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Saturday 8 August 2009


Economic Stability Is Not The Norm

The exceptional market conditions of the last couple of years are a reminder that we should regard stable markets as a pleasant interlude rather than the normal state of affairs. In general, of course, people tend to expect tomorrow to be much the same as yesterday and to behave as such. It’s little wonder, then, that when everything goes wrong people start to panic, assuming the world is coming to an end.

Of course, so far, the world hasn’t come to an end – although a lot of people have lost lots of money in the meantime. What we can see from history is not that market panics are exceptional but that they’re the norm.

Kindleberger on Economic History

Every investor should read and re-read Charles Kindleberger’s seminal “Manias, Panics and Crashes" which details the course of market disasters over a near three hundred year period. Kindleberger was an economist of a different hue to many we’ve met before: an economic historian who relied not on mathematical models – about which he was enjoyably and pointedly vague – but on historical incident and anecdote. At the very least, he argued, the various competing economic schools have to explain the happenings of the markets rather than either ignoring them, or simply claiming that they shouldn’t happen so they’re going to stick their fingers in their ears and go “tra-la-la” until they go away.

Underpinning the concept is a simple idea – people are irrational, they do the irrational things which it suits them to do and the consequences are often very nasty. What he set out to show was that the mental behaviour of market participants that we’ve recently witnessed is a perfectly normal state of affairs. Indeed, based on the historical records one ends up wondering how anything ever works at all in the markets. Everything going wrong is what happens, all the time, it seems.

The Fallacy Of Composition

However, it’s not simple irrationality that drives the market. Underlying this is a sneaky human behavioural failing known as the fallacy of composition – a trait that sees every individual acting in their own self interests yet, at the same time, acting in a manner calculated, en-masse, to cause them to lose. If fire breaks out in a crowded theatre then the maximum number of people will be saved by avoiding panic. However, as an individual you might not be one of them so it’s probably in your own best interests to fight tooth and claw over soon to be dead bodies to get to the exit.

In investment this is simply the argument of the Greater Fool writ large. As markets go up more and more people pile in, in order to obtain their piece of the overall pie. Eventually booms rely increasingly on less and less intelligent money to keep the whole thing going. It’s a Ponzi scheme – more and more new entrants are needed to provide the money needed to pay off the earlier investors. Success depends ultimately on them being able to flip their holdings to someone else before the market succumbs to its inevitable heat death as the stupid money exhausts itself. And when the fuel of new investors runs out then the market stalls, falters and eventually fails.

Fuelling The Monetary Flames

Although the argument rests soundly on behavioural irrationality it’s critically dependent on the availability of money. Freely available funds allow investors to fuel the monetary flames and is the economic genesis of market booms and bust. Before the markets make mad, first they make money freely available.

Money’s a funny thing. It’s not just coins and notes, or checks and credit cards. There are a million ways in which money can be created and not just by central bankers or even normal banks. You and I are worth whatever money we can persuade people to lend us, not just the funds in our bank accounts and the flippable stocks in our portfolios. Anything that expands credit leads to an expansion in the money supply and as the availability of money increases so does the urge to find ever new investments. As weight of money starts to push up asset values more and more people jump on the bandwagon, asset prices rise further and a positive feedback loop develops.

The Minsky Moment

The problem with credit comes when it needs to be repaid. Most, if not all, crashes arrive when over-borrowed individuals or institutions suddenly find that their cash flow doesn’t meet their requirements to repay their debt. So assets need to be sold, which leads to a decline in asset value, which means borrowing secured on those assets may be in jeopardy. And so the downward spiral starts.

This point at which this reversal happens is known as the Minsky Moment, named after the economist Hyman Minsky of whom we will hear more at some point. Of course, economists can’t exactly agree on when our most recent Minsky Moment was, but it’s certainly around the middle of 2007 when Bear Sterns pledged a loan of $3.2 billion invested in collateralised debt to bail out one of their hedge funds in which they had originally invested capital of just $35 million. The tide was going out and stressed executives suddenly found themselves standing on the deck of the Titanic trying to fashion lifeboats out of deckchairs.

One Damn Panic After Another

The list of panics and crashes over the past few hundred years is fearful. From 1720 up until the end of the twentieth century Kindleberger lists 32 – or one every eight years or so. Most of these were international in nature. For those people convinced that globalisation is a modern phenomena it’s a sobering read. Consider: by what mechanism did the ’29 crash on Wall Street communicate itself to the rest of the world? Not only did the collapse in Wall Street lead to later problems in Europe but seems to have started in Europe due to problems originating in First World War.

This view of the world doesn’t offer much in the way of hope that we can avoid similar problems in the future. There seems to be an inevitability about the way human psychology interacts with capitalist markets to cause nasty things to happen and the longer the world goes without something nasty then the more likely it is to occur. It’s like an earthquake fault, with pressure building up, waiting to be released. Better small slips and often than large ones rarely.

Historical and Behavioural

Personally I find this kind of historical analysis of what has actually happened much more persuasive than any amount of beautifully constructed economic theories regardless of whether they’re built on the basis of people being rational or not. It’s the way that people interact with the markets not the superstructure of clever analysis, brilliant models or even stupid bankers that causes periodic failures.

However, there's a human element to this: for a real manic market to develop people must have had enough time since the last time to both forget and to gather enough money to invest again. It may even be generational – there are plenty enough anecdotes of those poor souls caught up in the Great Depression who spent the rest of their lives embracing prudence to suggest that the lasting effects of a major crash may scar whole generations. Maybe it takes the onset of a new group of investors before a new boom, and eventual bust, can kick-off.

The Last Resort

Regardless of the underlying causes and the eventual outcomes there’s one other point that Kindleberger makes at length and with due cause. Mostly crises don’t just burn themselves out and wither away. Nearly always someone, a lender of last resort, ends up stepping in to rescue the markets. It may be that markets would eventually right themselves but when the bears are truly running there are few politicians and central bankers willing to take the risk. And when this doesn't happen - as in the 1930's - the consequences can be dreadful.

It’s a historical fact: private banks finance the boom, governments finance the bust. Read the book, weep and then throw away your economic theories.

Manias, Panics, and Crashes: A History of Financial Crises (Wiley Investment Classics)This Time Is Different: Eight Centuries of Financial FollyCan "It" Happen Again?: Essays on Instability and Finance

Related Articles: Going Dutch, The Benefits of Sound Money, You Can't Trust The Experts With Your Investments, Fairy Tales for Investors


  1. Good comment
    Investors are only as entitled to complain about the economy as sailors are about storms on the ocean. Its bumpy, get used to it.

  2. People need to have the inevitably of panics built into their asset allocation strategies. I advocate Valuation-Informed Indexing. With this strategy, you lower your stock allocation as prices rise to insanely high levels and you increase it as they drop to insanely low levels. Panics still happen but they don't hurt you much (panics always begin at times of insanely high prices and those following a Valuation-Informed Indexing strategy have little invested in stocks at such times).

    People often say that stocks are a risky asset class. That's so only for those who practice Passive Investing (sticking to the same stock allocation regardless of valuation levels). Almost all of the risk involved in stocks comes from overinvesting in stock at times of high prices. Stop doing that, and this is not really such a risky asset class anymore.

    We all need to develop the habit of thinking that the valuation level for stocks is the most important thing to know when deciding whether to buy them or not. The promotion of Passive Investing has encouraged us to ignore price. That's why we are in the mess we are in today.


  3. Herman Minsky? Is he any relation to the economist Hyman Minsky?

  4. Hi fboness ...

    One tiny mistake :) I've shot the proofreader. Fixed, now. Thanks.

  5. Cap weighted passive investing is indeed a major source of instability today because of the positive feed back effect. The higher a stock rises the more cap weighted money it attracts however high its valuation.

  6. When I first started investing I read about periods of steady upwards expansion coupled (in small print) with the risk of bear markets.

    Ever since then it's been one panic or crash after another - LTCM, the Asian currency crisis, dotcom bust, September 11th, the panic over insurer solvency, the recent credit crunch.

    Instability is the norm, as you say. I think every panic is different, so it can't be systemised, so economists dismiss each one as a freak event.