Charles P Kindleberger in 1978 essay

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Prices crashed. Without the speculative buyers, there were no buyers, and properties remain to this day unsold.

Kindleberger bases his views on a pattern of irrationality. Market theory fails, he hypothesizes, because it is based on investor rationality. He argues, however, that while the investor by and large is rational that the market, being comprised of a large group of investors, witnesses a reduction of rationality as a result of mob psychology. His mob psychology theory goes through six stages, but the most important of which is the final one: "irrationality may exist insofar as economic actors choose the wrong model, fail to take account of a particular and crucial bit of information, or go so far as to suppress information that does not conform to the model implicitly adopted." (p.29). This component of the theory against illustrates the information gap between insiders and speculators. Insiders understand that economic rationality has been distorted. Speculators lack this understanding specifically because they are part of the lack of knowledge that causes the decline in rationality. They are not investing in a hot commodity because they have a deep understanding of the industry's fundamentals. They are investing because they feel there is a quick buck to be made.

The concept of rational actors is key to modern market theory. These bubbles occur because of the introduction of irrational actors - speculators - who know little of the dynamics of the market they are entering and often do not care to know. Why do these irrational actors enter the market? Simply put, for the opportunity to gain quick and easy profit. The market, by and large, is made up of knowledgeable and rational actors. The occasional irrational actor with a few bucks to throw around may enter the market, and may even do well, but their irrationality does not override the rationality that the vast majority of the market participants around them possess. Irrational actors are only able to influence the market under certain circumstances. These are the same circumstances that Kindleberger outlines. First, that a tight supply and increasing demand of a product creates a normal, rational demand. Rational investors begin to make money, driving the price up further. A handful of well-heeled irrational investors can enter the market at any point, but the tipping point for a mania to occur is when easy, cheap credit brings a mass of irrational investors into the market that is sufficiently substantial to dilute the impact of rationality. From this point, the market which is ostensibly comprised of rational investors begins to act irrationally, because the small component of irrational investors has become large enough to have genuine influence of demand and price. As an example, he uses the case of the 1830s railroad bubble in England, in which the early stages of the bubble were driven by rational investors - experienced businessmen - and the later stages after 1835 were driven by promoters selling shares to "a different class of investors, including ladies and clergymen." (p. 31) in other words, unsophisticated investors who cannot be expected to behave rationally. Yet market theory never adequately accounts for such irrationality and the actors involved seem to forever fail to deal adequately with the notion of irrationality intruding of their logical, rational markets. Indeed, Milton Friedman is discussed (p.97) as having advocated government information programs given that the government knows more about the bubble than the speculators. The speculators, however, not only don't know. They don't care. Failure to recognize that fact, is a problem for capital markets that exacerbates the disconnect between market theorists' understanding of manias and reality.

Interestingly, this core discussion of rationality/irrationality is rooted firmly in Kindleberger's beliefs about the nature of economic study. The study of economics, especially with regards to capital markets, is based on rationality. Rationality can, in general, be translated into numbers. Kindleberger received his schooling in the 1930s, before the advent of modern mathematical models. He specifically eschewed their use in writing Manias, Panics and Crashes. Mathematical models do a wonderful job of illustrating a crash, in terms of its patterns of price increases and the availability of capital. Yet they do little to address the issue why, which is at the core of Kindleberger's qualitative approach. This old-school approach to such a fundamental economic issue is perhaps why Kindleberger remains relevant today, thirty years after Manias, Panics and Crashes was first published.

This leaves that question of why, if this pattern has been identifiable since the 18th century, does it still occur. The critics Kindleberger mentions are common to every generation. There is a certain myopia whereby each generation views its own as being special. That the rules of the past no longer apply. At the end of chapter 2, Kindleberger mentions several factors that have been cited, from the advent of unions to improved communications. As has been identified, one of the core underlying assumptions of Manias, Panics and Crashes is that the patterns are repeated time and time again. Kindleberger states at the outset that these patterns have held relevance since the advent of modern banking in the 18th century. His entire point is that the game has not changed since, essentially, it was invented. The only time when manias and crashes may have worked differently was before a modern, organized banking system even existed.

He outlines cases two hundred years old to illustrate the potency of his model. In that time, as any reasonable person can see, there have been vast changes in society, technology, and even the capital markets themselves. These changes have had the impact of a rule change in sports - the game may be played a little bit differently but the way it works is essentially the same. He outlines this to point out the fallacy of assuming that whatever the latest modern invention or improvement is, it will not eliminate the pattern he's laid out. One of the reasons the pattern persists is the myopic view that old rules no longer apply, on account of some modern creation or invention.

So in part the pattern still occurs because people believe it will not occur. Another reason is that human nature drives the irrational investing. Human nature is relatively constant, and the desire to seek profit when it is available is innate. The role of human nature in economics is not new by any means - Adam Smith and Karl Marx among others built it into their philosophies. Yet, when it comes to manias, humans are slow learners and fast forgetters. Kindleberger touches upon this in Chapter 2, that the nature of any rational investor is to take easy profit. The profit does not have to actually be easy, it merely has to have that illusion. This comes back again to access to credit. Speculative bubbles are created because of insufficient controls on credit during the course of the bubble.

Another reason for mania is belief is something present as continuing ad infinitum. Kindleberger supplies several examples of instances where speculation drove up prices right from the beginning, merely on the expectation that a shortage would occur to drive up the price. This, for example, is a reasonable expectation for this year's dramatic rise in crude oil prices. The reality is that consumption rates have not dramatically increased, nor have production numbers fallen, but the price has skyrocketed based on speculation that oil prices will rise. Eventually, they will. But there is little logic in driving up the price on delivery of oil three months from now, when the shortage is more likely to occur thirty or sixty years hence. The problem, according to Kindleberger, is that at the time, the investors believe their decision to be rational. This notion of rationality is enforced by the fact that others, too, are doing it. This mob psychology, when combined with the easy credit, is what drives the market to the point of mania.

At some point during the mania, economic reality sets it. This point in the subprime crisis built gradually, as the rock bottom credit was merely a loss leader. When the rates inevitably increased, that was economic reality setting in. The example is no different than when the World's Exposition in Vienna failed to reverse the solvency issues of Viennese enterprises buried in debt. The notion that the Exhibition would solve the problem was a distortion of reality, but when the opening of the Exhibition came and went without solving the serious solvency issues of these firms, the bubble burst and a crash ensued in short order. This example may seem somewhat ridiculous - that a world's fair could solve serious financial problems - but Kindleberger's point is that such ideas always seem reasonable at the time. Thus, the investors are acting rationally. That they all believe what they believe is rational and in doing so they are on aggregate acting irrationally. The point of distress is when reality - rationality - is realized and from…[continue]

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