An understanding of how manias develop and later devolve into panics helps navigate them with minimal damage.
Financial Manias occur when the initial optimism among investors and firms produced by an external event, which promised significant productivity gains and large profit opportunities, escalates into euphoria and widespread speculation. The escalation is propelled by the optimistic forecast of prices and demand in a particular sector of the economy – thanks to the external event – by early enthusiasts and by the over-investment made by those early enthusiasts. Lenders expanded credit to the sector that was initially utilized for productive investments but later largely diverted towards speculation.
This post discusses the momentous period when a mania peaks and distress ensues, which may or may not, escalate into a financial crisis.
Before the Implosion
During the late stages of a mania, many investors encouraged by the rapid increase in stock prices get attracted to the stock market. They purchase stocks expecting the rapid price increase to continue. Those expectations become self-fulfilling as the consequent purchases lead to further price increases. These investors will experience a confidence boost when a few such purchases turn lucrative. Impelled by over-confidence, many use borrowings to finance their next purchases under the impression that the rise in prices will more than pay for the interest on their borrowings and act as collateral for new loans.
During a mania, stocks are in a bubble as their prices have risen faster than their earnings growth for an extended period. However, bubbles’ inherent nature is that they eventually get pricked and implode. The steep price decline following the implosion can have severe consequences.
The Inexorable Collapse
The collapse of asset prices fuelled by euphoria and speculation is imminent and somewhat predictable. It is usually an incident that triggers the collapse. The incident could take many forms – a currency devaluation, increase in interest rates by central banks, failure of a major industrial firm, financial troubles at a systemically important financial institution, a bank run, massive selling by foreign investors, among many others.
In the early 1990s, the new incoming Japanese central bank governor asked Japanese banks to limit their real estate loan growth relative to the total loans. This was the ‘trigger event’ that led to the implosion of the bubble in Japanese real estate and stock prices. In the early 2000s, the Federal Reserve’s decision to withdraw liquidity – introduced earlier in the wake of Y2K – was the trigger event that led to the bursting of the dot-com bubble.
In whatever form the ‘trigger event’ arrives, it does three things: 1) it overturns the prevailing market sentiment from confidence to pessimism; 2) it makes investors cautious and brings a pause to the asset price rise; and most importantly, 3) it changes expectations – the earlier forecast of future price and value of an asset seems too optimistic and unrealistic now.
Investors and firms realise that their indebtedness is far greater than their income. Individual investors sell assets on the realisation that their investment income wouldn’t be enough to cover the interest on their borrowings. Firms slow down investment, cut spending, and sell assets to raise money to reduce their indebtedness. Prices decline due to the heavy, distressed selling. When prices decline, the value of collaterals declines, which requires the asset owners to either provide more collateral or reduce assets. Under financial distress, the overwhelming choice would be to reduce assets; so more selling follows. More selling causes more price declines. The price declines and the resultant decline in collateral value forces banks to call in outstanding loans, or at least stop advancing new loans. This risk-averse behaviour from lenders causes some of their customers to go bankrupt.
Every financial distress doesn’t have to escalate into a panic or crash. Asset prices might fall steeply, but their negative economic impact might be mild and brief.
Foreknowing is Elusive
Two aspects make manias (and panics) enigmatic. One is the timing issue. Although many might be aware that the prevailing asset prices are far away from their long-run equilibrium levels and must revert to equilibrium, it is hard to determine when the reversion to the equilibrium might happen.
In December 1996, concerned about the elevated stock prices, the then Fed Chairman Alan Greenspan warned that “stock prices are too high and rapidly rising.” S&P 500 was trading at 760 then. But stock prices continued rising for the next three-and-half years – peaking at 1,460 in August 2000. An investor would have missed a significant part of the price rally if he had heeded to the Fed Chairman’s warning. As such warnings that prove wrong – although temporarily – might incite a public backlash, authorities usually avoid publicly expressing their genuine concerns apprehensive of unfavourable public reactions.
The other enigmatic aspect is the inability to foreknow the firms that might fail or be greatly affected in a financial crisis. Despite extensive studies into hundreds of financial crises that have occurred over the past few centuries, the only takeaway we have is that: 1) firms that have made rapid market share and asset increases recently, largely using short-term money from the wholesale market, are the most vulnerable, 2) while firms with low indebtedness and banks with solid deposit base are the least vulnerable.
Can Authorities Do Something About It?
The role of authorities – government, regulators, bankers – needs serious consideration. It is the change in expectations that precipitates both manias and panics. The policies of authorities at the time have a significant role in setting and altering those expectations. There was a boom in the Kuwaiti stock market in the late 1970s when investors were allowed to buy stocks using post-dated cheques. This led to a steep stock rally and a bubble that eventually imploded when many cheques bounced. Meanwhile, many a bubble has been pricked by measures taken by regulators to contain excessive speculation, as seen in the case of Japan in the 1990s, when a statement by the central bank governor to limit real estate loan growth led to the implosion of its stock and real estate bubble.
But the same authorities have a poor track record in preventing manias and panics from happening. One reason is that manias and panics are caused by the rapid rise and fall in asset prices, which is not a primary concern for the authorities. Their attention is largely directed at inflation targeting, economic growth, and employment. Even if authorities become concerned about elevated asset prices and their rapid rise, they hesitate to take strict measures to contain them due to concern about the negative impact those measures might have on the economy.
In the early stages of a mania, authorities may issue warnings about the risks the elevated asset prices and their rapid rise pose. But it is unlikely that anyone heeds such warnings when asset prices are rising at 20-30 percent annually. History shows that in most such instances, the price rise does pause for some time but then continues rising.
Another reason why authorities have a dismal record in preventing manias and panics is that once a trend has been formed, despite the best of intentions, it is hard to change its course. The essence of financial mania is euphoria: it is intractable once set in motion. Similarly, the essence of financial distress is the lack of confidence: once lost reviving it is arduous.
Buffering the Impact
The final stages of many a financial mania – that is, just before the bubble is about to implode – have three common features: 1) elevated and rapidly rising asset prices (asset bubble); 2) flurry of new investors to purchase the asset anticipating the price rise to continue (speculation); and 3) a significant portion of those purchases are financed with short-term borrowings (credit expansion). An investor who can discern these features in a market is not left off guard when the inevitable financial distress occurs.
Notes
“The Critical Stage – When the Bubble is About to Pop”, Manias, Panics, and Crashes: A History of Financial Crises, Charles P. Kindleberger and Robert Z. Aliber
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