3

Speculative Manias

Rationality of markets

The word ‘mania’ suggests a loss of a connection with rationality, perhaps mass hysteria. Economic history is replete with canal manias, railroad manias, joint stock company manias, real estate manias and stock price manias – surges in investment in a particular activity. Economic theory assumes that men and women are rational – and hence manias would not occur. There is a disconnect between the observations that manias occur episodically, and the rationality assumption. This chapter focuses on the investor demand for a particular type of asset or security and the next chapter is centered on changes in the supply of credit.

The ‘rational expectations’ assumption is that investors react to changes in economic variables as if they are always fully aware of the long-term implications of each of these changes, either because they are clairvoyant or because they have Superman-like vision. Thus the cliché that ‘all the information is in the price’ reflects the view that prices in each market change immediately and fully to every news item so that no ‘money is left on the table’.

Contrast the rational expectations assumption with the adaptive expectations assumption that the values of certain variables in the future are extensions of their recent values – the assumption that is implicit in the view that there are ‘trends’ in the changes in asset prices. The cliché that ‘the trend is your friend’ reflects that prices will continue to increase if they have been increasing. In contrast the thrust of the rational expectations view is that the prices that are anticipated next week and next month determine the prices that prevail today, in effect a backward-looking view from the future to the present. Thus the price of gold in the spot market today is derived from the anticipated prices of gold two or three or more years from now as revealed in a futures market discounted to the present by an appropriate interest rate, usually the one on risk-free US Treasury securities. The Canadian dollar price of the US dollar today is the anticipated price of the US dollar for a distant future date discounted to the present by the difference between US and Canadian interest rates. If a government reduces tax rates to stimulate consumption spending or investment spending, the rational expectations view implies that investors immediately will realize that the larger fiscal deficit today implies higher tax rates tomorrow and so they will increase the amounts they save in anticipation of the projected increase in their tax bills.

What does it mean to say that investors are rational?¹ One assumption is that most investors behave rationally most of the time. A second is that all investors behave rationally most of the time. A third is that each and every participant in the markets has the same intelligence, the same information, the same objectives and uses the same economic model. A fourth is that all investors behave rationally all the time.

Each of these assumptions has different implications for the way that investors behave. Obtaining agreement on the assumption that most investors behave rationally most of the time is easier than obtaining agreement on the assumption that each investor behaves rationally all of the time. Frequently the argument is between two polar positions, one that holds that no investor is ever rational while the other asserts that all investors are always rational. Harry G. Johnson offered this description of the difference between an older group of economists and a younger group interested in international monetary reform:

The difference can be encapsulated in the proposition that whereas the older generation of economists is inclined to say ‘the floating rate system does not work the way I expected, therefore the theory is wrong, the world is irrational and we can only regain rationality by returning to some fixed rate system to be achieved by cooperation among national governments’ while the younger group is inclined to say ‘the floating rate system is a system that should be expected to operate rationally, like most markets; if it does not seem to work rationally by my standards, my understanding of how it ought to work is probably defective; and I must work harder at the theory of rational maximizing behavior and its empirical consequences if I am to achieve understanding’. This latter approach is the one that is being disseminated, and intellectually enforced, through the [younger] network.²

Rationality is an a priori assumption about the way the world should work rather than a description of the way the world has actually worked. The assumption that investors are rational in the long run is a useful hypothesis because it illuminates understanding of changes in prices in different markets; in the terminology of Karl Popper, it is a ‘pregnant’ hypothesis. Hence it is useful to assume that investors are rational in the long run and to analyze economic issues on the basis of this assumption. One interpretation of the rationality assumption is that prices in a particular market today must be consistent with the prices one and two months from now and one and two years from now adjusted for the ‘costs of storage’; otherwise there would be a profitable and relatively riskless arbitrage opportunity.

Ragnar Nurkse summarized his survey of changes in the values of the French franc and the German mark in the 1920s with the statement that speculation in the currency market had been destabilizing. Milton Friedman asserted that destabilizing speculation cannot occur – or at least is unlikely to persist – because investors that bought as prices were increasing and sold as prices were declining ‘would be buying high and selling low’; because of these losses, they would either go out of business or change their strategy. The Friedman view is that since the destabilizing speculators would fail to survive, destabilizing speculation cannot occur.³ One response is that from time to time some investors follow strategies that would lead to losses.

There have been many historic episodes of destabilizing speculation, although at times the language has been imprecise and at other times hyperbolic. Consider some of the phrases in the literature: manias ... insane land speculation ... blind passion ... financial orgies ... frenzies ... feverish speculation ... epidemic desire to become rich quick ... wishful thinking ... intoxicated investors ... turning a blind eye ... people without ears to hear or eyes to see ... investors living in a fool’s paradise ... easy credibility ... overconfidence ... overspeculation ... overtrading ... a raging appetite ... a craze ... a mad rush to expand.

Fernand Braudel used the terms ‘craze’ and ‘passion’ when he discussed everyday life in Europe from the fifteenth to the eighteenth centuries, largely in connection with consumption but also extended to spices, styles of dress, craving for knowledge, and purchases of land.⁴

The principals in the London banking firm of Overend, Gurney, which crashed on Black Friday in May 1866, were said to be ‘sapient nincompoops’.⁵ ‘These losses,’ said Bagehot, ‘were made in a manner so reckless and so foolish that one would think a child who had lent money in the City of London would have lent it better.’⁶

Clapham’s description of the Baring firm in 1890 is understated in a characteristic British fashion: ‘They had not considered these enterprises or the expected investors in them coolly or wisely enough [but had] gone far beyond the limits of prudence.’⁷

Consider Adam Smith’s comment on the South Sea Bubble: ‘They had an immense capital dividend among an immense number of proprietors. It was naturally to be expected, therefore, that folly, negligence, and profusion should prevail in the whole management of their affairs. The knavery and extravagance of their stock-jobbing operations are sufficiently known [as are] the negligence, profusion and malversation of the servants of the company.’⁸

And finally a description by the usually restrained Alfred Marshall:

The evils of reckless trading are always apt to spread beyond the persons immediately concerned ... when rumors attach to a bank’s credit, they make a wild stampede to exchange any of its notes which they may hold; their trust has been ignorant, their distrust was ignorance and fierce. Such a rush often caused a bank to fail which might have paid them gradually. The failure of one caused distrust to rage around others and to bring down banks that were really solid; as a fire spreads from one wooden house to another until even fireproof buildings succumb to the blaze of a great conflagration.⁹

Rationality of the individual, irrationality of the market

Manias are associated on occasion with ‘irrationality’ or mob psychology. The relationship between rational individuals and an irrational group of individuals can be complex. A number of distinctions can be made. One assumption is that of mob psychology, a ‘group think’ when virtually each of the participants in the market changes his or her views at the same time and moves as a ‘herd’. Alternatively various individuals change their views about prospective developments in markets at different times as part of a continuing process; most start rationally and then more of them lose contact with reality, gradually at first and then more quickly. A third possible case is that rationality differs among different groups of traders, investors, and speculators, and that an increasing number of individuals in these groups succumb to the hysteria as asset prices increase. A fourth case is that all the market participants succumb to the ‘fallacy of composition’, the view that from time to time the behavior of the group of individuals differs from the sum of the behaviors of each of the individuals in the group. The fifth is that there is a failure of a market with rational expectations as to the quality of a reaction to a given stimulus to estimate the appropriate quantity, especially when there are lags between the stimulus and the reactions. Finally irrationality may exist because investors and individuals use the wrong model, or fail to consider a particular and crucial bit of information, or suppress information that does not conform to the model that they have implicitly adopted. The irrationality of the gullible and greedy in succumbing to swindlers is discussed in a later chapter.¹⁰

Mob psychology or hysteria is well established as an occasional deviation from rational behavior. Some economic models highlight the demonstration effect, which leads the Smiths to spend more than their incomes – at least for a while – as they seek to keep up with the Joneses. Another is the Duesenberry effect: both the Smiths and the Joneses increase their consumption expenditures when their incomes increase and both are reluctant to reduce their spending when their incomes decline. Politics has its ‘bandwagon effects’ when individuals back the most probable winners (or ‘rats desert the sinking ship’ when they turn from losers – though if the ship is really sinking, the rational rats leave). The French historian Gustave LeBon discussed this subject in The Crowd.¹¹ Charles MacKay in his discussion of the South Sea Bubble¹² mentioned a banker who purchased £500 worth of South Sea stock in the third subscription list of August 1720, saying, ‘When the rest of the world are mad, we must imitate them in some measure.’¹³ In 2008 Chuck Prince, then the Chair of Citigroup, said ‘You have to keep dancing as long as the music is playing’.

Minsky highlighted a mild form of this type of irrationality in his discussion of ‘euphoria’ in markets. In an earlier day, such waves of excessive optimism perhaps followed by extreme pessimism might have been explained by ‘sunspots’¹⁴ or the paths of Venus or Mars through the heavens. In Minsky’s formulation these waves of optimism start with a ‘displacement’ or shock, which leads to an increase in optimism of investors and business firms and of bank lenders. More confident expectations of a steady stream of prosperity and of an increase in profits induce investors to buy riskier stocks. Banks make riskier loans in this more optimistic environment. The optimism increases and may become self-fulfilling until it evolves into a mania.

An earlier alternative explanation for this un-sober upswing were provided by Irving Fisher and by Knut Wicksell who emphasized that the real rate of interest was too low.¹⁵ Consumer prices increase in economic expansions and while interest rates increase, they increase less rapidly than the inflation rate so the real rate of interest declines. Lenders have ‘money illusion’ and ignore the decline in the real rate of interest. In contrast borrowers do not have money illusion; they recognize that the real rate of interest has declined. Rational investors buy more stocks or real estate in this environment of increases in anticipated profits and lower real interest rates. (The Fisher and Wicksell explanations were effective descriptions of the changes in nominal and real interest rates in the 1970s.)

This model relies on the ad hoc assumption that two groups of market participants systematically differ in their susceptibility to money illusion.

Too low an interest rate is a special case of what is perhaps a wider phenomenon – the pricing of financial innovations. Initially these innovations may be under-priced as ‘loss leaders’ so they will be more readily accepted, but the low price also may lead to excess demand. Alternatively, undue risks may be taken by recent entrants in an industry as they reduce their selling prices to increase their market shares. One notable example is that of Jay Cooke, the last prominent banker of the early 1870s to back a railroad, the Northern Pacific.¹⁶ Other examples include Rogers Caldwell in the municipal bond market of the late 1920s,¹⁷ Bernard K. Marcus of the Bank of the United States in mortgages in the same era,¹⁸ and Michele Sindona of the Franklin National Bank in the early 1970s.¹⁹

Speculation often develops in two stages. In the first, sober stage households, firms and investors respond to a shock in a limited and rational way; in the second, the anticipations of capital gains play an increasingly dominant role. ‘The first taste is for high interest but that taste soon becomes secondary. There is a second appetite for large gains to be made by selling the principal.’²⁰ In the 1830s in the United States investors initially bought land to cultivate more high-priced cotton; thereafter they purchased land for the anticipated capital gains they would achieve when they sold the land. In the 1850s farmers and planters both cultivated and speculated in land. In ordinary times they bought more land than they cultivated as a hedge against the declining value of the acres they planted; in booms this more or less sound basis was discarded, and farms were heavily mortgaged to buy more land, which in turn was mortgaged so they could buy still more land to profit from anticipated increases in land prices.²¹ The 1830s railway boom in Britain also had two stages: the first prior to 1835 when the projects were not bubbles, and a second after 1835 when they were. In the first phase, shares were sold by promoters to local chambers of commerce, Quaker capitalists, and hard-headed Lancashire businessmen, both merchants and industrialists – that is, to men of substance who anticipated benefits from the construction of the railroads. These groups were able to meet both the initial 5 to 10 percent payment and the subsequent calls for payment as the construction progressed. In the second phase, professional company promoters – many of them rogues interested only in quick profits – tempted a different class of investors, including ladies and clergymen.²² The same stages were evident in building sites in Vienna in the early 1870s; initially these sites were bought for construction but then later were snapped up like speculative poker chips for profitable resale.²³ Ilse Mintz noted a two-stage process in the sale of foreign bonds in New York in the 1920s; these bonds were sound prior to 1924 and the Dawes loan (which touched off the boom) and inferior thereafter.²⁴ The loans to Mexico and Brazil in the early 1970s were based on the realistic assessments of the credit standing of the borrowers; thereafter the banks wanted to increase their loans and they had less concern with the quality of the projects that were being financed.

In the Florida real estate bubbles between 2003 and 2006 speculators traded titles to condominium apartments in buildings that were still under construction. One wag developed a ‘Condo-Flip’ website.

Essentially there was a reversal between the objective and the process, and in the end the objective became the process. The lenders became so enthusiastic about the process that they failed to appreciate the end-game and provide an answer to the question, ‘Where will the borrowers get the cash to pay the interest if they no longer had access to cash from new loans?’ Initially the junk bond market may have been rational, but then the supply of junk bonds surged and the creditworthiness of the borrowers declined more or less continuously. A lot of attention in the US housing debacle that began in 2007 has been given to the defaults on ‘subprime mortgages’, whose share of the market for new mortgages had increased from 8 percent in 2004 to 20 percent in 2005 and 2006. This sharp increase reflected that there weren’t enough prime mortgage loans to satisfy the demands of those who wanted to buy mortgages.

The market in just-built and unfinished houses in southern California, sold from one person to another at ever-higher prices with the help of an active market in second mortgages, peaked in 1981 and then collapsed, with price declines of 40 percent.²⁵ There was a condominium ‘craze’ in Boston in 1985 and 1986; 60 percent of the buyers intended to sell the units. The condo market turned soft in 1988,²⁶ in a pattern similar to the ‘flat craze’ in Chicago in 1881.²⁷ A similar boom and dip occurred in the apartment market in Chicago in 2003.

The analysis in terms of two stages suggests two groups of speculators, the insiders and the outsiders. The insiders destabilize by driving the price up and then sell at or near the top to the outsiders. The losses of the outsiders necessarily are equal to the gains of the insiders. Johnson pointed out that for every destabilizing speculator there must be a stabilizing one.²⁸ But the professional insiders initially destabilize by exaggerating the upswings; these insiders follow the mantra that the ‘trend is my friend’. At one stage, these investors were known as ‘tape watchers’; more recently they have been called ‘momentum investors’. The outsider amateurs who buy high and sell low are the victims of euphoria that affects them late in the day. After they lose, they go back to their normal occupations to save for another splurge in five or ten years.

The evidence from the gold panic of 1869 is consistent with the hypothesis that Gould and Fisk first drove up the gold price and then sold at the top in a manner that is consistent with destabilizing speculation, although Larry Wimmer does not agree that speculation had been destabilizing.²⁹ The information available to the two groups of speculators differed. In the early stage, Gould tried to persuade the US government of the desirability of forcibly depreciating the US dollar by driving up the ‘agio’ or premium on gold to increase grain prices, while the outsider speculators operated on the expectation derived from past performance that the US government would seek to drive the agio down so that greenbacks would again be convertible into gold at the pre-Civil War parity. On 16 September the outsiders abandoned this expectation and adopted Gould’s; they bought gold and the price went up. On 22 September Gould learned from his associate, President Grant’s brother-in-law, that the outsiders originally had been right and that his plan was not going to be adopted; Gould then sold. Belatedly the outsiders saw they were wrong. The result was the Black Friday of 23 September 1869 when stock prices collapsed.

Another case that involves two sets of speculators, insiders and outsiders, is the ‘bucket shop’. This term has practically disappeared from the language since the Securities and Exchange Commission declared the practice illegal, but the men and women who run the boiler shops are the children of those who ran bucket shops. Bucket shops are described in novels; a classic picture is given in Christina Stead’s excellent House of All Nations.³⁰ The insiders in a bucket shop take orders from the public to buy and sell securities but do not execute these orders because they assume that the outsider’s bet will prove to be wrong. And the bucket shop has the advantage of a hedge. If the outsiders should turn out to be right by ‘buying low and selling high’, the bucket-shop operators decamp. In House of All Nations, Jules Bertillon in 1934 fled to Latvia.

Bucket shops evolved into boiler shops that hustled untutored investors with promises of quick sure-fire gains. The owners of the boiler shops had brought forth their own firms; initially they owned nearly all or all of the shares in these firms. Robert Brennan of First Jersey Securities owned and operated or was associated with a series of boiler shops; the names kept changing but the scam was always the same. Their buddies hustled increases in the prices of stocks of very small, little-known firms; once the stock prices were increasing, they used tele-marketing to sell the stocks to dentists and undertakers in small towns all over America. They managed to increase the prices of the stock day by day until most of the shares in the firms had been sold to the gullible investors who were congratulating themselves on how much money they had made. When one of these investors tried to convert the paper profits into cash, there suddenly were no buyers.

For a further example of an outside destabilizing speculator who bought high and sold low, there is the story of the great Master of the Mint, Isaac Newton, the world-class scientist. In the spring of 1720 he stated: ‘I can calculate the motions of the heavenly bodies, but not the madness of people.’ On 20 April, accordingly, he sold his shares in the South Sea Company for £7000, a 100 percent profit. Later an infection from the mania gripping the world that spring and summer caused him to buy a larger number of shares near the market top and he lost £20,000. In the irrational habit of so many who experience financial disaster, he put it out of his mind and for the rest of his life he could never bear to hear the name South Sea.³¹

Yet euphoric speculation with insiders and outsiders may also lead to manias and panics when the behavior of every participant seems rational. Consider the fallacy of composition when the whole differs from the sum of its parts. The action of each individual is rational – or would be if many other individuals did not behave in the same way. If an investor is quick enough to get in and out ahead of the others, he may do well, as insiders generally do. Carswell quotes a rational participant on the South Sea Bubble:

The additional rise above the true capital will only be imaginary; one added to one, by any stretch of vulgar arithmetic will never make three and a half, consequently all fictitious value must be a loss to some person 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.³²

‘Devil take the hindmost’, ‘sauve qui peut’, ‘die Letzen beissen die Runde’ (‘dogs bite the laggards’), and the like are recipes for a panic. The analogy is someone yelling ‘fire’ in a crowded theater. The chain letter is another analogy; because the chain cannot expand infinitely, only a few investors can sell before the prices start declining. It is rational for an individual to participate in the early stages of the chain and to believe that all others will think they are rational too.

Closely akin to the fallacy of composition is the standard ‘cobweb’ demonstration in elementary economics in which demand and supply are linked with a lag rather than simultaneously, as in an auction that clears the market at each moment. ‘Displacement’ consists of events that change the situation, extend the horizon, and alter expectations. In such cases, otherwise rational expectations of some investors fail to recognize the strength of similar responses by others. When there appears to be a shortage of physicists or mathematicians or schoolteachers many young people enter graduate school to prepare for one of these professions; by the time they have finished their studies, there may be an ‘excess supply’ of individuals trained for careers in this field. After the belated surge in supply, job opportunities suddenly become scarce. But the excess supply becomes known only after the long gestation period. Responses to shortages of coffee, sugar, cotton, or some other commodity may be similarly excessive. The price increases sharply in response to the initial surge in demand and then declines even more rapidly as the new supply becomes available.

The history of manias and panics is full of examples of destabilizing ‘cobweb’ responses to exogenous shocks. When Brazil opened as a market for British goods in 1808, more Manchester goods were sent to the market in a few weeks than had been consumed there in the previous twenty years, including ice skates and warming pans that, as Clapham noted, proved to be the accepted illustration of commercial madness among nineteenth-century economists.³³ In the 1820s, independence for the Spanish colonies triggered a boom in lending to new Latin American governments, investing in mining shares and exporting to the area; the surge in investment proved excessive. ‘The demand is sudden, and as suddenly stops. But too many have acted as if it were likely to continue.’³⁴

In the 1830s the cobweb fluctuation had a two-year periodicity. ‘Each merchant would be ignorant of the amounts that other merchants would be bringing forward by the time his own merchandise was on the market.’³⁵ The same was true in the United States in the 1850s following the discovery of gold in California:

The extraordinary and undue expectations entertained not only in the United States but in this country [Britain] as to the capability of California – after the 1849 gold discovery – unquestionably aided in multiplying and extending the disaster consequent on the American crisis. When it was again and again stated, both in London and in Boston, in regard to all shipments to San Francisco, that six, or at most eight, moderately-sized or assorted cargos per month were all that were required or could be consumed; instead of that eastern shippers dispatch twelve to fifteen first-class ships a month, fully laden.³⁶

A rather far-fetched line of reasoning led from the phylloxera that ruined many vineyards and set back wine production in France to the 1880s boom in brewery shares in Britain, as one after another, private breweries sold shares to investors for the first time in the public-companies mania. Among them, Arthur Guinness and Co. was bought for £1.7 million and sold for £3.2 million.³⁷ ‘The success of the issue was like the firing of a starting pistol; by November 1890, 86 other brewery companies had issued new shares to the public for the first time.’³⁸

There was a boom in Britain at the end of World War I when businessmen thought victory would ensure the elimination of German competition in coal, steel, shipping, and cotton textiles. Prices of industrial assets, ships, stocks, and even houses increased. Companies were merged; many of the mergers were financed with large amounts of credit. Then sober realization set in from the summer of 1920 to the coal strike of the second quarter of 1921.³⁹

Three more cases are on the borderline of rationality. The first deals with target workers, so to speak – individuals who get used to a certain level of income and find it difficult to adjust their spending downward when their incomes decline. In consumption theory, this is the Duesenberry effect that was noted earlier. In labor supply, it constitutes the ‘backward-bending supply curve’, which suggests that higher wages or salaries produce not more work but less and that the way to increase effort is to lower the wage per unit of time. In economic history books, this principle is known as ‘John Bull can stand many things but he cannot stand 2 percent’. John Stuart Mill put it thus:

Such vicissitudes, beginning with irrational speculation and ending with a commercial crisis, have not hitherto become less frequent or less violent with the growth of capital and the extension of industry ... Rather they may be said to have become more so: in consequence, it is often said, of increased competition; but, as I prefer to say, of a low rate of profit and interest, which makes the capitalists dissatisfied with the ordinary course of safe mercantile gains.⁴⁰

In France at the end of the Restoration and the beginning of the July Monarchy – that is, between 1826 and 1832 – speculation was rife despite the ‘distrust that the French always feel toward ill-gotten money’. Landowners earned 2.25 to 3.75 percent on their assets; industrialists tried to do better than the long-run interest rate on their fixed investments by 2 to 4 percentage points and earn 7 to 9 percent. Merchants and speculators in raw materials sought returns in the range of 20 to 25 percent on their investments.⁴¹ Charles Wilson noted that earlier the Dutch were converted from merchants into bankers (accused of idleness and greed); they developed habits of speculation because of the decline in the rate of interest in Amsterdam to 2.5 and 3 percent.⁴² Large-scale conversions of public debt in 1822 and 1824 and again in 1888 led to a decline in the rate of interest and induced British investors to buy more foreign securities.⁴³ Andréadès observed that ‘When interest goes down, the English commercial world, unable to reduce its mode of life, deserts its usual business in favour of the more profitable, but on that very account more risky undertakings ... speculation leads to disaster and ultimately must be borne by the central bank.’⁴⁴

The boom in Third World bank-syndicated loans in the 1970s followed a sharp decline in interest rates on US dollar securities in the spring of 1970 as the Federal Reserve adopted a more expansive policy. Banks were highly liquid and looked for attractive borrowers which they found in Third World governments and government-owned firms, mostly in Latin America. The 1960s had been a decade of accelerating internationalization for the major US banks and they had rapidly increased the number of their foreign branches. Because of the sharp increase in commodity prices, nominal and real incomes in Mexico, Brazil, and most other developing countries were expanding at above-trend rates. Commodity prices declined sharply in the early 1980s in response to the surge in US interest rates, and then nominal and real incomes declined in these indebted countries. Should the banks have foreseen that the decline in commodity prices was inevitable?

The second borderline case involves hanging on in the hope of some improvement or failing to take a specific type of action when circumstances change. On the first score, note the failures of the New York Warehouse and Security Company, of Kenyon, Cox & Co., and of Jay Cooke and Co. on 8, 13, and 18 September 1873, because of loans made to railroads (respectively, the Missouri, Kansas and Texas, the Canada Southern, and the Northern Pacific) with which they were associated. These railroads were unable to sell bonds to obtain the funds they needed to complete construction because Berlin and Vienna had stopped lending to the United States.⁴⁵ Similarly, when US long-term lending to Germany stopped in 1928, as US investors turned to stocks and stopped buying bonds, New York banks and investment houses continued to make short-term loans to German borrowers. When riding a tiger or holding a bear by the tail, it seems rational to hang on – at least for a while.

For an error of omission, note the plight of Hamburg banks that had made large loans to Swedish banks that were financing smuggled goods into Russia during the Crimean War; the Hamburg banks failed to cancel these loans when peace came. The Swedes used the money to speculate in shipbuilding, factories, and mining, which helped embroil Hamburg in the world crisis of 1857.⁴⁶

The third borderline case is to have a rational model in mind, but the wrong one. The most famous example in another field is the French ‘Maginot Line psychology’, though this may be thought of less as a case of irrational expectations than one of an undistributed lag. ‘ “When a man’s vision is fixed on one thing,” thought Ponzi, “he might as well be blind”.’⁴⁷ Or Bagehot on Malthus: ‘Scarcely any man who has evolved a striking and original conception ever gets rid of it.’⁴⁸ In the 1760s, Hamburg merchants were not hurt by the fall in commodity prices until the end of the Seven Years’ War. Thus in 1799 while the Napoleonic Wars were continuing they were unprepared for the decline in prices that came with the penetration of the blockade of Napoleon’s 1798 Continental system.⁴⁹ Or take the French bankers and industrialists who formed the copper ring in 1888, patterned after the cartel movement in iron and steel, steel rails, coal, and sugar in the early part of the decade, attracted by the successes of the diamond syndicate in South Africa and of the Rothschilds’ mercury monopoly in Spain. (Many economists and analysts extrapolated from the apparent success of the Organization of Petroleum Exporting Countries in increasing the price of petroleum in the 1970s to assume that successful price-fixing cartels would reduce the output of practically every other raw material and foodstuff and lead to much higher prices for these products.) By 1890 the French syndicate owned 60,000 tons of high-priced copper plus contracts to buy more; the older mines were reworked and firms began to process scrap while the copper price was declining rapidly. The collapse of the copper price from £80 to £38 a ton in 1889 almost took with it the Comptoir d’Escompte, which was saved by an advance of 140 million francs from the Bank of France, reluctantly guaranteed by the Paris banks.⁵⁰

Financial innovation in the form of deregulation or liberalization has often been a shock. In the early 1970s Ronald McKinnon led an intellectual attack on ‘financial repression’, that is, the segmentation of financial markets in developing countries that led to preferential treatment of government borrowers that were involved in foreign trade, and large firms.⁵¹ The message appealed particularly to Latin American countries already influenced by the Chicago doctrine of liberalism. Some countries deregulated their financial systems, which was followed by a rapid growth of new banks and rapid increases in credit and in inflation; subsequently some of the new banks collapsed.⁵² McKinnon felt that the lesson was that the several steps in the process of deregulation should be staged carefully.⁵³

The same questions surfaced again in Poland and in the former Soviet Union in the early 1990s in fierce debates over whether the shift from command to market economies should be carried through rapidly or slowly. The success of a transition from a command economy seems to depend on the extent to which individuals in the socialist economy remember the institutional background of its early capitalism. The memory of the market economy was far greater in Poland than in Russia; long years of socialism and corruption had eradicated the memory of market institutions in Russia. Such memory is more important to transitional success than the speed of decontrols and of the privatization of state monopolies.

One purely irrational case involves a society that pins its hopes on some outstanding event of limited relevance to its current economic circumstances and another is when a society ignores evidence that it would prefer not to think about. Many Austrian enterprises had invested extensively in anticipation of the increase in business activity that would follow from the opening of World Exhibition in Vienna on 1 May 1873; their liquid liabilities greatly exceeded their liquid assets and they had acute financial distress. The objective of these world’s fairs is to increase business activity, so there is significant investment in facilities designed to accommodate those who will attend the fairs. The credit at banks was stretched to the limit; a move from commodities, land, shares, and debt back into money was under way and the chain of accommodation bills was extended as far as it would go. Nonetheless the banks and the firms hung on, waiting for the exhibition to open, because they thought or at least hoped that the increase in sales would save the situation. When the exhibition opened and the increase in sales was disappointing, the market collapsed in early May.⁵⁴

As an illustration of repression of contradictory evidence – the cognitive dissonance case – consider J.W. Beyen’s analysis of the German failure to restrict short-term borrowing from abroad at the end of the 1920s. He suggested that the dangers were not faced, even by Schacht, the German finance minister, and added: ‘It would not have been the first nor the last time that consciousness was being “repressed”.’⁵⁵ These examples suggest that despite the general usefulness of the assumption of rationality, markets have on occasions – infrequent occasions – acted in ways that were irrational even when each participant in the market believed he or she was acting rationally.

Displacements

A displacement is an outside event or shock that changes horizons, expectations, anticipated profit opportunities, behavior – ‘some sudden advice many times unexpected’.⁵⁶ A surge in the oil price is a displacement. An unanticipated devaluation is another – although most devaluations have been anticipated. A change in financial regulations, especially the liberalizations on restrictions to loans to particular groups of borrowers is a displacement. The shock must be sufficiently large to have an impact on the economic outlook. Each day’s events produce some changes in outlook, but few are significant enough to qualify as a shock.

War is a major shock. Some crises occur immediately at the beginning or end of a war, or soon enough after the end to permit a few expectations to be falsified. For beginnings, the most notable is the crisis of August 1914. The displacements at the end of wars include the crises of 1713, 1763, 1783, 1816, 1857, 1864, 1873, and 1920. Moreover there have been an impressive series of crises seven to ten years after the end of a war, long enough for expectations formed at the end of the original crisis to be falsified; these included 1720, 1772, 1792, 1825, 1873 in the United States, and 1929.

Far-reaching political changes may also change expectations. The Glorious Revolution of 1688 gave rise to a boom in company promotion. By 1695 there were 140 joint stock companies with a total capital of £4.5 million; more than 80 percent had been formed in the previous seven years. By 1717 total capitalization had reached £21 million.⁵⁷ In July 1720 the Bubble Act forbade formation of new joint-stock companies without explicit approval of parliament, a limitation that lasted until 1856. Although this regulation has normally been interpreted as a reaction against the South Sea Company speculation, Carswell asserts that it was undertaken to support the South Sea Company, as king and parliament sought to repress the development of rival companies that might attract cash that was intensely needed by the South Sea promoters.⁵⁸

The events of the French Revolution, Terror, Directorate, Consulate, and Empire, along with incidents of the Napoleonic Wars themselves, set in motion large-scale specie movements in 1792–93 and 1797 and opening and closing markets in Europe and elsewhere for British and colonial goods. Further political events of the kind in France were the Restoration (1815), the July Monarchy (1830), the February 1848 revolution, and the Second Empire (1852). The Sepoy Mutiny in India in May 1857, followed by a Hindustan military revolution, contributed to the distress of London financial markets.⁵⁹ These events were a precedent for the Invergordon disorder of September 1931, when a contingent of British sailors came close to striking over reductions in pay decreed by the new national government. Continental Europeans interpreted this response as a mutiny by a great British institution, the navy, and this interpretation contributed to the British decision to stop pegging the pound to gold.⁶⁰

War, revolution, restoration, change of regime, and mutiny come largely from outside the system; they are beyond the usual set of risky events that can be modeled as a probability distribution – hence they qualify as a ‘black swan’. Monetary and financial displacements are more difficult to describe as exogenous. But maladroit recoinage, tampering with gold-silver ratios under bimetallism, conversions undertaken to economize on government revenue that unexpectedly divert investor attention to other avenues, new lending that proves successful beyond all anticipation – these also are displacements.

The Kipper- und- Wipperzeit of 1619–23 (noted earlier) got its name from the action of money changers who took the debased coins that were coming from the increase in the number of princely mints and rigged their scales as they sought to exchange bad money for good with naive peasants, shopkeepers, and craftsmen. Rapidly rising debasement spread from state to state until the coins used in daily transactions became worthless.⁶¹

Two later German recoinages provide a study in contrast. In 1763, Frederick II of Prussia bought silver in Amsterdam on credit to provide for a new coinage to replace that which had been debased during the Seven Years’ War. He withdrew the old debased money from circulation before the new money was issued, which precipitated a deflationary crisis and the collapse of a chain of discounted bills.⁶² More than 100 years later, after the Franco-Prussian indemnity, the German authorities issued new money but this time before the old money was withdrawn to save on their interest payments. In three years the circulation of coins rose threefold from 254 million thalers (762 million marks). The result was inflation.⁶³

The crisis of 1893 in the United States, which arose from the threat to gold convertibility from the Sherman Silver Act of 1890, has already been noted. So have the British debt conversions of 1822, 1824, 1888, and 1932, although the last was associated with a boom in housing that did not lead to a crisis. In France, conversion of the 5 percent rente was discussed after 1823 as the money supply expanded and the rate of interest would have fallen had investors not been reluctant to buy rentes at a premium. Each of three bankers had a different idea of the purpose of the conversion: Rothschild wanted to sell more rentes; Greffuhle (and Ouvrard) hoped to attract investors into canals while Laffitte wanted to ensure the development of industry. In the event, political obstacles prevented passage of the necessary legislation, and the market finally gave up its objection to maintaining the rente at a premium. This sharp decline in interest rates touched off speculation.⁶⁴ Canals were built by the government with private money⁶⁵ and the faint glow of a railroad boom could be seen in France along the Loire, the Rhone, and the Seine. But the main object of speculation was building in and around the major cities – Toulouse, Lyons, Marseilles, Le Havre.⁶⁶ Honoré de Balzac’s novel César Birotteau, written in 1830, was inspired by this experience; he recounted the doleful story of a perfumer who was enticed into buying building lots in the vicinity of the Madeleine on borrowed money for ‘one quarter of the value they were sure to have in three years’.⁶⁷

The success of loans in recycling reparations or indemnities after the Napoleonic and Franco-Prussian wars and World War I has been mentioned. Any surprising success of a security issue, with a large multiple over-subscription and a quick premium for subscribers, attracts borrowers, lenders, and especially investment bankers. The Baring loan of 1819 – ‘the first important foreign loan contracted by a British bank’⁶⁸ – led quickly to a series of issues for France, Prussia, Austria, and, later, after independence, the countries that had been Spanish colonies. The Thiers rente made French banking houses salivate in the hope of foreign loans, a hunger that received a further fillip from the 1888 conversion loan for czarist Russia that bailed out German investors and sent French investors down a trail that was to end, after revolution in 1917, with a whimper rather than a bang. The Dawes loan in 1924 opened the eyes of American investors to the romance of buying foreign securities. The Thiers rente was oversubscribed fourteen times, and the Dawes loan eleven times; far more important than the size of the multiple, however, was its relation to expectations. Rosenberg described the three French loans of 1854 and 1855 as sensational, since they were oversubscribed almost two to one (468 million francs on an offering of 250 million), four to one (2175 million francs for an issue of 500 million), and five to one (3653 million against 750 million). In Austria and Germany, however, when the speculative boom of the 1850s was under way, the Credit Anstalt opening stock sale was oversubscribed 43 times, largely by people who had stood in line all night; and when the Brunswick Bank sought 2 million thalers in May 1853, it was offered 112 times that amount in three hours.⁶⁹

Among major recent displacements, as noted earlier, have been deregulation of banks and financial institutions; such innovations as derivatives (which existed earlier but only on a much modest scale); mutual and hedge funds, offering new opportunities to acquire wealth, with, however, the risk of loss; REITs (Real Estate Investment Trusts); bank flotation of loans and mortgages as marketable securities; and initial public offerings (IPOs) of private companies.

The deregulation of financial institutions was a major contributory factor to the asset price bubble in Japan in the 1980s and especially during the second half of that decade. Each Japanese bank was keenly interested in its position on the hit parade in terms of assets and deposits; each wanted to move to a higher position on the hit parade ladder – which meant that each had to ‘grow its loans’ more rapidly than the banks that had higher positions.

The technological revolution in the 1920s – the sharp increase in automobile production, the electrification of much of America, the rapid expansion of the telephone system, the increase in the number of movie theaters, and the beginning of radio – was a major shock. Investment surged. Similarly, in the 1990s, especially in the second half of the decade, there was a major technological information revolution. The venture capital firms, especially those in the San Francisco Bay area, were eager suppliers of finance to many of the engineers who had ideas. Then, at a later stage, these firms received ‘mezzanine financing’. The next stage was that the firms had an initial public offering (IPO) arranged by one of the major investment banks such as Merrill Lynch, Morgan Stanley or Credit Suisse First Boston. The investment banks would arrange ‘road shows’ for these firms as they were about to go public; entrepreneurs would visit the mutual funds and the pension funds and the managers of other pools of cash. Based on the demand, the investment banks would price the shares at $19 or $23 or $31 and perhaps 20 percent of the firms’ outstanding shares would be sold. Often the price of the shares at the end of the first day’s trading would be three or four times the IPO price.

The ‘pop’ in the share price on the first day’s trading was an advertisement that stock prices only increase. During the late 1990s an extremely high proportion of new stock issues experienced these large price pops on the first day of trading. The price pops encouraged lots of new stock offerings.

Objects of speculation

In the last several decades of the twentieth century investors speculated primarily in real estate or stocks; in earlier periods the objects of speculation were more diverse. A stylized table of cycles is presented in the Appendix. The list shows the tendency for these objects to move from a few favored items at the beginning of the period of observation to a wide variety of commodities and other assets and securities at the end. The list is partial but suggestive.

How likely is it that a displacement will lead to a shock that induces individuals to invest for capital gains and especially short-term gains? Assume that destabilizing speculation can occur in a world of normally rational individuals. Then assume a shock; these individuals misjudge its impact. Then assume a shock; these individuals misjudge the impacts of the shocks. There are many shocks: only a relatively small proportion of shocks lead to a speculative mania.

One question is whether two or more objects of speculation such as real estate and stock are likely to be involved before ‘overtrading’ reaches sufficient dimensions to result in a crisis. Consider several occasions when two or more objects have been involved in speculation.

The 1720 South Sea and Mississippi bubbles were related, and fueled by monetary expansion in Britain and France that supported a high head of speculative steam. Speculation that started in the securities of the South Sea Company and the Sword Blade Bank in England and in those of the Mississippi Company and John Law’s banques in France spread rapidly to other ventures and to commodities and land; many of these other ventures were swindles. The South Sea Company was brought down by its attempt to suppress rival speculations, bringing proceedings under the Bubble Act of June 1720 against York Buildings, Lustrings, and Welsh Copper. The effort boomeranged.⁷⁰ The spread of speculation from one object to another, to generalize the rise of prices, occurred because the speculators that sold South Sea stock when prices were approaching their peak purchased banks and insurance stocks and country houses.⁷¹ Then the price of land began to move with the price of the South Sea stock quotations.⁷² In France land prices rose in the fall of 1719 and speculators started to take their profits from the Mississippi Bubble.⁷³

The 1763 boom was based exclusively on government war expenditure and its finance through chains of discount bills. The DeNeufville Brothers, whose failure set off the panic, sold ‘commodities, ships, and securities like so many Dutch firms’,⁷⁴ with hundreds of thousands of florins in acceptance liabilities against which they rarely kept more than a few thousand guilders in cash reserves.

Some contribution to the downturn in business may have been brought on by an unparalleled drought in England in 1762, with a shortage of hay and scarcities of meat, butter, and cheese.⁷⁵ The crisis of 1772 was precipitated by speculation in Amsterdam and London in the stock of the East India Company and by the collapse of the Ayr Bank (Douglas, Heron & Co.). Numerous complex details were involved, including the political reverses of the East India Company and restriction on its credit by the Bank of England; the practice of the thrusting new Ayr Bank (which was left bad loans by the established banks) in borrowing from London when its acceptances came due; and the flight in July 1772 of Alexander Fordyce, who had lost his firm’s money selling East India Company stock prematurely. When the stock fell in the autumn, Clifford & Co., the Dutch bank that had headed a syndicate trying to push the price up, failed. These phenomena seem superficial, however. Extensive investment in Britain in houses, turnpikes, canals, and other public works had put a strain on resources.⁷⁶ One source relates the fall in coffee prices beginning in 1770 to the financial crisis of 1772–73,⁷⁷ but this is not mentioned by Wilson, the standard source, or by Ashton, Clapham, or Buist.⁷⁸

In 1793 there were several causes – country banks, canals, the Reign of Terror – that stimulated a flow of money to Britain, as well as bad harvests. In 1799 there was one cause, the tightening and loosening of the blockade. Contrariwise, the crisis of 1809–10 had ‘two separate causes: a reaction from the speculation in South America; and a loosening and then tightening of the continental blockade’.⁷⁹ There was a postwar boom in exports to Europe and the United States in 1815–16 that was larger then the amount that could be sold, plus a fall in the price of wheat. Canals and South American government bonds and mines combined in 1825; British exports, cotton, land sales in the United States, and the beginning of the railroad mania contributed to the crisis in the mid-1830s. The crisis of 1847 was caused by the railway mania, the potato blight, a wheat crop failure one year and a bumper crop the next, followed by revolution in Europe.

Thus at least two objects of speculation were involved in most of the significant crises. Just as the national markets were connected, so the speculation was connected by the underlying credit conditions. But when a crisis like that of 1847 arises from objects as disparate as railroads and wheat, there is some basis for suggesting that the crisis is accidental in origin unless the monetary weakness that feeds it is systematic.

In Japan and in the Asian countries, bubbles in real estate and stocks have generally occurred together. In some countries, especially small ones, the market value of real estate companies is a high proportion of the market value of all stocks as a group. When real estate prices increase, the value of the assets owned by real estate companies increases, and the market value of the real estate companies also increases. Those investors who have sold the real estate stocks have cash to invest and much of their cash is likely to be invested in stocks of firms not involved in the real estate business. Moreover when the real estate prices increase, then the construction business is likely to boom and the market value of the construction companies is likely to increase. The bank loan losses are likely to be below trend when real estate prices are increasing. And the symbiotic relationship is symmetric; when real estate prices decline, stock prices also decline.

National difference in speculative temperament

One suggestion is that investors in some countries are more likely to speculate than those in others. Despite Ruth Benedict’s distinction between cultures with Apollonian (balancing) and those with Dionysian (orgiastic) temperaments,⁸⁰ the proposition is dubious. And despite this implausibility, the opinion among historians is that the Brabanters had a strong gambling temperament in the sixteenth century, and that those tens of thousands who migrated to the United Provinces after the sack of Antwerp in November 1576 and its devastating siege in 1585 took it with them.⁸¹ In the Dutch Republic, the gambling instinct of bankers, investors, and even common folk existed in great tension with Calvin and Lutheran frugality and abstemiousness.⁸² There may be substance to the view that banking institutions facilitate more speculation in some countries than in others. Juglar, for example, claims the French crises in the eighteenth century were less abrupt and less violent than those of Britain because (after the John Law affair) credit in France was less used and less abused.⁸³ A different view ascribes French experience to a more severe bankruptcy law:

Whether by the education forces of law and established institutions, or by tradition, a high standard of business honesty prevails in France. The act of sons in toiling for years to pay the debts of their fathers, and of notaries in paying for the defalcations of one of their number, for the sake of the profession, although without personal association with him, indicates a standard of compliance with business obligations which cannot be without influence upon the material prosperity of a people. It may be surprising that the nation whose soldiers are so noted for dash in war should furnish financiers and business men who are the embodiment of conservatism in their methods, but such is clearly the case.

This author continues, ‘England is the country in which a spirit of adventure and speculation has done most to promote crises and depressions.’⁸⁴

One historian has suggested that mining and sheep grazing contributed to a love of gambling, and that Australians, starting with the gold discoveries of 1851–52, developed a particular love of gambling, expressed both through horse racing and speculation in land.⁸⁵

A common view is that the United States is ‘the classic home of commercial and financial panics’, presumably because of wildcat banking.⁸⁶ This was observed in the 1830s by Michel Chevalier who contrasted French moderation with American speculation (but who believed, however, that the latter was a stimulus to the production of canals, railroads, roads, factories, and villages).⁸⁷ Letter 25 of his letters from America to France is devoted to a discussion of speculation: ‘All the world speculates and it speculates on everything. From Maine to the Red River (in Arkansas) the United States has become an immense Rue Quincampoix [the Wall Street of the Mississippi Bubble].’⁸⁸ Partly the origins lie in permissive institutions. But it is easy to find abundant and contradictory views on the demand side for other countries. ‘The French nation is prudent and economical, the English nation is enterprising and speculative.’⁸⁹ ‘France has not shown proofs of prudence equal to those of Scotland; its nerves are extremely susceptible, impressionable in matters of credit.’⁹⁰ ‘The character of this nation [Britain] is in carrying everything to excess ... virtue, vice.’⁹¹ After 1866, a new arrogance was said to have taken hold of the Germans, but they surpassed the French only in ‘stock-market swindling and speculation horrors’.⁹² Morgenstern found ten panics in France, two more than in the United States, which is ‘not surprising, given the unstable character of French politics’.⁹³ (To be sure, this addresses displacements rather than love of speculation.) Contrast, however, the opinion of a French financier who claims that ‘the French love money not for the possibilities of action which it opens, but for the income it assures’.⁹⁴ Or consider two views, at the level of a Harvard–Yale debate, from a fictional Frenchman and an Englishman in 1931:

WILLIAM BERTILLION:  England’s such a Christmas tree for sharepushers. Noble lords will sit on the board of any company for a couple of quid a sitting. And the public. Loco or idiotic. God, I’ve never heard of such people, except perhaps some peasants in Bessarabia, or the niggers in the Cameroons, who believe in what they believe in. Magic. Put up any sort of business that sounds utterly impossible and they gulp it down.⁹⁵

STEWART:  England’s the world’s banker. Never failed yet, never failed yet. She keeps her word, that’s why ... None of this – none of this speculation you get in the American stock market. Every Tom, Dick and Harry trying to make a pile – like in France.⁹⁶

It’s a stand-off. The speculative temperament may differ among countries. The amount of speculation in a country may change as the national mood swings between elation and depression.