The Ascent of Money: A Financial History of the World

Chapter 3 describes the joint-stock, limited-liability corporation and the booms and busts that have accompanied some of the major stock market bubbles in history. Such entities are “jointly” owned by investors and, since corporations are considered “people” in terms of the law, the liability of investors is limited to only what each has put into the company, shielding their other assets.

Ferguson writes that financial bubbles have five stages: (1) displacement, a change that creates new sources of profit; (2) euphoria, also called “overtrading,” when share prices rise based on expected future gains; (3) mania or bubble, when investors flock to the stock hoping to make an easy profit; (4) distress, when share prices become so high that people begin selling after concluding that expected profits don’t justify such a high price; (5) revulsion or discredit, when everyone wants to sell, share prices fall, and the bubble bursts.

Bubbles also have three features. First, asymmetric information is the fact that people with more knowledge of a company exploit those with less knowledge. Second is the role of cross-border capital flows: bubbles occur more frequently in situations where capital can flow between countries. Finally, easy credit must be present to allow such speculation.

The recurrence of stock market bubbles feed on a kind of collective amnesia. Ferguson illustrates this with examples from 1979, when stocks were considered dead only to grow strongly throughout the 1980s and 1990s (with a brief interruption in 1987). By 1999, “the average price of a major US corporation had risen nearly twelve-fold in just twenty years” (123). Predictions were for continued stellar growth. Yet a few months later, the dot-com bubble burst, sending the value of stocks plummeting. Still, the author shows that stocks have outperformed bonds by a good amount over the past forty years.

“The Company You Keep”

This section relates the story of John Law’s role in the first boom-to-bust cycle in stocks. Born in Scotland, Law got into trouble with the law as a young man in London and fled to Amsterdam. The Dutch city was a center of financial innovation, as Chapter 2 showed regarding the way the Netherlands financed its war with Spain. The joint-stock company was also created there, as a way to pool resources to fund the risky sailing expeditions made to Asia, for the spice trade.

After early limitations (such as a small number of investors), improvements to such companies led to the development of a healthy market for stocks. Multiple companies were also combined into the United Dutch Charted East India Company, which was given a monopoly on all the nation’s trade in the Far East. At the same time, the Amsterdam Exchange Bank was founded, which accepted stocks as collateral for loans. Next, loans were allowed for the purpose of buying shares. The Dutch East India Company prospered in the 17th century, greatly increasing its trade with Asia and evolving when necessary to stay profitable. From its founding in 1602 to 1733, its stock had more than a sevenfold increase in value; what’s more, its rise was gradual, such that it never created a bubble. John Law absorbed all this taking place in his adopted city, and soon he had ideas of his own for how to improve upon various aspects. For one thing, he thought that banks should produce banknotes (paper money, which the Amsterdam Exchange Bank did not do), convinced that public confidence was the key to credit.

“The First Bubble”

Law’s schemes were rejected in several countries before he found success in France. He was allowed to set up a national bank, the Banque Générale, in 1716, based on the Amsterdam model—except that it would issue banknotes. The following year, he was granted a twenty-five-year monopoly on trade with the Louisiana territory, Frances’s colony in the New World, with the founding of the Company of the West. The Banque Générale was nationalized in 1718, becoming France’s first central bank, and changed its name to the Banque Royale. The Company of the West was given certain privileges from the crown, and expanded in 1719, when it took over another company to form the Mississippi Company. Law’s system had increased the money supply in France, giving its economy a necessary boost.

The flaw was that Law was the majority stakeholder in the entire scheme and ended up making decisions that would enrich himself personally, rather than benefit the company, the bank, or the economy in general. For example, to acquire new companies, he issued new shares, rather than use profits. What allowed this to continue was Law’s promise of future profits from Louisiana, which he promoted as “a veritable Garden of Eden” (144). It would, he argued, pay off in vast amounts of trade, flowing through the city he founded and named New Orleans, after the Duke of Orleans, his benefactor in the government. When, on top of this, he became Controller General of Finances in early 1720, Law was in charge of virtually all of France’s financial system. Soon, however, the price of his company’s shares began to slip, and inflation rose quickly as a result of the increase in the money supply. The government used various strategies to prop up the price of shares and the value of banknotes, including royal edict, but in the end it could not dictate events and the bubble burst. By the end of May 1720, the Banque Royale was forced to close and Law was arrested; he later fled the country, virtually penniless. The episode had ripple effects into the future, hampering France’s financial development as it put “Frenchmen off paper money and stock markets for generations” (154).

“Bulls and Bears”

This section explores the causes of the 1929 stock market crash in the United States, which set off the Great Depression. The US seemed to be in good economic shape when it happened, so the cause of the crash is difficult to pinpoint. It may seem counterintuitive, but Ferguson argues that the very strength of the economy may have aided in its undoing. Technology and greater productivity promised greater future earnings, and people were so optimistic that normal standards and restrictions were abandoned. For example, people used loans to buy stocks on margin, paying only a small percentage of their worth on expectations of higher future prices. This only fueled the bubble.

Economists Milton Friedman and Anna Schwartz largely blamed the Federal Reserve System (“the Fed”), not for the stock bubble itself, but for the allowing the crash to cause the Depression. They argued that the Fed should have done more to increase the credit supply after the failure of numerous banks through 1930. Instead, the Fed reduced the amount of outstanding credit, prompting banks to sell off assets to maintain liquidity, which ultimately resulted in even more bank failures in 1931. In addition, it raised the discount rate (the rate at which banks borrow money) in response to Britain leaving the gold standard, which pushed more banks into failure. The Fed also waited too long–until April 1932–to attempt to improve liquidity by purchasing securities on the open market. Yet more banks failed at the end of 1932, leading to the first of “bank holidays,” or temporary closures, at the state level. Finally, the Fed raised the discount rate again in response to the fear that incoming President Franklin Roosevelt would devalue the dollar. As a result, only two days after being inaugurated, Roosevelt declared a nationwide bank holiday, “a holiday from which 2,000 banks never returned” (163). All these measures, or lack thereof, led to a great contraction of the money supply and amount of credit available, as the total of nearly 10,000 bank failures reduced both bank deposits and loans.

“A Tale of Fat Tails”

This section tells how the Fed has managed more recent stock crises, from the 1980s to the 2000s. The term “fat tails” refers to the extremes of a statistical distribution that are much greater than in a normal distribution. The chart of monthly activity in stock market indexes would have such fat tails since extreme increases and extreme decrease happen with some regularity. The Fed thus needs to have tools ready to deal with such swings.

The postwar years did not see another serious depression despite a number of crises in the stock market. One occurred in October 1987, in what came to be called “Black Monday.” The Dow Jones Industrial Average fell by 23%, wiping out almost a trillion dollars in value. The causes were not clear, although mechanical selling and the lack of a “circuit breaker,” which would have interrupted a sustained sell-off, are widely seen as contributing factors. The real story, however, is that no depression followed, either immediately or in 1988. The newly-appointed Fed chairman, Alan Greenspan, reassured the markets with a strong statement indicating that the Fed was prepared to ensure the liquidity of banks. It also purchased government bonds, which increased the money supply and reduced the rate at which banks borrowed from the Fed.

Greenspan’s next test came in the 1990s, with technology stocks fueling the dot-com bubble. Ferguson compares this decade to the bubble caused by John Law’s Mississippi Company, since it also involved “a company that claimed to have reinvented the entire financial system”: Enron (168). Ferguson draws many parallels between John Law and Enron’s founder, Kenneth Lay. There were similarities in their backgrounds, but mostly both used political connections, the promise to revolutionize a part of the financial system, and, in the end, deception to reach unprecedented financial heights.

Enron was in the energy business, seeking to replace public utilities that both provided and sold energy. Lay wanted to create an “Energy Bank” between suppliers and consumers that sold energy as a commodity. But as Ferguson notes, “like John Law’s System, the Enron ‘System’ was an elaborate fraud, based on market manipulation and cooked books” (172). For instance, the company persuaded producers of electricity to reduce production in order to keep prices high; this not only defrauded customers, but also led to rolling blackouts. Moreover, Enron used unlawful accounting practices to create profits from losses. This could not be sustained forever, and fairly quickly in late 2001, Lay resigned, the SEC initiated an investigation, and the company went bankrupt.