Past performance is no guarantee

A stock trader looks across 500 years of market turmoil - and blames government

New communications technologies paved the way for an astonishing stock market boom. Ordinary citizens quit their jobs and devoted themselves full-time to playing the market. And major corporations fell apart amid corruption and fraud scandals.

A recap of the last few years in the world's financial markets? Try the last few hundred years. In his comprehensive and readable new book, B. Mark Smith details the history of the global stock market and shows that, no matter what seemingly new headlines the financial world produces, we've invariably been there before. But despite the tumult, more and more people in more and more places have bought into the "equity culture," trusting their financial futures to economic forces beyond their control or understanding.

A former stock trader with major US investment banks, Smith couples an insider's insights with a deep understanding of the intellectual breakthroughs that have shaped global finance since the 15th century, when Italian city-states developed the first rudimentary securities markets.

He devotes much attention to the various market crashes of the last several centuries, offering strange anecdotes of market euphoria. On the streets of Paris in the early 1700s, for instance, a resourceful hunchback "leaned against a mulberry tree and rented out his hump," allowing frenzied investors to write out their contracts for stocks. Now that's a bubble!

Smith also offers perspective on the sages and scoundrels who have built and bilked international markets throughout history. There was John Law, a gambling goldsmith who somehow gained control of French economic policy in 1720 and used it to support the share price of his own trading enterprise. Jay Gould and Jim Fisk secretly sold shares of their company, Erie Railroad, and tried to use the proceeds to bribe US President Grant. And contemporary speculator George Soros "broke the Bank of England" in 1992 by selling billions of pounds in foreign-exchange markets until the government capitulated and devalued the currency.

Despite these tales of scurrilous behavior, "The Equity Culture" offers a suspiciously recurring explanation for virtually all market debacles: The government did it. Again and again, Smith reproaches meddlesome governments for triggering market misfortunes. Government actions rig the market and investors merely take advantage - a so-called "rational bubble."

The decade-long collapse of the Japanese stock market during the 1990s and Taiwan's abrupt market plummet in 1990 resulted, he claims, more from state intrusion and "manipulation by powerful institutions" than from the carelessness of investors.

At times, his dour view of government policy is, well, right on the money. For example, the Federal Reserve deserves a decent share of the blame for the crash of 1929. But can we conclude that if those pesky bureaucrats just got out of the way, global markets could work their magic and make the world rich?

Maybe not. Two recent episodes in global financial markets - which Smith inexplicably omits - reveal how market players can make a mess all by themselves. In 1995, Barings, a venerable British investment house, suddenly became insolvent due to the unsupervised transactions of a lone 28-year-old trader in Singapore. And in 1998, the unexpected swoon of a Connecticut-based hedge fund called Long-Term Capital Management threatened to upend the US financial system. The Federal Reserve Bank of New York hastily coordinated a rescue package with several Wall Street banks. Apparently, government can help out occasionally, too.

Such omissions aside, Smith is most impressive when surveying the academic ideas and unlikely thinkers that have influenced markets over the years. For instance, in 1900, a French doctoral student named Louis Bachelier published a dissertation that would revolutionize financial markets. His "efficient market hypothesis" claims that prices on stock exchanges represent the best possible valuation for any given stock. Similarly, in 1934, Ben Graham developed the notion of "value investing" and is now widely regarded as the father of modern security analysis. And in 1980, economist Robert Shiller helped develop the "behavioral" view of markets, which posits that irrational investor sentiments influence prices in inefficient ways.

Sometimes these thinkers capitalized on their insights and made money. Others missed out. For instance, young Bachelier's dissertation was awarded a mere "honorable mention" by his professors, rather than the "very honorable mention" needed to secure academic employment. Apparently, in the intellectual marketplace, just as in any bourse around the world, even the best ideas can be severely undervalued.

Carlos Lozada is the managing editor of Foreign Policy magazine.

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