Current Issues Exercise (See related pages) Boom and Bust: Lessons from the Financial Crisis by Mark Lovewell Speculative Manias in History Economists assume individual decision-makers are rational. However this assumption can be broken. The recent boom and bust in global property and stock markets is a good illustration of seemingly irrational behavior, when otherwise level-headed people allow themselves to be swept up in a wave of heady optimism. Either through greed or short-sightedness, individuals believe that the price of something will keep rising, despite the laws of demand and supply. Sooner or later, each of these speculative manias has come to an end, as sky-high prices fall to earth with breath-taking speed. One of the best-known cases occurred in Britain during 1720. This involved the South Sea Company, which had agreed to take over all of the British government's debt, by converting it into its own shares. Due to a misguided impression that this scheme would provide a steady stream of profit to South Sea's shareholders, a popular frenzy caused the company's share price to soar by 1000 percent in just a few months. By the time the frenzy subsided, and the share price had tumbled, numerous small shareholders had lost their fortunes, leading one observer to remark that it had "almost become unfashionable not to be bankrupt."1 The South Sea Bubble is not the only historical example of a speculative mania. Other cases include tulip bulbs in Holland during the 1630s, the New York stock market in the 1920s, and the Japanese property boom during the 1980s. But all of these have been dwarfed by the property and stock market booms that began in the late 1990s and extended through most of the 2000s, before coming to a crashing halt in the financial crisis that began to emerge in 2007, then hit with full force in the fall of 2008. The Boom Years of the 2000s In the middle years of the 2000s, fuelled by easy credit, the global economic boom that had begun in the mid-1990s was evident in most parts of the world, driven not just by relatively low interest rates and high demand in high income countries – especially the United States – but by the rapid export-led growth in emerging economies such as China and India. The fact that a speculative bubble was being created was evident in three main ways. Overheated Property Markets Real estate markets in the US and in several other parts of the world (e.g. the UK, Australia, Ireland and Spain) became severely overheated, with price increases continuing year after year in what, in retrospect, was a clearly unsustainable trend. A speculative cycle was created. as increasing real estate values had their own impact on the global economy. Many homeowners went on a consumption spree, prompted by the paper wealth they were gaining through the rising value of their property; numerous others entered property markets for the first time, taking advantage of the easy availability of so-called subprime mortgages (mortgages with high interest rates given to those with weak credit ratings) available from banks and other lenders in several major countries. What would happen if the property price increases were reversed, and paper wealth began to shrink, was a possibility that, in the euphoria of the moment, was easy to overlook. As long as property buyers believed that there were others willing to pay even more for over-inflated assets, then the expectation was that the high returns from owning real estate would continue. Financial Oversight Financial markets during the boom years were undergoing rapid change, with the creation of new types of financial derivatives. These products – far more complex than futures and options contracts discussed earlier in the OLC article „Markets in Motion‟ – were marketed as ways to reduce overall financial risk. But their properties were so complicated that it was virtually impossible, even for financial experts, to predict how their prices would behave under different market conditions. Government regulators did little to limit the use of these new products, because their complexity made them difficult to regulate, while their use spanned national borders. To make matters worse, government regulators in most major countries overlooked more basic defects in financial markets – including outright fraud in some cases. This do- nothing stance was driven not just by laissez faire principles, but by a lack of resources to adequately police increasingly complicated financial activity. The End of Business Cycles? A third factor – less tangible than the other two, but no less significant – was also at play during the boom years. There was a growing belief that major downturns in the global economy were a thing of the past thanks to the ability of experts to smooth out cyclical fluctuations. Unfortunately some of this unwarranted faith in modern-day policy-making was driven by economists themselves. In the words of one American economist, Gregory Clarke: “Academic economists were confident that episodes like the Great Depression had been confined to the dust bins of history. There was indeed much recent debate about the sources of "The Great Moderation" in modern economies, the declining significance of business cycles.”2 The Crash The crash, when it came, was deep and rapid. The first signs had arisen in the summer of 2007 with a ballooning number of foreclosures on American real estate – much of it bought through the use of subprime mortgages – as well as the highly publicized difficulties of some financial institutions, not just in the United States but also in the United Kingdom. By the fall of 2008, a continuing litany of foreclosures and financial failures, mostly in the United States and Europe, was causing panic. The crisis conditions soon spread globally. By October 2008, the tumble in confidence and stock market prices had become a rout, as access to financial credit for both households and corporations dried up, and signs of a major worldwide meltdown became clear. Pierre Duguay, the Bank of Canada‟s Deputy Governor, provided a useful summary of the underlying trends in a speech he gave just as the crisis conditions were beginning to subside. “[W]holesale funding markets came to a standstill in many countries,” he noted, “and commercial banks essentially stopped making unsecured loans to one another at terms longer than overnight. The crisis rippled through various markets as investors became very risk averse. Corporate bond spreads surged to new all-time highs, equity prices plunged, and foreign exchange rates became very volatile… The combination of these factors has produced … what has become the deepest, broadest, and longest financial crisis since the 1930s.”3 As a result, government policy makers in Canada as well as other countries were forced to respond to prop up their financial sectors while applying expansionary fiscal and monetary policies to deal with the emerging recession. Canada‟s financial markets had been less affected by the speculative conditions than those in many other countries, because of the reluctance of Canadian financial institutions to engage in high-risk mortgage lending and because property values in most Canadian markets had not succumbed to the same bubble conditions as in some other countries. But because of Canada‟s close integration in the global economy, worldwide events could not help but have a huge impact. Like other major central banks, the Bank of Canada counteracted shortages of liquidity with emergency measures that made credit available to a wide range of financial institutions, for the first time including pension funds and some other major financial players as possible recipients of this credit, and promised intervention if necessary to prop up struggling financial institutions. It also immediately loosened monetary policy by pumping reserves into the banking system and reducing interest rates. Because interest rates were driven so low, the only way the Bank was able to continue engaging in expansionary policy was through so-called “quantitative easing,” which involved the Bank increasing the money supply by using its own reserves to buy extensive holdings of government bonds. In the longer term Canada‟s fiscal policy makers also added to this stimulative effect through deficit-financed government purchase increases and tax cuts, both at the federal and provincial levels. Lessons from the Crisis It is as yet unclear how long and deep the slump triggered by the financial crash will continue. But even once the worldwide recession has come to an end, it is likely that it will take some time for global stock indexes, especially in the most affected countries, to return to their former levels. More importantly, the financial crisis and its aftermath provide some important lessons. First, central banks cannot concentrate so much on prices for consumer products that they ignore possible speculative bubbles in asset markets. Second, the need for regulation of financial markets has not been lessened by global financial integration and the increasing sophistication of financial instruments. These trends might mean that forms of financial regulation may need to change, however. From now on, more emphasis will likely be placed on globally coordinated regulation through policy coordination at the international level as well as possible new global regulatory agencies. Third, government budget deficits still have a part to play in countercyclical fiscal policy. Fourth, and most importantly, recent events prove that speculative bubbles and the business cycle are by no means things of the past. There is no doubt that economists will keep these lessons in mind in the ways they approach macroeconomic issues in the years to come. Notes 1. Quoted in Edward Chancellor, Devil Take the Hindmost (Harmondsworth: Penguin, 1999), p. 84. 2. Gregory Clark, “Dismal Scientists: How the Crash is Reshaping Economics” The Atlantic, Feb. 16 2009. (at http://business.theatlantic.com/2009/02/wheres_my_money_idiot.php) 3. Pierre Duguay, “Check Against Delivery,” Remarks delivered in Pictou, Nova Scotia, Nov. 27 2008. (at http://www.bankofcanada.ca/en/speeches/2008/sp08-15.html) If directed to do so by your instructor, the following questions can be answered online and emailed to him/her or yourself. 1 not raising interest rates central banks such as the Bank of Canada for prolonging the 2000s boom, by Many economists blame early enough to lessen the boom‟s speculative impact. Explain how an increase in global interest rates could have lessened the bubbles in both property and stock markets. 2 Explain why international coordination of financial markets, rather than separate regulation within each country, could be increasingly necessary in the aftermath of the financial crisis.
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