An Intro to Market Crashes

While the stock market is a great way to store extra wealth, it’s also a terrifying place where you could lose it all. For example, if you buy 100 shares of Facebook, going for 130.99 as of today (a $13099.00 investment), and it went down a single dollar, you would lose $100 dollars instantly. Now, $100 is tiny compared to $13099. However, a $1 movement in the stock market isn’t anything alarming; when the market crashes, investors are liable to lose quite a bit more wealth from rapidly falling prices. Combine this with leveraging, and you can see why market crashes are so dangerous (leveraging is essentially borrowing money to invest. It can help you make higher returns, but is a poor decision right before a recession because the value of the securities you bought are lowered, while what you owe still stays the same; in other words, more money has to come out from your own pocket to cover the difference).

Why does the stock market even crash in the first place? When it comes down to it, these crashes happen because of lack of confidence in the market. If companies as a whole stop doing well, investors may collectively decide that they should sell their current positions. If too many of these investors sell, they’ll cause a run. In other words, the share price will plummet because of basic supply and demand laws; since there is high supply and little demand, the share prices will lower until they reach equilibrium. If the share price goes low enough, even more investors will cut their losses and sell, driving the share price even lower, and the cycle goes on. Granted, the share price will likely stay above a certain level because of the solvency of the company, but much wealth can be lost in these runs.

And if there are runs for a whole bunch of companies, we get something called a recession (like the 2008 one or the Great Depression). Unfortunately, minor runs quickly go bad, because investors may decide to exit the whole market instead of just the rotten bits. For example, in 2008, when details of the shady parts of the mortgage business were realized, investors ran from all financial institutions that dealt with mortgages, even the relatively safe ones.

So, how the heck does America get out of a recession and make investors come back to the table? The key is in confidence. If investors believe that their money is safe with a company and there’s the potential to make a return, they’ll dump in all of their spare change. The Federal Reserve, America’s big bank, can cut down interest rates to convince smaller banks to do the same and lend a lot to consumers (this process is called easing). What this does is jumpstart the economy a little. It costs less to borrow money, incentivizing the buying and selling that drives our economy.

Granted, this does seem counterintuitive. If the economy does slow down, the government should aim to cut costs, just like families and businesses do in these situations, right? Wrong. That is literally the worst thing the government can do, because it guarantees a long and hard recession where everyone tries to get by on as little as possible. Instead, they should work to increase confidence and the private sector’s demand for securities. This process usually works in the form of firm bailouts, bank deposit guarantees, and so on. Unfortunately, this efficient choice will cause a political uproar in all sectors. In 2008, there was quite a bit of backlash over “big bank bailouts”, while these banks were outraged over the overly harsh terms they had to accept in order to keep running.

Overall, financial crises are a terrible phenomenon, often followed by recessions. However, they can be avoided. With “safeguards” such as increasing the capital requirements for banks or higher down payments for houses, the likelihood of a crash in the first place is lowered. There is also emergency authority, which grants the Federal Reserve and Treasury special powers in times of crises. When the crisis initially hits, there is much turmoil, and with quick and decisive actions, it can be made far less alarming. WIth this knowledge in mind, perhaps America’s next recession will be short-lived.


Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )


Connecting to %s