by Roger Bourke White Jr., copyright June 2015
The 2007 Stock Market Crash has been the scariest financial event of the new century. It is the scariest crash since the 1929 crash, and like that crash, has involved a lot of financial hardship and unprecedented government intervention. The intervention is still going on today, eight years after it happened.
This is an essay about its causes.
The root of money and finance are humans cooperating, and as mankind becomes more civilized he invents new ways of cooperating. This, like every other inventing process, is filled with lots of experimenting, lots of uncertainty, and lots of surprises -- some pleasant and some painful.
The pleasant surprises are when a new way of cooperating is discovered, proves very useful, and becomes widespread. These are boom times. The painful surprises are when a popular way of cooperating stops working well, and things have to change. These are busts.
The small busts happen when what was a good process encounters diminishing returns and no longer provides as much benefit as it did. Examples of this would be a forest running out of trees to harvest or or a mine running out of high-grade ore to extract. Then the community must research, discover and implement a new style of cooperating for the boom times to come back. This is what happens during a recession. It is painful but the problem gets solved. There are two basic solutions: the community finds something new to boom on, such as a new crop to grow, or the ambitious "brightest and best" leave the community and join a boom happening somewhere else -- a diaspora of some nature.
In finance the big painful surprises are crashes. Traditionally these were called bank panics. Something deeply scary would happen in the community and in response to it the banks could no longer give or get credit. The panic would then spread through the rest of the community and deeply hard times for everyone would follow. As stock markets became more important as ways of cooperating, they became as involved in panics as the banks were, and the term switched to a stock market crash.
A bank panic or deep stock market crash happens when many people get scared and loose confidence in their money system. In response to this fear they head "back to the basics" in their money thinking. If a still trusted style of money exists this means pulling it out of a bank and storing it under a mattress. If trusted money doesn't exist, or can't be acquired, then people will hoard tangible assets such as food, medicine and gold. (These days, people who do this kind of hoarding when there is no panic happening are called "preppers". The term changes every twenty years, or so.)
There are two common causes for these big panics:
o One cause is some foundation of the financial system, some "given", turns out to be not as predictable as people were counting on -- this is a foundation assumption crumbling. An example of this is when the French monarchy ran out of money in the late 1770's and a bank panic and the French Revolution followed.
o A second cause is that many people in the community get swept up by a "rainbow idea" that looks very promising, and very tangible. (my term -- some others are "momentum", "asset bubble" and "herd mentality") People invest a lot, but then the scheme doesn't come through as planned. One of the early famous examples of this was The South Sea Bubble in 1720. Many people on the British isles invested in a company that was going to make millions on projects in South America. The projects never happened and a bank panic followed.
The immediate cause of the 2007 panic was a foundation assumption crumbling. In this case it was that housing prices in the US would continue rising, as they had been doing for more than twenty years previously.
What had been happening during those twenty years was the inventing new ways of cooperating -- new financial tools -- based on this foundation assumption and they had been spreading widely. The most famous for causing trouble was a type called Collateralized Debt Obligations (CDO's). This was a tool that allowed home mortgages to be bundled into packages and sold to many different kinds of investors.
The market for these got huge, and being something brand new, the full ramifications of the changes they were making to the mortgage industry were not understood... until the crash happened, and the crash turned out to be a bank panic of a magnitude not experienced since the stock market crash of 1929. As that was being dealt with, the weaknesses and abuses of this new tool were revealed to all.
As is common with a big, novel and scary event like this, there was a lot of "Monday Morning Quarterbacking" following it. There were lots of people who claimed to have seen it coming, and claimed to know how to fix things after it happened.
In practice, the Federal Reserve, Congress and many government agencies all took fast action to contain the crisis, and then more deliberate actions to prevent a repeat -- one of the more famous being the Dodd-Frank Act passed by Congress in 2010.
Sadly, many of these actions, even the deliberate ones, were taken hastily and not thought through using cool-headed thinking. The result of these hasty remedies has been a lot of waste, such as fixing problems that did not need to be fixed, and making the future cooperating much more difficult through cumbersome regulations. This kind of wasteful fixing is something I call a Blunder and I write a lot about it in my Cyreenik Says blog.
The experimenting to find new ways of cooperating will continue. Where old ways are too cumbersome to serve well, and new ways are discovered that work better, the new ways will be implemented and spread widely, and after a while how these new ways can be abused will be revealed. Mobile payment systems are an example of this currently happening.
But people remember -- those who have been burned have learned. They will be cautious and investigate more carefully. And their kids will as well... but not their grand kids -- their's will be a whole new, exciting world.
This means the cycle of boom and recession will be repeated often, but the big panics will be separated by a few generations.
--The End--