Sunday, June 27, 2010

The 1990's: Decade of Crises

Most Americans think of the 1990's as a golden age of prosperity that we would love to return to and so it was -- for the United States. For much of the rest of the world, the 1990's were a time rocked by one financial crisis after another, an escalating series of warnings that our financial system was badly out of control. This is one of the areas where Zandi and Krugman complement each other best. Zandi has a chart showing the LIBOR spread (the difference between interest on US treasury bond and loans between major banks), demonstrating how financially turbulent the '90's really were, although his narrative mostly sticks to the 2000's. Krugman describes some of these crises in detail.

The Savings and Loan Crisis: A warning shot across our bow. This one actually began in the 1980's. One of the major reforms of the 1930's was government insurance of deposits in commercial banks (including savings and loans) in exchange for tighter regulation. This reform was highly successful. It stopped bank runs and kept finance on a sound basis up at least until the mid 1970's. Trouble came in the '70's in the form of high inflation. Inflation eroded the value of people's savings, so long as checking accounts were forbidden under Depression-era laws from paying interest. There were no panicked bank runs, but people began more and more moving their money from traditional bank accounts into something that paid interest. The trend accelerated in the early '80's when interest rate skyrocketed. Banks felt a squeeze. Savings and Loans lobbied to be allowed to pay interest to depositors. But this caused a new set of problems, as interest rates on deposits varied, but thrifts kept receiving the same fixed rate on their mortgages. So they pressed (successfully) to be allowed to make higher-risk, higher-return loans. A classic boom and bust followed, with many S&L's taking excessive risks, an epidemic of overbuilding. As required by law, the federal government shut down the involvent thrifts, paid their depositors, and cleaned up the mess they left. The cost was just as much, relative to GDP, as the cost of TARP. Areas where the overbuilding boom was strongest took years to recover. But the damage to the national economy was minimal. Commentators differ on whether the crisis had anything to do with the 1990-91 recession. Even if it did, the recession was a mild one.

Seen from the clear light of hindsight, the Savings and Loan crisis was a clear warning that the general trend toward deregulation sweeping the country should not be extended to finance.

Japan's lost decade. It does not make Zandi's LIBOR chart, but Krugman points out that the Savings and Loan debacle was merely one of many speculative bubbles that formed in the 1980's. Sweden and the other Scandinavian countries had a severe speculative bubble after deregulating banks in the late 1980's and are widely seen as writing the book on how to handle such a crisis. Japan, by contrast, may be seen as writing the book on how not to handle such a crisis. Japan let its bubble build to such extraordinary heights that when it finally deflated, real estate and stock prices fell by 60%. (In our case, the figure is closer to 30%, a somewhat comforting thought). Furthermore, when asset prices fell but debts remained, everyone refused to face what was happening. Banks did not write off bad debts; regulators did not close failed banks. Japan went into a decade of stagnation and deflation. Krugman fears much the same for us today.

Orange County and Baring Bank. Although Krugman does not discuss it, Zandi's chart shows a small blip around 1993 with the Orange County bankruptcy. The timing is odd, since Orange County actually went bankrupt in December, 1994, but the crisis was real and unsettling. Municipal funds are supposed to make only the most conservative investments because taxpayer money is at stake, but conservative, tax-averse Orange County looked the other way as its treasurer made some high-risk, high return investments in derivatives dependent on low short-term interest rates. So long as the investments were successful, Orange County had good services with low taxes and no one asked any questions. Then interest rates went up, the investments failed, and Orange County ended up defaulting on its bonds. About two months later, in February, 1995, England's Barings Bank failed because of a poorly supervised trader's high-risk speculation in derivatives. The story was much the same as in Orange Country; so long as his investments paid off, no one asked whether such high returns were actually a danger sign. Then they failed, taking down more than the bank's available trading capital, and broke the bank.

Mexican and Argentine peso crisis. These financial crises were overshadowed by one that broke in Mexico (and Argentina) in December, 1994. (Clearly the end of 1994 and beginning of 1995 were a bad time for financial crises). To give a brief background, in the 1970's, rising oil prices gave Arab countries more money than they knew what to do with. This money generally ended up in foreign banks, which made large loans, especially to Latin America, without too much thought to countries' ability to repay. Throughout the 1980's, much of Latin America was mired in intractible economic downturn, with living standards declining as debt service ate up more and more of their income. Ultimately, the IMF convinced these countries that the remedy was to fight inflation, cut government spending (especially on any sort of social program) and open up their countries to more foreign trade and investment. For a time, it seemed to work. Argentina stopped inflation by tying the peso to the dollar to prevent the Argentine government from financing by printing press. Mexico let foreign imports and investment flood in. All seemed well, at least to foreign investors.

But troubles were developing just below the surface. Argentina's tying the peso to the dollar left that country at the mercy the dollar's fluctuations and unable to respond when dollars began to withdraw from the country. And Mexico was showing other problems. It developed a huge trade deficit, i.e., shortfall of exports compared to imports, eventually reaching 8% of GDP. How can a country import more than it exports on a sustained basis? How does it finance all those imports. The answer is, by foreign investment. Well, isn't that what developing countries are supposed to want to attract, to make them grow? Yes, but you can get too much of a good thing. Foreign investment tends to be a fickle ally turn against a country on a moment's notice. That was what happened to Mexico in December, 1994. The Mexican peso was overvalued and hurting Mexican exports. But devaluation caused a panic, sent foreign investors fleeing, and threw the economy into a severe downturn.

The Asian Contagion. I remember well that throughout Latin America's debt crisis of the 1980's financial commentators were forever asking Latin American countries why they couldn't be like the rapidly growing Asian countries. If Latin America was seen as the embodiment of vice, Asia was the embodiment of virtue. And then in 1997, something similar struck Asia.

It began in Thailand. Thanks to foreign investment, Thailand was growing rapidly, become one of the Asian exporters. But too much foreign investment was coming in, chasing too few productive outlets. And, as always, this led to asset inflation, i.e. rampant speculation and a bubble. As in Mexico, the trade deficit started growing ominously, reach 6% of GDP, 7% and even 8%. As in Mexico, too many investors were all investing in the same place at once and, as in Mexico, eventually they figured out their mistake and all fled at once. (And, as in Mexico, the triggering event was a devaluation). The financial crisis rapidly spread from Thailand to Malaysia, Indonesia, the Philipinnes, and even South Korea and Hong Kong.

The crisis was blamed in large part on "crony capitalism," the there was also a vague realization at the time that international capital flows were much to blame. Capital flows showed an unfortunate tendancy to turn into capital stampedes, with everyone rushing into the same country at once, and then rushing out again when it appears over-saturated. It the influx had been kept to a manageable level in the first place, capital flight would never have taken place. China largely escaped the contagion because it had capital controls in place, and there was some discussion of whether such controls might be acceptable in general. Krugman heavily emphasizes the Asian crisis in his book, which was originally written shortly afterward.

Long Term Capital Management. I must admit, I had never heard of this 1998 crisis, although it threatened to crash the whole financial system. Krugman's account is harder to follow than most of his book, due to greater use of jargon such as "liquidity and risk premia," "ever narrower profit margins" and "arbitraging away liquidity and risk premia." What I understand him to be saying is this. Riskier investments carry a higher return than safe ones. The reasons are somewhat complex, but the most obvious reason is that investors are normally risk-averse and prefer safer investmensts over riskier ones. So high risk investments have to offer higher returns to persuade people to invest.

Enter hedge funds. Hedge funds have nothing to do with garden stores, and are not even the hedges that mark the outer limits of the finance system. They are so called because they hedge, i.e., limit risk by making contrary investments. (Of course, hedging would also limit returns). They also borrow huge amounts of money compared to original investment, which magnifies both risk and returns. Hedge funds believed that they could cash in on the higher returns of high-risk investments while avoiding actual risk by clever hedging strategies, and thereby have their cake and eat it too. At first it worked, leading to consistently high returns. But in the end you can't have your cake and eat it too. Thinking the risk was eliminated, more and more investors flocked in and more and more hedge funds got in on the act. With more and more people wanting to take on risky investments, the need for higher returns diminished more and more. So hedge funds took greater and greater risks, making investments no sane person would touch with a ten foot pole, and borrowing more and more, assuring themselves all the time that clever hedging strategies were avoiding the risks. But, once again, convincing investors their hedging strategies avoided the risk caused more investors to flock in and returns to diminish. Sooner or later, they were bound to end up in over their heads, taking risks so great no hedging strategy could elminate them.

Eventually they overreached by investing heavily in Russia at a time when Russia was in such complete economic and social breakdown that it did not even have a functioning currency and operated on a barter system. But its stock market was booming, courtesy of insane speculators. Sooner or the Russian stock market had to crash. When it did, people who had lent hedge funds the money they invested in Russia started calling in loans, i.e., the hedge funds suffered a run. To pay their lenders, hedge funds all simultaneously had to sell their high-risk investments that nobody else would touch with a ten-foot pole -- and nobody did. This came perilously close to crashing the whole finance system, but Alan Greenspan cut interest rates, and the panic ceased. In the clear light of hindsight, maybe it would have been less disasterous if the finance system had crashed them, as it became even more perilous in the ten years that followed.

Y2K and the tech bubble. Zandi's chart shows too other financial crises, Y2K (which never amounted to anything) and the bursting of the tech bubble, which did.

And now for the scary part. All these crises were symptoms of a financial system badly out of control, but they all showed it out of control in different ways. The earlier crises, such as the savings and loans, or Japan's lost decade, were the results of conventional banks allowed to run riot. Orange County and the Barings Bank demonstrated the dangers of derivatives. The Latin American and Asian crises showed the dangers of too free and rapid movement of international capital. The LTCM crises showed just how easily hedge funds can crash the whole system. If there is a single theme here, I would say it is the danger of stampedes. Investors can create a bubble in even the soundest investment if they all stampede in at once. And some stampedes are driven by little more than everyone else stampeding somewhere at the same time.

The current financial reform in the process of passing tightens regulations on the largest conventional banks and on derivatives. So far as I can tell, it does nothing to address the dangers of international capital, or of hedge funds, much less of the system's general tendancy to stampede. But only by fighting stampedes can we possibly avert such a crisis in the future.

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