A History of Financial Crises

Dreams and Follies of Expectations

Cihan Bilginsoy

• Publisher: Routledge
• Year: 2014
• ISBN:
  9781317703808
• Edition: 1
• Topic: Business
• Subtopic: Business General
• Index: Business

"Once-in-a-lifetime" financial crises have been a recurrent part of life in the last three decades. It is no longer possible to dismiss or ignore them as aberrations in an otherwise well-functioning system. Nor are they peculiar to recent times. Going back in history, asset price bubbles and bank-runs have been an endemic feature of the capitalist system over the last four centuries. The historical record offers a treasure trove of experience that may shed light on how and why financial crises happen and what can be done to avoid them - provided we are willing to learn from history.

This book interweaves historical accounts with competing economic crisis theories and reveals why commentaries are often contradictory. First, it presents a series of episodes from tulip mania in the 17th century to the subprime mortgage meltdown. In order to tease out their commonalities and differences, it describes political, economic, and social backgrounds, identifies the primary actors and institutions, and explores the mechanisms behind the asset price bubbles, crashes, and bank-runs. Second, it starts with basic economic concepts and builds five competing theoretical approaches to understanding financial crises. Competing theoretical standpoints offer different interpretations of the same event, and draw dissimilar policy implications.

This book analyses divergent interpretations of the historical record in relation to how markets function, the significance of market imperfections, economic decision-making process, the role of the government, and evolutionary dynamics of the capitalist system. Its diverse theoretical and historical content of this book complements economics, history and political science curriculum.

1 Introduction

DOI: 10.4324/9781315780870-1

Consider a household which plans to buy a home, a firm that plans to build a new plant, or a government that plans to improve highways. If their income is insufficient to finance the projects these households, firms, and governments are called deficit units. On the other side of the ledger there are surplus units, households, firms and governments with incomes greater than their expenditures and which want to increase their income further by investing their savings. The role of the financial system is to facilitate transactions between these two types of units. In financial markets the deficit units bid for the excess funds of the surplus units by selling instruments of debt (e.g. short-term commercial paper, IOUs, bonds) or ownership (shares) to raise funds to carry out planned expenditures (Figure 1.1). These instruments entitle the surplus units to returns or income streams in the form of interest payments or dividends to be received at future dates. But financing is not always direct; the surplus units do not always meet the deficits units “face to face” as direct buyers of financial instruments. The financial system also includes intermediary institutions such as banks, credit unions, pension funds, insurance companies, hedge funds, and mutual funds, which facilitate financial transactions. As shown in Figure 1.2, these financial intermediaries stand between the surplus and deficit units and serve as hubs that gather savings of the surplus units and market them to the deficit units. They also collect the returns and distribute them among the surplus units after deducting the fees for their services.

Figure 1.1 Direct financing.

Figure 1.2 Financial intermediation.

If everything goes well and mutually beneficial exchanges take place, both sides of the trade improve their well-being. On the deficit-unit side households enjoy their new homes, firms expand their capacity and raise profits, and the governments provide new highways that save time and reduce traffic hazards. The surplus units receive returns and add to their wealth.

There is, of course, always the possibility that the actual outcomes may be different from the plans. There are always risks associated with forward-looking actions. The homebuyer may be unable to make mortgage payments and face foreclosure. A recession may force a firm to abandon its new plant and face bankruptcy. The surplus units may not be able to collect the expected payments. The fact that the future is unknown is what really makes financial markets shine. They price the risk and match borrowers who pursue high-risk projects with portfolio holders who can tolerate more risk in return for higher interest or dividends. They offer means to manage risk in forms of portfolio diversification and trading instruments of insurance. Finally, they make risk more affordable by distributing it among many wealth holders. Thus, financial markets are markets in which economic agents raise funds, invest in assets, and manage risk by trading instruments such as short- and long-term loans, stocks, and derivative contracts.

From a social perspective, finance lubricates the channels of commerce and production. Merchants need lines of credit because buying and selling are usually temporally separated. Producers rely on credit to pay their daily production costs. Allocation of surplus funds among the deficit units creates new industries, products, and neighborhoods. The construction of merchant fleets and the emergence of long-distance trading companies that globalized the economy in the seventeenth and the eighteenth centuries required large numbers of investors both to amass sufficient funds and to distribute risk among many stakeholders. At the dawn of the industrial revolution large-scale projects such as canals and railways required the mobilization of savings across the economy through loans and common stocks. Not surprisingly, many economists today fervently advocate the development and growth of financial markets across the globe with the expectation that they will be the handmaidens of economic growth.

However, the enthusiasm about the beneficence of the financial system is hardly universal. Skeptics point out that the laudatory accounts of textbook descriptions of the financial system overlook its unappealing features. Certain financial innovations are merely bets against future market movements, and, as such, move money around without creating much social value. Financial markets may not function efficiently due to various kinds of frictions and imperfections, such as differential access to information, perverse incentives, and price manipulation. The troubles of a few institutions may spread to the rest of the system quickly due to financial institutions’ interdependence, especially during periods of heightened risk and excessive debt creation. The outcomes of this contagion are often a generalized run on banks, pervasive defaults, and stock-market crashes. Even worse, these crashes may spill over to the real sector (industry, commerce, agriculture, services) and trigger a generalized economic contraction. Boom-and-bust cycles throughout financial history are the primary evidence offered in support of this view. These observations are usually coupled with the recommendation that it is necessary to impose rules and regulations on financial institutions by public authorities to alleviate excessive speculative activity and reduce the likelihood of crises.

The “vision” thing

Financial crises have been a recurrent feature of the capitalist economy. The earlier classic episodes are the Dutch tulip mania, the Mississippi Bubble, and the South Sea Bubble that took place in the seventeenth and eighteenth centuries. Throughout the nineteenth century speculation in land and railways, stock-market booms and busts, and subsequent periods of stagnation were rampant in Britain and the US. The crash of 1929 is still recognized as the ultimate financial meltdown, and the launching pad of the Great Depression. After a lull that lasted until the 1980s financial crises came back with a vengeance. In the US savings and loan institutions failed in the 1980s at the cost of hundreds of billions of dollars to the taxpayers. 1987 witnessed the biggest one-day Wall Street crash. The hedge fund Long-Term Capital Management was saved by a consortium of investment banks and the Federal Reserve System in 1998. The dot-com bubble burst in 2000. Finally, the subprime-mortgage crisis of 2007–8 triggered fears of another Great Depression. However, there is still no consensus among economists on whether these events were ordinary responses of the markets to exogenous shocks or symptoms of endemic market failures.

One might think that experts, with the benefit of historical hindsight, must have by now determined the sources of financial instability, learned to anticipate the tell-tale signs of looming problems, and designed measures to avert a crisis. This is not the case. A common response among the commentators in the face of widespread defaults, bank failures, and asset-price crashes is surprise. After the near meltdown of the financial system in 2008 US Vice-President Cheney, in an Associated Press interview in January 2009, stated, “I wouldn’t have predicted that… I don’t think anybody saw it coming.” President George W. Bush wrote in his memoirs that he was “blindsided” by the crisis. The president and the vice-president may be excused for their inadequate forecasting abilities due to the numerous issues that demanded their attention daily, from wars in Iraq and Afghanistan to security leaks in the administration—and they were not specialists in financial turmoil. It is the job of experts in academia, business, and government to take note of the potholes and hazardous conditions in the economy, inform the public and the policymakers, issue warnings, and make recommendations.

But they also failed—collectively. Throughout the decades preceding the crisis most of the experts hailed the incessant rise in home prices, securitization of debt instruments, and the proliferation of opaque financial derivatives as beneficial forces that created an age of unprecedented prosperity and demonstrated the omnipotence of the “free market system” (a euphemism for capitalism unfettered by government regulations). They ignored or downplayed how these new markets and instruments increased the fragility of the financial system and elevated the risk exposure of the entire financial system and the economy. The dominant conceptual framework propounded by economists and promoted, among others, by Alan Greenspan and Ben Bernanke (successive chairs of the Federal Reserve System), bank executives, and real-estate-industry insiders was that innovations in financial markets stimulated the flow of savings to securities and reduced risk across the system. These savings ostensibly enabled technological revolutions, enhanced productivity, and improved the global standard of living. Potential problems, such as the subprime-mortgage defaults, were thought to be isolated in remote corners of the financial world, unlikely to spill over to the rest of the system. The media held the party line by constantly talking up the riches to be attained in the financial markets.

What these economists, policymakers, business people, regulators, and much of the public shared was a particular “vision” or frame of mind that shaped how they observed and conceptualized the developments in the economy. Economist Joseph Schumpeter drew attention to the role of this frame of reference in economic analysis:

[I]n order to be able to posit ourselves any problems at all, we should first have to visualize a distinct set of coherent phenomena as a worthwhile object of our analytical efforts. In other words, analytical effort is of necessity preceded by a preanalytic cognitive act that supplies the raw material for the analytic effort. In this book this preanalytic cognitive act will be called Vision.

(1954: 41)

Schumpeter’s preanalytic vision is the researcher’s perception of the “world in which we live” that selects certain facts as important or relevant and ignores others. It precedes the analytical work of constructing theoretical models to conceptualize the vision. The preanalytic vision is obviously closely related with ideology.

In fact, [ideology] enters on the very ground floor, into the preanalytic cognitive act of which we have been speaking. Analytic work begins with material provided by our vision of things, and this vision is ideological almost by definition. It embodies the picture of things as we see them, and wherever there is any possible motive for wishing to see them in a given rather than another light, the way in which we see things can hardly be distinguished from the way in which we wish to see them.

(Schumpeter 1954: 42)

The important point here is that ideology is an essential ingredient of the preanalytic vision and an indispensable component of the endeavor to make sense of the world. ¹ As such, it may restrict the researcher to thinking in limited structures, and fail to discern contrarian trends and to ask appropriate questions. In light of Schumpeter’s comments, ideological proclivities explain the failure of a large majority of the experts to see the oncoming subprime meltdown. The dominant vision in the post-1980 period precluded systemic financial fragility and crisis. Most experts, despite the benefit of historical hindsight, failed to anticipate the telltale signs of looming problems because, within their frame of reference, unfettered markets were inherently stable, and innovations only further improved the resilience and stability of the financial system.

Alan Greenspan made the same point at a post-2008 congressional hearing: “An ideology is, is a conceptual framework with the way people deal with reality. Everyone has one. You have to—to exist, you need an ideology.” ² He further announced that the subprime crisis revealed an error in his ideology: “I found a flaw in the model that I perceived as the critical functioning structure that defines how the world works.” During the same hearing, he explained:

I made a mistake in presuming that the self-interests of organizations, specifically banks and others were such that they were best capable of protecting their own shareholders and equity in firms … So the problem here is something which looked to be a very solid edifice and, indeed, a critical pillar to market competition and free markets, did break down… [T]hat shocked me. I still do not understand why it happened and, obviously, to the extent that I figure out what happened and why, I will change my views.

What happens when events that are deemed anomalous from the perspective of the dominant “vision” occur? Various outcomes are possible, depending on the frequency, significance, and severity of such occurrences. Sometimes the anomalies are ignored or dismissed by the public, investors, and experts. Believers in the magic of the markets adhere to the “once in a lifetime” cliché and relegate crashes to mere aberrations. After passing through stages of blame and atonement investors pick up the pieces and proceed to the next speculative boom, sharing the sentiment expressed by the “four most dangerous words” in investing attributed to Sir John Templeton: “This time it’s different.” Academics who side with the dominant orthodoxy of the supremacy of unfettered markets offer versions or interpretations of events to align them with their framework.

However, conceptual complacency is not universal. Crises, especially when they are severe and long-lasting, may lead to alternative visions of how the economy works and theoretical fault lines. Market turbulences, in fact, motivated many economists to design models to explain the conditions under which financial markets fail to function efficiently and apply these theories to episodes of boom and crash. While these economists imply that financial markets do not guarantee socially optimal outcomes, there is substantial variation among the visions of these alternative models. One set of models focuses on consequences of the imperfectly competitive market structures. Another set emphasizes the decision-making process of investors. Others go further by positing a vision of capitalist dynamics as inherently unstable and fragile rather than harmonious, balanced, and steady.

As for this book, it acknowledges a plurality of explanations (although it does not subscribe to the relativist view that all theories are valid on their own terms and that there is no discoverable, objective truth). Its objective is to lay out the preanalytics and analytics of competing explanations of financial crises, illustrate them in historical perspective, and present the current state of the debate in the economics discipline. It is important to appreciate the differences between alternative approaches and their implications because, as current discussions over the regulation of financial markets attest, theories inform the public policies that influence people’s everyday lives.

Types of financial crises and the scope of the book

A financial crisis occurs when a large number of wealth holders attempt to liquidate their assets simultaneously due to the fear that the value of their holdings will depreciate. Three types of asset may underlie three types of crisis: bank deposits (or other short-term loans to banks), securities (government debt, private bonds, and stocks), and currencies. When banknote holders, depositors, and other short-term lenders grow uneasy about a bank’s solvency they rush to redeem their loans to banks. Concerns about depreciation of the value of securities force their owners to sell their portfolios. The expectation that a national currency will lose value vis-à-vis other currencies leads to a run from the currency.

Once agents’ apprehension is kindled and spreads, the crisis can easily become a self-fulfilling prophecy and turn into a bank run, bond- or stock-market crash, or a currency collapse. In each of these instances owners of these assets try to convert their wealth to safe alternatives, which may take the form of gold, cash, Treasury bills, and so forth, depending on time an...