113 pages, Penguin, 1993
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.
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.
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.