The word bubble, in the context of financial markets, gets thrown around a lot these days. Some of this is understandable considering the global economy was, and still is, recovering from the incredible recession of 2008-2009. Our senses have been heightened to watch out for what may be coming next. Regardless, the excessive usage begs the question: What defines a true bubble?

Originally published in 1978, Kindleberger’s Manias, Panics, and Crashes is brimming with examples of financial furor from the past several centuries, both domestic and international. The discussion is framed around a model originally proposed by economist Hyman Minsky, which offers a methodical explanation of how bubbles start, grow, peak and crash. The model itself is fairly generic and in a refreshing way contains no mathematical components–it doesn’t suffer from “physics envy.” In a qualitative sense it’s as relevant today as it was 40 years ago, and can be broken down into the following five stages:

1) Displacement
The formation of a panic or crisis begins when an external event shifts expectations and creates new opportunities for profit. The change may and has come in many different forms as the subject is always unique from previous panics. In the 1990s improvements in technology allowed online businesses to form and flourish. Shortly thereafter home loans in the United States became easier to obtain. Whatever the subject it is large and far reaching.

2) Boom!
While the potential for profit is created by a displacement, it is fueled further by an expansion of bank credit. More loans are made and the total money supply increases. But money is only a construct, and Kindleberger suggests that new forms of money can always be created to help fuel a boom. Highly liquid assets or close money substitutes may be able to monetize credit and thus act as a form of “money”–at least in theory.

The expansion of credit and the corresponding increase of the money supply allow asset prices to be bid higher and higher. What was once a rational opportunity for profit begins to mutate into a lucrative capital gain.

3) Speculation and Over-trading
Euphoria sets in. Growth potential is overestimated. The phrase “this time is different” may be used as a rationalization for purchasing assets at increasingly inflated prices, with the expectation that they may be sold at ever higher prices. The concept of true investment has gone out the window

Pure speculation, of course, involves buying for resale rather than use in the case of commodities, or for resale rather than income in the case of financial assets. [1a]

At this stage speculators have lost touch with reality, and speculation turns into mania. It’s worth noting that this irrationality is at odds with a large swath of economic theory, which assumes that market participants behave in a completely rational manner. Humans aren’t automatons. We’re subject to a number of emotions and biases that shape our decisions, and we don’t always act in the most economically reasonable way. In the context of a financial boom the role of greed should not be underestimated. Easy money is always tempting. When individuals or firms see their neighbors profiting off speculative behavior they inherently want a piece of the action. They become less diligent in their assessment of investment opportunity, allowing fraudulent schemes flourish

At a late stage, speculation tends to detach itself from really valuable objects and turn to delusive ones. A larger and larger group of people seek to become rich without a real understanding of the process involved. [1b]

4) Distress
Speculation can’t continue indefinitely and several factors may align that bring about a change in regime. Credit may be stretched thin, and creation of the “new money” that fuels the boom starts to slow. With less new money available price appreciation concurrently begins to slow.

A turnover in participants also starts to take place. As the boom trends higher insiders begin to take their profits by selling out of the speculative object. For a period of time new recruits to the speculation will balance with these early sellers. This turnover has a stabilizing effect and a temporary equilibrium in price may be established, but it’s only a matter of time. Eventually these outside speculators begin to realize that the game is up, and they too begin to sell.

5) Revulsion and Discredit
Distress can quickly turn into panic, and the trigger can be any number of events or circumstances. An important bank may fail. A major scandal or fraudulent activity may come to light. The price of the speculative object itself may begin to decline rapidly. More and more market participants attempt to cash out and leave the object of speculation

Prices fall. Expectations are reversed. The movement picks up speed. To the extent that speculators are leveraged with borrowed money, the decline in prices leads to further calls on them for margin or cash, and to further liquidation. As prices fall further, bank loans turn sour, and one or more mercantile houses, or brokerages fail. The credit system itself appears shaky, and the race for liquidity is on. [1c]

The situation isn’t all that different from a mad rush to get out of a burning building. The situation may be chaotic as evidenced by massive swings in price.

The Lender of Last Resort
The lender of last resort plays off the idea that the cure for a financial panic is the provision or access to some form of money that provides assurance to market participants. In certain instances simply reassuring market participants that liquidity is available may prove sufficient to slow or stop a crisis from accelerating.

However, the fact that participants have knowledge of an entity that will “save the day” presents a rather serious problem in the form of moral hazard. Venturing down this course may encourage banks and other financial institutions to take on excessive amounts of risk, fully understanding that their downside is limited when that risk works against them.

Alternatively a central bank can do nothing and leave the market to determine who succeeds and fails. The idea being that the surviving institutions will learn from their mistakes, and modify their behavior, thus preventing a future panic or crash from occurring.

The dominant argument against the a priori view that panics can be cured by being left alone is that they almost never are left alone. The authorities feel compelled to intervene. [1d]

Timing plays a critical role for rolling out a stimulus. Enough time is required for insolvent firms to fail, but waiting too long may cause solvent firms to deteriorate as well.

There is an additional albeit somewhat smaller effect that the lender of last resort may have on financial markets–more specifically on the behavior of certain individuals. Assuring market participants that it will intervene and attempt to halt a panic is essentially a form of insurance, and not much different from a put option. In 2010 one intrepid hedge fund manager described how he was able to profit from what has been aptly named “the Fed put” (a.k.a. the Greenspan put or the Bernanke put)

The government told you what they were going to do.

They said they want the market up. Okay, so what am I? I’m gonna say “No Fed I disagree with you?”

So what I got, is I got two different situations. One, that the economy gets better by itself. The other situation is the Fed comes in with money. Now up to the point the Fed comes in with money the stock market can go down a little bit, but not that much, because I got a put. And you gotta love a put. Um, especially when the government’s issuing it.

-David Tepper on CNBCs “Squawk Box” [2]

Humans aren’t always rational, markets aren’t always efficient, and history is wrought with examples. It has happened before and it will happen again. We simply can’t help ourselves.

References
1. Kindleberger, Charles. Manias, Panics, and Crashes. Basic Books, Inc. New York, NY. 1978.
(a) p. 17
(b) p. 18
(c) p. 107
(d) p. 143
2. David Tepper CNBC Interview: https://vimeo.com/74407612

NOTES – Manias Panics and Crashes.pdf

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