When Large Matters Go Awry

When large matters go awry, they often follow standard patterns. So perhaps this volume, like a bird-watcher’s handbook, will help the reader identify some of the familiar ones—groupthink, hubris-nemesis, the Ponzi scheme, speculative manias, the “distance lends enchantment” mirage, and other raptures—as they occur, alone or in combination.

1. Groupthink

That aspect of the herd instinct sometimes called groupthink is one of the strongest forces in life. People will go along with an authoritative leader’s crazy decision even though they half-know that they are being led to perdition. They become sleepwalkers. Groupthink rules the stock market, and one sees it gripping the participants in the speculative frenzies described in these pages. Every experienced person has also encountered groupthink on the committee level. Pearl Harbor was a prodigious example. Not one officer on Admiral Kimmel’s staff dared dispute his conviction that the Japanese would not attack the base, even though Washington sent out one war alert after another. So operations were never placed on a war footing and the fleet was destroyed. If an irascible boss holds your career in his hands, it takes courage to contradict him. You’ll be odd man out even if the future proves you right.

The convincing, but wrong, idea—the claire idėe fausse—is an important groupthink variation. Exciting buzzwords and clever slogans often transmit fallacies, since mankind craves simple solutions to complicated problems. It would not seem premature to include Communism as a claire idėe fausse. The miseries of stock market “technical analysis” provide a fine example. The Pruitt-Igoe project qualifies, and one sees the principle contributing to the John Law scandal debacle. For one subvariation I’ve coined the term “Noah’s Ark fallacy.” This arises when an enthusiastic buyer pays twice book value for shares in the Noah’s Ark Shipbuilding Company. He’s vainly hoping for a recurrence of a one-time situation, as when Xerox sunk a billion dollars into Scientific Data Systems. S.D.S.’s business had enjoyed an enormous boom furnishing powerful computers to the space program, but having satisfied that demand, they couldn’t hope to repeat the sale right away.

2. Hubris

The classic description of hubris leading to nemesis is Quem vult perdere deus, prius dementat (“Whom god would destroy he first drives mad”)—with power, typically, the way we often say “drunk with power.” Pride cometh before a fall. In many of the preceding stories, the protagonist, as in a Greek drama, believing he has become godlike, is undone by hubris: de Lesseps, Ivar Krueger, Richard Whitney, Bernie Cornfeld. A variation is underestimating the opponent. Juan March’s victims didn’t study his record closely enough to realize his immense ingenuity and utter ruthlessness. Like a prominent mob-connected businessman, his high connections were no indication of respectability; indeed, they made things worse. To save themselves his victims needed to plan their defenses as far ahead as March planned his attack. In the same way many large international companies, responding to Italian government incentives, started factories in Sicily in the 1960s, only to give up when they discovered the full costs of doing business in a Mafia environment. Another invisible opponent that historically has often taken a fearful toll is disease. Soldiers know about it more than financiers. Dysentery killed far more British soldiers in the Crimea than the Russians; Napoleon’s defeat in Russia was due as much to hypothermia as enemy action. Just so with the Compagnie des Indes colonists in Louisiana, and de Lesseps’ engineers in Panama.

3. Ponzi scheme

A Ponzi scheme, simply stated, consists of paying off the earlier participants in a bubble with the money of the later ones. Americans encounter it regularly in pyramid clubs and door-to-door-selling organizations of the “Dare to Be Great” variety, in which your payoff comes from recruiting salesmen, who are supposed to recruit even more salesmen, and so on ad infinitum. Something always comes along to break the flow of endless buildup. You can depend on constant revivals of the Ponzi scheme paradigm. A recent one was called J. David & Co. Mr. David (like Ponzi, this was a nom de guerre) had a plan to make your money grow with wondrous speed. First you turned it over to him. Then he embarked on your behalf in great speculations, notably in foreign currencies. You received no detailed reports, just an occasional bulletin reporting how your fortune had grown—20 percent, 50 percent, 100 percent, 200 percent. Of course, currency speculators can’t do that well steadily. Both currency and commodity speculators almost always lose their touch (and their money) in due course. And yet J. David was able to collect over $100 million with this flytrap, from people who should have known better. Now the investigators are trying to discover where the funds disappeared to.

4. Speculative manias

Speculative manias have Ponzi characteristics, since as prices rise and the mania spreads, more money floods in, putting prices higher than ever. Under the “bigger fool” theory you pay too much, knowing you’re a fool, because you hope a bigger fool will pay you still more. The Dutch Tulipomania is the classic example of this genre, but the whole stock exchange occasionally turns into a self-inflicted Ponzi scheme during the blowoff stage of a boom, when problematic companies sell for fifty times earnings, amidst assurances on every side that “So-and-So can only go up.” Listen for those words! They are the trumpets of doom. Students of the cultural anthropology of the stock maket will recognize the “New Era” mirage in the Kuwait Stock Exchange story. “This time, things are quite different,” the crowd assures itself; the law of gravity is hereby officially suspended, and Fidogenetics or whatever no really is worth three times what anybody had thought. (Then, of course, it collapses.) One would expect the present epidemic of “leveraged buyouts” to grow into such a speculative splurge, like the “hi-tech,” conglomerate, and hedge fund fads of the past decade.

5. Welsher of Last Resort

The “welsher of last resort” problem—of impossibly large government indebtedness, as described in the John Law, South Sea Bubble, and War Loan Conversion chapters—is with us today. A long war or a populist government often semi-bankrupts a country, so that its creditors, including holders of paper money, cannot be paid. Repudiation is inevitable; the only question is what form it will take. Governments have learned to debauch their currency to get out of debt: where ten marks once bought a pair of shoes, soon it takes a thousand or a million or even a billion. (In the German hyperinflation, it took 40 trillion.) That makes a hundred-billion-mark national debt manageable soon enough. In the eighteenth century, before the popularization of this technique, both France and England succeeded in coaxing the holders of government I.O.U.s into swapping them for shares in El Dorado speculations—the Compagnie des Indes and the South Sea Company. The British devised a neat alternative in this century by appealing to their citizens’ patriotism to exchange a mediocre piece of paper for a bad one: the War Loan Conversion.

One wonders what technique will be used to solve today’s debt crisis. Few countries can pay the interest, let alone the principal, on their indebtedness. Even America’s national debt now equals the value of all the companies on the stock exchange, and its interest equals our budget deficit. So really we are printing money to pay the interest, like any Third World country. Eventually, something will snap. The eighteenth-century solution of an officially sponsored company whose shares can be paid for with wormy government paper might work again abroad. It could be a huge holding company of shares in nationalized industries. I hereby offer the idea, gratis to Mexico, Brazil, and Argentina.

Felix Rohatyn and others suggest that governments should guarantee an stretch out international debt at much lower interest rates than those now prevailing. This would enable the inevitable repudiation in real terms to occur gently by letting inflation accomplish its mighty working over time. Perhaps a future version of this volume will include the then former Secretary of the Treasury Rohatyn together with sometime Chancellor of the Exchequer Neville Chamberlain among the high priests of finance who administered ritual euthanasia to intractable public indebtedness.

6. Distance Lends Enchantment to the View

A category of folly that recurs endlessly can be styled the “distance lends enchantment to the view” paradigm. One blithely embarks on projects in faraway lands that one would shun at home where one understood the hazards: de Lesseps’ catastrophe in Panama, the Groundnuts Scheme, the South Sea Bubble, the Compagnie des Indes. The Scottish colonization of Darien, in Central America, during the last years of the seventeenth century, was another grim story of this type. The entire project came to nothing; of the thousands of settlers only a handful survived.

In our own day, prosperous citizen D.K. Ludwig plunged a cool billion into his plan to raze the forests of northern Brazil and substitute more productive varieties of agriculture. He was laid low not only by the physical problems of the venture, but by that Latin American specialty, the predatory politician, who has taken over the function previously filled by the anopheles mosquito. A recent “distance lends enchantment” fiasco was Adela, a venture-capital company conceived by Senator Jacob Javits and hatched by a large group of splendid international banks and industrial companies—Citicorp, Exxon, Philips Lamp, and the like—to show the world how one could make money in Latin America. It opened offices in all the Latin American capitals, and hired green business-school graduates to spread its funds among hundreds of ventures. In spite of the high sponsorship and the ever-enthusiastic reports of President Ernst Keller, the shareholders’ money was lost. Adela’s lamentable story needs to be written, and I commend it to Ph.D candidates.

7. Invincible Ignorance

Invincible Ignorance is perhaps the name for the misplaced government interventions recounted to “Whiskey in Mali,” as well as those of the French revolutionary hyperinflation. Now that we no longer read history we have only recent experience to learn from. We can see a similar folly devastating my own city, New York, in the form of permanent rent control. Every observer knows what rent control does to a big city: it induces low-skilled people to remain where there are few low-skilled jobs, which forces the high skilled people to live far away or perhaps leave. Then you bankrupt the landlords, often persons of modest means themselves, so that the buildings can’t be maintained, and eventually are lost. Mile upon mile of Harlem and the South Bronx have been burned out, like German cities in World War II, except that we have done it to ourselves. That, of course, shrinks the housing supply, raising housing costs. Do the politicians understand this fatal process? Perfectly. Do they espouse rent control to get elected? Of course. When special interests get strong enough to control decision-making, sound government becomes impossible.

Invincible Ignorance is overcome when its price is seared into the national consciousness with a branding iron. Ever since the hyperinflation of the Weimar Republic and its disastrous consequences, including, indirectly, Hitler, the Germans have watched over the soundness of their currency, just as we stretch “safety nets” to ward off a repetition of the 1930s Depression. Italy may be relatively safe from counterproductive price controls, since they form the central episode in the greatest Italian prose work of the nineteenth century, which every Italian schoolchild almost memorizes, Manzoni’s I Promessi Sposi (The Betrothed). As inflation, in the novel, rages on, the authorities decree longer and longer periods of imprisonment in chains or forced service in the galleys for infractions of price controls, but no measure has any effect. As one sees in the present volume’s chapter on the French Revolutionary hyperinflation, once “funny money” comes in, no amount of regulation can hold prices down. Perhaps some modern-day Manzoni will save New York by writing honestly of the fatal consequences of rent control plus “welfare.” Alas, it seems unlikely. My writer friends are solidly dug into rent-controlled apartments themselves and are charmed by that arrangement.

The syndrome that begets inflation and then unavailing price controls seems as old as history. Hammurabi’s code in about 1745 B.C. and Diocletian’s in A.D. 301 attempted minute regulation of prices. Hammurabi prescribed execution (apparently by drowning) for merchants who demanded payment in silver; so did the Directory, during the French hyperinflation. Diocletian’s code specified the price of each quality of shirt, as, unavailingly, did our Office of Price Administration in World War II. But suppressing the symptoms doesn’t halt the disease. The price of wheat rose over one hundred times between Augustus and Diocletian’s code; far from being arrested, in the next generation it rose about a thousandfold. So why, after all these millennia, do we still treat inflation by controlling prices instead of government expenses and the money supply? Invincible Ignorance. “Semper vult mundus decipi: decipietur,” said the Swidish chancellor Oxenstierna: “The world always wishes to be deceived: let it be deceived.” ■


Excerpted from Famous Financial Fiascos.