If we burn our hands on a hot stove, we probably won’t touch another anytime soon. If we see someone else burn their hands on a hot stove, we can learn the same lesson but without the painful cost. History, in its own way, is a treasure trove of other people’s mistakes. If we heed the lessons of the past, we might be able to save ourselves from painful experiences in the present.
This post will focus on the mistakes littered throughout economic history: booms, manias, bubbles, and the eventual busts. An asset bubble occurs when the price of a financial asset rises to levels well above its intrinsic value. Robert Shiller, in his book Irrational Exuberance, describes it this way:
A situation in which news of price increases spurs investor enthusiasm, which spreads by psychological contagion from person to person, in the process amplifying stories that might justify the price increases and bringing in a larger and larger class of investors, who, despite doubts about the real value of an investment, are drawn to it partly through envy of others’ successes and partly through a gambler’s excitement.
Why should we study these manias? Recall that hot stove; imagine we burn our hands and decide the best way to not get burned again is to stay out of the kitchen. Years pass, and we start to wonder if maybe stoves only run cold now. We get burned again, we leave the kitchen again, and we forget again. This is a decent approximation for what happens in real life markets. Carmen Reinhart, in her book This Time Is Different, put it best:
More money has been lost because of four words than at the point of a gun. Those words are ‘This time is different’.
Tulip mania (1637)
One of the earliest and most famous examples of a speculative bubble was the “tulipmania” that struck Holland in the 17th century. Tulips were introduced to Western Europe at the end of the 16th century, and its unique features quickly made it a coveted luxury item among the rich. The middle-class and poorer families eventually joined the craze and demand for tulips soared.
Data from the period is scarce, but it is estimated that tulip prices increased 20x between November 1636 and February 1637, before plunging 99% by May 1637. At the peak, a single tulip bulb could sell for more than 10x the annual income of a skilled craftsman. People would even mortgage their homes in order to buy a tulip bulb with the hope of reselling it at an even higher price.
When the market suddenly crashed, people couldn’t even get back a quarter of what they originally paid for tulip bulbs. Now, they only had large loans and worthless flowers. Panic began to spread as people tried to recover whatever they could. The government tried to halt the crash by offering 10% of face value for tulip contracts, but even that proved unsustainable. A depression set in and even the people who sold early were hit hard.
South Sea Company (1720)
In 1711, the South Sea Company was formed to convert £10 million of British government war debt into its shares. In return, the company was granted a monopoly on trade with the South Seas and South America. The company had no problem attracting investors despite poor management and an ever-increasing issuance of shares.
Management would circulate stories about the riches waiting to be plundered in the new world and investors would eat them up. The price share price of the company increased 8x in 1720 alone. This success led to many other IPO’s which all sold like mad. The Mississippi Company, a similar enterprise, was worth 80x all the gold and silver in France at its peak. Even companies with crazy business plans – like building floating mansions or reclaiming sunshine from plants – had no problem attracting money.
Eventually, the management of the South Sea Company realized that years of mismanagement had led to a company nowhere near worth the current share valuation. Management began to sell their shares in the summer of 1720. When the news got out, panic ensued. Shares in all those other companies also collapsed and a severe economic crisis took hold in much of Europe.
The British government was able to stabilize the banking industry, but their domestic credit was stretched to its limit as a result. Parliament led investigations which imprisoned corrupt politicians and businessmen, and clawed back over £2 million from South Sea Company’s management.
Roaring Twenties (1929)
The 1920’s was a good time to live in American. The first world war had been won, industrialization brought forth new technologies, the Federal Reserve had been established, regulation was relaxed, free trade was extended, and the productivity of workers was expanding. This “new era” economy led to surging U.S. stock prices.
A herd mentality took hold as a flood of uneducated investors bought up stocks with complete disregard of underlining fundamentals. It wasn’t only the uneducated though; Irving Fisher, a Ph.D economist, famously claimed on October 17, 1929:
Stock prices have reached what looks like a permanently high plateau. I do not feel there will be soon if ever a 50 or 60 point break from present levels, such as bears have predicted. I expect to see the stock market a good deal higher within a few months.
In reality, most of the boom could be attributed to expanding leverage as post war gold flooded into the US. Consumer credit soared, and stocks were increasingly being purchased on margin. When the music stopped, and debts were called in, the panic broke out. On October 29, a record 16.5 million shares changed hands in what is now refereed to as “Black Tuesday.” A twelve-year worldwide depression ensued. This was the greatest destruction of economic potential that the United States has ever experienced.
More recent manias
History is full of manias and bubbles. To go through them all would take more time than I want to allocate here. There was the railway mania of the 1840s, the Brazilian Enchilhamento bubble of the 1880s, and the Florida housing bubble of the 1920’s.
More recently, we had the Japanese asset price bubble of the 1980s, the Asian financial crisis of the 1990s, the Dot-com bubble of the late 1990s, the housing bubble of the 2000s, and the Bitcoin bubble of 2013. Mark Twain once said:
History doesn’t repeat itself but it often rhymes.
Most of these cases share two main characteristics: an increased use of leverage and a willingness of participants to suspend their disbelief. The most important lesson from these historical events is that they occur more frequently than would be expected. The time between “internet stocks can never go down” and “housing prices can never go down” was a mere 5 years. As Rose Bertin once said:
There is nothing new except what is forgotten.
Hyman Minsky’s great contribution to economic theory is that stability breeds instability. When things seem good, people forget to account for the bad. Minsky argued that rising asset prices encourage people to borrow money and buy assets. Initially, people can service both the interest and principle payments. As assets continue to rise, people take out even riskier loans with the hope that they can just refinance later at increased valuations. Reinhart puts it this way:
What is certainly clear is that again and again, countries, banks, individuals, and firms take on excessive debt in good times without enough awareness of the risks that will follow when the inevitable recession hits.
History teaches us that most things will prove to be cyclical and that the greatest opportunities arise when other people forget this. Howard Marks puts it this way:
Investment markets follow a pendulum-like swing: between euphoria and depression, between celebrating positive developments and obsessing over negatives, and thus between overpriced and underpriced.
The important questions for us are: how far will the pendulum swing in its arc and when will its direction change? The answers are unknowable, but having an understanding of history can remind us to be prepared for some dramatic swings.