this bubble world

The Reverend "I can calculate the motions of the heavenly bodies," said Isaac Newton, "but not the madness of the people." The madness of 1720 was puffing up the South Sea bubble. The "South Sea" was a metonym for the Spanish colonies in South America, to which the South Sea Company held a trade monopoly. This right was granted by the British government in return for the company assuming the government's war debt. Company shares were to be exchanged for government debt. The setup for the conversion was arcane, but the payoff would come from rising share prices. The details ensured that the government, the company, the company shareholders, and the debt holders all foresaw their fortunes in rising share prices. For a history of what emerged from the details, you rarely find better than Edward Chancellor's book <a href="http://www.amazon.com/Devil-Take-Hindmost-Financial-Speculation/dp/0452281806">Devil Take the Hindmost: A History of Financial Speculation</a>. Chancellor defines speculation by observing: <blockquote> The propensity to barter and exchange is an innate human characteristic. An inclination to divine the future is another deeply ingrained trait. Together they comprise the act of financial speculation. </blockquote> The bubble is an old symbol of human vanity, for the "evanescence of human life." A bubble "was sustained only by air or wind," and it "grew rapidly, delighting beholders with its reflective brilliance, but disappeared instantaneously." The blowhard behind the bubble of 1720, South Sea Company head John Blunt, huffed and puffed by two maxims. First, "That the advancing by all means of the price of stock, was the only way to promote the good of the company." Second, "the more confusion the better; People must not know what they do, which will make them the more eager to come into our measures; the execution of the scheme is our business." An anonymous pamphleteer understood the method: <blockquote> The additional rise of this stock above the true capital will be only imaginary; one added to one, by any rules of vulgar arithmetic, will never make three and a half; consequently, all the fictitious value must be a loss to some persons or other, first or last. The only way to prevent it to oneself must be to sell out betimes, and so let the Devil take the Hindmost. </blockquote> Yet the madness, as the then Chancellor of the Exchequer said, would yield to no one. "It became difficult to govern it; and let those gentlemen that opened the floodgates wonder at the deluge that ensued as much as they please it was not in one man's power, or in the power of the whole administration to stop it, considering how the world was borne away by the torrent." There are echoes of the recent past in this scheme from the eighteenth century, and others reverberate in every chapter of Chancellor's book. The basic institutions of finance ("banking, double–entry bookkeeping, joint–stock companies, bills of exchange, and stock markets") could all be found in the Netherlands over three–and–a–half centuries ago. In Amsterdam, annuities, municipal bonds, and maritime insurance were all traded. So, too, were "financial contracts which derive their value from an underlying asset," known now as derivatives. In the 1630s, as the first chapter recounts, the Dutch were overtaken by speculative mania for tulip bulbs. Each following chapter of Devil Take the Hindmost is set around a different mania: London's early stock exchange in the 1690s, the South Sea Bubble of 1720, emerging markets in the 1820s, English railways in the 1840s, America's first Gilded Age of the nineteenth century, American common stocks in the 1920s, leveraged buyouts and savings and loans in the 1980s, and Japan in the 1980s. Across speculative manias, the details vary, but a certain structure recurs: <blockquote> Charles Kindleberger, in his book <a href="http://www.amazon.com/Manias-Panics-Crashes-Financial-Investment/dp/0471467146/">Manias, Panics and Crashes</a>, suggests that speculative manias typically commence with a displacement which excites speculative interest. The displacement may come either from an entirely new object of investment or from the increased profitability of established investments. It is followed by positive feedback as rising share prices induce inexperienced investors to enter the stock market, and results in euphoria—a sign that investor's rationality is weakened. During the course of the mania, speculation becomes more diffuse and spreads to different classes of assets. New companies are floated to take advantage of the euphoria, investors leverage their gains using either financial derivatives or stock loans, credit becomes overextended, swindling and fraud proliferate, and the economy enters a period of financial distress which is the prelude to the onset of a crisis. </blockquote> In spite of a searing threat to wings built of wax, the heavens tempt. With fallen interest rates and rising asset prices, stratospheric fortunes can be seized by using other people's money. An example, from <a href="http://www.nybooks.com/articles/22655">a sober account of the recent ascension</a>: <blockquote> Suppose I have $100,000 of my own, and I see an opportunity to earn a 10 percent return. If it pans out, I make $10,000; if it earns nothing, I have my original stake. If it loses money, that comes out of my initial capital. But I have a shot at something bigger. I can borrow $900,000 at, say, 5 percent interest, and invest the whole million. If it earns the expected 10 percent, I have $1,100,000; I can pay off my debt, plus interest of $45,000, and have $155,000 left. I have earned 55 percent on my money. Only in America! Of course, if the investment earns zero, I must still pay back my borrowing, with interest, which leaves me with $55,000. I have lost almost half of my capital; and it could be worse. Risk cuts both ways. What I have just described is 10–to–1 leverage; the size of the total bet is ten times my equity. In the past, 10–to–1 leverage would have been about par for a bank. More recently, during the housing bubble that preceded the current crisis, many large financial institutions, including now–defunct investment banks such as Bear Stearns and Lehman Brothers, reached for 30–to–1 leverage, sometimes even more. So suppose I borrow $2.9 million to go with my very own $100,000—leverage of 29 to 1. I can buy $3 million of whatever asset I fancy. If it earns 10 percent, I repay the $2.9 million plus $145,000 in interest and go home with $255,000, having earned a mere 155 percent on my own capital. But now, if the investment earns zero, I have an asset worth $3 million and liabilities of $3.045 million. I am, to coin a phrase, bankrupt. And this is when I have invested in an asset that is worth, at the end of the year, exactly what I paid for it at the beginning. If I had bought a piece of a complicated package of subprime mortgages, as many investors did, it might be worth less than I paid for it a year ago. In fact, there might be no takers at all. There is no way of knowing what the package of mortgages might be worth in a couple of years; when it comes to raising more cash to cover my debt, it is worth essentially nothing, i.e., it can neither be sold nor used as collateral. Whoever lent me the $3.045 million, including interest, has lost the whole thing. </blockquote> Credit, according to Chancellor, was "the Siamese twin of speculation; they were born at the same time and exhibited the same nature; inextricably linked, they could never be totally separated." The Latin root from which "credit" is derived means "to believe." Credit, said James Grant, is "money of the mind." A market system depends upon credit, which extends between an irrevocable past and an uncertain future. Credit allows for companies to invest before the doors open and the revenue comes in. Credit supports consumer purchases before the paycheck is cut. Credit, it has been said, "takes the waiting out of wanting." Today's obligations are created with yesterday's expectations, and they will be tested by tomorrow's realities. Crises emerge when expectations diverge far enough from reality. The importance of uncertainty to the emergence of crisis was central to John Maynard Keynes. After publishing his General Theory, Keynes answered the first volley of reviews with a summary essay. In <a href="http://meanstochoose.org/keynes.html">"The General Theory of Employment"</a>, he condensed the basic ideas of his book. On uncertainty, he wrote: <blockquote> By "uncertain" knowledge, let me explain, I do not mean merely to distinguish what is known for certain from what is only probable. The game of roulette is not subject, in this sense, to uncertainty; nor is the prospect of a Victory bond being drawn. Or, again, the expectation of life is only slightly uncertain. Even the weather is only moderately uncertain. The sense in which I am using the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest twenty years hence, or the obsolescence of a new invention, or the position of private wealth–owners in the social system in 1970. About these matters there is no scientific basis on which to form any calculable probability whatever. We simply do not know. Nevertheless, the necessity for action and for decision compels us as practical men to do our best to overlook this awkward fact and to behave exactly as we should if we had behind us a good Benthamite calculation of a series of prospective advantages and disadvantages, each multiplied by its appropriate probability, waiting to be summed. </blockquote> Edward Chancellor elaborated on these insights in <a href="http://www.iimagazine.com/article.aspx?articleID=1234217">a 2007 Polk–award–winning piece</a>, "Ponzi Nation," on an impending crisis. Depending on the recent past in lending to an uncertain future, stability becomes destabilizing: <blockquote> Most economists see the world in terms of production and exchange, with money added on somewhat as an afterthought, but [economist Hyman] Minsky had <a href="http://www.levy.org/vdoc.aspx?docid=392">a very financial understanding of the capitalist system</a>. He looked at all participants in the economy—whether households, companies or financial institutions—in terms of their balance sheets and cash flows. [....] Balance sheets are composed of assets and liabilities, while cash flows validate the liabilities. Minsky's economy comprises what he calls a "web of interlocking commitments"—a vast and complex network of interconnected balance sheets and cash flows that is always changing and evolving. During periods of stability people feel more confident. According to Minsky, they respond by increasing their liabilities relative to income. Borrowing the phrase of Warren Buffett's mentor, the noted value investor Benjamin Graham, Minsky suggests that the "margin of safety" declines. Minsky created his own categories of balance sheets, which reflected the degree of risk market participants assumed. The riskiest of these he categorized as "Ponzi finance," named after the swindler Carlo Ponzi, who operated a notorious pyramid scheme in Boston in 1920. The key feature of a Ponzi scheme is its need to attract ever greater sums of money. Ponzi finance, in Minsky's terminology, describes the condition of those who can neither repay the principal on their liabilities nor meet their interest payments from current cash flows. To survive they must refinance, either by selling assets or by raising more debt. For this to happen asset prices must continue to rise. Ponzi finance typically emerges during a speculative bubble, when the margin of safety has been extinguished. </blockquote> If cash flows are sufficient to cover both the interest and the principal on its debts, a balance sheet is called "hedged." If cash flows cover only interest, with additional funds needed to cover principle, then a balance sheet is called "speculative." If cash flows cover neither interest nor principal, and debt payments must come from somewhere else, then a balance sheet is called "Ponzi." Raising funds from somewhere else requires either the sale of assets or further borrowing. The less a given cash flow can be relied upon to cover liabilities, the more a balance sheet is exposed to fluctuations in asset prices and interest rates. When indebted investors are forced to pay their debts, they can sell off their assets. But when a herd of investors sells off the same assets at the same time, their actions become self–defeating. The face value of their debts remain as the market value of their assets plunge. The resulting plunge in prices does more to wreck than repair their balance sheets. <a href="http://fraser.stlouisfed.org/meltzer/record.php?collection_references_id=4252">As seen in the Great Depression</a>, the more debtors pay, the more they owe. Such extremes of debt can be reached through financial innovation, another source of instability. Again, from Chancellor's "Ponzi Nation": <blockquote> Stability is not the only factor that induces people to engage in risky behavior. Competition also plays a role. Minsky observed that financial institutions compete furiously, both when investing and providing credit to others. We read a lot nowadays about Schumpeter's notion of "creative destruction" in relation to developments in technology. Minsky saw this in a rather different light. "Nowhere," he wrote in "Schumpeter and Finance," a 1993 essay, "is evolution, change and Schumpeterian entrepreneurship more evident than in banking and finance and nowhere is the drive for profits more clearly a factor in making for change." Anyone who has spent some time observing the behavior of Wall Street will understand what he means. In the financial world, according to Minsky, competition goes hand in hand with innovation. This tends to increase the availability of finance, which boosts the demand for existing assets, pushing up their prices. Higher asset prices, in turn, allow even more debt to be taken on, thereby increasing the demand for finance. There is, however, a dark side to financial innovation: It can be used to bypass existing regulations intended to safeguard the credit system. In his 1982 book, Can "It" Happen Again?, Minsky observed that in periods of stability there is "the reappearance of prohibited practices in new and unprohibited forms." </blockquote> As innovation voids the letter of the law, so fraud violates the spirit of the law. As already noted, fraud is one of the symptoms of speculative manias. The rate of theft, or the "bezzle," as John Kenneth Galbraith dubbed it in his classic history <a href="http://www.amazon.com/Great-Crash-1929-Kenneth-Galbraith/dp/0395859999/">The Great Crash 1929</a>, thrives in a boom: <blockquote> To the economist embezzlement is the most interesting of crimes. Alone among the various forms of larceny it has a time parameter. Weeks, months, or years may elapse between the commission of the crime and its discovery. (This is a period, incidentally, when the embezzler has his gain and the man, who has been embezzled, oddly enough, feels no loss. There is a net increase in psychic wealth.) At any given time there exists an inventory of undiscovered embezzlement in—or more precisely not in—the country's businesses and banks. This inventory—it should perhaps be called the bezzle—amounts at any moment to many millions of dollars. It also varies in size with the business cycle. In good times people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression all this is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks. [....] Just as the boom accelerated the rate of growth, so the crash enormously advanced the rate of discovery. Within a few days, something close to universal trust turned into something akin to universal suspicion. </blockquote> Speculation, writes Chancellor, "is anarchic, irreverent, and antihierarchic." It "grew out of the crowds and bustle of the Renaissance fairs and carnivals, and although by the seventeenth century the carnival was in decline and fairs had been replaced by permanent stock exchanges, the carnival spirit lingered in the markets." However profane, "speculation is not simply about greed." It retains a "Utopian yearning;" it "has always been, and remains to this day, the Carnival of Capitalism, a '<a href="http://www.newadvent.org/cathen/06132a.htm">Feast of Fools</a>.'" 2009-07-08T12:23:03Z 2009-07-08 5 this bubble world

2009-10-10T01:55:18Z