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May 5,1980
Lessons of the Bubbles
Speculative
bubbles often cause widespread economic disruption, both when prices
soar and when they crash.5
Kindleberger
argues that, as speculation
spreads, credit is
pulled away from its normal uses of supporting investment and consumption
of real
goods. Thus, production
may begin falling,
even in the midst of the speculative mania.6
Expenditure
may fall because of restrictive
monetary
policy aimed at choking off the
mania. In 1929, prices of several commodities
were already falling, even as stock prices
soared. Residential
and nonresidential
construction
had been falling since 1926 and

Speculative
bubbles tend to be fueled
by expanding
inflationary
economies,
rapid
expansion of money and credit, and expectations that these conditions would continue?
Bubbles also seem to spread easily from one
commodity
to another.
The
Mississippi
Bubble spread to the South Sea Bubble and
then to the shares of other companies.
Speculation
in silver and gold likewise spread
to other commodities.
The Wall Street crash
in 1929 spread to European financial markets.
Speculative
fever is often the temptation that triggers unscrupulous
dealings.
Swindles
then arise in many imaginative
forms. One of the most popular swindlesoriginally used by the South Sea Company

continued to fall until the early 1930s.
On the other hand, when prices crash,

directors-is

wealth is lost, leading to a fall in spending and
possibly severe monetary contraction
due to
bankruptcy
and bank failure. The South Sea
crash in 1720 caused British banks to fail,
commerce
to dry up, credit to disappear,
and unemployment
to rise. The 1929 stock
market
crash
destroyed
wealth,
caused

this swindle dividends are paid to old shareholders with revenues from the sales of new
shares. Like a bubble, the chain eventually
breaks; the people
near the end of the
insolvent
chain are swindled.
Even today,
the "chain letter" continues to be one of the
favorite methods of swindlers.

banks to fail, caused spending to fall, and
increased
unemployment.
The silver crash
in 1980 caused the Dow Jones industrial
average to fall 25 points in one hour. The
silver crash
prompted
fears that
worse
repercussions would follow. Paul A. Volcker,
chairman of the Board of Governors of the
Federal Reserve System, made the following
statement
on May 1, 1980, before the
Subcommittee
on Agricultural
Research and
General Legislation:

There

is

evidence

was an attempt
significant

indicating

to control

commodity;
uncertainty

expectations

more

declined,

positions
credit,

and

had, wittingly
amount

funding

of a

and
of

inflationary
As the market

the

speculative

substantial

amounts

market

intermediaries

certain

or not, committed

of their

speculative

the supply

generally.

required

there

to some degree, this

stimulated
price

that

own capital

activity

of

turn
others

have
and

those

in support

severe

institutions

and their failure

triggered

financial
financial

letter"

method.

In

Can speculative bubbles be prevented?
Although
there may be no way to ensure
that bubbles would not occur, perhaps some
steps could be taken to make their occurrence less likely or at least to mitigate their
consequences.
The U.S. Congress has promulgated
a
number
of laws to prevent
speculative
bubbles.
The Securities
Exchange
Act of
1934 delegated
the authority
to regulate
securities

credit

to the Board

of Governors

of the Federal Reserve System. The Board
sets a margin requirement
that specifies the
minimum
down payment
required
for a
securities
transaction.
The Board's
Regulations T, U, G, and X specify the terms and
conditions

that

various

lending

institutions

an excessive

in one commodity

some of

placed in jeopardy,

"chain

Bubble Bursting

of

by a

5.

Compare Kindleberger,
1929-1939, chap. 3.

6.

Kindleberger,

single group of people. As the market values
collapsed,

the

were

losses

for

The World in Depression 1929-

1939, chap. 3, p.14.

could in

disturbances.

The World in Depression

7.

Compare

Crashes,

Kindleberger,
chap. 4.

Manias, Panics, and

and borrowers must follow when
credit is extended. The Board may
margin requirement
to restrain the
use of credit for purchasing
or

securrtres

cushion

raise the
excessive
carrying

markets
could turn bubbles
into serious
contractions,
similar to those that have
occurred
in the past. The solution would
have to be a delicate
intermediate
role,
where intervention
took place when really

securities.
In addition,
the Securities
and
Exchange Commission
and the Commodity
Futures
Trading
Commission
oversee the
securities and commodities
markets, respectively. All of these regulations
represent
interference
in the
normal
day-to-day
operations of markets.
These
number
of

markets
essential

ordinarily
functions,

perform
a
including

allowing
numerous
transactors
to hedge
risks. While the costs of maintaining
these
regulations
during
periods
of "normal
market
behavior"
have not been formally
estimated,
they are doubtless considerable,
and reduce the efficiency of these markets.
Yet, the rules presumably
are maintained to
safeguard
against the extreme
swings to
which these markets seem prone. In spite of
the regulations,
these swings occasionally
occur, and there are serious questions as to
the
effectiveness
of the
regulations
in
preventing speculative bubbles.
Regulating speculation is considered as
more an art than a science. Consider the
difficulties
in any such policy. We know
that speculation
can lead to severe financial
disruption
and monetary contraction
due to
large financial
losses suffered
by many
during crashes. The monetary authorities can
prevent
these disruptions
from spreading
only by intervening,
by acting as insurers,
or by lending and offering guarantees
on
loans to banks, investors, and perhaps even
speculators.
But, if this rescue function
is
taken for granted, then speculation would be
"safer" and would occur more often, thereby
increasing the frequency of bubbles.
On the other hand, if the regulatory
authorities
never intervened,
some bubbles
perhaps would end harmlessly,
except for
the losses to those speculators
caught in
the crash. But, repercussions
of the collapse
of the speculative
bubbles
may be farreaching-extending
beyond the effects on
the participants
most directly
involved. In
such cases, failure of the authorities
to

the

financial

and

commodity

large dangers were present; but, such intervention would not be a foregone response,
thus avoiding the
more speculation.

encouragement

of even

This was precisely
the predicament
faced by the U.S. government
in the aftermath of the recent silver crash and the
Hunt
brothers'
huge
losses.
Chairman
Volcker testified on April 30, 1980, to the
House Subcommittee
on Commerce,
Consumer, and Monetary Affairs:
Englehard
ration),

(Minerals

while

asset position,
a decision

and Chemical

itself

in a strong

on Monday
forcing

possibly

triggering

positions

those

to sue the Hunts for

probable

bankruptcy

massive

the

to

the peril
indirectly

customers

institutions

reaction ....

in

In the

of

of all creditor
placing

In this issue:

After Silver and Gold:
Some Sober Thoughts
on Speculative Bubbles

in

creditors

and
a

and

liquidation

and

institutions,
jeopardy

and

felt they might be faced with

payment,
silver

Corpo-

profits

ECONOMIC
COMMENTARY

of

financial

following

chain

days, the

Federal Reserve and other agencies continued
efforts

to

develop

information

on

Hunt-related
potential

the

more
extent

obligations

vulnerability

comprehensive
of

Hunt

and

and to appraise the
of

the

banks

and

other intermediaries.

Chairman
Volcker added in his April
30 testimony,
"The question
is how to
minimize the dangers, arising rarely, without
smothering the markets in their useful, even
indispensable,
everyday work." The development of policy to deal with such situations
remains one of the most difficult
for the regulatory authorities.

challenges

The views stated herein are those of the
author
and not necessarily
those of the
Federal
Reserve Bank of Cleveland or of
the Board of Governors
of the Federal
Reserve System.
Economic Commentary

NOTE:

No

on April

21,1980.

was published

Research Department
Federal Reserve Bank of Cleveland
Post Office Box 6387
Cleveland. Ohio 44101

BULK RATE
U.S. Postage Paid
Cleveland, OH
Permit No. 385

After Silver and Gold:
Some Sober Thoughts on Speculative Bubbles

Table 1 Profiles of Several Speculative Bubbles

Chart 1 Prices of Silver and Gold
Monthly through 1979; weekly thereafter

.

Gold
1979-1980

Silver
1979-1980

New York
stocks
1926-1932

South Sea
shares
1719-1720

Mississippi
shares
1719-1720

Initial price before
bubble began

$200/ounce
(early 1979)

$6/ounce
(early 1979)

100 (index)
(July 1926)

£ 100/share
( 1719)

300 livre/
share
(early 171 9)

Peak price before
crash

$850/ounce
(1/21/80)

$48.70/ounce
(1/17/80)

216 (index)
(Sept. 1929)

£ 1OOO/share
(July 1720)

20,000 livre/
share
(early 1720)

Price after crash

$518/ounce
(4/30/80)

$14.05/ounce
(4/30/80)

£160/share
(Dec. 1720)

Worthless
(early 1721)

by Steven E. Plaut
Dollars per troy ounce
I can calculate the motions of the heavenly bodies, but not the madness of people.
(who lost £13,000
Recent months
have. witnessed
a seeming
madness
in many of the world's financial
markets.
Following
the crises in Iran and
Afghanistan,
investors appeared to be moving
out of dollar assets and into precious metals.
The prices of silver and gold soared. Gold
had been selling for less than $200 per ounce
in the beginning
of 1979, yet its price
climbed to over $800 per ounce one year
later.! On January 21,1980,
gold peaked at
a closing price in London of $850 per ounce;
two mornings later, it "crashed" to $650 per
ounce (see chart 1). The downward
trend
continued
until gold reached its 1980 low
point of $480 per ounce on March 17; the
price of gold has since hovered close to $520.
Silver prices exhibited a similar pattern,
following
gold prices upward
and then
quickly
downward.
Silver sold for $2 per
ounce in the early 1970s. By mid-January
1980, silver was selling briefly at more than
$50 per ounce, but plummeted
to $14 per
ounce by late March, where it has remained
since. In perhaps the largest financial losses
ever suffered by any single family, the Hunt
brothers
of Texas and their Arab partners
lost mill ions of dollars when the silver
market crashed. The Hunts had been buying
silver futures heavily on margin; when they
received margin calls, a sudden brief panic
swept the entire capital market, and many
commodity
markets
as well. As the price
sank, all those who had been speculating
on higher silver prices found
themselves
considerably
poorer.
The fact that speculative bubbles and
crashes are both possible and indeed common

SILVER

remains an important
thorn in the side of
many economic doctrines.
Most economists
spend a great deal of their time admiring the
rational
and optimally
efficient characteristics that markets generally exhibit. Speculative swings are really abnormal exceptions
to this rule, and are quite rare when compared
with the more common pattern of efficient
market behavior.
However, markets in the
midst of mania or panic clearly cannot be said
to be operating efficiently
or "rationally."
This fact should be a source of considerable
irritation
to proponents
of the "rational
expectations"
school of economics.
Even if
the effects of speculation
usually are stabilizing, one must consider
the possibility
that wildly
fluctuating
prices sometimes
occur because of destabilizing speculation.
Speculative
booms
and busts have
occurred
for hundreds of years. Indeed, in
the nineteenth
century
many
observers
claimed to have established
a link between
such market
madness
and sunspots.
typical pattern of a speculative bubble
follows:

The
is as

1. Speculation
centers on one commodity
or set of commodities;
2. As the price of the commodity
rises,
people begin to expect that the price will
continue to rise;
3. This expectation
leads to more buying
and higher prices, which in turn reinforces
people's expectations;
4. The price continues to soar, until suddenly
expectations
reverse themselves;
5. Then the price crashes, as people sell in
panic, trying to get rid of the specific
commodity
further.

Steven E. Plaut is research associate, Federal
Reserve Bank of Cleveland, and assistant
professor of economics, Oberlin College.

50

SIR ISAAC NEWTON
in the South Sea Bubble)

before

the

price

falls even

1. See Gerald H. Anderson, "The Surge in Gold
Prices," Economic Commentary, Federal Reserve Bank of Cleveland, January 28, 1980.

50

-~

January 1980
Daily

30

20

10

o

45

--

-

~

40

40

~

35

r-

-~
~

II

-~

~
I

I

I

I

-~

-~

-~

~

~

~

...

};...{'

""",o,:."""::::'/,',} ""

""~""""",'/{~"""""",,,
7 .;;';"'-''''''''''''''''''''''
""""".

,}

GOLD

800

700

600

--

850

January 1980
800 -Daily

--

750

-

-~

o

I

I

I

I

-~

0~
I
I

-~

-

I-

300

r-

I-

400

\fi

650 I600

500

-

700 f-

--

--

-

~
""

~

7

~8:','"
1

...•

.J

I

~"""""""""""""""""""""",

:::

,,.. """

i
Jan. Feb. Mar. Apr. May

1979
Data are mid-week, except for the daily data shown in the insets.

1980

In a few cases, bubbles have developed
in
response to the efforts of some speculators'
attempts to "corner" a market, by purchasing

controlled.
This "Mississippi Company"
had
a monopoly
on trade with the French territories in the New World. In early 1719, a

large amounts

speculative
boom
began
in Mississippi
shares.
Between
July
1719 and January
1720, share prices rose an average of 10

of the existing

supply

of the

product.

m

34 (index)
(June 1932)

Speculative Cycles of the Past
Speculative bubbles have been observed
in such markets as tulip bulbs, stocks, bonds,

points
per day. Over 30,000
foreigners
flocked to Paris to speculate, and the word
millionaire was first coined. Eventually, the

foreign
exchange,
land, real estate,
and
commodltles.Z
Stock
markets
have experienced
many speculative cycles. Perhaps

caused; the price of Mississippi shares crashed.

the most unforgettable
was the New York
stock market crash of 1929, which symbol ized the onset of the Great Depression.

At almost the same time in London,
a bubble began for shares in the South Sea
Company,
a firm that was to expand trade

Between January 1926 and September
1929,
prices on the New York Stock Exchange
more than doubled, and the boom seemed
unstoppable
(see table
1). As President
Calvin Coolidge left office in March 1929, he
claimed that the economy
was sound and
stocks were cheap at current prices. Between
September
1929 and December 1932, stock
prices fell by 80 percent on average.3
Two of the most famous speculative
crises were the South Sea and the Mississippi
Bubbles of the early eighteenth centurv.f
In

with the Spanish colonies in South America.
The company was controlled
by John Blunt
and his associates,
who performed
an impressive range of swindles and bribery in
order to support the rapidly climbing price
of shares. Speculative fever in Paris spread to
London in 1720, particularly
after the crash
of the Mississippi stock. South Sea shares
also were marketed
throughout
Europe.
Fortunes were made but as quickly lost when
the price crashed in the autumn of 1720.

1716, John Law, a fugitive from Scotland, set
up the Banque Generale in Paris; this bank
became the equivalent of a central bank for
France. Law used his position to expand the
money supply in France in order to support
speculation
d'Occident,

in shares
a trading

of the Compagnie
company
that
he

French government forced Law to stop printing money because of the inflation that it

2. A seminal history of these crises is found in
Charles P. Kindleberger, Manias, Panics, and
Crashes (Basic Books, lnc., 1978).
3. CharlesP. Kindleberger, The World in Depression
1929-1939 (University of California Press,
1973).
4. For a history of these speculative bubbles,
see John Carswell, The South Sea Bubble
(CressetPress,1960).

After Silver and Gold:
Some Sober Thoughts on Speculative Bubbles

Table 1 Profiles of Several Speculative Bubbles

Chart 1 Prices of Silver and Gold
Monthly through 1979; weekly thereafter

.

Gold
1979-1980

Silver
1979-1980

New York
stocks
1926-1932

South Sea
shares
1719-1720

Mississippi
shares
1719-1720

Initial price before
bubble began

$200/ounce
(early 1979)

$6/ounce
(early 1979)

100 (index)
(July 1926)

£ 100/share
( 1719)

300 livre/
share
(early 171 9)

Peak price before
crash

$850/ounce
(1/21/80)

$48.70/ounce
(1/17/80)

216 (index)
(Sept. 1929)

£ 1OOO/share
(July 1720)

20,000 livre/
share
(early 1720)

Price after crash

$518/ounce
(4/30/80)

$14.05/ounce
(4/30/80)

£160/share
(Dec. 1720)

Worthless
(early 1721)

by Steven E. Plaut
Dollars per troy ounce
I can calculate the motions of the heavenly bodies, but not the madness of people.
(who lost £13,000
Recent months
have. witnessed
a seeming
madness
in many of the world's financial
markets.
Following
the crises in Iran and
Afghanistan,
investors appeared to be moving
out of dollar assets and into precious metals.
The prices of silver and gold soared. Gold
had been selling for less than $200 per ounce
in the beginning
of 1979, yet its price
climbed to over $800 per ounce one year
later.! On January 21,1980,
gold peaked at
a closing price in London of $850 per ounce;
two mornings later, it "crashed" to $650 per
ounce (see chart 1). The downward
trend
continued
until gold reached its 1980 low
point of $480 per ounce on March 17; the
price of gold has since hovered close to $520.
Silver prices exhibited a similar pattern,
following
gold prices upward
and then
quickly
downward.
Silver sold for $2 per
ounce in the early 1970s. By mid-January
1980, silver was selling briefly at more than
$50 per ounce, but plummeted
to $14 per
ounce by late March, where it has remained
since. In perhaps the largest financial losses
ever suffered by any single family, the Hunt
brothers
of Texas and their Arab partners
lost mill ions of dollars when the silver
market crashed. The Hunts had been buying
silver futures heavily on margin; when they
received margin calls, a sudden brief panic
swept the entire capital market, and many
commodity
markets
as well. As the price
sank, all those who had been speculating
on higher silver prices found
themselves
considerably
poorer.
The fact that speculative bubbles and
crashes are both possible and indeed common

SILVER

remains an important
thorn in the side of
many economic doctrines.
Most economists
spend a great deal of their time admiring the
rational
and optimally
efficient characteristics that markets generally exhibit. Speculative swings are really abnormal exceptions
to this rule, and are quite rare when compared
with the more common pattern of efficient
market behavior.
However, markets in the
midst of mania or panic clearly cannot be said
to be operating efficiently
or "rationally."
This fact should be a source of considerable
irritation
to proponents
of the "rational
expectations"
school of economics.
Even if
the effects of speculation
usually are stabilizing, one must consider
the possibility
that wildly
fluctuating
prices sometimes
occur because of destabilizing speculation.
Speculative
booms
and busts have
occurred
for hundreds of years. Indeed, in
the nineteenth
century
many
observers
claimed to have established
a link between
such market
madness
and sunspots.
typical pattern of a speculative bubble
follows:

The
is as

1. Speculation
centers on one commodity
or set of commodities;
2. As the price of the commodity
rises,
people begin to expect that the price will
continue to rise;
3. This expectation
leads to more buying
and higher prices, which in turn reinforces
people's expectations;
4. The price continues to soar, until suddenly
expectations
reverse themselves;
5. Then the price crashes, as people sell in
panic, trying to get rid of the specific
commodity
further.

Steven E. Plaut is research associate, Federal
Reserve Bank of Cleveland, and assistant
professor of economics, Oberlin College.

50

SIR ISAAC NEWTON
in the South Sea Bubble)

before

the

price

falls even

1. See Gerald H. Anderson, "The Surge in Gold
Prices," Economic Commentary, Federal Reserve Bank of Cleveland, January 28, 1980.

50

-~

January 1980
Daily

30

20

10

o

45

--

-

~

40

40

~

35

r-

-~
~

II

-~

~
I

I

I

I

-~

-~

-~

~

~

~

...

};...{'

""",o,:."""::::'/,',} ""

""~""""",'/{~"""""",,,
7 .;;';"'-''''''''''''''''''''''
""""".

,}

GOLD

800

700

600

--

850

January 1980
800 -Daily

--

750

-

-~

o

I

I

I

I

-~

0~
I
I

-~

-

I-

300

r-

I-

400

\fi

650 I600

500

-

700 f-

--

--

-

~
""

~

7

~8:','"
1

...•

.J

I

~"""""""""""""""""""""",

:::

,,.. """

i
Jan. Feb. Mar. Apr. May

1979
Data are mid-week, except for the daily data shown in the insets.

1980

In a few cases, bubbles have developed
in
response to the efforts of some speculators'
attempts to "corner" a market, by purchasing

controlled.
This "Mississippi Company"
had
a monopoly
on trade with the French territories in the New World. In early 1719, a

large amounts

speculative
boom
began
in Mississippi
shares.
Between
July
1719 and January
1720, share prices rose an average of 10

of the existing

supply

of the

product.

m

34 (index)
(June 1932)

Speculative Cycles of the Past
Speculative bubbles have been observed
in such markets as tulip bulbs, stocks, bonds,

points
per day. Over 30,000
foreigners
flocked to Paris to speculate, and the word
millionaire was first coined. Eventually, the

foreign
exchange,
land, real estate,
and
commodltles.Z
Stock
markets
have experienced
many speculative cycles. Perhaps

caused; the price of Mississippi shares crashed.

the most unforgettable
was the New York
stock market crash of 1929, which symbol ized the onset of the Great Depression.

At almost the same time in London,
a bubble began for shares in the South Sea
Company,
a firm that was to expand trade

Between January 1926 and September
1929,
prices on the New York Stock Exchange
more than doubled, and the boom seemed
unstoppable
(see table
1). As President
Calvin Coolidge left office in March 1929, he
claimed that the economy
was sound and
stocks were cheap at current prices. Between
September
1929 and December 1932, stock
prices fell by 80 percent on average.3
Two of the most famous speculative
crises were the South Sea and the Mississippi
Bubbles of the early eighteenth centurv.f
In

with the Spanish colonies in South America.
The company was controlled
by John Blunt
and his associates,
who performed
an impressive range of swindles and bribery in
order to support the rapidly climbing price
of shares. Speculative fever in Paris spread to
London in 1720, particularly
after the crash
of the Mississippi stock. South Sea shares
also were marketed
throughout
Europe.
Fortunes were made but as quickly lost when
the price crashed in the autumn of 1720.

1716, John Law, a fugitive from Scotland, set
up the Banque Generale in Paris; this bank
became the equivalent of a central bank for
France. Law used his position to expand the
money supply in France in order to support
speculation
d'Occident,

in shares
a trading

of the Compagnie
company
that
he

French government forced Law to stop printing money because of the inflation that it

2. A seminal history of these crises is found in
Charles P. Kindleberger, Manias, Panics, and
Crashes (Basic Books, lnc., 1978).
3. CharlesP. Kindleberger, The World in Depression
1929-1939 (University of California Press,
1973).
4. For a history of these speculative bubbles,
see John Carswell, The South Sea Bubble
(CressetPress,1960).

After Silver and Gold:
Some Sober Thoughts on Speculative Bubbles

Table 1 Profiles of Several Speculative Bubbles

Chart 1 Prices of Silver and Gold
Monthly through 1979; weekly thereafter

.

Gold
1979-1980

Silver
1979-1980

New York
stocks
1926-1932

South Sea
shares
1719-1720

Mississippi
shares
1719-1720

Initial price before
bubble began

$200/ounce
(early 1979)

$6/ounce
(early 1979)

100 (index)
(July 1926)

£ 100/share
( 1719)

300 livre/
share
(early 171 9)

Peak price before
crash

$850/ounce
(1/21/80)

$48.70/ounce
(1/17/80)

216 (index)
(Sept. 1929)

£ 1OOO/share
(July 1720)

20,000 livre/
share
(early 1720)

Price after crash

$518/ounce
(4/30/80)

$14.05/ounce
(4/30/80)

£160/share
(Dec. 1720)

Worthless
(early 1721)

by Steven E. Plaut
Dollars per troy ounce
I can calculate the motions of the heavenly bodies, but not the madness of people.
(who lost £13,000
Recent months
have. witnessed
a seeming
madness
in many of the world's financial
markets.
Following
the crises in Iran and
Afghanistan,
investors appeared to be moving
out of dollar assets and into precious metals.
The prices of silver and gold soared. Gold
had been selling for less than $200 per ounce
in the beginning
of 1979, yet its price
climbed to over $800 per ounce one year
later.! On January 21,1980,
gold peaked at
a closing price in London of $850 per ounce;
two mornings later, it "crashed" to $650 per
ounce (see chart 1). The downward
trend
continued
until gold reached its 1980 low
point of $480 per ounce on March 17; the
price of gold has since hovered close to $520.
Silver prices exhibited a similar pattern,
following
gold prices upward
and then
quickly
downward.
Silver sold for $2 per
ounce in the early 1970s. By mid-January
1980, silver was selling briefly at more than
$50 per ounce, but plummeted
to $14 per
ounce by late March, where it has remained
since. In perhaps the largest financial losses
ever suffered by any single family, the Hunt
brothers
of Texas and their Arab partners
lost mill ions of dollars when the silver
market crashed. The Hunts had been buying
silver futures heavily on margin; when they
received margin calls, a sudden brief panic
swept the entire capital market, and many
commodity
markets
as well. As the price
sank, all those who had been speculating
on higher silver prices found
themselves
considerably
poorer.
The fact that speculative bubbles and
crashes are both possible and indeed common

SILVER

remains an important
thorn in the side of
many economic doctrines.
Most economists
spend a great deal of their time admiring the
rational
and optimally
efficient characteristics that markets generally exhibit. Speculative swings are really abnormal exceptions
to this rule, and are quite rare when compared
with the more common pattern of efficient
market behavior.
However, markets in the
midst of mania or panic clearly cannot be said
to be operating efficiently
or "rationally."
This fact should be a source of considerable
irritation
to proponents
of the "rational
expectations"
school of economics.
Even if
the effects of speculation
usually are stabilizing, one must consider
the possibility
that wildly
fluctuating
prices sometimes
occur because of destabilizing speculation.
Speculative
booms
and busts have
occurred
for hundreds of years. Indeed, in
the nineteenth
century
many
observers
claimed to have established
a link between
such market
madness
and sunspots.
typical pattern of a speculative bubble
follows:

The
is as

1. Speculation
centers on one commodity
or set of commodities;
2. As the price of the commodity
rises,
people begin to expect that the price will
continue to rise;
3. This expectation
leads to more buying
and higher prices, which in turn reinforces
people's expectations;
4. The price continues to soar, until suddenly
expectations
reverse themselves;
5. Then the price crashes, as people sell in
panic, trying to get rid of the specific
commodity
further.

Steven E. Plaut is research associate, Federal
Reserve Bank of Cleveland, and assistant
professor of economics, Oberlin College.

50

SIR ISAAC NEWTON
in the South Sea Bubble)

before

the

price

falls even

1. See Gerald H. Anderson, "The Surge in Gold
Prices," Economic Commentary, Federal Reserve Bank of Cleveland, January 28, 1980.

50

-~

January 1980
Daily

30

20

10

o

45

--

-

~

40

40

~

35

r-

-~
~

II

-~

~
I

I

I

I

-~

-~

-~

~

~

~

...

};...{'

""",o,:."""::::'/,',} ""

""~""""",'/{~"""""",,,
7 .;;';"'-''''''''''''''''''''''
""""".

,}

GOLD

800

700

600

--

850

January 1980
800 -Daily

--

750

-

-~

o

I

I

I

I

-~

0~
I
I

-~

-

I-

300

r-

I-

400

\fi

650 I600

500

-

700 f-

--

--

-

~
""

~

7

~8:','"
1

...•

.J

I

~"""""""""""""""""""""",

:::

,,.. """

i
Jan. Feb. Mar. Apr. May

1979
Data are mid-week, except for the daily data shown in the insets.

1980

In a few cases, bubbles have developed
in
response to the efforts of some speculators'
attempts to "corner" a market, by purchasing

controlled.
This "Mississippi Company"
had
a monopoly
on trade with the French territories in the New World. In early 1719, a

large amounts

speculative
boom
began
in Mississippi
shares.
Between
July
1719 and January
1720, share prices rose an average of 10

of the existing

supply

of the

product.

m

34 (index)
(June 1932)

Speculative Cycles of the Past
Speculative bubbles have been observed
in such markets as tulip bulbs, stocks, bonds,

points
per day. Over 30,000
foreigners
flocked to Paris to speculate, and the word
millionaire was first coined. Eventually, the

foreign
exchange,
land, real estate,
and
commodltles.Z
Stock
markets
have experienced
many speculative cycles. Perhaps

caused; the price of Mississippi shares crashed.

the most unforgettable
was the New York
stock market crash of 1929, which symbol ized the onset of the Great Depression.

At almost the same time in London,
a bubble began for shares in the South Sea
Company,
a firm that was to expand trade

Between January 1926 and September
1929,
prices on the New York Stock Exchange
more than doubled, and the boom seemed
unstoppable
(see table
1). As President
Calvin Coolidge left office in March 1929, he
claimed that the economy
was sound and
stocks were cheap at current prices. Between
September
1929 and December 1932, stock
prices fell by 80 percent on average.3
Two of the most famous speculative
crises were the South Sea and the Mississippi
Bubbles of the early eighteenth centurv.f
In

with the Spanish colonies in South America.
The company was controlled
by John Blunt
and his associates,
who performed
an impressive range of swindles and bribery in
order to support the rapidly climbing price
of shares. Speculative fever in Paris spread to
London in 1720, particularly
after the crash
of the Mississippi stock. South Sea shares
also were marketed
throughout
Europe.
Fortunes were made but as quickly lost when
the price crashed in the autumn of 1720.

1716, John Law, a fugitive from Scotland, set
up the Banque Generale in Paris; this bank
became the equivalent of a central bank for
France. Law used his position to expand the
money supply in France in order to support
speculation
d'Occident,

in shares
a trading

of the Compagnie
company
that
he

French government forced Law to stop printing money because of the inflation that it

2. A seminal history of these crises is found in
Charles P. Kindleberger, Manias, Panics, and
Crashes (Basic Books, lnc., 1978).
3. CharlesP. Kindleberger, The World in Depression
1929-1939 (University of California Press,
1973).
4. For a history of these speculative bubbles,
see John Carswell, The South Sea Bubble
(CressetPress,1960).

May 5,1980
Lessons of the Bubbles
Speculative
bubbles often cause widespread economic disruption, both when prices
soar and when they crash.5
Kindleberger
argues that, as speculation
spreads, credit is
pulled away from its normal uses of supporting investment and consumption
of real
goods. Thus, production
may begin falling,
even in the midst of the speculative mania.6
Expenditure
may fall because of restrictive
monetary
policy aimed at choking off the
mania. In 1929, prices of several commodities
were already falling, even as stock prices
soared. Residential
and nonresidential
construction
had been falling since 1926 and

Speculative
bubbles tend to be fueled
by expanding
inflationary
economies,
rapid
expansion of money and credit, and expectations that these conditions would continue?
Bubbles also seem to spread easily from one
commodity
to another.
The
Mississippi
Bubble spread to the South Sea Bubble and
then to the shares of other companies.
Speculation
in silver and gold likewise spread
to other commodities.
The Wall Street crash
in 1929 spread to European financial markets.
Speculative
fever is often the temptation that triggers unscrupulous
dealings.
Swindles
then arise in many imaginative
forms. One of the most popular swindlesoriginally used by the South Sea Company

continued to fall until the early 1930s.
On the other hand, when prices crash,

directors-is

wealth is lost, leading to a fall in spending and
possibly severe monetary contraction
due to
bankruptcy
and bank failure. The South Sea
crash in 1720 caused British banks to fail,
commerce
to dry up, credit to disappear,
and unemployment
to rise. The 1929 stock
market
crash
destroyed
wealth,
caused

this swindle dividends are paid to old shareholders with revenues from the sales of new
shares. Like a bubble, the chain eventually
breaks; the people
near the end of the
insolvent
chain are swindled.
Even today,
the "chain letter" continues to be one of the
favorite methods of swindlers.

banks to fail, caused spending to fall, and
increased
unemployment.
The silver crash
in 1980 caused the Dow Jones industrial
average to fall 25 points in one hour. The
silver crash
prompted
fears that
worse
repercussions would follow. Paul A. Volcker,
chairman of the Board of Governors of the
Federal Reserve System, made the following
statement
on May 1, 1980, before the
Subcommittee
on Agricultural
Research and
General Legislation:

There

is

evidence

was an attempt
significant

indicating

to control

commodity;
uncertainty

expectations

more

declined,

positions
credit,

and

had, wittingly
amount

funding

of a

and
of

inflationary
As the market

the

speculative

substantial

amounts

market

intermediaries

certain

or not, committed

of their

speculative

the supply

generally.

required

there

to some degree, this

stimulated
price

that

own capital

activity

of

turn
others

have
and

those

in support

severe

institutions

and their failure

triggered

financial
financial

letter"

method.

In

Can speculative bubbles be prevented?
Although
there may be no way to ensure
that bubbles would not occur, perhaps some
steps could be taken to make their occurrence less likely or at least to mitigate their
consequences.
The U.S. Congress has promulgated
a
number
of laws to prevent
speculative
bubbles.
The Securities
Exchange
Act of
1934 delegated
the authority
to regulate
securities

credit

to the Board

of Governors

of the Federal Reserve System. The Board
sets a margin requirement
that specifies the
minimum
down payment
required
for a
securities
transaction.
The Board's
Regulations T, U, G, and X specify the terms and
conditions

that

various

lending

institutions

an excessive

in one commodity

some of

placed in jeopardy,

"chain

Bubble Bursting

of

by a

5.

Compare Kindleberger,
1929-1939, chap. 3.

6.

Kindleberger,

single group of people. As the market values
collapsed,

the

were

losses

for

The World in Depression 1929-

1939, chap. 3, p.14.

could in

disturbances.

The World in Depression

7.

Compare

Crashes,

Kindleberger,
chap. 4.

Manias, Panics, and

and borrowers must follow when
credit is extended. The Board may
margin requirement
to restrain the
use of credit for purchasing
or

securrtres

cushion

raise the
excessive
carrying

markets
could turn bubbles
into serious
contractions,
similar to those that have
occurred
in the past. The solution would
have to be a delicate
intermediate
role,
where intervention
took place when really

securities.
In addition,
the Securities
and
Exchange Commission
and the Commodity
Futures
Trading
Commission
oversee the
securities and commodities
markets, respectively. All of these regulations
represent
interference
in the
normal
day-to-day
operations of markets.
These
number
of

markets
essential

ordinarily
functions,

perform
a
including

allowing
numerous
transactors
to hedge
risks. While the costs of maintaining
these
regulations
during
periods
of "normal
market
behavior"
have not been formally
estimated,
they are doubtless considerable,
and reduce the efficiency of these markets.
Yet, the rules presumably
are maintained to
safeguard
against the extreme
swings to
which these markets seem prone. In spite of
the regulations,
these swings occasionally
occur, and there are serious questions as to
the
effectiveness
of the
regulations
in
preventing speculative bubbles.
Regulating speculation is considered as
more an art than a science. Consider the
difficulties
in any such policy. We know
that speculation
can lead to severe financial
disruption
and monetary contraction
due to
large financial
losses suffered
by many
during crashes. The monetary authorities can
prevent
these disruptions
from spreading
only by intervening,
by acting as insurers,
or by lending and offering guarantees
on
loans to banks, investors, and perhaps even
speculators.
But, if this rescue function
is
taken for granted, then speculation would be
"safer" and would occur more often, thereby
increasing the frequency of bubbles.
On the other hand, if the regulatory
authorities
never intervened,
some bubbles
perhaps would end harmlessly,
except for
the losses to those speculators
caught in
the crash. But, repercussions
of the collapse
of the speculative
bubbles
may be farreaching-extending
beyond the effects on
the participants
most directly
involved. In
such cases, failure of the authorities
to

the

financial

and

commodity

large dangers were present; but, such intervention would not be a foregone response,
thus avoiding the
more speculation.

encouragement

of even

This was precisely
the predicament
faced by the U.S. government
in the aftermath of the recent silver crash and the
Hunt
brothers'
huge
losses.
Chairman
Volcker testified on April 30, 1980, to the
House Subcommittee
on Commerce,
Consumer, and Monetary Affairs:
Englehard
ration),

(Minerals

while

asset position,
a decision

and Chemical

itself

in a strong

on Monday
forcing

possibly

triggering

positions

those

to sue the Hunts for

probable

bankruptcy

massive

the

to

the peril
indirectly

customers

institutions

reaction ....

in

In the

of

of all creditor
placing

In this issue:

After Silver and Gold:
Some Sober Thoughts
on Speculative Bubbles

in

creditors

and
a

and

liquidation

and

institutions,
jeopardy

and

felt they might be faced with

payment,
silver

Corpo-

profits

ECONOMIC
COMMENTARY

of

financial

following

chain

days, the

Federal Reserve and other agencies continued
efforts

to

develop

information

on

Hunt-related
potential

the

more
extent

obligations

vulnerability

comprehensive
of

Hunt

and

and to appraise the
of

the

banks

and

other intermediaries.

Chairman
Volcker added in his April
30 testimony,
"The question
is how to
minimize the dangers, arising rarely, without
smothering the markets in their useful, even
indispensable,
everyday work." The development of policy to deal with such situations
remains one of the most difficult
for the regulatory authorities.

challenges

The views stated herein are those of the
author
and not necessarily
those of the
Federal
Reserve Bank of Cleveland or of
the Board of Governors
of the Federal
Reserve System.
Economic Commentary

NOTE:

No

on April

21,1980.

was published

Research Department
Federal Reserve Bank of Cleveland
Post Office Box 6387
Cleveland. Ohio 44101

BULK RATE
U.S. Postage Paid
Cleveland, OH
Permit No. 385

May 5,1980
Lessons of the Bubbles
Speculative
bubbles often cause widespread economic disruption, both when prices
soar and when they crash.5
Kindleberger
argues that, as speculation
spreads, credit is
pulled away from its normal uses of supporting investment and consumption
of real
goods. Thus, production
may begin falling,
even in the midst of the speculative mania.6
Expenditure
may fall because of restrictive
monetary
policy aimed at choking off the
mania. In 1929, prices of several commodities
were already falling, even as stock prices
soared. Residential
and nonresidential
construction
had been falling since 1926 and

Speculative
bubbles tend to be fueled
by expanding
inflationary
economies,
rapid
expansion of money and credit, and expectations that these conditions would continue?
Bubbles also seem to spread easily from one
commodity
to another.
The
Mississippi
Bubble spread to the South Sea Bubble and
then to the shares of other companies.
Speculation
in silver and gold likewise spread
to other commodities.
The Wall Street crash
in 1929 spread to European financial markets.
Speculative
fever is often the temptation that triggers unscrupulous
dealings.
Swindles
then arise in many imaginative
forms. One of the most popular swindlesoriginally used by the South Sea Company

continued to fall until the early 1930s.
On the other hand, when prices crash,

directors-is

wealth is lost, leading to a fall in spending and
possibly severe monetary contraction
due to
bankruptcy
and bank failure. The South Sea
crash in 1720 caused British banks to fail,
commerce
to dry up, credit to disappear,
and unemployment
to rise. The 1929 stock
market
crash
destroyed
wealth,
caused

this swindle dividends are paid to old shareholders with revenues from the sales of new
shares. Like a bubble, the chain eventually
breaks; the people
near the end of the
insolvent
chain are swindled.
Even today,
the "chain letter" continues to be one of the
favorite methods of swindlers.

banks to fail, caused spending to fall, and
increased
unemployment.
The silver crash
in 1980 caused the Dow Jones industrial
average to fall 25 points in one hour. The
silver crash
prompted
fears that
worse
repercussions would follow. Paul A. Volcker,
chairman of the Board of Governors of the
Federal Reserve System, made the following
statement
on May 1, 1980, before the
Subcommittee
on Agricultural
Research and
General Legislation:

There

is

evidence

was an attempt
significant

indicating

to control

commodity;
uncertainty

expectations

more

declined,

positions
credit,

and

had, wittingly
amount

funding

of a

and
of

inflationary
As the market

the

speculative

substantial

amounts

market

intermediaries

certain

or not, committed

of their

speculative

the supply

generally.

required

there

to some degree, this

stimulated
price

that

own capital

activity

of

turn
others

have
and

those

in support

severe

institutions

and their failure

triggered

financial
financial

letter"

method.

In

Can speculative bubbles be prevented?
Although
there may be no way to ensure
that bubbles would not occur, perhaps some
steps could be taken to make their occurrence less likely or at least to mitigate their
consequences.
The U.S. Congress has promulgated
a
number
of laws to prevent
speculative
bubbles.
The Securities
Exchange
Act of
1934 delegated
the authority
to regulate
securities

credit

to the Board

of Governors

of the Federal Reserve System. The Board
sets a margin requirement
that specifies the
minimum
down payment
required
for a
securities
transaction.
The Board's
Regulations T, U, G, and X specify the terms and
conditions

that

various

lending

institutions

an excessive

in one commodity

some of

placed in jeopardy,

"chain

Bubble Bursting

of

by a

5.

Compare Kindleberger,
1929-1939, chap. 3.

6.

Kindleberger,

single group of people. As the market values
collapsed,

the

were

losses

for

The World in Depression 1929-

1939, chap. 3, p.14.

could in

disturbances.

The World in Depression

7.

Compare

Crashes,

Kindleberger,
chap. 4.

Manias, Panics, and

and borrowers must follow when
credit is extended. The Board may
margin requirement
to restrain the
use of credit for purchasing
or

securrtres

cushion

raise the
excessive
carrying

markets
could turn bubbles
into serious
contractions,
similar to those that have
occurred
in the past. The solution would
have to be a delicate
intermediate
role,
where intervention
took place when really

securities.
In addition,
the Securities
and
Exchange Commission
and the Commodity
Futures
Trading
Commission
oversee the
securities and commodities
markets, respectively. All of these regulations
represent
interference
in the
normal
day-to-day
operations of markets.
These
number
of

markets
essential

ordinarily
functions,

perform
a
including

allowing
numerous
transactors
to hedge
risks. While the costs of maintaining
these
regulations
during
periods
of "normal
market
behavior"
have not been formally
estimated,
they are doubtless considerable,
and reduce the efficiency of these markets.
Yet, the rules presumably
are maintained to
safeguard
against the extreme
swings to
which these markets seem prone. In spite of
the regulations,
these swings occasionally
occur, and there are serious questions as to
the
effectiveness
of the
regulations
in
preventing speculative bubbles.
Regulating speculation is considered as
more an art than a science. Consider the
difficulties
in any such policy. We know
that speculation
can lead to severe financial
disruption
and monetary contraction
due to
large financial
losses suffered
by many
during crashes. The monetary authorities can
prevent
these disruptions
from spreading
only by intervening,
by acting as insurers,
or by lending and offering guarantees
on
loans to banks, investors, and perhaps even
speculators.
But, if this rescue function
is
taken for granted, then speculation would be
"safer" and would occur more often, thereby
increasing the frequency of bubbles.
On the other hand, if the regulatory
authorities
never intervened,
some bubbles
perhaps would end harmlessly,
except for
the losses to those speculators
caught in
the crash. But, repercussions
of the collapse
of the speculative
bubbles
may be farreaching-extending
beyond the effects on
the participants
most directly
involved. In
such cases, failure of the authorities
to

the

financial

and

commodity

large dangers were present; but, such intervention would not be a foregone response,
thus avoiding the
more speculation.

encouragement

of even

This was precisely
the predicament
faced by the U.S. government
in the aftermath of the recent silver crash and the
Hunt
brothers'
huge
losses.
Chairman
Volcker testified on April 30, 1980, to the
House Subcommittee
on Commerce,
Consumer, and Monetary Affairs:
Englehard
ration),

(Minerals

while

asset position,
a decision

and Chemical

itself

in a strong

on Monday
forcing

possibly

triggering

positions

those

to sue the Hunts for

probable

bankruptcy

massive

the

to

the peril
indirectly

customers

institutions

reaction ....

in

In the

of

of all creditor
placing

In this issue:

After Silver and Gold:
Some Sober Thoughts
on Speculative Bubbles

in

creditors

and
a

and

liquidation

and

institutions,
jeopardy

and

felt they might be faced with

payment,
silver

Corpo-

profits

ECONOMIC
COMMENTARY

of

financial

following

chain

days, the

Federal Reserve and other agencies continued
efforts

to

develop

information

on

Hunt-related
potential

the

more
extent

obligations

vulnerability

comprehensive
of

Hunt

and

and to appraise the
of

the

banks

and

other intermediaries.

Chairman
Volcker added in his April
30 testimony,
"The question
is how to
minimize the dangers, arising rarely, without
smothering the markets in their useful, even
indispensable,
everyday work." The development of policy to deal with such situations
remains one of the most difficult
for the regulatory authorities.

challenges

The views stated herein are those of the
author
and not necessarily
those of the
Federal
Reserve Bank of Cleveland or of
the Board of Governors
of the Federal
Reserve System.
Economic Commentary

NOTE:

No

on April

21,1980.

was published

Research Department
Federal Reserve Bank of Cleveland
Post Office Box 6387
Cleveland. Ohio 44101

BULK RATE
U.S. Postage Paid
Cleveland, OH
Permit No. 385