Essay title - Manias, Panics and Crashes: A History of Financial Crises
Manias, Panics and Crashes: A History of Financial Crises by Charles P. Kindleberger is about bank failures and financial crises from the bursting of the asset price bubble or devaluation of national currencies in the foreign exchange market and sometimes these crises started bank crises and vice versa (i.e. bank crises triggered foreign exchange crises). They spread like a plague from one country to another, e.g. from Tokyo to Bangkok to New York. Kindleberger in his book has set out the financial crisis which was given by Hyman Minsky also known as Minsky Bubble Model.
Minsky gave the idea of 'stability is instability' which means that long unusual periods of economic stability encourage investors to take more risk and then they borrow more to overpay assets. This model covers the boom and the subsequent burst and centres on the periodic nature of the manias and the subsequent crises. He argued that the financial system is unbalanced, delicate and prone to crisis and that a bubble begins with a 'displacement', such as a significant invention e.g. the internet which creates profitable opportunities in the sector affected, but alone it is not enough. Financial improvement is needed to give people access to the cheap credit required to kick off the next phase: overtrading. People pile into the sector, driving demand and prices higher. The increase in the credit expansion in the first country may not be followed by a contraction of credit in the second country, because investors in the second country may respond to rising prices and profits abroad by demanding more credit so they can buy the assets and securities whose prices they expect to increase. The potential contraction from the shrinkage in the monetary base in the second country may be affected by the increase in speculative interest and the increase in the demand for credit. Speculation for capital gains leads away from normal, rational behaviour to mania or bubble. The word mania emphasizes irrationality; bubble indicates that some values will eventually burst. Economists use the term bubble to mean any derivation in the price of an asset or a security or a commodity that cannot be explained in terms of the fundamentals. Small price variations based on fundamentals are called noise. A bubble is an upward price movement over an extended period of fifteen to forty months that then implodes.
The Minsky model faces some criticism. The First criticism which has been directed to the model is that each crises is unique so the general model is not relevant meaning that there are wide differences in the economic crises as a group that they should be broken down into various forms, each with its own particular features. Each crisis also has its unique individual characteristics like nature of shock, object of speculation, form of credit expansion, originality of the fraud and nature of incident. The second criticism faced by this model is that this model is not relevant because of changes in business and the economic environment. It means structural changes in the institutional economy, including the rise of the corporation, emergency of big labour unions and big government, modern banking and speedier communications. Another criticism is that asset price bubbles are highly impossible because all the information is in the price of the efficient market view of finance which means that there can be no bubbles because market prices always reflect the economic fundamentals, and that the sharp declines in the asset prices usually reflect policy switching by government or central banks.
The more logical attack was made by Alvin Hansen who claimed that the model was relevant prior to the middle of the nineteenth century but ceased to be so because of changes in the institutional environment. He emphasis the importance of the relationship between savings and investment and does not require the rejection of the view that changes in supply of credit can have important impacts on the prices of securities and the level of economic activity. The critics suggest that the model is mis-specified that something was going on not taken into account by the theory and that more research is called for.
This model is relevant today in the sense that it can be readily applied to the foreign exchange market and to the time when values of national currencies are too high or low which might exceed the limits or fall short. Changes in the foreign exchange values of national currencies have been large relative to long-run stable values despite sizable intervention in the market by central banks. Speculation in foreign currencies has resulted in large losses for some firms and some banks while others have made substantial trading profits.
Here are illustrations of a few speculative bubbles that burst in history.
The Dutch Tulip Bubble 1636
One of the famous speculative bubbles occurred in Holland in the 1600s: the Dutch Tulip Bubble. The speculation drove the value of tulip bulbs to extremes. The most expensive rarest tulip bulbs traded for as much as six times the average person's annual earnings.
During the early 17th century Holland was entering into its Golden Age of business after fighting for independence from Spain. Amsterdam merchants could give profits of 400% from a single journey and were in middle profiting East Indies trade. They constructed big villas surrounded with flower gardens to show there success. The Dutch population appeared becoming weakened by opposing wants, one was a terror of living over its means and second one was the love of a gambling. There entered the tulip. There colours were more deep and strong than of an ordinary tulip plants. Regardless of the odd prices demanded by extraordinary bulbs, the price of ordinary tulips was a pound. A new type of tulip fancier appeared, tempted by the story of heavy profits around the 1630s and searches began for the flower lovers and speculators by florists or professional tulip traders. The supply of tulip buyers grew quickly but the supply of bulbs did not. There was a shortage supply of tulip. Seven years are required for one tulip to grow from seed and whereas bulbs can produce two or three replicas annually, the mother bulb lasts for few years only.
Prices of Bulb increased gradually during the 1630s and more speculators got in the market. Everything was mortgaged by farmers and weavers so that they could make some cash to do business. Three rare bulbs were exchanged for a farmhouse in Hoorn, in 1633. By 1636, one tulip even a bulb, was sold for hundreds of guilders whereas nowadays the tulip is considered worthless. There was a scope of future market for bulbs and tulip traders were doing their business in many Dutch inns, bars and pubs. Love for tulip reached its pinnacle during the winter of 1636-37 due to which sometimes bulbs were exchanged ten times in one day. The tulip business reached its climax, when in an auction to help seven orphans whose only asset was 70 fine tulips left by their father. The highest record noted was of a rare Violetten Admirael van Enkhuizen bulb which was sold for 5200 guilders. All flowers brought in sold for 53000 guilders.
The tulip market crashed totally thereafter. It happened in a routine bulb auction when a person refused to show up and pay. The panic spread across the country and the market for tulips ended leaving behind the efforts of traders to support demand. Flowers which charged 5,000 guilders a few weeks before now obtained one-hundredth that amount. There was always a speculation in tulip bulbs which stayed alive at the boundaries of Dutch economic life. After the market crash a compromise was negotiated that let most traders resolved their debts in exchange of their liability. The overall outcome on the Dutch economy was negligible.
The bubble in real estate and stocks in Japan 1985-89
In the 1980s Japan's economic bubble burst. It took place when Japan encouraged people to save their income and introduced inflexible tariffs and policies after World War II. Loans and credit became easier to obtain with more money in banks and running large trade surpluses, the YAnd at one point the government issued 100 year bonds. Additionally, banks granted increasingly risky loans.
Speculative purchases of real estate induced a boom in the stock market due to financial liberalization and the flow of foreign exchange value of Yen. The Bubble had significant impact on South Korea, Taiwan and the state of Hawaii because they were parts of the Japanese supply chain and if Japan is doing well in the economy its former colonies will also do well just as Miami is connected to New York. Hawaii experienced a real estate boom in the 1980s as the Japanese bought second homes, golf courses and hotels. The decline in stock prices on 19 October, 1987 were practically instantaneous in all national financial centres (except Tokyo), faster than can be accounted for by arbitrage, income changes, capital flows or money movements. Prices were highest in Tokyo's
The Dot-com bubble in the United States 1995-2001
The dot-com bubble was a Legal or Regulatory response to Dot-com Bubble in the United States 1995-2001
After the downfall of the dot-com bubble came high profile cooperate scandals like Enron, WorldCom and Bre-X, the 9/11 terrorist attacks and conflict in the Middle East. These events damaged the image of financial markets and have reduced the faith and confidence of investors.
After the decline in the financial markets due to failing investor confidence, the US federal government enacted a law that established more strict reporting requirements, and placed responsibility for corporate reporting directly on the shoulders of CEOs and CFOs. This legislation is known as the Sarbanes-Oxley Act of 2002, also known as the Public Company Accounting Reform and Investor Protection Act of 2002 and commonly called SOX or Sarbox. It was enacted on July 30, 2002 in response to a number of major
This Act gave a rebirth to corporate governance as new regulatory reporting requirement and the explicit, legal responsibility of the CEO and CFO for the company's reporting has re-established executive responsibility for the actions and performance of the company. It established strict new rules and reporting requirements related to a wide range of questionable corporate practices that have been under recent scrutiny. They intended to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws and SOX places much more focus and responsibility on the roles and public companies senior management, chief executive officers (CEOs), chief financial officers (CFOs), boards of directors, audit committees and independent auditors. It also establishes severe new financial reporting requirement for CEOs and CFOs to sign-off on these reports, taking personal responsibility for their accuracy and completeness. It also contains provisions impacting many of the other key players in the capital market control process. For auditors, there is a new system of private oversight, a revised set of independence rules and new requirements for public reporting. For auditing committees, the rules governing their independence and financial expertise have been revised and their role in the corporate reporting framework continues to expand and now includes direct responsibility for overseeing external auditors, pre-approving all audit and non-audit services of such external parties. Attorneys are subject to new professional conduct regulations. And securities analysts are subject to revised compensation and internal review structure that strengthen their independence from the investment banking side of their firms.
SOX also establishes new reporting requirements for companies that trade on public markets in the US that require timely disclosure of information related to any material changes in the financial condition or operations of the company. The new requirement will provide near real time visibility into the operations and trade relationships of public companies, an issue that contract management solutions can help.
All publicly-traded companies are required to submit an annual report on the effectiveness of their internal accounting controls to the SEC. Provisions of the Sarbanes Oxley Act (SOX) detail criminal and civil penalties for non-compliance, certification of internal auditing, and increased financial disclosure. It affects public U.S. companies and non-U.S. companies with a U.S. presence. SOX are all about corporate governance and financial disclosure.
