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FINANCIAL MARKET HISTORY

DAVID CHAMBERS AND ELROY DIMSON, EDS,

 

CFA Institute Research Foundation, Univ. of Cambridge, U.K., 2016, 278 pgs., notes, bibliography, graphs, paperback. This is essays by 22 financial academics focused on what went wrong in 2008 and the modern history of financial markets, role of central banks, understanding of risk, investment methods and more.

 
 

Reviewer comments:
The content is packed with data, detailed information and analysis. The subject is history in both the material and imaginary realms. The material world is the history of facts about interest rates, money supply, inflation, financial policy, and the events and actions of real people. The imaginary realm is the history of thinking about these subjects and expressing opinions about them. Each essay includes its own extensive, focused bibliography. The prose is clear and conclusions are well expressed. But 'reader beware' this is not for the casual reader. To gain a full understanding of the interrelated subjects will require study, attention, and perhaps recourse to other sources, such as from the bibliographies.
A lead section contains enlightening bibliographies of the authors, fully establishing their credentials. The authors are very kind, probably not on purpose. The conference and the essays are an effort to increase attention on and study of the actual historical record and the many theories that claim to be based on factual history. While hoping to increase such efforts they describe the many, various, difficulties, such as lack of actual records, and biases in the reported data. They are kind, first of all, in not mentioning the political and personal biases of the various creators of the predictive methods that they evaluate. But, more broadly, they don't mention that a very large and significant number of economists don't even look at real history, but base their elaborate economic -especially econometric - theories on deductive reasoning - it is theory first, facts afterwards to support theories or reliance on the received economic gospel selected from long ago authors they claim are famous.

 
 

Preface:
This section describes the content and its organization into sections and chapters. These essays are the result of a 'workshop' held at the University of Cambridge in 2015. The genesis of the conference: "Since the 2008 financial crisis, there has been a resurgence of interest in economic and financial history among investment professionals." The third section is focused on 'bubbles' a subject that has generated many books and articles since 2008.

 
 

Introduction:
By Stephen Brown: He mentions his career as an educator in the financial management field. He elaborates in detail the content of each essay and its author(s), summarizing their subjects and their views on them.
The first section studies the 'trade-off of risk for return from an extensive analysis of historical returns on equities, bonds, and other assets."
The second section relates the "historical evolution of how financial claims are traded." The process pits bankers and investment management firms versus stock traders.
The third section discusses the common idea that "financial markets are inherently prone to irrational exuberance and bubbles."
The fourth section narrates the history of financial innovation since the 18th century.
A final monograph in which Barry Eichengreen "argues that the research frontier in financial history will be driven by current concerns motivated by the 2008-09 financial crisis." But, that: "looking to the past may not of itself allow us to predict what might happen in the future...."

 
 

Part 1: Risk and Return over the Long Run

 
 

1 Elroy Dimson, et al., Long Term Asset Returns:
The three authors (Elroy Dimson, Paul Marsh, and Mike Staunton) describe their research work from which they have created a DMS Dataset of the annual returns (stocks, bonds, and bills, plus inflation and exchange rates) of 21 countries from 1900 to 2016. They describe their methodology. They depict the results in 7 graphic figures.
Their conclusion: During the 20th century there was a very significant transformation of the size of stock markets and their content of industries included. They found that during that period the returns on investment in stocks "outperformed" bills by 4.2% annually and of bonds by 3.2% annually. During that century the relative values of national currencies 'fluctuated considerably'. The Swiss franc strengthened while most other currencies weakened against the US dollar. The fluctuations were caused mostly by rates of inflation. They include 7 appendices - tables of statistics on the returns.
The prose is clear - but its analysis will require considerable study.

 
 

2 Antti Ilmanen, A Historical Perspective on Time-Varying Expected Returns:
The author describes the content: "This chapter discusses the evolving thinking about time-varying expected returns. the reasons behind it, and its practical relevance in today's environment of low expected returns." He has organized the material into sections:
Introduction
The expanded research in market history has shown that expected returns on investments are not constant but change over time. Dr. Ilmanen is concerned that investors are overconfident that since market returns change they can 'tine' these changes.

Shifting Conventional Wisdom from Constant to Time-Varying Expected Returns
He finds that investors in bonds look first at current market yields. But investors in equities rarely begin with that, rather, they look at long-term future returns, considering the average return over time. In other words they consider the 'average' return to be equivalent to the 'constant' return. He notes that Bill Sharpe's standard asset pricing model theory (CAPM) presupposes a constant return. He also describes the 'random walk' theory and 'efficient market' theory. In the 1980's behavioral economics became popular and favored by Robert Schiller and Larry Summers. The theory that long term market predictability would be possible became popular. He mentions Eugene Fama and Kenneth French. In the 1990's Robert Schiller created his CAPE ratio. Then the tech boom and bust cycle again changed 'conventional wisdom'. He continues the narration of the seemingly cyclical shifts in economic theory between pro and anit- predictability views.

State of the Art: How to Predict Asset Returns?
Dr. Ilmanen cites his own book, Expected Returns: An investor's Guide to Harvesting market Rewards' in which he wrote that 'the assessment of expected returns is as much art as science". He discusses the rational and irrational explanations.

Focus on Value- or Yield- based Expected Returns
He notes that there are now many theoretical methods being proposed so describes two. One is the expected real return based on the inverse of the Shiller earnings yield. The other is based on the dividend discount model. He depicts these in a graph.

Promising Forecasting Ability and Disappointing Reality
He analyzes the theories on which the two methods depicted in the previous section graph. His evaluation: "However, let's get more realistic. First, this evidence is 'in-sample', and second, it may not work as well over shorter horizons. His subsequent comments are also adverse.

How Can Investors Better Take Advantage of Time-Varying Expected Returns?
"One constructive approach for tactical market timers is to combine both contrarian and momentum signals; for example, when market valuations signal cheapness, it may be worth waiting for a confirmatory signal from momentum that the market has turned."

Conclusion:
Good advice for the amateur reader: So the returns one might expect from investments are not constant but rather vary over time. Prediction, especially of the future, ain't easy. His recommendation "Well-diversified strategic exposures across many rewarded factors may be the most reliable way to earn consistent long-term returns".

 
 

3. Jan Annaert et al., Financial History Databases: Old Data, Old Issues, New Insights?

The authors question the validity of the data in earlier historical constructs. |

Introduction:
The problem: "The recent financial crisis again highlighted the weak empirical foundations of the economic and financial analytial models used to study stakeholder expectations financial innovation, regulations, and investment strategies."

General issues
One of the problems with collecting stock and bond indices is the 'easy data' bias. That refers to the over use of that historical data that is easy to obtain. "Another problem is selection bias". Wars and government regimes may distort or simply not enable obtaining data. "Survivorship bias is a special case of selection bias.".. "The indices that are available are not necessarily representative of the investable universe." There are other problems as well.

Stocks
The quality of data about stocks is highly variable and subject to variations in the real time frame. The authors mention many more problems.

Bonds
The authors note that many of the same problems with stocks are shown for bonds. Plus
bond markets show even more diversity that equity markets." The structure of indices varies such as for issuers, maturity, coupon payment and liquidity. They provide tables as illustrations of the use of approximations for data.

Conclusions:
They note that financial data indices can be "only partially compared across time and space." They expand the details in tables in an appendix.

 
 

4. Olivier Accominotti, Foreign Exchange Markets and Currency Speculation: Historical Perspectives
The author first provides a brief history of the development of currency markets in the Middle Ages. That was an era in which multiple governments minted coins of various domination and quality - both of the metal and the minting process. But the necessity of establishing the relative 'value' of different coins began in ancient times, a service provided by the 'hated' money changers mentioned in the Bible. But the role of money changers who provide a service for a fee is not the subject of interest in this chapter. Rather, it is the activity of speculation in the money market, not as a service to people needing comparison values between different currencies. This is accomplished by betting on expected changes in relative values and investing to profit from being correct.
Dr. Accominotti organizes the information in the below topical headings.

I am not interested in speculation on the FEDEX so won't comment much here

Introduction
Interesting data point: "Between 2001 and 2016 the global turnover on currency markets increased from 1.21 to 5.1 trillion US dollars per day. The foreign exchange market is now considered the largest financial market in the world."
Why is that? Is it due to expanded world trade? NO. "The once dominant form of dealings, spot transactions, have now been surpassed by such derivatives as foreign exchange swaps, outright forwards, and currency options. Derivatives are now the most actively traded currency instruments. " In other words the original purpose of a market in which businesses and countries could exchange one currency for another to finance the exchange of real goods and services. But now the exchange market is dominated by the speculation in imaginary financial 'values' on ledgers in computers. The question that intrigues economists is - are the traders making a profit? They are obviously risky. The author's investigation suggests that, yes. it is possible for the traders to make a profit. Unmentioned is the well known fact that the 'house' always makes the real profit. The authors do not mention or consider WHO makes the market? Who owns the casino? Judging from the published financial statements of such outfits as JPMorgan my guess is that the consistent profit accrues to the quickest fingers on the trading desks at the biggest banks. Read Nassim Talib for some 'inside' comment. But Lombard Street has not been excluded - don't forget the 'whale'. Also, the authors do not mention that in the olden days when international currency transactions were balanced by shifting accounts measured in gold there were some limits that do not exist today when institutions are shifting imaginary accounts.

Foreign Exchange Markets and Speculation in History Currency Markets from the Middle Ages to the Early Modern Period
This topic is dexamined in the following sections.
Developments in the 19th and 20th Centuries
The Emergence of Foreign Exchange Derivatives
Fixed and Floating Exchange Rate Regimes
Long-Run Evidence on Currency Returns
Currency Speculation Strategies in the Post-Bretton Woods Period
Currency Returns over the Last 100 Years
Currency Investor Case Studies

Conclusion
This chapter provides a historical perspective on currency speculation and currency returns. Speculation in currency values is an ancient activity. The evidence from the last 100 years shows that it may be profitable but is very risky.

 
 

5. Christophe Spaenjers, The Long-Term Returns to Durable Assets

Introduction
This subject deals with an important subject because such assets comprise a major part of the 'wealth' of many families. And institutions such as insurance companies and endowments are also considering these assets as a means for 'diversifying their total wealth. Analysis of the 'value' of these assets is difficult, for one reason, because it is difficult to evaluate the risk involved. They may also be illiquid, especially in a crisis. The author has focused on the capital gain (or loss) generated for the assets rather than the dividend income they might create.

Housing and Land
He summarizes the long-term real (inflation-adjusted) prices for US and UK real estate between 1900 and 2014 in a table. He uses the Shiller price index since 1953, and farmland values per acre starting in 1910. From the table he observes that the long-term appreciation has been low. During the first few years land actually lost relative value. His conclusion, no doubt, will disturb real estate salesmen.
He does not venture an opinion on why this occurred. For one obvious reason he uses farmland rather than urban real estate. And farmland lost value because agriculture (food production) lost value after WWI when wartime demand declined and then declined even more during the depression of 1930-50. It shows a dramatic increase from about 1950 to 1980 when agriculture was generating huge increases in food per acre. Housing prices are influenced by demographics.

Collectibles
For collectibles he considers art, stamps, wine, and violins. For art and stamps the obvious reason for the declining years is World War I, when money was not being spent on such things. For wine the decline in 1949 is likely due to the greatly increased in supply when post WWII wine became available.

Gold, Silver and Diamonds
His graph and table are interesting. Probably the fluctuations can be correlated with events. The one obvious example is the dramatic spiked rise in gold and sliver in 1980-1 and then rapid crash. This was due to the Hunt brothers attempt to corner the silver market generating the huge upward spike followed by the rapid decline when the US government intervened. The simultaneous spike and decline is gold was due to investors presuming that the then popular idea that gold is valued at 15 times silver generated the speculative reaction.

Diversification and Inflation Hedging
The author uses regression analysis (least square variations) and finds some positive and some negative covariance with equity market, bond market and inflation.
Conclusion
He considers that they " are unlikely to be good inflation hedges, but they may still help diversify a portfolio because of their imperfect correlations with financial assets." He shows that the returns on these assets over the 20th century "had relative low capital gains and substantial price fluctuations."

 
 

Part 2: Stock Markets

 
 

6. Larry Neal, The Role of Stock Exchanges in Financial Globalization: A Historical Perspective

Dr. Neal provides the historical background of the increasing number of stock exchanges since 1973. He cites the World Federation of Exchanges list showed 189 exchanges in 2015. Prior to WWI experts listed 89. Not only the number of exchanges has increased but also the volume of shares and the volume of trade in such shares has increased. He provides two tables, one showing the capitalization on the London, Paris, Berlin and New York exchanges before WWI and the other showing capitalization versus GDP on several exchanges in 2015. Also, the structure and ownership of the leading exchanges changed, and so has the functions from which they derive most of their income. They are now corporations having shareholders and 'they all now seek ways to generate overall profits for the exchange and their shareholders, whether by creating new products or attracting new customers." "Their customers now consist of institutional managers of huge portfolios held on behalf of pension funds, insurance companies, state and local governments, sovereign wealth funds, and hedge fund investors." ... "they seek profit from the volume of trades."
In other words the exchanges are casinos that profit from the volume of traders (gamblers), who are professionals whose custom requires the exchange owners to cater to their needs - NOT those of the simple, individual investors. But these 'institutions' are themselves playing with other people's money - including that of those individuals who are themselves attempting to profit from their investments in the same assets. He refers to the best selling book, Flash Boys as "a story of the centuries old conflict between bankers and investment management firms, on the one hand, and stock traders on the other, about the best way to serve their clients."
Meaning, who will retain the most profit from client fees. He describes some of the hidden activities.
He mentions the competition between banking institutions whose interest rates for customers (depositors) were set by government and mutual funds that paid greater interest. One result was customers ( depositors) shifted funds to the second resulting in bankruptcies of some of the first. (Savings and Loan crisis)

How Did the Separation of Banks, Markets and Regulators Begin?
Dr. Neal begins by discussing the British national debt in the 18th century, which expanded to fund the wars with France. The debt was denominated largely in the BoE consols, which were traded by increasing numbers of brokers, as Bagehot describes. He shows that 1801 was the year that these traders (initially 260 in number) decided to establish an organization and location in London to regularize the activity and exclude crooks, that is, traders, that were jobbers or brokers, likely to go bankrupt. He names the place "London's Exchange Alley" but Bagehot names it as "Lombard Street". The organization became the London Stock Exchange. He notes the result was the separation of ownership from operators. The operators wanted to exclude anyone of doubtful risk. The owners wanted to increase the membership as much as reasonable because membership cost a historically fixed entrance fee and new members would generate more new customers. Thus, the London Stock Exchange grew with world wide connections during the following century, until 1876. Members were prohibited from having anything to do with a bank. Memory of the role of banks in the 18th century 'bubbles' did not die. Jobbers were market makers who held an inventory from which they bought and sold, profiting from the difference between bid and ask prices. Brokers represented their clients seeking the best price for buyers or sellers.

Owners versus Operators
Dr. Neal describes the most dramatic test of the LSE structure in 1822 when younger or newer members defaulted, having previously laid off their risks with option contracts made with the older and better capitalized members, who then suffered losses. This generated a battle between the two groups of members. The issue then involved Parliament. He continues with the fascinating story of that battle and subsequent developments including the establishment of a Foreign Stock Market to deal in securities being created by the expansion of trading in world wide trade and investment.

London and the Provincial Exchanges
In addition to the LSE there were regional or local stock markets which dealt with each other. With the advent of the telegraph and rapid communication a new type of trader was able to profit from buying in one market and selling at a higher price in another. And banks were able to establish branches in many locations.

Foreign Alternative Financial Systems
The different legal and political conditions in the other major countries resulted in the stock markets there performing basically the same functions but with different methods and organizational structures.

Conclusion
Dr. Neal discusses the situation since 1971. One change since the 19th century is that owners of an exchange became the operators of that exchange. Competition between exchanges increased.

 

7. Caroline Fohlin, Frictions: Lessons from the History of Financial Markets

Introduction
Dr. Fohlin decribes her essay. "The basic theory of microstructure pits traders and market makers against one another in strategic games in which players strive to maximize their profits."... "In this chapter, I offer ideas on what lessons we might glean from the history of financial markets, focusing on microstructure history....I lay out the major issues that pervade market microstructure analysis, regardless of the era."

Financial Market Microstructure
"The key insight of microstructure theory is that asymmetric information causes frictions that impede market quality." ... "the study of microstructure is fundamentally the study of transaction costs -- how they arise and why they vary -- across securities and over time."

A Brief History of Financial Market Development
"Most securities markets evolved out of markets that traded in either commodities or commercial paper; as a result, the originators tended to be merhants of some sort." And the security in largest supply and demand initially was government debt - that is, government purchases exchanged for paper credit. Dr. Folhin does not mention it, but most of that debt was to finance war.
-- Call Auction versus Continuous Trading. This method was used with small quantities of individual securities when the traders gathered to announce to each other the bid and sell prices on offer until compromises led to clearing the exchnge. Later, when the volume and variety of securities on offer at a large exchange, such as the NYSE in 1872, a specialist in certain securities was stationed at a specific post, where he could adjust the bid and sell prices.
- Trading Technology and Speed. Dr. Fohlin makes the siginficant oint that all activity requires the collection and availability of information. Hence, the developing technology for collecting and disseminating information was key to successful expansion of the trading markets. Naturally, he discusses the telegraph from 1844 and telephone at the NSE in 1878. The first telephone call between NY and San Francisco was in 1914. Today, of course, we have electronic tranmission between computers.

What We've Learned from Historical Analysis So Far
Dr. Fohlin notes the recent significant expansion of available data enabling research and analysis. One benefit he highlights is "Market Competition is Good for Investors" He explains why. Another conclsion is: "Market Liquidity Reflects Information Flow" - Illiquidity increases when surprises suddenly reveal risks. And that may increase the spread in prices. It can also increase fixed transaction costs
- Opaqueness Damages Market quality, especially during crisis. Crisis means 'panic'. These come and develop from information problems.
- Uncertainty Shocks Destabilize Markets, and Interventions Can Restore Order - He uses the sudden financial crisis that increased volatility and spreads athe sudden advent of WWI, which caused stock markets to close until uncertainty was reduced.

Conclusions
Despite the modern development of high speed techical market operations, there are lessons than may be learned from financial history.

 
 

8. Carsten Burhop, and David Chambers, Initial Public Offerings: A Historical Overview

Introduction
The authors identify three fundamental questions that prospective investors need answered when considering to buy and state the answers that 'empirical evidence" indicates.
1 "How soon can the firm go public? answer: IPO's tend to exhibit substantial flucuation in activity over time.
2. What price wll we get for our shares? IPO's are, on average, underpriced andrise in price in initial trading;
3. How will the shares perform after the IPO? IPO's tend to perform poorly over the long run."
They analyze the historical information under the following headers.

Historical IPO Data

IPO Cycle

IPO Underpricing

Long=Run IPO Performance

Concluding Comments
Financial historians have answered the questions based on the historical evidence.They consider that investors will be 'disappointed' - although 'in the case of the Unitesd States, these IPO's may well not have performeed any worse than seasoned firms with similar characteristics.'
I believe what they are recommending is for investors who are not the insiders who invested before the IPO, it is better to wait until the initial IPO activity has passed and then consider the value time has shown.

 
 

Part 3: Bubbles and Crises

 
 

9. William N. Goetzmann, Bubble Investing: Learning from History
Now we come to what I consider the most important issues.

Introduction
The attention given to famous bubbles and crashes is well known and the subject of media attention. But Dr Goetzmann argues: "that using past crashes in this way is misleading to both investors and policymakers." He claims that: "Particularly during periods of market booms, focusing attention on a few salient crashes in financial history ignores the base rate for bubbles". "not all booms resulted in crashes. He has reached his conclusion based on "empirical evidence drawn from more than a century of global stock market data." He presents much data in graphics.

Data Markets and Bubbles
History identifies market 'bubbles' starting with the 15th century in German mining shares. His graph depicts the great fluctuations in share prices of the San Giorgio bank in Genoa during the 16tb to 17th century.

Analysis
He ceners his analysis on the data created in the DMS and JG/ICF data bases. The information is presented in a large table titled 'Sumary Statistics for Global Markets', in which are presented markets in 35 counries for various time periods between 1900 and 2014. He describes the sources for the data. For this he defines 'a bubbls is defined as a boom followed by a crash, A boom is a large, raid increase in stock prices. A crash is a large, raid decline inmrket prices." In the next table he provides data on 'what happened when a stock market doubled or halved in value.' And in the next table he shows what happened in specific years for the markets in those countries.

Conclusion
His conclusion is somewhat reassuring. "The most imortant thing a financial historian can tell investors about bubbles is that they are rare". He continued by noting that actual recent evidence is lacking. The DMS data presented in the first chapter provides 'some insignt into the rarity of bubbles showing that the overwhelming proportion of price increases in global markets were not followed by crashes."

But by his definition a price increase that was not followed by a crash was not a 'bubble'.

He has noted previously that stock markets (like other variables) will revert to their mean - so up is followed by down and down is followed by up. All efforts at prediction involve uncertainty. He observes that regulators should consider whether or not an intervention to 'deflate a bubble' is the right course. But, again, the price increase wasn't a bubble until after it 'deflated'.

He recommends that historians study the many 'bubbles' that have not benefited from this research.

 
 

10. Eugene N. White, "The Fundamental things Apply": How to Face Up to Asset Market Bubbles
Dr. White discusses the issues by answering the following questions. He presumes that: "Bubbles in asset markets are propelled by investors' belief that some industry or the economy in general has entered a new era of unparalleled expansion - an era in which fundamentals that previously dictated more limited growth do not apply". His purpose in writing is to help investors (what about consumers?) see the 'opportunities and perils' involved.

I question whether this is the actual cause. For one thing, the price level of the entire available assets may rise when a government increases the nominal supply of 'money' (which reduces the real value of money') while the supply of goods and services available to exchange in the market does not increase sufficiently to absorb that free money. Or the nominal 'value' of all or even only a set of assets increases because a government is buying (confiscating) a greater quantity of the asset in competition with the desire to buy by the private sector. And David Fischer Hackett reveales in his famous book "The Great Wave' that there were periods of dramatic price increases, while the supply of currency available to consumers increased greatly absent a relative increase ( sometimes actually a decrease) of the assets available for consumption. Moreover, a dramatic increase in a price level may occur before most consumers recognize it until after the fact.

Question 1: Do Bubbles Exist?
Dr. White prints a series of equations that depict what he terms 'fundamental principles of finance' which 'require that the price of a stock at a point of time, P, equals the present discounted value of all expected future dividends." These boil down to the calculation of Price to dividend ratios and price to earning ratios. He notes that there are problems with these ratios. He notes the influence of human behavior. He also notes the academic controversies such as the questioning of Robert Schiller's measure to identify fundamental prices.

Question 2: Can A Bubble Be Measured?
He offers a truism: "The diversity of opinon within the economics profession about the presence and magnitude of bubbles is striking. "

May I mention that the divrsity of opinion among academic or other economists about nearly all of the subject matter they have brought within their demesne is immense and frequently the venue for 'heated' (an understatement) personal vituberation ? There is no consenses on how such measurement can be performed, when the metric by which it might be measured, itself is questionable.
He cites someopinions, sch as fheld by Manard Lord Keynes,. Robert Schiller, and John Cochrane. Dr. White posits seven comon features he believes can be found in 'bubbles'. And he presents these as being meaningful in a table of 11 famous bubbles.

He identifies the reality: "Identification of the fundamentals driving a rapidly rising market and then causing it to collapse has proven to be notoriously difficult"... "The problem of constructing a model to separate out the fundamental and non-fundamental factors driving asset prices is that if fundamentals do not completely explain price movements, one cannot claim there is a bubble element because the model may be mispecified or some variable mismeasured or omitted." He continues by citing other problems.

Question 2: Should a Bubble Be Popped?
Naturally, since there is so much controversy and so little understanding, the role of goveernment and central banks in "attempting to suppress or pop asset bubbles lacks agrement". He discusses the events of the 1920's in the US and the Federal Reserve's actions in 1929 and subsequently. He then discusses government responses to the French Mississippi bubble and the British South Sea bubble. He describes FED chariman Ben Bernanke's unprecedented actions during the financial crisis of 2008.

Question 4: How Can An Investor Protect Herself/Himself?
With great dificulty. The author repeats that bubbles "present both a danger and an opportunity for the investor."

Conclusion
His basic conclusion is be careful and learn from the experience. The bibliography includes excellent references including several dated post 2008.

 
 

11. Charles Goodhart, Financial Crises
This topic is different from 'bubbles' and their collapse but financial crises may be created by that collapse.

The Facts
Dr. Goodhart considers that much can be learned by study of potential crises that were averted. He begins with the potenetial default of Mexico Argentina, and Brazil in 1981-82, which would have been a world disaster if not averted. He notes that in some other situations it was government inaction or inappropriate action that made the crisis "more severe and longer lasting". He identifies the US in 1929-33 and Japan in 1991-95.

Causes of Crises

Macroeconomic Effects of Crises

Possible Cures for Crises?

Conclusions
Unfortunately, "Economic agents default on their promises to pay (IOU's) on a regular basis. Then other people's IOU's may become questionable and then not acceptable for payment." Banks are considered more trustworthy but also are not riskless. And when a bank fails that might call into question by other depositors or creditors and generate a general 'run'. No one can forcast when a crisis will hit. "But we can discern when they may become more likely- for example, when there is an asset boom largely financed by bank credit expansion in a context of general macroexconomic over-optimism." We may,'to some extent' be able to "alter the structure of the banking and financial system to make such crises less frequent and less virulent." But recent attempts have been "misguided".

 
 

Part 4: Financial Institutions

 
 

 12. K. Geert Rouwenhorst, Structural Finance and the Origins of Mutual Funds in 18th Century Netherlands
This is an interesting chapter about history.

Introduction "Predecessors of Mutual Funds
Mutual funds have become more popular for individual investors. The number of such funds now exceeds the number of securities listed on the NYSE. These funds have "advantages of liquidity and diversification at a relatively low cost." The origins of mutual funds are not recent. The British Foreign and Colonial Government Trust dates from 1868.

Predecessors of Mutual Funds
These include survival contracts "in which a borrower promises to pay a group of individuals an annuity that will be divided among the surviving members." and there were also plantation loans, which had some of the characteristics of investment trusts..

The Wikipedia definition: {short description of image}A tontine (/'t?nta?n, -i?n, ?t?n'ti?n/) is an investment linked to a living person which provides an income for as long as that person is alive. Such schemes originated as plans for governments to raise capital in the 17th century (often to fund war) and became relatively widespread in the 18th and 19th centuries.

The First Mutual Fund: Eendragt Maakt Magt
This was created in 1774 by the Amsterdam broker, Abraham van Ketwich. The members invested in foreign government or bank bonds, or plantation loans from the West Indies. They were promised a 4% interest dividend. It has an interesting history, which the author has found in a manuscript copy. He includes facimialies with the essay.

Subsequent Funds
"The initial success of (this fund) soon invited followers." One was founded in 1776.

The Demise of the Early Mutual Funds
They were largely investment in those plantation loans. With the outbreak of the"Fourth English War" in 1780 colonial shipments were curtailed. He means from the British viewpoint, the 4th Anglo-Dutch War. naturally with British control of the seas Dutch investments in the West Indies took a beating. But the major fighting in the West Indies was between the British and the French. Amazingly, the final disposition of the successor took place in 1893 with a disribution of 430.55 guilders per par value 500 guilder investment, a 87% payment.

Speculation on the Financial; Fortunes of the United States
dr. Rouwenhorst recounts the history of many successful investment trusts from the 1780s which speculated on US government securities. The Dutch had financed, along with the French and Spanish, much of the American Revolution. The story of the depreciation of the US currency and loans is well known. He does not give Alexander Hamilton credit for establishing the government promise to repay those loans.

Depository Receipts
Dr. Rouwenhorst brings the idea up to date by noting that: "Closed end mutual funds and plantation loans are examples of liquidity creation through asset substitution and securitization." He gives some examples, such as the Hope & Co which raised funds in Holland for the Russian Tsar. Depository receipts created to facilitate foreign trade in govedrnmentdebt became widespread.

Nineteenth-Century Mutual Funds
He writes that: "The first documented investment trust outside of the Netherlands is the Foreign and Colonial Government Trust, founded in 1868 in London." "By 1875 there were 18 trusts formed in London". They were introduced into the United States in the 1890's.

Concluding Remarks
He considers that in the 18th century the Dutch created a "Remarkable set of innovations that form the foundation of modern-day markets for mortgage-backed securities, pension funds, mutual funds, and depository receipts;" marking the origins of structured finance. He cnsiders it a "puzzle" that the expansion of adoption of financial innovations was slow. He recommends further historical study to find out what enables success and contains failure in the process.

 

13. Tom Nicholas, The Origins of High-Tech Venture Investing in America

Introduction
Here we get down to the amazing features of 21st century financial activity - 'high-tech investment and venture capital.

The Pathway to ARD: Formation and Structure

Initial Investments

Digital Equipment Corporation"

Venture Capital Supply and Entrepreneurial Demand

Regional advantage, Investment Cycles and Bubbles

Conclusion

 
 

14. Janette Rutterford and Leslie Hannah, The Rise of Institutional Investors
The chapter is an interesting historical summary of the expansion of 'instiutional' investment organizations as owners of stocks and bonds relative to the ownership of these by individuals. The article is full of data, numbers and years. Beingfrom England, as it the publisher as well, they give at least equal attention to the British scene as to the US.

Introduction
The main institutional management institutions the authors describe are: insurance companies, pension funds, investment trusts (closed end funds), and unit trusts (open end trusts). They note that London was the center of global investment in the early 20th century but now the leader is the US (such as the NYSE and other exchanges). Not only has the number of institutions grown but also the value of assets under management. For instance: "The capitalization of the US equity market grew by a factor of more than 200 between 1950 and 2010." But in Germany and France banks and insurance companies are larger than pension or mutual funds.

Origins
The authors present a full historical picture. In the early 20th century stock exchanges were already very large in comparison with the size of their economies. And most investors in both stocks and bonds were individuals. London was "representative of the advanced industrial world" Railroad securities were still a major component, but induistrial equities were more in the LSE than in the NYSE. They conclude that: "The rise of institutional investment in both countries was likely driven by the extension of shareholding to less-wealthy people - those with limited exprience in managing investments and thus in need of more assistance in the management of their assets."

Why They grew
"Of the four types of investment institutions, insurance companies have the longest history," They date from the early 18th century. Pension funds became significant only after WWII, but then they expanded rapidly. The authors point to government promotion via special tax rates and favorable regulations, for instance on marketing and advertising.
In my opinion governments wanted to foist off to the individuals and institutions the resposibility of the 'welfare state' in securing retirement incomes. But later, when the fiscal burden on employers became onerous the responsibility was delegated even more to the individuals themselves. And they need even more 'expert' professional management. The authors describe how this need has been 'met', if at all, by the creation of more and more mutual funds despite the vagarities of the asset markets.

What They Invested In
The authors have dug deeply into records to calculate the quantity and distribution of various types of investments the individual shareholders and the institutions bought. A sample of their research: "A sample of 33,078 shareholders in 261company share registers relating to 47 UK-registered companies, spread across all sectors for the period 1870 to 1935 reveals that only 505 of the shareholders were institutional investors. They held 4.2% of the value of these securities in the decade of the 1900's 7.7% in the 1910's, 60% in the 1920's, and 23.8$% by the 1930's." There is much more information in the article, including their analysis of the data they found and their conclusions. One conclusion is that the US and UK investment institutions "were slow to invest in overseas equities." This 'domestic bias' particularly in government and corporate bonds continues.

How They Managed Their Investments
They fond that only 1% to 2% of the population held most of the securities. They conclude that these were wealthy investors who either knew how to invest or used the assistance of banks and trust departments and stockborkers who advised' their clients.

Performance Measurement
The authors identify two types of performance measurement of investment results - one is to compare with peer groups and the other is to match against a passive benchmark. They describe how both developed during the 20th century to today.

The Changed Situation Today
They present more data about who owns what. Among their conclusions: "London is the world's largest center for asset management in invests a good deal beyond the United Kingdom". "Insurers now own more equities than they did in the early 20th century, but they are now less dominant among asset managers."

An interesting comment: "Some question whether there is now too much financial intermediation by those who have lost sight of their investors' objectives." Bravo - excactly my opinion. These financial intermeditors are playing with other people's money and rake off sizable capital from what they are managing in fees and bonuses. And, if there is not enough real capital created from the returned earnings of production, they create imaginary capital out of credit instruments that they create out of givernment debt via central banks.

Corporate Governance, Agency Costs, and Institutional Investors
The author's opinion: "The rise of intermeditiaries in principle offered several improvements." They cite three. But then they identify a negative fact. "The extra layers between investors and multiple intermediaries have introduced further problems of agency and added costs to the investment chain." Indeed so. Just check the large sums that the CEO's of major banks receive and the sallries and bonuses of their market traders. The authors point to another result - short termism. They do not elaborate, but what they mean is that the investment companies cater to their stockholders and other owners who want immediate profits. And the employees seek to increase their commissions and annual bonuses by year-end manipulative activity. One conclusion they write: "It is difficult to conclude that investment institutions have unequivocally improved governance and returns, althogh clearly they have sometimes done so."

 

Part 5: New Frontiers in Financial History

 
 

15. Barry Eichengreen, Financial History in the Wake of the Global Financial Crisis

Introduction
Dr Eichengreen points out that what observers see from research in financial history depends on where they are sitting. He states: "My own persepectve isthat the research in financial history will now be shaped by two sets of considerations. First, the greater ease of digitizing archival data will allow financial historians to pursue microeconomic analyses of a sort that were prohibitively costly before." 'In addition to being data driven, the research frontier in financial history will be driven by a second consideration: concerns highlighted by the 2008-2009 global financial crisis."

Effects of Technology and Research
He believes that: "The lower cost of assembling and analyzing large datasets will incline research in financial history in directions that capitalize on their availability." He describes some of the topics that this research will address and identifies the names of some researchers who are already active.

Effects of the Global Financial Crisis on Research

Conclusion

 
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Philip E Tetlock & Dan Gardner, Superforecasting The Art and Science of Prediction

 
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Nassim Taleb., The Black Swan

 
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Nasim Taleb, Fooled by Randomness

 
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George Cooper, The Origin of Financial Crises

 
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Walter Bagehot - Lombard Street

 
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Wikipedia entry describing Bagehot's book - Lombard Street

 
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Lombard Street

 
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Perry Mehrling, The New Lombard Street

 
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Lombard Street

 
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Lombard Street

 
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Justin Fox, The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street

 
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Barry Eichengreen, Exorbitant Privilege

 
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Return to Xenophon .