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Friday, January 30, 2009

Manias, Panics, and Crashes

Continuing my preparation for my last university exam (assuming I am not going the PhD route that is) as well as my self-education concerning economics. I finished Manias, Panics, and Crashes - A History of Financial Crises by Charles P. Kindleberger a few days ago. While the edition I read dated from the mid-90s and did not include the financial crisis of our times a few weeks ago, Kindleberger's book did provide for an interesting analysis of the nature of crises in general. In fact, it was quite the spooky read at times simply because some of the quotes on, say, the Tulip crisis of the 17th century seemed like a perfect description of the recently exploded bubble.

In more general terms, Kindleberger presents a model and an analysis of crises over the last 400 years that leaves the reader stunned due to the lack of singularity of our financial crisis. Evidently, this one was bigger, as far as countries hit by it as well as sheer numbers, than most other crises but the basic underlying principles are the same. Kindleberger sees an exogenous event such as a new invention (.com bubble!) at the origin of every speculative bubble (I am not quite sure what this could have been in our case, 9/11 and the fact that (turning the non-existence of something negative into a positive element) nothing bad (economically speaking) resulted from it?). This is followed by a monetary expansion (global low interest rates, especially in the USA; massive capital imports into the US from especially China) including the emergence of new credit instruments (sub primes!) multiplying this expansion. Finally, 'overtrading', the creation of a speculative bubble takes place.

Describing a housing boom in Chicago in 1857(sic!):
'In the ruin of all collapsed booms is to be found the work of men who bought property at prices they knew perfectly well were fictitious, but who were willing to pay such prices simply because they knew that some still greater fool could be depended on to take the property off their hands and leave them with a profit.' Putting it more succinctly: 'The first taste is for high interest, but that taste soon becomes secondary. There is a second appetite for large gains to be made by selling the principal.'

When this bubble bursts, everyone tries to get out as fast as possible and prices fall only faster. Individual rational actors and decisions result in collectively irrational results. Or, 'the actions of each individual is rational – or would be, were it not for the fact that others are behaving in the same way.'

Talking about bad omens for today's situation (not that we need any considering we're already in a recession in any case): 'A 'financial crisis [can be][...] the culmination of a period of expansion and lead[...] to downturn.' The only piece of good news would be that Kindleberger believes that a 'lender of last resort shortens depressions.' Yet, here Keynes (and Krugman today) comes in arguing that in the special circumstances of deflation combined with a zero interest rate monetary policy becomes ineffective (1, 2 book reviews on this topic). I definitely do not want to open this Pandora's box right now though.

A fun quote on the irrationality of economics to end this post instead (even when I am not certain as to the validity or importance of this part of his argument):
'A competent driver of an automobile, for example, or an expert chess player [or an experienced basketball player I might add] has moved beyond the stage of calculating what needs to be done at a given time. That individual sees the situation and does what is required without pausing to reason out the optimal course of action [...] The notion that asset markets are made up of [...] intelligent, well-informed [...] speculators who calculate by rational steps is [...] not [necessarily true].'

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