By Kim Tae-gyu
Staff Reporter
Economic bubbles, no matter how robust they seem to be at their peaks, are destined to burst. Experts point out this is what history teaches us with regard to unsustainable economic expansion.
The world by no means lacks examples of speculative manias, which date back to the early 1600s in Europe. There were probably other types of crazes even before then that have not been written about.
Included in the most notable market crashes are the Tulip mania, the South Sea (Company) bubble, the Great Depression, the Asian currency crisis, the Dotcom bubble and today's financial tsunami.
According to Wikipedia, an economic bubble refers to trade in high volumes at prices that are considerably at variance with intrinsic value.
In other words, asset prices are typically overrated by far beyond their fundamental values. Prices fluctuate erratically, and become impossible to predict from supply and demand alone.
``The problem of bubbles is that it misallocates scarce resources to non-optimal uses in both business areas and time horizons. It will eventually reduce the welfare of a society,'' Prof. Kim Sang-jo at Hansung University said.
``More seriously, the aftermath of the bubble burst is too severe as many companies or households are destined to fold, thus causing a protracted downturn,'' he said.
He added that delving into the history of speculative bubbles is of great importance because the current financial crisis has been caused by housing and investment banking bubbles.
``Think of the soap bubbles your children like to blow. Economic bubbles sometimes seem to rise forever, but they inevitable pop as they don't have anything substantive,'' he said.
``Understanding the boom and bust phases of bubbles is crucial. In many cases, bubble bursts led to stock market crashes and long-lasting recessions,'' he said.
In the early 1600s, Dutch traders saw the price of Tulip bulbs soar too high, the bubble burst and their value go down to merely a hundredth of their former price in a single day.
In time with the 17th century Dutch Golden Age, when the country led the world in trade, science and art, tulips were relatively recently introduced flowers.
Popular among wealthy people across the Europe, contract prices for tulip bulbs were prohibitively high as demand outstripped supply of the highly coveted luxury flowers.
The competition among the Amsterdam merchants was stiff to possess the flowers, which took seven years to grow from seeds, and some rare bulbs commanded outlandish prices.
At its peaks during the winter of 1636 and 1637, some tulip futures contracts sold for more than 10 times the annual income of a highly skilled laborer.
The craze collapsed early 1637 as buyers of the futures contracts did not appear to purchase tulips, thus failing to settle the contracts on the market.
This caused people to panic and sell without regard to losses. Hence, the prices dived to rock bottom.
In the 1720s, a similar frenzy that deserves a place in the ``Chronicles of Mania'' took place in Great Britain that involved the South Sea Company (SSC), infamously dubbed recently as the ``Enron of England.''
The British government, which was highly indebted after a war related to the royal succession in Spain in the early 1700s, granted exclusive trading rights in South American colonies to the SSC.
In exchange for the lucrative monopoly, the SSC agreed to take charge of the debt incurred during the war.
In order to fund its seemingly juicy scheme of exchanging gold and jewelry in South America for the wool and fleece clothing of the British, the SSC issued shares several times.
Lured by the extravagant facilities of the SCC head office as well as the rosy schemes, many people rushed to buy SSC stocks. This caused a wave of speculating frenzy.
The share price jumped almost 10-fold in 1720 from around 100 pounds in January to reach 1,000 pounds in August.
However, the firm's dismal earnings fell far short of buttressing the super-high share prices. As the investors got wind of the fact, panic selling set in and the share prices plunged to almost nothing.
The burst of the South Sea Company bubble caused lots of investors who snapped up the stocks on credit, including many noblemen, to go bankrupt. Also a number of companies involved shut down.
Putting behind the Great Depression in 1929, the world economy enjoyed a golden time in the 1950s and 1960s. The two oil shocks in the 1970s and the 1987 stock market crash plagued the global economy but it showed resilience.
Then came the currency crisis in the late 1990s, which caught emerging countries in such Asian countries as Korea, Malaysia, Thailand and the Philippines off guard.
For example, share prices plummeted on the Seoul bourse and the Korean won reached around 2,000 won to the dollar from 800 won before the financial turmoil.
One of the country's top chaebol, Daewoo Group, went under. This put an end to the ``too-big-to-fail'' myth that chaebol, Korea's economic growth engine, couldn't fold as they would be helped by the government and banks.
The International Monetary Fund came to the rescue to prevent a sovereign default, while obliging many Western-style measures such as reducing debt ratios, enhancing transparency and opening up financial markets.
Although the crisis devastated some Asian economies, most Western countries remained unaffected by the debacle.
In particular, the U.S. enjoyed the best of times boosted by emerging technologies, which some analysts said would promise an advent of a new economy.
``When the bubble is being inflated, there always emerge people who come up with theories aimed at soothing nervous investors,'' a Seoul analyst said.
``The new economy is one and another is the Goldilocks economy, which some observers created during the economic upturn over the past few years,'' he said.
Anyway, prosperity appeared to continue thanks to technology. Many high-tech companies without any substantial business model garnered a huge amount of cash in stock offering.
Angel capitalists went gaga over the venture start-ups and their shares continue to head north throughout the 1990s.
However, most of the high-tech companies failed to meet the hype because they could not make money despite a huge amount of investment.
In 2000, the tech-loaded Nasdaq headed south after peaking in March and by 2001 the bubble was deflating at full speed. The bust was accelerated by the 9/11 terrorist attacks in 2001.
This wreaked havoc on the global economy for the next couple of years.
The consensus is that the current economic turmoil is attributable to the bubbles in housing markets and over-investment by highly-leveraged investment banks such as the now defunct Lehman Brothers.
Experts point out bubbles should be prevented in order to avoid a crash in the aftermath of their busts, which in many cases end up causing a recession.
Prof. Lee Joon-koo at Seoul National University, arguably the most famous micro-economist in Korea, spearheads the efforts to warn against the devastating risks of market crazes.
``Once the bubble starts to be inflated, it tends to become as big as it can be. When it is getting bigger in size, people easily believe that all is fine,'' Lee said.
``However, the fact does not change that the bubble is so called because it cannot be inflated forever. Since its size is bigger than it deserves, it will eventually burst,'' he said.
Lee went on to say that capitalism inclines to create bubbles to get the maximum growth in the shortest term when the system remains unchecked. Under this mantra, he proposes managed capitalism as an alternative to unbridled capitalism.
``The unrestrained management of capital on the back of ultra-high leverage is responsible for the ongoing financial crisis. Such unbridled capitalism is on the decline,'' Lee said.
``There is nothing sacred about the almighty market, which has drawbacks and advantages at the same time. In order to control the drawbacks, we have to bring checks and balances in the form of managed capitalism,'' he said.
Financial Services Commission Chairman Chin Dong-soo concurs with Lee.
``From the global economic distress, we should learn that the intrinsic instability of the financial market combined with a lack of regulation caused the problems,'' Chin, the country's top financial policymaker, told businessmen in Busan in mid-March.
``We should accept that the vulnerabilities of the financial market resulted in the current crisis and have to make efforts to improve the paradigm of today's financial capitalism,'' he said.