The Lessons of History
The last four hundred years have been replete with financial crises, which often followed increases in the supplies of credit, greater investor optimism, and more rapid economic growth. More and more individuals purchased securities and assets for short-term profits from the increases in their prices. Asset prices increased. Household wealth rose and consumption spending grew. Business firms became more upbeat and invested more. Economic booms followed and then euphoria developed. The increases in the supplies of credit led to bubbles in prices of real estate and of stocks; these prices were too high to be sustainable in the long run.
The uniqueness of the last forty years is that there have been four waves of financial crises; each wave was preceded by a wave of credit bubbles that involved three, four, or in some episodes eight or ten countries. The similarity of increases in the prices of assets in so many countries at about the same time suggests a common cause. The pattern has been that the increases in the flows of money to countries usually led to increases in the values of their currencies and to increases in the prices of their bonds, stocks, and real estate.
The likelihood that these four waves of bubbles were independent and unrelated events is low. Instead it seems plausible that there was a systematic relationship among several of these successive waves, and that the money flows associated with the implosion of one wave of bubbles contributed to the next wave.
The increases in the supplies of credit generally were provided by banks. However, the buyers of bulbs during the Dutch ‘tulipmania’ of the 1630s could pay the increasingly high prices only because the sellers provided credit. As bulb prices increased, rational exuberance morphed into irrational exuberance, the Dutch economy boomed – and then when bulb prices tumbled, the growth rate slowed. Both the South Sea Bubble in London and the Mississippi Bubble in Paris in 1720 resulted from rapid increases in the supplies of credit from newly established banks. The coincidence of these two bubbles reflects that financial innovations in London were mimicked in Paris.
The ‘mother of all bubbles’ in Tokyo in the second half of the 1980s resulted from the rapid growth in the supply of credit and the relaxation of regulations that had limited bank loans for purchases of real estate. Once property prices began to increase by 20 to 30 percent a year, there was a surge in the demand for real estate, since the anticipated returns from further increases in the prices of apartment buildings and office buildings and land were so much higher than the returns in other sectors of the economy. Real estate was the collateral for bank loans; as prices increased, the value of the collateral increased, and the supply of credit for purchases of real estate increased in response to the increase in demand.
The bubbles in the real estate markets in the United States, Britain, Spain, Ireland, and Iceland that began about 2002 resulted from the increases in the flows of money to each of these countries, which led to increases in the supplies of credit for the purchases of homes and commercial properties. The increases in the flows of money to these countries generally led to higher values for their currencies.
The increases in the prices of assets in the United States, Britain, Mexico, Iceland, and other countries during each of these waves were an integral part of the adjustment process induced by the money flows, which required a corresponding increase in net imports of goods. Higher asset prices led to increases in household wealth and to more spending on both domestic and foreign goods.
Financial crises developed once some borrowers were no longer able to pay the interest on their outstanding indebtedness. The crises in the eighteenth and nineteenth centuries often followed a sharp decline in commodity prices, which handicapped the ability of farmers to pay the interest on the loans that had enabled them to purchase seeds and real estate. At other times the crises developed in response to sharp declines in stock prices. Crises generally were infrequent, often about once a generation – the United States had one crisis in 1907, and then a severe one in the early 1930s; however in the first half of the nineteenth century a crisis occurred almost every ten years. Four waves of crises in the thirty years since the early 1980s, each involving three, four or more countries, are exceptional.
The bubble in US stock prices in the late 1920s followed an economic boom that resulted from the surge in the production of automobiles and the expansion of highways, the electrification of millions of households, and the rapid expansion of telephones; there was a remarkable increase in investor optimism. Stock prices increased threefold between 1927 and 1929, in part because the Federal Reserve made credit more readily available to reduce the likelihood that the surge in productivity would lead to declines in the price level. Real estate prices trended upward, although not as rapidly as stock prices.
The increase in interest rates on US dollar securities in 1928 led to a reduction of American purchases of foreign bonds and complicated the ability of central banks in Europe and in Latin America to maintain the parities for their currencies because they lacked the money to finance their trade deficits. A series of currency crises followed in the 1930s; initially pressure was directed at the Austrian schilling. The depreciation of the schilling triggered the contagion effect, which led to speculative pressures directed at the German mark and soon thereafter at the British pound, and then at the US dollar. After the establishment of a new US dollar price of gold at $35, the speculative pressure was directed at the currencies of the ‘gold bloc’ countries – the French franc, the Swiss franc, the Italian lira, and the Dutch guilder, whose convertibility into gold was suspended in 1936.
There were episodic currency crises between the late 1940s and the early 1970s as investors became increasingly skeptical that governments would incur the costs required to maintain the parities for their currencies, which had been set at the end of World War II. Patterns of production and trade had been disrupted by massive destruction of factories and of infrastructure during the war. Many European countries devalued their currencies in September 1949 to adjust for more rapid increases in their price levels than in the US price level during and after World War II. The French franc was devalued by 10 percent in 1959. The British pound was subject to speculative pressure in 1964, and was eventually devalued in the autumn of 1967. There was speculation that the German mark would be revalued in 1969 and that the French franc would be devalued at about the same time. Then the speculative pressure was directed at the US dollar; investors anticipated that either that the currencies of other industrial countries would be revalued or appreciate, or that the US dollar price of gold would be increased.
Most of the currency crises in the 1950s and 1960s were preludes to the devaluations of currencies by 10 to 20 percent; none was associated with a banking crisis. Speculative pressure did not lead to excessively large changes in the values of currencies relative to the values projected from differences in inflation rates.
The uniqueness of the period since the early 1980s is that nearly all of the banking crises have been associated with currency crises. The principal exception is that the financial crisis in Japan in the first half of the 1990s was not associated with a crisis about the value of the yen. Another exception is that the banking crisis in Ireland in 2008 and 2009 was not associated with a currency crisis because Ireland was a member of the European Monetary Union. The financial crisis that involved the debt of the Greek government in the spring of 2010 was centered on the ability of the Greek government to reduce its fiscal deficit and make its debt service payments in a timely way and thus was a credit crisis; however the euro depreciated because some investors were concerned about its viability.
The waves of cross-border money flows that began in the early 1970s were too large to be sustained, because the external indebtedness of individual countries was increasing much more rapidly than their GDPs. When the flows of money to these countries slowed, their currencies depreciated. Often the depreciations were extremely sharp as investors sought to move money from the countries that had formerly received money from abroad.
The coincidence of the waves of banking and of currency crises since the early 1980s reflects that the money flows to individual countries led to the appreciation of their currencies and contributed to increases in their asset prices. Domestic credit often expanded at a rapid rate, since the appreciation of their currencies dampened inflationary pressures in the goods market and enabled the central banks to continue their expansive policies.
When the flows of money to countries slowed and their currencies depreciated, some of the borrowers in these countries became distress sellers of assets because they could no longer obtain the money to pay the interest by borrowing more money. Their sales depressed asset prices. Moreover the reduction in money inflows led to increases in interest rates, which contributed to the declines in the prices of real estate and stocks. Households and firms that had loans denominated in the US dollar, the Swiss franc, or some other foreign currency often went bankrupt because the depreciation of their currencies led to large revaluation losses on their foreign loans. The failures of banks – the financial crises – followed from the large losses incurred by extensively indebted firms and individuals; the value of the collateral pledged to the banks declined sharply relative to the value of the loans.
Domestic financial crises have become less frequent in the last one hundred years after central banks were established to act as lenders of last resort – they were able and willing to provide cash to banks in response to sharp declines in investor demand for speculative assets.
The feature of crises in the twentieth century was that central banks often had to choose between whether they should give priority to maintaining the value of their currencies or instead to give priority to domestic financial stability. Initially many central banks increased interest rates to convince investors that they had an unshakable commitment to their parities; higher interest rates often led to sharp declines in asset prices and economic activity. Then the central banks reversed their priorities. The contagion effect in the 1930s was triggered by the initial mis-alignment of currencies and price levels; the sequence of currency crises reflected that investors became concerned that central banks would not maintain their parities after one of their major trading partners had devalued. Each central bank then would conclude that the costs of retaining its parity was too high in terms of business failures and unemployment.
The contagion effect of the late 1990s was triggered by the sharp depreciation of the Thai baht; investors suddenly realized that money flows to Thailand’s neighbors and to other emerging-market countries would decline sharply and that the central banks in these countries would no longer be able to support their currencies because money would flow from these countries in anticipation of the subsequent depreciations. Immediately speculative pressure shifted to one or several other currencies that still retained their pre-crisis values.
This sequence of large declines in the values of the currencies both in the 1930s and then in the second half of the 1990s leads to the question whether an international lender of last resort would have enabled countries to avoid the deflate-and-devalue cycle. Domestic lenders of last resort can provide abundant credit to reduce the likelihood that liquidity crises will cascade into a solvency crisis. The problem in both the 1930s and the 1990s was that currencies were not appropriately aligned with national price levels, and that once one country devalued or allowed its currency to depreciate, speculative pressure was deflected to the currencies of its trading partners.
The counter-factual question is whether an increase in the supply of international reserve assets in the early 1920s, when the potential shortage of gold was first recognized, would have obviated some of the changes in the currency values in the interwar period. National price levels had increased much more rapidly in some countries than in others during and after World War I, with the result that currency values were not aligned with price levels. A larger volume of international reserve assets would have made it possible for the adjustment of currency values to occur over a longer period. But neither a larger volume of international reserve assets nor an international lender of last resort would have obviated the need for the adjustments of currency values. But a larger volume – or perhaps a much larger volume – might have reduced the frequency and severity of speculative attacks.
During the interwar period central banks were committed to pegging their currencies to gold, initially at their pre-war parities, while the general view since the early 1970s is that currencies should float – although central banks in some countries in Asia have intervened extensively to limit the appreciation of their currencies.
The large variability in asset prices and in currency values and in the number and severity of banking crises since the early 1980s suggest that the lessons of the interwar period have been overlooked – if they have been remembered. One of the lessons was that cross-border movements of money often distort national competitiveness in the short and medium run – for three, four, or more years. Another was that currencies ‘overshoot’ and ‘undershoot’ their long-run average values unless central banks are committed either to parities for their currencies or to limiting the variability in currency values. A third is that some countries will manage the values of their currencies to secure competitive advantages in the goods market unless they are constrained by international agreement or rules from doing so. ‘Permanent undershooting’ is a form of currency protectionism and invites critical responses from trading partners.
The three decades since the early 1980s have been the most tumultuous in monetary history in terms of the number, scope, and severity of financial crises. More national banking systems collapsed than in any previous comparable period; the loan losses of banks in Japan, in Sweden and Norway and Finland, in Thailand and Malaysia and Indonesia, and in Mexico (twice), in Brazil and Argentina, and in the United States and Britain and Iceland and Ireland ranged from 10 to 50 percent of their assets. In some countries the costs to the taxpayers of providing the money to fulfill the implicit and explicit government guarantees on bank deposits and other bank liabilities amounted to 15 to 20 percent of their GDPs. The loan losses in many countries were much greater than those in the United States in the Great Depression of the 1930s.
Occasionally the failure of a bank was firm-specific; Franklin National Bank of New York City and then Herstatt AG of Cologne lost the large bets that they had made on changes in currency values. However most of the bank failures since the early 1980s have been systemic events that have occurred in waves and involved large numbers of lenders in different countries because of dramatic changes in the international financial environment. In some episodes virtually all of the banks in a country failed. Usually these countries experienced sharp declines in real estate values after periods when these prices had increased rapidly.
The dominant pattern, evident in Mexico, Argentina, Thailand, Malaysia, and Russia and many other countries was that banking and currency crises occurred together. These crises followed periods when money flows to these countries led to increases in the value of their currencies and in the prices of domestic assets. Often the subsequent sharp depreciations of the currencies led simultaneously to deflationary shocks as interest rates surged, and to inflationary shocks as the prices of tradable goods soared.
In the early 1980s many banks in Texas, Oklahoma, and Louisiana failed when oil prices declined sharply while small banks in Iowa, Kansas and other states in the agricultural Midwest also went under because the sharp declines in the prices of cereals led to even larger percentage declines in the value of farm real estate. The failure of these lenders resulted from the reversal of US monetary policy in the autumn of 1979 and the resulting sharp decline in anticipated US and global inflation rates. Several thousand US thrift institutions failed in the early 1980s when short-term interest rates surged. Many banks in Thailand, South Korea, and Indonesia failed in the Asian Financial Crisis; in the late 1990s, soon after the financial debacle in Russia, Long-Term Capital Management, then the largest US hedge fund, collapsed and would have failed if the Federal Reserve had not mandated that its largest creditors invest equity capital in the firm.
The range of movement in currency values since the early 1970s has been much larger than in any previous period. Moreover this range was much larger than the proponents of floating currencies had anticipated; they believed that allowing the values of currencies to adjust to differences in national inflation rates and other shocks was preferable to forcing adjustment of national economies so that the established parities could be retained. These large swings in currency values initially were attributed to the lack of familiarity of market participants with freely floating exchange rates. Then the large changes in currency values were explained because of the inherent lags before the supplies of tradable goods could increase in response to changes in the relationship between domestic and foreign prices and costs.
Moreover the scope of overshooting and undershooting of currency values was much larger than in any previous period. Thus the appreciation of the German mark and the Japanese yen in the late 1970s was greater than the increases that would have been forecast based on the excess of the US inflation rate over the inflation rates in Germany and in Japan. Then in the early 1980s both currencies depreciated sharply even though the US inflation rate remained higher than their inflation rates. In the late 1990s the US and European inflation rates were similar but the newly established euro – the successor to the German mark, the French franc, the Italian lira and the currencies of the other countries that joined the European Monetary Union – depreciated by 30 percent following its establishment at the beginning of 1999.
Overshooting and undershooting are an integral part of the adjustment process in response to cross-border movement of money when currencies are floating. Changes in the cross-border movement of money must be accompanied by corresponding changes in the cross-border movement of goods and in trade balances. Countries that experience inflows of money must develop larger trade deficits, which result from increases in consumption spending attributable to higher levels of wealth and the appreciation of their currencies.
The increases in the flows of money to countries are like increases in the savings available in these countries, which can adjust by counterpart increases in household consumption, business investment, and larger government deficits. Household consumption accounts for 60 to 70 percent of GDP in most countries; as a result most of the adjustment to an increase in money inflows involves increases in household consumption – or what is the same thing, reductions in household savings. The increases in the availability of foreign savings lead to higher asset prices and more consumption spending and hence to declines in domestic saving.
The large swings in the values of the currencies result from the reversal in the direction of cross-border money flows. Increases in the flows of money to countries often lead to real appreciations of 20 or 30 percent and hence to overshooting. Then when the shock occurs and money leaves the countries, these currencies may depreciate by 40 or 50 percent. Hence the initial money flows to various countries and then the inevitable reversals lead to bubbles in currency values.
The increases in the flows of money to countries often followed from an institutional innovation, including the relaxation of financial regulations. These movements may have been reinforced because the appreciations of the currencies enhanced the anticipated rates of return available to investors that were willing to incur the cross-border risks. However, as a group these investors failed to appreciate the end-game, and that the currencies eventually would depreciate because the borrowers’ indebtedness had been increasing too rapidly.
Thus the financial crises followed from reversals in the pattern of cross-border money flows following one, two, or more years when these flows increased rapidly. When the cross-border movements of money slowed, some of those who had borrowed to finance the purchases of real estate or stocks or some other assets became distress sellers because they needed to pay the interest on their indebtedness. The values of the Mexican peso, the Brazilian cruzeiro, the Argentinean peso, and the currencies of many other developing countries plummeted in the early 1980s when the money inflows diminished sharply. The depreciation of these currencies led to large revaluation losses by firms that had liabilities denominated in the US dollar. When these firms went bankrupt, the banks in these countries incurred large loan losses.
The scope of overshooting and undershooting of the currencies of the emerging-market countries has been even larger than for the industrial countries. The Mexican peso lost nearly half of its value during that country’s presidential transition at the end of 1994 and the beginning of 1995. The values of the Thai baht, the Malaysian ringgit, the Indonesian rupiah, and the South Korean won declined by 50 to 70 percent in the last six months of 1997. The Russian ruble depreciated sharply in August 1998. The Argentinean peso lost more than two-thirds of its value in January 2001.
There were more waves of credit and asset-price bubbles between 1970 and 2010 than in any other comparable period. The first wave involved increases in bank loans to the governments and government-owned firms in Mexico, Brazil, Argentina, and other developing countries in the 1970s; their external indebtedness increased from $125 billion to $800 billion. Then real estate prices and stock prices in Japan increased more than fivefold in the 1980s; household wealth surged, and the economy boomed. Finland, Norway, and Sweden also experienced bubbles in their real estate markets and their stock markets at about the same time. The third wave involved bubbles in the real estate and stock markets in Thailand, Malaysia, Indonesia, and several nearby countries in Southeast Asia in the first half of the 1990s; in most of these countries the bubbles in real estate begat the bubbles in stocks because many of the companies listed on the stock exchanges owned large amounts of property. US stock market wealth doubled in the late 1990s and the market values of the stocks of the firms in the dot.com and information technology industries increased fourfold. The fourth wave involved sharp increases in the market value of real estate in the United States, Britain, Ireland, Spain, Iceland, and South Africa after 2002.
One feature of each of these waves of bubbles was that the indebtedness of a large group – occasionally governments, most often investors in real estate, including home owners – increased by 20 to 30 percent a year for three, four, or more years. Rapid increases in indebtedness enabled borrowers to use the money from new loans to pay the interest on their outstanding loans. The indebtedness of these borrowers could increase more rapidly then their GDPs for a few years, but eventually the lenders became more cautious in extending new loans, and some of the borrowers then had to scramble to get the money to pay the interest. Since most of these waves of bubbles involved cross-border money flows, declines in the flows of money to countries led to the depreciation of their currencies.
The bubbles in real estate and stock markets and the failure of banks was systematically related to the overshooting and the undershooting of currencies, and resulted from changes in the amounts and direction of cross-border money flows. The four waves of crisis followed from the sharp depreciations of the currencies which automatically led to increases in the indebtedness of the domestic firms that had debts denominated in the US dollar, the Swiss franc or some other foreign currency. The almost universal surges in interest rates as the currencies depreciated triggered sharp declines in the values of real estate and of stocks during the crash phase of the financial cycle. Most of these crises were ‘predictable’, since increasing reliance on money from new foreign loans to pay the interest on the outstanding foreign indebtedness was not sustainable; the uncertainty involved the sharpness of the declines in the values of the currencies when the money inflows diminished. Thus the mania phase of the expansions in Mexico and the other developing countries in the 1970s and again in the 1990s and in Thailand and Malaysia and Indonesia in the 1990s could not continue because the borrowers’ indebtedness was increasing too rapidly relative to their incomes. It was inevitable that the lenders would become more cautious in increasing their loans to these borrowers, although the details and the timing of these moves could not have been predicted. As the flow of cash from new loans diminished, the borrowers would need a new source of money for their interest payments. The likelihood that these countries could adjust to the decline in the inflow of money without the depreciation of their currencies was low. Similarly, at some stage it was inevitable that Japanese real estate prices would stop increasing; many of those that had recently borrowed money to buy properties would encounter a cash bind because the interest payments on their loans would be larger than their rental income.
The causes of financial tumultuousness
The financial tumult since the early 1970s resulted from the impacts of monetary shocks and credit market shocks on the direction and scope of cross-border money flows. The monetary shocks involved unanticipated changes in the rates of money supply growth and the accompanying impacts on anticipated inflation rates and on interest rates. The credit market shocks involved the relaxation of financial regulations that allowed the banks to increase their loans to specific groups of borrowers, who then became more attractive to lenders. In several cases a monetary shock and a credit shock occurred at the same time and had complementary impacts on money flows across national borders.
Increases in the flows of money to countries induced both increases in the values of their currencies and increases in the prices of their assets, which moved above their long-run equilibrium values. The money flows could not be sustained indefinitely; declines in the flows almost always led to a depreciations of these currencies and often triggered crashes in asset prices of 50 or 60 percent or more.
The first major shock in this extended period was the increase in the annual US inflation rate to the range of 5 and 6 percent in the second half of the 1960s; in the previous twenty years this rate was almost always below 3 percent and usually less than the inflation rates in Germany and its neighbors in Western Europe. Annual US payments deficits surged at the end of the 1960s as it seemed increasingly likely that the prices of the European currencies and the Japanese yen would increase. Investors and firms moved money from the United States to avoid losses and profit from these anticipated changes in parities. Because the United States was reluctant to increase the US dollar price of gold and Germany and France and Japan were unwilling to revalue their currencies, the payments imbalances became larger and the international reserve assets owned by Germany and Japan and other countries with payments surpluses increased more rapidly. Then in 1971, when the US economy slowed and the inflation rate declined the Federal Reserve adopted a more expansive monetary policy, and the decline in interest rates on US-dollar securities led to larger flows of money from New York to foreign centers.
The global inflation in the early 1970s was an unprecedented peacetime event that followed from the combination of the more rapid growth of the US money supply after monetary policy was eased and the more rapid growth in the money supplies in Germany and in Japan in response to their increasingly large payments surpluses. The more rapid increase in the US inflation rate meant that a realignment of the values of national currencies was inevitable. Because the US inflation rate exceeded the inflation rate in Germany by more than 2 percent, the Bretton Woods system of adjustable parities was no longer viable and the abandonment of parities for the German mark, the Japanese yen, and the currencies of other industrial countries became inevitable.
Interest rates on US dollar securities increased as the US inflation rate climbed; however interest rates on US dollar demand deposits were subject to ceilings that the Federal Reserve had adopted to limit competition among banks. These ceilings did not apply to interest rates on US dollar deposits in London and other foreign financial centers, which increased and induced investors to move funds from domestic to offshore financial centers. The rapid increases in money supply growth in the United States and other industrial countries in the early 1970s contributed to sharp increases in demand for primary products, and in the prices of oil, wheat, and other commodities. The rates of growth of GDP in the countries that produced these primary products increased. The Saudi Arabian embargo on oil shipments to the United States and the Netherlands following the Yom Kippur War of October 1973 triggered a sharp increase in the demand for petroleum and the oil price surged. The decline in oil supplies following the Iraqi invasion of Iran in 1979 had a much larger impact on the price of oil and global inflation. Investors increased their purchases of gold and other precious metals, collectibles, real estate, and other ‘hard assets’ as inflation hedges.
The first wave of credit bubbles
The increase in the rates of economic growth in the primary producing countries in the 1970s led to the growth of bank loans to governments and government-owned firms in Mexico, Brazil, Argentina, and other developing countries of 30 percent for about ten years; the external indebtedness of these countries increased by 20 percent a year. Banks headquartered in Canada, several European countries and Japan used US dollars that they borrowed in the offshore deposit markets in London, Zurich, and Luxembourg to fund these loans and to ‘poach’ on what had been the turf of US banks. The US banks responded aggressively to minimize the declines in their market shares. Moreover US and foreign banks wanted to circumvent the regulations that limited the growth of their domestic loans and assets. The increase in the flows of money to Mexico, Brazil, Argentina and other developing countries enabled them to finance larger trade deficits.
The change in the operating procedures of the Federal Reserve in October 1979 (the so-called ‘Volcker shock’) was the next major shock. Previously the Federal Reserve had stabilized interest rates and market forces had determined the growth of credit; under the new policy the Fed sought to limit the growth of credit, and market forces determined interest rates – which surged. The US dollar price of gold peaked ten weeks after this policy change; the anticipations that the inflation rate would continue to increase were shattered. Investment spending fell, a recession followed, and the prices of petroleum and other commodities dropped sharply.
The combination of the much higher interest rates on US dollar securities and the sharp reduction in the anticipated US inflation rate led to an increase in investor demand for US dollar securities, and the German mark, the Japanese yen, and other currencies depreciated. Mexico and other developing countries were squeezed by the scissors-like increase in the interest rates on their foreign loans and the decline in both the volumes and the prices of their exports. Banks in Texas were similarly impacted by higher interest rates and lower oil prices. Interest rates paid by US thrift institutions on their short-term deposits increased rapidly and in many cases began to exceed the interest rates on their long-term mortgage loans.
The second wave of credit bubbles
The appreciation of the Japanese yen that began in the spring of 1985 induced the Bank of Japan to buy US dollars to dampen the strengthening of the currency; the central bank’s holdings of US dollar securities surged, which led to a rapid increase in the money supply. The Japanese financial system had been extensively regulated with the intent to provide loans to corporate borrowers at very low interest rates. Moreover administrative guidance required that these banks extend loans to firms in the industries that the government bureaucrats believed were strategically important. One motive for financial liberalization was that the industrial demand for bank loans had declined so that it was not longer necessary to allocate credit among borrowers on a preferential basis; another was that the US authorities demanded that US banks and other US financial firms have access to the banking and capital markets in Tokyo on terms comparable to the access available to Japanese banks in New York.
Financial deregulation enabled the banks headquartered in Tokyo and in Osaka to increase their real estate loans at a rapid rate. Because of building restrictions and the time consumed in assembling larger lots for construction, the increase in the demand for real estate had a much larger impact on the price of land than on the supplies of living space and office space. Many of the firms that were listed on the Tokyo Stock Exchange were real estate investment companies; the increases in real estate prices contributed to sharp increases in the value of their assets and in the prices of their stocks.
Restrictions on the foreign investments of Japanese banks and firms were relaxed in the effort to limit the upward pressure on the yen. These banks rapidly increased the number of their branches and subsidiaries in London, New York, Zurich, and other financial centers. The flow of savings from Japan to the United States and various European countries surged; the cliché in both New York and Tokyo was ‘Where will the US Treasury get the money to finance its fiscal deficit if the Japanese stop buying US government securities?’ These newly established foreign branches of Japanese banks increased their loans in their host countries, using the funds obtained in the offshore deposit market; these newly established branches charged lower interest rates than their host-country competitors because they wanted to increase their market shares. Moreover Japanese investors began to purchase real estate – office buildings, apartment buildings, golf courses, and ski resorts – in the United States and in other industrial countries; most of these purchases were funded with money borrowed from the branches of Japanese banks in London, Zurich, and other offshore financial centers.
Financial liberalization in Finland, Norway, and Sweden enabled banks headquartered in these countries to source for domestic loans by borrowing in the offshore market. Stock prices and real estate prices in these countries increased sharply in response to the money inflows. The decision of the newly appointed Chair of the Board of the Bank of Japan at the beginning of 1990 to restrict the growth of bank loans for real estate pricked the asset-price bubble; heavily indebted borrowers could no longer obtain enough money from new loans for their scheduled interest payments. Stock prices declined by 30 percent in 1990 and by 25 percent in 1991. The growth of the Japanese economy slowed dramatically. The Japanese yen appreciated as exports surged relative to imports. Japanese firms responded to the adverse impact of the increase in the value of the yen on their profitability by increasing their investments in manufacturing facilities in China and Thailand and other countries in Southeast Asia that would be used primarily as sources of supply for markets in Japan, the United States and other industrial countries. Japanese banks rapidly increased their loans in these countries.
The third wave of credit bubbles
The development of the Brady bonds in 1989 and 1990 enabled Mexico and other developing countries to convert bank loans that had been in default into long-term bonds that were partially guaranteed by the US government, which effectively ended their financial isolation (‘the lost decade’) from the global capital market. Mexico began to prepare for membership in the North American Free Trade Agreement; the Bank of Mexico adopted a contractive monetary policy to reduce the inflation rate, hundreds of government-owned firms were privatized, and government regulations on international trade and business practices were liberalized. Foreign direct investment in Mexico surged as US, European, and Japanese firms rapidly increased their manufacturing facilities in Mexico. US money market funds bought peso securities because the interest rates were high and attractive. US pension funds and mutual funds increased their purchases of stocks of a new asset class – ‘emerging market equities’. Mexico’s current account deficit increased to 6 percent of its GDP.
Similarly there was a surge in money flows to Brazil, Argentina, Thailand, Malaysia, and other emerging-market countries (which had been re-christened after having been known as developing countries for several decades). Their currencies appreciated in real terms, and their trade and current account deficits increased.
Then at the beginning of 1994 several political incidents – an Indian uprising in the southernmost province and then the assassination of the leading presidential candidate of the dominant political party – led to a decline in the flow of money to Mexico, which meant that the Bank of Mexico could no longer finance its large trade and current account deficits with the money inflows and the peso depreciated sharply. The flow of money to Thailand slowed significantly in late 1996 because the non-bank finance companies that had been established by the banks to circumvent regulations on consumer loans were incurring large loan losses – which in effect were the losses of the banks once-removed. The Bank of Thailand was unable to maintain the value of the Thai baht once its international reserve assets had been depleted at the beginning of July 1997. The depreciation of the baht triggered the contagion effect that rippled through the Asian countries as well as to Brazil, Argentina, and Russia; the imports of this group of countries declined relative to their exports by $150 billion. Several of these shocks were true surprises: the political events in Mexico in the first few months of 1994 could not have been foreseen. However, the Mexican current account deficit was too large to be sustained and some trigger eventually would have led to a decline in the inflow of money. Similarly the current account deficits of Thailand and Malaysia in 1996 were too large to be sustained. Some event would have led to declines in money flows, although the catalyst for these declines could not have been foreseen. The implosion of the bubbles in real estate prices and stock prices Thailand and Malaysia was inevitable when the money flows to these countries declined.
The fourth wave of credit bubbles
The striking feature of the period between 2002 and 2007 was the sharp increases in the prices of residential and commercial real estate in the United States, Britain, Spain, Ireland, Iceland, South Africa, New Zealand, and several other countries. The prices of residential real estate in several of these countries more than doubled. The increases in prices of residential real estate in the United States were smaller than in other countries; however, these US price increases occurred primarily in one-third of the states, that were in the south and along both seaboards, and the prices in some of these states more than doubled.
Each of these countries experienced an increase in money inflows and their currencies appreciated, except for Spain and Ireland, which were members of the European Monetary Union. Once again the rate of increase in indebtedness was too large to be sustained. When the money flows to the United States and Britain declined, the supplies of credit available for real estate purchases fell, and real estate prices tumbled. The prices of mortgage-related securities declined, and many financial institutions in the United States and in Britain failed. Ireland had experienced a massive construction boom; its banks failed when the bubble burst. Iceland had experienced a spectacular increase in stock prices during the years when there were large inflows of money; when these inflows stopped, stock prices declined sharply and the currency lost nearly half of its value.
US real estate prices began to decline at the beginning of 2007. One of the large investment banks was merged into one of the largest commercial banks with a wedding dowry that might reach nearly $30 billion depending on its loan losses. In mid-September 2008, two of the large government-sponsored mortgage lenders that owned 50 percent of US mortgages were effectively taken over by the US Treasury; the owners of their common stock and their preferred stock lost all their money. The owners of the bonds of these mortgage lenders were ‘bailed out’ by the US Treasury; otherwise they would have incurred losses of several hundred billion dollars. Several days later, Lehman Brothers, the fifth largest US investment bank, failed; the efforts to negotiate the sale of the firm were not successful. A massive credit panic and crash followed; the interest rates of corporate bonds surged relative to interest rate on US Treasury securities. A few months later there were runs on the bonds of the governments of Greece and Portugal. The fiscal deficit of the Greek government was more than 12 percent of its GDP, and its total indebtedness was more than 125 percent of its GDP. The large international banks had been willing to acquire the bonds of these governments, which enabled them to finance fiscal deficits that were much too large to be sustained. The total indebtedness of the Greek government had surged in part because one or several previous governments had not been fully forthcoming with information about its total indebtedness. Nevertheless the indebtedness of these governments had surged because the ‘money was there’ – the banks were willing to buy the bonds which enabled the governments to finance large deficits. Then the crises occurred when the bank lenders suddenly became much more cautious, and the governments did not have enough cash to pay the interest on their indebtedness and meet the government payrolls.
The identity of the borrowers in each of the wave of credit bubbles differs. The borrowers in the first wave were governments and government-owned firms in Mexico and ten other developing countries. The borrowers in the second wave were home owners and real estate companies in Japan; similarly it was the banks and home owners in Finland, Norway, and Sweden that were the borrowers. The borrowers in the third wave often were banks in emerging-market countries, who used external sources of funding because they were less costly than the domestic sources. The borrowers in the fourth wave were primarily home owners and property developers.
Several large banks were lenders in more than one wave. Banks headquartered in the United States, Canada, Japan, Britain, and France were among the lenders in the first wave. Japanese banks were the primary lenders in their domestic real estate bubble in the 1980s. US banks as well as banks based in Britain, Ireland, Iceland, and Spain were among the lenders in the fourth wave. Several of the US banks that encountered large losses during this wave also had incurred large losses in the first wave.
Despite these differences in the identities of the borrowers and the lenders in these several waves, there was remarkable similarity in the pattern of cash flows. Most of the countries that were identified with credit bubbles also experienced an appreciation of their currencies and an increase in their current account deficits. Japan is an exception in that it had a current account surplus; however, the yen appreciated and its trade and current account surplus declined as its credit bubble expanded. The increases in the flows of money to these countries contributed to the increases in asset prices.
The appreciation of currencies of these countries and the increase in asset prices were responses to the increase in money inflows and components of the international adjustment problem; domestic consumption had to increase to ensure that the increase in imports more or less matched the money inflows. The higher levels of consumption spending induced by the elevated asset prices led to economic booms. The governments in some of these countries – including the US government in the late 1990s – realized fiscal surpluses in response to the spending booms, although several governments increased their spending almost as rapidly as their revenues increased.
The pattern of cash flows between lenders and borrowers in each wave was Ponzian – the rate of increase in the indebtedness of the borrowers was several times higher than the interest rate on their indebtedness. For three, four, or more years, the borrowers incurred no burden in their debt service payments, since there was more than enough cash from new loans to pay the interest on their indebtedness. However, the pattern of cash flows was not sustainable; at some stage it was inevitable that the lenders would become more cautious in extending new loans, perhaps because their loans to this group of borrowers were becoming a larger share of their loan portfolios. Any slowing in the growth of cross-border loans to this group of borrowers would lead to depreciation of their currencies – which might contribute to the greater cautiousness by the lenders. The borrowers would incur a real debt-servicing burden for the first time when the rate of growth of indebtedness declined below the interest rate; then they would need to find some other source of money for part of their interest payments. Governments would need to increase their taxes relative to their expenditures to get the money to make the interest payments – or they would default.
In a world with perfect foresight, the lenders would have foreseen that the inevitable depreciation of the borrowers’ currencies would lead to massive losses by the borrowers, which might spill over to large losses by the lenders. The losses by the lenders were so large that the reasonable conclusion is that the lenders had less than perfect foresight; they failed to ask ‘Where will the borrowers get the money to pay the interest on their outstanding indebtedness if there are not enough new loans to provide the money?’.
The likelihood is high that these several waves of bubbles were not independent events; instead there was a systematic relationship between the implosion of one wave and the beginning of the next wave. When the first wave of bubbles imploded in the early 1980s, the currencies of Mexico and the other developing countries depreciated sharply, and their trade balances morphed into surpluses. The countries that had developed large trade surpluses when the credit bubbles were expanding would experience the real appreciation of their currencies and declines in their trade surpluses.
The Japanese were reluctant to accept the decline in their trade surplus in the second half of the 1980s because of the adverse impacts on profits and employment in their export industries; the intervention by the Bank of Japan to dampen the appreciation of the yen led to the surge in the reserves of the Japanese banks and the increase in the money supply. Regulations that constrained domestic and foreign transactions were liberalized to limit the appreciation of the yen; banks were able to increase the supply of credit available for real estate purchases, which led to higher property prices.
When the bubble in real estate and stock prices in Japan imploded, the yen appreciated; Japanese firms then increased their investments in Thailand, Malaysia, and nearby countries in anticipation that production costs for low-value-added activities would be below the domestic costs. About the same time, money flows to the emerging-market countries increased rapidly because investment banks had discovered ‘emerging market equities as a new asset class’. Many countries were involved in extensive privatization activities, which attracted firms based in the industrial countries.
When the bubbles in Thailand and its neighbors imploded, their currencies depreciated sharply and their trade deficits morphed into trade surpluses. The counterpart was that there was a surge in the flow of money to the United States as they reduced their foreign indebtedness, which contributed to the increase in the US trade deficit and the bubble in US stock prices.
After the US stock price bubble imploded in the spring of 2000, the US dollar began to depreciate. The flow of money to the United States, Britain, and other countries increased from about 2002, and the currencies of these countries appreciated, and asset prices in these countries increased. Thus the large changes in the cross-border money flows led to large changes in currency values and in the prices of assets, and these changes contributed significantly to the bubbles in currencies and in asset prices. The real estate bubbles that developed in the United States, Britain, and other countries after 2002 were a response to the increases in the inflows of money. It is as if there is a pool of international money that can be tapped by borrowers in various countries when they conclude that the net interest costs are lower than the costs of obtaining funds in their domestic markets. Many of these borrowers incur the currency exposure but presumably they have concluded that the reduction in their interest payments more than compensates for this risk.
The impacts of monetary shocks and credit market shocks
The striking feature of the last forty years has been the variability of cross-border flows of money. The German mark and the Japanese yen appreciated throughout most of the 1970s and then depreciated sharply in the first half of the 1980s. When the money was flowing to Mexico in the early 1990s and its economy was booming, the peso appreciated significantly after adjustment for differences in inflation rates, and the Mexican trade deficit reached 6 percent of its GDP. When money was withdrawn from Mexico at the end of 1994, the peso depreciated sharply and the Mexican trade surplus reached 4 percent of its GDP. This change in cross-border money flows was massive and sudden, and had powerful impacts on the value of the peso, the inflation rate in Mexico, the prices of peso securities and of real assets and the solvency of Mexican firms, households, and banks.
Financial market events in Thailand, Norway, Indonesia, Iceland, and many other countries were similar to those in Mexico. The Minsky story of the cyclical variability in the supplies of credit in domestic economies is dramatically evident in the global economy in the variability in the cross-border money flows. In domestic economies, increases in the credit supply contribute to the economic booms and euphoria, which in turn lead investors to become more optimistic and encourage lenders to extend more credit. Increases in the flows of money to countries led to the appreciation of their currencies and to dramatic increases in the prices of securities and other assets. Investor optimism led lenders to provide more credit to domestic borrowers and economic booms often followed.
Some of the credit market and monetary shocks led to increases in the flows of money to countries and to increases in the prices of commodities, currencies, stocks, and real estate. As long as the currencies appreciated and asset prices were increasing, the rates of return on these currencies and securities were high and increasing; optimism about the economic futures increased. Then another shock would trigger a decline or reversal in cross-border money flows; and the prices of currencies, securities, and other assets crashed.
These manic-type shocks resulted from extensive changes in the preferences of investors for securities and other assets denominated in different currencies. Investors became concerned that the US inflation rate would increase in the 1970s; they sold US dollar securities and bought securities denominated in the German mark, the Swiss franc, and the British pound, and these currencies appreciated by much more than the excess of the US inflation rate over the foreign inflation rates. During the same period the US dollar price of gold increased ‘because gold was a good inflation hedge’, although the annual percentage increases in the price of gold in the second half of the 1970s were many times larger than the percentage increases in the US price level. Early in 1980 investors became convinced that the US inflation rate would decline; they sold securities denominated in the German mark and other foreign currencies and these currencies depreciated rapidly.
One explanation for the greater variability of cross-border capital flows in the last thirty years is that shocks, and especially those that involved changes in the stance of monetary policy, have been larger than in earlier periods when currencies were pegged or when there was a commitment to parities for national currencies. One of the major arguments in the case for floating exchange rates is that central banks then would have greater independence to change their monetary policies and the rates of growth of their money supplies and their interest rates to achieve their domestic economic objectives. In effect the commitments to parities for national currencies constrained changes in the central banks’ monetary policies and especially the adoption of more expansive monetary policies; these commitments meant that national inflation rates could not differ significantly from the inflation rates in the countries’ major trading partners. In the absence of a commitment to parities, the policies adopted by central banks have led to changes in the current and anticipated inflation rates that in turn induced large changes in cross-border flows of money. Hence the much greater variability in the cross-border flows of money in part reflects that changes in national monetary policies, and the changes in anticipated inflation rates have been larger than when currencies have been pegged.
The much greater variability in the cross-border flows of money in part reflected that the monetary shocks were greater than when currencies had been pegged; these shocks led to changes in investor estimates of the inflation rates in different countries and hence in the anticipated currency values at various future dates. The expansive US monetary policies of the late 1960s and the early 1970s led investors to revise upward their estimates of the US inflation rate and also to revise upward their estimates of the anticipated values for the German mark and the Japanese yen. Investors sold US dollar securities and bought securities denominated in the German mark, the Swiss franc, and the British pound, which led to the sharp appreciation of these currencies.
If, as a group, investors increase the proportion of non-dollar securities in their portfolios, then the United States would develop a larger current account surplus (or a smaller current account deficit), which would require that the German mark – or the euro as its successor – the Japanese yen, and other foreign currencies appreciate less rapidly than would be inferred from the difference in national inflation rates. These foreign currencies overshoot the values inferred from the differences in national inflation rates as long as investors increased the rate at which they acquired foreign securities.
The adoption of a more contractive US monetary policy in the autumn of 1979 led investors to reduce their estimates of the US inflation rate and to revise downward their estimates of the values of the German mark, the Japanese yen, and other foreign currencies. Their purchases of US dollar securities led to the depreciation of the mark and the yen.
Overshooting was inevitable whenever investors wished to increase their holdings of securities denominated in a particular currency; similarly, undershooting was inevitable whenever investors wished to decrease their holdings of securities denominated in this currency. The earlier clichés applied to large and rapid deviations between the currency values and those that were consistent with the differences in national inflation rates – the ‘vicious and virtuous cycle’ and ‘destabilizing speculation’ – reflected the impacts of sudden changes in the direction of cross-border money flows. Changes in anticipated inflation rates – more precisely changes in the differential in national inflation rates – lead to overshooting and undershooting because the impact of the changes in these differentials on the anticipated currency values induce changes in cross-border money flows.
Because the bubble in Japanese stocks and real estate attracted more money from abroad, the yen appreciated. Credit market shocks impact the values of individual currencies as they affect investor demand for securities denominated in different currencies. The credit market shocks in the last thirty years have had major impacts on the values of the Mexican peso, the Thai baht, and many other currencies because they led to changes in the amounts of the securities denominated in these currencies that investors wished to hold.
A second, complementary, explanation for the greater variability in cross-border money flows is that when currencies are not pegged, a shock of a given magnitude in the form of an increase in demand for securities denominated in a currency has a larger immediate impact on the country’s GDP as a result of the increase in the prices of its securities and real estate. When currencies were pegged, the immediate impact of increases in the flows of money to countries was that their central banks’ holdings of international reserve assets increased and their monetary liabilities increased correspondingly. The price of securities available in the country also increased in response to the purchases by the foreign investors.
When currencies were not pegged, comparable increases in the foreign demand for securities denominated in these currencies initiated the adjustment process to ensure that the countries’ trade balances changed by the amounts that corresponded to the increases in the money inflows. The invisible hand operated to ensure that the immediate impacts of the increases in the flows of money was that domestic investment spending increased as the cost of capital declined and consumption spending increased in response to higher levels of household wealth. Household consumption spending is three or four times larger than investment spending in most countries, and accounted for most of the increase in total spending. The inevitable outcome of the adjustment process was that domestic saving declined in the countries that received large inflows of cross-border money.
The invisible hand led to increases in the values of the currencies of the countries that experienced larger money inflows and to increases in the values of assets in these countries. Moreover the invisible hand led to higher rates of growth of GDP as asset prices increased and consumption spending climbed. Thus the increases in the variability in the ratios of the changes in the trade balances to GDP that resulted from the initial increase in the flows of money to countries induced changes in the adjustment process that led to higher rates of return on securities and other assets in these countries. The increase in wealth contributed to the economic boom. In effect there was a feedback mechanism from the initial increases in the flows of money to the higher rates of return that induced further money inflows. The economic booms were prolonged and pervasive; many of the participants may have failed to recognize that the cross-border pattern of flows of money could not be sustained. One of the patterns in the data is that increases in the flows of money to countries were associated with economic booms, which were evident in Mexico and other developing countries in the 1970s, in Mexico, Thailand, and other Asian countries in the first half of the 1990s, and in the United States in the second half of the 1990s. The appreciation of their currencies reduced the inflationary pressures associated with a robust economic expansion and the increase in export prices relative to import prices led to higher rates of economic growth. The money flows were also associated with a non-sustainable pattern of cash flows because some of the borrowers in these countries obtained the cash to pay the interest to their creditors from new loans. The continuation of the economic booms may explain why the lenders – at least a large number of them – failed to recognize that eventually there would be costly adjustments.
Could an international lender of last resort have made a significant difference?
Might the financial tumultuousness of last thirty years have been mitigated if there had been an international lender of last resort? Central banks were established as lenders of last resort to reduce the likelihood that the increase in the demand for money would lead to distress sales of assets and trigger solvency crises; these banks would increase the supply of money in response to the exceptional increase in demand. During the expansion phase of the cycle, investors took on greater risks in anticipation of higher returns – and they reduced their estimates of the risks attached to various securities. And at the same time, many lenders became less cautious in the effort to increase their share of the markets for mortgages, and for loans to business and governments.
Could an international lender of last resort have made a significant difference and reduced the frequency and scope of financial crises since the early 1980s? Or could a more active international lender of last resort have made a significant difference? The source of the problem – one source of the problem – is that the cross-border money flows have been much larger than when currencies were attached to parities, and more highly variable. Would an international lender of last resort have moderated the volume of cross-border money flows that have led to exceptional increases in the supplies of credit, or is it possible that investors’ demand for foreign securities would have been even larger because they would have greater confidence that the central banks would be more ambitious in their efforts to moderate the changes in currency values? The answer depends on the responsibilities and the financial resources available to the international lender of last resort and its willingness to extend credit to central banks whose currencies may depreciate sharply, perhaps because of the decline in money inflows. Would the international lender of last resort have the authority and be willing to caution central banks about the volume and variability of cross-border money flows?
This variant of the moral hazard argument is that efforts to stabilize the changes in currency values in response to the sharp variations in cross-border movements of money might lead investors to incur larger cross-border risks because they would have greater confidence that the range of movement in the currency values would be smaller. The lender of last resort might seek to moderate the flows of money to various countries – but the likelihood that countries would agree that the international lender might place limits on money inflows seems low. The lender might be empowered to provide cautionary statements that the cross-border flows are non-sustainable. National governments would seem more likely to agree to an arrangement that would enable to them to have access to more money from an international lender to moderate the undershooting when the direction of the money flows is reversed – if they could agree on the source of the money for the international lender.
Most of the currency crises since the early 1980s have resulted from the reversal in cross-border money flows. In virtually all of these country cases the pace of the money flows was too high to be sustained because the borrowers’ indebtedness was increasing too rapidly. During the manic phase the currencies appreciated – and overshot – in response to the increase in money inflows. The inevitable first sign of a modest slackening of the pace of money inflows would have led to the depreciation of the currencies, which would feed back to much sharper declines in the inflows and then to massive depreciations.
Overshooting and undershooting were an inevitable part of the adjustment process to the changes in the volume and direction of the cross-border movement of money. In some countries the temporary severe depreciation of the currency associated with its undershooting would imperil the solvency of domestic firms that had debts denominated in foreign currencies because of the sharp increases in the domestic currency equivalent of their interest payments. The bankruptcy of these firms could imperil the solvency of domestic banks and other financial institutions.
A domestic lender of last resort might on occasion make some public statements that stock prices were increasing too rapidly and that the market was characterized by irrational exuberance. Similar statements might be made about prices in the markets for residential and commercial real estate; the central bank might advise banks to limit the increases in their real estate loans. The counterpart is that an international lender of last resort might provide private and even public statements that the increases in the external indebtedness of one or several countries were too rapid to be sustained and that the eventual adjustment to sustainable values could be costly and perhaps messy. Investors and other market participants would be left to draw their own conclusions about the implications of these statements.
The International Monetary Fund was established in the 1940s to assist countries in financing their balance of payments deficits and thus to reduce the pressure on countries to devalue their currencies because of a shortage of funds to finance their cyclical or otherwise temporary payments deficits. The motive for establishing the IMF was the belief that much of the financial instability in the 1920s and especially in the 1930s could have been avoided or mitigated if there had been an international lender of last resort. Fund staff visit each of the member countries once or twice a year to discuss the country’s economic policies. The Fund is a large repository of data and country experiences about the changes in asset prices and changes in international indebtedness of individual countries. It has rarely sounded the alarm that the external indebtedness of member countries was increasing too rapidly – that their current account deficits were too large, and that the transition to sustainable values for their current account balances would be costly in terms of economic stability – and that there was more likely to be a ‘hard landing’ than a ‘soft landing’. Nor has the IMF been able to provide the credits at the time of the crash to avoid extensive and debilitating undershooting.
Many of these countries used money from the Fund to limit the depreciation of their currencies after the advent of the currency crisis. Some countries were reluctant to accept money from the IMF because the conditions attached to acceptance would deflate their economies.
The US Treasury became a lender of last resort to Mexico at the time of that country’s financial crisis at the end of 1994, because the financial resources from the IMF were too small relative Mexico’s needs; the IMF and several foreign governments also provided assistance. The announcement that this money would be available limited the further depreciation of the peso. If a comparable initiative had been taken one or several weeks earlier, the undershooting of the peso would have been smaller, and the adverse impacts of the depreciation of the peso on the Mexican economy would have been less severe.
Whether the shortfall in the performance of the IMF relative to the ambitions that led to its establishment has resulted from the failures of analysis or policy or member country truculence is a topic for another book.