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October 5, 2008
David Warsh, Proprietor

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Some Bodkin!

How peculiar is it that the leading introductory economics texts scarcely mention the cycles of manias, panics and crashes that have been a familiar feature of global capitalism since its emergence in the seventeenth century?

 No propensity to bubble or bail is among the ten big ideas that govern economics in N. Gregory Mankiw’s text, for example. Ben Bernanke, in the book he wrote with Robert Frank before he became chairman of the Fed, discusses the 1990s banking crisis in Japan, the episode in the US and the Argentine collapse in 2001, along with the Great Depression, on which he is an expert; he even mentions in passing the “reckless lending” that led to the US savings and loan crisis in the 1980s: but the tendency to repeated financial crises is not remarked, and neither “bubble” nor “credit crunch” appear in the glossary. 

There’s a lucid discussion of banking panics in Paul Krugman’s principles text with Robin Wells; he asks whether the Fed should have sought to puncture the stock bubble of the late ’90s: but the “sovereign debt bomb” of the ’70s and the S&L crisis of the ’80s have disappeared in the dim mists of time.  Even Karl Case and Ray Fair don’t make much of a case for the perennial nature of crises (at least in my edition), though Case, of Wellesley College, and his colleague Robert Shiller, of Yale University, have played a prescient and central role in the analysis of the real estate crash.

As usual, William Nordhaus and Paul Samuelson tee up the issue with the greatest clarity in their textbook, but mainly as a prelude to a discussion of personal investment strategies:  “The history of finance is one of the most exciting, and sobering, parts of economics. As Burton Malkiel writes in his survey of bubbles, panics and the madness of crowds, ‘Greed run amok has been an essential feature of every spectacular boom in history.’”


So it falls to government officials and hordes of commentators to begin anew the discussion of each succeeding episode, explaining the role of the lender of last resort, the various strategies available to governments and their respective perils – except, of course, for the work of a handful of historical economists, for whom financial crises are central.


The greatest of these was Walter Bagehot, 1826-1877, a businessman, journalist (editor of The Economist for several years) and author of, among other books, Lombard Street.  It was Bagehot who, in his essay on Edward Gibbon, produced the classic description of the cycle:

 Much has been written about panics and manias, much more than with the most outstretched intellect we are able to follow or conceive; but one thing is certain, that at particular times a great deal of stupid people have a great deal of stupid money…. At intervals, from causes which are not to the present purpose, the money of these people – the blind capital, as we call it, of the country – is particularly large and craving; it seeks for someone to devour it, there is a “plethora;” it finds someone, and there is “speculation;” it is devoured, and there is “panic.”

And it was Bagehot who, in Lombard Street, did the most to legitimize  the concept of government as a lender of last resort, chiefly the central bank (though, under some circumstances, also the Treasury). It’s not that the idea was entirely new.  Even as staunch an advocate of laissez faire as the banker Lord Overstone, a distinguished opponent of Bagehot’s views, had acknowledged that a  panic might sometimes require “that power, which all governments necessarily possess, of exercising special interference in unforeseen emergency and great state necessity.” On another occasion, he added, “There is an old Eastern proverb which says, you may with a bodkin stop a fountain, which if suffered to flow, will sweep away whole cities in its course.” (A bodkin is a tapered arrowhead, a dagger shaped like one, or even a large needle.)


Milton Friedman and Anna Schwartz varied the metaphor only slightly when they wrote in their Monetary History of the United States, 

The detailed story of every banking crisis in our history shows how much depends on the presence of one or more outstanding individuals willing to assume responsibility and leadership….Economic collapse often has the characteristics of a cumulative process.  Let it go beyond a certain point, and it will tend to gain strength from its own development…. Because no great strength would be required to hold back the rock that starts a landslide, it does not follow that the landslide will not be of major proportions.

It was Charles P. Kindleberger who gave these matters their familiar modern statement in Manias, Panics, and Crashes: A History of Financial Crises.  That celebrated book appeared in 1977 and now is in its fifth edition. It contains, among a thousand other treasures, the three quotations repeated just above.  That his discussion took off from a discussion of a formal model of financial speculation and credit by Hyman Minsky, of Washington University, has helped confer on Minsky a certain immortality, too.


But the really powerful rhetorical device in the book is its “Stylized Outline of Financial Crises, 1618-1990,” a table describing 34 episodes over the course of 270 years, or about one every eight years, everything from the Kipper-und-Wipperzeit debasement that preceded the outbreak of the Thirty Years War in 1618 and the South Sea and Mississippi Bubbles of 1720 to the Sovereign Debt Crisis of the early 1980s and the Japanese Asset Bubble of the ’90s.

Kindleberger died in 2003, at 92, leaving behind much that was useful, including a coterie of students at Bank for International Settlements in Basel, and, of course, the book. So reliable a seller was Manias, Panics, and Crashes that its publisher, John Wiley and Sons, was reluctant to let it fade.  So Kindleberger agreed to let his friend Robert Aliber, of the Graduate School of Business of the University of Chicago, to prepare a fifth edition and so he did – a sixth is scheduled to appear next year. What qualified Aliber to take over?  He is the author of his own long-term best-selling primer, The International Monetary Game, now The New International Money Game, itself headed for yet another edition. 

What does Aliber think? Four years retired from teaching, living in Hanover, N.H. (and summering in the Vermont house built by Milton and Rose Friedman twenty five miles across the Connecticut River that he and his wife bought in 1982), he remains an active market participant.  “I feel as though I am sitting in the front row of a play that I wrote,” he says, “listening to the actors make speeches that I have written. The pattern is so familiar.”


There have been five waves of credit bubbles in the last thirty years, says Aliber.  First was the rapid growth of lending to Mexico and other developing nations in the 1970s, a matter of “petrodollar recycling,” that led to the crisis in sovereign debt; then came “the mother of all bubbles,” the surge in asset prices in Japan in the second half of the 1980s, with the Scandinavian countries experiencing real estate bubbles of their own about the same time, and the savings and loan bubble in the US; a third bubble spread through Asian asset markets in the mid ’90s in the run-up to the global crisis of 1997-98; a fourth bubble surfaced in real estate values the United States and other Anglo-Saxon countries after 2003; and China saw a fifth bubble in stocks and real estate in 2007.  The boom in the US was an important bubble, Aliber says, but since it was not a credit bubble financed by banks, the banking system was unaffected when US stocks lost $4 trillion in market value in a few months.


Nevertheless, six asset price bubbles in thirty years?  It’s a new world record, says Aliber.


About the current attempt to allay the panic that has all but frozen bank lending for the past two weeks, Aliber has mixed feelings. “Rescue plan” would have looked better to him in the headlines than “bailout,” he says. It is true that big banks will benefit, but the US Treasury probably eventually will earn tens of billions of dollars by its intervention, and US gross domestic product will be higher by several hundred billion dollars than if a crash had been permitted to occur.   But, he says, the stabilization could be accomplished more expeditiously.  Like many others, he has an alternative plan.

This is not the bankruptcy of modern economics, as my friend Robert Samuelson put it the other day in Newsweek, a shattering of the conceit that the problem of stability had been solved once and for all. Economists have done pretty well at stitching the global economy together these last thirty years, during a period of unprecedented growth. The failure to give recurring financial crises a more prominent place in its undergraduate texts is, however, somewhat embarrassing, or so it seems to me. Kindleberger was of the opinion that both Keynesian orthodoxy and monetarism were incomplete because they left out credit cycles altogether (he was writing in the mid ’70s, remember).

He was right. Last summer, Olivier Blanchard, of the Massachusetts Institute of Technology, author of the leading intermediate macro text, now serving a stint as chief economist of the International Monetary Fund, observed in a survey of macroeconomics that the New Keynesian orthodoxy that, for the past twenty years or so had constituted the mainstream textbook view, had, with respect to asset prices, fallen “short of the mark.” The conventional view, in which banks are presented as institutions that have no equity capital and merely perform arbitrage in interest rates, was misleading. 

It had become vividly clear, he wrote, that financial institutions do matter, and that shocks to their capital or liquidity positions can be potentially seriously damaging to macroeconomic health. Research on credit and financial markets was proceeding vigorously, though, Blanchard concluded, and “one can be confident that progress will happen rapidly.”


It can’t happen too quickly for the next editions of those intermediate macro and introductory texts.


Meanwhile, the time is long past when the measure adopted by the Congress last week could be described as a bodkin in a fountain or a finger in a dike.  It was more like an attempt to head off a dangerous stampede. The requirement definitely applied that there be “one or more outstanding individuals willing to assume responsibility and leadership.” Treasury Secretary Paulson, Federal Reserve Chairman Ben Bernanke, the Congressional leadership and President George Bush deserve collective credit for having come to grips with a full-throated panic and (apparently) stopped it. It will be interesting to gradually discover who among them was key.


But understand that all their bold action bought was time. Hope that they bought enough, since the actual repair of the battered US banking system can’t begin until next year. (It will be expensive.)  And batten down for further heavy weather.


For Aliber is no doubt right when he says that the drama of the last two weeks has been altogether too US-centric; that, as a result of global trade imbalances, the current crisis involves not just the United States but Iceland, Britain, South Africa, Spain, and probably Australia as well. Recession and turmoil in currency markets lie ahead, as the necessary adjustments take place.

It is the next Secretary of the US Treasury who will have the really interesting job.

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