Excessive Leverage Caused 1929 Stock Market Crash and 2008 Economic Collapse

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Even if many years separate these two painful events, the common denominator of what caused them is the same.

In the 1920s, you could deposit a dollar and buy ten dollars of stocks. This type of leverage is great when the stock market goes up, causing stock prices to go up and also great confidence in investors who thought they couldn't lose.

As stocks grew more and more, it seemed like they were okay.

But when the market stopped growing, the stockbrokers started to call their clients to let them know that they needed to put in more money. Some could sell stocks to cover their accounts, but when each brokerage firm grabbed all of their clients with the same message, it was like shouting into a crowded theater. With all these people trying to sell everything at once, the price drop was very rapid and severe.

Not only did the stock market crash collapse, but people were also afraid of their money in the banks and when thousands of people went to withdraw their money, the rush for the banks caused further economic hardship.

Now fast forward about 80 years and replace over-indebtedness of stocks with over-indebted banks and many people speculating in the housing market. With interest rates at historically low levels collectively, these problems have helped drive home prices up to stupid levels.

In the years leading up to 2008, people had been conditioned to believe that you couldn't lose money on real estate. Not only did the average person believe it, but it seems the banks believe it too.

More and more people have started to enter the housing market and borrow more money to buy a bigger house, some have also bought an investment property and others have built up a portfolio of investment houses.

Well, it's obvious that these weren't investments at all, much more like casino bets, big bets in fact.

New mortgage players have also played a key role in raising house prices, as they have allowed more than banks to offer mortgages. This additional competition started to have an impact on the banks' profits and they therefore tried to find other ways to make money.

Some have come up with less brilliant schemes that have allowed them to take their money and leverage it so that they can try to earn more money.

Unlike in the past when investors were allowed to put 10% to buy stocks in the 1920s, these bankers only had to drop a few percent.

Why bankers have been allowed to gain such significant leverage is an important question to ask, but what is much more important is to prevent them from doing it again.

The combination of bankers taking advantage of their balance sheets and consumers doing the same with their personal balance sheets are the main reasons for the economic collapse of 2008. Historically low interest rates were also behind of the problem, so that Federal Reserve makers should also get some of the credit.

Just like the stock market of the 1920s, when stocks continued to rise, it wasn't a problem until they hit ridiculous prices and the same thing happened to house prices in the years leading up to 2008. The liquidation was happy because it seemed like you couldn't lose, but the next process was quick and very painful.

After the great stock market crash of 1929, the government intervened and tried to change many rules and regulations and set up many agencies to try to prevent a repeat in the future.

Some will rightly debate the effectiveness of all of these actions, but one of the most important is the restriction of leverage. You could no longer put down ten cents to buy stocks worth a dollar and that is a very good thing.

Now, politicians and heads of government institutions are proposing plans to try to avoid a repeat of 2008. One problem with their efforts is that they seem to be throwing out all kinds of ideas that sometimes waste money. view the biggest problem which is the rise of bankers and consumers which has pushed house prices to ridiculous levels. This is the key problem which has caused the recent economic collapse which has raised fears of another great depression.

Signs appear that suggest that we have probably avoided another economic depression well in the trough phase and it appears that the recovery will lead to significant economic expansion.

But it would be unwise to ignore what just happened as it seems like we are headed in a more positive direction. Instead, we need to stay focused on the underlying reasons that caused the problems and look for ways to prevent them from happening again.

Rules and regulations that keep bankers and consumers from breaking their way over their heads, which could cause them to fall and drown almost the entire global economy, should be at the center of change.

The leverage effect caused the stock market crash of 1929 just as it caused the economic collapse of 2008 and reducing this risk is the most important problem to be resolved.

Banks and consumers have started to deleverage without any changes to the rules and regulations, but even if these are systemic changes, they are still needed.

There is nothing wrong with leverage until it reaches extreme levels and this applies to banks as well as individuals. The new rules and regulations should be very strict to avoid excessive leverage.

Some would argue that this forces the government to get too involved with bankers and consumers. It is a pity. Excessive leverage is far too important and dangerous to politicize and it is essential to try to prevent as no one wants a repeat of the stock market crash of 1929 or the economic collapse of 2008.

These two events were far too painful not to learn from them, and the most important lesson they taught us is the ramifications of excessive leverage.

It is not possible to completely eliminate the risks of economic calamities in the future, but making them more difficult is worth it. Excessive leverage is the main reason why these painful events happened and also the key to reducing the risk of them happening again.


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