The Critical Stage — When the Bubble is About to Pop

Abstract

The standard model of the sequence of events that leads to a banking crisis is that a shock triggers an economic expansion that morphs into an economic boom and then euphoria develops; the prices of securities and real estate increase rapidly, much more rapidly than GDP. Then there is a pause in the pace of these increases in the price of securities. A few savvy or lucky investors sell some of their securities to park their speculative gains in a secure store of value. The slowing of the increases in the prices of securities and real estate may induce a more cautious approach by others. Distress is likely to follow as the prices of securities begin to decline. The pattern is biological in its regularity. A panic is likely and then a crash may follow. Lord Overstone, the leading British banker of the middle of the nineteenth century, saw a similar pattern and was quoted with approval by Walter Bagehot: ‘quiescence, improvement, confidence, prosperity, excitement, overtrading, CONVULSION [sic], pressure, stagnation, ending in aquiesence’.1 Overstone identified five stages of euphoria before the financial crisis, or, in his words, the convulsion.