Financial Crises Seem to Have Predictive Value Only in Retrospect

NEW YORK —  Sir Isaac Newton, the supreme rationalist regarded as one of history’s leading geniuses, saw the South Sea Bubble of 1720 for what it was and sold his stake early at a heartwarming profit of 7,000 pounds.

But then, in a spell of the dreaded malady “irrational exuberance,” Sir Isaac plunged back in, losing a fortune of 20,000 pounds when, inevitably, the bubble burst.

When even the discoverer of the law of gravity embraces a market that defies it, you have what Charles P. Kindleberger calls investment mania.

A new edition of Kindleberger’s classic study, “Manias, Panics and Crashes” (John Wiley & Sons, 250 pages, $19.95), has just arrived as a sort of cautionary counterweight to the notion that economists and industrialists have somehow banished the boom-and-bust business cycle and brought us the gift of a permanently rising stock market.

Kindleberger, a retired professor of economic history at MIT, cheerfully acknowledged in a recent interview from his Boston-area home that as a stock market pessimist, he has been “wrong for the last six months at least.”

Still, he sees in the current mutual fund craze a bubble similar to those described in his book, including the South Sea fiasco in which a British company’s Latin American trade franchise sparked a frenzy for its shares; the 17th century “tulip mania” in Holland, where even garden-variety tulip bulbs became objects of frantic speculation; and the U.S. stock market explosions of 1929 and 1987.

Financial crises follow patterns that, unhappily, have predictive value only in retrospect because of another phenomenon that Kindleberger has noted, namely that each successive group of speculators is able to persuade itself that its own situation is unique in history.

Among the common elements Kindleberger lists:

* The public becomes fixated on “fads,” sometimes obscure factors that it believes are infallible keys to the market, while ignoring more obvious “fundamentals,” such as the location of real estate or the earnings of a company.

In the high-inflation 1970s, for example, “it used to be that every Friday afternoon, people would see what happened to the money supply, and the market would respond up or down,” Kindleberger said. “Now everything works on interest rates, the 30-year [U.S. Treasury] bond yield. These are fads.”

The only apparent fundamentals that applied to tulips during the Dutch mania were the scarcity of the varieties and the beauty of their blooms. Yet Kindleberger points out that the speculative climax occurred in the winter of 1636-37, when the bulbs had already been planted and wouldn’t bloom until spring, and many investors had only vague descriptions to guide their bidding.

Similarly, in the hunger for shares of South Sea Co. nearly a century later, market participants overlooked that Spain, which claimed all of South America, had not signed off on the firm’s supposed trade monopoly. A French banker named Martin, proffering his 500-pound investment, reasoned, “When the rest of the world are mad, we must imitate them in some fashion.”

* Jeremiahs get treated like, well, Jeremiah.

Paul M. Warburg, a prominent investment banker and a founder of the Federal Reserve System, was assailed viciously for his February 1929 warning about “unrestrained speculation,” Kindleberger noted. The stock market dipped sharply after his statement, but soon resumed streaking upward toward the October crash.

Similarly, such present-day bears as investment advisor Elaine Garzarelli have been heaped with scorn--albeit more mildly expressed than in Warburg’s day--for their predictions of imminent market collapse. On July 23, when Garzarelli pronounced that stocks would fall 15% to 25% from their spring heights, the Dow Jones industrial average shed 44 points to close at 5,346.55. Since then, as the bulls have been kind enough to remind Garzarelli, the Dow has soared another 19%.

* A single unforeseen event can pop the bubble.

In 1799, for example, England sought to alleviate a severe cash shortage on the European Continent by shipping 1 million pounds sterling to Amsterdam aboard the frigate Lutine. However, the Lutine and its silver cargo sank in a storm, triggering the very crisis the British had hoped to forestall. (The recovered bell of the Lutine now resides at the Lloyds of London insurance market, where it is rung to announce news of overdue ships.)

British politician Robert Walpole pushed through the Bubble Act of 1720, ostensibly as a check on reckless speculation, but more likely to protect South Sea Co. from competition. Whatever the motive, it hastened the collapse.

The U.S. stock market crash of Monday, Oct. 19, 1987, was caused in part, Kindleberger argued, by massive mutual fund redemptions over the preceding weekend. “You typically think of a crash coming when the insiders get out,” he said, “but these were the peasants who sold.”

Last month, Federal Reserve Board Chairman Alan Greenspan caused a sharp, one-day reversal in global stock and bond markets by asking rhetorically how central banks should react to signs of “irrational exuberance” in financial markets.

Was Greenspan’s jawboning enough to cool the overheated markets without precipitating a crash? It’s too soon to say, but Kindleberger noted that the Fed today faces a dilemma similar to one that vexed the Bank of Japan in 1989: How do you use monetary policy to discourage undue speculation at a time of slow economic growth and low inflation? Kindleberger likened it to using a shotgun to blast one target while leaving its neighbor unscathed.

When, after much soul searching, the Japanese central bank finally raised the discount rate in December 1989, it sparked a horrendous market crash a month later--one that led to an economic downturn that Japan has been struggling with ever since.

* The length of a market’s collective memory during a manic phase seldom exceeds a decade.

“In 19th century England, every 10 years they had these financial crises, so why didn’t the markets learn?” Kindleberger asked. “I think the answer probably is that one generation learns, but then you get a lot of new guys. The question is, of the people in the market now--they don’t remember 1929--but do they remember 1987? It’s always the new boys who need to get a baptism of fire.”

From his research into financial manias through history, Kindleberger has distilled another observation that applies to all of them, whether the object of investor affection is tulips, Southern California real estate or shares in a hot technology company: “There is nothing so disturbing to one’s well-being and judgment as to see a friend get rich.”

NICE MARKET. WE’LL TAKE IT!

Stock Prices Seem to Withstand Anything, But What if an Alien Idea Like Fear Takes Hold and.... REALITY ATTACKS!

“Irrational!?”--Alan Greenspan

“Exuberant!?” --Alan Greenspan

Elaine Garzarelli as THE BEAR

Mutual Fund Flows as THE FORCE

Newt Gingrich as THE BUDGET HAWK

Alan Greenspan as THE PARTY POOPER

Baby Boomers as MARKET MOVERS

Bill Clinton as THE BIG NON-SPENDER

LONG BULL RUN PRODUCTIONS presents in association with Lois Interest and Coldwar Ender a HIGH YIELD film “Reality Attacks”

Directed by the FEDERAL RESERVE

Also Starring TICKLE-ME ELMO as the innocent investor, BOB DOLE as the missed opportunity, MERYL STREEP as Merrill Lynch, and MADONNA as the upside risk.

Music by COUNTING CROWS

Screenplay by OPEN MARKET COMMITTEE

Special Effects by DEMOGRAPHICS

Production design by CAPITALISM

Co-Produced by TECHNOLOGY SECTOR