Part 1 (2/2)

As the stock market crashed, foreclosures mounted, firms failed, and consumers stopped spending. Vast Ponzi schemes came to light, as did evidence of widespread fraud and collusion throughout the financial industry. By then the sickness in the United States had spread to the rest of the world, and foreign stock markets, banks, and investment firms came cras.h.i.+ng down to earth. Unemployment soared, industrial production plummeted, and falling prices raised the specter of deflation. It was the end of an era.

What we're describing didn't happen a couple of years ago; it happened more than eighty years ago, on the eve of the Great Depression. Then as now, speculative bubbles in real estate and stocks, minimal financial regulation, and a flurry of financial innovation conspired to create a bubble that, when it burst, set the stage for the near collapse of the financial system on Wall Street, a brutal economic downturn on Main Street, and a worldwide bust. That the recent crisis bears so many eerie similarities to a catastrophe that unfolded decades ago is not a coincidence: the same forces that gave rise to the Great Depression were at work in the years leading up to our very own Great Recession.

Even more striking, the irrational euphoria, the pyramids of leverage, the financial innovations, the a.s.set price bubbles, the panics, and the runs on banks and other financial inst.i.tutions shared by these two episodes are common to many other financial disasters as well. Change a few particulars of the foregoing narrative, and you could be reading about the infamous South Sea Bubble of 1720, the global financial crisis of 1825, the boom and bust that foreshadowed j.a.pan's Lost Decade (1991-2000), the American savings and loan crisis, or the dozens of crises that hammered emerging markets in the 1980s and 1990s.

In the history of modern capitalism, crises are the norm, not the exception. That's not to say that all crises are the same. Far from it: the particulars can change from disaster to disaster, and crises can trace their origins to different problems in different sectors of the economy. Sometimes a crisis originates in the excesses of overleveraged households; at other times financial firms or corporations or even governments are to blame. Moreover, the collateral damage that crises cause varies greatly; much depends on the scale and appropriateness of government intervention. When crises a.s.sume global dimensions, as the worst ones so often do, much hangs on whether cooperation or conflict characterizes the international response.

The stakes could not be higher. When handled carelessly, crises inflict staggering losses, wiping out entire industries, destroying wealth, causing ma.s.sive job losses, and burdening governments with enormous fiscal costs. Even worse, crises have toppled governments and bankrupted nations; they have driven countries to wage retaliatory trade battles. Crises have even paved the way for wars, much as the Great Depression helped set the stage for World War II. Ignoring them is not an option.

Creatures of Habit.

Early in 2007, when signs of a looming housing and subprime mortgage crisis in the United States appeared on the horizon, the initial reaction was disbelief and denial. In March, Federal Reserve chairman Ben Bernanke confidently told Congress, ”At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained.” That summer Treasury Secretary Henry Paulson dismissed the threat of the subprime mortgage meltdown: ”I don't think it poses any threat to the overall economy.”

Even after the crisis exploded, this refusal to face facts persisted. In May 2008, after the collapse of Bear Stearns, Paulson offered a characteristically upbeat a.s.sessment. ”Looking forward,” he said, ”I expect that financial markets will be driven less by the recent turmoil and more by broader economic conditions and, specifically, by the recovery of the housing sector.” That summer saw the collapse of mortgage giants Fannie Mae and Freddie Mac, yet even then many remained optimistic.

Perhaps the most infamous bit of cheerleading came from stock market guru and financial commentator Donald Luskin, who on September 14, 2008, penned an op-ed in The Was.h.i.+ngton Post laying out the case for a quick recovery. ”Sure,” he conceded, ”there are trouble spots in the economy, as the government takeover of mortgage giants Fannie Mae and Freddie Mac, and jitters about Wall Street firm Lehman Brothers, amply demonstrate. And unemployment figures are up a bit too.” But ”none of this,” he forcefully argued, ”is cause for depression-or exaggerated Depression comparisons. . . . Anyone who says we're in a recession, or heading into one-especially the worst one since the Great Depression-is making up his own private definition of 'recession.' ” The next day Lehman Brothers collapsed, the panic a.s.sumed global proportions, the world's financial system went into a cardiac arrest, and for two quarters the global economy experienced a free fall comparable to that of the Great Depression.

As it became apparent that the crisis was real, many commentators tried to make sense of the disaster. Plenty of people invoked Na.s.sim Nicholas Taleb's concept of the ”black swan” to explain it. Taleb, whose book of that t.i.tle came out on the eve of the crisis, defined a ”black swan event” as a game-changing occurrence that is both extraordinarily rare and well-nigh impossible to predict. By that definition, the financial crisis was a freak event, albeit an incredibly important and transformational one. No one could possibly have seen it coming.

In a perverse way, that idea is comforting. If financial crises are black swans, comparable to plane crashes-horrific but highly improbable and impossible to predict-there's no point in worrying about them. But the recent disaster was no freak event. It was probable. It was even predictable, because financial crises generally follow the same script over and over again. Familiar economic and financial vulnerabilities build up and eventually reach a tipping point. For all the chaos they create, crises are creatures of habit.

Most crises begin with a bubble, in which the price of a particular a.s.set rises far above its underlying fundamental value. This kind of bubble often goes hand in hand with an excessive acc.u.mulation of debt, as investors borrow money to buy into the boom. Not coincidentally, a.s.set bubbles are often a.s.sociated with an excessive growth in the supply of credit. This could be a consequence of lax supervision and regulation of the financial system or even the loose monetary policies of a central bank.

At other times a.s.set bubbles develop even before the credit supply booms, because expectations of future price increases are sufficient to foster a self-fulfilling rise in the a.s.set's price. A major technological innovation-the invention of railroads, for example, or the creation of the Internet-may lead to expectations of a brave new world of high growth, triggering a bubble. No such new technology prompted the current housing-driven crisis, although the complex securities manufactured in Wall Street's financial laboratories may qualify, even if they did little to create real economic value.

But that would not be new either. Many bubbles, while fueled by concrete technological improvements, gain force from changes in the structure of finance. In the last few hundred years, many of the most destructive booms-turned-bust have gone hand in hand with financial innovation, the creation of newfangled instruments and inst.i.tutions for investing in whatever is the focus of a speculative fever. They could be new forms of credit or debt, or even new kinds of banks, affording investors novel opportunities for partic.i.p.ating in a speculative bubble.

Regardless of how the boom begins, or the channels by which investors join it, some a.s.set becomes the focus of intense speculative interest. The coveted a.s.set could be anything, but equities, housing, and real estate are the most common. As its price shoots skyward, optimists feverishly attempt to justify this overvaluation. When confronted with the evidence of previous busts, they claim, ”This time is different.” Wise men and women a.s.sert-and believe-that the economy has entered a phase where the rules of the past no longer apply. The recent housing bubble in the United States followed this script with remarkable fidelity: real estate was said to be a ”safe investment” that ”never lost value” because ”home prices never fall.” The same was said of the complex securities built out of thousands of mortgages.

From such beginnings, financial disasters proceed along a predictable path. As credit becomes increasingly cheap and abundant, the coveted a.s.set becomes easier to buy. Demand rises and outstrips supply; prices consequently rise. But that's just the beginning. Because the a.s.sets at the heart of the bubble can typically serve as collateral, and because the value of the collateral is rising, a speculator can borrow even more with each pa.s.sing day. In a word, borrowers can become leveraged.

Again, this pattern played out from 2000 in the United States: as home values rose markedly and wages stagnated, households used their homes as collateral in order to borrow more, most often in the form of a home equity withdrawal or home equity loans; people effectively used their homes as ATM machines. As housing prices climbed, borrowers could borrow even more, using what they'd purchased-home improvements, even second homes-as additional collateral. By the fourth quarter of 2005, home equity withdrawals peaked at an annualized rate of a trillion dollars, enabling millions of households to live well beyond their means. At the same time, the household savings rate plunged to zero, then went into negative territory for the first time since the Great Depression. However unsustainable, this debt-financed consumption had real economic effects: households and firms purchasing goods and services fueled economic growth.

Such a dynamic creates a vicious cycle. As the economy grows, incomes rise and firms register higher profits. Worries about risk drop to record lows, the cost of borrowing falls, and households and firms borrow and spend more with ever greater ease. At this point, the bubble is not just a state of mind but a force for economic change, driving growth and underwriting new and increasingly risky business ventures, like housing subdivisions in the desert.

In the typical boom-and-bust cycle, people are still saying, ”This time is different,” and claiming that the boom will never end, even though all the elements of a speculative mania-”irrational exuberance” and growing evidence of reckless, even fraudulent, behavior-are in place. American homeowners, for example, enthusiastically embraced the fiction that home prices could increase 20 percent every year forever, and on the basis of that belief they borrowed more and more. The same euphoria held sway in the shadow banking system of hedge funds, investment banks, insurers, money market funds, and other firms that held a.s.sets that appreciated as housing prices boomed.

At some point, the bubble stops growing, typically when the supply for the bubbly a.s.set exceeds the demand. Confidence that prices will keep rising vanishes, and borrowing becomes harder. Just as a fire needs oxygen, a bubble needs leverage and easy money, and when those dry up, prices begin to fall and ”deleveraging” begins. That process began in the United States when the supply of new homes outstripped demand. The excessive number of homes built during the boom collided with diminished demand, as excessively high prices and rising mortgage rates deterred buyers from wading any further into the market.

When the boom becomes a bust, the results are also predictable. The falling value of the a.s.set at the root of the bubble eventually triggers panicked ”margin calls,” requests that borrowers put up more cash or collateral to compensate for falling prices. This, in turn, may force borrowers to sell off some of their a.s.sets at fire-sale prices. Supplies of the a.s.set soon far outstrip demand, prices fall further, and the value of the remaining collateral plunges, prompting further margin calls and still more attempts to reduce exposure. In a rush for the exits, everyone moves into safer and more liquid a.s.sets and avoids the a.s.set at the focus of the bubble. Panic ensues, and just as prices exceeded their fundamental value during the bubble, prices fall well below their fundamental values during the bust.

That's what happened over the course of 2007 and 2008. As homeowners defaulted on their mortgages, the value of the securities derived from those loans collapsed, and the bust began. Eventually the losses suffered by highly leveraged financial inst.i.tutions forced them to hunker down and limit their exposure to risk. As happens in every bust, the banks overcompensated: they trimmed their sails, curtailed lending, and thereby triggered an economy-wide liquidity and credit crunch. Individuals and firms could no longer ”roll over,” or refinance, their existing debt, much less spend money on goods and services, and the economy began to contract. What started as a financial crisis spilled over into the real economy, causing plenty of collateral damage.

That's the recent crisis in a nutsh.e.l.l, but it could be the story of almost any financial crisis. Contrary to conventional wisdom, crises are not black swans but white swans: the elements of boom and bust are remarkably predictable. Look into the recent past, and you can find dozens of financial crises. Further back in time, before the Great Depression, many more lurk in the historical record. Some of them hit single nations; others reverberated across countries and continents, wreaking havoc on a global scale. Yet most are forgotten today, dismissed as relics of a less enlightened era.

The Dark Ages.

Financial crises come in many shapes and guises. Before the rise of capitalism, they tended to be a result of government malfeasance. From the twelfth century onward, governments of countries and kingdoms as diverse as Spain and England debased their currencies, cutting the gold or silver content of coins while maintaining the fiction that the new coins were worth as much as the old. These naked attempts to discharge debts in depreciated currency became even easier with the advent of paper money. Governments could literally print their way out of debt. The Chinese pioneered this practice as early as 1072; European nations adopted it much later, beginning in the eighteenth century.

A government that owed money to foreign creditors could take a more honest route and simply default, much as Edward III did in the mid-fourteenth century. Having borrowed money from Florentine bankers, he refused to pay it back, sowing chaos in Italy's commercial centers. It was a harbinger of things to come; plenty of other sovereigns took this route, with predictable consequences for their creditors. Austria, France, Prussia, Portugal, and Spain all defaulted on their debts at various times from the fourteenth century onward.

While important and destabilizing, these episodes were crises of confidence in overindebted governments, not of capitalism. But with the emergence of the Netherlands as the world's first capitalist dynamo in the sixteenth and seventeenth centuries, a new kind of crisis made its appearance: the a.s.set bubble. In the 1630s ”tulip mania” gripped the country, as speculators bid up the prices of rare tulip bulbs to stratospheric levels. While historians continue to debate the consequences of this bit of speculative fever (and some economists even deny it was a bubble, arguing that all bubbles are driven by fundamentals), it set the stage for larger bubbles whose destructive effects are not in doubt. Most infamous was John Law's Mississippi Company, a sprawling speculative venture that dominated the French economy in the late 1710s. At its peak in 1719, Law's company controlled several other trading companies, the national mint, the national bank, the entire French national debt, and for good measure much of the land that would become the United States.

Not to be outdone, the British caught the bubble bug around the same time. At the center was a corporation known as the South Sea Company, which at its height effectively controlled much of the British national debt. Speculation in its shares gave rise to a mania for stocks of all kinds, including many fraudulent corporations. After the company's stock price increased by 1,000 percent, the day of reckoning came: the stock market crashed, leaving the economy in shambles and a generation of British investors wary of financial markets. An even more devastating crisis. .h.i.t France at the same time, as Law's schemes unraveled spectacularly, stunting the development of financial inst.i.tutions for decades.

These crises figure significantly in any standard history of speculative manias, panics, and crashes, but they did not trigger global financial crises. By contrast, the panic of 1825 reverberated around the world. It began in Britain and had all the hallmarks of a cla.s.sic crisis: easy money (courtesy of the Bank of England), an a.s.set bubble (stocks and bonds linked to investments in the emerging market of newly independent Peru), and even widespread fraud (feverish selling of the bonds of a fict.i.tious nation called the Republic of Poyais to credulous investors).

When the bubble burst, numerous banks and nonfinancial firms in Britain failed. It was, the English economist Walter Bagehot recalled, ”a period of frantic and almost inconceivable violence; scarcely anyone knew whom to trust; credit was almost suspended; [and] the country was . . . within twenty-four hours of [entering] a state of barter.” Bagehot, one of the first writers to argue that a central bank should act as a lender of last resort when a panic and bank run occurs, lamented that ”applications for a.s.sistance were made to the Government, but . . . the Government refused to act.” The financial crisis quickly spread to the rest of Europe, and panicked investors pulled money out of Latin America. By 1828 every country on the continent except Brazil had defaulted on its public debt. It took three decades for the flow of capital to the region to return to earlier levels.

No less global in scope was the panic of 1857. The boom began in the United States, with speculation in slaves, railroads, financial instruments, and land. The bubble burst, and banks in New York City panicked, curtailing credit and trying to sh.o.r.e up their positions, but to no avail: holders of the banks' obligations presented them for redemption, draining the banks of gold and silver reserves, a cla.s.sic case of a bank run. A little over a month later, panic hit London, and the Bank of England's reserves were drawn down with similar speed. The panic spread to the rest of Europe and from there to India, China, the Caribbean, South Africa, and Latin America. Countries around the world saw their economies suffer, and the crisis put an end to one of the longest economic expansions in modern times.

The most dramatic nineteenth-century global meltdown may have been the crisis of 1873. Once again, investors in Britain and continental Europe made enormous speculative investments in railroads in the United States and Latin America, as well as other projects. Worse, reparations paid by France to Germany in the wake of the Franco-Prussian War sparked a speculative boom in German and Austrian real estate. When this boom collapsed, the stock markets in Vienna, Amsterdam, and Zurich imploded, prompting European investors to liquidate overseas investments. This put strain on the United States, which itself was in the grip of a speculative boom in railroad securities. When the investment banker Jay Cooke failed to find buyers for securities issued to underwrite construction of the new Northern Pacific Railroad, both his bank and the railroad collapsed, triggering a ma.s.sive panic on Wall Street. This calamity sparked further secondary panics in Europe, and much of the world plunged into a brutal economic depression and a deflationary spiral. In the United States a quarter of the nation's railroads went under, while soaring unemployment and wage cuts led to b.l.o.o.d.y riots and strikes. The collapse in the global economy had particularly pernicious effects outside the United States and Europe, hitting the Ottoman Empire, Greece, Tunisia, Honduras, and Paraguay.

This account is but a sampling of the crises that plagued the nineteenth century; there were many, many more: the panics of 1819, 1837, 1866, and 1893, to name a few. All had their unique qualities, but many shared a common set of features. Typically they began in more developed economies after excessive speculative lending and investments went bust, triggering a banking crisis. As the global economy sputtered and slowed, countries on the periphery that depended on exporting commodities saw their economies wither. Government revenue collapsed, leading some countries to default on their domestic debt, if not loans from overseas. In some cases, these defaults spurred additional meltdowns at the economic core, as investors in these emerging markets lost their s.h.i.+rts.

The early twentieth century saw its shares of panics too. The crisis of 1907 began in the United States after a speculative boom in stocks and real estate collapsed. So-called trust companies-lightly regulated commercial banks bound together by complicated chains of owners.h.i.+p-suffered runs on their reserves, and panic spread throughout the country. The stock market crashed, and as the crisis spiraled out of control, the nation's most powerful banker, J. P. Morgan, convened a series of emergency meetings with New York City's banking establishment to stop the bank run. On the first weekend of November, Morgan, in a famous act of brinksmans.h.i.+p, invited the bankers to his private library. When they failed to agree to come to one another's aid, he locked them in a room and pocketed the key. The bankers eventually agreed, and the crisis came to an end shortly thereafter. While Morgan received credit for averting a catastrophe, the events of 1907 persuaded many of the need for a central bank to provide lender-of-last-resort support in future crises, and six years later the Federal Reserve was born.

In theory, a central bank like the Federal Reserve can serve as a bulwark against financial crises, providing lender-of-last-resort support in the event of a bank run. But during the catastrophic crash of 1929, as the crisis spun out of control, the Fed stood idly by. Rather than pursuing an expansionary monetary policy, it tightened the reins, making a bad situation even worse. As a consequence, the money supply sharply contracted between 1929 and 1933, leading to a severe liquidity and credit crunch that turned a stock market bust into a banking crisis and eventually into a severe economic depression.

The reaction of the rest of the federal government wasn't much better. Andrew Mellon, Herbert Hoover's Treasury secretary, believed a purge was necessary. Hoover described Mellon as a ”leave-it-alone liquidationist” who had no pity for those caught in the crisis. ”Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate,” Mellon was said to have counseled. Mellon believed that financial panic would ”purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life.”

Perhaps, but from 1929 to 1933 the United States plunged into the worst depression in its history. Unemployment rates shot from 3.2 percent to 24.9 percent; upwards of nine thousand banks suspended operations or closed, and by the time Franklin Delano Roosevelt took office, a good part of the nation's financial system had effectively collapsed, much as it had in other countries around the world. Many of those other countries experienced comparable rates of unemployment and economic decline. Currency wars led to trade wars. In the United States the infamous Smoot-Hawley Tariff triggered retaliatory tariffs across the world and contributed to a breakdown of world trade. Many nations in Europe eventually depreciated their currencies, debased their debts via inflation, and even formally defaulted on debts, including Germany, where the crisis paved the way for Hitler's rise to power and the worst war in human history.

For all its horrific consequences, World War II made possible a wholesale transformation of the world's financial system. In 1944, as the end of the war drew near, economists and policy makers from the Allied nations met in Bretton Woods, New Hamps.h.i.+re, to hammer out a new world economic order. Their deliberations gave rise to the International Monetary Fund, as well as the forerunner of the World Bank, and a new system of currency exchange rates known as the Bretton Woods system or dollar exchange standard. In this system, every nation's currency would be exchanged into dollars at a fixed rate. Foreign countries that held dollars then had the option of redeeming them for U.S. gold at the price of thirty-five dollars an ounce. In effect, the dollar became the world's reserve currency, while the United States alone remained on a gold standard in its dealings with other countries. Thus began a remarkable-and extraordinarily anomalous, given the previous centuries' crises-era of financial stability, a pax moneta that depended on the dollar and on the military and economic power of the newly ascendant United States. That stability rested as well on the widespread provision of deposit insurance to stop bank runs; strict regulation of the financial system, including the separation of American commercial banking from investment banking; and extensive capital controls that reduced currency volatility. All these domestic and international restrictions kept financial excesses and bubbles under control for over a quarter of a century.

All good things come to an end, and the postwar era was no exception: the Bretton Woods system fell apart in 1971, when the United States finally went off the last vestiges of the gold standard. The reason? The twin U.S. fiscal and current account deficits (which we will discuss in chapter 10) triggered by the Vietnam War caused an acc.u.mulation of dollar reserves by the creditors of the United States-primarily Western Europe and j.a.pan-that became unsustainable. In effect, the creditors of the United States realized that there wasn't enough gold to back up the dollars in circulation. When that happened, Bretton Woods collapsed, the dollar depreciated, and the world moved to a system of flexible exchange rates.

This move unshackled monetary authorities that, freed of the constraints of a fixed-rate regime, could now print as much money as they wanted. The result was a rise in inflation and commodity prices, even before the 1973 Yom Kippur War led to an oil embargo and a quadrupling of oil prices. Stagflation, a deadly combination of high inflation and recession, followed the two oil shocks of 1973 and 1979 (the latter triggered by the Iranian Revolution) as well as the botched monetary policy response to these shocks. It took a new Federal Reserve chairman, Paul Volcker, to set things right. He sharply raised interest rates to stratospheric levels, triggering a severe double-dip recession in the early 1980s. While brutal, this shock treatment worked, breaking the back of inflation and ushering in a decade of growth.

Every silver lining has its cloud: Volcker's policies also helped trigger the Latin American debt crisis of the 1980s. In the 1970s many Latin American governments embarked on ma.s.sive economic development projects financed with foreign capital. The resulting fiscal and current account deficits were financed with loans brokered by banks in the United States and Europe. The interest rates on these foreign currency loans were linked to a benchmark short-term interest rate known as the London Interbank Offered Rate (LIBOR). When Volcker hiked interest rates, the LIBOR rate rose sharply as well, making it impossible for Latin American countries to service their debts. Even worse, the real value of these debts rose as these countries' currencies depreciated.

As a consequence, multiple governments defaulted on their debt. In Mexico in 1982, the default ushered in an economic collapse that led to the nationalization of Mexico's private banking system and then a devastating recession; Brazil, Argentina, and other countries in Latin America soon followed suit. In many ways, these defaults replayed earlier crises, as events in the world's leading economies reverberated in less developed countries.

The Latin American debt crisis had profound consequences: lost growth, political instability, and social unrest throughout the region. Only in the late 1980s, when the loans were reduced in face value and converted into bonds (the ”Brady bonds”), did the region start to recover. Many banks in the United States and Europe struggled to recuperate as well. It took an enormous amount of regulatory forbearance and international crisis management, led by the United States and the IMF, to stop the banks from going under.

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