Throughout history, there have been occasions when mankind has gone into frenzied bubbles and then seen them collapse, impoverishing the innocent. The patterns are not identical, but they rhyme, with some common factors:
Declaimer: This article was originally in February 2020, and some data points may be outdated
- It starts with the power to create artificial money, by the fiat of the government
- It is centered around something exotic, a perceived monopoly.
- It is reinforced by Fear of Missing Out (FOMO) & gullibility, a mania among the crowds.
- The bursting of such a bubble creates a Trust Deficit, which affects all. Even normal commercial transactions grind to a standstill.
- Invariably, it is the real economy that suffers, while the financial economy rebounds.
The Learners in Economic History
We’re poorer learners in Economic History, perhaps because the consequences are maybe, less final. The results are a lot less nebulous, and the destruction of a man’s savings is not reported with the same seriousness as the destruction of his Life.
Throughout history, we have had occasions when there has been a sudden, cataclysmic drop in Confidence (this article mostly focuses on Financial Assets) and the resultant Loss of Trust. It is well-known that Capitalism, in fact, the fruits of human endeavor, follows directly the measure of Trust in the economy. Trust is a soft, nebulous thing, but it has measurables, which provide us surrogates for the level of Trust in the economy. Behavioral Economists have been spending time measuring Trust (cf. the famed Stolen Wallet Study) and come to the conclusion that Trust is a big indicator of Happiness & well-being, which leads to Net Economic Welfare (NEW).
The faith in money is one of the big indicators of Trust in the economy. And a collapse of the faith in money leads to a failure of Trust. Throughout multiple episodes in history, if you trace histories of Lost Faith, you will find multiple patterns, some recurring, some rhyming, which will help you to understand the current evolution of circumstances. Take Tulip Mania:
understand the current evolution of circumstances
- Europe’s travelers brought back exotic fruits and vegetables, as they went round the world. Potatoes, peppers, tomatoes, even Tulip Bulbs. The tulip was an exotic, attractive flow, which was not just rare, but fanciful. It first attracted the rich, especially the nouveau, the gentry that had just gotten rich from the Dutch East Indies trade. Just like in any public obsession, there were different varieties to appeal to different tastes, and like modern-day art, everyone had to have one. This converted a consumer product, a perishable, into a Store of Value, an ‘asset’ that would see a rise in value, as it went from one foolish hand to an even Bigger Fool. At one point, prices reached the impossible heights of 10 years’ of a tradesman’s earnings.
- Compare that with the 7 years’ income that you put down for a house today. Supply was restricted by the 7-12 years it takes to grow a bulb, so obsessions for a particular color or a pattern got exotic names, which created a Feedback Loop that some today would call ‘reputation’, somewhat similar to how ‘Umrao Jaan’ got her place in history. To this day, the Tourist High Season in The Netherlands is driven by the limited ripening cycle of its most exotic tulips.
A funny, simultaneous development was the development of a Futures Contract in tulips, which could be canceled if you had a loss (preventing Short Sales of the bulb). This little rule created one of the biggest bubbles in history, setting up the role of the derivatives markets in all bubble collapses. And gave the first example of the Bigger Fool Theory, now armed with the Moral Hazard that he could cancel the contract if he lost money. They did not call them Investment Banks & NBFCs then, that was a later development….
- By 1636, the tulip bulb became the fourth leading export product of the Netherlands, after gin, herrings, and cheese. The price of tulips skyrocketed because of speculation in tulip futures among people who had never seen the bulbs. It’s a long and entertaining story, that traces out the origins of most of our current ‘market practices’.
- The mania peaked in 1636, as some bulbs traded upto10 times a day, very similar to how IT companies accounted for more than 80% of the trading turnover at the peak of the bubble.
- The collapse began when, for the first time, buyers refused to show up at a routine bulb auction. This may have been because Haarlem was then suffering from an outbreak of bubonic plague. The existence of the plague may have helped to create a culture of fatalistic risk-taking that allowed the speculation to skyrocket in the first place; this outbreak might also have helped to burst the bubble. Does that ring a bell?
Then, coinciding with the rise of Britain as an imperial power, came the South Sea Bubble in 1711.
- The co was granted a monopoly to trade with the islands in the “South Seas” and South America, a non-existent business because Britain was at war with Spain, which, together with Portugal, controlled South America.
- The Bubble Act 1720, which forbade the creation of joint-stock companies without a royal charter, was promoted by the South Sea Company itself before its collapse. Everything that we now know: Price-fixing, cartels, insider trading, paying politicians to support laws, loans for share buybacks, persons acting in concert, market-fixing, gouging, talking up shares with business news, even renaming a Slave Trade as ‘business’, it can all be traced back to that time.
The collapse of this company, promoted its rival, the Bank of England to handle the national debt.
Around the same time, across the English Channel, a certain John Law created a Bank with paper money and came to the same conclusion that Mr. Nixon reinvented in 1971 (namely, that if you delinked Paper Money from its metal coinage, in this case, gold, you took on the greatest power on Earth).
In August 1717, Law bought the Mississippi Company to help the French colony in Louisiana. It had a trade monopoly in the West Indies and North America from the French government. The bank became the Royal Bank in 1718, meaning the notes were guaranteed by the king, Louis XV of France. Thereafter, Mr. Law went on an acquisition spree that would put our Indian industrialists to shame, funded by paper money that no longer had the backing of coinage.
The acquisitions ran so short of people, that Europeans had to be adopted (Germans, etc) and prisoners freed, then married to prostitutes, to be sent to the Mississippi Region. The shares were bid up by stories of untold riches from Louisiana, somewhat like the Indian media talked up NBFCs recently, IT in 2001, etc. The shares ran up so high, that Bank Notes had to be printed to pay for those shares, in a Feedback Loop (no, I think that was invented later). Then, lo & behold, the Bank & the Co was merged, the equivalent of RBI merging with RCom, and Mr. Law became THE LAW…. The whole thing ran up to a level that the French government had to admit that it did not have the metal to convert the Bank Notes into coinage. In 1720, there was a run on the Bank, which had the long-term effect of destroying confidence in The Crown. ‘Became The Law’ is still a term connoting a coming destruction.
This is perhaps the first episode that denotes The End of Money, albeit in the limited ‘civilized world’ of Europe. In every country that rose to the top of the European hierarchy (The Netherlands, England, France, Spain), there came a bubble that had to do with the definition of money.
Spain had its own story of the stolen gold from the Incas, some 6000 tons and 12,000 tons of silver. This is slightly less than the gold lying in Fort Knox and led to the first known episode of what later, surprisingly, came to be known as Dutch Disease: the phenomenon that if a certain enterprise (in this case, the Inca expeditions to South America) succeeds spectacularly, all other enterprise shuts down, and becomes unviable. This was spectacularly evident in Spain, which took nearly 150 years to recover from the deleterious effects of having too much currency.
Spain is the first recorded example of a phenomenon that has since been recognized by public policy. The Scandinavian countries, particularly Norway, ‘sterilized’ their windfall gains from oil, into a Sovereign Wealth Fund, which was mostly invested outside the country, used sparingly for investments inside Norway, and protected the Kroner from excessive appreciation by separating the Oil surplus from distorting the pricing of their other exporting sectors.
Spain had such a lot of gold that even barber shops started to charge in gold. The Incas did not consider gold as a precious metal. Attractive, yes, but NOT valuable. It used to be treated somewhat like how we treat Stainless Steel in our society today: shiny, and clean, but not valuable. I have always wondered why Indian women have not taken to wearing Stainless Steel trinkets if aesthetics was the sole objective.
It’s funny that the world values Gold, and it’s across cultures. With few exceptions. And the Incas, God bless their dead souls, were one such. They certainly could have bought better armaments, if not better soldiers, had they done that.
This Dutch Disease has a lot of recent parallels, particularly the story of Venezuela. I will skip the post-Adam Smith period in history, the 1800s, which seemed to avoid many of these bubbles, perhaps because of the rise in industrial productivity and the consequent increase in the purchasing power of money.
Till 1918. The Weimar Republic was the German state from 1918 to 1933.
In its fourteen years, the Weimar Republic faced numerous problems, including hyperinflation, political extremism (which led to the eventual rise of Hitler), and the WWI reparations, which drove it bankrupt. In trying to debase the value of its currency to reduce the burden of the Treaty of Versailles, it caused a collapse of domestic confidence, which resulted in the rise of Nationalistic Fascism.
The last year saw the German version of the Great Depression, coming from Bruning’s deflationary policy (not coincidentally, co-ordinated with the Fed’s tightening in 1929). The resulting bank failures (NOT the stock market decline) caused the Great Depression.
The political impact of all this has many parallels with current conditions, but that is the subject of another column. I will stick to economic history.
Cut to the story of Venezuela, another case of long-term Dutch Disease:
Venezuela has spiraled from being Latin America’s richest country to a poverty-stricken nation where 80% of the population lives below the poverty line. It is the worst economic collapse outside of war in more than four decades.
- Venezuela used to be a poor country, exporting coffee, cocoa, and leather. All that changed in 1914, when the first oil well was discovered. This attracted foreign drillers, and in just 14 years, Venezuela had become the foremost producer of oil in the world. By 1930, it was the biggest exporter of oil, but almost all of it was in the hands of the oil companies.
- In 1940, a huge tax on the oil companies transferred these riches to the government. This grew to a 50:50 sharing. Notice the ever-increasing greed of the government. This is the human condition, all extraordinary riches are nationalized & the country goes left-wing (Saudi Arabia, under America’s protective umbrella, has remained stable and right-wing).
- A right-wing coup in 1948-58 resulted in a military dictatorship, but the oil riches were distributed through welfare programs & infrastructure spending. By 1950, Venezuela had become the world’s fourth richest nation behind the USA, Switzerland, and New Zealand, with a GDP per capita of $7,424 (equivalent to around $77.5k/£62k today). By 1958, Venezuela’s GDP per capita was 90% of that of the affluent USA. It led to the creation of the multinational OPEC organization in 1960,
- During the 1960s, the Venezuelan government attempted to avoid the so-called Dutch curse and diversify the oil-reliant economy. Hydroelectric, iron, and steel industries were established, but the lure of oil was too great, and the attempts at diversification came to naught.
- By the 70’s, Venezuelan workers were earning the highest wages in Latin America, and heavily subsidized food, healthcare, education, and transport made for a comfortable life for many of the country’s citizens. The country ditched the 50:50 rule and imposed an oil profit tax of 70%, paving the way for the nationalization of the oil industry. The government upped spending on housing, education, healthcare and more, which further improved the standard of living for the average person in the country. Venezuelans had never had it so good. This is the recent history of Saudi Arabia, just rhymes with Venezuela.
- The first Oil Crisis saw huge riches for the government, which finally nationalized the domestic oil industry. In 1976, came the state-run monopoly Petróleos de Venezuela (PDVSA). This opened the door to corruption and Leftist dole-outs. By 1979, the country was mired in debt, despite the huge oil revenues. The low Oil prices of 1980 ran the country bankrupt. In 1983, the bolívar, Venezuela’s currency, was devalued on what is now dubbed Black Friday, sparking a severe economic crisis in the country. This brought in the famed Hugo Chavez, later compared to Stalin, who first attempted a coup. Venezuela’s banks failed in 1994 and government bailouts nearly destroyed the government.
- Between 1984 and 1995, the percentage of Venezuelans living below the poverty line soared from 36% to 66%, while extreme poverty more than tripled. This brought the now-pardoned, extreme Left-wing Chávez, who won the election with 56.2% of the popular vote and promptly changed the name of the country to the Bolivarian Republic of Venezuela, in honor of the revolutionary hero Simón Bolívar. The new president then set about dismantling the pro-market reforms enacted by Pérez, focusing much of his attention on the country’s oil industry.
- Clueless about how the industry worked, Chávez placed his close friends and associates in prominent positions within PDVSA, the state-controlled oil monopoly, and used it to fund his socialist welfare projects. Depleted of cash, PDVSA was unable to invest in heavy oil extraction – the country’s light oil supplies had been greatly depleted – and production plummeted. The strongman leader assumed the slowdown in supply would raise prices, but he was sorely mistaken. The 2008 collapse of Oil prices, proved to be the end of the old Venezuela. The murder rate in Venezuela, for instance, increased from an already high 19 per 100,000 in 1999 to an estimated 75 per 100,000 in 2011.
- In 2017, the Venezuelan economy was 35% smaller than it was in 2013 and GDP per capita had shrunk by a whopping 40%. Shockingly, over the past few years, the Venezuelan economy has contracted more than that of the US during the Great Depression and the economy of Russia following the fall of communism. The crisis had left 80% of the population in food insecurity, according to a 2018 nationwide study.
- For the year 2018, inflation was at a staggering 130,060% according to Venezuela’s central bank. Thankfully the rate of inflation dropped sharply to 9,585.5% for the year 2019, The Trump sanctions and the current collapse of Oil prices is the final death knell. The number of intensive care beds available in the country is barely close to 80. That’s from being one of the richest countries on Earth, barely 50 years back.
the US version of Dutch Disease,
The final chapter in this story is the US version of Dutch Disease, which is very similar to Spain coming upon the Inca gold, and losing all of its industry (like the US last lost its industrial backbone to China). The watershed in this chapter, over a long story, is Nixon’s delinking the Gold peg from the Dollar. The Dollar Peg is the equivalent of the Inca Gold, and you can see how the story rhymes.
The US today, is by far, the Store of Value (>60% of Central Bank Fx Reserves are denominated in USD) and the Medium of Exchange (>40% of global debt is denominated in USD, and >60% of physical world trade and >90% of Fx trading is in USD). Foreigners hold about 40% of US debt issued. Whichever way you look at it, the USD far outpaces the influence of the US economy in the world economy.
The rise of US consumerism came on the back of its ability to fund consumer debt and run huge deficits. It attracted immigrants for its IT industry, with the overvalued Dollar. If and when Confidence collapses, it will be global. China will be left holding trash in its cupboard, and the US will lose its ability to drive world commerce. The Indian opinion about the US Dollar is an important input towards holding up the currency. The final denouement of this episode of Dutch Disease, cannot ignore the fact that past episodes have rhymed:
- Whenever the issue of money (the medium of exchange & the store of value) has shifted to human hands (Tulip Mania, The South Sea/Mississippi Bubbles, the Spanish Inca riches, the Venezuelan Oil supplies, or the power to print the Dollar), it has led to bubbles, the debasement of the currency and an economic collapse. The US got control over most of the gold reserves in the world, and the USD was backed by a fixed amount of gold coinage from 1944 (Bretton Woods) till 1971.
- Like in the case of John Law, tiny tweaks that went unnoticed by the global community, led to huge changes later, somewhat like a snowball rolling downhill. John Law’s sovereign guarantee was misused to buy speculative assets, and nobody has noticed that both the BoJ and the US Fed are buying ETFs and junk bonds, risky assets that may not protect capital, let alone provide a return.
- Something similar was done by Richard Nixon, when he shifted countries from an implied Gold Peg (through a fixed Dollar: Gold exchange rate) to a Dollar peg, effectively becoming John Law to the world economy. It’s very important to understand this.
- The Oil embargo of 1973 created a higher supply of Dollars, which was met by printing Dollars. This would have caused inflation, had the agreement with Saudi Arabia to create a petro-dollar market (by ensuring that Oil can be paid for only in Dollars) not come into force. A circular economy, wherein Saudi dollars in the petro-dollar market, would be recycled through London Banks, to Asian importers hungry for Dollars to pay for Mideast oil, created a huge Ponzi pyramid, into which the US could park a new supply of freshly minted currency. This ‘concession’ was arranged by a quiet Security Agreement that kept the House of Saud in power over the years. So the Saudis bought insurance for their crown with the petro-dollar market (it later came to be known as the Euro Dollar market, yet another minor tweak, reminiscent of John Law.
- On the liability side, the US consumption boom took charge of the economy, from 57% to 70%, the entire Baby Boomer generation saw the benefits of the flood of printed cash, funded by the petrodollar (and later China) markets, and borrowed by the Boomers in an ever-rising Ponzi that has not yet come home to roost. So the world’s dominant currency issuer is also the world’s largest borrower, but this little contradiction has not been noticed in more than 50 years.
- At one level, you wonder who is fooling whom. Saudi would not know what to do with their oil, and China would have a serious problem with its people (so would India, come to think of it) if it did not keep them in the factories, working away for those sham Dollars. Government debt, at 106% (up from 68% in 2008) doesn’t look excessive, except that it is 40% external debt, something no other country in the world has the guts to do. A sudden loss of confidence would create a Currency Crisis, which would bring the US down to the situation of Greece. Japan and China have debt, but it is all domestic, funded by the massive Savings hoard of its people. In the case of Japan, they are still the largest creditor nation on Earth.
- A trigger, such as a virus, that freezes global activity, hence Oil demand, would have unforeseen consequences. The impact on Venezuela can be estimated, with their Fiscal break-even cost at $118 per barrel of oil. The new stimulus of $2 trn, betrays confidence in the USD, which might be misrepresented. This becomes the biggest risk to the world economy, the echos of which would be remembered long after the virus is a faint memory.
So far, we have only seen local bubbles throughout recorded history, limited to a country or a region. What the Europeans used to call the Free World, the Civilised World, was not the whole world. This time, except Antarctica, it IS the entire world….
