Sunday, February 21, 2010

They Really Said It ! [8]

Book Review : Short History Of Financial Euphoria
Author : John Kenneth Galbraith
My Rating : 5 out of 5 stars

Most of the previous articles I wrote in this "They Really Said It" series were about criticizing people for denying the existence of the housing bubble. All my objections may seem as just another instance of 20/20 hindsight. Was it possible to identify the bubble before ? Were most of the people who warned about the imminent crash like a broken clock that's right twice a day ? Well, how about a book that was written in 1993, that analyzed historical bubbles and gave clear reasoning as to why these phases routinely repeat !

John Kenneth Galbraith was one of the most influential economist in 20th century. He was born in Canada, but lived most of his life in US. An adviser to President Kennedy, he was appointed as The US Ambassador to India. There, he often advised India's 1st Prime Minister Nehru on economic matters. For his service, he received 2 Presidential Medal Of Honors from US, the "Padma Vibhushan" from India and also Order Of Canada.

In "The Short History Of Financial Euphoria" he covers all the well-known bubbles and even some smaller ones - from the "Tulip Mania" to the Crash of 1987. It's a very short book and written in a witty style. Instead of merely reviewing, I would prefer to quote entire passages that I absolutely adore.

How does it start and how does it end ?

Galbraith argues that bubbles always begin on sound fundamentals. Then there are basically two types of participants. Majority are the ones, who believe in a new paradigm and a small minority who is there just for the ride, hoping to get off before the fall. But ...
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. ...... the speculative episode always ends not with a whimper but with a bang.
Galbraith is saying only disaster is assured in aftermath. Now, does anyone remember that Fed was going to engineer a soft landing ?

What about those who manage to not fall in above two categories ?
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.
He does not shy away from describing the groups as he sees it.
Those involved in the speculation are experiencing an increase in wealth - getting rich or being further rewarded. 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. ... Speculation buys up, in a very practical way, the intelligence of those involved.
There are of course some who recognize the "mass insanity" as Galbraith calls it. How are they received ?
There are, however, few matters on which such a warning is less welcomed. In 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 the lack of faith in the inherent wisdom of the market itself.
Yes, any critic of the euphoria was trivialized as just sour for "having missed the run". Galbraith gives more detailed account of this elsewhere in the book. He himself was accused as "Galbraith doesn't like to see people making money" !

But why do these bubbles keep happening ?
There can be few fields of human endeavor in which history counts for so little as in the world of finance. Past experience, to the extent that is part of memory at all, is dismissed as the primitive refuge of those who do not have the insight to appreciate the incredible wonders of the present.
That's a classic quote ! Another reason, he argues, that people have blind reverence for those who have a lot of money.  "Money is the measure of capitalist achievement" !
Finally and more specifically, we compulsively associate unusual intelligence with the leadership of the great financial institutions ...
Really ! Often in such episodes there is "financial innovation" involved.
The rule is financial operations do not lend themselves to innovation. ... The world of finance hails the invention of wheel over and over again, often in a slightly more unstable version. All financial innovation involves, in one form or another, the creation of debt assured in greater or lesser adequacy by real assets.
This is simply my most beloved quote in the entire book ! I wish Greenspan had read this book before arguing against any bubble due to financial innovation :-)

What happens after the crash ?
This, invariably will be time of anger and recrimination and also of profoundly unsubtle introspection. The anger will fix upon the individuals who were previously most admired for their financial imagination and acuity. ... There will also be scrutiny of the previously much-praised financial instruments and practices ... There will be talk of regulation and reform. What will not be discussed is the speculation itself or the aberrant optimism that lay behind it.
Now, did he have a time machine in 1993 ? This above does not seem like having been written before, does it ?

Now knowing all this and more, the obvious question is why can't the warnings be taken seriously ? Can these bubbles be avoided ? During the foreword, Galbraith offers his pessimism.
Recurrent speculative insanity and the associated financial deprivation and larger devastation are, I am persuaded, inherent in the system. Perhaps it is better that this be recognized and accepted.
Go read this book ! You will fee like reading Nostradamus.

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