[Note for bibliographic reference: Melberg, Hans O. (1998), Arguments searching for proofs: A Review of Galbraith's A Short History of Financial Euphoria, www.oocities.org/hmelberg/papers/980909.htm]

Arguments searching for proofs
- A Review of Galbraith's A Short History of Financial Euphoria

by Hans O. Melberg

A Short History of Financial Euphoria
John Kenneth Galbraith
Whittle books in association with Viking (Penguin), New York/London, 1993
113 pages, ISBN: 0-670-85028-4

Introduction
J. K. Galbraith's book A Short History of Financial Euphoria is good in the sense that it suggests some potentially important psychological mechanisms that create financial disasters. The verdict, however, is not only favourable since the suggested mechanisms are not empirically proven. Another flaw is the relatively superficial description - mainly drawn from secondary sources - of a number of financial disasters.

Galbraith's argument: The mechanisms
Galbraith's main argument is that speculative booms are caused by unavoidable psychological mechanisms. As he writes: "The circumstances that induce the recurrent lapses into financial dementia have not changed in any truly operative fashion since the Tulipomania of 1636-37. Individuals and institutions are captured by the wondrous satisfaction from accruing wealth. The associated illusion of insight is protected, in turn, by the oft-noted public impression that intelligence, one's own and that of others, marches in close step with the possession of money. Out of that belief, thus instilled, then comes action - the bidding up of values, whether in land, securities, or, as recently, art. The upward movement confirms the commitment to personal and group wisdom. And so to the movement of mass disillusion and crash" (p. 106).

More specifically, he describes two main mechanisms and two supporting mechanisms behind booms. The first describes how overconfidence increases as a result of initial speculation. "Those involved with the speculation are experiencing an increase in wealth - getting richer or being further enriched. No one wishes to believe that this is fortuitous or undeserved; all wish to think that it is the result of their own superior insight or intuition" (p. 5). In this way, "Speculation buys up, in a very practical way, the intelligence of those involved" (p. 5).

The second mechanism, relates to how critical comments against speculation are discouraged. People "ignore, exorcise, or condemn those who express doubts" (p. 11) since they do not want to believe the good times can end. One well known example is Paul M. Warburg - a respected banker who in 1929 wrote critically about the excessive speculation at the time. In return he received comments about how he was "sandbagging American prosperity" (quoted on p. 7).

The two supporting mechanisms are, first, "the extreme brevity of financial memory" and "the specious association of money and intelligence" (p. 13). The short memory implies that people do not learn from the last crisis, the association of intelligence and money results in uncritical attitudes that allow speculations to continue. Galbraith also offers suggestions as to why these mechanisms exist. The first is supported by the need to find external scapegoats after a crisis. People do not want to blame themselves, but when they don't they don't learn the lesson). Moreover, Galbraith believes people wants to find external causes since they want to believe in the goodness of the free market economy. The second mechanism is, amongst other things, the result of everyday experience. As he writes: "Those with money to lend are, by long force of habit, tradition, and more especially the needs and desires of borrowers, accorded a special measure of deference in daily routine. This is readily transmuted by the recipient into an assurance of mental superiority" (p. 16, see also p. 88).

In sum, we have four observations:
1. Psychologically earning money makes you overconfident in your own abilities since there is an individual need to believe that you deserve the money (i.e. that your gain was not pure luck).
2. It is very difficult to speak out against speculation since people who do are subject to bitter personal attacks. Why? Since the message is negative there is a tendency to dislike the messenger.
3. People have very short financial memory. One reason why this is so is the need to blame the crisis on external factors and to protect the belief in the market.
4. People who lend out money tend to become overconfident because they are routinely in situations in which they are treated as superiors.

There is, also, a fifth observation that he makes, which is worth pointing out:
5. Money and leadership tend to go to people who have an aura of authority and/or those who are "indifferent to legal constraints" (p. 14 and 15). The first means that people with a great deal of self-confidence tends to become leaders and it may be difficult to voice critical opinions to such people. The second points out that the association of money and intelligence may be partly spurious since it is indifference to legal constraints that makes people rich.

How then do these mechanism explain financial euphoria? Galbraith admits that he cannot explain in the sense of pointing to ultimate causes. No one knows, he claims, exactly how the euphoria gets started. Instead the mechanisms explain how an initial small successful speculation may grow into a large financial euphoria. The mechanisms also try to explain why these euphoria are recurring events. Galbraith's story is, in short, one of overconfidence and lack of critical attitudes. Both mean that asset values may sometimes depart greatly from the realistic estimates of expected future returns from the asset. Overconfident people buy at too high prices and no one dares to warn them (which only increases their confidence).

The evidence?
Gailbraith is good at making grand claims and suggestions. He is less good at proving the existence and empirical relevance of these mechanisms. His basic approach is to go through a number of financial euphorias to show that the mechanisms he identified were operating in all these episodes. For instance, to prove the mechanism of scapegoating, he shows how John Law became the scapegoat of the French financial disaster in 1720 (Banques Royal and the Mississippi Company). He also calls it "nonsense" and "ridiculous" to suggest that the 1987 crash was caused by the deficit or computer controlled selling of stocks or that the 1929 crash was caused by the money supply contraction. These historical events serve as evidence of the mechanism that we need a scapegoat and it is probably the mechanism that is best documented by his historical examples.

Some of the other mechanisms are less well documented. That is not the same as saying that they are wrong. They are often plausible, but their strength end empirical relevance is not proven. For instance, the argument that people associate money with intelligence, and that earning money makes you overconfident, is simply a hypothesis for which he gives little proof. True, in some speculative episodes we observe how people ascribe almost mystical powers of foresight to some of the leaders (such as the mentioned John Law in France). We may also observe individual businessmen who become overconfident after initial gains, such as Donald Trump or the Canadian developer Robert Campeau. Yet, we need more rigorous proof both of the strength of this belief and its empirical relevance in creating financial euphorias.

One way of testing these hypothesis is to conduct surveys and experiments. For instance, when asked to reveal their strength in the belief that "money income and IQ is related" the mean result was 4.7 among 20 students at the University of Oslo (survey conducted among students of psychology and economics at a statistics seminar). Of course, these kind of surveys need to be done on a larger scale and followed up by experiments (maybe people do not reveal their true opinions) to get reliable results. However, the point is that we need some kind of independent proof of the hypothesis before we accepts it strength and existence.

The need for more evidence also applies to the alleged short term memory of financial markets. The fact that financial euphorias appear again and again, does not necessarily prove that people have forgotten the last crisis. For instance, Krugman presents a model in which it is rational for speculators to pay more than the expected return for an asset as long as they gamble with other people's money. In this model the reason for financial euphoria is not overconfidence, but over-guaranteed and under-regulated banks. Once again, this is not to deny that there is some truth to the argument that financial memory is short. The point is that we need more evidence that this is true, to what extent it is true and exactly how it creates crisis.

The argument that people do not dare to speak out against speculation because there is an inherent belief in the goodness of the market economy, is also unproven. While this may apply to some economists, it seems safe to say that since Keynes (or indeed, Marx) there has been no shortage of economists who were willing and able to speak out against the free-market. Moreover, there should be great incentive to do so and to act on the knowledge that the market price was wrong. Personally you are rewarded with fame afterwards, and if you bet on the downfall (speculate on the options market) you can earn a handsom sum of money.

There is also a problem in the sense that the psychological tendencies Galbraith describes always exist, while financial euphoria is less than permanent. In fact, the market economy seems to be working fine most of the time. A good theory should therefore describe not only the mechanisms that create crisis, but also why these crisis do not occur constantly.

Finally, consider Galbraith's statement that "Recurrent speculative insanity and the associated financial deprivation and large devastation are, I am persuaded, inherent in the system" (preface viii). The truth of this statement depends on how you define "inherent" and "the system." The mechanisms described by Gailbrath are mainly psychological. This leads me to believe that by "inherent" he means that overconfidence is an unaviodable part of human nature. The system, in this context, must mean the capitalist free-market. There is, however, a slight tension here. Most conservative economist work on the assumption that people are rational and selfish. The question of whether financial euphoria is inherent to the system, is then a question of whether bubbles and crashes can occur in an economy with rational individuals (and all the other neo-classical assumptions). Conservative economists would not deny that panics might be inherent to the system if you assume that people act irrationally. They may, however, deny that irrationality plays such a prominent role in asset pricing.

The above comment suggests that a good way of examining financial euphoria, would be to list all the neo-classical assumptions (rationality, perfect information, perfect competition and so on). The next step would be to examine how (and if) cycles can be generated, first, within the system without changing the assumptions (maybe only introduce time lags?). Second, one could see how changing each assumption would affect the tendency of the system to generate cycles and depressions. Galbraith has attached the assumption of rationality. Alternative arguments would be to attack the assumption of linearity, assumptions of information and so on.

Conclusion
On a scale from 0 to 10 I give this book 5. There is little original research (the description of the episodes is sometimes from modern secondary textbooks) and few rigorous arguments and proofs. Yet, it contains interesting suggestions and ideas worth a closer examination. It is also very brief and relatively well written.

_{[Note for bibliographic reference: Melberg, Hans O. (1998), Arguments searching for proofs: A Review of Galbraith's A Short History of Financial Euphoria, www.oocities.org/hmelberg/papers/980909.htm]}