Financial Bubbles and Market
Failure
Prof. Mohamed Amine ISSAMI
Lecture 9
April 03rd, 2024
Agenda
• Overview of Manias, Crashes & Panics
• Explanation of Key Terms & Timeline
• Rational vs. Irrational Exuberance
• Lenders of Last Resort
• Frauds & Scandals
• Article (Homework Assignment)
2
Overview
• Charles Kindleberger (1910-2003)
– Professor of Economics at MIT
– 5th Edition of “Manias…”
• Historical perspective
• Human nature
• Relevance of topics throughout history
– “History is philosophy learned through examples”
Thucydides, 420 BC
3
Bubbles
• Bubble: non-sustainable pattern of price changes
or cash flows:
– Refers to increases in asset prices in the mania phase
of the cycle.
– A bubble is an upward price movement over period
of 15 to 40 months.
• Booms and bubbles are fueled by the expansion of
credit.
4
Big Ten Financial Bubbles
1. Dutch Tulip Bulb Bubble – 1636
2. South Sea Bubble – 1720
3. Mississippi Bubble – 1720
4. Late 1920s Stock Price Bubble – 1927-29
5. Surge in Bank Loans to Mexico, Developing Countries – 1970s
6. Real Estate and Stocks in Japan – 1985-89
7. Real Estate and Stocks in Scandinavia – 1985-89
8. Real Estate and Stocks in SE Asia – 1992-97
9. Foreign Investment in Mexico – 1990-93
10. OTC Markets in the United States – 1995-2000 5
6
7
Manias
• Economic euphoria – money seems “free”.
• Associated with expansion phase of business
cycle:
– Virtually every mania is associated with a robust
economic expansion, but only a few economic
expansions are associated with a mania.
8
Manias
• Increases in real estate, stocks, and/or
commodities leads to increases in consumption
and spending, accelerates economic growth.
• Investors and lenders are optimistic about the
future and asset prices increase more rapidly.
9
Panics & Crashes
• Displacement
– Outside event or shock that changes horizons, expectations,
anticipated profit opportunities, behavior.
– Ex. War – August 1914.
• Can come as a result of distress sales
– Price of assets decline below their purchase price, therefore investors
sell these assets and prices decline further.
• Often precipitated by revelation of misfeasance, malfeasance, or
malversation that occurred during mania
– Frauds & Scandals.
10
Minsky Model
• Hedge Finance
– Anticipated operating income greater than the interest
and scheduled reduction of its indebtedness.
• Speculative Finance
– Anticipated operating income covers interest payments,
must use cash from new loans to repay portion of
maturing loans.
• Ponzi Finance
– Anticipated operating income insufficient to pay
obligations – firm must either increase indebtedness or
sell some assets to generate cash.
11
Currency
vs.
Banking Schools of Thought
Currency School Banking School
• Advocate a firm limit on the • Believe that increases in the
expansion of the money supply to supply of money would not lead
avoid inflation. to inflation as long as these
• Wanted a simple rule to fix the increases were associated with
growth rate of the money supply business transactions.
at 2 or 4 or 5 percent. • Increase of the money supply at
the start of an economic
expansion.
12
Timeline
Economic
Growth
Boom, Bubble
Boom, Bubble
Panic Mania Panic
Mania Crash
Crash
Time
13
Summary
• Manias are times of euphoria, which can lead to
a bubble. When a displacement occurs to “pop”
the bubble, panic may ensue and can lead to a
crash in the market.
• Minsky Model.
• Schools of Thought.
14
Robert J. Shiller
ANXIOUS ABOUT THE NEXT BUBBLE
VIDEO
15
Rational versus Irrational Exuberance
Rational
• Buying based upon genuine, fundamental value.
Irrational
• Increase that is based upon a speculative bubble -
“unsustainable increase in prices brought on by investors’
buying behaviour”.
• Need to understand the value investors have imputed in the
market so we can adjust and plan accordingly if the value
shouldn’t be there.
16
Irrational Exuberance
• Many parts that play a role in irrational exuberance for
the financial world:
– Structural
– Cultural
– Psychological
• There are also many ways to rationalize exuberance.
17
Structural Factors
1. The arrival of the Internet at a time of solid earnings
growth.
2. Triumphalism and the decline of foreign economic rivals.
3. Cultural changes favouring business success or the
Appearance Thereof.
4. A Republican Congress and capital gains tax cut.
5. The baby boom and its perceived effects on the market.
6. An expansion in media reporting of business news.
18
Structural Factors (cont’d)
7. Analysts’ increasingly optimistic forecasts.
8. The expansion of defined contribution pension plans.
9. The growth of mutual funds.
10.The decline of inflation and the effects of money illusion.
11. Expansion of the volume of trade.
12. The rise of gambling opportunities.
19
Amplification Mechanisms
• Type of naturally occurring Ponzi process.
• “Investors, their confidence and expectations
buoyed by past price increases, bid up stock
prices further, thereby enticing more investors to
do the same, so that the cycle repeats again and
again, resulting in amplified response to the
original precipitating factors.”
– Robert Shiller (2000)
20
Psychological Factors
• Quantitative anchors – people are weighing numbers against
prices when they decide whether stocks (or other assets) are
priced right:
– Example: Wheel of Fortune type game.
• Moral anchors – people compare the intuitive or emotional
strength of the argument for investing in the market against
their wealth and their perceived need for money to spend
now.
• Social pressures – such as “group think”.
• Herd behaviour.
21
Attempts to Rationalize Exuberance
• Fama’s efficient markets theory:
– The appearance of prices being too high or too low is just an
illusion.
– Differing abilities do not produce differing investment
performance.
• Mispricing:
– Priced for the long-run (Jeremy Seigel’s book Stocks for the
Long Run).
– The 1636 Tulip Mania.
• Stock prices roughly track earnings over time – despite
great fluctuations in earnings, price-earnings ratios have
stayed within a comparatively narrow range.
22
Evidence for or against the efficient market
theory?
• Many anomalies have been discovered within
the efficient markets theory:
– January effect (stock prices tend to go up between
December and January).
– Small-firm effect (small firms’ stocks tend to have
higher returns).
– Day-of-the-week effect (stock market tends to do
poorly on Mondays).
23
Summary
• Irrational exuberance comes due to many factors:
– Structural changes.
– Cultural diversification.
– Psychological patterns.
• Society tries to rationalize exuberance through
efficient markets theory and other methods.
24
Lenders of Last Resort
• Two Types:
1) Domestic lender of last resort
• Reduce likelihood that a shortage of domestic liquidity will
cause bankruptcies that wouldn’t have occurred in the
absence of distress and precautionary selling.
2) International lender of last resort
• Provide liquidity to improve the extent of necessary exchange
rates and prevent those changes that aren’t required.
25
Lenders of Last Resort
• Should there be a lender of last resort?
– If investors are confident that they’ll be bailed out by a lender
of last resort, their self-reliance may be weakened.
• Who should the lender be?
1) Domestic lender of last resort
• Central Bank
• Government (Treasury)
2) International lender of last resort
• International Monetary Fund
• World Bank
26
Advantages & Disadvantages to the Lender
of Last Resort
• Advantages:
– Crisis or panic can be avoided
– Bankruptcies can be prevented
• Disadvantages:
– Expensive
– Investors become less self-reliant
27
Summary
• Lenders of Last Resort:
– Domestic
– International
• Can help to avoid financial panics and crashes.
• Expensive, investors may be less responsible
in the marketplace.
28
Frauds
• Frauds and illegal activity are closely associated
with euphoric periods as some people succumb to
greed and try to maximize wealth by all means
necessary.
• As individual wealth increases in times of euphoria
and gains of 30-40% are realized, trends show an
increase in fraudulent behaviour to incur even more
rapid gains to their personal wealth.
29
Swindles and the Credit Cycle
• Swindles, fraudulent behaviour, defalcations, and
elaborate hustles are part of life in market
economies, more so in some countries than in others
(International transparency ).
• During crashes and tightening of the credit supply,
fraudulent behaviour is prevalent as people try to
avert large losses and “double-down,” which in many
cases causes financial disaster. (Nick Leeson).
30
Fraud and Euphoria
• Most fraud occurs in the mania phase and is obscured by the
growth of the bubble.
– Individuals become greedy for a share of the increase in wealth and
swindlers come forward to exploit that greed.
• The amount of swindlers increase relative to the amount of
“gullible” people entering the market and taking chances. In a
euphoria there is a pervasive air of optimism and people
believe the market will continue to go up and maintain high
returns. Because of an overly positive view of the market,
some investors will more easily part with their money and be
caught off guard by swindlers.
• Most often the ‘’low class’’ swindles involve Ponzi finance.
• Kozlowski & Conrad Black - Greed grew faster than wealth. 31
White Collar Crime
• “The 1920’s in the United States has been called ‘the greatest era of
crooked high finance the world has ever known’ – but that was before the
1990’s.”
– Enron, WorldCom, Adelphia, Tyco, Global Crossing, Martha Stewart,
etc.
• Reasons:
– 1. Decline in adherence to moral standards.
– 2. Risk-Reward trade-off skewed – stock options provide greater pay for financial
success/greed.
– 3. Companies pay for audit services and can lean on accountants or bribe to
produce desired results.
• Crash and Panic - Try to forestall bankruptcy or financial disaster – Nick
Leeson.
• Those who commit white collar crime get off relatively lightly and spend
limited time in jail and keep large portions of illegal earnings. i.e. Michael
Milken.
32
Summary
• Frauds arise during boom periods, when people
want to “keep up with the Jones”.
• Relatively mild repercussions for committing
white collar crimes, if you are charged.
33
Article – Financial Bubbles and
Regulation
After reading the article, outline answers to the
following questions.
1. What is a financial bubble?
2. Why should we care? Is a financial bubble a market
failure?
3. Why or why not?
4. What is the economic role of the government?
5. What are the possible failures in that role? Why is it
so difficult to get it right?
34
