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The Lesson Never Learned

January 4, 2010

In October of 1929, Wall Street had a crash that is pegged as the start of the Great Depression.  While the stock market crash known as “Black Tuesday” is an easy event to see, the real cause of the crash has to be traced back to understand how it all came about.

The “roaring 20s” is the name given to the 1920s, a decade of excess.  Not just in revelry and all night parties but in financial matter too.  Home values had a quick rise; the stock market did the same.  So much so that everyone wanted to invest.  Most believed prices would continue to rise and brokers wanted to take advantage of the new demand.  To this end, shares of stock were sold at about two-thirds their face value, allowing for more shares to be sold.  The remaining one-third would be recouped when the stock was sold at a profit.  It worked very well until the housing bubble burst and home prices went down.

With property values declining, economic confidence declined too.  People began to hang on to what money they had.  Stock prices stopped increasing and brokers started demanding the money they were owed.  This started a chain of events that saw fortunes evaporate overnight.  One failure lead to another until the entire financial system became unstable.  The Great Depression was in full swing.  While there are many other factors involved, they all have a common trait, a loose monetary policy.  The lesson can be boiled down to this: financial markets and institutions need strong federal regulations prevent economic collapse.

In 1929 the United States monetary system was backed with gold, what is commonly called “the gold standard.”  Today, our system is backed by a promise, what is called ‘fiat money” or “legal tender.”  To avoid a lengthy lesson in economics, think of it like this, our money is only as good as our faith in the government to back it.  It has no real value relative to something like gold or silver.

Why is this important… because a large financial institution can have a great impact on that faith.  Our recent troubles are a prime example.  Investment banks, this time, saw an opportunity to make large amounts of money by speculating on the value of stocks.  Everyone thought the value was only going to increase, so much so that insurance companies wanted their slice of the pie too.  To get it they basically “insured” the speculative investments.  As in 1929, the bubble burst.  This time when the music stopped, it was the insurance companies left without a chair.  They could not cover the losses they underwrote.  Everything was coming unglued as confidence plummeted.  Then came the government bail-out.

The argument over the bail-out will go on for years, was it effective or even necessary.  Engaging in it misses the point – the mess was made by removing the protections put in place after the Great Depression.  We forgot the lesson.  This time it seems we will not even attempt to learn it again.  Congress is not likely to pass meaningful legislation to restore restraint over Wall Street.  Given the fact that our financial stability is dependent upon people, and other countries, having faith that our economy is sound, it is only prudent that we force large financial institutions to act in a responsible manner.  We simply cannot allow them to self-regulate or even become “too large to fail.”  It forces the government to make decisions that run roughshod over sound economic policies and saddle the tax payer with unacceptable levels of debt.

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