CHAPTER 2
How We Got Here: A History of Financial Crises

INTRODUCTION

Financial crises are far from a new phenomenon, having occurred as long as money and financial markets have been in existence. On the surface, it may appear that there is little to be learned from any event that occurred hundreds of years ago. Clearly the global financial services industry that exists today bears little resemblance to the one that existed even 50 years ago, due to changes in market structures, technological advances, the sophistication of risk analytical tools, and the highly developed nature of global financial regulatory frameworks.

It is outside the scope of this book to categorize every crisis throughout history, or to draw definitive conclusions about their primary causes. However, despite the vast differences in the way financial markets operate today, a brief review of key past events will reveal some common themes with respect to the nature and causes of such events. An understanding of these themes can assist the many actors involved in the study of systemic risk (e.g., risk managers, academics, policymakers, or regulators) to obtain a broader perspective on certain risks that have manifested themselves repeatedly throughout history and potentially identify the buildup of these risks before they become a full-fledged crisis. Consider the following remarks by well-known academics Carmen Reinhart and Kenneth Rogoff;

Until very recently, studies of banking crisis have focused either on episodes drawn from the history of advanced countries (mainly the banking panics before World War II) or on the experience of modern day emerging markets. This dichotomy has perhaps been shaped by the belief that for advanced economies, destabilizing, multi-country financial crises are a relic of the past. Of course, the Second Great Contraction, the global financial crisis that recently engulfed the United States and Europe, has dashed this misconception, albeit at a great social cost.1

After reading this chapter you will be able to:

  • Cite examples of some of the most noteworthy financial crises in history.
  • Explain some of the common themes behind prior systemic events.
  • Understand what is meant by an “asset bubble” and describe the economic conditions that typically lead to a bubble.
  • Describe which countries have been the source of most sovereign defaults in history.
  • Understand the ways in which international contagion either fueled or contributed to the severity of prior financial crises, including the Great Depression.

COMMON DRIVERS OF HISTORICAL CRISES

Table 2.1 presents a timeline of select historical crises. In nearly all cases, a close examination of each of the crises listed in Table 2.1 will result in a myriad of causes. Furthermore, in all cases the occurrence of just one of the underlying events likely wouldn't have led to the full-fledged crisis that ensued. Rather, it was often the simultaneous occurrence of multiple underlying events or the spillover and linkages among multiple countries or markets that ultimately caused these systemic events to take place. Given the multitude of underlying causes and the inherent complexity of every crisis, we attempt to group such causes into higher-level themes as a starting point for trying to understand, analyze, and identify tools that might help avoid similar events in the future.

Table 2.1 Timeline of Selected Historical Crises

Year Event County/Region Broad Category
1636 Dutch Tulip Crisis Europe Asset Price Bubbles
1720 South Street Sea Bubble Europe Speculative Mania
1763 End of Seven Years War Amsterdam Asset Price Bubbles
1825 Crisis of 1825–1826 Europe/Latin America Sovereign Default
1837 Crisis of 1836–1839 America/England Price of Cotton
1857 Hamburg Crisis of 1857 Sweden/Hamburg Expansion of Credit
1873 Panic of 1873 U.S., Austria, Germany Global Contagion
1907 Panic of 1907 Global Banking Crisis
1929 Great Depression U.S./Europe Banking Crisis
1977 “Big Five” Crisis Spain Real Estate Bubble/Banking Crisis
1980s Debt Crisis of the 1980s U.S. Sovereign Default, Currency Crash
1987 “Big Five” Crisis Norway Real Estate Bubble/Banking Crisis
1990s “Big Five” Crisis Finland, Sweden, Japan Real Estate Bubble/Banking Crisis
1990s Junk Bond Market Crash U.S. Asset Price Bubbles
1994 Mexican Debt Crisis Mexico Currency/Banking Crisis
1997 Asian Financial Crisis Asia Currency Crash
1998 Long-Term Capital Mgt. U.S. Credit
1990s Latin American Debt Crisis Latin America Sovereign Default
2000 Dot-Com Tech Bubble U.S. Asset Bubble
2008 Credit Crisis U.S./Europe Asset Bubble

Bursting of Asset Bubbles

Table 2.1 provides several examples of asset bubbles throughout history. One definition of an asset bubble is an upward price movement of an asset over an extended time period of 15–40 months, which then implodes. Economists use the term to mean any deviation in the price of an asset, security, or commodity that can't be explained solely by fundamentals. Asset price bubbles are most often fueled by a combination of a rapid growth in the availability of credit and the irrational behavior of investors and markets.

Although bubbles can theoretically take place with respect to any asset that has an observed value, most bubbles have tended to occur within a securities asset class, individual security, or real estate. In the past 30 years alone, major real estate bubbles have burst in Japan, non-Japan Asia, and most recently in the United States.

The following sequence of events are representative of a typical model of a financial crisis fueled by an asset bubble:

  • Economic expansion/boom
  • Euphoria and rapid increase in asset prices
  • Pause in asset-price increases
  • Distress/panic/crash

Asset price bubbles, at least the large ones, are almost always associated with economic euphoria. In contrast, the bursting of bubbles leads to a downturn in economic activity and is often associated with the failure of financial institutions, frequently on a large scale. The failure of these institutions disrupts the channels of credit, which in turn can lead to a slowdown in economic activity. As mentioned previously, bubbles in stock markets and real estate are often closely linked with three prominent examples of linkages and connections between these two asset markets:2

  1. In many countries, and especially smaller nations and those in early stages of industrialization, a substantial amount of the stock market valuation consists of real estate companies and construction companies and firms in other industries that are closely associated with real estate, including banks.
  2. Another connection is that individuals whose wealth has increased sharply because of the increase in real estate values want to keep their wealth diversified and so they buy stocks.
  3. The third connection is the mirror-image of the second: the individual investors who have profited extensively tend to buy larger and more expensive homes.

Dutch Tulip Crisis: One of the earliest financial crises that was documented extensively is often referred to as the Dutch Tulip Crisis or Mania, when the prices of tulip bulbs increased by several hundred percent in the autumn of 1636. For more exotic and rare bulbs, price increases were even more dramatic.

In the mid-16th century tulips were introduced to Holland via the Ottoman Empire and quickly became a status symbol among its citizens, setting off a frenzy of speculative behavior across the country. The speculation became rampant in September 1636 as the bulbs were in their normal planting cycle and therefore could no longer be physically inspected by potential buyers who had to commit to purchases long before the spring bloom. This led to many investors purchasing bulbs at extraordinary prices that they had never seen.

Nobles, citizens, farmers, mechanics, footman, maid-servants, even chimney sweeps and old clothe woman dabbled in tulips.3

This frenzy was accompanied by the introduction of call options that further fueled speculative buying, resulting in a 20-fold increase in prices between November 1636 and February 1637.

As traditional bank financing was not fully developed at that time, most investors used in-kind down payments, which included things such as tracts of land, houses, furniture, silver and gold vessels, paintings, and so on. When the prices of tulip bulbs crashed, it led to the complete loss of savings of many citizens and fueled an overall decline in the European economy with the Dutch economy suffering into the 1640s.

Dot-Com Bubble of 2000: Another more recent example of the bursting of an asset bubble was the dramatic rise and fall of Internet stocks in the late 1990s. Per one index that tracked the performance of Internet stocks, prices of this sector rose 1,000% from October 1998 to February 2000.4 Prices started to drop in February 2000 and ultimately lost 80% of their peak value by the end of 2000, equating to approximately $8 trillion in lost market value. The Internet bubble exhibited similar characteristics of previous bubbles, including over-inflated prices driven by speculative buying, subsequent selling by insiders, short selling made easier by significant increases in asset float, and an eventual crash in prices.

Speculative Manias: Many crises throughout history can be traced to the rampant speculation by investors in any number of assets or investment opportunities. Herbert Simpson in a 1933 paper discusses the urban boom and collapse in the period 1921–30:

The economic history of this country is colorful with recurring speculative epochs and episodes, growing out of varying conditions and with varying effects upon our economic structure and welfare. We have had periods of gigantic speculation in western lands; periods of oil and mining speculation; periods of bank speculation; and of railroad speculation.5

The term mania implies that investors are behaving irrationally. This contrasts with the rational expectations assumption, which holds that investors behave rationally and react to changes to economic variables as if they are fully aware of the long-term implications of such changes. This is an example of the long-used axiom that all available information about a company is fully reflected in its security price, as investors theoretically react immediately to any new news about the company. Many theories exist as to why investment manias occur. One example is groupthink, when all investors in a market change their views simultaneously and act together.

The South Sea Company of 1720: An example of an event that can be categorized as a speculative mania, which in turn led to an asset bubble, occurred in Britain in 1720. The South Sea Company had been given special rights by the British government to trade with Spain's American colonies, which resulted in an effective monopolistic position. The price of the company's stock rose 330% in a five-month period to £550. Following its success, several other companies attempted to enter this market and trade in the same stock market. The South Sea Company successfully convinced Parliament to approve what was called the Bubble Act of 1720, which prevented such firms from becoming publicly traded, further boosting their stock price to over £1,000. Insiders of South Sea Company realized the company's business opportunities did not support a price so high and started to sell, fueling a dramatic decline in the share price to below £100 before end of the year. Consider the following comment by Adam Smith about the South Sea Company crisis:

The evils of reckless trading are always apt to spread beyond the persons immediately concerned. When rumors attached to a bank's credit they make a wild stampede to exchange any of its notes which they may hold; their trust has been ignorant, their distrust was ignorance and fierce. Such a rush often caused a bank to fail which might have paid them gradually. The failure of one caused distrust to rage around others and to bring down banks that were really solid.6

The Great Depression: The 1921–30 period of investment speculation in the United States was fueled mainly by growth of urban populations and wealth. The rural sections of the country had been in a state of depression throughout most of this period, and the very cities in which active real estate speculation had been carried on had been surrounded by rural populations in severe distress. It was the agricultural depression that led to shifting population, income, and wealth to the cities, in addition to the numerous other factors contributing to the urban growth of this period. The urban population of the United States increased 14.5 million in the decade 1920–30. It was this growth of urban population and wealth that provided the basis for real estate speculation.

As such, real estate, real estate securities, and real estate affiliations in some form were the largest single factor in the failure of the thousands of banks that closed their doors during the Great Depression. We discuss the Great Depression in detail in Chapter 14.

Banking Crises

Systemic events often occur not because of a single idiosyncratic event, but rather the linkages or spillovers that occur among several different segments of the financial system or global economy. A good example of such a common linkage is the prior discussions about asset booms in real estate, often fueled by speculative behavior on the part of investors, which is financed by the banking sector.

Banking crises may be defined as either the failure, takeover, or forced merger of one of the largest banks in a given nation or, absent such corporate events, a large-scale government bailout of a group of large banks in that nation. Using this definition, there have been a tremendous number of banking crises that have occurred globally throughout history. Dating back to the year 1800, 136 countries have experienced some form of banking crisis.7

A high rate of banking failures occurred during the Great Depression of the 1930s in the United States. Following this period of extreme global banking stress, there was a prolonged hiatus of failures between 1940 and the 1970s, after which several events such as the breakup of Bretton Woods fixed exchange rate system and a spike in oil prices led to an extended global recession and a renewal of bank failures.

The volume of bank failures during the past 30 or 40 years has been much larger in scope than in previous decades. For example, between 1970 and 2011 there have been 147 episodes of systemic banking crises around the globe and the costs to society have been substantial.8 While not every recent banking crisis was of equal magnitude, with some representing isolated events, many have had systemic implications for a nation or even the global economy.9

During the 1980s, many Mexican banks failed as a result of the country's currency devaluation and credit losses to local banks. Also during the 1980s, U.S. taxpayers suffered losses of more than $100 billion due to the failure of approximately 3,000 U.S. savings & loan associations and thrift institutions. In Japan, the economy continues to recover from the collapse of its banking system in the 1990s, fueled by the bursting of asset bubbles in real estate and stocks. The Japanese banking crisis led to 25% reduction to the gross domestic product (GDP).10 In March 2001, a bank run occurred in Argentina that led to partial withdrawal restrictions and the restructuring of fixed-term deposits to stem the outflow of funds. Lastly, the recent Credit Crisis resulted in hundreds of bank failures and set off a prolonged economic contraction in both the United States and Europe. During this crisis, the stock market in the United States fell by 42%, and the U.K. market fell by 46% (in dollar terms). Similarly, the global GDP fell by 0.8%, representing the first decline experienced in many years, while international trade fell 12%.

Sovereign Debt Crisis

There have been numerous prior crises brought on by the default by governments on both their external debt (e.g., default on payment to creditors under another country's jurisdiction), as well as domestic debt. There were at least 250 sovereign external defaults during 1800–2009 and at least 68 instances of default on domestic public debt. Perhaps the most well-known example of the former was Argentina's 2001 default on $95 billion of external debt, while a notable example of the latter was Mexico's 1994–1995 near default on local debt.

During the 500-year period ended 1799, both France and Spain could be considered serial defaulters, with these nations defaulting on their external debt on eight and six occasions, respectively (see Table 2.2). The dominance of France and Spain as serial defaulters pre-1800 may be explained by the basic fact that these countries were the only ones that had the resources and stability to engage in international trade and borrowing on a large scale.

Table 2.2 European External Defaults: 1300–179912

Country Years of Default Number of Defaults
France 1558, 1624, 1648, 1661, 1701, 1715, 1770, 1788 8
Spain 1557, 1575, 1596, 1607, 1627, 1647 6
England 1340, 1472, 1594* 2*
Austria 1796 1
Germany (Prussia) 1683 1
Portugal 1560 1

* Unclear if England's default was external or internal.

The negative impact on a country that defaults on its debt can be significant and long lasting. For example, it took Russia decades to finally resolve its 1918 external default with creditors. In addition, because of Greece's default in 1826, the country's access to global capital markets was very limited for the next half century.

As one of the goals of this book is to identify tools that will help financial industry participants identify the early signs of a financial crisis, it is worth noting that episodes of sovereign default have exhibited some noticeable macroeconomic trends prior to the actual default event. The average total decline in domestic GDP during the three years prior to domestic debt defaults is 8%, compared to an average decline of 1.2% for external defaults. Meanwhile, inflation averages 170% during the year of a domestic default versus 33% for external debt crises.11

As shown in Table 2.3, Spain and France led Europe in defaults between 1800 and 2008, similar to what occurred prior to 1800. Furthermore, starting in 1800 there was a significant increase in the volume of external defaults globally. This trend may be attributed to many factors, including the development of international capital markets and the establishment of many new nations.

Table 2.3 Cumulative Defaults and Reschedulings: Europe and Latin America (Year of Independence to 2008)13

Country Number of Defaults or Reschedulings Share of Years in Default since Independence or 1800
Europe
Spain 13 23.7%
France 9 4.3
Germany 8 13.0
Hungary 7 37.1
Austria 7 17.4
Portugal 6 10.6
Turkey 6 15.5
Greece 5 50.6
Latin America
Venezuela 10 38.4
Brazil 9 25.4
Chile 9 27.5
Costa Rica 9 38.2
Ecuador 9 58.2
Peru 8 40.3
Uruguay 8 12.8
Mexico 8 44.6
Argentina 7 32.5
Columbia 7 36.2
Dominican Republic 7 29.0
Guatemala 7 34.4
Paraguay 6 23.0
Nicaragua 6 45.2
Bolivia 5 22.0
El Salvador 5 26.3
Panama 3 64.0
Honduras 3 27.9

Since 1800 there have been several distinct periods of high sovereign defaults:

  • Napoleonic wars
  • 1820s–1840s
  • 1870s–1890s
  • Great Depression era: 1930s–early 1950s
  • Emerging markets: 1980s–1990s

INTERNATIONAL CONTAGION

Financial crises throughout history were often not an isolated event geographically. This is because countries around the world are often linked in a number of ways. Furthermore, very often crises are fueled by more than one of the categories we are discussing in this chapter. Often it is the combination of several of these drivers that ultimately leads to systemic events. As one example, during the period of 1900 to 2008, there was a high correlation between the percentage of all countries experiencing a default on their external debt and those countries that suffered a banking crisis in the same year. Some potential explanations for this linkage include:

  • When a developed nation experiences a banking crisis it tends to have a substantially negative impact on global growth, which hurts exports of smaller emerging market countries, making it more challenging to service external debt.
  • Banking crises in large countries tend to lead to reduced lending and capital flows to less-developed nations, which can strain their debt service capacity.14

Arbitrage connects national markets; the implication of the law of one price is that the difference in the prices of identical or similar goods in various countries cannot exceed the costs of transport and trade barriers. Similarly, the security markets in the various countries are also linked, since the prices of internationally traded securities available in different national markets must be virtually identical after a conversion of prices in one currency into the equivalent in other currencies at the prevailing exchange rates. Some examples of international transmission mechanisms include:

  • Inflation and capital flows
  • Exchange rates
  • Securities prices and markets
  • The gold exchange standard in the 1920s

Let's explore each of these examples.

Inflation and Capital Flows: The security and asset markets in various countries are linked by movements of money. An economic boom in one country almost always attracts money from abroad. To some extent, such capital flows depend on the extent of globalization. For example, high inflation rates in the United States during the 1960s and 1970s fueled a substantial capital outflow to countries such as Germany and Japan, both of which eventually suffered from inflation as their money supply increased.

Exchange Rates: Appreciation of a currency and deflation in that country's goods market or the increase in the foreign exchange value of the national currency leads to declines in the prices of internationally traded goods and to bankruptcies and the de-capitalization of financial firms. For example, from the 1997 Southeast Asian crisis one can make the following transmission connections: Thailand, Malaysia, Indonesia, Philippines, South Korea, Russia, Brazil, and Argentina.

Securities Prices/Markets: A common mechanism of international contagion is the extent to which a decline in one country's stock market leads to a similar decline or crash in one or more other countries' stock markets. For example, during the U.S stock market crashes of 1929 and October 1987, global stock markets crashed simultaneously. Investors who likely sought portfolio diversification by owning stocks in different securities markets around the world lost significant sums of money during these two events since correlations increased significantly across world stock markets.

Gold Exchange Standard in the 1920s:15 Perhaps one of the most noteworthy and analyzed examples of international contagion occurred during the Great Depression due to the gold standard. The gold standard refers to a monetary system in which the standard unit of currency is freely convertible into gold at a fixed rate. The gold standard was adopted in Britain in 1821 and later in the 1870s by Germany, France, and the United States. Eventually, given large U.S. gold deposits and stock of bullion and uneven supplies of gold within nations, many countries moved to an international, rather than a purely domestic, gold standard. As a result, they began to hold U.S. dollars as a supplement to their own gold bullion reserves. The gold standard served to provide stability in the international markets for goods and services by establishing fixed prices of exchange for currencies linked to gold.

One of the effects of the international gold standard was that it created linkages between nations and could serve as a medium for transmission of financial contagion. The gold standard was put in place to provide the United States with a self-regulating tool to promote economic stability and control the U.S. money supply. The intended impact of the gold standard was to create confidence in our nation's currency as a stable store of value and to create a self-regulating mechanism to support international trade. The gold standard also was intended to limit the supply of money created by any nation and act as a control over inflation. Countries on the gold standard could not create money unless they held gold stock or other currencies in reserve that were convertible into gold. The gold standard prevented countries from inflating their way out of their debts to other nations by expanding the money supply.

The establishment of the Federal Reserve in 1913 was intended to supplement, not replace, the gold standard. The Federal Reserve Act in 1913 included a requirement that “nothing in this act shall be considered to repeal the parity provisions contained in the Gold Act of 1890.” The Federal Reserve assumed many responsibilities previously undertaken by the Treasury. It had a mandate to back the U.S. currency by gold or eligible commercial, agricultural, or industrial loans, or loans secured by U.S. government securities rediscounted by member banks; loans to member banks secured by paper eligible for rediscount or by government securities; or bankers' acceptances. Outright government securities owned by the Federal Reserve did not count as collateral reserves to support the U.S. currency until the Glass-Steagall Act was passed in 1932. The amount of gold held by the Fed in excess of its reserve requirement was referred to as “free gold.”

The United States held a significant amount of “free” or excess gold reserves during the 1920–1930s. This allowed the United States to grow its economy rapidly in the 1920s. During this period the United States experienced a significant increase in the supply of free gold, had rising asset prices, and could expand the money supply. Bubbles were created in several asset classes, including stocks and real estate. By 1931, the Fed's stock of gold was almost 40% of the world monetary gold stock.

In the panic following the stock market crash of 1929, it became difficult for the United States to act unilaterally to control the U.S. money supply as global investors sold U.S. assets and demanded gold payment. The Federal Reserve had to honor its liability to deliver gold to nations that were selling U.S. assets, receiving U.S. currency, and demanding payments in gold. Many assets were sold at panic prices and dollars were exchanged for gold, causing price deflation. Stopping the outflow of gold would have required the Federal Reserve to aggressively raise interest rates to retain gold and maintain the money supply.

The Federal Reserve's power to expand the money supply and inflate or support asset prices was further eroded by a decline in the market prices of eligible collateral. Eventually deflationary pressure and declining prices overtook the U.S. economy. The inability of the Fed to accept expanded forms of collateral or deviate from the terms of the gold standard left the Federal Reserve paralyzed. They were also unable or unwilling to create currency to offer liquidity to its member banks or the public, which was withdrawing deposits for hard currency. The public demand for hard currency further drained the Federal Reserve's resources during this period and led to significant lending contraction, bank holidays, and bank failures.

There is little debate in the literature that monetary contraction was a primary cause of the Great Depression. The money supply contracted 33% from 1929 to 1933. The Federal Reserve's strict adherence to the gold standard and a hoarding of free gold was in part due to the Fed's fear of an attack by speculators on the U.S. dollar if excess reserves fell too quickly. There was also a great concern that the Fed would use its free gold to over-expand the money supply and create excessive inflation and a rapid rise in interest rates.

KEY POINTS

  • Some of the more common causes of past financial crises include the bursting of asset bubbles, speculative manias, banking crises, sovereign defaults, and international contagion.
  • There are usually four stages to an asset bubble that leads to a systemic event: economic expansion/boom; euphoria and rapid increase in asset prices; pause in asset-price increases; and distress/panic/crash.
  • While asset bubbles have originated from many sources throughout time, the most common forms include real estate and stock market bubbles.
  • Speculative manias contradict the rational expectations assumption, which posits that investors always behave rationally.
  • One of the first well-documented examples of a financial crisis has been referred to as the “Dutch Tulip Crisis” that occurred in early 1600s. Like many historical crises, this event was fueled by rampant speculation by a wide array of institutional and individual investors. In this case, the asset bubble that drove the event was the price of rare tulip bulbs in Europe, in which many ordinary citizens wagered life savings on the price of a single tulip bulb in the futures market.
  • There were at least 250 sovereign external defaults during 1800–2009.
  • Between the years of 1300 and 1799 and from 1800 to 2008, France and Spain accounted for most recorded external sovereign defaults in Europe.
  • Between 1800 and 2008, Venezuela defaulted on external debt on 10 occasions, leading all Latin American countries.
  • There are many factors that fuel international contagion, including inflation and capital flows, exchange rate changes, and securities price changes.
  • Dating back to the year 1800, 136 countries have experienced some form of banking crisis.
  • Although bank failures have occurred for centuries, the volume of bank failures during the past 30 or 40 years has been much larger in scope than in previous decades.
  • A famous example of international contagion was the use of the gold standard leading up to the Great Depression. The inability of the Fed to accept expanded forms of collateral or deviate from the terms of the gold standard left the Federal Reserve paralyzed. It was also unable or unwilling to create currency to offer liquidity to its member banks or the public, which was withdrawing deposits for hard currency. The public demand for hard currency further drained the Federal Reserve's resources during this period and led to significant lending contraction, bank holidays, and bank failures.

KNOWLEDGE CHECK

  1. Q2.1: What is a commonly used definition of an asset bubble?

  2. Q2.2: What characteristics typically exist in the period leading up to the bursting of an asset bubble?

  3. Q2.3: While asset bubbles have occurred in many different types of assets in history, what are the two most common forms of bubbles, particularly in the 20th century?

  4. Q2.4: Explain a linkage between real estate speculation/bubbles and the stock market.

  5. Q2.5: What are some of the more common transmission mechanisms that have turned localized financial events into an international contagion?

  6. Q2.6: Which two European countries have recorded the highest number of external defaults or reschedulings since the year 1300?

  7. Q2.7: What were the five primary periods of high external sovereign default since the start of 1800?

  8. Q2.8: What is the definition of the gold standard that many feel contributed to the Great Depression?

NOTES

..................Content has been hidden....................

You can't read the all page of ebook, please click here login for view all page.
Reset