The Ascent of Money (2008) – Episode 3 – Blowing Bubbles [Transcript]

Why do stock markets produce bubbles and busts? Professor Ferguson goes back to the origins of the joint stock company in Amsterdam and Paris.
Portrait of the Family of Dirck Bas Jacobsz

Why do stock markets produce bubbles and busts? Professor Ferguson goes back to the origins of the joint stock company in Amsterdam and Paris. He draws telling parallels between the Great Recession and the 18th century Mississippi Bubble of Scottish financier John Law and the 2001 Enron bankruptcy. He shows why humans have a herd instinct when it comes to investment, and why no one can accurately predict when the bulls might stampede.

* * *

Some people today say that companies – and particularly multinational corporations – rule the world. It’s pretty hard to believe that any kind of human organisation could tame the vast natural barriers of South America. But one company believed it could. By constructing a 1.5 billion dollar gas pipeline from Bolivia right across the South American continent to the Atlantic coast of Brazil. By running gas along the longest pipeline in the world 4,000 miles from the tip of Patagonia to the Argentine capital Buenos Aires.

Such schemes exemplify the vaulting ambition of modern capitalism, but they’re only possible because of one invention – the joint stock company.

If the 16th century had seen a revolution in money and credit, and the 17th had witnessed the birth of the bond market, then the next step in the story of the ascent of money was the rise of the joint stock limited liability company. But the ability of the company to transform our lives would depend on another innovation… The stock market. The price that people are prepared to pay for a company’s shares in the market tells you how much money they think it’ll make in the future. But as we have discovered in recent months of financial turmoil, stock markets can also be shock markets.

The future is always uncertain. But we human beings are prone to over-optimism. When prices here on the New York Stock Exchange surge upwards in synch, it’s as if investors are gripped by a kind of collective euphoria – what the former chairman of the Federal Reserve, Alan Greenspan, once famously called “irrational exuberance”. So stock markets really can be like soap bubbles. We never quite know when they’re gonna burst.

The exuberance was especially irrational and the burst especially painful for the company that proposed those vast projects in Latin America. Enron became the biggest corporate fraud in modern American history. But Enron was very far from the only corporate scam since shares were first bought and sold 400 years ago. And the shady practices it epitomised live on. Indeed, they’ve been a key cause of the financial crisis we’re living through now. Cooked books? Stock prices rigged? Been there. Done that. For centuries. Nothing illustrates more clearly than the history of stock market bubbles how hard human beings find it to learn from history.

Blowing Bubbles

Hidden away among the many splendours of Venice is a small clue to one of the most astonishing tales of adventure in all financial history.

“To the honour and memory of John Law of Edinburgh, “most distinguished controller of the treasury of the Kings of the French.” This is the final resting place of the man who invented the stock market bubble. An ambitious Scot, a convicted murderer, a compulsive gambler and a flawed financial genius, he not only caused the first true boom and bust in asset prices, he also indirectly caused the French Revolution.

There was a time when John Law owned a quarter of what is now the United States, only to lose it all in history’s first great crash. From Edinburgh to Amsterdam to Paris, all the way here to New Orleans, and finally to Venice, Law’s story is a classic tale of boom and bust. It’s also very much a story for our own times.

Hidden away here in the warehouse of the Louisiana State Museum is the only known painting of John Law. Here he is. With that lean and hungry look, he really is, for all the world, a Scotsman on the make.

The path that led Law “from obscurity to celebrity, to notoriety” is a path that many of the great stock market players have followed since. Law was born here in Edinburgh in 1671, the son of a successful goldsmith and heir to the estate of Lauriston. In 1694, while living in London, Law killed a man in a duel over a woman and was sentenced to death. Somehow, Law managed to escape from prison and fled to Amsterdam. He couldn’t have picked a better town to lie low in. By the 1690s, Amsterdam was the world capital of financial innovation. To help finance their war against Spain, the Dutch had introduced one of the world’s first national lotteries. To protect their merchants from dodgy coinage, they’d created the world’s first central bank.

But the one that had the biggest impact on Law was the single greatest Dutch invention of them all – the company. The story of the company had begun 100 years before Law’s arrival as Dutch traders spread out all over the world, from Manhattan island to the Cape of Good Hope. But it was Asia that became the primary target of Dutch commercial expansion. Why?

The East Indies were so alluring because of these – spices – pepper, cloves, nutmeg, ginger. Europeans craved them to flavour their food, but also to preserve it. Traditionally, they’d come overland by the Spice Road. But the Dutch plan was to fetch them the longer, but quicker way, by sea. And that pungent aroma was the smell of money to be made.

This painting shows the return of one of the first Dutch fleets from the East. The inscription reads, “Four ships sailed to go and get the spices towards Bantam and also established trading posts. And came back richly laden to the poles of Amsterdam. Departed 1 st May 1598. “Returned 19th July 1599.” The Asian spice trade was so profitable that just one return trip could pay for the construction costs of a ship like this. But so prolonged was the journey round the Cape of Good Hope to the East and so hazardous that merchants had to pool their resources and their risk. The result was around six fledgling East India enterprises.

In 1602, at the instigation of the Dutch government, these various companies came together to form the United Dutch East India Chartered Company, or Vereenigde Oost-Indische Compagnie for short. And this is its original charter, which spells out that the company was to enjoy a monopoly on all trade from the Cape of Good Hope all the way east to the Straits of Magellan. Pretty much half the world.

The structure of the new entity was novel. The capital of the company was divided unequally between all the major Dutch cities. Citizens were invited to participate in the new venture by investing. It was the form of this investment that was the real novelty.

This rather wonderful painting is of the family of one of the founders of the Dutch East India Company, Dirck Bas. For 6,000 guilders, he and 16 other so-called “participants”, became the firm’s managing directors, the bewindhebber. After 1606, however, anyone who put his money into the East India Company received an “aktie” – literally an “action”, or as we would say, “a piece of the action” – a share in the company’s future profits. And here it is, the world’s very first share certificate, issued by the world’s very first multinational company. Almost exactly four centuries ago.

Three years later, Bas and his fellow directors declared that any shareholders who wanted their cash back could not have it refunded, but would have to sell their shares to another investor. Overnight, a market for the company’s shares was born – the world’s first true stock market. This invention was to change the face of finance for ever, because it created a mechanism whereby the price of shares was determined by the laws of supply and demand, sellers and buyers. And as the renegade Scotsman John Law couldn’t help but notice, the trading of these company stocks was making the world’s first shareholders very rich indeed.

By 1610, the world’s first joint stock company, the Dutch East India Company, was ready to conquer the world. It had a new charter, new shareholders and a burgeoning trade in these shares. But it had to fight to survive, literally. Having established a string of factories and warehouses across South Asia from Java to India, the company had to struggle to keep the Spaniards and their English competitors at bay. With 40 warships and a private army of 10,000 soldiers, the directors of the East India Company were the original corporate raiders.

For the Dutch East India Company, firepower and foreign trade went hand in hand. But the key to the company’s success wasn’t just its cannons like these ones aboard The Batavia, the pride of its fleet. Like all big companies, it was able to combine economies of scale with reduced transaction costs and what economists call “network externalities” – the ability to pool information between multiple employees and agents. The Batavia was part man-of-war, part multinational corporation.

The big networked company was simply more efficient. That was why, by the 1620s, it had established a virtual monopoly on spice exports from Asia to Europe. The world’s first multinational was making its shareholders enormously wealthy.

I’m looking here at the original shareholders’ register of the Dutch East India Company, and literally every name in here was a winner. If you’d put 1,000 guilders into the company at its very inception, by 1736, your investment would have been worth 7,000. Over its entire lifetime, the company paid an average annual dividend of 16.5%. Virtually all its profits were paid back to the shareholders. Dirck Bas’s original shareholding of 6,000 guilders had been transformed into a 500,000 guilder fortune.

To John Law, lying low in Amsterdam having escaped the gallows in London, the workings of the Dutch East India Company came as a revelation. Law was living off his winnings at the gambling table. But he was fascinated by the relationships between the company, with its splendid offices in the Hoogstraat, the nearby stock exchange, where dealers busily traded the company shares, and the Bank of Amsterdam. Yet this Dutch financial system struck Law as not quite complete.

To Law’s financially supercharged mind, the Dutch were missing a trick, or two. For one thing, it seemed completely nuts to restrict the number of East India Company shares when the markets were so clearly enamoured of them.

Law was also puzzled by the conservatism of the Bank of Amsterdam. It had created an internal system which allowed merchants to settle their accounts by direct cashless transfers, but it hadn’t issued any real banknotes to the public.

The idea was already taking shape of a breathtaking modification of the institutions that Law had first encountered here in Amsterdam. Only combine the properties of a monopoly trading company and a public bank and the sky really would be the limit. Law was preparing to unleash a whole new system of finance on an unsuspecting nation.

In 1716, John Law arrived in Paris. He had identified France as the ideal laboratory for what would be the biggest experiment in the history of the stock market. But why did the French give him his chance? The answer is that France’s fiscal problems were exceptionally desperate. The country was saddled with enormous public debts as a result of the wars of Louis XIV. When the Sun King died in 1715, the Duke of Orleans, who was acting as Regent for the under-age king Louis XV, faced a country on the brink of its third bankruptcy in less than a century. It was the perfect opportunity for Law, the maverick self-taught economist who’d developed his theories somewhere between the casino and the stock market.

Law’s ambition was to revive economic confidence in France by establishing a bank on the Dutch model, but with the difference that this bank would issue paper money like this 100 livres note. As money was invested in the bank, the government’s huge debt would be consolidated. But at the same time, and this was the really important part of Law’s system, paper money would revive French trade, and with it French economic power.

The Royal Government gained doubly. Consolidation simply meant that its onerous debts were magically transformed into shares in Law’s bank. At the same time, the monarch gained the ability to print as much money as he liked. As Law wrote – “I maintain 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. “In credit, supreme power must reside in only one person.”

That absolute power was in the hands of the Duke of Orleans who lived here in the Palais Royal, just a short step from Law’s apartment in the Place Vendome. It was to him that Law now unfolded his scheme. The prize was nothing less than the revival of French power through financial engineering. But that was only half of Law’s ingenious plan.

As Law wrote, “The bank is not the only, nor the grandest of my ideas. “I will produce a work which will surprise Europe “by changes more powerful than were produced by the discovery of the indies.” The second part of Law’s idea was that a huge monopoly trading company should be established, the Compagnie d’Occident, the Company of the West. As he put it, the whole nation would become a body of traders and Law himself, named here as the company’s chief director, would be at its head.

The focus for this wildly ambitious scheme would be in America, where the French laid claim to a vast tract of land either side of the Mississippi – Louisiana. The Regent gave Law’s company, what was to become the Mississippi Company, a monopoly on trade with the new colony. Frenchmen, regardless of rank, were encouraged to buy shares in the company. Law’s name headed the list of directors.

In modern parlance, what these documents tell us is that Law was attempting a reflation. And why not? France in 1716 was in a depression and Law’s banknotes helped stimulate a recovery. At the same time, what he was doing was effectively transforming a burdensome and badly managed public debt into shares in what was a privatised tax-gathering and trade company. Well, what was not to like about that?

In a fever of mass speculation, the Mississippi Company’s share price soared, from the original price of 500 livres to 5,000 on September 4th. By December 1719, it had reached 10,000.

And this is where it all happened. This was where Law’s share issuing office was located, the Rue Quincampoix. You can imagine the scenes of frenzy here as half of Paris descended on this narrow alleyway all desperate for a piece of the action. The higher the share price went, the more they wanted to buy. It was a classic stock market feedback loop.

It was in these heady times that the word “millionaire” was first coined. Yes, millionaires, like entrepreneurs, were invented in France. And by January 1720, John Law was the richest of them all. Louis XIV had said “L’etat, c’est moi” – “I am the state.” Now the renegade Scotsman, John Law, was able to say, “L’economie, c’est moi” – “I am the economy.”

Ensconced in his palatial suite, here in the Place Vendome, that’s the Ritz Hotel over there, Law had achieved a greater concentration of financial power in his hands than any individual in all French history. As Controller-General of French Finances, he was literally in charge of the collection of all France’s indirect taxes, the entire French national debt, the 26 mints that produced the country’s gold and silver coinage, the Company of the Indies – better known as the Mississippi Company – which had a monopoly on the import of tobacco, all of France’s trade with Africa and Asia, oh, and the Louisiana colony, which covered around a quarter of what is today the United States.

In his own right, Law also owned the Mazarin Palace, more than a third of the buildings around the Place Vendome, more than 12 country estates, several plantations in Louisiana, and a hundred million livres of shares in the Mississippi Company.

Not bad going for a man who, when he’d first come here 12 years before, had been identified as a joueur – a professional gambler and a possible spy.

By January 1720, Law’s triumph seemed complete. A Scots murderer was, in effect, Prime Minister of France. Law’s problem was that he had no clear idea where to stop. On the contrary, he had a strong personal interest in printing more money, which his own bank controlled, to drive up the price of his own company’s shares.

Fortunately for Law, both his bank and his company were now operating out of the very same building, the Mazarin Palace, which he himself happened to own. So all he had to do in order to drive up the company’s share price was to take a walk down the corridor from the office where the shares were issued, to the office where the money was printed. You could say that Law had become the ultimate insider trader.

At root, Law’s system was what we nowadays call a Ponzi scheme, after the legendary Italian-American conman, Charles Ponzi. To pay out the generous returns it’s promised to the first lot of suckers, a Ponzi scheme needs to take in more money from the next lot of suckers. In John Law’s scheme, the acquisitions of other companies and the generous dividends Law paid were financed not from company profits, but simply by selling new shares.

Like all Ponzi schemes, however, the effect of Law’s system was to generate an unsustainable bubble. Law had reflated the French economy with a combination of paper money and public confidence. Now, unfortunately, his bubble was about to go pop.

By the beginning of 1720, France was in the grip of a mania – the Mississippi Bubble. But the man responsible, the renegade Scots murderer and gambler, John Law, who’d risen to become master of the entire French economy, was about to discover an inviolable law of finance… Trees don’t grow to the sky.

According to Law’s PR campaign, the huge profits he was projecting would come from the French colony of Louisiana, which he painted as a veritable Garden of Eden, inhabited by friendly noble savages willing to exchange a cornucopia of exotic goods. These would flow to France through a new city at the mouth of the Mississippi, New Orleans, named to flatter the always susceptible French Regent, the Duke of Orleans. All the colony lacked was settlers. Grasping that Frenchmen were more interested in stock market speculation than the hard graft of colonisation, Law launched a recruitment drive in the Franco-German borderlands. Several thousand bold Germans signed up and set sail to the promised land. They ended up here.

This was the unfortunate immigrants’ first glimpse of Louisiana, an insect-infested swamp. Within a year, 80% of them had died of starvation or tropical diseases like yellow fever. Sadly for Law, the Mississippi Company’s principal asset, its monopoly on trade with Louisiana, looked like being more or less worthless.

As the inscription on this Dutch cartoon put it, “This is the wondrous Mississippi land made famous by her 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.” To Law, economic success was all about confidence. But this was a confidence trick. In Paris, the first rumours began to circulate that all was not well with Law’s system. The share price of the Mississippi Company began to slide. In a desperate bid to avert meltdown, Law called on the Duke of Orleans to cut the official share price from 9,000 livres to 5,000. This was when the limits of royal absolutism, the foundation of Law’s system, suddenly became apparent. Within weeks, the share price was in freefall. Angry crowds gathered outside Law’s bank. Stones were thrown, windows broken. By December, the shares had lost more than 90% of their value.

This French map from 1730 gives an absolutely wonderful visual representation of the world’s first stock market bubble. Here at the top is the goddess Fortuna, pouring down goodies from her horn of plenty. Here are the happy investors receiving their shares in the Mississippi Company from flying cherubs. But down below, there are some other cherubs chopping up the shares beside a shattered printing press. And there are two more cherubs blowing bubbles. To the right, there are four very unhappy looking men, one of whom is preparing to commit suicide by falling on his sword.

As if pricked by a sword, the Mississippi Bubble had now burst. It was at this moment that Law, vilified by the French people, fled the country. He never saw his wife and daughter again. He spent the rest of his life in Venice, dividing his time between writing long, self-justifying letters and gambling. He died in 1729. In France, however, his devastating legacy lived on.

Law’s bubble and bust fatally set back France’s financial development, putting Frenchmen off paper money and stock markets for more than a generation. The French monarchy’s fiscal crisis went unresolved and for the rest of the reign of Louis XV and Louis XVI, the crown lived from hand to mouth. Eventually, France was driven by royal bankruptcy to revolution.

The Mississippi Bubble of 1719 was the first stock market bubble in history. But it’s been by no means the largest. When we think of stock market bubbles, we think of this. The nightmare that haunts the world of finance, which has returned to haunt us in the last few months, is that there could ever be a bust to match the Great Wall Street Crash, which began on October 24th 1929, Black Thursday. Over the next three years, the US stock market declined a staggering 86%, reaching its nadir in June 1932. What was worse, this asset price deflation was accompanied by the worst depression in all history. In the United States, output collapsed by nearly a third. Unemployment reached a quarter of the civilian labour force. Why did the 1929 crash happen? Why, indeed, does any crash happen? This remains one of the most hotly debated questions in financial history.

There are all kinds of technical explanations for stock market crashes. But at root, it’s all about herd psychology. In a bull market, that’s when share prices are rising, even the smartest investors can succumb to what the former chairman of the American Federal Reserve, Alan Greenspan, famously called “irrational exuberance”. But when the herd changes direction, sometimes in reaction to nothing more than a change in the wind, their mood can also change from euphoria to gloom. The herd stampedes.

One cow gets scared, and that fear just translates to the whole herd and they all take off. And the rest of them don’t know why they’re scared. They just feel that fear and they run. Fear overwhelms all rational thinking. Until it’s over.

In market jargon, the buyers have turned into sellers, the bulls into bears.

Despite the zoological imagery, the point is that markets are mirrors of the human psyche. Like homo sapiens, they are prone to mood swings, from greed to fear. They can suffer from depression. And sometimes they can experience complete breakdowns. That happens rather more often than some financial theories would lead you to expect, but not so often that we’re ever quite ready for the next breakdown.

If movements in financial markets were statistically distributed like human heights, there would hardly be any crashes. Most months would be clustered around the average, with only a tiny number witnessing extreme ups or downs. Let’s face it, not many of us are below four feet in height or above eight feet.

This is the classic bell-shaped curve, where things are distributed according to their frequency – the most commonly occurring clustered here around the middle and the relatively rare dwarves and giants out here at the extremes. That’s why it’s quite a steep curve, because most human heights are quite close to the average. But if you do the same thing for financial markets, for daily moves in the stock market, you end up with something that looks more like this, with relatively fewer small movements and relatively more big movements down or up. And these are what the statisticians mean when they talk about long or fat tails.

If stock market movements were distributed like human heights, a drop of 10% would happen only once every 500 years. And stock market crashes of 20% in a year would be unheard of, rather like people just six inches tall. Whereas in fact, there have been seven such crashes in the past century. As it turned out, those who feared that the brief panic of October 1987 would turn into the next great crash were proved wrong. The market had one really bad month, then rallied. But that bubble provided a golden opportunity for corporate crookery.

What John Law’s Mississippi Company had been to the bubble that launched the 18th century, so another company would be to the bubble that ended the 20th. It was a company that promised its investors wealth beyond the dreams of avarice. It was a company that claimed to have reinvented the entire financial system. And it was a company that used 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, that company was… Enron. Seven years after its collapse, most of us have consigned Enron to the dustbin of financial history. Yet it pioneered many of the dubious business practices that continue to plague us today.

In the three years up to August 2000, shares of the Houston energy company had gone through the roof. Once a small-time gas company in Nebraska, Enron was now the fifth largest company in the United States, with stated revenues of 111 billion dollars. Enron was the darling of Wall Street. Yet a little historical knowledge might have made Enron’s investors think twice. Indeed, the story of Enron was like a re-run of the Mississippi Bubble 280 years before. John Law’s plan had been to revolutionise French government finance. Ken Lay, the chairman of Enron, planned to revolutionise the global energy business. For years, the industry had been dominated by huge utility companies, which both produced the energy, pumped the gas and generated the electricity, and sold it on to consumers. Lay’s big idea was to create a kind of energy bank, which would act as the intermediary between suppliers and consumers. His dream was to make Enron the greatest energy company in the world. Caught up in the heady spirit of the times was senior Enron executive, Sherron Watkins.

[Sherron Watkins] It was very electric. You felt like you could… If you came up with a good idea, Enron would give you the money and you could go for it at a very young age.

Like John Law, Ken Lay had friends in high places. He contributed generously to George H.W. Bush’s presidential campaign. As President, Bush duly pushed through legislation that deregulated the energy industry. Riding a global wave of energy privatisation, Enron snapped up assets all over the world. In Latin America alone, the company had interests in Colombia, Ecuador, Peru and Bolivia, where they laid a huge pipeline across the continent to Brazil.

And thanks to the intervention of Ken Lay’s personal friend, George W. Bush, Enron was able to acquire a controlling stake in the largest natural gas pipeline network in the world, here in Argentina.

Above all, however, Enron traded. Not only in energy, but in virtually all the ancient elements of earth, water, fire and air. It even traded in internet bandwidth. Enron led a Wall Street surge unnervingly reminiscent of the Mississippi Bubble. Despite his half-hearted warnings against “irrational exuberance”, this bull market was propelled upward by the chairman of the US Federal Reserve, Alan Greenspan. As in John Law’s time, a stock market bubble could only happen if money was abundant. And by raising interest rates only once between February 1995 and June 1990, Greenspan made sure that it was.

The rewards for investors were immense, and also for the managers here at the company’s Houston headquarters, who were generously incentivised with share options. In the space of just three years after 1997, the Enron stock price rose by a factor of very nearly five, from below 20 dollars a share to above 90. It was the Mississippi Company all over again.

Even a city used to extravagant oil-fired living had seen nothing like it. This is where Ken Lay and his Enron executives used to live, in River Oaks, Houston’s most exclusive neighbourhood. In the final year of its existence, Enron paid its top 140 executives an average of 5.3 million dollars each. Luxury car sales went through the roof.

[Sherron Watkins] You got multiples of your annual base pay. You were really less thought of if you got a percentage, even if it was 75% 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.

And Lay, the pillar of society, espoused the highest moral standards for his company.

“Enron is a company that deals with everyone with absolute integrity. We play by all of the rules, we stand by our word, we mean what we say, we say what we mean.”

The only problem was that, like John Law’s system, the Enron system was an elaborate fraud.

[Tape recording of a telephone conversation]
“El Paso.”
“Hey, this is David up at Enron. There’s not much demand for power at all and we’re running kinda fat.”

In this tape, an Enron trader is discussing with the El Paso Electric Company how to hold California’s consumers to ransom by closing power stations to restrict the supply of electricity.

“If you took down a steamer, how long would it take to get it back up?”
“3 or 4 hours, something like that.”
“Well, why don’t you just go ahead and shut it down then if that’s okay.”

OK. The results were not only the higher prices Enron wanted, but also, despite there being plenty of power available, repeated blackouts for consumers. Enron’s money was stolen in more ways than one. The company’s stated assets were vastly inflated. But its key financial innovation was to remove its debts from the balance sheet and hide them in so-called “special purpose entities”, dubious names like Chewco and Raptor. Each quarter, the company’s executives had to use more smoke and more mirrors to make actual losses look like bumper profits. It couldn’t last.

[Sherron Watkins] When you cook the books and then you try to hide it, you’re toast.

When they sensed the game would soon be up, Lay and his cronies started to unload hundreds of millions of dollars worth of shares, while at the same time reassuring the public that the share price would continue to soar. Like John Law’s desperate attempts to stem the freefall of Mississippi Company shares, all Ken Lay’s reassurances were in vain. On November 15th 2001, Alan Greenspan, head of the US Federal Reserve, received the Enron Prize for Distinguished Public Service, adding his name to a roll of honour that included Mikhail Gorbachev and Nelson Mandela. Greenspan deserved it, because without his monetary policies in the late ’90s, the Enron bubble, and the dotcom bubble that coincided with it, would surely have been impossible. Just two weeks after the award ceremony, Enron filed for bankruptcy. The company owed billions. But just how many billions?

[Sherron Watkins] When Enron declared bankruptcy, December 2001, they met with their creditors to say, “Erm, guys, I know on our balance sheet, “we have reported 13 billion dollars of long-term debt. “Our true long-term debt picture is 38 billion dollars. “There’s 25 billion dollars in off-balance-sheet debt”.
[Niall Ferguson] Did those numbers come as a shock to you? You knew there were problems, but not on that scale.
[Sherron Watkins] Yes, I mean, I think we were all flabbergasted.

The day before 4,500 employees at Enron’s HQ were given their marching orders, a final round of bonus cheques were issued to grateful executives. In May 2006, Ken Lay was convicted on all six counts of securities and wire fraud. His sidekick, Jeffrey Skilling, was sentenced to 24 years in prison. Lay died before sentencing, while on holiday in Aspen, Colorado. Yet the fraudulent practices that propelled Enron’s rise and fall didn’t die with Ken Lay. On the contrary, the habit of hiding debt off-balance-sheet that Enron pioneered subsequently spread throughout the Western financial system. The unravelling of this dodgy accounting has been a key component of the current crisis.

[Sherron Watkins] In many respects, I think the Enron problem was in a Petri dish and the germ has spread throughout the financial markets. Some of which comes from Enron traders and finance folks that are gainfully employed at banks and energy trading houses. So that rot is everywhere in the financial markets.

The joint stock limited liability company truly is a miraculous institution. And yet throughout financial history, there have always been a few crooked companies, just as there have occasionally been irrational markets. Indeed, the two go hand in hand, because it’s precisely when the bulls are stampeding most enthusiastically that people are most likely to get taken for the proverbial ride.

As we’ve seen in the past year, the path of financial markets can never be as smooth as we would like. Since the current credit crunch began, some stock markets around the world have fallen by as much as 50%. 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 a line not unlike the jagged and irregular 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’ll be on a nice, 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’ll see in the next episode of The Ascent Of Money, finance is as much about risk as it is about return. And the big question is, are you insured? Or are you hedged?


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