Why Do We Keep Having Financial Crises?

Why, in our modern world, do we have so many financial crises? Or banking crises? This never happened before, did it?

The Roman Republic ceased to exist in 27 BC after Octavian was given the title Augustus. After Augustus Caesar, Tiberius became emperor. Tiberius was cautious with government spending so the government treasury had money. In 33 AD a financial crisis struck in the private sector. Mortgages were at the center of the problem. Sound familiar?

Eventually Tiberius had to use government funds by intervening in credit markets. If you removed the dates of the crisis we might believe we are talking about the subprime mortgage crisis of 2007-08.

What triggered the financial crisis in 33 AD? Historians believe renewed enforcement of laws enacted by Julius Caesar decades before was a root cause. These laws were originally enacted to deal with a financial crisis in the 50s BC.

No matter where you start in your studies of financial crises, you always find the roots in the prior crisis. And back in time you go. All the way back to when money was first used.

In 386 BC grain dealers in Athens faced the death penalty for price fixing.

Before that, there are cuneiform records going back centuries more, recording the price of various commodities. Well before the time of Christ people understood prices moved cyclically. To this day many people try their hand at reading the tea leaves to see if they can find predictive powers in the price movements.

Stock Markets

The Temple of Castor and Pollux, Roman Forum, is considered the first stock market. Unlike modern trading in corporations with limited liability, contracts were auctioned and traded at the temple. From this humble beginning the modern stock exchange arose.

It is natural to believe a modern stock market crash was the worst of all time. The 22.6% decline in the Dow Jones Industrial Average (DJIA) on October 19, 1987 in a single day still haunts the memories of those who lived through the crash.

Of course, we have the 89% drop in the DJIA from 1929 to 1932. Fewer alive have memories of what it felt to live through that kind of financial and economic crisis. Such a massive market crisis required a bit over 29 years for the DJIA to recover. The S&P 500 index recovered in about 25 years. That is a long time to wait for the market to push into new high territory.

None of these American drops in market value can hold a candle to the crash of 1720.

In the spring of 1720 maritime insurers were able to buy shipping routes as a monopoly. This set off a buying frenzy in insurance companies listed on the Rotterdam and Amsterdam exchanges. August of that year saw shares rise 90% that month alone. Insurance company responsible for the gains sold more shares. And investors were hungry for those shares. (Sounds like meme stocks of today.)

People could buy shares with a mere 10% down, with the remainder paid on installments. Early investors could sell their rights for a massive profit and did.

Companies traded at huge premiums. Emotional investing and investor exhaustion opened a crack in the facade. Payments to the government for the monopoly needed to be paid.

What started the stock market Bubble of 1720? Maritime insurance was a competitive business in late 1719 and by June of 1720 became a monopoly with monopolistic pricing dreams. However, to receive the monopoly grant, the South Sea Company had to pay the government 600,000 pounds to secure the king’s favor. The amount was to be paid in four payment at one, three, five, and ten months from the issuing date of the charter.

Another offering was planned for September of that year to pay the government. But that meant overstepping the bounds of their charter. The York Building Society (another insurance company with a monopoly on certain shipping routes) was announced as a major transgressor of the Bubble Act on August 18th and faced legal action. It was the beginning of the end.

The Company stock climbed from £350 in April 1720, to £600 by the end of May, £950 by the end of June, before peaking in early August at £1,050. Then the news on the York Building Company and more concerns on companies paying their government fees for monopoly routes hit. The share price dropped to £190 quickly, below the original value, before dropping to £124 in December. The South Sea Bubble had popped.

The traditional inquiry into what went wrong took place.The past could not be changed; regulations were put in place; the public lost interest in securities for over 100 years. It was only in the early 1820s when stock markets truly started to recover.

A single blog post cannot do justice to even a single economic event. Money Changes Everything: How Finance Made Civilization Possible by William N. Goetzmann is must read. It is one of the most comprehensive and enjoyable books on money and finance from the beginning to today ever written. I strongly encourage you to take the time to learn why money matters. This, and other, financial crises are discussed in the book, along with solutions. The connections between crises is instructive.

Future Financial Crises

Could 1720 happen again? What about 1929? 1987?

It does not take an imagination to see the regular occurrence of financial and banking crises. Working backwards, COVID gave us a short market scare in 2020. The response to that crisis has set the foundation for the next financial crisis. Before COVID we has the subprime mortgage crisis of 2007-08, then the dotcom bubble burst in 2000, the Asian financial crisis of 1997, the Japanese asset bubble bust of 1992, the savings and loan crisis of 1989, the 1987 market crash the stagflation of the 1970s, the oil embargoes of the 1970s, stock market crash of 1962 (people forget this one), WWII, The Great Depression, the Teapot Dome scandal of the early 1920s, the Panic of 1907, and on and on we go.

Where do the financial disasters end? As far back as we have records there are financial crises. As soon a money comes on the scene, inequality and excesses built until rupture. Money solved many problems, but added a new set of problems still plaguing us today.

Future financial and banking crises will find their roots in prior crises. Just as Tiberius had to deal with excesses in the private market—triggered by the revival of regulations from a prior crisis—future financial breaks will become obvious after the fact. Prior financial sins often begin as good medicine. Then people see the new financial order, adjust, and begin building excesses again. As long as human nature is unchanged, financial crises will be the norm every decade or so.

The Greatest Invention of Mankind

The greatest invention of humanity is money. Money allowed us to build bigger and better. Nothing in our modern world is possible without money. Even the written word finds roots in money and accounting.

Before money, elaborate credit systems were used. (Debt: The First 5,000 Years by David Graeber, is another must-read book.) Tally sticks, later used, provided a right of claim. Many systems worked side-by-side. Various credit systems and tally sticks were tools used by people thousands of years ago.

Today we have no problem visualizing virtual money or transactions. Imagine the leap required for the first person to think, Hey, we can replace tally sticks, barter, and running to the local temple if we use coins. All that was needed was to convince people to have a shared fantasy that gold or silver coins had value.

The prior link outlines shared fantasies required for money to work. Money allowed for easier accumulation of wealth. That meant bigger public works projects, bigger businesses, and better funded armies.

That leads us to the second greatest invention of all time, limited liability.

It sounds strange to modern ears, but investing in times past put more at risk than your original investment. Businesses were organized as joint ventures or partnerships. Investors bought an ownership share. The company was often put in the hands of managers.

If the managers mismanaged the company, embezzled, or just have bad luck, the owners had additional risk. The joint venture could borrow money. Investors may not know management borrowed money. If the business sours the lender wants his money back. NOW!

And they get it from the investors. Management may not even have an ownership stake so they face much less risk, if any, compared to the investors with no limited liability.

Then the idea of the stock corporation with limited liability was invented. President Teddy Roosevelt called corporations a new construct that was evil. Limited liability goes back to at least the 15th century. The state of New York enacted the first modern limited liability law in 1811.

Partnerships have general and limited partners. General partners face the same liability risks joint ventures of the past.

The Limited Liability Company (LLC) was first introduced in Wyoming in 1977. The LLC was designed to give partnerships the same limited liability protection as corporations.

Investors today have it easy. A bad investment doesn’t show up at your doorstep demanding additional monies.

Limited liability allows for yet bigger business ventures, since investors can invest more without risk of losses over their original investment.

Limited liability isn’t without critics. As limited liability evolved, many felt people acting through an agent (managers running a business for owners) should be responsible for the agent’s acts. If profits go to the investor, so should the losses.

Still, limited liability opened avenues for economic growth and invention. Many technologies would not exist, or would have been substantially delayed, without limited liability. Imagine investing in Tesla way back at the beginning. There was no guarantee of success and losses mounted early on. Without limited liability, investors faced the real threat of bankruptcy. The electric vehicle owes a thank you to limited liability.

Profiting from Financial Crises

Since money wants to accumulate by its very nature and only really bad events truly lower inequality (see The Great Leveler: Violence and the History of Inequality from the Stone Age to the Twenty-First Century by Walter Scheidel), the best you can do is understand how money works and plan accordingly.

I am no fan of market timing. However, selling an obviously overvalued investment is not timing. Buying when the price of an investment is below it true value is also not timing. Warren Buffett is sometimes accused of timing the market when he sells. However, selling after a large gain when the business owned appears wildly overvalued is not even close to timing the market.

For mere mortals (compared to Warren Buffett) without time to dig as deep into investments as Buffett, dollar cost averaging (DCA) is the best choice. DCA a set amount each month into an index fund is the surest way to a sizable net worth as time accumulates gains. (See The Simple Path to Wealth by JL Collins.)

Another important point to consider is how much money to keep in cash.

There is nothing that says you must have every dollar invested in long-term investments. An emergency fund is an important part of any financial plan.

It is often recommended to keep six-months of living expenses in cash. This is too simple a recommendation. The earlier you are in your journey, the less you will probably keep in cash as you need as much money as possible invested for the longest time possible.

At minimum, $1,000 is needed for an emergency fund. As your net worth grows, your liquid cash position also needs to grow. Reaching the six-month reserve level is a good place for most people.

However, as you get closer to retirement and when you are in retirement, more money is need in the liquid column.

A good amount to keep in cash near, and in, retirement is two to three years of spending. Funds needed from investments can come from selling securities when prices are up and from the liquid funds when the market is down. Steep market declines can be weathered longer by temporarily suspending the automatic reinvestment of dividends and capital gains. Those distributions can be sent to the liquid account. Using this method allows you the ability to withstand five or more years of bad markets. Once markets climb dividends and capital gains can be reinvested again after the liquid account is restored to its appropriate value.

Final Notes

After all these thousands of year we still do not really understand what money is or how it works. The proof of this is in the recurring financial breaks. We have some, but not complete control over the economy. Interest rates are set by the government, but people decide price. If the government imposes a price, black markets develop.

We understand money better now than in the past. But the recent subprime mortgage crisis and massive U.S. federal government debt (growing rapidly as I write) are testaments to our still limited understanding of money. We want to believe this time is different. It isn’t.

Money, by its very nature, wants to accumulate in the fewest hands as possible. Go back to the beginning of money and move forward to our modern age and it is clear what money tends to do. Only war, disease, and other upheavals reduce inequality for any amount of time. Government redistributions works, but people with money don’t want to give up their advantage, even when the additional taxes will reduce their lifestyle by zero. Human greed never abates.

Human behavior guides money and its excesses. People are the same and so we get similar results. The crisis gets a different name, but a financial (or banking) crisis it still is.

The biggest trick to having money is to keep some of it when it hits your hand. Pay-yourself-first! It is old advice. It also works. Says so in the Bible and every ancient and modern reliable text on money.

Once you have money to invest, money starts to accumulate in your pile. Invested excess funds give you a right of claim on your pro rata share of profits and appreciation. Until you get that assimilated in your mind you will always be broke. Once you understand money creates more of itself over time you are well on your way to a financially wealthy life, regardless the crisis.

Suggested Reading

Two books you really need to read now and are recommended for purchase:

Money Changes Everything: How Finance Made Civilization Possible by William N. Goetzmann

Debt: The First 5,000 Years by David Graeber

This next book is also recommended for purchase and required reading. This book is shorter and includes some different information than the two books above.

Money: The Unauthorized Biography by Felix Martin

The last two books on our list are elective. The Dawn of Everything takes a different look at equality in societies around the world and through time. Globalizing Capital is a deep dive into the modern international monetary system. A library visit should do for most. Depending on your level of interest and seriousness about understanding money, you may wish to own.

The Dawn of Everything: A New History of Humanity by David Graeber and David Wengrow

Globalizing Capital: A History of the International Monetary System by Barry Eichengreen