Financial Bubbles

The Latin American debt crisis of the 1980s may be been the last crisis of the era of international finance, while Mexico's 1994-95 "peso panic" was probably the first crisis of the new era of global finance. Global investment patterns, not national economic policies, are increasingly the cause of instability in the financial structure. Global financial flows are more volatile and harder to regulate than out nationally-based financial issues. (1)

Mexico's peso panic is an example of an international investment bubble. Currency crises are so much a natural part of international markets that its is perhaps true that the only way truly to eliminate them is to eliminate currencies themselves by regressing to a barter system or to eliminate exchange rates by adopting a single world currency. Money and exchange rates will always be a feature of the international system, and so therefore will currency crises. (2)

The common features or stages in the development a financial crisis, according to experts Charles P. Kindleberger and Hyman P. Minsky, are these:

1. Displacement.
2. Expansion.
3. Euphoria.
4. Distress.
5. Revulsion.
6. Crisis.
7. Contagion.

Imagine for a moment a market for investments that has reached some sort of equilibrium, where investment flows are consistent with the information known to and expectations held by the market's participants. According to Minsky and Kindleberger, financial crises can appear and then develop through the following stages.

Displacement refers to an external shock or some "news" that alters fundamentally the economic outlook in a market, shifting expectations concerning future profits in some significant way. Displacement in this sense of change that affects expected profits happens all the time, of course, and seldom leads to panic, crisis, or instability of any sort. The sorts of displacement we are concerned with creates an object of speculation, some asset or financial instrument that becomes the focus of investors based upon the news, creating a "boom."

Speculative objects appear and disappear with great frequency in financial markets, seldom creating panics or crises. So speculation and crisis may be related, but they are not the same phenomenon. Expansion is a necessary pre-requisite for a financial crisis to rise out of a speculative episode. Expansion is the stage where the boom is fed by an increase in liquidity, which provides the means for the boom to grow, perhaps becoming a bubble. Although Kindleberger focuses on increases in bank credit as a common source of expanding liquidity, there are many potential sources. Financial innovations, increased leverage, margin buying, and other techniques can stretch more buying power from a given monetary base.

Perhaps the most obvious form of expansion, is the widening of the pool of potential investors or speculators, from a set of "insiders" to a larger group of "outsiders." Walter Bagehot, the great 19th Century political economist, suggested that panics formed when an object of speculation attracts the greed of authors, rectors, and grandmothers. "At intervals, from causes which are not to the present purpose, the money from these people - the blind capital, as we call it, of the country - is particularly craving; it seeks for some one to devour it, and there is a 'plethora'; it finds some one, and these is 'speculation'; it is devoured, and there is 'panic'." (3)

Expansion becomes euphoria when trading on the basis of price alone takes the place of investment based on fundamentals. The purpose of buying is to sell and take a capital gain as the price rises up and up. The new buyer's motives are the same, and this euphoria continues so long as expectations do not change and liquidity holds out. This is the period of what Adam Smith called "over-trading" and Kindleberger terms "pure speculation" - that is speculation on the basis of rising prices alone. A bubble (that will burst) or a mania (driven by wild-eyed investor-maniacs) may here be created.

Distress is the next stage of a classic crisis. Distress is the stage between euphoria and revulsion and when there is concern that the strength of the market may be fragile or that the limits of liquidity may be near. Distress is an unsettled time and the reactions to this unsettled environment often deflate the bubble and defuse the mania. Distress can persist from lengths of time until the crisis is averted, or it can turn sharply into revulsion.

Revulsion is a sharp shift in actions and expectations caused by new information or a significant event. "Insiders" realize the importance of the news and sell first, perhaps at the top of the market, while "outside" authors and rectors are still buying. Liquidity dries up, especially bank lending, causing "discredit."

In Minsky's model, revulsion and discredit lead to crisis, as outsiders join insiders in selling off. Kindleberger proposes the image created by the German term Torschlusspanik, gate-shut panic, to describe the rush to liquidity. The falling prices feed on themselves creating self-fulfilling prophecies. The result is a crisis, which may also be crash (collapse in price), panic (sudden needless flight).

The crisis may be confined to a single market or it may spread, which is termed contagion. We are especially concerned with crises that spread from nation to nation through international linkages such as capital, currency, money, and commodity markets, trade interdependence effects, and shifting market psychology. Paul Krugman reserves the term "contagion crisis" for a financial crisis that spreads internationally to the extent that it causes a worldwide depression. (4)

What brings the crisis to an end? There are three possibilities, according to Kindleberger. The crisis may turn into a fire sale, with prices falling until buyers are eventually brought back into the market. Or trading may be halted by some authority, limiting losses. Or, finally, a lender of last resort, of which we will hear more soon, may step in to provide the liquidity necessary to bring the crisis to a "soft landing."

Mexico's peso panic followed this pattern fairly closely. Mexico's entrance into NAFTA (North American Free Trade Agreement -- see Chapter 12) may have been the displacement that started the bubble in this case. Certainly NAFTA altered the views of many regarding Mexico's prospects for political stability and economic growth. Capital began to flow into Mexico to take advantage of the new opportunities people thought were about to open up.

Expansion followed, driven by many factors. By the 1990s financial markets were well-organized to mobilize the funds of authors, rectors, and grandmothers to invest in foreign countries that many would be hard-pressed to find on a map. The era of "global" and "emerging markets" mutual funds was here, creating the conditions for a classic speculative bubble. A modest recover in economic prospects from the dismal 1980s led to large capital gains for those few investors who had been willing to put money into Third World markets. Their success led other investors to jump in, driving prices up still further. And by 1993 or so "emerging markets funds" were being advertised on the television and the pages of some popular magazines."(5) As speculation on price alone took off, even fund managers became uncritical of their investment decisions, driven as they were to invest the huge sums coming in from authors and rectors every day. "We went into Latin America not knowing anything about the place," one of them noted after the Mexican crisis. "Now we are leaving without knowing anything about it."(6) You can see how disconnected investment became from any analysis of the realities involved.

Euphoria came next. "During the first half of the 1990s," according to Paul Krugman, "a set of mutually reinforcing beliefs and expectations created a mood of euphoria about the prospects for the developing world. Markets poured money into developing countries, encouraged both by the capital gains they had already seen and by the belief that a wave of reform was unstoppable." (7)

Distress can be located in March 1994, with the assassination of ruling party's presidential candidate Donaldo Colosio, which raised significant doubts among foreign investors in the political stability of Mexico. The era of political stability and economic expansion that President Carlos Salinas had engineered was suddenly threatened. Insiders began to shift funds out of Mexico, which is the stage of distress.

Revulsion came in November 1994 as Mexican authorities found themselves in a position where they had to choose between their international financial responsibilities and their domestic political survival at a time when pressure was rising both inside and outside the country. They wanted to keep their exchange rate fixed to the dollar, but that required raising domestic interests rates to keep capital from fleeing. But raising domestic interest rates would have been damaging both to Mexican borrowers and their banks and also would have created a political crisis just as the Presidential vote was taking place. It was too much to risk. Inevitably, domestic issues were found to be more important and the peso was allowed to fall in value. Insiders caught the scent of a crisis and ran for the shutting gate doors.

Contagion occurred both within Mexico and between Mexico and other countries. The effects of peso depreciation, domestic inflation, and higher interest rates caused Mexico to experience a severe recession. Unemployment rose sharply from just 3.2 percent in December 1994 to 7.6 percent in August 1995 before falling somewhat to about 6.0 percent in 1996. Inflation, as measured by monthly changes in the National Consumer Price Index, rose from 3.8 percent per month in January 1995 to 8.0 percent in April, then falling back to a 2-3 percent per month range in 1996.Interbank interest rates soared, reaching 86.03 percent in March before falling back, although they remained above 40 percent until April 1996. It is hard to know what the final impact of capital flight from Mexico will be. Foreign capital deserted both weak and some strong investments.

While the peso crisis recession in Mexico may turn out to be relatively short, it is also relatively deep and its effects may be long lasting. Mexico's GDP fell dramatically in 1995, effectively wiping out the short-run gains from the NAFTA boom and leaving Mexico's citizens not much better off if at all than in the old days before market reforms. Recovery was well under way by early 1996, but growth was highly concentrated in the export sector, which benefited from the peso's lower value. Mexico's internal economy, that part not directly affected by exports, remained deeply depressed by a combination of high interest rates, credit shortages, and general poverty. (8)

International contagion also occurred, notably to other "emerging market" nations that suffered from the "tequila hangover" effect. Krugman took a pessimistic view that because "… the 1990-95 euphoria about developing countries was so overdrawn, the Mexican crisis is likely to be the trigger that sets the process in reverse."(9) Krugman, however, overestimated the memories of international investors. Within a couple of years they were back into emerging markets again, but in Asia this time. The bubble they created there is one of the contributing factors to the Asian financial crisis of the l997-98.

How can bubbles be prevented? The classical solution, which Walter Bagehot present over 100 years ago, is an international lender of last resort, who will lend when no one else will, who will hold open the shutting gate and so stop the panic. You would imagine that the IMF would be the international lender of last resort, based on its central role in the international monetary system, but in fact that has not been the case. The IMF lacks the resources and institutional commitment to perform this task effectively.

In the 1990s, it was the United States who performed the lender of last resort's duties, usually in cooperation with other countries and with international organization. It is unclear, however, how long or how often one nation can play this role before will is exhausted or resources run out. The IPE remains vulnerable to bubbles and other global financial crises for the foreseeable future.

(1) This section is based on Veseth, Selling Globalization, Chapter 4.
(2) The best place to learn about currency crises in particular and financial crises in general is a little book by Charles P. Kindleberger, Manias, Panics, and Crashes: A History of Financial Crises (New York: Basic Books, 1978). Kindleberger synthesizes the theoretical model of Hyman P. Minsky with his own deep understanding of financial history and experience of contemporary international economics.
(3) Walter Bagehot quoted in Rudiger Dornbusch, "International Financial Crises." in Martin Feldstein (editor) The Risk of Economic Crisis. Chicago: University of Chicago Press, 1991, p. 117.
(4) Paul Krugman, "Financial Crises in the International Economy." in Martin Feldstein (editor) The Risk of Economic Crisis. Chicago: University of Chicago Press, 1991, p. 100.
(5) Paul Krugman, "Dutch Tulips and Emerging Markets." Foreign Affairs. 74:4 July/August 1995. pp. 36-37.
(6) Quoted by Moisés Naím, "Latin America the Morning After." Foreign Affairs 74:4 July/August 1995, p. 51.
(7) Krugman, "Dutch Tulips" p. 39.
(8) Lesley Crawford, "Survey of Latin American Finance and Investment: Only Zedillo Optimistic," Financial Times, March 25, 1996, p. 4.
(9) Krugman, "Dutch Tulips," p. 43.