Common causes of financial crises (1/2) (Note)

Summary:

· The « this time it’s different » syndrome is a systematic marker of the upward phase of the economic and financial cycle preceding the downturn. The last financial crisis was no exception to this rule, masked by the « Great Moderation »;

· Economic history forces us to temper the optimism of those who see financial overheating as merely the reflection of a new era of risk-free profits. It highlights a causal matrix common to financial crises: poorly calibrated financial innovations, a feedback loop between accelerated credit distribution and asset bubbles, high economic inequalities, and finally conflicts of interest conducive to laissez-faire.

· Financial innovations have played a central role in the emergence of financial crises: most often aimed at attracting savings and facilitating transactions, they also serve to circumvent existing regulations and multiply opaque connections between market players.

· Combined with these financial innovations, excessive bank lending fuels asset bubbles, amplifies the financial cycle, and exacerbates the consequences of a downturn.

The « this time it’s different » syndrome, most often used to justify the steep rise in asset prices, is a systematic marker of the upward phase of the economic and financial cycle preceding the downturn. The last financial crisis, responsible for the Great Recession since 2008, was no exception to this rule. Indeed, the dominant macroeconomic theory had long claimed victory in view of the stability that developed economies had enjoyed since the mid-1980s. Many economists, such as Bernanke (2004), explained this Great Moderation in inflation and growth volatility by pointing to improvements in the effectiveness of monetary policy. Since the Great Recession, this intellectual edifice has been greatly challenged by the inability of most economists to identify the fragility of the economic system. The issue of the cycle through growth and inflation volatility masked the evolution of other key economic variables: private debt, inequality, and financial deregulation. Economists now know that they did not look in the right place, as in previous crises.

Given the limitations of macroeconomic theory, knowledge of economic history is invaluable. On the one hand, it tells us that economic and financial crises are endogenous to the functioning of capitalism. On the other hand, and perhaps more importantly, economic history urges us to be cautious: the lessons of past crises force us to temper the optimism of those who see a credit-driven boom as the reflection of a new era and prospects for risk-free profits, mirroring the blindness of economist Irving Fisher in 1929.

Here we highlight the invariants at work in the emergence of the major financial crises described by Chavagneux (2013). Through the tulip crisis in 17th-century Holland, the collapse of Law’s system in 18th-century France, the panic of 1907, the crisis of 1929, and the subprime crisis, we show that there is a common causal matrix for financial crises, consisting of four main elements: poorly calibrated financial innovations, a feedback loop between accelerated credit distribution and asset bubbles, high economic inequality, and finally, conflicts of interest conducive to laissez-faire.The first two are discussed here and the latter two in a forthcoming contribution.

1. Poorly controlled financial innovations

We adopt a fairly broad definition of financial innovations here, namely the emergence of new products, new players, or new rules in the financial sector. Their functions can be diverse: most often aimed at capturing savings flows through more efficient or less expensive vehicles, they can also be used to circumvent existing regulations or to increase financiers’ commissions by increasing returns. Thus, while their goal is generally to streamline financial transactions while ensuring greater security, these innovations have played a central role in periods of emerging financial crises and have therefore amplified the cycle and consequences of the downturn, due to their misuse, haphazard calibration, or insufficient regulation.

The tulip trade in Holland in the early 17th century was a niche market operating through direct sales from horticulturists to customers, with the latter placing orders in the fall and paying for their purchases the following summer. Three innovations appeared in the market from 1635 onwards. First, an intermediary emerged between the horticulturist and the customer: the florist. Second, in order to free up financial transactions that had previously been limited to the summer months, promissory notes (i.e., forward contracts) were created, allowing tulips, still in the ground, to be bought and sold at a price set in advance. This second innovation transformed the niche market into a genuine over-the-counter financial market consisting of a primary and, above all, a secondary segment in which forward contracts were increasingly traded for their own sake, without any relation to the characteristics of the bulbs underlying the contracts. A third financial innovation emerged when certain market players offered to sell futures contracts with insurance against the risk of falling prices, fueling a final wave of speculation before the crash of February 1637. Although the crash had little impact on the real economy, the intertwining of financial contracts made it considerably more complex to clean up the balance sheets of the agents involved.

The system set up by John Law in 18th-century France was also built on a series of financial innovations. First, Law obtained from Regent Philippe d’Orléans the right to create a private bank in May 1716, without state guarantee, with a capital of 6 million livres, to collect deposits and discount bills of exchange.The unique feature of this bank was that investors were allowed to contribute only a quarter of the price of the bank’s shares, three-quarters of which could be paid in government securities. Secondly, after authorizing the use of notes issued by Law for the payment of taxes in April 1717, Philippe d’Orléans endorsed the transformation of Law’s bank into the Banque Royale in December 1718. Investors were reimbursed in cash and debt securities were converted into shares in a new company. This was the third innovation: in August 1717, the Mississippi Company was created. The Company gradually absorbed numerous trading posts and obtained the privilege of minting coins. The fourth innovation was Law’s proposal to the Regent to buy back the entire French debt for 1.2 billion and offer the debt holders shares in the company. Law also requested the entire Ferme Générale and became Comptroller General of Finances in January 1720. In Law’s eyes, the financial arrangement consisting of these four innovations was a flawless system: profits from trade and tax collection supported the rise in share prices, which in turn guaranteed the value of the banknotes issued. However, one final innovation precipitated his downfall: the possibility for investors to use company shares as collateral for new loans quickly undermined confidence in Law’s currency.

In the crisis of 1907, the Heinze brothers were initially victims of past financial innovations: margin buying and short selling. Convinced, wrongly, that certain financiers were short selling shares in their copper company, the United Copper Company, they bought up a large proportion of the securities available on the market to prevent the price from falling. Misled by their intuition, they hastened their own bankruptcy: the increase in the price caused by their purchases prompted all security holders to sell and realize their gains. However, it was a financial innovation contemporary to this crisis that explains the spread of the banking panic targeting the banks owned by the Heinzes to part of the US financial system: the emergence of opaque and poorly regulated trusts at the end of the 19th century, combining wealth management, market financing, bank credit, and deposit collection activities.

The financial crises that led to the Great Depression in the 1930s and the Great Recession that began in 2008 were also fueled by multiple financial innovations. Three of these innovations were particularly characteristic of the 1929 crisis: the rapid growth in the 1920s of investment companies that speculated on the financial markets and competed fiercely to attract available savings; the emergence of savings banks specializing in real estate that required fewer guarantees than commercial banks; the beginnings of the credit insurance market and the transformation of real estate loans into financial assets. In a climate of speculation fueled by the optimism of the 1920s, increased competition led financial players into a race for commissions, encouraging their clients to issue securities beyond their repayment capabilities.

As for the innovations that led to the subprime crisis, these manifested themselves in the mid-1990s in the rise of securitization techniques using special investment vehicles and the increasing complexity of derivatives that were illiquid in the event of financial shocks. These products were sold in particular by a handful of systemic players, already considered « too big to fail » following the race for concentration in previous decades. It is now clear that securitization led banks to relax their efforts to select and monitor credit files, and investors to overestimate the virtual liquidity of securities provided by the CDS market (credit default swaps). Finally, it is worth mentioning the strategy adopted by certain banks (Merrill Lynch, Bankers Trust, etc.) in the 1970s to create financial products that were halfway between commercial banking and investment banking in order to obtain the regulator’s repeal of the Glass-Steagall Act of 1933, which was achieved in 1999.

2. Excessive credit

The second component of the financial instability matrix is the excessive distribution of bank credit. This argument in no way reflects nostalgia for an economy based solely on financing through prior savings, as may be the case in the criticism of credit by the Austrian school of economics. Rather, we want to emphasize that when credit is used to finance the purchase of assets in excessive quantities, it feeds, amplifies, and further destabilizes financial bubbles. The link between bank credit and asset prices is also noted in the theoretical literature. One example is the model developed by economists Allen and Gale (2000), which is based on the existence of a particular agency relationship between investors and the banks from which they borrow. The bank’s inability to perfectly monitor the use of funds and the limited liability associated with debt contracts encourage investors to increase their demand for risky assets, pushing the price of these assets above their fundamental value. The dynamics of asset prices within the bubble depend on uncertainty about their future returns and anticipated changes in credit. In this model, a slight slowdown in anticipated credit growth is enough to cause the bubble to burst and economic agents to default.

Let us now examine the role played by credit in the various financial crises studied. We will not dwell on the tulip crisis because the historical data is unreliable. Law, meanwhile, is often considered one of the first great thinkers on the link between credit, debt, and economic growth. He learned a great deal about these subjects both by speculating himself on the sovereign bond markets and during his various travels throughout Europe. When he settled permanently in France in 1714, he was convinced that Western economies were operating below their potential output. He believed that freeing the French economy from the constraints of metal currency could boost activity and improve public finances by increasing tax revenues. He applied his ideas, as his bank always issued banknotes for a value well above the amount of precious metals held in reserve. This dynamic was greatly amplified when he allowed savers to borrow £2,500 to purchase new securities for any company shares provided as collateral. By May 1720, banknotes represented four times the amount of metal reserves.

The other three crises also had credit dynamics at their core. The Heinze brothers partnered with Charles Morse, a banker who specialized in « chain banking, » a practice of using holdings in one economic organization as collateral to obtain loans to acquire other holdings, and so on. Heinze used shares in his copper company, the United Copper Company, to invest in six large national banks, local banks, investment banks, and insurance companies. Thus, financing the purchase of securities through bank credit is all the more risky because it is secured by fluctuations in collateralized assets.

The 1929 bubble was also fueled by excessive debt: during the decade, banks not only increased the share of stocks in their balance sheets by 8 points, but also increased their speculative loans from 23% to 38% of their assets, resulting in a fivefold increase in stock trading volume.

The same diagnosis applies to the crisis that began in 2007. Financial players increased their leverage to buy products backed by subprime mortgages taken out by low-income American households. Moreover, since the last crisis, much empirical work reevaluating the link between finance and growth has converged on a similar conclusion: the size of the financial sector, measured by the total amount of credit granted to the private sector relative to GDP (or by the share of finance in total employment), has a nonlinear impact on economic growth. In particular, economists Cecchetti and Kharroubi (2012) conclude, based on a sample of 50 advanced and emerging economies between 1980 and 2009, that finance has a negative marginal effect on growth when private credit exceeds 100% of GDP (or when the financial sector accounts for more than 3.9% of total employment). In this regard, the stock of US private debt remains very high today (see Figure 1).

Figure 1: Evolution of US private debt since 1834

Sources: calculations by Steve Keen (http://www.debtdeflation.com/blogs/2014/02/02/modeling-financial-instability/#_ENREF_10)

Conclusion

To counter the temptation to say « this time it’s different, » we have highlighted a matrix of financial instability common to crises, the first two elements of which have been developed:

– Poorly calibrated and insufficiently regulated financial innovations contribute to the financial sector’s autonomy from the real economy and its fragility.

– Excessive private credit amplifies the financial cycle by increasing the balance sheets of all economic agents.

In a future contribution, the other two links will be examined. On the one hand, increasing inequality creates an unstable macroeconomic regime by polarizing savings surpluses and debt surpluses on either side of the income distribution scale. On the other hand, conflicts of interest at the heart of certain decision-making bodies can prevent the implementation of more restrictive rules to ensure financial stability.

References

Allen, F., Gale, D. (2000), « Bubbles and Crises, » Economic Journal, 110, 236-255.

(https://www.jstor.org/stable/2565656)

Bernanke, B. (2004), « The Great Moderation, » Remarks at the Meetings of the Eastern Economic Association, Washington, DC, February 20.


(https://www.federalreserve.gov/boarddocs/speeches/2004/20040220/)

Cecchetti, S., Kharroubi, E. (2012), « Reassessing the impact of finance on growth, » BIS working paper, No. 381. (http://www.bis.org/publ/work381.pdf)

Chavagneux, C. (2013), Une Brève Histoire des Crises Financières : Des Tulipes aux Subprimes, La Découverte, Paris.