Buy the Book: John Kenneth Galbraith journeys through the recurring theme of speculative mania and financial ruin inherent in markets, His big picture view describes the common features associated with most euphoric episodes.
The Notes
- It should be accepted that speculative euphoria and financial ruin are inherent in the system.
- More regulation or economic knowledge won’t prevent people from joining the next speculative rush. Only a clear understanding of euphoric characteristics can help, but not a guarantee.
- Warnings of speculative euphoria are treated in the short run as an attack, as envy and lack of faith in the asset’s potential and the wisdom of the market. Participants defend their vested interest. Doubters are castrated as unimaginative or “too old” or “too out of touch” to understand the new paradigm driving values.
- “The rule, supported by the experience of centuries: the speculative episode always ends not with a whimper but with a bang.”
- “All people are most credulous when they are most happy.” — Walter Bagehot
- “The euphoric episode is protected and sustained by the will of those who are involved, in order to justify the circumstances that are making them rich. And it is equally protected by the will to ignore, exorcise, or condemn those who express doubts.”
- Two factors contribute to speculative euphoria:
- Financial Memory Loss — Financial disasters are forgotten and the next speculative episode is driven by a new generation extremely confident in the new next innovation in finance or the world.
- Associating Money with Intelligence — It’s become accepted practice to equate money with intelligence. The more money, the greater the genius needed to attain it. And superior intelligence is endowed on leaders of financial institutions. It ignores a vast history of wealth attained by luck, illegal gain, or inheritance. Individuals are just as likely to believe themselves intelligent, as they do others, after making money off a stroke of luck.
- “There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that it is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.”
- “The rule will often be here reiterated: financial genius is before the fall.”
- Common Features of Speculative Episodes:
- New Innovation: All speculative episodes are driven by the thought of something new, exciting that catches the public imagination. It’s rich in imaginative prospects, but light on realistic prospects. Speculators take pride in a discovery or new innovation (financial or other), thinking they’re ahead of their time (much like early adopters of new tech). Eventually, others recognize it and pile in. Financial innovations are less innovation and more a twist on a past financial concept or product, unknown to a new generation of speculators. “The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version.”
- Debt: “All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets.” Leverage against assets scaled to an extreme keeps prices aloft.
- Crash: The innovation finally receives the scrutiny it deserved, albeit too late. Regulation and reform are debated. Once praised promoters (and their genius) of said innovation are scorned. The euphoria and optimism are ignored. The blame gets a rational response, while the irrational acts get ignored. “In the aftermath of speculation, the reality will be all but ignored.”
- Two reasons why excessive optimism driving speculative mania is ignored after the fact:
- For the whole financial community to fall prey to a mania reeks of stupidity but runs counter to the idea of equating money with intelligence. There had to be another reason other than naivety.
- The assumption that the market is free from error, so something else, external or an abuse, had to cause the crash.
- “Markets in our culture are a totem; to them can be ascribed no inherent aberrant tendency or fault.”
- The Mississippi Bubble:
- John Law helped set up the Banque Royale for France in 1716 to issue notes to pay government expenses and take over past government debts. Notes could be exchanged for coin.
- Revenue to support the notes came in the form of monopoly rights to trade in the Louisiana Territory. Law created the Mississippi Company, a joint-stock company, offering shares to the public while promoting the “wealth” of Louisana. The public took to it, prices rose quickly, and speculation ran wild.
- It turned out to be a scheme. Proceeds from the sale of stock went to pay off government debt. The notes that paid the government debt were used to buy more stock, stock prices rose and demand for more shares rose, more shares were issues, paying off debt — it created a vicious circle that fueled speculation. Ultimately, the number of notes created by the Banque Royale far exceeded the coin available to cover the notes. It was pure leverage.
- The scheme came crashing down in 1720 with a run on the bank. People demanded coin for their notes instead of stock. Of course, there was none. Shares of the Mississippi Company tanked. Law went from financial genius to condemned overnight.
- South Sea Bubble:
- The South Sea Company, a joint-stock company, was created in 1711 with the idea of assuming Britain’s debt in exchange for sole trade rights to the Americas. Shares of the company were offered to the public.
- By 1720, the public rushed to share in the quick richest — shares that sold around £128 in January 1720, were £330 by March, £550 by May, £890 in June, and £1,000 by late summer.
- By December 1720 the price was back to its January high.
- But the episode produced many other joint-stock companies based of imaginative ideas — horse insurers, perpetual motion machines, soap maker, attempt to turn mercury into other metals — trying to take advantage of the boom.
- “I can measure the motions of bodies but I cannot measure human folly.” — Isaac Newton on losing £20,000 speculating in South Sea shares.
- “Nobody seemed to imagine that the nation itself was as culpable as the South Sea Company. Nobody blamed the credulity and avarice of the people — 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.” — Charles Mackay
- “The financial memory is brief, but subjective public attitudes can be more durable.”
- The US experienced a number of debt bubbles and collapses — 1751, 1810, 1819, 1837, 1857, 1873, 1907 — in its early years, not unlike emerging markets do today. Two of the biggest bubbles came from shifts in transportation — canals (busted in 1837) and railroads (busted in 1873) — mostly funded by British money.
- Florida Real Estate Boom:
- By 1924-25, Florida “beachfront” property (it was mostly swampland and marsh) could be purchased with 10% down. Prices doubled after a few weeks.
- It collapsed in 1926. Blame was placed on two hurricanes that fall.
- Maimi bank clearings over $1 billion in 1925, dropped to $143 million in 1928.
- 1929:
- Had all the ingredients for a speculative episode: leverage, over-optimism, and financial innovation.
- Stock could be bought on a 10% margin. Margin rates ran from 7-15% in 1929.
- Investment trusts were the new innovation. The trusts levered up spectacularly.
- Trading corporations, like the Goldman Sachs Trading Corp. (launched by Goldman Sachs), were created solely to speculate in stocks. The Goldman Sachs Trading Corp would launch the Shenandoah Corp. to speculate in stocks, which launched the Blue Ridge Corp. to do the same. All leveraged to the hilt, speculating in stocks. Each one’s “value” reflected in its creator, due to the speculative euphoria in stock prices.
- “Stock prices have reached what looks like a permanently high plateau.” — Irving Fisher
- The end began on Oct. 21, culminating on Oct. 29 with the single worst day ever (up to that point).
- “Prices driven up by the expectation that they would go up, the expectation realized by the resulting purchases. Then the inevitable reversal of these expectations because of some seemingly damaging event or development or perhaps merely because the supply of intellectually vulnerable buyers was exhausted. Whatever the reason (and it is unimportant), the absolute certainty, as earlier observed, is that this world ends not with a whimper but with a bang.”
- The collapse was blamed not on excess speculation but on weakening economic indices. A rational response to an irrational episode.
- “For practical purposes, the financial memory should be assumed to last, at a maximum, no more than 20 years. This is normally the time it takes for the recollection of one disaster to be erased and for some variant on previous dementia to come forward to capture the financial mind. It is also the time generally required for a new generation to enter the scene, impressed, as had been its predecessors, with its own innovative genius.”
- “Only in the financial world is there such an efficient design for concealing what, with the passage of time, will be revealed as self- and general delusion.”
- Other euphoric periods built on innovation: Go-Go ’60s, REITs in the ’70s, junk bonds (fueling takeovers and LBOs) in the ’80s, commercial real estate in the ’80s (fueled by S&Ls), the Japanese stock market in 1990.
- “The only remedy…is an enhanced skepticism that would resolutely associate too evident optimism with probable foolishness and that would not associate intelligence with the acquisition, the deployment, or, for that matter, the administration of large sums of money.”
- “Let the following be one of the unfailing rules…: there is the possibility, even the likelihood, of self-approving and extravagantly error-prone behavior on the part of those closely associated with money.”
- “A further rule is that when a mood of excitement pervades a market or surrounds an investment prospect, when there is a claim of unique opportunity based on special foresight, all sensible people should circle the wagons; it is the time for caution.”
- “Fools, as it has long been said, are indeed separated, soon or eventually, from their money. So alas, are those who, responding to a general mood of optimism, are captured by a sense of their own financial acumen. Thus it has been for centuries; thus in the long future it will also be.”
