The Dutch tulip crisis (1630s)
Perhaps it is possible to understand why investors abandoned all economic logic, and ignored historical evidence, during the dot com bubble. After all, the internet is an astonishing phenomenon, as is the personal computer. But tulip bulbs? What sane person would ruin their family’s fortunes over tulip bulbs? A large proportion of the Dutch well-to-do in the early 17th century, as it turns out.
It was the 1630s when tulipmania took hold, and as with most bubbles, the great and the good, in this case the local mayors, were investing heavily when the market began to wilt. Not wishing their investments to rot, the mayors initiated some neat financial engineering. They agreed to convert their contracts with the-planters from a contract to buy bulbs at a fixed price, to an option to do so if a higher price was reached. If not they paid a fraction of the contract price to the planters.
And so, in the winter of 1637, it was in everyone’s interests for the market to go up. By February 1637 the contract price was 20 times greater than the previous year. One person supposedly paid over 6,500 guilders for a single bulb, the equivalent of an Amsterdam townhouse. But, in the spring of 1637, as all bubbles do eventually, the tulip bulb market burst.
The South Sea Bubble
In February 1720, shares in the South Sea Company, based in England, were trading at £130; by June the price was an astonishing £1050. Adam Anderson, a clerk with the company, described events of the time as an “unaccountable frenzy”. By November 1720, however, the share price was back to £170. The frenzy had subdued. The South Sea bubble, as it is famously known, had burst.
While the South Sea Company may conjure up images of oceanic trading, it was actually established in 1711 as a rival to the Bank of England. Backed by the Lord Treasurer, Robert Harley, it was promised a monopoly of all trade to the Spanish colonies in South America (then the South Seas) in return for taking over and consolidating the national debt incurred as a result of the War of Spanish Succession.
Ultimately, the trading proved to be a diversion, the main money making enterprise being converting government debt into South Sea Company shares and then talking up the trade prospects to inflate the share price.
In a masterstroke of financial innovation four share subscription offers were made to the public using a credit payment system where investors made an upfront payment, paying the balance in instalments over a fixed period. Each issue involved a different down payment and instalment period.
Despite it being effectively the same product – the original shares and four different subscription contracts, the receipts of which quickly became tradeable – the prices of the four assets deviated from each other, and arbitraging failed to bring about price convergence.
The aberrant investor behaviour, described by one lawyer for a Dutch investor as “nothing so much as if all the lunatics had escaped out of the madhouse at once”, has been put down to factors such as complexity and excitement. It certainly must have been both to confuse one of the world’s greatest thinkers. “I can calculate the motions of the heavenly bodies but not the madness of people,” observed Sir Isaac Newton, who lost money amid the feverish speculation.
The Wall Street Crash
Ask the average person in the street to name a financial crisis or stock market crash and the chances are they will name the Wall Street Crash of 1929. Not a single steep one day fall, but rather a long protracted affair, the Crash involved not one but three “black” days – Thursday, Monday and Tuesday (October 24, 28 and 29)– in quick succession.
In August 1921, the Dow Jones Industrial Average was at 63.9. There followed a period of economic boom, through the Roaring Twenties, fuelled by the optimism of a new technological age – radio, cinema, the car, telephone, and aviation. Stock prices reached new records, driving the Dow to a peak of 381.17 in September 1929.
In October 1929, however, the market turned, it fell and continued to fall, (38 points on Black Monday). Mass selling overloaded the telephone and telegraph system. After a brief recovery, the Dow headed southwards once more, and by July 1932 had reached 41.22, it would take over 20 years to recover. At the same time the mass withdrawal of savings precipitated a banking crisis, with the number of banks declining from 25,568 in 1929, to 14,771 in 1933.
Apart from its severity the Wall Street Crash is notable for the great names that it reduced from riches to rags. William Crapo Durant, the founder of General Motors, King Camp Gillette of shaving razor fame, Charles Schwab, one of America’s greatest industrialists; these and many more great businessman (and ordinary investors) were ruined by the Crash of 29.
The Weimar Republic – a banking and currency crisis
A large bank gets into severe difficulties. It reacts by cutting back lending to other banks and to businesses, which in turn has a knock-on effect inducing turmoil in the financial markets. Sound familiar? But on this occasion it is not North America in 2007, but Germany in 1931.
In July 1931, the Weimar republic suffered a major economic blow. The Reichsbank, Germany’s central bank, found itself in difficulty because of a combination of factors, including the collapse of international trade and Germany’s debt burden, and reacted by reining back credit facilities. The result was a panic in the banking sector that led to the nationalisation of two of Germany’s biggest banks, the rescheduling of short-term foreign debt, and the introduction of capital controls.
More significant, however, were the long term effects. Germany ceased World War One reparation payments in 1932 and defaulted on is foreign debt in 1933, both events were important precursors to the rise of the NSDAP party in Germany and the eventual outbreak of the next world war.
Oil crisis 1973
Although not strictly a financial crisis, the oil crisis of 1973 merits inclusion in this list, if only because of the far reaching effects it had on western economies. The catalyst for the oil crisis was the Yom Kippur War, between Syria and Egypt on one side, and Israel on the other, which began on October 6, 1973. The conflict triggered a cascading sequence of events that caused chaos, inflation and recession in the West.
The Organisation of Arab Petroleum Exporting Countries (the Arab members of OPEC plus Egypt and Syria) announced an oil embargo, affecting the US and other nations that supported Israel. In the US, oil imports from the Arab nations plummeted from some 1.2 million barrels daily to around 20,000 barrels. Oil prices rose rapidly and the US suffered its first fuel shortage since the Second World War.
Across Europe the effects of the embargo were patchy. The Netherlands, which supplied arms to the Israelis, was badly hit, whilst France was relatively untroubled. After the embargo was announced on October 17, 1973, the NYSE lost nearly $100bn in just a few weeks. The embargo was lifted in March 1974, although the effects rumbled on, manifest most noticeably in an increased drive for energy security among western nations, as well a radical reshaping of the automobile industry and the rise of the hatchback.
Black Monday, or, if you are Australian, Black Tuesday, is the popular name for Monday, October 19, 1987, the most spectacular of global stock market crashes to date. Not the steepest one day market fall though, that honour lies with the Dow Jones’ 24.39 percent collapse on December 12, 1914.
The significance of Black Monday, when the Dow Jones fell by 22.6 percent, is severalfold. It was a substantial fall, the second largest in the Dow’s history in percentage terms. It was a global event, starting in Hong Kong and rippling across international time zones. By the end of the month markets had declined by 45 percent in Hong Kong, 41 percent in Australia, and 26 percent in the UK.
Perhaps the most interesting thing about Black Monday, however, is that it was not predicted, and has yet to be explained satisfactorily. Not that there is any shortage of suggested causes. Some attribute the crash to automated programme trading, derivative trades, and portfolio insurance, others to recession fears, others still to overvaluation of stocks.
Certainly the supposed “rational investor” of economic theory, capable of absorbing changes in events and making sensible well-informed, if self centred decisions, appeared to have vanished, replaced by irrational, excitable, exuberant investors, who blindly followed the crowd.
But, just as soon as the panic started, it was over. Historic blip behind it, the Dow Jones carried on climbing as normal service was resumed.
Another black day in the world of finance, at least from the UK’s perspective, Wednesday the 16th September 1992, was the day that the UK government was forced to withdraw from the European Exchange Rate Mechanism (ERM). The decision came on a day during which the UK treasury spent some $27bn of foreign currency reserves in an attempt to shore up the value of sterling (although the total cost weighing other factors is said to be £3.3bn). At the same time, currency speculators and investors, most notably George Soros, made a small fortune betting against the UK government’s ability to beat the markets.
The UK’s plight demonstrated the perils of fixed exchange rates. With UK sterling entering the ERM in 1990 tied to the deutschmark at DM 2.95, it soon became clear that keeping sterling within its exchange rate limits was at odds with the needs of the domestic economy. Germany was reining back inflation as result of a post unification boom, while the UK needed to promote growth on the back of the recession. When Germany’s interest rates went up, the UK found it painful to follow. A strong pound was damaging exports and prolonging recession.
Currency speculators figured it was a only a matter of time before the UK allowed sterling to devalue, beyond its narrow ERM bands, and that there was not the political will on behalf of the other EU countries to defend the pound. Consequently, they began to short sterling, confident they would be able to buy it back more cheaply in the near future.
Initially, the UK government resisted devaluation, mounting a concerted campaign to shore up sterling both through trading and by hiking interest rates. Matters came to a head on Black Wednesday, as the Chancellor of the Exchequer announced a series of interest rate rises in quick succession, from 10 percent to 15 percent (although the last was never implemented), it was clear to everyone that the game was up, however, and the UK withdrew from the ERM.
The Asian financial crisis
Whether you prefer to call it the Asian financial crisis, East Asian financial crisis, or IMF crisis, the fact remains that the financial crisis that gripped Asia from the summer of 1997 onwards was one of the most significant and long running financial events of the latter half of the 20th century.
Like many other crises, the Asian financial crisis follows an all too familiar pattern. First the boom. During the mid-1990s, foreign investment flooded into Asia and the emerging economies, resulting in high interest rates, high asset prices, and rapid growth rates. Countries like Thailand, Malaysia, Indonesia, the Philippines, Singapore, and South Korea were growing at average rates of over eight percent. Much of the investment was highly leveraged.
Then the bust. The US, emerging from its recession during the early 1990s, began to focus on keeping inflation down, and raised interest rates. Investors switched attention to the US; the US dollar increased in value. At the same time, many of the Asian nations had pegged their currencies to the US dollar and in an effort to remain an attractive investment destination were forced to raise interest rates and expend reserves defending their currencies to avoid devaluation.
You just know that there is going to be trouble when a Prime Minister makes a public announcement that they will not devalue their currency. And so it proved when, in June 1997, Prime Minister Chavalit Yongchaiyudh of Thailand refused to countenance devaluation of the baht, leaving the way clear for currency speculators. Inevitably the baht was eventually floated, and the currency slumped.
And so, temporarily, the “Asian economic miracle” shuddered to a halt, as panic spread throughout the region, badly affecting Indonesia, South Korea, Hong Kong, Malaysia, Laos and the Philippines, with the IMF pumping in $40 billion in an effort to stabilise currencies in South Korea, Thailand, and Indonesia.
On a wider scale the Asian crisis knocked confidence in lending to developed countries, which has a negative impact on oil prices, contributing in part to the Russian financial crisis.
The Russian financial crisis
The bank’s motto may have been, “We are for real, we are here to stay,” however Inkombank had not reckoned with the ferocity of Russia’s 1998 currency crisis, which reached a peak on August 13 1998.
Like many banking crises, the Russian banking crisis was caused by a combination of factors. In 1997 and 1998, the effects of a declining economy were exacerbated by the Asian financial crisis and the decline in demand and price of oil and other commodities that Russia produced.
In the background, amidst the impending crisis, the government were issuing short term bonds, known as GKOs, to help finance the budget deficit. However their issuance resembled something of a pyramid or Ponzi scheme, with the interest on matured obligations met using the proceeds of newly issued obligations.
Internal debt obligations became difficult to fulfil. By August 1, 1998 there was over $10 billion in unpaid wages owed to Russian workers. Various workers were on strike –including the coal miners. And as with the UK and the ERM crisis, Russia’s problems were compounded by its policy of linking the rouble, to another country’s currency, in this case the US dollar. Throughout 1997 and 1998 the Russian government expended billions of its US dollar reserves, supporting the rouble.
Finally, on August 13, 1998, the Russian financial system went into meltdown. Stock, bond, and currency markets collapsed, as investors scrambled to get their money back. The stock market was temporarily closed because of the steep falls. In the fallout, several banks closed, including the not so permanent Inkombank. Russia’s recovery, however, was surprisingly swift, driven in part by a rapid rise in the price of oil and other commodities.
The Great Credit Crunch (2007-08/09?)
In contrast to the short sharp shock of most stock market crashes, the present credit crunch crisis is more like death by a thousand cuts.
The origins of the crunch are well rehearsed. Speculative unsound mortgage lending, the repackaging and reselling of sub-prime mortgage debt as supposedly attractive financial products, the gradual realisation that those products were not quite as attractive as their credit ratings might suggest, the consequent unwinding of positions, recalling of funds, and reluctance of banks to lend money to each other.
If it feels as if the current crisis is interminable, that’s probably because it has been rumbling along since the beginning of 2007 when it became clear that a number of sub-prime lenders in the US were in trouble. Ever since, it has been an endless procession of write downs, financial losses, CEO resignations and now rights issues.
Along the way Wall Street investment bank Bear Stearns has been acquired by JP Morgan Chase, and the UK bank Northern Rock taken into public ownership. The response of the central banks wavered initially between wanting to avoid a banking catastrophe, and not wishing to encourage moral hazard and reward poor lending practices. In the end, the former won out, with concerted action pumping hundreds of billions of dollars into the system in an effort to lubricate interbank lending and bring down the LIBOR rate.
Has it worked? Who knows. Everyone has an opinion, but it is early days still. The only certain thing is that it will happen again, and that one quick read through the following shows that we should all, banks, investors, regulators and governments, know better. Forget neoclassical economics and efficient market theory; fear and greed, that is where it’s at.