Financial bubbles are as old as capitalism. The Long Depression of had begun with a financial crash following a speculative boom. But — until — the greatest crash by far was that of The way a bubble works is simple. If demand for a paper asset is high enough, its price will rise. If the price of an asset is rising, more investors will want to buy it, hoping to profit from further rises when they re-sell. If there is enough surplus capital around, and if paper assets keep rising in price because of high demand, take-off becomes possible: assets continue to rise in price simply because more and more investors want to buy them — irrespective of the relationship between their price and the actual value of the goods or services represented.
Paper assets are essentially loans of money in return for titles to ownership. They can be corporate shares, government bonds, insurance policies, currency holdings, bundles of mortgages, advance purchases of commodities, and many other things. These companies produced nothing. They simply traded in the stock of other companies. Often enough, the companies they invested in would be other holding companies and investment trusts.
Sometimes the layers of fictitious capital could be five or ten deep. The Goldman Sachs Trading Corporation was an example. It was formed on 4 December With this initial capital, it invested in the stock of other companies. In February , Goldman Sachs merged with another investment trust.
In July, the joint enterprise launched the Shenandoah Corporation. No-one wanted to miss out on the money-for-nothing miracle that was Goldman Sachs. The company duly obliged and issued yet more stock. As the frenzy mounted, capital was sucked out of foreign loans, industrial investment, and infrastructure projects. Nothing was as profitable as speculation on Wall Street. Loose money and a weak economy gave rise to a massive imbalance between the price of paper assets and the value of real commodities.
In industrial crises, blind competition leads to over-investment in production, a glut of commodities, and a wave of factory closures. In financial crises, it leads to a speculative bubble of inflated asset-prices and fictitious capital, followed by a crash, a black-hole of bad debt, and a wave of banking collapses.
Thousands of finance-capitalists were wiped out. Millions of ordinary people lost their savings. Once it started, the crash, like the bubble, was self-sustaining. The whole complex weave of financial obligations was suddenly unravelling. They eventually went down to 50 cents. Two years later, you could buy them for a dollar or two.
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The crash did not come from nowhere. Agriculture had been depressed since , and industry was afflicted by a classic cyclical downturn due to over-expansion and under-consumption during the spring and summer of The agricultural and industrial crisis triggered the financial crash. But the crash then fed back into the real economy, collapsing credit, drying up loans, choking off investment, shrinking demand.
The centralisation and concentration of capital magnified the scale of the crisis. When a small or medium-sized firm is bankrupted, the overall impact is limited, and many others remain. When a major bank or industrial corporation is bankrupted, it pulls many others down with it, sending a deflationary wave across the wider economy. So it was now. By , 9, US banks had failed, industrial production was down by a third, and one in four workers was unemployed.
Nor was there the slightest sign of any recovery. The system was dead in the water. Government policies were worse than useless. They made the crisis deeper and more intractable.
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And the effect was to drive the economy deeper into crisis. Governments also devalued their currencies to make their own exports cheaper, while imposing tariffs on imports to make them more expensive.
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But protectionism is a competitive process. When rival states followed suit, the world economy was locked into a race to the bottom, with falling prices and shrinking markets leading to a catastrophic collapse in international trade.
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Deflation and protectionism, on top of the economic downturn and the financial crash, destroyed any possibility of recovery. Democracy, moreover, was soon under attack as hard-right regimes drove through cuts in the face of mass resistance. He did this at a time when one in four German workers was unemployed.
The depth of the economic crisis and the polarisation of German society paralysed the political system.
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None commanded a parliamentary majority. The combination of such irresponsible fiscal and monetary policies threatens to erode confidence in the dollar as a reserve currency. As the value of the dollar erodes, other countries respond with their own currency manipulation. European countries have implemented more extensive policies along similar lines. China rejects these claims, arguing that firms such as Solar World benefit from U. Not surprisingly, other countries have responded in kind with their own protectionist trade policies.
Brazil recently raised tariffs on hundreds of products, citing U. In the wake of such policies half a decade following the start of the current financial crisis, U. The determining factor will be if and how we choose to apply the lessons learned from our past. Barry W. Looking for more financial tips? Click here to subscribe to our monthly newsletter. They saw the value of their housing equity evaporate from their net worth and some defaulted on mortgages and lost their homes altogether.
How could these impacts have been avoided? The lessons about over-concentrating on housing can apply to any large allocation on your personal balance sheet. Recall that the Great Recession started with the bubble in housing prices bursting, but went on to affect investments that were themselves reliant on the housing sector, such as mortgage-backed securities. What this meant in practice is that even households that did not overspend on housing may have been affected by the drop in housing values, as the impact of falling house prices spread through the U.
This ripple outwards affected the value of stock investments across the economy. As with housing values, many investors may have been lulled into a sense of security by rising stock prices, thinking that they were being rewarded financially as a result of taking the risk of investing in equities. How could investors have protected themselves from the effects of falling equity markets? Employment rates have gone up, and stock markets and house prices are recovering. Overall, the message is optimistic.