No.

2

2014
Fear, Folly, and Financial Crises
Joachim Voth

Abstract

Financial crises devastate human lives, causing major shocks to economic output, trade, employment, income, and wealth. And as the financial crisis of 2007/08 showed, these crises do not just happen in distant countries or in the distant past – they are part of the economic realities of developed countries today. It is therefore of paramount importance to understand the causes of financial crises, and to come up with sound policy advice about how to reduce their frequency and depth. The present Public Paper looks at the rich history of financial crises, analyzing both contemporary and historical data on financial instability, and combining this with insights from economic theory. It argues that financial folly – collective mass-hysteria in financial decision-making – is not a helpful concept for understanding financial crises. While changes in sentiment occur, and can affect asset prices, financial crises are best understood as time- and location-specific responses to misaligned incentives and poor regulation. This paper proposes a set of policies, which have the potential to reduce the number of financial crises and to soften their consequences. The Public Paper also explains why regulating crises out of existence would not be a good idea.

Financial crises devastate human lives, causing major shocks to economic output, trade, employment, income, and wealth. And as the financial crisis of 2007/08 showed, these crises do not just happen in distant countries or in the distant past – they are part of the economic realities of developed countries today. It is therefore of paramount importance to understand the causes of financial crises, and to come up with sound policy advice about how to reduce their frequency and depth. The present Public Paper looks at the rich history of financial crises, analyzing both contemporary and historical data on financial instability, and combining this with insights from economic theory. It argues that financial folly – collective mass-hysteria in financial decision-making – is not a helpful concept for understanding financial crises. While changes in sentiment occur, and can affect asset prices, financial crises are best understood as time- and location-specific responses to misaligned incentives and poor regulation. This paper proposes a set of policies, which have the potential to reduce the number of financial crises and to soften their consequences. The Public Paper also explains why regulating crises out of existence would not be a good idea.

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Callout

Financial history may hold many lessons, but the inevitability of crises is not one of them. Although it is relatively easy to stop them, doing so comes at a cost, and this cost may be quite high. In other words, the right number of financial crises is probably not zero.

Introduction

Until recently, financial crises and the major economic downturns they caused seemed as far removed from the economic realities of developed countries as the Thirty Years War – they happened either in distant countries like Mexico or Indonesia or in the distant past. This changed abruptly after the world financial crisis of 2007/08. The United States and almost all countries in Europe were faced with a major shock to output and employment that originated in the financial sector; the aftereffects reverberated in debt markets in the eurozone, creating a second financial crisis where many governments were effectively shut out of debt markets.

Just before the crisis hit, central bankers and economists alike had declared that a new age of seeming stability and steady growth, the “Great Moderation”, was upon us – that central bank independence coupled with prudent interest rate policy and flexible labor markets had banished boom and bust cycles for good.1 While output and employment were plummeting in the fall of 2008, academic journals were publishing papers accepted months and years earlier pinpointing the exact reasons why even moderate output fluctuations had died down as much as they did.

Faced with a new, unanticipated phenomenon, economists, journalists and policymakers began looking for explanations. Why did the world find itself in a situation that looked like a likely repeat of the Great Depression of the 1930s? How could leading economic powers end up in a situation reminiscent of Third World countries? As is often the case in times of confusion, a single, powerful narrative rises to prominence. In this case, it was the idea that financial folly – of excessive individual risk-taking and collective mass-hysteria – is a constant of human life, erupting periodically with the same inevitability as earthquakes near major fault lines. In particular, the influential work of Carmen Reinhart and Kenneth Rogoff, based on a close reading of the last 800 years of financial chaos, argues that the idea that “This Time Is Different” has led to repeated swings from stability to crisis – after each crisis, people begin acting cautiously, taking fewer risks, and this was combined with good regulation. Gradually, they convince themselves that instability is a matter of the past, and thereby sow the seeds of the next crisis. The pattern then repeats.

This survey analyzes both contemporary and historical data on financial instability. Combined with insights from economic theory, it argues that financial folly is not a helpful guiding principle for interpreting and understanding financial crises. While changes in sentiment occur, and can affect asset prices, misaligned incentives and poor regulation are the main drivers of instability. Financial crises do not share one key underlying problem like pervasive financial folly. Instead, they are best understood as a mixture of highly time- and location-specific factors interacting with more general patterns that produce instability. The purpose of this essay is to uncover what mix of institutions and incentives creates chaos, and which guiding principles should be applied in reducing their frequency.

Until recently, financial crises and the major economic downturns they caused seemed as far removed from the economic realities of developed countries as the Thirty Years War – they happened either in distant countries like Mexico or Indonesia or in the distant past. This changed abruptly after the world financial crisis of 2007/08. The United States and almost all countries in Europe were faced with a major shock to output and employment that originated in the financial sector; the aftereffects reverberated in debt markets in the eurozone, creating a second financial crisis where many governments were effectively shut out of debt markets.

Just before the crisis hit, central bankers and economists alike had declared that a new age of seeming stability and steady growth, the “Great Moderation”, was upon us – that central bank independence coupled with prudent interest rate policy and flexible labor markets had banished boom and bust cycles for good.1 While output and employment were plummeting in the fall of 2008, academic journals were publishing papers accepted months and years earlier pinpointing the exact reasons why even moderate output fluctuations had died down as much as they did.

Conclusions

Financial crises devastate human lives, causing major losses of wealth and unemployment. What to do about them will be one of the defining policy questions of the next decade. Public debate is correct in strongly discussing financial instability and its potential sources. One popular interpretation of the origins of financial instability is that the frailties of the human mind as well as susceptibilities to greed and fear make crises inevitable. Financial history over the last 800 years is often invoked as the key proof for the case that financial folly is deeply woven into the human psyche, and is inevitable. The American journalist H.L. Mencken in the 1920s famously remarked that “there is always a well-known solution to every human problem – neat, plausible, and wrong.” The aftermath of the crisis of 2007/08 reminds us that this is still true today. Weaknesses of the human mind, like the tendency to overestimate the likelihood of low-probability events or the insufficient updating of priors in the face of new information, amplify financial crises28 – but these cannot be reduced to a constant of human life. Financial history may hold many lessons, but the inevitability of crises is not one of them.

Clio, the muse of history, suggests that crises are not inevitable – given sufficient political determination and a will to live with adverse consequences, it is relatively easy to stop them. Doing so comes at a cost, and this cost may be quite high. To avoid crises completely, the financial sector would have to be stifled and regulated to the point where it would accomplish little of economic value; growth inevitably suffers. In other words, the right number of financial crises – the frequency that a policy-maker should aim for – is probably not zero. For every eyecatching crisis avoided, there is more poverty, more social exclusion, and more unemployment than would otherwise be the case.

The aftermath of the 2007/08 Great Recession demonstrates eloquently that policy-makers can learn from history. Drawing the right lessons from the 1930s was essential in avoiding a much more severe downturn – one that could easily have occurred had it not been for energetic policy intervention, guided by detailed knowledge of what made the Great Depression truly “great”. Similarly, there is scope for reducing the frequency of sovereign debt crises and the size and incidence of bubbles if we listen to Clio’s whispers. Sovereign debt contracts can be made much more resilient, by reducing banks’ exposure to government bonds, by making risk transfers actually effective, and by writing contingent debt contracts that reduce the procyclicality of fiscal policy.

In the same vein, much can be done to reduce the size and frequency of bubble episodes. The risk of bubbles is much lower where artificial short-selling restrictions are avoided, shares of new firms come to market only once they are relatively mature and profitable, and a large number of shares can be traded with ease. In addition, perverse incentive effects that come from delegating the management of funds to professional managers can be reduced. All of these factors will level the playing field between optimists and pessimists, allow speculators to attack mispricings effectively, and increase the overall stability of financial markets. The Swiss art historian Jakob Burckhardt famously argued that the purpose of history was not to be smart the next time, but to be “wise forever”. Financial crises will continue to be among the most vexing problems in modern economies; listening to Clio’s wisdom will make it easier to reduce their number, soften their consequences, and appreciate why regulating them out of existence would be a really bad idea.

Financial crises devastate human lives, causing major losses of wealth and unemployment. What to do about them will be one of the defining policy questions of the next decade. Public debate is correct in strongly discussing financial instability and its potential sources. One popular interpretation of the origins of financial instability is that the frailties of the human mind as well as susceptibilities to greed and fear make crises inevitable. Financial history over the last 800 years is often invoked as the key proof for the case that financial folly is deeply woven into the human psyche, and is inevitable. The American journalist H.L. Mencken in the 1920s famously remarked that “there is always a well-known solution to every human problem – neat, plausible, and wrong.” The aftermath of the crisis of 2007/08 reminds us that this is still true today. Weaknesses of the human mind, like the tendency to overestimate the likelihood of low-probability events or the insufficient updating of priors in the face of new information, amplify financial crises28 – but these cannot be reduced to a constant of human life. Financial history may hold many lessons, but the inevitability of crises is not one of them.

Clio, the muse of history, suggests that crises are not inevitable – given sufficient political determination and a will to live with adverse consequences, it is relatively easy to stop them. Doing so comes at a cost, and this cost may be quite high. To avoid crises completely, the financial sector would have to be stifled and regulated to the point where it would accomplish little of economic value; growth inevitably suffers. In other words, the right number of financial crises – the frequency that a policy-maker should aim for – is probably not zero. For every eyecatching crisis avoided, there is more poverty, more social exclusion, and more unemployment than would otherwise be the case.

Authors

UBS Foundation Professor of Macroeconomics and Financial Markets

Joachim Voth received his PhD from Oxford in 1996. He works on financial crises, long-run growth, as well as on the origins of political extremism. He has examined public debt dynamics and bank lending to the first serial defaulter in history, analysed risk-taking behaviour by lenders as a result of personal shocks, and the investor performance during speculative bubbles. Joachim has also examined the deep historical roots of anti-Semitism, showing that the same cities where pogroms occurred in the Middle Age also persecuted Jews more in the 1930s; he has analyzed the extent to which schooling can create radical racial stereotypes over the long run, and how dense social networks (“social capital”) facilitated the spread of the Nazi party. In his work on long-run growth, he has investigated the effects of fertility restriction, the role of warfare, and the importance of state capacity. Joachim has published more than 80 academic articles and 3 academic books, 5 trade books and more than 50 newspaper columns, op-eds and book reviews. His research has been highlighted in The Economist, the Financial Times, the Wall Street Journal, the Guardian, El Pais, Vanguardia, La Repubblica, the Frankfurter Allgemeine, NZZ, der Standard, der Spiegel, CNN, RTN, Swiss and German TV and radio.

UBS Foundation Professor of Macroeconomics and Financial Markets

Joachim Voth received his PhD from Oxford in 1996. He works on financial crises, long-run growth, as well as on the origins of political extremism. He has examined public debt dynamics and bank lending to the first serial defaulter in history, analysed risk-taking behaviour by lenders as a result of personal shocks, and the investor performance during speculative bubbles. Joachim has also examined the deep historical roots of anti-Semitism, showing that the same cities where pogroms occurred in the Middle Age also persecuted Jews more in the 1930s; he has analyzed the extent to which schooling can create radical racial stereotypes over the long run, and how dense social networks (“social capital”) facilitated the spread of the Nazi party. In his work on long-run growth, he has investigated the effects of fertility restriction, the role of warfare, and the importance of state capacity. Joachim has published more than 80 academic articles and 3 academic books, 5 trade books and more than 50 newspaper columns, op-eds and book reviews. His research has been highlighted in The Economist, the Financial Times, the Wall Street Journal, the Guardian, El Pais, Vanguardia, La Repubblica, the Frankfurter Allgemeine, NZZ, der Standard, der Spiegel, CNN, RTN, Swiss and German TV and radio.