Timeless economics

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Shame and greed in financial crises

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Frank & Ernest

The ingredients of financial crises

The history of financial crises is colorful and dramatic. The ingredients are fear, greed, and irrationality. The symptoms are manias, bubbles, crashes, and panics.

Raymond Goldsmith (cited by Kindleberger) defined a financial crisis as a sharp, brief, ultra-cyclical deterioration of all or most of a group of financial indicators – short-term interest rates, asset prices, commercial insolvencies, and failures of financial institutions.

Michael Bordo includes among the indicators of financial crisis such things as a reduction in the money supply, a change in expectations, fear of insolvency of some financial institutions, and attempts to convert real or illiquid assets into money (i.e., a flight to cash).

Financial crises happened even before economics was a science. The Dutch tulip mania took place in 1636-40. Adam Smith, writing in 1776, described the famous South Sea bubble of 1719-20 in terms of the activities of its promoters. He wrote: “They had an immense capital dividend among an immense number of proprietors. It was naturally to be expected, therefore, that folly, negligence, and profusion should prevail… The knavery and extravagance of their stock-jobbing operations are sufficiently known [as are] the negligence, profusion and malversation of the servants of the company.”

To understand the workings of a financial crisis, Kindleberger suggested the use of a model proposed by Hyman Minsky. It should be noted that Minsky’s work had been foreshadowed by the work of J. S. Mill, Alfred Marshall, Knut Wicksell, and Irving Fisher.

What are the elements of the Minsky model?

One is the idea that debt contracted to finance irrational speculation eventually causes financial difficulties when the debtor cannot, in the end, repay.

Two, a crisis unfolds in three phases:

o First, there is a “displacement,” which induces speculation or boom.

o The boom is then fed by an expansion of credit, typically by bank credit, and during the boom, there is “euphoria” – the second phase – as the price of the thing that is the object of speculation increases through a “positive feedback” (the price increase opens up profit opportunities that fuel further speculation, which leads to further price increases, etc.). When the behavior is no longer rational, it is called a mania and/or a bubble.

o The third phase – the crisis itself – comes after the price increases and resulting price levels eventually become unsustainable because the supply of debt finance is not limitless, and a turning point is reached. Crisis is attended by panic, when more participants than can be accommodated seek to disinvest even as prices now fall, and credit extension that had earlier fed the boom turns to a “crunch” when credit no longer becomes available (the lenders no longer lend because they also expect the price of the collateral to fall further). The crisis ends when prices return to “normal” or when a “lender of last resort” appears to restore confidence.

Three, the Minsky model requires two groups of speculators – the insiders and outsiders. The former destabilize by driving the price up, in order to sell at the top to the latter group, who are the irrational “victims of euphoria.”  Of course, while the bubble is on, there is uncertainty among the speculators as to who among them are favored insiders or hapless outsiders. Crises therefore share many features of Ponzi schemes. (A Ponzi scheme, named after Charles Ponzi who left his creditors “holding the bag” in 1920, is one where investors are paid out of money from subsequent investors.) It happens often enough that panics are attended by a discovery of some fraud such as a Ponzi scheme.

A criticism of the Minsky model is that it describes and explains the past, but cannot predict the future. The empirical evidence that supports the model comes from the many historical anecdotes cited by Kindleberger in his famous book (Manias, Panics, and Crashes, originally written in 1978). These episodes of crises include the South Sea bubble, the Dutch tulip mania, and the U.S. gold panic of 1869.

How should crises be dealt with?

Kindleberger believed that financial crises are best handled when there is a lender of last resort. Today, such a lender takes the form of the various national monetary authorities or central banks. In Kindleberger’s words: “Economists think they know how to handle financial crises: throw money at them, and after the crisis is over, mop the money up.”

The liquidity required to handle crises are somewhat like crocodile tears. Why? This is because, in my opinion, were it not for the inordinate greed that fed into the crisis, there would have been no crying shame in the thereafter. Or maybe, there is an element of schadenfreude on the part of a spectator who observes financial crises.

The unpredictability of crises

It can also happen that a bubble is not immediately obvious. A “latent” bubble is one that involves a profitable but unsustainable price of a product. For example, I would guess that certain products in the Philippines were unsustainably priced at one time or another. They include pre-need plans, text messages, electricity, some petroleum products, lottery tickets, certain types of real estate, and stocks in corporations involved in gambling or mining, etc.Expectations could arise that such pricing might last long enough to arouse some form of irrational investor behavior, which would then set the stage for a crisis. The related bubble is nonetheless not easy to imagine, and the timing of the subsequent crash is difficult to predict.


Edward Chancellor, Devil Take the Hindmost: A History of Financial Speculation (Farrar, Straus, and Giroux, 1999).

Charles P. Kindleberger,  Manias, Panics, and Crashes, 3rd edition (Wiley, 1996).

Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds (1841).

Hyman Minsky, “The Financial Instability Hypothesis,” (working paper, 1992, and available at http://www.levy.org/pubs/wp74.pdf).


Written by Orlando Roncesvalles

March 5, 2009 at 11:36 PM

One Response

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  1. On reconsideration, Kindleberger’s lender of last resort prescription for a financial crisis may not work. Lending into a crisis may simply re-start another bubble. Some adherence to the practical rules set up by Bagehot would seem to be called for. In short, the lender of last resort should lend only to illiquid but solvent parties.

    Orlando Roncesvalles

    March 6, 2009 at 12:41 AM

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