A Short History Of Financial Euphoria by John Kenneth Galbraith

Summary

Every boom and bust cycle in the history of financial markets revolves around 2 things: mass psychology and leverage. Financial memory lasts about ~20 years before history repeats itself. This short book should be mandatory reading for anyone wanting to invest.

Key Takeaways

• “Anyone taken as an individual is tolerably sensible and reasonable – as a member of a crowd, he at once becomes a blockhead.” – Friedrich van Schiller
• Contributing to speculative euphoria and programmed collapse is the specious association of money and intelligence.
• Financial genius is before the fall.
• Financial operations do not lend themselves to innovation. All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets.
• The sight of some becoming so effortlessly affluent brought the rush to participate that further powered the upward thrust.
• For practical purposes, the financial memory should be assumed to last, at a maximum, no more than 20 years.
• There are few references in life so common as that to the lessons of history. Those who know it not are doomed to repeat it.
• The circumstances that induce the recurrent lapses into financial dementia: 
  1. Individuals and institutions are captured by the wondrous satisfaction of accruing wealth. 
  2. 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. 
  3. Out of that belief, thus instilled, then comes action – the bidding up of values, whether in land, securities, or, as recently, art. 
  4. The upward movement confirms the commitment to personal and group wisdom. And so on to the moment of mass disillusion and the crash. 
  5. 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. 
  6. Those who are involved never wish to attribute stupidity to themselves. Markets also are theologically sacrosanct.
  7. The least important questions are the ones most emphasized: What triggered the crash? Were there some special factors that made it so dramatic or drastic? Who should be punished?
• Let the following be one of the unfailing rules: there is the possibility, even the likelihood, of self-approving and extravagantly error-prone behaviour 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. 

What I got out of it

Friedrich van Schiller’s quote summarizes this book perfectly: “Anyone taken as an individual is tolerably sensible and reasonable – as a member of a crowd, he at once becomes a blockhead.”

Rather than explaining or trying to identify causes to the various booms and busts in financial history, Galbraith simply retells what happened – this is perhaps the most valuable way of teaching anything.

My biggest takeaway: “All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets.”
A real eye-opener.

Summary Notes

The Speculative Episode

“Anyone taken as an individual is tolerably sensible and reasonable – as a member of a crowd, he at once becomes a blockhead.” – Friedrich van Schiller

The speculation building on itself provides its own momentum. This process, once it is recognized, is clearly evident, and especially so after the fact. So also, if more subjectively, are the basic attitudes of the participants. These take two forms. There are those who are persuaded that some new price-enhancing circumstance is in control, and they expect the market to stay up and go up, perhaps indefinitely. Then there are those, superficially more astute and generally fewer in number, who perceive or believe themselves to perceive the speculative mood of the moment.

The rule, supported by the experience of centuries: the speculative episode always ends not with a whimper but with a bang.

The saved will be the exception to a very broad and binding rule. They will be required to resist two compelling forces: one, the powerful personal interest that develops in the euphoric belief, and the other, the pressure of public and seemingly superior financial opinion that is brought to bear on behalf of such belief.

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.

The Common Denominators

The first is the extreme brevity of the financial memory. In consequence, financial disaster is quickly forgotten.

There can be few fields of human endeavour 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 second factor contributing to speculative euphoria and programmed collapse is the specious association of money and intelligence.

Possession must be associated with some special genius. This view is then reinforced by the air of self-confidence and self-approval that is commonly assumed by the affluent.

We compulsively associate unusual intelligence with the leadership of the great financial institutions – the large banking, investment banking, insurance, and brokerage houses. The larger the capital assets and income flow controlled, the deeper the presumed financial, economic, and social perception.

Self-scrutiny: the greatest support to minimal good sense.

Only after the speculative collapse does the truth emerge. What was thought to be unusual acuity turns out to be only a fortuitous and unfortunate association with the assets.

Financial genius is before the fall.

In all speculative episodes, there is always an element of pride in discovering what is seemingly new and greatly rewarding in the way of a financial instrument or investment opportunity. The individual or institution that does so is thought to be wonderfully ahead of the mob. This insight is then confirmed as others rush to exploit their own, only slightly later vision. This perception of something new and exceptional rewards the ego of the participant, as it is expected also to reward his or her pocketbook. And for a while it does.

The rule is that financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design, one that owes its distinctive character to the aforementioned brevity of the financial memory.

All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets.

All subsequent financial innovation has involved similar debt creation leveraged against more limited assets with only modifications in the earlier designs. All crises have involved debt that, in one fashion or another, has become dangerously out of scale in relation to the underlying means of payment.

The final and common feature of the speculative episode – in stock markets, real estate, art, or junk bonds – is what happens after the inevitable crash. This, invariably, will be a time of anger and recrimination and also of profoundly unsubtle introspection. The anger will fix upon the individuals who were previously most admired for their financial imagination and acuity.

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. Nothing is more remarkable than this: in the aftermath of speculation, the reality will be all but ignored.

In the first place, many people and institutions have been involved, and whereas it is acceptable to attribute error, gullibility, and excess to a single individual or even to a particular corporation, it is not deemed fitting to attribute them to a whole community, and certainly not to the whole financial community.

The second reason that the speculative mood and mania are exempted from blame is theological. In accepted free-enterprise attitudes and doctrine, the market is a neutral and accurate reflection of external influences; it is not supposed to be subject to an inherent and internal dynamic of error. This is the classical faith.

The Classic Cases I: The Tulipomania; John Law And The Banque Royale

Speculation, it has been noted, comes when popular imagination settles on something seemingly new in the field of commerce or finance.

The immutable rules governing such episodes, each upsurge in prices persuaded more speculators to participate.

It is possible to see here again the constants in these matters. Associated with the wealth of the Banque Royale, Law was a genius – intelligence, as ever, derived from association with money. When the wealth dissolved and disappeared, he was a fugitive mercilessly reviled.

The Classic Cases II: The Bubble

The discovery that justified the boom, or, as always and more precisely, the rediscovery, was of the joint-stock company. Such companies went back a hundred years and more in England; suddenly, nonetheless, they now emerged as the new wonder of finance and the whole economic world.

As ever, the sight of some becoming so effortlessly affluent brought the rush to participate that further powered the upward thrust.

He later saved himself by turning in to the government his fellow conspirators in high places – a common modern design. Individuals associated with the company were expelled from Parliament, and directors and other officials (including Blunt) had their money and estates confiscated to provide some compensation to the losers.

All the predictable features of the financial aberration were here on view. There was large leverage turning on the small interest payments by the Treasury on the public debt taken over. Individuals were dangerously captured by belief in their own financial acumen and intelligence and conveyed this error to others. There was an investment opportunity rich in imagined prospects but negligible in any calm view of reality. Something seemingly exciting and innovative captured the public imagination, in this case the joint-stock company, although, as already noted, it was of decidedly earlier origin. And as the operative force, dutifully neglected, there was the mass escape from sanity by people in pursuit of profit.

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.

The American Tradition

Here is a seemingly innovative and wonderful financial instrument and here again the special wonder of leverage. This was debt in the form of the paper notes backed by markedly fewer solid assets, meaning hard money, than were available should all the notes be present at once for payment.

In 1837 came the inevitable disenchantment and collapse. A period of marked depression again ensued. This episode did, however, have two new features – one of them of continuing significance today. It clearly left behind the improvements, notably the canals, which had been the source of the speculative enthusiasm. And it introduced a distinctly modern attitude toward the loans that were outstanding: in the somber conditions following the crash, these were viewed with indignation and simply not repaid. Mississippi, Louisiana, Maryland, Pennsylvania, Indiana, and Michigan all repudiated their debts, although there was some mild later effort at repayment. Anger was expressed that foreign banks and investors should now, in hard times, ask for payment of debts so foolishly granted and incurred. 

A point must be repeated: only the pathological weakness of the financial memory, something that recurs so reliably in this history, or perhaps our indifference to financial history itself, allows us to believe that the modern experience of Third World debt, that now of Argentina, Brazil, Mexico, and the other Latin American countries, is in any way a new phenomenon.

From the neatly timed sequence of boom and bust in the last century came, in later years, another design to conceal the euphoric episode. That, in effect, was to normalize it. Boom and bust were said to be predictable manifestations of the business cycle. Mania there might be, as Joseph Schumpeter thus characterized it, but mania was a detail in a larger process, and the benign role of the ensuing contraction and depression was to restore normal sanity and extrude the poison, as some other scholars put it, from the system.

1929

How little, it will perhaps be agreed, was either original or otherwise remarkable about this history. 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.

Predictable also in the ensuing explanations of events was the evasion of the hard reality. This was in close parallel with what had occurred in previous episodes and was to have remarkable, sometimes fanciful, replication in 1987 and after. The market in October 1929 was said only to be reflecting external influences. During the previous summer there had been, it was belatedly discovered, a weakening in industrial production and other of the few currently available economic indices. To these the market, in its rational way, had responded. Not at fault were the speculation and its inevitable aftermath; rather, it was those deeper, wholly external influences. Professional economists were especially cooperative in advancing and defending this illusion. A few, when dealing with the history, still are.

As ever, the attention was on the instruments of speculation. Nothing was said or done or, in fact, could be done about the decisive factor – the tendency to speculation itself.

October Redux

For practical purposes, the financial memory should be assumed to last, at a maximum, no more than 20 years.

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. Thus impressed, it becomes bemused by the two further influences operating in this world that are greatly seductive of error. The first, as sufficiently noted, is the ease with which any individual, on becoming affluent, attributes his good fortune to his own superior acumen. And there is the companion tendency of the many who live in more modest circumstances to presume an exceptional mental aptitude in those who, however evanescently, are identified with wealth. 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.

Reprise

There are few references in life so common as that to the lessons of history. Those who know it not are doomed to repeat it.

The circumstances that induce the recurrent lapses into financial dementia: 

1. Individuals and institutions are captured by the wondrous satisfaction of accruing wealth. 
2. 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. 
3. Out of that belief, thus instilled, then comes action – the bidding up of values, whether in land, securities, or, as recently, art. 
4. The upward movement confirms the commitment to personal and group wisdom. And so on to the moment of mass disillusion and the crash. 
5. 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. 
6. Those who are involved never wish to attribute stupidity to themselves. Markets also are theologically sacrosanct.
7. The least important questions are the ones most emphasized: What triggered the crash? Were there some special factors that made it so dramatic or drastic? Who should be punished?

There is nothing in economic life so willfully misunderstood as the great speculative episode.

The only remedy, in fact, is an enhanced scepticism that would resolutely associate too evident optimism with probably 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 behaviour 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. Perhaps, indeed, there is opportunity. Maybe there is that treasure on the floor of the Red Sea. A rich history provides proof, however, that, as often or more often, there is only delusion and self-delusion.

Fools, as it has long been said, are indeed separated, soon or eventually, from their money.