On the nature of financial crises

by Wynn Quon (Canadian MoneySaver, November 2009)

If bankers were engineers, every few years all of our bridges would collapse. The bankers aren’t the only ones at fault though. Indeed, the bankers wouldn’t get far if we, the investors, weren’t so happy gathering up sheaves for straw bridges.

It doesn’t take a genius to see a financial crisis coming. The telltale signs are unsustainable levels of debt, sky-high asset prices (usually stocks or real-estate) and irrational optimism. The mystery is not how some people can see it coming, the mystery is why many people can’t. Possibly the most powerful psychological force that blinds us during a speculative bubble is the ‘This Time is Different” syndrome. This is the idea that the old rules no longer apply. It is at its most dangerous when it seduces the gatekeepers of financial order. Central bankers, economists, ratings agency analysts and other captains of the finance industry are smart people. So when they embrace the New Era, their arguments are more than enough to convince the average fellow on the street. When Alan Greenspan says there is no real-estate bubble, who’s going to argue? When top economists claim that we have tamed the economic cycle and use a decade of detailed statistics to back it up, who’s going to take the contrary position? Alas, one of the great lessons of a bubble is to demonstrate the painful difference between the smart and the wise.

Antidotes to financial madness

The best that individual investors can do to keep their feet firmly on the ground during a bubble is to steep themselves in the history of financial disasters. This is no easy task because the number of excellent books on this subject remains small. Among them I count John Kenneth Galbraith’s The Great Crash, Barry Wigmore’s The Crash and its Aftermath,both of which deal with the 1929 Crash and the Great Depression. Edward Chancellor’s Devil take the Hindmost is also worthwhile. It’s a colorful history of the more notorious speculative episodes; from the South Sea Bubble all the way to the dot-com bubble of a decade ago.

The good news is the recent publication of a new book that is a valuable addition to the canon. Appropriately enough, the book is entitled This Time is Different: Eight Centuries of Financial Folly, by Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard.

This Time is Different brings several new and important perspectives. First it takes an unabashedly quantitative approach. Most books on the subject (with the exception of Wigmore mentioned above) avoid statistics but they end up sacrificing precision for readability. Reinhart and Rogoff don’t shy away from the numbers even if it makes for dry reading at times. Second it captures the characteristics of financial crises from hundreds of examples across history as well as from emerging markets. The latter is especially illuminating for those considering international investment. Finally the book is recent enough to have an in-depth analysis of the current crisis and how it compares with those in the past.

The authors classify financial crises into different categories -- inflation crises, currency crashes, banking crises, external debt defaults and domestic default. While developed countries have largely put external debt defaults and currency crashes behind them, we have not been so lucky with banking crises. They persist with regrettable regularity. (A banking crisis is one that involves multiple failures/bailouts of large banks or financial institutions).

Lessons from prior banking crises

Is there anything we can learn from previous banking crises? The authors confirm the common feature of all banking crises -- the abnormal rise in real estate prices before things fall apart. In the U.S. for example, between 1996 and 2006, the cumulative real price increase was about 92 percent - more than three times the cumulative 27 percent increase in the previous ninety years.

They list a total of nineteen banking crises across the world from 1990 to the current day. The duration of the resulting downturns range from a mininum of three years to an ongoing maximum of eighteen years in the case of Japan (an example we’ve mentioned in earlier columns). The majority of the crises experienced downturns between four and seven years (measured from after their peak year in housing prices).

Applied to our current crisis (which began in 2006), it would be unusual if we see a recovery before 2010. A recovery in 2011-2013 would fit the existing historical pattern. On the other hand, the Japanese scenario cannot be ruled out and that would imply a staggering period of stagnation that would continue until 2026 at least. The extreme range of outcome is disheartening but to know the past is better than to rely on wishful thinking.

One of the harshest tolls of any economic recession is unemployment. According to Reinhart and Rogoff, unemployment rises by an average of 7 percent from its base rate after a banking crisis. In the U.S. this would mean an eventual rate of about 11 percent. Their latest reported rate is 9.8 per cent and increasing. The historical record suggests that the loss of jobs will get worse before it gets better.

With respect to stocks, Reinhart and Rogoff calculate that post-crisis stock prices suffer an average decline of 55 per cent with the decline lasting about three and a half years. But again, Japan is the problematic example since their stock market plunged by 80 percent at its post-crash low and has never recovered its high of 1989. In our current downturn, we have seen a maximum decline of 56% in the S&P 500 index.

On the policy side, how successful are stimulative measures in helping economies recover? (Stimulative measures include government bailouts, tax cuts, and job creation such as those being implemented in the U.S as we speak). The bad news is that stimulative measures have only been tried on a large scale once. The worse news is that it was done in Japan. With only one case to go by, we can’t conclude that stimulative policies have made Japan’s recession worse, and if those policies have made things better the outcome is certainly not reassuring.

Are there any shortcomings in the book? The only one I can think of is that there isn’t any mention of the psychological forces at work that inflate, sustain and eventually bursts a bubble. This is quite a fascinating topic and has been studied by behavioral economists in detail. My own personal observation during the boom years is that nothing erases prudence as effectively as the news that one’s neighbor or acquaintance has made a killing.

Market Outlook – A glimpse ahead

The statistical record can only take us so far in predicting how our current crisis will unfold. Where statistics leave off, we can only step in with fallible judgement. I offer this caveat about forecasts: Would you put your financial fate into the hands of a weatherman? Of course not. And yet predicting the path of the economy is infinitely more difficult. The weatherman can tell you with ninety percent accuracy whether it will rain within two days. No stock market forecaster can achieve the equivalent when it comes to the TSX or the Dow Industrials. They can’t even get it right five minutes into the future. That’s something to keep in mind whenever you read any forecast including mine.

With that said, I offer the following:

I continue to think that the weight of evidence falls on the cautionary side. The run-up in stocks over the summer and into the autumn looks like a selling opportunity rather than a permanent recovery in stock market values. And even though forecasts may be useless; forecasting is essential. My advice: A decade of declining stock prices must be considered as a possibility in any financial planning exercise.

One of the important facts not being factored into stock prices is the further blows that will fall on the U.S. housing market. At the moment 14 million American homeowners have ‘underwater’ mortgages – they owe more on their houses than their house is worth. There are US$750 billion of adjustable rate mortgages whose financing terms will change in the next few years. Buyers signed up for these toxic loans tempted by low initial monthly payments that didn’t cover the interest owed. Instead the shortfall was added to the loan balance. At some point the loan is recast, and the borrower can see their monthly payments skyrocket. The bottom line is more defaults, foreclosures and bankruptcies.

If, as I believe, we will see a continuing rise in U.S. unemployment and a worsening of the credit picture then the adjustment in expectations could be severe and abrupt.

Another significant danger is that the longer the downturn lasts, the shorter the patience of the electorate and impatience does not make for good government policy. Take the recently introduced home-buyers tax credit in the U.S. for example. According to the CalculatedRisk blog, the tax credit increased house sales by 350,000 units this year. The total cost to the taxpayer is about $43,000 per house. Not exactly an efficient use of funds. Spending the equivalent on extending unemployment benefits or on other services would have been far better.

Bad policy-making is a natural consequence of hard times. The economics profession lost a huge amount of credibility over the past two years. Unfortunately, public disillusionment with the ‘dismal science’ can go too far. Economists may have let us down but that doesn’t justify a whole-scale jettisoning of economics. During the Great Depression, for example, legislators raised trade barriers, acting against the advice of the majority of economists and made things drastically worse. Today, economists in the U.S. are arguing against a renewal of the home-buying tax credit but it’s likely they will be steam-rolled by politicians looking for quick fixes.

Readers must forgive my preoccupation with our neighbors to the South. Despite what looks like a continuing robustness in our country, our fate is still tied strongly to theirs. The tail wags slower when the dog is sick. On the positive side, our public finances here in Canada are in much better shape. This bodes well for our dollar (great for consumers buying imported goods, not so good for Canadian firms doing business in the U.S.). The American dollar on the other hand is headed into stormy waters. Their huge trade and government deficits argue for continuing decline of their currency. In particular, a crisis of confidence cannot be ruled out, especially in the twelve or eighteen months leading up to the next American election in 2012. Electoral politics raises uncertainty (note how the subprime crisis struck just before the end of the Bush administration’s term in office).

Such a crisis would send gold prices very high which is why it may be wise to have some exposure to gold stocks. Buying opportunities will arrive because gold stock prices are still strongly coupled with stock market prices in general. If stocks fall as I expect, picking up some gold stocks on the cheap would be a nice consolation.

I need to modify my position on oil prices. In previous columns I’ve said that oil prices will likely decline in the short to medium term. I still think that plausible but the drop will be overshadowed by the weakness in the US dollar. Since oil is priced in U.S. currency, we may not see a price of US$30 per barrel as I wrote a few months ago. What we’re more likely to see is a decline in the price of oil as measured by Canadian and other robust currencies.

In the final analysis, the spookiest question of all is the one I continue to struggle with-- the one that stands out like a scarecrow at a tea-party: What made Japan’s banking crisis last so long? My sad suspicion is that it was because the size of the bubble was extremely large in comparison to their economy. If this is correct then the fate of the U.S. economy stands on fragile ground. The size of the American real estate bubble is the largest in historical record. This by itself argues for a long recession. For the next few years, any breathing room in the form of a stock market rally will likely be temporary.


1. For number of "underwater" mortgages see: http://www.bloomberg.com/apps/news?pid=20603037&sid=adBYDzUMt68k and http://www.nytimes.com/2009/08/27/us/27arms.html?_r=2

Wynn Quon is chief investment analyst at Legado Associates (www.legadoassociates.com). You can send e-mail to me at wynn_quon@hotmail.com