Last October the International Monetary Fund warned of the risk of another global financial crisis. The Fund sees a 60% rise in global indebtedness in the last ten years and the exposure of banks to illiquid assets as major risks.
It might seem premature to be talking of the next financial crisis when we have only just marked the tenth anniversary of the last one. But history shows that financial crises are frequent events in the life of market economies. In the 20 years up until 2008 the world witnessed deep financial crises in Russia and Asia, banking crises in Sweden and Finland, Black Monday, a general equity market crash in 1987 and the dotcom collapse of 2001.
The proximate causes varied - overvalued tech stocks getting their comeuppance in 2001, a reversal of inflows of foreign capital in Asia in 1997 and so on, but the underlying drivers are eerily similar.
On this subject there’s no better guide than the magisterial “Manias, Panics and Crashes” by Charles Kindelberger, first published in 1978. It is testimony to the enduring relevance of his message that despite Kindelberger’s death in 1996 the book is now in its seventh edition, co-authored by Chicago economist Robert Aliber.
Kindleberger’s great insight was to show that financial crises, far from being exceptional events, are recurring features of the market system. His work shows that three factors are especially conducive to bubbles.
First, long periods of economic stability tend to inflate asset prices by making people too confident, too willing to borrow and too oblivious to risk.
The 15 or so years before 2007 was just such a period, marked by good growth, falling inflation and low interest rates. Volatility and major economic crises were notable by their absence. This stability fostered the impression that credit would stay cheap for ever and that asset prices would keep on rising. There was a similar boom before the US crash of 1929, marked by soaring car production and highway construction, and the rapid introduction of electricity and telephones to households. In the late 1920s and early 2000s what appeared to be a new era of technologically-driven prosperity pushed asset prices ever higher.
Rapid growth in the supply of credit is the second enabler of asset bubbles.
This, too, is a very old story. Kindelberger shows how the legendary South Sea investment bubble of the early eighteenth century was fuelled by credit from newly established banks. Almost three hundred years later, in the early 2000s, a boom in the availability of mortgage credit for high risk buyers in the US sowed the seeds of the global financial crisis.
The third feature of a boom that is heading to bust is rapid financial innovation. It played a role in one of the first recorded bubbles, the Dutch tulip mania of 1636 where sellers of bulbs provided buyers with the necessary credit. The failure of innovative and opaque financial structures, such as collateralised debt obligations, played a key role in the financial crisis of 2008. Financial innovation is important because it enables large numbers of less-specialist investors to join in the boom. The legend goes that when shoe shine boys started giving stock tips in the late 1920s seasoned investors sold out. Today one might substitute taxi driver for shoe shine boy.
Now of course economic stability, a good supply of credit and financial innovation, are highly desirable. Politicians, the public and policymakers love strong and stable growth. Credit is the essential lubricant of a market economy. Innovations in finance, from the ATM to peer-to-peer lending and PayPal, make life easier.
The judgement that regulators need to make is when we have had too much of a good thing. As William McChesney Martin, chairman of the US Federal Reserve in the '50s and '60s, said that it is the job of central bankers to "take away the punch bowl just when the party gets going".
Getting the timing right is difficult. Regulation and timely changes in policy help reduce the frequency and severity of crises. But to prevent all crises policymakers would need to eliminate the risk taking essential for growth. That dilemma won’t go away, nor will financial crises. They are, as Kindelberger reminds us, a ‘hardy perennial’ of our economic system.
PS: Last week the world’s largest sovereign wealth fund, the Norwegian Government’s Pension Fund, said that it intended to increase its holdings in UK equities and other assets irrespective of the outcome of Brexit negotiations. Over the last two years international investors have been wary of domestically-facing UK equities over concerns about Brexit. By contrast the CEO of the Norwegian fund, Yngve Slyngstad, asserted a robustly long-term view: “With our time horizon, which is 30 years plus, current political discussions do not change our view of the situation.”