Wednesday, July 8, 2009

The Madness of Crowds

The recent Rolling Stone article, "The Great American Bubble Machine", had good insights but was simplistic. Wall Street no doubt operates well below its potential; too often more of a tax on the system than facilitator of value creation.

Yet blaming the excesses 100% on Goldman and Wall Street is a stretch. There were other contributing factors (and not just things like the Federal Reserve and policymakers).

According to Charles Mackay, author of Extraordinary Popular Delusions and the Madness of Crowds (1841)*, the cause of bubbles is much broader than that.

In the book, Mackay says it is common after an episode of financial euphoria to place blame on those in power (execs, directors, politicians etc). That makes sense. Yet, he makes the point that "nobody seemed to imagine that the nation itself was as culpable" (John Kenneth Galbraith made a similar point about the Crash of 1929 and other episodes of financial euphoria).

Here is a more complete version of the quote from Mackay. In describing the aftermath of the South Sea Bubble, he said:

"Public meetings were held in every considerable town of the empire, at which petitions were adopted, praying the vengeance of the legislature upon 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. 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 above doesn't seem much different than the more recent housing and internet bubbles.

An inevitable painful economic contraction followed the South Sea Company bubble. As a result of the excesses, Parliament banned trading public companies for decades. Yet England's economy grew just fine in the following decades without any publicly traded shares.

"The people who are in the business of prospering because there's a lot of stock being traded in casino-like frenzy wouldn't like this example if they studied it enough. It didn't ruin England to have a long period when they didn't have publicly traded shares." - Charlie Munger in this UC Santa Barbara Speech

History repeats frequently when it comes to financial euphoria. If the seemingly obvious lessons from these episodes going back almost 400 years haven't been learned yet, chances are it isn't going to be any different the next time.

Galbraith explains why these bubbles recur so often with what he calls "financial memory" (or the lack thereof). Basically every 20 years the new players involved in the financial system, the so-called smart money**, become convinced "it's different this time" because of some new innovation, financial or otherwise (ie. The Joint Stock Corporation in the 1700's, holding companies in the 1920's, junk bonds in the 1980's, internet stocks in the late 90's, derivatives like CDO, CDS etc more recently). Here are some relevant excerpts from John Kenneth Galbraith's book, A Short History of Financial Euphoria:

"The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version. All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets." - John Kenneth Galbraith in A Short History of Financial Euphoria (Page 19)

"All [financial] crises have involved debt that, in one fashion or another, has become dangerously out of scale in relation to the underlying means of payment." - John Kenneth Galbraith 
in A Short History of Financial Euphoria (Page 20)

"Let it be emphasized once more, and especially to anyone inclined to a personally rewarding skepticism in these matters: 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." - John Kenneth Galbraith in A Short History of Financial Euphoria (Page 87)

One of the common elements in these episodes is the use of debt to finance speculation.

Historically, the so-called financial innovations from these episodes of euphoria have just been leverage in a different guise.


Three chapters of that book describe bubbles as far back as the Mississippi Company bubble in the 1700's, the South Sea Company bubble in 1700's, and the Dutch tulip mania in the 1600's.

** There is a natural tendency for the investing public to believe that those who have/manage lots of money must be the "smart money".

In reality, Galbraith says no such correlation exists if you pay attention to history. Financial heroes or geniuses before a bubble bursts become the villains after the crash. Those that are supposed to be the "smart money" seem to often get it very wrong.

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