Charles Kindleberger Manias Panics and Crashes Research Proposal

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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.

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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'.

Research Proposal on Charles Kindleberger Manias Panics and Crashes Assignment

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… [END OF PREVIEW] . . . READ MORE

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