Do
you remember Occupy Wall Street? The people “fighting
back against the corrosive power of major banks and multinational
corporations over the democratic process and the role of Wall Street
in creating an economic collapse that has caused the greatest
recession in generations”?
They
would probably be disillusioned upon reading “Manias, Panics, and
Crashes”, the reference book on financial crises written by Charles
P. Kindleberger and Robert Z. Aliber. Why? Because once you read this
book, you will understand that the next crisis is already underway –
it’s just a question of time…
The
course of a financial crisis
Walking
us through the history of many financial crises, the authors outline
a typical financial crisis:
Phase
1 – Going up
Asset
price increase
The
cycle starts with cheap credit – lots of credit.
At
the beginning, companies raise funds through hedge
financing: Their operating income is
more than sufficient to pay both interest and scheduled reduction in
indebtedness. At one point in time, speculative
financing kicks in: A company’s
operating income is sufficient to pay interest but not the
indebtedness itself. For the latter, the company must raise new
money. The final stage involves so called Ponzi
financing, meaning that the anticipated
operating income is not enough to pay interest and/or principal. The
company must either raise new financing or sell assets to pay back.
On
the retail side, households see that others are profiting from
speculative purchases and invest as well. Trading volumes increase.
The
above trends then spread around – from one country to another, from
one sector to another, from one asset class to another, etc. This
process is often self-enhancing. Let’s take the example of money
flows between countries:
-
The receiving country attracts foreign capital because its economy is booming.
-
The incoming capital leads to higher asset, especially stock, prices. Higher stock prices mean that raising capital for investment becomes less expensive. This further accelerates the economic boom.
-
The economic boom and higher asset prices lead to an increase in household wealth and this, in turn, favors household spending. This then further enhances the economic boom.
The
result of the above is higher asset prices. The curve goes up.
At
the end of phase 1, an increasing number of investors seek short-term
capital gains from increases in prices of real estate and stocks
rather than from the investment income based on the productive use of
these assets. In other words, people want to earn money not through
holding on to the asset but through re-selling it as soon as possible
with a profit. This is the moment when the famous bubble builds up.
The authors write about a “loss of
touch with rationality”.
Can
central bankers do something about it?
The
short answer is: No. They can perhaps shorten the supply of money as
such. However, financial history tells us that there are many close
substitutes of money that people can revert to: credit in all
possible forms, real estate, commodities such as gold, crypto
currencies, etc. Every time the monetary authorities try to control
the amount of money, people will circumvent that covert by producing
more near-money substitutes.
How
to detect a bubble
If
we cannot avoid the next financial crisis, can we, at least, detect
the bubble before it bursts? For stock markets, the authors give some
hints: In the long run,
-
the level of stock prices should reflect the growth rate of GDP;
-
the profit share of GDP (= corporate profits / GDP) should be about 8 %;
-
the price / earnings ratio for stocks (= stock prices / corporate earnings) should be about 18x;
-
excesses in the debt / capital ratio of a large number of firms and individuals lead to financial distress.
Phase
2 – Stay high
During
phase 2, we remain in the bubble but it stops growing. At the end,
buyers become less and the sellers more eager.
Oftentimes,
when prices stay high but don’t sprout any more, fraud and swindle
spread around: As a matter of fact, when credit becomes scanty,
people start using fraud to compensate. This is especially true in
case of evergreen finance: This hints to the practice of loans being
paid back not through earnings but through cash from new loans.
Phase
3 – Going down
In
phase 3, both firms and individuals realize that it’s time to
become more liquid, i.e. to reduce holdings of real estate and
stocks, and increase holdings of money. Prices start declining and
credit is nowhere.
At
this point in time, a specific event (failure / bankruptcy of a
specific bank or firm, namely one which has previously been thought
successful; revelation of a swindle; sharp fall in the price of a
specific security or commodity such as oil; an unanticipated
devaluation of a currency; a war or other far-reaching political
changes; etc.) precipitates the crisis. The bubble bursts. It has to
be like this; bubbles always implode because, by definition, they
involve a non-sustainable pattern of price changes or cash flows.
The
panic is often magnified through international contagion. Indeed,
only very few markets are completely separated. This is all the more
true in today’s globalized 21st
century. Financial crises either affect a number of countries at the
same time or, alternatively, spread from the centers where they
originate to other countries. The means of transportation can take
various forms – commodities, bank deposits, bills of exchange,
specie, and last, but not least, pure psychology.
Phase
4 – Going up again
At
one point in time, public authorities will feel obliged to intervene
to avoid further price decline. Without doubt, such intervention can
create moral hazard:
-
Investors first benefit privately on the upside and then avoid losses on the downside through public intervention.
-
Today’s intervention might fuel the next future crisis.
Still,
in practice, authorities always arbitrate to stop the panic.
Kindleberger and Aliber write – “Today wins over tomorrow.”
Panoply
of interventions
How
can public authorities react? The book puts together possible
measures which have been applied throughout financial history:
-
Formal deposit insurance
-
Informal state guarantee to cover losses if banks fail
-
Lender of last resort
-
Close banks or markets temporarily to take political, military, and other measures
-
Suspend the publication of bank / financial statements: “What you don’t know won’t hurt you.”
-
Set daily limits on the maximum change in commodity and other asset prices
-
Set a time out in financial markets whenever the imbalance between buy and sell orders becomes exceptionally large
-
Issuing clearinghouse certificates (= near-money substitutes which constitute the liability of a group of large banks or other financial institutions) for use by a bank which is under a bank run
-
Other forms of bank collaboration (loan funds, funds for guarantees of liabilities, arranged mergers of weak banks and firms, etc.)
-
Issuance of marketable securities to a firm in financial difficulty against appropriate collateral
-
Tighten financial regulation such as daily mark to market, reserves and write-offs of problematic loans, capital requirements as a percentage of assets or other liabilities
National
and international lender of last resort
Who
can intervene to stop a financial crisis? There are plenty national
lenders of last resort in financial history. By contrast,
international lenders of last resort are rather sporadic.
On
a national level, the lender of last resort is either the treasury or
central bank. The former can be less effective. By definition, a
Government’s treasury cannot print money. This, indeed, makes it
less flexible to meet any potential demand on the part of sellers. Is
simply cannot buy once it has spent all funds and is unable to raise
additional liquidity.
Financial
crises oftentimes spread across countries, hence the need for an
international lender of last resort. But such lender encounters
several shortfalls:
-
There isn’t one unique world currency that could be used to face the financial crisis.
-
On an international level, there is no (or, at least, only a very limited) legal framework which could govern the international lender of last resort.
The
International Monetary Fund is today the main example for an
international lender of last resort, even though his intervention is
also pretty much dependent on its member states.
A
somewhat similar form of international lender of last resort is the
international SWAP network among national central banks.
The book undeniably teaches you to take a step
back and accept any financial crisis as what it really is: An
unavoidable and recurring pattern of any financial system. In my
view, it is a good preparation for the next crisis. On the downside,
I found it sometimes a bit repetitive. But this is perhaps due to the
fact that financial history itself is iterative.
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