Anatomy of a Typical Crisis 27 banks to increase market share can lead to rapid growth of credit and money because the established banks have often been reluctant to ac- cept a decline in market share that they would otherwise incur.In the 1970s the European banks were beginning to poach on the turf of the U.S.banks in making loans to the governments in Latin America Minsky argued that the growth of bank credit has been very unstable; at times the banks as lenders have become more euphoric and have lent freely and then at other times they have become extremely cautious and let the borrowers 'swing in the wind.' One central policy issue centers on the control of credit from banks and from other suppliers of credit.Often the authorities in a country have applied strict controls to the ability of banks to make certain types of loans.The banks then set up wholly-owned subsidiaries that can make the loans the banks themselves are prohibited from making.Or the loans are made by the bank holding companies.Even if the instability of credits from the financial institutions were controlled,increases in the supply of personal credit could finance the boom. Assume an increase in the effective demand for goods and services After a time,the increase in demand presses against the capacity to produce goods.Market prices increase,and the more rapid increase in profits attracts both more investment and more firms.Positive feedback develops as the increase in investment leads to increases in the rate of growth of national income that in turn induce additional investment so the rate of growth of national income accelerates. Minsky noted that 'euphoria'might develop at this stage.Investors buy goods and securities to profit from the capital gains associated with the anticipated increases in the prices of these goods and securities. The authorities recognize that something exceptional is happening in the economy and while they are mindful of earlier manias,'this time it's different,'and they have extensive explanations for the difference. Chairman Greenspan discovered a surge in U.S.productivity about a year after he first became concerned about the high level of U.S.stock prices in 1996;the increase in productivity meant that profits would increase at a more rapid rate,and so the higher level of stock prices relative to corporate earnings did not seem unreasonable. Minsky's three-part taxonomy Minsky distinguished between three type s of finan -hedge finance speculative finance,and Ponzi on the basis of the relatior
c02 JWBK120/Kindleberger February 13, 2008 15:14 Char Count= Anatomy of a Typical Crisis 27 banks to increase market share can lead to rapid growth of credit and money because the established banks have often been reluctant to accept a decline in market share that they would otherwise incur. In the 1970s the European banks were beginning to poach on the turf of the U.S. banks in making loans to the governments in Latin America. Minsky argued that the growth of bank credit has been very unstable; at times the banks as lenders have become more euphoric and have lent freely and then at other times they have become extremely cautious and let the borrowers ‘swing in the wind.’ One central policy issue centers on the control of credit from banks and from other suppliers of credit. Often the authorities in a country have applied strict controls to the ability of banks to make certain types of loans. The banks then set up wholly-owned subsidiaries that can make the loans the banks themselves are prohibited from making. Or the loans are made by the bank holding companies. Even if the instability of credits from the financial institutions were controlled, increases in the supply of personal credit could finance the boom. Assume an increase in the effective demand for goods and services. After a time, the increase in demand presses against the capacity to produce goods. Market prices increase, and the more rapid increase in profits attracts both more investment and more firms. Positive feedback develops as the increase in investment leads to increases in the rate of growth of national income that in turn induce additional investment so the rate of growth of national income accelerates. Minsky noted that ‘euphoria’ might develop at this stage. Investors buy goods and securities to profit from the capital gains associated with the anticipated increases in the prices of these goods and securities. The authorities recognize that something exceptional is happening in the economy and while they are mindful of earlier manias, ‘this time it’s different,’ and they have extensive explanations for the difference. Chairman Greenspan discovered a surge in U.S. productivity about a year after he first became concerned about the high level of U.S. stock prices in 1996; the increase in productivity meant that profits would increase at a more rapid rate, and so the higher level of stock prices relative to corporate earnings did not seem unreasonable. Minsky’s three-part taxonomy Minsky distinguished between three types of finance—hedge finance, speculative finance, and Ponzi finance—on the basis of the relation
28 Manias,Panics,and Crashes between the operating income and the debt service payments of indi vidual borrowers.A firm is in the hedge finance group if its anticipated operating income is more than sufficient to pay both the interest and scheduled reduction in its indebtedness.A firm is in the speculative fi nance group if its anticipated operating income is sufficient so it can pay the interest on its indebtedness;however the firm must use cash from new loans to repay part or all of the amounts due on maturing loans.A firm is in the Ponzi group if its anticipated operating income is not likely to be sufficiently large to pay all of the interest on its indebtedness on the scheduled due dates;to get the cash the firm must either increase its indebtedness or sell some assets. Minsky's hypothesis is that when the economy slows,some of the firms that had been involved in hedge finance are shunted to the group involved in speculative finance and that some of the firms that had been involved in the speculative finance group now find they are in the Ponzi finance group. The term'Ponzi finance'memorializes carlos ponzi who onerated a small loans company in one of the Boston suburbs in the early 1920s Ponzi promised his depositors that he would pay interest at the rate of 30 percent a month and his financial transactions went smoothly for three months.In the fourth month however the inflow of cash from new depositors was smaller than the interest payments promised to the older borrowers and eventually Ponzi went to prison. The term Ponzi finance is now a generic term for a nonsustainable pattern of finance.The borrowers can only meet their commitments to pay the high interest rates on their outstanding loans or deposits if they obtain the cash from new loans or deposits.Since in many arrangements the interest rates are very high,often 30 to 40 percent a year,the contin- uation of the arrangement requires that there be a continuous injection of new money and often at an accelerating rate.Initially many of the existing depositors are so pleased with their high returns that they allow their interest income to compound:the cliche is that they are'earning interest on the interest.'As a result the inflow of new money can be below the promised interest rate for a few months.But to the extent that some depositors take some of their interest returns in cash,the arrangement can operate only as long as these withdrawals are smaller than the inflow of new money. The result of the continuation of the process is what Adam Smith and his contemporaries called 'overtrading.'This term is less than precise and in- cludes speculation about increases in the prices of assets or commodities, an overestimate of prospective returns,or 'excessive leverage.Specula tion involves buving commodities for the capital gain from anticipated increases in their prices rather than for their use.Similarly speculation involves buying securities for resale rather than for investment income
c02 JWBK120/Kindleberger February 13, 2008 15:14 Char Count= 28 Manias, Panics, and Crashes between the operating income and the debt service payments of individual borrowers. A firm is in the hedge finance group if its anticipated operating income is more than sufficient to pay both the interest and scheduled reduction in its indebtedness. A firm is in the speculative fi- nance group if its anticipated operating income is sufficient so it can pay the interest on its indebtedness; however the firm must use cash from new loans to repay part or all of the amounts due on maturing loans. A firm is in the Ponzi group if its anticipated operating income is not likely to be sufficiently large to pay all of the interest on its indebtedness on the scheduled due dates; to get the cash the firm must either increase its indebtedness or sell some assets. Minsky’s hypothesis is that when the economy slows, some of the firms that had been involved in hedge finance are shunted to the group involved in speculative finance and that some of the firms that had been involved in the speculative finance group now find they are in the Ponzi finance group. The term ‘Ponzi finance’ memorializes Carlos Ponzi, who operated a small loans company in one of the Boston suburbs in the early 1920s. Ponzi promised his depositors that he would pay interest at the rate of 30 percent a month and his financial transactions went smoothly for three months. In the fourth month however the inflow of cash from new depositors was smaller than the interest payments promised to the older borrowers and eventually Ponzi went to prison. The term Ponzi finance is now a generic term for a nonsustainable pattern of finance. The borrowers can only meet their commitments to pay the high interest rates on their outstanding loans or deposits if they obtain the cash from new loans or deposits. Since in many arrangements the interest rates are very high, often 30 to 40 percent a year, the continuation of the arrangement requires that there be a continuous injection of new money and often at an accelerating rate. Initially many of the existing depositors are so pleased with their high returns that they allow their interest income to compound; the cliche is that they are ‘earning ´ interest on the interest.’ As a result the inflow of new money can be below the promised interest rate for a few months. But to the extent that some depositors take some of their interest returns in cash, the arrangement can operate only as long as these withdrawals are smaller than the inflow of new money. The result of the continuation of the process is what Adam Smith and his contemporaries called ‘overtrading.’ This term is less than precise and includes speculation about increases in the prices of assets or commodities, an overestimate of prospective returns, or ‘excessive leverage.’3 Speculation involves buying commodities for the capital gain from anticipated increases in their prices rather than for their use. Similarly speculation involves buying securities for resale rather than for investment income
Anatomy of a Typical Crisis 29 attached to these commodities.The euphoria leads to an increase in the optimism about the rate of economic growth and about the rate of in- crease in corporate profits and affects firms engaged in production and distribution.In the late 1990s Wall Street security analysts projected that U.S.corporate profits would increase at the rate of 15 percent vear for five vears.(If their forecasts had been correct.then at the end of the fifth vear the share of US.corporate profits in US.GDP would have been 40 percent higher than ever before.)Loan losses incurred by the lenders decline and they respond and become more optimistic and reduce the minimum down payments and the minimum margin require- ments.Even though bank loans are increasing,the leverage-the ratio of debt to capital or to equity- -of many of their borrowers may decline because the increase in the prices of the real estate or securities mean that the net worth of the borrowers may be increasing at a rapid rate. A follow-the-leader process develops as firms and households see that others are profiting from speculative purchases.There is nothing as disturbing to one's well-being and judgment as to see a friend get rich. Unless it is to see a nonfriend get rich.Si imilarly banks may crease their loans to various groups of borrowers because they are reluctant to lose market share to other lenders which are increasing their loans at a more rapid rate.More and more firms and households that previously had been aloof from these speculative ventures begin to participate in the scramble for high rates of return.Making money never seemed easier Speculation for capital gains leads away from normal,rational behavior to what has been described as a 'mania'or a bubble. The word'mania'emphasizes rrationality;bubble'fore shadows tha some values will eventually burst.Economists use the term bubble to mean any deviation in the price of an asset or a security or a commod- ity that cannot be explained in terms of the 'fundamentals.'Small pric variations based on fundamentals are called noise.'In this book,a bub- ble is an upward price movement over an extended period of fifteen to forty months that then implodes.Someone with 'perfect foresight should have foreseen that the process was not sustainable and that an implosion was inevitable In the twentieth century most of the manias and bubbles have cen- tered on real estate and stocks.There was a mania in land in Southeast Florida in the mid-1920s and an unprecedented bubble in U.S.stocks in the second half of the 1920s.In Japan in the 1980s the speculative pur- chases of real estate induced a boc m in the stock market.Similarly the bubble in the Asian countries in the 1990s involved both real estate and
c02 JWBK120/Kindleberger February 13, 2008 15:14 Char Count= Anatomy of a Typical Crisis 29 attached to these commodities. The euphoria leads to an increase in the optimism about the rate of economic growth and about the rate of increase in corporate profits and affects firms engaged in production and distribution. In the late 1990s Wall Street security analysts projected that U.S. corporate profits would increase at the rate of 15 percent a year for five years. (If their forecasts had been correct, then at the end of the fifth year the share of U.S. corporate profits in U.S. GDP would have been 40 percent higher than ever before.) Loan losses incurred by the lenders decline and they respond and become more optimistic and reduce the minimum down payments and the minimum margin requirements. Even though bank loans are increasing, the leverage—the ratio of debt to capital or to equity—of many of their borrowers may decline because the increase in the prices of the real estate or securities means that the net worth of the borrowers may be increasing at a rapid rate. A follow-the-leader process develops as firms and households see that others are profiting from speculative purchases. ‘There is nothing as disturbing to one’s well-being and judgment as to see a friend get rich.’4 Unless it is to see a nonfriend get rich. Similarly banks may increase their loans to various groups of borrowers because they are reluctant to lose market share to other lenders which are increasing their loans at a more rapid rate. More and more firms and households that previously had been aloof from these speculative ventures begin to participate in the scramble for high rates of return. Making money never seemed easier. Speculation for capital gains leads away from normal, rational behavior to what has been described as a ‘mania’ or a ‘bubble.’ The word ‘mania’ emphasizes irrationality; ‘bubble’ foreshadows that some values will eventually burst. Economists use the term bubble to mean any deviation in the price of an asset or a security or a commodity that cannot be explained in terms of the ‘fundamentals.’ Small price variations based on fundamentals are called ‘noise.’ In this book, a bubble is an upward price movement over an extended period of fifteen to forty months that then implodes. Someone with ‘perfect foresight’ should have foreseen that the process was not sustainable and that an implosion was inevitable. In the twentieth century most of the manias and bubbles have centered on real estate and stocks. There was a mania in land in Southeast Florida in the mid-1920s and an unprecedented bubble in U.S. stocks in the second half of the 1920s. In Japan in the 1980s the speculative purchases of real estate induced a boom in the stock market. Similarly the bubble in the Asian countries in the 1990s involved both real estate and
30 Manias,Panics,and Crashes stocks,and generally increases in real estate prices pulled up stock prices. The U.S.bubble in the late 1990s primarily involved stocks,although the increases in household wealth in Silicon Valley and several regions led to surges in real estate prices.The oil price shocks of the 1970s led to surges in real estate activity in Texas,Oklahoma,and Louisiana.Similarly the sharp increases in the prices of cereals in the inflationary 1970s led to surges in land prices in lowa,Nebraska,and Kansas and other Midwest farm states. International propagation Minsky focused on the instability in the supply of credit in a single country.Historically euphoria has often spread from one country to others through one of several different channels.The bubble in Japan in the 1980s had significant impacts on South Korea,Taiwan,and the State of Hawaii.South Korea and Taiwan were parts of the Japanese supply chain;if Japan is doing well economically,its former colonies will do well.Hawaii is to Tokyo as Miami is to New York;Japanese travel to Hawaii for rest and recreation in the sun.Hawaii experienced a real estate boom in the 1980s as the Japanese bought second homes and golf courses and hotels. One conduit from a shock in one country to its impacts in other countries is arbitrage which ensures that the changes in the price of a commodity in one national market will lead to comparable changes in the prices of the more or less identical commodity in other national markets.Thus changes in the price of gold in Zurich,Beirut,and Hong Kong are closely tied to changes in the price of gold in London.Similarly changes in the prices of securities in one national market will lead to nearly identical changes in the prices of the same securities in other national markets. In addition increases in national income in one country induce in creases in its demand for imports and hence increases in counterpart ex- rities from one country will lead to increases in both the price of these securities and the value of its currency in the foreign exchange market. Moreover there are psychological connections,as when investor eu phoria or pessimism in one country affects investors in others.The de- clines in stock prices on October 19,1987,were practically instanta neous in all national financial centers(except Tokyo),far faster than can
c02 JWBK120/Kindleberger February 13, 2008 15:14 Char Count= 30 Manias, Panics, and Crashes stocks, and generally increases in real estate prices pulled up stock prices. The U.S. bubble in the late 1990s primarily involved stocks, although the increases in household wealth in Silicon Valley and several regions led to surges in real estate prices. The oil price shocks of the 1970s led to surges in real estate activity in Texas, Oklahoma, and Louisiana. Similarly the sharp increases in the prices of cereals in the inflationary 1970s led to surges in land prices in Iowa, Nebraska, and Kansas and other Midwest farm states. International propagation Minsky focused on the instability in the supply of credit in a single country. Historically euphoria has often spread from one country to others through one of several different channels. The bubble in Japan in the 1980s had significant impacts on South Korea, Taiwan, and the State of Hawaii. South Korea and Taiwan were parts of the Japanese supply chain; if Japan is doing well economically, its former colonies will do well. Hawaii is to Tokyo as Miami is to New York; Japanese travel to Hawaii for rest and recreation in the sun. Hawaii experienced a real estate boom in the 1980s as the Japanese bought second homes and golf courses and hotels. One conduit from a shock in one country to its impacts in other countries is arbitrage which ensures that the changes in the price of a commodity in one national market will lead to comparable changes in the prices of the more or less identical commodity in other national markets. Thus changes in the price of gold in Zurich, Beirut, and Hong Kong are closely tied to changes in the price of gold in London. Similarly changes in the prices of securities in one national market will lead to nearly identical changes in the prices of the same securities in other national markets. In addition increases in national income in one country induce increases in its demand for imports and hence increases in counterpart exports in other countries and in the national incomes in these countries. Capital flows constitute a third link; the increase in the exports of securities from one country will lead to increases in both the price of these securities and the value of its currency in the foreign exchange market. Moreover there are psychological connections, as when investor euphoria or pessimism in one country affects investors in others. The declines in stock prices on October 19, 1987, were practically instantaneous in all national financial centers (except Tokyo), far faster than can
Anatomy of a Typical Crisis 31 be accounted for by arbitrage,income changes,capital flows,or money movements. In the ideal textbook world an increase in the gold coins in circula- tion in one country because of the flow of gold to that country would be matched by a corresponding decline in the gold supplies in other coun tries,and the increase in the money supply and the credit expansion in the first country would be offset by the contraction of credit and the money supply in the second.In the real world,however,the increase in the credit expansion in the first country may not be followed by a con- traction of credit in the second country,because investors in the second country may respond to rising prices and profits abroad by demand ing more credit so they can buy the assets and securities whose prices they anticipate will increase.The potential contraction from the shrink age in the monetary base in the second country may be overwhelmed by the increase in speculative interest and the increase in the demand for credit. As the speculative boom continues,interest rates,the speed of pay- ments and the commodity price level increase.The purch ases of se rities or real estate by 'outsiders'means that the insiders-those who owned or purchased these assets earlier-sell the same securities and real estate and take some profits.A few insiders take their profits and sell; indeed if newcomers to the market are buyers,then the insiders must be sellers.At every moment the purchases of real estate or stocks by the new investors or outsiders are necessarily balanced by sales by the in- siders.In 1928 the market value of the stocks traded on the New York Stock Exchange increased at an annual rate of 36 percent,and in the first eight months of 1929 the market value increased at an annual rate of 53 percent.Similarly in 1998 the market value of the stocks traded on the NASDAQincreased at an annual rate of 41 percent;in the subsequent fif- teen months they increased at the annual rate of 101 percent.Investors rush to get on the train before it leaves the station and accelerates.If the eagerness of the outsiders to buy is stronger than the eagerness of the insiders to sell,the prices of the assets or securities continue to increase. in contrast if the sellers become more eager than the buyers,then the prices will decline As the buyers become less eager and the sellers become more eager an uneasy period of'financial distress'follows;the term is from corporate finance and reflects that a firm is unable to adhere to its debt servicing commitments.For the economy as a whole,the equivalent is the aware ness on the part of a considerable segment of both firms and individual
c02 JWBK120/Kindleberger February 13, 2008 15:14 Char Count= Anatomy of a Typical Crisis 31 be accounted for by arbitrage, income changes, capital flows, or money movements. In the ideal textbook world an increase in the gold coins in circulation in one country because of the flow of gold to that country would be matched by a corresponding decline in the gold supplies in other countries, and the increase in the money supply and the credit expansion in the first country would be offset by the contraction of credit and the money supply in the second. In the real world, however, the increase in the credit expansion in the first country may not be followed by a contraction of credit in the second country, because investors in the second country may respond to rising prices and profits abroad by demanding more credit so they can buy the assets and securities whose prices they anticipate will increase. The potential contraction from the shrinkage in the monetary base in the second country may be overwhelmed by the increase in speculative interest and the increase in the demand for credit. As the speculative boom continues, interest rates, the speed of payments and the commodity price level increase. The purchases of securities or real estate by ‘outsiders’ means that the insiders—those who owned or purchased these assets earlier—sell the same securities and real estate and take some profits. A few insiders take their profits and sell; indeed if newcomers to the market are buyers, then the insiders must be sellers. At every moment the purchases of real estate or stocks by the new investors or outsiders are necessarily balanced by sales by the insiders. In 1928 the market value of the stocks traded on the New York Stock Exchange increased at an annual rate of 36 percent, and in the first eight months of 1929 the market value increased at an annual rate of 53 percent. Similarly in 1998 the market value of the stocks traded on the NASDAQ increased at an annual rate of 41 percent; in the subsequent fifteen months they increased at the annual rate of 101 percent. Investors rush to get on the train before it leaves the station and accelerates. If the eagerness of the outsiders to buy is stronger than the eagerness of the insiders to sell, the prices of the assets or securities continue to increase. In contrast if the sellers become more eager than the buyers, then the prices will decline. As the buyers become less eager and the sellers become more eager an uneasy period of ‘financial distress’ follows; the term is from corporate finance and reflects that a firm is unable to adhere to its debt servicing commitments. For the economy as a whole, the equivalent is the awareness on the part of a considerable segment of both firms and individual