Sunday, September 11, 2011

A Short History Of Financial Euphoria: Chapter 2

While there is no doubt that free enterprise gives rise to recurrent episodes of speculation, the features that are common to these episodes are rarely analyzed, according to the author of A Short History of Financial Euphoria, John Kenneth Galbraith. This book from 1990 offers perspectives on bubbles that are still useful today. By paying attention to the signs, "there is a chance - a slim chance, to be sure, given the sweeping power of financial euphoria - that otherwise vulnerable individuals will be warned."

Contributing to the euphorias are two factors that receive very little attention. The first is that history counts for little in the finance industry. In no other industry do memories appear to be so short. The wheel is constantly re-invented, yet each "wheel" is simply another method of employing an old trick: extracting more debt from limited assets.

The second factor has to do with society's perception of a strong link between money and intelligence. There very well may be a multitude of intelligent people with lots of money, but this is not often the case more often than presumed. In many cases money has been inherited, or its acquirer has not been one to be bothered by legal constraints. In the case of large companies with money, those currently running it are likely in their executive roles because they were bureaucratically the least inimical, and are likely to command authority rather than solicit adverse opinions or criticisms.

On the subject of the common denominators of euphorias, Galbraith cites a number of observations. First, there's always something supposedly new or innovative. Buyers feel pride in discovering it, and more pride still when it is found that others have made the discovery some time later. As others rush in and the price continues to rise, both the pocketbook and the ego are helped.

But experience establishes that there is no real financial innovation. From the time banks discovered they could print more notes than they had on deposit (until such time as high leverage resulted in a run on the bank) to Michael Milliken's junk bond issuances (more risk garnering a higher yield...hardly innovative stuff), these "innovations" are only new ways of using leverage to increase profits.

Once the bubble has popped, one can also be sure of the way the population will react. There will be blame (and sometimes even jail-time) for the leaders of the euphoria, and there will be talk of regulating whatever the "new" instrument was. Absent from the discussion, however, will be the rampant speculation and aberrant optimism of the masses.

Galbraith argues that there are two reasons for this. First, it seems acceptable in our society to blame an individual or corporation but not an entire community, even if the stupidity of the latter is manifest. Second, there is a theological acceptance that the market is accurate, and therefore some external abuse must have hampered its normally perfect performance.

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