Book Review: A Short History of Financial Euphoria

This book review has been submitted by Ankit Kanodia.

If anyone would ask me to summarize A Short History of Financial Euphoria in quick words, I would borrow the following three quotes to make my point…

All I want to know is where I’m going to die so I’ll never go there. ~ Charlie Munger

History does not repeat itself, it rhymes. ~ Mark Twain

There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know. ~ John Kenneth Galbraith

For starters, the book does not give you any tip on how to compound wealth or how to invest to earn great returns on capital. On the contrary, it brings to your notice how you can lose it all and thus how difficult but important it is to avoid that danger.

A small, thin book of only 110 pages, it consists of almost everything one needs to know about the speculative bubbles in economic history.

The book is a marvellous piece of financial history on speculative bubbles. Starting from the crisis of Tulipomania in 1630s, it refers to almost all the major crises up until the 1987 crash in US stock market. The author John Kenneth Galbraith draws a pattern found in all the crises and narrates how the same things happen over and over again but are always labelled as “this time it’s different.”

The main point highlighted throughout the book is that recurrent speculative insanity, associated financial deprivation, and larger devastation are inherent in this system. Perhaps it is better that this is recognized and accepted.

To quote the author…

In small ways, the history of the great speculative boom and its aftermath does change. Much, much more remains the same.

Extreme Brevity of Financial Memory
It is the extreme brevity of financial memory which leads us to forget the financial disasters very quickly. Several stock market crashes have happened in the past where a great many people lost their fortune. Still, we don’t learn anything from that. Instead, we quickly forget the last crisis and often commit the same mistakes over and over again. Market participants may change from time to time, but the psychology of the crowd, as a whole, remains largely the same. We can draw a parallel here with a similar comment made by the legendary investor Seth Klarman, who wrote this in one of his annual letters –

Below, we highlight the lessons that we believe could and should have been learned from the turmoil of 2008. Some of them are unique to the 2008 meltdown; others, which could have been drawn from general market observation over the past several decades, were certainly reinforced last year. Shockingly, virtually all of these lessons were either never learned or else were immediately forgotten by most market participants.

Is the Richest the Most Intelligent Too?
In financial history, there is always a specious association of money and intelligence. It’s been a hard fact of life that people tend to believe it is their intelligence and not their good luck which is making them grow richer. Money is considered as the measure of capital achievement. A man is considered as accomplished if his pockets are filled with money. It hardly matters how the money has come to him. The richer one gets, the more intelligent he is perceived by the crowd and even by himself. Stock market participants keep enjoying the rally as they really get richer for some time before the eventual and inevitable fall.

The author captures the madness of the crowd in the following words –

Those involved with the speculation are experiencing an increase in wealth-getting rich or being further enriched. No one wishes to believe that this is fortuitous or undeserved; all wish to think that it is the result of their own superior insight or intuition.

It’s the Debt, Stupid!
As described by the author, all financial innovation has involved debt creation leveraged against more limited assets. All crises have involved debt that, in one way or another, has blown out of proportion in relation to the underlying means of payment. While there has been slight modifications in the style of debt every time, but the inherent characteristics remain intact all the time.

If we really want to understand the risk involved in the debt issued by banks against inadequate security, we should read the following remarks made by the author –

Banks discovered that they could print bank notes and issue them to borrowers in a volume in excess of the hard money deposits in the bank’s strong rooms. The depositors could be counted upon, it was believed or hoped, not to come all at once for their money. There was no seeming limit to the debt that could thus be leveraged on a given volume of hard cash. A wonderful thing. The limit became apparent, however, when some alarming news, perhaps of the extent of the leverage itself, caused too many of the original depositors to want their money at the same time.

Thus, the whole speculative process is the same each time, as drawn below. The only difference between all the speculative episodes is a seemingly new financial instrument or investment opportunity.

The Speculative Process

10 Big Ideas from the Book
Here is a list of top ten ideas from the book –

1. Economic life is in a process of continuous transformation. What was observed by earlier scholars – Adam Smith, John Stuart Mill, Karl Marx, Alfred Marshal – is an uncertain guide to the present or future.
2. Individuals and institutions are captured by a wondrous satisfaction from accruing wealth. They even falsely believe that one who is becoming wealthy is necessarily intelligent and genius.
3. The upward movement (whether in land, securities, or art) confirms the commitment to personal and group wisdom.
4. The inevitable crash never comes gently. It is always accompanied by a desperate and largely unsuccessful effort to get out.
5. Markets are theologically sacrosanct. Those who are involved never wish to attribute stupidity to them.
6. The least important questions are the ones most emphasized – What triggered the crash? Were there some special factors that made it so dramatic? Who should be punished?
7. There is nothing in economic life, so willfully misunderstood as the great speculative episode.
8. The only remedy, in fact, is an enhanced skepticism that would resolutely associate intelligence with the acquisition, the deployment, or, for that matter, the administration of large sums of money.
9. There is always a possibility, even the likelihood, of self-approving and extravagantly error-prone behaviour on the part of those closely associated with money.
10. Most important lesson:
    a. There will be another of these episodes, and yet more beyond.
    b. Fools, as it has long been said, are indeed separated, soon or eventually, from their money.
    c. So, alas, are those who, responding to a general mood of optimism, are captured by a sense of their own financial acumen.
    d. Thus it has been for centuries, thus in the long future it will also be.

Before I end, I would like to leave you with my favourite passage from the book. I guess, it is also the most important message to all who are connected to financial markets. I also believe, in times of better market performance or superlative performance of one’s own portfolio, a reading of this book comes handy. If nothing else, it keeps you grounded and your optimism gets checked. And believe me, being aware of the excesses on both sides, keeps you guarded and safe. Anyways, that important passage from the book reads –

Only after the speculative collapse does the truth emerge. What was thought to be unusual acuity turns out to be only a fortuitous and unfortunate association with the assets. Over the long years of history, the result for those who have been thus misjudged (including, invariably by themselves) has been opprobrium followed by personal disgrace or a retreat into the deeper folds of obscurity. Or it has been exile, suicide, or, in modern times, at least moderately uncomfortable confinement. The rule will often be here reiterated: financial genius is before the fall.