32 Manias,Panics,and Crashes investors that it is time to become more liquid-to reduce holdings of real estate and stocks and to increase holdings of money.The prices of goods and securities may fall sharply.Some highly leveraged investors may go bankrupt because the decline in asset prices is so sharp that the value of their assets declines below the amounts borrowed to buy the same assets.Some investors continue to hold the assets despite the decline in price because they believe that the decline in prices is tempo- rary,a hiccup.The prices of the securities may begin to increase again; in Tokyo in the 1990s there were six 'bear market rallies'that involved stock price increases of more than 20 percent even though the trend was that stock prices had been declining.But some investors believed that stock prices had declined too far,and so they wanted to be among the first to buy the stocks while they were still cheap. As the decline in prices continues,more and more investors realize that prices are unlikely to increase and that they should sell before prices decline further;in some cases this realization occurs gradually and in others suddenly.The race out of real or long-term financial securities and into money may turn into a stampede The specific signal that precipitates the crisis may be the failure of a bank or of a firm,the revelation of a swindle or defalcation by an investor who sought to escape distress by dishonest means,or a sharp fall in the price of a security or a commodity.The rush is on-prices decline and bankruptcies increase.Liquidation sometimes is orderly but may degenerate into panic as the realization spreads that only a relatively few investors can sell while prices remain not far below their peak values. In the nineteenth century the word 'revulsion'was used to describe this behavior.The banks become much more cautious in their lending on the collateral of commodities and securities.In the early nineteenth century this condition was known as'discredit. 'Overtrading,'revulsion,'discredit'have a musty,old-fashioned fla- vor;they convey a graphic picture of the decline in investor optimism Revulsion and discredit may lead to panic (or as the Germans put it. Torschlusspanik,'door-shut-panic)as investors crowd to get through the door before it slams shut.The panic feeds on itself until prices have de- clined so far and have become so low that investors are tempted to buy the less liquid assets,or until trade in the assets is stopped by setting limits on price declines,shutting down exchanges or otherwise clos- ing trading,or a lender of last resort succeeds in convincing investors that money will be made available in the amounts needed to meet the
c02 JWBK120/Kindleberger February 13, 2008 15:14 Char Count= 32 Manias, Panics, and Crashes investors that it is time to become more liquid—to reduce holdings of real estate and stocks and to increase holdings of money. The prices of goods and securities may fall sharply. Some highly leveraged investors may go bankrupt because the decline in asset prices is so sharp that the value of their assets declines below the amounts borrowed to buy the same assets. Some investors continue to hold the assets despite the decline in price because they believe that the decline in prices is temporary, a hiccup. The prices of the securities may begin to increase again; in Tokyo in the 1990s there were six ‘bear market rallies’ that involved stock price increases of more than 20 percent even though the trend was that stock prices had been declining. But some investors believed that stock prices had declined too far, and so they wanted to be among the first to buy the stocks while they were still cheap. As the decline in prices continues, more and more investors realize that prices are unlikely to increase and that they should sell before prices decline further; in some cases this realization occurs gradually and in others suddenly. The race out of real or long-term financial securities and into money may turn into a stampede. The specific signal that precipitates the crisis may be the failure of a bank or of a firm, the revelation of a swindle or defalcation by an investor who sought to escape distress by dishonest means, or a sharp fall in the price of a security or a commodity. The rush is on—prices decline and bankruptcies increase. Liquidation sometimes is orderly but may degenerate into panic as the realization spreads that only a relatively few investors can sell while prices remain not far below their peak values. In the nineteenth century the word ‘revulsion’ was used to describe this behavior. The banks become much more cautious in their lending on the collateral of commodities and securities. In the early nineteenth century this condition was known as ‘discredit.’ ‘Overtrading,’ ‘revulsion,’ ‘discredit’ have a musty, old-fashioned flavor; they convey a graphic picture of the decline in investor optimism. Revulsion and discredit may lead to panic (or as the Germans put it, Torschlusspanik, ‘door-shut-panic’) as investors crowd to get through the door before it slams shut. The panic feeds on itself until prices have declined so far and have become so low that investors are tempted to buy the less liquid assets, or until trade in the assets is stopped by setting limits on price declines, shutting down exchanges or otherwise closing trading, or a lender of last resort succeeds in convincing investors that money will be made available in the amounts needed to meet the
Anatomy of a Typical Crisis 33 demand for cash and that hence security prices will no longer decline because of a shortage of liquidity.Confidence may be restored even with- out a large increase in the volume of money because the confidence that one can get money may be sufficient to reduce the demand for liquiditv. Whether a lender of last resort should provide liquidity to forestall a panic and the decline in prices of real estate and stocks has been debated extensively.Those who oppose the provision of liquidity from a lender of last resort argue that the knowledge that such credits will be available encourages speculation.Those who want a lender of last resort worry more about coping with the current crisis and reducing the likelihood that a liquidity crisis will cascade into a solvency crisis than they do about forestalling a future crisis.In domestic crises.government or the central bank has responsibility to act as a lender of last resort.At the international level.there is neither a world government nor any world bank adequately equipped to serve as a lender of last resort.The Inter- national Monetary Fund has not met the expectations of its founders as a lender of last resort. The validity of the model Three types of criticism have been directed at the Minsky model.One criticism is that each crisis is unique so that a general model is not relevant.A second is that this type of model is no longer relevant because of changes in business and economic environments.A third is that asset price bubbles are highly improbable because 'all the information is in the pricethe mantra of the efficient market view of finance. Each criticism merits its own response. The first criticism is that each crisis is unique,a product of a unique set of circumstances,or that there are such wide differences among eco nomic crises as a class that they should be broken down into various species,each with its own particular features.Financial crises were fre quent in the first two-thirds of the nineteenth century and in the last third of the twentieth century.In this view,each unique crisis is a prod- uct of a specific series of historical accidents-which was said about 1848 and about 1929,5 and may be inferred from the historical accounts of separate crises referred to throughout this book.Each crisis also has its unique individual features-the nature of the shock,the object of spec ulation.the form of credit expansion.the ingenuity of the swindlers. and the nature of the incident that touches off revulsion.But if one may
c02 JWBK120/Kindleberger February 13, 2008 15:14 Char Count= Anatomy of a Typical Crisis 33 demand for cash and that hence security prices will no longer decline because of a shortage of liquidity. Confidence may be restored even without a large increase in the volume of money because the confidence that one can get money may be sufficient to reduce the demand for liquidity. Whether a lender of last resort should provide liquidity to forestall a panic and the decline in prices of real estate and stocks has been debated extensively. Those who oppose the provision of liquidity from a lender of last resort argue that the knowledge that such credits will be available encourages speculation. Those who want a lender of last resort worry more about coping with the current crisis and reducing the likelihood that a liquidity crisis will cascade into a solvency crisis than they do about forestalling a future crisis. In domestic crises, government or the central bank has responsibility to act as a lender of last resort. At the international level, there is neither a world government nor any world bank adequately equipped to serve as a lender of last resort. The International Monetary Fund has not met the expectations of its founders as a lender of last resort. The validity of the model Three types of criticism have been directed at the Minsky model. One criticism is that each crisis is unique so that a general model is not relevant. A second is that this type of model is no longer relevant because of changes in business and economic environments. A third is that asset price bubbles are highly improbable because ‘all the information is in the price’—the mantra of the efficient market view of finance. Each criticism merits its own response. The first criticism is that each crisis is unique, a product of a unique set of circumstances, or that there are such wide differences among economic crises as a class that they should be broken down into various species, each with its own particular features. Financial crises were frequent in the first two-thirds of the nineteenth century and in the last third of the twentieth century. In this view, each unique crisis is a product of a specific series of historical accidents—which was said about 1848 and about 1929,5 and may be inferred from the historical accounts of separate crises referred to throughout this book. Each crisis also has its unique individual features—the nature of the shock, the object of speculation, the form of credit expansion, the ingenuity of the swindlers, and the nature of the incident that touches off revulsion. But if one may
34 Manias,Panics,and Crashes borrow a French phrase,the more something changes,the more it re- mains the same.Details proliferate;structure abides More compelling is the suggestion that the genus'crises'should be divided into commercial,industrial,monetary,banking,fiscal,and fi- nancial (in the sense of financial markets)species or into local,re- gional,national,and international groups.Taxonomies along such lines abound.This view is not accepted because the primary concern is with international financial crises that involve a number of critical elements-speculation,monetary expansion,an increase in the prices of securities or real estate or commodities followed by a sharp fall and a rush into money.The test is whether use of the Minsky model provides insights about the broad features of the crises The second criticism is that the Minsky model of the instability of the supply of credit is no longer relevant because of structural changes in the institutional underpinnings of the economy,including the rise of the corporation,the emergence of big labor unions and big government, modern banking and speedier communications.The financial debacles in Mexico,Brazil,Argentina,and more than ten other developing coun tries in the early 1980s are consistent with the Minsky model:the in- creases in the external indebtedness of these countries were much higher than the interest rates on their loans so the borrowers were obtaining all of the cash to pay the scheduled interest from the lenders.The bubble in real estate prices and stock prices in Japan in the second half of the 1980s and the subsequent implosion of asset prices is consistent with the Minsky model since the annual increases in the prices of stocks and real estate was three or four times higher than the interest rates on the funds borrowed to finance the purchases of these assets.The booms and the subsequent busts in Thailand and Hong Kong and Indonesia and then in Russia feature the same pattern of cash flows. The third criticism is that there can be no bubbles because market prices always reflect the economic fundamentals,and that sharp declines in asset prices usually reflect 'policy switching'by government or central banks.Those who take this position suggest that the alleged bubble appears to be the result of herd behavior,positive feedback or bandwagon effects-credulous suckers following smart insiders.These critics suggest that the model is'misspecified,'that is,that something was going on not taken into account by the theory,and that more research is called for Some of the research ignored by those with this belief is offered in this book
c02 JWBK120/Kindleberger February 13, 2008 15:14 Char Count= 34 Manias, Panics, and Crashes borrow a French phrase, the more something changes, the more it remains the same. Details proliferate; structure abides. More compelling is the suggestion that the genus ‘crises’ should be divided into commercial, industrial, monetary, banking, fiscal, and fi- nancial (in the sense of financial markets) species or into local, regional, national, and international groups. Taxonomies along such lines abound. This view is not accepted because the primary concern is with international financial crises that involve a number of critical elements—speculation, monetary expansion, an increase in the prices of securities or real estate or commodities followed by a sharp fall and a rush into money. The test is whether use of the Minsky model provides insights about the broad features of the crises. The second criticism is that the Minsky model of the instability of the supply of credit is no longer relevant because of structural changes in the institutional underpinnings of the economy, including the rise of the corporation, the emergence of big labor unions and big government, modern banking and speedier communications. The financial debacles in Mexico, Brazil, Argentina, and more than ten other developing countries in the early 1980s are consistent with the Minsky model; the increases in the external indebtedness of these countries were much higher than the interest rates on their loans so the borrowers were obtaining all of the cash to pay the scheduled interest from the lenders. The bubble in real estate prices and stock prices in Japan in the second half of the 1980s and the subsequent implosion of asset prices is consistent with the Minsky model since the annual increases in the prices of stocks and real estate was three or four times higher than the interest rates on the funds borrowed to finance the purchases of these assets. The booms and the subsequent busts in Thailand and Hong Kong and Indonesia and then in Russia feature the same pattern of cash flows. The third criticism is that there can be no bubbles because market prices always reflect the economic fundamentals, and that sharp declines in asset prices usually reflect ‘policy switching’ by government or central banks. Those who take this position suggest that the alleged bubble appears to be the result of herd behavior, positive feedback or bandwagon effects—credulous suckers following smart insiders. These critics suggest that the model is ‘misspecified,’ that is, that something was going on not taken into account by the theory, and that more research is called for.6 Some of the research ignored by those with this belief is offered in this book
Anatomy of a Typical Crisis 35 A more cogent attack on the Minsky model was by Alvin Hansen who claimed that the model was relevant prior to the middle of the nine- teenth century but ceased to be so because of changes in the institutional environment. Theories based on uncertainty of the market,on speculation in com- modities,on 'overtrading,'on the excesses of bank credit,on the psychology of traders and merchants,did indeed reasonably fit the early 'mercantile'or commercial phase of modern capitalism.But as the nineteenth century wore on,captains of industry .became the main outlets for funds seeking a profitable return through savings and investments. Hansen-who was a foremost expositor of the Keynesian model of the business cycle and especially of persistent high levels of unemployment-sought to explain the business cycle and wanted to downplay the significance of alternative explanations for changes in the level of economic activity.Hansen's emphasis on the importance of the relation between savings and investment does not require the rejection of the view that changes in the supply of credit can have important impacts on the prices of securities and the level of economic activity. The model's relevance today The Minsky model can be readily applied to the foreign exchange mar- ket and to periods of overvaluation and undervaluation of nationa currencies that are associated with'overshooting'and 'undershooting. Changes in the foreign exchange values of national currencies have beer large relative to long-run equilibrium values despite sizable intervention in the market by central banks.speculation in foreign currencies has resulted in large losses for some firms and some banks while others have made substantial trading profits. Consider the growth in the external debt of Mexico,Brazil,Argentina, and the other developing countries from $125 billion in 1972 to $800 billion in 1982;bank loans to these countries increased at the rate of 30 percent a year and the total external debt of these countries was increasing at the rate of 20 percent a year.The bank loans generally had a maturity of eight years and interest rates were floating and set with a specified markup over the LIBOR,the London Interbank Offer Rate.An
c02 JWBK120/Kindleberger February 13, 2008 15:14 Char Count= Anatomy of a Typical Crisis 35 A more cogent attack on the Minsky model was by Alvin Hansen who claimed that the model was relevant prior to the middle of the nineteenth century but ceased to be so because of changes in the institutional environment. Theories based on uncertainty of the market, on speculation in commodities, on ‘overtrading,’ on the excesses of bank credit, on the psychology of traders and merchants, did indeed reasonably fit the early ‘mercantile’ or commercial phase of modern capitalism. But as the nineteenth century wore on, captains of industry ... became the main outlets for funds seeking a profitable return through savings and investments.7 Hansen—who was a foremost expositor of the Keynesian model of the business cycle and especially of persistent high levels of unemployment—sought to explain the business cycle and wanted to downplay the significance of alternative explanations for changes in the level of economic activity. Hansen’s emphasis on the importance of the relation between savings and investment does not require the rejection of the view that changes in the supply of credit can have important impacts on the prices of securities and the level of economic activity. The model’s relevance today The Minsky model can be readily applied to the foreign exchange market and to periods of overvaluation and undervaluation of national currencies that are associated with ‘overshooting’ and ‘undershooting.’ Changes in the foreign exchange values of national currencies have been large relative to long-run equilibrium values despite sizable intervention in the market by central banks. Speculation in foreign currencies has resulted in large losses for some firms and some banks while others have made substantial trading profits.8 Consider the growth in the external debt of Mexico, Brazil, Argentina, and the other developing countries from $125 billion in 1972 to $800 billion in 1982; bank loans to these countries increased at the rate of 30 percent a year and the total external debt of these countries was increasing at the rate of 20 percent a year. The bank loans generally had a maturity of eight years and interest rates were floating and set with a specified markup over the LIBOR, the London Interbank Offer Rate. An
36 Manias,Panics,and Crashes average of the interest rates was about 8 percent although they tended to increase throughout the decade.The cash that borrowers received from new loans was substantially larger than the interest payments on their outstanding loans,so in effect they incurred no burden or hardship in making their debt service payments on a timely basis. The inflow of foreign funds led to a real appreciation of the curren- cies of the capital-importing countries which was necessary so that the increase in their trade and current account deficits would more or less match the increase in their capital account surpluses.Obviously at some future date the inflow of cash from new loans would decline below the interest payments on the outstanding loans,and at that time the for- eign exchange value of their currencies would decline;the counterpart of the decline in the capital inflow was that these countries would need trade and current account surpluses to get some of the cash necessary to pay the interest to their foreign creditors.Most of these borrowers effectively defaulted on their loans when the lenders stopped making new loans.The cost to the lenders of these defaults has been estimated at $250 billion in the form of the reduction in the face value of the loans and what in effect was a reduction in the interest rates.The lenders had failed to ask the question 'Where will the borrowers get the cash to pay us the interest if we stop supplying them with the cash in the form of new loans?' During the 1980s real estate prices in Japan increased by a factor of ten and stock prices by a factor of six or seven:in the second half of the decade Japan experienced an economic boom.The rates of return earned by real estate investors appeared to be about 30 percent a year.Business firms recognized that the profit rate on real estate investment was sub- stantially higher than the profit rate from making steel or automobiles or TV sets and so they became large investors in real estate using money borrowed from the banks.Real estate prices were increasing many times more rapidly than rents.At some stage,the net rental income declined below the interest payments on the funds borrowed to buy the real es- tate and so the borrowers had a'negative carry.'The borrowers might obtain the funds to make the interest payments by increasing their loans against some of the properties that they already owned.At the begin- ning of 1990,the incoming governor of the Bank of Japan instructed the banks to limit the growth in new real estate loans as a share of their total loans.Once the bank loans for real estate began to increase at 5 or 6 percent a year rather than 30 percent a year,some of the firms and investors that needed the cash from new loans to pay the interest on the
c02 JWBK120/Kindleberger February 13, 2008 15:14 Char Count= 36 Manias, Panics, and Crashes average of the interest rates was about 8 percent although they tended to increase throughout the decade. The cash that borrowers received from new loans was substantially larger than the interest payments on their outstanding loans, so in effect they incurred no burden or hardship in making their debt service payments on a timely basis. The inflow of foreign funds led to a real appreciation of the currencies of the capital-importing countries which was necessary so that the increase in their trade and current account deficits would more or less match the increase in their capital account surpluses. Obviously at some future date the inflow of cash from new loans would decline below the interest payments on the outstanding loans, and at that time the foreign exchange value of their currencies would decline; the counterpart of the decline in the capital inflow was that these countries would need trade and current account surpluses to get some of the cash necessary to pay the interest to their foreign creditors. Most of these borrowers effectively defaulted on their loans when the lenders stopped making new loans. The cost to the lenders of these defaults has been estimated at $250 billion in the form of the reduction in the face value of the loans and what in effect was a reduction in the interest rates. The lenders had failed to ask the question ‘Where will the borrowers get the cash to pay us the interest if we stop supplying them with the cash in the form of new loans?’ During the 1980s real estate prices in Japan increased by a factor of ten and stock prices by a factor of six or seven; in the second half of the decade Japan experienced an economic boom. The rates of return earned by real estate investors appeared to be about 30 percent a year. Business firms recognized that the profit rate on real estate investment was substantially higher than the profit rate from making steel or automobiles or TV sets and so they became large investors in real estate using money borrowed from the banks. Real estate prices were increasing many times more rapidly than rents. At some stage, the net rental income declined below the interest payments on the funds borrowed to buy the real estate and so the borrowers had a ‘negative carry.’ The borrowers might obtain the funds to make the interest payments by increasing their loans against some of the properties that they already owned. At the beginning of 1990, the incoming governor of the Bank of Japan instructed the banks to limit the growth in new real estate loans as a share of their total loans. Once the bank loans for real estate began to increase at 5 or 6 percent a year rather than 30 percent a year, some of the firms and investors that needed the cash from new loans to pay the interest on the