbraith doesn’t say is equally as interesting. While he says that busts can depress countries for years, he doesn’t say for how long. For example, take the Great Depression. The commonly cited doom and gloom statistic is that it took the Dow twenty-five years to return to 387, the high point in October 1929. There are many stock charts that illustrate this calamity. But factor in dividends (the stock chart doesn’t include dividends, which amounted to about 14% of the return) and deflation (even though prices were down, the purchasing power of each dollar went up because goods and services cost less), it took the Dow–drum-roll here–four and a half years to recover.

What Galbraith doesn’t say is that, during a bust, the best thing to do may be to do nothing. If you do do something, do not sell. Buy. With some patience, busts may be godsends. Keep some powder dry. Another example of a bust Galbraith gives is Canary Wharf. While Paul Reichman, the developer, did go bust in 1992, the Canary Wharf development recovered to become the main financial centre of UK and one of the main financial hubs of the world. His vision, if not his use of leverage, was vindicated. It’s the same with the Great Recession of 2008 or the Dot-Com bust of 2000: do nothing and investments will recover. While Galbraith’s book focusses on the human tendency to speculate and bust, that negative tendency is counterbalanced by the human capacity to work through crises to emerge stronger. It would be interesting to see how investors would have fared in each of the busts he discusses if they had simply held on and done nothing.

The other thing that Galbraith doesn’t talk about is why people pursue speculative excess. He does say that it is motivated by want of gain. And he does write about the notable incidents since the 1600s when speculators were wrong: Tulip Mania, the Banque Royale, the South Sea Company, and so on. But what if the speculators were not as misguided as he believe?–sometimes speculators win! Since the beginning of the bull market on March 9, 2009, Royal Caribbean Cruises is up 1911%, Apple is up 1715%, Alaska Air is up 1818%, and there are many others. To me, the true question to ask is whether speculation can be, in many instances, justified. If, on every occasion, rapid price escalation ends in a wailing and a gnashing of teeth, the answer is no. But that appears not to be the case. Many instances prove otherwise.

All in all, an excellent book in need of an indexer.

Until next time, I’m Edwin Wong and I’m doing Melpomene’s work.

Deflation: What Happens When Prices Fall – Farrell

228 pages, Collins, 2004

Book Blurb

Deflation is one o the most feared terms in economics. It immediately conjures visions of abandoned farms and idle factories, and streams of unemployed workers standing in breadlines.

In this important new book Chris Farrell explains that deflation need not presage a collapse. In the process he provides new ways of looking at our economic and financial futures. More than an introduction to the subject, Farrell points out that deflation has always been a fundamental aspect of the business cycle.

As they did in 19th century America, deflation and fast economic growth can coexist. However, the impact on business, consumers, investors, policymakers–and you–is the subject of this incisive volume.

Author Blurb

Chris Farrell, contributing economics editor at BusinessWeek, is an award-winning journalist who started writing about the New Economy in the early 1990s. Chris is also economics editor for Sound Money, a one-hour nationally syndicated weekly personal finance call-in show produced by Minnesota Public Radio. He is chief economics correspondent for American RadioWorks, a regular commentator for Nightly Business Report, Marketplace, MSNBC, and CNNfn, as well as author of Right on the Money!: Taking Control of Your Personal Finances.

Deflation: What Happens When Prices Fall Review

Chapter 1

Parallels between the 1920s (automobiles, radios, electric power, appliances) and the 1990s (internet, new economy). Will the bubble pop? Is a Great Recession around the corner? Greenspan is worried. The Fed is worried. Deflation in 2002 affects 13.1% of all countries, quite a rise from 1.2% in 1996. Japan, which functions like a canary in a coal mine, has been, since 1989, the deflation nation. Run to the hills!

Chapter 2

Globalization and the internet encourage deflation by allowing third world countries access to join the global labour pool. Discount retailers such as Wal-Mart and Target wring out cost inefficiencies out of the retail supply chain promote deflation. In the 90s, General Electric CEO Jack Welch structured GE to handle the impending threat of deflation. From 1776 to 1965, price index level in US essentially flat.

Chapter 3

There is no empirical link between deflation and depression: deflation gets a bad rep from one occurrence. Unfortunately, that occurrence was the Great Depression. Prices stable in nineteenth century thanks to gold standard. Monetarism or the quantity theory of money developed by David Hume holds that changes in the quantity of money drive inflation and deflation. 0.8% deflation each year in Britain from 1875-1896. Even more in US: from 1870-1900 prices fell 1.5% annually. But these deflations were accompanied by rapid economic expansion and higher living standards. For example, wages in Britain went up 33% from 1875-1900 and 84% from 1850-1900. China and Japan’s recent deflation (the book came out in 2004) from 1998-2002 was also benign and accompanied by economic growth.

Chapter 4

Three pervasive and structural factor make deflation likely: 1) globalization (worldwide competition in previously insular markets, international trade goes up for 13% in 1970 to 33% in 2002), 2) rise of the information age increases productivity as industry learns how to use computers and the internet, and 3) rise of central bankers who target inflation. By targeting inflation at low levels (e.g. 2%), deflation is always around the corner. The gold standard is replaced by credibility in central banks. BRIC countries, at 6% of the G6 economies (2002), can exceed G6 in less than 40 years.

Chapter 5

Economic growth comes from neither spending nor saving, but innovation says Schumpeter and his disciples. Late nineteenth century politics dominated by monetary policy. Populists wanted inflation, debt relief, and bimetal standard. Free silver moment had high point in 1896 with William Jennings Bryan’s “Cross of Gold” speech: “You shall not press down upon the brow of labor this crown of thorns, you shall not crucify mankind upon a cross of gold.” Wizard of Oz is allegory of 1890s monetary policy: cowardly lion is Bryan, cyclone is depression-era foreclosures, wizard is President McKinley. Oz is ounce, the measure of gold and silver. Central bankers fear deflation because it redistributes income from debtors to creditors. Easier for Fed to control inflation (by raising rates) than to control deflation (can’t force nominal benchmark interest rate below 0%–but this conventional wisdom has changed since the writing of the book with negative interest rates in European countries and quantitative easing in the US).

Chapter 6

Money is a standard of exchange and a measure of value. “Credit” from Latin term credere “to believe.” Great moments in financial history: Bank of England established in late seventeenth century, preference shares and debentures aided capital flow for railway building in eighteenth century, investors could access home mortgages in the 1970s through securitization. “Substantial inflation is always and everywhere a monetary phenomenon,” says Friedman. CPI fails to capture improvements in quality. CPI struggles to incorporate new technologies. CPI fails to capture how homeowners are not buying the same basket of goods. If orange juice goes up in price, homeowners may buy apple juice instead. As a result, CPI may overstate inflation by 0.5 to 1.5% (is this an investable idea?–e.g. buy TIPS or real return bonds, which are based on an overstated CPI figure). Federal Reserve Board created in 1913 to address the 1907 credit crunch. J.P. Morgan had ended the credit crunch privately, people wanted the government to take this role.

Chapter 7

The great and often passionate interest that is evoked by practical questions relating to money and its value, can only be explained by the fact that the monetary system of a people reflects all that a people wants, all that it suffers, all that it is; as well as by the fact that a people’s monetary system is an important influence on its economy and on the fate of society in general. – Joseph Schumpeter

US economy fell by a third from 1929-1933. Real rate of interest during Great Depression (fall in CPI + nominal interest rate) reached 15% in 1931 and 1932. What caused Great Depression?–Keynes blames collapse in business confidence, Friedman and Schwartz blame the Fed, Termin blames fall in consumer spending, Schumpeter argues economy plagued by underconsumption, Bernanke credit contraction, Kindleberger fall in commodity prices, and Galbraith the bursting of the stock market bubble. Depression works good by wiping away speculative excess says Schumpeter, Hayek, Robbins, Mellon, and others of the liquidationist perspective. In 1931, 47 countries on gold standard, by 1936 gold standard was abandoned.

Chapter 8

More than half WWII soldiers coming back from war saw another depression. Instead they came back to a roaring boom. 1982 unemployment at 10% and inflation at 14% at 1980. 1970s inflation due to lack of credibility at Fed under Burns and Miller. But who could see inflation coming?–from 1800 to 1970 inflation averaged 0.4%. At Bretton Woods, gold fixed at $35 an ounce (interesting, if we input $35 into a US inflation calculator, $35 in 1944 would be worth $501 in 2018. An ounce of gold today goes for $1281. Gold has done well under a fiat currency). Government spending to GDP 8% in 1913, 21% in 1950 and 31% in 1973 (today, in 2018 it has breached 37%, government is getting bigger in relation to the rest of the economy). Paul Volcker takes a 2×4 to inflation!

Chapter 9

In 1956 the typical American works 16 weeks for each 100 sq/ft of house; in 2002 it is now 14 weeks for each 100 sq/ft of house (in Victoria in 2018, it has gotten worse: it costs about 60 weeks of work for each 100 sq/ft of house). Percentage of American who describe themselves has happy, despite rising economic indicators, has not moved in 50 years: widespread material abundance cannot overcome a sense lives lack purpose.

Chapter 10

Half of US households own stocks making deflation an important issue. Long-term Treasury bonds do well during deflation: Alfred Lee Loomis and Landon Thorne made a killing during the Great Depression by swapping stocks into T-bills. During mild inflation and deflation real returns of stocks and bonds are similar. But during pronounced deflation (>2.5%) stocks tank. In today’s deflationary environment (defined as a world in which central banks target inflation at 2% and technological innovation puts downwards pressure on prices), 3.5-4% economic growth possible. Couple this with a dividend yield of 1.6% (on the Dow), a real return of 5-6% is possible. Mathematics suggests, with bond yields at 40-year lows, little capital appreciation is possible in fixed-income, where a return between 3-4% is realistic. From 1991-1996 the stock market returned 17.9%. Traders who engaged in the highest levels of trading pocketed only 11.4%.

Chapter 11

The world needs more globalization to increase prosperity and keep a lid on inflation. Farmers make up 2% of the workforce today, compared to 20% in the 1930s, yet over last two decades they have gotten 300 billion in aid: why not, for example, outsource farming to developing nations? Reform the social security net by making health care universal. Simplify the tax code to reduce compliance costs.

Some Thoughts…

This is one of the more accessible books on deflation out there. Farrell’s view of deflation, however, is interesting. I think–but am not sure–that he’s claiming that we already experience deflation today. His argument runs something like this: we experience (mild) deflation because: 1) the Fed, to preserve credibility in the post gold standard world, aggressively targets inflation at 2%, which is almost like having deflation, 2) the CPI figure the Fed uses as a benchmark overstates inflation because consumers shop opportunistically and goods have more features, 3) globalization increases competition, driving down costs, and 4) technology wrings out cost-inefficiencies, driving down costs. With this view of deflation, Farrell dispels the commonplace notion that deflation is to be feared, a notion that we got from associating the Great Depression with deflation. Mild deflation (or inflation) contributes to global prosperity.

Is the deflation scenario investable? Farrell advocates holding a diversified portfolio of stocks and bonds, and to continue investing in human capital (learning new skills, taking courses or certificate programs). His advice doesn’t stand out from what the crowd is saying, and I found this disappointing. I had been looking for tips on how to invest during deflation. The lack of specific advice and his definition of deflation (see above paragraph) stood out to me.

How would long bonds, the classic deflation hedge, have done from 2004 (when the book came out) to 2017? Plugging the numbers into the handy online asset mixer, long bonds would have returned 4.9%. How would the TSX Composite (including dividends) have fared?–7.9%. How would the S&P 500 have fared?–8.4%. So, in hindsight, Farrell was right to have advocated a diversified portfolio of stocks instead of the long bonds, the traditional investment of choice during deflation. I do, however, call to question whether the 2000s will be remembered as a deflationary period. As always, Farrell’s book serves as a reminder that the world of finance can always surprise you. In finance, “this time is not different” until it is. Take, for example, the widespread use of quantitative easing and negative interest rates that were, in 2004, unthinkable.

What I liked about Farrell’s book is how it recounts the history of the gold standard and the rise of the Fed when the gold standard ran out of gas. The narrative of how the Fed had to rise to contain inflation caused by profligate government spending makes sense. Before, when gold was the standard, the money supply was limited by the amount of gold. If governments spent recklessly, gold would flee the country. This was a sort of check to government spending. But in today’s age of fiat currencies, governments can print money. In a world of printed money, you have to find a way of making money more scarce so that money doesn’t flee your country: the answer is the Fed, which makes money scarcer by making it more expensive by hiking rates.

Another thing I noticed: it’s hard to make predictions. Farrell predicted that the BRIC countries, which accounted for 6% of the G6 economies in 2002, could exceed the economic output of the G6 economies “in less than 40 years.” Well, as of 2017 (fifteen years later), the BRIC countries already exceed the G6 economies by 50%!

Until next time, I’m Edwin Wong, and I’m doing Melpomene’s work.

Risk Theatre Modern Tragedy Competition – January 2019 Update

Happy New Years, it’s time to ring in 2019 with the latest press release from assiduous competition manager Michael Armstrong!–

Exciting New Playwriting Opportunity!

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December 28, 2018. Victoria, BC, Canada

Hello fellow playwrights and theatre artists,

The Risk Theatre Modern Tragedy Competition is an exciting new playwriting competition dedicated specifically to the creation of contemporary tragedies. The competition is hosted by the Langham Court Theatre in Victoria, BC, Canada, and is sponsored by critic, Edwin Wong. We received our first submission on June 4, this past summer, four days after we opened the competition.

To date, we have already received over fifty plays from around the world. From Australia to Ireland, from New York to Los Angeles, from Toronto and London. As we move closer to our deadline of March 29, 2019, we expect the pace of submissions to pick up. We are well on our way to exceeding our expectations for this first iteration of our unique competition. Three judges, one each from England, the United States, and Canada, successful writers and critics in their own right, are looking forward to reading your plays.

If you have not yet entered our competition, we invite you to check us out at risktheatre.com for more information about our competition. Prizes include $8000 for first place and four runner-up prizes of $500 each. The winning playwright will also receive a stipend of up to $1000 to travel to Victoria, British Columbia, Canada, for a professionally led workshop at Langham Court Theatre (our host) that will culminate in a staged reading. We have also approached several significant theatres in the US, Canada and England towards an agreement to read our finalists. More on this later.

In addition, all of the playwrights that enter the competition will receive a copy of our sponsor’s book The Risk Theatre Model of Tragedy: Gambling, Drama, and the Unexpected by Edwin Wong, which is due out this February.

Thank you for your interest and support of the Risk Theatre Modern Tragedy Competition. Happy writing, wherever you are!

Yours truly,

Michael Armstrong. Playwright, Actor, Director.
Competition Manager
tragedycompetition@gmail.com

Until next time, I’m Edwin Wong, and I’m doing Melpomene’s work.