9.1 Historical Bubbles and Crashes
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the state finances, he was granted the monopoly on trading with the newly acquired
overseas territories in North America. He started issuing bonds that promised large
profits. Soon speculation in these bonds took off and caused a huge bubble, partly
fueled by Law being in charge of issuing liquidity in the form of paper money.
The bubble crashed early in 1720 when speculators tried to realize their profits by
converting Mississippi bonds to gold.
Almost simultaneously the South sea bubble developed in England during a prosperous period when the South Sea Trading Company was granted the monopoly to
trade with Spanish colonies in the West Indies and South America. The expectation of large profits caused speculation in its shares, despite an on-going war with
Spain. The profits were expected to appear once the war ended. The success of the
South Sea company caused imitators with less than credible get-rich-quick schemes
to appear, a development that was halted by Parliament issuing the “Bubble Act,”
which required all joint ventures to have a Royal charter. This eliminated many competitors and caused the stock of the South Sea company to rise enormously which
triggered a selling avalanche to realize the profits. This in turn caused the bubble to
implode, causing a huge destruction of wealth, including part of Isaac Newton’s [2].
After the upheaval caused by the first World War, the 1920s are characterized by
peace and prosperity, especially in the US. New developments such as automobiles,
radios, movies, and air traffic are part of the reason. Simultaneously, the increased
flow of people moving from rural to urban areas improved the economic conditions
and increased consumption of a large fraction of the public. Many people had money
to spend and invested it in the stock market, which appeared to expand without limit.
Borrowing money to invest and using one’s portfolio as collateral was common,
which works well as long as the stock market goes up. In 1929, however, first signs
appeared that there is a limit to growth and reduced optimism and doubt caused
widespread attempts to realize profits from the stocks. But sellers found few buyers,
which caused the value of the stocks to drop. This triggered margin calls from the
money lenders, because the stocks did not cover the value of the borrowed money.
Thus, the speculative bubble of the 1920s ended in the great crash of 1929 [3] that
led to the great depression of the 1930s.
In the second half of the 1950s the emerging electronics industry following the
discovery of the transistor and the start of the space race in 1957 caused a bubble,
called the “Tronics boom” that deflated or fizzled in 1962 with a decline of the Dow
of about 25% over a few months rather than in a sudden crash.
After having left behind the era of oil crises in the 1970s, the early 1980s were
characterized by liberal economics under the recently elected President Reagan.
Tax policies favored mergers of companies, which was often funded by massively
borrowing money from the public by issuing so-called junk bonds, which promised
high returns but also carried a high risk. The promise of increased efficiency and
increased prospective profits caused euphoric market conditions with many willing
investors. In order to safeguard the gains and limit losses new technologies such
as automated trading and portfolio insurance with put options were implemented.
The bubble grew but started to wobble when people started to realize profits. Then
automatic portfolio insurance kicked in, which led to an enormous surge of sell
115
the state finances, he was granted the monopoly on trading with the newly acquired
overseas territories in North America. He started issuing bonds that promised large
profits. Soon speculation in these bonds took off and caused a huge bubble, partly
fueled by Law being in charge of issuing liquidity in the form of paper money.
The bubble crashed early in 1720 when speculators tried to realize their profits by
converting Mississippi bonds to gold.
Almost simultaneously the South sea bubble developed in England during a prosperous period when the South Sea Trading Company was granted the monopoly to
trade with Spanish colonies in the West Indies and South America. The expectation of large profits caused speculation in its shares, despite an on-going war with
Spain. The profits were expected to appear once the war ended. The success of the
South Sea company caused imitators with less than credible get-rich-quick schemes
to appear, a development that was halted by Parliament issuing the “Bubble Act,”
which required all joint ventures to have a Royal charter. This eliminated many competitors and caused the stock of the South Sea company to rise enormously which
triggered a selling avalanche to realize the profits. This in turn caused the bubble to
implode, causing a huge destruction of wealth, including part of Isaac Newton’s [2].
After the upheaval caused by the first World War, the 1920s are characterized by
peace and prosperity, especially in the US. New developments such as automobiles,
radios, movies, and air traffic are part of the reason. Simultaneously, the increased
flow of people moving from rural to urban areas improved the economic conditions
and increased consumption of a large fraction of the public. Many people had money
to spend and invested it in the stock market, which appeared to expand without limit.
Borrowing money to invest and using one’s portfolio as collateral was common,
which works well as long as the stock market goes up. In 1929, however, first signs
appeared that there is a limit to growth and reduced optimism and doubt caused
widespread attempts to realize profits from the stocks. But sellers found few buyers,
which caused the value of the stocks to drop. This triggered margin calls from the
money lenders, because the stocks did not cover the value of the borrowed money.
Thus, the speculative bubble of the 1920s ended in the great crash of 1929 [3] that
led to the great depression of the 1930s.
In the second half of the 1950s the emerging electronics industry following the
discovery of the transistor and the start of the space race in 1957 caused a bubble,
called the “Tronics boom” that deflated or fizzled in 1962 with a decline of the Dow
of about 25% over a few months rather than in a sudden crash.
After having left behind the era of oil crises in the 1970s, the early 1980s were
characterized by liberal economics under the recently elected President Reagan.
Tax policies favored mergers of companies, which was often funded by massively
borrowing money from the public by issuing so-called junk bonds, which promised
high returns but also carried a high risk. The promise of increased efficiency and
increased prospective profits caused euphoric market conditions with many willing
investors. In order to safeguard the gains and limit losses new technologies such
as automated trading and portfolio insurance with put options were implemented.
The bubble grew but started to wobble when people started to realize profits. Then
automatic portfolio insurance kicked in, which led to an enormous surge of sell