Financial Euphoria

Timothy Wilken

What is coming next? Some of our  wisest humans warn that we are rapidly approaching a negative turning  point in our economy. This downturn will result in a major deflation.  What is deflation?

How does Deflation work in our economy? How might it affect my life? Good questions!

To provide us with some answers will require three voices—the first voice is spoken by a female, she is a economic realist who goes by the name of Stoneleigh. Stoneleigh2010 says deflation is already here and ignoring it would be really really stupid!

The second voice is that of a well educated, very successful individual known as Philip M. Halperin. He has lived and worked all over the world in many different fields, holds advanced degrees in three different subjects, and currently consults for Global Banking and Business.

Mr. Halperin1999 provides a review of John Kenneth Galbraith’s small  book, A Short History of Financial Euphoria originally published in 1990. It is considered one of the best introductions to understanding deflation.

And our third voice will be John Kenneth Galbraith1990 with the words from the first chapter from his book. From the Wikipedia 2010:

“Galbraith was a prolific author who produced four dozen books and over a thousand articles on various subjects. Among his most famous works was a popular trilogy on economics, American Capitalism (1952), The Affluent Society (1958), and The New Industrial State (1967). He taught at Harvard University for many years. Galbraith was active in politics, serving in the administrations of Franklin D. Roosevelt, Harry S. Truman, John F. Kennedy and Lyndon B. Johnson; and among other roles served as United States Ambassador to India under Kennedy.”

Without further ado, let’s get started with an overview from Stoneleigh.

Stoneleigh: It is surprising how many commenters, many of whom have for the longest time dismissed the possibility of deflation, often in a smugly superior manner, are ignorant of what it actually is. They look at Japan and ask how a country can become mired in a long and drawn-out deflation, and why the Japanese experience is so different from the rapid and accelerating deflationary spiral of the Great Depression.

They assume that central bankers possess the tools to prevent deflation, which suggests that they think those in control in other times or places must simply be too stupid to employ them. If it were so simple to prevent deflation then it would never have occurred anywhere, and yet it has.

Many persist in viewing deflation as a price phenomenon, rather than as the monetary phenomenon it always is. They cling to the notion of the fundamentals driving the credit markets, and then wonder why it is impossible to make accurate predictions. In short, the causation runs the other way. The availability of credit drives the real economy, because credit expansions are Ponzi schemes that generate large swings of positive-feedback (self-fulfilling prophecies) in both directions. It is only the context and scale that are different.

Japan’s experience of deflation has been blunted, so far, by the enormous quantity of money that they had available to burn through, which enabled them to put off addressing the bad debt in their banking system, and by the availability of a booming global economy, which allowed them to generate wealth from exporting goods to consumer societies. We do not have these luxuries. In place of a vast pile of money, we have a vast sinkhole of debt at every level – personal, corporate, governmental.

We will not have the ability to export, partly because we produce very little of value, but also because the global market will not have the purchasing power to allow the export model to survive in any case. We will be fully exposed in the short term to the logic of our credit expansion business model, which creates primarily virtual wealth, whereas Japan was not. We will resemble Argentina (only worse), not Japan.

It is not that deflation is poorly understood, except by the mainstream, which unfortunately includes most economists. There are very clear and comprehensive explanations available for what deflation is and therefore why it is inevitable. We here at TAE have consistently, since our inception, pointed out the mechanism behind this critical aspect of our future. See for instance At the Top of the Great Pyramid, on the nature and critical importance of Ponzi dynamics, or The Big Picture According to TAE.

We have pointed out that credit expansion creates multiple and mutually-exclusive claims to the same pieces of underlying wealth-pie, thereby creating a fictitious wealth that will implode once people realize its existence and reality. Deflation is the chaotic elimination of excess claims to underlying real wealth – the collapse of a money supply that has come to be dominated by ephemeral credit and debt.

For those who are interested, one of the most concise formulations of inflation and deflation has been available for many years in the form of JK Galbraith’s A Short History of Financial Euphoria, a history of the periodic rediscovery of leverage (and the consequences thereof) written in 1990. It is short, very clear and readable, and highly recommended. Galbraith points out that financial innovation has led to the formation of many bubbles throughout history, and that the collapse of the unpayable debt thereby created, which is deflation by definition, always follows.

JK Galbraith: “A point must be repeated: only the pathological weakness of the financial memory…allows us to believe that the modern experience of….debt…is in any way a new phenomenon.”

Our current credit expansion is different only in scale, in quantity, not in quality, from what has happened time and time again in human history. … … You can read the full article at The Automatic Earth

Our next voice is that of a 48 yo male who lives in Europe and speaks 5 languages, Halperin reviewed Stoneleigh’s recommended book eleven years before she recommended it. In January 1999, Philip. M. Halperin wrote the following review of  John Kenneth Galbraith’s A Short History of Financial Euphoria(1990):

Halperin: If you can read only one financial disaster book, this is probably the one to pick. A short (110 pp.) and fast read, it is an elegant summary of past financial manias, with a good analysis and summary of the underlying themes common to all. Unfortunately, it was written before the current (1998) fun and games, but as one reads the analyses of past third world debt euphoria and past stock market bubbles (recall the phrase “new paradigm” that was common in early 1998?), one cannot but marvel at the mindless and memoryless behaviour that has typified the recent financial era.

This book works on several levels. Most importantly, Galbraith describes the characteristics of the mass psychosis that typifies the period of financial euphoria that precedes the inevitable crash. In the first instance, the general paper profit-making becomes (temporarily) a self-fulfilling prophecy, that leads to self-sustaining and self-congratulatory behaviour, what Galbraith terms “a vested interest in error” on the part of the participants, who, as members of a crowd are willing to suspend disbelief: Galbraith quotes Walter Bagehot – “all people are most credulous when they are most happy”. To this, the author adds an elegant statement of the power of the vested interests who condemn and criticise doubting voices in an almost tribal manner.

Galbraith does not spare sarcasm in his characterisation of the attitudinal follies that lead to and sustain these episodes. He is brutally succinct in describing the extreme shortness of financial memory and the ignorance of history which leads to the same mistakes being repeated under similar circumstances within a few short years. (Regrettably, he does not discuss the degree to which this is institutionalised, on the one hand by the ageist behaviour of the financial community in hiring traders and managers and laying off senior people who have seen this before, and on the other by the short time horizons mandated in current historical back-testing requirements). He also lambastes the specious attribution of mental acumen to financial success, “accordingly, possession [of money] must be associated with some special genius.”

Galbraith writes: “In practice, the … individuals at the top of these institutions are often there because, as happens regularly in great organizations, theirs was mentally the most predictable and, in consequence, bureaucratically the least inimical of the contending talent.

“…they are then endowed with the authority that encourages acquiescence from their subordinates and applause from their acolytes and and that excludes adverse opinion or criticism. They are thus admirably protected in what may be a serious commitment to error.”

Relatedly, he describes the special deference accorded to heads of large financial institutions and lenders in particular, which creates an aura close to infallibility in marked contrast to the actual ability and judgement of those individuals:

The second important insight of the book is the summary of common denominators in all such episodes, many of which are visible in the period we are currently experiencing. Among these (and probably inevitable given the shortness of financial memory) is the appearance of specious financial innovation. This is treated at length in the discussions of the South Sea Bubble, John Law, and Miliken (regrettably, the book antedated exotic options and submerging markets hedge funds). Galbraith argues that most of these seeming innovations were essentially variations on the theme of leverage. In some cases, there was not even the semblance of innovation, as in the 1920s. Finally, there are some interesting parallels to be drawn from the terrible outcomes of speculative enthusiasm in investment in developing-country infrastructure, such as the historic collapse of British investments in the United States in 1837:

Galbraith writes: “It [the collapse of 1837] 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…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…allows us to believe that the modern experience of Third World debt…is in any way a new phenomenon.”

The Short History of Financial Euphoria is an elegant tour-de-force of financial folly, and should be read, and re-read.

The following is the first chapter of Galbraith’s tour-de-force.

Financial Euphoria

John Kenneth Galbraith

That the free-enterprise economy is given to recurrent episodes of speculation will be agreed. These great events and small, involving bank notes, securities, real estate, art, and other assets or objects are, over the years and centuries, part of history. What have not been sufficiently analyzed are the features common to these episodes, the things that signal their certain return and have thus the considerable practical value of aiding understanding and prediction. 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.

There are, however, few matters on which such a warning is less welcomed. In the short run, it will be said to be an attack, motivated by either deficient understanding or uncontrolled envy, on the wonderful process of enrichment. More durably, it will be thought to demonstrate a lack of faith in the inherent wisdom of the market itself.

The more obvious features of the speculative episode are manifestly clear to anyone open to understanding. Some artifact or some development, seemingly new and desirable tulips in Holland, gold in Louisiana, real estate in Florida, the superb economic designs of Ronald Reagan—captures the financial mind or perhaps, more accurately, what so passes. The price of the object of speculation goes up. Securities, land, objects 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.

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. It is adjusting to a new situation, a new world of greatly, even infinitely increasing returns and resulting values. 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. They are in to ride the upward wave; their particular genius, they are convinced, will allow them to get out before the speculation runs its course. They will get the maximum reward from the increase as it continues; they will be out before the eventual fall.

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. Something, it matters little what—although it will always be much debated—triggers the ultimate reversal. Those who had been riding the upward wave decide now is the time to get out. Those who thought the increase would be forever find their illusion destroyed abruptly, and they, also, respond to the newly revealed reality by selling or trying to sell. Thus the collapse. And thus the rule, supported by the experience of centuries: the speculative episode always ends not with a whimper but with a bang. There will be occasion to see the operation of this rule frequently repeated.

So much, as I’ve said, is clear. Less understood is the mass psychology of the speculative mood. When it is fully comprehended, it allows those so favored to save themselves from disaster. Given the pressure of this crowd psychology, however, 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. Both stand as proof of Schiller’s dictum that the crowd converts the individual from reasonably good sense to the stupidity against which, as he also said, “the very Gods Themselves contend in vain.”

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. The very increase in values thus captures the thoughts and minds of those being rewarded. Speculation buys up, in a very practical way, the intelligence of those involved.

This is particularly true of the first group noted above—those who are convinced that values are going up permanently and indefinitely. But the errors of vanity of those who think they will beat the speculative game are also thus reinforced. As long as they are in, they have a strong pecuniary commitment to belief in the unique personal intelligence that tells them there will be yet more. In the last century, one of the most astute observers of the euphoric episodes common to those years was Walter Bagehot, financial writer and early editor of The Economist. 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. Or their motivation is deeply suspect. In the winter of 1929, Paul M. Warburg, the most respected banker of his time and one of the founding parents of the Federal Reserve System, spoke critically of the then-current orgy of “unrestrained speculation” and said that if it continued, there would ultimately be a disastrous collapse, and the country would face a serious depression. The reaction to his statement was bitter, even vicious. He was held to be obsolete in his views; he was “sandbagging American prosperity”; quite possibly, he was himself short in the market. There was more than a shadow of anti-Semitism in this response.

Later, in September of that year, Roger Babson, a considerable figure of the time who was diversely interested in statistics, market forecasting, economics, theology, and the law of gravity, specifically foresaw a crash and said, “it maybe terrific.” There would be a 60- to 80-point drop in the Dow, and, in consequence, “factories will shut down…men will be thrown out of work…the vicious circle will get in full swing and the result will be a serious business depression.” Babson’s forecast caused a sharp break in the market, and the reaction to it was even more furious than that to Warburg’s. Barron’s said he should not be taken seriously by anyone acquainted with the “notorious inaccuracy” of his past statements. The great New York Stock Exchange house of Hornblower and Weeks told its customers, in a remarkably resonant sentence, that “we would not be stampeded into selling stocks because of a gratuitous forecast of a bad break in the market by a well-known statistician.” Even Professor Irving Fisher of Yale University, a pioneer in the construction of index numbers, and otherwise the most innovative economist of his day, spoke out sharply against Babson. It was a lesson to all to keep quiet and give tacit support to those indulging their euphoric vision.

Without, I hope, risking too grave a charge of self-gratification, I might here cite personal experience. In the late winter of 1955, J. William Fulbright, then the chairman of the Senate Banking and Currency Committee, called hearings to consider a modest speculative buildup in the securities market. Along with Bernard Baruch, the current head of the New York Stock Exchange, and other authorities real or alleged, I was invited to testify. I refrained from predicting a crash, contented myself with reminding the committee at some length as to what had happened a quarter of a century earlier, and urged a substantial protective increase in margin requirements down payments on the purchases of stocks. While I was testifying, the market took a considerable tumble.

The reaction in the next days was severe. The postman each morning staggered in with a load of letters condemning my comments, the most extreme threatening what the CIA was later to call executive action, the mildest saying that prayers were being offered for my richly deserved demise. A few days later I broke my leg in a skiing accident, and newsmen, seeing me in a cast, reported the fact. Letters now came in from speculators saying their prayers had been answered. In a small way I had done something for religion. I posted the most compelling of the communications in a seminar room at Harvard as an instruction to the young. Presently the market recovered, and my mail returned to normal.

On a more immediately relevant occasion, in the autumn of 1986, my attention became focused on the speculative buildup then taking place in the stock market, the casino manifestations in program and index trading, and the related enthusiasms emanating from corporate raiding, leveraged buyouts, and the mergers-and-acquisitions mania. The New York Times asked me to write an article on the subject; I more than willingly complied.

Sadly, when my treatise was completed, it was thought by the Times editors to be too alarming. I had made· clear that the markets were in one of their classically euphoric moods and said that a crash was inevitable, while thoughtfully avoiding any prediction as to precisely when. In early 1987, the Atlantic published with pleasure what the Times had declined. (The Times later relented and arranged with the Atlantic editors for publication of an interview that covered much of the same ground.) However, until the crash of October 19 of that year, the response to the piece was both sparse and unfavorable. “Galbraith doesn’t like to see people making money” was one of the more corroding observations. After October 19, however, almost everyone I met told me that he had read and admired the article; on the day of the crash itself, some 40 journalists and television commentators from Tokyo, across the United States, and on to Paris and Milan called me for comment. 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. Before going on to look at the great speculations of the past, I would like further to identify the forces that initiate, sustain, and otherwise characterize the speculative episode and which, when they recur, always evoke surprise, wonder, and enthusiasm anew. All this we will then see in nearly invariant form occurring again and again in the history I here record.

Google John Kenneth Galbraith . . . Google Philip. M. Halperin . . . Google Stoneleigh