Crashes, Bangs & Wallops

tauringhuang.

By Richard Lambert

Thursday, August 07, 2008
  
[ Next ]  Page 1 of 3


  
Each
separate panic has had its own distinctive features, but all have resembled each other in occurring immediately after a period of apparent prosperity, the hollowness of which it has exposed. So uniform is this sequence, that whenever we find ourselves under circumstances that enable the acquisition of rapid fortunes, otherwise than by the road of plodding industry, we may almost be justified in auguring that the time for panic is at hand."

That could have been said yesterday. In fact it was written in 1859, in a history of the commercial crisis of 1857-58. Financial shocks all feel different, but most of them are pretty much the same.

Let's start with an obvious parallel. The run on Northern Rock was the first big bank failure in this country since 1866, when Overend, Gurney went down. Both were long-established institutions with histories of prudent and highly respectable finance: Northern Rock as a mutually owned building society in the north-east, Overend with its roots deep in Quaker East Anglia.

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The leadership of both had been taken over by a new breed of growth-hungry executives, anxious to expand their loan books rapidly: Northern Rock in mortgages at the top of a house-price bubble, Overend in some decidedly dubious enterprises including shipbuilding, grain trading, railway finance and much else besides. Both made the fatal mistake of relying on short-term borrowing to fund their rapidly expanding and increasingly risky loan books. And just like Northern Rock, Overend paid the price for its flawed business model. The one big difference was that the Bank of England let Overend fail, and take down other firms with it in the ensuing panic.

Two American economists, Carmen Reinhart of Maryland and Ken Rogoff of Harvard, have recently published an analysis of the current financial crisis in the context of what they identify as the previous 18 banking crises in industrial countries since the second world war. They find what they call "stunning qualitative and quantitative parallels across a number of standard financial crisis indicators" - the common themes that translate these individual dramas into the big-picture story of financial boom and bust. Their study is focused on the US, but if you look at the relevant numbers, most of their analysis also applies to the UK.

Ahead of each big financial shock, house prices rose rapidly, as did equity prices. Current account deficits ballooned, with capital inflows accelerating up to the eve of the crisis. Rising public debt is a near universal precursor of other postwar crises. And overall economic growth started to fall away as trouble loomed. In addition, financial shocks in the past have often been preceded by periods of financial deregulation.

I witnessed as a wide-eyed reporter the secondary banking crisis of 1973-74, which came within a whisker of pulling down some of our most powerful financial institutions; and I still have in my possession the press release put out by one of the big four clearing banks denying that it was in difficulties. That drama had several different triggers: one was the Competition and Credit Control scheme introduced at the end of 1971, which removed the ceiling on loans, reduced banks' liquidity requirements and ended the interest rate cartel. Over the next two years, total credit advances to UK residents multiplied 2.5 times.

Deregulation has also played a part in today's events. To quote Paul Volcker, former chairman of the US Federal Reserve, over the past 25 years "we have moved from a commercial-bank-centred, highly regulated financial system, to an enormously more complicated and highly engineered system. Today, much of the financial intermediation takes place in markets beyond effective official oversight and supervision, all enveloped in unknown trillions of derivative instruments."

Another common feature, this one identified in a recent FT article by Charles Goodhart and Avinash Persaud, is that asset-price bubbles often follow periods of price stability. They cite as examples the US in 1929, Japan in the 1990s, Asia in 1997-98 and the implosion of subprime mortgages in 2007-08.

Low inflation leads to low interest rates and the accumulation of real assets. That in turn leads investors to take bigger risks in order to secure a higher return on their investments. A classic example came in the 1970s, when petrodollars flooded the international capital market and drove interest rates down. Banks were flush with liquidity and looking around for new outlets. They found what they were looking for in the developing economies of central Europe and Latin America. But things came to a grinding halt in August 1982, when the Mexican government suspended debt service.

Much the same has happened in the past few years. Indeed Rogoff and Reinhart rather cheekily suggest that this time round, a large chunk of money has effectively been recycled to a developing economy - but one that this time exists within America's own borders. More than a trillion dollars were channelled into the US subprime mortgage market, which is made up of the poorest and least creditworthy borrowers.

The common feature here is that risk is misunderstood, and so mispriced. In 1929, it was excess leverage in investment funds that went wrong. In the Asian crisis of 1997-98, it was about mismatched currency exposures. In the dotcom boom, the thought was that the internet would lead to everlasting growth. And in the recent credit bubble, the idea was that by slicing and dicing debt, and distributing it widely around the world, junk debt could be miraculously converted into triple-A investments.

Is it really any different this time?

Yet another feature that this latest drama has in common with other similar episodes in history is that it is truly international in character. Time and again over the centuries it has been clear that optimism, greed, euphoria and despair do not recognise national boundaries. Well before the internet, changing market moods swept across the world with astonishing speed.

The falls in share prices on October 24 and 29 1929, and again on October 19 1987, were practically instantaneous in all financial markets, except Japan. This was far faster than could be explained by arbitrage, capital flows or money movements. The South Sea and Mississippi bubbles of 1720 were related, stoked by deregulation and powerful monetary expansion in England and France. And the crisis that followed them rippled across the Netherlands and northern Italy, as well as northern Germany. The list of such international earthquakes is just about endless.

Of course there have always been physical connections between national economies around the world - internationally traded commodities and bullion, exports and imports, capital and money flows, and so on. But what I find fascinating are the purely psychological connections, as when the mood of investors in one country infects those in another, sometimes great distances away. And what we always have to remember when thinking about financial euphoria and panic is that rational behaviour can very often go out of the window. Isaac Newton, one of the greatest minds in history, speculated wildly in South Sea stock and ended up losing his shirt. As he observed glumly: "I can calculate the motions of the heavenly bodies, but not the madness of people."

What are the consequences of big financial shocks?

The great source of knowledge on this is the economic historian charles kindleberger, whose classic book, Manias, Panics and Crashes, was published in 1978. Kindleberger's view, rather tentatively expressed, is that the role of lender of last resort, properly exercised, is the key to shortening the business slowdowns that normally follow financial crises. He cites as evidence the crashes of 1720, 1873, 1882, 1890, 1921 and 1929. In none of these was a lender of last resort effectively present. The depressions that followed them were much longer and deeper than others. Those of the 1870s and the 1930s were both known as "the Great Depression".

The role of lender of last resort was classically defined by Walter Bagehot. His great book Lombard Street was published in 1873, and set out what has become the guiding mantra for central banks in times of crisis ever since: lend freely at high rates against good collateral. Lend freely, in his words, "to stay the panic". At high rates, so that "no one may borrow out of idle precaution without paying well for it". And lend on all good banking securities to an unlimited extent - because the "way to cause alarm is to refuse someone who has good security to offer".

But, unfortunately, life is not as simple as that. For one thing, central bankers don't always do the job well. The Bank of England is generally thought to have played a poor hand in its intervention in the panic of 1825. City historian David Kynaston shows how its policy veered wildly between complacency and an over-sharp contraction of credit. More than 70 banks collapsed, and according to legend the Bank of England itself narrowly escaped disaster. Just as it ran out of £5 and £10 notes, someone discovered a block of £1 notes left in the vaults since 1797. These were issued with government approval, and "worked wonders". The ensuing depression lasted several years: by the end of 1827, according to one report, "in commerce, almost every one still smarting under the losses which the climax of 1825 had left them - and fearing from the long continuance of the swell after the storm even now to venture far from shore".

Another problem is that over-enthusiastic central bank intervention can store up real trouble for the future. This lies behind the energetic debate over the economic legacy of Alan Greenspan, who stepped down as chairman of the Federal Reserve in January 2006. The classic role of the Federal Reserve has been to lean against the wind, easing credit in hard times and tightening it before things get out of hand. In the words of William McChesney Martin, who served 18 years as chairman, up to the time of President Nixon: "The function of the Federal Reserve is to take away the punch bowl just as the party is getting good." Greenspan's critics claim that far from taking away the punch bowl, he was only too happy to chuck in an extra bottle of brandy at the first sign of the party coming to an end.

They also say that no matter what went wrong, the Fed under chairman Greenspan would save the day by creating enough cheap money to buy off trouble. After the crash of October 1987, the Fed cut rates three times in six weeks - and stocks quickly recovered. The same happened after the Asian crisis in 1997-98, and again after 9/11.

But there are limits to how far central banks can go. Cheap money and negative real interest rates lead over time to frothy speculation and inflation. This is what central bankers mean when they warn about the dangers of moral hazard - the risk that bailing bankers out of trouble will only encourage them to be even more irresponsible in future. The great difficulty lies in attempting to draw a distinction between individual culpability, when you should let an institution go bust, and the risk of systemic failure that might have desperately serious consequences.

For this reason, banking authorities over the years have often resolved not to intervene, only to find themselves forced to cave in under pressure. Lord Liverpool threatened to resign as chancellor of the exchequer in 1825 if the speculators were bailed out - but eventually they were. Kindleberger finds similar examples in 1763, 1869, 1897 and 1975, with the rescue of New York City. And Mervyn King, the present Bank of England governor, also made powerful warnings against the risks of moral hazard until the Bank was ready to make what looks like a classic Bagehot-style intervention a couple of months ago.

It's a difficult balance between teaching speculators a lesson and averting systemic failure. Only history will be able to judge the different approaches of Greenspan and King.

In its response to the latest crisis, the US Federal Reserve has gone considerably further than its predecessors. Faced with the threatened collapse of the Wall Street investment bank Bear Stearns, with its huge exposure to the derivative and securitised loans markets, the Fed, to use Paul Volcker 's words again, judged it necessary to take actions that "extend to the very edge of its lawful and implied powers, transcending certain long-embedded central banking principles and practices".

As such, this bail-out must surely lead to a radical reshaping of US securities regulation. If the Fed is to stand behind such institutions in future, it will require a much more direct degree of supervision than permitted under current rules. No wonder Volcker sounds concerned.

How long and deep is any economic slowdown likely to be?

Of course any answer has to be hedged around with lots of variables. The key one is the presence and performance of a lender of last resort. But there are many others, because booms and busts seldom have a single trigger. For example, the crisis of 1847 had the railway mania, the potato disease, a wheat crop failure one year and a bumper crop the next, followed on the continent by revolution. The Wall Street Panic of 1857 was turned into a prolonged recession by civil war. Libraries of textbooks have been written on the causes of the 1930s depression, to which the Great Crash was by no means the only contributor.

(To be continued)

tauringhuang.

Much the same has happened in the past few years. Indeed Rogoff and Reinhart rather cheekily suggest that this time round, a large chunk of money has effectively been recycled to a developing economy - but one that this time exists within America's own borders. More than a trillion dollars were channelled into the US subprime mortgage market, which is made up of the poorest and least creditworthy borrowers.

The common feature here is that risk is misunderstood, and so mispriced. In 1929, it was excess leverage in investment funds that went wrong. In the Asian crisis of 1997-98, it was about mismatched currency exposures. In the dotcom boom, the thought was that the internet would lead to everlasting growth. And in the recent credit bubble, the idea was that by slicing and dicing debt, and distributing it widely around the world, junk debt could be miraculously converted into triple-A investments.

Is it really any different this time?

tauringhuang.

Yet another feature that this latest drama has in common with other similar episodes in history is that it is truly international in character. Time and again over the centuries it has been clear that optimism, greed, euphoria and despair do not recognise national boundaries. Well before the internet, changing market moods swept across the world with astonishing speed.

The falls in share prices on October 24 and 29 1929, and again on October 19 1987, were practically instantaneous in all financial markets, except Japan. This was far faster than could be explained by arbitrage, capital flows or money movements. The South Sea and Mississippi bubbles of 1720 were related, stoked by deregulation and powerful monetary expansion in England and France. And the crisis that followed them rippled across the Netherlands and northern Italy, as well as northern Germany. The list of such international earthquakes is just about endless.

Of course there have always been physical connections between national economies around the world - internationally traded commodities and bullion, exports and imports, capital and money flows, and so on. But what I find fascinating are the purely psychological connections, as when the mood of investors in one country infects those in another, sometimes great distances away. And what we always have to remember when thinking about financial euphoria and panic is that rational behaviour can very often go out of the window. Isaac Newton, one of the greatest minds in history, speculated wildly in South Sea stock and ended up losing his shirt. As he observed glumly: "I can calculate the motions of the heavenly bodies, but not the madness of people."

What are the consequences of big financial shocks?

The great source of knowledge on this is the economic historian charles kindleberger, whose classic book, Manias, Panics and Crashes, was published in 1978. Kindleberger's view, rather tentatively expressed, is that the role of lender of last resort, properly exercised, is the key to shortening the business slowdowns that normally follow financial crises. He cites as evidence the crashes of 1720, 1873, 1882, 1890, 1921 and 1929. In none of these was a lender of last resort effectively present. The depressions that followed them were much longer and deeper than others. Those of the 1870s and the 1930s were both known as "the Great Depression".

The role of lender of last resort was classically defined by Walter Bagehot. His great book Lombard Street was published in 1873, and set out what has become the guiding mantra for central banks in times of crisis ever since: lend freely at high rates against good collateral. Lend freely, in his words, "to stay the panic". At high rates, so that "no one may borrow out of idle precaution without paying well for it". And lend on all good banking securities to an unlimited extent - because the "way to cause alarm is to refuse someone who has good security to offer".

But, unfortunately, life is not as simple as that. For one thing, central bankers don't always do the job well. The Bank of England is generally thought to have played a poor hand in its intervention in the panic of 1825. City historian David Kynaston shows how its policy veered wildly between complacency and an over-sharp contraction of credit. More than 70 banks collapsed, and according to legend the Bank of England itself narrowly escaped disaster. Just as it ran out of £5 and £10 notes, someone discovered a block of £1 notes left in the vaults since 1797. These were issued with government approval, and "worked wonders". The ensuing depression lasted several years: by the end of 1827, according to one report, "in commerce, almost every one still smarting under the losses which the climax of 1825 had left them - and fearing from the long continuance of the swell after the storm even now to venture far from shore".

Another problem is that over-enthusiastic central bank intervention can store up real trouble for the future. This lies behind the energetic debate over the economic legacy of Alan Greenspan, who stepped down as chairman of the Federal Reserve in January 2006. The classic role of the Federal Reserve has been to lean against the wind, easing credit in hard times and tightening it before things get out of hand. In the words of William McChesney Martin, who served 18 years as chairman, up to the time of President Nixon: "The function of the Federal Reserve is to take away the punch bowl just as the party is getting good." Greenspan's critics claim that far from taking away the punch bowl, he was only too happy to chuck in an extra bottle of brandy at the first sign of the party coming to an end.

They also say that no matter what went wrong, the Fed under chairman Greenspan would save the day by creating enough cheap money to buy off trouble. After the crash of October 1987, the Fed cut rates three times in six weeks - and stocks quickly recovered. The same happened after the Asian crisis in 1997-98, and again after 9/11.

But there are limits to how far central banks can go. Cheap money and negative real interest rates lead over time to frothy speculation and inflation. This is what central bankers mean when they warn about the dangers of moral hazard - the risk that bailing bankers out of trouble will only encourage them to be even more irresponsible in future. The great difficulty lies in attempting to draw a distinction between individual culpability, when you should let an institution go bust, and the risk of systemic failure that might have desperately serious consequences.

For this reason, banking authorities over the years have often resolved not to intervene, only to find themselves forced to cave in under pressure. Lord Liverpool threatened to resign as chancellor of the exchequer in 1825 if the speculators were bailed out - but eventually they were. Kindleberger finds similar examples in 1763, 1869, 1897 and 1975, with the rescue of New York City. And Mervyn King, the present Bank of England governor, also made powerful warnings against the risks of moral hazard until the Bank was ready to make what looks like a classic Bagehot-style intervention a couple of months ago.

It's a difficult balance between teaching speculators a lesson and averting systemic failure. Only history will be able to judge the different approaches of Greenspan and King.

In its response to the latest crisis, the US Federal Reserve has gone considerably further than its predecessors. Faced with the threatened collapse of the Wall Street investment bank Bear Stearns, with its huge exposure to the derivative and securitised loans markets, the Fed, to use Paul Volcker 's words again, judged it necessary to take actions that "extend to the very edge of its lawful and implied powers, transcending certain long-embedded central banking principles and practices".

As such, this bail-out must surely lead to a radical reshaping of US securities regulation. If the Fed is to stand behind such institutions in future, it will require a much more direct degree of supervision than permitted under current rules. No wonder Volcker sounds concerned.

How long and deep is any economic slowdown likely to be?

Of course any answer has to be hedged around with lots of variables. The key one is the presence and performance of a lender of last resort. But there are many others, because booms and busts seldom have a single trigger. For example, the crisis of 1847 had the railway mania, the potato disease, a wheat crop failure one year and a bumper crop the next, followed on the continent by revolution. The Wall Street Panic of 1857 was turned into a prolonged recession by civil war. Libraries of textbooks have been written on the causes of the 1930s depression, to which the Great Crash was by no means the only contributor.

(To be continued)

tauringhuang.

Another problem is that over-enthusiastic central bank intervention can store up real trouble for the future. This lies behind the energetic debate over the economic legacy of Alan Greenspan, who stepped down as chairman of the Federal Reserve in January 2006. The classic role of the Federal Reserve has been to lean against the wind, easing credit in hard times and tightening it before things get out of hand. In the words of William McChesney Martin, who served 18 years as chairman, up to the time of President Nixon: "The function of the Federal Reserve is to take away the punch bowl just as the party is getting good." Greenspan's critics claim that far from taking away the punch bowl, he was only too happy to chuck in an extra bottle of brandy at the first sign of the party coming to an end.

They also say that no matter what went wrong, the Fed under chairman Greenspan would save the day by creating enough cheap money to buy off trouble. After the crash of October 1987, the Fed cut rates three times in six weeks - and stocks quickly recovered. The same happened after the Asian crisis in 1997-98, and again after 9/11.

But there are limits to how far central banks can go. Cheap money and negative real interest rates lead over time to frothy speculation and inflation. This is what central bankers mean when they warn about the dangers of moral hazard - the risk that bailing bankers out of trouble will only encourage them to be even more irresponsible in future. The great difficulty lies in attempting to draw a distinction between individual culpability, when you should let an institution go bust, and the risk of systemic failure that might have desperately serious consequences.

tauringhuang.

For this reason, banking authorities over the years have often resolved not to intervene, only to find themselves forced to cave in under pressure. Lord Liverpool threatened to resign as chancellor of the exchequer in 1825 if the speculators were bailed out - but eventually they were. Kindleberger finds similar examples in 1763, 1869, 1897 and 1975, with the rescue of New York City. And Mervyn King, the present Bank of England governor, also made powerful warnings against the risks of moral hazard until the Bank was ready to make what looks like a classic Bagehot-style intervention a couple of months ago.

It's a difficult balance between teaching speculators a lesson and averting systemic failure. Only history will be able to judge the different approaches of Greenspan and King.

In its response to the latest crisis, the US Federal Reserve has gone considerably further than its predecessors. Faced with the threatened collapse of the Wall Street investment bank Bear Stearns, with its huge exposure to the derivative and securitised loans markets, the Fed, to use Paul Volcker 's words again, judged it necessary to take actions that "extend to the very edge of its lawful and implied powers, transcending certain long-embedded central banking principles and practices".

As such, this bail-out must surely lead to a radical reshaping of US securities regulation. If the Fed is to stand behind such institutions in future, it will require a much more direct degree of supervision than permitted under current rules. No wonder Volcker sounds concerned.

How long and deep is any economic slowdown likely to be?

Of course any answer has to be hedged around with lots of variables. The key one is the presence and performance of a lender of last resort. But there are many others, because booms and busts seldom have a single trigger. For example, the crisis of 1847 had the railway mania, the potato disease, a wheat crop failure one year and a bumper crop the next, followed on the continent by revolution. The Wall Street Panic of 1857 was turned into a prolonged recession by civil war. Libraries of textbooks have been written on the causes of the 1930s depression, to which the Great Crash was by no means the only contributor.

(To be continued)