A Short History of Financial Euphoria (Business)

by John Kenneth Galbraith

Anyone taken as an individual is tolerably sensible and reasonable—as a member of a crowd, he at once becomes a blockhead. —FRIEDRICH VON SCHILLER,

Regulation and more orthodox economic knowledge are not what protect the individual and the financial institution when euphoria returns, leading on as it does to wonder at the increase in values and wealth, to the rush to participate that drives up prices, and to the eventual crash and its sullen and painful aftermath. There is protection only in a clear perception of the characteristics common to these flights into what must conservatively be described as mass insanity. Only then is the investor warned and saved.

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.

For built into this situation is the eventual and inevitable fall. Built in also is the circumstance that it cannot come gently or gradually. When it comes, it bears the grim face of disaster. That is because both of the groups of participants in the speculative situation are programmed for sudden efforts at escape.

the speculative episode always ends not with a whimper but with a bang.

Although only a few observers have noted the vested interest in error that accompanies speculative euphoria, it is, nonetheless, an extremely plausible phenomenon. Those involved with the speculation are experiencing an increase in wealth—getting rich or being further enriched. No one wishes to believe that this is fortuitous or undeserved; all wish to think that it is the result of their own superior insight or intuition.

Speculation buys up, in a very practical way, the intelligence of those involved.

To him we are indebted for the observation that “all people are most credulous when they are most happy.”

Strongly reinforcing the vested interest in euphoria is the condemnation that the reputable public and financial opinion directs at those who express doubt or dissent.

It is said that they are unable, because of defective imagination or other mental inadequacy, to grasp the new and rewarding circumstances that sustain and secure the increase in values.

Clearly, given the nature of the euphoric mood and the vested interest therein, the critic must wait until after the crash for any approval, not to say applause.

To summarize: 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 first is the extreme brevity of the financial memory. In consequence, financial disaster is quickly forgotten.

There can be few fields of human endeavor in which history counts for so little as in the world of finance.

The second factor contributing to speculative euphoria and programmed collapse is the specious association of money and intelligence.

Having money may mean, as often in the past and frequently in the present, that the person is foolishly indifferent to legal constraints and may, in modern times, be a potential resident of a minimum-security prison.

The rule is that 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.

This was true in one of the earliest seeming marvels: when banks discovered that they could print bank notes and issue them to borrowers in a volume in excess of the hard-money deposits in the banks’ strong rooms.

All subsequent financial innovation has involved similar debt creation leveraged against more limited assets with only modifications in the earlier design.

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.

Speculators may do no harm as bubbles on a steady stream of enterprise. But the position is serious when enterprise becomes the bubble on a whirlpool of speculation. —JOHN MAYNARD KEYNES, The General Theory of Employment Interest and Money

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

Prices were extravagant; by 1636, a bulb of no previously apparent worth might be exchanged for “a new carriage, two grey horses and a complete harness.”

Charles Mackay, in Extraordinary Popular Delusions and the Madness of Crowds, his classic book on speculation (and other departures from reason), tells gleefully a story first told in Blainville’s Travels, that of a young sailor who, for bringing word of a shipment of goods from the Levant, was rewarded by a merchant with a fine red herring for his breakfast. Presently the merchant, who was much involved in the tulip speculation, found missing a bulb of a Semper Augustus worth some 3,000 florins, an unimaginable $25,000 to $50,000 today. When he sought out the sailor to question him, the latter was discovered contentedly finishing the onion, as he had supposed it to be, along with the fish.

In an especially memorable passage, Mackay tells of the mood of the country as the speculation continued: The demand for tulips of a rare species increased so much in the year 1636, that regular marts for their sale were established on the Stock Exchange of Amsterdam, in Rotterdam, Harlaem, Leyden, Alkmar, Hoorn, and other towns…. At first, as in all these gambling mania, confidence was at its height, and every body gained. The tulip-jobbers speculated in the rise and fall of the tulip stocks, and made large profits by buying when prices fell, and selling out when they rose. Many individuals grew suddenly rich. A golden bait hung temptingly out before the people, and one after the other, they rushed to the tulip-marts, like flies around a honey-pot. Every one imagined that the passion for tulips would last for ever, and that the wealthy from every part of the world would send to Holland, and pay whatever prices were asked for them. The riches of Europe would be concentrated on the shores of the Zuyder Zee, and poverty banished from the favored clime of Holland. Nobles, citizens, farmers, mechanics, seamen, footmen, maid-servants, even chimney-sweeps and old clotheswomen, dabbled in tulips. People of all grades converted their property into cash, and invested it in flowers. Houses and lands were offered for sale at ruinously low prices, or assigned in payment of bargains made at the tulip-mart. Foreigners became smitten with the same frenzy, and money poured into Holland fr...

It was wonderful; never in their history had the Dutch seemed so favored. In keeping with the immutable rules governing such episodes, each upsurge in prices persuaded more speculators to participate. This justified the hopes of those already participating, paving the way for yet further ...

In 1637 came the end. Again the controlling rules were in command. The wise and the nervous began to detach, no one knows for what reason; others saw them go; the rush to sell became a...

M issing from the history of the Tulipomania and the predictable circumstances associated with it, as with all great speculations, are the names of the major players.

We are more fortunate in the next of the classic episodes; it is dominated by one of the central figures in all financial history, that of the Scotsman John Law.

The proceeds of the sale of the stock in the Mississippi Company went not to search for the as yet undiscovered gold, but to the government for its debts. The notes that went out to pay the debt came back to buy more stock. More stock was then issued to satisfy more of the intense demand, the latter having the effect of lifting both the old and the new issues to ever more extravagant heights. All the notes in this highly literal circulation were, it was presumed, backed by coin in the Banque Royale, but the amount of the coin that so sustained the notes was soon minuscule in relation to the volume of paper. Here was leverage in a particularly wondrous form.

In 1720, the end came. The leverage went sharply into reverse, as was to be the experience in a hundred such occurrences, great and small, in the next 250 years.

The precipitating factor, it is said, was the decision of the Prince de Conti, annoyed by his inability to buy stock, to send his notes to the...

Whatever the facts, there was a run on the bank—people seeking to convert their notes not into the stock of the Mississippi Company but into gold.

Next came the predictable anger, the search for the individual or institution to be blamed. The search did not have far to go. In the preceding months a grateful sovereign had raised the foreigner, gambler, and escaped murderer John Law to the highest public post in the kingdom, where, in fact, he instituted some useful economic and tax reforms: idle lands of the clergy were given to the peasants, local tolls were abolished, and tariffs reduced.

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.

N or was the South Sea Company the only opportunity. Its success spawned at least a hundred imitators and hitchhikers, all hoping to take part in the boom.

However, by this time the end of that company was in sight. The stock went into a tail-spin, partly, without doubt, the result of inspired profit-taking by those inside and at the top. By September it was down to £175, by December to £124. Heroic efforts, rhetorical and otherwise, were made to sustain and revive confidence, including an appeal for help to the newly formed Bank of England. Eventually, with some support from the government, shares leveled off at around £140, approximately one-seventh of their peak value. As before and later, once the crash comes, it overrides all efforts to reverse the disaster.

There soon followed the search for scapegoats; it was fierce, even brutal. Blunt, by now Sir John Blunt, narrowly escaped death when an assailant, presumably a victim, sought to shoot him down in a London street.

Exceptional, however, was the notice this latter circumstance was eventually accorded. Charles Mackay, in a singularly acute account of the South Sea Bubble, pointed out the truth: [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. 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 financial memory is brief, but subjective public attitudes can be more durable.

In 1890, the Bank of England had to pull the great house of Baring Brothers back from bankruptcy caused by its perilous involvement in Argentine loans. No one should suppose that the modern misadventures in Third World loans are at all new.

It then seemed a minor step for the colonial government to issue paper notes promising eventual payment in gold or silver; for two decades thereafter the paper circulated side by side and at par with the metals on the basis of this promise. Here 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 presented at once for payment.

Eventually, in 1751, the Parliament in London forbade the paper issues in New England and, a little later, elsewhere in the colonies. There was sharp anger over this action; paper and its associated leverage remained strongly in the minds of the American colonists as an economic good.

The word panic as it pertained to money entered the language. Later, in eager search of milder, less alarming reference, crisis, depression, recession, and now, of course, growth adjustment came successively to denote the economic aftermath.

F or a decade after the bursting of the debt bubble in 1837, business conditions were depressed in the United States.

Then, after another 10 years, public memory faded again. Confidence returned, bank charters exfoliated, bank notes once more became available to finance speculation, and in 1857 there was another panic and collapse.

The preceding years were ones of generally increasing and pyramiding values and generally euphoric conditions in manufacturing, farming, and public construction. Increasing values again brought increasing values. As with the canals and turnpikes, it was transportation, this time the railroads, that was the focus of the speculation. Here the horizons seemed truly without limit.

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. University courses on business cycles now accepted as routine the alternation between high, even extravagant, expectations and low.