Leading in a time of Adversity
I am honoured to have been asked to address this meeting of the Financial Services Regulation Coordinating Committee (FSRCC). The FSRCC stands at the apex of Nigeria’s regulatory architecture, chaired by the Governor of the Central Bank of Nigeria. I need not remind you how awfully important your role is to the ultimate soundness of our financial and banking system as a whole. I believe that a sound banking and financial system is not only vital to our economic prosperity; it is essential for the long-term survival of our fledgling democracy. I have always viewed democracy and prosperity as Siamese twins.
I have been asked to speak on the management of financial crises. What I intend to do is, first, to consider the nature and origins of financial crises. I will then discuss the two major financial crises that the world has seen, namely, the Wall Street Crash of 1929 and the subprime crisis that began in Wall Street in 2008. I will also evaluate the ramifying effects of those crises and the responses by authorities and their efficacy or otherwise. Such a historical approach will help illustrate the dynamics and drama of financial crises and the lessons they pose in terms of sound financial regulation and financial crisis management.
These issues are also relevant to understanding our on-going recession in this country and, in particular, the search for viable policy options that will restore the economy to the path of recovery and growth.
A financial crisis, as you all know, is a situation where system breakdown occurs, often associated with panics and banks runs; a situation whereby investors resort to selling off assets or withdrawing their savings from financial institutions out of fear that their values are likely to fall or even disappear if they remain in the formal financial system. The scenario is typically one in which money demand outstrips supply; banks cease to advance credit or demand early loan repayments; they may also seek to liquidate some of their assets and may impose higher collateral terms on potential borrowers; balance sheets become impaired; rumours send triggers of fear and panic; bank runs may then occur; psychological panic becomes a self-reinforcing prophecy; contagion effects may spread throughout the economy and beyond national borders.
Financial crises can arise in the form of a currency crisis, sovereign defaults or regulatory failures. They can also be triggered by banking crises, asset-liability mismatch, sudden stops, foreign and domestic debt crises, stock market crashes, speculative bubbles or over-leveraging. It is a well established axiom in economic science that plateaus and troughs are inherent in the dynamics of the capitalist world economy as we have always known it. Some of the cycles, known as Kondratieff curves, are long-term cycles of the order of magnitude of seventy years or thereabouts. The more familiar ones are, of course, the more short-term business cycles that take place every couple of years.
Financial crises are difficult to predict. There are long-term path-dependent trends that build up to major financial crises. But there are also ‘black swans’ — a metaphor referring to unanticipated high-impact events that take everyone by surprise. The metaphor was popularised by the financial trader and statistician Nassim Nicholas Taleb who used it to describe high-profile, rare, non-computable events that stand beyond the realm of normal expectations or probability theory. Some scholars have employed the butterfly effect hypothesis in quantum physics to explain the outbreak of some financial crises. This hypothesis is premised on the proposition that there are situations in which a small change in one state of a deterministic nonlinear system could trigger massive disproportionate impacts on another aspect of the system. A butterfly waving its wings in Table Mountain in Cape Town, for example, could trigger a tsunami in the shores of Japan. Apparently small financial mishaps in one corner of the world could trigger a contagion that could spread all over, with highly deleterious effects.
There have been 13 major world financial crises so far: 1720, 1792, 1825, 1837, 1857, 1873, 1907, 1929, 1973, 1987, 1997, 2001 and 2008. What we know for sure is this: for as long the world capitalist market economy endures financial crises will recur with a high degree of inevitability. A few countries, notable among them Switzerland, have been able to guarantee a century of peace, prosperity and financial strength. Swiss banking stands at the apex of solidity while the Swiss franc has been as solid as the proverb Rock of Gibraltar. For most countries, however, there is something rather inevitable about financial downturns. It therefore goes without saying that central bankers, monetary authorities and financial regulators must forever remain vigilant. In these matters, supreme mindfulness is the better part of virtue; eternal vigilance, the ultimate price of liberty.
There is a whole library of scholarship on the economic theories underlying financial crises. The Swedish economist Knut Wicksell traced their origins to what he termed ‘cumulative expansion’. According to him, financial crises derive from the contradictions of capitalist over-production, whereby the economy fails to absorb the surplus that is produced, which then leads to investors cutting back on production, which in turn reduces national output and sends the wrong signals to the financial system. Financial crises occur, according to this theory, when the financial system diverges from the real sector, with very little linkages or feedback with the financial system. Nobel laureate Milton Friedman, in his eponymous study on the monetary history of the United States (with Anna Schwarz), put the emphasis on the over-supply of money which inflicts inflationary pressures on the economy, leading to a general downward spiral and collapse of the financial system.
The late Charles Kindleberger of Harvard University drew our attention to the ‘herd spirit’ which characterises the financial markets, in which reason and rational calculus are overwhelmed by the human frailties of greed, fear and panic. From some of his work, a new school of behavioural economics has emerged. It seeks to apply psychological theories to understanding how markets and individuals behave. Robert Shiller and Daniel Kahnemann, both of them Nobel laureates, have done work of original importance on the behavioural foundations of global financial markets and how these can lead to financial crises.
Perhaps the most influential contributor by far to our understanding financial crises has been Hyman Minsky. Minsky was very much the most under-rated economist during his long and industrious career. It was well after the subprime crisis and the Great Recession that the intellectual world community understood and appreciated the originality of his thought. Minsky’s Financial Instability Hypothesis (FIH) takes its premise from the notion that financial crises are inherent in the capitalist system itself. According to him, in prosperous times, when more profits are made, speculators engage in all sorts of risky ventures. Speculative bubbles and euphoria soon emerge. In the end, debt balloons beyond what borrowers can repay from their incoming revenues, which in turn intensifies the fragility of banking and financial systems, leading to financial crisis. Minsky’s ideas emphasise the need to strengthen the regulatory function monetary authorities while reinforcing the primary role of the central bank as a lender of last resort.
By far the worst of the financial crises in world history was the Wall Street Crash of 1929. The Dow Jones Index fell from a high plateau of 390 in 1929 to a low of 20 in 1932. Billionaires suddenly became paupers. Men threw themselves headlong from the windows of their proud towers to a grim and certain death. Bank runs spread all over the major cities, forcing the authorities to declare banking holidays. Some 11,000 of America’s 25,000 banks collapsed.
Calvin Coolidge, the American President of the United States during the years 1923 to 1929 did nothing. He withdrew into his own make-believe world. His successor, Herbert Hoover (1929-1933), was not any better. He downplayed the crisis in public, but in private he was a frightened and confused man. Meanwhile, the American Federal Reserve committed the gravest folly of all: they raised interest rates. Of this folly, Milton Friedman wrote: “The Depression….in my opinion would have been over in 1931 at the latest had it not been that the Federal Reserve pursued a course of followed a policy which led to bank failures, and led to a reduction in the quantity of money.”
It was during the Franklin Roosevelt years that hope gradually returned to America. Franklin Delano Roosevelt came into the Presidency (1933-1945) with a warrior mission to save the American republic from self-destruction. He spoke with moral force and with conviction. He famously declared that “The only thing we have to fear is fear itself”. His New Deal package was anchored on programmes to address the depression; provision of relief for the down and out; debt spending to galvanise recovery; boosting of consumption; public works projects that will stimulate employment; and a robust role for government in re-booting long-term growth.
Roosevelt had been in communication with John Maynard Keynes from across the Atlantic. Keynes supported his New Deal efforts and urged him to stay the course: “If you fail, rational change will be gravely prejudiced throughout the world, leaving orthodoxy and revolution to fight it out. But if you succeed, new and bolder methods will be tried everywhere, and we may date the first chapter of a new economic era from your accession to office.”
One of the most important pieces of legislation that emerged during this period was the Glass-Steagall Act 1933. Before the Act, banks were free to engage in deposit taking as well as underwriting activities and stock market speculation. With the passage of that Act, commercial banking was separated from investment banking.
Economists have continued to debate the effectiveness of the Roosevelt New Deal. Some cynics have argued that recovery was painfully slow and was only galvanised by the demand for war armaments after 1939. A major effect of the 1930s depression was the fact that it spread to Europe and had a particularly destructive impact on Germany. Two decades earlier, at Versailles Settlement of 1919, the victorious Allied powers had imposed ruinous reparations on a defeated Germany. A little known adviser to the British Treasury freshly down from Cambridge, John Maynard Keynes, warned that the Allies were only sowing the seeds of a future catastrophe. Written in his late twenties, The Economic Consequences of the Peace made Keynes an intellectual celebrity throughout the civilised world. Banking collapses in New York forced American creditors to demand early repayments from the Germans, who were facing an unprecedented hyperinflation. The German economy collapsed. Extremist ideologies took over. The country was on the verge of civil war, as fascists and communists clashed. Radicals such as Karl Liebknecht and the revolutionary Marxist economist Rosa Luxemburg were executed by mobs and their bodies dumped in the Landwehr Canal in Berlin. Hitler and the fascists won the democratic elections in 1933. The world was plunged into darkness. It was not before long that the whole of Europe lay in ruins.
The capital lesson: financial crises, if not well managed, can trigger economic collapse, which in turn can trigger a world conflagration.
(Being an abridged version of a lecture to the Workshop of the Financial Services Regulation Coordinating Committee (FSRCC), Organised by the Central Bank of Nigeria, Channel View Hotel, Calabar, Thursday 6 October, 2016).
OBADIAH MAILAFIA