Adventures in Global Finance [Part II]

The Stock Market

Of Trees and Origins

New York has long been a home of speculation & intense trading.
In 1791 and 1792, there was so much speculation that the state cracked down & banned auctions of securities [citation]. To deal with this, twenty-four traders met one day in May, beneath a tree where they regularly met. (A buttonwood, or sycamore, tree). They signed an agreement to form a private club, where they could trade stocks with each other, with a set rate of commission. (The "Buttonwood Agreeement.")

After that, they didn't hang out under the tree, but met regularly at the Tontine coffee house to gossip and trade stocks. In 1817, this exclusive club became the New York Stock Exchange & Board, and rented a room to do business in. Over the years it grew, but maintained exclusivity: and until 2005, only those with one of the 1,366 seats could trade directly on it (the price for a seat peaked at $4 million). In 2005, the NYSE became a for-profit, publicly traded company, which sells 1-year licenses to people who wish to trade on it. Now the largest stock exchange in the world (in dollar volume -- the Tokyo exchange is larger by other measurements) it meets in this well-guarded building at 11 Wall Street.



It is interesting to note that the stock exchange began as an illicit attempt to avoid a law, by taking business into the private room... also that it has such a simple, narrative beginning. The sycamore tree, the coffeehouse, the twenty-four guys: it all began so simply, convivially, so classically & charmingly human.


Stock Crashes: What caused the stock market crash of 1929?

Surprisingly, there is really no consensus on this. (What does it signify that 70-80 years later, we have no explanation for what happened? Have we made a real effort to understand it, or are the causes still obscure because the practices involved are still at work today?)

Basically, the famous stock market crash preceding/causing the Great Depression had either one cause or many; either domestic or foreign causes; it may have been an inevitable result of business practices, or it may have been caused by governmental actions -- your interpretation of the origins of this crash will be determined by your economic philosophy.

Here are some of the oft-cited causes:

-- a decline in consumer spending/investment
-- the size of the money supply (too small, according to some experts)
-- the amount of personal debt citizens carried (they had just began to use payment-in-installment credit schemes, then)
-- corporate mergers / consolidation of wealth into the hands of a few
-- the fact that the economy was too dependent on just a few industries (autos, for example)
-- a wide gap between rich & poor; the polarization of incomes
-- deregulation actions
-- stock speculation

There was a speculative boom in stocks, which led to the market being overvalued; people were living with the anticipation of future riches rather than in economic reality.

Because of the practice of "buying on margin", people only needed 10% of a stock's price as a down-payment to buy stock: they would borrow the rest from their broker. In Sept. 1929, for example, there was 8.5 billion in outstanding broker loans.

Once people realised this was a bad idea, there was a lot of panic selling... and then, the famous stock market "crash" (which actually was a rolling slide that stretched for several weeks, in the autumn of 1929).

the ticker tape from the NYSE which tracked the crash of 1929,
on display at Wall Street's Museum of Finance

The crash followed a period of genuine optimism, fueled by the industrial boom during this time. The industrial boom gave people the idea that they were in a glorious era of something-for-nothing, and this confidence fueled all kind of schemes, like a real-estate bubble in Florida.


Could the stock market crash again, like in 1929?

To begin somewhat tangentially, we should consider the role of mood in the stock market. The 1929 crash was as much a crash of confidence as it was of stocks. Why do you think "consumer confidence" is constantly "measured" by economists? Because the mood is important, somehow. Whether there is an all-out panic or a mild sell-off depends on mood.

"Irrational Exuberance" was a phrase coined by Greenspan, to describe the mood of the markets (back in 1996)-- the phrase seems to echo the mood of the Roaring Twenties.

So, will the irrational exuberance of the 1990s result in a crash? Consider this paragraph from a dated (2002) but interesting article by economist Ellen Frank:

In 1999 alone, the market value of U.S. equities swelled by an astounding $4 trillion. During that same year, U.S. output, on which stocks represent a claim, rose by a mere $500 billion. What would have happened if stockholders in 1999 had all tried to sell their stock and convert their $4 trillion into actual goods and services? The answer is that most would have failed. In a scramble to turn $4 trillion of paper gains into $500 billion worth of real goods and services, the paper wealth was bound to dissolve, because it never existed, save as a kind of mass delusion.

I suggest that a stock market crash happens when reality crashes delusion. But as long as confidence is high, the delusion can be sustained.

Can't it be good to get rid of your delusions?

As Andrew Mellon told President Herbert Hoover, regarding the crash & Depression: "...it will purge the rottenness out of the system. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people."

Cold, no? The truth lies in the part about "values being adjusted"; this could be quite positive.

It's worth nothing that a stock crash today would be quite different than in 1929, because today, most middle-class people own some stock (only a small percentage of the population did in 1929). Your retirement money, or your parents' retirement money, likely involves a 401(k) or a mutual fund plan, etc. If the market crashes, and the baby boomers lose their retirement savings overnight, it will not be a good situation. (I know how weak that sentence reads, but I'm pressing on...)

I think that we will have a crash of confidence again, in the next decade -- for many reasons, some of which I will go into later (the two main reasons being energy & demographics). But basically, there is a gulf between image and reality that needs to be corrected; a gap that will correct itself eventually. A stock market crash, or at least a downturn, will likely be part of this.

The foundation of the whole system, whose shape I am beginning to discern, lies with responsibility -- the cracks in the foundation lie with irresponsibility. People in the 1920s who bought stocks on margin were acting irresponsibly, as are people who run up credit card debt today, as are the recent mortgage lenders who urged poor people into unreasonable sub-prime loans, as are the banks which bought these loans, as is a national government who runs up its debt into the trillions: all of it childish & irresponsible.

But why should you care if some people act irresponsibly? ... because we will all fall together.

In the next part of this series, we'll look deeper at speculation -- if you've ever wanted to know about futures, options (vanilla and exotic) -- or if you just wonder why it costs so much to buy a bag of flour this year -- well, we will try to understand it together. Stay tuned!

me posing with legendary financier J.P. Morgan
In 1907 there was a financial panic
in which stocks fell 50% (due to speculation, that evil spectre)
J.P. Morgan stepped in and saved the economy,
bailing out the market with a team of bankers he organised.
Who can play J.P. Morgan today?