EconomicsFinance & Investment

Manias, Panics, and Crashes: A History of Financial Crises

Charles P. Kindleberger

Have you ever wondered if the economic crises in different countries are intertwined? Is there a pattern in bubbles around the world? For that is precisely what you will learn now! The authors of this book attempt to delineate patterns and reveal how financial crises follow a natural rhythm: a favorable economic moment, followed by stagnation and major setbacks. Who are the key actors involved, what are the most important factors, and how can we avoid or stop crises?

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Financial crises worldwide

The world has faced numerous financial crises in the last century. Several countries such as Malaysia, Thailand, Japan and the United States had their greatest difficulties linked to real estate prices. These countries experienced great financial bubbles.

The problem is that these bubbles always implode. By definition, a bubble involves a non-sustainable pattern of price change or financial flows. The implosion of asset prices in the Japanese bubble led to the failure of a large number of banks and other firms in the country, causing more than a decade of slow economic growth. The implosion of asset prices in the Thai bubble led to an accelerated decline in stock prices in the region.

The cost of these crises was very high. The result was a series of losses for banks in all countries involved, slowing economic growth rates.

These problems occurred in three different waves: the first in the early 1980s, the second in the early 1990s, and the third in the second half of the same decade. The 1970s saw accelerated inflation in the United States. The prevailing view in the late 1970s was that inflation rates in the US and the rest of the world would accelerate.

The indebtedness of countries like Mexico, Argentina and Brazil increased from $ 125 billion in 1972 to $ 800 billion in 1982. That same year, the currencies of these countries depreciated, and most banks went bankrupt because of the large loan losses.

Already in the early 1990s, real estate prices in Japan imploded. And within a few years, the big Japanese banks declared bankruptcy and only continued to function because the government was protecting investors from financial losses. This is one of the stories of mania and ruin – but a ruin without panic because people believed that the government could handle losses.

The examples of this kind of crisis in the world are innumerable. Although it is impossible to compare the different time periods perfectly, it can be concluded that the financial failure of the last thirty years was much more extensive and universal than at any time.

Manias and easy credit

Manias are usually dramatic but infrequent: in two hundred years, there were only two occurrences in the American stock market. Manias are often associated with the expansion phase of the business cycle because euphoria can often lead to an increase in expenses.

During the craze, rising property prices and some commodities contribute to increased consumption and investment spending. This increase leads to an acceleration in economic growth rates, at least for a time.

Manias are associated with economic euphoria. In this scenario, companies grow and spending on investment too because the credit is excessive. So some event like a government change leads to a pause in that growth. Thus the scenario changes completely, with falling asset prices and large losses for investors. All this starts to panic and crash.

The emergence of bubbles and manias raises a pertinent political question: should governments intervene? Should they moderate the increase in asset prices? All major countries have already established a central bank as a last resort to deal with the scarcity of liquidity generated by a crisis.

When asset prices fall sharply, government intervention can be helpful in pursuing stability. The problem with this is that if investors knew in advance of government support in times of crisis, markets could break even more often. This would happen because investors would act with less caution in the purchase of assets or securities.

Human rationality premise and economic theory

In some ways, mania may suggest a loss of rationality. But economic theory assumes that the human being is rational, so manias are not consistent with economic theory.

When we assume that the investor is rational, we can assume that this happens in the long run, which helps us understand the changes in prices in different markets. Current prices in a given market should be consistent with prices in one or two months, and in one or two years’ time – with due cost adjustments.

Irrationality during mania can sometimes be called collective hysteria, which generates a deviation from rational behavior by a group of people.

Irrational cases may involve societies that depend on extraordinary events that have little relevance to their economic circumstances. They may also involve cases where society ignores the evidence and prefers not to think about it.

Many Austrian companies invested in advance to increase business activity followed by the opening of the World Exhibition in Vienna in 1873. The fair was aimed at increasing sales of companies, which required high investment. Banks increased their credit as much as possible, and so they waited for the fair to open to raise business revenue and recover the investment.

When the fair opened, the increase in sales was disappointing, and a few days later the market collapsed.

Despite the assumption of rationality, markets sometimes behave as irrational even when their participants believe otherwise.

Shocks that impact the economy

Displacement is an external event that changes expectations, behaviors and profit opportunities. An increase in the price of oil can be considered a displacement, for example. The shock should be enough to make an impact on the economy.

Many daily events produce changes in the economy, but few of them are significant enough to be considered as displacements.

Major objects of speculation

In the last decades of the 20th century, investors speculated mainly on the real estate and stock market. Before that, the objects of speculation were much more diverse.

Most major global crises involved at least two objects of speculation and at least two separate markets. And just as national markets are connected, speculation is probably also connected by credit conditions. That is, when real estate prices rise, the construction business is likely to boom, and the market value of construction companies will increase. The relationship is symmetrical: when real estate prices fall, stock prices are likely to fall as well.

Effects of credit expansion

Speculative manias gain speed through the expansion of credit and money. But most expansions do not lead to mania. Expansions occur in greater proportion compared to mania, but manias are always associated with credit expansion.

This helps to understand that credit expansion does not happen by chance, but for hundreds of years through systematic development. Meanwhile, financial market participants try to reduce transaction and liquidity costs.

During the economic booms, the amount of money defined as a form of payment has expanded continuously. Also, the money supply was used more efficiently to finance growing economic activity and purchases of real estate and bonds and commodities in search of capital gains. Central bank efforts to limit and control the growth of this money supply was balanced by the development of cash substitutes.

Changes in investors’ expectations

A shock leads to economic expansion, which turns into an economic boom. From there, the euphoria develops and then there is a pause in the increase of the prices of the assets. The distress will probably happen, as asset prices begin to fall. Then panic is likely to come, followed by the crash.

The theory of rational expectations assumes that investor expectations change instantly in response to each shock. It also assumes that investors see the impacts of long-term price shocks on real estate, stocks, and commodities.

The shift in investor mindsets, from a sense of confidence to pessimism, is the source of instability in the credit markets. This happens to some borrowers, be they people or businesses, realize that the debt is too great about income. These borrowers begin to adjust their new perceptions about the economic future by reducing their spending so that they have the money to pay the debt or to save more.

Some companies can sell divisions and units of operations to receive money and pay off debts. Lenders recognize that they have many risky loans and therefore seek repayment of the riskier debts. They are also more reluctant to renew these loans over time. Lenders also raise the credit default for new loans. The period of financial hardship can last for weeks, months or even years.

The role of governments in the crisis cycle

Government policies play a vital role in shaping expectations, so should the government intervene to moderate this cycle? Can the government deflect itself from a financial crisis if it lowers the expectations that develop in the euphoric phase? Should government seek to reduce the impacts of declining stock, real estate, and commodity prices after the bubble implodes?

If the government has more knowledge than speculators, it could make this knowledge available or publish its predictions. Thus, it could calm the concerns and fears of investors, make the knowledge public.

The right time to intervene is complex. If government authorities want the alert to be effective, they need to provide warnings early enough to anticipate the excesses of the euphoric period, and late enough for these warnings to be credible.

Financial distress

Distress is widely used in discussions about financial crises. The term is inaccurate: it can be interpreted as a state of suffering or as a risky situation. The commercial distress reflects the first definition; the financial distress reflects the second.

The financial distress for a company means that its profitability has dropped considerably, representing a great loss. Therefore, there is a high probability that this company will not be able to pay interest on its debts. Financial distress for an economy implies the need for economic adjustments. Companies may be close to bankruptcy and banks may need recapitalization.

Distress is not an easily measured condition. Investors may be apprehensive when the values ​​of certain variables diverge from the mean values. In fact, some of these variables include the proportion of the central bank’s gold reserve; the proportion of debt to the capital of many companies or individuals; the losses of banks in relation to capital; the proportion of foreign debt repayment and a country’s export earnings; and the proportion of price-earnings to shares and real estate rents.

The causes and symptoms of distress are observed at the same time and include accelerated growth of interest rates in the capital market segments; an increase in interest rates paid by subprime borrowers; a large depreciation of the currency in the foreign market; an increase in bankruptcies; and the end of price increases in commodities, securities and real estate. Usually, these events are intertwined and demonstrate that lenders are overburdened, as well as trying to reduce risks.

Distress may arise from an increase in the flow of funds from a country. In a practical example, poor harvesting may require an increase in imports. Similarly, an increase in interest rates in a major international financial center may cause funds to lose interest in domestic financial markets.

The essence of financial distress is the loss of trust, and what comes next? One of the consequences is a slow recovery of the belief in the future since several aspects of the economy are intertwined. The other, worse still, would be a collapse in prices, panic, bankruptcies, and a rush to get rid of un-liquid assets.

The crash or panic following the financial distress can be immediate, can happen in a few weeks or take many years.

Crash and panic

A crash is a collapse of asset prices, or perhaps the failure of a major company or bank. A panic, or a sudden fear without cause, can occur in asset markets or involve securities with little liquidity, which are often replaced by government bonds. That hope in government exists around the belief that government can not go bankrupt since it can always print money. A financial crisis can involve crash and panic, together or not.

Debt-deflation cycles involve a decline in asset and commodity prices, leading to a reduction in the value of collateral and inducing banks to borrow. Meanwhile, the fall in prices causes the bankruptcy of many companies. Also, households sell their securities and companies postpone loans and investments, causing prices to fall further. And declines in the value of loan guarantees lead to settlements.

The bankruptcy of companies incurs losses for banks, which also declare bankruptcies. With the bankruptcy of banks, depositors withdraw money from the bank.

Withdrawals of deposits require more loans to banks and an increase in the sale of securities. Trades, industrial companies, investors and banks need money – their risky securities cannot be sold at any price, and they are forced to sell their best securities, so the price falls into decline.

Banks can help known companies for a while, in the expectation that prices will improve. But when a bankruptcy occurs, you need to search for a solution to the bad loans. At the height of the panic, money is no longer available.

Euforia and economic booms

The association between asset price bubbles and economic euphoria is very strong. Changes in the level of prosperity of households, associated with rising asset prices, directly affect consumption and corporate spending. There are two links between the rise in real estate and stock prices and the growth rate of national income.

One link comes from increases in household wealth relative to increases in household spending. Families have savings or wealth goals, and with rising wealth from asset prices, households save less than the income they earn. Thus, consumption increases.

The second link comes from the rise in stock prices relative to investment spending. When stock prices rise, companies can raise investors’ money at a lower cost and can make new, less profitable projects. So the cost of capital of a company varies inversely with the level of the share price: the higher the share price relative to the earnings of these companies, the lower the cost of capital. The lower the cost of capital of these companies, the greater the investments in plants and equipment, as high stock prices help companies to profit even with a lower rate of return.

There is a symmetry between increases in economic activity in response to increases in asset prices; and declines in economic activity when asset prices fall. During the expansion phase, companies increase loan requests in response to increased equity.

Banks increase lending and may lower your criteria. As asset prices explode, banks suffer heavy losses, and some of them may be forced to close or obtain state capital.

Real estate and stock markets

Many bubbles in the stock market are related to real estate bubbles. There are three different connections between these two markets:

The first is that in many countries a large amount of the stock market is made up of real estate, construction, and other real estate-related industries – including banks.

The second connection is that people who have increased their wealth, as a result of rising real estate values, want to continue to diversify wealth and so buy stocks. And there are not many easy ways to diversify wealth.

The third connection is related to the second. Investors who have profited from rising stock market valuations buy bigger and bigger houses.

The euphoria that spreads from one Market to another is easily understood. Capital gains can be acquired without any special skills. When asset prices collapse, shareholders know they will face problems and need to reduce their debts. Investors with high leverage recognize that wealth is declining and therefore sell stocks.

Central banks concerns during bubbles

Most central banks choose price stability as a target for monetary policies. Recently, the inflation “target” has been used as a political mantra – central banks seek to achieve a rate of inflation below a certain value.

However, if the implosion of a bubble, in stocks or the real estate market, lead to a decline in bank solvency, the central bank should be concerned about asset prices?

On the one hand, the price of the assets should be incorporated into the overall price level. In a world of efficient markets, they represent a forecast of future prices and consumption. But this view assumes that asset prices are determined by economic fundamentals and that they are not affected by the behaviors that lead to a bubble.

Central banks are usually not reluctant to raise interest rates to avoid an increase in the rate of inflation. But they are reluctant to try to deal with asset price bubbles, or even acknowledge that bubbles exist – although they recognize it after the event.

Financial crises affect various countries

Some countries may not be affected by international crises that impact their neighbors for obvious reasons. Still, financial crises are often international and can affect several countries at the same time.

One of the links between these countries is arbitrage that connects national markets. The implication of the law of a price is that the difference in prices of identical goods in several countries cannot exceed transport costs or trade barriers.

Similarly, bond markets in several countries are also connected, as the prices of internationally traded securities in different national markets should be the same after currency conversion. The prices of internationally traded securities, which are listed on the stock markets of different countries, increase and decrease together.

When stock price changes are small, the correlations between the price movement in different domestic markets are low. As changes increase, correlations increase as well.

Booms and panics are transmitted from one country to another in different ways, including arbitrage in commodities or securities; and financial movements of various forms – kind, bank deposits, and exchange currencies. Securities and asset markets in various countries are linked by financial movements.

Capital movements can respond to real causes, including:

Wars and revolutions;

Technical innovations;

The opening of new markets and new sources of raw materials;

Changes in the relationship between growth rates in different countries;

And the changes in monetary and fiscal policies.

The privatization of government enterprises in different countries can induce influxes of foreign buyers. Consider the connections between the appreciation of currency and deflation in the commodity market of that country – or the connections between currency depreciation and inflation in the goods market; the increase in the value of the national currency leads to declines in the prices of internationally traded goods and bankruptcies of financial companies.

Booms and bankruptcies are connected in many ways. An economic boom in a country almost always attracts money from outside. Similarly, a boom in one country can reduce the flow of money to other countries.

Connection between bubbles and frauds

The implosion of a bubble in the price of assets always leads to the discovery of fraud. In the absence of credit, fraud increases and spreads significantly.

This fraudulent behavior is mostly illegal, but some issues may be hazy and lie in a fine line between what is allowed and what is not. Should the premiums on options for directors and employees be considered a cost like wages? Or should they be buried in a footnote so that costs and profits are not affected? The answer can determine the speed of growth of profits, and the speed of growth of stock prices.

Frauds in financial markets may involve statements about earnings growth or “assured” stock prices by companies. A typical statement is that “Amazon’s share price” will grow to $ 400 per share by July 4, or it could be “our target price is $ 400 per share”. Another statement could be “corporate profits will increase at a rate of 15% per year for the next five years.”

Some financial market frauds may involve excessive optimism about corporate earnings or future stock prices when the people who issued the statements know that this simply can not be true.

The rise in the stock price is twice as common as the fall in price, so even without any special skills, the chances are that market strategists are right more often. Market strategists are often reluctant to indicate that stock prices will fall, and very rarely suggest that a company’s share price falls – the company’s executives would be furious with that.

Corruption cannot be measured unless an economy or society has laws, rules or rules that differentiate permitted behavior from illegal or immoral behavior.

Anything may be permissible or acceptable in a society without rules or norms, but in theory, all societies have them. Laws may be different between countries, what is legal in some countries may be illegal in others. Also, within a country, laws, and regulations may change over time.

Fraudulent behavior increases in economic booms. Fortunes emerge in booms, individuals become greedy, and frauds help fuel that greed. Greed also causes some amateurs to commit fraud, misappropriation and other abuses of authority.

There are no bank data that allow comparisons of fraudulent behavior in different countries, but the progress of journalism has contributed to exposing the illegal activities of companies. Exposure is the great risk run by fraudsters, but the reward in wealth may be far greater than risk.

The revelation of fraud and deviance, as well as arrests and punishments for those who violated the law, are important signs that the economic euphoria has been excessive and that there are serious social consequences.

Last resource domestic creditor’s role

The lender of last resort is ready to lend money and help when needed, but how much money? For whom? Under what circumstances? When?

These questions are faced by these lenders, who also face another dilemma: if investors believe that these lenders are supporting banks or other institutions in times of distress, they will act with less caution during the next boom. The public good of the lender of last resort weakens the responsibility of the private creditors to ensure that they are making prudent loans.

However, in a panic situation, the rush to convert bonds and commodities into cash cannot be ignored. Sales of these assets by investors, in an attempt to minimize losses, led to declining asset prices, causing a large number of companies – which were previously healthy – to declare bankruptcy.

International last resource lender

The main argument for the creation of an international lender as a last resort is the historical record of the transmission of deflationary pressure from one country to another. This transmission was associated with changes in exchange rates, with devaluations when currencies are pegged and depreciated when currencies aren’t pegged.

An international lender of last resort faces a different problem from home lenders. Since there are separate national currencies and a national central bank, changes in exchange rates are inevitable. Some of these changes will be needed, especially when a country is not as successful as its trading partners in achieving low inflation rates; a reduction in the exchange value of a country’s currency may be a cheaper way to seek balance – if compared to the unemployment associated with an overvalued currency.

The primary responsibility of a lender of last resort is to reduce the likelihood of a lack of domestic liquidity, which can lead to a solvency problem and cause bankruptcy.

The lender of last resort needs to work in a thin line: on the one hand, avoid saving financial institutions that are already bankrupt because of risky investments; and on the other side save healthy competitors from insolvency that could occur as a result of declining prices and the emergence of deflation.

Differently, the primary responsibility of an international lender of last resort. Is to provide liquidity to improve the reach of the required changes in exchange rates. Thus he acts to avoid the changes that are not required by economic fundamentals.

International lending has been extended for at least four centuries when governments have lent it to other countries. At the same time, it was when private banks in one country relied on banks from other countries for assistance in the event of a sudden withdrawal of funds.

Regimes work well at quiet times, but during a crisis, more decisive leadership is important. And the probability of escaping future financial and economic crises seems small.

The International Monetary Fund was created in 1940 to act as a last resort for international aid. The reason for its creation was the financial instability in the 1920s and 30s, which could have been avoided or mitigated. Fund officials visit each of the member countries twice a year to discuss the country’s economic policies.

Final Notes

The monetary history of the last four hundred years is fraught with financial crises. The pattern was that investor optimism increased as economies expanded, credit growth increased, and economic growth accelerated. The increase in credit supply and the more favorable economic outlook led to economic booms.

After that, however, the growth was halted, and the crises arose. Some of these crises have involved the failure of a large number of banks, some of which have involved a lack of confidence in a country’s ability to maintain currency balance and a few have involved the implosion of a bubble in the stock and real estate markets.

The banks’ failure was due to a large depreciation of national currencies or thanks to declines in real estate values ​​and stocks during the crash phase of the financial cycle.


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