Markets Don't Make Bubbles, People Do

Ferguson sketches the rollicking career of John Law: Scottish con man, killer, genius, lover and creator, in 1719-20, of one of history's great stock market bubbles. Law effectively took control of the French national debt, substituted paper currency for gold and sold shares in the company that controlled French Louisiana. As the shares rose in price and investors borrowed against them, the volume of paper money doubled in a year, breeding inflation, speculation and the new term "millionaire" before Law's system collapsed. From that day on, Ferguson writes, all bubbles have followed five stages:

1) Displacement, as economic change brings a chance for extraordinary profits; 2) Euphoria, as investors take advantage of the opportunity, 3) Mania, as novices, crowds and swindlers rush in; 4) Distress, as insiders see their prospects for profit declining because of the mania and start selling; and 5) Revulsion, as all stampede for the exits.

Ferguson provides a more flattering portrayal of Nathan Rothschild, patriarch of the banking family and mastermind of empires. Nineteenth-century states needed to issue bonds to finance wars; Rothschild was at the ready. When Wellington defeated Napoleon at Waterloo, Rothschild made huge and risky bets on British bonds and secured his family's dominance of the London market for half a century. When the Rothschilds turned down a plea to back the confederacy's bonds, the fate of the Southern rebellion darkened irreversibly. "Money is the god of our time," declared the German poet Heinrich Heine in 1841, "and Rothschild is his prophet."

From recent times, Ferguson gives deft summaries of the lives of Hernando de Soto, the Peruvian champion of property rights for the poor; Milton Friedman, the apostle of monetarism, who saw the supply of money as the key to the economy; and George Soros, the hedge fund philosopher and financier of liberal causes. I found myself understanding Soros's theory of reflexivity for the first time. (Market prices, Ferguson explains, are "reflections of the ignorance and biases, often irrational, of millions of investors . . . [which] affect market outcomes, which in turn change investors' biases, which again affect market outcomes" -- in short, reflexivity.)

Judging from the text, Ferguson finished writing The Ascent of Money in mid-2008, after the sub-prime mortgage crisis had hit but before September's credit freeze and the subsequent plunge in stock prices. As I turned his pages about the soaring trade in complex derivatives, I wanted to cry out to Wall Street: Don't go down that road, the bridge is out!

The shadow world of derivatives, credit-default swaps, the sales of U.S. bonds to China -- all seem to bring brilliant results, until they get too big. Indeed, "Too Big to Fail" is the catchphrase of this autumn. But the follow-up question is: How do we know that whatever institution is wearing that label doesn't harbor a hidden cesspool of putrid assets? When should we withdraw our "inscribed trust?"

In a provocative afterword, Ferguson wrestles with "creative destruction," the benefits of allowing companies to fail and investments to sour. He doesn't come to a definite conclusion, but he notes that viewing the financial world from an evolutionary perspective argues for weeding out what the political scientist Joseph Schumpeter called "the hopelessly unadapted" -- and quickly. "The experience of Japan in the 1990s," Ferguson comments, "stands as a warning to legislators and regulators that an entire banking sector can become a kind of economic dead hand if institutions are propped up despite underperformance, and bad debts are not written off."

Ferguson is making the rounds with his new book, saying last week on MSNBC that the United States should follow up the G-20 Economic Summit with a "G-2" meeting with just the Chinese. The professor also winningly confesses that even he is confused about the thrust of Treasury Secretary Henry Paulson's $700 billion rescue fund. Ferguson has, nonetheless, written an admirably illuminating book that will take its place beside such modern classics as John Train's The Money Masters, Peter L. Bernstein's Against the Gods, and Adam Smith's Supermoney.

Fear, greed and folly -- according to a Wall Street maxim, you always have them in the market. If only you knew in which order they come, then you could make some money. But past results, as investment companies sternly warn, are no guarantee of future returns, not in 2008. Money descends, too. ·

Shelby Coffey III is a senior fellow and trustee at the Newseum and former editor of the Los Angeles Times.