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[Note for bibliographic reference: Melberg, Hans O. (1998), Not bad, but more popular than it deserves: A Review of "Manias, Panics and Crashes: A History of Financial Crisis",]


Not bad, but more popular than it deserves

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

Manias, Panics, and Crashes
A History of Financial Crises

Charles P. Kindleberger
John Wiley & Sons, New York, 1996 (third edition, first in 1978)
263 pages, ISBN: 0 471 16171 3 (paperback)

To make The Beatles popular their manager bough enough records to get them into the hit lists. People then bough the record simply because the group appeared to be popular. But, by so doing the group became genuinely popular; popularity was self-fulfilling and self-sustaining. To some extent the same goes for academic works. I read Charles P. Kindleberger's book Manias, Panics, and Crashes: A History of Financial Crises because so many articles on economic collapse referred to Kindleberger. It turned out that the popularity was at least partially misleading. Although the book has its good sides, there are also many flaws.

In this review I shall first present Kindleberger's argument and the questions discussed in the book. I shall then criticize the book under three headings: the choice of issues to be discussed, the method employed to prove points and the conclusion from the arguments. This negative criticism will then be balanced by a discussion of some of the virtues of the book.

His argument
"The heart of this book", writes Kindleberger, is the view that Keynesian and Monetarist theory are incomplete because they leave out "the instability of expectations, speculation, and credit and the role of leveraged speculation in various assets" (p. 18). This instability leads him to argue that "our conclusion is that money supply should be fixed over the long run but be elastic during the short-run crisis. A lender of last resort should exist, but his presence should be doubted" (p. 9).

When asked why the system is unstable, Kindleberger's answer is that "What happens, basically, is that some event changes the economic outlook. New opportunities for profits are seized, and overdone , in ways so closely resembling irrationality as to constitute a mania" (p. 2, my emphasis). In other words, psychological forces stimulate speculation (causa remota) and the crash comes when some incident snaps confidence (causa proxima) (p. 92).

There are, of course, lots of blanks to be filled in this argument. We need to know the various links and mechanisms that create speculation, asset price increases, the links between the asset price collapse and the real economy and so on. Moreover, the explanation should be compatible with the fact that crashes do not occur permanently; usually the economy works fine.

A more detailed outline of his theory, which he claim is build on the Minsky model, is as follows. First, there is some exogenous shock (policy switching, technology, financial innovation). Second, the boom created by the profit opportunities after the shock is fed by increasing money supply. There is little to be done about this because the money supply is endogenous (new banks enter, personal credit increases, new credit instruments are used). Third, the boom leads to speculation that initially has positive feedback; speculators earn money and invest more as well as making more people invest. This leads to what Adam Smith calls "overtrading" which can be caused by pure speculation (buying something with the aim of selling it later at a higher price), overestimation of the true expected return and excessive gearing (low initial cash requirements when buying something). Fourth, the overtrading spreads from one market to another (psychological links and others). Fifth, speculation spreads internationally (again, psychological mechanisms are important, as well as: arbitrage, foreign trade multiplier, and capital flows). Sixth, at the peak some insiders leave the market, there is "financial distress" and a bankruptcy or the revelation of a swindle leads to the final stage; the rush for liquidity. The panic (or "revulsion") feeds itself until prices become so low that people are tempted to once again go into less liquid assets, trade is cut off or a lender of last resort convinces the market that three is enough money for all.

In sum, economic crises are caused by psychological mechanisms which lead asset prices to be volatile. Combine this with a bank and credit system that is fragile. When asked why it is fragile, Kindleberger answers: "The system is one of positive feedback. A fall in prices reduces the value of collateral and induces banks to call loans or refuse new ones, causing mercantile houses to sell commodities, households to sell securities, industry to postpone borrowing, and prices to fall still further. Further decline in collateral leads to more liquidation. If firms fail bank loans go bad, and then banks fail. As banks fail depositors withdraw their money (...) Deposit withdrawals require more loans to be called ..." (and so on , p. 97).

Finally, the link between the financial and the real sector is not primarily that people buy less because falling asset prices leads to less wealth, but that the credit sector is "paralyzed." Thus, psychological forces are magnified through the banking system which, in turn, are magnified in the real sector. The story is one of feedback (non-linearities), discontinuities and differences in adjustment speed.

The issues
Stylistically I think the book could have benefited from the inclusion of a short overview of financial crisis. For readers unacquainted with the history of financial crisis it becomes confusing when the author writes that the crisis of year x, y, and z prove a point. True, there is a good table in appendix A with an overview of crises, but a short verbal history would have been better.

Second, I sometimes found the argument slightly unfocused. For instance, the argument does not require him to discuss whether some cultures have a greater tendency to speculate than others (p. 41-43) or the appropriate punishment of speculators (p. 81-82). True, these are minor flaws and on the whole his discussion sticks to the real argument.

A third missing element, was the relative lack of analytical discussion of the precise mechanisms behind the crisis. Consider, for example, the argument that speculation is cause by (irrational) psychological mechanisms. While this may well be true, we want a close description of the precise mechanisms. Maybe people have a tendency to ignore negative information, maybe there is herd-behaviour, maybe making money makes you overconfident in your own abilities (as suggested by Galbraith). These, and other mechanisms, must be discussed more closely if we want to explain crisis. Once again, Kindleberger touches the issue (see p. 23), but the discussion is too brief given the importance he gives speculation as a cause of crisis.

Finally, I think a closer discussion of the definition of crisis is required. He claims that it may be hard to define but recognizable when encountered (p. 3). But I do not find this satisfactory. Later he claims that " ... we are concerned primarily with international crises involving a number of critical elements - speculation, monetary expansion, a rise in the price of assets followed by a sharp fall, and a rush into money. Crises that fall outside these dimensions do not, on the whole, concern us, and there are enough within the category to suggest that the broad genus is worthy of study" (p. 17). Yet I am unsure whether this is precise enough, and more seriously I wonder whether it represents arbitrary domain restriction (see below for more on this).

The method
In his own words, the book is "literary economics" as opposed to mathematical economics (models) and statistical economics. Moreover, his approach is not guided by the assumption that people are always rational. Finally, the evidence he uses is largely historical correlation. For instance, to examine whether a lender of a last resort is good or a bad, he simply contrasts the outcome of crisis with or without a lender of last resort.

On the first - literary economics - I have no serious complaints. It is fully possible to write good economic without using mathematics, but I also tend to believe that formalization tend to make our understanding more precise and may reveal potential inconsistencies.

I also agree that we cannot by assumption exclude irrational behaviour when we explain an empirical phenomenon. However, the way to prove the irrational causes is not to list the words used by contemporaries to describe speculation (craze, rush, mad, feverish, blind passion and so on, see p. 22). The point is that what might seem crazy, may turn out to be rational once we go deeper into the issue. For instance, ethnic violence used to be explained by irrational and ancient hatred, but recently "rational" models have increased understanding of some of the mechanisms involved (tipping models, the impossibility of credible commitments, the benefits of pre-emptive strikes). Hence, phenomena which appear irrational, may be explained by rational individual behaviour. It seems to me an important task of the social sciences to investigate these possibly counterintuitive truths and not to accept the judgment of commentators at face value.

Finally, and most seriously, there is a problem with the way Kindleberger uses history to "prove" his argument. Consider the mentioned argument that a lender of last resort is beneficial. The argument is as follows: "... we are prepared to make the case, tentatively, that a lender of last resort does shorten the business depression that follows financial crises. The evidence turns mainly on 1720, 1873, 1882 in France, 1890, 1921, and 1929. In none of these was a lender of last resort effectively present. The depression that followed them were much longer and deeper than others ..." (p. 190).

While it would be absurd to deny evidence of this kind, the conclusion becomes much more convincing when it can be made using a model where the mechanisms that show why a lender of last resort is good. As always Kindleberger has sensible suggestions, but the impression is unavoidably that we are dealing with ad hoc reasoning. The reason I stress this, is that using historical correlation to prove an argument can often be very deceptive because it may be spurious and accidental (see my paper "Against Correlation").

Only when you have a general frame and a detailed account of the mechanisms involved, can you claim to have a reliable explanation. Reliable because you reduce the problem of spurious correlation; Explanation because you make the causal links explicit, unlike a mere correlation.

Finally, Kindleberger explicitly excludes small economic fluctuations from his study. As he writes: "We are not interested in the business cycle as such, ... but only in the financial crisis that is the culmination of a period of expansion and leads to a downturn" (p. 1, see also p. 17 for a limitation of the subject). Initially this may seem a perfectly acceptable way of limiting a large subject. However, when he claims that the story should be judged by its ability to explain crisis, he tries to shield himself from the argument that his theory is contradicted by the many calm periods of capitalism. In short, if capitalism is as unstable as Kindleberger argues, why do we not experience more crisis and less calm? I think this is a valid argument against Kindleberger and he should not be allowed to side-step the issu e by arguing that he does not want to explain the whole business cycle. (Note: While I believe in the argument made above, I have to admit that I am less than perfectly certain. It is legitimate to restrict the domain of your research. The question is what restrictions are valid. See The Pathologies of Rational Choice Theory by Green and Shapiro for more on arbitrary domain restrictions.)

The conclusions
The main analytic conclusion is that irrational speculation leads to excessive asset prices which collapses and causes real problems because of the fragility and importance of the banking system. The main policy conclusion "is that money supply should be fixed over the long run but be elastic during the short-run crisis. A lender of last resort should exist, but his presence should be doubted" (p. 9). Both conclusions can be critizised.

One the first issue, Kindleberger does not really go into alternative explanations of economic fluctuations and crisis. One such alternative is that the economic system is pervaded by non-linearities and discontinuities. In such a world asset prices may fluctuate widely even if people are close to or perfectly rational. In other words, instead of blaming irrational people, one might blame the instability of the technology of the system. This leads to chaos and catastrophe models that Kindleberger admits is beyond his competence.

On the second issue he admits that "The dilemma, of course, is that if markets know in advance that help is forthcoming under generous dispensations, they break down more frequently and function less effectively" (p. 4). Yet, this admission is not followed up by truing to decide the issue empirically or analytically. Even if there have been fewer banking crisis after the Federal Deposit Insurance Corporation was introduced, does not prove the point since many other variables have also changed since then.

This is not to say that I disagree with Kindleberger, only that in a perfect textbook on economic crisis I would like to have a more general framework with alternative theories and policy implications compared. I want more detailed mechanisms and more analytic arguments within an encompassing logical structure. This is, of course, asking for too much, but it is valid to argue that a general book should provide more of this than Kindleberger does.

It follows from what I have said so far that I seek the details of the mechanisms that produce crisis. Sometimes Kindleberger gives the reader new and possibly important mechanisms and for this he deserves credit. Here are some examples.

Consider first a type of mechanisms that fits Jon Elsters definition, that is - a frequently occurring and easily recognizable causal pattern that are triggered under generally unknown conditions or with indeterminate consequences (p. 45 in HedstrÝm and Swedberg: Social mechanisms ). Here are three quotations which illustrate this type of mechanism:

"Tight money in a given financial center can serve either to attract funds or to repel them, depending upon the expectations that a rise in interest rates generates." 8

"A rise in the price of a commodity may lead consumers to postpone purchases in anticipation of the decline, or to speed them up against future increases." 8

"Where foreigners took raising of the discount rate as a sign not of strength but of weakness, and sold rather than bought the currency ...." 165

In short, the same action (tightening monetary or fiscal policy, raising the interest rate, increasing prices) can have different effects and it may be impossible to determine the effect in advance. Yet, after the fact we see which effect that was the strongest in aggregate and can use the mechanism to explain what happened; We may explain but not predict.

Another common fallacy, is the fallacy of compositions. As Kindleberger writes this is when The action of each individual is rational - or would be, were it not for the fact that others are behaving in the same way (p. 28). This may lead to cycles by way of overinvestment (and resulting underinvestment and possible cob-wed cycles). For instance, observing that railroad investments are currently very profitable, many people may invest in railroads and the aggregate effect is that railroads become a very unprofitable business (overinvestment). This may help explain the overinvestment in railroads in the US in 1840-50. It may also explain some of the cycles in the Norwegian shipping industry.

A third mechanism is the kind of positive feedback already quoted in this review ("The system is one of positive feedback. A fall in prices reduces the value of collateral and induces banks to call loans or refuse new ones, causing mercantile houses to sell commodities, households to sell securities, industry to postpone borrowing, and prices to fall still further p. 97).

In addition tot he mechanisms suggested by Kindleberger, I found that parts of the book was entertaining and well written. It is also a veritable database of small anecdotes, quotes and facts. It is useful to know that during the condominium craze in Boston in 1985 and 1986 about 60% of the people buying did so with the objective of reselling (p. 26). Another interesting fact is the use of postdated checks from 1977-82 on the Kuwait Souk al-Manakh (stock exchange). Unsurprisingly, it turned out that some of these cheques were worthless (totaling $91 billion! See p. 45). The incident should illustrate that with enough ingenuity (and dishonesty) the market will find ways to increase the money supply.

The mechanisms that led me to buy this book may help to explain the subject of the book; I bought it because it was popular. By so doing I contributed to its popularity and further sales based on existing popularity. In other words, there is a self-reinforcing mechanisms. Cycles and crashes may arise by similar mechanisms in many levels and sectors; I buy an asset because other buy and by do doing I make the price increase which confirms the wisdom of buying that asset - which in turn may lead other people to buy and so on. Kindleberger gives us some of these mechanisms and he allows irrationality, confidence, expectations and psychology to play a role that many economists try to avoid. For this he deserves praise, but the book cannot be considered the final book since it does not have an encompassing frame in which the various theories are considered (such as modern non-linear theories). I would also like to see more mechanisms derived from a logical structure and less ad hoc reasoning. In short, unlike The Beatles the popularity was only partially a sign of good quality.


[Note for bibliographic reference: Melberg, Hans O. (1998), Not bad, but more popular than it deserves: A Review of "Manias, Panics and Crashes: A History of Financial Crises",]