Chapter Fifteen

A Species of Neuralgia

The Multiple, Recurring Causes of Financial Crises

IN NOVEMBER 2008, as Britain sank into its worst recession since the 1940s, Queen Elizabeth asked the elite scholars at the London School of Economics, why didn’t anyone see it coming? The eminent economists convened a conference to study the question, then sheepishly drafted a letter to the queen. “Your Majesty, the failure to foresee the timing, extent and severity of the crisis,” they wrote, “was principally a failure of the collective imagination.”

They shouldn’t have felt so bad. The only thing more inevitable than crises is our failure to anticipate them. As Carmen Reinhart and Kenneth Rogoff note in This Time is Different: Eight Centuries of Financial Folly, crises have been a fixture of finance since 1340 when Edward III of England defaulted, bankrupting the Florentine bankers who financed his war with France. Almost continuously since 1800, some part of the world has been in a banking or debt crisis. And for centuries, societies have been trying to find ways to stop them. They created central banks to prevent crises by giving banks a lender of last resort, and the International Monetary Fund to do the same for countries.

There’s no single definition of a crisis—as a judge said of pornography, you know one when you see one. The trigger is unpredictable and the event is violent, often emotional, as investors and lenders move as a herd to protect themselves. Markets are normally self-correcting, as lower prices bring out buyers. Crises are self-reinforcing as lower prices bring out more sellers.

Almost by definition, crises are unexpected because they involve collective errors of judgment.

Almost by definition, crises are unexpected because they involve collective errors of judgment. “Financial crises that are foreseeable . . . rarely happen,” Alan Greenspan wrote in his memoir, The Age of Turbulence. If a crash seems imminent, “speculators and investors will try to sell out earlier. That defuses the nascent bubble and a crash is avoided.” For example, in the late 1990s Ed Yardeni, a prominent economist, predicted that computers’ inability to cope with Y2K, the millennial date change on January 1, 2000, could trigger a global recession.⁸ Forewarned, the world spent billions of dollars to fix the problem and nothing happened.

Crises will always be with us because they are rooted in humans’ inbred tendency to extrapolate the past, their inability to predict the future, and their regular swings between greed and fear. Of course, these things are always present in the economy. For them to produce a financial crisis, though, some combination of other conditions must also be present.

Condition 1: Afloat on a Bubble

Every asset has some intrinsic value. For a stock, it is future profits, dividends, and cash flows. For a home, it is the cost of renting instead of owning it. For oil, it is the cost of getting more of it out of the ground. Yet calculating intrinsic value is never easy. What are future profits? Are there any other houses like this? How soon can that oil be pumped? Most of us end up assuming an asset’s value is what other people think it is worth, much as we choose a restaurant not based on a careful examination of the menu and critics’ reviews, but on how crowded it is. These assumptions make it relatively easy for an asset to become unmoored from fundamentals. In 2000, the S&P 500 topped 30 times earnings, double its historical average. In 2006, the ratio of home prices to rents reached 47 percent above its multiyear average.

Jeremy Grantham, a fund manager who’s made the study of bubbles a personal passion, says that in all of them, the asset in question has reverted to its long-term average value: “There are no exceptions.” Why then, do bubbles recur? At the start of every bubble is a kernel of economic truth: the Internet really was transforming U.S. business, just as railroads had a century and a half earlier. The public thus concludes old rules don’t apply. In the 1980s, Japanese stocks traded at two to four times the valuation of U.S. stocks, but this was attributed to the effect of cross-shareholdings between companies. Sky-high land prices were justified by Japan’s shortage of land. Both, of course, collapsed.

Not all bubbles lead to crises. To produce a crisis requires leverage.

Many people correctly identify a bubble before it bursts, but profiting from that prescience is difficult when the tide of opinion and money is running against them. The Economist raised alarms about U.S. property prices in 2002; prices rose for four more years. As I write this book, home prices in Australia and Britain, which rose far more than prices in the United States, had yet to deflate. History says they will; when, is anybody’s guess.

Condition 2: Leverage, the Prime Suspect

Not all bubbles lead to crises. To produce a crisis requires something else: leverage, which means lots of debt relative to assets or income. Leverage does not cause a market to crash any more than driving fast on a highway causes your car to crash. But leverage, like speed, makes the crashes that happen way more deadly. Leverage amplifies profits and losses when markets move. Suppose you spend $1 on a stock and it falls 50 percent. You lose half of your investment. Suppose you take your dollar, borrow another dollar, and buy $2 worth of the stock, which then falls 50 percent. After repaying the dollar you borrowed, you’ve lost your entire investment.

The fall in house prices that began in 2006 did far more damage than the decline in stocks after the dot-com bubble burst in 2000, even though the loss of value was about the same. Why? During the dot-com bubble very few stocks were bought with borrowed money, whereas during the housing boom, almost all homes were. As home prices plunged, owners defaulted, and loan losses ate away at lenders’ capital. Indeed, the worst financial crises usually involve banks because banks are, by their nature, leveraged.

Leverage often gets a helping hand from moral hazard, a term originally borrowed from insurance. It means that a person will take more risks if he is insulated from the consequences. If you pay for your son’s car insurance and speeding tickets, odds are he’ll drive faster. If investors believe the government won’t let a company fail, they’ll give it more money and charge it less interest. In the 1980s, federal deposit insurance enabled thrifts to lend recklessly to real estate developers. Investors lent to Russia on the view it was “too nuclear to fail.” It defaulted in 1998. Though Fannie Mae and Freddie Mac were owned by shareholders, investors assumed the government wouldn’t let them fail and lent to them for almost as little as they charged the U.S. government. Can you blame them? After the two collapsed from all that subsidized borrowing, taxpayers bailed them out.

Leverage is an early warning sign of a crisis. It could be rising corporate debt-to-income ratios, or it could be an entire country’s foreign debt as a share of GDP—a feature of Thailand that tipped some off to the 1990s crisis in East Asia.

But leverage can also be hard to spot because borrowers may use subterfuge, creative accounting, derivatives, and outright fraud to hide their debt. When investors realize the truth, all hell breaks loose—as with Greece’s understated deficit in 2009, Enron’s use of off-balance-sheet entities in 2000, or Korea’s puffed-up foreign exchange reserves in 1997.

When your deadbeat brother-in-law can’t repay your loan, he first buys time by claiming the check is in the mail. Likewise, a company or country lurching toward insolvency first claims to be merely illiquid.

Condition 3: Mismatches, the First Coconspirator

When an avid mountain climber marries someone who’s scared of heights, divorce may be in the cards. Similar mismatches in finance are usually a sign of trouble. A company whose sales are in Indonesian rupiah borrows in dollars. A homeowner whose wages are in Hungarian forint borrows in Swiss francs. A country borrows from foreign banks in some other country’s currency. In all these cases, a plunge in the local currency will make it dramatically harder to repay the foreign loan.

Rising dependence on short-term borrowing is often a telltale sign of trouble.

A similarly dangerous sort of mismatch is borrowing short-term to make long-term investments. Relying on short-term loans is like having to reapply for your job every three months. Good luck if it happens on a day your boss takes a dislike to you! Short-term borrowing spells trouble if interest rates rise sharply or investors balk at refinancing the loans as they come due. In fact, rising dependence on short-term borrowing is often a red flag: it may mean nervous investors won’t make long-term loans except at punitive rates. As such, countries, companies, and individuals are often tempted to rely excessively on short-term funding because it is cheaper. Mexico’s 1994 peso crisis was precipitated by heavy dependence on short-term borrowing, much of it linked to foreign currencies.

Condition 4: Contagion

The failure of one bank, one company, or one hedge fund seldom constitutes a crisis; the threshold is crossed when the panic spreads to others, a phenomenon dubbed contagion.

Contagion has several causes. One is guilt by association. When Lehman Brothers failed in the fall of 2008, investors began to bet that Morgan Stanley and Goldman Sachs would be next. When Thailand devalued its currency in July 1997, investors naturally worried that Malaysia, Indonesia, the Philippines, and Korea would do the same, since their economic circumstances were similar. They rushed to sell the local currency, precipitating more devaluation.

Another source of contagion is the fact that countries, companies, and banks have countless relationships with lenders, borrowers, trading partners, and investors often around the world. As a result, the failure of one company can bring down all its counterparties. For instance, if Bank A defaults on a loan to Bank B, Bank B may not be able to pay its loan to Bank C, and so on. The more interconnected a company, the bigger a threat it is to the financial system. Lehman Brothers employed only a tenth as many people as General Motors but its bankruptcy did far more damage because it was much more interconnected.

Earlier in this chapter, I described how someone who is insolvent first claims to be merely illiquid. Yet there are times when, because of contagion, an otherwise healthy hedge fund, bank, or country will become illiquid (that is, unable to borrow), and collapse. In the Depression, insolvency and illiquidity contributed about equally to bank failures.

Condition 5: Elections

Crises often come in election years. They are often a result of economic stresses that can only be fixed with painful remedies that politicians running for election don’t want to administer. Politicians may ignore or paper over the problem in hopes of addressing it after the election, as Mexico did in 1982 with the Federal Reserve’s help and Greece did in 2009. After Bear Stearns nearly failed in March 2008, Henry Paulson, the Treasury Secretary, didn’t seek authority to handle failures at similar firms, like Lehman Brothers, because Democrats in Congress would not act until after that fall’s election. Opposition candidates have little incentive to commit themselves to unpleasant courses of action, which leaves a fog of uncertainty. That unsettles investors and causes them to flee, as occurred in Korea in 1997 and Brazil in 1998. The years 2012 and 2016 may be delicate ones for the United States.

Into the Weeds

In the wake of the 1987 stock market crash the President’s Working Group on Financial Markets, comprising the heads of the Federal Reserve, Treasury, Securities and Exchange Commission, and Commodity Futures Trading Commission, was formed to periodically meet and consult on the stability of the markets. Conspiracy theorists ascribe every inexplicable market rally to the machinations of this “Plunge Protection Team.” This endowed them with far too much power and wisdom. In practice, when crises hit, the Treasury and the Fed would resort to ad hoc bailouts, jawboning, and prayer.

The sweeping financial overhaul of 2010 aims to tackle crisis prevention more thoroughly. It creates a 16-member Financial Stability Oversight Council, composed of the heads of the federal regulatory agencies and the Treasury Secretary, to look for threats with the power to rein in or even break up anyone dangerous.

Regulators could order the seizure of any big market player (much as the Federal Deposit Insurance Corporation can seize a bank), and close it down while paying off just enough of its debts to contain panic. In theory, the system is saved, fools take their lumps, and taxpayers are protected. In practice, who knows if future politicians will risk the fallout of liquidating a big company? What if it is the government itself that’s the cause of the next crisis?

Shortly after the Federal Reserve was created in 1913, John S. Williams, the Comptroller of the Currency, wrote, “Financial and commercial crises or ‘panics’ . . . with their attendant misfortunes and prostrations, seem to be mathematically impossible.” It wasn’t true then. It’s not true now.

The Bottom Line

• Every crisis is different but they share certain traits. An asset price that deviates from historical fundamentals may signal a bubble, but not when or how the bubble will burst.

• Debt is a prime suspect in every crisis. Currency and interest rate mismatches, reliance on short-term debt, and moral hazard are all coconspirators.

• Crises are spread through contagion: Investors burned on one company or country flee others that look like it. A failing bank pulls down others with whom it trades or has other relationships. Because of contagion, companies or countries that were merely illiquid become insolvent and collapse.