Manias, Panics, and Crashes: Kindleberger's Crisis Theory

Overview of Kindleberger's Framework

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 to write by the 1974–75 recession. The book is one of the seminal works in 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 examined in rich historical context. The purpose of this paper is to evaluate the concepts presented within Manias, Panics, and Crashes.

Kindleberger approaches the issue of manias and crashes in terms of generalities. He outlines his view that economics is a general study, that "forces in society and nature behave in repetitive ways" (p. 14). Perhaps owing to this conviction, or perhaps owing to his discomfort with mathematical formalism, he does away with quantitative models entirely. He builds his theories around a basic model of how crashes work, providing several illustrations that trace a recurring pattern: speculation, credit expansion, financial distress at peak, crisis, panic, and crash.

The Minsky Model: Speculation and Credit Expansion

Kindleberger's speculation theory is based on the work of Hyman Minsky, in which a rise in demand causes a price increase that in turn fuels speculation about further price increases. This leads to pure speculation with no intent for use of the underlying asset. The market eventually attracts entrants who do not normally participate in such markets, and this influx produces the mania. In Minsky's view, this process is fueled by the expansion of credit (p. 16).

As more novices are drawn into the mania, more sophisticated investors begin to exit. The effect is that new entrants are no longer driving prices upward, because an increase in supply now meets their demand. Kindleberger terms this point "financial distress." At the point of distress, some speculators notice the increase in liquidity. Since a lack of liquidity originally drove prices up, an increase in liquidity naturally signals risk to those high prices. Many speculators then begin looking for an exit while prices are still elevated and demand remains. The increase in liquidity thus becomes a self-fulfilling prophecy, leading to a crisis as speculators attempt to sell while still in profit and prices continue to fall. The end stage is the panic — the mass sell-off that immediately precedes the crash, the stage at which prices plummet.

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

Applying the Model to Modern Crises

Interestingly, Kindleberger specifically avoided passing judgment on the applicability of his 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 remain evident. The globalization of capital markets took the dot-com boom to international markets to some extent, but this did little to alter 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 led to speculative purchases of technology stocks. Industry and market insiders saw how irrational the market had become — how every Internet IPO soared as soon as the opening bell rang, regardless of fundamentals. They began to sell firms with triple-digit price-to-earnings ratios and firms with no earnings at all. A panic ensued, followed by a 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 especially significant in that event. Housing prices were already rising, attracting an increasing number of buyers. Supply was constrained by the availability of land in key locations and by the time and labor required to build additional homes. As Minsky and Kindleberger propose, this alone would not have produced a mania. Enter subprime mortgages. The model requires easy access to credit to function, and subprime lending provided precisely that access, allowing new market entrants who would not otherwise have participated. Two key developments then followed. First, supply outstripped demand: even with very cheap mortgages, housing prices in many markets rose to the point where legitimate purchasers were priced out. The reduction in genuine demand, coupled with continuous speculative buying on cheap and easy credit, produced the financial distress Kindleberger describes.