Financial or Economic Crises?

From National to International

See Doug Nolan's Credit Bubble Bulletin at http://www.financialsense.com/Experts/2007/Noland.html http://www.prudentbear.com/index.php/commentary/creditbubblebulletin

In this session we will look at 1) National financial crises and global crises 2) The problem of the relation between stock, bank, financial and economic crises 3) The common features of early and later crises 4) Stock prices and crisis 5) State debt 6) Bank losses and assets 7) Cases 8) Derivatives 9) Mergers and acquisitions 10)Gold

From mid 2007 to end 2008 the USA experienced a major financial panic, which apparently then became economic. This is not a unique occurrence. In the USA there has been a financial crisis roughly every 14 to 20 years : in 1819, 1836, 1857, 1873 (& the so-called 'Long Depression' of 1873-1896 ),1893, 1907, (1918 post war was an industrial collapse, 1919 boom and 1920 crisis) the 1929 great crisis to 1933, then ..... 1973, 1987, 1997 and now 2007-8. Many of these marked the beginning of a period of economic depression, not simply a recession. According to the US Bureau of Economic Analysis, during the post war boom, real gross domestic product fell throughout the 1945-7 period (war production reduced) and in 18 of the 104 quarters between 1948 and 1973. In 1949, 1953-4, 1957-8 and 1969-70 it declined for at least two quarters in a row, but these output recessions were not financial crises, and the distinction must be retained.
http://online.wsj.com/article/SB122360636585322023.html

US financial crises do not always tie in with the 23 slumps in the world market. The coincidence is indicated in red. World slumps broke out successively in 1825 (undercapitalised banks collapse), 1836, 1847, 1866(OverendGurney crash), 1873, 1882, 1891, 1900, 1907, 1913, 1921, 1929, 1937, 1949, 1953, 1957, 1960, 1970, 1974, 1981, 1990, 2001 and 2007. Nor do UK national problems always link clearly with wider international phenomena, thus the Stock exchanges Spanish panic of 1835, or the British railway share bust of 1837, the 1933 Kaffir (tea shares) boom, the Western Australian boom, the 1890 Barings Crisis, the Marconi Scandal 1912 are international events not much affecting national.

Many economists attempt to establish a regularity or explain the periodicity of crises. I think that the momentum of this stumbling giant is not regular, nor can it be constantly re-explained as ever new contingencies. Rather such movements arise from a recurring general problem of how to avoid decreasing profitability. Many factors promote profitability, that vary in type, weight and consequence, and we encounter a conflicts between inbuilt characteristics of capital growth. Growth certainly takes place, but at increasing cost to entire societies and their natural basis. Stagnation and crisis seem ever present and grow ever more persistent.

US Financial crises have all been managed differently but with a greater degree of centralised management every time. There was no US central bank from 1828 to 1913.
As a result, the panics of the 19th century were far worse in the USA than in Europe and precipitated longer and deeper depressions. In fact in 1907, J.P. Morgan, probably the most powerful private banker who ever lived, acted as the central bank to end the panic that year. Resentment at his power provoked a new Fed Reserve in 1913. A stock market crisis is NOT in itself a financial crisis (except for individuals!). Financial crises are those which seem to arise from financial activity itself, borrowing, lending, and so interest rate issues, and the purchase of paper claims on other assets, including the use of foreign exchange, and NOT from the production or commercial spheres where money is used to purchase inputs, or to sell non financial outputs. Since a crises can only express itself generally (ie on a large scale) in monetary terms, because of the way value measured, the focus on the first news (financial indices) of a crisis can create the illusion that it is only a financial issue, or is then the cause of an economic crisis rather than its expression or result.

President Andrew Jackson attacking the Bank of the United States. Lithograph, 1828. The 1st Bank of
the United States was established in 1791, closed 1811 after southern states against it. A 2nd bank was established 1816 until opposed by Jackson, it s charter expired in 1836. The Federal Reserve was created in 1913 as 12 separate banks, then finally centralised in 1934.

Dot .com bust Black Monday 10/87 2007 crash

The movement of profits does not necessarily coincide with stock price changes. The Black Monday (19 Oct 1987) decline was, until then, the largest one-day percentage decline in stock market history. The most popular explanation for the 1987 crash was selling by program traders

Last resort lending from the start!

Writing at the time of (probably the worlds first) the1825 banking crisis, Jeremiah Harman, Director of the Bank, described it thus:

We lent [money] by every possible means and in modes we have never adopted before; we took in stock on security, we purchased Exchequer bills, we made advances on Exchequer bills, we not only discounted outright, but we made advances on the deposit of bills of exchange to an immense amount, in short, by every possible means consistent with the safety of the BankSeeing the dreadful state in which the public were, we rendered every assistance in our power.

The 1866 UK failure of Overend, Gurney and Company Ltd, followed the acceptance of bills of less and less satisfactory quality after 1856-7, and lending to companies with unsatisfactory collateral. It was floated (note the same with US investment banks at the turn of the 21st century!) in 1856 as a limited company. Bad debts increased as companies linked to OGC failed, its stock fell, it was refused aid by the bank of England in May. It collapsed bringing down country banks and firms, then other London banks then a run on the Bank of England. The Bank Charter Act was suspended, and the fiduciary issue expanded to save the day! So whats new today??

Tuesday 29 October1929 crisis: was preceded by speculation using margin payments. Thus 1925 to 1929 saw turnover in securities doubling. The Smoot-Hawley Tariff Act of 1930 was considered by many to be the factor that transformed the U.S. recession into a global depression. It was enacted on 17 June 1930, about 8 months after the collapse of the U.S. stock market. It quadrupled import tariffs on 20,000 goods, particularly agricultural products. Retaliation, brought international trade to a halt and depressed global demand. Ironically, the U.S. economy was showing signs of recovery by the spring of 1930. Unemployment stood at 7.8%, but the decline in global trade doubled the rate by 1931 to 7m. and wages fell 39% from 1929-31. Britain went off the gold standard in 1931.The unemployment rate in the U.S. continued to climb, peaking at 32% in 1933. 19 April gold standard abandoned and $35 an ounce of gold by Jan 1934. Only France adhered to the gold standard.

In 1933 the US Banking Act or Glass-Steagall Act was passed, following the collapse of nearly 5000 banks, forcing commercial and investment banks to separate. Commercial banks could not underwrite stocks and bonds sales. Investments banks could not take deposits. It was repealed in 1999 The Financial Services Modernisation Act (by the Republicans Gramm, Leach and Bliley). Now these banks could combine and join with Insurance companies. This allowed eg Citigroup to emerge after Citibank merged with Travellers and then expanded through takeovers.

Ignoring emerging markets (which have to be explained within the whole picture), from 1975 to 2007, there were 5 BIG wealthy nation crises, Spain 1977, Norway 1987, Finland 1991, Sweden 1991 and Japan 1992 (all starting dates) plus the EU /EMU/ crisis of 1992. These are associated with major declines in economic performance for a time, the Japanese for a lost decade .* Other non emerging market banking and financial crises were in Australia 1989, Canada 1983, Denmark 1987, France 1994 (Credit Lyonnaise), Germany 1977, Greece 1991, Iceland 1985, Italy 1990, New Zealand 1987, UK 1974 (Secondary banking crisis) and 1991 (BCCI and 91-93 Small banks crisis and 1992 abandonment of EMS), 1995 (Barings fraud) and 1984 USA started its Savings and Loans crisis (cost 3.2% GDP), 1997 (NYSE stopped trading, with Asian Financial crisis), 1998 (LTCM/Russian) An estimated 42 systemic banking crises between 1970 and 2007
Kaminsky GL and Reinhart CM AER Vol 89 1999: Caprio G Klingebeil D Laeven L Noguera G 2005 Banking Crisis Database in Honohan P & Laeven L Sustemic Financial Crises CUP. See http://ssrn.com/abstract=1282250

It is difficult to separate out and prioritise all these crises, and they need to be examined and linked to the (unmentioned here) developing economy crises : Thus 2000-3 there was a major fall in stock prices globally, as dot.com boom ended, and 2001 Argentine default occurred. Now we have US/Global 2007-2009 crisis! These financial crises are continuous and yet have not properly been assessed as linked within a global process. They are usually presented as separate and different, with multiple causes. They need to be connected to general economic crises.

Financial markets are risky /unstable because participants expect future yields. The future is uncertain . Financial instability itself can intensify to financial crises. The liberalisation of the global financial markets since the late 1970s, several speculation waves have affected different world regions leading to serious debt and financial crises: eg the third world was hit by the debt crisis of the 1980s. The result was a lost decade , but actually the problem is continuous!!! Emerging markets faced a financial crisis, beginning with Mexico in 1974, and then reaching the Asian tigers in 1997, Brazil suffered a setback in 1999, and Argentina in 2001. The USA also went through some financial crises: the Savings and Loan crisis (1987) and the crisis following the wave of unfriendly takeovers (1986 and 1989),

Following the financial crises in Asia, Russia, Turkey and Latin America, capital surpluses flowed into the new techno-economy and pumped up a speculative bubble there. This burst in 2000. The rescued capital was invested in the real estate sector - until the subprime crisis erupted in 2007 which caused massive losses in almost all countries of the world. The crisis on the financial markets is still primarily being fought with trillions of dollars and euros. No one wants to think of the losses, and they have not yet been finally distributed between classes and nations. The plagues of climate collapse, peak oil and hunger are neglected in the discussion. The conflict to determine who the devil will take has only just started.

DJIA (30 stocks) broke 12000 (12,049.5) for first time in 110 years 18.10.2006. 12,000. FTSE also 5 year high of 6172 earlier in that week. Prices are actuals. It will fall to 7000 by start 2009 (below 1997level)

2000-3 Stock crash

12 stocks in 1896

20 stocks in1916

30 stocks in 1928

1929

1945

1970

1987 1980 Crash 2000

22.61% fall

These 30 stocks are of the biggest US monopolies dramatically expanding after 1980

The TWO FT examples here ignore the sharp falls in stock prices (capitalisation) e.g. 1903, 1914 (world war starts), 1920, 1937. Why?

! ! ! !

Y axis is log scale

NB: from 66-83, the period of the great rethink, there is a stagnation around 1000 pts.

UK

UK Statistics 1988 to 2006

2008 estimate

The bigger crises have interesting similarities: financial liberalisation precedes the majority of crises; there is a rise in housing prices, (best leading indicator of countries with large capital inflows) that level out or dip about 1 year before ; the rate of growth in equity prices also slows then falls up to 3 years before the crisis; the momentum of real growth slows for three years going into crisis and remains low for 2 years. Rising public debt near universal precursor of other post war crises (accelerating thereafter). The consequences are an average drop in real per capita output growth is 2%, with two years to return to trend . In the 5 big cases drop in growth pa is over 5%, with 3+ years required for recovery.

In 2011 Jean Claude Trichet will retire as head of ECB Much of his career has been spent battling economic disaster, he said, from Latin America to Africa, Russia, Mexico and Asia WSJ 27 Jan 2010.

The role of Banks in the national economy

In the UK 1970 to 2007, the contribution of the financial sector to the GDP rose from 5.1% to 8.3%. We can compare this to Real estate which went from 10.8% to 23.6%, or manufacturing which fell from 31.7% to 12.4%, or mining (including oil and gas) which rose from 1.6% to 2.6%. But such figures need to be investigated to see how much of the actual profit element in society came from different sectors, and especially the retained/reinvestable profits. Furthermore we need to see which sectors were critical to paying for imports or capital exports.

To Sept 2008 only

CASES

Bank of Credit and Commerce International (BCCI) scandal 1991 BCCI was a major international bank founded in London in 1972 by Agha Hasan Abedi, a leading Pakistani financier. Registered in Luxembourg, at its peak it operated in 78 countries, had over 400 branches and had assets in excess of US $20bn. making it the 7th largest bank in the world by assets. It became the focus in 1991 of the world's worst financial scandal what was called a "$20-bn + heist". Regulators in the US and UK found it to be involved in money laundering, bribery, support of terrorism, arms trafficking, the sale of nuclear technologies, the commission and facilitation of tax evasion, smuggling, illegal immigration, and the illicit purchases of banks and real estate. The bank had at least $13 bn unaccounted for. The bank was dubbed the "Bank of Crooks and Criminals International. A Bank of England report was drawn up on the collapse and regulatory issues. The Bank of England was not blamed.

An attempt was made to tighten cross border coordination after this BCCI collapse, but US insolvency law dictates that most of liquidity and capital in US must stay there. Each state prefers to protect its own taxpayers. So will cross border regulators oblige banks with US presence to store extra cash elsewhere? Still in 2010 not the case.

UK small bank failures & liquidity problems, 1991-93 crisis : I

Started pre-BCCI, but exacerbated by it. Regulators contained a liquidity problem . Bank of England kept the problem secret until after resolution. Asset quality deteriorated as property prices fell (banks focused on property lending). Wholesale funding withdrawn as US and Japanese banks reduced deposits due to long recession.

UK small bank failures & liquidity problems, 1991-93: II

Bank of England actions: - 25 banks failed or closed due to problems during the period. - BoE monitored 40 small banks very closely; - told many banks to reduce assets and/or increase their liquidity; - supply of liquidity in form of loans to a few small banks. Contagion was feared. A realistic fear?

Barings, 1995: I
Rogue trader in Singapore (bet on Tokyo share index holding 19,000 against downward pressure) without supervision. (2010 its at 10,000) Losses of 800mn on derivative contracts, on Bank s capital base of 540mn. Insolvency highly likely. Was contagion likely? Bank of England decided no : - small merchant bank; - problems due to fraud.

Barings, 1995: II
Reputational risk to other merchant banks or to London as a financial centre? Bank of England tried to put together a lifeboat but failed. Bank of England said it would provide liquidity to markets if necessary but refused to use public funds to bail out Barings. Barings acquired by ING, Dutch bank/insurance co.

Long term Capital management crisis 1998

In 1994, John Meriwether, (famed Salomon Brothers trader), founded a hedge fund called Long-Term Capital Management, with academics models and traders' market skills. Sophisticated investors, including many large investment banks initially invested $1.3 bn. By end September 1998, the fund had lost substantial amounts of investors' equity capital and at brink of default. The proximate cause for LTCM's debacle was Russia's default on its government obligations (GKOs). The banks guaranteeing the rouble hedge shut down when the Russian rouble collapsed. The Russian government prevented further trading in its currency. LTCM was than caught in a "flight to liquidity" across the global fixed income markets. To avoid the threat of a systemic crisis in the world financial system, the Federal Reserve orchestrated a $3.5 bn rescue package from leading U.S. investment and commercial banks. In exchange the participants received 90% of LTCM's equity. Small change compared to 2008.
http://www.erisk.com/Learning/CaseStudies.asp

US consumer debt sharply increased from < US$740bn in 1975 to almost US$11,500bn in 2005, (from 62.0% to 127.2% of disposable income). Ratio of total debt to GDP rose from approx. 160% at the beginning of the 1970s to 340% in 2005. The debt of consumers corresponds to an increase in monetary wealth of suppliers. Demand for investment opportunities leads to the supply of new vehicles promising high returns. A large part of this monetary wealth is hoarded as foreign currency reserves by China, Japan, Russia and some other countries with a positive balance of payments, such as Germany.

From 1990, Finance capital turned to derivatives, wherever it looked a possible haven, and so implicitly to loan packages of various kinds, as well. Over the counter derivatives rose 5 times from 2001 to 2008, while credit default swaps rose 62 times, from almost $1 trillion to $62 trillion. The Dow Jones index of shares rose 7 times from 1987. The house price rise in the USA and the UK was just one aspect of this a huge asset inflation during this period. The rewards to finance capital soared: its share of the American stock market climbed from 5.2% pa in 1980 to 23.5% pa 2007. The fall of commodity prices, including oil in particular, preceded the threat of meltdown. Oil had dropped by almost half from $147 US in July2008 to $70 in October 2008 and $47 in December. Commentators talk of the socialisation of risk and the privatisation of profit, but that has always been the case.

* On Aug 2010 Corus and SSI Thailands largest steel producer sign MoU for the potential sale of
Teesside Cast Products.

Lower production of gold in 2008 than 2000. Jewellery 70% end use.

Reinhart, C. M and Rogoff, K (2009), This Time is Different: Eight Centuries of Financial Folly, Princeton University Press. Sheppard, D. K (1971), The Growth and Role of U.K. Financial Institutions 18801962, Methuen.

Laeven, L. and Valencia, F. V (2009), Systemic Banking Crises: A New Database, IMF Working Paper No. 08/224. Logan, A (2000), The Early 1990s Small Banks Crisis: Leading Indicators, Bank of England Financial Stability Review Issue 09. Ahamed, Liaquat. Lords of Finance: a history of the economics of World War I and the Depression Penguin 2009 David Kynastons The City of London: A World of Its Own, 1815-90 (Vol. 1) The City of London: Golden Years, 1890-1914 (Vol. 2), The City of London: Illusions of Gold, 1914 - 1945 (Vol. 3), The City of London: Club No More, 1945-2000 (Vol. 4) Bloomsbury 2010