Financial Crises Don’t Happen by Accident

By Marc Faber

As a distant but interested observer of history and investment markets I am fascinated how major events that arose from longer-term trends are often explained by short-term causes. The First World War is explained as a consequence of the assassination of Archduke Franz Ferdinand, heir to the Austrian-Hungarian throne; the Depression in the 1930s as a result of the tight monetary policies of the Fed; the Second World War as having been caused by Hitler; and the Vietnam War as a result of the communist threat.

Similarly, the disinflation that followed after 1980 is attributed to Paul Volcker’s tight monetary policies. The 1987 stock market crash is blamed on portfolio insurance. And the Asian Crisis and the stock market crash of 1997 are attributed to foreigners attacking the Thai Baht (Thailand’s currency). A closer analysis of all these events, however, shows that their causes were far more complex and that there was always some “inevitability” at play.

Simply put, a financial crisis doesn’t happen accidentally, but follows after a prolonged period of excesses…

Take the 1987 stock market crash. By the summer of 1987, the stock market had become extremely overbought and a correction was due regardless of how bright the future looked. Between the August 1987 high and the October 1987 low, the Dow Jones declined by 41%. As we all know, the Dow rose for another 20 years, to reach a high of 14,198 in October of 2007.

These swings remind us that we can have huge corrections within longer term trends. The Asian Crisis of 1997-98 is also interesting because it occurred long after Asian macroeconomic fundamentals had begun to deteriorate. Not surprisingly, the eternally optimistic Asian analysts, fund managers , and strategists remained positive about the Asian markets right up until disaster struck in 1997.

But even to the most casual observer it should have been obvious that something wasn’t quite right. The Nikkei Index and the Taiwan stock market had peaked out in 1990 and thereafter trended down or sidewards, while most other stock markets in Asia topped out in 1994. In fact, the Thailand SET Index was already down by 60% from its 1994 high when the Asian financial crisis sent the Thai Baht tumbling by 50% within a few months. That waked the perpetually over-confident bullish analyst and media crowd from their slumber of complacency.

I agree with the late Charles Kindleberger, who commented that “financial crises are associated with the peaks of business cycles”, and that financial crisis “is the culmination of a period of expansion and leads to downturn”. However, I also side with J.R. Hicks, who maintained that “really catastrophic depression” is likely to occur “when there is profound monetary instability — when the rot in the monetary system goes very deep”.

Simply put, a financial crisis doesn’t happen accidentally, but follows after a prolonged period of excesses (expansionary monetary policies and/or fiscal policies leading to excessive credit growth and excessive speculation). The problem lies in timing the onset of the crisis. Usually, as was the case in Asia in the 1990s, macroeconomic conditions deteriorate long before the onset of the crisis. However, expansionary monetary policies and excessive debt growth can extend the life of the business expansion for a very long time.

In the case of Asia, macroeconomic conditions began to deteriorate in 1988 when Asian countries’ trade and current account surpluses turned down. They then went negative in 1990. The economic expansion, however, continued — financed largely by excessive foreign borrowings. As a result, by the late 1990s, dead ahead of the 1997-98 crisis, the Asian bears were being totally discredited by the bullish crowd and their views were largely ignored.

While Asians were not quite so gullible as to believe that “the overall level of debt makes no difference … one person’s liability is another person’s asset” (as Paul Krugman has said), they advanced numerous other arguments in favour of Asia’s continuous economic expansion and to explain why Asia would never experience the kind of “tequila crisis” Mexico had encountered at the end of 1994, when the Mexican Peso collapsed by more than 50% within a few months.

In 1994, the Fed increased the Fed Fund Rate from 3% to nearly 6%. This led to a rout in the bond market. Ten-Year Treasury Note yields rose from less than 5.5% at the end of 1993 to over 8% in November 1994. In turn, the emerging market bond and stock markets collapsed. In 1994, it became obvious that the emerging economies were cooling down and that the world was headed towards a major economic slowdown, or even a recession.

But when President Clinton decided to bail out Mexico, over Congress’s opposition but with the support of Republican leaders Newt Gingrich and Bob Dole, and tapped an obscure Treasury fund to lend Mexico more than$20 billion, the markets stabilized. Loans made by the US Treasury, the International Monetary Fund and the Bank for International Settlements totalled almost $50 billion.

However, the bailout attracted criticism. Former co-chairman of Goldman Sachs, US Treasury Secretary Robert Rubin used funds to bail out Mexican bonds of which Goldman Sachs was an underwriter and in which it owned positions valued at about $5 billion.

At this point I am not interested in discussing the merits or failures of the Mexican bailout of 1994. (Regular readers will know my critical stance on any form of bailout.) However, the consequences of the bailout were that bonds and equities soared. In particular, after 1994, emerging market bonds and loans performed superbly — that is, until the Asian Crisis in 1997. Clearly, the cost to the global economy was in the form of moral hazard because investors were emboldened by the bailout and piled into emerging market credits of even lower quality.

…because of the bailout of Mexico, Asia’s expansion was prolonged through the availability of foreign credits.

Above, I mentioned that, by 1994, it had become obvious that the emerging economies were cooling down and that the world was headed towards a meaningful economic slowdown or even a recession. But the bailout of Mexico prolonged the economic expansion in emerging economies by making available foreign capital with which to finance their trade and current account deficits. At the same time, it led to a far more serious crisis in Asia in 1997 and in Russia and the U.S. (LTCM) in 1998.

So, the lesson I learned from the Asian Crisis was that it was devastating because, given the natural business cycle, Asia should already have turned down in 1994. But because of the bailout of Mexico, Asia’s expansion was prolonged through the availability of foreign credits.

This debt financing in foreign currencies created a colossal mismatch of assets and liabilities. Assets that served as collateral for loans were in local currencies, whereas liabilities were denominated in foreign currencies. This mismatch exacerbated the Asian Crisis when the currencies began to weaken, because it induced local businesses to convert local currencies into dollars as fast as they could for the purpose of hedging their foreign exchange risks.

In turn, the weakening of the Asian currencies reduced the value of the collateral, because local assets fall in value not only in local currency terms but even more so in US dollar terms. This led locals and foreigners to liquidate their foreign loans, bonds and local equities. So, whereas the Indonesian stock market declined by “only” 65% between its 1997 high and 1998 low, it fell by 92% in US dollar terms because of the collapse of their currency, the Rupiah.

As an aside, the US enjoys a huge advantage by having the ability to borrow in US dollars against US dollar assets, which doesn’t lead to a mismatch of assets and liabilities. So, maybe Krugman’s economic painkillers, which provided only temporary relief of the symptoms of economic illness, worked for a while in the case of Mexico, but they created a huge problem for Asia in 1997.

Similarly, the housing bubble that Krugman advocated in 2001 relieved temporarily some of the symptoms of the economic malaise but then led to the vicious 2008 crisis. Therefore, it would appear that, more often than not, bailouts create larger problems down the road, and that the authorities should use them only very rarely and with great caution.

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Carney is off to the Bank of England — Pray for England

Bank of Canada Governor and ex-Goldman bankster Mark Carney was selected to become the next Governor of the Bank of England. He will now be overseeing a central bank with nearly ten times the assets of the Bank of Canada. That is a big promotion in the world of central planners! Carney will now be able to create even larger disturbances in economic systems.

Truly, the worst rise to the top.

Good riddance, I say. Not that I expect him to be replaced with anyone much better. But there is always a chance.

I feel bad for England, though. They have no idea what they are getting themselves into (from Bloomberg):

Carney, who holds an economics degree from Harvard and a doctorate from Oxford University, swaps oversight of an economy which bounced back from the global recession without witnessing a single bank bailout for one which slipped back into recession in the second quarter and required multiple bank rescues.

Did you see what they did there?

Carney … swaps oversight of an economy which bounced back from the global recession without witnessing a single bank bailout for one which slipped back into recession in the second quarter and required multiple bank rescues.

Carney … swaps oversight of an economy which bounced back from the global recession without witnessing a single bank bailout … 

an economy which bounced back from the global recession without witnessing a single bank bailout …

without witnessing a single bank bailout

Excuse me? The banks that pushed for Carney to be their man in England have surely put the shucks on the rubes.

Of all the deleterious myths that persist about the Canadian financial system, none are more harmful or obnoxious than the bogus story that its banks never needed and/or never got a bailout.

Anyone who says this is simply lying or has no idea what they are talking about. Those are the only real possibilities. We have covered this at CMR previously, but let us quickly review.

The mainstream news doesn’t even try to deny it anymore. The Canadian banks got a bailout. Now they simply try to play down the significance of it. Even though it is was much bigger than anyone was led to believe.

So is this “no bailouts in Canada” proposition challenged by anyone in the UK? Carney is being sold on the pretense that there were no bailouts?   

(Side note: We could also mention that Canadian banks received assistance from emergency Federal Reserve lending facilities, which by itself is very interesting. We could also mention that rather material fact that Canadian banks are basically in a state of “perma-bailout” by virtue of the Canadian Deposit Insurance Corporation. The existence of the CDIC amplifies the level of risk banks are willing to engage in — it is classic “moral hazard.”)

So it would seem one is more likely to see bank bailouts with Carney, rather than less. That is precisely why the UK banking cartel wants Carney in this position.

Yet that is not the only reason citizens of the UK should worry.

Mark Carney is not only a believer in bailouts — he is a believer in Keynesianism and mercantilism. This means nothing more than this: he sees a connection between depreciating the currency and growing the economy. This he shares with nearly all central bankers (except, perhaps, those in Singapore): he regards a strong currency as harmful to “the nation”. Because when he talks about “the nation,” he is not talking about the consumers (i.e. everyone) who use their stronger currency to buy and invest in more goods. For men such as Carney, “the nation” instead refers to politically-connected export industries that are benefited by making it cheaper for foreigners to buy their stuff.

That being the case, Carney will tend to increase the money supply by adding assets to the central bank’s balance sheet whenever he thinks it’s a good idea. But this means prices must rise and debts will deepen. Britain already has big problems in these areas.

This should be the last thing someone in the UK should desire. The British pound has plummeted in value the last five years against stronger currencies like the yen. Here in Canada, it seems Carney’s manipulations have been obscured by strong demand for Canadian commodities, yet with the slowdown in Asia, Europe, and soon the US, I doubt this will persist. The Bank of Canada has been growing its balance sheet for nearly two years now, since offloading some of its emergency acquisitions during the financial crisis.

Also, it should be known that Carney likes to troll citizens whose currency he manages by blaming them for behavior that is strongly encouraged by his own central bank policies. What a jerk.

I am happy to see Carney go. While I am happy he no longer oversees the Canadian dollar, I am apprehensive about who his replacement will be. Most of all, I must also bemoan the lack of justice. Carney should be serving a prison sentence for counterfeiting, rather than getting $1 million a year to manipulate huge economies.

Jim Rogers, Andrew Schiff, and some economic ignoramus named Doug Henwood talk about TBTF and taxes.

Listening to this Doug Henwood fellow on taxes is truly unbearable. Have fun.

This is an entertaining discussion but it is pretty boisterous and a lot of cogent points get lost. The group talks about the Too Big To Fail policy as “socialism for the rich,” which is a legitimate given the policy of bailing out big, insolvent financial institutions. There is no dispute with any of this.

Socialism for the rich should be rejected, but Schiff makes a valid point that, insofar as bailing out financial institutions was intended to keep credit flowing liberally to borrowers whose credit-worthiness was otherwise inadequate, the TBTF policy was “socialism for the poor” as well. American consumers are addicted to debt and low interest rates.

Rogers and Schiff are apparently opposed to socialism in principle, but Henwood is only against “socialism for the rich.” He likes other forms of economic interference, such as that which distorts interest rates, or that which taxes the rich.

Henwood thinks it is perfectly justified to say that higher taxes can possibly help economic growth. This is untrue, and the economic case against it is probably irrefutable. I will summarize:

If economic actors exchange property voluntarily, then it is implied that both actors are better off than they would be in absence of this trade. If both did not expect to benefit from the trade, they would not take part. The matter is quite different in the case of taxation. With taxation, the producer’s supply of goods is reduced against his will to a level below what it would be absent the taxation. In addition to this reduction of present goods, the supply of future goods is reduced as well. For taxation is not unsystematic and random, but systematic and expected to continue in one form or another. Therefore, it implies a reduced rate of return on investment and produces an added incentive to engage in fewer acts of production in the future than one otherwise would. Overall incentive to be a taxpayer decreases, and incentive to become a tax-consumer increases.

This is always true. But Mr. Henwood would disregard economic science and make his inferences based on a shallow analysis of empirical data. Of the US, he says the Clinton years saw a period of great economic growth, and tax rates were higher than they are now. So, he infers, higher tax rates contribute to economic growth.

This doesn’t make any sense. If Henwood were an economist, I would call him a crank. But he is not an economist, he is an English major. He does not have a background in economics, but he likes to write about it. There is no evidence that he is capable of applying formal theory to reality and interpreting it.

In addition to being completely fallacious, the above argument for higher taxes is only credible on the most superficial analysis. If Austrian business cycle theory is correct, then one could easily argue that the much-heralded ‘growth’ of the Clinton years was just phony wealth created by economic bubbles brought about by artificially low interest rates.

When Reagan was elected in 1980, short-term rates were 11.4 percent. When Bush I lost to Clinton in 1992, the rate was 3.4 percent. Rates moves upwards over the course of the Clinton years, and in 2000 the average Treasury bill rate was 5.8. The manipulation of interest rates created economic dislocations — the dot-com bubble, among other things — and the inevitable crash.

Doug Henwood doesn’t know what he is talking about.

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