Another great innovation of modern history is the invention of the joint-stock limited-liability company. It allows individuals to pool resources while not having to risk their entire personal fortune. In spite of the theory that vigilant shareholders hold control over the management through a non-executive directory, the practice is that millions of shareholders will continually buy and sell the infinitesimally small part of the company, thereby estimating the future cash flows it will realise. This results in a kind of collective ‘mood’ on the stock exchange. Usually it follow 5 paths:
- Displacement, where a shift in the economic environment creates profitable opportunities.
- Euphoria: a feedback loop of buyer creates ‘overtrading’
- Mania: the bubble is created by buyers not having a clue
- Distress: the exorbitance becomes clear to the well-informed
- Revulsion: the bubble bursts and especially the uninformed sell off in large quantities
A number of factors will typically facilitate this process, such as information asymmetry towards insiders, easy credit and the free flow of capital. What is also very common is the short duration of the investors’ memory, helping to create the next bubble rapidly.
Nevertheless, over the long run it has shown profitable to invest in stock rather than bonds, especially in the US.
John Law was the first one to ever create a stock market bubble. He learned the stock market dynamics in Amsterdam, where the United East India Company (VOC) had come to existence in 1602. Its shares, and dividends, were widely traded in the years after. By 1650 the VOC, monopolizing the trade of goods from the East Indies, was a very large profitable company governed by the modern concept of management and ownership. Surrounded by this financial innovation, Law sought to combine the monopoly of a company and the sole issuance of notes by an institution like the Bank of England.
France, fighting off enormous war debts, was the country he could try his idea out. Under his impulse, a private bank was erected which had the monopoly of issuing notes that were payable in gold for a 20 year period in 1716. This injection of capital revived the French economy and centralised the royal debt, delegating its management to a trading company (Banque Royale). Law later gained the permission of developing the French overseas Mississippi delta (the Company), to the example of the Dutch and English trading companies, to collect all the revenue from tobacco and later acquired the Senegal Company. By then it became the first French central bank. Because he was a major shareholder, he allowed an ample monetary expansion. More and more, new shareholders had to be attracted by promises of future profits and higher face values. By printing extra paper money, share prices soared and Law was creating his bubble, while controlling vast parts of France’s economy. The first signs of distress appeared and at first the value of the share was guaranteed. Any downward adjustment of the shares had a very substantial impact. The notes issued were representing 4 times the reserve in gold and thus the exchange of it into gold became prohibited. After some legislative and regulatory turmoil by a self-serving absolutist and centralistic government, the inflation soared, the share of the Company plummeted and Law was placed under arrest and later fled the country. France’s economic revival fell back, discouraged development of the stock market, left the monarchy in fiscal crisis and laid the foundation of the Revolution.
Great Britain had a similar South Sea Bubble, but because this company never had control over the Bank of England, and the latter increased the borrowing conditions, the consequences were less grave and, ruined fewer people and did not do systemic damage to the stock market.
On 29 October 1929, the worst stock exchange crash ever occurred. For the next 3 years, DJIA dropped 89%, only reaching its 1929 level in 1954. Mainly the US and Germany were hit by the biggest depression ever. Unemployment soared and world trade shrank because of protectionist measures. It is unclear what the direct cause for this was. The occurrence of major dips in stock markets are much more frequent than what a standard normal statistical model predicts. Apart from the psychological and emotional dimension, the chronic production overcapacity after the world war together with the increased union power made it hard for countries to expand. Especially in the US an increased portion of the sales was financed by credit. The Fed did little to fight the credit crunch banks imposed on the rest of the economy (10,000 banks went bust). Only in 1932 did it directly interfere with market operations, which had a positive impact. Since then, we know that credit needs to be expanded and direct market operations are desirable to avert depression. Something that Alan Greenspan had done in 1987, thereby unwillingly provide so much cash that a bubble was allowed to form in mid ‘90s.
Enron was in the middle of that bubble as it was promising, very analogous to John Law’s Company, huge returns at no risk. It wanted to revolutionize the energy sector when it became deregulated. Stock prices went times five and management was very lavishly remunerated. But both profit statements and market prices were massaged and fraudulently over-inflated. Profits were reported because dodgy constructions were set up to hide the losses. When this came out, the 4th largest US enterprise also appeared to have not 13 but 38 billion USD in long term debt. Stock prices fell from 90 USD to 40 cents and some top managers were sent to jail. On top of that, and just like with John Law’s Company, thousands of people lost all their savings.
Source: “The Ascent of Money“, by Niall Ferguson