The crisis of 2007: some lessons from history

There is a strong tendency in the media and policy circles to view each crisis as totally new and unexpected. Financial crises, however, are as old as financial markets. Here are the lessons drawn by one of the world’s leading economic historians of financial crises.

Recent financial instability triggered by the collapse of the U.S. subprime mortgage market has many features with great resonance from financial history.

The crisis occurred following two years of rising policy interest rates. Its causes include lax oversight and a relaxation of normal standards of prudent lending in a period of abnormally low interest rates. The default on a significant fraction of subprime mortgages has produced spillover effects around the world via the securitized mortgage derivatives into which these mortgages were bundled, to the balance sheets of hedge funds, investment banks and conduits (which are bank owned but off their balance sheets) which intermediate between mortgage and other asset backed commercial paper and long term securities. The uncertainty about the value of the securities collateralized by these mortgages spread uncertainty about the value of commercial paper collateral, and uncertainty about the soundness of loans for leveraged buyouts. All this has led to the freezing up of the interbank lending market across the world in August 2007 and substantial liquidity injections by the ECB and the Federal Reserve to avert a credit crunch from impacting on the real economy. The credit crunch has not yet been alleviated and a recession in the US with consequences for Europe and other countries threatens.

A historical perspective

Many of the financial institutions and instruments caught up in the crisis are part of the centuries old phenomenon of financial innovation. The new instruments –often devised to avoid regulation – are then proved to be successful or not by the test of financial stress such as we have been recently encountering. The rise and fall of financial institutions and instruments occurs as part of a lending boom and bust cycle financed by bank credit. The credit cycle is connected to the business cycle.

Irving Fisher and others have told the story of a business cycle upswing driven by a displacement leading to an investment boom financed by bank credit and new credit instruments. The boom leads to a state of euphoria and possibly an asset bubble. A state of over-indebtedness develops which often ends in a bust.

A key dynamic in the crisis is information asymmetry manifest in the spread between risky and safe securities. The bust would in the past often lead to bank failures and possibly panics. The process could be short circuited by a lender of last resort providing ample liquidity at a penalty rate.

Countercyclical monetary policy is also an integral part of the boom-bust credit cycle. For example the historical record shows that stock market booms occur in environments of low inflation, rising real GDP growth and low policy interest rates. As the boom progresses and inflationary pressure builds up, central banks inevitably tighten policy to trigger the ensuing crash. The story is similar for housing.

Stock market crashes have serious real consequences via wealth effects and possible liquidity crises. Housing busts, in addition to directly producing negative effects on the real economy, can also destabilize the banking system . These risks are present in the current housing bust .

Bordo ( 2007) presents some historical empirical evidence for the U.S. from 1921 to the present on the relationship between credit crunches, recessions , financial crises and monetary policy. I plot the monthly spreads between the Baa corporate bond rate and the ten year Treasury constant maturity bond rate, as a measure of the financial markets assessment of credit risk . I also show NBER recession dates and major financial market events including stock market crashes, financial crises and some major political events that affected financial markets. I also show policy interest rates ( the federal funds rate and the discount rate).

The patterns revealed by the data show that peaks in the credit cycle proxied by the spreads are often lined up with the upper turning points of the business cycle. Also many of the events like banking crises and stock market crashes occur close to the peaks. Furthermore, policy rates peak very close to or before the peaks of the credit cycle.

The historical relationship for the U.S. between real housing prices( and other measures of the housing market) ,the business cycle and policy rates reveals a similar pattern . Tightening of monetary policy is associated with reversals of real housing prices and business cycle downturns.

Financial innovation and financial crises

Historically, financial crises originate on the liability side of banks balance sheets as depositors rush to convert deposits into currency in the face of a financial shock. In recent decades, since the advent of deposit insurance, pressure has come form the asset side. Examples include the commercial paper market in the 1970 Penn Central crisis, emerging market debt on money center banks in 1982 and hedge funds in the LTCM meltdown in 1998. An historical example was the 1763 crisis in the market for bills of exchange.

In many of these cases financial innovation which increased leverage and was often devised to circumvent regulations was an integral part of the story of the boom. Examples include Penn Central in 1970 with innovation in the commercial paper market; the savings and loan crisis of the 1980s with junk bonds; LTCM with derivatives and hedge funds and today with the securitization of subprime mortgages. In this episode risk has been shifted from the originating bank into mortgage-backed securities which bundles shaky risk with the creditworthy. Asset backed securities were absorbed by hedge funds, offshore banks and commercial paper. The shifting of risk from the banks to the financial markets as banks tried to avoid regulated capital requirements did not reduce systemic risk and increased the risk of a more widespread meltdown. Indeed the exposure of the non bank financial sector has ultimately put pressure on the banking system.

International spillovers

Financial crises have always had an international dimension. Contagion spreads through asset markets, international banking and the exchange rate standard. The Baring Crisis of 1890, when Argentina defaulted on its debt, is a classic historical example of contagion. Tightening by the Bank of England created the backdrop for the crisis. It led to sudden stops in lending from the European core to the periphery. This led to currency crises and debt defaults in a pattern similar to 1997-98.

The current crisis has spread between advanced countries via the holding of opaque subprime mortgage derivatives in diverse banks in Europe and elsewhere. Emerging countries have so far avoided crises because of defensive measures, especially large foreign exchange reserves, in reaction to the 1990s meltdown. However, if the credit crunch continues and the U.S. economy goes into recession, the emerging countries will also be affected.

Policy lessons

Lesson #1: Anna Schwartz once made a distinction between real financial crises, defined as a scramble for liquidity requiring lender of last resort action and pseudo crises( asset busts leading to wealth losses) which do not require the lender of last resort. The recent wealth losses by hedge funds and others represent pseudo crises.

However the spillover of the subprime crisis into the interbank loan market and the freezing of liquidity to the banking system has posed the threat of a real crisis and have been dealt with properly by the ECB and the Federal Reserve. By contrast the Bank of England initially followed a strict Bagehot policy of keeping its discount window open at a penalty rate. The run on Northern Rock on September 14, 2007 and the Bank’s apparent volte-face likely did not reflect the failure of the Bank’s lender-of-last-resort policy but perceived inadequacies in the UK’s deposit insurance, the lack of coordination between the Financial Stability Authority and the Bank, and political pressure.

Lesson #2: The Federal Reserve by cutting its Funds rate by 100 basis points between September and December has correctly followed the conventional approach to monetary policy by temporarily putting its inflation objectives in abeyance to prevent an incipient recession. As long as the Fed’s commitment to its goal of a low inflation nominal anchor is perceived to be credible, such easing should not be inflationary. However once the threat of recession dissipates it behooves the Fed if it wishes to maintain its credibility, to take back the money and raise rates. The ECB and Bank of England as of now have not cut their policy rates although they have been countering the liquidity crisis by injecting funds into the money markets. Should the risk of recession become as serious as in the U.S. they should follow the Fed’s example.

Lesson #3: The Fed has followed the conventional wisdom and acted reactively by dealing with the consequences of an asset boom after it has bust. However there may be a case for the central bank in some circumstances acting in a preemptive manner to forestall a low probability event such as a national housing bust.

Finally I speculate on whether the recent financial crisis could have been avoided if the Fed had not provided as much liquidity as it did from 2001 to 2004. The Fed injected liquidity following shocks (the tech bust, 9/11) that might lead to financial crises, but when no financial crises occurred, it permitted the additional funds to remain in the money market. It also overreacted to the threat of deflation in 2003-2004 which most likely was of the “good” (productivity driven) variety rather than the “bad” recessionary variety.

If consequent upon these events the markets had not been infused with liquidity as much as they were and for so long, then interest rates would not have been as low in recent years as they were and the housing boom which just bust may not have expanded as much as it did.

Reference

Michael D. Bordo ( 2007), T’he Crisis of 2007: The Same Old Story Only the Players have Changed’. At Michael Bordo’s webpage.


Originally published at VOX EU and reproduced here with the author’s permission.

One Response to "The crisis of 2007: some lessons from history"

  1. Edward Hugh   July 12, 2008 at 2:49 am

    Hello Michael,Thanks for an interesting and insightful piece. I too agree that history is replete with lessons and insights which may help us labour with our current difficulties. So to dive straight in."Bordo ( 2007) presents some historical empirical evidence for the U.S. from 1921 to the present on the relationship between credit crunches, recessions , financial crises and monetary policy."I wonder if you are aware of the work of the late Christopher Dow in this regard: Major Recessions, Britain and the World,1920-1995. Dow was IMHO the most outstanding UK economist of the last quarter of the twentieth century, combining as he did an almost unique range of abilities and experiences as both theoretician and analyst, macroeconomist and policy adviser. And above all, he spent a significant part of his professional career working at the Bank of England. That is he knew something about how banks work, and he understood the meaning of the term "sentiment", which I feel is now at the heart of the present problem.The most important part of Dow’s theoretical legacy, I feel, is the short critique he makes – as an appendix to his otherwise most exhaustive and interesting book – of Bernanke’s review of Eichengreen’s "Golden Fetters". Basically Dow argues that there is a basic misunderstanding at the heart of our appreciation of what happened in 1929, quite simply because far too much emphasis has been placed historically on what happened on the liability side (the deposits, and bank run). and far too little thought has been given to what was going on on the asset side (the loan book basically, and what we could loosely call the "credit conditions").In fact there is no consensus in the correlations about which produced which, ie whether the bank run produced the change in credit conditions, or whether the latter produced the former. If it did, then we are going about all this the wrong way round. Thus it would seem that our reaction to the current mess has been possibly unduly influenced by this rather one-sided appreciation of what happened in 1929, with a lot of emphasis being placed on avoiding even the vaguest hint of a bank run, but rather less thought being given to the issue of sentiment, and what to do about it. Hence the shock people are getting at the speed with which the change in bank sentiment is hitting the real economy in a country like Spain.Basically, I would say, that a move from having 70 odd % of mortgage loans with a LtV of circa 100% to one where virtually no loan can carry more than an 80% LtV (with of course much stricter valuation procedures)in a country dependent on external funding and with very low domestic saving is almost bound to produce a very dramatic impact on the real economy, and you need look no further to understand what is now happening."Its causes include lax oversight and a relaxation of normal standards of prudent lending in a period of abnormally low interest rates."Well, all this was termed a financial revolution, and undoubtedly some part of the package was truly innovative, but raising the LtVs, extending mortgage terms off towards infinity (50 year mortgages were common in Spain before the bust) and raising the loan to income ratios certainly were not. Nor was giving investment grade to securities (like the spanish cedulas hipotecarias) which should never have had them. In particular because:"The uncertainty about the value of the securities collateralized by these mortgages spread uncertainty about the value of commercial paper collateral"And I would add the insecurity about the underlying value of the property pools which back the securities in markets which are as notoriously volatile as the housing ones are is a very big reason why such instruments should not get investment grade other than under the strictest of conditions (ie much stricter than were actually operated either in the US or in some parts of Europe)."A key dynamic in the crisis is information asymmetry manifest in the spread between risky and safe securities. The bust would in the past often lead to bank failures and possibly panics."Yep, well this is what I am saying. I think we are putting too much emphasis on this part, and not thinking enough about the underlying real economy problems which are going to be produced by the credit crunch."Historically, financial crises originate on the liability side of banks balance sheets as depositors rush to convert deposits into currency in the face of a financial shock. In recent decades, since the advent of deposit insurance, pressure has come form the asset side."Ditto. I’m not sure this reading is quite right. The problems on the asset side were always there. Or so Dow argues."However once the threat of recession dissipates it behooves the Fed if it wishes to maintain its credibility, to take back the money and raise rates."Well, this is a big "once", I mean I doubt we are talking about a simple recession here. We are evidently in for what may well be a fairly sizable dose of stagflation, with low growth heading out probably over a number of years, and the possibility that some countries (Spain, Italy??) could fall into outright deflation if it goes on long enough. So maybe we need to take this one step at a time now. Let’s clean up the mess, then have an extensive "post mortem"."Finally I speculate on whether the recent financial crisis could have been avoided if the Fed had not provided as much liquidity as it did from 2001 to 2004."I think it is also worth asking the question whether Spain and Ireland would be where they are now had the ECB basically not been fuelling them with negative interest rates for so long."The credit crunch has not yet been alleviated and a recession in the US with consequences for Europe and other countries threatens."Well, I agree with the first part, but – and looking at the May data – might we not now say that a recession here in Western Europe may well now have consequences for those further to the East (the EU10), and China and Japan, who basically depend on us as customers for their exports. That is to say, I think the whole problem has now moved up a rung.