Modeling a Typical Financial Crisis

Last week, I came across someone mentioning Bagehot's law, which is essentially “Lend without limit, to solvent firms, against good collateral, at a penalty rate”.  Bagehot was most well known in his time for being the editor of the Economist, a newspaper Lenin called “a journal which speaks for British millionaires”. But I think that we should not dismiss him for his class position. He was worried about the same things we’re worried about in the material well being of the country. He wrote this in the shadow of the panic of 1873, which led to what is known as the Long Depression or alternatively the Great Depression before the one sixty years later stole that title. This downturn is forgotten today except for in the minds of nineteenth history historians and some economists, but Bagehot’s rule lives on. He was cited for the bailouts after 2008, even if we didn’t know how solvent the firms were, or how good the collateral was, or if we used a high enough penalty rate to make the backstop hurt enough. 

That we can still invoke Bagehot’s law means that we can still see the outlines of the business cycle and see the ups and downs of the cycle as a broader phenomenon that can be modeled. Though, as Charles Kindleberger argues in his book “Manias, Panics, and Crashes,” the historians want to look closely and describe each crash in detail – and for those who have lived through a crash, it feels like a uniquely malevolent event that is specifically targeting you, especially in the west as there have been fewer crashes in recent generations.

We can pull back and describe a typical crash in broad outlines, and that is what Kindleberger does in chapter two of his book. Kindleberger uses the work of Minsky to draw his model. In this view, the crash is based on the flows of credit. As the economy is growing, leverage is growing, and people are more optimistic about the value of assets and the future path of growth. So, the economy is growing, and banks are handing out money. The growth comes from an exogenous event. Some sort of positive shock from outside the system makes people rethink their positions, and the future path of growth and the riskiness of the assets they have borrowed to hold. This positive shock keys a boom; a sense that this time is different. Kindleberger notes that the shocks have varied, from highway growth to internet technology. Credit and the boom go hand in hand, a self-reinforcing cycle. This might tip the economy into a euphoric state where demand outpaces supply, driving up prices and creating inflation. Though in retrospect it seems that these steps should have been obvious that they were leading to ruin, to not participate in the boom and even the mania leaves you open to the charge that you are leaving money on the table. As a businessperson or even just an individual, the worst thing in the world isn’t not getting rich. The worst thing is to not get rich while those around you are getting rich. The boom can spread – money flows outward from the manias, as cash is thrown off by the investments. Lots of capital sit there waiting for something to do. The Japanese bought real estate in Manhattan, AOL merged with Time Warner, every time, this was the new economy that could do no wrong.

The mania finds a top though. It always has. People who were late to the game start buying in, the shoeshine boy is passing stock tips around. Everyone gets sucked into the point where the first movers start looking for opportunities to take their profit. Fewer people on the sidelines means the prices aren’t being bid up as fast anymore. People start to wonder if this is the top. So, they sell out. Others see that and they sell out. The credit tsunami has crashed, people start trying to sell out. There are more sellers than buyers and asset prices slump. People who had borrowed based on higher prices start to see their debt obligations as insurmountable, so they must sell. The crash happens, either all at once or in slow motion. I leave the bottom to Kindleberger in this beautiful sentence: “The panic feeds on itself until prices have declined so far and have become so low that investors are tempted to buy the less liquid assets, or until trade in the assets is stopped by setting limits on price declines, shutting down exchanges or otherwise closing trading, or a lender of last resort succeeds in convincing investors that money will be made available in the amounts needed to meet the for cash and that hence security prices will no longer decline because of a shortage of liquidity” (32-3)

The question is if you accept this sort of model of growth to mania to crash is how to you prevent it? In the run-up there is all sorts of malinvestment, capital that is in hindsight poorly invested but made sense to throw at the projects. For example, in Chicago there is a hole in the ground by the river where they were going to build a 2000-foot corkscrew, the worlds tallest all-residential tower. The plans looked nice, until the real-estate bubble crashed. Do you intervene to stop the bubble, and can you even identify one as it is running up? Greenspan warned of “irrational exuberance” in 1996 and he still let it run. It is hard policy-wise to step in and say you are creating too much wealth right now, let me stop it - -even if that is part of the central bank’s job. The other thing to do is wait around until the crash and try to make it as soft a landing as possible. Even then, we have the problem we saw above. Bagehot said to solvent business against good collateral – both of those can be hard to find as the world starts burning. If you don’t do something then you’re doing nothing, stepping aside until the bottom is found and letting the cycle run again and again until the world ends.