Human fallibility is the principal reason behind all major financial manias, panics, and crashes. Greed dominates a person’s psyche; he speculates on borrowed money for quick, speculative gains.
A market is in a mania stage when the behaviour of most of the investors can be categorized as ‘irrational’. Greed and euphoria are the dominant sentiments then. Manias causes bubbles to develop. An asset is said to be in a bubble if its price rises at a pace that cannot be justified by its fundamentals. During manias, investors are attracted to an asset whose price has risen a lot; they buy the asset expecting the price to rise further, which leads to a further rise in prices that again attracts another cohort of investors.
Although many conducive factors could cause manias to develop, a few factors are more common. The policies of monetary and capital market institutions and the level of economic activity at the time are examples. Firms become upbeat and increase their investment spending. Consumers are optimistic and increase their consumption spending. These spending increases lead to an increase in economic growth. The consequent increase in economic growth triggers another round of optimism boost and a further increase in investment and consumption spending. The bankers follow a risk-tolerant attitude in such environments, leading to high credit growth that often exceeds economic growth. Credit growth might exceed economic growth for two, three, or even five years, but not for an extended period.
Stock prices rise because corporate profits are rising propelled by the cycle of increased credit growth, increased investment spending, increased consumption spending, and increased economic growth. Moreover, during these exciting times, as asset prices – primarily, real estate prices and stock prices – keep rising, there will be an increase in the number of short-term investors – who speculate to make quick, short-term profits. Later, these investors will use borrowed money to finance their enterprising operations.
Manias are much more pervasive now than ever. Today as our economies and financial systems are closely interconnected more than ever before, it has become more likely that manias (or panics) at one part of the system can more readily percolate to other sectors, and even other economies, in no time. The global financial crisis of 2007-2009 has its origin in a small part of the US economy – the subprime mortgage market. But, through financial innovations like CDO and CDS, a major part of the international financial system was exposed to the risks from the US subprime mortgage market. When the US real estate bubble – fuelled largely by sub-prime mortgages – imploded, the real estate bubbles in Britain, Iceland, and Spain too imploded; and through CDOs and CDSs, those repercussions were felt throughout the global economy.
The Catalyst
The root cause of a mania is usually an exogenous event – an innovation or invention that promises significant productivity gains, societal transformation, and huge profit opportunities. Manias have developed (and subsequently crashed) following the commercialization of railroads, automobiles, and telecommunication. There were manias associated with financial innovations like junk bonds and collateralised debt obligations. The dot-com bubble was precipitated by the mania associated with – ‘how the internet can transform the economy’. There have been manias associated with international lending and investing in emerging market equities.
This is how a mania develops: a particular sector of the economy suddenly gains prominence caused by an exogenous event, like any of the ones discussed above. Now the sector is expected to generate immense productivity gains for society, and hence, offers large profit opportunities: many individuals and firms enter the sector to capitalize on those opportunities. Artificial intelligence is having such a moment now. Digital currencies and NFTs had their moment in late 2020 and 2021. But that bubble crashed in 2022 and the mania has fizzled out, leaving behind a trail of fallen personalities, billions in losses, and failure of many firms that were at the vanguard.
Lenders increase credit supply to the sector because they don’t want to miss the bus. Lenders become risk-tolerant and increase credit supply during economic booms but turn risk-averse and reduce credit supply during economic slowdowns. It is the variability of the credit supply that makes our financial system vulnerable to occasional episodes of manias, panics, and crashes.
When large amounts of money flow to a sector, firms in those sectors become flush with money. They invest aggressively, and as always, they over-invest. Of course, the over-investment was not evident to them at the time because their optimism caused them to overestimate the prospective demand for the sector.
Why does a mania occur?
There are many reasons. It normally happens when many market participants lose contact with reality. Manias develop when irrationality insidiously sweeps into the minds of many market participants. Manias could develop abruptly when people change their views at the same time and act like a herd. Or it might develop gradually, when only a few are hysterical initially, however, as the asset price keeps increasing, more and more turn hysterical.
We discussed earlier that manias originate from the euphoria and speculation following a sudden exogenous shock or event. At the beginning of the mania, investors and entrepreneurs approach the exogenous shock rationally. They are in it for the realistic profit opportunities the shock provides. However, due to human fallibility, the initial optimism transforms into euphoria, which facilitates widespread speculation that finally escalates into a mania.
Centuries ago, when textile mills were flourishing, there was high demand for cotton. Cotton cultivation was a lucrative business then. Enterprising individuals bought land to cultivate cotton. Land prices increased due to the increased demand for land for cotton cultivation. But, as this trend of increasing land prices continued for some time, cultivators started buying land to profit from their anticipated price increases. Land speculation became the dominant goal rather than profiting from cotton cultivation. When this proclivity became widespread, it evolved into a mania.
Manias could also occur when many investors increase their tolerance for risk-taking during economic expansion. Even though both inflation and interest rates increase during economic expansion, the interest rate increases are usually less than the increase in inflation rate. Hence, real rates (inflation-adjusted interest rates) are low or in decline during economic expansion. Consequently, investors are forced to embrace higher risks to achieve their financial goals. They increase their exposure to riskier assets like stocks and real estate.
Initially, investors’ increased interest in stocks and real estate would be limited and rational: the prime motivator is the respective asset’s earnings power. However, as the asset price keeps rising, earnings power as the primary motivator is gradually sidelined, and anticipated capital gains become the prime motivator. In the later stages of the mania, anticipated quick and sudden capital gains become the prime motivator, and many try to achieve it through borrowed money.
Manias can also develop due to the inelasticity of consumer spending. During economic expansion, household income increases. Consequently, households increase their consumption spending. However, when the economic growth and household income growth slow, they are unwilling to reduce their consumption spending. Instead, they turn to riskier assets that are in favour then – due to some exogenous shock – to compensate for the reduced income. This proclivity when overextended might evolve into a mania.
The Final Stage
At the final stage of a mania, that is before the bubble is about to burst, investors are exuberant and asset prices are rising steeply. These investors have flocked to the market under the impression that since asset prices have been rising for some time, they will keep rising. They ignore the economic fundamentals and the earnings power of the assets. Unfortunately, most of these investors have financed their asset purchases with borrowed money.
This trend is unsustainable. Even though these investors sideline economic fundamentals and earnings power, these factors are the real drivers of an asset’s price – they matter more than anything else. This unsustainable trend can go on only when 1) the increase in borrowings is greater than the interest payment on earlier borrowings, and 2) the increase in asset prices outpaces the interest rate on borrowings used to purchase those assets.
What usually brings an end to this unsustainable trend would be some event – failure of a major firm, change in government or central bank policy, or currency depreciation – that puts a break on the price rally. Fed’s decision to raise interest rates starting from 2006 onwards eventually led to the bursting of the US housing bubble. In 2022, the bubble in digital assets – cryptocurrencies and NFTs – crashed when the Fed decided to withdraw its asset purchase programs and raise interest rates from zero that were introduced in the wake of the COVID-19 pandemic.
Lenders become cautious in lending practices aghast of such events. Investors tamper down asset purchases that slow down the rate of the price increases. Lenders reduce credit supply due to increased uncertainty. When credit supply slows, the asset price rally fuelled by credit flow loses steam. When the price increase slows, investors’ return from these assets fails to meet interest rates on their borrowings; new indebtedness would be insufficient to meet interest payment of existing indebtedness.
Reversal of Fortune: The Panic
Now investors sell assets in distress causing price declines. The price decline causes some investors’ asset values to be less than their indebtedness, triggering another round of distress selling and price declines. Now prices have declined to such an extent that several speculators receive margin calls from their brokers. When many among them fail to meet the margin call, the brokers would be forced to liquidate the defaulters’ position, en masse, which triggers a sudden, steep fall in stock prices. Now we have a classic panic situation.
When the price fall is so large and sudden, certain buyers might emerge, who want to purchase assets because stock prices are thought to be cheap after the price declines. This is why we have bear market rallies. But such rallies are unsustainable, the trend remains downward. Once investors become convinced that prices will not recover as anticipated, the bear rally loses steam and prices start declining.
Now the mood has become so sombre and market prospects so uncertain that even conservative investors decide to stay away from the market. This exacerbates the price fall due to the dearth of buyers to provide support to the falling prices. Previously, during the mania phase, we saw price increases begot further price increases. Now, in the panic phase, each price decline begets further price decline.
In certain situations, the price decline is so steep, sudden, and unexpected that we have a market crash. Markets crashed in January 2008 with the onset of the global financial crisis of 2008-2009. Markets crashed in March 2020 due to the sudden imposition of national lockdowns in response to the Coronavirus pandemic.
The Aftermath
The panic selling and the consequent price decline cause a decisive turnaround in the attitude and sentiment of bankers, firms, and individuals. The previously risk-tolerant bankers become risk-averse, which slows credit growth and tightens liquidity. Firms cut down their investment spending because of concerns regarding future demand, which were anticipated during optimistic times. Low demand and cost pressures cause firms’ profitability to suffer and their stock prices to decline.
Consumers too cut back on their consumption spending due to concerns about job security, financial security, and economic uncertainty. These factors – lower demand, cut back in investment spending and consumption spending, tight liquidity, and lower credit growth – slow economic growth. A severe slowdown will see the economic output decline, and an economy will enter a recession if it experiences two consecutive quarters of decline in economic output.
Pessimism dominates now. Investors and businesses call for intervention by the government and regulators to restore confidence. However, there is a strong ongoing debate on such interventions. The argument ‘against’ such interventions is that – if authorities intervene whenever a crisis occurs, it will encourage speculation by investors and businesses who come to believe that authorities will always bail them out when something bad happens. This will make our financial system fragile and vulnerable. The argument ‘for’ such interventions is that – if authorities don’t intervene, the present liquidity crisis might morph into a solvency crisis that finally culminates in recession, high unemployment, and widespread hardship for the general populace.
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