12.2 Financial instability: bubbles and crises

The issue of interest rates and other bank charges again came to the fore in the UK

at the beginning of April 2006 following a report by the Ofce of Fair Trading (OFT)

which stated that credit card default charges had generally been set at a signicantly

higher level than was legally fair. The OFT estimated that across the industry this had

led to unlawful penalty charges in excess of £300m a year. They argued that such

charges should only be made to cover acceptable administration costs to the banks

of default and set £12 as the highest possible gure that could be regarded as fair.

They threatened to challenge charges above £12 in the courts and gave the industry

until the end of May 2006 to respond. As a result, at the end of May, Barclays, Lloyds

TSB and HSBC all announced that they were cutting their penalty charges from

£20 to £12. It was, however, expected that banks would be likely to raise interest

rates to recoup the fall in prots.

This was just another of many skirmishes between the very protable banking

industry and organisations concerned with consumer welfare over the behaviour of

banks towards their clients.

12.2Financial instability: bubbles and crises

There have been many examples of booms and busts in nancial markets. Euphoria

has accompanied very rapid increases in the prices of nancial assets, seemingly

driving them well away from any possible assessment of their fundamental values.

Under such circumstances, private investors go heavily into debt in order to join the

rush into nancial markets in the quest for large and easy fortunes. We saw, however,

in Chapter 6 that this view of the behaviour of nancial markets is rejected by con-

ventional economics which assumes market agents to behave rationally at all times

in the sense that they always act to maximise their own individual (or household)

utility and ensure that nancial asset prices always reect market fundamentals.

On this argument, since asset prices reect the present value of a future stream of

income, the fundamentals always involve an assessment of future conditions and

these assessments can change quickly and by large amounts as new information

becomes available to the market. Nonetheless, we pointed out in section 6.5 that

price changes are sometimes so large and occur so rapidly that it is difcult to believe

that individual behaviour is not, on some occasions at least, strongly inuenced by

what other people in the market are doing. After all, investment in nancial markets

always involves uncertainty and there are many cases where human beings clearly

feel more secure if they are behaving in the same way as everyone else, whether

or not we understand the reasons for the general behaviour. Indeed, one can easily

see this as maximising behaviour – where information is scarce and choice among

conicting alternatives is difcult, assuming that the majority is correct may, on

balance, produce the best results. Thus, we shall here look a little more closely at the

notion that market behaviour is, at least on occasions, irrational.

A well-known book written from this point of view by Charles Kindleberger

(1996) is entitled Manias, Panics and Crashes.Applied to nancial markets, a ‘mania’

is a frenzied burst of buying of a nancial asset that causes the price of the asset to

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Chapter 12 • Financial market failure and nancial crises

rise very sharply. People buy on the assumption that the price will continue to rise

and thus they will be able to sell at a higher price later, making a speculative prot.

The irrational element in this behaviour is that people appear to forget the possibility

that the price might fall and dismiss from their minds potential losses. The use of the

words ‘craze’ and ‘frenzied’ in descriptions of behaviour in periods of price bubbles

suggests that greed and rapaciousness dominate rationality. This, in turn, implies that

the big increase in the demand for the asset has little logical basis.

It is also possible that people do not entirely forget the fundamentals underlying the

asset price and that they remain aware of the losses they stand to make if the price

were to fall. Thus, as they continue to buy at higher and higher prices, they are aware

that they are taking ever greater risks. They can only justify these increasing risks by

reecting on the prospects of ever-greater prots. In these circumstances, it can be

argued, it is rational to go on buying and, indeed, to buy in ever greater quantities,

causing the price to rise even faster. According to this view, the situation has become

unreal but people behave rationally within it. Rational individual behaviour produces

an irrational market outcome.

Of course, price bubbles, like any other, might easily burst and the price might

collapse just as quickly as it rose. This happens as soon as any doubt that price rises

will continue causes some people to stop buying. As soon as the rate of increase in

demand slows, the price rise slows and people begin to sell to take their prot. The

price starts to fall. The mania has ended. This leads people to ask how far the price

might fall and to an assessment of the fundamental basis of the value of the asset.

People begin to become aware of the extent of the loss they are facing. It becomes

imperative to sell before the price falls very far. Many investors rush to sell, the price

falls sharply and panic, in which fear becomes contagious, sets in. Even those who

have no idea of market fundamentals take part in the frenzied selling. The price

might be driven below any possible idea of a fundamental value.

Supporters of this view of behaviour in nancial markets see the market as failing

because of both lack of information and the irrational behaviour of market participants.

They also see many external effects of manias and panics. The sharp rises and falls in

the prices of nancial assets have effects on the real economy. The sharp nancial

losses induce cut backs in consumer spending and thus affect aggregate demand,

production and employment. Consequently, they see a role for government in

overcoming market failure or in correcting the undesirable results of free market

behaviour. On the other hand, holders of the view that market agents always behave

rationally and market prices always reect market fundamentals believe that markets

should be left to operate freely and that any apparent inadequacies in market out-

comes stem from the constraints placed upon markets, notably by governments. For

example, it might be argued that sharp price rises are fuelled by easy credit causing

low interest rates, and crashes are caused by sudden monetary tightening. That is,

governments cause market problems rather than counteracting market failures.

The proposition that markets are subject to manias and panics has largely been

supported by the analyses of historical episodes of sharp price rises. The best-known

examples from the distant past relate to the tulip market in Holland in the late

seventeenth century and the South Sea bubble in England in the eighteenth century.

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