Paper type: Essay Pages: 13 (3132 words)
Financial bubbles have existed from the time humans began trading with one another. However, these bubbles were usually confined to a particular commodity or company and when the bubble burst the fallout was usually limited to a small segment of the population. As human enterprise evolved and the financial system developed complexity and became more intertwined with a larger segment of the population, a bursting financial bubble would have a more far reaching and destructive effect on the society. For many millennia, humans pursued agricultural enterprise but this started to change just over 200 years ago with the coming of the Industrial Revolution.
Innovations in technology were a revolutionary force that changed human society. Since then, technology revolutions have been more frequent and they have drastically changed the way humans live. These technological revolutions are transformative but also disruptive, as an unintended consequences is the formation of financial bubbles. These technological revolutions generate the conditions that breed financial bubbles as the demand for vast amounts of cheap capital is needed to fund investment in the new technology.
This demand for capital presents exciting opportunity for investors to finance the new technology. As more investors pile in, an unsustainable bubble develops which eventually bursts. The consequences are usually a financial crisis or depression as wealth is destroyed. In the past 200 years there have been a number of these technological revolutions and the resultant financial bubbles.A technological revolution occurs when an innovation creates the means to make new products, and industries are formed that cause significant disruption in an economy. These breakthroughs spread beyond the industries from which they originate and penetrate social practice, legislation, governance, and ideology in the entire society. The Industrial Revolution starting in the late 18th century witnessed the mechanization of labor, the building of transport and distribution systems to support the factory produced goods and the invention of the steam engine for ships and railways. The Industrial Revolution culminated with the Railway Mania in the mid-1840s. The Second Industrial Revolution, starting in the 1870s, saw the electrification of cities, new communications systems, the expansion of factories and the development of assembly line work which made goods cheaper for the consumer. New inventions and the globalization of trade were features of this period. The Stock Market Crash of 1929 was the bubble that developed in response to this technological revolution. In the late 20th century, semiconductors improved computing power and the development of the Internet led to a new information age. New companies were formed to profit from this new technology, eventually this ended with the Dot.Com bust in early 2000. The chart below identifies the five technological revolutions in the past two centuries with their approximate start date and the key developments of the technology. In a financial context, a “bubble” refers to a condition where the price for an asset greatly exceeds its fundamental value, in other words – the price is a lot more than what the asset is really worth. Prices in a bubble become highly inflated, bearing little relation to the intrinsic value of the asset. Studies have identified five progressive stages in a bubble – displacement, boom, euphoria, profit-taking, and panic. At the displacement stage, investors learn of the new technology and realize the potential to make a large profit. They become enamored with the new innovation and provide the initial capital. As word spreads of the new technology, prices start to rise slowly at first, but then gain momentum as more participants enter the market. The general public becomes aware of the new technology. Touts and swindlers become involved and start to promote investment opportunities. Media coverage becomes widespread and gullible investors start to fear missing out of what can be a once-in-a-lifetime opportunity. This leads to even more speculation as new investors are drawn into the opportunity. This is the boom stage. At the next stage,euphoria, the price skyrockets and investors begin to rationalize the high valuations they are willing to pay. Investor’s become convinced that this time is different and new metrics are contrived to support the high prices. During the Dot.Com bubble in the late 1990’s, investors were told profits or sales did not matter, but eyeballs or clicks were the most important metric to measure the value of a new internet company. The smart money starts to see the warning signs and begins selling to take profits. The bubble that has gone up sharply is delated just as fast when panic sets in. A minor event can cause asset prices to reverse course. In the final panic stage, prices start to fall as the selling overwhelms the demand. Speculators seeing their profits evaporate, start to liquidate at any price, just to get out.A financial bubble is quite easy to see in hindsight but during the euphoria investors seem willing to convince themselves this time is different. An illustrative example is the financial bubble that was formed surrounding the South Sea Company, one of the first stock bubbles. The South Sea Company, founded in 1711, was a a publicly traded company formed in to trade with the Spanish South American colonies. Sir Isaac Newton, the renowned scientist, became an investor in the company in 1720 when he bought shares. He quickly doubled his money and sold his position to make a profit. As the stock continued to climb, and his friends were becoming rich, Newton decided to buy even more shares than he originally had. By the end of 1720, the shares in the company collapsed and Newton lost his fortune. It is estimated that he lost over $3 million in today’s money. The chart below shows the stock price of the South Sea Company and the points where Newton entered and sold his stake. Between January and June of 1720, shares in the South Sea Company skyrocketed over 900 percent – by the end of 1720, the shares were worth the same as at the beginning of the year.The above chart shows the pattern a financial bubble follows – from displacement, to boom, to euphoria, to profit-taking, and finally panic. The anecdote about Newton shows that even the most intelligent can fall prey to the excitement of a bubble. The secret ingredient to any bubble is greed, that combined with a dose of technological innovation, is a recipe for financial disaster, even ensnaring for the most intelligent.The first financial bubble linked to a technological revolution was the Railway Mania which occurred in the 1840’s. Railways were a driving technology of the Industrial Revolution and they transformed the United Kingdom from a rural, agricultural economy into a urban, industrialized nation. The Industrial Revolution started using new energy sources to mechanize the mass production of finished goods. Steam was the new energy source that started this revolution when Thomas Newcomen, a British engineer, in 1712 made a steam engine prototype. The textile industry began to develop in the late 1700s when British weaver James Hargreaves invented the Spinning Jenny. This device reduced the time to produce threads from raw materials and raised the output of a single worker eight times. Other inventors applied steam energy to the railway locomotive – invented in 1804 by Richard Trevithick – and to the steamboat – invented in 1807 by Robert Fulton. The surge in industrial activity required an effective network to transport large quantities of raw materials and finished goods. Significant capital was needed to finance the building of this infrastructure which included canals and waterways, steam engines and railways, and ships and ports. Railways started to be developed beginning in the late 18th century but they entered a period of intense growth around 1830. Railways made it possible to move vast quantities of raw materials and finished goods more cheaply and quickly. In 1830 England had 98 miles of railway track and by 1840 there were about 1,500 miles of track, and by 1849 England had a network of 6,000 miles linking all of its major cities. At its peak, railway investment represented half of total investment in the UK economy. This intense railway development sparked a speculative financial bubble known as the Railway Mania (1844 – 1846) which had its origin in 1830 when the world’s first commercial passenger railway line was opened between Liverpool and Manchester – two growing cities of the Industrial Revolution. Previously, railways had been used to transport goods and few people considered using trains to transport passengers. The Liverpool-Manchester line was a big success and investors saw the profit potential in passenger travel. Also, in the early 1840s, the Bank of England lowered interest rates making the cost of capital less expensive. The railway companies needed this capital and the started to aggressively promote investment in shares of their companies. By late 1845, railway share advertisements covered over half the space in many papers. These ads were rife with inflated claims, optimistic revenue projections and questionable accounting practices, whipping up euphoria among investors. Britain’s emerging middle class responded to these marketing efforts and started to invest in railway shares. The investor base was further enlarged when stocks could be purchased with just a 10% deposit. However, it was not just the public who speculated in railway shares but many luminaries such as Charles Darwin, John Stuart Mill, the Bronte sisters and Benjamin Disraeli also participated. From 1844 to 1846, an index of railroad company stocks nearly doubled, driven by the promise spectacular profit growth.As shares in railway stocks soared, the rail companies overbuilt thousands of miles of lines throughout the UK. Then in 1845, the Bank of England raised interest rates making credit more expensive for borrowers. Soon after, in 1846, the railway stock index peaked and began to drop rapidly due to the combination of higher interest rates and the growing investor realization that many of the railway companies would never be profitable. Railway company stocks fell by 50% from 1846 to 1850. The chart below shows the price index of British railway shares from 1830 to 1850 (source: and depicts the bubble and its collapse. This plunge made the situation even worse when investors had to payback the remaining 90% of the money they had borrowed to buy stock. Many investors who had sunk their life savings into railway stocks were ruined. Many companies went out of business and there were enormous debts throughout the country but arguably in the long term the UK may have benefitted from the bubble. The overbuilding frenzy left behind a usable network of railway tracks which a few larger companies bought up at a fraction of their original value. By 1850, the UK had a modern 6,000-mile rail network which formed the backbone of the country’s transportation system. In subsequent decades, this transportation system was put to good use and became the foundation upon which Britain built its manufacturung base.A Second Industrial Revolution started to emerge in the latter half of the 19th century and into the late 1920s. New inventions emerged that improved communications, transportation and manufacturing. This new technological revolution was being fuelled by new power sources that included electricity, oil and gas. There was also an explosion of new affordable consumer products such as the automobile, the radio and movies. In 1844 Samuel Morse invented the telegraph and revolutionized communications as people could now communicate quickly over great distances. The telegraph was improved upon, and communication was personalized in 1876, when Alexander Graham Bell patented the telephone. Cities were becoming electrified and people were able to light their homes when Thomas Edison improved the light bulb. Electrification had a profound impact on society as new products such as the radio and the washing machine were being produced affordably for a large segment of the population. These consumers worked in the factories that produced these new marvels. For example, in 1900 only the wealthy could afford to own an automobile but with the introduction of the Model T in 1908, Henry Ford made automobiles affordable to the general public. Henry Ford revolutionized production methods when he set up large factories with assembly lines to reduce the cost of making an automobile through the specialization of labor. He paid his workers a generous wage so that they could be consumers of the automobiles that they produced. Over 15 million Model Ts were sold in the next 15 years. New inventions, production methods and energy sources greatly changed society in the early 20th century but this technological change lay the groundwork for a massive financial bubble that would culminate in the 1929 Stock Market Crash.Optimism was abundant after the First World War in the U.S. as consumers were buying the products that were being produced by American industry. Consumer credit expanded as Americans used credit to finance purchases of new products such as automobiles and radios, which were created using new techniques of mass production that additionally helped to drive down prices. The period from 1924 to 1929 was known as the Roaring Twenties because of the general exuberance in this era. The overall economic climate in the United States was healthy in the 1920s, with unemployment down, and new industries were booming. This general confidence spilled over into the stock market. The stock market increased six-fold from August 1921 to September 1929 with new technology industries such as the automobile, motion picture, and aircraft industries, going up the most. As example, in 1928, radio stocks rose by 400 percent. Respected financial experts of the time proclaimed a new economic era as the stock market was setting new highs seemingly everyday. Just days before the stock market crashed in October 1929, a leading economist, Irving Fisher, concluded: Stock prices have reached what looks like a permanently high plateau. On September 3, 1929, the stock market reached a high before the bubble started to deflate. The first large decline occurred on Thursday October 24 when the stock market lost 11 per cent of its value. The following Friday was quieter but then on Monday October 28 the stock market fell nearly 13 percent and on the next day, known as Black Tuesday, it was down another 12 percent. Following the chaos of October 1929, the market went up through spring 1930 before plummeting again. The stock market would not return to its September 3, 1929 peak until November 23, 1954.At the time of the crash, stock prices were overpriced and were fuelled by the optimism of the new technology. Investors were confident that stock prices would only continue to rise and this view was supported by many leading experts and reinforced by the market itself as it continued to rise. A reckless overconfidence extended to average consumers and small investors, too, leading to an asset bubble’. The general public widely participated in playing the stock market and many small investors bought stocks on margin’, meaning they paid only a small percentage of the value and borrowed the rest from a bank or broker. Leverage allowed investors to borrow money to buy shares using very little of their own money. This practice can amplify returns but can also be very dangerous when asset prices decline and the investor could end up owing more money than they originally invested. This use of leverage exacerbated the panic when prices started to sputter. In August 1929 the interest rate was raised from 5 to 6 percent. This interest rate increase dampened investor enthusiasm and served to reduce economic growth. After the stock market crashed, people rushed to banks to withdraw their money in a bank run but the banks did not have the depositors’ money on hand. Even worse, many banks themselves had invested and lost money in the stock market. This led to bank failures and a banking crisis which worsened the financial situation. Investors and the general public lost their entire savings, while numerous banks and companies went bankrupt. The stock market crash of 1929 contributed to the the Great Depression in the 1930s as the economy stagnated for many years. Despite the hardships the stock market crash inflicted on society, a number of benefits came about. New consumer products became available to a growing middle-class that saw the foundations of its prosperity later in the 20th century laid down during the 1920’s. Regulation of the securities markets, to ensure fairness and limit margin lending, was implemented with the formation Securities and Exchange Commission in 1934. Roads and highways were built to accommodate a travelling public who became infatuated with the automobile and the freedom it offered the average person.On March 11, 2000, the so-called Dot.Com Bubble comprised principally of internet and related stocks such as telecommunication companies started to unfold. This bubble had been building up over a number of years but started reach for the stratosphere as the new millenium approached. The Dot.Com Bubble started growing in the late ’90s, as access to the internet expanded and computing became widespread throughout the general public with the invention of the personal computer. Startups in the online retailing space were a large driver of this internet growth as consumers began buying goods from sites like Pets.com, Amazon.com and Stamps.com. The investing public recognized that the personal computer and internet connectivity would change the way consumers interacted with retailers and the excitement to invest in Dot.Com stocks grew. The NASDAQ stock index that contained these new Dot.Com companies rose from nearly 700% from January 1995 to March 2000 – reaching a level of about 5,000 points. The euphoria of the bubble was solidified as more new companies were being formed. These companies would offer their shares to the investing public and they would double or triple in price over the their offering price on the first day of trading. These new offerings would be touted by analysts on specialized business television channels such as CNBC. These analysts promoted these stocks and even made up new measurements to justify the lofty stock prices. The reality was that most of these companies were losing money and really had very little hope to every make a profit for their shareholders. But in the midst of the euphoria, it seemed to the public as if everyone was making money. Some people even quit their jobs to day trade these stocks. Investors slowly began to realize that most of the hot Dot.Com companies would never be profitable and the race to exit out of these stocks started. The bubble started to unfold on March 11, 2000 and by early April almost a trillion dollars of stock value evaporated. Many companies went bankrupt while others were merged or acquired by other companies at bargain prices. The chart below shows the Nasdaq stock index at almost 5,000 points in March 2000 as the Dot.Com Bubble was peaking; the index would reach and surpass this level almost 15 years later.
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Financial bubbles have existed from the time humans began trading with one. (2019, Aug 20). Retrieved from https://studymoose.com/financial-bubbles-have-existed-from-the-time-humans-began-trading-with-one-essay