Crisis Economics Part 1

Crisis economics : a crash course in the future of finance.

Nouriel Roubini and Stephen Mihm.

Introduction.

In January 2009, in the final days of the Bush administration, Vice President d.i.c.k Cheney sat down for an interview with the a.s.sociated Press. He was asked why the administration had failed to foresee the biggest financial crisis since the Great Depression. Cheney's response was revealing. "n.o.body anywhere was smart enough to figure [it] out," he declared. "I don't think anybody saw it coming."

Cheney was hardly alone in his a.s.sessment. Look back at the statements that the wise men of the financial community and the political establishment made in the wake of the crisis. Invariably, they offered some version of the same rhetorical question: Who could have known? The financial crisis was, as Cheney suggested in this same interview, akin to the attacks of September 11: catastrophic, but next to impossible to foresee.

That is not true. To take but the most famous prediction made in advance of this crisis, one of the authors of the book-Nouriel Roubini-issued a very clear warning at a mainstream venue in the halcyon days of 2006. On September 7, Roubini, a professor of economics at New York University, addressed a skeptical audience at the International Monetary Fund in Was.h.i.+ngton, D.C. He forcefully sounded a warning that struck many in the audience as absurd. The nation's economy, he predicted, would soon suffer a once-in-a-lifetime housing bust, a brutal oil shock, sharply declining consumer confidence, and inevitably a deep recession.

Those disasters were bad enough, but Roubini offered up an even more terrifying scenario. As homeowners defaulted on their mortgages, the entire global financial system would shudder to a halt as trillions of dollars' worth of mortgage-backed securities started to unravel. This yet-to-materialize housing bust, he concluded, could "lead . . . to a systemic problem for the financial system," triggering a crisis that could cripple or even take down hedge funds and investment banks, as well as government-sponsored financial behemoths like Fannie Mae and Freddie Mac. His concerns were greeted with serious skepticism by the audience.

Over the next year and a half, as Roubini's predictions started coming true, he elaborated on his pessimistic vision. In early 2008 most economists maintained that the United States was merely suffering from a liquidity crunch, but Roubini forecast that a much more severe credit crisis would hit households, corporations, and most dramatically, financial firms. In fact, well before the collapse of Bear Stearns, Roubini predicted that two major broker dealers (that is, investment banks) would go bust and that the other major firms would cease to be independent ent.i.ties. Wall Street as we know it, he warned, would soon vanish, triggering upheaval on a scale not seen since the 1930s. Within months Bear was a distant memory and Lehman Brothers had collapsed. Bank of America absorbed Merrill Lynch, and Morgan Stanley and Goldman Sachs were eventually forced to submit to greater regulatory oversight, becoming bank holding companies.

Roubini was also far ahead of the curve in spotting the global dimensions of the disaster. As market watchers stated confidently that the rest of the world would escape the crisis in the United States, he correctly warned that the disease would soon spread overseas, turning a national economic illness into a global financial pandemic. He also predicted that this hypothetical systemic crisis would spark the worst global recession in decades, hammering the economies of China, India, and other nations thought to be impervious to troubles in the United States. And while other economists were focused on the danger of inflation, Roubini accurately predicted early on that the entire global economy would teeter on the edge of a potentially crippling deflationary spiral, of a sort not seen since the Great Depression.

Roubini's prescience was as singular as it was remarkable: no other economist in the world foresaw the recent crisis with nearly the same level of clarity and specificity. That said, he was not alone in sounding the alarm; a host of other well-placed observers predicted various elements of the financial crisis, and their insights helped Roubini connect the dots and lay out a vision that incorporated their prescient insights. Roubini's former colleague at Yale University, Robert s.h.i.+ller, was far ahead of almost everyone in warning of the dangers of a stock market bubble in advance of the tech bust; more recently, he was one of the first economists to sound the alarm about the housing bubble.

s.h.i.+ller was but one of the economists and market watchers whose views influenced Roubini. In 2005 University of Chicago finance professor Raghuram Rajan told a crowd of high-profile economists and policy makers in Jackson Hole, Wyoming, that the ways bankers and traders were being compensated would encourage them to take on too much risk and leverage, making the global financial system vulnerable to a severe crisis. Other well-respected figures raised a similar warning: Wall Street legend James Grant warned in 2005 that the Federal Reserve had helped create one of "the greatest of all credit bubbles" in the history of finance; William White, chief economist at the Bank for International Settlements, warned about the systemic risks of a.s.set and credit bubbles; financial a.n.a.lyst Na.s.sim Nicholas Taleb cautioned that financial markets were woefully unprepared to handle "fat tail" events that fell outside the usual distribution of risk; economists Maurice Obstfeld and Kenneth Rogoff warned about the unsustainability of current account deficits in the United States; and Stephen Roach of Morgan Stanley and David Rosenberg of Merrill Lynch long ago raised concerns about consumers in the United States living far beyond their means.

The list goes on. But for all their respectability, these and other economists and commentators were ignored, a fact that speaks volumes about the state of economics and finance over recent decades. Most people who inhabited those worlds ignored those warnings because they clung to a simple, quaint belief: that markets are self-regulating ent.i.ties that are stable, solid, and dependable. By this reasoning, the entire edifice of twenty-first-century capitalism-aided, of course, by newfangled financial innovation-would regulate itself, keeping close to a steady, self-adjusting state of equilibrium.

It all seems naive in retrospect, but for decades it was the conventional wisdom, the basis of momentous policy decisions and the rationale for grand-scale investment strategies. In this paradigm, not surprisingly, economic crises had little or no significant place. Indeed, if crises appeared at all, they were freak events: highly improbable, extremely unusual, largely unpredictable, and fleeting in their consequences. To the extent that crises became the object of serious academic study, they were generally considered to afflict less developed, "troubled" countries, not economic powerhouses like the United States.

This book returns crises to the front and center of economic inquiry: it is, in short, about crisis economics. It shows that far from being the exception, crises are the norm, not only in emerging but in advanced industrial economies. Crises-unsustainable booms followed by calamitous busts-have always been with us, and with us they will always remain. Though they arguably predate the rise of capitalism, they have a particular relations.h.i.+p to it. Indeed, in many important ways, crises are hardwired into the capitalist genome. The very things that give capitalism its vitality-its powers of innovation and its tolerance for risk-can also set the stage for a.s.set and credit bubbles and eventually catastrophic meltdowns whose ill effects reverberate long afterward.

Though crises are commonplace, they are also creatures of habit. They're a bit like hurricanes: they operate in a relatively predictable fas.h.i.+on but can change directions, subside, and even spring back to life with little warning. This book sets out the principles by which these economic storms can be tracked and monitored and, within reason, forecast and even avoided. Using the recent crisis as an object lesson, it shows how it's possible to foresee such events and, no less important, prevent them, weather them, and clean up after them. Finally, this book seeks to show how we can rebuild our financial levees so as to blunt the effects of future storms. For what we just lived through is a taste of what is to come. Crises will figure in our future.

To understand why, we will tackle a host of unresolved, lingering questions about the recent disaster, beginning with the most obvious: Why did the bubble behind the worst financial meltdown in decades first form? Was it a function of excessive risk taking by financial inst.i.tutions, made possible by lax regulation and supervision? Or was it the inevitable consequence of excessive government interference in financial markets? These questions cut to the core of very different, even antagonistic ways of understanding financial crises. They also point toward radically different remedies.

This book also examines why the recent crisis. .h.i.t when it did. Was it merely a collapse of confidence, a withering of what John Maynard Keynes called the "animal spirits" of capitalism? Or was it the inevitable consequence of the fact that some portions of the economy were (and arguably remain) excessively leveraged and effectively bankrupt? Put differently, did the crisis result from a mere lack of liquidity or from a more profound lack of solvency? If the latter, what does that portend for the future?

From there the questions multiply. In the midst of the crisis, central bankers around the world became "lenders of last resort" for vast swaths of the financial system. Did their actions prevent something worse from happening? Or will they only encourage excessive risk taking in the future, setting us up for bigger and more destructive bubbles and busts? Likewise, what will be the result of the rush to reregulate? Will it produce a more robust and resilient financial system and more stable growth, or will its effects be merely cosmetic, incapable of preventing more virulent bubbles and crises in the future?

None of these questions are hypothetical. John Maynard Keynes, a giant in twentieth-century economics, once rightly observed that "the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed, the world is ruled by little else. . . . Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back." Keynes wrote those oft-quoted words more than seventy years ago, but they are equally pertinent today. Much of our framing and understanding of the worst financial crisis in generations derives from a set of a.s.sumptions that, while not always wrong, have nonetheless prevented a full understanding of its origins and consequences.

We want to make it clear at the outset that we are not devotees of any particular economist's thought; almost every school of economics has something relevant to say about the recent crisis, and our a.n.a.lysis relies on a range of thinkers. Keynes has his say, but so do other voices. In fact, we believe that understanding and managing crises requires a more holistic and eclectic approach than is perhaps customary. It's necessary to check ideology at the door and look at matters more dispa.s.sionately. Crises come in many colors, and what works in one situation may not work in another.

That same pragmatism pervades this book's a.s.sessment of the financial system's future. Going forward, it asks, should we worry more about inflation or deflation? What will be the long-term consequences of policy measures like the stimulus packages implemented by many countries, never mind the emergency measures undertaken by the Federal Reserve and other central banks? And what is the future of the Anglo-Saxon model of unfettered laissez-faire capitalism? What is the future of the dollar? Does the recent crisis mark the beginning of the end of the American empire, and the rise of China and other emerging economies? Finally, how can we reform global economic governance in order to mitigate the damage from future crises?

The modest ambition of this book is to answer these questions by placing the recent crisis in the context of others that have occurred over the ages and across the world. After all, the past few years conform to a familiar, centuries-old pattern. Crises follow consistent trajectories and yield predictable results. They are far more common and comprehensible than conventional wisdom would lead you to believe. In the pages that follow, we'll move between past and present, revealing how the foregoing questions were asked and answered in the wake of previous crises.

Along the way we'll explain several intimidating and often misunderstood concepts in economics: moral hazard, leverage, bank run, regulatory arbitrage, current account deficit, securitization, deflation, credit derivative, credit crunch, and liquidity trap, to name a few. We hope our explanations will prove useful not only to financial professionals on Wall Street and Main Street but also to corporate executives at home and abroad; to undergraduate and graduate students in business, economics, and finance; to policy makers and policy wonks in many countries; and most numerous of all, to ordinary investors around the world who now know that they ignore the intricacies of the international financial order at their peril.

This book follows a straightforward arc, starting with a history of older crises and the economists who a.n.a.lyzed them. It then addresses the very deep roots of the most recent crisis, as well as the ways this catastrophe unfolded in a very predictable pattern, conforming to time-honored precedents. Finally, the book looks to the future, laying out much-needed reforms of the financial system and addressing the likelihood of other crises in the coming years. Chapter 1 takes the reader on a tour of the past, surveying the many booms, bubbles, and busts that have swept the economic landscape. We focus in particular on the relations.h.i.+p between capitalism and crisis, beginning with the speculative bubble in tulips in 1630s Holland, then ranging forward to the South Sea Bubble of 1720; the first global financial crisis in 1825; the panic of 1907; the Great Depression of the 1930s; and the many crises that plagued emerging markets and advanced economies from the 1980s onward. Crises, we argue, are neither the freak events that modern economics has made them seem nor the rare "black swans" that other commentators have made them out to be. Rather, they are commonplace and relatively easy to foresee and to comprehend. Call them white swans.

In most advanced economies, the second half of the twentieth century was a period of relative, if uncharacteristic, calm, culminating in a halcyon period of low inflation and high growth that economists dubbed the "Great Moderation." As a result, mainstream economics has either ignored crises or seen them as symptoms of troubles in less developed economies. To gain a more expansive way of viewing and understanding crises of the past, present, and future, one must go back to an earlier generation of economists. Chapter 2 introduces economic thinkers who can help us do just that. Some, like John Maynard Keynes, are reasonably well known; others, like Hyman Minsky, are not.

Chapter 3 explains the deep structural origins of the recent crisis. From the beginning, it has been fas.h.i.+onable to blame it on recently issued sub-prime mortgages that somehow infected an otherwise healthy global financial system. This chapter challenges that absurd perspective, showing how decades-old trends and policies created a global financial system that was subprime from top to bottom. Beyond the creation of ever more esoteric and opaque financial instruments, these long-standing trends included the rise of the "shadow banking system," a sprawling collection of nonbank mortgage lenders, hedge funds, broker dealers, money market funds, and other inst.i.tutions that looked like banks, acted like banks, borrowed and lent like banks, and otherwise became banks-but were never regulated like banks.

This same chapter introduces the problem of moral hazard, in which market partic.i.p.ants take undue risks on the a.s.sumption that they will be bailed out, indemnified, and otherwise spared the consequences of their reckless behavior. It also addresses long-standing failures of corporate governance, as well as the role of government itself, though we do not subscribe to the usual contradictory explanations that the crisis was caused by too much government or too little. The reality, we argue, is much more complicated and counterintuitive: government did play a role, as did its absence, but not necessarily in the way that either conservatives or liberals would have you believe.

Several subsequent chapters focus on the crisis itself. Numerous accounts already exist, but almost all have painted it as a singular, unprecedented event particular to twenty-first-century finance. Chapter 4 dispels this naive and simplistic view by comparing it to previous crises. We argue that the events of 2008 would have been familiar to financial observers one hundred or even two hundred years ago, not only in how they unfolded but in how the world's central banks attempted to defuse them by serving as lenders of last resort. The particulars of the crisis differed from those of its predecessors, but in many ways it stuck to a familiar script, amply ill.u.s.trating the old adage that while history rarely repeats itself, it often rhymes.

History confirms that crises are much like pandemics: they begin with the outbreak of a disease that then spreads, radiating outward. This crisis was no different, though its origin in the world's financial centers rather than in emerging markets on the periphery made it particularly virulent. Chapter 5 tracks how and why the crisis went global, hammering economies as different as Iceland, Dubai, j.a.pan, Latvia, Ireland, Germany, China, and Singapore. We break with the conventional wisdom that the rest of the world merely caught a disease that originated in the United States. Far from it: the vulnerabilities that plagued the U.S. financial system were widespread-and in some cases, worse-elsewhere in the world. The pandemic, then, was not indiscriminate in its effects; only countries whose financial systems suffered from similar frailties fell victim to it.

While other books on the financial crisis focus heavily or exclusively on the United States, this one frames it as a broad crisis in twenty-first-century global capitalism. By tracing its sometimes surprising international dimensions, chapter 5 uncovers truths about global finance, international macroeconomics, and the cross-border implications of national monetary and fiscal policy. The crisis can tell us a great deal about the workings of the global economy in both normal times and not-so-normal times.

All crises end, and this one was no exception. Unfortunately, the aftershocks will linger on for years if not decades. Chapter 6 shows why they do, and why deflation and depression loom large in the wake of any crisis. In the past, central bankers used monetary policy to counter crises, and now they've revived some of these approaches. At the same time, many financial crises force central bankers to innovate on the fly, and the recent crisis was no exception. Unfortunately, while these emergency measures may work, they can, like any untested remedy, end up poisoning the patient.

That's the case with fiscal policies as well. In chapter 7 we examine how policy makers used the government's power to tax and spend in order to arrest the spread of the crisis. Some of these tactics were first articulated by Keynes; many more represented a ma.s.sive, unprecedented intervention in the economy. This chapter a.s.sesses the future implications of the most radical measures, particularly the risks they may create down the line.

The level of intervention necessary to stabilize the system challenges the sustainability of traditional laissez-faire capitalism itself; governments may end up playing a much larger direct and indirect role in the postcrisis global economy, via increased regulation and supervision. Chapters 8 and 9 lay out a blueprint for a new financial architecture, one that will bring new transparency and stability to financial inst.i.tutions. Long-term reforms necessary for stabilizing the international financial system include greater coordination among central banks; binding regulation and supervision of not just commercial banks but also investment banks, insurance companies, and hedge funds; policies to control the risky behavior of "too big to fail" financial firms; the need for more capital and liquidity among financial inst.i.tutions; and policies to reduce the problem of moral hazard and the fiscal costs of bailing out financial firms. These chapters also grapple with the vexing question of what future role central banks should play to control and pop a.s.set bubbles.

Chapter 10 tackles the serious imbalances in the global economy and the more radical reforms of the international monetary and financial order that may be necessary to prevent future crises. Why have so many emerging-market economies suffered financial crises in the last twenty years? Why has the United States run ma.s.sive deficits, while Germany, j.a.pan, China, and a host of emerging-market economies have run surpluses? Will these current account imbalances-which were one of the causes of the financial crisis-be resolved in an orderly or a disorderly way? Could the U.S. dollar crash, and if so, what would replace it as a global reserve currency? What role can a reformed IMF play in reducing global monetary distortions and financial crises? And should the IMF become a true international lender of last resort?

This part of the book recognizes an inescapable truth: the ability of the United States, much less the G-7, to dictate the terms of these reforms is limited. These changes in global economic governance will play out under the watchful eye of a much more extensive group of stakeholders: Brazil, India, China, Russia, and the other countries that make up the ascendant G-20. These increasingly powerful nations will profoundly shape the handling of future crises; so will a host of new players and inst.i.tutions in the global financial system, like sovereign wealth funds, offsh.o.r.e financial centers, and international monetary unions.

The final "Outlook" section surveys the road ahead, taking a hard look at the many dangers that await the world economy. The crisis that gave us the Great Recession may be over for now, but potential pitfalls and risks loom large. What issues will determine the future volatility of the world economy and its financial system? Will the global economy return to high growth, or will it experience a long period of subpar and anemic growth? Has the loose monetary policy adopted in the wake of the crisis created a risk of new a.s.set bubbles that will go bust? How will the U.S. government and other governments deal with the ma.s.sive amounts of debt a.s.sumed on account of the crisis? Will the government resort to high inflation to wipe out the real value of public and private debts, or will deflation pose the bigger danger? What is the future of globalization and of market economies? Will the pendulum swing toward greater government intervention in economic and financial affairs, and what will be the consequences of such a s.h.i.+ft? While many commentators have a.s.sumed that the future belongs to China and that the United States is destined for a long decline, this look to the future sets out various scenarios in which both existing and emerging economies might survive and thrive-or struggle and collapse.

More generally, the final chapters of the book wrestle with several open questions: How will globalization affect the probability of future crises? How will we resolve the global imbalances that helped create the recent crisis? How, in other words, will we reform global capitalism? Here too the lessons of the past may have some bearing. After all, we've been down this road before, many times. In 1933 John Maynard Keynes declared, "The decadent international but individualistic capitalism, in the hands of which we found ourselves after the [First World] war, is not a success. It is not intelligent, it is not beautiful, it is not just, it is not virtuous-and it doesn't deliver the goods. In short we dislike it, and we are beginning to despise it. But when we wonder what to put in its place, we are extremely perplexed."

That perplexity was eventually resolved, and it will be once again. This book contributes to that resolution, giving some sense of how to reform a capitalism that has delivered serial crises instead of delivering the goods on a consistent and stable basis. Indeed, while market-oriented reforms have taken many emerging market economies out of endemic poverty and under-development, the frequency and virulence of economic and financial crises have increased in both emerging markets and industrial economies. To that end, we offer a road map, not merely of how we got into this mess, but how we can get out-and stay out.

Chapter 1.

The White Swan.

When did the boom begin? Perhaps it began with the sudden mania for flipping real estate, when first-time speculators bought and sold subdivision lots like shares of stock, doubling and tripling their profits in weeks if not days. Or possibly things got out of balance when the allure of a new economy founded on new technology and new industries drew ordinary people to wager their life savings on Wall Street.

Politicians and policy makers, far from standing in the way of these get-rich-quick schemes, encouraged them. No less an authority than the president of the United States proclaimed that government should not bother business, while the Federal Reserve did little to stem the speculative tide. Financial innovation and experimentation were hailed for their tremendous contributions to economic growth, and new kinds of financial firms emerged to market little-understood securities to inexperienced investors and to make extensive lines of credit available to millions of borrowers.

At some point the boom became a bubble. Everyone from high-flying banks to ordinary consumers leveraged themselves to the hilt, betting on the dubious yet curiously compelling belief that prices could only go up. Most economists blessed this state of affairs, counseling that the market was always right; it was best not to interfere. The handful of dissidents who warned of a coming crash found themselves mocked if not ignored.

Then came the crash, and as it echoed up and down in the canyons of Wall Street, venerable inst.i.tutions tottered, besieged by fearful creditors. During lulls in the storm, some declared that the worst had pa.s.sed, but then conditions worsened. Financial firms slid toward the abyss, and though a few investment banks-most notably Goldman Sachs-managed to escape the conflagration, other storied firms collapsed overnight. Lines of credit evaporated, and the financial system's elaborate machinery of borrowing and lending seized up, leaving otherwise creditworthy companies scrambling to refinance their debts.

As the stock market crashed, foreclosures mounted, firms failed, and consumers stopped spending. Vast Ponzi schemes came to light, as did evidence of widespread fraud and collusion throughout the financial industry. By then the sickness in the United States had spread to the rest of the world, and foreign stock markets, banks, and investment firms came cras.h.i.+ng down to earth. Unemployment soared, industrial production plummeted, and falling prices raised the specter of deflation. It was the end of an era.

What we're describing didn't happen a couple of years ago; it happened more than eighty years ago, on the eve of the Great Depression. Then as now, speculative bubbles in real estate and stocks, minimal financial regulation, and a flurry of financial innovation conspired to create a bubble that, when it burst, set the stage for the near collapse of the financial system on Wall Street, a brutal economic downturn on Main Street, and a worldwide bust. That the recent crisis bears so many eerie similarities to a catastrophe that unfolded decades ago is not a coincidence: the same forces that gave rise to the Great Depression were at work in the years leading up to our very own Great Recession.

Even more striking, the irrational euphoria, the pyramids of leverage, the financial innovations, the a.s.set price bubbles, the panics, and the runs on banks and other financial inst.i.tutions shared by these two episodes are common to many other financial disasters as well. Change a few particulars of the foregoing narrative, and you could be reading about the infamous South Sea Bubble of 1720, the global financial crisis of 1825, the boom and bust that foreshadowed j.a.pan's Lost Decade (1991-2000), the American savings and loan crisis, or the dozens of crises that hammered emerging markets in the 1980s and 1990s.

In the history of modern capitalism, crises are the norm, not the exception. That's not to say that all crises are the same. Far from it: the particulars can change from disaster to disaster, and crises can trace their origins to different problems in different sectors of the economy. Sometimes a crisis originates in the excesses of overleveraged households; at other times financial firms or corporations or even governments are to blame. Moreover, the collateral damage that crises cause varies greatly; much depends on the scale and appropriateness of government intervention. When crises a.s.sume global dimensions, as the worst ones so often do, much hangs on whether cooperation or conflict characterizes the international response.

The stakes could not be higher. When handled carelessly, crises inflict staggering losses, wiping out entire industries, destroying wealth, causing ma.s.sive job losses, and burdening governments with enormous fiscal costs. Even worse, crises have toppled governments and bankrupted nations; they have driven countries to wage retaliatory trade battles. Crises have even paved the way for wars, much as the Great Depression helped set the stage for World War II. Ignoring them is not an option.

Creatures of Habit.

Early in 2007, when signs of a looming housing and subprime mortgage crisis in the United States appeared on the horizon, the initial reaction was disbelief and denial. In March, Federal Reserve chairman Ben Bernanke confidently told Congress, "At this juncture, however, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained." That summer Treasury Secretary Henry Paulson dismissed the threat of the subprime mortgage meltdown: "I don't think it poses any threat to the overall economy."

Even after the crisis exploded, this refusal to face facts persisted. In May 2008, after the collapse of Bear Stearns, Paulson offered a characteristically upbeat a.s.sessment. "Looking forward," he said, "I expect that financial markets will be driven less by the recent turmoil and more by broader economic conditions and, specifically, by the recovery of the housing sector." That summer saw the collapse of mortgage giants Fannie Mae and Freddie Mac, yet even then many remained optimistic.

Perhaps the most infamous bit of cheerleading came from stock market guru and financial commentator Donald Luskin, who on September 14, 2008, penned an op-ed in The Was.h.i.+ngton Post laying out the case for a quick recovery. "Sure," he conceded, "there are trouble spots in the economy, as the government takeover of mortgage giants Fannie Mae and Freddie Mac, and jitters about Wall Street firm Lehman Brothers, amply demonstrate. And unemployment figures are up a bit too." But "none of this," he forcefully argued, "is cause for depression-or exaggerated Depression comparisons. . . . Anyone who says we're in a recession, or heading into one-especially the worst one since the Great Depression-is making up his own private definition of 'recession.' " The next day Lehman Brothers collapsed, the panic a.s.sumed global proportions, the world's financial system went into a cardiac arrest, and for two quarters the global economy experienced a free fall comparable to that of the Great Depression.

As it became apparent that the crisis was real, many commentators tried to make sense of the disaster. Plenty of people invoked Na.s.sim Nicholas Taleb's concept of the "black swan" to explain it. Taleb, whose book of that t.i.tle came out on the eve of the crisis, defined a "black swan event" as a game-changing occurrence that is both extraordinarily rare and well-nigh impossible to predict. By that definition, the financial crisis was a freak event, albeit an incredibly important and transformational one. No one could possibly have seen it coming.

In a perverse way, that idea is comforting. If financial crises are black swans, comparable to plane crashes-horrific but highly improbable and impossible to predict-there's no point in worrying about them. But the recent disaster was no freak event. It was probable. It was even predictable, because financial crises generally follow the same script over and over again. Familiar economic and financial vulnerabilities build up and eventually reach a tipping point. For all the chaos they create, crises are creatures of habit.

Most crises begin with a bubble, in which the price of a particular a.s.set rises far above its underlying fundamental value. This kind of bubble often goes hand in hand with an excessive acc.u.mulation of debt, as investors borrow money to buy into the boom. Not coincidentally, a.s.set bubbles are often a.s.sociated with an excessive growth in the supply of credit. This could be a consequence of lax supervision and regulation of the financial system or even the loose monetary policies of a central bank.

At other times a.s.set bubbles develop even before the credit supply booms, because expectations of future price increases are sufficient to foster a self-fulfilling rise in the a.s.set's price. A major technological innovation-the invention of railroads, for example, or the creation of the Internet-may lead to expectations of a brave new world of high growth, triggering a bubble. No such new technology prompted the current housing-driven crisis, although the complex securities manufactured in Wall Street's financial laboratories may qualify, even if they did little to create real economic value.

But that would not be new either. Many bubbles, while fueled by concrete technological improvements, gain force from changes in the structure of finance. In the last few hundred years, many of the most destructive booms-turned-bust have gone hand in hand with financial innovation, the creation of newfangled instruments and inst.i.tutions for investing in whatever is the focus of a speculative fever. They could be new forms of credit or debt, or even new kinds of banks, affording investors novel opportunities for partic.i.p.ating in a speculative bubble.

Regardless of how the boom begins, or the channels by which investors join it, some a.s.set becomes the focus of intense speculative interest. The coveted a.s.set could be anything, but equities, housing, and real estate are the most common. As its price shoots skyward, optimists feverishly attempt to justify this overvaluation. When confronted with the evidence of previous busts, they claim, "This time is different." Wise men and women a.s.sert-and believe-that the economy has entered a phase where the rules of the past no longer apply. The recent housing bubble in the United States followed this script with remarkable fidelity: real estate was said to be a "safe investment" that "never lost value" because "home prices never fall." The same was said of the complex securities built out of thousands of mortgages.

From such beginnings, financial disasters proceed along a predictable path. As credit becomes increasingly cheap and abundant, the coveted a.s.set becomes easier to buy. Demand rises and outstrips supply; prices consequently rise. But that's just the beginning. Because the a.s.sets at the heart of the bubble can typically serve as collateral, and because the value of the collateral is rising, a speculator can borrow even more with each pa.s.sing day. In a word, borrowers can become leveraged.

Again, this pattern played out from 2000 in the United States: as home values rose markedly and wages stagnated, households used their homes as collateral in order to borrow more, most often in the form of a home equity withdrawal or home equity loans; people effectively used their homes as ATM machines. As housing prices climbed, borrowers could borrow even more, using what they'd purchased-home improvements, even second homes-as additional collateral. By the fourth quarter of 2005, home equity withdrawals peaked at an annualized rate of a trillion dollars, enabling millions of households to live well beyond their means. At the same time, the household savings rate plunged to zero, then went into negative territory for the first time since the Great Depression. However unsustainable, this debt-financed consumption had real economic effects: households and firms purchasing goods and services fueled economic growth.

Such a dynamic creates a vicious cycle. As the economy grows, incomes rise and firms register higher profits. Worries about risk drop to record lows, the cost of borrowing falls, and households and firms borrow and spend more with ever greater ease. At this point, the bubble is not just a state of mind but a force for economic change, driving growth and underwriting new and increasingly risky business ventures, like housing subdivisions in the desert.

In the typical boom-and-bust cycle, people are still saying, "This time is different," and claiming that the boom will never end, even though all the elements of a speculative mania-"irrational exuberance" and growing evidence of reckless, even fraudulent, behavior-are in place. American homeowners, for example, enthusiastically embraced the fiction that home prices could increase 20 percent every year forever, and on the basis of that belief they borrowed more and more. The same euphoria held sway in the shadow banking system of hedge funds, investment banks, insurers, money market funds, and other firms that held a.s.sets that appreciated as housing prices boomed.

At some point, the bubble stops growing, typically when the supply for the bubbly a.s.set exceeds the demand. Confidence that prices will keep rising vanishes, and borrowing becomes harder. Just as a fire needs oxygen, a bubble needs leverage and easy money, and when those dry up, prices begin to fall and "deleveraging" begins. That process began in the United States when the supply of new homes outstripped demand. The excessive number of homes built during the boom collided with diminished demand, as excessively high prices and rising mortgage rates deterred buyers from wading any further into the market.

When the boom becomes a bust, the results are also predictable. The falling value of the a.s.set at the root of the bubble eventually triggers panicked "margin calls," requests that borrowers put up more cash or collateral to compensate for falling prices. This, in turn, may force borrowers to sell off some of their a.s.sets at fire-sale prices. Supplies of the a.s.set soon far outstrip demand, prices fall further, and the value of the remaining collateral plunges, prompting further margin calls and still more attempts to reduce exposure. In a rush for the exits, everyone moves into safer and more liquid a.s.sets and avoids the a.s.set at the focus of the bubble. Panic ensues, and just as prices exceeded their fundamental value during the bubble, prices fall well below their fundamental values during the bust.

That's what happened over the course of 2007 and 2008. As homeowners defaulted on their mortgages, the value of the securities derived from those loans collapsed, and the bust began. Eventually the losses suffered by highly leveraged financial inst.i.tutions forced them to hunker down and limit their exposure to risk. As happens in every bust, the banks overcompensated: they trimmed their sails, curtailed lending, and thereby triggered an economy-wide liquidity and credit crunch. Individuals and firms could no longer "roll over," or refinance, their existing debt, much less spend money on goods and services, and the economy began to contract. What started as a financial crisis spilled over into the real economy, causing plenty of collateral damage.

That's the recent crisis in a nutsh.e.l.l, but it could be the story of almost any financial crisis. Contrary to conventional wisdom, crises are not black swans but white swans: the elements of boom and bust are remarkably predictable. Look into the recent past, and you can find dozens of financial crises. Further back in time, before the Great Depression, many more lurk in the historical record. Some of them hit single nations; others reverberated across countries and continents, wreaking havoc on a global scale. Yet most are forgotten today, dismissed as relics of a less enlightened era.

The Dark Ages.

Financial crises come in many shapes and guises. Before the rise of capitalism, they tended to be a result of government malfeasance. From the twelfth century onward, governments of countries and kingdoms as diverse as Spain and England debased their currencies, cutting the gold or silver content of coins while maintaining the fiction that the new coins were worth as much as the old. These naked attempts to discharge debts in depreciated currency became even easier with the advent of paper money. Governments could literally print their way out of debt. The Chinese pioneered this practice as early as 1072; European nations adopted it much later, beginning in the eighteenth century.

A government that owed money to foreign creditors could take a more honest route and simply default, much as Edward III did in the mid-fourteenth century. Having borrowed money from Florentine bankers, he refused to pay it back, sowing chaos in Italy's commercial centers. It was a harbinger of things to come; plenty of other sovereigns took this route, with predictable consequences for their creditors. Austria, France, Prussia, Portugal, and Spain all defaulted on their debts at various times from the fourteenth century onward.

While important and destabilizing, these episodes were crises of confidence in overindebted governments, not of capitalism. But with the emergence of the Netherlands as the world's first capitalist dynamo in the sixteenth and seventeenth centuries, a new kind of crisis made its appearance: the a.s.set bubble. In the 1630s "tulip mania" gripped the country, as speculators bid up the prices of rare tulip bulbs to stratospheric levels. While historians continue to debate the consequences of this bit of speculative fever (and some economists even deny it was a bubble, arguing that all bubbles are driven by fundamentals), it set the stage for larger bubbles whose destructive effects are not in doubt. Most infamous was John Law's Mississippi Company, a sprawling speculative venture that dominated the French economy in the late 1710s. At its peak in 1719, Law's company controlled several other trading companies, the national mint, the national bank, the entire French national debt, and for good measure much of the land that would become the United States.

Not to be outdone, the British caught the bubble bug around the same time. At the center was a corporation known as the South Sea Company, which at its height effectively controlled much of the British national debt. Speculation in its shares gave rise to a mania for stocks of all kinds, including many fraudulent corporations. After the company's stock price increased by 1,000 percent, the day of reckoning came: the stock market crashed, leaving the economy in shambles and a generation of British investors wary of financial markets. An even more devastating crisis. .h.i.t France at the same time, as Law's schemes unraveled spectacularly, stunting the development of financial inst.i.tutions for decades.

These crises figure significantly in any standard history of speculative manias, panics, and crashes, but they did not trigger global financial crises. By contrast, the panic of 1825 reverberated around the world. It began in Britain and had all the hallmarks of a cla.s.sic crisis: easy money (courtesy of the Bank of England), an a.s.set bubble (stocks and bonds linked to investments in the emerging market of newly independent Peru), and even widespread fraud (feverish selling of the bonds of a fict.i.tious nation called the Republic of Poyais to credulous investors).

When the bubble burst, numerous banks and nonfinancial firms in Britain failed. It was, the English economist Walter Bagehot recalled, "a period of frantic and almost inconceivable violence; scarcely anyone knew whom to trust; credit was almost suspended; [and] the country was . . . within twenty-four hours of [entering] a state of barter." Bagehot, one of the first writers to argue that a central bank should act as a lender of last resort when a panic and bank run occurs, lamented that "applications for a.s.sistance were made to the Government, but . . . the Government refused to act." The financial crisis quickly spread to the rest of Europe, and panicked investors pulled money out of Latin America. By 1828 every country on the continent except Brazil had defaulted on its public debt. It took three decades for the flow of capital to the region to return to earlier levels.

No less global in scope was the panic of 1857. The boom began in the United States, with speculation in slaves, railroads, financial instruments, and land. The bubble burst, and banks in New York City panicked, curtailing credit and trying to sh.o.r.e up their positions, but to no avail: holders of the banks' obligations presented them for redemption, draining the banks of gold and silver reserves, a cla.s.sic case of a bank run. A little over a month later, panic hit London, and the Bank of England's reserves were drawn down with similar speed. The panic spread to the rest of Europe and from there to India, China, the Caribbean, South Africa, and Latin America. Countries around the world saw their economies suffer, and the crisis put an end to one of the longest economic expansions in modern times.

The most dramatic nineteenth-century global meltdown may have been the crisis of 1873. Once again, investors in Britain and continental Europe made enormous speculative investments in railroads in the United States and Latin America, as well as other projects. Worse, reparations paid by France to Germany in the wake of the Franco-Prussian War sparked a speculative boom in German and Austrian real estate. When this boom collapsed, the stock markets in Vienna, Amsterdam, and Zurich imploded, prompting European investors to liquidate overseas investments. This put strain on the United States, which itself was in the grip of a speculative boom in railroad securities. When the investment banker Jay Cooke failed to find buyers for securities issued to underwrite construction of the new Northern Pacific Railroad, both his bank and the railroad collapsed, triggering a ma.s.sive panic on Wall Street. This calamity sparked further secondary panics in Europe, and much of the world plunged into a brutal economic depression and a deflationary spiral. In the United States a quarter of the nation's railroads went under, while soaring unemployment and wage cuts led to b.l.o.o.d.y riots and strikes. The collapse in the global economy had particularly pernicious effects outside the United States and Europe, hitting the Ottoman Empire, Greece, Tunisia, Honduras, and Paraguay.

This account is but a sampling of the crises that plagued the nineteenth century; there were many, many more: the panics of 1819, 1837, 1866, and 1893, to name a few. All had their unique qualities, but many shared a common set of features. Typically they began in more developed economies after excessive speculative lending and investments went bust, triggering a banking crisis. As the global economy sputtered and slowed, countries on the periphery that depended on exporting commodities saw their economies wither. Government revenue collapsed, leading some countries to default on their domestic debt, if not loans from overseas. In some cases, these defaults spurred additional meltdowns at the economic core, as investors in these emerging markets lost their s.h.i.+rts.

The early twentieth century saw its shares of panics too. The crisis of 1907 began in the United States after a speculative boom in stocks and real estate collapsed. So-called trust companies-lightly regulated commercial banks bound together by complicated chains of owners.h.i.+p-suffered runs on their reserves, and panic spread throughout the country. The stock market crashed, and as the crisis spiraled out of control, the nation's most powerful banker, J. P. Morgan, convened a series of emergency meetings with New York City's banking establishment to stop the bank run. On the first weekend of November, Morgan, in a famous act of brinksmans.h.i.+p, invited the bankers to his private library. When they failed to agree to come to one another's aid, he locked them in a room and pocketed the key. The bankers eventually agreed, and the crisis came to an end shortly thereafter. While Morgan received credit for averting a catastrophe, the events of 1907 persuaded many of the need for a central bank to provide lender-of-last-resort support in future crises, and six years later the Federal Reserve was born.

In theory, a central bank like the Federal Reserve can serve as a bulwark against financial crises, providing lender-of-last-resort support in the event of a bank run. But during the catastrophic crash of 1929, as the crisis spun out of control, the Fed stood idly by. Rather than pursuing an expansionary monetary policy, it tightened the reins, making a bad situation even worse. As a consequence, the money supply sharply contracted between 1929 and 1933, leading to a severe liquidity and credit crunch that turned a stock market bust into a banking crisis and eventually into a severe economic depression.

The reaction of the rest of the federal government wasn't much better. Andrew Mellon, Herbert Hoover's Treasury secretary, believed a purge was necessary. Hoover described Mellon as a "leave-it-alone liquidationist" who had no pity for those caught in the crisis. "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate," Mellon was said to have counseled. Mellon believed that financial panic would "purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life."

Perhaps, but from 1929 to 1933 the United States plunged into the worst depression in its history. Unemployment rates shot from 3.2 percent to 24.9 percent; upwards of nine thousand banks suspended operations or closed, and by the time Franklin Delano Roosevelt took office, a good part of the nation's financial system had effectively collapsed, much as it had in other countries around the world. Many of those other countries experienced comparable rates of unemployment and economic decline. Currency wars led to trade wars. In the United States the infamous Smoot-Hawley Tariff triggered retaliatory tariffs across the world and contributed to a breakdown of world trade. Many nations in Europe eventually depreciated their currencies, debased their debts via inflation, and even formally defaulted on debts, including Germany, where the crisis paved the way for Hitler's rise to power and the worst war in human history.

For all its horrific consequences, World War II made possible a wholesale transformation of the world's financial system. In 1944, as the end of the war drew near, economists and policy makers from the Allied nations met in Bretton Woods, New Hamps.h.i.+re, to hammer out a new world economic order. Their deliberations gave rise to the International Monetary Fund, as well as the forerunner of the World Bank, and a new system of currency exchange rates known as the Bretton Woods system or dollar exchange standard. In this system, every nation's currency would be exchanged into dollars at a fixed rate. Foreign countries that held dollars then had the option of redeeming them for U.S. gold at the price of thirty-five dollars an ounce. In effect, the dollar became the world's reserve currency, while the United States alone remained on a gold standard in its dealings with other countries. Thus began a remarkable-and extraordinarily anomalous, given the previous centuries' crises-era of financial stability, a pax moneta that depended on the dollar and on the military and economic power of the newly ascendant United States. That stability rested as well on the widespread provision of deposit insurance to stop bank runs; strict regulation of the financial system, including the separation of American commercial banking from investment banking; and extensive capital controls that reduced currency volatility. All these domestic and international restrictions kept financial excesses and bubbles under control for over a quarter of a century.

All good things come to an end, and the postwar era was no exception: the Bretton Woods system fell apart in 1971, when the United States finally went off the last vestiges of the gold standard. The reason? The twin U.S. fiscal and current account deficits (which we will discuss in chapter 10) triggered by the Vietnam War caused an acc.u.mulation of dollar reserves by the creditors of the United States-primarily Western Europe and j.a.pan-that became unsustainable. In effect, the creditors of the United States realized that there wasn't enough gold to back up the dollars in circulation. When that happened, Bretton Woods collapsed, the dollar depreciated, and the world moved to a system of flexible exchange rates.

This move unshackled monetary authorities that, freed of the constraints of a fixed-rate regime, could now print as much money as they wanted. The result was a rise in inflation and commodity prices, even before the 1973 Yom Kippur War led to an oil embargo and a quadrupling of oil prices. Stagflation, a deadly combination of high inflation and recession, followed the two oil shocks of 1973 and 1979 (the latter triggered by the Iranian Revolution) as well as the botched monetary policy response to these shocks. It took a new Federal Reserve chairman, Paul Volcker, to set things right. He sharply raised interest rates to stratospheric levels, triggering a severe double-dip recession in the early 1980s. While brutal, this shock treatment worked, breaking the back of inflation and ushering in a decade of growth.

Every silver lining has its cloud: Volcker's policies also helped trigger the Latin American debt crisis of the 1980s. In the 1970s many Latin American governments embarked on ma.s.sive economic development projects financed with foreign capital. The resulting fiscal and current account deficits were financed with loans brokered by banks in the United States and Europe. The interest rates on these foreign currency loans were linked to a benchmark short-term interest rate known as the London Interbank Offered Rate (LIBOR). When Volcker hiked interest rates, the LIBOR rate rose sharply as well, making it impossible for Latin American countries to service their debts. Even worse, the real value of these debts rose as these countries' currencies depreciated.

As a consequence, multiple governments defaulted on their debt. In Mexico in 1982, the default ushered in an economic collapse that led to the nationalization of Mexico's private banking system and then a devastating recession; Brazil, Argentina, and other countries in Latin America soon followed suit. In many ways, these defaults replayed earlier crises, as events in the world's leading economies reverberated in less developed countries.

The Latin American debt crisis had profound consequences: lost growth, political instability, and social unrest throughout the region. Only in the late 1980s, when the loans were reduced in face value and converted into bonds (the "Brady bonds"), did the region start to recover. Many banks in the United States and Europe struggled to recuperate as well. It took an enormous amount of regulatory forbearance and international crisis management, led by the United States and the IMF, to stop the banks from going under.