Monday, 28 May 2012

Book Review - A Short History of Financial Euphoria, by John Kenneth Galbraith

In the 1993 revised edition of A Short History of Financial Euphoria, John Kenneth Galbraith, one of the twentieth century's leading economists, concedes, "Recurrent speculative insanity and the associated financial deprivation and larger devastation are, I am persuaded, inherent in the system" (viii).  Fresh in his memory are Michael Milken, the "speculative orgy" (ix) in real estate in the 1980s accompanied by the S & L crisis, and the Salomon Brothers disaster.
These were only the most recent examples in an age-old pattern that has involved not just real estate, banks and junk bonds, but securities of all kinds, bank notes, art, tulip bulbs, joint-stock companies, and so on.  However similar to past instances - including the "Tulipomania" in the 1630s, the South Sea bubble in the 18th century, and the "roaring" 1920s - these episodes "always evoke surprise, wonder and enthusiasm anew" (11).
Galbraith doesn't just offer a laundry list of manic episodes, but identifies the characteristics they all have in common.  Though he knows that few will heed his warnings, Galbraith hopes to spare at least some people from the devastating consequences of financial manias and the ensuing crash, which in the past has taken the form of disgrace, impoverishment, exile, suicide, and imprisonment.
Psychology is a powerful element of speculative manias.  People benefiting from an inflating bubble chafe at any criticism.  Partly this is financial, but people also prefer to believe that they are getting rich due to their own superior talent or intelligence.  Others will reinforce such views in a capitalist economy, where wealth is often considered synonymous with brains and ability, not a result of dumb luck.  Money plus ego is a powerful combination.  Lucky naysayers will be merely ignored or dismissed; unlucky ones will be attacked, accused of envy, stupidity, or worse.
People often believe that there is "something new in the world" (18), some exception to the usual rules that will allow prices to continue rising quickly indefinitely.  The tulip bulb mania in the 1630s was particularly bewildering, since it was nothing but a flower that had long been grown in the Mediterranean.  However, they were new to Europe in the early 1600s, and people were more attracted to the blooms the rarer and stranger they were. 
Very often leverage is a cause and aggravating factor in a mania.  In the South Sea Bubble, for example, the company of the same name incurred large leverage owed by the British government in exchange for a monopoly on trade in certain areas.  In the years preceding the Great Depression, investors were able to borrow at a 10-to-1 ratio on margin, though only at a very high interest rate.  Debt played a large part in corporate takeovers and leveraged buyouts in the 1980s.
Frequently, financial "innovation" contributes to bubble, often involving "the creation of debt secured in greater or lesser adequacy by real assets" (19).  The joint-stock company had in fact been around for centuries by the time the South Sea company was formed, but memories are short and fuzzy in the financial industry, and investors believed that a creative new instrument would lead them to enormous wealth.  The "discovery" of junk bonds, high risk bonds accompanied by a high-yield, led to a bubble in that area the 1980s.
Government as Backstop
The state often ends up as the "recourse of last resort" (34) in the aftermath of mania turned to panic.  Insuring deposits, limiting bank leverage, creating regulatory regimes, enacting Keynesian economic stimulus, placing curbs on the use of margin, bailing out failed businesses - most or all of these forms of government intervention were in response to financial manias.
It's striking and heartbreaking how right Galbraith was, not only in his analysis, but in his knowledge that few will heed his warning, and certainly not enough to preempt future bubbles.  The ink was hardly dry in his book before the Dot Com bubble of the late-1990s began to inflate, because the revolutionary arrival of the internet made standard economic rules look old and analog (novelty); derivatives worth hundreds of trillions of dollars, more than all the assets in the world, built up before the 2008 crash (leverage); collecting and repackaging mortgages and selling them as securities relieved banks of the pesky burden of assessing borrowers (innovation).  The peculiar psychology that always helps to cause and reinforce bubble was present in these recent cases, just as it was in innumerable past instances.  Governments and central banks, as ever, were forced to avert worldwide disaster by massive intervention of all kinds.
Galbraith’s target audience is the odd stray investor, banker, or real estate developer that may be ambivalent in the face of a developing mania; he’s too realistic to believe that one book alone can wrestle with such powerful forces all working in the same direction.  By reading this short, useful book, you, dear reader, may yet avoid the next bubble and its inevitable aftermath.

Source: Galbraith, John Kenneth. A Short History of Financial Euphoria. New York: Viking Penguin, 1993.

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