China isn't the first to mishandle a stock panic

By Stephen Mihm

The Chinese and Hong Kong national flags fly near the Hong Kong Stock Exchange in China. Photo / Bloomberg
The Chinese and Hong Kong national flags fly near the Hong Kong Stock Exchange in China. Photo / Bloomberg

The Chinese authorities' seemingly capricious decision last week to trigger circuit breakers, then rapidly remove them, added to the chaos in the country's stock exchanges and intensified unease about the world's second- largest economy and its commitment to free markets.

China has been roundly criticized for its hit-or-miss approach to keeping excessive volatility in check. Yet it may be worth recalling that similar mechanisms to halt trading when share prices drop or rise too precipitously are in place in many countries, including the US, and were developed over more than a century of trial and error.

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The current system, which briefly suspends trading on the New York Stock Exchange in the event of swings between 7 percent and 13 percent and shuts the market for the day when the swings reach 20 percent, resulted from the so-called Black Monday crash of 1987.

Before then, closures of the stock exchange took place, but in a more ad-hoc fashion: the five-day hiatus in 1933, imposed alongside Franklin Roosevelt's famous bank holiday during the depths of the Great Depression; and the lengthy closure throughout the fall of 1914 at the outbreak of World War I.

Those circumstances, however, differ from the recent turmoil in China because the suspensions and shutdowns were triggered by events unrelated to normal day-to-day trading (for 1987, a computer glitch, and in the other two cases, political, economic and foreign crises).

A man stands in front of an electronic board displaying share prices at a securities exchange house in Shanghai, China. Photo / Bloomberg
A man stands in front of an electronic board displaying share prices at a securities exchange house in Shanghai, China. Photo / Bloomberg

Instead, the best parallel for the China meltdown is the very first closing of the New York Stock Exchange during the panic of 1873.

That incident, like the one in China, took place against the backdrop of huge overinvestment in infrastructure (mostly railroads, heavily subsidized by the federal government) and a highly leveraged financial sector.

In the summer of 1873, a few ominous tidings had snowballed into a more serious panic on Wall Street. Still, until September of that year, most market watchers remained confident that a crisis could be averted.

Then came the collapse of Jay Cooke and Co., one of the leading investment banks. When news reached the floor of the New York Stock Exchange, the traders became unhinged.

The New York Tribune reported: A monstrous yell went up and seemed to literally shake the building in which all these mad brokers were confined.

The trading floor became the backdrop for scenes of desperation, as stocks found no buyers and prices plummeted. Still, most traders resisted closing the exchange: a broker who floated the idea on Friday, September 19 was "hooted at and reviled" by his fellows, the Tribune reported.

By the next day (the stock exchange operated on Saturday during this era) the mood had shifted. A delegation of brokers went to Vice-Chairman M.A. Wheelock, demanding that he halt trading. He demurred, arguing that only the Governing Committee could shutter the exchange.

Traders then took matters in their own hands. They huddled around a large oval table and passed a resolution that declared the exchange closed, giving authority to the Governing Committee to reopen it. Faced with this rebellion, the committee officially halted trading -- for the first time in the history of the exchange.

The closure was controversial.

But many observers thought there was no other option. Indeed, after shuttering the exchange, Wheelock told a reporter that he believed it should have been closed a day earlier:

If it had been done, the majority of the firms that suspended this morning would have been rescued from ruin, and millions of dollars saved.

President Ulysses Grant arrived in New York a few hours after the closing, as did Secretary of the Treasury William Richardson. The city's leading financiers begged the federal government to intervene, and it did: Richardson began buying federal bonds on Monday to inject liquidity into the market.

For most market observers, pragmatism trumped idealism.

Traders work on the floor of the New York Stock Exchange in New York, US. Photo / Bloomberg
Traders work on the floor of the New York Stock Exchange in New York, US. Photo / Bloomberg

The New York Times, for example, argued that the only way to halt the panic was to shut the site of the brokers' "suicidal struggle" until the storm had passed. "It is not necessary now to discuss the question of whether the remedy was not worse than the disease, or whether the evil would have not cured itself, had it been allowed."

In any case, the remedy worked. On Monday, the Times reported that the panic had begun to subside "in consequence of the wise expedient of closing the Stock Exchange, and of the favorable results following the actions of the Government."

The exchange reopened Tuesday, Sept. 30, and prices moved upward. The makeshift circuit breaker had worked, though stock prices would decline again in the ensuing weeks, but without the same level of hysteria that had accompanied the original panic.

There's a coda to the story that should give pause to anyone who believes that circuit breakers, whether old school or new school, can avert disaster. In 1873, the stock market panic subsided. On the other hand, the larger economy, burdened by massive overinvestment in railroads and other industrial ventures and dangerous levels of debt, slipped into one of the worst depressions the country had ever endured. It lasted until 1879.

China shouldn't be condemned for attempting to arrest panic on its fledgling stock exchange, as the U.S. did many years ago. But the broader historical lesson, still valid today, is that even when such measures work in the short term, no matter of meddling can truly short-circuit the bust that follows a boom.

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