Boganmeldelse af Charles Kindleberger og Robert Alibers "Manias, Panics, and Crashes"

Book Summary

Manias, Panics, and Crashes: A History of Financial Crises

January 28, 2018

This post is also available in: Dansk

Abstract

  • An archetypical boom-and-bust cycle goes something along the lines of: Imagine that we’re at the bottom of a credit cycle. A narrative that re-ignites optimism. Consumers ‘freeze up’ and begins spending again. Lenders start to lend, and borrowers borrow. As optimism flourish, speculation in assets are well under way, hence driving up prices based on “the greater fool” theory. At the top of the cycle, ‘insiders’ decide to exit the market. Then the inevitable happens: a sudden and collective rush towards the exit, causing mass panic and thus drives down prices. The dust eventually settles. Now, a few ‘first movers’ are tempted by the cheap prices on various assets and they decide to dive in once again. A new buying frenzy is lurking – we just need a narrative to kickstart the cycle once more.
  • An appreciation in asset prices, which can’t be justified by an increase in underlying fundamental/intrinsic values, is a bubble.
  • When it comes to bubbles and rapid price appreciation, remember the wise words: “If something cannot go on forever, it will stop.”

Charles Kindleberger and Robert Aliber can’t be blamed for having written a colorful or very engaging book on the movements of financial markets. To be frank, I found it quite dry. However, there are some valuable lessons to be learned. The book centers on the Minsky model, which is what I’ll focus on in this book summary.

The anatomy of a typical crisis
In chapter 2, the authors present a model that explains a typical cycle, i.e. what leads up to a bubble, why it pops and the reverberations.

Let’s take a journey through an archetypical cyclical, starting from the bottom. We’ve just experienced a market top and the subsequent recession, what now? First, a narrative is created. Just as Irrational Exuberance says, Charlie and Robert explains that a technological development, a radical political initiative or a financial invention takes the world by storm to such a degree that market participants suddenly believe in a financial resurrection.

Lenders/creditors recognize the profit opportunities in said narrative. They regain the courage to issue loans to both private and corporate borrowers. Businesses take on loans/credit to boost their operations as well as invest in financial markets or other businesses. Private people borrow to pay for cars, securities, consumption or real estate. Businesses naturally wish to accommodate the increased demand for goods and services, so they extend their credit line to expand production facilities. Banks obviously have a desire to capitalize on this flourishing optimism, so they lend out even more money. In sum, a substantial expansion of credit is taking place.

We not enter the third phase of the cycle: speculation. As the wider population recognizes the increases in the financial markets, they wish to jump on the wagon. This creates a feedback loop in which speculators (note speculators, not investors) profit more by plowing more money into the markets, which once again causes more people to plow even money in. Assets are acquired with one end in mind: dumping it to a greater fool later on. The build-up to the bubble escalates. A bubble is defined as an increase in asset prices that can’t be justified by its fundamentals.

At the top of the cycle some ‘insiders’ – who know the distinction between price and value – decide to exit the market. There is often a convergence between these persons’ exit and an array of financial suffering such as bankruptcies and liquidity issues. These issues often arise when the banks are no longer willing to lend the businesses the capital they need to stay afloat.

Shortly thereafter, the inevitable happens: a sudden and collective rush towards the exit. Everyone wishes to dump their assets, which causes a mass panic and thus drives down prices. What is self-reinforcing on the way up is self-reinforcing on the way down – but with far greater speed and vigor (an upswing usually last 7-8 years whereas a recession/tumble lasts 1-2 years). The dust settles, governments and federal reserves ensure the publics that the turmoil is behind us and order is sure to be restored. Now a few ‘first movers’ are tempted by the cheap prices on various assets and they decide to dive in once again. Baby steps have been taken towards the buying frenzy that’ll soon enough be realized – we just need a narrative to kickstart the cycle once more.

One timeless lesson can surely be extracted from this model. Humans never change. To quote George Santayanas’ wise words once more: “Those who do not remember the past are condemned to repeat it.”

Bitcoins – this century’s Tulipmani?
Let’s jump into the timemachine. Destination: Amsterdam, 1636. The price on tulip bulbs went through the roof, appreciating hundreds and hundreds percent. A Semper Augustus bulb cost the same as five acres of land. The Viceroy bulb went for an amount that corresponded to two lorries of wheat, four lorries of rye, four oxens, eight picks, a dozen sheep, two huge pots of wine, four tons of beer, four tons of butter, 500 kilograms of cheese, a bed, clothes and a silver cup. These bulbs didn’t even exist most of the time. Often it was merely contracts – futures – on bulbs that were neither sown, grown or harvested. You literally betted the farm on a piece of paper stating you would receive a tulip bulb next spring.

Let’s try to put this historic event into the model. First, a narrative surfaced. Namely, tulip bulbs were regarded as this rare and exotic plant from the Ottoman Empire, an unparalleled status symbol. With the popularity spiking, a huge influx of money floated ‘the market’ in the shape of e.g. future contract. In other words, it was the ‘hot’ financial invention of the 17th century. The nation was captivated by the phenomenon and quickly there was a consensus that any purchase price would do, since the bulbs’ prices were destined to continue to appreciate. People pawned all their assets to buy these bulbs. In short, it was a classic feedback loop where price appreciation breeds price appreciation based on the ‘greater fool’ theory. Remember, an appreciation in asset prices that can’t be justified by an increase in intrinsic values is a bubble. Sure enough, there was no value, as the subsequent crash cements. The bubble bursted, everybody wanted out fast. Prices collapsed, and the bulbs as well as the contracts were completely worthless.

I am by no means a cryptocurrency expert – quite the opposite, actually. So perhaps I’m missing something fundamental, but I’ve long wondered what constitutes Bitcoins’ value? I’m fascinated by the asset’s journey, but I couldn’t bring myself to invest in it. I simply can’t figure out what the intrinsic value is (if there is any?) If cryptocurrencies become a widely accepted method of payment, it will have utility, and thus value. But until that happens, I tend to agree with this statement: “Only potential, no real value.” But again, I know close to nothing about this asset class, so perhaps I’m totally off. And what’s the difference between cryptocurrencies and e.g. gold? Gold doesn’t seem to have an intrinsic value either, so isn’t it the same issue? Perhaps.

Regardless, when it comes to bubbles and rapid price appreciation, remember the wise words: “If something cannot go on forever, it will stop.”

This post is also available in: Dansk

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