Financial fraud can be fascinating. There is something compelling about the way confidence men, from Thomas Cochrane to Bernard Madoff, take advantage of both the human willingness to believe and the weakness of greed. Madoff’s scam was exposed as markets crashed in 2007. For Cochrane, who made a fortune on a false rumour of Napoleon’s death in April 1814 in London, Ian Klaus’ new book – “Forging Capitalism: Rogues, Swindlers, Frauds and the Rise of Modern Finance” – provides not only the facts but the economic context of that early example of market manipulation.
Klaus, now working for the U.S. State Department, chooses Cochrane as an emblematic figure of financial skullduggery in the early days of modern financial markets. In that era, social status was enough to gain trust in the still-small circle of capital markets. Cochrane, a flamboyant war hero from a good family, was readily believed. On the other side, the still relatively new stock exchange was anxious to prove that it was, as Klaus puts it, “an arena of sociability and character… not a haven for roguish, credit-manipulating speculators.”
The Cochrane affair ended inconclusively. He went to prison but always protested his innocence. The details as presented by Klaus are not simply entertaining, they provide valuable lessons for today. The first is that “fraud is the tax for creative capitalism.” In other words, the rapid shifts in the financial world continually undermined the networks of trust which restrain evil and desperate operators in more static financial arrangements. It was, Klaus argues, a tax worth paying, as enduring capitalism could not have been forged without some trickery.
The second point is that Adam Smith was wrong to believe that markets could be kept honest through a combination of sociability, virtuous moral sentiments and self-interest. “Instead, trust was built through a series of deliberative approaches created or enhanced over a century,” Klaus writes. Those approaches can be summarised by the slogan, “trust but verify.” Honesty can win out, but not without careful procedures, objective standards and constant checks.
Klaus makes his case through stories. The tales get more technical as time goes on because the scale of financial dealings widened, as did the complexity of deceit. By the middle of the 19th century, there was too much information and scepticism about for simple lies to gain credence. However, with a little work, dishonest prospectuses and forged bills and insurance policies could divert money to the wrong places. In response, the guardians of financial markets had to become more vigilant. They relied less on personal testimonies and developed the now-familiar techniques of detailed verification.
Klaus is both persuasive and a good narrator. It is hard to resist figures like Walter Watts, an insurance clerk who embezzled enough money in the late 1840s to buy a few theatres and live a jolly life for a few years. Readers might be less enthralled with some of the arcane details, but frauds, then as now, often turn on the ability to find a weakness in procedures which were meant to keep them away.
Klaus limits his discussion to the ability of financial markets to become trustworthy, but that is only one part of a much bigger story. One of the great triumphs of modern industry is that consumers trust products made by thousands of people they cannot possibly know. Indeed, despite all the checks and procedures in finance, the industry remains a problem child in developed economies.
Madoff chose the right business. There would be far too many inspections and concrete tests for him to keep funds flowing in for an imaginary gold mine or a fraudulent airline. As a financier, though, he could rely on his customers’ greedy desire for outsized returns and their gullibility in a plausible-sounding man with good connections. Thomas Cochrane would have understood.