Thursday, October 23, 2008

Financial markets and change

Lately, I've been re-watching an excellent series of videos on the Industrial Revolution. The show tries to explain, in part, why the Industrial Revolution happened in England, and not in, say, Holland or France, either of which would have seemed more likely candidates to contemporary observers.

Their answer is that many unusual ingredients were required to go from a pre-industrial, static world to an industrial one in which growth was expected. England happened to have them all at the right time.

One of these ingredients, the show argues, was the existence of modern-style financial markets.

In general, before the 15th century-ish we don't see much paper trading in Europe. No stocks, bonds, or other fancy financial instruments. When people bought something, it was usually because they actually wished to own the object or service in question. If someone paid for the construction of a church, it wasn't to 'flip' it. It was because they wanted a church there. There wasn't much lending for the simple reason that most religions frowned on usury, and the law of most lands paid at the very least lip service to religion.

All of this contributed to the static nature of society. Things didn't change because no one was willing to take the risk. People bought what THEY wanted, and not what they hoped other people would like. Producers produced to known tastes, with changes in style or technique being unusual and revolutionary. There were relatively few risky ventures. Society consisted of haves, and have-nots. If you had money, then you usually were in a position to continue to have it. There was no reason for you to risk tossing it all away on something that may not pay off. If you didn't have it, there was (almost) no one willing to lend you the money, because they wouldn't be able to charge a very high interest rate, if any at all.

In general, then, yes, I'd definitely agree that the existence of modern-ish financial markets is absolutely necessary for the kind of prosperous, innovative, dynamic society we've come to know and love.

That doesn't mean that it's without its pitfalls...

According to the video, the Dutch invented modern finance. I'm not sure I agree with this, but let's take it as given for the sake of argument. If nothing else, the Dutch were certainly popularizers of the practice.

Holland started trading paper. A lot of it. Prior to the 17th-ish century, when you bought a share in a ship's voyage, that's exactly what it was. Trading ships were expensive, and so were trips to the Indies, not to mention risky. You bought a share in the ship in order to share your risk with other investors. When it came back to port, you took the corresponding share of the profits from her cargo. If she failed to return to port... well, you had a problem.

The Dutch made popular the practice of trading shares in these ships. Cargo futures, if you will. Instead of holding them to maturity, you'd sell your share to someone else, who could then hold it or share it, and so on.

The same happened with other types of risk and stream of income or future windfall.

What was one of the first uses it was put to?

Tulips.

The video series dwells on this for quite some time. Essentially, what happened was this:

Tulips were new to the Dutch. They imported them from the East. Certain kinds of tulip had ink-blot-like markings. These were considered especially beautiful. ulips grow from bulbs. Bulbs all look pretty much alike and don't tell you what the future flower will look like. Today, we know it was the mosaic virus that caused these markings. Back then, the Dutch thought it was just random chance.

What took place next may look a little familiar...

At first, people bought tulip bulbs because they actually valued the tulips they might grow into.

People noticed that some tulips were selling for extremely high prices, and decided to start selling tulips.

Other people noticed the people who noticed the rise in tulip prices, and joined in.

The rise in people buying tulips raised the price of tulips - even though these people were only buying them in order to sell them at a higher price later on.

The higher the price became, the more people joined in the market, driving the price even higher, which attracted more people.

Eventually, it all fell apart when a few people decided to... NOT pay the price of a house for a tulip bulb.

The Dutch economy went through a crisis, and people left holding tulips lost everything.

This type of bubble happens over and over again.

It's always caused by a large sum of people buying an asset only in order to sell again, without ever intending to act like an owner of the asset.

The bubble gains momentum when the relative price of the asset that is being traded rises for an extended period of time. (The relative price is the price of the good compared to the price of other goods in the economy. Let's say that tulips and onions both start selling for a dollar each. If the price of BOTH goes up to 2000 dollars each, that's not very interesting. If the price of ONLY tulips goes up to 2000 dollars, while that of onions stays at 1 dollar, then there's a problem.)

The tulip bubble is striking because everyone KNEW they were just flowers, and yet jumped in anyway.

The lesson? Buying to sell to others who are buying to sell is a good way to start a disaster. Modern financial markets make this easier than in earlier times, but in the end, the responsibility lies with the investors.

That's easier said than done, of course. It's difficult to stay out of it when someone tells you, 'sell me tulips, even if you think they're over-valued and part of a bubble about to crash, and I'll give you a hefty management fee'.