Common section


Blowing Bubbles

The Andes stretch for more than four thousand miles like a jagged, crooked spine down the western side of the South American continent. Formed roughly a hundred million years ago, as the Nazca tectonic plate began its slow but tumultuous slide beneath the South American plate, their highest peak, Mount Aconcagua in Argentina, rises more than 22,000 feet above sea level. Aconcagua’s smaller Chilean brethren stand like gleaming white sentinels around Santiago. But it is only when you are up in the Bolivian highlands that you really grasp the sheer scale of the Andes. When the rain clouds lift on the road from La Paz to Lake Titicaca, the mountains dominate the skyline, tracing a dazzling, irregular saw-tooth right across the horizon.

Looking at the Andes, it is hard to imagine that any kind of human organization could overcome such a vast natural barrier. But for one American company, their jagged peaks were no more daunting than the dense Amazonian rainforests that lie to the east of them. That company set out to construct a gas pipeline from Bolivia across the continent to the Atlantic coast of Brazil, and another - the longest in the world - from the tip of Patagonia to the Argentine capital Buenos Aires.

Such grand schemes, exemplifying the vaulting ambition of modern capitalism, were made possible by the invention of one of the most fundamental institutions of the modern world: the company. It is the company that enables thousands of individuals to pool their resources for risky, long-term projects that require the investment of vast sums of capital before profits can be realized. After the advent of banking and the birth of the bond market, the next step in the story of the ascent of money was therefore the rise of the joint-stock, limited-liability corporation: joint-stock because the company’s capital was jointly owned by multiple investors; limited-liability because the separate existence of the company as a legal ‘person’ protected the investors from losing all their wealth if the venture failed. Their liability was limited to the money they had used to buy a stake in the company. Smaller enterprises might operate just as well as partnerships. But those who aspired to span continents needed the company.1

However, the ability of companies to transform the global economy depended on another, related innovation. In theory, the managers of joint-stock companies are supposed to be disciplined by vigilant shareholders, who attend annual meetings, and seek to exert influence directly or indirectly through non-executive directors. In practice, the primary discipline on companies is exerted by stock markets, where an almost infinite number of small slices of companies (call them stocks, shares or equities, whichever you prefer) are bought and sold every day. In essence, the price people are prepared to pay for a piece of a company tells you how much money they think that company will make in the future. In effect, stock markets hold hourly referendums on the companies whose shares are traded there: on the quality of their management, on the appeal of their products, on the prospects of their principal markets.

Yet stock markets also have a life of their own. The future is in large measure uncertain, so our assessments of companies’ future profitability are bound to vary. If we were all calculating machines we would simultaneously process all the available information and come to the same conclusion. But we are human beings, and as such are prone to myopia and to mood swings. When stock market prices surge upwards in sync, as they often do, it is as if investors are gripped by a kind of collective euphoria: what the former chairman of the Federal Reserve Alan Greenspan memorably called irrational exuberance.2 Conversely, when investors’ ‘animal spirits’ flip from greed to fear, the bubble of their earlier euphoria can burst with amazing suddenness. Zoological imagery is of course an integral part of stock market culture. Optimistic buyers of stocks are bulls, pessimistic sellers are bears. Investors these days are said to be an electronic herd, happily grazing on positive returns one moment, then stampeding for the farmyard gate the next. The real point, however, is that stock markets are mirrors of the human psyche. Like homo sapiens, they can become depressed. They can even suffer complete breakdowns. Yet hope - or is it amnesia? - always seems able to triumph over such bad experiences.

In the four hundred years since shares were first bought and sold, there has been a succession of financial bubbles. Time and again, share prices have soared to unsustainable heights only to crash downwards again. Time and again, this process has been accompanied by skulduggery, as unscrupulous insiders have sought to profit at the expense of naive neophytes. So familiar is this pattern that it is possible to distil it into five stages:

1. Displacement: Some change in economic circumstances creates new and profitable opportunities for certain companies.

2. Euphoria or overtrading: A feedback process sets in whereby rising expected profits lead to rapid growth in share prices.

3. Mania or bubble: The prospect of easy capital gains attracts first-time investors and swindlers eager to mulct them of their money.

4. Distress: The insiders discern that expected profits cannot possibly justify the now exorbitant price of the shares and begin to take profits by selling.

5. Revulsion or discredit: As share prices fall, the outsiders all stampede for the exits, causing the bubble to burst altogether.3

Stock market bubbles have three other recurrent features. The first is the role of what is sometimes referred to as asymmetric information. Insiders - those concerned with the management of bubble companies - know much more than the outsiders, whom the insiders want to part from their money. Such asymmetries always exist in business, of course, but in a bubble the insiders exploit them fraudulently.4 The second theme is the role of cross-border capital flows. Bubbles are more likely to occur when capital flows freely from country to country. The seasoned speculator, based in a major financial centre, may lack the inside knowledge of the true insider. But he is much more likely to get his timing right - buying early and selling before the bubble bursts - than the naive first-time investor. In a bubble, in other words, not everyone is irrational; or, at least, some of the exuberant are less irrational than others. Finally, and most importantly, without easy credit creation a true bubble cannot occur. That is why so many bubbles have their origins in the sins of omission or commission of central banks.

Nothing illustrates more clearly how hard human beings find it to learn from history than the repetitive history of stock market bubbles. Consider how readers of the magazine Business Week saw the world at two moments in time, separated by just twenty years. On 13 August 1979, the front cover featured a crumpled share certificate in the shape of a crashed paper dart under the headline: ‘The Death of Equities: How inflation is destroying the stock market’. Readers were left in no doubt about the magnitude of the crisis:

The masses long ago switched from stocks to investments having higher yields and more protection from inflation. Now the pension funds - the market’s last hope - have won permission to quit stocks and bonds for real estate, futures, gold, and even diamonds. The death of equities looks like an almost permanent condition.5

On that day, the Dow Jones Industrial Average, the longest-running American stock market index, closed at 875, barely changed from its level ten years before, and nearly 17 per cent below its peak of 1052 in January 1973. Pessimism after a decade and half of disappointment was understandable. Yet, far from expiring, US equities were just a few years away from one of the great bull runs of modern times. Having touched bottom in August 1982 (777), the Dow proceeded to more than treble in the space of just five years, reaching a record high of 2,700 in the summer of 1987. After a short, sharp sell-off in October 1987, the index resumed its upward rise. After 1995, the pace of its ascent even quickened. On 27 September 1999, it closed at just under 10,395, meaning that the average price of a major US corporation had risen nearly twelve-fold in just twenty years. On that day, readers of Business Week read with excitement that:

Conditions don’t have to get a lot better to justify Dow 36,000, say James K. Glassman and Kevin A. Hassett in Dow 36,000: The New Strategy for Profiting From the Coming Rise in the Stock Market. They argue that the market already merits 36K, and that stock prices will advance toward that target over the next 3 to 5 years as investors come to that conclusion, too . . . The market - even at a price-to-earnings ratio of 30s - is a steal. By their estimates, a ‘perfectly reasonable price’ for the market . . . is 100 times earnings.6

This article was published less than four months before the collapse of the dot-com bubble, which had been based on exaggerated expectations about the future earnings of technology companies. By October 2002 the Dow was down to 7,286, a level not seen since late 1997. At the time of writing (April 2008), it is still trading at one third of the level Glassman and Hassett predicted.

The performance of the American stock market is perhaps best measured by comparing the total returns on stocks, assuming the reinvestment of all dividends, with the total returns on other financial assets such as government bonds and commercial or Treasury bills, the last of which can be taken as a proxy for any short-term instrument like a money market fund or a demand deposit at a bank. The start date, 1964, is the year of the author’s birth. It will immediately be apparent that if my parents had been able to invest even a modest sum in the US stock market at that date, and to continue reinvesting the dividends they earned each year, they would have been able to increase their initial investment by a factor of nearly seventy by 2007. For example, $10,000 would have become $700,000. The alternatives of bonds or bills would have done less well. A US bond fund would have gone up by a factor of under 23; a portfolio of bills by a factor of just 12. Needless to say, such figures must be adjusted downwards to take account of the cost of living, which has risen by a factor of nearly seven in my lifetime. In real terms, stocks increased by a factor of 10.3; bonds by a factor of 3.4; bills by a factor of 1.8. Had my parents made the mistake of simply buying $10,000 in dollar bills in 1964, the real value of their son’s nest egg would have declined in real terms by 85 per cent.

No stock market has out-performed the American over the long run. One estimate of long-term real stock market returns showed an average return for the US market of 4.73 per cent per year between the 1920s and the 1990s. Sweden came next (3.71), followed by Switzerland (3.03), with Britain barely in the top ten on 2.28 per cent. Six out of the twenty-seven markets studied suffered at least one major interruption, usually as a result of war or revolution. Ten markets suffered negative long-term real returns, of which the worst were Venezuela, Peru, Colombia and, at the very bottom, Argentina (-5.36 per cent) .7 ‘Stocks for the long run’ is very far from being a universally applicable nostrum.8 It nevertheless remains true that, in most countries for which long-run data are available, stocks have out-performed bonds - by a factor of roughly five over the twentieth century.9This can scarcely surprise us. Bonds, as we saw in Chapter 2, are no more than promises by governments to pay interest and ultimately repay principal over a specified period of time. Either through default or through currency depreciation, many governments have failed to honour those promises. By contrast, a share is a portion of the capital of a profit-making corporation. If the company succeeds in its undertakings, there will not only be dividends, but also a significant probability of capital appreciation. There are of course risks, too. The returns on stocks are less predictable and more volatile than the returns on bonds and bills. There is a significantly higher probability that the average corporation will go bankrupt and cease to exist than that the average sovereign state will disappear. In the event of a corporate bankruptcy, the holders of bonds and other forms of debt will be satisfied first; the equity holders may end up with nothing. For these reasons, economists see the superior returns on stocks as capturing an ‘equity risk premium’ - though clearly in some cases this has been a risk well worth taking.

The Company You Keep

Behind the ornate baroque façade of Venice’s San Moise church, literally under the feet of the tens of thousands of tourists who visit the church each year, there is a remarkable but seldom noticed inscription:



‘To the honour and memory of John Law of Edinburgh. Most distinguished controller of the treasury of the kings of the French.’ It is a rather unlikely resting place for the man who invented the stock market bubble.

An ambitious Scot, a convicted murderer, a compulsive gambler and a flawed financial genius, John Law was not only responsible for the first true boom and bust in asset prices. He also may be said to have caused, indirectly, the French Revolution by comprehensively blowing the best chance that the ancien régime monarchy had to reform its finances. His story is one of the most astonishing yet least well understood tales of adventure in all financial history. It is also very much a story for our times.

Born in Edinburgh in 1671, Law was the son of a successful goldsmith and the heir to Lauriston Castle, overlooking the Firth of Forth. He went to London in 1692, but quickly began to fritter away his patrimony in a variety of business ventures and gambling escapades. Two years later he fought a duel with his neighbour, who objected to sharing the same building as the dissolute Law and his mistress, and killed him. He was tried for duelling and sentenced to death, but escaped from prison and fled to Amsterdam.

Law could not have picked a better town in which to lie low. By the 1690s Amsterdam was the world capital of financial innovation. To finance their fight for independence against Spain in the late sixteenth century, as we saw in the previous chapter, the Dutch had improved on the Italian system of public debt (introducing, among other things, lottery loans which allowed people to gamble as they invested their savings in government debt). They had also reformed their currency by creating what was arguably the world’s first central bank, the Amsterdam Exchange Bank (Wisselbank), which solved the problem of debased coinage by creating a reliable form of bank money (see Chapter 1). But perhaps the single greatest Dutch invention of all was the joint-stock company.

The story of the company had begun a century before Law’s arrival and had its origins in the efforts of Dutch merchants to wrest control of the lucrative Asian spice trade from Portugal and Spain. Europeans craved spices like cinnamon, cloves, mace, nutmeg and pepper not merely to flavour their food but also to preserve it. For centuries, these commodities had come overland from Asia to Europe along the Spice Road. But with the Portuguese discovery of the sea route to the East Indies via the Cape of Good Hope, new and irresistibly attractive business opportunities opened up. The Amsterdam Historical Museum is full of paintings that depict Dutch ships en route to and from the East Indies. One early example of the genre bears the inscription: ‘Four ships sailed to go and get the spices towards Bantam and also established trading posts. And came back richly laden to . . . Amsterdam. Departed May 1, 1598. Returned July 19, 1599.’ As that suggests, however, the round trip was a very long one (fourteen months was in fact well below the average). It was also hazardous: of twenty-two ships that set sail in 1598, only a dozen returned safely. For these reasons, it made sense for merchants to pool their resources. By 1600 there were around six fledgling East India companies operating out of the major Dutch ports. However, in each case the entities had a limited term that was specified in advance - usually the expected duration of a voyage - after which the capital was repaid to investors.10 This business model could not suffice to build the permanent bases and fortifications that were clearly necessary if the Portuguese and their Spanish alliest were to be supplanted. Actuated as much by strategic calculations as by the profit motive, the Dutch States-General, the parliament of the United Provinces, therefore proposed to merge the existing companies into a single entity. The result was the United East India Company - the Vereenigde Nederlandsche Geoctroyeerde Oostindische Compagnie (United Dutch Chartered East India Company, or VOC for short), formally chartered in 1602 to enjoy a monopoly on all Dutch trade east of the Cape of Good Hope and west of the Straits of Magellan.11

The structure of the VOC was novel in a number of respects. True, like its predecessors, it was supposed to last for a fixed period, in this case twenty-one years; indeed, Article 7 of its charter stated that investors would be entitled to withdraw their money at the end of just ten years, when the first general balance was drawn up. But the scale of the enterprise was unprecedented. Subscription to the Company’s capital was open to all residents of the United Provinces and the charter set no upper limit on how much might be raised. Merchants, artisans and even servants rushed to acquire shares; in Amsterdam alone there were 1,143 subscribers, only eighty of whom invested more than 10,000 guilders, and 445 of whom invested less than 1,000. The amount raised, 6.45 million guilders, made the VOC much the biggest corporation of the era. The capital of its English rival, the East India Company, founded two years earlier, was just £68,373 - around 820,000 guilders - shared between a mere 219 subscribers. 12 Because the VOC was a government-sponsored enterprise, every effort was made to overcome the rivalry between the different provinces (and particularly between Holland, the richest province, and Zeeland). The capital of the Company was divided (albeit unequally) between six regional chambers (Amsterdam, Zeeland, Enkhuizen, Delft, Hoorn and Rotterdam). The seventy directors (bewindhebbers), who were each substantial investors, were also distributed between these chambers. One of their roles was to appoint seventeen people to act as the Heeren XVII - the Seventeen Lords - as a kind of company board. Although Amsterdam accounted for 57.4 per cent of the VOC’s total capital, it nominated only eight out of the Seventeen Lords. Among the founding directors was Dirck Bas, a profit-oriented paterfamilias who (to judge by his portrait) was far from embarrassed by his riches.13

Ownership of the Company was thus divided into multiple partijen or actien, literally actions (as in ‘a piece of the action’). Payment for the shares was in instalments, due in 1603, 1605, 1606 and 1607. The certificates issued were not quite share certificates in the modern sense, but more like receipts; the key document in law was the VOC stock ledger, where all stock-holders’ names were entered at the time of purchase. 14 The principle of limited liability was implied: shareholders stood to lose only their investment in the company and no other assets in the event that it failed.15There was, on the other hand, no guarantee of returns; Article 17 of the VOC charter merely stated that a payment would be made to shareholders as soon as profits equivalent to 5 per cent of the initial capital had been made.


The oldest share: share no. 6 of the Dutch East India Company

(not strictly speaking a share certificate but a receipt for part

payment of share, issued by the Camere Amsterdam on 27 September

1606, and signed by Arent ten Grotenhuys and Dirck van Os)

The VOC was not in fact an immediate commercial success. Trade networks had to be set up, the mode of operation established and secure bases established. Between 1603 and 1607, a total of twenty-two ships were fitted out and sent to Asia, at a cost of just under 3.7 million guilders. The initial aim was to establish a number of factories (saltpetre refineries, textile facilities and warehouses), the produce of which would then be exchanged for spices. Early successes against the Portuguese saw footholds established at Masulipatnam in the Bay of Bengal and Amboyna (today Ambon) in the Moluccas (Malukus), but in 1606 Admiral Matelief failed to capture Malacca (Melaka) on the Malay Peninsula and an attack on Makian (another Moluccan island) was successfully repulsed by a Spanish fleet. An attempt to build a fort on Banda Neira, the biggest of the nutmeg-producing Banda islands, also failed.16 By the time a twelve-year truce was signed with Spain in 1608, the VOC had made more money from capturing enemy vessels than from trade.17 One major investor, the Mennonite Pieter Lijntjens, was so dismayed by the Company’s warlike conduct that he withdrew from the Company in 1605. Another early director, Isaac le Maire, resigned in protest at what he regarded as the mismanagement of the Company’s affairs.18

But how much power did even large shareholders have? Little. When the Company’s directors petitioned the government to be released from their obligation to publish ten-year accounts in 1612 - the date when investors were supposed to be able to withdraw their capital if they chose to - permission was granted and publication of the accounts and the repayment of investors’ capital were both postponed. The only sop to shareholders was that in 1610 the Seventeen Lords agreed to make a dividend payment the following year, though at this stage the Company was so strapped for cash that the dividend had to be paid in spices. In 1612 it was announced that the VOC would not be liquidated, as originally planned. This meant that any shareholders who wanted their cash back had no alternative but to sell their shares to another investor.19

The joint-stock company and the stock market were thus born within just a few years of each other. No sooner had the first publicly owned corporation come into existence with the first-ever initial public offering of shares, than a secondary market sprang up to allow these shares to be bought and sold. It proved to be a remarkably liquid market. Turnover in VOC shares was high: by 1607 fully one third of the Company’s stock had been transferred from the original owners.20 Moreover, because the Company’s books were opened rather infrequently - purchases were formally registered monthly or quarterly - a lively forward market in VOC shares soon developed, which allowed sales for future delivery. To begin with, such transactions were done in informal open-air markets, on the Warmoesstraat or next to the Oude Kerk. But so lively was the market for VOC stock that in 1608 it was decided to build a covered Beurs on the Rokin, not far from the town hall. With its quadrangle, its colonnades and its clock tower, this first stock exchange in the world looked for all the world like a medieval Oxford college. But what went on there between noon and two o’clock each workday was recognizably revolutionary. One contemporary captured the atmosphere on the trading floor as a typical session drew to a close: ‘Hand-shakes are followed by shouting, insults, impudence, pushing and shoving.’ Bulls (liefhebbers) did battle with bears (contremines). The anxious speculator ‘chews his nails, pulls his fingers, closes his eyes, takes four paces and four times talks to himself, raises his hand to his cheek as if he has a toothache and all this accompanied by a mysterious coughing’.21

Nor was it coincidental that this same period saw the foundation (in 1609) of the Amsterdam Exchange Bank, since a stock market cannot readily function without an effective monetary system. Once Dutch bankers started to accept VOC shares as collateral for loans, the link between the stock market and the supply of credit began to be forged. The next step was for banks to lend money so that shares might be purchased with credit. Company, bourse and bank provided the triangular foundation for a new kind of economy.

For a time it seemed as if the VOC’s critics, led by the disgruntled ex-director le Maire, might exploit this new market to put pressure on the Company’s directors. A concerted effort to drive down the price of VOC shares by short selling on the nascent futures market was checked by the 1611 dividend payment, ruining le Maire and his associates.22 Further cash dividends were paid in 1612, 1613 and 1618.23 The Company’s critics (the ‘dissenting investors’ or Doleanten) remained dissatisfied, however. In a tract entitled The Necessary Discourse (Nootwendich Discours), published in 1622, an anonymous author lamented the lack of transparency which characterized the ‘self-serving governance of certain of the directors’, who were ensuring that ‘all remained darkness’: ‘The account book, we can only surmise, must have been rubbed with bacon and fed to the dogs.’24Directorships should be for fixed terms, the dissenters argued, and all major shareholders should have the right to appoint a director.

The campaign for a reform of what would now be called the VOC’s corporate governance duly bore fruit. In December 1622, when the Company’s charter was renewed, it was substantially modified. Directors would no longer be appointed for life but could serve for only three years at a time. The ‘chief participants’ (shareholders with as much equity as directors) were henceforth entitled to nominate ‘Nine Men’ from among themselves, whom the Seventeen Lords were obliged to consult on ‘great and important matters’, and who would be entitled to oversee the annual accounting of the six chambers and to nominate, jointly with the Seventeen Lords, future candidates for directorships. In addition, in March 1623, it was agreed that the Nine Men would be entitled to attend (but not to vote at) the meetings of the Seventeen Lords and to scrutinize the annual purchasing accounts. The chief participants were also empowered to appoint auditors (rekening-opnemers ) to check the accounts submitted to the States-General. 25 Shareholders were further mollified by the decision, in 1632, to set a standard 12.5 per cent dividend, twice the rate at which the Company was able to borrow money.u The result of this policy was that virtually all of the Company’s net profits thereafter were distributed to the shareholders.26 Shareholders were also effectively guaranteed against dilution of their equity. Amazingly, the capital base remained essentially unchanged throughout the VOC’s existence.27 When capital expenditures were called for, the VOC raised money not by issuing new shares but by issuing debt in the form of bonds. Indeed, so good was the Company’s credit by the 1670s that it was able to act as an intermediary for a two-million-guilder loan by the States of Holland and Zeeland.

None of these arrangements would have been sustainable, of course, if the VOC had not become profitable in the mid seventeenth century. This was in substantial measure the achievement of Jan Pieterszoon Coen, a bellicose young man who had no illusions about the relationship between commerce and coercion. As Coen himself put it: ‘We cannot make war without trade, nor trade without war.’28 He was ruthless in his treatment of competitors, executing British East India Company officials at Amboyna and effectively wiping out the indigenous Bandanese. A natural-born empire builder, Coen seized control of the small Javanese port of Jakarta in May 1619, renamed it Batavia and, aged just 30, duly became the first governor-general of the Dutch East Indies. He and his successor, Antonie van Diemen, systematically expanded Dutch power in the region, driving the British from the Banda Islands, the Spaniards from Ternate and Tidore, and the Portuguese from Malacca. By 1657 the Dutch controlled most of Ceylon (Sri Lanka); the following decade saw further expansion along the Malabar coast on the subcontinent and into the island of Celebes (Sulawesi). There were also thriving Dutch bases on the Coromandel coast.29 Fire-power and foreign trade sailed side by side on ships like the Batavia - a splendid replica of which can be seen today at Lelystad on the coast of Holland.

The commercial payoffs of this aggressive strategy were substantial. By the 1650s, the VOC had established an effective and highly lucrative monopoly on the export of cloves, mace and nutmeg (the production of pepper was too widely dispersed for it to be monopolized) and was becoming a major conduit for Indian textile exports from Coromandel.30 It was also acting as a hub for intra-Asian trade, exchanging Japanese silver and copper for Indian textiles and Chinese gold and silk. In turn, Indian textiles could be traded for pepper and spices from the Pacific islands, which could be used to purchase precious metals from the Middle East.31 Later, the Company provided financial services to other Europeans in Asia, not least Robert Clive, who transferred a large part of the fortune he had made from conquering Bengal back to London via Batavia and Amsterdam.32 As the world’s first big corporation, the VOC was able to combine economies of scale with reduced transaction costs and what economists call network externalities, the benefit of pooling information between multiple employees and agents.33 As was true of the English East India Company, the VOC’s biggest challenge was the principal-agent problem: the tendency of its men on the spot to trade on their own account, bungle transactions or simply defraud the company. This, however, was partially countered by an unusual compensation system, which linked remuneration to investments and sales, putting a priority on turnover rather than net profits.34 Business boomed. In the 1620s, fifty VOC ships had returned from Asia laden with goods; by the 1690s the number was 156.35 Between 1700 and 1750 the tonnage of Dutch shipping sailing back around the Cape doubled. As late as 1760 it was still roughly three times the amount of British shipping.36

The economic and political ascent of the VOC can be traced in its share price. The Amsterdam stock market was certainly volatile, as investors reacted to rumours of war, peace and shipwrecks in a way vividly described by the Sephardic Jew Joseph Penso de la Vega in his aptly named book Confusión de Confusiones (1688). Yet the long-term trend was clearly upward for more than a century after the Company’s foundation. Between 1602 and 1733, VOC stock rose from par (100) to an all-time peak of 786, this despite the fact that from 1652 until the Glorious Revolution of 1688 the Company was being challenged by bellicose British competition.37 Such sustained capital appreciation, combined with the regular dividends and stable consumer prices,v ensured that major shareholders like Dirck Bas became very wealthy indeed. As early as 1650, total dividend payments were already eight times the original investment, implying an annual rate of return of 27 per cent.38 The striking point, however, is that there was never such a thing as a Dutch East India Company bubble. Unlike the Dutch tulip futures bubble of 1636-7, the ascent of the VOC stock price was gradual, spread over more than a century, and, though its descent was more rapid, it still took more than sixty years to fall back down to 120 in December 1794. This rise and fall closely tracked the rise and fall of the Dutch Empire. The prices of shares in other monopoly trading companies, outwardly similar to the VOC, would behave very differently, soaring and slumping in the space of just a few months. To understand why, we must rejoin John Law.

To the renegade Scotsman, Dutch finance came as a revelation. Law was fascinated by the relationships between the East India Company, the Exchange Bank and the stock exchange. Always attracted by gambling, Law found the Amsterdam Beurs more exciting than any casino. He marvelled at the antics of short-sellers, who spread negative rumours to try to drive down VOC share prices, or the specialists in windhandel, who traded speculatively in shares they did not themselves even own. Financial innovation was all around. Law himself floated an ingenious scheme to insure holders of Dutch national lottery tickets against drawing blanks.

Yet the Dutch financial system struck Law as not quite complete. For one thing, it seemed wrong-headed to restrict the number of East India Company shares when the market was so enamoured of them. Law was also puzzled by the conservatism of the Amsterdam Exchange Bank. Its own ‘bank money’ had proved a success, but it largely took the form of columns of figures in the bank’s ledgers. Apart from receipts issued to merchants who deposited coin with the bank, the money had no physical existence. The idea was already taking shape in Law’s mind of a breathtaking modification of these institutions, which would combine the properties of a monopoly trading company with a public bank that issued notes in the manner of the Bank of England. Law was soon itching to try out a whole new system of finance on an unsuspecting nation. But which one?

He first tried his luck in Genoa, trading foreign currency and securities. He spent some time in Venice, trading by day, gambling by night. In partnership with the Earl of Islay, he also built up a substantial portfolio on the London stock market. (As this suggests, Law was well connected. But there remained a disreputable quality to his conduct. Lady Catherine Knowles, daughter of the Earl of Banbury, passed as his wife and was the mother of his two children, despite the fact that she was married to another man. In 1705 he submitted to the Scottish parliament a proposal for a new bank, later published as Money and Trade Considered. His central idea was that the new bank should issue interest-bearing notes that would supplant coins as currency. It was rejected by the parliament shortly before the Act of Union with England.39 Disappointed by his homeland, Law travelled to Turin and in 1711 secured an audience with Victor Amadeus II, Duke of Savoy. In The Piedmont Memorials, he again made the case for a paper currency. According to Law, confidence alone was the basis for public credit; with confidence, banknotes would serve just as well as coins. ‘I have discovered the secret of the philosopher’s stone, he told a friend, ‘it is to make gold out of paper.’40 The Duke demurred, saying ‘I am not rich enough to ruin myself.’

The First Bubble

Why was it in France that Law was given the chance to try out his financial alchemy? The French knew him for what he was, after all: in 1708 the Marquis of Torcy, Louis XIV’s Foreign Minister, had identified him as a professional joueur (gambler) and possible spy. The answer is that France’s fiscal problems were especially desperate. Saddled with enormous public debt as a result of the wars of Louis XIV, the government was on the brink of its third bankruptcy in less than a century. A review (Visa) of the crown’s existing debts was thought necessary, which led to the cancellation and reduction of many of them, in effect a partial default. Even so, 250 million new interest-bearing notes called billets d’état still had to be issued to fund the current deficit. Matters were only made worse by an attempt to reduce the quantity of gold and silver coinage, which plunged the economy into recession.41 To all these problems Law claimed to have the solution.

In October 1715 Law’s first proposal for a public note-issuing bank was submitted to the royal council, but it was rejected because of the opposition of the Duke of Noailles to Law’s bold suggestion that the bank should also act as the crown’s cashier, receiving all tax payments. A second proposal for a purely private bank was more successful. The Banque Générale was established under Law’s direction in May 1716. It was licensed to issue notes payable in specie (gold or silver) for a twenty-year period. The capital was set at 6,000,000 livres (1,200 shares of 5,000 livres each), three quarters to be paid in now somewhat depreciated billets d’état (so the effective capital was closer to 2,850,000 livres).42 It seemed at first quite a modest enterprise, but Law always had a grander design in mind, which he was determined to sell to the Duke of Orleans, the Regent during the minority of Louis XV. In 1717 he took another step forward when it was decreed that Banque Générale notes should be used in payment for all taxes, a measure initially resisted in some places but effectively enforced by the government.

Law’s ambition was to revive economic confidence in France by establishing a public bank, on the Dutch model, but with the difference that this bank would issue paper money. As money was invested in the bank, the government’s huge debt would be consolidated. At the same time, paper money would revive French trade - and with it French economic power. ‘The bank is not the only, nor the grandest of my ideas,’ he told the Regent. ‘I will produce a work which will surprise Europe by the changes which it will effect in favour of France - changes more powerful than were produced by the discovery of the Indies . . .’43

Law had studied finance in republican Holland, but from the outset he saw absolutist France as a better setting for what became known as his System. ‘I maintain’, he wrote, ‘that an absolute prince who knows how to govern can extend his credit further and find needed funds at a lower interest rate than a prince who is limited in his authority.’ This was an absolutist theory of finance, based on the assertion that ‘in credit as in military and legislative authorities, supreme power must reside in only one person’.44 The key was to make royal credit work more productively than in the past, when the crown had borrowed money in a hand-to-mouth way to finance its wars. In Law’s scheme, the monarch would effectively delegate his credit ‘to a trading company, into which all the materials of trade in the kingdom fall successively, and are amassed into one’. The whole nation would, as he put it, ‘become a body of traders, who have for cash the royal bank, in which by consequence all the commerce, money, and merchandise re-unite’.45

As in the Dutch case, empire played a key role in Law’s vision. In his view, too little was being done to develop France’s overseas possessions. He therefore proposed to take over France’s trade with the Louisiana territory, a vast but wholly undeveloped tract of land stretching from the Mississippi delta across the Midwest - equivalent to nearly a quarter of what is now the United States. In 1717 a new ‘Company of the West’ (Compagnie d’Occident) was granted the monopoly of the commerce of Louisiana (as well as the control of the colony’s internal affairs) for a period of twenty-five years. The Company’s capital was fixed at 100 million livres, an unprecedented sum in France. Shares in the Company were priced at 500 livres each, and Frenchmen, regardless of rank, as well as foreigners were encouraged to buy them (in instalments) with the billets d’état, which were to be retired and converted into 4 per cent rentes (perpetual bonds). Law’s name headed the list of directors.

There was some initial resistance to Law’s System, it is true. The Duke of Saint-Simon observed wisely that:

An establishment of this sort may be good in itself; but it is only so in a republic or in a monarchy like England, whose finances are controlled by those alone who furnish them, and who only furnish as much as they please. But in a state which is weak, changeable, and absolute, like France, stability must necessarily be wanting to it; since the King . . . may overthrow the Bank - the temptation to which would be too great, and at the same time too easy.46

As if to put this to the test, in early 1718 the Parlement of Paris launched fierce attacks on the new Finance Minister René D’Argenson (and on Law’s bank) following a 40 per cent debasement of the coinage ordered by the former, which had caused, the Parlement complained, ‘a chaos so great and so obscure that nothing about it can be known’.47 A rival company, set up by the Pâris brothers, was meanwhile proving more successful in attracting investors than Law’s Company of the West. In true absolutist fashion, however, the Regent forcefully reasserted the prerogatives of the crown, much to Law’s delight - and benefit. (‘How great is the benefit of a despotic power’, he observed, ‘in the beginnings of an institution subject to so much opposition on the part of a nation that has not yet become accustomed to it!’)48 Moreover, from late 1718 onwards the government granted privileges to the Company of the West that were calculated to increase the appeal of its shares. In August it was awarded the right to collect all the revenue from tobacco. In December it acquired the privileges of the Senegal Company. In a further attempt to bolster Law’s position, the Banque Générale was given the royal seal of approval: it became the Banque Royale in December 1718, in effect the first French central bank. To increase the appeal of its notes, these could henceforth be exchanged for either écus de banque (representing fixed amounts of silver) or the more commonly used livres tournois (a unit of account whose relationship to gold and silver could vary). In July, however, the écu notes were discontinued and withdrawn,49 while a decree of 22 April 1719 stipulated that banknotes should not share in the periodic ‘diminutions’ (in price) to which silver was subject.50 France’s transition from coinage to paper money had begun.

Meanwhile, the Company of the West continued to expand. In May 1719 it took over the East India and China companies, to form the Company of the Indies (Compagnie des Indes), better known as the Mississippi Company. In July Law secured the profits of the royal mint for a nine-year term. In August he wrested the lease of the indirect tax farms from a rival financier, who had been granted it a year before. In September the Company agreed to lend 1.2 billion livres to the crown to pay off the entire royal debt. A month later Law took control of the collection (‘farm’) of direct taxes.

Law was proud of his System. What had existed before, he wrote, was not much more than ‘a method of receipts and disbursements’. Here, by contrast, ‘you have a chain of ideas which support one another, and display more and more the principle they flow from.’51 In modern terms, what Law was attempting could be described as reflation. The French economy had been in recession in 1716 and Law’s expansion of the money supply with banknotes clearly did provide a much-needed stimulus.52 At the same time, he was (not unreasonably) trying to convert a badly managed and burdensome public debt into the equity of an enormous, privatized tax-gathering and monopoly trading company. 53 If he were successful, the financial difficulties of the French monarchy would be at an end.

But Law had no clear idea where to stop. On the contrary, as the majority shareholder in what was now a vast corporation, he had a strong personal interest in allowing monetary expansion, which his own bank could generate, to fuel an asset bubble from which he more than anyone would profit. It was as if one man was simultaneously running all five hundred of the top US corporations, the US Treasury and the Federal Reserve System. Would such a person be likely to raise corporation taxes or interest rates at the risk of reducing the value of his massive share portfolio? Moreover, Law’s System had to create a bubble or it would fail. The acquisition of the various other companies and tax farms was financed, not out of company profits, but simply by issuing new shares. On 17 June 1719 the Mississippi Company issued 50,000 of these at a price of 550 livres apiece (though each share had a face value of 500 livres, as with the earlier Company of the West shares). To ensure the success of the issue, Law personally underwrote it, a characteristic gamble that even he admitted cost him a sleepless night. And to avoid the imputation that he alone would profit if the shares rose in price, he gave existing Company of the West shareholders the exclusive right to acquire these new shares (which hence became known as ‘daughters’; the earlier shares were ‘mothers’).54 In July 1719 Law issued a third tranche of 50,000 shares (the ‘granddaughters’) - now priced at 1,000 livres each - to raise the 50 million livres he needed to pay for the royal mint. Logically, this dilution of the existing shareholders ought to have caused the price of an individual share to decline. How could Law justify a doubling of the issue price?

Ostensibly, the ‘displacement’ that justified higher share prices was the promise of future profits from Louisiana. That was why Law devoted so much effort to conjuring up rosy visions of the colony as a veritable Garden of Eden, inhabited by friendly savages, eager to furnish a cornucopia of exotic goods for shipment to France. To conduct this trade, a grand new city was established at the mouth of the Mississippi: New Orleans, named to flatter the always susceptible Regent. Such visions, as we know, were not wholly without foundation, but their realization lay far in the future. To be sure, a few thousand impoverished Germans from the Rhineland, Switzerland and Alsace were recruited to act as colonists. But what the unfortunate immigrants encountered when they reached Louisiana was a sweltering, insect-infested swamp. Within a year 80 per cent of them had died of starvation or tropical diseases like yellow fever.w


The object of speculation: A one-tenth share

in the Compagnie des Indes (otherwise

known as the Mississippi Company)

In the short term, then, a different kind of displacement was needed to justify the 40 per cent dividends Law was now paying. It was provided by paper money. From the summer of 1719 investors who wished to acquire the ‘daughters’ and ‘granddaughters’ were generously assisted by the Banque Royale, which allowed shareholders to borrow money, using their shares as collateral; money they could then invest in more shares. Predictably, the share price soared. The original ‘mothers’ stood at 2,750 livres on 1 August, 4,100 on 30 August and 5,000 on 4 September. This prompted Law to issue 100,000 more shares at this new market price. Two further issues of the same amount followed on 28 September and 2 October, followed by a smaller block of 24,000 shares two days later (though these were never offered to the public). In the autumn of 1719 the share price passed 9,000 livres, reaching a new high (10,025) on 2 December. The informal futures market saw them trading at 12,500 livres for delivery in March 1720. The mood was now shifting rapidly from euphoria to mania.55

A few people smelt a rat. ‘Have you all gone crazy in Paris?’ wrote Voltaire to M. de Génonville in 1719. ‘It is a chaos I cannot fathom . . .’56 The Irish banker and economist Richard Cantillon was so sure that Law’s System would implode that he sold up and left Paris in early August 1719.57From London Daniel Defoe was dismissive: the French had merely ‘run up a piece of refined air’. Law’s career, he sneered, illustrated a new strategy for success in life:

You must put on a sword, kill a beau or two, get into Newgate [prison], be condemned to be hanged, break prison if you can - remember that by the way - get over to some strange country, turn stock-jobber, set up a Mississippi stock, bubble a nation, and you will soon be a great man; if you have but great good luck . . .58

But a substantial number of better-off Parisians were seduced by Law. Flush with cash of his own making, he offered to pay pension arrears and indeed to pay pensions in advance - a sure way to build support among the privileged classes. By September 1719 there were hundreds of people thronging the rue Quincampoix, a narrow thoroughfare between the rue St Martin and the rue St Denis where the Company had its share-issuing office. A clerk at the British embassy described it as ‘crowded from early in the morning to late at night with princes and princesses, dukes and peers and duchesses etc., in a word all that is great in France. They sell estates and pawn jewels to purchase Mississippi.’59 Lady Mary Wortley Montagu, who visited Paris in 1719, was ‘delighted . . . to see an Englishman (at least a Briton) absolute in Paris, I mean Mr. Law, who treats their dukes and peers extremely de haut en bas and is treated by them with the utmost submission and respect - Poor souls!’60 It was in these heady times that the word millionaire was first coined. (Like entrepreneurs, millionaires were invented in France.)

Small wonder John Law was seen at Mass for the first time on 10 December, having converted to Catholicism in order to be eligible for public office. He had much to thank his Maker for. When he was duly appointed Controller General of Finances the following month, his triumph was complete. He was now in charge of:

the collection of all France’s indirect taxes;

the entire French national debt;

the twenty-six French mints that produced the country’s

gold and silver coins;

the colony of Louisiana;

the Mississippi Company, which had a monopoly on the

import and sale of tobacco;

the French fur trade with Canada; and

all France’s trade with Africa, Asia and the East Indies.


The end of the show in the rue Quincampoix, 1719, from The

Great Scene of Folly, published in Amsterdam a year later

Further, in his own right, Law owned:

the Hôtel de Nevers in the rue de Richelieu (now the Bibliothèque


the Mazarin Palace, where the Company had its offices;

more than a third of the buildings at the place Vendôme

(then place Louis le Grand);

more than twelve country estates;

several plantations in Louisiana; and

100 million livres of shares in the Mississippi Company.61

Louis XIV of France had said ‘L’état, c’est moi’: I am the state. John Law could legitimately say ‘L’économie, c’est moi’: I am the economy.

In truth, John Law preferred gambling to praying. In March 1719, for example, he had bet the Duke of Bourbon a thousand new louis d’or that there would be no more ice that winter or spring. (He lost.) On another occasion he wagered 10,000 to 1 that a friend could not throw a designated number with six dice at one throw. (He probably won on that occasion, since the odds against doing so are 66 to 1, or 46,656 to 1.) But his biggest bet was on his own System. Law’s ‘daily discourse’, reported an uneasy British diplomat in August 1719, was that he would ‘set France higher than ever she was before, and put her in a condition to give the law to all Europe; that he can ruin the trade and credit of England and Holland, whenever he pleases; that he can break our bank, whenever he has a mind; and our East India Company. ’62 Putting his money where his mouth was, Law had made a bet with Thomas Pitt, Earl of Londonderry (and uncle of the Prime Minister William Pitt), that British shares would fall in price in the year ahead. He sold £100,000 of East India stock short for £180,000 (that is at a price of £180 per share, or 80 per cent above face value) for delivery on 25 August 1720.63 (The price of the shares at the end of August 1719 was £194, indicating Law’s expectation of a £14 price decline.)

Yet the con at the heart of Law’s confidence could not be sustained indefinitely. Even before his appointment as Controller General, the first signs of phase 4 of the five-stage bubble cycle - distress - had begun to manifest themselves. When the Mississippi share price began to decline in December 1719, touching 7,930 livres on 14 December, Law resorted to the first of many artificial expedients to prop it up, opening a bureau at the Banque Royale that guaranteed to buy (and sell) the shares at a floor price of 9,000 livres. As if to simplify matters, on 22 February 1720 it was announced that the Company was taking over the Banque Royale. Law also created options (primes) costing 1,000 livres which entitled the owner to buy a share for 10,000 livres over the following six months (that is an effective price of 11,000 livres - 900 livres above the actual peak price of 10,100 reached on 8 January). These measures sufficed to keep the share price above 9,000 livres until mid-January (though the effect of the floor price was to render the options worthless; generously Law allowed holders to convert them into shares at the rate of ten primes per share).

Inflation, however, was now accelerating alarmingly outside the stock market. At their peak in September 1720, prices in Paris were roughly double what they had been two years before, with most of the increase coming in the previous eleven months. This was a reflection of the extraordinary increase in note circulation Law had caused. In the space of little more than a year he had more than doubled the volume of paper currency. By May 1720 the total money supply (banknotes and shares held by the public, since the latter could be turned into cash at will) was roughly four times larger in livre terms than the gold and silver coinage France had previously used.64 Not surprisingly, some people began to anticipate a depreciation of the banknotes, and began to revert to payment in gold and silver. Ever the absolutist, Law’s initial response was to resort to compulsion. Banknotes were made legal tender. The export of gold and silver was banned as was the production and sale of gold and silver objects. By the arrêt of 27 February 1720, it became illegal for a private citizen to possess more than 500 livres of metal coin. The authorities were empowered to enforce this measure by searching people’s houses. Voltaire called this ‘the most unjust edict ever rendered’ and ‘the final limit of a tyrannical absurdity’.65

The Mississippi Bubble: Money and share prices (livres)


At the same time, Law obsessively tinkered with the exchange rate of the banknotes in terms of gold and silver, altering the official price of gold twenty-eight times and the price of silver no fewer than thirty-five times between September 1719 and December 1720 - all in an effort to make banknotes more attractive than coins to the public. But the flow of sometimes contradictory regulations served only to bewilder people and to illustrate the propensity of an absolutist regime to make up the economic rules to suit itself. ‘By an all new secret magic,’ one observer later recalled, ‘words assembled and formed Edicts that no one comprehended, and the air was filled with obscure ideas and chimeras.’66 One day gold and silver could be freely exported; the next day not. One day notes were being printed as fast as the printing presses could operate; the next Law was aiming to cap the banknote supply at 1.2 million livres. One day there was a floor price of 9,000 livres for Mississippi shares; the next day not. When this floor was removed on 22 February the shares predictably slumped. By the end of the month they were down to 7,825 livres. On 5 March, apparently under pressure from the Regent, Law performed another U-turn, reinstituting the 9,000 livre floor and reopening the bureau to buy them at this price. But this meant that the lid was once again removed from the money supply - despite the assertion in the same decree that ‘the banknote was a money which could not be altered in value’, and despite the previous commitment to a 1.2 million livre cap.67 By now the smarter investors were more than happy to have 9,000 livres in cash for their each of their shares. Between February and May 1720 there was a 94 per cent increase in the public’s holdings of banknotes. Meanwhile their holdings of shares slumped to less than a third of the total number issued. It seemed inevitable that before long all the shares would be unloaded on the Company, unleashing a further flood of banknotes and a surge in inflation.

On 21 May, in a desperate bid to avert meltdown, Law induced the Regent to issue a deflationary decree, reducing the official price of Company shares in monthly steps from 9,000 livres to 5,000 and at the same time halving the number of banknotes in circulation. He also devalued the banknotes, having revoked the previous order guaranteeing that this would not happen. This was when the limits of royal absolutism, the foundation of Law’s System, suddenly became apparent. Violent public outcry forced the government to revoke these measures just six days after their announcement, but the damage to confidence in the System was, by this time, irrevocable. After an initial lull, the share price slid from 9,005 livres (16 May) to 4,200 (31 May). Angry crowds gathered outside the Bank, which had difficulty meeting the demand for notes. Stones were thrown, windows broken. ‘The heaviest loss’, wrote one British observer, ‘falls on the people of this country and affects all ranks and conditions among them. It is not possible to express how great and general their consternation and despair have appeared to be on this occasion; the Princes of the blood and all the great men exclaim very warmly against it.’68 Law was roundly denounced at an extraordinary meeting of the Parlement. The Regent retreated, revoking the 21 May decree. Law offered his resignation, but was dismissed outright on 29 May. He was placed under house arrest; his enemies wanted to see him in the Bastille. For the second time in his life, Law faced jail, conceivably even death. (An investigative commission quickly found evidence that Law’s issues of banknotes had breached the authorized limit, so grounds existed for a prosecution.) The Banque Royale closed its doors.

John Law was an escape artist as well as a con artist. It quickly became apparent that no one but him stood any chance of averting a complete collapse of the financial system - which was, after all, his System. His recall to power (in the less exalted post of Intendant General of Commerce) caused a rally on the stock market, with Mississippi Company shares rising back to 6,350 livres on 6 June. It was, however, only a temporary reprieve. On 10 October the government was forced to reintroduce the use of gold and silver in domestic transactions. The Mississippi share price resumed its downward slide not long after, hitting 2,000 livres in September and 1,000 in December. Full-blown panic could no longer be postponed. It was at this moment that Law, vilified by the people, and lampooned by the press, finally fled the country. He had a ‘touching farewell’ with the Duke of Orleans before he went. ‘Sire,’ said Law, ‘I acknowledge that I have made great mistakes. I made them because I am only human, and all men are liable to err. But I declare that none of these acts proceeded from malice or dishonesty, and that nothing of that character will be discovered in the whole course of my conduct.’69 Nevertheless, his wife and daughter were not allowed to leave France so long as he was under investigation.

As if pricked by a sword, the Mississippi Bubble had now burst, and the noise of escaping air resounded throughout Europe. So incensed was one Dutch investor that he had a series of satirical plates specially commissioned in China. The inscription on one reads: ‘By God, all my stock’s worthless!’ Another is even more direct: ‘Shit shares and wind trade.’ As far as investors in Amsterdam were concerned, Law’s company had been trading in nothing more substantial than wind - in marked contrast to the Dutch East India Company, which had literally delivered the goods in the form of spices and cloth. As the verses on one satirical Dutch cartoon flysheet put it:

This is the wondrous Mississippi land,

Made famous by its share dealings,

Which through deceit and devious conduct,

Has squandered countless treasures.

However men regard the shares,

It is wind and smoke and nothing more.

A series of humorously allegorical engravings were produced and published as The Great Scene of Folly, which depicted barearsed stockbrokers eating coin and excreting Mississippi stock; demented investors running amok in the rue Quincampoix, before being hauled off to the madhouse; and Law himself, blithely passing by castles in the air in a carriage pulled by two bedraggled Gallic cockerels.70

Law himself did not walk away financially unscathed. He left France with next to nothing, thanks to his bet with Londonderry that English East India stock would fall to £180. By April 1720 the price had risen to £235 and it continued to rise as investors exited the Paris market for what seemed the safer haven of London (then in the grip of its own less spectacular South Sea Bubble). By June the price was at £420, declining only slightly to £345 in August, when Law’s bet fell due. Law’s London banker, George Middleton, was also ruined in his effort to honour his client’s obligation. The losses to France, however, were more than just financial. Law’s bubble and bust fatally set back France’s financial development, putting Frenchmen off paper money and stock markets for generations. The French monarchy’s fiscal crisis went unresolved and for the remainder of the reigns of Louis XV and his successor Louis XVI the crown essentially lived from hand to mouth, lurching from one abortive reform to another until royal bankruptcy finally precipitated revolution. The magnitude of the catastrophe was perhaps best captured by Bernard Picart in his elaborate engraving Monument Consecrated to Posterity (1721). On the left, penniless Dutch investors troop morosely into the sickhouse, the madhouse and the poorhouse. But the Parisian scene to the right is more apocalyptic. A naked Fortuna rains down Mississippi stock and options on a mob emanating from the rue Quincampoix, while a juggernaut drawn by Indians crushes an accountant under a huge wheel of fortune and two men brawl in the foreground.71


Brokers turning coin into Mississippi stock and wind: engraving

from The Great Scene of Folly (1720)


Bernard Picart, Monument Consecrated to Posterity (1721)

In Britain, by contrast, the contemporaneous South Sea Bubble was significantly smaller and ruined fewer people - not least because the South Sea Company never gained control of the Bank of England the way Law had controlled the Banque Royale. In essence, his English counterpart John Blunt’s South Sea scheme was to convert government debt of various kinds, most of it created to fund the War of the Spanish Succession, into the equity of a company that had been chartered to monopolize trade with the Spanish Empire in South America. Having agreed on conversion prices for the annuities and other debt instruments, the directors of the South Sea Company stood to profit if they could get the existing holders of government annuities to accept South Sea shares at a high market price, since this would leave the directors with surplus shares to sell to the public.72 In this they succeeded, using tricks similar to those employed by Law in Paris. Shares were offered to the public in four tranches, with the price rising from £300 per share in April 1720 to £1,000 in June. Instalment payment was permitted. Loans were offered against shares. Generous dividends were paid. Euphoria duly gave way to mania; as the poet Alexander Pope observed, it was ‘ignominious (in this Age of Hope and Golden Mountains) not to Venture’.73

Unlike Law, however, Blunt and his associates had to contend with competition from the Bank of England, which drove up the terms they had to offer the annuitants. Unlike Law, they also had to contend with political opposition in the form of the Whigs in Parliament, which drove up the bribes they had to pay to secure favourable legislation (the Secretary to the Treasury alone made £249,000 from his share options). And, unlike Law, they were unable to establish monopolistic positions on the stock market and the credit market. On the contrary, there was such a rush of new companies - 190 in all - seeking to raise capital in 1720 that the South Sea directors had to get their allies in Parliament to pass what came to be known as the Bubble Act, designed to restrict new company flotations.x At the same time, when the demand for cash created by the South Sea’s third subscription exceeded the money market’s resources, there was nothing the directors could do to inject additional liquidity; indeed, the South Sea Company’s bank, the Sword Blade Company, ended up failing on 24 September. (Unlike the Bank of England, and unlike the Banque Royale, its notes were not legal tender.) The mania of May and June was followed, after a hiatus of distress in July (when the insiders and foreign speculators took their profits), by panic in August. ‘Most people thought it wou’d come,’ lamented the hapless and now poorer Swift, ‘but no man prepar’d for it; no man consider’d it would come like a Thief in the night, exactly as it happens in the case of death.’74

Yet the damage caused by the bursting of the bubble was much less fatal than on the other side of the Channel. From par to peak, prices rose by a factor of 9.5 in the case of South Sea stock, compared with 19.6 in the case of Mississippi stock. Other stocks (Bank of England and East India Company) rose by substantially smaller multiples. When stock prices came back down to earth in London, there was no lasting systemic damage to the financial system, aside from the constraint on future joint-stock company formation represented by the Bubble Act. The South Sea Company itself continued to exist; the government debt conversion was not reversed; foreign investors did not turn away from English securities.75 Whereas all France was affected by the inflationary crisis Law had unleashed, provincial England seems to have been little affected by the South Sea crash.76 In this tale of two bubbles, it was the French that had the worst of times.

Bulls and Bears

On 16 October 1929 Yale University economics professor Irving Fisher declared that US stock prices had ‘reached what looks like a permanently high plateau’.77 Eight days later, on ‘Black Thursday’, the Dow Jones Industrial Average declined by 2 per cent. This is when the Wall Street crash is conventionally said to have begun, though in fact the market had been slipping since early September and had already suffered a sharp 6 per cent drop on 23 October. On ‘Black Monday’ (28 October) it plunged by 13 per cent; the next day by a further 12 per cent. In the course of the next three years the US stock market declined a staggering 89 per cent, reaching its nadir in July 1932. The index did not regain its 1929 peak until November 1954. What was worse, this asset price deflation coincided with, if it did not actually cause, the worst depression in all history. In the United States, output collapsed by a third. Unemployment reached a quarter of the civilian labour force, closer to a third if a modern definition is used. It was a global catastrophe that saw prices and output decline in nearly every economy in the world, though only the German slump was as severe as the American. World trade shrank by two thirds as countries sought vainly to hide behind tariff barriers and import quotas. The international financial system fell to pieces in a welter of debt defaults, capital controls and currency depreciations. Only the Soviet Union, with its autarkic, planned economy, was unaffected. Why did it happen?

Some financial disasters have obvious causes. Arguably a much worse stock market crash had occurred at the end of July 1914, when the outbreak of the First World War precipitated such a total meltdown that the world’s principal stock markets - including New York’s - simply had to close their doors. And closed they remained from August until the end of 1914.78 But that was the effect of a world war that struck financial markets like a bolt from the blue.79 The crash of October 1929 is much harder to explain. Page 1 of the New York Times on the day before Black Thursday featured articles about the fall of the French premier Aristide Briand and a vote in the US Senate about duties on imported chemicals. Historians sometimes see the deadlock over Germany’s post-First World War reparations and the increase of American protectionism as triggers of the Depression. But page 1 also features at least four reports on the atrocious gales that had battered the Eastern seaboard the previous day.80 Maybe historians should blame bad weather for the Wall Street crash. (That might not be such a far-fetched proposition. Many veterans of the City of London still remember that Black Monday - 19 October 1987 - came after the hurricane-force winds that had unexpectedly swept the south-east of England the previous Friday.)

Contemporaries sensed that there was a psychological dimension to the crisis. In his inaugural address, President Franklin Roosevelt argued that all that Americans had to fear was ‘fear itself’. John Maynard Keynes spoke of a ‘failure in the immaterial devices of the mind’. Yet both men also intimated that the crisis was partly due to financial misconduct. Roosevelt took a swipe at ‘the unscrupulous money changers’ of Wall Street; in his General Theory, Keynes likened the stock market to a casino.

In some measure, it can be argued, the Great Depression had its roots in the global economic dislocations arising from the earlier crisis of 1914. During the First World War, non-European agricultural and industrial production had expanded. When European production came back on stream after the return of peace, there was chronic over-capacity, which had driven down prices of primary products long before 1929. This had made it even harder for countries with large external war debts (including Germany, saddled with reparations) to earn the hard currency they needed to make interest payments to their foreign creditors. The war had also increased the power of organized labour in most combatant countries, making it harder for employers to cut wages in response to price falls. As profit margins were squeezed by rising real wages, firms were forced to lay off workers or risk going bust. Nevertheless, the fact remains that the United States, which was the epicentre of the crisis, was in many respects in fine economic fettle when the Depression struck. There was no shortage of productivity-enhancing technological innovation in the inter-war period by companies like DuPont (nylon), Procter & Gamble (soap powder), Revlon (cosmetics), RCA (radio) and IBM (accounting machines). ‘A prime reason for expecting future earnings to be greater,’ argued Yale’s Irving Fisher, ‘was that we in America were applying science and invention to industry as we had never applied them before.’81 Management practices were also being revolutionized by men like Alfred Sloan at General Motors.

Yet precisely these strengths may have provided the initial displacement that set in motion a classic stock market bubble. To observers like Fisher, it really did seem as if the sky was the limit, as more and more American households aspired to equip themselves with automobiles and consumer durables - products which instalment credit put within their reach. RCA, the tech stock of the 1920s, rose by a dizzying 939 per cent between 1925 and 1929; its price-earnings ratio at the peak of the market was 73.82 Euphoria encouraged a rush of new initial public offerings (IPOs); stock worth $6 billion was issued in 1929, one sixth of it during September. There was a proliferation of new financial institutions known as investment trusts, designed to capitalize on the stock market boom. (Goldman Sachs chose 8 August 1929 to announce its own expansion plan, in the form of the Goldman Sachs Trading Corporation; had this not been a free-standing entity, its subsequent collapse might well have taken down Goldman Sachs itself.) At the same time, many small investors (like Irving Fisher himself) relied on leverage to increase their stock market exposure, using brokers’ loans (which were often supplied by corporations rather than banks) to buy stocks on margin, thus paying only a fraction of the purchase price with their own money. As in 1719, so in 1929, there were unscrupulous insiders, like Charles E. Mitchell of National City Bank or William Crapo Durant of GM, and ingenuous outsiders, like Groucho Marx.83 As in 1719, flows of hot money between financial markets served to magnify and transmit shocks. And, as in 1719, it was the action of the monetary authorities that determined the magnitude of the bubble and of the consequences when it burst.

In perhaps the most important work of American economic history ever published, Milton Friedman and Anna Schwartz argued that it was the Federal Reserve System that bore the primary responsibility for turning the crisis of 1929 into a Great Depression.84 They did not blame the Fed for the bubble itself, arguing that with Benjamin Strong at the Federal Reserve Bank of New York a reasonable balance had been struck between the international obligation of the United States to maintain the restored gold standard and its domestic obligation to maintain price stability. By sterilizing the large gold inflows to the United States (preventing them for generating monetary expansion), the Fed may indeed have prevented the bubble from growing even larger. The New York Fed also responded effectively to the October 1929 panic by conducting large-scale (and unauthorized) open market operations (buying bonds from the financial sector) to inject liquidity into the market. However, after Strong’s death from tuberculosis in October 1928, the Federal Reserve Board in Washington came to dominate monetary policy, with disastrous results. First, too little was done to counteract the credit contraction caused by banking failures. This problem had already surfaced several months before the stock market crash, when commercial banks with deposits of more than $80 million suspended payments. However, it reached critical mass in November and December 1930, when 608 banks failed, with deposits totalling $550 million, among them the Bank of United States, which accounted for more than a third of the total deposits lost. The failure of merger talks that might have saved the Bank was a critical moment in the history of the Depression.85Secondly, under the pre-1913 system, before the Fed had been created, a crisis of this sort would have triggered a restriction of convertibility of bank deposits into gold. However, the Fed made matters worse by reducing the amount of credit outstanding (December 1930-April 1931). This forced more and more banks to sell assets in a frantic dash for liquidity, driving down bond prices and worsening the general position. The next wave of bank failures, between February and August 1931, saw commercial bank deposits fall by $2.7 billion, 9 per cent of the total.86 Thirdly, when Britain abandoned the gold standard in September 1931, precipitating a rush by foreign banks to convert dollar holdings into gold, the Fed raised its discount rate in two steps to 3.5 per cent. This halted the external drain, but drove yet more US banks over the edge: the period August 1931 to January 1932 saw 1,860 banks fail with deposits of $1.45 billion.87 Yet the Fed was in no danger of running out of gold. On the eve of the pound’s departure the US gold stock was at an all-time high of $4.7 billion - 40 per cent of the world’s total. Even at its lowest point that October, the Fed’s gold reserves exceeded its legal requirements for cover by more than $1 billion.88 Fourthly, only in April 1932, as a result of massive political pressure, did the Fed attempt large-scale open market operations, the first serious step it had taken to counter the liquidity crisis. Even this did not suffice to avert a final wave of bank failures in the last quarter of 1932, which precipitated the first state-wide ‘bank holidays’, temporary closures of all banks.89 Fifthly, when rumours that the new Roosevelt administration would devalue the dollar led to a renewed domestic and foreign flight from dollars into gold, the Fed once again raised the discount rate, setting the scene for the nationwide bank holiday proclaimed by Roosevelt on 6 March 1933, two days after his inauguration - a holiday from which 2,000 banks never returned.90

The Fed’s inability to avert a total of around 10,000 bank failures was crucial not just because of the shock to consumers whose deposits were lost or to shareholders whose equity was lost, but because of the broader effect on the money supply and the volume of credit. Between 1929 and 1933, the public succeeded in increasing its cash holdings by 31 per cent; commercial bank reserves were scarcely altered (indeed, surviving banks built up excess reserves); but commercial bank deposits decreased by 37 per cent and loans by 47 per cent. The absolute numbers reveal the lethal dynamic of the ‘great contraction’. An increase of cash in public hands of $1.2 billion was achieved at the cost of a decline in bank deposits of $15.6 billion and a decline in bank loans of $19.6 billion, equivalent to 19 per cent of 1929 GDP.91

There was a time when academic historians felt squeamish about claiming that lessons could be learned from history. This is a feeling unknown to economists, two generations of whom have struggled to explain the Great Depression precisely in order to avoid its recurrence. Of all the lessons to have emerged from this collective effort, this remains the most important: that inept or inflexible monetary policy in the wake of a sharp decline in asset prices can turn a correction into a recession and a recession into a depression. According to Friedman and Schwartz, the Fed should have aggressively sought to inject liquidity into the banking system from 1929 onwards, using open market operations on a large scale, and expanding rather than contracting lending through the discount window. They also suggest that less attention should have been paid to gold outflows. More recently, it has been argued that the inter-war gold standard itself was the problem, in that it transmitted crises (like the 1931 European bank and currency crises) around the world.92 A second lesson of history would therefore seem to be that the benefits of a stable exchange rate are not so great as to exceed the costs of domestic deflation. Anyone who today doubts that there are lessons to be learned from history needs do no more than compare the academic writings and recent actions of the current chairman of the Federal Reserve System.93

A Tale of Fat Tails

Sometimes the most important historical events are the non-events: the things that did not occur. The economist Hyman Minsky put it well when he observed: ‘The most significant economic event of the era since World War II is something that has not happened: there has not been a deep and long-lasting depression’.94 This is indeed surprising, since the world has not been short of ‘Black Days’.

If movements in stock market indices were statistically distributed like human heights there would hardly be any such days. Most would be clustered around the average, with only a tiny number of extreme ups or downs. After all, not many of us are below four feet in height or above eight feet. If I drew a histogram of the heights of the male students in my financial history class according to their frequency, the result would be a classic bell-shaped curve, with nearly everyone clustered within around five inches of the US average of around 5’ 10". But in financial markets, it doesn’t look like this. If you plot all the monthly movements of the Dow Jones index on a chart, there is much less clustering around the average, and there are many more big rises and falls out at the extremes, which the statisticians call ‘fat tails’. If stock market movements followed the ‘normal distribution’ or bell curve, like human heights, an annual drop of 10 per cent or more would happen only once every 500 years, whereas on the Dow Jones it has happened about once every five years.95 And stock market plunges of 20 per cent or more would be unheard of - rather like people just a foot tall - whereas in fact there have been nine such crashes in the past century.

On ‘Black Monday’, 19 October 1987, the Dow fell by a terrifying 23 per cent, one of just four days when the index has fallen by more than 10 per cent in a single trading session. The New York Times’s front page the next morning said it all when it asked ‘Does 1987 Equal 1929?’ From peak to trough, the fall was of nearly one third, a loss in the value of American stocks of close to a trillion dollars. The causes of the crash were much debated at the time. True, the Fed had raised rates the previous month from 5.5 to 6 per cent. But the official task force chaired by Nicholas Brady laid much of the blame for the crash on ‘mechanical, price-insensitive selling by a [small] number of institutions employing portfolio insurance strategies and a small number of mutual fund groups reacting to redemptions’, as well as ‘a number of aggressive trading-oriented institutions [which tried] to sell in anticipation of further market declines’. Matters were made worse by a breakdown in the New York Stock Exchange’s automated transaction system, and by the lack of ‘circuit breakers’ which might have interrupted the sell-off on the futures and options markets.96 The remarkable thing, however, was what happened next - or rather, what didn’t happen. There was no Great Depression of the 1990s, despite the forebodings of Lord Rees-Mogg and others.97 There wasn’t even a recession in 1988 (only a modest one in 1990-91). Within little more than a year of Black Monday, the Dow was back to where it had been before the crash. For this, some credit must unquestionably be given to the central bankers, and particularly the then novice Federal Reserve Chairman Alan Greenspan, who had taken over from Paul Volcker just two months before. Greenspan’s response to the Black Monday crash was swift and effective. His terse statement on 20 October, affirming the Fed’s ‘readiness to serve as a source of liquidity to support the economic and financial system’, sent a signal to the markets, and particularly the New York banks, that if things got really bad he stood ready to bail them out.98 Aggressively buying government bonds in the open market, the Fed injected badly needed cash into the system, pushing down the cost of borrowing from the Fed by nearly 2 per cent in the space of sixteen days. Wall Street breathed again. What Minsky called ‘It’ had not happened.

Having contained a panic once, the dilemma that lurked in the back of Greenspan’s mind thereafter was whether or not to act pre-emptively the next time - to prevent the panic altogether. This dilemma came to the fore as a classic stock market bubble took shape in the mid 1990s. The displacement in this case was the explosion of innovation by the technology and software industry as personal computers met the Internet. But, as in all history’s bubbles, an accommodative monetary policy also played a role. From a peak of 6 per cent in June 1995, the Federal funds target rateyhad been reduced to 5.25 per cent (January 1996-February 1997). It had been raised to 5.5 per cent in March 1997, but then cut in steps between September and November 1998 down to 4.75 per cent; and it remained at that level until May 1999, by which time the Dow had passed the 10,000 mark. Rates were not raised until June 1999.

Why did the Fed allow euphoria to run loose in the 1990s? Greenspan himself had felt constrained to warn about ‘irrational exuberance’ on the stock market as early as 5 December 1996, shortly after the Dow had risen above 6,000.z Yet the quarter point rate increase of March 1997 was scarcely sufficient to dispel that exuberance. Partly, Greenspan and his colleagues seem to have underestimated the momentum of the technology bubble. As early as December 1995, with the Dow just past the 5,000 mark, members of the Fed’s Open Market Committee speculated that the market might be approaching its peak.99 Partly, it was because Greenspan felt it was not for the Fed to worry about asset price inflation, only consumer price inflation; and this, he believed, was being reduced by a major improvement in productivity due precisely to the tech boom. 100 Partly, as so often happens in stock market bubbles, it was because international pressures - in this case, the crisis precipitated by the Russian debt default of August 1998 - required contrary action.101 Partly, it was because Greenspan and his colleagues no longer believed it was the role of the Fed to remove the punchbowl from the party, in the phrase of his precursor but three, William McChesney Martin, Jr.102 To give Greenspan his due, his ‘just-in-time monetary policy’ certainly averted a stock market crash. Not only were the 1930s averted; so too was a repeat of the Japanese experience, when a conscious effort by the central bank to prick an asset bubble ended up triggering an 80 per cent stock market sell-off and a decade of economic stagnation. But there was a price to pay for this strategy. Not for the first time in stock market history, an asset-price bubble created the perfect conditions for malfeasance as well as exuberance.

The nineties seemed to some nervous observers uncannily like a re-run of the Roaring Twenties; and indeed the trajectory of the stock market in the 1990s was almost identical to that of the 1920s. Yet in some ways it was more like a rerun of the 1720s. What John Law’s Mississippi Company had been to the bubble that launched the eighteenth century, so another company would be to the bubble that ended the twentieth. It was a company that promised its investors wealth beyond their wildest imaginings. It was a company that claimed to have reinvented the entire financial system. And it was a company that took full advantage of its impeccable political connections to ride all the way to the top of the bull market. Named by Fortune magazine as America’s Most Innovative Company for six consecutive years (1996-2001), that company was Enron.

In November 2001, Alan Greenspan received a prestigious award, adding his name to a roll of honour that included Mikhail Gorbachev, Colin Powell and Nelson Mandela. The award was the Enron Prize for Distinguished Public Service. Greenspan had certainly earned his accolade. From February 1995 until June 1999 he had raised US interest rates only once. Traders had begun to speak of the ‘Greenspan put’ because having him at the Fed was like having a ‘put’ option on the stock market (an option but not an obligation to sell stocks at a good price in the future). Since the middle of January 2000, however, the US stock market had been plummeting, belatedly vindicating Greenspan’s earlier warnings about irrational exuberance. There was no one Black Day, as in 1987. Indeed, as the Fed slashed rates, from 6.5 per cent down in steps to 3.5 per cent by August 2001, the economy looked like having a soft landing; at worst a very short recession. And then, quite without warning, a Black Day did dawn in New York - in the form not of a financial crash but of two deliberate plane crashes. Amid talk of war and fears of a 1914-style market shutdown, Greenspan slashed rates again, from 3.5 per cent to 3 per cent and then on down - and down - to an all-time low of 1 per cent in June 2003. More liquidity was pumped out by the Fed after 9/11 than by all the fire engines in Manhattan. But it could not save Enron. On 2 December 2001, just two weeks after Greenspan collected his Enron award, the company filed for bankruptcy.

The resemblances between the careers of John Law, perpetrator of the Mississippi bubble, and Kenneth Lay, chief executive of Enron, are striking, to say the least. John Law’s philosopher’s stone had allowed him ‘to make gold out of paper’. Ken Lay’s equivalent was ‘to make gold out of gas’. Law’s plan had been to revolutionize French government finance. Lay’s was to revolutionize the global energy business. For years the industry had been dominated by huge utility companies that both physically provided the energy - pumped the gas and generated the electricity - and sold it on to consumers. Lay’s big idea, supplied by McKinsey consultant Jeffrey K. Skilling, was to create a kind of Energy Bank, which would act as the intermediary between suppliers and consumers.103 Like Law, Lay, the son of a poor Missouri preacher, had provincial beginnings - as did Enron, originally a small gas company in Omaha, Nebraska. It was Lay who renamed the companyaa and relocated its headquarters to Houston, Texas. Like Law, too, Lay had friends in high places. Himself a long-time ally of the Texan energy industry, President George H. W. Bush supported legislation in 1992 that deregulated the industry and removed government price controls. Around three quarters of Enron’s $6.6 million in political contributions went to the Republican Party, including $355,000 from Lay and his wife in the 2000 election. Senator Phil Gramm was Enron’s second-largest recipient of campaign contributions in 1996, and a strong proponent of Californian energy deregulation.


Alan Greenspan and Kenneth Lay

By the end of 2000, Enron was America’s fourth-largest company, employing around 21,000 people. It controlled a quarter of the US natural gas business. Riding a global wave of energy sector privatization, the company snapped up assets all over the world. In Latin America alone the company had interests in Colombia, Ecuador, Peru and Bolivia, from where Enron laid its pipeline across the continent to Brazil. In Argentina, following the intervention of Lay’s personal friend George W. Bush, Enron bought a controlling stake in the largest natural gas pipeline network in the world. Above all, however, Enron traded, not only in energy but in virtually all the ancient elements of earth, water, fire and air. It even claimed that it could trade in Internet bandwidth. In a scene straight out of The Sting, bank analysts were escorted through fake trading floors where employees sat in front of computers pretending to do broadband deals. It was the Mississippi Company all over again. And, just as in 1719, the rewards to investors seemed irresistible. In the three years after 1997, Enron’s stock price increased by a factor of nearly five, from less than $20 a share to more than $90. For Enron executives, who were generously ‘incentivized’ with share options, the rewards were greater still. In the final year of its existence Enron paid its top 140 executives an average of $5.3 million each. Luxury car sales went through the roof. So did properties in River Oaks, Houston’s most exclusive neighbourhood. ‘I’ve thought about this a lot,’ remarked Skilling, who became Enron chief operating officer in 1997, ‘and all that matters is money . . . You buy loyalty with money. This touchy-feely stuff isn’t as important as cash. That’s what drives performance.’104 ‘You got multiples of your annual base pay at Enron,’ Sherron Watkins recalled when I met her outside the now defunct Enron headquarters in Houston. ‘You were really less thought of if you got a percentage, even if it was 75 per cent of your annual base pay. Oh, you were getting a percentage. You wanted multiples. You wanted two times your annual base pay, three times, four times your annual base pay, as a bonus.’105 In the euphoria of April 1999, the Houston Astros even renamed their ballpark Enron Field.

The only problem was that, like John Law’s System, the Enron ‘System’ was an elaborate fraud, based on market manipulation and cooked books. In tapes that became public in 2004, Enron traders can be heard asking the El Paso Electric Company to shut down production in order to maintain prices. Another exchange concerns ‘all the money you guys stole from those poor grand-mothers of California’. The results of such machinations were not only the higher prices Enron wanted, but also blackouts for consumers. In the space of just six months after the deregulation law came into effect, California experienced no fewer than thirty-eight rolling blackouts. (In another tape, traders watching television reports of Californian forest fires shout ‘Burn, baby, burn!’ as electricity pylons buckle and fall.) Even with such market-rigging, the company’s stated assets and profits were vastly inflated, while its debts and losses were concealed in so-called special-purpose entities (SPEs) which were not included in the company’s consolidated statements. Each quarter the company’s executives had to use more smoke and more mirrors to make actual losses look like bumper profits. Skilling had risen to the top by exploiting new financial techniques like mark-to-market accounting and debt securitization. But not even chief finance officer Andrew Fastow could massage losses into profits indefinitely, especially as he was now using SPEs like the aptly named Chewco Investments to line his and other executives’ pockets. Enron’s international business, in particular, was haemorrhaging money by the mid 1990s, most spectacularly after the cancellation of a major power generation project in the Indian state of Maharashtra. EnronOnline, the first web-based commodity-trading system, had a high turnover; but did it make any money? In Houston, the euphoria was fading; the insiders were feeling the first symptoms of distress. Fastow’s SPEs were being given increasingly ominous names: Raptor I, Talon. He and others surreptitiously unloaded $924 million of Enron shares while the going was good.

Investors had been assured that Enron’s stock price would soon hit $100. When (for ‘personal reasons’) Skilling unexpectedly announced his resignation on 14 August 2001, however, the price tumbled to below $40. That same month, Sherron Watkins wrote to Lay to express her fear that Enron would ‘implode in a wave of accounting scandals’. This was precisely what happened. On 16 October Enron reported a $618 million third-quarter loss and a $1.2 billion reduction in shareholder equity. Eight days later, with a Securities and Exchange Commission inquiry pending, Fastow stepped down as CFO. On 8 November the company was obliged to revise its profits for the preceding five years; the overstatement was revealed to be $567 million. When Enron filed for bankruptcy on 2 December, it was revealed that the audited balance sheet had understated the company’s long-term debt by $25 billion: it was in fact not $13 billion but $38 billion. By now, distress had turned to revulsion; and panic was hard on its heels. By the end of 2001 Enron shares were worth just 30 cents.

In May 2006 Lay was found guilty of all ten of the charges against him, including conspiracy, false statements, securities fraud and bank fraud. Skilling was found guilty on 18 out of 27 counts. Lay died before sentencing while on holiday in Aspen, Colorado. Skilling was sentenced to 24 years and 4 months in prison and ordered to repay $26 million to the Enron pension fund; an appeal is pending. All told, sixteen people pled guilty to Enron-related charges and five others (so far) have been found guilty at trial. The firm’s auditors, Arthur Andersen, were destroyed by the scandal. The principal losers, however, were the ordinary employees and small shareholders whose savings went up in smoke, turned into mere ‘wind’, just like the millions of livres lost in the Mississippi crash.

Invented almost exactly four hundred years ago, the joint-stock, limited-liability company is indeed a miraculous institution, as is the stock market where its ownership can be bought and sold. And yet throughout financial history there have been crooked companies, just as there have been irrational markets. Indeed the two go hand in hand - for it is when the bulls are stampeding most enthusiastically that people are most likely to get taken for the proverbial ride. A crucial role, however, is nearly always played by central bankers, who are supposed to be the cowboys in control of the herd. Clearly, without his Banque Royale, Law could never have achieved what he did. Equally clearly, without the loose money policy of the Federal Reserve in the 1990s, Ken Lay and Jeff Skilling would have struggled to crank up the price of Enron stock to $90. By contrast, the Great Depression offers a searing lesson in the dangers of excessively restrictive monetary policy during a stock market crash. Avoiding a repeat of the Great Depression is sometimes seen as an end that justifies any means. Yet the history of the Dutch East India Company, the original joint-stock company, shows that, with sound money of the sort provided by the Amsterdam Exchange Bank, stock market bubbles and busts can be avoided.

In the end, the path of financial markets can never be as smooth as we might like. So long as human expectations of the future veer from the over-optimistic to the over-pessimistic - from greed to fear - stock prices will tend to trace an erratic path; indeed, a line not unlike the jagged peaks of the Andes. As an investor you just have to hope that, when you have to come down from the summit of euphoria, it will be on a smooth ski-slope and not over a sheer cliff.

But is there nothing we can do to protect ourselves from real and metaphorical falls? As we shall see in Chapter 4, the evolution of insurance, from humble eighteenth-century beginnings, has created a range of answers to that question, each of which offers at least some protection from the sheer cliffs and fat tails of financial history.

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