Archive for the ‘History’ Category

The Great Crash of 1929

Friday, May 11th, 2007

A few days ago, back in Crash alert?to short the stock market or not?, we issued our first crash alert. To be honest, we do not know exactly when a crash will occur. But we believe one is on its way. Also, the longer the coming crash is ?postponed,? the more devastating it will be when it finally arrives?the longer it delays, the greater the number of people who will be sucked into complacency.

Today, we will look a bit into history of the 1929 crash. Hopefully, we can learn from them and be better prepared for what is to come. Since most of us were not even born yet in 1929, the investors and traders of today largely forgot the lessons of that unprecedented crash.

Contrary to popular belief, the Great Crash of 1929 was not completely without any warning. As early as November 15 1925, Alexander D. Noyes, a highly respected financial editor of the New York Times, warned in a very long article that the ?speculative mania? of the 1920s was not unlike previous bubbles and that stock prices could not rise forever. Long before the Great Crash, the contrarians of the day were already sounding the alarm.

Also contrary to popular impressions, that Great Crash was not a one-day event. It was a series of events that marked the beginning of an even more devastating consequence?the Great Depression. In fact, it took a year after the Great Crash for the average person on the street to feel the effects of the ensuing Great Depression. Did the Great Crash cause the Great Depression or was it merely a symptom of it? We believe it was the latter.

For five years leading to the Great Crash, the stock market had an amazing run. By the beginning of September 1929, the stock market had reached a peak. Then for the next month, the stock market fell 17% for a month, before rallying for the next two weeks, recovering half of the initial fall. Then it fell again, culminating in a ?Black Thursday? of October 24 1929, in which a then record of 13 million shares were traded. On the afternoon of ?Black Thursday,? a rally reduced the losses. That rally continued on to Friday, which was then followed by weak actions on Saturday. On Monday, the market fell 13% in one day. The next day, which was known as the ?Black Tuesday? of October 29 1929, the market fell another 12% in another record volume of 16.4 million shares.

By November 13 1929, an interim bottom was reached, followed by several months of rally, resulting in an interim peak on April 1930. Then it was downhill again, reaching a bottom in July 1932, which was 89% down from the then record high in 1929.

Can it happen again today? Can the Federal Reserve save us from such a disaster? Remember, almost 80 years ago, people had the same faith in that institution. In the next article, we will extract lessons that we can learn from the Great Crash. Keep in tune!

Podcast on the Great Depression

Monday, May 7th, 2007

Here is a MP3 from a podcast in the Mises Institute on Herbert Hoover and the Great Depression.

Ancient Chinese fiat paper money

Monday, March 19th, 2007

The ancient Chinese were the first to experiment with fiat paper money. Records showed that the first paper money was used in China in around A.D. 600s. After 1455, there have been no known references to paper money. Thus, after having 500 to 800 years of paper money experience with repeated episodes of inflation and currency reforms, the ancient Chinese finally gave up using fiat money. Below is the picture of an ancient Chinese paper money used in the 1300s.

Chinese fiat paper money in the 1300s

Marco Polo, when he first saw such money, was amazed. Europeans could never understand how paper could be valuable. Today, much of our money is not even made of paper?it can even be made up of digital information stored in a computer!

The world is currently using a fiat money standard. Is it so different this time that humanity has finally discovered the secret to make fiat money work? Have central bankers finally found the technique to control price inflation the way an engineer controls a machine precisely via knobs and levers?

As the famous saying by George Santayana goes, ?Those who cannot remember the past are condemned to repeat it.? The wise sees danger ahead and for this reason, will accumulate gold (see What should be your fundamental reason for accumulating gold?).

Example of mal-investments?dot-com bubble

Wednesday, February 14th, 2007

In our previous article, The first step in an economic slowdown?mal-investment in capital, we mentioned that one of the causes for slowdowns in the business cycle is the presence of mal-investments. Mal-investments will eventually have to be liquidated, resulting in a cyclical slowdown of the economy. In that article, we discussed about the structure of capital, which gives rise to the concept of mal-investments, which is unique to the Austrian School of economics. It should be emphasised that unlike other schools of economics, the Austrian School makes a distinction between overinvestment and mal-investment. It is the latter that is of primary concern in Austrian theory. Today, we will look at a real-life example of mal-investments and its effects.

During the dot-com bubble of 1996-2000, the NASDAQ flew from around 1000 to around 5000. Credit for ?investments? were abundant and plentiful. Any stocks related to the Internet were soaring well beyond its fundamentals. Spending on IT projects were mushrooming up everywhere; loss-making dot-com companies were floated; consumer spending, which were fuelled by the monetary print press (and not from sound savings), remained strong; Real-estates in the Silicon Valley sky-rocketed. Indeed, IT investments were running very high.

This is an example of a mal-investment.

Entrepreneurs, as a whole, invested as if all capital goods will be available at their disposal to ensure the success of all their plans. From the hindsight of today, it is clear that this was not true?there were shortages of programmers, network engineers, and technical managers. We recalled the days when a fresh IT graduate, who hardly had any experience and skills on the latest technologies, could fetch a salary of more than AU$50,000! Consequently, all the idealism of wealth through technology crumbled when reality sets in. As many IT start-up companies realised, the cost of staying in business was so prohibitive that eventually, a large number of them had to be liquidated. Today, only a few survivors remained alive. The resulting deflation of the bubble led to a recession (albeit the mildest one ever).

A brief history of money and its breakdown- Part 2

Wednesday, January 10th, 2007

In today?s topic, we will continue from the previous topic, A brief history of money and its breakdown- Part 1 by touching on the gradual breakdown of the monetary system from two centuries ago till now. Today, the world?s money is totally fiat (money that enjoys legal tender status through the authority of the government instead of through the choice of the free market). Again, the recommended reading for today is Murray Rothbard?s What Has Government Done to Our Money? As Rothbard said in that book:

To understand the current monetary chaos, it is necessary to trace briefly the international monetary developments of the twentieth century, and to see how each set of unsound inflationist interventions has collapsed of its own inherent problems, only to set the stage for another round of interventions. The twentieth century history of the world monetary order can be divided into nine phases.

In the first phase, lasting from 1815 to 1914, the Western world was on a classical gold standard. Each national ?currency? was just a definition of a weight of gold. For example, the ?dollar? was defined as 1/20 of an ounce of gold. Each national currency was redeemable for gold on its pre-defined weight. Thus, if a nation were to recklessly inflate the supply of its money, it would run into danger of having its gold drained from its treasury. At this point, we must stress that gold was not any arbitrary choice by the government. Rather, it was the choice of the free market over the course of centuries as the best money. Thus, at that time, the world had a uniform money medium, which as Rothbard said, ?facilitated freedom of trade, investment, and travel throughout that trading and monetary area, with the consequent growth of specialization and the international division of labour.? Furthermore, such an international gold standard put a rein on government inflating the money supply as well as helped kept the balance of payment of each nation in equilibrium. Though it was not perfect, it ?provided us with by far the best monetary order the world has ever known, an order which worked, which kept business cycles from getting out of hand, and which enabled the development of free international trade, exchange, and investment.?

Next, the First World War arrived. Under the confusion of a wide-scale war, each warring government (except the United States) came off the gold standard and printed money to fund the prohibitive cost of waging war, which would not be possible under the gold standard. Thus, national currencies were devalued and fell in relative value to gold and the US dollar.

After the First World War, the most logical step would be to return to the gold standard at a redefined weight of gold for each national currency. However, British insistence at maintaining the unrealistic pre-war definition (due to national pride) led to their economic malaise. Instead of rectifying the folly of their ways, they induced and coerced foreign governments into the same mistakes at the Genoa Conference of 1922. This resulted in a gold exchange standard whereby (1) the US remained in the gold standard, (2) the British remained in a pseudo-gold standard and ?US-dollar standard,? and (3) the rest on the ?pound standard.? The outcome was a ridiculous pyramid of US dollars on gold, pounds on dollars and the other European currencies on pound. By 1931, as expected, the absurd gold exchange standard collapsed.

At this point in time, it was back to the post-war chaos of fiat currencies again. The US went off the gold standard partially?US dollars were only redeemable to foreign governments and central banks at a re-defined rate of 1/35 of an ounce. International trade and investment were at a standstill and ensuing economic conflict was said to be one of the leading causes of World War Two.

After World War Two, the United States led the way to a new monetary system?the Bretton Woods system. In this system, the US remained in a partial gold standard?US dollars were redeemable for gold by foreign governments. Other countries pyramid their currencies on top of the US dollars. Initially, the US dollar was undervalued and European currencies were overvalued. However, as time went by, with the US inflating their supply of dollars, their gold was increasingly being redeemed by European governments. Soon, it became harder and harder for the US to maintain the free market value of gold at $35.

By 1968, there was a crisis in confidence in the US dollars. The US then decided to abandon maintaining the US dollar at $35 in the free market. From then on, the US decided to ignore the gold free market and maintain the inter-government gold peg at $35. As expected, the free market value of gold soared above $35.

In August 15 1971, the US severed the last link between gold and the dollar. As a result, from then on, the world?s monetary system became totally fiat.

In December 1971, the Smithsonian Agreement was introduced to create some order by maintaining fixed exchange rates among currencies and without any gold backing. With the US continuing to inflate their dollars, fixed exchange rates were untenable. Finally, the agreement collapsed in February 1973.

Finally, that is what we have today?freely fluctuating fiat currencies. As Rothbard said,

Since the U.S. went completely off gold in August 1971 and established the Friedmanite fluctuating fiat system in March 1973, the United States and the world have suffered the most intense and most sustained bout of peacetime inflation in the history of the world. It should be clear by now that this is scarcely a coincidence.

A brief history of money and its breakdown- Part 1

Monday, January 8th, 2007

Today, for this part, we will give a brief introduction on the history of money. For the next part, we will then look at how the monetary system had (and are still today) broken down. For a more in-depth coverage of this topic, we recommend Murray Rothbard?s excellent book: What Has Government Done to Our Money?, which is just only 58 pages?a quick read over the weekend. This background knowledge is highly useful for understanding the value of gold (and the corresponding absurdities of the fiat monetary system that we now have) with regards to today?s monetary system.In the beginning of history, mankind simply used barter for economic exchange. Obviously, barter is problematic because it requires a coincidence of wants. Even if coincidence of wants exists, they require costs to search for them. Also, for some goods (e.g. a live cow), there is no way to divide them for exchanges with more than one counter-parties. Thus, barter is highly restrictive.

The next stage of monetary development is indirect exchange. For this, if you have A and wants C, you exchange A for B and then exchange B for C. Though this way may look inefficient at first glance, it actually works because B may be a more highly sought-after good than A. Therefore, it makes sense to acquire B first as the intermediate step towards acquiring C.

At this third stage of monetary development, a highly marketable good will eventually emerge as the most sought-after intermediate good for the purpose of exchange with other goods. This intermediate good functions as money as we know it. Obviously, such an intermediate good must have characteristics of portability, divisibility, durability and sufficiently rare (but not too rare). Historically, goods like tobacco, cattle, grain, cooper and tea had functioned as money. But over the course of centuries, gold and silver, for whatever reason, were eventually selected by most civilisations as money?gold for larger exchanges and silver for smaller exchanges. That is why we must not make the mistake of following the market?s error by seeing gold and silver as industrial commodities (see Is gold a commodity?).