Apr 11, 2013

Manias, Panics and Crashes

Last night the History Book Club met to discuss Manias, Panics and Crashes: A History of Financial Crises by Charles P. Kindleberger and Robert Z. Aliber. This is a classic book, regularly cited by other economists. It was first published in 1978, but we read the sixth edition published in 2011. That edition covered the U.S. housing bubble and the subsequent financial crisis which led to the Great Recession.

18 members participated in a lively discussion. In fact, the discussion was so lively that we drew in a couple of passing B&N customers. There was agreement that the book was a tough read -- one member suggested it be marketed as a cure for insomnia. On the other hand it deals with a timely topic of great interest to the members.

The book provides a theory of how financial bubbles start, evolve, pop and crash. (The theory is well described in this review of the book.) It then shows how the theory applies to a large number of financial bubbles that have occurred over several centuries, including the tulip mania in Holland in the 17th century.

The discussion was introduced by a member who has had a long career as a professional economist. (Here are notes he provided on the book.)  He told us that the book mentioned several of the well known theories of business cycles, failing to mention the long term Kondratiev waves relating to technological revolutions. (The implication is that Kindelberger and Alber because they to incorporate the mechanisms of the business cycles have produced only a partial model.) He suggested that the book so emphasized the historical record because it was probably written to counteract a very conservative trend in economic theory in the American universities at the time of its first printing.

Our economist led us into a discussion of the Bretton Woods Agreements, the World Bank and the International Monetary Fund. He was especially negative about the emphasis of the IMF for many years on austerity measures as the only solution for developing countries that got into financial problems. He noted examples from his own experience of UN-World Bank projects that failed to recognize the intersectoral nature of development projects, preferring instead relatively narrowly focused, single sector projects.

In the latter part of Manias, Panics and Crashes, it is suggested that in the last 40 years, the pattern of financial crises has changed. Not only are these crises more likely to affect several countries, but (according to the authors) the changes in the changes in the relative values of currencies that follow a crash lead to bubbles in the countries that become newly attractive to investors, thus triggering new crises. It was noted that 1971, 40 years before this edition was published, was when the Nixon administration took the dollar off the gold standard, marking the end of the Bretton Woods system. In that system, countries were obligated to link their currencies to gold or the U.S. dollar, allowing the value to move in only a narrow range. Since 1971, currencies have floated, changing greatly in relative values during financial crises. Moreover, the magnitude of international financial flows has magnified enormously over time with globalization of financial systems.

Kindleberger and Alber stress the role of "lender of last resort" in dealing with financial crises. The most important of these today are the central banks of the United States, the European Union, and Japan, as well as the IMF. The authors noted the problems faced by the managers of the lenders of last resort in choosing how and when to intervene to deal with crises.

We also discussed the current effort to reform the IMF. When it was created in the 1940s, the United States and the colonial powers controlled most of the world's economy. In 2014 it is predicted that developing and emerging nations will produce more than half of the world's GDP. The reform efforts are intended to increase the funds available to the IMF, and change the quotas to more accurately reflect the current economic conditions. Unfortunately, it appears that the United States Congress is too deadlocked over domestic economic issues to ratify the new IMF agreements.

The fundamental issue addressed by the book is the instability of financial systems. It was suggested that one problem is that the systems involved are hugely complex and getting more so. Their management thus is difficult and getting more difficult. There was also a significant point made that economic knowledge does not seem to be adequate to the job. Mention was made of Nassim Talib's The Black Swan: The Impact of the Highly Improbable in respect to its description of the failure of financial models in the last U.S. bubble, crisis and crash. It was also mentioned that whenever rules are put into effect to control the rate of growth of credit, people invent new ways to circumvent those rules (legally or illegally).

The group tossed around the question, "what is money", recognizing that the question itself was beyond our capability, although we noted that at least one city in New York state has its own money in circulation in parallel with the dollar. We chatted about virtual money in cyberspace and a recent bubble in its worth. Similarly we wondered what was real about "value"; what does it mean when a Chinese vase if auctioned for millions of dollars? How could the land around the Tokyo royal palace have had a nominal price comparable to that of all the land in California? One of our members suggested that for these things to have any real meaning one had to know who were the buyers and bidders, and who were the sellers.

We also discussed the political problems involved in increasing the stability of the financial system. Politics define the rules of the game and the regulatory agencies that enforce them. These rules and regulators in theory can damp the rate of increase and decrease of prices and can provide negative feedback (as central banks modify interest rates to provide negative feedback to control inflation). However, the rules and regulators depend on political action. Financial firms and the big players in financial markets often lobby effectively to limit the rules and reduce the authority of regulators. Moreover, the public -- participating too often in the mania -- also discourage politicians from putting effective regulations in place to ameliorate the instability of financial systems.

Mention was made of The Great Deformation: The Corruption of Capitalism in America by David Stockman. Central banks are currently intervening in financial markets to an unprecedented level, flooding the world with new money in order to restore the economic growth of the United States, Europe and Japan, thereby to create jobs and decrease unemployment. Interest rates are being kept very low. Money has been flowing into the United States from Europe due to the financial insecurity related to the crises in Iceland, Ireland, Greece, Cyprus, Spain, Portugal and other countries. There must soon be an unwinding of these policies as the central banks refocus on debt; they will have to sell off troubled assets that they acquired as lenders of last resort. The question is whether they will navigate this untested unwinding successfully, or whether it will lead into still another crisis.

Kindleberger and Alber hold that the world has faced unprecedented challenges of managing contagion of financial crises in a globalized economy with floating currencies. Our members wondered if the world will face still a more complex and more dangerous challenges as the central banks try to unwind from the last crisis.

These might help as you read the book:

Here are some blog posts by one of our members on reading the book: