THE
ASCENT OF MONEY: A FINANCIAL HISTORY OF THE WORLD
BY
NIALL FERGUSON
3. BLOWING BUBBLES
The Andes
stretch for more than four thousand miles like a jagged, crooked spine down the
western side of the South American continent. Formed roughly a hundred million
years ago, as the Nazca tectonic plate began its slow but tumultuous slide
beneath the South American plate, their highest peak, Mount Aconcagua in
Argentina, rises more than 22,000 feet above sea level. Aconcagua’s smaller
Chilean brethren stand like gleaming white sentinels around Santiago. But it is
only when you are up in the Bolivian highlands that you really grasp the sheer
scale of the Andes. When the rain clouds lift on the road from La Paz to Lake
Titicaca, the mountains dominate the skyline, tracing a dazzling, irregular
saw-tooth right across the horizon.
Looking at
the Andes, it is hard to imagine that any kind of human organization could
overcome such a vast natural barrier. But for one American company, their
jagged peaks were no more daunting than the dense Amazonian rainforests that
lie to the east of them. That company set out to construct a gas pipeline from
Bolivia across the continent to the Atlantic coast of Brazil, and another - the
longest in the world - from the tip of Patagonia to the Argentine capital
Buenos Aires.
Such
grand schemes, exemplifying the vaulting ambition of modern capitalism, were
made possible by the invention of one of the most fundamental institutions of
the modern world: the company. It is the company that enables thousands of
individuals to pool their resources for risky, long-term projects that require
the investment of vast sums of capital before profits can be realized. After
the advent of banking and the birth of the bond market, the next step in the
story of the ascent of money was therefore the rise of the joint-stock, limited-liability
corporation: joint-stock because the company’s capital was jointly owned by
multiple investors; limited-liability because the separate existence of the
company as a legal ‘person’ protected the investors from losing all their
wealth if the venture failed. Their liability was limited to the money they had
used to buy a stake in the company. Smaller enterprises might operate just as
well as partnerships. But those who aspired to span continents needed the
company.1
However,
the ability of companies to transform the global economy depended on another,
related innovation. In theory, the managers of joint-stock companies are
supposed to be disciplined by vigilant shareholders, who attend annual
meetings, and seek to exert influence directly or indirectly through
non-executive directors. In practice, the primary discipline on companies is
exerted by stock markets, where an almost infinite number of small slices of
companies (call them stocks, shares or equities, whichever you prefer) are
bought and sold every day. In essence, the price people are prepared to pay for
a piece of a company tells you how much money they think that company will make
in the future. In effect, stock markets hold hourly referendums on the
companies whose shares are traded there: on the quality of their management, on
the appeal of their products, on the prospects of their principal markets.
Yet stock
markets also have a life of their own. The future is in large measure
uncertain, so our assessments of companies’ future profitability are bound to
vary. If we were all calculating machines we would simultaneously process all
the available information and come to the same conclusion. But we are human
beings, and as such are prone to myopia and to mood swings. When stock market
prices surge upwards in sync, as they often do, it is as if investors are
gripped by a kind of collective euphoria: what the former chairman of the
Federal Reserve Alan Greenspan memorably called irrational exuberance.2 Conversely,
when investors’ ‘animal spirits’ flip from greed to fear, the bubble of their
earlier euphoria can burst with amazing suddenness. Zoological imagery is of
course an integral part of stock market culture. Optimistic buyers of stocks
are bulls, pessimistic sellers are bears. Investors these days are said to be
an electronic herd, happily grazing on positive returns one moment, then
stampeding for the farmyard gate the next. The real point, however, is that
stock markets are mirrors of the human psyche. Like homo
sapiens, they can become depressed. They can even suffer complete
breakdowns. Yet hope - or is it amnesia? - always seems able to triumph over
such bad experiences.
In the
four hundred years since shares were first bought and sold, there has been a
succession of financial bubbles. Time and again, share prices have soared to
unsustainable heights only to crash downwards again. Time and again, this
process has been accompanied by skulduggery, as unscrupulous insiders have
sought to profit at the expense of naive neophytes. So familiar is this pattern
that it is possible to distil it into five stages:
1. Displacement:
Some change in economic circumstances creates new and profitable opportunities
for certain companies.
2. Euphoria or
overtrading: A feedback process sets in whereby rising expected profits lead to
rapid growth in share prices.
3. Mania or
bubble: The prospect of easy capital gains attracts first-time investors and
swindlers eager to mulct them of their money.
4. Distress:
The insiders discern that expected profits cannot possibly justify the now
exorbitant price of the shares and begin to take profits by selling.
5. Revulsion or
discredit: As share prices fall, the outsiders all stampede for the exits,
causing the bubble to burst altogether.3
Stock
market bubbles have three other recurrent features. The first is the role of
what is sometimes referred to as asymmetric information. Insiders - those
concerned with the management of bubble companies - know much more than the
outsiders, whom the insiders want to part from their money. Such asymmetries
always exist in business, of course, but in a bubble the insiders exploit them
fraudulently.4 The second theme is the role of
cross-border capital flows. Bubbles are more likely to occur when capital flows
freely from country to country. The seasoned speculator, based in a major
financial centre, may lack the inside knowledge of the true insider. But he is
much more likely to get his timing right - buying early and selling before the
bubble bursts - than the naive first-time investor. In a bubble, in other
words, not everyone is irrational; or, at least, some of the exuberant are less
irrational than others. Finally, and most importantly, without easy credit
creation a true bubble cannot occur. That is why so many bubbles have their
origins in the sins of omission or commission of central banks.
Nothing
illustrates more clearly how hard human beings find it to learn from history
than the repetitive history of stock market bubbles. Consider how readers of
the magazine Business Week saw the world at two moments in
time, separated by just twenty years. On 13 August 1979, the front cover
featured a crumpled share certificate in the shape of a crashed paper dart
under the headline: ‘The Death of Equities: How inflation is destroying the
stock market’. Readers were left in no doubt about the magnitude of the crisis:
The
masses long ago switched from stocks to investments having higher yields and
more protection from inflation. Now the pension funds - the market’s last hope
- have won permission to quit stocks and bonds for real estate, futures, gold,
and even diamonds. The death of equities looks like an almost permanent
condition.5
On that
day, the Dow Jones Industrial Average, the longest-running American stock
market index, closed at 875, barely changed from its level ten years before,
and nearly 17 per cent below its peak of 1052 in January 1973. Pessimism after
a decade and half of disappointment was understandable. Yet, far from expiring,
US equities were just a few years away from one of the great bull runs of
modern times. Having touched bottom in August 1982 (777), the Dow proceeded to
more than treble in the space of just five years, reaching a record high of
2,700 in the summer of 1987. After a short, sharp sell-off in October 1987, the
index resumed its upward rise. After 1995, the pace of its ascent even
quickened. On 27 September 1999, it closed at just under 10,395, meaning that
the average price of a major US corporation had risen nearly twelve-fold in
just twenty years. On that day, readers of Business Weekread with
excitement that:
Conditions don’t have to get a lot better to
justify Dow 36,000, say James K. Glassman and Kevin A. Hassett in Dow 36,000: The New Strategy for Profiting
From the Coming Rise in the Stock Market. They argue that the market
already merits 36K, and that stock prices will advance toward that target over
the next 3 to 5 years as investors come to that conclusion, too . . . The
market - even at a price-to-earnings ratio of 30s - is a
steal. By their estimates, a ‘perfectly reasonable price’ for the market . . .
is 100 times earnings.6
This
article was published less than four months before the collapse of the dot-com
bubble, which had been based on exaggerated expectations about the future
earnings of technology companies. By October 2002 the Dow was down to 7,286, a
level not seen since late 1997. At the time of writing (April 2008), it is
still trading at one third of the level Glassman and Hassett predicted.
The
performance of the American stock market is perhaps best measured by comparing
the total returns on stocks, assuming the reinvestment of all dividends, with
the total returns on other financial assets such as government bonds and
commercial or Treasury bills, the last of which can be taken as a proxy for any
short-term instrument like a money market fund or a demand deposit at a bank.
The start date, 1964, is the year of the author’s birth. It will immediately be
apparent that if my parents had been able to invest even a modest sum in the US
stock market at that date, and to continue reinvesting the dividends they
earned each year, they would have been able to increase their initial
investment by a factor of nearly seventy by 2007. For example, $10,000 would
have become $700,000. The alternatives of bonds or bills would have done less
well. A US bond fund would have gone up by a factor of under 23; a portfolio of
bills by a factor of just 12. Needless to say, such figures must be adjusted
downwards to take account of the cost of living, which has risen by a factor of
nearly seven in my lifetime. In real terms, stocks increased by a factor of
10.3; bonds by a factor of 3.4; bills by a factor of 1.8. Had my parents made
the mistake of simply buying $10,000 in dollar bills in 1964, the real value of
their son’s nest egg would have declined in real terms by 85 per cent.
No stock
market has out-performed the American over the long run. One estimate of
long-term real stock market returns showed an average return for the US market
of 4.73 per cent per year between the 1920s and the 1990s. Sweden came next
(3.71), followed by Switzerland (3.03), with Britain barely in the top ten on
2.28 per cent. Six out of the twenty-seven markets studied suffered at least
one major interruption, usually as a result of war or revolution. Ten markets
suffered negative long-term real returns, of which the worst were Venezuela,
Peru, Colombia and, at the very bottom, Argentina (-5.36 per cent) .7 ‘Stocks
for the long run’ is very far from being a universally applicable nostrum.8 It
nevertheless remains true that, in most countries for which long-run data are
available, stocks have out-performed bonds - by a factor of roughly five over
the twentieth century.9This can scarcely surprise us. Bonds,
as we saw in Chapter 2, are no more than promises by governments to pay
interest and ultimately repay principal over a specified period of time. Either
through default or through currency depreciation, many governments have failed
to honour those promises. By contrast, a share is a portion of the capital of a
profit-making corporation. If the company succeeds in its undertakings, there
will not only be dividends, but also a significant probability of capital
appreciation. There are of course risks, too. The returns on stocks are less
predictable and more volatile than the returns on bonds and bills. There is a
significantly higher probability that the average corporation will go bankrupt
and cease to exist than that the average sovereign state will disappear. In the
event of a corporate bankruptcy, the holders of bonds and other forms of debt
will be satisfied first; the equity holders may end up with nothing. For these
reasons, economists see the superior returns on stocks as capturing an ‘equity
risk premium’ - though clearly in some cases this has been a risk well worth
taking.
THE
COMPANY YOU KEEP
Behind
the ornate baroque façade of Venice’s San Moise church, literally under the
feet of the tens of thousands of tourists who visit the church each year, there
is a remarkable but seldom noticed inscription: HONORI ET MEMORIAL JOANNIS LAW
EDINBURGENSES REGII
GALLIARUM AERARII PREFECTI CLARISSIMA (‘To the honour and memory of John Law of Edinburgh. Most distinguished controller of the treasury of the kings of the French.’)
GALLIARUM AERARII PREFECTI CLARISSIMA (‘To the honour and memory of John Law of Edinburgh. Most distinguished controller of the treasury of the kings of the French.’)
It is a
rather unlikely resting place for the man who invented the stock market bubble.
An
ambitious Scot, a convicted murderer, a compulsive gambler and a flawed
financial genius, John Law was not only responsible for the first true boom and
bust in asset prices. He also may be said to have caused, indirectly, the
French Revolution by comprehensively blowing the best chance that the ancien
régime monarchy had to reform its finances. His story is one of the
most astonishing yet least well understood tales of adventure in all financial
history. It is also very much a story for our times.
Born in
Edinburgh in 1671, Law was the son of a successful goldsmith and the heir to
Lauriston Castle, overlooking the Firth of Forth. He went to London in 1692,
but quickly began to fritter away his patrimony in a variety of business
ventures and gambling escapades. Two years later he fought a duel with his
neighbour, who objected to sharing the same building as the dissolute Law and
his mistress, and killed him. He was tried for duelling and sentenced to death,
but escaped from prison and fled to Amsterdam.
Law could
not have picked a better town in which to lie low. By the 1690s Amsterdam was
the world capital of financial innovation. To finance their fight for
independence against Spain in the late sixteenth century, as we saw in the
previous chapter, the Dutch had improved on the Italian system of public debt
(introducing, among other things, lottery loans which allowed people to gamble
as they invested their savings in government debt). They had also reformed
their currency by creating what was arguably the world’s first central bank,
the Amsterdam Exchange Bank (Wisselbank), which solved the problem of
debased coinage by creating a reliable form of bank money (see Chapter 1). But
perhaps the single greatest Dutch invention of all was the joint-stock company.
The story
of the company had begun a century before Law’s arrival and had its origins in
the efforts of Dutch merchants to wrest control of the lucrative Asian spice
trade from Portugal and Spain. Europeans craved spices like cinnamon, cloves,
mace, nutmeg and pepper not merely to flavour their food but also to preserve
it. For centuries, these commodities had come overland from Asia to Europe
along the Spice Road. But with the Portuguese discovery of the sea route to the
East Indies via the Cape of Good Hope, new and irresistibly attractive business
opportunities opened up. The Amsterdam Historical Museum is full of paintings
that depict Dutch ships en route to and from the East Indies. One early example
of the genre bears the inscription: ‘Four ships sailed to go and get the spices
towards Bantam and also established trading posts. And came back richly laden
to . . . Amsterdam. Departed May 1, 1598. Returned July 19, 1599.’ As that
suggests, however, the round trip was a very long one (fourteen months was in
fact well below the average). It was also hazardous: of twenty-two ships that
set sail in 1598, only a dozen returned safely. For these reasons, it made
sense for merchants to pool their resources. By 1600 there were around six
fledgling East India companies operating out of the major Dutch ports. However,
in each case the entities had a limited term that was specified in advance -
usually the expected duration of a voyage - after which the capital was repaid
to investors.10 This business model could not suffice to
build the permanent bases and fortifications that were clearly necessary if the
Portuguese and their Spanish alliest were to be
supplanted. Actuated as much by strategic calculations as by the profit motive,
the Dutch States-General, the parliament of the United Provinces, therefore
proposed to merge the existing companies into a single entity. The result was
the United East India Company - the Vereenigde Nederlandsche Geoctroyeerde
Oostindische Compagnie (United Dutch Chartered East India Company, or
VOC for short), formally chartered in 1602 to enjoy a monopoly on all Dutch
trade east of the Cape of Good Hope and west of the Straits of Magellan.11
The
structure of the VOC was novel in a number of respects. True, like its
predecessors, it was supposed to last for a fixed period, in this case
twenty-one years; indeed, Article 7 of its charter stated that investors would
be entitled to withdraw their money at the end of just ten years, when the
first general balance was drawn up. But the scale of the enterprise was
unprecedented. Subscription to the Company’s capital was open to all residents
of the United Provinces and the charter set no upper limit on how much might be
raised. Merchants, artisans and even servants rushed to acquire shares; in
Amsterdam alone there were 1,143 subscribers, only eighty of whom invested more
than 10,000 guilders, and 445 of whom invested less than 1,000. The amount
raised, 6.45 million guilders, made the VOC much the biggest corporation of the
era. The capital of its English rival, the East India Company, founded two
years earlier, was just £68,373 - around 820,000 guilders - shared between a
mere 219 subscribers. 12 Because the VOC was a
government-sponsored enterprise, every effort was made to overcome the rivalry
between the different provinces (and particularly between Holland, the richest
province, and Zeeland). The capital of the Company was divided (albeit
unequally) between six regional chambers (Amsterdam, Zeeland, Enkhuizen, Delft,
Hoorn and Rotterdam). The seventy directors (bewindhebbers), who were
each substantial investors, were also distributed between these chambers. One
of their roles was to appoint seventeen people to act as the Heeren XVII -
the Seventeen Lords - as a kind of company board. Although Amsterdam accounted
for 57.4 per cent of the VOC’s total capital, it nominated only eight out of
the Seventeen Lords. Among the founding directors was Dirck Bas, a
profit-oriented paterfamilias who (to judge by his portrait)
was far from embarrassed by his riches.13
Ownership
of the Company was thus divided into multiple partijen or actien,
literally actions (as in ‘a piece of the action’). Payment for the shares was
in instalments, due in 1603, 1605, 1606 and 1607. The certificates issued were
not quite share certificates in the modern sense, but more like receipts; the
key document in law was the VOC stock ledger, where all stock-holders’ names
were entered at the time of purchase. 14 The principle
of limited liability was implied: shareholders stood to lose only their
investment in the company and no other assets in the event that it failed.15There
was, on the other hand, no guarantee of returns; Article 17 of the VOC charter
merely stated that a payment would be made to shareholders as soon as profits
equivalent to 5 per cent of the initial capital had been made.
The VOC
was not in fact an immediate commercial success. Trade networks had to be set
up, the mode of operation established and secure bases established. Between
1603 and 1607, a total of twenty-two ships were fitted out and sent to Asia, at
a cost of just under 3.7 million guilders. The initial aim was to establish a
number of factories (saltpetre refineries, textile facilities and warehouses),
the produce of which would then be exchanged for spices. Early successes
against the Portuguese saw footholds established at Masulipatnam in the Bay of
Bengal and Amboyna (today Ambon) in the Moluccas (Malukus), but in 1606 Admiral
Matelief failed to capture Malacca (Melaka) on the Malay Peninsula and an
attack on Makian (another Moluccan island) was successfully repulsed by a
Spanish fleet. An attempt to build a fort on Banda Neira, the biggest of the
nutmeg-producing Banda islands, also failed.16 By the
time a twelve-year truce was signed with Spain in 1608, the VOC had made more
money from capturing enemy vessels than from trade.17 One
major investor, the Mennonite Pieter Lijntjens, was so dismayed by the
Company’s warlike conduct that he withdrew from the Company in 1605. Another
early director, Isaac le Maire, resigned in protest at what he regarded as the
mismanagement of the Company’s affairs.18
But how
much power did even large shareholders have? Little. When the Company’s
directors petitioned the government to be released from their obligation to
publish ten-year accounts in 1612 - the date when investors were supposed to be
able to withdraw their capital if they chose to - permission was granted and
publication of the accounts and the repayment of investors’ capital were both
postponed. The only sop to shareholders was that in 1610 the Seventeen Lords
agreed to make a dividend payment the following year, though at this stage the
Company was so strapped for cash that the dividend had to be paid in spices. In
1612 it was announced that the VOC would not be liquidated, as originally
planned. This meant that any shareholders who wanted their cash back had no
alternative but to sell their shares to another investor.19
The
joint-stock company and the stock market were thus born within just a few years
of each other. No sooner had the first publicly owned corporation come into
existence with the first-ever initial public offering of shares, than a
secondary market sprang up to allow these shares to be bought and sold. It
proved to be a remarkably liquid market. Turnover in VOC shares was high: by
1607 fully one third of the Company’s stock had been transferred from the
original owners.20 Moreover, because the Company’s books
were opened rather infrequently - purchases were formally registered monthly or
quarterly - a lively forward market in VOC shares soon developed, which allowed
sales for future delivery. To begin with, such transactions were done in
informal open-air markets, on the Warmoesstraat or next to the Oude Kerk. But
so lively was the market for VOC stock that in 1608 it was decided to build a
covered Beurs on the Rokin, not far from the town hall. With
its quadrangle, its colonnades and its clock tower, this first stock exchange
in the world looked for all the world like a medieval Oxford college. But what
went on there between noon and two o’clock each workday was recognizably
revolutionary. One contemporary captured the atmosphere on the trading floor as
a typical session drew to a close: ‘Hand-shakes are followed by shouting,
insults, impudence, pushing and shoving.’ Bulls (liefhebbers) did battle
with bears (contremines). The anxious speculator ‘chews his nails, pulls
his fingers, closes his eyes, takes four paces and four times talks to himself,
raises his hand to his cheek as if he has a toothache and all this accompanied
by a mysterious coughing’.21
Nor was
it coincidental that this same period saw the foundation (in 1609) of the
Amsterdam Exchange Bank, since a stock market cannot readily function without
an effective monetary system. Once Dutch bankers started to accept VOC shares
as collateral for loans, the link between the stock market and the supply of
credit began to be forged. The next step was for banks to lend money so that shares
might be purchased with credit. Company, bourse and bank provided the
triangular foundation for a new kind of economy.
For a
time it seemed as if the VOC’s critics, led by the disgruntled ex-director le
Maire, might exploit this new market to put pressure on the Company’s
directors. A concerted effort to drive down the price of VOC shares by short
selling on the nascent futures market was checked by the 1611 dividend payment,
ruining le Maire and his associates.22 Further cash
dividends were paid in 1612, 1613 and 1618.23The Company’s
critics (the ‘dissenting investors’ or Doleanten) remained
dissatisfied, however. In a tract entitled The Necessary Discourse (Nootwendich
Discours), published in 1622, an anonymous author lamented the lack of
transparency which characterized the ‘self-serving governance of certain of the
directors’, who were ensuring that ‘all remained darkness’: ‘The account book,
we can only surmise, must have been rubbed with bacon and fed to the dogs.’24Directorships
should be for fixed terms, the dissenters argued, and all major shareholders
should have the right to appoint a director.
The
campaign for a reform of what would now be called the VOC’s corporate
governance duly bore fruit. In December 1622, when the Company’s charter was
renewed, it was substantially modified. Directors would no longer be appointed
for life but could serve for only three years at a time. The ‘chief
participants’ (shareholders with as much equity as directors) were henceforth
entitled to nominate ‘Nine Men’ from among themselves, whom the Seventeen Lords
were obliged to consult on ‘great and important matters’, and who would be
entitled to oversee the annual accounting of the six chambers and to nominate,
jointly with the Seventeen Lords, future candidates for directorships. In
addition, in March 1623, it was agreed that the Nine Men would be entitled to
attend (but not to vote at) the meetings of the Seventeen Lords and to
scrutinize the annual purchasing accounts. The chief participants were also
empowered to appoint auditors (rekening-opnemers ) to check the
accounts submitted to the States-General. 25 Shareholders
were further mollified by the decision, in 1632, to set a standard 12.5 per
cent dividend, twice the rate at which the Company was able to borrow money.u The
result of this policy was that virtually all of the Company’s net profits
thereafter were distributed to the shareholders.26 Shareholders
were also effectively guaranteed against dilution of their equity. Amazingly,
the capital base remained essentially unchanged throughout the VOC’s existence.27 When
capital expenditures were called for, the VOC raised money not by issuing new
shares but by issuing debt in the form of bonds. Indeed, so good was the
Company’s credit by the 1670s that it was able to act as an intermediary for a
two-million-guilder loan by the States of Holland and Zeeland.
None of
these arrangements would have been sustainable, of course, if the VOC had not
become profitable in the mid seventeenth century. This was in substantial
measure the achievement of Jan Pieterszoon Coen, a bellicose young man who had
no illusions about the relationship between commerce and coercion. As Coen
himself put it: ‘We cannot make war without trade, nor trade without war.’28 He
was ruthless in his treatment of competitors, executing British East India
Company officials at Amboyna and effectively wiping out the indigenous
Bandanese. A natural-born empire builder, Coen seized control of the small
Javanese port of Jakarta in May 1619, renamed it Batavia and, aged just 30,
duly became the first governor-general of the Dutch East Indies. He and his
successor, Antonie van Diemen, systematically expanded Dutch power in the
region, driving the British from the Banda Islands, the Spaniards from Ternate
and Tidore, and the Portuguese from Malacca. By 1657 the Dutch controlled most
of Ceylon (Sri Lanka); the following decade saw further expansion along the
Malabar coast on the subcontinent and into the island of Celebes (Sulawesi).
There were also thriving Dutch bases on the Coromandel coast.29 Fire-power
and foreign trade sailed side by side on ships like the Batavia -
a splendid replica of which can be seen today at Lelystad on the coast of
Holland.
The
commercial payoffs of this aggressive strategy were substantial. By the 1650s,
the VOC had established an effective and highly lucrative monopoly on the
export of cloves, mace and nutmeg (the production of pepper was too widely
dispersed for it to be monopolized) and was becoming a major conduit for Indian
textile exports from Coromandel.30 It was also acting as
a hub for intra-Asian trade, exchanging Japanese silver and copper for Indian
textiles and Chinese gold and silk. In turn, Indian textiles could be traded
for pepper and spices from the Pacific islands, which could be used to purchase
precious metals from the Middle East.31 Later, the
Company provided financial services to other Europeans in Asia, not least
Robert Clive, who transferred a large part of the fortune he had made from
conquering Bengal back to London via Batavia and Amsterdam.32 As
the world’s first big corporation, the VOC was able to combine economies of
scale with reduced transaction costs and what economists call network
externalities, the benefit of pooling information between multiple employees
and agents.33 As was true of the English East India
Company, the VOC’s biggest challenge was the principal-agent problem: the
tendency of its men on the spot to trade on their own account, bungle
transactions or simply defraud the company. This, however, was partially
countered by an unusual compensation system, which linked remuneration to
investments and sales, putting a priority on turnover rather than net profits.34 Business
boomed. In the 1620s, fifty VOC ships had returned from Asia laden with goods;
by the 1690s the number was 156.35 Between 1700 and 1750
the tonnage of Dutch shipping sailing back around the Cape doubled. As late as
1760 it was still roughly three times the amount of British shipping.36
The
economic and political ascent of the VOC can be traced in its share price. The
Amsterdam stock market was certainly volatile, as investors reacted to rumours
of war, peace and shipwrecks in a way vividly described by the Sephardic Jew
Joseph Penso de la Vega in his aptly named book Confusión de
Confusiones (1688). Yet the long-term trend was clearly upward for
more than a century after the Company’s foundation. Between 1602 and 1733, VOC
stock rose from par (100) to an all-time peak of 786, this despite the fact
that from 1652 until the Glorious Revolution of 1688 the Company was being
challenged by bellicose British competition.37 Such
sustained capital appreciation, combined with the regular dividends and stable
consumer prices,v ensured that major shareholders like
Dirck Bas became very wealthy indeed. As early as 1650, total dividend payments
were already eight times the original investment, implying an annual rate of
return of 27 per cent.38 The striking point, however, is
that there was never such a thing as a Dutch East India Company bubble.
Unlike the Dutch tulip futures bubble of 1636-7, the ascent of the VOC stock
price was gradual, spread over more than a century, and, though its descent was
more rapid, it still took more than sixty years to fall back down to 120 in
December 1794. This rise and fall closely tracked the rise and fall of the
Dutch Empire. The prices of shares in other monopoly trading companies,
outwardly similar to the VOC, would behave very differently, soaring and
slumping in the space of just a few months. To understand why, we must rejoin
John Law.
To the
renegade Scotsman, Dutch finance came as a revelation. Law was fascinated by
the relationships between the East India Company, the Exchange Bank and the
stock exchange. Always attracted by gambling, Law found the Amsterdam Beursmore
exciting than any casino. He marvelled at the antics of short-sellers, who
spread negative rumours to try to drive down VOC share prices, or the
specialists in windhandel, who traded speculatively in shares they
did not themselves even own. Financial innovation was all around. Law himself
floated an ingenious scheme to insure holders of Dutch national lottery tickets
against drawing blanks.
Yet the
Dutch financial system struck Law as not quite complete. For one thing, it
seemed wrong-headed to restrict the number of East India Company shares when
the market was so enamoured of them. Law was also puzzled by the conservatism
of the Amsterdam Exchange Bank. Its own ‘bank money’ had proved a success, but
it largely took the form of columns of figures in the bank’s ledgers. Apart
from receipts issued to merchants who deposited coin with the bank, the money
had no physical existence. The idea was already taking shape in Law’s mind of a
breathtaking modification of these institutions, which would combine the
properties of a monopoly trading company with a public bank that issued notes
in the manner of the Bank of England. Law was soon itching to try out a whole
new system of finance on an unsuspecting nation. But which one?
He first
tried his luck in Genoa, trading foreign currency and securities. He spent some
time in Venice, trading by day, gambling by night. In partnership with the Earl
of Islay, he also built up a substantial portfolio on the London stock market.
(As this suggests, Law was well connected. But there remained a disreputable
quality to his conduct. Lady Catherine Knowles, daughter of the Earl of
Banbury, passed as his wife and was the mother of his two children, despite the
fact that she was married to another man. In 1705 he submitted to the Scottish
parliament a proposal for a new bank, later published as Money and
Trade Considered. His central idea was that the new bank should issue
interest-bearing notes that would supplant coins as currency. It was rejected
by the parliament shortly before the Act of Union with England.39Disappointed
by his homeland, Law travelled to Turin and in 1711 secured an audience with
Victor Amadeus II, Duke of Savoy. In The Piedmont Memorials, he
again made the case for a paper currency. According to Law, confidence alone
was the basis for public credit; with confidence, banknotes would serve just as
well as coins. ‘I have discovered the secret of the philosopher’s stone, he
told a friend, ‘it is to make gold out of paper.’40 The
Duke demurred, saying ‘I am not rich enough to ruin myself.’
THE
FIRST BUBBLE
Why was
it in France that Law was given the chance to try out his financial alchemy?
The French knew him for what he was, after all: in 1708 the Marquis of Torcy,
Louis XIV’s Foreign Minister, had identified him as a professional joueur (gambler)
and possible spy. The answer is that France’s fiscal problems were especially
desperate. Saddled with enormous public debt as a result of the wars of Louis
XIV, the government was on the brink of its third bankruptcy in less than a
century. A review (Visa) of the crown’s existing debts was thought
necessary, which led to the cancellation and reduction of many of them, in
effect a partial default. Even so, 250 million new interest-bearing notes
called billets d’état still had to be issued to fund the
current deficit. Matters were only made worse by an attempt to reduce the
quantity of gold and silver coinage, which plunged the economy into recession.41 To
all these problems Law claimed to have the solution.
In October
1715 Law’s first proposal for a public note-issuing bank was submitted to the
royal council, but it was rejected because of the opposition of the Duke of
Noailles to Law’s bold suggestion that the bank should also act as the crown’s
cashier, receiving all tax payments. A second proposal for a purely private
bank was more successful. The Banque Générale was established under Law’s
direction in May 1716. It was licensed to issue notes payable in specie (gold
or silver) for a twenty-year period. The capital was set at 6,000,000 livres
(1,200 shares of 5,000 livres each), three quarters to be paid in now somewhat
depreciated billets d’état (so the effective capital was
closer to 2,850,000 livres).42 It seemed at first quite
a modest enterprise, but Law always had a grander design in mind, which he was
determined to sell to the Duke of Orleans, the Regent during the minority of
Louis XV. In 1717 he took another step forward when it was decreed that Banque
Générale notes should be used in payment for all taxes, a measure initially
resisted in some places but effectively enforced by the government.
Law’s
ambition was to revive economic confidence in France by establishing a public
bank, on the Dutch model, but with the difference that this bank would issue
paper money. As money was invested in the bank, the government’s huge debt
would be consolidated. At the same time, paper money would revive French trade
- and with it French economic power. ‘The bank is not the only, nor the
grandest of my ideas,’ he told the Regent. ‘I will produce a work which will
surprise Europe by the changes which it will effect in favour of France -
changes more powerful than were produced by the discovery of the Indies . . .’43
Law had
studied finance in republican Holland, but from the outset he saw absolutist
France as a better setting for what became known as his System. ‘I maintain’,
he wrote, ‘that an absolute prince who knows how to govern can extend his
credit further and find needed funds at a lower interest rate than a prince who
is limited in his authority.’ This was an absolutist theory of finance, based
on the assertion that ‘in credit as in military and legislative authorities,
supreme power must reside in only one person’.44 The key
was to make royal credit work more productively than in the past, when the
crown had borrowed money in a hand-to-mouth way to finance its wars. In Law’s
scheme, the monarch would effectively delegate his credit ‘to a trading
company, into which all the materials of trade in the kingdom fall successively,
and are amassed into one’. The whole nation would, as he put it, ‘become a body
of traders, who have for cash the royal bank, in which by consequence all the
commerce, money, and merchandise re-unite’.45
As in the
Dutch case, empire played a key role in Law’s vision. In his view, too little
was being done to develop France’s overseas possessions. He therefore proposed
to take over France’s trade with the Louisiana territory, a vast but wholly
undeveloped tract of land stretching from the Mississippi delta across the
Midwest - equivalent to nearly a quarter of what is now the United States. In
1717 a new ‘Company of the West’ (Compagnie d’Occident) was granted the
monopoly of the commerce of Louisiana (as well as the control of the colony’s
internal affairs) for a period of twenty-five years. The Company’s capital was
fixed at 100 million livres, an unprecedented sum in France. Shares in the
Company were priced at 500 livres each, and Frenchmen, regardless of rank, as
well as foreigners were encouraged to buy them (in instalments) with the billets
d’état, which were to be retired and converted into 4 per cent rentes (perpetual
bonds). Law’s name headed the list of directors.
There was
some initial resistance to Law’s System, it is true. The Duke of Saint-Simon
observed wisely that:
An establishment of this sort may be good in
itself; but it is only so in a republic or in a monarchy like England, whose
finances are controlled by those alone who furnish them, and who only furnish
as much as they please. But in a state which is weak, changeable, and absolute,
like France, stability must necessarily be wanting to it; since the King . . .
may overthrow the Bank - the temptation to which would be too great, and at the
same time too easy.46
As if to
put this to the test, in early 1718 the Parlement of Paris launched fierce
attacks on the new Finance Minister René D’Argenson (and on Law’s bank)
following a 40 per cent debasement of the coinage ordered by the former, which
had caused, the Parlement complained, ‘a chaos so great and so obscure that
nothing about it can be known’.47 A rival company, set
up by the Pâris brothers, was meanwhile proving more successful in attracting
investors than Law’s Company of the West. In true absolutist fashion, however,
the Regent forcefully reasserted the prerogatives of the crown, much to Law’s
delight - and benefit. (‘How great is the benefit of a despotic power’, he
observed, ‘in the beginnings of an institution subject to so much opposition on
the part of a nation that has not yet become accustomed to it!’)48Moreover,
from late 1718 onwards the government granted privileges to the Company of the
West that were calculated to increase the appeal of its shares. In August it
was awarded the right to collect all the revenue from tobacco. In December it
acquired the privileges of the Senegal Company. In a further attempt to bolster
Law’s position, the Banque Générale was given the royal seal of approval: it
became the Banque Royale in December 1718, in effect the first French central bank.
To increase the appeal of its notes, these could henceforth be exchanged for
either écus de banque (representing fixed amounts of silver)
or the more commonly used livres tournois (a unit of account
whose relationship to gold and silver could vary). In July, however, the écu notes
were discontinued and withdrawn,49 while a decree of 22
April 1719 stipulated that banknotes should not share in the periodic
‘diminutions’ (in price) to which silver was subject.50 France’s
transition from coinage to paper money had begun.
Meanwhile,
the Company of the West continued to expand. In May 1719 it took over the East
India and China companies, to form the Company of the Indies (Compagnie des
Indes), better known as the Mississippi Company. In July Law secured the profits
of the royal mint for a nine-year term. In August he wrested the lease of the
indirect tax farms from a rival financier, who had been granted it a year
before. In September the Company agreed to lend 1.2 billion livres to the crown
to pay off the entire royal debt. A month later Law took control of the
collection (‘farm’) of direct taxes.
Law was
proud of his System. What had existed before, he wrote, was not much more than
‘a method of receipts and disbursements’. Here, by contrast, ‘you have a chain
of ideas which support one another, and display more and more the principle
they flow from.’51 In modern terms, what Law was
attempting could be described as reflation. The French economy had been in
recession in 1716 and Law’s expansion of the money supply with banknotes
clearly did provide a much-needed stimulus.52 At the
same time, he was (not unreasonably) trying to convert a badly managed and
burdensome public debt into the equity of an enormous, privatized tax-gathering
and monopoly trading company. 53 If he were
successful, the financial difficulties of the French monarchy would be at an
end.
But Law
had no clear idea where to stop. On the contrary, as the majority shareholder
in what was now a vast corporation, he had a strong personal interest in allowing
monetary expansion, which his own bank could generate, to fuel an asset bubble
from which he more than anyone would profit. It was as if one man was
simultaneously running all five hundred of the top US corporations, the US
Treasury and the Federal Reserve System. Would such a person be likely to raise
corporation taxes or interest rates at the risk of reducing the value of his
massive share portfolio? Moreover, Law’s System had to create a bubble or it
would fail. The acquisition of the various other companies and tax farms was
financed, not out of company profits, but simply by issuing new shares. On 17
June 1719 the Mississippi Company issued 50,000 of these at a price of 550
livres apiece (though each share had a face value of 500 livres, as with the
earlier Company of the West shares). To ensure the success of the issue, Law
personally underwrote it, a characteristic gamble that even he admitted cost
him a sleepless night. And to avoid the imputation that he alone would profit
if the shares rose in price, he gave existing Company of the West shareholders
the exclusive right to acquire these new shares (which hence became known as
‘daughters’; the earlier shares were ‘mothers’).54 In
July 1719 Law issued a third tranche of 50,000 shares (the ‘granddaughters’) -
now priced at 1,000 livres each - to raise the 50 million livres he needed to
pay for the royal mint. Logically, this dilution of the existing shareholders
ought to have caused the price of an individual share to decline. How could Law
justify a doubling of the issue price?
Ostensibly,
the ‘displacement’ that justified higher share prices was the promise of future
profits from Louisiana. That was why Law devoted so much effort to conjuring up
rosy visions of the colony as a veritable Garden of Eden, inhabited by friendly
savages, eager to furnish a cornucopia of exotic goods for shipment to France.
To conduct this trade, a grand new city was established at the mouth of the
Mississippi: New Orleans, named to flatter the always susceptible Regent. Such
visions, as we know, were not wholly without foundation, but their realization
lay far in the future. To be sure, a few thousand impoverished Germans from the
Rhineland, Switzerland and Alsace were recruited to act as colonists. But what
the unfortunate immigrants encountered when they reached Louisiana was a
sweltering, insect-infested swamp. Within a year 80 per cent of them had died
of starvation or tropical diseases like yellow fever.w
In the
short term, then, a different kind of displacement was needed to justify the 40
per cent dividends Law was now paying. It was provided by paper money. From the
summer of 1719 investors who wished to acquire the ‘daughters’ and
‘granddaughters’ were generously assisted by the Banque Royale, which allowed
shareholders to borrow money, using their shares as collateral; money they
could then invest in more shares. Predictably, the share price soared. The
original ‘mothers’ stood at 2,750 livres on 1 August, 4,100 on 30 August and
5,000 on 4 September. This prompted Law to issue 100,000 more shares at this
new market price. Two further issues of the same amount followed on 28
September and 2 October, followed by a smaller block of 24,000 shares two days
later (though these were never offered to the public). In the autumn of 1719
the share price passed 9,000 livres, reaching a new high (10,025) on 2
December. The informal futures market saw them trading at 12,500 livres for
delivery in March 1720. The mood was now shifting rapidly from euphoria to
mania.55
A few
people smelt a rat. ‘Have you all gone crazy in Paris?’ wrote Voltaire to M. de
Génonville in 1719. ‘It is a chaos I cannot fathom . . .’56 The
Irish banker and economist Richard Cantillon was so sure that Law’s System
would implode that he sold up and left Paris in early August 1719.57From
London Daniel Defoe was dismissive: the French had merely ‘run up a piece of
refined air’. Law’s career, he sneered, illustrated a new strategy for success
in life:
You must put on a sword, kill a beau or two,
get into Newgate [prison], be condemned to be hanged, break prison if you can
- remember that by the way -
get over to some strange country, turn stock-jobber, set up a Mississippi
stock, bubble a nation, and you will soon be a great man; if you have but great
good luck . .
.58
But a
substantial number of better-off Parisians were seduced by Law. Flush with cash
of his own making, he offered to pay pension arrears and indeed to pay pensions
in advance - a sure way to build support among the privileged classes. By
September 1719 there were hundreds of people thronging the rue Quincampoix, a
narrow thoroughfare between the rue St Martin and the rue St Denis where the
Company had its share-issuing office. A clerk at the British embassy described
it as ‘crowded from early in the morning to late at night with princes and
princesses, dukes and peers and duchesses etc., in a word all that is great in
France. They sell estates and pawn jewels to purchase Mississippi.’59 Lady
Mary Wortley Montagu, who visited Paris in 1719, was ‘delighted . . . to see an
Englishman (at least a Briton) absolute in Paris, I mean Mr. Law, who treats
their dukes and peers extremely de haut en bas and is treated
by them with the utmost submission and respect - Poor souls!’60 It
was in these heady times that the word millionaire was first
coined. (Like entrepreneurs, millionaires were invented in France.)
Small
wonder John Law was seen at Mass for the first time on 10 December, having
converted to Catholicism in order to be eligible for public office. He had much
to thank his Maker for. When he was duly appointed Controller General of
Finances the following month, his triumph was complete. He was now in charge
of:
the collection of all France’s indirect
taxes; the entire French national debt; the twenty-six French mints
that produced the country’s gold and silver coins; the colony of
Louisiana; the Mississippi Company, which had a monopoly on the
import and sale of tobacco; the French fur trade with Canada; and all
France’s trade with Africa, Asia and the East Indies.
Further,
in his own right, Law owned:
the Hôtel de Nevers in the rue de Richelieu
(now the Bibliothèque Nationale); the Mazarin Palace, where the
Company had its offices; more than a third of the buildings at the place
Vendôme (then place Louis le Grand); more than twelve country
estates; several plantations in Louisiana; and 100 million livres of
shares in the Mississippi Company.61
Louis XIV
of France had said ‘L’état, c’est moi’: I am the state. John Law could
legitimately say ‘L’économie, c’est moi’: I am the economy.
In truth,
John Law preferred gambling to praying. In March 1719, for example, he had bet
the Duke of Bourbon a thousand new louis d’or that there would be no more ice
that winter or spring. (He lost.) On another occasion he wagered 10,000 to 1
that a friend could not throw a designated number with six dice at one throw.
(He probably won on that occasion, since the odds against doing so are 66 to
1, or 46,656 to 1.) But his biggest bet was on his own System. Law’s ‘daily
discourse’, reported an uneasy British diplomat in August 1719, was that he
would ‘set France higher than ever she was before, and put her in a condition
to give the law to all Europe; that he can ruin the trade and credit of England
and Holland, whenever he pleases; that he can break our bank, whenever he has a
mind; and our East India Company. ’62 Putting his money
where his mouth was, Law had made a bet with Thomas Pitt, Earl of Londonderry
(and uncle of the Prime Minister William Pitt), that British shares would fall
in price in the year ahead. He sold £100,000 of East India stock short for
£180,000 (that is at a price of £180 per share, or 80 per cent above face
value) for delivery on 25 August 1720.63 (The price of
the shares at the end of August 1719 was £194, indicating Law’s expectation of
a £14 price decline.)
Yet the
con at the heart of Law’s confidence could not be sustained indefinitely. Even
before his appointment as Controller General, the first signs of phase 4 of the
five-stage bubble cycle - distress - had begun to manifest themselves. When the
Mississippi share price began to decline in December 1719, touching 7,930
livres on 14 December, Law resorted to the first of many artificial expedients
to prop it up, opening a bureau at the Banque Royale that guaranteed to buy
(and sell) the shares at a floor price of 9,000 livres. As if to simplify
matters, on 22 February 1720 it was announced that the Company was taking over
the Banque Royale. Law also created options (primes) costing 1,000
livres which entitled the owner to buy a share for 10,000 livres over the
following six months (that is an effective price of 11,000 livres - 900 livres
above the actual peak price of 10,100 reached on 8 January). These measures
sufficed to keep the share price above 9,000 livres until mid-January (though
the effect of the floor price was to render the options worthless; generously
Law allowed holders to convert them into shares at the rate of ten primes per
share).
Inflation,
however, was now accelerating alarmingly outside the stock market. At their
peak in September 1720, prices in Paris were roughly double what they had been
two years before, with most of the increase coming in the previous eleven
months. This was a reflection of the extraordinary increase in note circulation
Law had caused. In the space of little more than a year he had more than
doubled the volume of paper currency. By May 1720 the total money supply
(banknotes and shares held by the public, since the latter could be turned into
cash at will) was roughly four times larger in livre terms than the gold and
silver coinage France had previously used.64 Not
surprisingly, some people began to anticipate a depreciation of the banknotes,
and began to revert to payment in gold and silver. Ever the absolutist, Law’s
initial response was to resort to compulsion. Banknotes were made legal tender.
The
Mississippi Bubble: Money and share prices (livres)
The
export of gold and silver was banned as was the production and sale of gold and
silver objects. By the arrêt of 27 February 1720, it became
illegal for a private citizen to possess more than 500 livres of metal coin.
The authorities were empowered to enforce this measure by searching people’s
houses. Voltaire called this ‘the most unjust edict ever rendered’ and ‘the
final limit of a tyrannical absurdity’.65
At the
same time, Law obsessively tinkered with the exchange rate of the banknotes in
terms of gold and silver, altering the official price of gold twenty-eight
times and the price of silver no fewer than thirty-five times between September
1719 and December 1720 - all in an effort to make banknotes more attractive
than coins to the public. But the flow of sometimes contradictory regulations
served only to bewilder people and to illustrate the propensity of an
absolutist regime to make up the economic rules to suit itself. ‘By an all new
secret magic,’ one observer later recalled, ‘words assembled and formed Edicts
that no one comprehended, and the air was filled with obscure ideas and
chimeras.’66 One day gold and silver could be freely
exported; the next day not. One day notes were being printed as fast as the
printing presses could operate; the next Law was aiming to cap the banknote
supply at 1.2 million livres. One day there was a floor price of 9,000 livres
for Mississippi shares; the next day not. When this floor was removed on 22
February the shares predictably slumped. By the end of the month they were down
to 7,825 livres. On 5 March, apparently under pressure from the Regent, Law
performed another U-turn, reinstituting the 9,000 livre floor and reopening the
bureau to buy them at this price. But this meant that the lid was once again
removed from the money supply - despite the assertion in the same decree that
‘the banknote was a money which could not be altered in value’, and despite the
previous commitment to a 1.2 million livre cap.67By now the
smarter investors were more than happy to have 9,000 livres in cash for their
each of their shares. Between February and May 1720 there was a 94 per cent increase
in the public’s holdings of banknotes. Meanwhile their holdings of shares
slumped to less than a third of the total number issued. It seemed inevitable
that before long all the shares would be unloaded on the Company, unleashing a
further flood of banknotes and a surge in inflation.
On 21
May, in a desperate bid to avert meltdown, Law induced the Regent to issue a
deflationary decree, reducing the official price of Company shares in monthly
steps from 9,000 livres to 5,000 and at the same time halving the number of
banknotes in circulation. He also devalued the banknotes, having revoked the
previous order guaranteeing that this would not happen. This was when the
limits of royal absolutism, the foundation of Law’s System, suddenly became
apparent. Violent public outcry forced the government to revoke these measures
just six days after their announcement, but the damage to confidence in the
System was, by this time, irrevocable. After an initial lull, the share price
slid from 9,005 livres (16 May) to 4,200 (31 May). Angry crowds gathered
outside the Bank, which had difficulty meeting the demand for notes. Stones
were thrown, windows broken. ‘The heaviest loss’, wrote one British observer,
‘falls on the people of this country and affects all ranks and conditions among
them. It is not possible to express how great and general their consternation
and despair have appeared to be on this occasion; the Princes of the blood and
all the great men exclaim very warmly against it.’68 Law
was roundly denounced at an extraordinary meeting of the Parlement. The Regent
retreated, revoking the 21 May decree. Law offered his resignation, but was
dismissed outright on 29 May. He was placed under house arrest; his enemies
wanted to see him in the Bastille. For the second time in his life, Law faced
jail, conceivably even death. (An investigative commission quickly found
evidence that Law’s issues of banknotes had breached the authorized limit, so
grounds existed for a prosecution.) The Banque Royale closed its doors.
John Law
was an escape artist as well as a con artist. It quickly became apparent that
no one but him stood any chance of averting a complete collapse of the
financial system - which was, after all, his System. His recall to power (in
the less exalted post of Intendant General of Commerce) caused a rally on the
stock market, with Mississippi Company shares rising back to 6,350 livres on 6
June. It was, however, only a temporary reprieve. On 10 October the government
was forced to reintroduce the use of gold and silver in domestic transactions.
The Mississippi share price resumed its downward slide not long after, hitting
2,000 livres in September and 1,000 in December. Full-blown panic could no
longer be postponed. It was at this moment that Law, vilified by the people,
and lampooned by the press, finally fled the country. He had a ‘touching
farewell’ with the Duke of Orleans before he went. ‘Sire,’ said Law, ‘I
acknowledge that I have made great mistakes. I made them because I am only
human, and all men are liable to err. But I declare that none of these acts
proceeded from malice or dishonesty, and that nothing of that character will be
discovered in the whole course of my conduct.’69 Nevertheless,
his wife and daughter were not allowed to leave France so long as he was under
investigation.
As if
pricked by a sword, the Mississippi Bubble had now burst, and the noise of
escaping air resounded throughout Europe. So incensed was one Dutch investor
that he had a series of satirical plates specially commissioned in China. The
inscription on one reads: ‘By God, all my stock’s worthless!’ Another is even
more direct: ‘Shit shares and wind trade.’ As far as investors in Amsterdam
were concerned, Law’s company had been trading in nothing more substantial than
wind - in marked contrast to the Dutch East India Company, which had literally
delivered the goods in the form of spices and cloth. As the verses on one
satirical Dutch cartoon flysheet put it:
This is the wondrous Mississippi land,
Made famous by its share dealings,
Which through deceit and devious conduct,
Has squandered countless treasures.
However men regard the shares,
It is wind and smoke and nothing more.
A series
of humorously allegorical engravings were produced and published as The
Great Scene of Folly, which depicted barearsed stockbrokers eating coin and
excreting Mississippi stock; demented investors running amok in the rue
Quincampoix, before being hauled off to the madhouse; and Law himself, blithely
passing by castles in the air in a carriage pulled by two bedraggled Gallic
cockerels.70
Law
himself did not walk away financially unscathed. He left France with next to
nothing, thanks to his bet with Londonderry that English East India stock would
fall to £180. By April 1720 the price had risen to £235 and it continued to
rise as investors exited the Paris market for what seemed the safer haven of
London (then in the grip of its own less spectacular South Sea Bubble). By June
the price was at £420, declining only slightly to £345 in August, when Law’s bet
fell due. Law’s London banker, George Middleton, was also ruined in his effort
to honour his client’s obligation. The losses to France, however, were more
than just financial. Law’s bubble and bust fatally set back France’s financial
development, putting Frenchmen off paper money and stock markets for
generations. The French monarchy’s fiscal crisis went unresolved and for the
remainder of the reigns of Louis XV and his successor Louis XVI the crown
essentially lived from hand to mouth, lurching from one abortive reform to
another until royal bankruptcy finally precipitated revolution. The magnitude
of the catastrophe was perhaps best captured by Bernard Picart in his elaborate
engraving Monument Consecrated to Posterity (1721). On the
left, penniless Dutch investors troop morosely into the sickhouse, the madhouse
and the poorhouse. But the Parisian scene to the right is more apocalyptic. A
naked Fortuna rains down Mississippi stock and options on a mob emanating from
the rue Quincampoix, while a juggernaut drawn by Indians crushes an accountant
under a huge wheel of fortune and two men brawl in the foreground.71
In
Britain, by contrast, the contemporaneous South Sea Bubble was significantly
smaller and ruined fewer people - not least because the South Sea Company never
gained control of the Bank of England the way Law had controlled the Banque
Royale. In essence, his English counterpart John Blunt’s South Sea scheme was
to convert government debt of various kinds, most of it created to fund the War
of the Spanish Succession, into the equity of a company that had been chartered
to monopolize trade with the Spanish Empire in South America. Having agreed on
conversion prices for the annuities and other debt instruments, the directors
of the South Sea Company stood to profit if they could get the existing holders
of government annuities to accept South Sea shares at a high market price,
since this would leave the directors with surplus shares to sell to the public.72 In
this they succeeded, using tricks similar to those employed by Law in Paris.
Shares were offered to the public in four tranches, with the price rising from
£300 per share in April 1720 to £1,000 in June. Instalment payment was
permitted. Loans were offered against shares. Generous dividends were paid.
Euphoria duly gave way to mania; as the poet Alexander Pope observed, it was
‘ignominious (in this Age of Hope and Golden Mountains) not to Venture’.73
Unlike
Law, however, Blunt and his associates had to contend with competition from the
Bank of England, which drove up the terms they had to offer the annuitants.
Unlike Law, they also had to contend with political opposition in the form of
the Whigs in Parliament, which drove up the bribes they had to pay to secure
favourable legislation (the Secretary to the Treasury alone made £249,000 from
his share options). And, unlike Law, they were unable to establish monopolistic
positions on the stock market and the credit market. On the contrary, there was
such a rush of new companies - 190 in all - seeking to raise capital in 1720
that the South Sea directors had to get their allies in Parliament to pass what
came to be known as the Bubble Act, designed to restrict new company
flotations.x At the same time, when the demand for cash
created by the South Sea’s third subscription exceeded the money market’s
resources, there was nothing the directors could do to inject additional
liquidity; indeed, the South Sea Company’s bank, the Sword Blade Company, ended
up failing on 24 September. (Unlike the Bank of England, and unlike the Banque
Royale, its notes were not legal tender.) The mania of May and June was
followed, after a hiatus of distress in July (when the insiders and foreign
speculators took their profits), by panic in August. ‘Most people thought it
wou’d come,’ lamented the hapless and now poorer Swift, ‘but no man prepar’d
for it; no man consider’d it would come like a Thief in the night,
exactly as it happens in the case of death.’74
Yet the
damage caused by the bursting of the bubble was much less fatal than on the
other side of the Channel. From par to peak, prices rose by a factor of 9.5 in
the case of South Sea stock, compared with 19.6 in the case of Mississippi
stock. Other stocks (Bank of England and East India Company) rose by
substantially smaller multiples. When stock prices came back down to earth in
London, there was no lasting systemic damage to the financial system, aside
from the constraint on future joint-stock company formation represented by the
Bubble Act. The South Sea Company itself continued to exist; the government
debt conversion was not reversed; foreign investors did not turn away from
English securities.75 Whereas all France was affected by
the inflationary crisis Law had unleashed, provincial England seems to have
been little affected by the South Sea crash.76 In this
tale of two bubbles, it was the French that had the worst of times.
BULLS
AND BEARS
On 16
October 1929 Yale University economics professor Irving Fisher declared that US
stock prices had ‘reached what looks like a permanently high plateau’.77 Eight
days later, on ‘Black Thursday’, the Dow Jones Industrial Average declined by 2
per cent. This is when the Wall Street crash is conventionally said to have
begun, though in fact the market had been slipping since early September and
had already suffered a sharp 6 per cent drop on 23 October. On ‘Black Monday’
(28 October) it plunged by 13 per cent; the next day by a further 12 per cent.
In the course of the next three years the US stock market declined a staggering
89 per cent, reaching its nadir in July 1932. The index did not regain its 1929
peak until November 1954. What was worse, this asset price deflation coincided
with, if it did not actually cause, the worst depression in all history. In the
United States, output collapsed by a third. Unemployment reached a quarter of
the civilian labour force, closer to a third if a modern definition is used. It
was a global catastrophe that saw prices and output decline in nearly every
economy in the world, though only the German slump was as severe as the
American. World trade shrank by two thirds as countries sought vainly to hide
behind tariff barriers and import quotas. The international financial system
fell to pieces in a welter of debt defaults, capital controls and currency depreciations.
Only the Soviet Union, with its autarkic, planned economy, was unaffected. Why
did it happen?
Some
financial disasters have obvious causes. Arguably a much worse stock market
crash had occurred at the end of July 1914, when the outbreak of the First
World War precipitated such a total meltdown that the world’s principal stock
markets - including New York’s - simply had to close their doors. And closed
they remained from August until the end of 1914.78 But
that was the effect of a world war that struck financial markets like a bolt
from the blue.79 The crash of October 1929 is much
harder to explain. Page 1 of the New York Times on the day
before Black Thursday featured articles about the fall of the French premier
Aristide Briand and a vote in the US Senate about duties on imported chemicals.
Historians sometimes see the deadlock over Germany’s post-First World War
reparations and the increase of American protectionism as triggers of the
Depression. But page 1 also features at least four reports on the atrocious
gales that had battered the Eastern seaboard the previous day.80 Maybe
historians should blame bad weather for the Wall Street crash. (That might not
be such a far-fetched proposition. Many veterans of the City of London still
remember that Black Monday - 19 October 1987 - came after the hurricane-force
winds that had unexpectedly swept the south-east of England the previous
Friday.)
Contemporaries
sensed that there was a psychological dimension to the crisis. In his inaugural
address, President Franklin Roosevelt argued that all that Americans had to
fear was ‘fear itself’. John Maynard Keynes spoke of a ‘failure in the
immaterial devices of the mind’. Yet both men also intimated that the crisis
was partly due to financial misconduct. Roosevelt took a swipe at ‘the
unscrupulous money changers’ of Wall Street; in his General Theory,
Keynes likened the stock market to a casino.
In some
measure, it can be argued, the Great Depression had its roots in the global
economic dislocations arising from the earlier crisis of 1914. During the First
World War, non-European agricultural and industrial production had expanded.
When European production came back on stream after the return of peace, there
was chronic over-capacity, which had driven down prices of primary products
long before 1929. This had made it even harder for countries with large
external war debts (including Germany, saddled with reparations) to earn the
hard currency they needed to make interest payments to their foreign creditors.
The war had also increased the power of organized labour in most combatant
countries, making it harder for employers to cut wages in response to price
falls. As profit margins were squeezed by rising real wages, firms were forced
to lay off workers or risk going bust. Nevertheless, the fact remains that the
United States, which was the epicentre of the crisis, was in many respects in
fine economic fettle when the Depression struck. There was no shortage of
productivity-enhancing technological innovation in the inter-war period by
companies like DuPont (nylon), Procter & Gamble (soap powder), Revlon
(cosmetics), RCA (radio) and IBM (accounting machines). ‘A prime reason for
expecting future earnings to be greater,’ argued Yale’s Irving Fisher, ‘was
that we in America were applying science and invention to industry as we had
never applied them before.’81 Management practices were
also being revolutionized by men like Alfred Sloan at General Motors.
Yet
precisely these strengths may have provided the initial displacement that set
in motion a classic stock market bubble. To observers like Fisher, it really
did seem as if the sky was the limit, as more and more American households
aspired to equip themselves with automobiles and consumer durables - products
which instalment credit put within their reach. RCA, the tech stock of the
1920s, rose by a dizzying 939 per cent between 1925 and 1929; its
price-earnings ratio at the peak of the market was 73.82 Euphoria
encouraged a rush of new initial public offerings (IPOs); stock worth $6
billion was issued in 1929, one sixth of it during September. There was a
proliferation of new financial institutions known as investment trusts,
designed to capitalize on the stock market boom. (Goldman Sachs chose 8 August
1929 to announce its own expansion plan, in the form of the Goldman Sachs
Trading Corporation; had this not been a free-standing entity, its subsequent
collapse might well have taken down Goldman Sachs itself.) At the same time,
many small investors (like Irving Fisher himself) relied on leverage to
increase their stock market exposure, using brokers’ loans (which were often
supplied by corporations rather than banks) to buy stocks on margin, thus
paying only a fraction of the purchase price with their own money. As in 1719,
so in 1929, there were unscrupulous insiders, like Charles E. Mitchell of
National City Bank or William Crapo Durant of GM, and ingenuous outsiders, like
Groucho Marx.83 As in 1719, flows of hot money between
financial markets served to magnify and transmit shocks. And, as in 1719, it
was the action of the monetary authorities that determined the magnitude of the
bubble and of the consequences when it burst.
In
perhaps the most important work of American economic history ever published,
Milton Friedman and Anna Schwartz argued that it was the Federal Reserve System
that bore the primary responsibility for turning the crisis of 1929 into a
Great Depression.84 They did not blame the Fed for the
bubble itself, arguing that with Benjamin Strong at the Federal Reserve Bank of
New York a reasonable balance had been struck between the international
obligation of the United States to maintain the restored gold standard and its
domestic obligation to maintain price stability. By sterilizing the large gold
inflows to the United States (preventing them for generating monetary
expansion), the Fed may indeed have prevented the bubble from growing even
larger. The New York Fed also responded effectively to the October 1929 panic
by conducting large-scale (and unauthorized) open market operations (buying
bonds from the financial sector) to inject liquidity into the market. However,
after Strong’s death from tuberculosis in October 1928, the Federal Reserve
Board in Washington came to dominate monetary policy, with disastrous results.
First, too little was done to counteract the credit contraction caused by
banking failures. This problem had already surfaced several months before the
stock market crash, when commercial banks with deposits of more than $80
million suspended payments. However, it reached critical mass in November and
December 1930, when 608 banks failed, with deposits totalling $550 million,
among them the Bank of United States, which accounted for more than a third of
the total deposits lost. The failure of merger talks that might have saved the
Bank was a critical moment in the history of the Depression.85Secondly,
under the pre-1913 system, before the Fed had been created, a crisis of this
sort would have triggered a restriction of convertibility of bank deposits into
gold. However, the Fed made matters worse by reducing the amount of credit
outstanding (December 1930-April 1931). This forced more and more banks to sell
assets in a frantic dash for liquidity, driving down bond prices and worsening
the general position. The next wave of bank failures, between February and
August 1931, saw commercial bank deposits fall by $2.7 billion, 9 per cent of
the total.86 Thirdly, when Britain abandoned the gold
standard in September 1931, precipitating a rush by foreign banks to convert
dollar holdings into gold, the Fed raised its discount rate in two steps to 3.5
per cent. This halted the external drain, but drove yet more US banks over the
edge: the period August 1931 to January 1932 saw 1,860 banks fail with deposits
of $1.45 billion.87 Yet the Fed was in no danger of
running out of gold. On the eve of the pound’s departure the US gold stock was
at an all-time high of $4.7 billion - 40 per cent of the world’s total. Even at
its lowest point that October, the Fed’s gold reserves exceeded its legal
requirements for cover by more than $1 billion.88 Fourthly,
only in April 1932, as a result of massive political pressure, did the Fed
attempt large-scale open market operations, the first serious step it had taken
to counter the liquidity crisis. Even this did not suffice to avert a final
wave of bank failures in the last quarter of 1932, which precipitated the first
state-wide ‘bank holidays’, temporary closures of all banks.89 Fifthly,
when rumours that the new Roosevelt administration would devalue the dollar led
to a renewed domestic and foreign flight from dollars into gold, the Fed once
again raised the discount rate, setting the scene for the nationwide bank
holiday proclaimed by Roosevelt on 6 March 1933, two days after his
inauguration - a holiday from which 2,000 banks never returned.90
The Fed’s
inability to avert a total of around 10,000 bank failures was crucial not just
because of the shock to consumers whose deposits were lost or to shareholders
whose equity was lost, but because of the broader effect on the money supply
and the volume of credit. Between 1929 and 1933, the public succeeded in
increasing its cash holdings by 31 per cent; commercial bank reserves were
scarcely altered (indeed, surviving banks built up excess reserves); but
commercial bank deposits decreased by 37 per cent and loans by 47 per cent. The
absolute numbers reveal the lethal dynamic of the ‘great contraction’. An
increase of cash in public hands of $1.2 billion was achieved at the cost of a decline
in bank deposits of $15.6 billion and a decline in bank loans of $19.6 billion,
equivalent to 19 per cent of 1929 GDP.91
There was
a time when academic historians felt squeamish about claiming that lessons
could be learned from history. This is a feeling unknown to economists, two
generations of whom have struggled to explain the Great Depression precisely in
order to avoid its recurrence. Of all the lessons to have emerged from this
collective effort, this remains the most important: that inept or inflexible
monetary policy in the wake of a sharp decline in asset prices can turn a
correction into a recession and a recession into a depression. According to
Friedman and Schwartz, the Fed should have aggressively sought to inject
liquidity into the banking system from 1929 onwards, using open market
operations on a large scale, and expanding rather than contracting lending
through the discount window. They also suggest that less attention should have
been paid to gold outflows. More recently, it has been argued that the
inter-war gold standard itself was the problem, in that it transmitted crises
(like the 1931 European bank and currency crises) around the world.92 A
second lesson of history would therefore seem to be that the benefits of a
stable exchange rate are not so great as to exceed the costs of domestic
deflation. Anyone who today doubts that there are lessons to be learned from
history needs do no more than compare the academic writings and recent actions
of the current chairman of the Federal Reserve System.93
A
TALE OF FAT TAILS
Sometimes
the most important historical events are the non-events: the things that did
not occur. The economist Hyman Minsky put it well when he observed: ‘The most
significant economic event of the era since World War II is something that has
not happened: there has not been a deep and long-lasting depression’.94 This
is indeed surprising, since the world has not been short of ‘Black Days’.
If
movements in stock market indices were statistically distributed like human heights
there would hardly be any such days. Most would be clustered around the
average, with only a tiny number of extreme ups or downs. After all, not many
of us are below four feet in height or above eight feet. If I drew a histogram
of the heights of the male students in my financial history class according to
their frequency, the result would be a classic bell-shaped curve, with nearly
everyone clustered within around five inches of the US average of around 5’
10". But in financial markets, it doesn’t look like this. If you plot all
the monthly movements of the Dow Jones index on a chart, there is much less
clustering around the average, and there are many more big rises and falls out
at the extremes, which the statisticians call ‘fat tails’. If stock market
movements followed the ‘normal distribution’ or bell curve, like human heights,
an annual drop of 10 per cent or more would happen only once every 500 years,
whereas on the Dow Jones it has happened about once every five years.95And
stock market plunges of 20 per cent or more would be unheard of - rather like
people just a foot tall - whereas in fact there have been nine such crashes in
the past century.
On ‘Black
Monday’, 19 October 1987, the Dow fell by a terrifying 23 per cent, one of just
four days when the index has fallen by more than 10 per cent in a single
trading session. The New York Times’s front page the next morning
said it all when it asked ‘Does 1987 Equal 1929?’ From peak to trough, the fall
was of nearly one third, a loss in the value of American stocks of close to a
trillion dollars. The causes of the crash were much debated at the time. True,
the Fed had raised rates the previous month from 5.5 to 6 per cent. But the
official task force chaired by Nicholas Brady laid much of the blame for the
crash on ‘mechanical, price-insensitive selling by a [small] number of
institutions employing portfolio insurance strategies and a small number of
mutual fund groups reacting to redemptions’, as well as ‘a number of aggressive
trading-oriented institutions [which tried] to sell in anticipation of further
market declines’. Matters were made worse by a breakdown in the New York Stock
Exchange’s automated transaction system, and by the lack of ‘circuit breakers’
which might have interrupted the sell-off on the futures and options markets.96 The
remarkable thing, however, was what happened next - or rather, what didn’t
happen. There was no Great Depression of the 1990s, despite the forebodings of
Lord Rees-Mogg and others.97 There wasn’t even a
recession in 1988 (only a modest one in 1990-91). Within little more than a
year of Black Monday, the Dow was back to where it had been before the crash.
For this, some credit must unquestionably be given to the central bankers, and
particularly the then novice Federal Reserve Chairman Alan Greenspan, who had
taken over from Paul Volcker just two months before. Greenspan’s response to
the Black Monday crash was swift and effective. His terse statement on 20
October, affirming the Fed’s ‘readiness to serve as a source of liquidity to
support the economic and financial system’, sent a signal to the markets, and
particularly the New York banks, that if things got really bad he stood ready
to bail them out.98 Aggressively buying government bonds
in the open market, the Fed injected badly needed cash into the system, pushing
down the cost of borrowing from the Fed by nearly 2 per cent in the space of
sixteen days. Wall Street breathed again. What Minsky called ‘It’ had not
happened.
Having
contained a panic once, the dilemma that lurked in the back of Greenspan’s mind
thereafter was whether or not to act pre-emptively the next time - to prevent
the panic altogether. This dilemma came to the fore as a classic stock market
bubble took shape in the mid 1990s. The displacement in this case was the
explosion of innovation by the technology and software industry as personal
computers met the Internet. But, as in all history’s bubbles, an accommodative
monetary policy also played a role. From a peak of 6 per cent in June 1995, the
Federal funds target rateyhad been reduced to 5.25 per cent
(January 1996-February 1997). It had been raised to 5.5 per cent in March 1997,
but then cut in steps between September and November 1998 down to 4.75 per
cent; and it remained at that level until May 1999, by which time the Dow had
passed the 10,000 mark. Rates were not raised until June 1999.
Why did
the Fed allow euphoria to run loose in the 1990s? Greenspan himself had felt
constrained to warn about ‘irrational exuberance’ on the stock market as early
as 5 December 1996, shortly after the Dow had risen above 6,000.z Yet
the quarter point rate increase of March 1997 was scarcely sufficient to dispel
that exuberance. Partly, Greenspan and his colleagues seem to have
underestimated the momentum of the technology bubble. As early as December
1995, with the Dow just past the 5,000 mark, members of the Fed’s Open Market
Committee speculated that the market might be approaching its peak.99 Partly,
it was because Greenspan felt it was not for the Fed to worry about asset price
inflation, only consumer price inflation; and this, he believed, was being
reduced by a major improvement in productivity due precisely to the tech
boom. 100 Partly, as so often happens in stock
market bubbles, it was because international pressures - in this case, the
crisis precipitated by the Russian debt default of August 1998 - required
contrary action.101 Partly, it was because Greenspan and
his colleagues no longer believed it was the role of the Fed to remove the
punchbowl from the party, in the phrase of his precursor but three, William
McChesney Martin, Jr.102 To give Greenspan his due, his
‘just-in-time monetary policy’ certainly averted a stock market crash. Not only
were the 1930s averted; so too was a repeat of the Japanese experience, when a
conscious effort by the central bank to prick an asset bubble ended up
triggering an 80 per cent stock market sell-off and a decade of economic
stagnation. But there was a price to pay for this strategy. Not for the first
time in stock market history, an asset-price bubble created the perfect
conditions for malfeasance as well as exuberance.
The
nineties seemed to some nervous observers uncannily like a re-run of the
Roaring Twenties; and indeed the trajectory of the stock market in the 1990s
was almost identical to that of the 1920s. Yet in some ways it was more like a
rerun of the 1720s. What John Law’s Mississippi Company had been to the bubble
that launched the eighteenth century, so another company would be to the bubble
that ended the twentieth. It was a company that promised its investors wealth
beyond their wildest imaginings. It was a company that claimed to have
reinvented the entire financial system. And it was a company that took full
advantage of its impeccable political connections to ride all the way to the
top of the bull market. Named by Fortune magazine as America’s
Most Innovative Company for six consecutive years (1996-2001), that company was
Enron.
In
November 2001, Alan Greenspan received a prestigious award, adding his name to
a roll of honour that included Mikhail Gorbachev, Colin Powell and Nelson
Mandela. The award was the Enron Prize for Distinguished Public Service.
Greenspan had certainly earned his accolade. From February 1995 until June 1999
he had raised US interest rates only once. Traders had begun to speak of the
‘Greenspan put’ because having him at the Fed was like having a ‘put’ option on
the stock market (an option but not an obligation to sell stocks at a good
price in the future). Since the middle of January 2000, however, the US stock
market had been plummeting, belatedly vindicating Greenspan’s earlier warnings
about irrational exuberance. There was no one Black Day, as in 1987. Indeed, as
the Fed slashed rates, from 6.5 per cent down in steps to 3.5 per cent by
August 2001, the economy looked like having a soft landing; at worst a very
short recession. And then, quite without warning, a Black Day did dawn in New
York - in the form not of a financial crash but of two deliberate plane crashes.
Amid talk of war and fears of a 1914-style market shutdown, Greenspan slashed
rates again, from 3.5 per cent to 3 per cent and then on down - and down - to
an all-time low of 1 per cent in June 2003. More liquidity was pumped out by
the Fed after 9/11 than by all the fire engines in Manhattan. But it could not
save Enron. On 2 December 2001, just two weeks after Greenspan collected his
Enron award, the company filed for bankruptcy.
The
resemblances between the careers of John Law, perpetrator of the Mississippi
bubble, and Kenneth Lay, chief executive of Enron, are striking, to say the
least. John Law’s philosopher’s stone had allowed him ‘to make gold out of
paper’. Ken Lay’s equivalent was ‘to make gold out of gas’. Law’s plan had been
to revolutionize French government finance. Lay’s was to revolutionize the
global energy business. For years the industry had been dominated by huge
utility companies that both physically provided the energy - pumped the gas and
generated the electricity - and sold it on to consumers. Lay’s big idea,
supplied by McKinsey consultant Jeffrey K. Skilling, was to create a kind of
Energy Bank, which would act as the intermediary between suppliers and
consumers.103 Like Law, Lay, the son of a poor Missouri
preacher, had provincial beginnings - as did Enron, originally a small gas
company in Omaha, Nebraska. It was Lay who renamed the companyaa and
relocated its headquarters to Houston, Texas. Like Law, too, Lay had friends in
high places. Himself a long-time ally of the Texan energy industry, President
George H. W. Bush supported legislation in 1992 that deregulated the industry
and removed government price controls. Around three quarters of Enron’s $6.6
million in political contributions went to the Republican Party, including $355,000
from Lay and his wife in the 2000 election. Senator Phil Gramm was Enron’s
second-largest recipient of campaign contributions in 1996, and a strong
proponent of Californian energy deregulation.
By the
end of 2000, Enron was America’s fourth-largest company, employing around
21,000 people. It controlled a quarter of the US natural gas business. Riding a
global wave of energy sector privatization, the company snapped up assets all
over the world. In Latin America alone the company had interests in Colombia,
Ecuador, Peru and Bolivia, from where Enron laid its pipeline across the
continent to Brazil. In Argentina, following the intervention of Lay’s personal
friend George W. Bush, Enron bought a controlling stake in the largest natural
gas pipeline network in the world. Above all, however, Enron traded, not only
in energy but in virtually all the ancient elements of earth, water, fire and
air. It even claimed that it could trade in Internet bandwidth. In a scene
straight out of The Sting, bank analysts were escorted through fake
trading floors where employees sat in front of computers pretending to do
broadband deals. It was the Mississippi Company all over again. And, just as in
1719, the rewards to investors seemed irresistible. In the three years after 1997,
Enron’s stock price increased by a factor of nearly five, from less than $20 a
share to more than $90. For Enron executives, who were generously
‘incentivized’ with share options, the rewards were greater still. In the final
year of its existence Enron paid its top 140 executives an average of $5.3
million each. Luxury car sales went through the roof. So did properties in
River Oaks, Houston’s most exclusive neighbourhood. ‘I’ve thought about this a
lot,’ remarked Skilling, who became Enron chief operating officer in 1997, ‘and
all that matters is money . . . You buy loyalty with money. This touchy-feely
stuff isn’t as important as cash. That’s what drives performance.’104 ‘You
got multiples of your annual base pay at Enron,’ Sherron Watkins recalled when I
met her outside the now defunct Enron headquarters in Houston. ‘You were really
less thought of if you got a percentage, even if it was 75 per cent of your
annual base pay. Oh, you were getting a percentage. You wanted multiples. You
wanted two times your annual base pay, three times, four times your annual base
pay, as a bonus.’105 In the euphoria of April 1999, the
Houston Astros even renamed their ballpark Enron Field.
The only
problem was that, like John Law’s System, the Enron ‘System’ was an elaborate
fraud, based on market manipulation and cooked books. In tapes that became
public in 2004, Enron traders can be heard asking the El Paso Electric Company
to shut down production in order to maintain prices. Another exchange concerns
‘all the money you guys stole from those poor grand-mothers of California’. The
results of such machinations were not only the higher prices Enron wanted, but
also blackouts for consumers. In the space of just six months after the
deregulation law came into effect, California experienced no fewer than
thirty-eight rolling blackouts. (In another tape, traders watching television
reports of Californian forest fires shout ‘Burn, baby, burn!’ as electricity
pylons buckle and fall.) Even with such market-rigging, the company’s stated
assets and profits were vastly inflated, while its debts and losses were
concealed in so-called special-purpose entities (SPEs) which were not included
in the company’s consolidated statements. Each quarter the company’s executives
had to use more smoke and more mirrors to make actual losses look like bumper
profits. Skilling had risen to the top by exploiting new financial techniques
like mark-to-market accounting and debt securitization. But not even chief
finance officer Andrew Fastow could massage losses into profits indefinitely,
especially as he was now using SPEs like the aptly named Chewco Investments to
line his and other executives’ pockets. Enron’s international business, in
particular, was haemorrhaging money by the mid 1990s, most spectacularly after
the cancellation of a major power generation project in the Indian state of
Maharashtra. EnronOnline, the first web-based commodity-trading system, had a
high turnover; but did it make any money? In Houston, the euphoria was fading;
the insiders were feeling the first symptoms of distress. Fastow’s SPEs were
being given increasingly ominous names: Raptor I, Talon. He and others
surreptitiously unloaded $924 million of Enron shares while the going was good.
Investors
had been assured that Enron’s stock price would soon hit $100. When (for
‘personal reasons’) Skilling unexpectedly announced his resignation on 14
August 2001, however, the price tumbled to below $40. That same month, Sherron
Watkins wrote to Lay to express her fear that Enron would ‘implode in a wave of
accounting scandals’. This was precisely what happened. On 16 October Enron
reported a $618 million third-quarter loss and a $1.2 billion reduction in
shareholder equity. Eight days later, with a Securities and Exchange Commission
inquiry pending, Fastow stepped down as CFO. On 8 November the company was
obliged to revise its profits for the preceding five years; the overstatement
was revealed to be $567 million. When Enron filed for bankruptcy on 2 December,
it was revealed that the audited balance sheet had understated the company’s
long-term debt by $25 billion: it was in fact not $13 billion but $38 billion.
By now, distress had turned to revulsion; and panic was hard on its heels. By
the end of 2001 Enron shares were worth just 30 cents.
In May
2006 Lay was found guilty of all ten of the charges against him, including
conspiracy, false statements, securities fraud and bank fraud. Skilling was
found guilty on 18 out of 27 counts. Lay died before sentencing while on
holiday in Aspen, Colorado. Skilling was sentenced to 24 years and 4 months in
prison and ordered to repay $26 million to the Enron pension fund; an appeal is
pending. All told, sixteen people pled guilty to Enron-related charges and five
others (so far) have been found guilty at trial. The firm’s auditors, Arthur
Andersen, were destroyed by the scandal. The principal losers, however, were
the ordinary employees and small shareholders whose savings went up in smoke,
turned into mere ‘wind’, just like the millions of livres lost in the
Mississippi crash.
Invented
almost exactly four hundred years ago, the joint-stock, limited-liability
company is indeed a miraculous institution, as is the stock market where its
ownership can be bought and sold. And yet throughout financial history there
have been crooked companies, just as there have been irrational markets. Indeed
the two go hand in hand - for it is when the bulls are stampeding most
enthusiastically that people are most likely to get taken for the proverbial
ride. A crucial role, however, is nearly always played by central bankers, who
are supposed to be the cowboys in control of the herd. Clearly, without his
Banque Royale, Law could never have achieved what he did. Equally clearly,
without the loose money policy of the Federal Reserve in the 1990s, Ken Lay and
Jeff Skilling would have struggled to crank up the price of Enron stock to $90.
By contrast, the Great Depression offers a searing lesson in the dangers of
excessively restrictive monetary policy during a stock market crash. Avoiding a
repeat of the Great Depression is sometimes seen as an end that justifies any
means. Yet the history of the Dutch East India Company, the original
joint-stock company, shows that, with sound money of the sort provided by the
Amsterdam Exchange Bank, stock market bubbles and busts can be avoided.
In the
end, the path of financial markets can never be as smooth as we might like. So
long as human expectations of the future veer from the over-optimistic to the
over-pessimistic - from greed to fear - stock prices will tend to trace an
erratic path; indeed, a line not unlike the jagged peaks of the Andes. As an
investor you just have to hope that, when you have to come down from the summit
of euphoria, it will be on a smooth ski-slope and not over a sheer cliff.
But is
there nothing we can do to protect ourselves from real and metaphorical falls?
As we shall see in Chapter 4, the evolution of insurance, from humble
eighteenth-century beginnings, has created a range of answers to that question,
each of which offers at least some protection from the sheer cliffs and fat
tails of financial history.
NOTES
1 For a recent
contribution to a vast literature, see Timothy Guinnane, Ron Harris, Naomi R.
Lamoreaux, and Jean-Laurent Rosenthal, ‘Putting the Corporation in its Place’,
NBER Working Paper 13109 (May 2007).
2 See especially
Robert J. Shiller, Irrational Exuberance (2nd edn., Princeton,
2005).
3 See Charles P.
Kindleberger, Manias, Panics and Crashes: A History of Financial Crises (3rd
edn., New York / Chichester / Brisbane / Toronto / Singapore, 1996), pp. 12-16.
Kindleberger owed a debt to the pioneering work of Hyman Minsky. For two of his
key essays, see Hyman P. Minsky, ‘Longer Waves in Financial Relations:
Financial Factors in the More Severe Depressions’, American Economic
Review, 54, 3 (May 1964), pp. 324-35; idem, ‘Financial
Instability Revisited: The Economics of Disaster’, in idem (ed.), Inflation,
Recession and Economic Policy (Brighton, 1982), pp. 117-61.
4 Kindleberger, Manias,
p. 14.
5 ‘The Death of
Equities’, Business Week, 13 August 1979.
6 ‘Dow
36,000’, Business Week, 27 September 1999.
7 William N.
Goetzmann and Philippe Jorion, ‘Global Stock Markets in the Twentieth
Century’, Journal of Finance, 54, 3 (June 1999), pp. 953-80.
8 Jeremy J. Siegel, Stocks
for the Long Run: The Definitive Guide to Financial Market Returns and
Long-Term Investment Strategies (New York, 2000).
9 Elroy Dimson,
Paul Marsh and Mike Stanton, Triumph of the Optimists: 101 Years of
Global Investment Returns (Princeton, 2002).
10 Paul
Frentrop, A History of Corporate Governance 1602-2002 (Brussels,
2003), pp. 49-51.
11 Ronald Findlay
and Kevin H. O’Rourke, Power and Plenty: Trade, War, and the World
Economy in the Second Millennium (Princeton, 2007), p. 178.
12 Frentrop, Corporate
Governance, p. 59.
13 On the
ambivalence of the Calvinist capitalist Dutch Republic, see Simon Schama, The
Embarrassment of Riches: An Interpretation of Dutch Culture in the Golden Age(New
York, 1997 [1987]).
14 John P. Shelton,
‘The First Printed Share Certificate: An Important Link in Financial
History’, Business History Review, 39, 3 (Autumn 1965), p. 396.
15 Shelton, ‘First
Printed Share Certificate’, pp. 400f.
16 Engel Sluiter,
‘Dutch Maritime Power and the Colonial Status Quo, 1585-1641’, Pacific
Historical Review, 11, 1 (March 1942), p. 33.
17 Ibid., p. 34.
18 Frentrop, Corporate
Governance, pp. 69f.
19 Larry Neal,
‘Venture Shares of the Dutch East India Company’, in William N. Goetzmann and
K. Geert Rouwenhorst (eds.), The Origins of Value: The Financial
Innovations that Created Modern Capital Markets (Oxford, 2005), p.
167.
20 Neal, ‘Venture
Shares’, p. 169.
21 Schama, Embarrassment
of Riches, p. 349.
22 Ibid., p. 339.
23 Neal, ‘Venture
Shares’, p. 169.
24 Frentrop, Corporate
Governance, p. 85.
25 Ibid., pp. 95f.
26 Ibid., p. 103.
Cf. Neal, ‘Venture Shares’, p. 171.
27 Neal, ‘Venture
Shares’, p. 166.
28 Findlay and
O’Rourke, Power and Plenty, p. 178.
29 Ibid., pp.
179-83. Cf. Sluiter, ‘Dutch Maritime Power’, p. 32.
30 Findlay and O’Rourke, Power
and Plenty, p. 208.
31 Femme S. Gaastra,
‘War, Competition and Collaboration: Relations between the English and Dutch
East India Company in the Seventeenth and Eighteenth Centuries’, in H. V.
Bowen, Margarette Lincoln and Nigel Ribgy (eds.), The Worlds of the
East India Company (Leicester, 2002), p. 51.
32 Gaastra, ‘War,
Competition and Collaboration’, p. 58.
33 Ann M. Carlos and
Stephen Nicholas, ‘ “Giants of an Earlier Capitalism”: The Chartered Trading
Companies as Modern Multinationals’, Business History Review, 62, 3
(Autumn 1988), pp. 398- 419.
34 Gaastra, ‘War,
Competition and Collaboration’, p. 51.
35 Findlay and
O’Rourke, Power and Plenty, p. 183.
36 Ibid., p. 185,
figure 4.5.
37 Gaastra, ‘War,
Competition and Collaboration’, p. 55.
38 Jan de Vries and
A. van der Woude, The First Modern Economy: Success, Failure and
Perseverance of the Dutch Economy, 1500- 1815 (Cambridge, 1997), p.
396.
39 Andrew McFarland
Davis, ‘An Historical Study of Law’s System’, Quarterly Journal of
Economics, 1, 3 (April 1887), p. 292.
40 H. Montgomery
Hyde, John Law: The History of an Honest Adventurer (London,
1969), p. 83.
41 Earl J. Hamilton,
‘Prices and Wages at Paris under John Law’s System’, Quarterly Journal
of Economics, 51, 1 (November 1936), p. 43.
42 Davis, ‘Law’s
System’, p. 300.
43 Ibid., p. 305.
44 Thomas E. Kaiser,
‘Money, Despotism, and Public Opinion in Early Eighteenth-Century Finance: John
Law and the Debate on Royal Credit’, Journal of Modern History, 63,
1 (March 1991), p. 6.
45 Max J. Wasserman
and Frank H. Beach, ‘Some Neglected Monetary Theories of John Law’, American
Economic Review, 24, 4 (December 1934), p. 653.
46 James
Macdonald, A Free Nation Deep in Debt: The Financial Roots of Democracy(New
York, 2003), p. 192.
47 Kaiser, ‘Money’,
p. 12.
48 Ibid., p. 18.
49 Hamilton, ‘Prices
and Wages’, p. 47.
50 Davis, ‘Law’s
System’, p. 317.
51 Antoin E.
Murphy, John Law: Economic Theorist and Policy-Maker (Oxford,
1997), p. 233.
52 Hamilton, ‘Prices
and Wages’, p. 55.
53 Murphy, John
Law, p. 201.
54 Ibid., p. 190.
55 See Larry
Neal, The Rise of Financial Capitalism: International Capital Markets
in the Age of Reason (Cambridge, 1990), p. 74.
56 Kaiser, ‘Money’,
p. 22.
57 For evidence of
English speculators exiting Paris in November and December, see Neal, Financial
Capitalism, p. 68.
58 Murphy, John
Law, pp. 213f.
59 Ibid., p. 205.
60 Lord Wharncliffe
(ed.), The Letters and Works of Lady Mary Wortley Montagu(Paris,
1837), pp. 321f.
61 Earl J. Hamilton,
‘John Law of Lauriston: Banker, Gamester, Merchant, Chief?’, American
Economic Review, 57, 2 (May 1967), p. 273.
62 Murphy, John
Law, pp. 201-2.
63 Hamilton, ‘John
Law’, p. 276.
64 Murphy, John
Law, p. 239. Cf. Hamilton, ‘Prices and Wages’, p. 60.
65 Kaiser, ‘Money’,
pp. 16, 20.
66 Ibid., p. 22.
67 Murphy, John
Law, p. 235.
68 Ibid., p. 250.
69 Hyde, Law,
p. 159.
70 Schama, Embarrassment
of Riches, pp. 366ff.
71 Ibid., pp. 367ff.
72 For contrasting
accounts see Neal, Financial Capitalism, pp. 89- 117; Edward
Chancellor, Devil Take the Hindmost: A History of Financial Speculation (London,
1999), pp. 58-95.
73 Chancellor, Devil
Take the Hindmost, p. 64.
74 Ibid., p. 84.
75 Neal, Financial
Capitalism, pp. 90, 111f. As Neal has observed, an investor who had bought
South Sea stock at the beginning of 1720 and sold it at the end of the year,
ignoring the intervening bubble, would still have realized a 56 per cent annual
return.
76 Julian Hoppitt,
‘The Myths of the South Sea Bubble’, Transactions of the Royal
Historical Society, 12 (2002), pp. 141-65.
77 Tom Nicholas,
‘Trouble with a Bubble’, Harvard Business School Case N9-807-146 (28 February
2007), p. 1.
78 William L.
Silber, When Washington Shut Down Wall Street: The Great Financial
Crisis of 1914 and the Origins of America’s Monetary Supremacy (Princeton,
2006).
79 Niall Ferguson,
‘Political Risk and the International Bond Market between the 1848 Revolution
and the Outbreak of the First World War’, Economic History Review,
59, 1 (February 2006), pp. 70- 112.
80 New York Times,
23 October 1929.
81 Nicholas,
‘Trouble with a Bubble’, p. 4.
82 Ibid., p. 6.
83 Chancellor, Devil
Take the Hindmost, pp. 199ff.
84 See Milton
Friedman and Anna J. Schwartz, A Monetary History of the United States,
1867-1960 (Princeton, 1963), pp. 299-419. This chapter, ‘The Great Contraction’,
should be required reading for all financial practitioners.
85 Ibid., pp. 309f.,
n. 9. Anyone who reads this footnote will understand why the Fed moved so
swiftly and open-handedly to ensure that JP Morgan bought Bear Stearns in March
2007.
86 Ibid., p. 315.
87 Ibid., p. 317.
88 Ibid., p. 396.
89 Ibid., p. 325.
90 Ibid., p. 328.
91 US Department of
Commerce Bureau of the Census, Historical Statistics of the United
States: Colonial Times to 1970 (Washington, DC, 1975), p. 1019.
92 Barry Eichengreen, Golden
Fetters: The Gold Standard and the Great Depression, 1919-1939 (New
York / Oxford, 1992). See also idem, ‘The Origins and Nature of the
Great Slump Revisited’, Economic History Review, 45, 2 (May 1992),
pp. 213-39.
93 See e.g. Ben S.
Bernanke, ‘The Macroeconomics of the Great Depression: A Comparative Approach’,
NBER Working Paper 4814 (August 1994).
94 Hyman P. Minsky,
‘Introduction: Can “It” Happen Again? A Reprise’, in idem (ed.), Inflation,
Recession and Economic Policy (Brighton, 1982), p. xi.
95 The index has
fallen by 10 per cent or more in 23 out of 113 years.
96 See Nicholas
Brady, James C. Cotting, Robert G. Kirby, John R. Opel and Howard M.
Stein, Report of the Presidential Task Force on Market Mechanisms,
submitted to the President of the United States, the Secretary of the Treasury
and the Chairman of the Federal Reserve Board(Washington, DC, January
1988). Of especial interest to the historian is the comparison with 1929: see
Appendix VIII, pp. 1-13.
97 James Dale
Davidson and William Rees-Mogg, The Great Reckoning: How the World Will
Change in the Depression of the 1990’s (London, 1991).
98 For Greenspan’s
own version of events, see Alan Greenspan, The Age of Turbulence:
Adventures in a New World (New York, 2007), pp. 100-110.
99 Greenspan, Age
of Turbulence, p. 166.
100 Ibid., p. 167.
101 Ibid., pp. 190-5.
102 Ibid., pp. 200f.
103 The best account
remains Bethany McLean and Peter Elkind, The Smartest Guys in the Room:
The Amazing Rise and Scandalous Fall of Enron (New York, 2003).
104 Ibid., p. 55.
105 See her own
account of events in Mimi Swartz and Sherron Watkins, Power Failure:
The Inside Story of the Collapse of Enron (New York, 2003).
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