Why Laws Won't Prevent Financial Bubbles And Crashes

The recent financial crisis has led to a consensus among policymakers that the speculative bubble and subsequent financial crisis can never happen again and new laws or policies must be formulated to prevent it. Unfortunately for our society, governments have made many previous attempts to control speculation through legislation and failed.

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South Sea Bubble
One of the earliest attempts to control speculation arose in the wake of the South Sea Bubble in England in the early 1700s. The Bubble Act was passed at the height of the speculative frenzy at the time, and the act prohibited the issuance of transferable stock certificates by unincorporated joint stock companies. While some suggest that the act was passed to protect the South Sea Company from competing bubble companies, the fact is that the speculative excess did not slow down. The English government even declared dozens of companies illegal for not following the law, but nothing could stop the greed of man at the time. The South Sea Bubble ended in spectacular fashion a short time later.

Redux
Twenty years later, Parliament passed the "Acts To Prevent the Infamous Practice of Stock Jobbing" which is how speculators were referred to in that day. This law, also called Sir John Barnard's Act, tried to ban "time bargains" which referred to a common practice at the time of buying and selling securities without transferring shares or paying cash up front. The trades would be settled by the difference between the purchase and sale price. Think of it as 100% margin trading. The law made little difference as the practice continued to flourish. (Learn more about bubbles and turmoil in our Market Crashes Tutorial.)

Early America
This fruitless attempt to control the excesses of human behavior transferred to the new world. In 1792, New York passed a similar sounding law called "An Act to Prevent the Pernicious Practice of Stock Jobbing, and for Regulating Sales at Public Auction." This law banned time bargains and options unless the party selling held the certificates physically. The law also banned securities trading utilizing public outcry, which is another term for an auction market.

Hughes Commission
Some governments studied the issue and didn't overreact. The Hughes Commission was set up to study the New York Stock Exchange in the wake of the Panic of 1907. The commission resisted strong pressure to ban or restrict short selling, despite the belief that it aggravated volatility. The commission didn't fall for it though, and noted that New York had a law on the books from 1812 to 1858 that banned short selling except for registered owners of the security. The Hughes Commission said that the rule had failed in other countries and was probably in conflict with U.S. Supreme Court rulings. (Learn about what happens when the government gets involved in the economy. Read Economic Meltdowns: Let Them Burn Or Stamp Them Out?)

German Exchange Act of 1896
Germany also saw speculative excesses in the late 19th century that led to multiple bank failures, precipitating the creation of a commission to investigate how to best control future events.

In 1893, the commission delivered its report, and three years later, the German Exchange Act was passed. The law banned futures trading in grain and flour, and required extensive registration requirements for buyers and sellers of other commodities or stock. The law had the opposite effect as it increased volatility in prices as the loss of the short side and its corrective influence on the market led to larger asset price inflation during bull market periods.

Bottom Line
The record of passing legislation to restrict speculation through various means has been tried many times over the last 300 years in many different countries. The attempt usually ends in failure as human behavior is difficult to control or channel with these methods.

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