Lukas Püttmann    About    Research    Blog

"Manias, Panics and Crashes", by Charles Kindleberger

The German newspaper Süddeutsche Zeitung not long ago portrayed a number of German economists. They were asked to name their two favorite books and “Manias, Panics and Crashes: A History of Financial Crises” by Charles Kindleberger was mentioned twice.

What causes financial crises?

In the book, Kindleberger shows that there’s a pattern common to these events and that financial crises aren’t all that rare if you zoom out enough:

Speculative excess, referred to concisely as a mania, and revulsion from such excess in the form of a crisis, crash, or panic can be shown to be, if not inevitable, at least historically common. (p4)

A common sequence is followed:

What happens, basically, is that some event changes the economic outlook. New opportunities for profits are seized, and overdone, in ways so closely resembling irrationality as to constitute a mania. Once the excessive character of the upswing is realized, the financial system experiences a sort of “distress,” in the course of which the rush to reverse the expansion process may become so precipitous as to resemble panic. In the manic phase, people of wealth or credit switch out or borrow to buy real or illiquid financial assets. In panic, the reverse movement takes place, from real or financial assets to money, or repayment of debt, with a crash in the prices of […] whatever has been the subject of the mania. (p5)


[…] [I]rrationality may exist insofar as economic actors choose the wrong model, fail to take account of a particular and crucial bit of information, or go so far as to suppress information that does not conform to the model implicitly adopted. (p29)

Kindleberger then writes:

The end of a period of rising prices leads to distress if investors or speculators have become used to rising prices and the paper profits implicit in them. (p103)

Causa remota of the crisis is speculation and extended credit; causa proxima is some incident which snaps the confidence of the system, makes people think of the dangers of failure, and leads them to move [from the object of speculation] back into cash. […] Prices fall. Expectations are reversed. […] The credit system itself appears shaky, and the race for liquidity is on. (p107-108)

How to avoid financial crises or deal with them?

Kindleberger identifies a rise in the leverage in the economy as the culprit:

Speculative manias gather speed through an expansion of money and credit or perhaps, in some cases, get started because of an initial expansion of money and credit. (p52)

There’s plenty of research showing that credit plays an important role for financial crises. Kaminsky and Reinhart (1999) and Schularick and Taylor (2012) provide cross-country statistical evidence that financial crises are preceded by credit booms. Mian and Sufi (2009) similarly show that the parts of the United States in which the credit supply to less financially healthy (“subprime”) households increased more strongly, also experienced more mortgage defaults during the financial crisis of 2007 onwards. This leads them to write in their book:

As it turns out, we think debt is dangerous. (p12)

And in their research (pdf) with Emil Verner, they argue it’s the supply of credit rather than demand for it that drives these cycles of debt accumulation. López-Salido, Stein and Zakrajšek also show that optimistic credit conditions predict economic downturns.

So maybe the regulator should stop credit bonanzas before they become dangerous. The central bank could “lean against the wind” in good times by sucking liquidity out of credit markets. George Akerlof and Robert Shiller put it like this:

But financial markets must also be targeted [by the central bank]. (“Animal Spirits”, p96)

Kindleberger’s response (which I found the most interesting thought of the book) is that what counts as money isn’t obvious and that it’s therefore also difficult to control the credit supply:

The problem is that “money” is an elusive construct, difficult to pin down and to fix in some desired quantity for the economy. As a historical generalization, it can be said that every time the authorities stabilize or control some quantity of money \(M\), either in absolute volume or growing along a predetermined trend line, in moments of euphoria more will be produced. (p57)

My contention is that the process is endless: fix any \(M_1\) and the market will create new forms of money in periods of boom to get around the limit and create the necessity to fix a new variable \(M_j\). (p58)

He goes through a range of possibilities of what he calls the

[…] virtually infinite set of possibilities of expanding credit on a fixed money base. (p68)

Instead - he argues - the central bank should step in when the crisis occurs:

If one cannot control expansion of credit in boom, one should at least try to halt contraction of credit in crisis. (p165)

He argues forcefully that the central bank should act as lender of last resort. This means that the central bank expands the money supply in times of crisis and provides liquidity to banks.

In a word, our conclusion is that money supply should be fixed over the long run but be elastic during the short-run crisis. The lender of last resort should exist, but his presence should be doubted. (p12)

Kindleberger is aware of the moral hazard problem: If banks know that they’ll be bailed out, then they might behave recklessly. But he says there’s no alternative (his emphasis):

The dominant argument against the a priori view that panics can be cured by being left alone is that they almost never are left alone. (p143)

He says that it shouldn’t be certain whether banks will be bailed out:

Ambiguity as to whether there will be a lender of last resort, and who it will be, may be optimal in a close-knit society. (p174)

He thinks central banks should decide on an ad-hoc basis:

The rule is that there is no rule. (p176)

Nothing we can do?

I find it discouraging to think that we live in the 21st century, but we can’t properly control the money or the credit supply and have to resort to ambiguity on whether banks will be saved to control them. I’m all for bending the rules in times of crisis, but isn’t there more we could do to not get there in the first place?

Anat Admati and Martin Hellwig argue that banks should be required to finance more through stocks and less through deposits and bonds:

Whatever else we do, imposing significant restrictions on bank’s borrowing is a simple and highly cost-effective way to reduce risks to the economy without imposing any significant cost on society. (“The Bankers’ New Clothes”, p10)

The benefit of this that the owner of the bank stocks would bear losses which could avert the danger of a bank going bankrupt or the threat of a bank run.

Similarly, Atif Mian says about nominal debt:

The key characteristic of debt, which makes it so destructive at times for the macroeconomy is the inability of a debt contract to share risk between the borrower and the lender. And in particular when I say “share risk”, it’s really the downside risk that we’re talking about.


We want to move away from a world where debt is the predominant contract. (link)

Doomed if we do, doomed if we don’t

But Hans-Joachim Voth writes:

“The optimal number of financial crises is not zero” (download pdf)

This is based on the evidence by Roman Rancière, Aaron Tornell and Frank Westermann that countries that experience more drastic contractions in credit tend to do better economically in the long run than countries who cripple their financial institutions and hence have stable but inefficient financial systems.

Other researchers studying a longer time horizon than Rancière et al. document that we traded lower real volatility against fewer but more harmful crises.

Rancière et al. also write:

We would like to emphasize that the fact that systemic risk can be good for growth does not mean that it is necessarily good for welfare. (“Systemic crises and growth”, p404)

And that is because we don’t like what follows financial crises if they lead to an emotional scarring that brings political polarization, a loss of trust and a lasting unwillingness to bear risks.

Liberalized financial markets were probably good for growth. But if they mean severe rare crises, then maybe it wasn’t a good choice and we should return to a world of more boring, safer banking. And we might even want to give up some of our future prosperity for that.