Financial Security For Dummies - Eric Tyson

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and dramatic reversals of fortune when a panic struck. Even in a relatively mild panic, fortunes evaporated, and lives ended in ruin.”

      In 1907, numerous important countries in the world’s economy had a banking crisis. Problems began in the United States. and then spread to Denmark, France, Italy, Japan, Sweden, Chile, and Mexico. Some trust companies, which were quasi-banking institutions that had reserves on hand of only 5 percent of their obligations, became insolvent when their lending to copper companies led to losses when copper prices dropped.

      In April 1906, the great San Francisco earthquake squeezed insurers and caused them to liquidate large portions of their financial holdings — stocks and bonds. Also in 1906, the Interstate Commerce Commission, which was the first U.S. regulatory agency (created in 1887), began price regulations on the economically important railroads. That and the resulting collapse in railroad stock prices contributed to the financial crisis.

      U.S. stock prices got hammered, dropping by nearly half (49 percent) during this tumultuous economic two-year period from early 1906 to late 1907. Trust company and bank failures continued until banker John Pierpont Morgan (whose firm today is known as J.P. Morgan) put up his own money and enlisted other prominent New York bankers to do the same. The need for a banker of “last resort” led to the creation of the Federal Reserve System and their fulfilling that need (when properly engaged) during future such events. However, the Federal Reserve made some major mistakes during the Great Depression (discussed in the next section), so the Federal Reserve was very much a work in progress in the aftermath of its creation following the Panic of 1907.

      Stock prices fully recovered from the 1906–1907 period decline by mid-1909. It’s also worth noting that although the words “panic” and “crisis” are used to describe the economy and stock market of this period, the rate of the stock market decline was typical for a bear market. While the 49 percent stock market decline was among the larger bear markets, it played out over 22 months so there was really no “panic,” and the rate of decline was about 2.2 percent a month on average over the entire period.

      The Great Depression

      The economic calamity that lasted a full decade (most of the 1930s) is known as the Great Depression. It was characterized by high unemployment, falling prices (deflation), collapsing stock prices, and mostly inept and wrong government responses.

      The roaring ’20s that preceded the Great Depression was a decade of a strong and expanding economy. U.S. stock prices advanced nearly 500 percent, marking the greatest bull market in U.S. market history, from their 1921 lows to their late 1929 peak. Over this period, the Dow Jones Industrial Average advanced from about 64 to 381.

      Many factors led to the economic and financial market disaster known as the Great Depression:

       The record run in stock prices was fueled in part by easy credit conditions for buying stock with borrowed money — known as margin loans. Investors were able to buy stock by putting up only 10 percent of the cost via their own money and borrowing up to 90 percent. Having just a 10 percent equity stake left little margin for a big decline in stock prices, which led to margin calls — forced selling of stock holdings which accelerated the decline once started.

       The Federal Reserve raised interest rates in 1928–1929 to curb speculation in the financial markets. “This action slowed economic activity in the United States. Because the international gold standard linked interest rates and monetary policies among participating nations, the Fed’s actions triggered recessions in nations around the globe,” according to the St. Louis Federal Reserve. To rein in speculative buying of stocks, the Fed should have raised the stock margin purchase requirement from its low level of 10 percent (note that today it is at 50 percent).

       The Smoot-Hawley Tariff Act passed by Congress and signed into law in 1930 led to a trade war which depressed global trade. The United States slapped 20 percent tariffs on imports to the United States, which set off retaliatory tariffs by many other countries.

       Economic problems and falling stock prices led to depressed consumer confidence and a run on banks. The Federal Reserve failed to step in and act as the lender of last resort, and the resulting bank failures contributed to the further downward economic spiral.

       The Federal Reserve allowed the nation’s money supply to drop 30 percent, which led to an equivalent, deflationary price decline. With all of the previously mentioned economic problems, the Fed added to the misery by allowing the nation’s money supply to shrink 30 percent from 1930 to 1933, which led to an approximate 30 percent deflationary decline in prices. This deflation had the impact of increasing the burden of debt among those who owed money and further harmed the overall economy.

      In addition to the stock market being crushed, the unemployment rate in the United States stayed above 10 percent for more than a decade — from 1931 through 1941. In fact, it hit a high of 25 percent in 1933 and was above 20 percent for four straight years around that time.

      Over time, economists and others have come to realize how the government’s response caused and greatly worsened the Great Depression. Furthermore, reforms coming out of this period led to the Federal Reserve becoming a “modern central bank” and lender of last resort.

      World War II

      Many folks believe that wars are bad for the financial markets and economy, but often they are not. For sure, unforeseen negative events like the attacks on Pearl Harbor (December 7, 1941) can cause a short-term decline/shock. But coming out of the Great Depression and the high unemployment rate of that period, World War II led to increased demands for various manufactures and other products needed for the wartime efforts. Hiring and output soared, and unemployment quickly declined to less than 2 percent.

      Stock prices were reasonably stable during this period, rising about 30 percent over six years. After an initial modest rally following the outbreak of the war, an excess corporate profits tax enacted by Congress squashed the stock market upswing. The attack on Pearl Harbor triggered a near 10 percent decline. Stocks then resumed their rally when the Allies began to get the upper hand.

      Coming out of World War II, the U.S. government had a huge debt load. This led the government and Federal Reserve to keep interest rates low in the years following the war to help service the large U.S. government debt. Keeping rates low hurt bondholders who were stuck receiving low interest rates, and when rates finally did rise, bond prices dropped, reducing bondholders’ returns through declining bond market values.

      Arab oil embargo and Watergate/Nixon’s resignation

      I remember 1974 well. That time period made a major impression on me. Stocks got hammered and experienced a waterfall decline as they did during the height of the 2008 financial crisis. From a peak of 1,000 in late 1973, the Dow plunged under 600 by the late summer of 1974. The country and economy had many problems. Folks were highly disillusioned with government after Vice President Agnew resigned (due to an income tax evasion scandal) and then so did President Richard Nixon (due to Watergate).

      There was a war raging in the Middle East, and oil supplies were being cut off due to the Arab Oil Embargo (drivers back then remember the long lines at gas stations). Inflation was surging and broke 10 percent annually. The unemployment rate was surging to 9 percent.

      The 1970s was a bad period for stocks and the economy. President Nixon instituted wage

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