The Big Question: What can we learn from previous stock market panics?

Why are we asking this now?

Share prices around the world took a mauling yesterday, despite the surprise move by the United States Federal Reserve to cut interest rates by three-quarters of a percentage point. It is still early days, but many analysts are beginning to regard this latest bout of volatility on global equity exchanges as a full-blown stock market crash.

Has anything like this happened before?

Financial panics are nothing new. They date back as far as "Tulipmania" in the 17th century, when Dutch investors pushed up the price of tulip bulbs to ridiculous levels only to see the bottom fall out of the market. There were various financial "bubbles" in the shares of joint-stock companies during the first half of the 18th century in Britain and acute banking crises in 1825 and 1866.

The greatest economic shock of the 20th century was the Wall Street Crash, which resonated around the world. It took a quarter of a century for the Dow Jones industrial average to return to the levels of pre-October 1929.

The next major global crash came in the 1980s. In October 1987, the Dow Jones dropped by 22 per cent. Eighteen other major industrial nations saw their stock markets lose more than a fifth of their value.

The Japanese stock market disintegrated in 1990, with the Nikkei shedding three-quarters of its value in a matter of months. Markets crashed in developing economies across Asia in 1997. And eight years ago, Western stock markets endured the dotcom collapse.

Why do they happen?

No financial panic is identical, but they tend to have features in common. A certain type of investment becomes popular. Those with a vested interest in the shares hype the price still further. People who do not understand what they are buying pile in solely to avoid missing out. A piece of bad news emerges. Investors start to panic and sell off stock, all at the same time.

Often (although not always) these panics coincide with a peak in the business cycle. The process can be summarised as an emotional roller coaster of greed, followed by euphoria, and finally fear. The late economist J K Galbraith in his A Short History of Financial Euphoria describes a kind of mass psychosis taking hold of investors. Large numbers have "a vested interest in error" because they want to see the price of their holdings rise and are willing to "suspend disbelief", even when the evidence tells them that the holdings are overvalued, or when it is clear that a scheme will never pay out on the scale expected.

Why don't investors learn from history?

Bubbles tend to be accompanied by that dread phrase, "It's different this time". Speculative frenzies often feed on a theory of a fundamental economic shift.

In Holland in the 1620s, newly imported tulips from the Ottoman Empire were believed to be so beautiful that the bulbs would eventually be worth more than gold. The South Sea Bubble of the 1710s was supported by a faith in the new profitability of Trans-Atlantic trade. American investors in the "Roaring Twenties" were enthralled by new industries such as broadcasting and car-making.

Their counterparts in the 1980s were seduced by talk of a revolution in supply-side economics. In the early 1990s, the mania was for Japanese land. The dotcom bubble was fuelled by the transforming power of the internet.

Are there any other common features?

Bubbles often also involve dubious financial innovation. In the early 1700s investors were beguiled by a new model for funding government debt. In 1987, the frenzy was partially fuelled by assumptions about junk bonds. This all helps with the suspension of disbelief by investors.

But J K Galbraith points to a more basic psychological explanation for booms and subsequent panics: "There is a possibility, even the close likelihood, of self-approving and extravagantly error-prone behaviour on the part of those closely associated with money."

So is this the story of the latest crash?

This crisis is slightly different. It is not a direct result of a bubble in share prices, but rather a banking crisis combining with the beginnings of a slowdown. Stock markets are responding to those two factors.

But the banking side of the crisis does have very similar features to past panics. For instance, the hunger of bankers for huge returns led to their selling home loans to hundreds of thousands of Americans in recent years who simply could not afford them. Corporate investors and insurers then bought up complex financial securitisation packages such as "collateralised debt obligations" made up of these dodgy loans, without really understanding what they were acquiring.

Are crashes more dangerous nowadays?

Perhaps the major development in recent years is the influence of hedge funds and computers. Hedge funds place huge bets on small market movements with borrowed money. Some argue that this can drastically affect markets in a crisis.

The collapse of the US hedge fund Long Term Capital Management (LTCM) is a good example. When Russia defaulted on government bonds in August 1998, investors fled from other government paper to the safe haven of US Treasury securities. LTCM, which had borrowed a huge amount of money from other companies to invest in international bonds, stood to lose billions. To liquidate its positions, it was forced to sell its Treasury bonds, plunging US credit markets into turmoil and forcing up interest rates.

Computerised trading systems can also have a dramatic effect on panics. In October 1987, a newly introduced computerised trading system exacerbated share falls as sell orders were executed automatically when stock prices reached a certain level. These two new trends came together last summer when hedge funds with complicated computer trading programmes were forced to offload shares automatically, exacerbating market volatility.

How should the authorities respond?

The experience of the 1929 Wall Street Crash shows how financial authorities can make matters far worse in a crisis if they act foolishly. In that case, the Federal Reserve raised interest rates to protect the value of the dollar and preserve the gold standard. But in doing so, it starved the markets of liquidity. The financial system went into meltdown and ensured that the contagion spread into the broader economy. Companies went under. There were massive lay-offs and suffering. At one stage, one third of the American workforce was unemployed. The US economy shrank by 50 per cent.

There was similar absence of foresight from the British authorities in the Overend & Guerney crisis in London in 1866. Overend was a discount bank that provided money for commercial and retail banks in the capital. When it was declared bankrupt, many smaller banks were unable to access funds, even though they were otherwise solvent. The shock transmitted itself at bewildering speed through the financial system.

The good news is that governments seem to have learned from these traumatic experiences. Central banks are more active and primed to deal with liquidity crises in their role as "lender of last resort".

So is cutting interest rates the solution?

There are hazards in this approach. Rate cuts in Britain in the wake of the 1987 crash arguably contributed to a housing bubble that, when it eventually burst in the early 1990s, led to recession. The risks of rate cuts were even more starkly illustrated after the 2000 dotcom bubble. Central banks in Britain and the US went too far in lowering interest rates. Credit was made too cheap and plentiful, sowing the seeds of the present panic.

Then there is the spectre of Japan. The country has still not fully recovered from the 1990 crash. Failing companies were bailed out by ultra-low interest rates. And still Japanese consumers refused to spend. Central bankers will be fervently hoping that this is one piece of recent history they are not going to see repeated.