Financial Euphoria and Aftershock Jayati Ghosh

It speaks volumes for the nature of capitalism that a slim little book first written more than half a century ago can still seem so fresh and relevant. John Kenneth Galbraith’s wise and delightfully written tract “A Short History of Financial Euphoria” has just been reissued by Penguin Books, but one variant of it has been almost continuously in print since it was first published to mark the twenty-fifth anniversary of the Great Depression.

As Galbraith himself charmingly notes in his Preface to the 1993 edition, every time the book was about to pass out of print, some new speculative episode or disaster would renew public demand for it. “Over a lifetime I have been, in a modest way, a steady beneficiary of the speculative aberration in its association with more than occasional insanity. Only a stalwart character keeps me from welcoming these events as proof of personal prescience and as a source of small financial reward.” (pp. vii-viii)

Galbraith begins with what is now more widely accepted: that the capitalist economy is prone to recurrent bouts of speculation. He documents some of the classic examples from history: “Tulipomania” in 17th century Holland; the frenzy around the Banque Royale created by the remarkable adventurer John Law in early 18th century France; the South Sea Bubble just after that in London; the state debt bubble in the US in the 1830s; the euphoria and crash of 1929, heralding the Great Depression; and the more recent Wall Street debacle of September 1987.

Each of these is a fascinating story in itself, perceptively told. But what is most interesting is how Galbraith draws upon the commonality of experience in all these varying episodes to describe what he sees as an essential tendency in market behaviour.

Usually such episodes begin with what the economist Charles Kindleberger called “displacement” – some new discovery or invention, a new market, a new economic policy, or even a feel-good rumour – which captures the financial imagination and encourages a price rise in a particular market. As the price of the object of the speculation goes up, it inevitably attracts new buyers, who ensure a further price increase, in an upward spiral providing its own momentum.

The buyers are of two kinds: those who believe that the market will just keep going up, because economic realities have changed fundamentally (much as in the “new economy” bubble), and those who think they can ride the wave and jump off before it breaks, so as to get maximum reward from the rise before what they also see as inevitable collapse.

In all such events there is a thought that there is something new, and an element of pride in discovering what is seemingly new and greatly rewarding as financial instrument or investment opportunity. But Galbraith convincingly argues that financial operations do not lend themselves to innovation. “All financial innovation involves, in one form or another, the creation of debt secured in greater or lesser adequacy by real assets.” (p. 17) And consequently, all crises essentially involve debt that in some way or the other has grown dangerously out of scale with the underlying means of payment.

The moment of the crash rarely comes gently and quietly: mass disillusion is always accompanied by desperate (and largely unsuccessful) attempts by the public at large to get out, when it is already too late.

This seems obvious post facto, but seems to be forgotten with surprising regularity, reflecting what Galbraith calls “the brevity of financial memory”. In the boom, some new innovation is treated as somehow reducing or doing away with risk (whether it is supposed increases in productivity from new technology or instruments like mortgage-backed securities or credit-default swaps).

Euphoria also involves the widespread perception that those driving and benefiting from the boom are inherently brighter and more deserving than others: “we compulsively associate unusual intelligence with the leadership of great financial institutions… In practice (they) 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.” (p. 15) Nevertheless, public fascination with them, and the sense that with so much money involved they cannot be wrong, also reduces any tendency they may have for self-scrutiny. Meanwhile any dissenting voices are ignored at best or pilloried for their defective imagination, mental inadequacy or even suspect motivation.

Of course the crash, when it inevitably occurs, changes the public mood totally. Those who were celebrated are now scorned as the objects of public anger and recrimination, and those who received the greatest adulation for their financial genius are the ones on whom the most opprobrium in heaped.

Surprisingly, in all the talk of regulation and reform that ensues in the aftermath of the crash, the basic reality of the aberrant public optimism that encouraged the speculation is all but ignored. Instead, some blame is placed on the more spectacular and felonious of the previous speculators, but not to all participants who entered the market, who are seen instead as victims. Culprits are sought, who are to be punished, and there is also scrutiny of the same financial instruments that facilitated and financed the speculative phase. But there is no questioning of the essential principles of market functioning that underlay the entire process of boom and crash.

One reason for this is of course human unwillingness to accept the widespread naiveté or even stupidity that was displayed during the period of euphoria. But a more basic reason for this lack of recognition of the broader public tendency could be theological: the sacrosanct nature of markets.

“In accepted free-enterprise attitudes and doctrine, the market is a neutral and accurate reflection of external influences; it is not supposed to be subject to an inherent and internal dynamic of error. This is the classical faith. So there is need to find some cause of the crash, however farfetched, that is external to the market itself. Or some abuse of the market that has inhibited its normal performance… Markets in our culture are a totem; to them can be ascribed no inherent aberrant tendency or fault”. (pp. 23-24)

This is what leads Galbraith to argue that “there is nothing in economic life so wilfully misunderstood as the great speculative episode”. (pp. 107-108) After such wisdom, his final conclusion is a bit of a disappointment: “beyond a better perception of the speculative tendency and process itself, there is probably not a great deal that can be done.” (p. 108) He even dismisses regulation as leading to an ineffective body of law, and suggests that only a philosophical acceptance of this inevitable tendency will allow us to cope with it.

Yet the answer as to what is to be done lies in Galbraith’s own analysis, not even buried but just under the surface. The nature of capitalism itself and the associated theological devotion to free markets are clearly at the root of the problem, and so the solution too has to go beyond capitalist markets and profit motivation. It may be too much to expect those who have invested their lives, imagination and resources in this system to consider moving away from it, but surely that cannot be true of the general public. If we are not to be condemned to keep repeating this unfortunate and even embarrassing history, we must be willing to understand and move away from this system.