Money, Banking, and Finance Chapter 11

Modern Economies Are Much More Dependent Than Ever on Finance

• In the euro area, total financial assets banking sector roughly doubled from 2003 to 2013 to a total of €57 trillion (almost six times euro area annual GDP)
• In the UK and US, financial assets have surpassed the equivalent of ten times the respective national GDP
• Financial transactions is even larger. For the U.S., this value was 73 times GDP already in 2009, primarily a result of rapid growth in high-frequency trading

Is Too Much Finance Bad for the Economy?

• When economies grow on the basis of mass investment in assets with questionable foundations, yet rise in price, the growth is unstable and destined to be of short duration
• Such irrational speculative price rises are called bubbles

The Dutch Tulip Frenzy (Tulip Mania) 1636-37

• Different tulip types had different values
• Mass speculation
• first: only wealthy Dutch were buying them
• eventually, everyone was buying tulips
• Rapid increase in prices
• peak: March 1637
• some select bulbs sold for several times the yearly income of a skilled craftsman
• shortly thereafter, confidence in their value vanished
• Almost overnight, the tulip market crashed, and many speculators were ruined.

Stock Market Bubble 1929

• “new reality”
• establishment of the Federal Reserve in 1913
• government policies to extend free trade, fight inflation, relaxation of antitrust laws
• 1920s: everyone is buying shares
• consumer debt was taken on to buy stock shares (instead of consumer goods)
• October 1929: the stock market crash
• The Great Depression

Dow-Jones Industrial Stock Price Index for USA, 1914-1942

Source: National Bureau of Economic Analysis

Since the 1970s, Many Other Bubbles Developed…

• East Asia 1997
• “Dot-com” stock market bubble 1999/2000
• Housing bubbles in the US, UK, Ireland, Spain and other European countries late 2000s
• Bubbles are characterized by a rapid increase in prices that are not generally accompanied by an equally rapid improvement in economic conditions
• buying begets more buying
• appreciation in the asset values is fleeting