Monday, May 3, 2010

Was the 2008 financial crisis unprecedented?

Not at all! It would be a mistake to consider this crisis unprecedented and assume that "this time is different", according to a new report (particularly, see pp.11; this blog post is a summary of that section). For a discussion about growth in developing countries after the 2008 financial crisis, see this.

There were similar crises before: the US in the early 1990s during the Savings and Loans (S&L) debacle, costing 3% of GDP; Japan and Sweden in 1992; Mexico in 1994; Hong Kong, Indonesia, Malaysia, the Philippines, South Korea, and Thailand in 1997-98 (cost of bank restructuring: 50%, 25% and one-third of GDP in Indonesia, Japan and Thailand and South Korea respectively) ; Brazil and the Russian Federation in 1999; Turkey in 2000; and Argentina and Uruguay in 2002.

The 2008 crisis follows a pattern seen many times before. The pattern is captured by Hyman Minsky model.

  1. In a successful capital economy, the financial structure abets enterprise but when finance fosters speculation the performance of a capitalist economy falters. Keynes defined enterprise as the "activity of forecasting the prospective yield of assets over their whole life" and speculation as the "activity of forecasting the psychology of the market."
  2. Some exogenous event improves the prospects for profits, justifying speculative bets. Usually financial liberalization is followed by speculation as happened after the financial liberalization in Japan in the 1980s and in Sweden preceding 1992 crisis. The 2008 financial crisis was preceded by a significant increase in asset prices, fueled by leverage, low interest rates, and the perception that financial innovation had tamed financial risk.
  3. Expectations take off, losing touch with reality. Euphoria, optimism, irrational exuberance, manias, bubbles, blindness to risk, animal spirits are some of the way to describe the psychological forces at work.
  4. Credit system permits highly leveraged investments in the pursuit of socially valuable goods. But it also enables the pursuit of short-term capital gains in real estate, commodities or financial assets. Borrowers tend to progress from hedge finance (where the yield on an asset is sufficient to pay the interest and principal of the loan that financed) to speculative finance (where it is sufficient to pay only interest) to Ponzi finance (where the borrower is wholly dependent on capital gains).
  5. A negative event triggers a reversal in the cycle. The greater the leverage, the more violent the downward journey. Prices fall and leveraged borrowers are unable to honor their debt.