Financial Crises

Brenda Spotton Visano

• Publisher: Routledge
• Year: 2006
• ISBN:
  9781134229987
• Edition: 1
• Topic: Commerce
• Subtopic: Finance

This study explores the major patterns of change in the evolution of financial crises as enduring phenomena and analyzes the paradoxical position that crises are at once similar to and different from each other. Brenda Spotton-Visano examines economic, psychological and social elements intrinsic to the process of capitalist accumulation and innovation to explain the enduring similarities of crises across historical episodes. She also assesses the impact that changing financial and economic structures have on determining the specific nature of crises and the differential effect these have in focal point, manner and extent of transmission to other, otherwise unrelated, parts of the economy.

Financial Crises offers a consistent method for interpreting variations in financial crises through time and allows for a better overall appreciation for both the transitory fragility and enduring flexibility of financial capitalism and the potential vulnerability created by on-going financial development. Topical and informative, this key book is of keen interest to all those studying and researching international economics and political economy.

Part I
The socio-economic context

1
An introduction to the evolution of financial fragility

Financial crises of foremost concern are those financial disruptions that adversely affect the general well functioning (or an important part) of the economy. Financial crises may first appear as the dramatic collapse in the prices of marketable financial instruments or the insolvency of lending establishments and suspension of their credit facilities. The breakdown in financial markets or sudden withdrawal of credit can adversely affect on a large scale the day-to-day commercial operations of organisations in the non-financial sectors of the economy. In this way, financial crises can precede both temporally and causally economic crises in employment, production and trade. At the economic level financial crises are systemic disturbances to the financial system that impede the system’s ability to allocate financial capital and disrupt the economy’s capacity to function. Triggering a loss of economic value, the crisis impairs the economy’s ability to allocate its resources, causing severe financial and economic distress. Triggering a loss in confidence, the crisis ushers in a state of normlessness, or Durkheimian anomie. Shattered is the feeling of certainty in action, and an anxious uncertainty replaces a prior confidence in comprehension.

Yet rarely are two historical episodes of crises identical. As some have argued, there is no single type of crisis.¹ Comparative analyses of historical crises typically offer taxonomies of the crises with types differentiated variously by sectors (public versus private or corporate arenas), objects of speculation or institutional spheres of finance (banks versus financial markets).² Comparative historical analysis has ventured little beyond the taxonomy to examine the manner in which the underlying institutional and economic structures may explain the variations. And there remains debate surrounding the relative importance of financial development versus financial structure in influencing the overall stability of the financial system (see Dolar and Meh, 2002). The challenge that remains is to explore a means of understanding the similarities common to all crises in a framework that is flexible enough to permit a consistent explanation of historical differences.

This study attempts to perceive in its major contours the evolution of the financial crisis as an enduring phenomenon that unfolds in historical time and that will transform itself in specific detail through time. The extent to which a crisis is the inescapable consequence of the economic and social elements intrinsic to the process of capitalist accumulation and innovation explains the enduring similarities of the crisis across historical episodes. The influence of the mutating financial and economic structures in which the crisis occurs ensures that the historical detail of each crisis will differ markedly in focal point, manner and extent of transmission to other, otherwise unrelated, parts of the economy. The key to understanding the seemingly paradoxical position that crises are at once similar to and different from each other lies in the role institutions play in the operation of the finance capitalist system.³ By exploring the essential role of financial institutions in informing and transforming the financial crisis, this study attempts to achieve a consistent means of interpreting variations in financial crises through time.

Institutions are variously conceived of as a legal enterprise (such as a bank), a social practice (such as market exchange) or a system of rules as forms of constraint ‘that human beings devise to shape human interaction’ (North, 1990:4).⁴ While institutions may be informal as defined by custom or formal as defined by law, in this work I am concerned with those formal institutions that define the financial structure in capitalist systems and which, in the broader sense, operate to structure incentives and guide behaviour.

That financial crises are, in their essence, an institutional phenomenon demanding explicit location in the economic and financial structures in which they occur is not a new idea. Neither is it novel to suggest that an analysis of institutions can explain the differential performance of economies through time. Insofar as the present study grounds the existence of institutions on the human desire to create predictability in the face of uncertainty, permits the social construction of knowledge and understanding to define an outcome, examines financial crises as a fundamentally institutional phenomenon and explores the influence of institutions on the differential performance of the financial economy, the schema it proposes shares many features of extant institutional analyses of crises specifically and the relationship between structure of financial institutions and the economy more generally. Yet, to date, there is no study that seeks to combine the evolution of financial institutions, as a social construct, with the variations in the types of financial crises we can observe when looking back through history.

Whereas economic analyses of institutions and institutional change limit their focus to the rational individual who is constrained in ability to access and process information, the present study permits the intrusion of the social. In permitting the social to shape individual understandings and to inform individual actions in a manner consistent with the social interaction literature, the path along which both the crisis and the speculation that precedes it develop, becomes dependent on both the historical past and the collective understanding of the present.

Whereas studies that examine the relationship between the economy and its structure of financial institutions focus on explaining variations in longer-term rates of economic growth and development, this study applies the structural–functional analysis of the finance–economy relationship to the question of transitory crises. In this way, the present study retains the insights offered by extant institutional analyses of crises in a framework that permits the interaction between institutions and crises to evolve over time. The flexibility of the structural–functional approach permits, in turn, an analysis of crises in both the markets for financial instruments and lending institutions and, if successful, begins to bridge a gap that currently exists in the economic literature of crises.

In short, by combining research on social interaction in a capitalist system with a psychological–economic analysis of institutions and examining the relationship between financial institutions and financial crises in an evolving economy, this study brings together well-researched parts into a different whole. The hope is that by understanding better the interaction between the crisis and the underlying institutional structure in a social context, we might gain a better overall appreciation for both the transitory fragility and enduring flexibility of finance capitalism.

This study proceeds as follows. Following a brief tour of six historical crises occurring at various times in three different countries, the opening chapters of Part I explore the foundations of an institutional perspective on financial crises. Chapter 3 explores capitalism as a culture that values material wealth and focuses on material gain, innovation and accumulation. Chapter 4 explores the general nature of uncertainty and information. It examines the process of understanding the behaviour and examines the information and guidance available to decide what action to take when uncertainty about objective future outcomes prevents a calculus of probabilities from informing any cost–benefit analysis of material gain. Chapter 5 considers the rather unsatisfactory nature of traditional explanations of financial instability when orthodox explanations are confronted with their assumption of knowable future outcomes.

With the foundations of culture, innovation and behaviour established, and the deficiencies of traditional explanation exposed, the next three chapters of Part II explain the three primary dimensions of instability that appear common to all historical crises.⁵ Chapter 6 explores the manner in which speculation via financial instruments financed by credit expansion at once facilitates the process of adopting the innovation and creates the fragility that foretells a crisis, Chapter 7 examines the role of credit in financing a speculation and the particular role of banks and Chapter 8 investigates the nature of the distress and the conditions under which distress degenerates into panic. In a world where future outcomes are neither known nor knowable, current and future prospects are contingent on collective understandings. This environment opens the door to an evolution in speculative investment and credit creation that is defined not by objective circumstances, as efficient markets theorists and pure monetarists would have it, but by subjective, path dependent developments that serves to increase fragility as the episode unfolds.

The last two chapters provide a sketch of a framework flexible enough to expose the differences in crises arising from institutional variations. Chapter 9 relates the nature of the financial crises to both the contemporaneous financial structure and the nature of the economic transition spawned by the contemporaneous innovations. Chapter 10 explores the use of balance sheet indicators of the financial structure and the networks of linkages represented in this framework and considers the extent to which the indicators may be reasonable and practicable for portraying and analysing historical crises. A concluding chapter offers some reflections and projections.

2
Illustrations of manias, panics and crises

History does not repeat itself…but it rhymes.

(commonly attributed to Mark Twain)

Episodes of financial crises punctuate the history of finance capitalism. Since the early beginnings of formal financial systems in the late 1600s, developing nations have periodically experienced episodes of fantastic speculative optimism followed by recoil in pessimism and calamity. Of the many episodes occurring intermittently throughout the last three centuries, six are briefly described later. These are simply six important episodes chosen as illustrations of a single phenomenon that varies in considerable detail over time and in an ever-widening global space.

Early eighteenth-century England

In the second decade of the 1700s, the English parliament sanctioned a radically innovative plan to privatise the government’s burdensome debt. With the March 1720 passage of the Refunding Act, Parliament granted the South Sea Company permission to acquire government debt and to finance the acquisition by expanding its issue of company shares.¹ Easy credit terms (with subscriptions available for only a fraction of the market value required on purchase),² together with the uncertain promise of a great experiment never before tried, encouraged the initial speculation by leading members of Parliament, themselves encouraged by inducements paid by the South Sea Company to these persons of influence. Speedy and substantial price increases fuelled further excitement. A ‘bubble’ in the prices of the shares of the company holding the monopoly on the conversion ensued. A spectacular rise in the share prices of the South Sea Company rose to a peak of 1,050 pounds per share in August of 1720,³ from a mere 128 pounds per 100 pound par value share the previous January.⁴ By the end of September, however, share prices had collapsed to around 200 pounds reaching a low point of 124 pounds in late December.

The speculation subsided with the enactment of legislation prohibiting the operation of unauthorised joint-stock companies.⁵ It is common to point to the Bubble Act as the beginning of the demise of the South Sea Bubble and by the price estimates available, it appears that the rate at which prices increased in the remaining time slowed considerably. Initial reactions to the passage of the Act started a rush to liquidity, according to Davies (1994), which reached the state of a general panic by August. Ashton (1959:119) identifies the issue of writs against unauthorized companies on 18 August, ‘that brought the frail structure to the ground’.

With the slowdown and eventual decline in share prices, the debt burden of margined shareholders increased significantly. Although the collapse did not wipe out the Company itself, its directors and others involved in what was then viewed as general corruption were heavily fined, imprisoned and had their estates confiscated to help to compensate the victims of the crash. The principal creditor of the Company and major competitor of the Bank of England in the sphere of commercial banking, the Sword Blade Bank, failed in September of 1720. The failure of its primary competitor in commercial banking, and the diminished capacity of its primary competitor in government banking, secured the Bank of England’s central importance in the London financial market.

While the 1720 financial crisis was remarkable and accounts of it are remarkably vivid, evidence suggests that the adverse impact, measured in terms of reported bankruptcies in otherwise unrelated activities, was minimal and remained limited to those directly participating in the sphere of public finance. Hoppit (1986), through careful analysis of bankruptcy totals, shows that bankruptcies ‘moved above their trend line only once, in the final quarter of 1720’, affecting the edifice of public credit all but exclusively. As these data would not reflect the distress of farmers and landowners, who by law could not be dealt with via bankruptcy, Hoppit implies that increased land sales marked the distress experienced by the naïve speculator and turns to E.P. Thompson’s (1985 [1977]) account in Whigs and Hunters. ‘It was the small speculator, the petty country gentleman or substantial farmer, jealous of the gains of his wealthy neighbours, who came late into the game, without experience and without London advisers, who was most likely to lose his all’ (as quoted in Hoppit 1986:48).⁶

Early nineteenth-century England

A century later, the rising democracies of the newly liberated South American countries in need of funds found ready suppliers in Britain. The Latin American needs appealed to the new British political idealism and supporting commercial strategy that had developed during the profound transformation that marked readjustment to peacetime production following the Napoleonic wars. The South American opportunities for mining investment offered the principal speculative focus in 1822–1824.⁷ Technological innovations that advanced the steam engine together with the profound social and economic transformation that ad...