From Tulips to Mortgage-Backed Securities: The Nature of Crashes

Thirty years ago, economist Charles Kindleberger published a little book, Manias, Panics, and Crashes (New York, 1978), describing the normal tendency of capitalist financial markets to fluctuate between speculative excess (or "irrational exuberance" in the words of a recent central banker) and panic. Kindleberger describes about 40 of these panics over the nearly 260 years from 1720–1975, or one every seven years. Following Kindleberger’s arithmetic, we were due for a panic because it had been seven years since the high-tech bubble burst and the stock market panic of 2000–1. And the panic came, bringing in its wake a tsunami of economic woe, liquidity shortages, canceled investments, rising unemployment, and economic distress.

Of course, more than mechanics and arithmetic are involved in the current financial panic. But there is a sense of inevitability about the manias and panics of capitalist financial markets, a sense described by writers from Karl Marx to John Maynard Keynes, Hyman Minsky, John Kenneth Galbraith, and Robert Shiller. The problem is that financial markets trade in unknown and unknowable future returns. Lacking real information, they are inevitably driven by the madness of crowds.

Unlike tangible commodities whose price should reflect its real value and real cost of production, financial assets are not priced according to any real returns, nor even according to some expected return, but rather according to expectations of what others will pay in the future, or, even worse, expectations of future expectations that others will have of assets’ future return. Whether it is Dutch tulips in 1637, the South Sea Bubble of 1720, Florida real estate in the 1920s, or mortgage-backed securities today, it is always the same story of financial markets floating like a manic-depressive from euphoria to panic to bust. When unregulated, this process is made still worse by market manipulation, and simple fraud. Speculative markets like these can make some rich, and can even be exciting to watch, like a good game of poker; but this is a dangerous and irresponsible way to manage an economy.

There was a time when governments understood. Learning from past financial disasters, the United States established rules to limit the scope of financial euphoria and panic by strictly segregating different types of banks, by limiting financial speculation, and by requiring clear accounting of financial transactions. While they were regulated, financial markets contributed to the best period of growth in American history, the "glorious thirty" after World War II. To be sure, restrictions on speculative behavior and strict regulations made this a boring time to be a banker, and they limited earnings in the financial services sector. But, limited to a secondary role, finance served a greater good by providing liquidity for a long period of steady and relatively egalitarian economic growth.

Of course, over time we forgot why we had regulated financial markets, memory loss helped along by the combined efforts of free-market economists and self-interested bankers and others on Wall Street. To promote "competition," we lowered the barriers between different types of financial institutions, widening the scope of financial markets. We moved activities such as home mortgage lending onto national markets and allowed a rash of bank mergers to create huge financial institutions too large to be allowed to fail, but never too large to operate irresponsibly. Despite the growing scope and centralization of financial activity, the government accepted arguments that we could trust financial firms to self-regulate because it was in their interest to maintain credible accounting.