A History of Financial Speculation

By Edward Chancellor

Farrar Straus Giroux. 386 pp. $25

Reviewed by Steven Mufson

It was the roaring '90s -- the 1690s -- and British investors were swept up in a passion for new technologies, emerging markets and new theories of the discounted value of future earnings. Initial public offerings were the rage, new financial derivatives were invented, and ordinary citizens invested as never before. Centuries later, the era's commercial zeal was even elevated to philosophical heights by no less than Max Weber, who declared the robust capitalism of the age an extension of the Enlightenment and evidence of the triumph of rationalism.

Yet there was little rational about the 1690s. A bout of speculative fever had been sparked by a New England sea captain, William Phipps, who returned to England with 32 tons of silver and jewels raised from a sunken Spanish plate ship. Inspired by the 10,000 percent return for his investors, the British public drove up the prices of shares in diving companies, which bragged of new technologies for searching the sea floor for sunken treasures. One prospectus assured investors of a 100 percent return. The public's thirst for quick riches spilled over into shares of companies ranging from those with new patents for burglar alarms or fire-extinguishing engines to banks and the bellwether East India Company. The government capitalized on the gambling mood of the times and raised money by running lotteries.

Then it ended. A crisis in public finance, a flight of foreign investors and a loss of investor confidence sank the prices of the leading companies. Shares of the blue chips of the day -- the East India Company, Hudson's Bay Company and Linen Company -- sank by 70 to 90 percent. Of 140 Scottish and English companies operating in 1693, only 40 survived four years later. The rest, including all the diving and new patent companies, vanished without a trace.

The tale of the roaring 1690s is just one of many investment bubbles recounted in Edward Chancellor's engaging -- and sobering -- Devil Take the Hindmost: A History of Financial Speculation. Chancellor, who studied history at Oxford and Cambridge and worked for the investment bank Lazard Freres, also recounts episodes of investor madness such as the Dutch tulip mania, the British South Sea Bubble, the British Railway Mania, the pre-crash U.S. stock market of the 1920s and Japan's "kamikaze capitalism" during the 1980s.

Like many other works of history, this one is written with a message for today. Chancellor believes that the surging U.S. stock market of the 1990s has less to do with the emergence of a new economy or a new economic paradigm than it does with the sort of delusions that gave rise to earlier speculative bubbles. "The modern investor is just as liable to be whipped up into a frenzy over companies introducing a new technology as [investors in] the diving engine `cullies' of the 1690s," he writes. "The early stock markets were moved by hopes and fears as much as their later counterparts. . . . This explains why all great speculative events seem to repeat themselves and why the experience of the 1690s seems so familiar."

And in reading about these earlier investment manias, it is startling and alarming to see just how similar many of today's investment mantras are to the wrongheaded beliefs of the past. Many analysts and investors will, of course, disagree. Financial journalist James Grant, quoted frequently by Chancellor, has been predicting financial-market doom for 10 years or more. The Federal Reserve of today is much more sophisticated than the Federal Reserve of the 1920s or the Bank of England of the 1690s. Moreover, as Chancellor acknowledges, speculation has successfully funnelled money into some lasting innovations, such as railroads and automobiles, even when it has come with occasional ruin to individual investors. Maybe computer technology really is bringing about a lasting increase in productivity.

But regardless of whether you believe that stocks like Yahoo and AOL are worth hundreds of times their annual earnings or Microsoft is worth a $500-billion market capitalization, Devil Take the Hindmost is an enjoyable read packed with detail about the speculative waves of the past and the spirit of excess that accompanied them. This isn't a breezy book, like Liar's Poker or Barbarians at the Gate, which chronicled recent episodes of excess. Devil Take the Hindmost is a history that begins with the Roman origin of the word "speculation" and attempts to raise questions about why investors fall prey to the madness of crowds. In spots it could be clearer, but overall it is well-written, well-researched and important reading for anyone interested in the investment world.

Perhaps the most extraordinary of the speculative bubbles is the oft-cited but rarely recounted tulip mania. Buoyed by the disappearance of the Spanish military threat and by the booming Dutch textile trade, Dutch consumers in the early 1600s enjoyed the highest incomes in Europe. As prosperity spread, a market for tulips, a flower associated with nobility, blossomed. At the peak of the tulip mania during the winter of 1636, a pound of sought-after yellow tulip bulbs rose 60-fold to a level equal to five years' average pay or enough to buy four small townhouses. When the tulip market suddenly crashed in February 1637, there were few buyers at any price. Many investors, who mortgaged their properties for a chance of quick gains, were ruined. More than a year later, a government commission wiped out defaulted tulip contracts at 3.5 percent of their value.

The later South Sea Bubble took its name from a company that privatized a portion of the British national debt in return for annual interest payments from the British government and government-granted monopolies on trade with South America. South Sea then turned around and sold shares of stock to the public. As the price rose, more and more investors felt they had to buy in, much like today's momentum investors. The price had little connection to the modest interest payments from the government, and the South American trading operation was losing money. Nonetheless, the company's share price soared more than seven-fold and lured investors like the poet Alexander Pope, Sir Isaac Newton, King George I and the Bank of England -- before it crashed. Thousands of people were ruined, including the Bank of England's director, who was forced into bankruptcy.

These and later speculative bubbles share many characteristics, Chancellor notes. Often they are inspired by new technologies, such as the railroad, the automobile or the Internet, that promise to change the character of the economy. Sometimes they are inspired by a belief that new economic rules apply. After the establishment of the Federal Reserve in 1913, many investors believed that the business cycle could be abolished (a similar refrain has been heard recently). Other times bubbles begin with new theories of value that justify changes in the traditional rules of investing, whether it applies to tulips or the Tokyo real estate market of the 1980s.

The madness of investors is only part of the story, though. Corruption was central in deflecting government supervision, from the dispensing of South Sea shares to members of the 17th-century British parliament to the bribing of Japanese government leaders. Manipulation has often been to blame, as when railway tycoon Jim Fisk primed and deflated company stocks to suit his own investment positions. And government regulation has often been lax, from the minimal margin requirements of the United States in the 1920s to the absence of regulation of hedge funds in the 1990s.

Is there a difference between today's enthusiasm for AOL, America Online, and the 1920s enthusiasm for AOT, Any Old Thing? Is there a difference between the price paid on future earnings in today's markets -- where the ratio of price to earnings is roughly double historical averages -- and the 1920s, when it was said that investors were discounting not only future earnings but earnings in the hereafter?

"During the 1990s, the United States experienced a bull market remarkably similar to that of the 1920s," Chancellor writes. "Yet in the past a point has always been reached where both speculation and credit arrive at the limits of their expansion. At that moment the business cycle reappears with a vengeance . . . and the new era is consigned to history."

Steven Mufson, a former member of The Post's financial staff, now covers diplomatic affairs for the paper.