A Brief History of Doom

by Richard Vague

  Financial crises deserve heightened attention because among the major types of economic crisis, they are the most damaging to major economies. As part of their excellent work, economists Carmen Reinhart and Ken Rogoff have listed six different categories of crisis: external sovereign debt crises, internal sovereign debt crises, currency crises, inflation crises, stock market crises, and financial (or banking) crises. Looking at them since 1960 and taking into account the size of the country, the three most prevalent by far have been financial crises, currency crises, and stock market crises.1 And among these three, the one that has caused the most impairment to major economy GDPs has been the financial, or banking, crisis. Sovereign debt and inflation crises have been comparatively rare, even though these have drawn disproportionate scholarly attention.

  Table I.1. Major Financial Crises

  Table I.1 shows the crises that are covered in this book, if not in detail, at least in passing. This list is derived from a number of excellent lists compiled by noted economists.2 For convenience I have designated a specific year for each crisis, although most have unfolded over a period of several years.

  These and other financial crises have been explained by and attributed to many factors, separately and in combination, including interest rates, gold policy, trade, greed, deregulation, global savings gluts, and lack of confidence, to name just a few. All of these factors and more can play a part in a crisis. We’ll discuss them briefly throughout, as appropriate, although a full review is beyond the scope of this book. The research presented in this book demonstrates another thesis. Private debt is key, and the story of financial crisis is, at heart, a story of private debt and runaway lending. Time and again it is a story of lending booms in which bankers and other lenders make far too many bad loans.

  The importance of private debt is minimized altogether by some, who reason that for every borrower paying more interest and therefore reducing spending in a given period, there is a lender receiving interest as income and increasing spending in that period, and it all nets to zero. In practice, however, this tends not to be true since lenders need not increase their spending by the same amount that distressed borrowers are forced to cut back. And even if it does increase the spending of the lender, that usually happens later. In the economy as in business, the timing of spending is everything. More important, it does not capture the duress of those borrowers forced to constrain their activity because of overleverage, and the crippling impairment to lenders when too many loans are not repaid.

  But financial crises recur so frequently and are so often linked to rapid increases in lending that we have to wonder why lending booms happen at all. The answer is this: growth in lending is what brings lenders higher compensation, advancement, and recognition. Until a crisis point is reached, rapid lending growth can bring euphoria and staggering wealth. Lending booms are thus caused by an intense desire to win, to prevail, and to increase wealth. They are driven by a ferocity of ambition that is ever present and incites, compels, and pervades these booms. It’s no different than a computer company’s desire to sell more computers, a coach’s desire to win championships, or, for that matter, a king’s desire to conquer new territories. Lending booms are driven by competition, inevitably accompanied by the fear of falling behind or missing out.

  In a lending boom, optimism pervades projections of earnings and valuations, and credit standards around such things as debt ratios, down-payment requirements, and past credit issues get relaxed. Hence delusion, especially self-delusion, is also a prerequisite for a financial crisis, even if it is delusion couched in carefully extrapolated graphs and serious, high-toned presentations. Property values will continue to rapidly rise. Housing demand will continue to increase. Corporate earnings will continue to strengthen.

  Time and again, a financial crisis emerges directly not just from ambition but also from this capacity for self-delusion and deceit, intended or unintended, official or unofficial. Time and again, lending is the platform for that delusion. This intense ambition is impossible to overestimate and crucial to understanding business and economics in general, not just booms and crises. To seek to explain booms solely through impersonal, technical factors is to miss their single most important characteristic. It is to miss completely the fact that economics is a behavioral and not a physical science.

  It is to miss the essence of financial crises.

  In an accelerated lending boom, the ones that concern me in this book, resistance of lenders to the siren song of accelerated loan growth is rare. These lenders tentatively depart from conservative lending to make loans that have somewhat greater risk, and as they do, the economy gets better, asset values rise (since lending helps cause these valuation gains), and employment and growth trends improve. The compensation of these lenders and their companies’ stock price both get better. Other lenders take note and are judged unfavorably if their lending trends fall behind. Bit by bit, most respond by accelerating their own growth, and soon enough, a large swath of the lending industry is locked in competitive overdrive, making incrementally riskier loans. Most often, borrowers are happily complicit. Many times in my career, I have seen companies borrow more simply because loans were so readily available. The saying has always been that “the time to borrow is when lenders are lending.”

  A lending boom feels great while it is happening. The economy gets better because certain core forms of lending, especially bank lending, actually create new money and thus create more demand. At the moment when a bank makes a loan and deposits the funds in that borrower’s account, new money is created. Businesses that receive these loans accelerate spending and hiring. Employment increases, far more than dictated by organic demand—the demand that would exist without this lending boom. Consumer borrowers increase their spending. Government revenues go up since businesses and individuals are making more money and therefore paying more taxes. The impact of this excess lending spills outward. New jobs abound, unemployment plummets, incomes go up, housing and other asset values go up, and the government debt profile usually improves.

  Why do lending booms happen? Having spent a lifetime in the industry, I can report that there is almost always the drive to grow loans aggressively and increase wealth, and lenders, as a practical (and sometimes perilous) matter, are usually not greatly constrained in the amount of loans they can make. So the better and more profound question is, why are there periods in which loan growth isn’t booming?

  Lending doesn’t boom when regulators or risk managers have the upper hand and when lenders are chastened—often in the years following a crisis. In fact, a few countries have gone so far as to enact explicit limits on credit growth. Lending also tends not to boom in phases when businesses and other borrowers are overleveraged and not in a position to rapidly increase their borrowing. Apart from those periods (which include calamities such as wars, most notably World War II), the era covered by this book is one in which private debt always outgrows GDP, and often by a wide margin. It’s the rule rather than the exception. It’s endemic to developed economies.

  The United States had lending booms in the 1830s, 1850s, late 1860s and early 1870s, late 1880s and early 1890s, mid-1900s, 1920s, 1980s, and 2000s—and all resulted in a financial crisis. This list is not exhaustive. Lending booms have preceded almost every financial crisis.

  Financial crises are calamitous enough that in one sense it’s surprising that they recur, and lenders touch this hot stove time and again. Yet gradually, after a crisis, memories of earlier troubles fade, and lenders can point to a lengthening accumulation of years in which problems have not occurred and begin to accelerate lending and slacken lending standards once again. “This time is different” rationalizations—or amnesia—set in.

  Soon enough, a new lending boom begins.

  The germ of financial crisis begins with overlending in a sector or sectors big enough to pose a systemic risk to the economy. In recent decades, residential and commercial real estate (Figure I.1) have become the larges
t lending sector and the ones most susceptible to rapid expansion through lending. Mortgage loans alone went from $5 trillion to $10.6 trillion, or 44 percent of all private loans, during the 2008 crisis in the United States. If 10 percent of those loans were bad, it would equal more than $1 trillion in an industry that only had less than $2 trillion in capital at that point. In contrast, it would be hard to create enough bad loans in the consumer staples sector to create a national crisis since loans to that sector are less than 2 percent of all private debt.

  As lending in a sector increases, the value of that sector’s assets go up because that lending increases demand. This is especially true in real estate. Lenders believe that they are following a trend when, in fact, their loans are driving a trend. This becomes a feedback spiral: because more lending results in more borrowers, it results in rising real estate prices. This increase in prices boosts lenders’ confidence that they have lent wisely, which translates into even more real estate lending and development. It’s a self-reinforcing cycle and a self-fulfilling prophecy—at least for a time.

  Booms do not just happen in banks. The initial lending boom often comes from a secondary type of financial institution with less regulatory scrutiny. For example, mortgage banks played an outsized role in 2008, savings and loans in the 1980s, trust banks in 1907, Baubanken in 1873 Germany, and so on. Another portion of this lending occurs outside of regulated banks and savings institutions altogether, in an area often called “shadow banking” that includes insurance companies, hedge funds, private equity funds, and more.

  Figure I.1. 2017 U.S. Private Debt by Sector (Total $29.4 Trillion)

  Note: Business debt is dark gray, household debt is light gray.

  For all data sources for charts throughout the book, please visit www.bankingcrisis.org.

  The crisis is inevitable before it is obvious. “External shocks,” a phrase popular with economists to describe disruptive factors, often emerge but are not required to ignite the crisis at the point when massive overcapacity is reached. Overlending and overcapacity themselves can bring a crisis. At some point the tragedy begins. Participants gradually realize that too many of these loans will not be repaid. Lending is curtailed. Building or other business activity will then likely decline. Lenders soon find themselves in a crisis trap: the only way to maintain prices is to continue to make real estate loans using high valuations, but that continued lending creates more bad debt. Yet if lending abates, values decline, which exposes problem loans. The good times that these lending booms bring are so good, and the bad times that a reversal will bring are so bad, that those benefiting the most are highly reluctant to accept the troubling news as it emerges.

  Financial crises don’t often happen at a single point in time. They unravel over years. In Japan, overbuilding occurred in the late 1980s, stocks crashed in 1990, real estate values plummeted in 1991, and yet the government showed unusual forbearance and did not widely recapitalize banks until 1998. For the crisis of 2008, housing construction peaked in 2005, building slowed and housing prices declined in 2006, the stock market unraveling started in the fall of 2007, and the famed Lehman Brothers failure came in 2008. (Stock market crashes are a symptom—admittedly sometimes the most luridly visible one—and not a cause of financial crises. But they can compound the downward pressure.) Lenders that have made too many bad loans—bad loans that approach in amount their total capital and reserves—fail or have to be rescued. Even banks not as far gone can fail because depositors and funders will “withdraw now and ask questions later.” Banks operate at much higher levels of leverage than most other types of businesses and are thus inherently more vulnerable to adversity. Lending totals often (but not always) slow or decline. The economy slows. Large-scale layoffs follow.

  This is the onset of phase two, the bust after the boom. All booms look more or less the same—very rapid growth in private debt and widespread overcapacity—but recoveries do not. The duration and severity of bust periods that follow vary widely, depending largely on the policies employed to combat them. The sheer size of the problem means that often only the government is large enough to rescue the troubled institutions. And as these chapters show, government response at this point can range from passive and hands-off to active and interventionist. Institutions can be allowed to fail or be rescued. Typically, active intervention means a softer short-term impact on the economy but an economy that remains overleveraged. Conversely, less intervention can mean more short-term distress but greater deleveraging. There are, of course, a variety of government responses between these two extremes.

  Crises often happen at similar times across several countries. In 1837, 1857, and 1873, to cite just three examples, a crisis erupted in both Europe and the United States. This should not surprise us. Bankers on both sides of the Atlantic had strong financial ties to each other, often overlaid with family ties. The Warburg banking family of Hamburg was related to the Kuhn and Loeb banking family in New York. There were Morgans in New York and London. Technologies tend to develop simultaneously in different locales as well. This was especially true of the railroads that were at the root of so many nineteenth-century crises. Railroad building, and almost inevitable overbuilding, occurred simultaneously in several countries. Price or volume swings in such commodities as wheat and copper in one market rippled around the globe, sometimes compounding crises. And the core forces of competition and envy that motivate lenders’ ambition do not know national boundaries. They affect lenders across borders, just as they do within.

  Rapid growth in lending is the key harbinger of financial crisis. In examining financial crises from 1945 forward, a period for which we have more complete data, I’ve found that a financial crisis is highly likely if the ratio of private debt to GDP grows by 15 to 20 percentage points or more in a five-year period and the ratio of overall private debt to GDP reaches or exceeds 150 percent. This is a general guideline, to be applied with reflection and judgment. The deeper issue is how much overcapacity is being created and that country’s policy accommodations for lending institutions. For example, China is well over these thresholds but is uniquely situated since its government owns or controls all the relevant components of crisis—lenders, borrowers, and regulators. Nevertheless, when we apply this rough formula to a database of forty-seven countries in the postwar period for which we have relatively complete data, this straightforward formula predicts a “calamity” roughly 80 percent of the time—where calamity means a financial crisis or a 2 percent GDP decline, or both. This rapid debt growth is the measurable residue of overcapacity in the making. At the very least, most of the worst financial crises are those preceded by credit booms. (This analysis can be found on this book’s website, www.bankingcrisis.org.)

  It is important to note that only in rare cases have financial crises occurred when not preceded by rapid private debt growth.

  Rapid debt growth can also bring overcapacity in countries with less than 150 percent private debt to GDP, as we will see often in this book, especially in the 1800s. However, at this lower overall ratio, rapid private debt growth results in crisis far less certainly, since that low ratio may indicate undercapacity, as was the case in the United States after World War II. In other words, whether rapid debt growth results in a crisis has much to do with how much capacity existed before the lending boom—be it housing or office space or some other category, as well as the nature of the policy response. Private debt levels of 150 percent or more of GDP implies ample existing capacity, which would mean that a lending boom that rapidly adds more capacity will likely bring too much. Further, as Steve Keen has shown, when overall private debt is higher, a drop in new lending results in a drop in total economic demand; when it is lower, it does not.3

  As far as hypotheses go, this book won’t have quite the emphasis on gold (or silver) in crises in the 1800s and early 1900s that most accounts do. As I will elaborate in the chapters to follow, lending booms could and did happen without additions of gold reserves. And while withdr
awals of gold could and did bring contractions of loans and often exacerbate a crisis, withdrawal of gold was not the primary issue: it occurred after the damage from profligate lending and overcapacity had already taken place.

  Nor will the book emphasize the role of the central bank (or some surrogate) as the lender of last resort since the role of the lender of last resort comes only after the lending misbehavior has occurred and the emphasis of this book centers more on that misbehavior itself. Though as we will see, a lender of last resort can make a profound difference in how a crisis plays out once it has begun.

  The story told here is not entirely new, but it has been widely overlooked and ignored. Some observers as early as the 1800s attributed their financial crises to profligate lending. The hypothesis and explanation most in keeping with the story I tell here comes from economist Hyman Minsky (1919–1996). He powerfully articulated something close to the theory of private debt that I espouse in this book.4 I learned from and relied on much of what he has written as I developed my own theories and observations.

  Minsky held that the mechanism that pushes an economy toward an inevitable crisis is rampant speculation and the accumulation of debt by the private sector (investors, banks, and companies). Minsky claimed that in prolonged periods of prosperity, actors take on more risk, and a speculative euphoria develops.

  Minsky’s view was that lenders start first with “hedge” loans, loans where interest and principal can be repaid from cash flow. Next, they move to “speculative” loans, where cash flow can service interest but not principal, and then lastly to “Ponzi” loans, where cash flow can repay neither interest nor principal and the asset or business must be sold to repay the debt. When a preponderance of the loans in a sector is closer to this Ponzi category, a crash becomes highly likely. This movement of the financial system from stability to fragility followed by sudden major collapse that brings a crisis point is often called the “Minsky moment.”