Manias, Panics and Crashes – Review Part 1

This book was on my reading list for long time now. Every time I started reading, I left after reading first few pages. Reason being too much information! Yes, it is great book but not so easy. Needs at least two readings.

In second chapter “Anatomy of a Typical Crisis”, Charles goes through the Minsky model and how it is used to predict financial crisis. The model is based on how emotions control the markets and how that leads to manias and bubbles. When people are optimistic they borrow more in anticipation of higher profits and slowly the cycle starts in the whole economy (and same is true on opposite side).

According to Minsky, there is always an outside shock to macro-economic system that leads to crisis (1920’s in U.S., 1980’s in Japan and 1990’s in Asia). 

Minsky explains how real world is totally different from the text-book economic theories. According to him, when money starts flowing in easily, one needs to get out.

Minsky model focuses on the changes in the supply of credit. Credit increases when the economy is booming and decreases during slowdowns. Minsky emphasized on the behavior of borrowers who increased their indebtedness in the expansion to finance the purchase of real estate or stocks for short-term capital gains.

These things remind me of years 2005-2006 in India. The Indian markets were going through one of the strongest bull phases ever. I found that same people who used to talk about long-term, started focussing on buy today sell tomorrow strategy (popularly known as BTST). Now how this is interesting is for these trades, traders didn’t have to pay any upfront margin. At that time you had up to 11 am next day to pay for the trades.

Indian markets used to close at 3:30 pm and people used to buy around 3:20-3:25 pm (sometimes also at 3:29:59!) in anticipation that tomorrow when markets will open at 9:55 am they would be able to make 1-2%. That was free money.

How all that went sour? I remember it was May 22, 2010 and as usual markets were to open at 9:55 am. Everything was going well. Few hours before the market open, there was news that government was trying to restrict the flow of money into India from foreign investors (exact details I will have to find out).

There was a panic on T.V. and all so-called experts started giving negative statements about India. 9:55 am and markets opened. 9:56 am and markets closed. They had hit 10 percent down circuit. Indices were down 10 percent and the hot BTST stocks lost  anywhere from 20-50 percent in the matter of 2 minutes (one minute yesterday and one minute that morning!).

According to Minsky, boom is fueled by an expansion of credit and in modern days we have banks to help us out with that as compared to vendor financing of seventeenth century. If the government tries to restrict the ability of banks to make loans, banks set up wholly owned subsidiaries to make the loans the banks themselves are prohibited from making.

This starts the whole vicious cycle. Prices increase and profits increase and that attracts more money into the system. As Prof. Kindleberger says that there is nothing as disturbing to one’s well-being and judgement as to see a friend get rich.

The reason people bought assets changes from earning fixed regular income to fixed regular income plus appreciation in the value of principal.

Experts come on T.V. and say this time it is different and there is genuine growth in economy etc. This behavior now transfers from traders to big institutions, which can’t see their competitors making more loans than themselves. The virus slowly spreads to other nations.

As I said before, Prof. Kindleberger has put enormous information in these 350 pages that it is gonna take time to relate that to recent happenings in markets. More to come soon…


About Danish Kapur

Danish Kapur is a writer, commentator and actively follows the global financial markets.

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