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.