But what experience and history teach is this – that peoples and governments never have learned anything from history, or acted on principles deduced from it.
The Mississippi Bubble
France, 1716. The country had been at war for twenty-three years of the last twenty-six and lost; war debts had bankrupted the country. Reforms and austerity were out of the question.
Enter John Law of Lauriston, who devised and implemented le Système — to monetize and swap the monarch’s debts by combining a national bank that issued notes as legal tender with a state-owned public trading company — that unleashed the first stock market mania in history.
Paris, September 1719
Anyone who bought just one share at the Mississippi Company’s sumptuous new headquarters in the Palais Mazar, could immediately walk down the road to the Place Vendôme and sell it for 5,000 livres. People from all walks of life made hitherto unimaginable fortunes. A waiter made 30 million livres, a beggar made 70 million, a shopkeeper made 127 million. An aristocratic society hostess in the foyer of the Opéra found herself confronted by a woman whose décolletée was a dazzling cascade of diamonds. Raising her lorgnette, she was amazed to recognize her cook, and demanded what on earth she thought she was doing. The cook replied brazenly that she was now equal of any aristocrat. A new word was even coined by the aristocracy to describe these people: they were referred to disdainfully as millionnaires.
[One year later] France’s financial system was bankrupted. An eerie calm settled over the city. People stood on street corners in dazed groups. So many had been forced to sell their carriages that there was hardly any traffic.
~ A Brief History of Economic Genius
The South Sea Bubble
The excess money [printed in France] started to push up prices at an alarming rate. By the end of 1719 goods had risen by an average of nearly 75 per cent, with some essential foodstuffs in the Paris markets rising to three times their previous price.
In February 1720 Law took a further step against coinage by restricting all individual holdings of coins to 500 livres. But the novelty of banknotes was beginning to wear off, and the public’s underlying suspicion concerning this form of currency began to increase. Although large fortunes were now being made in banknotes, their owners were quick to convert these paper fortunes into more solid assets. The price of jewellery, houses and land multiplied. Others began to invest in the booming markets of Amsterdam and London (where the share prices of the South Sea Bubble were now beginning to spiral).
~ A Brief History of Economic Genius
How We Got Here
It all started in Amsterdam with paper share certificates. The year was 1602. The limited liability company was a brilliant idea conceived to spread risk among insiders that became a mechanism to divest risk to the public. By 1609, the Dutch East India Company no longer redeemed shares from investors. Instead, they were forced to sell them to others in the world’s first stock market at prices set by the law of supply and demand.
Printing Paper Money
In his 1705 book, John Law argued, “If 2000 lib. of paper money, is equal to the property of land 2000 lib. in silver; then that 2000 lib. of paper money, is equal to 2000 lib. of silver.” He further argued that paper banknotes (government IOUs) were superior to silver, precisely because it had zero intrinsic value. It was a clever argument used to confiscate tangible stores of value such as gold and silver from the masses in return for paper money as a medium of exchange. Of course, the monarch benefited the most by printing loads of it to pay off debts.
Silver and Inflation
While the arguments made by John Law for paper banknotes as a superior medium of exchange compared to silver coins were invalid, what we now think of as hard money (silver and gold) made no sense either — to the Inca. When the Spanish Conquest flooded Europe with silver, inflation raged.
Credit and the Moneylenders
At one time, warlords paid with gold, silver and loot. Merchants pooled resources for trade expeditions. As war debts got out of hand and commercial ventures grew, those in power sought to use Other People’s Money (“OPM”) to strengthen the establishment and to keep even more of the rewards for themselves. But first, someone had to figure out how to charge interest on loans without burning in hell.
Banking and Commerce
By charging commission to convert foreign exchange, money lending evolved into commercial banking. In the process, a lowly Italian clan transformed themselves into a dynasty that paid for the Renaissance, the House of Medici.
Warring Italian city-states were defended by mercenaries, and since taxes failed to cover the cost of war even during the good times, citizens were forced to lend money to their own governments. With this development, the bond market was created and interest rates set by supply and demand came to pass.
And What of the People of France?
Surprisingly, it wasn’t a total loss.
Paul Strathern wrote in A Brief History of Economic Genius, “Some historians even contend that the overall situation was now significantly better than before Law had taken over. The excess of paper money meant that almost everyone had managed to pay off their debts (many of which had been crippling and of long standing). The administrations of several provincial cities had lost fortunes, but the cities themselves had been stirred into a new commercial life. Also, the flight from paper money into solid goods meant that there were now many more property owners. At the same time the rigid social barriers of the ancien régime had been seriously undermined: the seeds of democracy had been sown. Many, like the cook with her diamonds, felt themselves the equal of their so-called superiors. In seventy years’ time this feeling of egalité would combine with liberté and fraternité to become the French Revolution.”
As for John Law, he “had now become a celebrity throughout Europe, and a pardon was quickly granted.” He had “salted away no money of his own. All his property in France had been seized, and he owed millions.”
The Grapes of Wrath
On December 4, 1928, U.S. President Calvin Coolidge said in the state of the union address that, “No Congress of the United States ever assembled, on surveying the state of the Union, has met with a more pleasing prospect than that which appears at the present time. . . . The requirements of existence have passed beyond the standard of necessity into the region of luxury. Enlarging production is consumed by an increasing demand at home and ail expanding commerce abroad. The country can regard the present with satisfaction and anticipate the future with optimism.”
One year later, the nation was in ruins.
The Crash of 1987
We only need to look at most recent market crises to know that the financial framework left to us by John Law will always be unstable. That’s why the best minds on Wall Street focus on efforts to contain risk and limit losses. In 1987, so-called portfolio insurance actually exacerbated the crash. Once again, few were protected and many were impoverished.
Japan’s Lost Decades
Perhaps it was inevitable that the post-war asset bubble would end. It crashed in 1990, but what happened afterwards is a lesson troubled nations and their central bankers (Princes of the Yen) have not learned to this day.
Two Nobel Prize Winners Walk into a Bar
The legacy of paper money, share certificates and their derivative products are the basis of financial engineering, bubbles and crashes to this day. In 1998, a Nobel Prize winning thesis of picking up nickels in front of a steamroller failed spectacularly and plunged the planet into chaos.
Wall Street Alchemy
As if it weren’t enough to finance war and trade with credit, stocks and bonds, banks began lending to individuals. For a fee, Wall Street came up with ways to divest risk for lending institutions by packaging (“securitization”) loan and mortgage portfolios into pieces of paper that could be sold to investors and much more. But as we all know, if something sounds too good to be true, it probably is.
Too Big to Fail
When the entire house of cards came tumbling down in 2007, the ultimate irony was the fact that the governments had only one choice, and that was to print more money to keep banks from collapsing and ending the world as we know it. Over the next ten years, central banks around the world did one better than John Law; they bought up their own government bonds. Where we go from here, only the hairdresser knows for sure. For more, watch the Frontline documentary.
Remember the Latin phrase sapere aude: dare to know. Understand that most investments offered to the public are created to transfer risk from the few to the many, at full retail price. The fact that most of these are traded on exchanges after issuance at prices set by supply and demand means individuals must be shrewd and knowledgeable in order to profit from fluctuating prices. Seems simple, but it’s not easy, because it’s only human to get carried away like those who came before us.
The Reverse Robinhood
Anyone with average intelligence can learn to trade. This is not rocket science. However, it’s much easier to learn what you should do in trading than to do it. Good systems tend to violate normal human tendencies. Of the people who can learn the basics, only a small percentage will be successful traders.
If a betting game among a certain number of participants is played long enough, eventually one player will have all the money. If there is any skill involved, it will accelerate the process of concentrating all the stakes in a few hands. Something like this happens in the market. There is a persistent overall tendency for equity to flow from the many to the few. In the long run, the majority loses. The implication for the trader is that to win you have to act like the minority. If you bring normal human habits and tendencies to trading, you’ll gravitate toward the majority and inevitably lose.
~ William Eckhardt in The New Market Wizards: Conversations with America’s Top Traders