Why Don't We Know A Bubble When We See One?

N'en déplaise à ces fous nommés sages de Grèce,
En ce monde il n'est point de parfaite sagesse;
Tous les hommes sont fous, et malgré tous leurs soîns
Ne diffèrent entre eux que du plus ou du moins.
- BOILEAU

Whatever these crazy appointed sages of Greece,
In this world there is no perfect wisdom;
All men are mad, and despite all their care
Differ among themselves as more or less.


So reads the somewhat cynical inscription to Extraordinary Popular Delusions and the Madness of Crowds, written in 1841 by Charles Mackay.  It was a book about bubbles.  The first two chapters are about financial bubbles.

Cross-posted at The National Gadfly

The Mississippi Scheme.

In 1717 John Law, a gambler took purchase of a bankrupt company that had claimed property rights over a large swath the Louisiana / Mississippi.  He then curried the favor of the governing body, a regent ill-disposed to hard work and looking for a quick fix to buck up the economy and placate the masses.  Law came up with the idea of speculating on the future wealth that the French territories would yield and he began trading shares of his company, basing value upon those imagined riches.The company stock price skyrocketed but of course the asset value of the company was considerably lower.  In nine months, share prices went from 500 livres to 15,000 livres.

(Gee...doesn't this sound familiar?)

People were falling all over themselves to get shares of this stock.  The most intelligent, the most reasoned and the most critical of the entire operation found themselves succumbing to the irresistible temptation to invest in this company that was making people money, hand over fist.

The price of shares sometimes rose ten or twenty per cent in the course of a few hours, and many persons in the humbler walks of life, who had risen poor in the morning, went to bed in affluence. An extensive holder of stock, being taken ill, sent his servant to sell two hundred and fifty shares, at eight thousand livres each, the price at which they were then quoted. The servant went, and, on his arrival in the Jardin de Soissons, found that in the interval the price had risen to ten thousand livres. The difference of two thousand livres on the two hundred and fifty shares, amounting to 500,000 livres, or 20,000l. sterling, he very coolly transferred to his own use, and giving the remainder to his master, set out the same evening for another country.

They should have known better.  They did know better and participated anyway because the money was too good.  They would have been fools not to, or so the thinking was at that time.
Two sober, quiet, and philosophic men of letters, M. de la Motte and the Abbé Terrason, congratulated each other, that they, at least, were free from this strange infatuation. A few days afterwards, as the worthy abbé was coming out of the Hôtel de Soissons, whither he had gone to buy shares in the Mississippi, whom should he see but his friend La Motte entering for the same purpose.

"Ha!" said the abbé smiling, "is that you?"

"Yes," said La Motte, pushing past him as fast as he was able; "and can that be you?"


The government sought to buy up shares because of its own debt issues, while the share price was high.  Then, the company's creditors bought back the shares from the government with bonds and debt papers (debt-for-equity).  All government debt became property of the company, so shareholders and government climbed into a fictitious economy based on juggled books, projected earnings and debt-as-commodity.

When it all came crashing down, John Law fled the country and they went into a depression.

(Sounding at all familiar?  Anyone?)

The South Seas Bubble. (Yep, they even called it a bubble 167 years ago)

In England, 1711 England and Spain were fighting over South America.  To fund the war, Lord Treasurer Robert Harley established what was on the face, a trading company.  It was really a way to fund the national debt.  They sold shares in the company which was really debt-as-equity and promised investors an annual return plus their original investment when the vast riches of South America arrived. It took longer than projected, so the government decided to issue more shares of debt-as-equity because it seemed like such a good idea the first time.

Eventually, the dispute with Spain was resolved but not in England's favor.  Only one ship per year was allowed to import to England from South America.  The failed returns on the massive speculative investment caused the economy to crash.  The losses could have been worse, but the company did manage to dabble in slave trading as a secondary line of revenue along this route.

(So...a military-industrial complex that feeds off the population through the government funding is dabbling in human misery as an additional revenue stream in order to keep the bubble from bursting.  God! Does this ever sound familiar?)

These two bubbles happened one after the other, in two countries that are right next to each other.  The first one was even called a bubble.  The scenarios are virtually identical.  The government partners with private industry to convince the country to invest in speculative, future goods in exchange for debt today.  The French had every option to see this coming and still fell for it.

Wow.  It makes me wonder just exactly how old this scam is.

I've been thinking about exactly 'how?' and 'why?' this happens - over and over again.  I have a couple of thoughts.

On the 'how?' of it, I think back to something I observed in the Army.  Paperwork.  The Army lives on paperwork.  They have forms for everything, in triplicate.  The Army has been around for centuries, so I would think they should have been the very best at paperwork.  The opposite was true.  It was always screwed up.

'FUBAR' (F'd Up Beyond All Recognition) is an Army term that is not about the battlefield.

The problem for the Army is turnover.  Anyone that becomes excellent at something is promoted or reassigned.  Knowledge and wisdom are always walking out the door.  It is like that everywhere, including the economy.

This is why laws exist.  The law is a gift from one generation to those that follow.  Laws are written by a society in crisis, in an attempt to describe and codify a problem.  Society uses language to document the law, agreement to adopt the law and judgement to understand the problem.  The role of law, is to preserve knowledge for those that follow.  In general, the way that a law works is to protect society from its own errors and in specifics to protect society from individuals that would harm others.

In most societies, the law abiding masses take a lot for granted.  We assume that the laws are protecting us.  We assume that our government is looking out for us.  We assume that people who are smarter or richer or more powerful than ourselves are going to watch out for us, lead us and do the right thing.  Every generation further away from the crisis that spurred the creation of the law becomes more and more unaware of the nature or severity of that hazard.  It becomes a piece of minutiae, no different than an opinion.  I call this the problem of knowledge decay.

The way to counter it is education.  The hard fought lessons of conflict and strife cannot be omitted, glossed over or avoided because they are painful to remember.  This is a problem of people not knowing any better and not being challenged to learn or remember.

Then comes the problem of laziness.  When it comes to government, as a rule people want to 'set it and forget it'.  We like to think that our part of society ends at the ballot box (if we're lucky enough to have one).

So, what happens when the people that lived through the crisis that gave birth to the law that would protect society from the crisis repeating are gone and most people really don't care about or understand the law or the problem?

The very people who the law was meant to protect us from, are always looking for an inroad.  They never let up.  It's what they do.  They operate by gaining the confidence of people in power.  Government, Armies, Banks and Organized religion.  Their goal is to make themselves rich with no limit to either their gain or society's loss. They appeal to people's greed and use it to swindle them.  The public believe because their government is involved, that they are investing in something risk-free.  In fact, it is like a casino in Las Vegas - the odds favor the house.  Only with these bubbles, the losses are much more deadly.

When the swindlers are winning, they are taking money in hand over fist.  When the market collapses, they immediately begin to sow the seeds of doubt in the laws that are raised to prevent the next assault.  Such as the GOP labeling the New Deal as the cause of the Great Depression, calling that statement "an historical fact".  They are always laying the ground for their next assault upon the wealth of the masses.  Society cycles between vigilance and crisis as we lower and raise our guard, over and over again.

Mackay makes another point, later in the book in the section, POPULAR ADMIRATION OF GREAT THIEVES.  He notes how people rally behind a successful thief, especially one that robs the well-to-do living among masses of the very poor.  If our penchant for ignoring history has brought us to the ruin of yet another bubble, will we also succumb to reveling in the demise of the wealthy at the hands of thieves?  Will we extol the virtues of vigilante financial justice doled out to Wall St. CEO's that gave themselves billions in bonuses with taxpayer money?

While we are asking ourselves about that, we might consider whether such a zeal for the downfall of others might not have played a part in taking us into the bubble in the first place.  Our worship of thieves, Wall St. 'raiders' and corporate mercenaries all plundering society to fill their own pockets.

Prosperity, security and dignity are available when we choose the Golden Rule over the Rule of Gold.

Mackay believed that we're all mad, differing only in the extent.  Maybe we're still perfecting the understanding of human nature.  So long as we embrace delusion, we're going to keep making this mistake.  We need to view the people in government, religion, military and any other position of great power as forever under assault from those that would do society harm.  When we accept a vision of ourselves as hyper vigilant in minding our rulers, then we have a chance.

As we set about the business of writing the laws to solve this crisis for society, we cannot accept the terms of the solution or the framework to understand the problem to come from the people that delivered the disaster to us for their own greed.  That would be a great place to start.

-gadfly


Tags: bubble, depression, Economy, government, mackay, military, popular delusions, scheme, swindle (all tags)

Comments

6 Comments

mojo, flair, etc. n/t

by the national gadfly 2009-02-11 08:10PM | 0 recs
A Bubble When We See One?

The Mackay book is one of the few books that have stood the test of time. It is also an easy read.

If you want a more technical analysis, try Markus Konrad Brunnermeier's "Asset Pricing Under Asymmetrical Information".

But to answer your question, one man's "irrational exuberance" is another man's bubble.

by Charles Lemos 2009-02-11 08:55PM | 0 recs
Another Gadfly masterpiece, way over my head...

I've already commented at MM but wanted to come here and pay my respect...

by louisprandtl 2009-02-11 09:51PM | 0 recs
May be We Know?

I studied bubbles in my economics graduate school courses and there is no consensus to your question. Some economists say that we know when we see bubbles, but we play the bubble in hopes that we are smart enough to sell before the bubble bursts. Other economists say that bubbles are more likely when we haven't experienced a bubble for a long time and are caused because the majority of investors are too inexperienced to recognize a bubble. A large group of economists deny that true bubbles exists and that what we think are bubbles are just rational reactions to market information (I disagree with this view).

I have a theory that the baby boom generation is more prone to bubbles because ever since they were born, they have been prone to faddish behavior. Historically, baby booms have been drawn into more fads than most other generations. In a sense, bubbles are really just fads. Whether it be dolls, toys, fashion, rock stars, stocks and real estate, fads are part of the baby boomer personality trait.

by Zzyzzy 2009-02-12 05:10AM | 0 recs
Mackay believed that we're all mad....

Mad surely, and the more intelligent you are, the more you can delude yourself...Blinded by your own hubris glasses...

To leverage off of Izzy posts, I loved reading "When Genius Fails" about Long Term Capital Management and how the two guys that actually kind of came up with a lot of the theories, Scholes and Merton were on-board when the ship of hubris hit the reef.

Two Nobel Prize Winners, who created their owm mini-bubble and watched it pop right before their eyes!

I think it's not only fads, but we Boomers were absoltutely convinced of our infalibilty...(maybe a little water is seeping in now...)

After all, we were the Children of the Greatest Generation?

How could we fail?

I think the millenials have a more fatalistic view, though they have their own set of blinders on IMHO....

by WashStateBlue 2009-02-12 08:53AM | 0 recs
They did know better and participated anyway

Most people do know a bubble when they see one. Many people who feed bubbles know perfectly well when we are in the midst of one. What they don't know is when it will pop. That was the case in both the dot com and real estate bubbles, plenty of people knew they were bubbles and were trying to make a buck before they popped.

The recent prevalence of bubbles is a regulatory thing, not a generational thing. The Reagan revolution was all about weakening the post-Depression regulatory regime, and predictably without regulation we have more bubbles. That is a big part of why Democrats see Reagan as such a malign force, and why we consider his ideas so bad.

by souvarine 2009-02-12 10:18AM | 0 recs

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