Wealth

Part 10 - Bubbles and Crashes

The Dutch Republic had the highest per capita income in the world between 1600 and 1720 and, perhaps as a result, in February 1637, it experienced the first speculative bubble on record. The price of bulbs of the recently introduced tulip flowers rose to extraordinary levels before collapsing. At the peak of the tulip mania a single tulip bulb sold for more than 10 times the annual income of a skilled artisan. However, this did not cause a significant economic crisis. 

In London, businesses could issue stock in some wild new venture and often made thousands of pounds Stirling before a single ship left harbour.

The South Sea Company, was formed in 1711 to trade with South America, and the Mississippi Company was set up to trade with France's Louisiana colony. Investors snapped up shares in these new companies and even in the shares of "a company for carrying out an undertaking of great advantage, but nobody to know what it is".

In 1720, at the height of the mania, the South Seas Bubble began collapsing as investors began to realize expectations were overblown. In London, Parliament passed the Bubble Act, which stated that only royally chartered companies could issue public shares. Despite this ban, the London Stock Exchange was officially formed in 1801. Since companies were not allowed to issue shares until 1825, this was an extremely limited exchange which set back stock market development in Britain for years.

Stock market crashes are typically preceded by speculative economic bubbles and there have been a number of major crashes throughout history. They include the 1929 crash when the Dow Jones Industrial Average lost 50% of its value, wiping out billions of dollars and sending America and much of the world into the Great Depression.

The stock market crash of 1987 began in Hong Kong, where stock markets fell 45.5% between October 19 and October 31. By the end of October, major stock markets around the world had all experienced double digit collapses. The Australian markets dropped 42%, while the United States and Canada suffered losses of about 23%.

The dot.com bubble was caused by massive speculation in Internet-related companies. Between 1995 and 2000, the Nasdaq Composite index rose 400% but by October 2002 had fallen by 78% from its peak. During the crash, many online shopping companies and communication companies shut down. Others, like Cisco, Amazon and Qualcomm survived but with large losses in share prices.

The 2008 stock market crash was caused by banks providing high risk mortgage loans and then offloading the risk by packaging loans and selling them as low risk, mortgage backed securities. When the inflated housing market in the USA collapsed, these highly leverage securities lost most of their value. This severely damaged financial institutions globally causing an international banking crisis and the most severe global recession since the Great Depression.

In 2012, the NYSE devised a 'single-stock circuit breaker' designed to reduce the probability a stock market crash and limit the damage if a crash did occur. If the Dow dropped by a specified number of points the circuit breaker automatically halted trading. This technique was adopted by all major stock exchanges and also for individual stocks trading at very much more than average volume.