Financial crises in a historical perspective

1. Financialcrises in a historicalperspective Lecture9 Reinhart&Rogoff

2. How to learn from the past? It is the only thing we have to go on - the future is embedded in history History does not repeat itself, but very often it rhymes

3. Thinking historically A. Structures, processes, functions and institutions B. Continuities and discontinuities. Creative Destruction, Financial crises C. Comparative analysis – case method. Equivalent to experimental method in natural science

4. Achieved knowledge • One way to understand greatness and become great is to see how greatness—for individuals, firms and for nations—has been achieved in the past. • You can’t learn from the past unless you can make sense of it. • Making sense of it involves not just understanding the facts, but understanding and applying a logic of causation, understanding the context in which decisions are taken.

5. Whatweknow from Crises in the Post-war Era • Collapse of markets for different assets:House prices down 35 percent in 6 yearsListed shares down 56 percent over 3.5 years • Production down 9 percent over two years. • It takes 4.5 years before production reaches the level before the crisis. • Unemployment is rising 7 percentage points in the downward phase of just over 4 years

6. More observations Central government debt rises sharply, on average 86 percent as a result of: • Private balance sheets reduces • Rescue costs and re-capitalization of banks • Reduced tax revenue • Rising interest rates and more expensive loans, lower credit rating

7. General Definition ofFinancialCrisis (Kaufman) • There has been a markedincrease in short-term borrowing. • There is a willingnesstofinance at floatinginterest rate comparetofixedinterest rate, becauseof the uncertainty in the market. • There is also a tendencytoshorten the maturityofborrowings.

8. General Definition • A failureof the equity market toprovide a net new source ofcapital for business. • The last danger signal associatedwith the rapid swellingofdebt is the fragilityofmanyof the financial institutions. Their assets and liabilititeshave risen muchmorequicklythantheircapitalaccounts.

9. Varioustypesofcrises

10. Definition of the variouscrises • Inflation Crisis - Inflation over 20 percent more year (Angola 4000%, Zimbabwe 66 000%) • Currency Crisis - depreciation of 15 percent (Zimbabwe 10 billion to one. Germany 4.2 trillion mark for $ 1 in 1923) • Price bubble - strong fall for housing prices and industrial stocks • Banking Crisis - system-wide, bank runs, each individual bank is insolvent or bankrupt • Debt Crisis - foreign, can not amortize or pay; domestic debt

11. BankingCrisisCycle

12. Main thesis • It's not every recession that coincides with a financial crisis. The crises have in common that they have been preceded by a thorough re-regulation during a long economic boom, in the interface between market and politics. • This leads to an institutional conflict between previous and new rules, with consequences for the actors' risk management in capital markets.

13. Main thesis • An institutional conflict is a prerequisite for a financial crisis, but only a re-regulation is not sufficient for a financial crisis will occur. It also requires a shift from boom to recession. • There is no changing economic conditions that create the banking crisis without economical political decisions that change the rules on capital markets.

14. Cycle Model for Banking crises The model focuses procedural and structural changes in the financial sector, with its relationship to the economy, government and other businesses. Step 1. Optimism and demandStep 2. Financial muscleStep 3. New rules and institutional clashStep 4. Idle capitalStep 5. Debt accumulationStep 6. The bubble burstsStep 7. Debt crisis and restructuring

15. Step 1. Optimism and demand. Higher demand for goods and services and rising internal financing rate among non-financial companies. Normal cyclical movements follow. Step 2. Financial muscles. Higher demand for financial capital among non-financial corporations, in the context of a permanent nature rules. Organizational adaptation among financial players. Increased integration of resources. Mergers and acquisitions in order to strengthen the "financial muscle". 

16. Step 3. The Critical Step in the Cycle Step 3. New rules and institutional clash. Re-regulation combined with institutional inertia = institutional conflict, financial innovation, more sophisticated financial markets. New financial organizations, more or less regulated.

17. Step 4. Idle capital. Over-liquidity. Too much venture capital. Investments in "fake" innovations, speculation in the welfare society peripheral and non-long-term growth-enhancing sectors. Step 5. Debt accumulation. Increased debt, expectations of rising asset prices, price inflation, financial assets / GDP peaks. Financial bubbles build up.

18. Step 6. The bubble burst. Desinflation(reduced inflation) - deflation (price decline), depreciation of assets, more or less selling in panic, sharp stock market declines, bankrun (financial stress, increased systemic risk). Step 7. Debt crisis and restructuring. Bailouts by the government (bad banks), bank (lender of last resort) and industry (structural changes, illiquid players purchased by liquid ones), state debt increase, contractions in the private sector, credit crunch, new and stricter laws, more transparency.

19. The Cyclerepeatsitself The cycle starts over with Step 1. Short organizational memory in the private and public sectors together with bad institutions created after the previous crisis. Some countries and some banks will soon experience a new institutional clash and subsequently a new crisis.

20. Bailoutcostsofbankingcrises, estimated as percentageofgdp

22. Great depression vs Greatcontraction

23. Politicalconsequences

24. Long-term consequencesof the greatcontraction • The Large Contraction - deep and long-lasting. • Southern European crisis over in about five years. • U.S. falls back, but no new world power replaces the role of the U.S. • Free trade will continue. • Democratic capitalism is growing (north Africa, Middle East, China, Latin-America).

25. Whathavewelearntoday? • There is nothing new in this crisis, except what has been forgotten. • Financial crises is the other side of the coin of capitalism, and behave the same way now as then. • History is our best prediction tool! • Challenge: Find good early warning systems!