Wednesday, October 17, 2007

A brief history of bubbles

History has given us many of bubbles to learn from. It seems however that being human we tend to forget the lessons of the past. Lets take brief tour of some of the more famous bubbles and see what we should have known would happen in this one.

One of the oldest and most famous bubbles was the 1634 Tulip bubble. Tulips became wildly popular in Holland after their introduction from Turkey in 1593. Soon everyone wanted to get in on the action of dealing in tulip bulbs. People were buying up bulbs in a feeding frenzy. This caused a shortage of bulbs which sent the prices even higher. Soon people were trading their life savings, their land and anything else they could liquidate for tulip bulbs. At one point the value of them went up 20 fold in a month.

Of course at some point a few of the more intelligent people see what’s coming and decide to cash out. Once that happened the stampede for the exits began and the value of the bulbs crashed taking the whole Dutch economy with it.

The next great speculative bubble was the South Seas bubble in the UK. The South Seas Company was established in the early 1700s and using an IOU purchased the rights to all the trade in the south seas. Back then companies only offered limited amounts of stock so the shares were hard to get and very lucrative. It did not take long for the company to discover that selling stock was more profitable than running the company. They sold more and more stock, feeding the appetite of the seemingly endless supply of investors. Soon the stock was selling for 1000 pounds a share (a lot of money in 1720!). Once again at some point the people in the know decided that there was no correlation between the stock price and the value of the asset. They sold, setting off the alarm bells and triggering a crash of gargantuan proportions.

The next great bubble was the 1926 Florida real estate bubble. Land in Florida was once cheap. The state was hard to get to and generally thought of as a swamp, infested with all manor of nasty creatures and diseases. Once rail and road was laid savvy businessmen began to market Florida as a vacation paradise and a cure all for all your medical problems. Soon enough land values began to rise and people began to move to Florida. this caused a further shortage of available land, causing the values to rise even farther. Soon investors got word of this and they started buying anything at nearly any price. Land prices skyrocketed up to 600% in a year in some areas. At some point the buying stopped. The prices got to high or there were no greater fools. Whatever the reason the buying stopped and the panic began. Prices started to fall and then fell off a cliff as panic selling ensued. When all the air finally escaped prices had returned to pre-bubble levels.

The next bubble is the great depression. I don’t think I need to go into any great detail here but there are remarkable similarities between this crash and current conditions. Most people think of it only as a stock market crash but it was far more than that. It took the real estate market down, it took banks down and it took the economy down. Like all great bubbles people were buying stock at any price regardless of its fundamental value. Value was based more on what people thought they could sell the stock for tomorrow. Once the selling started there was no stopping it. Millions of uneducated investors lost everything and we all know the rest.

The Japanese market crash is a good example of a slow motion train wreck. So far all the crashes we looked at happened fairly quickly (Although contrary to popular belief the 1929 market crash actually took 3 or 4 years to fully play out.). The Asian crisis started after a long period of economic gains. From 1960 to 1990 land prices in Japan increased something like 70 times and stocks 100 times. Soon trading was a national sport in Japan. People were buying anything and paying incredible prices for it. I remember well Japanese businessmen buying golf courses for incredible amounts of money. The Japanese government in an attempt to slow down this runaway train increased interest rates. Unfortunately, instead of slowing the train it caused it to jump the tracks and the Nikkei index dropped more than 30000 points. Real estate values plunged and continued to decline for 15 years. At the peak a square foot of prime Tokyo real estate was selling for up to $140,000! At one point the royal palace was valued at more than all of Florida. In 5 years real estate values were cut in half but they continued a gradual decline until only a few years ago when prices bottomed out at 20% of their bubble values. The government tried to halt this collapse by lowering interest rates (sound familiar?). However even with rates as low as one percent the decline continued.

The Japanese crash is an interesting example of how little governments can do when the inevitable happens. Once the investors/public realize that it was a bubble and things really aren’t worth that kind of money there is little the government or banks can do to bring back the glory days. Even with free money people were unwilling to pay inflated real estate prices. The attempts to halt the crash probably did little more than slow it down, causing it to last 15 years rather that they 5 it should have taken.

Let’s hope our leaders have learned a little something from the Japanese. Sometimes it’s better to take your medicine and allow the markets to quickly correct rather than trying to manipulate a free market.

The fed can lower the interest rates to zero and I still will not buy a grossly overpriced POS house!

Disclaimer, I am not an economist nor a historian although I did stay at a Holiday Inn Express last night. Any errors or omissions are 100% my fault and I apologize in advance.


Anonymous said...

Great history lesson. I enjoy reading your blog. Keep up the good work.

Anonymous said...

Danes live in Denmark. The Dutch live in Holland. Otherwise, good article :)

golfer_X said...

Damn those Danes, they should stay out of Holland....