Is history repeating itself?

"The fundamentals of our economy are strong." President George W. Bush, September 2007.

"The fundamental business of the country is on a sound and prosperous basis." President Herbert Hoover, four days before Black Thursday, October 1929.

As the quotations above show, if there's one lesson the great financial crises of the past can tell us right away, it's this: never expect the people at the top to tell the truth. That they don't is understandable. George Bush is no more likely to say that America's economy is teetering perilously close to a massive recession than he is to declare the war in Iraq was the biggest mistake since Vietnam.

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But the truth is that things look grim for the US economy. The housing market just keeps getting weaker, with more and more people defaulting on their mortgages. And because of the way that these mortgages were parcelled up and sold on to investors around the world, the consequences are being felt globally from the seizing up of the UK's money markets to the new-found volatility in global stockmarkets. And the problems aren't over yet not by a long chalk.

So it's no surprise that commentators and analysts are looking back to past crises for indications of what could happen next. History may not repeat itself, but it does rhyme, as Mark Twain once said. So what is history telling us today? Over the past century, two crashes in particular could prove especially edifying when it comes to the current crisis: those of 1907 and 1998.

What happened in 1907?

A new, lightly regulated financial player comes along, promising higher returns for little extra risk. This bold new financial technology is quietly adopted and invested in by more and more players in the market. Eventually it becomes so widespread that one bad bet reveals just how interlinked the whole system has become, and everyone panics because they don't know who is going to end up running into trouble next.

Sound familiar? In 1907, the new players on the market were not hedge funds or private-equity groups they were trust companies. A trust company was similar to a bank, but more lightly regulated. They were allowed to maintain lower cash reserves than banks, which enabled them to deliver better returns to their customers. When first introduced, these firms were relatively conservative. But with customers flocking to their doors, they got a bit frisky taking on tricky investments, such as collateralised loans which were pools of loans that banks wouldn't touch because they tended to be extended to firms who wouldn't normally be able to secure loans (much like subprime mortgages). By 1907 trusts had seen their assets grow from $396.7m in 1897 to $1,394m at a time when national banks' assets grew from $915.2m to $1,800m.

But with little transparency about the firms' finances and very little reserves to back their borrowing, these companies were highly susceptible to bank runs, whereby panicked customers all rush to withdraw their savings at once, says Simon Constable on TheStreet.com. Everything was fine when times were good, but the system was very vulnerable to disruption as investors soon found out.

In 1907, stockmarkets were already suffering the after-effects of the huge earthquake and fire that destroyed San Francisco in 1906, forcing insurers (many based in London) to sell assets to raise cash to cover costs. And another nasty surprise was just around the corner. On 17 October 1907, news came that financier F. Augustus Heinze had lost $50m in an attempt to corner the copper market. It soon became clear that he had been bankrolled by an intricate network of banks and financial institutions across New York, including the Knickerbocker Trust, the third-largest trust company in the city.

As news of Knickerbocker's involvement in the collapsed copper deal became public, depositors rushed to withdraw their money, and the trust collapsed. As the close links between banks and trusts were revealed in the wake of the collapse (many banks effectively owned trusts, or had the same directors sitting on each other's boards), the panic spread to other trusts and banks in the city. Millions of dollars were withdrawn, lending seized up, and banks closed their doors. New York City was on the verge of bankruptcy.

Today, the only reason 1907 isn't mentioned in the same breath as 1929 and 1987 is down to finance legend JP Morgan, says Tim Bond in the FT. In the midst of the crisis, Morgan marched down to the New York Clearing House and strongarmed the bankers into flooding the system with scrip certificates (these are basically a short-term IOU between banks) to pass as a temporary substitute for scarce cash. Morgan then convinced a consortium of international financiers to plough capital into the faltering banks, before securing $25m in bonds from the government to back up the system. By February 1908, confidence was restored, although by then the stockmarket had fallen nearly 50% from its peak in 1906. The success of the recovery plan inspired the government to set up the Federal Reserve in 1913. But it couldn't do anything about the human appetite for financial innovation and the promise of a free lunch which also lay behind the crisis in 1998.

What happened in 1998?

In 1998, the new financial innovation was hedge funds. At the time, nobody really knew how big hedge funds were, says Paul Krugman in The Return of Depression Economics and nobody thought it necessary to find out. As far as regulators were concerned, if you were able to wager such large sums (some hedge funds demanded an initial outlay up to $10m) just to get in the door, you didn't need government protection. And in any case, hedge funds were supposed to make markets more efficient. As Andy Kessler puts it in the New York Times, hedge funds are playing a rapid-fire game of whack-a-mole: whenever a mispriced asset in any market raises its head, the hedge-fund manager quickly whacks it into submission, buying up underpriced shares and dumping overpriced ones.

But many opportunities that hedge funds were exploiting involved investing in risky and illiquid assets, which came with a tasty premium to cover the extra risk. So a hedge fund could borrow in trusty, dependable Japanese debt to buy up shaky Russian debt, and pocket the difference. That was fine when markets were flush with liquidity but no one thought about what might happen if liquidity dried up.

It was exactly this scenario that brought the Long Term Capital Management hedge fund to its knees. When Russia defaulted on its debt in 1998, LTCM found that all the people it had borrowed from in order to take up its positions in Russian debt got very nervous indeed and started calling for their money back, forcing LTCM to sell off assets to fund withdrawals. But because LTCM was such a big player, it had pretty much cornered the market in the assets it was selling, and prices tumbled. This created a massive problem for other hedge funds that owned the same illiquid assets. Just as with subprime mortgages today, big players suddenly found themselves holding virtually unsellable assets that were worth a great deal less than they'd thought. A rash of fire sales by big hedge funds saw equities fall by 20% in the US. By all taking on the same risky plays, the hedge funds had in effect created a "financial doomsday device", says Paul Krugman.

So what saved the markets in 1998? Fed governor Alan Greenspan convinced a consortium of investors to bail out LTCM. He also calmed markets by firmly stating that the Fed would support them, slashing interest rates to back this statement up. His reassurances were so successful that equities embarked on a huge surge, which only ended two years later when the tech boom collapsed.

2007 this time it's different

1907, 1998, and today's credit crunch all confirm JK Galbraith's belief that the world of finance has a remarkable ability to "hail the invention of the wheel over and over again". In recent years, we've been asked to recognise credit derivatives as the new shining hope for financial markets, allowing banks to parcel up the risk of all sorts of once-untouchable assets and spread it around the world. But emboldened by this idea of passing credit risk down the line, all that's happened is that financial institutions have taken on more and bigger risks than they ever would have before. Credit derivatives are now leveraged to the tune of $340trn, notes Mike Shedlock of Whiskey and Gunpowder, and institutions that most investors would consider conservative (money market funds, for example, or German regional banks) turn out to be up to their eyeballs in subprime debt.

The experiences of 1907 and 1998 suggest that all we need to calm the market is a Morgan or a Greenspan to step in with a firm hand and an open wallet - Ben Bernanke perhaps. As Edward Hadas says on Breakingviews, 1998 was large enough to freeze up global money markets, yet Greenspan's intervention meant it did not lead to crippling losses, let alone bankruptcies, amongst any of the big financial players.

Unfortunately, this time it's not as easy as that. There are a number of reasons why the crisis in the markets today looks more daunting that it did in 1907 and 1998. For a start, there is the sheer size of the debt that has built up. The scale of today's problem utterly dwarfs the episodes in 1907 and 1998 a situation that Greenspan can take much of the blame for. As Bill Bonner notes in his new book, Mobs, Messiahs, and Markets, by keeping interest rates at rock-bottom levels for most his watch, Greenspan let home-mortgage debt jump from $1.8trn to over $8trn and consumer debt climb from $2.7trn to over $11trn. While the final fallout from the LTCM debacle was estimated to be in the region of $3bn, the fallout in the subprime market is reckoned to be somewhere between $50bn and $200bn, says Gillian Tett in the FT.

Secondly, while many cling to the hope that this crisis can be confined mainly to the financial markets, as in 1907 and 1998, there are already worrying signs that it has spread to the real' economy. The news from the US housing market continues to get worse, and rising delinquencies are going to wreak further havoc on credit markets. As Wolfgang Munchau says in the FT, "if your subprime mortgage exceeds the value of your house by 10%, and if the monthly payments exceed your income, no positive interest rate could bail you out."

August's dreadful jobless figures are another kick in the teeth for optimists. And as consumption slows in the US, the credit problems can be expected to spread to credit cards and car finance, loans that have also been parcelled up and sold around the globe. "The credit market is very deep and offers significant potential for contagion," says Munchau.

Is it 1929 again?

One crash we haven't mentioned yet is the best known of all: 1929. Very few commentators are comparing today's problems with those of the Depression, but as the Bank for International Settlements recently commented: "virtually nobody foresaw the Great Depression of the 1930s... [the] downturn was preceded by a period of non-inflationary growth exuberant enough to lead many commentators to suggest that a new era' had arrived". Then, as now, cheap credit fuelled a consumer and property boom. Throughout the 1920s, the Fed deliberately stimulated the stockmarkets by holding the interest rate, Greenspan-style, at an artificially low level, notes Mike Shedlock. Investors borrowed heavily and leveraged up their bets on equity markets as stock prices soared, and banks were happy to fund them the Dow Jones rose more than sixfold from 1921 to a peak of 381 in September 1929. But by the summer of 1929, the economy was starting to slow and investors' increasing anxiety resulted in a series of market slumps, starting with Black Thursday on 24 October. Overborrowed investors were then forced to sell to meet margin calls. The crash arguably marked the beginning of the Great Depression and the market would not bottom out until July 1932, by which time the Dow had lost 89% of its value. America, meanwhile, had slumped into a devastating recession that it didn't recover from until after World War II.

A repeat of 1929 may seem far-fetched, but as Justin Urquart Stewart of Seven Management points out, there are some unnerving parallels. The US savings rate has not been negative for this long since the Depression era; nor has house-price growth. Even more worrying is the current trend in the US towards anti-Chinese, protectionist sentiment. One major factor most economists agree exacerbated the Depression was the 1930 Smoot-Hawley Tariff Act, which raised tariffs to record levels on more than 20,000 imported goods. This caused retaliation from other countries and US exports and imports more than halved. Last year, US politicians suggested putting tariffs of 27.5% on all Chinese imports if China didn't revalue the yuan; and safety fears over Chinese goods also threaten to erupt into trade wars.

Of course, there are also big differences between now and 1929 stockmarkets look far less overvalued than they did then. Yet the vital ingredients for further panic are in place: a slowing real economy, a US housing market in free fall, and a banking system intent on battoning down the hatches just as more people than ever are up to their necks in debt. In the words of Nouriel Roubini of New York University, we could be facing the "first great financial crisis of the modern era".

A brief history of financial crises

Financial crises are certainly nothing new, and neither are they particularly unusual. In fact, investment bank Lehman Brothers reckons there have been 66 in the past 400 years. 1929 was the mother of all crashes, but here are some other contenders.

1873 Railway crash

A boom in railroad construction heralded a New Era of development. But as the railway companies were launching ambitious transcontinental building plans, the money to finance them was drying up and they started going bankrupt. The NYSE closed for ten days in the ensuing panic, with 89 of the 364 US railway companies going bust. The US economy fell into a depression that would last five years.

1982 Souk Al-Manakh crash

Buoyed by oil revenues, Kuwaitis began investing in companies on this unofficial over-the-counter stock exchange. Kuwait's total market cap rose from $5bn to $100bn. Unfortunately, traders had allowed Kuwaitis to pay for stocks using post-dated cheques. When one of these bounced, confidence in the whole market collapsed; $91bn of worthless cheques was eventually written off.

1987 Black Monday

The single biggest one-day fall in financial history. The Dow Jones plunged 22% on 19 October 1987 after investors baulked at the debt they were carrying. New computerised trading made things worse by automatically executing sell trades.

1990 Japan's lost decade

The financial crash with the biggest hangover. The Japanese economy had grown larger than that of the US on the back of a technology and manufacturing boom. But the economy had a hugely inflated property bubble at its heart and when the Japanese government raised interest rates to cool it, the bubble burst. The Nikkei fell to 8,000 from its 40,000 peak. The Japanese economy is still recovering.

2000 Dotcom crash

The internet seemed to usher in a new era for the economy, but most tech firms weren't actually earning any money. When this dawned on investors, the Nasdaq dived, falling 78% between March 2000 and October 2002.