Minsky’s three-part taxonomy

Minsky distinguished between three types of finance—hedge finance,
speculative finance, and Ponzi finance—on the basis of the relation

between the operating income and the debt service payments of indi-

vidual borrowers. A firm is in the hedge finance group if its anticipated

operating income is more than sufficient to pay both the interest and

scheduled reduction in its indebtedness. A firm is in the speculative fi-

nance group if its anticipated operating income is sufficient so it can pay

the interest on its indebtedness; however the firm must use cash from

new loans to repay part or all of the amounts due on maturing loans. A

firm is in the Ponzi group if its anticipated operating income is not likely

to be sufficiently large to pay all of the interest on its indebtedness on

the scheduled due dates; to get the cash the firm must either increase its

indebtedness or sell some assets.

Minsky’s hypothesis is that when the economy slows, some of the

firms that had been involved in hedge finance are shunted to the group

involved in speculative finance and that some of the firms that had been

involved in the speculative finance group now find they are in the Ponzi

finance group.

The term ‘Ponzi finance’ memorializes Carlos Ponzi, who operated a

small loans company in one of the Boston suburbs in the early 1920s.

Ponzi promised his depositors that he would pay interest at the rate of

30 percent a month and his financial transactions went smoothly for

three months. In the fourth month however the inflow of cash from new

depositors was smaller than the interest payments promised to the older

borrowers and eventually Ponzi went to prison.

The term Ponzi finance is now a generic term for a nonsustainable

pattern of finance. The borrowers can only meet their commitments to

pay the high interest rates on their outstanding loans or deposits if they

obtain the cash from new loans or deposits. Since in many arrangements

the interest rates are very high, often 30 to 40 percent a year, the contin-

uation of the arrangement requires that there be a continuous injection

of new money and often at an accelerating rate. Initially many of the

existing depositors are so pleased with their high returns that they allow

their interest income to compound; the clich ́ is that they are ‘earning

interest on the interest.’ As a result the inflow of new money can be below

the promised interest rate for a few months. But to the extent that some

depositors take some of their interest returns in cash, the arrangement

can operate only as long as these withdrawals are smaller than the inflow

of new money.

The result of the continuation of the process is what Adam Smith and his

contemporaries called ‘overtrading.’ This term is less than precise and in-

cludes speculation about increases in the prices of assets or commodities,

an overestimate of prospective returns, or ‘excessive leverage.’3 Specula-

tion involves buying commodities for the capital gain from anticipated

increases in their prices rather than for their use. Similarly speculation

involves buying securities for resale rather than for investment income

attached to these commodities. The euphoria leads to an increase in the

optimism about the rate of economic growth and about the rate of in-

crease in corporate profits and affects firms engaged in production and

distribution. In the late 1990s Wall Street security analysts projected

that U.S. corporate profits would increase at the rate of 15 percent a

year for five years. (If their forecasts had been correct, then at the end

of the fifth year the share of U.S. corporate profits in U.S. GDP would

have been 40 percent higher than ever before.) Loan losses incurred by

the lenders decline and they respond and become more optimistic and

reduce the minimum down payments and the minimum margin require-

ments. Even though bank loans are increasing, the leverage—the ratio

of debt to capital or to equity—of many of their borrowers may decline

because the increase in the prices of the real estate or securities means

that the net worth of the borrowers may be increasing at a rapid rate.

A follow-the-leader process develops as firms and households see that

others are profiting from speculative purchases. ‘There is nothing as

disturbing to one’s well-being and judgment as to see a friend get rich.’4

Unless it is to see a nonfriend get rich. Similarly banks may increase their

loans to various groups of borrowers because they are reluctant to lose

market share to other lenders which are increasing their loans at a more

rapid rate. More and more firms and households that previously had

been aloof from these speculative ventures begin to participate in the

scramble for high rates of return. Making money never seemed easier.

Speculation for capital gains leads away from normal, rational behavior

to what has been described as a ‘mania’ or a ‘bubble.’

The word ‘mania’ emphasizes irrationality; ‘bubble’ foreshadows that

some values will eventually burst. Economists use the term bubble to

mean any deviation in the price of an asset or a security or a commod-

ity that cannot be explained in terms of the ‘fundamentals.’ Small price

variations based on fundamentals are called ‘noise.’ In this book, a bub-

ble is an upward price movement over an extended period of fifteen

to forty months that then implodes. Someone with ‘perfect foresight’

should have foreseen that the process was not sustainable and that an

implosion was inevitable.

Jail time, fines and financial penalties: financial behavior in the 1990s U.S. economic boom

Enron was the poster-child of the 1990s boom; the company had trans-
formed itself from the owner of regulated natural gas pipelines into a
financial firm that traded natural gas, petroleum, electricity, and broad-
band width as well as owning water systems and an electrical power

generating system. The top executives of Enron felt the need to show

continued growth in profits to keep the stock price high, and in the late

1990s they began to use off-balance sheet financing vehicles to obtain

the capital to grow the firm; they also put exceptionally high prices on

some of their long trading positions so they could report that their trad-

ing profits were increasing. The collapse of Enron led to the failure of

Arthur Andersen, which previously had been the most highly regarded of

the global accounting firms.

MCIWorldCom was one of the most rapidly growing telecommunica-

tions firms. Again the need to show continued increases in profits led

the managers to claim that several billion dollars of expenses should

be regarded as investments. Jack Grubman had been one of the sages in

Salomon Smith Barney (a unit of the Citibank Group); he was continually

promoting MCIWorldCom stock. Henry Blodgett was a security analyst

for Merrill Lynch who was privately writing scathing e-mails about the

economic prospects of some of the firms that he was otherwise promoting

to investors; Merrill Lynch paid $100 million to move the story off the

front pages. Ten investment banking firms paid $1.4 billion to forestall

trials. The chairman and chief executive officer of the New York Stock

Exchange resigned soon after it became known that he had a compensa-

tion package of more than $150 million; the exchange served both as a

tent for trading stocks and as a regulator and it appeared that the man-

agers of some of the firms that were being regulated served as directors of

the exchange and participated in determining the compensation package.

Then a number of large U.S. mutual funds were revealed to have allowed

firms to trade on stale news.

More individuals have already gone to prison than in the aftermath of

any previous crisis, and a number are still awaiting trial. Six Enron senior

managers already have been jailed. One Arthur Andersen partner who

worked on the Enron account went to prison. Two of the senior financial

officials of MCIWorldCom have gone to jail. Martha Stewart was found

guilty of obstruction of justice and imprisoned for five months.

The subject of Chapters 10 and 11 is crisis management at the domestic

level. The first of these two chapters considers the range of domestic re-

sponses to a crisis; at one extreme the government may take a hands-off

position, at the other there is a range of miscellaneous measures. Those

who believe that the market is rational and can take care of itself pre-

fer the hands-off approach; according to one formulation, it is healthy

for the economy to go through the purgative fires of deflation and

bankruptcy to get rid of the mistakes and excesses of the boom. Among

the miscellaneous devices are holidays, bank holidays, the issuance of

scrip, guarantees of liabilities, issuance of government debt, deposit in-

surance and the formation of special institutions like the Reconstruction

Finance Corporation in the United States (in 1932) or the Istituto per la

Ricostruzione Industriale (IRI) in Italy (in 1933). The Italian literature

calls the process the ‘salvage’ of banks and companies; the British in

1974–1975 referred to saving the fringe banks as a ‘lifeboat’ operation.

The questions related to a domestic lender of last resort are the focus

of Chapter 11—primarily whether there should be a lender of last resort,

who this lender should be and how it should operate. A key topic is

‘moral hazard’—if investors are confident that they will be ‘bailed out’

by a lender of last resort, their self-reliance may be weakened. But on the

other hand, the priority may be to stop the panic, to ‘save the system

today’ despite the adverse effects on the incentives of investors. If there is

a lender of last resort, however, whom should it save? Insiders? Outsiders

and insiders? Only the solvent, if illiquid? But solvency depends on the

extent and duration of the panic. These are political questions, and they

are raised in particular when it becomes necessary to legislate to increase

the capital of the Federal Deposit Insurance Corporation (FDIC) or the

Federal Savings and Loan Insurance Corporation (FSLIC) when one or the

other runs out of funds to lend to banks in trouble in time of acute stress.

The issue was particularly acute in the 1990s in Japan, where the collapse

of the Nikkei stock bubble in 1990 uncovered all sorts of bad real estate

loans by banks, credit unions, and other financial houses, confronting

the government with the neuralgic question of how much of a burden

to put on the taxpayer. Particularly troubling was the catatonic state of

government in Japan in the 1990s, slow to decide how to meet the crisis

and slower to act.

The penultimate chapter centers on the need for an international

lender of last resort to provide global monetary stability even though

there is no responsible government or agency of government with the

de jure responsibility for providing this public good. U.S. government

support for Mexico, first in 1982 and again in 1994 was justified on the

grounds that countries of the North American Free Trade Agreement

(NAFTA) should stick together and that assistance to Mexico would

dampen or neutralize the contagion effect and prevent a collapse of

lending to the ‘emerging market’ countries of Brazil and Argentina and

other developing countries. The sharp depreciation of the Thai baht in

the early summer of 1997 triggered crises in nearby Asian countries in-

cluding Indonesia, Malaysia, and South Korea as well as in Singapore,

Hong Kong, and Taiwan.

The last chapter seeks to answer two questions; the first is why there

has been so much economic turmoil in the international financial econ-

omy in the last thirty years, and the second is whether an international

lender of last resort would have made a difference. The International

Monetary Fund was established in the 1940s to act as an international

lender of last resort and to fill an institutional vacuum; the view was

that financial crises in the 1920s and the 1930s would have been less

severe had there been an international lender of last resort. The large

number of crises in the last thirty years leads to the question of whether

the presence of the IMF as a supplier of national currencies to countries

with financial crises encouraged profligate national financial policies.

Financial arrangements need a lender of last resort to prevent the es-

calation of the panics that are associated with crashes in asset prices. But

the commitment that a lender is needed should be distinguished from

the view that individual borrowers will be ‘bailed out’ if they become

over-extended. For example, uncertainty about whether New York City

would be helped, and by whom, may have proved just right in the long

run, so long as help was finally provided, and so long as there was doubt

right to the end as to whether it would be. This is a neat trick: always

come to the rescue, in order to prevent needless deflation, but always

leave it uncertain whether rescue will arrive in time or at all, so as to in-

still caution in other speculators, banks, cities, or countries. In Voltaire’s

Candide, the head of a general was cut off ‘to encourage the others.’ A

sleight of hand may be necessary to ‘encourage’ the others (without,

of course, cutting off actual heads) to participate in the lender of last

resort activities because the alternative is likely to have very expensive

consequences for the economic system.

The chapter-by-chapter story

The background to the analysis, and a model of speculation, credit ex-
pansion, financial distress at the peak, and then crisis that ends in a panic
and crash is presented in Chapter 2. The model follows the early classi-
cal ideas of ‘overtrading’ followed by ‘revulsion’ and ‘discredit’—musty
terms used by earlier generations of economists including Adam Smith,
John Stuart Mill, Knut Wicksell, and Irving Fisher. The same concepts
were developed by the late Hyman Minsky, who argued that the finan-
cial system is unstable, fragile, and prone to crisis. The Minsky model
has great explanatory power for earlier crises in the United States and
in Western Europe, for the asset price bubbles in Japan in the second
half of the 1980s and in Thailand and Malaysia and the other countries

in Southeast Asia in the mid-1990s, and for the bubble in U.S. stocks,

especially those traded on the NASDAQ, at the end of the 1990s.

The mania phase of the economic expansion is the subject of

Chapter 3. The central issue is whether speculation can be destabilizing

as well as stabilizing—in other words, whether markets are always ratio-

nal. The nature of the outside, exogenous shock that triggers the mania is

examined in different historical settings including the onset and the end

of a war, a series of good harvests and a series of bad harvests, the open-

ing of new markets and of new sources of supply and the development of

different innovations—the railroad, electricity, and e-mail. A particular

recent form of displacement that shocks the system has been finan-

cial liberalization or deregulation in Japan, the Scandinavian countries,

some of the Asian countries, Mexico, and Russia. Deregulation has led to

monetary expansion, foreign borrowing, and speculative investment.4

Investors have speculated in commodity exports, commodity imports,

agricultural land at home and abroad, urban building sites, railroads, new

banks, discount houses, stocks, bonds (both foreign and domestic), glam-

our stocks, conglomerates, condominiums, shopping centers and office

buildings. Moderate excesses burn themselves out without damage to

the economy although individual investors encounter large losses. One

question is whether the euphoria of the economic upswing endangers

financial stability only if it involves at least two or more objects of specu-

lation, a bad harvest, say, along with a railroad mania or an orgy of land

speculation, or a bubble in real estate and in stocks at the same time.

The monetary dimensions of both manias and panics are analyzed in

Chapter 4. The occasions when a boom or a panic has been triggered

by a monetary event—a recoinage, a discovery of precious metals, a

change in the ratio of the prices of gold and silver under bimetallism,

an unexpected success of some flotation of a stock or bond, a sharp

reduction in interest rates as a result of a massive debt conversion, or

a rapid expansion of the monetary base—are noted. A sharp increase

in interest rates may also cause trouble through disintermediation, as

depositors flee banks and thrift institutions; the long-term securities still

owned by these institutions fall in price. Innovations in finance, as in

productive processes, can shock the system and lead to overinvestment

in some types of financial services.5

The difficulty of managing the monetary mechanism to avoid ma-

nias and bubbles is stressed in this edition. Money is a public good but

monetary arrangements can be exploited by private parties. Banking,

moreover, is difficult to regulate. The current generation of monetarists

insists that many, perhaps most, of the cyclical difficulties of the

past have resulted from mismanagement of the monetary mechanism.

Such mistakes were frequent and serious. The argument advanced in

Chapter 4, however, is that even when the supply of money was nearly

adjusted to the demands of an economy the monetary mechanism did

not stay right for very long. When government produces one quantity

of the public good, money, the public may proceed to produce many

close substitutes for money, just as lawyers find new loopholes in tax

laws about as fast as legislation closes up older loopholes. The evolution

of money from coins to bank notes, bills of exchange, bank deposits and

finance paper illustrates the point. The Currency School might be right

about the need for a fixed supply of money, but it is wrong to believe

that the money supply could be fixed forever.

The emphasis in Chapter 5 is on the domestic aspects of the crisis stage.

One question is whether manias can be halted by official warning—

moral suasion or jawboning. The evidence suggests that they cannot, or

at least that many crises followed warnings that were intended to head

them off. One widely noted remark was that of Alan Greenspan, chair-

man of the Federal Reserve Board, who stated on December 6, 1996, that

he thought that the U.S. stock market was irrationally exuberant. The

Dow Jones industrial average was 6,600; subsequently the Dow peaked

at 11,700. The NASDAQ had been at 1,300 at the time of the Greenspan

remark and peaked at more than 5,000 four years later. A similar warning

had been issued in February 1929 by Paul M. Warburg, a private banker

who was one of the fathers of the Federal Reserve system, without slow-

ing for long the stock market’s upward climb. The nature of the event

that ultimately produces a turning point is discussed: some bankruptcy,

defalcation or troubled area revealed or rumored, a sharp rise in the

central bank discount rate to halt the hemorrhage of cash into domestic

circulation or abroad. And then there is the interaction of falling

prices—the crash—and its impact on the liquidity in the economy.

Domestic propagation of the mania and then the panic is the subject

of Chapter 6. The inference from history is that a boom in one market

spills over into other markets. ‘A housing boom in Houston is an oil

boom in drag.’ Thus a financial crisis may be more serious if two or more

assets are the subject of speculation. When and if a crash comes, the

banking system may seize and banks may ration credit to reduce the

likelihood of large loan losses even if the money supply is unchanged;

indeed the money supply may be increasing. The connections between

price changes in the stock and commodities markets were especially

strong in New York in 1921 and the late 1920s, and those linking stocks

and real estate were strong in the late 1980s in Japan and in Norway,

Sweden and Finland.

The policy implications

The appearance of a mania or a bubble raises the policy issue of whether
governments should seek to moderate the surge in asset prices to reduce
the likelihood or the severity of the ensuing financial crisis or to ease
the economic hardship that occurs when asset prices begin to decline.
Virtually every large country has established a central bank as a domestic
‘lender of last resort’ to reduce the likelihood that a shortage of liquidity
would cascade into solvency crisis. The practice leads to the question
of the role for an international ‘lender of last resort’ that would assist
countries in stabilizing the foreign exchange value of their currencies and
reduce the likelihood that a sharp depreciation of the currencies because
of a shortage of liquidity would trigger large numbers of bankruptcies.
During a crisis, many firms that had recently appeared robust tumble
into bankruptcy because the failure of some firms often leads to a decline
in asset prices and a slowdown in the economy. When asset prices de-
cline sharply, government intervention may be desirable to provide the
public good of stability. During financial crises the decline in asset prices
may be so large and abrupt that the price changes become self-justifying.
When asset prices tumble sharply, the surge in the demand for liquidity
may drive many individuals and firms into bankruptcy, and the sale of
assets in these distressed circumstances may induce further declines in
asset prices. At such times a lender of last resort can provide financial sta-

bility or attenuate financial instability. The dilemma is that if investors

knew in advance that governmental support would be forthcoming un-

der generous dispensations when asset prices fall sharply, markets might

break down somewhat more frequently because investors will be less

cautious in their purchases of asset and of securities.

The role of the lender of last resort in coping with a crash or panic is

fraught with ambiguity and dilemma. Thomas Joplin commented on the

behavior of the Bank of England in the crisis of 1825, ‘There are times

when rules and precedents cannot be broken; others, when they cannot

be adhered to with safety.’ Breaking the rule establishes a precedent and

a new rule that should be adhered to or broken as occasion demands.

In these circumstances intervention is an art rather than a science. The

general rules that the state should always intervene or that the state

should never intervene are both wrong. This same question of interven-

tion reappeared with whether the U.S. government should have rescued

Chrysler in 1979, New York City in 1975, and the Continental Illinois

Bank in 1984. Similarly, should the Bank of England have rescued Baring

Brothers in 1995 after the rogue trader Nick Leeson in its Singapore

branch office had depleted the firm’s capital through hidden transac-

tions in option contracts? The question appears whenever a group of

borrowers or banks or other financial institutions incurs such massive

losses that they are likely to be forced to close, at least under their

current owners. The United States acted as the lender of last resort at the

time of the Mexican financial crisis at the end of 1994. The International

Monetary Fund acted as the lender of last resort during the Russian

financial crisis of 1998, primarily after prodding by the U.S. and German

governments. Neither the United States nor the International Monetary

Fund was willing to act as a lender of last resort during the Argentinean

financial crisis at the beginning of 2001. The list of episodes highlights

that coping with financial crises remains a major contemporary problem.

The conclusion of The World in Depression, 1929–1939, was that the

1930s depression was wide, deep, and prolonged because there was no

international lender of last resort.2 Great Britain was unable to act in

that capacity because it was exhausted by World War I, obsessed with

pegging the British pound to gold at its pre-1914 parity and groggy

from the aborted economic recovery of the 1920s. The United States

was unwilling to act as an international lender of last resort; at the time

few Americans had thought through what the United States might have

done in that role. This book extends the analysis of the responsibilities

of an international lender of last resort.

The monetary aspects of manias and panics are important and are

examined at length in several chapters. The monetarist view—at least

one monetarist view—is that the mania would not occur if the rate

of growth of the money supply were stabilized or constant. Many of

the manias are associated with the surge in the growth of credit, but

some are not; a constant money supply growth rate might reduce the

frequency of manias but is unlikely to consign them to the dustbins of

history. The rate of increase in U.S. stock prices in the second half of the

1920s was exceptionally high relative to the rate of growth of the money

supply, and similarly the rate of increase in the prices of NASDAQ stocks

in the second half of the 1990s was exceedingly high relative to the

rate of growth of the U.S. money supply. Some monetarists distinguish

between ‘real’ financial crises that are caused by the shrinkage of the

monetary base or high-powered money and ‘pseudo’ crises that do not.

The financial crises in which the monetary base changes early or late

in the process should be distinguished from those in which the money

supply did not increase significantly.

Chain letters, pyramid schemes, Ponzi finance, manias, and bubbles

Chain letters, bubbles, pyramid schemes, Ponzi finance, and manias are
somewhat overlapping terms. The generic term is nonsustainable patterns
of financial behavior, in that asset prices today are not consistent with
asset prices at distant future dates. The Ponzi schemes generally involve
promises to pay an interest rate of 30 or 40 or 50 percent a month; the
entrepreneurs that develop these schemes always claim they have discov-
ered a new secret formula so they can earn these high rates of return.
They make the promised interest payments for the first few months with
the money received from their new customers attracted by the promised
high rates of return. But by the fourth or fifth month the money received
from these new customers is less than the monies promised the first sets
of customers and the entrepreneurs go to Brazil or jail or both.
A chain letter is a particular form of pyramid arrangement; the proce-
dure is that individuals receive a letter asking them to send $1 (or $10 or
$100) to the name at the top of the pyramid and to send the same letter to
five friends or acquaintances within five days; the promise is that within
thirty days you will receive $64 for each $1 ‘investment.’
Pyramid arrangements often involve sharing of commission incomes
from the sale of securities or cosmetics or food supplements by those who
actually make the sales to those who have recruited them to become sales
personnel.
The bubble involves the purchase of an asset, usually real estate or
a security, not because of the rate of return on the investment but in

anticipation that the asset or security can be sold to someone else at an

even higher price; the term ‘the greater fool’ has been used to suggest

the last buyer was always counting on finding someone else to whom the

stock or the condo apartment or the baseball cards could be sold.

The term mania describes the frenzied pattern of purchases, often an

increase in prices accompanied by an increase in trading volumes; indi-

viduals are eager to buy before the prices increase further. The term bub-

ble suggests that when the prices stop increasing, they are likely—indeed

almost certain—to decline.

Chain letters and pyramid schemes rarely have macroeconomic conse-

quences, but rather involve isolated segments of the economy and involve

the redistribution of income from the late-comers to those who were in

early. Asset price bubbles have often been associated with economic eu-

phoria and increases in both business and household spending because

the futures are so much brighter, at least until the bubble pops.

Virtually every mania is associated with a robust economic expansion,

but only a few economic expansions are associated with a mania. Still

the association between manias and economic expansions is sufficiently

frequent and sufficiently uniform to merit renewed study.

Some economists have contested the view that the use of the term

bubble is appropriate because it suggests irrational behavior that is highly

unlikely or implausible; instead they seek to explain the rapid increase

in real estate prices or stock prices in terms that are consistent with

changes in the economic fundamentals. Thus the surge in the prices of

NASDAQ stocks in the 1990s occurred because investors sought to buy

shares in firms that would repeat the spectacular successes of Microsoft,

Intel, Cisco, Dell, and Amgen.

Manias and credit

The production of books on financial crises is counter-cyclical. A spate
of books on the topic appeared in the 1930s following the U.S. stock
market bubble in the late 1920s and the subsequent crash and the Great
Depression. Relatively few books on the subject appeared during the
several decades immediately after World War II, presumably because the
recessions from the 1940s to the 1960s were mild.

The first edition of this book was published in 1978, after U.S.

stock prices had declined by 50 percent in 1973 and 1974 following a

fifteen-year bull market in stocks; the stock market debacle and the U.S.

recession led to the bankruptcies of the Penn-Central railroad, several of

the large steel companies, and a large number of Wall Street brokerage

firms. New York City was on the verge of default on its outstanding

bonds and was saved from insolvency by the State of New York. Not

quite a crash, unless you were a senior official or a stockholder in one

of the firms that failed or the Mayor of New York City.

This edition appears after thirty tumultuous years in global financial

markets, a period without a good historical precedent. There was a mania

in real estate and stocks in Japan in the 1980s and a crash in the 1990s;

during the same period there was a mania in real estate and stocks in

Finland and Norway and Sweden and then a crash. There was a mania in

U.S. stocks in the second half of the 1990s—the subsequent 40 percent

decline in stock prices probably felt like a crash for those who owned

large amounts of Enron, MCIWorldCom, and dot.com stocks. Compar-

isons can be made between the stock market bubbles in the United States

in the 1920s and the 1990s, and between these U.S. bubbles and the one

in Japan in the 1980s.

The big ten financial bubbles

The Dutch Tulip Bulb Bubble 1636

The South Sea Bubble 1720

The Mississippi Bubble 1720

The late 1920s stock price bubble 1927–1929

The surge in bank loans to Mexico and other developing countries

in the 1970s

The bubble in real estate and stocks in Japan 1985–1989

The 1985–1989 bubble in real estate and stocks in Finland, Norway

and Sweden

The bubble in real estate and stocks in Thailand, Malaysia, Indonesia

and several other Asian countries 1992–1997

The surge in foreign investment in Mexico 1990–1993

The bubble in over-the-counter stocks in the United States

1995–2000

The earliest bubble noted in the box involved tulip bulbs in the Nether-

lands in the seventeenth century, and especially the rare varieties of

bulbs. Two of the bubbles—one in Great Britain and one in France—

occurred at more or less the same time, at the end of the Napoleonic

Wars. There were manias and financial crises in the nineteenth cen-

tury that were mostly associated with the failures of banks, often after

an extended investment in infrastructure such as canals and railroads.

Foreign exchange crises and banking crises were frequent between 1920

and 1940. The percentage increases in stock prices in the last thirty years

have been larger than in earlier periods. Bubbles in real estate and in

stocks have often occurred together; some countries have experienced

a bubble in real estate but not in stocks, while the United States had a

stock price bubble in the second half of the 1990s but not one in real

estate.

Manias are dramatic but they have been infrequent; only two have oc-

curred in U.S. stocks in two hundred years. Manias generally have been

associated with the expansion phase of the business cycle, in part because

the euphoria associated with the mania leads to increases in spending.

During the mania the increases in the prices of real estate or stocks or in

one or several commodities contribute to increases in consumption and

investment spending that in turn lead to accelerations in the rates of eco-

nomic growth. The seers in the economy forecast perpetual economic

growth and some venturesome ones proclaim no more recessions—

the traditional business cycles of the market economies have become

obsolete. The increase in the rate of economic growth induces investors

and lenders to become more optimistic about the future and asset prices

increase more rapidly—at least for a while.

Manias—especially macro manias—are associated with economic eu-

phoria; business firms become increasingly up-beat and investment

spending surges because credit is plentiful. In the second half of the

1980s Japanese industrial firms could borrow as much as they wanted

from their friendly bankers in Tokyo and in Osaka; money seemed ‘free’

(money always seems free in manias) and the Japanese went on a con-

sumption spree and an investment spree. The Japanese purchased ten

thousand items of French art. A racetrack entrepreneur from Osaka paid

$90 million for Van Gogh’s Portrait of Dr Guichet, at that time the high-

est price ever paid for a painting. The Mitsui Real Estate Company paid

$625 million for the Exxon Building in New York even though the initial

asking price had been $310 million; Mitsui wanted to get in the Guin-

ness Book of World Records for paying the highest price ever for an office

building. In the second half of the 1990s in the United States newly-

established firms in the information technology industry and bio-tech

had access to virtually unlimited funds from the venture capitalists who

believed they would profit greatly when the shares in these firms were

first sold to the public.

The 1990s bubble in NASDAQ stocks

Stocks in the United States are traded on either the over-the-counter mar-
ket or on one of the organized stock exchanges, principally the New
York Stock Exchange or the American Stock Exchange or one of the re-
gional exchanges in Boston, Chicago, and Los Angeles/San Francisco. The
typical pattern was that shares of young firms would initially be traded
on the over-the-counter market and then most of these firms would in-
cur the costs associated with obtaining a listing on the New York Stock
Exchange because they believed that such a listing would broaden the
market for their stocks and lead to higher prices. Some very successful
new firms associated with the information technology revolution of the
1990s—Microsoft, Cisco, Dell, Intel—were exceptions to this pattern; they
chose not to obtain a listing on the New York Stock Exchange because
they believed that trading stocks electronically in the over-the-counter
market was superior to trading stocks by the open-outcry method used
on the New York Stock Exchange.
In 1990 the market value of stocks traded on the NASDAQ was 11
percent of that of the New York Stock Exchange; the comparable figures
for 1995 and 2000 were 19 percent and 42 percent. The annual average
percentage rate of increase in the market value of NASDAQ stocks was
30 percent during the first half of the decade and 46 percent during the
next four years. A few of the newer firms traded on the NASDAQ would
eventually become as successful and as profitable as Microsoft and Intel
and so high prices for their stocks might be warranted. The likelihood

that all of the firms whose stocks were traded on the NASDAQ would be

as successful as Microsoft was extremely small, since it implied that the

profit share of U.S. GDP would be two to three times higher than it ever

had been previously.

The bubble in U.S. stock prices in the second half of the 1990s was asso-

ciated with a remarkable U.S. economic boom; the unemployment rate

declined sharply, the inflation rate declined, and the rates of economic

growth and productivity both accelerated. The U.S. government devel-

oped its largest-ever fiscal surplus in 2000 after having had its largest-

ever fiscal deficit in 1990. The remarkable performance of the real econ-

omy contributed to the surge in U.S. stock prices that in turn led to

the increase in investment spending and consumption spending and

an increase in the rate of U.S. economic growth and the spurt in fiscal

revenues.

U.S. stock prices began to decline in the spring of 2000; in the next

three years U.S. stocks as a group lost about 40 percent of their value

while the prices of NASDAQ stocks declined by 80 percent.

One of the themes of this book is that the bubbles in real estate and

stocks in Japan in the second half of the 1980s, the similar bubbles

in Bangkok and the financial centers in the nearby Asian countries in

the mid-1990s, and the bubble in U.S. stock prices in the second half

of the 1990s were systematically related. The implosion of the bubble

in Japan led to an increase in the flow of money from Japan; some of

this money went to Thailand and Malaysia and Indonesia and some

went to the United States. The increase in the inflow of money led to

the appreciation of their currencies in the foreign exchange market and

to increases in the prices of real estate and of securities available in

these countries. When the bubbles in the countries in Southeast Asia

imploded, there was another surge in the flow of money to the United

States as these countries repaid some of their foreign indebtedness; the

U.S. dollar appreciated in the foreign exchange market and the annual

U.S. trade deficit increased by $150 billion and reached $500 billion.

The increase in the flow of money to a country from abroad almost

always led to increases in the prices of securities traded in that country

as the domestic sellers of the securities to the foreigners used a very

high proportion of their receipts from these sales to buy other securities

from other domestic residents. These domestic residents in turn similarly

used a large part of their receipts to buy other domestic securities from

other domestic residents. These transactions in securities occurred at

ever-increasing prices. It’s as if the cash from the sale of securities to

foreigners was the proverbial ‘hot potato’ that was rapidly passed from

one group of investors to others, at ever-increasing prices.

A striking story of a mania and a crash

The sharp increase in real estate prices and stock prices in Japan in
the 1980s was associated with a boom in the economy; Japan as Number
One: Lessons for America1 was a bestseller in the country. The banks head-
quartered in Tokyo and Osaka increased their deposits and their loans
and their capital much more rapidly than banks headquartered in the
United States and in Germany and in the other European countries; usu-
ally seven or eight of the ten largest banks in the world were Japanese.
Then at the beginning of the 1990s real estate prices and stock prices in
Japan imploded. Within a few years many of the leading Japanese banks
and financial institutions were broke, kaput, bankrupt, and insolvent,
and remained in business only because of an implicit understanding
that the Japanese government would protect the depositors from finan-
cial losses if the banks were closed. A striking story of a mania and a
crash—but a crash without a panic, apparently because of the belief that
government would socialize the loan losses.

Three of the Nordic countries—Norway, Sweden, and Finland—repli-

cated the Japanese asset price bubble at the same time. A boom in real

estate prices and stock prices in the second half of the 1980s associated

with financial liberalization was followed by a collapse in real estate

prices and stock prices and the failure of the banks.

Mexico had been one of the great economic success stories of the early

1990s as it prepared to enter the North American Free Trade Agreement.

The Bank of Mexico had adopted a tough contractive monetary policy

that reduced the inflation rate from 140 percent to less than 10 percent in

a four-year period; during the same period several hundred government-

owned firms were privatized and business regulations were liberalized.

Foreign capital flowed to Mexico because the real rates of return on

government securities were high and because the prospective profit rates

on industrial investments were also high. The universal expectation was

that Mexico would become the low-wage, low-cost base for producing

automobiles and washing machines and many other manufactured

goods for the U.S. and Canadian markets. Because the large inflow of

foreign savings led to a real appreciation of the peso, Mexico developed

a trade deficit that reached 7 percent of its GDP. Mexico’s external debt

was 60 percent of its GDP and the country obtained the money to pay the

interest on its increasing foreign indebtedness from the inflow of new

investments. Then several political incidents, partly associated with the

presidential election and transition in 1994, led to a sharp decline in the

inflow of foreign funds, the Mexican government was unable to continue

to support the peso in the foreign exchange market, and the currency

lost more than half of its value in several months. Once again the depre-

ciation of the peso resulted in large loan losses, and the Mexican banks —

which had been privatized in the previous several years—failed.

In the mid-1990s real estate prices and stock prices surged in Bangkok,

Kuala Lumpur, and Indonesia; these were the ‘dragon economies’ that

seemed likely to emulate the economic successes of the ‘Asian tigers’

of the previous generation—Taiwan, South Korea, Hong Kong, and Sin-

gapore. Japanese firms and European and U.S. firms began to invest in

these countries as low-wage, low-cost sources of supply, much as U.S.

firms had invested in Mexico as a source of supply for the North Ameri-

can market. European and Japanese banks rapidly increased their loans

in these countries. The domestic lenders in Thailand then experienced

large loan losses on their domestic credits in the autumn and winter

of 1996 because they had not been sufficiently discriminating in their

evaluations of the willingness of Thai borrowers to pay the interest on

their indebtedness. Foreign lenders sharply reduced their purchases of

Thai securities, and then the Bank of Thailand, much like the Bank of

Mexico thirty months earlier, did not have the foreign exchange reserves

to support its currency in the foreign exchange market. The sharp de-

cline in the foreign exchange value of the Thai baht in early July 1997

led to capital outflows from the other Asian countries and the foreign

exchange values of their currencies (except for the Hong Kong dollar

and the Chinese yuen, which remained rigidly pegged to the U.S. dollar)

declined by 30 percent or more. The Indonesian rupiah lost 80 percent

of its value in the foreign exchange market. Most of the banks in the

area—except for those in Hong Kong and Singapore—would have been

bankrupt in any reasonable ‘mark-to-market’ test. The crises spread from

Asia to Russia, there was a debacle in the ruble, and the country’s banking

system collapsed in the summer of 1998. Investors then became more

Anatomy of a Typical Crisis

For historians each event is unique. In contrast economists maintain
that there are patterns in the data and particular events are likely to
induce similar responses. History is particular; economics is general.
The business cycle is a standard feature of market economies; increases
in investment in plant and equipment lead to increases in house-
hold income and the rate of growth of national income. Macroeco-
nomics focuses on the explanations for the cyclical variations in the
rate of growth of national income relative to its long-run trend rate of
growth.

An economic model of a general financial crisis is presented in this

chapter, while the various phases of the speculative manias that lead

to crises are illustrated in the following chapters. This model of general

financial crises covers the boom and the subsequent bust and centers

on the episodic nature of the manias and the subsequent crises. This

model differs from those that focus on the variations and the period-

icity of economic expansions and contractions, including the Kitchin

inventory cycle of thirty-nine months, the Juglar cycle of investment

in plant and equipment that has a periodicity of seven or eight years

and the Kuznets cycle of twenty years that highlights the rise and fall in

housing construction.1 In the first two-thirds of the nineteenth century,

crises occurred regularly at ten-year intervals (1816, 1826, 1837, 1847,

1857, 1866), thereafter crises occurred less regularly (1873, 1907, 1921,

1929).

A model developed by Hyman Minsky is used to interpret the financial

crises in the United States, Great Britain, and other market economies.

Minsky highlighted the pro-cyclical changes in the supply of credit,

which increased when the economy was booming and decreased during

economic slowdowns. During the expansion phase investors became

more optimistic about the future and they revised upward their estimates

of the profitability of a wide range of investments and so they became

more eager to borrow. At the same time, both the lenders’ assessments

of the risk of individual investments and their risk averseness declined

and so they became more willing to make loans, including some for

investments that previously had seemed too risky.

When the economic conditions slowed, the investors became less op-

timistic and more cautious. At the same time, the loan losses of the

lenders increased and they became much more cautious.

Minsky believed that the pro-cyclical increases in the supply of credit

in good times and the decline in the supply of credit in less buoyant

economic times led to fragility in financial arrangements and increased

the likelihood of financial crisis.

This model is in the tradition of the classical economists, including

John Stuart Mill, Alfred Marshall, Knut Wicksell, and Irving Fisher, who

also focused on the instability in the supply of credit. Minsky followed

Fisher and attached great importance to the behavior of heavily indebted

borrowers, particularly those that increased their indebtedness in the ex-

pansion to finance the purchase of real estate or stocks or commodities

for short-term capital gains. The motive for these transactions was that

the anticipated rates of increase in the prices of these assets would ex-

ceed the interest rates on the funds borrowed to finance their purchases.

When the economy slowed some of these borrowers might be disap-

pointed because the rates of increase in the prices of the assets proved

smaller than the interest rates on the borrowed money and so many

would become distress sellers.

The nature of the shock varies from one speculative boom to another.

The shock in the United States in the 1920s was the rapid expansion

of automobile production and associated development of highways to-

gether with the electrification of much of the country and the rapid

expansion of the number of households with telephones. The shocks

in Japan in the 1980s were financial liberalization and the surge in the

foreign exchange value of the yen. The shock in the Nordic countries in

the 1980s was financial liberalization.

The shock in the Asian countries in the 1990s was the implosion of

the asset price bubble in Japan and the appreciation of the yen which led

to increases in the inflows of money from Tokyo together with financial

liberalization at home. The shock in the United States in the 1990s was

the revolution in information technology and new and lower-cost forms

of communication and control that involved the computer, wireless

communication, and e-mail. At times the shock has been outbreak of

war or the end of a war, a bumper harvest or crop failure, the widespread

adoption of an invention with pervasive effects—canals, railroads. An

unanticipated change of monetary policy has been a major shock.

Financial Crisis: A Hardy Perennial

The years since the early 1970s are unprecedented in terms of the volatil-
ity in the prices of commodities, currencies, real estate and stocks, and
the frequency and severity of financial crises. In the second half of the
1980s, Japan experienced a massive bubble in its real estate and in its
stock markets. During the same period the prices of real estate and of
stocks in Finland, Norway, and Sweden increased even more rapidly than
in Japan. In the early 1990s, there was a surge in real estate prices and
stock prices in Thailand, Malaysia, Indonesia, and most of the nearby
Asian countries; in 1993, stock prices increased by about 100 percent
in each of these countries. In the second half of the 1990s, the United
States experienced a bubble in the stock market; there was a mania in
the prices of the stocks of firms in the new industries like information
technology and the dot.coms.

Bubbles always implode; by definition a bubble involves a non-

sustainable pattern of price changes or cash flows. The implosion of

the asset price bubble in Japan led to the massive failure of a large num-

ber of banks and other types of financial firms and more than a decade

of sluggish economic growth. The implosion of the asset price bubble

in Thailand triggered the contagion effect and led to sharp declines in

stock prices throughout the region. The exception to this pattern is that

the implosion of the bubble in U.S. stock prices in 2000 led to declines

in stock prices for the next several years but the ensuing recession in

2001 was brief and shallow.

The changes in the foreign exchange values of national currencies

during this period were often extremely large. At the beginning of the

1970s, the dominant market view was that the foreign exchange value of

the U.S. dollar might decline by 10 to 12 percent to compensate for the

higher inflation rate in the United States than in Germany and in Japan

in the previous few years. In 1971 the United States abandoned the U.S.

gold parity of $35 an ounce that had been established in 1934; in the

next several years there were two modest increases in the U.S. gold parity

although the U.S. Treasury would no longer buy and sell gold. The effort

to retain a modified version of the Bretton Woods system of pegged

exchange rates that was formalized in the Smithsonian Agreement of

1972 failed and there was a move to floating exchange rates early in

1973; in the 1970s the U.S. dollar lost more than half of its value relative

to the German mark and the Japanese yen. The U.S. dollar appreciated

significantly in the first half of the 1980s, although not to the levels of

the early 1970s. A massive foreign exchange crisis involved the Mexican

peso, the Brazilian cruzeiro, the Argentinean peso, and the currencies of

many of the other developing countries in the early 1980s. The Finnish

markka, the Swedish krona, the British pound, the Italian lira, and the

Spanish peseta were devalued in the last six months of 1992; most of

these currencies depreciated by 30 percent relative to the German mark.

The Mexican peso lost more than half of its value in terms of the U.S.

dollar during the presidential transition in Mexico at the end of 1994

and the beginning of 1995. Most of the Asian currencies—the Thai baht,

the Malaysian ringgit, the Indonesian rupiah, and the South Korean

won—depreciated sharply in the foreign exchange market during the

Asian Financial Crisis in the summer and autumn of 1997.

The changes in the market exchange rates for these individual cur-

rencies were almost always much larger than those that would have

been inferred from the differences between national inflation rates in

particular countries. The scope of ‘overshooting’ and ‘undershooting’ of

national currencies was both more extensive and much larger than in

any previous period.