Financial Crisis

The United States in the Early Twenty-First Century

J. Hendrickson

• Publisher: Palgrave Macmillan
• Year: 2013
• ISBN:
  9781137311054
• Topic: Betriebswirtschaft
• Subtopic: Buchhaltung

This book offers a critical look at prominent theories of financial crisis to try to understand how prepared the profession is for identifying the next financial crisis. An analysis of the first financial crisis of the twenty-first century serves as a starting point for rethinking the efficacy of existing economic models and theories.

Part I

Theories of Financial Crisis

The first financial crisis of the twenty-first century hit the United States and the world with great surprise and force. Indeed, the crisis blindsided governments, economists, policy-makers, businesses and households alike. Once the dust had settled, we wanted to know how this happened and why we did not see it coming. One obvious place to look for an answer is financial crisis theory. Certainly, theory exists to offer explanations and understanding of how crises develop. A logical follow-up question is whether existing theory is still sufficient; does the existing theory still reflect actual behavior and developments in the economy? The primary objective of this book is to provide an answer to this last question. To do so, it carefully explains existing theories of financial crisis and evaluates them in light of economic performance in the United States between 2000 and 2011. Chapter 1 offers some explanations for how the crisis provides new challenges to how economists and policy-makers think about macroeconomics generally and, more specifically, financial crisis in the future. It also provides the motivation for the writing of this book and the contribution it may be able to make as crisis theory is reconsidered. Chapter 2 outlines four important theories of financial crisis that have made their way to prominence in light of the crisis. The objective of this chapter is to provide a thorough understanding of each of the theories so that later in the book each can be evaluated based upon actual crisis experience. In Chapter 3, the four theories from Chapter 2 are analyzed relative to one another and their similarities and differences are identified. This framework for understanding how the theories overlap and how they are unique is important when, later in the book, the theories are put to the test with the most recent financial crisis.

1

Caught Off-Guard by Another Crisis

Financial crises have a long tradition both in the United States and globally. Despite this, most people were caught by surprise in the fall of 2008 when markets exploded and a global financial crisis commenced in earnest. Could we have been more prepared? Do we have the tools to be more prepared next time? The economics profession relies on theories of all sorts to make sense of what actually happens in the world. For our purposes, economists use theories of financial crises to help explain and understand financial crises. However, only by testing the theories to the data will we learn which are relevant and which are not in today’s world. That is the primary objective of this book – to determine which contemporary theories of financial crises stand up against empirical scrutiny and which do not. Because the health of the financial sector is positively related to the health of the macroeconomy, it is vital to have crises theories which help us understand real-life events.¹

This chapter begins with an explanation for why the most recent financial crisis caught almost everyone by surprise. It also explains the inevitable nature of crises. This inevitably, in turn, means that we will need to be prepared for future crises. The remaining sections of the chapter explain more about the objectives, methodology, terminology and outline of this book.

I Why were we surprised?

Few people saw the most recent financial crisis coming. For example, the Chair of the Federal Deposit Insurance Corporation admitted that regulators neither understood nor identified that a crisis was brewing.² Similarly, Alan Greenspan, the Chair of the Federal Reserve for the two decades prior to the financial crisis, argued that it was not possible for regulators to foresee the crisis when he commented that “History tells us [regulators] cannot identify the timing of a crisis, or anticipate exactly where it will be located or how large the losses and spillovers will be.”³ On March 16, 2008, the then Treasury Secretary Henry Paulson told CNN: “I have great confidence in our capital markets and in our financial institutions. Our financial institutions, banks and investment banks, are strong.” Eight months later, on November 16, 2008, Paulson observed: “We are going through a financial crisis more severe and unpredictable than any in our lifetimes.”⁴ As a final example, consider that in 2006, before house prices started to fall and the crisis hit, scholars at the Federal Reserve Bank of St. Louis researched the growth of house prices and concluded that banks were at lower risk of loss if house prices started to fall than at any time historically.⁵

At the same time, however, there were contrarian voices warning of mounting risk and a growing, unsustainable fragility. For the most part, these voices were ignored or, perhaps even more to the point, were rarely heard outside of small circles. For example, Peter Wallison, a scholar at the American Enterprise Institute, warned in September 1999 of the danger of pressing for home ownership through the subprime mortgage market.⁶ Also in 1999, the then Treasury Secretary Larry Summers also warned of the rapid and dangerous growth of government-sponsored enterprises that would, at the height of the crisis, require a massive government bailout because of subprime mortgages and mortgage-backed securities.⁷ Yet, for the vast majority, the collapse of real estate prices, investment banks, commercial banks, and markets generally came as a real surprise. It was not simply the family down the street with dual incomes, two children, and a mortgage who were surprised; it was also the economists from academia and the private sector, key leaders at central banks, policy-makers, businesses, and governments around the globe who were not prepared and failed to anticipate the crisis.

Why were we caught so off-guard and unprepared? This is a difficult question to answer. Ideally, we could answer this question with precision and, in the process, be prepared for the future. Unfortunately, a precise answer is elusive and, instead, a range of expert opinions exist. Here, two prominent possibilities are explored.

A Things are different today

One perspective that falls under the heading of “things are different today” is the idea that technological and financial innovation has allowed the economy generally and the financial sector more specifically to become more efficient at allocating capital and handling risk. Indeed, Bernanke remarked as much in 2004.⁸ The world of finance in the twenty-first century is, in many aspects, much like it has always been. However, very important aspects are, at the same time, very different. A simple comparison of the balance sheets and income statements of financial institutions between 1995 and 2005 illustrates such changes. For example, bankers historically made loans and they remained as assets on the balance sheet until the loan matured or was paid off. Today, bankers are increasingly securitizing loans. In this process, loans are often sold off the balance sheet very soon after the loan is originated. In another example, businesses historically took out loans from commercial bankers. Increasingly, businesses rely on commercial paper or loans from finance companies for short-term borrowing. A final example is the increasing use of nonbanks for savings vehicles. Traditionally, consumers would establish savings accounts at commercial banks or thrifts. Today, consumers are increasingly turning to mutual fund companies and alternative financial institutions to save and achieve higher investment returns. The prevalent thinking was that things were different today; a crisis would not happen again because of a highly integrated and technologically advanced financial sector.

In their book This Time is Different, Reinhart and Rogoff argue that human psychology, often in the form of confidence, has a long history of influencing financial crises.⁹ The unpredictability of confidence and the unreliable nature of human expectations make it difficult, if not impossible, to predict or anticipate crises. In their own words, Reinhart and Rogoff maintain:

Perhaps more than anything else, failure to recognize the precariousness and fickleness of confidence – especially in cases in which large short-term debts need to be rolled over continuously – is the key factor that gives rise to the this-time-is-different syndrome. Highly indebted governments, banks, or corporations can seem to be merrily rolling along for an extended period when bang! – confidence collapses, lenders disappear, and a crisis hits.¹⁰

This means that even those who know of past crises can easily be lulled into thinking that this time around the outcome will be better. We fail to learn from our mistakes. We get collectively swept up in the confidence around us and act as if tomorrow will be better than today. Perhaps some of this confidence comes from the technological innovation mentioned above. In other words, it is likely that technology, and the financial innovations that followed, reinforced the confidence during the good times and masked its fragility.

B The failure of economic theory

Another perspective that may explain our inability to anticipate the crisis is that economists failed to provide the tools necessary for us to expect such a development. Indeed, the critique that pits different empirical models against one another as evidence of such failure is popular in academic circles. In the empirical model debate, it often appears to be staged as a version of Keynesianism versus the neoclassical model. Within this debate, there is often the distinction between rationality on the one hand and “animal spirits” on the other. The Keynesian approach, initially established by John Maynard Keynes shortly after the Great Depression, gave an important role to what Keynes called “animal spirits,” a term meant to capture the uncertainty of human behavior.¹¹ In sharp contrast, the neoclassical model assumes perfect competition and completely rational human behavior. In light of the most recent financial crisis, many scholars are revisiting the efficacy of these models and their treatment of human action.¹² I refer to this debate as the “model failure” explanation for why the crisis caught us unawares. Sufficient attention is afforded to this discussion, so it is not considered in this book.

Much less attention has been given to analyzing how theories of financial crises may have failed to adequately warn us. I refer to this possibility as the “theory failure” explanation. The difference between model and theory failure is that the model debate focuses on empirical macroeconomic models derived from particular schools of thought. As indicated above, this is typically some form of Keynesian or neoclassical theory. In contrast, the theory failure perspective asks if existing theories of financial crisis, as opposed to macro, statistical models, are adequate for understanding financial crises in the twenty-first century. If the crises theories are not adequate, this would also explain, in part, why the most recent crisis was unanticipated.

Theories of financial crises are distinct from macroeconomic models in that they have a narrower focus. In other words, macroeconomic models are empirical in nature and are designed to explain the business cycle. This means that the focus is on understanding fluctuations in output and employment in an economy. The model is necessarily concerned with explaining fluctuations in the whole economy and might (but often does not) include disturbances in the financial sector. In contrast, theories of financial crises explain crisis or turmoil that must include elements of disruption in the financial sector. Further, many theories of financial crises do not treat a crisis as an anomaly but, rather, view the economy as crisis-prone.

Financial panic and distress are not new. Some of the earliest speculation and panics occurred in ancient Rome during the second century B.C. At that time, the Roman financial system was relatively well developed with an established credit system.¹³ More famous was the tulip bulb panic in the Netherlands in 1636. Several significant panics took place in 1720; two of the most prominent are the South Sea and Mississippi crises.¹⁴ With such experiences came scholars eager to understand and study them. Since the use of credit is central to financial crises, one would assume that crises and their theories came about as a result of the widespread use of credit. However, it is unclear if money predated credit; that is, most monetary theorists today believe that money came first in the evolution of exchange and monetary systems, but this view is far from unanimous.¹⁵ This unresolved issue sheds light on the origins of crises and crises theory. Since crises typically require credit and it is believed that credit has been around almost as long as money, crises has an impressive history. While theories emerged to understand crises, it has not been until the twentieth century that comprehensive, stand-alone theories of financial crisis were articulated. Thorstein Veblen developed one theory of financial crises in 1904, followed quickly by his student Wesley Clair Mitchell in 1913.¹⁶ Also interested in money and the possibility of crises was Irving Fisher, who entered the field of business cycles and crashes following the Great Depression.¹⁷ Perhaps most famously, in 1963 Milton Friedman and Anna Jacobson Schwartz published A Monetary History of the United States, 1876–1960, which, although not a theory of financial crises, was a comprehensive analysis of the Great Depression and the role of the financial sector. Since the financial instability of the mid-1960s, there has been more interest in developing theories of financial crises and so the field opens up considerably. Several of these theories are considered in this book.

II What about next time?

Make no mistake about it – there will be another financial crisis. Despite rigorous mathematical models, theories from prominent economists, innovation in financial markets, and increasing sophistication in risk assessment, it is inevitable that another crisis will occur. In their historical inquiry into crises around the world, Reinhart and Rogoff lament that we have failed to graduate from the cycle of financial crises both in the United States and globally.¹⁸ Perhaps even more alarming is the fact that not only have we been unable to avoid crises, but they are also becoming increasingly more severe and frequent.¹⁹

Even though crises are inevitable, we should not throw up our hands in defeat. We can become better educated on crises and, in the process, be more prepared the next time around. Indeed, testing and improving financial crises theory will not, by itself, allow us to graduate from the crises cycle. We could, however, reconsider and improve theory through analysis and possibly synthesis. In doing so, we could be better prepared to anticipate and resolve upcoming crises. The Chairman of the Economic Development and Review Committee at the Organisation for Economic Co-operation and Development (OECD) agrees:

Evidently, simply improving our analytical frameworks will not be sufficient to avoid future crises. Nonetheless, such a reevaluation is necessary. There are many dead ends from which to escape, but there are also many promising strands of thought yet to be pursued.²⁰

Meteorologists and weather experts are always re-evaluati...

Table of contents

• Cover
• Title
• Copyright
• Contents
• List of Figures and Tables
• Part I Theories of Financial Crisis
• Part II Financial Crisis in the US in the Twenty- First Century
• Part III Evaluating Theories Against the Evidence
• Notes
• References
• Index