What economic crises teach us

Many crises have in common the phenomenon of an overheated asset. When some value causes a frenzy of demand, it sells for much more than its real value. When the value approaches a figure that is unacceptable to potential buyers, the market crashes the price. There are fewer people willing to buy the asset, sellers lower the bar, but it doesn’t help. A panic sale replaces the frenzied demand. This continues until the price bounces off the bottom and goes up, but not at the same pace.

You can make money in turbulent markets, but the risk of losing everything is much higher. We tell you how it happens on the example of several crises.

The Tulip Crisis in Holland, 1636-1637.
This is the first documented economic crisis in detail. The story is simple: unusual flowers with variegated petals began to appear among ordinary tulips. Most were not viable: the flowers were infected by viruses and looked unusual because of this. However, in Holland of the XVII century, a real hunt for special flowers began.

Rare bulbs became a lucrative asset: the price of one was many times the annual salary of an artisan. Among the buyers were professional flower growers, art collectors, and investors who planned to make money on flowers.

Obviously, tulips don’t grow in winter. Then enterprising flower growers began to sell the crop that they were only going to grow in the season. The deal was concluded with the following conditions: the seller promised to deliver the goods by spring, and the buyer undertook to buy the goods back. The price was determined before delivery, at the time of the deal.

This obligation, signed by the parties, could be traded as successfully as tulips themselves. Prices for such paper were actively fueled by speculators’ rumors and promises that soon everyone would be interested in the flower, and prices would increase many times over.

This is how futures trading works: an investor does not buy an asset, but a commitment to buy or sell it in the future, but at the current market price. It was during the tulip crisis that futures trading took shape as a phenomenon.

The overheated asset already collapsed in the spring of 1637. Why – the question is debatable to this day. Probably, the invisible hand of the market worked: bulbs grew less than planned, contracts were not fulfilled. They stopped buying them – and then panic sales began. Physical bulbs became 20 times cheaper, and futures lost liquidity altogether, driving most traders into bankruptcy.

Two years later, when the psychological bottom was passed, the market rose again, although not to the levels of 1636. Tulips began to sell at a fair market price, without frenzied demand or panic selling. Tulip prices then declined smoothly, no longer causing catastrophic consequences for bidders.

The sickly but once valuable tulips died out after a few generations. And history got the first well-documented stock market bubble. The names of those who made fortunes from tulip speculation have not survived to this day. However, the conclusion is self-evident: those who were able to stop in time and get out of the game just at the moment when the price of bulbs and futures was growing or was already the highest possible. Tulip growers were lucky: they managed to sell the overheated asset before the market collapsed.

Black Thursday, October 24, 1929, U.S.A.
Economists are still arguing about the causes of this crisis. However, the stock exchange crash that preceded it developed according to the same laws as the tulip crisis in Holland.

In the 1920s, the US economy was experiencing an economic boom after World War I: production and market capitalization of companies were growing. Government policy encouraged big business, and a consumer society was actively forming. At the same time, loans became cheaper, allowing citizens with low incomes to get large sums. This led to the fact that the mass of Americans began to speculatively trade in securities.

Demand for stocks raised prices, rising prices attracted new investors, prices rose again, and more investors got involved in speculative trading. Stocks were bought far above their fair market price, often on credit. Margin loans were then widespread and are still in use today: the investor leveraged the stock for trading. This allowed to operate with sums several times larger than equity capital. Profit from transactions with such an instrument increases, but risks also grow: in case of unprofitable transactions, settlements with the lender may destroy the investor’s entire capital in one or two transactions.

Due to the frenzy of demand and the use of credit, the value of companies’ securities ceased to correlate with their real capitalization. The share price grew only due to the enthusiasm of investors. This led to the formation of a stock bubble, just like in the case of Dutch tulips. It burst on Black Thursday, October 24, 1929. On that day, several brokers simultaneously demanded the settlement of margin loans. In order to pay, investors began to sell shares, which led to a decrease in their price. The panic began: securities began to be sold en masse for any money to avoid losing everything.

The stock market lost about 40% of its capitalization or $30 billion.

Black Thursday began the Great Depression, an economic shock that the U.S., and then the rest of the world, endured for several years. After this crisis, in 1932, the U.S. created the Securities and Exchange Commission (SEC), designed to prevent a repeat of the stock market crash. The regulator monitors the issue and circulation of securities, does not allow transactions that would significantly affect the price level and does not allow abuses in the market. Currently, every country with at least one stock exchange has such a body.

However, even in these desperate economic times, it was possible to make a fortune. One of these lucky people was lawyer Floyd Bostwick Odlum. On the eve of the crisis, he managed to withdraw most of his capital from stocks to currency. After the collapse, Odlum bought shares in companies for nothing, and when the stock began to grow again, he found himself among the ten richest people in America.

The Soviet Union also benefited, and a large part of its industrialization was based on cheaper American technology and specialists from Europe who fled the crisis and immigrated to the USSR.

Black Monday, 1987, USA
On October 19, 1987, for no apparent reason, the Dow Jones Index, a measure of the value of the 30 largest U.S. companies, suffered its biggest drop in history. And this was after several years of rapid growth. The chain reaction spread all over the globe, and in a few days stock exchanges in Australia lost 41.8%, Hong Kong stock exchanges – 45.8%, Canadian stock exchanges – 22.5%, and in Great Britain the fall reached 26.4%. It is interesting that low power of computers saved from the world financial crisis at that time. Deals were conducted in automatic mode, they were executed by stock exchange terminals. During the attempt of a panic sale, the systems simply depended on the number of orders and slowed down the price collapse.

Versions of what happened are still being discussed. One of the main ones is the automation of the exchange. Orders were placed by robots and executed by them, which led to too many transactions and system freezes.

Despite the shock fall in the indices, stock markets recovered relatively quickly – within a couple of years – and the real economy took almost no damage.

The main lesson that stock exchange regulators learned then was that trading should be suspended if the market was getting too unstable. What a computer glitch did in 1987 is now part of stock exchange practice. If there is a frenzy of demand or a sharp sell-off, trading is halted for a few minutes. This prevents securities from changing their value significantly.

The dotcom crash, 2000, USA
On March 10, 2000, the NASDAQ index (an exchange that specializes in high-tech stocks) reached its all-time high of 5132 points and almost immediately rushed downward.

Dotcoms were the name given to high-tech companies focused on Internet business, such as Google or Amazon. The name itself comes from .com, dot-com or dot-com, the name of a domain popular among commercial companies.

In the early 2000s, investors perceived the dot-com or Internet-oriented nature of companies as an indicator of promising prospects – and bought the securities of these companies en masse. But the mass excitement was not backed up by anything real: most business models of high-tech companies turned out to be unviable. As a result, the market, which was considered super promising, turned out to be overheated. It took several years for high-tech companies to regain the market’s trust.

The wave of IT-company bankruptcies has significantly cleared the market of weak players, and the share price on the NASDAQ exchange, inflated before it, returned to the real indicators of market capitalization of enterprises.

The biggest victims of the dot-com crash were telecommunications providers NorthPoint Communications Group, Global Crossing, and Covad Communications Group, while WorldCom’s bankruptcy was the third largest in U.S. history. At the same time, companies that survived the crisis, such as Amazon, eBay and Goggle, are now leading the market.

World economic crisis, 2008
The most global and most widespread crisis since the Great Depression. In 2009, for the first time since World War II, global GDP went into negative territory. The rise in unemployment was also unprecedented: almost 200 million people were left without a job.

The trigger for the global recession was the US mortgage crisis. Banks gave loans to more and more dubious borrowers. As a result, the percentage of debt burden averaged 127% of the family income. While real estate prices were rising, people were actively taking out mortgages, reselling or renting out space. As soon as real estate prices began to decline, real estate investments ceased to be profitable and demand for mortgages fell.

As the number of borrowers grew, derivative securities became increasingly popular: mortgage bonds and mortgages. In fact, mortgage foreclosure rights were freely resold on the market, and banks issued bonds secured by the mortgage debtors’ payments. When demand for mortgages fell and payments on mortgages declined due to unreliable borrowers, derivatives also depreciated sharply.

Financial institutions associated with them suffered, in particular the investment bank Lehman Brothers, which became the symbol and starting point of the 2008 global financial crisis.

Whether this crisis is over is still a debatable issue in the expert community. The global recession came to Russia at the end of May 2008, when Russian stock indices stopped growing and began a rather rapid decline. The World Bank report notes that the 2008 crisis came precisely as a crisis of the private sector “in the context of a profound triple shock: from the terms of foreign trade, capital outflows and tightening external borrowing conditions… with the worst external economic environment since World War II”. Public finances then demonstrated resilience.

Be prepared
Crisis scenarios are similar – a frenzy of demand, a sharp rise in price and an equally sharp collapse. Often the excitement arises due to the appearance of a new instrument on the market: for example, unusual tulips.