The Cheek and The Stupidity.

The great 19th-century German banker Carl Furstenberg liked to remark that his customers were stupid and cheeky. Stupid, because they gave their money to someone else, and cheeky, because they then expected some return on it. If Furstenberg were alive today, he would amend that to a high return--and would soon find himself under investigation by the legion of prosecutors and regulators hunting down promoters of the late dot-com boom.

Furstenberg had a point. Cheek and stupidity do drive speculative fevers. There is a story that investors tell themselves--or that their brokers tell them--about above-average returns in an exciting new sector. The original vision may be partly true, but the majority of companies engaged in any new sector will fail. This was the story of railroad companies in the late 19th century, and technology companies in the late 20th. Vast wealth was destroyed each time.

Investors in effect give away the money that makes technical development possible. Appalled at their losses, they then demand government action to correct what they see as a terrible abuse, even as they go searching for the next big payoff. Speculative manias thus appear at frequent intervals, and tend to feed on one another. Despite all the wealth destruction, there is always plenty of money to move around. Thus in the late 19th century, after the railroad bust, capital moved on to the "emerging markets" outside Europe and North America. When Argentina defaulted spectacularly in 1890, new targets emerged: money flowed for the rest of the 1890s into Russian government securities and private equity. In the late 1970s and early 1980s, after American banks were similarly burned in foreign markets, money moved into real estate in the United States and Britain. The pattern was repeated after the stock-market collapses following 2000.

The collapse of confidence is painful. Regulators and central banks have two kinds of responses, and both help to propagate the cycle of speculation. One is to try to reassure the market by providing liquidity and regulatory relief, which fuel the next great boom and therefore also the next collapse. The stock-market euphoria of the late 1990s was a response to the ...