A Little History of Financial Crises

The claim by the Fed and Treasury that spending $700 billion of public money is the best way to recapitalize banks has absolutely no factual basis or justification. - Nouriel aka Dr. Doom Roubini

I woke up this morning to see the blog buzz word of the day is Nationalization as Economics bloggers hunt for the solution to the financial crisis.

As we are aware, the bail out deal is being ramrodded through Congress and the legislation text, now over 100 pages, still is not available for public review. One is guaranteed to find a host of clauses, written for special interests, in such a case if the history of legislation is our guide.

Let's go do some homework to see why the blogs are talking about this and the history thereof.

In Is the U.S. Subprime Crisis So Different? (02/08, pdf):

The apparent decline in U.S. productivity growth and in housing prices does not provide a particularly favorable backdrop for withstanding a credit contraction.

Most noteworthy, they imply the United States has a 3rd world country within it's own borders:

A large chunk of money has effectively been recycled to a developing economy that exists within the United States’ own borders. Over a trillion dollars was channeled into the sub-prime mortgage market, which is comprised of the poorest and least credit worth borrowers within the U.S.

Carmen M. Reinhart & Kenneth S. Rogoff also wrote a comparison paper, This Time is Different: A Panoramic View of Eight Centuries of Financial Crises (05/08, pdf) for the National Bureau of Economic Research. This work is full of graphs, pattern examples and one thing stands out, believing a collapse cannot happen here or will not happen again is a fool's folly.

Global conflagration can be a huge factor in generating waves of defaults. Our extensive new dataset also confirms the prevailing view among economists that global economic factors, including commodity prices and center country interest rates, play a major role in precipitating sovereign debt crises.

From the IMF, Systemic Banking Crises(pdf), is a history of wrong solutions and results thereof. In this badly formatted paper, Dr. Roubini went through and tabulated the solutions. He found:

Only in 32 of the 42 cases there was government financial intervention of any sort; in 10 cases systemic banking crises were resolved without any government financial intervention. Of the 32 cases where the government recapitalized the banking system only seven included a program of purchase of bad assets/loans (like the one proposed by the US Treasury). In 25 other cases there was no government purchase of such toxic assets.
In 6 cases the government purchased preferred shares; in 4 cases the government purchased common shares; in 11 cases the government purchased subordinated debt; in 12 cases the government injected cash in the banks; in 2 cases credit was extended to the banks; and in 3 cases the government assumed bank liabilities.

Even in cases where bad assets were purchased – as in Chile – dividends were suspended and all profits and recoveries had to be used to repurchase the bad assets. Of course in most cases multiple forms of government recapitalization of banks were used.
But government purchase of bad assets was the exception rather than the rule. It was used only in Mexico, Japan, Bolivia, Czech Republic, Jamaica, Malaysia, and Paraguay.  Even in six of these seven cases where the recapitalization of banks occurred via the government purchase of bad assets such recapitalization was a combination of purchase of bad assets together with other forms of recapitalization (such as government purchase of preferred shares or subordinated debt).

In the Scandinavian banking crises (Sweden, Norway, Finland) that are a model of how a banking crisis should be resolved there was not government purchase of bad assets; most of the recapitalization occurred through various injections of public capital in the banking system. Purchase of toxic assets instead – in most cases in which it was used – made the fiscal cost of the crisis much higher and expensive (as in Japan and Mexico).

So, what the hell did Sweden really do and what were the effects thereof?

The Swedes:

  • Sweden told its banks to write down their losses promptly before coming to the state for recapitalization
  • Then came the imperative to bleed shareholders first
  • The finance minister told institutions there would be no sacred cows. In other words, no financial institution was "too big to fail"
  • For every Swedish buck put into the system, Sweden made sure it got ownership for it

By nationalizing the banks, Sweden said to the private sector, that's tough, you lose, we own it now and as a result, long term they only lost about 2% of GDP versus over 4%.

Looking back, Swedish official say the tough approach toward the banks paved the way for success. It eliminated "moral hazard," the problem of relieving investors of bad decisions. And, much as it might be a shock in the United States, the demise of shareholders also underpinned the political consensus that help restore stability to financial markets even before the bailout was truly under way

A little history on how the Sweden financial crisis came about....ah, notice deregulation and resulting housing bubble.

Those who cannot learn from history are doomed to repeat it. -- George Santayana



Financial crisis by design?

I'll understand if you don't answer this question. Putting character and morality aside for a moment, if one was familiar with previous financial crisis, i.e., Sweden and Finland - Would it be possible/likely to adjust laws in order to arrange/ provoke a crisis by which some could benefit, then help "solve" said crisis? Would it be worth the risk?

Little is said about post-crisis prosecution. Was there any? Or was it assumed that problems were "unintended consequences"?

The Shock Doctrine

We have character and morality these days, any political flavor? I think those with such traits just were defeated.

If you want to read more about creation or exaggeration of a crisis, or taking advantage of a crisis to push a corporate agenda through, the link is to a book by Naomi Klein. Just because you are paranoid does not mean they are not out to get you.

On post crisis prosecutions, I think most of it was made perfectly legal by law, just as our Corrupt Government (both parties) has repealed various regulations per corporate lobbyist demands...

What Sweden did that really worked was they said, "shareholders, executives, you are first up to have all of your ownership, wealth, pay stripped if we must bail out you. Kiss it Good-bye" and magically some of these private CEOs/boards/owners/shareholders come up with money to bail themselves out.

We just passed a bail out that does none of that. It's only window dressing but the actual legislation does not limit CEO bonuses, pay or strip shareholders of value.

Nice blog, welcome to EP!