A Mental Model of Financial Euphoria

The book A Short History of Financial Euphoria by John Kenneth Galbraith provides a succinct description of the common denominators of financial euphoria, illustrated beautifully with actual euphoric episodes through the ages. The following are some key points to help us recognise such speculative episodes:

  • Uniformly in all financial euphoria there is the thought that there is something new and desirable in the world — tulips in Holland, gold in Louisiana, the invention of holding companies, the opportunities provided by the internet and e-commerce, mastery of credit through debt securitization, etc.
  • An important class of these new new things comes in the guise of financial innovation that are nothing more than reinvention of the financial wheel (aka leverage), often in a more unstable form. And all financial innovation involves, in one way or another, the creation of debt secured in greater or lesser adequacy by real assets.
  • Another class of new new things come in the form of new frontiers — geographical, technological, psychological — that are expected to bring massive but hard-to-quantify new riches.
  • Whatever the form of the new new thing, the price or demand of the object of speculation goes up. The increase and prospect of further increases attract new buyers, whose participation assure a further increase. Yet more are attracted; yet more buy and the increase continues.
  • There are two types of participants in such a speculative episode. Those who are persuaded that some new world order is in place, and they expect the market to stay up and go up, perhaps indefinitely. Then there are those, superficially more astute and generally fewer in number, who believe they understand the speculative mood of the moment but their particular genius will allow them to get out before the eventual fall.
  • Two compelling forces protects and sustains the speculative episode.
    • One is the powerful personal interest that develops in the euphoric belief. Participants will do what they can to justify the circumstances that are making them rich, and that includes ignoring, exorcising, or condemning those who express doubts.
    • The other, the pressure of public and seemingly superior financial opinion that is brought to bear on behalf of such belief. This is made worse by the common association between money and intelligence, supported by the (mistaken) belief that the more money, the greater the achievement and the intelligence that supports it.
  • Another major contributing factor is the extreme brevity of the financial memory.
  • The speculative episode always ends not with a whimper but with a bang. When the eventual and inevitable fall built into the speculative episode comes, it bears the grim face of disaster because both groups of participants are programmed for sudden efforts at escape.

There you have it, the blueprint of financial euphoria.

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