Those Who Forget the Past....

OK let’s start. First we need to understand what a crisis is. If we look at a plot of  stock market prices  we can see cyclic price reversal over the course of time, going back as far as records can show. This is the result of pricing bubbles, and the subsequent bubble burst. This does not however define a crisis.

But what turns a bubble bursting into a catastrophic fallout?

There have been many major crises in the last few hundred years which warrant mention. The Great Depression (1929 US Stock market crash), the 1997 Asian Crisis (Collapse of the Thai Bhat), the Eurozone Crises (European government debt) and the Current global recession (2007 US housing market crash) are to name a few. Although it can be seen that all these involve different catalysts (stocks, real assets, currency etc.) there is a common trend which drives all crises. That is investors and banks borrowing and lending at an unsustainable level.

Let’s consider the most recent current economic crises and what caused it. 

This was the result of the housing bubble bursting in 2007 . Banks had issued high volumes of morgages on  properties when the price was increasing, the bubble burst, properties became worth-less, and there was in increase in the number of defaults on loans and the cost of loans went up. The real problems arose when it was made obvious that the banks couldn't sustain their levels of debt  This cost the banks as they had given out more loans than they cost afford to, resulting in defaulting banks, bankruptcy and the need for government intervention. The scale of these problems was unprecedented and unexpected, which is essentially the cause of the crises. What followed was the collapse of one of the four biggest investment banks, Lehman Brothers, and recession which was very difficult to recover from due to the fallout of the banking problems. 

Claessens et. al.(2010)* highlight the similarities and differences between this financial crises and those which have occurred in the past. I have summarized them below;

Similarities to Past Financial Crises	New Conditions to financial Crises
Sharp asset price increase	New, more sophisticated financial intermediaries and instruments meant financial markets where more tightly interconnected. This affected the severity of the oncoming financial crises.
Credit Booms which led to excess debt burden.	Large reliance on wholesale and short term funding in many advanced countries and emerging markets created systemic fragility.  A small shock to the system triggered severe liquidity shortages.
Build-up of marginal loans and systematic risk.	Exposure to US orientated assets allowed problems to spill over into other global markets.
House price sharply rose, reminiscent of the last big 5 financial crises.	Troubles intermediaries were forced to deleverage and the crises spread through the ‘common-lender effect’
Growth in credit coincides with increase in economic activity, current accounts deteriorate with this change in spending .	Unprecendated large household sector financial problems played a more significant role than in the past.
Increase in leverage and declines in lending standards, level of defaulting loans increased, causing problems for the banks.	A feedback look of falling home value and credit shortages set off a trend of reduced consumer spending. This resulted in declines in corporate profitability and staff layoffs, increasing unemployment.

Why was this allowed to happen? Could we not see that banks where operating on the edge? Why is there not adequate regulation to avoid these sorts of problems? What roles does the government play in monitoring the banks? In the next week I will look at Government policy and their role in financial crises.

 Although the western world is suffering difficult financial times, many places around the world are prospering. A good way to illustrate this is by looking at the worlds tallest buildings, which are generally a flagship for wealth. Today only two of the worlds 10 tallest buildings is in the West (Trumph tower, and the Willis building in Chicago). The rest are all in Asia, five of which are in China. This swing of wealth in recent times shows how countries can emerge from financial difficulties in a relatively short period of time. Perhaps a nice reminder that things are not a bad as they seem.

*Claessens, S., Dell’Ariccia, G., Igan, D. & Laeven, L. 2010, "Cross‐country experiences and policy implications from the global financial crisis", Economic Policy, vol. 25, no. 62, pp. 267-293