Charles P. Kindleberger in 1978,

Charles P. Kindleberger

In 1978, MIT Professor Emeritus Charles P. Kindleberger published Manias, Panics and Crashes. There had been a long gap in literature on the subject of speculative bubbles and subsequent crashes, but Kindleberger was spurred by the 1974-75 recession. The book is one of the seminal pieces of economics literature, examining the many manias and crashes that have occurred since the advent of modern banking at the outset of the 18th century. A basic pattern of such events is laid out, and the framework examined in rich historical context. It is the purpose of this paper to examine Manias, Panics, and Crashes and evaluate the concepts presented within.

Kindleberger approaches the issue of manias and crashes in terms of generalities. He outlines his views that economics is a general study, that "forces in society and nature behave in repetitive ways." (p.14). Perhaps owing to these, or perhaps owing to his nature discomfort with such things, he does away with mathematical models. He builds his theories around a basic model of how crashes work. Several illustrations are provided outlining a repetition of the following pattern: speculation, credit expansion, financial distress at peak, crisis, panic and crash.

His speculation theory is based on the work of Hyman Minsky, in which a rise in demand causes a price increase, and this fuels speculation about further price increases. This leads to pure speculation, with no intent for use. The market eventually sees entrants who do not usually enter such markets, and this leads to the mania. This is fueled, in Minsky's view, by the expansion of credit (p.16). As more novices are drawn into the mania, more savvy investors start to exit. The effect of this is that new entrants are no longer driving prices up, as there is now an increase in supply to meet their demand. This point is termed by Kindleberger as 'financial distress'.

At the point of distress, some of the speculators notice the increase in liquidity. The lack of liquidity is what ultimately drove up the prices in the first place, so an increase in liquidity can be naturally seen to be a risk to the high prices. At this point, many speculators begin to look at getting out, while prices are still high and there is still demand. The increase in liquidity thus becomes a self-fulfilling prophecy, leading to a crisis as speculators attempt to sell while they are still in the black, and prices continue to fall. The end stage is the panic, the mass selloff that immediately precedes the crash, the stage where prices plummet.

Even at the time of writing, there were critics of this model. These critics cited the emergence of new institutions that allegedly changed the nature of the game, rather than merely changing some of the ways in which the game is played. The emergence of new institutions, the rise of unions, improved communications, modern banking - all of these were cited as reasons the Minsky model espoused by Kindleberger was no longer valid. However, recent bubbles such as dot-com and real estate illustrate that the same basic human behavior and underlying economic conditions can override institutional changes and improved communication.

Interestingly, Kindleberger specifically avoided passing judgment on the applicability of the model to the domestic economy of his day. He did, however, state that it still applies to international currency markets. If the basic model of mania, panic, and crash is applied to the two most recent crises those conditions still remain. The globalization of capital markets took the dot-com boom to international markets to some extent, but this did little to change the pattern. The Internet boom began with a handful of stocks posting strong growth numbers, which drove up demand. Credit at the time was relatively easy to obtain, which lead to speculative purchases of technology stocks. Industry and market insiders saw how ludicrous the market had become towards such stock - how irrational the behavior was that every Internet IPO went over the moon as soon as the bell rung. They began to sell the firms with the triple-digit P/E ratios, and the firms with no earnings at all. A panic ensued, followed by the devastating crash.

Much the same situation occurred in the housing bubble. Minsky's idea that bubbles are largely created by an expansion of credit is significant in that event. Housing prices were already subject to increases, and this brought an increasing amount of buyers into the market. Supply was constrained by availability of land in key locations, and by the time and labor required to build more homes. As Minsky/Kindleberger propose, this in and of itself would have not resulted in a mania. Enter subprime mortgages. The model requires easy access to credit to work. Subprime represented that access, and this allowed new entrants to the market who would not otherwise be there. The model worked perfectly, and two key things happened. First, supply outstripped demand. Even with dirt cheap mortgages, housing prices in many markets skyrocketed to the point where legitimate purchasers were flushed out of the market. The reduction in demand, coupled with the continuous increase in speculative buying with cheap and easy credit, resulted in the financial distress.

Kindleberger outlines that it is insiders who begin the selling when the prices reach their peak. Manias, Panics and Crashes does not expend sufficient energy describing the relevance of the information gap between these insiders and the mass of speculators in the market. The critics of the basic model cited improved communications as one of the key reasons why the model was invalid. The reason the critics have been proven wrong in these recent crises is because they fail to understand the nature of speculators. These speculators are entering the market often with little knowledge of the market, other than the fact that there is money to be made. Market insiders, however, are acutely aware of the nature of the business in which they are dealing. During the dot-com bubble, market insiders were keenly aware that the Internet was merely another method of doing the same old business, rather than something entirely new. They saw that a firm that was essentially a retail outlet should not trade at the levels at which these stocks found themselves.

Likewise, those in the real estate industry could see that demand could not sustain the price growth they were seeing, that once prices ruled out the middle class and easy credit began to dry up, the bubble would burst. Speculators were fueled by the thought that many real estate markets had grown consistently over the past hundred years. Indeed, the West Coast real estate bubble that Kindleberger alludes to would have seen prices that look absurdly low by today's standards. Yet, this notion of steady ongoing growth in a vague one. More specific industry analysis could determine, for example, that Miami-Dade Country has an average household income among the lowest of any major metropolitan area in the nation and therefore could not sustain limitless speculative growth. There are plenty of rich people, but once that market was tapped the county simply didn't have a sizeable upper middle class to back it up, the way that the West Coast cities do. The bubble was going to burst hard there, and the difference is that insiders could see that, whereas the speculators weren't interested in such market research. The point the critics made about improved communication was moot because speculators, by their very nature, do not concern themselves with gathering information. So while the information was widely available, the speculators did not make use of it. Hence, we see that the point of distress still occurs, because there remains an information gap between speculators and insiders. The insiders, being rational investors, ride the wave of rising prices for a time, but they will inevitably become nervous first, as they have a keener sense of the size of the bubble, and have been aware of its development for longer. The example of Miami is specifically poignant because unlike the West Coast, Florida suffered two previous real estate manias in the 1920s and 1970s, and no savvy investor should have ignored that key fact about that real estate market.

The speculators may have an inkling of the bubble, but they will not typically have this before the insiders. Thus, the insiders' selling occurs before the speculators begin to sell themselves. The result is that the prices have already flatlined before the speculators begin to sell. We can see in the real estate bubble that the point of distress occurred specifically when the supply of cheap and easy credit disappeared. This was the fuel that fired the bubble, and when it disappeared, the bubble began to burst. The Minsky-Kindleberger theory about the basic nature of manias, panics and crashes became reality once again. Panic set in, as evidenced by the number of foreclosures. Real estate prices crashed. The regions where the rise was least sustainable, the Miami example being appropriate here, suffered the most. 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 there the collective illusion that helped to fuel the bubble is gone, taking the bubble with it.

These realities are forgotten quickly. A 1930s characterization of the English investing public was that they believed in "magic." The spirit of adventure and entrepreneurship fuels a public willing to believe in any great story. This allows them to indulge time and time again in speculative bubbles. For a time in the early 19th century, a bubble and crisis occurred every ten years. For whatever you can say about the public, they really should never be expected to behave rationally at all times. Only experienced, knowledgeable investors should bear that expectation. The general public at large will never be a rational investor.

However, an irrational investing public is not the only key cause of manias, panics and crashes. The main institutional factor identified is monetary expansion. That is, after all, what allows many of the irrational investors to enter the market. It stands to reason, though, that the actors within the banking system, or those who regulate the banking system, should be rational enough to understand the role they play in speculative bubbles and take steps to avoid such activities.

Kindleberger addresses the issue succinctly: "it can be said that every time the authorities stabilize or control some quantity of money...in moments of euphoria more will be produced." (p.57). The reason is that developed economies have many forms of money - liquid instruments that can easily be substituted. This means that when the supply of money itself is constricted, other instruments will tae its place. The problem is that these instruments, while liquid, are not as liquid as money. This aspect of the theory again holds up well when applied to modern crises. During the subprime crisis the real estate was the collateral securing the debt. This worked so long as the real estate was viewed as liquid - the underlying theory of the mania was that demand for housing was constantly growing (and apparently price inelastic). Crisis hit when the reality hit that the real estate wasn't nearly as liquid as thought. The same applies to the dot-com bust. Margin trading seemed perfectly reasonable when prices were forever rising. The margin was simply covered by the rise in the value of the shares. When the shares began dropping, margin calls began to be issued. The liquidity of the underlying assets was by that point reduced. In both cases, the monetary expansion was not as a result of money supply, but through the use of previously underutilized instruments.