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Bubbles, Panics and Crashes Lecture Notes 22/23
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Bubbles, Panics and Crashes Lecture Notes 22/23
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Bubbles, Panics and CrashesLecture 2: Financial crises in historical perspective (week 2)
Rogoff and Reinhart this time is different
Financial crises in historical context
- Tulipmania 1636/37
- Mississippi Bubble 1719/20
- South Sea Bubble 1720
- Baring Crisis 1890
- Great Depression 1929
- Asian Crisis 1997
Number of financial crises from 1636-1997 (Kindleberger/Aliber): 38
Tulipmania (1636/37)
The tulips in question were originally wildflowers from central Asia but were subsequently cultivated
for Dutch people’s gardens. From something exotic, they quickly turned into a convenient way to
demonstrate your wealth. 17th century Holland was both rich and nouveau riche; very suddenly, a lot
of people wanted to have tulips and had the means to afford them.
The natural scarcity of tulips due to the difficulties of cultivating them: at times there were only 12
tulips in the whole of Holland. High demand and low supply make the prices shoot up, people start
buying tulips only to sell them at an even higher price. Tulip purchases are increasingly financed by
borrowing money. Derivatives, forward contracts and other financial innovations emerge in the
process.
In early 1637, one tulip cost as much as a luxurious city house in central Amsterdam. By February
1637, the bubble burst at an auction in Haarlem: prices declined dramatically within a few days,
many people are ruined as they had taken out loans to buy, now worthless, tulips. The government
intervened (to a certain extent) to avoid the worst repercussions of the bust.
Mississippi bubble 1719/20
In 1719, John Law (a Scot working for the French king) founded the Compagnie des Indes
Occidentales as a joint stock company. The goal of the company was to exploit the riches of the
Mississippi valley. The 1719 issue price of shares is 500 livres but in 1720, shares are traded at
18,000 lives (factor 36). Joint stock companies and shares were new altogether to the wider French
public; people of very modest means buy shares in the hope of ever-increasing prices.
News from Mississippi valley suggest, above all, a lot of swamps and mosquitos and not the
promised new Eldorado. John Law attempts to stem the tide by circulating news suggesting the
opposite remain unsuccessful. The bubble burst spectacularly in 1720 and Law had to leave the
country.
,What do these two crises have in common?
- Exogenous events that provide new highly profitable opportunities for investment
- A commodity is turned into an investment object and bubble begins
- This investment booms is supported by bank money (later in history: accommodative
monetary policy) and/or financial innovation.
- People who wouldn’t normally participate in this kind of business enter the market (most
usually for the first – and often last – time in their lives)
- Financial innovations are often difficult to understand, especially for outsiders
- A state of euphoria undermines investors’ ability to differentiate between sound and
unsound investment prospects
- Kindleberger: whenever the outsiders go in, the insiders go out and the crash follows.
Similarities of financial crises: a typical pattern
What is a bubble?
A financial asset (e.g. a stock) exhibits a bubble when its price exceeds the present value of the
future income (such as interest or dividends).
There are two problems
- What is the present value of the future income?
- Isn’t the present value of the future income mean to equal the price of a financial asset?
Economic theory has found it extremely difficult to understand bubbles as they seem to challenge
very fundamentally some key assumptions of modern economics.
Solutions to this paradox
, - This is currently one of the, if not the big topic in economics.
- Giving up (at least partly) on the “rationality assumption” of modern economics
- Path-breaking: Robert Shillers’ Irrational Exuberance (1999)
- Differentiation between individual rationalist and collective irrationality
- Focus on principal-agent relations and issues of asymmetric information might allow to
reconcile the existence of bubbles with the key assumptions of modern economics
- Theories of financial crises (and economic crises more general) have often been (or appear
to have been) politically motivated
- John Stuart Mill: “Of the tendency of profits to a minimum” (Principles of Political Economy)
- Marx: “Law of the tendency for the rate of profit to fall” (Das Kapital)
- More specifically about financial crises: Andrew Gunder Frank, Immanuel Wallerstein and
other leading figures of the World Systems Theory.
Can we predict a financial crisis?
We cannot predict a financial crisis because as soon as we could, it would not happen. In other
words, most economists did not predict the 2007/08 financial crisis but they did point out to other
fundamental problems which is why those problems are resolved more gradually (slow asset price
decreases as opposed to a crash). This means that our discipline is needed despite of what a lot of
people think.
The above-said however does not rule out that individuals predict a financial crisis correctly (as
NYU’s Nouriel Roubini did). The best advice is do not believe “This time is different” (Reinhart and
Rogoff, 2009).
Why did pre-2007 investors think “this time is different”?
- They believed everything was fine because of globalisation
- The technology boom
- The superior US financial system
- Better understanding of monetary policy
- Phenomenon of securitised debt
, Lecture 2 continued: Financial crises in historical perspective (week 2)
Classification of different crises
A financial crisis is an episode of financial market volatility marked by significant problems of
illiquidity and/or insolvency among financial market-participants (note: needs multiple participants).
Systemically relevant institutions – pre 2008, CBs argued that institutions must be systemically
relevant to cause a financial crisis, however, we now know even small institutions can have an effect.
A banking crisis is financial distress resulting in the erosion of most or all of aggregate banking
system capital. Often happen simultaneously or shortly after one another. In a banking crisis, either
assets come under a lot of pressure (the items they hold are no longer worth what they used to be,
e.g. holding gov bonds that then lose their value, or in extreme cases, default) or liabilities increase.
Banking crises are very hard to spot in real time; we don’t see bank balance sheets.
A currency crisis is a forced change in parity, an international rescue, and abandonment of a pegged
exchange rate.
A twin crisis is when a currency and banking crisis occur in the same or immediately adjoining years.
A government debt crisis is
The frequency of financial crises
The frequency is the annual probability of crisis occurrence.
- Growing frequency of crises in general
- Currency crises increase possible to due democratisation
- Banking and twin crises increase
- The majority of financial crises occur in emerging countries
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