The Nature of Disaster

The Daily Reckoning PRESENTS: What constitutes a financial “disaster”? What causes these disasters? Below, Byron King reviews a book, History of Financial Disasters, which looks to answer those questions – and more. Read on…


What is a disaster? The Latin roots of the word are “dis” and “astro.” Literally, the two combined words mean “ill-starred.” In ancient times, if you offended the gods, the deities would align the stars against you and bring a bad set of events down upon your house, if not upon your head. So the word itself has come to mean, according to the Oxford English Dictionary, “a sudden or great misfortune; an event of ruinous or distressing nature; a calamity; complete failure.” Let’s look at some examples, just to illustrate the point.

In classical times, there was hardly a more disastrous event, or an event with more calamitous outcome, than the Athenian invasion of Sicily in 415 B.C. This disaster was chronicled by no less than Thucydides in his classic work, The Peloponnesian War. The short version of the story is that the Athenians had been fighting the neighboring Spartans for many years and eventually decided to attempt to break what had turned into a military stalemate. The Athenians determined to outflank their enemy by sending an army halfway across the Mediterranean Sea to Sicily and raising a threat to Sparta’s rear.

But talk about offending the gods? Someone sure did. (Thucydides said that it was Alcibiades, but who really knows?) The Athenians were filled with hubris at the prospect of their own success. But their distant expedition met with trouble from the outset, encountering almost every form of problem that a distant military campaign could have. And once the Athenians had landed on the shores of hostile Sicily, things went from bad to worse. After losing a major battle at the Sicilian town of Syracuse, the Athenians were thrown into headlong retreat. Eventually, the soldiers of Syracuse caught up with the main body of Athenians at the Assinarus River, on the southeast coast of Sicily. There, according to Thucydides, the thirsty Athenians were slaughtered in droves as they trampled each other trying to get to the water.

Thucydides summed up the expedition to Sicily in sad words, but words that still convey the sense of total loss. In the end, he wrote, “They were destroyed, as the saying is, with total destruction, their fleet, their army, everything was destroyed, and few out of many returned home. Such were the events in Sicily.” Now there is a disaster for you.

“But mankind has moved beyond these sorts of things,” some people still say. Yes, of course. Except that we humor ourselves when we say such things. The same sorts of calamities still occur. We suffer from the same sense of hubris that doomed the Athenian army and the good ship Titanic and its captain. Mankind still has that almost willful blindness to exercising the vision to forecast and avoid disaster in the making.

For an example of a modern disaster, no one who was around at the time could ever forget the famous words broadcast from NASA’s Mission Control on Jan. 28, 1986, perhaps the understatement of the age: “It appears we have had a major malfunction of the vehicle.”

“A major malfunction?” Space shuttle Challenger had just exploded, less than two minutes after liftoff. The vehicle was destroyed. The crew was killed. Debris rained down from the sky, falling into the blue sea offshore Cape Canaveral. And it was all on television, live and in color, no less.

The immediate cause of the Challenger disaster was a faulty device called an “O-ring,” part of an otherwise tight seal between two sections of one of the solid rocket boosters. When cooled to a freezing temperature, as had occurred on the cold night before the deadly launch, the rubber in the O-ring lost its resilience and became somewhat brittle. During the stress of launch, the exhaust from the solid rocket booster literally burned through the O-ring, causing the rocket booster to shift from its proper position in flight, resulting in a sequence of failure events that led directly to the explosion that destroyed Challenger and killed the crew.

So can we really say that a disaster results from just the single triggering event? Of course, every disaster has its penultimate cause. In Sicily, the Athenians lost a battle at Syracuse. The O-ring on one of Challenger’s booster rockets burned through. But is this the end of how to think about it? Not by a long shot. Thucydides, for example, writes his history but does not shirk from detailing a chain of errors and misjudgments on the part of the Athenian leaders who sent their army to its doom in Sicily.

In the case of the Challenger explosion, no less a mind than Richard Feynman, physicist and Nobel Laureate, noted that the source of the explosion was a pervasive cultural disease within the institution of NASA. Feynman noted that NASA had evolved away from its roots as a scientific and engineering agency within the U.S. government to become a vast bureaucracy that allowed safety standards to slip, and which permitted grievous errors to go unnoticed for years at a time. To paraphrase Mahan, NASA had become a “system” that allowed its bureaucratic nature to “pervert standards.”

Now that we have discussed a couple examples of famous disasters, let’s take a look at the idea of “financial disaster.”

“What is a financial disaster? The phrase brings to mind images of panicked merchants huddled around an exchange waiting for the latest news to arrive via post, telegraph, or computer, of stock market crashes, of unemployment and charts showing a precipitate drop in the price of shares, indexes, or currencies.”

The foregoing comes from the introduction of a remarkable three-volume set of books entitled History of Financial Disasters 1763-1995, released in April 2006 by the London-based firm of Pickering & Chatto.

As the title implies, these three volumes review the origins and consequences of the Western world’s most important financial crises in the past quarter millennia. The editors have chosen to highlight and delve into 19 seminal economic crises between 1763-1995. Rare public and private papers, offering trenchant firsthand accounts from some of the principal insiders, offer rich source material and penetrating background on the events that occurred. In addition, the editors have culled the stacks of academic literature to assist the reader in interpreting these events and in drawing conclusions and lessons for our own time.

There are only a few people in the economic world that could have assembled this type on insightful collection. The general editor of this important historical review is Mark Duckenfield, an accomplished economist and historian at the London School of Economics. With the able assistance of co-editors Stefan Altorfer and Benedikt Koehler, also accomplished economic historians, Dr. Duckenfield has cast a broad net to gather what are among the best source materials that could be found in the world.

In general, the editors follow the definition of “financial crisis” established by the great analyst Charles Kindleberger. That is, financial crises are “associated with changed expectations that lead owners of wealth to try to shift quickly out of one type of asset into another, with resulting falls in prices of the first type of asset, and, frequently, bankruptcy.”

Thus, according to the editors, financial crises are a product of sudden alterations of expectations, rooted in reality or imagination. If you are looking for a way to avoid financial disaster, this is the key level of understanding. The impending alteration of people’s expectations sends a glaring signal to which you should train your mind to react.

In these three volumes, and for each of the financial crises that bears examination, the editors provide the reader with a look beyond the immediate crisis itself, and a view of the series of events that constituted the whole disaster. Here is the true value of this set of books.

The editorial approach is similar to the way that one might view the onshore wreckage caused by a hurricane, and from which natural disaster the recovery efforts can take years to come to fruition. In other words, the landside wreckage is only the most visible feature of a natural phenomenon that had its origins far out to sea. To avoid the impact of the storm, you should learn to forecast the weather. And then prepare yourself for the hit, if not just plain get out of the way.

The editors use a broad conception of financial disasters that includes objectively describing the origins and resultant consequences of the phenomena. But the editors go many steps further as well by presenting information about how each disaster related to broader themes of the times. This includes providing the reader with fascinating information about the historical context, changes in the view of government intervention in the economy, the development of broad economic thought, the role of the media, and the openness (or what we now call “globalization”) of markets.

Large-scale changes could be triggered by the dawn of a realization that a government’s currency policies were highly inflationary. As an example, the editors review both the French Assignat inflation of the 1790s and German Weimar hyperinflation of the 1920s, and what followed when people came to realize that their currency was plummeting to worthlessness. Or people may begin to perceive that a government might have less political stability than had previously been thought, such as occurred with the Mexican peso crisis of 1994. On occasion, the financial meltdown begins not with overt monetary inflation, but with the pricking of a credit balloon and associated asset price bubble, such as the New York crashes of 1929 and 1987. Or there could be a herd mentality when investors respond to rumors and fears of insolvency, as with the collapse of the British entity of Overend & Gurney in 1867.

In addition, no one can consider himself or herself knowledgeable about the origins of modern monetary policy, and, in particular, the role of the U.S. Federal Reserve, without a solid grounding in the events of the Crisis of 1907. This section alone ought to be required reading for anyone who wants to understand the Fed and its origins, as well as its future direction as the U.S. dollar continues its century-long decline in value.

Every disaster has its proximate cause, the roots whence it grows. The Athenians lost a battle at Syracuse. The Titanic hit an iceberg. The O-rings of space shuttle Challenger became brittle in the cold. But as we discussed, there were deeper causes and origins, not to neglect the general human affliction of hubris.

Until next we meet,

Byron King
for The Daily Reckoning
September 19, 2006

P.S. History of Financial Disasters 1763-1995 is a treasure chest of historical perspective on the subject of economic and monetary disasters, and a valuable tool in your personal workbench of financial and historical knowledge. These books give you insight into the origins and consequences of financial disasters.

As I said at the beginning of this review, if your goal is to avoid something whose effects are not good, it certainly helps to know what that particular something looks like, and to understand its nature. Then at least you can get your money off the table and get yourself out of the way when it is headed in your direction. You could not do better than to read these three outstanding volumes and work to acquire the financial insight that might make all the difference in the world to you and to your family when the economic ship hits the next iceberg.

Editor’s Note: Byron King currently serves as an attorney in Pittsburgh, Pennsylvania. He received his Juris Doctor from the University of Pittsburgh School of Law in 1981 and is a cum laude graduate of Harvard University. He is a regular contributor to the free e-letter, Whiskey and Gunpowder, which covers resources, oil, geopolitics, military history, geology and personal freedom.

“Everything that rises must converge,” observed the famous but unorthodox Catholic philosopher, Teilhard de Chardin.

He was speaking of the tendency of all things to be drawn into a common field…and then to quickly become part of the universal mind.

Although there were no hedge funds around when he wrote, Teilhard might have been talking about them. For, now we have news that one of these secret and speculative private groups is planning to go public. You, too, can now own a piece of hedge fund action.

The New York Times tells us that the Fortress Investment Group is planning to let down its drawbridge…and go public this fall. Billing itself as a “global alternative investment and asset management firm,” the atypical fund, which manages $24.3 billion and has 500 employees, is going to go public not just with the funds it manages but, in a radical move, with its own business. That would allow investors to buy into its huge investment advisory fees as well as its incentive compensation – the heart and nerves of the hedge fund industry.

We doubt if Teilhard would call hedge funds good, but there’s no denying that this is convergence in a big way. What was once the game of a select and sophisticated group of wealthy investors has turned into a goody for the lumpen investing public to bumble around with. Like every other new financial innovation…or fad…or gimmick, the once marginal strategy of hedging will be taken up and passed around like a fifth of bourbon at a dipsomaniac’s convention.

But our concern, as always, is not just with the follies and foibles of the financial monde…but with the bigger picture. What does it mean when hedge funds – quintessentially private groups – go public?

It means, we think, that the hedge fund industry is struggling. It means that the profits are harder to find…or can be found only at the margins – at the extremes. It means that hedge funds are cash strapped and hungry for money. It means that hedge funds are not doing so well anymore. Are we right?

Hedge fund industry expert, Priya Jestin, writes:

“With the year 2005 already behind us, experts have finished tabulating how they [hedge funds] fared over all in the year. One clear-cut feature of the year was that the returns were abysmally low. The year recorded an average return rate of less than 7%.”

And experts believe that 2006 will end as badly….

Less than 7% from a hedge fund? With some money market funds now offering 5%, that can’t be good news for the business. What happens when the weaker funds begin to fold?

Only time will tell, but we venture to guess – nothing good.

And now comes further confirmation that hedge funds are not the only ones cash-strapped in America. The Arizona Republic illustrates what we announce daily in these pages – Americans are among the most cash-starved people on earth.

“In a new survey, Americans report being the second-most ‘cash-strapped’ nation, trailing only residents of Portugal.

“In all, the Internet survey by ACNielsen elicited responses from more than 21,000 people in 40 countries, mainly in Europe, Asia and North America. About 22 percent of Americans say they have no spare cash after covering basic living expenses vs. 23 percent of Portuguese and 13 percent of people overall, the global average. The Dutch and British tied for third place, with 17 percent of respondents claiming to be cash-strapped. Canadians, French and Turks were next at 16 percent.”

But does this worry the average American? We turn to a recent piece by financial columnist, Robert Kiyosaki:

“Most Americans live in la-la land. They’re clueless about what’s going on in the world of money, and still think we’re the richest country in the world. In reality, we’re the biggest debtor nation there is.

“Most Americans also still think our government will protect them. The world is changing at an alarming rate, yet most people here waddle stubbornly through the crosswalk, so to speak, still believing that this country has the right of way and that our political institutions are still sound…

“In the next five years, the United States and the world will go through some of the most financially disturbing times in the history of the world. Once again, the rich will become very, very, rich, and the unsuspecting will be left like the passengers on the S.S. Titanic, heading straight for an economic iceberg.”

More news…


Mike “Mish” Shedlock, reporting for Whiskey and Gunpowder:

“…I have it on great authority that there will not be a hard landing in real estate. Who told me that? It was none other than Mike Morgan at MorganFlorida. Please listen in to what Morgan has to say…”

For the rest of this story, see today’s issue of Whiskey and Gunpowder.


And more views…

*** “Every metropolitan community in the West is looking for water,” John Carpenter, retired rancher and Nevada state assemblyman once said.

“Las Vegas, Nevada, is the classic case,” reports Capital and Crisis’ Chris Mayer. “The city adds about 5,000 new residents per month. The Colorado River provides over 90% of Las Vegas’s water. But as The Washington Post recently noted, Las Vegas ‘lives on a diet, an allocation of water it was awarded decades ago, when Las Vegas was a whistle-stop.’

“The city needs more water. Water officials are looking for new sources of water. Their plan is to cut into aquifers across the state, in a great swath. Some of these water sources are hundreds of miles away. A plan is already set for a 250-mile network of pipeline to bring fresh water from Nevada’s valleys. This a $2 billion project.

“The problem is what’s on the top of aquifers: small towns and ranchers, who do not want to see their water tapped and don’t want to risk turning their lands into a dust bowl. ‘Nevada’s valleys are majestic and arid,’ the Post reports, ‘sloping floors covered in greasewood bushes and fields of alfalfa irrigated with springs or wells the ranchers have dug themselves.’ Wildlife – rabbits, coyotes, antelopes – gather at pools.

“All of that could be at risk if they drain the valleys. People know what happened to California’s Owens Valley, drained 100 years ago to provide water for Los Angeles. The once lush valley is now a wasteland.

“This sets up tensions between the growing cities that want water and the rural areas that have it. So far, the cities are winning. Coastal California, Phoenix and Salt Lake City, for example, all draw water from distant sources.

*** We are still at the Chateau Malesherbes, an hour’s drive south of Paris, slaving in your interests, dear reader. It is, as you can see, a tedious task…

The place has a long and important involvement with French royalty. Its first owner, François de Balzac d’Entragues, was well known for the relationship between his daughter, Henriette, and Henry IV. He was later condemned by Parliament for conspiring with the Spanish against the French king. He was imprisoned for life in the chateau, where he died. Around 1726, the place came into the hands of the de Lamoignon family, which made the striking improvements that have made it a showcase of eighteenth century architecture.

The grandson of the original buyer was the famous Chancellor de Lamoignon, who served as avocat of Louis XVI at his trial. The great Malesherbes’ passionate interest in botany transformed the extensive grounds into a quiet refuge for Louis and his family during their periodic exiles. Malesherbes was a liberal administrator, who enabled the publication of the Encyclopedie (one of the great intellectual projects of the Enlightenment and one which spawned the central tenets of the French Revolution). He also campaigned for the civil rights of French Protestants and Jews. But his enlightened ideas don’t seem to have done him much good with the sans culottes. He was arrested shortly after the king’s trial and then guillotined as a royalist – along with his daughter and grandchildren – although he had actually bravely opposed royal absolutism during his career.

The Chateau was then requisitioned by the members of the Committee of Public Safety, and its furnishings dispersed.

Thus did the Enlightenment end that dangerous century by eating its own children…

The Daily Reckoning