Excessive leverage caused the stock market crash of 1929 and the economic crash of 2008
Although many years separate these two painful events, the common denominator of what caused both is the same.
In the 1920s, you could put in a dollar and buy ten dollars worth of stock. This type of leverage is fine when the stock market goes up, causing stock prices to drop and also high confidence in investors who felt they couldn’t lose.
As the stock rallied higher and higher, it seemed they were correct.
But when the market stopped rising, brokers started calling their clients to inform them that they had to bring in more money. Some could sell stocks to cover their bills, but when all the brokerages communicated with all their clients with the same message, it was like screaming fire in a crowded theater. With all these people trying to sell everything at once, the price drop was very fast and severe.
Not only did the stock market crash, people also feared for their money in the banks and when the crowds went to withdraw their money, the bank run caused more economic pain.
Now fast forward around 80 years and replace excessive leverage in stocks with overly leveraged banks and lots of people speculating in the real estate market. Also with interest rates at historically low levels together, these problems conspired to drive home prices to absurd levels.
In the years leading up to 2008, people had been conditioned to believe that you couldn’t lose money on real estate. Not only did the average person believe this, but it seems that banks believed it too.
More and more people began to enter the housing market and borrow more money to buy a bigger house, some also bought investment property and some built a portfolio of investment houses.
Well, these were obviously not investments at all, much more like gambling at the casino, big stakes indeed.
New players in the mortgage business also played an integral role in driving up home prices, allowing more than just banks to offer mortgages. This additional competition began to affect the banks’ profits, so they tried to find other ways to make money.
Some came up with not-so-brilliant schemes that allowed them to take your money and put it to good use so they could try to make more money.
Unlike in the past, when investors were allowed to bet 10% to buy stocks in the 1920s, these bankers only had to bet a small percentage.
Why the bankers were allowed to be so leveraged is an important question, but what is far more important is to prevent them from doing it again.
The combination of bankers leveraging their balance sheets and consumers leveraging their personal balance sheets are the key reasons for the 2008 economic collapse. Historically low interest rates were also a culprit for the problem, which is why formulators Federal Reserve policy makers should also get some of the credit.
As in the stock market of the 1920s, when stocks continued to rise, it wasn’t a problem until they hit ridiculous prices, and so did house prices in the years leading up to 2008. The end was joyous. as it seemed. like you couldn’t lose, but the next relaxation was quick and very painful.
After the great stock market crash of 1929, the government stepped in and tried to change many rules and regulations and put in place many agencies to try to avoid a recurrence in the future.
Some would rightly debate the effectiveness of all these actions, but one of the most important was restrictions on leverage. You could no longer put down a dime to buy stocks worth dollars and this is a very good thing.
Now, politicians and leaders of government institutions are drawing up plans to try to avoid a repeat of what happened in 2008. One problem with their efforts is that they seem to be throwing up all kinds of ideas that sometimes make people lose sight of. the biggest problem being the leverage of bankers and consumers that drove house prices to ridiculous levels. This is the key issue that caused the recent economic collapse that brought back fears of another great depression.
Signs are emerging suggesting that we are likely to see another slump with the economy in the bottom phase and it looks like there will be a recovery afterward that will lead to significant economic expansion.
But it would be unwise to ignore what has just happened because it seems that we are going in a more positive direction. Instead, we must focus on the fundamental reasons that caused the problems and work on ways to try to prevent them from happening again.
Rules and regulations that prevent bankers and consumers from leveraging too much over their heads that could topple them and nearly drown the entire global economy should be the focus of changes.
Leverage caused the stock market crash of 1929 just as it caused the economic crash of 2008 and reducing this risk is the most important problem to solve.
Banks and consumers have started deleveraging without any changes to the rules and regulations, but even though they are systemic changes, changes are still needed.
There is nothing wrong with leverage until it reaches extreme levels and that applies to banks as well as individuals. The new rules and regulations must be very strict to avoid excessive leverage.
Some will say that this causes the government to become too involved in the business of bankers and consumers. That’s too bad. Excessive leverage is too important and dangerous to politicize and it is critical to try to prevent it, as no one wants a repeat of the stock market crash of 1929 or the economic crash of 2008.
These two events were too painful not to learn from them, and the most important lesson they taught us is the ramifications of excessive leverage.
It is not possible to totally eliminate the chances of an economic calamity in the future, but it is worth making it more difficult. Excessive leverage is the key reason these painful events occurred and also the key to reducing the risk of them happening again.