The Directed Life

Date read: 2/15/23

My notes from Edward Chancellor’s Devil Take the Hindmost which provides a fascinating history of financial speculation from the beginning of markets to today.

Big takeaway is the argument against modern economic theory—markets are not efficient and certainly not always reflective of “rational man.” The history of speculation proves this time and again.

A speculator lies somewhere in the middle of investor and gambler. Speculation necessitates some form of unknown risk or uncertainty while at the same time not being a complete shot in the dark. (xiii)

The poetic words Chancellor opens up chapter 1 with:

The propensity to barter and exchange is an innate human characteristic. An inclination to divine the future is another deeply ingrained trait. Together they comprise the act of financial speculation. (3)

The Roman Market: Rome’s Forum was the center of the ancient power’s economy: people bartered for goods, sold shares of tax companies and used credit for distant homes, shops, ships, slaves, and cattle. The Roman government gave contracts to private companies of men with capital called publicani. (4)

St. Thomas Aquinas and St. Augustine’s ideas influencing the ages to come:

Medieval schoolmen revived the Aristotelian notion of a “just price,” following the teaching of St. Thomas Aquinas, who declared that it was unjust and unlawful to “sell dearer or buy cheaper than a thing is worth.” … St. Augustine considered the unlimited lust for gain, appetitus divitarum infinitus, as one of the three principal sins, alongside the craving for power and sexual lasciviousness … When contemporary politicians rise to condemn the pernicious actions of speculators, they perpetuate unconsciously the Scholastic prejudices of medieval monks. (6-7)

In Renaissance Florence they traded state loans in a similar structure to Ancient Rome of companies (the monti) divided into tradeable shares taking on the burden of tax collection. (7)

The “Dutch Republic was the most advanced and thriving economy” by the 17th century. This was due to Dutch merchants travelling the world for goods, increasing national wealth and utilizing trade of goods with the other nations they came into contact with. The Dutch didn’t invent any of the financial institutions but they were the first to unite them altogether in an economy with profit as a chief motive. (9)

Products were traded on the Amsterdam Exchange. Chancellor on how the products created financial leverage:

Futures, options, and ducaton shares are all examples of what we call derivatives, namely financial contracts which derive their value from an underlying asset, such as a share. Together with stock loans, they created the opportunity for financial leverage, so that small share rises in prices brought larger percentage gains to speculators (with small price declines producing the opposite effect). (10)

Chancellor compares the market to Hobbes’ Leviathan: the actions of individuals are found in mass bull / bear markets explained mostly by mass psychology. (14)

In describing the Tulip Mania Chancellor defines why Tulips were the ripe commodity for such speculation: the randomness of color and variety was unknown until the bulb opened, which may skyrocket any one tulip’s value: “a plain breeder tulip might break out into a precious Semper Augustus.” (16)

Crashes precipitate when the number of sellers greatly outweighs the number of buyers. (19)

• I made a note that the same idea appears in Sebastian Mallaby’s More Money than God

After the tulip crash the Semper Augustus regained its price level prior to the mania, but the more common tulips never approached the same outlandish prices again. When evaluating an asset it’s important to ask whether the item is of intrinsic value or if it is riding along another asset of value? (20)

Bubble as an analogy for the human condition, which makes it more understandable why and how bubbles continuously crop up in financial history:

Homo bulla est, man is a bubble, the Roman moralist Varro had declared. A bubble grew rapidly, delighting beholders with its reflective brilliance, but disappeared instantaneously. (21)

In bull markets, quality of stocks typically decline as mania progresses. The Tulip crash had several characteristics often always prevalent in manias and crashes: rumors fueling prices, using leverage through futures and credit, “conspicuous consumption among speculators”, prices rising fast and then “panic without cause”, late government intervention. (26)

The Austrian economist J.A. Schumpeter observed that speculative manias commonly occur at the inception of a new industry or technology when people overestimate the potential gains and too much capital is attracted to new ventures. (26)

• The too much capital idea was also prevalent in Mallaby’s The Power Law, where Y combinator and a16h pioneered the idea that oftentimes start-ups needed guidance and structure more than boatloads of capital

The evolution of speculation and why it retained that mode of being driven by human emotion:

Speculation grew out of the crowds and bustle of the Renaissance fairs and carnivals, and although by the seventeenth century the carnival was in decline and fairs had been replaced by permanent stock exchanges, the carnival spirit lingered in the markets. (27)

Late 17th century England was home to the Financial Revolution, where financial innovations coincided together and restructured England’s markets: the stock market, Bank of England, government loans, transferability of debts. This also caused many men to look for ways to turn “the financial innovations of the day to their personal advantage.” (32)

During the Glorious Revolution among great national wealth and prosperity, companies created for expeditions and seeking treasure were floated onto the public exchange so that anyone could buy shares of potential returns. Chancellor marks this shift in saying that:

The age of adventuring, a tradition going back to Elizabethan privateers, suddenly gave way to an age of speculation. (35)

Public lists of weekly stock market prices and increased public knowledge of the new financial tools of the day (puts, options, etc.) encouraged speculation and stock-jobbing. (39) Speculation became a natural extension of the gambling that took place on Exchange Alley. (42-43)

Chancellor includes a footnote referencing Adam Smith’s idea in the Wealth of Nations that we are all prone to overvaluing our luck and undervaluing risk and our ability to lose everything. (43)

Chancellor on Keynes and how human nature doesn’t change when it comes to money and speculation / investing:

Keynes’s claim that the game of investment is ”intolerably boring and over-exacting to any one who is entirely exempt from the gambling instinct; whilst he who has it must pay to this propensity the appropriate toll” is as valid for the seventeenth century as for the twentieth. The successful establishment of the stock market and the joint-stock company over other forms of capital organisation lay in their incorporating within themselves elements of the gaming room. In the origins of financial capitalism, rationalism was very much a subsidiary element. (44)

• Made me think of one of the main ideas in Morgan Housel’s The Psychology of Money that the price you pay for being in the market is being able to handle the ups and downs emotionally; the toll is obviously less the safer the investment is, but it’s still there

The effect that the Financial Revolution had:

In the new economic system brought into existence by the Financial Revolution, there was no longer a substantial economic reality: values were the product of a skittish and trivial mass psychology, trade was dependent on a transient state of confidence, and companies “floated” on waves of speculative euphoria. (47-48)

The flotation of the Bank of England marked the turning of a corner in financial history, as their first loans to the government were not backed by gold:

Paper currency, the philosopher’s stone of financial capitalism, had received the first tentative mark of government approval. (50)

Chancellor’s speculative paradigm, inspired by the framework from Charles Kindleberger:

• A displacement, from either a “new object of investment” or from an old object suddenly generating increased profits, incites speculation
• Positive feedback loop emerges where rising prices invite new investors into the market which drives prices higher
• This results in euphoria, the tell-tale sign of weakened rationality
• New companies emerge to capitalize on the euphoria
• Investors leverage gains causing credit to become overextended
• Economy suffers and a crisis emerges

Turn this loop above into a graphic. Key signs are new investors (ignorantly) and new companies (unworthily) flocking in. (53)

History repeating itself:

As with many later stock market booms (including that of the 1990s), the mania of the 1690s played itself out through a series of mini-bubbles, starting with diving schemes and finishing with banks. Shares were driven above their intrinsic values by speculators using financial derivatives (stock options and futures) as well as paper credit. The boom lost momentum after sanguine expectations were disappointed and doubtful enterprises failed. The collapse of share prices contributed to a severe economic crisis. (55)

How not much has changed:

Already in the seventeenth century, both in Amsterdam and London, we find financial derivatives being used for both risk control and speculation. We find sophisticated notions of value, together with the idea of “discounted” cash flows and present values … The modern investor is just as liable to be whipped up into a frenzy over companies introducing a new technology as the diving engine “cullies” of the Projecting Age. (57)

John Law played an integral role in the shift of viewing money as intrinsically valuable to a form of exchange. Law’s conception as well as his Mississippi Company monopoly increased speculation in France in the early 18th century. (60-61) Chancellor highlights Law’s chief error, conflating money with shares of companies:

Law’s great error was his confusion of shares with money. Since rising share prices led to the printing of more money, which in turn was ploughed back into shares, there was no potential limit to the ensuing asset inflation … this circularity is always present in modern financial systems where credit creation is dependent on asset values. (61)

Chancellor notes how the men in charge of these bubble companies were so consumed with greed that increasingly fraudulent measures were taken to keep pumping the stock of their company up (74), including this great quote on greed:

Operations of financial alchemy, as Sir Isaac Newton discovered, were more likely to damage the mind of the alchemist than to achieve any lasting transmutation of base metals into gold. (76)

Chancellor on the South Sea Bubble, noting that the most experienced investors sell before a crash precipitates, which in of itself forewarns a crash coming:

The departure of the more experienced market operators at, or near, the peak of a bubble is a common feature of speculative booms. (78)

The Bubble Act, Scire Facias writ, and enhanced dividend all drove down the South Sea Company’s price, along with other companies crashing that forced investors to sell South Sea stock to cover their losses on credit as well as investors reinvesting profits elsewhere in smaller new bubble companies. (83)

People made fortunes speculating on bonds issued by Britain during the Napoleonic wars. Interest in foreign loans to places like South America increased as it served as a new playground for speculation. (98)

Chancellor summarizes the start of Disraeli’s path to success was speculation and encouraging the South American bull market. (103-104)

Speculation as a two-sided coin, as acknowledged by Chancellor and Lord Liverpool:

As Lord Liverpool acknowledged, speculation was inevitable in a modern commercial society and an attempt to control it would restrain the “invisible hand” that directed economic affairs with an almost divine omniscience. The government also recognised that joint-stock companies had an increasingly important role to play in providing funds for capital-intensive businesses such as banks, insurance companies, canals, railways, gasworks, and waterworks. Yet there was an acute awareness of speculation as an “evil,” both corrupting and—in its etymological sense—overbearing and excessive. Speculation threatened to induce a general crisis in which the innocent would suffer along with the guilty. (108-109)

History repeating itself again, this time in the form of governmental ignorance:

Whereas British goods, capital, and skills were to modernise the South American states after their liberation from the dead hand of the Spaniard, in the 1900s it was to be American goods and capital that replaced the sclerosis of state socialism. In their euphoria, modern investors in emerging markets ignored the profound differences between their own political and economic cultures and those of the counties in which they invested, just as their British predecessors had done in the 1820s. (117)

Chancellor cites the forces that come together to make emerging markets speculatively attractive:

Emerging market speculation tends to appear at a juncture in the economic cycle when declining yields on domestic bonds combine with an excess of capital to make foreign investments particularly attractive. (118)

How and why the South American bubble began to burst:

During the boom, the unrestricted growth of credit caused asset prices to rise, stimulating yet another further credit creation. The situation reached a turning point in the spring of 1825, after which declining asset prices undermined confidence, caused a contraction of credit, and eventually brought on a crisis. (119-120)

According to John Stuart Mill, the seeds of each boom are sown during the preceding crisis, when the liquidation of credit causes asset prices to decline so severely that they become genuine bargains. Their subsequent sharp rise from a low level leads to a revival of speculation. After each crisis, the financial markets invariably shrug off past follies and losses to confront the future with bright optimism and fresh credulity. Capital becomes “blind,” to use Bagehot’s term. Unable to remember the past, investors are condemned to repeat it. (121)

Advances in communications attracts speculation which contributes to the establishment of the new innovation—railways, radio, planes, computers, and the Internet. (123)

The rise of the Internet had striking similarities to the rise of the railways. However, internet companies didn’t have the same huge upfront costs and high capital investment the way railway companies needed. (150)

Speculation had strong ties with colonialism—the Americas were a huge speculative gamble. (152)

The call loan system emerged in the middle of the 19th century which revolutionized Wall Street. (157) The system only increased the market’s volatility by making banks more vulnerable to crises. (158)

The New York Stock Exchange was rife with corruption in the 1860s. (187) Chancellor on the corruption of the market:

Believers in efficient markets claim that speculators help to “discover” values and that stock prices move randomly because they reflect all information relevant to their value. In the nineteenth century American market, however, intrinsic values were actually hidden by the operations of speculators … What were known as the three M’s—mystery, manipulation, and (thin) margins—hindered the stock market from fulfilling its theoretical function of allocating capital efficiently. Instead, railroads were placed where they were not needed, companies were crippled that might have prospered had they kept away from the market, and stock market panics caused unnecessary bank failures … Samuel Johnson defined gambling as the redistribution of wealth without an intermediate good. The speculation of the Gilded Age conformed to Dr. Johnson’s definition: it brought more harm than good and transferred property from the hands of the many into the pockets of the few. (189-190)

Common theme of investors believing that for some reason the modern age of investing is different from the old and now risk is heavily fortified against, when in fact it’s almost never the case. This was apparent before the collapse of the stock market that began the Great Depression:

The first premise of the “new economics,” as it was otherwise called, was that the business cycle … had been effectively abolished by the establishment of the Federal Reserve System in 1913 … As a result, bankers and speculators alike were lulled into a false security which led them to operate irresponsibly, exacerbating the severity of the ensuing crisis. (192)

Principal step towards a bubble and burst is false security. (192)

Capitalism requires savers and consumers: however, consumption via credit begins a reinforcing loop of using future earnings to consume more in the present, squeezing out room for saving which is also necessary. (197-198)

Call loans presented the market with a vicious cycle of increasing prices from buyers buying on the margins. (199)

Use of debt in the 1920s:

The dominant feature of the 1920s stock market was not the wild pursuit of speculative innovations but the use of debt to pyramid investments and enhance gains.

Leverage was not confined to individual speculators’ margin holdings; it became built into the financial structure of corporate America. Utility and railway companies were consolidated into giant holding companies, called “systems” (an unconscious echo of John Law’s Mississippi System), which were constructed upon multiple layers of debt. (207)

Stock market is driven by the crowd and share many characteristics similar to the crowd—thriving on rumors, uncertainties, intellectual weakening from crowds. (212)

Throughout the history of the stock market oftentimes the winners are found on the inside, with secrets and trading of information. The outsider suffers from asymmetrical information. (221)

In his General Theory Keynes spoke out against speculation not as inherently evil but as not directing the price in markets efficiently as others might have imagined—capital being directed by “activities of a casino.” (222)

The Great Depression shifted national sentiment from optimistic dreaming of the future in the roaring 20s to severe fear and risk aversion. (225)

The 1990s reflected the 1920s in the indulgence and repercussions that come with excessive consumption on credit. (226) The 90’s also experienced the bubble loop of rising share prices increasing the share prices even more, until a point where speculation and credit can’t expand any further. (232)

The effects of the 1970s fiscal policy:

After the end of the Bretton Woods system, money became only a figment of the imagination, weightless and ethereal … Henceforth, all currency values would be a reflection of their perceived future values: the present would be as much determined by the future as the future by the present. And the grand arbiter of this confusing new system was the speculator. (237)

When financial information spreads and communication increases more players tend to enter the speculative game. (238) Today, because there is so much widespread information it becomes a competitive advantage to avoid the information being spread to and consumed by the masses. (239) Additionally, increased communication has not been correlated with increased performance from professional investors. (240)

Markets collapse after we forget the lessons of burdensome debt and overextending credit. (255)

At some point principled laissez-faire gives way to a widespread acceptance of shortcuts in the pursuit of self-interest, and from there it is but a short step to outright dishonesty. (271)

Chancellor’s insight on manias occurring during times of shirting global economic power:

Speculative euphoria is often a symptom of hubris. For this reason, we find great speculative manias at times when the economic balance of power is shifting from one nation to another. (286)

The 1980s Japanese bubble:

The capital expenditure of the bubble years created the illusion that Japan’s economic miracle was continuing long after its real vigour had diminished, and produced a vast misallocation of resources into unproductive investments. By attempting to use speculation as a tool of economic policy, the mandarins of the Finance Ministry had opened a Pandora’s box. (292)

Moral hazard:

Perhaps more than anything the bubble economy illustrates the danger that arises when investors believe that market risk is shouldered by the government rather than by themselves (what economists refer to as the problem of “moral hazard”). (325)

• My connection: almost all business, government, law, life is properly aligning incentives (Munger) and ensuring people have to take on the risks of reaping potential rewards (Taleb “Skin in the Game”)

Common fallacy in finance is assuming past volatility serves accurate predictor of future volatility. (345)