Financial Crashes Past And Present - 2018

This book rather continues the theme of past and present financial crises. If anything, it belongs in the category of 'financial crises soon to come'. It has been interesting to chart how financial crises arise (the Overends Crisis of 1866) and how a policy response was framed (the financial crisis of 1914). It is disturbing to see that the conditions of 1866 are not that very different to those today, and our policy response is quite timid compared to that of 1914.

The book starts by considering two shortcomings of conventional macroeconomics - the belief in the exogeneity of the money supply and the consequent setting aside of the financial sector. This provides the starting point for the book. The author demonstrates how credit conditions have a multiplier effect within the financial sector. This makes the money supply endogenous to the system, and not exogenous, as is currently assumed by the mainstream.

If we take that insight, we can derive some interesting conclusions from it. For example, one that stayed with me the most is that, if we move from the monetary economy to the real economy, purchasing power can be seen as aggregate demand plus credit growth. This helps to explain the recent bout of debt fuelled growth in China, which has been a bit of a puzzle. It also helps to explain the observation that households have been maintaining their living standards in the face of falling real incomes by taking on more debt. Our recent growth has not been propelled by growth in our productive capacity. It has been propelled by the growth in total credit within the economy.

This works fine until credit growth stops. One of the reasons why it stops is that lenders become wary about the ability of the borrowers to repay and service their loans. If credit growth just falters - a stumble rather than a fall - then the multiplier effect works in the reverse direction. Credit then becomes scarce and operational conditions in the real economy become tighter. A downturn begins. Conventional economics says that this downturn couldn't happen, which is probably why conventional economics was blind-sided by the crash of 2007.

The policy prescriptions in this case are quite clear. There is a case for the government to make up any reductions in aggregate demand through a programme of spending. Spending on investment is better, but spending on the current account will do just as well. This will help to shore up credit and help to counter the downward multiplier.

Since 2010, we have seen the exact opposite of this. Whereas trading conditions have called for a fiscal expansion, we have actually been on the receiving end of a fiscal contraction - austerity. The role of a fiscal expansion is to inject liquidity into the monetary system, as well as demand into the real economy to mop up that additional liquidity. A monetary expansion through QE serves to inject liquidity into the monetary system. Without the corresponding fiscal expansion, that monetary injection only serves to pump up asset bubbles, in our case in the stock markets and property markets. These then have the side effect of growing inequality.

It is at this point that we get to see the answer in the title. Pumped up asset bubbles have not gone any way to resolve the disruption of the credit system. We still have the global financial imbalances that gave rise to the growth of credit to begin with. This suggests that it is a matter of time before we experience another financial crisis, except that, this time around, the monetary authorities have far fewer policy tools through which they can address it.

A heavy dose of inflation would help to resolve the matter, but politics tends to get in the way here. Inflation tends to redistribute income shares from the 'haves' to the 'have nots', and the current political structure is not geared to achieve this. It is for this reason we can expect that future economic turbulence may be closely associated with political turbulence. One feels that the political pressure is rising as further austerity fails to resolve the crash of 2007.

This is a very short book, but it is very deep. It is surprisingly easy to read for an economics polemic. The author understands what he is saying, and sets it out in a very clear, logical, and methodical way. Prior familiarity with economics would be useful in reading the book, but a lay person acquainted with current affairs ought not to find it too much of a struggle. I found it to be a very useful text.

Stephen Aguilar-Millan

© The European Futures Observatory 2018

Financial Crashes Past And Present - 1914

This is the second of two books about financial crises that I have been studying. The first - Bagehot's 'Lombard Street' - dealt with the Overends crash of 1866, and set out the principles by which the Bank of England ought to manage the British monetary system. This book concerns itself with the first great stress test of those principles - the great crash of 1914. In doing so, it set the pattern by which the Bank of England managed the financial crisis of 2007. Disguised as a history book, this is a manual of contemporary financial management.

In the Spring of 1914, German banking and commercial interests started to draw gold out of the Bank of England. They were heavily involved in the discounting of European bills - an early form of revolving credit - and simply did not renew the lines of credit as they were repaid. This caused a tightening of credit in the London market. Onto this tight market was overlaid a series of political threats and ultimata that eventually led to what we know as the First World War.

The political turbulence spooked the markets. There was a rush to gold - Sterling being completely convertible to gold at that point - the hoarding of money, and lines of credit freezing up. As credit became frozen, firms sought to liquidate their financial assets in order to cover their positions, leading to a collapse of the stock market. The stock market closed, which accelerated the banking crisis. That rapidly fed into the real economy and firms started to lay off workers, who they were unable to pay. In the meantime, the government, who had no contingency plans, had to give thought to how they would prosecute the war. In short, things were in a real mess.

The first act was to get credit flowing again. This involved a general moratorium (the suspension of clearing), a suspension of convertibility, and an injection of fiat currency into the economy. The government injected liquidity into the economy through war purchases, then it provided a guarantee for unresolved bills - both domestic and foreign - and finally, the normalisation of commercial trading conditions, which led to the re-opening of the London stock exchange in January 1915.

In doing so, a model was established of Breakdown - Containment - Revival. This model would reappear at the next great financial crisis - that of 2007. The parallels between 2007 and 1914 are striking. So are the differences. In both crises, we see a mountain of debt that is, in essence, a house of cards. When one piece falls, everything else falls. Both systems of finance were highly inter-connected and highly inter-dependent. In 1914, the global inter-dependence was centred on London and connected by telegraph. In 2007, the global inter-dependence was centred on New York and connected by the internet. In both cases, these rapid inter-connections meant that contagion spread quickly and deeply.

In both cases, containment was a question of deciding which participants to support and which to let go to the wall. In 1914, greater use was made of the interest rate as a way of distinguishing between the illiquid (who survived) and the insolvent (who were left to go to the wall). The basis of decision making in 2007 appears less clear, and one suspects that political connections had a greater place in 2007 than in 1914. In both cases, bank balance sheets were greatly impaired and both relied upon public funds to bail them out. However, the major difference between 1914 and 2007 is apparent when we consider the recovery phase.

Recovery in 1914 involved a major increase in debt fuelled government spending to prosecute the war. The main source of funds was New York, and the price of the funding was that London lost it's pre-eminence as a financial centre. It could be argued that this was because London turned it's back on regional finance in the USA, but there simply weren't enough funds to both finance the First World War and the growth of the American economy. However, the war did act as a stimulus for the British economy, and recovery came rather quickly.

It is almost the exact opposite case for 2007. The policy response in 2007 was a monetary expansion through QE, which acted to shore up the balance sheets of the banks, but it also contained a fiscal contraction through the policy of austerity. This is not working well. Not only has it suppressed aggregate demand, the government now admits that it has led to a decrease in the trend growth rate - the ability to generate future prosperity - as well. We are now 10 years into the recovery phase and we are still trying to catch up with where we were in 2007. Living standards have declined, society has become more fragmented, and we are now talking of a blighted generation. This is a very different experience to that of 1914, where a generation was lost on the battlefields of Flanders.

The book is an academic text, and I suspect that only those with a burning desire to understand financial history would make it to the end. There is a lot of jargon and an assumption on the part of the author that the reader is conversant with the financial structure and commercial practices of 1914. This makes it a rather specialist read. The style is academic - one for the awards rather than the book sales - which means that, in places, it tends to get a bit bogged down. It is a hard read, but a very rewarding one, if you have an interest in historical financial crises.

I do, so I quite liked it.

Stephen Aguilar-Millan

© The European Futures Observatory 2018 

Financial Crashes Past And Present - 1866

This is the first of two books I am reading about financial crises. Originally written in 1873, this volume alludes to the Overends financial crisis of 1866, and sets out the prudent principles that ought to govern the operation of a central bank in the face of a crisis. In our current financial environment, it has much to recommend it.

The Overends crisis of 1866 bears an uncanny resemblance to the collapse of RBS 140 years later. Overends was a bank engaged in the boring, but essential, work of bill discounting in the 1840s and 1850s - the branch banking of its day. The profits weren't spectacular, but they did provide a steady return on capital. Then new management came along, and they wanted to shake things up. To make their mark. The company moved away from the steady work of bill discounting and started to take on the more heady work of railway speculation. Needless to say, the bubble of railway stocks burst, and Overends tumbled with them. However, because of their central role in the discounting of bills, credit froze in London and the house of cards collapsed.

The similarity to RBS is striking. In that case we have established banking brands (Royal Bank of Scotland and NatWest), earning steady returns from boring branch banking. New management looks to spice up the bottom line by engaging in casino banking. Everything works well until the bubble - a property bubble, in this case - pops. Credit freezes and the bank collapses. One key difference between 1866 and 2008 is that the Overends directors had the good sense to ringfence the casino operations to isolate the contagion from the bill discounting business. The geniuses at RBS didn't.

How should a central bank respond to such a crisis? That is the subject of this book. In 1866, the Bank of England made credit freely available, but at a price. Bagehot considers this to be the best possible response, and his views still dominate today. In a policy of what we would now consider as QE, the Bank of England lent freely into the banking sector, but avoided the moral hazard of cheap money by making it relatively expensive. This was to separate those institutions suffering from a liquidity crisis (owing to a mis-match of maturities) from those suffering from a solvency crisis (they were busted flushes).

The book doesn't touch upon how effective this was in 1866, but we now know that the difference between the two can be very fine at times, and that politics helps to determine which is which. Unanswered questions that remain in my mind from our own crisis include, was HBoS solvent when it was absorbed into Lloyds? Did Northern Rock have to be sacrificed? Was Lehman Bros a going concern when Barclays bought the casino banking business? I have no answers to these questions, just ill formed suspicions. What we do know from 1873 is that the resolution of the fall out took decades. Any hope for a resolution in our times, for our crisis, seems like pie in the sky to me.

One final point of interest from the book is the way in which it charts the rise of London as a financial centre. According to Bagehot, the centripetal force in the English monetary system allowed large sums of capital to be accumulated in the London banks, which were then lent to promising ventures, first in England, and then around the world. The routing of capital to find a home at the highest return, combined with the impact of leverage upon the balance sheets of the early capitalists, provided the impetus to allow London to rise as the pre-eminent financial centre in 1873. London still retains it's pre-eminence today, but one wonders if it might not be compromised by Brexit? That is a question for another day, but the start of an answer is locked away in this book.

The aim of the book was to outline the principles by which the Bank of England should assume responsibility for the English monetary system. It was quite influential in its day, and laid down the basis by which future crises were met - lend freely, but lend dearly. Of course, such principles can only be appraised when they are tested, and that is the subject of the second volume in my reading - the great financial crash of 1914.

Stephen Aguilar-Millan

© The European Futures Observatory 2018