Economic Bubbles and Financial Crises, Past and Present

Stock-Markets / Credit Crisis 2010
Mar 20, 2010 - 10:08 AM

By: Prof_Rodrigue_Trembl


"It is well enough that people ... do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning." Henry Ford, American industrialist

"It seems to me that Europe, especially with the addition of more countries, is becoming ever-more susceptible to any asymmetric shock. Sooner or later, when the global economy hits a real bump, Europe's internal contradictions will tear it apart." Milton Friedman, American economist

"The normal functioning of our economy leads to financial trauma and crises, inflation, currency depreciations, unemployment and poverty in the middle of what could be virtually universal affluence-in short ... financially complex capitalism is inherently flawed." Hyman Minsky, American economist

I have spent some fifty years studying economic cycles and teaching international finance, but I had never seen the likes of what we witnessed and experienced over the last three years. That's because such financial crises seem to happen 60 to 75 years apart.

—It is a fact that the outbreak of this severe worldwide financial crisis two years ago was a surprise to many people. For instance, it was widely thought that financial crises, and the severe economic recessions and sometimes depressions they provoked, were really a thing of the past thanks to the protective net of financial regulations that was designed in the 1930s to prevent a repeat of such financial collapses.

—But here we are again, mired in the most severe economic crisis since the 1930s. We may ask why?

The main reason is that the U.S economy, but also most of the world economy, has been subjected to a financial experiment, over the last some 10 years, which has turned sour. In fact, it has turned into a financial fiasco.

Indeed, it must be understood that a completely new type of banking finance was invented; but all the risks involved had not been properly assessed. For a while, the debt pyramid was allowed to grow, but it collapsed when its shaky and unsound foundation disintegrated.

—Of course, there have been similar financial collapses in the past, (notably in 1873, in 1907 and in 1931) and the overall cause is always the same: the financial sector takes too much risk and becomes overextended, creating in the process a debt load for the economy that is unsustainable.

Let's consider a striking fact of today financial situation: The debt load imposed on the economy is even higher today than it was in the 1930s when total total debt reached the level of some 300% of the annual production or GDP.

Well, today, the ratio of total debt to the U.S. Gross Domestic Product (GDP) is close to 400 percent.

Keep in mind that it took nearly 20 years to bring this ratio down to about 140, in 1952.

What this means is that today it takes about $4.00 of debt to create one dollar of economic activity while it took only $1.40 of debt in the early 1950s to create one dollar of GDP activity. This shows how complex the financial system has become. The question that remains to be answered is whether it will take 20 years to lower the debt ratio from 400% to, say, 200%!

This all shows how this can be devastating for the real economy when financial flows are disrupted and when credit becomes difficult to obtain.

—Sadly, this is our situation today: Investors and producers have a lot of problems financing their new investment projects. This is a big monkey on the back of the economy and it is an important cause of current, and possibly future, economic stagnation.

But before looking into the future, let's review quickly the main reasons why financial crises arise. Why, in other words, the financial tail is sometime allowed to wag the economic dog.

1. First, the question of deregulation. Too much optimism, overconfidence or simple naiveté sometimes allow the development of some form of risky Ponzi-scheme finance. And, this is pretty much what we have seen over the last 10 years.

—Under the old traditional financial rules, a bank or a credit union would collect deposits or borrow in the open market, lend this money to investors, keep reserves for contingencies, and would hold onto the loans until maturity.

For big banks, at least, this is no longer the model. With the merging of investment banking and commercial banking after 1999, traditional financial rules were pushed aside and they were replaced with the rules of asset securitization through which large banks ceased being banks to become brokers, that is they ceased being lenders to become sellers of sophisticated new securities. More about that later.

Under these new rules, a bank still accepts deposits or borrows in the open market, but it does not hold on to the loans it makes. Rather, it takes a bunch of heterogeneous loans made by itself or by others, repackages and slices them up, and sells them as investment vehicles to third parties. That's what is called the “securitizationâ€