By ZACK LIGHT, Ridgefield, USA
Stanford Summer High School College
Professor: Robert Leeson
Teaching Assistants: Kevin Hoan Nguyen and Guido Alejo Martirena
The aphorism that “Those who cannot remember the past are condemned to repeat it” can not be more evident when talking about financial crises. For a long time, the financial crises are deemed a perennial side effect of capitalism, and few believe there is a way to foresee and prevent them. However, this essay, divided into two sessions, “causes” and “solutions”, will discuss only the mostly agreed and general causes of the financial crises and propose ways to avoid them, with many references to the global financial crisis.
General Causes of Financial Crises
Perspective from Asset Price Bubbles
There can be many causes for the financial crises. As is indicated by a Harvard study investigating the 19 previous financial crises, perhaps one of the most common signal or direct cause of financial crises is asset price bubbles, usually defined as “the part of a grossly upward asset price movement that is unexplainable based on fundamentals” (Claessens & Kose, 2013; Kenneth & Reinhart, 2008).
To explain the “unexplainable” bubbles, some theories suggest that such babbles are results of individual’s irrationality such as speculation and bank-runs, taking the bounded rationality in behavior economics into consideration. In spite of that, in many cases “bubbles can appear without distortions, uncertainty, speculation, or bounded rationality.” (Claessens & Kose, 2013) To not give up neoclassical economics models, some economists argue asset bubbles are agents’ “justified” expectations about future returns and accountable by neoclassical models because expectation can be considered one of the factors that push the demand curve upward. Still a number of economists admit “financial system does not behave according to the laws of the efficient market hypothesis.” In fact, if the laws of the efficient market hypothesis are always true, “asset prices are always and everywhere at the correct price,” (Cooper, 2010) but it does not reconcile with the dramatic volatility of prices during financial crises. (Cooper, 2010)
In the case of the global financial crisis, the “savings glut” lowered the global interest rates and created conditions for the bubble. (Taylor, 2009) Many believe there was a global capital flow resulted from the growth of savings, especially in developing Asian countries. In the U.S., as the government continued to promote home ownership, most of the excess went to the “prosperous” real estate market, which, in fact, “had been booming since the late 1990s”. (Cooper, 2010) There were more gradually rising overall prices as well as CPI inflation averaged 3.2 percent at an annual rate from 2005 to 2009. (Taylor, 2009) In fact, studies suggest a highly strong positive correlation between the deviation of interest rates from the one set by the Taylor rule and changes in housing investment in Europe.
Second, the government’s or Fed’s misperception about bubbles could also lead to bubbles. By “placing the management of a country’s central bank beyond (direct) control of elected government.” (Claessens & Kose, 2013), the Fed indulges in its optimism and turns a blind eye to bubbles. It is said that “the US Federal Reserve does not appear to believe there can be an excessive level of money growth, credit creation or asset inflation.” (Cooper, 2010) Moreover, the Fed is often led “into a mode of monetary policy that is generating a series of ever-larger credit cycles” (Cooper, 2010), becoming captives of firms through regulatory capture.
After the bubble was created during the global financial crisis, the academia was described as a battlefield because economists loyal to different schools “split in different directions, mostly ignoring each other, or else engaging in bitter fights and controversies.” (Blanchard, 2008) (Blinder & Ricardo, 2005) A number of economists urged the Fed to take action to deal with the possible bubble. For example, economist Robert Leeson wrote in 2005, the fact that “house prices increased nationally by 12.5 percent” indicated “a speculative bubble.” (Leeson, 2005) Such advice is often ignored by the Fed, many of which indirectly received huge “bonuses” from Wall Street as is depicted in the documentary, Inside Job. The Fed then optimistically concluded “the state of macro is good,” even in August of 2008, one month before the bankruptcy of the Lehman Brothers. In fact, for years preceding the crisis, “U.S. monetary policy has been said to be on ‘the Greenspan standard,’ meaning that it is whatever Alan Greenspan,” chairman of the Fed, “thinks it should be.” It was argued “that the property markets in different American cities would rise and fall independently of one another.” (Financial Crisis Inquiry Commission, 2011)
Third, bubbles could have been avoided if the government applied effective and quick response. Often following its misperception or stuck in its ideology, the government chooses to let the market solve the problem by itself and thus prolong or worsen the situations. It can be illustrated by Laissez Faire capitalism used by President Hoover during the early stage of the Great Depression.
As for the global financial crisis, “the government was ill prepared for the crisis, and its inconsistent response added to the uncertainty and panic.” (Financial Crisis Inquiry Commission, 2011) Some decisions and interventions such as TAF actually prolonged the crisis. When the Fed decided “not to prevent the bankruptcy of Lehman Brothers,” it created “a seizure in the real economy.” (Taylor, 2009; The Economist Newspaper, 2013). The TARP proposed later “were questioned intensely in this testimony, and the reaction was quite negative” because the public realized “the intervention plan had not been fully thought through and that conditions were much worse than many had been led to believe” alone with “relentless upward movement in Libor-OIS spread.” (Financial Crisis Inquiry Commission, 2011)
Fourth, after the bubbles are pricked, and the asset market cools down, the phenomenon of contagion often played an important role in worsening the situation by spilling over the problem from one industry to others. Notable cases include the financial industry leading to a successive collapse of other industries during the Great Depression. Many of the financial institutions grew aggressively through poorly executed acquisition and integration strategies that made effective management more challenging. (Financial Crisis Inquiry Commission, 2011) In some way, “too big to fail meant too big to manage” because those big firms were “interconnected to too many other firms.” (Financial Crisis Inquiry Commission, 2011)
Perspective from Credit Bubbles
Now we can look at another common signal of financial crises, credit bubbles that sometimes come alone with asset price bubbles. First, credit bubbles are most often associated with accommodative monetary policies that over-stimulate the market by an extentive low interest rate. “Analytical models, including on the relationship between agency problems and interest rates suggest more risk-taking when interest rates decline and a flight to quality when interest rates rise.” (Claessens & Kose, 2013) In fact, many see the low interest rate in the years preceding the global financial crisis as a root cause of the bubble.
“Monetary policy under Greenspan has been remarkably flexible and adaptable to changing circumstances.” (Blinder & Ricardo, 2005) In fear of deflation like the one that happened in Japan in the 1990s, “the U.S. Federal Reserve cut its key rate, the federal funds rate, to 1% in mid- 2003 and held it there until mid-2004.” (Cooper, 2010) It was considered an “effectively discretionary government interventions” (Taylor, 2009), although largely deviant from the Taylor rule shown in the following graph.
Second, “the majority of historical crises are preceded by financial liberalization”. (Kenneth & Reinhart, 2008) It is reported that “roughly a third of booms they identify follow or coincide with financial liberalization episodes.” (Claessens & Kose, 2013) Meanwhile, regulation, supervision, and market discipline are slow to catch up with greater competition and innovation (possibly set in motion by shocks or liberalization).
From as early as the end of the 1990s, economists had been transforming the financial industry “toward a new financial architecture for a globalized world.” (Camdessus, 1998) Till the global finanial crisis, corporate governance and risk management in the financial industry failed, and the problems mostly came from the “shadow banking sector”. “Through a series of deregulation and innovation of risk management, adjustable-rate sub-prime and other mortgages were packed into mortgage-backed securities”. (Financial Crisis Inquiry Commission, 2011) The risk of investment banks was significantly reduced. Meanwhie, rating agencies severely lacked competition and accountability. (Taylor, 2009) When doing testimonials in front of the congress, rating agencies, which were “paid by, and so beholden to, the banks that created the CDOs”, argued that "When we say something is rated triple-A... that is merely our 'opinion.' You shouldn't rely on it." (Inside job, Frank Partnoy; The Economist Newspaper, 2013) As a result, “financial institutions made, bought, and sold mortgage securities they never examined, did not care to examine, or knew to be defective.” (Financial Crisis Inquiry Commission, 2011) Investment banks also rely too heavily on leverage to multiply their gains by giving out risky loans, “leveraging up to the level of 33-to-1”. (Inside Job, Daniel Alpert)
Third, a decline in lending standards is often linked to credit bubbles, perhaps as a result of the second cause. When people who are unable to repay get money, and loans become junk loans, the bursts of bubbles (fail in prices of collaterals) endanger both the lender and the borrower.
It was perhaps a “rational speculation” because of the obvious benefits of loaeing for houses when the house price keeps rising yet before the bubbles burst. A systemic breakdown in accountability and ethics happened as borrowers “took out mortgages that they never had the capacity or intention to pay” and “lenders made loans that they knew borrowers could not afford, and that could cause massive losses to investors in mortgage securities.” (Financial Crisis Inquiry Commission, 2011) On the other hand, the fact that the companies that received triple A ratings “ ‘mushroomed’ from just a handful to thousands and thousands” (Inside Job, Jerome Fons) also meant lowering of the standard.
Fourth, in this increasing integration increases the risk of financial crisis and facilitates its spread. Sharp increases in international financial flows have been observed during the creation of bubbles. After the bubbles burst in one country, often the United States, they influence other countries profoundly.
Some economists, represented by Vice Chairman of the Financial Crisis Inquiry Commission Bill Thomas, nevertheless believe the global financial crisis was a worldwide trend, and the Fed’s response played little role in the deterioration of the crisis since “credit bubble appeared in both the United States and Europe” that “operated in different regulatory and supervisory regimes than U.S. commercial and investment banks.” (Financial Crisis Inquiry Commission, 2011) Whereas, after the bankruptcy of the Lehman Brothers, the financial panic was worldwide and “almost every large and midsize financial institution in the United States and Europe was questioned.” (Financial Crisis Inquiry Commission, 2011) Moreover, The Economist newspaper points out “Europe had its own internal imbalances that proved just as significant as those between America and China.” (The Economist Newspaper, 2013) “Some research also implicates European banks, which borrowed greedily in American money markets before the crisis and used Most commented the funds to buy dodgy securities.” (The Economist Newspaper, 2013) It is also worthy noting that during the global financial crisis, “seven countries that experienced a real estate boom, but not a credit boom, only two went through a systemic crisis and, on average, had relatively mild recessions.” (Claessens & Kose, 2013) It seems like it is the combination of asset price bubble and credit bubble that gives the worst outcome.
In conclusion, the major reasons for the specific global financial crisis were “collapse of the housing bubble, financial crisis, credit crunch, commodity price inflation, stock market collapse, and greater uncertainty in the market.” (Taylor & Weerapana, 2012)
Solutions to Financial Crises
To prevent financial crises from happening again, there are many potential remedies or solutions.
First, it is important that “all participants in the economy” have a good degree of understanding of economics and” must recognise the proper role and limitations of macroeconomic policy.” (Cooper, 2010) On one hand, the economics academia should realize the imperfections of neoclassical models and be quick at adapting to real-world changes such as speculation or bank-runs. On the other hand, policies “must be viewed in the context of human nature and individual and societal responsibility.” (Financial Crisis Inquiry Commission, 2011) That would enable us to base “any future government interventions on a clearly stated diagnosis of the problem and a rationale for the interventions.” (Taylor, 2009) However, politicians and regulators often align with bankers due to similar interests. (Admati & Martin, 2014)
As in the years before the crisis, bankers have been lobbying relentlessly and speaking up in public against tighter banking regulation. (Admati & Martin, 2014)
Acts such as Federal Housing Enterprise Regulatory Reform Act of 2005 that could have helped alleviated the risk were not passed. Regulators relied too heavily on top managers of bankers that, “since the mid-1990s, have been allowed to use their own models to assess the risks of their investments” because of their more up-to-date information about these risks”, even though there was a serious conflict of interest between the bankers and the public. (Admati & Martin, 2014) In one word, the asymmetric information problem has to be addressed.
Second, proper monetary and fiscal policies should be put in place to prevent the next financial crisis. The interest rate must be strictly adhered to standards such as the Taylor rule “that worked well during the Great Moderation.” (Financial Crisis Inquiry Commission, 2011) From a national perspective, the U.S. government must cut the deficits, in case “foreign investors might at some point refuse to finance these deficit” to “drive the dollar down” and “push inflation and interest rates up”. (Bergsten, 2009) The government can try to restore the balance sheet in boom years. It has also been proposed that we should “adapt to a global currency system less centered on the dollar” to promote the stability of global financial system and decrease the exportation advantages countries like China now enjoys.” (Bergsten, 2009) It is likely that competition between currencies would help the U.S. dollar to maintain a current account deficit averaging no more than three percent of GDP economic policies and improve performance by forcing market discipline. (Bergsten, 2009) Domestically, the public should be encouraged to save more. Professor Robert Leeson at Stanford University avocates the method of taxation after saving, although much has to be studied.
Third, organizational or structural readjustments are necessary. The current financial industryfaces a great problem of instability. Statistics has shown that “only 10 percent survive 20 years. Moreover, of those that do survive 20 years, more than a fourth disappears during the ensuing five years.” (William & Nystrom, 2015) Again, there are many possible types of readjustments. One is to create “a predictable exceptional access framework for providing financial assistance to existing financial institutions.” (Taylor, 2009) Some, like another Stanford professor John B. Taylor suggests to follow “the example of how the International Monetary Fund set up an exceptional access framework to guide its lending decisions to emerging market countries”. (Taylor, 2009) At this time, traditional Laissez-faire still seems to be able to find its supports. Some argue that, instead of buying all big banks out, we should just close banks to “recognize hidden insolvencies and to close zombie banks” (Admati & Martin, 2014). This requires speed and confidence. Supports find evidence in the greater robustness of European banks in 2012. Another is simply to require banks to “get a larger share of the funds they invest by selling stock.” (Lazear, 2015) Yet the problem of how to make equity regulations work has long been a headache for policy-makers because of bankers’ moral hazard. Stanford professor Anat R. Admati proposes a quite promising plan that involves “an equity requirement of 4.5 percent and a so-called capital conservation buffer of 2.5 percent”. (Admati & Martin, 2014) If a bank’s equity fails under the buffer requirement, it is required to take internal adjustments and is not allowed to give dividends and such. Once its equity fails below the core requirement of 4.5 percent, it will be forced to “rebuild their equity immediately, if necessary by issuing new shares.” (Admati & Martin, 2014)
Fourth, from an international perspective, much can also be done through cross-boarder cooperation. Researchers have proposed three approaches to build a safer global financial system. The first is to share global assets equitably among creditors “according to the legal priorities of the home country;” The second is to ringfence assets “so that they are first available for resolution of local claims;” the third is use a modified universal approach, an intermediate approach to tackle the financial trilemma. (Claessens, Stijn, et al, 2010) Datng back to the Great Depression, a trade war through increasing tariffs to retaliate has significantly worsened the situation. During global financial crisis, there was little cooperation between countries. While many believe more cooperation could improve the financial stability, others argue the effect of spillover would make “periodic bubbles” spread faster. Perhaps, there is an optimal balance to be found.
Fifth, unconventional solutions are worthy noting. Economist Omar Rachedi states that “The US Government should have bailed out the households and not the banks” to reduce the moral hazard of banks and the panic of the public, although the approach does not directly address the roots of the financial crises such as lack of regulations and bubbles.
Although every financial crisis is distinct and has different causes, it is not hard to find similarities and even universal ways to study the true reasons behind them. For the U.S., the Fed, the one entity empowered to set more prudent standards, usually plays the biggest role. It is propitious to realize that most of the academia agree that the Great Depression, in a large part, was avoidable or stoppable. As time goes by, more and more studies are to be conducted, and the possibilities and effectiveness of the causes of and solutions to the financial crises in this essay would surely be explored in the future.
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