This series is a three-part exploration on our next financial crisis. This first article explores the fundamental questions behind the theory of financial crises: what is a financial crisis; what causes it; and why is there an increasing number of them?

According to The Economist, in a recent report on long-term asset returns, Deutsche Bank defines a financial crisis as having at least one of the following four characteristics: a fifteen percent annual decline in equities; a ten percent fall in the currency or government bonds; a default on the national debt; or a period of double-digit inflation. In recent decades, spotting one of the four characteristics has become increasingly easy.

Among the prevalent theories about what causes a financial crisis is Hyman Minsky’s financial instability hypothesis, which argues that overconfidence during times of financial stability inevitably begets financial instability, and this cycle leads to booms and busts. To read more about Minsky’s theory of booms and busts, click here. Along the same lines of placing behavioral factors as the main drivers of financial crises is Robert Shiller’s theory of social contagion of boom thinking. In his book, “The Subprime Solution”, Shiller argues that booms and busts are analogous to a virus, which has a contagion rate and a removal rate (the removal rate is the point where the individual is no longer contagious). Epidemics follow when the contagion rate is higher than the removal rate.

Take, for example, the Global Financial Crisis. Feverish excitement about the property market prevailed in the US, and poorly-backed-up statements such as “property prices have nowhere to go but up” permeated most conversations about property. The prominence of such statements was confirmation of their truth to people. People then disregarded their own judgments and opinions in favor of this general information. Consequently, their contrarian views were never shared with the rest of society, and did not feature in the collective judgement. Thus, over time, the quality of group information declined. Shiller refers to this a feedback loop, in which optimism begat more optimism.

Shiller’s theory of social contagion is further aggravated by herding, where, according to John Cassidy, “at the peak of a bubble, stories of ordinary people getting rich circulate widely, exerting great psychological pressure on others to join the herd”. In a YouTube interview, Shiller elaborates on his point: “We emerged into the 21st century, believing that nothing could go wrong, and so we bought tons of houses. However, the biggest factor is our general complacency.”

The busts were similarly exacerbated by social thinking. At the height of the 2008 crash, nobody knew which bank had exposure to what bad assets, and the overconfidence and hubris that had built rapidly during the boom suddenly turned into to a lack of confidence, which was equally as contagious as the previous build-up of confidence.

Shiller also discusses in depth the role of the media in exacerbating both the booms and busts. For example, in the Global Financial Crisis, the type of stories that interested the media were the ones about poor people getting rich, instead of complicated collateralized debt obligations (CDOs, i.e. sub-prime mortgages that were packaged together and sold to investors). In an essay, Narrative Economics, Shiller explains the role of media in the Great Depression, this time on its crash: “The first narrative of the Great Depression was that of the stock market drop on October 28, 1929. This narrative was especially powerful, in its suddenness and severity, focusing public attention on a crash as never before in America.”

Concrete examples of Shiller’s theory of social contagion during the Global Financial Crisis are abundant. Take, for example, the Icelandic Financial Crisis, and Ireland’s financial crisis. Iceland is a small island and was very closely networked, both socially and politically. There was no one in either politics or business that did not go to the same school or mix in the same circles. This provided a fertile ground for social contagion of thought patterns, which perpetuated the belief that markets could only go up, leading the Icelandic banks to assume ever greater amounts of debt in pursuit of profits. The close interconnectedness of the Icelandic economy meant that the feedback loop was quicker and more vicious.

Ireland, like Iceland, was a small island that was characterized by homogeneity. The small size of the country ensured that politicians and financiers knew each other well, and were thus rendered subject to herd behavior. The media in Ireland exacerbated the boom it faced: it had close ties to the property market, and consequently, huge incentives to keep up property prices. According to Shiller, the media talked up the boom, and the bust was consequently much rougher.

In all previous crises, we have seen telltale signs of financial stability breeding instability, and social contagion causing booms and busts. These have been constant factors in the human nature, but still we see more crises in the last few decades than ever before. Why is there an increasing number of financial crises?

Deutsche Bank argues that the answer lies in the monetary system. Before the early 1970s, when the Bretton Woods fixed exchange rate system was in place, money creation was limited. A country that increased its supply of money too quickly faced inflation. This led to the price of exports increasing, which led to a decrease in exports, which led to exchange rate depreciation, which led the central bank to no longer expand money supply too quickly. In other words, it was hard for financial bubbles to form, given the central bank’s control over money supply.

However, following the abolition of Bretton Woods in the early seventies, most developed countries switched to a floating exchange-rate regime. This new system allows them to not “subordinate other goals to maintaining a currency peg” (to see a central bank’s goals in relation to a currency peg, read this article on the Mundell-Fleming trilemma). This allows for greater trade imbalances, as the currency can bear the burden of it – at least for a while.

These problems are reflected in government debt, which, since floating rate regimes, has been rising as a ratio to GDP. Governments find no pressing reasons to reduce the debt-to-GDP ratio: according to The Economist, “Japan has had a deficit every year since 1966, and France since 1993. Italy has managed just one year of surplus since 1950.” Consumers and companies, as well, have been taking on more debt as well.

This is especially worrying. In previous crises, such as the Global Financial Crisis, debt has financed the purchase of assets to cause an upwards spiral, i.e. a boom, and this similar downwards spiral can happen during a bust. To understand the role of debt in a bust, it is important to understand leverage. Leverage is the degree to which an investor is using borrowed money as opposed to his own funds (equity).

Consider, first, an asset bubble. Assume an asset price goes up. This enables investors to borrow more against the assets, while maintaining the proportion of debt. In fact, encouraged by the rising asset prices, lenders are willing to raise the proportion of debt. With the additional debt available, investors are able to buy more assets, raising the asset prices further in an upward spiral.

A similar process in reverse happens during the deleveraging stage. In fact, the longer the deleveraging cycle persists, the worse the situation gets. During deleveraging, firms usually sell the easy-to-sell assets that are the most liquid. The longer this goes on, the worse the quality and liquidity of the remaining assets.

A sudden fall in asset prices during a deleveraging cycle does not happen randomly: it is often caused by an external event. CNBC refers to the Deutsche Bank report, and cites a multitude of potential triggers for a fall in asset prices, if we are, in fact, in an asset bubble. Among these triggers is a potential Italian crisis. Deutsche states: "A country nearing an election and with high populist party support, with a generationally underperforming economy, a comparatively huge debt burden, and a fragile banking system which continues to have to deal with legacy toxic debt holdings ticks a number of boxes to us for the ingredients of a potential next financial crisis." Other triggers that Deutsche has cited are Brexit, and a rise in populism.

If we are in a bubble, then we can expect to see a bust in the coming years. If this is the case, central banks must have enough tools to protect the economy from this bust. As a reaction to the crisis, in 2008, central banks cut interest rates and bought assets directly in a mechanism known as quantitative easing. This stopped the previous crisis, but each boom and bust cycle has reflected higher debt levels and asset prices. Now we see that the combined valuation of bonds and equities in the developed world is at its record high.
 
If this really is the case, all evidence points to a debt-related boom-and-bust cycle. If we are in an asset bubble, we should be able to see the social contagion of thinking exacerbated by the media, as well as risky investments replacing safe ones. In the next article, I will look at signs that we are currently in an asset bubble, including the prices of stocks, equities, and property.

Synopsis: How economics has shaped the evolution of politics.

Click here to read the original article. 

Discussion:

This article discusses the history of prevalent economic thought and its effects on politics. Throughout history, politicians have adopted only those economic policies that allow them to stay in power. In this way, a country’s economic issues can be viewed through the “prism of the political structure.”

19th Century:

Political scenario: Wealthy creditors with no real interest in the government were concerned with “maintaining the real value of their money”, as can be seen by the use of the gold standard (explained in Key Terms) and their one allowance of government intervention, through the use of the central bank, to ensure the success of the financial system.

Economic climate: Classical theory dominated economics. Classical theory concerned itself with the self-correcting nature of an economy (explained in Context), and thus reasoned that the government had little place in the free market.

1914 – 1929:

Political scenario: World War I (1914-1918) resulted in the sudden need for ammunition and manpower. The brief respite during the Roaring Twenties was overshadowed by the Great Depression, which began in 1929.

Economic climate: Government intervention, high inflation and debt during World War I destroyed classical theory. Any attempts to rebuild classical theory during the twenties were outweighed by the Great Depression: there was great reluctance by mass democracies to put the strain of the gold standard on the already suffering working class.
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1930s and 40s:

Political scenario: In the aftermath of the Great Depression, economies did not return to full employment. This was a great cause for concern among politicians, and the worry was carried into World War II.

Economic climate: Popular economist J.M. Keynes focused on government spending to boost demand, and thus, lower unemployment, through the use of fiscal policy (explained under Key Terms). This theory gained traction during World War II, where government intervention increased greatly and unemployment was wrestled down to a manageable level. Welfare states (explained in Key Terms) seemed like a small concession compared to the threat of communism (explained in Context).

1960s and 70s:

Political scenario: The rapid rise of inflation led politicians to believe that the government focus on unemployment was wrong. Middle-class voters, angry at high taxes, were quick to support an economic reform. Reagan and Thatcher adopted new policies quickly, with Europe following later, having been shaken by the scare of Eurosclerosis (explained under Key Terms).

Economic climate: The previously successful Phillips curve (explained under Context) was falling apart. Milton Friedman and his followers thus argued that governments should shift their focus away from controlling unemployment and towards managing inflation through controlling the money supply. Supply-side economics (explained in Key Terms) became popular quickly, as did monetary policy, which led to an active central bank.

1980s and 90s:

Political scenario: The fall of inflation resulted in a reputation boost for central bankers, despite the fact that inflation may have decreased due to China’s entry into the global economy (explained under Context). Reagan's and Thatcher’s reforms were well underway, which led to a rise in the debt-to-GDP ratio.

Economic climate: Reagan's and Thatcher’s reforms meant the recognition of the financial sector as a key player in any economy.

1987:

Political scenario: The riskiness of the system that ensued from the increasing debt-to-GDP ratio encourage central banks to cut interest rates during any period of uncertainty, as was seen on Black Monday.

Economic climate: Economic actors interpreted central banks’ nervous response to a wobbly economy as their “[underwriting of] asset prices”. Buying assets with borrowed money seemed to be the quick and easy way to make fortunes.

1990s:

Political scenario: The end of fixed exchange rates, and along with it, capital controls (explained in Context) made global finance very powerful, as money could easily enter and exit economies and sectors. At the same time, the wealth of the financial sector allowed its key players to fund and win favour of the political elite.

Economic climate: The loss of control over capital flows turned government focus towards dissuading capital flight, while the wealth of the financial sector meant that politics supported economic policy that favoured financial markets.

1980s to 2007:

Political scenario: The threat of communism fell along with the Soviet Union. Center-right politicians who had acquiesced to government regulation during the Great Depression gained political power, while center-left politicians supported more right-wing policies. At the same time, trade-union power fell, partially due to globalization, and partially due to the “relative decline in manufacturing”. Organizing protests became harder when many of its remaining members were dispersed across different jobs in different economies.

Economic climate: Right-wing economic policies such as the freedom for free markets to function with minimal intervention were established. The decline in trade-union power and blue-collar worker votes resulted in the larger economic actors having a greater say in shaping economic policy. It is no surprise that today we see the central banks and other large institutions as the most powerful actors in our economies.

During this time, mainstream economic theory became more micro-based as well as mathematical, despite the rise of behavioural economics.

2008 on:

The aftermath of the Great Financial Crisis has taught us that debt and the financial sector should be more central to macroeconomics and macroeconomic policy. Popular policy focus now is on attacking and trying to prevent the effects of globalization, such as the movement of jobs away from developed economies to countries that provide cheap labor. The problem is that globalization has already happened, and its effects are already underway. What will determine the success of globalization is how the Chinese economy will deal with its financial system and whether the Federal Reserve will withdraw its monetary stimulus effectively.

Just as politicians have always reacted to the economic climate, we may find that our future economic state may be a shift away from globalization and towards nationalism.

​Key terms:

1. Gold standard: A system in which the value of currency is fixed in terms of gold, and could be traded in for gold.

2. Fiscal policy: the process of government spending to stimulate demand (fiscal expansion) or government saving to decrease debt (austerity).

3. Welfare state: Where the state plays a pivotal role in protecting and promoting the economy and its citizens.

4. Eurosclerosis: A term coined in the 70s by Herbert Giersch to describe the state of stagnation in Europe that may have resulted from over-regulation by the government.

5. Supply-side economics: also known as “trickle-down economics” and “Reaganomics” – the latter due to Reagan’s active promotion of supply-side economics – argues that production is the most important determinant of economic growth. For this reason, investors and businessmen should face less barriers to production and investment through lower taxes.

Context:

​1. Classical theory: The self-correcting nature of markets was first alluded to by the father of Classical theory, Adam Smith. The idea is that prices adjust themselves and equilibrium is regained in the economy.

Suppose this is the market for a good X. Initially, the supply of X is denoted by S, and the demand denoted by D1. The resulting price P1 and quantity Q1 is shown by the intersection of D1 and S at equilibrium point A.

Now, demand for X increases to D2. At the original price P1, more of X is demanded, resulting in quantity demanded Q3. This is point B. Seeing the increase in demand, suppliers increase the price of X to increase their profits. Now, fewer people can afford the good, but enough people still want more of the good that suppliers feel like they can increase the price. Still fewer people can afford the good, but suppliers can still increase the price. This process, indicated by the red arrows, continues until the economy adjusts to a new equilibrium C, where all the demand is met by supply. Classical economists refer to this as the work of the invisible hand, guiding the economy from one equilibrium to another.

While the theory of the invisible hand is often attributed to Adam Smith, Smith used it as a term to
discuss international trade, and did not mean it to be the process described above. Still, Smith, along with other classical economists like David Ricardo and John Stuart Mill, believed the economy to be self-correcting.

2. Why would the presence of a welfare state result be a small price to pay in the face of the threat of communism? During the Great Depression, it is the democratic countries that suffered, while communist countries seemed to be fairing better. To ensure that communism does not dominate democratic countries, the government had to ameliorate the economic situation by being heavily involved in the economy.

3. To learn more about the Phillips curve and its failure in the U.S. economy, read my article here.

4. Why did China’s entry into the global economy decrease inflation? Not only were cheap goods and services provided by China, but so was cheap labor. For this reason, costs of goods, services and labor fell around the world, resulting in decreased inflation.

5. Why would the end of the fixed exchange rate system lead to the end of capital controls? Under a fixed exchange rate regime, high levels of reserves are needed to keep the exchange rate from fluctuating. For example, Hong Kong needs high levels of reserves for its currency to remain pegged to the U.S. dollar. If, for some reason, Hong Kong becomes less appealing to investors, the demand for the Hong Kong dollar will decrease, and the reserves will deplete. Capital controls are needed to make sure sudden capital influx or capital flight does not deplete the reserves, and thus, the exchange rate.