What caused the Wall Street Crash?

Answer 1

This is a simple question which cannot be answered in a few lines. Volumes have been produced to try to answer this question. Several factors lead to Stock Market crashes.

Usually there is a speculative bubble, where the price of stocks exceeds their real value greatly. In such times, an irrational demand drives the prices way up. When a critical point is reached, large institutional stock holders will usually dump their stock, as they see that they are getting a really good price for their stock. Such selling drives the prices back down. A wave of selling can occur then, like a flock of birds, everyone begins selling their stock because they see the prices coming down and want to get out before it hits bottom. It often happens that in a short time by this process the stock prices will fall so sharply that they are measurably less than their real value.

Another major factor to Stock Market crashes is the money supply. If the money supply contracts, a number of things happen. A contraction, or reduction in the availability of money itself, will cause stock prices to go down. Not because the stock is worth less, but because money is less available and thus worth more. Such a contraction also creates other problems for stock markets. For instance, if an investment bank has a big overnight loan to pay back but finds itself short on cash because it has little cash on hand and no one is willing to make it further loans because of a low money supply, the bank will have to liquidate some of its assets in order to come up with the cash to pay back the loan. This may include the selling of large amounts of stock. If many banks have to do this all at once because there is suddenly a money shortage, all of that selling of stocks puts a great deal of downward pressure on the stock prices.

The money supply problem described above best describes what happened a couple years ago in the US and Britain. Many banks failed because they were in a compromised position when they could not pay back money they had borrowed because they could not themselves borrow new money. This 'phenomenon' is created by "fractional reserve banking" whereby the supply of money is completely unregulated and subject to the behaviors of market participants. Those behaviors are governed by self interest and self preservation, not overall good or stability. This is a major flaw in the economic system and it inevitably leads to a boom and bust cycle. An over supply in money always leads to speculation and inflation of stock values until a peak is reached (BOOM), then large institutions begin to sell off and hoard their money, simply because it is natural to sell when the price is high, and natural to hoard the money because there are very few markets which are not overpriced and worth buying into. THis is the BUST part. It gets worse, when suddenly smaller institutions and retail investors find that their stock portfolios are worth much less. When their loans come due (overnight bank loans, mortgages, etc) which were made in the past with their portfolios as collateral, whoever is lending money may not be willing to refinance the loan or mortgage because there is no more collateral. Or maybe the lending companies themselves need the cash to cover their own debts, and are not lending more money regardless of collateral. In other words, stock market crashes and recessions are built in to the system. THis is actually not complicated, and can be understood with a little bit of studying. To better understand this ROOT CAUSE of all stock market crashes, you should go to Google videos or some place and search "fractional reserve banking". Watch several videos on the subject and you will begin to pick up on the concept of how that works.

This is truly the underlying cause to economic instability. Many people say that the recent crash was caused by the real-estate bubble. But a real estate bubble can only happen in the way that it did when Fractional Reserve banking allows banks collectively to lend out more money than they have. In pouring so much money out into the markets in the form of sub prime mortgage loans, the value of US real estate began to climb because of Increased demand from new home buyers taking advantage of cheap loans, money supply driven inflation, and resulting speculation. The rug was pulled out from underneath all of this when certain institutions reached their lending limits, and money supply driven inflation caused rising prices which impacted the bottom lines of households and businesses alike, affecting their ability to pay loans back. As the markets began to turn, institutional lenders began to try to shelter themselves from the inevitable bust by not refinancing or lending their money, and people had to sell their homes to pay back loans. With a glut of selling occurring, prices fell, and a lot of people lost a lot when they could not sell their homes for as much as they bought it for, and could not even pay the mortgage back fully from the sale of the home. This affected consumer spending in a major way, which had a broad effect on the economy. So you can see that the "real estate bubble" is just one step in the whole process which begins with fractional reserve banking. One should ask, "how is it even possible that a bank can make 'subprime' lending?" This is a good question, because it seems on the surface to be ridiculous. Why would a bank lend money at a lower cost than which they can borrow it? The answer is that through fractional reserve banking, a bank can in effect lend out more money than they actually have! Crazy? I think so. If you did that as an individual (loaned non existent money) that would be fraud somehow I think. But a bank has a "charter" which allows it to do just that!