There is no better way to set the stage for this book than by providing you with one of my all time favorite quotes:
History doesn’t repeat itself, but it does rhyme.
– Mark Twain
One book that gives detailed proof of this statement is the classic Manias, Panics, and Crashes: A History of Financial Crises by Charles P. Kindleberger. As explained by the subheading, the book is a collection and review of all financial crises that this world has experienced. Moreover, the book provides a very good overview of the stages and the common threads of these crises but also the lessons that can been drawn from them.
Although I’m not a top-down investor, staying away from macroeconomic analysis and forecasting, I still consider Manias, Panics, and Crashes one of the most important books to read as an investor. This is especially true if you have little or no real life experience of being an investor during a crises. As many times before, my thoughts about this subject has been influenced by one of my favourite investors, Howard Marks. Therefore, in connection to reading this book I urge you to read his memo ‘You Can’t Predict. You Can Prepare.‘ and especially note the following two paragraphs:
In my opinion, the key to dealing with the future lies in knowing where you are, even if you can’t know precisely where you’re going. Knowing where you are in a cycle and what that implies for the future is very different from predicting the timing, extent and shape of the next cyclical move. And so we’d better understand all we can about cycles and their behavior.
So forecasts are unlikely to help us foresee the movements of the economic cycle. Nevertheless, we must be aware that it exists and repeats. The greatest mistakes with regard to the economic cycle result from a willingness to believe that it will not recur. But it always does – and those gullible enough to believe it won’t tend to lose money.
– Howard Marks
Please comment if you have read the book and what you thought of it. Also, if you have found a worldly wisdom in the book that you think I should have included please comment on that as well. I’m very interested in what caught your eye while reading and why.
Worldly wisdom’s from the book
“The thesis of this book is that the cycle of manias and panics results from the pro-cyclical changes in the supply of credit; the credit supply increases relatively rapidly in good times, and then when economic growth slackens, the rate of growth of credit has often declined sharply. A mania involves increases in the prices of real estate or stocks or a currency or a commodity in the present and near-future that are not consistent with the prices of the same real estate or stocks in the distant future. The forecasts that the price of oil would increase to $80 a barrel after the earlier increase from $2.50 a barrel at the beginning of the 1970s to $36 at the end of that decade was manic. During the economic expansions investors become increasingly optimistic and more eager to pursue profit opportunities that will pay off in the distant future while the lenders become less risk-averse. Rational exuberance morphs into irrational exuberance, economic euphoria develops and investment spending and consumption spending increase. There is a pervasive sense that it is ‘time to get on the train before it leaves the station’ and the exceptionally profitable opportunities disappear. Asset prices increase further. An increasingly large share of the purchases of these assets is undertaken in anticipation of short-term capital gains and an exceptionally large share of these purchases is financed with credit.”
“ Financial arrangements need a lender of last resort to prevent the escalation of the panics that are associated with crashes in asset prices. But the commitment that a lender is needed should be distinguished from the view that individual borrowers will be ‘bailed out’ if they become over-extended. For example, uncertainty about whether New York City would be helped, and by whom, may have proved just right in the long run, so long as help was finally provided, and so long as there was doubt right to the end as to whether it would be. This is a neat trick: always come to the rescue, in order to prevent needless deflation, but always leave it uncertain whether rescue will arrive in time or at all, so as to instill caution in other speculators, banks, cities, or countries. In Voltaire’s Candide, the head of a general was cut off ‘to encourage the others.’ A sleight of hand may be necessary to ‘encourage’ the others (without, of course, cutting off actual heads) to participate in the lender of last resort activities because the alternative is likely to have very expensive consequences for the economic system.”
“A follow-the-leader process develops as firms and households see that others are profiting from speculative purchases. ‘There is nothing as disturbing to one’s well-being and judgment as to see a friend get rich.’ Unless it is to see a nonfriend get rich. Similarly banks may increase their loans to various groups of borrowers because they are reluctant to lose market share to other lenders which are increasing their loans at a more rapid rate. More and more firms and households that previously had been aloof from these speculative ventures begin to participate in the scramble for high rates of return. Making money never seemed easier. Speculation for capital gains leads away from normal, rational behavior to what has been described as a ‘mania’ or a ‘bubble.’”
“Yet euphoric speculation with insiders and outsiders may also lead to manias and panics when the behavior of every participant seems rational in itself. Consider the fallacy of composition when the whole differs from the sum of its parts. The action of each individual is rational—or would be if many other individuals did not behave in the same way. If an investor is quick enough to get in and out ahead of the others, he may do well, as insiders generally do. Carswell quotes a rational participant on the South Sea Bubble:
“The additional rise above the true capital will only be imaginary; one added to one, by any stretch of vulgar arithmetic will never make three and a half, consequently all fictitious value must be a loss to some person or other first or last. The only way to prevent it to oneself must be to sell out betimes, and so let the Devil take the hindmost.”
‘Devil take the hindmost,’ ‘sauve qui pent,’ ‘die Letzen beissen die Runde,’ (‘dogs bite the laggards’), and the like are recipes for a panic. The analogy is someone yelling fire in a crowded theater. The chain letter is another analogy; because the chain cannot expand infinitely, only a few investors can sell before the prices start declining. It is rational for an individual to participate in the early stages of the chain and to believe that all others will think they are rational too.”
“Speculative manias gather speed through expansion of money and credit. Most expansions of money and credit do not lead to a mania; there are many more economic expansions than there are manias. But every mania has been associated with the expansion of credit.”